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Dubai Financial Services Authority (DFSA): Contents

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  Versions
(1 version)
 
Dec 9 2012 onwards

PIB A5.9.1 Guidance



Whole Section PDF

The definitive version of DFSA handbook text is the PDF version as that is the text of the instrument as made and published by the DFSA.

To view past versions of this module in PDF format, please visit the Archive.

Qualitative standards

1. Any internal model used for purposes of PIB chapter 5 of PIBG should be conceptually sound and implemented with integrity and, in particular, all of the following qualitative requirements should be met:
a. any internal model used to calculate Capital RequirementsG for equity risk, interest rate risk, foreign exchange risk or commodities risk should be closely integrated into the daily risk management process set out in (b) and serve as the basis for reporting risk ExposuresG to senior management;
b. the Authorised FirmG should have a risk control unit that is independent from business trading units and reports directly to senior management. The unit should be responsible for designing and implementing any internal model used for purposes of PIB chapter 5. The unit should conduct the initial and on-going validation of any internal model used for purposes of PIB chapter 5. The unit should produce and analyse daily reports on the output of any internal model used for calculating Capital RequirementsG for position risk, foreign exchange risk and commodities risk, and on the appropriate measures to be taken in terms of trading limits;
c. the Authorised Firm'sG management body and senior management should be actively involved in the risk control process and the daily reports produced by the risk control unit are reviewed by a level of management with sufficient authority to enforce both reductions of positions taken by individual traders as well as in the Authorised Firm'sG overall risk ExposureG ;
d. the Authorised FirmG should have sufficient numbers of staff skilled in the use of sophisticated internal models, and including the ones used for purposes of PIB chapter 5, in the trading, risk-control, audit and back-office areas;
e. the Authorised FirmG should have established procedures for monitoring and ensuring compliance with a documented set of internal policies and controls concerning the overall operation of its internal models, and including the ones used for purposes of PIB chapter 5;
f. any internal model used for purposes of PIB chapter 5 should have a proven track record of reasonable accuracy in measuring risks;
g. the Authorised FirmG should frequently conduct a rigorous programme of stress testing, including reverse stress tests, which encompasses any internal model used for purposes of PIB chapter 5 and the results of these stress tests should be reviewed by senior management and reflected in the policies and limits it sets. This process should particularly address illiquidity of markets in stressed market conditions, Concentration RiskG , one way markets, event and jump-to-default risks, non-linearity of products, deep out-of-the-money positions, positions subject to the gapping of prices and other risks that may not be captured appropriately in the internal models. The shocks applied should reflect the nature of the portfolios and the time it could take to hedge out or manage risks under severe market conditions; and
h. the Authorised FirmG should conduct, as part of its regular internal auditing process, an independent review of its internal models, and including the ones used for purposes of PIB chapter 5.
2. The review referred to in (h) of GuidanceG note 1 above, should include the activities both of the business trading units and of the independent risk-control unit. At least once a year, the Authorised FirmG should conduct a review of its overall risk management process. The review should consider the following:
a. the adequacy of the documentation of the risk-management system and process and the organisation of the risk-control unit;
b. the integration of risk measures into daily risk management and the integrity of the management information system;
c. the process the Authorised FirmG employs for approving risk-pricing models and valuation systems that are used by front and back-office personnel;
d. the scope of risks captured by the risk-measurement model and the validation of any significant changes in the risk-measurement process;
e. the accuracy and completeness of position data, the accuracy and appropriateness of volatility and correlation assumptions, and the accuracy of valuation and risk sensitivity calculations;
f. the verification process the Authorised FirmG employs to evaluate the consistency, timeliness and reliability of data sources used to run internal models, including the independence of such data sources; and
g. the verification process the Authorised FirmG uses to evaluate back-testing that is conducted to assess the models' accuracy.
3. As techniques and best practices evolve, Authorised FirmsG should apply those new techniques and practices in any internal model used for purposes of PIB chapter 5.

Specification of Market RiskG factors

4. Any internal model used to calculate Capital RequirementsG for equity position risk, interest rate risk, foreign exchange risk, commodities risk and any internal model for correlation trading should meet all of the following requirements:
a. the model must capture accurately reflect, on a continuous basis, all material price risks, including General Market RisksG and, where approval has been granted in relation to Specific RiskG , Specific RisksG arising on the underlying portfolio, and should ensure that sufficient risk factors are properly specified; and
b. the model should capture a sufficient number of risk factors, depending on the level of activity of the Authorised FirmG in the respective markets. The risk factors in the model should be sufficient to capture the risks inherent in the Authorised Firm'sG portfolio of on and off-balance sheet trading positions. The Authorised FirmG should at least incorporate those risk factors in its model that are incorporated into its pricing model. The risk-measurement model should capture nonlinearities for options and other products as well as correlation risk and basis risk. Where proxies for risk factors are used they should show a good track record for the actual position held. Although an Authorised FirmG will have some discretion in specifying the risk factors for its internal models, the DFSAG expects that such models will meet the criteria specified in the following paragraphs.
5. Any internal model used to calculate Capital RequirementsG for position risk, foreign exchange risk or commodities risk should meet all of the following requirements:
a. the model should incorporate a set of risk factors corresponding to the interest rates in each currency in which the Authorised FirmG has interest rate sensitive on or off balance sheet positions. The Authorised FirmG should model the yield curves using one of a number of generally accepted approaches, for example, by estimating forward rates of zero-coupon yields. For material ExposuresG to interest-rate risk in the major currencies and markets, the yield curve should be divided into a minimum of six maturity segments, to capture the variations of volatility of rates along the yield curve. The model should also capture the risk of less than perfectly correlated movements between different yield curves. The risk measurement system should incorporate separate risk factors to capture spread risk, for example, between bonds and swaps;
b. the model should incorporate risk factors corresponding to gold and to the individual foreign currencies in which the Authorised Firm'sG positions are denominated. For Collective Investment FundsG the actual foreign exchange positions of the FundG should be taken into account. Authorised FirmsG may rely on third party reporting of the foreign exchange position of the FundG , where the correctness of this report is adequately ensured. If an Authorised FirmG is not aware of the foreign exchange positions of a FundG , this position should be carved out of the model and treated separately;
c. the model should use a separate risk factor at least for each of the equity markets in which the Authorised FirmG holds significant positions. At a minimum, this will include a risk factor that is designed to capture market-wide movements in equity prices, for example, a market index. Positions in individual securities or in sector indices could be expressed in "beta-equivalents" relative to this market-wide index. A relatively more-detailed approach would be to have risk factors corresponding to various sectors of the overall equity market, for instance, industry sectors or cyclical and non-cyclical sectors. The most extensive approach would be to have risk factors corresponding to the volatility of individual equity issues;
d. the model should use a separate risk factor at least for each commodity in which the Authorised FirmG holds significant positions. The model must also capture the risk of less than perfectly correlated movements between similar, but not identical, commodities and the ExposureG to changes in forward prices arising from maturity mismatches. It should also take account of market characteristics, notably delivery dates and the scope provided to traders to close out positions; For more actively traded portfolios, the model should also take account of variation in the "convenience yield" between derivative positions such as forwards and swaps and cash positions in the commodity; and
e. the Authorised Firm'sG internal model should conservatively assess the risk arising from less liquid positions and positions with limited price transparency under realistic market scenarios. In addition, the internal model should meet minimum data standards. Proxies should be appropriately conservative and should be used only where available data is insufficient or is not reflective of the true volatility of a position or portfolio.
6. Authorised FirmsG may, in any internal model used for purposes of PIB chapter 5, use empirical correlations within risk categories and across risk categories only if the Authorised Firm'sG approach for measuring correlations is sound and implemented with integrity.

Quantitative standards

7. The DFSAG will usually only approve an internal Value-at-Risk (VaR) model or its use when the VaR model meets the following quantitative criteria:
a. VaR should be computed at least on a daily basis;
b. in calculating the value-at-risk, a 99th percentile, one-tailed confidence interval is to be used;
c. in calculating VaR, an instantaneous price shock equivalent to a 10 day movement in prices is to be used, i.e., the minimum "holding period" will be 10 trading days;
d. an effective historical observation period of at least one year except where a shorter observation period is justified by a significant upsurge in price volatility; and
e. its data set is updated by the Authorised FirmG no less frequently than once every month and is reassessed whenever market prices are subject to material changes.
8. An Authorised FirmG may use VaR numbers calculated according to shorter holding periods than 10 days scaled up to 10 days by an appropriate methodology that is reviewed periodically.

Qualitative standards

9. In addition to 7 and 8:
a. no particular type of model is prescribed. So long as each model used captures all the material risks run by the Authorised FirmG , the Authorised FirmG will be free to use models based, for example, on variance-covariance matrices, historical simulations, or Monte Carlo simulations;
b. an Authorised FirmG will have discretion to recognise empirical correlations within broad risk categories, for example, interest rates, exchange rates, equity prices and commodity prices, including related options volatilities in each risk factor category;
c. an Authorised Firm'sG models should accurately capture the unique risks associated with options within each of the broad risk categories; and
d. an Authorised FirmG should calculate, on a daily basis, its Market Risk Capital RequirementG or any component for which an internal model is used, expressed as the higher of (a) its previous day's VaR number measured according to the parameters specified in this section and (b) an average of the daily VaR measures on each of the preceding sixty business days, multiplied by a multiplication factor.
10. The DFSAG will usually set a multiplication factor of 3 that must be used by the Authorised FirmG where all the qualitative and quantitative criteria are satisfied. This will be imposed as a condition on the approval and may be varied by the DFSAG should circumstances require.
11. In addition to the calculation of VaR, an Authorised FirmG using internal VaR models, an Authorised FirmG should at least on a weekly basis, calculate a 'Stressed VaR' of the current portfolio, in accordance with the requirements set out in GuidanceG note 7, with VaR model inputs calibrated to historical data from a continuous 12-month period of significant financial stress relevant to the Authorised Firm'sG portfolio. The choice of such historical data should be subject to at least annual review by the Authorised FirmG , which should notify the outcome to the DFSAG .
12. An Authorised FirmG using an internal model should calculate Capital RequirementG for the relevant risk categories, as the sum of points (a) and (b):
a. the higher of:
i. its previous day's VaR number calculated in accordance with GuidanceG note 7 of this guidance under PIB A5.9.1; or
ii. an average of the daily value-at-risk numbers calculated in accordance with GuidanceG note 7 of PIB A5.9.1, on each of the preceding sixty business days (VaRavg), multiplied by the multiplication factor referred in GuidanceG note 8 of PIB A5.9.1; plus
b. the higher of:
i. its latest available stressed-value-at-risk number calculated in accordance with GuidanceG note 9 of PIB A5.9.1 (sVaRt-1); or
ii. an average of the stressed VaR numbers calculated in accordance with GuidanceG note 9 of PIB A5.9.1 during the preceding sixty business days (sVaRavg), multiplied by the multiplication factor (ms) according to GuidanceG note 10.

RegulatoryG back-testing and multiplication factors

13. The results of the Stressed VaR calculations referred to in GuidanceG note 11 of PIB A5.9.1 should be scaled up by the multiplication factors given below.
14. The multiplication factor referred above is defined as the sum of 3 and an addend between 0 and 1 in accordance with 1. That addend should depend on the number of violations for the most recent 250 business days as evidenced by the Authorised Firm'sG back-testing of the VaR as set out in GuidanceG note 7 above.
Number of violations addend
Fewer than 5 0.00
5 0.40
6 0.50
7 0.65
8 0.75
9 0.85
10 or more 1.00
15. An Authorised FirmG should count daily violations on the basis of back-testing on hypothetical and actual changes in the portfolio's value. A violation for this purpose is defined as a one-day change in the portfolio's value that exceeds the related one-day VaR number generated by the Authorised Firm'sG model. For the purpose of determining the addend the number of violations should be assessed at least on a quarterly basis and should be equal to the higher of the number of violations under hypothetical and actual changes in the value of the portfolio.
16. Back-testing on hypothetical changes in the portfolio's value should be based on a comparison between the portfolio's end-of-day value and, assuming unchanged positions, its value at the end of the subsequent day. Back-testing on actual changes in the portfolio's value should be based on a comparison between the portfolio's end-of-day value and its actual value at the end of the subsequent day excluding fees, commissions, and net interest income.
17. The DFSAG may in individual cases limit the addend to that resulting from violations under hypothetical changes, where the number of violations under actual changes does not result from deficiencies in the internal model.
18. In order to enable the DFSAG to monitor the appropriateness of the multiplication factors on an ongoing basis, the Authorised FirmG should notify promptly, and in any case no later than within five working days, any violations that result from its back-testing programme.

Internal Validation

19. Authorised FirmsG should have processes in place to ensure that all their internal models used for purposes of PIB chapter 5 have been adequately validated by suitably qualified parties independent of the development process to ensure that they are conceptually sound and adequately capture all material risks. The validation should be conducted when the internal model is initially developed and when any significant changes are made to the internal model. The validation should also be conducted on a periodic basis but especially where there have been any significant structural changes in the market or changes to the composition of the portfolio which might lead to the internal model no longer being adequate. As techniques and best practices for internal validation evolve, Authorised FirmsG should apply these advances. Internal model validation should not be limited to back-testing, but should, at a minimum, also include the following:
a. tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate or overestimate the risk;
b. in addition to the regulatory back-testing programmes, Authorised FirmsG should carry out their own internal model validation tests, including back-testing, in relation to the risks and structures of their portfolios; and
c. the use of hypothetical portfolios to ensure that the internal model is able to account for particular structural features that may arise, for example material basis risks and Concentration RiskG .
20. The Authorised FirmG should perform back-testing on both actual and hypothetical changes in the portfolio's value.

Requirements for modelling Specific RiskG

21. An internal model used for calculating Capital RequirementsG for Specific RiskG and an internal model for correlation trading should meet the following additional requirements:
a. it explains the historical price variation in the portfolio;
b. it captures concentration in terms of magnitude and changes of composition of the portfolio;
c. it is robust to an adverse environment;
d. it is validated through back-testing aimed at assessing whether Specific RiskG is being accurately captured. If the Authorised FirmG performs such back-testing on the basis of relevant sub-portfolios, these must be chosen in a consistent manner;
e. it captures name-related basis risk and should in particular be sensitive to material idiosyncratic differences between similar, but not identical, positions; and
f. it captures event risk.

Exclusions from Specific RiskG models

22. An Authorised FirmG may choose to exclude from the calculation of its Specific RiskG Capital RequirementG using an internal model those positions for which it fulfils a Capital RequirementG for Specific RiskG in accordance with relevant sections of PIB chapter 5.
23. An Authorised FirmG may choose not to capture default and migration risks for debt instruments in its internal model where it is capturing those risks through internal models for incremental default and migration risk.
Derived from RM111/2012 (Made 15th October 2012). [VER20/12-12]