FRTB – Scaling Risk to a Specific Liquidity Horizon

Overview:

The Fundamental Review of Trading Book (FRTB) has proposed liquidity horizons up to 120 days, depending on the risk factor. The main focus of this white-paper is on scaling one day risk to different liquidity horizons as proposed by FRTB. It also briefly discusses the problems associated with increasing the liquidity horizon to a longer term using square root time rule. Specifically, risk factors from different asset classes as specified in the FRTB are considered, and our proposed scaling using power law is compared empirically with the square-root-of time rule. For the risk factors under consideration, it is concluded that using square root of time results in higher regulatory capital requirements for longer horizons.