Letters to the Editor / Corrections & Clarifications
To the Editor:
In a letter to the Oct. 1, 2003, , a letter from Lewis Evans and Kevin...
Risk-Management Principles for the Utility CEO
every hedging decision: how much to hedge, when to hedge it, whether to leg-in to the hedge or execute all at once, what maturity to use, whether to use options or forwards, and whether to modify the hedge over time. These are all speculative elements that creep into hedging decisions. Words such as "speculate" must be clearly defined in order to carefully distinguish between permitted and unpermitted activities. Speculation is neither inherently good nor evil. Speculation is nothing but another business activity of the firm. If it earns more over time than it costs to support the business, including capital and risk charges, it should be maintained as a business. If not, it should be reduced to a minimum.
Also, the term "hedging," Merton Miller once said, is like an old coin whose face has been rubbed down by overuse. Hedging has one meaning for accountants, and another for economists. For accountants, a fixed-price fuel purchase is a hedge. For economists, unless the power is hedged simultaneously, it is likely not a hedge. Once again, the use of the word "hedge" in a hedging policy must be clearly defined to have any meaning at all.
Finally, risk reduction for its own sake has limited benefit. Yes, we probably want to stay out of bankruptcy. Beyond that, shareholders may prefer that we take risks when the returns justify it. Although this appears contradictory on the surface, it is not. Risk reduction may be sanctioned up to some minimum level, and subject to higher hurdles thereafter. This is not impossible to implement. One need only specify a two-part set of risk management principles consistent with this two-part objective.
Principle #3: Benchmarks are both specific and achievable.
What is a benchmark? In the case of a trading or spec book, one popular example is that one "must beat Treasuries," , earn a higher return on cash employed than earned on U.S. Treasury bills. A second popular example is to earn a higher return than Treasuries after risk charges. A third example is to beat the risk-adjusted return of other activities of the firm.
Each of these benchmarks may reflect alternative ways to use cash capital and risk capital that are specific and achievable. For example, the first benchmark is achievable by shutting down the trading operation and putting the cash in money-market funds. The second example is not specific, but does set a minimum standard that is achievable by doing nothing. The third is achievable only if the capital can be redeployed to earn a return for the firm elsewhere. If this is not possible, it is not an achievable benchmark.
It is unfortunate that many management teams will direct the trading group to do only hedges and make money for the firm. Another popular directive is stay between 25 percent and 50 percent hedged, but do whatever you want in between those ranges to make money. The first is not achievable, since there is no trade that is guaranteed to make money for the firm, let alone do so while hedging. The second is