Consider a utility (natural gas) company that is unable to raise prices beyond a capped level by regulation to gas supplied to its customers. Assume it supplies a fixed volume each day. It therefore asks Enron for a fixed volume natural gas contract at a price tied to a natural gas index and capped at a determined level:

Explain what combination of the physical asset and derivative contract could Enron use to create the capped contract for the utility. Please provide payoff diagrams of the individual contracts as well as the sum of the payoffs to illustrate your answer. Please provide labels to your figure and mark off the strike, and all prices and contract values where there are kinks in the payoff?

(b) Explain why Enron, which also had an options trading business would be in a better position to supply such a contract than another energy company that has no access to the derivatives market?

Answer rating: 100% (QA)

a Enron can use a combination of a physical natural gas contract and a natural gas price cap option to create the capped contract for the utility The ... View the full answer