SBA: Risk Sensitivities – Residual Risk Add-On (RRAO)

Relevant provisions: Paragraph 58 of the January 2016 market risk framework.

BCBS response: Yes. Bonds with multiple call dates would be considered as instruments bearing other residual risks, as they are path-dependent options.

Referenced FRTB text:
58. The residual risk add-on is to be calculated for all instruments bearing residual risk separately and in addition to other components
of the capital requirement under the standardised approach for market risk.

(a) The residual risk add-on must be calculated in addition to any other capital requirements within the standardised approach.

(b) The scope of instruments that are subject to the residual risk add-on must not have an impact in terms of increasing or decreasing the scope of risk factors subject to the delta, vega, curvature or default risk capital treatments in the standardised approach.

(c) The residual risk add-on is the simple sum of gross notional amounts of the instruments bearing residual risks, multiplied by a risk weight of 1.0% for instruments with an exotic underlying and a risk weight of 0.1% for instruments bearing other residual risks.

(d) Instruments with an exotic underlying are trading book instruments with an underlying exposure that is not within the scope of delta, vega or curvature risk treatment in any risk class under the sensitivities-based method or default risk charges in the standardised approach.

(e) Instruments bearing other residual risks are those that meet criteria (i) and (ii) below:

i. instruments subject to vega or curvature risk capital charges in the trading book and with payouts that cannot be written or perfectly replicated as a finite linear combination of vanilla options with a single underlying equity price, commodity price, exchange rate, bond price, CDS price or interest rate swap; or

ii. instruments that fall under the definition of the correlation trading portfolio (CTP) in paragraph 61, except for those instruments which are recognised in the Market Risk Framework as eligible hedges of risks within the CTP.

(f) In cases where a transaction exactly matches with a third-party transaction (ie, a back-to-back transaction), the instruments used
in both transactions must be excluded from the residual risk add-on charge. Any instrument that is listed and/or eligible for central clearing must be excluded from the residual risk add-on.

(g) A non-exhaustive list of other residual risks types and instruments that may fall within the criteria set out in paragraphs 58(e)
include:

Gap risk: risk of a significant change in vega parameters in options due to small movements in the underlying, which results in hedge slippage. Relevant instruments subject to gap risk include all path dependent options, such as barrier options, and Asian options, as well as all digital options.

■ Correlation risk: risk of a change in a correlation parameter necessary for determination of the value of an instrument with multiple underlyings. Relevant instruments subject to correlation risk include all basket options, best-of-options, spread options, basis options, Bermudan options and quanto options.

■ Behavioural risk: risk of a change in exercise/prepayment outcomes such as those that arise in fixed rate mortgage products where retail clients may make decisions motivated by factors other than pure financial gain (such as demographical features and/or and other social factors. A callable bond may only be seen as possibly having behavioural risk if the right to call lies with a retail client.

(g) When an instrument is subject to one or more of the following risk types, this by itself will not cause the instrument to be subject to the residual risk add-on:

i. Risk from a cheapest-to-deliver option;

ii. Smile risk – the risk of a change in an implied volatility parameter necessary for determination of the value of an instrument with optionality relative to the implied volatility of other instruments optionality with the same underlying and maturity, but different moneyness.

iii. Correlation risk arising from multi-underlying European or American plain vanilla options where all underlyings have sensitivities for delta risk of the same sign, and from any options that can be written as a linear combination of such options. This exemption applies in particular to the relevant index options.

iv. Dividend risk arising from a derivative instrument whose underlying does not consist solely of dividend payments.

Authors’ comment: This answer makes clear that adding optionality to bonds is likely to significantly increase the regulatory capital cost of holding those bonds through the residual risk add on. Banks developing bond structures with more than a single call option will want to minimise the amount of such bonds they retain in inventory.