SEC FRR No. 48 and analyst forecast accuracy

ABSTRACT

SEC FRR No. 48 requires that all firms report their market risk exposures by choosing among three alternative formats: sensitivity analysis, tabular and value at risk (VaR). In this article, we examine how different methods affect analyst forecast accuracy. By regressing analyst forecast errors on a company’s choice of disclosure method, we find that analyst forecast errors are smaller for firms using VaR and tabular than for firms using sensitivity analysis. Our findings suggest that VaR and tabular approaches are more informative than sensitivity analysis.

KEYWORDS:

• FRR No. 48
• value at risk
• forecast accuracy
• market risk disclosures

JEL CLASSIFICATION:

• G24
• M48

Disclosure statement

No potential conflict of interest was reported by the authors.

Exhibit 1 Sensitivity example: Kohl’s Corporation

(Source: Khol’s Corporation 10-K filing for the fiscal year ended 29 January 2005)

The Company’s primary exposure to market risk consists of changes in interest rates or borrowings. At 29 January 2005, the Company’s long-term debt, excluding capital leases, was $996.6 million, all of which is fixed rate debt.

Long-term fixed rate debt is utilized as a primary source of capital. When these debt instruments mature, the Company may refinance such debt at then existing market interest rates, which may be more or less than interest rates on the maturing debt. If interest rates on the existing fixed rate debt outstanding at 29 January 2005 and 31 January 2004 changed by 100 basis points, the Company’s annual interest expense would change by $10.0 million and $10.1 million, respectively.

During fiscal 2004, average borrowings under the Company’s variable rate revolving credit facilities and its short-term financing of its proprietary accounts receivable were $76.1 million. If interest rates on the average fiscal 2004 and fiscal 2003 variable rate debt changed by 100 basis points, the Company’s annual interest expense would change by $761,000 and $797,000, respectively, assuming comparable borrowing levels.

During fiscal 2004 and fiscal 2003, the Company did not enter into any derivative financial instruments.

Exhibit 2 Tabular example of interest rate risk: Scana Corporation

(Source: The Scana Corporation 10-K filing for the fiscal year ended 31 December 2004)

All financial instruments held by the Company described below are held for purposes other than trading.

Interest rate risk – The tables below provide information about long-term debt issued by the Company and other financial instruments that are sensitive to changes in interest rates. For debt obligations the tables present principal cash flows and related weighted average interest rates by expected maturity dates. For interest rate swaps, the figures shown reflect notional amounts and related maturities. Fair values for debt and swaps represent quoted market prices.

Table

While a decrease in interest rates would increase the fair value of debt, it is unlikely that events which would result in a realized loss will occur.

The above table excludes approximately $94 million and $65 million in long-term debt as of 31 December 2004 and 2003, respectively, which amounts do not have a stated interest rate associated with them.

Exhibit 3 Value at risk example: Walt Disney

(Source: The Walt Disney 10-K filing for the fiscal year ended 30 September 2004)

The Company utilizes a VAR model to estimate the maximum potential one-day loss in the fair value of its interest rate, foreign exchange and market sensitive equity financial instruments. The VAR model estimates were made assuming normal market conditions and a 95% confidence level. Various modelling techniques can be used in a VAR computation. The Company’s computations are based on the interrelationships between movements in various interest rates, currencies and equity prices (a variance/co-variance technique). These interrelationships were determined by observing interest rate, foreign currency and equity market changes over the preceding quarter for the calculation of VAR amounts at 30 September 2004. The model includes all of the Company’s debt as well as all interest rate and foreign exchange derivative contracts and market sensitive equity investments. The values of foreign exchange options do not change on a one-to-one basis with the underlying currencies, as exchange rates vary. Therefore, the hedge coverage assumed to be obtained from each option has been adjusted to reflect its respective sensitivity to changes in currency values. Forecasted transactions, firm commitments and receivables and accounts payable denominated in foreign currencies, which certain of these instruments are intended to hedge, were excluded from the model.

The VAR model is a risk analysis tool and does not purport to represent actual losses in fair value that will be incurred by the Company, nor does it consider the potential effect of favourable changes in market factors.

VAR on a combined basis decreased from $51 million at 30 September 2003 to $31 million at 30 September 2004. The majority of the decrease is due to increased correlation benefits and lower market value of interest rate sensitive instruments.

The estimated maximum potential one-day loss in fair value, calculated using the VAR model, is as follows (unaudited, in millions):

Table

The VAR for Euro Disney and Hong Kong Disneyland is immaterial as of 30 September 2004. In calculating the VAR it was determined that credit risks are the primary driver for changes in the value of Euro Disney’s debt rather than interest rate risks. Accordingly, we have excluded Euro Disney’s borrowings from the VAR calculation.