Fair value of a liability

Assume that Entity X and Entity Y each enter into a contractual obligation to pay cash (€500) to Entity Z in five years. Entity X has a AA credit rating and can borrow at 6 per cent, and Entity Y has a BBB credit rating and can borrow at 12 per cent.

Entity X will receive about €374 in exchange for its promise (the present value of €500 in five years at 6 per cent). Entity Y will receive about €284 in exchange for its promise (the present value of €500 in five years at 12 per cent).

Fair value of a liability

The fair value of the liability to each entity (i.e., the proceeds) fully reflects that entity’s credit standing. The following example illustrates the measurement of liabilities and the effect of non-performance risk (including an entity’s own credit risk) on a fair value measurement.

On 1 January 20X7 Entity A, an investment bank with a AA credit rating, issues a five-year fixed rate note to Entity B. The contractual principal amount to be paid by Entity A at maturity is linked to an equity index. No credit enhancements are issued in conjunction with or otherwise related to the contract (i.e., no collateral is posted and there is no third-party guarantee).

Entity A designated this note as at fair value through profit or loss under applicable FRS. The fair value of the note (i.e., the obligation of Entity A) during 20X7 is measured using an expected present value technique. Changes in fair value are as follows:

  1. Fair value at 1 January 20X7. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the government bond curve at 1 January 20X7, plus the current market observable AA corporate bond spread to government bonds, if non-performance risk is not already reflected in the cash flows, adjusted (either up or down) for Entity A’s specific credit risk (resulting in a credit-adjusted risk-free rate). Therefore, the fair value of Entity A’s obligation at initial recognition takes into account non-performance risk, including that entity’s credit risk, which presumably is reflected in the proceeds.
  2. Fair value at 31 March 20X7. During March 20X7, the credit spread for AA corporate bonds widens, with no changes to the specific credit risk of Entity A. The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the government bond curve at 31 March 20X7, plus the current market observable AA corporate bond spread to government bonds, if non-performance risk is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (ie resulting in a credit-adjusted risk-free rate). Entity A’s specific credit risk is unchanged from initial recognition. Therefore, the fair value of Entity A’s obligation changes as a result of changes in credit spreads generally. Changes in credit spreads reflect current market participant assumptions about changes in non-performance risk generally, changes in liquidity risk and the compensation required for assuming those risks.
  3. Fair value at 30 June 20X7. As of 30 June 20X7, there have been no changes to the AA corporate bond spreads. However, on the basis of structured note issues corroborated with other qualitative information, Entity A determines that its own specific creditworthiness has strengthened within the AA credit spread.

Fair value measurement of a liability

The expected cash flows used in the expected present value technique are discounted at the risk-free rate using the government bond yield curve at 30 June 20X7, plus the current market observable AA corporate bond spread to government bonds (unchanged from 31 March 20X7), if non-performance risk is not already reflected in the cash flows, adjusted for Entity A’s specific credit risk (i.e., resulting in a credit adjusted risk-free rate). Therefore, the fair value of the obligation of Entity A changes as a result of the change in its own specific credit risk within the AA corporate bond spread.

Fair value measurement of a liability Fair value measurement of a liability Fair value measurement of a liability

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