Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 65 rated counterparty, and operates a small speculative trading operation that enters into deals with a BB-rated counterparty. The fact that the portfolio owner enters into forward contracts based on expected output and fuel consumption rather than tolling agreements leaves some market risk in the portfolio. The assumption of all fuel being purchased from a CCC counterparty led to a higher credit risk number than would be experienced with a larger, more diverse portfolio of counterparties. Credit risk taken on is usually less than the market risk reduction, because not only do prices have to move but the counterparty must also default. With a portfolio of only 3 counterparties one of whom is CCC, this reduction in total risk is pretty small. Hedged Case Results Available vs. Required Capital ($ millions) BBB Rated BB Rated Available Capital 571 571 Debt 286 286 Required Economical Capital Market Risk 6 6 Credit Risk 16 16 Operative Risk 22 22 Diversification Effect - Across Risks -13 -13 Total Required Economic Capital 30 30 Economic Capital Adequacy 255 255 Sources of Liquidity 600 400 Fixed Payments 200 200 Contingent Liquidity 0 7 Liquidity Capital Adequacy 400 193 In the hedged example, combined market and credit risk is $22 million versus $23 million in the unhedged case. This difference would be even greater with more counterparties. For the liquidity calculation, the uncertainty of the cash stream is reduced in the hedged case by $27 million, but a downgrade event to BB requires an incremental margin payment of $7 million. The simulation was also run with all counterparties set at BBB to reflect the average rating of many portfolios. The credit risk remained at zero with a 95% confidence level, while market risk was reduced from $23 million to $6 million. Level 3 – Base of Pyramid: Considering the Portfolio of Assets The base of the pyramid represents analyzing capital requirements for assets as part of a portfolio. We examine the risk of the portfolio as a whole and the market risks of each component of the portfolio separately.