Value at Risk as a Diagnostic Tool for Corporates: The Airline Industry

In recent years the Value at Risk (VaR) concept for measuring downside risk has been widely studied. VaR basically is a summary statistic that quantifies the exposure of an asset or portfolio to market risk, or the risk that a position declines in value with adverse market price changes. Three parties have been particularly interested: financial institutions, regulators and corporates. In this paper, we focus on VaR use for corporates. This field is relatively unexplored. We show how VaR can be helpful to study market value risk -- proxied by share price risk. We develop a methodology to decompose the overall VaR into components that are attributable to underlying external risk factors and a residual idiosyncratic component. Apart from developing theoretical results, we study the airline industry to show what practical results our 'Component VaR framework' can yield. Like any multinational company, an airline faces significant exposures to external risk factors, e.g. commodity prices, interest rates and exchange rates. In our opinion, Component VaR analysis can enrich discussions in the company on financial risk management and shareholder value.