Project Risks and Associated

Hedging
Session 13 + Session 14
Lifecycle of a project…

• Companies submit Technical Bid and Financial Bid simultaneously in

separate sealed envelopes
• Technical bids are opened first, evaluated and companies that meet
technical threshold / requirements are declared qualifying companies
• For qualifying companies, Financial Bids are opened and evaluated
• Lowest financial bid is declared L1
• Project is awarded to L1 bidder

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Lifecycle of a project… (continued…)

• While making Financial Bid, various assumptions need to be made:

• Project execution phase
• Timeline estimates
• Build-out cost estimates

• Revenue phase
• Concession period / availability period and Traffic estimates
• Maintenance capex estimates

• Typically, profit margins are low: 8% to 10% range

3
Lifecycle of a project… (continued…)

• While making Financial Bid, various assumptions need to be made:

• Project execution phase
• Commodity Price Risk
• Timeline estimates • FX Risk
• Interest Rate Risk
• Build-out cost estimates

• Revenue phase
• Concession period / availability period and Traffic estimates 1. Risk Identification
• Maintenance capex estimates 2. Risk Measurement

• Typically, profit margins are low: 8% to 10% range

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Lifecycle of a project… (continued…)

• While making Financial Bid, various assumptions need to be made:

• Project execution phase
• Timeline estimates 3. Risk Management
Mandate • There is hardly any
• Build-out cost estimates room for error!
• High operating leverage
• Revenue phase
• Concession period / availability period and Traffic estimates
• Maintenance capex estimates

• Typically, profit margins are low: 8% to 10% range

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Lifecycle of a project: Added Complexity #1
 Technical Bid submitted  Lowest Financial Bid
 Financial Bid submitted (L1) announced

01 03

02 04
 Technically qualifying  Project is awarded to L1
companies announced bidder
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Lifecycle of a project: Added Complexity #1
(continued…)

 Technical Bid submitted  Lowest Financial Bid

 Financial Bid submitted (L1) announced

01 03
Timelines = 1 week to 12 months
Timelines = 1 week
to 1 month

02 04
 Technically qualifying  Project is awarded to L1
companies announced bidder
7
Lifecycle of a project: Added Complexity #1
(continued…)

Added Complexity #1
• Timelines for bidding process can stretch anywhere from few weeks to 12
months!
• Since the financial bid (with all its FX / Rates / Commodity price
assumptions) is already submitted on Day 0, it can lead to significant
market risk for companies
• Financial Bid cannot be changed further, even though large market moves take place!

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Lifecycle of a project: Added Complexity #1
(continued…)

• One potential solution can be to just fully hedge the market risks,
when submitting the bid
• But that can possibly lead to bigger problems…
• Why?

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Lifecycle of a project: Added Complexity #2
 Technical Bid submitted  Lowest Financial Bid
 Financial Bid submitted (L1) announced

01 03

Hedges are put in place 02 04

 Technically qualifying  Project is awarded to L1
companies announced bidder
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Lifecycle of a project: Added Complexity #2
(continued…)

 Technical Bid submitted  Lowest Financial Bid

 Financial Bid submitted (L1) announced

01 What if the company does

03
not qualify on technical bid?

Hedges are put in place 02 04

 Technically qualifying  Project is awarded to L1
companies announced bidder
11
Lifecycle of a project: Added Complexity #2
(continued…)

 Technical Bid submitted  Lowest Financial Bid

 Financial Bid submitted (L1) announced

01 03 What if the
company is not the
lowest bidder?


Hedges are put in place 02 04
 Technically qualifying  Project is awarded to L1
companies announced bidder
12
Lifecycle of a project: Added Complexity #2
(continued…)

• If company does not win the project (either due to technical

disqualification or due to not being the lowest bidder), then company
has no underlying business risk exposure!

• However, with hedges already in place at inception (i.e. done at T=0),

company is now exposed to large market risks!

13
Lifecycle of a project: Added Complexity #2
(continued…)

• Unwinding of existing hedges can have large cash flow implications

for the company
• Large market moves can lead to significant MtM (Mark-to-Market)

• Cash outflow (due to hedge unwinding) coupled with loss of future

revenue (due to a unsuccessful bid) is nightmare!

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How to manage market risks for projects…?

Probability
+
OTM Options
+ +
Forwards / Swaps
+
Real Options

Note: OTM Options stands for “Out-of-The-Money Options”

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Use of Probability

• Use of additional competitive information to assess probability of

winning a bid
• Which competitors are bidding for the same project
• Competitor’s track record on similar projects
• Capacity utilization at competitors
• Recent financial performance of competitors
• Raw material sourcing policy and EXIM benefits enjoyed by competitors

16
Use of Probability (continued…)

• Basis these factors, treasury (along with project team) can make
educated estimate of probability of winning that bid

• At ‘Risk Measurement’ step, in addition to underlying risks, we need

to factor in probability of winning to arrive at ‘Calibrated Risk
Measurement’

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Use of Probability (continued…)

• With passage of time, as bid evaluation progresses, we need to re-

assess the probability of winning the bid

• Using freshly assessed probability, we need to recalibrate ‘Risk

Measurement’ and rebalance the hedges immediately

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Use of OTM Options + Forwards / Swaps

• “Money-ness” of an Option
• Strike price of an option relative to current price of underlying asset

• Examples
• In-the-Money (ITM) Option
• At-the-Money (ATM) Option
• Out-of-the-Money (OTM) Option

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Use of OTM Options + Forwards / Swaps
(continued…)

• Out-of-the-Money (OTM) Options

• Strike price away from current Spot price
• Call Option: Strike Price higher than Spot Price
• Put Option: Strike Price lower than Spot Price

• Cheaper than ATM or ITM Options

• Typically used as insurance or as Worst-Case-Protection

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Use of OTM Options + Forwards / Swaps
(continued…)

• Choosing the strike of an OTM Option

• Balance between strike (worst-case protection) and cost of option (hedge
cost)

21
Use of OTM Options + Forwards / Swaps
(continued…)

• Portfolio Optimization using OTM Options and Forwards / Swaps

Expected Hedge Rate

(Net of hedge cost)

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Real Options

• Choices at disposal of a corporation with respect to business

investment opportunities
• Called “Real” Options
• Because it involves choices between tangible assets, potential projects, new
technologies, plant and machinery
• Because these are not financial instruments

23
Real Options (continued…)

• Examples
• Option to expand
• Option to abandon
• Option to wait / defer an investment
• Option to switch

24
Real Options (continued…)

• Examples
• Newbuilding Option
• Charterer's purchase option
• Charterer's charter option

• Used extensively to optimize costs, achieve economies of scale and

enhance RoE

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Disclaimer
• This presentation, including all references / links / related material, is intended to be used and must be used for
informational and educational purposes only.
• The purpose of any discussion / presentation is for analysing, learning and discussing general and generic information,
and should not be construed as financial advice, tax or legal advice, or advice of any nature whatsoever.
• The views and opinions expressed are those of the authors and do not necessarily reflect the official policy or position of
any other agency, organization, employer or any company.
• The author cannot be responsible for use of the information contained in or linked.
• The author is not responsible for any errors or omissions, or for the results obtained from the use of this information. All
information is provided as-is, with no guarantee of completeness, accuracy, timeliness or of the results obtained from the
use of this information.

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