The Trouble with Risk Measures

Deck: 

Companies should adopt a far more robust metric.

Fortnightly Magazine - October 2006
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Market risk remains one of the most significant issues for gas and power merchants. The SEC requires disclosure of market risks in a company’s annual filings. However, the allowable metrics fail to communicate the type of information an investor actually can use to gain an understanding of the market risk embedded in a company’s business.

An “earnings-based” market-risk metric is an alternative to the existing “value-based” risk metric. This article provides a simple example that demonstrates how the metric works for an energy merchant that controls generation and wants to hedge that exposure using gas and power swaps.

One common “value-based” risk metric is value at risk, or VaR, which is well defined and reasonably understood in the power and gas sector. In fact most investor-owned utilities use VaR to satisfy the SEC’s market-risk disclosure rules. VaR is defined as the maximum reduction of value that could be experienced from the impact of a set of market risks for a specfic holding period given a selected confidence level. Generally, holding periods are one to five days, while the confidence level is 95 to 99 percent.

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