Introduction / Background / Definitions

CVA = price adjustment made to a ptf based on risk of the trading counterparties defaulting on their obligations.

This only applies to OTC transactions --> exchange-traded contracts are protected from default by the exchange.

In the past, a derivative ptf was marked to market and all CFs were assumed to have risk-free values.

However, 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.

- All entities engaging in OTC derivative transactions must consider if a fair value adjustment for credit risk is required.

- 2 forms of credit-related adjustments to consider: CVA/DVA to reflect the counterparty’s or the entity’s own default risk.

- No specific guidance on the methods used to calculate CVA/DVA, which creates challenges in estimation.

Background:

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 entity's own credit risk.

As a result, IFRS 13 requires entities to consider the effects of credit risk when determining a fair value measurement.

No specific method is prescribed --> various approaches used in practice.

Estimation can be complex and requires the use of significant judgement, often influenced by following qualitative factors:

- materiality of the entity's derivative's carrying value to its financial statements

- number and type of contracts for derivatives in the entity's ptf

- extent to which derivatives are either deeply ITM/OTM

- existence and terms of credit mitigation arrangements

- cost and availability of technology to model complex credit exposures

- cost and consistent availability of suitable input data to calculate an accurate credit adjustment

- credit worthiness of the entity and its counterparties

Definition of terms:

CDS = Credit Default Swap

A credit derivative whereby the seller of the CDS compensates the buyer in the event of default or other specified credit event based on an underlying reference entity or index.

CSA = Credit Support Annex

A legal document that regulates the credit support for derivative transactions and forms part of an ISDA Master Agreement.

DCF = Discounted cash flow

A technique used to calculate the PV of future CFs.

ISDA Agreement = International Swaps and Derivatives Association agreement

Part of a framework of documents designed to enable OTC derivatives to be documented fully and flexibly.

The ISDA master agreement sets out the standard terms that apply to all transactions and is published by the ISDA.

Hypothetical derivative

A mathematical expedient for calculating hedge (in)effectiveness using a derivative that would have critical terms that exactly match those of a hedged item.

LGD = Loss given default

The amount that one party expects not to recover if the other party defaults.

OTC = Over-the-counter

A bilateral derivative executed between two counterparties outside of a regulated derivatives exchange environment.

PD = Probability of default

The probability that the counterparty or reporting entity defaults.