determining the fair value of the derivative liability. We believe this generally would
apply even if the LOC were deemed separable from the derivative contract. In our view,
including the effect of separable credit enhancements while excluding the effect of
inseparable credit enhancements would contradict the principles of IFRS 13.
11.3.2
Does IFRS 13 require an entity to consider the effects of both
counterparty credit risk and its own credit risk when valuing its
derivative transactions?
IFRS 13 addresses the issue of credit risk both explicitly and implicitly. As discussed
at 11.3 above, in relation to an entity’s own credit risk in the valuation of liabilities, the
guidance is explicit; the fair value of a liability should reflect the effect of non-
performance risk, which includes own credit risk.
The standard’s requirements are less explicit regarding counterparty credit risk. IFRS 13
requires the fair value of an asset or liability to be measured based on market participant
assumptions. Because market participants consider counterparty credit risk in pricing a
derivative contract, an entity’s valuation methodology should incorporate counterparty
credit risk in its measurement of fair value.
1012 Chapter 14
11.3.3
How should an entity incorporate credit risk into the valuation of its
derivative contracts?
As discussed at 11.3.2 above, IFRS 13 requires entities to consider the effects of credit
risk when determining a fair value measurement, e.g. by calculating a debit valuation
adjustment (DVA) or a credit valuation adjustment (CVA) on their derivatives.
As no specific method is prescribed in IFRS 13, various approaches are used in practice
by derivatives dealers and end-users to estimate the effect of credit risk on the fair value
of OTC derivatives.
The degree of sophistication in the credit adjustment valuation method used by a
reporting entity is influenced by the qualitative factors noted below. Estimation can be
complex and requires the use of significant judgement which is often influenced by
various qualitative factors, including:
• the materiality of the entity’s derivative’s carrying value to its financial statements;
• the number and type of contracts for derivatives in the entity’s portfolio;
• the extent to which derivative instruments are either deeply in or out of the money;
• the existence and terms of credit mitigation arrangements (e.g. collateral
arrangements in place);
• the cost and availability of technology to model complex credit exposures;
• the cost and consistent availability of suitable input data to calculate an accurate
credit adjustment; and
• the credit worthiness of the entity and its counterparties.
While the degree of sophistication and complexity may differ by entity and by the size and
nature of the derivative portfolio, any inputs used under any methodology should be
consistent with assumptions market participants would use. The complexity and judgement
involved in selecting and consistently applying a method may require entities to provide
additional disclosures to assist users of financial statements (see 20 below). 11.3.3.A to
11.3.4.B below provide further insights into some of the considerations for determining
valuation adjustments for credit risk on derivatives measured at fair value, except for which
a quoted price in an active market is available (i.e. over-the-counter derivatives).
In situations where an entity has a master netting agreement or credit support annex19
(CSA) with a counterparty, the entity may consider the credit risk of its derivative
instruments with that counterparty on a net basis if it qualifies to use the measurement
exception noted at 2.5.2 above (see 12 below for more detail on applying the
measurement exception for financial instruments with offsetting credit risks).
11.3.3.A
How do credit adjustments work?
In simple terms, the requirement for a credit adjustment as a component of fair value
measurement can be analogised to the need for a provision on a trade receivable or an
impairment charge on an item of property, plant and equipment. Whilst this analogy helps
conceptualise the requirement, the characteristics of derivatives mean that the calculation
itself can be significantly more complex than for assets measured at amortised cost.
Consistent with the fact that credit risk affects the initial measurement of a derivative
asset or liability, IFRS 13 requires that changes in counterparty credit risk or an entity’s
Fair value measurement 1013
own credit standing be considered in subsequent fair value measurements. It cannot be
assumed that the parties to the derivative contract will perform.
The terms of the asset or liability were determined based on the counterparty’s or
entity’s credit standing at the time of entering into the contract. In addition, IFRS 13
assumes a liability is transferred to another party with the same credit standing at the
measurement date. As a result, subsequent changes in a counterparty’s or entity’s credit
standing will result in the derivative’s terms being favourable or unfavourable relative
to current market conditions.
Unlike the credit exposure of a ‘vanilla’ receivable, which generally remains constant
over time (typically at the principal amount of the receivable), the bilateral nature of the
credit exposure in many derivatives varies, whereby both parties to the contract may
face potential exposure in the future. As such, many instruments may possibly have a
value that is either positive (a derivative asset) or negative (a derivative liability) at
different points in time based on changes in the underlying variables of the contract.
Figure 14.5 below illustrates the effect on the income statement and on the statement of
financial position of CVA and DVA adjustments as a component of fair value
measurement on a single derivative asset or liability.
Figure 14.5:
Accounting for CVA and DVA
Derivative asset
Derivative liability
CU
CU
example – CVA
example – DVA
Derivative
Risk-free derivative
100,000
Risk-free derivative
(100,000)
position valued
asset
liability
using the risk-free
curve (1)
Credit adjustment
Counterparty credit
(10,000)
Debit adjustment
5,000
required (2)
adjustment
based on own credit
Credit-adjusted
Derivative asset
90,000
Derivative liability
(95,000)
derivative position
Subsequent credit movements
Counterparty
A gain arises in the income
Own credit
A loss arises in the income
credit improves
statement and is reflected by a
improves
statement and is reflected by a
larger derivative asset in the
larger derivative liability in the
statement of
financial position
statement of financial position
Counterparty
A further CVA charge is
Own credit
A further DVA credit is required
credit deteriorates
required in the income
deteriorates
to the income statement and is
statement and is reflected by a
reflected by a reduced derivative
reduced derivative asset in the
liability in the statement of
statement of financial position
financial position
Notes:
(1)
The
table
represents a point-in-time during the life of a derivative asset or liability
(2)
For illustrative purposes, we have assumed the counterparty credit valuation adjustment is CU 10,000 and
the debit valuation adjustment is CU 5,000. These credit adjustments are not intended to reflect reality
1014 Chapter 14
11.3.3.B Valuation
methods
The determination of a credit adjustment can be complex. Part of the complexity stems
from the particular nature of credit risk in many OTC derivative contracts. Credit risk
associated with a derivative contract is similar to other forms of credit risk in that the
cause of economic loss is an obligor’s default on its contractual obligation. However, for
many derivative products, two features set credit risk apart from traditional forms of
credit risk in instruments such as debt:
• the uncertainty of the future exposure associated with the instrument – this is due
to the uncertainty of future changes in value of the derivative, as the cash flows
required under the instrument stem from: (a) movements in underlying variables
that drive the value of the contract; and (b) the progression of time towards the
contract’s expiry; and
• the bilateral nature of credit exposure in many derivatives, whereby both parties
to the contract may face potential exposure in the future – this can occur in
instruments, such as swaps and forwards, given the potential for these derivatives
to ‘flip’ from an asset to a liability (or vice versa), based on changes in the underlying
variables to the contract (e.g. interest rates or foreign exchange rates).
As previously noted at 11.3.3 above, IFRS does not prescribe any specific valuation
methods to quantify the impact of non-performance risk on derivatives’ fair value. IFRS 13
is a principles-based standard intended to provide a general framework for measuring fair
value. It was not intended to provide detailed application guidance for calculating the fair
value of various types of assets and liabilities. Likewise, IFRS 9 does not provide specific
valuation guidance related to derivatives. As a result, extensive judgement needs to be
applied, potentially resulting in diversity in the methods and approaches used to quantify
credit risk, particularly as it pertains to derivatives. As discussed at 11.3.3 above, a variety
of factors may influence the method an entity chooses for estimating credit adjustments.
In addition, the cost and availability of technology and input data to model complex credit
exposures will also be a contributing factor.
In recent years, some derivative dealers have started to include a funding valuation
adjustment (FVA) in the valuation of their uncollateralised derivative positions, as is
illustrated in Extract 14.1 at 20.2 below. FVA is included in order to capture the funding
cost (or benefit) that results from posting (or receiving) collateral on inter-bank
transactions that are used to economically hedge the market risk associated with these
uncollateralised trades. The methods for determining FVA can vary. As such,
determining whether these methods comply with IFRS 13 requires judgement based on
the specific facts and circumstances. A number of valuation adjustments have also
emerged in addition to CVA, DVA and FVA. Examples include self-default potential
hedging (LVA), collateral (CollVA) and market hedging positions (HVA), as well as tail
risk (KVA), collectively these are now referred to as X-Value Adjustments (XVA). It is
important to note that some of these valuation adjustments may be useful for internal
reporting, but may not be appropriate to use when measuring fair value in accordance
with IFRS 13. As noted above, the inputs used in measuring fair value must reflect the
assumptions of market participants transacting for the asset or liability in the principal
(or most advantageous) market at the measurement date.
Fair value measurement 1015
11.3.3.C Data
challenges
In addition to the method employed to determine a credit adjustment, the inputs used
in the various approaches can often require significant judgement. Regardless of the
method used, probability of default, loss given default (i.e. the amount that one party
expects not to recover if the other party defaults) or credit spread assumptions are
important inputs. While the sources of information may vary, the objective remains
unchanged – that is, to incorporate inputs that reflect the assumptions of market
participants in the current market.
Where available, IFRS 13 requires entities to make maximum use of market-observable
credit information. For example, credit default swap (CDS) spreads may provide a good
indication of the market’s current perception of a particular reporting entity’s or
counterparty’s creditworthiness. However, CDS spreads will likely not be available for
smaller public companies or private entities. In these instances, reporting entities may
need to consider other available indicators of creditworthiness, such as publicly traded
debt or loans.
In the absence of any observable indicator of creditworthiness, a reporting entity may
be required to combine a number of factors to arrive at an appropriate credit valuation
adjustment. For example, it may be necessary to determine an appropriate credit spread
using a combination of own issuance credit spread data, publicly available information
on competitors’ debt pricing, sector specific CDS spreads or relevant indices, or
historical company or sector-specific probabilities of default.
In all cases, identifying the basis for selecting the proxy, benchmark or input,
including any analysis performed and assumptions made, should be documented.
Such an analysis may include calculating financial ratios to evaluate the reporting
entity’s financial position relative to its peer group and their credit spreads. These
metrics may consider liquidity, leverage and general financial strength, as well as
comparable attributes such as credit ratings, similarities in business mix and level of
regulation or geographic footprint.
The use of historical default rates would seem to be inconsistent with the exit price
notion in IFRS 13, particularly when credit spread levels in the current environment
differ significantly from historical averages. Therefore, when current observable
information is unavailable, management should adjust historical data to arrive at its best
estimate of the assumptions that market participants would use to price the instrument
in an orderly transaction in the current market.
Figure 14.6 below high
lights some of the common sources of credit information and the
advantages and disadvantages of using each input for the credit adjustment calculation.
1016 Chapter 14
Figure 14.6:
Credit data requirements
Data requirements
Advantages
Disadvantages
CDS curve (own or
• Market observable
• Not available for many entities
counterparty)
• Information is current (for
• May not be representative of all the
counterparties with adequate CDS
assets of the entity
trading volume)
• May have liquidity issues due to low
• Easy to source from third party data
trading volumes, resulting in higher-than-
providers
expected spreads and additional volatility
• Exposure specific data available for
in calculations
most banking counterparties
• CDS quotes may be indicative quotes,
not necessarily reflective of actual trades
Current debt credit
• Market observable
• May require an adjustment for illiquidity
spread
• Available for some publicly traded
• May require a judgemental adjustment
debt instruments
due to maturity mismatch and amount of
• Easy to source from third party data
security of debt issuance and derivative
providers
to be valued
Sector-specific CDS
• Market-observable
• Not exposure-specific; may require
Index or competitor
• Information is current
judgemental adjustments to reflect
CDS Curve
• Easy to source from third party data
differences between proxy and entity
providers
(e.g. size, credit rating, etc.)
• Proxy CDS curve mapping is possible
• Index CDS curves can be influenced by
for almost all entities
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 200