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Best Practice Analysis of Credit Valuation Adjustment (CVA) Methodologies Under ASC 820 (formerly FAS 157)

I. OBJECTIVE AND BACKGROUND

Objective
This white paper compares various approaches to calculating the fair value and the attendant credit valuation adjustment (CVA) for interest rate and foreign exchange derivatives in accordance with the provisions of Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures, (formerly Statement of Financial Accounting Standards No. 157, Fair Value Measurements).

The guidelines of Topic 820 require that valuations incorporate the assumptions that market participants would use in performing valuations of financial instruments measured at fair value. In practice, two broad methods for determining CVAs have emerged. One approach uses simplified current exposure methods which focus on the current values of derivative positions to estimate the effect of credit risk on these values. The other approach uses more complex models to calculate the total expected exposure of the derivative positions, based on both current and potential future exposure. This paper will outline these different approaches and compare the results of current and potential future exposure models using specific examples of each.

Background
Topic 820 is an accounting standard issued in September 2006 as FAS 157 whose adoption is mandatory and which became effective for fiscal years beginning after November 15, 2007 (January 1, 2008 for calendar year entities). The guidance defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.

Under Topic 820, fair value is defined as, “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” (TOPIC 820-10-20). The fair value measures the price of a “hypothetical transaction… considered from the perspective of a market participant that holds the asset or owns the liability” and attempts to determine the “exit price” rather than the “entry price” (TOPIC 820-35-3). The fair value must be “determined based on the assumptions that market participants would use in pricing the asset or liability” in the “principal (or most advantageous) market” (TOPIC 820-35-9). Specifically with regard to liabilities, “a fair value measurement assumes… the liability is transferred to a market participant at the measurement date (the liability to the counterparty continues; it is not settled)” and that “the nonperformance risk relating to that liability is the same before and after its transfer” (TOPIC 820-35-16). In evaluating current and potential future exposure models, it will be important to examine how each approach conforms to these key considerations in the standard.

II. APPROACHES TO CALCULATING CVAs

A. General Principles
Before exploring the different approaches to calculating the exposure faced by the counterparties in a derivative contract, it is useful to first outline two key commonalities between all valid approaches to calculating CVAs.

First of all, every correct approach to calculating CVAs for derivative contracts must take into account the entire set of transactions between two counterparties and not simply look at an individual position. The unit of valuation for derivatives is generally at the counterparty portfolio level because master netting arrangements (the ISDA) and collateral terms, if any, exist to reduce the aggregate credit risk related to all derivatives between those parties. Accordingly, market participants appropriately consider credit risk for derivatives at the counterparty portfolio level whenever an ISDA document governs the counterparty relationship. Therefore a valid method for determining CVAs would by necessity calculate these adjustments at the counterparty level. For example, if a company has three interest rate swaps and an interest rate cap with a single bank counterparty, an accurate CVA would look at the net exposure represented by this set of positions rather than looking at each transaction separately.

Second, all methodologies for determining appropriate CVAs on derivatives apply some measure to account for the probability of default and expected loss given default on the transaction in question. Some approaches apply these factors directly and others use credit spreads or credit default swap spreads as an indicator of these factors. Chatham’s earlier whitepaper provides a detailed explanation of how these factors are used to calculate the CVA. Simplifying approaches use flat spread assumptions across time while more complex methodologies utilize a term structure of credit adjusted for the probability of survival, but all approaches require some factor that captures the implied nonperformance risk of the two counterparties to the transaction to determine the CVA. With these two fundamental components in place, it is possible to examine the divergent approaches to calculating the exposure involved in a derivative….CONTINUED.