June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 25 of 92 this does provide the risk manager with valuable knowledge as to what capital structure to maintain in light of the risks that the company faces. Another approach to risk aggregation is Combined Simulation Approach, where risk factors common to Market, Credit, and Operative risks are simulated via a Monte Carlo or similar type technique, and the impact to earnings and equity can be assessed simultaneously across the risk categories. This method can be difficult and require some broad assumptions however the process of achieving this technique can be as insightful as the result itself. Figure 3.5 displays in general how the combined simulation of market and credit risks can be approached. Figure 3.5: Joint Market / Credit Risk Simulation To the extent that Operative risk factors can be mapped to market risk factors such as commodity prices, foreign exchange rates, or other market risk factors, then the Operative risk assessment can be included in the joint simulation as well. When aggregating risks, one can gain significant perspective from determining and upper and lower bound, using the Simple Sum and MPT methodologies respectively, and then running a Combined Simulation to assess where within the upper and lower bound the simulated result resides. In this exercise the process can be as informative as the result itself. 3.2.2. The “Cushion” Commodity Foreign Exchange Interest Rate Equity Rates MARKET RISK COMPONENTS EaR or CFaR Potential Credit Loss EaR or CFaR w/ Credit Component Effect on EaR / CFaR Components Effect on MTM of Credit Exposure 0.000 0.050 0.100 0.150 0.200 0.250 0.300 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 -11 Loss f r om Cr edit Def ault s ( $M M ) 0 0.005 0.01 0.015 0.02 0.025 0.03 $0 $9 $18 $27 $36 $45 $54 $63 $72 $81 $90 $99$108$117$126$135