VAR calculators designed specifically for corporates are coming your way

By Nilly Ostro-Landau

Attempts to migrate value-at-risk from bank derivatives desks to the halls of corporate treasury have hit a dreary but important roadblock. While companies stand to gain plenty from adapting VAR methodology-and perhaps will have little choice once the SEC releases its disclosure requirement proposal-there is a lack of affordable, useful systems that are adapted to corporate needs.

"Clearly the current generation of VAR calculators have been built as offshoots of methodology used in banks," admits Jacques Longerstaey, vice president at JP Morgan and resident VAR guru. "Although some corporates have been able to use the RiskMetrics methodology because their treasury operations are almost indistinguishable from banks, a lot do not. The risk definitions that underlie VAR need to be extensively modified."

Longerstaey and most other risk management experts feel there is nothing in the market right now that fully addresses both methodology and risk definition concerns. However, some are on the horizon. Software vendors like Theoretics, Financial Engineering Associates (FEA) and even JP Morgan are busy revising their models to make them more useful and affordable to corporates treasuries. Many are already including Monte Carlo simulators to get around the limitations of variance/co-variance. The release of such corporate-friendly systems is just a matter of time. "The corporate market is an emerging market," says Mark Garman of FEA. And FEA, like other vendors, is working to make sure it is well positioned to benefit once that market evolves.

Interim solutions

In the meantime there are a few relatively affordable VAR calculators out there that can certainly help bridge the gap. Their costs run from $18,000 to $75,000. The low-end models require much system mapping and data preparation. Buying an integrated risk management may cut down on the data-preparation and mapping time. However, those are obviously more expensive and run at $100,000 and more. At the top end, flexible fully integrated systems with Monte Carlo simulation cost upward of $300,000. Those are outside the reach of most treasuries, particularly because many companies will only end up using their VAR calculators six to 12 times a year and not on a daily basis like banks.

"Buying the system is only part of the expense, however," cautions Peter Marshall, a senior associate at Emcor Risk Management Consulting in Irvington, New York. He believes one should not underestimate the amount of work it takes to get the information into a useful format. "The investment in terms of personnel and other corporate resources associated with calculating VAR in-house, even with the cheapest system, is considerable."

Longerstaey of JP Morgan points out, however, that this "intangible cost" is there whether you buy a $18,000 system or a $300,000 one. "It's true for a million-dollar application as well. You need to do the mapping, etc., no matter what you do." Thus, putting aside related costs such as integration, developing internal expertise, and system mapping and data formatting, here's what's currently available for corporate use:

1. Outlook from Financial Engineering Associates.

At the bottom end of the low end, Financial Engineering Associates' Outlook reigns supreme. Starting at $18,000, Outlook is a set of spreadsheet add-ons, templates and utilities that map cash flows and calculate VAR and VARDelta. The system supports both JP Morgan's RiskMetrics and CS First Boston's Prime Risk methodologies via the variance/co-variance paradigm. The current version, Outlook 1.3, works in the Windows Excel desktop environment, and hence is highly affordable for most companies. It covers FX, commodities, equities and interest rate instruments including futures and options. The spreadsheet setup makes Outlook a more "flexible system," says FEA's Garman. "Everyone who knows how to use Excel can use Outlook." That cuts down on valuable learning time.

In support of variance/co-variance's applicability to corporate treasury, Garman offers two thoughts. First, he says, he feels that when users compare the VAR results for variance/co-variance and Monte Carlo simulators, they'll find they are often indistinguishable. "There's been a lot of theoretical discussion, but most of this has been based on a single instrument and not a portfolio, and typically based on some unreasonable trading horizon," he explains. Second, Garman is quick to point out, FEA is planning to add in a Monte Carlo simulator in an upcoming version, while keeping the package at its current cost level.

2. TARgA from Theoretics.

A bit more upscale (and more flexible in its functionality) is TARgA from Theoretics, which incorporates what used to be Price Waterhouse's VAR package into an FX­interest rate product. TARgA is a two-piece system that, "although powerful as any dealer's system, is PC-based," says Scott Robinson, vice president at Theoretics.

TARgA comes in two pieces. The first is a front-end pricing software that can be purchased on its own for $25,000. It claims to be able to price any currency or I/R derivative from plain vanilla to the most exotic, using zero-coupon methodology for the latter, and including a Monte Carlo simulator. The second piece is the VAR calculator, and must be bought in conjunction with the first for a total of $50,000.

This portion pulls the trade from the front-end application, and runs it through a portfolio analysis system. "It gives you a VAR either using Monte Carlo or variance/co-variance," says Robinson. It also generates detailed management reports by counterparty, currency, trade type, etc. Plans for the next release in the middle of 1997 call for inclusion of the third VAR methodology: historical analysis.

Theoretics says it has adopted the corporate market as a target audience. It already has two areas of GMAC using TARgA and has recently signed on another corporate user.

3. JP Morgan's 4:15

JP Morgan's own internal risk management system spits out a system-wide risk number every afternoon at 4:15.

It has recently released a version of its in-house system for the annual license of $25,000 plus a $10,000 installation fee. JP Morgan clients can use 4:15 to come up with their VAR figure, although Longerstaey says nonclients will not be turned away. "We don't actively market it. But we would entertain positive feedback," says Longerstaey. Though 4:15 has been criticized as too banklike, adjustments such as delta-gamma option valuation and longer trading horizons are making the system more corporate-friendly than many others. JP Morgan's development plan is to move toward offering the full features of a top-of-the-line system in an affordable package. "Within a year," predicts Longerstaey, "we will offer 80 percent of that capability."

4. INSSINC's Orchestra.

Although at this point, Orchestra Version 5.0 covers interest rate instruments only, the New Jersey company does plan to combine its back office FUTRAK system with Orchestra and offer FX analytics as well. Orchestra is written in Visual Basic and relies on a Microsoft Access data base. The system comes on a single CD-ROM users can simply plug and play. Nissan Finance is already using Orchestra to track VAR on its swap positions. The current version sells from $25,000 to $75,000 annually, which includes all support and maintenance.

Bridging the gap

These four systems, above all, provide affordable albeit partial solutions to the overall VAR problem. But there are other routes companies can pursue while they await the rollout of more corporate-friendly models.

One is to use spreadsheet add-ins, such as @Risk from Palisade Corporation, to augment their variance/co-variance­based models with Monte Carlo simulation capabilities. "Spreadsheet add-ins performing Monte Carlo simulations may not provide the computational power, nor the underlying data management capabilities, to tackle the extensive financial exposure found within the operations of a nonfinancial company," says Joseph Neu, publisher of International Treasurer. "But in skilled hands they certainly can deliver excellent value in analyzing smaller-scale exposures in their financial portfolios."

Outsourcing the number-crunching is another option. It may make the most sense for companies that may not want to use the calculators more than a few times a year for reporting purposes. Some banks, like Goldman Sachs, JP Morgan and Bankers Trust, will do the number-crunching for their clients and nonclients-for a fee. The upside is that treasuries can get relatively cheap access to very high-end systems. The cost varies. BT, for example, charges about $50,000 per run for its RAROC system.

The downside, however, is that companies often get a black-box solution. There's no hand-holding in figuring out which data to include and how, or in understanding the significance of the resulting VAR figure.

Other consulting companies like Emcor offer number-crunching and consulting packages. Emcor, for example, will help clients come up the VAR learning curve, prepare the data, and then upload and download the information for number-crunching on its Sun-based system in Irvington. But managing director Bob Baldoni acknowledges that outsourcing may be an interim solution for clients awaiting the release of less expensive yet useful corporate models. "We are working with several vendors that are developing such applications," he says.

Corporate interest in VAR is growing, not merely because of the SEC's impending rule change. VAR can come in useful in a variety of ways and fits within the trend of greater treasury accountability.

A common criticism of bank models is that they rely on variance/co-variance models that assume a short time horizon. That's because they define volatility as standard deviation versus the mean-a mean set at zero, which does not hold true for long-term risks. Instead, suggests JP Morgan's Longerstaey, corporates have to estimate mean returns and calculate deviation from it. "It's an extra step, but it is not an impossibility," he says.

The other criticism has been that variance/co-variance calculations treat options as having constant delta. The result is that the VAR will tend to overstate or understate the risk associated with nonlinear instruments. Here, too, adjustments are being made. JP Morgan, for example, incorporates convexity of options via a delta-gamma methodology.

But while many have focused on the shortcomings of variance/co-variance, the real issue, according to Longerstaey and others, goes beyond a single methodology. "The biggest issue for corporates is how you define risk," says Longerstaey. "If you are not in the mark-to-market environment, but rather in an accrual environment looking at risk to cash flow, you are going to be looking at a totally different framework. Banks define risk as change in the market value of their positions. Corporates may be forced to do that down the road. But right now, they do not."

One of the persistent criticisms of so many derivatives strategies and models is that they have no historicity: They exist only in the hopeful present. For those who'd cast a backward glance, here is a useful tool for checking out wisdom or gut sense. Courtesy of Optionomics, makers of the Orion Risk Management System, which is networked inside a number of banks, the Options Trading Research Tool (OTR) will go back as far as nine years and appraise the profit and loss of various futures strategies.

Rob Hodson, vice president of marketing, sees OTR working as follows. "Say a fund manager sells strangles on the bond contract every 60 days before expiration and then gets out 10 days before expiration," he explains. "And say he hedged his position every Thursday. He's been doing this on a hunch, because he knows the market. Now he can validate his suspicions."

Other targeted users are hedgers and research departments. In addition to back-testing buy and sell strategies, it will test in-the-money and out-of-the-money strikes, seasonal strategies, bull and bear spreads and ratio spreads, dynamically hedged deltas and hedged delta on moving averages or day of the week. OTR has a Microsoft NT or Windows interface and sells for around $9,400 a unit. For more information contact Rob Hodson at (801) 466-2111.

The Coopers & Lybrand Multimedia Guide to Swaps, released last month, uses a single CD-ROM that offers the equivalent of nearly 6,000 written instructional pages. It was created and designed by Boris Antl, a former Chemical Bank FX expert who has developed the disk with some accounting and legal inputs from the accounting giant. It is the first of a series that will run the gamut of derivatives, including options and futures.

The disk comes in two versions: 1) a lower-end fundamentals version, covering an overview of swaps for the uninitiated, which will sell at $500 per copy; and 2) a more comprehensive format that runs over seven hours of instructional text and graphics, plus exercises and tests. The higher-end version also boasts a 300-page encyclopedia of terms and explanations of markets and jargon. This version is designed to be sold on a negotiated-price basis to large institutions, "as an economical way to train bank personnel. It is much cheaper than a classic training program," says a spokesman.

The strength of this guide is in the details. Even someone with an MBA and three to four years of general finance experience-say in credit or equity analysis-would be challenged to complete the comprehensive test in a single day and get all the answers correct. It covers fixed-to-fixed vanillas, fixed-to-fixed zeros, fixed-to-floating vanillas, amortizeds and forwards, and fixed-to-floating asset interest rate swaps. Another plus is that it straddles accounting and legal conventions in all three major swap markets: the U.S., the U.K. and Japan. For more information contact John R. Hardy, Intercap Investments, at (212) 751-7641.

The recurring issue of standards, and accurate and consistent software calculations, was addressed last month by the Securities Industry Association (SIA) and the Public Securities Association (PSA). These trade groups jointly offered a comprehensive software library for valuation and analysis of fixed income analytics. One benefit of the library is that it will lead to more consistency between trading and operating departments and between dealers and customers. Extensive testing proves that the library (with 900 analytic building blocks already written) will work on all types of hardware. A 30-day free trial can be obtained from TIPS, the developer, at (908) 522-8950.

Risk Insights, a new four CD-ROM educational package, is the most technologically and pedagogically sophisticated product in this nascent field. It is built around 350 different video clips of such eminences as Charles Smithson (CIBC), Rajiv Nanda (AIG) and James Lam (Fidelity), as well as members of a 15-person "faculty" that includes faces from the finance departments of FMC and Outboard Marine, offering an elegant tour of the stations of risk management. If the clips were strung end to end they'd run about four hours, but with questions, menus and explications (some animated), the process runs six to eight hours.

The creature of a new Chicago-based venture called Learning Insights, Risk Insights covers its topic at a level of generalization suitable to a novice or a typical CEO or CFO, or to nondealer segments of any large bank that wants to make risk management an integral part of its corporate culture.

The product is structured in conformity with theories developed by Roger Schank, head of Northwestern University's Institute for Learning Sciences. Schank is a well-publicized educational gadfly-guru who derides conventional school learning and seminars. People absorb maximum information interactively, he believes, that is to say in a conversational setting where interruptions are possible and where it is possible to explore and seek elaboration. Only in such a setting, says Schank, do people get passionate about knowledge, and without passion instruction is wasted.

With Risk Insights the user clicks on a menu of preset questions and the experts respond in short cameo appearances. The answer then leads to another menu, where the choice of questions leads to a different guru fielding the question or presenting a case study. And so on to the next. These videos suffer a bit from repetitive camera angles, but have good lighting and sound. Like a conversation, the structure is nonlinear. Each user wanders around and sets his or her path through the material by chasing down the questions they want answered. The behind-the-scenes structure covers identifying risk, measuring it, figuring strategies for it, risk management tools, execution and monitoring.

Much of this mapping was done by Kenneth Cunningham, former derivatives head at the Continental Bank. The price is $1,000 for one to five licenses, and less than $500 per copy for orders of a 100 or more. The creators of Risk Insights are hoping for big orders from big financial institutions. They recognize, too, that most offices don't have PCs with 4x CD-ROM and 8-bit Sound Blaster or a comparable 16-bit sound card with speakers. Says a company spokesman, "We've priced it in the hope that people will take it home from work and make copies and learn about risk management in their spare time." Contact Wesley P. Pascavis of Learning Insights at (312) 496-4107 or wpascavis@learninginsights.com for more information.

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