IFPRU 6.2 Guidance on market risk

Article 331(2) of the EU CRR (Interest rate risk in derivative instruments) states conditions that must be met before a firm not using interest rate pre-processing models can fully offset interest-rate risk on derivative instruments. One of the conditions is that the reference rate (for floating-rate positions) or coupon (for fixed-rate positions) should be 'closely matched'. The FCA will normally consider a difference of less than 15 basis points as indicative of the reference rate or coupon being 'closely matched' for the purposes of this requirement.

1. (1)

   The FCA's starting assumption is that all overshootings should be taken into account for the purpose of the calculation of addends. If a firm believes that an overshooting should not count for that purpose, then it should seek a variation of its VaR model permission under article 363 of the EU CRR (Permission to use internal models) in order to exclude that particular overshooting. The FCA would then decide whether to agree to such a variation.

2. (2)

   One example of when a firm's overshooting might properly be disregarded is when it has arisen as a result of a risk that is not captured in its VaR model but against which own funds are already held.

The rest of this section sets out the guidance for the derivation of notional positions for standardised approaches.

Futures or forwards on a basket or index of debt securities should be converted into forwards on single debt securities as follows:

1. (1)

   futures or forwards on a single currency basket or index of debt securities should be treated as either:

   1. (a)

      a series of forwards, one for each of the constituent debt securities in the basket or index, of an amount which is a proportionate part of the total underlying the contract, according to the weighting of the relevant debt security in the basket; or

   2. (b)

      a single forward on a notional debt security; and

2. (2)

   futures or forwards on multiple currency baskets or indices of debt securities should be treated as either:

   1. (a)

      a series of forwards (using the method in (1)(a)); or

   2. (b)

      a series of forwards, each one on a notional debt security to represent one of the currencies in the basket or index, of an amount which is a proportionate part of the total underlying the contract according to the weighting of the relevant currency in the basket.

Notional debt securities derived through this treatment should be assigned a specific risk position risk adjustment and a general market risk position risk adjustment equal to the highest that would apply to the debt securities in the basket or index.

The debt security with the highest specific risk position risk adjustment within the basket might not be the same as the one with the highest general market risk position risk adjustment. A firm should select the highest percentages, even where they relate to different debt securities in the basket or index, and regardless of the proportion of those debt securities in the basket or index.

Where a debt security pays coupons in one currency but will be redeemed in a different currency, it should be treated as:

1. (1)

   a debt security denominated in the coupon's currency; and

2. (2)

   a foreign currency forward to capture the fact that the debt security's principal will be repaid in a different currency from that in which it pays coupons, specifically:

   1. (a)

      a notional forward sale of the coupon currency and purchase of the redemption currency, in the case of a long position in the debt security; or

   2. (b)

      a notional forward purchase of the coupon currency and sale of the redemption currency, in the case of a short position in the debt security.

Other futures, forwards, and swaps where a treatment is not specified in article 328 of the EU CRR ((Interest rate futures and forwards) should be treated as positions in zero specific risk securities, each of which:

1. (1)

   has a zero coupon;

2. (2)

   has a maturity equal to that of the relevant contract; and

3. (3)

   is long or short according to the table in IFPRU 6.2.9 G.

Interest-rate swaps or foreign currency swaps with a deferred start should be treated as the two notional positions (one long, one short). The paying leg should be treated as a short position in a zero specific risk security with a coupon equal to the fixed rate of the swap. The receiving leg should be treated as a long position in a zero specific risk security, which also has a coupon equal to the fixed rate of the swap.

The maturities of the notional positions are shown in the table in IFPRU 6.2.12 G.

For interest-rate risk, a firm should treat a swap (such as an equity swap) with only one interest rate leg as a notional position in a zero specific risk security:

1. (1)

   with a coupon equal to that on the interest rate leg;

2. (2)

   with a maturity equal to the date that the interest rate will be reset; and

3. (3)

   which is a long position if the firm is receiving interest payments and short if making interest payments.

1. (1)

   A firm should treat a foreign currency forward, future or CFD as two notional currency positions as follows:

   1. (a)

      a long notional position in the currency which the firm has contracted to buy; and

   2. (b)

      a short notional position in the currency which the firm has contracted to sell.

2. (2)

   In (1), the notional positions should have a value equal to either:

   1. (a)

      the contracted amount of each currency to be exchanged in a forward, future or CFD held in the non-trading book; or

   2. (b)

      the present value of the amount of each currency to be exchanged in a forward, future or CFD held in the trading book.

1. (1)

   A firm should treat a foreign currency swap as:

   1. (a)

      a long notional position in the currency in which the firm has contracted to receive interest and principal; and

   2. (b)

      a short notional position in the currency in which the firm has contracted to pay interest and principal.

2. (2)

   In (1), the notional positions should have a value equal to either:

   1. (a)

      the nominal amount of each currency underlying the swap if it is held in the non-trading book; or

   2. (b)

      the present value amount of all cash flows in the relevant currency in the case of a swap held in the trading book.

Where a forward, future or CFD settles according to:

1. (1)

   the difference between the price set on trade date and that prevailing at contract expiry, then the notional position should:

   1. (a)

      equal the total quantity underlying the contract; and

   2. (b)

      have a maturity equal to the expiry date of the contract; and

2. (2)

   the difference between the price set on trade date and the average of prices prevailing over a certain period up to contract expiry, then a notional position should be derived for each of the reference dates used in the averaging period to calculate the average price, which:

   1. (a)

      equals a fractional share of the total quantity underlying the contract; and

   2. (b)

      has a maturity equal to the relevant reference date.

Commitments to buy or sell at the average spot price of the commodity prevailing over some period between trade date and maturity should be treated as a combination of:

1. (1)

   a position equal to the full amount underlying the contract with a maturity equal to the maturity date of the contract, which should be:

   1. (a)

      long, where the firm will buy at the average price; or

   2. (b)

      short, where the firm will sell at the average price; and

2. (2)

   a series of notional positions, one for each of the reference dates where the contract price remains unfixed, each of which should:

   1. (a)

      be long if the position under (1) is short, or short if the position under (1) is long;

   2. (b)

      equal to a fractional share of the total quantity underlying the contract; and

   3. (c)

      have a maturity date of the relevant reference date.

The forward cash leg of a repurchase agreement or reverse repurchase agreement should be treated as a notional position in a zero specific risk security which:

1. (1)

   is a short notional position in the case of a repurchase agreement and a long notional position in the case of a reverse repurchase agreement;

2. (2)

   has a value equal to the market value of the borrowing or deposit;

3. (3)

   has a maturity equal to that of the borrowing or deposit, or the next date the interest rate is reset (if earlier); and

4. (4)

   has a coupon equal to:

   1. (a)

      zero, if the next interest payment date coincides with the maturity date; or

   2. (b)

      the interest rate on the borrowing or deposit, if any interest is due to be paid before the maturity date.