At Hedgebook we are often asked by our clients what the appropriate credit spreads are when calculating CVA (Credit Value Adjustment) under the current exposure method. The current exposure method requires a credit spread over the risk-free rate (swap rates) to determine the discount factor for future Cashflows. The current exposure method is appropriate for calculating credit adjustments for vanilla financial instruments such as foreign exchange forwards and options, and interest rate swaps. If your derivatives are in-the-money then the credit valuation adjustment quantifies the risk of your counterparty defaulting.
One appropriate source for quantifying appropriate credit spreads is the secondary bond market where bank/corporate bonds are traded amongst fixed income participants. The banks are active issuers into this market and as such provide a useful guide to how the market views their credit worthiness. By looking at spreads over swap we can derive a credit term structure to use in the calculation of CVA.
The following table shows the spread over swap for senior bank bonds in the NZ fixed income market. The data has been extracted using the January 2015 month-end corporate bond pricing information from one of the four Australian owned NZ registered trading banks.
|6 mths to
|1 to 2 yrs||2 to 3 yrs||3 to 4 yrs||4 to 5 yrs|
|ANZ||20 to 30 bp||N/A||42 bp||52 to 59 bp||60 to 61 bp|
|ASB||22 bp||N/A||41 to 50 bp||55 bp||N/A|
|BNZ||21 bp||N/A||N/A||55 to 60 bp||63 bp|
|Westpac||N/A||N/A||41 bp||57 bp||64 bp|
* bp = basis points per annum. 1bp = 0.01%
As each of these banks is rated AA- by S&P it is intuitive that their senior bonds trade within close proximity to each other. From the information we can generalise and build a credit term structure that can be plugged into valuation models to determine CVA. An estimated AA- credit curve could be:
- 1 year = 25 bp
- 2 year = 35 bp (linearly interpolated between 1 and 3 year points)
- 3 year = 45 bp
- 4 year = 55 bp
- 5 year = 65 bp
The reality is that the CVA calculation is not very sensitive to these inputs so it is not necessary for a corporate with vanilla instruments to agonise over the credit assumptions. That said, the assumptions must be defensible and, more importantly from an IFRS 13 perspective, observable.
Furthermore, we would argue that if you are a corporate banked by more than one of the four banks in the table above then there is little added value in creating a curve for each counterparty. As we have shown, there is little difference in the market’s credit view between one AA- NZ bank and another.
The CVA module within the HedgebookPro app allows the user to create multiple credit curves and assign them appropriately to the relevant instruments. However, creating multiple curves will only be of added value if the counterparties are of materially different credit standing.