Enron Case

Introduction

Enron is one of the market maker of the energy market, it also delivers physical commodities, risk management, and weather derivative contracts to customers around the world. Weather derivative is a kind of financial instruments to hedge the risk caused by uncertain weather. Derivatives are a kind of alternative investment that do not contain any direct value, its valuedepends on fluctuation of the underlying variables which can be the price of underlying asset, interest rates, indices, etc. Weather derivatives are considered as one of the derivatives because they do not have values themselves, their values are generated by other underlying variables, like rain, temperature, snow, and are traded in the stock exchange like futures.

There are several structures forweather derivatives, they are floor, ceiling cap, collar, swap, future contracts and option of future contracts. Investors should depend on their criteria to choose a suitable weather derivative. These contracts are used to lever, hedge or lessen the risk in the underlying by entering into a derivative contract which value varies in the opposite direction to their underlying position and offsets part or all of it. They can also generate option ability which the value of derivatives is connected to specific event or condition.

Contract to PNW

Enron has proposed a weather protection product to Pacific Northwest Electric (PNW), which produces electric power in America. Enron is the floating amount payer (seller) while PNW is thefixed amount payer (buyer) of theprotection product. PNW commits to buy the contract and therefore it is taking the long position andpays the premium to Enron for the contract. The option type of this weather derivative is HDD Weather Floor, which provides PNWwith protection against volume risk when the floating amount is below the strike amount of 400 HDD. The determination period is between November 1, 2000 and March 31, 2001. The final payment amount for the floor is equal to the strike amount differential times the national amount which is $20,000 per heating degree day.However, the seller of this weather derivative, Enron, is unwilling to bear all the downside risk and therefore, it sets a payout limit of $800,000. That means, if the floating amount is less than 360 HDD (Exhibit 1), Enron will only pay at the maximum amount which shall not exceed the payout