Estimating Valuation Adjustments for Financial Instruments
Financial instruments are increasingly valued using models rather than observable market prices, particularly over-the-counter derivatives and inactively traded bonds for which active markets and reliable price data may not exist. Yet valuation models are, by design, simplifications of reality and typically produce theoretical or mid-market values. As a result, a model’s output may not reflect the price at which an instrument could actually be exited – its fair value – at the measurement date, and the judgement required to bridge that difference can be significant.
This IVSC Perspectives Paper, developed by the IVSC Financial Instruments Board, examines how and why valuation adjustments are applied to reconcile model-derived values with fair value. It sets out what a valuation adjustment is, why the use of models gives rise to the need for them, and a structured approach to identifying, assessing, applying and documenting them in a consistent and transparent way.
The paper also illustrates how such adjustments arise in practice. It discusses counterparty credit risk through Credit and Debit Valuation Adjustments (CVA and DVA); adjustments for parameter uncertainty and model risk where inputs are unobservable, drawing on the examples of Bermudan swaptions and inactively traded bonds; discounts for lack of marketability; and concentration adjustments, where the size of a position relative to market depth affects the price at which it can be exited. Throughout, it considers how this work relates to the requirements of IVS 105, IVS 106 and IVS 500.
At a time of growing regulatory and investor scrutiny, the paper highlights the importance of applying valuation adjustments within a disciplined, transparent and consistently applied framework – reflecting factors not fully captured by an otherwise appropriate model, rather than compensating for inappropriate models or data. Such an approach can help improve the reliability and comparability of fair value measurements and strengthen stakeholder confidence.
IVSC welcomes feedback from market participants, valuers, investors, auditors, regulators and other stakeholders to help inform future work.