2. Strictly Confidential
In November 2017 we considered a number of strategies on a typical IR portfolio and considered a number of
hedging strategies
• GBP portfolio referencing a couple of benchmarks and gilt curve, gilt futures, typical strategies across the
curve such as spreads and butterflies
• Smaller EUR portfolio across a couple of benchmarks
• Three legs of a AUD/GBP cross currency position in AUD 3M Libor, GBP 3M Libor and the AUD/GBP xccy
basis
• UK RPI inflation long-dated position hedged in the short-end
• USD isolated 3s 6s Libor position in the long-end
In March 2018 Basel Committee proposed a softening of the 0.75% correlation scenario for highly correlated
pairs, we have re-run the calculations to understand the impact of the change.
The overall impact is to reduce the charge by 28% and makes the single waterfall much more efficient with the
pairwise approach remaining the most efficient way to hedge the capital charge
Hedging FRTB SBA
This is the second in a series of analysis on how to create a hedging strategy for FRTB SBA
THE ANALYSIS PROVIDES EVIDENCE ON HOW TO CREATE AN EFFICIENT HEDGING STRATEGY
3. Strictly Confidential
Recap - The Portfolio is Unchanged
The portfolio has been designed to provide some insight on which positions carry a high capital cost to run.
There are 50 positions across a number of currencies, curves and maturity buckets (”Vertex”)
4. Strictly Confidential
Linear Approach – Old Correlation
First strategy is to start unwinding each holding in blocks of 1,000 DV01 until position is zeroed out
The curve against a straight line suggest a reasonable linear link between shaving off risk and the reduction in capital
charge. With less positions in the latter half there is a drop in efficiency
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5. Strictly Confidential
Linear Approach with New Correlation
New Correlation rule is: Max(2 corr - 1, 0.75 corr) that reduces impact of the 75% correlation on highly correlated pairs
The overall capital charge is 22% lower, the reduction in delta approach is less efficient compared to old approach
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6. Strictly Confidential
Waterfall Approach vs Linear Approach – Old Correlation
The waterfall approach neutralises the exposure that creates the largest reduction in the capital. Once neutralised, the
process is repeated
The results suggest the second strategy works well, but eventually flat-lines and becomes erratic
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Waterfall Approach– New Correlation
Comparison of the waterfall approach between old approach (Blue) and new approach (Purple)
The waterfall approach under the new correlation is initially more efficient, but becomes erratic towards the end
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8. Strictly Confidential
Pair-wise Waterfall – Old Correlation
The final approach takes all combination of pairs and calculates the impact of neutralising the risk. The pair that creates
the largest drop in capital is chosen and the exercise is then repeated with the smaller population.
This analysis suggest that all hedging strategies for FRTB need to view the portfolio as a collection of pairs of trades and
execute remediation along those lines.
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9. Strictly Confidential
Pair-wise Waterfall – New Correlation
The pair-wise strategy remains the most efficient way to manage capital. The new correlation provides a very efficient way
to reduce the capital by 90% but has a strange blip at the end that requires further analysis
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Comparison of the pair-wise waterfall approach between old approach (Blue) and new approach (Purple)
10. Strictly Confidential
Comparison in the Order of Hedging for Pair-wise Waterfall approach
Initially (light blue box) both approaches highlight the large and uncorrelated pairs to unwind, after that the sequencing
diverges dramatically
The Old Correlation (blue box) leaves short end instruments at the end, these are hedged earlier with new correlation.
The New correlation left some large Euribor positions to the end which destabilised the calculation
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OrderofhedgingforOldCorrelation
Order of hedging for New Correlation
GBP GILT 3
GBP Libor3M 3
GBP GILT 15
GBP LONG GILT FUT 15
GBP Libor3M 0.25
GBP Libor3M 2
GBP Libor3M 0.5
GBP Libor3M 1
GBP SHORT STERLING 0.25
GBP SHORT STERLING 0.5
GBP SHORT STERLING 2
GBP SONIA 0.5
EUR EURIBOR3M 5
GBP GILT 20
EUR EURIBOR6M 10
EUR EURIBOR3M 15
11. Strictly Confidential
Capital Charge Down
• Overall charge is down around 22%, reflecting the original over-charging of highly correlated positions such
as same currency/curve and near vertex. This is a welcome improvement
Waterfall efficiency up
• The new correlation enables better selection of positions to neutralise. The reduction of capital by 90%
happens much faster
Pair-wise waterfall a mixed bag
• Both approaches pick out the large and uncorrelated positions to hedge first. In any hedge strategy, these
should be the primary interest for a desk to manage their capital down
• After that the picture is more nuanced and is unclear after the first 10 trades (5 pairs) which approach is
most efficient
The three hedging strategies need to be sequenced in the following way:-
Conclusions
The portfolio used here is attempting to be representative of a small portfolio of GIRR instruments, but diverse enough to
allow us to make some conclusions:-
FOCUS ON THE FIRST
UNCORRELATED PAIRS
PICK OUT INDIVIDUAL
POSITIONS TO
NEUTRALISE
CONTINUE TO CHIP AWAY
AT DELTAS1 2 3
12. Strictly Confidential
Shearer Limited as to the accuracy, completeness or correctness of the
opinions, information and recommendations contained in this document
and any such liability is expressly disclaimed.
This document is not a service offering or a statement of work and is
hence not intended to be contractually binding.
Kerr Shearer is a limited company registered in England and Wales.
Registration number: 10920004. Address: H5 Ash Tree Court,
Nottingham, NG8 6PY.
This document has been prepared by Kerr Shearer Limited for the
sole purpose of providing a point of view or proposal for the recipient
and appropriate management to validate the overall capability of Kerr
Shearer Limited.
This document has been compiled by Kerr Shearer Limited and
includes material which may have been obtained from information
provided by various sources and discussions with management. No
representation or warranty, directly or indirectly, is given and no
responsibility or liability is or will be accepted by or on behalf of Kerr
David K Kelly
Director
E: risk@kerrshearer.co.uk
T: +4477 0326 2195
W: www.kerrshearer.co.uk
V: appear.in/kerr-shearer
