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.

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.

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.

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

CVA is here to stay

Nine months ago we at Hedgebook engaged audit firms, banks and corporates to discuss Credit Value Adjustment (CVA) and Debit Value Adjustment (DVA) as the introduction of IFRS 13 loomed. The overwhelming response was one of ignorance and/or disinterest. Either they didn’t know about it or they didn’t want to know. On my recent business trip to Europe an audit firm in France recounted a story about a get together they had with their clients to explain the requirement for CVA. The whole room burst out laughing. Adjust the financial instrument valuations for my credit worthiness – you must be kidding.

In some ways this wasn’t surprising as IFRS 13 really only began to impact corporates for their 31 December 2013 annual results, even though their half year results should have included the adjustment. Now six months down the track and the requirement to adjust for credit worthiness can’t be ignored.

Whether we like it or not the valuation of financial instruments has become more complex as the regulators are now focusing more closely on this area. In fact when we talk about valuations for financial instruments the understanding is that it includes the credit adjustment under the new standard. CVA is part of this change in focus and is here to stay. The question for corporates therefore is how do I calculate these values accurately but in a simple and cost-effective way?

Although this isn’t new for the US it is new for the rest of the world and it appears that Australia and New Zealand are leading the charge. Europe has been pre-occupied with the new regulatory changes, especially the reporting requirements under EMIR and so it is only now that it has come on their radar.

Of course CVA and DVA are not new. The banks have been adjusting for credit for a number of years but in the corporate space it is new and many have tried to over complicate the calculation. Monte-Carlo simulations might be appropriate for companies that have cross currency swaps or more exotic option hedging strategies but the vast majority of corporates globally are using vanilla products – fx forwards, options and interest rate swaps. For these instruments a simple methodology to calculate CVA is not just acceptable but also appropriate.

It appears that common sense is already coming to the fore with the current exposure method gaining common acceptance, where the discount curve is flexed to adjust for the credit worthiness of both parties. Although a more simplified method it is still not straightforward, requiring two valuations and an adjustment of the yield curves for credit margin. Not something the banks will be providing and so therefore there is the requirement to source this from someone who specialises in financial market valuations. It doesn’t need to be expensive though and there are low cost solutions available.

Given the numbers are mostly small there is a natural reluctance to pay very much for what are in some cases reasonably immaterial numbers. However the audit firms are insisting on its inclusion and rightly so – it is a requirement under the accounting standards and the materiality or immateriality needs to be proven. Of course credit conditions are benign at the moment but as we know this can change quickly and it won’t take much to make the credit adjustment more material.

IFRS 7 – Disclosure Requirements of Financial Instruments

A key pillar of Hedgebook’s ethos is to make life easier for corporates in managing and reporting their financial derivative exposures. This approach extends to aiding Treasurers and CFOs comply with the ever increasing compliance requirements of accounting standards. The most recent standard to create further onus on corporates is the CVA requirements of IFRS 13. We have discussed IFRS 13 on numerous occasions via this blog (and will continue to do so!)

However, the focus of this blog post is the disclosures required by IFRS 7 and specifically the quantitative disclosures in assessing the risks faced by an entity in regards to its financial instruments. Quantifying the risks is demonstrated via a sensitivity analysis.

The Hedgebook application allows a user to perform sensitivity analyses on foreign exchange and interest rate positions at the press of a button and in doing so helps achieve compliance to IFRS 7 as simply and efficiently as possible. These numbers can be included directly into the Notes to the Financial Statements.

Interest Rate Swaps

There is a report within the suite of Hedgebook interest rate reports called the IR Sensitivity Report. A user is able to run the sensitivity analysis in three easy steps:

–          select the appropriate interest rate swap portfolio or individual deals

–          select the valuation date and currency

–          run the IR Sensitivity Report

The Hedgebook app produces the fair value per instrument based on the valuation date zero curve and also the fair values following pre-defined shifts in the yield curve.

Using the 31 March 2014 AUD zero curve as an example, the chart below shows the actual zero curve plus the alternative yield curves that are applied to the swap portfolio:

Sensitivity analysis

The zero curve is flexed by a parallel shift of +/-50, +/-100 and +/-200 basis points. The output of the report is the hypothetical fair value of each transaction under the aforementioned yield curves. The analysis provides information about the extent to which the entity is exposed to risk. The subsequent Hedgebook report can be printed, copied into a document or downloaded to excel for inclusion in the Notes to the Financial Statements.

Foreign exchange

Hedgebook’s sensitivity analysis for fx instruments follows a similar vein to interest rates. The fx curve (spot plus forwards) is flexed by a +/-1%, +/-5%, +/-10% and +/-20% to derive the hypothetical valuations. The subsequent Hedgebook report can be printed, copied into a document or downloaded to excel for inclusion in the Notes to the Financial Statements.

Summary

As regulatory and compliance requirements continue to increase it is important that corporates find ways to increase efficiency and find alternative ways to complete increasing workloads without increasing personnel. A low cost system such as Hedgebook allows senior members of the finance team to focus on added value tasks and not become encumbered by compliance requirements that can be automated such as sensitivity analyses for IFRS 7 disclosure requirements.

CVA is here to stay

Six months ago we at Hedgebook engaged audit firms, banks and corporates to discuss Credit Value Adjustment (CVA) and Debit Value Adjustment (DVA) as the introduction of IFRS 13 loomed. The overwhelming response was one of ignorance and/or disinterest. Either they didn’t know about it or they didn’t want to know. On my recent business trip to Europe an audit firm in France recounted a story about a get together they had with their clients to explain the requirement for CVA. The whole room burst out laughing. Adjust the financial instrument valuations for my credit worthiness – you must be kidding.

In some ways this wasn’t surprising as IFRS 13 really only began to impact corporates for their 31 December 2013 annual results, even though their half year results should have included the adjustment. Now six months down the track and the requirement to adjust for credit worthiness can’t be ignored.

Although this isn’t new for the US it is new for the rest of the world and it appears that Australia and New Zealand are leading the charge. Europe has been pre-occupied with the new regulatory changes, especially the reporting requirements under EMIR and so it is only now that it has come on their radar.

Of course CVA and DVA are not new. The banks have been adjusting for credit for a number of years but in the corporate space it is new and many have tried to over complicate the calculation. Monte-Carlo simulations might be appropriate for companies that have cross currency swaps or more exotic option hedging strategies but the vast majority of corporates globally are using vanilla products – fx forwards, options and interest rate swaps. For these instruments a simple methodology to calculate CVA is not just acceptable but also appropriate.

It appears that common sense is already coming to the fore with the current exposure method gaining common acceptance, where the discount curve is flexed to adjust for the credit worthiness of both parties. Although a more simplified method it is still not straightforward, requiring two valuations and an adjustment of the yield curves for credit margin. Not something the banks will be providing and so therefore there is the requirement to source this from someone who specialises in financial market valuations. It doesn’t need to be expensive though and there are low cost solutions available.

Given the numbers are mostly small there is a natural reluctance to pay very much for what are in some cases reasonably immaterial numbers. However the audit firms are insisting on its inclusion and rightly so – it is a requirement under the accounting standards and the materiality or immateriality needs to be proven. Of course credit conditions are benign at the moment but as we know this can change quickly and it won’t take much to make the credit adjustment more material.

Whether we like it or not the valuation of financial instruments has become more complex as the regulators are now focusing more closely on this area. CVA is part of this change in focus and is here to stay. The question for corporates therefore is how do I calculate these values accurately but in a simple and cost-effective way?

Will auditors enforce CVA compliance?

There is no doubt that CVA (credit value adjustment) and DVA (debit value adjustment) is rapidly becoming front of mind as corporations who have a 31 December balance date and outstanding financial instruments discover something else that needs to be calculated for inclusion in the annual accounts.

The world has changed from when a valuation was just something you took from the bank, plugged into the accounts and moved on. First it was sensitivity analysis on the outstanding instruments. What would the effect be if exchange rates moved up 10% or interest rates moved down 1%? Interesting, but not necessarily that important, especially as this analysis is only on the hedged position not on what isn’t hedged. If you have only hedged 20% of your expected future exposure because you are waiting for the exchange rate to move in your favour, then you will know the effect on 20% of your business, but not the other 80%. The sophisticated investor might look through this, most won’t.

Now we have something called CVA and DVA to consider when we value a financial instrument. What is the impact if my counterparty falls over, or if I fall over, on the value of my outstanding instruments? Interesting, however more relevant during and immediately after the GFC. Less so now and not straightforward to calculate, by any means. However, it is a requirement under the recently released IFRS 13, and not something your bank is going to provide.

How hard will the auditors push to have these numbers included is up for debate. Some of the numbers are immaterial. If you have short dated foreign exchange deals, the numbers are small; if you have long dated interest rate swaps the numbers are more material. Either way they are not something that can be calculated on the back of an envelope.

Hence the problem for CFOs and auditors. The standards have moved down a path whereby the fair value of a financial instrument is not straightforward anymore, nor easily obtained. The relevant purpose is debateable and already the cries of “enough already” can be heard by CFOs who have enough to worry about without debating the benefits or otherwise of the new standards. Likewise the audit dollar is getting squeezed at every turn in an environment where the audit itself is under more scrutiny and regulation.

CFOs may be quite justified to push back when it comes time to including CVA in their valuations, given the usefulness and materiality of the numbers. Whether the audit fraternity accept this or not is too early to tell – material or not you still need to calculate the numbers to decide on their materiality. Whatever the result it will be fascinating to see how this plays out and whether the standards come out on top or the tide of CFO pressure prevails.

IFRS 13: Fair value measurement – Credit Value Adjustment

The purpose of this blog is to examine IFRS 13 as it relates to the Credit Value Adjustment (CVA) of a financial instrument. In the post GFC environment, greater focus has been given to the impact of counterparty credit risk. IFRS 13 requires the valuation of counterparty credit risk to be quantified and separated from the risk-free valuation of the financial instrument. There are two broad methodologies that can be considered for calculating CVA: simple and complex. For a number of pragmatic reasons, when considering the appropriate methodology for corporates, the preference is for a simple methodology to be used, the rationale for which is set out below.

IFRS 13 objectives

Before considering CVA it is worthwhile re-capping the objectives of IFRS 13. The objectives are to provide:

–          greater clarity on the definition of fair value

–          the framework for measuring fair value

–          the disclosures required about fair value measurements.

Importantly, from a CVA perspective, IFRS 13 requires the fair value of a liability/asset to take into account the effect of credit risk, including an entity’s own credit risk. The notion of counterparty credit risk is defined by the risk that a party to a financial contract will fail to fulfil their side of the contractual agreement.

Factors that influence credit risk

When considering credit risk there are a number of factors that can influence the valuation including:

–          time: the longer to the maturity date the greater the risk of default

–          the instrument: a forward exchange contract or a vanilla interest rate swap will carry less credit risk than a cross currency swap due to the exchange of principal at maturity

–          collateral: if collateral is posted over the life of a financial instrument then counterparty credit risk is reduced

–          netting: if counterparty credit risk can be netted through a netting arrangement with the counterparty i.e. out-of-the money valuations are netted with in-the-money valuations overall exposure is reduced

CVA calculation: simple versus complex

There are two generally accepted methodologies when considering the calculation of CVA with each having advantages and disadvantages.

The simple methodology is a current exposure model whereby the Net Present Value (NPV) of the future cashflows of the financial instrument on a risk-free basis is compared to the NPV following the inclusion of a credit spread. The difference between the two NPVs is CVA.  The zero curve for discounting purposes is simply shifted by an appropriate credit spread such as that implied by observable credit default swaps.

Zero curve

To give a sense of materiality, a NZD10 million swap at a pay fixed rate of 4.00% with five years to maturity has a positive mark-to-market of +NZD250,215 based on the risk-free zero curve (swaps). Using a 200 basis point spread to represent the credit quality of the bank/counterparty the mark-to-market reduces to +NZD232,377. The difference of -NZD17,838 is the CVA adjustment. The difference expressed in annual basis point terms is approximately 3.5 bp i.e. relatively immaterial. In the example we have used an arbitrary +200 bp as the credit spread used to shift the zero curve. In reality the observable credit default swap market for the counterparty at valuation date would be used.

The advantages of the simple methodology is it is easy to calculate and easy to explain/demonstrate. The disadvantage of the simple methodology is takes no account of volatility or that a position can move between being an asset and a liability as determined by the outlook for interest rates/foreign exchange.

The complex methodology is a potential future exposure model and takes account of factors such as volatility (i.e. what the instrument may be worth in the future through Monte Carlo simulation), likelihood of counterparty defaulting (default probability) and how much may be recovered in the event of default (recovery rate). The models used under a complex methodology are by their nature harder to explain, harder to understand and less transparent (black box). Arguably the complex methodology is unnecessary for “less sophisticated” market participants such as corporate borrowers using vanilla products, but more appropriate for market participants such as banks.

Fit for purpose

An important consideration of the appropriate methodology is the nature of the reporting entity. For example, a small to medium sized corporate with a portfolio of vanilla interest rate swaps or Forward Exchange Contracts (FECs) should not require the same level of sophistication in calculating CVA as a large organisation that is funding in overseas markets and entering complex derivatives such as cross currency swaps. Cross currency swaps are a credit intensive instrument and as such the CVA component can be material.

Valuation techniques

Fair value measurement requires an entity to explain the appropriate valuation techniques used to measure fair value. The valuation techniques used should maximise the use of relevant observable inputs and minimise unobservable inputs. Those inputs should be consistent with the inputs a market participant would use when pricing the asset or liability. In other words, the reporting entity needs to be able to explain the models and inputs/assumptions used to calculate the fair value of a financial instrument including the CVA component. Explaining the valuations of derivatives including the CVA component is not a straightforward process, however, it is relatively easier under the simple methodology.

Summary

IFRS 13 requires financial instruments to be fair valued and provides much greater guidance on definitions, frameworks and disclosures. There is a requirement to calculate the credit component of a financial instrument and two generally accepted methodologies are available. For market participants such as banks, or sophisticated borrowers funding offshore and using cross currency swaps, there is a strong argument for applying the complex methodology. However, for the less sophisticated user of financial instruments such as borrowers using vanilla interest rate swaps or FECs then an easily explainable methodology that simply discounts future cashflows using a zero curve that is shifted by an appropriate margin that represents the counterparty’s credit should suffice.