Monte Carlo Simulations and Corporate Risk Management in Germany

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Courtesy of Oracle Crystal Ball GBU

Introduction

Against a background of dynamic markets and a changing business environment, companies everywhere face the challenge of taking strategic decisions on the basis of imperfect information. In the long run, no company can afford to bear more risk than its equity base can cushion. Therefore, market participants must plan strategically while keeping an eye on uncertain future developments that bring opportunities and risks for their companies. Risk management should thus be high on the corporate agenda.

German corporations in particular face important and urgent risk management issues. On the one hand, market price risks are a very important issue:

  • Many market prices for those commodities widely needed by German corporations have become both higher and more volatile in the course of 2005. As an example, in the last few years the price of platinum has more than doubled. This is of serious concern to, among others, makers of auto catalysts.
  • The dollar/euro exchange rate, the main foreign exchange rate for most German companies, has oscillated between 1.17 and 1.35 during the year a range of more than 15%. Monthly moves of 2% or more were not exceptional (see graph on next page).
  • In the energy sector, the business environment has become so much more dynamic that corporations in this sector nowadays have to manage complex portfolios of oil, gas, CO2 certificates and electricity.

However, it were not just market price risks that kept German managers awake at night in 2005:

  • An electricity shortage in December 2005 cut several companies off the power grid for a prolonged period.
  • The German trade union IG Metall forced chip maker Infineon to accept an expensive redundancy package for its employees in a factory in Munich after a oneweek strike.1
  • German companies as a whole are faced with a “retreat” of socalled soft facts in the assessment of corporate credit risk by banks under the new Basel II regulations. More than ever before, “hard” financial figures and reliable cash flow and profit forecasts will be the prime determinants whether a company will get credit from German banks.

The task of risk management is to identify, analyze and quantify risks as well as showing their impact on the cost of capital and thus the value of the company. However, while lots of impressively titled books and glossy covered
presentations describe the concepts of risk management, corporations (especially midcaps) have few “how to’s” to resort to when it comes to aggregating and simulating risks in such a concrete and reliable way that strategic decisions can be based on the results of the analysis.

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