Enron Case Study

Finance 485

Questions for Enron Corporation's Weather Derivatives case

NOTE: Please don't waste any time at all seeking factual information outside this case about Enron, PNW, or weather conditions in the Pacific Northwest. Be assured that these are dead-end activities. Everything needed to answer the questions is inside the case.

QUESTIONS:

1. Why do they call these contracts "derivatives?" What are the various ways in which they are option-like?

2. Draw a diagram of the exposure of PNW's value to heating degree days (HDD) before it institutes a hedge.

3. a. Draw a diagram of the payoffs at the end of the life of the contract presented in case Exhibit 1.

a. Draw a diagram of the exposure of PNW to HDD after it uses the hedging contract presented in case Exhibit 1.

1. These contracts are called derivatives because the value of the contracts are derived from the underlying which are the deviation of degree days. The various ways in which these are option-like is because of the conceptual aspect of exercising if the amount of degree days or a weather variable deviates enough from the neutral point. It's option like in that there is a strike amount and a theoretical current amount.

3. puts

4.

Pro- protected against fluctuations in weather deviation

Protecting earnings from unseasonably warm weather

Guaranteed steady income

Protected against

5.

Enron- premiums

No competitors with wath,

Large untapped market

Unregulated

Lower correlation between returns associated with weather, and returns from other financial instruments.

Extremely liquid- a lot of buyers

b. Deconstruct the options embedded in the contract given in case Exhibit 1. Are they puts or calls? Are the positions long or short from PNW's perspective?

4. What are the pros and cons of weather protection from PNW's perspective?

5. Why is Enron in this situation? How does Enron stand to gain?