A Model Implementation of Incremental Risk Charge

Abstract: Abstract In 2009 the Basel Committee on Banking Supervision released the final guidelines for computing capital for the Incremental Risk Charge, which is a complement to the traditional Value at Risk intended to measure the migration risk and the default risk in the trading book. Before Basel III banks will have to develop their own Incremental Risk Charge model following these guidelines. The development of such a model that computes the capital charge for a portfolio of corporate bonds is described in this thesis. Essential input parameters like the credit ratings of the underlying issuers, credit spreads, recovery rates at default, liquidity horizons and correlations among the positions in the portfolio will be discussed. Also required in the model is the transition matrix with probabilities of migrating between different credit states, which is measured by historical data from Moody´s rating institute. Several sensitivity analyses and stress tests are then made by generating different scenarios and running them in the model and the results of these tests are compared to a base case. As it turns out, the default risk contributes for the most part of the Incremental Risk Charge.