June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 11 of 92 5.4. Bond Based Approach 50 5.5. Equity Based Approach 53 5.6. Default Rate Volatilities and Correlations 56 5.7. Recovery Rate and Recovery Rate Volatility 57 5.8. Rating Migration 57 5.9. Econometric Factors 58 5.10. Current and Potential Future Exposures 59 6. Market Risk ......................................................................................................................................... 62 6.1. Introduction 62 6.2. Definition of Market Risks 62 6.3. Elements of the Framework 63 6.4. Exposure Mapping 63 6.4.1. Identify all Market Risks 63 6.4.2. Determine Market Risk Factor Volatilities and Correlations 64 6.4.3. Define How Market Risks Relate to Earnings 65 6.5. Scenario Generation 66 7. Business Risk, Stress Testing, and the Risk Capital Determination ................................................... 68 7.1. Introduction 68 7.2. Conclusion 70 8. Liquidity Adequacy ............................................................................................................................. 71 8.1. Introduction 71 8.2. Elements of the Framework 72 8.3. Stress Testing, Trigger Events, and Other Contingencies 75 8.4. Loss or Reduction of Threshold 75 8.5. Adequate Assurance 75 8.6. Debt / Equity Trigger 76 8.7. Credit / Counterparty Terminations / Defaults 76 8.8. Operative Risk 77 8.9. Conclusion 77 9. Conclusion........................................................................................................................................... 78 10. Appendix A: Practical Application ..................................................................................................... 79 10.1. Utilizing Capital Adequacy Modeling as a Key Management Tool 79 10.2. Application of Capital Adequacy Concepts 80 10.2.1. Overview 80 10.2.2. Modeling Approach 81 10.2.3. Agent Based Modeling Technique 81 10.2.4. EMTCo Parameters for Agent Based Modeling 82 10.2.5. Equity at Risk Methodology 83 10.2.6. Current EMTCo Operations 84 10.2.7. EMTCo New Marketing Opportunities 85 10.2.8. Decomposing EMTCo’s Portfolio 87 10.2.9. Impact of New Marketing Activities on Hedging Strategy 89 10.2.10. Conclusion 90