At-risk measures

Among Treasury's more challenging aspects is the management of risks arising from its core tasks (provision of liquidity, financing and investment, management of foreign currencies). Identifying the various risk factors and quantifying the potential impact is a fundamental prerequisite for managing these risks. With regard to identifying the relevant material risk factors, standards have been established in treasury that most companies follow.

But the situation is less standardized when it comes to quantifying risks. As far as methodology is concerned, we are seeing a continuous development of key figures, mathematical models and calculation methods that make use of the constantly growing technological possibilities. In contrast, a spectrum of different approaches can be found when it comes to practical application.

For market risk, nominal exposure and simple sensitivities, such as a fixed exchange rate change or a constant parallel shift in all yield curves, are still widely used as primary indicators. For credit risk related to banks, investment volume and rating typically form the core of limit allocation and investment management. It is still far from standard practice in corporate treasury to use actual risk measures such as value-at-risk or cash flow-at-risk. And even where these indicators are already part of the reporting system, they are often not at the heart of actual risk management.

The second logical step in risk measurement after identifying the key risk factors is to determine the associated exposure. Within the complex interrelationships of a company's operational and financial processes, implementation is not easy. Among the challenges are specific issues such as the exchange rate used in the accounting system (daily or previous day's rate?), organizational issues (where to obtain planning data for exchange rate hedging without currency-specific planning?) and fundamental issues such as hedging translation risks or the objectives of interest rate risk management. Tackling these issues and further developing the processes for determining exposure often ties up a large part of the available resources and results in a focus on simple, portfolio-oriented key figures.

Unfortunately, this narrow focus means that the big picture is not taken into account: For instance, the interplay of different exchange rates and markets is not taken into account. Let's look at a typical example: With an assumed exchange rate change of 10%, you can determine the change in value of the underlying portfolio for each currency. It is then possible to add up the individual values to obtain an overall effect, but this does not take into account the different fluctuation margins and dependencies between the currencies. This type of key figure is therefore of little informative value and unsuitable for managing an overall position or a sub-portfolio.

It is precisely this shortcoming that key figures such as the at-risk risk measures address. Starting from a target figure such as market value, cash flow or earnings, the effect of a "reasonable" scenario can be determined for all market variables under consideration. Here, the definition of reasonable is derived from a predefined level of certainty (confidence level). The option of assigning the overall effect to the individual risk factors remains. This way, instead of managing the individual variables separately, the portfolio is managed as a coherent variable.

In practice, the simple limit for nominal or sensitivity per risk factor (e.g. currency) can be replaced by an at-risk limit, thereby already taking into account the different volatilities. However, it is only by switching from factor-specific limits to a portfolio limit that diversification and cluster effects between the risk factors can be accounted for.

While banks manage financial risks as part of their core business, corporate treasury as a necessary function alongside the actual operating business is typically lean, particularly with regard to capacities for quantitative methodology and data analysis as well as the associated software tools. As a result, corporate treasury solutions require a high degree of automation and standardization and need to integrate well into the existing IT landscape.

Generally, it is also difficult to compile suitable market data. For example, events such as currencies that are dropped or added, reference interest rates that change or changes in market conventions must be properly taken into account when compiling and maintaining data histories. If, for instance, no artificial history is supplemented for a new currency during a currency transition, the standard processes will implicitly impute a constant price and underestimate the actual risk. Alongside the time series for the actual market data, additional data such as correlations or volatilities can also be included, which require special attention in terms of both availability and completeness.

With regard to methodology, it is not only necessary to determine the correct risk measures and choose between different calculation methods (e.g. model-based approximation methods or simulation approaches), but also to consider ways to verify the results for the relevant time periods.

Apart from these technical aspects, it is also necessary to consult closely with all departments concerned when switching to a portfolio view and new risk measures.

Implementing at-risk risk measures is not an end in itself, but is rather directly linked to a portfolio analysis. To successfully implement this, the first step is to agree on the objectives, as very different requirements may arise. For example, the choice of calculation method will be very different for a retrospective, periodic calculation of at-risk values for reporting purposes only, as opposed to a real-time calculation for active position management. Similarly, the choice of a daily or weekly observation period results in completely different backtesting options than with an annual horizon, and possibly different market effects must also be taken into account.

This means that the range of possible methods can be narrowed down from the objective, which must then be translated into a suitable solution, with due consideration of the customer-specific system and data landscape. At this point, it is imperative to carefully analyze the process if a high degree of automation and integration is to be achieved.

This is the basis for the actual implementation, which typically includes the following blocks:

• Market data – compiling and cleansing historical market data, adding any missing market variables and ensuring a process for ongoing data supply and quality assurance
• Systems – configuring or adapting the treasury management or reporting system, integrating a separate tool for calculating key risk figures if needed
• Reporting – adapting and creating the necessary reports for position, data and risk analysis
• System of limits – adjusting the limit logic based on the at-risk risk measures and defining initial limits
• Validation – checking the implemented solution and setting up a process for regular backtesting

The various work packages are not completely separate from each other, but can (and must at least partially) be performed in parallel.

For Treasury, new opportunities open up when switching to a portfolio-oriented approach and using suitable risk measures such as cash flow at risk or value at risk. One immediate advantage is that diversification and cluster effects are (correctly) taken into account in risk measurement. 

In this way, a more precise management approach is made possible by weighing up risk and expected return. As a result, Treasury's value contribution can be increased without necessarily having to take greater risks.

This can be managed in the traditional way using exogenous limits, with the option of using approaches from financial mathematical portfolio theory - as an additional expansion stage, so to speak - that use suitable optimization algorithms to determine an ideal portfolio composition.

Implementing a portfolio approach can be done in sub-areas, such as in currency management, but it can also be part of a holistic approach that can be designed in the form of a risk appetite framework, for example, and that promotes a uniform, consistent balance between risk and return across markets or organizational units.

Source: KPMG Corporate Treasury News, Edition 141, March 2024
Authors:
Nils Bothe, Partner, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG
Dirk Bondzio, Senior Manager, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG