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Are They Betting The Company?

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

Fortnightly Magazine - July 2006

keep everyone on track.

Although the principles that a successful policy and hedging strategy are based upon will differ from company to company, a complete list must address 11 key questions:

1) What are the financial goals and objectives of the firm?

In other words, if we could maximize one thing, what would it be? Earnings before interest, taxes, depreciation, and amortization? Free cash flow? Earnings per share? Equity value?

2) What are the constraints on the most important financial objective?

If the firm’s primary financial objective was to maximize EPS, it could attempt to do so by taking on as much debt as possible and not hedging its fuel purchases or power sales, thereby providing the shareholders with the highest possible returns. Of course, this is a very risky strategy for equity holders, since there is a high probability that the firm will become insolvent. In this case, we would say that maintaining debt service is the constraint on the goal of maximizing earnings per share.

3) How do the company’s financial objectives link to the risk policy?

The company’s risk policy and metrics should reflect its financial objectives, not the other way around. For example, if meeting certain EPS targets has been defined as the key financial goal, then one of the key limits should be on earnings-at-risk (EaR) rather than on value-at risk (VaR) for a particular and specific exposure.

4) Who pulls the trigger on hedging decisions and how are they made?

When and how much to hedge are some of the most important decisions a company can make. Unfortunately, these decisions often are made without a lot of rigor and with limited information and metrics. For example, the CEO will decide to hedge, giving the order to “sell 150 MW at $75 or so.” Why 150 MW? Why not 200 MW? Why $75? Why not $80? And why now and not yesterday or some other time? The answers to these questions usually are that the CEO is acting on his own feel of the market and that his specific instruction “feels right.” Hedging decisions based on pre-defined hedge-efficiency metrics that take into account the amount of risk before and after the hedge is put in place would be much better and more rigorous.

5) How is the performance of the hedging book judged?

Hedges are usually judged solely by whether they make or lose money and not by the criteria used when originally transacted. Establishing appropriate performance measurements for hedging is extremely important. It is not uncommon to hear, “We’re not going to hedge this year because we lost money doing it last year.” This is akin to saying “I’m not going to renew my homeowner’s insurance policy this year because my house didn’t burn down last year.”

While this may be an extreme example, it illustrates one of the potential goals of a hedging program—to insure against severe price outcomes. A better measure of performance would incorporate how the business performed relative to the hedging strategy. In other words, if the firm incurred losses in its