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w = w s f where w = change in value of the position w = value of the position s = sensitivity f = change in the price-relevant factor
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(2.9)
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For the quantification of market risks using Equation (2.9), the direction of the change of the relevant risk factors is less important than the change per se. This is based on the assumption that the long and short positions are influenced by the same risk factors, which causes a loss on the net position. The extent of the potential changes of the relevant risk factors has been defined by BIS such that the computed potential losses, which would have to be supported by capital, cover approximately 99 percent of the value changes that have been observable over the last 5 to 10 years with an investment horizon of 2 weeks. The framework of the standard approach is based on the buildingblock concept, which calculates interest rate and equity risks in the trading book and currency, precious metals, and commodity risks in the entire institution separate from capital requirements, which are subsequently aggregated by simple addition. The building-block concept is also used within the risk categories. As with equity and interest-rate risks, separate requirements for general and specific market risk components are calculated and aggregated. From an economic viewpoint, this concept implies that correlations between the movements the changes in the respective risk factors are not included in the calculation and aggregation. With movements in the same direction, a correlation of +1 between the risk factors is assumed, and with movements in opposite directions, a correlation of 1 is assumed. The standard approach is thus a strong simplification of reality, as the diversification effect based on the correlations between the risk factors is completely neglected, which results in a conservative risk calculation. Related to this risk measurement approach is a higher capital requirement (relative to the internal model). Contrary to the internal model, apart from the general requirements for risk management in trading and for derivatives, no further specific qualitative minimums are required. The implementation must be carefully examined by the external auditor, in compliance with the capital adequacy regulations, and the results confirmed to the national regulator. 2.7.1 General and Specific Risks for Equityand Interest-Rate-Sensitive Instruments In the standard approach, the general and specific components of market risk for the equity- and interest-rate-sensitive instruments in the trading
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book are calculated separately. The different types of market risks can be defined as follows:
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Specific risk includes the risk that an individual debt or equity security may move by more or less than the general market in day-to-day trading (including periods when the whole market is volatile) and event risk (when the price of an individual debt or equity security moves precipitously relative to the general market, e.g., on a takeover bid or some other shock event; such events would also include the risk of default).86 The specific market risk corresponds to the fraction of market risk associated with the volatility of positions or a portfolio that can be explained by events related to the issuer of specific instruments and not in terms of general market factors. Price changes can thus be explained by changes in the rating (upgrade or downgrade) of the issuer or acquiring or merging partner. General market risk corresponds to the fraction of market risk associated with the volatility of positions or a portfolio that can be explained in terms of general market factors, such as changes in the term structure of interest rates, changes in equity index prices, currency fluctuation, etc.
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The capital adequacy requirements of the revised regulation assume that splitting the individual risk components is possible. The credit risk components of market risk positions may not be neglected, as they as well are regulated and require capital support. Forward transactions have a credit risk if a positive replacement value (claims against the counterparties) exists. Off-balance-sheet positions have to be converted into the credit equivalents and supported by capital. A critical condition for the application of the current market risk measurement regulations is the correct mapping of the positions. In order to do so, all trading-book positions must be valued mark-to-market on a daily basis. In an additional step, all derivatives belonging to the trading book must be decomposed adequately to allocate the risk exposure to the corresponding risk factors. An aggregation between spot and forward rates requires the mapping of forwards, futures, and swaps as combinations of long and short positions, in which the forward position is mapped as either of the following:
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A long (or short) position in the underlying physical or fictive (e.g., derivatives) basis instruments An opposite short (or long) position in the underlying physical or fictive (e.g., derivatives) basis instruments
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An interest-rate swap can be decomposed as shown in Figure 2-7.
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