April 2019 Q1 iii c

[dazed and confused]

Hi all,

I'm confused by the examiner's report's answer to this question.

It says that "A widening of credit spreads... would lead to a reduction in the spread risk sub-module capital requirement."
That would imply that it would be the opposite, a narrowing of credit spreads, that would then be the "stress" scenario.

I thought that a widening of credit spreads should produce a positive SCR, and therefore in this case the capital requirement would increase.

Please could someone explain?

Thanks!

 

[Em Francis]

Hi all,

I'm confused by the examiner's report's answer to this question.

It says that "A widening of credit spreads... would lead to a reduction in the spread risk sub-module capital requirement."
That would imply that it would be the opposite, a narrowing of credit spreads, that would then be the "stress" scenario.

I thought that a widening of credit spreads should produce a positive SCR, and therefore in this case the capital requirement would increase.

Please could someone explain?

Thanks!

The fall in required capital is due to the lower market value being stressed. The market value of the bond has decreased due to the spread widening.
Hope this makes sense.

 

[ac1003]

Hi I don’t follow why changes in market value or exposure directly impacts the SCR. Because wouldn’t the base and stress move in the same way. So any changes to SCR are only if/when you change your stress (because of the higher risk/exposure)?

 

[Lindsay Smitherman]

SCR = Value at risk
Lower risk exposure -> less risk -> lower Value at risk -> lower SCR

If you want to break this down, let's use a simple example of holding 100 worth of corporate bonds with a 20% market value fall being the applied spread stress within the SCR module, and with BEL = 70 which we will assume is unchanged under the stress scenario (ie risk-free discount rates unchanged).

Base {assets - BEL} = 100 - 70 = 30
Stressed {assets - BEL} = 80 - 70 = 10
SCR = Base - Stressed = 30 - 10 = 20

So actually, SCR simply = 20% of the value of bonds (which makes sense: that is what we would 'lose' under the stress)

Now let's see what we get after the market value impact has actually happened, so we now have bonds worth 80. We have the same 20% stress and BEL = 70 still (since risk-free rates are unchanged).

Base {assets - BEL} = 80 - 70 = 10
Stressed {assets - BEL} = 64 - 70 = -6
SCR = Base - Stressed = 10 - -6 = 16

So again, SCR simply = 20% of the value of the bonds. But we now have a lower value of bonds to start with, so less exposure to risk and less to lose if the spreads widen.

Hope that helps.