Enron s Weather Derivatives
Case summary – Enron Corporation’s Weather Derivatives
Steve Haik, Dan Sleker and Bas van Bellegem – March 2003
Background
In October Mary Watts, CFO of Pacific Northwest Electric (PNW) reviewed the forward plan for PNW’s 200-2001 season. PNW’s has been experiencing nearly no EPS growth since 1995 due to deregulation and warmer-than-average winter climate. The stock price had suffered accordingly, but there maybe a way to hedge the weather risk via a new “weather derivative” being proposed by Enron’s Mike James. Since the colder the season, the greater the electrical usage and the recent weather advisory called for another unseasonably warm winter, Mary was considering on of the Enron “weather derivatives”.
Problem Statement
Mary Watts wants to know how the “weather derivative” products worked, and how they maybe restore PNW’s credibility in the capital markets. Should Mary consider purchasing Enron’s weather protection products for the upcoming winter season? Mary would need to decide soon about he use of these derivatives is she wanted to put in place a hedge for the3 winter months ahead.
1 – What is the “optionality” in the weather derivative contracts, i.e. why are these contracts derivatives? Draw a diagram of the payoffs at the end of the life for the contract as presented in Exhibit 1 of the case.
A weather derivative or weather option is a financial instrument that has a payoff derived from variables such as temperature, snowfall, humidity and rain-fall. However, the industry has set up temperature as the common underlying for those contracts. Unlike insurance and catastrophe linked-instruments, which cover high-risk and low probability events, weather derivatives shield revenues against low-risk and high probability events (such as mild winters). Temperature contracts are more specifically traded in what is called Heating Degree-Days (HDD) or Cooling Degree-Days (CDD) defined on daily average temperatures.
The optionality is that one does
Steve Haik, Dan Sleker and Bas van Bellegem – March 2003
Background
In October Mary Watts, CFO of Pacific Northwest Electric (PNW) reviewed the forward plan for PNW’s 200-2001 season. PNW’s has been experiencing nearly no EPS growth since 1995 due to deregulation and warmer-than-average winter climate. The stock price had suffered accordingly, but there maybe a way to hedge the weather risk via a new “weather derivative” being proposed by Enron’s Mike James. Since the colder the season, the greater the electrical usage and the recent weather advisory called for another unseasonably warm winter, Mary was considering on of the Enron “weather derivatives”.
Problem Statement
Mary Watts wants to know how the “weather derivative” products worked, and how they maybe restore PNW’s credibility in the capital markets. Should Mary consider purchasing Enron’s weather protection products for the upcoming winter season? Mary would need to decide soon about he use of these derivatives is she wanted to put in place a hedge for the3 winter months ahead.
1 – What is the “optionality” in the weather derivative contracts, i.e. why are these contracts derivatives? Draw a diagram of the payoffs at the end of the life for the contract as presented in Exhibit 1 of the case.
A weather derivative or weather option is a financial instrument that has a payoff derived from variables such as temperature, snowfall, humidity and rain-fall. However, the industry has set up temperature as the common underlying for those contracts. Unlike insurance and catastrophe linked-instruments, which cover high-risk and low probability events, weather derivatives shield revenues against low-risk and high probability events (such as mild winters). Temperature contracts are more specifically traded in what is called Heating Degree-Days (HDD) or Cooling Degree-Days (CDD) defined on daily average temperatures.
The optionality is that one does