Exposure-Based Cash-Flow-at-Risk: An Alternative to VaR for Industrial Companies

Abstract

Cash-Flow-at-Risk (CFaR) is the cash flow equivalent of Value-at-Risk (VaR), a measure widely used as the basis for risk management in financial institutions. Whereas VaR-based systems specify the maximum amount of total value a firm is expected to lose under most foreseeable conditions (for example, with a 99% confidence level), CFaR-based systems determine the maximum shortfall of cash the firm is willing to tolerate. CFaR is gaining in popularity among industrial companies for much the same reasons VaR has succeeded with financial firms: it sums up all the company's risk exposures in a single number that can be used to guide corporate risk management decisions. The authors describe a six-step process for calculating a measure they call “exposure-based CFaR” and then demonstrate its application to Norsk Hydro, the Norwegian industrial conglomerate. Exposure-based CFaR involves the estimation of a set of exposure coefficients that provide information about how various macroeconomic and market variables are expected to affect the company's cash flow, while also accounting for interdependencies among such effects. The resulting model enables management to estimate the variability in corporate cash flow as a function of various risks, and to predict how a hedging contract or a change in financial structure will alter the company's risk profile.