The ABC of Risk Management: Understanding Financial Risk Modeling & Ratios

Needing to deliver risk ratios for management reporting: this is part and parcel of every treasurer’s daily work. The good thing is that treasury systems readily provide these ratios. You can quickly export them, create a short report and share the ratios – all done! However, the part that really matters – risk analysis and drawing conclusions based on these ratios – often falls by the wayside. Some of the reasons are a lack of time or knowledge of calculation logic and methods. That can be changed though!

There are a number of complex approaches that enable treasurers to estimate risk with mathematical precision, for example Value at Risk (VaR) or Cash Flow at Risk (CFaR). Risk management strategies (including hedging) as well as methods for analyses (for example scenario analysis) are equally varied and often highly complex. Some companies have perfected the use of quantifying risk with these methods. They often have a dedicated risk analyst – a proper expert on efficient analyses so to speak. Other companies however do not have their own risk specialist, and for them risk management represents an added task that falls under the responsibility of the treasury department. Given the many different responsibilities of treasury, and the complexity of these methods there is often not enough time to really wrap your head around the calculation logic. In turn, analyses are inconclusive and do not lead to relevant actions or can even result in wrong decisions.

Acquainting themselves with the basics of risk ratios and tools could go a long way for businesses that have little previous experience with risk management.  When and how does hedging make sense? How do I compute VaR in my treasury system and what does this figure then mean for my analysis? When, and in what context should I be using scenario analyses? When is interest rate simulation the right option? Matthias Deschner, one of Coupa Treasury's experts, discusses these questions in our new blog series “the ABCs of Risk Management” – with easy to follow explanations that don’t require any in-depth knowledge of financial mathematics.

Part 1: Value at Risk (VaR) – a (not quite standardized) standard ratio

VaR is considered one of the standard ratios used to measure and quantify financial risk; executive management in particular often includes it in their reporting requirements. It is standard in the sense that it is commonly used. VaR represents the maximum loss a set of investments might incur, or more specifically the maximum loss that will not be exceeded within a certain time frame with a certain probability. What is far from standardized is the way this ratio is computed: treasurers have some flexibility when it comes to determining assumptions. First of all, they need to select which deals, accounts, cash flows and liquidity forecasting data is to be included in the calculation. Secondly, treasurers decide if they analyze each individual deal or if they use group deals. For example, they can compute the maximum loss that will not be exceeded within a certain time frame for all outstanding FX deals, or for individually selected derivatives. An additional decision concerns the time frame that is considered: how long is the holding period, how many trading days is the calculation based on? Furthermore, the predetermined probability will influence the calculation. Treasurers must choose between different confidence levels in order to indicate how reliable the risk calculation is, the most common ones being 90, 95 or 99% . Particular levels of confidence may be acceptable, depending on the relevance of the investment for overall business, and risk tolerance. Selecting a confidence level of 95%, you still have a 5% probability that the loss will be higher than calculated. This is something treasurers should be aware of from the start – VaR is never a “fixed position”— it makes it easier to quantify risk but you will not be given a definite number.

This is due to risk factors for whose future development we can only make predictions, not determine a definite course. It is essential that treasurers consider the most important influencing factors: for example, various rates including interest rate developments and risks, and commodity prices are important factors for the performance of an investment. Treasurers who use a Treasury Management System to compute VaR should take a closer look at which of these factors have been taken into consideration. Only then can they interpret and use the result in a meaningful way; only then is it more than a ratio needed for management reporting.

Another aim of this introduction is to provide some input on relevant calculation methods. A very common approach is the Variance Covariance Method. Variance refers to the predicted changes to each risk factor, and covariance to the interdependency of different risk factors, i.e. the way they influence each other. For example, a change to interest rates usually also impacts exchange rates. This method is based on the assumption that normal distribution applies to the development of risk factors (i.e. random distribution), meaning you can use historical data to make predictions for the future.

Based on historical market data (i.e. for interest rate developments or exchange rate developments), lines of development are extrapolated and used to compute new figures. What does that mean for treasurers? Reliable and correctly maintained data is essential for these influencing factors – the result can only ever be as good as the data it is based on. If I don’t have any data on interest rate developments or exchange rates, my VaR calculation will not produce a conclusive and reliable result.

However, if I can ensure that I have reliable data and consistent information, that I’ve considered all relevant factors and used meaningful units, time frames and confidence levels, then the resulting VaR can be of immense value for my treasury. It can influence liquidity planning or risk management strategies such as hedging. I can also use the result for other purposes to achieve even more precise results: for example, I could compute VaR for multiple currencies, for individual deals and a group of deals. This can then be used for plausibility checks based on existing cash positions. This turns a ratio into a meaningful and helpful tool for risk analysis, on which you can base recommended action.

Find out more about risk management strategies, in particular, hedging, in the second part of our series.

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