WHOLESALE BANKING & MARKETS IMPACT OF IFRS. Johann Kruger CA (SA), CFA and Gerry Daly IFRS and Financial Risk Management Consultants

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1 WHOLESALE BANKING & MARKETS IMPACT OF IFRS Johann Kruger CA (SA), CFA and Gerry Daly IFRS and Financial Risk Management Consultants

2 AGENDA IFRS accounting for financial instruments: Loan FX forward Interest rate swap Cash Liquid resources: investment in bonds

3 Questions: 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

4 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

5 CASE STUDY: MEET ENGINE LTD Winning commercial contracts and managing financial risks

6 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

7 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? 6

8 FUNDING THE PROJECT, INTEREST RATE RISK Borrowings, cash, short term investments and hedging the interest rates

9 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

10 Financial Instruments Measurement Categories IAS 39 -How would the borrowing be classified? -And the cash? Fair value revaluation: FINANCIAL ASSETS Fair value through PL Held to maturity Loans and receivables Available for sale PL Not revalued Not revalued Equity Fair value through PL Other liabilities FINANCIAL LIABILITIES

11 How would a loan (or a deposit) be recorded at inception? At fair value 60 And Interest Receive now Interest (coupon) Principal 1,000 inception Year 1 Year 2 Year 3 Year 4 Time - 1,000 Discounting at 6% Total future cash flows: 1,240

12 How would the investment in bonds be classified? FINANCIAL ASSETS Fair value through PL Held to maturity Loans and receivables Available for sale Fair value through PL Other liabilities FINANCIAL LIABILITIES

13 Corporate Bond Investment : Change in Fair Value due to Change in Market Interest end of year 1 And Interest Principal 60 Future Interest (coupon) 1,000 Value now Already happened Was 1,000 Now 901, FV loss: 99 Discounting at 10% Year 1 Year 2 Year 3 Year 4 Total future cash flows: 1,180 Time

14 Available for Sale: ongoing Equity Profit or loss 99 Fair value Revaluation loss 60 Interest

15 Available for Sale: on sale of the investment Equity Profit or loss 99 Fair value Revaluation loss

16 Funding the project interest rate risk Borrowed 10m, bullet 4 years Expects interest rates to rise enters into an interest rate swap

17 Interest rate exposure Balance sheet + 10m Operating assets Profit & Loss account - 10m Floating rate debt Cash Flow & Accounting Volatility + Fixed revenue (uncorrelated with i%) - Floating interest Revenue uncorrelated to interest vs. floating interest on debt

18 Interest rate hedge before IFRS (UK GAAP) + 10m Operating assets + Fixed revenue (uncorrelated with i%) Balance sheet Profit & Loss account - 10m Floating debt + floating interest (swap) - floating interest (debt) - Fixed i% (swap) - Fixed i% + floating i% SWAP (FV) = Smoother cash flows and accounting profits UK GAAP: swap is off BS, coupon accruals in P&L acct

19 Interest rate swap cash flow hedge - IFRS + 10m Housing assets + Fixed revenue (uncorrelated with i%) Balance sheet Profit & Loss account - 10m Floating rate debt - Floating interest 1.5m fair value - Pay Fixed + floating SWAP = Smoother Cash flows Acct Volatility Float Dr 1.5m change in FV - Pay Fixed interest and + floating SWAP swap FV Assume swap fair value is 1.5m liability Assuming hedge accounting not applied Cash flow position is hedged However P&L for the year will be volatile due to swap fair value movement

20 Cash flow hedge accounting Assets + 10m Operating assets Balance sheet 1.5m fair value - Pay Fixed + floating SWAP - 10m Floating rate debt Equity Liabilities + Fixed revenue (uncorrelated with i%) Profit & Loss account -Fixed interest - Fixed - Floating interest Charge (per the swap) Release to P&L Dr 1.5m change in FV -Pay Fixed + floating SWAP CFH accounting allows to park fair value of the swap in equity And then release a portion to P&L to reflect the hedged rate

21 Hedge effectiveness test for IRS an example

22 Key Phases Of A Swap Underwrite And Syndication PRE EXECUTION AT EXECUTION SYNDICATION PHASE 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

23 The hedging/hedge accounting process 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 Reliable measurement of effectiveness 5. Producing hedge documentation 6. Prospective hedge effectiveness testing 7. Retrospective hedge effectiveness testing 8. Accounting journal entries formal hedge documentation + risk management policy FORMAL DESIGNATION The hedge is expected to be and is highly effective

24 IAS 39 requires hedge effectiveness between %: Requires hedge effectiveness between %: Hedge Effectiveness 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) Regression parameters R-squared >.8 Slope 0.8 to 1.25 IAS Cash flow hedge lesser of the cumulative change

25 IAS 39 Overview of the CFH and other models Hedge Type How is P&L fair value volatility neutralised Timing of income statement recognition of deferred derivative gains/losses Cash Flow Hedge Net Invest. Hedge Fair Value Hedge Remove volatility from Income statement post it to equity Remove volatility from Income statement post it to equity Show fair value of underlying item in balance sheet and post changes to income statement to offset those of the derivative When underlying cash flow occurs Upon disposal of underlying net investment 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

26 HEDGING THE FX RISKS OF THE PROJECT Protecting the downside FX value of future cash flows

27 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

28 Hedge designation: FX options May 2011 May 2011 Future US$ cash flow -10 US$ Jan 2012 Option to buy +10 US$ buy Jan 2012 Time Value Intrinsic Value

29 Hedge Effectiveness Report for an FX Option

30 FX Option Hedge Accounting Journals

31 Conclusion So what have we covered today? Accounting for financial instruments: Loans / borrowings Cash Investments in a corporate bonds FX options Interest rate swaps Main hedge accounting models IFRS hedge documentation Hedge effectiveness examples Questions?

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