The Proposed Regulation on Incremental Risk Charge

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Incremental Risk Charge

The Denition of the IRC

The reference documents:

Guidelines for computing capital for incremental risk in the trading book Revisions to the Basel II market risk framework

The denition of IRC is: ... the bank must have an approach in place to capture in its regulatory capital default and migration risk in position subject to a capital charge for specic interest rate risk but not subject to the treatment outlined in paragraphs 712(iii) to 712(vi) above that are incremental to the risks captured by the VaR-based calculation as specied in paragraph 718(Lxxxviii) above (incremental risks). No specic approach for capturing the incremental risks is prescribed.

Incremental Risk Charge

The Object of the IRC

From the denition we have that the positions subject to the IRC are: Corporate Bonds CDS Credit Derivatives Explicitly excluded positions: Securitisation exposures It is possible to include: Listed equities Derivatives on listed equities

Incremental Risk Charge

The Main Guidelines

The model to measure the IRC should comply with Measured Risks:
Default Credit migration

They have to account for:

Correlation between defaults and migrations Correlation between defaults or migrations and other market risks Concentration

Liquidity Horizon
Floor at three months Longer for non-investment grade

Optionalitys impact and model risk have to be properly taken into account Constant level of risk over one-year horizon Level of condence set at 99.9%

Incremental Risk Charge

A Possible Approach

Given the Regulators guidelines, we identify the following features of a theoretical framework to measure the IRC: A reduced form approach, which allows for:
An easy calibration to market and/or internal data A quick simulation of the default events

Stochastic default intensity, which allows to

Simulate credit migrations, trough a mapping spreads/ratings Consistently price products with embedded optionality

Multi-factor specication, to account for

Correlation amongst obligors Correlation between defaults/migrations and market factors

Incremental Risk Charge

The Theoretical Framework (1)

We assume that, for a given obligor i, at each time t before the default time i , the default arrives at some (risk neutral) intensity i (t), given the available information, with probability: P(t < i < t + t|Ft ) i (t)t for small t. The (risk neutral) survival probability for a given time s > t can be calculated as: Q(i > s|Ft ) = 1i >t E e
s t

i (u)du

If the intensity is of the ane kind, then Q(i > s|Ft ) admits explicit solutions of the form: Q(i > s|Ft ) = e i (t,s)+i (t,s)i (t)

Incremental Risk Charge

The Theoretical Framework (2)

The intensity i (t), is the sum of an idiosyncratic component and m systematic components:
m

i (t) = Xi (t) +
j=1

ij Yj (t)

where ij is the loading factor for the j-th component, referring to the obligor i. The idiosyncratic component and m 1 systematic components evolve according to an Ane Jump Diusion dynamics: dXi (t) = i (i Xi (t))dt + i dYj (t) = Yj (Yj Yj (t))dt + Yj Xi (t)dBi (t) + dJi (t) Yj (t)dBYj (t) + dJYj (t)

where Ji and JYj are jumps occurring with intensity li and LYj .
Incremental Risk Charge

The Theoretical Framework (3)

The m-th systematic component is the instantaneous interest rate and it evolves according to a generalized Vasicek (HW) model: dYm (t) = Ym (Ym (t) Ym (t))dt + Ym dBYj (t) This allows for a generalized model to conveniently price also interest rate derivatives The common factors can be thought as sectors or economic areas and the factors loadings command the inuence of those risks on the single obligors The common factors make the framework suitable to take into account the correlation amongst obligors The m-th factor makes the default intensities dependent on the interest rates, thus implicitly considering the correlation between defaults and market factors The ane form entails an explicit formula for survival probabilities and hence a quick and eective simulation of the defaults times
Incremental Risk Charge