This document discusses credit value adjustments (CVAs), which represent an adjustment made to the value of over-the-counter derivatives to account for counterparty credit risk. It outlines the history and challenges around incorporating counterparty credit risk into valuations, and describes different methodologies used to calculate CVAs. It also discusses implications for assessing hedge effectiveness when CVAs are incorporated into derivative valuations.
Counterparty credit risk (CCR) refers to the risk that a counterparty will default on financial contracts before fulfilling their obligations. CCR is managed through tools like netting, collateralization, and hedging. Key CCR indicators include exposure at default and expected positive exposure. Basel II introduced capital requirements for CCR based on these indicators. Basel III added a new CVA capital charge to account for mark-to-market losses from CCR not covered by Basel II. However, market failures like moral hazard and free-rider problems can still limit the effectiveness of CCR management.
This document summarizes key topics related to over-the-counter (OTC) collateralization, credit valuation adjustment (CVA), and funding valuation adjustment (FVA). It discusses:
1) Practical challenges of untangling credit and funding costs in derivatives valuation given changing regulation and market standards.
2) Issues around risk-free rates, multi-curve environments, and risky sovereign debt affecting collateral and valuation.
3) Evolving business models around central clearing counterparties (CCPs), CVA desks, and collateral transformation in response to these issues.
4) Modeling of collateral agreements and the reduction but not elimination of counterparty risk through collateralization.
5)
Global Derivatives 2014 - Did Basel put the final nail in the coffin of CSA D...Alexandre Bon
FVA in presence of stochastic funding spreads, Inititial Margins and imperfect collateralisation conditions.
Since the birth of CSA discounting during the GFC, major regulatory changes have been reshaping collateral practices in a way that challenges the fundamental assumptions of the method.
Agenda:
- FVA for economic value & incremental pricing
- FVA via CSA discounting or Exposure simulation
- Funding spreads and exposure co-dependence
- Collateralisation regimes in the New Normal and Initial Margins
Long horizon simulations for counterparty risk Alexandre Bon
The Challenges of Long Horizon Simulations in the context of Counterparty Risk modeling : CVA, PFE and Regulatory reporting.
This joint presentation reviews the key decisions that need making regarding the choice of risk factor evolution models and calibration methods. In particular, we will analyse the performance of classical historical calibration methods (such as Maximum Likelihood and the Efficient Method of Moments) in estimating the volatility and drift terms of the Hull & White class of Interest Rate models ; both in terms of convergence and stability.
As most methods perform satisfactorily for volatility but disappoint on the mean reversion estimation, we propose a new modified Variance Estimation method that significantly outperform the classical approaches.
Lastly, after reviewing historical economic evidence of mean-reversion dynmics in high interest rate regime, we propose modifying classical models by making mean reversion non-linear and accelerating for high rates - that can be referred as "+R" models.
This model address unrealistically large and persistent interest rates values often observed at high quantile in PFE and CVA simulations.
RiskMinds - Did Basel & IOSCO put the final nail in the coffin of CSA-discoun...Alexandre Bon
FVA in presence of stochastic funding spreads, Inititial Margins and imperfect collateralisation conditions.
Since the birth of CSA discounting during the GFC, major regulatory changes have been reshaping collateral practices in a way that challenges the fundamental assumptions of the method.
Agenda:
- FVA via CSA discounting or Exposure simulation
- Funding spreads and exposure co-dependence
- Collateralisation regimes in the New Normal and Initial Margins
- FVA/MVA for VaR-based IMs and the SBA-M
- FVA for economic value & incremental pricing
Counterparty Credit Risk and CVA under Basel IIIHäner Consulting
Financial institutions which apply for an IMM waiver under Basel III need to fullfill a broad set of requirements. We present the quantitative, organizational and operational implications and provide some hand-on guidance how to fulfill the regulatory requirements.
OTC Collateralisation : implementations issues in the context of CVA & FVA
- The ideal CSA hypothesis : Imperfect collateralisation for credit mitigation and/or funding
- FVA vs. CSA-discounting
- Implications in terms of curves calibrations and management
- FVA for Cleared positions
- FVA or CSA-discounting : which funding management model?
Quantifi Whitepaper: The Evolution Of Counterparty Credit Riskamoini
This white paper explores the evolution of approaches to counterparty credit risk management in major banks over the past two decades. It traces how models have progressed from simple reserve-based approaches to active simulation and hedging of counterparty exposures. Recent priorities include incorporating wrong-way risk, collateral risks, and clearing more products through central counterparties to reduce capital charges under Basel III. Overall banks have converged on actively managing counterparty risk through central simulation and hedging functions.
Counterparty credit risk (CCR) refers to the risk that a counterparty will default on financial contracts before fulfilling their obligations. CCR is managed through tools like netting, collateralization, and hedging. Key CCR indicators include exposure at default and expected positive exposure. Basel II introduced capital requirements for CCR based on these indicators. Basel III added a new CVA capital charge to account for mark-to-market losses from CCR not covered by Basel II. However, market failures like moral hazard and free-rider problems can still limit the effectiveness of CCR management.
This document summarizes key topics related to over-the-counter (OTC) collateralization, credit valuation adjustment (CVA), and funding valuation adjustment (FVA). It discusses:
1) Practical challenges of untangling credit and funding costs in derivatives valuation given changing regulation and market standards.
2) Issues around risk-free rates, multi-curve environments, and risky sovereign debt affecting collateral and valuation.
3) Evolving business models around central clearing counterparties (CCPs), CVA desks, and collateral transformation in response to these issues.
4) Modeling of collateral agreements and the reduction but not elimination of counterparty risk through collateralization.
5)
Global Derivatives 2014 - Did Basel put the final nail in the coffin of CSA D...Alexandre Bon
FVA in presence of stochastic funding spreads, Inititial Margins and imperfect collateralisation conditions.
Since the birth of CSA discounting during the GFC, major regulatory changes have been reshaping collateral practices in a way that challenges the fundamental assumptions of the method.
Agenda:
- FVA for economic value & incremental pricing
- FVA via CSA discounting or Exposure simulation
- Funding spreads and exposure co-dependence
- Collateralisation regimes in the New Normal and Initial Margins
Long horizon simulations for counterparty risk Alexandre Bon
The Challenges of Long Horizon Simulations in the context of Counterparty Risk modeling : CVA, PFE and Regulatory reporting.
This joint presentation reviews the key decisions that need making regarding the choice of risk factor evolution models and calibration methods. In particular, we will analyse the performance of classical historical calibration methods (such as Maximum Likelihood and the Efficient Method of Moments) in estimating the volatility and drift terms of the Hull & White class of Interest Rate models ; both in terms of convergence and stability.
As most methods perform satisfactorily for volatility but disappoint on the mean reversion estimation, we propose a new modified Variance Estimation method that significantly outperform the classical approaches.
Lastly, after reviewing historical economic evidence of mean-reversion dynmics in high interest rate regime, we propose modifying classical models by making mean reversion non-linear and accelerating for high rates - that can be referred as "+R" models.
This model address unrealistically large and persistent interest rates values often observed at high quantile in PFE and CVA simulations.
RiskMinds - Did Basel & IOSCO put the final nail in the coffin of CSA-discoun...Alexandre Bon
FVA in presence of stochastic funding spreads, Inititial Margins and imperfect collateralisation conditions.
Since the birth of CSA discounting during the GFC, major regulatory changes have been reshaping collateral practices in a way that challenges the fundamental assumptions of the method.
Agenda:
- FVA via CSA discounting or Exposure simulation
- Funding spreads and exposure co-dependence
- Collateralisation regimes in the New Normal and Initial Margins
- FVA/MVA for VaR-based IMs and the SBA-M
- FVA for economic value & incremental pricing
Counterparty Credit Risk and CVA under Basel IIIHäner Consulting
Financial institutions which apply for an IMM waiver under Basel III need to fullfill a broad set of requirements. We present the quantitative, organizational and operational implications and provide some hand-on guidance how to fulfill the regulatory requirements.
OTC Collateralisation : implementations issues in the context of CVA & FVA
- The ideal CSA hypothesis : Imperfect collateralisation for credit mitigation and/or funding
- FVA vs. CSA-discounting
- Implications in terms of curves calibrations and management
- FVA for Cleared positions
- FVA or CSA-discounting : which funding management model?
Quantifi Whitepaper: The Evolution Of Counterparty Credit Riskamoini
This white paper explores the evolution of approaches to counterparty credit risk management in major banks over the past two decades. It traces how models have progressed from simple reserve-based approaches to active simulation and hedging of counterparty exposures. Recent priorities include incorporating wrong-way risk, collateral risks, and clearing more products through central counterparties to reduce capital charges under Basel III. Overall banks have converged on actively managing counterparty risk through central simulation and hedging functions.
Credit derivatives are financial instruments whose value is derived from an underlying credit asset like a bond or loan. The two main types are credit default swaps and total return swaps. Credit default swaps allow one party to transfer the credit risk of a bond or loan to another party. Total return swaps transfer both the credit risk and interest rate risk of the underlying asset. These instruments allow investors to take on or reduce exposure to specific credit risks.
Counterparty Risk in the Over-The-Counter Derivatives MarketNikhil Gangadhar
This paper discusses counterparty risk that may stem from the over-the-counter (OTC) derivatives market in the wake of the 2008 financial crisis. The paper aims to assess potential losses to the financial system if one or more major banks or brokers default on their OTC derivative contracts. To estimate counterparty risk, the paper calculates potential losses under different scenarios, taking into account the exposure of the financial system to institutions and the probability that other institutions may also default if a major counterparty fails. The results are discussed in the context of ensuring banking system stability.
This document discusses quantitative portfolio management of default risk. It introduces a model for measuring default risk of individual assets based on the market value and volatility of the underlying company's assets. It describes how to infer asset values from observable equity characteristics. It also discusses measuring portfolio diversification through correlations between asset values and quantifying the expected and unexpected loss from defaults. The goal is to apply modern portfolio theory to debt portfolios in order to minimize risk and maximize returns through diversification.
This chapter discusses several factors that influence interest rates: marketability, liquidity, default risk, call privileges, prepayment risk, convertibility, and taxation. It explains how each of these factors affects the promised and expected yields on different types of financial assets. The risk-free interest rate underlies all other interest rates, which are scaled upward depending on their degree of additional risk factors like default risk or prepayment risk.
The document discusses financial derivatives, including their definition, common types, and risks. It provides details on options, forwards, futures, stripped mortgage-backed securities, structured notes, swaps, rights of use, and hedge funds. It discusses why derivatives exist, the risks involved, leveraging, trading of derivatives, and both positive and negative perspectives on their use.
Credit risk modeling helps estimate potential credit losses and determine how much capital is needed to protect against such risks. It is more complex than market risk modeling due to factors like limited data on defaults, illiquidity in credit markets, non-normal distributions of losses, and correlations between obligors that increase in downturns. The main approaches are default mode, which considers losses from defaults, and mark-to-market, which also incorporates losses from credit quality deterioration. Structural models link default to a firm's asset value while reduced form models view default as a random event. Correlations between probability of default, exposure at default, and loss given default are also important to consider.
This document discusses three main approaches to modeling credit risk: structural, reduced form, and incomplete information. It provides details on the structural approach using the Merton and first passage models and the reduced form approach using a Poisson process for default. It also discusses extending these models to value bank loans, specifically comparing the structural KMV model and reduced form CreditRisk+ model. The critiques note limitations like non-observability of variables, lack of dynamics, and potential underestimation of risk.
Exchanges are centralized places where certain securities, commodities, derivatives, and other financial instruments are traded. In order to facilitate trading among buyers and sellers of these products, exchanges take the central position of being the counterparty to both buyers and the sellers of the product. This is done to remove the possibility of disputes that may arise from the non-performance of the counterparty. The exchange guarantees trades will be honored. This creates credit risk for the exchange attributable to the buyers and the sellers of its products. To address the potential loss due to the credit risk undertaken by exchanges from these buyers and sellers of the exchange traded products, exchanges demand certain margin requirements from their counterparties.
This presentation addresses in detail the issues that are considered for calculation of margin requirements and maintenance.
Coupling of Market Risk,Credit Risk, and Liquidity RiskGateway Partners
The main risks of any financial product are market risk, credit risk, and liquidity risk. When we reference credit risk, we are including both market-based credit risk, where widening of credit spreads is indicative of credit quality deterioration, as well as counterparty credit risk. This may be caused by the loss in the market value of the portfolio holdings or market illiquidity. Similarly, liquidity risk includes the funding liquidity as well as the market liquidity of different asset classes. In general, these risks are treated separately as if they are totally Independent of each other. That assumption is untrue as any loss in market value impacts both funding costs as well as credit quality loss. Similarly, any loss in liquidity can impact the credit performance risk as well as the market prices of an asset. If we measure the market, credit, and liquidity risk separately, this risk can be significantly understated as the coupling can be highly non-linear, thus increasing the losses several orders of magnitude.
The following presentation discusses this coupling of market, credit, and liquidity risk as well as the difficulties in measuring them in addition to possible solutions to hedge them.
Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances. For example:
• A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan
• A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company
• A business or consumer does not pay a trade invoice when due
• A business does not pay an employee's earned wages when due
• A business or government bond issuer does not make a payment on a coupon or principal payment when due
• An insolvent insurance company does not pay a policy obligation
• An insolvent bank won't return funds to a depositor
• A government grants bankruptcy protection to an insolvent consumer or business.
To reduce the lender's credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance or seek security or guarantees of third parties, besides other possible strategies. In general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt.
Case study of a comprehensive risk analysis for an asset managerGateway Partners
The following case study is an excerpt of a comprehensive risk analysis prepared for an asset manager client of Gateway Partners. This client is a medium-sized asset manager with offices in both the U.S. and abroad who needed assistance in both quantifying and fully understanding the risk profile of their multi-billion dollar portfolio. Additional risk concerns of this client include “worst case” risk scenario analysis and the use of derivative instruments to assist in the hedging of their portfolio. While this case study has been used with the permission of our client, specific securities and the amounts they represent in the client portfolio have been changed and reduced to protect the identity of the client. Gateway Partners is proud to present this case study as an example of the risk management services we provide to our clients.
This document introduces derivatives and their role in managing risk. It discusses forwards, futures, and options contracts and introduces the basic concepts needed to analyze these instruments. It also discusses the major traders involved in these markets and some key terms like long/short positions and bid-ask spreads.
This document provides an overview of credit derivatives, including:
- Their origin in the 1980s securitization market and formal launch in 1991.
- Definitions, including that they allow one party to transfer credit risk of a reference asset to another party.
- Types, including credit default swaps, total return swaps, and credit linked notes.
- Benefits for banks and financial institutions, such as freeing up capital, maintaining client relationships, constructing customized risk portfolios, and diversifying credit risk.
This document provides an overview of asset liability management (ALM) and hire-purchase agreements. It defines ALM as a technique to manage risks and earn returns by balancing assets and liabilities. Key aspects of ALM include measuring interest rate, credit, and liquidity risks. Models for ALM include gap analysis, duration gap analysis, VAR, and simulation. Hire-purchase agreements conditionally sell goods, allowing buyers to hire goods and later purchase them by installments. The document outlines rights and obligations of hirers and owners under such agreements.
The document introduces credit derivatives and their key types. Credit derivatives allow parties to transfer credit risk by buying and selling protection against the default of a reference entity. The main types discussed are credit default swaps, credit spread options, and credit-linked notes. Credit default swaps allow a party to buy protection, paying a premium in exchange for a payout if the reference entity defaults. Credit spread options grant the right to buy a bond at a strike spread. Credit-linked notes transfer risk from the issuer to investors by tying note repayment to a reference loan.
This document provides an overview and introduction to derivatives. It defines derivatives as contracts that derive their value from an underlying asset, and lists some common types including forwards, futures, options, swaps, and various structured products. It states that most derivatives are traded over-the-counter or on exchanges, and that they are one of the main categories of financial instruments along with stocks and debt.
The document discusses establishing appropriate credit limits for customers. It recommends considering qualitative factors like a customer's character, capacity to pay, and capital, as well as quantitative factors from financial statements. A sample credit limit policy is provided that establishes criteria like granting 10% of a customer's tangible net worth as the base limit and adjusting up or down based on additional factors like security, payment history, and financial ratios. The policy outlines obtaining annual financial statements and reviewing accounts regularly.
Fim project credit derivatives in indiaBishnu Kumar
This document discusses credit derivatives, which allow one party to transfer credit risk associated with a loan or bond to another party. The main types of credit derivatives are credit default swaps, total return swaps, credit linked notes, and credit spread options. Credit default swaps are the most common type and involve periodic payments from the protection buyer to the protection seller in exchange for a payoff if the underlying asset defaults. Risks of credit derivatives include credit risk, market risk, and legal risk related to counterparty failure and lack of standard documentation. The credit derivatives market has grown significantly in recent years as a way to diversify risk.
Dear students get fully solved assignments
Send your semester & Specialization name to our mail id :
help.mbaassignments@gmail.com
or
call us at : 08263069601
IFRS 13 CVA DVA FVA and the Implications for Hedge Accounting - By Quantifi a...Quantifi
International Financial Reporting Standard 13: fair value measurement (IFRS 13) was originally issued in May 2011 and applies to annual periods beginning on or after 1 January 2013. IFRS 13 provides a framework for determining fair value, clarifies the factors to be considered for estimating fair value and identifies key principles for estimating fair value. IFRS 13 facilitates preparers to apply, and users to better understand, the fair value measurements in financial statements, therefore helping improve consistency in the application of fair value measurement.
This document provides an introduction to credit derivatives. It defines credit risk and credit deterioration risk as the risks of financial loss due to a borrower defaulting or their credit quality decreasing. Credit derivatives allow investors to transfer these risks. The global market for credit derivatives has grown significantly. Common credit derivative products include credit default swaps, which transfer default risk, total rate of return swaps, which transfer both credit and price risk, and credit spread products. The document discusses the key features and uses of these different credit derivative products.
Credit derivatives are financial instruments whose value is derived from an underlying credit asset like a bond or loan. The two main types are credit default swaps and total return swaps. Credit default swaps allow one party to transfer the credit risk of a bond or loan to another party. Total return swaps transfer both the credit risk and interest rate risk of the underlying asset. These instruments allow investors to take on or reduce exposure to specific credit risks.
Counterparty Risk in the Over-The-Counter Derivatives MarketNikhil Gangadhar
This paper discusses counterparty risk that may stem from the over-the-counter (OTC) derivatives market in the wake of the 2008 financial crisis. The paper aims to assess potential losses to the financial system if one or more major banks or brokers default on their OTC derivative contracts. To estimate counterparty risk, the paper calculates potential losses under different scenarios, taking into account the exposure of the financial system to institutions and the probability that other institutions may also default if a major counterparty fails. The results are discussed in the context of ensuring banking system stability.
This document discusses quantitative portfolio management of default risk. It introduces a model for measuring default risk of individual assets based on the market value and volatility of the underlying company's assets. It describes how to infer asset values from observable equity characteristics. It also discusses measuring portfolio diversification through correlations between asset values and quantifying the expected and unexpected loss from defaults. The goal is to apply modern portfolio theory to debt portfolios in order to minimize risk and maximize returns through diversification.
This chapter discusses several factors that influence interest rates: marketability, liquidity, default risk, call privileges, prepayment risk, convertibility, and taxation. It explains how each of these factors affects the promised and expected yields on different types of financial assets. The risk-free interest rate underlies all other interest rates, which are scaled upward depending on their degree of additional risk factors like default risk or prepayment risk.
The document discusses financial derivatives, including their definition, common types, and risks. It provides details on options, forwards, futures, stripped mortgage-backed securities, structured notes, swaps, rights of use, and hedge funds. It discusses why derivatives exist, the risks involved, leveraging, trading of derivatives, and both positive and negative perspectives on their use.
Credit risk modeling helps estimate potential credit losses and determine how much capital is needed to protect against such risks. It is more complex than market risk modeling due to factors like limited data on defaults, illiquidity in credit markets, non-normal distributions of losses, and correlations between obligors that increase in downturns. The main approaches are default mode, which considers losses from defaults, and mark-to-market, which also incorporates losses from credit quality deterioration. Structural models link default to a firm's asset value while reduced form models view default as a random event. Correlations between probability of default, exposure at default, and loss given default are also important to consider.
This document discusses three main approaches to modeling credit risk: structural, reduced form, and incomplete information. It provides details on the structural approach using the Merton and first passage models and the reduced form approach using a Poisson process for default. It also discusses extending these models to value bank loans, specifically comparing the structural KMV model and reduced form CreditRisk+ model. The critiques note limitations like non-observability of variables, lack of dynamics, and potential underestimation of risk.
Exchanges are centralized places where certain securities, commodities, derivatives, and other financial instruments are traded. In order to facilitate trading among buyers and sellers of these products, exchanges take the central position of being the counterparty to both buyers and the sellers of the product. This is done to remove the possibility of disputes that may arise from the non-performance of the counterparty. The exchange guarantees trades will be honored. This creates credit risk for the exchange attributable to the buyers and the sellers of its products. To address the potential loss due to the credit risk undertaken by exchanges from these buyers and sellers of the exchange traded products, exchanges demand certain margin requirements from their counterparties.
This presentation addresses in detail the issues that are considered for calculation of margin requirements and maintenance.
Coupling of Market Risk,Credit Risk, and Liquidity RiskGateway Partners
The main risks of any financial product are market risk, credit risk, and liquidity risk. When we reference credit risk, we are including both market-based credit risk, where widening of credit spreads is indicative of credit quality deterioration, as well as counterparty credit risk. This may be caused by the loss in the market value of the portfolio holdings or market illiquidity. Similarly, liquidity risk includes the funding liquidity as well as the market liquidity of different asset classes. In general, these risks are treated separately as if they are totally Independent of each other. That assumption is untrue as any loss in market value impacts both funding costs as well as credit quality loss. Similarly, any loss in liquidity can impact the credit performance risk as well as the market prices of an asset. If we measure the market, credit, and liquidity risk separately, this risk can be significantly understated as the coupling can be highly non-linear, thus increasing the losses several orders of magnitude.
The following presentation discusses this coupling of market, credit, and liquidity risk as well as the difficulties in measuring them in addition to possible solutions to hedge them.
Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances. For example:
• A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan
• A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company
• A business or consumer does not pay a trade invoice when due
• A business does not pay an employee's earned wages when due
• A business or government bond issuer does not make a payment on a coupon or principal payment when due
• An insolvent insurance company does not pay a policy obligation
• An insolvent bank won't return funds to a depositor
• A government grants bankruptcy protection to an insolvent consumer or business.
To reduce the lender's credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance or seek security or guarantees of third parties, besides other possible strategies. In general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt.
Case study of a comprehensive risk analysis for an asset managerGateway Partners
The following case study is an excerpt of a comprehensive risk analysis prepared for an asset manager client of Gateway Partners. This client is a medium-sized asset manager with offices in both the U.S. and abroad who needed assistance in both quantifying and fully understanding the risk profile of their multi-billion dollar portfolio. Additional risk concerns of this client include “worst case” risk scenario analysis and the use of derivative instruments to assist in the hedging of their portfolio. While this case study has been used with the permission of our client, specific securities and the amounts they represent in the client portfolio have been changed and reduced to protect the identity of the client. Gateway Partners is proud to present this case study as an example of the risk management services we provide to our clients.
This document introduces derivatives and their role in managing risk. It discusses forwards, futures, and options contracts and introduces the basic concepts needed to analyze these instruments. It also discusses the major traders involved in these markets and some key terms like long/short positions and bid-ask spreads.
This document provides an overview of credit derivatives, including:
- Their origin in the 1980s securitization market and formal launch in 1991.
- Definitions, including that they allow one party to transfer credit risk of a reference asset to another party.
- Types, including credit default swaps, total return swaps, and credit linked notes.
- Benefits for banks and financial institutions, such as freeing up capital, maintaining client relationships, constructing customized risk portfolios, and diversifying credit risk.
This document provides an overview of asset liability management (ALM) and hire-purchase agreements. It defines ALM as a technique to manage risks and earn returns by balancing assets and liabilities. Key aspects of ALM include measuring interest rate, credit, and liquidity risks. Models for ALM include gap analysis, duration gap analysis, VAR, and simulation. Hire-purchase agreements conditionally sell goods, allowing buyers to hire goods and later purchase them by installments. The document outlines rights and obligations of hirers and owners under such agreements.
The document introduces credit derivatives and their key types. Credit derivatives allow parties to transfer credit risk by buying and selling protection against the default of a reference entity. The main types discussed are credit default swaps, credit spread options, and credit-linked notes. Credit default swaps allow a party to buy protection, paying a premium in exchange for a payout if the reference entity defaults. Credit spread options grant the right to buy a bond at a strike spread. Credit-linked notes transfer risk from the issuer to investors by tying note repayment to a reference loan.
This document provides an overview and introduction to derivatives. It defines derivatives as contracts that derive their value from an underlying asset, and lists some common types including forwards, futures, options, swaps, and various structured products. It states that most derivatives are traded over-the-counter or on exchanges, and that they are one of the main categories of financial instruments along with stocks and debt.
The document discusses establishing appropriate credit limits for customers. It recommends considering qualitative factors like a customer's character, capacity to pay, and capital, as well as quantitative factors from financial statements. A sample credit limit policy is provided that establishes criteria like granting 10% of a customer's tangible net worth as the base limit and adjusting up or down based on additional factors like security, payment history, and financial ratios. The policy outlines obtaining annual financial statements and reviewing accounts regularly.
Fim project credit derivatives in indiaBishnu Kumar
This document discusses credit derivatives, which allow one party to transfer credit risk associated with a loan or bond to another party. The main types of credit derivatives are credit default swaps, total return swaps, credit linked notes, and credit spread options. Credit default swaps are the most common type and involve periodic payments from the protection buyer to the protection seller in exchange for a payoff if the underlying asset defaults. Risks of credit derivatives include credit risk, market risk, and legal risk related to counterparty failure and lack of standard documentation. The credit derivatives market has grown significantly in recent years as a way to diversify risk.
Dear students get fully solved assignments
Send your semester & Specialization name to our mail id :
help.mbaassignments@gmail.com
or
call us at : 08263069601
IFRS 13 CVA DVA FVA and the Implications for Hedge Accounting - By Quantifi a...Quantifi
International Financial Reporting Standard 13: fair value measurement (IFRS 13) was originally issued in May 2011 and applies to annual periods beginning on or after 1 January 2013. IFRS 13 provides a framework for determining fair value, clarifies the factors to be considered for estimating fair value and identifies key principles for estimating fair value. IFRS 13 facilitates preparers to apply, and users to better understand, the fair value measurements in financial statements, therefore helping improve consistency in the application of fair value measurement.
This document provides an introduction to credit derivatives. It defines credit risk and credit deterioration risk as the risks of financial loss due to a borrower defaulting or their credit quality decreasing. Credit derivatives allow investors to transfer these risks. The global market for credit derivatives has grown significantly. Common credit derivative products include credit default swaps, which transfer default risk, total rate of return swaps, which transfer both credit and price risk, and credit spread products. The document discusses the key features and uses of these different credit derivative products.
This white paper explores the evolution of approaches to counterparty credit risk management in major banks over the past two decades. It traces how models have progressed from simple reserve-based approaches to active simulation and hedging of counterparty exposures. Current priorities include incorporating wrong-way risk, recognizing collateral risks, capturing more of the portfolio, and using central counterparties and active management to reduce capital charges under Basel III.
Challenges in Implementing a Counterparty Risk Management ProcessQuantifi
The document discusses the challenges of implementing a counterparty risk management process. It outlines key objectives such as centralized data storage, CVA pricing that incorporates collateral and netting agreements, and regulatory capital calculations. Significant challenges include gathering transaction data from multiple systems, performing complex CVA calculations on the entire portfolio, and meeting objectives like near real-time pricing while managing regulatory requirements.
A credit derivative is a financial contract in which the underlying is a credit asset (debt or fixed-income instrument). The purpose of a credit derivative is to transfer credit risk (and all or part of the income stream in relation to the borrower) without transferring the asset itself.
A credit derivative serves as a sort of insurance policy allowing an originator or buyer to transfer the risk on a credit asset (of which he may or may not be the owner) to the seller(s) of the protection or counterparties.
Credit derivatives are financial instruments that allow parties to transfer credit risk of underlying entities like loans or bonds between each other. There are various types of credit derivatives, including credit default swaps (CDS) where one party pays an annual fee in exchange for a payout if the underlying entity defaults, and synthetic CDOs which invest in CDS or other assets to obtain exposure to credit risks. While credit derivatives help distribute risk, their value depends on the credit quality of both the underlying borrower and the counterparty assuming the risk.
Quantifi whitepaper how the credit crisis has changed counterparty risk man...Quantifi
This paper will explore some of the key changes to internal counterparty risk management processes by tracing typical workflows within banks before and after CVA desks, and how increased clearing due to regulatory mandates, affects these workflows. Since CVA pricing and counterparty risk management workflows require extensive amounts of data, as well as a scalable, high-performance technology, it is important to understand the data management and analytical challenges involved.
• Current trends and best practices
• Key data and technology challenges
Journal Of Pension Planning & Compliance Otc Derivativeswhhope
This document summarizes key features and risks of over-the-counter (OTC) derivatives and lessons for their use in retirement plans. OTC derivatives are customized transactions between two parties that take place in an unregulated market. They expose parties to market, counterparty credit, operations, and legal risks due to their complexity. Recent high-profile losses from unauthorized trades and valuation errors remind plans of derivatives' risks. Proper risk management including board oversight, constraints on use, and risk monitoring can help plans mitigate risks from using OTC derivatives.
- First American Bank is considering using a credit default swap to help mitigate Charles Bank International's credit risk in providing a $50 million loan to CapEx Unlimited, a telecommunications company.
- Through the CDS, CBI would make periodic fee payments to First American Bank in exchange for credit protection on the loan to CapEx. This would transfer some of the credit risk from CBI to First American Bank.
- There are various ways to calculate the appropriate spread for the CDS, including using historical default data or bond prices of comparable companies. The estimated spread would likely be between 1.3-5.5%.
Credit default swaps (CDS) are contracts that transfer credit risk from one party to another. A CDS controls credit risk, while an interest rate swap controls interest rate risk. If a reference entity experiences a credit event like default, the protection seller compensates the buyer. Restructuring is a controversial credit event because it can trigger a payout even for routine debt restructurings. A CDS has an option-like payoff because payment depends on a credit event occurring. For asset-backed securities, the focus is on cash flow adequacy rather than bankruptcy. Physical settlement of a CDS involves delivery of the reference obligation, while cash settlement involves a payment equal to the price difference.
The failure of credit ratings agencies to accurately rate structured financial products like mortgage-backed securities and collateralized debt obligations contributed significantly to the 2008 financial crisis. While some reforms have been implemented, the ratings process remains opaque and problematic. This paper proposes establishing a single, public numerical scale for rating structured credits as a better way to standardize risk measures, increase transparency, and empower investors to evaluate risk more accurately. Such a benchmark scale, treated as a public good, should be developed and supported by a federal financial regulator.
This document discusses credit default swaps (CDS). A CDS is an agreement where the buyer makes periodic payments to the seller, who agrees to make a payment to the buyer if a loan defaults. CDS can be used to hedge against default risk or speculate on credit risk. They allow entities to transfer default risk to investors willing to bear it. The document outlines the terms of CDS agreements, how they are used for hedging versus speculation, and provides examples of each.
Interest rate risk management what regulators want in 2015 7.15.2015Craig Taggart MBA
Areas covered in this section
Why Interest Rate Risk (IRR) should not be ignored
• Forward Rate Agreements (FRA’s) Forwards, Futures
• Swaps, Options
Why Bank Regulators continue to have a poor handle on interest rate risk
• Interest Rate Caps, floors, Collars
• LIBOR and UBS & Barclays rigging rates
• How should Financial Institutions determine which IRR vendor models are appropriate?
IRR Measurement methodologies are institutions
This document discusses two approaches to credit risk management: internally oriented and market oriented. The internally oriented approach estimates expected costs and volatility of future credit losses based on a firm's assessment, while the market oriented approach focuses on credit spreads observed in the market.
It then provides details on the internally oriented approach, which can use either a statistical analysis of historical default and loss data or an option-theoretic model. The statistical approach estimates probability of default and loss rates based on credit ratings and loan seniority. The option model views equity as a call option on firm assets, allowing calculation of default probability, recovery rates, and required credit spreads.
Issues with option models include their difficulty in capturing behavioral aspects of default
This document discusses the risks involved in structured finance transactions that rating agencies must assess beyond traditional credit risks. It identifies four categories of non-credit risks: 1) risks from the liability structure due to conflicting interests between different tranches, 2) risks from the underlying asset pool such as prepayment risk, 3) risks from third parties whose performance could impact the transaction, and 4) legal and documentation risks. It highlights how rating agencies evaluate these risks through cash flow analysis under various scenarios to determine appropriate credit enhancements and assign ratings. Structural features like waterfall payment rules and excess spread rules aim to balance competing investor interests, but conflicting incentives remain an ongoing challenge.
Drafting the Math – Understanding Financial Covenants, Tests, and Benchmarks ...Richard Saad
While it is impossible to describe and explain all financial covenants, and the variations thereof, that are commonly seen in lending and transactional work, here's a brief explanation as to purpose, calculation, expression and rationale, with an example of application.
Drafting the math – understanding financial covenants, tests, and benchmarks ...bennettjones
While it is impossible to describe and explain all financial covenants, and the variations thereof, that are commonly seen in lending and transactional work, here's a brief explanation as to purpose, calculation, expression and rationale, with an example of application.
Valuing a business, especially a financial institution, is complex and involves both quantitative and qualitative factors. There is no single correct valuation, as the value depends on the perspective of the buyer and weighting given to various drivers. When valuing banks, traditional methods like cash-free/debt-free and EBIT multiples are inappropriate because interest payments are a major revenue and cost factor. Parties typically use alternatives like applying a multiple to net asset value, valuing financial instruments individually, discounting loan portfolios, and basing value on assets under management. Completion accounts and purchase price adjustments are also common to address volatility between signing and closing deals involving banks.
Mercer Capital's Bank Watch | January 2020 | Community Bank Valuation Part 5Mercer Capital
This document summarizes valuation techniques for controlling interests in community banks, particularly in the context of acquisitions. It discusses evaluating earnings accretion, tangible book value earn-back periods, discounted cash flow analysis, and the comparable transactions method using recent bank M&A deals. Controlling interest valuations consider factors like cost savings, revenue enhancements, credit risks, cultural fit, and accounting impacts when evaluating a potential acquisition.
Synthetic securitization is a process where a bank transfers only the credit risk of a pool of assets, rather than the assets themselves, to a special purpose vehicle (SPV). The SPV issues credit-linked notes to investors. If a credit event occurs, such as default, the SPV uses the proceeds from credit default swaps to pay investors. This allows banks to reduce credit risk on their balance sheets while maintaining ownership of the original assets.
Economic Risk Factor Update: June 2024 [SlideShare]Commonwealth
May’s reports showed signs of continued economic growth, said Sam Millette, director, fixed income, in his latest Economic Risk Factor Update.
For more market updates, subscribe to The Independent Market Observer at https://blog.commonwealth.com/independent-market-observer.
STREETONOMICS: Exploring the Uncharted Territories of Informal Markets throug...sameer shah
Delve into the world of STREETONOMICS, where a team of 7 enthusiasts embarks on a journey to understand unorganized markets. By engaging with a coffee street vendor and crafting questionnaires, this project uncovers valuable insights into consumer behavior and market dynamics in informal settings."
Understanding how timely GST payments influence a lender's decision to approve loans, this topic explores the correlation between GST compliance and creditworthiness. It highlights how consistent GST payments can enhance a business's financial credibility, potentially leading to higher chances of loan approval.
Vicinity Jobs’ data includes more than three million 2023 OJPs and thousands of skills. Most skills appear in less than 0.02% of job postings, so most postings rely on a small subset of commonly used terms, like teamwork.
Laura Adkins-Hackett, Economist, LMIC, and Sukriti Trehan, Data Scientist, LMIC, presented their research exploring trends in the skills listed in OJPs to develop a deeper understanding of in-demand skills. This research project uses pointwise mutual information and other methods to extract more information about common skills from the relationships between skills, occupations and regions.
[4:55 p.m.] Bryan Oates
OJPs are becoming a critical resource for policy-makers and researchers who study the labour market. LMIC continues to work with Vicinity Jobs’ data on OJPs, which can be explored in our Canadian Job Trends Dashboard. Valuable insights have been gained through our analysis of OJP data, including LMIC research lead
Suzanne Spiteri’s recent report on improving the quality and accessibility of job postings to reduce employment barriers for neurodivergent people.
Decoding job postings: Improving accessibility for neurodivergent job seekers
Improving the quality and accessibility of job postings is one way to reduce employment barriers for neurodivergent people.
Lecture slide titled Fraud Risk Mitigation, Webinar Lecture Delivered at the Society for West African Internal Audit Practitioners (SWAIAP) on Wednesday, November 8, 2023.
2. Elemental Economics - Mineral demand.pdfNeal Brewster
After this second you should be able to: Explain the main determinants of demand for any mineral product, and their relative importance; recognise and explain how demand for any product is likely to change with economic activity; recognise and explain the roles of technology and relative prices in influencing demand; be able to explain the differences between the rates of growth of demand for different products.
Falcon stands out as a top-tier P2P Invoice Discounting platform in India, bridging esteemed blue-chip companies and eager investors. Our goal is to transform the investment landscape in India by establishing a comprehensive destination for borrowers and investors with diverse profiles and needs, all while minimizing risk. What sets Falcon apart is the elimination of intermediaries such as commercial banks and depository institutions, allowing investors to enjoy higher yields.
"Does Foreign Direct Investment Negatively Affect Preservation of Culture in the Global South? Case Studies in Thailand and Cambodia."
Do elements of globalization, such as Foreign Direct Investment (FDI), negatively affect the ability of countries in the Global South to preserve their culture? This research aims to answer this question by employing a cross-sectional comparative case study analysis utilizing methods of difference. Thailand and Cambodia are compared as they are in the same region and have a similar culture. The metric of difference between Thailand and Cambodia is their ability to preserve their culture. This ability is operationalized by their respective attitudes towards FDI; Thailand imposes stringent regulations and limitations on FDI while Cambodia does not hesitate to accept most FDI and imposes fewer limitations. The evidence from this study suggests that FDI from globally influential countries with high gross domestic products (GDPs) (e.g. China, U.S.) challenges the ability of countries with lower GDPs (e.g. Cambodia) to protect their culture. Furthermore, the ability, or lack thereof, of the receiving countries to protect their culture is amplified by the existence and implementation of restrictive FDI policies imposed by their governments.
My study abroad in Bali, Indonesia, inspired this research topic as I noticed how globalization is changing the culture of its people. I learned their language and way of life which helped me understand the beauty and importance of cultural preservation. I believe we could all benefit from learning new perspectives as they could help us ideate solutions to contemporary issues and empathize with others.
Abhay Bhutada, the Managing Director of Poonawalla Fincorp Limited, is an accomplished leader with over 15 years of experience in commercial and retail lending. A Qualified Chartered Accountant, he has been pivotal in leveraging technology to enhance financial services. Starting his career at Bank of India, he later founded TAB Capital Limited and co-founded Poonawalla Finance Private Limited, emphasizing digital lending. Under his leadership, Poonawalla Fincorp achieved a 'AAA' credit rating, integrating acquisitions and emphasizing corporate governance. Actively involved in industry forums and CSR initiatives, Abhay has been recognized with awards like "Young Entrepreneur of India 2017" and "40 under 40 Most Influential Leader for 2020-21." Personally, he values mindfulness, enjoys gardening, yoga, and sees every day as an opportunity for growth and improvement.
1. BASICS OF CREDIT VALUE ADJUSTMENTS
AND IMPLICATIONS FOR THE ASSESSMENT
OF HEDGE EFFECTIVENESS
This is the third paper in an ongoing series that outlines the principles of hedge
accounting under current and expected International and U.S. accounting
standards, including the practical challenges typically faced by organizations.
Prepared by
2. Basics of Credit Value Adjustments and Implications for the Assessment of Hedge Effectiveness
2
Under current U.S. and International accounting standards, the fair market value for Over-the-Counter
(OTC) derivatives should reflect the credit quality of the derivative instrument, which is generally cap-
tured through any applicable Credit Value Adjustment (CVA). CVA represents an adjustment made to the
value of the derivative to account for the credit risk of the counterparty to the instrument.
BRIEF HISTORY OF THE CREDIT VALUE ADJUSTMENT
The concept of default and its painful financial repercussions have been well established in history
and understood by investors. There have been many examples, including Sovereign entities such
as Russia (1998) and Argentina (2001), and Corporates such as Long Term Capital Management
(1998), WorldCom Inc. (2002), and Lehman Brothers (2008). These types of default events and the
subsequent financial fall-out lead to the evolution and development of credit risk management.
Much of the research in credit risk management was focused around the identification and
quantification of credit risk, particularly Counterparty Credit Risk (CCR) which is the exposure to loss
as a result of a counterparty failing to meet its contractual obligations due to default. While CCR was
conceptually understood, for years it was broad industry practice to value OTC derivative instruments
without considering CCR largely due to the mistaken belief that large derivative counterparties were
“too big to fail” or that it would be highly unlikely that counterparties would default. It was not until
the financial crisis in 2007/2008 that market participants realized the cold reality that no entity
was immune from default risk and began to incorporate the value of CCR and price into the cost of
derivative instruments, especially at the deal level.
CHALLENGES AROUND COUNTERPARTY CREDIT RISK
A derivative instrument is a contract between two counterparties whose price is dependent upon or
derived from one or more underlying variables. Derivatives can be classified as either a unilateral
derivative or as a bilateral derivative depending on the nature of the payoff of the instrument.
For the holder of a unilateral derivative instrument, like an investor in a purchased option position for
example, the exposure is to any loss that would occur if the counterparty were to default. The loss for
the investor would be measured as approximately the fair value of the instrument (less any recoveries)
at the time of default. The counterparty’s obligation and exposure arising from its sale of the option to
the investor remains the same whether or not the investor defaults. Any money owed to the investor
would still be owed to the investor’s estate, even in the event of default or bankruptcy by the investor.
Bilateral instruments, such as interest rate swaps and foreign exchange forward contracts, are more
complex than unilateral instruments since there is two-way or bilateral counterparty risk as both
the investor and the counterparty are exposed to each other. In the case of the swap, for example,
one counterparty is simultaneously long the receiving leg and short the paying leg, while the other
counterparty is simultaneously short the receiving leg and long the paying leg. The value of the swap
is the net value of the two legs and, in the event of default, the recovery is on the net market value of
the swap.
3. Basics of Credit Value Adjustments and Implications for the Assessment of Hedge Effectiveness
3
The challenge with bilateral instruments is that, at any given valuation measurement date, they may
be in either an asset or liability position or have no value at all. For this reason, each counterparty
is potentially exposed to the other. For example, Counterparty A, in an in-the-money positive asset
position today, is exposed to its Counterparty B because, in the event of default, Counterparty B would
owe it the positive market value of the swap. On the other hand, even Counterparty B, in the out-of-
the-money negative liability position, has potential credit exposure to Counterparty A. This is because
over time, that same swap may convert to an asset position. Even for a swap with zero net value,
counterparties are exposed to one another because the derivative has the potential to change to an
asset or liability position anytime.
This counterparty credit exposure or default risk may be mitigated through the netting and offset
provisions of the underlying International Swap Dealers Association (ISDA) master agreement (typically
an entity must first enter into an ISDA master agreement with a bank or dealer prior to transacting
derivative instruments), which permits offsetting negative or liability positions against positive or asset
positions with a specific counterparty in the event of default. There may also be an ISDA Credit Support
Annex (CSA) that provides for the posting of collateral to cover all or a portion of the net market value
of the position to limit the exposure.
WHAT IS A CREDIT VALUATION ADJUSTMENT?
CVA is the price of the default risk for a derivative or portfolio of derivatives with a particular
counterparty considering the effect of offsetting collateral. In other words, CVA is the price one would
pay to hedge the derivative instrument or portfolio of instruments’ specific counterparty credit risk.
CVA is calculated as the difference between the risk free value and the true risk-adjusted value. In
most cases, CVA reduces the mark-to-market value of an asset or a liability by the CVA’s amount.
CVA was introduced as an enhancement to fair value accounting around 2007/2008, coinciding with
the advent of the credit crisis. It made an entrance as a new requirement focusing on quantifying
the price of CCR just at the time when CCR and spreads attributable to those risks escalated to
unprecedented high levels. CVA has attracted much attention among derivative market participants
and their regulators alike as most major market participants already measure CVA in their accounting
statements and integrate CVA into deal pricing.
CVA VALUATION METHODOLOGIES
While CVA valuation methodologies are well advanced, they are still not standardized and may vary
amongst market participants, ranging from relatively simple to highly complex methodologies that are
driven largely by the sophistication and resources available to the market participant. Depending on
the particular market participant, CVA can be significant, particularly for large financial institutions that
are highly active in the derivative markets.
In order to determine CVA, organizations start by quantifying and measuring net counterparty credit
exposures (typically using specialized software). The next step is then to price the credit risk of those
exposures using the contractual terms and conditions of the derivative instrument or portfolio and
4. Basics of Credit Value Adjustments and Implications for the Assessment of Hedge Effectiveness
4
market inputs such as interest rates, foreign exchange rates, credit default swap (CDS) spreads and
other relevant variables.
Determining which CVA valuation methodology to adopt is often driven by the organization’s
sophistication, technical ability and resource constraints. The simplest approach involves calculating
the current mark-to-market value of the derivative and then repeating the calculation by adjusting the
discount rates, in a discounted cash flow framework, by the counterparty’s credit spread when the
exposure is to the counterparty (i.e. the derivative is in-the-money or an asset) or one’s own credit
spread if the counterparty is exposed to the entity (i.e. the derivative is out-of-the-money or a liability).
The difference between the two resulting present values is the CVA amount.
A more robust approach relies on a swaption type valuation approach to estimate the contingent
replacement value of the derivative using the counterparty’s respective credit spread. This approach
requires more sophisticated knowledge of derivative valuations and access to more specific market
data such as interest rate volatility surfaces.
More advanced approaches involve simulation modeling of market risk factors and risk factor
scenarios and then revaluing each derivative using, for example, thousands of simulation scenarios
by a hundred time steps. The resulting matrix of simulations by scenario and time steps is then
aggregated to generate an expected exposure profile for each netting counterparty. A collateralized
expected exposure profile is then derived by adjusting each counterparty’s expected exposure profile
to account for the receiving and posting of collateral as applicable.
Some market participants only consider CVA pertaining to their exposures to counterparties (i.e.
exposures that are at risk when counterparties default), though the majority also calculate an offsetting
Debt Valuation Adjustment (DVA), which is the counterparty’s exposure to the market participant. CVA
and DVA are then netted to calculate bilateral CVA.
COMMON CHALLENGES IN DETERMINING THE
CREDIT VALUE ADJUSTMENT
Often entities struggle with CVA due to system limitations which are tied to business needs. For
example, large financial institutions that have significant derivative portfolios actively manage CVA
through a dedicated CVA trading desk. These entities typically have advanced systems and analytics
along with the supporting infrastructure (including skilled staff) needed to run the simulations,
compute expected exposure and track and manage net collateral by counterparty that is netted against
the expected exposures.
Entities that have only a handful of derivatives would be hard-pressed to justify the same high cost
of the technology, infrastructure and people and tend to look for more cost and resource effective
alternatives such as spreadsheet models or some third-party web-based solutions. Computing CVA
using spreadsheet-based solutions is generally the least desirable solution, as they tend to be highly
unwieldy and prone to manual input error and typically still require some degree of analytical skill to
come up with the assumptions for the solution. However, for many organizations this may be the only
practical option.
5. Basics of Credit Value Adjustments and Implications for the Assessment of Hedge Effectiveness
5
A common challenge for all entities computing CVA (though with varying degrees) is obtaining the
necessary market data required for the calculation and, in particular, the expected exposure. At a
high level, discount curves, credit spread curves and volatility surfaces are generally all needed for
the exposure determination. The challenge lies in the fact that often this market data is not readily
available even for large financial institutions and requires some degree of judgment in coming up
with proxy data to be used to compute CVA. Name-specific or proxy CDS spreads are typically used
for credit spreads if available. Alternatively, credit spread proxy measures such as new debt issuance
spreads are commonly used where CDS spreads are not readily available. Significant judgement can
also be required in determining which proxy measures to choose, particularly if for example there are
no recent appropriate name-specific debt-issuances to reference and/or one has to then explore debt
issuance spreads for peers.
Generally, third-party market data service providers are needed to supply both the current and
historical market data required to perform the assessment analysis as conventional data sources such
as newspapers and the internet are insufficient and do not provide adequate historical data.
CREDIT VALUE ADJUSTMENT AND HEDGE ACCOUNTING
This principle of credit risk and CVA also extends to the valuation of OTC derivatives when assessing
the effectiveness of hedge relationships and measuring ineffectiveness. For example, when comparing
the change in the fair value of the derivative hedging instrument to the change in the fair value of the
hedged item (such as a fixed rate bond) in a Fair Value hedge, the valuation of the derivative should
include the applicable CVA. Similarly, when using a statistical technique, such as Regression Analysis,
to assess effectiveness, the impact of CVA should be included in the data points that represent the
derivative hedging instrument. This principle generally applies to all types of hedge relationships,
including Fair Value hedges, Cash Flow hedges and Net Investment hedges, though differences
in application exist between International and U.S. standards. Under U.S. standards, when certain
conditions relating to the probability of default of either the entity or the counterparty are met, credit
risk may be excluded from the valuation of derivatives for purposes of assessing effectiveness only.
It also follows that in principle, the method or approach selected by an entity to incorporate CVA in
the valuation of OTC derivatives should be the basis for the method or approach used when valuing
hedging derivatives for purposes of assessing and measuring effectiveness for hedge accounting.
Consequently, the challenges associated with CVA have a tendency to compound when the methods
selected for assessing effectiveness are more complex, for example, with regression-based
methodologies. The need for sufficient and appropriate expertise and resources therefore becomes
even more critical for those organizations that have a significant derivative portfolio and apply hedge
accounting extensively.
6. Basics of Credit Value Adjustments and Implications for the Assessment of Hedge Effectiveness
6
CONCLUSION
It is clear that capturing the dollar value of credit in the fair value of a derivative instrument or
portfolio makes sense notwithstanding that it is also a requirement under International and U.S.
accounting standards. However, doing so is somewhat of an art as well as a science. Regardless of
the methodology used to compute CVA, a certain level of expertise and management judgement is
required to ensure that CVA has been considered and appropriately applied. This is true not only for
general derivative valuation purposes, but also for the assessment and measurement of effectiveness
for those hedge relationships subject to hedge accounting. In choosing a methodology, an entity needs
to consider the availability of expertise and resources as well as how material the impact of such an
adjustment may be to the financial results.
Given the complexity and level of judgement involved, it is best to discuss CVA with your financial
advisors, accountants, systems providers, auditors and other practitioners in this field who are
conversant with market practices and current trends to determine the most appropriate approach to
apply.
The next paper in the series is titled “Upcoming Changes to Hedge Accounting under International
and U.S. Standards” and will provide further insight on the changes to hedge accounting currently
being deliberated by the International Accounting Standards Board and the U.S. Financial
Accounting Standards Board.
7. Basics of Credit Value Adjustments and Implications for the Assessment of Hedge Effectiveness
7
About KPMG
KPMG is a global network of professional firms providing Audit, Tax and Advisory services. KPMG
operates in 150 countries and has 138,000 people working in member firms around the world. The
independent member firms of the KPMG network are affiliated with KPMG International Cooperative
(“KPMG International”), a Swiss entity. Each KPMG firm is a legally distinct and separate entity and
describes itself as such.
About FINCAD
Founded in 1990, FINCAD provides advanced modelling solutions built on award-winning, patent
pending technology. With more than 4,000 clients in over 80 countries around the world, FINCAD
is the leading provider of financial analytics technology, enabling global market participants to make
informed hedging and investment decisions. FINCAD provides software and services supporting the
valuation, reporting and risk management of derivatives and fixed income portfolios to banks, corporate
treasuries, hedge funds, asset management firms, audit firms, and governments. FINCAD Analytics can
be accessed through Excel, MATLAB, as a Software-as-a-Service or embedded into an existing system
through software development kits. Now, over 70 FINCAD Alliance Partners embed FINCAD Analytics
within their solutions. FINCAD provides sales and client services from Dublin, Ireland, and Vancouver,
Canada.
Note: Organizations should consult the appropriate financial accounting standards prior to applying hedge accounting. These
include International Accounting Standard 39 – Financial Instruments: Recognition and Measurement, and in the U.S.,
Accounting Standards Codification 815 – Derivatives and Hedging. This article is for information purposes only and is not
intended to prescribe in detail how to meet the requirements for hedge accounting under International or U.S. accounting
principles. In addition, an entity’s accountants should be involved in any assessment regarding the application of hedge
accounting.