Fair value measurement in practice

CVA and DVA in the new world of IFRS 13

Fair value measurement in practice

IFRS 13 poses new requirements on the fair value measurement of financial instruments. It is applicable for accounting periods beginning on or after 1 January 2013 and requires incorporating a credit value adjustment (CVA) and a debt value adjustment (DVA). How do you incorporate CVA and DVA in practice in the fair value measurement of your derivatives? What does it imply for your valuation process? Which market data is necessary?

This article will describe, using an example, the different actions to perform and the issues you may encounter during the process.

Our example is a European construction company with a portfolio of two interest rate swaps (IRSs) and two cross-currency interest rate swaps (CCIRSs). To show the impact of CVA and DVA over time, two valuation dates are compared. This will help to understand the extra layer of volatility coming from the CVA/DVA on top of the usual marked-to-market (MtM) volatility within financial instruments.

The tables below summarize the characteristics of the instruments of the portfolio.

What are CVA and DVA?

The CVA and DVA are adjustments that capture the credit risk of counterparties (CVA) and yourself (DVA). A good proxy for the credit risk is the credit default swaps (CDS) spread of larger institutions, for which market data is available through your usual data provider.
A simple, largely accepted methodology to incorporate the CVA/DVA in the valuation of derivatives is to add (in the case of CVA) or subtract (for DVA) the CDS spreads from the discount curve. These spreads are the same for all different instruments with the same counterparty. If there are several counterparties for the same financial instrument, a separate valuation has to be performed for each counterparty.

The DVA adjustment valuation is done the same way as the CVA, i.e. by subtracting your credit spread from the discounting curve. The difficulty that may occur here is that your company may not have CDSs quoted on the market. In this case a good alternative is to create a peer group representing your sector and your credit rating1. The peer group in our example would consist of other European construction companies. The credit spread for the DVA will be the average of the spreads of the peer group. It is important to regularly (once a year) assess the members of the peer group.

The effects of CVA and DVA

The graph below represents the CVA and DVA adjustments as per 31 December 2012 and shows the effect of these adjustments on the market value.

The adjustment amount is influenced by the instrument’s cash flow pattern, the level of the CDS spreads, the maturity of the instrument, the type of product (exchange of notional or not) and whether the instrument is at par or not. The sign of the current market value (positive or negative) and the future cash flow pattern is an important determinant of the sign of the adjustment. One important remark is that the sign of the adjustment does not have a one-on-one relation with the sign of the current market value. This is because the sign of the amount is not only impacted by the current market value but also by the (sign of) future total cash flow. Do you pay more interest in the future or do you receive more interest?

Besides, one could check the amount of adjustments by looking at the level of the spreads. A lower spread will result, all things being equal, in a lower adjustment amount (in absolute value). The same general observations are applicable for DVA. Please note that the CCIRSs are already carrying a basis spread2. In order to value the CVA, the basis spread has to be removed, since only one spread can apply at each valuation.

The influence of CVA and DVA over time

The impact of the CVA-DVA adjustment is presented in the table below where the differences are shown between 31 December 2012 and 31 May 2013.

It can be seen that the portfolio MtM move of EUR 216,000 becomes EUR 1,243,000 when including the CVA-DVA adjustments. This is mainly explained by the rise of the 10-year CDS spreads of some banks during this period. The 20-year CDS point is not liquid and therefore not used. Instead, the 10-year point is the longest CDS tenor used, causing it to have a major influence on the contracts with a long maturity. From this table it can be concluded that the inclusion of CVA and DVA results in more volatility in the total results.

The CVA and DVA adjustments are an important requirement imposed by IFRS 13. It requires having your system ready to perform the extra valuations and possibly to have extra market data. You should be prepared to see extra volatility in the market value of your financial instruments. Furthermore, extra considerations should be taken into account such as portfolio netting, collateral agreement and hedge accounting impacts. More advanced methods for calculating CVA/ DVA adjustments seen in the market are combining the Monte Carlo simulation (to compute the expected exposure) and probability of defaults (derived from the CDS spreads).

1 Zanders provides rating services based on state-of-the- art credit risk modeling techniques. Should you require a rating report for yourself or one of your counterparties, please contact Charles Zondag: c.zondag@zanders.eu or +31 35 692 89 89.
2 See the article ‘How to value a cross currency swap