Document ID: chunk:federal_register_of_legislation:F2024L01519:body:0:p44
Version: federal_register_of_legislation:F2024L01519
Segment Type: other
Provision Reference: 
Character Range: 121843–124906

strategies, a rebalancing of the hedge within the liquidity horizon of the hedged position may also be recognised. Such recognition is only admissible if the ADI (i) chooses to model rebalancing of the hedge consistently over the relevant set of trading book risk positions, (ii) demonstrates that the inclusion of rebalancing results in a better risk measurement, and (iii) demonstrates that the markets for the instruments serving as hedge are liquid enough to allow for this kind of rebalancing even during periods of stress. Any residual risks resulting from dynamic hedging strategies must be reflected in the capital charge. An ADI must validate its approach to capture such residual risks to APRA's satisfaction.
Optionality

 1.          An ADI's IRC model must include the nonlinear impact of options and other positions with material nonlinear behaviour with respect to price changes. The ADI must also have due regard to the amount of model risk inherent in the valuation and estimation of price risks associated with such products.
Validation

 1.          In designing, testing and maintaining their IRC models an ADI must evaluate conceptual soundness and conduct ongoing monitoring, including process verification and benchmarking, and outcomes analysis. Some factors that must be considered in the validation process include:
        1.           liquidity horizons must reflect actual practice and experience during periods of both systematic and idiosyncratic stresses;

        2.           the IRC model for measuring default and migration risks over the liquidity horizon must take into account objective data over the relevant horizon and include comparison of risk estimates for a rebalanced portfolio with that of a portfolio with fixed positions;

        3.           correlation assumptions must be supported by analysis of objective data in a conceptually sound framework. If an ADI uses a multi-period model to compute incremental risk, it must evaluate the implied annual correlations to ensure they are reasonable and in line with observed annual correlations. An ADI must validate that its modelling approach for correlations is appropriate for its portfolio, including the choice and weights of its systematic risk factors. An ADI must document its modelling approach so that its correlation and other modelling assumptions are transparent to supervisors; and

        4.           owing to the high confidence standard and long capital horizon of the IRC, robust direct validation of the IRC model through standard back-testing methods at the 99.9 per cent/one-year soundness standard will not be possible. Accordingly, validation of an IRC model necessarily must rely more heavily on indirect methods including, but not limited to, stress tests, sensitivity analyses and scenario analyses, to assess its qualitative and quantitative reasonableness, particularly with regard to the model's treatment of concentrations. Such tests must not be limited to the range of events experienced historically. An ADI must agree its set