“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!

 

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.

 

LIBOR rate set: massive fee hikes

The LIBOR rate-setting scandal has resulted in a massive increase in the cost of LIBOR to users and distributors of that rate. Given that $350 trillion of financial products have LIBOR as the underlying reference rate then that equates to a huge number of users. LIBOR is used as the rate-set for a vast array of financial instruments such as FRAs, interest rate swaps, interest rate options, loans and mortgages across a number of currencies (GBP, USD, CHF, EUR, JPY). Owners of such instruments need to know the LIBOR rate-set to determine cashflows.

LIBOR, or London Interbank Offered Rate, is set daily by the world’s largest banking institutions and was supposed to represent the rate at which these banks could borrow for pre-determined time periods. The manipulation of LIBOR first came to light with the onset of the global financial crisis in 2008 as the benign credit environment spectacularly imploded. The high levels of short-term debt held by institutions became incredibly expensive to fund, that’s if it could be funded at all. Banks became fearful of lending to each other as they did not have confidence that they would be repaid. During this period LIBOR was cynically dubbed “the rate at which banks don’t lend to each other”. The chart below shows the fear that gripped the interbank market at the height of the GFC when rates spiked to close to 7.00% for USD LIBOR.

USD LIBORThere were two main incentives for banks to manipulate LIBOR:

  • to give the impression banks’ balance sheets were healthier than they actually were
  • to profit from trading activities

Since the scandal first came to light there have been huge fines handed out to complicit banks, criminal investigations, as well as reforms in the administration of LIBOR. Since the mid-1980s until recently, the administration of LIBOR was carried out by the British Bankers’ Association (BBA). Earlier this year the administration of LIBOR was taken over by NYSE Euronext which is regulated by the UK’s Financial Conduct Authority. NYSE Euronext is now owned by the Intercontinental Exchange (ICE) Group.

As of 1 July 2014 the ICE Benchmark Administration is introducing a new commercial model for users and distributors of LIBOR. The fee depends on:

  • the timeliness of the data (live data is more expensive than delayed data)
  • who is using the data (financial institutions are charged more than non-financial institutions)
  • whether the data is being redistributed (such as via treasury systems).

From a rate-set perspective there has been a move away from LIBOR. In the 1990s there were 16 currencies that used LIBOR which dropped to 10 following the introduction of the Euro. There are now only five currencies. The most recently terminated currencies are the CAD, NZD and AUD with rate-setting now determined by CDOR, BKBM and BBSW respectively. Although these rate-sets are managed by various bodies, and come at a cost, at least the user, or redistributor, can pick and choose which rates/currencies to subscribe to. Unlike ICE which provides all five currencies whether you want them or not. Here’s hoping the additional regulation for these rate-sets eradicates corrupt practices. Unfortunately, as we have seen with the breaking of the forex rate-setting scandal there is plenty of other opportunities for greed and dishonesty.

Understandably increased administration costs, as well as the costs of (as it turns out much needed) regulation/policing, need to be recouped, however, the quantum of the fee increase seems excessive. As we have previously commented there is a clear trend for higher data costs and this is one of the challenges we at Hedgebook need to navigate to provide a simple and intuitive, but also low cost, treasury management solution.

 

 

Hedgebook acquires financial data services company Infoscan

We’re pleased to announce our acquisition of New Zealand-based financial data services company Infoscan.

In a move designed to augment the existing Hedgebook offering as well as create new IP, we see the acquisition as a key step in our expansion into international markets.

With an offering that now encompasses our flagship Hedgebook Pro cloud-based treasury management, Hedgebook Audit (our valuation tool designed for auditors), Excel-based modelling tools, rate feed packages and mobile solutions, we feel we are now well positioned as one of the leading providers financial derivative management solutions.

“This acquisition is an important step in Hedgebook’s growth. It extends the Hedgebook offering, creates economies of scale and allows us to innovate with the combined Hedgebook-Infoscan technologies.” says Hedgebook director and Xero co-founder Hamish Edwards. “Our first priority is to make sure that the transition is a positive one for current Infoscan customers. From there we will be working hard to bring new products to market that take advantage of the combined IP that we now have in our kitbag.”

Hedgebook CEO Richard Eaddy is equally excited about the acquisition. “We have worked with Infoscan as a provider of data for the Hedgebook products for some time now. This acquisition made sense on many levels as it allows us to deliver greater value to Hedgebook and Infoscan customers, and it also means that we now have one of the most comprehensive sets of derivative management tools available” says Eaddy. “We feel that this acquisition positions us well in a growing market.”

The opportunity created by new accounting standards was a key driver for our Infoscan acquisition. “With IFRS 13 coming on stream, the rigour that companies need to apply to accounting for financial derivatives has gone to another level. Tools like Hedgebook that offer the ability to quickly gain independent valuations will be an important part of a finance team’s toolkit,” says Eaddy.

New derivative valuation tool released to assist auditors with IFRS 13 compliance

Today Hedgebook announced the launch of Hedgebook Audit, an online derivative valuation tool designed specifically for use by auditors.

Hedgebook CEO Richard Eaddy says “we’ve had a number of conversations with CA firms around the world and it became evident that most simply do not have access to the tools they need to calculate or validate fair values of even vanilla currency, interest rate or commodity derivatives.”

“The implementation of IFRS 13. and the rigour that this brings to the calculation of fair values, means that the requirement for truly independent valuations is greater than ever. Bank supplied valuations just don’t cut it anymore” says Eaddy.

IFRS 13 was implemented at the start of 2013 and defines fair value on the basis of an ‘exit price’ notion and uses a ‘fair value hierarchy’, which results in a market-based measurement.

“We’ve worked closely with key personnel within audit teams to understand what this means to them and what their requirements are. They recognise that their processes are going to need to change so we have developed Hedgebook Audit based on the insights that these interactions generated,” continues Eaddy.

Hedgebook Audit is a cloud-hosted application that gives audit teams access to accurate, independent fair values for a large range of currency, interest rate and commodity instruments, whether in the office or out in the field. A client’s portfolio is recorded in the system and can then be valued quickly either individually or as an entire portfolio.

Hedgebook is available on a monthly subscription. For more information please contact us at enquiries@myhedgebook.com

Sterling Pounded by Weak Growth and a Distressed Chancellor

This post will discuss the recent downgrade of the United Kingdom by Moody’s Investors Service, why the Bank of England may be ill-prepared to act, and why the Government’s refusal to act could keep the British economy, as well as the British Pound, in the gutter for 2013.

As the last week of February arrived, the British Pound found itself in a precarious position: it was the worst performing major currency in 2013. Yes, worse than the Canadian Dollar; yes, even worse than the Japanese Yen. Yes, the Japanese Yen! This is quite astounding, purely because the Bank of Japan and the Japanese government are working double-time to Yen in order to foster inflation, introducing significant stimulus on both the fiscal (new spending programs) and the monetary (doubling the inflation target and introducing an open-ended QE program to begin in January 2014) fronts, while the Bank of England appears to continue to sit on its hands.

Two central banks, moving in slightly different directions, and yet the more aggressively-dovish one doesn’t have the weaker currency. This truly emphasizes how weak the British economy is, and why it is likely that the British Pound remains weak, alongside its economy, for the rest of 2013.

Post 5a image

Growth has been modest at best, with the 4Q’12 GDP print only revised to +0.3% annualized the last week of February, helping the economy elude the difficult economic condition known as stagflation, or a period of economic conditions characterized by low or negative growth, high inflation, and high unemployment. These conditions were exacerbated by Chancellor of the Exchequer George Osborne’s austerity program, a choke on the British economy, which too is heavily dependent on consumption: higher taxes take a chunk out of that 64% of headline GDP figure.

Post 5b image

Ideally, in response to these conditions, the Bank of England would be acting. Instead, it seems unwilling to do so. The most recent policy meeting notes show that outgoing BoE Governor Mervyn King was outvoted trying to increase the central bank’s QE program by £25B. With outgoing Bank of Canada Governor/incoming BoE Governor Mark Carney talking up dovish central bank actions the past several months – going so far as to say that global central banks haven’t let “hit their limits”  – it appears a low rate environment is in store for the British economy, further undercutting the British Pound.

Indeed, these fiscal and monetary forces have provoked Moody’s Investors Service into downgrading the United Kingdom from its pristine ‘Aaa’ rating, to ‘Aa1,’ giving the U.K. a split rating just like the United States. In the near-term (remainder of 1Q’13), there may be few new negative catalysts that might present themselves, preventing the Sterling from getting pounded any further. But for the remainder of the year, as the economy gets worse amid steeper austerity conditions and a BoE that will be struggling to find its new identity, the British Pound could remain one of the weakest major currencies, next to the Japanese Yen. The GBPUSD should move towards 1.4250 by the end of 2013.

This series of eight posts will focus on the major themes affecting currency markets. The sixth post in this series will discuss the diminished economic outlook for the Euro-zone, and why the crisis hasn’t been truly resolved.

 

“D-Day for fund managers and administrators, new fair value requirements in 2013” (article from Thomson Reuters)

I read a good article today from Thomson Reuters about the looming “D-Day” for fund managers and administrators with the new fair value requirements coming into force on 1 January 2013.

Clearly it is not just fund managers who will be affected by IFRS 13, as anyone using financial derivatives will be required to adhere to the the new standard’s definition of Fair Value and their method of calculation.

For the record:
Fair value = the price that would be received to sell an asset of paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e. an exit price).

The article does a good job of spelling out how fair values are to be obtained (the fair value hierarchy) and the importance of leveraging a “reputable data provider that uses robust and transparent pricing mechanisms…”

The article is a nice easy read and well worthwhile if you are responsible for the accounting or administration of financial derivatives.

You can read the full article here.

Real World Example: Swaps Between Companies

This is part 6 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 6, we’ll provide a real world example of how swaps are constructed and executed.

We’ve discussed the workings of swaps on a very basic level at this point (parts 1 through 4) and even covered some of the basic questions asked by those seeking information on swaps and their function in the economy (part 5), but we have yet to outline a real world example of how two parties might initiate a swap (for the case of making a point, the yields discussed henceforth are theoretical and not tied to current market rates).

In this example, we’ll discuss how a company, Coca-Cola, would approach a bank, JPMorgan, to initiate a swap, and given the concept of a comparative advantage, both parties would ultimately benefit from a swap.

Example:

Coca-Cola needs to raise $150 million for transactions over the next 5 years. In the United States, Coca-Cola is able to borrow $150 million at an interest rate of 4.50%, or 100-basis points above the 5-year U.S. Treasury Note (3.50%). However, outside of the United States, it is able to borrow at 4.20%, or 70-basis points above the 5-year U.S. Treasury Note. Thus, there is an incentive for Coca-Cola to seek funding outside of the United States so as to reduce its borrowing costs.

It turns out that outside of the United States, there is strong demand for non-U.S. Dollar bond issues, thus creating the necessity for Coca-Cola to issue debt in a currency other than U.S. Dollars. With New Zealand zero-coupon issues selling well in Europe at the time of its financing needs, Coca-Cola issues a N$367 million zero-coupon, 5-year Eurobond. With the New Zealand Dollar interest rate at 8%:

At the rates used in this example, Coca-Cola would thus take N$250 million of proceeds, or 68%, of its N$367 million issuance. Now Coca-Cola can easily obtain its desired $150 million by converting the N$250 million at the prevailing $/N$ rate of 0.6000.

But wait? Doesn’t this leave Coca-Cola exposed to currency fluctuations? Yes – which is why swaps come into play as a hedge against risks.

Instead of simply converting its proceeds, Coca-Cola enters into a 5-year swap agreement with JPMorgan, swapping the N$267 million for the desired $150 million. Accordingly, given the parameters of this example, Coca-Cola would pay JPMorgan 4.20% over the life of the contract. When the contract matures, Coca-Cola would swap $150 million for N$267 million; and now Coca-Cola has eliminated its exposure to exchange rate fluctuations.

What about JPMorgan? The bank now bears the currency risk, so it must hedge as well. JPMorgan must find a New Zealand bank (or any counterparty) that is willing to make a swap U.S. Dollars for New Zealand Dollars.

JPMorgan and Rabobank agree to a swap contract, with JPMorgan making annual payments of LIBOR -50-basis points. However, Rabobank cannot take on the full N$267 million. Instead, it can only swap N$200 million, meaning JPMorgan still has currency exposure of N$67 million. JPMorgan can exchange its N$67 million in the foreign exchange spot market for $40 million.

To protect itself from further risk, JPMorgan would have to agree to a forward contract with Rabobank, exchanging its $40 million 5-years out at a predetermined rate. By using forwards, JPMorgan insulates itself from currency fluctuations entirely, given this example. Interest rate risks still exist (from the obligation to Rabobank), so it would thus enter into an interest rate swap with another bank that’s willing to exchange a floating rate for JPMorgan’s fixed rate.

Conclusion: both Coca-Cola and JPMorgan were able to hedge away their risks via a series of currency swaps and interest rate swaps, reducing potential losses to both company’s balance sheets and shareholders. Without swaps, Coca-Cola would be at risk of exchange rate fluctuations, likely forcing it to pay a higher borrowing cost than it otherwise would have.

In part 7 of 10 of this series, we will lay out the importance of currency swaps not on a micro level (company-to-company), but on a macro level (between central banks).

The differences between Currency Swaps and Interest Rate Swaps

This is part 2 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 1, we discussed the beginnings of swaps. In part 2, we’ll explore the differences between the two major types of swaps and their different uses for financial institutions.

There are two main types of interest rate swaps, currency swaps and interest rate swaps. Although there are many other variations – including the more recently popular commodity swaps and credit default swaps – this series will concentrate on the main two types. Since 1981, the swaps market has grown into the largest financial derivatives market in the world, with trillions of funds in use today.

Broadly speaking, a swap is a financial derivative in which two parties (called counterparties) exchange future cash flows of the first party’s financial instrument for the future cash flows of the second party’s financial instruments. The most common type of swap is a plain vanilla swap, or an interest rate swap, and is when one party exchanges its fixed rate obligation with a second party’s floating rate obligation. Why would two parties want to exchange future cash flow obligations?

Typically, swaps occur when the two parties have differing interest rate forecasts. For example, if the party holding the floating rate instrument believes rates will increase in the short-term while the party holding the fixed rate instrument believes rates will decrease in the short-term, they might swap obligations.

Let’s be clear – both parties are seeking a comparative advantage, hence the desire to swap obligations. When borrowing money, a party wants to seek the lowest possible borrowing rate in order to reduce future payments. In some conditions – like those experienced by the World Bank in 1981 – a party does not always find itself borrowing in its desired environment, i.e., when it seeks to borrow at a floating rate but can only finance at a fixed rate. In parts 3 and 4, we’ll dive into specific examples of interest rate swaps and how they’re calculated.

Currency swaps differ slightly from plain vanilla swaps or interest rate swaps. A currency swap is an agreement to exchange principal interest and fixed interest in one currency (i.e. the U.S. Dollar) for principal interest and fixed interest in another currency (i.e. the Euro). Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Hedging against exchange rate risks is vital to companies in the global market. For example, if a U.S. company is selling products in Germany, it receives payments for those goods in Euros. If the value of the Euro plummets while those goods are being sold, then it loses potential profit. To hedge against this type of risk, that company might sell Euro futures. That way, any value that the Euro loses that could hurt revenue is insulated by the offsetting position in the futures market.

The purpose of currency swaps is similar to that of futures: to limit risk from international financial transactions. The HedgeBook Blog recently discussed interest rate swaps and their basic functions in the recent blog post, “Just What is an Interest Rate Swap?”

In parts 3 and 4 of this series, we’ll discuss the differences between the common fixed-for-floating swaps and less common but still prevalent floating-for-floating and fixed-for-fixed swaps. Bring your calculator!