The PRIIP Regulation will bring significant challenges for the investment sector. As explained in our first blog post about this topic, there is an urgency as firms are preparing for the regulatory changes. The Regulatory Technical Standards (RTS) that were published in April this year include calculation details for the various indicators that need to be measured to define the overall risk class. Because of the high complexity in defining and calculating the required risk indicators, we decided to collect and present regulatory details and impacts within this and following blog posts.

Since 2011 the asset management industry is already dealing with Key Investor Information Documents (KIIDs) under the UCITS (Undertakings for the Collective Investment in Transferable Securities) regulation. These documents include a Synthetic Risk and Reward Indicator (SRRI). The UCITS KIIDs are currently exempt from the need to produce KIDs for PRIIPs. The replacement is planned for January 1st 2020. Similar to the SRRI, the KID for PRIIPs will also contain a risk indicator, the SRI (Summary Risk Indicator). This indicator is a combination of a Market Risk Measure (MRM, range: 1 [low risk] to 7 [high risk]) and a Credit Risk Measure (CRM, range: 1 [low risk] to 6 [high risk]). As the PRIIP regulation refers to a wide universe of products the regulator classified those into 4 Categories. The MRM is calculated differently depending on the category of the PRIIP, so let’s have a look at those categories.

Different PRIIP Categories

PRIIPs are separated into 4 categories depending on the structure of the PRIIP (for the exact definition please refer to the Annexes to the Regulatory Technical Standards (RTS) about Key Information Documents (KIDs) for PRIIPs on page 5 and 6).

  • Category 1 includes products in which the loss may be higher than the capital invested or products (or their underlyings) not fulfilling certain requirements on the availability of historical prices and/or pricing frequency
  • Category 2 consists of products offering non-leveraged exposure to the prices of underlying investments (or leveraged but with constant multiples) with certain requirements on the availability of historical prices.
  • Category 3 includes products offering leveraged exposure to the prices of underlying investments (but not with constant multiples) with certain requirements on the availability of historical prices.
  • Category 4 is used for PRIIPs which are dependent on factors that cannot be observed in the market like insurance-based products distributing a portion of the PRIIP manufacturer’s profits to retail investors.

Standard unit linked products unlike structured products will thus get assigned to Category 2. So to not go beyond the scope of this article we will here present first insights about the MRM definition for the KIDs for PRIIPs assigned to Category 2.

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Calculation of VaR-equivalent Volatility (VEV)

The MRM Class is assigned according to the Value-at-Risk equivalent annualised Volatility (VEV), which is calculated using the 97.5% confidence level.

Before explaining the exact calculation methodology for estimating the MRM for Category 2 PRIIPs, it is important to talk about the timeframes and required input data. The calculation has to take place when new prices are published, at the minimum on a monthly basis (otherwise the PRIIP is Category 1 or 4). In case daily prices are available, the MRM class must be checked and recalculated on a daily basis, the same applies in respect to weekly or bi-monthly prices.

Depending on the frequency of the price determination, the minimum historical data requirements are as follows:

  • Daily prices -> 2 years
  • Weekly prices -> 4 years
  • Bi-monthly or monthly prices -> 5 years

In case more data as required is available, all data exceeding the minimum until 5 years should be included in the calculation. Just in case the minimum data requirements cannot be fulfilled, you may use representative benchmarks or proxies to meet the data requirements. In case this is not possible, the PRIIP is automatically Category 1 and the MRM Class is 6.

Under consideration of the data requirements, the VEV calculation demands the usage of continuous returns. In contrast to linear and discrete returns, continuous returns are calculated using the natural logarithm. Learn more about the differentiation in one of our last Blog Posts.

The exact formula for the VEV for Category 2 PRIIPs is:

    \[VEV = \frac{\sqrt{3.842 - 2 * VaR} -1. 96}{\sqrt{T}}\]

While the VaR (RETURN SPACE) is calculated using the Cornish Fisher expansion as follows:

    \begin{flalign*} &VaR= \\ &\sigma\sqrt{N} * (-1.96 + 0.474 * \frac{\mu_{1}}{\sqrt{N}} - 0.0687 * \frac{\mu_{2}}{N} + 0.146 * \frac{\mu_{1}^2}{N}) - 0.5\sigma^2N \end{flalign*}

Next to the number of trading periods in the recommended holding period (N), the formula includes the volatility, skew and kurtosis (\sigma, \mu_{1} and \mu_{2}) which can be measured from the return distribution. Using the VaR and the length of the recommended holding periods in years (T), one can easily calculate the VEV.

An exception from the explained process can be found when it comes to PRIIPs invested in different financial asset classes (e.g. equities and bonds). For those PRIIPs the VEV of the pro-forma asset mix and (if available) the VEV according to the risk limit of the fund have to be considered next to the VEV calculated using the methodology explained above.

Assigning MRM class based on the VEV

After the VEV calculation there is just one last step that needs to be taken into account when it comes to the MRM class definition. In case the calculation is based on monthly price data, the MRM class assigned is based on the table below increased by one additional class. Is the calculation based on more frequently price data, the MRM class can be assigned as given in the table.

MRM classAnnualised volatility (VEV)
1< 0.5 %
20,5 % - 5.0 %
35.0 % - 12 %
412 % - 20 %
520 % - 30 %
630 % - 80 %
7>80 %

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