Category Archives: exposure

The perils of hedging the price of jet fuel

Bloomberg had a news article earlier this week that highlights the practical problem of implementing a hedging strategy even in one of the largest commodity markets, jet fuel. Many airlines attempt to hedge some portion of the anticipated cost of jet fuel purchases over the coming year. In large part, they do this by purchasing futures contracts on either crude oil, the feedstock for producing jet fuel, or heating oil, another refined product that is slightly different from jet fuel. The prices of the three commodities are correlated, but only imperfectly. In the long run, if the price of crude oil goes up significantly, the price of the refined products must also go up. But in the short run, the relationship is very erratic. The price of crude and jet fuel can even sometimes move in opposite directions as they have recently. Here is a graph of the crack spread over the last number of years:

The spread graphed is the difference between the price of the refined products produced from a barrel of oil and the price of the barrel of oil. The graph shows the most widely quoted version of the crack spread, the 3:2:1 spread–i.e., 3 barrels of crude oil yields 2 barrels of gasoline and 1 barrel of heating oil. Clearly this spread swings significantly through time.

This is a classic case of basis risk, which is just the volatility in the differential between two related commodities or between one commodity for delivery at different locations or different delivery dates. Basis risk undermines the effectiveness of a hedge built using a related commodity. Airlines that used crude oil futures to hedge their jet fuel prices are finding that the hedges are losing money at the very same time that jet fuel prices are going up. This is exacerbating the cash flow volatility that the hedge is designed to reduce.

What can be done about this? Continue reading

Hedging with vertical integration — oil company edition

The NYTimes today carries a Reuters Breakingviews column arguing for a break up of the vertically integrated oil majors. The author trots out a number of questionable arguments in favor of a break up. He then voices a counterargument that is directly relevant to the themes of this blog:

“Executives argue that lumping refiners and explorers together offers a natural hedge. In theory, when falling crude prices hurt production, the refining business gets relief from lower input costs.”

Some might claim this is just a straw man, but I hear this thinking often enough that I think it is worth pushing back against it.

Two points.

First, in its simplest form, this argument just has to be wrong. At a first approximation, combining production with refining in no way hedges production. The oil producer is a natural long. The refiner is neither long nor short. The refiner both buys crude oil and sells refined oil products. It captures the margin between the two. Adding up the exposure of a producer with the exposure of a refiner yields a company that still has the exposure of a producer. There is no natural hedge there.

What I mean by ‘at a first approximation’ is that we assume that the price of crude and the prices of refined products all move together, one-for-one. Of course, this assumption doesn’t hold. When crude prices move, margins on refining often move, too. But the relationship is complicated, and in no way can it be described as a natural hedge. At best, it is like any two distinct operations within a broadly defined industry which have exhibited some negative correlations in the past so that profits from the two divisions seem to hedge one another. Whether the correlation is really there and reliable in the future is a very difficult question to resolve.

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More on the Good Sense of a Short-Term Focus for Hedging

In an earlier post we discussed one of several reasons why companies tend to focus their hedges on short-term cash flows, leaving long-term cash flows unhedged. There we pointed out that the right response over the long-run to fluctuating prices and other risk factors, is changes in the operations and investments of the firm in order to re-maximize profits in light of the new competitive conditions. But there are several distinct reasons for the practice, and that was only one of them.

Another reason why firms concentrate their financial hedges on short term cash flows has to do with uncertainty about the nature of the exposure at longer time horizons. Competitive exposures are very complicated, and involve many, many risk factors. We oftentimes focus on a single specific risk factor and quantify the exposure in very simplistic models. This is necessary if we are going to implement a financial hedge. For example, the airline needs to buy or sell futures contracts on a specific type of fuel delivered at a specific location on a specific date. To design that hedge we try to quantify the airline’s exposure measured in terms of the commodity represented by that specific fuel. But this focus on a single risk factor and exposure measured using recent data is only valid for very short horizons. The correlation between the futures price for that specific fuel and the airline’s actual cash flow may not hold at some distant date. All sorts of changes could undermine the validity of extrapolating that correlation. Some of these may be changes in the industry’s competitive dynamics, some may be in the types of fuels that are used by the airlines. For example, if bio-fuels gradually replace fossil-based fuels in jets, then the correlation between crude oil prices and the airline’s exposure will almost certainly change. The higher the uncertainty about the industry dynamics, the less a firm should commit to hedge, because it knows less how much it should hedge. And the essence of uncertainty is that it increases just with the length of time into the future. Prudence (i.e., sound risk management) indicates that it is not right to make commitments – either firm or contingent – when ignorance pervades.

When a Short-Term Focus Makes Good Sense

People are often surprised at the short horizon of many corporate hedges. For example, airlines with disciplined hedging programs, only buy fuel forward for a short horizon. A typical hedging program locks in 100% of anticipated fuel purchases over only the next few months—possibly 3-6 months. Thereafter the hedge ratio declines sharply, so that the airline has no hedges for fuel purchases beyond 24 months or so. The airline is left fully exposed to long-term fuel price fluctuations. This fact contributes to the concentration of hedge trading in the shortest maturity futures contracts.

There are multiple reasons why it makes sense for corporates to concentrate their hedging on short horizon exposures. One of the main reason is that the best way to respond to medium and longer horizon exposures is through active management of the firm’s business operations and adjustments in the firm’s investment program. Financial hedges are useful for covering short-run exposures when the company has little flexibility to adjust its operations and investments.

A rise in fuel prices is a change in the real price of doing business. Operations and investments ought to respond to real prices.

One way an airline can respond is to pass the higher cost along to the customer in the form of higher ticket prices. When that is possible, it isn’t even technically correct to say that the airline is exposed to the price of fuel oil, and it doesn’t make any sense for the airline to lock in the price of fuel. Of course, the cost cannot always be passed on. In the short horizon, there may be frictions that prevent the airline from adjusting ticket prices. For example, it may have already sold some tickets and committed to the price. At longer horizons these frictions aren’t relevant, but some consumers will be price sensitive and may cutback on their flying, limiting the airline’s ability to simply raise prices. This brings us to the second way that an airline can respond. If some customers are unwilling to pay the higher cost of flying, then the airline needs to adapt the profile of products it is offering. This may include changing its route structure, its mix of business and economy class seating, as well as the number of flights/seats on certain routes, and so on. Obviously these actions take time and cannot happen immediately. But over a longer horizon these should be the real focus of the airline’s decision making.
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What’s Special About Stress Tests?

The Fed has just announced a second round of stress tests for US banks. This follows the first round of tests in Spring 2009 with results announced in May. There are many interesting issues one could touch on in regard to the role of stress tests in regulating the banking system. But this blog is focused on risk management at non-financial corporations, and so we will leave most of those issues for discussion in other venues. But risk management at non-financial corporations obviously employs many of the same tools as risk management at banks and other financial institutions, so there are a few interesting questions that are common to the two realms. One of them is “What is special about stress tests?”

Are they any different than the other quantitative tools employed to measure risk? If the Fed is already calculating a VaR for each bank, it would seem that it already has a more comprehensive piece of information than would be contained in a stress test. The stress test identifies a single bad scenario and calculates the bank’s losses in that scenario. When calculating its VaR, a bank is effectively determining its losses under many, many possible scenarios. The bank then generates a probability distribution of losses. The VaR just locates the tail on this distribution. What extra information could the Fed extract by forcing the banks to focus on a single scenario instead of the full probability distribution of scenarios?
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Mario Goes to the FX Market

Nintendo’ management has decided to keep in US$ a significant fraction of its revenues from exports. Nintendo has a large $7.4 billion pile of cash held in foreign currencies (70% of Nintendo’s total cash reserves). See this Wall Street Journal article.

With the sharp rise in the Yen since May 2010, after a crisis in the Eurozone erupted, and recently with the FED stimulating the economy with an aggressive monetary policy, Nintendo has accumulated large currency losses, when most of the other large currencies (Euro, Sterling and $) depreciated against the Yen.

Does it matter?

At first, one would say no. These are merely translation losses, and the competitive position of Nintendo (its ability to sell its products) is not affected by accounting losses. Moreover, Nintendo has expenses in foreign currency, so matching its revenues with operating costs in foreign currency makes sense.

This is not entirely correct, however.

Nintendo has over the past years aggressively shorted the yen to invested in other currencies, and taken advantage of higher yields abroad when compared with almost zero interest rates in Japan. This foreign currency strategy goes by the name of carry-trade, and has been massively employed by both Japanese companies and households since the late 1990s. It yielded very large gains until the eruption of the current financial crisis. Since then, investors and companies in Japan have used this strategy on and off depending on market conditions.

The Japanese Yen, like the Swiss Franc, is a currency of refuge to investors when markets get nervous. In recent years, the correlation between different measures of market volatility (for example, the Vix and iTraxx) and the Yen has been pretty high. When investors become more risk averse and fearful they go long the Yen, and when markets calm down and volatility declines, the Yen tends to lose its value. The point is that a lot of companies and individuals use the Yen to express their fears about deteriorating economic and financial conditions. And there’s plenty of that nowadays.

What this means is that, in addition to matching the currency in which its cash is held with the currency of its cash flows, Nintendo’s management has deliberately made a bet on currencies with the shareholders’ money. And recently, the bet has lost money, as in the past it has made money.

This begs the following question: Should Nintendo’s management use shareholders’ money to bet on currencies, or should it let investors decide by themselves on currency betting?

It is obvious that the majority of Japanese shareholders in Nintendo are upset with Nintendo’s currency losses, as they were presumably quite happy when Nintendo was making profits in the past from its portfolio of foreign currencies. But the management should not be surprised with shareholders’ reaction. Shareholders give the management discretion as to how retained earnings are invested, but voice their disapproval when management decisions go wrong. Betting on currencies is no different from any other investment decision. Except for the fact that Nintendo’s management has no business on betting on currencies. It’s hard to make a case that they have particular skills in doing that.

The other part of the problem relates to executive compensation. More precisely, how currency betting is treated in compensating management. Often times, currency losses and gains are not treated symmetrically in managerial compensation. Because of this, the management might be inclined to take currency bets, if it can persuade shareholders that currency gains are the result of its talent, and therefore should be followed by unexpected higher bonuses, while at the same time currency losses are not penalized with lower bonuses. How the compensation is designed creates the incentives to act so as to maximize the chances of getting the targeted compensation. Moreover, executive compensation is not entirely outside of the management’s control, and can be subtly manipulated by managers. In general, managers are smart operators, and are able to focus the attention of shareholders on operating profits when (financial losses such as currency losses) occur, claiming that these are unpredictable, and therefore not their fault. Shifting shareholders’ attention on different results ex-post is a very common managerial tactic.

Risks Are Not Constant Through Time: Capacity Factor Risk at Nuclear Power Plants

My colleague, Yangbo Du, and I have just released a study of the dynamic structure of capacity factor risk through the life-cycle of a nuclear power plant. This is based on the performance of reactors in countries all around the world, using the International Atomic Energy Agency’s database. Here is the profile of the variance in the capacity factor through the life of the reactor:

The risk is greatest when the reactor is just starting up. It then declines dramatically. Over time, however, due to the small, but cumulating possibility of a permanent shutdown it rises again.

This is a nice demonstration of the fact that risks are not typically constant through time. The constant compounding of risk is a key assumption behind the usual discounting rule, but many people forget about this and just apply the rule to any and all problems, even when risks evolve in more complicated ways.

Packaging Exposure to China

Risks usually come in a bundle. If you want exposure to a particular factor risk – or you want to hedge that particular risk and concentrate your exposure onto other factor risks – you may have to find a way to create that exposure synthetically. Investment managers are constantly looking for ways to do this. The Financial Times had a nice piece on getting exposure to China risk. Hedge fund manager Hugh Hendry seems to think that a portfolio of Japanese corporate bonds has a big China exposure.