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Table of contents
1. VAR: A new tool for corporate treasury........................................................................................................ 1
Bibliography...................................................................................................................................................... 6

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VAR: A new tool for corporate treasury


Author: Chapey, Frederick J, Jr
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Abstract: In recent years, commercial banks have pioneered the development of value at risk (VAR), a new and
powerful procedure for managing risk. VAR was pioneered in response to the fundamental recognition that
managing market risk is a bank's business. VAR seeks to quantify market risk for a bank by measuring the
potential decline in the value of its portfolio associated with a specific level of probability. At Chase Manhattan
Bank, this concept is implemented in a daily VAR report that is seen by the chairman every morning. Its focus is
a single number that represents the largest possible loss that is likely to occur with a 2.5% probability for the
bank's portfolio on that day. Chase's goal is to optimize its risk-return profile by maximizing risk-adjusted
returns. The best and easiest place to begin building a cash flow at risk model is with a firm's strategic planning
model. Building on the cash flow model, the cash flow at risk approach applies the insight of VAR, based
fundamentally on the insight of probability and statistics, to the firm.
Full text: In recent years, commercial banks have pioneered the development of "value at risk," a new and
powerful procedure for managing market risk. Since nearly 90 percent of the trading done at Chase Manhattan
Bank is for customers, we have worked with companies to explore ways in which value at risk (VAR)
approaches can meet the needs of non-financial firms. The goal has been to move beyond the approach to
VAR first developed for banks, so that companies can use the methodologies of VA for other corporate finance
applications, especially managing cash flows. Cash flow, of course, is critical for day-to-day operations and
long-term growth, and maximizing its stability and predictability is a significant benefit.
The growing interest in VAR is driven by several factors. The business environment is riskier than it was 20
years ago, with significantly more volatility in interest rates, foreign exchange rates, and commodity prices. VAR
addresses such risks and enables a company model simultaneously the impact of all market risks it faces.
Moreover, VAR can be employed to evaluate risk management programs. Finally, and perhaps most important,
VAR provides a unique methodology for communicating about risks between risk managers who deal with
market risks daily, and senior executives who must understand these risks in order to set corporate policies.
VAR: Origins as a Tool for Bank Risk
JAR was pioneered by banks in response to the fundamental recognition that managing market risk is a bank's
business, where market risk is defined as any unanticipated change in the value of financial instruments and
positions arising from shifts in interest rates, foreign exchange rates, and commodity prices. VAR seeks to
quantify market risk for a bank by measuring the potential decline in the value of its portfolio associated with a
specific level of probability.
At Chase, this concept is implemented in a daily VAR report that is seen by our chairman every morning. Its
focus is a singe number that represents the largest possible loss that is likely to occur with a 2.5 percent
probability for the bank's portfolio on that day. Thus, a $1 million VAR would mean that the probability of a loss
greater than $1 million on a given day is 2.5 percent. Chase's 2.5 percent probability threshhold reflects a
carefully chosen risk tolerance. A firm with a greater appetite for risk could work with a larger number, while a
more risk-averse firm could select a smaller number. Note that Chase's VAR does not imply that the bank will
not see a loss greater than $1 million; rather, it implies that it will only see a loss that size on 25 days out of
every thousand. VAR itself does not limit risk; instead, VAR provides information so that risks can be
understood and appropriate actions taken in response.
Chase's goal is to optimize its risk-return profile by maximizing risk-adjusted returns. To this end, the daily VAR
report breaks down the bank's overall value at risk by geography, instrument, and risk type, and it shows
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composite VARs for the bank's main businesses. In total, more than 50 different ways of looking at risk are
reported. The report also shows the accuracy of the previous 10 days' risk forecasts and measures returns
against risks taken. VAR even allows risk to be monitored down to the level of the individual trader.
VAR: A Spectrum of Applications
As Chase has looked at risk from many different angles, a family of risk concepts has developed, which
embraces a variety of risk management objectives. Depending on the objectives chosen, VAR models can be
viewed across time horizons and asset classes. At one end of the spectrum is the daily mark-to-market
valuation of readily traded financial products. VAR as practiced by banks applies to this end and is most
applicable to firms whose value is determined by the market value of these assets. The daily mark-to-market
approach is suited to trading financial instruments, reflecting the dynamics of price movements in financial
markets.
Within the VAR spectrum, one can apply the same tools to look at risk from the alternative perspectives of
earnings, investment return, stock price, or cash flow at risk. These perspectives are useful for many different
missions. For example, investment return at risk is useful to pension funds evaluating the performance of
individual portfolio managers. A VAR approach might also evaluate ROI for corporate investment projects such
as building a plant overseas or R&D expenditures.
These different applications of VAR concepts involve different perspectives on the meaning of risk.
Consequently, it is critical for a company to determine which dimensions are important. What matters most is
often expressed in corporate objectives, such as maintaining quarterly dividends, achieving a specified return
on assets or equity, or optimizing the debt structure. VAR techniques can then be tailored to measure and
support desired objectives.
Cash Flow at Risk
Or many industrial companies, the most meaningful perspective will be cash flow. Unlike financial institutions,
most corporations don't actively trade a large portfolio of financial instruments, and heir time horizon is longer,
not daily. The instruments they hold are mostly for hedging purposes.
The non-financial assets and liabilities found in many firms don't lend themselves to a mark-to-market approach
Moreover, the value of industrial firms is largely determined by future cash flows--the firm may not even have
any assets in place--as well as other growth options such as new product development, acquisition
opportunities, etc. Taking this perspective, Chase has worked with a number of firms such as Pennzoil
see sidebar
to apply VAR techniques.
The Company's Cash Flow Model
A basic model of the company's cash flows is the starting point for such an analysis. All cash flows have five
primary characteristics: magnitude, direction (income or expense), timing, quality (i.e., certainty), and currency.
Models at various levels of sophistication can be developed to capture these characteristics: an important early
issue is clarifying the purpose of the analysis and who will use the findings.
The best, and easiest, place to begin building a cash flow at risk model is with the firm's strategic planning
model. The planning model provides a "circuit diagram" of the firm. It is the first place to look for sources of
exposure to interest rates, currencies and commodities. Typically, input to the model will include projected
values for most of the uncertain quantities of concern to the firm, including financial prices. The output of the
strategic planning model is likely to be projected financial statements.
Many firms simply project revenues and costs outside the model--exposures are not specified at all within the
model. In these circumstances, the cash flow at risk model must start one step backward: with the fundamental
financial statements, including the income statement and balance sheet. Chase's approach to creating a cash
flow at risk model from these statements begins by linking sales, costs, and financial price movements. This link
between sales, costs, and financial price movements is the most critical component in the cash flow at risk
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model. Following what has become a fairly well-established approach, we advocate modeling this link as an
elasticity. That is, we define exposure as the percentage change in the level of the expected future sales or
costs for a given percentage change in the financial price in question.
No two firms will experience exactly the same impact from financial price changes and there is unlikely to be a
simple formulation of the impact of a price change on the firm. However, by carefully working through exposures
with operating managers, the treasurer can identify the price levels that cause a significant change in operating
variables, and begin to quantify these effects in a dynamic model
Tools for Cash Flow at Risk Analysis
Probability and Statistics
Building on the cash flow model, the cash flow at risk approach applies the insight of VAR, based fundamentally
on the insight of probability and statistics, to the industrial firm This insight is employed to determine the range
of potential cash flow outcomes and the probability distribution of the various outcomes over that range for a
given period of time. In other words, the goal is to determine the probability distribution of future P&L in light of
risk factors.
Monte Carlo Simulation
Simulation analysis is the key tool for "imagining" the future. Simulations show how cash flow changes under
various scenarios of financial price changes. Traditional budget and planning models assume that financial
prices can be forecasted. The new generation of models using VAR tools recognizes that financial prices are
stochastic. These tools also permit management to consider alternative structures. For example, the portfolio of
projects, the debt/equity ratio, the debt structure and the like can be varied.
The effects of uncertainty can be modeled via Monte Carlo simulation, and VAR is implemented using Monte
Carlo methods. The first step in a cash flow at risk application, as described earlier, is to build a model that
relates financial risk variables such as interest rates, foreign exchange (FX) rates, and commodity prices to the
firm's revenues and expenses. Then, randomly selected values for the risk variables are plugged into the model
and a projection of net cash flow is generated In the Monte Carlo approach, several thousand scenarios are
customarily run to produce a probability distribution of possible cash flow outcomes, as shown in Figure
1.(Figure 1 omitted) Historical volatilities and correlations can determine reasonable bounds for the scenarios.
Stress Testing
Stress testing is a necessary and complementary element in risk analysis because of the parameters built into
any model Stress testing involves a non-statistical view of the impact on P&L of catastrophic price changes.
Extreme adverse price moves are picked to analyze "worst case" scenarios not covered by the model. To
illustrate, Chase's 97.5 percent confidence level is based on a statistical benchmark of two standard deviations
from average historical market movements, and in a year of 250 business days, prices will theoretically move
beyond two standard deviations on six days Chase uses a 100-day historical time horizon, which captures
current volatility of the markets but not the infrequent, yet very dangerous, "events" like the market crash of
1987. In stress tests, we model exceptional events like the crash. Since extreme market moves do occur, stress
testing is necessary for us to adequately understand our risk. A non-financial institution would also employ
stress tests to assess the impact of potential market shocks such as the chaos sparked by the Iraqi invasion of
Kuwait, which caused a 10-plus standard deviation move in oil prices.
From Understanding Risk to Managing Risk
Out of the kinds of analyses addressed here can grow useful new policies and procedures. For example, better
recognition of risks can lead to conscious choices about which risks to accept and which to lay off, as opposed
to passive, unintended and potentially costly speculation. Limits can be established for the risks that the firm is
prepared to bear, and defensive strategies can be set to meet extraordinary and unacceptable circumstances.
With VAR models in place, it is readily possible to test the impact of proposed risk management strategies. If a
firm effectively manages its financial price risk, then the volatility of the firm's real cash flows will decline. Thus,
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cash flow at risk analysis can conceptually integrate derivatives with a portfolio of real risks faced by a company
for a richer, more realistic development of potential risk management strategies. For example, one of our oil
company clients entered a hedge that links interest expense and commodity-based revenue. In brief, the
company locked in a fixed interest rate to be paid on a base dollar amount in future periods through the life of
the swap when the average daily price of a benchmark crude was below a certain threshold (e.g., 5 percent on
$100,000,000 when West Texas Intermediate was below $19 per barrel). The locked-in interest rate was below
the market rate, which meant significant savings when the company's revenues were down because the price of
oil was low, below the threshold The terms of the swap called for higher interest payments when oil prices were
up and cash flow could sustain more debt service because the company's revenues were also up The tools of
cash flow at risk help to open up a world of such possibilities. More effective management of cash flows can
enhance operations and increase the value of the firm in many ways, from the obvious (e.g., increasing debt
capacity) to the more indirect (e.g., enhancing customer confidence in the long-term reliability of service
contracts, or decreasing tax costs). Rooted in the classic value at risk methodologies that financial institutions
have pioneered, cash flow at risk analysis provides the treasurer with powerful new tools for more effective cash
flow management.
Note: TM indicates Trade Mark; SM indicates Service Mark.
Frederick J. Chapey, Jr. is the Global Derivatives Executive and a Managing Director of The Chase Manhattan
Corporation. He is responsible for managing all interest rate and currency derivative origination, structuring and
trading worldwide.
Subject: Risk assessment; Monte Carlo simulation; Models; Cash management; Cash flow; Case studies;
Banking industry;
Location: US
Company / organization: Name: Chase Manhattan Bank; DUNS: 00-698-1815;
Classification: 9190: US; 9130: Experimental/theoretical treatment; 9110: Company specific/case studies;
8100: Financial services industry; 3100: Capital & debt management
Publication title: TMA Journal
Volume: 16
Issue: 2
Pages: 22
Number of pages: 5
Publication year: 1996
Publication date: Mar/Apr 1996
Year: 1996
Publisher: Association for Financial Professionals
Place of publication: Atlanta
Country of publication: United States
Publication subject: Business And Economics--Banking And Finance
ISSN: 10801162
Source type: Trade Journals

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Language of publication: English


Document type: PERIODICAL
Accession number: 01206974, 00568506, 00285234
ProQuest document ID: 226002004
Document URL: http://search.proquest.com/docview/226002004?accountid=143338
Copyright: Copyright Treasury Management Association Mar/Apr 1996
Last updated: 2014-05-18
Database: ABI/INFORM Global

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Bibliography
Citation style: Harvard
Chapey, F.J.,Jr 1996, "VAR: A new tool for corporate treasury", TMA Journal, vol. 16, no. 2, pp. 22.

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