June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 24 of 92 among the risk types, or perhaps a negative correlation depending upon where the exposures to a company reside. To demonstrate how to use MPT in building the lower boundary, let us assume that a zero correlation is appropriate for the risks in question. Assuming the lower bound to be at the zero correlation among risk buckets is predicated upon the notion that these risk buckets are at least somewhat positively correlated. It does stand to reason that as the market risk posture increases, so too does the credit risk posture and operative risk posture. For example, as is common during a hot summer day, as power prices increase and the corresponding volatility increases, the market risk for those participating in this environment may also increase. In addition, this situation results in increased power demand, which puts strain on generating plants, power lines, etc. which may increase the probability for an operational failure. As this situation unfolds, companies who must purchase power in this environment are now at risk of not having sufficient liquidity to purchase that power, thereby increasing the credit risk posture of those exposed to these counterparties. __________________________________ Risk Capital =√[(Market)2 + (Credit)2 + (Operative)2 ______________________________________ = √($200 MM)2 + ($100 MM)2 + ($50 MM)2 = $229 MM Compare this value to the simple sum ($200 + $100 + $50 = $350 MM), and one can see that the band of potential outcomes spans $121 MM ($350 - $229), a significant difference by any measure. The $121 MM is considered a diversification effect due to the assumption of zero correlation between the risks. Therefore, the risk capital table at the zero correlation level would look like the following: Operative Risk Capital $50 MM Credit Risk Capital $100 MM Market Risk Capital $200 MM Diversification Effect ($121 MM) Total Risk Capital $229MM The reality is that the Risk Capital requirement will fall somewhere between the upper $350 MM and lower $229 MM bounds and determining exactly where can be very difficult as it requires one to determine very specific correlations between each risk categories. Broad assumptions can be made regarding the correlations however, the amount of historical data to support such correlations is quite limited.5 Nonetheless, 5 Energy Modeling. Capital Adequacy for Companies Transacting in US Electric Power Markets. Laura L. Brooks. Risk Books. 2005. pgs. 372-373.