Investment banking operations revised reading material

IB Operations

Background Reading Material

March 2010

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IB Operations Background Reading

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Transaction Types: Buy-Sell and Borrow-Lend

Based on the nature of flows between the two parties, we can classify transactions into buy-sell and borrow transactions (there are two more types, swap and option, discussed later)

Buy-Sell Transaction

• One flow is in a financial asset and the other is in money: it is exchange of an asset for

money.

• The exchange occurs simultaneously at a point of time called settlement date.

• The two sides of the transaction are called buy and sell; and the two parties, buyer and

seller.

Borrow-Lend Transaction

• Both flows are in money: it is exchange of money for money.

• To make the exchange meaningful, the exchange cannot be simultaneous but split over

a period of time, marked by start date and end date.

• The two sides of the transaction are called borrow and lend; and the two parties,

borrower and lender.

The amount of money on end date must include the amount on start date plus an additional amount, representing the “rent” on money for the period. This rent is called interest, which represents the “time-value” of money. The following exhibit shows the two types of transactions and their flows.

Buy-Sell Transaction

BUYER

SELLER

asset money

Settlement Date

Exchange at a point of time

Borrow-Lend Transaction

BORROWER

LENDER

money money

Start Date End Date

Exchange over a period of time

time time


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Transaction Life Cycle

The transaction life cycle consists of many stages, but the important among them are trade and settlement.

The trade part precedes settlement part and consists of both parties negotiating and agreeing on the terms of trade, which consist of the following features.

For buy-sell transaction: identification of the asset, quantity, price, and settlement date.

For borrow-lend transaction: amount of money, interest rate, and period of borrowing specified by start date and end date.

The settlement part occurs after the trade part and involves executing the terms of trade: exchange of asset for money on settlement date (for buy-sell trades) or payment and repayment of money on start date and end date, respectively (for borrow-lend trades).

If the settlement date or start date is the same as trade date, it is called “T+0” settlement, the zero indicating that there is no gap between trade date and settlement date/start date. For most trades, however, there is a delay between them, and settlement date/start is on first business day (T+1) or second business day (T+2) or even third business day (T+3) following the trade date.

Besides the trade and settlement stages, there are many other stages in the trade life cycle: validation/review/repair, documentation, confirmation, pre-settlement confirmation, accounting, reconciliation, margining, market-to-market, etc.

Trade Cash Flows Types

Any financial instrument is, in the final analysis, is a bundle of cash flows. Based on the type of cash flows, we give it a name (e.g. equity, bond, forex, etc). Each cash flow is described by its three attributes: occurrence, timing and amount.

• occurrence: whether it will occur; qualified as certain (i.e. it will surely occur) or

uncertain (i.e. its occurrence is conditionally on the occurrence of a specified event)

• timing: when it will occur; qualified as certain (i.e. its timing is known) or uncertain

(i.e. its timing is not known at inception)

• amount: how much it will be; qualified as certain (i.e. its amount is known) or

uncertain (i.e. its amount is not known at inception)

Based on the combination of attributes, we categorize cash flows into fixed, floating and contingent. If the cash flow is fixed, all the three attributes are certain: it will occur, and its timing and amount are known at inception. If the cash flow is floating, its occurrence and timing are certain and known, but its amount is not known at inception: it will be known only in future. If the cash flow is uncertain, its occurrence is uncertain because it is conditional on the occurrence of a specified event. If it occurs, its timing and amount may be certain (known in advance) or uncertain (not known in advance but known only in future). The following exhibit summarizes the properties of three cash flow types.


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Types of Cash Flows

Type Occurrence Timing Amount

Fixed Certain Certain Certain

Floating Certain Certain Certain

Contingent Uncertain Uncertain/Certain Uncertain/Certain

Financial Markets

Market is the mechanism which brings the two sides of the trade (i.e. buyer/sell, borrower/lender) together and enables business between them in the form of a transaction.

At the first level, we can classify financial markets into three types: underlying markets, derivatives markets and structured products.

Underlying Markets

The underlying markets are the fundamental and most important markets because the other two markets are derived from them. The underlying markets have the following qualifying features.

• They are independent

• The prices in these markets are determined by demand-supply forces

• The price and value are frequently different: price is set by the demand-supply forces in

the market while the value is subjectively perceived by each market participant.

• To accurately and consistently forecast the price is impossible

The underlying markets are used for consumption and investment, and can be grouped into money, bond, equity and forex markets. The first two are also called debt or fixed-income securities markets, and are money trades. The last two are asset trades.

Money and Bond Markets

Together called debt or fixed-income securities (FIS) markets, they involve borrowing are

lending of money: they are money transactions. The difference between the two markets is the

period of borrowing/lending. In money market, the period is less than one year; and in bond

market, it is one year or more.

It may be noted that we may create a “paper” or “security” to channel the money

borrowing as “buy” or “sell” of that security. The essence, however, is money borrowing or

lending between the two parties.


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Equity Market

Trades in equity market are buy-sell trades, the asset being the ownership of a business, which

is exchanged for money. Equity and debt markets together are called capital markets, which

are the source of finance for businesses.

Forex Market

Forex trades are buy-sell trades, like in equity market. It consists of exchanging one brand of

money for another. Of the two, one serves as a financial asset and the other as money. The

following exhibit summarizes the nature of transactions in the four underlying markets.

Underlying Markets

Market Transaction Type

Market Sides Remark

Money Borrow-lend Borrow, Lend Money exchanged for money for a period of less than one year

Bond Borrow-lend Borrow, Lend Money exchanged for money for a period of one year or more

Equity Buy-sell Buy, Sell Money exchanged for ownership of business

Forex Buy-sell Buy, Sell One brand of money exchanged for another

Derivatives Market

Derivatives market, unlike underlying market, are not independent but derived (and hence the

name “derivative”) from underlying market. The underlying market is the object and the

derivative market is the shadow, so to speak. To be qualified as a financial derivative, the

International Accounting Standard #39 (IAS 39) stipulates the following criteria.

• Value of derivative is linked in some way to the value of underlying, rather than determined by demand-supply forces directly

• The derivative trade must settle on a future date

• At inception, the derivative requires no cash outlay or a fraction of trade value

Each underlying market (i.e. money, bond, equity and forex) has its counterpart in

derivatives (e.g. money derivatives, bond derivatives, etc.). Derivative instruments exist on

non-financial underlyings such as commodities, energy, power, weather, freight, etc. They also

exist on non-physical underlyings such as credit, which does not exist separately but in

association with money transactions. Derivatives are used for different purposes than


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underlyings. Whereas underlying assets are used for investment and consumption, derivatives

are used for risk management.

Structured Products

Structured products, like derivatives, are not independent but derived from other assets. The

can be further classified into two types: securitization products and “bespoke” or hybrid

products.

The securitization products are derived by combining different underlying assets from bond

or money markets. The process consists of pooling assets of same class but different character,

grading, and blending to create new assets backed by the underlying. Examples of such

synthetic assets are mortgage-backed securities (MBS), asset-backed securities (ABS) and

collateralized debt obligations (CDO).

The “bespoke” or hybrid assets are derived by combing a bond and a derivative asset on

equity, forex or commodity. The hybrid assets will now have the features of bond and the other

asset class, offering the fixed cash flows of bond and floating cash flows of equity, forex or

commodity. The following exhibit summarizes the financial markets.

DEBT EQUITY

SECURITIZATION

products

BESPOKE or HYBRID

instruments

Money trades

Asset trades

Structured

Products Markets

Derivatives Markets

Underlying Markets

CAPITAL FOREX

BOND MONEY

MONEY

DERIVATIVES

BOND

DERIVATIVES

EQUITY

DERIVATIVES

FOREX

DERIVATIVES


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The table below summarizes the features of underlying, derivative and structured products

markets.

Feature Underlying Derivative Structured Product

Independent? Yes No (derived) No (derived)

Role Investment Risk management Investment

Pricing Demand-supply Arbitrage Arbitrage

Forex Trade: Currency Pair Every forex transaction is a currency pair, and the forex price (or rate) is the price of one currency in terms of the other currency. We can compare the three types of exchange: barter, money and forex. In barter, it is exchange of one goods (or services) for another goods (or services). In money, it is exchanges of goods (or services) for money. In forex, it is exchange of one brand of money for another brand of money.

Type Exchange

Barter Goods versus goods

Money Goods versus money

Forex Money versus money

Base Currency and Quoting Currency Of the two currencies in the pair, one is called the base currency (BC) and the other, the quoting currency (QC). Base currency is the currency that is priced: it is bought and sold like a commodity (hence the name “commodity currency”) and ceases to act in the traditional role of money. Quoting currency is the currency that prices the base currency, and is thus acting in the role of money. What is quoted in the market as forex price (or rate) is the price of base currency in units of quoting currency. This statement always holds in all “quotation styles” (explained later) and must be memorized.

Forex Price = Price of BC in QC The amount of BC is fixed (usually at one unit) and the amount of QC naturally varies as the market price varies over time. Accordingly, BC and QC are also called “constant/fixed amount currency” and “variable amount currency”, respectively. ISO / SWIFT Codes International Organization for Standardization (ISO) has given three-letter alpha code for every currency in their ISO 4217 standard. The first two letters are the country code defined by ISO in their standard ISO 3166, and the third letter is usually (but not always) taken from the first letter in the currency name.

Country Currency ISO Code

United Kingdom pound GBP

European Union euro EUR

United States dollar USD

Switzerland franc CHF

Japan yen JPY

India rupee INR

China renminbi CNY

South Africa rand ZAR


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FX Deal Types

All forex deals are classified into two types: outright and FX swap. Every forex transaction is

analyzed with respect to two risk parameters: exposure (or position) and mismatch (or gap).

Outright Deal

An outright transaction involves buying or selling a currency. Since the forex trade is an

exchange of two currencies, it is simultaneously buying a currency and selling an equivalent

amount of another currency. The following examples illustrate the outright deals.

Deal #1: Bought EUR 1 million on EUR/USD currency pair @ 1.5665 value date spot

Deal #2: Sold JPY 500 million on USD/JPY currency pair @ 104.00 value date spot

In the deals, only one currency (“deal currency”) amount and the price are specified.

The other currency (“derived currency”) amount has to be derived by ‘crossing’ the deal

currency amount with the deal price.

In deal #1, the deal currency is base currency. The deal price in all cases is the price of

base currency (here EUR) in terms of quoting currency (here USD). Accordingly, the price here

implies that EUR 1 = USD 1.5665 or EUR 1 million is equal to USD 1.5665 million. The ‘crossing’

here means multiplication of deal currency with deal price.

In deal #2, the deal currency is quoting currency. It is a market practice that deal

currency can be either base currency or quoting currency. If the requirement is to buy or sell a

specific amount of quoting currency, then the action will be specified in that currency. The

deal price implies that USD 1 = JPY 104.00, so that JPY 500 million will be equivalent to 500 /

104.00 = USD 4.789272 million. The ‘crossing’ here means division of deal currency amount by

deal price.

To sum up, the outright deal always involves a bought currency and a sold currency.

The amount of one of them and the price is specified. The amount of the other currency is

derived by ‘crossing’ the deal amount with the price. The ‘crossing’ is multiplication or

division, depending on whether the deal currency is base currency or quoting currency,

respectively.

Deal Currency = Base Currency

Derived Currency Amount = Deal Currency Amount ×××× Price Deal Currency = Quoting Currency

Derived Currency amount = Deal Currency Amount / Price


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FX Swap Deal

FX swap is different from another product of similar name called currency swap. FX swap was

called simply “swap” earlier. In the early 1980s, another instrument was invented, which was

called “currency swap”. To make the distinction between the two, the traditional “swap” is

now called FX swap and the new instrument is called currency swap.

FX swap consists of simultaneous purchase and sale of same currency on the same

currency pair for the same amount but for different value dates. The value dates must be

necessarily different because without such a condition, the buy and sell will square up each

other, leaving no transaction in existence. The following example illustrates the FX swap.

Leg #1: Bought EUR 1 million on EUR/USD currency pair @ price1 value date spot

Leg #2: Sold EUR 1 million on EUR/USD currency pair @ price2 value date 1-month

The above are not two independent transactions but two legs of one transaction. The

leg that settles first is called the near leg and the other leg is called the far leg. The near leg is

always written first. Accordingly, we distinguish two kinds of FX swaps: buy-sell (B−S) and sell-

buy (S−B) swaps. In B−S swap, the market side of the near leg is buy and that of far leg is sell;

and the converse for S−B swap.

The legs have the same deal currency and amount, same currency pair, but different

value dates. The only trade parameter we have not considered is the price for two legs. We

cannot put any restriction such as “same” or “different” on the prices of two legs because that

is market-driven. All combinations are possible: the buy price may be more than, less than or

equal to the sell price. If the buy price is less than the sell price, does it mean profit? And loss,

when the buy price is more than the sell price? And if they are the same, what is motive in

doing such a transaction? Let us examine the cash flows from the swap transaction illustrated

above. We consider that Party A has executed the above swap with Party B. For the Party A, it

is a B−S swap in EUR and S−B swap in USD for equivalent amount; and the converse for the

Party B.

Party A

Time

Near Date Far Date

Party B

EUR USD EUR USD


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For a moment, ignore the USD cash flows and consider only the EUR cash flows? What is

this transaction? It is obviously a money transaction in EUR with Party A as borrower and Party

B as lender. Consider now only the USD cash flows and ignore the EUR cash flows. It is now a

USD money transaction with Party A as lender and Party B as borrower. Consider now the flows

only on the near date, and ignore the far date cash flows. The transaction now is a forex

transaction in EUR/USD currency pair with Party A as EUR buyer/USD seller; and party B as EUR

seller/USD buyer. Consider now the flows only on the far date, and ignore the near date cash

flows. The transaction is again a forex transaction in EUR/USD currency pair with Party A as

EUR seller/USD buyer; and party B as EUR buyer/USD seller. Consider all flows together: it is a

B−S swap in EUR (or S−B swap in USD) for Party A; and S−B swap in EUR (or B−S swap in USD) for

Party B. FX swap is thus essentially a combination of borrowing and lending in two difference

currencies.

Perspective Party A Party B

EUR cash flows EUR Borrower EUR Lender

USD cash flows USD Lender USD Borrower

Near date cash flows EUR buyer/USD seller EUR seller/USD buyer

Far date cash flows EUR seller/USD buyer EUR buyer/USD seller

Entirety FX swap: B−S in EUR or S−B in USD FX swap: S−B in EUR or B−S in USD

We can see from the above that two money trades are combined into a single package

called FX swap. The currency lent is secured by the currency borrowed or vice versa. FX swap is

similar to the repo/reverse repo trade in money market. Whereas repo/reverse repo is

exchange of money for a security (and hence a collateralized money lending or securities

lending), FX swap is exchange of two currencies (or two brands of money). On the near date,

the rate of exchange between the currencies is linked to the prevailing market price. On the

far date, the same amounts of currencies are re-exchanged along with the two interest

amounts. The two interest amounts are converted into quoted currency and clubbed with the

principal amount to derive the price for far leg.


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Risks

At a trade level, we can identify the four sources of risk: counterparty, instrument market, and

the entity itself. With respect to counterparty, there are three risks: settlement risk, credit

risk and counterparty credit risk.

Settlement Risk

Settlement risk arises in buy-sell trades: whenever there is an exchange of two flows between

the parties. It refers to the possibility that one party fulfils his obligation while the other fails.

For example, buyer delivers money but the seller fails to delivery the asset; or seller delivers

the asset but the buyer does not pay money. Settlement risk is faced by each party on the

other. The loss amount is called credit exposure, which is equal to the transaction amount.

Settlement risk is much more enhanced in forex trades because the settlement involves

two different business centers that are separately in time zones. The delay between the legs of

the settlement can be as long as 13 hours such as the case in USD/JPY trades. Settlement risk

is lowered or eliminated by following means.

• Delivery-versus-Payment (DvP) form of settlement: this is practiced usually for

sovereign bonds

• Netting and Clearing: this is practiced in most markets

• Trade guarantee by a third party: this is practiced in all derivatives exchanges

• Continuous linked settlement (CLS): this is practiced in forex market

Credit Risk

Credit risk arises in borrow-lend trades. It refers to the possibility that the borrower may not

repay the amount due. Unlike settlement risk, credit risk is faced only by lender against the

borrower, not the other way. The size of risk (or credit exposure) is the amount under default.

Credit risk is probably the oldest financial risk since money borrowing existed in

Sumerian Civilization (circa 3000 BC). The most prominent form of mitigating credit risk is

collateral and margin: money is lent against collateral and the amount lent is less than the

current value of collateral.

Note that the settlement risk in buy-sell trades will transform finally into credit risk,

but we use different terms because settlement risk is faced by both parties and arises only on


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settlement date, while credit risk faced by only one party (namely, the lender) and arises

during the entire period.

Counterparty Credit Risk

Counterparty credit risk arises in all OTC derivative trades. One of the defining features of

derivatives is that the settlement is postponed to a future date (as in forward, futures, option)

or settlement occurs over many dates in future (as in swaps).

If the counterparty fails to fulfill his obligations in settlement, the other counterparty

will not lose the entire value of trade because he, too, withholds his obligations. However, the

non-defaulting party has to replace the contract with another in the market at the prevailing

prices/rates. The loss suffered in replacement, due to change in the market price/rate, is the

size of counterparty credit risk.

Counterparty credit risk arises between trade date and settlement date of the

derivative. On settlement date, the same risk transforms itself as settlement risk if the

underlying is an asset or credit risk or price risk if the underlying is money. For this reason, it is

also called pre-settlement risk.

The following exhibit summarizes the settlement risk (in asset trades), credit risk (in

money trades) and counterparty credit risk (in derivative trades).

UNDERLYING TRADE

DERIVATIVE TRADE

T = Trade (negotiation of trade terms)

S = Settlement (exchange of asset and money)

Time

T S

T+0, T+1, T+2 or T+3

more than T+2 or T+3

S T


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In exchange-traded derivatives, there is no credit risk because of trade guarantee from

a third party called Clearing Corporation. In OTC derivatives market, the counterparty credit

risk is mitigated by incorporating certain legal covenants in the “master agreement” with the

counterparty. The standard legal provisions are:

• Margining: each party posting a fraction of contract value with a third party; or the

weaker party posting with the stronger party.

• Mark-to-market: change in the value of contract is settled before trade settlement

• Mandatory early termination: if a certain specified event (defined in the master

agreement as “events of default” and “termination events”) occurs on a party, the

other party has the right to prematurely terminate all outstanding contracts at the

prevailing market prices/rates

SR

CR

Legend

UNDERLYING MARKETS

time

Trade Date Settlement Date (T+2)

SR in asset trades

CR in money trades

DERIVATIVE MARKETS

time

Trade Date Settlement Date (more than T+2)

if underlying is asset trade

if underlying is money trade

CCR

SR Settlement Risk CR Credit Risk CCR Counterparty Credit Risk


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• Optional early termination (a.k.a. “mutual termination”): each party has the right to

prematurely terminate all outstanding contracts at the prevailing market prices/rates

at specified times in future. The difference between mandatory and early terminations

is that the former is the cure and the latter is the prevention.

• Close-out netting: during mandatory or early termination, all outstanding contracts are

netted out for their replacement cost, and only the net amount is settled in

termination.

The following exhibit summarizes the profile of three risks from counterparty.

Risk Who Faces? Size of Risk Mitigation

Settlement Risk Each Trade amount DvP, trade guarantee, netting & clearing, CLS

Credit Risk only Lender Default amount Collateral, margin

Counterparty Credit risk

Each Replacement cost trade guarantee, margining, mark-to-market, mandatory and early termination, close-out netting

Two Concepts in Risk Identification: Exposure/Position and Mismatch/Gap

Exposure (a.k.a. Position)

Exposure (or position in FX traders’ lingo) defines the price risk (a.k.a. market risk) in a forex

trade. What we mean by risk is the uncertainty about future return, which could be positive or

negative. The popular names for positive and negative returns are profit and loss, respectively.

For example, if we buy EUR on EUR/USD currency pair, there will be either profit or

loss in future, respectively, if the price rises or falls. We say we have a position or are exposed

to price risk or market risk. When we buy a currency, we say we have long or overbought

exposure; and when we sell it, we have short or oversold exposure. When there is no exposure,

we say square. Since every forex trade involves two currencies with opposite market sides (i.e.

buy one and sell the other), the exposure arises simultaneously in two currencies in a

complementary way: overbought in one currency and oversold in the other for equivalent

amount. If there is exposure in only one currency, it is profit/loss and not exposure. The

following deals illustrate the exposure and profit/loss.

Deal #1: Bought EUR 100 on EUR/USD currency pair @ 1.5665

The deal above results in an overbought exposure for EUR 100 and oversold exposure

for USD 156.65. If the rate goes up subsequently, it results in profit; and if the rate goes down,


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it results in loss. Let us assume that we have contracted the second trade subsequently as

follows.

Deal #2: Sold EUR 100 on EUR/USD currency pair @ 1.5765

The second trade creates an oversold exposure for EUR 100, which will exactly offset

the existing overbought exposure, leaving a square exposure in EUR. In USD, the second trade

creates overbought exposure for USD 157.65, which will eliminate the existing oversold

exposure of USD 156.65, leaving a net overbought exposure of USD 1. Since exposure by

definition arises in two currencies and in a complementary way, the single exposure in USD

must be considered profit/loss from the two trades. If the exposure in one currency is

overbought, it is inflow and thus profit; if oversold, it is outflow and hence loss.

Outright trades create new exposure, and if the new exposure is complementary to an

existing exposure, they eliminate the existing exposure. FX swap trades involve simultaneous

buying and selling of same currency and amount on the same currency pair; and therefore do

not create any new exposure, but leave the existing exposure unchanged.

Mismatch (a.k.a. Gap)

Mismatch (or gap in traders’ lingo) refers to the cash balances in currencies. The cash balance

in a currency can be surplus, deficit or square. Whereas the surplus requires lending and

deficit requires borrowing, the square situation is the ideal state. Unlike exposure, mismatch is

computed for each day at the closing, because the day is the unit of accounting.

When we buy a currency, there will be cash inflow or surplus in that currency.

Similarly, when we sell it, there will be cash outflow or deficit. Since forex trade always

involves buying one currency and selling another of equivalent value, mismatch arises

simultaneously in two currencies: surplus in one and deficit in another for equivalent value.

Whenever there is an exposure, it necessarily follows that there will be a mismatch. Outright

trades create exposure and therefore create mismatch. FX swaps do not create exposure but

create mismatch because the buying and selling are for different value dates. The better way

to understand the concepts of exposure and mismatch is by analyzing the cash flows.

Cash Flow Analysis

Analyzing the cash flows is always fool-proof because every product, however complicated, will

be ultimately translated into a set of cash flows. The cash flows are shown in a table: row

represents the date of cash flow; and the column, the type of cash flow. Different columns

represent different flows in assets.


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Each transaction is split into a pair of flowsan inflow and an outflowand each flow is

mapped to the two-dimensional grid.

For example, consider the 3-month forward sale transaction on a stock at the price of 100 for

quantity of 5. The flows are: (1) outflow of 5 units of stock; and (2) inflow of 500 units of

currency, both occurring at 3-month. Thus, the flows occur in the same row but in different

columns. Similarly, consider the money transaction of borrowing Rs 100 from spot to 1-month

at the rate of 12% pa. The flows are: (1) inflow of Rs 100 on spot; and (2) an outflow of Rs 101

(representing principal and interest) at 1-month. The flows occur in the same column but in

different rows.

The two-dimensional grid above is not merely a map of cash flows. Its format indicates two

parameters of risk identification: mismatch and exposure.

Mismatch impacts the cash position, and is qualified as surplus or deficit. In terms of cash

flows, mismatch is defined as the sum of cash flows at a specific date (i.e. a date) for each

type of cash flow (i.e. a column). If the sum is positive we have “surplus”; and if it is negative,

we have deficit.

Exposure is what exposes us to risk from price movements, and is qualified as long (a.k.a.

overbought) or short (a.k.a. oversold). In terms of cash flows, exposure is defined as sum of

cash flows on all dates for each column. If the sum if positive, we are “long”; and if it is

negative, we are “short” in that type of cash flow.

Rs Stock Remark

Spot +100 Money trade – initial borrowing

1-month –101 Money trade – Repayment

3-month +500 –5 Forward purchase

General Note

Buy/sell trades occur as two flows in the same row

but different columns

Money trades occur as two flows in the same column

but different rows

ISDA Documentation

Financial contracts in money, bond, equity and forex markets are sufficiently covered by

securities laws and economic legislation. For OTC derivatives, however, there is no such

specific legislation because the products are new, complex, and have provisions that are not

explicitly provided by the existing securities laws.


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Accordingly, the International Swaps and Derivatives Association (ISDA), an association of

banks and dealers in OTC derivatives, has come out with a model set of documentation that is

the foundation for governing the relationships between parties in OTC derivative trades.

Architecture of ISDA Documentation

ISDA Documentation consists of three elements: Master Agreement (MA), Schedule to Master

Agreement (SCH), and Trade Confirmation (CNF).

Master Agreement

Master Agreement (MA) is the body of ISDA documentation. The following are the features

about MA.

• It contains standard and legal terms; and it does not contain economic terms or terms

specific to a particular trade

• MA applies to all trades that are contracted in future between the same parties

• MA has no expiry: it remains in force until one of the parties revokes it

• MA is a boilerplate document: it is the same wording throughout the words and

between any two parties to the MA

• MA is drafted in such a way that some provisions will always apply, while others will

apply only if they are specifically elected elsewhere in documentation (e.g. SCH, which

is explained below)

Schedule

Schedule (SCH) is an attachment to the MA. Its purpose is to make the MA flexible and tailor-

made to the counterparty.

Since all counterparties are not the same in terms of credit quality, financial strength, etc,

we would like to deal with them differently. We can affect such counterparty-specific

documentation in two ways. First, negotiate the MA provisions separately for each counterpart

so that each MA between a pair is unique. Second, make the MA a boilerplate document; and

make it counterparty-specific by electing, deleting or modifying some of the provisions in the

SCH. The second method is efficient and elegant; and is the method adopted by ISDA.

Thus, the purpose of SCH is to elect, delete and modify the MA provisions so that the

universal standard template of MA is made counterparty-specific and flexible. For this reason,

the parties that enter into ISDA MA will spend considerable time in negotiating the terms of

SCH.


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Confirmation

Trade confirmation (CNF) is the third element in the documentation. It differs from MA and

SCH in two important ways.

• Whereas the MA and SCH contain the general and legal terms, the CNF contains the

trade-specific economic terms

• MA and SCH apply to all trades, past and future, and are executed once; CNF applies

only to a particular trade, and must be exchanged for each trade.

Single Agreement and Resolution of Inconsistency

For the purpose of legal interpretation, the MA, SCH and CNF will constitute a single

agreement. It should be noted that the provisions of MA and SCH applies to all trades, but the

provisions of CNF will apply to a specific trade. Since three different documents reference the

same trade, it is possible that there is a conflict in the provisions. For example, MA sanctions a

particular provision, which is reversed by SCH, but is reinstated by CNF. In such cases, the

following order of precedence will resolve the inconsistencies in the different parts of

documentation.

• Conflict between MA and SCH

SCH will prevail over MA, because SCH is specifically negotiated whereas the MA is a

boilerplate: if SCH is in conflict with the MA, then the parties want it that way and

provided for it in the SCH

• Conflict between SCH and CNF; or between MA and CNF

CNF will prevail over SCH or MA, because CNF is drafted after SCH and MA, and applies

only to a particular trade.

Key Provisions of MA

ISDA has come out with MA in 1992 in two versions: local currency single jurisdiction and multi-

currency cross-border. Based on the subsequent events (e.g. Russian bank moratorium,

liquidation of Hong Kong-based dealer-broker, Peregrine, market disruption in the wake of

9/11 terrorist act, etc), ISDA had revised the MA in 2002. The following are the key provisions

of 2002 MA.

• Payments Netting

Automatic netting applies for payments and receipts falling due on the same date in the

same currency and from the same trade. The parties may extend the scope of payment

netting to multiple trades falling due on the same day in the same currency by specifically


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electing that “Multiple Transaction Payment Netting” shall apply in the SCH; and specifying

the starting date for such netting.

• Withholding Tax

Withholding tax is the tax imposed by a country on foreigners on the interest income and

capital gains earned in that country. The MA provides that the payer has the right to

deduct it from the amount due. If the payer is subsequently taxed, then the payee must

reimburse the payer for the amount of deduction.

• Events of Default (EoD)

Most OTC derivative trades have a life of 5 – 10 years (and up to 50 years in some cases).

Each party is naturally concerned about the financial soundness of the counterparty during

the life of the trade. The MA provides that if one party suffers deterioration in financial

standing, the other party has a right to prematurely terminate all the outstanding trades

(called “Early Termination”, which is discussed below). It is a mechanism to mitigate the

counterparty credit risk. The deterioration in financial standing is defined in terms of

“Events of Default” (EoD). The MA defines the following events to be the EoD.

o Failure to Pay (money) or Deliver (security), unless remedied within a local

business day (the grace period was three days in 1992 MA but was reduced to one

day in 2002 MA)

o Bankruptcy: The launch of bankruptcy proceedings by the party itself or the

regulator will constitute an EoD without waiting for formal declaration. When the

proceedings are instituted by others, it will be an EoD unless it is dismissed within

15 days (reduced from 30 days in 1992 MA). Bankruptcy applies to the

counterparty, its “Credit Support Provider” or the “Specified Entity” (both

described later).

o Breach or Repudiation of Agreement: if the counterparty disaffirms, disclaims,

repudiates or rejects, in whole or part, or challenges the validity of MA or a

transaction covered by it, it will be an EoD, unless remedied within 15 local

business days (reduced from 30 days in 1992 MA)

o Credit Support Default: credit support refers to providing collateral by the

counterparty or another party (called the “Credit Support Provider”) on behalf of

the counterparty. Credit support default covers expiry, failing, terminating or

ceasing of credit support document. The 2002 MA extends it to cases where the

expiry or failure happens in respect of security interest granted under credit

support document; and to repudiation of credit support document by the


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counterparty, its Credit Support Provider, or an entity empowered to act on behalf

of them.

o Cross Default: It is a provision that enables the non-defaulting party to declare that

an amount has become prematurely due (called “acceleration default”) because of

actual default on another trade (which is “payment default”). Cross default is

subject to a Threshold Amount, which is computed by summing the acceleration

default and payment default.

o Default under a Specified Transaction: it is triggered when the counterparty party,

its Credit Support Provider or its Specified Entity defaults on or disaffirms its

obligations in relation to certain types of financial markets transactions ("Specified

Transactions") with the other party or one of its Specified Entities, regardless of

documentation under which the transaction is documented. The 2002 MA covers

repos, securities lending, and credit derivatives. The definition of “specified

transaction” now covers any new types of transactions that may become common

place in the future, which should negate the need to amend the definition of

"Specified Transaction" in the future. The default in respect of a "Specified

Transaction" must result in acceleration or early termination of all transactions

under documentation applicable to the Specified Transaction. This has been

included to avoid the situation, where a failure to deliver, say, under a single repo

(which failure may not be credit related) could lead to an Event of Default under

the ISDA document. Under the new wording, a failure in respect of, in our

example, one repo, would lead to an Event of Default only if that failure led to a

general default with respect to all applicable repo transactions. This amendment

was made particularly because defaults under repo or securities lending

transactions are not necessarily indicative of the creditworthiness of the

counterparty, but may be a result of isolated difficulties in delivery. Failures of

these kinds tend to be relatively common in repo and securities lending

transactions and should not result in the close-out of all the transactions

documented under the master agreement.

o Merger without Assumption of Obligations

• Termination Events

Termination Events (TE) are similar to but different from Events of Default; and are

another tool to mitigate counterparty credit risk. The following are considered the

termination events.

o Illegality


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Illegality is the situation in which it becomes impossible or illegal to make or

receive payment or delivery due to an event or circumstances other than any

action caused by the party or its credit support provider.

o Tax Event Upon Merger

o Credit Event Upon Merger

Merger results in lower credit standing of the party, its credit support provider or

its specified entity.

o Force Majeure

It is incorporated in 2002 MA and is similar to Illegality and specific to the

particular office affected. The difference between Illegality and Force Majeure is

that the latter requires that only the cause is out of control but will also apply if it

could not be prevented after reasonable effort.

The difference between TE and EoD is in the scope their applicability and the source of

their origin. On the occurrence of EoD, the non-defaulting party can early-terminate all

outstanding trades; and on the occurrence of termination event, the early termination

applies only to the affected trades. The origin of EoD is internal (e.g. business distress,

bankruptcy, etc) but the origin of termination events is external (e.g. changes in

regulations, tax, etc).

• Hierarchy of Events

If an event is capable being an Event of Default and a Termination Event, then it should be

construed as an Event of Default; and if an event is capable being an Illegality and Force

Majeure event, then it should be construed as an Illegality.

• Early Termination

On the occurrence of Event of Default, the non-defaulting party has the right to terminate

all outstanding trades with the defaulting party. On the occurrence of Termination Event,

the parties may transfer the rights and obligations to another office or chose early

termination but only for the affected trades.

The procedure for early termination is to value the trades at the prevailing market

prices and net off the amounts from all trades (called “cross netting”) and make a single

claim. The 1992 MA provided two methods of valuation: Market Quotation method (based

on liquidated damages) and Loss method (based on un-liquidated damages). The 2002 MA

replaced the two methods with a single method called Close-out Amount, under which the

determining party will calculate the amount in "commercially reasonable" manner based on


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quotations from one or more third parties, market data or internal data. The change is

motivated by practical difficulties experienced. Market Quotation method requires

obtaining quotes of early-terminated transactions, which typically tend to be off-market

trades at the time of termination. In times of market stress and volatility, it may not be

possible to obtain quotes for off-market trades. This was particularly evident in energy

derivatives in the wake of Enron bankruptcy. Even if such quotes are obtained, they may be

influenced and of questionable commercial value. The Loss method involves generating the

appropriate value for the early-terminated transactions by developing price curves from

the current market quotes to compute the loss on early termination. This is tedious and has

legal uncertainty.

• Single Office or Multi-Office Party

The parties need to specify whether the MA will cover the particular office or all offices of

the parties. If stated to be a multi-office party, then the same MA will cover all the

specified offices of the party.

• Notify Address

Under ISDA documentation, the CNF is not addressed to the office that is a party to the

trade. It is addressed to a nodal office specified in the MA. This is in contrast to trades in

cash markets where the CNF is always addressed to the office that is the party to the

transaction.

Credit Support Agreement

In addition to the MA-SCH-CNF structure of the legal documentation, there may be optional

Credit Support Agreement (CSA) between the parties. The CSA is to collateralize the trades

between the two parties. The collateral under the CSA is arranged either by the counterparty

directly or, on his behalf, by a third party called Credit Support Provider. In general, whenever

the counterparty is subsidiary of a well-known parent, the parent will act as Credit Support

Provider for the subsidiary. The CSA specifies the following.

• Mark-to-market interval

It specifies the interval at which all outstanding trades between the parties are valued at

the prevailing market rates. On such valuation, the trade will typically have a positive

value for one party and negative value for the other. The party with a negative mark-to-

market value should post the collateral with the other party for the amount of negative

mark-to-market value.

• Collateral Type


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It specifies whether the collateral should be in cash or a security. If security, it will further

specify a list of acceptable securities along with the haircut (which is mark-down value

applied on the market value of the security). For example, the acceptable securities are all

index stock with a hair cut of 20%. The counterparty offers an eligible security whose

market value is USD 1 million. For the purpose of collateralization, the value of the offered

security is computed as:

Market Value / (1 + haircut) = 1,000,000 / 1.20 = 833,333.33

• Collateralization Type

It specifies whether each party should post collateral (two-way collateralization) or only

one of the specified party should post collateral (one-way collateralization) whenever a

party faces negative mark-to-market value. For example, if collateralization applies to only

Party B, then whenever the Party B faces negative mark-to-market value, he should post

the collateral to Party A; but Party A will not post any collateral to Party B whenever Party

A faces negative mark-to-market value.

ISDA Definitions

Besides the MA, SCH and CNF, ISDA has also published various “Definitions”, which describe the

technical terms used in derivatives documentation, particularly in the CNF. Describing each

technical term and market practice in a precise legal language will make the CNF to be very

long (“long form” CNF) and its preparation tedious. The solution to this problem is to use the

technical terms without explaining them in CNF, but make a reference to the particular ISDA

Definitions document for an explanation of them. This makes the CNF to be short (“short form”

CNF) and its preparation fast. ISDA has so far published nine different Definitions documents

for different derivatives.

Structure of the CNF

The CNF documents the trade-specific economic terms of the trade. It is always addressed to

the nodal office of the party as specified in the SCH, and not to the office that executed the

trade. The CNF has the following structured format.

• It makes a reference to the date of MA that will govern the relationship of the parties. It

also makes a reference to the particular “ISDA Definitions” that will govern the definitions

of technical terms used in the CNF. Any word beginning with a capital letter should be

understood in the way it was defined in the specified ISDA Definitions document.

• The next section documents the economic terms of the trade: date, amount, etc. The

description of economic terms in OTC derivatives is different from cash market trades in

two ways. First, there are a series of payments (rather than one or two) spread over 5 – 20


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years. Instead of describing them as a complete schedule of dates and amount, it is the

practice to specify them parametrically using few parameters. Second, in most trades, the

amounts payable on future dates are not known in advance, but linked to specified market

variables prevailing at the time of payment. Therefore, the procedure to determine

amount, rather than the amount, is documented.

• The next section specifies the “standard settlement instructions” (SSI). Certain info of the

trade (e.g. account particulars, contact details, etc) do not change from trade to trade but

remain the same. Such data are called “static data” and are stored separately. For all

trades, a call is made on “static data” and it is blended with the trade-specific information

in the CNF.

• The next section specifies the names of offices that are parties to the trade. Note that the

CNF is not addressed to the office that has executed the trade. Rather, it is addressed to

the nodal office where the documentation is centralized. Only by looking in this section,

we will know the offices of both parties that have executed the trade.

The last section specifies who the “Calculation Agent” is. As we stated earlier, the CNF

specifies the procedure to compute the payment amounts rather than directly specifying the

amount. Therefore, there is a need to periodically apply the procedure on market rates and

compute the payment amounts. One of the two parties (or even a third party) will act as

Calculation Agent to compute the amounts.

Day Count Fraction

Since the interest is always quoted as rate for year and the period of borrowing/lending is

usually other than a year, we need to convert the period into year fraction, which is called day

count basis in money and bond markets, day count fraction in OTC derivatives market and

simply basis by traders. The ‘basis’ here is different from the ‘basis” in futures market where it

refers to the difference between current spot price and current price of the futures contract.

Day count basis is expressed as a fraction. The numerator indicates the method of counting the

number of days between the start date and the end date of the period; and the denominator

indicates the total number of days in a year or ‘full coupon period’. There are different

conventions, which can be classified into the following four categories.

Actual / constant


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For the numerator, count the actual number of days in the given period; and for the

denominator, assume constant number of days in a year. The conventions in this category are:

Actual/365 Fixed and Actual/360.

Actual / Actual

For the numerator, count the actual number of days in the given period; and for the

denominator, count the actual number of calendar days in a year or full coupon period. The

conventions in this category are: Actual/Actual-ISDA, Actual/Actual-AFB and Actual/Actual-

ISMA.

30 / 360 (or 360 / 360)

This category assumes that the year consists of 12 months, each of which has exactly 30 days.

In other words, for the numerator, count the number of days in the given period by assuming

that every completed month has 30 days; and for the denominator, assume a constant of 360.

The conventions in this category are: 30E/360, 30/360, 30/360 German, 30/360 SIA, 30A/360,

30E+/360 and 30/360 Italian.

Others

All other conventions that do not fit into any of the three categories above are grouped in this

category. The conventions in this category are: Actual/365 Japan and Actual/365 Sterling.

Note on Accrual Days

It is the convention in all markets (except the 30/360 Italian method) to include the first day of

the period and exclude the last day of the period for interest accrual. For example, in the

period from 30-April-2006 to 05-May-2006, there is one day in April and four days in May. In the

30/360 Italian method, both the start date and end date of the period are counted.

In contrast to the above practice, most software utilities exclude the first day and include

the last day. As long as one of them is included and the other is excluded, they will result in

the same result except in Actual/Actual-ISDA convention, as explained later.

Actual/365 Fixed

Count the actual number of days in the given period and divide it by the constant of 365

regardless of leap or non-leap year.

In the earlier days, it was called simply ‘Actual/365’. However, the 2000 Definitions of ISDA

documentation defined “Actual/365” in a different way. To avoid confusion, what used to be

simply ‘Actual/365’ in the earlier days is now renamed as ‘Actual/365 Fixed’, particularly in

ISDA documentation. This method is used money markets of UK and all Asia-Pacific countries


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except Indonesia. In India, all financial transactions except dirty price calculations for

government securities.

Example: Accrual period is from 25-Jan-2005 to 03-Feb-2005. There are seven days in January

2005 (including Jan 25) and two days in February 2005 (excluding Feb 03), and the basis is

(7+2)/365 = 0.024657534.

Actual/360

Count the actual number of days in the given period and divide it by a constant of 360. This is

widely followed in most money markets, including those in the US and Europe. It is sometimes

called “money market basis.”

Example: Accrual period is from 25-Jan-2005 to 03-Feb-2005. There are seven days in January

2005 (including Jan 25) and two days in February 2005 (excluding Feb 03), and the basis is

(7+2)/365 = 0.025.

For a given interest rate, the Actual/360 convention will always results in higher interest

amount than the Actual/365 Fixed convention because of its lower denominator and the same

numerator. We can transform the interest rate in A/365F basis to its equivalent rate in A/360

basis or vice versa using the following formula.

A/365F from A/360:

Rate (A/365F) =Rate (A/360) × 365 / 360

A/360 from A/365F:

Rate (A/360) =Rate (A/365F) × 360 / 365

Actual / Actual-ISDA (a.k.a. Actual/365 in ISDA documentation)

In ISDA 2000 Definitions, it is also designated as ‘Actual/365’. Since there is already a method

named ‘Actual/365’ in practice, which is different from Actual/Actual, the former is now

called ‘Actual/365 Fixed’.

The basis is computed as follows. If the entire period falls in a non-leap year, count the

actual number of days in the period and divide them by 365. If the entire period falls in a leap

year, count the actual number of days in the period and divide them by 366. If the period falls

partly in leap year and partly in non-leap year, then divide the period is divided into two sub-

periods, each for leap and non-leap portions. The actual number of days for each sub-period is

computed separately. The days in leap part are divided by 366 and those in non-leap part by

365, and the resulting fractions are summed.


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Example: Accrual period is from 27-Dec-2004 to 05-Jan-2005. Since the period falls partly in

leap year (i.e. 2004) and partly in non-leap year, we will have to divide it into two sub-periods.

Leap sub-period consists of five days (i.e. Dec 27, 28, 29, 30, 31)

Non-leap sub-period consists of four days (i.e. Jan 1, 2, 3, 4)

Day count basis = (5 / 366) + (4 / 365)

= 0.013661202 + 0.010958904 = 0.024620106

Note on border date between two sub-periods

For working out the sub-periods in a spreadsheet, the border date between the sub-periods

should be set as January 01 rather than December 31. In the above example, the sub-periods

should be December 27, 2004 to January 01, 2005 and January 01, 2005 to January 05, 2005.

The reason for choosing the first day of next calendar year (rather than the last day of same

calendar year) is that the spreadsheets exclude the start date and include the end date,

whereas the market convention is to include the start date and exclude the end date.

Actual / Actual – AFB (a.k.a. Actual / Actual Euro, 365 – 366, Actual / 365-366)

The leap year is identified by the occurrence of February 29 in the accrual period, rather than

by the calendar year. If February 29 occurs in the accrual period, the actual number of days in

the period is divided by 366. If February 29 does not occur, then the actual number of days in

the period is divided by 365, though it may fall in a leap calendar year.

For bonds that pay semi-annual coupon, interest may over-accrue or under-accrue in one

period relative to the coupon payment, but the difference will be always nullified in the next

coupon period.

Example: Accrual period is from 15-Jan-2008 to 15-Feb-2008. Since there is 29 February in the

period, the denominator of 365 is used, despite the period completely falling in leap year.

If the period is longer than one year, it is divided into full year, starting backward from the

end date, and keeping the irregular period (“stub”) at the beginning. When counting backward,

if the end date is February 28, then the full year is counted back to the February 28 of previous

calendar year except when February 29 exists, in which case, February 29 will be used.

Actual / Actual – ICMA (a.k.a. Actual / Actual – Bond, Actual / Actual)

This convention differs from all other conventions in its definition of the denominator. The

denominator is the ‘full coupon period’ rather than year; and the number of actual days in the

full coupon period is multiplied by the number of coupons in a year.


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This convention is defined by ICMA rules Section 250 Rule 251 (iii) and applies to all USD-

denominated straight and convertible Eurobonds issued after December 1998. The US

treasuries, UK gilts (after 1998) and all EUR-denominated bonds follow this convention. Outside

ISDA documentation, when the convention is stated to be simply “Actual/Actual”, this

convention can be safely assumed.

Example: Accrual period is from 01-Nov-2003 to 01-May-2004 (which is the full coupon period).

Actual / Actual – ISDA: (61 / 365) + (121 / 366) = 0.49772438.

Actual / Actual – AFB: (182 / 366) = 0.49726776.

Actual / Actual – ICMA:(182 / (182 * 2) = 0.5.

The Actual / Actual – ICMA convention can raise more issues when dealing with irregular

(“stub”) calculation periods. ICMA has recommended that irregular periods should be avoided.

30E/360 (a.k.a. Eurobond basis, AIBD basis, 30/360 ISMA, 30/360 Special German, 30S/360)

If the day of either start date or end date is 31, it is arbitrarily set to 30. It is followed in

Eurobond and many domestic European bond markets. After the day of start date and end date

are shortened when required, the period as year fraction is computed as:

[360 × (Y2 − Y1) + 30 × (M2 − M1) + (D2 − D1)] / 360

where Y, M and D are the year, month and day, respectively; and 1 and 2 refer to the start

date and end date, respectively.

Example: Accrual period is from 31-Dec-2004 to 25-Jan-2005. The day of the start date, being

31, needs to be shortened to 30, while the day of the end date requires no adjustment. After

the adjustment, the Y2, Y1, M2, M1, D2 and D1 are 2005, 2004, 1, 12, 25 and 30, respectively.

[360 × (2005 − 2004) + 30 × (1 − 12) + (25 − 30)] / 360 = 25/360 (or 0.069444)

Association of International Bond Dealers (AIBD) is a body that formulates rules on issuance,

trading and settlement of Eurobonds. It was renamed as International Securities Market

Association (ISMA) in 1991. In July 2005, there was a merger between ISMA and International

Primary Market Association (IPMA), and the merged entity is now named as International

Capital Market Association (ICMA). Please see their website www.icma-group.org

30/360 (a.k.a. bond basis, 30/360 US Muni, 360/360)

It differs from 30E/360 in the following way. While the shortening of the day of the start date

is automatic, the shortening of the day of the end date is conditional. The following is the

procedure.


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If the day of the start date is 31, then shorten it to 30 (i.e. automatic, like in 30E/360)

If the day of the end date is 31, shorten it to 30 only if the day of the start date is 30.

Otherwise (i.e. day of the start date is 29 or less), do not shorten it.

After adjusting the day of the start date and end date as above, use the equation given

under 30E/360 convention to compute the period as year fraction. This is the method by

Municipal Securities Rulemaking Board (MSRB) in their rule G-33 for the US Municipal Bonds.

30E/360 (ISDA)

It is similar to 30E/360 convention with the following additional adjustment. If the day of the

start date is the last day of February (i.e. 29 in leap year and 28 in non-leap year), it is

changed to 30. Similar lengthening of the last day of February to 30 is applied to the day of the

end date, unless the day of the end date is the maturity day of the instrument (called

Termination Date in ISDA documentation). In other words, if the instrument begins has

semiannual payments on the last day of February and August and expires on 28 February 2009,

the every payment period is considered to end on 30 February except the last payment date,

which ends on 28 February 2009.

30A/360 (a.k.a. 30/360 NASD, 30/360 PSA, 30/360 BMA)

It is similar to 30/360 SIA except that the lengthening of day is applied to the start date but

not to the end date. Thus,

If the day of the start date is 31, it is shortened to 30; and if it is the last day of February (i.e.

29 in leap years and 28 in non-leap years), it is lengthened to 30.

If the day of the end date is 31, then shorten it to 30 only if the day of the start date is 30.

Otherwise, do not shorten it.

Note on 30/360 conventions

They were originally invented to ease manual calculations. Though they did ease manual

calculations, they are internally inconsistent. For example, the length of coupon period (a) may

not always be equal to the sum of accrual days (b) and the days remaining to the next coupon

date (c). For this reason, the b should never be computed directly but always derived as (a – c).

Actual/365 Sterling (a.k.a. Actual/365 L, Actual/Actual – Basic)

The denominator is 365 if the payment date falls in a non-leap year; and 366 if it falls in a leap

year. It is used for GBP floating rate notes.


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Actual/365 Japan

The denominator is a constant of 365. The numerator, though referred to as “actual”, does not

involve counting the actual days. If there is no February 29 in the period, we take the actual

number of days for the numerator; if it exists, then take the actual number of days and deduct

one from them. For the denominator, use the constant of 365.

What happens when the start date or end date is 29 February and the other date is

adjacent calendar day? For example, you borrow a loan from the bank on 29-Feb-2004 and

repay it on 01-Mar-2004. Will bank charge interest for “zero” day? No. In such case, the

numerator is treated as 1.

Microsoft Excel Function for Day Count Basis

=YEARFRAC(StartDate, EndDate, basis) supports of five types of day count basis. Its input

values must be specified as follows.

StartDate and EndDate inputs must be provided through: (1) link to the cells where their values

are stored; (2) using =DATE (yyyy, mm, dd) function; or (3) as text, but must be within double

quotes and in the format the Excel/Windows is set.

Basis is a value from the following list:

0 for 30A/360

1 for Actual/Actual-ICMA

2 for Actual/360

3 for Actual/365

4 for 30E/360

The Excel’s output for Actual/Actual-ICMA is not always reliable. It always assumes

annual frequency for payment and projects a quasi coupon date from the start date, and

positions it after the end date.

ISDA Template for Trade Confirmation of Interest Rate Swap

The Trade Confirmation, which is an important document in legal documentation, has to be

drawn in conformity with the ISDA template. ISDA has standardized the terminology. It is

important to use the ISDA terminology since it has legal implications. The following table maps

the front office terminology to ISDA terminology.

Front Office Terminology ISDA Terminology

Start Date Effective Date

End Date Termination Date

Payer Fixed-rate (or Fixed Amount) Payer


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Receiver Floating-rate (or Floating Amount) Payer

Day Count Basis Day Count Fraction

Business Day Adjustment Business Day Convention

Holiday Calendar Business Days

Benchmark Floating Rate Option

Tenor of Benchmark Designated Maturity

Note that ISDA names both the parties as “payers”: one is a payer of fixed amount and the

other, the payer of floating amount.

ISDA template for OTC derivatives is uniform for most products. It has the following

structure.

Opening Para: It makes reference to the: (a) names of the parties to the swap; and (b) the

reference to the 2000 ISDA Definitions for interest rate derivatives.

Section 1: makes a reference to the date of ISDA Master Agreement between the parties.

Section 2: contains the “economic” details of the trade and consist of the following.

(1) Notional: must consist of the three-letter ISO code for currency and the amount in full

(not abbreviated as MM or M).

(2) Trade Date

(3) Effective Date

(4) Termination Date along with the Business Day Convention. If the latter is not specified,

then the fallback value in ISDA Definitions (which is “no adjustment applies)

(5) Fixed Amount: it specifies the details of fixed-rate leg of swap, and consists of

specifying the following information separately.

a. Fixed Amount Payer: name of the party paying fixed-rate

b. Period End Date with Business Day Convention: they are specified only if they

are different from Payment Dates

c. Payment Dates with Business Day Convention: they are usually described

parametrically rather than as a list

d. Rate: interest rate applicable to the fixed-rate leg of swap. It is not necessary

to mention explicitly as “percentage per annum” since it is so defined in ISDA

Definitions


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e. Business Days: name of the center for considering holidays and Business Day

Convention.

f. Day Count Fraction

(6) Floating Amount: it specifies the details of floating-rate leg of the swap, and consists

of the following information separately.

a. Floating Amount Payer: name of the party paying floating-rate

b. Period End Date with Business Day Convention: they are specified only if they

are different from Payment Dates

c. Payment Dates with Business Day Convention: they are usually described

parametrically rather than as a list

d. Floating Rate Option: the benchmark applicable to the floating-rate leg. It

consists of three parts: (a) ISO code of the currency (e.g. USD, INR, etc) (b)

name of the benchmark (e.g. LIBOR, MIBOR, etc.); and (c) name of the provider

of rate (e.g. BBA, FIMMDA). If the provider is not specified, then the name of

Reference Banks will be specified; or it is left to the Calculation Agent.

Whatever it is, the relevant details or procedure must be specified.

e. Designated Maturity: it is the tenor of Floating Rate Option.

f. Spread: Spread, if any, to be loaded on to the Floating Rate Option for

computing the interest amount. The spread may be applicable or inapplicable.

If inapplicable, the word “zero” or “none” is indicated. If applicable, it is

stated as a number (in which case it is understood as percentage per annum) or

explicitly as “basis points”. If the spread is negative, it is explicitly stated as

“minus.”

g. Reset Dates: list of dates on which the interest rate is to be reset. They are not

specified as a complete list, but linked to a specified date in the Calculation

Period. (e.g. the first day in the Calculation Period)

h. Fixing Dates: the date on which the Floating Rate Option is obtained for each

Reset Period. Usually, they are not stated and understood to be the second

business day before the Reset Date. They need to be specified only if the Fixing

Dates are positioned otherwise.

i. Payment Date Business Days: name of he business center to determine holidays

and adjusting the Payment Dates


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j. Reset Date Business Days: name of he business center to determine holidays

and adjusting the Reset Dates. If the fixing center for the Floating Rate Option

and settlement center for the currency are different, then both centers are

named.

k. Compounding: it specifies whether the compounding is applicable or not.

Compounding is applicable when the payment frequency is less than reset

frequency.

Section 3: gives information about the account details of both parties (called “static data”). It

includes the account number and the name of correspondent banks, SWIFT code, etc.

Section 4: specifies the names of offices of the counterpart for correspondence on the trade.

Section 5: specifies the name of the Calculation Agent, who will be responsible for obtaining

the rate fixings and advising the interest amount payable by both the parties. The Schedule to

ISDA Master Agreement usually specifies which of the parties will act as Calculation Agent.

However, Trade Confirmation may specify a different party than mentioned in the Schedule,

and what is written in the Trade Confirmation will prevail. The Calculation Agent can be also a

third party, in which case the Trade Confirmation will specify who will pay for the services of

the third party acting as Calculation Agent.

Section 6: makes a reference to the standard disclaimers.

ISDA Template for Trade Confirmation of FX Option

The trade confirmation for FX option will document the following.

Buyer

Name of the option buyer

Seller

Name of the option seller/writer

Expiry Date and Time

It defines the date and time in the location of option expiry. It consists of the following

three: Date, Time and Cut Name. The last is a scheme with pre-defined time at a

specified business center. For example, the following are the some of the schemes and

their description.

Scheme Description


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Comex 2:30pm New York

ECB 1:30pm London

New York 10:00am New York

SilverLondon 12:15pm London

Exercise Style

It takes the value from the pre-defined list of: American, Bermuda and European

FX Option Premium

It specifies the premium exchange for a single option or option strategy. For zero-cost

option strategies, this is not applicable. When applicable, it has the following

parameters.

Payer: Name of the payer

Receiver: Name of the receiver

Premium Amount: specified as a combination of SWIFT code for currency and

amount, and represents the currency amount of premium

Premium Settlement Date: the date on which the premium amount is settled

Premium Quote: this is optional and for information only. When specified, it

consists of the following parameters.

Premium Value: specified as number, which is either percentage or an

explicit amount

Premium Quote Basis: it takes the value from the following pre-defined

list: percentage of call currency amount, percentage of call currency

amount, call currency per put currency or put currency per call

currency

Value Date

It specifies the date when the currencies are exchanged if the option is exercised by its

buyer.

Cash Settlement Terms

This is applicable only when the settlement method is “cash settlement”. When

applicable, it is specified with the following parameters.


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Settlement Currency: SWIFT code of the currency in which the option is settled

Fixing: It is specified with the following parameters: primary rate source,

secondary rate source (optional), fixing time (reference to the business center

and time) and fixing date.

Put Currency Amount

Must be specified as a combination of SWIFT code for the currency and its numerical

amount, and is the currency amount with right to sell

Call Currency Amount

Must be specified as a combination of SWIFT code for the currency and its numerical

amount, and is the currency amount with right to buy

FX Strike Price

It consists of the following two parameters.

Rate: The rate of exchange between the two currencies. It must be specified

with the following parameter.

Strike Quote Basis: It takes the value from the following pre-defined list: put

currency per call currency and call currency per put currency.


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Hedge Accounting

Financial Instruments: Classification Besides qualifying financial instruments into types as specified in the previous section, IAS 39

also requires that they should be classified into one of the following five categories.

Loans and receivables (LR)

Assets with fixed or determinable payments, have fixed maturity, not actively quoted in the

market, and are not intended to be sold in the short term. Qualifying assets that intended to

be sold in the short term should be classified in HFT; qualifying assets actively quoted in the

market should be classified in HTM; and qualifying assets for which all of the initial investment

may not be recoverable for reasons other than credit deterioration must be classified as AFS.

Held to maturity (HTM)

Assets with fixed or determinable payments and must have fixed maturity; there must be

positive intention and ability to hold them to maturity, and such intention and ability is

assessed at each balance sheet date; and do not meet the definition of LR. This definition

makes preference shares and ordinary shares ineligible to be classified as HTM in usual

circumstances.

The category should be used sparingly. If the items in this category are sold or reclassified

except for irrelevant portion or in exceptional circumstances, then the category cannot be

used for a period of two years. Further, “hedge accounting” (described later) cannot be

applied to the items in this category.

Held at fair value through profit and loss (FVTPL)

It consists of items from two streams:

Held for trading (HFT)

Financial asset or liability held for short term or part of the portfolio where there is an

actual short term profit taking; or derivative asset or liability, including separated

embedded derivatives, except those derivatives that are designated as hedging

instruments.

Measured at fair value or “fair value option” (FVO)


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Any financial asset or liability that is designated as held at fair value. Such designation is a

one-time election on initial recognition and irrevocable, and the asset stays in this

category until sold, matures or extinguished. If fair value of an item cannot be reliably

measured, then it cannot be designated as FVPTL at initiation.

Though IAS 39 allows designating both financial asset and liability to be FVPTL on the

above conditions, banking regulators do not allow it in all cases. For example, European

Union forbids banks from such designation for liabilities.

Available for sale (AFS)

All assets that do not fit into any of the above categories and any non-derivative financial

asset recognized as AFS at initial recognition.

Non-trading liabilities (NTL)

Other liabilities (note that financial liabilities can be classified only in FVTPL or NTL)

Financial Instruments: Measurement Financial assets and liabilities are measured separately at initial recognition and in subsequent periods. Measurement at initial recognition The general principle is that all financial assets and liabilities must be measured at their

initial cost on initial recognition. For items in FVTPL, transaction costs (e.g. brokerage,

commission, etc) are separated from the initial cost and are taken into income. For items that

are not FVTPL, transaction costs are included in the initial cost.

Measurement in subsequent periods

The accounting treatment for measuring in subsequent periods takes into account the change

in the value, and is made consistent with the category, de described below.

Category Accounting Treatment

LR Measured at amortized cost

HTM Measured at amortized cost

FVTPL Measured at fair value and changes in fair value are brought into income (see Note 1 below)

AFS Measured at fair value and changes in fair value at brought into equity,


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unless impaired or sold, in which case the cumulative gain/loss previously recognized in equity is recognized in income for the period (see Note 1 below) However, interest is recorded in income (see Note 2 below)

NTL Measured at amortized cost

Note 1

If the fair value cannot be reliably measured, then the items are measured at cost. However,

such circumstances should be limited and reserved only for unquoted equity instruments and

derivatives on them and only when valuation methodology results in a wide range of fair value.

It should be noted that private equity investments do not come under FAS 133/IAS 39.

Note 2

Interest from an AFS asset must be recorded at the effective yield (i.e. internal rate of return,

which is also called yield-to-maturity in bond market) after including transaction costs. The

difference between fair value and amortized cost should be brought into equity as gain/loss.

For monetary AFS assets (e.g. bonds), the foreign currency gain/loss rising from translation of

amortized cost should be brought into the income.

The AFS assets that are equity are not considered monetary assets, and therefore the foreign

currency translation gain/loss should be recorded in equity, unless the foreign currency risk is

hedged (when it will come under hedge accounting)

Note that participating interests (e.g. investments in associates whose accounts are brought in

consolidated financial statements) are outside the scope of FAS 133/IAS 39.

Hedge Accounting

Hedging is the processes of eliminating specified risks from items (called “hedged items”) by

transacting in certain instruments (called “hedging instruments”) that offset the gain/loss from

hedged items. Under FAS 133/IAS 39, all derivatives must be recognized in balance sheet at fair

value. This leads to a problem when the hedged exposure is either not yet recorded in balance

sheet (because it is a forecast transaction) or recorded in balance sheet but not at fair value.

The situation creates a mismatch in the sense that gain/loss on derivative are not offset by the

complementary gain/loss from hedged exposure. Hedge accounting is introduced to manage

such mismatch in the timing of offsetting gain/loss from hedging instrument and hedged


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exposure. To be eligible for hedge accounting, the following “hedge documentation” criteria

must be satisfied.

� Identification of hedged item and hedging instrument

� Identification of type of hedge

� Identification of risk that is hedged and risk management strategy

� hedge effectiveness criteria, which consists of:

o Prospective hedge effectiveness (“Will the hedge be effective?”)

o Retrospective hedge effectiveness (“Has the hedge been effective?”)

o Method to test hedge effectiveness

Hedged Items

They can be:

� Asset

� Liability

� Firm commitment

� Highly probable forecast transaction

� Net investment in a foreign operation (i.e. having a subsidiary, branch or associate whose functional currency of operation is different from that of the entity) that is exposed to risk of change in fair value or future cash flow.

The following cannot be designated as hedged items.

• Intra-group items (because the inter-company transactions affect only the entity’s

financial statements and not the consolidated financial statements of the group). The

exceptions to this are monetary items (i.e. payable or receivable between two

subsidiaries) or highly probable forecast transactions. They can be considered hedged

items in consolidated financial statements provided they are denominated in a

currency other than the functional currency of the entity entering into that transaction

and the currency risk will affect the consolidated profit or loss.

• Overall business risks (because they cannot be identified and measured)

• Assets in HTM category for interest rate risk or prepayment risk (because hedging them

will be inconsistent with the objectives of HTM category). However, they can be

hedged for currency risk and credit risk

• Derivatives, except written options which can hedge purchased option


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• Net exposure of a portfolio of assets or liabilities (because hedge effectives requires

measuring the changes in fair value or cash flows of a hedged item or a group of similar

item). However, note that though the net exposure does not qualify to be a hedged

exposure, part of the underlying exposure in the portfolio can be hedged. For example,

a company has export receivable of EUR 500,000 and import payable of EUR 200,000. It

designates an the net amount of EUR 300,000 as hedged item, which is acceptable

because the hedged item is considered a part of the EUR 500,000 receivable.

• Own equity (because it does not expose the entity to any risk). A forecast dividend

cannot be a hedged item because distributions to equity holders are directly debited to

equity and therefore do not impact P/L.

• Non-financial assets or liabilities can be hedged items only for all risks or for currency

risk alone. For example, Indian vegetable oil extracting company purchasing soy bean

futures priced in US dollar can hedge: (1) commodity price risk plus currency risk; or

(2) currency risk. It cannot hedge commodity price risk alone, until hedge effectiveness

is proved (explained later).

The eligible hedged items can be hedged fully or partially. For example, consider a 7-year

fixed-rate loan in AFS or FVTPL category. This can be hedged as follows.

• For all cash flows (i.e. fixed interest payments) on the entire fair value

• For all cash flows on 50% of the fair value

• For all cash flows due to specific risk (e.g. risk-free rate)

• For 50% of cash flows due to specific risk (e.g. risk-free rate)

• For specific risk (e.g. currency rate) for principal alone

• For specific risk (e.g. currency rate) for interest alone

Hedging Instruments

Hedging instruments are generally derivatives. However, even non-derivative financial assets or

liabilities can be designated as hedging instruments for currency provided they meet the test of

hedge effectiveness (explained later). Examples of such cases are foreign currency loans or

deposits.

All derivatives except written options, which are carried at fair value, can be hedging

instruments provided it is designated for the entirety of its maturity. A written option cannot

be a hedging instrument except for a purchased option. The following actions are permissible

for hedging.


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• Part of the hedging instrument can be hedge, but not part of its life

• One derivative can be designated as hedge for multiple risks

• Two or more derivatives, in full or part amount, can jointly be designated as hedging instrument. However, if the combination includes written and purchased options, it cannot be a hedging instrument if there is net written option or net premium received.

• A combination of derivative and non-derivative can be designated as hedging instrument only for currency risk

Types of Hedge Accounting

Hedge accounting classifies hedges into fair value hedge, cash flow hedge, and net investment

hedge for foreign operations.

Fair Value Hedge (FVH):

It must satisfy the following criteria.

• The hedged item must be a recognized asset, liability or an unrecognized firm commitment

• Their prices/rates (or quantity in case of firm commitments) are fixed so that subsequent changes in their market prices will affect their fair value

In other words, the derivative hedges against the change in fair value.

Cash Flow Hedge (CFH):

It must satisfy the following criteria.

• The hedged item is an existing asset or liability with variable future cash flows; or a highly probable forecast transaction

• Their prices/rates are not fixed so that subsequent changes in their market prices will affect their value

Thus, the derivative fixes the price/rate of cash flows and reduces their variability

Net Investment Hedge (NIH):

It is similar to CFH except that applies to net investment in foreign operations (e.g. subsidiary,

branch, etc, located outside the home country) and therefore is a hedge against currency risk.

It allows matching foreign currency gains/losses from derivative or liability against revaluation

of net investment in foreign operations. This type of hedge accounting is not available for the

stand-alone accounts of the parent company if the overseas subsidiaries are not equity-

accounted. In such cases, FVH should be applied to the net investment.

Forecast transactions are always under CFH and firm commitments are generally under FVH.

The exception to this principle is the currency risk of a firm commitment, which can be either


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CFH or FVH. Annex I summarizes the various exposures and the hedge types that can be

associated with them.

Nature of Risk and Risk Management Strategy

The entity must document the nature of risk being hedged: that is, whether it is currency risk,

interest rate risk, credit risk, etc. The nature of risk being hedged must also be consistent with

the overall documented policies on risk management.

Hedge Effectiveness

FAS 133/IAS 39 requires that, to qualify for hedge accounting, the hedging instrument must be

effective in hedge. The standard does not specify the procedure to test hedge effectiveness,

but rather requires that the entity should specify the method to assess hedge effectiveness at

the inception; and apply it consistently for the duration of the hedge. Mathematical or

statistical techniques like ratio analysis, regression analysis, etc can be used. The method

chosen must be consistent with the risk management strategy and objective (explained below)

and applied consistently to all similar hedges unless different methods are explicitly justified.

Hedges cannot be designated or documented retrospectively.

The test for hedge effectiveness must be both prospective (“Will it be effective?”) and

retrospective (“Has it been effective?”). The prospective test must be proved at the inception.

Hedge effectiveness cannot be assumed even if the terms of hedging instrument and hedged

item are the same. It must be assessed and measured, because hedge ineffectiveness may arise

from changes in the liquidity, counterparty credit risk, etc. For the retrospective test,

hedge must be assessed and the effectiveness must be within 80 – 125% range, and the

assessment must be on each balance sheet date and on dates the interim financial statements

are prepared.

To ensure hedge effectiveness, the following are permitted.

• Hedge ratios: the ratio is permitted instead of one-to-one. For example, if the hedging

instrument changes in value by only 90% of unit change in hedged item, then the

amount of hedging instrument can be: 100 / 90 = 111% of the amount of hedged item.

• Retrospective test for effectiveness is permitted on period-by-period or cumulative

basis

• In measuring effectiveness, time value of the derivative price can be separated from its

intrinsic-value, and only the latter can be considered for the hedge relationship. The

time-value will then be considered the ineffective part of the hedge, and the change in

fair value will be shown in P&L.


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• Designating only a portion of total risk: only certain risks can be designated as hedged

while others remain un-hedged. For example, a BBB-rated company can enter into an

interest rate swap with LIBOR benchmark (which reflects the credit quality of AA-rated

banks) and designate the portion of risk related to LIBOR and excluded the changes in

the fair value of the hedged item due to its own credit quality.

Accounting for FVH

Change in the fair value of both hedging instrument and hedged item are recognized as

gain/loss in income, thus offsetting each other. These criteria are applicable even if the

hedged item is in AFS so that its changes in fair value are measured in equity. They also apply

to the hedged items that are measured at cost.

For unrecognized firm commitments, the subsequent cumulative change in fair value

attributable to hedged risk is recognized as asset or liability in the balance sheet with a

corresponding gain or loss in P/L. The change in fair value of hedging instrument is also

recognized in P/L. The initial recognition of asset or liability to which the firm commitment

relates: the initial carrying amount of asset or liability that results from fulfilling the firm

commitment is adjusted to include the cumulative change in the fair value of the firm

commitment attributable to the hedged risk that was recognized in balance sheet.

Example

The company raises a 5Y fixed-rate debt for INR 100M with a fixed rate of 8%, and hedges it

through a 5Y interest rate swap under which it pays floating rate and receives the fixed rate of

6.5%. The difference between the fixed-rate of swap and the fixed-rate of debt is 150 basis

points, which represents the credit spread on the company’s debt. The company designates the

swap as fair value hedge, and leaves the credit spread un-hedged.

The following table shows the fair value of debt and changes in the fair value of swap on

different dates.

Issue Date Reporting Date #1 Reporting Date #2

Debt (100) (107) (105)

Swap 0 7 5

The following will be the journal entries for the example above.

On Issue Date


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Issuance of debt is recorded, but no entries for swap since its fair value at inception is zero.

Dr. Cash for 100

Cr. Debt for 100

On Reporting Date #1

Swap has acquired positive value and the debt has correspondingly acquired negative value.

Entries are passed for change in the fair value for both.

Dr. Swap for 7

Cr. P/L for 7

Dr. P/L for 7

Cr. Debt for 7

There is no impact on P/L because the changes in fair value are offsetting.

On Reporting Date #2

Swap has acquired positive value and the debt has correspondingly acquired negative value.

Entries are passed for change in the fair value for both.

Dr. P/L for 2

Cr. Swap for 2

Dr. Debt for 2

Cr. P/L for 2

Because the credit risk is not hedged, the carrying amount of debt in balance sheet does

not represent the full fair value but was a hybrid of amortized cost and changes in fair value

due to movements in interest rates alone. If the company has not elected to start amortizing

the hedging gain/loss while the hedge was outstanding, the adjustment would have remained

as part of debt instrument until it was extinguished or no longer hedged. If hedge accounting

ceased prior to the debt being extinguished, the fair value adjustment of debt would have

been amortized as yield adjustment over the expected remaining life of debt (which is

explained later).

Example

On 15-Sep-05, an Indian company has realized its export receivable for USD 1M. The spot

rate is USD/INR is 45. However, the company does not convert USD into INR because it has

a firm commitment to pay USD 1M on 15-Mar-06. It keeps the export proceeds in an EEFC

account, and designates it as hedge for the firm commitment of USD payable. The

company’s balance sheet date is 31-Dec-05. The forex rates on various dates are as follows.


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31-Dec-05 (Balance Sheet Date): 46

15-Mar-06 (Settlement Date): 44

The following are the journal entries.

On 15-Sep-05

The deposit is recorded at the spot rate of 45 for an amount of INR 45M. However, no entries are passed for change in fair value since the firm commitment is not yet recognized.

On 31-Dec-05

The changes in the fair value of deposit and firm commitment are recognized in income statement. The latter is also recognized as liability in the balance sheet.

Dr. Deposit for INR 1M

Cr. P/L for INR 1M

Dr. P/L for INR 1M

Cr. Exposure for INR 1M

On 15-Mar-06

The changes in the fair value of import payable since 31-Dec-05 is recognized (which is a

profit of INR 2M).

Dr. Exposure for INR 2M

Cr. P/L for INR 2M

The amount for the import payable on this date is INR 44M; and there is an amount of INR

1M against the exposure so far, which is added to the actual payment. In other words, the

final price of the import payable will be the same as the rate prevailing on the hedge date

of 15-Sep-05.

Accounting for CFH

Changes in the fair value of derivative are measured and decomposed into “effective portion”

and “ineffective portion” (which is the time value of derivatives). The effective portion is

deferred into a separate reserve in equity, and the ineffective portion is recognized

immediately in profit or loss. The effective portion is moved out of equity and into profit or

loss in the period the hedged items affects the income.

The amount deferred in equity is limited to the lesser of the absolute amount of:

• Cumulative gain/loss on hedging instrument since the inception of hedge


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• Present-value of cumulative change in the fair value of the expected future cash flows

of the hedged item since the inception of hedge.

Notice that if the former is less than the latter, the cash flow hedge is under-hedged, but it

does not affect the P/L. In other words, the hedge ineffectiveness is not captured in P/L. This

is in contrast to the situation in FVH where the hedge ineffectiveness from both over-hedge

and under-hedge is reflected in profit or loss. The following example illustrates the different

situations.

Changes in fair value Entries Comment

Future cash flows: (100)

Hedging instrument: 90


Equity: 90

P/L: 0

Under-hedge

No effect on P/L

Future cash flows: 100

Hedging instrument: (110)


Equity: 100

P/L: 10

Over-hedge

P/L affected

Future cash flows: (50)



Equity: 0

P/L: 100

Hedge ineffective

Does not qualify for hedge accounting

If the derivative is contracted at market price (which implies its fair value is zero), no

journal entry occurs on trade date. However, if the derivative is contracted at off-market price,

then its fair value will not be zero, and the non-zero fair value must be recorded in equity.

CFH for forecast transactions must be highly probable and is an exposure to variations in

cash flow that will affect profit or loss. If the gain/loss from hedging instrument deferred in

equity subsequently results in recognition of a non-financial asset or liability, the entity can

chose two options, as follows, for accounting it.

• Reclassification: reclassify the gain/loss into profit or loss in the same period the

asset/liability affects profit or loss

• Basis adjustment: adjust the carry amount of asset or liability with the associated

gain/loss deferred in the equity. In this route, the gain/loss from hedging

instrument will affect profit or loss when the non-financial item is sold or

depreciated.

In the Example of the previous section, the company used CFH instead of FVH, and the

company’s policy is not to “basis-adjust” non-financial items in CFH. Whether basis-adjusted

(i.e. firm commitment is fair-value-hedged) or not (i.e. firm commitment is cash-flow-hedged


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without basis adjustment), the net impact on P/L of either CFH or FVH is the same. For CFH,

whether the entity basis-adjusts a non-financial item the forecast purchase of which has been

cash-flow-hedged, or chooses to recycle hedging gain/loss deferred in equity, the net impact

on P/L is the same.

Example

An Indian company has an export order for EUR 4M and enters into a forward sale of EUR.

On the date of forward sale contract

No journal entries since derivative is contracted at fair value and hence has zero value

On the interim reporting date

EUR weakened and the forward sale resulted in positive value of INR 100,000. The change in fair value is taken into equity

Dr. Forward Sale for INR 100,000

Cr. Equity for INR 100,000

On balance sheet date

EUR weakened further, resulting in a further profit of INR 10,000

Dr. Forward for INR 10,000

Cr. Equity for INR 10,000

On the settlement date of hedged item (the EUR/INR = 50)

Sale

Dr. Cash for INR 20 Cr

Cr. Sales for INR 20 Cr

Settlement of forward

Dr. Cash INR 110,000

Cr. Forward INR 110,000

Re-cycle cumulative gain/loss from equity to P/L

Dr. Equity INR 110,000

Cr. Sales INR 110,000

(Note: we have not discounted the change in fair value of forward for simplicity)

Discontinuation of Hedge Accounting

Hedge accounting must be discontinued in the following cases.


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• Hedging instrument expires or is sold, terminated or exercised; or

• Hedge no longer meets the effectiveness test

• Forecast transaction is no longer highly probable

• Entity declares the hedge to be discontinued. In such cases, the entity may designate

new instrument as hedge provided the new hedging instrument meets the hedge

criteria

In all cases of hedge discontinuation, the cumulative gain/loss on hedging instrument deferred in equity so far will have to be immediately recognized in profit/loss. However, if the discontinued hedge is a CFH for a forecast transaction, the accumulated gain/loss can continue to be deferred in equity if the forecast transaction is still expected to occur (though no longer highly probable). Journal Entries for Interest Rate Swap The IRS may be a trading or hedge transaction, and its market side may pay (i.e. pay fixed and receive floating) or receive (i.e. receive fixed and pay float), giving a four possible situations: (1) Trading – Pay (2) Trading – Receive (3) Hedge – Pay (4) Hedge – Receive. The accounting entries are separately described for each of them. (1) Trading – Pay (i.e. pay fixed and receive floating)

(A) On Effective Date Book the memo item for the Notional.

Dr. IRS (Trading) Receive Floating A/c (for Notional) Cr. IRS (Trading) Pay Fixed A/c (for Notional)

(B) On every interest Settlement Date during swap life Interest amount is accounted separately for floating and fixed sides of the swap; and the difference between them is accounted for as the balancing item, as illustrated below. (i) Net interest amount is a payment

Dr. IRS (Trading) Interest (Fixed) A/c (for fixed-rate amount) Cr. IRS (Trading) Interest (Floating) A/c (for floating-rate amount) Cr. Counterparty/Branch Clearing A/c (for the balance amount)

(ii) Net interest amount is a receipt Dr. IRS (Trading) Interest (Fixed) A/c (for fixed-rate amount) Dr. Counterparty/Branch Clearing A/c (for the balance amount) Cr. IRS (Trading) Interest (Floating) A/c (for floating-rate amount)

(C) On Termination Date Interest amount for the last calculation period will be settled as described in the previous section. In addition, the original memo item will have to reversed, as follows.

Dr. IRS (Trading) Pay Fixed A/c (for Notional) Cr. IRS (Trading) Receive Floating A/c (for Notional)

(D) On Cancellation / Early Termination On the date of cancellation/early termination, three sets of accounting entries will have to be passed. First, the interest accrued (for both sides) from the last calculation period end date to cancellation date. The procedure for them is as described in section (1)(B). Second, the reversal of memo item, which shall be in accordance with the procedure described in section (1)(C). The third set relates to the gain or loss resulting from cancellation/early termination of the contract, for which the following entries will be posted. (i) Cancellation results in gain/receipt

Dr. Counterparty/Branch Clearing A/c (for receipt) Cr. IRS (Trading) Gain A/c (for receipt)


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(ii) Cancellation results in loss/payment Dr. Counterparty/Branch Clearing A/c (for payment) Cr. IRS (Trading) Gain A/c (for payment)

(E) On Revaluation Date (i) Revaluation results in gain

Dr. IRS (Trading) Unrealized Gain on Revaluation A/c (for gain) Cr. IRS (Trading) Revaluation Gain A/c

(ii) Revaluation results in loss Dr. IRS (Trading) Revaluation Loss A/c (for loss) Cr. IRS (Trading) Un-crystallized loss A/c (for loss)

The above entries will have to be reversed at the beginning of next business day. (F) On Balance Sheet Date

Interest accrual (separately for each side of swap) is to be computed from last calculation period end date to balance sheet date, and the following entries need to be passed. For the accrued payment (i.e. fixed-rate amount)

Dr. IRS (Trading) Interest (Fixed) A/c Cr. IRS (Trading) Interest (Fixed) Payable A/c

For the accrued receipt (i.e. floating-rate amount) Dr. IRS (Trading) Interest (Floating) Receivable A/c Cr. IRS (Trading) Interest (Floating) A/c

Both the set of entries will have to be reversed at the beginning of the next business day.

(G) Fee Paid or Received (i) Fee is payable

Dr. Commission A/c (for fee amount) Cr. Counterparty A/c (for fee amount)

(ii) Fee is receivable Dr. Counterparty A/c (for fee amount) Cr. Commission A/c (for fee amount)

If the IRS is struck at off-market-rates, the difference between market rate and contract rate is settled separately as “Other Payments” either on Trade Date or subsequently. In such cases, the entry may be posted in the control register if its settlement date is other than Trade Date; and, more important, the amount should be accounted for in Interest on IRS (Trading) A/c rather than Commission A/c. The reason is that the amount represents the interest amount rather than service cost.

(2) Trading – Receive (i.e. receive fixed and pay floating) (A) On Effective Date

Book the memo item for the Notional. Dr. IRS (Trading) Receive Fixed A/c (for Notional) Cr. IRS (Trading) Pay Floating A/c (for Notional)


Dr. Interest (Floating) on IRS (Trading) A/c (for floating-rate amount) Cr. Interest (Fixed) on IRS (Trading) A/c (for fixed-rate amount) Cr. Counterparty/Branch Clearing A/c (for the balance amount)

(ii) Net interest amount is a receipt Dr. Interest (Floating) on IRS (Trading) A/c (for floating-rate amount) Dr. Counterparty/Branch Clearing A/c (for the balance amount) Cr. Interest (Fixed) on IRS (Trading) A/c (for fixed-rate amount)

(C) On Termination Date


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Interest amount for the last calculation period will be settled as described in the previous section. In addition, the original memo item will have to reversed, as follows.

Dr. IRS (Trading) Pay Floating A/c (for Notional) Cr. IRS (Trading) Receive Fixed A/c (for Notional)

(D) On Cancellation / Early Termination On the date of cancellation/early termination, three sets of accounting entries will have to be passed. First, the interest accrued (for both sides) from the last calculation period end date to cancellation date. The procedure for them is as described in section (2)(B). Second, the reversal of memo item, which shall be in accordance with the procedure described in section (2)(C). The third set relates to the gain or loss resulting from cancellation/early termination of the contract, for which the entries will be passed as described in sections (1)(D)(i) and (ii).

(E) On Revaluation Date As described in section (1)(E).

(F) On Balance Sheet Date Interest accrual (separately for each side of swap) is to be computed from last calculation period end date to balance sheet date, and the following entries need to be passed. For the accrued payment (i.e. floating-rate amount)

Dr. Interest (Floating) on IRS (Trading) A/c Cr. Interest (Floating) Payable on IRS (Trading) A/c

For the accrued receipt (i.e. floating-rate amount) Dr. Interest (Fixed) Receivable on IRS (Trading) A/c Cr. Interest (Fixed) on IRS (Trading) A/c

Both the set of entries will have to be reversed at the beginning of the next business day.

(G) Fee Payable/Receivable As described in section (1)(G)

(3) Hedging – Pay (i.e. pay fixed and receive floating) (A) On Effective Date

Book the memo item for the Notional. Dr. IRS (Hedge) Receive Floating A/c (for Notional) Cr. IRS (Hedge) Pay Fixed A/c (for Notional)


Dr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount) Cr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount) Cr. Counterparty/Branch Clearing A/c (for the balance amount)

(ii) Net interest amount is a receipt Dr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount) Dr. Counterparty/Branch Clearing A/c (for the balance amount) Cr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount)


Dr. IRS (Hedge) Pay Fixed A/c (for Notional) Cr. IRS (Hedge) Receive Floating A/c (for Notional)

(D) On Cancellation / Early Termination On the date of cancellation/early termination, three sets of accounting entries will have to be passed. First, the interest accrued (for both sides) from the last calculation period end date to cancellation date. The procedure for them is as described in section (3)(B). Second, the reversal of memo item, which shall be in


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accordance with the procedure described in section (3)(C). The third set relates to the gain or loss resulting from cancellation/early termination of the contract, which has to be amortized over the life of remaining maturity of swap or the life of hedged exposure, whichever is shorter, as follows. Amortization entries (at daily, weekly, monthly or quarterly interals) (i) Amount is gain/receipt

Dr. Interest on IRS (Hedge) Received in Advance A/c (for gain) Cr. Interest on IRS (Hedge) A/c (for gain)

(ii) Amount is loss/payment Dr. Interest on IRS (Hedge) A/c (for loss) Cr. Interest on IRS (Hedge) Paid in Advance A/c (for loss)

(E) On Balance Sheet Date Interest accrual (separately for each side of swap) is to be computed from last calculation period end date to balance sheet date, and the following entries need to be passed. For the accrued payment (i.e. fixed-rate amount)

Dr. Interest (Fixed) on IRS (Hedge) A/c Cr. Interest (Fixed) Payable on IRS (Hedge) A/c

For the accrued receipt (i.e. floating-rate amount) Dr. Interest (Floating) Receivable on IRS (Hedge) A/c Cr. Interest (Floating) on IRS (Hedge) A/c

Both the set of entries will have to be reversed at the beginning of the next business day. Besides the accounting entries for the interest amount, the swap will have to be marked-to-the-market (MtM), and the resulting MtM gain or loss should be adjusted to the market value of the underlying hedged exposure. If the revaluation of underlying hedged exposure is reversed at the beginning of next business day, then the adjusted MtM gain or loss from swap should be reversed at the beginning of next business day, too.

(F) Fee payable or receivable The amount will have to be amortized over the life of the swap. For details, see the “Amortization Entries” in section (3)(D).

(G) Re-designation of Hedge Re-designation of hedge means that a swap is taken off the hedge book; it may be (but not necessarily) substituted with another swap; the swap remains and the underlying exposure is substituted with another exposure; or a combination of them. The following entries are recommended for various events in the re-designation of hedge (i) Swap is taken off the hedge

(a) Reverse the memo items as described in section (3)(C) (b) Provision for the interest accrual, as described in section (3)(E) (c) Mark-to-market (MtM) of the swap, and amortize the MtM gain or loss over the remaining life of swap or the life of hedged exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).

(ii) New swap replaces the old swap for hedge Follow the procedure applicable for new IRS (Hedge)

(iii) Underlying exposure is substituted with another exposure Both the hedge and the hedged underlying exposure are marked to the market; he offsetting MtM entry adjustments are treated as the amount paid or received for hedging the new underlying exposure; and such amount should be amortized over the maturity of swap or underlying exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).

(4) Hedging – Receive (i.e. receive fixed and pay floating) (A) On Effective Date

Book the memo item for the Notional. Dr. IRS (Hedge) Receive Fixed A/c (for Notional)


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Cr. IRS (Hedge) Pay Floating A/c (for Notional) (B) On every interest Settlement Date during swap life

Interest amount is accounted separately for floating and fixed sides of the swap; and the difference between them is accounted for as the balancing item, as illustrated below. (i) Net interest amount is a payment

Dr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount) Cr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount) Cr. Counterparty/Branch Clearing A/c (for the balance amount)

(ii) Net interest amount is a receipt Dr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount) Dr. Counterparty/Branch Clearing A/c (for the balance amount) Cr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount)


Dr. IRS (Hedge) Pay Floating A/c (for Notional) Cr. IRS (Hedge) Receive Fixed A/c (for Notional)

(D) On Cancellation / Early Termination On the date of cancellation/early termination, three sets of accounting entries will have to be passed. First, the interest accrued (for both sides) from the last calculation period end date to cancellation date. The procedure for them is as described in section (4)(B). Second, the reversal of memo item, which shall be in accordance with the procedure described in section (4)(C). The third set relates to the gain or loss resulting from cancellation/early termination of the contract, which has to be amortized over the life of remaining maturity of swap or the life of hedged exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).

(E) On Balance Sheet Date Interest accrual (separately for each side of swap) is to be computed from last calculation period end date to balance sheet date, and the following entries need to be passed. For the accrued payment (i.e. floating-rate amount)

Dr. Interest (Floating) on IRS (Hedge) A/c Cr. Interest (Floating) Payable on IRS (Hedge) A/c

For the accrued receipt (i.e. fixed-rate amount) Dr. Interest (Fixed) Receivable on IRS (Hedge) A/c Cr. Interest (Fixed) on IRS (Hedge) A/c

Both the set of entries will have to be reversed at the beginning of the next business day. Besides the accounting entries for the interest amount, the swap will have to be marked-to-the-market (MtM), and the resulting MtM gain or loss should be adjusted to the market value of the underlying hedged exposure. If the revaluation of underlying hedged exposure is reversed at the beginning of next business day, then the adjusted MtM gain or loss from swap should be reversed at the beginning of next business day, too.

(F) Fee payable or receivable The amount will have to be amortized over the life of the swap. For details, see the “Amortization Entries” in section (3)(D).

(G) Re-designation of Hedge Re-designation of hedge means that a swap is taken off the hedge book; it may be (but not necessarily) substituted with another swap; the swap remains and the underlying exposure is substituted with another exposure; or a combination of them. The following entries are recommended for various events in the re-designation of hedge (i) Swap is taken off the hedge


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(a) Reverse the memo items as described in section (4)(C) (b) Provision for the interest accrual, as described in section (4)(E) (c) Mark-to-market (MtM) of the swap, and amortize the MtM gain or loss over the remaining life of swap or the life of hedged exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).

(ii) New swap replaces the old swap for hedge Follow the procedure applicable for new IRS (Hedge)

(iii) Underlying exposure is substituted with another exposure Both the hedge and the hedged underlying exposure are marked to the market; he offsetting MtM entry adjustments are treated as the amount paid or received for hedging the new underlying exposure; and such amount should be amortized over the maturity of swap or underlying exposure, whichever is shorter. For details, see the “Amortization Entries” in section (3)(D).

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Investment banking operations revised reading material