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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.

* 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…..

* 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 FLOOR to provide financial protection against adverse weather conditions and simultaneously SELL a FLOOR or a CAP at a different STRIKE price that limits the financial upside if weather is favorable. The 2nd part (the sale) helps financing the protection part (insurance).

* SWAPS, FUTURES, OPTIONS on FUTURES: More standardized contracts traded on organized exchanges (see case for a description).

* INSURANCE: Products typically geared to catastrophic events such as hurricanes, floods, and tornadoes. Insurance companies typically pool risks across a large number of insured parties. So long as the insured events are independent, cross-sectionally and over time, pooling would pay.

Here is how the FLOOR works:
1. Winter: November till end March (2000-2001), 5 months derivative contracts now available. 2. Risk of WARM winter sales revenue too low or, in HDD terms, ↑A 65 – A ↓, HDD↓, Σ HDD ↓. 3. Strike = 400 HDD; $/HDD = $20,000.

4. FLOOR pay-off = $20,000*MAX{0, STRIKE–Σ HDD}= $20,000 * MAX{0, 400 – Σ HDD} 5. Interpretation: 400 HDD = effectively a FLOOR if cumulative HDD drops below this number, there will be a pay-out to PNW of $20,000 per HDD below 400. This is equivalent to ENRON selling PNW a PUT-option on HDD w/strike 400. 6. PNW is LONG PUT-option. However, pay-out is CAPPED at $800,000 or 360 HDD ($800,000/$20,000 = 40 HDD x $20,000). This last part is equivalent to a SHORT PUT with a 360 HDD strike.

ASSIGNMENT: Put yourself in Mary Watts’ position and write an analysis and action plan to your superior(s) that will be discussed at an upcoming board meeting where you will have to defend it. You will have to include the following aspects referring to content, style, and format:

* Clearly defines the problem. A problem is a situation that requires a solution, i.e., actions to alter the situation and bring it in a more favorable state. *...
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