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3. Deconstruct the options embedded in the contract. Are they puts or calls?
Are the positions long or short from PNW’s standpoint?
The contract is like a ‘put spread’. PNW is long a put with X = 400 HDD, and it is short a put with X =
360 (because the maximum payout was $800,000)
One could also say that PNW is short HDDs. From only the contract’s point of view, PNW hopes that
the realized HDDs (on Seattle-Tacoma Airport) falls below 400..
Of course the contract is a (limited) hedge for PNW. Its energy business is long HDD. The contract is a
protection against a warm winter:
Net Income
NI hedged against warm winter
6. How should Mary Watts proceed? Should she buy weather protection?
She should do an NPV analysis. Find the different weather scenarios and probabilities, possible based
on historical data.
Then see whether the total cashflows to the firm (the incremental cashflows) have a positive NPV.