IFRS 13– The Impact on Derivative Valuation, Hedge...

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IFRS 13– The Impact on Derivative Valuation, Hedge Accounting and Financial Reporting

24 September 2013 Dan Gentzel & Peter Ahlin

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Webinar Administrative Details

• Technical Issues? • Contact WebEx: +1 916.861.3155 (International)

+1 866.569.3239 (US & Canada) • CPE/CTP Credit

• Listen to the entire broadcast • Answer 3 of 4 polling questions • Certificates will be emailed within 10 business days

• Questions? • Use the Q&A window provided to submit any questions to All Panelists • If we do not get to your question, we will answer them afterwards individually

• Slides • Will be sent out in follow up email

• Recording • Available on our website within the week: http://www.chathamfinancial.com/thought-leadership/webinars/see-all-webinars/

http://www.chathamfinancial.com/thought-leadership/webinars/see-all-webinars/

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Disclaimer

TRANSACTIONS IN OVER-THE-COUNTER DERIVATIVES (OR “SWAPS”) HAVE SIGNIFICANT RISKS, INCLUDING, BUT NOT LIMITED TO, SUBSTANTIAL RISK OF LOSS. YOU SHOULD CONSULT YOUR OWN BUSINESS, LEGAL, TAX AND ACCOUNTING ADVISERS WITH RESPECT TO PROPOSED SWAP TRANSACTION AND YOU SHOULD REFRAIN FROM ENTERING INTO ANY SWAP TRANSACTION UNLESS YOU HAVE FULLY UNDERSTOOD THE TERMS AND RISKS OF THE TRANSACTION, INCLUDING THE EXTENT OF YOUR POTENTIAL RISK OF LOSS. THIS MATERIAL HAS BEEN PREPARED BY A SALES OR TRADING EMPLOYEE OR AGENT OF CHATHAM HEDGING ADVISORS AND COULD BE DEEMED A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION. THIS MATERIAL IS NOT A RESEARCH REPORT PREPARED BY CHATHAM HEDGING ADVISORS. IF YOU ARE NOT AN EXPERIENCED USER OF THE DERIVATIVES MARKETS, CAPABLE OF MAKING INDEPENDENT TRADING DECISIONS, THEN YOU SHOULD NOT RELY SOLELY ON THIS COMMUNICATION IN MAKING TRADING DECISIONS.

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Today’s Speakers

Dan Gentzel, CPA Peter Ahlin Managing Director,

Accounting Advisory Practice Managing Director,

Analytics

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The Chatham Difference - independent hedging advisor

Interest Rate Hedging FX Hedging Commodity Hedging Hedge Accounting Advisory Regulatory Advisory Debt & Capital Advisory

Full web-based platform Financial risk mgt modules Debt management modules Covered by SSAE 16 audit

Serving 1000+ clients annually $2.5 trillion notional transacted 5 Locations globally in U.S., Europe, and Asia

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Chatham’s Experience

half million+ CVAs each month

The fair value standards are converged between the FASB and the IASB. ASC 820, the US equivalent to IFRS 13, has been effective since January 1, 2008.

Chatham has assisted more than 500 companies in adopting ASC 820, including companies in the real estate, banking, and broader corporate sectors.

Chatham calculates more than half a million credit valuation adjustments each month on behalf of clients.

Chatham is uniquely positioned to help companies implement IFRS 13

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Polling Question #1

• What is the primary reason for your decision to join our webinar today?

A) I was not aware that IFRS 13 affected derivative valuation and hedge accounting

B) I was searching for more information about the impact of IFRS 13 on derivative valuation and hedge accounting

C) My auditors have been asking how I plan to incorporate IFRS 13 into my derivative valuation approach

D) I need educational credits (CPE/CTP)

E) Other

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Agenda

IFRS 13 – the Impact on Derivatives 1

2 Calculation of Credit – Adjusted Fair Value

3 Accounting & Reporting Impact

4 Key Takeaways

5 Questions

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Agenda




4 Key Takeaways

5 Questions

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IFRS 13: The Impact on Derivatives

An IFRS that: Is converged with US GAAP, specifically ASC 820 Defines fair value Requires disclosures about fair value measurements

Applied for annual periods beginning on or after 1 January 2013 (earlier application was permitted)

What is IFRS 13?

When do companies need to begin applying IFRS 13?

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Impact

IFRS 13 is already effective

Companies should:

Assess how the IFRS affects their current valuation approaches

Assess the materiality of the impact

Consider the need to change valuation methodology

When do companies need to begin applying

IFRS 13?

What is IFRS 13?

When do companies need to begin applying IFRS 13?

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First, the IAS 39 definition: Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Now, the amended definition per IFRS 13: Fair value is 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.

The measurement is for a particular asset or liability

The measurement shall consider the characteristics of the asset or liability that market participants consider when pricing the asset or liability

The unit of account for recognition and disclosure purposes depends on the related IFRS that requires or permits fair value measurement

How is fair value defined in IFRS 13?

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Impact

The definition of how to measure fair value has changed

Derivative financial instruments are impacted – they fall under the scope of IFRS 13

The transfer of a liability assumes the liability would not be extinguished but would remain outstanding after the transfer

Companies need to consider the characteristics that market participants would use to measure the fair value of the instrument

How is fair value defined in IFRS 13?

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Yes. The fair value of a liability must reflect the effect of non-performance risk

Non-performance risk includes, but may not be limited to, an entity’s own credit risk, which is assumed to be the same before and after the transfer of the liability under IFRS 13

Bi-lateral nature of many derivatives causes the need to consider both the company’s own as well as its counterparty’s credit risk

Credit risk is reflected in the fair value measurement by calculating a credit valuation adjustment (“CVA”)

Does credit risk need to be considered in calculating the fair value of a derivative?

How do market participants incorporate credit risk into the fair value measurement?

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Impact

Because of the bi-lateral nature of many derivatives, they should be measured based on price to transfer, rather than price to sell or extinguish

Represents a significant change to method of measuring fair value

Properly incorporating non-performance risk is very complex and requires the calculation of a CVA

Does credit risk need to be considered in calculating the fair value of a derivative?



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Estimated credit risk existing in either an individual derivative instrument or a group of derivative instruments with the same counterparty that are managed on a net basis for credit risk

For derivatives, such an approach is complex and highly sophisticated and considers:

−The total expected exposure (current and future) of the derivatives involved in the calculation,

−Market rates and volatility assumptions, and −Portfolio netting or collateral provisions that

exist with counterparties.

What is a CVA?

How do you properly calculate a CVA?

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Impact

Complying with IFRS 13 requires companies to incorporate a CVA into the measurement of the fair value of their derivatives

Calculating a CVA properly is very complex and may be very challenging for many companies

Most companies will need to make changes to their valuation methodology to incorporate credit risk

Before making significant changes, companies may want to first assess the materiality and overall impact of the CVA on their derivatives

When the CVA is material, companies’ valuations will likely undergo significant scrutiny from their auditors

What is a CVA?

How do you properly calculate a CVA?

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An entity is permitted to measure the fair value of a group of financial assets and financial liabilities on the basis of the price that would be received to sell a net long position or to transfer a net short position for a particular risk exposure in an orderly transaction between market participants at the measurement date under current market conditions.

Yes, if… The company has made the accounting policy

decision to measure the fair value of a group of financial assets/liabilities entered into with a particular counterparty on a net basis, and When market participants would take into

account any existing arrangements that mitigate credit risk exposure in the event of default.

Do master netting agreements and collateral provisions impact CVA?

Does the existence of offsetting financial assets and financial liabilities with the same counterparty impact CVA?

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Impact

When credit risk with a counterparty is managed on a net basis, the calculation of the CVA can be based on the net position

An accounting policy election is required to calculate CVAs on a net basis

When collateral exists, it should be considered and will impact the CVA

Does the existence of offsetting financial assets and financial liabilities with the same counterparty impact CVA?

Do master netting agreements and collateral provisions impact CVA?

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Polling Question #2 • How are you incorporating credit risk into the fair value measurement of your

derivative portfolio?

A) We are not incorporating credit risk

B) We are using a “qualitative” approach

C) We are using a current exposure approach

D) We are using a total expected exposure approach

E) Other

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Agenda




4 Key Takeaways

5 Questions

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Potential Future

Exposure

Understanding Fair Value: Two Approaches

Easier to apply because they do not consider rate volatility

Techniques vary widely and may include discounted cash flow analysis, or estimates of the hypothetical cost to purchase protection against the applicable credit exposure

Based on current expectations of the probabilistic distribution of potential future obligations Represent a fuller range of potential outcomes because they

incorporate rate volatility. For at-market transactions, rate movement over time is the primary driver of risk Employed by sophisticated market-making participants Common techniques include Monte Carlo simulation, scenario

analysis, and trinomial tree modeling

Although IFRS 13 mandates including credit risk in fair value calculations, it prescribes no specific methodology for calculating the credit and debit valuation adjustments (CVA and DVA)

Current Exposure Approaches Potential Future Exposure Approaches

Current Exposure

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Potential Future

Exposure

Current Exposure

Potential Future

Exposure

Current Exposure

The PFE method requires more complicated calculations and additional data inputs (particularly volatility), so it’s challenging for many firms to perform the required calculations

The potential future exposure (PFE) method delivers more accurate results than the current exposure method − It incorporates rate variability, rather than just passage of

time effects − It introduces less earnings fluctuation from period to

period − It matches the methods used by major market participants

to price non-performance risk, thus yielding inception values closer to zero

Accuracy of Results Difficulty of Implementation

Understanding Fair Value: Comparison of Two Approaches

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Trade 1 Portfolio Termination Value

Understanding Fair Value: Trade Level vs. Portfolio Level For a portfolio comprised of some assets and liabilities spread across maturities, the magnitude of the sum of all individual trades’ (CVA + DVA) will be greater than or equal to the magnitude of the net portfolio’s (CVA + DVA)

Termination Value

*Credit Valuation Adjustment; **Debit Valuation Adjustment

IFRS 13 Fair Value

Trade 1

Trade 1 Termination

Value

CVA*

DVA**

Trade 2

Termination Value

IFRS 13 Fair Value

Trade 2

CVA

DVA

Trade N

Termination Value

IFRS 13 Fair Value Trade N

CVA

DVA

Trade 2 Termination

Value

Net CVA Net DVA

IFRS 13 Fair Value Portfolio

Trade N Termination

Value … …

… … …

Single Trade Fair Value Trade Portfolio Fair Value

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Calculate CVA, DVA and IFRS 13 Fair Value

CALCULATE CVA, DVA, and IFRS 13 FAIR VALUE

BUILD TERM STRUCTURE OF CREDIT

ADJUST FOR ANY APPLICABLE CREDIT ENHANCEMENTS

OBTAIN REQUIRED MODEL INPUTS

MODEL RATE VOLATILITY TO CREATE PORTFOLIO VALUE DISTRIBUTIONS

CALCULATE TERMINATION VALUE

STEP 0

STEP 1

STEP 2

STEP 3

STEP 4

STEP 5

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Calculating Credit-Adjusted Fair Value

Required Model Inputs

Type of trade Notional Maturity

Collateral thresholds Mutual puts

Probability of default Loss given default

Interest / FX / Commodity Rates Volatility Correlations

Trade Level Details

OBTAIN REQUIRED MODEL INPUTS

STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5

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Calculating Credit-Adjusted Fair Value CALCULATE TERMINATION VALUE


*A similar analysis applies for currency and commodity derivatives as well, but we focus on interest rate derivatives here in order to show CVA and DVA effects of multiple rather than single cash flow dates

0.30%

1.34%

0.72% 0.72%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

Dec 2013 Jun 2014 Dec 2014 Jun 2015 Dec 2015 Jun 2016

(37) (45) (52) (58) (64) (74) (87)

(102) (116)

(132) (150)

(165)

90 91 92 92 89 90 91 91 90 89 90 89

-£200

-£150

-£100

-£50

£0

£50

£100

£150

Thou

sand

s

The termination value of a single interest rate swap is the sum of the cash flows, where the floating cash flows are determined by the forward curve*

The current exposure at any time is the sum of the remaining present-valued cash flows

For most Current Exposure methods, TERMINATION VALUE = 0

CURRENT EXPOSURE(𝑡𝑡0) = 0

However, the swap clearly has significant potential future exposure which is not reflected in the current termination value

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Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5

CALCULATE TERMINATION VALUE

The dotted line in the middle shows net current exposure, in a portfolio with some assets and some liabilities

Net Current Exposure

Total Expected Exposure The grey and red lines show the impact

of considering potential future exposure, depicting the total expected exposure

Total Expected Exposure

-£3

-£2

-£1

£0

£1

£2

£3

£4

Jul '13 Jan '14 Jul '14 Jan '15 Jul '15 Jan '16 Jul '16 Jan '17 Jul '17 Jan '18 Jul '18

Mill

ions

Sponsor Exposure to DealerDealer Exposure to SponsorNet Current Exposure

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Distribution of Rates Distribution of Portfolio Values

Using an interest rate volatility surface, we can model the distribution of interest rates over a period of time

The distribution of interest rates implies a distribution of cash flows, which average to portfolio values at every point in time Note that the portfolio can easily shift from asset to liability

and back again

-£6.0

-£4.0

-£2.0

£0.0

£2.0

£4.0

£6.0

£8.0

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5

Mill

ions

Time (in Years) Time (in Years)

0%

5%

10%

15%

20%

25%

30%

0 2 4 6 8 10

When a data point in the portfolio distribution is positive, the portfolio is an asset to the sponsor

When a data point in the portfolio distribution is negative, the portfolio is a liability to the sponsor

3M GBP LIBOR Forward

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-£6.0

-£4.0

-£2.0

£0.0

£2.0

£4.0

£6.0

£8.0

0 1 2 3 4 5

Mill

ions

Time (in Years)



The expected value of our distribution is the exposure

Distribution of Portfolio Values

Year 1 Year 2 Year 3 Year 4 Year 5

Sponsor Exposure to Dealer

Average Total Expected Exposure

£ (1,277,000) £ (2,544,000) £ (2,560,000) £ (2,144,000) £ (860,000)

Dealer Exposure to Sponsor

£ 2,718,000 £ 2,366,000 £ 1,419,000 £ 815,000 £ 233,000



Current Exposure Potential Future Exposure

-£3

-£2

-£1

£0

£1

£2

£3

£4


Mill

ions

Sponsor Exposure to DealerDealer Exposure to Sponsor

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Netting Threshold Amount

Guarantees

Mutual Puts

Collateral Posting

Raw Portfolio Distribution

Credit Enhancements The raw distribution of portfolio values needs to be adjusted

by relevant credit enhancements These apply at the specific counterparty – dealer bank level

Including credit enhancements generally reduces:

the distribution of portfolio values

the total expected exposure

the CVA and DVA

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Credit-Enhanced Distribution of Portfolio Values (COLLATERAL)

Total Expected Exposure (After Credit Enhancement)




£ (1,277,000) £ (2,471,000) £ (2,497,000) £ (2,144,000) £ (860,000)


£ 2,497,000 £ 2,322,000 £ 1,419,000 £ 815,000 £ 233,000

Total Expected Exposure (Before Credit Enhancement)




£ (1,277,000) £ (2,544,000) £ (2,560,000) £ (2,144,000) £ (860,000)


£ 2,718,000 £ 2,366,000 £ 1,419,000 £ 815,000 £ 233,000

-£6.0

-£4.0

-£2.0

£0.0

£2.0

£4.0

£6.0

£8.0

0 1 2 3 4 5

Mill

ions

Time (in Years) -£3

-£2

-£1

£0

£1

£2

£3

£4


Mill

ions


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Credit-Enhanced Distribution of Portfolio Values (MUTUAL PUT)

Total Expected Exposure (After Credit Enhancement)




£ (1,277,000) £ (2,544,000) £ (2,560,000)

£ 0 £ 0


£ 2,718,000 £ 2,366,000 £ 1,419,000

£ 0 £ 0

Total Expected Exposure (Before Credit Enhancement)




£ (1,277,000) £ (2,544,000) £ (2,560,000) £ (2,144,000) £ (860,000)


£ 2,718,000 £ 2,366,000 £ 1,419,000 £ 815,000 £ 233,000

-£6.0

-£4.0

-£2.0

£0.0

£2.0

£4.0

£6.0

£8.0

0 1 2 3 4 5

Mill

ions

Time (in Years) -£3

-£2

-£1

£0

£1

£2

£3

£4


Mill

ions


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BUILD TERM STRUCTURE OF CREDIT

Credit Spreads

Entities will want to document the support utilized to explain the spreads used

Data Providers

Spreads on Outstanding Borrowings

CDS Spreads

PD*, CAD*, LGD*, etc.

Bond Spreads

Adjust for changes in: − Credit sector spreads − Entity-specific credit spreads − Time remaining − General market conditions − Related collateral or other credit

enhancements

Obtaining Credit Spread

When credit data is unavailable

*Probability of default; Credit exposure at default; Loss given default

Survival to given period

Default in that period

Loss given default

Building Credit Curve

When credit data is available

Time (in Years)

Spre

ad o

ver L

IBO

R (b

ps)

Credit Spread Curve

Whatever the source, we need spread data that provides the implied probability for each period

0

50

100

150

200

250

300

350

1 2 3 4 5 6 7 8 9 10

Sponsor Dealer

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CALCULATE CVA, DVA, and IFRS 13 FAIR VALUE (PORTFOLIO)

CVA (Credit Valuation Adjustment) DVA (Debit Valuation Adjustment) Each point on the dealer’s credit curve multiplied by the

corresponding present-valued point on the sponsor’s own exposure curve

Each point on the sponsor’s own credit curve multiplied by the corresponding present-valued point on the dealer’s exposure curve


Sponsor Exposure to Dealer Dealer Spread CVA Dealer Exposure to Sponsor Sponsor Spread DVA £ (1,277,000) £ (2,544,000) £ (2,560,000) £ (2,144,000) £ (860,000)

0.27% 0.44% 0.68% 0.91% 1.02%

£ (3,400) £ (11,200) £ (17,300) £ (19,500) £ (8,800)

£ 2,718,000 £ 2,366,000 £ 1,419,000 £ 815,000 £ 233,000

0.78% 1.45% 2.35% 3.31% 3.42%

£ 21,200 £ 34,400 £ 33,300 £ 25,500 £ 8,000

-£30,000

-£20,000

-£10,000

£0

£10,000

£20,000

£30,000

£40,000

£50,000


DVA per period Total DVA Total CVA CVA per period

Time (in Years)

Spre

ad o

ver L

IBO

R (b

ps)

-£4

-£2

£0

£2

£4


Mill

ions


Total Valuation Adjustment Credit / Exposure Curve

0

50

100

150

200

250

300

350

1 2 3 4 5 6 7 8 9 10

Sponsor Dealer

Total £ (60,200) £ 122,400

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£ 186,600


CALCULATE CVA, DVA, and IFRS 13 FAIR VALUE (INDIVIDUAL INSTRUMENT)

Total Post-netting Portfolio Level CVA

Swap 1

CVA

Pre-netting CVA / DVA (Individual Instruments) Weight

£ (42,800)

Swap 2

Swap 3

Swap 4

Swap 5

£ (28,400)

£ (32,400)

£ (6,800)

£ (2,500)

37.9%

25.2%

28.7%

6.0%

2.2%

Total £ (112,900) 100.0%

Swap 1

DVA

£ 99,600

Swap 2

Swap 3

Swap 4

Swap 5

£ 73,200

£ 47,400

£ 63,400

£ 15,900

33.3%

24.4%

15.8%

21.2%

5.3%

Total £ 299,500 100.0%

£ (60,200)

£ 122,400

Post-netting CVA / DVA (Individual Instruments)

£ (22,800)

£ (15,200)

£ (17,300)

£ (3,600)

£ (1,300)

£ (60,200)

£ 40,700

£ 29,900

£ 19,300

£ 25,900

£ 6,500

£ 122,400

Relative Credit Adjustment Approach: Apply pre-netting CVA/DVA weight to post-netting CVA/DVA amount to allocate portfolio CVA/DVA to each instrument

Net Adjustments

£ 62,200 £ 62,200

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Calculating Credit-Adjusted Fair Value

Swap 1

Swap 2

Swap 3

Swap 4

Swap 5

Total

Termination Value DVA CVA

£ (60,200) £ (2,083,000) £ 122,400 £ 62,200 £ (2,020,800)

Net Credit Adjustment IFRS 13 Fair Value

£ (1,375,000)

£ (1,450,000)

£ 2,809,000

£ (2,067,000)

£ 0

£ (22,800)

£ (15,200)

£ (17,300)

£ (3,600)

£ (1,300)

£ 40,700

£ 29,900

£ 19,400

£ 25,900

£ 6,500

£ 17,900

£ 14,700

£ 2,100

£ 22,300

£ 5,200

£ (1,357,100)

£ (1,435,300)

£ 2,811,100

£ (2,044,700)

£ 5,200

CALCULATE CVA, DVA, and IFRS 13 FAIR VALUE (INSTRUMENT & PORTFOLIO)

Calculating the trade-level and portfolio-level fair value


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Calculating Credit-Adjusted Fair Value: Funding Valuation Adjustment

Valuation Perspective Corporate Finance Perspective

Charging FVA contradicts the risk-neutral valuation principle that is the bedrock of the correct economic valuation of derivatives

According to corporate finance theory, valuation decisions should be separate from funding decisions (except when debt receives beneficial tax treatment)

John C. Hull

Alan White

“FVA should not be considered when determining the value of the derivatives portfolio, and it should not be considered when determining the prices the dealer should charge when buying or selling derivatives. The apparent excess funding cost the derivatives desk faces should not be considered when a trading decision is made. Assuming the objective is to maximise shareholder value rather than employ some accounting measure of performance, FVA should be ignored.”

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Polling Question #3 • Have you considered incorporating a CVA based on a total expected exposure

model into your valuation methodology?

A) No, and we do not intend to do so

B) No, but we intend to do so

C) Yes, but we have decided not to incorporate such an approach

D) Yes, and we are looking for a solution to help us do this

E) Other

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Agenda




4 Key Takeaways

5 Questions

41

Accounting & Reporting Impact: Four Cases

Pay fixed / receive floating interest rate swap Not designated for hedge accounting

1

Receive fixed / pay floating interest rate swap Designated as a fair value hedge of IR risk

2

Pay fixed / receive floating interest rate swap Designated as a cash flow hedge with no mismatches

3

Pay fixed / receive floating interest rate swap Designated as a cash flow hedge with a reset date mismatch

4

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Last day of each month

Accounting & Reporting Impact: Four Cases

£ 50MM

Interest Rate Swap

30 June 2012

30 June 2022

1.70 %

1M GBP LIBOR

1st of each month

£ 50MM

Fixed Rate Debt

30 June 2012

30 June 2022

1.70 %

N/A

Notional / principal

Trade Date

Maturity Date

Fixed rate

Floating Index

Payment Date

£ 50MM

Hypo Derivative 1 (no mismatch)

30 June 2012

30 June 2022

1.70 %

1M GBP LIBOR

£ 50MM

Hypo Derivative 2 (with mismatch)

30 June 2012

30 June 2022

1.65 %

1M GBP LIBOR

0

100

200

300

400

500

600

700

1 2 3 4 5 6 7 8 9 10

Sponsor Dealer

Credit Curve Swap Exposure Curve

Below is a summary of the key terms of the instruments used in our examples

1st of each month

N/A

-£4

-£3

-£2

-£1

£0

£1

£2

Jun'12

Jun'13

Jun'14

Jun'15

Jun'16

Jun'17

Jun'18

Jun'19

Jun'20

Jun'21

Jun'22

Mill

ions


Time (in Years)

Spre

ad o

ver L

IBO

R (b

ps)

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Accounting & Reporting Impact Example 1: Non-Designated Interest Rate Swap

6/30/2012

£ (1,090,000)

9/30/2012

£ (127,000)

£ (1,217,000)

£ (1,090,000)

Periodic Change

£ (127,000)

£ (1,217,000)

£ (2,119,000)

12/31/2012

£ 42,000

£ (2,077,000)

£ (1,029,000)

Periodic Change

£ 198,000

£ (831,000)

Key takeaways

Swap Term Value

CVA/DVA

Fair Value - Swap

£ 0

£ 0

£ 0

CVA/DVA has direct impact on earnings because there is no offset from a hedged item or a hypothetical derivative CVA/DVA can change from being positive to negative depending on underlying inputs used in calculation

Represents the settlement value of the derivative (pre-CVA/DVA)

Adding in the CVA/DVA

Equals the IFRS 13 fair value

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Accounting & Reporting Impact Example 2: Interest Rate Swap – Fair Value Hedge of IR Risk

£ (50,000,000) £ (50,977,000) £ (977,000) £ (52,075,000) £ (1,098,000)

£ 0 £ (450,000) £ 255,000

Key takeaways

A CVA/DVA is included in the fair value of the hedging instrument A CVA/DVA is not included in the fair value of the hedged item As a result, CVA/DVA represents a source of hedge ineffectiveness and earnings volatility Interest rate swaps and fixed rate bonds do not experience dollar for dollar offsetting changes given the same change in

underlying market data, which leads to additional ineffectiveness

Fair Value - Debt Equals the fair value of the hedged debt due to changes in IR risk

– no CVA/DVA is included

Hedge Ineffectiveness Hedge ineffectiveness, largely due to the CVA/DVA

6/30/2012

£ 1,090,000

9/30/2012

£ 337,000

£ 1,427,000

£ 1,090,000

Periodic Change

£ 337,000

£ 1,427,000

£ 2,119,000

12/31/2012

£ 151,000

£ 2,270,000

£ 1,029,000

Periodic Change

£ (186,000)

£ 843,000

Swap Term Value

CVA/DVA

Fair Value - Swap

£ 0

£ 0

£ 0




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Accounting & Reporting Impact Example 3: Interest Rate Swap –Cash Flow Hedge with no Mismatches

Key takeaways

A CVA/DVA is included in the fair value of the actual derivative A CVA/DVA is not included in the fair value of the hypothetical derivative For cash flow hedges, hedge ineffectiveness is only recognized when the cumulative change in fair value of the actual derivative

is greater than the cumulative change in fair value of the hypothetical derivative In situations where there are no mismatches in the hedging relationship, it is possible that hedge ineffectiveness due to the

CVA/DVA could be recognized

£ 0 £ (1,090,000) £ (1,090,000) £(2,119,000) £ (2,119,000)

£ 0 £ 127,000 £ 0

Fair Value - Hypo The fair value of the hypothetical derivative – no CVA/DVA is

included

Hedge Ineffectiveness Hedge ineffectiveness

6/30/2012

£ (1,090,000)

9/30/2012

£ (127,000)

£ (1,217,000)

£ (1,090,000)

Cumulative Change

£ (127,000)

£ (1,217,000)

£ (2,119,000)

12/31/2012

£ 42,000

£ (2,077,000)

£ (2,119,000)

Cumulative Change

£ 42,000

£ (2,077,000)

Swap Term Value

CVA/DVA

Fair Value - Swap

£ 0

£ 0

£ 0




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Accounting & Reporting Impact Example 4: Interest Rate Swap –Cash Flow Hedge with Mismatches

Key takeaways

A CVA/DVA is included in the fair value of the actual derivative A CVA/DVA is not included in the fair value of the hypothetical derivative For cash flow hedges, hedge ineffectiveness is only recognized when the cumulative change in fair value of the actual derivative

is greater than the cumulative change in fair value of the hypothetical derivative In situations where there are mismatches in the hedging relationship, CVA/DVA may either distort or mask true sources of

ineffectiveness that exist

£ 0 £ (903,000) £ (903,000) £ (1,917,000) £ (1,917,000)

£ 0 £ 314,000 £160,000

Fair Value - Hypo The fair value of the hypothetical derivative – no CVA/DVA is

included

Hedge Ineffectiveness Hedge ineffectiveness

6/30/2012

£ (1,090,000)

9/30/2012

£ (127,000)

£ (1,217,000)

£ (1,090,000)

Cumulative Change

£ (127,000)

£ (1,217,000)

£ (2,119,000)

12/31/2012

£ 42,000

£ (2,077,000)

£ (2,119,000)

Cumulative Change

£ 42,000

£ (2,077,000)

Swap Term Value

CVA/DVA

Fair Value - Swap

£ 0

£ 0

£ 0




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Accounting & Reporting Impact

Impact

Judgment is required when determining classification

Expect an increase in both volume and complexity of disclosures, especially when measurement falls into Level 3

Classification within the Fair Value Hierarchy

Level 2 Inputs Inputs other than quoted prices included within

Level 1 that are observable for the asset or liability, either directly or indirectly

Level 1 Inputs Unadjusted quoted prices in

active markets for the asset or liability that the entity can access

at the measurement date

FV Measurement is categorized in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement

Level 3 Inputs Unobservable inputs for the asset or liability

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Accounting & Reporting Impact

Required Disclosures Level 1 Level 2 Level 3

Fair value of the asset or liability at period-end

Level of the measurement within the fair value hierarchy

Transfers between Level 1 and Level 2

Valuation techniques used and the inputs used in the fair value measurement

Nature and reason for a change in valuation methodology

Quantitative information about the unobservable inputs used in the measurement

Detailed reconciliation of the opening and closing balances

Gains and losses recognized in profit or loss

Sensitivity to changes in unobservable inputs if changes could lead to a significant change in measurement

Effect of reasonably possible alternative assumptions that could significantly impact the measurement

Election to measure credit risk on a net basis by counterparty portfolio

Existence of inseparable third-party credit enhancements

Quantitative disclosures presented in tabular format unless another format is more appropriate

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Polling Question #4 • Are you considering performing a CVA/DVA "materiality assessment" on your

portfolio of derivatives?

A) No, we are not considering performing an assessment

B) Yes, and we have already performed an assessment

C) Yes, and we have a plan to do this but have not performed it yet

D) Yes, and we are considering how to perform the assessment

E) Other

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Agenda

IFRS 13 – the Impact on Derivatives

Chatham’s Experience

2



1

5 Key Takeaways

6 Questions

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Key Takeaways

IFRS 13 became effective at the start of 2013 1

IFRS 13 changes the way fair value is measured for derivatives 2

Incorporating credit risk into the fair value measurement is very complex, resulting in the calculation of a CVA/DVA 3

Changes in valuation methodologies are likely needed in order to calculate a CVA/DVA properly 4

The CVA/DVA will have a direct impact on earnings in certain situations 5

Disclosures under IFRS 13 are more complex and expansive than previous requirements 6

Expect an increase in derivative valuation-related questions from your auditors 7

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IFRS 13– The Impact on Derivative Valuation, Hedge...

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