1. Forward Contract Quantitative Analysis April 15, 2008

2. 1 Overview 1.PG&E’s Power Mix 2.What is a Forward Contract 3.Some features of Forward Contract 4.Why do we use Forward Contracts? 5.Pricing Forward Contract 6.Valuing Forward Contract 7.Swaps

3. 2 What is Forward Contract? Definition: An agreement between two parties to buy or sell an asset at a certain future time for a certain price. Example 1] Company A contracts to buy 5,000 bushels of wheat from Company B for delivery in 1 year. Price is agreed at 300 cents/bushel  Total value of the contract (Forward Price) = 300cents/bushel * 5000 bushels = $15,000 * 1 bushel ~ 60 lb Example 2] Today, PG&E contracts to buy 10,000 mmBtu of Natural Gas from BP Energy Co. for delivery on the day of May 15 which in 1 month. Price is agreed at $8.25/mmBtu  Total Value of the contract (Forward Price) = $8.25/mmBtu * 10,000 mmBtu = $82,500 * 1 mmBtu ~ 28.26 m³

4. 3 Some Features of Forward Contract No money or goods change hands before maturity Can buy and sell risk without holding the physical Good for hedging (or speculating)

5. 4 Why do we use Forward Contracts? PG&E Power Mix

6. 5 Pricing Forward Contract Suppose we have a forward contract on one share of common stock that pays no dividends. Under the assumption of no arbitrage, this should be equal to the current stock price, hence:

7. 6 Valuing Forward Contract

8. 7 Swaps In reality, traders use Swaps rather than Forward Contracts or Futures (standardized Forward Contract traded in exchanges such as NYMEX) What is Swap? Swap is an agreement to exchange one cash flow stream for another 1.Purchase 10,000 mmBtu/day of gas for delivery at PG&E Citygate in Jan 2009 2.Execute a fixed-for-floating swap at $8/mmBtu also for delivery in Jan 2009