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First American Energy, a large midwestern IOU, has two years remaining on a fixed price term contract to purchase 60,000 tons of coal per month at $23.50/ton. The current market price for this quality coal is $27.50/ton. First American feels the market has reached a peak. First American can use a swap to capture the value of its below-market contract.
First American enters into a two-year swap with Enron for 60,000 tons per month at index, which,
combined with its physical position, offers the IOU price protection below current market levels.
During the life of this swap:
- First American continues to buy coal at $23.50/ton under its term contract.
- First American and Enron exchange payments on a monthly basis equal to the difference between the fixed price of $27.50/ton and the floating index price.
For example, if the index price for a given month is $26.00/ton, First American will receive $1.50/ton (a $90,000 payment) from Enron. The net cost of coal to First American is reduced to $22.00/ton because the swap enables First American to benefit from the favorable price move. However, if the index price rises to $27.75/ton, First American will pay Enron $0.25/ton and the net cost of coal rises to $23.75/ton.
- Believing the market has reached its peak, First American has positioned itself to benefit from any downside price movement by accepting the risk of upward price movement.
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