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“).


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


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.


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.

New European Hedgebook distributor

We are pleased to announce the appointment of Konzept1 as our distributor of HedgebookPro in Germany and Austria.

Konzept1 markets third party software and is headed by Jorg Leuker. Jorg has previously been a user of HedgebookPro and was so impressed with the system he wanted his company to be able to distribute the product.

Jorg explained that “with the increasing reporting and compliance requirements HedgebookPro, with its simple and intuitive interface, fulfils a need in the German market”.

We look forward to working with Jorg and Konzept1.

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.



CVA module: simple and inexpensive

We have been busy developing a Credit Value Adjustment (CVA) module over the last couple of months which will be released prior to 30 June 2014. The timing allows users with 30 June balance dates to inexpensively include CVA/DVA as part of the fair value of their financial instruments as prescribed by IFRS 13.

In line with the Hedgebook “demographic” we have deliberately kept the CVA module towards the simpler end of the CVA calculation spectrum. We use the current exposure method which we feel is appropriate for vanilla instruments such as fx forwards, fx options and interest rate swaps for an entity using these instruments for hedging purposes.

The module is broken into the following steps:

  • Creating new credit curves (both for the counterparty to the transaction and the company’s own credit).
  • Managing previously created credit curves
  • Assigning credit curves to instruments
  • Running the CVA/DVA report

Creating credit curves

The user needs to include at least one data point for Hedgebook to create a credit curve. Hedgebook linearly interpolates/extrapolates as appropriate. The more data points that can be included the better and sources such as treasury advisors, banks, corporate bonds and bank funding costs are all useful sources for determining credit spreads. The user will need to add at least two curves – one to reflect the counterparty to the transaction and one to represent the company’s own credit standing. Hedgebook adds the credit curve to the risk-free curve so that future cashflows can be discounted to present value and compared against the risk-free valuation.

Once the credit curves have been added they are saved and can be amended/deleted as necessary:

Manage credit curve

The final step before running the report is applying the counterparty credit curves to individual deals as appropriate. All of the curves created by the user are available.

Assign credit curve

Once the user is satisfied the deals have been correctly assigned with a credit curve, the CVA report can be run. The output of the report is split by instrument type and includes the risk-free valuation as well as the fair value and CVA/DVA amount.

CVA report

We have focused on providing a relatively simple solution to a new and complex area of financial reporting. For many companies 30 June will be the first time CVA/DVA has been included in the fair value of financial instruments. If CVA is causing you an expensive headache then get in touch because we can help.

FX management and a good night’s sleep

How hard is it really to manage your foreign exchange positions? Often we over think it and probably over-complicate things at the same time. Sure if you are a large corporate with many and varied risks it isn’t easy but for most it can be pretty straightforward. You are either an importer or an exporter. Maybe you can offset some receipts or payments or maybe you can’t but generally you should be looking at managing your net position. That would be a good start to simplifying things.

Next, no matter how big you are you should have a treasury policy that tells you what instruments you can use, who you can deal with and any parameters you need to keep within e.g. Minimum and maximum hedging levels. Generally you should be able to deal with fx forwards and vanilla options. Of course many corporates will only do options if they don’t have to write a cheque, so probably it’s only fx forwards and zero-cost collars.

Ideally you would have two banks to deal with to keep some competitive tension and online dealing platforms are more common now so you don’t even need to ring up the bank to do the deal. You might want to for some advice or to remind the dealer that you are available for the rugby next week. What’s important with currencies though is the medium term trend, not what is going to happen in the next 24 hours.

You should have some parameters to keep within that reflect your business risks and competitive situation. Despite what some may tell you no-one knows where the currencies are going so it makes sense to carry minimum amounts of cover just in case you, your advisor or bank is wrong. Budget rates and costing rates are important to keep front of mind. No one will thank you for protecting the budget rate but everyone will point the finger if you don’t.

We live in an age of information overload so don’t get bogged down on too much detail. Everyone will have a different story on where the currency is going and why. Form your own view on the basis of your own business. If you are unprofitable at a certain level then make sure you have as much cover as possible if it gets close to those key rates. If you know your competitor is covering everything on a short term basis you might need to reflect this in your own policy.

It is also really important to keep an accurate record of your positions and hedges. Not just for yourself to make the right decisions but also to easily report where you are to senior management. For whatever reason everyone seems to have a view on where the currency is going and happy to tell you when you get it wrong. Having good controls and recording mechanisms in this area will give others in the organisation confidence in the way you are managing a sensitive part of the business. They might just ask a few less questions too!

I am not saying currency hedging is easy, far from it, but it shouldn’t keep you up at night either if you follow some basic guidelines and principles.

Welcome to the team Chris Coote

As the Hedgebook business continues to expand and break into new territories, it is important that we maintain adequate resources to support the existing client base and maintain our development goals. The business cannot function without skilled people to develop, implement and support our technology solutions. Recently, Chris Coote has joined the team in the role of Product Solutions Co-ordinator. Hailing from Auckland, New Zealand Chris will have primary responsibility for the day-to-day running of Infoscan, Hedgebook’s financial market data business. Ensuring End of Day and real-time data are processed quickly and accurately are key responsibilities for Chris, enabling our clients to make fully informed decisions on a timely basis. Looking ahead, Chris will be responsible for driving the upgrades and improvements to the Infoscan platform to ensure the delivery of a world-class product. In an environment where access to data is on the one hand easier (web on PCs, laptops, tablets, phones, etc.) but on the other hand more expensive (exchanges are either charging for data or increasing fees) maintaining an extensive library of financial instruments at competitive prices is both challenging and full of potential.

Chris is a University of Auckland graduate achieving a Bachelor of Commerce in Finance and Economics and has worked previously in the commercial insurance sector. He also has a background in Computer Science which makes him an ideal fit for the Hedgebook business. Outside of work Chris has an affinity with the water having been a swim instructor, lifeguard and waterpolo coach at various times so he’ll have no problem keeping his head above water at Hedgebook. Welcome to the team Chris Coote!

Chris Coote