1.Simplified approach

XYZ bank is exposed to a number of positions in the same commodity. The bank’s reporting currency is AED. The following positions are held in EUR:

Firstly, calculate the current value for these positons in the reporting currency.

The following is the current situation:

Further calculation to the position after conversion to local reporting bank’s currency

640*4.25=2,720
-800*4.25=-3,400
480*4.25=2,040
-480*4.25=-2,040

Calculate the capital charge, first a capital charge of 15% of the overall net open position in the commodity is required.

The overall net position is the sum of the long and short positions:
AED 2,720 – AED 3,400 + AED 2,040 – AED 2,040 = - AED 680
The overall net positon is short AED 680. This leads to a capital charge of AED 102 (680 * 15%) Next, a capital charge of 3% of the bank’s gross positon in the commodity is required.
The gross position is the sum of the absolute values of the long and short positions:
AED 2,720 + AED 3,400 + AED 2,040 + AED 2,040 = AED 10,200

XYZ bank’s gross position is AED 10,200. This leads to a capital charge of AED 306 (10,200 * 3%).
Now, sum the charges to find the total capital charge for this commodity. The charge for the overall net open position is AED 102, and the charge for the bank’s gross position in the commodity is AED 306.
Therefore, XYZ bank’s total market risk capital charge for positions held in this commodity is AED 102 + AED 306, or AED 408.

   2.Maturity ladder approach

Recall that XYZ bank is exposed to a number of positions in the same commodity. The bank’s reporting currency is AED. The following positions are held in EUR:

Step 1:

First express each commodity position in terms of the standard unit of measurement, and value in the reporting currency at the current spot price.

The following is the current situation:

This is done the same way as for the simplified approach.

Step 2:

Slot each position into a time band in the maturity ladder according to its remaining maturity. Physical stocks should be allocated to the first time band.

Step 3:

Apply a capital charge: of 1.5% to the sum of the matched long and short positions in each time band to capture spread risk.

*start with the 3-6 months’ time band.
Multiply the sum of the ling and short matched positions by the spread rate 1.5%, to calculate the capital charge: (AED 2,720 + AED 2,720) * 1.5% = AED 81.6

Step 4:

Apply a capital charge of 0.6% to the residual net position carried forward to the next relevant time band, multiplied by the number of time bands it is carried forward.

The maturity ladder approach allows for netting between unmatched long and short positions across time bands. The residual net position in a time band can be carried forward to the next relevant time band, thus offsetting exposures in time bands further out. Because this is imprecise, resulting in an “imperfect hedge”; a capital charge is required.

The residual net position in the 3-6 months’ band is short AED 680. This net position is carried forward two time bands to offset exposures in the next relevant time band, the 1-2 years’ band.

*The capital charge is calculated as follows: AED 680 * 2 * 0.6% = AED 8.16

Step 5:

Repeat step 3 and step 4 for each time band.

When determining the matched position in each time band, take into account the residual net position carried forward.

*(680+680)*1.5% = AED 20.4
**(1,360*2*0.6%) = AED 16.32
***(1,360+1360) *1.5% = AED 40.8

Step 6:

Apply a capital charge of 15% to the overall long or short net open position.

The net position in the final time band is subject to a capital charge of 15% as to say 680 * 15% = AED 102

Step 7:

Derive the total capital charge by summing the charges for spread risk, for positions carried forward and for the overall net open position.

In this example, the capital charge calculated using the maturity ladder approach; AED 269.28 is significantly lower than that calculated using the simplified approach, AED 408.