Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 15 4.2 Measurement of Market Risk To determine the impact of price changes on physical and financial performance, the components of the asset/business that change with price movements are modeled through an exposure map4. To quantify market risk, processes for determining these price movements are formulated and applied to the exposure map to produce a probability distribution of financial performance. Financial performance may be measured using metrics that include but are not limited to EBIT, EBITDA, Cash Flow from Operations, Net Income, and the like. An example of a distribution of potential financial performance is presented in Figure 8. Figure 8: Example of a Probability Distribution of Financial Performance Market risk is measured by taking the difference between the expected value of the performance measure and the value of the measure at a certain confidence level on the distribution. The benefits of using a probability distribution include identifying the expected value and measuring the dispersion and skew around the expected value. The timeframe over which the value change is measured is a business decision. To the extent that the financial performance distribution is specific to a single financial reporting period, e.g., one year, then this dispersion, or market risk, is a proxy for an “earnings-at-risk” type of measure. Alternatively, to determine the market risk under the economic capital framework, this distribution could contain the financial performance of the asset/business over its economic life, not just for one distinct financial reporting period. Under such an approach, distributions for the net present value (NPV) of the asset/business over the entire economic life are developed. Economic capital for market risk can then be measured as the distance between the mean and the appropriate confidence level on the NPV distribution. 4 Long asset positions benefit from price increases, and short asset positions benefit from price decreases. Assets have optimized attributes and may or may not be economically exercised. Market Risk Net Operating Profit Less Adjusted Taxes (NOPLAT) Solvency Standard Expected Net Operating Profit Less Adjusted Taxes (NOPLAT)