Applying IFRS IFRS 13 Fair Value Measurement Credit valuation adjustments for derivative contracts April 2014 April 2014 Credit valuation adjustments for derivative contracts 1 Contents In this issue: Challenging market conditions following the economic crisis and the introduction of IFRS 13 Fair Value Measurement (IFRS 13) have highlighted the need to reflect credit risk appropriately in the fair value of derivative contracts. This publication provides insight into some of the methods used in practice to determine valuation adjustments for credit risk on all derivatives measured at fair value, except those for which a quoted price in an active market is available (i.e., over-the-counter (OTC) derivatives). In addition, we briefly discuss some of the practical implications including data challenges, portfolio considerations and how these adjustments may affect hedge accounting. Issues and questions are likely to be raised in the future as entities continue to apply IFRS 13. In addition, various groups, such as the International Valuation Standards Council, are developing guidance in respect of credit and debit valuation adjustments. We encourage readers to closely monitor developments. What you need to know ?All entities engaging in OTC derivative transactions must consider whether a fair value adjustment for credit risk is required Two forms of credit-related adjustments should be considered: a credit valuation adjustment (CVA); and a debit valuation adjustment (DVA) to reflect the counterpartys or the entitys own default risk. There is no specific guidance on the methods used to calculate CVA and DVA, which creates challenges in estimation. 1. Background . 2 2. What has changed? . 2 3. How do credit adjustments work? . 4 4. Valuation methods . 5 5. Data challenges . 7 6. Portfolio approaches and credit mitigation arrangements . 9 6.1 Collateral arrangements . 9 6.2 Netting arrangements . 9 6.3 Allocation of portfolio-level credit adjustments . 10 7. Interaction with hedge accounting . 11 Appendix: Credit risk modelling for derivatives . 13 2 April 2014 Credit valuation adjustments for derivative contracts 1. Background IFRS 13 became effective for annual periods commencing on or after 1 January 2013. IFRS 13 requires that fair value be measured based on market participants assumptions, which would consider counterparty credit risk in derivative valuations. Furthermore, the standard is explicit that the fair value of a liability should reflect the effect of non-performance risk, including, but not limited to, an entitys own credit risk (as defined in IFRS 7 Financial Instruments: Disclosures). As a result, 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 the accounting literature, 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 entitys derivatives carrying value to its financial statements The number and type of contracts for derivatives in the entitys 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 The credit worthiness of the entity and its counterparties 2. What has changed? Although the requirements of IFRS 13 for non-performance risk in the valuation of liabilities are consistent with the prior fair value measurement guidance in IFRS, it is clearer that fair value includes such adjustments. IAS 39 Financial Instruments: Recognition and Measurement (IAS 39) refers to making adjustments for credit risk if market participants w