CAPITAL CHARGE FOR MARKET RISK

NISHA RAGHUVANSHI (06) VASIST A M (18) RUPALI SHIROLE (30) SIDDHARTH BIJOOR (42) SRISHTI MITTAL (54)

INTRODUCTION
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MARKET RISK It is the risk of the banks losses due to unfavorable changes in the market value of financial instruments in the trading portfolio or financial derivatives of the credit institution, as well as foreign currency and/or precious metals exchange rates. CAPITAL CHARGE It is the estimate of capital requirement to cover the risk.

CAPITAL CHARGE FOR MARKET RISK

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The market risk positions subject to capital charge

requirement are:

The risks pertaining to interest rate related instruments and equities in the trading book; and Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading books).

Scope and coverage of capital charge for Market Risks

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Trading book for the purpose of capital adequacy will

include:

Securities included under the Held for Trading category Securities included under the Available for Sale category Open gold position limits Open foreign exchange position limits

The open position in a currency is the sum of (a) the net spot position, (b) the net forward position and (c) the net options position.

Trading positions in derivatives, and Derivatives entered into for hedging trading book exposures.

POSITION OF BANK
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S.No

Details

Amount Rs. Crore 200.00 200.00 500.00 1,000.00 500.00 300.00 2,000.00 300.00 5,000.00

1 Cash & Balances with RBI 2 Bank balances Investments: Held for Trading 3 Available for Sale Held to Maturity Equities 4 Advances (net) 5 Other Assets 6 Total Assets

COMPONENTS OF MARKET RISK

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General market risk

Specific market risk

GENERAL MARKET RISK

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Interest Rate Risk

Foreign Exchange Rates

Currency Valuation Equity Prices

Commodity Prices

SPECIFIC MARKET RISK

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Default risk

Credit Migration risk

Credit Spread Risk Incremental risk

MEASUREMENT OF CAPITAL CHARGE FOR INTEREST RATE RISK

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Capital charge for specific risk:

Standardized capital charge given by RBI guidelines which depends upon:

1. Issuer 2. Type of Security 3. Remaining maturity of Security

It is 0% for central and state government securities and 100% for securities rated B and below or those securities which are unrated.

GENERAL MARKET RISK

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Capital Charge for General Market Risk:

Computed under Standardized Duration Method using the formula given below:

Capital Charge for General Market Risk = Modified Duration x Market Value of Security x Assumed Change in Yield

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EQUITY RISK
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Equity risk is the risk that one's investments will

depreciate because of stock market dynamics causing one to lose money. The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will describe the normal fluctuations one can expect in that particular security above and below the mean, or average.

MEASUREMENT OF CAPITAL CHARGE FOR EQUITY RISK

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The capital charge for equities would apply on their current

market value in banks trading book. Capital charge for banks capital market investments, including those exempted from CME norms, for specific risk will be 11.25 per cent or higher and specific risk is computed on banks gross equity positions. The general market risk charge will be 9 per cent on the gross equity positions. Specific Risk Capital Charge for banks investment in Security Receipts will be 13.5 per cent (equivalent to 150 per cent risk weight). Since the Security Receipts are by and large illiquid and not traded in the secondary market, there will be no General Market Risk Capital Charge on them.

Measurement of Capital Charge for Foreign Exchange Risk

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The open position must first be measured separately

for each foreign currency. The open position in a currency is the sum of

The net spot position The net forward position and The net options position.

Measurement of Capital Charge for Foreign Exchange Risk CONTD

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Net Spot Position - The net spot position is the difference between

foreign currency assets and the liabilities in the balance sheet. This should include all accrued income/expenses. less all amounts to be paid in the future as a result of foreign exchange transactions which have been concluded. These transactions which are recorded as off-balance sheet items in the bank's books would include:

Net Forward Position represents the net of all amounts to be received

spot transactions which are not yet settled; forward transactions; guarantees and similar commitments denominated in foreign currencies which are certain to be called; net of amounts to be received/paid in respect of currency futures, and the principal on currency futures/swaps.

Options Position - The net delta-based equivalent of the total book of

foreign currency options

Measurement of Capital Charge for Foreign Exchange Risk CONTD

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Calculation of the Overall Net Open Position

This involves measurement of risks inherent in a bank's mix of long

and short position in different currencies. It has been decided to adopt the 'shorthand method' which is accepted internationally for arriving at the overall net open position. Banks may, therefore, calculate the overall net open position as follows:
I. II. III. IV.

Calculate the net open position in each currency. Convert the net position into rupees at the FEDAI indicative spot rates for the day. Arrive at the sum of all the net short positions. Arrive at the sum of all the net long positions.

Overall net foreign exchange position is the higher of (iii) and (iv).

The overall net foreign exchange position arrived at as above must be kept within the limit approved by Reserve Bank.

MEASUREMENT OF CAPITAL CHARGE

As seen above capital charges for specific risk and general market risk are to be computed separately before aggregation. For computing the total capital charge for market risks, the calculations may be plotted in the following table:
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Risk Category I. Interest Rate (a+b) a. Specific Risk

Capital Charge

b. General market risk

II. Equity III. Foreign Exchange & Gold IV. Total capital charge for market risks (I+II+III)

A bank may have the following position:

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Sr. No. 1 2 3

4 5 6

Details Cash and bank balances with RBI Bank balances Investments: Government Securities (HFT & AFS) Bank Bonds (HFT & AFS) Other Securities (AFS & HFT) Securities and Bonds (HTM) Equities Advances (net) Other Assets Total assets

Amount (cr.) 200 200 700 500 300 500 300 2000 300 5000

As, in case of measurement of capital charge for market risk, only trading book is considered and not the banking book, thus securities which are held to maturity have been ignored along with advances and other assets (these are considered in case of credit risk)

Sr. No.

Details

Amount (cr.)

1
2 3

Cash and bank balances with RBI

Bank balances Investments: Government Securities (HFT & AFS) Bank Bonds (HFT & AFS) Other Securities (HFT & AFS) Equities

200
200 700 500 300 300

Total assets

5000

In Addition, Foreign exchange open position is assumed to be Rs. 60 crore Gold open position is assumed to be Rs. 40 crore
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Calculation of Capital Charge of Specific Risk

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Interest Rate related Trading Book Securities Book Value Value Govt. Securities 700 300

Total Value 1000

Capital Charge 0%

Capital Charge in Rs. 0

Bank Bonds
Other Securities Total

500
300

0
0

500
300

1.07%
9.00%

5.325
27 32.325

Capital charge for specific risk for equities is 9%. Thus, specific risk capital charge on equities would work out to be = 9% of 300 = 27 cr. Thus, Total capital charge on specific risk = 32.325 + 27 = 59.325 cr.

Calculation of Capital Charge of General Risk

Counter Party Government Government Government Government Government Government Government Bank Bonds Bank Bonds Bank Bonds Bank Bonds Bank Bonds Other Securities Other Securities Other Securities Total

Maturity Date 01-03-2004 01-05-2003 31-05-2003 01-03-2015 01-03-2010 01-03-2009 01-03-2005 01-03-2004 01-03-2005 01-03-2004 01-05-2003 31-05-2003 01-03-2006 01-03-2007 01-03-2004

Amount market value 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 1500

Coupon (%) 12.50 12.00 12.00 12.50 11.50 11.00 10.50 12.50 12.00 12.00 12.50 11.50 12.50 12.00 12.00

Capital Charge for general market risk 0.84 0.08 0.16 3.63 2.79 2.75 1.35 0.84 0.08 0.16 1.77 2.29 0.84 0.08 0.16 17.82

Capital charge for general risk for equities is 9%. Thus, general risk capital charge on equities would work out to be = 9% of 300 = 27 cr. Thus, Total capital charge on general risk = 17.82 + 27 = 44.82 cr.
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Capital charge on foreign / gold position would be computed at 9%. Thus the same works out to be = 9% * (60+40) = 9 cr. Thus, capital charge for market risk in this example is calculated as follows: Risk Category I. Interest Rate Risk (a+b) a. Specific Risk b.General Market Risk II. Equity (a+b) a. Specific Risk b. General Market Risk III. Foreign Exchange & Gold Total Capital Charge for Market Risk (I+II+III)
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Capital Charges (Rs.) 50.145 32.325 17.82 54 27 27 9 113.145

Models - Capital Charge for Market Risk

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Basel II Framework offers a choice between two broad methodologies in

measuring market risks for the purpose of capital adequacy.

1. 2.

Standardised Measurement Method (SMM) Internal Models Approach (IMA)

Banks have been using Standardized Measurement Method (SMM) since March 31, 2005 for both held-For-Trading (HFT) and Available for Sale (AFS) portfolios.
Under the standardised method there are two principal methods of measuring

market risk :

maturity method duration method

Capital Charge for Market Risk: Standardized Maturity Method

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Standardised Maturity method

Positions weighted by prescribed price sensitivity factor
Partial offset (10% capital charge) for weighted longs and shorts in each

time band

Two rounds of horizontal partial offsetting between time bands

pursuant to prescribed scale

Capital Charge for Market Risk: Standardized Duration Method

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Under standardised Duration method banks are required to measure the general market risk charge by calculating the price sensitivity (modified duration) of each position separately. Under this method, the mechanics are as follows:
first calculate the price sensitivity (modified duration) of each instrument apply the assumed change in yield to the modified duration of each

instrument between 0.6 and 1.0 percentage points depending on the maturity of the instrument slot the resulting capital charge measures into a maturity ladder with the fifteen time bands subject long and short in each time band to a 5 per cent vertical disallowance designed to capture basis risk carry forward the net positions in each time-band for horizontal offsetting subject to the disallowances set out in

Capital Charge for Market Risk: Internal Models Approach

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This approach allows banks to use risk measures derived from their own internal market risk management models
The permissible models under IMA calculates a value-at-risk (VaR) -

based measure of exposure to market risk This model can be used to measure both General Market Risk and Specific Risk Banks interested in migrating to IMA for computing capital charge for market risk are advised to assess their preparedness with reference to these Guidelines :1. give Reserve Bank of India a notice of intention for the same 2. RBI will first make a detailed assessment of the banks risk management system and its modelling process.

Comparison between SMM and IMA

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IMA is more risk sensitive than SMM

Positions held in the AFS are more illiquid and market prices for them may not be available. So, it would not be feasible to compute meaningful VaR measures for AFS portfolios. The AFS portfolio should continue to be under SMM for computation of capital charge for market risk. actual losses than SMM

IMA Aligns the capital charge for market risk more closely to the

Source RBI Guidelines on Implementation of Internal Models Approach for Market Risk 7th April 2010

THANK YOU

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