June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 84 of 92 around each time period specifically how the equity component changes each period based upon the risks the organization faces and the impact these risks have on the company’s functions. Using agent-based modeling allows for the tracking of equity as economic and business conditions dictate and the firm reacts to these changes. Modeling these path dependencies in an agent based framework provides insights on how equity and liquidity requirements evolve over time. The first step is to calculate the equity for each time period in the simulation as follows: Equity (t) = Equity (t-1) + Net Income (t) – Dividends (t) – Changes in Debt (t) This equation assumes that unrealized MtM gains32 and losses are included within net income. To the extent that these unrealized gains and losses are not included, the equation would be revised to the following: Equity (t) = Equity (t-1) + Net Income (t) + Change in MtM (t) – Dividends (t) – Changes in Debt (t) As Section 2.3.2 details, a company will need a “cushion” of equity for a source of capital in order to continue operations should the risk events become realized. This “cushion” amount is based on what a company feels comfortable with in relation to these risk events becoming realized. Therefore, Available Equity (t) = Equity (t) – Cushion (t) The changes in this available equity each time period will be the focus of the simulation model. 10.2.6. Current EMTCo Operations The company’s operations are simulated over the 5 year period and the resulting available equity is calculated at each iteration. In this example, the cushion is assumed to be $74MM therefore, Available Equity (t) = Equity (t) - $74MM To the extent that the firm’s available equity becomes negative for a given period, the most negative value for that scenario is then determined. This most negative value will become the terminal equity value for that scenario since we assume the firm is insolvent at that period and cannot benefit from any future economic conditions. 32 The model’s approach to equity is to use an Economic Equity measure that captures the fair market value of the company’s assets and liabilities.