Credit Value Adjustments: IFRS 13
Alankar Karol
April 2013
IFRS 13 provides a guideline for the measurement and definition of fair value which is required or
permitted by other Standards. It lays out the disclosure rules around fair value measurements and
redefines fair value as a market-based measurement in contrast to an entity-based measurement.
Essentially, the Standard defines fair value as an exit-price and any intention to hold the asset to
maturity or to settle the liability is not taken into consideration.
Implicit within the exit price definition is the notion of non-performance risk which can be attributed
to credit risk. Although IAS 39 (which previously defined fair value) alludes to considering credit
risk while fair valuing assets and liabilities, IFRS 13 makes it mandatory for credit risk to be
considered while valuing both assets and liabilities. In other words, mid-market pricing of financial
instruments which do not consider the quantitative effect of credit will no longer suffice as an
acceptable fair value.
Most companies will have to report under IFRS 13 for the financial year ending June 30, 2013 and
as such will have to consider the impact of credit. This poses the dual challenge of sourcing the
appropriate credit spreads and then applying these spreads to their derivative valuations and edge
accounting under IAS 39.
Valuation Techniques
The Standard is not prescriptive regarding the methodology to be applied. However, it does
stipulate that the technique used should maximise the use of observable inputs and minimise the
use of unobservable inputs. The observable and unobservable inputs are along the lines of IFRS 7
which defined a fair-value hierarchy giving the highest priority to quoted prices and the lowest
priority to unobservable inputs.
Three widely used valuation techniques are:
Market Approach: this uses information generated by similar transactions to estimate the price.
Cost Approach: this estimates the price by estimating the cost that would be incurred to replace
the current asset or liability.
Income Approach: this converts future cash-flows to a single current discounted amount and
takes into consideration the market expectations about the future cash-flows. It takes into account
the risk premium associated with the uncertainty around the expected future cash flows (both
timing of the cash flows and the amount). The income approach is the most widely used valuation
methodology and uses inputs which might or might not be directly observable in the market– i.e.
interest rates, implied volatilities and credit spreads quoted in the market at observable intervals
and interpolated rates for intermediate intervals.
Although different present value techniques exist for the income approach, they only differ on the
basis of how they adjust for the risk premium. A well-established technique for accounting for the
risk premium is the discount rate adjustment technique which adjusts the discount factors with the
appropriate credit spread. The standard also suggests an alternative methodology for the present
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value technique called the expected present value technique which incorporates the calculation of
the probabilities of cash flows occurring in the future and discounts them at a risk adjusted rate.
The risk adjusted rate in the two methods is of different quantum and is generally higher in the
discount rate adjustment technique due primarily to the fact that the risk rate incorporates the
probabilities of default rather than calculating them explicitly. No matter which approach is
undertaken, the methodology for credit adjusted valuations will require an adjustment to the market
value (calculated on a flat, unadjusted market zero curve) of a financial instrument using:
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Counterparties credit spread if the position is an asset.
Company’s own credit spread if the position is a liability.
Mechanically this means that the curve used for discounting cash flows will be different for assets
and liabilities and also different for assets with different counterparties. This not only has the
counterintuitive consequence of reducing the value of a company’s liabilities but also the
unintended consequence of leaving the company with a net asset or a net liability position if the
company has closed out a derivative by taking an equal but opposite derivative position. Moreover,
if a company has taken out exactly the same derivative with two different counterparties of different
credit rating, then the balance sheet value of each contract will be different.
Credit Spreads
The introduction of the Standard raises an important question around the source of the credit
spreads. Most corporates do not issue debt on a regular basis and as such it is difficult for them to
gauge their credit. However, the standard explicitly states that the difficulty in sourcing is not a
sufficient reason to preclude them from valuation.
Credit default swap rates, which are quoted in the market lend themselves to the discount rate
adjustment technique since they already incorporate the probability of default. Corporates which do
not have a market quoted credit spread can use the CDS rates of other entities either in the same
sector or those of entities with a similar credit rating as a proxy to their own credit spreads.
Figure 1: Historic 3-year Credit Default Swap rates for a BBB entity and AA entity.
As can be seen from Figure 1, the CDS rates continue to exhibit significant volatility since the
GFC. This has important ramifications for the credit adjusted valuations since this volatility will be
reflected in the valuation of the various financial instruments.
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Figure 2: Term structure of credit spreads for entities of different credit rating.
As shown in Figure 2, CDS rates exhibit a term structure i.e. credit default swap rates of different
tenor have a different credit rates with longer tenor swaps generally having a higher rate primarily
due to the fact that the probability of default increases with time. Once again this has important
consequences regarding the impact of credit since cashflows that occur further out will contribute
more to the size of the credit adjustment. Consequently financial instruments which have large
payments/receivables at maturity will have a large credit impact, for example, Cross Currency
Interest rate swaps with principal exchanges.
Impact on Hedge Accounting
The impact of credit on derivative valuations is made more difficult by the fact that the derivative
can oscillate from being an asset to a liability and vice-versa numerous times during its life.
Figure 3 is calculated based on 5 year $100M Interest Rate Swap paying fixed 6.38% and
receiving BBSW quarterly between a company rating BBB and a bank counterparty rating AA. It
illustrates how the market value varies over 5yrs and the impact of credit on those valuations.
Figure 3: The mark-to-market value of a swap during its life (left axis): changes from being an asset for the first
two years to being a liability for the final three. Also shown is the % change in the market value due to credit on
the above swap (right axis)
As can be seen from Figure 3, the market value of this vanilla swap can fluctuate by as much as
6% (Note: the impact for a Cross Currency Swap or large commodity or FX positions can be
substantially larger). If the company is hedge accounting for these derivatives under IAS39, then
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such fluctuations could have a big impact on the accounting treatment of the derivatives, causing a
previously good relationship to subsequently fail.
This is primarily due to the fact that in a cash flow hedge reserve, the hypothetical derivative is
valued excluding the impact of credit while the actual derivative includes the effect of credit.
Similarly in the case of a fair value hedge, the underlying excludes the impact of credit and as such
the value of the derivative will not completely offset the change in the value of the underlying and
could possibly fail the effectiveness test.
Figure 4: The impact in the profit and loss statement due to the effect of credit for a cash flow hedge for the
swap in Figure 3. The hypothetical derivative does not take into account the effect of credit. As such a
relationship which was 100% effective now shows significant P&L volatility.
Conclusion
With financial year-end reporting drawing close for some companies, treasurers and their auditors
will need to quickly agree on the valuation methodology to ensure compliance with IFRS 13. On
the upside, for organisations with significantly out-of-the money derivatives, adoption can deliver
an unintended benefit of reducing the value of a company’s liabilities.
Sourcing of credit data will present challenges where the organisation has no market quoted
spread against it. Valuations may also experience significant volatility if using spreads derived from
counterparty CDS rates. But perhaps the most significant impact will be on hedge accounting as
effectiveness is likely to be reduced by the application of different credit spreads throughout the
derivative’s life and the exclusion of those spreads when constructing the hypothetical derivative.
Using the income approach to valuation, it will be necessary to use different curves for
discounting cash flows arising from assets and liabilities, as well as assets with different
counterparties. This will likely generate significant computational overhead, driving a need for an
analytically advanced system.
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