Financial risk management for non-financial corporations is a relatively new concept. To state the problem succinctly, corporate risk is complex. Unlike pure, well-defined financial risks, the risk characteristics of a corporation cannot be easily described by a single equation containing a few variables. Instead, non-financial corporations face many sources of risk. There are some classes of risk that derive mainly from the underlying operations of the business. For instance competitive risks, business-cycle or macroeconomic risks and technological risk can be named as business risks. There are other classes of risk that include currency risk, interest rate and commodity price risks. As with any attempt at classification, there are items that do not fit clearly into categories. These include systems risks, potential fraud and unanticipated regulatory changes.

The main issue with corporations is the greater focus on cash flows rather than market values of assets and liabilities. In evaluating their major risks, most non-financial companies will want to know how much volatility in their cash flows or firm value an exposure can be expected to cause over periods of at least a year. The question management would like to be able to answer is this; if they define financial distress as a situation where they cannot raise funds with a BBB credit rating, or where our cash flows or the value of equity fall below some target, what is the probability of distress over the next year?

The primary goal of this article is to offer a better understanding of the variability problems of cash flow, shaped by the combined various sources of risk and their inseparable effect on overall corporate risk.

Value at Risk (VAR) and Corporate Objectives

When a company hedges an exposure, its primary concern is the likelihood of distress during the year, which depends on the value of the cumulative loss throughout the year. Thus, it must be concerned about the path of the company's value during a period of time rather than distribution of the firm's value at the end of the period. Given this focus on cumulative changes in company value during a period of time, perhaps the most practical approach to assessing a company's probability of financial distress is to conduct sensitivity analysis on the expected distribution of cash flows. Using Monte Carlo simulation techniques for example, one could project the company's cash flows over a 10 year horizon in a way that is designed to reflect the combined effect of all the firm's major risk exposures on its default probability. The probability of distress over that period would be measured by the fraction of simulated distribution that falls below a certain threshold level of cumulative cash flow. (Stulz,1997)

Academic literature focuses on volatility reduction (variance minimisation) as the primary objective or risk management, and on variance as the principal measure of risk. Many banks and financial institutions now attempt to quantify the probability of lowertail outcomes by using a measure known as "value-at risk" (VAR). VAR summarises the expected maximum loss over a target horizon within a given confidence level. (Jorion, 2000). To measure risk using VAR allows managers to make statements such as "we do not expect losses to exceed £1million on more than one out of the next 20 days."

But such a focus on variance is inconsistent both with most corporate practice and with the theory of risk management. Some companies may have a comparative advantage in bearing certain financial risks. Rather than aiming to reduce variance, most corporate risk management programmes appear designed just to avoid "lower-tail outcomes" while preserving upside potential. (Stulz, 1997). Their risk management goals are designed to reduce the expected costs of financial trouble while preserving the company's ability to exploit any comparative advantage in riskbearing it may have.

Limitation of VAR Methods for Corporates

The most obvious limitation of VAR is that it does not provide a measure of the absolute worst loss. VAR only provides an estimate of losses. However, there is a 95% probability that a company's loss on a given day, or in a given month, will not exceed a certain amount. VAR is not a useful tool when the management's concern is whether the firm's value will fall below some critical value over an extended period of time.

The main purpose of a VAR type risk measure is to quantify potential losses under "normal" market conditions. The problem is that VAR measures based on recent historical data can fail to identify extremely unusual situations that could cause severe losses. This is why VAR methods should be supplemented by a regular programme of stress testing. Stress testing can be described as a process to identify and manage situations that could cause extraordinary losses. While VAR focuses on the dispersion of revenues, stress testing instead examines the tails. Stress testing is an essential component of a risk management system because it can help to ensure the survival of an institution in times of market turmoil. This can be done by scenario analysis.

One of the advantages of using simulation techniques in this context is their ability to incorporate any special non-normalities of cash flows. The VAR approach assumes that the gains and losses from risky positions are "serially independent" which means that if your firm experiences a loss today, the chance of experiencing another loss tomorrow is unaffected.

But this assumption is likely to be wrong when applied to the operating cash flow of a non-financial firm: if cash flow is poor today, it is more likely to be poor tomorrow. Simulation has the ability to build this "serial dependence" of cash flows into an analysis of the probability of financial distress.

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