In my experience working for and with companies concerned with risk management, inevitably one of the most common questions I am asked is, “does your software perform value-at-risk (VAR) and does it use Monte Carlo simulations?” It is usually a “yes” or “no” question, but when faced with the “no” answer, I often ask myself:
– Why are so many corporate treasury departments interested in VAR and Monte Carlo?
– Is VAR really a practical method of measuring the future risk, if modeled correctly?
Reading the title of this post makes a strong statement and it is not intended to make definitive stance. It is only my opinion and my chance to pay homage to Edwin Starr (although I do prefer the Bruce Springsteen remake).
Philosophically, there is no perfect method for accurately measuring what “the market” will do. Even though we try to numerically represent the changes in gains and losses, companies still struggle with what is the best approach to predict the factors that will affect their profit and loss. Anyone who is engaged in the derivative market and financial instruments has at one point dealt with concepts in VAR, debated the merits, and also looked at alternatives to VAR. In this particular blog, I will discuss the applicability in treasury, the most common alternatives: stress testing and cash flow at risk (CFAR) and what I believe to be applicable points in corporate treasuries.
VAR vs. Stress Testing vs. CFAR
The best starting point is to understand, from a high level, the intentions behind each approach.
VAR is the maximum loss that can occur in a portfolio with a 99 percent confidence level by computing the normal linear returns or reconstructing a history of returns or a simulated series of possible future events with re-sampled actual returns (bootstrapping), or normal or non-normal computer-generated factors, mapped into returns (Monte Carlo).
Stress testing is series of defined movements on a single transaction or portfolio transactions which can focus on a individual market input or multiple market inputs into the valuation model. Stress testing is tedious to set-up and relies on the insight of experienced managers.
CFAR is a combination of statistics and simulations (Monte Carlo or stress testing) and answers the questions of how large the deviation between actual cash flow and the planned value (or that used in the budget) is due to changes in the underlying risk factors. This probability is quantified by a probability e.g. 95 percent in the next 12 months. A positive of CFAR is the ability to incorporate correlations between assets classes such as interest rate, foreign exchange, and, in some cases, commodities.
Corporate Risk Management vs. Trading Risk Management
The most commonly used method in corporate treasury is stress testing/scenario analysis. Trading or speculative shops use a VAR-based model and are not as concerned with the extreme losses on the tails, but are interested in predicting the trends based on past history and incorporating into their trading strategies. Thus, the speculative shops are strategically positioning themselves to make a profit on the financial instruments while mitigating their risk exposure and minimizing the market potential for losses. A key distinguishing factor for a corporation that hedges is that they must be balanced; meaning their position in a derivate should equally offset their asset or liability on the balance sheet for purposes of mitigating the risk associated with their normal business operations.
What is the best fit?
Honestly, it is a matter of opinion.
At a bare minimum stress testing will perform educated market movements and incorporate those factors, and show the affect on your financial instruments. Although arduous to configure and set-up, it will allow for a step-up or step-down approach. For instance, focusing on interest rate and the step-up approach, we all know interest rates are at all time low. They cannot go much lower even though we would all like to pay zero percent interest. However, the Fed is going to increase rates, but the question is “How much will they increase?”
Using stress test scenarios, one could construct multiple scenario sets:
– Increase of 25 basis points for each quarter for the next year.
– Increase of 50 basis points for the first quarter and then 25 basis points for the next three quarters.
I could create multiple endless scenarios and then review the dollar impact on my portfolio.
In addition, I could leverage VAR and CFAR analytics and try and simulate, based on historical movements, with a high degree of probability the maximum increase of rates and the impact to my cash flow and incorporate into my stress tests.
Finally, coming to the end of this post, I still wonder is one vs. the other better?
I do believe that question will always be debated, but my preference is bare minimum to have stress testing and the option to leverage VAR or CFAR to have as much information as possible.
That’s my opinion. What is yours?