Since the financial crisis, many organisations have experienced significant P&L volatility on their cross currency interest rate swaps through movements in currency basis. This is in spite of the hedges being perfectly matched to the underlying exposure and the application of best case hedge accounting techniques. Recently, a new technique for applying hedge accounting to these instruments has emerged which has significantly reduced the ineffectiveness flowing through to the bottom line.
As companies seek out cheap funding in the US, we are also seeing more cross currency swaps being dealt to lock in the currency and at times interest rate risk. In instances where an organisation looks to swap to floating rates locally, the accounting has been problematic because the principal and benchmark elements must be represented in a Fair Value hedge, not a Cash Flow hedge. In a Fair Value hedge relationship, the hedging instrument (cross currency swap) must be valued with currency basis applied whereas the hedged item (US denominated debt) does not – any movement in currency basis therefore causes P&L volatility.
In the days before the GFC, currency basis represented a small element of a valuation with little volatility. Post crisis, we have seen significant swings in currency basis by over 50 basis points or more at times which can cause havoc to a treasurer’s P&L on what is ‘suppose’ to be a perfect hedge. This has caused frustration for many corporations who know that economically they are hedged yet their financial statements do not reflect it.
Some auditors and advisors are now working with their clients to create a new way of designating hedge relationships that better reflect the economic hedging reality. In this manner of designation, all of the movements in currency basis are effectively maintained within Other Comprehensive Income. The only impact to P&L may be a small amount of ineffectiveness arising on the first coupon of the swap’s floating leg – a much better result for corporate.
Why the change of heart? Clearly the recent volatility has made this a higher priority for treasurers and CFO’s and they have encouraged their stakeholders to consider alternative approaches here. However, I think there is also an emerging pragmatic trend in hedge accounting under IFRS. More and more, auditors are looking to align the accounting results with the economic hedging situation and each company’s risk management policy. We see this now at the highest levels, where the IASB’s tentative decisions around IFRS 9 include aligning hedge accounting outcomes consistent with your risk management policy.
This is all good news for those who have suffered the whims of currency basis through their profit and loss. On a bigger scale, it is also very encouraging development for other aspects around hedge accounting, particularly when we get our first look at Phase 3 of IFRS 9 – for many, it can’t come soon enough.