Hedging - A way to manage risk and create certainty
Risk Management
Options: What are they?
Examples: REC Seller - Buy a Put
Examples: REC Buyer - Buy a Call
Examples: Sell a Call
Accounting
Legal, Tax, Credit Risk & Market Risk
Looking Forward
Hedging – A way to manage risk and create certainty
Options are nothing new in the world of the generic suite of products used by clients to manage exposure worldwide. Nextgen have been actively dealing in the local options markets for quite some time now in both RECs and NGACs and are currently developing structures around both AEUs and CERs.
Hedging is like a form of insurance, which allows companies to protect against, or at least manage, a risk that may directly affect their bottom line. In conjunction with their financial advisers, clients should have a process for identifying their risks and for determining which hedging strategy and which tools, such as forwards and options contracts, they need to use.
Locking in prices not only removes exchange risk but can guarantee a profitable transaction. This creates synergies on many levels within the company. With more certain cash flows, management can more accurately budget and more efficiently allocate funds across the business. In general, banks are a lot more comfortable extending credit to companies that show awareness of and a willingness to address the risks that affect their business.
However, there are two issues in hedging. One is the opportunity cost that may be a profit forgone on a beneficial price movement. The other cost is that of paying the interest differential on forward rates or the premium on options. The decision to hedge or not to hedge may then come down to an assessment of the stability of the relevant prices and of the transaction costs of hedging.
For the larger companies, the question is not whether to hedge or not to hedge all exposures, but what proportion should be hedged. Any decision here should relate to the nature of your business and any natural offsets that you can recognize within your diverse portfolio of interest rate and commodity exposures. This becomes a measure of “Cash Flow at Risk”.
As it is the role of management to ensure the ongoing viability of a business, management should be addressing any risks that materially affect the company’s profitability. Ultimately, it comes down to how much risk the company’s owners want to bear.
The key issue is to put in place policies regarding hedging that are consistent with the company’s strategy and to communicate these policies to stakeholders. If greater certainty of cash flow is required, then hedging can remove some of the major risks than a company faces…
Risk Management
Options can be easily managed by in a manner that is consistent with the current risk management policies and procedures of the company. This is not a new product and does not require a separate management process, rather an additional few steps within the current risk management process.
As every option deal will be of a different nature in regards products and tenor (very similar to a forward deal) a separate sign-off procedure for each deal would become onerous to manage.
Nextgen can work with you to manage these products in such a way as to not expose the company to any additional risk.
The process would normally follow these steps:
- Assess the company risk portfolio to determine their requirements for spot, forwards & options.
- Create/Design an options structure.
- Ensure structure falls within the company’s limits and tenor structure.
- Present a hedging solution to management.
Options can take many forms and the same structure can be called many different and varied names. However the credit implications can have only two outcomes:
If the company purchases an option and pays a premium, there would be no credit usage and no liability to the company. That is, in this situation the company has the rights.
If the company sells an option there will be some usage of our credit limits and some contingent liability which is very much similar to a forward transaction.
Options: What are they?
- A bought option contract is the right but not the obligation to transact a commodity (RECs) at a fixed price and fixed date in the future.
- A sold option contract is a contingent liability to make good this contract under certain conditions ie. If you are exercised.
- It is called an option because the buyer is not obliged to exercise the contract, if for whatever reason they choose not to (as in the case of a tender).
Options can be a form of “price insurance”.
Examples: REC Seller – Buy a Put
- Looking first at the “price insurance” benefits of options:
- If for example, you were to buy a Put at $50.00 in the Cal09 for RECs 50,000.
- At expiry in January 2010 if the spot price was above $50.00 you would sell your RECs at the market price on the day.
- If however, the spot price was below $50.00 at expiry you would have the right but not the obligation to sell your RECs at $50.00.
- This would thus provide a form of “price insurance” in that your worst case scenario would be your ability to sell your RECs at $50.00.
Examples: REC Buyer – Buy a Call
- If for example, you were to buy a Call at $50.00 in the Cal09 for RECs 50,000.
- At expiry in January 2010 if the spot price was below $50.00 you would buy RECs at the market price on the day.
- If however, the spot price was above $50.00 at expiry you would have the right but not the obligation to buy RECs at $50.00.
- This would thus provide a form of “price insurance” in that your worst case scenario would be your ability to buy RECs at $50.00.
Examples: Sell a Call
- Additional Revenue Stream or as part of a structure;
- If for example, you were to sell Calls against your expected production of RECs and sold the Cal09 $50.00 Call you would receive around $5.00 per REC in today’s money.
- At expiry, if the spot price of RECs was above $50.00, you would have a contingent liability to sell RECs at $50.00.
- If however, at expiry the spot price of RECs was below $50.00 you would bank the premium and the option would expire un-exercised. Thus adding an additional revenue stream to your business.
- In this example, if you were exercised, I would expect that you would be quite happy as you would have sold a portion of your book at this level if the opportunity were to arise.
You can also put these two deals together in the form of a “Collar”. Please ring the Dealing Room on +613 8684 2300 for more information.
Accounting
In relation to international accounting standards, the IASB have taken the view in IAS39 that certain transactions are simply not eligible for hedge accounting. It is useful to be aware of these and with this in mind, all hedging solutions outlined from Netxgen will be IAS39 compliant. IAS39 guidelines do not consider net written options to be hedging instruments as they are not considered to limit or reduce risk.
As part of a single instrument a written option can be included provided that the instrument is not a net written option in total ie. Collars & Risk Reversals, Smart Forwards & Knock-In & Knock-Out Barriers etc.
Legal, Tax, Credit Risk & Market Risk
These issues should all be handled under the existing guidelines of the company.
Looking Forward...
Looking ahead, the continued development and support of the CPRS in Australia provides some insight into how Options will increasingly be employed in the carbon market. The primary strategy behind carbon derivatives will likely continue to be the pre-emptive hedging of perceived risk. This makes perfect sense when you consider that trading in the carbon market, without employing Options to offset your risk against adverse and dramatic price movements can be considered to analogous to driving without car insurance.
As an example, if you were to buy a Put, this is an asset that effectively accrues value as the underlying asset loses value, thus insuring against unexpected adverse price movements.
Looking beyond Options, when the local market is more developed, we may see a situation in which participants are able to trade the disparity in price between RECs and AEUs via the swap market. When the two markets diverge to trade beyond certain parameters, which may be inconsistent with what some perceive as value, arbitrageurs may then move in and attempt to exploit the differential in price and in doing so provide a two-way counter flow in respect to the instruments thus increasing liquidity in the separate contracts.
Ultimately, these types of more complex trades and the resulting increase in volatility will help to facilitate a more robust two-way flow driven market. This also has the general flow on effect of generating more liquidity as market participants are instigating theoretically larger positions in the confidence that they can get in and out of the market much more easily.
Another example of an arbitrage style trade approach which has a direct effect on volatility comes from Option traders who employ the volatility based market maker strategy, usually called a volatility book. Using the combination of Call and Put Options in conjunction with futures, they effectively trade Options in a similar way to a traditional bookmaker. The traders look to return a small but regular spread profit. Their need to dynamically Delta hedge their Option positions thus creates further liquidity in the underlying contracts and can also arguably provide some resistance to the flow of the market. View the current market on NGESOPTIONS if you have Reuters or in the members area on our website.
