What is the Residual Risk Add-On under FRTB, and which exotic instruments are in scope?

The Residual Risk Add-On (RRAO) is a simple notional-based capital charge applied to instruments with exotic underlying risk drivers or bearing other residual risks that are not adequately captured by the Standardized Approach's delta, vega, and curvature risk charges.

Why RRAO Exists:

The SA's sensitivity-based framework captures first-order (delta), second-order (curvature), and volatility (vega) risks. However, exotic instruments carry risks that these sensitivities miss:

• Gap risk in barrier options
• Correlation risk in multi-asset products
• Behavioral risk in prepayable instruments
• Path-dependency risk in lookbacks and cliquets

Instruments in RRAO Scope:

Category	Examples	RRAO Rate
Exotic underlyings	Longevity risk, weather derivatives, natural catastrophe instruments	1.0% of notional
Other residual risks	Barrier options, digital options, Asian options, lookbacks, rainbow options, cliquets, autocallables, Bermuda swaptions beyond 1-year lockout	0.1% of notional

Calculation:

RRAO = sum over exotic-underlying instruments: (1.0% x Gross Notional_i) + sum over other-residual-risk instruments: (0.1% x Gross Notional_i)

No netting or hedging recognition is permitted. Long and short positions are both charged at their absolute notional.

Worked Example: Crestview Trading holds the following exotic positions:

Instrument	Notional	RRAO Category	Rate	Charge
Barrier calls on Thornbury Mining	$50M	Other residual	0.1%	$50K
Lookback puts on Apex 500 Index	$30M	Other residual	0.1%	$30K
Weather derivative (HDD swap)	$20M	Exotic underlying	1.0%	$200K
Autocallable on basket of 3 stocks	$80M	Other residual	0.1%	$80K
Catastrophe bond exposure	$15M	Exotic underlying	1.0%	$150K

Total RRAO = $50K +$30K + $200K +$80K + $150K = **$510K**

This is added to the SA or IMA capital charge.

Exemption Possibility:

National supervisors may exempt instruments from RRAO if the bank can demonstrate that:

• The instrument's residual risks are immaterial
• The risks are captured by internal hedging strategies recognized in the ES or DRC
• The bank has a comprehensive risk management framework for the specific exotic features

However, the exemption process is supervisor-dependent and generally difficult to obtain.

Interaction with IMA: RRAO applies regardless of whether the desk uses IMA or SA. Even an IMA desk must compute and add the RRAO for its exotic positions. This creates a meaningful incentive to reduce exotic exposure or simplify payoff structures.

Study FRTB capital components in our FRM Part II materials.