DACT autumn diner workshop. Risk management, valuation and accounting

DACT autumn diner workshop Risk management, valuation and accounting

Agenda 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 Pagina 2

DACT autumn diner workshop 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) Pagina 4

Basel III capital charge for CVA From the start of 2013 banks are required to hold capital for CVA Cross currency swaps, for example: Single A corporate EUR/USD Basel II Basel II + III 5.2 bp 18 bp 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 Pagina 5

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 Pagina 6

Risk mitigants Collateral Reduces exposure, CVA, capital and therefore pricing 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 Source: Risk Magazine (based on quotes from a large European bank ) Increases liquidity risk (collateral management) Pagina 7

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 Pagina 8

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) Pagina 9

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 Pagina 10

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 Pagina 11

DACT autumn diner workshop Valuation & accounting

DACT autumn diner workshop 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 Pagina 14

Currency basis spread USD 3M vs. EUR 3M spread (20Y tenor) Pre crisis: limited spreads and volatility Post crisis: increased spreads and volatility Source: Bloomberg Currency spreads have increased and have become much more volatile Pagina 15

Currency basis spread Cross currency swap example - pricing Source: Bloomberg Currency spreads are an important component in derivatives pricing Pagina 16

Currency basis spread Cross currency swap example - valuation 6-5-2012: Euro falls to three week low after Hollande wins French election 12-5-2012: Euro falls to three month low against dollar on Greek debt concern Source: Bloomberg 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: 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 Pagina 17

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 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 10 oktober 2012 Pagina 18

Currency basis spread Cross currency swap example - fair value hedge accounting Fair value hedge accounting results: 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) Hedge effectiveness (in. spread) Hedge effectiveness (ex. spread) (1.478.293) (1.215.801) 4.256.299 7.678.498 44,2% 39,7% 131,8% 107,3% 85,1% 81,5% 120% 109,6% Alternatives: Restructure into multiple hedge relationships (interest and fx) Dynamic coupon method Pagina 19

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 crosscurrency swaps 4. The increased amount of ineffectiveness caused by the basis spread has led to a change in my funding policy Pagina 20

DACT autumn diner workshop 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 Pagina 22

Tenor basis spread 3M vs 6M EURIBOR (20Y tenor) Source: Bloomberg Tenor basis spreads have increased and have become more volatile Pagina 23

Tenor basis spread Interest rate swap example - pricing Pagina 24

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; Fixed leg Fixed coupon Variable leg 3M EURIBOR Forwarding n.a. 6M EURIBOR Discounting 6M EURIBOR 6M EURIBOR Fair value (30.06.12): 4.979.903 Increase of tenor basis spreads prohibits this approximation: Fixed leg Fixed coupon Variable leg 3M EURIBOR Forwarding n.a. 3M EURIBOR Discounting 6M EURIBOR 6M EURIBOR Fair value (30.06.12): 6.686.882 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 Pagina 25

Tenor basis spread Interest rate 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 2. Cash flow hedge accounting: Hedged item modelled as hypothetical derivative, which is also sensitive to forward and discount curve Assuming 100% effective, changes in fair value reported in Other Comprehensive Income (OCI) 3. Fair value hedge accounting: Hedged item sensitive to one curve (i.e. No tenor basis spread) Reduced effectiveness and additional ineffectiveness Worst case scenario: tenor basis spread can result in ineffective hedges (no hedge accounting) Additional volatility in Profit or Loss 10 oktober 2012 Pagina 26

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; 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) The hedged item is sensitive to one curve only; the discount curve Using a multi-curve valuation approach will result in additional hedge ineffectiveness; Hedged item Hedging instrument Forwarding n.a. 3M EURIBOR Discounting 6M EURIBOR 6M EURIBOR Pagina 27

Tenor basis spread Interest rate swap example - fair value hedge accounting (continued) Alternatives: Re-define hedged risk in line with interest rate sensitivity; Hedged item Hedging instrument Forwarding n.a. 3M EURIBOR Discounting 3M EURIBOR 6M EURIBOR Dynamic coupon method Pagina 28

Tenor basis spread Interest rate swap example - fair value hedge accounting (continued) 1. Single-curve approach (and no 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% 2. Multi-curve approach (and no change in valuation hedged item): 30.06.2012 Change in fair value hedging instrument 6.686.882 Change in fair value hedged item (5.110.057) Hedge effectiveness 131% 3. Multi-curve approach (and change in valuation hedged item): 30.06.2012 Change in fair value hedging instrument 6.686.882 Change in fair value hedged item (6.739.290) Hedge effectiveness 99% Pagina 29

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? 10 oktober 2012 Pagina 30

DACT autumn diner workshop 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.. Pagina 32

OIS discounting OIS vs 6M EURIBOR spread Source: Bloomberg The spread between the OIS curve (collateralised) and the 6M EURIBOR curve (uncollateralised) has increased significantly 10 oktober 2012 Pagina 33

Interest rate swap under CSA Example IRS Subject to a CSA (i.e. collateralised): Fair value EURIBOR discounting 43,009,842 OIS discounting (EONIA) 44,355,960 Difference 1,346,118 Changing from one discount curve to another can have a significant impact on the fair value of a derivative ( one-off adjustment) Pagina 34

OIS discounting 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 2. Cash flow hedge accounting: Hedged item modelled as hypothetical derivative, which is also sensitive to forward and discount curve. Assuming 100% effective, changes in fair value reported in Other Comprehensive Income (OCI) 3. Fair value hedge accounting: Hedged item sensitive to one curve (i.e. No tenor basis spread) Reduced effectiveness and additional ineffectiveness Worst case scenario: tenor basis spread can result in ineffective hedges (no hedge accounting) Additional volatility in Profit or Loss 10 oktober 2012 Pagina 35

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) Pagina 36

DACT autumn diner workshop IFRS update

The objective of hedge accounting Represent in the financial statements the effect of an entity s risk management activities 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 Page 38

How to achieve hedge accounting? Define risk management (RM) strategy and objective Identify eligible hedged item(s) and eligible hedging instrument(s) No Yes 1) Is there an economic relationship between hedged item and hedging instrument? Yes 2) Does effect of credit risk dominate fair value changes? No To avoid ineffectiveness, the ratio may have to differ from the one used in RM Yes Base hedge ratio on the actual quantities used for risk management 3) Does hedge ratio reflect an imbalance that would create hedge ineffectiveness? No Formal designation and documentation Page 39

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 Page 40

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) 3 months later Foreign exchange forward contract to hedge the aggregated exposure (foreign exchange risk) Hedge designation 1 st level relationship 2 nd 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 Page 41

Forward points and time value of options Hedging strategies, where the spot element only is designated 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 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 Page 42

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? 10 oktober 2012 Pagina 43

DACT autumn diner workshop Wrap up

Questions Pagina 45

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 Pagina 46

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DACT autumn diner workshop Thank you!

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