Understanding Risk Probabilistic Scenarios for Companies

Laura Oliva Financial risk management guide Leave a Comment

Knowing the likelihood of loss or gain is essential for any company, especially when exposed to financial risks.
Knowing in advance the chances of getting a positive financial margin from payments in foreign currencies. Or, knowing there is a favorable trend of the exchange rate for a currency you have to pay to foreign suppliers (i.e. the US Dollar). Knowing all this information in advance allows you to implement the best strategic choices and protect the company’s performance.

Managing and reducing the exposure to financial risks is a topic of great importance today for companies.
The previous year was a difficult one, marked by one significant price fluctuation. The risks of financial markets impacted heavily on companies. Think of what happened in January to the Swiss Franc: in a single day, it gained more than 17% against the Euro, or to the devaluation of the Yuan, last summer and the fall in prices of the industrial raw materials.

Euro CHF scenario

Probabilistic scenarios

The main technology internationally used to measure financial risks is the probabilistic scenarios. It is an instrument easy to understand because it gives the chances of getting a positive or negative result. The probabilistic scenarios are the methodology used by the world’s largest banks to calculate the risks from investment. It is the same model and the same information used by those who sell financial instruments to put them in the balance sheets according to IAS39. It is a must-have technology for those who deal professionally with protection against financial risks.
The probabilistic scenarios are the core of the eKuota risk model. The assumption is that each company has in its budget a succession of monetary income and expenditure the amount of which depends on the prices quoted in the financial markets. Receipts or purchases in foreign currencies, purchases of raw materials such as precious metals, industrial metals, energy (oil, gas, fuel oil) and also agricultural commodities (coffee, wheat, corn, sugar).

Because the future prices in the financial markets are uncertain, you should know the possible values and their probabilities. The essence of the risk measurement is to represent a realistic view of what might happen in the future and in particular of what might happen to the cash flows.

It is not a prediction of what will happen in detail, but a crucial information on the scale and distribution of possible outcomes.

Probability and Forecast

As everyone knows, predicting the future in detail, is an unrealistic mission for humans.
Getting the probabilities associated with each event is rather an important tool we daily use. In fact, we generally inquire about the weather.

For example, it is impossible to perfectly predict a hurricane in the Atlantic Ocean. Conversely, the experts at NOAA know the probabilities associated with an intensification of devastating events in the hurricane season. Furthermore, the odds change as time passes. At the beginning of the year, the odds may be small and are perhaps revised upwards on the arrival of the critical season.

Similarly, no one can accurately predict the copper price at the end of the next quarter, but we can know how likely the prices will be higher or lower than today. Plus, we have the opportunity to frequently monitor these data to see if the odds move in the right direction or not.

We cannot predict what will happen in the next quarter. This is a fact; the future is always uncertain; however, we can determine how likely we will have a good or bad event. This information does not remove the uncertainty but puts significant limitations to the indeterminacy.

The eKuota probabilistic scenario explores the value of the cash flow at year-end. It is an immediate and intuitive graphical representation of the company’s risks.
If we know the probabilities associated with the risks, we know everything there is to know about the risks that are facing the company.

The case – the risks for payments in US Dollar

Let’s see how to measure the risks with an example. At the beginning of the year, the company “IHateRisk” makes its annual budget. The company plans to buy components from a supplier who wants to be paid in US Dollars.
The purchase costs in Euro are calculated applying the beginning of the year euro/dollar exchange rate. Sale prices are set at the beginning of the year, taking into account the costs in euro plus an economic margin.
In this case, if during the year the US Dollar appreciates, the bills to be paid in Euro will cost more than expected in the company’s budget. The economic margins, at constant list prices, will be reduced and may even vanish. The company is exposed to the financial risk due to the fluctuations of the Euro/Dollar exchange rate.

The analysis of the financial risks with the probabilistic scenarios is shown in Figure 2.

Probabilistic Scenarios

It is a histogram that summarizes the results of the model. In the case of our example, the likelihood of good performance of the budget at the end of the year is very low. The company has a high risk of failing to achieve the expected economic margins. More than 66% of odds against.

Having this information allows the company to evaluate alternatives for the protection of the financial results. There are several strategies you can implement. The company could negotiate flexible terms with suppliers, or could change prices in the price catalogue or even hedge the currency risk with financial products.

Conclusions

Knowing the risks is the first essential rule for a healthy and prudent management.

“Risk comes from not knowing what you’re doing” (Warren Buffett).

Thanks to a very effective technology, (probabilistic scenarios), we can measure the degree of financial risk facing the company.
The year 2015 was marked by the way, from the failure of four Italian banks. The investors who had invested their savings in subordinated bonds issued by these institutions lost everything. It was a shocking event, especially because many of those investors were not aware of the risks of their investments.

Investing in financial markets always mean taking risks. Before investing, you should inquire about the probability of loss or gain. If had been used probabilistic scenarios, investors would have known before investing in subordinated notes that the risk of losing 50% of the capital had a probability between 37 and 60%. A very high risk.

Managing a company without knowing in advance the risks means making inconsistent choices. Choices that could harm the company’s future.

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About the Author

Laura Oliva

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Co-founder of eKuota. Degree in Corporate Finance from the Universita’ Luigi Bocconi in Milan, she has more than a decade of experience in capital markets. She was Head of Debt Capital Markets within the Allianz Group, she worked at a number of international investment banks. She was Global Product Specialist, Head of Structured Finance and ABS team, Head of Syndication and Credit Analyst. She managed and executed bond issues and loans syndication for major italian companies. She is a Fixed income and Securitization expert, she deals with financial analysis and financial markets. Co-Author of the AdviseOnly blog. Mom of three, born in Rimini now she lives happily in Milan.

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