How does the FRTB Standardized Approach for market risk work?
I'm studying the Fundamental Review of the Trading Book (FRTB) for FRM Part II. The new Standardized Approach (SA) seems completely different from the old Basel 2.5 standardized method. What are the main components and how do they aggregate to produce the capital charge?
The FRTB Standardized Approach (SA) is a sensitivity-based method that replaced the old crude notional-based approach. It computes capital based on actual risk factor sensitivities (deltas, vegas, curvatures) rather than simple notional amounts, making it more risk-sensitive while still being standardized.
The Three Components
- Sensitivities-Based Method (SbM) — the main charge, covering delta, vega, and curvature risks
- Default Risk Charge (DRC) — covers jump-to-default risk (separate Q&A)
- Residual Risk Add-On (RRAO) — covers exotic risks not captured by SbM
Total SA Capital = SbM + DRC + RRAO
Sensitivities-Based Method (SbM) in Detail
The SbM aggregates risk across seven risk classes:
| Risk Class | Examples |
|---|---|
| General Interest Rate Risk (GIRR) | Rates, swap curves |
| Credit Spread Risk (non-securitization) | Corporate bonds, CDS |
| Credit Spread Risk (securitization, non-CTP) | ABS, RMBS |
| Credit Spread Risk (securitization, CTP) | Correlation trading |
| Equity Risk | Stock prices, equity indices |
| Commodity Risk | Oil, gold, agriculture |
| FX Risk | Exchange rates |
For each risk class, the process is:
Step 1: Compute weighted sensitivities
Weighted sensitivity = Sensitivity x Risk Weight
For example, if a portfolio has a delta sensitivity of $2 million to the 5-year EUR swap rate, and the prescribed risk weight is 1.1%, the weighted sensitivity is $2M x 1.1% = $22,000.
Step 2: Aggregate within buckets using prescribed correlations
Buckets group similar risk factors (e.g., all EUR interest rate tenors in one bucket). Within-bucket aggregation uses:
K_b = sqrt(sum_i sum_j rho_ij x WS_i x WS_j)
Step 3: Aggregate across buckets using three correlation scenarios
This is the innovative part of FRTB. The capital charge is computed three times:
- High correlation: rho x 1.25 (correlations increase in a rally)
- Medium correlation: rho (base case)
- Low correlation: rho x 0.75 (correlations decrease in stress)
The maximum of the three is the SbM charge for that risk class.
Why FRTB Changed the Approach:
- Old method used notional amounts — a $100M ATM option and a $100M deep OTM option had similar charges despite vastly different risk
- New SbM uses actual sensitivities, so charges reflect genuine risk exposure
- Three correlation scenarios capture the instability of correlations during market stress
Exam Tip: Know the seven risk classes, the three correlation scenarios, and the aggregation hierarchy (within bucket → across buckets → across risk classes). Also know that SbM covers delta, vega, AND curvature — not just delta.
Explore our FRM Part II FRTB materials for deeper coverage.
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