What’s at Risk? The Use of Sensitivity Analysis to Measure Your Portfolio’s Risk

'Risk’ – a four letter word that has gained increased prominence since the financial crisis hit.

More appropriately the lack of risk management is being blamed for helping to deepen the financial crisis. Companies are now focusing on the various types of risk management techniques available to them and the list is extensive: Liquidity, collateral, counterparty, market, etc. As part of their risk management policy, companies need to decide how they are going to determine their portfolio’s exposure to the various types of risk. What happens if interest rates go up? What if we have another crash – what will be the impact on my company? The true cost of risk management comes in not having a properly defined risk management process. The consequence of having an ill-conceived or inadequate process means that your organisation has no visibility into how even the simplest changes will impact the bottom line. And using a method that is insufficient is detrimental. How do you decide where to begin? This article will examine sensitivity analysis methods in more detail and discuss some of issues you need to think about when incorporating Value-at-Risk (VaR) into your risk management process.

FAS and IFRS – regulatory pressures for better risk management

Risk calculations, such as sensitivity analysis and VaR, have been around for many years and are important components of a good risk management policy. But beyond just best practices, regulations are also requiring treasuries and finance departments to perform some kind of risk measurement in disclosures in the financial statements. In the Quantitative and Qualitative Disclosures about Market Risk section 7a under Financial Accounting Standards Board (FASB) and under International Financial Reporting Standards 7 (IFRS 7), paragraph 40 states that financial statements need to explicitly state the potential impact of market movements companies are principally exposed to:

“Financial Instruments Disclosures: a requirement exists to calculate the potential impact of each market risk variable or conduct a value-at-risk analysis.”

With the regulations requiring some form of risk analysis, treasurers need to find a method that fits with their resources and overall risk management policy. As evidenced in a survey of corporate treasuries,over 40% of respondents reported adjusting their risk management strategy after the crisis to include sensitivity analysis and/or VaR1. Corporations are recognising the importance and starting to make risk measurement a priority.

Sensitivity analysis and VaR

Whether you manage the treasury of a $100m company or a billion-dollar company, the different types of risks can have a significant impact on your bottom line. Subtle swings in FX or interest rates could affect your financial statements and without proper risk management analysis, you could be in for an unpleasant surprise. With proper analysis you can determine the risk and then hedge appropriately against it.

We’ll first examine in-depth the different types of risk a company can face and the ways to analyse them using sensitivity analysis.

Sensitivity analysis, or a what-if analysis as it is sometimes called, is used to determine how much the valuation of an individual trade, and ultimately your portfolio, changes by varying an independent input. This type of analysis is very common and has been in use for the past few decades. The advantage of sensitivity analysis is that it is a relatively simple risk measure to calculate, and is an important output for people that review the results. In fact, many mathematical models output sensitivities directly. For example, the term ‘Greeks’ is used to define the sensitivities that can be calculated based on your option portfolio. The Greeks, sometimes specifically referred to as delta, gamma, vega, theta and rho, are sensitivities to certain inputs used to determine the change in the resulting output. These can then be used to determine hedging strategies.

Every company needs to perform some kind of sensitivity analysis on its risk portfolio. It is an important part of your overall risk management strategy. Whether the company is public or private, a manufacturer importing raw materials or a service-based company dealing in foreign currencies, almost every company will experience some sort of risk be it interest rate, foreign exchange, and/or commodity risk. It is very likely that companies will be exposed to multiple risks. These risks require corporations to review how changes will impact their business. Having the visibility into the risk your organisation faces is important information that can be passed to internal people with a vested interest in the results, such as the CEO, COO and CFO and also is important for external reviewers including your board of directors, auditors and, of course, investors. A few common sensitivity analyses that are particularly applicable to a corporate treasury include analysing the impact of changes in interest rates, foreign exchange and commodity prices. Some companies even extend the analysis to their employee stock options.

Interest rate risk

Interest rate sensitivity analysis is very important for most corporations. Interest rate risk in general, can be lowered by including some fixed and/or floating rate debt. The corresponding debt and interest costs could also be managed by entering into a derivative contract such as an interest rate swap or a treasury lock. With respect to sensitivity analysis, the treasury department should ensure that the portfolio is subjected to rigorous testing to determine what the change in value might be given a change in interest rates.

A key rate risk analysis is one of the most commonly used methods of evaluating interest rate risk. This analysis is essentially completing a more rigorous sensitivity analysis by varying each data input that is used in building the yield curve. A sample analysis could include individually adjusting the 3, 6 and 12 month points of the yield curve along with the 5, 10, or 20 year point. The adjusted yield curves are then used to re-value the portfolio with the new result being compared with the original value. By doing this type of analysis, a risk profile can be created to determine which part of the yield curve they are most exposed to risk. The treasury department can then make a decision as to how it wants to manage this risk. The key rate analysis is also important for cash flow management and will allow for better forecasting.

Foreign exchange and commodity risk

Many organisations are not dealing with just a single currency. Their costs such as wages and debt payments might be in one currency while raw material costs are in another. In addition, sales may also be invoiced in multiple currencies. This makes it important to determine what the impact on income might be with changes to commodity prices or foreign exchange rates. Although many organisations may be able to create a natural hedge by matching their inputs and outputs in the same currencies, it is difficult to attain a perfect offset for all the exposures.There are many different types of derivative instruments available, such as cross-currency swaps, forwards/futures and or options that can be used to reduce your exposure. Many of these hedging instruments are available for both commodities and foreign exchange and can be created on various types of raw materials and currencies.

However, before an instrument can be used to hedge the risk, companies need to determine the magnitude of this risk. This can be done by conducting a sensitivity analysis to all of the commodity prices and FX rates that an organisation may be exposed to. This is very similar to what was described above in the interest rate risk section: change the price / rate of one of the inputs in order to determine what could happen to your commodity or FX trades and see where the risks lie. Note that there can be both positive and negative impacts to the financial statements when risks are not hedged. Making a decision of how much or which risk to hedge will be determined by the company’s risk policy. However, without any type of sensitivity analysis a decision as to how best to manage this risk cannot be made.

Employee stock options

Employee stock options (ESOs) are another area that an organisation (not specifically the treasury) may want to conduct a sensitivity analysis on. ESOs have been around for many years and are regulated through various standards including FAS 123R and IFRS 7. For those organisations that have issued ESOs, sensitivity analysis can be conducted on the portfolio to see what the costs could be to their income statement or how many options will be exercised if the options were to move from being out-of-the-money to in-the-money. Many corporations who use the Black-Scholes or lattice model may not realise that the sensitivity analysis output is easily available. In the case of stock options, the delta can provide the organisation with an understanding of how much the option value would change given a change in the underlying stock price. This data can be used to estimate what the potential impact on the financial statement could be. While sensitivity analysis will be adequate in most cases, VaR, a more complex type of analysis, may be used to further scrutinise your portfolio’s exposure.

Value-at Risk

VaR is another way of measuring the risk in a portfolio and has also been around for many decades. More recently, it has been famously blamed as exacerbating the financial crisis by being a risk measure that does not accurately capture the risk in a portfolio. VaR has typically been seen as a more sophisticated risk measure and therefore is used primarily in the financial sector and some of the larger non-financial organisations. For smaller organisations, the challenges in understanding and calculating VaR independently can be significant. This article will not debate the merits of VaR as an appropriate measure of market risk other than to state that it is a measure that a corporate treasury should have available, but it shouldn’t be the only one that is relied upon. More recently, we have seen more corporates investigating the use of VaR as a risk measure in part due to the fallout from the financial crisis. However, when many find out the amount of work that is required to run this analysis, they tend to revert to simpler measures such as sensitivity analysis. The two main issues with using VaR are:

It is important to understand the model before using it to analyse the exposure in your portfolio. This is a particular challenge given that there are multiple ways to calculate the VaR of a portfolio, whether it be Variance/Covariance, Historical or Monte Carlo. Each method has its own pros and cons. Also, given that there are multiple methods available, users have to understand what type of data will be required and any specific hardware requirements given that some can be calculation intensive. All of the above barriers can be removed by finding a solution that has all the necessary data available, can easily take in the portfolio details and is fully documented with respect to the model and assumptions that are being made.

Conclusion

As we come out of the financial crisis, organisations are facing significant challenges as they rush to provide information that is being demanded of them by their stakeholders. For larger companies, the challenge is to ensure that the risk process is capturing the necessary information and make the necessary modifications. For smaller organisations, the challenge can be more difficult as they not only need to understand the risk, but may also need to put the methodology in place. As this article has discussed, there are multiple types of risk that a company can measure along with multiple methods to capture that risk. Whichever risk methodology is used, whether by itself, together with or alongside the many other measures, it is imperative to incorporate these analyses into your risk management programme and vital to your overall business strategy.The cost of not having a solid risk management policy in place is too great.