June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 77 of 92 and the counterparty ends up defaulting. This position was completely hedged with another counterparty over the life of contract, and the hedge was out-of-the-money (negative MTM). In this situation, the company would have to replace the contracts of the defaulting counterparty at a loss and seek recovery from that counterparty through bankruptcy or arbitration. If a company chooses not to replace contracts, it increases market risk. Regardless of the decision to replace contracts, a company is still expected to perform on the hedge contracts of the unaffected counterparty. Consequently, the company becomes exposed to additional and unexpected demand for cash for the difference between the hedge price and replacement price of contracts or market value of contracts. Modeling the impact on liquidity as a result of credit defaults can be very complex. Most companies use a portfolio approach and do not always tie a hedge to a specific transaction. For this reason and others, it is difficult to assess the probability of liquidity demands. Given the complexity, it may be difficult to map exposures in CFAR calculation that relate to liquidity demands as a result of credit defaults. Companies can use an expected and maximum scenario in modeling liquidity demands due to credit defaults and disclose assumptions. The contingent liquidity exposure would be additive to the exposure calculated under CFaR. 8.8. Operative Risk Operative risk may cause a cash flow loss due to an event not modeled under market or credit risk. This could be a key system failure, plant loss, etc. As with liquidity risk for credit defaults, modeling the effect of operational/operations risk on liquidity risk is difficult. Companies can use an expected and maximum scenario in modeling liquidity demands due to operational/operations risk and disclose assumptions. The contingent liquidity exposure would be additive to the exposure calculated under CFaR. 8.9. Conclusion In the discussion of liquidity/financing risks, we outlined the basic components of a framework for assessing liquidity adequacy. This framework can be used to promote and support stakeholder confidence and decision-making in performance management, as well as to increase transparency into the financial health of an organization. Depending on the size and complexity of the organization, different models or methodologies to assess risk factors in measuring liquidity adequacy can be used. The framework supports simple or more robust approaches.