Risk Metrics
The process to calculate CFaR and EaR is firm-specific
and requires careful analysis and understanding of material risks. Too many modelling shortcuts can result in significant inaccuracies and introduce material model risk. For example, many standard valuation and risk
models only focus on a subset of the risks involved in a transaction or investment decision. To obtain a comprehensive view of the risks involved and their interactions, various dimensions such as market, credit and operational risk need to be explicitly brought into the analysis. For example, volume related variability embedded in
Box I: What is the Difference Between Cashflow at Risk, Value at Risk & Earnings at Risk?
Value at Risk (VaR) is probably the most common metric used for market risk management. VaR is a measure of the potential variability in the mark-to-market value of a portfolio. It is particularly useful as a short-term risk metric for trading firms, but it has very limited information for most energy and commodity firms.
Cashflow at Risk (CFaR) measures the potential variability of cash inflows and outflows at multiple time horizons as a result of the firm’s operation as well as changes in the value of the hedging portfolio.
Earnings at Risk (EaR) measures the potential earnings variability for multiple time horizons based on a set of earnings recognition rules that determine in which reporting period those earnings fall.
many physical and derivative contracts, and operations related constraints such as ramp-up and ramp-down rates and plant outages, need to be explicitly accounted for to obtain a realistic value and risk estimates. The same is true for critical operating constraints from our assets, the material clauses in contracts as well as the limitations of physical and financial arbitrage strategies such as market liquidity and available hedging instruments.
Using Cashflow at Risk to Design & Manage Hedging & Trading Strategies Some firms have found out the hard way that a hedging or
trading strategy that does not anticipate cashflow and collateral implications may have unintended consequences and expose the firm to the problem known as ‘hedger’s ruin’. It is surprising
that many market participants are still unable to adequately calculate margin calls as well as potential collateral based on a ratings change and/or market changes.
... many standard valuation and risk models only focus on a subset of the risks involved in a transaction or investment decision
Market Scenarios
Mark-to-Market/Mark-to-Model Multiple Time Steps (periods)
Portfolio Ageing & Walk Forward Analysis Netting Agreements
Collateral & Margin Clauses
Portfolio Trading/Hedging Strategies Counterparty Default Hedge Effectiveness Rules Rating Downgrade Operational Risks
Dynamic Hedging Strategy Volumetric Risks Source: NQuantX, LLC
56
Table 1. Differences Between VaR, CFaR & EaR VaR CaR & CFaR EaR YES YES NO NO NO NO NO NO NO NO NO NO NO
YES YES YES YES YES YES YES YES NO YES YES YES YES
YES YES YES YES YES YES YES YES YES YES YES YES YES
For example, when commodity prices collapsed in the summer of 2008, many firms experienced a large volume of collateral calls that forced them to go to the capital markets to raise extra capital at a time when banks were suffering a severe liquidity crisis themselves. Firms without contingency plans in place found themselves paying large spreads to borrow money to fund their positions or just unable to continue funding their hedges.
Evaluating Potential Collateral Requirements Margin management for derivatives
traded on exchange, as well as collateral management for OTC derivatives, is gradually moving from an ancillary back- office, often silo-based function into the heart of integrated credit and liquidity risk management. Given its growing importance, margin
and collateral have become one of the more volatile components in a Cashflow at Risk model in energy and commodity firms with significant derivatives positions in their books. The use of collateral for OTC energy derivatives has increased dramatically
worldPower 2010
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