Banks Act, 1990 (Act No. 94 of 1990)RegulationsRegulations relating to Banks' Financial Instrument TradingChapter 7 : Use of Internal Models26. Specification of market-risk factors |
| (1) | An important part of a bank's internal market-risk measurement system is the specification of an appropriate set of market-risk factors, that is, the market rates and prices that affect the value of the bank's trading positions. The risk factors contained in a market-risk measurement system shall be sufficient to capture the risk inherent in the bank's portfolio of on- and off-balance-sheet trading positions. Although banks will have some discretion in specifying the risk factors for their internal models, there shall be compliance with the following guidelines: |
| (a) | For interest rates, there shall be a set of risk factors corresponding to interest rates in each currency in which the bank has interest-rate-sensitive on- or off-balance-sheet positions; |
| (b) | the risk-measurement system shall model the yield curve using one of a number of generally accepted approaches, for example, by estimating forward rates of zero coupon yields. The yield curve shall be divided into various maturity segments in order to capture variation in the volatility of rates along the yield curve; there shall typically be one risk factor corresponding to each maturity segment. For material exposures to interest-rate movements in the major currencies and markets, banks shall model the yield curve using a minimum of six risk factors. The number of risk factors used should, however, ultimately be determined by the nature of the bank's trading strategies. For instance, a bank with a portfolio of various types of securities across many points of the yield curve and that engages in complex arbitrage strategies would require a greater number of risk factors in order to capture interest-rate risk accurately; and |
| (c) | the risk-measurement system shall incorporate separate risk factors in order to capture spread risk (for example, between bonds and swaps). A variety of approaches may be used in order to capture the spread risk arising from less than perfectly correlated movements between Government and other fixed-income interest ,rates, such as specification of a completely separate yield curve for non-Government fixed-income instruments (for instance, swaps or municipal securities) or estimation of the spread over Government rates at various points along the yield curve. |
| (2) | For exchange rates (which may include gold), the risk-measurement system shall incorporate factors to the individual foreign currencies in which a bank's position is denominated. Since the value-at-risk figure calculated by the risk-measurement system will be expressed in the bank's domestic currency, any net position denominated in a foreign currency will introduce a foreign-exchange risk. Thus, there shall be risk factors corresponding to the exchange rate between the domestic currency and each foreign currency to which a bank has a significant exposure. |
| (3) | For equity prices, there shall be risk factors corresponding to each of the equity markets in which a bank holds significant positions: |
| (a) | As a minimum, there shall be a risk factor that is designed to capture marketwide movements in equity prices (for example, a market index). Positions in individual securities or in sector indices could be expressed in "beta-equivalents" relative to this market-wide index. |
| (b) | A more detailed approach would be to have risk factors corresponding to various sectors of the overall equity market (for instance, industry sectors or cyclical and non-cyclical sectors). As above, positions in individual stocks within each sector shall be expressed in beta-equivalents relative to the sector index. |
| (c) | The most extensive approach is that risk factors shall correspond to the volatility of individual equity issues. |
| (d) | The sophistication and nature of the modelling technique for a given market shall correspond to the bank's exposure to the overall market, as well as its concentration in individual equity issues in the market. |
| (4) | For commodity prices, there shall be risk factors corresponding to each of the commodity markets in which the bank holds significant positions: |
| (a) | For a bank with relatively limited positions in commodity-based instruments, a straightforward specification of risk factors shall apply. Such a specification would likely entail one risk factor for each. commodity price to which a bank is exposed. In cases when the aggregate positions are relatively small, the bank shall use a single risk factor for a broad subcategory of commodities (for instance, a single risk factor for all types of oil). |
| (b) | For more active trading, the model shall also take account of variation in the "convenience yield" between derivatives positions such as forwards and swaps and cash positions in the commodity. |