FRTB's Sensitivity Based Approach: Methodology, Procedure and Business Impact

The Standardized Approach (SA) is here to stay. All banks subject to the Fundamental Review of Trading Book (FRTB) will now be required to use the Standardized Approach in some capacity, even if their trading desks utilize an Internal Model Approach (IMA). Desks using an IMA will still need to calculate the SA and compare the two—with the SA possibly providing a floor to the capital requirements in many cases. As such, the Sensitivity Based Approach (SBA) will be a critical component of FRTB reporting, and while many financial institutions are already prepared to conduct SBA calculations—many are not.

What does the SBA entail when it comes down to underlying methodology and risk sensitivity calculations for Delta, Curvature and Vega charges and what does its implementation mean from a business impact perspective?

Highlights of the paper include:

1. Breakdown of Recent Key Enhancements to FRTB and the Sensitivity Based Approach
2. SBA Methodology, Structure and Procedure to Calculate Delta Risk Charge, including:
   1. Examination of a case in which Delta approximation is not enough to cover all of the loss implied by a sample swaption PV when rates move up by 2.4%—and why an additional risk charge is needed on top of the Delta Risk Charge.
3. SBA Methodology, Structure and Procedure to Calculate Curvature Risk Charge, including:
   1. Examination of a case in which there is a short-position on a sample swaption, and why there is Curvature coming in. Conversely, why when long-dated on this same swaption, there is no Curvature.
   2. Why the Curvature Capital Charge is now considered essential by regulators to reduce portfolio losses during financial stress periods
4. SBA Methodology, Structure and Procedure to Calculate Vega Risk Charge, including:
   1. Examination of why Vega capital charge is also now considered essential by regulators to reduce portfolio losses during financial stress.
   2. A sample of GIRR Vega Intra-Bucket Correlation matrix—why and how it works.
   3. Demonstration of Two-Step Aggregation (aka. Cascading Approach to Variance Calculation) and why Basel Committee recommends this approach.
   4. Exploration of how to avoid Vega and Delta charges adding up when no correlation exists

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