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Cash at Risk: Managing Liquidities
Arnaud Bruneton, Senior Manager |
Cash at Risk is a statistical measurement of company liquidity levels. Like Value at Risk (VaR), it measures the lowest level of cash on hand anticipated in non-worst-case situations. Formally, “worst-case” configurations of 1% probability (either 5% or 0.1% according to company thresholds) are excluded. To this end, cash inflows and outflows have to be figured as probabilistic variables. The approach is particularly valuable, since it requires identifying the risk factors to which the company is exposed. Like VaR, the approach must be complemented so that the measurement of risks isn’t excessively approximate, and the risk assessment over-optimistic. A “Multi-horizon” measurement of Cash at Risk reduces the drawbacks of VaR and is more in line with a dynamic picture of company cash positions over several months. Likewise, the implementation of Stress Tests also strengthens liquidity management. |
Liquidity Management
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Budgets derived from a company accounting perspective are “translated” into forecasted cash inflows and outflows by the treasurer. The latter must ensure the company’s ability to deal with its expenses. In this way, she manages the financing of the company by anticipating its cash position. In the short term, she relies on the annual budget, and in the long term, she must act in accordance with the investment plan. The cash position thus brings to light financing needs that must be evaluated as meticulously as possible in order to avoid needlessly increasing finance costs, or cash surpluses whose investment should be optimized. Budget management should therefore allow the company to carry out liquidity management. In this area, the more fine-tuned the forecasts, the more efficient the policy implemented to manage financing or investment will be.
Liquidity management is conducted through management of current assets and liabilities and risk/return oversight under normal operating conditions. As such, liquidity is measured by comparing contractual debt maturities and estimates of other cash inflows/outflows. Even over short time horizons, the latter are changeable.
By modeling this uncertainty using risk factors with an estimated probability distribution, liquidity is measurable through Cash at Risk, which relies on the principles of Value at Risk (VaR). It amounts to measuring the liquidity balance resulting from all cash inflows and outflows, with a certainty of x%, within a given time horizon (6 months, a year). It allows the treasurer to manage the company’s exposure to variations in economic conditions and, more generally, in risk factors likely to affect cash inflows and outflows (accelerated growth, increased supply costs, drops in turnover and, thus, in accounts receivable, rises in inventory expenditures, etc.). Such variations can have several consequences on the conditions in which the company operates:
> Reevaluation of financing or refinancing policy;
> Interest rate variations undermining hedging strategies;
> Limitation of the company’s ability to procure additional financing due to excessive indebtedness;
> Downgrade of the company’s rating.
The calculation of Cash at Risk relies on a three-step method:
Step 1:
Identification of risk factors likely to affect monetary flows
Step 2:
Quantification of economic and behavioral sensitivities or elasticities: market- or, more generally, risk-factor-movement scenarios impact production volumes, sometimes sales prices (rates), competitors’ reactions, supply changes, etc. It is at this stage that “economic” approaches to Cash at Risk, which take into account the company’s specific industry, distinguish themselves from purely financial and statistical approaches. Indeed, there is no generic modeling, for elasticities are specific to each company.
Step 3:
Stochastic (Monte Carlo Method) or economic (Stress Tests) future scenarios: cash flow projections over x periods within different scenarios and identification of the probability distribution of the aggregates considered: cash, net income, debt to equity, etc.
This scenario-generation enables modeling the company’s “response” to shocks for associated risk factors; again, the determination of the company’s response may be more or less sophisticated:
> The capital optimization structure and the optimization structure of derivative strategies;
> Evaluation of static or dynamic hedging and borrowing and investment policies;
> The approach also allows one to include counterparty risk and exposure measurements.
It is of course possible to utilize the approach using only certain risk factors (i.e. financial), leaving unchanged traditional liquidity management practices.
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Towards Better Management of Extreme Situations
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Stress Tests
VaR and statistical approaches have been seriously called into question during the recent crisis due to their inability to measure risks ex-ante, especially those bearing on liquidity, within banking establishments.
Similarly, “traditional” Cash at Risk is not sufficient to account for companies’ liquidity risks, for it does not deal with extreme events like liquidity crises, which we have once again recently experienced. The use of crisis scenarios, Stress Tests, should complement Cash at Risk.
Stress Tests represent hypothetical (either historical or adverse1) scenarios for risk factors. They are used in order to identify vulnerabilities to and distortions of the balance sheet. Their analyses consequently enable the determination of contingency plans in case of crisis, i.e., the best reply when the alarm bells go off. The tests are an integral part of internal controls. VaR measures loss risk in “non-crisis situations.” A variant of VaR, C-VaR, takes the tails of the distribution into account and remains a simple statistical measurement. However, it doesn’t allow one to modify, as is the case with a Stress Test, the company’s best reply to a shock.
(1) See OTC Conseil Letter no. 38 - April 2009, "Vulnérabilité et Stress tests adverses" (in French).
Multi-Horizon VaR
Beyond balance-sheet management linked to a budgetary year, it is important to construct a view of the company’s cash gaps over the entire year.
An approach based on Multi-horizon VaR2 allows the company to generate reports projecting the minimal liquidity level for a given level of risk for all dates, from a single day to one year. It thus becomes possible to simulate portfolios or loans in a way that respects specific requirements according to different dates. Although probabilistic, the approach succeeds in quantifying the uncertainty of an already uncertain cash budget forecast. It offers truly dynamic management by better measuring consequences and decisions with different horizons, including the implementation of optional strategies.
Specific stress scenarios are easy to add. This includes adverse risk scenarios, which aim at measuring the company’s ability to deal with extreme economic situations and even with those approaching bankruptcy.
(2) OTC Conseil is leading a collaborative project, approved by Finance Innovation (Paris Financial Services Cluster), on Multi-horizon VaR. |
Implementing Liquidity Management: a Source of Value
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The vision of liquidity management proposed here is a source of value for the company, providing better visibility and better cash management – and, therefore, greater financial optimization. Its implementation also requires the identification of company risk factors, which, in itself, is one of the keys to good management, and may be set out in three steps:
Step 1:
An initial inventory is based on four analyses:
> Cash cycles: their existence and causes have to be identified
> The information available to the treasurer: budget estimates at different time horizons, end-of-year estimates for the beginning of the following fiscal year, the tools to deal with the information
> The sources of company financing
> The company’s liquidity deficit at different time horizons
Step 2:
Identification and quantification of risks are handled in two ways:
> Analysis of risk factors of the business, examples of which have been given above
> Modeling of economic elasticities of company income and spending in line with these risk factors
Step 3:
As for management, it depends on implementing simulation – and therefore risk-calculation – and reporting models, as well as on establishing recommendations.
The depth or exhaustiveness in terms of risk factors or method (simple Cash at Risk, Stress Tests, Contingency Plans, Multi-Horizon VaR, etc.) should be defined according to the company’s specific preferences and, in any case, should be put in place gradually. |
A Management Tool
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Liquidity management can be conducted using traditional budget data. The introduction of a risk-based approach is easily feasible. It represents a complementary analysis for decision-making by combining considerations of risk and purely economic ones. Cash at Risk allows one to include management planning within the global policy of risk management and to equip the company with additional management tools on the basis of considerations specific to its particular industry • |
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Cash at Risk
Managing Liquidities
Stress Tests
Management Tool
Multi-Horizon VaR
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