Saturday, 28 February 2009

Incremental risk in the trading book 1

As part of a series on the new Basel Committee Trading Book proposals, notice first that the text contains quite a sophisticated notion of time horizon:
A bank’s IRC model must measure losses due to default and migration at the 99.9% confidence interval over a capital horizon of one year, taking into account the liquidity horizons applicable to individual trading positions or sets of positions. Losses caused by broader market-wide events affecting multiple issues/ issuers are encompassed by this definition.

This... implies that a bank rebalances, or rolls over, its trading positions over the one-year capital horizon in a manner that maintains the initial risk level, as indicated by a metric such as VaR or the profile of exposure by credit rating and concentration. This means incorporating the effect of replacing positions whose credit characteristics have improved or deteriorated over the liquidity horizon with positions that have risk characteristics equivalent to those that the original position had at the start of the liquidity horizon. The frequency of the assumed rebalancing must be governed by the liquidity horizon for a given position.

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