Additional Valuation Adjustment (AVA): Definition and Key Issues in 2024

Fair value is, by definition, based on the closing price, since it represents the price received for the sale of an asset or the price paid for the transfer of a liability in a normal transaction. At inception, fair value is normally the price agreed upon at the time of the transaction. Subsequently, it must be based primarily on mark-to-market, and otherwise on mark-to-model or mark-to-self, depending on the availability and observability of market data.

It was with a view to adopting a more conservative valuation method that the Council of the EU adopted the CRR/CRD IV Directive in 2013, which introduced the concept of “Prudent Value.” This concept aims to use a prudent value to address the uncertainty involved in valuing instruments at fair value in the calculation of capital and Basel ratios.

The goal is to arrive at a value that, in 90% of plausible scenarios, allows the position to be closed out. It is this Prudent Value that yields the AVA (“Additional Value Adjustment”) by calculating the difference between the FV and the PV. For a position in the asset, this results in:

Consequently, AVA is a measure used in the financial sector to adjust the fair value of an asset or liability by taking into account various risk factors or uncertainties that are not always adequately reflected in market prices. The objective of AVA is to adjust the accounting valuation of a financial instrument so that it better reflects its true economic value, taking into account factors such as credit risk, market illiquidity, volatility, and other considerations specific to the instrument in question.

There are nine types of AVAs, each of which accounts for an adjustment not included (when the conditions apply) in the FV:

The regulation on prudent valuation sets out guidelines for calculating prudent valuation adjustments (AVAs) deducted from CET1 capital in accordance with Articles 105 and 34 of the CRR. It specifies that all positions measured at fair value in the banking and trading portfolios are subject to these requirements, but provides exemptions for those positions where a change in fair value has no impact on regulatory capital.

With regard to the calculation of AVAs, the regulation proposes two approaches: a simplified approach for institutions with a portfolio of less than 15 billion euros, where a single AVA is set at 0.1% of the aggregate absolute amount of positions at fair value, and a main approach for institutions that exceed this threshold or choose this method.

The simplified AVA is calculated only once at the institutional level, rather than on an instrument-by-instrument or category-by-category basis as in the “core” approach. The calculation method is as follows:

It should be noted that, when calculating the AVA for each financial instrument—and, consequently, for each of the categories described below—there are three distinct calculation methods:

• The first approach is based on generating various possible scenarios by estimating a range of plausible values for each category of uncertainty in order to select the point that we are 90% certain to reach (Prudent Value).
• The second scenario occurs when there is insufficient data to develop a consistent set of values for a given valuation; in such cases, institutions adopt an approach that draws on the expertise of qualified individuals. This approach incorporates the available qualitative and quantitative information, as well as the strategic perspective of experts in the field, to determine our Prudent Value.
• The third is the “fallback” approach, which will be used as a last resort if we are unable to apply the previous two methods; the AVA is calculated using this approach as follows:

This AVA focuses on the exit price of positions (mark-to-market) and the parameters used in valuation models (mark-to-model). Therefore, to calculate this category of AVA, a series of plausible exit values must be generated in order to estimate the PV, which in this case corresponds to the 90th percentile of these values.

This gives us:

This AVA is zero if, in a liquid two-way market, we are certain of the available information. Specifically, the information available in the market (transaction prices, firm quotes, broker consensus, and estimates) leaves no significant uncertainty regarding the valuation of the position.

The AVA COC captures the uncertainty (and costs) associated with the (sometimes) inability to close out a position at the mid price. In fact, since we cannot be certain that we will be able to close our positions at the market price (Mid), we may incur a margin reflecting market illiquidity at the time the position is closed and, as a result, face additional fees charged by our broker.

To calculate this AVA, we need to construct a series of plausible spreads between the bid and ask prices, then estimate the PV of that spread so that we are 90% certain that the spread will allow us to close out the position. And in that case:

This AVA is zero if the MPU AVA was calculated based on exit prices, or if the market is liquid enough that we are 90% certain we can close out the position at the mid-price.

The AVA for this category takes into account the risk associated with the valuation model that arises from the potential existence of various models or calibrations used by market participants, as well as the absence of a defined exit price for the specific product being valued.

To the extent possible, institutions calculate the AVA MR by simulating a range of plausible values generated using alternative modeling and calibration approaches. In this context, institutions identify a point within this range of values at which they are 90% certain they can close their position at that price or at a more favorable price.

AVAUCS captures the risk associated with the uncertainty inherent in adjustments made to the valuation of an instrument to reflect counterparty risk (CVA). To ensure accuracy, the AVA UCS is subdivided into distinct categories: Market Price Uncertainty (MPU), Closing Cost Uncertainty (COC), and Model Risk (MR). Each subdivision is then allocated to its respective AVA category.

This specific adjustment is made to account for uncertainty in the estimation of financing costs used in determining the exit price, in accordance with the applicable accounting framework. Institutions break down AVAIFC into specific categories such as market price uncertainty (MPU), liquidation cost uncertainty (COC), and model risk (MR). Each of these subcategories is then reallocated to its respective AVA categories.

This specific type of AVA, known as the “individual AVA for concentrated positions,” is estimated in three distinct steps. First, institutions identify concentrated positions. Next, for each identified position, in the absence of an applicable market price, a conservative exit period is estimated. If this period exceeds ten days, an AVA is calculated by taking into account the volatility of the valuation data, the volatility of the bid-ask spread, and the potential impact of the hypothetical exit strategy on market prices.

When a complete exit from the exposure is being considered, the institution may estimate a zero AVA for future administrative expenses. However, if an exposure cannot demonstrate a zero AVA in accordance with this, institutions calculate the AVA for future administrative costs (AVAF) by taking into account administrative costs and future hedging costs over the expected life of the exposures subject to the assessment. This estimate is discounted using a rate that approximates the risk-free rate.

The AVA ET estimates losses related to non-contractual early terminations of client transactions by taking into account the percentage of such terminations as well as the resulting losses.

The OR VA focuses on assessing the risk of potential losses that may result from operational errors in the valuation process. Unlike other VAs, it is not calculated at the position level, but directly within the operational risk category.