Category Archives: hedging

The True Cost of Government Guarantees — Take 2

As part of the fallout from last August’s bankruptcy of the Federally-backed solar firm Solyndra, the Obama Administration appointed Herbert Allison, a Republican banker and former Treasury official to review the Department of Energy’s loan guarantee program. His report was completed at the end of January and released earlier this week. It contains many useful observations and recommendations and is criticized as well for what it doesn’t contain.

I want to use this post to focus on one specific issue: the correct measure of the cost of a government loan guarantee. In an earlier post about a recent CBO report on the nuclear loan guarantees I described how the current, legislatively mandated method for calculating the budgetary cost significantly understates the cost because it ignores the full cost of the risk imposed on taxpayers. Future payouts on the guarantees are discounted at US Treasury rates, but the true cost of those future payouts should include a market risk premium. I used the CBO report to estimate that the underestimate of the cost of the guarantees for the new nuclear plant at Vogtle amount to $640 million. The Allison Report tells us something about the underestimate on other parts of the portfolio.

The key comparison is between the last column of figures in Table 4, where the cost is estimated using the legislatively mandated FCRA method that ignores the price of risk, and the last two columns of figures in Table 6, where the cost is estimated using the FMV or fair market value method that uses the market price of risk. In total, the FCRA subsidy cost is $2.682 billion whereas the FMV subsidy cost is between $4.970 and $6.839 billion. Taking the FMV cost as the benchmark, the FCRA cost ignores between 46 and 61% of the full cost to taxpayers because it ignores the price of risk.

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The Value in Futures

Today’s Wall Street Journal has a piece by Ian Berry about the possible restructuring of the CME’s rice futures contract. The design of the contract determines how effectively “farmers, elevator operators and beer brewers” can use the contract to do their hedging. The article is about problems that have shown in up in recent times and proposals to fix them. These problems impact how farmers and others manage their operations and investments:

“We are losing rice acres to other crops, and the lack of ability to comfortably hedge is a major reason,” said John Owen, a Louisiana producer who has chaired a committee with the U.S.A. Rice Federation, a trade group, to examine the issue.

Farmers said growing rice becomes too risky if they can’t lock in prices at the start of the season. Most of their expenses come up front, so they need some assurances on what they will get for their crop.

“We need to get our rice farmers back to farming rice,” said John David Frith, a farmer in East Carroll Parish, La., where a vast majority of growers have stopped planting the grain.

Designing the terms of a futures contract is a tough problem. Getting it right is how a market like the CME helps make the economy more productive.

The Promise and Pitfalls of Indexed Debt

The promise

We saw two recent commentaries by eminent economists advocating the use of indexed debt instruments.

Ken Rogoff, of Harvard’s Economics Department, was interviewed in the McKinsey Quarterly about the current Great Recession and what can be done about it. Among a number of other points about long-run structural reforms, he says that:

And then I’d say governments need to find ways to spark market innovation in indexing debt instruments. If we had housing loans indexed to, say, regional housing prices, as Bob Shiller has advocated, it would have helped a lot and provided better incentives to borrowers and lenders. If in 200 or 300 years, we’re experiencing fewer and milder financial crises, it will be because we figured out how to put some basic indexation clauses into debt that make it a little less vulnerable to systemic risk.

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The True Cost of Government Guarantees

The August bankruptcy at the solar panel manufacturer Solyndra has generated a predictable political kerfluffle, since the company had received $527 million in loan guarantees from the Obama Administration. The political issues raised by the case are fair game. But I’m more interested in a more general issue:

What is the true cost to taxpayers of loan guarantees?

Obviously, we learn the cost of a particular loan guarantee, like the one for the bankrupt Solyndra, ex post—it’s the amount of money the government has to payout to the creditors. But what is the right estimated cost ex ante?

Coincidentally, August was also the month that saw the CBO publish a report on the true cost to taxpayers of Federal Loan Guarantees for the Construction of Nuclear Power Plants.

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The Volcker Rule & Trader Compensation

A Bloomberg article details how a draft of the Volcker Rule uses the structure of trader compensation to distinguish between proprietary trading and market making. Exactly right!

Lesson from UBS on trader compensation

The case of the $2.3 billion trading loss at UBS holds many lessons for any company that trades derivatives. Remember, UBS wants to claim its trader was a rogue that victimized the company. There was a time that a bank could shout ‘rogue’ as an effective excuse of senior management. But that time is now long past. There have been plenty of penetrating questions asked about the self-evident shoddiness of UBS’ control systems. Another area that deserves scrutiny is the compensation system. How is a trader’s pay determined?

Pay should be for performance. But what counts as performance?

The metrics for performance on a proprietary trading portfolio should be different from the metrics for performance by a market maker. A market maker ought to be compensated, in part, for how successfully s/he is hedging trades. For a market maker, outsized gains on the unhedged component should not count towards a bonus, whereas for a trader running a proprietary portfolio, they should.

How was performance measured at UBS’ Delta One desk? If the traders were being rewarded based on the total profitability of the desk, then UBS was incentivizing them to speculate, and the Delta One desk shouldn’t be described as customer facing or market making.

This same lesson applies to non-financial companies that hedge through their own trading desk. The metrics for performance on hedging should incentivize minimizing risk. The metrics should measure risk reduction. When the desk reports big profits — after netting out the matched positions — that’s a bad sign, not a good one.

If you pay out bonuses when bets payoff, be prepared to see some bets that lose big, too. It’s not a rogue trader if the risky bets are rewarded by the compensation system.

Distinguishing proprietary trading from hedging

Good internal risk controls involve carefully distinguishing between different types of trading. Many companies that do significant trading to hedge their market risks explicitly forbid proprietary trading. Others explicitly try to profit from proprietary trading, but it is still important to keep the proprietary trading book separate and under proper control.

So, for anyone interested in this issue, it is instructive to watch the implementation of the Volker Rule — section 619 of the Dodd-Frank Act — which restricts the proprietary trading operations at the major banks. Last week, Politico’s Morning Money posted a study by Deloitte discussing how regulators might identify proprietary trading and the measures banks would need to take to clearly mark transactions as “market making” or other permitted activities as opposed to proprietary trading.

While the Volker Rule is about banks, and this blog is about end-users, it will still be informative to end-users to watch how this process plays out at banks. After all, proprietary trading is proprietary trading, wherever it is pursued, and the fingerprints of proprietary trading are likely to be similar, too.

Two other good reads on the telltale markers distinguishing proprietary and other trading are a paper by NYU’s William Silber, and an old paper by Braas and Bralver in the Journal of Applied Corporate Finance (paywalled).

The unorthodox model of risk pricing behind the UK EMR #5: creating value out of thin air

The UK’s Electricity Market Reform White Paper claims to have quantified how offering low-C generators a hedge creates value:

In our central scenario, the FiT CfD reduces the cost of decarbonisation to 2030 by £2.5 billion compared to using the Premium Feed-in Tariff (PFiT) to deliver the same investment. ( § 2.3, p. 37)

Given that my previous post says there can be no net value at all, I find this claim startling and it should be informative to investigate exactly how this number is arrived at.

Bottom line: (i) they calculate the benefit of a hedge captured by the low-C generator, but, (ii) they completely ignore the cost to the taxpayer or ratepayer from providing that hedge.

Ignoring (ii), the cost to taxpayer or ratepayer, is obviously the big problem, and we could stop there. But let’s take the bait and go ahead to examine (i), how they calculate the benefit of hedge captured by the low-C generator.

The White Paper purports to have assessed how providing the hedge (in the form of a Contracts for Differences, or CfD) lowers the cost of capital for different types of projects. Here is Figure 7 from the White Paper with the results:

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The unorthodox model of risk pricing behind the UK EMR #4: no value to hedging

The UK’s Electricity Market Reform (EMR) White Paper suggests that providing low-C generation projects with a hedge of the wholesale electricity price can lower the cost of providing low-C electricity. Can this be?


A fairly priced hedge changes both the project’s risk and it’s return. The first order effect of the two is to leave the risk-adjusted cost of the project unchanged. This is commonly known as the M-M Proposition of Hedging.

In an earlier post I showed a stylized graph of a low-C generator’s revenue, costs and profit margin, all unhedged, and associated with them a present value for each of the three cash flow streams using a simple risk-pricing model. Now, using the exact same risk-pricing model I can construct a fair value hedge. A fair value hedge is one with NPV=0. The hedge is a swap in which the low-C generator sells the floating cash flow, tied to the wholesale electricity price, and receives the fixed cash flow:

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The M-M Proposition of Hedging

Students of corporate finance are familiar with the Modigliani-Miller irrelevance propositions. Proposition 1 says that the value of a firm is determined by the firm’s cash flow from assets and is independent from its capital structure. The Proposition is often presented to demonstrate the irrelevance of choosing between debt and equity, but the underlying logic is more general than that. The Proposition applies to any choice in the set of contracts used to finance the firm. These include hedges, for hedges are implemented with financial contracts that change the balance sheet of the firm. So, what we call the M-M Proposition of Hedging is simply a corollary to the original M-M Proposition 1.

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