WHAT IS PRAG? Accounting for Derivatives in Pension Schemes

Transcription

1 WHAT IS PRAG? Accounting for Derivatives in Pension Schemes Pensions Research Accountants Group (PRAG) is an independent research and discussion group for the development and exchange of ideas in the pensions field. The membership of the Group comprises accountants and managers of pension schemes, together with practitioners in the actuarial, accountancy, legal and pensions consultancy What is PRAG? professions. It therefore represents a wide cross-section of pensions expertise. Pensions Research Accountants Group (PRAG) is an independent research and discussion group for the development and exchange of ideas in the pensions field. The membership of The the Group main activity comprises of accountants the group is and to managers produce of publications pension schemes, on various together pension with topics. These practitioners publications in the actuarial, are concentrated accountancy, legal mainly and pensions in the area consultancy of financial professions. reporting It and accounting therefore represents for pension a wide cross-section schemes, but of pensions it has also expertise. produced reports on a wide range of topics concerned with pension scheme finance. The main activity of the Group is to produce publications on various pension topics. These publications are concentrated mainly in the area of financial reporting and accounting for The publications are prepared by working parties, which are established for the pension schemes, but it has also produced reports on a wide range of topics concerned with specific pension scheme purpose. finance. Due to this method of operation, the contents of PRAG s publications do not necessarily reflect the views of the membership as a whole or of the The Executive publications Committee. are prepared by working parties, which are established for the specific purpose. Due to this method of operation, the contents of PRAG s publications do not Anecessarily detailed reflect list of the publications views of the membership issued by as PRAG a whole together or of the with Executive membership Committee. information is included on the PRAG website, A detailed list of publications issued by PRAG together with membership information is included on the PRAG website, This guidance is intended to be a broad practical overview of this subject and should not be used as a substitute for specific specialist advice. No responsibility or liability can be accepted by PRAG or by any member of any working party or committee of PRAG for any loss incurred by any person whomsoever as a result of anything contained in or omitted from this publication or arising from any action taken or refrained from on the basis of this publication. ISBN: Pensions Research Accountants Group 2007

2 )25(:25' In recent years the use of derivatives by pension schemes has increased significantly. This has been driven by several factors including: The increase in matching investment assets against actuarial liabilities; Increasing use of derivatives for efficient portfolio management purposes; Increasingly diverse and innovative derivative products available in the market; and Increasing understanding and acceptance of derivatives as pension scheme investments by pension scheme trustees. These developments mean that more than ever before pension scheme accountants need to understand the key aspects of derivatives and how to account for them. PRAG recognises this need and this guidance is designed to provide practical assistance to pension scheme accountants in understanding derivatives; maintaining accounting records for derivative contracts; reporting them in financial statements; and exercising key controls over them. This guidance replaces the previous PRAG publication Pension Fund Investments: Futures and Options. The Statement of Recommended Practice (SORP) has recently been updated and one of the key changes was to remove the requirement for presenting derivatives in the net asset statement using the economic exposure method. This brings pension schemes into line with the rest of the investment management industry and ensures consistency with the approach adopted by the Investment Managers Association. This guidance is consistent with the updated SORP. PRAG intends to issue a discussion paper on the disclosure requirements of FRS 29: Financial Instruments Disclosure. This guidance recommends certain disclosures for derivative instruments but this is not intended to be FRS 29 compliant. When implementation of FRS 29 for pension schemes is agreed this guidance will require revision. This guidance focuses on the core types of derivative used today by pension schemes, namely futures; options; swaps and forward foreign exchange contracts. The derivatives market is highly dynamic and innovative and new products or variations of existing products are continuously being introduced. Because of this it is inevitable that not all derivative products used by pension schemes will be covered by this guidance. We have however sought to make it as relevant as possible and to give it the maximum possible shelf life by focussing on key accounting principles backed up by limited detail. One thing became clear to us whilst drawing up this guidance: in today s world of complex financial instruments pension scheme accountants need to make sure they have a clear and comprehensive understanding of the nature of the derivative instrument their scheme uses and the nature and timing of the cash flows arising. This knowledge is key to achieving correct accounting for derivatives. We would like to thank the many contributors to this guidance, in particular from the working party, for their input and support. Kevin Clark Chairman Derivatives Working Party July

3 7$%/(2)&217( Introduction 3 2. Derivative contracts background characteristics 6 3. Accounting lifecycles of typical contracts Financial reporting Risk Control considerations 27 Appendices 1. Bibliography Glossary of terms Index options accounting worked example Futures accounting worked example Interest rate swap contract accounting worked example Forward foreign exchange contract accounting worked example Pricing 58 2

4 ,QWURGXFWLRQ 6FRSHRIWKLVJXLGDQFH A derivative is a financial contract between two parties whose value is derived from an underlying asset s price or an index based on asset prices. There are many different types of derivative contracts and the market is constantly developing and evolving. This guidance focuses on four main types of derivative contracts commonly used by pension schemes today. These are defined by the revised SORP as: ³2SWLRQV are contracts that give the purchaser the right, but not the obligation, to buy (call option) or sell (put option), from/to the seller of the option, a specified quantity of a particular product at a specified price. Conversely, options which are written give the seller the obligation to buy or sell a specified quantity of a particular product at a specified price, should the buyer decide to exercise that option. Options can be exchange traded or over the counter. The cost of the option is known as the premium. The price of the underlying security at which the option can be exercised is known as the strike price. )XWXUHVcontracts are exchange traded contracts to sell or buy a standard quantity of a specific asset at a pre-determined future date now. There are many types of futures contracts including equity, bond and interest rate futures. 6ZDSV are over the counter contracts where the parties to the contract agree to exchange cash flows, the amount of which is determined by reference to an underlying asset, index, instrument or notional amount. An interest rate swap, for example, is an exchange of interest rates on a specified amount of notional capital. One party pays to the other a fixed rate of interest on the notional capital amount and receives in return the floating rate of interest on the same notional amount (fixed leg for floating leg ). )RUZDUGIRUHLJQH[FKDQJHFRQWUDFWV are contracts whereby two parties agree to exchange currencies on a specified future date at an agreed rate of exchange. Forward foreign exchange contracts are over the counter so the size of the deal, the settlement date, and price, are all negotiable between the two counterparties. [2.126] The derivatives market is constantly evolving and the willingness of trustees to use derivatives is increasing. It is therefore very likely that whilst pension schemes will be using derivatives included in the above they could also be using new derivative products not covered by this guidance. It is therefore important for pension scheme accountants to thoroughly understand the nature of derivative instruments used by their scheme and the related cash flows in order to correctly interpret and apply this guidance to their circumstances. ([FKDQJH7UDGHGDQG2YHUWKH&RXQWHUGHULYDWLYHV A key differential between derivative contracts is whether they are Exchange Traded (ET) or Over the Counter (OTC). ET derivatives are traded on an exchange, where the exchange acts as a middleman between counterparties. This type of market is typically characterised by daily mark-tomarket pricing and margining whereby parties settle gains and losses from pre-established margin accounts which effectively eliminates counterparty risk. It also provides a highly 3

5 liquid market with market prices. Typical ET derivative contracts are futures and certain types of options. 1.5 OTC derivatives are contracts entered into between two parties on terms that are potentially unique to the particular contract. There is no central exchange and no quoted prices. Contract terms are normally set out on term sheets. To minimise credit risk OTC derivatives often have associated collateral arrangements. Typical OTC derivative contracts are swaps, options and forward foreign exchange (FX). Accounting standards and the SORP 1.6 Derivatives fall under the definition of financial instruments in FRS 26 Financial Instruments: Measurement: any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity Financial assets = cash, equities, contractual rights to receive cash or another financial asset ie bonds, derivatives etc 1.7 Under FRS 26 and the revised SORP issued in May 2007 [2.137] derivatives are required to be reported at fair value at the reporting date. This will be the bid price for asset positions and the offer price for liability positions. Where there is no bid/offer spread available, the mid, single price will be used. This arises where valuation models are used to value derivative contracts. FRS 26 and its related standards do not recognise the economic exposure method of presentation recommended for derivatives by the previous SORP. Accordingly, this guidance illustrates how fair value reporting applies to derivatives as recommended by the revised SORP and does not illustrate economic exposure accounting. 1.8 FRS 29 Financial Instruments: Disclosure requires significant qualitative and quantitative disclosures of risks associated with financial instruments. PRAG is currently consulting on how this standard should be interpreted and applied to pension schemes and therefore this guidance does not seek to make recommendations for risk disclosures in accordance with FRS 29. However, as an interim measure, it does recommend minimum disclosures about the derivative contracts to allow the reader of the financial statements to understand their key features. Investment regulations 1.9 The 2006 Pension Scheme Investment Regulations set out certain statutory requirements for trustees to use derivatives. These are: The assets of a pension scheme must consist predominantly of investments admitted to trading on regulated markets and investments in assets which are not admitted to trading on such markets must be kept to a prudent level; Investments in derivative instruments may only be made if they contribute to a reduction of risks or facilitate efficient portfolio management (including reduction of the cost of generation of additional capital or income with an acceptable level of risk); and Investments in derivatives must be made and managed so as to avoid excessive risk exposure to a single counterparty. 4

6 Use of derivatives by trustees 1.10 There are a number of circumstances in which trustees will authorise the use of derivative contracts for their pension schemes. The use of derivatives is normally set out in the Statement of Investment Principles and also within the investment manager mandates and should have regard to the above legal requirements. (a) (b) (c) (d) Matching - The trustees may wish to better match their assets with the long term liabilities of the pension fund. They can do this by entering into derivative contracts that change the duration of their bond portfolio; match their pension inflation; and/or match cash flows. Derivatives are often a cheaper more efficient way of modifying a bond portfolio than using the underlying market. In some cases the physical market cannot provide the equivalent opportunities, for example, there are not enough long dated bonds available for all schemes to effectively match the duration of their long term liabilities. Efficient portfolio management - In certain circumstances the trustees may wish to increase or decrease exposure to a particular market or market sector without disturbing the underlying assets. The derivative position can be opened very quickly and replaced later by buying or selling the underlying assets or the position can be closed at any time up to the expiry of the contract. Depending on the contract entered into, delivery of the assets can be taken on the settlement date. Derivatives often provide a cheaper, more efficient way of modifying portfolio risk than buying or selling in the underlying market, eg there are no stamp duty costs involved with derivatives and spreads are smaller. Hedging risk - In certain circumstances the trustees may wish to increase or decrease risk in the portfolio by entering into a derivative position to match assets that are already held by the portfolio without disturbing the underlying assets or to create an asset position without entering into the market. A recent development in risk management through use of derivatives is credit-default swaps. These derivatives are used to increase or decrease the amount of credit risk for a bond or a bond portfolio. Trading - It is possible to enter into derivative positions very frequently with the aim of achieving small profits with little regard to the underlying portfolio. For example, trustees can enter forward FX contracts for alpha rather than hedging currency risk. 5

7 2. Derivative contracts background characteristics 2.1 This section provides a brief description of the main characteristics of each of the types of derivative contract covered by this guidance. Options 2.2 An option is a legally binding contract between two counterparties that gives the purchaser the right, but not the obligation, to either buy (call) or to sell (put) a standard specified nominal amount of an asset at a specified date (European option) or a specified date range (American option) in the future at a price specified today (strike price). The purchaser pays the seller an immediate non-returnable premium (the price) to secure the option. In return for the premium the seller accepts a contingent obligation to buy or sell the asset at the specified date at the specified price. Options may be ET or OTC. The range of contracts that can be traded OTC is extensive whereas the exchange traded options are limited to those quoted on that exchange. 2.3 Options have two distinct parties: the purchaser referred to as the holder and the seller referred to as the writer. The holder of an option has paid a premium and has a right to exercise the contract if it is to his advantage. The writer of an option has received a premium in exchange for the obligation to meet the terms of the option contract if exercised by the holder. At maturity (or earlier if an American option) the holder can choose to buy or sell the underlying security, whereas the writer is obliged to buy or sell. 2.4 The holder of a put option has the right to sell an underlying security; the put therefore creates a short position a decrease in the exposure to the underlying market. The holder of a call option has the right to buy an underlying security; the call therefore creates a long position an increase in the exposure to the underlying market. 2.5 There is a wide range of assets that can be the underlying security to the option including equities, bonds, currency, commodities, interest rates, indexes and credit risk. In practice anything that can be bought and sold can be subject to an option. (a) Equity options - These are based on individual quoted equities. (b) (c) (d) (e) Bond options - These are based on individual quoted bonds. Currency options - These are based on the exchange rate for a specified pair of currencies. Commodities options - These are based on a range of physical commodities that are traded on commodity exchanges. Index options - These are based on market indexes such as the FTSE. 2.6 For ET options a price is quoted by the exchange for each traded option for a series of expiry dates. For OTC options the price is agreed between the parties at the time of the transaction. There is no quoted price. 2.7 The premium for an ET option is based on the price and is the sum that must be settled in order to take out an option contract. The premium is calculated using a formula and is based on the market price and the expiration date. For OTC options the amount to be paid in order to take out the option contract is set out in the agreement. 6

8 2.8 The premium is expressed as a rate per underlying security, for example a premium of 10p per share of the XYZ Co. for a 1,000 share option would amount to 100. Usually a contract size is specified with say 1,000 shares per contract. Commission is payable on the same basis. 2.9 The strike price or exercise price is the price at which the underlying physical security can be bought or sold and is fixed to suit the requirements of the parties for the duration of the contract. Therefore the holder of a put option is anticipating a fall in the price of the underlying security so that he can sell at the strike price because it is higher than the market price. The holder of a call option is anticipating an increase in the price of the underlying security so that he can buy at the strike price because it is lower than the market price An option will become valueless if the market price is above (for a put option) or below (for a call option) the strike price as the holder of the option can complete the transaction more efficiently by going to the open market. In this situation the option is referred to as being out of the money. Conversely, an option with a value is referred to as being in the money Options can be combined in many ways. A typical combination is a zero cost position where options are bought and sold with the net effect of not requiring a premium to be settled between the counterparties. These arrangements are often accompanied by collateral arrangements to reduce credit risk between the parties Pension schemes may typically use options to give protection against falls in the market value of assets held. Futures 2.13 A future is a legally binding exchange traded contract between two counterparties to buy or to sell a standard specified nominal amount of an asset at a specified settlement date in the future at a price specified today. There is no immediate settlement although collateral may be deposited or received during the life of the contract. A clearing house holds the initial and variation margin deposits and acts as counterparty for the buyer and seller, thereby reducing counterparty risk. Contracts are executed via a broker The use of futures contracts enables the investment manager to increase or decrease the exposure of the assets of the fund without having to buy or sell the equivalent underlying asset. An increase in the exposure to the underlying market is called a long position and conversely a decrease is called a short position Futures are normally traded on recognised exchanges in standardised contracts. The market is therefore well regulated with good liquidity, high volumes and quoted prices Although trades will be executed with a broker the counterparty to the trade will be the clearing house for the exchange. The risk of the trade failing is with the central counterparty not the broker who transacted the business As well as securities futures there are many other types of futures for example: (a) Stock Index Futures - These are based on the index of various exchanges around the world such as the FTSE 100 in the UK or the S&P 500 in the USA or the Nikkei 300 in Japan. 7

9 (b) (c) (d) Interest Rate Futures - These are based on long or short interest rates and will be linked to Government Bonds or Treasury Notes. Currency Futures - These are based on the exchange rate for a specified pair of currencies. Commodities Futures - These are based on a range of physical commodities that are traded on commodity exchanges An essential element of the futures market is the giving and receiving of collateral to reduce credit risk between counterparties. Collateral is usually in the form of cash but can be covered by the deposit of securities. Where existing collateral is not held, an initial margin is paid as a fixed amount when the contract is traded and settled the following working day (T+1); a variation margin is also calculated each close of trading on the market movement and settled the following working day (T+1). The calculation and control of margin accounts is a specialised task and usually handled by clearing agents or custodians. Often, round sums of cash are deposited with these agents to avoid numerous daily movements of cash. The calculation of the initial margin differs from market to market and allowance can be made for offsetting long and short positions to take account of the portfolio positions The valuation of an open futures contract is calculated by multiplying the number of contracts by the movement in the original opening price of the contract and the market price on the valuation date. This is usually the closing exchange price based on fair value principles A typical use of futures is to change schemes exposure to equity markets and facilitate more efficient portfolio management. Swaps 2.21 Swaps used by trustees are typically: (a) (b) (c) Interest rate swaps these involve one party exchanging fixed rate cash flows for another party s floating rate cash flows over a fixed period. Inflation swaps these involve one party exchanging a fixed or variable cash flow for another party s inflation-linked cash flow. Portfolio or cash flow swaps these involve one party exchanging cash flows arising from a portfolio of bonds for a pre-defined series of cash flows tailored to a scheme s cash flow requirements This guidance focuses on interest rate swaps, but the principles described apply equally to inflation and cash flow swaps An interest rate swap is a contract between two parties, over an agreed period, on a common notional principal amount. Typically, one party pays the other a fixed rate of interest on the notional principal, and receives in return a floating rate of interest on the same notional principal There is no exchange for swaps; all swaps are OTC. There is normally no explicit commission paid on swaps. 8

10 2.25 Other types of interest rate swap are possible, such as exchanging one floating rate for a different floating rate, and there are many types of swap other than interest rate swaps The notional principal amount is for calculation of interest only. Unlike futures, no margin is required to enter into a swap contract. At inception the value of the swap will usually be nil and no cash changes hands between the parties until the first payment date. There are some exotic swaps that do not start with a nil value, for example a forward start interest rate swap. In this case there may be interest payments/receipts due on opening the contract Cash flows are exchanged during the life of the contract and are normally netted. Settlements are made at the end of each period, and the floating interest rate resets at the same time. The timing and amount of the cash flows are set out in the terms of the contract. There are no standard terms. Each contract is potentially unique. For some types of swap cash flows may be infrequent resulting in potential credit risk if the swap increases in value. In these circumstances collateral arrangements are normally put in place between the counterparties The floating side of the transaction is usually pegged to a well known measure, eg interest rates, RPI or some other measure. Market conventions have evolved over time for the most common types of swaps in the most common currencies The fixed in exchange for floating type of contract described above is the most common type, but many other types are possible, such as exchanging floating 3 month LIBOR for floating 6 month LIBOR ( floating versus floating ) There are no quoted prices for swap contracts. Their value is the discounted value of net future cash flows based on market expectations of interest rates and other parameters relevant to the swap contract, eg RPI The deposit of acceptable securities as collateral is laid down by each market and a discount to market value is imposed (this is known as the haircut ). If collateral has to be transferred into the name of the clearing organisation the trust deed of the pension fund will have to allow this A scheme may use swaps to change the duration of a bond portfolio giving an improvement in liability matching. Forward foreign exchange contracts 2.33 The forward foreign exchange (FX) market is an OTC market; the size of the deal, the settlement date and the price are all negotiable between the two counterparties and each contract is potentially unique. There is normally no commission payable The main type of FX transaction is a Forward FX transaction this is a deal whereby two parties agree to exchange currencies on a specific future date at an agreed rate of exchange The above transaction can be combined to create many different types of FX derivative arrangements, sometimes used in conjunction with other types of derivative contracts such as interest rate swaps, futures or options FX transactions do not normally involve margin receipts or payments. Settlement normally takes place on a gross basis on the settlement date but settlement terms can allow net settlement for matched contracts. 9

11 2.37 Pension schemes use forward FX contracts for the three main reasons noted below. (a) (b) (c) To settle transactions in foreign currencies - Pension schemes can invest in overseas investments resulting in foreign currency receipts and payments. These tend to be short term contracts. Hedging FX risks - Pension schemes invest in overseas securities and may wish to hedge their foreign exchange risks. These may be risks associated with expected overseas receipts and payments or risks associated with the currency exposures within the investment portfolio. Pension schemes typically use forward foreign exchange contracts to manage and reduce exposure to currency risk. This is sometimes referred to as passive currency management. Alpha programmes - Pension schemes may use FX contracts to earn an investment return. This type of programme is not related to any underlying foreign currency investments and is therefore not hedging any risk. It is intended to make a return in its own right by actively managing the currency exposure. This is sometimes referred to as active currency management There are no quoted prices for the particular FX positions taken out by a pension scheme. The value of these positions must be determined for each contract but these are calculated using published market information on forward FX rates Typically, there are no collateral arrangements relating to FX contracts. 10

12 3. Accounting lifecycles of typical contracts Introduction 3.1 This section describes the typical accounting lifecycle for each of the main types of derivative contract covered by this guidance. It sets out the typical double entry bookkeeping at each of the key stages within the accounting lifecycle. Options 3.2 Options can be purchased or written. This guidance covers both scenarios. A worked example is set out in Appendix The accountancy life cycle for a purchased option is set out below. (a) The purchase of a put or call option will be transacted via a broker. The premium will be calculated and agreed and the contract details confirmed between the counterparties. Dr Option premiums paid Cr Amount due to broker (b) (c) On the following business day (T+1) the amount of premium will be paid in cash to the broker. Dr Amount due to broker Cr Cash at bank The contract will be valued at the reporting date at fair value. This will typically be the current price or premium for that contract. If the contract is out of the money the value will be nil. A purchased option will never have a negative value. Dr/Cr Investments unrealised gain / loss Dr/Cr Change in market value (Fund account) (d) Maturity valueless - if on maturity the option contract is valueless or out of the money the original premium and previously recognised unrealised gains or losses must be written off. Dr Change in market value (Fund account) Cr Option premiums paid Dr/Cr Unrealised gains /losses (e) Maturity in the money cash settlement - If the option contract is valuable (or in the money ) it can be sold for cash at any time before maturity. In a similar manner if the contract is in the money at maturity the cash value of the contract can be taken rather than taking delivery. The sale proceeds will be posted against the premium paid of the option and any previous unrealised gains / losses recognised. 11

13 Dr Amount due from broker Dr/Cr Change in market value (Fund account) Cr Option premium paid Dr/Cr Unrealised gains / losses (Net assets statement) On the following business day (T+1) the amount of the sale proceeds of the option will be paid by the counterparty. Dr Cash at bank Cr Amount due from broker (f) Maturity in the money delivery - If on maturity (exercise date) the option contract is valuable or in the money the contract is exercised by buying or selling the specified number of shares at the strike price. The contract will be confirmed in the normal way and will be subject to stamp duty and commission and entered in the same way as any other stock purchase or sale. The original premium and any previously recognised unrealised gains/losses must be posted to the Fund account and the option contract details removed from the fund s accounts. Dr Change in market value Cr Option premium paid (Fund account) Dr/Cr Unrealised gains / losses 3.4 The accounting lifecycle for written options is set out below. (a) As for the purchase of an option, the sale of a put or call option will be transacted via a broker. The premium will be calculated and agreed and the contract details confirmed. Dr Amount due from broker Cr Option premiums received (b) On the following business day (T+1) the amount of premium will be paid in cash to the scheme. Dr Cash at bank Cr Amount due from broker (c) The value at the reporting date will typically be the current price or premium for that contract. The seller of an option runs the risk of an unlimited liability the amount of which will depend on the exercise of the option by the purchaser. If the current premium is less than the original premium an unrealised gain is recognised. If the current premium is more than the original premium a loss is recognised. Dr/Cr Unrealised gains / losses Dr/Cr Change in market value (Fund account) (d) If on maturity the option contract is valueless or out of the money the original premium plus or minus any previously recognised unrealised gains or losses is the gain to the seller. 12

14 Dr Option premium received Dr/Cr Change in market value (Fund account) Cr Change in market value (Fund account) Dr/Cr Unrealised gains / losses (e) If the option contract is in the money at maturity the seller of the contract has to provide the cash value of the contract or the underlying stocks. The premium received and any previously unrealised gains / losses will be set off against the cost of buy out maturity proceeds of the option. Dr Option premiums received Cr Change in market value (Fund account) Dr/Cr Change in market value (Fund account) Dr Change in market value (Fund account) Dr/Cr Unrealised gains / losses Cr Amount due to broker (cost of buy out/purchase of shares) Futures 3.5 The accounting lifecycle for a futures contract is set out below. A worked example is given in Appendix 4. (a) (b) On opening a futures position there is no initial consideration. Fund managers will however record details of the commitments to open contracts, the initial margin, the variation margin and commission amounts. Initial margin is the number of contracts multiplied by the initial margin required by the market per lot. This amount will be held by the clearing broker until the contracts are closed out. Dr Initial margin at clearing broker Cr Amount due to / from clearing broker (c) Variation margin is the value of the market movement between the opening deal price and that day s closing price multiplied by the number of contracts. Entries to the variation margin account will typically be made on a daily basis reflecting the movement in the market. Cash will only be moved backwards and forwards as required by the clearing agent. Dr/Cr Variation margin at clearing broker Dr/Cr Amount due to / from clearing broker (d) Commission is the agreed rate per contract multiplied by the number of contracts. Normally half the commission will be charged on opening the contracts and half charged on closing. 13

15 Dr Change in market value (Fund account) Cr Amount due to/from clearing broker (e) Margin calls and repayments will be made by the clearing agent as frequently as required and reflect the movement in the contract price and whether the contract is for a long or short position. The account must be reconciled daily with the statement produced by the clearing agent. A debit balance on the clearing broker account represents the amount of surplus margin deposited and a credit balance represents a margin shortfall which will be met by a margin call. (f) The value of an open futures contract is calculated by multiplying the number of contracts by the movement between the opening price of the contract and the market price on the valuation date. The bid price will be used for long positions and the offer price for short positions. This value will typically be close to the amount of the variation margin calculated at mid price and held at the clearing broker. Dr/Cr Unrealised gains / losses Dr/Cr Change in market value (Fund account) (g) The unrealised gain or loss on the futures contract will be fully realised when closed out. When the contract is closed out the initial margin is reversed to bring the initial margin at broker to zero and the total amount of variation margin movements will represent the realised profit or loss on the contracts. The margin balance at the clearing broker is brought to zero. Dr Amount due to/from clearing broker Cr Initial margin at clearing broker Dr/Cr Variation margin Dr/Cr Amount due to/from Clearing broker (h) (i) On maturity previously recognised unrealised gains and losses become realised so there is overall a nil impact on the Fund account. Interest is payable on the balance held by the clearing agent in accordance with the terms of the market and is usually credited to the clearing account monthly. Dr Amount due to/from clearing broker Cr Interest received (Fund account) (j) On the next business day (T+1) the amount of cash to bring the clearing broker account to zero is transferred. This will be made up of initial and variation margin plus any surplus margin held. The balance will also recognise commissions paid and interest received on the account to the extent that previous cash transfers have not already been made. Dr/Cr Amount due to/from clearing broker Dr/Cr Cash at bank 14

16 If there is an ongoing programme of contracts, cash may not be returned/paid on closure but retained by the broker for use as collateral on future contracts. Swaps 3.6 The accounting lifecycle of a swap is set out below. A worked example is given in Appendix 5. (a) At inception the value of a swap is usually nil because the current values of the two legs of the swap are equal and opposite. There is, therefore, no need to make a financial accounting entry at this stage. However, the swap should be recorded in the scheme s investment records. Swaps are normally presented in investment records on two separate lines, one asset and one liability, usually referred to respectively as the long and short positions, which together have zero value. This has the advantage that the two sides of the swap can subsequently be independently revalued. However, the swap is one contract and the cash flows are legally inseparable and, therefore, should be accounted for on a net basis when reporting in the financial statements. Dr Book cost long swap positions Cr Book cost short swap positions The two entries should have an identifier included so that it is clear they relate to the same swap. If the swap is accounted for on a net basis then the book cost is normally zero. (b) During the life of the swap interest is accrued on each side of the contract. This can be done as frequently as is necessary for reporting purposes. The contract terms and market conventions will indicate whether the interest rates are to be applied linearly or continuously compounded. The cash settlement of the interest accruals will also be defined in the swap terms. These amounts can either be treated as gains and losses or as income or expense. The accounting treatment will depend on the purpose of the swap, as defined by the revised SORP: Where the nature of the cash flow is income related such as in the case of an interest rate swap, the net cash flow should be reported as investment income. Where the nature of the cash flow is related to an asset or liability the net cash flow should be reported within change in market value [2.133] In either case the net amounts payable or receivable under the swap are reported as a single item rather than as separate items of expense and income since they arise from one contract. Where the swap is only valued on a dirty basis, the only option is to report the cash flows within change in market value. Dr/Cr Interest expense/income (Fund account) Dr/Cr Cash at bank or Dr/Cr Change in market value (Fund account) Dr/Cr Cash at Bank (c) During the life of the swap, it is revalued as frequently as is necessary for reporting purposes. Both sides of the contract are revalued. If the swap is recorded as two legs the double entry will be: 15

17 Dr/Cr Unrealised gains / losses on short positions Dr/Cr Unrealised gains / losses on long positions Dr/Cr Change in market value (Fund account) Dr/Cr Change in market value (Fund account) If the swap is recorded as a single line the double entry will be: Dr/Cr Unrealised gains / losses on swaps Dr/Cr Change in market value (Fund account) (d) The contract terms will specify the length of time for which the swap will run. At the end of this period the parties will settle any remaining liabilities between themselves and the swap will be removed from their net asset statements. Alternatively the swap may be cancelled at any time by agreement between the parties. At the point of closing out, the outstanding value of the swap and the accrued interest will be settled. Dr/Cr Cash at bank Dr Interest payable Dr Book cost of short positions Dr/Cr Unrealised gains / losses on long positions Cr Interest receivable Cr Book cost of long positions Dr/Cr Unrealised gains / losses on short positions Dr/Cr Change in market value (Fund account) If recorded as a single item, the double entry will be: Dr/Cr Unrealised gains / losses on swaps Dr/Cr Change in market value (Fund account) Dr/Cr Cash at bank Forward Foreign Exchange Contracts 3.7 The accounting lifecycle for forward foreign exchange contracts is set out below. A worked example is given in Appendix 6. 16

18 (a) Forward FX contracts are typically recorded by investment managers showing the two legs of the transaction. For example, a forward FX contract to sell $ for would initially be recorded as receivable and $ payable, i.e. the long and short positions. At inception the two legs have equal value. Dr Currency receivable Cr Currency payable The contract could alternatively be recorded as a single line with nil value. (b) Forward FX contracts have a fair value at dates prior to settlement that is the unrealised profit or loss that would arise if the contract was closed out by entering into an equal and opposite contract at the valuation date. Dr/Cr Change in market value (Fund account) Dr/Cr Currency payable If the contract is recorded as a single line the double entry would be: Dr/Cr Unrealised loss on FX contract Dr/Cr Change in market value (Fund account) (c) (d) (e) Unrealised FX balances at the year end should not be offset unless legal right of offset exists on settlement. Realised and unrealised FX gains and losses would normally be reported within the Fund account within change in market value; however there may be circumstances where it would be more appropriate to report them as investment income, depending on the underlying purpose of the FX contract. FX gains and losses included in the Fund account should be separately disclosed in the financial statements (if material). On close out or maturity of the contract the currencies are either exchanged or settled on a net basis. Dr Cash currency received Cr Cash currency paid Dr/Cr Change in market value (Fund account) Dr Book cost currency payable Cr Book cost currency receivable 17

19 4. Financial Reporting 4.1 This section of the guidance sets out how derivatives should be reported in the financial statements in accordance with the revised SORP issued in May Net Asset Statement 4.2 Derivative contracts should be reported as a separate investment class under financial assets and liabilities in the net asset statement. For example, in the net asset statement derivative contracts would be presented as shown below: Investments 200X 200X Financial Assets Fixed interest securities 500 Equities 500 Pooled Investment Vehicles 100 Derivatives*: Options 10 Futures 50 Swaps 20 Forward Foreign Exchange Cash Deposits: Margin balances 10 Deposits Other financial assets: Amounts due from broker 15 Dividends due Total financial assets 1,250 Financial Liabilities Derivatives*: Options (5) Futures (10) Swaps (5) Forward Foreign Exchange (15) (35) Other financial liabilities Margin balances (10) Amounts due to brokers (20) (30) Total financial liabilities (65) Net financial assets 1,185 * Analysis by major type of investment contract can be provided on the face of the net asset statement if individual types are material or provided in the notes to the financial statements. 18

20 Fund Account 4.3 Gains and losses arising on derivative contracts will normally be reported within Change in market value in the Fund account. The main exceptions to this are: Interest on margin accounts reported within interest receivable in investment income Commissions and other transactions costs reported within investment management costs Accounting policies 4.4 Typical accounting policies for valuation and accounting for derivative contracts are set out below. (a) (b) (c) Options - Options are valued at their mark to market value. If a quoted market price is not available on a recognised exchange the fair value is calculated using pricing models such as Black-Scholes, where inputs are based on market data at the year end date. Futures - Open futures contracts are included in the net asset statement at their fair market value, which is the unrealised profit or loss at the current bid or offer market quoted price of the contract. Amounts due from the broker represent the amounts outstanding in respect of the initial margin (representing collateral on the contracts) and any variation margin which is due to or from the broker. The amounts included in change in market value are the realised gains or losses on closed futures contracts and the unrealised gains or losses on open futures contracts. Swaps - Swaps are revalued monthly. The fair value is calculated using pricing models such as Bloombergs, where inputs are based on market data at the year end date. Interest is accrued monthly on a basis consistent with the terms of each contract. The amounts included in change in market value are the realised gains or losses on closed contracts and the unrealised gains or losses on open contracts. Net receipts or payments on swap contracts are either (a) reported within investment income or (b) reported within change in market value. (d) Foreign Exchange - Forward foreign exchange contracts outstanding at the year end are stated at fair value which is determined as the gain or loss that would arise if the outstanding contract was matched at the year end with an equal and opposite contract.. Investment reconciliation table 4.5 The revised SORP requires major investment classes to be included in the investment reconciliation table, including derivatives. The headings of the investment reconciliation table have been amended to recognise that cash receipts and payments arising under derivatives contracts typically do not represent traditional purchases and sales. This guidance also recommends that derivatives are set out separately in the investment reconciliation table for reasons of clarity and are reconciled on a net basis as opposed to gross as reported in the net asset statement. This is to facilitate the reconciliation. An example investment table prepared in accordance with these recommendations is set out overleaf: 19

21 Investment reconciliation table Brought forward Purchases at cost and derivative payments Sales proceeds and derivative receipts Change in Market Value Carried forward Fixed interest (10) Equities (70) Pooled Investment Vehicles (30) (110) Derivatives: Options 15 5 (10) (5) 5 Futures 45 5 (20) Swaps (5) 10 (5) Forward foreign exchange - - (10) 5 (5) (155) Other financial assets/liabilities: Cash deposits (15) 25 Margin balances (10) 0 Amounts due to/from broker - (5) Dividends due (15) 10 (40) 30 Net financial assets The cash flows relating to derivatives are recognised in the investment table as follows: (a) Options premiums paid and received are reported as payments or receipts in the table together with any close out costs or proceeds arising from early termination. (b) (c) (d) (e) Futures on close out or expiry of the futures contract the variation margin balances held in respect of unrealised gains or losses are recognised as cash receipts or payments in the investment reconciliation table, depending on whether there is a gain or loss. Swaps the payments or receipts under the swap contract are reported in the reconciliation table, together with any close out costs or proceeds arising on early termination. Forward foreign exchange the forward FX trades settled during the period are reported within the table. If trades are settled net, it is acceptable to include the net cash receipt or payment in the reconciliation table. If settled gross, they should be included in the table as gross receipts and payments. Volumes of foreign currency settlements could be very high if settled and reported gross. Collateral receipts and payments that are not beneficially owned by the pension scheme are excluded from the net asset statement and the reconciliation table. However, as defined by the revised SORP: A scheme should disclose the fair value of financial assets that it has pledged as collateral for liabilities or contingent liabilities, the asset type pledged and the terms and conditions relating to the pledge. A scheme should also disclose the fair value of any collateral held, for example under derivative contracts. [2.198] 20

22 Disclosure of derivatives 4.7 The revised SORP requires: the disclosure of the key details of the contracts in place at the year end. This should include the types of contracts, an indication of the period covered by the contracts, the counterparties to the contracts, the nominal value or gross exposures of the contracts, the values of the contracts. an explanation of the objectives and policies for holding derivatives and strategies for achieving those objectives. Derivative contracts should be further analysed between ET and OTC contacts Set out below are suggested disclosure details to meet the revised SORP s requirements. Objectives and policies 4.8 The trustees have authorised the use of derivatives by their investment managers as part of their overall investment strategy for the pension scheme. The main objectives for the use of derivatives and the policies followed during the year are summarised as follows: (a) (b) (c) (d) Options the trustees want to benefit from the potentially greater returns available from investing in equities but wish to minimise the risk of loss of value through adverse equity price movements. During the year the scheme bought a number of equity option contracts that protect it from falls in value in the main markets in which the scheme invests, mainly in the UK and US. Futures the trustees had to hold cash assets towards the end of the year in order to meet the settlement of a bulk transfer out. The trustees did not want this cash to be out of the market and therefore bought index-based futures contracts which had an underlying economic value broadly equivalent to the cash held pending settlement of the bulk transfer. Swaps the trustees aim is to match as far as possible the fixed income portfolio and the scheme s long term liabilities, in particular in relation to their sensitivities to interest rate movements. Due to the lack of available long dated bonds the trustees have entered into interest rate swaps during the year that extend the duration of the fixed income portfolio to better match the long term liabilities of the scheme. Forward foreign exchange the trustees have set the maximum foreign exchange exposure for the investment portfolio at 15% in order to balance the risk of investing in foreign currencies whilst having an obligation to settle benefits in Sterling. In order to maintain appropriate diversification of investments within the portfolio and take advantage of overseas investment returns the underlying investment portfolio is 50% invested overseas. A currency hedging programme, using forward foreign exchange contracts, has been put in place to reduce the currency exposure of these overseas investments to the 15% target. 4.9 Illustrated disclosures of derivatives held at the year end are set out overleaf. 21