Guidance on credit and debit valuation adjustments released
4 December 2013
Following a project to identify and promote best practice, the International Valuation Standards Council (IVSC) has today issued draft guidance for calculating credit and debit valuation adjustments (CVA/DVA).
The guidance follows the increasing adoption of International Financial Reporting Standards (IFRS) around the world, which has led to a requirement for banks and other financial institutions to make credit and debit valuation adjustments to reflect changes in their credit status.
This requirement has controversially resulted in some banks showing increased profits after a decline in their credit rating because the value of their liabilities has reduced. The accounting requirement has also brought into question how adjustments for changes in the credit worthiness of counterparties should be made when valuing assets and liabilities. This is a particular problem for holdings of derivatives and other financial instruments that have to be recorded at their current value on the balance sheet.
The IVSC’s guidance explores these issues and suggests best practice for calculating the adjustments.
Chris Thorne, IVSC Technical Director, comments:
“Because a derivative can change from being an asset to a liability or vice versa during its term, the proper reflection of changes in the credit rating of both counterparties can be a significant challenge. Our aim is to improve consistency in the way these valuation adjustments are carried out.”
While the challenge of credit and debit valuation adjustments is a key issue for banks and other financial institutions who both invest and deal in derivatives, it is also of concern for any company that invests in derivatives. For example, manufacturing companies may hold derivatives to hedge against fluctuations in exchange rates or commodity prices.
Chris Thorne explains:
“The large banks have highly specialised teams and invested in sophisticated systems to calculate valuation adjustments. However, for companies for whom derivatives are not a core activity there is a real need for guidance on this issue.”
A copy of the draft guidance, Credit and Debit Valuation Adjustments, is available here from the IVSC website. Comments are invited before 28 February 2014.
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