Further, a slew of regulatory measures, such as Basel III, Dodd-Frank and new accounting standards IFRS 13 and ASC 820 introduced under the International Financial Reporting Standards (IFRS) and US GAAP respectively, have been introduced to address the issue of counterparty credit risk.
IFRS 13, which became effective for annual periods commencing on or after 1 January 2013, requires that fair value be measured based on exit price. Market participants must consider credit risk in derivative valuations, for example, by calculating a debit valuation adjustment (DVA) or a credit valuation adjustment (CVA) on their derivatives. Exit price under IFRS 13 is the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Most market participants are able to rationalise the conceptual need for a CVA on their derivative assets after the financial crisis. However, many end users – principally corporates – have cited various reasons for finding it difficult to incorporate DVA in their derivative liability positions, including:
- The counterintuitive impact of recognising a gain in profit or loss as their own creditworthiness deteriorates.
- Difficulty or inability to monetise or obtain economic benefit from their own credit gain upon transfer or close-out of the derivative liability.
The difficulty in rationalising could be based on the notion to settle or otherwise fulfill the liability. It should be noted that an entity’s intention to hold an asset, or to settle or otherwise fulfill the liability, is not relevant when measuring fair value. The transfer notion under IFRS 13 is necessary for measuring fair value because it captures the market participants’ expectations, whereas a settlement notion considers entity-specific factors.
For example, a B-rated company sells a two-year European-style call option to a AA-rated counterparty bank. From the valuation perspective of the single call option instrument, it would incorporate the necessary market risk factors and also the credit risk of the B-rated company being the seller of the option.
Assuming all market participants, including the company, use the same valuation model, they would arrive at a single fair value for the instrument, with the counterparty bank booking it as an asset while showing it as a liability in the company books. However, had the company considered the fair value of the call option from a settlement perspective, it would have excluded its own credit risk. This is clearly not in line with the notion of IFRS 13, where fair value has to consider factors and assumptions in the same way that market participants would.
The standard is a principles-based standard and does not specify valuation methods to quantify CVA or DVA. As a result, various factors may influence the method an end-user chooses for estimating credit adjustments.
For corporate treasury functions, which have access to significant IT systems and to the support of quantitative experts, the method generally adopted would be the Expected Future Exposure (EFE) approach. This is considered the most advanced approach for calculating credit adjustments and is the most widely adopted by the banking sector.
This method approximates the expected future mark-to-market (MTM) value over the life of the derivative either through simulation-based or option-replication technique. The expected future MTM value, which is essentially the EFE profile, is then used to determine a CVA and DVA by applying counterparty and own probability of defaults (PDs), respectively.
Other alternative and less complex approaches for estimating credit risk exist and these approaches calculate CVA or DVA based on the current market value of the derivative, without simulating different possible future outcomes.
Other approaches calculate future exposure of a derivative based on current market information (such as forward rates), assessing whether the derivative is expected to be an asset or liability at several future dates. As these approaches do not reflect possible outcomes for the fair value in the future, they are generally referred to as current exposure methods (CEM).
Depending on the “moneyness” of the derivative, the CEM approach may result in significant adjustment to the derivative. For example, using the current market value of a 10-year interest rate swap (IRS) to compute own credit risk (assuming below investment grade) would result in significant DVA adjustment to the derivative. This approach assumes the current market value remain the same throughout the 10-year life of the IRS.
This is analogous to computing the cost of protection of buying a credit default swap to hedge the credit risk of a bond with fixed notional amount. However, such an approach has its limitation in the case of a derivative instrument; for example an IRS. The future MTM value of an IRS may not remain constant, may flip to asset or liability and would typically have its value trend towards zero as it realises the cash flow streams and approaches maturity.
It is well-known that Asian markets generally have a lack of credit information and it does not help that the standard requires entities to make maximum use of market-observable input, such as Credit Default Swap (CDS) spreads, publicly traded debt or loans. As we have seen, the general Asian corporate practice in selecting credit data can be illustrated with the flow chart below.
- Availability of market CDS
- Imply credit rating based on information derived from borrowings
- Comparison against comparable peers with credit information
- Selecting relevant comparable peers as proxies
- Depending on the choice of approach, credit spread or PD can be derived accordingly
It is worth mentioning that there are existing legal arrangements to mitigate credit exposure. Most end users have an existing master netting agreement – such as under the International Swaps and Derivatives Association (ISDA) – with their counterparty bank. Such a netting arrangement allows CVA or DVA to be assessed at a portfolio level, with the potential of reducing net exposure and correspondingly the computed adjustment.
For example, an end-user holds a long call option position and subsequently squares the position with a short call option. On a particular valuation date, prior to credit or debit adjustment, the long call option is valued at US$10,000 and the short call option at US$9,000. When evaluated on a standalone basis, CVA would be applied on the $10,000 and DVA on the $9,000. However, under a netting arrangement, CVA would be applied only at net exposure basis and in this example, the net exposure is $1,000.
Another credit mitigating arrangement is collateral arrangements, such as the non-mandatory credit support annex (CSA) under the ISDA document, which could reduce CVA or DVA. Many collateral arrangements do not require collateral to be posted until a certain threshold has been reached, such as credit exposed for valuation below the threshold. Finally, collateral arrangements may be either unilateral or bilateral. Unilateral arrangements require only one party to the contract to post collateral, whereas under bilateral agreements both counterparties are subject to collateral requirements – although potentially at different threshold levels.
The application of CVA and DVA requires a good quantitative understanding and also its application under the accounting standard such as IFRS 13. For companies that have not given much thought to this topic, it is recommended that the corporate treasury function starts working with the financial reporting function to present the fair valuation figures better to the readers of the financial statements.
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