Interest Rate Risk

Full allowance will be recognised for positions hedged by credit derivatives when the values of two legs (ie long and short) always move in the opposite direction and broadly to the same extent. This would be the case in the following situations, in which cases no specific risk capital requirement applies to both sides of the position: (1) the two legs consist of completely identical instruments; or (2) a long cash position (or credit derivative) is hedged by a total rate of return swap (or vice versa) and there is an exact match between the reference obligation and the underlying exposure (ie the cash position). 57 According to [14.16] to [14.18], the offsetting treatment is applied to a cash position that is hedged by a credit derivative or a credit derivative that is hedged by another credit derivative, assuming there is an exact match in terms of the reference obligations. The illustration of the treatment would be as following: [14.16] to [14.18], are applicable not only when the underlying position being hedged is a cash position, but also when the position being hedged is a credit default swap (CDS) or other credit derivative. They also apply regardless of whether the cash positions or reference obligations of the credit derivative are single-name or securitisation exposures. For example, when a long cash position is hedged using a CDS, the 80% offset treatment of [14.17] (the partial allowance treatment of [14.18]) generally applies when the reference obligation of the CDS is the cash instrument being hedged and the currencies and remaining maturities of the two positions are (are not) identical. Similarly, when a purchased CDS is hedged with a sold CDS, the 80% offset treatment (the partial allowance treatment) generally applies when both the long and short CDSs have the same reference obligations and the currencies and remaining maturities of the long and short CDSs are (are not) identical. The full allowance (100% offset) treatment generally applies only when there is zero basis risk between the instrument being hedged and the hedging instrument, such as when a cash position is hedged with a total rate of return swap referencing the same cash instrument and there is no currency mismatch, or when a purchased CDS position is hedged by selling a CDS with identical terms in all respects, including reference obligation, currency, maturity, documentation clauses (eg credit payout events, methods for determining payouts for credit events, etc), and structure of fixed and variable payments over time. It is worth noting that the conditions under which partial or full offsetting of risk positions that are subject to interest rate specific risk are narrowly defined. In practice, offsets between securitisation positions and credit derivatives are unlikely to be recognised in most cases due to the explicit requirements in [14.16] to [14.18] on reference names etc. 14.17 An 80% offset will be recognised when the value of two legs (ie long and short) always moves in the opposite direction but not broadly to the same extent. This would be the case when a long cash position (or credit derivative) is hedged by a credit default swap (CDS) or a credit-linked note (or vice versa) and there is an exact match in terms of the reference obligation, the maturity of both the reference obligation and the credit derivative, and the currency of the underlying exposure. In addition, key features of the credit derivative contract (eg credit event definitions, settlement mechanisms) should not cause the price movement of the credit derivative to materially deviate from the price movements of the cash position. To the extent that the transaction transfers risk (ie taking account of restrictive payout provisions such as fixed payouts and materiality thresholds), an 80% specific risk offset will be applied to the side of the transaction with the higher capital requirement, while the specific risk requirement on the other side will be zero.