Case 4Adjusting the Forward Curve in the Backroom

What do you mean the interest rate swaps don’t work any more? What has changed? I’m not aware of any major new developments in the gas market. The basic parameters under which they were negotiated are still in effect. There is no reason for the swaps to be adjusted.

RAY BROWN, A NEWLY HIRED MANAGER OF DERIVATIVES RISK ANALYSIS (DRA), was stunned by what he was hearing. Hired in July 1995, Ray had taken charge of Enron’s thirty-man group responsible for analyzing and structuring complex derivative-based hedge positions. As the year wound down, DRA had built up a substantial interest rate swap position.

At 9:00 am on November 11, Ray had been visited by Tom Hopkins, assistant manager of the Natural Gas Trading Division (NGTD). Tom had brought unsettling news. Upon further review, NGTD had determined that its forward purchase transactions were not as profitable as first assumed. Expectations of future natural gas prices had been revised to lower levels. This change reduced the expected differential between the projected forward curve and the contract price at which some gas had been bought. Based on this revised outlook, Tom asked Ray to adjust the interest rate swaps associated with the deal:

“Your swap position is too large now. There isn’t the same level of expected profits anymore. You probably need to readjust “notional principal” by about $70 million, spread over years five to ten.”

Ray immediately reacted with incredulity. ...

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