Briefing Note – An Approach to Risk modelling and VAR

When dealing with financial risk, a typical approach would include these three steps: (i) identify the risk (ii) understand and quantify the risk, and (iii) propose risk management alternatives. Most fast-growing, small to medium-sized companies, especially those doing cross boarder business, may be aware they are exposed to adverse moves in foreign currency exchange rates, interest rates or commodity prices, but they may not be aware of the location and magnitude of some of these risks, as well as simple ways of mitigating them. We will explore one approach which can be used when assessing a company's current state. It can also be used to run “what-if” scenarios for mergers, acquisitions, divestitures, or changes to a company's capital structure.

VAR, or Value at Risk, is a useful way of quantifying financial risks. VAR models will stress market inputs – FX rates, interest rates and commodity prices – to see how it effects a company's value or profitability. Most VARs use Monte Carlo simulation to determine most probable outcomes, as well as “worst case” scenarios. The analogy of throwing darts at a dart board thousands of times is useful. If the number of scenarios is statistically significant one can look at the distribution of outcomes. We typically look at the 2 standard deviation worst case, which is a loss amount that would not be exceeded 97.7% of the time. Looked at another way, the loss would be expected to exceed this amount roughly only 1 in 40 times. The inputs of a multi-factor Monte Carlo simulator are the prices or values of the variables being modelled (example, FX and interest rates), their volatility, and the correlations between each variable. Keep in mind that although popular, this is only one way to model market moves. Real life can not always be predicted by models. Take for example the market moves that were witnessed during the financial crisis of 2008-2009. Even model inputs are sometimes “educated guesses”. Would we use historical volatilities and correlations, and if so, over which time periods? Implied volatilities based on option prices quoted on rates and FX can provide the market's view of volatility, but they can sometimes be distorted by market imbalances.

Identification of financial risks is the first step in the process. This is done via an analysis of financial statements and interviews with management and staff. Some risks are easily identifiable. For example, if a Canadian manufacturer has a 2 year contract to buy parts from a US company, and a pre-specified US dollar amount is paid in 24 monthly instalments, then the Canadian company is at risk if the US dollar strengthens versus the Canadian dollar. Other risks are less easy to spot. For example, contracts giving customers the ability to pay CAD 12,800 or USD 10,000 per month gives the customer economic value which can only be hedged using FX options.

The VAR model will allow you to quantify and understand risks by modelling the company's financial data. The analysis is done over a time horizon, say 3 years, and includes some management assumptions of revenue and cost growth over this period. The output of this analysis can be in table or graph form. The information will show the company's sensitivity to various market moves. For example, if a 2 standard deviation appreciation in the US dollar reduces revenues 10%, management may decide that is too much risk and may hedge all or some of it. If management is comfortable with this potential volatility, it may decide there is nothing to do.

It is typical that companies put in place hedging policies or guidelines, specifying what risks should be managed and how. This framework allows the board of directors and management to agree on how risk is to be dealt with and reduces the possibility of negative surprises. The policy should also define acceptable hedging instruments to be used, ensuring the internal infrastructure is in place to manage and account for trades properly. Lastly, an execution process should be put in place to ensure pricing is transparent and competitive.

This information is purely illustrative, using simplified examples for educational purposes only. For more information, please contact me at edmurphyconsulting@gmail.com