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Enron Corporation’s Weather Derivatives

Enron Corporation’s Weather Derivatives. Who is PNW and what problem is it facing?. Pacific Northwest Electric Facing the 2000-2001 winter season Recent warmer-than-average winters Hurts revenues Deregulation doesn’t allow them to pass costs on to customers PNW’s stock has lagged benchmarks

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Enron Corporation’s Weather Derivatives

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  1. Enron Corporation’s Weather Derivatives

  2. Who is PNW and what problem is it facing? • Pacific Northwest Electric • Facing the 2000-2001 winter season • Recent warmer-than-average winters • Hurts revenues • Deregulation doesn’t allow them to pass costs on to customers • PNW’s stock has lagged benchmarks • Borrowing costs increasing because lower rating

  3. Example of how weather can affect a business adversely • Too warm of winters reducing a utility’s revenues from less heating usage • Too mild of summer reducing a utility’s revenues from less air conditioning usage • Storms keeping shoppers indoors • Lack of snow affecting ski resorts • Too rainy / too cool summer affecting beach destinations • Too hot of a summer might lead to too much demand of a product and stockouts might occur (turn people away)

  4. How could weather insurance help? • Smooth Revenues • Cover Excess Costs • Reimburse lost-opportunity costs • Stimulate Sales • Diversify investment portfolios

  5. Some Utility lingo… • Heating Degree Days (HDD) • Cooling Degree Days (CDD) • Based on deviations from 65 degrees Fahrenheit

  6. Possible weather-protection products • Floor (too warm of winter and HDDs fall) • Ceiling Cap (too much snow – city expenses) • Collar (long one contract, short another) • Swap (receive fixed revenue stream; pay floating payments based on HDD/CDD) • Futures Contract (cash settlement based on several airport temps)

  7. The contract at hand… (Exhibit 1) • Draw its payoff diagram (to PNW) $ Payoff 800,000 Max Payout $20,000 notional amount per HDD 800,000 / 20,000 = 40 400 – 40 = 360 is the HDD where they would cap out at. 800,000 HDDs 360 400

  8. Pros and Cons of this contract

  9. Can Black-Scholes be used to price? • No.Black-Scholes assumes a random walk in the price of the underlying asset over a period of time • Here, we have a cumulative level as our underlying, so their “walk” through time is not random. It is based on prior days’ events. • A simulation tool like Crystal Ball would have to be used to simulate possible payouts under a large number of trials. An expected payout would then be found and a premium set above that level. • You need to look at a reasonably large sample of historical records to find the average HDDs and CDDs and their standard deviations. Then you need determine if there is a trend to consider.

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