Essay on Contracts Derivatives

960 Words Apr 6th, 2011 4 Pages
Why do they call these contracts derivatives? Where is the optionality in these contracts?

Weather derivatives structures commonly used are:
i) cap - a call option; ii) Floor - a put option; iii) Collar - a put and a call option, usually with little or no premium; iv) Swap - a derivative with a profit and loss profile of a futures contract
v) Digital option - an option that pays either a predetermined amount if acertain temperature or degree day level is reached, or nothing at all in other case.

A business with weather exposure may choose to buy or sell a futures contract, Which is equivalently to a swap such that one counterparty gets paid if the degree Day over a specific period are greater than the strike level, and the other
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The most common indexes in the market are Heating Degree Days (HDDs) and Cooling Degree Days (CDDs) – these measure the cumulative variation of average daily temperature from 65oF or 18oC over a season and are standard indexes in the energy industry that correlate well with energy consumption.
3) Weather station from which the temperature data are obtained;
4) The strike level (price);
5) The tick size;
6) The maximum payout

These parameters are common for all weather derivatives and by formulating those, securities are created.

Why is Enron in this situation? What does Enron stand to gain?

The strong El Nino event of 1997-1998. The anomalously warm weather in the northern US coupled with the fact that many energy companies are dependent on sales of gas and electricity to the large populations in this region left many companies with massively reduced profits. This warm winter effect was enhanced by the deregulation of the electricity markets, a process ongoing since 1996.
Energy companies were particularly keen to examine ways of mitigating this weather risk. The most important of these was Enron. For all its well-documented problems, Enron promoted innovation and a constant investigation of risks within its own business. In 1996 whilst investigating the revenue fluctuations from the gas pipeline

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