Introduction
Market risk management: The corporate perspective
Many companies have expressed an interest in understanding how
the principles of Value-at-Risk, which were initially developed for
managing market risk in a financial environment, can be applied in
the corporate environment. In our discussions with corporate
clients, they have raised a number of issues about implementing a
strategic risk management program within their companies. This
document outlines a framework we have entitled CorporateMetrics
™ that addresses the unique market risk management needs of
corporations as follows:
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Market risk versus business risk:
Risk management in the corporate environment is inherently more
complex than in a pure financial environment (i.e., trading and
investment functions) in that companies have both non-hedgeable
business risks (relating to the nature of their specific products
and services) and hedgeable market risks (e.g., commodity,
currency, interest rate, equity exposures). The level of market
risks is furthermore a function of business risks, which can make
the implementation of a risk management system a complex process.
This document proposes an analytical framework for identifying the
market risks inherent in the business activities of corporations by
integrating risk measurement into the budgeting and planning
process.
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Financial results and firm value:
Whereas financial managers (e.g., trader, portfolio manager,
treasurer) tend to manage the value of their assets and
liabilities, corporate managers tend to focus more on the level,
growth, and, increasingly, the volatility of corporate financial
results such as earnings and cash flow as benchmarks for good
performance. In this document, we propose a re-characterization of
Value-at-Risk concepts from a financial environment to an earnings
and cashflow environment. We also discuss the implications of
managing earnings volatility for the valuation of the company.
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Short-term versus long-term management cycle:
Compared to financial institutions, which may actively take
short-term risk positions to generate trading profits, corporations
are generally less sensitive to daily fluctuations in the market
and focus more on monthly and quarterly earnings volatility when
measuring performance. We discuss the issues relating to a shift
from managing daily market volatility to a longer management
cycle.
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Capital: In a number of industries, there is growing
interest in assessing the level of capital to sustain
risk-generating activities and relating the cost of capital to the
riskiness of business activities and projects. The risk measures
proposed in this document can provide insights into capital-related
decisions.
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Derivative disclosure requirements:
Not only are shareholders and investors more interested in
understanding the dynamics of earnings risk and the company's risk
management philosophy, but the Securities and Exchange Commission
(SEC) and the Financial Accounting Standards Board (FASB) have
issued a set of requirements to regulate how companies are to
disclose both the level and the effectiveness of their risk
management programs. In this document, we propose a methodology
that can be used to help address some of these requirements.
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