Hedge Accounting

[tanjm]

This isn't exactly a value investing question... or perhaps it is. May need a trained accountant to answer this.

This question arose when I was reading a financial report. But I have also noticed it in others.

If you do a hedge (e.g. a cashflow hedge), do the accounting rules say that you have to describe the hedge? e.g. I have a 5 year loan. In my report, I say that I have a cashflow hedge. Am I required to describe it as a 5 year swap with a fixed rate XX? It is entirely possible that you only partially hedged the 5 year loan e.g. with a 2 year swap. So if the accounting notes do not describe the hedge, I am no wiser. Indeed, I would imagine that if you call it a "cash flow" hedge, you must either assume "all cashflows" hedged or describe it?

Similarly for other hedges. e.g. do I use an FX option, a cross currency swap etc and what are the terms.

My concern is that there is no full disclosure of the hedge in the financial report.

[YMPL]

I reckon, companies need to strike a balance between disclosure and trade confidentiality.

I am comfortable with the level of disclosure. The effectiveness of the hedge can be roughly judged by the details in ARs.  The end result is more important than the detail, IMHO.

[tanjm]

I reckon, companies need to strike a balance between disclosure and trade confidentiality.

I am comfortable with the level of disclosure. The effectiveness of the hedge can be roughly judged by the details in ARs.  The end result is more important than the detail, IMHO.

Supposing I say that I have a 5 year loan at USD Libor + 2%

Then in my financial report, I say I have a cashflow hedge, but no other details. I get a 2 year swap at a fixed rate of 1%. Then I publicize that my hedge fixes my debt interest 1+2 = 3%. But in actual fact, this is true only for 2 years. Without knowing that, I may assume they are hedged to 5 years, not 2 years.

At the 2 year mark, interest rates are higher. Then, if they refinance, they will be hit with higher interest rates. If they choose not to refinance, they are also hit with the higher interest rates because the USD Libor will reset higher. i.e. they are really only hedged till 2 years.

Of course, they might say that USD Libor could go lower. Then at the 2 year mark, they will benefit. But this is really speculation, not hedging. A hedge is a 2 way sword. By not hedging fully, you are really saying, "I chose to speculate on the direction of interest rates. I think they will go lower".

Both views are valid. But as an investor, I want to know just how much risk they are taking. Hence transparency in the financial report.

[tanjm]

Just to be clear, we are talking about hedges. Not trading, like investment banks do. So "trade confidentiality" (i.e. your position vis a vis competitors) is not an issue here. But whether you are truly hedged or not, is.

The case I am thinking of, the report says they are hedged without elaborating. I only found out some other way that they are really not hedged fully.

[Clement]

This isn't exactly a value investing question... or perhaps it is. May need a trained accountant to answer this.

This question arose when I was reading a financial report. But I have also noticed it in others.

If you do a hedge (e.g. a cashflow hedge), do the accounting rules say that you have to describe the hedge? e.g. I have a 5 year loan. In my report, I say that I have a cashflow hedge. Am I required to describe it as a 5 year swap with a fixed rate XX? It is entirely possible that you only partially hedged the 5 year loan e.g. with a 2 year swap. So if the accounting notes do not describe the hedge, I am no wiser. Indeed, I would imagine that if you call it a "cash flow" hedge, you must either assume "all cashflows" hedged or describe it?

Similarly for other hedges. e.g. do I use an FX option, a cross currency swap etc and what are the terms.

My concern is that there is no full disclosure of the hedge in the financial report.

Hi,

The accounting standards (specifically FRS 107) require that, when applying hedge accounting, whether fair value hedge or cash flow hedge, the company shall disclose a description of the hedging instruments and the nature of the risk being hedged. For a hedge designated as a cash flow hedge, the company is required to disclose the period the related cash flows are expected to occur.

[tanjm]

This isn't exactly a value investing question... or perhaps it is. May need a trained accountant to answer this.

This question arose when I was reading a financial report. But I have also noticed it in others.

If you do a hedge (e.g. a cashflow hedge), do the accounting rules say that you have to describe the hedge? e.g. I have a 5 year loan. In my report, I say that I have a cashflow hedge. Am I required to describe it as a 5 year swap with a fixed rate XX? It is entirely possible that you only partially hedged the 5 year loan e.g. with a 2 year swap. So if the accounting notes do not describe the hedge, I am no wiser. Indeed, I would imagine that if you call it a "cash flow" hedge, you must either assume "all cashflows" hedged or describe it?

Similarly for other hedges. e.g. do I use an FX option, a cross currency swap etc and what are the terms.

My concern is that there is no full disclosure of the hedge in the financial report.

Hi,

The accounting standards (specifically FRS 107) require that, when applying hedge accounting, whether fair value hedge or cash flow hedge, the company shall disclose a description of the hedging instruments and the nature of the risk being hedged. For a hedge designated as a cash flow hedge, the company is required to disclose the period the related cash flows are expected to occur.

Thanks very much. I'll look up FRS 107 for detail.

[weijian]

hi tanjm,
Fundamental analysis is not 1 way. I reckon u shd be able to seek details from either emailing the IR or during AGM.

The longer into the future, the more uncertain and so the charges by the investment bank will be higher. So it is really a double edged sword, that depends on how the future will pan out.

My layman view is that businessmen should just focus on the business and hedge their immediate needs based on their project or periodical budget, period. A simple example would be if airlines start selling the next 6months' tickets at those prices, then it better hedge its fuel exposure. If a chinese company that earns its revenue solely on mainland, borrows offshore USD market for 5years based on LIBOR, then it better starts hedging via interest rate swaps (at least) for the next 5years.

My point is, maybe we are none the wiser trying to 2nd guess whether they are doing it right or nt. Their track record (via earnings or FCF) would eventually show for it.

[tanjm]

hi tanjm,
Fundamental analysis is not 1 way. I reckon u shd be able to seek details from either emailing the IR or during AGM.

The longer into the future, the more uncertain and so the charges by the investment bank will be higher. So it is really a double edged sword, that depends on how the future will pan out.

My layman view is that businessmen should just focus on the business and hedge their immediate needs based on their project or periodical budget, period. A simple example would be if airlines start selling the next 6months' tickets at those prices, then it better hedge its fuel exposure. If a chinese company that earns its revenue solely on mainland, borrows offshore USD market for 5years based on LIBOR, then it better starts hedging via interest rate swaps (at least) for the next 5years.

My point is, maybe we are none the wiser trying to 2nd guess whether they are doing it right or nt. Their track record (via earnings or FCF) would eventually show for it.

My point is not whether they are doing it right or not. My point is whether they give an impression they are hedged when they are not. That impacts an investors evaluation of the risk. In this case, I Judge one of their principal risk is interest rates. Anyway, more than one company doing because I've noticed it before. Just because most people don't understand what a hedge is (especially an interest rate hedge) should not mean they can be non transparent about it. 

I've only mentioned an underhedge. What if they overhedge (which amounts to pure betting)? Or use leverage in the financial bet? The boundary between speculation and hedging is a thin one.

[YMPL]

I've only mentioned an underhedge. What if they overhedge (which amounts to pure betting)? Or use leverage in the financial bet? The boundary between speculation and hedging is a thin one.

I reckon, weijian's point was highlighting the grey between "under-hedged/over-hedged" and "hedged". It is a skilled job, and thus need a high paid CFO. How do we know he/she has done it right? The only way is to see the long-term performance. Very few can do a good job by luck over a few years.

Isn't it the same for investing. Howard Marks's Oaktree is "betting" on distress debts. It sounds high risk, but low risk based on the consistent long-term performance.

https://en.wikipedia.org/wiki/Howard_Marks_(investor)

[chialc88]

I always think that MM has a good governance model,
so, I just grep *hedge* from it's latest FY16 AR: 4 hits.

Extract from page  48 section 3.5 Financial Instruments

Derivative financial instruments
The Group holds derivative financial instruments to hedge its foreign currency risk exposures.
Derivatives are recognised initially at fair value; attributable transaction costs are recognised in profit or loss as incurred.
Subsequent to initial recognition, derivatives are measured at fair value, and changes therein are accounted for as described below:

Non-trading derivatives
When a derivative financial instrument is not designated in a hedge relationship that qualifies for hedge accounting,
all changes in its fair value are recognised immediately in profit or loss.

Extract from page 53 section 3.16 New standards and interpretation not yet adopted

FRS 109 Financial Instruments
FRS 109 will replace most of the existing guidance in FRS 39 Financial Instruments:
Recognition and Measurement.
It includes revised guidance on classification and measurement of financial instruments,
a new expected credit loss model for calculating impairment on financial assets,
and new general hedge accounting requirements.
It will change the existing accounting standards and guidance applied by the Group in accounting for financial instruments.
The Group is currently assessing the impact upon adoption of this standard in the financial year ending 30 June 2019.

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