By Andrew Howard,2014-05-16 16:42
14 views 0



    by Lang Gibson

Barring Congressional amendment of the new SEC Rule on Disclosures About Derivatives and Other

    Financial Instruments, all public companies will soon, if they have not done so already, have to face a

    decision of disclosing all derivative hedging activity in a “tabular presentation” format versus building

    the quantitative underpinnings of a risk management infrastructure. The full text of the SEC Rule can be

    found at the SEC’s web site (http:\ under File No. S7-35-95. Compliance with the SEC’s market risk disclosure requirements serves as a first step to building a worldclass risk strategy framework

    with a risk-adjusted vision, methodology and infrastructure, including the right combination of analytics,

    business strategy and technology. This paper will first present some of the choices and challenges

    corporate treasurers face. Since the rules do not specify how to quantify market or cash flow risk, we present two solutions here -- a “bottom-up” cash flow model (for non-financial entities) and a “top-

    down” shareholder value creation approach (for financial and non-financial entities) to measuring and managing enterprise-wide risk.

Heretofore, few companies have opted for tabular disclosure in their SEC filings under SFAS 119, a

    FASB statement encouraging derivatives disclosure. The SEC mandates “full and fair” disclosure by

    corporations issuing securities on an interstate basis. The public availability of financial reports to

    competitors, suppliers, customers, employees, and the government gives companies pause to expand upon

    the reported information (particularly information about prospects for the future) beyond what is required

    by the SEC. Companies risk losing operating advantages by disclosing derivative hedging activities to

    competitors. Consequently, when faced with the requirement to choose between tabular disclosure and

    risk quantification disclosure, most companies will choose the latter, which only discloses the net result

    of hedging strategy. Exhibit A Inclusion of the following exposures is encouraged by the SEC:Once the decision has been made to invest in risk ?Contractual (operating) cash flowsquantification, companies serious about risk ?Anticipated cash flowsmanagement should build both value-at-risk (VaR) ?Physical delivery commodity forwards

    ?Commodity positionsand stress test models, although they are only ?Non-derivative off-balance sheet exposuresrequired to choose one of the two. VaR is only an insurance contractslease contractsestimate of risk under normal scenarios and stress pension and postretirement benefitstesting is needed to compliment the VaR measure to warranty obligations and rightsShareholders equity (including minority interests, quity method test the impact on risk under extreme market investmentstrade accounts (receivables and payables)movements. Although the SEC only requires risk quantification of the derivative and securities portfolio, companies are well advised to include the

    underlying hedged exposures as well to adequately represent the company’s true market risk. (Exhibit A

    depicts exposures not required, but encouraged, by the Rule). Otherwise, the risk measure is incomplete

    and excludes the opposite side of the hedge. For example, if a company only quantified the risk on a

    currency forward and excluded the risk on the hedged currency receivable, the risk would appear

    excessive. Indeed, true risk is a function of the volatilities, correlations and position size of the

    underlying currency and the forward derivative,

    Exhibit Bwhich has the opposite sign of the balance sheet

    Unique Characterizations of Corporatesitem. Risk heavily dependent on anticipated future events Subjectivity of balance sheet valuationsClearly, it is more difficult for a corporate to Economic valuation versus accrual accountingmeasure the market risk of its contractual and Lack of publicly available historical data

     Importance of operational leverage riskforecast cash flows than it is for a financial fixed versus variable costsinstitution to measure the market risk of its securities Importance of free cash flow as a valuation toolor security-like balance sheet items (unique value of firm determined by future cash flowscharacterizations of corporates are presented in risk = operational levg + financial levg + liquidity risk


    DRAFT OF 4/28 (2,700 WORDS + 12 EXHIBITS) Exhibit B). Most financial institutions already measure income and equity risk, so the new SEC

    requirements pose less of a burden for them. Alternatively, most corporates, especially smaller ones, do

    not quantify enterprise-wide market or income risk. Since many corporate balance sheet items are

    difficult to mark-to-market on a current date, much less future dates, income, or cash flow, models may

    be most appropriate. An example is a pharmaceutical company which has virtually no balance sheet

    items. The greater part of its value is the expected cash flows generated from its research and

    development. (Exhibit C presents some further challenges to quantifying corporate market exposure).

    Exhibit CThe risk management industry, comprised of

    Corporate Market Risk is difficult to quantifyconsultants, industry risk managers and software Integrating forecast cash flows into modeldevelopers, has innovated a number of creating pseudo trades for contractual and anticipated exposuresmethodologies for estimating firmwide corporate Complexity & high cost of aggregating operational, financial & credit riskrisk. Most of these models have been cash flow- Complexity of pricing and repricing certain balance sheet items such asPP&E and Goodwillor earnings-based for the reasons presented in Option and long-term exposures require simulationExhibit C. In this paper, we present both a Future elasticities of supply and demand are subjective quantities

    “bottom-up” and a “top-down” approach to Certain corporates such as R&D driven ones (e.g. Pharmaceuticals) donhave assets in place to valuecompliment each other in quantifying market

    and earnings risk to comply with the new SEC Rule, and even more importantly, build the foundation for

    a sophisticated risk management infrastructure. The “bottom-up” approach is the more rigorous of the

    two and complies with the new SEC requirements for corporates on its own. Since this approach does

    not capture all risks, it is not ideal for firmwide capital allocation. The “top-down” approach is most ideal for allocating capital between activities on a risk-adjusted basis because it measures all risks

    equivalently across both financial and non-financial entities. Since the “top-down” approach is substantially less granular and relies only on the free cash flow of the total division, it does not satisfy

    the new SEC requirements on its own. Nevertheless, it can be substantially less costly to implement.

    Further, it has the advantage that the methodology may be implemented by outsiders using public

    information to compare company valuations on a risk-adjusted basis.

     Exhibit DBottom-Up: Cash-at-Risk (CaR) Bottom-Up: Cash-at-Risk (CaR)Every derivative and security is comprised of cash Project Cash Flowsflows expected to occur at some date in the future. As out x periods for allexposuressuch, in CaR, financial instruments are placed on an Create stochasticarbitrage-freeEffect of changes inequivalent footing with the contractual and anticipated market prices onscenariosproductioncash flows of the company. CaR pushes corporate quantities andRevenue & Costproduct mark-upsElasticitiestreasury beyond transaction and accounting exposure Effect of Shiftingmanagement to economic exposure management. The competitive alternativeHedging Scenariosadvantages R&D Spendingbetween producersplanningfuture performance of all financial instruments as well Dividend PolicyFundingas the exposures listed in Appendix A above are Distribution ofvaluessimulated together in the model as depicted in Exhibit

     D. The theoretical basis of CaR is the arbitrage-free

    yield curve and FX relationships in each currency in which the corporate has exposures. By generating

    stochastic scenarios of where the multiple yield curves may evolve through the horizon date, an

    aggregated, implicitly-correlated cash flow distribution is generated. To address true economic 12%exposure, pseudo trades with attached probabilities must be 10%created to serve as proxies for Sample Histogram 8%CaR Return Distributionanticipated cash flows. The 6%Exhibit E254%resultant histogram of values Economic & Behavioral5% Quantile 20Elasticities must be embedded2%(adjacent chart) can be analyzed to into scenario market movements:150%determine whether the current 10 Volume/production changes-2%hedge strategy is desirable. For Price changes5# Observations-4% Competitive reactionsexample, the 5% far left quantile of 0 Alternative sourcing-6% Correlations to related marketsthe distribution would represent the -8% Variation of above assumptionsHistorical Annual Return


    DRAFT OF 4/28 (2,700 WORDS + 12 EXHIBITS)

    potential expected cash flow shortfall under a 95% confidence level.

Importantly, variable market prices impact business factor elasticities, such as the effect of currency

    prices on pricing and sourcing (Exhibit E). Considerable research has been done on the phenomenon of

    elasticities of market price changes caused by unexpected market rate changes. Generalizations are

    difficult to make, as elasticities are very firm-specific. The model must address elasticities and the

    timing of such elasticities because future cash flows are not determined strictly by the evolution of

    market prices and rates. For example, the user may determine, based on subjective estimates made by

    divisional heads or regression analysis, that a 1% rise in the $/Mark rate is associated with only a 0.3%

    short-term rise in DM denominated prices in Germany (due to domestic competitors whose revenue is not

    affected as much by the FX rate change); a 0.2% long-term decline in costs (due to improved sourcing to

    compensate for lower USD revenue); and a long-term 0.5% decline in volume (the company will focus

    on more favorable risk-adjusted opportunities elsewhere). The simulation should take account of the

    appropriate time lag for each of these elasticities, some of which are longer term than others.

    Exhibit FA base case simulation should then be contrasted with Specific Cash-at-Risk uses include the following:alternative planning scenarios, such as alternative Quantifying operational and financial exposureshedging scenarios, R&D spending, dividends, and net incomeinterest/dividend coverfunding scenarios (i.e. optimizing fixed versus floating debt-to-equity ratioshareholder valueand quantity of foreign currency debt). In so doing, the

    Optimizing capital structure and derivative strategiescorporate is best able to derive benefit from its Evaluating static or dynamic hedging, borrowing andinvestment in the SEC-required risk quantification. CaR investment policiesmodels can be used for a number of additional corporate Measuring worst-case counterparty exposure

    Measuring risk relative to a benchmarktreasury tasks as depicted in Exhibit F.

    Stress Testing

    To compliment CaR, the company should stress test the impact on the balance sheet of extreme market

    scenarios. Stress tests are hypothetical market rates and price scenarios to reflect possible, near term

    changes in those rates and prices. Examples include repricing company value or earnings under a 500

    basis point parallel shift in yield curves; a 10% change in FX rates; a 5 standard deviation market move;

    or a 50% increase in portfolio volatilities and correlations. A drawback with stress testing is that

    correlations between market prices are not empirically addressed as they are in CaR.

Exhibit G depicts the impact on net income as Exhibit GStress Testing Net Income Variation of Negatively Convex Balance Sheetinterest rates are trended linearly over 12 months up

    and down 100, 300 and 500 basis points. 30%Up 500Importantly, elasticities of market demand and 20%Up 300Up 10010%supply are estimated at each month to determine how Baseline0%business variables may change in relation to interest Down 100-10%Down 300rates. In this example, treasury can examine its -20%Down 500exposure to rising volatilities (negative convexity) -30%Net Income Variation-40%because it has provided its customers and suppliers -50%with options allowing them to buy product and sell -60%12345678910111213supplies, respectively, when interest rates and their Monthimpact on supply and demand are most favorable for

    them and least favorable for the company. Although the hypothetical company is funded by short-term

    CP, has short-term costs, and has longer-term contractual and anticipated cash flow revenues, the impact

    of shifting rates is not linear. A 500 basis point increase in rates decreases net income by 60%; while a

    500 basis point decline in interest rates increases net income by only 30%.


    DRAFT OF 4/28 (2,700 WORDS + 12 EXHIBITS)

    Stress scenarios test where extreme market values and elasticities of supply and demand can affect

    company net income and value. Lastly, elasticity assumptions should also be tested to determine how

    forecast errors may impact upon company income or value.

     Exhibit H

    Top-Down: Free Cash Flow at Risk (FCFaR) Top-Down: Free Cash Flow at RiskAlthough the new SEC requirements can be satisfied Objectiveswith the above CaR and stress test models, Account for correlations between all risksincreasing shareholder value through risk-adjusted Define risk as historical volatility of economic Free Cash Flow (FCF)capital allocation between businesses requires a

    model that can take account of market and other FCF = EBIT (1-T) + Depreciation - Change in NWC - Investment + Tax Benefitrisks, such as credit, operational, legal, and

    reputation. Free cash flow (FCF) is the true VolatilitiesFree CashConfidenceHolding=&Flow at Riskeconomic cash flow of a division or company (either LevelPeriodCorrelations(FCFAR) financial or non-financial) that is available to capital

    providers and thus incorporates the impact of all risks on company performance. The textbook definition

    of FCF is earnings before interest and taxes (EBIT) plus Depreciation minus change in net working

    capital (NWC) minus capital expenditures (Investment) plus the Tax Benefit (debt multiplied by the tax rate), as depicted in Exhibit H.

In the top-down approach, Free Cash Flow at Risk (FCFaR) is a statistical estimate, given a certain

    probability, of how much FCF a division risks losing over a specified period of time due to changes in

    cash flows. The holding period is often one quarter, as corporate performance is performed quarterly and

    FCF estimates are often made for quarterly or yearly periods ahead. Although FCFaR can be calculated

    ex-post or ex-ante, an outsider will have to rely on historical FCFs (the lookback period should be as far

    back as annual report data segments divisional earnings). Volatilities and correlations can be calculated

    parametrically (empirical standard deviations and correlations) or via historical simulation to estimate

    the true distribution. The marginal FCFaR of each division to enterprise risk should be calculated to

    capture the diversification benefits between businesses. The sum of the marginal FCFaR for each

    division should add up to less than the absolute FCFaR of each division on its own, and the difference

    represents the diversification benefit.

Top-Down: Shareholder Value Ratio (SVR)

    Similar to risk-adjusted performance measurement (RAPM) used by financial institutions, the

    Shareholder Value Ratio (SVR) allows financial and non-financial entities to allocate capital between

    divisions on a risk-adjusted basis. Traditional shareholder value analysis addresses risk only in the

    choice of a risk-adjusted discount rate for expected cash flows and allocates capital to projects with

    positive value. The SVR methodology recognizes that such discounted cash flow (DCF) analysis only

    addresses the expected return side of the problem and does not take account of explicit correlations

    between activities. DCF analysis is no different from discounting the cash flows of a corporate bond by

    the Government zero curve plus a spread to reflect the corporate’s risk versus Governments. But the

    expected return still needs to be compared to the project or division’s contribution to enterprise-wide risk

    as done with RAPM measures.

    Exhibit ISVR is simply expected return divided by risk as

    Top-Down: Shareholder Value Ratio (SVR)depicted in Exhibit I. For a given level of risk, the

    company will allocate capital only to those activities Objectiveswith the highest expected modified internal rates of Allocate capital between activities on a risk-adjusted basisMaximize forecast FCF (discounted at appropriate rate) forreturn (MIRR). As cash inflows and outflows in a expected riskcorporate project are distributed randomly over the

    SV Ratio = IRR of Forecast FCF discounted by beta-adjusted WACCproject’s lifetime, return is defined as the MIRR of Contribution to Risk Capital *the project or divisional cash flows. Specifically,

    return is the MIRR of forecast FCF discounted by a * Contribution to Risk Capital = Cash Flow at Risk WACC


    DRAFT OF 4/28 (2,700 WORDS + 12 EXHIBITS)

    beta-adjusted weighted average cost of capital (WACC). Divisional managers (insiders) often forecast net income or FCF out ten years; while outsiders can use Value Line forecasts and public company data to estimate FCF. The PV of FCF beyond ten years can be treated as a lump sum perpetuity and divided by the WACC minus the expected growth rate (as depicted in the last column of Exhibit K below).

     Exhibit JThe WACC is defined based on the capital asset pricing model WACC = RxW+ RWDD EE(CAPM) as depicted in Exhibit J. Although company Betas are R = R+ B x (Risk Premium) [CAPM]EF supplied by data vendors such as Datastream, Betas for individual B is based on regression of revenue volatility toactivities must be estimated through regression analysis. So for the betas of companies in similar activity

    Rhypothetical Activity A depicted in Exhibit K, a population of is the zero swap curveF public companies that concentrate in strictly that activity is

    identified. The population of company sales volumes smoothed over economic cycles are regressed against the population Betas to estimate Activity A’s Beta. The Beta along the regression line with a sales volume corresponding to Activity A is then used in the CAPM formula to discount each period’s FCF. The risk-free rate is defined as the Government zero rate at each maturity. (The 10-year yield to maturity rate, which is suggested by many textbooks, fails to take account of the forecast FCF’s

    particular distribution).

Exhibit K calculates the Activity AExhibit KMillionsYear 1Year 2Year 3Year 4Year 5Year 6Year 7Year 8Year 9Year 10PerpetuityMIRR for a series of

    Forecast FCF-200-200110116121127134140147155700periodic FCFs. The

    WACC12.0%12.2%12.5%12.7%13.0%13.2%13.5%13.8%14.1%14.3%14.6%MIRR considers both the PV Periodic FCF-178.57-158.7677.2971.5165.8560.3655.0649.9745.1240.52155.92cost of the investment

    (WACC) and the interest SV Ratio =105 (21% MIRR of FCFs x Economic Capital) 500(Economic Capital = FCFaR / WACC)received on reinvestment

    of cash.

    The risk side of the ratio is defined by the Economic Capital required for the activity. Economic Capital is that amount of capital required to support the marginal FCFaR of the activity to perpetuity. Fortunately, marginal FCFaR does not have to be forecast for each period to perpetuity - we simply use the perpetuity formula to calculate the required economic capital that will support the periodic reinvestment of the next year’s FCFaR. To express risk and return equivalently, the MIRR of the FCF estimates is multiplied by the Economic Capital of $500 million to arrive at the final Shareholder Value Ratio (105/500). Companies can then use the tool to identify those businesses with the highest SV Ratio. With multiple activities, this may require linear programming to correctly account for the diversification benefits between businesses. Too many financial institutions simply allocate capital to businesses with the highest RAPM ratio.


    The non-standardization of the new SEC Rule requires companies to take a hard look at how they plan to manage and quantify risk. In developing a risk management infrastructure in response to the new rules, it is important that companies follow a methodical process to determine the appropriate types of risk measures, processes, policies and controls for their particular organization. This paper has presented some of the choices and challenges treasurers face in implementing the new SEC Rules. We have proposed various implementation methodologies for complying with the new SEC requirements for market risk disclosure. Further, we have presented a methodology for companies to improve shareholder value by building the foundation for a risk management infrastructure allowing entities to allocate capital between activities on a risk-adjusted basis.

Lang Gibson can be reached in New York at 212-355-9034


    DRAFT OF 4/28 (2,700 WORDS + 12 EXHIBITS)


    Alfred Rappaport, Creating Shareholder Value: The new standard for business performance, The Free Press, NY 1986

T. Copeland, T. Koller and J. Murrin (McKinsey & Co.), Valuation: Measuring and managing the

    value of companies, , John Wiley & Sons, NY, 1996 (second edition)

Chris Matten (Executive Director, SBC), Managing Bank Capital, John Wiley & Sons, NY, 1996

    Gunter Dufey and Ian H. Giddy, The Handbook of International Accounting (Management of FX Risk), John Wiley & Sons, 1992

    Diane Wunnicke, David R. Wilson and Brooke Wunnicke, Corporate Financial Risk Management, John Wiley & Sons, NY, 1992

Ian H. Giddy, Global Financial Markets, D.C. Heath and Company, MA, 1994


Report this document

For any questions or suggestions please email