Credit risk and derivative instruments

Publication date: 05 Jul 2013

This practice aid provides examples of possible methods for calculating credit risk adjustments on financial instruments as required by IFRS 13 for periods commencing 1 January 2013. IFRS 13 does not prescribe any specific method for taking ‘non-performance’ into account.

Examples:

Example 1: Impact of master netting arrangements on the credit risk adjustment

As of December 31, 20X8, company A has several derivative contracts with counterparty X as follows:

Type of derivative Amount Asset/(Liability)
Interest rate swap $(20,000) Liability
Interest rate swap 10,000 Asset
Total interest rate swaps (10,000) Net liability
     
Gas commodity contract 6,000 Asset
Gas commodity contract 5,000 Asset
Electricity commodity contract 8,000 Asset
Electricity commodity contract (12,000) Liability
Total commodity contracts 7,000 Net asset
Total of all contracts $  (3,000) Net liability


As these contracts are with the same counterparty, management initially considers whether it should measure credit risk associated with the net $3,000 liability. However, in evaluating its netting and other arrangements with counterparty X, company A determines that it has a netting arrangement that covers the interest rate swaps and a separate master netting arrangement that affects all commodity derivatives, including both gas and electricity contracts. Accordingly, management determines that it should separately measure credit risk associated with the following:

  • Interest rate swaps—Rights and obligations under these contracts are not eligible to be netted with those relating to the commodity derivatives. As of the reporting date, company A would measure the credit risk for the net interest rate swap liability based on a market participant’s view of company A’s credit standing.
  • Commodity contracts—All commodity contracts are covered by a single master netting arrangement. Company A should measure the credit risk associated with the $7,000 net asset based on a market participant’s view of counterparty X’s credit.

This example illustrates how the form and substance of commercial agreements can impact the measurement of credit risk and will yield different credit risk adjustments. In this example, if there were no netting arrangements, company A would calculate the credit risk adjustment separately for each of the derivatives. Alternatively, if all of the contracts were covered under a single master netting arrangement, credit risk would be calculated based on a net liability of $3,000. However, because the swaps and commodity contracts are subject to separate netting arrangements, credit risk should be separately evaluated for the net swap exposure and for the net commodity exposure.

Reference:

“When using the exception in paragraph 48 to measure the fair value of a group of financial assets and financial liabilities entered into with a particular counterparty, the entity shall include the effect of the entity’s net exposure to the credit risk of that counterparty or the counterparty’s net exposure to the credit risk of the entity in the fair value measurement when market participants would 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 on the basis of each party’s net exposure to the credit risk of the other party).” (IFRS 13 para 56)

Example 2: Impact of collateral and credit support on the credit risk adjustment

This example has the same fact pattern as example 1; however, company A has received $5,000 of cash collateral from counterparty X.

Based on review of the underlying agreements, company A determines that counterparty X has posted collateral associated with the commodity contracts. Company A’s net exposure is as follows:

Derivative type Position Collateral Asset/(Liability)
Interest rate swap $(10,000) $       — $(10,000)
Commodity contracts 7,000 5,000) 2,000
  $  (3,000) $ (5,000) $  (8,000)


As a result of the posted collateral, Company A has a net $2,000 commodity derivative asset from counterparty X, instead of the $7,000 asset calculated in example 1. Therefore, company A should calculate the credit risk adjustment for the commodity contracts based on the net $2,000 balance. The posted collateral has no impact on the calculation of the credit risk adjustment associated with the interest rate swap.

In this fact pattern, depending on the requirements of the underlying agreement, Counterparty X also may have been able to meet its collateral obligation by providing a parent company guarantee or a bank letter of credit. Company A could not take the letter of credit into account in determining the credit adjustment for its liability but there is no similar prohibition for counterparty X in IFRS 13.

Reference:

The fair value of a liability reflects the effect of non-performance risk on the basis of its unit of account. The issuer of a liability issued with an inseparable third-party credit enhancement that is accounted for separately from the liability shall not include the effect of the credit enhancement (eg a third-party guarantee of debt) in the fair value measurement of the liability. If the credit enhancement is accounted for separately from the liability, the issuer would take into account its own credit standing and not that of the third party guarantor when measuring the fair value of the liability.” [IFRS 13 para 44].

Example 3: Using company-specific market information

In September 20X8, company B, a gas distribution company, enters into a two-year pay-fixed and receive-floating gas swap with counterparty M, a gas marketer, based on the NYMEX Henry Hub monthly index. The swap meets the definition of a derivative and Company B will record it at fair value with changes to fair value reported in the income statement each reporting period. The swap is not subject to a master netting arrangement and no collateral has been posted. As of December 31, 20X8, the fair value of the swap, without any adjustment for credit risk, is a liability of $365,000.

Since the contract is in a liability position, the credit adjustment will be based on market participant assumptions about company B’s credit risk (that is, the amount market participants would require for assumption of this liability in a transfer). Company B assesses the available credit information as follows:

  • Credit rating—Company B’s credit rating on September 30, 20X8 was BBB, which is generally consistent with comparable companies in the industry. Based on this credit rating, company B noted that the historical default tables indicate a default rate of less than 0.6% over the term of the swap contract. However, the use of the historical default rate method is unlikely to provide a current market participant’s assumption about credit risk. Because company B is not at least AA rated, market participants would likely consider other market indicators in assessing credit risk.
  • Credit spreads—Company B’s publicly traded, unsecured debt was trading with yields in the range of 1.4%-1.7% over U.S. Treasury bonds as of December 31, 20X8. Company B considered the use of this information in the calculation of the credit risk adjustment; however, it determined that CDS rates are available and more appropriate to the derivative being measured. In addition, given the currently volatile credit markets, company B determines that CDS rates provide a more timely and reliable indicator of credit risk.
  • Credit default swaps—There are publicly quoted CDS rates available for company B, with current activity through December 31, 20X8. Company B is able to obtain CDS rates from an information service without undue cost or delay. The CDS rate is approximately 273 basis points for the first year of the contract, decreasing to 258 basis points for the second year. The spreads have been increasingly volatile. Company B incorporates CDS rates in its assessment of counterparty credit risk for its risk management purposes.

Company B’s perspective is that the risk of default is minimal and would be consistent with the risk indicated by historical default rates. In addition, company B is concerned about the high level of volatility and thin trading associated with CDS rates. However, it determines that CDS rates provide the best indicator with respect to the current market view of its risk of default as of the reporting date. Accordingly, based on the reasonably available information, company B concludes that using the CDS rate provides the best estimate of credit risk from the market participant perspective.

If there were no quoted CDS rates available for company B then it might choose to calculate the credit risk adjustment by weighting company-specific credit spreads and sector specific CDS rates for the gas distribution sector.

Example 4: Evaluating various types of market information

Company B is valuing $1.0 million in preferred stock that was issued to private investors. This stock is classified as debt on the balance sheet because it is mandatorily redeemable. Company B is required to calculate the fair value of the preferred stock for purposes of the fair value disclosures required by IFRS 13. In considering the valuation process, management observes that:

  • Market conditions for debt have deteriorated.
  • Its sector has been affected by a number of negative factors.
  • Recently there has been a widening of credit spreads.

Company B’s management believes that the company tends to follow industry trends with a slight 'positive' factor due to a lower than average debt-to-equity ratio. Company B’s management also obtains the following inputs for consideration:

  • The credit spread on company B’s public debt is 3%.
  • The public debt is senior to the preferred stock. Due to current credit conditions and company B’s lower than average risk of default, company B’s management believes that an adjustment of 1% is required to reflect the lower seniority of the preferred stock in relation to the public debt. Therefore, the implied credit spread for the preferred stock is 4%.
  • Company B is able to obtain a quote for company H’s preferred stock that has similar terms and characteristics. The current credit spread implied in this issuance is 4%. Company H has the same credit rating as company B; however, company B operates in an industry that has a lower risk profile. Furthermore, company H trades at a higher price in its credit category than company B. Management determines that the difference in sectors and position within its credit category require a downward adjustment of .5%. Therefore, the credit spread implied by these inputs is 3.5%.
  • Management obtains a quote for a publicly traded series of subordinated debt for company J, a company within company B’s sector with a credit rating a grade below company B’s. The debt has characteristics (for example, subordination, covenants, and other terms) that are similar to, though not exactly the same as, company B’s preferred stock. In addition, company J has covenants that include restrictions beyond those imposed with company B’s preferred stock. The credit spread on the debt is 6% at the reporting date. Given the additional restrictions and the lower credit quality of company J, management adjusts the credit spread downward by 1.5%, for an implied spread of 4.5%.

Company B considers the three reference inputs which, as adjusted, range from a low of 3.5%, a mid-point of 4.0%, to a high of 4.5%. In assessing the appropriate rate to apply in calculating the credit risk adjustment, management considers the quality of the data sources. It notes that the first price is considered to be the most relevant as it starts with company B’s own debt and adjusts for the risk in the preferred stock. However, the second two inputs reference subordinated debt, which is a better comparison to the subordinated position of the preferred stock. Because the credit markets place a premium on seniority, and because company B operates in a lower risk sector, management has determined that the weighting should be closer to the subordinated debt spreads and assigns a credit spread of 4.5%.

Example 5: Discount rate adjustment technique—Using a credit spread

The following example demonstrates the calculation of the credit risk adjustment for the preferred stock discussed in Example 4. The preferred stock is mandatorily redeemable at its par value of $1.0 million in 5 years. The preferred stock provides for 20 quarterly dividend payments of $17,500, based on a fixed annual rate of 7%.

The preferred stock rates are comprised of the following:

  Issuance Date Measurement Date
LIBOR rate 4.00% 5.00%
Credit spread 3.00% 4.00%
  7.00% 9.00%


The credit risk adjustment may be calculated as follows:

Calculation of total fair value    
Present value of redemption payment at the end of 5 years, discounted at 9.0% (20 quarterly periods, 9%/4 per period)1   $640,816
Present value of 20 quarterly dividend payments, discounted at 9.0%   279,364
Fair value of the preferred stock at the measurement date   $920,180
Components of change in fair value    
Change attributable to changes in interest rates LIBOR rate increase of 1% $  39,910
Change attributable to changes in credit risk Credit spread increase of 1% 39,910
Total change in fair value $1,000,000 par, minus fair value 920,180 $  79,820


1 The calculation does not take into account the compounding effect of the interest over the period.

In this example, the credit risk adjustment was calculated as part of the discount rate applied in the overall calculation of fair value.

Example 6: Discount rate adjustment technique—Using a CDS rate

Company C holds an interest rate swap with counterparty S. Under the terms of the swap, company C pays 7% in exchange for receiving three-month LIBOR plus 1% (5% at September 30, 20X8) on $33,333,333 notional amount. The swap has a three-year remaining term until maturity. The swap meets the definition of a derivative and company C records it at fair value with changes recognized in earnings each reporting period. The swap is not subject to a master netting arrangement and no collateral has been posted.

As of September 30, 20X8, the cash flows associated with the fair value of the swap, without any adjustment for credit risk, represent cash outflows of $333,333 at the end of each of the following three years totaling to an expected outflow of $999,999. As the contract is in a liability position, the credit risk adjustment will be based on market participant assumptions, such as company C’s risk of default, liquidity of credit and other factors (that is, based on the amount market participants would require for assumption of this liability in a transfer). Company C assesses the available credit information and determines that market participants would price credit based on company C’s CDS rate, which is available by reference to a number of pricing services. The credit risk adjustment is calculated as follows:

Year Cash flow CDS quote (basis points) CDS quote (%) FV of credit risk adjustment Risk free rate (LIBOR) Risk adjustment rate Discounted credit risk adjustment
(t) (a) (b) (c) = (b) / 10,000 (d) = (a) x (c) x (t) (r) (s) = (r) + (c) (d) / (1 + (s)) xt
1 $333,333 38 0.38% $1,267 5.00% 5.38% $1,202
2 $333,333 45 0.45% $3,000 5.00% 5.45% $2,698
3 $333,333 60 0.60% $6,000 5.00% 5.60% $5,095
PV (cash flows) $907,748           $8,995


The credit risk adjusted cash flows (column (d) in the table above) are discounted at the risk-adjusted rate to determine the credit risk adjustment as of the reporting. The risk-free rate is assumed to be 5% for purposes of this example.


Based on the calculation, company C should record a credit risk adjustment of $8,995. Therefore, as of September 30, 20X8, company C reports a net derivative liability of $898,753 equal to the present value of the net swap cash flows discounted at the risk-free rate ($907,748) less the credit risk adjustment of $8,995. The impact of the credit risk adjustment should be included in the fair value change for the derivative recorded in the income statement.

Example 7: Application of credit allocation methods

Assume that company E holds three derivative positions with counterparty Q as of the reporting date. The fair values prior to any credit adjustment are as follows:

Derivative Amount Classification
Derivative 1 $(1,000) Liability
Derivative 2 1,500 Asset
Derivative 3 (2,000) Liability
  $(1,500) Net liability

 

The companies have a master netting arrangement which applies to all three positions. For purposes of this example, assume all contracts are due within one year. Based on available CDS information, the risk of default associated with company E is 10% and counterparty Q’s risk of default is 5%. As the derivatives are in a net liability position, company E calculates the credit risk adjustment using its own default risk and determines that a portfolio level credit risk adjustment of $150 is required on the net liability position.

Company E must allocate this adjustment for financial reporting purposes. Therefore, it considers the impact of using each of the four acceptable answers as follows:

  • Relative fair value—Method 1: Company E allocates the total credit adjustment of $150 to each of the derivatives in its portfolio, based on the relative value of each derivative to the net position with the counterparty. For example, the allocation to derivative 1 is calculated as follows:
Derivative 1 $(1,000)
Divided by net position (1,500)
Allocation percentage 66.66%
Multiplied by total credit adjustment 150
Allocated credit adjustment $    100

 

  • Relative fair value—Method 2: Company E allocates the total credit adjustment to only those derivatives in the same position as the net position based on their relative fair values (in this case, only to the liabilities). For example, the allocation to Derivative 1 is calculated as follows:
Derivative 1 $(1,000)
Divided by total liability position (3,000)
Allocation percentage 33.33%
Multiplied by total credit adjustment 150
Allocated credit adjustment $      50

 

  • Relative credit adjustment: Company E calculates the total credit risk adjustment for each derivative on a stand-alone basis (using the in-exchange approach described below). For example, the standalone credit risk adjustment for derivative 1 is calculated as ($1,000) multiplied by 10% (the risk of default for a liability position), which results in a standalone credit risk adjustment of $100. However, note that the standalone adjustment for derivative 2 would be calculated by applying the risk of default for counterparty Q, resulting in a standalone credit risk adjustment of ($75).

Company E then allocates the net credit risk adjustment of $150 to each derivative based on its relative standalone credit adjustment. The allocation to derivative 1 is calculated as follows:

Derivative 1—Standalone credit risk $ 100
Divided by total credit risk adjustment, in-exchange basis 225
Allocation percentage 44.44%
Multiplied by total credit adjustment 150
Allocated credit adjustment $   67

 

  • In-exchange or full-credit: In the in-exchange method, netting arrangements are ignored and credit risk adjustments are calculated for each derivative on a standalone basis, as discussed in the first step in the relative credit adjustment approach above. Application of the in-exchange method results in a higher overall credit risk adjustment then would be recorded if the netting arrangements are applied.

The overall results for each of the methods are depicted below:

  Relative fair value— Method 1 Relative fair value— Method 2 Relative credit adjustment In-exchange or full credit
Derivative 1 $ 100 $  50 $  67 $100
Derivative 2 (150) (50) (75)
Derivative 3 200 100 133 200
Total adjustment $ 150 $150 $150 $225
Net asset adjustment $(150) $ (50) $ (75)
Net liability adjustment $ 300 $150 $200 $300


Where the offsetting requirements of IAS 32 are not met, company E will allocate the credit risk adjustment to assets and liabilities based on the allocation methodology selected. The allocations should also be used for purposes of evaluating effectiveness of hedge accounting, for IFRS 7 offsetting disclosures and in determining how the valuation is classified in the fair value hierarchy.

 
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