Question on financial terms

[verma.rahul]

Dear David

In Box 1-1 The origin of VAR (page 18 of Jorion chapter 01), Can you please clarify the terms "value risks" and "earning risks." Also, investing in cash does not make any sense to me as investing in cash is decreasing your purchasing power even though market value stays constant. Finally there is there anything like fully hedged thing?

Rahul

 

[David Harper CFA FRM]

Hi Rahul,

To support your other point, this box 1-1 is the tip of larger iceberg topics. I didn't so much notice until now, but GARP dropped Stulz Chapter 4 on Cash Flow at Risk (CFaR) (I am not sure CFaR appears in 2009?...)

The "earnings risk" here would map to cash flow at risk (CFaR). And the value risk to VaR. If we step back from measurements, here is the difference between:

* the "flow" of an income statement or cash flow statement; e.g., $10 million income/profit/cash flow in the calendar year, versus
* the "stock" (point in time value) of a balance sheet or an adjusted b/s; e.g., book value of $100 million in net assets or market value of $100 million in assets , or $100 million in market capitalization. All balance sheet perspectives

"Earnings" is often used (as Jorion does) as a generic term for a bottom-line flow metric - there are dozens. So earning risk is the risk that this bottom line metric (e.g., free cash flow, net cash flow), say over the period calender 2008, falls below some threshold

Versus "Value at risk" which is the risk the value of the entity, say at Dec 31, 2008, falls below some threshold.

Each of those can be measured in so many ways. I am using "earnings" as a term generic that includes "cash flow." To me, cash flow is merely an earnings that is adjusted. But some would maybe disagree...

"Also, investing in cash does not make any sense to me as investing in cash is decreasing your purchasing power even though market value stays constant."

Right, it can open a whole debate, but IMO the ERM theory in FRM agrees with your statement. I think one risk perspective on cash is: a company needs at least some to minimize *funding liquidity risk* (i.e., stay solvent) but, at a certain point, shareholders can invest in cash on their own, they don't need the company to do that for them. Shareholders do not want a riskless company, they pay for the company to make risky investments, so excess cash should be returned via dividend or repurchase.

Finally there is there anything like fully hedged thing?
Great question! I cannot think of such a thing myself ?? I have said too many times that "basis risk is the mother of all risk and cannot be eliminated in a hedge." Last year, total commodities like corn futures were not converging so....I cannot think of a pure hedge only many almost hedges....

Thanks for good thoughts! David

 

[verma.rahul]

Thanks again David for all the insight you provide to the doubts that come our way.

Rahul