The following definitions are provided for educational purposes only. They are not in any way meant to serve as legal or official definitions, nor are they meant to serve as standard market definitions. In practice, terminology can differ across firms and across market segments.

5. Product description: Forward contracts

25. What is a credit derivative?

A credit derivative is a privately negotiated agreement that explicitly shifts credit risk from one party to the other.

26. Product description: Credit default swaps

A credit default swap is a credit derivative contract in which one party (protection buyer) pays an periodic fee to another party (protection seller) in return for compensation for default (or similar credit event ) by a reference entity. The reference entity is not a party to the credit default swap. It is not necessary for the protection buyer to suffer an actual loss to be eligible for compensation if a credit event occurs.

27. What risks does do the parties to a credit default swap give up and what risks do they take on?

31. Definition: Payment netting

Payment netting reduces payments due on the same date and in the same currency to a single net payment. Payment netting is essentially identical to the legal concept of set-off.

32. Definition: Close-out netting

Close-out netting is a process consisting of three parts. The first is early termination of transactions with the defaulting counterparty. The second is valuation of defaulted transactions under a contract. The third is calculation of close-out amount as the sum of offsetting positive and negative replacement costs. If the defaulting party owes the close-out amount, it can apply collateral posted by the defaulting party and then becomes an unsecured creditor for the remainder. If the non-defaulting party owes the close-out amount, it can in many cases set off the amount against amounts owed by the defaulting party but then must pay any remaining amount to the insolvency administrator.

33. What is the status of an individual transaction under the ISDA Master Agreement?

In jurisdictions where close-out netting is enforceable, all transactions under the ISDA Master Agreement constitute a single agreement between the two counterparties instead of being separate contracts. The confirmation of a transaction serves as evidence of that transaction, and each transaction is incorporated into the ISDA Master Agreement.

34. What are commodity derivatives?

Commodity derivatives are agreements that transfer commodity price risk from one party to the other. The basic types of commodity derivative are commodity forwards, commodity swaps, and commodity options.

Definition: Commodity forward

A commodity forward is an agreement to exchange an agreed quantity of a commodity at an agreed future date at a forward price agreed on the trade date. Commodity forwards can be cash settled. which means one party pays the other the difference between the forward price and the price prevailing on the settlement date, multiplied by the agreed quantity. Or they can be physically settled. which means that on the settlement date one party pays the forward price for the agreed quantity and the other party delivers the agreed quantity.

Definition: Commodity swap

A commodity swap is a cash-settled agreement in which two parties agree to a series of cash flows based on an agreed (notional) quantity of a commodity. One party typically pays a fixed price for the notional quantity and the other a floating price. The major distinction between a forward and a swap is that a forward is an agreement on one exchange, while a swap is an agreement on a series of exchanges.

Definition: Commodity option

A commodity option is an agreement, normally cash settled, in which the buyer, in return for payment of a premium, has the right but not the obligation to buy or to sell an agreed quantity of a commodity at an agreed (strike) price on or until a specified (expiration, expiry) date. An option to buy is known as a call option, and an option to sell is known as a put option. Over-the-counter commodity options are often Asian style options .

Definition: Asian option

An Asian style option involves the payment of the difference between the strike price and the average price calculated over a specified period (e.g. one month) prior to exercise (or vice versa), multiplied by the notional quantity. A European style option, in comparison, involves the payment of the difference between the strike price and the price prevailing on the exercise date, multiplied by the notional quantity. Asian options are popular commodity options for end-users because an Asian option is generally a better hedge than a European style option for purchases that occur continually over a month.

35. How do commodity markets differ from financial markets?

Financial markets are distinguished by their time horizon (money versus capital markets) as well as by currency. Commodity markets, in contrast, are distinguished by the underlying commodity. Further, most major commodity markets are transacted in US dollars. Commodity markets include but are not limited to the following:

• Energy

• Petroleum products
• Natural gas
• Electricity

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