What is the Residual Risk Add-On (RRAO) under FRTB and which instruments trigger it?
I'm studying FRTB for FRM Part II and I see that besides the SbM and DRC, there's a Residual Risk Add-On. It seems like a catch-all for exotic risks. Which instruments trigger the RRAO, how is it calculated, and can it be waived?
The Residual Risk Add-On (RRAO) is the third component of the FRTB Standardized Approach capital charge. It acts as a safety net for risks that are not adequately captured by the sensitivities-based method (SbM) or the Default Risk Charge (DRC) — essentially covering 'exotic' or 'complex' payoffs.
Why RRAO Exists
The SbM captures delta, vega, and curvature risk — which works well for vanilla products. But some instruments have risks that don't fit neatly into these categories:
- Correlation risk (e.g., correlation trading portfolios)
- Gap risk (discontinuous payoffs)
- Behavioral risk (e.g., mortgage prepayment)
- Other path-dependent or non-linear risks
Which Instruments Trigger RRAO?
The RRAO applies to instruments bearing risks not captured by SbM at two prescribed rates:
| RRAO Rate | Instrument Types |
|---|---|
| 1.0% of notional | Instruments with exotic underlying: longevity risk, weather derivatives, natural disaster derivatives, future realized volatility (as opposed to implied vol) |
| 0.1% of notional | Instruments bearing other residual risks: correlation trading (CDO tranches, nth-to-default), gap risk (barrier options, digital options), prepayment-sensitive instruments |
Calculation
RRAO = sum of (Gross Notional x Applicable Rate) across all qualifying instruments
Example:
Stonebridge Trading's exotic desk holds:
| Instrument | Notional | RRAO Rate | RRAO Charge |
|---|---|---|---|
| Weather swap (HDD) | $50M | 1.0% | $500,000 |
| Longevity swap | $200M | 1.0% | $2,000,000 |
| Barrier option (knock-in) | $80M | 0.1% | $80,000 |
| CDO mezzanine tranche | $120M | 0.1% | $120,000 |
| Digital option (binary) | $30M | 0.1% | $30,000 |
| Total RRAO | $2,730,000 |
Can RRAO Be Waived or Reduced?
National regulators have discretion to waive the RRAO for specific instruments if the bank can demonstrate that:
- The instrument's risks are adequately captured by the SbM
- The bank has robust internal models for the specific risk
- The instrument is not truly exotic (some regulators may classify certain barriers differently)
However, in practice, most regulators apply the RRAO conservatively.
Interaction with IMA
Banks using the Internal Models Approach (IMA) for FRTB do not need to compute RRAO — the IMA's expected shortfall and stress testing are assumed to capture residual risks. The RRAO is only required under the Standardized Approach.
Exam Tip: Be able to identify which instruments fall under the 1.0% vs. 0.1% category. The key distinction is: exotic underlyings (weather, longevity, catastrophe) get 1.0%, while complex payoff structures on standard underlyings (barriers, digitals, correlation) get 0.1%.
For more FRTB content, check our FRM Part II practice section.
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