An ADI must obtain prior approval from APRA to use an approach to the treatment of options. An ADI:
that uses solely purchased options[32] may use the simplified approach to the treatment of options; or
that also writes options must use either the delta-plus method, contingent loss method or the internal model approach (refer to Attachment C), depending on the significance of its trading.[33]
An ADI must, for the delta-plus method and the contingent loss approach, calculate the specific risk capital charges separately by multiplying the delta-equivalent amount of each option by the specific risk weights set out in paragraphs 3 to 55 of this Attachment.
Simplified approach
An ADI using the simplified approach may use the capital charges outlined in Table 10. In this approach, the positions for the options and the associated underlying assets, cash or forward, are not subject to the standard methodology but rather are ‘carved-out’ and subject to separately calculated capital charges that incorporate both general market risk and specific risk. The risk numbers thus generated are then added to the capital charges for the relevant category, i.e. interest rate related instruments, equities, foreign exchange and commodities.
Table 10: Simplified approach: Capital charges
Position
Treatment
Long cash and long putorShort cash and long call
The capital charge will be the market value of the underlying security[34] multiplied by the sum of specific and general market risk charges[35] for the underlying less the amount the option is in the money (if any) bounded at zero.[36]
Long callorLong put
The capital charge will be the lesser of:the market value of the underlying security multiplied by the sum of specific and general market risk charges for the underlying; andthe market value of the option.[37]
Delta‑plus method
An ADI that writes options may be allowed to include delta‑weighted options positions within the standard method. The ADI must report such options as a position equal to the sum of the market values of the underlying multiplied by the sum of the absolute values of the deltas. As delta does not cover all risks associated with options positions, the ADI must measure gamma (which measures the rate of change of delta) and vega (which measures the sensitivity of the value of an option with respect to a change in volatility) in order to calculate the total capital charge. These sensitivities must be calculated using an approved Exchange model or a proprietary options pricing model approved, in writing, by APRA.
Part Treatment of options - Banking (prudential standard) determination No. 7 of 2024 - Treatment of options | Zoe
When calculating general market risk using the delta-plus method, an ADI must place delta-weighted positions with debt securities or interest rates as the underlying into the interest rate time bands by using a two-legged approach, where there is one entry at the time the underlying contract takes effect and a second at the time the underlying contract matures.[39] An ADI using the delta-plus method must treat caps and floors as a series of European-style options.
For options with debt securities as the underlying, an ADI must apply a specific risk charge to the delta-weighted position on the basis of the issuer of the underlying security according to the approach in paragraphs 5 to 19 of this Attachment.
The capital charge for options with equities as the underlying must also be based on the delta-weighted positions that will be incorporated in the measure of market risk (both specific and general market risk) described in paragraphs 42 to 55 of this Attachment. An ADI must calculate the capital charge for options on foreign exchange and gold positions according to the method in paragraphs 56 to 64 of this Attachment. For delta risk, the net delta‑based equivalent of the foreign currency and gold options must be incorporated into the measurement of the exposure for the respective currency (or gold) position. The capital charge for options on commodities must be based on the incorporation of delta-weighted positions into either the maturity ladder (refer to paragraphs 72 to 75 of this Attachment) or the simplified approach (refer to paragraph 76 of this Attachment).
An ADI using the delta-plus method must calculate the gamma and vega capital charges for each option position separately.
The capital charges for ‘gamma risk’ must be calculated as:
Gamma impact = ½ gamma (VU)2
where VU denotes the variation in the price of the underlying of the option. VU must be calculated as follows:
for interest rate options, if the underlying is a bond, the market value of the underlying must be multiplied by the risk weights outlined in Table 6 of this Attachment. An equivalent calculation, based on the assumed changes in yield in Table 6, must be carried out where the underlying is an interest rate;
for options on equities and equity indices, the market value of the underlying must be multiplied by eight per cent;
for options on foreign exchange and gold, the market value of the underlying must be multiplied by eight per cent; and
for options on commodities, the market value of the underlying must be multiplied by 15 per cent.
When calculating the gamma impact, an ADI must treat as the same underlying:
for interest rates,[40] each time band outlined in Table 6 for an ADI using the maturity method. An ADI using the duration method must use the time bands as set out in the second column of Table 6;
for equities and stock indices, each national market;
for foreign currencies and gold, each currency pair and gold; and
for commodities, each individual commodity as defined in paragraph 68 of this Attachment.
Each option on the same underlying will have a gamma impact that is either positive or negative. An ADI must sum these individual gamma impacts, resulting in a net gamma impact for each underlying that is either positive or negative. Only those gamma impacts that are negative are included in the capital calculation. The total gamma capital charge is the sum of the absolute value of the net gamma impacts.
To calculate vega risk, an ADI must multiply the vega for each option by a 25 per cent proportional shift in the option's current volatility. The results must then be summed across each underlying. The total capital charge for vega risk is calculated as the sum of the absolute value of vega across each underlying.
Contingent loss approach
An ADI may also base the market risk capital charge for options portfolios and associated hedging positions on contingent loss matrix analysis. This requires the ADI to specify a fixed range of changes in the option portfolio’s risk factors (i.e. underlying price and volatility) and calculate changes in the value of the option portfolio at various points along this matrix. For the purpose of calculating the capital charge, the ADI must revalue the option portfolio using matrices for simultaneous changes in the option’s underlying rate or price and in the volatility of that rate or price. A different matrix must be set up for each individual underlying as defined in paragraph 86 of this Attachment. As an alternative, an ADI that is a significant trader in options may, for interest rate options, base the calculation on a minimum of six sets of time bands if not more than three of the time bands (as defined in column 1 of Table 6) are combined into any one set.
An ADI must evaluate the options and related hedging positions over a specified range above and below the current value of the underlying to define the first dimension of the matrix. The range for interest rates is consistent with the assumed changes in yield in Table 6. An ADI using the contingent loss approach for interest rate options must use, for each set of time bands, the highest of the assumed changes in yield applicable to the group to which the time bands belong.[41] The other ranges are ± eight per cent for equities, ± eight per cent for foreign exchange and gold, and ±15 per cent for commodities. For all risk categories, at least seven price shifts (including the current observation) must be used to divide the range into equally spaced intervals.
The second dimension of the matrix entails a change in the volatility of the underlying rate or price. While a single change in the volatility of the underlying rate or price equal to a proportional shift in volatility of ±25 per cent may be sufficient in most cases, APRA may require that a different change in volatility be used and/or that intermediate points on the matrix be calculated.
After calculating the matrix, each cell will contain the net profit or loss of the option and the underlying hedge instrument. The capital charge for each underlying must then be calculated as the largest loss contained in the matrix.
An ADI using the contingent loss approach must calculate the specific risk charge using the same approach as for the delta-plus method (refer to paragraphs 82 and 83 of this Attachment).
An ADI using the contingent loss approach must comply with the qualitative standards set out in Attachment C that are appropriate to the nature of the ADI’s business.
An ADI undertaking significant options business must, at a minimum, closely monitor any other risks associated with options, e.g. rho (rate of change of the value of the option with respect to the interest rate). The ADI may incorporate rho into its capital calculations for interest rate risk.