Challenges in the regulatory environment

Challenges in the regulatory environment

The continually changing regulatory environment challenges companies to comply and receive approval from the auditor. Here are several examples of how the Zanders Valuation Desk can support your compliance efforts with the valuation of financial instruments and hedge accounting.

The regulatory changes relating to valuation and hedge accounting are:

  • IFRS 13, which requires Credit Value Adjustment (CVA) and Debit Value Adjustment (DVA) on fair value. This has changed hedge accounting effectiveness testing. As CVA and DVA give rise to another source of ineffectiveness, most of our clients have moved from a dollar-offset method to a more complex regression test to tackle this source of ineffectiveness.
  • A general consensus exists on the CVA and DVA calculation for interest rate derivatives, but require more off-the-shelf solutions for other types of derivatives.
  • IFRS 9 is coming soon and will require hedge accounting to be considered from a different angle.

The different cases below highlight some of the challenges faced by our clients in complying with IFRS and obtaining the necessary approval from auditors.

Case 1: Are my hedge relations optimal and is my CVA-DVA material? One of our clients has hedging activities for its foreign currency exposure. This risk is hedged with FX forwards which are included in cash-flow hedge relationships.

The client faced two main challenges. The first one was to create the optimal hedge relations regarding the FX exposure. The second challenge was to have a quantitative proof on the non-materiality of the CVA-DVA for the FX forwards. We set up the optimal time bucket exposures, which allowed the client to optimize the effectiveness of its hedge relationships and therefore reduced its P&L volatility in compliance with IAS 39. A quantitative assessment on the non-materiality of the CVA-DVA for FX forwards in compliance with IFRS 13 has been done, providing the client with strong arguments in the discussion with its auditors.

Case 2: How to compute CVA and DVA in compliance with IFRS 13 on commodity swaps?

A client who has commodity swaps with different non-financial counterparties faced challenges to quantify the CVA and DVA. The main challenge for the client was the availability of market data to compute the probabilities of default (PDs) as these counterparties do not have CDS-quotes nor public ratings. In collaboration with the client we have defined a clearly documented set-up on how to define the proxies for different PDs. This enabled our client to have an approval of its auditors on the methodology and market values including CVA-DVA in compliance with IFRS 13.

Case 3: Is the price of the derivatives from the counterparty market conform?

The counterparty of one of our clients proposed to hedge the client’s FX exposure with FX instruments, including complex ‘optionalities’. However, the client didn’t have a good understanding of the product and the price proposed by the counterparty. With the report that we provided, the client had a clear explanation of the mechanisms of the derivative and the different parameters (quantifiable and unquantifiable) impacting the price. A sensitivity analysis on the parameters was included to provide a clear view on the hedge results. The client was therefore able to make an informed decision on the use of these derivatives.

Case 4: How to compute the fair value of mortgages?

Mortgages in the Netherlands have a limited second market, making it difficult to value them. Therefore, models have to be used in order to discount the future cash flows of the individual mortgages. There are several challenges regarding the curve(s) to be used to discount the cash flows. Should the curve be based on current offer rates from a specific lender, a combination of them or based on a swap curve? How should the credit worthiness of the borrower be included in the valuation, via for example a tranching model or via fixed spreads? Can the materialized costs of the lender be isolated and excluded from the spreads? We validate and calculate the fair value of mortgages on a regular basis and follow the development on this active market closely. This enables our clients to have market values in compliance with IFRS and approved by the auditors.

What is new in IFRS 9 for hedge accounting?

The new standard from the IASB issued in 2014 aims to better link risk management activities with accounting. Some of the major changes in IFRS 9 are:

  • The old ‘80%-125%’ threshold has been eliminated. Under the new standard a hedging relationship must meet the following three criteria:
    1. An economic relationship exists between the hedged item and the hedging instrument.
    2. The effect of credit risk does not dominate the fair value changes.
    3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge.
  • Increased eligibility of hedged items, for example risk components of non-financial items (such as crude oil, grains or base metals) if the risk component is separately identifiable and measurable;
  • A combination of a non-derivative and a derivative can now be combined as an aggregated exposure, provided that the exposure is managed as one exposure;
  • A group of hedged items and net positions (if meeting certain conditions) can be an eligible hedged item
  • Increased eligibility of hedging instruments
  • Voluntary discontinuation is no longer permitted
  • Dynamic hedge documentation
  • Concept of rebalancing

We can help you to review and assess your current situation (e.g. risks, hedged items, hedging instruments, documentation, valuation, tests and system support), to identify the impacts and the opportunities of the new standard and help you to implement the changes and the new possibilities.

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Independent, high quality, market practice and accounting standard proof are the main drivers of our Valuation Desk. For example, we ensure a high quality and professionalism with a strict, complete and automated check on the market data from our market data provider on a daily basis. Furthermore, we have increased our independence by implementing the F3 solution from FINCAD in our current valuation models. This permits us to value a larger range of financial instruments with a high level of quality, accuracy and wider complexity.