Enron Corporation - Weather Derivative & Optionality

1. Weather Derivative & Optionality

Weather derivative is s new class of derivative securities which has been created to offer corporate managers an instrument to hedge their firms against climate conditions' hazards, i.e. to minimize or avoid the risks due to changes in weather conditions. When a firm's sales depend on the weather, the managers can use the weather derivative to insure against negative influences caused by weather changes. Financial investors can also use weather derivatives to diversify their investment portfolios. Since the value of the weather-protection products depends on some underlying variables, such as heating degree days (HDD) or cooling degree days (CDD), the contract is called derivatives. The only difference from other derivatives is that the underlying asset of the weather derivatives does not have direct value that can be used to price the derivatives.

There are several structures of weather derivative contracts, including floor, ceiling cap, collar, swap, futures contracts, etc. And the one referred in the case of Enron Corporation is the floor, which are referred as "put options". When the underlying variable, such as HDD, fell below the established threshold, that is, the strike price in an option contract, the seller of the floor will pay the buyer the HDD differential times a price per HDD. This contract protects buyers from downside risk which is very similar to a put option. The profit presentation of HDD floor is as following. (Figure 1)

Weather is ever changing and unpredictable and it is not necessary to accurately predict the weather to protect the business from the weather. So there may be partial hedge or no hedge by using the weather derivative. And for a single derivative, price risk, default risk and systematic risk are the optionality involved in the derivative itself, which is the same case for weather derivatives.

Figure 1 Figure 2

2. Diagrams of payoffs for the contract

For the contract in Exhibit 1, at the end of the life for the contract, the payoff diagram should be as Figure 2. The seller will pay the buyer the difference between 400 HDD and the sum of HDD each day during the determination period times $20,000 per HDD if the floating amount is smaller than the strike amount. But as stated in the case that the national amount is $20,000 per HDD, the strike amount is 400 HDD and the maximum amount payable by the floating amount payer should not exceed $800,000, thus the put option with a short position should have a strike price of 400- 800,000/20,000=360. So we can draw the payoff diagram as Figure 2. How the options embedded in the contract are constructed? It can be deconstructed as one long position in a put with a strike price of 400 HDD and one short position in a put with a strike price