Extending Relative VaR into the Corporate World

By following a Value-at-Risk approach in a corporate framework. Senior Managers can compute the cost of economic capital, including goodwill, the probabilities of falling short of specific targets such as earnings or they can measure the probabilities of success and costs associated with risky projects.

Business VaR provides an opportunity to measure the likelihood of any business opportunity. 

• Cost of Capital, where capital at risk is computed by discounting earnings at risk with the rate of return
• Earnings at Risk (EAR) : Sale volumes or revenues denominated in different currencies 
• Balance Sheet Translation Risks BSTR (such as borrowing or investing funds in different currencies.
• Cash-flow at risk (CFAR).
• A strategic investment, a large stake in a company.
• Realization Risk. 
• Event Risk: Dependency against business risk (sales, commodity prices, exchange rates levels, taxes, lawsuits, catastrophic events, etc.

Differences with Computing Value-At-Risk

1. The Target
   
   In practice business VaR is similar to Benchmark VaR but with a different twist:
   Instead of selecting a benchmark against which we will measure returns, we specify a target from which we will measure the outcomes (the chances of reaching this target or of falling above or below. 
   In this case the target is usually deemed strategic, such as a budgeted amount, a profitability level, a breakeven rate, a return target, an estimate from an analyst.etc.

    

2. The Calculation of Expected Values
   
   Corporate returns are based on much longer horizons than pure investments. Additionally, there is seldom a market from which we can source prices directly, worse there are no industry standard fair value models but rather case by case proprietary models, if any. The approach might sound daunting, but there is actually a solution:
   
   1. For long term simulations, We begin by computing confidence bands on projections For each projected price or level (fx rate, borrowing cost, we obtain a maximum and minimum bands.
   2. We then incorporate the business risk such as sales projections, foreign exchange dependency, cost of borrowing, return on investments etc.
   3. From this we can estimate the worst case and best case scenarios. In a multivariate Framework this should lead to a full Monte-Carlo simulation combined with what-if scenarios and stress tests. This is especially important, since correlation might not be always reliable and combined risk might actually be higher than their individual parts! (an anomaly well known to credit risk professionals).
      
      If data is not available or is too scarce, a solution is to select a series of proxies that can be used to gauge levels and volatilities. There are actually many techniques to extract the information you need from proxy data.
      
      
      
      

3. Interpretation of Results

   The Final outcome depends on the analysis. This could be earnings at risk, cash flow at risk,  targets from budgets, estimates of Earnings or losses:  
   You have 95% chances of falling within 2 mio for one project or 99% chances of falling 250 000 below the estimated budget for each quarter during the next 5 years. (i.e. with the risk that one quarter out of 20 (i.e. 5 Years) will go beyond that limit...)
   

   This means that a senior manager can assert with a given confidence level that his earnings or cash flows will not fall short of a forecasted or budgeted amount or that one project presents significant advantages with regard to other projects that carry the same risks.

Typical applications

• Assessing the impact of currency fluctuations on the sales, which in turn affect earnings and subsequently cash-flows at risk
• Assessing the impact of competing sales and marketing campaigns.
• Assessing the Risk of creating unsustainable exposure, be it direct or indirect exposures such as loans or inventory.
• Measuring Correct corporate sensitivity by balancing equity & fixed income ratio + stock options, convertibles & reverse (equity swap).
• Accommodating unforeseen losses due to external events,
• Hedging unwanted exposure.
• Any decision that affects goodwill and the long term profitability of the company.