Performing Strategic Risk Management with simulation models


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“How can you be better than us to understand our business risk?"

This is a question we often hear and the simple answer is that we don’t! But by using our methods and models we can utilize your knowledge in such a way that it can be systematically measured and accumulated throughout the business and be presented in easy to understand graphs to the management and board.
The main reason for this lies in how we can treat uncertainties 1 in the variables and in the ability to handle uncertainties stemming from variables from different departments simultaneously.

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Performing Strategic Risk Management with simulation models

  1. 1. “How can you be better than us to understand our business risk?"This is a question we often hear and the simple answer is that we don’t! But by using ourmethods and models we can utilize your knowledge in such a way that it can besystematically measured and accumulated throughout the business and be presented ineasy to understand graphs to the management and board.The main reason for this lies in how we can treat uncertainties 1 in the variables and in theability to handle uncertainties stemming from variables from different departmentssimultaneously.Risk is usually compartmentalized in “silos” and regarded as proprietary to the departmentand - not as a risk correlated or co-moving with other risks in the company caused bycommon underlying events influencing their outcome:When Queen Elizabeth visited the London School of Economics in autumn 2008 she askedwhy no one had foreseen the crisis. The British Academy Forum replied to the Queen in aletter six months later. Included in the letter was the following: “One of our major banks, now mainly in public ownership, reputedly had 4000 risk managers. But the difficulty was seeing the risk to the system as a whole rather than to any specific financial instrument or loan (...) they frequently lost sight of the bigger picture.” 21 Variance is used as measure of uncertainty or risk.2 The letter from the British Academy to the Queen is available at: Page 1 of 7
  2. 2. To be precise we are actually not simulating risk as such, risk just is a bi- product from simulation of a company’s financial and operational (economic) activities. Since the variables describing these activities - and their forecasts – is of stochastic nature, which is to say contains uncertainty, all variables in the P&L and Balance sheet will contain uncertainty. They can as such best be described by the shape of their frequency distribution – after thousands of simulations -and it is the shape (tails) of these distributions that describe the uncertainty in the variables.Most ERM activities are focused on changing the left or downside tail - the tail thatdescribes what normally is called risk.We however are also interested in the right tail or upside tail, the tail that describes possibleoutcomes increasing company value.S@R thus treats company risk holistic by modeling risks (uncertainty) as parts of the overalloperational and financial activities, thus being able to “add up” the risks - to a consolidatedlevel. Since this can’t be done with ordinary addition3 (or subtraction) we have to use MonteCarlo simulation.The value added by this are: 1. A method for assessing changes in strategy; investments, new markets, new products etc. 2. A heightening of risk awareness in management across an organization’s diverse businesses3 The variance of the sum of two stochastic variables is the sum of their variance plus the covariance betweenthem. Page 2 of 7
  3. 3. 3. A consistent measure of risk allowing executive management and board reporting and response across a diverse organization 4. A measure of risk (including credit and market risk) for the organization that is able to be compared with capital required by regulators, rating agencies and investors 5. A measure of risk by organization unit, product, channel and customer segment which allows risk adjusted returns to be assessed, and scarce capital to be rationally allocated 6. A framework from which the organization can determine its risk mitigation requirements rationally 7. A measure of risk versus return that allows businesses and in particular new businesses (including mergers and acquisitions) to be assessed in terms of contribution to growth in shareholder valueThe independent risk experts are often essential for consistency and integrity. They can alsoadd value to the process by sharing risk and risk management knowledge gained bothexternally and elsewhere in the organization. This is not just a measurement exercise, butan investment in risk management culture.ForecastingAll business planning are built on forecasts of market sizes, market shares, prices and costs.They are usually given as low, mean and high scenarios without specifying the relationship Page 3 of 7
  4. 4. between the variables. It is easy to show that when you combine such forecasts you can endup very wrong4. However the 5 %, 50 % and 95 % values from the scenarios can be used toproduce a probability distribution for the variable and the simultaneous effect of thesedistributions can be calculated using Monte Carlo simulation, giving for instance theprobability distribution for profit or cash flow from that market. This can again be used toconsolidate the company’s cash flow or profit etc.Controls & Insurance MitigationControls and insurance play a significant part in reducing the likelihood of a risk event or theamount of loss should one occur. They also have a material cost. One of the drivers ofmeasuring risk is to support a more rational analysis of the costs and benefits of controlsand insurance.The mathematics of the mitigation offered by controls is not straightforward. A distinctionneeds to be made between those controls that reduce the likelihood of occurrence (such assegregation of duties) and those that minimize the impact should the event occur (such asbusiness continuity planning). These need to be adjusted for separately. The precisemathematics will vary with the underlying risk distributions.The result after mitigation for controls and insurance becomes the final or residual riskdistribution for the particular risk for the organization.Distributing Diversification BenefitsAt each level of aggregation within a business diversification benefits accrue, representingthe capacity to leverage the risk capital against a larger range of non-perfectly correlatedrisks. How should these diversification benefits be distributed to the various businesses?This is not an academic matter, as the residual risk capital attributed to each businesssegment is critical in determining its shareholder value creation and thus its strategic worthto the enterprise. Getting this wrong could lead the organization to discourage its bettervalue creating segments and encourage ones that dissipate shareholder value.The simplest is the pro-rata approach which distributes the diversification benefits on a pro-rata basis down the various segment hierarchies (organizational unit, product, customersegment etc.).A more accurate approach that can be built into the Monte Carlo simulation is thecontributory method which takes into account the extent to which a segment of theorganization’s business is correlated with or contrary to the major risks that make up theGroups overall risk. This rewards countercyclical businesses and others that diversify theGroups risk profile.4 Page 4 of 7
  5. 5. The S@R Process Implementation Problem Creation of of the S&R Simulation and Description Framework model software Reporting Definition of Time frame Systemic EBITDA model value and cost Implementation P&L and Balance drivers and Quantification: of EBITDA model model their distributions Opening balance Data entry Valuation Inventories template for simulation Dependencies Taxes, etc. EBIDA model ("Correlations") Forecasts and between cost Legal requirements Data for balance distributions and value drivers model template Company Interest rates Evaluation and environment: (yield curves) treatment of taxes, Exchange rates Results interest rates Financial strategy etc etc.Aggregation with market & credit riskFor many parts of an organization there may be no market or credit risk - for these areas,such as sales and manufacturing, operational and business risk covers all of their risks.But at the Group level the operational and business risk measure needs to be integratedwith market and credit risk to establish an overall measure of risk being run by theorganization. And it is this combined risk capital measure that needs to be apportioned outto the various businesses or segments to form the basis for risk adjusted performancemeasures.It is not sufficient just to add the operational, credit and market risks together. This wouldover count the risk - the risk domains are by no means perfectly correlated, which a simpleaddition would imply. A sharp hit in one risk domain does not imply equally sharp hits in theothers.Yet they are not independent either. A sharp economic downturn will affect credit andmany operational risks and probably a number of market risks as well.The combination of these domains can be handled in a similar way to correlations withinoperational risk, provided aggregate risk distributions and correlation factors can beestimated for both credit and market risk. Page 5 of 7
  6. 6. Correlation riskMarkets that are part of the same sector or group are usually very highly correlated or movetogether. Correlation risk is the risk associated with having several positions in too manysimilar markets. By using Monte Carlo simulation as described above this risk can becalculated and added to the company’s risks distribution that will participate in forming thecompany’s yearly profit or equity value distribution. And this is the information that themanagement and board will need.Decision makingThe distribution for equity value (see above) can then be used for decision purposes. Bymaking changes to the assumptions about the variables distributions (low, medium and highvalues) or production capacities etc. this new equity distribution can be compared with theold to find the changes created by the changes in assumptions etc.: Page 6 of 7
  7. 7. A versatile toolThis is not only a tool for C-level decision making but also for controllers, treasury,budgeting etc.The results from these analyses can be presented in form of B/S and P&L looking at thecoming one to five (short term) or five to fifteen years (long term); showing the impacts toe.g. equity value, company value, operating income etc. With the purpose of:• Improve predictability in operating earnings and its’ expected volatility• Improve budgeting processes, predicting budget deviations and its’ probabilities• Evaluate alternative strategic investment options at risk• Identify and benchmark investment portfolios and their uncertainty• Identify and benchmark individual business units’ risk profiles• Evaluate equity values and enterprise values and their uncertainty in M&A processes, etc.If you always have a picture of what really can happen you are forewarned and thusforearmed to adverse events and better prepared to take advantage of favorable events.Many examples of this are given on our home page: Page 7 of 7