CorporateMetrics Technical Document

Sep 7, 2003

Many companies have expressed an interest in understanding how the principles of Value-at-Risk, which were initially developed for managing market risk in a financial environment, can be applied in the corporate environment. In our discussions with corporate clients, they have raised a number of issues about implementing a strategic risk management program within their companies. This document outlines a framework we have entitled CorporateMetrics (tm) that addresses the unique market risk management needs of corporations as follows:

• Market risk versus business risk:
  Risk management in the corporate environment is inherently more complex than in a pure financial environment (i.e., trading and investment functions) in that companies have both non-hedgeable business risks (relating to the nature of their specific products and services) and hedgeable market risks (e.g., commodity, currency, interest rate, equity exposures). The level of market risks is furthermore a function of business risks, which can make the implementation of a risk management system a complex process. This document proposes an analytical framework for identifying the market risks inherent in the business activities of corporations by integrating risk measurement into the budgeting and planning process.
• Financial results and firm value:
  Whereas financial managers (e.g., trader, portfolio manager, treasurer) tend to manage the value of their assets and liabilities, corporate managers tend to focus more on the level, growth, and, increasingly, the volatility of corporate financial results such as earnings and cash flow as benchmarks for good performance. In this document, we propose a re-characterization of Value-at-Risk concepts from a financial environment to an earnings and cashflow environment. We also discuss the implications of managing earnings volatility for the valuation of the company.
• Short-term versus long-term management cycle:
  Compared to financial institutions, which may actively take short-term risk positions to generate trading profits, corporations are generally less sensitive to daily fluctuations in the market and focus more on monthly and quarterly earnings volatility when measuring performance. We discuss the issues relating to a shift from managing daily market volatility to a longer management cycle.
• Capital: In a number of industries, there is growing interest in assessing the level of capital to sustain risk-generating activities and relating the cost of capital to the riskiness of business activities and projects. The risk measures proposed in this document can provide insights into capital-related decisions.
• Derivative disclosure requirements:
  Not only are shareholders and investors more interested in understanding the dynamics of earnings risk and the company's risk management philosophy, but the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) have issued a set of requirements to regulate how companies are to disclose both the level and the effectiveness of their risk management programs. In this document, we propose a methodology that can be used to help address some of these requirements.