The whitepaper explores the challenges, risk factors, calculation techniques, and concepts for measuring financial instruments under IFRS 13. It examines the effect of CVA and DVA on hedge effectiveness, the different approaches for testing hedge effectiveness and best practice for inclusion or exclusion of CVA and DVA in setting up hypothetical derivatives.
With the introduction of IFRS 13, more emphasis has been placed on valuation adjustments including CVA and DVA. 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.
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 counterparty risk, credit risk, market risk, liquidity and funding risk. IFRS 13 requires that the credit risk of a counterparty 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 counterparty 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.