.

IAS39 System (Reporting) Procedure (for data retrieval and processing) MASTER FILE 1 2 06

(7-5-1xx)

Department/Location / Finance Division, Head Office
Players / IAS 39 User
Product or Service Description
Reports
Exhibits
Screens
Data Dictionaries
Reference Material
Vendor Manuals
Codes
Code Value / Description
SY / Systematics (all subsystems)
CI / Systematics CIS
IM / Systematics IMPAC system.
ST / Systematics Saving/Time deposits system.
ALS / Systematics Advanced Loans system.
MI / Midas system.
EX / EXIMBILLS system.
I2 / IMPART 2
GL / General Ledger Millennium.
HR / Human Resources
OI / Operation Investment
CF / Corporate Finance Dept., International Division
IN / Investment Department, International Division
OV / Overseas Department, International Division
MJ / Manual Adjustment
MN / Manual Feeding

Table of Contents

Generic Diagram of IAS39 System

IFRS Summary (as related to IAS39)

Assets

Liabilities

Introduction

Entering rates and uploading Excel data (spreadsheet format) from Risk Management

(IRS side) Uploading initial data to the IAS39 application

(MM side) Uploading initial rate data to the IAS39 application

Printing reports - Saving data as Excel files

Producing the Hedge Effectiveness Report

Reports

Mark to Market of Hedging Instrument (Interest Rate Swap) Report IAS39_IRD.rep

Interest Rate Swap Summary Report IAS39_IRD_Smr.rep

Interest Rate Swap Summary Report IAS39_IRD_Smr1.rep

Interest Rate Swap vs. Money Market Report IAS39_IRS_MM.rep

Mark to Market Hedged Item(s) Report IAS39_MM.rep

Hedged Item(s) Summary Report IAS39_MM_Smr.rep

Backup and Restore Procedures

Appendix A – Hedge Effectiveness Strategy

Appendix B – Tables in Oracle (some)

SOURCE CODE from Oracle

Types of hedging calculations

IAS 39 Source Code from Oracle (Riyad Bank’s Hedge Effectiveness Tool)

'Conguratulation .. Job completed ..' Synchronize

'Conguratulation .. Job completed ..' Synchronize

'Conguratulation .. Job completed ..' Synchronize

'Update MIDASD.INTEREST_RATE_DERIVATIVES Table'Synchronize

'Delete and Create MIDASD.INTEREST_RATE_Avr Table'Synchronize

'Delete and Create MIDASD.IAS39_IRS_MM_NET Table (Final Table)'Synchronize

Fields in the Reports for IAS39 Related Information

Generic Diagram of IAS39 System

IFRS Summary (as related to IAS39)

Assets
Type / Valuation / How
1. / Financial assets at Fair Value through P & L / Fair Value
Fair value must be verifiable
Quoted or observable data
Purchased with the intention of making a profit from short-term market fluctuations
All derivatives must be included here. Derivatives must always be shown at fair value. / P & L
Held for trading
Investments, which are held for trading, are subsequently measured at fair value and any gain or loss arising from a change in fair value is included in the statement of income in the period in which it arises.
2. / Held to Maturity Investments / Amortised Cost
Must be quoted on an active market
Fixed maturity with positive intent and ability to hold to maturity / P & L- Cannot include equities or mutual funds i.e. As they do have a maturity date.
Held to maturity
Investments which have fixed or determinable payments and are intended to be held to maturity are subsequently measured at amortized cost, less provision for impairment in their value. Amortized cost is calculated by taking into account any discount or premium on acquisition. Any gain or loss on such investments is recognized in the statement of income when the investment is derecognized or impaired.
The estimated fair values of originated debt and held to maturity investments are based on quoted market prices, when available, or pricing models in the case of certain fixed rate bonds.
3. / Loans and Receivables (Used to be called Originated Debt)
Originated by the enterprise. / Amortised Cost
Includes financial assets with fixed or determinable payments that do not have a quoted price in an active market.
Subject to impairment testing / Cannot include quoted investments
Originated debt
Securities, which are purchased directly from the issuer other than those purchased with the intent to be sold immediately or in the short term, are, classified as originated debt investments. Originated debt investments whose fair values have not been hedged are stated at amortized cost, less provision for impairment. Any gain or loss is recognized in the statement of income when the investment is derecognized or impaired.
4. / Available for Sale financial assets
(All other financial assets) / Fair Value
Active market
Securities intended to be held for an indefinite period of time and which may be sold in response to needs for liquidity, changes in interest rates or equity prices. / Equity (Fair Value Reserve)
Includes most investment portfolios
Available for sale
Investments, which are classified as “available for sale”, are subsequently measured at fair value. For an available for sale investment where fair value has not been hedged, any gain or loss arising from a change in its fair value is recognized directly in other reserves under shareholders’ equity until the investment is derecognized or impaired, at which time, the cumulative gain or loss previously recognized in shareholders’ equity is included in the statement of income for the period.
Available for sale investments where fair value cannot be reliably measured are carried at amortized cost.

Liabilities

Type / Valuation / How
At fair value through P & L
Trading / Fair value / Adjustments recognized in income
Measured at amortised cost (Default)
All other liabilities / Amortised Cost

To mitigate volatility two sorts of hedge accounting are allowed: (1) fair value and (2) cash flow.

Fair value hedges are the best sort to have. Both the hedged asset, or liability, and the hedging derivative are stated at fair value and the offsetting gains and losses go to the profit in the period.

Cash flow hedging is not as good as fair value hedging as balance sheet volatility is not avoided. Here the derivative’s fair value (positive or negative) is taken directly to equity and released in the following periods to match with the cash flows from the hedged item.

Interest rate hedges can potentially be treated either as cash flow or fair value hedges.

Unrestricted hedge accounting can be a powerful tool in manipulating and disguising the true results of a company. So IAS 39 requires that, to qualify, all hedges must be:

  • Designated from the start identified assets or liabilities and the derivative contracts
  • Documented fully
  • Proven to remain effective. This is easier said that done. For banks especially, the sheer volume of financial instruments they have over a period make these requirements difficult to achieve. The banks want therefore to be able to group their assets or liabilities into portfolios for designation as fair value hedges and not have to use individual items or have to treat them as cash flow hedges. The banks have now achieved this objective by way of the 31 March 2004 amendment to IAS39. The banks are still unhappy about other aspects of IAS39 however. They would like to be able to include deposits repayable on demand (for example, current accounts) in these portfolios. Further amendments are planned.

The best evidence of fair value is quoted market prices in an active market.

If quoted prices are not available, entities use valuation techniques incorporating observable data. Cost less impairment is a last resort for investments in unlisted equity instruments. Implementation may involve not only new accounting, but also new data to be gathered for disclosures, new valuation methods and even new systems to enable this process.

Managed Portfolios

Classification will depend on the underlying activities of the portfolio.

Fair Value

The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction. In an active market, for assets, it is the market bid price that determines fair value and for liabilities it is the market offer price that determines fair value.

Active market-quoted price

Bid price for assets and offer price/asking price for liabilities

No active market-valuation techniques

Recent arms length

Current fair value of another instrument that is substantially the same

Discounted Cash Flow analysis

Option pricing models

At initial recognition normally transaction price (consideration given or received)

-Unquoted Equities

Reliably measured if the variability in the range of reasonable fair value estimates is not significant for that instrument or the probabilities of the various estimates within the range can be reasonably assessed and used in estimating fair value.

Fair Value Hedge

A hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss.

Hedge Documentation

Risk management objective and strategy

Identification of the hedging instrument

The related hedged item or transaction

The nature if the risk being hedged

How the entity will assess the hedging instrument’s effectiveness

Hedge Effectiveness

The degree to which offsetting changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument.

Cannot hedge net positions

What are we hedging?

  • Interest rate
  • FX
  • Credit Risk
  • Equities, commodities, gold

To qualify for hedge accounting, the revised IAS 39 requires the hedge to be highly effective. There are separate tests to be applied prospectively and retrospectively, and these tests are mandatory.

* See revision dated 31 March 2004 which relaxes rules below on the prospective effectiveness test. It also enables fair value hedge accounting to be used more readily for a portfolio hedge of interest rate risk.

Prospective effectiveness testing has to be performed at inception of the hedge and at each subsequent reporting date during the life of the hedge. This testing consists of demonstrating that the entity expects changes in the fair value or cash flows of the hedged item to be almost fully offset (i.e. nearly 100%) by the changes in the fair value or cash flows of the hedging instrument.

Retrospective effectiveness testing is performed at each reporting date throughout the life of the hedge in accordance with a methodology set out in the hedge documentation. The objective is to demonstrate that the hedging relationship has been highly effective by showing that the actual results of the hedge are within the range of 80-125%.

Hedge ineffectiveness is systematically and immediately reported in the income statement.

Hedging Instrument

A designated derivative or a designated non-derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item.

Hedging Rules

Must be formally documented at inception:

  • Hedge instrument
  • Risk or transaction being hedged
  • How effectiveness will be assessed

Defining "Highly Effective"
What, exactly, is a highly effective hedge? One response is that a highly effective hedge substantially offsets the change in the fair value (or the cash flow) of the hedged item. That is, if the hedged item in a fair value hedge appreciates by $100,000, then there is some range of decline in values of the hedge that can be defined as substantially offsetting this change. Defining this range is a matter of subjective judgment. A highly effective hedge has been suggested as offsetting at least 80% of this change and no more than 125%. Then the acceptable range of the change in value for the derivative would be between -$80,000 and -$125,000. This method of testing for effectiveness has the additional merit that it leads directly to the accounting treatment of the change in value of the derivative. To the extent that the sum of the changes in values is not zero, there is an element of ineffectiveness in the hedge that is included in current income. Thus, even when a hedge is determined to be highly effective, there is an impact on current earnings when there is not an exact offset of the hedged risk. If, for example, the change in value of the derivative were -$110,000, then the hedge would be highly effective, because this change in value falls within the specified range and hedge accounting would report an effect on income of +$100,000 - $110,000 = -$10,000. This idea of offsetting has found its way into the hedge effectiveness testing literature in the form of the dollar-offset method of testing, discussed in detail below.
A second response to this question is that a highly effective hedge substantially offsets risk associated with the change in the fair value (or the cash flow) of the hedged item. A widely accepted measure of risk is variance. Estimating variances requires multiple observations. To extend the example above, suppose that over four quarters the changes in fair value of the hedged item were +$100,000, +$40,000, -$120,000, +$5,000, and the corresponding changes in the fair value of the derivative were -$110,000, -$35,000, + $128,000, -$8,000. The recorded hedged income effects would then be -10,000, +$5,000, + $5,000, -$3,000. The variance without hedging is 8.623 billion (dollars squared) and the variance of the income stream with hedging is 0.07 billion (dollars squared). Hedging eliminated 99% of all of the variance of income. This variance measure of effectiveness formalizes the clear conclusion that the hedge eliminated most of the risk.

Methods of Testing Hedge Effectiveness
There are three primary methods of testing the hedging effectiveness of forwards, futures, and swaps when the critical terms of the hedging derivative and the hedged item are not identical: the dollar-offset method, the variability-reduction method, and the regression method. The following examples illustrate each method.

Dollar-Offset Method [what we use at Riyad Bank]
The dollar-offset method, which has some historical significance for the accounting profession (DIG Issue E7), compares the changes in the fair value or cash flow of the hedged item and the derivative. The dollar-offset method can be applied either periodbyperiod or cumulatively (DIG Issue E8). For a perfect hedge, the change in the value of the derivative exactly offsets the change in the value of the hedged item. Therefore, the ratio of the cumulative sum of the periodic changes in the value of the derivative and the cumulative sum of the periodic changes in the value of the hedged item would equal one in a perfect hedge (after multiplying the ratio by negative one to adjust for the two sums having opposite signs in a hedging relationship).
Of course, perfection is not necessary to qualify for hedge accounting. In a speech at the SEC's 1995 Annual Accounting Conference, a member of the SEC's Office of the Chief Accountant articulated an 80/125 standard for hedge effectiveness as measured by the dollar-offset method. This became a guideline for assessing the hedge effectiveness of futures contracts under SFAS 80, and has carried over to SFAS 133.
Anyone choosing this test should be aware that researchers question its reliability because of its excessive sensitivity to small changes in the value of the hedged item or the derivative. For example, suppose that the hedged item is inventory valued at $1 million and the hedge is a short position in a futures contract. At the end of the quarter, suppose that the value of the inventory increased by some small amount, say $10,000 (1%). The short futures position will decrease in value by $10,000, offsetting the change in the value of the underlying asset, plus or minus the change in the futures' basis. If the change in the basis is as little as 0.33% of the notional value (?$3,333), then the dollar-offset method implies that the hedge is ineffective because the short futures' value change is ?33% of the inventory's value change. Canabarro (1999) has shown that under reasonable assumptions about the distribution of changes in prices, the 80/125 standard rejects as ineffective 36% of all hedges when the coefficient of determination (correlation squared) R2 is 0.98.
Variability-Reduction Method
The variability-reduction method and the regression method are closely related. The difference is that the variability-reduction method assumes that the risk-minimizing derivative position is equal and opposite to the hedged item, that is, a one-to-one hedge. The regression method assumes that a more effective hedge is based on a statistical estimate of the risk-minimizing hedge.
If a one-to-one hedge performs perfectly, the change in the value of the derivative exactly offsets the change in the value of the hedged item. The variability-reduction method compares the variability of the fair value or cash flow of the hedged (combined) position to the variability of the fair value or cash flow of the hedged item alone. This method places greater weight on larger deviations than on smaller ones by using the squared changes in value to measure ineffectiveness. The preferred test statistic for this method is the proportion of the hedged item's mean-squared deviation from zero that the hedge eliminates. To calculate the test statistic, subtract from one the ratio of the sum of the squared periodic changes in the hedge and the hedged item to the sum of the squared changes in the hedged item.
The mean-squared deviation from zero is used because the variance ignores certain types of ineffectiveness. For example, suppose that the change in the value of the hedged position is always -$0.20. If this is used in the numerator, the test statistic is 1.0 because the variance measures the variability around the mean of -$0.20. However, because this variance is -$0.20 in every period in this example, the offset is not perfect. By using mean-squared deviations, the test statistic reflects the lack of offset in the means.
The critical value for determining how large a reduction in variability is sufficient to demonstrate hedge effectiveness must be specified in order for this measure to be useful. Because of the similarity of this test to the regression method test, a standard of 80% is appropriate.
Regression Method
The prospective measure of hedging effectiveness is based on the adjusted R2 produced by a regression in which the change in the value of the hedged item is the dependent variable and the change in the value of the derivative is the independent variable.
Ederington (1979) showed that the estimated slope coefficient is the variance-minimizing hedge ratio. Given the definitions of X and Y, the slope of this regression equation should be negative and close to -1.0. In terms of a prospective effectiveness test, if the adjusted R2 is greater than 80%, then a hedge ratio equal to the regression slope coefficient would have been highly effective. The interpretation of the intercept term is also important. It is the amount per (data measurement) period, on average, by which the change in value of the hedged item differs from the change in value of the derivative. Because the hedge should aim for a combined change in value of 0.0, the hedger should account separately for the intercept term.