Hedge accounting Principi contabili e informativa finanziaria Prof.ssa Pucci Sabrina a.a

Risk definition Risk is an abstract term (we are all faced with risk in our everyday lives) Risk is the chance of injury, damage or loss. It is the event probability multiplied by consequences effects Pure and speculative risk Risk is often related to the volatility of future value of a position due to changes in creditworthiness, market behaviour or uncertain events, unexpected happenings and other outliers Risk lies in the variability of costs and revenues The measure of variance around an expected value is the quantitative expression of risk 2

Risk definition - continued Type of risk: – traditional risk (such as credit risk, liquidity risk and market risk) – non-traditional risk (such as stategic and business risk, event risk and legal risk, reputational risk) All risks concerning an entity must be identified, measured, evaluated and managed 3

Risk definition - continued measuring. monitoring and controlling risks are key activities in accounting and in auditing innovation, leverage, volatility, liquidity and their lack combine to increase the risk of major exposure, which has the potential to destroy a financial institution or any other entity 4

Risk control Various approaches in risk evaluation: insurance approach, managerial approach, financial approach Techniques of risk control: – Physical control (elusion, prevention, protection); – Financial control (retention, insurance, non-insurance transfer) – Evaluation of convenient retention level 5

Risk management the science of risk management, if not practised beforehand, cannot be gained when it becomes necessary. Nor indeed can the athlete bring high spirit to the contest, who never has been trained to practise it (Roger of Hourden) Risk management and risk taking are not opposites, but two sides of the same coin (M.Crouhy, D.Galai, R. Mark, 2005) 6

Thinking out of the box It is necessary that: accountants improve their ability to calculate additional risk factors that exist outside the immediate trading and back office functions; boards of directors improve their understanding of risk management; firms introduce continuous effective risk control based on: rigorous auditing, better performance measurement, appropriate capital allocation and realistic pricing of financial products. 7

What accountants should do: learn risk management calibrate tools to retain risk and to register risk exposures; apply value differentiation provided by traders, loans officers, risk managers, senior executives; use accounting practices that respond to the need to focus on every signal connected to exposure. 8

The accountants mission in risk control to develop risk accounting and cost accounting based on both qualitative and quantitative criteria, for which metrics must be provided to develop appropriate standards to analyze risk exposure and to present this information to develop comprehensive internal controls with authorization procedures, compliance checks and follow-ups of non compliance clearly defined at every level of activity. 9

The accountants mission in risk control - continued To develop systems and procedures that: – clearly delineate risk elements – allow efficient management of the limits system, – monitor conterparty and financial market risks, – manage assets and liabilities in a consistent and secure manner – apply stress testing (as a defensive weapon) in risk accounting to help identify what is wrong and what may happen in future if some fundamental variables change. 10

Situations that must be analyzed by accountants Uncertainty (frequency and impact of expected and unexpected events) Volatility (and correlation between markets and instruments) Liquidity (of market and firms) Solvency (also default point characteristics) 11

Economic and accounting hedging Economic hedging – Use of appropriate instruments to neutralize unfavourable trends of variables like: interest rates, exchange rates, … – The economic effect of the variation of value of the hedged financial instrument and of the hedging instrument is equal to zero; Accounting hedging – How is a hedging operation recognised in financial statements? 12

Hedge accounting This is a technique that modifies the normal basis for recognising gains and losses (revenues and expenses) associated with a hedged item or a hedging instrument. This enables gains and losses on the hedging instrument to be recognised in the P&L in the same period as offsetting losses and gains on the hedged item. Hedge accounting takes three forms under IAS – IFRS: - fair value hedge - cash flow hedge - net investment hedge (IAS 21) 13

Hedge accounting: requirements To be able to apply hedge accounting, very strict criteria must be met at inception and throughout the life of the hedging relationship: the hedging relationship must be documented in detail, the hedge must be expected to be highly effective at inception, for cash flow hedging, the forecast transaction must be highly probable, hedge effectiveness must be measured reliably, the effectiveness of the hedging relationship must be assessed on an ongoing basis, and the relationship must be deemed to be highly effective throughout the entire hedge relationship term. 14

Hedge accounting – example of the impacts In year x, the entity acquires a derivative to hedge risk exposure of an item that is already recognised in the balance sheet. The derivative matures in x+1 and the hedged item settles in x+2. It can be observed that only the fair value hedge provides perfect synchronisation between the hedging instrument and the hedged item recognition. 15

Hedge accounting: example x+1x+2total Without hedging Hedging instrument1.000 Hedged item (realized gain)(1.000) Net profit/(loss)1.000(1.000)0 With fair value hedge Hedging instrument1.000 Hedged item (unrealized gain)(1.000) Net profit/(loss)000 With cash flow hedge Hedging instrument (after deferral in equity) Hedged item (realized gain)(1.000) Net profit/(loss)000 16

Hedge accounting: types fair value hedge the objective is to reduce exposure to changes in the fair value of an asset or liability already recognised in the balance sheet that is attributable to a particular risk and could affect reported P&L. The aim is to offset the change in fair value of the hedged item with the change in fair value of the derivative; cash flow hedge the portion of gain or loss on the hedging instrument that is determined to be an effective hedge is recognised directly in a separate reserve in equity. Any ineffective portion of the fair value movement on the hedging instrument is recorded immediately in the P&L; net investment hedge is a hedge of foreign currency exposure arising from the reporting entitys interest in the net assets of a foreign operation. The effective portion of the gain or loss is recognised in equity. Any ineffective portion of the fair value movement on the hedging instrument is recorded immediately in the P&L. 17

Hedge relationship documentation risk management objective and hedging strategy type of hedge risk being hedged hedging instrument hedged item assessment of effectiveness testing (by comparing changes in the fair value of the hedging instrument to changes in the fair value of the expected cash flow. (prospective test and retrospective test) 18

Hedge accounting: effectiveness tests o prospective test o the objective is to prove that the hedge is expected to be highly effective in future. This test must be performed at inception and at least at each balance-sheet date o retrospective test o the objective is to prove whether the actual hedging relationship was effective in the last period (since the last test was performed). This test must be completed at each reporting date. In order to pass the test, the hedging instrument must be within the range of per cent in the terms of effectively offsetting the changes in value of the hedged item. IAS 39 does not specify a single method for assessing retrospective hedge effectiveness. In general the ratio analysis method is used. 19