Market risk is the risk of losses because the market value of the Group's assets, liabilities and off-balance-sheet items varies with changes in market conditions. Market risk includes interest rate risk, currency risk and equity market risk.
- Interest rate risk is the risk of losses because of changes in interest rates.
- Currency risk is the risk of losses on the Group's positions in foreign currency because of changes in exchange rates.
- Equity market risk is the risk of losses because of changes in equity prices.
CRD includes two methods to measure market risk:
- Standardised Approach
- Internal Models Approach
Standardised Approach
The standardised approach on market risk was introduced in Denmark in 1996 on the basis of the April 1995 proposal. In the standardised approach market risk is separated into four asset classes:
- interest rate positions
- equity market positions
- currency positions and
- commodity positions,
with separate calculation methods for each asset class. The capital requirements for interest rate risk and equity market risk are added only to positions in the trading book, whereas the capital requirements for currency risk and commodity risk are added to the bank's total positions.
The capital requirement for interest rate positions is calculated on the basis of the interest rate sensitivity with a standard set of assumed volatilities in the yield curve and addedrequirements for yield curve risk. The capital requirement is calculated per currency.
The capital requirement on equity market risk is calculated on the bank's positions in each individual equity.
The currency risk capital requirement is calculated as a percentage of the bank's net open position in each currency.
The commodity risk requirement is calculated as a percentage of the bank's open position in each currency plus a requirement for maturity mismatch of the contracts.
Internal Models Approach
The Internal Models Approach (IMA) determines capital requirements on the basis of the bank's Value-at-Risk (VaR), which is calculated using the bank's own internal model. By using a VaR approach to determine capital requirement, it is possible to take diversification effects between different asset classes into account, which is not the case under the Standardised Approach.
The VaR used for capital requirement is calculated on a 99% confidence level over a ten-trading-day horizon (two weeks). The VaR figure must be calculated on a daily basis using a minimum historical ob-servation period of one year. The capital requirement for market risk is equal to the average VaR estimate over the previous 60 trading days multiplied by a scaling factor. The minimum multiplier is equal to 3 and the maximum multiplier is 4. The exact scaling factor will be determined by the regulators based on a survey of the quality of the model.
Back-tests of the model must be performed on a daily basis by comparing the actual daily trading losses with the VaR figures. The bank is also required to perform extensive stress-tests of the model on a regular basis and to report the test results to the Board. In addition, there are a number of other qualitative requirements that must ensure that the model is up-to-date as regards documentation, calculation methods and control procedures. Finally, independent surveys of the model must be performed by internal audit.
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Last updated/revised on January 31, 2008