Used to monitor risk profile relative to appetite.Cash Flow at Risk (CFaR)Measuring potential changes in earnings or cash flows for the enterprise.Enterprise wide measure of risk to financial objectives. Used to monitor risk profile relative to tolerance on earnings and cash flow objectives.Economic CapitalMeasuring the potential changes in the enterprise value from all material risks that have a financial consequences. Shareholder focus.Enterprise wide measure of risk to financial objectives that uses the outputs of VaR and CFaR. Can be used for risk criteria, pricing for risk, performance and remuneration.
59Scenario analysis defined▪Scenario analysis entails defining one or more business scenarios with associated key assumptions (sources of uncertainty termed “drivers”) that determine the severity of the consequences on a key objective.▪Given the likelihood of the input drivers being observed, the forecasted consequence can have an estimated likelihood.▪A stress test involves a “worst-case” scenario to test resilience of key financial risk appetite objectives such as solvency and earnings.▪Advantages of scenario analysis are:–Historically observed scenarios (eg. GFC or competitor action) can be replayed through the organisation’s risk profile and the impact can be compared with the organisation’s actual history (have we become more resilient over time?)–It is easily understood by non-quantitative management and stakeholders.–Can identify sources of weakness (sensitivity of objectives to drivers)–Suitable for comparing relative riskiness across different firms for the same scenario (eg. Regulatory stress tests).
60▪VaR answers the question: for a given likelihood how large could the negative consequence be (ie. How low can the asset value fall or the liability value rise)?▪A VaR statistic has three components: a time period (eg. 1 day or 20 days), a confidence level and a loss amount.▪VaR is only used for objectives with financial consequences resulting from revaluation (profit and/or solvency), requires knowledge of the statistical properties of the drivers, and data to support calibration of the forecasts.Value at Risk
61Cash Flow at Risk (CFaR) defined (refer COSO)▪Cash Flow at Risk is a quantitative risk measure built on a causal model where specific risk factors drive future uncertainty of key financial cash flow or earnings objectives.▪Each risk factor is modelled in detail and incorporated into an overall model of the firm’s cash flows or earnings.▪Unlike simple budgeting or extrapolating past experiences, CFaR gives insight into the potential variability of future cash flows and earnings.▪CFaR answers the question: For a given likelihood how large could the negative consequence be (ie. How low can cash flow and earnings fall?)▪A CFaR statistic has three components: a time period (usually one or more multiple years), a confidence level and a loss amount.
62Technical definition of economic capital▪
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