23. In principle, all derivatives (except for those held outside the trading book) would be converted into positions in the relevant underlying and become subject to the proposals for applying specific and general market risk under the building-block methodology. There would, however, be the possibility of alternative treatments for options which are considered in Annex 5. A summary of the proposals for dealing with debt derivatives is attached at Annex 6.

1. Reporting of positions

24. In order to calculate the standard building-block formula described above, positions in derivatives would need to be converted into notional security positions. Thus the amounts reported would be the market value of the principal amount of the underlying or notional underlying.

(a) Futures and forward contracts, including forward rat agreements

25. These instruments would be treated as a combination of a long and a short position in a notional government security. The maturity of a future or an FRA would be the period until delivery or exercise of the contract, plus - where applicable - the life of the underlying security. For example, a long position in a June three month interest rate future (taken in April) would be reported as a long position in a government security with a maturity of five months and a short position in a government security with a maturity of two months. Where a range of deliverable instruments may be delivered to fulfil the contract, the institution would be free to elect which deliverable security goes into the maturity ladder. In the case of a future on a corporate bond index, positions would be included at the market value of the notional underlying portfolio of securities.

26. A few members believe that a two-legged treatment for futures and forwards would be a needless complexity which only captures a small financing cost. In particular, there would be very little difference for a short-term future when the instruments deliverable against the future have long maturities. These members would prefer an approach that slots in the value of the securities that are deliverable against the futures contract. In at least some cases, the two-legged approach would require less capital because the financing leg would be allowed to hedge other- unrelated positions in the underlying itself when the deliverable is short-term in nature.

(b) Swaps

27. Swaps would be treated as two notional positions in government securities with relevant maturities. For example, an interest rate swap under which a firm is receiving floating rate interest and paying fixed would be treated as a long position in a floating rate instrument of maturity equivalent to the period until the next interest fixing and a short position in a fixed-rate instrument of maturity equivalent to the residual life of the swap. For swaps that pay or receive a fixed or floating interest rate against some other. reference price, e.g. an equity index, the interest rate component would be slotted into the appropriate repricing maturity category, with the equity component being included in the equity framework. The separate legs of cross- currency swaps would be reported in the relevant maturity ladders for the currencies concerned.

(c) Exchange-traded and OTC options

28. The treatment of options poses problems because of the asymmetrical risk and the inherent complexity of the products. The proposals on this topic are therefore less definitive than for most other elements of the framework and comments from practitioners would be especially welcome. It is proposed that there should be a choice between two or perhaps more methods at the discretion of the individual supervisor. Only one of the methods identified in this paper would be compatible with the building-block methodology and the reporting procedure is described below. Two other possible methods are referred to in Annex 5.

29. The approach to be used for the treatment of options within the building-block methodology would be for institutions to report their options positions on a delta-weighted ²² basis (such deltas to be calculated according to an approved exchange model or the institutions proprietary options pricing model subject to oversight by the supervisor). Options would thus be reported as a position equal to the market value of the underlying multiplied by the delta. Annex 5 invites comment on the appropriateness of some additional capital requirement for those using the delta-based approach.

30. In slotting deltas into the time-bands, a two-legged approach could be used as for other derivatives, requiring one entry at the time the underlying contract takes effect ant a second at the time the underlying contract matures. For instance, a bought call option on a June three-month interest-rate future would in April be considered, on the basis of its "delta" equivalent value, to be a long position with a maturity of five months and a short position with a maturity of two months. The written option would be similarly slotted as a long position with a maturity of two months and a short one with a maturity of five months.

31. Floating rate instruments with caps or floors would be treated as a combination of floating rate securities and a series of European-style options. For example, the holder of a three-year floating rate bond indexed to six month LIBOR with a cap of 15% would treat it as:

1. a debt security that reprices in six months; and

2. a series of five written call options on a FRA with a basis of 15%, each with a negative sign at the time the underlying FRA takes effect and a positive sign at the time the underlying FRA matures.

2. Calculation of capital charges under the standard building-block methodology

(a) Allowable offsetting of matched positions

32. Long and short positions (both actual and notional) in identical instruments with exactly the same issuer, coupon, currency and maturity would be offsettable and thus fully matched positions would be excluded from the reporting framework altogether (for both specific and general market risk). A matched position in a future ant its corresponding underlying could be offset except when the future comprises a range of deliverable instruments. No offsetting would be allowed between positions in different currencies.²³ Thus the separate legs of cross-currency swaps or forward foreign exchange deals would be treated as notional positions in the relevant instruments and entered on the appropriate currency reporting form.

33. In addition, opposite positions in the same category of instruments could in certain circumstances be regarded as matched and allowed to offset fully. This would have the effect of removing, for example, closely matched swap positions from the need to apply a 10% disallowance to the matched long and short positions in each time-band. To qualify for this treatment the positions would need to relate to the same underlying instruments, be of the same nominal value and denominated in the same currency. In addition:

1. for futures: offsetting positions in the notional or underlying instruments to which the futures contract relates would need to be for identical products and mature within seven days of each other;

2. for swaps, FRAs: the reference rate (for floating rate positions) would need to be identical and/or the coupon (for fixed-rate positions) closely matched (i.e. within 10 - 15 basis points);

3. for swaps, FRAs and forwards: the next interest fixing date or, for fired coupon positions or forwards, the residual maturity would need to correspond within the following limits:
   • less than one month hence: same day;
   • between one month and one gear hence: within seven days;
   • over one year hence: within thirty days.

34. The Committee invites comment on an alternative approach for sophisticated institutions with large swap books which could use sensitivity models to calculate the positions to be included in the maturity ladder. These models would take all cash flows on swaps discounted using zero coupon rates and convert them into a portfolio of bonds (with the same interest rate sensitivities at the appropriate maturities), which would then be subject to the building-block approach. This procedure would capture more closely the true risk in large swap books.

Such models could, however, only be allowed if:

• the supervisor were fully satisfied with the accuracy of the systems being used;

• the positions calculated were fully to reflect the sensitivity of the cash flows to interest rate changes;

• the positions were denominated in the same currency.

Once slotted into the maturity ladder, the net position produced by these models would be subject to the usual disallowance factors.

(b) Specific risk

Specific risk is intended to address the credit-related and liquidity risks associated with the underlying instrument. The majority of interest-rate sensitive off-balance-sheet instruments relate to an underlying or notional underlying security which does not bear an identifiable specific risk, e.g. currencies or market interest rates. Thus interest rate and currency swaps, FRAs, forward foreign exchange contracts and interest rate futures an; options would not be subject to a specific risk charge. This exemption would also apply to futures and options on a short-term ( e.g. LIBOR) interest rate index. However, in the case of futures and options contracts where the underlying is a debt security, or an index representing a basket of debt securities, a specific risk charge would apply according to the credit risk of the issuer as set out in I above. This would require separate reporting outside the maturity schedule referred to below. For governments, specific risk would be zero.

(c) General market risk

General market risk would apply to positions in all derivative products referred to in this section in the same manner as for cash positions, subject only to an exemption for fully or very closely matched positions in identical instruments as defined in paragraphs 32 and 33. The various categories of instruments would be slotted into the maturity ladder according to the reporting rules identified earlier. As with cash securities, offsetting would be permitted for opposite positions within each maturity band, subject to a 10Z vertical disallowance, and also between different maturity bands and zones according to the scale of horizontal disallowances set out in Annex 3.

Footnotes:

22. This treatment would also encompass a simplified proxy of delta.

23. But see paragraph 19.