Give me a call with any questions.



Christian Yoder

09/27/99 03:54 PM
To: Christian Yoder/HOU/ECT
cc: Elizabeth Sager/HOU/ECT@ECT 
Subject: Request for Editing

Mark,
We are one step away from signing a brand new, much needed master power 
agreement with Duke, with whom we presently have over $46 million of MTM in 
the money exposure without adequate contracts.  That one step is over the 
hurdle of how we calculate termination payments.  Please, as you have so 
helpfully done in the past,  edit the following conversation between Mr. Know 
it All and Mr. Struggler.

Know It All:  I don't have a lot of time so get to the point.

Struggler:  Why can't we supplement  the expression "present value of the 
economic benefit" when we define the word "Gains" with the expression:  
"using the Discount Rate" and defining the term so everybody understands how 
we calculate the present value of the  gains?

Know it All:   I've gone over this a number of times with you before, but 
here we go again:  there are a number of ways to calculate gains and losses.  
when we calculate our gains or losses, we are really just going One method is 
to go out to the market and asking a third party how much they would charge 
us (or pay us) to step into the tragically truncated transaction.   Because 
it is relatively fair, straightforward and easy enough to document, this 
would probably be our first approach in a default situation.

Struggler:  So, why don't we just say:  "the value of the foregone economic 
benefit?"  Why do we even have to say anything about the stupid present value 
of it?

Know it All:  Ahem, because, we want to maintain as much flexibility as 
possible and another method would be to calculate the total string of 
payments we might have expected to recieve from the defaulting party reduced 
by the payments we would have had to make.  Since we will receive the 
termination payment up front, it isn't fair to get the full amount of that 
total but rather only the "present value."  In addition, using the 
replacement transaction (market quote) method the present value is the 
already built into the curve price that's quoted you numbskull!  Another 
method would be to unwind our hedge on the other side of the terminated 
transaction - presumably the amount the counterparty to the hedge would 
charge (or pay) to unwind that transaction will be very close to the amount 
calculated by the market quotation (replacement transaction) method.  This 
last method is quite handy when the terminated transaction was entered into 
to offset a particular trade or when the market has dried up and there are no 
quotes to be had.

Struggler:  Okay,  my understanding of present value is that you imagine a 
guy who is going to get $100 at a future date, let us say, one year from 
now.  Do you follow me so far?

Know it All:  Please.

Struggler:  Now, instead of the guy getting the $100 one year from now, he 
gets it today.  But, the $100 today is worth a lot more  than it will be one 
year from now because the guy is also getting a year of time and time is 
money and he can invest the money at a known return rate and so if you gave 
him the full $100 today he would invest it and one year from now have  $170 
instead of $100 and that wouldn't be fair so you are supposed to give him 
today just the minimal amount you can get away with so he can invest it and 
come out with $100 one year from now.  And so, to figure out how much less 
than $100 to give the guy today, you "DISCOUNT" the $100 by some damn rate 
that everybody seems to know about.   Do you understand?

Know it All:   You've pretty well botched it up at a sixth grade level, but 
that's the idea.

Struggler:  So, now, if we are calculating the "present value of the economic 
gain" of a terminated transaction aren't we basically saying that we would 
have received $100 in the future for the power , however we now should get 
$30 because we have discounted it with the sacred rate and so why can't we 
say that the present value is derived from the "Discount Rate?"

Know it All:  Your lack of real world experience is painful to behold.  Pleae 
make sure you call somebody if you are ever asked to calculate one of these 
things.  The Curves price that is quoted to us by the presumably creditworthy 
replacement counterparty or the counterparty to a hedge that is being unwound 
already takes into account the present valuing principle.  And of course, if 
you end up having to discount a stream of payments, there are big problems.  
First, how will you figure out what those payments might have been?  This 
isn't a loan where principle and interest payments can be caluclated in 
advance with certainty - the payments will fluctuate witht the floating price 
in a swap or the cost of replacement power in a physical deal.  And even if 
we can figure that out how can we agree on the appropriate discount rate?  An 
in-the-money non-defaulting party wants it to be as low as possible since 
that will maximize the termination payment received.  But if the 
non-defaulting party is out-of-the-money then he will want the discount rate 
as high as possible to minimize the payment he has to make.  And just to 
complicate things a bit further, these contracts are usually bilateral so we 
have to be willing to eat what we serve.  So our contract language just says 
the whole thing has to be "commercially reasonable."  In our view that's 
enough to protect us from a rapacious counterparty if we default and flexible 
enough to let us come to a reasonable result when we are the non-defaulting 
party.

Struggler:  I thought the curve was just a list of prices.  You go out to 
October 2000 and you see $34.  Isn't that number the price we expect to pay 
for power or get paid for it on that future date and shouldn't we discount 
that number if we are getting the money one year early?

Know it All:  No!  That $34 is the present value amount we would be willing 
to pay today of what we think for power that will be delivered one year from 
now.

Struggler:  You mean we thing one year from now that power will actually be 
$100 and that discounted, it comes back to $34 on our curve at this very 
moment?

Know it All:  You've got it buddy.  Do you think you can handle that 
concept?  Or do I have to go over it again?  

Struggler:  Hmmm.  Well I guess so, but why don't we just say  "the value of 
the economic benefit based on the Non-Defaulting Party's curve"?

Know it All:  Because then somebody would want to define the word "curve" and 
at that point you are getting too close to our holy of holies and we won't 
ever define our curve.

Struggler.  Hmmm.  Okay.  Thanks.