Are They Betting The Company?


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

Fortnightly Magazine - July 2006

It is almost impossible to design an effective hedge program without first determining the exact objectives a company wants to achieve. Although this sounds obvious, it rarely is. Management usually can agree that the firm should hedge to reduce risk, but “risk” is too vague a term to justify hedging on its own.

Risk is best defined as the uncertainty around the firm’s ability to meet its stated objectives. Board members, senior management, traders, and the risk manager do not always share the same views of the company’s objectives, and therefore may define risk differently. For example, the CFO may be most concerned with achieving earnings-per-share (EPS) forecasts given to equity analysts; the risk manager with avoiding surprises in the mark-to-market; senior management with accumulating cash for strategic acquisitions; and the board with achieving other broad strategic goals.

Since objectives rarely are discussed, the parties involved usually are unaware that their opinion of the company’s objectives often differs from that of everyone else. Different objectives are exposed to different risks, so hedging and risk management strategies will vary.

As an example, suppose a firm’s objective is to ensure sufficient operating cash flow to fund an acquisition. A hedging strategy that could potentially deplete the firm’s cash reserves through collateral requirements would then not be as attractive as one that delivers cash upfront and is supported by contingent capital.

Aligning company objectives can be a time-consuming but useful experience. The first step is to interview all relevant personnel. Company interviews should include members of the board, senior management, the risk manager, and the head of trading, but the interviews need not stop within the company. Equity and debt analysts can provide insight into how investors and lenders perceive the company’s objectives and risks. Poorly performing and poorly communicated hedging strategies often have resulted in significant declines in equity value and investor confidence, so it pays to invest some time understanding analyst concerns and educating them on the company’s objectives and reasons for hedging.

Standardized questions can help identify the most important issues and allow the various answers to be compared.

To avoid conflicts of interest, the interviews should be conducted by an independent source, such as the risk manager or an external third party. Whoever it is, someone who is formally tasked with its successful completion in a timely manner must lead the project.

Once the interviews are completed, the results may be collected and summarized into a consistent and complete set of financial objectives and risk-management principles from which an effective risk policy and hedging strategy can be derived. Of course, it’s not that simple; usually the final set of objectives and principles is the result of countless meetings and spirited discussion. A tight deadline from a ratings agency or the board usually serves to speed things up and 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 hedge program, did the business perform well enough to at least cover those losses? If the answer is no, then the hedge probably was poorly structured from the beginning. In cases where market conditions deteriorated and the hedges made money, did the firm make sufficient money to cover the business losses they were designed to protect against? Again, if the answer is no, the hedge probably was not well structured and should be judged to have performed poorly despite the fact that it made money.

6) What is the role and definition of speculation?

Even in companies with small, asset-based trading operations, this question receives a disproportionate amount of attention from senior management and the board. Even the exact definition of speculation can be unclear. Is it speculation to adjust power or fuel hedges once in place? What about building or buying power assets without corresponding fuel supply and offtake agreements? The former is usually considered speculation; the latter sometimes not. In any case, the amount of risk resulting from these activities must be clearly quantified to separate perception from reality.

7) What is the relationship between budgetary targets and hedging strategy and execution?

Budgets are static; markets are not. Hedging should not be curtailed because a certain budgetary target based on out-of-date curves is unachievable. Similarly, hedging should not be accelerated simply because there is an opportunity to lock in budgeted levels of profitability forecast several months ago.

To see such an approach in action, consider the abbreviated example below based on a utility that owns a fleet of generation assets and is financed with a mixture of unsecured debt and equity.

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

Our firm in the example could have several goals, depending on who is asked. The most obvious would be maximizing shareholder value, which is typically measured by EPS.

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

The most likely constraint on this firm’s financial goals would be the maintenance of its current credit rating. If the company took extreme amounts of risk, its credit rating could be affected adversely, its cost of capital increased, and shareholder value eroded because the company would be forced to reject potentially profitable investment opportunities. In this case it would be in the shareholders’ best interests for the company to maintain an investment-grade credit rating.

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

Ratings agencies rely heavily on cash-flow metrics to assess financial health. While this is in some ways not entirely consistent with maximizing shareholder value, it directly addresses the most significant constraint on the firm’s ability to sustain growth. As such, in this case a cash-flow-based risk metric would be most appropriate, since debt cannot always be serviced by monetizing future earnings.

11) How to think about hedging?

Since the constraint on the firm’s financial objective is maintaining solvency and a cash-flow-based metric is most appropriate, the expected hedge performance must be measured relative to debt-service targets. In this case, the company may have 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 quality. When and what to hedge are some of the most important decisions senior management is required to make. These decisions need not be dominated by arbitrary processes disconnected from the company’s actual financial objectives.