I. Definitions and general terminology

A. General terms

B. Transaction types

C. Netting sets, hedging sets, and related terms

D. Distributions

E. Exposure measures and adjustments

F. CCR-related risks

II. Scope of application

III. Cross-product netting rules²³⁹

Legal Criteria

Operational Criteria

IV. Approval to adopt an internal modeling method to estimate EAD

V. Internal Model Method: measuring exposure and minimum requirements

A. Exposure amount or EAD under the internal model method

25.	CCR exposure or EAD is measured at the level of the netting set as defined in Sections I and III of this Annex. A qualifying internal model for measuring counterparty credit exposure must specify the forecasting distribution for changes in the market value of the netting set attributable to changes in market variables, such as interest rates, foreign exchange rates, etc. The model then computes the firm’s CCR exposure for the netting set at each future date given the changes in the market variables. For margined counterparties, the model may also capture future collateral movements. Banks may include eligible financial collateral as defined in paragraphs 146 and 703 of this Framework in their forecasting distributions for changes in the market value of the netting set, if the quantitative, qualitative and data requirements for internal model method are met for the collateral.
26.	To the extent that a bank recognizes collateral in exposure amount or EAD via current exposure, a bank would not be permitted to recognize the benefits in its estimates of LGD. As a result, the bank would be required to use an LGD of an otherwise similar uncollateralized facility. In other words, the bank would be required to use an LGD that does not include collateral that is already included in EAD.
27.	Under the Internal Model Method, the bank need not employ a single model. Although the following text describes an internal model as a simulation model, no particular form of model is required. Analytical models are acceptable so long as they are subject to supervisory review, meet all of the requirements set forth in this section and are applied to all material exposures subject to a CCR-related capital charge as noted above, with the exception of long settlement transactions, which are treated separately, and with the exception of those exposures that are immaterial in size and risk.
28.	Expected exposure or peak exposure measures should be calculated based on a distribution of exposures that accounts for the possible nonnormality of the distribution of exposures, including the existence of leptokurtosis (“fat tails”), where appropriate.
29.	When using an internal model, exposure amount or EAD is calculated as the product of alpha times Effective EPE, as specified below:
EAD = α x Effective EPE (1)
30.	Effective EPE (“Expected Positive Exposure”) is computed by estimating expected exposure (EEt) as the average exposure at future date t, where the average is taken across possible future values of relevant market risk factors, such as interest rates, foreign exchange rates, etc. The internal model estimates EE at a series of future dates t1, t2, t3…240 Specifically, “Effective EE” is computed recursively as:
Effective EEtk = max(Effective EEtk-1, EEtk) (2)
where the current date is denoted as t0 and Effective EEt0 equals current exposure.
31.	In this regard, “Effective EPE” is the average Effective EE during the first year of future exposure. If all contracts in the netting set mature before one year, EPE is the average of expected exposure until all contracts in the netting set mature. Effective EPE is computed as a weighted average of Effective EE:
where the weights Δtk = tk – tk-1 allows for the case when future exposure is calculated at dates that are not equally spaced over time.
32.	Alpha (＜) is set equal to 1.4.
33.	Supervisors have the discretion to require a higher alpha based on a firm’s CCR exposures. Factors that may require a higher alpha include the low granularity of counterparties; particularly high exposures to general wrong-way risk; particularly high correlation of market values across counterparties; and other institution-specific characteristics of CCR exposures.

B. Own estimates for alpha

C. Maturity

38.	If the original maturity of the longest-dated contract contained in the set is greater than one year, the formula for effective maturity (M) in paragraph 320 of this Framework is replaced with the following:
where dfk is the risk-free discount factor for future time period tk and the remaining symbols are defined above. Similar to the treatment under corporate exposures, M has a cap of five years.241
39.	For netting sets in which all contracts have an original maturity of less than one year, the formula for effective maturity (M) in paragraph 320 of this Framework is unchanged and a floor of one year applies, with the exception of short-term exposures as described in paragraphs 321 to 323 of this Framework.

D. Margin agreements

E. Model validation

F. Operational requirements for EPE models

Qualifying standards on CCR Management

Use test

Stress testing

Wrong-way risk

Integrity of Modeling Process

VI. Standardized Method

69.	Banks that do not have approval to apply the internal models method for the relevant OTC transactions may use the standardized method. The standardized method can be used only for OTC derivatives; SFTs are subject to the treatments set out under the Internal Model Method of this Annex or under the Part 2, Section II.D, of this Framework. The exposure amount (under the standardized approach for credit risk) or EAD is to be calculated separately for each netting set. It is determined as follows:
CMV = current market value of the portfolio of transactions within the netting set with a counterparty gross of collateral, i.e.CMV =∑CMV , where CMVi is the current market value of transaction i.
CMC = current market value of the collateral assigned to the netting set, i.e.
CMC =∑CMC, where CMCl is the current market value of `collateral l.
i =	index designating transaction.
l =	index designating collateral.
j =	index designating supervisory hedging sets. These hedging sets correspond to risk factors for which risk positions of opposite sign can be offset to yield a net risk position on which the exposure measure is then based.
RPTij =	Risk position from transaction i with respect to hedging set j245.
RPClj =	Risk position from collateral l with respect to hedging set j.
CCFj =	Supervisory credit conversion factor with respect to the hedging set j246.
ß =	Supervisory scaling parameter.
Collateral received from a counterparty has a positive sign; collateral posted to a counterparty has a negative sign.
Collateral that is recognized for the standardized approach is confined to the collateral that is eligible under paragraphs 146 and 703 of this Framework for credit risk mitigation.
70.	When an OTC derivative transaction with linear risk profile (e.g. a forward, a future or a swap agreement) stipulates the exchange of a financial instrument (e.g. a bond, an equity, or a commodity) for a payment, the payment part is referred to as the payment leg. Transactions that stipulate the exchange of payment against payment (e.g. an interest rate swap or a foreign exchange forward) consist of two payment legs. The payment legs consist of the contractually agreed gross payments, including the notional amount of the transaction. Banks may disregard the interest rate risk from payment legs with a remaining maturity of less than one year from the following calculations. Banks may treat transactions that consist of two payment legs that are denominated in the same currency (e.g. interest rate swaps) as a single aggregate transaction. The treatment for payment legs applies to the aggregate transaction.
71.	Transactions with linear risk profiles that have equity (including equity indices), gold, other precious metals or other commodities as the underlying financial instruments are mapped to a risk position in the respective equity (or equity index) or commodity (including gold and the other precious metals) hedging set. The payment leg of these transactions is mapped to an interest rate risk position within the appropriate interest rate hedging set. If the payment leg is denominated in a foreign currency, the transaction is also mapped to a foreign exchange risk position in the respective currency.
72.	Transactions with linear risk profiles that have a debt instrument (e.g. a bond or a loan) as the underlying instrument are mapped to an interest rate risk positions with one risk position for the debt instrument and another risk position for the payment leg. Transactions with linear risk profiles that stipulate the exchange of payment against payment (including foreign exchange forwards) are mapped to an interest rate risk position for each of the payment legs. If the underlying debt instrument is denominated in a foreign currency, the debt instrument is mapped to a foreign exchange risk position in the respective currency. If a payment leg is denominated in a foreign currency, the payment leg is also mapped to a foreign exchange risk position in this currency.247 The exposure amount or EAD assigned to a foreign exchange basis swap transactions is zero.
73.	For all but debt instruments, the size of a risk position from a transaction with linear risk profile is the effective notional value (market price multiplied by quantity) of the underlying financial instruments (including commodities) converted to the firm’s domestic currency.
74.	For debt instruments and the payment legs of all transactions, the size of the risk position is the effective notional value of the outstanding gross payments (including the notional amount) converted to the firm’s domestic currency, multiplied by the modified duration of the debt instrument or payment leg, respectively.
75.	The size of a risk position from a credit default swap is the notional value of the reference debt instrument multiplied by the remaining maturity of the credit default swap.
76.	The size of a risk position from an OTC derivative with non-linear risk profile (including options and swaptions) is equal to the delta equivalent effective notional value of the financial instrument that underlies the transaction, except in the case of an underlying debt instrument.
77.	For OTC derivative with non-linear risk profiles (including options and swaptions), for which the underlying is a debt instrument or a payment leg, the size of the risk position is equal to the delta equivalent effective notional value of the financial instrument or payment leg multiplied by the modified duration of the debt instrument or payment leg.
78.	Banks may use the following formulas to determine the size and sign of a risk position:
a.	for all but debt instruments:
effective notional value, or delta equivalent notional value =

where
ρref	price of the underlying instrument, expressed in the reference currency
v	value of the financial instrument (in the case of an option: option price; in the case of a transaction with a linear risk profile: value of the underlying instrument itself)
p	price of the underlying instrument, expressed in the same currency as v b. for debt instruments and the payment legs of all transactions:
effective notional value multiplied by the modified duration, or delta equivalent in notional value multiplied by the modified duration
where
v	value of the financial instrument (in the case of an option: option price; in the case of a transaction with a linear risk profile: value of the underlying instrument itself or of the payment leg, respectively)
r	interest level
If v is denominated in a currency other than the reference currency, the derivative must be converted into the reference currency by multiplication with the relevant exchange rate.
79.	The risk positions are to be grouped into hedging sets. For each hedging set, the absolute value amount of the sum of the resulting risk positions is computed. This sum is termed the “net risk position” and is represented as in the formulas in paragraph 70 of this Annex.
80.	Interest rate positions arising from debt instruments of low specific risk are to be mapped into one of six hedging sets for each represented currency. A debt instrument is classified as being of low specific risk when it is subject to a 1.6 percent or lower capital charge according to paragraphs 710 to 711(ii). Interest rate positions arising from the payment legs are to be assigned to the same hedging sets as interest rate risk positions from debt instruments of low specific risk. Interest rate positions arising from money deposits received from the counterparty as collateral are also to be assigned to the same hedging sets as interest rate risk positions from debt instruments of low specific risk. The six hedging sets per currency are defined by a combination of two criteria:
(i)	The nature of the referenced interest rate — either a sovereign (government) rate or some other rate.
(ii)	The remaining maturity or rate-adjustment frequency — less than one year, between one and five years, or longer than five years.
	Table 1
	Hedging Sets for Interest Rate Risk Positions Per Currency
Remaining maturity or rate-adjustment frequency Sovereign-referenced interest rates Non-sovereign referenced interest rates One year or less X X Over one year to five years X X Over five years X X
81.	For underlying debt instruments (e.g. floating rate notes) or payment legs (e.g. floating rate legs of interest swaps) for which the interest rate is linked to a reference interest rate that represents a general market interest level (e.g. government bond yield, money market rate, swap rate), the rate-adjustment frequency is the length of the time interval up to the next re-adjustment of the reference interest rate. Otherwise, the remaining maturity is the remaining life of the underlying debt instrument, or, in the case of a payment leg, the remaining life of the transaction.
82.	There is one hedging set for each issuer of a reference debt instrument that underlies a credit default swap.
83.	There is one hedging set for each issuer of a debt instrument of high specific risk, i.e. debt instruments to which a capital charge of more than 1.60 percent applies under the standardized measurement method for interest rate risk in paragraph 710. The same applies to money deposits that are posted with a counterparty as collateral when that counterparty does not have debt obligations of low specific risk outstanding. When a payment leg emulates a debt instrument of high specific risk (e.g. in the case of a total return swap with one leg that emulates a bond), there is also one hedging set for each issuer of the reference debt instrument. Banks may assign risk positions that arise from debt instruments of a certain issuer or from reference debt instruments of the same issuer that are emulated by payment legs or that underlie a credit default swap to the same hedging set.
84.	Underlying financial instruments other than debt instruments (equities, precious metals, commodities, other instruments), are assigned to the same respective hedging sets only if they are identical or similar instruments. The similarity of instruments is established as follows:
	•	For equities, similar instruments are those of the same issuer. An equity index is treated as a separate issuer.
	•	For precious metals, similar instruments are those of the same metal. A precious metal index is treated as a separate precious metal.
	•	For commodities, similar instruments are those of the same commodity. A commodity index is treated as a separate commodity.
	•	For electric power, delivery rights and obligations that refer to the same peak or off-peak load time interval within any 24-hour interval are similar instruments.
85.	The credit conversion factor that is applied to a net risk position from a hedging set depends on the supervisory hedging set category as given in paragraphs 86 to 88 of this Annex.
86.	The credit conversion factors for underlying financial instruments other than debt instruments and for foreign exchange rates are given in Table 2.
Table 2
Exchange Rates Gold Equity Precious Metals (except gold) Electric Power Other Commodities (excluding precious metals 2.5% 5.0% 7.0% 8.5% 4% 10.0%
87.	The credit conversion factor for risk positions from debt instruments are as follows:
	•	0.6 percent for risk positions from a debt instrument or reference debt instrument of high specific risk.
	•	0.3 percent for risk position from a reference debt instrument that underlies a credit default swap and that is of low specific risk.
	•	0.2 percent otherwise.
88.	Underlying instruments of OTC derivatives that are not in any of the categories above are assigned to separate individual hedging sets for each category of underlying instrument. A credit conversion factor of 10 percent is applied to the notional equivalent amount.
89.	There may be transactions with a non-linear risk profile for which the bank cannot determine the delta with a model that the supervisor has approved for the purposes for determining the minimum capital requirements for market risk (instrument models approved for the purposes of the standardized approach for market risk, or instrument models approved as part of the firm's admission to the internal modeling approach for market risk). In the case of payment legs and transactions with debt instruments as underlying, there may be transactions for which the bank cannot determine the modified duration with such a model. For these transactions, the supervisor will determine the size of the risk positions and the applicable credit conversion factors conservatively. Alternatively, supervisors may require the use of the current exposure method. Netting will not be recognized: in other words, the exposure amount or EAD is to be determined as if there were a netting set that comprises just the individual transaction.
90.	The supervisory scaling parameter β (beta) is set at 1.4.

VII. Current Exposure Method

^* This Annex # 5 is the same of Basel II of June 2006.
²³⁷ In the present document, the terms “exposure at default” and “exposure amount” are used together in order to identify measures of exposure under both an IRB and a standardized approach for credit risk.
²³⁸ Transactions for which the probability of default is defined on a pooled basis are not included in this treatment of CCR.
²³⁹ These Cross-Product Netting Rules apply specifically to netting across SFTs, or to netting across both SFTs and OTC derivatives, for purposes of regulatory capital computation under IMM. They do not revise or replace the rules that apply to recognition of netting within the OTC derivatives, repo-style transaction, and margin lending transaction product categories under the 1988 Accord, as amended, or in this Framework. The rules in the 1988 Accord and this Framework continue to apply for purposes of regulatory capital recognition of netting within product categories under IMM or other relevant methodology.
²⁴⁰ In theory, the expectations should be taken with respect to the actual probability distribution of future exposure and not the risk-neutral one. Supervisors recognize that practical considerations may make it more feasible to use the risk-neutral one. As a result, supervisors will not mandate which kind of forecasting distribution to employ.
²⁴¹ Conceptually, M equals the effective credit duration of the counterparty exposure. A bank that uses an internal model to calculate a one-sided credit valuation adjustment (CVA) can use the effective credit duration estimated by such a model in place of the above formula with prior approval of its supervisor.
²⁴² In other words, the add-on equals EE at the end of the margin period of risk assuming current exposure of zero. Since no roll-off of transactions would be occurring as part of this EE calculation, there would be no difference between EE and Effective EE.
²⁴³ This section draws heavily on the Counterparty Risk Management Policy Group’s paper, Improving Counterparty Risk Management Practices (June 1999); a copy can be found online at http://www.mfainfo.org/washington/derivatives/Improving%20Counterparty%20risk.pdf.
²⁴⁴ See Part 2, Section VI D 1 (paragraphs 718 (LXX) to 718 (LXXIII).
²⁴⁵ E.g. a short-term FX forward with one leg denominated in the firm’s domestic currency will be mapped into three risk positions: 1. an FX risk position, 2. a foreign currency interest rate risk position, 3. a domestic currency risk position.
²⁴⁶ Calibration has been made assuming at the money forwards or swaps and given a forecasting horizon of one year.
²⁴⁷ E.g. a short-term FX forward with one leg denominated in the firm’s domestic currency will be mapped into three risk positions: 1. an FX risk position, 2. a foreign currency interest rate risk position, 3. a domestic currency risk position.
²⁴⁸ Payments netting, which is designed to reduce the operational costs of daily settlements, will not be recognized in the capital framework since the counterparty's gross obligations are not in any way affected.
²⁴⁹ In cases where an agreement as described in 96(ii) (a) has been recognized prior to July 1994, the supervisor will determine whether any additional steps are necessary to satisfy itself that the agreement meets the requirements set out below.
²⁵⁰ Thus, if any of these supervisors is dissatisfied about enforceability under its laws, the netting contract or agreement will not meet this condition and neither counterparty could obtain supervisory benefit.
²⁵¹ A_Gross equals the sum of individual add-on amounts (calculated by multiplying the notional principal amount by the appropriate add-on factors set out in paragraph 92(i) of this Annex) of all transactions subject to legally enforceable netting agreements with one counterparty.
²⁵² SAMA may permit a choice of calculating the NGR on a counterparty by counterparty or on an aggregate basis for all transactions subject to legally enforceable netting agreements. If supervisors permit a choice of methods, the method chosen by an institution is to be used consistently. Under the aggregate approach, net negative current exposures to individual counterparties cannot be used to offset net positive current exposures to others, i.e. for each counterparty the net current exposure used in calculating the NGR is the maximum of the net replacement cost or zero. Note that under the aggregate approach, the NGR is to be applied individually to each legally enforceable netting agreement so that the credit equivalent amount will be assigned to the appropriate counterparty risk weight category.