Minimizing the Risk of Shortfall in Cash Flow for Long-Term Service Agreements Provision

Abstract

Long-term service agreements (LTSAs) for the maintenance of capital-intensive equipments like gas turbines, medical equipments, aircraft and locomotive engines, are gaining popularity. A typical LTSA contract, spanning 5-20 years, makes a provider responsible for fully maintaining the equipments. Effective management of LTSAs, using reliability assessment and maintenance strategy, is important since these equipments are vital to basic infrastructure and the economy of a country. Even if a provider utilizes optimal maintenance and operations management strategies, residual financial risks of cash flow shortfalls remain. In this article, a framework for LTSAs risk management is developed to construct hedging strategies that minimize cash flow shortfall risk, while maximizing profit through the life of a contract. Optimal investment decisions for a set of securities are determined to construct the hedging strategies. Using the framework, a combined risk-return objective of the provider is significantly improved by the optimal hedging strategy.