THINKING ABOUT FAIR VALUE?
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Assess. Measure. Then take a big breath. Because if you’re not valuing your derivatives based on credit curves, your hedges might be sinking under water. |
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Krishnan, Hedge Accounting Technical Taskforce Leader @ Reval
Expert in resuscitating hedge accounting patients. |
Krishnan is responsible for Reval's solution consulting. He is also the Chairman of the Hedge Accounting Technical Task Force at Reval. He has published numerous articles in leading treasury publications and is a frequent speaker at conferences. Prior to joining Reval, he worked in the National Risk & Quality Group (National Office) at PricewaterhouseCoopers LLP and as a marketer on the derivative sales desk at Wells Fargo Bank N.A. He holds a Bachelor of Arts and an MBA in Finance and Accounting from Rutgers University.
Client: You mean fair valuing my hedge could turn it from an asset into a liability?
Krishnan: “Fair value under FAS 157 means you have to incorporate non-performance risk when you value derivatives on the balance sheet. What this means is that you need to determine whether the derivative is in an asset or liability position and then use the appropriate credit curve to incorporate non-performance risk under FAS 157.”
But market movements affect the value of a derivative.
“Yes. But now the credit adjustment factor also affects its value and can cause a material difference from just considering the market environment in its valuation. Your creditworthiness, and that of your counterparty, affects the value of your derivatives.”
So can this credit adjustment factor affect my hedge accounting under FAS 133?
“Yes. The interplay between FAS 157 and FAS 133 can create situations where problems surface and drive unwanted P&L volatility. Let’s say you have an interest rate swap that’s designated for hedge accounting. Once you apply a credit adjustment under FAS 157 on that derivative, you’ve created an opportunity for a valuation mismatch because the hedged item under FAS 133 would normally only be re-measured for movements in the benchmark interest rate."
So what do you advise?
"When considering risk management of your derivative portfolio, pay attention to the credit component that FAS 157 has introduced. We help our clients look at all scenarios, such as using FAS 159 and possibly forgoing hedge accounting, or documenting the use of non-performance risk in revaluing the hypothetical derivative. Our FAS 157 and IFRS 7 software modules address all the key dimensions associated with compliance and documentation.”
Krishnan:
Leading clients to solve complex issues arising from compliance with evolving accounting standards.
