The Value of Commodity Purchase Contracts With Limited Price Risk

This paper describes and demonstrates the equilibrium market valuation of commodity purchase contracts with price ceilings or price floors or both. These contracts, which we call "limited price risk" contracts, are significantly easier for buyers and sellers to agree upon than fixed price contracts when price uncertainty is high and buyers and sellers have inconsistent price expectations. Analysis of an actual natural gas contract as well as the existence of many brokers promoting limited price risk gas contracts, suggest that these contracts may be priced inefficiently in practice. Our example application should help managers to make use of modem financial techniques in assessing the value of these types of contracts.

An Option Valuation Analysis of Investment Choices by a Regulated Firm

This paper analyzes a utility power plant construction project using an option pricing model of the value of the capital investment. It includes descriptive factors frequently ignored in the valuation of capital investments by regulated firms, including lead time, lumpy and sequential cost outlays, irreversibility of expenditures, and uncertainty about regulatory outcomes for completed projects. The analysis shows the value of shorter lead time technologies, the value of flexibility to delay or abandon construction, the incentive to delay construction under uncertain regulation, and how cost recovery policies, such as possible disallowance of Allow for Funds Used During Construction (AFUDC), create incentives to invest less, but to complete construction quickly. The analysis may also apply in unregulated contexts, where the value of a completed project is affected by taxation, the possibility of nationalization, or possible competitors' actions that create uncertain restrictions on potential profits.uncertain regulation, electric utilities, real option valuation, capital investment, regulatory incentives