To embrace change or fight it? The choice to either act or wait and see is fraught with complexity.
Mastering the Mastering Agreement
Special Series Part 5: How to find "commercially reasonable" valuation in power contract terminations.
as soon as possible or expose itself to market risk that results directly from the termination by the defaulting party.
The non-defaulting party may decide that the price is unfavorable to it at the time of termination and therefore not replace the transaction. However, this would mean that it would be liable for any subsequent price movements, favorable or unfavorable, and would possibly be in violation of the good-faith provision of the contract when calculating the termination value. Regardless, instantaneous recovery or replacement valve only is possible when the contracts in question are liquid and readily quoted by third parties. This leads to two possible valuation methodologies, one for liquid, standard products, and one for products that are not readily quoted by third parties. Let's examine each separately.
Unfortunately, determining the close-out value of standard products is not as simple as it first appears. Although prices should be readily available from a number of sources (brokers, publications, other traders), power does not trade evenly across all maturities. Significant price gaps can and do occur even in the shorter maturities; off-peak price is poorly quoted across the board. Usually, acquiring quotes from several sources and eliminating the high and low quotes is usually enough to establish market prices. But again, the issue of which prices to use comes up-bid, offer, or mid-market. Consider the following example:
A counterparty has committed an event of default and we have subsequently terminated the agreement. Under the terminated contract, we had agreed to purchase 50 MW of peak power in the New England Power Pool region for August 2005 at $50.00/MWh. To instantaneously replace a purchase agreement, we would repurchase at the price that somebody was instantaneously willing to sell, or the ask price. Various third-party sources indicate that the offer for the August 2005 contract is $61.00/MWh, the bid is $57.00/MWh, and the midpoint is $59.00/MWh.
Assuming 23 peak days and 16 peak hours in August and a discount factor of 0.99, we can calculate two preliminary close-out amounts as below:
As is apparent, the difference in approach can account for substantial differences in close-out amounts. Which is more correct? In this case the bid is, because it represents the price that third parties believe are available for the instantaneous replacement of the contract. In this case, using the bid is synonymous with instantaneous replacement. It is important to note here that the mid-market price used to mark contracts to market in the normal course of business is indicative of the replacement value but not at all the same. The resulting mark-to-market is not an indication of where the book could be liquidated or replaced; rather, it is an indication of its value in comparison to transaction prices for standard amounts. For that reason, mark-to-market is not an appropriate method to determine the close-out amount.
Determining the replacement value of illiquid contracts is less straightforward. Such contracts usually are not actively traded, involve a complex derivative, and extremely large, long-term, and unique to a particular situation ( e.g., tolling agreements on a particular asset), or