Market risk

Part

BIPRU Prudential sourcebook for Banks, Building Societies and Investment Firms

Chapter

Market risk

Printed on: 26/11/2024

Rulebook at: 31/12/2009

BIPRU 7

Market risk

BIPRU 7.1

Application, purpose, general provisions and non-standard transactions

01/01/2007

Application

BIPRU 7.1.1

This chapter applies to a BIPRU firm.

01/01/2007

Purpose

BIPRU 7.1.2

The purpose of this chapter is to implement Annexes I, III, IV and V of the Capital Adequacy Directive.

01/01/2007

General provisions: Obligation to calculate PRR

BIPRU 7.1.3

A firm must calculate a PRR in respect of:

(1) all its trading book positions;
(2) all positions falling within BIPRU 7.5.3 R (Scope of the foreign exchange PRR calculation), whether or not in the trading book; and
(3) all positions in commodities (including physical commodities) whether or not in the trading book;

even if no treatment is provided for that position in the other sections of this chapter.

01/01/2007

BIPRU 7.1.4

A firm must calculate a PRR for any position falling into BIPRU 7.1.3 R using:

(1) the PRR calculations contained in BIPRU 7; or
(2) another method provided the firm is able to demonstrate that in all circumstances the calculation being employed results in a higher PRR for the position than would be required under (1).

01/01/2007

General provisions: Non-trading book items

BIPRU 7.1.5

Positions in instruments which are non-trading book items should be treated under BIPRU 3 (Standardised credit risk), BIPRU 4 (The IRB approach) or BIPRU 13 (Financial derivatives, SFTs and long settlement transactions) unless deducted as an illiquid asset. If they fall into BIPRU 7.1.3R(2) or (3) they also give rise to a PRR charge.

01/11/2007

General provisions: Frequency of calculation

BIPRU 7.1.6

A firm must be able to monitor its total PRR on an intra-day basis, and, before executing any trade, must be able to re-calculate PRR to the level of detail necessary to establish whether or not the firm's capital resources exceed its capital resources requirement.

01/01/2007

BIPRU 7.1.7

A firm may rely on intra-day limits for the purposes of BIPRU 7.1.6R.

01/01/2007

Purpose of rules for non-standard transactions and instruments for which no PRR treatment has been specified

BIPRU 7.1.8

The methodologies which have been developed for calculating PRR charges have been based on existing instruments and assume instruments with standard characteristics. However, as a result of innovation and because there are instruments which, although based on a standard contract, contain structural features which would make the rules in the rest of this chapter inappropriate, flexible rules are required. The rules in this section about transactions for which no PRR treatment has been specified and non-standard transactions are designed to address this.

01/01/2007

Instruments for which no PRR treatment has been specified

BIPRU 7.1.9

Where a firm has a position for which no PRR treatment has been specified, it must calculate the PRR for that position in accordance with BIPRU 7.1.12R-BIPRU 7.1.13R.

01/01/2007

BIPRU 7.1.10

If BIPRU 7.1.9 R applies, a firm must document its policies and procedures for calculating the PRR for that position of that type in its trading book policy statement.

01/01/2007

BIPRU 7.1.11

Under BIPRU 1.2.30 R (2) a firm should notify the FSA as soon as is reasonably practicable if its trading book policy statement is subject to significant changes. Therefore if a firm makes a change in accordance with BIPRU 7.1.10R it should consider whether it is necessary to report it to the FSA.

01/01/2007

BIPRU 7.1.12

A firm may calculate the PRR for a position falling into BIPRU 7.1.9R by applying by analogy the rules relating to the calculation of the interest rate PRR, the equity PRR, the commodity PRR, the foreign currency PRR, the option PRR or the collective investment undertaking PRR if doing so is appropriate and if the position and PRR item are sufficiently similar to those that are covered by those rules.

01/01/2007

BIPRU 7.1.13

Where a firm has a position for which no PRR treatment has been specified and it is not applying BIPRU 7.1.12R, it must calculate a PRR of an appropriate percentage of the current value of the position calculated under GENPRU 1.3 (Valuation).

01/01/2007

Instruments in non-standard form

BIPRU 7.1.14

(1) If a firm has a position:

(a) in a PRR item in non-standard form; or
(b) that is part of a non-standard arrangement; or
(c) that, taken together with other positions (whether or not they are subject to PRR charges under BIPRU 7), gives rise to a non-standard market risk;

the firm must notify the FSA of that fact and of details about the position, PRR item, arrangements and type of risk concerned.
(2) Except as (1) provides to the contrary, (1) applies to a position that is subject to a PRR under BIPRU 7.1.3R.
(3) The question of what is non-standard for the purposes of (1) must be judged by reference to the standards:

(a) prevailing at the time the rule is being applied; and
(b) of firms generally who carry on business which gives rise to PRRs under BIPRU 7 rather than merely by reference to the firm's own business.

01/01/2007

BIPRU 7.1.15

If a firm has a position or combination of positions falling into BIPRU 7.1.14R and the PRR relating to that position or positions materially underestimates the market risk incurred by the firm to which they give rise, the firm must calculate the PRR for that position or positions under BIPRU 7.1.13R.

01/01/2007

Meaning of appropriate percentage for non-standard transactions

BIPRU 7.1.16

(1) In BIPRU 7.1.13R and, to the extent that that rule applies BIPRU 7.1.13R, BIPRU 7.1.15R, an "appropriate percentage" is:

(a) 100%; or
(b) a percentage which takes account of the characteristics of the position concerned and of discussions with the FSA or a predecessor regulator under the Banking Act 1987 or the Financial Services Act 1986.

(2) Compliance with (1) may be relied on as tending to establish compliance with BIPRU 7.1.13R or, insofar as it incorporates the requirements relating to an appropriate percentage, BIPRU 7.1.15R.
(3) Contravention of (1) may be relied on as tending to establish contravention with BIPRU 7.1.13 R or, insofar as it incorporates the requirements relating to an appropriate percentage, BIPRU 7.1.15 R.

01/01/2007

Stress testing and scenario analyses of trading book positions

BIPRU 7.1.17

A firm must conduct a regular programme of stress testing and scenario analysis of its trading book positions, both at the trading desk level and on a firm-wide basis. The results of these tests must be reviewed by senior management and reflected in the policies and limits the firm sets.

14/12/2009

BIPRU 7.1.17A

The firm's stress testing programme should be comprehensive in terms of both risk and firm coverage, and appropriate to the size and complexity of trading book positions held.

14/12/2009

BIPRU 7.1.18

In carrying out the stress tests and scenario analyses required by BIPRU 7.1.17 R, a firm must incorporate and take into account any other relevant stress tests and scenario analyses that it is required to carry out under any other provision of the Handbook, and in particular under BIPRU 7.10.72 R where the firm has a VaR model permission.

14/12/2009

BIPRU 7.1.19

This paragraph gives guidance in relation to the stress testing programme that a firm must carry out in relation to its trading book positions.

(1) The frequency of the stress testing of trading book positions should be determined by the nature of the positions.
(2) The stress testing should include shocks which reflect the nature of the portfolio and the time it could take to hedge out or manage risks under severe market conditions.
(3) The firm should have procedures in place to assess and respond to the results of the stress testing programme. In particular, stress testing should be used to evaluate the firm's capacity to absorb losses or to identify steps to be taken by the firm to reduce risk.
(4) As part of its stress testing programme, the firm should consider how prudent valuation principles (see GENPRU 1.3) will be met in a stressed scenario.

14/12/2009

BIPRU 7.1.20

The stress testing and scenario analysis under BIPRU 7.1.17 R should be taken into account under the overall Pillar 2 rule.

14/12/2009

BIPRU 7.2

Interest rate PRR

01/01/2007

General rule

BIPRU 7.2.1

(1) A firm must calculate its interest rate PRR under BIPRU 7.2 by:

(a) identifying which positions must be included within the interest rate PRR calculation;
(b) deriving the net position in each debt security in accordance with BIPRU 7.2.36R-BIPRU 7.2.41R;
(c) including these net positions in the interest rate PRR calculation for general market risk and the interest rate PRR calculation for specific risk; and
(d) summing all PRRs calculated for general market risk and specific risk.

(2) A firm must calculate its interest rate PRR by adding the amount calculated under (1) to the amount calculated under the basic interest rate PRR calculation under BIPRU 7.3.45R.
(3) All net positions, irrespective of their signs, must be converted on a daily basis into the firm's base currency at the prevailing spot exchange rate before their aggregation.
(4) Net positions must be classified according to the currency in which they are denominated. A firm must calculate the capital requirement for general market risk and specific risk in each individual currency separately.

01/01/2007

BIPRU 7.2.2

The interest rate PRR calculation divides the interest rate risk into the risk of loss from a general move in market interest rates, and the risk of loss from an individual debt security's price changing for reasons other than a general move in market interest rates. These are called general market risk and specific risk respectively.

01/01/2007

Scope of the interest rate PRR calculation

BIPRU 7.2.3

A firm's interest rate PRR calculation must:

(1) include all trading book positions in debt securities, preference shares and convertibles, except:

(a) positions in convertibles which have been included in the firm's equity PRR calculation;
(b) positions fully deducted as a material holding under the calculations under the capital resources table, in which case the firm may exclude them; or
(c) positions hedging an option which is being treated under BIPRU 7.6.26R (Table: Appropriate treatment for equities, debt securities or currencies hedging options);

(2) include notional positions arising from trading book positions in the instruments listed in the table in BIPRU 7.2.4R; and
(3) (if the firm is the transferor of debt securities or guaranteed rights relating to title to debt securities in a repurchase agreement or the lender of debt securities in a debt securities lending agreement) include such debt securities if those debt securities meet the criteria for inclusion in the trading book.

01/01/2007

BIPRU 7.2.4

Table: Instruments which result in notional positions
This table belongs to BIPRU 7.2.3R(2)

Instrument

See

Futures, forwards or synthetic futures on debt securities

BIPRU 7.2.13 R

Futures, forwards or synthetic futures on debt indices or baskets

BIPRU 7.2.14R

Interest rate futures or forward rate agreements (FRAs)

BIPRU 7.2.18 R

Interest rate swaps or foreign currency swaps

BIPRU 7.2.21R

Deferred start interest rate swaps or foreign currency swaps

BIPRU 7.2.24R

The interest rate leg of an equity swap (unless the firm calculates the interest rate PRR on the instrument using the basic interest rate PRR calculation in BIPRU 7.3 (Equity PRR and basic interest rate PRR for equity derivatives))

BIPRU 7.2.27R

The cash leg of a repurchase agreement or a reverse repurchase agreement

BIPRU 7.2.30R

Cash borrowings or deposits

BIPRU 7.2.31 R

Options on a debt security, a basket of debt securities, a debt security index, an interest rate or an interest rate future or swap (including an option on a future on a debt security) (unless the firm calculates a PRR on the option under BIPRU 7.6 (Option PRR))

BIPRU 7.2.32R

Dual currency bonds

BIPRU 7.2.33R

Foreign currency futures or forwards

BIPRU 7.2.34R

Gold futures or forwards

BIPRU 7.2.34R

Forwards, futures or options (except cliquets) on an equity, basket of equities or equity index (unless the firm calculates the interest rate PRR on the instrument using the basic interest rate PRR calculation in BIPRU 7.3)

BIPRU 7.2.34R

Credit derivatives

BIPRU 7.11

A warrant must be treated in the same way as an option

01/01/2007

BIPRU 7.2.5

BIPRU 7.2.3R(1) includes a trading book position in debt security, preference share or convertible that is subsequently repo'd under a repurchase agreement or lent under a stock lending agreement. Clearly, if the security had initially been obtained via a reverse repurchase agreement or stock borrowing agreement, the security would not have been included in the PRR calculation in the first place.

01/01/2007

BIPRU 7.2.6

BIPRU 7.2.3R(1) includes net underwriting positions or reduced net underwriting position in debt securities.

01/01/2007

BIPRU 7.2.7

Firms are reminded that the table in BIPRU 7.6.5R (Table: Appropriate PRR calculation for an option or warrant) divides options and warrants on interest rates, debt securities and interest rate futures and swaps into:

(1) those which must be treated under BIPRU 7.6 (Option PRR); and
(2) those which must be treated under either BIPRU 7.2 or BIPRU 7.6, the firm being able to choose whether BIPRU 7.2 or BIPRU 7.6 is used.

01/01/2007

BIPRU 7.2.8

Cliquets on equities, baskets of equities or equity indices do not attract an interest rate PRR. The table in BIPRU 7.2.4R excludes them from the scope of the interest rate PRR calculation in BIPRU 7.2 and BIPRU 7.3.45R excludes them from the basic interest rate PRR calculation in BIPRU 7.3 (Equity PRR and basic interest rate PRR for equity derivatives).

01/01/2007

BIPRU 7.2.9

The table in BIPRU 7.2.4R shows that equity derivatives are excluded from BIPRU 7.2's PRR calculation if they have been included in the basic interest rate PRR calculation in BIPRU 7.3 (see BIPRU 7.3.45R).

01/01/2007

Derivation of notional positions: General approach

BIPRU 7.2.10

BIPRU 7.2.11 R - BIPRU 7.2.35R convert the instruments listed in the table in BIPRU 7.2.4R into notional positions in:

(1) the underlying debt security, where the instrument depends on the price (or yield) of a specific debt security; or
(2) notional debt securities to capture the pure interest rate risk arising from future payments and receipts of cash (including notional payments and receipts) which, because they are designed to represent pure general market risk (and not specific risk), are called zero-specific-risk securities; or
(3) both (1) and (2).

01/01/2007

BIPRU 7.2.11

(1) For the purposes of calculating interest rate PRR, unless specified otherwise, a firm must derive the value of notional positions as follows:

(a) notional positions in actual debt securities must be valued as the nominal amount underlying the contract at the current market price of the debt security; and
(b) positions in zero-specific-risk securities must be valued using one of the two methods in (2).

(2) A firm must use one of the following two methods for all positions arising under (1)(b) and must use the same method for all positions denominated in the same currency:

(a) the present value approach, under which the zero-specific-risk security is assigned a value equal to the present value of all the future cash flows that it represents; or
(b) the alternative approach, under which the zero-specific-risk security is assigned a value equal to:

(i) the market value of the underlying notional equity position in the case of an equity derivative;
(ii) the notional principal amount in the case of an interest rate or foreign currency swap; or
(iii) the notional amount of the future cash flow that it represents in the case of any other CRD financial instrument.

01/01/2007

BIPRU 7.2.12

A firm must use BIPRU 7.2.11R(2)(a) in respect of any positions that it includes in the interest rate duration method.

01/01/2007

Derivation of notional positions: Futures, forwards or synthetic futures on a debt security

BIPRU 7.2.13

Futures, forwards or synthetic futures on a single debt security must be treated as follows:

(1) a purchased future, synthetic future or forward is treated as:

(a) a notional long position in the underlying debt security (or the cheapest to deliver (taking into account the conversion factor) where the contract can be satisfied by delivery of one from a range of securities); and
(b) a notional short position in a zero coupon zero-specific-risk security with a maturity equal to the expiry date of the future or forward; and

(2) a sold future, synthetic future or forward is treated as:

(a) a notional short position in the underlying security (or the cheapest to deliver (taking into account the conversion factor) where the contract can be satisfied by delivery of one from a range of securities); and
(b) a notional long position in a zero coupon zero-specific-risk security with a maturity equal to the expiry date of the future, synthetic future or forward.

01/01/2007

Derivation of notional positions: Futures, forwards or synthetic futures on a basket or index of debt securities

BIPRU 7.2.14

Futures, forwards or synthetic futures on a basket or index of debt securities must be converted into forwards on single debt securities as follows (and then the resulting positions must be treated under BIPRU 7.2.13R):

(1) futures, synthetic futures or forwards on a single currency basket or index of debt securities must be treated as either:

(a) a series of forwards, one for each of the constituent debt securities in the basket or index, of an amount which is a proportionate part of the total underlying the contract according to the weighting of the relevant debt security in the basket; or
(b) a single forward on a notional debt security; and

(2) futures, synthetic futures or forwards on multiple currency baskets or indices of debt securities must be treated as either:

(a) a series of forwards (using the method described in (1)(a)); or
(b) a series of forwards, each one on a notional debt security to represent one of the currencies in the basket or index, of an amount which is a proportionate part of the total underlying the contract according to the weighting of the relevant currency in the basket.

01/01/2007

BIPRU 7.2.15

Under BIPRU 7.2.14R(2)(b), a forward on basket of three Euro denominated debt securities and two Dollar denominated debt securities would be treated as a forward on a single notional Euro denominated debt security and a forward on a single notional Dollar denominated debt security.

01/01/2007

BIPRU 7.2.16

The notional debt securities in BIPRU 7.2.14R are assigned a specific risk PRA and a general market risk PRA equal to the highest that would apply to the debt securities in the basket or index.

01/01/2007

BIPRU 7.2.17

The debt security with the highest specific risk PRA within the basket might not be the same as the one with the highest general market risk PRA . BIPRU 7.2.16R requires a firm to select the highest percentages even where they relate to different debt securities in the basket or index, and regardless of the proportion of those debt securities in the basket or index.

01/01/2007

Derivation of notional positions: Interest rate futures and forward rate agreements (FRAs)

BIPRU 7.2.18

Interest rate futures or FRAs must be treated as the two notional positions (one long, one short) shown in the table in BIPRU 7.2.19R.

01/01/2007

BIPRU 7.2.19

Table: Interest rate futures and FRAs
This table belongs to BIPRU 7.2.18R

A short position in a zero coupon zero-specific-risk security

A long position in a zero coupon zero-specific-risk security

Where the firm buys an interest rate future or sells an FRA

Maturity equals the expiry date of the future (or settlement date of the FRA)

Maturity equals the expiry date of the future (or settlement date of the FRA) plus the maturity of the notional borrowing/deposit

Where the firm sells an interest rate future or buys an FRA

Maturity equals the expiry date of the future (or settlement date of the FRA) plus the maturity of the notional borrowing/deposit

Maturity equals the expiry date of the future (or settlement date of the FRA)

01/01/2007

BIPRU 7.2.20

(1) The following example illustrates BIPRU 7.2.18R and BIPRU 7.2.19R in conjunction with BIPRU 7.2.11R (the last rule determines the value of notional positions). A firm sells £1mn notional of a 3v6 FRA at 6%. This results in:

(a) a short position in a zero-specific-risk security with a zero coupon, three month maturity, and a nominal amount of £1million; and
(b) a long position in a zero-specific-risk security with a zero coupon, six month maturity, and nominal amount of £1,015,000 (i.e. notional plus interest at 6% over 90 days).

(2) If a firm were to apply the approach in BIPRU 7.2.11R(2)(a) the two nominal amounts would have to be present valued.

01/01/2007

Derivation of notional positions: Interest rate swaps or foreign currency swaps

BIPRU 7.2.21

Interest rate swaps or foreign currency swaps without deferred starts must be treated as the two notional positions (one long, one short) shown in the table in BIPRU 7.2.22R.

01/01/2007

BIPRU 7.2.22

Table: Interest rate and foreign currency swaps
This table belongs to BIPRU 7.2.21R

Paying leg (which must be treated as a short position in a zero-specific-risk security)

Receiving leg (which must be treated as a long position in a zero-specific-risk security)

Receiving fixed and paying floating

Coupon equals the floating rate and maturity equals the reset date

Coupon equals the fixed rate of the swap and maturity equals the maturity of the swap

Paying fixed and receiving floating

Coupon equals the fixed rate of the swap and maturity equals the maturity of the swap

Coupon equals the floating rate and maturity equals the reset date

Paying floating and receiving floating

Coupon equals the floating rate and maturity equals the reset date

01/01/2007

BIPRU 7.2.23

For a foreign currency swap, the two notional zero-specific-risk securities would be denominated in different currencies. A foreign currency swap is also included in the foreign currency PRR calculation.

01/01/2007

Derivation of notional positions: Deferred start interest rate swaps or foreign currency swaps

BIPRU 7.2.24

Interest rate swaps or foreign currency swaps with a deferred start must be treated as the two notional positions (one long, one short) shown in the table in BIPRU 7.2.25R.

01/01/2007

BIPRU 7.2.25

Table: Deferred start interest rate and foreign currency swaps
This table belongs to BIPRU 7.2.24R

Paying leg (which must be treated as a short position in a zero-specific-risk security with a coupon equal to the fixed rate of the swap)

Receiving leg (which must be treated as a long position in a zero-specific-risk security with a coupon equal to the fixed rate of the swap)

Receiving fixed and paying floating

maturity equals the start date of the swap

maturity equals the maturity of the swap

Paying fixed and receiving floating

maturity equals the maturity of the swap

maturity equals the start date of the swap

01/01/2007

BIPRU 7.2.26

An example of BIPRU 7.2.24R is as follows. A firm enters into a five year swap which starts in two year's time. The firm has contracted to receive 6% and pay six month Libor on a principal amount of £1 million. This results in a long position in a 7 year debt security and a short position in a 2 year debt security. Both have a coupon of 6%. BIPRU 7.2.24R deals with the capital treatment of the delayed start date; once the swap has started, BIPRU 7.2.21R applies.

01/01/2007

Derivation of notional positions: Swaps where only one leg is an interest rate leg (e.g. equity swaps)

BIPRU 7.2.27

A firm must treat a swap with only one interest rate leg as a notional position in a zero-specific-risk security:

(1) with a coupon equal to that on the interest rate leg;
(2) with a maturity equal to the date that the interest rate will be reset; and
(3) which is a long position if the firm is receiving interest payments and short if making interest payments.

01/01/2007

BIPRU 7.2.28

BIPRU 7.2.27R includes equity swaps, commodity swaps and any other swap where only one leg is an interest rate leg.

01/01/2007

Derivation of notional positions: Cash legs of repurchase agreements and reverse repurchase agreements

BIPRU 7.2.29

Firms are reminded that for the purposes of BIPRU 7.2.30R, a repurchase agreement includes a sell/buy back or stock lending; and a reverse repurchase agreement includes a buy/sell back or a stock borrowing.

01/01/2007

BIPRU 7.2.30

The forward cash leg of a repurchase agreement or reverse repurchase agreement must be treated as a notional position in a zero-specific-risk security which:

(1) is a short notional position in the case of a repurchase agreement; and a long notional position in the case of a reverse repurchase agreement;
(2) has a value equal to the market value of the cash leg;
(3) has a maturity equal to that of the repurchase agreement or reverse repurchase agreement; and
(4) has a coupon equal to:

(a) zero, if the next interest payment date coincides with the maturity date; or
(b) the interest rate on the contract, if any interest is due to be paid before the maturity date.

01/01/2007

Derivation of notional positions: Cash borrowings and deposits

BIPRU 7.2.31

A cash borrowing or deposit must be treated as a notional position in a zero coupon zero-specific-risk security which:

(1) is a short position in the case of a borrowing and a long position in the case of a deposit;
(2) has a value equal to the market value of the borrowing or deposit;
(3) has a maturity equal to that of the borrowing or deposit, or the next date the interest rate is reset (if earlier); and
(4) has a coupon equal to:

(a) zero, if the next interest payment date coincides with the maturity date; or
(b) the interest rate on the borrowing or deposit, if any interest is due to be paid before the maturity date.

01/01/2007

Derivation of notional positions: Options and warrants

BIPRU 7.2.32

(1) Where included in the PRR calculation in BIPRU 7.2 (see the table in BIPRU 7.2.4R), options and warrants must be treated in accordance with this rule.
(2) An option or warrant on a debt security, a basket of debt securities or a debt security index must be treated as a position in that debt security, basket or index.
(3) An option on an interest rate must be treated as a position in a zero coupon zero-specific-risk security with a maturity equal to the sum of the time to expiry of the option and the length of the period for which the interest rate is fixed.
(4) An option on a future - where the future is based on an interest rate or debt security - must be treated as:

(a) a long position in that future for purchased call options and written put options; and
(b) a short position in that future for purchased put options and written call options.

(5) An option on a swap must be treated as a deferred starting swap.

01/01/2007

Derivation of notional positions: Bonds where the coupons and principal are paid in different currencies

BIPRU 7.2.33

Where a debt security pays coupons in one currency, but will be redeemed in a different currency, it must be treated as:

(1) a debt security denominated in the coupon's currency; and
(2) a foreign currency forward to capture the fact that the debt security's principal will be repaid in a different currency from that in which it pays coupons, specifically:

(a) a notional forward sale of the coupon currency and purchase of the redemption currency, in the case of a long position in the debt security; or
(b) a notional forward purchase of the coupon currency and sale of the redemption currency, in the case of a short position in the debt security.

01/01/2007

Derivation of notional positions: Interest rate risk on other futures, forwards and options

BIPRU 7.2.34

Other futures, forwards, options and swaps treated under BIPRU 7.2 must be treated as positions in zero-specific-risk securities, each of which:

(1) has a zero coupon;
(2) has a maturity equal to that of the relevant contract; and
(3) is long or short according to the table in BIPRU 7.2.35R.

01/01/2007

BIPRU 7.2.35

Table: Interest rate risk on other futures, forwards, options and swaps
This table belongs to BIPRU 7.2.34R.

Instrument

Notional positions

foreign currency forward or future

a long position denominated in the currency purchased

and

a short position denominated in the currency sold

Gold forward or future

a long position if the forward or future involves an actual (or notional) sale of gold

a short position if the forward or future involves an actual (or notional) purchase of gold

Equity forward or future, or option (unless the interest rate PRR is calculated under the basic interest rate PRR calculation in BIPRU 7.3)

A long position if the contract involves an actual (or notional) sale of the underlying equity

A short position if the contract involves an actual (or notional) purchase of the underlying equity

01/01/2007

Deriving the net position in each debt security: General

BIPRU 7.2.36

The net position in a debt security is the difference between the value of the firm's long positions (including notional positions) and the value of its short positions (including notional positions) in the same debt security.

01/01/2007

Deriving the net position in each debt security: Netting positions in the same debt security

BIPRU 7.2.37

(1) A firm must not net positions (including notional positions) unless those positions are in the same debt security. This rule sets out the circumstances in which debt securities may be treated as the same for these purposes.
(2) Subject to (3) long and short positions are in the same debt security, and a debt security is the same as another if and only if:

(a) they enjoy the same rights in all respects; and
(b) are fungible with each other.

(3) Long and short positions in different tranches of the same debt security may be treated as being in the same debt security for the purpose of (1) where:

(a) the tranches enjoy the same rights in all respects; and
(b) the tranches become fungible within 180 days and thereafter the debt security of one tranche can be delivered in settlement of the other tranche.

01/01/2007

Deriving the net position in each debt security: Netting the cheapest to deliver security with other deliverable securities

BIPRU 7.2.38

A firm may net a short notional position in the cheapest to deliver security arising from a short future or forward (see BIPRU 7.2.13R(2)(a)) under which the seller has a choice of which debt security it may use to settle its obligations against a long position in any deliverable security up to a maximum of 90% of the common nominal amounts. The residual long and short nominal amounts must be treated as separate long and short positions.

01/01/2007

BIPRU 7.2.39

The netting permitted by BIPRU 7.2.38R only relates to where the firm has sold the future or forward. It does not relate to where the firm has bought a future or forward.

01/01/2007

Deriving the net position in each debt security: Netting zero-specific-risk securities with different maturities

BIPRU 7.2.40

A firm may net a notional long position in a zero-specific-risk security against a notional short position in a zero-specific-risk security if:

(1) they are denominated in the same currency;
(2) their coupons do not differ by more than 15 basis points; and
(3) they mature:

(a) on the same day, if they have residual maturities of less than one month;
(b) within 7 days of each other, if they have residual maturities of between one month and one year; and
(c) within 30 days of each other, if they have residual maturities in excess of one year.

01/01/2007

Deriving the net position in each debt security: Reduced net underwriting positions in debt securities

BIPRU 7.2.41

A firm must not net a reduced net underwriting position in a debt security with any other debt security position.

01/01/2007

BIPRU 7.2.42

BIPRU 7.2.41R only relates to reduced net underwriting position.

01/01/2007

Specific risk calculation

BIPRU 7.2.43

(1) A firm must calculate the specific risk portion of the interest rate PRR for each debt security by multiplying the market value of the individual net position (ignoring the sign) by the appropriate PRA from the table in BIPRU 7.2.44R or as specified by BIPRU 7.2.45R - BIPRU 7.2.47R.
(2) Notional positions in zero-specific-risk securities do not attract specific risk.

01/01/2007

BIPRU 7.2.44

Table: specific risk PRAs
This table belongs to BIPRU 7.2.43R.

Issuer

Residual maturity

PRA

Debt securities issued or guaranteed by central governments, issued by central banks, international organisations, multilateral development banks or EEA States' regional governments or local authorities which would qualify for credit quality step 1 or which would receive a 0% risk weight under the standardised approach to credit risk.

Any

(A) Debt securities issued or guaranteed by central governments, issued by central banks, international organisations, multilateral development banks or EEA States' regional governments or local authorities which would qualify for credit quality step 2 or 3 under the standardised approach to credit risk.
(B) Debt securities issued or guaranteed by institutions which would qualify for credit quality step 1 or 2 under the standardised approach to credit risk.
(C) Debt securities issued or guaranteed by institution which would qualify for credit quality step 3 under BIPRU 3.4.34 R (Exposures to institutions: Credit assessment based method) or which would do so if it had an original effective maturity of three months or less.
(D) Debt securities issued or guaranteed by corporates which would qualify for credit quality step 1 or 2 under the standardised approach to credit risk.
(E) Other qualifying debt securities (see BIPRU 7.2.49R)

Zero to six months

0.25%

over 6 and up to and including 24 months

Over 24 months

1.6%

Any

(A) Debt securities issued or guaranteed by central governments, issued by central banks, international organisations, multilateral development banks or EEA States' regional governments or local authorities or institution which would qualify for credit quality step 6 under the standardised approach to credit risk.
(B) Debt securities issued or guaranteed by corporate which would qualify for credit quality step 5 or 6 under the standardised approach to credit risk.
(C) An instrument that shows a particular risk because of the insufficient solvency of the issuer of liquidity. This paragraph applies even if the instrument would otherwise qualify for a lower PRA under this table.

Any

12%

Note: The question of what a corporate is and of what category a debt security falls into must be decided under the rules relating to the standardised approach to credit risk.

01/01/2007

BIPRU 7.2.45

To the extent that a firm applies the IRB approach, to qualify for a credit quality step for the purpose of the table in BIPRU 7.2.44R the obligor of the exposure must have an internal rating with a PD equivalent to or lower than that associated with the appropriate credit quality step under the standardised approach to credit risk.

01/01/2007

BIPRU 7.2.46

A debt security issued by a non-qualifying issuer must receive a specific risk PRA of 8% or 12% according to the table in BIPRU 7.2.44R. However a firm must apply a higher specific risk PRA to such a debt security and/or not recognise offsetting for the purposes of defining the extent of general market risk between such a security and any other debt securities to the extent that doing otherwise would not be a prudent treatment of specific risk or general market risk.

01/01/2007

BIPRU 7.2.47

A securitisation exposures that would be subject to a deduction treatment under the treatment set out in GENPRU 2.2 (Capital resources) or risk weighted at 1250% as set out in BIPRU 9 (Securitisation) is subject to a capital charge that is no less than that set out under those treatments. Unrated liquidity facilities are subject to a capital charge that is no less than that set out in BIPRU 9.

01/01/2007

BIPRU 7.2.48

BIPRU 7.2.43R includes both actual and notional positions. However, notional positions in zero-specific-risk security do not attract specific risk. For example:

(1) interest rate swaps, foreign currency swaps, FRAs, interest rate futures, foreign currency forwards, foreign currency futures, and the cash leg of repurchase agreements and reverse repurchase agreements create notional positions which will not attract specific risk; whilst
(2) futures, forwards and swaps which are based on the price (or yield) of one or more debt securities will create at least one notional positions that attracts specific risk.

01/01/2007

Definition of a qualifying debt security

BIPRU 7.2.49

A debt security is a qualifying debt security if:

(1) it qualifies for a credit quality step under the standardised approach to credit risk corresponding at least to investment grade; or
(2) it has a PD which, because of the solvency of the issuer, is not higher than that of the debt securities referred to under (1) under the IRB approach; or
(3) it is a debt security for which a credit assessment by a nominated ECAI is unavailable and which meets the following conditions:

(a) it is considered by the firm to be sufficiently liquid;
(b) it is of investment quality, according to the firm's own discretion, at least equivalent to that of the debt securities referred to under (1); and
(c) it is listed on at least one regulated market or designated investment exchange; or

(4) it is a debt security issued by an institution subject to the capital adequacy requirements set out in the Banking Consolidation Directive that satisfies the following conditions:

(a) it is considered by the firm to be sufficiently liquid;
(b) its investment quality is, according to the firm's own discretion, at least equivalent to that of the assets referred to under (1) above; or

(5) it is a debt security issued by an institution that is deemed to be of equivalent or higher credit quality than that associated with credit quality step 2 under the standardised approach to credit risk and that is subject to supervision and regulatory arrangements comparable to those under the Capital Adequacy Directive.

01/01/2007

BIPRU 7.2.50

A firm must not treat a debt security as a qualifying debt security if it would be prudent to consider that the debt security concerned is subject to too high a degree of specific risk for it to be treated as a qualifying debt security.

01/01/2007

BIPRU 7.2.51

The manner in which a firm assesses a debt security for the purpose of treatment as a qualifying debt security will be subject to scrutiny by the FSA. The FSA may take action to overturn the firm's judgement if it considers that the debt security should not be treated as a qualifying debt security.

01/01/2007

General market risk calculation: General

BIPRU 7.2.52

A firm must calculate the general market risk portion of the interest rate PRR for each currency using either:

(1) the interest rate simplified maturity method;
(2) the interest rate maturity method; or
(3) the interest rate duration method.

01/01/2007

BIPRU 7.2.53

BIPRU 7.2.52R(3) is subject to BIPRU 7.2.54R.

01/01/2007

BIPRU 7.2.54

A firm must not use the interest rate duration method for index-linked securities. Instead, these securities must:

(1) be attributed a coupon of 3%; and
(2) be treated separately under either the interest rate simplified maturity method or the interest rate maturity method.

01/01/2007

General market risk calculation: Simplified maturity method

BIPRU 7.2.55

The interest rate simplified maturity method weights individual net positions to reflect their price sensitivity to changes in interest rates. The weights are related to the coupon and the residual maturity of the instrument (or the next interest rate re-fix date for floating rate items).

01/01/2007

BIPRU 7.2.56

Under the interest rate simplified maturity method, the portion of the interest rate PRR for general market risk equals the sum of each individual net position (long or short) multiplied by the appropriate PRA in the table in BIPRU 7.2.57R. A firm must assign its net positions to the appropriate maturity bands in the table in BIPRU 7.2.57R on the basis of residual maturity in the case of fixed-rate instruments and on the basis of the period until the interest rate is next set in the case of instruments on which the interest rate is variable before final maturity.

01/01/2007

BIPRU 7.2.57

Table: general market risk PRAs
This table belongs to BIPRU 7.2.56R.

Zone

Maturity band

PRA

Coupon of 3% or more

Coupon of less than 3%

One

0 ≤ 1 month

0.00%

> 1 ≤ 3 months

0.20%

> 3 ≤ 6 months

0.4%

> 6 ≤ 12 months

0.7%

Two

> 1 ≤ 2 years

> 1.0 ≤ 1.9 years

1.25%

> 2 ≤ 3 years

> 1.9 ≤ 2.8 years

1.75%

> 3 ≤ 4 years

> 2.8 ≤ 3.6 years

2.25%

Three

> 4 ≤ 5 years

> 3.6 ≤ 4.3 years

2.75%

> 5 ≤ 7 years

> 4.3 ≤ 5.7 years

3.25%

> 7 ≤ 10 years

> 5.7 ≤ 7.3 years

3.75%

> 10 ≤ 15 years

> 7.3 ≤ 9.3 years

4.5%

> 15 ≤ 20 years

> 9.3 ≤ 10.6 years

5.25%

> 20 years

> 10.6 ≤ 12.0 years

6.00%

> 12.0 ≤ 20.0 years

8.00%

> 20 years

12.50%

01/01/2007

General market risk calculation: The maturity method

BIPRU 7.2.58

The interest rate maturity method builds on the interest rate simplified maturity method by partially recognising offsetting positions. BIPRU 7.2.61G provides an illustration of the interest rate maturity method.

01/01/2007

BIPRU 7.2.59

Under the interest rate maturity method, the portion of the interest rate PRR for general market risk is calculated as follows:

(1) Step 1: each net position is allocated to the appropriate maturity band in the table in BIPRU 7.2.57R and multiplied by the corresponding PRA;
(2) Step 2: weighted long and short positions are matched within:

(a) the same maturity band;
(b) the same zone (using unmatched positions from (a)); and
(c) different zones (using unmatched positions from (b) and matching between zones 1 and 2 and 2 and 3 before zone 1 and 3); and

(3) Step 3: the portion of the interest rate PRR for general market risk is the sum of:

(a) 10% of the total amount matched within maturity bands;
(b) 40% of the amount matched within zone 1 under (2)(b);
(c) 30% of the amount matched within zones 2 & 3 under (2)(b);
(d) 40% of the amounts matched between zones 1 and 2, and between zones 2 and 3;
(e) 150% of the amount matched between zones 1 and 3; and
(f) 100% of the weighted positions remaining unmatched after (2)(c).

01/01/2007

BIPRU 7.2.60

The table in BIPRU 7.2.57R distinguishes between debt securities with a coupon of less than 3% and those with coupon in excess of 3%. However, this does not mean that the firm has to do a separate general market risk calculation for each; it merely ensures that when allocating debt securities to a particular band, their coupons are taken into account as well as their maturities. So for example, a 21 year 6% debt security falls into the same band as an 11 year 2% debt security. They are both weighted at 6%, and can be matched under BIPRU 7.2.59R(2)(a) (the first part of step two of the interest rate maturity method calculation) because they fall within the same band.

01/01/2007

BIPRU 7.2.61

This paragraph sets out an example of a calculation under the interest rate maturity method. In this example, a firm with a £ sterling base currency is processing its euro denominated positions.

01/01/2007

General market risk calculation: Duration method

BIPRU 7.2.62

The interest rate duration method produces a more accurate measure of interest rate risk than the maturity methods but it is also more complex to calculate.

01/01/2007

BIPRU 7.2.63

(1) A firm must use the following formula to calculate modified duration for the purpose of the interest rate duration method:
(2)
(3) For the purpose of the formulae in (1) and (2):

(a) C_t=cash payment at time t
(b) m=total maturity
(c) r=yield to maturity. In the case of a fixed-rate debt security a firm must take the current mark to market of the debt security and thence calculate its yield to maturity, which is the implied discount rate for that instrument. In the case of a floating rate instrument, a firm must take the current mark to market of the debt security and thence calculate its yield on the assumption that the principal is due on the date that the interest rate can next be changed.
(d) t=time

01/01/2007

BIPRU 7.2.64

Under the interest rate duration method, the portion of the interest rate PRR for general market risk is calculated as follows:

(1) Step 1: allocate each net position to the appropriate duration zone in the table in BIPRU 7.2.65R and multiply it by:

(a) its modified duration (using the formula in BIPRU 7.2.63R); and
(b) the appropriate assumed interest rate change in the table in BIPRU 7.2.65R;

(2) Step 2: match weighted long and short positions:

(a) within zones; and
(b) across zones (using unmatched positions from (2)(a) and following the process in BIPRU 7.2.59R (2)(c)); and

(3) Step 3: calculate the portion of the interest rate PRR for general market risk as the sum of:

(a) 100% of the weighted positions remaining unmatched after (2)(b);
(b) 2% of the matched weighted position in each zone;
(c) 40% of the matched weighted position between zones 1 and 2, and between zones 2 and 3; and
(d) 150% of the matched weighted position between zones 1 and 3.

01/01/2007

BIPRU 7.2.65

Table: Assumed interest rate change in the interest rate duration method
This table belongs to BIPRU 7.2.64R

Zone

Modified Duration

Assumed interest rate change
(percentage points)

0 ≤ 12 months

1.00

> 12 months ≤ 3.6 years

0.85

> 3.6 years

0.70

01/01/2007

BIPRU 7.2.66

If a firm uses the interest rate duration method it must do so on a consistent basis.

01/01/2007

BIPRU 7.3

Equity PRR and basic interest rate PRR for equity derivatives

01/01/2007

General rule

BIPRU 7.3.1

(1) A firm must calculate its equity PRR by:

(a) identifying which positions must be included within the PRR calculation (see BIPRU 7.3.2R);
(b) deriving the net position in each equity in accordance with BIPRU 7.3.23R;
(c) including each of those net positions in either the simplified equity method (see BIPRU 7.3.29R) or, subject to BIPRU 7.3.27R, the standard equity method (see BIPRU 7.3.32R); and
(d) summing the PRR on each net position as calculated under the simplified equity method and standard equity method.

(2) All net positions, irrespective of their signs, must be converted on a daily basis into the firm's base currency at the prevailing spot exchange rate before their aggregation.

01/01/2007

Scope of the equity PRR calculation

BIPRU 7.3.2

A firm's equity PRR calculation must:

(1) include all trading book positions in equities, unless:

(a) the position is fully deducted as a material holding under the calculations under the capital resources table, in which case the firm may exclude it; or
(b) the position is hedging an option or warrant which is being treated under BIPRU 7.6.26R (Table: Appropriate treatment for equities, debt securities or currencies hedging options);

(2) include notional positions arising from trading book positions in the instruments listed in the table in BIPRU 7.3.3R; and
(3) (if the firm is the transferor of equities or guaranteed rights relating to title to equities in a repurchase agreement or the lender of equities in an equities lending agreement) include such equities if those equities meet the criteria for inclusion in the trading book.

01/01/2007

BIPRU 7.3.3

Table: Instruments which result in notional positions
This table belongs to BIPRU 7.3.2R(2)

Instrument

See

Depository receipts

BIPRU 7.3.12R

Convertibles where:

(a) the convertible is trading at a market price of less than 110% of the underlying equity; and the first date at which conversion can take place is less than three months ahead, or the next such date (where the first has passed) is less than a year ahead; or

BIPRU 7.3.13R

(b) the conditions in (a) are not met but the firm includes the convertible in its equity PRR calculation rather than including it in its interest rate PRR calculation set out in BIPRU 7.2 (Interest rate PRR).

Futures, forwards, CFDs and synthetic futures on a single equity

BIPRU 7.3.14R

Futures, forwards, CFDs and synthetic futures on a basket of equities or equity index

BIPRU 7.3.15R

equity legs of an equity swap

BIPRU 7.3.19R

Options or warrants on a single equity, an equity future, a basket of equities or an equity index (unless the firm calculates a PRR on the option or warrant under BIPRU 7.6).

BIPRU 7.3.21R

01/01/2007

BIPRU 7.3.4

BIPRU 7.3.2R(1) includes a trading book position in an equity that is subsequently repo'd under a repurchase agreement or lent under a stock lending agreement. Clearly, if the equity had initially been obtained via a reverse repurchase agreement or stock borrowing agreement, the equity would not have been included in the trading book in the first place.

01/01/2007

BIPRU 7.3.5

BIPRU 7.3.2R(1) includes net underwriting positions or reduced net underwriting positions in equities. BIPRU 7.3.27R requires a firm to use the simplified equity method in the case of reduced net underwriting positions. In the case of net underwriting positions that have not been reduced according to BIPRU 7.8.27R (Calculating the reduced net underwriting position), there is no such restriction; a firm can choose which of the two equity methods to use.

01/01/2007

BIPRU 7.3.6

Firms are reminded that the table in BIPRU 7.6.5R (Table: Appropriate PRR calculation for an option or warrant) divides equity options and warrants into:

(1) those which must be treated under BIPRU 7.6 (Option PRR); and
(2) those which must be treated under either BIPRU 7.3 or BIPRU 7.6, the firm being able to choose whether BIPRU 7.3 or BIPRU 7.6 is used.

01/01/2007

BIPRU 7.3.7

The table in BIPRU 7.3.3R does not require every convertible to be included in BIPRU 7.3 's PRR calculation. Where a convertible is not included in this PRR calculation, BIPRU 7.2.3R (1) (Scope of the interest rate PRR calculation) requires that it be included in the BIPRU 7.2 PRR calculation.

01/01/2007

BIPRU 7.3.8

Some of the instruments listed in the table in BIPRU 7.3.3R are also included in a firm's interest rate PRR calculation. For simplicity, a firm may use the interest rate PRR calculation in BIPRU 7.3 rather than the calculation in BIPRU 7.2 (Interest rate PRR). BIPRU 7.3.44G explains this in more detail.

01/01/2007

Derivation of notional positions: General approach

BIPRU 7.3.9

BIPRU 7.3.10R - BIPRU 7.3.21R convert the instruments listed in the table in BIPRU 7.3.3R into notional positions in individual equities, equity baskets or equity indices.

01/01/2007

BIPRU 7.3.10

Unless specified otherwise, the value of each notional equity position equals the quantity of that equity underlying the instrument multiplied by the current market value of the equity.

01/01/2007

BIPRU 7.3.11

(1) An example of BIPRU 7.3.10R is as follows. The current market value of a particular equity is £2.50. If a firm contracts to sell this equity in five year's time for £3 it would treat the notional short equity position as having a value of £2.50 when calculating the equity PRR.
(2) In effect, the forward position has been treated as being equivalent to a spot position for the purposes of calculating equity PRR. To capture the risk that the forward price changes relative to the spot price, forward equity positions are included in the firm's interest rate PRR calculation (see BIPRU 7.3.45R or the table in BIPRU 7.2.4R (Table: Instruments which result in notional positions)).

01/01/2007

Derivation of notional positions: Depository receipts

BIPRU 7.3.12

A depository receipt must be treated as a notional position in the underlying equity.

01/01/2007

Derivation of notional positions: Convertibles

BIPRU 7.3.13

Where a convertible is included in BIPRU 7.3's PRR calculation (see the table in BIPRU 7.3.3R):

(1) it must be treated as a position in the equity into which it converts; and
(2) the firm's equity PRR must be adjusted by making:

(a) an addition equal to the current value of any loss which the firm would make if it did convert to equity; or
(b) a deduction equal to the current value of any profit which the firm would make if it did convert to equity (subject to a maximum deduction equal to the PRR on the notional position underlying the convertible).

01/01/2007

Derivation of notional positions: Futures, forwards and CFDs on a single equity

BIPRU 7.3.14

A future (including a synthetic future), forward or CFD on a single equity must be treated as a notional position in that equity.

01/01/2007

Derivation of notional positions: Futures, forwards and CFDs on equity indices or baskets

BIPRU 7.3.15

A future (including a synthetic future), forward or CFD on an equity index or basket must be treated as either:

(1) a position in each of the underlying equities; or
(2) the positions shown in the table in BIPRU 7.3.16R.

01/01/2007

BIPRU 7.3.16

Table: Instruments which result in notional positions
This table belongs to BIPRU 7.3.15R(2)

Under the simplified equity method (BIPRU 7.3.29R)

Under the standard equity method (BIPRU 7.3.32R)

Only one country in the index or basket (see BIPRU 7.3.32R)

One position in the index or basket

More than one country in the index or basket

One position in the index or basket

Several notional basket positions, one for each country

One notional basket position in a separate, notional country

01/01/2007

BIPRU 7.3.17

An example of BIPRU 7.3.16R is as follows. A firm decides to treat a FTSE Eurotop 300 future under the standard equity method, and furthermore, chooses to treat it as one notional position. The table in BIPRU 7.3.16R requires that this notional position be treated as if it were from a separate notional country rather than any of the countries to which the underlying equities are from.

01/01/2007

BIPRU 7.3.18

The notional positions created under BIPRU 7.3.15R have the following values:

(1) where only one notional position is created, it has a value equal to the total market value of the equities underlying the contract; or
(2) where more than one notional position is created, each one has a value which reflects the relevant equity's or country's contribution to the total market value of the equities underlying the contract.

01/01/2007

Derivation of notional positions: Equity legs of equity swaps

BIPRU 7.3.19

The equity leg of an equity swap must be treated as a position in the underlying equity, equity basket or equity index, which is:

(1) long, if the firm has contracted to receive any increase and pay any decrease in the value of the underlying equities or equity index; and
(2) short, if the firm has contracted to receive any decrease and pay any increase in the value of the underlying equities or equity index.

01/01/2007

BIPRU 7.3.20

The interest rate leg of an equity swap is included in a firm's interest rate PRR calculation (see the table in BIPRU 7.2.4R (Table: Instruments which result in notional positions)) unless it is treated under BIPRU 7.3.45R.

01/01/2007

Derivation of notional positions: Options

BIPRU 7.3.21

If included in BIPRU 7.3's PRR calculation (see the table in BIPRU 7.3.3R), options must be treated as follows:

(1) an option on a single equity must be treated as a notional position in that equity;
(2) an option on a basket of equities or equity index must be treated as a future on that basket or index; and
(3) an option on an equity future must be treated as:

(a) a long position in that future, for purchased call options and written put options; and
(b) a short position in that future, for purchased put options and written call options.

01/01/2007

Deriving the net position in each equity

BIPRU 7.3.22

The net position in each equity is the difference between the value of the firm's long positions (including notional positions) and the value of its short positions (including notional positions) in the same equity.

01/01/2007

BIPRU 7.3.23

(1) When deriving the net position in each equity, a firm must not net long and short positions except in accordance with this rule.
(2) Subject to (3), a firm may net long and short positions in the same equity. Two equities are the same if and only if they:

(a) enjoy the same rights in all respects; and
(b) are fungible with each other.

(3) Long and short positions in different tranches of the same equity may be treated as being in the same equity for the purpose of (1), where:

(a) the tranches enjoy the same rights in all respects; and
(b) the tranches become fungible with each other within 180 days, and thereafter the equity of one tranche can be delivered in settlement of the other tranche.

01/01/2007

BIPRU 7.3.24

A firm must not net a reduced net underwriting position with any other equity position.

01/01/2007

BIPRU 7.3.25

BIPRU 7.3.24R only relates to reduced net underwriting position.

01/01/2007

Simplified and standard equity methods

BIPRU 7.3.26

BIPRU 7.3.1R (1) requires that the net position in each equity be included in either the simplified equity method or the standard equity method, subject to the restriction in BIPRU 7.3.27R. A firm does not have to use the same method for all equities.

01/01/2007

BIPRU 7.3.27

A firm must use the simplified equity method for reduced net underwriting positions.

01/01/2007

BIPRU 7.3.28

A firm may use either method for a net underwriting position; BIPRU 7.3.27R only relates to reduced net underwriting positions.

01/01/2007

Simplified equity method

BIPRU 7.3.29

Under the simplified equity method, the PRR for each equity, equity index, or equity basket equals the market value of the net position (ignoring the sign) multiplied by the appropriate PRA from the table in BIPRU 7.3.30R. The result must be converted into the firm's base currency at current spot foreign currency rates.

01/01/2007

BIPRU 7.3.30

Table: simplified equity method PRAs
This table belongs to BIPRU 7.3.29R

Instrument

PRA

Single equities

12%

Qualifying equity indices (see BIPRU 7.3.38R)

All other equity indices or baskets

12%

If it is necessary to distinguish between the specific risk PRA and the general market risk PRA, the specific risk PRA for the first and third rows is 4% and that for the second row is 0%. The rest of the PRA in the second column is the general market risk PRA.

01/01/2007

Standard equity method

BIPRU 7.3.31

The standard equity method divides the risk of loss from a firm's equity positions into the risk of loss from a general move in a country's equity market and the risk of loss from an individual equity's price changing relative to that country's equity market. These are called general market risk and specific risk respectively.

01/01/2007

BIPRU 7.3.32

Under the standard equity method, a firm must:

(1) group equity positions into country portfolios as follows:

(a) a position in an individual equity belongs to:

(i) the country it is listed in;
(ii) any of the countries it is listed in, if more than one; or
(iii) the country it was issued from, if unlisted;

(b) a position in an equity basket or index that is treated under BIPRU 7.3.15R(2), is allocated to one or more country portfolios based on the countries to which the underlying equities belong to under (a) or a notional country provided for in the table in BIPRU 7.3.16R; and

(2) sum:

(a) the PRRs for specific risk calculated under BIPRU 7.3.33R; and
(b) the PRRs for general market risk for each country portfolio as calculated under BIPRU 7.3.41R and BIPRU 7.3.42R.

01/01/2007

Standard equity method: Specific risk

BIPRU 7.3.33

Under the standard equity method, a firm must calculate a PRR for specific risk based on the net position in each equity, equity index or equity basket by multiplying its market value (ignoring the sign) by the appropriate PRA from the table in BIPRU 7.3.34R.

01/01/2007

BIPRU 7.3.34

Table: PRAs for specific risk under the standard equity method
This table belongs to BIPRU 7.3.33R

Instrument

PRA

Qualifying equities

Qualifying equity indices (see BIPRU 7.3.38R)

All other equities, equity indices or equities baskets

01/01/2007

Definition of a qualifying equity

BIPRU 7.3.35

A qualifying equity is one that satisfies the following conditions:

(1) it belongs to a country portfolio that satisfies the following conditions:

(a) no individual position exceeds 10% of the portfolio's gross value; and
(b) the sum of positions (ignoring the sign) which individually represent between 5% and 10% of the portfolio's gross value, does not exceed 50% of the portfolio's gross value;

(2) it is not of an issuer that has issued only traded debt securities that currently attracts an 8% or 12% PRA in the table in BIPRU 7.2.44R (Specific risk PRA) or that attract a lower requirement only because they are guaranteed or secured; and
(3) it is a constituent of an index in the table in BIPRU 7.3.39R.

01/01/2007

BIPRU 7.3.36

(1) The following example illustrates BIPRU 7.3.35R(1).
(2) A country portfolio has a gross value of £100 and is made up of positions in 29 different equities (some are long positions, others are short positions). Not all the equities are constituents of an index used to create the FT All-World Index (this criterion only becomes relevant once a firm has determined whether the country portfolio meets the test in BIPRU 7.3.35R(1)).
(3) Six positions exceed the 5% threshold. The following diagram shows the composition of the portfolio.
(4) Part (a): the portfolio meets the first part of the test because no individual position is worth more than 10% of the portfolio's value.
(5) Part (b): the portfolio fails the second part of the test because the sum (ignoring the sign) of the six relevant positions is £52; this exceeds 50% of the portfolio's value.

01/01/2007

BIPRU 7.3.37

(1) A country portfolio can be split into two sub-portfolios if this enables one sub-portfolio to meet the requirements in BIPRU 7.3.35R(1). Individual positions may be sub-divided between sub-portfolios.
(2) Continuing the example above, one of the largest positions is taken out of the portfolio and put into a new portfolio. The new portfolio fails the two tests, but the amended portfolio meets both tests:

(a) Part (a): no single remaining position exceeds £9.10.
(b) Part (b): the sum of the five relevant positions is £43, this is less than 50% of the new portfolio's value of £91.

01/01/2007

Definition of a qualifying equity index

BIPRU 7.3.38

A qualifying equity index is one which is traded on a recognised investment exchange or a designated investment exchange and:

(1) is listed in the table in BIPRU 7.3.39R; or
(2) is not listed in the table in BIPRU 7.3.39R, but is constructed in such a way that:

(a) it contains at least 20 equities;
(b) no single equity represents more than 20% of the total index; and
(c) no five equities combined represent more than 60% of the total index.

01/01/2007

BIPRU 7.3.39

Table: Qualifying equity indices
This table belongs to BIPRU 7.3.38R

Country or territory

Name of index

Australia

All Ordinaries

Austria

Austrian Traded Index

Belgium

BEL 20

Canada

TSE 35, TSE 100, TSE 300

France

CAC 40, SBF 250

Germany

DAX

European

Dow Jones Stoxx 50 Index, FTSE Eurotop 300, MSCI Euro Index

Hong Kong

Hang Seng 33

Italy

MIB 30

Japan

Nikkei 225, Nikkei 300, TOPIX

Korea

Kospi

Netherlands

AEX

Singapore

Straits Times Index

Spain

IBEX 35

Sweden

OMX

Switzerland

SMI

FTSE 100, FTSE Mid 250, FTSE All Share

S&P 500, Dow Jones Industrial Average, NASDAQ Composite, Russell 2000

01/01/2007

Standard equity method: General market risk: General

BIPRU 7.3.40

Under the standard equity method, a firm must apply approach one, as set out in BIPRU 7.3.41R, to each country portfolio (or part portfolio) unless the conditions in BIPRU 7.3.42R(3) are met, in which case the firm may instead apply approach two, as set out in BIPRU 7.3.42R, to the relevant country portfolios (or part portfolios).

01/01/2007

Standard equity method: General market risk: Approach One: No offset between different country portfolios

BIPRU 7.3.41

Under approach one as referred to in BIPRU 7.3.40R, the PRR for general market risk equals the net value (ignoring the sign) of the country portfolio multiplied by 8%.

01/01/2007

Standard equity method: General market risk: Approach Two: Limited offset between different country portfolios

BIPRU 7.3.42

(1) Under approach two as referred to in BIPRU 7.3.40R, the PRR for general market risk is calculated using the following formula:
(2) In the formula in (1) CP_i denotes the net value of _ith country portfolio (converted to the firm's base currency using current spot foreign currency rates).
(3) The conditions referred to in BIPRU 7.3.40R that must be met for a firm to be able to use approach two as referred to in BIPRU 7.3.40R are as follows:

(a) at least four country portfolios are included (that is: n ≥ 4);
(b) only country portfolios for countries which are full members of the OECD, Hong Kong or Singapore are included;
(c) no individual country portfolio comprises more than 30% of the total gross value of country portfolios included; and
(d) the total net value of country portfolios included equals zero, that is:

01/01/2007

BIPRU 7.3.43

In order to meet BIPRU 7.3.42R(3)(d), it is likely that part of a country portfolio will have to be excluded from approach two under BIPRU 7.3.42R (and therefore included in approach one under BIPRU 7.3.41R), even if that country portfolio meets BIPRU 7.3.42R(3)(a) - (c).

01/01/2007

Basic interest rate calculation for equity instruments

BIPRU 7.3.44

A basic interest rate PRR calculation is included in BIPRU 7.3 for a firm that does not wish to use the calculation in BIPRU 7.2 (Interest rate PRR). However, it tends to result in higher charges than the methods in BIPRU 7.2, largely because the interest rate PRR is calculated on each notional equity position separately and then summed without offsetting long and short positions.

01/01/2007

BIPRU 7.3.45

This rule applies to a firm that does not include a forward, future, option or swap on an equity, basket of equities or equity index in the calculation of its interest rate PRR calculation under BIPRU 7.2 (Interest rate PRR). However it does not apply to cliquet as defined in BIPRU 7.6.18R (Table: Option PRR: methods for different types of option). A firm must calculate the interest rate PRR for a position being treated under this rule as follows:

(1) multiply the market value of the notional equity position underlying the instrument by the appropriate percentage from the table in BIPRU 7.3.47R; and
(2) sum the results from (1), ignoring the sign.

01/01/2007

BIPRU 7.3.46

Cliquets on equities, baskets of equities or equity indices do not attract an interest rate PRR. BIPRU 7.3.45R excludes them from the basic interest rate PRR calculation and the table in BIPRU 7.2.4R (Table: Instruments which result in notional positions) excludes them from the scope of the interest rate PRR calculation in BIPRU 7.2 (Interest rate PRR).

01/01/2007

BIPRU 7.3.47

Table: Percentages used in the basic interest rate PRR calculation for equity instruments
This table belongs to BIPRU 7.3.45R(1)

Time to expiration

Percentage (%)

0 ≤ 3 months

0.20

> 3 ≤ 6 months

0.40

> 6 ≤ 12 months

0.70

> 1 ≤ 2 years

1.25

> 2 ≤ 3 years

1.75

> 3 ≤ 4 years

2.25

> 4 ≤ 5 years

2.75

> 5 ≤ 7 years

3.25

> 7 ≤ 10 years

3.75

> 10 ≤ 15 years

4.50

> 15 ≤ 20 years

5.25

> 20 years

6.00

01/01/2007

Additional capital charge in relation to equity indices

BIPRU 7.3.48

If a firm nets off positions in one or more of the equities constituting an equity index future, forward or CFD against one or more positions in the equity index future, forward or CFD itself, the firm must apply an additional equity PRR to the netted position to cover the risk of loss caused by the value of the future, forward or CFD not moving fully in line with that of its constituent equities. The same applies if a firm holds opposite positions in a future, forward or CFD on an equity index that are not identical in respect of either their maturity or their composition or both.

01/01/2007

BIPRU 7.4

Commodity PRR

01/01/2007

General rule

BIPRU 7.4.1

A firm must calculate its commodity PRR by:

(1) identifying which commodity position must be included within the scope of the PRR calculation (see BIPRU 7.4.2R);
(2) expressing each such position in terms of the standard unit of measurement of the commodity concerned;
(3) expressing the spot price in each commodity in the firm's base currency at current spot foreign exchange rates;
(4) calculating an individual PRR for each commodity (see BIPRU 7.4.20R); and
(5) summing the resulting individual PRRs.

01/01/2007

Scope of the commodity PRR calculation

BIPRU 7.4.2

A firm's commodity PRR calculation must, regardless of whether the positions concerned are trading book or non-trading book positions:

(1) include physical commodity positions;
(2) (if the firm is the transferor of commodities or guaranteed rights relating to title to commodities in a repurchase agreement or the lender of commodities in a commodities lending agreement) include such commodities;
(3) include notional positions arising from positions in the instruments listed in the table in BIPRU 7.4.4R; and
(4) exclude positions constituting a stock financing transaction.

01/01/2007

BIPRU 7.4.3

Gold positions are excluded from the scope of the commodity PRR. Instead, they are included within the scope of the foreign exchange PRR (BIPRU 7.5).

01/01/2007

BIPRU 7.4.4

Table: Instruments which result in notional positions
This table belongs to BIPRU 7.4.2R(3)

Instrument

See

Forwards, futures, CFDs, synthetic futures and options on a single commodity (unless the firm calculates a PRR on the option under BIPRU 7.6 (Option PRR))

BIPRU 7.4.8R

A commitment to buy or sell a single commodity at an average of spot prices prevailing over some future period

BIPRU 7.4.10R

Forwards, futures, CFDs, synthetic futures and options on a commodity index (unless the firm calculates an PRR on the option under BIPRU 7.6)

BIPRU 7.4.13R - BIPRU 7.4.14R

Commodity swaps

BIPRU 7.4.16R - BIPRU 7.4.17R

A warrant relating to a commodity must be treated as an option on a commodity.

01/01/2007

BIPRU 7.4.5

BIPRU 7.4.2R includes a trading book position in a commodity that is subsequently repo'd under a repurchase agreement or lent under a stock lending agreement. Clearly, if the commodity had initially been obtained via a reverse repurchase agreement or stock borrowing agreement, the commodity would not have been included in the trading book in the first place.

01/01/2007

BIPRU 7.4.6

Firms are reminded that the table in BIPRU 7.6.5R (Table: Appropriate PRR calculation for an option or warrant) divides commodity options into:

(1) those which must be treated under BIPRU 7.6; and
(2) those which must be treated under either BIPRU 7.4 or BIPRU 7.6 (Option PRR), the firm being able to choose whether BIPRU 7.4 or BIPRU 7.6 is used.

01/01/2007

Derivation of notional positions: General

BIPRU 7.4.7

BIPRU 7.4.8R - BIPRU 7.4.19G convert the instruments listed in the table in BIPRU 7.4.4R into notional positions in the relevant commodities. These notional positions are expressed in terms of quantity (tonnes, barrels, etc), not value. The maturity of the position is only relevant where the firm is using the commodity maturity ladder approach or the commodity extended maturity ladder approach.

01/01/2007

Derivation of notional positions: Futures, forwards, CFDs and options on a single commodity

BIPRU 7.4.8

Where a forward, future, CFD, synthetic future or option (unless already included in the firm's option PRR calculation) settles according to:

(1) the difference between the price set on trade date and that prevailing at contract expiry, the notional position:

(a) equals the total quantity underlying the contract; and
(b) has a maturity equal to the expiry date of the contract; and

(2) the difference between the price set on trade date and the average of prices prevailing over a certain period up to contract expiry, there is a notional position for each of the reference dates used in the averaging period to calculate the average price, which:

(a) equals a fractional share of the total quantity underlying the contract; and
(b) has a maturity equal to the relevant reference date.

01/01/2007

BIPRU 7.4.9

(1) The following example illustrates BIPRU 7.4.8R (2).
(2) A firm buys a Traded Average Price Option (TAPO - a type of Asian option) allowing it to deliver 100 tonnes of Grade A copper and receive $1,750 in June. If there were 20 business days in June the short notional positions will each:

(a) equal 5 tonnes per day (1/20 of 100 tonnes); and
(b) have a maturity equal to one of the business days in June (one for each day).

(3) In this example as each business day in June goes by the quantity per day for the remaining days does not change (5 tonnes per day) only the days remaining changes. Therefore, halfway through June there are ten, 5 tonne short notional positions remaining each for the ten remaining business days in June.

01/01/2007

Derivation of notional positions: Buying or selling a single commodity at an average of spot prices prevailing in the future

BIPRU 7.4.10

Commitments to buy or sell at the average spot price of the commodity prevailing over some period between trade date and maturity must be treated as a combination of:

(1) a position equal to the full amount underlying the contract with a maturity equal to the maturity date of the contract which is:

(a) long, where the firm will buy at the average price; or
(b) short, where the firm will sell at the average price; and

(2) a series of notional positions, one for each of the reference dates where the contract price remains unfixed, each of which:

(a) is long if the position under (1) is short, or short if the position under (1) is long;
(b) equals a fractional share of the total quantity underlying the contract; and
(c) has a maturity date of the relevant reference date.

01/01/2007

BIPRU 7.4.11

The following guidance provides an example of BIPRU 7.4.10R. In January, a firm agrees to buy 100 tonnes of copper for the average spot price prevailing during the 20 business days in February, and will settle on 30 June. After entering into this agreement, the firm faces the risk that the average price for February increases relative to that for 30 June. Therefore, as highlighted in the table below:

(1) the short positions reflect the fact that this could occur because any one of the remaining forward prices for February increase; and
(2) the long position reflects the fact that this loss could occur because the forward price for 30 June falls.

01/01/2007

BIPRU 7.4.12

Table: Example of buying at the average spot price prevailing in the future
This table belongs to BIPRU 7.4.11G

Application of BIPRU 7.4.10R(1)

Application of BIPRU 7.4.10R(2)

From trade date to start of averaging period

Long position in 100 tonnes of copper with a maturity of 30 June.

A series of 20 notional short positions each equal to 5 tonnes of copper. Each position is allocated a maturity equal to one of the business days in February (one for each day).

During averaging period

Long position in 100 tonnes of copper with a maturity of 30 June.

As each business day goes by in February the price for 5 tonnes of copper is fixed and so there will be one less notional short position.

After averaging period

Long position in 100 tonnes of copper with a maturity of 30 June.

No short positions.

01/01/2007

Derivation of notional positions: CFDs and options on a commodity index

BIPRU 7.4.13

Commodity index futures and commodity index options (unless the option is included in the firm's option PRR calculation), must be treated as follows:

(1) Step 1: the total quantity underlying the contract must be either:

(a) treated as a single notional commodity position (separate from all other commodities); or
(b) divided into notional positions, one for each of the constituent commodities in the index, of an amount which is a proportionate part of the total underlying the contract according to the weighting of the relevant commodity in the index;

(2) Step 2: each notional position determined in Step 1 must then be included:

(a) when using the commodity simplified approach (BIPRU 7.4.24R), without adjustment; or
(b) when using the commodity maturity ladder approach (BIPRU 7.4.25R) or the commodity extended maturity ladder approach (BIPRU 7.4.32R), with the adjustments in BIPRU 7.4.14R.

01/01/2007

BIPRU 7.4.14

Table: Treatment of commodity index futures and commodity index options
This table belongs to BIPRU 7.4.13R(2)(b)

Construction of index

Notional position (or positions) and maturity

Spot level of index is based on the spot price of each constituent commodity

Each quantity determined in Step 1 as referred to in BIPRU 7.4.13R is assigned a maturity equal to the expiry date of the contract.

Spot level of index is based on an average of the forward prices of each constituent commodity

Each quantity determined in Step 1 as referred to in BIPRU 7.4.13R is divided (on a pro-rata basis) into a series of forward positions to reflect the impact of each forward price on the level of the index. The maturity of each forward position equals the maturity of the relevant forward price determining the level of the index when the contract expires.

01/01/2007

BIPRU 7.4.15

(1) An example of using BIPRU 7.4.13R and the table in BIPRU 7.4.14R is as follows.
(2) A firm is long a three-month commodity index future where the spot level of the index is based on the one, two and three month forward prices of aluminium, copper, tin, lead, zinc and nickel (18 prices in total).
(3) Step 1: the firm should decide whether to treat the full quantity underlying the contract as a single notional commodity position or disaggregate it into notional positions in aluminium, copper, tin, lead, zinc and nickel. In this case the firm decides to disaggregate the contract into notional positions in aluminium, copper, tin, lead, zinc and nickel.
(4) Step 2: if the firm uses the commodity simplified approach, nothing more need be done to arrive at the notional position. In this case the firm uses the commodity maturity ladder approach and so subdivides each position in each metal into three because the level of the index is based on the prevailing one, two and three month forward prices. Since the future will be settled in three months' time at the prevailing level of the index, the three positions for each metal will have maturities of four, five and six months respectively.

01/01/2007

Derivation of notional positions: Commodity swaps

BIPRU 7.4.16

A firm must treat a commodity swap as a series of notional positions, one position for each payment under the swap, each of which:

(1) equals the total quantity underlying the contract;
(2) has a maturity corresponding to the payment date; and
(3) is long or short according to BIPRU 7.4.17R.

01/01/2007

BIPRU 7.4.17

Table: Treatment of commodity swaps
This table belongs to BIPRU 7.4.16R

Receiving amounts which are unrelated to any commodity's price

Receiving the price of commodity 'b'

Paying amounts which are unrelated to any commodity's price

N/A

Long positions in commodity 'b'

Paying the price of commodity 'a'

Short positions in commodity 'a'

Short positions in commodity 'a' and long positions in commodity 'b'

01/01/2007

BIPRU 7.4.18

The table in BIPRU 7.4.17R shows that where the legs of the swap are in different commodities, a series of forward positions are created for each commodity (that is, a series of short positions in commodity 'a' and a series of long positions in commodity 'b').

01/01/2007

BIPRU 7.4.19

The table in BIPRU 7.4.17R also covers the case where one leg is unrelated to any commodity's price. This leg may be subject to a PRR under another part of BIPRU 7; for example, an interest rate based leg would have to be included in a firm's interest rate PRR calculation.

01/01/2007

Calculating the PRR for each commodity: General

BIPRU 7.4.20

A firm must calculate a commodity PRR for each commodity separately using either the commodity simplified approach (BIPRU 7.4.24R), the commodity maturity ladder approach (BIPRU 7.4.25R) or the commodity extended maturity ladder approach (BIPRU 7.4.32R).

01/01/2007

BIPRU 7.4.21

A firm must use the same approach for a particular commodity but need not use the same approach for all commodities.

01/01/2007

BIPRU 7.4.22

(1) A firm must treat positions in different grades or brands of the same commodity-class as different commodities unless they:

(a) can be delivered against each other; or
(b) are close substitutes and have price movements which have exhibited a stable correlation coefficient of at least 0.9 over the last 12 months.

(2) If a firm relies on (1)(b) it must then monitor compliance with the conditions in that paragraph on a continuing basis.

01/01/2007

BIPRU 7.4.23

If a firm intends to rely on the approach in BIPRU 7.4.22R(1)(b):

(1) it must notify the FSA in writing at least 20 business days prior to the date the firm starts relying on it; and
(2) the firm must, as part of the notification under (1), provide to the FSA the analysis of price movements on which it relies.

01/01/2007

Calculating the PRR for each commodity: Simplified approach

BIPRU 7.4.24

A firm which calculates a commodity PRR using the commodity simplified approach must do so by summing:

(1) 15% of the net position multiplied by the spot price for the commodity; and
(2) 3% of the gross position (long plus short, ignoring the sign) multiplied by the spot price for the commodity;

(and for these purposes the excess of a firm's long (short) positions over its short (long) positions in the same commodity (including notional positions under BIPRU 7.4.4R) is its net position in each commodity).

01/01/2007

Calculating the PRR for each commodity: Maturity ladder approach

BIPRU 7.4.25

A firm using the commodity maturity ladder approach must calculate the commodity PRR following the steps in BIPRU 7.4.26R and then sum all spread charges, carry charges and outright charges that result. A firm must use a separate maturity ladder for each commodity.

01/01/2007

BIPRU 7.4.26

(1) A firm must calculate the charges referred to in BIPRU 7.4.25R as follows.
(2) Step 1: offset long and short positions maturing:

(a) on the same day; or
(b) (in the case of positions arising under contracts traded in markets with daily delivery dates) within 10 business days of each other.

(3) Step 2: allocate the positions remaining after step 1 to the appropriate maturity band in the table in BIPRU 7.4.28R (physical commodity positions are allocated to band 1).
(4) Step 3: match long and short positions within each band. In each instance, calculate a spread charge equal to the matched amount multiplied first by the spot price for the commodity and then by the spread rate of 3%.
(5) Step 4: carry unmatched positions remaining after step 3 to another band where they can be matched, then match them. Do this until all matching possibilities are exhausted. In each instance, calculate:

(a) a carry charge equal to the carried position multiplied by the spot price for the commodity, the carry rate of 0.6% and the number of bands by which the position is carried; and
(b) a spread charge equal to the matched amount multiplied by the spot price for the commodity and the spread rate of 3%.

(6) Step 5: calculate the outright charge on the remaining positions (which will either be all long positions or all short positions). The outright charge equals the remaining position (ignoring the sign) multiplied by the spot price for the commodity and the outright rate of 15%.

01/01/2007

BIPRU 7.4.27

The matched amount in BIPRU 7.4.26R is the lesser (ignoring the sign) of either the total long position or the total short position. For example, a band with 1000 long and 700 short results in a matched amount of 700. The unmatched amount would be 300.

01/01/2007

BIPRU 7.4.28

Table: Maturity bands for the maturity ladder approach
This table belongs to BIPRU 7.4.26R

Band

Maturity of position

Band 1

0 ≤ 1 month

Band 2

> 1 month ≤ 3 months

Band 3

> 3 months ≤ 6 months

Band 4

> 6 months ≤ 1 year

Band 5

> 1 year ≤ 2 years

Band 6

> 2 years ≤ 3 years

Band 7

> 3 years

01/01/2007

BIPRU 7.4.29

BIPRU 7.4.30G is an example illustrating the calculation of the commodity PRR on an individual commodity using the commodity maturity ladder approach (BIPRU 7.4.26R). After the firm has carried out the pre-processing required by BIPRU 7.4.26R(2) (that is, step 1), it follows steps 2 to 5 as shown below. Because the firm is using the commodity maturity ladder approach the spread rate is 3%, the carry rate is 0.6% and the outright rate is 15%. The example assumes that the spot price for the commodity is £25.

01/01/2007

BIPRU 7.4.30

Table: Example illustrating the commodity maturity ladder approach
This table belongs to BIPRU 7.4.29G

01/01/2007

Calculating the PRR for each commodity: Extended maturity ladder approach

BIPRU 7.4.31

A firm may use the commodity extended maturity ladder approach to calculate the commodity PRR for a particular commodity provided the firm:

(1) has a diversified commodities portfolio;
(2) undertakes significant commodities business;
(3) is not yet in a position to use the VaR model approach to calculate commodity PRR; and
(4) at least twenty business days before the date the firm uses that approach notifies the FSA in writing of:

(a) its intention to use the commodity extended maturity ladder approach; and
(b) the facts and matters relied on to demonstrate that the firm meets the criteria in (1) - (3).

01/01/2007

BIPRU 7.4.32

A firm using the commodity extended maturity ladder approach must calculate its commodity PRR by:

(1) following the same steps as in BIPRU 7.4.26R but using the rates from the table in BIPRU 7.4.33R rather than those in BIPRU 7.4.26R; and
(2) summing all spread charges, carry charges and outright charge that result.

01/01/2007

BIPRU 7.4.33

Table: Alternative spread, carry and outright rates
This table belongs to BIPRU 7.4.32R

Precious metals (excluding gold)

Base metals

Softs (agricultural)

Other (including energy)

Spread rate (%)

2.4

Carry rate (%)

0.3

0.5

0.6

Outright rate (%)

01/01/2007

BIPRU 7.4.34

For the purposes of BIPRU 7.4.31R(1) a firm has a diversified commodity portfolio where it holds positions in more than one commodity in each of the categories set out in the table in BIPRU 7.4.33R and holds positions across different maturities in those individual commodities. A firm would not have a diversified commodity portfolio if it held positions in only one commodity in each of the categories set out in the table in BIPRU 7.4.33R. This is because the rates in the table in BIPRU 7.4.33R assume firms have positions in more than one of that category's commodities. Different commodities within a given category are likely to exhibit different volatilities, so where a firm does not have a diversified commodity portfolio in that category, the rates applying to that category might underestimate the regulatory capital required for a certain commodity at certain times.

01/01/2007

BIPRU 7.4.35

What constitutes significant business in BIPRU 7.4.31R(2) will vary from firm to firm. The more regularly the firm undertakes trades in commodities and the more consistently it has positions in the relevant commodity, the more likely it is to be undertaking significant business for the purposes of BIPRU 7.4.31R(2).

01/01/2007

BIPRU 7.4.36

Where a firm is:

(1) treating a commodity index derivative as if it was based on a single separate commodity (see BIPRU 7.4.13R(1)(a)); and
(2) using the commodity extended maturity ladder approach to calculate the commodity PRR for that commodity;

it must determine which index constituent incurs the highest rate in the table in BIPRU 7.4.33R and apply that rate to the notional position for the purposes of BIPRU 7.4.32R.

01/01/2007

BIPRU 7.4.37

Where an index is only based on precious metals, BIPRU 7.4.13R and BIPRU 7.4.36R allow the firm to treat the single notional position as precious metal for the purposes of BIPRU 7.4.32R. However, if the index contained a mix of precious metals and base metals the firm would have to treat the notional position under BIPRU 7.4.36R as a base metal because base metals attract a higher rate than precious metals in the table in BIPRU 7.4.33R.

01/01/2007

Liquidity and other risks

BIPRU 7.4.38

If a short position to which BIPRU 7.4 applies falls due before a long position to which BIPRU 7.4 applies, a firm must also guard against the risk of a shortage of liquidity which may exist in some markets.

01/01/2007

BIPRU 7.4.39

In particular, where BIPRU 7.4.38R applies and the short position constitutes a material position compared to a firm's total commodity positions, it should consider a further commodity PRR charge in respect of that position depending on the likelihood of a shortage of liquidity in that market.

01/01/2007

BIPRU 7.4.40

A firm must safeguard against other risks, apart from the delta risk, associated with commodity options.

01/01/2007

BIPRU 7.4.41

The interest-rate and foreign-exchange risks not covered by other provisions of BIPRU 7.4 or by the provisions of BIPRU 7.2 (Interest rate PRR) or BIPRU 7.5 (Foreign currency PRR) must be included in the calculation of general market risk for traded debt securities and in the calculation of foreign currency PRR.

01/01/2007

BIPRU 7.5

Foreign currency PRR

01/01/2007

General rule

BIPRU 7.5.1

A firm must calculate its foreign currency PRR by:

(1) identifying which foreign currency and gold positions to include in the PRR calculation;
(2) calculating the net open position in each currency in accordance with this section (including where necessary the base currency calculated in the same way as it is for foreign currencies) and in gold;
(3) calculating the open currency position for foreign currencies as calculated under BIPRU 7.5.19R and the net gold position (see BIPRU 7.5.20R); and
(4) multiplying the sum of the absolutes of that open currency position and that net gold position by 8%.

01/01/2007

BIPRU 7.5.2

An example of the operation of BIPRU 7.5.1R is as follows. A firm has an open currency position of £100 and a net gold position of £50. The sum (ignoring the sign) is £150, and so the foreign currency PRR is £12.

01/01/2007

Scope of the foreign currency PRR calculation

BIPRU 7.5.3

A firm's foreign currency PRR calculation must include the following items regardless of whether they are trading book or non-trading book positions:

(1) all gold positions;
(2) all spot positions in foreign currency (that is, all asset items less all liability items, including accrued interest, in the foreign currency in question);
(3) all forward positions in foreign currency;
(4) all CRD financial instruments and other items which are denominated in a foreign currency;
(5) irrevocable guarantees (and similar instruments) that are certain to be called and likely to be irrecoverable to the extent they give rise to a position in gold or foreign currency; and
(6) notional positions arising from the instruments listed in the table in BIPRU 7.5.5R.

01/01/2007

BIPRU 7.5.4

(1) The following are excluded from a firm's foreign currency PRR calculation:

(a) foreign currency assets which have been deducted in full from the firm's capital resources under the calculations under the capital resources table;
(b) positions hedging (a);
(c) positions that a firm has deliberately taken in order to hedge against the adverse effect of the exchange rate on the ratio of its capital resources to its capital resources requirement; and
(d) transactions to the extent that they fully hedge net future foreign currency income or expenses which are known but not yet accrued.

(2) If a firm uses an exclusion under (1) it must:

(a) notify the FSA before it makes use of it;
(b) include in the notification in (a) the terms on which the relevant item will be excluded;
(c) not change the terms of the exclusion under (b); and
(d) document its policy on the use of that exclusion in its trading book policy statement.

(3) A position may only be excluded under (1)(b) or (c) if it is of a non-trading or structural nature.

01/01/2007

BIPRU 7.5.5

Table: instruments which result in notional foreign currency positions
This table belongs to BIPRU 7.5.3R(6).

Instruments

See

Foreign currency futures, forwards, synthetic futures and CFDs

BIPRU 7.5.11R

Foreign currency swaps

BIPRU 7.5.13R

Foreign currency options or warrants (unless the firm calculates a PRR on the option or warrant under BIPRU 7.6 (Option PRR)).

BIPRU 7.5.15R

Gold futures, forwards, synthetic futures and CFDs

BIPRU 7.5.16R

Gold options (unless the firm calculates a PRR on the option under BIPRU 7.6).

BIPRU 7.5.17R

Positions in CIUs

BIPRU 7.5.18R

01/01/2007

BIPRU 7.5.6

Firms are reminded that the table in BIPRU 7.6.5R (Table: Appropriate PRR calculation for an option or warrant) divides foreign currency options and warrants into:

(1) those which must be treated under BIPRU 7.6 (Option PRR); and
(2) those which must be treated under either BIPRU 7.5 or BIPRU 7.6, the firm being able to choose whether BIPRU 7.5 or BIPRU 7.6 is used.

01/01/2007

BIPRU 7.5.7

When determining the currency of denomination firms must:

(1) use the currency in which the firm accounts for the instrument where an instrument is quoted in more than one currency; and
(2) treat depository receipts as positions in the underlying security.

01/01/2007

BIPRU 7.5.8

Instruments denominated in a foreign currency include, amongst other things, assets and liabilities (including accrued interest); non-foreign currency derivative; net underwriting positions; reduced net underwriting positions; and irrevocable guarantees (or similar instruments) that are certain to be called.

01/01/2007

BIPRU 7.5.9

Where a contract is based on a basket of currencies, the firm can choose either to derive notional positions in each of the constituent currencies or treat it as a single notional position in a separate notional currency.

01/01/2007

Derivation of notional positions: General

BIPRU 7.5.10

BIPRU 7.5.11R - BIPRU 7.5.18R derive notional currency positions for the instruments listed in the table in BIPRU 7.5.5R.

01/01/2007

Derivation of notional positions: Foreign exchange forwards, futures, CFDs and synthetic futures

BIPRU 7.5.11

(1) A firm must treat a foreign currency forward, future, synthetic future or CFD as two notional currency positions as follows:

(a) a long notional position in the currency which the firm has contracted to buy; and
(b) a short notional position in the currency which the firm has contracted to sell.

(2) In (1) the notional positions have a value equal to either:

(a) the contracted amount of each currency to be exchanged in the case of a forward, future, synthetic future or CFD held in the non-trading book; or
(b) the present value of the amount of each currency to be exchanged in the case of a forward, future, synthetic future or CFD held in the trading book.

01/01/2007

BIPRU 7.5.12

(1) The following example illustrates BIPRU 7.5.11R. In this example, a firm contracts to sell $106 for €108 in one year's time and the present values of each cash flow are $100 and €100 respectively.
(2) In the non-trading book, this forward would be treated as a combination of a €108 long position and a $106 short position.
(3) In the trading book, this forward would be treated as a combination of a €100 long position and a $100 short position.
(4) Firms are reminded that foreign currency forwards held in the trading book should also be included in the firm's interest rate PRR calculation (see BIPRU 7.2.4R (Instruments which result in notional positions for the purpose of the interest rate PRR)).

01/01/2007

Derivation of notional positions: Foreign currency swaps

BIPRU 7.5.13

(1) A firm must treat a foreign currency swap as:

(a) a long notional position in the currency in which the firm has contracted to receive interest and principal; and
(b) a short notional position in the currency in which the firm has contracted to pay interest and principal.

(2) In (1) the notional positions have a value equal to either:

(a) the nominal amount of each currency underlying the swap if it is held in the non-trading book; or
(b) the present value amount of all cash flows in the relevant currency in the case of a swap held in the trading book.

01/01/2007

BIPRU 7.5.14

(1) The following example illustrates BIPRU 7.5.13R. In this example a firm enters into a five year foreign currency swap where it contracts to pay six month US$ Libor on $100 in return for receiving 6% fixed on €100. The present values of each leg are $100 and €98 respectively.
(2) In the non-trading book, this swap would be treated as a combination of a €100 long position and a $100 short position.
(3) In the trading book, this swap would be treated as a combination of a €98 long position and a $100 short position.
(4) Firms are reminded that foreign currency swaps held in the trading book should also be included in the firm's interest rate PRR calculation (see BIPRU 7.2.4R (Instruments which result in notional positions for the purpose of the interest rate PRR)).

01/01/2007

Derivation of notional positions: Foreign currency options and warrants

BIPRU 7.5.15

Where included in BIPRU 7.5's PRR calculation (see the table in BIPRU 7.5.5R), a foreign currency option or warrant must be treated as a foreign currency forward.

01/01/2007

Derivation of notional positions: Gold forwards, futures, synthetic futures and CFDs

BIPRU 7.5.16

A forward, future, synthetic future or CFD on gold must be treated as a notional position in gold with a value equal to the amount of gold underlying multiplied by the current spot price for gold.

01/01/2007

Derivation of notional positions: Gold options

BIPRU 7.5.17

If included in the PRR calculation under BIPRU 7.5 (see the table in BIPRU 7.5.5R), a gold option must be treated as a gold forward.

01/01/2007

Derivation of notional positions: CIUs

BIPRU 7.5.18

(1) This rule deals with positions in CIUs.
(2) The actual foreign currency positions of a CIU must be included in a firm's foreign currency PRR calculation under BIPRU 7.5.1 R .
(3) A firm may rely on third party reporting of the foreign currency positions in the CIU, where the correctness of this report is adequately ensured.
(4) If a firm is not aware of the foreign currency positions in a CIU, the firm must assume that the CIU is invested up to the maximum extent allowed under the CIUs mandate in foreign currency and the firm must, for trading book positions, take account of the maximum indirect exposure that it could achieve by taking leveraged positions through the CIU when calculating its foreign currency PRR. This must be done by proportionally increasing the position in the CIU up to the maximum exposure to the underlying investment items resulting from the investment mandate.
(5) The assumed position of the CIU in foreign currency calculated in accordance with BIPRU 7.5.18R(4) must be treated as a separate currency according to the treatment of investments in gold, subject to the modification that, if the direction of the CIUs investment is available, the total long position may be added to the total long open foreign currency position and the total short position may be added to the total short open foreign currency position. No netting is allowed between such positions prior to this calculation.

06/04/2007

Open currency position

BIPRU 7.5.19

A firm must calculate its open currency position by:

(1) calculating the net position in each foreign currency;
(2) converting each such net position into its base currency equivalent at current spot rates;
(3) summing all short net positions and summing all long net positions calculated under (1) and (2); and
(4) selecting the larger sum (ignoring the sign) from (3).

01/01/2007

Net gold position

BIPRU 7.5.20

A firm must calculate its net gold position by:

(1) valuing all gold positions using the prevailing spot price for gold (regardless of the maturity of the positions);
(2) offsetting long and short positions; and
(3) converting the resulting net position into the base currency equivalent using the current spot foreign currency rate.

01/01/2007

BIPRU 7.6

Option PRR

01/01/2007

Option PRR calculation

BIPRU 7.6.1

A firm must calculate its option PRR by:

(1) identifying which option positions must be included within the scope of the option PRR calculation under BIPRU 7.6.3R - BIPRU 7.6.5R;
(2) calculating the derived position in each option in accordance with BIPRU 7.6.9R - BIPRU 7.6.15R;
(3) calculating the PRR for each derived position in accordance with BIPRU 7.6.16R - BIPRU 7.6.31R;
(4) summing all of the PRRs calculated in accordance with (3).

01/01/2007

BIPRU 7.6.2

Firms are reminded that the table in BIPRU 7.2.4R (Instruments which result in notional positions for the purposes of the interest rate PRR) and the table in BIPRU 7.3.3R (Instruments which result in notional positions for the purposes of the equity PRR) also require an interest rate PRR to be calculated for options on equities, baskets of equities or equities indices. The interaction between BIPRU 7.6 and the rest of Chapter 7 is illustrated in BIPRU 7.6.33G.

01/01/2007

Scope of the option PRR calculation

BIPRU 7.6.3

Except as permitted under BIPRU 7.6.5R, a firm's option PRR calculation must include:

(1) each trading book position in an option on an equity, interest rate or debt security;
(2) each trading book position in a warrant on an equity or debt security;
(3) each trading book position in a CIU; and
(4) each trading book and non-trading book position in an option on a commodity, currency or gold.

01/01/2007

BIPRU 7.6.4

BIPRU 7.6.3R(2) includes net underwriting positions or reduced net underwriting positions in warrants.

01/01/2007

BIPRU 7.6.5

Table: Appropriate PRR calculation for an option or warrant
This table belongs to BIPRU 7.6.3R

Option type (see BIPRU 7.6.18R) or warrant

PRR calculation

American option, European option, Bermudan option, Asian option or warrant for which the in the money percentage (see BIPRU 7.6.6R) is equal to or greater than the appropriate PRA (see BIPRU 7.6.7R and BIPRU 7.6.8R)

Calculate either an option PRR, or the most appropriate to the underlying position of:

(a) an equity PRR; or (b) an interest rate PRR; or (c) a commodity PRR; or (d) a foreign currency PRR; or (e) a collective investment undertaking PRR.

American option, European option, Bermudan option, Asian option or warrant:

(a) for which the in the money percentage (see BIPRU 7.6.6R) is less than the appropriate PRA (see BIPRU 7.6.7R and BIPRU 7.6.8R); or (b) that is at the money; or (c) that is out of the money.

Calculate an option PRR

All other types of option listed in BIPRU 7.6.18R (regardless of whether in the money, at the money or out of the money).

01/01/2007

The in the money percentage

BIPRU 7.6.6

(1) The in the money percentage is calculated in accordance with this rule.
(2) For a call option:
Current market price of underlying - Strike price of the option * 100
Strike price of the option
(3) For a put option:
Strike price of option - Current market price of underlying * 100
Strike price of the option
(4) In the case of an option on a basket of securities a firm may not treat the option as being in the money by the relevant percentage so as to enable the firm not to apply an option PRR under BIPRU 7.6.5R unless the conditions in BIPRU 7.6.5R are satisfied with respect to each kind of underlying investment.
(5) (4) also applies to an option on a CIU if a firm is using one of the CIU look through methods.

01/01/2007

The appropriate PRA

BIPRU 7.6.7

(1) The appropriate PRA for a position is that listed in the table in BIPRU 7.6.8R against the relevant underlying position.
(2) If the firm uses the commodity extended maturity ladder approach or the commodity maturity ladder approach for a particular commodity under BIPRU 7.4 (Commodity PRR) the appropriate PRA for an option on that commodity is the outright rate applicable to the underlying position (see BIPRU 7.4.26R (Calculating the PRR for each commodity: Maturity ladder approach) and BIPRU 7.4.33R (Table: Alternative spread, carry and outright rates)).
(3) If a firm does not have commodity positions treated under BIPRU 7.4 or does not have positions in the commodity in question treated under BIPRU 7.4 the restrictions in BIPRU 7.4 that regulate when a firm can and cannot use a particular method of calculating the commodity PRR apply for the purpose of establishing the appropriate PRA for the purposes of BIPRU 7.6.
(4) If a firm is using one of the CIU look through methods for an option on a CIU the leveraging requirements in BIPRU 7.7 (Position risk requirements for collective investment undertakings) apply (see BIPRU 7.7.11R). For this purpose the amount of the appropriate PRAs under BIPRU 7.6.6R(5) is increased by the amount of that leveraging (expressed as a percentage) as calculated under BIPRU 7.7, subject to a maximum appropriate PRA of 32%.

01/01/2007

BIPRU 7.6.8

Table: Appropriate PRA
This table belongs to BIPRU 7.6.7R

Underlying position

Appropriate PRA

Equity

The PRA applicable to the underlying equity or equity index in the table in BIPRU 7.3.30R (Simplified equity method)

Interest rate

The sum of the specific risk PRA (see BIPRU 7.2.43R to BIPRU 7.2.51G (Specific risk calculation)) and the general market risk PRA (as set out in BIPRU 7.2.57R (General market risk PRAs)) applicable to the underlying position

Debt securities

The sum of the specific risk PRA (see BIPRU 7.2.43R to BIPRU 7.2.51G (Specific risk calculation)) and the general market risk PRA (as set out in the table in BIPRU 7.2.57R (General market risk PRAs)) applicable to the underlying position

Commodity

18% (unless BIPRU 7.6.7R requires otherwise)

Currency

Gold

CIU

32% (subject to BIPRU 7.6.6R and BIPRU 7.6.7R)

01/01/2007

Calculating derived positions

BIPRU 7.6.9

A firm must calculate the derived position specified in the table in BIPRU 7.6.13R for each position included in its option PRR calculation.

01/01/2007

Netting positions

BIPRU 7.6.10

A firm may calculate a derived position for its net position in an option or a warrant, if the relevant options or warrants are identical or may be treated as identical under BIPRU 7.6.11R or BIPRU 7.6.12R.

01/01/2007

BIPRU 7.6.11

A firm may treat options or warrants as identical if they have the same strike price, maturity (except for an interest rate cap or floor - see BIPRU 7.6.12R) and underlying.

01/01/2007

BIPRU 7.6.12

A firm may treat as identical a purchased interest rate cap (or floor) and a written interest rate cap (or floor) only if they mature within 30 days of each other and all other terms are identical (a cap may not be netted against a floor).

01/01/2007

Derived positions

BIPRU 7.6.13

Table: Derived positions
This table belongs to BIPRU 7.6.9R

Underlying

Option (or warrant)

Derived position

Equity

Option (warrant) on a single equity or option on a future/forward on a single equity

A notional position in the actual equity underlying the contract valued at the current market price of the equity.

Option (warrant) on a basket of equities or option on a future/forward on a basket of equities

A notional position in the actual equities underlying the contract valued at the current market price of the equities.

Option (warrant) on an equity index or option on a future/forward on an equity index

A notional position in the index underlying the contract valued at the current market price of the index.

Interest rate

Option on an interest rate or an interest rate future/FRA

A zero coupon zero-specific-risk security in the currency concerned with a maturity equal to the sum of the time to expiry of the contract and the length of the period on which the settlement amount of the contract is calculated valued at the notional amount of the contract.

Option on an interest rate swap

A zero coupon zero-specific-risk security in the currency concerned with a maturity equal to the length of the swap valued at the notional principal amount.

Interest rate cap or floor

A zero coupon zero-specific-risk security in the currency concerned with a maturity equal to the remaining period of the cap or floor valued at the notional amount of the contract.

Debt securities

Option (warrant) on a debt security or option on a future/forward on a debt security

The underlying debt security with a maturity equal to the time to expiry of the option valued as the nominal amount underlying the contract at the current market price of the debt security.

Option (warrant) on a basket of debt securities or option on a future/forward on a basket of debt securities

A notional position in the actual debt securities underlying the contract valued at the current market price of the debt securities.

Option (warrant) on an index of debt securities or option on a future/forward on an index of debt securities

A notional position in the index underlying the contract valued at the current market price of the index.

Commodity

Option on a commodity or option on a future/forward on a commodity

An amount equal to the tonnage, barrels or kilos underlying the option with (in the case of a future/forward on a commodity) a maturity equal to the expiry date of the forward or Futures contract underlying the option. In the case of an option on a commodity the maturity of the position falls into Band 1 in the table in BIPRU 7.4.28R (Table: Maturity bands for the maturity ladder approach).

Option on a commodity swap

An amount equal to the tonnage, barrels or kilos underlying the option with a maturity equal to the length of the swap valued at the notional principal amount.

CIU
(These provisions about CIUs are subject to BIPRU 7.6.35R)

Option (warrant) on a single CIU or option on a future/forward on a single CIU

A notional position in the actual CIU underlying the contract valued at the current market price of the CIU.

Option (warrant) on a basket of CIUs or option on a future/forward on a basket of CIUs

A notional position in the actual CIUs underlying the contract valued at the current market price of the CIUs.

Gold

Option on gold or option on a future/forward on gold

An amount equal to the troy ounces underlying the option with (in the case of a future/forward on gold) a maturity equal to the expiry date of the forward or futures contract underlying the option.

Currency

Currency option

The amount of the underlying currency that the firm will receive if the option is exercised converted at the spot rate into the currency that the firm will sell if the option is exercised.

01/01/2007

Combinations of options which can be treated as one option

BIPRU 7.6.14

A firm may treat (for the purpose of calculating an option PRR under BIPRU 7.6) an option strategy listed in the table in BIPRU 7.6.15R as the single position in a notional option specified against that strategy in the table in BIPRU 7.6.15R, if:

(1) each element of the strategy is transacted with the same counterparty;
(2) the strategy is documented as a single structure;
(3) the underlying for each part of the composite position (including any actual holding of the underlying) is the same under the PRR identical product netting rules;
(4) the netting achieved does not result overall in a greater degree of netting in the calculation of the market risk capital requirement than would be permitted under the other standard market risk PRR rules;
(5) each option in the structure has the same maturity and underlying; and
(6) the constituent parts of the structure form an indivisible single contract, so that neither party can unwind or default on one part of the structure without doing so for the contract as a whole;

except that (1) and (6) only apply to the extent possible with respect to any part of the composite position held by the firm that consists of an actual holding of the underlying.

01/01/2007

BIPRU 7.6.15

Table: Option strategies
This table belongs to BIPRU 7.6.14R

Option strategy (and an example)

Notional option (and rule it must be treated under)

Bull Spread
(e.g. buy 100 call and sell 101 call)

One purchased option
(treat under BIPRU 7.6.20R)

Bear Spread
(e.g. sell 100 put and buy 101 put)

One written option
(treat under BIPRU 7.6.21R)

Synthetic Long Call
(e.g. long underlying and buy 100 put)

One purchased option
(treat under BIPRU 7.6.20R or BIPRU 7.6.24R)

Synthetic Short Call
(e.g. short underlying and sell 100 put)

One written option
(treat under BIPRU 7.6.21R or BIPRU 7.6.24R)

Synthetic Long Put
(e.g. short underlying and buy 100 call)

One purchased option
(treat under BIPRU 7.6.20R or BIPRU 7.6.24R)

Synthetic Short Put
(e.g. buy underlying and sell 100 call)

One written option
(treat under BIPRU 7.6.21R or BIPRU 7.6.24R)

Long Straddle
(e.g. buy 100 call and buy 100 put)

One purchased option
(treat under BIPRU 7.6.20R)

Short Straddle
(e.g. sell 100 call and sell 100 put)

One written option
(treat under BIPRU 7.6.21R but with no reduction for the amount the option is out of the money)

Long Strangle
(e.g. buy 101 call and buy 99 put)

One purchased option
(treat under BIPRU 7.6.20R)

Short Strangle
(e.g. sell 99 call and sell 101 put)

One written option
(treat under BIPRU 7.6.21R but with no reduction for the amount the option is out of the money)

Long Butterfly
(e.g. buy one 100 call, sell two 101 calls, and buy one 102 call)

One purchased option
(treat under BIPRU 7.6.20R)

Short Butterfly
(e.g. sell one 100 put, buy two 101 puts, and sell one 102 put)

One written option
(treat under BIPRU 7.6.21R but with no reduction for the amount the option is out of the money)

01/01/2007

The option PRR for an individual positions

BIPRU 7.6.16

A firm must calculate the option PRR for each individual derived option position using the method specified in the table in BIPRU 7.6.18R, or, if more than one method is permitted, using one of those methods.

01/01/2007

BIPRU 7.6.17

A firm must convert its positions into its base currency in accordance with the procedures that apply for whichever of the other PRR charges is appropriate (see BIPRU 7.2.1R(3), BIPRU 7.3.1R(2), BIPRU 7.4.1R(3), BIPRU 7.5.19R(2), BIPRU 7.5.20R(3) and BIPRU 7.7.1R(3)).

01/01/2007

BIPRU 7.6.18

Table: Option PRR: methods for different types of option
This table belongs to BIPRU 7.6.16R

Option

Description

Method

American option

An option that may be exercised at any time over an extended period up to its expiry date.

Option standard method or option hedging method if appropriate

European option

An option that can only be exercised at expiry.

Bermudan option

A cross between an American option and European option. The Bermudan option can only be exercised at specific dates during its life.

Asian option

The buyer has the right to exercise at the average rate or price of the underlying over the period (or part of the period) of the option. One variant is where the payout is based on the average of the underlying against a fixed strike price; another variant is where the payout gives at expiry the price of the underlying against the average price over the option period.

Option standard method or option hedging method if appropriate

Barrier option

An option which is either cancelled or activated if the price of the underlying reaches a pre-set level regardless of the price at which the underlying may be trading at the expiry of the option. The knock-out type is cancelled if the underlying price or rate trades through the trigger; while the knock-in becomes activated if the price moves through the trigger.

Corridor option

Provides the holder with a pay-out for each day that the underlying stays within a defined range chosen by the investor.

Ladder option

Provides the holder with guaranteed pay-outs if the underlying trades through a pre-agreed price(s) or rate(s) at a certain point(s) in time, regardless of future performance.

Lock-in option

An option where the pay-out to the holder is locked in at the maximum (or minimum) value of the underlying that occurred during the life of the option.

Look-back option

A European style option where the strike price is fixed in retrospect, that is at the most favourable price (i.e. the lowest (highest) price of the underlying in the case of a call (put)) during the life of the option.

Forward starting option

An option that starts at a future date.

Compound option

An option where the underlying is itself an option (i.e. an option on an option).

Option standard method or option hedging method if appropriate

Interest rate cap

An interest rate option or series of options under which a counterparty contracts to pay any interest costs arising as a result of an increase in rates above an agreed rate: the effect being to provide protection to the holder against a rise above that agreed interest rate.

Option standard method, but no reduction for the amount the option is out of the money is permitted

Interest rate floor

An interest rate option or series of options under which a counterparty contracts to pay any lost income arising as a result of a fall in rates below an agreed rate: the effect being to provide protection to the holder against a fall below that agreed interest rate.

Performance option

An option based on a reference basket comprising any number of assets, where the pay-out to the holder could be one of the following: the maximum of the worst performing asset, or 0; the maximum of the best performing asset, or 0; the maximum of the spreads between several pairs of the assets, or 0.

Option standard method or option hedging method - using the highest PRA of the individual assets in the basket

Quanto

Quanto stands for "Quantity Adjusted Option". A quanto is an instrument where two currencies are involved. The payoff is dependent on a variable that is measured in one of the currencies and the payoff is made in the other currency.

Subject to BIPRU 7.6.31R, the option standard method

Cliquet option

A cliquet option consists of a series of forward starting options where the strike price for the next exercise date is set equal to a positive constant times the underlying price as of the previous exercise date. It initially acts like a vanilla option with a fixed price but as time moves on, the strike is reset and the intrinsic value automatically locked in at pre-set dates. If the underlying price is below the previous level at the reset date no intrinsic value is locked in but the strike price will be reset to the current price attained by the underlying. If the underlying price exceeds the current level at the next reset the intrinsic value will again be locked in.

Option standard method for a purchased cliquet, or the method specified in BIPRU 7.6.30R for a written cliquet

Digital option

A type of option where the pay-out to the holder is fixed. The most common types are all-or-nothing and one-touch options. All-or-nothing will pay out the fixed amount if the underlying is above (call) or below (put) a set value at expiry. The one-touch will pay the fixed amount if the underlying reaches a fixed point any time before expiry.

The method specified in BIPRU 7.6.29 R

Any other option or warrant

The method specified for the type of instrument whose description it most closely resembles.

01/01/2007

BIPRU 7.6.19

(1) The option standard method is described in BIPRU 7.6.20R - BIPRU 7.6.22R.
(2) The option hedging method is described in BIPRU 7.6.23G - BIPRU 7.6.28R.

01/01/2007

The standard method: Purchased options and warrants

BIPRU 7.6.20

Under the option standard method, the PRR for a purchased option or warrant is the lesser of:

(1) the market value of the derived position (see BIPRU 7.6.9R) multiplied by the appropriate PRA (see BIPRU 7.6.8R); and
(2) the market value of the option or warrant.

01/01/2007

The standard method: Written options and warrants

BIPRU 7.6.21

Under the option standard method, the PRR for a written option or warrant is the market value of the derived position (see BIPRU 7.6.9R) multiplied by the appropriate PRA (see BIPRU 7.6.8R). This result may be reduced by the amount the option or warrant is out of the money (subject to a maximum reduction to zero).

01/01/2007

The standard method: Underwriting or sub-underwriting an issue of warrants

BIPRU 7.6.22

Under the option standard method, the PRR for underwriting or sub-underwriting an issue of warrants is the net underwriting position (or reduced net underwriting position) multiplied by the current market price of the underlying securities multiplied by the appropriate PRA, but the result can be limited to the value of the net underwriting position (or reduced net underwriting position) calculated using the issue price of the warrant.

01/01/2007

The hedging method

BIPRU 7.6.23

The option hedging method involves the option PRR being calculated on a combination of the option and its hedge.

01/01/2007

BIPRU 7.6.24

Under the option hedging method a firm must calculate the option PRR for individual positions as follows:

(1) for an option or warrant on an equity, basket of equities or equity index and its equity hedge(s), the firm must, to the extent specified or permitted in the table in BIPRU 7.6.26R, use the calculation in the table in BIPRU 7.6.27R;
(2) for an option or warrant on a debt security, basket of debt securities or debt security index and its debt security hedge(s), the firm must, to the extent specified or permitted in the table in BIPRU 7.6.26R, use the calculation in the table in BIPRU 7.6.27R;
(3) for an option on gold and its gold hedge, the firm must, to the extent specified or permitted in the table in BIPRU 7.6.26R, use the calculation in the table in BIPRU 7.6.27R; and
(4) for an option on a currency and its currency hedge, the firm must, to the extent specified or permitted in the table in BIPRU 7.6.26R, use the calculation in the table in BIPRU 7.6.28R.

01/01/2007

BIPRU 7.6.25

(1) A firm may not use the option hedging method for:

(a) an interest rate option and its hedge; or
(b) a commodity option and its hedge; or
(c) a CIU option and its hedge.

(2) A firm may only use the option hedging method if the item underlying the option or warrant is the same as the hedge of the option or warrant under the PRR identical product netting rules.

01/01/2007

BIPRU 7.6.26

Table: Appropriate treatment for equities, debt securities or currencies hedging options
This table belongs to BIPRU 7.6.24R

Hedge

PRR calculation for the hedge

Limits (if hedging method is used)

Naked position

An equity (hedging an option or warrant)

The equity must be treated in either BIPRU 7.3 (equity PRR) or the option hedging method (see the table in BIPRU 7.6.27R)

The option hedging method must only be used up to the amount of the hedge that matches the notional amount underlying the option or warrant

To the extent that the amount of the hedge (or option or warrant) exceeds the notional amount underlying the option or warrant (or hedge), a firm must apply an equity PRR, interest rate PRR or foreign currency PRR (or the option standard method)

A debt security (hedging an option or warrant)

The debt security must be treated in BIPRU 7.2 (interest rate PRR) or the option hedging method (see the table in BIPRU 7.6.27R)

As for the first row

Gold (hedging a gold option)

The gold must be treated in either BIPRU 7.5 (Foreign currency PRR) or the option hedging method (see the table in BIPRU 7.6.27R)

As for the first row

A currency or currencies (hedging a currency option)

The currency must be treated in either BIPRU 7.5 (Foreign currency PRR) or the option hedging method (see the table in BIPRU 7.6.28R)

As for the first row

01/01/2007

BIPRU 7.6.27

Table: The hedging method of calculating the PRR (equities, debt securities and gold)
This table belongs to BIPRU 7.6.24R(1) - (3)

PRR

Option or warrant position

In the money by more than the PRA

In the money by less than the PRA

Out of the money or at the money

Long in security or gold

Long put

Zero

Short call

Short in security or gold

Long call

Zero

Short put

Where:

Wp means

{(PRA-100%) x The underlying position valued at strike price}

The market value of the underlying position

Wc means

{(100% + PRA x The underlying position valued at strike price}

The market value of the underlying position

X means

The market value of the underlying position multiplied by the appropriate PRA

Y means

The market value of the underlying position multiplied by the appropriate PRA. This result may be reduced by the market value of the option or warrant, subject to a maximum reduction to zero.

Z means

The option hedging method is not permitted; the option standard method must be used.

01/01/2007

BIPRU 7.6.28

Table: The hedging method of calculating the PRR (currencies)
This table belongs to BIPRU 7.6.24R(4)

PRR

Option position

In the money by more than 8%

In the money by less than 8%

Out of the money or at the money

Long calls & long puts

Zero

W_L

Short calls & short puts

Zero

Where:

W_L means

(1.08% x U)

The market value of the underlying position

U means

The amount of the underlying currency that the firm will receive if the option is exercised, converted at the strike price into the currency that the firm will sell if the option is exercised

X means

The market value of the underlying position multiplied by 8%.

Y means

The market value of the underlying position multiplied by 8%. This result may be reduced by the market value of the option, subject to a maximum reduction to zero.

01/01/2007

Specific methods and treatments: Digital options

BIPRU 7.6.29

The option PRR for a digital option is the maximum loss of the option.

01/01/2007

Specific methods and treatments: Written cliquet options

BIPRU 7.6.30

The option PRR for a written cliquet option is the market value of the derived position (see BIPRU 7.6.9R) multiplied by the appropriate PRA (see BIPRU 7.6.8R) multiplied by F+1 (see the following provisions of this paragraph). This result may be reduced by the amount the option is out of the money (subject to a maximum reduction to zero). The option PRR for a written cliquet option is therefore defined by the following formula:
[ PRA * underlying * (F + 1)] - OTM
where:

(1)
(2) FR= Number of forward re-sets
(3) Y= Years to maturity
(4) OTM= the amount by which the option is out of the money

01/01/2007

Specific methods and treatments: Quantos

BIPRU 7.6.31

If the pay-out to the holder of a quanto option is fixed at the inception of the transaction a firm must add 8% to the PRA when applying the option standard method.

01/01/2007

Interaction with other chapters

BIPRU 7.6.32

The application of an option PRR to a position does not prevent any of the other PRR charges from applying if they would otherwise do so. In particular if a firm applies an option PRR to an equity derivative an interest rate PRR will also generally apply.

01/01/2007

BIPRU 7.6.33

The following diagram illustrates the relationship between BIPRU 7.6 and the rest of BIPRU 7.

01/01/2007

Options on a commodity

BIPRU 7.6.34

BIPRU 7.4.38R to BIPRU 7.4.41R (Liquidity and other risks) apply to commodity options treated under BIPRU 7.6 as well as to those treated under BIPRU 7.4 (Commodity PRR).

01/01/2007

Options on a CIU

BIPRU 7.6.35

For the purpose of identifying the appropriate treatment for the purpose of BIPRU 7.6.5R, the underlying position for the purpose of BIPRU 7.6.8R and the derived position under BIPRU 7.6.13R a firm may choose between treating an option on a CIU as being:

(1) a position in the CIU itself; or
(2) (if the conditions in BIPRU 7.7 (Position risk requirements for collective investment undertakings) for the use of the method in question are satisfied) positions in the underlying investments or assumed positions arising through the use of the standard CIU look through method or the modified CIU look through method.

01/01/2007

BIPRU 7.6.36

(1) This paragraph gives an example of how the appropriate PRA should be calculated for the purpose of deciding whether or not an option on a CIU is sufficiently in the money for the firm to have a choice whether or not to apply an option PRR. This example assumes that there is no leveraging (see BIPRU 7.7.11R (CIU modified look through method)).
(2) Say that the CIU contains underlying equity position and the firm is using one of the CIU look through methods. The appropriate PRA for some is 8% and for the others is 12%. The firm should identify the highest appropriate PRA for the underlyings. In this case it is 12%. Therefore in this case the option would need to be in the money by more than 12% in order for the firm to have a choice between applying the option PRR or one of the other PRR charges.
(3) However if the firm is not using one of the CIU look through methods the option would need to be in the money by more than 32% in order for the firm to have a choice between applying the option PRR or the CIU PRR.

01/01/2007

BIPRU 7.6.37

BIPRU 7.6.10R - BIPRU 7.6.12R are subject to BIPRU 7.7.3R (netting). BIPRU 7.7.4R (use of third party) applies for the purpose of BIPRU 7.6.

01/01/2007

BIPRU 7.7

Position risk requirements for collective investment undertakings

01/01/2007

Collective investment undertaking PRR calculation

BIPRU 7.7.1

A firm must calculate its CIU PRR by:

(1) identifying which CIU positions must be included within the scope of the PRR calculation (see BIPRU 7.7.2R);
(2) identifying which CIU positions are to be subject to the CIU PRR and which positions are to be subject to one of the other PRR charges;
(3) converting on a daily basis net positions into the firm's base currency at the prevailing spot exchange rate before their aggregation;
(4) calculating an individual PRR for each position in a CIU (see BIPRU 7.7.5R);
(5) summing the resulting individual PRRs.

01/01/2007

Scope of the PRR calculation for collective investment undertakings

BIPRU 7.7.2

(1) A firm's PRR calculation must include all trading book positions in CIUs.
(2) A firm's CIU PRR calculation must include all trading book positions in CIUs unless they are treated under one of the CIU look through methods and included in the PRR calculations for the relevant underlying investments or subject to an option PRR.
(3) A firm's PRR calculation for CIUs must include notional positions arising from trading book positions in options or warrants on collective investment undertakings.

01/01/2007

General rules

BIPRU 7.7.3

Unless noted otherwise, no netting is permitted between the underlying investments of a CIU and other positions held by a firm for the purposes of calculating the PRR charge for a position in a CIU.

01/01/2007

BIPRU 7.7.4

A firm may rely on a third party to calculate and report PRR capital requirements for position risk (general market risk and specific risk) for positions in CIUs falling within BIPRU 7.7.9R and BIPRU 7.7.11R, in accordance with the methods set out in BIPRU 7.7, provided that the correctness of the calculation and the report is adequately ensured.

01/01/2007

Calculation of the collective investment undertaking PRR

BIPRU 7.7.5

Without prejudice to other provisions in BIPRU 7.7, a position in a CIU is subject to a collective investment undertaking PRR (general market risk and specific risk) of 32%. Without prejudice to provisions in BIPRU 7.5.18R (Foreign currency PRR for CIUs) or, if the firm has a VaR model permission, BIPRU 7.10.44R (Commodity risks and VaR models) taken together with BIPRU 7.5.18R, where the modified gold treatment set out in those rules is used, a position in a CIU is subject to a securities PRR requirement for position risk (general market risk and specific risk ) and a foreign currency PRR of no more than 40%.

01/01/2007

Look through methods: General criteria

BIPRU 7.7.6

A firm may determine the securities PRR requirement for positions in CIUs which meet the criteria set out in BIPRU 7.7.7R, by one of the following methods:

(1) the standard CIU look through method (BIPRU 7.7.4R and BIPRU 7.7.7R - BIPRU 7.7.10R); or
(2) the modified CIU look through method (BIPRU 7.7.4R, BIPRU 7.7.7R - BIPRU 7.7.8R and BIPRU 7.7.11R - BIPRU 7.7.12R).

01/01/2007

BIPRU 7.7.7

The general eligibility criteria for using the methods in BIPRU 7.7.4R and BIPRU 7.7.9R - BIPRU 7.7.11R, for CIUs issued by companies supervised or incorporated within the EEA are that:

(1) the CIU's prospectus or equivalent document must include:

(a) the categories of assets the CIU is authorised to invest in;
(b) if investment limits apply, the relative limits and the methodologies to calculate them;
(c) if leverage is allowed, the maximum level of leverage; and
(d) if investment in OTC financial derivatives or repo-style transactions are allowed, a policy to limit counterparty risk arising from these transactions;

(2) the business of the CIU must be reported in half-yearly and annual reports to enable an assessment to be made of the assets and liabilities, income and operations over the reporting period;
(3) the units/shares of the CIU are redeemable in cash, out of the undertaking's assets, on a daily basis at the request of the unit holder;
(4) investments in the CIU must be segregated from the assets of the CIU manager; and
(5) there must be adequate risk assessment, by the investing firm, of the CIU.

01/01/2007

BIPRU 7.7.8

Third country CIUs are eligible if the requirements in BIPRU 7.7.7R (1) - BIPRU 7.7.7R (5) are met.

01/01/2007

Standard CIU look through method: General

BIPRU 7.7.9

(1) Where a firm is aware of the underlying investments of the CIU on a daily basis the firm may look through to those underlying investments in order to calculate the securities PRR for position risk (general market risk and specific risk) for those positions in accordance with the methods set out in the securities PRR requirements or, if the firm has a VaR model permission, in accordance with the methods set out in BIPRU 7.10 (Use of a Value at Risk Model).
(2) Under this approach, positions in CIUs must be treated as positions in the underlying investments of the CIU. Netting is permitted between positions in the underlying investments of the CIU and other positions held by the firm, as long as the firm holds a sufficient quantity of units to allow for redemption/creation in exchange for the underlying investments.

01/01/2007

Standard CIU look through method: Index or basket funds

BIPRU 7.7.10

(1) A firm may calculate the securities PRR for position risk (general market risk and specific risk) for positions in CIUs in accordance with the methods set out in the securities PRR requirements or, if the firm has a VaR model permission, in accordance with the methods set out in BIPRU 7.10 (Use of a Value at Risk Model), to assumed positions representing those necessary to replicate the composition and performance of the externally generated index or fixed basket of equities or debt securities referred to in (a), subject to the following conditions:

(a) the purpose of the CIU's mandate is to replicate the composition and performance of an externally generated index or fixed basket of equities or debt securities; and
(b) a minimum correlation of 0.9 between daily price movements of the CIU and the index or basket of equities or debt securities it tracks can be clearly established over a minimum period of six months.

(2) Correlation as referred to in (1)(b) means the correlation coefficient between daily returns on the CIU and the index or basket of equities or debt securities it tracks.

01/01/2007

CIU modified look through method

BIPRU 7.7.11

Where a firm is not aware of the underlying investments of the CIU on a daily basis, the firm may calculate the securities PRR for position risk (general market risk and specific risk) in accordance with the methods set out in the securities PRR requirements, subject to the following conditions:

(1) it must be assumed that the CIU first invests to the maximum extent allowed under its mandate in the asset classes attracting the highest securities PRR for position risk (general market risk and specific risk), and then continues making investments in descending order until the maximum total investment limit is reached;
(2) the firm must take account of the maximum indirect exposure that it could achieve by taking leveraged positions through the CIU when calculating its securities PRR for position risk, by proportionally increasing the position in the CIU up to the maximum exposure to the underlying investment items resulting from the investment mandate; and
(3) should the securities PRR for position risk (general market risk and specific risk) under this approach exceed that set out in BIPRU 7.7.5R, the PRR charge must be capped at that level.

01/01/2007

BIPRU 7.7.12

For the purpose of BIPRU 7.7.11R (1) the position in the CIU must be treated as a direct holding in the assumed position.

01/01/2007

CAD 1 models and VaR models

BIPRU 7.7.13

Where BIPRU 7.7 permits a firm to calculate the PRR charge for a position in a CIU using the rules in BIPRU 7 relating to the underlying investment, a firm that has:

(1) a CAD 1 model waiver that covers positions in CIUs may use the rules as modified by that waiver; and
(2) a VaR model permission that covers positions in CIUs may use its VaR model.

01/01/2007

Options on a CIU

BIPRU 7.7.14

An option on a CIU should be treated in accordance with BIPRU 7.6.35R to BIPRU 7.6.37G (Options on a CIU).

01/01/2007

BIPRU 7.8

Securities underwriting

01/01/2007

General rules

BIPRU 7.8.1

BIPRU 7.8 sets out the method for calculating a net underwriting position or reduced net underwriting position, which is then included in the PRR calculation in other parts of BIPRU 7. It also deals with concentration risk. BIPRU 7.8 only relates to new securities, which is defined in BIPRU 7.8.12R.

01/01/2007

BIPRU 7.8.2

A firm which underwrites or sub-underwrites an issue of securities must, for the purposes of calculating its market risk capital component and its concentration risk capital component:

(1) identify commitments to underwrite or sub-underwrite which give rise to an underwriting position (see BIPRU 7.8.8R);
(2) identify the time of initial commitment (see BIPRU 7.8.13R); and
(3) calculate the net underwriting position (set out in BIPRU 7.8.17R), reduced net underwriting position or the net underwriting exposure.

01/01/2007

BIPRU 7.8.3

A firm must include the net underwriting position or reduced net underwriting position in whichever one or more of the following is or are relevant:

(1) BIPRU 7.2.3R (1) where debt securities are being underwritten;
(2) BIPRU 7.3.2R (1) where equities are being underwritten;
(3) BIPRU 7.6.22R where warrants are being underwritten; and
(4) BIPRU 7.5.3R where the equities, debt securities or warrants being underwritten are denominated in a foreign currency.

01/01/2007

BIPRU 7.8.4

A firm must comply with BIPRU 7.8.3R from initial commitment (as determined under BIPRU 7.8.8R) until the end of the fifth business day after working day 0 (as determined under BIPRU 7.8.23R).

01/01/2007

BIPRU 7.8.5

Sub-underwriting is a commitment given by one firm to someone other than the issuer or seller of the securities to sub-underwrite all or part of an issue of securities.

01/01/2007

BIPRU 7.8.6

The net underwriting position calculated in BIPRU 7.8.17R will also be used in calculating the net underwriting exposure under BIPRU 7.8.34R.

01/01/2007

BIPRU 7.8.7

The net underwriting position or reduced net underwriting position arising from underwriting or sub-underwriting a rights or warrants issue should be calculated using the current market price of the underlying security for the purposes of the equity PRR or option PRR. However, the PRR will be limited to the value of the net underwriting position calculated using the initial issue price of the rights or warrants. Where there is no market price because the rights or warrants are in relation to a new class of securities and the initial price has not been set the net underwriting position or reduced net underwriting is the amount of the commitment.

01/01/2007

Commitment to underwriting securities

BIPRU 7.8.8

(1) For the purpose of BIPRU 7.8.2R (1), a firm has a commitment to underwrite or sub-underwrite an issue of securities where:

(a) it gives a commitment to an issuer of securities to underwrite an issue of securities; or
(b) (where BIPRU 7.8.12R (2) applies) it gives a commitment to a seller of securities to underwrite a sale of those securities;
(c) it gives a commitment to a person, other than the issuer of securities or, if BIPRU 7.8.12R (2) applies, the seller of the securities, to sub-underwrite an issue of securities; or
(d) it is a member of a syndicate or group that gives a commitment of the type described in (1)(a)-(c).

(2) Unless a rule deals with them separately or the context otherwise requires, a provision of BIPRU 7.8 that deals with underwriting also applies to sub-underwriting.

01/01/2007

Exclusions from BIPRU 7.8

BIPRU 7.8.9

(1) Block trades, including bought deals, and private placements are not within the scope of BIPRU 7.8 because they involve an outright purchase by the firm of the relevant securities.
(2) For the purpose of BIPRU 7.8 securities include debt and equity instruments and convertibles but excludes loans.

01/01/2007

Grey market transactions

BIPRU 7.8.10

(1) A firm that buys and sells securities before issue is dealing in the grey market for the purposes of BIPRU 7.8.
(2) BIPRU 7.8 does not apply to a firm with respect to its dealings in the grey market unless the firm:

(a) has an underwriting commitment to the issuer in respect of those securities; or
(b) has a sub-underwriting commitment in respect of those securities and is using the grey market solely for the purpose of reducing that sub-underwriting commitment.

(3) BIPRU 7.8 does not apply to a firm with respect to its dealings in the grey market if the transaction is undertaken by the proprietary trading part of the firm or is undertaken for proprietary trading purposes.
(4) BIPRU 7.8 does not apply to a firm with respect to its dealings in the grey market except as described in BIPRU 7.8.17R.

01/01/2007

BIPRU 7.8.11

In BIPRU 7.8 the grey market is the market in which dealers "buy" and "sell" securities ahead of issue. In reality the dealers are buying and selling promises to deliver the securities when issued.

01/01/2007

New securities

BIPRU 7.8.12

For the purposes of BIPRU 7.8, a firm must treat securities as being new for the purposes of the definition of underwriting if they are:

(1) securities that, prior to the allotment following the underwriting, were not in issue; or
(2) securities that do not fall within (1) but that have not previously been offered for sale or subscription to the public and have not been admitted to trading on a market operated by a recognised investment exchange or an overseas investment exchange.

01/01/2007

Time of initial commitment

BIPRU 7.8.13

Subject to BIPRU 7.8.14R, the time of initial commitment is the earlier of:

(1) (in the case of underwriting) the time the firm agrees with the issuer of securities to underwrite those securities; or
(2) (in the case of underwriting falling under BIPRU 7.8.12R (2)) the time the firm agrees with the seller of securities to underwrite those securities; or
(3) (in the case of sub-underwriting) the time the firm agrees with the person referred to BIPRU 7.8.8R (1)(c) to sub-underwrite those securities; or
(4) (in the case of BIPRU 7.8.8R (1)(d)) the time the group or syndicate in question (or a member of that group or syndicate on behalf of the others) agrees with the issuer or other person to whom the commitment is given as referred to in BIPRU 7.8.8R (1)(d) to underwrite or sub-underwrite the securities in question; or
(5) (if the firm at that time has a commitment, whether legally or binding or not) the time the price and allocation of the issue or offer are set.

01/01/2007

BIPRU 7.8.14

If a firm has an irrevocable and unfettered right to withdraw from an underwriting commitment, exercisable within a certain period, the commitment commences (and thus the time of initial commitment occurs) when that right expires.

01/01/2007

BIPRU 7.8.15

Subject to the existence of a right described in BIPRU 7.8.14R an underwriting commitment commences even if it is subject to formal, legal or other conditions that would normally be expected to be satisfied.

01/01/2007

BIPRU 7.8.16

A force majeure or material adverse change clause would not be a right of the sort referred to in BIPRU 7.8.14R.

01/01/2007

Calculating the net underwriting position

BIPRU 7.8.17

A firm must calculate a net underwriting position by adjusting the gross amount it has committed to underwrite for:

(1) any sales or sub-underwriting commitments received that have been confirmed in writing at the time of initial commitment (but excluding any sales in the grey market as defined in BIPRU 7.8.10R (1));
(2) any underwriting or sub-underwriting commitments obtained from others since the time of initial commitment;
(3) any purchases or sales of the securities since the time of initial commitment (other than purchases or sales in the grey market as defined in BIPRU 7.8.10R (1));
(4) (in the case of sales in the grey market as defined in BIPRU 7.8.10R (1)) any sales of the securities as at the time of initial commitment or since the time of initial commitment subject, in both cases, to the following conditions:

(a) any sales of the securities as at the time of initial commitment must be confirmed in writing at the time of initial commitment; and
(b) sales must be net of any purchases in the grey market as defined in BIPRU 7.8.10R (1); and

(5) any allocation of securities granted or received, arising from the commitment to underwrite the securities, since the time of initial commitment.

01/01/2007

BIPRU 7.8.18

If the allocation of securities has not been fixed a firm must calculate the gross amount of its commitment, for the purposes of BIPRU 7.8.17R, by reference to the maximum amount it has committed to underwrite until the time the allocation is set.

01/01/2007

BIPRU 7.8.19

An underwriting commitment may only be reduced under BIPRU 7.8.17R on the basis of a formal agreement.

01/01/2007

BIPRU 7.8.20

Allocations may arise, after date of initial commitment, from the agreement to underwrite. For example obligations or rights may be allocated to or from the issuer, the underwriting group or syndicate.

01/01/2007

Over-allotment options

BIPRU 7.8.21

(1) This rule deals with the treatment of short positions that arise when a firm commits to distribute securities that it is underwriting in an amount that exceeds the allocation to the firm made by the issuer of the securities being underwritten.
(2) When calculating its net underwriting position, a firm may use an over-allotment option granted to it by the issuer of the securities being underwritten to reduce the short positions in (1).
(3) A firm may also use an over-allotment option granted to another member of the underwriting syndicate for the purpose in (2).
(4) (2) and (3) only apply from working day 0.
(5) (2) and (3) only apply to the extent that the treatment is consistent with the terms of the over-allotment option.

01/01/2007

BIPRU 7.8.22

Except as provided in BIPRU 7.8.21R, a firm must not take into account an over-allotment option granted to it or another member of the underwriting syndicate in calculating its net underwriting position.

01/01/2007

Working day 0

BIPRU 7.8.23

For the purposes of BIPRU 7.8 working day 0 is the business day on which a firm that is underwriting or sub-underwriting becomes unconditionally committed to accepting a known quantity of securities at a specified price.

01/01/2007

BIPRU 7.8.24

For debt issues and securities which are issued in a similar manner, working day 0 is the later of the date on which the securities are allotted and the date on which payment for them is due.

01/01/2007

BIPRU 7.8.25

For equity issues and securities which are issued in a similar manner, working day 0 is the later of the date on which the offer becomes closed for subscriptions and the date on which the allocations are made public.

01/01/2007

BIPRU 7.8.26

For rights issues, working day 0 is the first day after the date on which the offer becomes closed to acceptances for subscription.

01/01/2007

Calculating the reduced net underwriting position

BIPRU 7.8.27

To calculate the reduced net underwriting position a firm must apply the reduction factors in the table in BIPRU 7.8.28R to the net underwriting position (calculated under BIPRU 7.8.17R) as follows:

(1) in respect of debt securities, a firm must calculate two reduced net underwriting positions; one for inclusion in the firm's interest rate PRR specific risk calculation (BIPRU 7.2.43R), the other for inclusion in its interest rate PRR general market risk calculation (BIPRU 7.2.52R); and
(2) in respect of equities, a firm must calculate only one reduced net underwriting position, and then include it in the simplified equity method (see BIPRU 7.3.29R).

01/01/2007

BIPRU 7.8.28

Table: Net underwriting position reduction factors
This table belongs to BIPRU 7.8.27R

Underwriting timeline

Debt

Equity

General market risk

Specific risk

Time of initial commitment until working day 0

100%

90%

90%

75%

75%

50%

25%

Working day 6 and onwards

01/01/2007

BIPRU 7.8.29

The table in BIPRU 7.8.30G gives an example of the reduced net underwriting position calculation. The example is based on the firm starting with a commitment to underwrite £100 million of a new equity issue. Firms are reminded that in the case of an equity, the reduced net underwriting position should be treated under the simplified equity method (see BIPRU 7.8.27R (Simplified and standard equity methods) and BIPRU 7.8.27R).

01/01/2007

BIPRU 7.8.30

Table: Example of the reduced net underwriting position calculation
This table belongs to BIPRU 7.8.29G

Time

Net underwriting position (see BIPRU 7.8.17R)

Percentage reduction (see BIPRU 7.8.28R)

Reduced net underwriting position

At initial commitment 9.00am Monday

£100m gross amount is reduced by £20m due to sales/sub-underwriting commitments confirmed in writing at the time of initial commitment (see BIPRU 7.8.17R (1)) and (4)).

£80m

90%

£8m

Post initial commitment 9.02am Monday

Remaining £80m is reduced by £40m due to further sales, sub-underwriting commitments obtained and allocations granted (see BIPRU 7.8.17R (2) - (5)).

£40m

90%

£4m

At the end of working day 1

Remaining £40m is reduced to £20m due to further sales.

£20m

90%

£2m

End of working day 3

Remaining £20m is reduced to £5m due to further sales.

£5m

75%

£1.25 m

End of working day 4

Remaining £5m is reduced to £2m due to further sales.

£2m

50%

£1m

End of working day 5

Remaining £2m is reduced to £1m due to further sales.

£1m

25%

£0.75 m

Start of working day 6

£1m remaining

£1m

01/01/2007

Large exposure risk from underwriting securities: Calculating the net underwriting exposure

BIPRU 7.8.31

For the purposes of calculating the total amount of its trading book exposures to a person for concentration risk purposes, a firm must include net underwriting exposure to that person.

01/01/2007

BIPRU 7.8.32

A firm must include any other exposures arising out of underwriting (including any counterparty exposures to any sub-underwriters) for the purposes of calculating the total amount of its trading book exposures to a person for concentration risk purposes.

01/01/2007

BIPRU 7.8.33

A firm, before entering into a new underwriting commitment, must be able to recalculate the concentration risk capital component to the level of detail necessary to ensure that the firm's capital resources requirement does not exceed the firm's capital resources.

01/01/2007

BIPRU 7.8.34

Except where otherwise specified by a requirement on its Part IV permission, a firm must calculate the net underwriting exposure to an issuer by applying the relevant reduction factors in the table in BIPRU 7.8.35R to its net underwriting position calculated under BIPRU 7.8.17R.

01/01/2007

BIPRU 7.8.35

Table: Calculation of net underwriting exposure
This table belongs to BIPRU 7.8.34R

Time

Reduction factor to be applied to net underwriting position

Initial commitment to working day 0

100%

100%

90%

75%

75%

50%

25%

Working day 6 onwards

01/01/2007

BIPRU 7.8.36

The effect of BIPRU 7.8.34R is that there is no concentration limit for net underwriting exposures between initial commitment and the end of working day 0, except where specified by a requirement on a firm's Part IV permission.

01/01/2007

Large exposure risk from underwriting securities: Monitoring and reporting concentration risk

BIPRU 7.8.37

For the purposes of concentration risk monitoring only, a firm must report its net underwriting exposure both before and after the application of the reduction factors in the table in BIPRU 7.8.35R.

01/01/2007

Risk management

BIPRU 7.8.38

A firm must take reasonable steps to establish and maintain such systems and controls to monitor and manage its underwriting and sub-underwriting business as are appropriate to the nature, scale and complexity of its underwriting and sub-underwriting business. In particular, a firm must have systems to monitor and control its underwriting exposures between the time of the initial commitment and working day one in the light of the nature of the risks incurred in the markets in question.

01/01/2007

BIPRU 7.8.39

A firm should take reasonable steps to:

(1) allocate responsibility for the management of its underwriting and sub-underwriting business;
(2) allocate adequate resources to monitor and control its underwriting and sub-underwriting business;
(3) satisfy itself that its systems to monitor exposure to counterparties will calculate, revise and update its exposure to each counterparty arising from its underwriting or sub-underwriting business;
(4) satisfy itself of the suitability of each person who performs functions for it in connection with the firm's underwriting and sub-underwriting business having regard to the person's skill and experience; and
(5) satisfy itself that its procedures and controls to monitor and manage its underwriting business address, on an on-going basis, the capacity of sub-underwriters to meet sub-underwriting commitments.

01/01/2007

BIPRU 7.9

Use of a CAD 1 model

01/01/2007

Introduction

BIPRU 7.9.1

A firm is required under GENPRU 2.1.52 R (Calculation of the market risk capital requirement) to calculate its market risk capital requirement using the rules in BIPRU 7. However, the FSA may at the firm's request modify GENPRU 2.1.52 R to allow the firm to calculate all or part of the PRR for the positions covered by that model by using a CAD 1 model (for options risk aggregation and/or interest rate pre-processing) or a VaR model (value at risk model) instead. BIPRU 7.10 (Use of a Value at Risk Model) deals with VaR model permissions.

01/01/2007

BIPRU 7.9.2

The purpose of BIPRU 7.9 is to provide guidance on the FSA's policy for granting CAD 1 model waivers under section 148 of the Act (Modification or waiver of rules). The policy recognises that CAD 1 models may vary across firms but, as a minimum, the FSA will need to be satisfied:

(1) about the quality of the internal controls and risk management relating to the model (see BIPRU 7.9.19G - BIPRU 7.9.23G for further details);
(2) about the quality of the model standards; and
(3) that the CAD 1 model captures and produces an accurate measure of the risks inherent in the portfolio covered by the CAD 1 model (see BIPRU 7.9.25G - BIPRU 7.9.53G for further details).

01/01/2007

BIPRU 7.9.3

BIPRU 7.9 also explains how the output from the CAD 1 model is fed into the market risk capital requirement calculation.

01/01/2007

BIPRU 7.9.4

If a CAD 1 model waiver is granted by the FSA, the waiver will contain certain requirements. In order adequately to address individual circumstances, these may differ from what is set out in BIPRU 7.9. The waiver will also identify the rules to which the waiver applies and the scope of model recognition granted to the firm.

01/01/2007

BIPRU 7.9.5

Waivers permitting the use of models in the calculation of PRR will not be granted if that would be contrary to the CAD. Any waiver which is granted will only be granted on terms that are compatible with the CAD. Accordingly, the only waivers permitting the use of models in calculating PRR that the FSA is likely to grant are CAD 1 model waivers and VaR model permissions.

01/01/2007

Scope of CAD 1 models

BIPRU 7.9.6

The FSA recognises two types of CAD 1 model. The table in BIPRU 7.9.7G describes them.

01/01/2007

BIPRU 7.9.7

Table: Types of CAD 1 model
This table belongs to BIPRU 7.9.6G

Options risk aggregation models

Interest rate pre-processing models

Brief description and eligible instruments

Analyse and aggregate options risks for:

• interest rate options;

• equity options;

• foreign currency options;

• commodity options; and

• CIU options.

May be used to calculate duration weighted positions for:

• interest rate futures;

• forward rate agreements (FRAs);

• forward commitments to buy or sell debt securities;

• options, swaps or warrants on interest rates or debt securities and options on such swaps;

• amortising bonds;

• equity futures, forwards, warrants and options (but only in relation to the interest rate risk inherent in these products); and

• foreign currency futures, forwards, swaps and options, but only in relation to the interest rate risk inherent in these products.

The output and how it is used in the PRR calculation

Depending on the type of model and the requirements in the CAD 1 model waiver granted, the outputs from an options risk aggregation model are used as an input to the market risk capital requirement calculation.

Depending on the type of model and the requirements in the CAD 1 model waiver granted, the individual sensitivity figures produced by this type of CAD 1 model are either input into the calculation of interest rate PRR under the interest rate duration method (see BIPRU 7.2.63R) or are converted into notional position and input into the calculation of interest rate PRR under the interest rate maturity method (see BIPRU 7.2.59R).

01/01/2007

BIPRU 7.9.8

Currently the FSA only envisages allowing recognition for options on CIUs if the CIU satisfies one of the following conditions:

(1) it is a regulated collective investment scheme; or
(2) the firm can demonstrate that it has characteristics that are similar to or better than an undertaking in (1) from the point of view of transparency and liquidity.

01/01/2007

The CAD 1 model waiver application and review process

BIPRU 7.9.9

Details of the general waiver process are set out in SUP 8 (Waiver and modification of rules). Further details of the waiver process applicable to certain waivers relating to BIPRU (including CAD 1 model waivers) can be found in BIPRU 1.3 (Applications for advanced approaches). Because of the complexity of a CAD 1 model waiver, it is recommended that, as set out in SUP 8.3.4 G and BIPRU 1.3.21 G, a firm contact its usual contact at the FSA to discuss its proposed application. It should also be noted that the waiver recognition process in the case of a CAD 1 model may take longer than the timescales indicated in SUP 8.3.5 G.

01/01/2007

BIPRU 7.9.10

In order to consider a CAD 1 model waiver request, the FSA may undertake a review to ensure that it is adequate and appropriate for the PRR calculation.

01/01/2007

BIPRU 7.9.11

The model review process may be conducted through a series of visits covering various aspects of the firm's control and IT environment. Before these visits the FSA may ask the firm to provide some information relating to its waiver request accompanied by some specified background material. The model review visits are organised on a timetable that allows a firm being visited sufficient time to arrange the visit and provide the appropriate pre-visit information.

01/01/2007

BIPRU 7.9.12

As part of the model review process, the following may be reviewed: organisational structure and personnel; details of the firm's market position in the relevant products; profit and risk information; valuation and reserving policies; operational controls; IT systems; model release and control procedures; risk management and control framework; risk appetite and limit structure and future developments relevant to model recognition.

01/01/2007

BIPRU 7.9.13

The FSA will normally require meetings with senior management and staff from the front office, financial control, risk management, operations, systems development, information technology and audit areas.

01/01/2007

BIPRU 7.9.14

A review by a skilled person may be used before a CAD 1 model waiver is granted to supplement the waiver process or after the waiver has been granted to review the CAD 1 model.

01/01/2007

BIPRU 7.9.15

If the FSA grants a CAD 1 model waiver, the waiver direction will specify the particular rule which has been modified, and set out the requirements subject to which the waiver has been granted. These requirements may include:

(1) the details of the calculation of PRR;
(2) the CAD 1 model waiver methodology to be employed;
(3) the products covered by the model (e.g. option type, maturity, currency); and
(4) any notification requirements relating to the CAD 1 model waiver.

01/01/2007

BIPRU 7.9.16

Where a firm operates any part of its CAD 1 model outside the United Kingdom, the FSA may take into account the results of any review of that model carried out by any overseas regulator concerned. The FSA may wish to receive information directly from that regulator.

01/01/2007

Maintenance of model recognition

BIPRU 7.9.17

No changes should be made to a CAD 1 model unless the change is not material. Material changes to a CAD 1 model will require a renewed waiver to be issued. Materiality is measured from the time that the waiver is granted or, if the waiver has been varied in accordance with section 148 of the Act, any later time that may be specified in the waiver for these purposes. If a firm is considering making material changes to its CAD 1 model, then it should notify the FSA at once. If a firm wishes to change the products covered by the model it should apply for a variation of its CAD 1 model waiver.

01/01/2007

BIPRU 7.9.18

If the CAD 1 model ceases to meet the requirements of the waiver, the firm should notify the FSA at once. The FSA may then revoke the waiver unless it is varied in accordance with section 148 of the Act. If the CAD 1 model waiver contains conditions it is a condition of using the CAD 1 model approach that the firm should continue to comply with those conditions.

01/01/2007

Risk management standards

BIPRU 7.9.19

A firm with a complex portfolio is expected to demonstrate more sophistication in its modelling and risk management than a firm with a simple portfolio.

01/01/2007

BIPRU 7.9.20

A firm should be able to demonstrate that the risk management standards set out in BIPRU 7.9 are satisfied by each legal entity with respect to which the CAD 1 model approach is being used (even though they are expressed to refer only to a firm). This is particularly important for subsidiary undertakings in groups subject to matrix management where the business lines cut across legal entity boundaries.

01/01/2007

BIPRU 7.9.21

(1) A firm should have a conceptually sound risk management system which is implemented with integrity and should meet the minimum standards set out in this paragraph.
(2) A firm should have a risk control unit that is independent of business trading units and reports directly to senior management. The unit should be responsible for designing and implementing the firm's risk management system. It should produce and analyse daily reports on the risks run by the business and on the appropriate measures to be taken in terms of the trading limits.
(3) A firm's senior management should be actively involved in the risk control process and the daily reports produced by the risk control unit should be reviewed by a level of management with sufficient authority to enforce reductions of positions taken by individual traders as well as in the firm's overall risk exposure.
(4) The risk control group should have a sufficient number of staff with appropriate skills in the use of models.
(5) A firm should have established procedures for monitoring and ensuring compliance with a documented set of appropriate internal policies and controls concerning the overall operation of the risk measurement and control framework. This should take into account the front, middle and back office functions.
(6) A firm should conduct, as part of its regular internal audit process, a review of the systems and controls relating to its CAD 1 model. This review should include the valuation process, compliance with the CAD 1 model waiver's scope and the activities of the business trading units and the risk control units. This review should be undertaken by staff independent of the areas being reviewed.

01/01/2007

BIPRU 7.9.22

In assessing whether the risk management and control framework is implemented with integrity, the FSA will consider the IT systems used to run the CAD 1 model and associated calculations. The assessment will include, where appropriate:

(1) feeder systems; risk aggregation systems; the integrity of the data (i.e. whether it is complete, coherent and correct); reconciliations and checks on completeness of capture; and
(2) system development, change control and documentation; security and audit trails; system availability and contingency procedures; network adequacy.

01/01/2007

BIPRU 7.9.23

A firm should take appropriate steps to ensure that it has adequate controls relating to:

(1) the derivation of the PRR from the CAD 1 model output;
(2) CAD 1 model development, including independent validation;
(3) reserving;
(4) valuation (see GENPRU 1.3 (Valuation)), including independent validation; and
(5) the adequacy of the IT infrastructure.

01/01/2007

Model standards

BIPRU 7.9.24

A firm should take appropriate steps to ensure that its CAD 1 model captures and produces an accurate measure of the risks inherent in the portfolio covered by the CAD 1 model. These risks may include, but are not limited to, gamma, vega and rho.

01/01/2007

Options risk aggregation models

BIPRU 7.9.25

For a firm to obtain a CAD 1 model waiver for its options risk aggregation model, it should have in place an appropriate options valuation model.

01/01/2007

BIPRU 7.9.26

The FSA does not specify the methodology that a firm should employ in order to produce the appropriate outputs from its options risk aggregation CAD 1 model. However, BIPRU 7.9.27G - BIPRU 7.9.43G provide details of how a firm could meet the requirement to capture gamma, vega and rho risks using a scenario matrix approach. Where a firm adopts the scenario matrix approach then the standards set out in BIPRU 7.9.27G - BIPRU 7.9.43G should be followed. The firm should also take into account other risks not captured by the scenario matrix approach. If a firm does not use the scenario matrix approach it should use an equivalent methodology. If a firm uses an equivalent methodology it should be able to demonstrate that the approach used meets the requirements of BIPRU 7.9.

01/01/2007

BIPRU 7.9.27

A scenario matrix is an approach by which an options portfolio is revalued given a number of simultaneous shifts in both the spot level of the underlying and the implied volatility.

01/01/2007

BIPRU 7.9.28

The scenario matrix approach may be employed for all types of options on all types of underlying asset.

01/01/2007

BIPRU 7.9.29

(1) This paragraph provides an outline of the initial steps to be taken when using the scenario matrix approach.
(2) A value for an option should be obtained using the firm's options valuation model.
(3) The inputs into the options valuation model for implied volatility of the underlying asset and the price of the underlying asset should then be altered so that a new value for the option is obtained (details of the amount by which the implied volatility and the price of the underlying should be amended are set out in BIPRU 7.9.30G - BIPRU 7.9.36G).
(4) The difference between the original value of the option and the new value obtained following the alterations should be input into the appropriate cell in the matrix. The value in the central cell where there is no change in implied volatility or price of the underlying should therefore be zero.
(5) The process of obtaining a new price for the option should be repeated until the matrix is completed.

01/01/2007

BIPRU 7.9.30

The alteration to the implied volatility (known as the implied volatility shift) referred to in BIPRU 7.9.29G (3) may be a proportional shift. The size of the shift depends on the remaining life of the option and the asset class of the underlying. The table in BIPRU 7.9.32G sets out the shifts that should be applied where a proportional shift is used. Alternatively, a firm may use a single shift across all maturities or use an absolute rather than a proportional implied volatility shift. Where a single shift or an absolute shift is used it should be at least as conservative as the proportional shifts. Any use of a single shift or an absolute shift should be reviewed and, if necessary updated, on a regular basis.

01/01/2007

BIPRU 7.9.31

A firm may choose to use a less detailed term structure than that in the table in BIPRU 7.9.32G, but the shifts used should be no less conservative than those set out in that table. For example, a firm that uses one <3 month band, rather than the two bands (≤ 1 month and 1-3 months) set out in the table, should use the most conservative shift set out in the table for the bands covered. In this example that shift is 30%.

01/01/2007

BIPRU 7.9.32

Table: proportional implied volatility shifts
This table belongs to BIPRU 7.9.30G

Remaining life of option

Proportional shift

Equities, foreign currency and commodities

Interest rates and CIUs

≤ 1 month

30%

> 1 ≤ 3 months

20%

> 3 ≤ 6 months

15%

> 6 ≤ 9 months

12%

> 9 ≤ 12 months

> 1 ≤ 2 years

> 2 ≤ 4 years

4.5%

> 4 years

01/01/2007

BIPRU 7.9.33

The size of the underlying price/rate shift depends on the asset class of the underlying as referred to in BIPRU 7.9.29G (3) and is set out in the table in BIPRU 7.9.34 G.

01/01/2007

BIPRU 7.9.34

Table: underlying price/rate shifts
This table belongs to BIPRU 7.9.33G

Underlying asset class

Shift

Equities

±8%

Foreign currency

±8%

Commodities

±15%, (but a firm may use the percentages applicable under the commodity extended maturity ladder approach if it would qualify under BIPRU 7.4 (Commodity PRR) to use that approach).

Interest rates

±100bp (but a firm may use the sliding scale of shifts by maturity as applicable to the interest rate duration method).

CIU

±32%, (but a firm may use the percentages applicable to the underlyings if the firm applies one of the CIU look through methods under BIPRU 7.7 (Position risk requirements for collective investment undertakings)).

01/01/2007

BIPRU 7.9.35

The shifts outlined in the table in BIPRU 7.9.34G are the maximum shifts required; in addition there will be a number of intermediate shifts as a result of the minimum matrix size criteria set out in BIPRU 7.9.36G.

01/01/2007

BIPRU 7.9.36

The minimum size of the scenario matrix should be 3x7, that is, three observations for implied volatility (including the actual implied volatility) and seven observations for the price of the underlying (including the actual price of the underlying). A firm should be able to justify its choice of granularity. Greater granularity may be required where the portfolio contains, for example, a large proportion of barrier options.

01/01/2007

BIPRU 7.9.37

(1) A different scenario matrix should be set up for each underlying asset type in accordance with this paragraph.
(2) For equities (including single equities, baskets and indices) there should be a separate matrix for each national market or non-decomposed basket or non-decomposed multi-national index.
(3) For foreign currency products there should be a separate matrix for each currency pair where appropriate.
(4) For commodity products there should be a separate matrix for each commodity. The question whether two items are the same commodity should be decided in accordance with BIPRU 7.4 (Commodity PRR).
(5) For interest rate products there should be a separate matrix for each currency. In addition, a firm should not offset the gamma and vega exposures (except in the circumstances set out in BIPRU 7.9.38G) arising from any one of the following types of product with the gamma and vega exposures arising from any of the other products in the list:

(a) swaptions (options on interest rates);
(b) interest rate options (including options on exchange-traded deposit or bill futures);
(c) bond options (including options on exchange-traded bond futures); and
(d) other types of options required by the CAD 1 model waiver to form their own separate class of underlying asset.

(6) The other types of options referred to in (5)(d) will generally be exotic options that do not fall easily into (5)(a) - (c)).
(7) For CIUs there should be a separate matrix for each CIU fund. If the firm applies one of the CIU look through methods under BIPRU 7.7 (Position risk requirements for collective investment undertakings), then (1) - (6) apply based on what the underlyings are.

01/01/2007

BIPRU 7.9.38

A firm may offset gamma and vega exposures arising from the products listed in BIPRU 7.9.37G (5) where it can demonstrate that it trades different types of interest rate-related options as a portfolio and takes steps to control the basis risk between different types of implied volatility. To the extent that this is the case an individual matrix is not required for each of the products listed in BIPRU 7.9.37G (5) and a combined scenario matrix may be used.

01/01/2007

BIPRU 7.9.39

Where it is imprudent fully to offset long-dated and short-dated vega exposure owing to the risk of non-parallel shifts in the yield curve, a firm should use an appropriate number of scenario matrices to take account of non-parallel shifts in the yield curve according to the maturity of the option or underlying.

01/01/2007

BIPRU 7.9.40

Following the steps outlined in BIPRU 7.9.29G, a firm then removes the portion of the values in the matrix that can be attributed to the effect that delta has had on the change in the value of the option (a process known as delta-stripping).

01/01/2007

BIPRU 7.9.41

Once the effect of delta has been removed from the matrix, the values left in the matrix relate to gamma and vega risk. A firm's PRR in relation to gamma and vega risk on the individual option is the absolute of the most negative cell in the scenario matrix produced. Where all cells are positive the PRR is zero. The total PRR for the gamma and vega risk on the portfolio of options is a simple sum of the individual requirements. This amount should then be fed into a firm's PRR calculation.

01/01/2007

BIPRU 7.9.42

The values that have been obtained for the delta-equivalent positions of instruments included in the scenario matrix should then be treated in the same way as positions in the underlying. Where the delta obtained relates to interest rate position risk, the delta equivalent positions may be fed into the firm's interest rate pre-processing model to the extent that the positions fall within the scope of interest rate pre-processing models as set out in BIPRU 7.9.7G and provided that the firm's CAD 1 model waiver allows the firm's CAD 1 model to be used in this way. Alternatively, the delta obtained should be fed into the standard PRR calculations in BIPRU 7.2 (Interest rate PRR), BIPRU 7.3 (Equity PRR and basic interest rate PRR for equity derivatives), BIPRU 7.4 (Commodity PRR) or BIPRU 7.5 (Foreign currency PRR) as appropriate.

01/01/2007

BIPRU 7.9.43

In using the scenario matrix approach, none of the steps followed will take specific account of a firm's exposure to rho risk. Where a firm can demonstrate that for interest rate-related options the rho sensitivity is effectively included in the delta sensitivities produced, there is no separate capital requirement relating to rho. For all other options except commodity options, a firm should calculate a rho sensitivity ladder by currency using its CAD 1 model and either feed this into the interest rate maturity method or interest rate duration method calculation or, where the firm's CAD 1 model waiver allows the firm's CAD 1 model to be used in this way, feed that ladder into an interest rate pre-processing model. Generally a CAD 1 model does not need to deal specifically with rho risk for commodity options.

01/01/2007

Interest rate pre-processing models

BIPRU 7.9.44

To the extent that a firm's CAD 1 model waiver is for the use of an interest rate pre-processing model the firm should use it for the pre-processing of the instruments set out in BIPRU 7.9.7G, from which the residual positions are fed into the interest rate maturity method or interest rate duration method calculation.

01/01/2007

BIPRU 7.9.45

There are a number of different methods of constructing pre-processing models but all should comply with BIPRU 7.9.45G - BIPRU 7.9.53G. All pre-processing models should generate positions that have the same sensitivity to defined interest rate changes as the underlying cash flows.

01/01/2007

BIPRU 7.9.46

In an interest rate pre-processing model each transaction is converted into its constituent cash flows. The cash flows are discounted using zero coupon rates derived from the firm's own yield curves.

01/01/2007

BIPRU 7.9.47

The cash flows are then calculated again using the firm's own yield curve shifted by the amount set out in BIPRU 7.9.49G.

01/01/2007

BIPRU 7.9.48

The difference between the present values calculated using the firm's own yield curve and those calculated using the firm's curve shifted under BIPRU 7.9.47G are known as the sensitivity figures. Alternatively, a firm may shift the yield curve by one basis point and multiply up the sensitivity figures by the appropriate amount in order to achieve the shifts set out in BIPRU 7.9.47G. These sensitivity figures are then allocated to each of the 15 maturity bands set out in BIPRU 7.9.49G.

01/01/2007

BIPRU 7.9.49

Table: yield curve shifts
This table belongs to BIPRU 7.9.47G

Zone

Modified duration

Assumed interest rate change (percentage points)

0 ≤ 1 months

1.00

> 1 ≤ 3 months

1.00

> 3 ≤ 6 months

1.00

> 6 ≤ 12 months

1.00

> 1.0 ≤ 1.9 years

0.90

> 1.9 ≤ 2.8 years

0.85

> 2.8 ≤ 3.6 years

0.85

> 3.6 ≤ 4.3 years

0.75

> 4.3 ≤ 5.7 years

0.70

> 5.7 ≤ 7.3 years

0.70

> 7.3 ≤ 9.3 years

0.70

> 9.3 ≤ 10.6 years

0.70

> 10.6 ≤ 12 years

0.70

> 12.0 ≤ 20 years

0.70

> 20 years

0.70

01/01/2007

BIPRU 7.9.50

Sensitivity figures calculated by a firm using an interest rate pre-processing model are usually produced in the format of a net sensitivity by maturity bucket or by discrete gridpoint. These maturity buckets or gridpoints should then be allocated to the 15 bands set out in BIPRU 7.9.49G. The number of maturity buckets or gridpoints used to represent a yield curve can be referred to as granularity. The granularity should always be adequate to capture the material curve risk in the portfolio. Curve risk can be defined as the risk associated with holding long and short positions at different points along the yield curve.

01/01/2007

BIPRU 7.9.51

Positive and negative amounts placed in each of the different maturity bands in BIPRU 7.9.49G under the sensitivity calculation in BIPRU 7.9.50G should then be netted off to produce one figure for each of the bands. There is no capital requirement for this netting process.

01/01/2007

BIPRU 7.9.52

The individual sensitivity figures produced should then be input into the interest rate duration method calculation. The individual sensitivity figures for each band should be included with the other positions in the appropriate column in the table in BIPRU 7.2.65R (Table: Assumed interest rate change in the interest rate duration method).

01/01/2007

BIPRU 7.9.53

Instead of using the approach in BIPRU 7.9.52G a firm may use an approach based on the interest rate maturity method, making appropriate adjustments to the sensitivity figures.

01/01/2007

BIPRU 7.10

Use of a Value at Risk Model

01/01/2007

Application

BIPRU 7.10.1

BIPRU 7.10 applies to a firm with a VaR model permission.

01/01/2007

Introduction and purpose

BIPRU 7.10.2

BIPRU 7.10 provides details of when the FSA expects to allow a firm to use a VaR model (value at risk model) for the purpose of calculating part or all of its PRR. It introduces the concept of a VaR model, the methodology behind it and the link to the standard market risk PRR rules. It then goes on to detail the application and review process. The bulk of BIPRU 7.10 specifies the model standards and risk management standards that firms will be required to meet in order to use a VaR model. It further stipulates requirements for stress testing, backtesting, capital calculations and finally the reporting standards expected by the FSA.

01/01/2007

BIPRU 7.10.3

The models described in BIPRU 7.10 are described as VaR models in order to distinguish them from CAD 1 models, which are dealt with in BIPRU 7.9 (Use of a CAD 1 model). A VaR model is a risk management model which uses a statistical measure to predict profit and loss movement ranges with a confidence interval. From these results PRR charges can be calculated. The standards described in BIPRU 7.10, and which will be applied by the FSA , are based on and implement Annex V of the Capital Adequacy Directive.

01/01/2007

BIPRU 7.10.4

The aim of the VaR model approach is to enable a firm with adequate risk management systems to be subject to a PRR requirement that is more closely aligned with the risks to which it is subject than the PRR requirements generated by the standard market risk PRR rules. This provides a firm with an incentive to measure market risks as accurately and comprehensively as possible. It is crucial that those responsible for managing market risk at a firm should be aware of the assumptions and limitations of the firm's VaR model.

01/01/2007

BIPRU 7.10.5

There are a number of general methodologies for calculating PRR using a VaR model. The FSA does not prescribe any one method of computing VaR measures. Moreover, it does not wish to discourage any firm from developing alternative risk measurement techniques. A firm should discuss the use of any alternative techniques used to calculate PRR with the FSA.

01/01/2007

BIPRU 7.10.6

A firm should not use the VaR model approach to calculate PRR unless it has a VaR model permission. If a firm does not have such a permission it should use the standard market risk PRR rules. Therefore, a firm needs to apply for a VaR model permission in order to calculate its PRR using a VaR model instead of (or in combination with) the standard market risk PRR rules.

01/01/2007

Conditions for granting a VaR model permission

BIPRU 7.10.7

A waiver or other permission allowing the use of models in the calculation of PRR will not be granted if that would be contrary to the Capital Adequacy Directive and any VaR model permission which is granted will only be granted on terms that are compatible with the Capital Adequacy Directive. Accordingly, the FSA is likely only to grant a waiver or other permission allowing the use of models in the calculation of PRR if it is a VaR model permission or a CAD 1 model waiver.

01/01/2007

BIPRU 7.10.8

BIPRU 7.10 sets out the minimum standards that the FSA expects firms to meet before granting a VaR model permission. The FSA will not grant a VaR model permission unless it is satisfied that the requirements of BIPRU 7.10 are met and it is satisfied about the procedures in place at a firm to calculate the model PRR. In particular the FSA will not normally grant a VaR model permission unless it is satisfied about the quality of:

(1) the internal controls and risk management relating to the VaR model (see BIPRU 7.10.56G - BIPRU 7.10.82R);
(2) the VaR model standards (see BIPRU 7.10.24R-BIPRU 7.10.55G); and
(3) stress testing and backtesting procedures relating to a VaR model (see, in addition to (2), BIPRU 7.10.83R - BIPRU 7.10.112G).

01/01/2007

BIPRU 7.10.9

The FSA recognises that the nature of VaR models will vary between firms. The scope of and the requirements and conditions set out in a VaR model permission may therefore differ in substance or detail from BIPRU 7.10 in order to address individual circumstances adequately. However any differences will only be allowed if they are compliant with the Capital Adequacy Directive. A VaR model permission will implement any such variation by modifying BIPRU 7.10. A VaR model permission may also include additional conditions to meet the particular circumstances of the firm or the model.

01/01/2007

The VaR model permission application and review process

BIPRU 7.10.10

Details of the general process for applying for a VaR model permission are set out in BIPRU 1.3 (Applications for advanced approaches). Because of the complexity of a VaR model permission, it is recommended that a firm discuss its proposed application with its usual contact at the FSA before it makes the application.

01/01/2007

BIPRU 7.10.11

In order for a VaR model permission to be granted, the FSA is likely to undertake a review to ensure that it is adequate and appropriate for the PRR calculation.

01/01/2007

BIPRU 7.10.12

The VaR model review process may be conducted through a series of visits covering various aspects of a firm's control and IT environment. Before these visits the FSA may ask the firm to provide some information relating to the firm's VaR model permission request accompanied by some specified background material. The VaR model review visits are organised on a timetable that allows the firm being visited sufficient time to arrange the visit and provide the appropriate pre-visit information.

01/01/2007

BIPRU 7.10.13

As part of the process for dealing with an application for a VaR model permission the following may be reviewed: organisational structure and personnel; details of the firm's market position in the relevant products; revenue and risk information; valuation and reserving policies; operational controls; information technology systems; model release and control procedures; risk management and control framework; risk appetite and limit structure; future developments relevant to model recognition.

01/01/2007

BIPRU 7.10.14

A visit will usually involve the FSA wishing to meet senior management and staff from the front office, financial control, risk management, operations, systems development, information technology and internal audit areas.

01/01/2007

BIPRU 7.10.15

The FSA may complement its own review of a VaR model permission request with one or more reviews by a skilled person under section 166 of the Act (Reports by skilled persons). Such a review may also be used where a VaR model permission has been granted to ensure that the requirements BIPRU 7.10 and of the VaR model permission continue to be met.

01/01/2007

Conditions for a VaR model outside the United Kingdom

BIPRU 7.10.16

Where a VaR model used outside the United Kingdom differs from that used in the United Kingdom the FSA may request details of the reasons for using different models.

01/01/2007

BIPRU 7.10.17

Where a firm operates any part of its VaR model outside the United Kingdom, the FSA may take into account the results of the home supervisor's review of that model. The FSA may wish to receive information directly from the home supervisor.

01/01/2007

Scope of VaR models

BIPRU 7.10.18

A firm must use the VaR model approach to calculate the PRR for a position:

(1) to the extent that the risks in relation to that position are within the scope of the VaR model permission (see BIPRU 7.10.136R (Link to standard PRR rules: Incorporation of the model output into the capital calculation)); and
(2) if the position is of a type that comes within the scope of the VaR model permission.

01/01/2007

BIPRU 7.10.19

In accordance with BIPRU 7.10.18R (1) a VaR model permission will set out the risk categories that it covers, which are expected to be one or more of the following types:

(1) interest rate general market risk;
(2) interest rate specific risk (in conjunction with interest rate general market risk);
(3) equity general market risk;
(4) equity specific risk (in conjunction with equity general market risk);
(5) CIU risk;
(6) foreign currency risk; and
(7) commodity risk.

01/01/2007

BIPRU 7.10.20

A VaR model permission will generally set out the broad classes of position within its scope. It may also specify how individual products within one of those broad classes may be brought into or taken out of the scope of the VaR model permission.

01/01/2007

BIPRU 7.10.21

The broad classes of position referred to in BIPRU 7.10.20G are as follows:

(1) linear products, which comprise securities with linear pay-offs (e.g. bonds and equities) and derivative products which have linear pay-offs in the underlying risk factor (e.g. interest rate swaps, FRAs, total return swaps);
(2) European, American and Bermudan put and call options (including caps, floors and swaptions) and investments with these features (see BIPRU 7.6.18R (Table: Option PRR: methods for different types of option) for an explanation of some of these terms);
(3) Asian options, digital options, single barrier options, double barrier options, lookback options, forward starting options, compound options and investments with these features (see BIPRU 7.6.18R for an explanation of some of these terms); and
(4) all other option based products (e.g. basket options, quantos, outperformance options, timing options) and investments with these features (see BIPRU 7.6.18R for an explanation of some of these terms).

01/01/2007

BIPRU 7.10.22

The categorisation described in BIPRU 7.10.21G may be amended or replaced in the case of a particular firm's VaR model permission.

01/01/2007

BIPRU 7.10.23

It is the FSA's view that, where a firm uses a VaR model for one risk category as described in BIPRU 7.10.19G, it is good practice to extend its model over time to calculate all of its PRR risk categories. A firm will typically be expected to have a realistic plan in place to do this.

01/01/2007

Model standards: General

BIPRU 7.10.24

A firm must comply with the minimum standards set out in BIPRU 7.10.26R - BIPRU 7.10.53R in calculating the model PRR.

01/01/2007

BIPRU 7.10.25

The FSA accepts that the scope and nature of VaR models varies across firms. This means that different firms are likely to calculate different estimates of market risk for the same portfolio. Systematic differences are due to length of data series, choice of methodology (historical or Monte Carlo simulation or variance-covariance method or a hybrid of these), differences in aggregating risks within and across broad risk factors, the treatment of options and other non-linear products and the specification of risk factors.

01/01/2007

Model standards: Frequency of calculations and confidence level

BIPRU 7.10.26

The model PRR must be computed at least once every business day, using a 99% one-tailed confidence limit.

01/01/2007

BIPRU 7.10.27

A firm may meet the requirement in BIPRU 7.10.26R by using different model parameters and employing a suitable adjustment mechanism to produce a figure which is equivalent to the figure produced using the parameters set out in BIPRU 7.10.26R. For example, a firm's model may use a 95% one-tailed confidence limit if the firm has a mechanism to convert the output of the model to reflect a 99% one-tailed confidence limit.

01/01/2007

Model standards: Holding period

BIPRU 7.10.28

In calculating the VaR number, a firm must either use a ten business day holding period, or use a holding period converted to a ten business day holding period. However if the firm's VaR model permission specifies that the firm must use a specific method, the firm must do so.

01/01/2007

BIPRU 7.10.29

If a firm uses a holding period other than 10 business days and converts the resulting VaR measure to a ten business day equivalent measure, it should be able to justify the choice of conversion technique. For example, the square root of time method will usually be justifiable. The FSA considers it good practice ultimately to move towards the application of an actual ten business day holding period, rather than using different holding periods.

01/01/2007

Model standards: Observation period

BIPRU 7.10.30

Subject to BIPRU 7.10.31R, the calculation of VaR numbers must be based on an effective historical observation period that is the longest possible consistent with a prudent VaR number. That period must be at least one year or such longer period as may be set out in the firm's VaR model permission. However if using that prescribed observation period does not result in a sufficiently prudent way of calculating a VaR measure or a component of a VaR measure the firm must shorten this observation period until the observation period is consistent with a prudent VaR number.

01/01/2007

Model standards: Data series

BIPRU 7.10.31

A firm must ensure that the data series used by its VaR model is reliable. Where a reliable data series is not available, proxies or any other reasonable value-at-risk measurement technique must be used. A firm must be able to demonstrate that the technique is appropriate and does not materially understate the modelled risks.

01/01/2007

BIPRU 7.10.32

A data series is unreliable if it has, for example, missing data points, or data points which contain stale data. Reliable data series may be difficult to obtain for new products (for example an instrument of longer dated tenor that did not previously trade) and for less liquid risk factors or positions. With regard to less liquid risk factors or positions, a firm may use a combination of prudent valuation techniques and alternative VaR estimation techniques to ensure there is a sufficient cushion against risk over the close out period which takes account of the illiquidity of the risk factor or position.

01/01/2007

BIPRU 7.10.33

(1) If a weighting scheme or other similar method is used to calculate VaR numbers, then the effective observation period must be at least one year. Where a weighting scheme is used, the weighted average time lag of the individual observations must not be less than six Months.
(2) If a specific observation period or weighted average time lag is specified in a firm's VaR model permission, the firm must comply with that if it is longer than the period specified in (1).
(3) However, if a weighting scheme in (1) or (2) would result in imprudent VaR numbers then the weighting scheme must be adjusted so that it is consistent with a prudent VaR number.

01/01/2007

BIPRU 7.10.34

A firm must update data sets in accordance with the frequency set out in its VaR model permission. If volatility in market prices or rates necessitates more frequent updating in order to ensure a prudent calculation of the VaR measure the firm must do so.

01/01/2007

BIPRU 7.10.35

The minimum updating frequency that can be specified in a VaR model permission is quarterly.

01/01/2007

Model standards: Aggregation across risk categories

BIPRU 7.10.36

The process for determining and implementing correlations within and across risk categories must be sound, implemented with integrity and consistent with the terms of the firm's VaR model permission.

01/01/2007

BIPRU 7.10.37

In aggregating VaR measures across risk or product categories, a firm must not use the square root of the sum of the squares approach unless the assumption of zero correlation between these categories is empirically justified. If correlations between risk categories are not empirically justified, the VaR measures for each category must simply be added in order to determine its aggregate VaR measure. But to the extent that a firm's VaR model permission provides for a different way of aggregating VaR measures:

(1) that method applies instead of this rule; and
(2) if the correlations between risk categories used for that purpose cease to be empirically justified then the firm must notify the FSA at once.

01/01/2007

Model standards: Risk factors: Introduction

BIPRU 7.10.38

Subject to BIPRU 7.10.53R (Model standards: Materiality), a VaR model should capture and accurately reflect all material risks arising on the underlying portfolio on a continuing basis insofar as those risks are within the scope of the VaR model permission. This should encompass general market risk and, to the extent that this comes within the scope of the VaR model permission, specific risk. A firm should ensure that the VaR model has sufficient risk factor granularity to be able to capture all such material risks and that these are properly documented and specified.

01/01/2007

Model standards: Risk factors: General

BIPRU 7.10.39

In the case of general market risk and risks with respect to which the standard market risk PRR rules do not distinguish between general market risk and specific risk, a firm's VaR model must capture a sufficient number of risk factors in relation to the level of activity of the firm and in particular the risks set out in BIPRU 7.10.40R - BIPRU 7.10.44R.

01/01/2007

BIPRU 7.10.40

For interest rate risk, a VaR model must incorporate a set of risk factors corresponding to the interest rate curves in each currency in which the firm has interest rate sensitive positions. A firm must ensure that it captures the variations of volatility of rates along the yield curve. In order to achieve this, a firm must divide the yield curves of, at a minimum, the major currencies and markets in which it has material interest rate exposures into a minimum of six maturity segments. The VaR model must also capture the risk of less than perfectly correlated movements between different yield curves.

01/01/2007

BIPRU 7.10.41

For equity risk, a VaR model must use a separate risk factor at least for each of the equity markets in which the firm has material positions.

01/01/2007

BIPRU 7.10.42

For foreign currency risk, a VaR model must incorporate risk factors corresponding to the individual foreign currencies, including gold, in which the firm's positions are denominated.

01/01/2007

BIPRU 7.10.43

For commodity risk, the VaR model must use a separate risk factor at least for each commodity in which the firm has material positions. The VaR model must also capture the risk of less than perfectly correlated movements between similar, but not identical, commodities and the exposure to changes in forward prices arising from maturity mismatches. It must also take account of market characteristics, notably delivery dates and the scope provided to traders to close out positions.

01/01/2007

BIPRU 7.10.44

(1) For CIUs the actual foreign currency positions of the CIU must be taken into account.
(2) A firm may rely on third party reporting of the foreign currency position of the CIU, where the correctness of this report is adequately ensured.
(3) If a firm is not aware of the foreign currency positions in a CIU, this position must be carved out and treated in BIPRU 7.5.18R (Derivation of notional positions in CIUs for the foreign currency PRR).

01/01/2007

BIPRU 7.10.45

(1) This paragraph contains guidance on the inclusion of CIUs in a VaR model.
(2) The FSA may allow all types of CIU to be included within the scope of a firm's VaR model permission.
(3) BIPRU 7.10 does not distinguish between specific risk and general market risk for positions in CIUs. Therefore even if specific risk is not otherwise included within the scope of a firm's VaR model permission, a firm should be able to demonstrate that its VaR model captures specific risk.
(4) A firm should also be able to demonstrate that its VaR model adequately captures correlations, concentration risk and risks associated with the illiquidity of the CIU itself should this be deemed necessary (see BIPRU 7.10.32G).
(5) A firm may use a look-through approach, under which the VaR model estimates are based on the underlying positions. If a firm uses a look through approach it should also ensure that all the relevant risk factors relating to the underlying positions are captured. BIPRU 7.7 (Position risk requirements for collective investment undertakings) sets out rules relating to the look through approach when a firm is using the VaR model approach.

01/01/2007

Model standards: Risk factors: Specific risk

BIPRU 7.10.46

(1) If a firm's VaR model covers the calculation of PRR with respect to specific risk the firm must meet the VaR specific risk minimum requirements in addition to the other requirements of BIPRU 7.10.
(2) The VaR model must explain the historical price variation in the portfolios concerned.
(3) The VaR model must capture concentration in terms of magnitude and changes of composition of the portfolios concerned.
(4) The VaR model must be robust to an adverse environment.
(5) The VaR model must capture name-related basis risk. That is the firm must be able to demonstrate that the VaR model is sensitive to material idiosyncratic differences between similar but not identical positions.
(6) The VaR model must capture event risk.
(7) In addition to the other requirements in BIPRU 7.10, a firm must have an approach in place to capture, in the calculation of its capital requirements, the default risk of its trading book positions that is incremental to the default risk captured by the VaR measures as specified in this rule, BIPRU 7.10.48R, BIPRU 7.10.49R and BIPRU 7.10.107R (Backtesting: Specific risk backtesting).
(8) A firm must be able to demonstrate that the approach referred to in (7) meets soundness standards comparable to the approach set out in BIPRU 4 (The IRB approach), under the assumption of a constant level of risk, and adjusted where appropriate to reflect the impact of liquidity, concentrations, hedging and optionality.

01/11/2007

BIPRU 7.10.47

This paragraph provides guidance on BIPRU 7.10.46R (3). Take as an example a VaR model based on a factor model or on a historical simulation model. The ability of the model to explain price variation could be demonstrated by a statistical comparison over the same period of time between actual price changes on the portfolio and the profit and loss impact of risk factors included within the model. A firm may wish to include an estimate of residual variation not explained by the model.

01/01/2007

BIPRU 7.10.48

(1) Where a firm is subject to event risk that is not reflected in its VaR measure, because it is beyond the 10-day holding period and 99 percent confidence interval (low probability and high severity events), the firm must ensure that the impact of such events is factored into its internal capital assessment.
(2) A firm's VaR model must conservatively assess the risk arising from less liquid positions and positions with limited price transparency under realistic market scenarios. In addition, the VaR model must meet minimum data standards. Proxies must be appropriately conservative and may be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio.

01/01/2007

BIPRU 7.10.49

As techniques and best practices evolve, a firm must avail itself of these advances.

01/01/2007

BIPRU 7.10.50

To avoid double counting capital requirements under BIPRU 7.10.46R (7) a firm may, when calculating its incremental default charge, take into account the extent to which default risk has already been incorporated into the VaR calculation, especially for risk positions that could and would be closed within 10 business days in the event of adverse market conditions or other indications of deterioration in the credit environment. Where a firm captures its incremental default risk through a surcharge, it must have in place methodologies for validating the measure.

01/01/2007

BIPRU 7.10.51

A firm that does not capture the incremental default risk through an internally developed approach must calculate the surcharge through an approach consistent with either the standardised approach to credit risk or the IRB approach.

01/01/2007

BIPRU 7.10.52

With respect to securitisation exposures that would be subject to a deduction treatment in the calculation of its capital resources or risk weighted at 1250% as set out in BIPRU 9, these positions (cash or synthetic) are subject to a capital charge that is no less than set forth under that treatment. A firm that is a dealer in these exposures may apply a different treatment where it could demonstrate to the FSA, in addition to trading intent, that a liquid two-way market exists for the securitisation exposures or, in the case of synthetic securitisation that rely solely on credit derivatives, for the securitisation exposures themselves or all their constituent risk components. For the purposes of this rule a two-way market is deemed to exist where there are independent good faith offers to buy and sell so that a price reasonably related to the last sales price or current good faith competitive bid and offer quotations can be determined within one day and settled at such a price within a relatively short time conforming to trade custom. For a firm to apply a different treatment, it must have sufficient market data to ensure that it fully captures the concentrated default risk of these exposures in its internal approach for measuring the incremental default risk in accordance with the VaR specific risk minimum requirements.

01/01/2007

Model standards: Materiality

BIPRU 7.10.53

A firm's VaR model must capture accurately all material price risks for positions within the scope of its VaR permission, including risks relating to options or option-like positions. The firm must ensure that, if its VaR model does not accurately capture any material risk, the firm has capital resources adequate to cover that risk. These capital resources must be additional to those required to meet its capital resources requirement.

01/01/2007

BIPRU 7.10.54

For example, BIPRU 7.10.53R might involve creating and documenting a prudent incremental PRR charge for the risk not captured in the VaR model and holding sufficient capital resources against this risk. In that case the firm should hold capital resources at least equal to its capital resources requirement as increased by adding this incremental charge to the model PRR. Alternatively the firm may make valuation adjustments through its profit and loss reserves to cover this material risk. These reserves should be transparent to senior management and auditable. The reserves should also be consistent with GENPRU 1.3 (Valuation) while not being excessive in relation to the principles of mark-to-market accounting. Therefore, a firm should be able to satisfy the FSA that all material risks are adequately addressed, whether this be through the VaR model, through taking an incremental PRR charge or through making an adjustment through profit and loss reserves.

01/01/2007

BIPRU 7.10.55

A firm is expected ultimately to move towards full revaluation of option positions. For portfolios containing path dependent options, an instantaneous price shock applied to a static portfolio will be acceptable provided that the risks not captured by such an approach are not material. Where a risk is immaterial and does not justify further capital resources, that immaterial risk should still be documented.

01/01/2007

Risk management standards: Introduction

BIPRU 7.10.56

A firm with a complex portfolio is expected to demonstrate greater sophistication in its modelling and risk management than a firm with a simple portfolio. For example, a firm will be expected to consider, where necessary, varying degrees of liquidity for different risk factors, the complexity of risk modelling across time zones, product categories and risk factors. Some trade-off is permissible between the sophistication and accuracy of the model and the conservatism of underlying assumptions or simplifications.

01/01/2007

BIPRU 7.10.57

A firm should be able to demonstrate that it meets the risk management standards set out in the VaR model permission on a legal entity basis. This is particularly important for a subsidiary undertaking in a group subject to matrix management where the business lines cut across legal entity boundaries.

01/01/2007

Risk management standards: General requirement

BIPRU 7.10.58

A firm must have a conceptually sound risk management system surrounding the use of its VaR model that is implemented with integrity and that in particular meet the qualitative standards set out in BIPRU 7.10.59R - BIPRU 7.10.82R.

01/01/2007

Risk management standards: Use requirement

BIPRU 7.10.59

A firm must base its model PRR calculation on the output of the VaR model which is used for its internal risk management rather than one developed specifically to calculate its PRR.

01/01/2007

BIPRU 7.10.60

The VaR model must be fully integrated into the daily risk management process of the firm, and serve as the basis for reporting risk exposures to senior management of the firm.

01/01/2007

BIPRU 7.10.61

A firm's VaR model output should be an integral part of the process of planning, monitoring and controlling a firm's market risk profile. The VaR model should be used in conjunction with internal trading and exposure limits. The links between these limits and the VaR model should be consistent over time and understood by senior management. The firm should regard risk control as an essential aspect of the business to which significant resources need to be devoted.

01/01/2007

Risk management standards: Risk control unit

BIPRU 7.10.62

A firm must have a risk control unit which is independent from business trading units and which reports directly to senior management. It:

(1) must be responsible for designing and implementing the firm's risk management system;
(2) must produce and analyse daily reports on the output of the VaR model and on the appropriate measures to be taken in terms of the trading limits; and
(3) conduct the initial and on-going validation of the VaR model.

01/01/2007

Risk management standards: Senior management

BIPRU 7.10.63

A firm's governing body and senior management must be actively involved in the risk control process, and the daily reports produced by the risk control unit must be reviewed by a level of management with sufficient authority to enforce both reductions of positions taken by individual traders as well as in the firm's overall risk exposure.

01/01/2007

BIPRU 7.10.64

It is the responsibility of a firm's own management to ensure the accuracy and integrity of its VaR model. This responsibility includes obtaining appropriate independent validation of the VaR model.

01/01/2007

Risk management standards: Skilled staff

BIPRU 7.10.65

A firm must have sufficient numbers of staff skilled in the use of sophisticated models in the trading, risk control, audit and back office areas.

01/01/2007

Risk management standards: Controls and compliance

BIPRU 7.10.66

A firm must establish, document and maintain policies, controls and procedures to an auditable standard:

(1) concerning the operation of its VaR model approach; and
(2) for monitoring and ensuring compliance with the policies, controls and procedures in (1).

01/01/2007

Risk management standards: Documentation

BIPRU 7.10.67

A VaR model must be adequately documented.

01/01/2007

BIPRU 7.10.68

(1) An example of documents required by BIPRU 7.10.67R may be a manual that describes the basic principles of the risk management framework, clearly setting out empirical techniques, principles and assumptions used within it.
(2) This documentation should be of sufficient detail for the FSA to be able to develop a clear understanding of how the VaR model works from that documentation on its own.

01/01/2007

Risk management standards: Track record

BIPRU 7.10.69

A firm's VaR model must have a proven track record of acceptable accuracy in measuring risk.

01/01/2007

Risk management standards: Development validation

BIPRU 7.10.70

Adequate procedures must be in place to ensure that model changes are validated before being introduced.

01/01/2007

BIPRU 7.10.71

The procedures in BIPRU 7.10.70R need not necessarily rely on backtesting using a back-run of recreated data.

01/01/2007

Risk management standards: Stress testing

BIPRU 7.10.72

(1) A firm must frequently conduct a rigorous programme of stress testing. The results of these tests must be reviewed by senior management and reflected in the policies and limits the firm sets.
(2) The programme must particularly address:

(a) concentration risk;
(b) illiquidity of markets in stressed market conditions;
(c) one way markets;
(d) event and jump to default risks;
(e) non linearity of products;
(f) deep out of the money positions;
(g) positions subject to the gapping of prices;
(h) full revaluation, or a reliable approximation, of positions;
(i) instant shocks as well as effects of longer term periods of stress;
(j) calibration changes under stressed conditions;
(k) secondary risk factors (such as volatility);
(l) basis risk;
(m) systemic and localised stresses; and
(n) other risks that may not be captured appropriately in the VaR model (for example, recovery rate uncertainty, implied correlations and skew risk).

(3) The shocks applied must reflect the nature of the portfolios and the time it could take to hedge out or manage risks under severe market conditions.

14/12/2009

BIPRU 7.10.73

The stress testing under BIPRU 7.10.72R should be taken into account under the overall Pillar 2 rule.

01/01/2007

BIPRU 7.10.73A

The firm's stress testing programme should be comprehensive in terms of both risk and firm coverage, and appropriate to the size and complexity of trading book positions held.

14/12/2009

Risk management standards: Valuation

BIPRU 7.10.74

A firm must have procedures to ensure that the valuation of assets and liabilities is appropriate, that valuation uncertainty is identified and appropriate reserving is undertaken where necessary.

01/01/2007

Risk management standards: Risk review

BIPRU 7.10.75

At least once a year, a firm must conduct, as part of its regular internal audit process, a review of its risk management process. This review must include both the activities of the business trading units and of the independent risk control unit, and must be undertaken by suitably qualified staff independent of the areas being reviewed. This review must consider, at a minimum:

(1) the adequacy of the documentation of the risk management system and process;
(2) the organisation of the risk control unit;
(3) the integration of market risk measures into daily risk management;
(4) the integrity of the management information system;
(5) the process for approving risk pricing models and valuation systems used in front and back offices;
(6) the validation of any significant changes in the risk management process;
(7) the scope of risks and products captured by the VaR model;
(8) the accuracy and completeness of position data;
(9) the process used to ensure the consistency, timeliness, independence and reliability of data sources (including the independence of such data sources);
(10) the accuracy and appropriateness of volatility and correlation assumptions;
(11) reserving policies and the accuracy of the valuation procedures and risk sensitivity calculations;
(12) the process employed to evaluate the VaR model's accuracy, including the programme of backtesting;
(13) the controls surrounding the development of the VaR model; and
(14) the process employed to produce the calculation of the model PRR.

01/01/2007

Risk management standards: Validation and backtesting

BIPRU 7.10.76

The FSA will require a period of initial monitoring or live testing before a VaR model can be recognised. This will be agreed on a firm by firm basis.

01/01/2007

BIPRU 7.10.77

In assessing the firm's VaR model and risk management, the FSA has regard to the results of internal model validation procedures used by the firm to assess the VaR model.

01/01/2007

BIPRU 7.10.78

A firm must have processes in place to ensure that its VaR model has been adequately validated by suitably qualified parties independent of the development process to ensure that it is conceptually sound and adequately captures all material risks. This validation must be conducted when the VaR model is initially developed and when any significant changes are made to the VaR model. The validation must also be conducted on a periodic basis but especially where there have been any significant structural changes in the market or changes to the composition of the portfolio which might lead to the VaR model no longer being adequate. As techniques and best practices evolve, a firm must avail itself of these advances. Model validation must not be limited to backtesting, but must, at a minimum, also include the following:

(1) tests to demonstrate that any assumptions made within the VaR model are appropriate and do not underestimate or overestimate the risk (including testing of the validity of the assumptions and approximations underlying the VaR model);
(2) in addition to the regulatory backtesting programmes, a firm must carry out its own model validation tests in relation to the risks and structures of its portfolios, such as statistical validation techniques and other methods of measuring performance and validity;
(3) the use of hypothetical portfolios to ensure that the VaR model is able to account for particular structural features that may arise, for example material basis risks and concentration risk; and
(4) investigation of the limitations of the VaR model including testing of the accuracy of parts of the VaR model as well as of the whole.

01/01/2007

BIPRU 7.10.79

(1) In addition to regulatory backtesting programs, testing for model validation should be carried out using additional tests which may include for example:

(a) testing carried out using hypothetical changes in portfolio value that would occur were end of day positions to remain unchanged;
(b) testing carried out for longer periods than required for the regular backtesting programme (for example, 3 years);
(c) testing carried out using confidence intervals other than the 99 percent interval required under the quantitative requirements in BIPRU 7.10; and
(d) testing of parts of portfolios.

(2) A longer time period generally improves the power of backtesting. However a longer time period may not be desirable if the VaR model or market conditions have changed to the extent that historical data is no longer relevant.

01/01/2007

BIPRU 7.10.80

Further material on backtesting can be found in BIPRU 7.10.91G - BIPRU 7.10.112G.

01/01/2007

Risk management standards: Information technology

BIPRU 7.10.81

In assessing whether the VaR model is implemented with integrity as described in BIPRU 7.10.58R (Stress testing), the FSA will consider in particular the information technology systems used to run the model and associated calculations. The assessment may include:

(1) feeder systems; risk aggregation systems; time series databases; the VaR model system; stress testing system; the backtesting system including profit and loss cleaning systems where appropriate; data quality; reconciliations and checks on completeness of capture;
(2) system development, change control and documentation; security and audit trails; system availability and contingency procedures; network adequacy; and
(3) operational statistics relating to the VaR model production process, including, for example, statistics relating to timeliness, number of re-runs required and the reliability of data feeds.

01/01/2007

Risk management standards: Controls

BIPRU 7.10.82

A firm must ensure that it has adequate controls relating to:

(1) the derivation of the model PRR;
(2) the integrity of the backtesting programme, including the calculation of the profit and loss account;
(3) the integrity and appropriateness of the VaR model, including the VaR model's geographic coverage and the completeness of data sources;
(4) the VaR model's initial and ongoing development, including independent validation;
(5) the valuation models, including independent validation; and
(6) the adequacy, security and integrity of the information technology infrastructure.

01/01/2007

Stress testing

BIPRU 7.10.83

BIPRU 7.10.84G-BIPRU 7.10.90G relate to stress testing of a VaR model (see BIPRU 7.10.72R (Risk management standards: Stress testing)).

01/01/2007

BIPRU 7.10.84

Stress testing is a way of identifying the risk to a firm posed by a breakdown of model assumptions or by low-probability events. Where stress tests reveal unacceptable vulnerability to a given set of circumstances, a firm should take prompt steps to manage those risks appropriately, for example by hedging against the outcome or reducing the size of the firm's exposure.

01/01/2007

BIPRU 7.10.85

A firm must have the capacity to run daily stress tests.

01/01/2007

BIPRU 7.10.86

Stress testing must involve identifying market scenarios or other low probability events in all types of risks that generate the greatest losses on a firm's portfolio.

01/01/2007

BIPRU 7.10.87

A firm must periodically and actively identify all the worst case scenarios that are relevant to its portfolio. Scenarios used must be appropriate to test the effect of adverse movements in market volatilities and correlations and the effect of any change in the assumptions underlying the VaR model. Scenarios involving low probability market events must nevertheless be plausible.

01/01/2007

BIPRU 7.10.88

Stress testing must capture non-linear effects.

01/01/2007

BIPRU 7.10.89

A firm must have procedures to assess and respond to the results produced from stress testing. In particular, stress testing results must be:

(1) used to evaluate its capacity to absorb such losses or identify steps to be taken to reduce risk; and
(2) communicated routinely to senior management and periodically to the governing body.

01/01/2007

BIPRU 7.10.90

A firm may want to conduct the more complex stress tests at longer intervals or on an ad hoc basis.

01/01/2007

Backtesting: Introduction

BIPRU 7.10.91

Backtesting is the process of comparing value-at-risk risk measures to portfolio performance. It is intended to act as one of the mechanisms for the ongoing validation of a firm's VaR model and to provide incentives for firms to improve their VaR measures.

01/01/2007

BIPRU 7.10.92

It is a condition for granting a VaR model permission that a firm should have a backtesting programme in place and should provide three months of backtesting history.

01/01/2007

BIPRU 7.10.93

Backtesting conducted only at a whole portfolio level using a single measure of profit and loss has limited power to distinguish an accurate VaR model from an inaccurate one. Backtesting should therefore be regarded as an additional safeguard rather than a primary validation tool. Such testing does however form the basis of the FSA's plus factor system. The test has been chosen as the basis of the backtesting regime because of its simplicity. A firm will therefore be expected to complement this backtesting with more granular backtesting analysis and involving more than one measure of profit and loss (i.e. both a clean profit and loss figure and a clean hypothetical profit and loss figure).

01/01/2007

BIPRU 7.10.94

A firm must have the capacity to analyse and compare its clean profit and loss figures and clean hypothetical profit and loss figures to the VaR measure, both at the level of the whole portfolio covered by the VaR model permission and at the level of individual books that contain material amounts of risk.

01/01/2007

BIPRU 7.10.95

Clean profit and loss backtesting should be used for regulatory backtesting and used to calculate plus factors. Hypothetical profit and loss backtesting is used for model validation and for reporting to the FSA.

01/01/2007

Backtesting: Basic testing requirements

BIPRU 7.10.96

A firm must, on each business day, compare each of its 250 most recent business days' clean profit and loss figures (ending with the business day preceding the business day in question) with the corresponding one-day VaR measures.

01/01/2007

BIPRU 7.10.97

Generally the positions underlying the profit and loss account and VaR measures should not be materially different.

01/01/2007

Backtesting: One day VaR measure

BIPRU 7.10.98

The one-day VaR measure for a particular business day is the VaR number for that business day calibrated to a one business day holding period and a 99% one-tailed confidence level.

01/01/2007

Backtesting: Calculating the clean profit and loss

BIPRU 7.10.99

The ultimate purpose of backtesting is to assess whether capital is sufficient to absorb actual losses. Therefore backtesting should be performed using a measure of actual daily profit and loss. Actual daily profit and loss means the day's profit and loss arising from trading activities within the scope of the VaR model permission. This measure should, however, be 'cleaned' using BIPRU 7.10.100R inclusion in profit and loss of non-modelled factors.

01/01/2007

BIPRU 7.10.100

The clean profit and loss figure for a particular business day is the firm's actual profit or loss for that day in respect of the trading activities within the scope of the firm's VaR model permission, adjusted by stripping out:

(1) fees and commissions;
(2) brokerage;
(3) additions to and releases from reserves which are not directly related to market risk (e.g. administration reserves); and
(4) any inception profit exceeding an amount specified for this purpose in the firm's VaR model permission (where inception profit is defined as any profit arising immediately on entering into a new transaction).

01/01/2007

BIPRU 7.10.101

The definition of clean profit and loss figure may be amended or replaced in an individual VaR model permission if the firm can demonstrate to the FSA that the alternative method meets the spirit and purpose of the provisions in BIPRU 7.10 about the clean profit and loss figure.

01/01/2007

BIPRU 7.10.102

The FSA will review as part of a firm's VaR model permission application the processes and documentation relating to the derivation of profit and loss used for backtesting. A firm's documentation should clearly set out the basis for cleaning profit and loss. To the extent that certain profit and loss elements are not updated every day (for example certain reserve calculations) the documentation should clearly set out how such elements are included in the clean profit and loss series.

01/01/2007

Backtesting: Definition of backtesting exception

BIPRU 7.10.103

A backtesting exception is deemed to have occurred for any business day if the clean profit and loss figure for that business day shows a loss, which in absolute magnitude, exceeds the one-day VaR measure for that business day. The only exception is if that business day is identified in the firm's VaR model permission as giving rise to an excluded backtesting exception.

01/01/2007

Backtesting: Obligation to notify the FSA

BIPRU 7.10.104

If a backtesting exception occurs, the firm must notify its usual supervisory contact at the FSA orally by close of business two business days after the business day for which the backtesting exception occurred. Within five business days following the end of each Month, the firm must submit to the FSA a written account of the previous Month's backtesting exceptions (if any). This explanation must include the causes of the backtesting exceptions, an analysis of whether the backtesting exception indicate a deficiency in the firm's VaR model and the firm's planned response (if any).

01/01/2007

Backtesting: Summary of the backtesting cycle

BIPRU 7.10.105

(1) This paragraph gives guidance on the backtesting calculation and reporting process in BIPRU 7.10.96R - BIPRU 7.10.104R.
(2) Let the day on which the loss referred to in BIPRU 7.10.100R is made be day n. The value-at-risk measure for that day will be calculated on day n-1, or overnight between day n-1 and day n. Profit and loss figures are produced on day n+1, and backtesting also takes place on day n+1. The firm's supervisor should be notified of any backtesting exceptions by close of business on day n+2.
(3) Any backtesting exception initially counts for the purpose of the calculation of the plus factor even if subsequently the FSA agrees to exclude it under the process described in BIPRU 7.10.106G. Thus, where the firm experiences a backtesting exception and already has four or more backtesting exceptions for the previous 250 business days, changes to the multiplication factor arising from changes to the plus factor become effective at n+3 (using the time-line terminology in (2)).

01/01/2007

Backtesting: Process for disregarding backtesting exceptions

BIPRU 7.10.106

(1) This paragraph gives guidance on the process for excluding backtesting exceptions as referred to in BIPRU 7.10.103R.
(2) The FSA will respond flexibly to backtesting exceptions. However, the FSA's starting assumption will be that a backtesting exception should be taken into account for the purpose of the calculation of plus factors. If the firm believes that a backtesting exception should not count for that purpose, then it should seek a variation of its VaR model permission in order to exclude that particular backtesting exception. The FSA will then decide whether to agree to such a variation.
(3) One example of when a firm's backtesting exception might properly be disregarded is when it has arisen as a result of a risk that is not captured in its VaR model but against which capital resources are already held.

01/01/2007

Backtesting: Specific risk backtesting

BIPRU 7.10.107

If a firm's VaR model permission covers specific risk, the firm must validate its VaR model through backtesting aimed at assessing whether specific risk is being accurately captured. This backtesting must be carried out in accordance with the provisions of its VaR model permission. If the VaR model permission provides for this backtesting to be performed on the basis of relevant sub-portfolios, these must be chosen in a consistent manner.

01/01/2007

BIPRU 7.10.108

Specific risk backtesting involves the backtesting of a standalone specific risk VaR measure against a profit and loss series determined by reference to exposure risk factors categorised as specific risk. Alternatively specific risk backtesting may take the form of regular backtesting of trading books and portfolios that are predominantly exposed to risk factors categorised as specific risk. The precise requirements for specific risk backtesting will be specified in the firm's VaR model permission as will the definition of a specific risk backtesting exception.

01/01/2007

Backtesting: Multiple exceptions

BIPRU 7.10.109

If ten or more backtesting exceptions or ten or more specific risk backtesting exceptions are recorded in a 250 business day period, a firm must take immediate corrective action.

01/01/2007

BIPRU 7.10.110

Where backtesting reveals severe problems with the basic integrity of the VaR model, the FSA may withdraw model recognition. In particular, if ten or more backtesting exceptions are recorded in a 250 business day period, the FSA may apply a plus factor greater than one or the FSA may consider revoking a firm's VaR model permission. The FSA may also consider revoking a firm's VaR model permission if ten or more specific risk backtesting exceptions occur in such a period.

01/01/2007

Backtesting: Hypothetical profit and loss

BIPRU 7.10.111

A firm must also perform backtesting against a clean hypothetical profit and loss figure with respect to each business day. A clean hypothetical profit and loss figure for a business day means the clean profit and loss figure that would have occurred for that business day if the portfolio on which the VaR number for that business day is based remained unchanged.

01/01/2007

BIPRU 7.10.112

(1) A clean hypothetical profit and loss figure is based on the day's change in the value of the same portfolio that was used to generate the value-at-risk forecast.
(2) Backtesting under BIPRU 7.10.111R, although carried out with respect to each business day, need not be carried out each day. A firm need only carry it out sufficiently frequently to comply with its reporting requirements under BIPRU 7.10.129R. An exception arising out of such backtesting need not be reported to the FSA under BIPRU 7.10.104R
(3) The firm may also need to calculate a clean hypothetical profit and loss figure in order to produce profit attribution reports and to analyse the cause of backtesting exceptions.

01/01/2007

Capital calculations: General

BIPRU 7.10.113

The model PRR is, for any business day (the "relevant" business day), calculated in accordance with the following formula:

(1) the higher of:

(a) the VaR number for the relevant business day; and
(b) the average of its daily VaR numbers for each of the 60 business days ending with the relevant business day, multiplied by the multiplication factor for the relevant business day; and

(2) (in the case of a VaR model permission that covers specific risk) the incremental default risk charge for the relevant business day.

01/01/2007

BIPRU 7.10.114

For any day that is not a business day, the model PRR is the amount for the prior business day.

01/01/2007

BIPRU 7.10.115

The VaR number for any business day means the VaR measure, in respect of the previous business day's close-of-business positions in products coming within the scope of the VaR model permission, calculated by the VaR model and in accordance with BIPRU 7.10 and any methodology set out in the VaR model permission. The VaR number must not be calculated taking into account matters on the business day for which it is the VaR number.

01/01/2007

BIPRU 7.10.116

The incremental default risk charge for any business day means the incremental default risk charge required under the provisions in BIPRU 7.10 about specific risk, in respect of the previous business day's close-of-business positions with respect to which those provisions apply.

01/01/2007

BIPRU 7.10.117

The following equation expresses BIPRU 7.10.113R mathematically:

where:

(1) PRR _Varis a firm's model PRR;
(2) VaR _t represents the previous day's value-at-risk figure;
(3) VaR _t-i represents the value-at-risk calculated for i business days earlier;
(4) f is the multiplication factor; and
(5) IDRC is the incremental default risk charge (if applicable).

01/01/2007

Capital calculations: Multiplication factors

BIPRU 7.10.118

The multiplication factor for any business day is the sum of the minimum multiplication factor and the plus factor for that day.

01/01/2007

BIPRU 7.10.119

The minimum multiplication factor is three or any higher amount the VaR model permission defines it as.

01/01/2007

BIPRU 7.10.120

The minimum multiplication factor will never be less than three. If the FSA does set the minimum multiplication factor above three the VaR model permission will have a table that sets outs the reasons for that add on and specify how much of the add on is attributable to each reason (see BIPRU 7.10.121R). If there are weaknesses in the VaR model that may otherwise be considered a breach of the minimum standards referred to in BIPRU 7.10.24R the FSA may apply such an add on to act as a mitigant for those weaknesses.

01/01/2007

BIPRU 7.10.121

Something that would otherwise be a breach of the minimum standards to in BIPRU 7.10.26R - BIPRU 7.10.53R is not a breach to the extent that that thing is identified in the firm's VaR permission as a reason for an increase in the minimum multiplication factor above 3.

01/01/2007

BIPRU 7.10.122

Typically, any add on will be due to a specific weakness in systems and controls identified during the FSA's review that the FSA does not consider material enough to justify withholding overall model recognition. The firm will be expected to take action to address the reasons for any add on. The FSA will then review these periodically and, where satisfactory action has been taken, the add on will be removed through a variation of the VaR model permission.

01/01/2007

BIPRU 7.10.123

The plus factor system is designed so that the more often a VaR model has under-predicted losses in the past, the higher should be the capital requirement based on the VaR model. It is intended to provide a capital incentive for the firm to continue to improve the accuracy of its VaR model.

01/01/2007

BIPRU 7.10.124

The table in BIPRU 7.10.125R sets out the plus factors to be added to the minimum multiplication factor for any business day. It is based on the number of backtesting exceptions that occurred during the backtesting period as referred to in BIPRU 7.10.96R (Backtesting: Basic testing requirements) ending three business days preceding the business day for which the model PRR is being calculated.

01/01/2007

BIPRU 7.10.125

Table: Backtesting plus factors
This table belongs to BIPRU 7.10.124R

Zone

Number of recorded exceptions

Plus factor

Green

4 or less

0.00

Yellow

0.40

0.50

0.65

0.75

0.85

Red

10 or more

1.00

01/01/2007

BIPRU 7.10.126

A VaR model that correctly predicts a one-tailed 99% confidence level is expected to produce, on average, 2.5 backtesting exceptions every 250 days. Random events may cause the number of backtesting exceptions actually observed to vary. The plus factor system is designed to take this into account. Hence plus factors are only imposed on the firm if it has five or more recorded backtesting exceptions. Therefore, where a backtesting exception appears to be caused simply by chance, it will not be appropriate for a VaR model permission to be varied to exclude that backtesting exception as described in BIPRU 7.10.106G (Backtesting: Process for disregarding backtesting exceptions).

01/01/2007

Capital calculations: Specific risk surcharge: transitional requirements

BIPRU 7.10.127

Firms who gained model recognition before 1 January 2007 will be permitted to calculate PRR for specific risk in accordance with the methodology they were permitted to use immediately before that date instead of capturing event and default risk in their models (see BIPRU TP 14 (Market risk: VaR models)). This treatment will not be available to a firm that gains model recognition after that date.

01/01/2007

Reporting procedures and requirements

BIPRU 7.10.128

A VaR model permission will contain requirements for what the firm should report to the FSA and the procedures for reporting. The precise requirements will vary from VaR model permission to VaR model permission. BIPRU 7.10.129R-BIPRU 7.10.130R set out what the FSA regards as the standard requirements.

01/01/2007

BIPRU 7.10.129

A firm must, no later than the number of business days after the end of each quarter specified in the VaR model permission for this purpose, submit, in respect of that quarter, a report to the FSA about the operation of the VaR model, the systems and controls relating to it and any changes to the VaR model and those systems and controls. Each report must outline as a minimum the following information in respect of that quarter:

(1) methodological changes and developments to the VaR model;
(2) the introduction of all new pricing models used in connection with the VaR model and any changes to any pricing models used in connection with the VaR model, including details of any material associated valuation or risk management issues;
(3) a summary of backtesting performance against clean profit and loss figures and clean hypothetical profit and loss figures, which must be provided in electronic format as stipulated by the VaR model permission;
(4) (if the VaR model permission covers specific risk) the results of the specific risk backtesting including specific risk backtesting exceptions;
(5) any change to any feeder or pre-processing systems in connection with the VaR model, including changes to any of the systems set out in the list described in BIPRU 7.10.131G (1) (as it exists at the date of the VaR model permission), and any introduction of a new such system;
(6) any changes to the products coming within the scope of the VaR model;
(7) any material changes or additions to any of the matters referred to in the firm's internal documentation in relation to the VaR model (as it exists at the date of the VaR model permission) or to any matters subsequently notified under (7);
(8) any changes in senior management;
(9) an up-to-date list of products covered by the VaR model permission showing all changes made since the VaR model permission was granted; and
(10) where applicable (nil returns are not required), details of:

(a) any use of a changed historical observation period in accordance with BIPRU 7.10.30R or any change in the use of any weighting scheme as described in BIPRU 7.10.33R;
(b) any data series becoming unreliable as described in BIPRU 7.10.31R and any subsequent use of alternative value-at-risk measurement techniques;
(c) the frequency of updating data sets being increased in accordance with BIPRU 7.10.34R;
(d) any change in the method employed to derive 10-day VaR measure (see BIPRU 7.10.28R);
(e) to the extent that the use of correlations is permitted by a firm's VaR model permission, a summary of any notifications that are required under BIPRU 7.10.37R; and
(f) the VaR model not accurately capturing risks (as referred to in BIPRU 7.10.53R) and any steps taken under BIPRU 7.10.53R.

01/01/2007

BIPRU 7.10.130

A firm must provide to, and discuss with, the FSA details of any significant planned changes to the VaR model before those changes are implemented. These details must include information about the nature of the change and an estimate of the impact on VaR numbers and the incremental default risk charge.

01/01/2007

Updating the VaR model permission

BIPRU 7.10.131

The VaR model permission will generally contain a list of the following:

(1) feeder systems and pre-processing systems;
(2) products covered by the VaR model permission; and
(3) the firm's internal documentation in relation to the VaR model.

01/01/2007

BIPRU 7.10.132

The information in BIPRU 7.10.131G will vary over time. It is therefore not included in a VaR model permission as a rule but for information only. The FSA will update that information regularly in accordance with information supplied under BIPRU 7.10.129R. That updating will not amount to a variation of the VaR model permission.

01/01/2007

Link to standard PRR rules: Incorporation of the model output into the capital calculation

BIPRU 7.10.133

A VaR model permission will modify GENPRU 2.1.52 R (Calculation of the market risk capital requirement) to provide that a firm should calculate its market risk capital requirement in accordance with BIPRU 7.10 to the extent set out in the VaR model permission.

01/01/2007

BIPRU 7.10.134

By modifying GENPRU 2.1.52 R (Calculation of the market risk capital requirement) to allow the firm to use the VaR model to calculate all or part of its PRR for certain positions, the FSA is treating it like an application rule. The modification means that the PRR calculation set out in BIPRU 7.10 supersedes the standard market risk PRR rules for products and risks coming within the scope of the VaR model permission.

01/01/2007

BIPRU 7.10.135

To the extent that a position does not fall within the scope of a firm's VaR model permission the firm must calculate the PRR under the standard market risk PRR rules or, as applicable, those provisions as modified by the firm's CAD 1 waiver.

01/01/2007

BIPRU 7.10.136

(1) This rule applies to a position of a type that comes within the scope of a firm's VaR model permission.
(2) If, where the standard market risk PRR rules apply, a position is subject to a PRR charge and the firm's VaR model permission says that it covers the risks to which that PRR charge relates, the firm must, for those risks, calculate the PRR for that position under the VaR model approach rather than under the standard market risk PRR rules.
(3) If, where the standard market risk PRR rules apply, a position is subject to one or more PRR charges and the firm's VaR model permission does not cover all the risks to which those PRR charges relate, the firm must calculate the PRR for that position under the VaR model approach (for those risks that are covered) and under the standard market risk PRR rules (for those other risks).
(4) Where the standard market risk PRR rules distinguish between specific risk and general market risk a firm's VaR model permission covers specific risk to the extent that it says it does. If the firm's VaR model permission does not cover specific risk, BIPRU 7.10.143R and BIPRU 7.10.144R apply.
(5) If a firm's VaR model permission covers positions in CIUs it covers specific risk with respect to those positions.

01/01/2007

BIPRU 7.10.137

A firm may exclude from the VaR model approach immaterial risks within the scope of its VaR model approach. If a firm does so it must instead apply the standard market risk PRR rules to those risks.

01/01/2007

BIPRU 7.10.138

(1) If a firm calculates its market risk capital requirement using a combination of the standard market risk PRR rules and either the VaR model approach or the VaR model approach with the CAD 1 model approach the PRR from each method must be added together.
(2) A firm must take appropriate steps to ensure that all of the approaches are applied in a consistent manner.

01/01/2007

BIPRU 7.10.139

An example of the effect of BIPRU 7.10.138R is that where a firm normally calculates the PRR for a particular portfolio using a VaR model, a firm should not switch to the standard market risk PRR rules purely to achieve a more attractive PRR.

01/01/2007

BIPRU 7.10.140

If:

(1) the standard market risk PRR rules provide for a choice of which of the PRR charges to use or specify that one type must be used in some circumstances and that another type must be used in other circumstances;
(2) one of those types is disapplied under BIPRU 7.10.136R; and
(3) the other type is not disapplied;

the firm:

(4) must use the VaR model approach if under the standard market risk PRR rules the firm must use the standard market risk PRR rules in (2); and
(5) may use the VaR model approach if under the standard market risk PRR rules the firm may use the standard market risk PRR rules in (2).

01/01/2007

BIPRU 7.10.141

The treatment of a convertible is an example of a situation in which BIPRU 7.10.140R applies. The table in BIPRU 7.3.3R (Table: Instruments which result in notional positions) shows that there are circumstances in which under the standard market risk PRR rules a firm should calculate an equity PRR and that there are circumstances in which a firm may choose between calculating an equity PRR and an interest rate PRR. BIPRU 7.10.140R would be relevant if a firm's VaR model permission only covers one of equity risk and interest rate risk.

01/01/2007

BIPRU 7.10.142

The standard market risk PRR rules for the option PRR are only disapplied to the extent that the derived positions arising under BIPRU 7.6.13R (Table: Derived positions) come within the scope of the VaR model permission.

01/01/2007

Link to standard PRR rules: General market risk only

BIPRU 7.10.143

If a firm's VaR model permission covers interest rate general market risk but not interest rate specific risk, the firm must calculate the interest rate PRR so far as it relates to interest rate specific risk in accordance with the standard market risk PRR rules except that the firm must not use the basic interest rate PRR calculation in BIPRU 7.3.45R (Basic interest rate calculation for equity instruments).

01/01/2007

Link to standard PRR rules: General market risk only

BIPRU 7.10.144

If a firm's VaR model permission covers equity general market risk but not equity specific risk, the firm must calculate the equity PRR so far as it relates to equity specific risk in accordance with the standard market risk PRR rules except that the PRR for equity specific risk must be calculated under the standard equity method.

01/01/2007

Link to standard PRR rules: Miscellaneous

BIPRU 7.10.145

(1) To the extent that a firm's VaR model permission does not allow it to use an approach set out in BIPRU 7.10 the relevant provisions in BIPRU 7.10 do not apply to that firm.
(2) If a provision of the Handbook refers to BIPRU 7.10, that reference must, in the case of a particular firm with a VaR model permission, be treated as excluding provisions of BIPRU 7.10 that do not apply under the VaR model permission and as taking into account any modifications to BIPRU 7.10 made by the VaR model permission. Such references also include requirements and conditions contained in the VaR model permission but not BIPRU 7.10 and to the rules modified by the VaR model permission.

01/01/2007

Requirement to use value at risk methodology

BIPRU 7.10.146

A VaR model must be a value-at-risk model. It must provide an estimate of the worst expected loss on a portfolio resulting from market movements over a period of time with the specified confidence level.

01/01/2007

Ceasing to meet the requirements of BIPRU 7.10

BIPRU 7.10.147

If a firm ceases to meet any of the requirements set out in BIPRU 7.10, the FSA's policy is that the VaR model permission should cease to have effect. In part this will be achieved by making it a condition of a firm's VaR model permission that it complies at all times with the minimum standards referred to in BIPRU 7.10.26R - BIPRU 7.10.53R. Even if they are not formally included as conditions, the FSA is likely to consider revoking the VaR model permission if the requirements are not met.

01/01/2007

BIPRU 7.10.148

If a firm ceases to meet the conditions or requirements in its VaR model permission or BIPRU 7.10 it must notify the FSA at once.

01/01/2007

Changes to a VaR model

BIPRU 7.10.149

A firm may change its VaR model to such extent as it sees fit, except that it must not make a change that (either on its own or together with other changes since the date of VaR model permission) would:

(1) be inconsistent with VaR model permission or BIPRU 7.10; or
(2) mean that backtesting in accordance with BIPRU 7.10 and the VaR model permission would result in the use of data that is inappropriate for the purposes of measuring the performance of the VaR model.

01/01/2007

BIPRU 7.11

Credit derivatives in the trading book

01/01/2007

Scope

BIPRU 7.11.1

This section applies to the treatment of credit derivatives in the trading book.

01/01/2007

Establishment of positions created by credit derivatives: Treatment of the protection seller

BIPRU 7.11.2

BIPRU 7.11.3R - BIPRU 7.11.11R relate to the treatment of the protection seller for the purpose of calculating the securities PRR. Positions are determined in accordance with BIPRU 7.11.4R - BIPRU 7.11.11R.

01/01/2007

BIPRU 7.11.3

When calculating the PRR of the protection seller, unless specified differently by other rules, the notional amount of the credit derivative contract must be used. For the purpose of calculating the specific risk PRR charge, other than for total return swaps, the maturity of the credit derivative contract is applicable instead of the maturity of the obligation.

01/01/2007

BIPRU 7.11.4

A total return swap creates a long position in the general market risk of the reference obligation and a short position in the general market risk of a zero-specific-risk security with a maturity equivalent to the period until the next interest fixing and which is assigned a 0% risk weight under the standardised approach to credit risk. It also creates a long position in the specific risk of the reference obligation.

01/01/2007

BIPRU 7.11.5

A credit default swap does not create a position for general market risk. For the purposes of specific risk, a firm must record a synthetic long position in an obligation of the reference entity, unless the derivative is rated externally and meets the conditions for a qualifying debt security, in which case a long position in the derivative is recorded. If premium or interest payments are due under the product, these cash flows must be represented as notional positions in zero-specific-risk securities.

01/01/2007

BIPRU 7.11.6

A single name credit linked note creates a long position in the general market risk of the note itself, as an interest rate product. For the purpose of specific risk, a synthetic long position is created in an obligation of the reference entity. An additional long position is created in the issuer of the note. Where the credit linked note has an external rating and meets the conditions for a qualifying debt security, a single long position with the specific risk of the note need only be recorded.

01/01/2007

BIPRU 7.11.7

In addition to a long position in the specific risk of the issuer of the note, a multiple name credit linked note providing proportional protection creates a position in each reference entity, with the total notional amount of the contract assigned across the positions according to the proportion of the total notional amount that each exposure to a reference entity represents. Where more than one obligation of a reference entity can be selected, the obligation with the highest risk weighting determines the specific risk.

01/01/2007

BIPRU 7.11.8

Where a multiple name credit linked note has an external rating and meets the conditions for a qualifying debt security, a single long position with the specific risk of the note need only be recorded.

01/01/2007

BIPRU 7.11.9

A first-asset-to-default credit derivative creates a position for the notional amount in an obligation of each reference entity. If the size of the maximum credit event payment is lower than the PRR requirement under the method in the first sentence of this rule, the maximum payment amount may be taken as the PRR requirement for specific risk.

01/01/2007

BIPRU 7.11.10

A second-asset-to-default credit derivative creates a position for the notional amount in an obligation of each reference entity less one (that with the lowest specific risk PRR requirement). If the size of the maximum credit event payment is lower than the PRR requirement under the method in the first sentence of this rule, this amount may be taken as the PRR requirement for specific risk.

01/01/2007

BIPRU 7.11.11

If a first or second-asset to default derivative is externally rated and meets the conditions for a qualifying debt security, then the protection seller need only calculate one specific risk charge reflecting the rating of the derivative.

01/01/2007

Establishment of positions created by credit derivatives: Treatment of the protection buyer

BIPRU 7.11.12

For the protection buyer, the positions are determined as the mirror image of the protection seller, with the exception of a credit linked note (which entails no short position in the issuer). If at a given moment there is a call option in combination with a step-up, such moment is treated as the maturity of the protection. In the case of n^th to default credit derivatives, a firm that is a protection buyer may off-set specific risk for n-1 of the underlyings (i.e., the n-1 assets with the lowest specific risk PRR).

01/01/2007

Recognition of hedging provided by credit derivatives against cash positions

BIPRU 7.11.13

(1) BIPRU 7.11.14R - BIPRU 7.11.17R relate to specific risk PRR for trading book positions hedged by credit derivatives for the purposes of the calculation of the securities PRR.
(2) A firm may take an allowance for protection provided by credit derivatives for the purposes in (1) in accordance with the principles set out in the rules referred to in (1).
(3) BIPRU 7.11.13 R - BIPRU 7.11.17 R are subject to the requirements of the credit default swap PRR methods.

01/01/2007

BIPRU 7.11.14

(1) A firm may take full allowance when the value of two legs always move in the opposite direction and broadly to the same extent.
(2) This will be the case in the following situations:

(a) the two legs consist of completely identical instruments; or
(b) a long cash position is hedged by a total rate of return swap (or vice versa) and there is an exact match between the reference obligation and the underlying exposure (i.e., the cash position).

(3) The maturity of the swap itself may be different from that of the underlying exposure for the purposes of (2)(b).
(4) In these situations, a firm must not apply a specific risk PRR to either side of the position.

01/01/2007

BIPRU 7.11.15

An 80% offset may be applied when the value of two legs always move in the opposite direction and where 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 must not cause the price movement of the credit derivative materially to deviate from the price movements of the cash position. To the extent that the transaction transfers risk, an 80% specific risk offset may be applied to the side of the transaction with the higher PRR, while the specific risk requirements on the other side are zero.

01/01/2007

BIPRU 7.11.16

(1) A firm may take partial allowance when the value of two legs usually move in the opposite direction. This would be the case in the situations set out in (2) - (4).
(2) The first situation referred to in (1) is that the position falls under BIPRU 7.11.16 R (2)(b) but there is an asset mismatch between the reference obligation and the underlying exposure. However, the positions meet the following requirements:

(a) the reference obligation ranks pari passu with or is junior to the underlying obligation; and
(b) the underlying obligation and reference obligation share the same obligor and have legally enforceable cross-default or cross-acceleration clauses.

(3) The second situation referred to in (1) is that the position falls under BIPRU 7.11.14 R (2)(a) or BIPRU 7.11.15 R but there is a currency or maturity mismatch between the credit protection and the underlying asset (currency mismatches must be included in the normal reporting with respect to the foreign currency PRR).
(4) The third situation referred to in (1) is that the position falls under BIPRU 7.11.15 R 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.
(5) In each of those situations, rather than adding the specific risk PRR requirements for each side of the transaction, only the higher of the two PRR requirements applies.

01/01/2007

BIPRU 7.11.17

In all situations not falling under BIPRU 7.11.14 R - BIPRU 7.11.16 R, a firm must assess a specific risk PRR charge against both sides of the positions.

01/01/2007

Special treatment of credit default swaps: Provisions applicable to all methods

BIPRU 7.11.18

BIPRU 7.11.18 R - BIPRU 7.11.58 R set out the calculation of the specific risk portion of the interest rate PRR for credit default swaps.

01/01/2007

BIPRU 7.11.19

The specific risk portion of the interest rate PRR is calculated separately for:

(1) credit default swaps (other than those in (2));
(2) credit default swaps that are also securitisation positions; and
(3) other positions;

that are subject to the interest rate PRR.

01/01/2007

BIPRU 7.11.20

The specific risk portion of the interest rate PRR for positions falling into BIPRU 7.11.19 R (1) and BIPRU 7.11.19 R (2) must be calculated in accordance with the credit default swap PRR methods rather than in accordance with BIPRU 7.2 (Interest rate PRR) and the other provisions of BIPRU 7.11. However a firm may apply BIPRU 7.11.13 R- BIPRU 7.11.17 R before applying the credit default swap PRR methods. If it does so the firm must apply the credit default swap PRR methods to the remaining position in credit default swaps.

01/01/2007

BIPRU 7.11.21

In accordance with the principle in BIPRU 7.11.19 R, there is no netting for the purpose of calculating specific risk PRR charges (BIPRU 7.2.37 R - BIPRU 7.2.40 R (Deriving the net position in each debt security: Netting positions in the same debt security) or otherwise) between:

(1) a position falling into BIPRU 7.11.19 R (1) or BIPRU 7.11.19 R (2) and one falling into BIPRU 7.11.19 R (3); or
(2) a position falling into BIPRU 7.11.19 R (1) and one falling into BIPRU 7.11.19 R (2).

01/01/2007

BIPRU 7.11.22

(1) A firm must calculate the interest rate PRR for specific risk for credit default swaps falling into BIPRU 7.11.19 R (1) under the ordinary credit default swap PRR method.
(2) A firm must calculate the interest rate PRR for specific risk for credit default swaps falling into BIPRU 7.11.19 R (2) under the securitisation credit default swap PRR method.

01/01/2007

Ordinary credit default swap PRR method: Introduction

BIPRU 7.11.23

BIPRU 7.11.24 R - BIPRU 7.11.37 R set out the ordinary credit default swap PRR method.

01/01/2007

Ordinary credit default swap PRR method: Grouping of credit derivatives

BIPRU 7.11.24

A firm must group together all credit default swaps being treated under the ordinary credit default swap PRR method that give rise to notional positions in the same security for specific risk purposes under the procedure in BIPRU 7.11.2 R - BIPRU 7.11.12 R and that may be netted under BIPRU 7.11.56 R.

01/01/2007

BIPRU 7.11.25

The provisions in BIPRU 7.11.2 R - BIPRU 7.11.12 R about the creation of a specific risk charge for credit default swaps reflecting the rating of the derivative (see BIPRU 7.11.11 R and part of BIPRU 7.11.5 R) do not apply for the purposes of calculating the ordinary credit default swap PRR method.

01/01/2007

Ordinary credit default swap PRR method: Main rule for calculating the specific risk PRR

BIPRU 7.11.26

The specific risk portion of the interest rate PRR or credit default swaps treated under the ordinary credit default swap PRR method is the higher of:

(1) an amount equal to what would have been the specific risk portion of the interest rate PRR for such credit default swaps if it had been calculated under of BIPRU 7.2.43 R to BIPRU 7.2.50 R (Specific risk calculation for interest rate risk), taking into account BIPRU 7.11.19 R and BIPRU 7.11.21 R; and
(2) the sum of the valuation change capital charge (see BIPRU 7.11.28 R) and the default capital charge (see BIPRU 7.11.36 R) for all such credit derivatives.

01/01/2007

Ordinary credit default swap PRR method: The valuation change capital charge

BIPRU 7.11.27

A firm must allocate each credit default swap grouped together under BIPRU 7.11.24 R to the time bands set out in BIPRU 7.11.33 R for the purposes of calculating the valuation change capital charge.

01/01/2007

BIPRU 7.11.28

The valuation change capital charge for a group of credit default swaps created under BIPRU 7.11.24 R is equal to three multiplied by the larger of the potential loss produced under BIPRU 7.11.29 R and the potential loss produced under BIPRU 7.11.30 R. The total valuation change capital charge for credit default swaps treated under the ordinary credit default swap PRR method is equal to the sum of such amounts for all such groups.

01/01/2009

BIPRU 7.11.29

(1) The amount of the potential loss calculated under this rule is calculated as follows.
(2) Within each time band the firm must calculate the net valuation change in the credit default swaps that would occur if spreads (as defined in BIPRU 7.11.55 R) were to increase by the amount shown in BIPRU 7.11.34 R. The amount of the change in spread is the same for each time band.
(3) The potential loss calculated under this rule is the sum of all bands that create a net loss. Bands which produce a profit must be ignored.
(4) The time bands referred to in this rule are those established under BIPRU 7.11.27 R.

01/01/2007

BIPRU 7.11.30

The amount of the potential loss calculated under this rule is calculated in the same way as it is under BIPRU 7.11.29 R except that the net valuation change is the one that would occur if spreads were to decrease by the amount shown in BIPRU 7.11.34 R.

01/01/2007

BIPRU 7.11.31

The valuation change in BIPRU 7.11.29 R - BIPRU 7.11.30 R is applied to the current value of the credit default swap.

01/01/2007

BIPRU 7.11.32

The credit quality step applicable under the table in BIPRU 7.11.34 R is that which would be attributable to the security in question under the standardised approach to credit risk. If a rating from an eligible ECAI is not available to the firm it must treat that position as having credit quality step 6. The security in question is the one by reference to which the grouping under BIPRU 7.11.24 R is carried out (the reference entity).

01/01/2007

BIPRU 7.11.33

Time bands
This table belongs to BIPRU 7.11.27 R

Time band

Residual contract maturity

Less than three months

Three months to one year

Over one year to two and half years

Over two and a half years to five years

Greater than five years

01/01/2007

BIPRU 7.11.34

Stress factors based on rating of reference entity
This table belongs to BIPRU 7.11.29 R and BIPRU 7.11.30 R

Credit quality step 1

Credit quality step 2

Credit quality step 3

Credit quality step 4

Credit quality step 5

Credit quality step 6

0.4 x spread

0.35 x spread

0.3 x spread

0.4 x spread

0.45 x spread

Spread is defined in BIPRU 7.11.55 R.

01/01/2007

Valuation changes for credit default swaps resulting in positions in multiple securities

BIPRU 7.11.35

(1) This rule applies if BIPRU 7.11.24 R results in a credit default swap being split into positions in more than one security.
(2) The firm must, for each notional security produced as described in (1), apply to the whole of the credit default swap in question the stresses in the table in BIPRU 7.11.34 R using the credit quality step in the table in BIPRU 7.11.34 R for that security.
(3) The firm must then allocate the different changes in the value of the credit default swap under (2) between the calculations for each security produced as described in (1) on a proportional basis in accordance with the principles in BIPRU 7.11.2 R - BIPRU 7.11.12 R. The firm must do this by multiplying the amount of the change in (2) calculated with respect to the security in question by a fraction based on the proportion of the credit default swap attributable to the security under those principles.

01/01/2007

Ordinary credit default swap PRR method: The default capital charge

BIPRU 7.11.36

The default capital charge for each group of credit default swaps created under BIPRU 7.11.24 R is equal to two multiplied by the amount in BIPRU 7.11.37 R. The total default capital charge for credit default swaps treated under the ordinary credit default swap PRR method is equal to the sum of such amounts for each such group.

01/01/2009

BIPRU 7.11.37

(1) The amount calculated under this rule is the amount resulting from the calculation in (5).
(2) A firm must fully net all notional positions along a timeline by calculating, for all credit default swaps in the group in question created under BIPRU 7.11.24 R, the net positions in the security in question for all times in the future until those positions expire or otherwise cease to exist.
(3) The firm must calculate the net positions under (2) in accordance with BIPRU 7.2.37 R - BIPRU 7.2.40 R (Deriving the net position in each debt security: Netting positions in the same debt security).
(4) The firm must identify the largest long position to which it is exposed over the next year.
(5) The firm must then multiply the amount established under (4) by the appropriate PRA that would have applied for the purpose of calculating the specific risk portion of the interest rate PRR under BIPRU 7.2 (Interest rate PRR).
(6) The security in question is the one by reference to which the grouping under BIPRU 7.11.24 R is carried out (the reference entity).

01/01/2007

Securitisation credit default swap PRR method: Introduction

BIPRU 7.11.38

BIPRU 7.11.39 R - BIPRU 7.11.53 R set out the securitisation credit default swap PRR method.

01/01/2007

Securitisation credit default swap PRR method: Main rule for calculating the specific risk PRR

BIPRU 7.11.39

The specific risk portion of the interest rate PRR for credit default swaps treated under the securitisation credit default swap PRR method is the higher of:

(1) an amount equal to what would have been the specific risk portion of the interest rate PRR for such credit default swaps if it had been calculated under of BIPRU 7.2.43 R to BIPRU 7.2.50 R (Specific risk calculation for interest rate risk), taking into account BIPRU 7.11.19 R and BIPRU 7.11.21 R; and
(2) the sum of the valuation change capital charge (see BIPRU 7.11.40 R) and the default capital charge (see BIPRU 7.11.48 R) for all such credit derivatives.

01/01/2007

Securitisation credit default swap PRR method: Valuation change capital charge: General

BIPRU 7.11.40

In order to calculate the valuation change capital charge a firm must group together each credit default swap that relates to the same securitisation. The valuation change capital charge for each such group is equal to three multiplied by the potential loss amount in BIPRU 7.11.41 R. The total valuation change capital charge for credit default swaps treated under the securitisation credit default swap PRR method is equal to the sum of such amounts for each such group.

01/01/2009

BIPRU 7.11.41

(1) The potential loss amount as referred to in BIPRU 7.11.40 R for a group of credit default swaps relating to the same securitisation is equal to the greatest loss the firm would suffer in the scenarios set out in the matrix in BIPRU 7.11.43 R. Each scenario consists of the combination of one of the nine scenarios on the vertical axis with one of the three scenarios on the horizontal axis.
(2) T as referred to in that matrix is the amount set out in the table in BIPRU 7.11.44 R.
(3) Stresses (1) - (4) as referred to in that matrix are further defined in BIPRU 7.11.45 R - BIPRU 7.11.46 R.
(4) The underlying reference entities referred to in that matrix refer to the obligor under the securities that are the subject of the securitisation in question. In the case of a resecuritisation the reference entities are the ultimate underling obligors (the obligors under the securitised securitisation).
(5) The valuation change under this rule is applied to the current value of the credit default swap.

01/01/2007

BIPRU 7.11.42

References in the table in BIPRU 7.11.43 R to credit quality steps are to the credit quality steps that would apply under the standardised approach to credit risk to the securities referred to in BIPRU 7.11.41 R (4). If a rating from an eligible ECAI is not available to the firm it must treat that security as having the lowest credit quality step.

01/01/2007

BIPRU 7.11.43

Calculation of the valuation change capital charge: Scenarios
This table belongs to BIPRU 7.11.41 R

Change in credit spread of the underlying reference entities

-T √spread

No change

+T √spread

(1)

Base correlation steepening (see row (1) of the table in BIPRU 7.11.46 R)

(2)

Base correlation flattening (see row (2) of the table in BIPRU 7.11.46 R)

(3)

Base correlation parallel up (see row (3) of the table in BIPRU 7.11.46 R)

(4)

Base correlation down (see row (4) of the table in BIPRU 7.11.46 R)

(5)

No correlation change

(6)

Combination of (1) and (3)

(7)

Combination of (1) and (4)

(8)

Combination of (2) and (3)

(9)

Combination of (2) and (4)

Spread is defined in BIPRU 7.11.55 R.

01/01/2007

BIPRU 7.11.44

Calculation of the valuation change capital charge: Definition of T
This table belongs to BIPRU 7.11.41 R

Credit quality step under the standardised approach to credit risk

0.4

0.35

0.3

0.4

0.45

01/01/2007

Securitisation credit default swap PRR method: Valuation change capital charge: Base correlation

BIPRU 7.11.45

(1) This rule explains how the correlation calculations in the vertical axis of the matrix in BIPRU 7.11.43 R are to be carried out.
(2) The firm must calculate the base correlation relating to each of the deemed tranches set out in the table in BIPRU 7.11.46 R. Base correlation refers, in relation to a securitisation position, to the correlation in credit risk between the securities that are the subject of that securitisation.
(3) The firm must then multiply the base correlation for each deemed tranche under (2) by the relevant figure in the table in BIPRU 7.11.46 R. It must calculate each such base correlation in the way that a person would use to calculate the fair market value of a credit default swap on the following basis:

(a) the tranche is the most junior tranche; and
(b) the thickness of the tranche (as referred to in BIPRU 9 (Securitisation)) is equal to the percentage figure at the head of the relevant column in the table in BIPRU 7.11.46 R.

(4) The firm must then produce a stressed base correlation curve through the use of interpolation based on the calculations under this rule.
(5) Notwithstanding (3), the curve in (4) must not show a correlation above 100%.
(6) The firm must then use the curve for the purpose of the revaluation of the credit default swap under BIPRU 7.11.41 R using an appropriate and prudent technique.

01/01/2007

BIPRU 7.11.46

Correlation moves
This table belongs to BIPRU 7.11.45 R

Thickness of tranche

10%

15%

30%

Scenario from BIPRU 7.11.43 R

(1) Base correlation steepening

0.7

0.9

1.1

1.3

(2) Base correlation flattening

1.3

1.1

0.9

0.7

(3) Base correlation parallel up

1.2

(4) Base correlation parallel down

0.8

01/01/2007

BIPRU 7.11.47

The fact that the FSA has used the base correlation methodology in this section does not mean that it endorses the use of that technique to value credit default swaps for other purposes. The FSA has used it in this section as it is well-known and publicly available. If a firm uses another technique to value its credit default swaps it should discuss this with the FSA.

01/01/2007

Securitisation credit default swap PRR method: Default charge

BIPRU 7.11.48

The default charge for a firm's position in a securitisation treated under the securitisation credit default swap PRR method is equal to the default charge for that position calculated under BIPRU 7.11.50 R and BIPRU 7.11.51 R. The total default charge for positions treated under the securitisation credit default swap PRR method is equal to the sum of those figures.

01/01/2007

BIPRU 7.11.49

To the extent that a firm has a matching long and short position in the same tranche of the same securitisation with the same maturity it may net the short and long positions.

01/01/2007

BIPRU 7.11.50

If a position is short, the default charge for that position is zero.

01/01/2007

BIPRU 7.11.51

If a position is long, the default charge for that position must be calculated in accordance with the following formula:
V x RW x AP
where:

(1) V means the notional amount of the position;
(2) RW means the risk weight that the position would attract under BIPRU 9 (Securitisation); and
(3) AP means the appropriate percentage from the table BIPRU 7.11.52 R.

01/01/2009

BIPRU 7.11.52

Calculation of the default requirement
This table belongs to BIPRU 7.11.51 R

Type of position

Resecuritisation position

Trades based on an index

Other

Risk weight

Less than 400%

4.8%

1.6%

3.2%

400% to less than 800%

6.4%

3.2%

4.8%

800% to less 1250%

4.8%

6.4%

1250% and
over

01/01/2007

BIPRU 7.11.53

(1) The column of the table in BIPRU 7.11.52 R headed "Trades based on an index" applies if:

(a) the position is not a resecuritisation position;
(b) the underlying reference entities (as defined in BIPRU 7.11.41 R (4)) are identical to those that make up an index of entities widely used by those who deal in credit default swaps;
(c) that index contains the price for entering into a credit default swap whose reference entities constitute all the entities in the index; and
(d) the credit default swap is constructed in such a way that the firm is able to price the credit derivative using the index.

(2) The column of the table in BIPRU 7.11.52 R headed "Other" applies to any case not covered by the other two categories in the table.

01/01/2007

Special treatment of credit default swaps: Supplementary material

BIPRU 7.11.54

BIPRU 7.11.55 R - BIPRU 7.11.58 R apply to each of the credit default swap PRR methods.

01/01/2007

BIPRU 7.11.55

The spread referred to in the tables in BIPRU 7.11.34 R and BIPRU 7.11.43 R refers to the premia and other cash flows referred to in BIPRU 7.11.5 R (expressed as a percentage). The spread must be calculated every business day. It is the spread that would apply if the credit default swap in question were entered into on that day on arm's length commercial terms.

01/01/2007

BIPRU 7.11.56

Where a credit default swap PRR method requires netting between positions, a firm may only net positions arising out of credit default swaps that have comparable deliverable obligations, identical credit events and documentation that will act identically on the occurrence of a credit event.

01/01/2007

BIPRU 7.11.57

A notional position in a zero-specific-risk security created under BIPRU 7.11.5 R must not be treated under either credit default swap PRR method. The firm must instead treat it in accordance with the other rules for the calculation of the interest rate PRR.

01/01/2007

BIPRU 7.11.58

(1) If the size of the maximum credit event payment under a credit default swap is lower than the PRR requirement that would otherwise apply, that credit default swap must be excluded from the credit default swap PRR methods. However BIPRU 7.11.19 R and BIPRU 7.11.21 R still apply.
(2) A firm must work out whether (1) applies to a credit default swap by calculating the PRR for that credit default swap in accordance with this section (including the applicable credit default swap PRR method) on the assumption that it is the only item for which an interest rate PRR is being calculated.

01/01/2007

Valuation

BIPRU 7.11.59

GENPRU 1.3.29 R - GENPRU 1.3.35 G (General requirements: Valuation adjustments or reserves) are particularly relevant for a firm trading credit derivatives, especially for credit default swaps that are also securitisation positions.

01/01/2007

Other risks relating to credit derivatives

BIPRU 7.11.60

A firm must be able to describe, demonstrate and explain to the FSA its trading strategies in relation to credit derivatives both in theory and in practice.

01/01/2007

BIPRU 7.11.61

BIPRU 7.11.62 G - BIPRU 7.11.64 G G cover risks relating to credit derivatives that may not be captured in this section. This guidance is of particular relevance to the overall financial adequacy rule, the overall Pillar 2 rule and the general stress and scenario testing rule.

01/01/2007

BIPRU 7.11.62

BIPRU 7.11.5 R requires a firm to recognise any premiums payable or receivable under the contract as notional zero-specific-risk securities. These positions are then entered into the general market risk framework. As premium payments paid under such contracts are contingent on no credit event occurring, a credit event could significantly change the general market risk capital requirement. A firm should consider, under the overall Pillar 2 rule, whether this risk means that the capital requirements under this section materially understate the firm's general market risk position.

01/01/2007

BIPRU 7.11.63

If a firm recognises profits on a non-accrual basis it should consider whether the capital requirements for its credit derivatives business adequately cover the risk that any recognised profit may not be achieved due to a credit event occurring. This includes positions for which the firm may have a perfect hedge in place.

01/01/2007

BIPRU 7.11.64

If a firm uses models in its valuation process, it should consider whether the default capital requirements under the credit default swap PRR methods adequately cover the default losses that the firm's model estimates it will be exposed to.

01/01/2007