Don’t shoot the messenger

We are only a week or so past 30 June (a common balance date for many Hedgebook clients) and already we are fielding questions/comments regarding the big movements in the mark-to-market valuations of our clients’ portfolios. The questions have nothing to do with the accuracy of the valuations but mostly around, “why has this happened?” Many of the big movements relate to our clients that hedge their interest rate risk via interest rate swaps.

It is no surprise given the sharp downward movements we have seen in the New Zealand and Australian yield curves over the last few months (see charts). A 1% move on a 5 year $5 million swap will result in a $250,000 move in the mark-to-market. Depending on the size of your swap portfolio, and the tenor of the swaps, the moves can be material.

NZD swap movements

AUD swap movements

An interest rate swap is a valuable hedging tool which helps companies manage their interest rate risk. Many companies have treasury policies which force them to have a proportion of fixed and floating interest rate risk which helps with certainty of interest cost as well as smoothing sharp interest rate movements, both up and down. However, there is also a requirement to mark-to-market swaps, and for many to post these changes to their profit and loss account. Some companies negate this profit and loss volatility by hedge accounting, but many don’t which often requires some explanation to senior management, directors and investors.

For publicly listed companies the impact, both real and perceived, of large movements in financial instrument valuations is even more critical. The requirement for continuous disclosure means that a large move in these valuations may require the issue of a profit warning, as we have recently seen from Team Talk, the telecommunications company. Team Talk’s shares dropped 6.3% on the back of the hit taken by a revaluation of interest rate swaps. The company noted that the change in the value of the interest rate swap portfolio was due to “wholesale interest rates falling significantly in the period”.

Equally we have a number of private companies and local governments who have been concerned at the change in their valuations and how they are going to be explained further up the tree. Having constant visibility over these changes will at least forearm any difficult conversations, as opposed to relying on the bank’s month end valuations.

Whilst Hedgebook won’t help improve mark-to-market valuations, it does assist with companies keeping abreast of changes in the value of swap portfolios on any given day. This is pretty much a “must have” for publicly listed companies that have the responsibility of continuous disclosure but forewarned is forearmed and many others are also seeing the benefit of having access to mark-to-market valuations at any time.

Year-end Financial Instrument Check List

30 June marks the financial year-end for many Australian and New Zealand public and private companies, as well as Councils. With an ever increasing compliance burden, we have put together a practical check list for those entities that have exposure to financial instruments such as FX forwards, FX options and interest rate swaps. Those familiar with the international accounting standards understand the minefield that they are, with pages upon pages of text. We have boiled them down to five simple, practical and fundamental items.

 

Fair value (IFRS 13 / AASB 13)

IFRS 13 clearly states that valuations need to be an independent “exit price” for the transaction. It is hard to argue that a valuation from one of the counterparties to the transaction (i.e. the bank), constitutes an independent valuation, however, there are still many companies that rely on their bank for this information. Such reliance on the bank is understandable when the auditor accepts this approach, although we are seeing a much bigger push by the audit community to challenge companies on the lack of independence of a bank valuation given the bank is counterparty and valuer of the financial instrument. Historically there have been few economic alternatives to bank valuations, that is no longer a valid argument.

 

CVA/DVA (IFRS 13 / AASB 13)

The most recent compliance requirement for companies using financial instruments is the adjustment to fair value for credit. IFRS 13 requires a Credit Value Adjustment (CVA) or Debit Value Adjustment (DVA) to all financial instruments. Financial institutions have been credit adjusting their own positions for years, however, the requirement has filtered down so that all parties to financial instrument transactions must calculate and apply a credit adjustment. There is a strong argument that it is overkill for companies using financial instruments to hedge their foreign exchange cashflows (payments/receipts) or debt using plain vanilla instruments to have to make CVA/DVA adjustments. There is little added-value to the company, there is a cost to calculate the adjustment and the number is often immaterial (still have to calculate the number to determine its immateriality, however). It is different if you are trading financial instruments or are using credit hungry instruments such as cross-currency interest rate swaps but auditors, as prescribed by the accounting standards, are (or should be) forcing all financial instruments to be adjusted by CVA/DVA. There is a multitude of approaches to calculating CVA/DVA from the complex (potential future exposure method) to the simple (current exposure method). For those using plain vanilla instruments such as FX forwards or interest rate swaps then a simple methodology is appropriate. It is worth noting that the movement in both FX rates and interest rates over the last 12 months means valuations have moved significantly over the last 12 months which results in higher, more material CVA/DVA adjustments.

 

Sensitivity analysis (IFRS 7)

As part of the notes to the accounts under IFRS 7 there is a requirement to include a sensitivity analysis for financial instruments. This is a “what if” scenario that requires the re-calculation of fair value if the underlying market data is flexed. Often a +/-10% movement in the spot rate is used for FX instruments and a +/-100bp parallel shift in the yield curve for interest rate instruments. In theory there should be some sense check applied to the probability of the movement occurring i.e. if interest rates are close to zero then there is a low probability of a -100 basis point adjustment in the curve. We see little evidence of this in practice.

 

Hedge effectiveness testing (IAS 39 / IFRS 9 / AASB 9)

One of the biggest headaches at year-end is for those hedge accounting. Hedge accounting was introduced for practical reasons – remove noisy P&L volatility from unrealised gains/losses on financial instruments and put these adjustments on the balance sheet instead. In the early days of hedge accounting the approach was complicated and expensive. As auditors and accountants understanding of hedge accounting has developed over time, the process of hedge accounting has become much less complex. The most important aspect is the documentation. The effectiveness testing aspect of hedge accounting is fairly straightforward, particularly when utilising a treasury management system. The replacement of IAS 39 by IFRS 9 (effective 1 Jan 2018) will make hedge accounting a little easier with the removal of the 80-125% bright line and removal of the requirement to split option valuations between time and intrinsic value.

 

Time versus intrinsic (IAS 39)

Until IFRS 9 is effective (Jan 2018), companies hedge accounting for FX options (whether outright purchased options or in a collar relationship) must split the value of an option into its time and intrinsic components. The intrinsic value of an FX option is the difference between the prevailing market forward rate for the expiry of the FX option versus the strike price. The time value of an FX option is the difference between the overall FX option valuation and the intrinsic value. By definition, time value is a function of the time left to the expiry of the FX option. The longer the time to expiry, the higher the time value as there is a greater probability of the FX option being exercised. The intrinsic value goes to the balance sheet whilst the time value goes to P&L. Splitting time and intrinsic value is not too easy to do on the back of an envelope/spreadsheet, rather it is something that lends itself to be derived from a system.

 

Summary

Many companies try to complete the necessary compliance through using spreadsheets and bank valuations which is not only poor practice (valuations should be independent) but also error prone and time consuming. There are low cost systems available that can streamline, simplify and improve the ever increasing burden of year-end reporting requirements.

This article should not be taken as accounting advice but rather a practical guide and check list.

Feature client: Ports of Auckland

As Auckland’s population continues its strong growth trajectory, the Ports of Auckland logo Ports of Auckland has had to keep pace in order to provide the goods a growing city requires. There is not only the domestic demand for cars, food, consumables, etc. to satisfy, but also NZ’s export industry and burgeoning cruise ship tourism.

At 30 June 2014 Ports of Auckland had approximately $180 million of debt, a portion of which was hedged using interest rate swaps. The company has irregular FX exposure through imported capital expenditure and is also required to adjust its derivative valuations for credit to comply with IFRS 13 (CVA/DVA).

Ports of Auckland is one of Hedgebook’s oldest clients having been a Hedgebook user for a number of years. Historically, Ports of Auckland relied on excel spreadsheets, bank valuations and treasury advisors to stay on top of its derivative exposures. Hedgebook does not replace the treasury advisor (entirely) but it does replace the spreadsheets and bank valuations.

Ports of Auckland specifically uses Hedgebook for year-end compliance and ongoing debt management.

Digital disruption in the Treasury Management System space

There is a digital revolution going on in the treasury management system space, not that you would necessarily know.  For many there is still a stark choice – over-priced, over-complex and over-engineered treasury systems or good old Excel spreadsheets. But the world is changing and as with all things technology, it is happening at a rapid pace.

Globally, larger organisations are well catered for as far as treasury management systems are concerned, and in fact it is a crowded and mature market. The PwC Global Treasury Survey of 2014 showed that 80% of those companies surveyed were using some type of treasury management system. However, as with big ERP systems, the issue for the providers of large, expensive treasury systems is how to offer a cost-effective alternative to the massive SME market without detrimentally affecting their existing market. The challenge is to offer a slimmed down treasury management system without compromising the huge premium that they currently charge.

So where is the competition for these large, expensive systems coming from? The answer is the cloud app revolution which is sweeping the world. Platforms are being developed that aggregate a whole bunch of cloud apps, both financial and non-financial. The really clever bit is the integration of these different apps and bringing it all together through a variety of widgets and dashboards to give a complete, and often unique, view of a company’s position. It’s like a Fitbit for business.

Not only are these cloud app aggregators bringing leading edge technology to the SME market but they are doing so for small monthly fees. The apps cross the spectrum of business tools such as accounting systems, CRMs, social media tools and now treasury management systems. All of this for a few hundred dollars a month.

In the on-line accounting world, Xero is leading the charge in the digital disruption revolution with its New Zealand developed, $50 per month product. Treasury systems will need to follow suit with a much cheaper solution.

By leveraging cloud technology, treasury systems can be implemented for costs palatable to the underserviced SME market. There is an enormous amount of importers and exporters hedging their foreign cashflows with forward exchange contracts and possibly FX options. These companies probably aren’t hedge accounting, even if they are reporting under IFRS, but the impact of exchange rate movements is vitally important to their bottom line.

SMEs require the ability to record, report and value their transactions but just as importantly they want access to tools to help them make better hedging decisions. This is not too different from larger companies except SMEs are mostly using plain vanilla instruments. For a small monthly fee SMEs can benefit from a treasury management system with basic functionality, which integrates perfectly with other cloud based apps. So as we have seen with cloud based accounting systems, the power that was once reserved for large organisations can be put in the hands of a much larger group for a fraction of the cost.

Whether the current treasury management system providers have a solution for the SME market remains to be seen. It maybe that they do not care for this part of the market, however there are parallels with the large and expensive ERP systems which have successfully moved into the mid-market space and are now looking at the next tier down. The conundrum for treasury management system providers will be that SMEs will desire the core functionality of a larger system but without the price tag. The digital revolution for treasury management systems may only be in its infancy but it is set to have major ramifications regardless of the size of organisation.

First published on Treasury Insider (www.treasuryinsider.com)

Know your position: FX Volatility, friend or foe?

The FX market is no stranger to volatility. Whether it is global economic or political uncertainties, or a country’s interest rate outlook, they all play out in the currency markets. The constant push and pull of both known and unknown information can lead to bouts of extreme volatility. FX traders love volatility. There are plenty of opportunities to enter and exit positions and make money. FX trading is not for the faint hearted however, it is easier to lose money than it is to make it. But how do businesses that are buying or selling goods and services in foreign currencies navigate their way through the challenges of managing FX risk? FX trading is not a core function for most businesses but yet the impact of the FX market can make or break a financial year. I have witnessed businesses being wiped out due to adverse FX movements such as the commodity exporter that saw commodity prices plummet at the same time as the FX rate soar, a catastrophic combination. On the other hand I have seen a business live to trade another year because it was sitting on significant gains from in-the-money FX hedges that were cashed up to offset the losses suffered in the core business.

There is a plethora of risk management approaches to FX risk. To start with there is the philosophical debate about whether to hedge or not. Some would say that it is a zero-sum game in the long run i.e. periods of currency strength will be offset by periods of weakness, therefore, there is no incentive to hedge, just live with the swings and roundabouts of the prevailing spot rate. Of course the question is whether a business can sustain periods of adverse currency movements long enough to stay in business and enjoy the good times. For those that do participate in FX hedging there are questions of how much to hedge, when to hedge, which financial instrument to use?

The NZD/AUD exchange rate in the last few months has demonstrated massive volatility strengthening 10c (>10%) in less than six months. For years the NZD was extremely weak against the high flying AUD. As every other economy was cutting interest rates following the GFC the Aussies were just digging up more of its natural resources and selling it to China. The global recession did not come to Australia. More recently there has been a significant change in the Australian economic outlook. Current account surplus has turned to deficit as its trading partners have slowed, forcing the Reserve Bank to loosen monetary policy. At the same time the better performing NZ economy has been able to sustain a removal of the post-recession super loose monetary policy conditions. As shown below the interest rate differential of NZ and Australia remains a clear influence on the exchange rate.

Aussie int rate diffs

 

The importance of the Australian economy to New Zealand means that there are a lot of NZ companies exporting to Australia that are having to manage the NZD/AUD exchange rate. Everyone has a view – some you pay for (treasury advisors, consultants) some you don’t (bankers, taxi drivers) but they all have one thing in common – nobody knows the future direction of FX rates. That’s not to say taking advice (paid for or otherwise) is not relevant. No advice will be right all of the time but so long as the view is well considered and relevant to your business then it is hard to be critical after the fact with the benefit of hindsight. Hedging buys a business the necessary time to adjust selling prices or supply contracts to the new FX level.

A fundamental aspect of FX hedging decisions is to quantify and understand the impact of FX movements on the business. By regularly making and updating foreign cashflow forecasts, capturing existing hedging in place and understanding the impact of FX movements on the unhedged component of foreign cashflows, a company is in a much better position to make informed hedging decisions. Whether it is a budget rate or a costing rate to protect knowing your position is essential for making better FX hedging decisions. One thing is certain – FX markets will always be volatile – the question is whether a company has enough visibility on its current position to make sound decisions about the future. Hedgebook is a tool that can help give a company the visibility it needs to make informed FX hedging decisions.

 

PwC treasury survey reveals over-reliance on spreadsheets

PwC’s recently released “New Zealand treasury management survey” (http://pwc.to/1DCSdse) threw up some interesting results, especially in relation to treasury management systems.

It may come as no surprise to many, including us at Hedgebook, that there is a significant number of corporates who are still relying on good old spreadsheets to manage their treasury risks. In fact a whopping 73% of those surveyed still use spreadsheets, with only 13% using any type of treasury management system.

PwC Treasury Survey

Admittedly the 73% is mainly concentrated in small to medium sized organisations, however, the relative risks are the same for these business as they are for larger ones. The key difference is smaller businesses cannot afford, nor justify, the $50k plus price tag associated with these complex systems.

Therefore, it is not surprising that one of the main reasons for the high proportion of spreadsheet usage is price. However, as PwC pointed out in their survey, with low cost, cloud based systems entering the market, the excuse of treasury systems being too expensive is fast disappearing. We would also argue that a lower cost system does not have to mean loss of functionality.

Again as PwC’s survey showed “executives want detailed information in a timely, up-to-date, reliable and relevant manner.” This is becoming increasingly difficult to achieve with spreadsheets, as reporting requirements become more focused on information to make better decisions, as opposed to information for information sake.

Hedgebook certainly fits the bill of a low cost solution, not only providing the ability to better record, report and value treasury risks but also providing unique analysis combining cashflows, hedging and current market rates to help make better hedging decisions.

It will be interesting to see these same survey results this time next year. – we may start to see a significant change.

Using Hedgebook to make smart fx hedging decisions

Has anyone told you lately that they know where the currency is going? Lots of people think they know if it is going up or down but the reality is that no one knows where it is going in the next 5 minutes, 5 days or 5 years. We might all be able to have an educated guess but that is all it is – a guess.

As a former risk manager I know how hard it is to advise corporates on the risks around fx management. I can remember going to a potential client and explaining to the owner of the business the importance of having a treasury policy and why you should follow it. We could add value in helping with the strategic decisions and the instruments to use but by the way we can’t pick the currency because no one really knows where it is going and we don’t try to. After listening to all this sage advice the owner turned to us and asked what use were we to him if we didn’t know where the currency was going? End of meeting.

It is true no one can pick where the currency is heading. What is important is:

  • Understanding the impact on your business when foreign exchange rates move.
  • Knowing the impact on budget rates or costing rates when foreign exchange rates move.
  • Knowing whether the business can afford to not cover i.e. if exchange rates go any further against you are you losing too much margin or indeed are you out of business.

Having the ability to compare the amount of foreign exchange hedging in place with the impact of exchange rate movements on the uncovered portion is vital information in making rational decisions in an irrational market.

Whilst we can’t pick currencies at Hedgebook (we are still working on that one) we can tell you the impact on your business if rates go up or down. We can tell you in dollars and cents what the impact will be  on unhedged foreign cashflows, what the exchange rate needs to be to achieve the budget or costing rate and what the value of existing hedges are.

Today’s fx risk management isn’t about picking exchange rates but about giving businesses greater visibility over its foreign exchange position. This allows for smarter foreign exchange hedging decisions using all available information. Sometimes the information isn’t what you want to hear but at least you don’t need to hope that things go your way. You can avoid the knee jerk decision – and chuck out the crystal ball.

Why use an interest rate swap and how does it work?

It seems like only yesterday that I started my treasury career at one of NZ’s leading treasury advisory consultants, alas it was closer to 15 years ago. “We advise clients on managing their fx and interest rate exposures”, they said. “We use derivatives such as interest rate swaps to hedge risk”, they said. “Eh?”, I thought!

The financial markets have a lot of jargon but one quickly learns that many of the underlying concepts are quite simple. It is easy to assume people in the finance industry have a more in depth understanding of financial products than they actually do. There are plenty of examples of people who are exposed to interest rate swaps but whose understanding is rudimentary. Examples are young auditors who are coming across financial instruments rarely, or the back office clerk who is settling cashflows. Quite frankly there are also plenty of senior people who one might reasonably expect to have a greater level of understanding of these financial products than they actually do, such as senior auditors and CFOs.

In this article I attempt to explain in simple terms the purpose of an interest rate swap and how it works.

Why use an interest rate swap? When I was first learning about IRSs it was explained to me that they were simply an exchange of cashflows, either fixed for floating or floating for fixed, to hedge interest rate risk. Might as well have been in French for all it meant to me at the time. So I will try and take a step back. To my mind the best way to understand an IRS is by way of an example and the easiest example is that of a borrower who wishes to fix his interest rate exposure. Many of us borrow money from the bank in the form of a mortgage for our home and we choose to lock in the certainty of the interest rate payments by way of fixing the interest rate for a few years. A pretty simple concept. The corporate borrower has a few more options available to them to achieve certainty over interest costs on borrowings. They could borrow on a fixed rate basis very much akin to our residential mortgages. Alternatively, the corporate borrower could borrow from the bank on a floating rate basis and then enter a pay fixed interest rate swap to lock in the interest rate. The outcome is the same, however, the advantage of the IRS is the flexibility it allows the borrower in regards to the term he or she can fix and the flexibility to restructure. In terms of tenor, it is common for a borrower to fix through the IRS market out to ten years or longer. It is much harder, and expensive, to get the bank to fix interest rates long term as the bank needs to be compensated for tying up capital for such an extended period of time. It is also much harder, and expensive, to break debt that has been borrowed on a fixed rate basis, however, restructuring an IRS is a straightforward process and allows the corporate borrower to take advantage of prevailing interest rate market opportunities or “play the yield curve” to use financial market parlance.

How does an IRS work? Explaining how an IRS works requires us to understand the concept of exchanging cashflows. The diagram below represents the cashflows associated with a borrower using an IRS to fix interest costs:

IRS cashflow

 

1) The company borrows money from the bank, say $1 million for our example, on a floating rate basis. There are floating rate benchmarks for different currencies i.e. BKBM in NZ, BBSW in Australia, EURIBOR in Europe, etc. and this floating rate changes/sets every day. The bank will charge a margin on the money it lends, say 2.00%. The effect for the company is it borrows money at floating rate + 2.00%.

2) The company wishes to fix his interest cost and to achieve this enters a pay fixed / receive floating IRS with a bank (maybe the same bank as it has borrowed from, but not necessarily). We will assume the company wishes to fix the entire $1 million i.e. the swap is entered for $1 million. It could just as easily decide to fix only half i.e. $500,000. Herein lies some of the flexibility an IRS allows the company when considering its interest rate risk management profile. Under the terms of the pay fixed swap the borrower will pay the bank a fixed interest rate and receive floating interest from the bank i.e. exchange of cashflows. Note, there is no exchange of principal, only interest.

The floating rate received through the swap offsets the floating rate paid to the bank for the debt. The net impact to the borrower is paying a fixed rate (through the swap) plus the margin the bank charges for borrowing the money (2.00%).

There are some important factors to consider when entering an IRS to ensure the hedge is at its most optimal. The roll-dates of the IRS should match that of the debt i.e. if the floating rate on the debt sets every three months then so should the floating rate on the IRS, and on the same day. The underlying reference rate on the debt and the swap should also match i.e. BKBM, BBSW, EURIBOR, etc. Both of these things ensure there is no “basis risk” within the hedge as well as ensuring it passes muster from a hedge accounting perspective if it is designated into a hedge relationship.

The example above is designed to provide a basic understanding of the concept of an interest rate swap. We have used the floating rate borrower as an example. However, IRSs are used by an array of market participants for a multitude of uses including investors wishing to structure their income profiles or borrowers who have borrowed on a fixed term but wish to have exposure to floating interest rates. However, the underlying concepts are fairly straightforward.

 

Feature client: Palmerston North City Council

Palmerston North City Council (PNCC) is fairly typical of a NZ local authority in that Council is a sophisticated borrower with autonomy around the management of its interest rate risk exposure. Councils can access funding through a number of sources such as traditional bank funding, private placements and, in more recent years, the Local Government Funding Agency (LGFA). As at 30 June 2014 PNCC had debt of $117 million and $104 million of pay fixed swaps to provide certainty of interest costs. PNCC has a Treasury Policy which prescribes that no more than 45% of the total borrowings should have a floating rate profile. Pay fixed interest rate swaps are entered into to hedge the fair value interest rate risk. PNCC has been a Hedgebook client for a number of years graduating from one-off valuations for 30 June Financial Reporting requirements, to an on-going subscription client using Hedgebook’s Treasury Management System, HedgebookPro. Says PNCC’s Strategy Manager – Finance Steve Paterson, “It is important that Council manages ratepayers’ money in a transparent and prudential manner. Using HedgebookPro provides an appropriate level of comfort that the risks arising from financial instruments are adequately captured and monitored. Additionally, the reporting functionality helps the Finance team to operate efficiently.”

The majority of NZ’s local authorities are borrowers and many are using derivatives to manage the interest rate risk. Several NZ councils are using Hedgebook’s Treasury Management System including Kapiti Coast District Council, Nelson City Council, Selwyn District Council, South Taranaki District Council, Western Bay of Plenty District Council, Greater Wellington Regional Council, Masterton District Council and Thames-Coromandel District Council.

Hedge accounting fx options: time versus intrinsic value

FX options make up an element of many companies fx risk management strategies. FX options lock in the certainty of worst case exchange rate outcomes while allowing participation in favourable rate movements. In my experience, companies are often reluctant to write out a cheque for the premium so for many the preferred strategy is collar options. A collar option involves writing, or selling, an fx option simultaneously as buying the fx option in order to reduce premium, often to zero.

After transacting the fx option, the challenge comes for those that are hedge accounting and the requirement to split the valuation of the fx option into time value and intrinsic value. IAS 39 allows the intrinsic value of an fx option to be designated in a hedge relationship and can therefore remain on the balance sheet. The time value of the fx option is recognised through profit or loss.

The intrinsic value of an fx option is the difference between the prevailing market forward rate for the expiry of the fx option versus the strike price. We can use an Australian based exporter to the US as an example. In our example the exporter forward hedged US$1 million of export receipts six months ago (the USD income is due to be received in three months’ time). At the time of hedging the AUD/USD rate was 0.8750 and the nine month forward rate was 0.8580. The company chose to hedge with a nine month zero cost collar[1] (ZCC). Six months’ ago the ZCC might have been as follows:

  • Option 1: Bought USD Put / AUD Call at a strike of 0.9000
  • Option 2: Sold AUD Put / USD Call expiring at a strike of 0.8000

AUD USD

The intrinsic value of each leg of the collar will be determined by the difference in the forward rate at valuation date versus the strike rates. For option 1, the bought option, if the forward rate is above the strike of 0.9000 then the fx option will have positive intrinsic value i.e. it is “in-the-money”. It is important to note that the intrinsic value of a bought fx option cannot be negative. The purchaser, or holder, of the fx option has all of the rights and would not choose to exercise the fx option if the market rate was below the strike price. They would simply choose to walk away from the fx option, let it expire worthless, and transact at the lower market rate.

For the sold fx option the opposite is true. If the forward rate is below the strike price (less than 0.8000 in our example) then the exporter, as the writer of the option, will be exercised upon and the difference between the market rate and the strike rate will be negative intrinsic value. Intrinsic value of a sold fx option cannot be positive.

The time value of an fx option is the difference between the overall fx option valuation and the intrinsic value. By definition, time value is a function of the time left to the expiry of the fx option. The longer the time to expiry, the higher the time value as there is a greater probability of the fx option being exercised. A purchased fx option begins life with positive time value that decays over time to zero. A sold fx option begins life with negative time value and tends to zero by expiry date.

When hedge accounting for fx options the splitting of intrinsic value (balance sheet) and time value (P&L) does not have to be a time consuming exercise. At Hedgebook we like to make life easy so as part of the FX Options Held Report the valuations are automatically split by intrinsic value and time value. The screen shot below shows the HedgebookPro output using our Aussie exporter example. With the significant weakening of the AUD in the last six months we see the zero intrinsic value of the bought option at a strike of 0.9000 and very little time value as there is little chance of the AUD strengthening to above 0.9000 by the time the option expires by 30 June. The sold fx option has a large, negative intrinsic value. The exporter will be exercised upon and have to convert the US$1 million of receipts at AUD/USD 0.8000 versus a market rate of closer to 0.7600. There is a small amount of negative time value.

HedgebookPro FX Options Held Report  

FX Options Held Intrinsic_Time

HedgebookPro’s easy to use Treasury Management System calculates fx option valuations split into intrinsic and time value. This simplifies life for those that already use fx options and hedge account, whilst removing obstacles to hedge accounting for those that perceive the accounting requirements as too hard.

The IASB is looking to remove the requirement to split fx option valuations into intrinsic and time components which will simplify the hedge accounting process further, however, currently this appears to be a 2018 story, unless companies choose to adopt early. In the meantime, HedgebookPro provides an easy to use system to ease the pain of hedge accounting fx options.

[1] Premium received from the sold option offsets the premium paid on the bought option.