Most finance professionals are familiar with the concept of Value at Risk (VaR), since it is widely used by financial institutions to estimate the potential loss of market values on a portfolio. The Cash Flow at Risk (CFaR) approach is a close cousin of VaR, measuring potential shortfalls of cash flow impacting the P&L statement and, consequently, earnings per share. Both can be used to estimate worst case risk scenarios, but CFaR provides a more precise and tailored way to measure risk for corporates. Here’s why:
1. Corporates care about risk over a longer time horizon. While financial institutions have the ability to quickly trade in and out of the market in response to short term changes in balance sheet fair values, corporates are locked into prices until their annual budget processes or contract renewals. Only then do they have an opportunity to lock in new prices. CFaR is a more suitable approach to modeling risk because it measures the potential cash flow shortfalls over a much longer time horizon than VaR, and it incorporates longer term changes in market prices.
2. Not all risks are the same. The Hong Kong dollar pegged to the U.S. dollar is less risky than, say, the price of oil. A good CFaR model enables corporates to leverage correlations between asset classes and their differing volatilities to formulate actionable hedging strategies that can translate into significant savings. Rather than overstating their risk by simply hedging all their exposures, companies can look at correlations between various asset classes, test their hedging assumptions, and tweak their hedging decisions, By analyzing exposures in this manner, companies can avoid over hedging and reduce as much as 40-60% of their transaction costs.
Risk measures such as VaR and CFaR are valuable in understanding exposures and developing solid risk management programs. But CFaR is more applicable for corporates as it more closely aligns with how they need to analyze their exposures from a P&L perspective and manage their risk over time.