This excerpt taken from the EOC 20-F filed Mar 16, 2006.
The Company has commodity derivative, financial derivative, and embedded derivative instruments that are recorded at fair value, with changes in fair value recognized in earnings under SFAS No. 133, as amended. In establishing the fair value of such contracts, management makes assumptions based on available market data and pricing models, which may change from time to time.
Calculation of fair value for commodity and embedded derivatives is done with internal models that are based primarily on discounted future cash flows. Inputs to such models include estimated forward prices of electricity and natural gas, interest rates, foreign exchange rates, inflation indices, transmission costs, and others. Simulation techniques are used to forecast electricity consumption levels for the countries in which the Company has derivative instruments with options in quantities. These inputs become more difficult to predict and the estimates are less precise, the further out these estimates are made. As a result, fair values are highly dependent upon the assumptions being used. The Company also adjusts fair value of certain commodity derivatives to reflect risks related to the performance of counterparties.
The Companys Argentine generation entities have access to the Brazilian energy market through an interconnection system between the two markets. The Company has entered into a number of power purchase agreements on the Argentine side and power sales agreements on the Brazilian side to export electricity from Argentina to Brazil. In order to calculate the fair values of the electricity purchase and sale contracts related to this interconnection business, the Company uses, as a reference, the availability of electricity in each market in order to comply with these sales contracts in Brazil. In the cases in which it is possible to supply these contracts from the Argentine market, we use the curve of expected prices of electricity in this market. In the cases in which we believe the supply of electricity should come directly from Brazil, we have used the Brazilian market as a reference. The Companys assumptions include our outlook regarding how long the energy crisis in Argentina will last. Such values are included in the reconciliation to U.S. GAAP in Note 32 (w) of the Consolidated Financial Statements.
The Companys financial derivative instruments are primarily short duration foreign currency forward exchange contracts to purchase U.S. dollars or Euros and sell UF and interest swaps and dollar and cross-currency swaps. The Company records these financial derivative contracts at fair value. Estimates of fair values of financial instruments for which no quoted prices or secondary market exists have been made using valuation techniques such as forward pricing models, present value of estimated future cash flows, and other modeling techniques. These estimates of fair value include assumptions made by the Company about market variables that may change in the future. Changes in assumptions could have a significant impact on the estimate of fair values disclosed. The net asset (liability) recorded under US GAAP related to financial derivative instruments was Ch$ (11.3) billion and Ch$ (13.1) billion as of December 31, 2004 and 2005, respectively.
The Companys accounting policy for derivative instruments is discussed in Notes 2 (p) and 32 of our Audited Consolidated Financial Statements.