Simplified approach

123. A Bank that does not write options must calculate capital charges in accordance with the provisions of :

(a) The paragraph 26 of this section H for a position that is a ‘long cash and long put’ or ‘short cash and long call’ position; or

(b) The paragraph 26 of this section H for a position that is a ‘long put’ or ‘long call’ position.

124. In the simplified approach, the position in the option and the associated underlying asset (cash or forward) is not subject to the standard method. Instead, each position is carved-out and subject to a separately calculated capital charge for specific risk and general risk.

Capital charges—‘long cash and long put’ or ‘short cash and long call’

125. For a position that is ‘long cash and long put’ or ‘short cash and long call’, the capital charge is calculated by multiplying the market value of the underlying security by the sum of the specific and general risk capital charges for the underlying, and then subtracting the amount by which the option is in-the-money (bounded at zero).

126. In cases (such as foreign exchange transactions) where it is unclear which side is the underlying security, the underlying should be taken to be the asset that would be received if the option were exercised. In addition, the nominal value should be used for items if the market value of the underlying instrument could be zero (such as in caps, floors and swaptions). Some options have no specific risk (such as those having an interest rate, currency or commodity as the underlying security); other options on interest-rate-related instruments and options on equities and stock indices, however, would have specific risk.

127. In the simplified approach, the capital charge is:

(a) 8% for options on currency; and

(b) 15% for options on commodities.

128. For options with a residual maturity of less than 6 months, a Bank must use the forward price (instead of the spot price) if it is able to do so. For options with a residual maturity of more than 6 months, the firm must compare the strike price with the forward price (instead of the current price). If the firm is unable to do this, it must take the in-the- money amount to be zero.

Capital charges—‘long put’ or ‘long call’

129. For a position that is ‘long put’ or ‘long call’, the capital charge is the lesser of:

(a) the market value of the underlying security multiplied by the sum of the specific and general risk capital charges for the underlying; and

(b) the market value of the option.

130. The book value of the option may be used instead of the market value if the position is not included in the Trading Book (for example, options on particular foreign exchange or commodities positions).

Delta-plus method

131. A Bank that writes options must calculate specific risk capital charges separately by multiplying the delta-equivalent value of each option by the risk-weight applicable under the sections relating to equity position risk and traded interest rate risk.

132. In calculating general risk capital charge, the firm must enter delta- weighted positions with a debt security or interest rate as the underlying into the interest rate time bands in table F1 by using a two-legged approach. Under this approach, there is one entry at the time the underlying contract takes effect and a second entry at the time the underlying contract matures. For an option with a debt security as the underlying, the Bank must apply a specific risk capital charge to the delta- weighted position based on the issuer’s rating and in accordance with Section F of this Chapter.

133. A Bank that writes options must include delta-weighted option positions in measuring its Market risk. The Bank must report such an option as a position equal to the sum of the market values of the underlying multiplied by the sum of the absolute values of the deltas. Because delta does not cover all risks associated with option positions, the Bank must calculate gamma and vega in calculating the regulatory capital charge. The firm must calculate delta, gamma and vega using the pricing model used by a recognized exchange, or a proprietary options pricing model approved, in writing, by the AFSA.

Capital charges—options

134. The capital charge for an option with equities as the underlying must be based on the delta-weighted positions included in the measurement of specific and general risks in accordance with Section G of this Chapter on equity position risk.

135. A Bank that writes options must calculate the capital charge for options on foreign exchange and gold positions in accordance with Section E of this Chapter on foreign exchange risk. For delta risk, the net delta-based equivalent of the foreign currency and gold options must be included in the measurement of the exposure for the respective currency (or gold) position.

136. The capital charge for an option on commodities must be based on the charge calculated using the simplified approach specified in Section I of this Chapter on Commodities risk capital requirement.

Gamma capital charges

137. A Bank that writes options must calculate the capital charge for gamma risk (gamma capital charge) for each option position separately. To calculate gamma capital charge, calculate the gamma impact of each option in accordance with the following formula:

Gammaimpact = 1 / 2 * gamma * VU2 where:

VU is:

(a) for an interest rate option:

i. if the option has a bond as the underlying—the market value of the underlying multiplied by the risk factor applicable under column 3 of table F1 in this Chapter; or

ii. if the option has an interest rate as the underlying—the market value of the underlying multiplied by the assumed changes in yield in column 4 of table F1 in this Chapter;

(b) for options on equities and stock indices—the market value of the underlying multiplied by 8%;

(c) for options on foreign exchange and gold—the market value of the underlying multiplied by 8%; or

(d) for an option on commodities—the market value of the underlying multiplied by 15%.

138. For the purpose of calculating the gamma impact for an option, the following positions must be treated as the same underlying instrument or asset:

(a) for interest rates—each time band in column 2 of table F1 (with each position allocated to separate maturity ladders);

(b) for equities and stock indices—each recognised exchange;

(c) for foreign currencies and gold—each currency pair and gold; and

(d) for commodities—that are deliverable against each other or those that are close substitutes for each other with a minimum price correlation of 0.9 over the previous 12 months.

139. An Authorised Firm must calculate its Capital Requirement for Gamma risk by:

(a) calculating the net Gamma impact in respect of each underlying financial instrument or commodity by aggregating the individual Gamma impacts for each option position in respect of that underlying financial instrument or commodity (which may be either positive or negative); and

(b) aggregating the absolute value of the net Gamma impacts that are negative.

140. The underlying financial instrument or commodity should be taken to be the asset which would be received if the option were exercised. In addition, the notional value should be used for items where the market value of the underlying financial instrument or commodity could be zero (e.g. caps and floors, swaptions). Certain notional positions in zero-specific-risk securities do not attract specific Risk, e.g. interest rate and currency swaps, Forward Rate Agreement (FRA), forward foreign exchange contracts, interest rate futures and futures on an interest rate index. Similarly, options on such zero-specific-risk securities also bear no specific Risk. For the purposes of this paragraph:

(a) the specific and general risk weights in respect of options on interest rate-related instruments are determined in accordance with section F of this Chapter;

(b) the specific and general risk weights in respect of options on equities and equity indices are determined in accordance with section G of this Chapter;

(c) the risk weight in respect of foreign currency and gold options is 8%; and

(d) the risk weight in respect of options on commodities is 15%.

(e) For options with a residual maturity of more than 6 months, the strike price should be compared with the forward, and not current, price. Where an Authorised Firm is unable to do this, the in-the-money amount would be zero.

141. A Bank which trades in exotic options (e.g. barriers, digitals) would use either the scenario approach or the Internal Models Approach (IMA) to calculate its Option Risk Capital Requirement for such options, unless it is able to demonstrate to the AFSA that the Delta-plus method is appropriate. In the case of options on futures or forwards, the relevant underlying is that on which the future or forward is based (e.g. for a bought call option on a June 3-month bill future, the relevant underlying is the 3-month bill).

Vega capital charges

142. A Bank must calculate the capital charge for vega risk (vega capital charge) by:

(a) multiplying the sum of the vegas for all option positions in respect of the same underlying financial instrument or commodity, defined in paragraph 39 of this section H, by a proportional shift in the option’s current volatility of 25%; and

(b) aggregating the absolute value of the individual capital requirements which have been calculated for vega risk.