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Derivative assets and liabilities within the scope of ASC 815 are required to be recorded at fair value at inception and on an ongoing basis. Applying ASC 820 to derivatives may be complex, depending on the terms of the instruments and the source of valuation information. Derivatives may be financial assets and liabilities (e.g., interest rate swaps) or nonfinancial assets and liabilities (e.g., commodity contracts). This chapter discusses all derivatives, as the process to determine a valuation is generally the same whether a derivative is a financial or nonfinancial instrument.
Application of ASC 820 to derivative assets and liabilities requires consideration of the following:
  • Unit of account

    As defined by ASC 815 the unit of account is generally the contract, unless the portfolio exception discussed in FV 6.6 can be elected.
  • Principal or most advantageous market

    The principal market is the market with the greatest volume of activity for the instrument to which the reporting entity has access. ASC 820-10-55-46 through ASC 820-10-55-49 (Example 5) illustrates a situation in which different swap counterparties, a swap dealer and a retail counterparty, execute a swap in the retail market, but have different principal markets.

    The dealer’s principal market for the swap is the dealer market. The example notes that if the dealer were to sell the swap, it would be to another dealer. Thus, it is in the dealer-to-dealer market.

    For the retail counterparty, the principal market is the retail market because the retail counterparty cannot access the dealer market. However, the example indicates that if it were selling the swap, the sale would be to a dealer in the retail market, not to another retail counterparty. Thus, it is in the retail-to-dealer market.

    In the absence of a principal market, the reporting entity must determine the most advantageous market.

    For general information on determining principal or most advantageous market, see FV 4.2.2.
  • Hypothetical market

    If the reporting entity is not able to access an actual market, it should determine a hypothetical market and the characteristics of relevant market participants.
  • Measurement of fair value

    Quoted market prices in active markets are the best evidence of fair value and are to be used if available. However, many derivatives are not exchange-traded; therefore, it is likely that a valuation technique will have to be applied to measure fair value.
  • Valuation approaches/valuation techniques

    The income and market approaches will generally be used when measuring the fair value of derivative instruments. For plain-vanilla swaps, a market approach would include obtaining accommodation quotes from dealers (with testing by the reporting entity). The income approach would involve a discounted cash-flow analysis based on available forward yield curves for plain-vanilla swaps of the same type.

    Regardless of the technique, the reporting entity should incorporate market participant assumptions, including model adjustments for risk if market participants would do so.

    For general information on valuation approaches and techniques, see FV 4.4.
  • Nonperformance risk

    ASC 820-10-35-17 requires incorporation of nonperformance risk (including credit risk of both the reporting entity and the counterparty) into the valuation of both assets and liabilities, including those arising from derivative contracts, if such nonperformance risk would affect the price received to sell the derivative in an asset position or paid to transfer the derivative in a liability position in an orderly transaction with market participants.

    As with other elements of fair value measurement, nonperformance risk should be measured from the perspective of external market participants. Some of the factors that would reduce nonperformance risk for derivatives include: master netting agreements that are effective upon default, collateral arrangements, and termination provisions. See further discussion of considerations for measuring counterparty credit risk in FV 8.
  • “Day one” gains and losses

    Under US GAAP, “day one” gain or loss is recognized if the transaction price and exit price are different at inception, even if based on unobservable inputs, assuming appropriate application of the models and valuation adjustments.

6.5.1 Cleared derivative contracts

Derivative contracts such as credit default swaps and interest rate swaps may be cleared through one of various clearing houses. Each clearing house may have a different method for calculating the daily variation margin. More specifically, the clearing house provides a “value mark” used to determine the amount of variation margin required to be moved. This value mark is generally not a “price” for the instrument as it is not a value at which a reporting entity could execute the trade at that particular point in time. As a result, this value mark is not considered an exit price or a Level 1 fair value input. However, the value mark is one data point that an end-user may consider in determining fair value.
The value provided by the clearing house and clearing member may not be solely attributed to changes in the valuation of the derivative. Reporting entities should keep this in mind when measuring their derivatives’ fair values in accordance with ASC 820.
Reporting entities should evaluate the specific facts and circumstances related to their portfolios, and assess clearing house values in a manner similar to vendor or counterparty prices.
Refer to FV 8.1.1.1 for further considerations related to the valuation of a financial derivative contract cleared through a clearing house.
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