Murex Helps Client Comply with Regulator Fair Value Determination Request

by Nuria Pereira, Solution Architect

The most common measure of the market liquidity of an asset is the size of its bid-ask spread. The more liquid the asset, the smaller the bid-ask spread, and vice versa.

Under IFRS 13, this spread must be used to compute the fair value of an asset or liability.

For an instrument that has a bid price and ask price, fair value measurement under IFRS 13 requires the use of the most representative price within the bid-ask spread. It permits (but doesn't require) the valuation of asset positions at bid prices and liabilities positions at ask prices.

But when readily available quotes are largely nonexistent and available quotes show wide bid-ask spreads, determining the most representative price within the bid-ask spread of an asset is not straightforward. Which point in the spread should be used to compute the right fair value?

If illiquidity makes fair value difficult to determine, regulators prefer a conservative estimate of fair value—even if this can be inaccurate.

Peruvian fair value regulation

An example of this conservative approach to fair value determination is a Peruvian regulation known as SBS 1737-2006, Article 8, published by the Superintendencia de Banca, Seguros y Administradoras Privadas de Fondos de Pensiones (SBS).

SBS regulates all banks in Peru, implements and enforces Peruvian banking law and supervises the market risk management process of Peruvian banks. To do this, SBS takes many factors into account, such as bank risk appetite and profile, and market and macroeconomic conditions. One of these factors is the risk of deterioration in market liquidity.

Article 8 applies to the trading books of Peruvian banks. Peruvian accounting standards for derivatives require the use of fair value measurements for financial derivatives, in line with international standards.

The rule stipulates that for derivatives in the trading book that are not perfectly hedged, valuation at mid-price is insufficient. The valuation must be done at fair value, using bid or ask prices, depending on whether the position is long or short, in the most conservative way.

What does conservative mean, in practice? It generally means valuing long positions at bid and short positions at ask.

Currency swap example

Consider the simple example of a currency swap. If we look at the value of the contract once initial amounts are settled and final amounts are fixed, the only prices needed to value the contract are in the interest rate curves used to discount the final amounts in each leg. One can comply with the rule by using an interest rate curve quoted in bid to discount the received (i.e., long) leg, and an interest rate curve quoted in ask to discount the paid (i.e., short) leg.

In the case of a currency swap, since there are flows in two distinct currencies and it is clear which flows relate to the long leg and which flows relate to the short leg, it can seem as if applying the bid or ask quotes to discount the individual cash flows makes sense.

Interest rate swap example

Now, take an interest rate derivative, such as an interest rate swap. It can seem initially tempting to extend the reasoning used above for the currency swap, discounting the received leg with an interest rate curve quoted in bid, and the paid leg with a curve quoted in ask.

A Peru-based client and Murex worked constructively to develop a different approach, relying on Murex expertise and experience on the matter.

Murex advised that the above-described approach by leg, while making sense for an FX outright or a currency swap, would be limiting for other derivatives, and therefore problematic. For example, in the case of an interest rate swap, the determination of whether a position is long or short depends on the underlying instrument and not just the direction of individual cash flows.

Generic methodology for all derivative products

For a portfolio of complex derivatives in different asset classes, some with more than one underlying, it is hard to come up with a general way to apply the rule to each underlying that could be automated without complex ad-hoc exceptions.

A better approach is to value the derivative initially with every underlying risk factor at mid, and then to apply an adjustment to account for the bid-ask spreads. The size of this adjustment can be computed by moving the prices of each underlying risk factor to bid or ask (depending on whether the position is long or short), measuring the impact on the value of the derivative and using that impact to adjust the initial value.

In fact, taking the assumption that the bid and ask spreads are symmetrical around the mid-price, this approach can be further simplified. This simplification consists of pricing the derivative with every risk factor in mid, and then adjusting the value by shocking all the prices to bid (rather than to bid or ask) and measuring the impact of the shock. If we then deduct the absolute value of the difference in pricing at mid and bid from the mid-point price, we arrive at a fair value adjustment that is tractable and easy to implement. (Taking the absolute value means that regardless of whether we are long or short, we apply the adjustment to fair value correctly.)

Implementation example

As referenced above, Murex collaborated closely with a Peru-based client to apply the adjustment in this way at the level of the underlying rather than at the level of individual cash flows—an optimal and generic method to implement the fair value adjustment.

Of course, such an elegant interpretation was made possible only due to MX.3’s wide product coverage for Peruvian and foreign instruments across rates, fixed income, foreign exchange asset classes, which brings consistency in pricing and official prudent valuation of all assets for financial reporting.

Murex’s client was ultimately able to work collaboratively with the Peruvian regulator, SBS, to secure approval for this approach.