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6.6 Measuring portfolios of financial instruments
Publication date: 31 Mar 2022
us Fair value guide
ASC 820-10-35-18D includes an exception to the general unit of valuation principles when the reporting entity does both of the following:
- Manages the group of financial assets and liabilities on the basis of the reporting entity’s net exposure to a particular market risk (or risks), or to the credit risk of a particular counterparty
- Reports information to management about the group of financial assets and financial liabilities on a net basis
The “portfolio exception” applies to portfolios managed based on credit risk if the mitigation of credit risk across the portfolio of assets and liabilities held by a particular counterparty is legally enforceable.
The portfolio exception allows fair value to be measured based on the portfolio’s net position for the risks being managed (i.e., the price that would be received to sell a net long position or transfer a net short position for a particular market or credit risk exposure). This represents an exception to how financial assets and financial liabilities are measured under ASC 820, which otherwise requires each financial asset or liability within a portfolio to be considered a separate unit of account and measured on a gross basis.
When the unit of account is the individual financial instrument, aggregation or offsetting of instruments to determine fair value would not be permitted. In addition, the ability to apply premiums and discounts in the measurement of each financial instrument would be more restrictive than absent use of the portfolio exception.
However, when a reporting entity elects the portfolio exception, the unit of measurement becomes the net position of the portfolio. In applying the portfolio exception, the valuation should be performed based on the price a market participant would pay (or be paid) to acquire the entire portfolio in a single transaction. In essence, this valuation would reflect the “net open risk” of the portfolio. Because the unit of measurement is the net position of the portfolio, size is an attribute of the portfolio being valued, and consequently, a premium or discount based on size is appropriate if incorporated by market participants.
The portfolio exception is available for financial assets and liabilities that can (pursuant to the fair value option) or must be measured at fair value on a recurring basis in the balance sheet. It does not apply to assets and liabilities for which fair value is only disclosed, or for which fair value is not measured on a recurring basis.
The portfolio exception pertains to fair value measurement, not to financial statement presentation. Whether the instruments in the portfolio or group can or must be presented on a net or gross basis in the financial statements depends on other guidance. Therefore, while the fair value of financial instruments managed within a group may be determined based on the net position when using the portfolio exception, the reporting entity should still allocate the resulting fair value based on the unit of account required by other guidance for those instruments. ASC 820-10-35-18F does not prescribe any allocation methodology; rather, the allocation should be performed in a reasonable and consistent manner that is appropriate in the circumstances. See FV 8.2.4.1 for further discussion of allocation methods.
6.6.1 Electing the portfolio exception
A reporting entity that elects use of the portfolio exception is required to support the assertion that the portfolio is managed based on the net exposure to market or credit risk. Examples of such support could include robust documentation of the reporting entity’s risk management or investment policies and strategies, risk committee meeting minutes, and internal management reporting information. In addition, management may want to consider the types and composition of portfolios the reporting entity has historically managed.
The portfolio exception is an accounting policy election and should be applied consistently from period to period. Management should support that it continues to manage risk exposures on a net basis in order to continue to qualify for the exception.
Since significant changes in risk management strategies are rare, changes in a reporting entity’s use of the portfolio exception are likewise expected to be infrequent.
6.6.2 Net exposure of market risks
Market risks refer to interest rate risk, currency risk, or other price risk.
The portfolio exception requirement relating to managing net exposure to market risk is limited to those risks that are substantially the same in nature and duration. Therefore, in applying the portfolio exception, it would be inappropriate to net a portfolio of unrelated risks, such as interest rate risk, currency risk, or other price risk.
Basis risk arises from a combination of two or more risks; it represents the risk that the underlying risks in the transaction or portfolio will not fluctuate in perfect correlation. We believe the portfolio exception can be applied to basis risk, provided that it is taken into account in the fair value measurement. As a result, provided a reporting entity meets the criteria for applying the portfolio exception, it would be appropriate to measure the fair value of financial instruments with different interest rate bases (e.g., LIBOR and treasury rates) on a net basis.
6.6.2.1 Degree of offset
When considering whether the portfolio exception is available for a group of financial assets and/or liabilities for a particular market risk, the reporting entity should consider the degree of exposure (or offset) of market risk to arrive at a net long or net short position. ASC 820-10-35 does not prescribe how much of a long or short position is permitted to qualify for the portfolio exception. For example, there is no requirement that assets in a portfolio with a certain risk be nearly 100% offset by liabilities. Rather, a reporting entity should assess the appropriateness of electing the portfolio exception based on the nature of the portfolio being managed in the context of its risk or investment management strategy. Broad risk management strategies, such as managing on the basis of value-at-risk (VAR), may not be sufficient alone for a group to be eligible for the portfolio exception because managing based on VAR is not necessarily the same as managing a business or portfolio to a net position.
We do not believe that there are bright lines or target percentages to determine whether there is sufficient offset of risk positions in a group or portfolio. However, we also believe it would be inappropriate to apply the portfolio exception to a portfolio with an aggregated position without offset or hedging (e.g., an aggregated block of equity shares). Such a position may relate to a trading strategy that is not managed on a net basis.
Furthermore, if the positions in a portfolio do not offset at the measurement date in accordance with expectations, the reporting entity may continue to use the portfolio exception at that measurement date, provided the lack of offset is temporary and due to unanticipated market events or operating conditions.
Finally, the portfolio exception should be applied based on the substance of the portfolio and how it is managed. For example, it would be inappropriate to enter into a non-substantive offsetting position in an attempt to qualify for the portfolio exception solely to be eligible to apply a blockage adjustment.
6.6.2.2 Mismatches in the portfolio
In applying the portfolio guidance, valuation of the net open risk position is required. Market participants may value a portfolio with basis risk differently than one that was perfectly hedged. The following are some examples of mismatches in the portfolio that affect the measurement of fair value.
Basis differences
Portfolios with basis differences may qualify for the portfolio exception. If there is any basis difference for dissimilar risks, the reporting entity should reflect that basis risk in the fair value of the net position. For example, a reporting entity may include financial instruments with different (but highly correlated) interest rate bases in one portfolio, provided the reporting entity manages its interest rate risk on a net basis. However, reporting entities should consider any difference in the interest rate bases (e.g., LIBOR vs. Treasury) in the fair value measurement.
Duration differences
Similar to basis differences, portfolios containing offsetting positions with different maturities may qualify for the portfolio exception. Reporting entities should adjust the fair value of the portfolio’s net position for such duration mismatches. Therefore, unmatched (or unhedged) portions of the terms to maturity of the financial assets and liabilities that form part of the portfolio could result in an adjustment to the net position. For example, in a portfolio of interest rate swaps with long (asset) positions of 30 years to maturity offset with short (liability) positions of 25 years to maturity, the reporting entity could avail itself of the portfolio exception for the net position for interest rate risk. However, the reporting entity would measure the five years of unhedged long position as part of the net position.
Question FV 6-1 addresses whether a company can apply the portfolio exception for offsetting market price risk in common shares of an entity.
Question FV 6-1
FV Company owns one million common shares of Entity X and enters into a forward sale agreement for 500,000 additional shares of Entity X. FV Company accounts for the shares at fair value using the fair value option. FV Company documents and manages the long position of shares and the forward sale agreement together as a net position according to its investment strategy.
Can FV Company apply the portfolio exception for offsetting market price risk? Specifically, could FV Company value the net position based on the price that is most representative within the bid-ask spread, by incorporating a discount to the net position if this is how market participants would price the net risk exposure?
FV Company owns one million common shares of Entity X and enters into a forward sale agreement for 500,000 additional shares of Entity X. FV Company accounts for the shares at fair value using the fair value option. FV Company documents and manages the long position of shares and the forward sale agreement together as a net position according to its investment strategy.
Can FV Company apply the portfolio exception for offsetting market price risk? Specifically, could FV Company value the net position based on the price that is most representative within the bid-ask spread, by incorporating a discount to the net position if this is how market participants would price the net risk exposure?
PwC response
Maybe. The portfolio exception changes the unit of measurement to the net position (rather than each individual share). Management should consider whether the degree of offset in the position is meaningful and determine whether the particular strategy is consistent with its overall investment policies and strategies.
Question FV 6-2 illustrates whether a company can apply the portfolio exception for offsetting interest rate risk positions with identical duration.
Question FV 6-2
FV Company has $500 million in 10-year pay 3-month LIBOR, receive fixed rate interest rate swaps (liability position) and $200 million in 10-year receive 3-month LIBOR, pay fixed rate interest rate swaps (asset position) that FV Company manages together and documents as a $300 million net liability position for purposes of managing interest rate risk.
Can FV Company elect the portfolio exception?
FV Company has $500 million in 10-year pay 3-month LIBOR, receive fixed rate interest rate swaps (liability position) and $200 million in 10-year receive 3-month LIBOR, pay fixed rate interest rate swaps (asset position) that FV Company manages together and documents as a $300 million net liability position for purposes of managing interest rate risk.
Can FV Company elect the portfolio exception?
PwC response
Yes. When elected, the portfolio exception allows a reporting entity to measure the fair value of those financial assets and financial liabilities based on the net positions of the portfolio. Assuming the reporting entity has met the requirements for electing the portfolio exception, the exception permits FV Company to determine fair value based on how market participants would price the net risk exposure within the bid-ask spread. FV Company would adjust the bid-ask spread of the $500 million short position and the $200 million long position to a new bid-ask spread for the net short $300 million position based upon how market participants would price the net risk exposure at the measurement date.
In this example, the interest rate risk exposure on the long and short positions (three-month LIBOR) and the terms to maturity (10 years) are identical so there is no need to adjust for basis or duration mismatches. However, FV Company should consider any need for a counterparty credit risk adjustment.
Question FV 6-3 discusses the ability to apply the portfolio method when positions have different durations. Question FV 6-3 illustrates the application of the portfolio exception when the offsetting asset and liability have different durations.
Question FV 6-3
FV Company has $500 million in 10-year pay 3-month LIBOR, receive fixed rate interest rate swaps (liability position) and $200 million in 10-year receive 3-month LIBOR, pay fixed rate interest rate swaps (asset position) that FV Company manages together and documents as a $300 million net liability position for purposes of managing interest rate risk.
Assume that the long position (i.e., the $200 million swap asset) has a term to maturity of 12 years instead of 10 years. FV Company documents its holding as a $300 million net liability position for purposes of managing interest risk.
Can FV Company elect the portfolio exception?
FV Company has $500 million in 10-year pay 3-month LIBOR, receive fixed rate interest rate swaps (liability position) and $200 million in 10-year receive 3-month LIBOR, pay fixed rate interest rate swaps (asset position) that FV Company manages together and documents as a $300 million net liability position for purposes of managing interest rate risk.
Assume that the long position (i.e., the $200 million swap asset) has a term to maturity of 12 years instead of 10 years. FV Company documents its holding as a $300 million net liability position for purposes of managing interest risk.
Can FV Company elect the portfolio exception?
PwC response
Yes, but FV Company would be required to adjust the fair value on the 10-year net position for the additional two years of net open risk. The fair value for the remaining two-year period on the 12-year swap would impact the valuation of the net position.
6.6.3 Exposure to counterparty credit risk
When applying the portfolio exception to a portfolio in which a specific counterparty’s credit risk is managed on a net basis, the reporting entity should consider market participants’ expectations about whether any arrangements in place to mitigate credit risk exposure are legally enforceable in the event of default (for example, through a master netting arrangement). In a portfolio of financial assets and liabilities within a master netting arrangement, the adjustment for credit risk could be applied to the net exposure to the counterparty, rather than to each of the financial assets and liabilities separately. The adjustment will be applied to the net position based on the individual counterparty’s credit risk in the case of a net asset position or the reporting entity’s own credit risk in the case of a liability position. The portfolio exception does not change the requirement to incorporate a credit valuation adjustment (CVA) or debit valuation adjustment (DVA) on a net open asset or liability position, respectively.
6.6.4 Portfolios of financial instruments and nonfinancial instruments
As originally written in ASC 820-10-35-18D, derivatives that do not meet the definition of a financial instrument did not qualify for the portfolio exception. This includes, for example, physically-settled commodity derivative contracts or combinations of cash-settled and physically-settled commodity derivative contracts.
ASU 2018-09 revised the language in the guidance (ASC 820-10-35-18D through 820-10-35-18F and ASC 820-10-35-18H through ASC 820-10-35-18L) to include not only financial assets and liabilities (as previously written), but also financial and nonfinancial derivatives subject to ASC 815. The correction allows reporting entities to measure fair value on a net basis for those portfolios containing financial assets and liabilities and nonfinancial derivatives. The update was effective upon issuance of ASU 2018-09.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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