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Accounting for Derivatives: Advanced Hedging under IFRS Juan Ramirez John Wiley & Sons Accounting for Derivatives For other titles in the Wiley Finance Series please see www.wiley.com/finance Accounting for Derivatives Advanced Hedging under IFRS Juan Ramirez C 2007 Copyright  John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) 1243 779777 Email (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on www.wiley.com All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher. 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Other Wiley Editorial Offices John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA 94103-1741, USA Wiley-VCH Verlag GmbH, Boschstr. 12, D-69469 Weinheim, Germany John Wiley & Sons Australia Ltd, 42 McDougall Street, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 6045 Freemont Blvd, Mississauga, ONT, L5R 4J3, Canada Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Anniversary Logo Design: Richard J. Pacifico Library of Congress Cataloguing-in-Publication Data Ramirez, Juan, 1961Accounting for derivatives: advanded hedging under IFRS / Juan Ramirez. p. cm.—(Wiley finance series) Includes bibliographical references and index. ISBN 978-0-470-51579-6 (cloth) 1. Financial instruments—Accounting—Standards. 2. Derivative securities—Accounting. 3. Hedging (Finance)—Accounting. I. Title. HF5681.F54R35 2007 657 .7—dc22 2007026416 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 978-0-470-51579-2 (HB) Typeset in 10/12pt Times by Aptara, New Delhi, India Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production. To my wife Marta and our children Borja, Martuca and David Contents Preface 1 The Theoretical Framework 1.0.1 EU’s IAS 39 versus IASB’s IAS 39 1.0.2 US Gaap FAS 133 1.1 Accounting Categories for Financial Assets and Liabilities 1.1.1 Financial Assets Categories 1.1.2 Financial Assets Recognition 1.1.3 Financial Liabilities 1.1.4 The Fair Value Option 1.2 The Amortised Cost Calculation: The Effective Interest Rate 1.2.1 Example of Effective Interest Rate Calculation 1.3 Hedge Accounting – Recognising Derivative Instruments 1.3.1 Derivative Definition 1.3.2 Hedge Accounting 1.3.3 Accounting for Derivatives 1.3.4 Undesignated or Speculative 1.3.5 Fair-value Hedge 1.3.6 Cash Flow Hedge 1.3.7 Net Investment Hedge 1.3.8 Embedded Derivatives 1.4 Hedging Relationship Termination Events 1.5 Hedged Item Candidates 1.6 Hedging Instrument Candidates 1.7 Hedging Relationship Documentation 1.8 Effectiveness Tests 1.8.1 Prospective test 1.8.2 Restrospective Test 1.8.3 Restrospective Test Failure 1.9 Methods for Testing Effectiveness 1.9.1 The Critical Terms Method 1.9.2 The Ratio Analysis or Dollar-Offset Method 1.9.3 The Regression Analysis Method xiii 1 1 1 1 2 3 4 4 5 6 6 6 7 8 8 8 9 11 11 13 14 16 17 18 18 19 20 21 21 21 22 viii Contents 1.9.4 The Scenario Analysis Method 1.9.5 The Volatility Risk Reduction Method (VRR) 1.9.6 The Short-Cut Method for Interest Rate Swaps 1.9.7 Concluding Remarks 1.10 The Hypothetical Derivative Simplification 1.11 Effects of Derivatives in the P&L Statement 24 25 26 26 27 27 2 An Introduction to the Derivative Instruments 2.1 FX Forwards 2.1.1 Product Description 2.1.2 IAS 39 Accounting Implications 2.2 Interest Rate Swaps 2.2.1 Product Description 2.2.2 IAS 39 Accounting Implications 2.3 Cross-Currency Swaps 2.3.1 Product Description 2.3.2 IAS 39 Accounting Implications 2.4 Standard (Vanilla) Options 2.4.1 Product Description 2.4.2 Standard Foreign Exchange Options 2.4.3 Interest Rate Options – Caps, Floors and Collars 2.4.4 IAS 39 Accounting Implications of Options – Intrinsic versus Time Value 2.4.5 IAS 39 Accounting Implications of Options – Written Options 2.5 Exotic Options 2.6 Barrier Options 2.6.1 Knock-Out Barrier Options – Product Description 2.6.2 Knock-in Barrier Options – Product Description 2.7 Range Accruals 29 29 29 30 32 32 33 33 33 36 36 36 37 40 3 Hedging Foreign Exchange Risk 3.1 Types of Foreign Exchange Exposures 3.2 Introductory Definitions 3.2.1 Functional Currency 3.2.2 Relevant Dates 3.3 Summary of IAS 21 Translation Rates 3.3.1 Monetary versus Non-Monetary Items 3.3.2 Translation Rates 3.4 Foreign Currency Transactions 3.4.1 Summary of Most Popular Hedging Derivatives – Foreign Exchange Risk Case 3.1 Hedging a Highly Expected Foreign Sale with a Forward Case 3.2 Hedging a Highly Expected Foreign Sale with a Tunnel Case 3.3 Hedging a Highly Expected Foreign Sale with a Participating Forward Case 3.4 Hedging a Highly Expected Foreign Sale with a Knock-in Forward Case 3.5 Hedging a Highly Expected Foreign Sale with a KIKO Forward 51 51 51 51 52 52 52 53 53 43 45 46 46 47 48 48 54 55 68 76 87 99