Contributor: Capital Markets
We’ve all been hearing a lot about Value at Risk (VaR) lately, from discussions about its usefulness as a risk metric to likening it to a hero’s journey in Star Wars. What we don’t see discussed quite as much is Cash Flow at Risk (CFaR), which can offer significant insights in as one looks to control costs. But it’s important to know the differences between VaR and CFaR, and to know how CFaR can benefit the firm.
How does CFaR differ from VaR?
VaR signifies the value which can be lost in a portfolio of financial derivatives with x% certainty (e.g. 95%), in a given time horizon (e.g. 1 day). On the other hand, CFaR signifies the cash that would be received from or paid to a portfolio of transactions with x% of certainty over a given time horizon (e.g. 365 days). Value at Risk looks at the anticipated change in the value, while Cash Flow at Risk looks at the expected cash-flows exchanged upon consummation of the transaction. This makes CFaR a value that corporate hedgers can use to identify the risk associated with changes in the prices of a commodity they may purchase or sell.
How could a firm use CFaR?
Cash Flow at Risk is a Monte Carlo simulation methodology with a longer time horizon. For example, an airline could use CFaR to simulate the future expected price of jet fuel for next quarter, or over the next six months, or even over the course of the next year.
If that airline were considering hedging their potential exposure that could result from jet fuel purchases, several critical management decisions must be made, starting with these:
- What is the firm’s business objective?
- Should we hedge at all?
- If so, how much should we hedge?
Step 3 is where CFaR really comes into play. Results from running a Cash Flow at Risk calculation ultimately represent a “market consensus” forecast of the jet fuel prices that uses objective statistical analysis, eliminating subjectivity. As a result, CFaR should increase shareholder and management confidence that the company is making intelligent hedging decisions, which should lead to better cost management.
It should go without saying that an effective risk management policy requires an objective and statistically sound methodology. Cash Flow at Risk is a tool that can provide this. At the end of the day, CFaR answers one of the most pressing questions facing the company: What is the consensus opinion on the outcome of commodity prices in the future? Knowing the answer to this question can mean the difference between making an intelligent or a misguided hedging decision.
While you’re here…
- Learn more about Cash Flow at Risk from our energy and commodities experts in our new paper, titled The Use of Cash-Flow-at-Risk Reports in Making Intelligent Hedging Decisions.
- Explore Kiodex solutions for corporate hedgers.