Citibank 2013 Annual Report Download - page 150

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FAIR VALUE ADJUSTMENTS FOR DERIVATIVES AND FAIR VALUE OPTION
LIABILITIES
The following discussion relates to the derivative obligor information and the
fair valuation for derivatives and liabilities for which the fair value option
(FVO) has been elected. See Notes 25 and 26 to the Consolidated Financial
Statements for additional information on Citi’s derivative activities and FVO
liabilities, respectively.
Fair Valuation Adjustments for Derivatives
The fair value adjustments applied by Citi to its derivative carrying values
consist of the following items:
• Liquidity adjustments are applied to items in Level 2 or Level 3 of
the fair-value hierarchy (see Note 25 to the Consolidated Financial
Statements for more details) to ensure that the fair value reflects the price
at which the net open risk position could be liquidated. The liquidity
reserve is based on the bid/offer spread for an instrument. When Citi
has elected to measure certain portfolios of financial investments, such
as derivatives, on the basis of the net open risk position, the liquidity
reserve is adjusted to take into account the size of the position. Citi uses
the relevant benchmark curve for the currency of the derivative (e.g., the
London Interbank Offered Rate for U.S. dollar derivatives) as the discount
rate for uncollateralized derivatives. As of December 31, 2013, Citi has
not recognized any valuation adjustments to reflect the cost of funding
uncollateralized derivative positions beyond that implied by the relevant
benchmark curve. Citi continues to monitor market practices and activity
with respect to discounting in derivative valuation.
• Credit valuation adjustments (CVA) are applied to over-the-counter
derivative instruments, in which the base valuation generally discounts
expected cash flows using the relevant base interest rate curves. Because
not all counterparties have the same credit risk as that implied by the
relevant base curve, a CVA is necessary to incorporate the market view of
both counterparty credit risk and Citi’s own credit risk in the valuation.
Citi’s CVA methodology is composed of two steps. First, the exposure
profile for each counterparty is determined using the terms of all individual
derivative positions and a Monte Carlo simulation or other quantitative
analysis to generate a series of expected cash flows at future points in time.
The calculation of this exposure profile considers the effect of credit risk
mitigants, including pledged cash or other collateral and any legal right
of offset that exists with a counterparty through arrangements such as
netting agreements. Individual derivative contracts that are subject to an
enforceable master netting agreement with a counterparty are aggregated
for this purpose, since it is those aggregate net cash flows that are subject to
nonperformance risk. This process identifies specific, point-in-time future
cash flows that are subject to nonperformance risk, rather than using the
current recognized net asset or liability as a basis to measure the CVA.
Second, market-based views of default probabilities derived from
observed credit spreads in the credit default swap (CDS) market are applied
to the expected future cash flows determined in step one. Citi’s own-credit
CVA is determined using Citi-specific CDS spreads for the relevant tenor.
Generally, counterparty CVA is determined using CDS spread indices for each
credit rating and tenor. For certain identified netting sets where individual
analysis is practicable (e.g., exposures to counterparties with liquid CDS),
counterparty-specific CDS spreads are used.
The CVA is designed to incorporate a market view of the credit risk
inherent in the derivative portfolio. However, most unsecured derivative
instruments are negotiated bilateral contracts and are not commonly
transferred to third parties. Derivative instruments are normally settled
contractually or, if terminated early, are terminated at a value negotiated
bilaterally between the counterparties. Therefore, the CVA (both counterparty
and own-credit) may not be realized upon a settlement or termination
in the normal course of business. In addition, all or a portion of the CVA
may be reversed or otherwise adjusted in future periods in the event of
changes in the credit risk of Citi or its counterparties, or changes in the
credit mitigants (collateral and netting agreements) associated with the
derivative instruments.
The table below summarizes the CVA applied to the fair value of derivative
instruments for the periods indicated:
Credit valuation adjustment
contra-liability (contra-asset)
In millions of dollars
December 31,
2013
December 31,
2012
Counterparty CVA $(1,733) $(2,971)
Citigroup (own-credit) CVA 651 918
Total CVA—derivative instruments $(1,082) $(2,053)
Own Debt Valuation Adjustments
Own debt valuation adjustments (DVA) are recognized on Citi’s liabilities for
which the fair value option (FVO) has been elected using Citi’s credit spreads
observed in the bond market. Accordingly, the fair value of the liabilities for
which the fair value option has been elected (other than non-recourse and
similar liabilities) is impacted by the narrowing or widening of Citi’s credit
spreads. Changes in fair value resulting from changes in Citi’s instrument-
specific credit risk are estimated by incorporating Citi’s current credit spreads
observable in the bond market into the relevant valuation technique used to
value each liability.
The table below summarizes pretax gains (losses) related to changes in
CVA on derivative instruments, net of hedges, and DVA on own FVO liabilities
for the periods indicated:
Credit/debt valuation
adjustment gain (loss) (1)
In millions of dollars 2013 2012 2011
Derivative counterparty CVA $ 291 $ 805 $ (830)
Derivative own-credit CVA (223) (1,126) 863
Total CVA—derivative instruments $ 68 $ (321) $ 33
DVA related to own FVO liabilities $(410) $(2,009) $1,773
Total CVA and DVA $(342) $(2,330) $1,806
(1) Amounts do not include CVA related to monoline counterparties for the years 2012 and 2011. In
addition, CVA and DVA amounts do not include losses related to counterparty credit risk on non-
derivative instruments, such as bonds and loans.