Forward Contract

Quantitative Analysis

April 15, 2008

2

Overview

1. PG&E’s Power Mix

2. What is a Forward Contract

3. Some features of Forward Contract

4. Why do we use Forward Contracts?

5. Pricing Forward Contract

6. Valuing Forward Contract

7. Swaps

3

What is Forward Contract?

• Definition:

An agreement between two parties to buy or sell an asset at a certain future time for a certain price.

• Example 1]

Company A contracts to buy 5,000 bushels of wheat from Company B for delivery in 1 year. Price is agreed at 300 cents/bushel

Total value of the contract (Forward Price)

= 300cents/bushel * 5000 bushels = $15,000

* 1 bushel ~ 60 lb

• Example 2]

Today, PG&E contracts to buy 10,000 mmBtu of Natural Gas from BP Energy Co. for delivery on the day of May 15 which in 1 month. Price is agreed at $8.25/mmBtu

Total Value of the contract (Forward Price)

= $8.25/mmBtu * 10,000 mmBtu = $82,500

* 1 mmBtu ~ 28.26 m³

4

Some Features of Forward Contract

• No money or goods change hands before maturity

• Can buy and sell risk without holding the physical

• Good for hedging (or speculating)

5

Why do we use Forward Contracts? PG&E Power Mix

6

Pricing Forward Contract

Suppose we have a forward contract on one share of common stock that pays no dividends.

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Under the assumption of no arbitrage, this should be equal to the current stock price, hence:

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7

Valuing Forward Contract

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8

Swaps

• In reality, traders use Swaps rather than Forward Contracts or Futures (standardized Forward Contract traded in exchanges such as NYMEX)

• What is Swap?

Swap is an agreement to exchange one cash flow stream for another

Bank PG&E Energy ProducerVariable Price Variable Price

Gas 10,000 mmBtu/day

$8 Fixed Price

1. Purchase 10,000 mmBtu/day of gas for delivery at PG&E Citygate in Jan 20092. Execute a fixed-for-floating swap at $8/mmBtu also for delivery in Jan 20091. Purchase 10,000 mmBtu/day of gas for delivery at PG&E Citygate in Jan 20092. Execute a fixed-for-floating swap at $8/mmBtu also for delivery in Jan 2009