June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 64 of 92 • Equity Rates (For Investing Activity) It is important that all factors are included in the analysis, and depending on the business type, different factors will be more important than others. Significance will play a key role in the determination and that significance will be based on the exposure to the particular market risk factor. 6.4.2. Determine Market Risk Factor Volatilities and Correlations Volatility can be defined as the measure of uncertainty of the future value of the market rate and can be expressed as the standard deviation of the returns of the instrument over a set time period. Correlation is a measure of the relationship between two or more variables and can be expressed as the degree of co-movement in the returns of market rates. When determining volatilities and correlations of market rates, there are 4 basic approaches 1. Straight Historical 2. Exponentially Weighted Moving Average (EWMA) 3. GARCH (1,1) 4. Implied Volatilities Each method has its strengths and weaknesses which are outlined in Table 6.1. Table 6.1 Strengths and Weaknesses of Volatility Measures Strengths Weaknesses Straight Historical • Simple to Implement • Easy to Understand • Backward Looking • Does not address relevance of data observations • Does not address Mean Reversion EWMA • Simple to Implement • Easy to Understand • Addresses Relevance of data observations • Backward Looking • Does not address Mean Reversion GARCH (1,1) • Addresses Relevance of data observations • Backward Looking • Added Complexity