Written by Uday Baral, Pioneer Solutions’ President/CEO
Are you prepared for financial regulations related to Credit Value Adjustments and Fair Value Disclosure?
Two counterparties are taking market risks as they enter into a trade. In addition, they are also taking credit risks against each other, due to counterparty default (i.e., counterparty credit risks). Credit risks should be adjusted appropriately with credit/debt value adjustments (i.e., CVA/DVA) in order to reflect the adjusted value of the portfolio.
The FASB and IFRS accounting standards require fair value adjustments, due to credit risks. These requirements are dealt with in ASC815 (FAS133) and ASC820 (FAS 157) FASB standards in the US. Similarly, IFRS standards IFRS7, IFRS9 and IFRS13 define these requirements. Fair value hierarchy disclosure is also required by both FASB and IFRS standards.
While the concepts of these requirements are simple, proper implementation could not be more complex. Because of this, companies will require a solution that requires tight collaboration among market and credit risks and derivative accounting processes/solutions.
How do you value CVA/DVA?
Credit Value Adjustment (CVA) is the difference between the risk-free portfolio value and true portfolio value that takes into account the possibility of a counterparty’s default. Besides CVA, trading parties are required to make such adjustments (i.e., Debt Value Adjustment or DVA) for its own liabilities (negative exposures). The combination of CVA and DVA may be defined as bilateral CVA.
CVA/DVA can be calculated on net future exposure or potential future exposure based on credit rating inputs, such as credit spreads or default probabilities. In addition, credit enhancements are taken into consideration on net exposure, which is based on the netting agreements in place with each counterparty.
What are the challenges?
Complying with accounting standards requires a robust risk analytic capability and system infrastructure. Some examples of challenges or considerations companies will face include:
- Is there a good credit risk management process and tool to manage counterparty credit files, ratings, default probabilities or credit spread rates?
- Does the current credit exposure reporting handle proper counterparty netting and collateral/enhancement management?
- Are there capabilities to calculate and report potential future exposure?
- If credit default spread rates and/or default probabilities are not available, what inputs are available to be used?
- How do you allocate a counterparty level CVA/DVA at the deal level that may be required for hedge accounting and disclosure?
- How do you apply CVA/DVA adjustments to hedge effectiveness testing?
- Do you have a robust derivative accounting solution to process for CVA/DVA adjustments and reporting?
How can we help?
Pioneer Solutions is experienced in helping customers in market and credit risks, derivative accounting and disclosure reporting. We provide software solutions to help companies manage these complex issues, among other business requirements.