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Inflation Houston 2010

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Overview of US inflation situation presented at the annual ACI conference in Houston

Overview of US inflation situation presented at the annual ACI conference in Houston

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    Inflation Houston 2010 Inflation Houston 2010 Presentation Transcript

    • INFLATION – UNCERTAINTY Bjornar Eide Strategic Risk Consulting (SRC)
    • Energy companies are faced with many risks, but perhaps one of the least talked about exposures is the risk of inflation and how it relates to the general energy pricing picture. This presentation will focus on how identification, monitoring and management processes can enhance the control of inflation exposure. a) Definition of inflation exposure b) Identify dollars exposed to inflation within their operating structure c) Understand the market place for inflation d) How to use hedging instruments such as TIPS, Inflation Swaps and non-linear alternatives e) Utilize risk measures in the overall communication of inflation exposure f) Incorporate inflation risk metrics in the overall risk reporting process
    • Budgeted net interest on the public debt was approximately $240 billion in fiscal years 2007 and 2008. This represented approximately 9.5% of government spending. Interest was the fourth largest single budgeted disbursement category, after defense
    • The debt is projected to nearly double to $20 trillion by 2015, but is expected to increase to nearly 100% of GDP by 2020 and remain at that level thereafter
    • Inflation Situation (The Keynesian view)  Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, “What is the current etc. balance between federal spending,  Cost-push Inflation, also called "supply shock inflation," is the US dollar and caused by a drop in aggregate supply (potential output). This unemployment?” may be due to natural disasters, or increased prices of inputs.  Built-in inflation is induced by adaptive expectations, and is often linked to the “price wage/spiral”. It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle„.
    • “Inflation is referred to as a rise in the general level of prices of goods and services in an economy over a period of time”. Source : Wikipedia Encyclopedia a) A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the consumer price index over time (CPI/CPURNSA), Personal “Is our exposure a Consumption Expenditures Price Index (PCEPI) and the GDP result of desired Deflator. indexation ?” a) The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities and financial assets. The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Asset price Inflation is a rise in the price of assets, as opposed to goods and services.
    • Identification of dollars exposed (Hedging Item – CPURNSA, the dependent variable) “Do our i. Identify contract with known escalation clauses accounting tied to CPI or CPI related components. system, data ii. Separate between labor and non-labor cost / warehouse or revenue components. other data depositories allow iii. For expense / revenue components not tied to for a break-down escalation clauses or/and FX, fixed income or of cost / revenue commodity related components but still subject to escalation periodic renegotiations, compute the correlation components?” coefficient to the monthly CPURNSA index. iv. Cash flow map dollars identified by linear and non linear characteristics to the CPURNSA index.
    • Sample of how to identify dollars exposed and contributing factors “The cash flow Source Labor/Non Duration Dollars Delta map should Labor break down the monthly linear / Insurance Labor 3.4 Years $950 MM 0.85 non-linear Benefits Labor 5.2 Years $1,240 MM 1.00 exposure against the CPURNSA Contract XX Non-Labor 6.4 Years $ 750 MM 1.00 index.” Contract XX Non-Labor 4.3 Years $ 250 MM 0.45 Contract XX Non-Labor 2.5 Years $ 345 MM 0.56 Contract XX Non-Labor 5.4 Years $ 450 MM 1.00
    • Market Place for Inflation Products (Hedging instruments) “Break-even inflation TIPS is the difference between the nominal Treasury Inflation-Protected Securities (or TIPS) are the yield on a fixed-rate inflation-indexed bonds issued by the U.S. Treasury. The investment and the principal is adjusted to the Consumer Price Index, the real yield (fixed commonly used measure of inflation. The coupon rate is spread) on an constant, but generates a different amount of interest when inflation-linked multiplied by the inflation-adjusted principal, thus protecting investment of similar the holder against inflation. TIPS are currently offered in 5- maturity and credit year, 10-year and 30-year maturities. The U.S. Treasury quality” replaced the 20-year maturity with the new 30-year maturity in February 2010.
    • Market Place for Inflation Products (Hedging instruments) “Current market liquidity has limited the availability of non-linear alternatives such as options on swaps or TIPS”
    • Spread between TIPS and Inflation Swaps (Mark up)
    • TIPS, Inflation Swaps and Non- Linear Alternatives Pros Cons “Current market Principal is adjusted by Initial cost + holding cost liquidity has limited TIPS CPI creating hedge of bond needs to be the availability of non-linear effectiveness. Bond can financed in full. alternatives such as not mature less than face options on swaps or value. TIPS” SWAPS Initial cost and holding Mark up against cost based on initial alternatives (TIPS) of 40- margining / maintenance 50 bps + liquidity margin under ISDA requirements agreements.
    • Sample of how to use inflation products to off-set inflation items Dollars Exposed Duration Hedged - Inflation Dollar Off-sett Residual Risk Instruments Ratio (10 Day Var) $ 450 MM < 1 Year $250 MM 56% $1.3 MM $ 650 MM 1 -3 Years $250 MM 38% $2.6 MM $ 1,000 MM 3- 5 Years $500 MM 50% $3.9 MM $ 1,500 MM 5-10 Years $ 500 MM 33% $8.9 MM $ 7,500 MM 10-30 Years $ 1,000 MM 13% $77.7 MM
    • Sample of how to use inflation products to off-set inflation items Duration – 5 years, Based on a $2billion NPV exposure “S&P Liquidity Requirements under margin accounts Strategy Residual Risk S&P Liquidity Holding Cost must be scaled for VaR (10 Day) 20% Shock Strategy initial margin (20%) and maintenance margin (accrued Naked $126 MM $0 $0 P&L)” 50 % TIPS $63 MM $0 $10 MM 75 % TIPS $32 MM $0 $ 15 MM 25% TIPS + $63 MM $24 MM $ 6.2 MM 25% SWAPS 75 % SWAPS $32 MM $73 MM $3.7 MM
    • How to aggregate the overall market risk picture to include the inflation component FX The overall market risk picture is a Equity / Asset function of Inflation Holdings understanding the behavior of inflation relative to other pricing components ERM Fixed Income Diversified Commodity RIsk
    • SUMMARY • CPI - Labor escalation clauses Identify • CPI - Non-Labor escalation clauses • Linear exposed dollars to CPI Quantify • Non-Linear exposed dollars to CPI • Risk Appetite (Limits) Monitor • Liquidity Utilization • Durational inflation curve Manage • Timing and type of hedges
    • BIBLIOGRAPHY  Bjornar Eide was the Director of Risk Management for Sempra Energy Utilities from September 2005 to January 2010. Bjornar oversaw the risk governance structure for San Diego Gas & Electric and Southern California Gas Company. He was a member of the Risk Management Committee for each of the utilities, which is responsible for managing each of the utility’s exposure to market, credit, liquidity and operational risk. Bjornar has over 15 years of experience from energy markets, serving in a variety of capacities in an international environment. Prior to joining Sempra Energy Utilities, he worked as an independent strategic risk consultant for a variety of clients in Europe and the US focusing on strategic risk management related issues and the design of risk assessment capability. As a Director of Risk Management for NRG (from 2000 – 2002) he built up the risk management department and during his four year tenure with Statoil A/S as a portfolio manager, he actively managed positions that involved petroleum products, crude, natural gas & electricity including the build-up of the power marketing department. Eide holds an MBA in Finance from San Francisco State University and a BA in Business Administration from California Lutheran University.