This article is by Eva De Leon, Product Manager for Hedge Accounting Solutions at Bloomberg L.P.
Adoption of IFRS 9 is now well under way. A large number of market participants have elected to transition to IFRS 9 for hedge accounting, despite the option to retain IAS 39 until the macro project has been finalised. One of the big draws has undoubtedly been the ability to apply a cost of hedging approach to the impact of foreign currency basis spreads.
Foreign currency basis spreads can be volatile. Under IAS 39, when designated in a fair value hedge, they were a source of hedge ineffectiveness and at worst a cause of hedge failure. IFRS 9 cost of hedging allows firms to separately account for the fair value movement attributable to foreign currency basis under other comprehensive income (OCI), thereby excluding its impact from the hedge designation itself. Currency basis must be recognised in earnings, in line with the exposure, on a transaction or time period basis.
Foreign currency basis spreads are implicit in the valuation of all foreign exchange contracts, but the most common application of cost of hedging is in cross currency interest rate swaps (CCIRS), which are typically material given their notional amount and duration. The removal of currency basis from a CCIRS is conceptually straightforward; the challenge is deciding which methodology to apply and executing this in a systematic and transparent way. If the CCIRS is collateralised, this adds another layer of complexity.
IFRS 9 is not prescriptive as to how currency basis should be quantified, however, market practice is evolving. With corporates, banks and the Big Four audit firms looking to converge on appropriate methodology, two main methods are emerging.
Method one: designate the contractual swap and remove currency basis from the market data, i.e. the discount factors. This method requires amortisation of the currency basis component, from OCI to earnings, over the life of the hedge relationship.
Method two: designate a theoretical swap identical to the contractual swap except for the coupon or spread, which is adjusted to remove the impact of currency basis from the interest payments.
This swap is valued using market data that does not contain currency basis (consistent with method one). The basis point charge for currency basis is often unknown. To approximate this component a simplified approach is to solve for the coupon or spread such that the theoretical swap has a zero NPV at designation (provided the contractual swap also has a zero NPV). Both approaches as described here do not take into consideration aligned versus actual, therefore the hedge and exposure are assumed to be designated at trade date, and critical terms matched.
An operational consideration in applying method two is the requirement to track the contractual CCIRS should any changes be made, for example through a partial unwind. There needs to be link, or a way to capture any changes made, to reflect these in the theoretical CCIRS.
Both of these approaches have their complexities and require a sound understanding of the market data used to value the deals, and the ability to create and incorporate/model a theoretical swap. Corporates in particular are seeking a simple-to-use, automated solution that is transparent and auditable. This is where system providers face a dilemma: whether to deliver an automated process requiring minimal user input or flexible, customisable solutions requiring a level of user input and knowledge. Balancing these requirements can be challenging. It is possible that with increased automation comes the risk of black box calculations and output.
Whichever methodology is applied, there should be transparency over the steps that have been followed to generate each valuation and possible subsequent adjustments. The additional complexities of incorporating collateral, making credit adjustments and even potentially rebalancing may require further consideration.
The Bloomberg hedge accounting solution (MARS HEFF <GO>) provides users with complete flexibility and control over the methodology applied in quantifying currency basis. The user can chose from a wide range of market curves, leverage the capabilities of Bloomberg’s pricing functions (including solver functionalities) and automatically generate the required accounting output, ensuring the appropriate treatment of the currency basis component as specified by the user.