On pages 330 & 331 of James Lam's ERM, it shows 3 methods of calculating earnings at risk. Just need help with understanding the simulation method abit more. For example, consider its use in assessing the suitability of risk appetite/ tolerance metrics with regards to earnings volatility. Give that I have forecast P&L can someone please walk through, practically, how i would determine the tolerance for my earnings at risk? Is the forecast also balance sheet also involved within this analysis or can i ignore for the time being when considering earnings to risk calculations?
EaR is a bit like VaR but applied to earnings. So, we may have a VaR limit that states "we are not prepared to lose more than X in one year with 95% probability". A similar EaR statement might be "we are not prepared for our earnings to fall by more than X in one year with 95% probability". X might be determined by discussions with investors ("we don't want earnings to fall by more than ...., so that dividend is maintained at ....") or credit ratings agencies ("in order to maintain AA ratings, your earnings must not fall below..."). While this is a P&L forecast, there is a knock-on effect on retained earnings in the B/S and EaR may be used to help determine capital requirements.
Thanks for your response. So just to confirm: For the purpose of testing the reasonbleness of certain tolerance metrics that affect the P&L, with regards to its impact on earnings at risk (as per investor's requirements) i would need to simulate the variable(s) in question and assess its impact on the bugetted results relative to the appetite specified by investors?
Yes, you could simulate the P&L (run 5,000 random scenarios and consider the 5% worst cases for example) or if you had an idea of the historic/forecast earnings volatility you could do it deterministically (eg assuming earnings follow a normal distribution)
