IFRS 13 The Impact on Derivative Valuation, Hedge Accounting and Financial Reporting. 24 September 2013 Dan Gentzel & Peter Ahlin

Transcription

1 IFRS 13 The Impact on Derivative Valuation, Hedge Accounting and Financial Reporting 24 September 2013 Dan Gentzel & Peter Ahlin 1

2 Webinar Administrative Details Technical Issues? Contact WebEx: (International) (US & Canada) CPE/CTP Credit Listen to the entire broadcast Answer 3 of 4 polling questions Certificates will be ed within 10 business days Questions? Slides 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 Will be sent out in follow up Recording Available on our website within the week: 2

3 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. 3

4 Today s Speakers Dan Gentzel, CPA Managing Director, Accounting Advisory Practice Peter Ahlin Managing Director, Analytics 4

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

6 Chatham s Experience 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, Chatham has assisted more than 500 companies in adopting ASC 820, including companies in the real estate, banking, and broader corporate sectors. half million+ CVAs each month 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 6

7 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 7

8 Agenda 1 IFRS 13 the Impact on Derivatives 2 Calculation of Credit Adjusted Fair Value 3 Accounting & Reporting Impact 4 Key Takeaways 5 Questions 8

9 Agenda 1 IFRS 13 the Impact on Derivatives 2 Calculation of Credit Adjusted Fair Value 3 Accounting & Reporting Impact 4 Key Takeaways 5 Questions 9

10 IFRS 13: The Impact on Derivatives What is IFRS 13? An IFRS that: Is converged with US GAAP, specifically ASC 820 Defines fair value Requires disclosures about fair value measurements When do companies need to begin applying IFRS 13? Applied for annual periods beginning on or after 1 January 2013 (earlier application was permitted) 10

11 IFRS 13: The Impact on Derivatives What is IFRS 13? Impact When do companies need need to begin to begin applying applying IFRS 13? IFRS 13? When do companies 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 11

12 IFRS 13: The Impact on Derivatives How is fair value defined in IFRS 13? 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 12

13 IFRS 13: The Impact on Derivatives Impact How is fair value defined in IFRS 13? 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 13

14 IFRS 13: The Impact on Derivatives Does credit risk need to be considered in calculating the fair value of a derivative? 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 How do market participants incorporate credit risk into the fair value measurement? Credit risk is reflected in the fair value measurement by calculating a credit valuation adjustment ( CVA ) 14

15 IFRS 13: The Impact on Derivatives Does credit risk need to be considered in calculating the fair value of a derivative? How do market participants How do market incorporate participants credit incorporate risk into credit the risk fair into value the fair measurement? value measurement? 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 15

16 IFRS 13: The Impact on Derivatives What is a CVA? 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 How do you properly calculate a CVA? 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. 16

17 IFRS 13: The Impact on Derivatives Impact What is a CVA? How do you properly calculate a CVA? 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 17

18 IFRS 13: The Impact on Derivatives Does the existence of offsetting financial assets and financial liabilities with the same counterparty impact CVA? 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. Do master netting agreements and collateral provisions impact CVA? 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. 18

19 IFRS 13: The Impact on Derivatives 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? 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 19

20 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 20

21 Agenda 1 IFRS 13 the Impact on Derivatives 2 Calculation of Credit Adjusted Fair Value 3 Accounting & Reporting Impact 4 Key Takeaways 5 Questions 21

22 Understanding Fair Value: Two Approaches 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 Potential Future Exposure Current Exposure 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 Potential Future Exposure Approaches 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 22

23 Understanding Fair Value: Comparison of Two Approaches Current Exposure Potential Future Exposure Current Exposure Potential Future Exposure Accuracy of Results 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 Difficulty of Implementation 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 23

24 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) Single Trade Fair Value Trade Portfolio Fair Value Trade 1 Trade 2 Trade N Portfolio Termination Value Termination Value CVA* Termination Value CVA Termination Value CVA Trade 1 Termination Value Trade 2 Termination Value Trade N Termination Value DVA** DVA DVA Net CVA Net DVA IFRS 13 Fair Value Trade 1 IFRS 13 Fair Value Trade 2 IFRS 13 Fair Value Trade N IFRS 13 Fair Value Portfolio *Credit Valuation Adjustment; **Debit Valuation Adjustment 24

25 Calculate CVA, DVA and IFRS 13 Fair Value STEP 5 CALCULATE CVA, DVA, and IFRS 13 FAIR VALUE STEP 4 BUILD TERM STRUCTURE OF CREDIT STEP 3 ADJUST FOR ANY APPLICABLE CREDIT ENHANCEMENTS STEP 2 MODEL RATE VOLATILITY TO CREATE PORTFOLIO VALUE DISTRIBUTIONS STEP 1 CALCULATE TERMINATION VALUE STEP 0 OBTAIN REQUIRED MODEL INPUTS 25

26 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 OBTAIN REQUIRED MODEL INPUTS Type of trade Notional Maturity Trade Level Details Collateral thresholds Mutual puts Required Model Inputs Probability of default Loss given default Interest / FX / Commodity Rates Volatility Correlations 26

27 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 CALCULATE TERMINATION VALUE 1.6% 1.4% 1.34% 1.2% 1.0% 0.8% 0.6% 0.72% 0.72% 0.4% 0.2% 0.30% 0.0% Dec 2013 Jun 2014 Dec 2014 Jun 2015 Dec 2015 Jun 2016 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 Thousands For most Current Exposure methods, TERMINATION VALUE = 0 CURRENT EXPOSURE(tt 0 ) = (37) (45) (52) (58) (64) (74) (87) (102) (116) (132) (150) (165) However, the swap clearly has significant potential future exposure which is not reflected in the current 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 27

28 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 CALCULATE TERMINATION VALUE Millions 4 3 Total Expected Exposure Sponsor Exposure to Dealer Dealer Exposure to Sponsor Net Current Exposure 2 1 Net Current Exposure The dotted line in the middle shows net current exposure, in a portfolio with some assets and some liabilities 0 Jul '13 Jan '14 Jul '14 Jan '15 Jul '15 Jan '16 Jul '16 Jan '17 Jul '17 Jan '18 Jul ' Total Expected Exposure The grey and red lines show the impact of considering potential future exposure, depicting the total expected exposure

29 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 MODEL RATE VOLATILITY TO CREATE PORTFOLIO VALUE DISTRIBUTIONS 30% 25% 20% 3M GBP LIBOR Forward Millions When a data point in the portfolio distribution is positive, the portfolio is an asset to the sponsor % % 5% 0% Time (in Years) When a data point in the portfolio distribution is negative, the portfolio is a liability to the sponsor Time (in Years) 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 29

30 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 MODEL RATE VOLATILITY TO CREATE PORTFOLIO VALUE DISTRIBUTIONS Millions Distribution of Portfolio Values The expected value of our distribution is the exposure Millions 4 3 Sponsor Exposure to Dealer Dealer Exposure to Sponsor Jul '13 Jan '14 Jul '14 Jan '15 Jul '15 Jan '16 Jul '16 Jan '17 Jul '17 Jan '18 Jul ' Time (in Years) Current Exposure Total Expected Exposure Potential Future Exposure Total Expected Exposure Year 1 Year 2 Year 3 Year 4 Year 5 Average Total Expected Exposure Sponsor Exposure to Dealer (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 30

31 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 ADJUST FOR ANY APPLICABLE CREDIT ENHANCEMENTS 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 Netting Threshold Amount Raw Portfolio Distribution Including credit enhancements generally reduces: the distribution of portfolio values the total expected exposure the CVA and DVA Guarantees Collateral Posting Mutual Puts 31

32 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 ADJUST FOR ANY APPLICABLE CREDIT ENHANCEMENTS Credit-Enhanced Distribution of Portfolio Values (COLLATERAL) Millions Time (in Years) Millions Sponsor Exposure to Dealer Dealer Exposure to Sponsor 0 Jul '13 Jan '14 Jul '14 Jan '15 Jul '15 Jan '16 Jul '16 Jan '17 Jul '17 Jan '18 Jul '18-1 Total Expected Exposure (Before Credit Enhancement) Year 1 Year 2 Year 3 Year 4 Year 5 Average Total Expected Exposure Sponsor Exposure to Dealer (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 Total Expected Exposure (After Credit Enhancement) Year 1 Year 2 Year 3 Year 4 Year 5 Average Total Expected Exposure Sponsor Exposure to Dealer (1,277,000) (2,471,000) (2,497,000) (2,144,000) (860,000) Dealer Exposure to Sponsor 2,497,000 2,322,000 1,419, , ,000 32

33 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 ADJUST FOR ANY APPLICABLE CREDIT ENHANCEMENTS Credit-Enhanced Distribution of Portfolio Values (MUTUAL PUT) Millions Time (in Years) Millions Sponsor Exposure to Dealer Dealer Exposure to Sponsor 0 Jul '13 Jan '14 Jul '14 Jan '15 Jul '15 Jan '16 Jul '16 Jan '17 Jul '17 Jan '18 Jul '18-1 Total Expected Exposure (Before Credit Enhancement) Year 1 Year 2 Year 3 Year 4 Year 5 Average Total Expected Exposure Sponsor Exposure to Dealer (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 Total Expected Exposure (After Credit Enhancement) Year 1 Year 2 Year 3 Year 4 Year 5 Average Total Expected Exposure Sponsor Exposure to Dealer (1,277,000) (2,544,000) (2,560,000) 0 0 Dealer Exposure to Sponsor 2,718,000 2,366,000 1,419,

34 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 BUILD TERM STRUCTURE OF CREDIT Obtaining Credit Spread When credit data is available CDS Spreads Building Credit Curve Whatever the source, we need spread data that provides the implied probability for each period Data Providers PD*, CAD*, LGD*, etc. Bond Spreads Survival to given period Default in that period Loss given default When credit data is unavailable Spreads on Outstanding Borrowings Adjust for changes in: Credit sector spreads Entity-specific credit spreads Time remaining General market conditions Related collateral or other credit enhancements Spread over LIBOR (bps) Credit Spread Curve Sponsor Dealer Credit Spreads Entities will want to document the support utilized to explain the spreads used *Probability of default; Credit exposure at default; Loss given default Time (in Years) 34

35 Calculating Credit-Adjusted Fair Value Credit / Exposure Curve STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 CALCULATE CVA, DVA, and IFRS 13 FAIR VALUE (PORTFOLIO) Total Valuation Adjustment Spread over LIBOR (bps) Millions Sponsor Dealer Time (in Years) Sponsor Exposure to Dealer Dealer Exposure to Sponsor 0 Jul '13 Jan '14 Jul '14 Jan '15 Jul '15 Jan '16 Jul '16 Jan '17 Jul '17 Jan '18 Jul '18 50,000 40,000 30,000 20,000 10,000 0 Jul '13 Jan '14 Jul '14 Jan '15 Jul '15 Jan '16 Jul '16 Jan '17 Jul '17 Jan '18 Jul '18-10,000-20,000-30,000 DVA per period CVA per period Total DVA Total CVA - 4 CVA (Credit Valuation Adjustment) Each point on the dealer s credit curve multiplied by the corresponding present-valued point on the sponsor s own exposure curve DVA (Debit Valuation Adjustment) 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 Year 1 Year 2 Year 3 Year 4 Year 5 (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, , , % 1.45% 2.35% 3.31% 3.42% 21,200 34,400 33,300 25,500 8,000 Total (60,200) 122,400 35

36 Calculating Credit-Adjusted Fair Value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 CALCULATE CVA, DVA, and IFRS 13 FAIR VALUE (INDIVIDUAL INSTRUMENT) Relative Credit Adjustment Approach: Apply pre-netting CVA/DVA weight to postnetting CVA/DVA amount to allocate portfolio CVA/DVA to each instrument Pre-netting CVA / DVA (Individual Instruments) Weight Total Post-netting Portfolio Level CVA Post-netting CVA / DVA (Individual Instruments) Swap 1 (42,800) 37.9% (22,800) Swap 2 (28,400) 25.2% (15,200) CVA Swap 3 Swap 4 (32,400) (6,800) 28.7% 6.0% (60,200) (17,300) (3,600) Swap 5 (2,500) 2.2% (1,300) Total (112,900) 100.0% (60,200) Swap 1 99, % 40,700 Swap 2 73, % 29,900 DVA Swap 3 Swap 4 47,400 63, % 21.2% 122,400 19,300 25,900 Swap 5 15, % 6,500 Total 299, % 122,400 Net Adjustments 186,600 62,200 62,200 36

37 Calculating Credit-Adjusted Fair Value Calculating the trade-level and portfolio-level fair value STEP 0 STEP 1 STEP 2 STEP 3 STEP 4 STEP 5 CALCULATE CVA, DVA, and IFRS 13 FAIR VALUE (INSTRUMENT & PORTFOLIO) Termination Value CVA DVA Net Credit Adjustment IFRS 13 Fair Value Swap 1 (1,375,000) (22,800) 40,700 17,900 (1,357,100) Swap 2 (1,450,000) (15,200) 29,900 14,700 (1,435,300) Swap 3 2,809,000 (17,300) 19,400 2,100 2,811,100 Swap 4 (2,067,000) (3,600) 25,900 22,300 (2,044,700) Swap 5 0 (1,300) 6,500 5,200 5,200 Total (2,083,000) (60,200) 122,400 62,200 (2,020,800) 37

38 Calculating Credit-Adjusted Fair Value: Funding Valuation Adjustment 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. 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) 38

39 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 39

40 Agenda 1 IFRS 13 the Impact on Derivatives 2 Calculation of Credit Adjusted Fair Value 3 Accounting & Reporting Impact 4 Key Takeaways 5 Questions 40

41 Accounting & Reporting Impact: Four Cases 1 Pay fixed / receive floating interest rate swap Not designated for hedge accounting 2 Receive fixed / pay floating interest rate swap Designated as a fair value hedge of IR risk 3 Pay fixed / receive floating interest rate swap Designated as a cash flow hedge with no mismatches 4 Pay fixed / receive floating interest rate swap Designated as a cash flow hedge with a reset date mismatch 41

42 Accounting & Reporting Impact: Four Cases Below is a summary of the key terms of the instruments used in our examples Interest Rate Swap Fixed Rate Debt Hypo Derivative 1 (no mismatch) Hypo Derivative 2 (with mismatch) Notional / principal 50MM 50MM 50MM 50MM Trade Date 30 June June June June 2012 Maturity Date 30 June June June June 2022 Fixed rate 1.70 % 1.70 % 1.70 % 1.65 % Floating Index 1M GBP LIBOR N/A 1M GBP LIBOR 1M GBP LIBOR Payment Date 1 st of each month N/A 1 st of each month Last day of each month Credit Curve Swap Exposure Curve Spread over LIBOR (bps) Sponsor Dealer Millions Jun - 1 '12 Jun '13 Jun '14 Jun '15 Jun '16 Jun '17 Jun '18 Sponsor Exposure to Dealer Dealer Exposure to Sponsor Jun '19 Jun '20 Jun '21 Jun ' Time (in Years)

43 Accounting & Reporting Impact Example 1: Non-Designated Interest Rate Swap 6/30/2012 9/30/2012 Periodic Change 12/31/2012 Periodic Change Swap Term Value Represents the settlement value of the derivative (pre-cva/dva) 0 (1,090,000) (1,090,000) (2,119,000) (1,029,000) Adding in the CVA/DVA CVA/DVA 0 (127,000) (127,000) 42, ,000 Fair Value - Swap Equals the IFRS 13 fair value 0 (1,217,000) (1,217,000) (2,077,000) (831,000) Key takeaways 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 43

44 Accounting & Reporting Impact Swap Term Value Represents the settlement value of the derivative (pre-cva/dva) 6/30/ Example 2: Interest Rate Swap Fair Value Hedge of IR Risk 9/30/2012 1,090,000 Periodic Change 1,090,000 12/31/2012 2,119,000 Periodic Change 1,029,000 Adding in the CVA/DVA CVA/DVA 0 337, , ,000 (186,000) Fair Value - Swap Equals the IFRS 13 fair value 0 1,427,000 1,427,000 2,270, ,000 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 (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 44

45 Accounting & Reporting Impact Swap Term Value Represents the settlement value of the derivative (pre-cva/dva) Example 3: Interest Rate Swap Cash Flow Hedge with no Mismatches 6/30/ /30/2012 (1,090,000) Cumulative Change (1,090,000) 12/31/2012 (2,119,000) Cumulative Change (2,119,000) Adding in the CVA/DVA CVA/DVA 0 (127,000) (127,000) 42,000 42,000 Fair Value - Swap Equals the IFRS 13 fair value 0 (1,217,000) (1,217,000) (2,077,000) (2,077,000) Fair Value - Hypo The fair value of the hypothetical derivative no CVA/DVA is included Hedge Ineffectiveness Hedge ineffectiveness 0 (1,090,000) (1,090,000) (2,119,000) (2,119,000) 0 127,000 0 A CVA/DVA is included in the fair value of the actual derivative Key takeaways 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 45

46 Accounting & Reporting Impact Swap Term Value Represents the settlement value of the derivative (pre-cva/dva) Example 4: Interest Rate Swap Cash Flow Hedge with Mismatches 6/30/ /30/2012 (1,090,000) Cumulative Change (1,090,000) 12/31/2012 (2,119,000) Cumulative Change (2,119,000) Adding in the CVA/DVA CVA/DVA 0 (127,000) (127,000) 42,000 42,000 Fair Value - Swap Equals the IFRS 13 fair value 0 (1,217,000) (1,217,000) (2,077,000) (2,077,000) Fair Value - Hypo The fair value of the hypothetical derivative no CVA/DVA is included Hedge Ineffectiveness Hedge ineffectiveness 0 (903,000) (903,000) (1,917,000) (1,917,000) 0 314, ,000 A CVA/DVA is included in the fair value of the actual derivative Key takeaways 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 46

47 Accounting & Reporting Impact Classification within the Fair Value Hierarchy 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 1 Inputs Unadjusted quoted prices in active markets for the asset or liability that the entity can access at the measurement date Level 2 Inputs Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly Impact Judgment is required when determining classification Expect an increase in both volume and complexity of disclosures, especially when measurement falls into Level 3 Level 3 Inputs Unobservable inputs for the asset or liability 47

48 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 48

49 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 49

50 Agenda 1 2 Chatham s Experience IFRS 13 the Impact on Derivatives 3 Calculation of Credit Adjusted Fair Value 4 Accounting & Reporting Impact 5 Key Takeaways 6 Questions 50

51 Key Takeaways 1 IFRS 13 became effective at the start of IFRS 13 changes the way fair value is measured for derivatives 3 Incorporating credit risk into the fair value measurement is very complex, resulting in the calculation of a CVA/DVA 4 Changes in valuation methodologies are likely needed in order to calculate a CVA/DVA properly 5 The CVA/DVA will have a direct impact on earnings in certain situations 6 Disclosures under IFRS 13 are more complex and expansive than previous requirements 7 Expect an increase in derivative valuation-related questions from your auditors 51

52 Any Questions? Survey Please take a moment to complete our brief survey at the close of the webinar CPE/CTP Certificates will be ed out within 10 business days Kennett Square 235 Whitehorse Lane Kennett Square, PA Denver West San Juan Way, Ste 150 Littleton, CO United States London 4th Floor, 16 Garrick Street London WC2E 9BA United Kingdom +44 (0) Dan Gentzel, CPA Managing Director, Accounting Advisory Practice dgentzel@chathamfinancial.com T: Peter Ahlin Managing Director, Analytics pahlin@chathamfinancial.com T: Singapore 20 Cross Street China Square Central #02-16/17 Singapore, Krakow ul. Rakowicka 7, III p Kraków Poland +48 (0)