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When the Price Is Right

How to measure hedging effectiveness and regulatory policy.

Fortnightly Magazine - October 2007

and genetic algorithms) have been shown to generate optimal portfolios under real-life conditions and require only a few minutes of computation using commercial libraries and compiled code.

While mathematics is fun, this is not a technical review paper. The key takeaway for policy and decision support purposes is recognizing that financial engineering algorithms are much more advanced than some people might think. They also are no longer just interesting academic artifacts, as current algorithms become far more accessible to real-life applications. For example, most stochastic optimization algorithms are implemented in standard mathematical libraries available to standard third-generation language compilers ( e.g., C++, Java, and C#). Notably, these methods consider the range of uncertainties typically encountered in real life, including “noisy” forecasts and missing price data, and they remain surprisingly robust with real-life data.

In fact, given the current state of knowledge in software engineering and financial engineering, it’s ironic that many so-called “simplified” hedging approaches, thumb rules, and models in use today are anything but simple to explain. They are rarely subjected to rigorous validation, mostly unaudited, and often yield counterproductive effects. It’s even more remarkable how much money can be bet blindly on such heuristics based solely on the notion that hedging, like motherhood and apple pie, is good intrinsically.

In today’s market, a higher pedigree of risk-capital methods is long overdue. Maybe Sarbanes-Oxley financial reporting and audit requirements will drive the process. Maybe evolving regulatory policy, such as what could soon come out of California, will provide the requisite leadership. Aside from the positive effects of these external drivers, my own view is that electric distribution companies and LDCs themselves will raise the bar on hedging methods. After all, it is increasingly likely to be shareholder money on the line, if it isn’t already.

 

Endnotes:

1. “Excessive Speculation in the Natural Gas Market,” Staff Report, United States Senate Permanent Subcommittee on Investigations, July 2007, p. 1.

2. Ibid., p. 49.

3. Administrative Law Judge (ALJ) Kim Malcolm, and President Michael R. Peevey, “Digest of Alternate Proposed Decision,” R.04-01-025 et al.: Re: Petitions to modify Decisions (D.) 05-10-043, D.05-10-015, D.04-01-047, D.02-06-023 and D.03-07-037 regarding gas hedging for the 2006-2007 winter season for Pacific Gas and Electric Company (PG&E), Southern California Gas Company (SoCalGas), and San Diego Gas & Electric Company (SDG&E), California Public Utilities Commission, July 18, 2006.

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