FAIR VALUE AND EXPECTED CREDIT LOSS ESTIMATION: AN ACCURACY COMPARISON OF BOND PRICE VERSUS SPREAD ANALYSIS USING LEHMAN DATA
The International Financial Reporting Standard (IFRS) 9 and the Financial Accounting Standard Board’s (FASB) Current Expected Credit Loss (CECL) model significantly raise the accuracy bar for valuation and credit risk analytics for all organisations which report under their aegis. In both cases, the visibility of the organisation’s valuation and credit risk assessment moves from the back office or middle office, seen primarily by risk experts, to centre stage, under a bright spotlight. Both these standards allow the use of creditworthiness assessment using approaches encompassing: (i) probabilities of default; (ii) internal or external credit ratings; and (iii) credit spreads.
The objective of the standards is the generation of 12 month and expected lifetime loan losses, based on changes to obligor creditworthiness from one observed point to the next.
One can take a model validation approach and compare two methods of valuation and credit loss assessment from an accuracy point of view. The first approach uses market-based credit spreads to establish obligor creditworthiness, estimate values and credit losses. The second approach uses observable market prices of securities, rather than credit spreads derived from them, directly in the valuation and credit assessment process. After this exercise, one can understand that the use of observable market prices is best practice, while listing the model validation issues that cause credit spreads (derived from market prices) to be a source of random errors in valuation and credit assessment.
Jan-Mar 2017 Issue
Kamakura Corporation