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Default Retail Supply: Making the Call on Market Price and Model Risk

How to set reserve levels for full requirements auctions.

Fortnightly Magazine - April 2005
Table 5 - Monthly Actual vs. Modeled Results

standard deviations away from the expected value.

The duration of the trade has an impact on the model's accuracy. Monthly trades have no opportunity to "diversify the model risk across time." Monthly sigmas (listed in Table 5) on the hedged trade range from 0.26 to 14.64 for the PSEG example.

Clearly, an actual result that is 14.65 standard deviations away from the mean would provide some evidence that the model used to generate these results is not capturing all of the risks driving the ultimate profitability of the trade. As such, this information should be used to generate a "model risk" charge. We suggest implementing the following framework for generating a model risk charge:

  • Generate an "optimal" hedge portfolio;
  • Use the duration of trade and the standard deviation of the earnings distribution to generate an overall model risk charge; and
  • Translate that charge into $/MWh by dividing it by the expected load.

Based on the detailed monthly analysis above, we have heuristically estimated a model-risk charge rule as follows:

  • For trades with delivery durations less than 9 months, use a sigma of 3; and
  • For trades with delivery durations of more than 9 months, use a sigma of 15.

This approach would generate a model risk charge of $894,000 on the PSEG trade. If this amount is divided by 856,772 MWh, a risk charge of $0.98/MWh would be added to the bid for model risk.

The recommended bid price on this trade should therefore be made up of four elements:

  • "Zero Value" base price: $42.19
  • Market Risk charge (25% RAROC): 2.86
  • Credit Risk charge (0 in this case): 0
  • Model risk charge (3 sigmas) 0.98
  • Total Bid price: $46.03.

These risk charges should be added as specific charges on the trade so that the "extra value" of the higher bid price is not misinterpreted and recognized as profit. The charge for market risk could be returned as the trade is hedged successfully. However, an additional amount then would need to be charged for credit risk. The model-risk charge would remain in place and charged only if back testing results generate lower average sigmas. Table 6 illustrates the absolute cash amounts of these charges. The $2.86/Mwh charge translates to a $2.5 million risk charge while the $0.98/MWh generates an $840 million risk charge.

The analysis presented assumes the trade is being considered on a standalone basis. Future articles will explore possible reasons why a bid from two parties with very different existing risk profiles will generate different bid prices.

The charge for market risk can be reduced if an effective set of hedges are put in place. But why hedge? Is it not more attractive to leave this position open so that it can hedge the bidder's existing positions?

A more effective market-risk charge should consider the overall portfolio's risk and each transaction's contribution to that risk profile. This practice could allow for bid price that are actually below the market (if there is an incremental risk reduction to the portfolio).