Minimum Capital Requirements for Market Risk

In the vega risk context: (1) Multi-underlying options (including index options) are usually priced based on the implied volatility of the option, rather than the implied volatility of its underlying constituents and a look-through approach may not need to be applied, regardless of the approach applied to the delta and curvature risk calculation as set out in [7.31] through [6.35]. 21 (2) For indices, the vega risk with respect to the implied volatility of the multiunderlying options will be calculated using a sector specific bucket or an index bucket defined in [7.53] and [7.72] as follows: (a) Where more than 75% of constituents in that index (taking into account the weightings of that index) would be mapped to a single specific sector bucket (ie bucket 1 to bucket 11 for equity risk; or bucket 1 to bucket 16 for CSR), the sensitivity to the index shall be mapped to that single specific sector bucket and treated like any other single-name sensitivity in that bucket. (b) In all other cases, the sensitivity may be mapped to an “index” bucket (ie bucket 12 or bucket 13 for equity risk or bucket 17 or bucket 18 for CSR). 13 The assignment of risk factors to the specified tenors should be performed by linear interpolation or a method that is most consistent with the pricing functions used by the independent risk control function of a bank to report market risks or P&L to senior management. 14 Cross-currency basis are basis added to a yield curve in order to evaluate a swap for which the two legs are paid in two different currencies. They are in particular used by market participants to price cross-currency interest rate swaps paying a fixed or a floating leg in one currency, receiving a fixed or a floating leg in a second currency, and including an exchange of the notional in the two currencies at the start date and at the end date of the swap. 15 For example, an option with a forward starting cap, lasting 12 months, consists of four consecutive caplets on USD three month Libor. There are four (independent) options, with option expiry dates in 12, 15, 18 and 21 months. These options are all on underlying USD three-month Libor; the underlying always matures three months after the option expiry date (its residual maturity being three months). Therefore, the implied volatilities for a regular forward starting cap, which would start in one year and last for 12 months should be defined along the following two dimensions: (i) the maturity of the option’s individual components (caplets) – 12, 15, 18 and 21 months; and (ii) the residual maturity of the underlying of the option – three months. 16 For example, a contract that can be delivered in five ports can be considered having the same delivery location as another contract if and only if it can be delivered in the same five ports. However, it cannot be considered having the same delivery location as another contract that can be delivered in only four (or less) of those five ports. 17 For example, for an FX forward referencing USD/JPY, the relevant risk factors for a CAD- reporting bank to consider are the exchange rates USD/CAD and JPY/CAD. If that CAD- reporting bank calculates FX risk relative to a USD base currency, it would consider separate deltas for the exchange rate JPY/USD risk and CAD/USD FX translation risk and then translate the resulting capital requirement to CAD at the USD/CAD spot exchange rate. 18 As specified in the vega risk factor definitions in [7.8] to [7.14], the implied volatility of the option must be mapped to one or more maturity tenors. 19 Since vega (, ∂v/∂σi ) of an instrument is multiplied by its implied volatility ( ), the vega risk sensitivity for that instrument will be the same under the log-normal assumption and the normal assumption. As a consequence, banks may use a log-normal or normal assumption for GIRR and CSR (in recognition of the trade-offs between constrained specification and computational burden for a standardised approach). For the other risk classes, banks must only use a log-normal assumption (in recognition that this is aligned with common practices across jurisdictions). 20 In other words, a bank can initially not apply a look-through approach, and later decide to apply it. However once applied (for a certain type of instrument referencing a particular index), the bank will require SAMA approval to revert to a “no look-through” approach. 21 As specified in the vega risk factor definitions in [7.8] to [7.14], the implied volatility of an option must be mapped to one or more maturity tenors. Sensitivities-Based Method: Definition of Delta Risk Buckets, Risk Weights and Correlations 7.39 [7.41] to [7.89] set out buckets, risk weights and correlation parameters for each risk class to calculate delta risk capital requirement as set out in [7.4] .