Implementing an Earnings at Risk Transformation

Published: March 01, 2012

Implementing an Earnings at Risk Transformation

by Pat Ryder, Director, Financial Risk Management, Eastman Chemical Company

Founded in 1920, Eastman Chemical Company is a global chemical company that manufactures and markets a broad portfolio of chemicals, fibres and plastics. Eastman has 20 manufacturing locations globally, and employs approximately 10,000 professionals. In 2011, the company generated sales revenues of $7.2bn.

Project background

In the past, risk management was undertaken on a siloed basis at Eastman. FX risk was managed by the pensions manager, and commodity risk was the responsibility of procurement, with a variety of disparate systems in place. At Eastman, we pride ourselves in engaging the best people, processes and technology, and in maintaining a best-in-class position across all of our activities. We recognized that we needed to refine our approach to risk management to align with these standards, so we approached our Board with a view to transforming the way that we assess and manage risk. We have a high-calibre Board, whose members have a detailed understanding of risk management issues. We therefore received considerable support for this initiative amongst senior management, which is imperative for delivering a complex project with a variety of stakeholders.

Centralizing risk

We recognized that we would be in a better position to monitor and manage risks on a group-wide basis if risk management was centralized in treasury. This would allow us to establish correlations between different types of risk, rationalize systems, and make our hedging more efficient. Having centralized risk-related activities, we needed to understand the reasons behind the risk management approach we had adopted in the past. This involved working with stakeholders across the business to understand where exposures are created, and how information is used. We recognized that data and process integrity was essential at every stage in order to ensure the quality and timeliness of risk management decision-making. We also needed to take into account the needs of each stakeholder and to make sure they understood and embraced a new approach.

An EAR strategy

Following this process, we focused on our commodities risk, which is one of the most significant risks for Eastman. We had previously monitored commodities risk on a short-term basis, and hedged a small proportion, primarily determined by the cost of hedging. We decided to modify this approach to adopt an earnings at risk (EAR) model. EAR measures the amount by which net income might change in the event of an adverse change in risk, created by changes to interest rates, FX rates or commodity prices. It is similar to value at risk (VAR); however, while VAR looks at the change in the entire value over the forecast horizon, EAR focuses on potential changes in cash flows or earnings. To achieve this, we sought to introduce a variety of advanced modelling techniques. We also needed the ability to perform iterative calculations over multiple time periods, taking into account every hypothetical change to prices. By modelling different scenarios across the risk-return spectrum, we could then make hedging decisions on a portfolio basis with a view to reducing earnings volatility. We are also taking the same approach to currency risk, although with different calculations due to the different way in which currencies are priced.

From concept to reality

To put this new concept into practice, we needed to introduce technology that would provide complex modelling tools and support iterative calculations. In 2009, we started to review systems that would enable us to record and report on transactions, automate the accounting entries and support our risk analytics. We reviewed a variety of systems, and found that while some provided the capabilities we required for commodities, these typically had less functionality to support other financial instruments, and lacked hedge accounting capability.[[[PAGE]]]

Consequently, we made the decision to implement Reval®. The system provided the required breadth of functionality across all of our instruments, including hedge accounting. In addition, we were very impressed by the level of knowledge of risk management and trading techniques amongst the team. For us, technology is simply a tool to enable us to manage our business requirements, and Reval was able to provide specialist risk analytics expertise. We finalized our decision at the end of December 2009, and began the project in January 2010. We quickly implemented our FX requirements in the system, and then progressed into commodities in June 2011. We knew in advance that there would be a few system changes to provide the functionality we required in this area, but Reval understood our priorities and took a collaborative approach to designing and developing the additional capabilities we needed.

Originally, we hosted an in-house system, but found the SaaS (Software-as-a-Service) model to be more advantageous as it freed up assets to manage the actual risk and not the system maintenance and upgrades.

Outcomes to date

Although we have been using EaR metrics as a basis for managing commodity risk exposure since 2007, the use of SaaS to help achieve this is relatively new, so we have yet to see the full range of benefits. However, from an FX perspective, transaction processing time has been reduced significantly whilst freeing up time for analysis, particularly in the middle and back office where the resource savings have been greatest. Users of Reval are finding the experience very positive, and we have also been very encouraged by the reaction of stakeholders who make use of the information we produce. In commodities, we are also a great deal more efficient; we have better analytics capabilities and hedge accounting is now robust and automated. This has helped considerably from an internal and external audit perspective. We are able to close our month end quickly and accurately, and we anticipate that the same should apply to the year end closing process.

Future steps

We are considering integrating Reval with our ERP. There are also some specific, complex requirements that we will be building into Reval. For example, we deal with some illiquid commodities, with data from a variety of sources that have been working to integrate into the system.

The ability to outsource the maintenance of the system has proved very beneficial, as we can focus on activities that create value to our business and leverage Reval’s technical platforms and knowledge base. Having a partner with both technical and business expertise to contribute to our project has been a major asset, and our successful implementation has been due in no small part to the support we have received from Reval.

Pat Ryder

Sign up for free to read the full article

Article Last Updated: May 07, 2024

Related Content