5.The capital charges, as explained below, for interest rate related instruments and equities would apply to the trading book. The capital charges for foreign exchange risk and for commodities risk will apply to banks’ total currency and commodity positions.

6.Banks must have clearly defined policies and procedures for determining which exposures to include in, and to exclude from, the trading book for purposes of calculating their regulatory capital, to ensure compliance with the criteria for trading book set forth in this Standard and taking into account the bank’s risk management capabilities and practices. These policies and procedures must be fully documented and subject to periodic internal audit, and at a minimum address the general considerations listed below:

• •The activities the bank considers to be trading and as constituting part of the trading book for regulatory capital purposes;
• •The extent to which an exposure can be marked-to-market daily by reference to an active, liquid two-way market;
• •For exposures that are marked-to-model, the extent to which the bank can:
  • –Identify the material risks of the exposure;
  • –Hedge the material risks of the exposure and the extent to which hedging instruments would have an active, liquid two-way market;
  • –Derive reliable estimates for the key assumptions and parameters used in the model.
• •The extent to which the bank can and is required to generate valuations for the exposure that can be validated externally in a consistent manner;
• •The extent to which legal restrictions or other operational requirements would impede the bank’s ability to effect an immediate liquidation of the exposure;
• •The extent to which the bank is required to, and can, actively risk manage the exposure within its trading operations; and
• •The extent to which the bank may transfer risk or exposures between the banking and the trading books and criteria for such transfers.

7.The following will be the basic requirements for positions eligible to receive trading book capital treatment:

• •Clearly documented trading strategy for the position/instrument or portfolios, approved by senior management (which would include expected holding horizon);
• •Clearly defined policies and procedures for the active management of the position, which must include;
  • –positions are managed on a trading desk;
  • –position limits are set and monitored for appropriateness;
  • –dealers have the autonomy to enter into/manage the position within agreed limits and according to the agreed strategy;
  • –positions are marked to market at least daily and when marking to model the parameters must be assessed on a daily basis;
  • –positions are reported to senior management as an integral part of the institution’s risk management process; and
  • –positions are actively monitored with reference to market information sources (assessment should be made of the market liquidity or the ability to hedge positions or the portfolio risk profiles). This would include assessing the quality and availability of market inputs to the valuation process, level of market turnover, sizes of positions traded in the market, etc; and
• •Clearly defined policy and procedures to monitor the positions against the bank’s trading strategy including the monitoring of turnover and stale positions in the bank’s trading book.

8.Term trading-related repo-style transactions that meet the requirements for trading- book treatment as stated in the paragraph above may be included in the bank’s trading book for regulatory capital purposes even if a bank accounts for those transactions in the banking book. If the bank does so, all such repo-style transactions must be included in the trading book, and both legs of such transactions, either cash or securities, must be included in the trading book. Regardless of where they are booked, all repo-style transactions are subject to a credit risk capital requirement under the Central Bank’s Standard for Credit Risk Capital.

9.When a bank hedges a banking book credit risk exposure using a credit derivative booked in its trading book (i.e. using an internal hedge), the banking book exposure is not deemed to be hedged for capital purposes unless the bank purchases from an eligible third party protection provider a credit derivative meeting the requirements in the Central Bank’s Standard for Credit Risk Capital. Where such third party protection is purchased and is recognized as a hedge of a banking book exposure for regulatory capital purposes, neither the internal nor external credit derivative hedge would be included in the trading book for regulatory capital purposes.

10.Positions in the bank’s own eligible regulatory capital instruments are deducted from capital. Positions in other banks’, securities firms’, and other financial entities’ eligible regulatory capital instruments, as well as intangible assets, will receive the same treatment as that set down by the Central Bank for such assets held in the banking book. Where a bank demonstrates to the Central Bank that it is an active market maker, then the Central Bank may establish a dealer exception for holdings of other banks’, securities firms’, and other financial entities’ capital instruments in the trading book. In order to qualify for the dealer exception, the bank must have adequate systems and controls surrounding the trading of financial institutions’ eligible regulatory capital instruments.

11.For the purposes of these Standards, the correlation trading portfolio incorporates securitisation exposures and nth-to-default credit derivatives that meet the following criteria:

• •The positions are neither resecuritisation positions, nor derivatives of securitisation exposures that do not provide a pro-rata share in the proceeds of a securitisation tranche; and
• •All reference entities are single-name products, including single-name credit derivatives, for which a liquid two-way market exists. This includes commonly traded indices based on these reference entities. Positions that reference an underlying that would be treated as a retail exposure, a residential mortgage exposure, or a commercial mortgage exposure under the standardized approach to credit risk are not included in the correlation-trading portfolio. Positions that reference a claim on a special purpose entity also are not included. A bank may include in the correlation trading portfolio positions that are hedges of securitisation exposures or nth-to-default credit derivatives, but that are not themselves either securitisation exposures or nth-to-default credit derivatives, where a liquid two-way market exists for the instrument or its underlying.

1.Interest rate risk

12.This Standard describes the framework for measuring the risk of holding or taking positions in debt securities and other interest rate related instruments in the trading book. The instruments covered include all fixed-rate and floating-rate debt securities and instruments that behave like them, including non-convertible preference shares. Banks should treat convertible bonds as debt securities if they trade like debt securities and as equities if they trade like equities.

13.The minimum capital requirement is expressed in terms of two separately calculated charges, one applying to the “specific risk” of each security, whether it is a short or a long position, and the other to the interest rate risk in the portfolio (“general mark

et risk”) where long and short positions in different securities or instruments can be offset.

Specific risk

14.In measuring the capital charge for specific risk, offsetting of long and short positions is restricted to matched positions in the identical issue (including positions in derivatives). No offsetting is permitted between different issues, even if the issuer is the same.
 

15.The specific risk capital charges for interest rate risk are as specified in Table 1 below.

Table 1: Specific Risk Charges for Interest Rate Risk

16.The category “government” includes all forms of government paper as defined in the Central Bank’s Standard for Credit Risk. Exposure to the Federal Government and Emirates Government receive 0% risk weight, if such exposures are denominated and funded in AED or USD for a transition period of 7 years from the date of implementation of this Standard. After the transition period, 0% risk weights are only applied to exposures that are denominated and funded in AED. In general, only government debt rated AA- or better is eligible for the 0% specific risk charge. However, for debt rated below AA-, when the government paper is denominated in the domestic currency and funded by the bank in the same currency, the Central Bank uses national discretion to apply a 0% specific risk charge.²¹ The national discretion is limited to GCC Sovereigns.

17.The “qualifying” category includes securities issued by public sector entities and multilateral development banks, plus other securities that are rated investment-grade by at least two credit rating agencies recognized by the Central Bank for this purpose per Central Bank standards, or are rated investment-grade by one rating agency and not less than investment-grade by any other rating agency recognized by the Central Bank. Unrated securities may be considered “qualifying” subject to Central Bank approval on a case-by-case basis if the bank deems them to be of comparable investment quality and the issuer has securities listed on a recognized stock exchange. Unrated securities that are considered “qualifying” by the Central Bank can be recategorised from time to time if the Central Bank deems this necessary.

18.The specific risk charges stated in Table 1 for instruments issued by a non-qualifying issuer may considerably underestimate the specific risk for certain debt instruments with a high yield to redemption relative to government debt securities. In such cases, the Central Bank may direct a bank to apply a higher specific risk charge to such instruments, and/or to disallow offsetting of general market risk between such instruments and any other debt instruments.

19.Banks must determine the specific risk capital charge for the correlation trading portfolio by computing (i) the total specific risk capital charges that would apply just to the net long positions from the net long correlation trading exposures combined, and (ii) the total specific risk capital charges that would apply just to the net short positions from the net short correlation trading exposures combined. The larger of these two amounts in terms of domestic currency is then the specific risk capital charge for the correlation-trading portfolio.

Specific risk rules for positions covered under the securitisation framework

20.The specific risk charges for securitisation exposures held in the trading book are based on the risk weights assigned to securitisation exposures under the Central Bank’s Standard on Required Capital for Securitisation Exposures. Specifically, banks should determine the applicable risk weight applied to such positions in the banking book, and multiply the result by 8% to obtain the specific risk charge for the trading book exposure.
 

21.A securitisation exposure subject to a risk weight of 1250% under the Central Bank requirements (and therefore to a 100% specific risk charge under this Standard) may be excluded from the calculation of capital for general market risk.

Limitation of the specific risk capital charge to the maximum possible loss

22.Banks may limit the capital required for an individual position in a credit derivative or securitisation instrument to the maximum possible loss. For a short risk position, this limit can be calculated as the change in value due to the underlying names immediately becoming default risk-free. For a long risk position, the maximum possible loss could be calculated as the change in value in the event that all the underlying names were to default with zero recoveries. The maximum possible loss must be calculated for each individual position.
 

Specific risk capital charges for positions hedged by credit derivatives

23.Full allowance and offset can be recognized when the values of two legs, that is, long and short, always move in opposite directions and move broadly to the same extent. This would be the case when the two legs consist of completely identical instruments (e.g. two instruments with exactly the same issuer, coupon, currency, and maturity), or when 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 cash position. (The maturity of the swap itself may be different from that of the underlying exposure.) In these cases, no specific risk capital requirement applies to either side of the position.
 

24.An 80% offset can be recognized when the value of long and short legs always move in opposite directions, but do not move 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 of the underlying exposure. In addition, key features of the credit derivative contract 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, that is taking account of restrictive payout provisions such as fixed payouts and materiality thresholds, an 80% specific risk offset can be applied to the side of the transaction with the higher capital charge, while the specific risk requirement on the other side is zero.

25.Partial allowance and offset can be recognized when the value of the long and short legs usually, but not necessarily always, move in opposite directions. This is the case in the following situations:

• •The position would meet the conditions for full allowance but there is not an exact match between the reference obligation and the underlying exposure; the position otherwise meets the operational requirements for credit derivatives for credit risk mitigation under the Central Bank’s Standard for Credit Risk Capital.
• •The position would meet the conditions for full allowance but there is a currency or maturity mismatch between the credit protection and the underlying asset.
• •The position would meet the conditions for full allowance 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.

In each of the cases above, rather than adding the specific risk capital requirements for each side of the transaction (i.e. the credit protection and the underlying asset), the bank can apply only the higher of the two capital requirements. Otherwise, in cases that do not meet the conditions above, a specific risk capital charge must be assessed against both sides of the position.

26.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 bank has a risk position in one of the reference credit instruments underlying a first-to-default credit derivative and this credit derivative hedges the bank’s risk position, the bank may 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 bank 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.

27.For nth-to-default credit derivatives with n greater than one, no offset of the capital charge for specific risk with any underlying reference credit instrument is allowed. If the nth-to-default credit derivative is externally rated, then the protection seller must calculate the specific risk capital charge using the approach applied for securitisation exposures held in the trading book. Specifically, banks should determine the applicable risk weight applied to such positions as securitisation exposures in the banking book, and multiply the result by 8% to obtain the specific risk charge for the derivative exposure. Otherwise, the capital charge for specific risk for nth-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. The capital charge for nth-to-default credit derivative positions applies irrespective of whether the bank has a long or short position, that is, whether the bank obtains or provides protection.

General market risk

28.For general market risk, positions are slotted into time bands. The capital charge is the sum of four components calculated from amounts in each time band:

• •The net short or long position in the whole trading book;
• •A small proportion of the matched positions in each time-band (the “vertical disallowance”);
• •A larger proportion of the matched positions across different time-bands (the “horizontal disallowance”); and
• •Where applicable, a net charge for positions in options.

29.A bank can choose between two principal methods of slotting positions into time bands for general market risk: a “maturity” method and a “duration” method.

30.In the maturity method, long or short positions in debt securities and other sources of interest rate exposures including derivative instruments are slotted into a maturity ladder comprising thirteen time-bands (or fifteen time-bands in case of low coupon instruments). Fixed rate instruments must be allocated according to the residual term to maturity and floating-rate instruments according to the residual term to the next repricing date. Opposite positions of the same amount in the same issues (but not different issues by the same issuer), whether actual or notional, can be omitted from the interest rate maturity framework, as can closely matched swaps, forwards, futures, and forward rate agreements (FRAs) that meet the conditions set out below in this Standard on allowable offsetting of matched positions.

31.The first step in the calculation is to weight the positions in each time-band by a risk weight designed to reflect the price sensitivity of those positions to assumed changes in interest rates. The weights for each time-band are set out in the risk-weight column of Table 2. Zero-coupon bonds and deep-discount bonds (defined as bonds with a coupon of less than 3%) should be slotted according to the time-bands set out in the column labeled “Coupon less than 3%” in Table 2.

Table 2: Risk Weights and Assumed Yield Changes for General Market Risk, by Zone and Time Band

32.The next step in the calculation is to offset the weighted longs and shorts in each time-band, resulting in a single short or long position for each band. A 10% capital charge to reflect basis risk and gap risk – the vertical disallowance – is levied on the smaller of the offsetting long or short positions in each time-band. The result is two sets of weighted positions, the net long or short positions in each time-band and the vertical disallowances, which have no sign.

33.Next, banks are allowed to conduct two rounds of “horizontal offsetting,” subject to disallowances expressed as a fraction of the matched positions. First, the weighted long and short positions in each of three zones identified in Table 2 may be offset, subject to the matched portion attracting a within-zone disallowance factor that is part of the capital charge:

34.Second, the residual net position in each zone may be carried over and offset against opposite positions in other zones, subject to a second set of disallowance factors that apply between zones:

35.Under the alternative duration method, banks with the necessary capability may, with the Central Bank’s consent, calculate the price sensitivity of each position separately. Banks must elect and use this method on a continuous basis unless a change in method is approved by the Central Bank. To apply the duration method, banks should apply the following steps in order:

• •Calculate the price sensitivity of each instrument in terms of a change in interest rates of between 0.6 and 1.0 percentage points depending on the maturity of the instrument per the last column of Table 2;
• •Slot the resulting sensitivity measures into the fifteen time-bands set out in the “Coupon less than 3%” column of Table 2;
• •Subject long and short positions in each time-band to a 5% vertical disallowance to reflect basis risk; and
• •Carry forward the net positions in each time-band for horizontal offsetting subject to the within-zone and between-zone horizontal disallowances specified above.

36.Under either the maturity method or the duration method, separate maturity ladders should be used for each currency, and capital charges should be calculated for each currency separately and then summed with no offsetting across currencies between positions of opposite sign.

37.In the case of currencies in which business is insignificant, the bank may construct a single maturity ladder, and slot within each appropriate time-band the net long or short position for each currency. However, these individual net positions must be summed within each time-band, irrespective of whether they are long or short positions, to produce a gross position figure. These gross positions in each time band are then subject to the risk weights from Table 2, with no further offsetting permitted.

Interest rate derivatives

38.Interest rate risk calculations for market risk capital should include all interest rate derivatives and off-balance-sheet instruments held in the trading book that respond to changes in interest rates. The derivatives should be converted into equivalent positions in the relevant underlying, and then be subject to the specific and general market risk requirements as described above. Amounts reported should be the market value of the notional amount of the underlying or of the notional underlying. For instruments where the apparent notional amount differs from the effective notional amount, banks must use the effective notional amount.

39.Futures and forward contracts, including forward rate agreements, should be treated as a combination of a long position and a short position in a notional government security. The contractual period until delivery or exercise of a future or FRA, plus the life of the underlying instrument where applicable, should be used as the maturity. Where a range of deliverable instruments may be delivered to fulfil the contract, the bank can choose which deliverable security goes into the maturity or duration ladder, but should take into account any conversion factor defined by the exchange. In the case of a future on a corporate bond index, the position should be included in the maturity or duration ladder at the market value of the notional underlying portfolio of securities.

40.Swaps should be treated as two notional positions in government securities with relevant maturities. For swaps that pay or receive a fixed or floating interest rate against some other reference price such as an equity price, the interest rate component should be slotted into the appropriate repricing maturity category, with the equity component being included in the equity framework. The separate legs of cross-currency swaps are to be reported in the relevant maturity ladders for the currencies concerned.

Allowable offsetting of matched positions

41.If a bank has matching long and short positions in the trading book, where both actual and notional match in identical instruments with exactly the same issuer, coupon, currency and maturity, those positions may be excluded from interest rate capital framework altogether, for both specific and general market risk. A matched position in a future or forward and its corresponding underlying may be fully offset, and thus excluded from the calculation. When the future or forward comprises a range of deliverable instruments, offsetting of positions in the future or forward contract and its underlying is only permissible in cases where there is a readily identifiable underlying security that is most profitable for the trader with a short position to deliver. No offsetting is allowed between positions in different currencies; the separate legs of cross-currency swaps or forward foreign exchange deals are to be treated as notional positions in the relevant instruments and included in the appropriate calculation for each currency.

42.Under certain conditions, opposite positions in the same category of instruments, including options at their delta-equivalent value and the separate legs of different swaps, can be regarded as matched and allowed to offset fully. The positions must relate to the same underlying instruments, be of the same nominal value, and be denominated in the same currency. In addition:

1. (i)for futures: offsetting positions in the notional or underlying instruments to which the futures contract relates must be for identical products and mature within seven days of each other;
2. (ii)for swaps and FRAs: the reference rate (for floating rate positions) must be identical and the coupon closely matched (within 15 basis points); and
3. (iii)for swaps, FRAs and forwards: the next interest fixing date or, for fixed coupon positions or forwards, the residual maturity must correspond to one another within the following limits:
   1. (a)less than one month hence: must be same day;
   2. (b)between one month and one year hence: must be within seven days of one another; or
   3. (c)over one year hence: must be within thirty days of one another.

Specific risk for interest rate derivatives

43.Interest rate and currency swaps, FRAs, forward foreign exchange contracts, and interest rate futures are not subject to a specific risk charge. This exemption also applies to futures on an interest rate index. However, in the case of futures contracts where the underlying is a debt security, or an index representing a basket of debt securities, such a specific risk charge does apply.
 

General market risk for interest rate derivatives

44.General market risk applies to positions in all derivative products in the same manner as for cash positions, subject only to the allowable offsetting of fully or very closely matched positions in identical instruments as defined above in this Standard. The various categories of instruments should be slotted into the maturity ladder and treated according to the rules identified earlier.

45.Table 3 below presents a summary of the regulatory treatment for interest rate derivatives for market risk purposes. Note that a contract for which the underlying instrument is a government debt security rated AA- or better has no capital requirement for specific risk. Also, note that the specific risk charge relates to the issuer of the instrument that is referenced by the derivative contract; the derivative is still subject to a separate capital charge for counterparty credit risk under the Central Bank’s Standard for Counterparty Credit Risk.

Table 3: Summary of treatment of interest rate derivatives

2.Equity position risk

46.This section covers market risk capital for positions in equities held in the trading book. It applies to long and short positions in all instruments that exhibit market behavior similar to equities. It applies to common stocks – whether voting or non-voting – convertible securities that behave like equities, and commitments to buy or sell equity securities, but not to non-convertible preference shares.
 

47.As with debt securities, the minimum capital standards for equities includes two separately calculated charges, one for the “specific risk” of holding a long or short position in an individual equity, and one for the “general market risk” of holding a long or short position in the market as a whole. The requirements apply in modified form to equity derivative products, stock indices, and index arbitrage; the relevant modifications are described later in this Standard.

Specific and general market risk

48.Specific risk is calculated as a percentage of the bank’s gross equity positions, that is, the sum of all long equity positions and all short equity positions, summed without regard to sign (that is, the sum of the absolute values of the positions in each equity). The capital charge for specific risk is calculated as 8% of gross equity positions.

49.General market risk is calculated based on overall net position in an equity market, which is the difference between the sum of the longs and the sum of the shorts. The capital charge for general market risk is calculated as 8% of overall net equity positions.

50.Long and short positions in the same issue may be reported on a net basis. The long or short position in the market must be calculated on a market-by-market basis, that is, a separate calculation has to be carried out for each national market in which the bank holds equities.

Equity derivatives

51.Equity derivatives and off-balance-sheet positions that are affected by changes in equity prices should be included in the measurement system, with the exception of certain options positions as described further below. This includes futures and swaps on both individual equities and on stock indices.

Calculation of positions

52.To calculate specific and general market risk, derivatives are converted into equivalent positions in the relevant underlying. Positions in derivatives should be converted into notional equity positions as follows:

• •Futures and forward contracts relating to individual equities should be reported at current market prices;
• •Futures relating to stock indices should be reported as the marked-to-market value of the notional underlying equity portfolio;
• •Equity swaps should be treated as two notional positions; and
• •Equity options and stock index options should either be “carved out” together with the associated underlying or be incorporated in the measure of general market risk described in this section according to the delta-plus method.

53.Matched positions in each identical equity or stock index in each market may be fully offset, resulting in a single net short or long position to which the specific and general market risk charges will apply. For example, a future in a given equity may be offset against an opposite cash position in the same equity. Any interest rate risk arising out of the future, however, should be treated per the requirements for interest rate risk in the trading book.

Specific Risk and General Market Risk for Equity Derivatives

54.Table 4 below presents a summary of the regulatory treatment for equity derivatives for market risk purposes. Note that derivatives are also subject to a separate capital charge for counterparty credit risk under the Central Bank’s Standard for Counterparty Credit Risk.

Table 4: Summary of treatment of equity derivatives

55.In addition to the general market risk requirement, a further capital charge of 2% must be applied to the net long or short position in index contracts on a diversified portfolio of equities, to cover factors such as execution risk.

56.Where a bank engages in a deliberate arbitrage strategy under which a basket of stocks is matched against a futures contract on a broadly-based index, a modified capital requirement applies, provided:

• •The trade has been deliberately entered into and separately controlled as part of the strategy; and
• •The composition of the basket of stocks represents at least 90% of the index when broken down into its notional components.

In such a case, the capital requirement is 2% of the gross value of the positions on each side. This requirement applies even if all of the stocks comprising the index are held in identical proportions. Any excess value of the stocks comprising the basket over the value of the futures contract or excess value of the futures contract over the value of the basket must be treated as an open long or short equity position.

57.However, on certain futures-related arbitrage strategies, the additional 2% capital charge is applied to only one side of the trade, with the opposite position exempt from this capital charge. This special treatment applies:

• •When a bank takes an opposite position in exactly the same index at different dates or in different market centers; or
• •When a bank has opposite positions in contracts involving different but similar indices at the same date (in which case, the Central Bank may determine whether the two indices in such a strategy are sufficiently similar, with sufficient common components).

58.A bank with a position in depository receipts against an opposite position in the underlying equity, or identical equities in different markets, may offset the positions the long and short positions, provided that any costs on conversion are fully taken into account. (Such trades may also introduce foreign exchange risk requiring market risk capital.)

3.Foreign exchange risk

59.This section sets out minimum capital standards to cover the risk of holding or taking positions in foreign currencies, including gold. Gold is treated as a foreign exchange position for purposes of market risk rather than as a commodity, because its volatility is more in line with foreign currencies and because banks typically manage gold exposures in a similar manner to foreign currencies. These requirements apply to all foreign currency and gold exposures throughout the entire bank, in both the trading book and the banking book.

Measuring the exposure in a single currency

60.The bank’s net open position in each currency, long or short, should be calculated by summing:

• •The net spot position calculated as all asset items less all liability items denominated in a given currency, including accrued interest and accrued expenses;
• •The net forward position calculated as all amounts to be received less all amounts to be paid under forward foreign exchange transactions in a given currency, including currency futures and the principal on currency swaps not included in the spot position;
• •Guarantees (and similar instruments) in the given currency that are certain to be called and are likely to be irrecoverable;
• •At the discretion of the reporting bank, net future income and expenses not yet accrued but already fully hedged;
• •Any other item representing a profit or loss in foreign currencies; and
• •The net delta-based equivalent of the total book of foreign currency options. (Options are also subject to additional considerations as described below in this Standard.)

61.Expected but unearned future interest and expenses may be excluded unless the amounts are certain and have been hedged. If a bank includes future income and expenses, it must do so on a consistent basis, and is not permitted to select only those expected future flows that reduce required capital.

62.Positions in composite currencies (such as SDRs or synthetic currencies) should be separately reported, but may be either treated as currencies in their own right or split into their component parts for measuring the bank’s open positions. While either approach may be used, the selected approach should be used consistently by the bank.

63.Positions (either spot or forward) in gold should first be expressed in common units (e.g. kilos or pounds), with the net position converted at current spot rates into UAE Dirham equivalent value. Where gold is part of a forward contract (quantity of gold to be received or to be delivered), any interest rate or foreign currency exposure from the other leg of the contract should be reported as set out for interest rate and currency exposures under this Standard.

64.Forward positions may be valued at current spot market exchange rates. However, banks that use net present values of positions in their normal management accounting are expected to use those net present values, discounted using current interest rates and valued at current spot rates, for measuring their forward currency and gold positions.

65.Items that are deducted from a bank’s capital when calculating its capital base, such as investments in non-consolidated subsidiaries, or other long-term participations denominated in foreign currencies, which are reported in the published accounts at historic cost, do not need to be included as foreign currency exposures for the foreign exchange risk calculation.

66.When assessing foreign exchange risk on a consolidated basis, it may be technically impractical in the case of some marginal operations to include the currency positions of some foreign branches or subsidiaries. In such cases, the bank may use an established internal position limit in each currency as a proxy for the actual position, provided there is adequate ex-post monitoring of actual positions against such limits to confirm that the limits are effective. The bank should add the limits, without regard to sign, to the net open position in each currency.

67.Banks should convert the nominal amount (or net present value) of the net position in each foreign currency and in gold at current spot rates into UAE Dirham (AED) equivalent for purposes of reporting and capital calculations.

Measuring market risk for foreign exchange positions

68.Calculation of market risk capital for foreign currency positions is based on the net open positions in foreign currencies and in gold. For purposes of market risk capital requirements, the Central Bank takes into account the stable relationship between the AED and the US dollar, which results in UAE banks facing no material foreign exchange market risk with respect to open US dollar positions.
 

69.A bank should calculate its overall net open foreign exchange position for the bank as follows:

• •Calculate the sum of all net short foreign currency positions, and the sum of all net long foreign currency positions, excluding the net open position in the US dollar.
• •Take the larger of the two sums, from the step above, and add the absolute value of the net position (short or long) in gold.

The capital charge for foreign exchange market risk is 8% of the position resulting from the calculation above.

70.A bank doing negligible business in foreign currency that does not take foreign exchange positions for its own account may, at the discretion of the Central Bank, be exempted from capital requirements on these positions provided that:

• •Its foreign currency business, measured as the greater of the sum of its gross long positions and the sum of its gross short positions in all foreign currencies including the US dollar, does not exceed 100% of total capital; and
• •Its overall net open foreign exchange position as defined in this section does not exceed 2% of total capital.

4.Commodities risk

71.This section establishes a minimum capital standard to cover the risk of holding or taking positions in commodities, including precious metals but excluding gold. Banks may choose between two alternative approaches for measuring commodities position risk: a maturity ladder approach based on seven time-bands, and a simplified approach.

72.Under either approach, long and short positions may be offset to calculate open positions in each commodity. Banks first express each commodity position (spot plus forward) in a standard unit of measurement (barrels, kilos, grams etc.), then convert the net position in each commodity into a value in AED at current spot rates. For markets that have daily delivery dates, any contracts maturing within ten days of one another may be offset.

73.In general, long and short positions in different commodities may not be offset. However, the Central Bank permits banks to offset long and short positions in different commodities within a given commodity type in cases where the commodities are deliverable against one another, where “commodity type” has the meaning as defined in the Counterparty Credit Risk Standard. The Central Bank may also permit offsetting if the commodities are close substitutes for each other and a minimum correlation of 0.9 between their price movements can be clearly established by the bank over a minimum period of one year. However, a bank basing its capital calculation on correlations must satisfy the Central Bank of the accuracy of the method chosen for assessing correlation, and must obtain the Central Bank’s prior approval. In addition, the bank must have an approved process for identifying commodity types under the Counterparty Credit Risk Standard.²²

74.All commodity derivatives and off-balance-sheet positions that are affected by changes in commodity prices should be included in this measurement framework. This includes commodity futures, commodity swaps, and options where the “delta plus” method is used. In order to calculate the risk, commodity derivatives should be converted into notional commodities positions and assigned to maturities as follows:

• •Futures and forward contracts relating to individual commodities should be incorporated in the measurement system as notional amounts of barrels, kilos etc. and should be assigned a maturity with reference to expiry date.
• •Commodity swaps where one leg is a fixed price and the other is the current market price should be incorporated as a series of positions equal to the notional amount of the contract, with one position corresponding to each payment on the swap and slotted into the maturity ladder accordingly. The positions would be long positions if the bank is paying fixed and receiving floating, and short positions if the bank is receiving fixed and paying floating.

75.Banks should incorporate commodity swaps where the legs are in different commodities into the relevant maturity ladder, with no offsetting allowed.

Maturity ladder approach

76.Under the maturity ladder approach, the bank assigns positions in each commodity to one of seven time bands, as shown in Table 5 below. Banks must use a separate maturity ladder for each commodity. Holdings of physical stocks of any commodity should be allocated to the shortest time band (that is, 0-1 month).

Table 5: Time-bands for the maturity ladder

77.Capital for commodity market risk consists of two broad components: a set of capital charges on the gross positions (long plus short) in each time band and capital charges against a series of net position calculations. Each component is described further below.

78.For the first component, the bank should calculate 1.5% of the gross position (long plus short, without offsetting) in each of the seven time bands, and sum the results across time bands.

79.For the second component, the bank should first calculate 0.6% of the net position (the absolute value of the difference between long and short positions) in time band 1. To this, the bank should add 0.6% of the net position in time bands 1 and 2 combined. The bank should do the same for time bands 1 through 3 combined, 1 through 4 combined, 1 through 5 combined, and 1 through 6 combined, each time adding 0.6% of the calculated net position. Finally, the bank should add 15% of the net position across all time bands (1 through 7).

80.Required capital for commodity market risk is then the sum of the two broad components calculated per the two paragraphs above.

Simplified approach

81.Under the simplified approach, the capital charge is set at 15% of the net position, long or short, in each commodity. However, each commodity is subject to an additional capital charge of 3% of the bank’s gross position - long plus short - in that particular commodity. In valuing the gross positions in commodity derivatives for this purpose, banks should use the current spot price.
 

5.Treatment of options

82.Two alternative approaches apply to options. Banks with purchased options only (rather than written or sold options) can choose to use a simplified approach described below. Banks with more complex option positions that also write options must use the delta- plus approach rather than the simplified approach.

83.If a bank has written option positions, but all of those written options are hedged by perfectly matched long positions in exactly the same options, no capital is required for market risk on those options.

Simplified approach

84.Under the simplified approach, banks use the following treatments for option positions as noted:

Purchased call or purchased put: The capital charge is the lesser of (1) the market value of the underlying security multiplied by the sum of specific and general market risk charges for the underlying, or (2) the market value of the option. Where the position does not fall within the trading book (i.e. options on certain foreign exchange or commodities positions not belonging to the trading book), it may be acceptable to use the book value instead of the market value.

Purchased put with a long position in the underlying cash instrument, or purchased call with a short position in the underlying cash instrument: The capital charge is the market value of the underlying security multiplied by the sum of specific and general market risk charges for the underlying, less the amount the option is in the money (if any), bounded at zero. For options with a residual maturity of more than six months, the strike price should be compared with the forward, not current, price. A bank unable to do this must take the in-the-money amount to be zero.

85.In some cases, such as foreign exchange, it may be unclear which side is the “underlying security.” In such cases, the asset that would be received if the option were exercised should be considered as the underlying. In addition, the nominal value should be used for items where the market value of the underlying instrument could be zero, such as caps and floors, swaptions, or similar instruments.

Delta-plus approach

86.Options should be included in market risk calculations for each type of risk as a delta-weighted position equal to the market value of the underlying multiplied by the delta.
 

87.For options with equities as the underlying, the delta-weighted positions should be incorporated into the equity market risk capital calculation described above in this Standard. For purposes of this calculation, each national market should be treated as a separate underlying. Similarly, the capital charge for options on foreign exchange and gold positions should be based on the method set out in the section on foreign exchange risk. The net delta-based equivalent of the foreign currency and gold options should be incorporated into the measurement of the exposure for the respective currency (or gold) position. The capital charge for options on commodities should be based on either the simplified or the maturity ladder approach.

88.Delta-weighted positions with debt securities or interest rates as the underlying should be slotted into the interest rate time-bands, using either the maturity method or the duration method, under the following procedure. A two-legged approach should be used as for other derivatives, requiring one entry at the time the underlying contract takes effect and a second at the time the underlying contract matures. For instance, a purchased call option on a June three-month interest-rate future should in April be considered, on the basis of its delta-equivalent value, to be a long position with a maturity of five months and a short position with a maturity of two months. A written option should be similarly slotted as a long position with a maturity of two months and a short position with a maturity of five months. Floating rate instruments with caps or floors should be treated as a combination of floating rate securities and a series of European-style options.

89.In addition to the capital charges arising from delta risk as described above, banks using the delta-plus approach are subject to capital charges for gamma and Vega risk as described below. Banks are required to determine the gamma and Vega for each option position (including hedge positions) separately. These sensitivities must be calculated using an approved exchange model, or using the bank’s proprietary options pricing models subject to oversight by the Central Bank. The capital charges should be calculated as follows:

1. (i)for each individual option a “gamma impact” should be calculated as:

   Gamma impact = ½ × Gamma × VU²
    

            where VU = Variation of the underlying of the option.

2. (ii)VU will be calculated as follows:
   • •For interest rate options if the underlying is a bond, the market value of the underlying should be multiplied by the risk weights set out in Table 2. An equivalent calculation should be carried out where the underlying is an interest rate, again based on the assumed changes in yield from Table 2;
   • •For options on equities and equity indices, the market value of the underlying should be multiplied by 8%;
   • •For foreign exchange and gold options, the market value of the underlying should be multiplied by 8%;
   • •For options on commodities, the market value of the underlying should be multiplied by 15%.
3. (iii)For the purpose of this calculation the following positions should be treated as the same underlying:
   • •For interest rates, each time-band as set out in Table 2;
   • •For equities and stock indices, each national market;
   • •For foreign currencies, each currency pair (and gold);
   • •For commodities, each individual commodity.
4. (iv)Each option on the same underlying will have a gamma impact that is either positive or negative. These individual gamma impacts should be summed; resulting in a net gamma impact for each underlying that is either positive or negative. Only those net gamma impacts that are negative should be included in the capital calculation.

90.The total gamma capital charge is the sum of the absolute value of the net negative gamma impacts as calculated above.

91.For volatility risk or Vega, banks are required to calculate the capital charges by multiplying the sum of the Vegas for all options on the same underlying, as defined above, by a proportional shift in volatility of +/-25%. The total capital charge for Vega risk is the sum of the absolute value of the individual capital charges that have been calculated for Vega risk.

²¹ This use of national discretion aligns the Market Risk Standard with the similar treatment under the Credit Risk Standard.

²² The Central Bank has exercised the national discretion provided under the BCBS framework to permit offsetting of long and short positions in closely related commodities under the conditions described in this Standards. The Central Bank believes that this approach provides appropriate recognition of the actual underlying risks, while requiring well-controlled processes to identify the relevant offsetting commodity positions. It also aligns the treatment of commodities under this Standards with the corresponding treatment of commodity positions with respect to market-driven exposure under the Central Bank’s counterparty credit risk requirements.

96.Banks must establish and maintain adequate systems and controls sufficient to give management and the Central Bank confidence that their valuation estimates are prudent and reliable. These systems must be integrated with other risk management systems within the organization (such as credit analysis). Such systems must include:

• •Documented policies and procedures for the process of valuation. This includes clearly defined responsibilities of the various areas involved in the determination of the valuation, sources of market information and review of their appropriateness, guidelines for the use of unobservable inputs reflecting the bank’s assumptions of what market participants would use in pricing the position, frequency of independent valuation, timing of closing prices, procedures for adjusting valuations, end of the month and ad-hoc verification procedures; and
• •Clear and independent (i.e. independent of front office) reporting lines for the department accountable for the valuation process. The reporting line should ultimately be to a main board executive director.

1.Marking to market

97.Marking to market is the at-least-daily valuation of positions at readily available close out prices that are sourced independently. Examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.

98.Banks must mark to market as much as possible. The more prudent side of a bid/offer spread should be used unless the institution is a significant market maker in a particular position type and it can close out at mid-market. Banks should maximize the use of relevant observable inputs and minimize the use of unobservable inputs when estimating fair value using a valuation technique. However, some observable inputs or transactions may not be relevant, such as in a forced liquidation or distressed sale, or transactions may not be observable, such as when markets are inactive. In such cases, the observable data should be considered, but may not be determinative.

2.Marking to model

99.Only where marking to market is not possible should banks mark to model, but this must be demonstrated to be prudent. Marking to model is defined as any valuation that has to be benchmarked, extrapolated, or otherwise calculated from a market input. When marking to model, an extra degree of conservatism is appropriate. The Central Bank will consider the following in assessing whether a mark-to-model valuation is prudent:

• •Senior management should be aware of the elements of the trading book or of other fair-valued positions that are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business.
• •Market inputs should be sourced, to the extent possible, in line with market prices (as discussed above). The appropriateness of the market inputs for the particular position being valued should be reviewed regularly.
• •Where available, generally accepted valuation methodologies for particular products should be used as far as possible.
• •Where the institution itself develops the model, it should be based on appropriate assumptions that have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. The model should be independently tested, including validation of the mathematics, the assumptions, and the software implementation.
• •There should be formal change control procedures in place, and a secure copy of the model should be held and periodically used to check valuations.
• •Risk management should be aware of the weaknesses or limitations of the models used, and should account for those model weaknesses or limitations when using the valuation output.
• •The model should be subject to periodic review to assess its performance (e.g. assessing continued appropriateness of the assumptions, analysis of P&L versus risk factors, comparison of actual close out values to model outputs).
• •Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation.

3.Independent price verification

100.Independent price verification is distinct from daily marking to market. It is the process by which market prices or model inputs are regularly verified for accuracy. While daily marking to market may be performed by dealers, verification of market prices or model inputs should be performed by a unit independent of the dealing room, at least monthly (or, depending on the nature of the market/trading activity, more frequently). It need not be performed as frequently as daily marking to market, since independent marking of positions should reveal any error or bias in pricing, which should result in the elimination of inaccurate daily marks.

101.Independent price verification entails a higher standard of accuracy in that the market prices or model inputs are used to determine profit and loss figures, whereas daily marks are used primarily for management reporting. For independent price verification, where pricing sources are more subjective, for example where there is only one available broker quote, prudent measures such as valuation adjustments may be appropriate.

4.Valuation adjustments

102.As part of their procedures for marking to market, banks must establish and maintain procedures for considering valuation adjustments. The Central Bank expects banks using third-party valuations to consider whether valuation adjustments are necessary. Such considerations are also necessary when marking to model.

103.The Central Bank expects the following valuation adjustments/reserves to be formally considered at a minimum: unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, and future administrative costs and, where appropriate, model risk.

104.Banks must establish and maintain procedures for judging the necessity of and calculating an adjustment to the current valuation of less liquid positions for regulatory capital purposes. This adjustment may be in addition to any changes to the value of the position required for financial reporting purposes and should be designed to reflect the illiquidity of the position. Banks should consider the need for an adjustment to a position’s valuation to reflect current illiquidity whether the position is marked to market using market prices or observable inputs, valued using third-party valuations, or marked to model. Such adjustments to the current valuation of less liquid positions should impact Tier 1 regulatory capital, and may exceed valuation adjustments made under financial reporting standards.

105.Bearing in mind that the assumptions made about liquidity in the market risk capital charge may not be consistent with the bank’s ability to sell or hedge out less liquid positions, where appropriate, banks must take an adjustment to the current valuation of these positions, and review their continued appropriateness on an on-going basis. Closeout prices for concentrated positions and/or stale positions should be considered in establishing the adjustment. Banks must consider all relevant factors when determining the appropriateness of the adjustment for less liquid positions. These factors may include, but are not limited to, the amount of time it would take to hedge out the position/risks within the position, the average volatility of bid/offer spreads, the availability of independent market quotes (number and identity of market makers), the average and volatility of trading volumes (including trading volumes during periods of market stress), market concentrations, the aging of positions, the extent to which valuation relies on marking to model, and the impact of other model risks.

106.For complex products such as securitisation exposures and nth-to-default credit derivatives, banks must explicitly assess the need for valuation adjustments to reflect both the model risk associated with using a possibly incorrect valuation methodology, and the risk associated with using unobservable (and possibly incorrect) calibration parameters in the valuation model.