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