Question

- Explain why electricity prices have wider price swings than wheat prices.

- List two advantages of developing standardized contracts on swaps.

Answer 1

- Electricity prices have wider price swings than wheat prices

Electricity prices depends on many factors, some of them are:

• prices of the fuels like natural gas,
• demand and supply of electricity
• Operational cost of the power plants

Out of these factors, prices of fuels play crucial role in the prices of electricity. Fuel cost can vary depending on its demand. During times of high demand high price of the fuel can result in increase in the price of electricity. On the other hand, the demand of wheat remains more or less the same. Hence there is not much fluctuation in the price of wheat.

The resources that are used to generate electricity like oil, natural gas and coal are not abundant and are continuously depleting. Moreover, the production of Oil and natural gas has declined significantly. Hence the production of these fuels effects the prices of electricity.

Also, the operational cost of the companies generating electricity is very high. Hence, they compensate for the same by increasing the price.

- Swap is an agreement between two parties to exchange future cash flow. Mostly one of the cash flow is based on fixed interest rate while the other is based on floating rate.

Two advantages of developing standardized contracts on swaps:

1. In standardized contracts the terms and conditions of the contract like quantity, price, date etc, are strictly defined by the exchange. Its trade is settled by the exchange center hence, the risk of default by any party reduces. It provides assurance to the parties that other party will not default.

2. Standardized contracts because they are exchange-traded, are highly liquid and also provide market-makers and the selling party has not to worry about finding a buyer as it is provided by the exchange itself.