dact autumn diner workshop - dact – dact · ifrs update 4. wrap up agenda 10 october 2012 pagina...

DACT autumn diner workshop

Risk management, valuation and accounting

1. Risk management - mitigate risk

► Cost of hedging

► Risk mitigants

► Risk management policy

2. Valuation & accounting - mitigate accounting volatility

► Currency basis

► Tenor basis

► OIS discounting

3. IFRS update

4. Wrap up

Agenda

Pagina 2 10 October 2012

Risk management


Counterparty credit risk and CVA

► Counterparty Credit Risk (CCR) is the amount that a financial institution would lose in

the event that one of its counterparties defaults before the final settlement of the

transaction (Basel II)

► Credit Valuation Adjustment (CVA) is the component of a derivative‟s fair value that

is determined by counterparty credit worthiness (based on: size of exposure, probability

of default and duration)

► Prior to the credit crisis: limited or ignored in derivative pricing

► After the credit crisis:

► Growing credit charges

► Growing differences between banks (different methodologies, portfolios, risk

mitigants and strategies)

► CVA is claimed as one of the main drivers of the credit crisis (accounting for two-thirds

of all counterparty credit related losses during the crisis)


Basel III capital charge for CVA

► From the start of 2013 banks are required to hold capital for CVA

► Cross currency swaps, for example:

Source: Risk Magazine (based on quotes from “a large European bank”)

► Some banks have already started taking into account this CVA charge when

pricing new derivative transactions

► Hedging will become even more expensive


Single A

corporate

EUR/USD

Basel II 5.2 bp

Basel II + III 18 bp

Discussion

1. Pricing is decisive in the selection of a counterparty, when entering

into new derivative transactions

2. Over the last years the cost of hedging has increased significantly

3. I see an increased difference in pricing between different

counterparties

4. I expect the cost of hedging to increase even further

5. The increased cost of hedging will influence my hedging strategy

going forward


Risk mitigants

► Collateral

► Reduces exposure, CVA, capital and therefore pricing

Source: Risk Magazine (based on quotes from “a large European bank”)

► Increases liquidity risk (collateral management)


Single A

corporate

EUR/USD

Uncollateralised Basel II 5.2 bp

Basel II + III 18 bp

Collateralised Basel II 0.5 bp

Basel II + III 1.6 bp

Risk mitigants (continued)

► On September 15th 2010, the European Commission published its final proposal for

European Market Infrastructure Regulation (EMIR);

► All standardised OTC derivatives to be cleared through Central Counterparty (CCP)

► Mandatory requirement for all OTC derivative transactions to be reported to trade

repositories, regardless of magnitude, with some exemptions to be explored for

SME's

► Exemption clause for corporate users who legitimately need to hedge, up to a

certain threshold

► New rules are expected to in place by the end of 2012 in line with G20

commitments

► On July 21, 2010, the 'Dodd-Frank Act' (DFA) was signed into law.

► Timeline for implementation can be long, but effective date for many elements is

July 21, 2011

► Emerging US and EU OTC regulations address similar themes but may differ in the

detail


Risk mitigants (continued)

► Intermediate cash settlements:

► Reduces exposure, reduces CVA and therefore pricing

► Introduces liquidity risk

► Break clauses:

► Shortens tenor, reduces exposure, reduces CVA and therefore pricing

► Until now rarely exercised (but gaining attention)

► Basel treatment uncertain (no formal position)

► Adds new risk(s):

► having to unwind in unfavourable times; and/or

► having to re-hedge at a higher price (after deterioration of credit risk)

► Shorten tenor:

► Reduces exposure, reduces CVA and therefore pricing

► Leaves part of the risk un-hedged (open position)


Potential impact on risk management policy

► In light of recent developments and the increasing cost of hedging,

companies may want to re-visit their hedging strategies, for example;

► Limit the use of certain types of derivatives

► Create natural hedges

► Stop hedging certain exposures

“Lufthansa expects hedging to become so expensive that the airline

will choose to accept higher levels of exposure instead”

Source: Risk Magazine


Discussion

1. I take into account potential future margin calls into my cash flow forecasting

2. My counterparty has exercised break clauses in the past

3. New legislation and/or changes in legislation are the main driver of changes

in my risk management policy

4. My risk management policy is very clear, I have to hedge my risks, regardless

the cost


Valuation & accounting


Currency basis spread


Currency basis spread Background


Currency basis spreads cannot be assigned to one currency. It is always an

interaction between two different currencies, and is an indicator for the perceived

liquidity and risk of the two currencies

Currency basis spread USD 3M vs. EUR 3M spread (20Y tenor)

► Currency spreads have increased and have become much more volatile


Source: Bloomberg

Pre crisis:

limited

spreads

and

volatility Post crisis:

increased

spreads

and

volatility

http://history.howstuffworks.com/ancient-greece/ancient-greece-pictures.htm

Currency basis spread Cross currency swap example - pricing


Source: Bloomberg

► Currency spreads are an important component in derivatives pricing

Currency basis spread Cross currency swap example - valuation


FV excl. Spread FV incl. Spread Difference

3-5-2012 1.861.972 (1.215.704) (3.077.782)

18-5-2012 8.232.116 4.256.299 (3.975.817)

Difference 5.636.463 4.612.003 -898.035

6-5-2012: Euro falls to three

week low after Hollande wins

French election

► Currency basis spreads are affected by macro-economic and political events and are

an important driver in the (changes in) fair value of cross currency derivatives:

12-5-2012: Euro falls to three

month low against dollar on

Greek debt concern

Source: Bloomberg

Currency basis spread Cross currency swap example - accounting

1. No hedge accounting:

► Derivative classified in „Fair Value through Profit or Loss‟ category and measured at fair value,

with changes in fair value reported in Profit or Loss

► Changes in fair value as a result of changes in currency basis spread are a source of (additional)

volatility in Profit or Loss

Pagina 18 10 oktober 2012

2. Cash flow hedge accounting:

► Hedged item modelled as „hypothetical

derivative‟, which is also sensitive to

currency basis spread

► Assuming 100% effective, changes in fair

value reported in Other Comprehensive

Income (OCI)

► Additional volatility in OCI

3. Fair value hedge accounting:

► No basis spread in hedged item (one

currency)

► Reduced effectiveness and additional

ineffectiveness

► Worst case scenario: currency basis spread

can result in ineffective hedges (no hedge

accounting)

► Additional volatility in Profit or Loss

Currency basis spread Cross currency swap example - fair value hedge accounting

► Fair value hedge accounting results:

► Alternatives:

► Restructure into multiple hedge relationships (interest and fx)

► Dynamic coupon method


30-4-2012 3-5-2012 18-5-2012 31-5-2012

Fair value item (73.816.203) (74.098.605) (80.390.310) (84.317.256)

Fair value instrument (in.

spread) (1.478.293) (1.215.801) 4.256.299 7.678.498

Change in fair value item 3.344.291 3.061.889 (3.229.817) (7.156.762)

Change in fair value

instrument (in spread) (1.478.293) (1.215.801) 4.256.299 7.678.498

Hedge effectiveness (in.

spread) 44,2% 39,7% 131,8% 107,3%

Hedge effectiveness (ex.

spread) 85,1% 81,5% 120% 109,6%

Discussion

1. I take into account macro-economic and political events when entering into

derivative transactions

2. The inclusion of currency basis spread into the valuation of cross currency

swaps has become market practice

3. I take into account currency basis spread into the valuation of my cross-

currency swaps

4. The increased amount of ineffectiveness caused by the basis spread has led

to a change in my funding policy


Tenor basis spread


Tenor basis spread Background


► The tenor basis accounts for the difference in credit and liquidity risk between

two re-pricing frequencies and is expressed as the spread which is paid in a

tenor basis swap, e.g. the 3M vs. 6M basis is calculated as the spread on the

3M floating leg in a 3M vs. 6M swap

► Historically, this spread was limited (in the order of 0.5-1 basis points); i.e. a

6-month EURIBOR was a compounded version of 3-month EURIBOR (no

differentiation in risk in a 3-month deposit and a 6-month deposit)

► Since the credit crisis, risk is taken into account, which caused these spreads

to increase significantly; a 6-month rate is no longer a compounded 3-month

rate.

2 x 3 ≠ 1 x 6

Tenor basis spread 3M vs 6M EURIBOR (20Y tenor)


► Tenor basis spreads have increased and have become more volatile

Source: Bloomberg

http://www.google.nl/imgres?imgurl=http://www.blogcdn.com/www.bloggingstocks.com/media/2008/08/bearstearns_logo.standard1.jpg&imgrefurl=http://www.bloggingstocks.com/2008/08/11/suspicious-options-activity-raises-questions-about-bear-stearns/&usg=__1UEPqqKrlQxzvaXSO3VsauvXc9I=&h=224&w=298&sz=8&hl=nl&start=9&zoom=1&tbnid=ehRcDXIUxOqR5M:&tbnh=87&tbnw=116&ei=teFSUKngOIrltQbUzIG4DA&prev=/search?q=bear+stearns&um=1&hl=nl&sa=N&gbv=2&tbm=isch&um=1&itbs=1


Tenor basis spread Interest rate swap example - pricing


Tenor basis spread Interest rate swap example - valuation

► As tenor spreads were minimal historically, it was customary to use the same curve for

forwarding and discounting;

► Increase of tenor basis spreads prohibits this approximation:

► Implementing a “multi-curve” valuation methodology will result in a “one-off” adjustment

and the fair value of the swap is now sensitive to two interest rate curves


Fixed leg

Fixed coupon

Variable leg

3M EURIBOR

Forwarding n.a. 6M EURIBOR

Discounting 6M EURIBOR 6M EURIBOR

Fixed leg

Fixed coupon

Variable leg

3M EURIBOR



Fair value (30.06.12):

€ 4.979.903

Fair value (30.06.12):

€ 6.686.882

Tenor basis spread Interest rate swap example - accounting








forward and discount curve



Income (OCI)


► Hedged item sensitive to one curve (i.e. No

tenor basis spread)


ineffectiveness

► Worst case scenario: tenor basis spread


accounting)


Tenor basis spread Interest rate swap example - fair value hedge accounting

► The fair value of the hedging instrument is most sensitive to the forward

curve;

► The hedged item is sensitive to one curve only; the discount curve

► Using a multi-curve valuation approach will result in additional hedge

ineffectiveness;


Fair value Change in fair value

Fair value on 30-06-2012 6.686.882

Discount curve - shift 25bp 6.615.859 (71.023)

Forward curve - shift 25bp 2.614.662 (4.072.220)

Hedged

item

Hedging

instrument



Tenor basis spread Interest rate swap example - fair value hedge accounting (continued)

► Alternatives:

► Re-define hedged risk in line with interest rate sensitivity;

► Dynamic coupon method


Hedged

item

Hedging

instrument



Tenor basis spread Interest rate swap example - fair value hedge accounting (continued)

1. Single-curve approach (and no change in valuation hedged item):

2. Multi-curve approach (and no change in valuation hedged item):

3. Multi-curve approach (and change in valuation hedged item):


30.06.2012

Change in fair value hedging instrument 4.979.903

Change in fair value hedged item (5.110.057)

Hedge effectiveness 97%

30.06.2012




30.06.2012




Discussion

1. Do you have a preference for a certain tenor when entering into a swap

transaction (e.g. 1M, 3M or 6M)?

2. My valuation system does not allow me to differentiate between the forward

curve and the discount curve

3. Which discount curve do you use when valuing an uncollateralized EUR IRS,

the 3M or 6M curve?

4. Has your definition of hedged risk changed?


OIS discounting


Collateral and discounting

► Current Credit Support Annex (CSA) offers optionality in eligible collateral:

► Cash vs non-cash

► Multi-currency

► Thresholds

► Triggers and termination events

► The type of collateral impacts the valuation as it drives the discount curve

► In case of cash collateral the corresponding OIS curve should be used;

► USD collateral – Fed Fund

► EUR collateral – EONIA

► etc..


OIS discounting OIS vs 6M EURIBOR spread

► The spread between the OIS curve (collateralised) and the 6M EURIBOR

curve (uncollateralised) has increased significantly


Source: Bloomberg

http://www.google.nl/imgres?imgurl=http://www.blogcdn.com/www.bloggingstocks.com/media/2008/08/bearstearns_logo.standard1.jpg&imgrefurl=http://www.bloggingstocks.com/2008/08/11/suspicious-options-activity-raises-questions-about-bear-stearns/&usg=__1UEPqqKrlQxzvaXSO3VsauvXc9I=&h=224&w=298&sz=8&hl=nl&start=9&zoom=1&tbnid=ehRcDXIUxOqR5M:&tbnh=87&tbnw=116&ei=teFSUKngOIrltQbUzIG4DA&prev=/search?q=bear+stearns&um=1&hl=nl&sa=N&gbv=2&tbm=isch&um=1&itbs=1


Interest rate swap under CSA Example

► IRS Subject to a CSA (i.e. collateralised):

► Changing from one discount curve to another can have a significant impact

on the fair value of a derivative (“one-off” adjustment)


Fair value

EURIBOR discounting € 43,009,842

OIS discounting (EONIA) € 44,355,960

Difference € 1,346,118

OIS discounting Accounting








forward and discount curve.



Income (OCI)


► Hedged item sensitive to one curve (i.e. No

tenor basis spread)


ineffectiveness

► Worst case scenario: tenor basis spread


accounting)


ISDA aims to eliminate sources of valuation disputes ► ISDA will introduce a new CSA:

► Every trade will be allocated to one of 17 silos, based on the currency of

the underlying trade

► Only cash collateral allowed

► Discount against relevant OIS rate (or if liquid OIS market does not exist,

against agreed alternative)


IFRS update


The objective of hedge accounting

► Focus shifts from hedging items to hedging risks

► Should result in more risks being eligible hedged items

► More economic hedging strategies should qualify for hedge

accounting

Represent in the financial statements the effect of an entity’s risk

management activities

How to achieve hedge accounting?

1) Is there an economic relationship between hedged item and hedging

instrument?

2) Does effect of credit risk dominate fair value changes?

Base hedge ratio on the actual quantities used for risk management

3) Does hedge ratio reflect an imbalance that would create hedge

ineffectiveness?

Formal designation and documentation

Identify eligible hedged item(s) and eligible hedging instrument(s)

Define risk management (RM) strategy and objective

To avoid

ineffectiveness, the

ratio may have to

differ from the one

used in RM

No

Yes

Yes

No

Yes

No

Eligible hedged items: Risk components

Extended to non-financial items, if separately identifiable and reliably measurable

Examples of contractually specified components

► Gas supply contracts – price escalation clauses based on the price of gas

oil or fuel oil

► Electricity contracts – contractually agreed price adjustments may include

elements of coal prices and the cost of emission rights

► Commodity contracts (metals, agricultural produce, chemicals, etc.) – prices

indexed to benchmark commodity

Examples of non-contractually specified components

► Crude oil component in jet fuel

► Benchmark coffee price component of a purchase of Arabica coffee from

Columbia

Eligible hedged items Aggregated exposures

Highly probable gas purchase in USD

(commodity price risk / foreign exchange risk) Gas future to hedge commodity price risk

Highly probable fixed price gas purchase in USD

(foreign exchange risk)

Foreign exchange forward contract to hedge the aggregated exposure (foreign exchange risk)

Hedge designation 1st level relationship 2nd level relationship

Hedged item Highly probable USD gas purchase USD fixed price highly probable gas

purchase

Hedging instrument Gas future Foreign exchange forward contract

Hedged risk Commodity price risk Foreign exchange risk

Life of hedge relationship 1 year 9 months

3 months later

Forward points and time value of options

Transaction related hedged item

Change in fair value of time value of

option is recognised in OCI

---

Remove from OCI and include directly in

initial cost of the asset or liability

(hedged item)

OR

Reclassification adjustment from OCI to

profit or loss when hedged item affects

profit or loss

Hedging strategies, where the spot element only is designated

Time period related hedged item

Change in fair value of time value of

option is recognised in OCI

Original time value paid at inception is

amortised from OCI to profit or loss on a

rational basis

---

Change in fair value of forward element

of forward contract is recognised in OCI

Forward element that exists at inception

is amortised from OCI to profit or loss on

a rational basis

Discussion

1. Will the general model of IFRS 9 have a large impact on your current

environment/systems?

2. Will you start analyzing new hedge accounting possibilities that were not

present in IAS 39?

3. Do you foresee an increase in complexity of the hedging products you will

use under IFRS 9?


Wrap up


Questions


Conclusions

► The cost of hedging has increased and is expected to increase even further

► Companies may want to re-visit their risk management policies

► Spreads have increased and markets have become more volatile

► Old valuation approaches may no longer be valid

► Part of this volatility cannot be avoided by applying hedge accounting

► Part of the volatility can be avoided by adjusting hedge accounting

strategies


Ernst & Young Treasury Advisory Services

Our Treasury Advisory Services cover the full spectrum of the issues faced

by treasuries and are structured as follows:

► Financial Risk Management

► Valuation & Accounting

► Organization and Governance

► Cash- and liquidity management

► Funding, ALM & Capital Markets

► Treasury Technology

► Performance Assessments

► Assurance & Control

October 10, 2012

Funding & Capital

Markets

Thank you!


49

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