-79-
portfolio. The unearned credit spread adjustment
represents amounts set aside to cover expected credit
losses and to provide compensation for credit exposure.
Expected credit losses should be based upon expected
exposure to counterparties (taking into account netting
arrangements), expected default experience, and overall
portfolio diversification. The unearned credit spread
should preferably be adjusted dynamically as these
factors change. It can be calculated on a transaction
basis, on a portfolio basis, or across all activities
with a given client.
Two additional adjustments are necessary for portfolios
that are not perfectly matched: the “close-out costs
adjustment” which factors in the cost of eliminating
their market risk; and the “investing and funding costs
adjustment” relating to the cost of funding and
investing cash flow mismatches at rates different than
the LIBOR rate which models typically assume.
The Survey reveals a wide range of practice concerning
the mark-to-market method and the use of adjustments to
mid-market value. The most commonly used adjustments
are for credit and administrative costs.
The G-30 report does not provide an objective standard as to
the calculation, measurement, or testing of either the unearned
credit spread (i.e., the credit adjustment) or the administrative
costs adjustment.
4. BC-277
Later in 1993, shortly after the G-30 report was issued, the
OCC released Banking Circular 277 (BC-277), entitled “Risk
Management of Financial Derivatives”. This document addressed
the valuation of financial derivatives and was sent to the chief
executive officer of every national bank. In relevant part, it
stated on the cover page:
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