By Margaret Elliot

The new filing requirements instituted by the Securities and Exchange Commission will be something of a cakewalk for most large financial institutions. The long-discussed new derivatives disclosure rules affect large companies filing 10-Ks with a June 30, 1997, fiscal year end.
But the same cannot be said for nonfinancial corporations. Although value-at-risk (VAR)—one of the methods acceptable under the new regulations for calculating a potential loss resulting from derivatives—has been discussed ad nauseum, few nonfinancial corporates have actually implemented VAR within their institutions.
That presents corporates with two distinct challenges: complying with the new regulations, and understanding the information the new disclosure provides, both to the company's own internal risk management and to outside observers such as shareholders and analysts.

Why do the new regulations present such a challenge? The short answer is that derivatives valuation and disclosure have developed quite differently on the corporate side. Most corporate derivatives users started small—and many remain infrequent users—using plain vanilla instruments to hedge interest rate, foreign exchange or commodity risk. "The vast majority of corporate derivatives users do not and never have used complicated instruments,” says consultant Bidyut Sen, managing director of TriCap International in New York. "Very few companies are engaged in highly leveraged transactions with say, a LIBOR-squared component.”

Nevertheless, few corporates initially had the expertise or computer power to value even the plain vanilla instruments they used. They relied on their dealer or bank counterparties to provide pricing and information. For widely traded instruments in liquid markets, that meant something as simple as a data feed from Reuters.

Valuation became more of an issue after the derivatives disasters of 1993 and 1994. When losses appeared, many senior managers looked into the issue and found themselves uncomfortable with this hand-in-glove approach. Into the breach leapt accounting firms, risk consultants and banks.

Fast-forward to the valuation landscape of 1997. Corporates have finally come to accept that the independent source of the valuation is as important—perhaps more important—than the number itself. According to Martin E. Titus, principal in risk strategy at KPMG, "There's no less need on behalf of a corporate end-user to understand the transaction. The dealer needs to understand and so does the end-user. The problems come when an end-user accepts without question the value of the instrument provided by the counterparty.”

This growing respect for independent valuation has prompted banks that set up independent risk management groups to pull out of the business. Accounting firms now handle the big picture and specialized consulting firms provide the intellectual firepower to value complicated instruments.

Dealers, of course, have retained their role as providers of third-party valuation when corporates shop deals in the market. But in practice, says Andy Feldman, managing director of America's derivatives origination and structuring for Chase Manhattan Bank, "we found that many corporates want valuation from a firm that is fully independent of the dealer community.”

Although dealers have all the intellectual firepower, systems and market knowledge to provide an accurate view of market value, corporates remain suspicous of services provided by an institution that probably in another guise sells the company other products. Even if a bank didn't sell a particular foreign exchange cap or swap, it's likely that the bank thinks of the corporate as a target customer.

"This whole exercise is not as valuable as it could be if corporates only think about meeting the disclosure requirements. The data could be use for strategic planning, mergers and acquisitions and the selection of hurdle rates.” Bob Baldoni partner, Ernst & Young

After a year or so of providing risk advisory services on a stand-alone basis, Chase disbanded the group. "We integrated the function into risk marketing,” says Feldman. "Of course we look at a company's derivatives portfolio, but we don't pretend that it is separate from our desire to sell the company something.”

That leaves the field of valuation open to the accounting firms and consultants, where a truly independent service continues to be available. But it's wrong to conceive of this business as a rerun of the dealer's version of counterparty valuation. "What's important,” says Tanya Styblo Beder, principal of Capital Market Risk Advisors, "is that our clients understand the risks they are taking. Our aim is to have corporates stand on their own two feet.” Which means not simply taking corporate information away and sending them a report that provides valuation numbers.

At least that is the theory. The Big Six do a good business in providing independent price verification for companies in time for their quarterly and annual reporting periods. But the new SEC disclosure requirements shift the focus. Until now valuation and marking-to-market of instruments were needed to produce accounting results, not necessarily to manage risks internally or to contemplate into the future the risks the enterprise is running. "Not all corporates have a good understanding of their risk profile,” says Mark Casella, a partner of Coopers & Lybrand. "They don't have the ability to price instruments internally. They are asking questions today, trying to understand the risks, both visibly in derivatives instruments and underneath in the underlying risks.”

The new disclosure requirements should encourage corporates to take the next step: moving from complying with regulatory requirements to actually facing and managing the risks they face. As Bob Baldoni, a partner at Ernst & Young, says, "This whole exercise is not as valuable as it could be if corporates only think about meeting the disclosure requirements. The data could be use for strategic planning, mergers and acquisitions and the selection of hurdle rates.”

Because there is no standard method of risk assessment, the requirements give three alternative methods by which to report market risk—tabular, sensitivity analysis or value-at-risk. Each will likely find users, even though the money is on VAR to become the standard method eventually.

The SEC is interested in disclosure of market-based risk, which translates essentially into derivatives instruments. Corporates, unlike financial institutions, often have huge underlying risk positions related to their business lines, which are not quantified under these requirements. An oil company, for instance, would be required to disclose market risk encompassing, say, forward oil contracts, foreign exchange and interest rate instruments all used to hedge an underlying exposure to oil implicit in the business.

Another challenge corporates face is matching the method used for disclosure to the way the company itself thinks of risk. Jacques Longerstaey, vice president at JP Morgan, says: "Most companies manage their risks on an accrual basis and are more interested in cash-flow-at-risk, which is an accrual-based measure of risk. The choice of which kind of disclosure will be used in reporting should have some bearing on the way the company already manages risk internally.”

And unlike banks or broker/dealers, corporates tend to view their derivatives and other holdings as long-term investments and look to value these on a less frequent basis. "There's no single answer to the question the SEC has posed,” says Beder. "It depends on the information available, and remember that a corporation typically has fewer data points available and that the time horizon for holding the instruments is likely to be much longer than for a financial institution, for instance, quarterly vs. daily.”

Multiple choice

Given these distinctions, how should corporates view the new requirements? Not all consultants agree on a single approach, though all suggest that certain methods work better for certain types of companies. The tabular method has the fewest proponents because the breadth of information needed to comply means most corporates will be releasing sensitive competitive information. "Essentially,” says Jitendra Sharma, a partner with Arthur Andersen in New York, "the idea is that the corporate releases raw information that can then be used to calculate a market risk measure. The tabular method doesn't require that the company do any calculation.”

"The choice of which kind of disclosure will be used in reporting should have some bearing on the way the company already manages risk internally.” Jacques Longerstaey vice president at JP Morgan

The tabular presentation does, however, require that the company provide quantitative information on all market-risk-sensitive instruments, including fair values of market-risk-sensitive instruments and contract terms sufficient to determine the future cash flows from those instruments, categorized by expected maturity dates. The information should allow readers to determine aggregate cash flows from these instruments for the next five years. Instruments are to be separated into categories based on common market-risk categories (that is, those entered into for trading purposes); those subject to specific market risk exposure, such as foreign currency or interest rate risk; and those within a specific category that are subject to different risk characteristics, such as different underlying commodity exposures or different functional currencies.

It doesn't take much common sense to see that any company with a wide variety of hedging activities would be giving away their hedging strategy and perhaps even their business strategy using this method of compliance. "If an airline had to disclose its jet oil fuel exposure and the hedging put in place to manage it, that would be giving away strategic information to competitors,” says Sharma.

The tabular method would be appropriate for smaller companies and those without a wide range of derivatives activities. And in practice, it may be more useful for larger users of derivatives if the SEC allows some aggregation of instrument information, which is being mooted according to those familiar with the agency's thinking on implementation.

Sensitive measure

Between sensitivity analysis and VAR, the other two choices, the decision becomes a bit more difficult. "Some companies,” says Sharma, "are running both side-by-side and back testing to see which is more appropriate for their business.” And, one assumes, which complies with the requirements without giving anything too valuable away.

Sensitivity analysis is just that, the sensitivity of a company's derivatives holdings to changes in market prices. Calculation is done using a general class of models that assess risk of loss in market-risk-sensitive instruments based on hypothetical changes in market rates or prices—an example would be duration analysis. The disclosure requires a description of the model used, its assumptions and parameters. Registrants must report this information over a period one year into the future from the filing date.

The problem with the sensitivity analysis method is a single line in the description of the new disclosure requirements: "Absent economic justification for the selection of a different amount, registrants should use changes that are not less than 10 percent of end period market rates or prices.” This suggests that no less than a 10 percent move will be considered appropriate, according to consultants.

Needless to say, in many markets a 10 percent move up or down would constitute a huge change. "It's unclear how the SEC views economic justification for using another rate,” says Fred Cohen, a partner of Price Waterhouse. "If you use a smaller movement for foreign exchange, for instance, what kind of further disclosure will you have to make to shareholders?”

As with most new SEC requirements, these disclosure mandates raise many questions for new filers. Roger Coffin, national director of regulatory services for Coopers & Lybrand in Washington and until recently a member of staff at the SEC, says that "The SEC has more work to do as far as these standards go. The reason three choices were given is because there is no singular acceptable way to disclose market risk in nonfinancial corporations. Maybe eventually there will be, but that understanding will only come from experience in implementation.” So it's not surprising that the first companies that need to file are going to the SEC for advice on such issues as the 10 percent rule in sensitivity analysis.

Inevitable choice

Whatever the outcome of those negotiations, the industry standard for financial institutions is fast becoming value-at-risk, and many believe that it will so be so for nonfinancial corporations. "It's inevitable,” says Ernst & Young's Baldoni. "VAR not only meets the SEC requirements but, more important, it allows companies to understand and manage their risks better internally.”

The value-at-risk disclosure requirement is sufficiently broad that almost all of the most popular ways to calculate this measure can be accommodated. It simply asks that companies express the potential loss in future earnings, fair value or cash flows of market risk instruments over a selected period of time, with a selected likelihood of occurrence, from changes in all the relevant market rates. The selection of confidence levels is left to the company, but, again, "absent economic justification” for another level, the confidence level should be 95 percent or higher. This, however, is market practice at the moment.

So which type of VAR is appropriate for nonfinancial corporates? The answer depends greatly on the type of company, but also, it seems, on the viewpoint of the consultant or accounting firm. The product most closely associated with VAR is JP Morgan's RiskMetrics®, which relies on a variance/covariance methodology to calculate risk. This approach may be appropriate for corporations with treasuries that function like dealer shops. If the mindset is short-term with large volumes of transactions, then variance/covariance could capture the risks appropriately.

No budget

It also depends on what a corporate is willing to spend on technology. Baldoni argues that nonfinancial companies should pay particular attention to the selection of various methodologies because of the long-term nature of their exposures and the need to track the exposures as they age. Others, however, believe that Monte Carlo methodologies are clearly best suited to track these long-term exposures. The main obstacle for corporates is the computer power needed for Monte Carlo sampling.

"We found that most corporates want valuation from a firm that is fully independent of the dealer community.” Andy Feldman managing director of North American derivatives, Chase Manhattan Bank

Similarly, a VAR approach that includes historical simulation may also be more appropriate for nonfinancial corporates yet requires a level of software and analytics that few companies have at the moment. According to Chase's Feldman, "Today risk analysis is really a software problem.” Yes, it remains possible to outsource the calculation of VAR, or for that matter sensitivity analysis, all the way out to full preparation of the SEC disclosure requirements. But for most large companies, the new requirements mean they will need to figure out how to do the valuation and the calculation of VAR internally. And that means new software.

End-user Advocacy from an Interdealer Broker? Interdealer brokers are usually happy to work in their own particular niche—shopping deals between dealers. At Euro Brokers, however, Peter Shapiro and John Keenan have developed an unusual and profitable niche advising companies that enter into a variety of Public Service Association (PSA) index-linked derivatives transactions. "We are asked to sit at the table on the side of the end-user to make sure that the deal that was done was fair to all sides,” he says. It's an idea that could have application for end-users across all sorts of industries. For Euro Brokers, their expertise in the municipal derivatives market meant that the firm was the obvious choice to be a value-added adviser. "We don't have a product to sell, or a book to push,” says Shapiro. "Yet we know the market very well. We know the dealers—they are our clients as interdealer brokers.” Euro Brokers has acted for a range of companies in the real-estate industry. From real-estate investment trusts (REITs) and builders of housing or office buildings to waste management companies, what these companies have in common is a need to use PSA-linked derivatives to hedge an existing portfolio of tax-exempt debt. While expert in their main business, the finance departments of these corporates don't always have the precise knowledge required to operate in the municipal derivatives market. That's particularly important now, because the U.S. real estate industry is in a major period of consolidation. The biggest players are buying up properties that have existing, underlying tax-exempt financing issued by a variety of municipal authorities—cities, towns, counties and infrastructure agencies among others. "This industry is undersecuritized compared with other financially driven industries,” says Shapiro. "Once major players have assembled a group of properties, they often have to figure out how to manage the risks involved, and that usually involves swaps and caps.” Shapiro gives several examples of how Euro Brokers has facilitated deals in this arena in the last year. A New York Stock Exchange-listed REIT, Irvine Apartment Communities, needed to restructure a portfolio of $300 million of existing PSA-linked swaps. The existing swaps had only three years or less to run, and the REIT needed to put seven- to 12-year financing in place. "We needed to extend the maturity, alter the collateral structure and replace the counterparty pool,” says Shapiro. Euro Brokers set up a competitive bidding process whereby it produced term sheets and rounded up appropriate counterparties, and conducted a series of telephone auctions. Since the swap restructuring was part of a larger corporate restructuring as the result of a refinancing, other investment banks led by Goldman Sachs were involved in the overall process. In another case, Euro Brokers negotiated a $180 million series of mirror-image PSA swaps for Equity Residential Property Trust, another NYSE-listed REIT, controlled by noted distressed investor Sam Zell and an affiliated company. The objective of this deal was to produce the desired mix of fixed- and floating-rate swaps. Euro Brokers was instrumental in identifying the proper counterparty and then sat at the table with the company's finance people and lawyers to negotiate the final structure. "In this case,” says Shapiro, "an auction would have been inappropriate as the deal was simply too complex for bidding; the objective was a particular mix and needed one counterparty to provide it.” Though both these transactions were substantial in size, Euro Brokers often assists in deals in the $10 million to $25 million range. Often a buyer will purchase two or more properties and need to cap a floating-rate tax-exempt exposure or simply adjust existing swaps to reflect the combination of the properties. The PSA-linked market, though growing, is not a transparent market. Euro Brokers provides weekly quotes to Bond Buyer, but Shapiro suggests that these prices are merely guidelines—"they reflect the middle of the market on a theoretical basis”—and no hard indication of where a bid for a particular swap would come in. "We ran a bid for a cap this morning,” says Shapiro. "Our model said 80 basis points; the best bid was 74 basis points and the worst was 90 basis points. That gives you a sense of the inefficiency of the market.”

It's a problem that many providers are rising to solve (see box). For those in the business of producing front-to-back-office systems for dealers, corporates have never been a key client base. Corporates don't need the trade routing and confirmation system. What they do need, however, is the analytic engine.

The full service dealer systems are far too expensive—millions of dollars is not unheard of. A corporate, by contrast, may balk at $50,000 for a system that it only uses to calculate one number for SEC disclosure. Two things are happening—the price of the appropriate software is coming down as vendors scale back their offerings to this market, and corporates spending this kind of money are putting a lot of thought into other ways they can use the information the system throws up.

Last year, JP Morgan entered the fray with a product called FourFifteen, which packages the bank's RiskMetrics® program in a software engine directed at nonfinancial corporates and smaller financial institutions. Launched a year ago, the product costs $25,000 a year. After a troubled first release, the program has since been revamped with the help of outside systems developers. "We've had tremendous interest on the part of corporates,” says Morgan's Longestaey. "It's been picking up dramatically as the first filers are working on the new requirements.”

"It's unclear how the SEC views economic justification for using another rate. If you use a smaller movement for foreign exchange, for instance, what kind of further disclosure will you have to make to shareholders?” Fred Cohen partner, Price Waterhouse

Accounting firms are also working on teaming up with software providers to deliver a fully outsourced product to smaller corporates that don't want to buy in the analytics, yet want a tailored set of numbers both for disclosure purposes and ongoing risk management. Ernst & Young, for example, is negotiating to use one vendor's product as the engine for a service whereby CFOs can access their VAR numbers on a secure web site. The corporate client would download the information to E&Y, which would crunch the numbers and then, on an ongoing basis, post them on a secure web page for the CFO.

Crunching numbers, however, isn't the end of the game. Corporates that choose the VAR measure will have to supply a description of the model, assumptions and parameters used. "This description, which will likely fall into the management discussion and analysis (MD&A) section, will have to be carefully crafted,” warns KPMG's Titus. "It is here that a company will need to explain why it chose the particular model it did, how it reflects the vagaries of the business and what the numbers tell shareholders about the risks the company is running.”

What will happen to the numbers once they are in the public domain? In the rush to figure out how to comply, few companies have spent much time considering this issue. The MD&A discussion, at least at the beginning, will have to educate the analysts and the shareholders on how best to interpret the risk numbers provided. "Because of the many different bases that can be used to determine these risk numbers, it wouldn't be appropriate to compare them across companies. Yet it is possible to compare them across different time periods,” says Jim Mountain, a partner at Deloitte & Touche.

Nobody knows quite what will happen when the legions of stock market analysts start poring over the risk numbers. "Unless the market—the stock market—finds some way to use these numbers, they may just be ignored,” predicts Mountain. The best guess is that securities analysts will be just as confused as the vast majority of corporate board members who missed out on Value At Risk 101.

At some point in the future, however, the circle could be closed. The risk management world could agree on a series of standard risk measures that would allow securities analysts true insight into the risks a company faces. Until then, the business of measuring corporate risk should continue to be a cash crop for the Big Six accounting firms.