Key Takeaways
- OTC derivatives mirroring futures settlement prices.
- Customizable terms; cash-settled with no physical delivery.
- Higher credit risk due to bilateral agreements.
- Used for hedging and tailored market exposure.
What is Look-Alike Contracts?
Look-alike contracts are over-the-counter (OTC) derivatives that replicate the settlement price of exchange-traded futures but settle entirely in cash, allowing for customized exposure without physical delivery. These contracts act as swaps, providing flexibility in contract size, expiration, and terms compared to standardized futures.
This type of contract enables market participants to gain or hedge exposure to commodity prices, such as oil or natural gas, while avoiding the complexities of physical delivery or centralized clearing. Understanding their structure is essential to managing your trading obligation effectively.
Key Characteristics
Look-alike contracts have distinct features that differentiate them from exchange-traded futures:
- Cash settlement: Unlike physically settled futures, these contracts settle in cash based on the official futures settlement price.
- Customization: Parties negotiate terms bilaterally, allowing tailored contract sizes, expiration dates, and collateral requirements.
- Bilateral credit risk: As OTC agreements, they expose both parties to counterparty risk without central clearing.
- Regulatory treatment: The CFTC treats them as swaps, often aggregating them with futures for position limit purposes.
- Derivative variants: Look-alike options mimic futures settlement in OTC options form, reducing exercise risks.
How It Works
Look-alike contracts are privately negotiated agreements where one party agrees to pay or receive the cash difference between the futures settlement price and a pre-agreed strike price. This payout is scaled by the contract size and occurs at the contract’s maturity.
The bilateral nature requires careful credit and risk management since you must rely on your counterparty’s ability to honor the contract. Unlike standardized futures on exchanges, you won’t have the benefit of central clearinghouses, so implementing effective risk controls and understanding the safeharbor provisions in regulations is crucial.
Examples and Use Cases
Look-alike contracts are widely used in commodity markets and by institutional investors for precise risk management:
- Oil exposure: Companies use look-alikes referencing Brent or WTI futures to hedge price risks without holding physical barrels; this includes major players like ExxonMobil and Chevron.
- Natural gas hedging: Firms seeking to avoid physical delivery often use look-alikes tailored to specific contract periods, relevant to Cheniere Energy and other gas market participants.
- Customized risk management: Institutional investors benefit from flexible contract terms that standard futures cannot provide, enabling more precise portfolio hedging.
Important Considerations
While look-alike contracts offer flexibility, you must weigh several risks and regulatory factors before engaging:
The bilateral credit exposure requires robust counterparty assessment and risk mitigation strategies. Additionally, CFTC regulations aggregate these contracts with futures under position limits, so understanding how your facility manages compliance is essential to avoid violations.
Moreover, the OTC nature increases operational and market risks, including potential illiquidity and pricing discrepancies compared to exchange-traded products.
Final Words
Look-alike contracts offer tailored exposure to futures prices without physical delivery, making them useful for precise hedging or speculation. Before entering into one, carefully assess counterparty credit risk and negotiate terms that match your specific needs.
Frequently Asked Questions
Look-alike contracts are over-the-counter derivatives that replicate the payout of exchange-traded futures contracts but settle in cash between private parties. They provide customized exposure without the need for physical delivery.
Unlike standardized exchange-traded futures, look-alike contracts are bilateral agreements with flexible terms such as size and expiration date, and they settle entirely in cash. They also carry direct counterparty credit risk instead of being centrally cleared.
They are primarily used for hedging price risks in commodities like oil and natural gas, allowing users to avoid physical delivery and customize contract terms to fit non-standard exposure periods.
Look-alike contracts offer tailored contract sizes and expiration dates, reduce logistical issues by settling in cash, and help guarantee costs or revenues with less price volatility.
Traders face credit risk due to the bilateral nature of the contracts, as well as potential market and operational risks from illiquidity or pricing discrepancies. Regulatory position limits also apply to prevent excessive market concentration.
The CFTC classifies look-alike contracts as swaps and aggregates them with futures under position limits if their terms closely match the underlying futures. Traders must perform due diligence to avoid violating these limits.
Yes, related variants called lookalike options are OTC options that settle in cash based on futures settlement prices, protecting writers from unexpected exercise obligations into physical futures.
