I am turning to this forum for an insight into a real world dilemma. The company I work for is preparing a bid to buy electricity from another company (it issued a tender to sell electricity). We need to deliver our bid to the other company on date T with specified price P. The counterparty has than the option to accept bids or not to accept it - it has to take the decision in N days. It is clear that the countepraty is long an option that needs to be priced, and that this option price should be incorporated in our bid price for electricity (e.g., if market price for electricity is 30, and option price is 1, than our bid price would be 29). Now the question is: what type of option does the counteparty have - is it a call or a put?
In my option it is a call - by delivering a bid we commit to buy the electricity. If the counterparty decides not to accept bids, it means it excercies call option, and buys back the electricity it commited to sell (thereby the traded quantity is 0). Does this make any sense?
you are correct that there is an option (in fact there is a series of options), but not necessarily in the structure you describe. The owner of the power station has call options to sell and dispatch the power year ahead, month ahead, day ahead…all the way to half-hour ahead if it is a mature market with liquidity.
What you describe is just a purchase of electricity. You need to determine who has the right to generate/dispatch the power before allocating any option premium to one side of the equation.
@krokodilizm: To explain better the situation - if the price will go up until date T+N, the other party will (or better, might) not accept our (or any other) bid, and issue a new invitation to tender. If price it falls, it will accept the best bid. To make it more clear, the tender validity date is more than 2 months before the start of the delivery period, so the other party can play as much as it wants (tender validity date is in the middle of October 2016, delivery period is Q1 and Q2 2016). For me tender validity date is expiration date…
@EdisonUK: I ain’t sure I understand correctly. Could you please elaborate, also given additional information to krokodalizm above.
If your company prepared a bid on public tender than, in my opinion, if tender would be accepted, your company’s electricity purchase from counterparty (seller) would become an obligation. Therefore the seller who organized the tender and spent a money for the tender (a premium) as you said has an option to accept any bid or not accept any of bids.
Thus, the counterparty is long put (right to sell or not to sell) and your company if would be chosen as best bidder has an obligation to buy an electricity what is short put.
Please set clear the object to be trade here. The company wants to sell electricity, so it is long a put option on electricity (the right but not the obligation to sell electricity). However, it seems you are confusing electricity itself with “the choice of delivering or not the promised electricity”. In that case, the company is long a call option on the choice of exercising the delivery action. The latter looks weird. I would recommend thinking about the put on electricity.
“Buying back the electricity it committed to sell” is not accurate at all. The company just don’t sell, period. So it is not a call, but a put.
Still I am not convinced. If you claim there is an option here then where is the premium? It is mentioned that this premium must be deducted from the bid price to arrive at a better deal for the applicant company.
Do what you must but you can’t impose a premium on the electricity company for the favorable bargaining position they are in. You should be begging them for business, not billing them.
EDIT @ Primus75 - a power plant has the right, but not the obligation to generate power based on the spread between power price and fuel costs at the time. This is a strip of call options. A quick google search can probably explain it better than I can, but this is definitely the way a lot of market participants consider it to be.