Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 23 income statement.10 Therefore, the focus is on quantifying the behavior of the futures or forward price markets over a short period of time. For most trading activity, market risk is measured using one-day Value-at-Risk (VaR). To quantify the market risk economic capital for these trading activities, an analytical solution may be applied to the daily VaR measure to extend the time horizon to more fully reflect the liquidation period of the trading portfolio. This liquidation period forms the basis for quantifying market risk economic capital. For example, to roughly approximate market risk economic capital for a trading portfolio with a one-year holding period, the 95% daily VaR is adjusted by the square root of time (252 trading days in one year) and any chosen confidence level, as follows: • Assume one-day 95% VaR is $10MM. • Assume chosen target confidence level is 99%, which is equivalent to 2.33 standard deviations. • The 95% confidence level used to compute VaR is equivalent to 1.65 standard deviations. • Thus, the market risk economic capital is estimated at $224MM and is obtained as: ($10MM/1.65) * 2.33 * 252 = $224MM. The square root of time adjustment loses reliability as the chosen time horizon or holding period is extended. For portfolios that are dynamic or that contain commodities whose price volatility has a term structure, extending the holding period beyond a month by the square root time multiplier is not advisable. Different VaRs can be used in the above calculation. Companies may use an average daily VaR calculated over a predefined period or decide to simply use the VaR limit that is in place for the trading unit, notwithstanding the actual daily VaR used by the group. To the extent a daily VaR is used for market risk economic capital, companies should endeavor to disclose which daily VaR is actually used in the calculation. The holding period that is used for the VaR calculation can be determined in two different ways depending on how the VaR calculation itself is to be used or understood. One way to determine it is to think of it in just the way it’s name implies – how long do I intend to hold this portfolio – a largely asset based portfolio that is not dynamically hedged may change very little over a week to 10 day time horizon while a proprietary trading portfolio may change hourly with a requirement to close open positions on a daily basis. Here senior management may want to know what risks are implied by these strategies. On the other hand, particularly during stress events, the concern may rest in the other direction – liquidity. The question becomes how long will it take to liquidate this portfolio under adverse conditions. Even though open positions are to be closed on a daily basis during stress events this may be impossible and a longer “holding” period will better reflect the realities of the liquidation process. Estimating the liquidation period is vital in determining a trading portfolio’s market risk economic capital. There is no “one size fits all” solution for every trading portfolio. Companies must make a detailed analysis by examining the unique characteristics of their trading strategy and portfolio, 10 Subject to proper treatment under FAS133 and/or EITF0203