BACHELOR THESIS

RISK MEASURES AND THEIR ROLE IN RISK

MANAGEMENT:
VALUE AT RISK & CASH FLOW AT RISK

Name

: Dirk Jan Loeters

ANR

: 272918

Study programme

: Pre-Master Finance

Type

: Literature research

Supervisor

: Y. Zhou

Subject

: Risk Measures and their role in Risk Management:

Value at Risk & Cash flow at Risk

Date of submission

: 05-18-2012

Abstract
Most firm managers have heard of Value at Risk (VaR) and Cash Flow at Risk (CFaR). But
some small firm managers may not know how to calculate those measures of risk while
measuring firms risk is becoming more important in current economic markets. This can lead
to situations where companies face more risk than managers expect them to do.
In this paper I try to explain both measures of firm risk more clearly and aim for a managers
better understanding of calculating and interpreting both measures. To get to the results for
this paper I used other publications about the subjects. I have read those publications and
filtered the useful information and combined that information into this paper. Furthermore I
wrote some conclusions about the methods of calculation.
With this paper, I hope to achieve that small firm managers get a better idea of both the VaR
and the CFaR and how those measures can be calculated. So that in the future companies can
calculate and thus handle their risk better than they do now.

Table of contents.

Chapter.
1.
2.
2.1
2.2
2.3
2.3.1
2.3.2
2.3.3
2.3.4
2.4
2.5
2.5.1
2.5.2
2.5.3
2.6
3.
3.1
3.2
4.

Title.
Introduction
Literature survey
When does one need to measure firm market risk?
What is VaR?
How is the Value at Risk calculated?
Historical simulation
Delta-Normal Approach
Monte Carlo Simulation
Which method is most practical in use?
What is Cash Flow at Risk (CFaR)?
How is Cash Flow at Risk calculated?
Bottom-Up method
Top-down method
Which of the methods is most practical in use?
Why or why not is the top-down method usable for calculating the
VaR?
Example of calculating VaR and CFaR
Calculating the Value at Risk using historical simulation method
Calculating the Cash Flow at Risk using the top-down method
Conclusions
References

Page.
4
6
6
7
9
9
11
14
15
16
16
16
17
19
19
20
20
22
24

1. Introduction
Due to globalization the financial world is becoming smaller. Therefore proper risk
management is becoming more important to companies. The exchange rate exposure, the
interest rate exposure but also the risk exposure taken by firms when they enter derivativecontracts, are a few examples of risk exposure firms face every day.
For risk managers there are many ways of measuring a firms risk. One of the most used
measures of risk within risk management is the VaR (Value at Risk). This is a way of
measuring the risk exposure of market risk for firms. VaR is typically used by financial
institutes. Risk managers and investors use the VaR to measure the risk of firms or stock
portfolios. In that way they are able to choose a portfolio that has an acceptable risk rate and
still has a respectable rate of return. Which level of return and risk is acceptable differs for all
companies and investors.
Searching for that acceptable risk rate is really important for investors and managers of firms
since it enables them to reduce the risk of losing money and simultaneously creating firm
value because by reducing the risk, the managers make sure the continuity of the company is
guaranteed. If the companys continuity is guaranteed, investors might buy more shares of
that company. The role of risk measurement within risk management is that a company or an
investor can measure how much money is at stake.
Despite earlier research about the VaR, a misunderstood concept for firm managers especially
in relatively small firms is risk management. What if the CEO of the company wants to
know how much risk his company is facing? In that case you, as risk manager, can say the
VaR of our company is $1.000.000 but there is a chance that your boss does not know what
VaR means.
In this paper I want to describe what VaR means, the mechanism of how it is calculated and
try to explain the measure easier so that it can be used and understood more easily by firm
managers. I also want to compare the VaR measure with other measures of market risk, such
as the CFaR (Cash Flow at Risk) and want to describe which measure is the most practical to
use in which situation. To answer that question I want to use the following research questions;

How does one use the Value at Risk and Cash Flow at Risk theories and are they the
best ways to measure firm risk?
o When does one need / want to measure risk?
o What is the Value at Risk (VaR)?
o How is the Value at Risk calculated?
o What is the Cash flow at Risk (CFaR)?
o How is the Cash flow at Risk calculated?
o Which of the models is most practical in which situation?

The Value at Risk and Cash Flows at risk can be calculated using the Historical simulation
method, the Delta-Normal approach and the Monte Carlo simulation method. The Cash
Flow at Risk has the additional Top-Down method. I think the historical simulation method
is most practical method of calculating the VaR for relatively small companies because it is
the easiest manner of calculating the VaR. In order to calculate the Cash Flow at Risk, I think
the top-down method is most practical. Because using that method the risk manager does not
have to create a formula with all the factors that influence their cash flows. But to say if those
methods are best ways to measure the firms risk is hard if not impossible to say. It depends
on the preferences and knowledge of the manager that needs to calculate them. But it is
certain that both are two reliable, complete and relatively easy ways of measuring firms
Value and Cash Flow at Risk.
This paper consists of 4 chapters. Chapter 1 consists of a short introduction. In chapter 2 I
give a literature survey and will answer most of my research questions. In chapter 3 I
calculate the VaR and CFaR to measure risk mostly using real and sometimes using
hypothetical data. I would like to discuss the positive and negative sides of both measures
since I would like to investigate which one of the theories is the most practical to use in
different situations. Finally I want to conclude, in chapter 4, which methods of calculating the
VaR and the CFaR are most practical to use.

2. Literature survey

2.1 When does one need to measure firm market risk?

Companies sometimes want to calculate how much risk they bear with their business. Two
ways of measuring firm risk are the VaR (Value at Risk) and the CFaR (Cash Flow at Risk).
Companies calculate the Value at Risk to guarantee the continuity of their company which
can lead to more investors buying assets of that company which can lead to an increase in
firm value.
To give an example, the Value at Risk with a 5 percent confidence level and a time horizon of
1 month is 5,000,000. In that case the company also needs 5,000,000 stashed away to
prevent any financial trouble. The confidence level and time horizon are explained later in this
paper.
Some firms, for example banks, investment banks, pension funds or other financial
institutions, continuously calculate the risk they bear. Other firms, for example non financial
institutions, calculate it less often, for example once per month. They do this less often
because of the smaller and often less volatile portfolio they have. If firm managers think the
risk is too high, they can take steps to reduce that risk within acceptable proportions. In order
to do so, they can use, for example, financial derivatives or other risk reducing steps to reduce
firm risk such as moving costs and profits to countries with the same currency. After they
took those risk reducing steps, they want to measure their risk again to check whether their
risk is actually reduced.
For example, imagine that you work for a relatively small public utility housing enterprise.
The independent accountant that handles the yearly audit of your financial statements advises
you to enter some financial derivates to reduce the interest risk the enterprise is facing. He
tells you that the VaR the enterprise faces is 2.500.000 and that the CFaR is 1.500.000. It
sounds like your company is in real financial distress. You will calculate the VaR and CFaR
yourself and come to the conclusion the accountant is right. So you enter the derivatives and
you calculate your risk again to check whether the firm risk has decreased.
Reasons of knowing a firms CFaR are: 1. Capital Structure Policy, 2. Risk management
Policy (Jeremy C. Stein et al. (2000)).

The first reason, Capital structure policy, means that with measuring a companys CFaR one
can determine if a company has too much or too little debt. If the volatility of cash flows is
relatively low, the CFaR is also relatively low and the company faces little risk. They might
be able to increase their debt position to benefit more from the tax advantages and have more
cash to invest. But if the volatility of cash flows is relatively high, in that case the CFaR is
also relatively high and the company faces more risk. If they are able, it might be interesting
to reduce their debt position to guarantee the continuity of the company. The second reason,
Risk management policy, is named because a companys management wants to know if their
risk management strategies worked out as intended. The management wants to know how
much money their strategies have cost them and how much money they have yielded. Do the
benefits of risk management exceed the cost of those strategies?
In my opinion a third reason to calculate the Cash Flow at Risk is, such as the Value at Risk,
to guarantee the companys continuity. If the company keeps producing positive cash flows at
all times, they can invest that money into new projects, continue to grow and thereby
guarantee their continuity and keep their lead due to competitive advantage.
Some companies never calculate their risk bearings, this may be because the managers think
they do not need to calculate it or it may be because sometimes small firm managers (with
emphases on managers of small firms) do not know what VaR and CFaR mean and how they
are being calculated. In this chapter I am going to describe what those measures mean and
how they can be calculated.
It is important that it is known how both are being calculated because it might be very
important to know how much risk the company is facing, if a derivative does reduce the firm
risk and if so, with what amount the risk is reduced.
2.2 What is VaR?
VaR (Value at Risk) is first mentioned in the late 1980s to measure portfolio risk of large
financial institutes such as investment banks. In 1994, JP Morgan gave value at risk a market
standard which helped the VaR grow enormously. Now it is used worldwide by financial
firms, investors and the use is starting to grow by non financial companies.
Value at Risk is a measure to help investors, managers etc. interpret the maximum of losses
their investments bring along. VaR gives the manager a number in Euros or Dollars or other
currencies. That amount is the maximum loss a company or investor can face resulting out of
7

a normal distributed market. And because VaR only consists of one number it is easy to use in
meetings hold by the board of directors, when the meaning of VaR is known by all that are
involved in those meetings.
According to Darrel Duffie and Jun Pan (1997) Measure the extent of exposure by trade,
profit center, and in various aggregates is one of the objectives in managing market risk. The
Value at Risk is a way of measuring that exposure by trade. To use VaR, a time horizon (t)
and a confidence level (p) need to be chosen. The Value at Risk (VaR) can be interpreted as
such; the VaR is the loss a company can face over the chosen time horizon (t) with the
probability 1 p, were p is the chosen confidence level.
For example, a public utility housing enterprise has entered some financial derivatives to
reduce their firm interest risk. The CEO of the enterprise wants to know the firm risk. The
CFO calculates the VaR and will, for example, use a time horizon of one week and a
confidence level of 95%. Then when the CFO tells the CEO our VaR is $1.000.000 it
means that the loss of the enterprise will exceed $1.000.000 in one week with a probability of
5%.
When calculating the VaR the user is free to choose whatever time horizon or confidence
level he wants. Obviously when the time horizon is longer, the VaR will be higher. And when
the confidence level is higher, for example 99%, the VaR will also be higher. This is all based
on a normally distributed market. Typically used confidence levels are 1, 2.5 and 5 percent
and most used time horizons are 1, 2, 10 days (workdays) and 1 month (Thomas J. Linsmeier
and Neil D. Pearson 2000). The time horizon depends on the type of company the VaR is
measured for. Due to the higher trading volume of financial firms, financial firms need to
measure risk more often, sometimes even more than once per day, and with a higher
confidence level compared to non financial firms.
In order to calculate the Value at Risk, the risk manager or investor need to identify the return
rates of the individual stocks in the portfolio, the prices of those individual stocks and with
those data one can calculate the value of the portfolio. In some cases the manager or investor
needs to add more variables such as the exchange rate between two currencies. Which
variables are needed depends on by which variables the market value of the portfolio is
affected (Thomas J. Linsmeier and Neil D. Pearson (2000)).

For example, company A has signed a contract to deliver 1 million Dollars in 2 months (61
days). In exchange for those 1 million Dollars company A will receive 1.2 million Euros. In
that case the variables that influence the market value of that contract are: the spot exchange
rate (Dollars/Euro) of the contract (S), the 2 month interest rate of the Dollar (rD) and the 2
month interest rate of the Euro (rE).
The formula for the mark to market value of the contract in the example will be:

where S in this formula denotes the expected spot exchange rate of, in this case, the two
currencies, rE denotes the expected interest rate of the Euro and rD denotes the expected
interest rate of the Dollar. In chapter 4 I will present some calculations based on real data1.
2.3 How is the Value at Risk calculated?
There are three common methods of calculating VaR, the historical simulation, the deltanormal approach and the Monte Carlo simulation (Thomas J. Linsmeier and Neil D.
Pearson (2000)).
2.3.1 Historical simulation.
In order to calculate VaR according to the historical simulation, it is required to make some
assumptions about the distribution of the market factors involved in the calculation.
In this approach it is necessary to use historical data about the exchange rates of the in the
portfolio used currencies and the interest rates of the used currencies. In that way it is possible
to calculate the expected mark-to-market value of the portfolio based on historical data. And
with those mark-to-market values one can calculate the expected profits and losses on the
portfolio value. One can make a distribution of those profits and losses (similar to the figure
on the next page) and with the confidence level, agreed on forehand, it is possible to read the
VaR in the distribution.

The data that is used in order to calculate this, is found using DataStream.

The distribution below shows the frequency of all the profits and losses in market value of the
portfolio. In this example, the 5 percent biggest losses is the VaR and this is pointed out with
the green arrow.

Distribution of profits and losses, necessary for calculating the VaR.

To determine the VaR by using the historical simulation approach, it is necessary to perform
five steps.
Step 1. Identify the factors that influence the market value of the portfolio. Such as the
formula in equation 1.
Step 2. Search for historical values of the factors that influence the market value. The
more records, the more reliable the outcome will be. The values will be used to calculate the
market values named in step 1 and 3.
Step 3. Calculate the expected profit and losses in comparison of todays portfolio for
each record found in step 2. With using the values found in step 2 one can calculate the daily
market value of the portfolio. Once the hypothetical daily market values are subtracted from
the actual value of the portfolio the daily losses and profits are calculated.
Step 4. Sort the expected losses en profits in order to make the distribution that looks like
the distribution shown in figure 1.
Step 5. Use the sorted outcomes to make the distribution and see what loss is exceeded
with (for example) 5 percent certainty. The value that belongs to that 5 percent is the actual
value that is at risk (VaR). That loss can be interpreted as follows, we can say that the loss
our company will have to bear with a probability of (for example) 5% (5 out of a 100 times) is
at least $x,xxx,xxx.

10

Since a portfolio does not only hold one type of derivate but (often) the portfolio is more
diversified, some of the steps are slightly different. As mentioned earlier, step 1 needs to be
extended because the market value of the portfolio depends on much more market factors
when there are more different derivatives involved. The daily losses and profits based on
historical data have to be summed up before they are ordered from highest to lowest (Thomas
J. Linsmeier and Neil D. Pearson (2000)).
Why or why not the historical simulation method?
Why is the historical simulation method to calculate the VaR used that often? An answer to
that question can be the following; the VaR is relatively simple to calculate using this method,
it is possible to use portfolios that include options. It is also rather easy to implement if there
are past values of the relevant market factors available. Furthermore the results are relatively
easy to understand by other managers of the firm. But, if financial history is not normally
distributed or available, this approach could produce misleading information which could lead
to erroneous decisions by firm management concerning the company. Also I think this
method requires more effort to calculate if the portfolio is dependent on more market factors.
Because all those factors have to be determined before one can calculate the VaR using this
method.
2.3.2 Delta-Normal Approach.
In the Delta-normal approach the assumption is made that the market factors used in a
portfolio are multivariate normally distributed. By using that assumption, it is possible to
determine the distribution of the mark-to-market profits and losses. As all the profits and
losses are obtained, it is possible to determine what loss will equal or exceeded at, for
example, 5 percent of the time. Once that value is determined the VaR with probability 5% is
known. (Thomas J. Linsmeier and Neil D. Pearson (2000)).
In this approach the VaR is calculated by using the formula shown in Equation 2: 2

Thomas J. Linsmeier and Neil D. Pearson (2000)

11

To make it less difficult I assume that, in this example, the expected change in portfolio value
is zero. Moreover this assumption is often made when there is a relatively short holding
period or a short time horizon and means that the portfolio will not be changed during the
time horizon. If the portfolio value changes, perhaps because of adding new shares to the
portfolio, the calculation needs to be redone.
If the standard deviation in this example is 45,000 the VaR in this example is as follows:
Since the expected change in portfolio value is very often assumed to be zero, the most
important variable in this formula is the standard deviation. This variable depends on the
standard deviations in all individual stocks and/or derivatives in the portfolio. It is also
important to know how they correlate. Because of the fact that a portfolio often exists of many
individual stocks and/or other derivatives, it is almost impossible to know all the individual
standard deviations and the correlations of them. Therefore a replicating portfolio is made.
That portfolio, a rather small portfolio, exists of stocks/bonds and a risk free loan, that
replicating portfolio needs to have the same risk level and rate of return as the original
portfolio. With that replicating portfolio the VaR is then calculated.
There are several steps to take when determining the VaR using the Delta-normal Approach.
Step 1. It is important to identify all relevant market factors and their standardized
positions. Then those positions have to be compared to a forward contract. In order to
calculate the standardized positions, it is necessary to know the relevant market factors.
In the following example I use the same situation as described before. First I have to know the
exposure to US$ interest rate. It can be calculated using the formula shown in Equation 4.

Then I need to know the value of the Euro part of the agreement in US$. This is calculated
using the following formula.

The fact that Y2 is equal to Y3 is because they both represent the value of the Euro part in
US$.

12

Step 2. During this step one needs to make the assumption that the percentage changes
in the market factors mentioned in step 1 are normally distributed. I then estimate the values
of that distribution. The standard deviations and correlations needed for calculating the VaR
will need to be listed. They can be requested for example by investment banks or institutions
such as Reuters.
Step 3. This step is used to determine the standard deviations and correlations of the
standardized positions calculated in step 1. If a standardized position changes with 2 percent
when the attendant market factor changes with 1 percent, the standard deviation of the
standardized position is twice as big as the standard deviation of the underlying market factor.
Step 4. Once the standard deviations and the correlations of the standardized positions
are known, one can calculate the real portfolio variance and standard deviation. And with
those variables it is possible to calculate the VaR of the portfolio. The variance of the markto-market portfolio can be calculated using the following formula3:

Assume that portfolio = 20,000. Then the VaR has to be calculated as follows4:

Why or why not Delta-Normal approach method?

First of all, the Delta-Normal approach is rather easy to implement for portfolios restricted to
currencies if there is any capable software available and if the information that you need is
available such as volatility of all the shares within the portfolio. If that software or the
information it is not available it is not that easy to implement. It also becomes more difficult
to implement if the portfolio gets bigger and contains more different financial products.
Moreover this approach is rather difficult to explain to other firm managers. And like the
historical simulation method this approach could produce misleading information if financial
past is not normal. Furthermore it is not always possible to create a suitable replicating
portfolio which has the same level of risk and level of return the original portfolio has.

+ 6 Thomas J. Linsmeier and Neil D. Pearson (2000)

13

2.3.3 Monte Carlo Simulation5.

This method has a lot of resemblance with the historical simulation method. The difference is
that with the historical simulation method, expectations are based on historical data. With this
method, the Monte Carlo Simulation, the expectations are based on statistical distributions
that give an approximation of the possible changes in portfolio value. With help of a
computer, many random changes in the market factors are made. Due to that the mark-tomarket value of the portfolio changes constantly. These hypothetical changes will produce
many hypothetical profits and losses on the portfolio. By using those/these profits and losses
the VaR can be calculated in the same way as the historical simulation method.
Also the Monte Carlo Simulation has a few steps which lead to the Value at Risk.
Step 1. The first thing to do is to search for the market factors that are relevant for your
portfolio. Obtain, with those factors, a formula by which the mark-to-market value can be
calculated. This step is the same as step 1 of the historical simulation method.
Step 2. In this step one needs to choose a distribution for the variation in market
factors that influence the mark-to-market values. The risk manager is free to choose whatever
distribution he likes but usually the normal distribution is used.
Step 3. The next step is to use a random number generator which generates a lot of
(more than 1,000 or even more than 10,000) hypothetical values of market factors. With these
changes and the formula obtained in step 1, all the mark-to-market values can be calculated.
Step 4 and step 5 are equal to step 4 and 5 in the historical simulation method.
Why or why not the Monte Carlo Simulation method?
First of all, because of the fact that a computer generates the random numbers, with this
method it is relatively easy to add more variables when the portfolio gets more diversified and
complicated. That is one of the most obvious differences with the historical simulation
method. Furthermore this method is still usable when financial past is not normal. But due to
the computer system it is not always easy to implement and it can be expensive for smaller
companies.

Thomas J. Linsmeier and Neil D. Pearson (2000)

14

2.3.4 Which method is most practical in use?

Historical simulation
Many different and

Delta-Normal approach

Monte Carlo simulation

XX

XXX

XXX

XX

XX

XXX

XXX

XX

complicated financial
derivatives.
Easy to explain?
No historical
information present?
Easy to implement?

Advantages and disadvantages of VaR approaches.

The more Xs there are in a box, the more suitable that approach is.
To say which of the three models is best, is not possible. As is shown in Table 1, it depends
on the type of portfolio you have. Does your portfolio consist of many different and
complicated financial products, such as many different options, then the historical or Monte
Carlo Simulation is probably the best way to calculate the VaR. If it is most important to
make your calculations clear to other firm managers, the historical simulation method is the
best. If no historical information is present, then the Delta-Normal or Monte Carlo simulation
methods seem to be the most practical to use. The choice the risk manager has to take when
choosing the methodology depends on what he thinks is most important for the company he
works for. I personally think the historical simulation method is most practical for smaller
companies who do not have to calculate the VaR that often. Because the information needed
to calculate the VaR is available in most cases. Furthermore the calculations are rather easy if
that information is indeed available, for an example of the calculation see chapter 3 of this
paper. For companies that have to calculate the VaR more than once per day, I think the
Monte Carlo simulation method is most practical to use because the computer system quickly
generates the changes in market value of the portfolio. An overall disadvantage of the VaR
measure is that it is assumed that the normal distribution provides a realistic view of the
portfolio return distribution. In reality the tails of the distribution are often fat what means
that the 5 percent gives a distorted picture of the reality. A possible solution to that problem is
to use the Expected Shortfall method. Instead of the minimal loss the company faces with a,
for example, 5 percent possibility, the average loss with that confidence level is used.

15

2.4 What is the Cash Flow at Risk (CFaR)?

An alternative for the Value at Risk is the Cash Flow at Risk. Cash Flow at Risk (CFaR) is
used by firms to measure the risk of not receiving the expected cash flows or receiving less
than expected. A distribution of operating cash flows over a time horizon in the future is
made. The distributions can be used to obtain information about the worst case scenarios a
company can have regarding their cash flows. The outcome of the Cash Flow at Risk can be
interpreted as: with what value will my cash flows decrease with a certain confidence level
(in percentages) over a certain time horizon?
The calculation methods of the Cash Flow at Risk are almost the same as the Value at Risk.
The main difference is that Cash Flow at Risk uses the expected cash flows instead of using
market values of the portfolio. It is used by many different companies but especially by nonfinancial firms. Financial firms use the VaR more often because they typically have many
portfolios with financial derivatives, stocks or other financial products. Nonfinancial firms
often dont have those portfolios, their continuity typically depends more on cash flows.
Thats the reason why non financial firms more often use CFaR as risk measure.
2.5 How is the Cash Flow at Risk calculated?
There are two main methods of calculating the Cash Flow at Risk. First there is the BottomUp method and secondly there is the Top-Down method. (Jeremy C. Stein et al. (2000)).
2.5.1 Bottom-Up method.
The Cash Flow at Risk can be calculated on the exact same way as the Value at Risk except
the Cash Flow at Risk is based on cash flows instead of market values. Typically the CFaR is
being calculated using the Monte Carlo simulation (Thomas J. Linsmeier and Neil D. Pearson
(2000)). The Monte Carlo simulation is used because of the many different variables that
influence the cash flows. But there are some important differences between using the Monte
Carlo simulation for the VaR and the CFaR. First of all, the focus is not on changes in market
value anymore. Now the focus of the calculation is on Cash flows. Hypothetical market
factors need to be combined with all different types of cash flows. With those combined
hypothetical market factors, one can create a hypothetical distribution similar to the VaR.
When using this method, all future cash flows have to be included in the distribution. This is
necessary because one does not only want to calculate the CFaR of cash flows that are

16

affected by the financial derivatives a company has, but also the cash flows that derive from
normal operating.
Because operating cash flows depend on many different market factors, it is hard to determine
what market factors are necessary to calculate the CFaR. The market factors are more
diversified in comparison to the VaR calculation. Another factor that makes the calculation
more difficult is that the time horizon of the CFaR usually is significantly longer than the time
horizon used in calculating the VaR. Furthermore mostly the incentive of calculating the
CFaR is not to measure and control the risk a company faces, but to use it as a variable in
making decisions regarding new investments the firm wants to make.
During the bottom-up method, it is necessary to conduct research on all market factors that
influence the future cash flows of the company. When those factors are known, one needs to
search for data regarding those factors. If the data is found, the calculation of the Cash Flow at
Risk is similar to the calculation of the Monte Carlo simulation.
2.5.2 Top-down method.
Because of the fact that the factors that are needed for the bottom-up method are sometimes
very difficult to determine, Jeremy C. Stein et al. (2000) developed a top-down approach to
measure Cash Flows at Risk.
As an example I will use the television section of the Philips concern. They manufacture and
sell televisions and accessories. It is easy to understand that the cash flow of the TV section of
Philips depends on a large number of variables. All those variables bring along different risks
in cash flows.
When one is using the bottom-up approach as mentioned before, it is very difficult to
determine all those variables (in the VaR approach those variables are called market factors).
If one managed to determine all relevant cash flow factors and risks, he needs to try to
quantify those risks. When using the same approach as the bottom-up approach, some risks
can easily be omitted or some risks will be wrongly interpreted by firm managers. Because of
that wrong estimates of Cash Flows at Risk can be made.
Given those conditions, it is more logical to, for example, to directly look at Philips historical
cash flows and use that data to determine the new Cash Flow at Risk. In that case it is not
necessary to examine all different variables that influence the cash flows anymore because all
17

those variables are already used when calculating historical cash flows. Because of that, one
does not have to create a new detailed model of the cash flows and all the variables that affect
that cash flow. That being said, it seems very favourable to determine the Cash Flow at Risk
using historical data of Philips cash flows. But in most cases it is only possible to use
quarterly cash flows, which leads to a very small set of observations. By using this small set
of observations this will not lead to a significant forecast of new cash flows or a predictable
Cash Flow at Risk. A possible solution to that problem is to use a group of companies that are
comparable to Philips. If a group of, for example, 20 companies is made, the number of
observations will grow significantly. In A Comparables Approach to Measuring Cashflowat-Risk for Non-Financial Firms, (2000) Jeremy C. Stein et al. calls this method a top-down,
comparables-based approach to C-FaR measurement.
The top-down method goes as follows: first the risk manager has to search for companies that
are comparable with, in this example, Philips. Those companies have to be compared with
Philips on four dimensions: 1. market capitalization, which means that the total value of
tradable shares of the company needs to be almost equal, 2. Profitability, 3. Industry riskiness,
the riskiness of the total industry needs to be almost equal, 4. Stock-price volatility, the
changes in stock-price (in percentages) needs to be almost equal.
Because the conclusions of the Cash Flow at Risk are directly based on historical changes in
cash flows, this method automatically produces an average Cash Flow at Risk.
A major disadvantage of using this method is when your company is atypical and does not
match other companies in the group, you might draw the wrong conclusion about the Cash
Flow at Risk. In other words, if one creates a group of 20 companies he thinks are similar to
Philips in order to calculate Philipss Cash Flow at Risk, and Philipss marketing division is
significantly better than the others, this is not included in the calculation. Another
disadvantage of the fact that historical information is used is that it is not possible to forecast
the change in Cash Flow at Risk when a company is changing their strategy. In those cases I
think the bottom up method, especially the Monte Carlo simulation, is the better methodology
to use.
When the manager finds all data (based on the four dimensions mentioned earlier) that is
necessary for the calculation, he has to make a distribution of all cash flows of all companies.
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The data that is most commonly used cash flows for the calculation are the EBITDA
(Earnings Before Interest, Taxes, Depreciation and Amortization) or the EBIT (Earnings
Before Interest and Taxes).
2.5.3 Which of the methods is most practical in use?

Typical or atypical

Historical

Delta-Normal

Monte

Carlo

simulation

approach

simulation

Top-down method

Atypical

Atypical

Atypical

Typical

XXX

XX

XX

XX

XXX

XXX

XX

XX

organization?
Easy to explain?
No historical
information present?
Easy to implement?

Advantages and disadvantages of CFaR approaches.

The more Xs there are in a box, the more suitable that approach is.
CFaR can be calculated in the same way as the VaR, the advantages and disadvantages of
those calculations are the same (see the table above). But there is a fourth way of calculating
the Cash Flows at Risk. That fourth measure is called the top down method. It is hard to say
which way of calculating the CFaR is best. If the company that is subject of the calculation is
a typical company and there is the opportunity of assembling data of peer companies, than
the top down method seems to be most practical in use. Because when using the Top-down
method, the manager that calculates the CFaR does not have to determine all the factors that
influence the cash flows. The manager only has to find the necessary information from peer
companies. But if the company that is subject of the calculation is an atypical company, it is
hard and if not impossible to assemble data of peer companies. In that case, the Monte Carlo
simulation seems to be best.
2.6 Why or why not is the top-down method usable to calculate the VaR?
At first you might think why not use the top-down method when calculating the VaR? I
think the answer to that question is hard to give. It depends on what the manager of the firm
wants. If an overall impression of the firms portfolio risk is sufficient, than I think the topdown method can be of use. But the Value at Risk is often used to measure risk of a portfolio
that consists of more than one financial product. In such a case the manager might want to
know which of the products bears most of the risk. If that is what the manager wants to know,
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I think the top-down method is not of use because it only provides an overall look at the
portfolio. In most cases, when the managers want to know which product bears most risk, I
think one of the bottom-up methods is better to use to calculate the VaR. Because the first
thing the manager needs to do when using one of those measures is to derive all market
factors that influence the portfolio value. When that is known the manager can also derive
what factor bears the highest risk and thus what financial product bears the highest risk.
Furthermore I think it is not necessary to use the top-down method in order to calculate the
VaR. In many cases, especially for small firms who often have small portfolios, most of the
information to make a distribution of profits and losses on portfolio value are rather easy to
find.
3. Example of calculating VaR and CFaR
To give an example of how to calculate the VaR and CFaR I have chosen to calculate the VaR
by using the historical simulation method. The reason why I chose that method is that it is
quite similar to the Monte Carlo simulation method. So with explaining one method it
becomes clear how to use two methods. Furthermore those are the two methods I think are
most uncomplicated to understand by managers of small firms who need to work with them.
In order to calculate the CFaR I chose to use the top-down method since the other methods are
calculated on the exact same way as for the VaR.
3.1 Calculating the Value at Risk using historical simulation method
Assume a forward contract of selling 10mln Euro (short position) for 11mln Dollar (long
position) in 3 months.
In the table below an example is given of how to calculate a hypothetical mark-to-market
value and with that value the profit or loss on a forward contract. I need to calculate these
profit and losses for all hypothetical data to calculate the 5% biggest losses to determine the
VaR.

Calculation of mark to market profit/loss on a forward contract..

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The table on the previous page shows the actual values of interest rate of the US Dollar, the
Euro and the actual value of the exchange rate on 3 different dates, the data is found using
DataStream.
The USD interest rate is found by using an USdollar 3 month treasury bill and the Euro
interest rate is found by using the EURIBOR interest rate. The first thing that is necessary to
do is finding the actual values of those nine variables. With those variables the historical
percentage change can be calculated using this formula:

Why do I use 14th of November? Thats because it is 100 working days before 30th of March.
In that case I can compute 100 observations to base my distribution on.
To get the hypothetical future values of those variables I used this formula:
(9)
With those variables, I can calculate the hypothetical future market value of the portfolio and
with that future market value I can compute the hypothetical profit or loss on the portfolio.
The table on the next page shows all profits and losses after they are sorted from biggest loss
to biggest profit. As can be seen, the 5 percent biggest losses exceed 188,000.00 Euro, so the
VaR this company faces with this portfolio is 188,886.19.
In this example the mark to market value today and the hypothetical mark to market value in
the future have to be calculated using the formula:

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Sorted profits and losses.

The data used to calculate the VaR is found using DataStream.

3.2 Calculating the Cash Flow at Risk using the top-down method
In order to calculate the Cash Flow at Risk, I chose to use the top-down method using
hypothetical data. It is possible to calculate the CFaR using the same approach as the VaR
only use cash flows instead of market values but if using one of those approaches it is
necessary to distinguish all factors that influence the cash flows. If your company is similar to
other companies in that industry, it is possible to use the top-down method.
Assume that the CEO of Philips wants to know the Cash Flow at Risk of the companys TV
division and that that sector is typical within the industry. The manager of that Division is
then going to search for other companies that are like Philipss TV division and do answer to
the four dimensions that need to be fulfilled (the four dimensions are described earlier in this
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paper). If the manager assembled the list of companies, he needs to determine all quarterly
cash flows of those companies. The more observations the more accurate the calculation will
be. The cash flows need to be adjusted to the size of the companies. A way of adjusting to size
can be to find EBITDA per share and multiply that by the total number of common shares
outstanding. All observations need to be listed from smallest cash flow to biggest cash flow.
In that way, a list is created similar to the list in the table below. The 5 percent smallest cash
flows together form the Cash Flow at Risk within the next quarter.

Cash Flows of different companies necessary for the Top-down method.

In this case it can be seen that the CFaR this company faces is 42,800.71. That means that
with a probability of 5% this company can lose 42,800.71 of its cash flow over the next
quarter.

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4. Conclusions
Value at Risk measures the risk of a company losing money on their portfolio of assets and
derivatives. It makes use of market values of all the assets, derivatives and other financial
products that the company holds in its portfolio.
The Cash Flow at Risk measures the risk of a company not to earn as much money as
expected. This measure makes use of cash flows instead of market values, therefore this
measure is called Cash Flow at Risk.
The Value at Risk and Cash Flows at Risk can be calculated using the Historical simulation
method, the Delta-Normal approach and the Monte Carlo simulation method. The Cash
Flow at Risk has the additional Top-Down method. I think the historical simulation method
is the most practical method of calculating the VaR for relatively small companies because it
is the easiest way of calculating the VaR. Another usable and relatively easy way of
calculating the VaR is the Monte Carlo simulation method. This method resembles the
historical simulation method but makes use of a variable generator to create the required
distribution. Therefore I think this method is more practical of use when the VaR has to be
calculated more often and if the portfolio consists of more different variables.
In order to calculate the Cash Flow at Risk, I think the top-down method is most practical.
Because using that method the risk manager does not have to create a formula with all the
factors that influence their cash flows. If historical information is not available, I think the
Monte Carlo simulation method is best to calculate the cash flows because hypothetical
changes in all different factors that influence the cash flows are quickly generated using the
computer controlled variable generator.
To say if those methods are best ways to measure the firms risk is hard to say, if not
impossible. It depends on the preferences and knowledge of the manager that needs to
calculate them and even more on the situation the company is facing. But it is certain that all
are reliable, complete and relatively easy ways of measuring firms Value and Cash Flow at
Risk.

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References
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Andrn, Niclas, Hkan Jankensgrd and Lars Oxelheim (2010), Exposure-Based CashFlow-at-Risk for Value-Creating Risk Management under Macroeconomic Uncertainty,
Journal of Applied Corporate Finance 17, 76-86.

Artzner, Philippe, Freddy Delbaen, Jean-Marc Eber and David Heath (1999), Coherent
measures of risk, Mathematical Finance 9, 203-228.

Beaver, William, Paul Kettler and Myron Scholes (1970), The association between
market determined and accounting determined risk measures, The Accounting Review
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Delbaen, Freddy (2000), Coherent Risk Measures on General Probability Spaces.

Duffie, Darrel, and Jun Pan (1997), An overview of Value at Risk, The Journal of
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Frittelli, Marco, and Emanuela Rosazza Gianin (2002), Putting order in risk measures,
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Linsmeier, Thomas J, Neal D. Pearson (2000), Value at Risk, Financial Analysts Journal
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Stein, Jeremy C, Stephen E. Usher, Daniel LaGattuta and Jeff Youngen (2000), A
Comparables Approach to Measuring Cashflow-at-Risk for Non-Financial Firms Journal
of Applied Corporate Finance 13, 100-109.

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