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Are They Betting The Company?

Eleven questions to ask senior managers about their risk-management objectives.

Fortnightly Magazine - July 2006

interest payments at the beginning of each fiscal quarter of $25 million. Hedging should be done to minimize (to some degree, depending on the desired credit rating) the likelihood of cash flows being insufficient to cover debt service. Figure 1 (see p. 21) shows a before and after hedging picture of cash flows after debt service (base case and a low case).

Many managers would say they already do this. Maybe, but the approach described above is very different from how most actually hedge. Many companies look at value at risk (VaR) as a driver for making hedge decisions. While that metric is certainly informative, VaR does not recognize the importance of timing. In other words, VaR considers $10 of risk in Q1-2007, the same as $10 of risk in Q4-2009. In reality, the timing of cash flows (and therefore risk) is important to maintaining solvency and meeting various obligations, such as capital expenditures and debt service. In our example, the cash-flow-based approach suggests that the firm hedge less in the near term and more further in the future, whereas VaR would suggest hedging more short term.

Hedge Selection Strategy

Faced with a seemingly unlimited universe of potential volumes and instruments with which to hedge, how should a firm decide on the best strategy? Start by narrowing the field to a manageable number of alternatives. If selling a $50 strike-price option doesn’t accomplish the goal or is too expensive, a $48 strike-price option probably isn’t going to be much better. Once a manageable number of alternatives have been selected, consistent metrics may be applied to evaluate and compare their potential performance. Focusing on a measure of risk-adjusted return is helpful, because it allows for comparison between hedge alternatives that cost money upfront (options) versus those that do not (swaps). Assume our firm is considering three potential hedging strategies: a) selling power forward at current market prices; b) spending $10 million on put options, and; c) entering a power purchase agreement where the firm receives $10 million in capacity payments.

Analyzing the ratio of return to risk (dividing base case CFADS by the CF at risk) allows management to understand which alternative provides the most efficient risk reduction. The PPA does little to reduce the amount of cash flow at risk but does provide $10 million in capacity payments, contributing to the expected case. The swap contributes the greatest amount of risk reduction per dollar spent ($60 million reduction in risk for no cash upfront), but the firm gives up all of the potential upside should prices rise. The put options result in the same amount of risk reduction as the swap (the puts have an at-the-money strike), but costs $10 million upfront, resulting in a lower return/risk ratio than the swaps. The put-option strategy does, however, allow the firm to keep all of the upside at a time when management expects to exceed debt-coverage ratios significantly. In this case, the put options may be the best alternative because they provide shareholders with the maximum potential benefit while addressing the constraints on credit