Instruments Subject to Each Component of the Sensitivities-Based Method
Effective from Dec 28 2022 - Dec 31 2022
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| 7.2 | In applying the sensitivities-based method, all instruments held in trading desks as set out in [4] and subject to the sensitivities-based method (ie excluding instruments where the value at any point in time is purely driven by an exotic underlying as set out in [9.3]), are subject to delta risk capital requirements. Additionally, the instruments specified in (1) to (4) are subject to vega and curvature risk capital requirements: | |||||
| (1) | Any instrument with optionality11. | |||||
| (2) | Any instrument with an embedded prepayment option12 this is considered an instrument with optionality according to above (1). The embedded option is subject to vega and curvature risk with respect to interest rate risk and CSR (non-securitisation and securitisation) risk classes. When the prepayment option is a behavioural option the instrument may also be subject to the residual risk add-on (RRAO) as per [9]. The pricing model of the bank must reflect such behavioural patterns where relevant. For securitisation tranches, instruments in the securitised portfolio may have embedded prepayment options as well. In this case the securitisation tranche may be subject to the RRAO. | |||||
| (3) | Instruments whose cash flows cannot be written as a linear function of underlying notional. For example, the cash flows generated by a plain-vanilla option cannot be written as a linear function (as they are the maximum of the spot and the strike). Therefore, all options are subject to vega risk and curvature risk. Instruments whose cash flows can be written as a linear function of underlying notional are instruments without optionality (eg cash flows generated by a coupon bearing bond can be written as a linear function) and are not subject to vega risk nor curvature risk capital requirements. | |||||
| (4) | Curvature risks may be calculated for all instruments subject to delta risk, not limited to those subject to vega risk as specified in (1) to (3) above. For example, where a bank manages the non-linear risk of instruments with optionality and other instruments holistically, the bank may choose to include instruments without optionality in the calculation of curvature risk. This treatment is allowed subject to all of the following restrictions: | |||||
| (a) | Use of this approach shall be applied consistently through time. | |||||
| (b) | Curvature risk must be calculated for all instruments subject to the sensitivities- based method. | |||||
11 For example, each instrument that is an option or that includes an option (eg an embedded option such as convertibility or rate dependent prepayment and that is subject to the capital requirements for market risk). A non-exhaustive list of example instruments with optionality includes: calls, puts, caps, floors, swaptions, barrier options and exotic options.
12 An instrument with a prepayment option is a debt instrument which grants the debtor the right to repay part of or the entire principal amount before the contractual maturity without having to compensate for any foregone interest. The debtor can exercise this option with a financial gain to obtain funding over the remaining maturity of the instrument at a lower rate in other ways in the market.