Contents - AL-Tax

11.4 Analysis Under Alternative Regime 159A more readily available proxy for capital employed (and certain types of risksassumed thereby) may serve the same purpose. Commodities trading firms measureand monitor their market risk continuously. 14 They also invest significant resourcesin the development and refinement of risk models and stress testing. 15 Value atrisk (VaR) is one common means of measuring market risk. It entails quantifyingpotential losses resulting from adverse price movements of a given percentage overa specified time horizon. Trading firms generally calculate VaR on a position-bypositionbasis and aggregate these individual measures into an overall risk position.VaR measures jointly capture the amount of capital invested in a given positionand the degree of price risk associated with the position: The larger the investmentand/or the greater the risk (as calibrated by the assumed percentage price change),the higher the VaR, all other things equal. As such, individual group members withlarger VaRs will have a higher cost of capital.VaRs could serve as a proxy for the relative amount of, and risk to, capitalemployed by individual group members, for purposes of allocating after-tax freecash flows among them. Ideally, one would average VaRs over days, rather thanweeks or months, given the fluidity of trading firms’ positions. Such an analysispresupposes that individual group members own limited intangible assets. However,even where this is not the case (e.g., where one group member is the counterparty toan offtake arrangement with discounted pricing), allocations of intangible incomeare more readily handled separately, prior to a VaR-based allocation of the remainingtrading income. (Stated differently, the income allocated to individual group membersas a result of their ownership of intangible assets should be removed from thepool of after-tax free cash flows to be allocated based on average VaRs.) For thispurpose, intangible assets do not need to be valued explicitly. Instead, one needonly estimate the amount of income generated by each such asset during the periodat issue, a much more manageable task. Given the one- or two-step allocation ofcombined after-tax free cash flows based on (a) income generated by intangibleassets and/or (b) average VaRs, it remains to convert such flows into before-tax netincome (see Chapters 4 and 9 for discussions of this issue).It should be noted that VaRs measure market risk, not credit or counterparty risk.However, as the latter risks become more pronounced, trading firms’ measures ofrisk will be refined accordingly. As such, the more general point to be made is thatcapital as is necessary to maintain a staff and premises. The latter members are effectively servicesproviders and should retain only enough free cash flows to compensate the providers of workingcapital in limited quantities. All other free cash flows should accrue to the group member thatfinances transactions, inasmuch as it must pay its shareholders and lenders for the use of theirfunds on a much larger scale.14 For the results of a survey of 17 commodities trading firms’ risk management procedures andpractices, see Commodity Firms Regulatory Capital Working Group, “An Alternative Approach tothe Application of the full CRD to Commodity Firms Active in the EU,” 2006, Appendix 3.15 Stress testing entails assuming dire financial market conditions and determining whether thefirm could withstand these conditions.