WHOLESALE BANKING & MARKETS
Johann Kruger CA (SA), CFA and Gerry Daly IFRS and Financial Risk Management Consultants
IMPACT OF IFRS
IFRS accounting for financial instruments:
Loan
FX forward
Interest rate swap
Cash
Liquid resources: investment in bonds
AGENDA
Determine which of the following scenarios is a cash flow, fair value or net investment hedge and explain why…
Corporate A issues a fixed rate bond and then uses an interest rate swap to convert that to floating rate debt. This is a cash flow hedge
True False Depends
Corporate B (£ functional ccy) issues a fixed rate $ bond and uses an interest rate swap to convert that to fixed rate £ debt. This is a fair value hedge
True False Depends
Bank A receives floating deposits from customers and protects against rises in interest rates using interest rate caps. This is a cash flow hedge
True False Depends
Questions:
Determine which of the following scenarios is a cash flow, fair value or net investment hedge and explain why…
Corporate C hedges its floating rate facility by using interest rate swaps to convert floating rate debt to fixed rate debt. This is a cash flow hedge
True False Depends
Corporate D sells an interest rate Floor to generate income. It has floating rate debt which it wishes to hedge. This is a cash flow hedge
True False Depends
Corporate E issues inflation linked debt and uses an interest rate swap to convert to fixed rate debt. This is a cash flow hedge
True False Depends
Questions:
High value-add UK engineering company
Engine Ltd
UK held company
Pays dividends in £
£ and US$ denominated costs
£, US$ and EUR denominated sales
30% gross margin
15% net profit margin
Holds only minimally necessary cash
6
Engine wins a large contract
In May 2011 Engine ltd signed a contract for sale of engine components to big UK name (a defense contractor)
Contract involves sourcing a significant amount of high-tech components from the US
Competitors are in US, Brazil and Singapore
Where should Engine Ltd base the production for the contract?
Hedge FX on USD purchases?
How should Engine Ltd fund the project?
FUNDING THE PROJECT, INTEREST RATE RISK
Borrowings, cash, short term investments and hedging the interest rates
Funding the project
Engine arranges a bank borrowing of £10m, with a bullet repayment in 4 years Expects interest rates to rise soon – enters into an interest rate swap (‘IRS’) Draws on the loan but does not need the cash for 6 months – invests in high
quality corporate bonds Later sells the bonds and spends cash on incremental CAPEX for the project
Financial Instruments Measurement Categories –IAS 39
Fair value through PL
Available for sale
Loans and receivables
Held to maturity
FINA
NC
IAL A
SSETS
Fair value through PL
Other liabilities
FINA
NC
IAL LIA
BILITIES
PL
Not revalued
Not revalued
Equity
Fair value revaluation:
-How would the borrowing be classified?
-And the cash?
How would a loan (or a deposit) be recorded at inception?
£1,000
Year 4
£60 And Interest
Interest (coupon)
£60 £60 £60
-£1,000
Year 1 Year 2 Year 3
Receive now
Loan @ inception
Discounting at 6% Total future cash
flows:£1,240
Time
Principal
At fair value…
How would the investment in bonds be classified?
Fair value through PL
Available for sale
Loans and receivables
Held to maturity
FINA
NC
IAL A
SSETS
Fair value through PL
Other liabilities
FINA
NC
IAL LIA
BILITIES
Corporate Bond Investment : Change in Fair Value due to Change in Market Interest Rates
Principal
Future Interest (coupon)
£60 £60
£1,000
-£901
Year 1 Year 2 Year 3 Year 4
£60
Total future cash flows:
£1,180
Value now
Time
Already happened
@ end of year 1
Was £1,000
Now £901,
FV loss: £99 Discounting
at 10%
And Interest
Funding the project – interest rate risk
Borrowed £10m, bullet 4 years Expects interest rates to rise– enters into an interest rate swap
Revenue uncorrelated to interest vs. floating interest on debt
Interest rate exposure
Balance sheet
Profit & Loss account
- 10mFloating rate debt
+ Fixed revenue (uncorrelated with i%)
+ £10m Operating assets
- Floating interest
Cash Flow & Accounting
Volatility
Interest rate hedge – before IFRS (UK GAAP)
Balance sheet
Profit & Loss account
-£10mFloating debt
- Fixed i% (swap)+ Fixed revenue (uncorrelated with i%)
+ £10m Operating assets
- Fixed i%+ floating i% SWAP
(FV)
+ floating interest (swap)- floating interest (debt)
= Smoother cash flows
and accounting
profits
UK GAAP: swap is off BS, coupon accruals in P&L acct
Assume swap fair value is £1.5m liabilityAssuming hedge accounting not appliedCash flow position is hedged However P&L for the year will be volatile due to swap fair value movement
Interest rate swap cash flow hedge - IFRS
Balance sheet
Profit & Loss account
- £10m Floating rate debt
+ Fixed revenue (uncorrelated with i%)
+ £10m Housing assets
£1.5m fair value- Pay Fixed
+ floating SWAP
Dr £1.5m change in FV- Pay Fixed
+ floating SWAP
= Smoother
Cash flows- Floating
interestAcct
Volatility – Float interest and
swap FV
CFH accounting allows to “park” fair value of the swap in equityAnd then release a portion to P&L to reflect the hedged rate
Cash flow hedge accounting
Profit & Loss account
Balance sheet
- £10m Floating rate debt
+ Fixed revenue (uncorrelated with i%)
+ £10m Operating assets
£1.5m fair value- Pay Fixed
+ floating SWAP
- Fixedinterest
Dr £1.5m change in FV- Pay Fixed
+ floating SWAP
Assets Liabilities
Equity
Release to P&
L- Floating interest
- Fixed interest Charge (per the swap)
Key Phases Of A Swap Underwrite And Syndication
Transparent: “Market Hedge”& relationship banks for syndication agreed
Confidential: Market hedge transacted based on agreed margin
Relationship: Banks supply credit / intermediation level
Competitive: Smart Hedge reviews pricing levels & selects counterparties
Counterparties informed and intermediation effected
AT EXECUTION SYNDICATION PHASEPRE EXECUTION
1 2 3 4 5
1. Defining the hedge structure
2. Testing it against IAS 39 criteria
3. Exploring the impact of not applying hedge accounting
4. Design desired solution
5. Producing hedge documentation
6. Prospective hedge effectiveness testing
7. Retrospective hedge effectiveness testing
8. Accounting journal entries
The hedging/hedge accounting process
FORMAL DESIGNATION
Reliable measurement
of effectiveness
The hedge is expected to be and is highly
effective
formal hedge documentation + risk management
policy
Requires hedge effectiveness between 80‐125%:
125%
100%
80%
No hedge accounting (P&L)
Ineffectiveness to P&L
CF: No Ineffectiveness FV: Ineffectiveness to P&L
No hedge accounting (P&L)
HedgeEffectiveness
IAS 39.96 Cash flow hedge lesser of the cumulative change
IAS 39 requires hedge effectiveness between 80-125%:
Regression parameters
R-squared >.8
Slope 0.8 to 1.25
Hedge Type
How is P&L fair value volatility neutralised Timing of income statement recognition of deferred derivative gains/losses
Cash Flow Hedge
Remove volatility from Income statement – post it to equity
When underlying cash flow occurs
Net Invest.Hedge
Remove volatility from Income statement – post it to equity
Upon disposal of underlying net investment
Fair Value Hedge
Show fair value of underlying item in balance sheet and post changes to income statement to offset those of the derivative
N/A
Note: CFH and NIH still impact ratios involving equity and the reserves available for dividend payments
Objective is to remove volatility from the income statement
IAS 39 – Overview of the CFH and other models
Hedging FX
Engine decides to use FX options to hedge FX risk of USD purchases Matching maturity and amount and currency
Designated as cash flow hedges
Intrinsic value basis
Delivery of components to Energy Ltd is delayed, the USD cash flows occur 2 months late
Energy would need to amend the hypothtical derivatives, keep hedge relationship, little impact on effectiveness
Options rolled into forwards Forwards settled net
Hedge designation: FX options
Future US$ cash flow
-10 US$
Option to buy +10 US$ buy £
Time Value
Intrinsic Value
May 2011
May 2011 Jan 2012
Jan 2012