“Counterparty credit risk is the risk that a party to a financial contract will fail to fulfil their side of the contractual agreement. This risk affects the fair value of the contract, which 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.
Under IFRS 13, fair value measurements have to take into account all risk factors that market participants would consider, including credit risk. This means that the fair value of a derivative financial instrument should reflect the effect of the counterparty’s credit risk (and the entity’s own credit risk, if the instrument is a liability or an own equity instrument). This effect is often quantified as a credit value adjustment (CVA) or a debit value adjustment (DVA), respectively.
A CVA is an adjustment that reduces the fair value of an asset to reflect the possibility that the counterparty may default or become unable to pay. A DVA is an adjustment that increases the fair value of a liability to reflect the possibility that the entity may default or become unable to pay. Both CVA and DVA are based on the expected loss from default, which depends on the probability of default, the exposure at default, and the loss given default.
There are different methods and models for calculating CVA and DVA, such as the market standard approach, which uses market-implied inputs and models, and other approaches, such as the historical simulation approach or the analytical approximation approach, which use historical or analytical data and models. The choice of method and model depends on the availability and reliability of market data, the complexity and diversity of the derivative portfolio, and the level of sophistication and accuracy required. Within these approaches, there are also different ways of estimating the exposure at default, such as the expected positive exposure approach, the potential future exposure approach, and the current exposure method, which use the average, maximum, or current exposure over the life of the contract, respectively.
However, CVA and DVA are not the only adjustments that need to be considered when measuring fair value under IFRS 13. Other factors, such as funding costs, liquidity risk, and wrong-way risk, may also have a significant impact on the fair value of derivative financial instruments.
How can these factors be incorporated into the fair value measurement framework, and what are the implications for financial reporting and risk management? For example, funding costs can be reflected by adjusting the discount rate or the cash flows of the contract, liquidity risk can be reflected by applying a liquidity premium or discount to the fair value, and wrong-way risk can be reflected by adjusting the probability of default or the exposure at default to account for the correlation between the credit quality of the counterparty and the value of the contract. These are some of the questions and challenges that face practitioners and researchers in the field of counterparty credit risk and fair value accounting.”