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I tried a search with google but I can't find a clear definition of what a Heat Rate Option is.
I would appreciate if someone could explain to me what this type of option is.
My understanding is that it has to do with energy options but I am not sure on the underlying.
That's a complicated subject. Unless you're on the trading desk of a power/chemical/refinery company, you probably won't find much information. In addition, if your company doesn't have the "marginal" (best) equipment, such that you compete on efficiency/price, you'll only watch from the sidelines.
Here's a previous discussion:
http://www.wilmott.com/messageview.cfm?catid=3&threadid=54982
Keep in mind that some plants produce electricity by simply burning coal. Some by gas fired turbines with secondary heat recovery. Some by other means. And, some of those plants produce only power while others produce products (power is a sideline). The economics of each plant is different, and those numbers change rapidly. As a result, pricing a plant specific heat rate versus a market heat rate can be a real humbling experience.
I've watched that game from the sidelines long enough to know that I don't know anything about it.
Edit 1 ======================
Some additional links:
http://nodal.ercot.com/docs/tntarc/mo/CAHeatRates.pdf
http://www.potomaceconomics.com/uploads/ercot_reports/2010_02_ERCOT_IMM_Monthly_Report.pdf
http://www.owlnet.rice.edu/~inal/energy/ManualForEnergyEconStudent.pdf
http://www.ferc.gov/market-oversight/mkt-electric/texas.asp
http://math.stanford.edu/~valdo/papers/siam.pdf
http://www.capitolareaenergy.com/index.php/capitol/electricity
A Heat Rate Option is a standard contract traded bi-laterally or on an exchange where the ratio between Electricity at an agreed location and Natural Gas at an agreed location is the strike price for an agreed quantity at an agreed expiration date.
This allows holder the ability to manage the the cost of the Market Implied Heat Rate.
For example if May Henry Hub is \$2.50 mmBtu and ERCOT South Power is \$25.00 MWh, then the Market Implied Heat Rate is 10. An option holder may want to buy a call with a strike price of 12, so they are capped from the risk of higher Market Implied Heat Rates.
The above whitepapers address the operational heat rate performance of a generating plant, which is difficult to replicate in the secondary physical or derivative markets.
I don't have a huge amount of market experience, but I have traded heat rate options at a merchant generation company and at an investment bank.
First off, I disagree Sid Jacobson's answer. Or at least I have never seen a contract with those settlement terms trade. Those terms are, for a heat rate call, eg, final settlement: C = P/G - K, which = P/G - HR, where K, the strike is a heat rate. So working from the example given, I'll change it around. Supposed the strike is a 10x heat rate and final settlement is 12x. So to plug in: C = 12 - 10 = "2". Two what? Two "gases". Or 2x the final gas price. Ok, that could work, but I've never seen it. But there's lots I probably haven't seen.
What I have seen trade between multiple generators and banks is called a heat rate option (but might more sensibly be called a spark spread option, given that the above sounds like what a HR opt should be). Final settlement is: C = P - G*HR - K (well Max(0,...)). Both the heat rate and the strike are fixed in the contract terms. (Strike can be zero or negative. Strike is typically a positive number representing the variable non-fuel/non-commodity costs associated with generation. Sometimes called VOM, I think variable operations and maintenance.)
The call has two underlyings, power and gas. In theory, either leg could settle either physically or financially. In practice I've always seen gas settled financially, and the power can be phys or fin. When both are fin, the holder bills the seller for the final settlement amount. When the power leg is phys, the holder takes delivery of power (which they typically will flip with an offsetting trade), and pays G*HR + K, for it. (We could imagine both legs phys, where holder takes power and delivers gas, but I haven't seen it.)
The two equations I've compared above can be rearranged into each other. But to speak literally of contract terms, I have only seen the form I give. And I have seen that one many times.
Edit: Also, I don't think I've ever seen an exchange listing (nymex/cme, or ICE) for HRO's. I have seem some quotes on broker sheets. It would be nice to have something listed. But I think they haven't been.
A Heat Rate Call Option, or HRCO as it's commonly known is an example of a class of options known as spread options. Specifically: Intrinsic Value_HRCO = Max(PowerPrice - GasPrice*Heat_Rate - Strike,0).The strike is fixed, and usually consists of items Variable and Operational Maintenance costs (VOM), Start Charge, Start Fuel etc.These are usually fixed and specified in a term sheet - a detailed document that lists out the various inputs used for pricing, settlement, credit etc. terms. HRCO's are not traded products; they are usually "Structured Products". A more basic version of spread options is also known as exchange options; where there are still two legs of the instrument, but no Strike. These are easier to value, in that they usually have a closed form solution. When you introduce a fixed strike, an analytical/closed form isn't available any more and numerical methods are used to calculate the price of the option (check me on this; I could be wrong). One such numerical method/approximation is called the Kirk Approximation, which works well when the strike is close to the underlying. A good starting point is perhaps the Energy Economics book by Davis Edwards. He has an excellent companion website:http://www.understandtrading.com/gbs.html ; where you can find more details.
