| (d) | Matters relating to the specification of relevant market risk factors |
In order to sufficiently capture the risks inherent in a bank's portfolio of on-balance- sheet and off-balance-sheet trading positions, as part of the bank's internal market risk measurement system, the bank shall specify an appropriate set of market risk factors, that is, market rates and prices that affect the value of the bank's trading positions, provided that—
| (i) | any factor deemed relevant by the bank for pricing purposes shall be included as a risk factor in the bank's value-at-risk model. |
When a risk factor is incorporated in the bank's pricing model but not in its value-at-risk model, the bank shall duly motivate, to the satisfaction of the Registrar, the omission of the said risk factor from the bank's value-at-risk model;
| (ii) | the bank's value-at-risk model shall duly capture— |
| (A) | nonlinearities associated with options and other relevant products, such as mortgage-backed securities, tranched exposures or n-th-todefault credit derivative instruments; |
| (B) | correlation risk and basis risk, for example, between credit default swaps and bonds; |
| (iii) | the bank shall demonstrate to the satisfaction of the Registrar that any proxy used by the bank in its value-at-risk model has a good track record in respect of the actual position held by the bank, such as an equity index used for a position in an individual instrument; |
| (iv) | in the case of interest rates— |
| (A) | based on the nature of the bank's trading strategies, the bank shall specify an appropriate set of risk factors that correspond to the relevant interest rates in each relevant currency in which the bank holds interest-rate-sensitive on-balance-sheet or off-balance-sheet positions, that is, a bank with a portfolio of various types of security across many points of the yield curve and that engages in complex arbitrage strategies, for example, requires a greater number of risk factors to accurately capture the bank's exposure to interest rate risk; |
| (B) | the bank's risk measurement system, amongst other things— |
| (i) | shall model the yield curve, for example, by estimating forward rates of zero coupon yields; |
| (ii) | shall incorporate separate risk factors to capture spread risk, for example, between bonds and swaps. |
A bank may use a variety of approaches to capture the spread risk arising from less than perfectly correlated movements between government and other fixed-income interest rates.
For example, the bank may model a completely separate yield curve for non-government fixed-income instruments, such as swaps or municipal securities, or estimate the spread over government rates at various points along the yield curve.
| (C) | in order to capture variation in the volatility of rates along a yield curve, the bank shall divide the yield curve into appropriate maturity segments and specify no less than one risk factor corresponding to each relevant maturity segment; |
| (D) | in respect of material exposure to interest rate movements in major currencies and markets, the bank shall model a yield curve using no less than six risk factors; |
| (v) | in the case of exchange rates, which include gold— |
| (A) | the bank shall, as a minimum, specify relevant risk factors in respect of the exchange rate between the domestic currency and each foreign currency in which the bank has a significant exposure; |
| (B) | the bank's risk measurement system shall incorporate the said risk factors relating to the individual foreign currencies in which the bank's positions are denominated. |
| (vi) | in the case of equities— |
| (A) | the sophistication and nature of the bank's modelling technique for a particular market shall correspond— |
| (i) | to the bank's exposure to the overall market; and |
| (ii) | to the bank's concentration in individual equity issues in the said market; |
| (B) | the bank shall, as a minimum, specify relevant risk factors in respect of each of the equity markets in which the bank holds significant positions, that is, based on the bank's exposure to the overall market and the bank's concentration in individual equity issues in the said market— |
| (i) | the bank shall, as a minimum, specify a risk factor designed to capture market-wide movements in equity prices, such as a market index, and, for example, express positions in individual securities or in sector indices as "beta-equivalents" relative to the said market-wide index; |
| (ii) | the bank shall specify risk factors in respect of the various sectors of the overall equity market, such as industry sectors or cyclical and non-cyclical sectors, and, for example, express positions in individual instruments within each sector as betaequivalents relative to the sector index; |
| (iii) | the bank shall specify risk factors relating to the volatility of individual equity issues. |
| (vii) | in the case of commodities the bank shall specify relevant risk factors in respect of each relevant commodity market in which the bank holds significant positions, provided that— |
| (A) | a bank with limited positions in commodity-based instruments may specify only one risk factor in respect of each commodity price to which the bank is exposed; |
| (B) | a bank that actively trades in commodities shall duly take account of any variation in the convenience yield between derivatives positions, such as forwards and swaps, and cash positions in the commodity, which yield— |
| (i) | reflects the benefits from direct ownership of a physical commodity, such as the ability to profit from temporary market shortages; |
| (ii) | is affected by market conditions and factors such as physical storage cost; |
| (C) | the bank shall duly manage its exposure to directional risk, forward gap and interest rate risk, and any relevant basis risk. |
