Impact Analysis of IFRS 9, November Update
Chatham Financial White Papers – November 2017
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Companies adopting IFRSs have historically been applying the hedge accounting provisions under IAS 39 – Financial Instruments: Recognition and Measurement which was issued back in 2001. However, many companies felt that IAS 39 was difficult to apply due to some of its onerous provisions. Some of these include restrictions on the types of hedging relationships that can qualify for hedge accounting and the need to perform periodic quantitative effectiveness assessments that evaluate how well the hedge has performed at hedging the designated risk. The IASB heard the criticisms of IAS 39 and drafted a new standard, IFRS 9 published in November 2013, which includes provisions that are aimed at simplifying the application of hedge accounting and bringing it more in line with a company’s risk management activities. Companies applying IFRSs issued by the IASB or IFRSs endorsed by the EU have a mandatory effective date for IFRS 9 for periods beginning on or after 1 January 2018 though they have the choice of deferring the application of the hedge accounting provisions contained in Chapter 6 of IFRS 9 until the IASB finalises its macro hedging project. This bulletin provides practical insight to help companies evaluate the impact of adopting Chapter 6 of IFRS 9. The transition provisions for those companies adopting Chapter 6 of IFRS 9 will be discussed in the last bulletin of this series.
Impact Analysis of IFRS 9: Assessment of the Impact of the IFRS 9 Standard on Hedge Accounting
Chatham Financial White Papers – June 2017
Companies adopting IFRSs have historically been applying the hedge accounting provisions under IAS 39 – Financial Instruments: Recognition and Measurement which was issued back in 2001. However, many companies felt that IAS 39 was difficult to apply due to some of its onerous provisions. Some of these include restrictions on the types of hedging relationships that can qualify for hedge accounting and the need to perform periodic quantitative effectiveness assessments that evaluate how well the hedge has performed at hedging the intended risk. The IASB heard the criticisms of IAS 39 and drafted a new standard, IFRS 9, which includes provisions that are aimed at simplifying the application of hedge accounting and bringing it more in line with a company’s risk management activities. The hedge accounting provisions in IFRS 9 were published in November 2013, and companies need to assess its impact on
their hedging programs, including what changes, if any, they will need to make in order to apply the new standard. Companies adopting IFRSs issued by the IASB or IFRSs endorsed by the EU will have a mandatory effective date of IFRS 9 beginning 1 January 2018 and have the choice of either early adopting the standard, if permitted in their jurisdiction, or waiting until the mandatory effective date in 2018. This whitepaper provides practical insight to help companies evaluate the impact of adopting IFRS 9 and assist them with evaluating whether early adopting the standard is a wise decision.
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FIs Investing in Municipal Bonds: What to look for
Chatham Financial White Papers – April 2017
Municipal bonds (“Munis”) can be an important asset class to hold in a FI’s investment portfolio, offering lower taxable income and higher tax equivalent yields (“TEY”) (often times more than 50bps) than similarly rated investment alternatives. However, additional risks lie within municipal bonds that may not immediately be apparent; risks which require more work on the FI’s part to understand and neutralize before investing in the enticing higher yields. Specifically, these risks include liquidity, credit risk and surveillance work, FI cost of funding, and potential political implications such as tax law changes. We will discuss how we at Chatham Investment Advisors analyze these risks, how to mitigate them, and how we work with FIs to provide the expertise and manpower to offset some of the risks and resources needed for municipal bond investment.
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Quantifying Currency Basis and Applying Hedge Accounting for Cross Currency Swaps under IFRS 9
Chatham Financial White Papers – February 2017
Cross currency (xccy) swaps are financial instruments often used by multinational companies to manage various combinations of currency risks and interest rate risks faced by their global businesses. A xccy swap most typically would be used to hedge fixed or floating rate debt issued in a foreign currency, as it involves the exchange of principal and interest payments in one currency for principal and interest payments of another currency. Economically, xccy swaps synthetically convert foreign debt to local debt, which can be beneficial when borrowing in foreign capital markets is more attractive than issuing local debt. Xccy swaps can also help mitigate mismatches between revenues and debt obligations by allowing the debt obligations to be serviced in the same currency as revenue receipts.
Xccy swaps exhibit substantial volatility in their fair values as a result of changes in spot FX rates and interest rate differentials of the different currencies during their terms. A less well-known contributor to this volatility is the “cross currency basis” or simply “currency basis,” which is a premium charged by market participants for funding in one currency relative to another currency over a period of time. Given that xccy swaps are classified as “derivatives” under IFRS, they must be measured at fair value and recorded on the balance sheet with changes in their fair values potentially being recorded in P&L. Fortunately, companies applying IFRS can elect to apply hedge accounting under IAS 39 – Financial Instruments: Recognition and Measurement for qualifying xccy swaps, which matches gains and losses on the derivative with the gains and losses of the exposures being hedged (i.e. the underlying debt), thereby minimising the potential P&L volatility from xccy swaps.
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The State of Financial Risk Management: Benchmark Report
October 31, 2016
Chatham Financial compiled a quantitative analysis looking at the 2015 financial risk management practices of more than 1,500 publicly listed corporations in the U.S. The result of this research is a quantitative benchmarking report on The State of Financial Risk Management, delving into how these companies address interest rate, currency, and commodity hedging and hedge accounting.
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The objective of the study was to review, analyze, and identify insights about the financial exposures and risk management practices of corporations in the United States. This study was conducted using the US Securities and Exchange Commission Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database. Data was gathered through individual review of more than 1,850 US public company annual 10-K financial statement filings.
Companies included in the study were those based in the US, publicly held, and with annual revenues between $500 million and $20 billion. Due to the study’s intent to understand common financial risk management practices, certain industries with a specialized financial nature and significant differences from average corporations were omitted. The excluded industries included Banks, Credit Reporting, Financial Services, Insurance, Investment Banking, Investment Services, Investment Trusts, and Property and Casualty Insurance. After filtering by revenue and industry, 1,589 companies were included in this study.
Companies were classified into groupings based on annual revenue, and into sector and sub-sectors using the North American Industry Classification System (NAICS). For analysis purposes, four revenue groupings and ten super sectors and numerous sub-sectors were identified to compare and contrast companies in the data set. The four revenue groupings were $0.5B to $1B, $1B to $2B, $2B to $5B, and $5B to $20B. Approximately one-quarter of the companies fell into each of the four revenue groupings. The ten primary industry sectors, including the number of companies researched, were Construction (33), Education & Health Services (31), Financial Activities (144), Information (111), Leisure & Hospitality (46), Manufacturing (493), Natural Resources & Mining (97), Other Services (9), Professional & Business Services (331), and Trade, Transportation & Utilities (294). For industry specific analysis, the three industry sectors Construction, Education & Health Services, and Other Services were not considered due to limited numbers of companies with exposures.
The most recent 10-K filings were used for the purposes of this research. For the majority of companies analyzed, the filing was for the fiscal year completed at the end of 2015. Each filing was reviewed to determine a number of key variables for each asset class of interest rates, currency, and commodities. Some of the variables included:
1. Exposure by asset class
2. Use of derivatives by asset class
3. Type of currency program utilized: balance sheet and cash flow
4. Application of hedge accounting by asset class
Negative LIBOR Strategy
Chatham Financial White Papers – May 2016
Negative USD LIBOR!?: A Brief Background
It was hard not to imagine Sisyphus’ allegorical rock rolling back down the hill when the topic of negative interest rates in the U.S. went viral in February. This, only a few short weeks after the Fed carefully raised their target range for the policy rate following years at the zero lower bound and simultaneously guided the markets to expect a smooth ride to a cruising altitude of 3% for the funds rate. Those of us who had forecast (or hoped) for the frequency of our use of the terms “inevitable, unprecedented, and unconventional” to decline to their pre-crisis levels were disappointed by a more volatile reality, yet again. But as we lay out the relatively rapid rise, and subsequent rationalization, of the market’s perception of the likelihood for a negative USD LIBOR setting, it seems to this observer that some of the more enduring risk management lessons will stem from our understanding of the market’s reaction to the possibility.
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Common Challenges to Hedging FX Risk
Chatham Financial White Papers – October 2015
Early 2015 ushered in currency volatility and dollar strength unseen in decades. Every day, new headlines of companies negatively impacted by large exchange rate movements greeted readers of financial news. Earnings calls are littered with references to “constant currency” impacts and earnings forecast reductions driven by significant currency movements. With this background, analysts, investors, Board Members and senior management have asked, “What is stopping us from hedging our risk more effectively?” This article will cover three key hurdles that companies face when crafting and maintaining currency hedging programs: Data, Design, and Accounting.
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Volcker Rule: balance sheet hedging and loan-level interest rate hedging
Chatham Financial White Papers – July 2015
Chatham believes that under the Volcker Rule, balance sheet hedging and loan-level interest rate hedging, generally do not constitute proprietary trading and therefore are exempt from the requirement for specific compliance programs. We have documented our conclusion in these white papers:
With the implementation of the Volcker Rule, the question arises as to the impact of the rule on balance sheet risk management (“BSRM”) hedging programs. The Volcker Rule’s proprietary trading ban is a prohibition on certain short-term speculative trading. As explained in this white paper, trades executed in BSRM hedging programs are not executed for purposes prohibited by the Volcker Rule. As a result, BSRM hedging transactions are typically not “proprietary trading” nor should the BSRM programs themselves be required to implement a compliance regime.
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With the implementation of the Volcker Rule, the question arises as to the impact of the rule on loan-level hedging programs. The Volcker Rule’s proprietary trading ban is a prohibition on certain short-term speculative trading. As explained in this white paper, trades executed in traditional loan-level hedging programs are not executed for purposes prohibited by the Volcker Rule. As a result, loan-level hedging transactions are typically not “proprietary trading” nor should the loan-level programs themselves be required to implement a compliance regime.
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Hedging Deposits to Reduce Liability Sensitivity
A Chatham Financial White Paper – April 2015
Chatham has long espoused POLAR (the Path Of Least Accounting Resistance) when it comes to balance sheet risk management. There is a bias towards simplicity and operating in the cash flow hedge accounting model whenever possible, in order to minimize or even eliminate hedge ineffectiveness and P&L volatility. For a liability sensitive FI, reducing asset duration or extending liability duration, or both, can have the desired impact on the FI’s interest rate risk position. Once a financial institution decides it will use derivatives to make these adjustments, the question of what to hedge takes center stage.
This white paper focuses on increasing liability duration (and thus reducing liability sensitivity) by hedging deposit accounts. Of course we apply our POLAR methodology to determine the simplest and most effective economic and accounting solution.
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The Hidden Costs of Non-Zero Interest Rate Floors in European Variable-Rate Debt Facilities
Floors above zero percent in leveraged finance transactions are not nearly as prevalent in Europe as they have been in the USA, but they have featured in an increasing proportion of European deals in recent years. The rationale for a floor is simple enough: when absolute levels of interest rates are depressed, it provides a targeted minimum yield for lenders without increasing the loan margin.
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In practical terms, however, floors impose two sets of burdens on the borrower:
1. Direct and indirect increases to interest expense, with the latter resulting from the time value inherent to options.
2. Considerable accounting complexity for the debt and any interest rate hedging under IFRS.
The goal of this paper is to explain the effects of these floors and conclude with a few examples of perhaps more efficient and less burdensome alternate means to satisfy the rationale for non-zero floors in variable-rate facilities. Although borrowers would certainly welcome a reversal of the trend altogether, a few subtle changes to the current market practice for floors could result in a more equitable outcome for all parties.
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