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<title>How to Stop Giving Away Free Options</title>
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<td width="75%" valign="top"><big><b><big><big>How to Stop Giving Away Free Options</big></big><br>
<big>& Learn to Love the Market</big></b></big><p><strong>by David C. Shimko --
Bankers Trust Company<br>
</strong><font face="Arial" size="2">(<em>originally published by PMA OnLine Magazine:
03/98</em>)</font></p>
<p>The power marketer’s day begins innocently enough. Management wants to increase
electricity market share without cutting prices. A megawatt-hour of power trades on the
screen at $25. Everyone can see the screen, and competition is fierce. Sales above $25 are
impossible, and sales below $25 are unprofitable. How to gain market share without
incurring paper losses?</p>
<b><p>How it happens</b></p>
<p>One competitor’s commodity product cannot be easily distinguished from
another’s --- hence they differentiate their product using innovative contract
features. For example, an option to extend the deal another three months may be granted to
the buyer to make a deal more attractive. But the deal can’t be sold above $25, since
that is what the competitor offers for a flat fixed-price deal without the option. So the
deal closes; $25 for fixed-price power with a free option to extend for three months. The
power marketer is a winner. He gets the deal, increases his paper profitability and his
market share, while his competitors suffer. The death spiral begins.</p>
<p>Competitors are shrewd, and will not be undersold. One offers $25 power with options to
"swing" or alter the volume, meeting a customer’s full requirements without
charging extra for the privilege, <i>in addition to</i> the option to extend the deal
three months. A second competitor offers options to swing, extend <i>and</i> cancel, all
for $25. To keep up and build market share, the power marketers continue to add more and
more options, while keeping the selling price at pre-option levels. The death spiral
continues.</p>
<p>At the end of the day, a power marketer is left with a book of trades with innumerable
sold options, options that may never be worth anything, saving the day for the marketer
who sold them. But for some unlucky marketers, the options will be exercised, turning an
invisible paper position into hundreds of millions of dollars of actual losses.</p>
<p>Not bad for a day’s work. The power marketer may be fired, only to be hired by
another desperate firm the next day. Management finds itself left with the chore of
explaining the shortfall to a confused press and unforgiving shareholder base. A few
companies go into default, to be picked up for a song by former competitors. Or, if
everyone writes the same options, and the market moves significantly, the entire industry
finds itself underwater. And we know the dangers of conducting electricity business
underwater...</p>
<b><p>How to stop it</b></p>
<p>The following three steps are essential to prevent a marketing death-spiral:<ol>
<li><i>Reecognize and measure option value. </i>Management has few options, if you’ll
pardon the pun. Marketers must know the value of options they are giving away. If power is
to be sold cheap to build market share, then at a minimum, managers must know the cost of
building market share. Every contract written by every marketer must be screened for
hidden options, and the profitability of each trade must be measured based on the profit
margin after considering option costs.</li>
<li><i>Find and measure risks</i>. Most power marketers do not explicitly incorporate
contract risks into contract pricing. This is acceptable to the extent that these risks
can be hedged. Yet, the unhedgeable risks (basis, term and credit) are often finessed and
not adequately incorporated into contract prices. Unhedgeable risks must earn a return
suitable to an ongoing risk-taking activity.</li>
<li><i>Adjust performance measurement for sold options and risks taken.</i> No-one will take
option valuation or risk assessment seriously unless their compensation is tied to the
value of options they give away and the risks they take. Marketers should be held to the
standard of profitability after adjusting for options and risk. </li>
</ol>
<b><p>An ironic ending</b></p>
<p>After following these three steps, you will find it is impossible to do business.
Ignorance is blissful while it lasts. Power with options attached may be worth $28 instead
of $25, and you should not sell power at a $3 loss. These types of losses cannot be made
up in volume. And it would be hard to argue that the market share gains are worth it ---
can anyone guarantee customer loyalty in electricity, the ultimate commodity product?</p>
<p>So should you do deals at a loss, or wait by the sidelines? The following table
summarizes the power marketing decision --- showing the outcome of each decision if the
options move against the seller or for the seller:</p>
<i><p>Choosing for or against doing deals with free options:</i></p>
<table BORDER="1" CELLSPACING="1" CELLPADDING="7" WIDTH="98%">
<tr>
<td WIDTH="33%" VALIGN="TOP"> </td>
<td WIDTH="33%" VALIGN="TOP"><b>Options movement:</b></td>
<td WIDTH="33%" VALIGN="TOP"> </td>
</tr>
<tr>
<td WIDTH="33%" VALIGN="TOP"> </td>
<td WIDTH="33%" VALIGN="TOP"><u>In favor of seller</u></td>
<td WIDTH="33%" VALIGN="TOP"><u>Against seller</u></td>
</tr>
<tr>
<td WIDTH="33%" VALIGN="TOP"><b>Do deals</b></td>
<td WIDTH="33%" VALIGN="TOP">WIN BIG</td>
<td WIDTH="33%" VALIGN="TOP">LOSE BIG</td>
</tr>
<tr>
<td WIDTH="33%" VALIGN="TOP"><b>Do not do deals</b></td>
<td WIDTH="33%" VALIGN="TOP">LOSE OPPORTUNITY</td>
<td WIDTH="33%" VALIGN="TOP">DO NOT LOSE</td>
</tr>
</table>
<p>If you do deals, you may win big if options are unexercised, but will lose big if
options are exercised. If you don’t do deals, you minimize your losses, but
you’re out of the game and have no chance at all to win. Ironically, the only choice
is to do deals!</p>
<p>The strategy of "doing deals" has worked in the insurance industry, where
declining underwriting margins lead insurers to increase asset risks, without major
blowouts. The savings & loan industry was not as fortunate --- shrinking margins and
higher risk levels (with some bad luck) capsized the entire industry.</p>
<p>To avoid repeating the S&L debacle, take the time to educate your competitors, your
staff and your clients about embedded options, hidden risks and their unmeasured values.
The more we know the value of these options and the size of these risks, the less willing
we will be to �give them away. Clients will appear to suffer in the short run by paying
higher prices for power, but they will benefit in the long run by purchasing power and
options from financially strong firms capable of delivering according to their promises.
What’s the point in winning free options from someone who won’t be able to pay
up?</p>
<blockquote>
<hr width="98%" color="#FFFF00" size="1">
<p><small><strong>David Shimko</strong> is a principal in Bankers Trust's award-winning
Risk Management Advisory group, specializing in risk management consulting to the power
and energy industry. Prior to joining Bankers, he held trading floor and risk management
positions at JPMorgan. </small></p>
<p><small>A former asst. professor of finance at the University of Southern California,
Shimko has authored over 50 publications in the areas of strategic risk management and
asset valuation, including a PhD level textbook, Finance in Continuous Time: A Primer.
Shimko is a monthly columnist appearing in Risk magazine. </small></p>
<blockquote>
<p><small>David Shimko</small><br>
<small>Principal</small><br>
<small>Bankers Trust Company</small><br>
<small>130 Liberty Street, MS 2344</small><br>
<small>New York, NY 10006</small></p>
<p><small>(212) 250-4715 Tel</small> <font color="#000080">|</font> <small>(212)
250-6969 Fax</small></p>
<p><a href="mailto:[email protected]"><small>[email protected]</small></a></p>
</blockquote>
</blockquote>
<font SIZE="2" COLOR="#000000"><hr color="#FFFF00">
<p></font><font COLOR="#000000"><small>Reprinted with permission, David Shimko, Risk
Magazine Advisory group. All rights reserved. Copyright 1998.</small></font></td>
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