VaR and CFaR: Two Ways of Measuring Risk in the Corporate World
by Bardia Nadjmabadi, Consultant for Financial risk management, KPMG
The risk measure Value-at-Risk (VaR) was designed to measure market risk for use in financial institutions. It can be regarded as a market standard for risk measurement. Its popularity in the market is based in part on the fact that risk management regulations for financial institutions have defined this measure to be an appropriate method of risk measurement. However, its success is also based on the fact that it is one single number, is easy to understand and can be implemented with a reasonable effort. Over the years, the approach has been developed further in terms of methodology, application, interpretation, implementation and other dimensions. However, in the corporate world, a discussion about the reference value of risk management and risk measurement and further practical thoughts have led to the development of a modified approach, the Cash Flow-at-Risk (CFaR).
The Value-at-Risk approach is defined as follows: The potential loss of a specific portfolio will not be larger than amount x given a confidentiality level of a and given a holding period of T days.
For example, if we consider a company exporting cars from Europe to the USA and its revenues in Q1 2012 based on today’s expectation of USD 100 Mio for the next quarter, the application of a Value-at-Risk approach could be implemented using the following steps - see chart 1.
The according calculations performed based on the assumptions might lead to the following result:
Figure 1 shows that the company might end up with a loss of EUR 1.75 Mio instead of a profit of EUR 2.25 Mio that it can expect or alternatively lock in directly by using FX-Forwards. The difference between the expected profit of EUR 2.25 Mio and the maximum expected loss of EUR 1.75 Mio implies a Value-at-Risk of EUR 4 Mio.