Hedging Strategy and Electricity Contract Engineering - IFOR

28 The electricity market
buyer of such contract has the option to switch one unit of gas for one unit of
electricity at a specified strike price.
2.7.2.4. Floating contract
A contract with a fixed quantity, but floating price is a long-term contract,
where the buyer however pays a short-term price in each period. This price
is typically based on the spot price. The floating price contract can thus be
seen as an indexed contract, where the index is the spot price or any other
short-term reference price. A floating contract has the same cost structure as
constantly buying electricity on the spot market. This can be compared with a
fixed income contract with a floating interest rate, like the FRN. 21
2.7.2.5. Caps and floors
A capped contract is a floating product, but with a maximum level on these
floating prices. A capped contract can basically be divided into the underlying
floating contract and a series of call options on the underlying contract with a
strike price equal to the capped level. A capped contract is therefore always
more expensive than the pure floating one. To achieve a lower price the buyer
can agree also on a floor level, in practice meaning that he sells back a series
of put options to the seller on the underlying contract. The effect that caps and
floors has on a floating product is illustrated in Figure 2.10.
2.7.2.6. Contracts for difference
When a future or option is bought in order to, for example, hedge away some
undesirable risks, the underlying spot price has to be defined. Because of transmission
costs and congestions, the spot price at different locations may differ,
as discussed in Chapter 2.4.1. In Nord Pool, for example, there are a number
21 A floating rate note (FRN) is a dept security with a long life, where the yield is periodically
reset relative to a reference index rate to reflect changes in the short- or
intermediate-term interest rates.