Volume 3 — Valuation and Risk Metrics © Copyright 2002, CCRO. All rights reserved. 32 IV RISK CAPITAL Risk capital is the capital required to meet the demand for managing market, credit, and operational risks. We include here an overview of some of the issues that the Committee will address more thoroughly in a future publication on capital adequacy. In the case of trading and marketing activity, determining a performance measure such as return on capital invested can be done in several ways. The simplest approach is to focus on the market risk that the trading and marketing activity is subject to and use the value at risk estimate (using a suitable degree of confidence and a suitable holding period) as a proxy for the capital that is needed for the trading and marketing activity to be viable. Under such an approach, the VaR is treated as the basis for the risk capital, and the MTM-based revenue stream (typically before taxes) is treated as the earnings from the trading business. Alternatively, a more systematic assessment of the capital employed in the trading and marketing business accounts for three demands on capital. The first, the “market risk” capital, is designed to ensure that the business has sufficient capital to withstand adverse shocks to the value of its portfolio due to changes in the market prices of underlying commodities. Market risk capital is also treated as the liquidation level of capital that is needed to be in the business in order to permit an orderly unwinding of the portfolio in the event it is decided to shut down the trading and marketing business. The second component of capital for trading and marketing activity is the “credit risk” capital. This component of capital is needed to ensure that the trading and marketing activity can withstand losses to the portfolio of its positions due to its counterparties failing to perform under contractual terms and/or seeking bankruptcy protection. The final component of capital is the “operational risk” capital. This is the level of equity that is needed to support trading and marketing activity in case of losses that may arise because of failures in processes and controls, errors of commission, failures of systems and operating equipment, business interruptions, and the like. The market risk and credit risk capital components typically use VaR-based methodologies coupled with counterparty default probabilities to arrive at the levels of capital needed to support a given trading and marketing business. The operational risk capital can be as simple as a percentage of the gross operating revenue or as sophisticated as a quantitative estimate of equity needed to withstand losses due to operational risks, using statistical techniques, operating loss frequencies, and loss-severity tables. The CCRO will work to develop a detailed methodology in the future.