Volume 3 — Valuation and Risk Metrics © Copyright 2002, CCRO. All rights reserved. 18 4.0 VaR-Type Metrics 4.1 Discussion of Metrics and Applicability There are several risk metrics that measure variability in specific financial variables such as earnings, operating margins, cash flow, and others. These metrics are referred to here as “VaR- type metrics,” including earnings at risk and cash flow at risk. Whereas VaR essentially measures the potential deterioration of a portfolio’s MTM value, VaR-type calculations measure potential deterioration in value as reflected in other financial variables. VaR is calculated as the difference between the expected MTM and a low percentile in the distribution from which the expectation is calculated (for example, the expected value minus the fifth percentile in the distribution is often used). The distribution from which the expectation and the percentiles are calculated can be developed using any of the three methodologies mentioned in the previous section. VaR-type metrics such as Earnings at Risk (EaR) and Cash Flow at Risk (CFaR) are defined similarly to VaR. The main difference is that earnings or cash flow may be calculated differently than MTM (or value). Once the earnings or cash flow is defined, a distribution is created and the expected earnings or cash flow is calculated as well as the low-percentile value of earnings and cash flow. Market factors affect earnings volatility, which can affect stock prices and shareholder value. Managing the earnings volatility enables companies to better manage their stock prices and shareholder value. In considering the applicability of VaR-type metrics to asset activity, one must consider certain important features of asset activity that distinguish it from pure trading activity: • The economic life of an asset is much longer. Therefore, appropriate consideration must be given to both the short-term and long-term nature of the relevant markets. • The size and level of positions that are typically associated with an asset may be several times larger than what is typical for trading activity. This affects the choice of holding period, which should reflect the amount of time necessary to put in place appropriate hedges that minimize risk around the future revenue stream from the asset. • Unlike simple derivative contracts that are typically associated with trading activity, physical assets invariably have operating constraints as well as contractual constraints, which can substantially affect value and risk. For example, the value of a power generating plant is affected by uncertainty both in demand (primarily driven by weather) and supply (driven by the operating characteristics and price of input fuels for the plant, as well as for all other units constituting the supply fleet). • Commodities produced by assets are of different qualities or grades (i.e., an asset is like a multi-commodity supply unit). • Physical assets have overhead and financial cost structures associated with them. • There are other external constraints that affect the value and risks of asset-based activity, such as the regulatory environment with regard to emission controls, price caps, etc.