6.Interest rate risk is the potential for losses in on- or off-balance sheet positions from adverse changes in interest rates. Instruments covered by the standardised approach for interest rate risk include all fixed rate and floating rate related instruments, such as debt securities, swaps, forwards and futures.

7.The standardised approach provides a framework for measuring interest rate risk. It takes into account the maturity or duration of the positions, basis risk, and certain correlations among risk factors.

8.Duration is a measure of the average maturity of a debt instrument's cash flows from both coupons and principal repayment. It is expressed in years and allows debt instruments with different coupons and maturities to be compared. Based on the duration, the sensitivity of a fixed income security's price with respect to a small change in its yield can be determined.

9.When hedging positions, basis risk is a key risk for the hedged position and needs to be managed and closely monitored.

Typically, two distinct components of market risk are recognised:

   1.General Market Risk

10.General market risk refers to changes in market prices resulting from general market behavior.

For example, in the case of an equity position, general market risk can arise from a change in a stock market index. In the case of a fixed income instrument, general market risk is driven by a change in the yield curve.

The capital charge for general market risk is designed to capture the risk of loss arising from adverse changes in market interest rates.

There are two steps for calculating the general market risk capital charge:

Step 1: Map each interest rate position to a time band

Interest rate positions have different price sensitivities to interest rate shifts depending on their residual maturity. Interest rate shifts are changes in the yield curve. Each interest rate position is mapped to a time band.

There are two methods for mapping interest rate positions:

a)Maturity method maps each position to a maturity ladder based on the residual maturity of each position.

Fixed weightings are used to adjust the positions for sensitivity to the changes in interest rates as per the relevant table under the standard.

Time Bands for the Maturity Method

1. •Fixed income instruments with low coupons have higher sensitivity to changes in the yield curve than fixed income instruments with high coupons, all other things being equal.
2. •Fixed income instruments with long maturities have higher sensitivity to changes in the yield curve than fixed income instruments with short maturities, all other things being equal.

This is why the maturity method uses a finer grid of time bands for low coupon instruments (less than 3%) with long maturities.

Fixed and Floating Rate Instruments

Fixed rate instruments are mapped according to the residual term to maturity. Floating rate instruments are allocated according to the residual term to the next repricing date.

b)Duration method

11.This method maps each position according to its duration to a duration ladder. Duration is a measure of the average maturity of a debt instrument’s cash flows from both coupons and principal repayment. It is expressed in years and allows debt instruments with different coupons and maturities to be compared. The duration method allows banks the necessary capability to calculate price sensitivity based on an instruments’ duration (with the supervisory consent).

Step 2: Calculate the capital charge

The capital charge is the sum of four components calculated from amounts in each time band:

:

1. •A charge on the net short or long position in the whole trading book:
2. •A vertical disallowance charge:

It is a charge, which is levied on the matched position in each time band. This charges accounts for basis risk and gap risk, which can arise because each time band includes different instruments with different maturities. Gap risk, or interest mismatch risk, is the risk of losses due to interest rate changes that arise when the periods over which assets and liabilities are priced, differs. This charge is levied on the matched position in each time band at:

1. •10% if the bank uses the maturity method
2. •5% of the bank uses the duration method

The matched position is the smaller absolute value of the long and short positions. For example: if you have a long position of 1,200 and a short position of 700, the matched position is 700 (the net open position is long 500).

1. •A horizontal disallowance charge:

It is a charge against correlation among the different time bands. It is allowed for correlation to offset positions across different time bands.

There are three rounds of horizontal disallowance:

1. •Round 1 levies a charge on the matched position in each zone. The charge is:
   1. o40% for zone 1
   2. o30% for zone 2 and zone 3
2. •Round 2 levies a charge of 40% on the matched positions between adjacent zones. The adjacent zones are:
   1. oZone 1 and zone 2
   2. oZone 2 and zone 3
3. •Round 3 levies a charge of 100% on the matched position between zone 1 and zone 3.
4. •Where applicable, a net charge for positions in options.

   2.Specific Risk

12.Specific risk refers to changes in market prices specific to an instrument owing to factors related to the issuer of that instrument.

13.Specific risk does not affect foreign exchange- and commodities-related instruments. This is because changes in FX rates and commodities prices are dependent on general market movements.

14.The charge for specific risk protects against price movements in a security owing to factors related to the individual issuer, that is, price moves that are not initiated by the general market.

a)Offsetting

15.When specific risk is measured, offsetting between positions is restricted.

1. •Offsetting is only permitted for matched positions in an identical issue.
2. •Offsetting is not allowed between different issues, even if the issuer is the same. This is because differences in coupon rates, liquidity, call features, and so on, mean that prices may diverge in the short run.

b)Specific Risk – Capital Charge

16.Under the standardised approach, market risk exposures are categorised according to external credit assessments (ratings) and based on those assessments a capital charge is assigned. This broad methodology for calculating the specific risk capital charge was not changed by Basel 2.5.

17.The capital charges assigned to those external credit assessments are similar to the credit risk charges under the standardised approach to credit risk.

Categorisation of Securities

18.Consistent with other sections, a lower specific risk charge can be applied to government paper denominated in the domestic currency and funded by the bank in the same currency. The national discretion is limited to GCC Sovereigns. This use of national discretion aligns the Market Risk Standards with the similar treatment under the credit risk standards. The Market Risk Standard is also aligned to the Credit Risk Standard when it comes to the transition period permitted for USD funded and denominated exposures of the individual Emirates.

Qualifying includes securities issued by public sector entities and multilateral development banks, plus other securities that are rated with investment grades by two rating agencies. Unrated securities can also be included, subject to supervisory approval (such as securities deemed to be of comparable investment quality).

Other securities comprise of securities that do not meet the definition of government or the definition of qualifying securities. This category receives the same risk charge as non-investment grade borrowers under the standardised approach to credit risk. However, it is recognised that for some high yielding debt instruments, an 8% specific risk charge may underestimate the specific risk.

Calculating the Capital Requirement for Market and Credit Risk

19.The standards contain different processes for calculating the capital requirement for market and credit risk. For credit risk, assets are first risk weighted (by multiplying them by a risk weight) and then a capital requirement is applied. In contrast, for market risk, exposures are simply multiplied by a specific risk capital charge. For an exposure with a given external credit assessment (rating), the specific risk capital charge is the same as the capital requirement calculated under the standardised approach for credit risk.

Specific Risk – Capital Charge for Positions Covered Under the Securitisation Framework

20.Following the 2009 enhancements to the BCF, the specific risk of securitisation positions held in the trading book are generally calculated in the same way as securitisation positions in the banking book.

21.Specific risk – the capital charges for positions covered under the standardised approach for securitisation exposures.

22.The default position for unrated securitisations can be thought of as a capital charge of 100 percent (that is, equivalent to a risk weight of 1250 percent where the capital charge is 8 percent).

23.Where the specific risk capital charge for an exposure is 100% such that capital is held for the full value of the exposure, it may be excluded from the calculation of the capital charge for general market risk. For further details, please refer to the securitisation framework.

Treatment of Interest Rate Derivatives

24.The interest rate risk measurement system should include all interest rate derivatives and off-balance sheet instruments assigned to the trading book that are sensitive to changes in interest rates.

25.The derivatives are converted into positions in the relevant underlying. These positions are subject to the general market risk charges and, where applicable, the specific risk charges for interest rate risk. The amounts reported should be the market value of the principal amount of the underlying or notional underlying.

26.For instruments where the apparent notional amount differs from the effective notional amount, banks will use the effective notional amount.

Interest rate derivatives include:

1. ▪forward rate agreements (FRAs)
2. ▪other forward contracts
3. ▪bond futures
4. ▪interest rate swaps
5. ▪cross currency swaps
6. ▪forward foreign exchange positions
7. ▪interest rate options

Refer to the examples below in this section for numerical illustrations

27.Market risk can be influenced by changes in equity prices, that is, equity risk.

28.Equity risk is the risk that movement in equity prices will have a negative effect on the value of equity positions. The capital charge for equity risk is the sum of the charges for general and specific market risk.

29.The Central Bank sets out a minimum capital standard to cover the risk of equity positions held in the trading book. It applies to long and short positions in all instruments that exhibit behavior similar to equities, with the exception of non-convertible preference shares, which fall under interest rate risk requirements.

   1.Capital Charges for Equity Risk

30.To calculate the minimum capital charge for equity risk, you must calculate two separate charges:

1. ▪A general market risk charge of 8% is applied to the net overall position.
2. ▪A specific risk charge of 8% is applied to the gross equity position. After offsetting long and short positions in the same issue, a bank's gross equity position is the sum of the absolute values of all long equity positions and all short equity positions.

31.Since banks may hold equities in different national markets, separate calculations for general and specific risk must be carried out for each of these markets.

Offsetting

Long and short positions in the same issue can be fully offset, resulting in a single net long or short position.

   2.Treatment of Equity Derivatives

32.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. This includes futures and swaps on both individual equities and on stock indices.

33.Positions in these equity derivatives should be converted into notional positions in the relevant underlying stock or portfolio of stocks. For example, stock index futures should be reported as the marked-to-market value of the notional underlying equity portfolio. A stock index future is an agreement to buy or sell a standard quantity of a specific stock index, on a recognised exchange, at a price agreed between two parties, and with delivery to be executed on a standardised future settlement date. As it is obviously not feasible to deliver an actual stock index, stock index futures contracts are settled by cash, calculated with reference to the difference between the purchase price and the level of the index at settlement.

34.An equity swap is an agreement between two counterparties to swap the returns on a stock or a stock index for a stream of payments based on some other form of asset return. Often, one payment leg is determined by a stock index with the second leg determined by a fixed or floating rate of interest. Alternatively, the second leg may be determined by some other stock index (often referred to as a relative performance swap).

35.Equity swaps should be treated as two notional positions. For example, in an equity swap where a bank is receiving an amount based on the change in value of one stock index and paying an amount based on a different index, the bank is regarded as having a long position in the former index and a short position in the latter index.

36.In addition to the general market risk requirement, a further capital charge of 2% will 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. As the standard stated.

Refer to the examples below in this section for numerical illustrations

37.Market risk can be influenced by changes in foreign exchange rates, that is, foreign exchange risk.

38.Foreign exchange risk is the risk that the value of foreign exchange positions may be adversely affected by movements in currency exchange rates. Foreign exchange positions or exposures incur only general market risk. The capital charge for foreign exchange risk also include a charge for positions 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, with the result that no capital is charged for open positions in USD. Foreign currency is any currency other than the bank's reporting currency.

39.Two steps are required to calculate the overall net open position:

Step 1: Determine the Exposure in Each Currency

The first step is to calculate the bank's open position, long or short in each currency.

The open position in each currency is the sum of:

1. ▪ the net spot FX position (Includes also all asset items less all liability items, including accrued interest, denominated in the currency)
2. ▪ the net forward FX position (Because forward FX rates reflect interest rate differentials, forward positions are normally valued at current spot exchange rates. The net forward position in an exposure should consist of all amounts to be received less all amounts to be paid under forward FX transactions, including currency futures and the principal on currency swaps not included in the spot position. For banks that base their management accounting on the net present values (NPVs), the NPV of each position should be used; discounted using current interest rates and valued at current spot rates)
3. ▪ guarantees and similar instruments that are certain to be called and are likely to be irrecoverable.
4. ▪ net future income and expenses not yet accrued but already fully hedged
5. ▪ any other item representing a profit or loss in foreign currencies
6. ▪ the net delta-based equivalent of the total book of foreign currency options

Step 2: Determine the Overall Net Open Position across FX Exposures

The second step in calculating the capital requirement for FX risk is to measure the risk in the bank's portfolio of foreign currency and gold positions.

You can determine the overall net open position of the portfolio by first converting the exposure in each foreign currency into the reporting currency at the spot rates. Then, calculate the overall net position by summing the following:

1. ▪ the greater of the sum of the net short positions or the sum of the net long positions (excluding the net open position in the US dollar
2. ▪ 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.

Foreign Exchange (FX) Exceptions

40.The Central Bank of UAE may allow banks to exclude certain FX positions from the capital charges calculation. Banks have to comply with both the requirement of para 70 of the Market Risk section of the standards.

41.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.

42.Banks with negligible business in foreign currencies and with no FX positions taken for their own account may exclude their FX positions if they meet both of the following requirements:

1. ▪ their FX business (the greater of the sum of their gross long positions and the sum of their gross short positions) does not exceed 100% of total capital (Tier 1 + Tier 2)
2. ▪ their overall net open position does not exceed 2% of its total capital

43.Market risk can be influenced by changes in commodity prices, that is, commodity risk. Commodity risk is the risk that on- or off-balance sheet positions will be adversely affected by movements in commodity prices.

44.A commodity is defined as a physical product that can be traded on a secondary market, for example, agricultural products, minerals and precious metals. Gold; however, is covered under the framework for foreign exchange.

45.Price risk in commodities is often more complex and volatile than price risk associated with currencies and interest rates. One reason for this is that commodity prices are influenced by natural events such as floods and droughts. Changes in supply and demand also have more dramatic effects on price and volatility, and commodity markets often lack liquidity.

46.Commodity risk only has a general market risk component because commodity prices are not influenced by specific risk.

47.Banks using portfolio strategies involving forward and derivative contracts on commodities are exposed to a variety of additional risks, such as:

1. ▪ Basis risk. the risk of changes in the cost of carry for forward positions and options. Cost of carry is a margin and refers to the net effect of borrowing funds for a certain period of time and investing them in a financial instrument or commodity for the same period of time. If the interest earned on the instrument or commodity is greater than the cost of borrowing, then the cost of carry is positive. The cost of carry can also be negative if the cost of borrowing is greater than the interest earned.
2. ▪ Forward gap risk. This is the risk wherein forward prices may change for reasons other than a change in interest rates.

48.It is important to note that these risks could well exceed the risk associated with changes in spot prices of commodities.

   1.Treatment of Commodities

Offsetting

49.When measuring risk in commodities, offsetting between positions is restricted.

1. ▪ Offsetting is allowed between long and short positions in exactly the same commodity to calculate open positions.
2. ▪ In general, offsetting is not allowed between positions in different commodities. However, the Central Bank may permit offset between different sub-categories of the same commodity, for example, different categories of crude oil, if:
   1. ▪ they are deliverable against each other
   2. ▪ they are close substitutes for each other, with a minimum correlation of 0.9 between price movements over a period of at least one year

Correlations

50.Banks using correlations between commodities to offset commodity positions must have obtained prior approval from the Central bank of UAE.

   2.Calculating the Capital Charge

51.Two alternative approaches for calculating the capital charge for commodities are set out by the standardised measurement method:

a)Simplified Approach

52.Under the simplified approach, banks must express each commodity position, spot plus forward, in terms of the standard unit of measurement (barrels, kilos, grams, and so on).

The capital charge is the sum of two charges:

1. ▪ 15% of the net position in each commodity. All commodity derivatives and off-balance sheet positions affected by changes in commodity prices should be included.
2. ▪ 3% of the bank's gross commodity positions, that is, the sum of the net long plus net short positions in each commodity, calculated using the current spot price. This charge addresses basis risk, interest rate risk and forward gap risk.

b)Maturity Ladder Approach

53.There are seven steps involved in calculating the capital charge for commodities using the maturity ladder approach. A separate maturity ladder must be used for each commodity.

   3.Treatment of Commodity Derivatives

54.All commodity derivatives and off-balance sheet positions affected by changes in commodity prices should be included in the commodities risk measurement framework. This includes commodity futures, commodity swaps, and options where the “delta plus” method is used.

Treatment of Options

55.There is a section of the market risk framework devoted to the treatment of options.

The market risk charge for options can be calculated using one of the following methods:

1. ▪ the simplified approach
2. ▪ an intermediate approach: the delta-plus method

56.The more significant a bank's trading activities, the more sophisticated the approach it should use. The following table shows which methods a bank can use:

57.Banks that solely use purchased options are free to use the simplified approach, whereas banks that also write options are expected to use the intermediate approach. If a bank has 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. However, banks need to report the hedged options in the respective sheet.

a)Simplified Approach

58.Option positions and their associated underlying (cash or forward) are 'carved out' from other risk types in the standardised approach. They are subject to separately calculated capital charges that incorporate both general market risk and specific risk. These charges are then added to the capital charges for the relevant risk categories: interest rate risk, equities risk, foreign exchange risk or commodities risk.

59.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.

60.The capital charges under the simplified approach are as follows:

b)Intermediate Approach

61.The procedure for general market risk is explained below. The specific risk capital charges are determined separately by multiplying the delta-equivalent of each option by the specific risk charges for each risk category.

   The delta-plus method

62.The delta-plus method uses the sensitivity parameters or Greek letters associated with options to measure their market risk and capital requirements.

63.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.

64.The delta-equivalent position of each option becomes part of the standardised approach, with the delta-equivalent amount subject to the applicable market risk capital charges. Separate capital charges are then applied to the gamma and Vega risks of the option positions.

Greek Letters: Five coefficients are used to help explain how option values behave in relation to changes in market parameters (price of the underlying asset, the strike price, the volatility of the underlying, the time to maturity and the risk-free interest rate). These are represented by the Greek letters delta, gamma, Vega, theta and rho, and are referred to as the 'option Greeks'.

1. •Delta (Δ) measures the rate of change in the value of an option with respect to a change in the price of the underlying asset.
2. •Gamma (Γ) measures the rate of change in the delta of an option with respect to a change in the price of the underlying asset.
3. •Vega (Λ) measures the rate of change in an option price with respect to a change in market volatility for the underlying asset price.