The Swap Dealer's Valuation Dispute at Quarter-End
A corporate has a 10-year receive-fixed/pay-floating swap with a dealer, notional $100 million, entered at par two years ago. At quarter-end, the dealer marks the swap at negative $4.8 million to the corporate (i.e., the corporate owes $4.8M if terminated). The corporate's treasury model, using its own curve and a mid-market convention, produces negative $3.9 million. The difference is $900,000. The dealer's mark includes a credit valuation adjustment (CVA) reflecting the corporate's own credit spread, which has widened. The corporate's auditor asks for the fair value hierarchy level and whether the $900K gap is acceptable. The company reports under ASC 820 and discloses Level 2 for the swap.
1. Explain the sources of the $900K valuation gap and whether the Level 2 classification is appropriate.
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The gap has at least three likely sources:
- CVA/DVA. The dealer's mark includes a CVA reflecting the corporate's widened credit spread - i.e., the dealer's exposure to the corporate is riskier, reducing the swap's value to the corporate. The corporate's own model may omit or understate this. Under ASC 820, fair value must reflect nonperformance risk, including the entity's own credit standing (DVA from the corporate's perspective).
- Curve and convention differences. The corporate uses its own curve and mid-market; the dealer uses its funding curve, different interpolation, and possibly a bid/offer spread. These produce small but real differences.
- Model inputs. Discounting conventions (OIS vs. LIBOR/SOFR), day-count, and reset assumptions can each contribute.
The $900K gap (~0.9% of notional) is plausible and not by itself evidence of error, but it must be explained. Level 2 classification is appropriate if the inputs are observable (yield curves, credit spreads, SOFR fixings) and the model is a standard discounted-cash-flow model - which it appears to be. Level 3 would be required only if significant inputs are unobservable. The company should confirm the CVA input is observable (credit default swap spreads or a comparable curve); if the corporate's credit spread is estimated internally, that input could push the valuation toward Level 3 for that component.
2. Recommend how the company should resolve the dispute and what it must disclose.
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Resolution steps:
- Reconcile line by line. Obtain the dealer's valuation breakdown (curve, discounting, CVA) and map each difference to the corporate model. Quantify each source.
- Adopt a consistent fair value methodology. The corporate should include CVA/DVA in its own mark to comply with ASC 820's requirement to reflect nonperformance risk. If it does, much of the gap should close.
- Use a mid-market or independent valuation as a check; if the gap persists, escalate to the dealer and consider an independent valuation agent.
- Document the conclusion. If the residual difference is within an established tolerance (e.g., <1% of notional) and explained, accept it; otherwise adjust.
Disclosure under ASC 820:
- Fair value hierarchy level (Level 2) and the valuation technique (discounted cash flow with observable inputs).
- CVA/DVA as a valuation adjustment and its effect.
- Transfers between levels, if any.
- The carrying amount and fair value of the derivative, and the nature of the credit risk.
The key judgement: the gap is not automatically an error, but the company cannot simply accept the dealer's number without understanding CVA - and it must ensure its own mark reflects nonperformance risk to be ASC 820-compliant.