HEDGE ACCOUNTING UPDATE: New Dollar Offset Theta (DOT): An evolution in hedge accounting methodology? [Technical]

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1 Discussion document JULY 218 HEDGE ACCOUNTING UPDATE: New Dollar Offset Theta (DOT): An evolution in hedge accounting methodology? [Technical] by Adam Piers Bridgewater Discussions with clients and their auditors over the last couple of months have highlighted that it may be possible to improve the existing market standard implementation of the Dollar Offset ( DO ) method of hedge accounting. Swaps with large values accounted at fair value normally reduce in to zero at maturity and this movement, without hedge accounting, flows through the P&L. Market movements can significantly impact the path of the swap to zero and hedge accounting often allows all or some of this movement to be diverted to CFHR rather than P&L. Under the existing DO method, swaps with a large at designation ( the Inception ) are hedge accounted against a hypothetical swap with zero at designation. The release of from the swap is not mirrored by the hypothetical, which can cause lower hedge accounting efficiencies and may not be the optimal treatment of the hedge relationship. An effective approach to Hedge Accounting may be to exclude the non-market movement in a swap, known in derivatives as the theta, from the Hedge Accounting calculation, with the time value change on the swap going directly through P&L. The remaining portion of the movement, relating to the risk hedged, would then be used in the hedge accounting calculation. This would lead to a more appropriate treatment of large out-of-the-money swap, and approximately mirrors the flow through P&L of loan discounts at amortised cost. There are several possible methodologies that could be used to quantify the amount of theta to be sent to P&L including: 1. Linear amortisation of the Inception This is the simplest method but is the least reflective of actual movement of the swap s theta over time. While this methodology is most similar to the amortised cost method used for loans, it may be considered less appropriate given that accounting standards generally favour marketbased calculations when dealing with hedge accounting derivatives. Moreover, FRS12 has moved away from simple linear amortisation of fixed-rate loan costs in any event, with the use of the effective interest rate (EIR) concept. In addition, the portion of actual theta not covered by the linear methodology would still have a detrimental impact on the hedge accounting calculation. A more subtle method of amortisation could potentially better align with the EIR approach, but it still would not appear consistent with the broader approach to non-basic financial instruments. Page 1 of 6

2 2. Dual-hypo The difference between the movement on the swap, and the movement of a swap hypothetical which has the same terms as the swap, but with a fixed rate such that the inception is zero, is taken to P&L. A normal hedge accounting calculation is then performed between the swap hypothetical and the normally produced hypothetical that is the perfect hedge to the loan. This method is straightforward to calculate however the theta movement to P&L using this method is impacted by market rates. This could lead to P&L volatility that hedge accounting is designed to reduce, as well as variable hedge accounting efficiency levels over time. 3. DOT method In our view the method we are proposing below is the most intellectually robust but is a more sophisticated and complex calculation, although this of course needs to be subjected to wider debate. Most importantly, it also needs to make sense to the users of accounts and reflect actual accounting policy decisions, so we are planning on discussing this with clients and their auditors in the coming months. On Market Swap At the start of the pay fixed swap one normally pays more interest on the fixed leg than the floating leg. At the end of the swap one is normally expected to receive more interest on the floating leg than on the fixed leg. The value of a swap therefore increases then decreases to zero once all the payments have been made. Off Market Swap For a swap with value of non-zero at the beginning a swap normally behaves as follows: Test modelling has shown that the DOT method results in a significantly improved hedge efficiency as well as typically an uplift to the P&L for portfolios for hedge accounting designations with large negative s. Centrus has designed the capabilities within its systems to deliver the DOT version of the hedge accounting calculation. Technical Description of Dollar Offset Theta (DOT) Methodology: Effectively a swap moves from the value at the start to a value at the end. For a swap with value of zero at the beginning a swap normally behaves as follows: If a hedge accounting relationship is designated after the beginning of the swap then due to the above, or more likely market movements, the swap may have a non-zero, often large,. Given that recently market rates are generally lower than , these s are often negative. The value of a normal vanilla swap is still zero at maturity and the negative unwinds over time as payments are made, resulting in a positive impact on the liability. Page 2 of 6

3 Standard Hedge Accounting Example In cashflow hedge accounting under the dollar offset method, a swap is normally designated against a hypothetical at the current market rate, resulting in a zero at designation and the following situation: Standard Hedge Accounting Example + Shock If theta is small or if there is a large negative movement in the market occurs then the economic relationship can be more clearly observed: This chart assumes that one receives fixed on the modelled hypothetical and then pays fixed on the swap. Without market movements it is expected that the of swap and hypothetical swap will initially move in opposite directions but then to start moving in the same direction at some point closer to maturity. Standard Hedge Accounting Example + Small Shock If a small negative movement in the market occurs then: The swaps may move in opposite direction with the hypothetical going positive and the swap going more negative but due to the Theta, the natural decay of the out of the money position the s appear to be moving in the same direction. The movement in rates outweighs the impact of Theta. In this scenario efficiency is likely to be higher but could well be some way away from 1%. New Methodology Dollar Offset Theta (DOT) The new methodology aims to remove the impact of Theta from the hedge accounting. The movement of the swap is split into two parts: Theta: The Theta of the swap goes straight to P&L, which if initially a negative results in a positive flow in to P&L. The Theta of the hypothetical is take away from the of the hypothetical s movement in the calculation of hedge accounting. Remaining Movement: A hedging relationship still exists as the swap is still hedging the loan and moving in more-or-less equal and opposite directions in response to a change in rates, but, the impact of theta is greater than the movement in rates. In this scenario efficiency is likely to be low or even negative. Page 3 of 6

4 Only the movement in the swap and hypothetical due to market shifts is used in the calculation of hedge accounting and, as such, the efficiency in future is expected to be significantly higher than before. Hedging and Hedged Item Accounting Comparison This hedge accounting calculation methodology for the swaps under DOT could be similar to the accounting treatment of an off-market loan or bond. An off-market loan is often introduced onto the balance sheet as a liability + a discount at amortised cost and, as such, the discount is amortised over the life of the loan through P&L, as calculated using EIR. Under DOT, the unwinding of the off-market element of the swap is also put through P&L but the amount is calculated using the expected change in value of the swap assuming that market rates stay constant from designation. Variation in the swap due to market rates will be hedge accounted and therefore P&L volatility will most likely be reduced significantly due to higher hedge efficiency. Documentation and Accounting Standards The new method can only be applied if the wording of the designation documentation allows it. Often the wording is sufficiently broad to allow the DOT method to be implemented. The method is closer to the core concept underlying the hedge accounting standards which generally aims to focus on hedge accounting for the market risk designated in the hedging relationship, which does not normally mention theta. Centrus is not aware of anything in the accounting standards that prohibits the above implementation of dollar offset hedge accounting. Accounting Entries on Migration The accounting implementation of DOT will vary from case to case but given current market conditions most clients with historical swap portfolios often have an overall negative. In addition, those which, along with most other market participants, introduced the standard form of dollar offset portfolio are likely to have already included much of the theta movement of the swap through CFHR. It is therefore likely that any current or prior year adjustment to the accounts are likely to require: Cr (P&L) Dr CFHR (through Other Comprehensive Income) In order to move the theta impact from CFHR to P&L. Side Note: DOT Method Resolving Re-designation One long standing issue discussion within the market has been on the most appropriate treatment of prior period calculation results in the event of novation or other hedge accounting re-designation events based on both practical implications and the wording of the accounting standards. Often in the past, on re-designation all previous hedge accounting has been pushed through P&L and hedge accounting effectively restarted from scratch, giving no benefit to the fact that a hedge relationship had taken place in the past. One of the practical reason for this is that if the amounts in CFHR were not taken through P&L on re-designation then there was no mechanism within the new hedge accounting relationship to reduce the prior CFHR amount, until a release on the maturity date. From a practical perspective, the DOT methodology provides a possible path to resolving this issue given that the on the day of redesignation the inception of the swap in the new relationship is likely to equate to sum of the amount in the CFHR and P&L reserve for the swap from previous hedge accounting calculations. The Page 4 of 6

5 reduction in the inception over the life of the swap using theta in the DOT method can be split into the reduction to CFHR and P&L reserve (by %) so that historical amounts of both are reduced over the life of the swap, allowing continuity to exist between the current hedge accounting calculation and relationship and the previous hedging accounting calculation and relationship. Previous Hedge Relationship Re-designation previously P&L CFHR P&L Current DOT Hedge Relationship Hedge accounting How Centrus can help Centrus has been involved in many technical hedge accounting discussions and the Centrus team is happy to provide advisory assistance including participating in discussions with your auditors. While Centrus does not provide accounting advice it is able to provide any assistance required as to the market calculations for hedge accounting. Centrus Analytics is able to provide hedge accounting calculation and services through its TMS system as well as through its Risk Management system Centrus Risk. *To read the background paper about the New Dollar Offset Theta methodology, please click here. Suggested re-designation P&L CFHR For any related enquieries, please feel free to contact: Adam Piers Bridgewater (Centrus Analytics Quantitative Lead) E: T: +44 () Hedging item movement (straight line for illustrative purposes) Theta movement movement through P&L movement through Cashflow Hedge Reserve (shown in OCI) Jonathan Clarke (Finance Advisory) E: T: +44 () Conor O Flynn (Commercial Director) E: conor.oflynn@centrusadvisors.com T: +44 () We fully recognise that this is a move away from what we tend to see in the market presently, however, we raise the point because we do think there is logic here as a potentially useful extension to the DOT concept. Page 5 of 6

6 About Centrus Centrus is an independent financial services group that believes in a better way of doing business. We specialise in corporate finance, technology and investment management and are united by a culture that values imagination, energy and purpose which unlocks significant value for our clients. Centrus supports a range of clients in their funding and financial strategy needs across residential, infrastructure, transportation, energy and utilities, corporates and financial sectors. Above all we re working towards a new financial landscape, which we define as modern finance because it funds and supports the things that deliver real benefits to people and society. For more information please visit: Please note that Centrus is a generalist adviser on corporate finance and treasury issues and not a firm of accountants and we do not offer formal technical accounting advice. All of our commentary on these issues should be read in that context; we accept no liability in relation to accounting decisions and defer to the views of clients and their auditors on these matters. We publish regular Treasury Insights, Market Updates and White papers on social media. Please follow the Centrus company page to be the first to receive them: IMPORTANT DISCLAIMER: Centrus Group consists of Centrus Corporate Finance Limited and its three wholly owned subsidiaries; Centrus Financial Advisors Limited, Centrus Advisors Limited and MDT (UK) Limited. Centrus Corporate Finance Limited is a limited company incorporated in England and Wales number MDT (UK) Limited is a limited company incorporated in England and Wales number Centrus Financial Advisors Limited is a limited company incorporated in England and Wales number Registered office for all UK legal entities is at 1 Queen Street Place, London EC4R 1BE. Centrus MDT, Centrus Advisors and Centrus are trading names of Centrus Financial Advisors Limited. Centrus Financial Advisors Limited is authorised and regulated by the Financial Conduct Authority Firm Reference Number Please visit for more information. Centrus Advisors Ltd is a limited liability company incorporated in Republic of Ireland number Registered office at 7 Sir John Rogerson s Quay, Dublin 2. Directors: P Jenkins (UK) and J Murphy (Managing Director). Centrus Advisors Ltd is a Tied Agent of Centrus Financial Advisors Limited, which is authorised and regulated by the Financial Conduct Authority. This report or document or any of its content must not be distributed or passed on, directly or indirectly, to any other person without the express written consent of Centrus. Nothing within this document should be construed as investment advice and should not be relied upon. All of the views expressed in this report or document accurately reflect the personal views of the responsible analyst(s). The information contained in this report or document has been compiled by Centrus from sources and using data believed to be reliable and unless stated otherwise should be assumed to be using end of day data, but no guarantee, representation or warranty, express or implied, is made by Centrus, its affiliates or any other person as to its accuracy, completeness or correctness. Centrus is under no obligation to update, modify or amend the information. All opinions and estimates contained in this report or document constitute Centrus judgement as of the date of this report or document, are subject to change without notice and are provided in good faith but without legal responsibility. This report or document is not an offer to sell or a solicitation of an offer to buy any securities. This material may be prepared for general circulation to clients and may not have regard to the particular circumstances or needs of any specific person who may read it. To the full extent permitted by law neither Centrus or any of its affiliates, nor any other person, accept no responsibility for and shall have no liability for any loss (including without limitation direct, indirect, consequential and loss of profit), damages, or for any liability to a third party however arising in relation to this report or document (including without limitation in relation to any projection, analysis, assumption and opinion in this report or document). Data is sourced from various sources including Bloomberg, Markit and Centrus Datasheet. Page 6 of 6