Hedge accounting has never been easier

It seems like a lifetime ago since hedge accounting was first introduced, nearly ten years ago now. My how auditors loved it. How complicated could they make it? Very, ,was the answer. How about insisting on regression testing for simple foreign exchange forward contracts or forcing options to be split between time and intrinsic value? No doubt the fees were good for a while but after a decade of hedge accounting the bleeding obvious is that it isn’t, and shouldn’t be, that hard.

Because auditors did over complicate the process the perception was that to hedge account was a time consuming and difficult process to follow and so unless there were very good reasons for doing so many shied away from it. The reality is obviously somewhat different.

Hedge accounting can be simple if you are using plain vanilla instruments and follow some simple, good treasury practices.

We will look at the FX Forwards, FX Options and Interest Rate Swaps to show that anyone can hedge account if they want and it doesn’t need to be difficult or time consuming.

FX Forwards

Let’s take the most simple and commonly used financial instrument, FX Forwards. To achieve hedge accounting you need to match off your expected cashflow or exposure with the FX Forward you have used to hedge this. Given that one of the underlying reasons for hedge accounting is to recognise the difference between hedging and speculating it makes sense that you can identify a cashflow that matches your hedge. More simply than that, assuming you haven’t hedged more than you expect to buy or sell in the foreign currency, the cashflow can be matched exactly against the FX Forward.

Under the standard currently, you need to do a quantitative test to prove the effectiveness of the hedge, ie ensure that the hedge falls between 80% and 125% effectiveness. In practical terms all you need to do is value the FX Forward, which can be easily done through Hedgebook, and then value the cashflow that is allocated against the hedge. To value the cashflow, you create a hypothetical FX Forward which matches the same attributes as the original FX Forward, ie is an exact match. So by valuing the original FX Forward you also have the value of the hypothetical and lo and behold by comparing one to the other the hedge relationship is 100% effective.

If you need to pre-deliver or extend the FX Forward then, as long as this is within a reasonable period (45 days either way is generally accepted) this won’t affect the effectiveness of the hedge.

This method can be used for both the retrospective and prospective methodology.

FX Options

The process is the same for FX Options as it is for FX Forwards in terms of matching the hedge (ie the option) with the cashflow. Again there is only the requirement to value the underlying FX Option and replicate this with the cashflow by creating a hypothetical deal which exactly reflects the details of the original option. As with the FX Forward you then just compare the value of the underlying hedge with the value of the hypothetical option and again it will be 100% effective.

Those sneaky auditors have managed to complicate things by interpreting the current standard as requiring to split out the intrinsic value of the option from the time value. Again Hedgebook can do this calculation automatically which takes the pain away from trying to calculate this rather complex computation. The value of the time value will need to be posted to the Profit and Loss account.

Interest Rate Swaps

Interest rate swaps can be treated largely the same as FX Forwards and options in as much as you need to match the hedge against the exposure. In this case this means matching the swap against the underlying borrowing or investment. Again good treasury management should dictate that the reason you have taken out a swap is to match against the same details of the debt or the investment, in terms of amount and rate set dates.

Assuming that this match is occurring it is again a matter of valuing the swap and creating a hypothetical, in this case of the debt or investment but mirroring the details of the swap. Again this would mean that the relationship is 100%, assuming the hedge matches the exposure.

If there is a difference between the rate set dates and the rollover of the debt or investment then the hypothetical swap can reflect these changes and this means that the two valuations are slightly different but hopefully still well within the 80% to 125% relationship.

Documentation

It is important that the relationship is properly documented. There are plenty of places where you can source the appropriate documentation, with Google being a good place to start. In most cases it is a matter of copying and pasting the specific details of the underlying hedge but the vast majority of the documentation won’t change from deal to deal. A bit of admin but not too hard or onerous.

Summary

Our experience, somewhat surprisingly, has been that more organisations are moving towards hedge accounting. Probably because many are realising that it doesn’t have to be that hard as hopefully we have demonstrated above. This has also been recognised as the introduction of IFRS9 in a few years’ time is simplifying some of the rules which should push more down this path as most would probably prefer not to have the volatility of financial instruments flowing through their Profit and Loss account if they can help it.

It should be noted that hedge accounting can be complex if you are using more exotic instruments or if you are leaning more towards speculation than hedging, however, if you are keeping it simple then it doesn’t need to be onerous. Sure you need to value the financial instruments but if you can do that pretty much you can hedge account. Hedgebook has a number of clients, including publicly listed companies, using this approach. So why don’t you give it a try it might not be the beast you once thought it was.

Quantifying bank counterparty credit spread inputs for CVA

At Hedgebook we are often asked by our clients what the appropriate credit spreads are when calculating CVA (Credit Value Adjustment) under the current exposure method. The current exposure method requires a credit spread over the risk-free rate (swap rates) to determine the discount factor for future Cashflows. The current exposure method is appropriate for calculating credit adjustments for vanilla financial instruments such as foreign exchange forwards and options, and interest rate swaps. If your derivatives are in-the-money then the credit valuation adjustment quantifies the risk of your counterparty defaulting.

One appropriate source for quantifying appropriate credit spreads is the secondary bond market where bank/corporate bonds are traded amongst fixed income participants. The banks are active issuers into this market and as such provide a useful guide to how the market views their credit worthiness. By looking at spreads over swap we can derive a credit term structure to use in the calculation of CVA.

The following table shows the spread over swap for senior bank bonds in the NZ fixed income market. The data has been extracted using the January 2015 month-end corporate bond pricing information from one of the four Australian owned NZ registered trading banks.

  6 mths to
1 yr
1 to 2 yrs 2 to 3 yrs 3 to 4 yrs 4 to 5 yrs
ANZ 20 to 30 bp N/A 42 bp 52 to 59 bp 60 to 61 bp
ASB 22 bp N/A 41 to 50 bp 55 bp N/A
BNZ 21 bp N/A N/A 55 to 60 bp 63 bp
Westpac N/A N/A 41 bp 57 bp 64 bp

* bp = basis points per annum. 1bp = 0.01%

As each of these banks is rated AA- by S&P it is intuitive that their senior bonds trade within close proximity to each other. From the information we can generalise and build a credit term structure that can be plugged into valuation models to determine CVA. An estimated AA- credit curve could be:

  • 1 year = 25 bp
  • 2 year = 35 bp (linearly interpolated between 1 and 3 year points)
  • 3 year = 45 bp
  • 4 year = 55 bp
  • 5 year = 65 bp

The reality is that the CVA calculation is not very sensitive to these inputs so it is not necessary for a corporate with vanilla instruments to agonise over the credit assumptions. That said, the assumptions must be defensible and, more importantly from an IFRS 13 perspective, observable.

Furthermore, we would argue that if you are a corporate banked by more than one of the four banks in the table above then there is little added value in creating a curve for each counterparty. As we have shown, there is little difference in the market’s credit view between one AA- NZ bank and another.

The CVA module within the HedgebookPro app allows the user to create multiple credit curves and assign them appropriately to the relevant instruments. However, creating multiple curves will only be of added value if the counterparties are of materially different credit standing.

Tru-Test, world leading supplier of agri products, subscribes to HedgebookPro

We are pleased to announce that Tru-Test Limited has recently subscribed to HedgebookPro.

Tru-Test Limited is a public unlisted company based in Auckland and is the world’s leading manufacturer of livestock weigh scale indicators and milk metering equipment. Almost four out of every five livestock weigh scales and milk meters sold in the world today bear the name Tru-Test.

Tru-Test is exposed to foreign exchange movements, with Australia, the Americas, Asia and Europe being its main markets and so having a system that can record, report and value these hedges is important for Tru-Test in managing its risks.

Tru-Test’s Chief Financial Officer Ian Hadwin said “as we have continued our growth we recognized that spreadsheets were no longer an appropriate way of managing our foreign exchange and interest rate risks. With The new IFRS 13 requirements to calculate CVA and DVA Hedgebook has made this easy.”

We welcome Ian and Tru-Test as new HedgebookPro users.

HedgebookPro new features and reports

Whilst many of us have been spending quality time at the beach and in the surf over recent weeks (in NZ anyway) the Hedgebook development team has been kept busy and out of the sunlight. We pride ourselves on being nimble and able to develop quickly in response to feedback from our users. As such we have completed three significant additions to the HedgebookPro app:

  • Real-time FX spot rates and forward points onto the landing page of the app
  • Email alerts
  • Interest Accrual Report

 

Real-time fx spot rates and forward points onto the landing page of the app

Naturally, a company that is using HedgebookPro to manage its fx derivatives requires visibility over key exchange rates to aid the decision making process when entering hedges. To date, the only underlying fx data exposed within the HedgebookPro app is the spot and forward rate used in the valuation of the derivative. We have added the ability for HedgebookPro users to subscribe to a live fx rates module which are displayed on the landing page when the user first logs into the app. The rates are real-time and refresh every five seconds. Currently we display key cross rates and forward points for NZ and Australia. The image below shows the NZD version. The rates can be “popped out” into a new browser window and will update even if the HedgebookPro app is closed. With the current high volatility in exchange rates, this new HedgebookPro feature will help decision makers keep abreast of their key fx rates. Contact us at help@hedgebook.co.nz if you wish to enable this feature.

Rates on HBPro

 

Email alert for maturing instruments

We have added email alerts functionality to HedgebookPro to help users administer their derivatives. Now a user can receive a daily email that summarises all their fx and interest rate products that are maturing, including drawn debt. The alert will help to ensure appropriate actions are made on a timely basis such as Cashflows at the maturity of fx forwards/options or refinancing of debt. An email into your inbox will clearly tell you what is imminent, in fact the user can decide how far in advance of maturity they want to be notified.

Interest Accrual Report

Many of our HedgebookPro users spend hours at month-end using spreadsheets to calculate the interest accrual on interest rate swaps for accounting purposes. HedgebookPro now does this at the click of a button. As one of our clients said, “That is great.  Will save our Accountant from some time consuming calcs each month.” Steve Paterson, Strategy Manager – Finance, Palmerston North City Council.

You’re welcome.

HedgebookPro will continue to evolve and offer the best value for money of any treasury management system on the market today and we look forward to sharing the developments in future newsletters. If you have any suggestions please share them with us as we are committed to delivering useful, practical features to the Hedgebook app to help make the treasury function run smoothly.

 

Publicly listed EBOS Group subscribes to HedgebookPro

We are pleased to announce that EBOS Group Limited has recently taken HedgebookPro.

EBOS Group is a publicly listed company on the New Zealand Stock Exchange and has over 2,200 staff headquartered in New Zealand with over 40 offices located throughout Australasia. EBOS Group is one of the largest suppliers of international healthcare brands in the Australasian region.

EBOS Group has multiple entities with various interest rate and foreign exchange derivatives. To effectively manage the financial reporting requirements of these multiple entities EBOS knew they needed a system. Independent derivative valuations, IFRS 7 and IFRS 9 compliance is made easy with HedgebookPro. Hedgebook’s solution fitted the bill with its simple but intuitive approach to a complex area. Cost was also an issue as EBOS Group, whilst being a large company, does not have overly complex hedges and so needed a system which did the basics well.

EBOS Group’s Group Accountant Tonia Johnson said “the key requirements for us were around complying with the accounting standards, specifically doing hedge accounting under IFRS9. Hedgebook covers this off, as well as being easy to use and cost-effective.”

We welcome Tonia and EBOS Group as new HedgebookPro users.

Credit spreads back to pre GFC levels

We have discussed CVA at length in our newsletter and blog as it is arguably the most significant change to the accounting standards, from a financial instruments valuation perspective, since hedge accounting was introduced. The standard relating to CVA, IFRS 13, was developed as a result of the Global Financial Crisis. It became apparent that credit risk had been mispriced for a long time in the lead up to the implosion of the credit markets in 2008/2009. IFRS 13 forces organisations to include an adjustment to financial instruments to represent a credit component – both for the reporting entity as well as the counterparty. The adjustment can be a reasonably immaterial number impacted by factors such as the remaining term to maturity and how far in- or out-of-the-money the derivatives are.

Some companies argue that the relative immateriality of the credit adjustment reduces the necessity of quantifying the credit component, to the extent that some companies are not bothering to do it. We understand that view as IFRS 13 seems like another regulatory requirement that adds little value to the business. However, the standard is explicit in its language that “fair value”, by definition, includes credit, therefore, the decision to do nothing about it cannot pass muster with the auditor.

A contributing factor to the “immateriality” argument is the prevailing benign credit conditions. The credit spread of banks can be observed through the Credit Default Swaps (“CDS”) market. A CDS is like an insurance policy – it compensates the holder of the policy if the underlying entity defaults on its debt obligations. As the chart below shows the credit quality of the big 4 Australian banks has been improving since the spike in 2011 and has continued to retrace back to levels that prevailed pre GFC. The resulting effect is to reduce the credit valuation impact on out-of-the-money derivatives (current exposure method). We would argue that although credit conditions have returned to benign levels it is only a matter of time before another credit shock occurs and companies will be better prepared to quantify such impacts if they already have a tried and tested methodology in place. Our Hedgebook clients benefit from the system’s low cost, easy to use CVA module.

Big 4 CDS 3 year

Infoscan – economical access to financial market data

At Hedgebook we are committed to providing economical solutions to assist the treasury function. Our low cost software, HedgebookPro, provides a treasury management system (“TMS”) entry point for companies that have historically relied on spreadsheets to manage their foreign exchange and interest rate exposures. HedgebookPro is also an alternative for companies that already use a TMS to capture their vanilla derivatives and feel they do not use the full functionality offered by these larger and more expensive systems.

We take a similar approach to financial market data through our company Infoscan. Hedgebook purchased the Infoscan business 12 or so months ago as it is a natural fit for Hedgebook. Many New Zealand market participants of a certain age will remember the Infoscan pagers – they carried a certain cachet at the time! Data is delivered to smartphones these days.

Many companies with exposure to foreign exchange and interest rate markets cannot justify the cost of a Bloomberg or Thomson Reuters product. Websites are OK for accessing spot fx rates on a rough and ready basis but are unsatisfactory for providing the required comfort when entering into larger derivative transactions. Infoscan gives users the visibility over real-time market spot fx rates but, more critically, the fx forward market too. As mentioned, free websites can give an indication of spot rates but accessing accurate forward point information is harder to ascertain.

Whether transacting a new FEC, or adjusting an existing one through pre-deliveries and extensions, it is important for decision makers to have good information at hand regarding the prevailing forward market. Transparency of the forward points provides greater confidence that a competitive market rate is achieved.

Infoscan can deliver data in a number of ways either through a website login or, alternatively, directly into spreadsheets. Like HedgebookPro the market data functionality is delivered in a no fuss, low cost manner and helps enhance fx conversion rates.

Website enhanced and app updates released

An important aspect of most companies marketing strategy these days is via their website. At Hedgebook we spend lots of time developing our derivative hedging software and have to date been somewhat remiss in the development of our web presence. We have taken some initial steps to address this by adding some extra information about the company and the individuals behind the company. We have also included some more technical aspects regarding the operations of the company, hosting of the application and disaster recovery. Additionally, we now display a selection of fx rates, interest rate swap rates and metals prices on our home page. The rates are live and update every five seconds. The aim is to provide a quick view of the key rates Hedgebook users care about.

We have also released an update to the Hedgebook application. We are constantly working on changes and improvements to the valuation and reporting software to give users either access to new instruments and features, or making existing ones more intuitive and easier to use. The most material changes from this software update include exposing the cashflow map for amortising interest rate swaps and we have also streamlined the reporting functionality.

Feedback always welcome.

Demo HedgebookPro for Free

Hedgebook is pleased to announce the launch of the free demo version of its flagship product HedgebookPro.

Potential users now have the ability to try before they buy. Simply go to the HedgebookPro website (www.hedgebookpro.com) and click on the big red button (it’s hard to miss). Fill in your details and we will send an email link of your login details so you can have a decent gander at the full functionality of HedgebookPro.

If you like what you see we can set you up with your own account by emailing us at enquire@hedgebook.co.nz. It’s as simple as that.

Give it a try and join the legion of users accessing the most cost-effective little treasury system known to man.