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Mastering Credit Adjustments in Derivative Pricing

 
June 2, 2016

Credit Valuation Adjustment (CVA) is not a new concept; it has been in existence for long but gained prominence after the financial crisis of 2008-09. CVA is referenced with marked-to-market losses resulting from the widening of credit spreads between counterparties. Financial institutions globally have been measuring these losses through their CVA desk, but have seldom incorporated these losses in the valuation process involving derivatives, especially OTC derivatives, for which market-related data is not available.

While there were several reasons that triggered the financial crisis of 2008-09, marked-to-market losses on OTC derivatives can be considered as one of the biggest contributor. Until that point, the derivatives market was largely unregulated, resulting in a hundred-fold increase in the outstanding volume of credit default swaps (CDS), with USD 54.6 trillion of notional amount outstanding of CDS contracts by mid of 2008 and the total OTC derivative notional value outstanding at USD 598.1 trillion as of December 2008. Around the same time, with a severe liquidity crisis in the interbank market due to the widening of the credit spread, financial institutions started to liquidate their outstanding positions in the derivatives market, resulting in a colossal decline in the market value of these derivatives. Since the outstanding positions in these derivatives were marked-to-market, it resulted in insurmountable losses.

The aftermath of the financial crisis saw regulatory tightening through a series of new standards, including IFRS 13 Fair Value Measurement and Credit Value Adjustment Framework under Basel III.

According to IFRS 13, financial institutions are required to account for credit adjustments into the fair value of OTC derivatives. The accounting standard mandates that the fair value should be adjusted for both, counterparty credit risk (credit valuation adjustment) when the derivative is a financial asset, and for own credit risk (debit valuation adjustment) when the derivative is a financial liability. While financial institutions have been willing to account for CVA into the fair value of the derivative asset, they have resisted adjusting for DVA from the fair value of the held derivative liability. This is because, in case of a derivative liability, an increase in DVA or own credit risk results in a lower derivative liability in the balance sheet, and a gain in the income statement.

Some reasons cited by financial institutions for not incorporating DVA into the fair value of derivative liability are, the impact of gain in P&L when own credit risk deteriorates, no economic benefit when own credit risk improves, and inconsistent industry practice in accounting these adjustments.

Therefore, since the valuation of the derivative is carried out at the initiation of trade, it does not matter whether the derivative liability is exited or settled with the counterparty during the life of the contract. Rather, the perception of the market participant on uncertainty, liquidity, and other factors is of essence during the valuation process. Thus, the fair value of any derivative, whether asset or liability, should be adjusted for the deterioration of both, own credit as well as counterparty credit.

Nitin Agarwal is a Domain Consultant with the Banking and Financial Services (BFS) business unit at Tata Consultancy Services (TCS). He has more than 13 years of experience in finance and risk management and has worked on several strategic regulatory projects. Nitins areas of expertise include capital management, regulatory reporting (Basel II / III and other global standards), impairment accounting under IFRS 9, and risk analytics. With rich experience in business processes such as credit underwriting, credit operations, loan servicing and default management, he anchors the delivery of priority projects for TCS leading clients.