Hypothetical Derivatives and Currency Basis

Since FAS 133 was introduced nearly a decade ago and IAS 39 was introduced over five years ago, we continue to see differing interpretations of these standards being applied in the marketplace.  A good example of this is the application of currency basis on Cross Currency Interest Rate Swaps (“CCIRS”) for effectiveness testing.

Raising funds in offshore currencies is becoming an increasingly popular funding strategy as companies seek a lower cost of funds. In particular, for companies based outside the US, it also opens up access to markets with greater liquidity. The trade off with this approach is that it brings additional currency risk in terms of coupon and principal repayments denominated in foreign currency. Companies often manage this risk by utilising CCIRS to convert the offshore cash flows into their functional currency.

When banks price up these CCIRS in the market, they incorporate a component called “currency basis” on the non-USD legs of the trade. Currency basis is the charge above the risk-free rate in the foreign country to compensate the counterparty for country risk. Currency basis is sensitive to each country’s relative sovereign rating and, as such, had become a lot more significant and volatile during the financial crisis.

Given this, when valuing a CCIRS, it is essential to include current market currency basis. However, we are seeing a difference in interpretation with regards to currency basis and the valuation of hypothetical CCIRS in cash flow hedges – specifically when being used in retrospective effectiveness testing required under IAS 39 and FAS 133.

Looking at the two arguments provides insight into the difference of opinion. The argument for currency basis to be included is influenced from the definition that a hypothetical derivative is a perfect hedge of the hedged item. If the hedge includes currency basis and the hypothetical derivative being the perfect derivative, then the currency basis should be applied to the hypothetical CCIRS.

The argument against the inclusion of currency basis is based off the interpretation that the hypothetical derivative is the best estimate of the hedged item. The hedged item does not include currency basis when it is valued, therefore the hypothetical CCIRS should also not include currency basis when valued. Naturally this approach is generally less desirable from a corporate point of view as it will lead to hedge ineffectiveness.

Historically the currency basis valuation component has generally been seen as immaterial, but in recent times currency basis have widened significantly and the impact has greatly influenced CCIRS valuations, becoming material in some instances. This materiality has seen some audit teams revisit their interpretation regarding this hedge scenario. For those using the dollar offset effectiveness testing methodology, this could produce enough ineffectiveness to fail the 80 to 125% criteria. This represents one more reason for companies to migrate to a regression-based methodology for even, ‘perfectly-matched’ hedge relationships.

1 Comment

  1. JAMES MCHARDY on April 27, 2010 at 12:38 am

    SO WHAT % OF THE AUDITOR COMMUNITY GLOBALLY ARE YOU SEEING IN THE INCLUSION/EXCLUSION CAMPS?
    ARE THERE INCONSISTENCIES ACROSS FIRMS IN DIFFERENT PARTS OF THE WORLD?