VaR Backtesting, DV01 Breach and Hedge Accounting
Treasury holds a RM500 million fixed-rate Malaysian government bond portfolio with a duration of 4.2 years. The desk hedges interest rate risk with a RM480 million pay-fixed interest rate swap. The one-day 99% VaR limit is RM12 million; current VaR is RM10.8 million. The DV01 limit is RM70,000 per basis point; the portfolio DV01 is RM85,000, and the swap DV01 is only RM68,000, leaving a net RM17,000 breach. Backtesting shows six exceptions in the last 250 days. Hedge effectiveness testing shows a dollar-offset ratio of 78%, a regression R-squared of 0.71 and a slope of 0.82. The CFO wants to keep hedge accounting and asks whether the excess can be treated as an approved exception. The CRO must decide what to report to the Asset-Liability Committee.
1. Interpret the backtesting result and the DV01 breach, and state the immediate risk actions.
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Six exceptions in 250 days at 99% is within the Basel yellow zone (5-9 exceptions), but it is not a pass. The model should be investigated for clustering, volatility and data quality; the VaR multiplier should be increased under the bank's policy and BNM expectations. Separately, the DV01 breach is a hard limit issue: net DV01 of RM17,000 per basis point is about 24% above the RM70,000 limit. The CRO should require the desk to reduce the under-hedge, either by increasing the swap notional or reducing bonds, unless a temporary limit exception is approved by ALCO with a remediation plan. A VaR reading of RM10.8 million below the RM12 million limit does not offset the DV01 breach because VaR is a statistical measure and DV01 captures a specific parallel-rate exposure. The ALCO pack should show both, plus stress tests for a 100 bp shift.
2. Assess whether the hedge can remain eligible for hedge accounting under MFRS 9.
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Under MFRS 9, hedge effectiveness is not assessed by the legacy 80-125% bright line. The bank must demonstrate an economic relationship, that credit risk does not dominate, and that the hedge ratio is consistent with risk management. A dollar-offset of 78%, regression R-squared of 0.71 and slope of 0.82 are weak: the hedge is under-hedging, and a slope below 1 suggests the swap does not track the bond. That does not automatically fail hedge accounting, but it requires rebalancing and a documented prospective assessment. The RM480 million swap against RM500 million bonds is a notional mismatch; the bank should adjust the hedge ratio or use a regression-based hedge. If the relationship cannot be supported, hedge accounting should be discontinued and the ineffectiveness recognised in profit or loss. The CFO's request for an approved exception is not a substitute for an effective hedge.
3. What should ALCO and the CRO do next, including reporting to the Board?
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ALCO should approve a 10-day plan to bring net DV01 within limit; require a VaR model review, including backtesting by desk and product; suspend any hedge-accounting designation until the effectiveness assessment is re-performed; report the limit breach and remediation to the Board Risk Committee; run a 100 bp and 200 bp stress on the bond and swap; and review the limit framework so VaR and DV01 limits are consistent. The CRO should not allow a permanent limit increase simply to accommodate the position. If the desk expects rates volatility, it should request a temporary limit with a clear expiry and capital impact. The Board should see the breach, root cause, customer or P&L impact, and the date the desk returned within limit.