Minimum Capital Requirements for Market Risk

Instruments bearing other residual risks are those that meet criteria (1) and (2) below: (1) Instruments subject to vega or curvature risk capital requirements in the trading book and with pay-offs that cannot be written or perfectly replicated as a finite linear combination of vanilla options with a single underlying equity price, commodity price, exchange rate, bond price, credit default swap price or interest rate swap; or (2) Instruments which fall under the definition of the correlation trading portfolio (CTP) in [ 6.5 ], except for those instruments that are recognised in the market risk framework as eligible hedges of risks within the CTP. The bonds with multiple call dates would be considered as instruments bearing other residual risks for the purpose of the RRAO as they are path-dependent options. 9.5 A non-exhaustive list of other residual risks types and instruments that may fall within the criteria set out in [9.4] include: (1) Gap risk: risk of a significant change in vega parameters in options due to small movements in the underlying, which results in hedge slippage. Relevant instruments subject to gap risk include all path dependent options, such as barrier options, and Asian options as well as all digital options. (2) Correlation risk: risk of a change in a correlation parameter necessary for determining the value of an instrument with multiple underlyings. Relevant instruments subject to correlation risk include all basket options, best-of- options, spread options, basis options, Bermudan options and quanto options. (3) Behavioural risk: risk of a change in exercise/prepayment outcomes such as those that arise in fixed rate mortgage products where retail clients may make decisions motivated by factors other than pure financial gain (such as demographical features and/or and other social factors). A callable bond may only be seen as possibly having behavioural risk if the right to call lies with a retail client. 9.6 When an instrument is subject to one or more of the following risk types, this by itself will not cause the instrument to be subject to the RRAO: (1) Risk from a cheapest-to-deliver option; (2) Smile risk: the risk of a change in an implied volatility parameter necessary for determining the value of an instrument with optionality relative to the implied volatility of other instruments optionality with the same underlying and maturity, but different moneyness; (3) Correlation risk arising from multi-underlying European or American plain vanilla options, and from any options that can be written as a linear combination of such options. This exemption applies in particular to the relevant index options; (4) Dividend risk arising from a derivative instrument whose underlying does not consist solely of dividend payments; and (5) Index instruments and multi-underlying options of which treatment for delta, vega or curvature risk are set out in [7.31] and [7.32] . These are subject to the RRAO if they fall within the definitions set out in this chapter. For funds that are subject to the treatment specified in [7.36] (3) (ie treated as an unrated “other sector” equity), banks shall assume the fund is exposed to exotic underlying exposures, and to other residual risks, to the maximum possible extent allowed under the fund’s mandate.