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CASE: ENRON CORPORATION’S WEATHER DERIVATIVES
WEATHER RISK:
Seasonal temperature levels and its fluctuations are the most important independent variable in the power business because they determine to a very large extent customer demand. The utility industry measures weather conditions in terms of heating or cooling degree-days (HDD and CDD, respectively). Degree-days are determined by the deviation of the average daily temperature from an established benchmark of 65 F. Weather conditions for a particular season were stated in terms of degree-days accumulated across the entire period: Σ CDD or Σ HDD.
Where HDD = MAX{0, 65 – A}, CDD = MAX{0, A – 65}, and A = {(Max Temp. + Min Temp. during day) / 2} as measured by the National Weather Service at the closest airport. Risk = The uncertainty surrounding the mean temperature for a season. Additionally, hedged firms may exploit their advantage to strengthen their competitive position (market share) by reducing prices and inflicting harm on un-hedged firms.
MOTIVES to HEDGE against WEATHER RISK: * Stabilize cash flows either by smoothing revenues (demand variability) or smoothing costs (input price variability) * “Money-back guarantees” may stimulate sales of resorts, cruises, ski-lift operators, golf courses, etc., but due to the volatility and uncertainty surrounding weather patterns are better be backed up by some form of hedging * Diversification (low correlation between returns associated with the weather and from other financial instruments). Among others…..
WEATHER PROTECTION PRODUCTS: * FLOOR: Downside protection if DD fall below threshold: Example FLOOR pay-off = Agreed upon $/DD * MAX{0, STRIKE – Σ HDD}. However, normally accompanied by a PAYOUT limit. * CAP: Upside protection if DD exceed threshold: Example CAP pay-off = Agreed upon $/DD * MAX{0, Σ CDD – STRIKE}. * COLLAR: Two part transaction: BUYING a CAP or a
CASE: ENRON CORPORATION’S WEATHER DERIVATIVES
WEATHER RISK:
Seasonal temperature levels and its fluctuations are the most important independent variable in the power business because they determine to a very large extent customer demand. The utility industry measures weather conditions in terms of heating or cooling degree-days (HDD and CDD, respectively). Degree-days are determined by the deviation of the average daily temperature from an established benchmark of 65 F. Weather conditions for a particular season were stated in terms of degree-days accumulated across the entire period: Σ CDD or Σ HDD.
Where HDD = MAX{0, 65 – A}, CDD = MAX{0, A – 65}, and A = {(Max Temp. + Min Temp. during day) / 2} as measured by the National Weather Service at the closest airport. Risk = The uncertainty surrounding the mean temperature for a season. Additionally, hedged firms may exploit their advantage to strengthen their competitive position (market share) by reducing prices and inflicting harm on un-hedged firms.
MOTIVES to HEDGE against WEATHER RISK: * Stabilize cash flows either by smoothing revenues (demand variability) or smoothing costs (input price variability) * “Money-back guarantees” may stimulate sales of resorts, cruises, ski-lift operators, golf courses, etc., but due to the volatility and uncertainty surrounding weather patterns are better be backed up by some form of hedging * Diversification (low correlation between returns associated with the weather and from other financial instruments). Among others…..
WEATHER PROTECTION PRODUCTS: * FLOOR: Downside protection if DD fall below threshold: Example FLOOR pay-off = Agreed upon $/DD * MAX{0, STRIKE – Σ HDD}. However, normally accompanied by a PAYOUT limit. * CAP: Upside protection if DD exceed threshold: Example CAP pay-off = Agreed upon $/DD * MAX{0, Σ CDD – STRIKE}. * COLLAR: Two part transaction: BUYING a CAP or a