Term Paper On Financial Risk Management

Financial Risk Measurement for Financial Risk Management

Torben G. Andersen, Tim Bollerslev, Peter F. Christoffersen, Francis X. Diebold

NBER Working Paper No. 18084
Issued in May 2012
NBER Program(s):Asset Pricing, Economic Fluctuations and Growth, International Finance and Macroeconomics

Current practice largely follows restrictive approaches to market risk measurement, such as historical simulation or RiskMetrics. In contrast, we propose flexible methods that exploit recent developments in financial econometrics and are likely to produce more accurate risk assessments, treating both portfolio-level and asset-level analysis. Asset-level analysis is particularly challenging because the demands of real-world risk management in financial institutions - in particular, real-time risk tracking in very high-dimensional situations - impose strict limits on model complexity. Hence we stress powerful yet parsimonious models that are easily estimated. In addition, we emphasize the need for deeper understanding of the links between market risk and macroeconomic fundamentals, focusing primarily on links among equity return volatilities, real growth, and real growth volatilities. Throughout, we strive not only to deepen our scientific understanding of market risk, but also cross-fertilize the academic and practitioner communities, promoting improved market risk measurement technologies that draw on the best of both.


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Document Object Identifier (DOI): 10.3386/w18084

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Energy risk management is important because energy is a commodity that is growing in demand worldwide, and speculation related to energy will continue to be active. The activity will be continuously high due to opportunities for energy producers as well as natural and man-made circumstances that influence energy investing. Companies can benefit from establishing an energy risk management program which starts with the support and education of top management and is followed by a careful analysis of a company's risk objectives and energy needs. Companies can also benefit from outside counsel on implementing risk management strategies.

Keywords Asset Valuation; Corporate Finance; Energy Deregulation; Energy Derivatives; Energy Finance; Financial Risk Management; Risk; Risk Management; The Federal Energy Regulatory Commission

Finance: Energy Financial Risk Management


Managing Energy Risk

Energy finance has to do with financial analysis, valuation and trading of positions in oil and gas exploration, production and distribution as well as power companies and energy trading. Energy finance can be highly specialized and complex, requiring specific financial knowledge as well as industry knowledge. According to Chevron Oil CEO John Watson, even on the most seemingly attractive projects, one needs to bake in a big margin of error (Helman, 2013). Some investors look to hedge or find protection against energy risk by investing in certain types of financial instruments that offer protection against price fluctuations. Energy companies may try to protect themselves against price fluctuations by investing in long term energy contracts or by employing trading staff who regularly engage in hedge trading in the energy market (Gerston, 1999).

Investment in the Energy Market

Zaccaria (1999) noted that market volatility is a major risk related to energy investing requiring the cautious to deploy some type of insurance against this risk. Insurance can come in the form of "hedging tools" to protect against rapid price changes. Left uninsured, companies face negative effects on "earnings, cash flow and stock price performance." Complex financial instruments are the typical weapon of choice in energy risk management. These include New York Mercantile Exchange (NYMEX) contracts, over-the-counter (OTC) contracts, call options and weather derivatives. Derivatives are financial instruments that are based on some underlying security. The speculative nature of these tools does not make them complete sources of hedging insurance and one tool may create risk not covered by other tools. Some of the risk may be due to unforeseen energy-related events that cannot be predicted such as supply shortages, power failure or power problems related to natural occurrences. If an option is selected as an investment hedge, the timing of the options expiration may leave the investor exposed.

Energy Insurance

Energy insurance may provide a better vehicle for the risk demands of the energy market. Insurance is needed in energy speculation to cover the natural variance of risk in a market like energy. It also is viable no matter what size the energy company might be. Zaccaria (1999) found that the cost of insurance was much less than risk protection from options in addition to the benefits of being a flexible and familiar choice in risk protection.

Energy Regulation

Another risk in the energy market is the deregulation of the utility industries. Gersten (1999) suggests an "energy risk management program" for companies with high energy consumption needs. Energy deregulation is a risk because it becomes more difficult to predict energy prices. For those who consume a lot of energy, high fluctuations in price could be devastating and unplanned. Companies can insure against energy risk by purchasing insurance or by using electricity based derivatives contracts that provide a hedge against price changes. There are also forward contracts which are similar to futures contracts that are not traded on futures exchanges and are privately negotiated that provide similar protection. Gersten noted that anyone can face energy risk if the energy is purchased from a deregulated supplier and the companies may be unable to pass this cost on to customers. The reason deregulation makes more risk is that demand varies widely and the competitive market's response to demand will be changes in price.

One impact of state deregulation has been power production being separated from distribution resulting in greater exposure to distributors who must purchase large amounts of energy (Gersten, 1999). Unplanned weather changes such as hotter than normal summers or colder than normal winters have become the norm making power consumption needs unpredictable. Under these circumstances, energy companies must provide the required energy to support the demand regardless of how much the energy costs at the moment.

Managing Energy Risk

Energy companies, banks and hedge fund managers are interested in managing energy risk. Energy companies are interested because they have the most to lose from exposure to energy risk and have little opportunity to pass this cost onto customers. Banks and hedge funds are interested because they often engage in financial transactions in the energy market. Both may employ energy traders who regularly monitor energy market activity and construct hedge and risk vehicles to insure against risk.

The Changing Energy Market

Managers of energy risk must understand the changing energy market. Deregulation and the increasing globalization of energy markets can affect energy companies and the level of risk present in the market. Global competition over energy resources creates geopolitical tensions between the world’s major powers (Navon, 2011). Globalization affects the energy commodity markets and can create change in geographic markets. For example, emerging countries have an increasing demand for electricity as they seek to modernize their societies. Developed countries have an increasing demand for energy as their cultures demand more conveniences and create a greater dependence on energy. A few years ago, many business districts in the United States were closed after dark and sometimes on weekends. Today, the United States has a 24 hour, seven days-a-week marketplace increasing the need for energy. Technology improvements have made technology a necessity instead of a luxury in homes, schools and businesses. So, despite improvements in the energy requirements of technology equipment, the increasing quantity of equipment in use has made if possible to work, play, learn longer and has increased the demand for energy. Global warming and unpredictable weather also change the demand patterns for energy. Control of various energy products such as oil can have fluctuations based on political scenarios and muscle flexing by countries controlling oil production.

In the late 1970s and early 1980s, deregulation efforts began in the electric and gas industries to reduce the monopoly and control that energy companies had over these markets. Thottam (2006) noted that Enron — most famous for poor management, illegal practices and causing workers to lose pensions and jobs — should really be thanked for pushing deregulation as a tool to reduce energy costs and for establishing smarter energy risk management. Enron was one of the first companies to use software for energy risk management. Prior to deregulation, electric cooperatives — groups that purchase and manage wholesale power — managed risk in energy prices through negotiating rates on the federal and state level (Tudor, 2003). Energy risk is most potentially damaging to power suppliers who have 70-80% of their normal business risk coming from energy risk (Tudor, 2003). Not having an energy risk management plan in place is potentially costly for energy firms. Tudor gives an example of how dangerous having no plan can be. In the 1990s, cooperative purchasers of power paid a daily or monthly price based on the price of power or natural gas. At low prices, contracts of this type were not risky but when prices multiplied to more than triple the normal cost, the high costs underscored the need for some risk management plan. Another example is of power companies that had agreements that were for a term of a few years and the companies then had to grapple with massive increases once the fixed price contracts expired. Passing that type of cost on to the consumer is impossible because the government would step in before allowing massive increases for consumers.

Creating a Risk Management Plan

Tudor suggests proactive risk management that begins with an analysis of the risk culture of the company and the decisions the company makes. Any change of cultural has to start at the top and must be supported by top management. In order to perform a risk-oriented analysis of management decisions, one must determine if a decision will create risk or lower it. Tudor (2003) suggests six steps to create an energy risk management plan. They include:

  • Establish a corporate culture that emphasizes risk awareness.
  • Identify, analyze and evaluate every risk area faced by the company.
  • Develop a formal policy to establish authority, responsibility and accountability regarding each risk area.
  • Develop procedural mechanisms to monitor and control the risk areas of the company.
  • Develop and disseminate formal risk management reports.
  • Establish specific time intervals to review risk management results and actions taken.

Ignoring risk won't make it go away. Allowing for risk and insuring against it requires a concerted effort that is steeped in a risk aware culture and an understanding of what risk means for a firm. Companies in risky industries such as energy must make risk a priority before it can be effectively tackled. The difficulty with the suggestions for a risk management program is that such a plan increases cost and the complexity of the approach along with making management processes more complex. Tudor noted...

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