The consultation, which runs until 22 June 2016, seeks input on Guidelines which aim to establish what type of adjustments to the modified duration (MD) - as defined according to the formulas in the Capital Requirements Regulation (CRR) - have to be performed in order to appropriately reflect the effect of the prepayment risk. The CRR establishes two standardised methods to compute capital requirements for general interest rate risk. The first is the maturity-based calculation for general interest risk, while the other one is the duration-based calculation of general risk.
The draft Guidelines are relevant for institutions applying the duration-based calculation, and propose two approaches to correct the modified duration calculation. The first approach treats the instrument with embedded optionality as if it were a combination of a plain vanilla bond and an option whilst the second approach proposes to calculate directly the change in value of the whole instrument subject to prepayment risk. The Guidelines also propose to compute additional adjustments to reflect the negative convexity as well as transaction costs and any relevant behavioural factors that may affect the modified duration of the instrument.