Treatment of Options

55.There is a section of the market risk framework devoted to the treatment of options.

The market risk charge for options can be calculated using one of the following methods:

1. ▪ the simplified approach
2. ▪ an intermediate approach: the delta-plus method

56.The more significant a bank's trading activities, the more sophisticated the approach it should use. The following table shows which methods a bank can use:

57.Banks that solely use purchased options are free to use the simplified approach, whereas banks that also write options are expected to use the intermediate approach. If a bank has option positions, but all of those written options are hedged by perfectly matched long positions in exactly the same options, no capital is required for market risk on those options. However, banks need to report the hedged options in the respective sheet.

a)Simplified Approach

58.Option positions and their associated underlying (cash or forward) are 'carved out' from other risk types in the standardised approach. They are subject to separately calculated capital charges that incorporate both general market risk and specific risk. These charges are then added to the capital charges for the relevant risk categories: interest rate risk, equities risk, foreign exchange risk or commodities risk.

59.In some cases, such as foreign exchange, it may be unclear which side is the “underlying security.” In such cases, the asset that would be received if the option were exercised should be considered as the underlying. In addition, the nominal value should be used for items where the market value of the underlying instrument could be zero, such as caps and floors, swaptions, or similar instruments.

60.The capital charges under the simplified approach are as follows:

b)Intermediate Approach

61.The procedure for general market risk is explained below. The specific risk capital charges are determined separately by multiplying the delta-equivalent of each option by the specific risk charges for each risk category.

   The delta-plus method

62.The delta-plus method uses the sensitivity parameters or Greek letters associated with options to measure their market risk and capital requirements.

63.Options should be included in market risk calculations for each type of risk as a delta- weighted position equal to the market value of the underlying multiplied by the delta.

64.The delta-equivalent position of each option becomes part of the standardised approach, with the delta-equivalent amount subject to the applicable market risk capital charges. Separate capital charges are then applied to the gamma and Vega risks of the option positions.

Greek Letters: Five coefficients are used to help explain how option values behave in relation to changes in market parameters (price of the underlying asset, the strike price, the volatility of the underlying, the time to maturity and the risk-free interest rate). These are represented by the Greek letters delta, gamma, Vega, theta and rho, and are referred to as the 'option Greeks'.

1. •Delta (Δ) measures the rate of change in the value of an option with respect to a change in the price of the underlying asset.
2. •Gamma (Γ) measures the rate of change in the delta of an option with respect to a change in the price of the underlying asset.
3. •Vega (Λ) measures the rate of change in an option price with respect to a change in market volatility for the underlying asset price.