Risk Analysis

Identify Exposures and Quantify Risk

An accurate risk measure estimates a transaction's potential loss arising from specific risk factors and the probability of that loss occurring. The measure is intended to help a company accurately assess what could happen and help it avoid unexpected events associated with changes in these factors. Consequently, the measure often acts as an incentive for the company to take actions to manage the risk.

The risk management process begins with the development of a comprehensive understanding of the exposures that create risk and the resources available to record and report such information. This requires that treasury and operating units work together to identify and quantify transactions that generate exposures and to develop the ability to forecast future exposures.

In order for a company to take advantage of the risk management process, it must be able to record and report the transactions that create the potential risks. Today, companies are continuously searching for new financial instruments that will help mitigate risk in the market. Derivatives are becoming increasingly popular as a means to hedge current or anticipated transactions.

Solution #9

After identifying the transactions that generate exposures, the next step in the process is to aggregate and quantify those risks. Many companies consider an effective risk management process to be the execution of derivative transactions that take advantage of specific market expectations. By not completely evaluating their specific risk objectives or defining risk in the corporate context, such a transactional approach can lead to a string of unrelated transactions. These transactions may create additional exposures rather than reduce risk. It is important to apply a comprehensive approach to managing risk and to disclose the effects of these risks on the company's financial statements. Without this disclosure, a shareholder or investor is not presented with the most accurate picture of the company's financial activities. Should Burns decide to not disclose the risks embedded within each financial transaction, management would not be providing the shareholders and investors with accurate information. Given the company's dire situation, Burns should be conservative in its appetite for taking on risks. The company has been advised to purchase a put option on natural gas futures. Purchasing options provide for limited risk of loss and an unlimited possibility for gains. At this time, Burns should not consider writing options since they afford limited gains and an unlimited risk of loss. If the company decided to write an option, the high level of risk involved could easily offset other profitable, limited risk transactions. This is primarily the reason why risks should be identified and quantified on the financial statements.

Currently, the most popular methodologies of valuing risk include the tabular format, sensitivity analysis, fixed-scenario, and value-at-risk methods. This evaluation will focus on the sensitivity analysis method of valuing risk with brief descriptions of the remaining three procedures.

Tabular Method

The tabular method allows a company to disclose derivatives activities in the financial statements simply by listing its positions that have financial risk along with their notional values. This procedure allows the shareholder or investor to distinguish one position from another, but it fails to aggregate the risk and quantify it. Furthermore, it leaves the measurement of risk open to the interpretation of the user based on the information provided. As a result, this method is not recommended.

Sensitivity Analysis

This procedure involves predicting a movement in a market relationship and calculating the gain or loss on a position or portfolio resulting from the move. It is often at the discretion of the user to determine the size and direction of the movement, but various statistical methods may be used to standardize the movement as well. A sensitivity analysis picks an ending rate to determine the risk, and it is useful when determining the risk profile of derivative instruments. The only major drawback of this method relates to choosing the market relationship moves when dealing with multiple exposures. This problem extends across all market relationships, therefore, a company using this methodology will not be able to show much of the risk reduction that results from diversification. A sensitivity analysis is beneficial in assessing and valuing risk for analyzing isolated exposures, it is not the most accurate technique for determining company-wide risk with multiple exposures.


The procedure for calculating risk is similar to the sensitivity analysis method, but the procedure for choosing the moves is different. In a sensitivity analysis, the goal is to choose possible, but less probable, market moves. The goal of the fixed-scenario method is to choose highly improbable moves as opposed to the possible ones. The market move should test what happens to the value of the transaction when extreme market conditions occur. A benefit of this method is that it allows a company to place less emphasis on historical statistics and determine more of a worst-case scenario. However, because of its reliance on the user to define the moves, it is not an ideal practice for company-wide risk disclosure to shareholders (Yeager 33).


Currently, value-at-risk (VAR) is the most popular method used for identifying and quantifying portfolio risk. VAR is a statistical estimation of the potential effect of market movements on a portfolio, within a defined probability. This tool also allow the measurement of risk across multiple exposures. VAR is not the answer for every risk management problem (the same can be said about the previous methods explained). VAR only expresses a potential loss associated with a company's underlying currency, interest rate, or in this case, commodity risk based upon statistical probabilities and does not determine a worst case scenario, which is often times management's only concern.

For example, the measure may state that there is only a 96 percent chance (confidence interval) that the firm could lose no more than $500,000 over 18 months as a result of the futures option. This measure allows companies to aggregate the potential risks of unfavorable market movements on a portfolio of risks rather than individual exposures.

Quantifying Risk for Burn Energy Associates

The value-at-risk method would be the best method for Burns because it allows for the measurement of risk across multiple exposures, it minimizes the need for the user to define moves, and it allows for the aggregation of risks rather than individual exposures. Burns can quantify risks from all of its derivative transactions including the futures option, floor, and collar. The only drawback is that the VAR system that Burns will require is an expensive investment the the company cannot make at this time. Consequently, Burns should use the sensitivity analysis method to value their risks. Risk measurement in this case is demonstrated in the Teaching Notes of this case (Solutions 1, 2, and 4). Each of the three scenarios demonstrates what Burns could stand to lose or gain depending on what option is chosen. To choose a less profitable option would result in a loss that could have otherwise been a gain. In Solution 1, the most profitable put option scenario turned out to be at the 1.170 strike. In purchasing a put option, the higher the strike price, the higher the premium paid to enter then contract (Zhang 60). A higher cost (i.e. at 1.240 strike) means that the company would incur an additional risk by entering into that contract--the risk of future loss. If Burns had chosen the option at the 1.120 strike, it loses as well because it could have made more if management had decided to increase their risk appetite. In this case, the best option contract for Burns was at the 1.170 strike--it proved to be the most profitable.

An explanation for the reasons why the VAR system is not feasible for use by Burns Energy Associates:

Three types of VAR methodologies exist that determine what type of analytical system the company will necessitate. The variance/covariance approach is the most common and inexpensive, but it has a drawback in that it cannot value instruments with asymmetrical risks such as options (as in this case). A detailed discussion of asymmetrical risks is provided in the Introduction to Derivatives. The historical simulation approach uses historical movements in market relationships and applies them on a forward-looking basis to determine the potential risk. The benefit of this technique is that it does not require the assumption that market movements are normally distributed. On the other hand, it is limited to changing markets in the way they have moved historically. Burns would not benefit from this approach because in this case, the natural gas market is a volatile one in which the company is looking to protect itself from. To rely on historical rates of natural gas would not provide for the most accurate and effective measurement of risk. The Monte Carlo simulation is perhaps the most accurate of the three and the best suited for the Burns corporate environment. The simulation begins with the generation of a random path into the future for each of the market relationships. After the path is chosen, the gains and losses on each position are calculated and the results are aggregated. This procedure is repeats itself a number of times, sometimes as many as 10,000 times. After all the results are summed and ranked, the distribution can be shown on a histogram and the desired confidence level can be chosen. Burns can utilize this this method of VAR to identify and aggregate the multitude of risks present across all of its financial transactions in the financial statements. The main drawback of this method that the management at Burns cannot overlook is that it is an expensive investment they cannot afford to make at this time. An investment of this magnitude cannot be made because all available funds need to be channeled into servicing their existing debts. The Monte Carlo VAR system is one that Burns needs to look into for the future.


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