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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.
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