IVSC draft guidance on counterparty and own credit risk in valuations

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05 Dec, 2013

The International Valuation Standards Council (IVSC) has published an exposure draft which would provide guidance on the determination of fair value under IFRS 13 'Fair Value Measurement', and for other purposes. The draft paper focuses on how counterparty credit risk and own credit risk are taken into account in the measurement of certain financial assets and financial liabilities measured at fair value.

The exposure draft, Credit and Debit Valuation Adjustments, if finalised, would result in the issue of an IVSC Technical Information Paper (TIP). Such papers are designed to provide guidance on approaches that may be suitable but will not prescribe or mandate the use of a particular approach in any specific situation.

IFRS 13 requires that the fair value of a liability reflect the effect of non-performance risk, which includes, but may not be limited to, an entity's own credit risk, which is referred to as a 'Debt Valuation Adjustment' (DVA) in the exposure draft. In addition, consideration of counterparty credit risk is relevant to the measurement of derivative financial instruments measured at fair value under IFRS 9 Financial Instruments or IAS 39 Financial Instruments: Recognition and Measurement, and the paper refers to this as a 'Credit Valuation Adjustment' (CVA).

The exposure draft is designed to provide clarification on the terminology used in regards to CVA and DVA and the underlying concepts, insights on how complex valuation challenges related to CVA and DVA are addressed by entities with larger or more complex derivative portfolios, and generally accepted practice suggestions for entities with smaller and less complex derivative portfolios.

In relation to CVA, the paper explores the key differences between loan arrangements and derivatives, which include:

  • derivatives tend to have a very small credit risk at inception
  • credit risk exposure can switch between counterparties over the life of the derivative
  • potential variability of cash flows can be much greater due to being linked to a much larger notional amount and the underlying which can be volatile
  • the impact of netting in the event of a default, and identifying when a default event has occurred.

The paper notes that accounting requirements and higher capital requirements proposed by Basel III have led to market participants incorporating counterparty credit risk into trade pricing. However, in practice a wide range of derivative quotes are evident in the market, which the paper suggests result from other exposures to a counterparty, non-representative CVA being charged and differences in valuation techniques. The paper concludes that "CVA charges are based on many assumptions and unobservable parameters and as a result may not correctly capture the full credit risk of a counterparty", and may not "consider scenarios where unexpected losses may occur".

The paper outlines a technical analysis of how expected exposures, master netting agreements and collateral, and CVA hedging arrangements (e.g. credit default swaps and contingent credit default swaps) impact valuation.  It then outlines a valuation methodology which references key inputs (e.g. default probabilities, expected exposures, and loss given default assumptions), modelling approaches to calculate CVA (which may depend on the type of exposure), reconciliations to calibrate to market value, and scenario analyses (often using Monte Carlo valuation techniques). In terms of DVA (own credit risk), the paper outlines the difficulties of 'monetisation' of DVA, which may be determined by considering termination, default or hedging. The practical application of the various methods and models in various situations are also provided.

The paper also outlines a number of topics where continuing debate between academics and practitioners means that generally accepted principles or procedures have not developed, including the cost of funding used in the Funding Valuation Adjustment (FVA) (used to adjust the measurement of derivatives to reflect an entity's funding cost), links and interactions between CVA, DVA and FVA, and the impact of the bilateral nature of derivatives on valuations (where the default of one counterparty can impact the risk of default of the other).

In relation to the requirements of IFRS 13, the paper notes:

While fair value as defined in IFRS 13 is based on the assumption of a market transaction and therefore is generally consistent with the definition of market value in the [International Valuation Standards], it is intended as an accounting measure that can be applied consistently across different accounting standards, is compatible with requirements in other standards and that can be applied by a wide range of different types of entity. IFRS 13 fair value does therefore require some assumptions and hypotheses that might not be applicable when estimating market value for a purpose other than financial reporting

The exposure draft is open for comment until 28 February 2014. Click for access to the exposure draft (link to IVSC website).

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