Contents

Introduction.......................................................................................................................................................................... 2
Early years of Enron..............................................................................................................................................................2
Special Purpose Vehicles (SPVs)...........................................................................................................................................2
Enron’s misuse of SPVs: Debt...............................................................................................................................................2
Enron’s misuse of SPVs: Earnings.........................................................................................................................................3
Mark-To-Market (MTM) Accounting....................................................................................................................................4
Derivatives Strengths and how Enron violated them..........................................................................................................4
Risk Management.....................................................................................................................................................4
Enhanced Market Liquidity...............................................................................................................................................4
Price Discovery and Market Efficiency...............................................................................................................................4
Derivatives and its Weaknesses...........................................................................................................................................5
Systemic Risk..................................................................................................................................................................... 5
Potential for Manipulation and Fraud...............................................................................................................................5
Complexity and Opacity....................................................................................................................................................5
AES Corporation: A Model of Prudent and Transparent Derivatives Management............................................................6
Key Differences in Derivatives Management Strategies......................................................................................................6
Enron vs the Market.............................................................................................................................................................6
Enron vs AES (Revenues)......................................................................................................................................................7
Enron vs AES (Asset Utilisation)...........................................................................................................................................7
Enron vs AES (Debt to Asset)................................................................................................................................................7
Enron vs AES (Total Asset)....................................................................................................................................................7
Enron (% of Derivatives in Total Assets)..............................................................................................................................7
Conclusion............................................................................................................................................................................ 8
 Unveiling the Duality of Financial Instruments
Introduction
Derivatives, financial instruments that derive their value from underlying assets, have become an integral part
of the modern financial landscape. While they offer valuable tools for risk management, price discovery, and
enhanced market liquidity, they also carry inherent risks that need to be carefully considered. In this
presentation, we will explore the contrasting approaches to derivatives management adopted by Enron, an
energy company that infamously collapsed in 2001, and AES Corporation, a global power company that has
consistently demonstrated sound risk management practices.

Early years of Enron

Enron, initially established in 1985 through the merger of Houston Natural Gas and InterNorth, began as a
traditional energy company. The early years saw Enron primarily involved in natural gas pipelines and the
transmission of electricity. Kenneth Lay, who had been with Houston Natural Gas, became the CEO of the
newly formed Enron.
The company gradually expanded its operations and shifted its focus from being a traditional utility to
becoming an energy trading and services powerhouse. In the 1990s, Enron underwent a significant
transformation under the leadership of CEO Jeffrey Skilling and CFO Andrew Fastow.

Special Purpose Vehicles (SPVs)

SPVs, also known as Special Purpose Entities (SPEs), are legal entities created by a company for a specific and
often temporary purpose. They are used to isolate financial risk, facilitate financial transactions, and achieve
specific financial or operational objectives.

Enron’s misuse of SPVs: Debt

Enron used SPVs to offload debt and improve its balance sheet appearance.
Establishment of SPEs: Enron established over 3000 SPEs, which are legal entities created for specific financial
purposes. These entities are designed to be independent, with their own assets, liabilities, and operations.
Transfer of Assets: Enron transferred assets to these SPEs. Typically, companies use SPEs to transfer assets,
such as receivables, off their balance sheets, thereby improving financial ratios and appearing financially
healthier than they might be.
External Investment Appearance: Enron manipulated the appearance of external investment in these SPEs.
Instead of involving genuine external investors, Enron engaged in deceptive practices to create the illusion of
third-party investment.
Sham Outside Investors: Enron, in violation of proper accounting practices and ethical standards, made it
seem like external investors were involved in the SPEs. In reality, Enron was, in a convoluted manner, providing
the funding or assets to these SPEs itself.
Using Enron's Own Stock: Enron went to great lengths to use its own common stock as the main asset of some
of its SPEs. This was a clear violation of the intended independence of these entities. By doing so, Enron
essentially became an investor in these SPEs by using its own stock as the source of value for the SPEs.

Enron’s misuse of SPVs: Earnings

Transfer of Assets with Inflated Fair Values: Enron transferred assets to the SPEs, recording these transfers as
sales under accounting standards like FAS 140. The gains and losses associated with these transfers were based
on estimated fair values. Enron, however, allegedly overstated these fair values, artificially inflating its earnings
per share.
Cosmetic Benefits from Derivative Instruments: Enron utilized derivative instruments, such as forward sales
contracts, to structure deals and manage risk. These derivatives were often transferred to SPEs, providing a
cosmetic benefit by shielding long-term, fixed-rate debt from being booked as a liability on Enron's balance
sheet.
Complex Derivative Structures: Enron engaged in complex derivative structures within SPEs, creating a web of
financial arrangements to hide losses and project a positive financial image. The Raptors I, II, and III, for
example, were derivative contracts with notional values of $1.5 billion, used to disguise losses and avoid
reporting substantial charges against earnings.
Artificially Maintaining Share Prices: As Enron's stock prices declined, triggering potential losses, the company
implemented intricate maneuvers to artificially maintain share prices above certain trigger points. This
involved cross-collateralization, additional Enron stock contracts, and questionable hedges and swaps within
the Raptors to avoid reporting significant losses.
Deceptive Use of Derivatives as Collateral: Enron used derivatives as collateral within SPEs, allowing these
entities to borrow substantial amounts at favorable rates. The economic benefit of achieving fixed-rate debt at
lower rates was coupled with the cosmetic benefit of not directly impacting Enron's balance sheet with long-
term liabilities.
Financial Crisis Triggered by Stock Price Decline: The collapse of Enron was exacerbated by trigger events tied
to the value of Enron's shares held by some SPEs. Plunging share prices activated contractual triggers, leading
to early debt collections and a subsequent financial crisis.

Mark-To-Market (MTM) Accounting

Enron engaged in a series of accounting irregularities to conceal its true financial condition and inflate its
earnings. These practices allowed Enron to appear to be a profitable and successful company when it was
actually on the brink of collapse. Some of the key accounting irregularities that Enron used include:
Mark-to-market accounting: Mark-to-market accounting is an accounting method that values an asset or
liability based on its current market value. In use of complex financial instruments, the market value is
calculated using self-made models. Enron used mark-to-market accounting to value its assets and liabilities
daily based on their expected market value. This method allowed Enron to inflate its earnings by recognizing
unrealized gains from future transactions.
Revenue recognition: Enron used aggressive revenue recognition practices to inflate its earnings. For example,
the company would recognize revenue from contracts before they were actually completed or delivered. This
gave the impression that Enron was generating more revenue than it actually was.
Asset inflation: Enron inflated the value of its assets by using unrealistic valuation methods. For example, the
company would use inflated appraisals of its energy assets and other holdings. This gave the impression that
Enron had more assets than it actually did.

Derivatives Strengths and how Enron violated them

Risk Management
Derivatives can be used to transfer or hedge against specific risks, such as fluctuations in interest rates,
currency values, or commodity prices. Enron, for example, used derivatives to hedge against price fluctuations
in energy markets. However, Enron's excessive use of derivatives, particularly complex and opaque
instruments, ultimately amplified its exposure to risk rather than mitigating it.

Enhanced Market Liquidity

Derivatives increase market liquidity by creating additional trading opportunities, making it easier for investors
to enter and exit positions. This can benefit both individual investors and institutional traders. Enron's use of
derivatives initially contributed to increased liquidity in the energy derivatives market, but this liquidity
evaporated when the company's financial problems came to light.

Price Discovery and Market Efficiency

Price Discovery: Enron's active participation in the derivatives market helped to facilitate price discovery by
providing more information about market expectations for future energy prices. This allowed other market
participants to make more informed decisions about their own energy transactions.
Market Efficiency: Enron's derivatives trading contributed to a more liquid and efficient energy derivatives
market. By providing additional buying and selling opportunities, Enron helped to reduce transaction costs and
improve price transparency.
How Enron Undermined Market Efficiency
Excessive Trading: Enron's dominant position in the energy derivatives market allowed them to influence
prices in their favor. This manipulation distorted market signals and made it more difficult for other
participants to make informed decisions.
Hiding Losses: Enron used derivatives to hide its massive accounting irregularities. By creating off-balance
sheet entities and engaging in mark-to-market accounting, Enron was able to conceal its losses and inflate its
earnings reports. This lack of transparency eroded investor confidence and undermined market integrity.
In essence, Enron's approach to derivatives transformed them from tools for price discovery and market
efficiency into instruments for manipulation and deception. Their actions eroded trust in the market and
ultimately contributed to the company's downfall.

Derivatives and its Weaknesses

Systemic Risk
Excessive use of derivatives can increase systemic risk, as interconnected financial institutions may be exposed
to cascading losses when derivative values deteriorate. Enron's extensive use of derivatives, particularly off-
balance sheet transactions, exposed the company's creditors and counterparties to significant risks. When
Enron collapsed, these risks spread throughout the financial system, contributing to the 2001 market
downturn.

Potential for Manipulation and Fraud

The complexity of derivatives can create opportunities for manipulation and fraud. Enron's executives
exploited the complexity of derivatives to manipulate market prices and conceal their financial losses. This
manipulation ultimately led to the company's collapse, causing significant losses for investors and employees.

Complexity and Opacity

Derivatives can be highly complex financial instruments, making it difficult for investors to fully understand and
assess their risks. Enron's use of complex derivatives, such as mark-to-market swaps, allowed the company to
hide its massive accounting irregularities. The complexity of these instruments made it difficult for auditors
and regulators to detect Enron's fraudulent activities.
AES Corporation: A Model of Prudent and Transparent Derivatives Management
In contrast to Enron's reckless approach, AES Corporation has demonstrated a disciplined and transparent
approach to derivatives management, utilizing these instruments strategically to mitigate financial risks and
enhance market efficiency. AES Corporation has implemented robust risk management frameworks to assess
and monitor its derivatives exposures, ensuring that these transactions align with the company's overall risk
appetite and financial objectives. The company's commitment to transparency has fostered investor
confidence and enabled it to effectively navigate the complexities of the derivatives markets.

Key Differences in Derivatives Management Strategies

The contrasting outcomes of Enron and AES Corporation highlight the critical role of sound derivatives
management practices in ensuring financial stability and long-term success. Here's a table summarizing the key
differences in their approaches:

Feature Enron AES Corporation

Excessive and irresponsible use of
Derivatives Use
derivatives contributed to downfall.
Flawed risk management practices,
Risk Management
failure to assess complex derivative
Practices
risks.
Transparency and Lack of transparency led to hiding
Accountability losses and misleading investors.
Regulatory Manipulative use of derivatives partly
Oversight due to a lack of regulatory oversight.
Prudent and transparent approach to
derivatives, contributing to long-term
success.
Implemented robust risk management
frameworks to anticipate and manage
derivative risks.
Maintains high transparency in
derivatives activities, fostering investor
confidence.
Actively adheres to regulatory
requirements for derivatives trading,
promoting market integrity.

AES Corporation's focus on long-term value creation, disciplined risk management, and transparency has
enabled the company to achieve sustainable growth and financial stability, while Enron's short-sighted pursuit
of unsustainable growth and fraudulent practices led to its inevitable collapse.
By contrasting Enron's downfall with AES Corporation's success, you can effectively demonstrate how
responsible risk management and ethical corporate practices can prevent financial scandals and promote long-
term financial stability in the energy sector.

Enron vs the Market

It is quite that the other companies earning revenue similar to Enron had almost 10 times employees than
Enron. A comparison of Enron with other companies with a similar number of employees also indicates that
Enron was, if its reports are not misleading, in a class by itself. Its revenue per employee was more than four
times Chevron and more than 13 times chipmaker Micron Technology. Moreover, if we compare Enron’s
Cumulative returns with the market, they had been abnormally outperforming the market. However,
intelligent investors noted that the S&P 500 is a diversified index that includes companies from a variety of
sectors. This diversification helped to reduce risk. Enron, on the other hand, was a company in a single sector
(energy). This concentration made it more vulnerable to market downturns and changes in the energy industry.

Enron vs AES (Revenues)

Both companies' revenues grew significantly over the ten-year period, but Enron's revenue growth was much faster.
Enron's revenue increased from $13 billion in 1997 to $101 billion in 2000, a nearly eightfold increase. AES Corporation's
revenue increased from $5 billion in 1997 to $17 billion in 2000, a more modest threefold increase.

Enron vs AES (Asset Utilisation)

Here we can see a graph similar to the previous one. Generally, Asset utilization is a key metric for businesses, as it
measures how efficiently they are using their assets to generate revenue. A high asset utilization rate indicates that a
company is using its assets effectively to produce output, while a low asset utilization rate indicates that a company is
not using its assets to their full potential. However, as stated earlier, the Revenues were highly inflated which made
Enron’s Asset utlisation appear better.

Enron vs AES (Debt to Asset)

AES Corporation's debt-to-asset ratio remained relatively stable over the ten-year period, at around 30%.
Enron's debt-to-asset ratio kept on declining steadily from 1997 to 2000, this was possible for Enron as they
had been keeping their debts off-balance sheet as part of their SPVs, while their Assets were being artificially
pumped and being overvalued on the books. We can also see that on the next slide:

Enron vs AES (Total Asset)

The chart shows the total assets of AES Corporation and Enron from 1997 to 2006. From 1997 to 2000, both
companies' total assets increased rapidly. AES Corporation's total assets increased from $11 billion to $33
billion, while Enron's total assets increased from $20 billion to $65 billion.
AES Corporation's total assets continued to increase post 2001, at a steady rate as they had grown themselves
sustainably over the 1990s. However, we’ll see on next slide how Enron overvalued majority of its assets.

Enron (% of Derivatives in Total Assets)

This suggests that the company was becoming increasingly reliant on price risk management activities to
protect its assets. The Derivatives were valued based on models developed internally, which made them
overvalued. Moreover, as discussed earlier, these derivatives contracts were done with their SPVs, which
meant that the risks and losses were eventually being transferred to their own SPVs.
Conclusion
Derivatives represent a double-edged sword in the financial world. They offer valuable tools for risk
management, price discovery, enhanced market liquidity, financial innovation, and financial inclusion.
However, their inherent complexity, potential for manipulation, and contribution to systemic risk make it
crucial to use them responsibly and with adequate oversight. The Enron case serves as a stark reminder of the
dangers of excessive and irresponsible use of derivatives. As we move forward, it is essential to strike a balance
between harnessing the benefits of derivatives and mitigating their risks through a comprehensive regulatory
framework and investor education.