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Accounting for the Changes in Valuation

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In the aftermath of the credit crisis, credit spreads soared to unpredicted heights. Basis spreads between three-month LIBOR and six-month Libor, for example, went from fractions of a basis point (where they had been quoted for decades) to double digits in a matter of months. Practitioners had to revise valuation methodologies to reflect these changes in the market. The accounting profession is now recognizing that these new market practices have important accounting implications as well.

The changes in the market environment have far reaching implications for the valuation of all derivative contracts. Classical no-arbitrage principles that formed the basis of all derivatives pricing no longer hold. For instance, before the credit crunch, one could safely combine a 3x6 forward rate agreement together with a 6x9 FRA to create a 3x9 rate (with an almost negligible adjustment). This is no longer the case as the basis between rates widened considerably reflecting that the 3x9 FRA contains different credit risk than the combined 3x6 and 6x9 FRAs.

The market now recognizes that Libor has a credit component and yield curve construction methodologies have been revisited to account for this. Valuation based on a single curve has been replaced with a multi-curve approach that separates the curve used for cash flow generation from the curve used for discounting. This change effects valuations of all derivatives from the simplest swap to the most complex exotic. It also affects the difference in valuations between collateralized and uncollateralized transactions. The new multi-curve interest rate curve paradigm has a significant impact on the value of all derivative transactions.

To comply with FASB 133/157, ISA 39, IFRS 9/13, this new valuation methodology needs to be implemented and accounting valuations have to reflect this new market standard.

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