11. 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 described. 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 equity derivatives is attached at Annex 8.

1. Reporting of positions

12. In order to calculate the standard x + y formula, positions in derivatives would need to be converted into notional equity positions.

(a) Futures and forward contracts relating to individua1 equities

13. These instruments would in principle be reported at current market prices.

(b) Futures relating to equity indices

14. These instruments would be reported as the marked-to-market value of the notional underlying equity portfolio.

(c) Equity swaps

15. Equity swaps would be treated as two notional positions. For example, an equity swap in which an institution is receiving an amount based on the change in value of one particular equity or equity index and paying a different index would be treated as a long position in the former ant a short position in the latter. Where one of the legs involves receiving/paying a fixed or floating interest rate, that exposure should be slotted into the appropriate repricing maturity band in the reporting form covering debt securities. The stock index would be covered by the equity treatment.

(d) Exchange-traded and OTC options ²⁵

16. The proposed treatment of equity options would be exactly the same as for options whose underlying is a debt instrument. One method, therefore, would be for options to be reported as a position equal to the market value of the underlying multiplied by the delta (or a simplified proxy of delta). Alternative treatments are described in Annex 5.

2. Calculation of capital charges (a) Measurement of specific and general market risk

17. In calculating the x and y factors referred to in Part I, matched positions in each identical equity in each market may be fully offset, resulting in a single net short or long position on which the x and y charge will apply. Thus a future in a given equity may be offset against an opposite cash position in the same equity.

(b) Specific risk in relation to an index

18. Where the underlying is an index representing a diversified portfolio of equities, the specific risk (i.e. the risk of divergence from the general market level) would be less than for a random sample of equities and a lower x factor than that applied to ordinary equities might be justified. However, even an index which closely matches the main stocks traded can move against the market so a nil weight is not favoured by most supervisors. It is proposed that a standard x factor of 2% should apply to the net position in an index comprising a diversified portfolio of equities. The national supervisory authorities would take care to ensure that this treatment applies only to well- diversified indices and not, for example, to sectoral indices.

(c) Arbitrage

19. Consideration needs to be given to the possibility of partial offsetting for futures-related arbitrage strategies where the full specific risk charge may seem unduly harsh. Two such circumstances are:

• when an institution takes opposite positions in exactly the same index at different dates (in which case the indices will move in price very closely, the difference between the prices being mainly the cost of carry);

• when an institution has opposite positions in different but similar indices at the same date (subject to supervisory oversight that the two indices contain sufficient common components to justify offsetting).

Comment is invited on the proposition that in these two circumstances the 2% factor proposed in paragraph 18 above should apply to only one index and not both.

20. Consideration also needs to be given to situations in which institutions have taken opposite positions in their cash book and in an index future or option. This can be done either to hedge a cash position or to arbitrage between prices in the cash and futures (or options) market (known as equity index arbitrage). While such strategies probably involve lower specific risk than having opposite positions in two unrelated equities, there are still two risks that arise: divergence risk (the risk of imperfect portfolio tracking) and execution risk (the risk of imperfect synchronisation, which at its worst may involve an inability to deal).

21. Since applying the full "x plus y" treatment to cash and futures (or options) positions that are closely matched would be relatively onerous, some favour allowing firms to carve out the arbitrage and apply a special treatment outside the "x plus y" system. For such deliberate arbitrage strategies, in which a futures or options contract on a broadly-based index matches a basket of securities, the Committee proposes that institutions be allowed to remove these positions from the building-block methodology on condition that:

1. the trade has been deliberately entered into and separately controlled

2. the basket of stocks represents at least 90% of the market value of the index;

3. there is a minimum capital requirement of 4%, i e., 2% of the gross value of the positions on each side to reflect divergence and execution risks. This would apply even if all of the securities comprising the index were held in identical proportions;

4. any excess value of the securities comprising the basket over the value of the futures contract or excess value of the futures contract over the value of the basket is treated as an open long or short position.

22. Other common arbitrage strategies which would appear to merit concessionary treatment under the standard x plus y methodology include position-taking in depository receipts, warrants or convertibles against opposite positions in the underlying equity. The proposed treatment of these strategies would be to permit full offsetting against the underlying equity provided that capital is required to cover any loss on conversion (or exercise in the case of warrants). The regulators would also be vigilant in ensuring that where a short position is taken in a warrant or a convertible, no offsetting would be permitted unless its market is sufficiently liquid and its price moves directly in line with the price of the underlying.

Footnote :

25. Warrants would be treated in the same manner as options.