Enron Weather Derivatives Assignment Answerkey

Enron Corporation Weather Derivatives. 1. Why do they call these contracts ‘derivatives’? Where is the optionality? Because their value depends on an underlying, and there payoff is non-linear. I.e. once you paid for the product (‘the premium’) you have the probability (the o ption) to receive a positive payoff. 2. Draw the payoff diagram of the contract in exhibit 1.

3. Deconstruct the options embedded in the contract. Are they puts or calls? Are the positions long or short from PNW’s standpoint? The contract is like a ‘put spread’. PNW is long a put with X = 400 HDD, and it is short a put w ith X =

360 (because the maximum payout was $800,000) One could also say that PNW is short HDDs. From only the contract’s point of view, PNW hopes that

the realized HDDs (on Seattle-Tacoma Seattle-Tacoma Airport) falls below 400.. Of course the contract is a (limited) hedge for PNW. Its energy business is long HDD. The contract is a protection against a warm winter: Net Income

NI hedged against warm winter

HDDs this winter

4. Pros and cons of weather protection from PNW’s perspective. Pros + reduce downside risk (naïve answer) + lower volatility of PNW’s sto ckprice. Lower Cost of Capital.

+ Better bond rating. Cheaper debt-financing. + Reduce overall cost of (external) financing and planning + Managerial incentives can better aligned with efforts, less with chance (Notice: in class, one student (Jukka) suggested that hedging may reduce incentives to better control

costs and increase efficiencies. This is not true, because the hedge is against the weather not the weather dependent costs. I.e. it will still pay for PNW to control costs under all weather conditions..) + Not mentioned in class, but in a few assignments: objective weather derivatives are likely to be cheaper than insurance where losses and/or shortfalls need to be proven/substantiated. This is a good point of course! + Also not mentioned in class: with more stable cashflows, PNW can compete stronger in the ‘product market’ Cons - The transaction costs (of contracting and monitoring) - The premium must be paid. Enron is unlikely to lose money on this..there’s no free lunch. - Unfamiliarity / Difficult to value. Informational disadvantage vis-à-vis Enron - Potential for counterparty risk. 5. Why is Enron in this situation? What does Enron stand to gain? Enron initiates the transaction and probably engineered it to its advantage, in expected value, or because it has an opposite exposure. Or it may have offsetting contracts with other parties (Real Estate management companies?) Enron wants to capitalize on its newly acquired knowledge of structuring, pricing and monitoring these derivatives.

6. How should Mary Watts proceed? Should she buy weather protection? She should do an NPV analysis. Find the different weather scenarios and probabilities, possible based on historical data. Then see whether the total cashflows to the firm (the incremental cashflows) have a positive NPV.