The European Banking Authority published translations of the final Guidelines on the correction required for the calculation of Modified Duration for debt instruments subject to prepayment risk under the Capital Requirements Regulation. The Guidelines will apply from March 1, 2017.

The CRR establishes two methods to calculate capital requirements for general interest rate risk. The relevant methods are the Maturity-Based calculation and the Duration-Based calculation of general risk. The final Guidelines apply to the Duration-Based calculation. The Duration-Based calculation uses the concept of Modified Duration pursuant to the formula outlined in the CRR. This method is only valid for instruments that are not subject to prepayment risk. The EBA is mandated to issue guidelines establishing how to correct the Modified Duration calculation to reflect prepayment risk. The EBA Guidelines propose two approaches to correct the calculation. One option is to treat the debt instrument with prepayment risk as if it is a combination of a plain vanilla bond and an embedded option. The Modified Duration of the plain vanilla bond is therefore corrected with the change in value of the embedded option, which is estimated according to its theoretical delta, resulting from a 100 basis point movement in interest rates. The other option is to directly calculate the change in value of the whole instrument subject to the prepayment risk resulting from a 100 basis point movement in interest rates.

View the Guidelines.