Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

Module II: Key Risks and their Measurement

Section B: Market Risk

Chapter 2: Market Risk Capital Charge – Standardized Duration

Approach
Dr. Kedar nath Mukherjee

Objectives

The discus about different types of sensitivity measures to capture interest rate risk,
and their use in estimating the market risk capital charge under the standardized
approach proposed by the Reserve Bank of India in its guidelines related to capital
adequacy for banks in India.

 Market Risk Capital Charge and its estimation under the Standardized Approach,
proposed by Basel and RBI
 Sensitivity Measures to capture IR Risk in Fixed Income Portfolio
 Duration, M-Duration, and PV01; Estimation of MRCC?
 Convexity, and it’s affect on the MRCC of a Trading Portfolio

Structure
1. Bond Price Sensitivity to Interest Rates: Meaning
2. Various Interest Rate Sensitivity Measures
2.2 Duration or Macaulay Duration; Modified Duration; Effective Duration; M-
Duration of Floating Rate Bond; Price Value of a Basis Point (PVBP) or PV01
3. Portfolio Sensitivity Measures
4. Limitations of Duration/M-Duration/PV01
4.1 Linearity in the Price-Yield Relations
4.2 Parallel Shift in Yield Curve
5 Convexity
6 Market Risk Capital Charge under SMM
6.1 MRCC on Fixed Income Portfolio under SMM
6.2 MRCC on Equity Portfolio under SMM
6.3 MRCC on Foreign Exchange & Gold Positions under SMM

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

6.4 MRCC on Interest Rate Derivatives Positions under SMM

7 Specific Risk Capital Charge for HFT and AFS Securities
8 Limitations of Standardized Method to Estimate MRCC

1.0 Bond Price Sensitivity to Interest Rates: Meaning

Since the value of any fixed income security at any point of time is broadly the present
value (PV) of all the future cash flows due on that security, and the PVs of future cash
flows are sensitive to the rate of interests for the respective tenors, the value of any
fixed income security is sensitive to any possible change in the rate of interest.
Alternatively, there is an inverse relation between the price of a bond or fixed income
security and the rate of interest. Any rise (fall) in the rate of interest leads to a fall (rise)
in the value of a bond, leading to make a capital loss (gain) for the investor or security
holder. Therefore, all investors investing in fixed income securities are said to be
exposed to Interest Rate Risk, comprises of Price Risk and Reinvestment Risk. Risk of
depreciating the value of a security due to rise in interest rates is known as Price Risk,
and the risk of earning a lower reinvestment income due to fall in interest rates is
termed as Reinvestment Risk.

2.0 Various Interest Rate Sensitivity Measures

There are some very important basic measures used to quantify the level of bond price
sensitivity to change in interest rates. These are Duration or Macaulay Duration,
Modified Duration (M-Duration), Price Value Basis Points (PVBP) or PV01, Convexity, etc.
There can be again variety of these measures applicable to different types of bonds.

2.1 Duration or Macaulay Duration:

Duration (also known as Macaulay Duration), of a bond, can be expressed in terms of

the Average life of the security within which the original investment is expected to be
recovered. Alternatively, Macaulay Duration is the Weighted Average Maturities of all
the assumed zero coupon bonds (equal to various Cash Flows of the coupon bond),
where the weights used at different periods are the Proportion of PV of cash flows at
each period and the Full Price of the bond (i.e. sum of the PVs of all CFs). In other words,
Duration is the time period at the end of which the value of all future cash flows will be
exactly equal to the current market price of the bond, irrespective of any change (Rise
or Fall) in the yield, making the cash flows insensitive to any change in interest rates.

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

For a zero coupon bond, Macaulay’s duration clearly equals the tenor/maturity of the
bond. Macaulay’s duration can be calculated as:

 n  n
 
Macaulay _ Duration  i 1 ti   PVCFi  PVCF  1 k 
i
  i 1 

Where PVCFi represents the present value of cash flows due in period i, and t i
represents the time when various interim cash flows are due till the maturity (n); k is
the frequency of interim coupon payments, and therefore is 2 for semi-annual coupon
bonds.
This Macaulay Duration can also be calculated through excel by using the following
function:

=DURATION(Settlement, Maturity, Coupon, Yld, Frequency, [Basis])

Where, the inputs are the Date of Settlement/measuring the duration (Settlement), Date
of Maturity (Maturity), Coupon Rate (Coupon), Yield to Maturity for the concerned tenor
(Yld), Coupon Payment Frequency (Frequency, 2 in case of Semiannual bond), and the
Day Count Convention followed (Basis => 4 in case of 30/360, 3 in case of Actual/365, 2
in case of Actual/360, and 1 in case of Actual/Actual convention).
Example:
Let us take a 2-Year 10% coupon bond, coupons are paid semiannually, currently trated
at a price of Rs.101.79/-, prevailing 2 year yield being 9%. The duration of the bond can
be calculated as:
Time period (half Total
1 2 3 4
years)
Cash Inflows (Rs.) 5 5 5 105
PV at an yield of 9% 4.78 4.58 4.38 88.05 101.79
PV × Time 4.78 9.16 13.14 352.20 379.28
Duration in number of semiannual periods = 379.28/101.79 = 3.73
Duration in Years = 3.73/2 = 1.86 Years.
Therefore, the average maturity of the bond is 1.86 years, within which the bond
investor is expected to get his original investment, i.e. the price of the bond, back,
irrespective of the change in market rate of interest. Throughout the maturity of the
bond, any change in rate of interest may cause reinvestment gain and price risk, or
reinvestment loss and price gain. But the gain may not completely offset the loss. If the
bond is hold till its duration (not till the maturity), the rise (fall) in reinvestment
income completely offset the fall (rise) in the present value of future cash flows, due to
any rise (fall) in interest rates.

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

2.2 Modified Duration:

Modified duration (MD) is a modified version of Macaulay Duration. Modified duration

follows the concept that interest rates and bond prices move in opposite direction. It
refers to the change in value of the security to one per cent (100 basis points) change in
interest rates (Yield). A formula that expresses the measurable change in the value of a
security in response to a change in interest rates is expressed as under:


MDuration  MacaulayDu ration 1  YTM
k

 n  n
  
Modified _ Duration  i 1 ti   PVCFi
 
 PVCF  1 k   1 1  YTM / k 
i
i 1  

Mathematically, M-Duration is the relative price change, i.e. the first order
differentiation of the bond price function [P=f (r)], and can be derived as:

1 dP 1 Ci Ci
  i 1  i  where P  i 1
n n
Duration   ;
P dr P 1  r i 1 1  r i
Like Macaulay Duration, Modified duration can also be calculated through excel by using
the following function:

=MDURATION(Settlement, Maturity, Coupon, Yld, Frequency, [Basis])

Where, the inputs are the Date of Settlement/measuring the duration (Settlement), Date
of Maturity (Maturity), Coupon Rate (Coupon), Yield to Maturity for the concerned tenor
(Yld), Coupon Payment Frequency (Frequency), and the Day Count Convention followed
([Basis]).
If we calculate the M-Duration from the above example, M-Duration = 1.86/
(1+0.09/2) = 1.78. Therefore, approximate % of Price Fall (Rise) due to the Possible
Rise (Fall) in Yield is such that:
Price Change = (- Duration) * (± Yield Change) * Current Price
In the present example, the percentage change in price of the concerned bond due to 2
per cent rise in yield is such that:
Price Change = - 1.78% × (+2% × 100) × 101.79 = Rs.3.62/-

2.3 Effective Duration:

Effective Duration is the same modified duration measure, but is used to capture the
interest rate risk of a bond with an embedded option (Call or Put). Alternatively,

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

Effective Duration is the percentage price change of a bond with embedded option (i.e.
callable or putable bond) due to one percent change in the rate of interest. Effective
duration is calculated as:

D  PdY  P dY  2  P0  dY 

Where, P-dY, P+dY, P0, and dY respectively represents the new price when yield is
expected to fall, new price when yield is expected to rise, original price, and the change
in yield. Pricing of a bond with embedded option cannot be done simply based on
discounted values of future cash flows, as in case of option-free bond, as is done through
the simple PRICE function in Excel. The pricing here need to be based on a framework
where interest rate volatility is duly taken care-off, preferably through an option pricing
framework like Binomial Model. It may be noted here that, Modified Duration for a
simple option-free bond can also be calculated from the above formula, by considering
normal bond pricing method. Therefore, effective duration can be used as a proxy
measure for modified duration, but modified duration cannot capture the effective
duration.
For example, considering the above case, a 2-Year option-free 10% semi-annual coupon
bond, currently priced at Rs.101.79/-, yielding 9%, Effective-cum-Modified Duration,
expected to be almost same, can be calculated as:

ED  PdY  PdY  2  P0  dY   (103.63  100) /( 2  101.79  1%)  1.78%

Effective Duration can also be estimated, as commonly observed in the market, through
the simple M-Duration process, but by reducing the maturity of the bond with call (put)
option simply to the first call (put) date, assuming that the option will be exercised in
the very first call (put) date.

2.4 M-Duration of Floating Rate Bond:

Since the coupon rate of a floating rate bond gets reset in every reset period, for
example in every six months, it behaves like a zero coupon bond within every reset
period. Therefore, the duration of a floating rate bond, without any spread/margin
above the reference rate, is just the time period left till the next coupon reset date.
Suppose if the coupon rate of an FRB is going to be reset in next 1 Month time, the
duration of that FRB at that point of time is just 1 Month. However, a floating rate bond
carrying a spread can be represented as a portfolio of two bonds with a coupon equal to
the reference rate and the spread over the reference rate. Duration of second part, i.e.
the spread can be calculated as of other fixed rate bonds. Accordingly, the M-Duration
can be estimated, considering the market yield for the bond.

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2.5 Price Value of a Basis Point (PVBP) or PV01:

Price Value of a Basis Point (PVBP), alternatively known as PV01, describes the actual
change in price of a bond if the yield changes by one basis point (1% / 100), such that

PVBP or PV01 = M-Duration × 0.0001 × Price

PV01 tells us how much value (in absolute terms) a position or a portfolio will gain or
lose for a 0.01% or 1 basis parallel movement in the yield curve. It therefore quantifies
interest rate risk for small changes in interest rates, and also in absolute value. It is
often used as a price alternative to Duration or M-Duration (a time or percentage
measure). Higher the PV01, the higher would be the volatility (sensitivity of price to
change in yield). From the modified duration (given in the above example), we know
that the security value will change by 1.78% for a 100 basis point (1%) change in the
yield. In value terms that is equal to 1.78*(101.79/100) = Rs.1.81. Hence the PV01 =
1.81/100 = Rs. 0.018, which is 1.8 paise. Thus, if the yield of a bond with a Modified
Duration of 1.78 moves from say 9% to 9.05% (5 basis points), the price of the bond
moves from Rs.101.79 to Rs.101.70 (reduction of 9 paise, i.e., 5 × 1.8 paise).

3.0 Portfolio Sensitivity Measures

Price sensitivity of individual securities can be ultimately converted into portfolio

measure, known as Portfolio Modified Duration, or Portfolio PV01. Weighted Average of
the M-duration of all the securities in the portfolio can be considered to measure the
price sensitivity of the bond portfolio to change in interest rates, such that:

M  Duration P  w1MD1  w2 MD2  w3 MD3  ...........  wk MDk

Here, Durations of each security is weighted by the proportion of the portfolio in that
security in terms of their current market value. So if 75% of a portfolio is in a security
with a M-duration of 8, and 25% is in a security with a M-duration of 12, then the M-
duration of the portfolio is (8% × 0.75) + (12% × 0.25) = 9%. This figure suggest that if
there is a 1% rise (fall) in the rate of interest, the value of the portfolio is going to fall
(rise) by 9 per cent of its current market value. Accordingly, a portfolio manager may
construct a bond portfolio, less sensitive to uncertain fluctuation of interest rates, by
reducing concentration on securities with higher M-duration. Similarly security-wise
PV01 can be simply added together to get the Portfolio PV01, which represent the
change in the market value of the entire portfolio due to one basis change in the interest
rate. A portfolio manager may like to have an optimum mixture of securities in his
portfolio, depending on his concern about both Risk and Return.

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

Suppose, a portfolio manager, as on December 05 2014, hold a G-Sec. portfolio of 27 GOI

securities of Rs.2506.21 crore, where portfolio M-Duration and Portfolio PV01 are
respectively 5.52% and Rs.1.3839 crore. Therefore, the portfolio manager is expected to
lose 138.39 crore due to 1 percent rise in the rate of interest, and the same loss will be
just Rs.1.3839 crore for every one basis rise in the interest rates. Since M-Duration is a
percentage measure, the portfolio sensitivity measure can be estimated by taking the
weighted average of the security-wise M-Duration. But PV01 is an absolute sensitivity
measure, and therefore security-wise PV01 can be simply summed-up to arrive at the
portfolio PV01, but with the same assumption of equal change in interest rates for all
securities.

4.0 Limitations of Duration/M-Duration/PV01

Duration, M-Duration, and PV01 are widely used as the important bond price sensitivity
measure to interest rate fluctuations. There is no doubt that Duration measures can
easily capture the interest rate risk of a fixed income security. But percentage change in
the bond’s price due to change in interest rates as captured by these measures and the
actual price change may or may not be the same. Such difference, if found to be large,
may lead these measures un-useful and irrelevant. Consistency between the estimates
of price change as depicted by these measures and the actual change depends upon the
degree of change in the rate of interest. Bond Price sensitivity estimated through
Modified Duration differs significantly with Actual in case of large interest rate shock.
More specifically, the limitations of these sensitivity measures are:

4. 1 Linearity in the Price-Yield Relations

Duration, M-Duration and PV01 assume a linear relation between the bond price and
yield. Alternatively, the rate of change in the price of a bond is constant for every similar
change, irrespective of the direction, in the yield or rate of interest, leading to the price-
yield curve as a downward slopping straight line. But the presence of non-linearity in
the price-yield relation makes this sensitivity measures less useful, especially at certain
circumstances. This non-linearity causes for a different change in price even if yield is
expected to change by a similar amount. Impact of this non-linear price-yield relation is
more prominent in case of large change in the yield. A market like in India may
comfortably capture interest rate risk on their bond portfolio through these measures
only because the interest rates are not sufficiently volatile and therefore change by a
smaller magnitude.

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

4.2 Parallel Shift in Yield Curve:

For the Portfolio Duration measures (Portfolio M-Duration, Portfolio PV01) to be

meaningful, it needs to be ensured that the interest shock should be same for all
securities, i.e. the Portfolio M-Duration measure exhibits the interest sensitivity in the
market value of the whole portfolio following a fixed 100 basis points change in the
yield of all the securities, irrespective of their maturities. Alternatively, if there is any
change (positive or negative) in the rate of interest for any tenor, all possible rates are
expected to change in the same direction and also by a similar magnitude. This property
of term structure of interest rates is known as Parallel Shift in the yield curve. If the
yield points changes by different magnitude depending on their respective maturities,
than this bond portfolio sensitivity measures may fail to capture the interest rate risk. In
general short-term interest rates are expected to be more volatile than the long-term
rates in normal market condition, leading to a different change in the yield points
depending on their maturities, and therefore an Un-parallel Shift in the yield curve. In
such case another sensitivity measure, known as Key Rate Duration may be useful. Key
Rate Duration captures the price effect due change in yield for a specific maturity of the
yield curve, holding other yields constant. Therefore there may be several interest rate
sensitivity estimates depending on the key yield points on the yield curve, and these
multiple risk estimates may be taken into consideration to capture the interest rate risk
of a bond portfolio consisting of various securities throughout the yield curve.

5.0 Convexity

M-Duration is a linear measure of how the price of a bond changes in response to

interest rate changes. As interest rates change, the price is not likely to change linearly,
but instead it would change over some curved function of interest rates. The more
curved the price function of the bond is, the more inaccurate M-Duration is as a measure
of the interest rate sensitivity. This feature of the price-yield curve is known as
Convexity. Alternatively, Convexity is a measure of the curvature of how the price of a
bond varies with interest rate. This is the change in duration of a bond per unit change
in the yield of the bond. Presence of convexity makes the modified duration measure to
overestimate the fall in price due to certain rise in yield, and underestimate the rise in
price due to similar fall in yield, especially for a significant change in the yield. Relative
Convexity (RC) can be measured as:

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

Where, P, r, i, and C respectively represent bond price, concerned yield, time, and cash
flows. Convexity can be both positive and negative. A bond with positive convexity will
not have any call features - i.e. the issuer must redeem the bond at maturity. On the
other hand, a bond with call features - i.e. where the issuer can redeem the bond early is
deemed to have negative convexity. Convexity can be alternatively calculated as:

 
Convexity  P dY  P dY  2 P0  2  P0  dY 2 
Where, P-dY, P+dY, P0, and dY represents respectively the new price when yield is
expected to fall, new price when yield is expected to rise, original price, and the change
in yield. Once security specific convexities are estimated, the portfolio convexity can be
arrived at by taking the weighted average of individual convexities. Suppose, for the
same portfolio manager, as on December 05 2014, holding a G-Sec. portfolio of 27 GOI
securities of Rs.2506.21 crore, the portfolio convexity comes to 23.16. This Relative
Convexity measure once converted into a measure called Convexity Adjustment (RC ×
Δy^2), can be further used to understand the bonds price sensitivity with more
accuracy and precision. The convexity adjustment measure for the specified portfolio of
securities may work out to be 0.2316%. This is the estimate which need to be adjusted
with the M-Duration of the concerned portfolio to get the true sensitivity measure, after
considering the non-linearity of the price-yield relationship. This measure is known as
Convexity-Adjusted Modified Duration. Therefore, change in bond’s price due to any
change in yield, after adjusting for the convexity, can be calculated as:

P P   MD  y RC  y   2

Example:
Suppose, as per the above example, where the value of the G-Sec. portfolio, consisting of
27 GOI securities, as on December 05 2014 stands at Rs.2506.21 crore, with a portfolio
M-Duration and convexity of 5.52% and 23.16 respectively. The portfolio sensitivity to
any change in interest rates, depending upon only M-Duration and M-Duration and
Convexity both, can be estimated as follows:
Fall (Rise) in the Value of the Portfolio due to 1% Rise (Fall) in interest rates, as per M-
Duration = 5.52% × Rs.2506.21 crore = Rs.138.39 crore.
But after adjusted with the convexity (i.e. Convexity Adjustment which is 0.2316%), the
relative change (Fall / Rise) in the value of the portfolio, due to Rise (Fall) in interests
are:

 
P P   5.52%  (1) 23.16  1%   5.2903%
2

P P   5.52%  (1) 23.16  1%   5.7535%

2

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

The above numbers clearly indicate that the actual fall in the value of securities and
therefore the whole portfolio, due to certain rise in the rate of interest, is relatively
small than the rise in their value, due to similar fall in the rate of interest. Therefore,
even if the M-Duration measure indicate a similar change (5.52%) in the value of the
portfolio, irrespective of the rise or fall in interest, the convexity adjusted M-Duration
measures shown 5.2903% fall in the value of the portfolio due to 1 percent rise in
interest rates, and 5.7535% rise in the value of the portfolio due to 1 percent fall in the
rate of interests. These clearly indicate that the convexity measure helps to reduce the
overestimation of losses under a regime of rising interest rates, and underestimation of
gains under falling interest rate regime, and thereby ensure an opportunity gains for the
portfolio manager under any circumstances.

6.0 Market Risk Capital Charge under SMM

Once the market risk on trading portfolio is measured, after adjusting for the hedging
positions (e.g. forward, futures, swaps, options contracts), banks need to maintain the
required market risk capital charge to finally manage the market risk. Under the
heading of Market Risk Capital Charge (MRCC), banks are required to provide the
necessary capital separately for different types of trading positions (fixed income
securities, foreign currency, equity, commodity, and derivatives). MRCC pertaining to
interest rate related instruments need to be maintained both for fixed income securities
included in trading book (HFT and AFS), and for Interest Rate Derivatives (IRD)
contracts entered into both for hedging and trading. This calculation of MRCC for fixed
income portfolio including IRD again depends upon the method or approach followed to
capture the market risk. Therefore, MRCC on fixed income portfolio may vary between
the SMM and IMA approach to capture interest rate risk.
The capital charge for interest rate related instruments would apply to current
market value of all securities in bank’s trading book. Since banks are required to
maintain capital for market risks on an ongoing basis, they are required to mark to
market their trading positions on daily basis. The current market value will be
determined as per the existing RBI Guidelines on valuation of investments. Minimum
Capital requirement for market risk is segregated into two different components:
 General Market Risk Capital Charge (GMRCC): To Capture the Risk of Loss in
Trading Portfolio due to change in market rate of interest; and
 Specific Risk Capital Charge (SRCC): To protect against adverse price movements
of individual security (Long and Short) owing to factors, termed as spread risk,
event risk and default risk, related to the individual issuer.

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

6.1 MRCC on Fixed Income Portfolio under SMM

The GMRCC for all trading positions (HFT and AFS) in interest rate related instruments
can be estimated through their M-Duration measures adjusted with the expected
interest rate shocks, as suggested by the RBI and given here bellow, followed by some
more adjustment to account for the basis risk and yield curve risk in fixed income
portfolio. On the other hand, SRCC need to be calculated, separately for HFT and AFS
positions, based on their maturity and / or credit worthiness, as indicated by the
regulator.
Table 1: Time Bands and Prescribed Yield Shock under Standardized Duration
Method
Time Bands Prescribed Yield Time Bands Prescribed
Shock Yield Shock
Zone 1: Zone 3
1 Month or Less 1.00 3.6 to 4.3 Year 0.75
1 to 3 Months 1.00 4.3 to 5.7 Year 0.70
3 to 6 Months 1.00 5.7 to 7.3 Year 0.65
6 to 12 Months 1.00 7.3 to 9.3 Year 0.60
Zone 2: 9.3 to 10.6 Year 0.60
1.0 to 1.9 Year 0.90 10.6 to 12 Year 0.60
1.9 to 2.8 Year 0.80 12 to 20 Year 0.60
2.8 to 3.6 Year 0.75 Over 20 Years 0.60
Steps required to follow to calculate GMRCC are:
 Calculate the M-Duration of each instrument separately;
 Apply the assumed yield change to the modified duration of each instrument
between 0.6% and 1.0% depending on their maturity;
 Slot the resulting capital charge measures into a maturity ladder with the fifteen
time bands (falls under three time zones) pre-specified by the regulator;
 Subject long and short (only in derivatives) positions in each time band to a 5 per
cent Vertical Disallowance designed to capture the basis risk;
 Carry forward the net positions in each time-band for the second round of
offsetting subject to the concerned Disallowances (Horizontal Disallowance) to
capture the yield curve risk.
For debt securities held under AFS category, in view of the possible longer holding
period and presence of higher specific risk, banks shall hold total MRCC, as the Higher of
the following:

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 Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

 SRCC, computed notionally for the AFS securities treating them as held under
HFT category, plus the GMRCC, as calculated following the above steps; and
 Alternative Total Capital Charge for the AFS positions computed notionally,
depending upon maturity and / or credit rating of different positions, treating
them as held in the banking book, following the respective numbers given by the
national regulator.

Example:

Suppose, a commercial bank in India, in its HFT portfolio, as on March 31 2017, holds
few GOI dated securities, details of which are given in the following table.
Bank follows the Standard Measurement Method to estimate the Market Risk (General
Market Risk) in all its Trading Positions and the resultant Capital Charges.
Given the basic details of all the securities/instruments hold by the bank in its trading
portfolio, and the standard approach (in terms of prescribed yield shock for different
types of securities based on their residual maturities) suggested by the Reserve Bank of
India, estimate the market risk capital charges, the bank is supposed to maintain as on
March 31 2017.

Table 2: Composition of G-Sec. Portfolio (HFT) as on March 31 2017

Sr. Maturity Res. Coupon Market
No Security Date Mat. Yield Rate Price Market Value
1 7.49% G.S. 2017 16-Apr-17 0.04 5.8589% 7.49% 100.06 100063444.71
2 8.07% G.S. 2017 03-Jul-17 0.26 5.9663% 8.07% 100.51 100505611.16
3 6.25% G.S. 2018 02-Jan-18 0.76 6.2412% 6.25% 99.99 99994401.59
4 7.83% G.S.2018 11-Apr-18 1.03 6.2412% 7.83% 101.56 101558853.99
5 8.12% G.S. 2020 10-Dec-20 3.69 6.6684% 8.12% 104.67 104668977.44
6 8.08% G.S. 2022 02-Aug-22 5.34 6.8288% 8.08% 105.51 105505273.71
7 7.35% G.S. 2024 22-Jun-24 7.23 6.9897% 7.35% 102.00 102001829.42
8 6.97% G.S. 2026 06-Sep-26 9.43 6.6582% 6.97% 102.15 102151821.71
9 6.79% G.S. 2029 26-Dec-29 12.74 7.0310% 6.79% 97.98 97979019.35
10 8.24% G.S. 2033 10-Nov-33 16.61 7.3745% 8.24% 108.20 108198907.51
Portfolio 6.5930% 1022628140.58

Solution:

Estimation of General Market Risk Capital Charge on the portfolio of 10 Govt. of India
dated securities are shown in the following table.

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Table 3: Estimation of General Market Risk Capital Charge under Standard

Duration Approach
Estimation of General Market Risk Capital Charge under Standard Duration Approach
1 2 3 4 5 6 7 8 9 10

GMRCC (Convexity
for 1% Rise in IR)
Convexity Adj. M-

Assumed Change

Adj. M-Duration)
Duration) (Rs. in
M-Duration (%)

Duration (in %,

in Yield (BPS)

(Rs. in Lakhs)
Market Value

GMRCC (M-
Convexity
Res. Mat.
Security

Lakhs)
Sr. No.

(INR)

(5-
6×1%^2) Given (5×4×8) (7×4×8)
7.49% G.S.
1 2017 0.04 100063445 0.0432 0.0020 0.0432 1.00 0.4321 0.4319
8.07% G.S.
2 2017 0.26 100505611 0.2509 0.0660 0.2502 1.00 2.5212 2.5146
6.25% G.S.
3 2018 0.76 99994401 0.7180 0.4419 0.7136 1.00 7.1796 7.1354
7.83% G.S.
4 2018 1.03 101558854 0.9459 0.7222 0.9387 0.90 8.6458 8.5798
8.12% G.S.
5 2020 3.69 104668977 3.0998 6.1716 3.0381 0.75 24.3341 23.8496
8.08% G.S.
6 2022 5.34 105505274 4.2706 11.4488 4.1562 0.70 31.5403 30.6947
7.35% G.S.
7 2024 7.23 102001829 5.4530 19.1065 5.2619 0.65 36.1538 34.8870
6.97% G.S.
8 2026 9.43 102151822 6.8381 29.7337 6.5408 0.60 41.9114 40.0890
6.79% G.S. 12.7
9 2029 4 97979019.4 8.2371 46.3739 7.7734 0.60 48.4238 45.6976
8.24% G.S. 16.6
10 2033 1 108198908 9.0110 61.3129 8.3979 0.60 58.4991 54.5187

Portfolio 1022628141 3.9205 17.7407 3.7431 259.6411 248.3983

102.2628 400.92 382.78
Crores Lakhs Lakhs

The interest rate sensitivity measures of the debt portfolio are as follows:
Market Value of the Debt Portfolio (HFT) = INR 102.2628 Crores
M-Duration of the Debt Portfolio = 3.9205%

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Convexity Adjusted Portfolio M-Duration = 3.7431%

Accordingly, the portfolio loss, due to change in general market condition, i.e. due to rise
in interest rate (of all tenors) by one percent, is estimated to be INR400.92 lakhs, as per
the simple M-Duration approach, considering linear change in the bond values due to
change in interest rates. But if the non-linearity in the price-yield relationship is
considered, and therefore the M-Duration is adjusted with the convexity, the portfolio
loss is estimated out to be INR 383.7786 lakhs. But in either of these cases, it is assumed
that the interest rates for all tenors are going to change by the same 1 percent, resulting
to a parallel shift in the yield curve.
Since yield curve is not expected to shift parallel (up or down), the yield shock for
different tenors are prescribed. According to the prescribed yield shock (for different
time bands under three time zones), the General Market Risk Capital Charge (GMRCC)
due to change in risk-free interest rates is estimated out to be:
INR 259.6411 lakhs (considering security-wise M-Duration)
INR 248.3983 lakhs (considering security-wise Convexity Adjusted M-duration)

6.2 MRCC on Equity Portfolio under SMM

 Under SMM, the capital required to be provided both for GMR and SR on the
gross equity positions is defined by the regulator, RBI.
 The MRCC both to capture the GMR and SR on the gross equity positions is based
on the minimum CRAR (which is 9%) and the Risk Weight assigned to the gross
equity positions (which is 100% for GMR, and 125% for SR in case of equity; and
150% in case of Security Receipts)
 Accordingly, the GMRCC and SRCC on equity investments are respectively 9%
(i.e. CRAR of 9% × R.W. of 100%) and 11.25% (i.e. CRAR of 9% × R.W. of 125%)
of the current market value of the gross equity positions; whereas the Total
MRCC on gross exposure in Security Receipts is 13.50% (i.e. CRAR of 9% × R.W.
of 150%) of the current market value of the gross positions.

Example:

Suppose, a bank in its AFS portfolio holds few equity shares, as given bellow. The bank
may like to estimate the Market Risk Capital Charge, under standardized approach, for
the concerned portfolio as on March 31 2017.

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

Table 4: Composition of Equity Portfolio (AFS) as on March 31 2017

Sl. Security Name Instrument Face value Market Value
No. Type (March 31 2017)
1 BHARAT HEAVY ELECTRICALS Shares 360000 42291000
2 HINDALCO INDUSTRIES Shares 240000 30960000
3 IFCI Shares 37866560 126284977.6
4 ILFS ENGINEERING CONSTR CO Shares 5016800 43997336
5 INDIA SME ASSET RECONST CO Shares 40000000 43070400
6 PETRONET MHB (CONVERSION) Shares 178737690 140693372.7
7 RELIANCE POWER Shares 1887550 10664657.5
8 SBI GLOBAL FACTORS LTD (GTF) Shares 69428570 128793468.8
9 SIDBI Shares 32000000 558727360
10 SUZLON ENERGY LIMITED Shares 17518536 239565979.8
11 TATA STEEL Shares 1040000 32942000

AFS - Equity Shares 384095706 1397990552

Solution:

As per the standardized approach, the MRCC on equity portfolio may be directly
estimated on the gross equity position. The GMRCC and SRCC, on the gross equity
position, are respectively 9 percent and 11.25 percent on the market value of the gross
equity positions as on March 31 2017.
Accordingly, the GMRCC and SRCC on the given equity portfolio of INR 139.7991 crores
are estimated out to be:
GMRCC on Equity Positions = 9% × INR 1397990552 = INR 12.5819 crores
SRCC on Equity Positions = 11.25% × INR 1397990552 = INR 15.7274
crores
Total MRCC on Equity Positions = 20.25% × INR 1397990552 = INR 28.3093
crores

6.3 MRCC on Foreign Exchange & Gold Positions under SMM

 Market Risk Capital Charge on the net open position in any foreign currency and
Gold positions, attracting a risk weight of 100%, is 9% (i.e. CRAR of 9% × R.W. of
100%).
 This capital charge is in addition to the capital charge for credit risk on items (On
& Off B/S) pertaining to FX and Gold transaction

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Chapter 2; Module II: Key Risk & Their Measurement; Course: Risk Management NIBM, Pune

6.4 MRCC on Interest Rate Derivatives Positions under SMM

The measurement of capital charge for market risks should include all interest rate
derivatives (e.g. FRA, IRS, IRF), currency derivatives (e.g. FX Forward, Currency Swaps,
Currency Futures, and Currency Options), and credit derivatives (e.g. CDS) in the
trading book and also derivatives contracts entered into for hedging trading book
exposures, reacting to the concerned risk factors.
 Any interest rate derivatives may be converted into positions in relevant
underlying and be subjected to GMRC and SRCC. Positions in FRA / IRS / IRF are
treated as a combination of a Long and a Short position in notional Govt. security
(s), where maturity of such positions will be the Delivery/Exercise period of the
contract and life of the underlying instrument.
 Long & Short derivatives positions may offset each other in case of identical
instruments and MRCC is applicable on Net Positions.
 No offsetting is allowed between positions in different currencies. Opposite
positions in the same category of instruments, if perfectly matched, may be
allowed to offset fully.
 GMRCC applies to any derivatives exposures (replicated as two cash positions of
concerned maturity) in the same manner as applicable for the cash positions,
subject to necessary offsets.
 IRS, FRAs, and IRF (other than Futures on Bond / Bond-Index) will not be subject
to any SRCC.
 However a specific risk charge will apply especially on OTC derivative products
according to the credit risk of the issuer.
 Because of their off-balance sheet nature, notional principal amount of each
instrument need to be multiplied by the Credit Conversion Factor (CCF), as
mentioned below, to get an Adjusted Value. The CCF again depends on the
maturity of the contract, such that:
Original Maturity Credit Conversion Factor
> One Year 0.5 per cent
≥ One Year; < Two Years 1.0 per cent
For each additional year 1.0 per cent
 The Adjusted value, after multiplying the CCF with the notional amount, need to
be multiplied by the counterparty’s risk weight: 20 per cent for Banks / All India
Financial Institutions, and 100 per cent for all others (except Govt.). PDs / NBFCs

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need to maintain additional capital at 12 per cent (15 per cent) of RWA towards
Specific (Credit) risk on Interest Rate contracts.

7.0 Specific Risk Capital Charge for HFT and AFS Securities

Estimation of credit risk on different types of investments, alternatively known as

Specific Risk, broadly depend upon the market risk management practices followed in
the bank. As per the Basel norms, bank may follow: Standard or Basic Approach or
Advanced Approach, to estimate its Credit, and / or Market Risk, and accordingly the
resulting capital charges. In its market risk management system, if bank follow the
standard approach, known as Standardized Duration Approach, the bank can estimate
the specific risk capital charge on its HFT securities as per the standard RBI Circular on
Capital Adequacy. In case of securities kept under AFS, having relatively higher risk due
to longer holding period, bank, apart from the general market risk, need to separately
estimate the specific risk and total risk, as per the RBI guideline, and accordingly need
to maintain the capital charge.

8.0 Limitations of Standardized Method to Estimate MRCC

Standardized Sensitivity Measures, proposed by the Basel Committee and approved and
implemented by the domestic regulator, may be simple enough to estimate the market
risk and resultant capital charge on various trading positions (e.g. Fixed Income
Security/Bonds, Equities, Foreign Currencies, etc.) of banks and other FIs. But these
measures/processes are not free from some severe limitations, in terms of capturing
the true level of risks of various positions before estimating the market risk capital
charge required to be maintained to safeguard the business. Some major limitations of
the standardized method may be described in the following section:

8.1 Limitation of Proposed Sensitivity Measures:

Under Standardized Duration method, the interest rate risk in fixed income
securities/portfolio is captured through M-Duration/PV01. Even if these measures
captures the sensitivity of the concerned position (s) to any change in interest rates, the
estimated change in the value (s) of such positions may be different from the actual
price change followed by any change in interest rates, especially due to the asymmetric
behavior of change in bond price due to change in interest rates. Alternatively, M-
Duration assumes a symmetric/linear price/yield relationship, due to which the
magnitude of change in bond’s value is same for both rise and fall in interest rates.
Whereas, the rise in bond’s value due to fall in interest rates is more than the fall in
bond’s value due to similar rise in interest rates, at least for plain vanilla (option-free)

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securities. This feature, commonly known as Convexity, is not captured in the existing
M-Duration based sensitivity measure to estimate the capital charge, leading to an
overestimation of losses and therefore the required capital charge due to any rise in
interest rates. Therefore, duration based sensitivity measures, if adjusted with the
respective convexity features, are considered to estimate the interest rate risk and
required capital charges, the same will be more robust and meaningful.

8.2 Pre-Specified Rate Shocks across Various Maturities

The interest rate risk losses at a portfolio level broadly depend on the change in interest
rates for different tenors, alternatively, the expected shift in the yield curve. Yield curve
shift may be parallel, or non-parallel, where interest rate for different tenors changes
with different magnitude. Possibility of Nonparallel Shift in the yield curve, which may
be more realistic, is dully considered while capturing the interest rate risk losses at a
portfolio level and thereby estimating the capital charge for interest risk by considering
various yield shocks, depending upon the maturity band of individual security/position.
But, there may be a possibility for some disagreement with regard to the magnitude of
the interest rate shocks prescribed for different maturity bands. Even if the interest rate
shocks, prescribed by the domestic regulator, ranges from 60 to 100 basis points,
depending upon the residual tenor of the security, there may some possibility of
disagreement towards the association between maturity level and prescribed yield
shock, and also the magnitude of yield shock at various maturity levels. Even if
prescribed yield shock is negatively associated with the maturity, with a minimum and
maximum shock of respectively 60 and 100 basis points, as prescribed, the interest rate
volatility may be positively associated with the residual tenor, or there may not be any
significant association at all. Even if there is some strong association, positive or
negative, the same need not to be fixed across the markets, and also across the periods.
These possibilities may lead to raise a requirement to capture the historical interest
rate volatility separately for various tenors and that also on an ongoing basis, to capture
the actual market situation, under various scenarios, without generalizing the same
across the markets and under all possible scenarios. Yield shocks for various maturities
arrived at under this mechanism may be more robust and realistic before the same are
prescribed to estimate the interest risk losses and therefore the interest risk capital
charge.

8.3 Pre-Specified Adjustments to arrive at MRCC for IR Risk

While netting off between Long and Short (in Govt. Securities and Derivatives)
positions, while estimating the market risk losses and therefore the required capital
charge, there may be some possibility to ignore the risk arises due to netting-off
between non-identical long and short positions under various time bands (i.e. Basis

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Risk), and also the risk for netting-off between net long and net short positions within
and across various time bands (i.e. Yield Curve Risk). These possibilities of incurring
additional market risk losses due to the Basis Risk and Yield Curve Risk gets adjusted
with the estimated market risk capital charge, through some pre-specified adjustments,
known as Vertical Disallowances (for Basis Risk), and Horizontal Disallowances (for
Yield Curve Risk). There is no doubt that these risk arises while estimating portfolio
losses after duly netting-off between long and short positions, but such adjustment is
again based on some pre-specified numbers, given by the domestic regulator. Unless
these numbers are robust and are derived after considering the actual market scenario,
there may be a possibility for improper (Higher or Lower) estimation of market risk
losses and therefore total market risk capital charge.

8.4 Fixed Capital Charges for Equity and FX Positions

Even if the interest rate risk on various debt securities are estimated through
standardized duration measures, to arrive at the market risk losses on debt portfolio,
the risk in equity and FX trading positions, under the standardized approach, are not at
all measured before arriving at the required market risk capital charge. Market risk
capital charge on Equity portfolio and FX portfolio are estimated on gross basis, with
the prescribed risk percentages provided by the domestic regulator, without estimating
the actual risk in individual positions (Equities and Foreign Currencies). Under this
approach, all stocks and foreign currencies are expected to be equally volatile, and that
also in all periods. Therefore any of these positions, at any point of time, are equally
risky and require the same amount of market risk capital charge to be maintained.
These fixed capital charges on Equity and FX positions may lead to improper estimation
of the concerned risk and therefore the required capital charge to manage the actual
risks.

8.5 Simple Risk Aggregation within and across Asset Classes

Once the risk in different positions or sub portfolios (debt, equity, FX) are separately
estimated and the required market risk capital charges under various heads are arrived
at, the total market risk capital charge at the whole trading portfolio level, under the
standardized approach, is arrived at through a simple summation process. Alternatively,
total market risk capital charge on the trading portfolio, under the standardized
approach, is just the simple sum of market risk capital charges in debt, equity and FX
portfolio. This process of simple risk aggregation among various asset classes, to arrive
at the portfolio risk, in terms of market risk capital charge on the whole trading
portfolio, completely ignore the co-movement (possibly negative) among various
segments of the financial market. If these major segments (debt, equity, FX) in the
financial market are expected to be negatively associated, as may be captured through

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negative correlation, simple risk aggregation among various asset classes may lead to
ignoring the natural diversification among various asset classes, which may possibly
overestimate the portfolio losses and therefore the required market risk capital charges.

Self-Learning Exercise

1. What is Market Risk in banking? What are the major risk factor that Banks/FIs in
India are exposed to in their investments?
2. What are the Important Sensitivity Measures to capture all the major risk factors,
comes under the broader category of market risk?
3. How the Interest Rate Sensitivity Measures, generally used to capture the
interest rate risk, are different from each other, in terms of their usefulness and
limitations?
4. “Convexity, if adjusted with Modified Duration, while estimating the interest rate
risk losses and therefore the resultant capital charge, allows banks/FIs to save
some capital.” - Explain.
5. What is General Market Risk (GMR) and Specific Risk (SR)? How to estimate
these risks for different types of financial market exposures (e.g. Bond, Equity,
and Foreign Exchange)?
6. What do you mean by Basis Risk and Yield Curve Risk? While estimating the
market risk at portfolio level, how presence of these risks are taken care off?
7. How to measure the equity price risk and FX risk to arrive at the required market
risk capital charge under the standardized approach? How to justify the
maintenance of required capital charge to manage the actual risk in these
portfolios?
8. How the market risk capital charge, under the standardized approach, on a
whole trading portfolio consisting of various positions is estimated? Is there any
limitation in this process of arriving at the portfolio level losses and required
capital charge?

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References:

 Frank J. Fabozzi, 2001; The Handbook of Fixed Income Securities (Chapter: 9);
McGraw-Hill.
 Martellini L and Other, 2003; Fixed Income Securities: Valuation, Risk
Management and Portfolio Strategies (Chapter: 5, 6); Wiley Finance.
 Bruce Tuckman, 2002; Fixed Income Securities: Tools for Today's Markets
(Chapter: 5, 6); John Wiley & Sons, Inc.
 Reserve Bank of India, July-2015; Prudential Guidelines on Capital Adequacy and
Market Discipline-New Capital Adequacy Framework (NCAF); RBI Master Circular.
 Reserve Bank of India, July-2015; Basel III Capital Regulations; RBI Master
Circular.

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