Post-Trade Management of Derivative Portfolios

by Jean-François Garneau, Director, Head of Financial Risk Management, Bombardier Transportation, Zürich

Some people think that risk management decisions are concerned with what happens up to and until a trade is executed, while hedge accounting ones are concerned with what happens post-trade, i.e., once a trade is on our books. This amalgamation of the distinction between risk management and hedge accounting with that between the pre-trade and post-trade occurrence of the decision can only be maintained as long as the size of one’s financial risk is not too high. The minute financial risk becomes significant, the accounting consequences of risk management start to matter tremendously, making it advisable that the risk management function be greatly involved in the set-up of the hedge accounting framework of the firm, and that hedge accounting specialists are called in whenever risk management decisions involve potential hedge accounting issues.

The better distinction to make is therefore not between a pre-trade risk management function divorced from hedge accounting and a post-trade hedge accounting function divorced from risk management, but between (i) a pre-trade decision-making process, where discretionary decisions can still be made with regard to both risk management and hedge accounting, and (ii) a post-trade decision-making process, which is almost entirely governed by the risk management decisions and hedge accounting set-up decided before the trade was executed. In this article, we would like to share with you four of the risk management and hedge accounting considerations that went into the set-up of our post-trade hedge accounting framework, with the hope that some of those insights could help you optimise your own post-trade set-up.

First consideration: Should you account for your derivatives as fair value hedges or as cash flow hedges? The answer depends in part on the sort of flows you are trying to hedge. This is because fair value hedge accounting can only be applied to firm commitments (i.e., to committed sales or purchase transactions with third parties). However, because cash flow hedge accounting can be applied to most sorts of flows whereas fair value hedge accounting cannot, we and many of the companies we benchmarked have preferred to deny ourselves the opportunity to use fair value hedge accounting. This has enabled us to keep our hedge accounting set-up as simple as possible (one rule for all) in addition to aligning us with the forecasts most experts make with regard to the disappearance of fair value hedge accounting as an option within the revised international hedge accounting standards.

Second consideration: Which portion of your forward contract should you designate as a hedging instrument for the purpose of hedge accounting? The question may sound odd, especially if one assumes that hedging instruments cannot be split for such purpose, which is an incorrect assumption. Within a forward contract, one may distinguish between the spot component of the instrument and the forward points component. The valuation of the spot component measures the FX gains or losses made on the volatility of the spot rate between inception and the date at which the derivative is valued whereas the valuation of the forward points tries to quantify everything else, i.e., both (i) the impact of the change in forward points between inception date and valuation date and (ii) the time value of money with which one must discount the value of a derivative on its maturity date to get to its present value today. The usefulness of such distinction is that since the time value of money is located entirely in the forward points, the non-inclusion of these forward points in the hedge designation allows the hedge thus designated to remain effective as long as there is no overhedging. Maturities of hedged items can change, roll over of hedges can occur: all these changes will impact the forward points, not the spot component of the derivative. [[[PAGE]]]

Removing hedge ineffectiveness

BT used to designate its entire forward contracts as hedging instruments. This created a high level of hedge ineffectiveness in our derivative portfolio, as forecasts of maturity dates kept changing. By moving to a spot component designation, we have made almost all hedge ineffectiveness disappear. Our gross margin and EBIT are now minimally exposed to the volatility created by foreign currency risk and although one consequence of our choice is that our P&L is impacted by the volatility of the undesignated forward points, this volatility is relegated to financial income & expense, that is: below EBIT.

If you are hedging a yearly forecast of sales or a yearly forecast of costs, the above considerations may not be as useful to you as they were to us. In fact, a spot designation is only particularly useful when any of the following considerations apply:

• You want to hedge exposures greater than one year and must therefore implement a roll over strategy either because there are no forwards available on the markets for the horizon you are looking for, or because the forward point cost of using long-dated forwards is prohibitive compared to the cumulation of short-dated ones (the current credit crisis implies that hedge maturities for non-investment grade companies may be well short of the maturity of many exposures). In such situations, a spot designation would allow you to roll over without creating hedge ineffectiveness.

• You want to pool exposures together to hedge them as one, but want be able eventually  to break that pool and roll forward parts of it to different maturities.In such situations, a spot designation would allow you to hedge a pool of cash flows and then break the pool to further roll a portion of it without creating hedge ineffectiveness.

• You are not sure exactly when the maturity of your cash flow will be and want to be able to roll back or roll forward your hedge, when you have more certainty. In such a situation, a spot designation would allow you to roll over without creating hedge ineffectiveness.

Third consideration: What sort of effectiveness test should you develop? Our answer to this question is to keep it as simple as possible. BT once had a really complex hedge effectiveness test, full of logarithms of this and exponentials of that. With the move to spot designation, we fortunately were able to bring the test down to something much easier to manage, akin to critical terms matching but without the name, and using minimal quantitative back-up to prove that only overhedging creates ineffective hedging. This has made our accounting much easier to perform and to explain. We suggest you take the same route whenever offered the opportunity.

Fourth and last consideration: What to do with embedded derivatives? In our business, most embedded derivatives are third party currency contracts (e.g., when a Swedish entity sells to a UK entity in euros). Whenever possible, our suggestion is to avoid fair market valuating currency contract embedded derivatives at forward rate, and revalue them at spot. This can only be done if the impact of not having valued the forward points remains within your materiality limit. This turns out to be the case at BT in most of the embedded derivatives we manage, and makes our accounting process much easier.

We also became expert at applying the substantial party clause as a way to avoid separating the embedded derivative from its host contract, thus avoiding to fair value it through income. What we call ‘the substantial party clause’ is the ability to not recognise an embedded derivative between two parties when they transact in a currency that is not their own. This is allowed when that currency can be documented as the functional currency of a party to the contract which, although it has not signed the contract, is nonetheless a party without which presence the contract would not have been executed. If such party can be identified, then the use of that third party currency would not create an embedded derivative separable from the host contract. The said clause has enabled us to avoid recognising an embedded derivative when a non-euro client signs in euro a contract with a non-euro entity of ours because they have received financing in euro from the European Commission. The same clause can also be used to avoid recognising an embedded derivative when the euro contract is signed because an internal supplier of our lead division is itself a euro-functional entity.

In this article, we have only mentioned a few of the insights that went into the setup of our hedge accounting framework. Should you want to discuss these issues further with us, simply send us an email to [email protected]