19. Hedging

For the purpose of calculating the IRC, institutions may net long and short positions only when they refer to strictly identical financial instruments.

Diversification effects associated with long and short positions may only be recognised by explicitly modelling gross long and short positions in the different instruments. In any case, institutions should demonstrate that diversification or hedging effects are not overestimated; in particular maturity mismatches should be reflected in models.

In order to reflect basis risk appropriately, where this risk is material, valuation for the purposes of the IRC for related positions (like, for example, bonds and CDSs

16 on the same obligor) should be differentiated. Thus, net long and net short positions that reference similar - but not identical - underlying assets should not result in an IRC measure equal to zero. Where basis risk is not accounted for, institutions should provide proof that this risk is not material.

Institutions should reflect the impact within the liquidity horizon of maturity mismatches between long and short positions (for example if a CDS matures before the underlying bond and the default happens after the CDS maturity), if the resulting risks are material. Therefore, an institution should be able to compute the P&L taking into account the impact of potential maturity mismatches between long and short positions. An institution should at least be able to prove that the above-mentioned risk is not a material risk, otherwise it should have to model the risk accordingly.