Caps and Floors

Like Swaps, Caps and Floors provide price protection, but they have the added advantage of providing benefit from favorable price movements. They are commonly thought of as price "insurance," i.e., for a premium you are entitled to full price protection when prices move through a specified level. A price Cap protects against rising prices without sacrificing the advantage of falling prices. Floors are the opposite of Caps; they guard against falling prices while preserving upside price potential.

With a Cap or Floor, the full cost of the protection is predefined - it is equal to the premium paid for the Cap or Floor. There are no potential future costs related to price movements.

Examples:

Cap: Consumer Application

SteelCo, a steel service center, wants to develop business with a prospect that has difficulty passing on price increases, but is expected to pass on decreases without delay.

To distinguish itself from competitors, SteelCo ensures its customer that, for the next 12 months, SteelCo will never ask for a price increase above its very competitive product prices, no matter how high steel prices go. And to sweeten the deal, SteelCo agrees to promptly pass on all steel price decreases as soon as they are announced, no questions asked.

The customer likes SteelCo's straightforward pricing policy and agrees to purchase 20,000 tons of steel per month from SteelCo. In order to honor its pricing promise without putting the company's margins at risk to rising prices, SteelCo purchases from Enron a one-year price cap on hot-rolled steel at $250/short ton for 20,000 tons per month. The cost of the cap is $7/short ton.

During the Life of the Price Cap

• SteelCo continues to buy hot-rolled steel from its regular supplier(s) at market price.
• Enron receives a $7/short ton premium from SteelCo for the $250/short ton price cap.
• If the market price for hot-rolled steel goes above $250/short ton in a given month, Enron will pay the difference to SteelCo.
• The effective cost of hot-rolled steel paid by SteelCo is the index price up to a maximum price of $250/short ton plus the $7/short ton premium paid for the cap.
• SteelCo has, for a known cost of $7/ton, captured new business by meeting the customer's product pricing needs without putting the company at risk to rising steel prices in the process.

SteelKing, a producer of hot-rolled steel, anticipates plant upgrades starting in three months' time and lasting for four months. The company intends to build extra hot-rolled steel inventory of 80,000 tons over the next three months to meet sales obligations during the four-month period the plant is taken off-line. There is a concern that prices could soften over the four-month period, squeezing the margin on the excess inventory to be sold during that time.

To protect against a sharp price reduction during the turnaround period, SteelKing buys a four-month hot-rolled steel price floor today that becomes effective in three months' time. The floor price is set at $250/short ton for 80,000 tons over the four-month period. The cost of the floor is $6/short ton.

During the Life of the Price Floor

• SteelKing sells excess hot-rolled inventory to its customers at prevailing index prices.
• Enron receives a $6/short ton premium from SteelKing for the $250/short ton price floor.
• If the index price for hot-rolled steel is greater than the $250/short ton floor price, there is no action under the floor contract. The effective price received by SteelKing for its hot-rolled steel is the index price less the $6/short ton premium.
• If the index price goes below the $250/short ton floor price to $240/short ton, for example, SteelKing will receive the $10/short ton difference from Enron. In this instance, SteelKing's effective price for hot-rolled steel is $244/short ton (the $250/short ton floor price less the $6/short ton premium).
• In summary, the price floor has established a minimum price of $250/short ton with full upside potential at a known cost of $6/short ton.

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