required to measure the fair value of over-the-counter derivatives trades under

International Accounting Standard (IAS) 39, which includes the recognition of

fair-value adjustments due to counterparty risk. Accounting rules are clear: the
measurement and recognition of credit value adjustment (CVA) is mandatory.
1
But IAS 39
does not specify how to evaluate CVA.
2
Despite this, it is possible to determine the appropriate accounting treatment by
considering three concepts simultaneously: common fair-value measurement practices,
impairment rules and nance theory. ese can be thought of as boundary conditions to
establish the correct treatment but it is not straightforward.
is article will show how the measurement of CVA under IAS 39 implies the use of
market rates to evaluate counterparty credit risk. e application of market rates under
IAS 39 in turn implies active hedging and management of CVA.
Three boundary conditions
Figure 1 illustrates the three boundary conditions for CVA that have to be fullled for IAS
39, and should be considered to achieve consistency.
IAS 39 requirements for non-defaulted derivatives: under IAS 39, the fair-value hierarchy
(IAS 39.48A) has to be considered to determine CVA. For this purpose, own credit risk
spreads also have to be taken into account. Since the use of the fair-value hierarchy to
gauge CVA implies the application of market credit spreads and commonly used pricing
models, there is a link to economic hedging.
Fair value considerations and economic hedging: the starting point is represented by
martingale pricing approaches (risk-neutral pricing), which are commonly used to
compute the fair value of derivatives. Within these theoretical approaches, pricing and
hedging come together so the hedging costs equal the price of the underlying. It follows
that market participants who do not take CVA (pricing of counterparty risk) into account
buy or sell at prices too high or too low and other participants can exploit this and lock
in a riskless prot. As a consequence, the assumption of an absence of arbitrage forms the
basis for the determination of CVA under IAS 39.
e connection between IAS 39 requirements for impaired derivatives and CVA: the
calculation of the CVA for non-defaulted derivatives should converge to the impairment
amount considered under IAS 39 if the counterparty defaults so convergence implies the
application of consistent approaches in the defaulted and non-defaulted cases. e amount
Banks are required to recognise fair-value adjustments for credit value adjustment
under International Financial Reporting Standards, but the rules are extremely
complex. In the rst of a two-part article, Dirk Schubert explains the boundary
conditions that need to be considered
Banks are
Fair-value accounting
risk-magazine.net 111
1
IAS 39.AG73
2
For the latest discussion on CVA in connection with nancial Developing Common Fair Value Measurement and Disclosure Requirements in
IFRSs and US GAAP accounting, refer to IASB, Comprehensive Project Summary July 2010
for CVA
ACCOUNTING
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112 Risk January 2011
ACCOUNTING
accounted for as CVA should be approximately the same as the
impairment amount in the event of a default to avoid large
jumps in the prot and loss (P&L) statement. e consistency
stems from the fact that any hedge for counterparty risk either
a credit default swap (CDS) or contingent credit default swap
(CCDS) is expected to almost fully oset the losses in the case
of a default.

Connection between IAS 39 requirements for impaired
derivatives and CVA
e following section shows that nancial accounting for
defaulted derivatives denes a major criterion for determining
CVA in the non-defaulted case.
In the following example, it is assumed an interest rate swap is
transacted under an International Swaps and Derivatives
Association master agreement. In case of default, the Isda
documentation stipulates a replacement cost approach, and oers
two possibilities: the market quotation or loss approach.
From the perspective of International Financial Reporting
Standards (IFRS), the following steps have to be performed to
account for defaulted derivatives:
Derecognition of the present value of the interest rate swap
(fair value) before default, since the derivative ceases to exist.
If the present value of the derivative is positive, a receivable
against the counterparty is recognised on the balance sheet,
which represents the claim against the defaulted counterparty in
a Chapter 11 procedure. Otherwise, a liability is recognised. e
carrying amount equals the replacement cost using the market
quotation or loss approach.
Measurement.
If this results in a liability, then the carrying amount remains
unchanged.
Application of IFRS impairment rules (IAS 39.63 in
connection with IAS 39.AG84) for the receivable against the
counterparty.
Estimation of the recovery rate of the interest rate swap (using
the result of the CDS auction procedure).
Impairment recognised in the P&L.
Inferences from impairment requirements
In case of default, the impairment amount under IAS 39 is
derived from current market value (present values) without credit
risk (discounting using an AA swap curve). is rules out
simplied counterparty exposure metrics involving potential
future exposure (PFE) for the evaluation of CVA, since these
modelling approaches measure quantiles of future mark-to-
market distributions, which are similar to value-at-risk
concepts.
3
Using PFE would imply that, in case of default, the
expected market value equals the current market value plus the
quantiles of future mark-to-market distribution(s) so PFE
cannot be an estimate of the expected market value in the event
of a default. Consequently, exposure measures such as the
add-on approach (the current mark-to-market value plus PFE
add-ons) are not compliant with CVA measurement under IAS
39, as they do not rely on the entire mark-to-market distribution.
Payout prole in default
Consider the following example of an interest rate swap between
party A and B. e carrying amount of an asset or liability after
the default can be dened as follows, assuming party A accounts
for the default of party B (see table A).
A. Payout prole from the perspective of party A in case
of the default of party B
IRS B defaults Carrying amount
PV is positive for A Rec
B
PV
A
(IRS)
+
= asset
PV is negative for A PV
A
(IRS)
-
= liability
If the present value (PV) is positive, then party A receives the
positive present value of the IRS PV
A
(IRS)
+
multiplied by the
recovery rate of party B (Rec
B
). If the present value is negative
(PV
A
(IRS)
-
), it represents a liability. is is similar to a
(counterparty default) option payout prole similarly, an own
default option prole can be derived introducing an
optionality component into the determination of CVA under
IAS 39. Consequently, two parties entering into a vanilla
xed-to-oating interest rate swap implicitly sell a default option
to each other. e CVA can be regarded as the value of these
implicit options.
4

Furthermore, neglecting the implicitly granted default options
for the determination of fair values leads to arbitrage opportuni-
ties, as they impact the fair value. is optionality property is
also exploited in connection with pricing models, and suggests
the following fair-value structure in order to take counterparty
credit risk into account:
Fair value including counterparty risk = fair value without
counterparty risk +/- CVA, where CVA is dened as:
3
For the collateralised interdealer OTC market, this condition can be relaxed
4
Refer to Bin Li, Yi Tang (2007) for further discussion
IAS 39 requirements
(in case of non-defaulted derivatives)
s If the market-quoted rate does not include credit risk or other factors that
market participants would include in valuing the instrument, the entity
adjusts for those factors [IAS 39.AG73]
s If counterparty risk is taken into account, then the fair value at inception of
the deal should not differ from the transaction price at inception (eg, zero
for interest rate swap without upfront payment) [IAS 39.9]
s Liabilities shall be measured with own credit spread [IAS 39.BC11Cc)]
s The appropriate benchmark curve shall be applied [IAS 39.AG82a)]
s Fair-value hierarchy has to be considered [IAS 39.48A]
IAS 39 requirements
(in case of defaulted derivatives)
Impairment rules require
consistency with respect to non-
defaultable derivatives; otherwise
unintended P&L changes occur
[IAS 39.59e)]
Fair value considerations and
economic hedging
(in case of non-defaulted derivatives)
s Martingale pricing is market standard
for the pricing of derivatives,
s Price of economic hedging (CCDS)
Consistency
1 Three boundary conditions for CVA on a stand-alone OTC interest
rate swap
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risk-magazine.net 113
CVA = fair value adjustment counterparty risk (counterparty
default option)
fair value adjustment own credit risk (option on own
default)
Signicantly, this fair-value structure imposes restrictions on
pricing models, as the CVA component can now be seen to
require an option model. Pricing models that do not assume
such modelling set-ups such as discounted cashow models
without discontinuities of cashows in case of default may
therefore not be compliant with IAS 39.
Utilisation of CDS spreads
e impairment rules under IAS 39 (see IAS 39.63 in
connection with IAS 39.AG84 and IAS 39.AG74-76) require the
application of discounted cashow methods to determine the
impairment amount.
CDSs represent traded instruments for credit risk hedging in
case of default, the settlement of outstanding CDS contracts will
be generally carried out using an auction settlement procedure
overseen by Isda. As a result of the auction, settlement prices
(fair value) for debt instruments with dierent seniority levels are
determined. ese prices (fair value) should be considered as
evidence in determining the impairment amount under IAS 39
(IAS 39.AG84).
5

is is similar to the application of the fair-value hierarchy
under IAS 39 for non-defaulted derivatives. In order to ensure
the convergence of CVA calculated in the non-defaulted case
and the impairment amount in default, the application of CDS
spreads is necessary. ats because the recovery rate is deter-
mined from auctions in the CDS settlement procedure in the
event of default.
e evaluation methods applied to determine CVA are
supposed to converge to the impairment amount in cases
where CDS spreads are available. As a consequence, it is not
possible to apply probability of default parameters evaluated
under Basel II for the determination of CVA under IAS 39.
Use of Basel II parameters is only possible if no CDS spreads
are available.
In case of a counterparty default, own credit risk does not
play a role. But it does if the non-default case is considered,
according to IAS 39. Since fair value considerations, economic
hedging and the IAS 39 requirements of non-defaulted
derivatives are related, both boundary conditions are jointly
described in the following section.
Non-defaulted case: fair value of CVA under IAS 39: trading
and hedging of counterparty risk exposure
Risk-neutral pricing models
e absence of arbitrage opportunities plays a signicant role
in the denition of CVA and common pricing models rely on
this assumption. With respect to counterparty risk, pricing
models adopt commonly used credit risk models to evaluate the
impact of counterparty and own credit risk adjustments. Credit
risk models can be subdivided into two major classes:
structural and reduced-form models. Within structural-based
models, default is modelled endogenously; while in reduced-
form models (intensity-based models), default is represented by
an exogenous variable.
Reduced-form models are widely applied to price various
types of nancial instruments, since these models can be
incorporated in a term structure model.
6
Within such a set-up,
the modelling of counterparty risk requires a model for the
following factors:
A pricing model for the (risk-free) market value of the
underlying OTC contracts (for example, term structure model
for interest rate risk) without counterparty risk.
A default model that covers the default behaviour of the
counterparty and own credit risk, which includes modelling of
time to default.
A model for the recovery rate (loss given default (LGD)).
A dependence or correlation model for market and
counterparty risk.
Such a model set-up also assumes liquid CDS spreads are
available for both counterparty and own credit risk, which
follows the application of the fair-value hierarchy according to
IAS 39.48A, as well as IAS 39.BC11Cc to account for own
credit risk.
The absence of arbitrage opportunities
plays a signicant role in the denition of
CVA and common pricing models rely
on this assumption
Market value (fair value) of a portfolio
of OTC derivatives contract including
counterparty and own credit risk
=
Market value (fair value) of a portfolio
of OTC derivatives contract without
counterparty and own credit risk (PV)
-
+
Fair-value adjustment for
own credit risk
Contingent leg
of a CCDS
EPE under
martingale
measure
ENE under
martingale
measure
Fair-value adjustment for
counterparty credit risk
F>LGDc,PJ

, Defaultc, Defaultown, DF@

F>LGDown,PJ
-
, Defaultc, Defaultown, DF@
2 Decomposition of the fair value of an OTC portfolio into three parts
5
For a discussion of market quotes as predictor for recovery rates, refer to Dllmann, K; Trapp, M (2004)
6
For theoretical descriptions of these models, refer to Jarrow, RA, Turnbull, SM (1995), Blanchett-
Scalliet, C, Jeanblanc, M (2004), Bielecki, TR, Rutkowski, M (2002) and Belanger, A, Shreve, SE,
Wong, D (2004)
7
Refer to Brigo D, Capponi, A (2009), Assefa, S, Bielecki, TR, Crpey, S, Jeanblanc, M (2009),
Gregory, J 2010
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114 Risk January 2011
ACCOUNTING
As shown in gure 2, the market value of a portfolio of OTC
derivatives contracts can be decomposed into three parts.
7

Properties of the model
Within the model set-up, the market value of a portfolio of
OTC derivatives contracts can be decomposed into a
component (fair value) that is free of counterparty risk/own
credit risk and fair-value adjustments for counterparty and own
credit risk. Both can be considered as functions dependent on
LGD, a risk-free discount factor (swap curve) and the default
processes (default probabilities and credit spreads).
Additionally, it covers the optionality component, positive
present value (PV
+
) versus negative present value (PV
-
), intro-
duced in the previous section. is means counterparty risk
(own credit risk) is only present if the fair value without
counterparty risk (own credit risk) is positive (negative). For
convenience, the pricing approach with respect to CVA
described is termed option-based.
Absence of arbitrage assumes the existence of a risk-neutral
measure. e risk-neutral measure implies that under this
probability measure, future cashows can be discounted using
the risk-free market interest rate (swap curve).
8

With such a model, one cannot assume the market is complete,
since completeness means that for every risk, a corresponding
hedging instrument is available with zero cost (no transaction cost).
Provided symmetric risk-neutral expected exposure proles of
the underlying OTC derivatives portfolio and similar credit
spreads and recovery rates, the fair-value adjustments for own
credit risk and counterparty risk oset each other. erefore, the
CVA measures the relative credit risk of two counterparties and
does not measure absolute credit risk of a counterparty. Further-
more, the model set-up assumes the swap curve (AA rating) is
default risk free.
e model also covers the situation where changes in market
value and credit spreads are dependent. According to the model
set-up, counterparty credit risk/own credit risk becomes
model-dependent and introduces optionality features into the
pricing, so the fair value depends on volatility (vega risk), the
underlying fair value (delta risk), and so on.
Furthermore, the introduction of optionality into the
pricing or fair-value considerations implies the CVA is a
non-linear function, which is especially important in case the
CVA has to be evaluated across netting sets and dierent
trading desks or segments. Here, it is impossible to simply add
dierent CVAs the CVA has to be evaluated at every
aggregation level separately.
Closed-form solutions can be provided only under
simplied assumptions, so numerical methods for the evalua-
tion of CVA generally have to be applied. Under simplied
assumptions, the fair-value adjustments can be represented by
using the concept of positive expected exposure (EPE) and
expected negative exposure (ENE) under the risk-neutral
probability measure. is means there is a direct connection
between exact pricing models and counterparty risk manage-
ment concepts.
9

As an immediate consequence, EPE and ENE can be used in
the calculation of CVA for IAS 39 if they are evaluated under
the risk-neutral measure (market credit spreads).
e absence of arbitrage and the existence of hedging
instruments imply the cost of hedging and the price for
counterparty (own) credit risk are almost the same. In case of
a complete market model, these are identical.
So within such pricing models, market participants are able
to set up a dynamic hedging strategy that replicates the payout
prole of the counterparty (own) credit risk. For example, if
the (risk-free) market value of the underlying portfolio of OTC
derivatives contracts changes, market participants can buy/sell
CDS contracts in order to adjust the notional of CDSs to the
current market value of the underlying OTC derivatives
contract, such that the counterparty (own) credit risk is
0
20,000
30,000
40,000
50,000
60,000
Swaps default-risk free market value
Default-adjusted swap market value
10,000
Sep 08 Dec 08 Mar 09 Jun 09 Sep 09 Mar 10 Jun10 Sep 10 Dec 09
E
u
r
o
3 Impact of the CVA on the market value of the interest rate swap
34
35
36
37
Sep 15, 2008
Credit benefit
effect
0
500
1,000
1,500
2,000
2,500
3,000
Sep
08
Dec
08
Mar
09
Jun
09
Sep
09
Dec
09
Mar
10
Jun
10
Sep
10
Credit charge hedged with CCDS
Symmetric CVA
E
u
r
o
4 Comparison of CVA and hedging cost using CCDS
8
See Bjrk, T (1998)
9
See Gregory, J (2010), Cesari, G et al (2009)
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risk-magazine.net 115
completely oset (hedged).
Such a dynamic hedging strategy using CDS contracts can
also be achieved by buying a CCDS. e process above can be
used to model the contingent leg of a CCDS, as the fair-value
adjustment for counterparty risk is identical to the contingent
leg of a CCDS under simplied assumptions.

Example
In gure 3, the impact of the CVA on the valuation of an
interest rate swap is illustrated.
In this example, the CVA lowers the overall default risk-free
market value of the interest rate swap. is is due to the fact that
the own credit risk spread is lower than the credit spread of the
counterparty. Market values are shown from the perspective of
the xed-rate receiver.
As described above, counterparty credit risk can be hedged by
a CCDS or a dynamic hedging strategy using CDSs. Figure 4
compares the CVA and the cost of hedging with a CCDS. e
result is not surprising, as the fair-value adjustment of the
counterparty risk equals the fair value of the CCDS, so the
dierence between the hedging cost for the CCDS (fair-value
adjustment for counterparty risk) and the total CVA is the
fair-value adjustment of own credit risk (credit benet), which is
not hedged by a CCDS.
Important implicit assumptions of these models are:
Within these pricing models, it is assumed price risk equals
credit risk, which is not always the case in practice. Due to
liquidity considerations or supply and demand in the CDS
market, price changes can occur without changes in credit
quality. is also impacts front-oce risk management/P&L.
If CVA is taken into account, then based on the price
sensitivities, a trader can oset the impact of CVA in terms of
sensitivity without lowering counterparty credit risk.
In general, hedging is also possible using bonds issued by the
counterparty (a short position in the bonds of the counterparty
to hedge derivatives exposure), which results in basis risk.
Hedging of own credit risk fair-value adjustment is dicult,
as it is possible to hedge against the price risk resulting from own
credit risk, but selling CDS protection on own credit risk on a
large scale would be a concern to other dealers, due to wrong-
way risk exposures.
In practice, the price of own credit risk does not exist. Typically,
pricing models neglect the impact on the capital structure, so own
credit risk is implemented using a weighted average of dierent
debt nancing instruments (liabilities with dierent seniorities) to
determine an own spread, in order to accurately reect the
funding situation. So, in practice, CVA measures counterparty
credit relative to the funding situation of the company. e impact
of own credit risk is therefore twofold: it reduces the impact of
fair-value adjustments of the counterparty, but it represents
unhedgeable risk, as well as P&L volatility. In addition, the
recognition of own credit spreads results in prices that are distinct
to each bank and are not comparable.
e concept of a CCDS or dynamic hedging strategy (delta
hedging) using CDSs is appealing, but there currently are not
many liquid CCDSs traded in the market. Furthermore, if the
counterparty suers a default and the CDS/CCDS is
exercised, the auction procedure determines prices (cash
settlement) of bonds/loans with dierent seniority levels. e
risk prole of a bond/loan has little to do with the exposure of
an OTC derivatives portfolio. Additionally, a delta-hedging
strategy has cost implications, which can be signicant and
may prevent hedging.
10

Conclusion
Based on the discussion above, the conditions under IAS 39 with
respect to CVA are summarised in gure 5.
is article shows the calculation of CVA under IFRS is not
straightforward and is based on a number of boundary condi-
tions. But then, the question arises as to how to set up a
framework that makes it feasible to achieve consistency between
performance measurement, counterparty risk management and
IAS 39. is will be discussed in the next article.
Dirk Schubert is a partner in the nancial services division at KPMG in
Frankfurt. Email: dschubert@kpmg.com
A full list of references for this article can be found online at
www.risk.net/risk-magazine
IFRS Source Boundary conditions
Compliance
Option
based
IAS 39.AG73
If the market-quoted rate does not include credit risk
or other factors market participants would include
in valuing the instrument, the entity adjusts for those
factors
IAS 39.9 & IAS
39.48A
If counterparty risk is taken into account then the fair
value at inception of the deal (IRS) should not differ
from zero
IAS 39.BC11Cc) Liabilities shall be measured with own credit spread
IAS 39.AG82a) The appropriate benchmark curve shall be applied
IAS 39.48A Fair-value hierarchy has to be considered
IAS 39.48A
Fair value of defaultable swap =
fair value of swap +/- counterparty default adjustment
IAS 39.59e)
Impairment rules require consistency with respect to
non-defaultable derivatives
5 Boundary conditions under IAS 39 and compliance with the
option-based approach
The concept of a CCDS or dynamic hedging
strategy (delta hedging) using CDSs is
appealing, but there currently are not many
liquid CCDSs traded in the market
10
For related discussions on CDS spreads refer to Singh, M., Youssef, K., Price of Risk Recent Evidence
from Large Financials, IMF Working Paper August 2010
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