Case Study Implementing IAS 39 with Fairmat Revision #3 In this tutorial we will show how international accounting standard 39 principles, which regulate how financial instruments must be accounted for on the balance sheet, can be implemented with Fairmat. 1 Introduction The IAS 39 accounting rules disciplines the representation and the valuation of financial instruments on the balance sheet. A fundamental principle in IAS is that all derivatives are measured at fair value. Besides innovation in the valuation process, the IAS 39 principle introduces relevant advances in the hedging instruments accounting ( Hedge Accounting ). Hedge accounting seeks to reflect the results of hedging activities, in particular hedging using derivatives, by reporting the effects of the derivative and the risk being hedged in the same period. These rules allows you to evaluate at the same time the effects at income statement level derived by hedging instrument and hedged item fair values changes. Hedge accounting is an exception with respect to the standard accounting principles: it allows entities to override the normal accounting treatment for derivatives (fair value through profit or loss) or to adjust the carrying value of assets and liabilities. Therefore, in order to apply hedge accounting, IAS 39 requires hedging instruments that satisfy given criteria. The specific requirements are: The hedging relationship must be formally designated and documented at the inception of the hedge. This must include identifying and documenting the risk management objective, the hedged item, the hedging instrument, the nature of the risk being hedged and how the effectiveness of the hedge will be assessed; The hedge must be expected to be highly effective at the inception of the hedge; 1
1 Introduction The effectiveness of the hedge must be tested regularly throughout its life and hedge accounting must terminate if the hedging instrument loses its efficacy. In particular, a hedge is regarded as highly effective only if both of the following tests are passed: Prospective Effectiveness Test: from the beginning of the derivatives (and for all the length of the hedging operation), the company can expect that changes to the fair value or of the subsequent cash flows given by the hedged activity ( hedged item ) will be almost compensated by changes of the fair value or cash flows of the hedging instrument. It is required, at a minimum, at the inception of the hedge and at each reporting date. Retrospective Effectiveness Test: the recorded relative changes must fall in the 80-125% interval. It is required, at a minimum, at each reporting date. Therefore, the possibility of implementing hedge accounting depends on the satisfying of the prospective and retrospective tests which are designed to guarantee that the hedging objectives are met. 1 IAS 39 hedge accounting prospective and retrospective tests can be performed on Fairmat projects. 1 For more information on the IAS 39 approach to accounting see http://www.ifrs. org and PWC (2006). 2
2 A Case Study 2 A Case Study Company A is a European company with an interest rate risk that arises from a debt undersigned on 20th March 2012 with the following characteristics: Variable Rate Debt Principal 12,500,000 amortizing Start Date 31/03/2012 Maturity Date 31/03/2015 Payment frequency Monthly Indexed Rate Euribor 6 month (act/365) Fixing mode Arrears - rounded to 0.05 Table 1: Hedged Item - Company A. In this example, we assume that risk management decides to hedge 80% of the debt from the interest rate risk. On the date on which the debt was concluded, Company A enters into the following Interest Rate Swap (Hedging Instrument). For the entire length of the hedging operation Company A pays a fixed rate of 1.45% and receives the six month EURIBOR. The variable leg of the swap is determined on the market interest rate measured at the beginning of each period and is paid at the end of every month (fixing in advance ). Hedging Instrument - IRS amortizing Notional 10,000,000 amortizing Trade Date 20/03/2012 Effective Date 31/03/2012 Maturity Date 31/03/2015 Issuer payment frequency Monthly Company payment frequency Monthly Flows CompanyA Issuer 1.45% Eur6M Conventions CompanyA Issuer Fixing Rate Advance day count adjustment act/360 act/360 Table 2: Hedging Instrument - Company A. With the objective of testing efficacy, the hedged item s interest rate can be modeled as an hypothetical derivative. This hypothetical derivative should be identified right at the beginning of the hedging operation and represent a perfect hedge of the underlying exposure in terms of contract specifications (payments and reset dates, notional etc.) and market conditions. In this case the Hypothetical Derivative replicates the risk management desk decision in according with the amount and the underlying to hedge. 3
Hypothetical Derivative - Hedged Item Notional 10,000,000 amortizing Trade Date 20/03/2012 Effective Date 31/03/2012 Maturity Date 31/03/2015 Issuer payment frequency Monthly Company payment frequency Monthly Flows CompanyA Issuer 1.252% Eur6M Conventions CompanyA Issuer Fixing Rate Arrears (rounded 0.05) day count adjustment act/365 act/365 Table 3: Hypothetical Derivative - Company A. 3 An implementation with Fairmat In order to use the IAS-39 plug-in you need either Fairmat Academic (which can be freely downloaded from www.fairmat.com/downloads or Fairmat Professional (see http://www.fairmat.com/solutions/fairmat-professional/). Detailed plug-in documentation and features can be found at the following link http://www.fairmat.com/plugins/documentation/ias-39-hedge-accounting. The IAS-39 plug-in makes IAS-39 implementation straightforward: IAS 39 Test can be performed on Fairmat projects where the hedged item represented by the hypothetical derivative and hedging instruments is defined using Fairmat option map scenario. The first scenario represents the hedging instrument cash flows, while the second the hedged item. Good practice to prepare a contract for IAS to model the hedge item and the hedging instrument as two branches and connect them using the SUM or Functional operator as shown in the figure below. 4
Figure 1: A Fairmat project suitable for the IAS-39. The two scenario represents the Hedging Instrument and the Hedged Item. Company A s reporting dates are 30 June and 31 December. We applied the effectiveness tests at the reporting date of the 30th June 2012 to verify both the prospective and retrospective tests, as at the inception of the hedge it is possible to apply only the prospective. 3.1 The prospective test on June 2012 The prospective effectiveness test is designed to assess the hedging expected efficacy until its maturity (forward-looking test), by performing a scenario analysis on the hedge item value drivers (interest rate - EURO zero coupon curve) and measuring the changes in the value of the hedging instrument with respect to the changes in the value hedged item. The prospective test is performed in Fairmat by comparing the numerical effects of parallel shifts of zero rate proportional with the volatility of short rate on both the fair value of the hedging instrument and the fair value of the hedged item (represented by a hypothetical derivative ). The method used in Fairmat to assess the hedge effectiveness prospectively is the regression analysis. 2 This statistical method investigates the strength of the statistical relationship between the hedged item and the hedging instrument. In the context of assessing hedge effectiveness, it establishes whether changes in the hedged item and hedging derivative are highly correlated. Regression analysis involves the 2 For more information about which methods can be used to assess hedge effectiveness see PWC (2006). 5
determination of line of best fit and then assessing the goodness of fit of this line. It provides a means of expressing, in a systematic fashion, the extent by which one variable (the dependent hedging instrument ) will vary with changes in another variable (the independent hedged item ). Regression analysis may be expressed as follows: Y = α + βx + ε Y : the dependent variable, changes in fair-value of hedging instrument. X: the independent variable, changes in fair-value of hedged item. α: intercept of the regression. β: coefficient of the regression. ε: statistic error. The critical test statistics to determine an effective hedge relationship using regression analysis are: 1. β must be negative: 1.25 β 0.8; 2. R 2 > 0.96; 3. F -statistic must be significant. This three statistic parameters are the output of the prospective test whit Fairmat. Prospective Test on June 2012 Effectiveness Test Effectiveness opinion Parameters IRS amortizing Prospective β 1.0161 Effectiveness R 2 1.0000 Effectiveness F -Statistic Significant Effectiveness Table 4: Result of the Prospective Effectiveness Test on 30th June 2012 as calculated by Fairmat. 6
Figure 2: Fairmat output: deltas on hedged item and hedging instrument calculated in different scenarios of interest rate evolution. The solid line represents the regression line, while the dashed line represents the optimal angular coefficient. Figure 3: Fairmat output: number of scenario and the three critical test statistics to determine the prospective effectiveness hedging relationship when using regression analysis. 7
3.2 The retrospective test on June 2012 The retrospective effectiveness test is a backward-looking test of whether a hedging relationship has actually been highly effective in a past period. This test should be performed at each reporting date using the specific algorithm dollar offset method. Hedge effectiveness is calculated by comparing the cumulative change in the fair value of the hedging instrument with the cumulative change in the fair value of the hedged item attributable to the hedged risk. The test is passed if delta Ratio falls within the required range of 80%-125%: Ratio = fair value hedging instrument fair value hedged item with fair-value as difference between fair-value at the trade date (20/03/2012) and fair-value at testing/valuation date (30/06/2012). Note that in order to correctly execute the retrospective test, the Fairmat model must be linked to market data, because Fairmat needs to calibrate models and evaluate the contracts either at the actual V aluation Date and at the T rade Date. Fairmat uses the effective date as trade date unless a constant called TradeDate is found on the Parameters & Function list. Result for accounting calculated on 30th June 2012 with Fairmat is: Figure 4: Fairmat s Retrospective Test output. 8
Retrospective Test on June 2012 t 0 t 1 20/03/2012 30/06/2012 FV FV Hedging Instrument 34, 087 72, 403 38, 317 FV Hedged Item 6 40, 087 40, 093 Ratio = 0.9557 Retrospective Effectiveness Opinion: Effectiveness % In-Effectiveness Hedging Instrument: 4.43% Table 5: Result of the Retrospective Effectiveness Test on 30th June 2012 as calculated by Fairmat. The Ratio is between the range 80%-125% hence the hedging is effective. We can conclude that at 30th June 2012 the hedging is highly effective. Both tests have been passed hence Company A obtains the right to apply hedge accounting rules. 9
References PWC (2006). Ias 39 achieving hedge accounting in practice. Available at PWC inform.