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  • CA-14.4 CA-14.4 Specification of Market Risk Factors

    • CA-14.4.1

      An important part of a conventional bank licensee's internal market risk measurement system is the specification of an appropriate set of market risk factors, i.e. the market rates and prices that affect the value of the conventional bank licensee's trading positions. The risk factors contained in a market risk measurement system must be sufficient to capture the risks inherent in the conventional bank licensee's portfolio of on- and off-balance-sheet trading positions. Conventional bank licensees must follow the CBB's guidelines, set out below, for specifying the risk factors for their internal models. Where a conventional bank licensee has difficulty in specifying the risk factors for any currency or market within a risk category, in accordance with the following guidelines, the conventional bank licensee must immediately contact the CBB. The CBB will review and discuss the specific circumstances of each such case with the concerned bank, and will decide alternative methods of calculating the risks which are not captured by the conventional bank licensee's model:

      (a) Factors that are deemed relevant for pricing must be included as risk factors in the value-at-risk model. Where a risk factor is incorporated in a pricing model but not in the value-at-risk model, the conventional bank licensees must justify this omission to the satisfaction of the CBB. In addition, the value-at-risk model must capture nonlinearities for options and other relevant products (e.g. mortgage backed securities, tranched exposures or n-th-to-default credit derivatives), as well as correlation risk and basis risk (e.g. between credit default swaps and bonds). Moreover, the CBB has to be satisfied that proxies are used which show a good track record for the actual position held (i.e. an equity index for a position in an individual stock).
      (b) For interest rates:
      (i) There must be a set of risk factors corresponding to interest rates in each currency in which the conventional bank licensee has interest-rate-sensitive on- or off-balance-sheet positions;
      (ii) The risk measurement system must model the yield curve using one of a number of generally accepted approaches, for example, by estimating forward rates of zero coupon yields. The yield curve must be divided into various maturity segments in order to capture variation in the volatility of rates along the yield curve; there will typically be one risk factor corresponding to each maturity segment. For material exposures to interest rate movements in the major currencies and markets, conventional bank licensees must model the yield curve using a minimum of six factors. However, the number of risk factors used must ultimately be driven by the nature of the conventional bank licensee's trading strategies. For instance, a conventional bank licensee which has a portfolio of various types of securities across many points of the yield curve and which engages in complex arbitrage strategies would require a greater number of risk factors to capture interest rate risk accurately;
      (iii) The risk measurement system must incorporate separate risk factors to capture spread risk (e.g. between bonds and swaps). A variety of approaches may be used to capture the spread risk arising from less than perfectly correlated movements between government and other fixed-income interest rates, such as specifying a completely separate yield curve for non-government fixed-income instruments (for instance, swaps or municipal securities) or estimating the spread over government rates at various points along the yield curve;
      (c) For exchange rates (which includes gold):
      (i) The risk measurement system should incorporate risk factors corresponding to the individual foreign currencies in which the conventional bank licensee's positions are denominated. Since the value-at-risk figure calculated by the risk measurement system will be expressed in the conventional bank licensee's reporting currency, any net position denominated in a currency other than the reporting currency will introduce a foreign exchange risk. Thus, there must be risk factors corresponding to the exchange rate between the reporting currency and each other currency in which the conventional bank licensee has a significant exposure;
      (d) For equity prices:
      (i) There must be risk factors corresponding to each of the equity markets in which the conventional bank licensee holds significant positions;
      (ii) At a minimum, there must be a risk factor that is designed to capture market-wide movements in equity prices (e.g., a market index). Positions in individual securities or in sector indices may be expressed in "beta-equivalents" relative to this market-wide index;
      (iii) A somewhat more detailed approach would be to have risk factors corresponding to various sectors of the overall equity market (for instance, industry sectors or cyclical and non-cyclical sectors). As above, positions in individual stocks within each sector could be expressed in "beta-equivalents" relative to the sector index;
      (iv) The most extensive approach would be to have risk factors corresponding to the volatility of individual equity issues; and
      (v) The sophistication and nature of the modelling technique for a given market must correspond to the conventional bank licensee's exposure to the overall market as well as its concentration in individual equity issues in that market; and
      (e) For commodity prices:
      (i) There must be risk factors corresponding to each of the commodity markets in which the conventional bank licensee holds significant positions (also see Section CA-12.1);
      (ii) For conventional bank licensees with relatively limited positions in commodity-based instruments, a straightforward specification of risk factors is acceptable. Such a specification would likely entail one risk factor for each commodity price to which the conventional bank licensee is exposed. In cases where the aggregate positions are reasonably small, it may be acceptable to use a single risk factor for a relatively broad sub-category of commodities (for instance, a single risk factor for all types of oil). However, conventional bank licensees which propose to use this simplified approach must obtain the prior written approval of the CBB; and
      (iii) For more active trading, the model must also take account of variation in the "convenience yield" between derivatives positions such as forwards and swaps and cash positions in the commodity.
      January 2015