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The corporate policy states that options can only be bought, not sold. Many go on to state that trading against long option positions is also unauthorized. However, for many firms that are involved incommodity markets by necessity rather than a desire to profit from them, such as many end use customers, the knowledge necessary to perform dynamic portfolio hedging is not a skill set they desire to acquire.
In a number of investor-owned utilities and end user engagements, we have observed that the corporate risk policy prohibits the hedging group from taking action to trade against long option positions, or to sell options. Our interpretation of that has been that no activity can be undertaken to reduce the hedge ratio implicit in the existing hedging portfolio – one that has been affirmed by the senior management in more than one case. However, this means that reducing the hedge ratio on a long option position – staying delta neutral in option terms as the option goes further out of the money – is against corporate policy. Companies who behave in this manner are treating commodity options as a binary option – as an insurance policy that pays off only at expiration and only if it is in the money.
There are two problems that arise from this position. First, under FAS 133, options have been treated on a mark-to-market basis in the past. If a company is not dynamically managing a long option position, then the mark-to-market P&L shown from a dynamic valuation may incorrectly state the potential profit the company can receive from holding a long option position. In essence, the corporate books can be overstated by the analysis – for example, if an option is bought in a low volatility environment the open market value of the option would go up but the “value” to the company would not. This change in value could be due solely to an increase in the implied volatility in forward option prices without any change in the underlying forward market price. For a company with policies of the type discussed above, this type of change in value is not available to be captured. This then leads to the second problem – in the post-Enron era a company does not want to have a significant misstatement of the corporate financial statements. If a company is not using dynamic portfolio management and if it does not intend to, then reporting hedging activities and results based on dynamic valuations may be incorrect.
A strike report and “death matrix” analysis of potential return on options at expiration could be much more appropriate in this instance. It is recommended that companies that do not allow or intend to allow dynamic portfolio management discuss these issues with whomever performs their regular risk audit or assure that their financial accountant understand these nuances. Volatility Managers would suggest that the regular risk audit be performed by an entity that understands these nuances and the implications of varying analytical approaches and their accounting results. If a company that does not allow dynamic hedging is using dynamic portfolio valuation tools and is using the resulting P&L from those tools to state the impact of hedging on corporate earnings, it is possible this discrepancy has a potential for a misstatement of earnings. Only by aligning the internal analytical structures with corporate policies and processes can a company be assured of providing accurate 10K results.
