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.

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.

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?

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.