CA-8.4.1

As stated in Section CA-8.1, banks which have a significant level of options trading activities, or have complex options trading strategies, are expected to use more sophisticated methods for measuring and monitoring the options risks. Banks with the appropriate capability will be permitted, with the prior approval of the Central Bank, to base the market risk capital charge for options portfolios and associated hedging positions on scenario matrix analysis. Before giving its approval, the Central Bank will closely review the accuracy of the analysis that is constructed. Furthermore, like in the case of internal models, the banks' use of scenario analysis as part of the standardised methodology will also be subject to external validation, and to those of the qualitative standards listed in Chapter CA-9 which are appropriate given the nature of the business.

CA-8.4.2

The scenario matrix analysis involves specifying a fixed range of changes in the option portfolio's risk factors and calculating changes in the value of the option portfolio at various points along this 'grid' or 'matrix'. For the purpose of calculating the capital charge, the bank will revalue the option portfolio using matrices for simultaneous changes in the option's underlying rate or price and in the volatility of that rate or price. A different matrix is set up for each individual underlying as defined in Section CA-8.3 above. As an alternative, in respect of interest rate options, banks which are significant traders in such options are permitted to base the calculation on a minimum of six sets of time-bands. When using this alternative method, not more than three of the time-bands as defined in Chapter CA-4 should be combined into any one set.

CA-8.4.3

The first dimension of the matrix involves a specified range of changes in the option's underlying rate or price. The Central Bank has set the range for each risk Category as follows:

For all risk categories, at least seven observations (including the current observation) should be used to divide the range into equally spaced intervals.

CA-8.4.4

The second dimension of the matrix entails a change in the volatility of the underlying rate or price. A single change in the volatility of the underlying rate or price equal to a shift in volatility of ±25% is applied.

CA-8.4.5

The Central Bank will closely monitor the need to reset the parameters for the amounts by which the price of the underlying instrument and volatility must be shifted to form the rows and columns of the scenario matrix. For the time being, the parameters set, as above, only reflect general market risk (see Paragraphs CA-8.4.10 to CA-8.4.12).

CA-8.4.6

After calculating the matrix, each cell contains the net profit or loss of the option and the underlying hedge instrument. The general market risk capital charge for each underlying is then calculated as the largest loss contained in the matrix.

CA-8.4.7

In addition to the capital charge calculated as above, the specific risk capital charge is determined separately by multiplying the delta-equivalent of each option position by the specific risk weights set out in Chapters CA-4 through CA-7.

CA-8.4.8

To summarise, capital requirements for, say OTC options, using the scenario approach are as follows:

CA-8.4.9

Banks doing business in certain classes of complex exotic options (e.g. barrier options involving discontinuities in deltas etc.), or in options at the money that are close to expiry, are required to use either the scenario approach or the internal models approach, both of which can accommodate more detailed revaluation approaches. The Central Bank expects the concerned banks to work with it closely to produce an agreed method, within the framework of these rules. If a bank uses scenario matrix analysis, it must be able to demonstrate that no substantially larger loss could fall between the nodes.

CA-8.4.10

In drawing up the delta-plus and the scenario approaches, the Central Bank's present set of rules do not attempt to capture specific risk other than the delta-related elements (which are captured as explained in Paragraphs CA-8.4.7 and CA-8.4.11). The Central Bank recognises that introduction of those other specific risk elements will make the measurement framework much more complex. On the other hand, the simplifying assumptions used in these rules will result in a relatively conservative treatment of certain options positions.

CA-8.4.11

In addition to the options risks described earlier in this Chapter, the Central Bank is conscious of the other risks also associated with options, e.g. rho or interest rate risk (the rate of change of the value of the option with respect to the interest rate) and theta (the rate of change of the value of the option with respect to time). While not proposing a measurement system for those risks at present, the Central Bank expects banks undertaking significant options business, at the very least, to monitor such risks closely. Additionally, banks will be permitted to incorporate rho into their capital calculations for interest rate risk, if they wish to do so.

CA-8.4.12

The Central Bank will closely review the treatment of options for the calculation of market risk capital charges, particularly in the light of the aspects described in Paragraphs CA-8.4.10 and CA-8.4.11.