Quantitative risk analysis
Common sense cannot be replaced by a model in any way, but quantitative analysis is an extremely useful addition to give an idea about how likely an outcome would be. It helps providing a comprehensive overview when evaluating the risk of a loss concerning a single financial contract, or, for example, creates a picture of where exchange rates are expected to be.
Below are examples of different situations in which quantitative analysis can be used as a tool in the decision process. We do not believe that a model should be used as the sole basis for decisions, nor should it be used to evade responsibility. We use it merely as a tool to provide a better basis for decisions if the advisory task contains an element where it is sensible to use this.
Currency risks
An example of where it is helpful to look at the expected volatility is if the company has a high risk from a particular currency. It may come from import, export or the foreign exchange risk from an investment in a foreign company.
The question is often whether the company should hedge some of the risk, and if so, at what rate and how much. It is a great help to look at the expected price fluctuations so that the company does not pay for a hedge which is unlikely to occur. Or, on the other hand, if the company seeks to obtain an insurance against an unlikely situation, the model helps to find an answer to the probability according to statistics.
The graphic shows an example where EUR / USD is expected to move within the next 12 months with 68.2% probability and 94.4% probability (1 and 2 standard deviations). Experience shows that the dividing line at 68.2% probability is interesting. It thus constitutes a decision parameter when selecting which areas are best to hedge. Alternatively it gives an idea of the limit when the company is seeking insurance against an unlikely situation.
Risks from interest rate swaps
It can be quite valuable to know the expectation of the mark-to-market value of one or more interest rate swaps. Today both small and large companies may be asked for additional collateral by the banks in connection with the interest rate swap they trade. It can be valuable to know the assessment of the risk of having to provide security. Before entering an interest rate swap it is important to know the expectation of future market-to-market values.
Balance sheet risks
The interest rate risk model for medium and large companies can be extended to cover not only the total hedge portfolio but also to include other cash flow effects from the total debt portfolio. This provides a sophisticated management tool when the optimal hedging is to be found.
Advanced Risk
Lundgreen’s Capital also has the capacity to deal with situations which require programming and simulation of risks in a Monte-Carlo model.
