Improving Hedge Effectiveness Levels using Clean Price Valuation

Improving Hedge Effectiveness Levels using Clean Price Valuation Shrenuj Parekh June 6, 2018 Abstract

The research demonstrates on how the use of clean price valuation as against dirty price valuation for retrospective hedge effectiveness testing can significantly improve Hedge Effectiveness levels and reduce Profit-loss statement statement volatilities.

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Contents 1

Introd Introduct uction ion

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1.1 Hedge Hedge Accoun Accountin tingg . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Types Types of Hedg Hedgee . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3 Hedge Hedge effecti effective venes nesss . . . . . . . . . . . . . . . . . . . . . . . . . .

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Use of Clean Prices Prices for for Hedge Effectiv Effectivenes eness s testing testing

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Concl Conclusi usion on

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1 1.1 1.1

Intr Introdu oduct ctio ion n Hedge Hedge Acco Accoun unti ting ng

Entit Entities ies are exposed exposed to financi financial al risks risks arisin arisingg from from many many aspects aspects of their their business. business. Different Different companies companies are concerned about different different risks (commodit (commodity y price price risk, inter interest est rate risk, risk, etc). etc). The objectiv objectivee of hedge hedge accoun accountin tingg is to represent, in the financial statements, the effect of risk management activities that that use financi financial al instrum instrumen ents ts to manage manage exposur exposures es arisin arisingg from from partic particula ularr risks risks that that could could affe affect ct profit profit or loss loss (P&L) (P&L) or other other com compre prehen hensiv sivee income income (OCI). Hedge Accounting aims at providing an offset to the Mark-to-Market movement of derivative financial instruments in the Profit and loss statement. This This reduce reducess Profit Profit and loss statem statemen entt volat volatilit ilities ies.. Hedge Hedge Accoun Accountin tingg is optional under IFRS 9, Ind AS 9.

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Types ypes of Hedg Hedge e

Cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with all or a component of a recognized asset or liability or a highly probable forecast transaction, and could affect profit profit or loss. Fair value value hedge is a hedge of the exposure exposure to changes changes in fair value of a recognized asset or liability or unrecognized firm commitment, or a component of any such item, that is attributable to a particular risk and could affect profit or loss.This loss.This article article pertains pertains to Fair Value Value Hedges. Hedges.

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Hedge Hedge effecti effective venes nesss

Hedge effectiveness is defined as the extent to which changes in the fair value or cash flows of the hedging instrument offset changes in the fair value or cash flows of the hedged item. A prospective prospective effectiveness effectiveness test is a forward-looking forward-looking test of whether a hedging relationship is expected to be highly effective in future periods. A retrospective effectiveness test is a backward-looking test of whether a hedging relationship relationship has actually actually been highly effective effective in a past period. Any ineffective portion of the hedge shall be recognized in profit or loss.

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Use of Clean Use Clean Price Pricess for for Hedg Hedge e Effec Effecti tiv venes enesss testing

The com commo mon n methodo methodolog logies ies for retros retrospect pectiv ivee Hedge Hedge Effecti Effective venes nesss are the Dollar Dollar Offset Offset method, method, Regres Regressio sion n method method & Varianc ariancee Reduct Reduction ion method. method. Thes Thesee meth methods ods invo involv lvee a comp compar aris ison on of the the Fair air Value aluess of the the Hedg Hedged ed instrumen instrument, t, i.e. the underlying, underlying, and the hedging hedging instrumen instrument.The t.The Valuatio Valuation n of the instruments may be at clean or dirty price. The clean price is the price of an instrument excluding any interest that has accrued since issue or the most recent coupon payment. Clean Clean P rice rice = Dirty Price − Accrued Accrued Interest

Let Let us stud study y the the impa impact ct of usin usingg clean clean pric pricee & dirt dirty y pric pricee on Hedg Hedgee effectiveness using deals of various tenors. Exampl Example e 1: 2 12 Years Deal

Parti articu cula lars rs

Hedg Hedged ed Item Item-U -Und nder erly lyin ingg

Hedg Hedgin ingg Inst Instru rume men nt

Instrument Cou Coupon pon

Fixed Rate Bond Pay Fixe Fixed d Rat Rate 1.25% .25%

Coupon Frequency Notional Amount Credit spread Tenor Start End Price at settlement

Semi Annual $ 100 Mio Nil 2 12 Years 03-Dec-2015 01-Jun-2018 100

Interest Rate Swap Rece Receiv ivee Fixe Fixed d Rat Rate 1.25 1.25% % Pay 6 Month Libor Semi Annual $ 100 Mio Nil 2 12 Years 03-Dec-2015 01-Jun-2018 0

Example Example 2: 3 Years Years Deal




Instrument Cou Coupon pon

Fixed Rate Bond Pay Fixe Fixed d Rat Rate 1.33% .33%


Semi Annual $ 100 Mio Nil 3 Years 03-Jun-2015 01-Jun-2018 100

Interest Rate Swap Rece Receiv ivee Fixe Fixed d Rat Rate 1.33 1.33% % Pay 6 Month Libor Semi Annual $ 100 Mio Nil 3 Years 03-Jun-2015 01-Jun-2018 0

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Exampl Example e 3: 3 12 Years Deal




Instrument Coupon pon

Fixed Rate Bond Pay Fixed Rate 1.4%


Semi Annual $ 100 Mio Nil 1 3 2 Years 03-Dec-2014 01-Jun-2018 100

Interest Rate Swap Receive Fixed Rate 1.4% .4% Pay 6 Month Libor Semi Annual $ 100 Mio Nil 1 3 2 Years 03-Dec-2014 01-Jun-2018 0

Example Example 4: 5 Years Years Deal




Instrument Coupon pon

Fixed Rate Bond Pay Fixed Rate 1.3%


Semi Annual $ 100 Mio Nil 5 Years 03-Jun-2013 01-Jun-2018 100

Interest Rate Swap Receive Fixed Rate 1.3% .3% Pay 6 Month Libor Semi Annual $ 100 Mio Nil 5 Years 03-Jun-2013 01-Jun-2018 0

We shall calculate Hedge Effectiveness the using the Variability reduction method. method. Under Under this this methodo methodolog logy y, Effecti Effective venes nesss is calcul calculate ated d as follows follows : 1(sum of the squared changes of the portfolio)/ (sum of the squared changes of the underlying). The Charts in the following page depict the cumulative change in the pricing of the underlying and the hedging instrument over the period of the deal.

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Deal Deal Tenor enor 1 Example 1 - 2 2 Years Deal Example 2 - 3 Years Deal Example 3 - 3 12 Years Deal Example 4 - 5 Years Deal

Hedge Effectiveness Dirt Dirty y Pric Pricee Valua aluati tion on Clea Clean n Pric Pricee Valua aluati tion on 16.71% 98.47% 70.00% 98.70% 80.28% 99.38% 82.66% 99.65%

The effectiveness percentage is significantly higher when we adopt the clean price approach.In Dirty price valuation, the mismatch in cumulative change in Fair Value of the instuments increases as we move farther from the nearest interest interest reset date and reduces significantly significantly on the reset date. The difference difference is on account account of accrue accrued d inter interest est.. Prima Prima facie it ma may y seem seem that that the interes interestt accrued element in the fixed side of the Underlying is causing a mismatch. However, the ‘pay fixed’ side of the underlying has an equal and opposite effect in the ‘receive ‘receive fixed’ side of the hedging instumen instument. t. It is the accrued accrued interest interest on the variable leg of the hedging instrument which does not have any offsetting component in the underlying which causes the mountain-like slopes. This leads to an incongruent/blunt comparison of fair values. To mitigate the above, it is recommended to use clean prices for comparison of Fair Fair values values since: 1) It would would lead to a more meaningful meaningful comparison comparison 2) The intention of the hedge is to mitigate future risky price changes. In absence absence of detailed detailed regulatory regulatory guidance regarding retrospective retrospective hedge effectiveness testing methodologies, entities may decide to formulate & adopt an internal risk Management policy which documents the use of Clean Price valuation in retrospective hedge effectiveness testing methodologies. The Dirty price valuation relatively yields higher effectiveness percentage when the deal tenor is long as compared to when it is short. This is because the ratio of interest accrued to the total valuation of the instrument is less when the residual tenor is more and hence the % mismatch on account of accrued interest 7

is less. While calculating Hedge Effectiveness percentage in the above examples, day day on day day chang hangee in Fair air Valua aluati tion on was used used for for rec reckonin oningg Hedg Hedgee effec effecti tive vene ness ss lev levels. els. Inst Instea ead d of taki taking ng daily daily valua aluati tion ons, s, if we redu reduce ce the the frequency of data points, hedge effectiveness levels shall increase. For example, if we tak take semi semi-a -ann nnua uall data data poin points, ts, hedg hedgee effec effecti tive vene ness ss shal shalll incr increa ease se signifi significan cantly tly since since inter interest est accrue accrued d would would be nil in semi-a semi-ann nnual ual data data points points since since our inter interest est reset freque frequency ncy is also also semi-a semi-ann nnual ual.. Ho Howe weve ver, r, this this would would cause an insufficienc insufficiency y of data points for Variability ariability reduction reduction method method since the deal tenor is only 5 years. years. The Variabili Variability ty reduction reduction method requires requires at least 40-60 data point p ointss for an appropriat appropriatee comparison. comparison. With Libor rates increasing since 2016, the interest accrued element in the floating leg of swap is also on the rise, thereby increasing the mismatch in the Fair value comparison of the Underlying & the hedging Swap. Higher the Libor rates, greater is the mismatch in the Fair valuation comparison under dirty price valuation. Severa Severall financi financial al instit instituti utions ons use the dirty dirty price price of an instru instrumen mentt for calc calcul ulat atin ingg Hedg Hedgee effec effecti tive vene ness ss.. Deal Dealss invo involv lving ing 6 Mo Mont nth h Libor Libor as the the benchmark typically have a longer tenor. The difference in Hedge Effectiveness levels levels using using Dirty Dirty & Clean Clean price price valuati aluation on is less less for deals havin havingg longer longer teno tenors rs.. This This is one one of the the reas reason onss why why inst instit itut utio ions ns neve neverr felt felt the the need need to explor exploree clean clean price price valuati aluation. on. Ho Howe weve ver, r, with with the value value of Hedging Hedging Book Bookss running in Billions, even a small % change in Hedge effectiveness can have a significan significantt impact impact on the Profit & Loss statement. statement.

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Conc Conclu lusi sion on

Use of Clean Clean price price valuati aluation on for retros retrospect pectiv ivee hedge hedge effecti effective venes nesss testin testingg is meanin mea ningfu gful, l, shall shall result result in higher higher hedge hedge effecti effective venes nesss and reduce reduce Profit Profit and loss statement volatilities.

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Improving Hedge Effectiveness Levels using Clean Price Valuation

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