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Blogger Choice – Basel II Stress Testing April 1, 2007

Posted by riskopedia in Basel II, EAD, LGD, Model, Of interest, PD, Regulator, Retail Risk, Risk Management, Stress test, Stress Testing.
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A good intro to Basel II Stress testing and has an example being illustrated:

http://www.findarticles.com/p/articles/mi_m0ITW/is_1_86/ai_n14897369

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1. Abhishek Pande - July 5, 2007

Basel 2 – Treatment of complex options (identifying the underlying)

I’ve been working on the intermediate approaches (delta plus and scenario matrix) to measure price risk of options. In the delta plus approach, we need to determine the delta, gamma and Vega weighted capital charge. The computation of gamma capital charge requires variation of the underlying as an input. I’m having difficulties in identifying the underlying in case of some complex options such as option on a bond future, option on a forex forward. If I take price of the bond future as the underlying and proceed further to calculate the gamma and Vega capital charge, then that won’t be according to Basel norms because Basel only defines time bands, bonds, equities, and commodities as underlying. (Refer to the new Basel amendment to accommodate market risks updated 2005, page number 32).
If I use a two legged approach and convert a complex instrument into two notional positions, then I’ll be able to determine the delta weighted capital charge. But again in case of gamma and Vega capital charge, what should go in as “variation (VU)” of the underlying?
For example going forward with the capital charge computation of option on a bond future, which variation of the underlying should be considered? Should it be variation of the price of a bond future, variation of market value of bond or variation of interest rates?
Any help in this regard would be highly appreciated. Thanks.


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