It seems like a lifetime ago since hedge accounting was first introduced, nearly ten years ago now. My how auditors loved it. How complicated could they make it? Very, ,was the answer. How about insisting on regression testing for simple foreign exchange forward contracts or forcing options to be split between time and intrinsic value? No doubt the fees were good for a while but after a decade of hedge accounting the bleeding obvious is that it isn’t, and shouldn’t be, that hard.
Because auditors did over complicate the process the perception was that to hedge account was a time consuming and difficult process to follow and so unless there were very good reasons for doing so many shied away from it. The reality is obviously somewhat different.
Hedge accounting can be simple if you are using plain vanilla instruments and follow some simple, good treasury practices.
We will look at the FX Forwards, FX Options and Interest Rate Swaps to show that anyone can hedge account if they want and it doesn’t need to be difficult or time consuming.
Let’s take the most simple and commonly used financial instrument, FX Forwards. To achieve hedge accounting you need to match off your expected cashflow or exposure with the FX Forward you have used to hedge this. Given that one of the underlying reasons for hedge accounting is to recognise the difference between hedging and speculating it makes sense that you can identify a cashflow that matches your hedge. More simply than that, assuming you haven’t hedged more than you expect to buy or sell in the foreign currency, the cashflow can be matched exactly against the FX Forward.
Under the standard currently, you need to do a quantitative test to prove the effectiveness of the hedge, ie ensure that the hedge falls between 80% and 125% effectiveness. In practical terms all you need to do is value the FX Forward, which can be easily done through Hedgebook, and then value the cashflow that is allocated against the hedge. To value the cashflow, you create a hypothetical FX Forward which matches the same attributes as the original FX Forward, ie is an exact match. So by valuing the original FX Forward you also have the value of the hypothetical and lo and behold by comparing one to the other the hedge relationship is 100% effective.
If you need to pre-deliver or extend the FX Forward then, as long as this is within a reasonable period (45 days either way is generally accepted) this won’t affect the effectiveness of the hedge.
This method can be used for both the retrospective and prospective methodology.
The process is the same for FX Options as it is for FX Forwards in terms of matching the hedge (ie the option) with the cashflow. Again there is only the requirement to value the underlying FX Option and replicate this with the cashflow by creating a hypothetical deal which exactly reflects the details of the original option. As with the FX Forward you then just compare the value of the underlying hedge with the value of the hypothetical option and again it will be 100% effective.
Those sneaky auditors have managed to complicate things by interpreting the current standard as requiring to split out the intrinsic value of the option from the time value. Again Hedgebook can do this calculation automatically which takes the pain away from trying to calculate this rather complex computation. The value of the time value will need to be posted to the Profit and Loss account.
Interest Rate Swaps
Interest rate swaps can be treated largely the same as FX Forwards and options in as much as you need to match the hedge against the exposure. In this case this means matching the swap against the underlying borrowing or investment. Again good treasury management should dictate that the reason you have taken out a swap is to match against the same details of the debt or the investment, in terms of amount and rate set dates.
Assuming that this match is occurring it is again a matter of valuing the swap and creating a hypothetical, in this case of the debt or investment but mirroring the details of the swap. Again this would mean that the relationship is 100%, assuming the hedge matches the exposure.
If there is a difference between the rate set dates and the rollover of the debt or investment then the hypothetical swap can reflect these changes and this means that the two valuations are slightly different but hopefully still well within the 80% to 125% relationship.
It is important that the relationship is properly documented. There are plenty of places where you can source the appropriate documentation, with Google being a good place to start. In most cases it is a matter of copying and pasting the specific details of the underlying hedge but the vast majority of the documentation won’t change from deal to deal. A bit of admin but not too hard or onerous.
Our experience, somewhat surprisingly, has been that more organisations are moving towards hedge accounting. Probably because many are realising that it doesn’t have to be that hard as hopefully we have demonstrated above. This has also been recognised as the introduction of IFRS9 in a few years’ time is simplifying some of the rules which should push more down this path as most would probably prefer not to have the volatility of financial instruments flowing through their Profit and Loss account if they can help it.
It should be noted that hedge accounting can be complex if you are using more exotic instruments or if you are leaning more towards speculation than hedging, however, if you are keeping it simple then it doesn’t need to be onerous. Sure you need to value the financial instruments but if you can do that pretty much you can hedge account. Hedgebook has a number of clients, including publicly listed companies, using this approach. So why don’t you give it a try it might not be the beast you once thought it was.