Financial Risk Management Framework - Cash Flow at Risk - PowerPoint by pzc38643

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									Financial Risk
Management Framework
- Cash Flow at Risk
2. Annual Conference of the Croatian
Association of Corporate Treasurers



                 September 2005   !@#
Presentation Outline
1. Financial Risk Management Framework
2. Risk Measures
  •   Value at Risk.
  •   Cash Flow at Risk.

3. at-Risk Engine – concept and
   implementation
4. Form of advisory support



                           2      !@#
Financial Risk Management Framework
The risk management framework in a corporate organization
 consists of the following components:
• Financial Risk Management Strategies
• Financial Risk Management Policies
• Financial Risk Management Methodologies
The risk management framework should be closely linked to
 the accounting (proper treatment of hedges under IAS 39).
The topic of the presentation is one particular methodology
 for measuring market risk.


                              3          !@#
Risks in Non-financial Companies
• Treasury survey which Ernst & Young conducted this year
  in the Czech republic in cooperation with the Czech
  association of treasury revealed that the most important
  risk for non-financial companies is the liquidity risk.
• The second in terms of significance is the FX risk. 97 % of
  the surveyed companies are exposed to FX risks, 93 % of
  surveyed companies hedge against FX risks.
• Interest rate risk and commodity risk were substantially
  less significant.

* The survey was conducted among large and mid-sized non-financial
  companies in the Czech republic in May 2005.

                                  4            !@#
Value at Risk
Market risk in financial institutions is primarily measured by
 value at risk (VaR):
• Quantification of losses due to movements in financial
  market variables (interest rates, foreign exchange rates,
  equities, and commodities) in given time horizon with
  certain probability.
• Statistical measure of potential downside risk.
• Simple to explain – one number aggregates the risks
  across the whole company.
• Time horizons usually from 1 day to 6 months. Confidence
  level of 95 or 99 percent.

                                5          !@#
Value at Risk vs. Cash Flow at Risk
Disadvantages of Value at Risk for Non-Financial Companies
• VaR measures how much the value of financial assets/liabilities
  – receivables, payables, equities, commodities, bonds –
  changes due to adverse market movement.
• VaR does not cover changes in value of cash flows.
• Compared to financial companies, non-financial companies
  have substantially higher ratio of cash flows (sales/purchases)
  to assets. Non-financial companies are exposed comparatively
  higher to changes in value of their cash flows.
• The right risk measure for these companies is different – for
  example CFaR.


                                 6            !@#
Cash Flow at Risk
CFaR measures the expected maximum decrease in
 expected cash flows resulting from an adverse market
 move, within a given confidence level, for a given period
                                    Frequency Distribution of Simulated Cash Flows in mln CZK for the year 2005

                                           CFaR to
                                          expected                                 Probability of decrease in net
                         2000                                                      cash flows in 2005 below that
                                          -180 CZK                                     amount is eqaul 5%
                         1800                                 2 355 CZK
                                                                                  Budgeted/Expected amount of
                                                          2 317 CZK               net cash flows in CZK for the
                         1600                                                               year 2005

                         1400
                                              2 175 CZK
                         1200
             Frequency




                                           CFaR to
                         1000             budgeted
                                          -142 CZK
                         800

                         600

                         400

                         200

                           0
                               5

                               5




                               5

                               5




                               5

                               5




                               5

                               5




                               5

                               5
                               5




                               5




                               5




                               5




                               5
                               5




                               5




                               5




                               5




                               5
                             02




                             22




                             42




                             62




                             82
                             97



                             07



                             17



                             27



                             37



                             47



                             57



                             67



                             77



                             87
                             92




                             12




                             32




                             52




                             72
                          1

                                1

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2

                           2
                                                            Simulated Cash Flows in mln CZK




                                                                          7                                         !@#
General Schematic for at-Risk Measures

   Input:               Mapping                 Portfolio
  Portfolio             Procedure               Mapping
  Holdings                                      P = θ (R)

                                                                  Transformation
                                                                  Procedure

  Input:                                      Characterization
                        Inference
  Market                                     of the Conditional
                        Procedure
   Data                                      Distribution of R

                  at-Risk Measure

 Used symbols:                                                        Value of the
 P … value of the portfolio/cash flows                                  at-Risk
 R … risk factors                                                       Metrics


                                         8                   !@#
Framework of Risk Measurement
To calculate CFaR the following steps are performed:
• Setting time horizon and confidence interval.
• Cash flow mapping.
• Identifying risk factors.
• Simulation of risk factors.
• Revaluation of cash flows.
• Constructing the probability distribution of cash flows.
• Reading the value of the particular quantile of the
  cash flow distribution based on the confidence level.

                                9       !@#
Methodologies of at-Risk measures
There are different methodologies of calculating at-
 Risk measures:
• Variance-covariance methodology (delta-normal)
• Historical simulation
• Monte Carlo simulation




                           10       !@#
Delta-normal method
• Simplest VAR approach.
• It assumes that the portfolio exposures are linear and that
  the risk factors are jointly normal distributed.
• Parameters of the risk factors are estimated from historical
  data and the distribution of the portfolio is directly
  calculated from the distribution of the risk factors.
• Main advantage of this approach is the simplicity, but this
  is also its drawback.
• It cannot account for nonlinear effects such as options.
• Conclusion: it is a good method for measuring FX risk if the
  company does not hedge with FX options.

                               11          !@#
Historical simulation
• The historical simulation approach is a full valuation
  method.
• It refers to the process of calculating the hypothetical
  distribution of profit and losses of the current portfolio
  based on applying historical asset returns.
• The advantage of this approach is that it does not use
  estimated variances and covariances, and it does not
  assume anything about the distribution of risk factors.
• The main disadvantage is the assumption that the future
  risk is much like the past risk. That is less frequent in
  today’s fast changing business environment.

                                12           !@#
Monte Carlo Simulation
• Monte Carlo simulation approach is a full valuation
  method.
• It is the process of calculating the distribution of profit
  and losses of the current portfolio based on randomly
  generated movements in risk factors from a given
  distribution.
• This method is the most flexible, but also carries an
  enormous computational burden.
• It requires users to make assumptions about the
  stochastic process and to understand the sensitivity of
  the results to these assumptions.

                              13          !@#
Architecture Outline – Data Flow

            Market Data
           are redirected
           and stored in             User defines            Results from
             database                parameters of          simulation are
                                      simulation           used in reporting




               Market Data    Analytical         Results
                Database       Engine           Database




                 Exposure
                 Database
                             14               !@#
FX Risk Measurement Tool
• Ernst & Young “Light” solution for non-financial
  companies.
• Implements Monte Carlo and Historical Simulation
  methods.
• Let’s see the calculations.




                                15     !@#
Step 1. Setting-up Parameters
                            • The tool supports
                              Monte Carlo and
                              Historical
                              Simulation.
                            • Up to 15 currencies.
                            • Time horizon up to
                              24 months.
                            • Various methods for
                              estimating volatility
                              such as simple
                              historical average,
                              weighted average,
                              implied volatility
                            • Confidence level up
                              to 99 %.
                   16      !@#
Step 2. Entering Market Data

                               • Necessary market
                                 data such as current
                                 and historical FX
                                 rates, interest rates
                                 and option implied
                                 volatilities are
                                 entered.
                               • The tool supports
                                 automated upload of
                                 market data.




                    17     !@#
Step 3. Mapping Exposures
                        • The user enters or
                          automatically uploads
                          currency exposures.
                        • Forecasting properly
                          currency exposures
                          and aggregating it
                          over the company or
                          the group in time is a
                          very demanding task
                          for most corporate
                          treasuries.




                  18        !@#
Step 4. Hedging Strategies
                             • The user enters or
                               automatically
                               uploads portfolio of
                               actual derivatives
                               held by the
                               company. The tool
                               supports forwards,
                               swaps and options.
                             • The user can add
                               any hypothetical
                               derivatives to
                               assess the impact of
                               new derivatives on
                               the FX risk.


                   19         !@#
Step 5. Calculation and Reading Results
                           • The calculation of
                             CFaR is conducted.
                             Depending upon the
                             number of
                             simulations it takes
                             seconds or minutes.
                           • The user can
                             compare CFaR for
                             various scenarios –
                             without derivatives,
                             with derivatives and
                             with hypothetical
                             derivatives.
                           • All the results are
                             supported by charts.



                   20      !@#
Form of advisory support
Ernst & Young provides various services in the area of
 corporate treasury:
• Reviews. Which basically give the companies
  assurance that the strategies, organization,
  processes, and methodologies are set the right way.
• Implementations. When the strategies, processes, and
  methodologies based on Best Practices are tailor-
  made for the corporations.




                           21         !@#
Questions and Discussion




                ?
                  22       !@#
Contact Information

Pavel Riegger                  Sinisa Dusic

Ernst & Young, s.r.o.          Ernst & Young d.o.o.
Karlovo nám. 10                M. Sachsa 1
120 00, Praha 2                10 000 Zagreb
Czech Republic                 Croatia

Tel. +420 225 335 114          Tel. +385 1 2480 728
pavel.riegger@cz.ey.com        sinisa.dusic@hr.ey.com




                          23        !@#

								
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