Independent Valuation and Credit Value Adjustment (CVA)

Investment Management Association of Singapore (IMAS)

11 Feb 2015

Alvin Lee

alvin.lee@markit.com

The Science of Finance

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Agenda

Valuation Regulations

─ SFA 04-G05: Independent valuation

─ FRS 113: Credit valuation adjustment (CVA)

─ International regulations

─ Use cases beyond regulations

Best Practices: Independent Valuation

─ Broad product coverage

─ Automated and transparent workflow

─ Comprehensive market data

Best Practices: Credit Valuation Adjustment

─ Advanced calculation methodology

─ Extensive counterparty credit data

─ Determine materiality of CVA

Valuation Regulations

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Securities and Futures Act: SFA-04-G05

http://www.mas.gov.sg/Regulations-and-Financial-Stability/Regulations-Guidance-and-Licensing/Securities-Futures-and-Funds-

Management/Guidelines/2012/Guidelines.aspx

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SFA-04-G05: Independent valuation

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IOSCO FR05/13

http://www.iosco.org/library/pubdocs/pdf/IOSCOPD413.pdf

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IOSCO FR05/13: Valuation policies and procedures

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Some High Profile Losses

September 2013 – Two traders at a US Bank charged by the US department of Justice with five criminal counts over their alleged roles in trying to hide part of a $6.2 billion trading loss by mis-marking the values of positions in a credit portfolio

The bank agreed to pay approximately $920 million in fines to various regulators. The OCC and SEC made the following comments respectively:

Auditors and Regulators: “[The bank] did not provide an adequate foundation to identify, understand, measure, monitor and control risk … [the bank] failed to keep watch over its traders as they overvalued a very complex portfolio to hide massive losses”

When valuations are not independent

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Financial Reporting Standards: FRS 113

http://www.asc.gov.sg/frsArchives2004to2012# > Financial Reporting Standards > FRS 113

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FRS 113: Credit valuation adjustment (CVA)

Principle Paragraph Extract

CVA 42

“The fair value of a liability reflects the effect of non-performance risk. Non-performance risk includes, but may not be limited to, an entity’s own credit risk … Non-performance risk is assumed to be the same before and after the transfer of the liability.”

Exit Price IN8“fair value as the price that would be received to sell an asset or paid to transfer a liability”

Risk Pricing IN9

“When measuring fair value, an entity uses the assumptions that market participants would use when pricing the asset or liability under current market conditions, including assumptions about risk.”

Observable

InputsIN10(d)

“maximise the use of relevant observable inputs and minimise unobservable inputs”

Same Inputs

as PricingIN10(d)

“inputs should be consistent with the inputs a market participant would use when pricing the asset or liability.”

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FRS 113: Credit valuation adjustment (CVA)

Principle Paragraph Extract

Own Credit

Risk42

“Non-performance risk includes, but may not be limited to, an entity’s own credit risk”

Portfolio

Netting48

“exception permits an entity 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 paid to transfer a net short position”

Credit

Mitigation56

“take into account any existing arrangements that mitigate credit risk exposure in the event of default (eg a master netting agreement with the counterparty or an agreement that requires the exchange of collateral)”

Calibration 64

“valuation technique shall be calibrated so that at initial recognition the result of the valuation technique equals the transaction price … After initial recognition, … an entity shall ensure that those valuation techniques reflect observable market data”

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International regulations

AIFMD IPV, Risk for European non-UCITS funds

UCITS III & IV IPV, Risk for all UCITS funds

Solvency II Prescriptive stress testing for insurers

EMIR, Dodd-Frank Valuations, Reporting, CCPs, IM/VM

IFRS 9, Topic 815 Accounting at fair value as exit price

IFRS 13, Topic 820 Fair value framework, CVA/DVA

IFRS 7 Credit and market risk disclosures

AIMA, IOSCO, HFSB IPV as best practice for hedge funds

Independent valuation … of internal and counterparty marks

Consistency, automation … to mitigate operational risk

Regula

tions

Accounting

Guid

elin

es

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Independent valuations not just for regulatory compliance

─ Net Asset Value (NAV) calculation

─ Fair value for financial reporting and hedge accounting

─ Benchmarking of counterparty marks, internal valuation

─ Calculation of variation margin for collateral disputes

─ Risk management, scenario analysis and stress testing

─ Submission to trade repository

Use cases beyond regulations

Best Practices: Independent Valuation

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150+ product types currently priced for clients globally

Broad product type coverage

Cash

CLOs, CMOs

Corporate / Municipal / Sovereign bonds

European ABS

Leveraged loans

US ABS / RMBS / CMBS

Commodity

Barrier options

Bespoke commodity products

Caps / Floors

Forwards

Swaps / TRS

Variance swaps

Credit

Asset backed CDS

Asset swaps

Bespoke credit products

CDO tranches (synthetic)

CDS (single name and index)

Commercial mortgage backed CDS

Credit default swap baskets

Credit linked notes

Loan CDS

Options on CDS indices

Recovery locks

Structured finance indices

Total return swaps

Equity

Accrual options

Accumulators

Altiplanos

Asian options

Atlas

Auto-callables

Barrier options

Basket options

Basket swaps

Basket TRS

Bespoke equity products

Best / worst of basket and barrier options

Cliquets

Contracts for difference

Convertible bonds

Corridor variance swaps

Crescendo auto-callables

Currency translated options

Digital options

Dispersion options

Dividend swaps

Double Asian options

Forwards

Freezer

Himalayan options

Index correlation swaps

Ladder options

Lookbacks

Outperformance options and autocallables

Quanto options

Range accruals (knockout, callable)

TARNs

Variance options and swaps (conditional)

FX

Accumulator options and forwards

American options

Asian options

Barrier options

Barrier exotics (multiwindow, quanto etc.)

Bespoke FX products

Best / worst of options

Co-Dependent digital options

Convex options

Currency swaps

Digital options (outperformance)

Double Asian options

Fader

Forward volatility agreements

Forwards

Lookbacks

NDFs

Quanto options

Range accruals (knockout, callable)

TARKO

Variance budget options

Variance swaps

Volatility swaps

Private Equity

Unlisted equity

Illiquid debt

Interest Rates

American swaptions

Amortizing swaps and swaptions

Basis swaps

Bermudan swaptions

Bespoke interest rate products

Bond options

Bond TRS

Caps / Floor (callable, flipper)

Callable swaps

CMS spread options (quanto, digital)

CMS swaps, caps / floors

Contingent swaptions

Cross currency IRS

Curve / annuity caps

Forward starting swaptions

FRAs

FVA swaption straddles

Inflation linked swaps

Inflation options

Longevity swaps

Mark-to-market swaps

OIS

PRDCs (callable, digital, trigger, etc.)

Price locks

Range accruals

Snowballs

Snowblades

TARNs

Zero coupon swaps

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Automated and audited workflow

XML

CSV

Web

PMS (e.g. Charles River)

Totem data

Valuation and Risk Calculations

External data

Valuation and risk reports

Analyst Viewer

(Excel)

XML

Markit data

Data

Cle

anin

g

Corrections to Trade Data

Quality Control:• Large P&L moves• Tolerance breaks• New trades• Revised trades• Market data review

Confirmation requests and price challenges

Database

(Warehouse)

WebserverScheduler

Webserver

Trade confirmations

(e.g. MarkitWire)

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Trade parameters

Viewable trade parameters

Trade details should be reviewed to verify

that valuation is based on accurate trade

representation

This is important as the majority of

valuation discrepancies are resolved by

correcting trade parameters.

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Market data

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Counterparty marks

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Discrepancy resolution

Resolution process

1. Trade economicsUnderlying trade detail review including analysis of termsheet or confirmation. Most challenges are closed out at this step.

2. Valuation settings

Account valuation rule review including configurations and settings. Examples include market data snap times and discounting methodologies.

3. Market inputs

Underlying market data review including comparison against counterparty market data. Examples include review of spots/fixings, curve, volatilities and correlations.

4. Models and methodology

Cash flow and detailed price calculation review. Detailed analysis by product

specialists and/or quantitative analysis team may be required.

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Market data Data sources

FX WM/Reuters, ECB, NDF. Volatilities bootstrapped from daily broker and Markit Totem consensus for ATM and OTM.

EquitiesExchange data (all major equity exchanges) via SIX Financial Information, Markit Distribution Platform and Markit Solutions. Corporate action and dividend data from Markit Equities and Exchange Data International. Volatilities from exchange data and Markit Totem consensus, incl. variance, volatility, dividend swaps.

CommoditiesExchange data (NYMEX, LME, ICE, CBOT etc) via Markit Distribution Platform and Markit Solutions. Daily broker and Markit Totem consensus for swaps, forwards and options.

Rates

Yield curve bootstrapped from daily broker/dealer quotes for deposits, futures, swaps, forward FX rates and cross-currency basis swaps, using OIS-LIBOR dual-currency methodology. Volatilities from daily broker ATM swaption volatilities, extended to OTM using monthly Markit Totem consensus. Inflation zero rates from Markit Totem consensus.

CreditSingle-name and index CDS consensus from main sell-side contributors via Markit CDS. Corporate actions via Markit RED. Volatilities and correlations from Markit Totem consensus.

Structured ProductsRespective spot, historical and volatility data as per each underlying asset. Implied correlations from Markit Totem consensus where available, otherwise historical correlation as proxy.

Cash Bond / LoansBond and loan pricing from active global sell-side desks via Markit Bonds and Markit Loans. Markit Evaluated Bonds for other cash bonds.

Structured Finance Daily contributed prices for cash ABS. Evaluated pricing for CMBS, CLO, CDO.

Private EquityComparable listed equity financial statements, comparable liquid debt from Markit Loans and Markit Evaluated Bonds database.

Comprehensive market data

Best Practices: Credit Valuation Adjustment

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FRS 113 fair value measurement of OTC derivatives requires the reporting of credit value adjustment (CVA) from 1st January 2013

Risk Pricing : “When measuring fair value, an entity uses the assumptions that market

participants would use … including assumptions about risk.”

International Financial Reporting Standards 13

Market participants using sophisticated approaches to calculate CVA

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— To quickly meet IFRS 13 compliance, used in-house simplified CVA approach

— Auditor expressed concern about methodology, especially:

— simplified present value-based approximation for future exposures

— historical probabilities of default

— Auditor required remediation plans to be put-in-place, and completed by following year-end reporting

Simplified CVA approach

“While a variety of less complex approaches exist, they typically focus on current exposure…

However, these approaches do not reflect different possible outcomes for the fair value at the point of default.”

IFRS 13 Fair Value Measurement: Credit valuation adjustments for derivative contracts, EY, April 2014

Simplified approach not compliant with IFRS 13

x

x

Typical experience of firms with significant OTC derivative positions

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Advanced calculation methodology

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Extensive counterparty credit data

Names in CDS universe

Proxy by name

Proxy using Markit Enhanced CDS Sector Curves

Name assigned with

1. Rating

2. Markit Sector

3. Region

Factor model

Function (Rating, Sector, Region)

Counte

rpart

y lis

t

─ Consumer goods─ Consumer services─ Government─ Industrials─ Utilities─ Basic materials

─ Energy─ Telecoms─ Financials─ Technology─ Healthcare

2.Sectors

3.Regions

─ Oceania─ Eastern Europe─ Middle East

─ North America─ Europe─ Japan─ Asia Ex-Japan

1.Ratings

─ AAA─ AA─ A

─ BBB─ BB ─ B

─ CCC

Rating Sector Region

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Portfolio characteristics

─ Cash, exchange-traded derivatives, OTC derivatives

─ Netting and collateral agreements

─ Counterparty risk

─ Portfolio and counterparty risk change over time

Materiality threshold

─ Qualitative assessment?

─ % of overall fund NAV? 10bps, 25bps, 50bps?

─ Calculate CVA to determine materiality, and then calculate CVA?

Determine materiality of CVA

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1. Local and international regulations require independent valuation and credit value adjustment

2. Additional use cases beyond regulatory compliance

3. Independent valuation best practices include broad product coverage, comprehensive data and automated processes

4. CVA best practices include advanced methodology, extensive credit data and materiality determination

Key Takeaways

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