LO 58.3: Describe and contrast the major elements—including a description of

LO 58.3: Describe and contrast the major elementsincluding a description of the risks coveredof the two options available for the calculation of market risk capital: Standardized Measurement Method
Internal Models Approach
The goal of the 1996 Amendment to the 1988 Basel Accord was to require banks to measure market risks associated with trading activities and maintain capital to back those risks. Banks must mark-to-market (i.e., fa ir value accounting) bonds, marketable equity securities, commodities, foreign currencies, and most derivatives that are held by the bank for the purpose of trading (referred to as the trading book). Banks do not have to use fair value accounting on assets they intend to hold for investment purposes (referred to as the banking book). This includes loans and some debt securities. The 1996 Amendment proposed two methods for calculating market risk: 1. Standardized Measurement Method.
Internal Model-Based Approach.
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Topic 58 Cross Reference to GARP Assigned Reading – Hull, Chapter 15
Standardized Measurement Method. This method assigns a capital charge separately to each of the items in the trading book. It ignores correlations between the instruments. Banks with less sophisticated risk management processes are more likely to use this approach.
Internal Model-Based Approach. This method involves using a formula specified in the amendment to calculate a value at risk (VaR) measure and then convert the VaR into a capital requirement. Capital charges are generally lower using this method because it better reflects the benefits of diversification (i.e., correlations between the instruments). As such, banks with more advanced risk management functions prefer the internal models approach.
Risks covered by the VaR model include movements in broad market variables such as interest rates, exchange rates, stock market indices, and commodity prices.
The VaR model does not incorporate company-specific risks such as changes in a firms credit spread or changes in a companys stock price. The specific risk charge (SRC) captures company-specific risks. For example, a corporate bond has interest rate risk, captured by VaR, and credit risk, captured by the SRC. Tier 3 capital consisting of short-term subordinated, unsecured debt with an original maturity of at least two years could be used to meet the market risk capital requirement at the time of the amendment. Tier 3 capital has subsequently been eliminated under Basel III.