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- How does it work?
How does it work?
Consistent with the fact that credit risk affects the initial measurement of a derivative asset or liability, IFRS 13 requires that changes in counterparty credit risk or an entity’s own credit standing must be considered in subsequent fair value measurements. It cannot be assumed that the parties to the derivative contract will perform.
Given the terms of the asset or liability were determined based on the counterparty’s or entity’s credit standing at the time of entering into the contract (and since IFRS 13 assumes a liability is transferred to another party with the same credit standing at the measurement date), subsequent changes in a counterparty’s or entity’s credit standing will result in the derivative’s terms being favourable or unfavourable relative to current market conditions.
Unlike the credit exposure of a vanilla receivable which remains constant over time, the bilateral nature of the credit exposure in many derivatives varies, whereby both parties to the contract may face potential exposure in the future. As such, many instruments have the possibility of having a value that is either positive (a derivative asset) or negative (a derivative liability) at different points in time based on changes in the underlying variables of the contract.
Table 1 below illustrates the income statement and balance sheet effect of CVA and DVA adjustments as a component of fair value measurement on a single derivative asset or liability.
