Whitepaper: Demystifying derivative instrument valuations – A commercial and accounting perspective

Market Insight
Adrian Li, Managing Director - Centrus

Recently several of our treasury clients have been querying the difference between the derivative valuations provided by banks, and the derivative valuations when looking at unwind values upon terminating a derivative prior to maturity. There have also been accounting valuation changes to further complicate matters.

In this white paper we address the differences between the “Mark-to-Market” of a derivative, a bank’s valuation of that same derivative, and the latest in accounting valuations. In summary:

  1. The Mark-to-Market of a derivative (we use as an example an uncollateralised interest rate swap), represents the Net Present Value of all future cashflows to be received and paid, discounted at LIBOR. This value is the same as that received in reporting statements from banks, and is often utilised for accounting purposes.
  2. The Bank Valuation of a derivative is the Mark-to-Market adjusted for the bank’s credit, funding and capital implications. It may also take into account the bank’s strategy, commercial considerations and a bank’s portfolio impact. This is an important factor to consider when terminating a derivative prior to maturity.
  3. The Accounting Valuation of a derivative, is usually the same as the Mark-to-Market described previously (taking into account certain valuation adjustments that depend on the relevant accounting standard). There have been accounting developments which most entities should be aware of which puts a greater emphasis on credit adjustments to the Mark-to-Market for accounting purposes.

This is a complex and technical area which requires an understanding of cashflows, market movements, internal bank processes and considerations, and accounting developments. We address these topics in more detail in the following paper.

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