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  • Specific Risk Capital Charges for Positions Hedged by Credit Derivatives

    • CA-9.2.12

      Full allowance will be recognised when the values of two legs (i.e. long and short) always move in the opposite direction and broadly to the same extent. This would be the case in the following situations:

      (a) The two legs consist of completely identical instruments; or
      (b) A long cash position 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 (i.e. the cash position)46.

      In these cases, no specific risk capital requirement applies to both sides of the position.

      46 The maturity of the swap itself may be different from that of the underlying exposure.

      January 2015

    • CA-9.2.13

      An 80% offset will be recognised when the value of two legs (i.e. 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 is hedged by a credit default swap 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 to the underlying exposure. In addition, key features of the credit derivative contract (e.g. 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 (i.e. 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 charge, while the specific risk requirement on the other side will be zero.

      January 2015

    • CA-9.2.14

      Partial allowance will be recognised when the value of the two legs (i.e. long and short) usually moves in the opposite direction. This would be the case in the following situations:

      (a) The position is captured in Paragraph CA-9.2.12 under (b), but there is an asset mismatch between the reference obligation and the underlying exposure. Nonetheless, the position meets the requirements in Paragraph CA-4.5.3 (g);
      (b) The position is captured in Paragraph CA-9.2.12 under (a) or CA-9.2.13 but there is a currency or maturity mismatch47 between the credit protection and the underlying asset; or
      (c) The position is captured in Paragraph CA-9.2.13 but there is an asset mismatch between the cash position and the credit derivative. However, the underlying asset is included in the (deliverable) obligations in the credit derivative documentation.

      47 Currency mismatches should feed into the normal reporting of foreign exchange risk.

      January 2015

    • CA-9.2.15

      In each of these cases in Paragraphs CA-9.2.12 to CA-9.2.14, the following rule applies. Rather than adding the specific risk capital requirements for each side of the transaction (i.e. the credit protection and the underlying asset) only the higher of the two capital requirements will apply.

      January 2015

    • CA-9.2.16

      In cases not captured in Paragraphs CA-9.2.12 to CA-9.2.14, a specific risk capital charge must be assessed against both sides of the position.

      January 2015

    • CA-9.2.17

      An n-th-to-default credit derivative is a contract where the payoff is based on the n-th asset to default in a basket of underlying reference instruments. Once the n-th default occurs the transaction terminates and is settled:

      (a) The capital charge for specific risk for a first-to-default credit derivative is the lesser of (1) the sum of the specific risk capital charges for the individual reference credit instruments in the basket, and (2) the maximum possible credit event payment under the contract. Where a conventional bank licensee has a risk position in one of the reference credit instruments underlying a first-to-default credit derivative and this credit derivative hedges the conventional bank licensee's risk position, the conventional bank licensee is allowed to reduce with respect to the hedged amount both the capital charge for specific risk for the reference credit instrument and that part of the capital charge for specific risk for the credit derivative that relates to this particular reference credit instrument. Where a conventional bank licensee has multiple risk positions in reference credit instruments underlying a first-to-default credit derivative this offset is allowed only for that underlying reference credit instrument having the lowest specific risk capital charge;
      (b) The capital charge for specific risk for an n-th-to-default credit derivative with n greater than one is the lesser of (1) the sum of the specific risk capital charges for the individual reference credit instruments in the basket but disregarding the (n-1) obligations with the lowest specific risk capital charges; and (2) the maximum possible credit event payment under the contract. For n-th-to-default credit derivatives with n greater than 1 no offset of the capital charge for specific risk with any underlying reference credit instrument is allowed;
      (c) If a first or other n-th-to-default credit derivative is externally rated, then the protection seller must calculate the specific risk capital charge using the rating of the derivative and apply the respective securitisation risk weights as specified in Paragraph CA-9.2.11B; and
      (d) The capital charge against each net n-th-to-default credit derivative position applies irrespective of whether the conventional bank licensee has a long or short position, i.e. obtains or provides protection.
      January 2015