Balance Sheet

Modelling for the future

Andy Winterton,
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Modelling for the future
The idea of business risk management has grown in sophistication and usage over
the last few years. Here Andy Winterton of Bank One looks at the reasons behind
that growth and the deficiencies of early approaches, assesses some of the more
modern interpretations and describes the risks of misinterpretation
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ACK IN THOSE happy,
B carefree days of our youth,
business risk modelling was a
much less complex game.
Before the widespread avail-
ability of cheap computing power,
treasury officers would perhaps perform
manual calculations of sensitivity testing.
These would probably have been single
variable, single timeframe scenario tests.
For example, what is the effect on my net
income if the short-term interest rate
increases by 200 basis points in 12
months’ time, or what would be the
impact of a 10% fall in the US dollar on
export revenues? Few analyses would
look at the impact of these two events
combined, and even fewer analyses
would try to estimate the probability of
these events happening individually, or
particularly the likelihood of the com-
bined events happening. Only the most
ambitious would attempt to calculate
probabilities quantitatively.
The impact of value-at-risk
The concept of value-at-risk (VAR) goes
back to the early 1990s, and originally
grew up in the banks and other active
trading companies. The idea was to try
to quantify the overnight risk position
being taken by financial institutions,
incorporating the tendency of some risks
to offset others. VAR proved to be a
popular response to this requirement,
which was driven as much by regulatory
pressure as by management’s desire for
better information. Even for this role,
however, VAR has limited effectiveness.
VAR comes in a number of different
guises. However, those systems that are
sufficiently simple for regular use are
inevitably compromised by unrealistic
assumptions. Some popular approaches
are unable to accommodate even vanilla
options, and are completely flummoxed
by barrier options.
Another implicit problem, common
to these analytical approaches, is that
they assume that the future cannot differ
very much from the past, and, in some
cases, only the relatively recent past is
considered. This has obvious dangers.
We all intuitively know that new devel-
opments can occur. Whether it is Russia
defaulting or Asian currencies devalu-
ing, VAR implicitly ignores the risk
because it is not included in the source
data. VAR is particularly vulnerable to
making mistakes about situations like
managed exchange rates, where a previ-
ously constant level implies that there is
zero risk of default. We know that this is
not the case, but a VAR programme
tends not to be intuitive!
Over-simplification
Using one number to describe a
sparkling array of risks could perhaps be
considered as too much of a simplifica-
tion. Even if a VAR number is qualified
by a timescale, input criteria and a per-
centage confidence level, no account is
taken of the shape of the distribution.
Many models assume either a normal
distribution or an empirical distribution
based on past history. As already dis-
cussed, using past history to predict
short-term moves is fraught with errors.
Using the normal curve is at least as
risky. The financial markets are very
aware that market movements are inad-
equately described by the normal distri-
bution, in that the real-life numbers have
BUSINESS RISK MODELLING
more very extreme events than a normal
curve. This is known as leptokurtosis or
‘fat tails’, and is one of the reasons for
the volatility smile seen in options pric-
ing. Of course, it is precisely these
extreme events that cause concern. As
risk managers, all those days that result
in little change do not have great signif-
icance for us. It is the extreme tail events
that cause the large losses. Therefore, it
is rather unfortunate that these are the
circumstances that are insufficiently cov-
ered by the distributions most widely
used. At Bank One, along with other
researchers, we have adopted tail-risk
distribution characterisations that
mimic real life much more accurately.
Some kind of tail-risk description is
much more valuable in illustrating the
ultimate ‘big-hit’ risk to an institution.
While VAR has deficiencies, it never-
theless does have some use in risk man-
agement. Any risk manager has to be
interested in measuring risk. The old
business school lecturer’s maxim that ‘if
you cannot measure it, you cannot man-
age it’, still holds true. It is certainly true
that there is value in seeing how the
number changes on a daily basis. If yes-
terday’s value was 6 and today it is 12,
then a risk manager would be correct to
look into the number to investigate what
had caused the change.
The career danger for the risk man-
ager occurs when senior management,
or even stockholders, take the VAR
number of 6 and misinterpret the rele-
vance that this has to the future. Any
risk manager who finds himself in his
boss’s office trying to explain how the
institution is facing a loss of 16 against a
VAR figure of 6 has clearly been
VOL 8 NO 1 | BALANCE SHEET | 11
 BUSINESS RISK MODELLING
unsuccessful in educating his superiors
of the true meaning of VAR.
VAR for corporates
These problems are compounded when
VAR is applied to corporates. It was
first offered to corporates as an addi-
tional market after banks had been
forced to construct systems for them-
selves. Usage started to become much
more widespread after the SEC made a
VAR statement a mandatory US
accounting requirement. However, the
guidelines were somewhat unspecific,
and so the numbers are still difficult to
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compare for one company against
another. For example, it was discre-
tionary as to whether the underlying
exposure is included as part of the cal-
culation. However, if the exposure is not
included, then the reported VAR would
actually increase as the amount of hedg-
ing increases. This has the perverse effect
that reducing actual risk has the appear-
ance of an increasing VAR, which
implies more risk.
The largest concern of applying VAR
to corporates is that any number it might
produce is largely irrelevant. Assume
that a corporate treasurer has a three-
year exposure to US interest rates, and
arranges a swap with his banker. If on
the next day the hedging deal could have
been completed at a slightly better or
worse rate, then so what? Our treasurer
still has the three-year exposure and still
has his hedging deal. He will not want to
lift the hedge and re-establish at the new
market level. What would be of more
significance is how the interest cost
might vary the next time it needs to be
fixed in three years time. How much
more or less might it cost then?
This does not mean that business
risk modelling has no use for corporates.
Value-at-risk fails to help corporates
because the timescale is too short.
Overnight financial market moves are
not relevant. However, the overall effect
of market moves over the long term is of
great interest and can be calculated
today.
VAR grows into business risk
modelling
Let us investigate what an ideal VAR for
corporates would look like. To be of
12 | BALANCE SHEET | VOL 8 NO 1
relevance to the senior management
decision-making process, VAR needs to
be of the same timescale as the medium-
term plans. Only by seeing how the
medium-term plans could be affected by
market moves and the combinations of
other variables does the business risk
modelling aid policy development and
decision making.
If the business risk model is to look
forward maybe five years, and provide
all that can be known about the future,
then it needs to be accurate. This can
only be achieved by including a great
deal of detail about the overall flows of
the business and the impacts of external
variables on the bottom line.
Equally important, second-order
effects should be included. For example,
if a UK exporter knows that a weaken-
ing yen will reduce sales volume in
Japan, that should be included.
Similarly, if he realises that a weakening
yen will reduce sales to the US due to
competitive effects, then that too should
be included in the analysis. The analysis
itself should be conducted as a Monte
Carlo simulation. This is a well
-established technique, used in the
financial, engineering, aerospace and
nuclear industries for up to 50 years.
In essence, hundreds or thousands of
scenarios will be generated for the future
rate development. These scenarios will
be generated such that each one appears
random, but in fact will be based on his-
torical volatilities and correlations. For
further investigations, it is possible to
vary these inputs. What is the impact if
there is a 30% chance of a devaluation
in an emerging market currency? These
sorts of non-linear, non-historic proba-
bility distributions can be tested in the
model, illustrating how the results of the
whole business would be affected. It is
this capability to examine the combined
impact of all of these non-linear, non-
historic probability distributions that
It is the ability to include the effects
of extra variables that enables
business risk modelling to add real
value to treasury decision making
separates business risk modelling from
simpler techniques like scenario testing.
It is also possible to include any vari-
able that has an impact on the business
and can be characterised with forecast
levels. Such forecast levels and volatility
can be derived either judgmentally or
from historic data. For example, sales
volume can be modelled as future distri-
butions. These could be modelled with
the mean as a projection of existing sales
trends and standard deviation as seen in
past sales numbers. Alternatively, sales
department budgets could be used with
the sales director’s estimates of plus or
minus guiding the distribution width. A
second alternative would be to model
sales growth as a function of extrinsic
variables such as GDP and unemploy-
ment levels. These extrinsic factors
would then have to be generated as part
of the Monte Carlo simulation.
It can be seen that this is much more
powerful than just testing with historical
rates. In addition, this technique is much
more informative than scenario testing.
Scenario testing might tell what happens
if the euro falls to £0.60, and even tie in
some second-order variables. However,
scenario testing will not calculate how
likely this outcome is, nor place it in the
context of the full range of possible out-
comes. It is the ability to include the
effects of extra variables that enables
business risk modelling to add real value
to treasury decision making.
Presentation of results
If 1,000 simulations are generated, each
one over five years, then that gives 5,000
balance sheets and annual profit and
loss accounts, and 5,000 year-on-year
changes (starting from this year). This is
a huge amount of data, and so presenta-
tion is key to interpretation. The first
thing is to establish which results are of
most concern. Earnings per share would
be a natural starting point for most
 BUSINESS RISK MODELLING
Results of alternative strategy tests
RESULTS Current profile
Average outcome $120 million
Best outcome $166 million
Worst outcome $66 million
Standard deviation 12%
Chance of failure 8.2%
Table 1
Results of alternative strategy tests
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Figure 1
businesses. Interest cost coverage, free
cash generation or net income might be
other prime objectives.
Take an example where a company
was very concerned to ensure that its net
income did not drop below $100 mil-
lion. Once the structure of the company
had been modelled and the model vali-
dated using historical data, it is possible
to check how likely the company is to
achieve its objective of realising net
income greater than $100 million. It is
then possible to test alternative strate-
gies to see what impact the changes have
on the probability distribution of results
(see Figure 1 and Table 1).
In this example, the current profile
has a debt equity ratio of 3.0, fixed
interest rates and all FX exposure cov-
ered by the purchase of at-the-money
forward options. It can be seen that this
gives an expected average result of $120
million, with a best result of $166 mil-
lion and a worst result of $66 million.
Of the simulated results (equivalent to
82 simulations out of 1,000), 8.2% gave
a result below the minimum requirement
of $100 million.
Alternative profile A shows a differ-
ent financial structure, with a debt
equity ratio of 2.0, all interest rates
floating and currency exposures hedged
with forwards. This profile has a higher
average, but the standard deviation is
14 | BALANCE SHEET | VOL 8 NO 1
Alternative profile A Alternative profile B
$140 million $110 million
$238 million $127 million
$44 million $91 million
20% 5%
7.7% 3.5%
larger too, giving a wider distribution. In
this case, the chance of failing the net
income requirement is 7.7%.
The right-hand chart illustrates
alternative profile B. This shows the out-
come with a debt equity ratio of 1.0,
with 50:50 fixed/floating interest rates
and no foreign-exchange hedging. With
this structure, the expected net income is
the lowest of the three possibilities.
However, despite this, the chance of fail-
ing the requirement for a net income of
$100 is the lowest of the alternatives.
In this example there is no obvious
answer – alternative profile B is the
safest, with only a 3% chance of break-
ing the $100 million net income require-
ment. However, it also gives the lowest
expected income at only $110 million.
So a trade-off will have to be made, the
reward of higher expected income being
set against the cost of greater risk of fail-
ing the net income objective. These
trade-offs must be made frequently. By
using business risk modelling, such
structural decisions can be made in a
quantitative framework. A better deci-
sion will be taken if the relative sizes of
the risks and rewards are actually
known. In many other cases, the deci-
sion will become more clear-cut once the
relative figures have been calculated.
These charts are a good illustration
of how, once the basic framework of a
company’s structure has been built, it is
easy to run multiple passes using differ-
ent financial structures and different
hedging strategies in order to see the
potential outcomes.
This kind of analysis becomes more
useful again during periods of change. A
prime application is if acquisitions or
divestitures are under consideration. In
these circumstances, it becomes even
more important to examine the chance
that the planned changes will dilute
earnings. How will the combined com-
pany be vulnerable to external moves?
Would a different hedging policy be sen-
sible? At such times, when public com-
panies are under greater scrutiny than
ever, and may be facing a broader range
of variables than seen previously by that
management team, the ability to exam-
ine rigorously hundreds or thousands of
future scenarios is of great value.
The verdict on VAR
We have seen how VAR was originally
developed to try to give a quantitative
measure of the kinds of market risks
being taken by banks and other financial
institutions. It has been widely adopted
within that community, but has strug-
gled to expand into the corporate world.
However, the basic idea behind VAR is
to illustrate quantitatively the probabili-
ties of a range of future outcomes. This
clearly adds value to a risk manager. In
the corporate world, the risks are not
overnight trading positions, but a whole
spectrum of external factors that can
have significant effects on the success of
the business over the medium term.
This approach will not guarantee a
corporation’s results in five years’ time,
but it can show the most likely out-
comes, and frame some of these critical
policy decisions into a quantitative con-
text rather than the traditional gut-feel
mode. This makes it a very powerful
technique, which should be a staple in
every corporate treasurer’s toolbox. ■
Andy Winterton is
European head of the
strategic risk manage-
ment advisory team at
Bank One.