(iv) Horizontal Offsets within Time Zones. In addition, the debt trading portfolio is
divided into three maturity zones: 1 (1 month to 12 months), 2 (more than 1 year to
4 years), and 3 (more than 4 years to 20 years plus). Again because of basis risk (i.e.,
the imperfect correlation of interest rates on securities of different maturities), short
and long positions of different maturities in these zones will not perfectly hedge each
other. This results in additional (horizontal) disallowance factors of 40% (zone 1),
30% (zone 2), and 30% (zone 3),^38 Part 3 of the bottom panel in Exhibit 8.8 shows
these calculations. Thehorizontal offsets are calculated using the sum of the general
market risk charges from the long and short positions in each time zone—columns
(2) and (3). As with the vertical offsets, the smallest of these totals is the “offset”
value against which the disallowance is applied. For example, the total zone 1
charges for long positions is $26.00 and for short positions is ($52.00). A disal-
lowance of 40% of the offset value (the smaller of these two values), $26.00 is
charged, that is, $10.40 ($26 ×40%). Repeating this process for each of the three
zones produces additional (horizontal offset) charges totaling $53.16.
(v) Horizontal Offsets between Time Zones. Finally, because interest rates on short ma-
turity debt and long maturity debt do not fluctuate exactly together, a residual long or
short position in each zone can only partly hedge an offsetting position in another zone.
This leads to a final set of offsets or disallowance factors between time zones, part 4 of
panel B of Exhibit 8.8. Here the BIS model compares the residual charges from zones
1 ($26.50) and 2 ($23.75). The difference, $2.75, is then compared to the residual from
zone 3 ($68.75). The smaller of each zone comparison is again used as the “offset”
value against which a disallowance of 40% for adjacent zones^39 and 150%^40 for non-
adjacent zones, respectively, is applied. The additional charges here total $13.62.
Summing the specific risk charges ($299), the general market risk charge ($66),
and the basis risk or disallowance charges ($9.00 + $53.16 + $13.62) produces a total
capital charge of $370.78 for this fixed income trading portfolio.^41
(b) Foreign Exchange. The standardized model or framework requires the FI to cal-
culate its net exposure in each foreign currency—yen, DM, and so on—and then con-
vert this into dollars at the current spot exchange rate. As shown in Exhibit 8.9, the FI
is net long (million dollar equivalent) $50 yen, $100 DM, and $150 £s while being
short $20 French francs and $180 Swiss francs. Its total currency long position is
$300, and its total short position is $200. The BIS standardized framework imposes a
capital requirement equal to 8% times the maximum absolute value of the aggregate
long or short positions. In this example, 8% times $300 million = $24 million. This
method of calculating FX exposure assumes some partial but not complete offsetting
of currency risk by holding opposing long or short positions in different currencies.
(c) Equities. As discussed in the context of the RiskMetrics market value model, the
two sources of risk in holding equities are (1) a firm specific, or unsystematic, risk el-
8 • 22 MARKET RISK(^38) The zones were also set subjectively by regulators.
(^39) For example, zones 1 and 2 are adjacent to each other in terms of maturity. By comparison zones 1
and 3 are not adjacent to each other.
(^40) This adjustment of 150% was later reduced to 100%.
(^41) This number can also be recalculated in risk-adjusted asset terms to compare with risk-adjusted as-
sets on the banking book. Thus, if capital is meant to be a minimum of 8% of risk-adjusted assets, then
$370.78×(1/1.08), or $370.78 ×12.5 = $4,634.75 is the equivalent amount of trading book “risk-ad-
justed assets” supported by this capital requirement.