June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 65 of 92 • Addresses Mean Reversion Implied Volatilities • Forward Looking • The Market’s assessment of what volatilities are (Consensus view) • Must have quoted forward traded options in order to calculate volatilities The purpose here is not to go into detailed discussion on volatility and correlation calculations, but to highlight where they fit into the earnings determination process. These elements will be instrumental during Scenario Generation discussed later in this chapter as they will be the fundamental building blocks in determining the distribution of earnings around an expected value. (For further information on calculating volatilities and correlations using these methods, see ‘Options, Futures, and Other Derivatives’ by John C. Hull). 6.4.3. Define How Market Risks Relate to Earnings In relating market risk factors to the earnings components it is important to establish both what is related and how it is related. Establishing What is Related It is essential to view earnings as a portfolio of instruments whose value changes with changes in market rates.29 Let us take an energy merchant for example who has operations in the US and Canada and has a natural gas fired generation fleet. Table 6.2 outlines the typical earnings components along with the market risk factors that affect those components. Table 6.2 Market Risk Factor Mapping Earnings Component Market Risk Factors Power Sales (Forward, Spot) Commodity Price, Foreign Exchange Rate Gas Purchases (Forward, Spot) Commodity Price, Foreign Exchange Rate Derivative Hedging Instruments Commodity Price, Foreign Exchange, Interest Rate Interest Expense Interest Rate Accounts Receivable / Payable Foreign Exchange Minority Interests Equity Prices, Foreign Exchange Operating Expenses Foreign Exchange This established link between the earnings components and market risk factors will be what drives the Scenario Generation. 29 CorporateMetrics, The Benchmark for Corporate Risk Metrics. Technical Document. Risk Metrics Group. 1999. Pg 41