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Annexes

Annex 5

Debt securities and equities Alternative treatment for options

1. The Committee believes that there needs to be both a simplified approach for institutions which use purchased options largely to hedge other positions and a more sophisticated approach to be used by those who write options and the major players in the market.

2. It is proposed that institutions doing a limited amount and range of options business could use a simplified approach, as set out below, for particular trades.

Cash position
0ption position Treatment
Long
Long put Position risk would be the market value of the underlying security multiplied by the sum of specific and general market risk charges for the underlying less the amount the option is in the money (if any) (34)

or
Short
Long call

None
Long call Position risk would be the lesser of:
  1. the market value of the underlying security multiplied by the sum of specific and general market risk charges for the underlying
  2. the market value of the option


or


Long put

3. The more sophisticated approach for use by institutions involved in more complex strategies than those set out above would give allowance for options-hedging for a variety of different trading book instruments. Comments from market participants would be especially welcome on how this can be done in a manner which is both sufficiently accurate and acceptable to supervisors and market participants for the purposes of minimum international standards. Two possible methods are being considered.

4. In the first of these, described in paragraph 29 of Section II and paragraph 16 of Section III, options positions would be delta weighted to convert them into positions in the underlying. which would then be treated as normal positions in the basic building- block approach. However, because this would neglect the gamma and volatility risk it is proposed that there should be an additional capital charge. One possibility would be to have a fixed add-on for open options positions and/or higher disallowances than assumed in the building-block methodology for hedged positions, for example a 60% disallowance. However, consideration would be given to alternative proposals from the industry.

5. In the second approach, approved options pricing models could be used to calculate the risks in options positions and related positions in the underlying or other derivatives, according to parameters set by the regulators. Far example, these parameters would be designed to cover interest rate changes up to 1% at the short end ant 0.6% at the long end (in line with the scale set out in Column B of Annex 2) ant changes in implied volatility of +l- 25% from the current level. This approach would not be consistent with the building-block methodology and would mean institutions having discretion to "carve out" positions from the framework.

6. Currently, for measuring the overall market risk in exchangetraded options, 35some securities regulators set the capital requirement at a level equal to the margin set by exchange in circumstances where the supervisor is fully satisfied that this accurately reflects the risk. On most exchanges participants are required to put up initial or original margin (typically in the range 5% to 10% of the contract price) plus any variation margin which results from marking to market the firm's position daily. The margin requirements are explicitly based on price risk measured according to historic volatility and are reassessed daily or sometimes more frequently with a view to covering expected market exposure over the subsequent trading day.

7. The Committee has concerns about tying a capital standard intended for prudential purposes to margin requirements designed to protect exchanges from member defaults. It notes that this would not ensure equal treatment and could lead to pressure on exchanges to soften their margining rules. It also wonders what effects might result from using different systems for OTC and exchange-traded products, ant from applying different capital charges to different exchanges. Finally, some Committee members are concerned about the systemic effects if capital requirements are free to rise sharply in periods of high market volatility, expressing a strong preference for setting capital at a level which is considered adequate for all market situations.

Footnotes:

34. For example, if a holder of 100 shares currently valued at $10 each holds an equivalent put option with a strike price of $ll. the capital charge would be: $1.000 x 16% (e.g. 8% specific plus 8% general market risk) - $160, less the amount the option is in the money ($ll - $10) x 100 - $100, i.e. the capital charge would be $60.

35. The same would also apply to exchange-traded futures

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