Fair-value accounting for CVA

Schubert, Dirk. Risk 24. 1 (Jan 2011): 111-115.

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Banks are required to measure the fair value of over-the-counter derivatives trades under International Accounting Standard (IAS) 39, which includes the recognition of fair-value adjustments due to counterparty risk. Accounting rules are clear: the measurement and recognition of credit value adjustment (CVA) is mandatory. But IAS 39 does not specify how to evaluate CVA. This article will show how the measurement of CVA under IAS 39 implies the use of market rates to evaluate counterparty credit risk. The application of market rates under IAS 39 in turn implies active hedging and management of CVA. This fair-value structure imposes restrictions on pricing models, as the CVA component can now be seen to require an option model. Pricing models that do not assume such modeling setups -- such as discounted cashflow models without discontinuities of cashflows in case of default -- may therefore not be compliant with IAS 39.

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Headnote Banks are required to recognise fair-value adjustments for credit value adjustment under International Financial Reporting Standards, but the rules are extremely complex. In the first of a two-part article, Dirk Schubert explains the boundary conditions that need to be considered Banks are required to measure the fair value of over-the-counter derivatives trades under International Accounting Standard (IAS) 39, which includes the recognition of fair-value adjustments due to counterparty risk. Accounting rules are clear: the measurement and recognition of credit value adjustment (CVA) is mandatory.1 But IAS 39 does not specify how to evaluate CVA.2 Despite this, it is possible to determine the appropriate accounting treatment by considering three concepts simultaneously: common fair-value measurement practices, impairment rules and finance theory. These can be thought of as boundary conditions to establish the correct treatment - but it is not straightforward. This article will show how the measurement of CVA under IAS 39 implies the use of market rates to evaluate counterparty credit risk. The application of market rates under LAS 39 in turn implies active hedging and management of CVA. Three boundary conditions Figure 1 illustrates the three boundary conditions for CVA that have to be fulfilled for IAS 39, and should be considered to achieve consistency.

* IAS 39 requirements for non-defaulted derivatives: under IAS 39, the fair-value hierarchy (IAS 39.48A) has to be considered to determine CVA. For this purpose, own credit risk spreads also have to be taken into account. Since the use of the fair-value hierarchy to gauge CVA implies the application of market credit spreads and commonly used pricing models, there is a link to economic hedging. * Fair value considerations and economic hedging: the starting point is represented by martingale pricing approaches (risk-neutral pricing), which are commonly used to compute the fair value of derivatives. Within these theoretical approaches, pricing and hedging come together - so the hedging costs equal the price of the underlying. It follows that market participants who do not take CVA (pricing of counterparty risk) into account buy or sell at prices too high or too low - and other participants can exploit this and lock in a riskless profit. As a consequence, the assumption of an absence of arbitrage forms the basis for the determination of CVA under IAS 39. * The connection between IAS 39 requirements for impaired derivatives and CVA: the calculation of the CVA for non-defaulted derivatives should converge to the impairment amount considered under IAS 39 if the counterparty defaults - so convergence implies the application of consistent approaches in the defaulted and non-defaulted cases. The amount accounted for as CVA should be approximately the same as the impairment amount in the event of a default to avoid large jumps in the profit and loss (P&L) statement. The consistency stems from the fact that any hedge for counterparty risk - either a credit default swap (CDS) or contingent credit default swap (CCDS) - is expected to almost fully offset the losses in the case of a default. Connection between IAS 39 requirements for impaired derivatives and CVA The following section shows that financial accounting for defaulted derivatives defines a major criterion for determining CVA in the non-defaulted case. In the following example, it is assumed an interest rate swap is transacted under an International Swaps and Derivatives Association master agreement. In case of default, the

Isda documentation stipulates a replacement cost approach, and offers two possibilities: the market quotation or loss approach. From the perspective of International Financial Reporting Standards (IFRS), the following steps have to be performed to account for defaulted derivatives: * Derecognition of the present value of the interest rate swap (fair value) before default, since the derivative ceases to exist. * If the present value of the derivative is positive, a receivable against the counterparty is recognised on the balance sheet, which represents the claim against the defaulted counterparty in a Chapter 11 procedure. Otherwise, a liability is recognised. The carrying amount equals the replacement cost using the market quotation or loss approach. * Measurement. * If this results in a liability, then the carrying amount remains unchanged. * Application of IFRS impairment rules (IAS 39.63 in connection with IAS 39.AG84) for the receivable against the counterparty. * Estimation of the recovery rate of the interest rate swap (using the result of the CDS auction procedure). * Impairment recognised in the P&L. Inferences from impairment requirements In case of default, the impairment amount under IAS 39 is derived from current market value (present values) without credit risk (discounting using an AA- swap curve). This rules out simplified counterparty exposure metrics involving potential future exposure (PFE) for the evaluation of CVA, since these modelling approaches measure quantiles of future mark-to-market distributions, which are similar to value-at-risk concepts.3 Using PFE would imply that, in case of default, the expected market value equals the current market value plus the quantiles of future mark-to-market distribution(s) - so PFE cannot be an estimate of the expected market value in the event of a default. Consequently, exposure measures such as the add-on approach (the current mark-to-market value plus PFE add-ons) are not compliant with CVA measurement under IAS 39, as they do not rely on the entire mark-to-market distribution. Payout profile in default Consider the following example of an interest rate swap between party A and B. The carrying amount of an asset or liability after the default can be defined as follows, assuming party A accounts for the default of party B (see table A).

If the present value (PV) is positive, then party A receives the positive present value of the IRS PV^sub A^ (IRS)+ multiplied by the recovery rate of party B (Rec^sub B^). If the present value is negative (PV^sub A^ (IRS)), it represents a liability. This is similar to a (counterparty default) option payout profile - similarly, an own default option profile can be derived - introducing an optionality component into the determination of CVA under IAS 39- Consequently, two parties entering into a vanilla fixed-to-floating interest rate swap implicitly sell a default option to each other. The CVA can be regarded as the value of these implicit options.4 Furthermore, neglecting the implicitly granted default options for the determination of fair values leads to arbitrage opportunities, as they impact the fair value. This optionality property is also exploited in connection with pricing models, and suggests the following fair-value structure in order to take counterparty credit risk into account: Fair value including counterparty risk = fair value without counterparty risk +/- CVA, where CVA is defined as: CVA = fair value adjustment counterparty risk (counterparty default option)

- fair value adjustment own credit risk (option on own default) Significantly, this fair-value structure imposes restrictions on pricing models, as the CVA component can now be seen to require an option model. Pricing models that do not assume such modelling set-ups - such as discounted cashflow models without discontinuities of cashflows in case of default - may therefore not be compliant with IAS 39. Utilisation of CDS spreads The impairment rules under IAS 39 (see IAS 39.63 in connection with IAS 39.AG84 and IAS 39.AG74-76) require the application of discounted cashflow methods to determine the impairment amount. CDSs represent traded instruments for credit risk hedging - in case of default, the settlement of outstanding CDS contracts will be generally carried out using an auction settlement procedure overseen by Isda. As a result of the auction, settlement prices (fair value) for debt instruments with different seniority levels are determined. These prices (fair value) should be considered as evidence in determining the impairment amount under IAS 39 (IAS 39.AG84).5 This is similar to the application of the fair-value hierarchy under IAS 39 for non-defaulted derivatives. In order to ensure the convergence of CVA calculated in the non-defaulted case and the impairment amount in default, the application of CDS spreads is necessary. That's because the recovery rate is determined from auctions in the CDS settlement procedure in the event of default. The evaluation methods applied to determine CVA are supposed to converge to the impairment amount in cases where CDS spreads are available. As a consequence, it is not possible to apply probability of default parameters evaluated under Basel II for the determination of CVA under IAS 39. Use of Basel II parameters is only possible if no CDS spreads are available. In case of a counterparty default, own credit risk does not play a role. But it does if the non-default case is considered, according to IAS 39. Since fair value considerations, economic hedging and the IAS 39 requirements of non-defaulted derivatives are related, both boundary conditions are jointly described in the following section. Non-defaulted case: fair value of CVA under IAS 39: trading and hedging of counterparty risk exposure Risk-neutral pricing models The absence of arbitrage opportunities plays a significant role in the definition of CVA - and common pricing models rely on this assumption. With respect to counterparty risk, pricing models adopt commonly used credit risk models to evaluate the impact of counterparty and own credit risk adjustments. Credit risk models can be subdivided into two major classes: structural and reduced-form models. Within structural-based models, default is modelled endogenously; while in reduced-form models (intensity-based models), default is represented by an exogenous variable. Reduced-form models are widely applied to price various types of financial instruments, since these models can be incorporated in a term structure model.6 Within such a set-up, the modelling of counterparty risk requires a model for the following factors: * A pricing model for the (risk-free) market value of the underlying OTC contracts (for example, term structure model for interest rate risk) without counterparty risk. * A default model that covers the default behaviour of the counterparty and own credit risk, which includes modelling of time to default. * A model for the recovery rate (loss given default (LGD)). * A dependence or correlation model for market and counterparty risk. Such a model set-up also assumes liquid CDS spreads are available for both counterparty and own credit risk, which follows the application of the fair-value hierarchy according to IAS 39.48A, as well as IAS 39.BC11Cc to account for own credit risk. As shown in figure 2, the market value of a portfolio of OTC derivatives contracts can be decomposed into three parts.

Properties of the model Within the model set-up, the market value of a portfolio of OTC derivatives contracts can be decomposed into a component (fair value) that is free of counterparty risk/own credit risk and fair-value adjustments for counterparty and own credit risk. Both can be considered as functions dependent on LGD, a risk- free discount factor (swap curve) and the default processes (default probabilities and credit spreads). Additionally, it covers the optionality component, positive present value (PV^sup +^) versus negative present value (PV^sup -^), introduced in the previous section. This means counterparty risk (own credit risk) is only present if the fair value without counterparty risk (own credit risk) is positive (negative). For convenience, the pricing approach with respect to CVA described is termed option-based. Absence of arbitrage assumes the existence of a risk-neutral measure. The risk-neutral measure implies that under this probability measure, future cashflows can be discounted using the risk-free market interest rate (swap curve).8 With such a model, one cannot assume the market is complete, since completeness means that for every risk, a corresponding hedging instrument is available with zero cost (no transaction cost). Provided symmetric risk-neutral expected exposure profiles of the underlying OTC derivatives portfolio and similar credit spreads and recovery rates, the fair-value adjustments for own credit risk and counterparty risk offset each other. Therefore, the CVA measures the relative credit risk of two counterparties and does not measure absolute credit risk of a counterparty. Furthermore, the model set-up assumes the swap curve (AArating) is default risk free. The model also covers the situation where changes in market value and credit spreads are dependent. According to the model set-up, counterparty credit risk/own credit risk becomes model-dependent and introduces optionality features into the pricing, so the fair value depends on volatility (vega risk), the underlying fair value (delta risk), and so on. Furthermore, the introduction of optionality into the pricing or fair-value considerations implies the CVA is a non-linear function, which is especially important in case the CVA has to be evaluated across netting sets and different trading desks or segments. Here, it is

impossible to simply add different CVAs - the CVA has to be evaluated at every aggregation level separately. Closed-form solutions can be provided only under simplified assumptions, so numerical methods for the evaluation of CVA generally have to be applied. Under simplified assumptions, the fair-value adjustments can be represented by using the concept of positive expected exposure (EPE) and expected negative exposure (ENE) under the riskneutral probability measure. This means there is a direct connection between exact pricing models and counterparty risk management concepts.9 As an immediate consequence, EPE and ENE can be used in the calculation of CVA for IAS 39 if they are evaluated under the risk-neutral measure (market credit spreads). The absence of arbitrage and the existence of hedging instruments imply the cost of hedging and the price for counterparty (own) credit risk are almost the same. In case of a complete market model, these are identical. So within such pricing models, market participants are able to set up a dynamic hedging strategy that replicates the payout profile of the counterparty (own) credit risk. For example, if the (risk-free) market value of the underlying portfolio of OTC derivatives contracts changes, market participants can buy/sell CDS contracts in order to adjust the notional of CDSs to the current market value of the underlying OTC derivatives contract, such that the counterparty (own) credit risk is completely offset (hedged). Such a dynamic hedging strategy using CDS contracts can also be achieved by buying a CCDS. The process above can be used to model the contingent leg of a CCDS, as the fairvalue adjustment for counterparty risk is identical to the contingent leg of a CCDS under simplified assumptions. Example In figure 3, the impact of the CVA on the valuation of an interest rate swap is illustrated. In this example, the CVA lowers the overall default risk-free market value of the interest rate swap. This is due to the fact that the own credit risk spread is lower than the credit spread of the counterparty. Market values are shown from the perspective of the fixed-rate receiver.

As described above, counterparty credit risk can be hedged by a CCDS or a dynamic hedging strategy using CDSs. Figure 4 compares the CVA and the cost of hedging with a CCDS. The result is not surprising, as the fair-value adjustment of the counterparty risk equals the fair value of the CCDS, so the difference between the hedging cost for the CCDS (fair-value adjustment for counterparty risk) and the total CVA is the fair-value adjustment of own credit risk (credit benefit), which is not hedged by a CCDS. Important implicit assumptions of these models are: * Within these pricing models, it is assumed price risk equals credit risk, which is not always the case in practice. Due to liquidity considerations or supply and demand in the CDS market, price changes can occur without changes in credit quality. This also impacts front-office risk management/P&L. IfCVA is taken into account, then based on the price sensitivities, a trader can offset the impact of CVA in terms of sensitivity without lowering counterparty credit risk. * In general, hedging is also possible using bonds issued by the counterparty (a short position in the bonds of the counterparty to hedge derivatives exposure), which results in basis risk. * Hedging of own credit risk fair-value adjustment is difficult, as it is possible to hedge against the price risk resulting from own credit risk, but selling CDS protection on own credit risk on a large scale would be a concern to other dealers, due to wrongway risk exposures. * In practice, the price of own credit risk does not exist. Typically, pricing models neglect the impact on the capital structure, so own credit risk is implemented using a weighted average of different debt financing instruments (liabilities with different seniorities) to determine an own spread, in order to accurately reflect the funding situation. So, in practice, CVA measures counterparty credit relative to the funding situation of the company. The impact of own credit risk is therefore twofold: it reduces the impact of fairvalue adjustments of the counterparty, but it represents unhedgeable risk, as well as P&L volatility. In addition, the recognition of own credit spreads results in prices that are distinct to each bank and are not comparable. * The concept of a CCDS or dynamic hedging strategy (delta hedging) using CDSs is appealing, but there currently are not many liquid CCDSs traded in the market. Furthermore, if the counterparty suffers a default and the CDS/CCDS is exercised, the auction procedure determines prices (cash settlement) of bonds/loans with different seniority levels. The risk profile of a bond/loan has little to do with the exposure of an OTC derivatives portfolio. Additionally, a delta-hedging strategy has cost implications, which can be significant and may prevent hedging.10 Conclusion Based on the discussion above, the conditions under IAS 39 with respect to CVA are summarized in figure 5.

This article shows the calculation of CVA under IFRS is not straightforward and is based on a number of boundary conditions. But then, the question arises as to how to set up a framework that makes it feasible to achieve consistency between performance measurement, counterparty risk management and IAS 39. This will be discussed in the next article. Sidebar The absence of arbitrage opportunities plays a significant role in the definition of CVA - and common pricing models rely on this assumption Sidebar The concept of a CCDS or dynamic hedging strategy (delta hedging) using CDSs is appealing, but there currently are not many liquid CCDSs traded in the market Sidebar A full list of references for this article can be found online at www.risk.net/risk-magazine Footnote 1 IAS39.AG73 2 For the latest discussion on CVA in connection with financial Developing Common Fair Value Measurement and Disclosure Requirements in IFRSs and US GAAP accounting, refer to IASB, Comprehensive Project Summary July 2010 Footnote 3 For the collateralised interdealer OTC market, this condition can be relaxed 4 Refer to Bin Li, Ti Tang (2007) for further discussion Footnote 5 For a discussion of market quotes as predictor fir recovery rates, refer to Dlbnann, K; Trapp, M (2004) 6 For theoretical descriptions of these models, refer to farrow, RA, Turnbull, SM (1995), Blanchett-Scalliet, C, feanblanc, M (2004), Bielecki, TR, Rutkowski, M (2002) and Belanger, A, Shreve, SF, Wong, D (2004) 7 Refer to Brigo D, Capponi, A (2009), Assefa, S, Bielecki, TR, Crpey, S, feanblanc, M (2009), Gregory, J 2010

Footnote 8 See Bjrk, T (1998) 9 See Gregory, J (2010). Cesari. G et al (2009) Footnote 10 For related discussions on CDS spreads refer to Singh, M., Youssef, K., Price of Risk Recent Evidence from Large Financials, IMF Working Paper August 2010 AuthorAffiliation Dirk Schubert is a partner in the financial services division at KPMG in Frankfurt. Email: dschubert@kpmg.com Copyright Incisive Media Plc Jan 2011