Fair Value Methodologies: what treasury should know

With International Financial Reporting Standards (IFRS) having adopted IFRS 13 in 2013, as well as increased scrutiny under Basel III capital adequacy rules, Fair Value methodologies and their related credit/debit valuation adjustment (CVA/DVA) has become an important topic. Treasurers around the world now have the benefit of learning from the experiences of their colleagues in Europe and the US, before the time that calculating these measures for hedging transactions becomes mandatory in their region.

What is CVA/DVA?

Historically, the mark-to-market (MTM) value of a derivative was determined by discounting cash flows using the LIBOR (London Inter-bank Offered Rate) curve, whose credit profile roughly corresponds to a large, AA-rated bank – essentially, although not quite risk-free. Since the 2008-09 global financial crisis (GFC) however, accounting and regulatory bodies have realized that the true MTM of a transaction must incorporate the possibility of losses due to default. CVA/DVA is the market value of the possibility of loss.

CVA refers to loss if your counterparty defaults – in the case of a derivative in the money from your perspective, it will reduce the MTM of the asset. DVA refers to your counterparty’s loss if you default: in the case of a derivative out of the money, it will reduce the MTM of the liability:

CVA DVA
Applied if …derivative is currently an asset …derivative is currently a liability
Based on … counterparty’s credit …your own credit
Impact on LIBOR based MTM … reduces value of asset … reduces value of liability
Impact on income statement …loss …gain

Why is it important?

Even if your accounting standards today do not require derivative MTM to incorporate CVA/DVA, there are several reasons for being aware of these measures:

  • Credit risk measure: As the GFC proved, not all counterparties are created equal. The CVA provides treasurers with an objective and quantitative method to differentiate derivative counterparties.
  • Price transparency: Your counterparty banks are most likely required to hold capital driven by your credit risk (the DVA from your perspective), and will pass the cost to you as a component of the spread they charge in originating derivative transactions. Knowing this value and how it is calculated becomes an important aspect of trade negotiation.
  • Accounting compliance: Accounting standards worldwide are requiring credit risk to become an input into derivative MTMs. In line with the US in 2007, and IFRS 13 in 2013, there is little doubt that Asian accounting standards will require CVA/DVA to be included in derivative MTMs in the near future; especially when one bears in mind that Asian accounting standard boards are already converging with IFRS.
  • Portfolio optimisation: Calculating CVA at the portfolio level could allow treasurers to discover that novating trades to a less-risky counterparty could actually result in income statement gains, as the CVA is reduced.

How is CVA/DVA calculated?

Although accounting standards require the incorporation of counterparty credit risk into derivative MTM values, they do not proscribe which method to use. Over time, two different methods have become prevalent:

  • Potential Future Exposure (PFE)-based methods: These methods model the future MTM of a derivative trade by using Monte Carlo simulations of market data that underlie a derivative MTM to create a distribution of future values. The CVA/DVA is derived by applying both your own and the counterparty’s default probabilities (derived from credit default swap (CDS) spreads) to the distribution, depending on whether the simulated value is negative or positive.This is the most quantitatively complex method of calculating CVA/DVA, and is considered to be the most accurate since it recognises that a derivative which is an asset today may become a liability in the future. Traditionally, this calculation has required significant systems and was only used by larger financial institutions; more recently, however, access to PFE-based CVA/DVA calculations has become more common and is available to corporations as well as banks.
  • Current Exposure-based methods: These methods calculate the CVA/DVA based only on the current market value or current market information (such as interest rate curves or forward rates). Although easier to implement, in certain situations, audit firms have opined that current exposure methods do not accurately reflect the market value of counterparty credit risk.
    Whatever method you choose, be sure to check with your auditors on the appropriateness of the method given your firm’s specific situation.

What impacts the CVA/DVA?

Regardless of the calculation method you choose, the following factors will most impact CVA/DVA:

  • Credit-worthiness (of your counterparty and your firm): obviously, as credit worthiness deteriorates, the impact of CVA/DVA increases. In fact, during the GFC and after, some institutions reported material gains on their derivative contracts as their own credit fell, reflecting the impact of DVA.
  • Time to maturity: the longer tenor of a derivative transaction, the greater likelihood of an adverse credit event occurring. As author Chuck Pahlaniuk wrote: “On a long enough time line, the survival rate for everyone drops to zero.”
  • Notional: the larger the transaction notional, the larger the CVA/DVA. Bear in mind, however, that the CVA/DVA expressed as a percentage of notional will remain constant.

The following graph illustrates the enormous impact these factors have on the CVA calculation, for example. The graph shows the value of CVA (in millions of US dollars) as calculated by Bloomberg on a US$100m Fix/Float swap with increasing maturities and with three representative counterparties with five year CDS spreads as detailed below:

Counterparty 1 (best credit) 45 bps
Counterparty 2 (median credit) 75 bps
Counterparty 3 (worst credit) 208 bps

Bloomberg 1

 

Our analysis shows that the CVA on a five-year swap with a relatively high-rated counterparty is approximately $100,000: meaning that the risk-free MTM of the swap is reduced by $100,000. A 30- year swap with the same counterparty is more than 10X greater at $1.4m; however, the same 30- year trade with a relatively low-rated counterparty is $3.7m! When all other factors in the hedging decision are equal, treasurers should look to transact short-dated trades with highly-rated counterparties to minimise the CVA/DVA impact.

What can you do?

Given the material impact credit-related valuation adjustments can have on their derivative MTM, treasurers will need to plan now before they are forced to act by accounting boards or regulators.

  • Review your valuation tools to determine whether they are capable of calculating CVA/DVA. In addition, they should be able to keep up as calculation standards change. For example, audit firms have recently asked their clients to incorporate the concept of “bilateral” credit valuation adjustments, which essentially nets the CVA/DVA together.
  • Ensure that credit risk mitigants are in place with your counterparty banks. These include collateral/credit support agreements and International Swaps and derivatives Association (ISDA) master netting agreements.
  • Discuss options with your auditors. In some cases, an auditor may determine that CVA/DVA will be immaterial – due, perhaps, to credit mitigants being in place or a relatively small derivative book. Auditors will request, however, that the firm make an effort to prove the immateriality of credit adjustments.
  • Above all, be prepared: the calculation of CVA/DVA will become a key part of your derivative and hedging processes in the years ahead.

A shorter version of this article was previously published in the Bloomberg Treasury Brief.

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