IFRS 13: Fair value measurement – Credit Value Adjustment

The purpose of this blog is to examine IFRS 13 as it relates to the Credit Value Adjustment (CVA) of a financial instrument. In the post GFC environment, greater focus has been given to the impact of counterparty credit risk. IFRS 13 requires the valuation of counterparty credit risk to be quantified and separated from the risk-free valuation of the financial instrument. There are two broad methodologies that can be considered for calculating CVA: simple and complex. For a number of pragmatic reasons, when considering the appropriate methodology for corporates, the preference is for a simple methodology to be used, the rationale for which is set out below.

IFRS 13 objectives

Before considering CVA it is worthwhile re-capping the objectives of IFRS 13. The objectives are to provide:

–          greater clarity on the definition of fair value

–          the framework for measuring fair value

–          the disclosures required about fair value measurements.

Importantly, from a CVA perspective, IFRS 13 requires the fair value of a liability/asset to take into account the effect of credit risk, including an entity’s own credit risk. The notion of counterparty credit risk is defined by the risk that a party to a financial contract will fail to fulfil their side of the contractual agreement.

Factors that influence credit risk

When considering credit risk there are a number of factors that can influence the valuation including:

–          time: the longer to the maturity date the greater the risk of default

–          the instrument: a forward exchange contract or a vanilla interest rate swap will carry less credit risk than a cross currency swap due to the exchange of principal at maturity

–          collateral: if collateral is posted over the life of a financial instrument then counterparty credit risk is reduced

–          netting: if counterparty credit risk can be netted through a netting arrangement with the counterparty i.e. out-of-the money valuations are netted with in-the-money valuations overall exposure is reduced

CVA calculation: simple versus complex

There are two generally accepted methodologies when considering the calculation of CVA with each having advantages and disadvantages.

The simple methodology is a current exposure model whereby the Net Present Value (NPV) of the future cashflows of the financial instrument on a risk-free basis is compared to the NPV following the inclusion of a credit spread. The difference between the two NPVs is CVA.  The zero curve for discounting purposes is simply shifted by an appropriate credit spread such as that implied by observable credit default swaps.

Zero curve

To give a sense of materiality, a NZD10 million swap at a pay fixed rate of 4.00% with five years to maturity has a positive mark-to-market of +NZD250,215 based on the risk-free zero curve (swaps). Using a 200 basis point spread to represent the credit quality of the bank/counterparty the mark-to-market reduces to +NZD232,377. The difference of -NZD17,838 is the CVA adjustment. The difference expressed in annual basis point terms is approximately 3.5 bp i.e. relatively immaterial. In the example we have used an arbitrary +200 bp as the credit spread used to shift the zero curve. In reality the observable credit default swap market for the counterparty at valuation date would be used.

The advantages of the simple methodology is it is easy to calculate and easy to explain/demonstrate. The disadvantage of the simple methodology is takes no account of volatility or that a position can move between being an asset and a liability as determined by the outlook for interest rates/foreign exchange.

The complex methodology is a potential future exposure model and takes account of factors such as volatility (i.e. what the instrument may be worth in the future through Monte Carlo simulation), likelihood of counterparty defaulting (default probability) and how much may be recovered in the event of default (recovery rate). The models used under a complex methodology are by their nature harder to explain, harder to understand and less transparent (black box). Arguably the complex methodology is unnecessary for “less sophisticated” market participants such as corporate borrowers using vanilla products, but more appropriate for market participants such as banks.

Fit for purpose

An important consideration of the appropriate methodology is the nature of the reporting entity. For example, a small to medium sized corporate with a portfolio of vanilla interest rate swaps or Forward Exchange Contracts (FECs) should not require the same level of sophistication in calculating CVA as a large organisation that is funding in overseas markets and entering complex derivatives such as cross currency swaps. Cross currency swaps are a credit intensive instrument and as such the CVA component can be material.

Valuation techniques

Fair value measurement requires an entity to explain the appropriate valuation techniques used to measure fair value. The valuation techniques used should maximise the use of relevant observable inputs and minimise unobservable inputs. Those inputs should be consistent with the inputs a market participant would use when pricing the asset or liability. In other words, the reporting entity needs to be able to explain the models and inputs/assumptions used to calculate the fair value of a financial instrument including the CVA component. Explaining the valuations of derivatives including the CVA component is not a straightforward process, however, it is relatively easier under the simple methodology.

Summary

IFRS 13 requires financial instruments to be fair valued and provides much greater guidance on definitions, frameworks and disclosures. There is a requirement to calculate the credit component of a financial instrument and two generally accepted methodologies are available. For market participants such as banks, or sophisticated borrowers funding offshore and using cross currency swaps, there is a strong argument for applying the complex methodology. However, for the less sophisticated user of financial instruments such as borrowers using vanilla interest rate swaps or FECs then an easily explainable methodology that simply discounts future cashflows using a zero curve that is shifted by an appropriate margin that represents the counterparty’s credit should suffice.

Interpreting Possible Fed Taper Scenarios

The US economy slowed in the months since the idea of QE3 tapering was first floated. In light of recent price developments, we examine the case: to taper or not to taper?

The Federal Reserve’s balance sheet has jumped by over $3 trillion since the global financial crisis erupted in 2008. QE1, the first large scale asset purchase (LSAP) program was bold: it mind as well as saved the entire global economy. Just how bold? Fed Chairman Ben Bernanke won TIME Magazine’s coveted “Person of the Year” anointment in 2009.

QE2 was similarly successful, but not met without its critiques. A $600 billion bond-buying program was nothing to shake a stick at; it propelled global equity markets higher from November 2010 through June 2011, before the Euro-Zone crisis decided to wake up and the U.S. lost its ‘AAA’ rating at Standard & Poor’s for continued political brinkmanship (which continues today).

QE3 has proven to be the least effective and most controversial easing plan to date, more so than the even bolder measures taken in Japan by the government and the Bank of Japan, collectively known as ‘Abenomics.’ When the Fed announced QE3 in September 2012, market pundits were convinced that U.S. yields would plummet and the U.S. Dollar would be thrashed – more of the same of QE1 and QE2. QE3 was dubbed “QE-infinity” given its open-ended nature. But instead, with the U.S. economy improving, and yields shooting up in favor of a stronger U.S. Dollar, there’s growing support inside and outside of the Fed for a reduction in QE3.

There are several reasons to taper and not to taper, and they will be weighed by the Fed at its future meetings as the central bank eventually winds down its purchases. On the positive side, the fiscal drag thanks to the budget sequestration has proven much less daunting than previously forecasted, and the U.S. fiscal deficit is falling at its fastest rate in over 50 years. The U.S. unemployment rate is now at 7.0%, as low as it’s been since 2008.

The negatives are evident as well. Labor market growth has slowed in recent months, and Nonfarm Payrolls figures have eroded through midyear. Consumption has started to fall, and that may be a symptom of recently higher interest rates; higher borrowing costs reduce disposable income, and with wage growth dead, it is likely that higher rates remain a negative influence on the U.S. economy. These consumption fears have manifested in soft inflation figures throughout 2013.

Whether or not the Fed tapers QE3 will be determined shortly, but given the meteoric rise in U.S. yields the past several months, any outcome – even a $15B taper – could provoke a pullback. Consider that within the past six months, the U.S. Treasury 10-year note yield was as low as 1.631% on May 2, and had risen to as high as 2.979% on September 5 – over a 40% increase.

We thus suggest: if the Fed decides only on a modest taper $0B-10B/month, there is a significant scope for U.S. yields to pullback. Between $10B-20B/month, recent downside pressures in emerging markets and upside pressures in U.S. yields will remain; these will continue to manifest into further emerging market FX and high yielding FX weakness.

Scope for Recovery by Australian Dollar Limited as Labor Suffers

The Reserve Bank of Australia cut its key benchmark interest rate to a record low 2.50% earlier this year, highlighting the central bank’s concerns over the sensitivity of the Australian economy to turmoil in emerging markets.

When discussing Australia at the turn of the year, we suggested that: “Now, with rates at all-time lows, it’s a good moment to reflect on why we’re in the current predicament. After all, dovish monetary policy is only implemented when worries of an economic slowdown persist.”

These concerns were well-informed, as the Australian labor market has only deteriorated over the course of the year, forcing the Reserve Bank of Australia to cut its main interest rate to a record low of 2.50% at its August policy meeting. This is a significant step lower from the 4.75% rate employed as recently as November 2011; an aggressive rate cut cycle the RBA has employed, indeed.

Nevertheless, it’s evident that concerns surrounding Australia will continue. The country’s most important sector, mining, continues to show signs of slowdown, and government advisors have reluctantly admitted that the global commodity supercycle – driven by rapidly growing emerging markets – may be finished.

We continue to believe that the changing economic climate of Australia will play a negative influence on the Australian Dollar. The labor market remains a primary concern, and has proven to be a major negative influence on the Australian Dollar in recent months:

AUDUSD_unemployment

Over the past two-plus years, after the AUDUSD peak near $1.1100 in the summer of 2011, the RBA’s aggressive easing cycle, in part to help soothe fears over the labor distress, has driven the AUDUSD down to its lowest exchange rate since September 2010, below $0.9000 in August.

Further pressure on the Australian labor market, and thus the Australian Dollar, seems likely. Whereas the AUDUSD was quite stable near $1.0500 for several months while labor markets deteriorated, it’s clear that reality has set in. Despite several rate cuts since November 2011, Australia’s unemployment rate has increased from 4.9% in April 2011 to 5.8% in August 2013, the highest rate since August 2009.

Scope for recovery in the labor market is limited at best as long as the commodity cycle slowdown persists. Data compiled by the RBA in August showed that base metals prices, perhaps most indicative of economic strength in the mining sector, sunk to their lowest level since late-2009 by midyear, an ominous sign considering the time before prices had reached that level it was on the way lower by another 30% amid the global financial crisis of 2008.

RBA CPI

Base metals prices continue to be the guiding light for Australia – and should they remain subdued going forward, we suspect that dovish guidance will remain in place at the RBA, serving as a consistent, bearish influence on the Aussie for the remainder of 2013.

Steel, iron ore and coking coal