Opening the Vault to Risk Disclosures Data

During the credit crisis, financial institutions have supplied important disclosures about their value-at-risk numbers. But has this data painted an accurate picture, and what metrics can we use to gain a better understanding of these risks? Aaron Brown analyzes recent VaR numbers reported by major Wall Street firms and explains how metrics (such as a risk price to earnings ratio) can be employed to shed more light on risk disclosures.

Monday, February 02, 2009 , By Aaron Brown

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As a professional risk manager, I feel that equity analysts pay inadequate attention to the risk information in financial statements. An earnings per share (EPS) surprise of a few cents can make a stock price jump, and equity analysis reports are filled with ratios and projections about future revenues, costs, cash flow and other accounting numbers. But who notices whether value-at-risk (VaR) went up or down? Who counts the VaR breaks -- i.e., the days when trading losses were greater than the VaR amount?

VaR has received insufficient attention paid partly because risk disclosures are buried in the notes. That's not the whole story, however, because analysts have learned to delve into the fine print for details about option plans, leases, reserve changes, etc. I think analysts also are deterred because the presentation of risk information is technical. Unless you're in the business, you probably don't have time to learn what you need to translate the financial note into a sophisticated understanding of the firm's risk strategy.

In an effort to address this problem, I propose two simple risk metrics that anyone can understand: a risk price to earnings (RPE) ratio and risk beta. Like other financial statement analysis metrics, such as price/earnings (PE) ratio or debt/equity (DE) ratio, these are indicators, not conclusive determinants. Not every low PE ratio stock is a good buy, and there are highly levered firms with low stated DEs.

The risk metrics I propose do not always point to the correct picture of risk. But most of the time, these ratios give you some good general information and help you ask questions. They let you do quick comparisons of many firms, even firms in different businesses.

I'm going to concentrate on VaR, because it underlies most risk reporting at financial firms (see "Flabby VaR" sidebar, pg. 14). The blue line in Figure 1 (above, right) shows the average one-day 95% VaRs reported by Goldman Sachs over the last eight years. I computed the red line, which I call "market-implied VaR."

I used the implied volatility of short term, deep out-of-the-money puts on Goldman Sachs stock to estimate the amount the market thought the firm's value could decline in one day, 5% of the time. I hereby name the ratio between market-implied VaR and reported VaR the risk price to earnings (RPE) ratio. For Goldman, it ranged from a low of 14 to a high of 48 over the eight-year period.

The numerator of the RPE ratio, market-implied VaR, is measured in terms of market capitalization, while the denominator, reporting VaR, is measured in terms of P&L or earnings. Therefore, the RPE ratio is a form of a PE ratio.

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