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Market Risk and Volatility Weighted Historical Simulation After Basel III

Jean-Paul Laurent () and Hassan Omidi Firouzi ()
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Jean-Paul Laurent: PRISM Sorbonne - Pôle de recherche interdisciplinaire en sciences du management - UP1 - Université Paris 1 Panthéon-Sorbonne
Hassan Omidi Firouzi: LABEX Refi - ESCP Europe - Ecole Supérieure de Commerce de Paris

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Abstract: Regulatory capital requirements for market risk, also known as the Fundamental Review of the Trading Book (FRTB), were disclosed by the Basel Committee on January 2016. This major overhaul of the Basel 2.5 framework challenges risk model specification and backtesting. Given the prevalence of historical simulation approach within large financial institutions, we focus on the Filtered (Volatility Weighted) Historical Simulation (VWHS) approach associated with a EWMA volatility filter. Volatility dynamics is then directed by a single parameter. We discuss how this decay parameter, chosen within a reasonable range, at banks' discretion, impacts capital metrics, backtesting statistics, as prescribed by the Basel Committee, and fouls the regulatory benchmarking of internal risk models. We show a trade-off between the resilience of risk models to periods of turmoil and the magnitude of capital metrics. Under the new regulatory rules, this would favour plain historical simulation, as compared with filtered or volatility weighed historical simulation. Understanding why, might be helpful for regulated banks, regarding the management of their market risk models, and supervisors involved in internal model approval.

Keywords: Basel III; Fundamental Review of the Trading Book; Market Risk; Historical Simulation; Backtesting; Capital Requirements (search for similar items in EconPapers)
Date: 2022-05-26
New Economics Papers: this item is included in nep-fmk and nep-rmg
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