Credit Value Adjustment

Credit Value Adjustment or CVA has been around for a long time, however, with the introduction of the accounting standard IFRS13, this year there is a requirement to understand it a bit better. The new standard requires the CVA component to be separately reported from the fair value of a financial instrument.

CVA is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk.

The big question is whether it will be material enough for most organizations to worry about; given the potential complexity around its calculation, most would hope not.

There is no doubt if you have cross-currency swaps the impact of CVA is likely to be material. However most companies that use these instruments would normally have a sophisticated treasury management system that would do this calculation at the push of a button.

Most other organizations however will probably be relying on spreadsheets to capture and record their treasury transactions and will lack the ability to calculate financial instrument valuations let alone the more complex CVA.

Will you need to worry about CVA is the question? Most do not know there is a requirement, let alone how it will be calculated and this is true of the audit profession as much as the corporate world.

Whether it is material or not may be the question, however, it is likely that even if it is not material there may be a requirement to prove this. At the end of the day the audit profession will decide whether organizations will need to calculate CVA or not. In the meantime we are keeping a watching brief on both the banks’ ability to provide the CVA component and the audit firms as to whether they will force organizations to calculate it.

Watch this space.

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.

Just what is an interest rate swap?


One of our team was recently asked to give a simple overview of interest rate swaps and how they work. Below was the explanation we put together, using a comparison between an interest rate swap to a fixed-rate bank loan to illustrate the key characteristics.

We think it is a nice, concise and clear way to explain interest rate swaps so thought we would share it.  Comments welcome.

Bank fixed-rate term loan

Interest rate swap

Bank loan type Separate fixed-rate term loan Borrow floating rate (i.e. 90-day rate resets at market rates plus lending margin). The bank can normally change the lending margin on an annual review of the facilities.
Amount being fixed No flexibility, the full loan amount is fixed. Interest rate swap contract can be entered for any amount, in multiples of $1m. E.g. Borrowing facility of $10m, decide to fix 50% now, therefore enter a $5m swap. Later on the percentage fixed can be increased by doing another swap contract.
Fixing of interest rate Per loan documentation, includes bank lending rate for term (say 5 years) plus bank lending margin = all up fixed interest rate that does not change over the term of the loan Interest rate fixed by entering an “interest rate swap” contract. The borrower pays fixed rate and receives floating rate under the swap contract. The floating interest rate received under the swap for the next 90 days nets off against the 90 day interest rate paid on the physical floating rate loan above. Net result is an all up fixed interest rate, being the fixed swap rate plus the normal bank lending margin on the borrowing facility.
Flexibility Cannot unwind early or unknown penalties applied by the bank for early termination. At any time the swap can be unwound or closed down. If term swap rates subsequently increase, the swap is closed down at a realised cash gain –  being the difference between the contracted swap rate and the higher market swap rate for the term left to run (and vice versa).
Documentation Normal bank loan documents Interest rate swap is a separate legal document under standard “ISDA” bank terms.
Term of fixing Interest rate is fixed for the term of the loan A fixed rate swap can be for any term, does not have to be the same maturity date as the underlying bank loan facility. May be shorter or longer.
Use of bank credit limits Loan principal plus 12 months interest cost usually. Loan principal plus 90 days interest cost, plus credit usage of swap agreement (normally 4% x number of years of swap x principal amount). In addition, if market swap rates subsequently reduce to below the contracted fixed rate of the swap, the bank will add on the unrealised “marked-to-market” revaluation loss onto the total credit usage. The bank normally imposes a a maximum term for swap contracts. They may allow fixing the swap interest rate for 10 years with a “right to break” clause that allows the bank to close down the swap after 5 years if they don’t like the borrower’s credit any more.
Cashflow Interest paid monthly or quarterly. Interest on 90-day physical borrowing paid every 90 days and then the bank calculates the difference between the swap fixed rate and market floating rate every 90 days, with the borrower paying the cash difference between the two interest rates to the bank and vice versa.
Fixing the interest rate in advance of loan drawdown Not really possible. “Forward start” swaps can be entered with the fixed rate commencing from a predetermined date. An option can be purchased to enter a fixed rate swap at a future date as well (“swaption”).

Are interest rate swaps heading the way of the dodo?

Previously I wrote about the bad press interest rate swaps have been receiving and that I felt much of the criticism was unjustified. I firmly believe that a lot of the negativity has been due to people not understanding why swaps are useful and, because of this, they fear their use.

Further muddying the waters has been the recent announcement of new margin requirements for over-the-counter (OTC) swaps. The Commodity Futures Trading Commission (CFTC) has published several important rules for compliance, including a proposed start date of October 12. This has been coming for some time with the Dodd-Frank Act requiring most OTC derivatives to be traded on a Swap Execution Facility (SEF). (A SEF is “a trading system or platform in which multiple participants have the ability to execute or trade swaps”.)

Image courtesy of The Telegraph

This has got everyone excited and even saw Risk Magazine undertake a poll to see what the impact of the proposed margin requirements on uncleared trades would have. The results, while on the face of it are not surprising, could well be mis-leading.

60% of respondents to the survey thought end-users will opt not to use derivatives as a result of initial and variation margins requiring to be posted on uncleared swap trades. When the sort of money being talked about in collateral is in the trillions it is not surprising that there is some concern over this, and questions over the use of swaps in the future.

However I think we need to “back the truck up” a bit here. These new regulations do not relate to non-financial entities. The new proposals state “the margin requirements need not apply to non-centrally-cleared derivatives to which non-financial entities that are not systematically-important are a party.”

So corporations are exempt and therefore can continue to use swaps as they have done before – as a risk management tool to hedge future movements in interest rate risks. Interest rate swaps have got organisations into trouble in the past and no doubt will do so in the future, but almost without exception the reason that the deals have gone sour is because the people entering into them in the first case did not understand them. Sure the sales people have been gung-ho in some cases and they may or may not have been the best tool to use at the time, but again if the organisations entering into the swaps had a clear understanding of their use, most of these problems would be averted.

It is timely to remind ourselves of what needs to be in place to confidently enter into derivative deals. Firstly, make sure you have an exposure that the derivative will accurately hedge.  If as a borrower you have floating rate debt then an interest rate swap whereby you swap your floating interest payments for fixed interest payments would be appropriate. If you have floating rate debt and you sell an option to receive a premium to offset your interest payments, then this is speculation and is not managing your interest rate risk as you still have unlimited risk on the top side.

Secondly, understand the product itself well enough so you know the risks you are taking on board. If you are unsure DO NOT ENTER THE TRANSACTION. Normally plain vanilla deals will suffice, if you move away from the plain vanilla again you need to understand intimately what you are getting into. If interest rates go up what is the impact on your portfolio? Likewise if interest rates go down, what does that mean to you?

Finally you need to be able to record, report and value these transactions so that at all times you have a good handle on your current position and what might happen in the future if interest rates change. If you can’t capture your deals appropriately and value them then this is when unpleasant surprises can happen. You need to know your position at all times.

So changes are on their way, but as a business there is no cause for concern that instruments like swaps will no longer be able to be used as a risk management tool. If you follow the common sense rules then they are still an important way to manage your risks – despite what the regulators may seem to be saying.

Richard Eaddy is the CEO and founder of Hedgebook and the Managing Director of ETOS Ltd, specialists in treasury outsourcing services. Richard has worked in the corporate treasury risk management industry for more than 20 years. He has held senior roles in large corporate treasury departments in both New Zealand and Europe, provided treasury risk management advice to major corporations and for the last ten years has headed up the largest treasury outsourcing company in Australasia. Richard can be contacted at