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.



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.



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.

Mis-selling of swaps case dismissed

Further to our article posted last week, there has been more evidence to confirm that borrowers crying about “mis-selling” of swaps is not going to garner sympathy in the courts. A sophisticated borrower, or an entity with access to expert advice, cannot lay blame at the door of the banks for their own misjudgments for what have been in hindsight poor hedging decisions.

Hedgebook commences SSAE 16 (SAS 70) audit with Grant Thornton.

We are pleased to report that, as part of our ongoing commitment to best-practice, and to provide further assurance to our customers of the integrity of our systems, processes and data, we have engaged Grant Thornton to conduct a SSAE 16 audit of Hedgebook.


Previously known as SAS 70, SSAE 16 is a widely recognized auditing standard developed by the American Institute of Certified Public Accountants (AICPA) that represents that a service organization has been through an in-depth audit of their control objectives and control activities. In the case of Hedgebook, this audit will focus on our IT infrastructure and the processes in place that ensure service levels are maintained and that data integrity and security is guaranteed.

Hedgebook recognizes that in today’s global economy, service organizations and service providers must demonstrate that adequate controls and safeguards are in place, particularly when hosting or processing data belonging to our customers.

Grant Thornton’s audit process is being conducted by Hamish Bowen, National Director, IT Audit & Advisory. This audit process has commenced and the first phase is expected to be complete in November.

For more information on SSAE 16/SAS 70 please visit here

Are interest rate swaps heading the way of the dodo?

Previously I wrote about the bad press interest rate swaps have been receiving and that I felt much of the criticism was unjustified. I firmly believe that a lot of the negativity has been due to people not understanding why swaps are useful and, because of this, they fear their use.

Further muddying the waters has been the recent announcement of new margin requirements for over-the-counter (OTC) swaps. The Commodity Futures Trading Commission (CFTC) has published several important rules for compliance, including a proposed start date of October 12. This has been coming for some time with the Dodd-Frank Act requiring most OTC derivatives to be traded on a Swap Execution Facility (SEF). (A SEF is “a trading system or platform in which multiple participants have the ability to execute or trade swaps”.)

Image courtesy of The Telegraph

This has got everyone excited and even saw Risk Magazine undertake a poll to see what the impact of the proposed margin requirements on uncleared trades would have. The results, while on the face of it are not surprising, could well be mis-leading.

60% of respondents to the survey thought end-users will opt not to use derivatives as a result of initial and variation margins requiring to be posted on uncleared swap trades. When the sort of money being talked about in collateral is in the trillions it is not surprising that there is some concern over this, and questions over the use of swaps in the future.

However I think we need to “back the truck up” a bit here. These new regulations do not relate to non-financial entities. The new proposals state “the margin requirements need not apply to non-centrally-cleared derivatives to which non-financial entities that are not systematically-important are a party.”

So corporations are exempt and therefore can continue to use swaps as they have done before – as a risk management tool to hedge future movements in interest rate risks. Interest rate swaps have got organisations into trouble in the past and no doubt will do so in the future, but almost without exception the reason that the deals have gone sour is because the people entering into them in the first case did not understand them. Sure the sales people have been gung-ho in some cases and they may or may not have been the best tool to use at the time, but again if the organisations entering into the swaps had a clear understanding of their use, most of these problems would be averted.

It is timely to remind ourselves of what needs to be in place to confidently enter into derivative deals. Firstly, make sure you have an exposure that the derivative will accurately hedge.  If as a borrower you have floating rate debt then an interest rate swap whereby you swap your floating interest payments for fixed interest payments would be appropriate. If you have floating rate debt and you sell an option to receive a premium to offset your interest payments, then this is speculation and is not managing your interest rate risk as you still have unlimited risk on the top side.

Secondly, understand the product itself well enough so you know the risks you are taking on board. If you are unsure DO NOT ENTER THE TRANSACTION. Normally plain vanilla deals will suffice, if you move away from the plain vanilla again you need to understand intimately what you are getting into. If interest rates go up what is the impact on your portfolio? Likewise if interest rates go down, what does that mean to you?

Finally you need to be able to record, report and value these transactions so that at all times you have a good handle on your current position and what might happen in the future if interest rates change. If you can’t capture your deals appropriately and value them then this is when unpleasant surprises can happen. You need to know your position at all times.

So changes are on their way, but as a business there is no cause for concern that instruments like swaps will no longer be able to be used as a risk management tool. If you follow the common sense rules then they are still an important way to manage your risks – despite what the regulators may seem to be saying.

Richard Eaddy is the CEO and founder of Hedgebook and the Managing Director of ETOS Ltd, specialists in treasury outsourcing services. Richard has worked in the corporate treasury risk management industry for more than 20 years. He has held senior roles in large corporate treasury departments in both New Zealand and Europe, provided treasury risk management advice to major corporations and for the last ten years has headed up the largest treasury outsourcing company in Australasia. Richard can be contacted at

The GFC, Corporate Governance and Hedgebook…

In the wake of the Global Financial Crisis (GFC), Corporate Governance has become a key focus, not just for large organisations but for small to medium sized entities as well.

Corporate Governance relates to the rules around how a company is controlled, whether it is by processes, policies, laws or customs.

Two of the key areas of Corporate Governance are reporting & disclosure, and risk management.

Reporting and disclosure means demanding integrity both in financial reporting and in the timeliness and balance of disclosures relating to the entity’s affairs. Risk management is regularly verifying that the entity has appropriate processes in place to identify and manage potential and relevant risks.

Hedgebook is ideally suited to assist in both these areas of Corporate Governance and is designed specifically to help any business better manage its foreign exchange and interest rate risks. From a reporting and disclosure point of view, it enhances the reporting around treasury giving more visibility to “what if” scenarios as well as better defining an organisation’s current position

For risk management, Hedgebook assists with not only the areas mentioned above but also in compliance with treasury policies, which is a key plank of any organisation’s risk management process. With having online access to valuations for financial instruments, Hedgebook gives greater transparency over risk management issues as well as assisting in making better business decisions. Hedgebook also tells an organisation not only what their risk position is today, but given current market conditions, what their position is in the future.

As we see increased awareness of corporate governance amongst small to medium sized companies, a tool like Hedgebook is putting information in the hands of these organisations at an affordable price.

This not only makes better corporate governance possible for these organisations, while at the same time enabling better decision making in a crucial area of business.

Look out for our next article on better Reporting and Disclosure coming soon.

Are interest rate swaps really that bad?

Interest rate swaps have been getting a bit of a bad rap lately. First it was the UK banks selling them to unsuspecting customers and now Goldman Sachs in the US is in a tangle with the City of Oakland over a swap they sold them fourteen years ago. A swap that has, not surprisingly, gone bad.

For those of us old enough to remember, none of this is very new. Back in 1988 the London Borough of Hammersmith and Fulham got itself caught up in an interest rate saga that continues be taught to first year law students but probably should also be taught to first year swaps traders. The London borough entered into a massive amount of interest rate swaps, totalling US $6 billion to manage debt of just US $350 million. The swaps were obviously speculative in the hope interest rates would go down and when they didn’t Hammersmith and Fulham were looking down the barrel of some enormous losses. The case went to the High Court and it was ruled that local governments could use interest rate swaps but not for speculative purposes and therefore the banks who sold them the swaps lost millions as they had to tear up the contracts. For those with a legal bent the contracts were deemed to be ultra vires or outside of the borough’s legal authority to enter into and hence is still studied as a landmark case today.

Whether the High Court got it right or not in terms of voiding the swap contracts is up for debate, caveat emptor or “let the buyer beware”, springs to mind, but the court did get it right by allowing British local authorities to enter into interest rate swap agreements for the purpose of limiting interest rate risk.

Interest rate swaps are a risk management tool and should be used as such. The basis of financial risk management is to smooth out volatility in financial markets so that organisations are not exposed to shock movements, whether it is interest rates, foreign exchange rates or commodity prices. The alternative is to remain unhedged and be at the mercy of financial markets. Good risk management should be coupled with a board-approved Treasury Policy which outlines the risks an organisation is prepared to take, including how much or how little hedging needs to be undertaken. Organisations should also have robust systems in place to record, report and value these instruments so that risk management decisions can be made with confidence. It is all very well to enter into these transactions but if you are not tracking them properly then this can open you up to even more risks.

The authorities haven’t been ignoring this issue either. The international accounting standards recognise the difference between speculative and non-speculative transactions through hedge accounting. If you can’t prove a deal is hedging an underlying exposure, such as floating rate debt, then any change in value is recognised in earnings.

Interest rate swaps should be used for what they are intended, to manage risk. They are not negating that risk, but they are giving certainty of interest rate cost and limiting any potential downside.

Banks should be obligated to make sure their customers understand the risks of what they are doing, but equally so the customer should not be entering into a financial transaction they don’t fully understand. There is a lot of talk about the negative side of interest rate swaps but used correctly they are a powerful risk management tool for the purpose of limiting interest rate risk, as the High Court in London all those years ago so rightly ruled.

Richard Eaddy is the CEO and founder of Hedgebook and the Managing Director of ETOS Ltd, specialists in treasury outsourcing services. Richard has worked in the corporate treasury risk management industry for more than 20 years. He has held senior roles in large corporate treasury departments in both New Zealand and Europe, provided treasury risk management advice to major corporations and for the last ten years has headed up the largest treasury outsourcing company in Australasia. Richard can be contacted at

“Hedge Accounting and Beyond: Currency Volatility and Movements Aren’t Just Treasury’s Problem”

I came across this nice little article today from Jason Busch of Enterprise Irregulars on the need, during such volatile economic times, for a wider understanding of Hedge Accounting and its role in managing an organization’s currency exposure.

As Busch says, management right across businesses with currency exposure (whether through global sourcing or international sales) need to have a much better understanding of the tools at their disposal, and need to stop relying on their treasury team (if they are lucky enough to have one) to manage these “stormy waters”. It takes a collaborative effort between Treasury and “the business” to make sure that a business is qualifying for hedge accounting, and therefore minimising the impact of currency shifts on their profitability.

As Richard Eaddy commented in his latest article, for most businesses hedge accounting need not be the onerous process that it is perceived as and is a vital tool in helping to ensure that the market volatility doesn’t have to flow through to your company’s income statement. But to Jason Busch’s point, it needs to be a team effort.