Lies, damned lies and valuations

With the passing of 30 June we have entered another busy period for year-end valuations. One of the most common questions we are asked at these important balance dates is “why is there a difference between the bank valuation and the Hedgebook valuation (or any other system’s valuation for that matter)?” The question is most commonly posed by auditors. It is probably not surprising that auditors want a perfect reconciliation between the client’s information and their own independent check but alas it will never come to pass. In this article we consider a selection of reasons that can lead to differences in valuations.

Although the modelling of interest rate swap valuations is relatively unchanged over many, many years there are subtle differences that will result in no two valuations being the same. From an interest rate swap perspective the most likely source of valuation differences is the construction of the zero curve. The zero curve is used to estimate the future cashflows of the floating leg of the swap, as well as the discount factors used to net present value the future values of the cashflows (both fixed and floating legs).

The underlying interest rate inputs into the zero curve construction (deposit rates, bank bills, LIBOR, futures, swap rates, etc.) may be slightly different between one system and another. Unlike official rate-sets such as BKBM, BBSW, LIBOR, EURIBOR, CDOR, etc. there is no one source for zero curves.

The mathematical technique to combine the various inputs into a zero curve can also differ (linear interpolation, cubic spline). These types of differences can lead to discrepancies between one valuation and another. Although on a percentage of notional basis the discrepancies are small, the monetary differences can become material if the notional of the swap is big enough i.e. a $500 difference on a $1 million interest rate swap becomes a $50,000 difference on a $100 million swap – a number that will draw attention but in reality is still immaterial.

The timing of the market snapshot for closing rates can be different, too. For example, Hedgebook uses New York 5pm as the end of day for valuation purposes, therefore, if the Hedgebook valuation is compared to a system that uses, say, Australia 5pm as its rate feed, then any movement in the intervening period will cause differences in valuations.

What we have talked about above is premised on the fact that two identical deals are being valued against each other. By far the most common reason for different valuations lies in human error around the inputting of a deal. From an interest rate swap perspective, the rate-set frequency (monthly, quarterly), accrual basis, business day conventions, margins on the floating leg are all possible areas which can result in valuation differences. The most common input error we come across relates to amortising interest rate swaps (changing face value and/or interest rate over the life of the swap). Very often there is no way for an auditor to realise that a swap is an amortising structure just by looking at the bank valuation. Often it is just the face value of the swap at the current valuation date that is shown on the bank valuation. It is the schedule at the end of the original bank confirmation that is required to accurately input and value such a structure.

Of course the true valuation of a derivative is determined by the price at which it can be sold/closed out which will be different to a valuation for accounting purposes. Valuations for accounting purposes are based on mid rates and, therefore, take no account of bid/offer spreads. Some of the changes we are seeing in the International Financial Reporting Standards are trying to provide greater consistency and more explicit definitions of fair value (IFRS 13). At least the “risk-free” component of an interest rate swap is a well-established methodology. The same cannot be said for the credit component (CVA), for which there is a myriad of approaches. It will be interesting to see how differences are reconciled and treated by auditors, as there is even less likelihood of two valuations being the same.

“Predicting rain doesn’t count; building Arks does.”

The ethos of Hedgebook’s Australian reseller, Noah’s Rule, is highly appropriate for a corporate risk management firm. Noah’s Rule (the company)isapassionate advocate of corporate risk management through active risk awareness. Noah’s Rule specialises in assisting clients to understand the products and strategies available for sensibly managing market risks, and then helping their clients develop greater acuity to their market risks. Understanding the risks improves their ability to harness those risks and, therefore, improve delivery on their long term strategic goals.

Noah’s Rule (the motto), “Predicting rain doesn’t count; building Arks does” reminds their clients that while it is impossible to predict which direction financial markets will head, there is enormous value in properly understanding their risks. The application of sound risk management strategies can buffer companies from adverse market movements. The chart below highlights the volatility that has been faced by those with exposures to USD gold and/or the AUD/USD exchange rate in recent years.

Gold_AUDNoah’s Rule’s emphasis on providing sound, independent risk management advice makes them an ideal reseller for HedgebookPro. Noah’s Rule recognises the importance of using HedgebookPro as a central repository for financial instruments; giving its clients much better visibility and control over its chosen risk management strategies and improving communication in relation to risk and risk mitigation.

The size of the Australian commodity and wider financial markets, presents a significant opportunity to Noah’s Rule and HedgebookPro. Let it rain!

 

Rakon Ltd takes HedgebookPro and Infoscan data

We are pleased to announce that Rakon Ltd has chosen HedgebookPro and Hedgebook’s market data service, Infoscan, to assist in managing their financial market exposures.

Rakon is a publicly listed technology company based in New Zealand with offices around the world. Rakon designs and manufactures world leading advanced frequency control and timing solutions with the main application being in telecommunications (base stations, fibre optics, small cells and network timing). Rakon was one of New Zealand’s first tech companies, being established in 1967.

Rakon required a cost effective treasury system to capture its foreign exchange and interest rate hedges whilst continuing to comply with hedge accounting. Furthermore, Rakon required oversight of the foreign exchange and interest rate markets in terms of live data, which they now access through Infoscan’s MarketFeed product. MarketFeed keeps key decision makers abreast with the fast moving global money markets.

Hedgebook was chosen for its simplicity and ease of use. Rakon’s Group Financial Controller Anand Rambhai said, “HedgebookPro ticked all the boxes for us in terms of achieving a robust framework to manage our financial instruments, including hedge accounting and CVA.”

We are delighted to welcome Anand and Rakon as new HedgebookPro users.

Forward exchange contracts: Pre-deliveries and extensions

When a company uses forward exchange contracts (FECs) to hedge forecasted future foreign currency exposures, often the hedge contract needs to be adjusted to reflect the actual timing of the cashflows as they fall due. For example, an exporter hedging forecast receipts of US$500,000 in six months’ time, may find that the actual amounts are different and may be received sooner or later than forecasted. A common practice is to pre-deliver or extend FECs as the actual timing of the foreign currency payments/receipts become clearer.

In HedgebookPro the functionality to pre-deliver or extend FECs is accessed via the Quick Edit icons that appear when the mouse pointer is hovered over the “View” icon in the Instrument Panel:

PDE image 1

By clicking on the pre-delivery and extension button “PDE image 9” the wizard pops up with the original Amount, Rate and Maturity Date details. Note, the Execution Date defaults to the current date (18 February 2014 in the example below):

PDE image 2Following the entering of the details of the pre-delivery or extension (full or partial) the user clicks “Next>”. Some examples of pre-deliveries and extensions with the pop up box are:

Full pre-delivery:

PDE image 3

Full extension:

PDE image 4Partial pre-delivery:

PDE image 5Partial extension:

PDE image 6Once the details of the pre-delivery or extension are entered, the deal can be saved.

If the deal is a partial pre-delivery or extension then saving creates a second deal in the Hedgebook application i.e. the parent (original deal) plus the child (pre-delivered or extended deal). Note, if the pre-delivery is for a date prior to the Valuation Date set in the app dashboard it will not show under the Current Instruments view, All Instruments must be selected.

Following the completion of the pre-delivery or extension the user is able to see the relationship between deals by using the “View the instrument’s parameters” icon on the Quick Edit icon tray (“PDE image 10“).

Parent

Using the partial extension as an example, you can see that on the “View the instrument’s parameters” of the parent deal that there is a notation to indicate that part of the deal has been extended. The deal number of the extension is a hyperlink for ease of seeing the deal’s details:

PDE image 8

Child

On the extended deal there is a notation to indicate which deal the extension has been transacted from:

PDE image 8Similar notations are included for partial pre-deliveries.

The parent/child deals will appear as appropriate in the FX Matured Deals Report, FX Hedges Held Report, and Transaction Diary Report.

HedgebookPro allows the user to manage pre-deliveries and extensions in a simple and straightforward way so that the true hedge position is always available.