Subject: hedging for outage options
From: [email-masked]
To: [email-masked], [email-masked]
Cc: [email-masked]
Date: Mon, 21 May 2001 18:13:00 -0700 (PDT)

as per has mentioned to you, there have been a number o factors working 
against us recently in obtaining insurance for the book.

i was expecting to have a positive response by tomorrow, but the person 
responsible had a baby on saturday, so this may be delayed until later in the 
week. (i had my computer with me in the delivery room for our first child, so 
its possible, (but i didnt for the second)).

one unexpected factor is that aquila has signed exclusive arrangements with 
some of the insurers who could have backed us.  these agreements prevent them 
from doing business with us.

another primary market, ace, is still pissed at me for leaving and going to 
enron, whom they consider a serious threat to their franchise.  this was 
somewhat expected, and i am already starting the groveling process to get 
them to transact with us.

another unexpected situation is the supply/demand imbalance.  given the fact 
that forced outage insurance policies have paid out no more than a few 
million in claims while collecting over $100 million in profits, the common 
wisdom in the insurance industry was that supply would increase and demand 
would decrease.  this year has surprised even me -- demand is as strong as 
ever and supply has not increased.  this is evidenced by the much higher 
margins we have collected on the few selected deals we have done.

we also got started too late in the season, so we did not have a sufficient 
portfolio to attract insurance partners earlier.  i tried to build the 
business too quickly from this position.

of course, my job is not to explain the reasons for things turning out 
differently from what we expected.  the current problem is that i need to 
hedge out our book in a difficult environment.

first, we agreed that we would take action on may 15 if we did not obtain 
reinsurance by that date.  i have halted origination activity in this area, 
which will result in the loss of ~75% of our business.  we are currently in 
final negotiations on 4 transactions, which will then make up our final 
portfolio for this year.  these are among the most profitable deals we have 
seen this year and should be the easiest to hedge.  this will leave us with 
$15 million in revenue and $250 million in total theoretical exposure (P99 = 
$30 million).

second, we agreed that we would not be sitting on a "high gamma" risk going 
into june.  i am still hoping that we get the insurance offer next week, but 
if it is not in place by june 1, we will hedge the book in the underlying 
commodity to gain time for placing the insurance.
this should buy us 2-3 more weeks to finalize the strategy without sitting on 
significant risk.
  
this may also be the best time to talk about our newest hedging strategy.  
when backed into a corner, and deprived of sleep (and food), i usually come 
up with my best business ideas.  since ive had little of either for the past 
2 months, i have been working with alex and larry to develop a generalized 
hedging theory for outage risk.  without going into much detail here, the 
idea is that there is a first derivative with respect to MW (i'm currently 
calling it omega (w = watt)), which is comparable to the delta and gamma 
hedging greeks.  on a single unit, this has no value, but for a portfolio, 
you can compute this omega and apply a combination of static and dynamic 
hedges to equalize your option position, much in the same way the 
black-scholes formula hedges an option with respect to changes in the 
underlying commodity.  for example, when you experience a single outage on 
the system, you increase your position so that you are prepared for the next 
outage.  our preliminary thoughts on this are that it can manage the tail 
risk of a portfolio as well, if not better, than insurance.  the other 
benefit of this approach is that it is much more consistent with the theory 
used by all other traded books to manage risk.  it may also create an entire 
new way of pricing unit-contingent power based on the hedging cost (just like 
B-S is used to value options).  i'm not suggesting that this solves all of 
our problems in the short term, but this development will be significant in 
power trading.  i am working with tim belden this week to apply this theory 
to the massive pacificorp deal, because it is the only way to effectively 
manage that risk.  the total hedging cost using this approach should be less 
than $30 million, compared to the offered premium of $140m.

we can talk about this on thursday, then i'd like to discuss with vince & 
vasant to get their thoughts.