Application of Multi-Curve Models to Accommodate the Change in Derivative Valuation
The valuation of derivatives, especially interest rate swaps, changed by taking into account specific tenor on the floating legs. Furthermore the impact of cash collateralisation is measured in a more sophisticated way, leading to a discount curve based on overnight index swap rates according to the interest rate paid on cash collateral. In case the currency of the cash collateral differs from the trade currency as well as for cross currency derivatives, the FX basis forms an additional relevant risk factor. For a consistent valuation of derivatives assuming absence of arbitrage multi-curve setups are used resulting in different forward and discount curves incorporating tenor and FX basis where applicable. Supported by this valuation model the relevant risk factors comprise tenor and FX basis risks. Due to their increased significance a higher volatility in the fair value (changes) of a derivative is likely.
Implications for Hedge Accounting under IAS 39
In general derivatives are recognized at fair value through profit and loss under IAS 39 and consequently higher volatility in financial statements is expected. In order to solve the accounting mismatch under IAS 39 (mixed model approach) for economic hedging relationships caused by the at cost recognition of the hedged item, hedge accounting according to IAS 39 may be applied if the requirements are met. Since derivatives as hedging instruments for hedge accounting have to be measured at fair value, the new valuation methods directly enter into the hedge accounting model. To represent the economic hedging relationship and to meet the effectiveness requirements the hedged item has to reflect the alteration in risk and valuation factors induced by financial markets.
Hedge Accounting Models under IAS 39 Incorporating Multi-Curve Valuation Approaches
The application of cash flow hedge accounting is comparably easy by the use of the hypothetical derivative method, since effectiveness testing directly adapts to the altered valuation context.
Although the economic underpinnings of cash flow and fair value hedge accounting are similar, the impact of multi-curve models is different. In a fair value hedge accounting model the hedged item is measured with respect to the hedged risk. Since economically risk and valuation factors of the hedging instrument have changed the definition of the hedged risk has to be adapted accordingly. This entails the incorporation of all relevant risk factors into the measurement of the hedged item. Defining the hedged risk by the common discount curve of hedged item and hedging instrument the valuation of the hedged item can be established following a hedging cost approach. This leads to an initially determined but dynamic hedging strategy. The compliance with IAS 39 is accomplished by the determination of the hedged risk through the common discount curve given by an accepted benchmark curve and the designation of a portion of cash flows according to IAS 39.81.
Implementation Issues and other Aspects
Apart from implementation aspects, as known from hedge accounting models for the single-curve case, additional issues arise in the multi-curve case since the accounting process is based on discrete dates whereas the derived hedging strategy is defined continuously.
The derived fair value hedge accounting model is based on the hedging cost approach that is also applied by treasury departments for determination of transfer prices. Thus a coherence of economic hedging and hedge accounting is achieved by following the same economic rationale.