At-risk risk measures

One of the challenging aspects of treasury is managing the risks arising from its original tasks (provision of liquidity, financing and investment, management of foreign currencies). A basic prerequisite for the management of these risks is the identification of the various risk factors and the quantification of the potential effects. Standards have been established in treasury with regard to the identification of the relevant material risk factors, which most companies follow. The situation is less standardised when it comes to quantifying risks. On the methodological side, a continuous development of key figures, mathematical models and calculation methods can be observed, which utilise the constantly growing technological possibilities. In practical application, on the other hand, there is a spectrum of different approaches. In the area of 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. In the case of credit risk vis-à-vis banks, investment volume and rating typically form the core of limit allocation and investment management. The use of actual risk measures such as value-at-risk or cash flow-at-risk is still far from standard in corporate treasury. And even where they are already part of the reporting system as key figures, they are often not at the heart of actual risk management.

After identifying the key risk factors, determining the associated exposure is the second logical step in risk measurement. Within the complex interrelationships of a company's operational and financial processes, implementation is not easy. The challenges range from detailed questions such as the exchange rate actually used for booking in the booking system (current or previous day's rate?) to organisational questions (where can planning data for exchange rate hedging come from without currency-specific planning?) to fundamental questions such as hedging translation risks or the objectives of interest rate risk management. The resolution of these issues and the further development of processes to determine exposure often tie up a large part of the available resources and result in a focus on simple, portfolio-orientated key figures. However, in this focus, the view of the overall position is lost: the interplay of different exchange rates or markets is not taken into account. Let's look at a typical example: assuming an exchange rate change of 10%, a change in the value of the underlying portfolio can be determined for each currency. In mathematical terms, the individual values can then be added up to an overall effect, but different fluctuation margins and dependencies between the currencies are not taken into account. Such a key figure is therefore of little informative value and is hardly suitable for managing an overall position or a sub-portfolio. It is precisely this shortcoming that is remedied by key figures such as the at-risk risk measures. Based on 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. The definition of meaningful results from a specified level of certainty (confidence level). The possibility of allocating the overall effect to the individual risk factors is retained. However, instead of managing the individual variables separately, the portfolio is managed as a coherent variable. In practical implementation, the simple limit for nominal or sensitivity per risk factor (as a currency, for example) can be replaced by an at-risk limit, which already takes into account the different volatilities. However, diversification and cluster effects between the risk factors can only be taken into account by switching from factor-specific limits to a portfolio limit.

While the management of financial risks is part of the core business at banks, corporate treasury is typically a lean function alongside the actual operational business, particularly in terms of capacities for quantitative methodology and data analysis as well as the associated software tools. Corporate treasury solutions therefore require a high degree of automation and standardisation and must integrate well into the existing IT landscape. The compilation of suitable market data is also usually associated with some difficulties. 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 setting up and maintaining data histories. If, for example, no artificial history is added for a new currency during a currency changeover, the standard procedures will implicitly assume a constant price and underestimate the actual risk. In addition to the time series for the actual market data, additional data such as correlations or volatilities can also be added, which require special attention in terms of both availability and completeness. On the methodological side, not only must the correct risk measures be determined and a choice made between different calculation methods (e.g. model-based approximation methods or simulation approaches), but options for verifying the results for the periods under consideration must also be considered. In addition to these technical aspects, careful involvement of all affected areas is necessary when switching to a portfolio view and new risk measures.

The introduction of at-risk risk measures is not an end in itself, but is directly linked to a portfolio analysis. For successful implementation, it is necessary to first harmonise the objectives, as very different requirements may arise. For example, the choice of the right calculation method is very different if a retrospective, periodic calculation of at-risk values is used for purely reporting purposes alongside a real-time calculation for actively managing the position. Similarly, the choice of a daily or weekly observation period results in completely different possibilities for backtesting than with an annual horizon, and different market effects may also have to be taken into account. The possible methods can therefore be narrowed down from the objective, which must then be incorporated into a suitable solution, taking into account the customer-specific system and data landscape. Careful analysis is necessary at this point if a high degree of automation and integration is to be achieved in the end. The actual implementation, which typically includes the following blocks, can then take place on this basis: Market data - collection and cleansing of historical market data, addition of any missing market variables and ensuring a process for ongoing data supply and its quality assurance Systems - configuration or customisation of the treasury management or reporting system. Reporting - Adaptation and creation of the necessary reports for position, data and risk analysis Limit system - Adaptation of the limit logic based on the at-risk risk measures and definition of initial limits Validation - Review of the implemented solution and creation of a process for regular backtesting The various work packages are not completely separate from each other, but can (and must at least partially) be processed in parallel.

The switch to a portfolio-oriented approach and the use of suitable risk measures such as cash flow-at-risk or value-at-risk opens up new opportunities for treasury. One immediate advantage is the (correct) consideration of diversification and cluster effects in risk measurement. This also opens the door to more precise management by weighing up risk and expected return. In principle, the value contribution of the treasury can be increased without necessarily having to take greater risks. Management can be carried out in the traditional way using exogenous limits, but there is also the option - as a further expansion stage, so to speak - of using approaches from financial mathematical portfolio theory, in which suitable optimisation algorithms are used to determine the best possible composition of the portfolio. A portfolio approach can be implemented in sub-areas, for example specifically in currency management, but it can also be integrated into a holistic approach, which can be formulated in the form of a risk appetite framework, for example, and which promotes a uniform, consistent weighing up of risk and return across markets or organisational units. Source: KPMG Corporate Treasury News, Issue 141, March 2024Authors: 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