Specification of market risk factorsSpecification of market risk factors

Specification of market risk factors

An ADI must specify, in its risk management system, an appropriate set of market risk factors (market rates and prices that affect the value of the ADI’s market‑related positions) that are sufficient to capture the risks inherent in the ADI’s portfolio of on-balance sheet and off-balance sheet trading positions.
The VaR model must capture nonlinearities beyond those inherent in options and other relevant products (e.g. mortgage-backed securities, tranched exposures or nth loss positions), as well as correlation risk and basis risk (e.g. between credit default swaps and bonds).
Where a risk factor is incorporated in a pricing model but not in the VaR model, the ADI must justify this omission to APRA’s satisfaction. An ADI must also justify, to APRA’s satisfaction, that all proxies used in the VaR model show a good track record for the actual position held (i.e. an equity index for a position in an individual stock).

Interest rates

An ADI must specify a set of risk factors corresponding to interest rates in each currency in which the ADI has interest rate sensitive on-balance sheet or off-balance sheet trading book positions. The number of risk factors used must be driven by the nature of the ADI’s trading strategies. For material exposures to interest rate movements in the major currencies and markets, an ADI must model the yield curves for those currencies using a minimum of six risk maturity segments.
An ADI must specify separate risk factors to capture credit spread risk (e.g. between government bonds, corporate bonds and swaps).

Equity prices

An ADI must specify risk factors corresponding to each of the equity markets to which it has material positions.

Exchange rates (including gold)

An ADI must specify risk factors corresponding to the exchange rate between the domestic currency and individual foreign currencies in which its positions are denominated.

Commodity prices

An ADI must specify risk factors corresponding to each of the commodity markets in which it holds material positions.
An ADI’s commodity risk factors must, at a minimum, encompass:

1. directional risk, to capture the exposure from changes in spot prices arising from net open positions;

2. forward gap and interest rate risks, to capture the exposure to changes in forward prices; and

3. basis risk, to capture the exposure to changes in the price relationships between two similar, but not identical, commodities.

   For more active trading, an ADI’s model must also take into account the variation in the ‘convenience yield’ between derivatives positions, such as forwards and swaps, and cash positions in the commodity.