Title[ Part 2: The First Pillar - Minimum Capital Requirements
Section[ 4. Specific risk capital charges for positions hedged by credit derivatives
713. Full allowance will be recognised when the values of two legs (i.e. long and short) always move in the opposite direction and broadly to the same extent. This would be the case in the following situations:
(a) the two legs consist of completely identical instruments, or
(b) a long cash position is hedged by a total rate of return swap (or vice versa) and there is an exact match between the reference obligation and the underlying exposure (i.e. the cash position). 114
In these cases, no specific risk capital requirement applies to both sides of the position.
714. An 80% offset will be recognised when the value of two legs (i.e. long and short) always moves in the opposite direction but not broadly to the same extent. This would be the case when a long cash position is hedged by a credit default swap or a credit linked note (or vice versa) and there is an exact match in terms of the reference obligation, the maturity of both the reference obligation and the credit derivative, and the currency of the underlying exposure. In addition, key features of the credit derivative contract (e.g. credit event definitions, settlement mechanisms) should not cause the price movement of the credit derivative to materially deviate from the price movements of the cash position. To the extent that the transaction transfers risk (i.e. taking account of restrictive payout provisions such as fixed payouts and materiality thresholds), an 80% specific risk offset will be applied to the side of the transaction with the higher capital charge, while the specific risk requirement on the other side will be zero.
715. Partial allowance will be recognised when the value of the two legs (i.e. long and short) usually moves in the opposite direction. This would be the case in the following situations:
(a) the position is captured in paragraph 713 under (b), but there is an asset mismatch between the reference obligation and the underlying exposure. Nonetheless, the position meets the requirements in paragraph 191 (g).
(b) The position is captured in paragraph 713 under (a) or 714 but there is a currency or maturity mismatch115 between the credit protection and the underlying asset.
(c) The position is captured in paragraph 714 but there is an asset mismatch between the cash position and the credit derivative. However, the underlying asset is included in the (deliverable) obligations in the credit derivative documentation.
716. In each of these cases in paragraphs 713 to 715, the following rule applies. Rather than adding the specific risk capital requirements for each side of the transaction (i.e. the credit protection and the underlying asset) only the higher of the two capital requirements will apply.
717. In cases not captured in paragraphs 713 to 715, a specific risk capital charge will be assessed against both sides of the position.
718. With regard to banks’ first-to-default and second-to-default products in the trading book, the basic concepts developed for the banking book will also apply. Banks holding long positions in these products (e.g. buyers of basket credit linked notes) would be treated as if they were protection sellers and would be required to add the specific risk charges or use the external rating if available. Issuers of these notes would be treated as if they were protection buyers and are therefore allowed to off-set specific risk for one of the underlyings, i.e. the asset with the lowest specific risk charge.
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