FOREX Risk: Measurement and Evaluation Using Value‐at‐Risk

Abstract:   We measure and evaluate the performance of a number of Value‐at‐Risk (VaR) methods using a portfolio based on the foreign exchange exposure of a small open economy (Ireland) among its trading partners. The sample period highlights the changing nature of Ireland's exposure to risk over the past decade in the run‐up to EMU. Our results offer an indication of the level of accuracy of the various approaches and discuss the issues of models ensuring statistical accuracy or more conservative leanings. Our findings suggest that the Orthogonal GARCH model is the most accurate methodology while the EWMA specification is the more conservative approach.     

Risk Measures for Hedge Funds: a Cross‐sectional Approach

This paper analyses the risk‐return trade‐off in the hedge fund industry. We compare semi‐deviation, value‐at‐risk (VaR), Expected Shortfall (ES) and Tail Risk (TR) with standard deviation at the individual fund level as well as the portfolio level. Using the Fama and French (1992) methodology and the combined live and defunct hedge fund data from TASS, we find that the left‐tail risk captured by Expected Shortfall (ES) and Tail Risk (TR) explains the cross‐sectional variation in hedge fund returns very well, while the other risk measures provide statistically insignificant or marginally significant results. During the period between January 1995 and December 2004, hedge funds with high ES outperform those with low ES by an annual return difference of 7%. We provide empirical evidence on the theoretical argument by Artzner et al. (1999) that ES is superior to VaR as a downside risk measure. We also find the Cornish‐Fisher (1937) expansion is superior to the nonparametric method in estimating ES and TR.     

What Do FAS 157 “Fair Values” Really Measure: Value Or Risk?

FAS 157, the U.S. accounting standard that prescribes how fair values of assets and liabilities are to be measured when other U.S. GAAP standards require fair valuation, stipulates that fair values be measured as the exit values of assets and liabilities—the proceeds for assets hypothetically sold on the date of the financial report, and, correspondingly, the amount required to settle liabilities on the date of the financial report. This conceptual article argues that exit values do not reflect the value of the net assets of the firm to shareholders, which is best reflected by discounted cash flows to maturity. Moreover, exit values—biasing fair values downward when markets are illiquid—have a pernicious, systemic risk effect; specifically, they give rise to write‐downs that in turn cause contagion: prices of equities and other financial instruments of peers react negatively, leading to further write‐downs by those peers. This may have aggravated the recent financial crisis. However, while exit values are not proper measures of value to shareholders, they are useful measures of downside risk when prospects turn sour for a firm. Thus, both exit values and discounted cash flows should be presented in financial statements.     

Target Company Cross‐border Effects in Acquisitions into the UK

We analyse the abnormal returns to target shareholders in cross‐border and domestic acquisitions of UK companies. The cross‐border effect during the bid month is small (0.84%), although cross‐border targets gain significantly more than domestic targets during the months surrounding the bid. We find no evidence for the level of abnormal returns in cross‐border acquisitions to be associated with market access or exchange rate effects, and only limited support for an international diversification effect. However, the cross‐border effect appears to be associated with significant payment effects, and there is no significant residual cross‐border effect once various bid characteristics are controlled for.     

Choices and Best Practice in Corporate Risk Management Disclosure

For over a decade, the SEC has required corporations to disclose in their 10‐K filings the nature and extent of their risk exposures using one or more of the following three methods: (1) sensitivity analysis; (2) the so‐called “tabular” format; and (3) value‐at‐risk (VaR). After discussing the significant differences in the type and level of information revealed by each method, this article presents the findings of a study that examines how corporate choices of disclosure method vary with firm‐specific and industry characteristics. While sensitivity analysis has been the “middle of the road” chosen by the majority of companies, there have also been significant minorities adopting the tabular and VaR methods. Those companies that have chosen the tabular method—in the authors' view, the most revealing of the three methods—have also had the largest interest rate and commodity exposures as well as the greatest demand for external financing. The propensity of companies to use VaR, the least revealing method, has been associated with larger size, perhaps reflecting scale economies in risk management, greater use of derivatives, and competitiveness concerns about revealing proprietary information.     

Managements' views on share buy‐backs: an Australian survey

Share buy‐backs are a relatively new concept in the Australian business environment. This study surveys managements' motivations and various other aspects concerning share buy‐back activity. The results reveal that these motivations vary across the five different types of buy‐backs. For on‐market buy‐backs the most relevant motivations are to improve financial performance (i.e., earnings per share) and financial position (i.e., net asset backing per share) followed by signalling of future expectations or underpricing. Interestingly, managements' response regarding the relevant motivations is similar regardless of whether their companies had conducted a buy‐back or not. This provides evidence of widespread support for the relevant motivations. In addition, Australian managers believe that they are familiar with the potential benefits and legislative requirements of buy‐backs, but that their shareholders often do not understand or are not favourably disposed towards buy‐back events. Finally, two major explanations are identified for the initial conservatism towards buy‐backs. Those explanations are (i) legal complexity and cost and (ii) the perceived negative disposition of the sharemarket towards buy‐backs.     

Managements' views on share buy‐backs: an Australian survey

Share buy‐backs are a relatively new concept in the Australian business environment. This study surveys managements' motivations and various other aspects concerning share buy‐back activity. The results reveal that these motivations vary across the five different types of buy‐backs. For on‐market buy‐backs the most relevant motivations are to improve financial performance (i.e., earnings per share) and financial position (i.e., net asset backing per share) followed by signalling of future expectations or underpricing. Interestingly, managements' response regarding the relevant motivations is similar regardless of whether their companies had conducted a buy‐back or not. This provides evidence of widespread support for the relevant motivations. In addition, Australian managers believe that they are familiar with the potential benefits and legislative requirements of buy‐backs, but that their shareholders often do not understand or are not favourably disposed towards buy‐back events. Finally, two major explanations are identified for the initial conservatism towards buy‐backs. Those explanations are (i) legal complexity and cost and (ii) the perceived negative disposition of the sharemarket towards buy‐backs.     

The Impact of Corporate Social Performance on Financial Risk and Utility: A Longitudinal Analysis

This study focuses on the wealth‐protective effects of socially responsible firm behavior by examining the association between corporate social performance (CSP) and financial risk for an extensive panel data sample of S&P 500 companies between the years 1992 and 2009. In addition, the link between CSP and investor utility is investigated. The main findings are that corporate social responsibility is negatively but weakly related to systematic firm risk and that corporate social irresponsibility is positively and strongly related to financial risk. The fact that both conventional and downside risk measures lead to the same conclusions adds convergent validity to the analysis. However, the risk‐return trade‐off appears to be such that no clear utility gain or loss can be realized by investing in firms characterized by different levels of social and environmental performance. Overall volatility conditions of the financial markets are shown to play a moderating role in the nature and strength of the CSP‐risk relationship.     

Downside Risk in Practice

Although investors associate risk with negative outcomes and downside fluctuations, modern portfolio theory does not. For investors, volatility per se is not necessarily bad; volatility below a benchmark is. A stock that magnifies the market's fluctuations is not necessarily bad; one that magnifies the market's downside swings is. Even Harry Mar‐kowitz, the father of modern portfolio theory, viewed downside risk as a better way to assess risk than the “mean‐variance” framework that he ultimately proposed and that has since become the standard. This article highlights the shortcomings of traditional measures of risk (the standard deviation and beta), introduces the concept of downside risk, and discusses two measures of it—the “semideviation” and “downside beta.” It also discusses the use of such measures in asset pricing models to estimate required returns on equity. Data from a few well‐known companies are used to illustrate that the cost of equity based on downside risk can be substantially different from that based on the CAPM. The article concludes with a brief discussion of risk‐adjusted returns and a comparison of the traditional method of calculating such returns with both the Sharpe ratio and its counterpart in a downside risk framework, the Sortino ratio. The appendix demonstrates how to calculate these risk measures in Excel.     

Delayed Expected Loss Recognition and the Risk Profile of Banks

This paper investigates the extent to which delayed expected loan loss recognition (DELR) is associated with greater vulnerability of banks to three distinct dimensions of risk: (1) stock market liquidity risk, (2) downside tail risk of individual banks, and (3) codependence of downside tail risk among banks. We hypothesize that DELR increases vulnerability to downside risk by creating expected loss overhangs that threaten future capital adequacy and by degrading bank transparency, which increases financing frictions and opportunities for risk‐shifting. We find that DELR is associated with higher correlations between bank‐level illiquidity and both aggregate banking sector illiquidity and market returns (i.e., higher liquidity risks) during recessions, suggesting that high DELR banks as a group may simultaneously face elevated financing frictions and enhanced opportunities for risk‐shifting behavior in crisis periods. With respect to downside risk, we find that during recessions DELR is associated with significantly higher risk of individual banks suffering severe drops in their equity values, where this association is magnified for banks with low capital levels. Consistent with increased systemic risk, we find that DELR is associated with significantly higher codependence between downside risk of individual banks and downside risk of the banking sector. We theorize that downside risk vulnerability at the individual bank level can translate into systemic risk by virtue of DELR creating a common source of risk vulnerability across high DELR banks simultaneously, which leads to risk codependence among banks and systemic effects from banks acting as part of a herd.     

The Cost of Capital of Cross‐listed Firms

This paper analyses the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for cross‐listed stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1979) and Sercu (1980) including both the global market portfolio and exchange rate risk premia and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross‐listed stocks from nine countries in the period 1980–99. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12% of the cross‐listed companies. The size of the cost of capital differential is around 50 basis points for the US, 80 basis points for the UK and 100 basis points for France.     

Sharing Risk with the Government: How Taxes Affect Corporate Risk Taking

Using 113 staggered changes in corporate income tax rates across U.S. states, we provide evidence on how taxes affect corporate risk‐taking decisions. Higher taxes reduce expected profits more for risky projects than for safe ones, as the government shares in a firm's upside but not in its downside. Consistent with this prediction, we find that risk taking is sensitive to taxes, albeit asymmetrically: the average firm reduces risk in response to a tax increase (primarily by changing its operating cycle and reducing R&D risk) but does not respond to a tax cut. We trace the asymmetry back to constraints on risk taking imposed by creditors. Finally, tax loss‐offset rules moderate firms’ sensitivity to taxes by allowing firms to partly share downside risk with the government.     

Do Large Blockholders Reduce Risk?

The conventional assumption in the asset pricing literature is that the identity of a company's owners is largely irrelevant, but studies of companies with “blockholders”—shareholders with large positions in a particular company—provide grounds for questioning this assumption. Unlike the well‐diversified investors of modern portfolio theory, blockholders have strong incentives to monitor corporate performance and, when necessary, to exert control over ineffective managements and boards. The findings of many studies support the idea that blockholders have a positive effect on rates of return. The authors of this article report the findings of their recent investigation of whether blockholders might also have a positive effect on shareholder value by reducing the risk of the companies in which their holdings are concentrated. After distinguishing between companies with individual as opposed to corporate blockholders, and those with one share, one vote as opposed to those with dual‐class shares, the authors find that ownership of large positions by individuals—but not corporations—was associated with lower systematic risk (when using both Fama‐French multiple factor and CAPM models). At the same time, they find that the firm‐specific risk of such companies was higher, but “biased” toward positive outcomes—that is, smaller downsides with larger upsides. What's more, this upward shift in performance and risk‐profile was achieved at least partly through increases in productivity as reflected in higher profit margins, profitability, profit per employee, and operating leverage, and lower costs of goods sold, SGA, and cash holdings. By contrast, in the case of blockholders in companies with dual‐class share structures, all of these positive associations with blockholders were either significantly weaker, or reversed. That is, whereas the presence of individual blockholders appears to increase productivity and value under a one share, one vote governance regime, blockholders in companies with dual‐class structures were associated with higher systematic risk and reduced productivity and value.     

Risk-shifting and investment asymmetry

I show that when shareholders can change not only the variance of the future firm value, but also its asymmetry, they can shift costly risk to bondholders while lowering the firm risk, and more importantly, the equity risk and the probability of bankruptcy. The implication of this result is that risk-shifting behavior can be more beneficial to shareholders than currently perceived in the literature.     

Valuing Companies with Cash‐Flow@Risk

The classic DCF approach to capital budgeting—the one that MBA students in the world's top business schools have been taught for the last 30 years—begins with the assumption that the corporate investment decision is “independent of” the financing decision. That is, the value of a given investment opportunity should not be affected by how a company is financed, whether mainly with debt or with equity. A corollary of this capital structure “irrelevance” proposition says that a company's investment decision should also not be influenced by its risk management policy—by whether a company hedges its various price exposures or chooses to leave them unhedged. In this article, the authors—one of whom is the CFO of the French high‐tech firm Gemalto—propose a practical alternative to DCF that is based on a concept they call “cash‐flow@risk.” Implementation of the concept involves dividing expected future cash flow into two components: a low‐risk part, or “certainty equivalent,” and a high‐risk part. The two cash flow streams are discounted at different rates (corresponding to debt and equity) when estimating their value. The concept of cash‐flow@risk derives directly from, and is fully consistent with, the concept of economic capital that was developed by Robert Merton and Andre Perold in the early 1990s and that has become the basis of Value at Risk (or VaR) capital allocation systems now used at most financial institutions. But because the approach in this article focuses on the volatility of operating cash flows instead of asset values, the authors argue that an internal capital allocation system based on cash‐flow@risk is likely to be much more suitable than VaR for industrial companies.     

Portfolio Diversification Effects of Downside Risk

Risk managers use portfolios to diversify away the unpricedrisk of individual securities. In this article we compare thebenefits of portfolio diversification for downside risk in casereturns are normally distributed with the case of fat-taileddistributed returns. The downside risk of a security is decomposedinto a part which is attributable to the market risk, an idiosyncraticpart, and a second independent factor. We show that the fat-tailed-baseddownside risk, measured as value-at-risk (VaR), should declinemore rapidly than the normal-based VaR. This result is confirmedempirically.     

Risk Management by Securities Settlement Agents

As developing countries search for ways to promote capital formation through the establishment of organized exchanges, they will need to pay more attention to the role of risk management in the securities settlement process. The delivery-versus-payment (DVP) agents that facilitate the process of exchanging securities for funds in most world markets have both the incentive and comparative informational advantage to monitor, measure, and manage risks inherent in the securities settlement system.
Unfortunately, most DVP agents have accomplished this task to date through the cumbersome use of position and net debit limits, capital requirements, and collateral requirements. Such limits and requirements are almost everywhere based on relatively arbitrary criteria that may have no relation to the actual replacement cost, principal, or liquidity risk of the transaction, portfolio, or participant on which they are imposed.
To remedy this shortcoming in the current state of risk management at DVP agents, this article holds out the possibility of integrated, comprehensive risk management processes that emphasize and rely on forward-looking measures of risk for individual brokers and across brokers. Many risk measures could serve the settlement agent's purposes, including "value at risk" (or "VaR"), "below target risk,""below-target probability," and "downside semi-variance." The actual summary risk measure used for risk monitoring and control is not as important as the methodology used to generate that risk measure. "The goal of such a process," as the authors put it, "is to ensure that the risks to which a settlement agent and its residual claimants are exposed are those risks to which the agent's shareholders think they are and want to be exposed."     

Alternativen zu Value at Risk

The industry standard for the measurement of the downside risk of financial positions, Value at Risk (VaR), has serious deficiencies. In the current article we systematically discuss properties of risk measures and alternatives to VaR. It is demonstrated that utility-based shortfall risk (UBSR) possesses many desirable properties.     

Shareholder Wealth Effects of European Domestic and Cross‐border Takeover Bids

This paper analyses the short‐term wealth effects of large intra‐European takeover bids. We find announcement effects of 9% for the target firms compared to a statistically significant announcement effect of only 0.7% for the bidders. The type of takeover bid has a large impact on the short‐term wealth effects with hostile takeovers triggering substantially larger price reactions than friendly operations. When a UK firm is involved, the abnormal returns are higher than those of bids involving both a Continental European target and bidder. There is strong evidence that the means of payment in an offer has an impact on the share price. A high market‐to‐book ratio of the target leads to a higher bid premium, but triggers a negative price reaction for the bidding firm. We also investigate whether the predominant reason for takeovers is synergies, agency problems or managerial hubris. Our results suggest that synergies are the prime motivation for bids and that targets and bidders share the wealth gains.     

Life Insurer Cost of Equity with Asymmetric Risk Factors

This study presents an improved model for estimating life insurer cost of capital with the inclusion of upside and downside risk factors and controlling for life insurer characteristics. Although various asymmetric measures of market risk have been shown to be priced factors for the broader equity market, life insurer realized equity returns include a much larger premium for bearing downside risk, even after controlling for firm characteristics and other measures of risk. Cross‐sectional regression analysis finds a positive (negative) premium for downside (upside) betas, conditional on down and up markets, respectively. Coskewness and cokurtosis are also priced factors.