20. Impact of rating change on market prices

Institutions may choose any of the approaches available to convert simulated rating variations into price variations, including using either absolute or relative differences between average spreads by rating class. The methodology used should be consistently applied and documented. In all cases, the relevant spread data should be as differentiated as possible according to the different categories of positions. The approach should be shown to differentiate sufficiently between positions with different pricing characteristics to the satisfaction of the competent authorities. For example, a credit default swap (CDS) and the underlying bond would have to be valued separately.

With regard to point 18 of these Guidelines, an institution may consistently assume an instantaneous rating change, implying that market conditions at the time determine prices after migration, taking into account any idiosyncratic valuation impact that would be expected when a migration event occurs (see point 20.5 below), ignoring all time effects on the price of an instrument whose rating changed.

If a simulation, e.g. the asset value process, has not resulted in a changed rating, no change in value should be assumed.

In the case of a rating migration, the variation of market prices should be recalculated. Full revaluation should be required unless an institution can prove that its pricing approach sufficiently reflects even the large price changes that are to be expected from a change in rating. This may be done as a pre-calculation in the sense that a vector of prices for each rating state might be an input in an IRC calculation. The impact of a rating migration on market prices should be estimated using either currently observed market data (e.g. spreads); or an average of historical market data observed over a maximum period of one year or any other relevant period

17 subject to approval by competent authorities. Historical PDs should not be used for discounting purposes when performing a full revaluation upon a rating change as they do not sufficiently reflect current market prices.

Positions migrating into the default state should be valued on the basis of the recovery rate or the loss given default rate. The recovery rate should be applied to the notional value of the position unless the estimates are derived relative to the market values of positions. It has to be shown to the satisfaction of the competent authorities that the estimate is appropriately differentiated for different categories of obligors and instruments. Calculations should be coherent between instruments. Any other approach should be duly justified and documented, in particular if generic market LGDs are used, and the institution should have a documented process in place describing on which criteria LGDs for individual positions are to be adjusted.

The model should capture divergences arising from differences in credit event definition, seniority in the capital structure or exposure to different entities within a group. This could, for example, be implemented through the use of stochastic recovery rates. Defaulted bonds are in principle included in the IRC portfolio if they are in the trading book (cf. Paragraph 4.5). Therefore, the model should capture the risk that post-default LGD marks or realisations may diverge from their pre-default estimates. The initial LGD or recovery rate applied to individual defaulted positions would have to be updated with the same frequency for the IRC as for the P&L calculation and the LGDs must be in line with the numbers used for the P&L calculation.