Instruments with Multiple Constituents

12.4 Instruments with Multiple Constituents

132 In the delta and curvature risk context: for index instruments and multi-underlying options, a look-through approach should be used. However, an AI may opt not to apply the look-through approach for instruments referencing any listed and widely recognised and accepted equity or credit index, where:

(i) It is possible to look-through the index (i.e. the constituents and their respective weightings are known);

(ii) The index contains at least 20 constituents;

(iii) No single constituent contained within the index represents more than 25% of the total index;

(iv) The largest 10% of constituents represents less than 60% of the total index; and (v) The total market capitalisation of all the constituents of the index is no less than

HKD 312 billion.

133 For a given instrument, irrespective of whether a look-through approach is adopted or not, the sensitivity inputs used for the delta and curvature risk calculation should be consistent.

134 Where an AI opts not to apply the look-through approach in accordance to paragraph 132, a single sensitivity shall be calculated with respect to each widely recognised and accepted index that an instrument references. The sensitivity to the index should be assigned to the relevant delta risk bucket defined in paragraphs 148 and 163 as follows.

 Where more than 75% of constituents in that index (taking into account the weightings of that index) would be mapped to a specific sector bucket (i.e.

bucket 1 to bucket 11 for equity risk, or bucket 1 to bucket 16 for CSR), the sensitivity to the index shall be mapped to that single specific sector bucket and treated like any other single-name sensitivity in that bucket.

 In all other cases, the sensitivity may be mapped to an “index” bucket (i.e.

bucket 12 or bucket 13 for equity risk; or bucket 17 or bucket 18 for CSR).

135 An AI should always use the look-through approach for indices that do not meet the criteria set out in paragraph 132(ii) to (v), and for any multi-underlying instruments that reference a bespoke set of equities or credit positions.

 Where a look-through approach is adopted, for index instruments and multi-underlying options other than the CTP, the sensitivities to constituent risk

factors from those instruments or options are allowed to net with sensitivities to single-name instruments without restriction.

 Index CTP instruments cannot be broken down into its constituents (i.e. the index CTP should be considered a risk factor as a whole) and the above-mentioned netting at the issuer level does not apply either.

 Where a look-through approach is adopted, it shall be applied consistently through time²⁵, and shall be used for all identical instruments that reference the same index.

136 For equity investments in funds that can be looked through as set out in paragraph 30, an AI should apply a look-through approach and treat the underlying positions of the fund as if the positions were held directly by the AI (taking into account the AI’s share of the equity of the fund, and any leverage in the fund structure), except for the funds that meet the following conditions:

 For funds that hold an index instrument that meets the criteria set out under paragraph 132, an AI should still apply a look-through and treat the underlying positions of the fund as if the positions were held directly by the AI, but the AI may then choose to apply the “no look-through” approach for the index holdings of the fund as set out in paragraph 134.

 For funds that track an index benchmark, an AI may opt not to apply the look-through approach and opt to measure the risk assuming the fund is a position in the tracked index only where: (i) the fund has an absolute value of a tracking difference (ignoring fees and commissions) of less than 1%; and (ii) the tracking difference is checked at least annually and is defined as the annualised return difference between the fund and its tracked benchmark over the last 12 months of available data (or a shorter period in the absence of a full 12 months of data).

137 For equity investments in funds that cannot be looked through, but that an AI has access to daily price quotes and knowledge of the mandate of the fund as set out in paragraph 30, the AI may calculate capital charges for the fund in one of three ways:

 If the fund tracks an index benchmark and meets the requirement set out in paragraph 136, the AI may assume that the fund is a position in the tracked index, and may assign the sensitivity to the fund to relevant sector specific buckets or index buckets as set out in paragraph 134.

25 In other words, an AI can initially not apply a look-through approach, and later decide to apply a look-through approach. But once it applies a look-through approach (for a certain type of instrument referencing a particular index), the AI will require supervisory approval to revert to a “no look-through”

approach.

 Subject to supervisory approval, the AI may consider the fund as a hypothetical portfolio in which the fund invests to the maximum extent allowed under the fund’s mandate in those assets attracting the highest capital charge under the sensitivities-based method, and then progressively in those other assets implying lower capital charge. If more than one risk weight can be applied to a given exposure under the sensitivities-based method, the maximum risk weight applicable should be used.

- This hypothetical portfolio should be subject to market risk capital charges on a standalone basis for all positions in that fund, separate from any other positions subject to market risk capital charges.

- The counterparty credit and CVA risks of the derivatives of this hypothetical portfolio should be calculated in accordance with the corresponding treatment of equity investments in funds in the banking book.

 An AI may treat their equity investment in the fund as an unrated equity exposure to be allocated to the “other sector” bucket (Bucket 11). In applying this treatment, the AI should also consider whether, given the mandate of the fund, the default risk capital risk weight prescribed to the fund is sufficiently prudent (as set out in paragraph 216), and whether the residual risk add-on should apply (as set out in paragraph 204).

138 Net long equity investments in a given fund in which the AI cannot look through or does not meet the requirements of paragraph 30 should be assigned to the banking book. Net short positions in funds, where the AI cannot look through or does not meet the requirements of paragraph 30, should be excluded from any trading book capital charges under the market risk framework, with the net position instead subjected to a 100% capital charge.

139 In the vega risk context:

 Multi-underlying options (including index options) are usually priced based on the implied volatility of the option, rather than the implied volatility of its underlying constituents and a look through approach may not need to be applied, regardless of the approach applied to the delta and curvature risk calculation as set out above.²⁶

 For indices, the vega risk with respect to the implied volatility of the multi-underlying options will be calculated using a sector-specific bucket or an index bucket defined in paragraphs 148 and 163 as follows:

26 The implied volatility of an option must be mapped to one or more maturity tenors.

- Where more than 75% of constituents in that index (taking into account the weightings of that index) would be mapped to a single specific sector bucket (i.e. bucket 1 to bucket 11 for equity risk; or bucket 1 to bucket 16 for CSR), the sensitivity to the index shall be mapped to that single specific sector bucket and treated like any other single-name sensitivity in that bucket.

- In all other cases, the sensitivity may be mapped to an “index” bucket (i.e.

bucket 12 or bucket 13 for equity risk or bucket 17 or bucket 18 for CSR).