Cash-Flow-at-Risk and Debt Capacity

Abstract

Value-at-Risk (VaR), which indicates the loss in value associated with a certain probability, is a widely used risk measure among financial institutions. Cash-Flow-at-Risk (CFaR) is an attempt to transfer the same ideas to the setting of a non-financial firm. In this paper I argue that at-Risk measures, in the context of corporate liquidity risk management, would benefit from an explicit and more thoughtful treatment of the firm's debt capacity. By so doing one obtains risk measures that can provide information on outcomes that are identified as costly by the risk management literature, in particular underinvestment due to financing constraints. Since assessing such outcomes requires information on the firm's presumed access to external sources of funding, what is called for is a framework in which cash flow-based measures of risk are conditional on the firm's debt capacity. The group of risk measures presented in this paper incorporates this information. They render hedgeable magnitudes that can inform risk management strategies by indicating if a hedge is likely to mitigate costly consequences of volatility by acting as a substitute for equity capital.

Keywords: Cash-Flow-at-Risk, Risk management, Liquidity, Debt capacity, Shortfall risk

JEL Classification: G30