Exposure-Based Volatility: An Application in Corporate Risk Management

Abstract

Purpose – This study develops a non-traditional measure of risk, an Exposure-Based Volatility, for the non-financial company and applies this measure to capture both the downside potential of cash flows and the probability of requiring additional external financing under most foreseeable conditions.

Design/methodology/approach – Various empirical models are applied in order to provide a reliable Exposure-Based Volatility measure. The empirical analysis is applied on a particular Bulgarian transport company.

Findings – The current analysis concludes that the proposed measure of exposure-based volatility manages to capture effectively the peaks and troughs in the variance of cash flows, thus significantly outperforming the historical standard deviation. It is further shown that through its application the particular measure of downside risk leads to a useful contribution in the corporate risk management process.

Research limitations/implications – This study demonstrates the application of Exposure-Based CFaR and the modified Merton model to a particular company, but the presented method provides a reliable tool for calculating the cash flow risk exposure of any enterprise.

Practical implications – The proposed measure of exposure-based volatility and its applications have been developed within the professional environment and thus, can be applied in a plethora of areas including, among others, corporate finance (e.g. capital budgeting, capital structure, financial modeling, etc.), investment and portfolio management and risk management and analysis. These tools can be especially valuable to the finance professionals as additional support in the day-to-day analytical business.

Originality/value – The particular paper extends existing methodologies in corporate risk management by including several additional econometric steps in order to arrive at a proprietary measure of risk. This non-traditional downside risk estimate is by itself extremely useful as it contains significant information about a given company. Furthermore, it can be used as a valuable input in several risk management tools; indicatively, in the current paper, a robust measure of CFaR and an original interpretation of Merton’s credit risk model are presented.

Keywords: Exposure-Based Volatility, Cash Flow-at-Risk (CFaR), Merton option pricing model, Liquidity risk, Corporate risk management

JEL Classification: G30, G31, G32, G33