When it comes to understanding risk, the growing frequency of so-called ‘rare’ market events today, together with elevated volatility, means that the traditional Value-at-Risk (VaR) approach is less than perfect. Yet, Lloyds Bank believes that with certain enhancements, a VaR based methodology can prove to be invaluable in helping treasurers and risk managers to prepare for what the future holds.
Associate Director, Financial Risk Advisory, Lloyds Bank Wholesale Banking & Markets
Managing Director, Head of Financial Risk Advisory, Lloyds Bank Wholesale Banking & Markets
Over the past 15 years, the world has seen an increase in the number of ‘rare’ events. In fact, once in a lifetime or ‘Six Sigma’ events have been happening almost every year since 1997. While these events are by definition ‘unexpected’, they now occur on an annual basis, and as such we have learned to expect the unexpected.
The significant market uncertainty surrounding the euro is a good example of this. But while the current turmoil was a known possibility, ‘a persistent uncertainty’ around the Eurozone could have a profound impact on markets around the world.
In this uncertain world, Value-at-Risk (VaR) – as it is traditionally understood – is no longer an accurate risk assessment methodology. The basic concept of VaR is simple: it is a measure of how much one can lose with a certain level of confidence over a given period. Most modern risk assessment techniques, including CFaR (cash flow at risk) are based on VaR philosophy. There are however two fundamental issues with VaR today.
First of all, classical VaR is short-term. It looks at what may happen in the space of a few days. That is no longer appropriate because companies really need to start thinking about longer horizons, as that is where the biggest threats lie.
The second issue with traditional VaR is the standard deviation concept. It assumes that the underlying variable will follow a known distribution. If you are talking about the company’s cash flows; interest coverage ratios; or covenants, for example, those things are never normally distributed.
But despite its shortcomings, VaR, if properly adjusted, can be a foundation for building solid risk management tools for corporate risk managers. As such, the focus needs to be on the ways of using this approach in order to produce a more meaningful assessment of a company’s risk. This constitutes looking more closely at how the market environment affects key risk metrics. So how can this be achieved in practice?
Four adjustments to VaR
In order to overcome the inadequacies of VaR (and VaR based tools) and obtain a more meaningful risk assessment, four modifications can be introduced:
Increase the time horizons
In order to gain a better understanding of the impact market changes can have, risk managers should start looking at a longer horizon of six months, one year, two years or three years, as opposed to using daily, weekly or monthly horizons.
Model the economic environment rather than individual market variables
A company’s performance is typically impacted by a number of market variables rather than one particular variable. When attempting to understand the impact of the market environment on a company’s performance, it is very important to consider the behaviour of different market variables taking into consideration the relationships between them.
For example, a particular shift in interest rates in two currencies is usually associated with a move of a relevant exchange rate; a certain level of inflation will have a certain impact on the dynamic of interest rates etc.
This creates a need for modelling the consistent economic environments, ie the state of different market variables at each particular point of time. By looking at market variables on an integrated basis, a risk manager will have a much more accurate assessment of how a company’s performance may be impacted.
The challenge in modelling consistent economic environments, however, is that the relationships between the market variables change constantly. To address this issue, risk practitioners should employ stress testing.
Stress test the assumptions
This is necessary to understand the reliability of the risk assessment. The best way to test assumptions is by changing them and seeing how the results of the entire analysis changes. If the answers are completely different, then this is an indication that more time needs to be invested in getting this particular assumption right. If however the results are only marginally impacted, the particular assumption does not need to be tested further.
This approach will give confidence that the results coming out of the analysis are truly relevant.
Incorporate dynamic portfolio testing
In particular where longer-term horizons are considered, it is important to take into account the fact that underlying exposures are evolving and not static – the business changes over time. When VaR is calculated it should not necessarily be the VaR of the exposures as they exist today, because the objective of the risk management exercise is to understand what to expect in the future. So VaR should not be undertaken as a static measure but on a dynamic basis to better reflect the changing dynamic of a balance sheet, or a business strategy.
Applying the four adjustments
For corporate risk managers looking to put this approach into action, the focus should not be on trying to anticipate what is going to happen in the future. Instead, the objective is to understand how a particular strategy might behave, given the uncertainties of the future marketplace. As such, the foremost task is not to guess where markets are going to go, but to focus on where they might go – and then to evaluate a particular strategy in light of all those market scenarios.
On a practical level, this involves modelling economic environments to evaluate a wide variety of market scenarios and look at instances where the company’s risk strategy causes pain beyond their threshold. Once these instances are identified, the risk manager can assess the market scenarios that led to particularly adverse results – for example, GBP/USD reaching 2.5 while LIBOR is 7%.
For a multinational business, the fundamental question is what will happen to the company’s competitiveness if GBP/USD reaches 2.5. If half of the company’s revenues come from the US and the dollar is very weak, is the FX impact the only concern or will the performance be further negatively impacted by the high interest expense?
The next question would be, how possible is this economic scenario? If this scenario is deemed to be feasible and the risk tolerance threshold is exceeded, then hedging must be undertaken.
Benefits for risk managers
Employing these four adjustments to the traditional VaR philosophy will allow corporates to gain a more insightful view of their risk. The adjusted methodology will also prompt risk managers to ask questions which will make them more aware of what could happen in the future – and how to deal with it if it does.
Meanwhile, the practice of modelling four or five years ahead – and understanding how different scenarios will impact on the company’s business strategy with the current portfolio – can be used to come up with early warning mechanisms. If the company’s risk manager has identified the market dynamics that will cause them to experience pain beyond their threshold, when they see markets moving in that direction they are in a position to act more swiftly than they otherwise would.
Implementing a better VaR
Taking these adjustments on board means that VaR still has a place as a risk measure in today’s financial landscape. Nevertheless, this improved VaR will only achieve its full potential as part of an integrated approach to managing risks.
A five step process could be followed:
Determine the relevant risk facets.
Identify the market variables that can impact the balance sheet and income statement, such as FX, rates, commodities and inflation, taking into consideration the business strategy moving forward.
Model market uncertainty.
The determined risk facets should then be modelled together to generate thousands of potential economic outcomes. This will preserve predefined relationships between market variables, whilst generating unique real life scenarios. It is important to remember that the goal is not trying to predict future market levels, but simply to characterise many possible market scenarios.
Identify the current level of risk.
Decide which performance metrics are important for the business from a risk standpoint. Overlay the current business plan onto the modelled economic scenarios to determine the VaR for each of the chosen metrics.
Establish the risk tolerances.
For each of the relevant risk metrics, determine what level/threshold would cause distress to the business. This could be a minimum free cash flow level, a bond linked covenant staying above a defined value, or a leverage level linked to the terms of a loan for example.
Decide on the risk management strategy.
Compare the current risk levels with the established risk tolerances and identify any areas of concern. In the instances where there is a significant disconnect between the two, consider undertaking a hedging exercise.
In summary, companies should create a risk management protocol which will allow for robust stress testing, integrating internal market view/scenarios. The protocol should also consider risk in the context of the balance sheet and income statement, characterise the impact on financial covenants and allow for reverse scenario engineering (determining the market scenarios that can impact the business most negatively).
There are many advantages to this approach. Overlaying various economic environments with the business strategy creates a more efficient risk management programme which is better aligned with the business strategy.
While some companies will have sufficient resources to undertake this risk management work in-house, others may require some external assistance – whether to identify their risk exposures, model risk scenarios or to determine appropriate risk mitigation tools and techniques.
Lloyds Bank Wholesale Banking & Markets
Lloyds Bank Wholesale Banking & Markets offers a broad range of finance, covering structured and asset finance, import and export trade finance, securitisation facilities and capital market funding. Our product specialists provide bespoke financial services and solutions including tailored cash management, international trade treasury and risk management services.
At Lloyds Bank we have the ability to aid in the transition to the enhanced VaR methodology and assist customers with implementing an integrated risk management approach. We have a team of financial risk advisors with expertise in delivering financial market risk solutions that are not only bespoke, but very relevant to the environment in which our customers are operating.