June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 62 of 92 6. MARKET RISK 6.1. Introduction The focus of this chapter will be in establishing a framework from which energy companies can assess their ‘Equity-at-Risk’ due to market risk factors. As with the Operative and Credit risk frameworks for assessing risk capital requirements, the Market Risk Capital Requirement should be focused on unexpected losses due to market risk factors (i.e. those events that erode equity). In so doing, it is essential to view these potential equity eroding events in terms of earnings. If earnings are positive, then equity, through retained earnings, grows even if earnings are short of expected targets. From a capital adequacy perspective, the concern comes when earnings are negative, as that is when the equity of a company is reduced and their ability to fund working and risk capital requirements is degraded. Therefore, the framework for determining Market Risk Capital Requirements will be built upon potential earnings and what impact they will have on the equity of a company. 6.2. Definition of Market Risks It is important to define what risks are being assessed to determine the market risk capital requirement. Market risks ‘refers to the uncertainty of future financial results that arises from market rate changes.’28 Market risk is broadly defined as the potential loss in value over a defined time period from adverse movements of market price variables such as: • Commodity Prices • Interest Rates • Foreign Exchange Rates • Inflation Rates • Equity Rates (For Investing Activity) 28 CorporateMetrics, The Benchmark for Corporate Risk Metrics. Technical Document. Risk Metrics Group. 1999. Pg 5