Credit spreads back to pre GFC levels

We have discussed CVA at length in our newsletter and blog as it is arguably the most significant change to the accounting standards, from a financial instruments valuation perspective, since hedge accounting was introduced. The standard relating to CVA, IFRS 13, was developed as a result of the Global Financial Crisis. It became apparent that credit risk had been mispriced for a long time in the lead up to the implosion of the credit markets in 2008/2009. IFRS 13 forces organisations to include an adjustment to financial instruments to represent a credit component – both for the reporting entity as well as the counterparty. The adjustment can be a reasonably immaterial number impacted by factors such as the remaining term to maturity and how far in- or out-of-the-money the derivatives are.

Some companies argue that the relative immateriality of the credit adjustment reduces the necessity of quantifying the credit component, to the extent that some companies are not bothering to do it. We understand that view as IFRS 13 seems like another regulatory requirement that adds little value to the business. However, the standard is explicit in its language that “fair value”, by definition, includes credit, therefore, the decision to do nothing about it cannot pass muster with the auditor.

A contributing factor to the “immateriality” argument is the prevailing benign credit conditions. The credit spread of banks can be observed through the Credit Default Swaps (“CDS”) market. A CDS is like an insurance policy – it compensates the holder of the policy if the underlying entity defaults on its debt obligations. As the chart below shows the credit quality of the big 4 Australian banks has been improving since the spike in 2011 and has continued to retrace back to levels that prevailed pre GFC. The resulting effect is to reduce the credit valuation impact on out-of-the-money derivatives (current exposure method). We would argue that although credit conditions have returned to benign levels it is only a matter of time before another credit shock occurs and companies will be better prepared to quantify such impacts if they already have a tried and tested methodology in place. Our Hedgebook clients benefit from the system’s low cost, easy to use CVA module.

Big 4 CDS 3 year

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.

The Future of Interest Rate Swaps: Will Regulation Kill this Investment Vehicle?

This is part 9 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 8, we discussed the role of interest rate swaps in the demise of Greece. Given the importance of swaps in the U.S. housing crash, new regulation has arisen that could threaten the future of this important financial derivative.

In late-2008, financial markets were a mess: credit markets had dried up; equity markets plummeted, eliminating trillions of dollars of wealth from the economy; and politicians needed someone to blame. Given the fact that a series of complex transactions involving swaps ultimately accentuated the market crash, OTC derivatives, specifically swaps, were an easy target.

With public outcry high for a scapegoat, U.S. Congressmen and Congresswomen called for action to regulate OTC derivatives, what the Bank of International Settlements has characterized as a $415.2 trillion market. Led by House Financial Services Committee Chairman Barney Frank, new regulations were set forth in December 2009 to curb risk tanking by large financial institutions. Regulations focused on two main issues:

  1. Should financial institutions have ownership in swaps clearinghouses? Should ownership be limited? A conflict of interest may arise provoking riskier activities if not addressed properly.
  2. Should regulators have the power to set capital and margin requirements for non-financial participants in the swaps market? Would this regulation result in lower market participation rates, thus creating a premium for liquidity?

When the Dodd-Frank Act (named after Senator Christopher Dodd and Representative Barney Frank, the chief architects) was signed into law by President Barack Obama in July 2010, many of the large financial institutions operating within the OTC market were forced to sell off operations involving swaps deemed uncritical to their in-house hedging operations; or the arms of the financial institutions trading in swaps markets for speculative purposes were forced to close. Additionally, OTC derivatives trading would be funneled through clearinghouses and exchanges for greater accountability.

Financial Scholars Group published perhaps the best perspective on the Dodd-Frank Act in July 2012:

Dodd-Frank legislation was passed in 2010 to overhaul the financial market with the objective of removing or alleviating systemic deficiencies. With respect to OTC IR swaps, Dodd-Frank seeks to lower systemic risk through centralized clearing of trades, better risk management, and trade reporting transparency. Yet despite its size, the IR swap market is small in important respects. Any policy attempting to address a market hundreds of trillions of dollars in size must also take into account that in some ways the swap market is quite nuanced, with some IR swaps trading very thinly and thus potentially substantially disrupted by even finely tuned regulatory policies.

FSG continued to say, “In thin markets disclosing deal terms can have the opposite effect. This is because statistical data is no longer anonymous. With a small number of trades, parties can potentially make inferences about the investment strategies of others. Thus, trade data for thin markets can have an undesirable, amplified signaling effect revealing the market expectations of some participants.”

Given these observations, we can draw a few necessary conclusions: first, OTC derivatives markets, especially those related to swaps, are under a microscope, especially in the United States. Second, a fundamental lack of understanding by legislators could lead to overregulation, diminishing the effectiveness of interest rate swaps (and other variations of swaps) as hedges.

Over the next few years, it is unlikely that regulation comes down hard on the OTC derivatives market barring a major financial crash with swaps at the center once more. This is a far-fetched outcome going forward, considering that loose monetary policies across the globe have introduced trillions of dollars of liquidity over the past few years, driving down borrowing rates in both developed and developing economies. As such, and in light of the increased globalized nature of financial markets in contemporary times, swaps will remain an important financial instrument for years to come.

In part 10 of 10 of this series, we’ll talk about the role of swaps in your company’s hedge portfolio and why, despite the bad rap they get from the U.S. housing crisis, the Goldman Sachs-Greece debacle, and political posturing, swaps remain an integral and important part of global financial markets

Why Are Interest Rate Swaps Important?: A Brief History

This is part 1 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 1, we discuss the history of interest rate swaps so as to better understand the vital importance of this investment vehicle.

What is an interest rate swap? We first must go back to 1981 to see their first application. In 1981, IBM and the World Bank made the first swap, a currency transaction. But why? The World Bank borrows money to lend funds to developing countries for mainly construction projects. In essence, similar to how commercial banks like Bank of America lend to small business, the World Bank lends to developing nations.

But the World Bank was in a bit of a conundrum: interest rates were sky high (at least compared to today’s levels), with the Federal Funds rate at 17%, the Swiss key rate at 8%, and the West German key rate at 12%. Similarly, per laws in both countries, the World Bank had reached its borrowing cap in Switzerland and West Germany.

At the same time, IBM held a large amount of debt priced in Swiss Francs and German Marks. To help one another out, the World Bank borrowed $290 million in U.S. markets and swapped those U.S. Dollar obligations in exchange for taking on IBM’s Swiss Franc and German Mark obligations; swaps were born.

Today, the swaps market is extremely liquid with hundreds of trillions of dollars worth of swaps in existence (according to the Bank of International Settlements, the swaps market totaled $415.2 trillion – almost 9 times global GDP!) in an over-the-counter (OTC) market (OTC means there is no centralized exchange). There are two main types of swaps, plain vanilla or interest rate swaps, and currency swaps. Other common swaps are commodity swaps and credit default swaps, but the majority of this series will concentrate on the two main types, as they comprise a majority of transactions in the deepest financial derivatives class in the world.

In part 2 of 10 of this series, we’ll explore the differences between the two major types of swaps – currency swaps and interest rate swaps – and their different uses for financial institutions, large or small.