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uSE oF CASh FLoW At rISK In MAKIng IntELLIgEnt hEdgIng dECISIonS
tAbLE oF ContEntS 2 3 3 3 4 6 6 7 Introduction value At risk versus Cash Flow At risk Application of the Cash Flow at risk Example using an Airline’s hedging Process the decision-Making Process the role of Subjective Judgments results of the hedge Program Conclusion .
It will also provide an illustration of a hedging process. using an airline as an example. Corporate hedgers can use similar methodologies to make informed hedging decisions. This paper will discuss the use of cash flow at risk methodology to formulate informed and intelligent hedging decisions.use of Cash Flow at risk in Making Intelligent hedging decisions 2 IntroduCtIon At risk methodologies have been employed by the investment banks and hedge funds for several decades to project worst case trading losses in order to set risk limits on traders. to provide a framework for both devising a hedging program and measuring its result. the paper will conclude with the evaluation of the hedge post facto. .
2004 an airline was considering hedging the exposure that would result from jet fuel purchases in the first quarter of 2005. ExAMPLE uSIng An AIrLInE’S hEdgIng ProCESS this paper uses an airline as an example to illustrate an objective hedging process and how it can be tested post facto. . the airline is budgeting fuel cost margin of 18%.3 use of Cash Flow at risk in Making Intelligent hedging decisions vALuE At rISK vErSuS CASh FLoW At rISK Value at risk signifies the value (change in the MTM) which can be lost in a portfolio of financial derivatives with x% (e. is a measure that corporate hedgers can use to identify the risk associated with changes in the prices of commodities they may purchase or sell. an airline can use it to simulate what jet fuel costs will be in a quarter. It is a statistical methodology that reflects the market opinion (through market forward curves and implied volatilities) on the worst case (defined as x% of certainty) and best case (defined as 1-x% of certainty) for commodity prices. 365 days) time horizon. cash flow at risk signifies the cash that would be received or paid in a portfolio of ‘transactions’ with x% of certainty in a given (e. Currently. Subjectivity may be employed in making hedging decisions evaluating various alternatives. therefore. that is. however.g. it expects the fuel cost to be 18% of total revenue. 95%) certainty in a given (e. but rather that subjective views devoid of rational statistical analysis should not be employed in making market forecasting decisions. Currently. For example. APPLICAtIon oF thE CASh FLoW At rISK Cash flow at risk is a Monte Carlo simulation methodology with a longer time horizon.g. Subjectivity. budgeting in many organizations is based on the view of its executives which may or may not be rooted in statistical analyses. needs to be bound by a range provided by executive management so that hedging decisions do not become speculation in the commodity markets. the airline purchases all of its fuel based on the daily Platt’s Jet/Kero oil index at uS gulf. this normal purchase or sale approach is significantly different from a corporation’s concern to ‘unwind’ its financial transactions. It is not the intention of this paper to profess that subjectivity should be completely taken out. On the other hand. Note that value at risk looks at the change in the value while cash flow at risk looks at the cash-flow exchange upon consummation of the transaction. Suppose that on december 24.g. 1 day) time horizon. six months. this methodology can be very useful to the treasury or procurement departments for budgeting processes. or a year’s time horizon. Cash flow at risk.
635) Start date - End date Jet Fuel * ConFIgurE rEPort *vIEW MArKEt dAtA SourCES (1. which was conducted by Sungard’s Avantgard Kiodex risk Workbench’s multi-factor Monte Carlo simulation model. and it must be answered by the airline’s executive board or board of directors.635 per gallon at the end of the 1st quarter of 2005. Collars. The price inputs for the calculation came from the markets through the forward curves and the implied volatilities. What tenor should we hedge (1months. In other words. HO. If so. Should we hedge at all? 3. etc) 7. 3 months. this could be construed as the “consensus” forecast of the jet fuel prices that is using an objective statistical analysis.50%-19. What locations or proxy commodities we should hedge (Crude.0% T im e H o rizo n : 110 da ys U n certain ty L ev el: 5% C o rrelatio n S tart D ate: 12/25/04 C o rrelatio n E n d D ate: 03/25/05 C o rrelatio n D ata F req u en cy: D a ily Portfolio book trade Id trade type underlying MarkettoMarket (1. How do we measure the efficacy of our hedging program? The first question is the most important.635) - . What hedging instruments should we use (Swaps. eliminating subjectivity. how much should we hedge? 4. The report clearly shows with 95% certainty that the jet fuel prices will not exceed $1. Options. Figure 1: Cash flow at risk showing worst case scenario rEPortS: Cfar R ep o rt ID : 10608429 R ep o rt N am e: W orst case jet prices in Q 1 B o o k: Jet F uel (U S D ) R u n O n : 3/25/05 A s o f D ate: 12/24/04 R ep o rt D escrip tio n : 95% confidence signifies the w orst case jet prices T rad e T yp e: A ll M arket: A ll U n d erlyin g : A ll C o u n terp arty: A ll T rad er: A ll T rad e D ate: A ll V aR L ev el: 95.276) CFar Marginal CFar (1. this paper will answer questions 2 and 3 although cash flow at risk can be used to answer all of the questions.635) Incrememental CFar (1. defined as a 95% at risk scenario on jet fuel prices.00%. thE dECISIon-MAKIng ProCESS The following is a cash flow at risk report that retrospectively examines a worst case scenario. etc)? 6. etc)? 5. For the following example we have assumed the following objective: The objective of the hedge program is to keep the fuel margin (the fuel cost as a percentage of the revenue) between 18.use of Cash Flow at risk in Making Intelligent hedging decisions 4 Several decisions must be made in the following order: 1. What is our business objective? 2.
90% that would be unacceptable based on the executive mandate.24% 18.0% 70.20% 21.0% 45.0% E ffectiv e P rice p er G allo n $1.4236 $1.5 use of Cash Flow at risk in Making Intelligent hedging decisions the use of the worst case “consensus forecast” will provide an objective framework for the airline to answer the series of questions listed on the previous page.70% 22.5293 $1. hedging 80% to 90% would ensure a fuel cost margin between 18.3002 $1.0% 55.0% 95.e.126 per gallon (18% budgeted fuel cost margin). the following table shows the effective price per gallon for a series of hedge percentages and the resulting fuel cost margin in each.45% 22.3531 $1.0% 50.0% 20.2826 W o rst C ase F u el M arg in P ercen tag e 22.00% 10.0% 100.0% 90.6315 $1.99% 18.0% 65.0% 60.0% 80. it is clear that not hedging at all could have a worst case impact of fuel cost margin of 22.5645 $1.5469 $1.0% 40.5998 $1.48% 19. .00 as mandated.3883 $1.0% 35.71% 21.49% 18.5117 $1.3178 $1.5821 $1.72% 20.635 per gallon.00% 5.97% 20. The table also answers the question: how much should we hedge? The table shows that hedging 80% to 90% of the total fuel purchase would ensure the executive mandate.28 market swap price on December 24.3707 $1.6174 $1.4940 $1.73% 19.4764 $1.4412 $1.3355 $1.46% 21.0% 85. In the table above. the effective price of fuel purchase calculated as: % hedged * hedged price ($1.47% 20.0% 75.00% Based on the worst case jet fuel prices of $1.96% 21.23% 19.90% 22.98% 19.0% 30.50% to 19. i.74% 18.21% 20.4588 $1. the airline must hedge to ensure its hedge objective that fuel cost does not to exceed 19%.0% 25. The revenue per gallon is assumed to be fixed at a current budgeted level of $7. Figure 2: Fuel margin calculation % H ed g ed 1.4059 $1.25% 18. 2004) + % unhedged * worst case prices) the fuel margin is calculated based on effective fuel cost per gallon / revenue per gallon.0% 15.
414. the choice to pick the percentage that can be hedged could be based on the management’s view about timing of the hedge. The following table shows the actual prices for the first quarter of 2005 and the outcome both with and without the recommended hedge: Figure 3: Prices with and without hedging Volume in Gallons Settlement Price $1. For example the subjectivity could come within the board’s objective of keeping the fuel margin within the recommended range.000 $1. This limited use of subjectivity.000. the airline’s management has some leeway to incorporate its subjective judgments into the final hedging decision.28 per gallon for 85% of the total fuel purchase.769) $1. the hedge was applied at 850. Assume that the total fuel purchase was expected to be 1 MM gallons. the management could decide to hedge between 80% of total fuel purchase or 90% of the fuel purchase based on their view.125.556 19.000 gallons of jet fuel through a swap at Platt’s USG.769) ($1. within clearly defined boundaries.675) $1.use of Cash Flow at risk in Making Intelligent hedging decisions 6 thE roLE oF SubJECtIvE JudgMEntS While still maintaining its hedge objective. As such.4148 Unhedged Unhedged Recommended Hedge Recommended Hedge (85% of total purchase) (85% of total purchase) ($1. they could hedge only 80% and then wait for the price to revert back to the mean and hedge the remaining amount later (if the ultimate objective is to hedge 90% of the fuel quantity). Using cash flow at risk analysis can help instill management discipline.414.4148 $7.414.306.125. In the example above.344 ($4. ensures that hedging is not being used as a tool for speculation.34% Total Purchases Hedge Flow Cash Payments Transaction Cost Net Costs Effective Cost Expected Revenue Fuel Margin ($1. For example if the management thinks that there has been a sharp rise in the prices recently.769) $112.250) ($1. rESuLtS oF thE hEdgE ProgrAM The hedge was put in at $1.85% .3067 $7. while still allowing room to maneuver at the tactical level.556 18.
This whitepaper is authored by Moazzam Khoja. i.7 use of Cash Flow at risk in Making Intelligent hedging decisions the transaction costs . what instruments we should use. the success is judged by how the hedge achieved its objective when it was put in place. no one has a crystal ball to know where fuel prices will actually end up. “what is the consensus opinion on the outcome of commodity prices in future?” By using such a statistical measure. it will offer assurance to the company’s debtors that the company has a sound process that will protect their investments and.e. but whether they achieved what they were mandated to achieve. swaps. The success of a hedge program is not judged by the lowest fuel margin possible! rather. the hedge program was successful.the difference between the fair market value and the offer price of the dealer . The cash flow at risk methodology can also be used to apportion the total hedge volume to several instruments like. an end user or a producer of a commodity can devise a hedge strategy that has a rational foundation and takes management’s personal opinions of the decision-making process into account. the success of any hedge program should be judged by whether it met the hedge objectives.75% of the revenue. The cash flow at risk tool and the fuel margin concept can be further applied to answer other critical questions for the management such as how much to hedge.are assumed to be $0. lastly it will reduce potential conflicts among management and give them confidence in making these types of hedging decisions. This hedge actually achieved an 18. Cash flow at risk is a tool that can provide this methodology.34% fuel margin. etc. Second. He has worked for the past eight years in the commodity risk management area including structuring of complex derivatives in energy and credit products. As the table demonstrates. ConCLuSIon An effective risk management policy requires an objective and statistically sound methodology. please contact avantgardinfo@sungard. the airline’s objective was to keep the fuel margin at 18. Please note that the hedge policy could have been more efficient if other hedging instruments like options were used. options.005/gallon. therefore. . a company’s board should judge management not by whether they ‘beat’ the market.com. For more information. etc. using the above approach will have several positive impacts for a business. it will provide confidence to the company’s shareholders that the company has a well disciplined process to manage commodity risk. He obtained his MBA from the Columbia Business School in 1996 and his chartered financial analyst designation in 2003. CFA. a subject matter expert in risk management solutions at SunGard. First. It answers the most pressing question facing the company.
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