Enron Corporation - Weather Derivative & Optionality

Published: 2021-09-10 05:10:08
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Category: Business

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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)

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