Deloitte is a provider of audit, consulting, financial advisory, risk management, tax and related services, while Quantifi is a provider of analytics, trading and risk management solutions.
Designed to improve the consistency of fair value measurement, IFRS 13 has significant implications for the measurement of financial assets. Fair value requirements have increased in complexity, taking into account counter party risk, credit risk, market risk, liquidity and funding risk. IFRS 13 requires that the credit risk of a counter party as well as an entity's own credit risk should be taken into account in the valuation of financial instruments.
In addition, all adjustments which market participants would make in setting the price for an instrument should be taken into account in order to arrive at an exit price. Credit valuation adjustment (CVA) and debit valuation adjustment (DVA), which are used to adjust the market value to take into account counter party and an entity's own credit risk, are consistent with the required valuation adjustments of IFRS 13. IFRS 13 has significant implications for all firms, including corporates that measure financial assets at fair value. As a result, CVA and DVA can also impact hedge designation and effectiveness testing.
This paper examines the effect that CVA and DVA have on the hedge effectiveness. It explores different approaches of hedge effectiveness testing, as well as best practice when it comes to inclusion or exclusion of CVA and DVA in setting up hypothetical derivatives.
"We have seen organisations struggle to incorporate CVA and DVA adjustments when performing hedge effectiveness testing. In some cases, CVA and DVA volatility has caused hedge ineffectiveness. It is critical for organisations to explore IFRS 13 compliant approaches that maximise hedge effectiveness," according to Phillip van den Berg and Searle Silverman, senior managers at Deloitte.
"With the introduction of IFRS 13, more emphasis has been placed on valuation adjustments including CVA and DVA," says Dmitry Pugachevsky, co-author and director of research at Quantifi.
"Incorporating these adjustments into derivatives valuations requires accuracy and consistency, for which we believe the best approach is the Monte Carlo simulation model as it takes into account all market dynamics affecting an instrument or portfolio. The output from these simulations can then be applied to the analysis of hedge effectiveness with the result being more reliable valuations," Pugachevsky concludes.
The webinar and supporting whitepaper, available at http://www.iasplus.com/en/publications/south-africa/other/ifrs-13-webinar.
