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D. Static Instead of Dynamic Procedure
FNBC used a static rather than dynamic procedure to
ascertain its credit adjustment. With a static procedure, the
credit adjustment for each swap is calculated once, usually at
the inception of the swap, and then amortized on a straight-line
basis. With a dynamic procedure, the credit adjustments for each
swap are redetermined periodically over the life of the swap, on
the basis of a new calculation of the loan equivalent amounts and
taking into account changes in credit ratings, market conditions,
and other developments. FNBC’s static methodology for
calculating the credit adjustment did not account for changes in
interest rates, credit quality, credit exposures, or credit risk
ratings. Nor did it account for early terminations or subsequent
chargeoffs.
FNBC’s practice of straight-line amortization instead of
revaluing the credit risk is inconsistent with the G-30 report’s
suggestion to adjust a credit adjustment dynamically. The cases
in which one might expect a credit adjustment to be sizable
(e.g., after the inception of a swap, when the fair market value
could most likely deviate the most from midmarket value) are the
very cases that are not captured in a static valuation system. A
dynamic approach must be used to capture the actual market value
of credit risk at a date later than the inception of a swap.
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