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IB Operations Background Reading
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Transaction Types: Buy-Sell and Borrow-Lend
Based on the nature of flows between the two parties, we can classify transactions into buy-sell and borrow transactions (there are two more types, swap and option, discussed later)
Buy-Sell Transaction
• One flow is in a financial asset and the other is in money: it is exchange of an asset for
money.
• The exchange occurs simultaneously at a point of time called settlement date.
• The two sides of the transaction are called buy and sell; and the two parties, buyer and
seller.
Borrow-Lend Transaction
• Both flows are in money: it is exchange of money for money.
• To make the exchange meaningful, the exchange cannot be simultaneous but split over
a period of time, marked by start date and end date.
• The two sides of the transaction are called borrow and lend; and the two parties,
borrower and lender.
The amount of money on end date must include the amount on start date plus an additional amount, representing the “rent” on money for the period. This rent is called interest, which represents the “time-value” of money. The following exhibit shows the two types of transactions and their flows.
Buy-Sell Transaction
BUYER
SELLER
asset money
Settlement Date
Exchange at a point of time
Borrow-Lend Transaction
BORROWER
LENDER
money money
Start Date End Date
Exchange over a period of time
time time
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Transaction Life Cycle
The transaction life cycle consists of many stages, but the important among them are trade and settlement.
The trade part precedes settlement part and consists of both parties negotiating and agreeing on the terms of trade, which consist of the following features.
For buy-sell transaction: identification of the asset, quantity, price, and settlement date.
For borrow-lend transaction: amount of money, interest rate, and period of borrowing specified by start date and end date.
The settlement part occurs after the trade part and involves executing the terms of trade: exchange of asset for money on settlement date (for buy-sell trades) or payment and repayment of money on start date and end date, respectively (for borrow-lend trades).
If the settlement date or start date is the same as trade date, it is called “T+0” settlement, the zero indicating that there is no gap between trade date and settlement date/start date. For most trades, however, there is a delay between them, and settlement date/start is on first business day (T+1) or second business day (T+2) or even third business day (T+3) following the trade date.
Besides the trade and settlement stages, there are many other stages in the trade life cycle: validation/review/repair, documentation, confirmation, pre-settlement confirmation, accounting, reconciliation, margining, market-to-market, etc.
Trade Cash Flows Types
Any financial instrument is, in the final analysis, is a bundle of cash flows. Based on the type of cash flows, we give it a name (e.g. equity, bond, forex, etc). Each cash flow is described by its three attributes: occurrence, timing and amount.
• occurrence: whether it will occur; qualified as certain (i.e. it will surely occur) or
uncertain (i.e. its occurrence is conditionally on the occurrence of a specified event)
• timing: when it will occur; qualified as certain (i.e. its timing is known) or uncertain
(i.e. its timing is not known at inception)
• amount: how much it will be; qualified as certain (i.e. its amount is known) or
uncertain (i.e. its amount is not known at inception)
Based on the combination of attributes, we categorize cash flows into fixed, floating and contingent. If the cash flow is fixed, all the three attributes are certain: it will occur, and its timing and amount are known at inception. If the cash flow is floating, its occurrence and timing are certain and known, but its amount is not known at inception: it will be known only in future. If the cash flow is uncertain, its occurrence is uncertain because it is conditional on the occurrence of a specified event. If it occurs, its timing and amount may be certain (known in advance) or uncertain (not known in advance but known only in future). The following exhibit summarizes the properties of three cash flow types.
Market is the mechanism which brings the two sides of the trade (i.e. buyer/sell, borrower/lender) together and enables business between them in the form of a transaction.
At the first level, we can classify financial markets into three types: underlying markets, derivatives markets and structured products.
Underlying Markets
The underlying markets are the fundamental and most important markets because the other two markets are derived from them. The underlying markets have the following qualifying features.
• They are independent
• The prices in these markets are determined by demand-supply forces
• The price and value are frequently different: price is set by the demand-supply forces in
the market while the value is subjectively perceived by each market participant.
• To accurately and consistently forecast the price is impossible
The underlying markets are used for consumption and investment, and can be grouped into money, bond, equity and forex markets. The first two are also called debt or fixed-income securities markets, and are money trades. The last two are asset trades.
Money and Bond Markets
Together called debt or fixed-income securities (FIS) markets, they involve borrowing are
lending of money: they are money transactions. The difference between the two markets is the
period of borrowing/lending. In money market, the period is less than one year; and in bond
market, it is one year or more.
It may be noted that we may create a “paper” or “security” to channel the money
borrowing as “buy” or “sell” of that security. The essence, however, is money borrowing or
lending between the two parties.
IB Operations Background Reading
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Equity Market
Trades in equity market are buy-sell trades, the asset being the ownership of a business, which
is exchanged for money. Equity and debt markets together are called capital markets, which
are the source of finance for businesses.
Forex Market
Forex trades are buy-sell trades, like in equity market. It consists of exchanging one brand of
money for another. Of the two, one serves as a financial asset and the other as money. The
following exhibit summarizes the nature of transactions in the four underlying markets.
Underlying Markets
Market Transaction Type
Market Sides Remark
Money Borrow-lend Borrow, Lend Money exchanged for money for a period of less than one year
Bond Borrow-lend Borrow, Lend Money exchanged for money for a period of one year or more
Equity Buy-sell Buy, Sell Money exchanged for ownership of business
Forex Buy-sell Buy, Sell One brand of money exchanged for another
Derivatives Market
Derivatives market, unlike underlying market, are not independent but derived (and hence the
name “derivative”) from underlying market. The underlying market is the object and the
derivative market is the shadow, so to speak. To be qualified as a financial derivative, the
International Accounting Standard #39 (IAS 39) stipulates the following criteria.
• Value of derivative is linked in some way to the value of underlying, rather than determined by demand-supply forces directly
• The derivative trade must settle on a future date
• At inception, the derivative requires no cash outlay or a fraction of trade value
Each underlying market (i.e. money, bond, equity and forex) has its counterpart in
derivatives (e.g. money derivatives, bond derivatives, etc.). Derivative instruments exist on
non-financial underlyings such as commodities, energy, power, weather, freight, etc. They also
exist on non-physical underlyings such as credit, which does not exist separately but in
association with money transactions. Derivatives are used for different purposes than
IB Operations Background Reading
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underlyings. Whereas underlying assets are used for investment and consumption, derivatives
are used for risk management.
Structured Products
Structured products, like derivatives, are not independent but derived from other assets. The
can be further classified into two types: securitization products and “bespoke” or hybrid
products.
The securitization products are derived by combining different underlying assets from bond
or money markets. The process consists of pooling assets of same class but different character,
grading, and blending to create new assets backed by the underlying. Examples of such
synthetic assets are mortgage-backed securities (MBS), asset-backed securities (ABS) and
collateralized debt obligations (CDO).
The “bespoke” or hybrid assets are derived by combing a bond and a derivative asset on
equity, forex or commodity. The hybrid assets will now have the features of bond and the other
asset class, offering the fixed cash flows of bond and floating cash flows of equity, forex or
commodity. The following exhibit summarizes the financial markets.
DEBT EQUITY
SECURITIZATION
products
BESPOKE or HYBRID
instruments
Money trades
Asset trades
Structured
Products Markets
Derivatives Markets
Underlying Markets
CAPITAL FOREX
BOND MONEY
MONEY
DERIVATIVES
BOND
DERIVATIVES
EQUITY
DERIVATIVES
FOREX
DERIVATIVES
IB Operations Background Reading
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The table below summarizes the features of underlying, derivative and structured products
markets.
Feature Underlying Derivative Structured Product
Independent? Yes No (derived) No (derived)
Role Investment Risk management Investment
Pricing Demand-supply Arbitrage Arbitrage
Forex Trade: Currency Pair Every forex transaction is a currency pair, and the forex price (or rate) is the price of one currency in terms of the other currency. We can compare the three types of exchange: barter, money and forex. In barter, it is exchange of one goods (or services) for another goods (or services). In money, it is exchanges of goods (or services) for money. In forex, it is exchange of one brand of money for another brand of money.
Type Exchange
Barter Goods versus goods
Money Goods versus money
Forex Money versus money
Base Currency and Quoting Currency Of the two currencies in the pair, one is called the base currency (BC) and the other, the quoting currency (QC). Base currency is the currency that is priced: it is bought and sold like a commodity (hence the name “commodity currency”) and ceases to act in the traditional role of money. Quoting currency is the currency that prices the base currency, and is thus acting in the role of money. What is quoted in the market as forex price (or rate) is the price of base currency in units of quoting currency. This statement always holds in all “quotation styles” (explained later) and must be memorized.
Forex Price = Price of BC in QC The amount of BC is fixed (usually at one unit) and the amount of QC naturally varies as the market price varies over time. Accordingly, BC and QC are also called “constant/fixed amount currency” and “variable amount currency”, respectively. ISO / SWIFT Codes International Organization for Standardization (ISO) has given three-letter alpha code for every currency in their ISO 4217 standard. The first two letters are the country code defined by ISO in their standard ISO 3166, and the third letter is usually (but not always) taken from the first letter in the currency name.
Country Currency ISO Code
United Kingdom pound GBP
European Union euro EUR
United States dollar USD
Switzerland franc CHF
Japan yen JPY
India rupee INR
China renminbi CNY
South Africa rand ZAR
IB Operations Background Reading
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FX Deal Types
All forex deals are classified into two types: outright and FX swap. Every forex transaction is
analyzed with respect to two risk parameters: exposure (or position) and mismatch (or gap).
Outright Deal
An outright transaction involves buying or selling a currency. Since the forex trade is an
exchange of two currencies, it is simultaneously buying a currency and selling an equivalent
amount of another currency. The following examples illustrate the outright deals.
Deal #1: Bought EUR 1 million on EUR/USD currency pair @ 1.5665 value date spot
Deal #2: Sold JPY 500 million on USD/JPY currency pair @ 104.00 value date spot
In the deals, only one currency (“deal currency”) amount and the price are specified.
The other currency (“derived currency”) amount has to be derived by ‘crossing’ the deal
currency amount with the deal price.
In deal #1, the deal currency is base currency. The deal price in all cases is the price of
base currency (here EUR) in terms of quoting currency (here USD). Accordingly, the price here
implies that EUR 1 = USD 1.5665 or EUR 1 million is equal to USD 1.5665 million. The ‘crossing’
here means multiplication of deal currency with deal price.
In deal #2, the deal currency is quoting currency. It is a market practice that deal
currency can be either base currency or quoting currency. If the requirement is to buy or sell a
specific amount of quoting currency, then the action will be specified in that currency. The
deal price implies that USD 1 = JPY 104.00, so that JPY 500 million will be equivalent to 500 /
104.00 = USD 4.789272 million. The ‘crossing’ here means division of deal currency amount by
deal price.
To sum up, the outright deal always involves a bought currency and a sold currency.
The amount of one of them and the price is specified. The amount of the other currency is
derived by ‘crossing’ the deal amount with the price. The ‘crossing’ is multiplication or
division, depending on whether the deal currency is base currency or quoting currency,
The denominator is 365 if the payment date falls in a non-leap year; and 366 if it falls in a leap
year. It is used for GBP floating rate notes.
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Actual/365 Japan
The denominator is a constant of 365. The numerator, though referred to as “actual”, does not
involve counting the actual days. If there is no February 29 in the period, we take the actual
number of days for the numerator; if it exists, then take the actual number of days and deduct
one from them. For the denominator, use the constant of 365.
What happens when the start date or end date is 29 February and the other date is
adjacent calendar day? For example, you borrow a loan from the bank on 29-Feb-2004 and
repay it on 01-Mar-2004. Will bank charge interest for “zero” day? No. In such case, the
numerator is treated as 1.
Microsoft Excel Function for Day Count Basis
=YEARFRAC(StartDate, EndDate, basis) supports of five types of day count basis. Its input
values must be specified as follows.
StartDate and EndDate inputs must be provided through: (1) link to the cells where their values
are stored; (2) using =DATE (yyyy, mm, dd) function; or (3) as text, but must be within double
quotes and in the format the Excel/Windows is set.
Basis is a value from the following list:
0 for 30A/360
1 for Actual/Actual-ICMA
2 for Actual/360
3 for Actual/365
4 for 30E/360
The Excel’s output for Actual/Actual-ICMA is not always reliable. It always assumes
annual frequency for payment and projects a quasi coupon date from the start date, and
positions it after the end date.
ISDA Template for Trade Confirmation of Interest Rate Swap
The Trade Confirmation, which is an important document in legal documentation, has to be
drawn in conformity with the ISDA template. ISDA has standardized the terminology. It is
important to use the ISDA terminology since it has legal implications. The following table maps
the front office terminology to ISDA terminology.
Front Office Terminology ISDA Terminology
Start Date Effective Date
End Date Termination Date
Payer Fixed-rate (or Fixed Amount) Payer
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Receiver Floating-rate (or Floating Amount) Payer
Day Count Basis Day Count Fraction
Business Day Adjustment Business Day Convention
Holiday Calendar Business Days
Benchmark Floating Rate Option
Tenor of Benchmark Designated Maturity
Note that ISDA names both the parties as “payers”: one is a payer of fixed amount and the
other, the payer of floating amount.
ISDA template for OTC derivatives is uniform for most products. It has the following
structure.
Opening Para: It makes reference to the: (a) names of the parties to the swap; and (b) the
reference to the 2000 ISDA Definitions for interest rate derivatives.
Section 1: makes a reference to the date of ISDA Master Agreement between the parties.
Section 2: contains the “economic” details of the trade and consist of the following.
(1) Notional: must consist of the three-letter ISO code for currency and the amount in full
(not abbreviated as MM or M).
(2) Trade Date
(3) Effective Date
(4) Termination Date along with the Business Day Convention. If the latter is not specified,
then the fallback value in ISDA Definitions (which is “no adjustment applies)
(5) Fixed Amount: it specifies the details of fixed-rate leg of swap, and consists of
specifying the following information separately.
a. Fixed Amount Payer: name of the party paying fixed-rate
b. Period End Date with Business Day Convention: they are specified only if they
are different from Payment Dates
c. Payment Dates with Business Day Convention: they are usually described
parametrically rather than as a list
d. Rate: interest rate applicable to the fixed-rate leg of swap. It is not necessary
to mention explicitly as “percentage per annum” since it is so defined in ISDA
Definitions
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e. Business Days: name of the center for considering holidays and Business Day
Convention.
f. Day Count Fraction
(6) Floating Amount: it specifies the details of floating-rate leg of the swap, and consists
of the following information separately.
a. Floating Amount Payer: name of the party paying floating-rate
b. Period End Date with Business Day Convention: they are specified only if they
are different from Payment Dates
c. Payment Dates with Business Day Convention: they are usually described
parametrically rather than as a list
d. Floating Rate Option: the benchmark applicable to the floating-rate leg. It
consists of three parts: (a) ISO code of the currency (e.g. USD, INR, etc) (b)
name of the benchmark (e.g. LIBOR, MIBOR, etc.); and (c) name of the provider
of rate (e.g. BBA, FIMMDA). If the provider is not specified, then the name of
Reference Banks will be specified; or it is left to the Calculation Agent.
Whatever it is, the relevant details or procedure must be specified.
e. Designated Maturity: it is the tenor of Floating Rate Option.
f. Spread: Spread, if any, to be loaded on to the Floating Rate Option for
computing the interest amount. The spread may be applicable or inapplicable.
If inapplicable, the word “zero” or “none” is indicated. If applicable, it is
stated as a number (in which case it is understood as percentage per annum) or
explicitly as “basis points”. If the spread is negative, it is explicitly stated as
“minus.”
g. Reset Dates: list of dates on which the interest rate is to be reset. They are not
specified as a complete list, but linked to a specified date in the Calculation
Period. (e.g. the first day in the Calculation Period)
h. Fixing Dates: the date on which the Floating Rate Option is obtained for each
Reset Period. Usually, they are not stated and understood to be the second
business day before the Reset Date. They need to be specified only if the Fixing
Dates are positioned otherwise.
i. Payment Date Business Days: name of he business center to determine holidays
and adjusting the Payment Dates
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j. Reset Date Business Days: name of he business center to determine holidays
and adjusting the Reset Dates. If the fixing center for the Floating Rate Option
and settlement center for the currency are different, then both centers are
named.
k. Compounding: it specifies whether the compounding is applicable or not.
Compounding is applicable when the payment frequency is less than reset
frequency.
Section 3: gives information about the account details of both parties (called “static data”). It
includes the account number and the name of correspondent banks, SWIFT code, etc.
Section 4: specifies the names of offices of the counterpart for correspondence on the trade.
Section 5: specifies the name of the Calculation Agent, who will be responsible for obtaining
the rate fixings and advising the interest amount payable by both the parties. The Schedule to
ISDA Master Agreement usually specifies which of the parties will act as Calculation Agent.
However, Trade Confirmation may specify a different party than mentioned in the Schedule,
and what is written in the Trade Confirmation will prevail. The Calculation Agent can be also a
third party, in which case the Trade Confirmation will specify who will pay for the services of
the third party acting as Calculation Agent.
Section 6: makes a reference to the standard disclaimers.
ISDA Template for Trade Confirmation of FX Option
The trade confirmation for FX option will document the following.
Buyer
Name of the option buyer
Seller
Name of the option seller/writer
Expiry Date and Time
It defines the date and time in the location of option expiry. It consists of the following
three: Date, Time and Cut Name. The last is a scheme with pre-defined time at a
specified business center. For example, the following are the some of the schemes and
their description.
Scheme Description
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Comex 2:30pm New York
ECB 1:30pm London
New York 10:00am New York
SilverLondon 12:15pm London
Exercise Style
It takes the value from the pre-defined list of: American, Bermuda and European
FX Option Premium
It specifies the premium exchange for a single option or option strategy. For zero-cost
option strategies, this is not applicable. When applicable, it has the following
parameters.
Payer: Name of the payer
Receiver: Name of the receiver
Premium Amount: specified as a combination of SWIFT code for currency and
amount, and represents the currency amount of premium
Premium Settlement Date: the date on which the premium amount is settled
Premium Quote: this is optional and for information only. When specified, it
consists of the following parameters.
Premium Value: specified as number, which is either percentage or an
explicit amount
Premium Quote Basis: it takes the value from the following pre-defined
list: percentage of call currency amount, percentage of call currency
amount, call currency per put currency or put currency per call
currency
Value Date
It specifies the date when the currencies are exchanged if the option is exercised by its
buyer.
Cash Settlement Terms
This is applicable only when the settlement method is “cash settlement”. When
applicable, it is specified with the following parameters.
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Settlement Currency: SWIFT code of the currency in which the option is settled
Fixing: It is specified with the following parameters: primary rate source,
secondary rate source (optional), fixing time (reference to the business center
and time) and fixing date.
Put Currency Amount
Must be specified as a combination of SWIFT code for the currency and its numerical
amount, and is the currency amount with right to sell
Call Currency Amount
Must be specified as a combination of SWIFT code for the currency and its numerical
amount, and is the currency amount with right to buy
FX Strike Price
It consists of the following two parameters.
Rate: The rate of exchange between the two currencies. It must be specified
with the following parameter.
Strike Quote Basis: It takes the value from the following pre-defined list: put
currency per call currency and call currency per put currency.
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Hedge Accounting
Financial Instruments: Classification Besides qualifying financial instruments into types as specified in the previous section, IAS 39
also requires that they should be classified into one of the following five categories.
Loans and receivables (LR)
Assets with fixed or determinable payments, have fixed maturity, not actively quoted in the
market, and are not intended to be sold in the short term. Qualifying assets that intended to
be sold in the short term should be classified in HFT; qualifying assets actively quoted in the
market should be classified in HTM; and qualifying assets for which all of the initial investment
may not be recoverable for reasons other than credit deterioration must be classified as AFS.
Held to maturity (HTM)
Assets with fixed or determinable payments and must have fixed maturity; there must be
positive intention and ability to hold them to maturity, and such intention and ability is
assessed at each balance sheet date; and do not meet the definition of LR. This definition
makes preference shares and ordinary shares ineligible to be classified as HTM in usual
circumstances.
The category should be used sparingly. If the items in this category are sold or reclassified
except for irrelevant portion or in exceptional circumstances, then the category cannot be
used for a period of two years. Further, “hedge accounting” (described later) cannot be
applied to the items in this category.
Held at fair value through profit and loss (FVTPL)
It consists of items from two streams:
Held for trading (HFT)
Financial asset or liability held for short term or part of the portfolio where there is an
actual short term profit taking; or derivative asset or liability, including separated
embedded derivatives, except those derivatives that are designated as hedging
instruments.
Measured at fair value or “fair value option” (FVO)
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Any financial asset or liability that is designated as held at fair value. Such designation is a
one-time election on initial recognition and irrevocable, and the asset stays in this
category until sold, matures or extinguished. If fair value of an item cannot be reliably
measured, then it cannot be designated as FVPTL at initiation.
Though IAS 39 allows designating both financial asset and liability to be FVPTL on the
above conditions, banking regulators do not allow it in all cases. For example, European
Union forbids banks from such designation for liabilities.
Available for sale (AFS)
All assets that do not fit into any of the above categories and any non-derivative financial
asset recognized as AFS at initial recognition.
Non-trading liabilities (NTL)
Other liabilities (note that financial liabilities can be classified only in FVTPL or NTL)
Financial Instruments: Measurement Financial assets and liabilities are measured separately at initial recognition and in subsequent periods. Measurement at initial recognition The general principle is that all financial assets and liabilities must be measured at their
initial cost on initial recognition. For items in FVTPL, transaction costs (e.g. brokerage,
commission, etc) are separated from the initial cost and are taken into income. For items that
are not FVTPL, transaction costs are included in the initial cost.
Measurement in subsequent periods
The accounting treatment for measuring in subsequent periods takes into account the change
in the value, and is made consistent with the category, de described below.
Category Accounting Treatment
LR Measured at amortized cost
HTM Measured at amortized cost
FVTPL Measured at fair value and changes in fair value are brought into income (see Note 1 below)
AFS Measured at fair value and changes in fair value at brought into equity,
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unless impaired or sold, in which case the cumulative gain/loss previously recognized in equity is recognized in income for the period (see Note 1 below) However, interest is recorded in income (see Note 2 below)
NTL Measured at amortized cost
Note 1
If the fair value cannot be reliably measured, then the items are measured at cost. However,
such circumstances should be limited and reserved only for unquoted equity instruments and
derivatives on them and only when valuation methodology results in a wide range of fair value.
It should be noted that private equity investments do not come under FAS 133/IAS 39.
Note 2
Interest from an AFS asset must be recorded at the effective yield (i.e. internal rate of return,
which is also called yield-to-maturity in bond market) after including transaction costs. The
difference between fair value and amortized cost should be brought into equity as gain/loss.
For monetary AFS assets (e.g. bonds), the foreign currency gain/loss rising from translation of
amortized cost should be brought into the income.
The AFS assets that are equity are not considered monetary assets, and therefore the foreign
currency translation gain/loss should be recorded in equity, unless the foreign currency risk is
hedged (when it will come under hedge accounting)
Note that participating interests (e.g. investments in associates whose accounts are brought in
consolidated financial statements) are outside the scope of FAS 133/IAS 39.
Hedge Accounting
Hedging is the processes of eliminating specified risks from items (called “hedged items”) by
transacting in certain instruments (called “hedging instruments”) that offset the gain/loss from
hedged items. Under FAS 133/IAS 39, all derivatives must be recognized in balance sheet at fair
value. This leads to a problem when the hedged exposure is either not yet recorded in balance
sheet (because it is a forecast transaction) or recorded in balance sheet but not at fair value.
The situation creates a mismatch in the sense that gain/loss on derivative are not offset by the
complementary gain/loss from hedged exposure. Hedge accounting is introduced to manage
such mismatch in the timing of offsetting gain/loss from hedging instrument and hedged
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exposure. To be eligible for hedge accounting, the following “hedge documentation” criteria
must be satisfied.
� Identification of hedged item and hedging instrument
� Identification of type of hedge
� Identification of risk that is hedged and risk management strategy
� hedge effectiveness criteria, which consists of:
o Prospective hedge effectiveness (“Will the hedge be effective?”)
o Retrospective hedge effectiveness (“Has the hedge been effective?”)
o Method to test hedge effectiveness
Hedged Items
They can be:
� Asset
� Liability
� Firm commitment
� Highly probable forecast transaction
� Net investment in a foreign operation (i.e. having a subsidiary, branch or associate whose functional currency of operation is different from that of the entity) that is exposed to risk of change in fair value or future cash flow.
The following cannot be designated as hedged items.
• Intra-group items (because the inter-company transactions affect only the entity’s
financial statements and not the consolidated financial statements of the group). The
exceptions to this are monetary items (i.e. payable or receivable between two
subsidiaries) or highly probable forecast transactions. They can be considered hedged
items in consolidated financial statements provided they are denominated in a
currency other than the functional currency of the entity entering into that transaction
and the currency risk will affect the consolidated profit or loss.
• Overall business risks (because they cannot be identified and measured)
• Assets in HTM category for interest rate risk or prepayment risk (because hedging them
will be inconsistent with the objectives of HTM category). However, they can be
hedged for currency risk and credit risk
• Derivatives, except written options which can hedge purchased option
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• Net exposure of a portfolio of assets or liabilities (because hedge effectives requires
measuring the changes in fair value or cash flows of a hedged item or a group of similar
item). However, note that though the net exposure does not qualify to be a hedged
exposure, part of the underlying exposure in the portfolio can be hedged. For example,
a company has export receivable of EUR 500,000 and import payable of EUR 200,000. It
designates an the net amount of EUR 300,000 as hedged item, which is acceptable
because the hedged item is considered a part of the EUR 500,000 receivable.
• Own equity (because it does not expose the entity to any risk). A forecast dividend
cannot be a hedged item because distributions to equity holders are directly debited to
equity and therefore do not impact P/L.
• Non-financial assets or liabilities can be hedged items only for all risks or for currency
risk alone. For example, Indian vegetable oil extracting company purchasing soy bean
futures priced in US dollar can hedge: (1) commodity price risk plus currency risk; or
(2) currency risk. It cannot hedge commodity price risk alone, until hedge effectiveness
is proved (explained later).
The eligible hedged items can be hedged fully or partially. For example, consider a 7-year
fixed-rate loan in AFS or FVTPL category. This can be hedged as follows.
• For all cash flows (i.e. fixed interest payments) on the entire fair value
• For all cash flows on 50% of the fair value
• For all cash flows due to specific risk (e.g. risk-free rate)
• For 50% of cash flows due to specific risk (e.g. risk-free rate)
• For specific risk (e.g. currency rate) for principal alone
• For specific risk (e.g. currency rate) for interest alone
Hedging Instruments
Hedging instruments are generally derivatives. However, even non-derivative financial assets or
liabilities can be designated as hedging instruments for currency provided they meet the test of
hedge effectiveness (explained later). Examples of such cases are foreign currency loans or
deposits.
All derivatives except written options, which are carried at fair value, can be hedging
instruments provided it is designated for the entirety of its maturity. A written option cannot
be a hedging instrument except for a purchased option. The following actions are permissible
for hedging.
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• Part of the hedging instrument can be hedge, but not part of its life
• One derivative can be designated as hedge for multiple risks
• Two or more derivatives, in full or part amount, can jointly be designated as hedging instrument. However, if the combination includes written and purchased options, it cannot be a hedging instrument if there is net written option or net premium received.
• A combination of derivative and non-derivative can be designated as hedging instrument only for currency risk
Types of Hedge Accounting
Hedge accounting classifies hedges into fair value hedge, cash flow hedge, and net investment
hedge for foreign operations.
Fair Value Hedge (FVH):
It must satisfy the following criteria.
• The hedged item must be a recognized asset, liability or an unrecognized firm commitment
• Their prices/rates (or quantity in case of firm commitments) are fixed so that subsequent changes in their market prices will affect their fair value
In other words, the derivative hedges against the change in fair value.
Cash Flow Hedge (CFH):
It must satisfy the following criteria.
• The hedged item is an existing asset or liability with variable future cash flows; or a highly probable forecast transaction
• Their prices/rates are not fixed so that subsequent changes in their market prices will affect their value
Thus, the derivative fixes the price/rate of cash flows and reduces their variability
Net Investment Hedge (NIH):
It is similar to CFH except that applies to net investment in foreign operations (e.g. subsidiary,
branch, etc, located outside the home country) and therefore is a hedge against currency risk.
It allows matching foreign currency gains/losses from derivative or liability against revaluation
of net investment in foreign operations. This type of hedge accounting is not available for the
stand-alone accounts of the parent company if the overseas subsidiaries are not equity-
accounted. In such cases, FVH should be applied to the net investment.
Forecast transactions are always under CFH and firm commitments are generally under FVH.
The exception to this principle is the currency risk of a firm commitment, which can be either
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CFH or FVH. Annex I summarizes the various exposures and the hedge types that can be
associated with them.
Nature of Risk and Risk Management Strategy
The entity must document the nature of risk being hedged: that is, whether it is currency risk,
interest rate risk, credit risk, etc. The nature of risk being hedged must also be consistent with
the overall documented policies on risk management.
Hedge Effectiveness
FAS 133/IAS 39 requires that, to qualify for hedge accounting, the hedging instrument must be
effective in hedge. The standard does not specify the procedure to test hedge effectiveness,
but rather requires that the entity should specify the method to assess hedge effectiveness at
the inception; and apply it consistently for the duration of the hedge. Mathematical or
statistical techniques like ratio analysis, regression analysis, etc can be used. The method
chosen must be consistent with the risk management strategy and objective (explained below)
and applied consistently to all similar hedges unless different methods are explicitly justified.
Hedges cannot be designated or documented retrospectively.
The test for hedge effectiveness must be both prospective (“Will it be effective?”) and
retrospective (“Has it been effective?”). The prospective test must be proved at the inception.
Hedge effectiveness cannot be assumed even if the terms of hedging instrument and hedged
item are the same. It must be assessed and measured, because hedge ineffectiveness may arise
from changes in the liquidity, counterparty credit risk, etc. For the retrospective test,
hedge must be assessed and the effectiveness must be within 80 – 125% range, and the
assessment must be on each balance sheet date and on dates the interim financial statements
are prepared.
To ensure hedge effectiveness, the following are permitted.
• Hedge ratios: the ratio is permitted instead of one-to-one. For example, if the hedging
instrument changes in value by only 90% of unit change in hedged item, then the
amount of hedging instrument can be: 100 / 90 = 111% of the amount of hedged item.
• Retrospective test for effectiveness is permitted on period-by-period or cumulative
basis
• In measuring effectiveness, time value of the derivative price can be separated from its
intrinsic-value, and only the latter can be considered for the hedge relationship. The
time-value will then be considered the ineffective part of the hedge, and the change in
fair value will be shown in P&L.
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• Designating only a portion of total risk: only certain risks can be designated as hedged
while others remain un-hedged. For example, a BBB-rated company can enter into an
interest rate swap with LIBOR benchmark (which reflects the credit quality of AA-rated
banks) and designate the portion of risk related to LIBOR and excluded the changes in
the fair value of the hedged item due to its own credit quality.
Accounting for FVH
Change in the fair value of both hedging instrument and hedged item are recognized as
gain/loss in income, thus offsetting each other. These criteria are applicable even if the
hedged item is in AFS so that its changes in fair value are measured in equity. They also apply
to the hedged items that are measured at cost.
For unrecognized firm commitments, the subsequent cumulative change in fair value
attributable to hedged risk is recognized as asset or liability in the balance sheet with a
corresponding gain or loss in P/L. The change in fair value of hedging instrument is also
recognized in P/L. The initial recognition of asset or liability to which the firm commitment
relates: the initial carrying amount of asset or liability that results from fulfilling the firm
commitment is adjusted to include the cumulative change in the fair value of the firm
commitment attributable to the hedged risk that was recognized in balance sheet.
Example
The company raises a 5Y fixed-rate debt for INR 100M with a fixed rate of 8%, and hedges it
through a 5Y interest rate swap under which it pays floating rate and receives the fixed rate of
6.5%. The difference between the fixed-rate of swap and the fixed-rate of debt is 150 basis
points, which represents the credit spread on the company’s debt. The company designates the
swap as fair value hedge, and leaves the credit spread un-hedged.
The following table shows the fair value of debt and changes in the fair value of swap on
different dates.
Issue Date Reporting Date #1 Reporting Date #2
Debt (100) (107) (105)
Swap 0 7 5
The following will be the journal entries for the example above.
On Issue Date
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Issuance of debt is recorded, but no entries for swap since its fair value at inception is zero.
Dr. Cash for 100
Cr. Debt for 100
On Reporting Date #1
Swap has acquired positive value and the debt has correspondingly acquired negative value.
Entries are passed for change in the fair value for both.
Dr. Swap for 7
Cr. P/L for 7
Dr. P/L for 7
Cr. Debt for 7
There is no impact on P/L because the changes in fair value are offsetting.
On Reporting Date #2
Swap has acquired positive value and the debt has correspondingly acquired negative value.
Entries are passed for change in the fair value for both.
Dr. P/L for 2
Cr. Swap for 2
Dr. Debt for 2
Cr. P/L for 2
Because the credit risk is not hedged, the carrying amount of debt in balance sheet does
not represent the full fair value but was a hybrid of amortized cost and changes in fair value
due to movements in interest rates alone. If the company has not elected to start amortizing
the hedging gain/loss while the hedge was outstanding, the adjustment would have remained
as part of debt instrument until it was extinguished or no longer hedged. If hedge accounting
ceased prior to the debt being extinguished, the fair value adjustment of debt would have
been amortized as yield adjustment over the expected remaining life of debt (which is
explained later).
Example
On 15-Sep-05, an Indian company has realized its export receivable for USD 1M. The spot
rate is USD/INR is 45. However, the company does not convert USD into INR because it has
a firm commitment to pay USD 1M on 15-Mar-06. It keeps the export proceeds in an EEFC
account, and designates it as hedge for the firm commitment of USD payable. The
company’s balance sheet date is 31-Dec-05. The forex rates on various dates are as follows.
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31-Dec-05 (Balance Sheet Date): 46
15-Mar-06 (Settlement Date): 44
The following are the journal entries.
On 15-Sep-05
The deposit is recorded at the spot rate of 45 for an amount of INR 45M. However, no entries are passed for change in fair value since the firm commitment is not yet recognized.
On 31-Dec-05
The changes in the fair value of deposit and firm commitment are recognized in income statement. The latter is also recognized as liability in the balance sheet.
Dr. Deposit for INR 1M
Cr. P/L for INR 1M
Dr. P/L for INR 1M
Cr. Exposure for INR 1M
On 15-Mar-06
The changes in the fair value of import payable since 31-Dec-05 is recognized (which is a
profit of INR 2M).
Dr. Exposure for INR 2M
Cr. P/L for INR 2M
The amount for the import payable on this date is INR 44M; and there is an amount of INR
1M against the exposure so far, which is added to the actual payment. In other words, the
final price of the import payable will be the same as the rate prevailing on the hedge date
of 15-Sep-05.
Accounting for CFH
Changes in the fair value of derivative are measured and decomposed into “effective portion”
and “ineffective portion” (which is the time value of derivatives). The effective portion is
deferred into a separate reserve in equity, and the ineffective portion is recognized
immediately in profit or loss. The effective portion is moved out of equity and into profit or
loss in the period the hedged items affects the income.
The amount deferred in equity is limited to the lesser of the absolute amount of:
• Cumulative gain/loss on hedging instrument since the inception of hedge
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• Present-value of cumulative change in the fair value of the expected future cash flows
of the hedged item since the inception of hedge.
Notice that if the former is less than the latter, the cash flow hedge is under-hedged, but it
does not affect the P/L. In other words, the hedge ineffectiveness is not captured in P/L. This
is in contrast to the situation in FVH where the hedge ineffectiveness from both over-hedge
and under-hedge is reflected in profit or loss. The following example illustrates the different
situations.
Changes in fair value Entries Comment
Future cash flows: (100)
Hedging instrument: 90
Hedging instrument: 90
Equity: 90
P/L: 0
Under-hedge
No effect on P/L
Future cash flows: 100
Hedging instrument: (110)
Hedging instrument: 110
Equity: 100
P/L: 10
Over-hedge
P/L affected
Future cash flows: (50)
Hedging instrument: 100
Hedging instrument: 100
Equity: 0
P/L: 100
Hedge ineffective
Does not qualify for hedge accounting
If the derivative is contracted at market price (which implies its fair value is zero), no
journal entry occurs on trade date. However, if the derivative is contracted at off-market price,
then its fair value will not be zero, and the non-zero fair value must be recorded in equity.
CFH for forecast transactions must be highly probable and is an exposure to variations in
cash flow that will affect profit or loss. If the gain/loss from hedging instrument deferred in
equity subsequently results in recognition of a non-financial asset or liability, the entity can
chose two options, as follows, for accounting it.
• Reclassification: reclassify the gain/loss into profit or loss in the same period the
asset/liability affects profit or loss
• Basis adjustment: adjust the carry amount of asset or liability with the associated
gain/loss deferred in the equity. In this route, the gain/loss from hedging
instrument will affect profit or loss when the non-financial item is sold or
depreciated.
In the Example of the previous section, the company used CFH instead of FVH, and the
company’s policy is not to “basis-adjust” non-financial items in CFH. Whether basis-adjusted
(i.e. firm commitment is fair-value-hedged) or not (i.e. firm commitment is cash-flow-hedged
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without basis adjustment), the net impact on P/L of either CFH or FVH is the same. For CFH,
whether the entity basis-adjusts a non-financial item the forecast purchase of which has been
cash-flow-hedged, or chooses to recycle hedging gain/loss deferred in equity, the net impact
on P/L is the same.
Example
An Indian company has an export order for EUR 4M and enters into a forward sale of EUR.
On the date of forward sale contract
No journal entries since derivative is contracted at fair value and hence has zero value
On the interim reporting date
EUR weakened and the forward sale resulted in positive value of INR 100,000. The change in fair value is taken into equity
Dr. Forward Sale for INR 100,000
Cr. Equity for INR 100,000
On balance sheet date
EUR weakened further, resulting in a further profit of INR 10,000
Dr. Forward for INR 10,000
Cr. Equity for INR 10,000
On the settlement date of hedged item (the EUR/INR = 50)
Sale
Dr. Cash for INR 20 Cr
Cr. Sales for INR 20 Cr
Settlement of forward
Dr. Cash INR 110,000
Cr. Forward INR 110,000
Re-cycle cumulative gain/loss from equity to P/L
Dr. Equity INR 110,000
Cr. Sales INR 110,000
(Note: we have not discounted the change in fair value of forward for simplicity)
Discontinuation of Hedge Accounting
Hedge accounting must be discontinued in the following cases.
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• Hedging instrument expires or is sold, terminated or exercised; or
• Hedge no longer meets the effectiveness test
• Forecast transaction is no longer highly probable
• Entity declares the hedge to be discontinued. In such cases, the entity may designate
new instrument as hedge provided the new hedging instrument meets the hedge
criteria
In all cases of hedge discontinuation, the cumulative gain/loss on hedging instrument deferred in equity so far will have to be immediately recognized in profit/loss. However, if the discontinued hedge is a CFH for a forecast transaction, the accumulated gain/loss can continue to be deferred in equity if the forecast transaction is still expected to occur (though no longer highly probable). Journal Entries for Interest Rate Swap The IRS may be a trading or hedge transaction, and its market side may pay (i.e. pay fixed and receive floating) or receive (i.e. receive fixed and pay float), giving a four possible situations: (1) Trading – Pay (2) Trading – Receive (3) Hedge – Pay (4) Hedge – Receive. The accounting entries are separately described for each of them. (1) Trading – Pay (i.e. pay fixed and receive floating)
(A) On Effective Date Book the memo item for the Notional.
(B) On every interest Settlement Date during swap life Interest amount is accounted separately for floating and fixed sides of the swap; and the difference between them is accounted for as the balancing item, as illustrated below. (i) Net interest amount is a payment
(ii) Net interest amount is a receipt Dr. IRS (Trading) Interest (Fixed) A/c (for fixed-rate amount) Dr. Counterparty/Branch Clearing A/c (for the balance amount) Cr. IRS (Trading) Interest (Floating) A/c (for floating-rate amount)
(C) On Termination Date Interest amount for the last calculation period will be settled as described in the previous section. In addition, the original memo item will have to reversed, as follows.
(D) On Cancellation / Early Termination On the date of cancellation/early termination, three sets of accounting entries will have to be passed. First, the interest accrued (for both sides) from the last calculation period end date to cancellation date. The procedure for them is as described in section (1)(B). Second, the reversal of memo item, which shall be in accordance with the procedure described in section (1)(C). The third set relates to the gain or loss resulting from cancellation/early termination of the contract, for which the following entries will be posted. (i) Cancellation results in gain/receipt
Dr. Counterparty/Branch Clearing A/c (for receipt) Cr. IRS (Trading) Gain A/c (for receipt)
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(ii) Cancellation results in loss/payment Dr. Counterparty/Branch Clearing A/c (for payment) Cr. IRS (Trading) Gain A/c (for payment)
(E) On Revaluation Date (i) Revaluation results in gain
Dr. IRS (Trading) Unrealized Gain on Revaluation A/c (for gain) Cr. IRS (Trading) Revaluation Gain A/c
(ii) Revaluation results in loss Dr. IRS (Trading) Revaluation Loss A/c (for loss) Cr. IRS (Trading) Un-crystallized loss A/c (for loss)
The above entries will have to be reversed at the beginning of next business day. (F) On Balance Sheet Date
Interest accrual (separately for each side of swap) is to be computed from last calculation period end date to balance sheet date, and the following entries need to be passed. For the accrued payment (i.e. fixed-rate amount)
(ii) Fee is receivable Dr. Counterparty A/c (for fee amount) Cr. Commission A/c (for fee amount)
If the IRS is struck at off-market-rates, the difference between market rate and contract rate is settled separately as “Other Payments” either on Trade Date or subsequently. In such cases, the entry may be posted in the control register if its settlement date is other than Trade Date; and, more important, the amount should be accounted for in Interest on IRS (Trading) A/c rather than Commission A/c. The reason is that the amount represents the interest amount rather than service cost.
(2) Trading – Receive (i.e. receive fixed and pay floating) (A) On Effective Date
Book the memo item for the Notional. Dr. IRS (Trading) Receive Fixed A/c (for Notional) Cr. IRS (Trading) Pay Floating A/c (for Notional)
(B) On every interest Settlement Date during swap life Interest amount is accounted separately for floating and fixed sides of the swap; and the difference between them is accounted for as the balancing item, as illustrated below. (i) Net interest amount is a payment
Dr. Interest (Floating) on IRS (Trading) A/c (for floating-rate amount) Cr. Interest (Fixed) on IRS (Trading) A/c (for fixed-rate amount) Cr. Counterparty/Branch Clearing A/c (for the balance amount)
(ii) Net interest amount is a receipt Dr. Interest (Floating) on IRS (Trading) A/c (for floating-rate amount) Dr. Counterparty/Branch Clearing A/c (for the balance amount) Cr. Interest (Fixed) on IRS (Trading) A/c (for fixed-rate amount)
(C) On Termination Date
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Interest amount for the last calculation period will be settled as described in the previous section. In addition, the original memo item will have to reversed, as follows.
(D) On Cancellation / Early Termination On the date of cancellation/early termination, three sets of accounting entries will have to be passed. First, the interest accrued (for both sides) from the last calculation period end date to cancellation date. The procedure for them is as described in section (2)(B). Second, the reversal of memo item, which shall be in accordance with the procedure described in section (2)(C). The third set relates to the gain or loss resulting from cancellation/early termination of the contract, for which the entries will be passed as described in sections (1)(D)(i) and (ii).
(E) On Revaluation Date As described in section (1)(E).
(F) On Balance Sheet Date Interest accrual (separately for each side of swap) is to be computed from last calculation period end date to balance sheet date, and the following entries need to be passed. For the accrued payment (i.e. floating-rate amount)
Dr. Interest (Floating) on IRS (Trading) A/c Cr. Interest (Floating) Payable on IRS (Trading) A/c
For the accrued receipt (i.e. floating-rate amount) Dr. Interest (Fixed) Receivable on IRS (Trading) A/c Cr. Interest (Fixed) on IRS (Trading) A/c
Both the set of entries will have to be reversed at the beginning of the next business day.
(G) Fee Payable/Receivable As described in section (1)(G)
(3) Hedging – Pay (i.e. pay fixed and receive floating) (A) On Effective Date
Book the memo item for the Notional. Dr. IRS (Hedge) Receive Floating A/c (for Notional) Cr. IRS (Hedge) Pay Fixed A/c (for Notional)
(B) On every interest Settlement Date during swap life Interest amount is accounted separately for floating and fixed sides of the swap; and the difference between them is accounted for as the balancing item, as illustrated below. (i) Net interest amount is a payment
Dr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount) Cr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount) Cr. Counterparty/Branch Clearing A/c (for the balance amount)
(ii) Net interest amount is a receipt Dr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount) Dr. Counterparty/Branch Clearing A/c (for the balance amount) Cr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount)
(C) On Termination Date Interest amount for the last calculation period will be settled as described in the previous section. In addition, the original memo item will have to reversed, as follows.
(D) On Cancellation / Early Termination On the date of cancellation/early termination, three sets of accounting entries will have to be passed. First, the interest accrued (for both sides) from the last calculation period end date to cancellation date. The procedure for them is as described in section (3)(B). Second, the reversal of memo item, which shall be in
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accordance with the procedure described in section (3)(C). The third set relates to the gain or loss resulting from cancellation/early termination of the contract, which has to be amortized over the life of remaining maturity of swap or the life of hedged exposure, whichever is shorter, as follows. Amortization entries (at daily, weekly, monthly or quarterly interals) (i) Amount is gain/receipt
Dr. Interest on IRS (Hedge) Received in Advance A/c (for gain) Cr. Interest on IRS (Hedge) A/c (for gain)
(ii) Amount is loss/payment Dr. Interest on IRS (Hedge) A/c (for loss) Cr. Interest on IRS (Hedge) Paid in Advance A/c (for loss)
(E) On Balance Sheet Date Interest accrual (separately for each side of swap) is to be computed from last calculation period end date to balance sheet date, and the following entries need to be passed. For the accrued payment (i.e. fixed-rate amount)
Dr. Interest (Fixed) on IRS (Hedge) A/c Cr. Interest (Fixed) Payable on IRS (Hedge) A/c
For the accrued receipt (i.e. floating-rate amount) Dr. Interest (Floating) Receivable on IRS (Hedge) A/c Cr. Interest (Floating) on IRS (Hedge) A/c
Both the set of entries will have to be reversed at the beginning of the next business day. Besides the accounting entries for the interest amount, the swap will have to be marked-to-the-market (MtM), and the resulting MtM gain or loss should be adjusted to the market value of the underlying hedged exposure. If the revaluation of underlying hedged exposure is reversed at the beginning of next business day, then the adjusted MtM gain or loss from swap should be reversed at the beginning of next business day, too.
(F) Fee payable or receivable The amount will have to be amortized over the life of the swap. For details, see the “Amortization Entries” in section (3)(D).
(G) Re-designation of Hedge Re-designation of hedge means that a swap is taken off the hedge book; it may be (but not necessarily) substituted with another swap; the swap remains and the underlying exposure is substituted with another exposure; or a combination of them. The following entries are recommended for various events in the re-designation of hedge (i) Swap is taken off the hedge
(a) Reverse the memo items as described in section (3)(C) (b) Provision for the interest accrual, as described in section (3)(E) (c) Mark-to-market (MtM) of the swap, and amortize the MtM gain or loss over the remaining life of swap or the life of hedged exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).
(ii) New swap replaces the old swap for hedge Follow the procedure applicable for new IRS (Hedge)
(iii) Underlying exposure is substituted with another exposure Both the hedge and the hedged underlying exposure are marked to the market; he offsetting MtM entry adjustments are treated as the amount paid or received for hedging the new underlying exposure; and such amount should be amortized over the maturity of swap or underlying exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).
(4) Hedging – Receive (i.e. receive fixed and pay floating) (A) On Effective Date
Book the memo item for the Notional. Dr. IRS (Hedge) Receive Fixed A/c (for Notional)
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Cr. IRS (Hedge) Pay Floating A/c (for Notional) (B) On every interest Settlement Date during swap life
Interest amount is accounted separately for floating and fixed sides of the swap; and the difference between them is accounted for as the balancing item, as illustrated below. (i) Net interest amount is a payment
Dr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount) Cr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount) Cr. Counterparty/Branch Clearing A/c (for the balance amount)
(ii) Net interest amount is a receipt Dr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount) Dr. Counterparty/Branch Clearing A/c (for the balance amount) Cr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount)
(C) On Termination Date Interest amount for the last calculation period will be settled as described in the previous section. In addition, the original memo item will have to reversed, as follows.
(D) On Cancellation / Early Termination On the date of cancellation/early termination, three sets of accounting entries will have to be passed. First, the interest accrued (for both sides) from the last calculation period end date to cancellation date. The procedure for them is as described in section (4)(B). Second, the reversal of memo item, which shall be in accordance with the procedure described in section (4)(C). The third set relates to the gain or loss resulting from cancellation/early termination of the contract, which has to be amortized over the life of remaining maturity of swap or the life of hedged exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).
(E) On Balance Sheet Date Interest accrual (separately for each side of swap) is to be computed from last calculation period end date to balance sheet date, and the following entries need to be passed. For the accrued payment (i.e. floating-rate amount)
Dr. Interest (Floating) on IRS (Hedge) A/c Cr. Interest (Floating) Payable on IRS (Hedge) A/c
For the accrued receipt (i.e. fixed-rate amount) Dr. Interest (Fixed) Receivable on IRS (Hedge) A/c Cr. Interest (Fixed) on IRS (Hedge) A/c
Both the set of entries will have to be reversed at the beginning of the next business day. Besides the accounting entries for the interest amount, the swap will have to be marked-to-the-market (MtM), and the resulting MtM gain or loss should be adjusted to the market value of the underlying hedged exposure. If the revaluation of underlying hedged exposure is reversed at the beginning of next business day, then the adjusted MtM gain or loss from swap should be reversed at the beginning of next business day, too.
(F) Fee payable or receivable The amount will have to be amortized over the life of the swap. For details, see the “Amortization Entries” in section (3)(D).
(G) Re-designation of Hedge Re-designation of hedge means that a swap is taken off the hedge book; it may be (but not necessarily) substituted with another swap; the swap remains and the underlying exposure is substituted with another exposure; or a combination of them. The following entries are recommended for various events in the re-designation of hedge (i) Swap is taken off the hedge
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(a) Reverse the memo items as described in section (4)(C) (b) Provision for the interest accrual, as described in section (4)(E) (c) Mark-to-market (MtM) of the swap, and amortize the MtM gain or loss over the remaining life of swap or the life of hedged exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).
(ii) New swap replaces the old swap for hedge Follow the procedure applicable for new IRS (Hedge)
(iii) Underlying exposure is substituted with another exposure Both the hedge and the hedged underlying exposure are marked to the market; he offsetting MtM entry adjustments are treated as the amount paid or received for hedging the new underlying exposure; and such amount should be amortized over the maturity of swap or underlying exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).