Risk and Return - Essay Example

The general market risk reflects the modified duration and interest rate shocks for each maturity of the bond. Generally, the market risk charge for the risk calculation purposes is achieve through multiplying the negative and/or positive dollar value positions of each instrument is multiplied with the specific market charge of the each category of the instrument. However the BASEL accord maintain that the long and short positions in the same maturity buckets but in different instruments can not be offset to get a net position of the dollar value positions therefore there are vertical and horizontal charges for the each class of instruments lying in the same maturity bucket.

These vertical and horizontal offsets are included in the calculations for the total capital charge. The formula for the general market risk charge is “The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.” (Investopedia, 2008) As discussed above that the total capital charge involve the vertical and horizontal allowance since the instruments in the same maturity bucket but having different nature can not be offset as per the BASEL accord therefore basis risk is achieved through following formula: (You can calculate the basis risk on the same basis.

Please note that the figure under offset will be the smallest figure between longs and shorts. The disallowance factor can be obtained from the BASEL Site as I don’t know the disallowance factors for each category) The total capital charge is the sum of the specific charge, vertical disallowances, horizontal disallowances within the same time zones and between the time zones and the residual general market risk after all offsets. The