Chatham Financial Issues Best Practice Analysis of Credit Valuation Adjustment (CVA) Methodologies

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KENNETT SQUARE, Pa.--(BUSINESS WIRE)-- Chatham Financial, who in December 2007 became the first third-party provider to develop and bring to market a potential future exposure model for calculating Credit Value Adjustments (CVAs) on derivatives, today issues its newest whitepaper on how to best consider CVAs as required under ASC Topic 820 (formerly FAS 157).

The whitepaper provides a thorough analysis of the five identified CVA methods for both foreign exchange and interest rate derivatives and how each method performed during a recent 18- month period of significant market volatility. Building upon Chatham's previous whitepaper that articulated how Potential Future Exposure (PFE) is the most accurate method to adjust for credit risk, this new study demonstrates that CVAs calculated using a PFE model exhibited less volatility than those calculated using any of the four current exposure methods.

The analysis focused on CVA calculation during a period of intense market volatility impacting interest rates, currency rates, credit spreads, termination values, and portfolio fair values. Chatham’s demonstrates that the most commonly used current exposure approach – one that simply multiplies the current exposure times a single credit spread – generally produces the most period-to-period volatility in CVAs. The PFE model, on the other hand, is the only approach that uses bilateral exposure – examining potential changes to the counterparty exposure that could shift some trades from assets to liabilities or vice versa. Because the potential exposure on both sides is examined under this model, the results are generally less volatile fluctuations of the CVA under almost all market conditions than those of the various current exposure models.

Chatham's PFE approach is recognized by many auditors as the gold standard for compliance with the requirements of ASC Topic 820 (FAS 157) on fair value measurement for financial instruments. In addition, Chatham’s approach quantifies nonperformance risk in the way that major market participants – and specifically most dealer banks – price credit. Chatham has been using the PFE model of CVA calculation for over three years and has calculated over 200,000 quarterly valuations using this approach on top of over 15 million daily valuations in that same period. Until recently Chatham was the only provider of the PFE model to the broader corporate world. Chatham continues to be the most comprehensive in the breadth of derivatives covered by its calculation engine and has built a deep foundation of experience and knowledge for this model.

"The professionals at Chatham clearly possess an in-depth understanding of fair value across the gamut of financial instruments” said Steve Broadwater, Senior Vice President and Chief Accounting Officer at Simon Property Group. “The firm’s expertise significantly enhances our finance team in assessing these financial instruments in a complex and evolving area of financial reporting and analysis.”

Not only are the CVAs calculated using the potential future exposure approach the least volatile and the most reflective of the principles of ASC Topic 820, but they also provide the most accurate measure of counterparty exposure and a company’s own credit risk.

“Calculating CVAs based upon the potential future exposure methodology involves greater complexity than the more simplified current exposure approaches,” said Stephen Barr, CFA, Director of Chatham’s Valuations Team. “Accurately determining PFE requires more data inputs – specifically about market-implied forward volatility – and greater computational rigor. But this approach provides a more accurate picture of a company’s own credit risk and true counterparty exposure, while producing CVAs that are often less volatile than those determined under a current exposure model.”

A copy of this whitepaper is available at www.chathamfinancial.com/thoughtleadership/whitepapers

About Chatham Financial

Chatham Financial is the largest independent interest rate and currency risk advisor, and a recognized leader in hedge accounting, valuations and debt advisory worldwide. Chatham provides innovative solutions in both the derivatives and debt markets through a powerful combination of advisory services and market-tested technology solutions. Founded in 1991, Chatham is the trusted advisory to over 1,000 market leading firms and annually advises on over 8,000 transactions and $350 billion notional from offices in the U.S., Europe and Asia. For more information, please visit www.ChathamFinancial.com