Post-Trade Management of Derivative Portfolios
by Jean-François Garneau, Director, Head of Financial Risk Management, Bombardier Transportation, Zürich
Some people think that risk management decisions are concerned with what happens up to and until a trade is executed, while hedge accounting ones are concerned with what happens post-trade, i.e., once a trade is on our books. This amalgamation of the distinction between risk management and hedge accounting with that between the pre-trade and post-trade occurrence of the decision can only be maintained as long as the size of one’s financial risk is not too high. The minute financial risk becomes significant, the accounting consequences of risk management start to matter tremendously, making it advisable that the risk management function be greatly involved in the set-up of the hedge accounting framework of the firm, and that hedge accounting specialists are called in whenever risk management decisions involve potential hedge accounting issues.
The better distinction to make is therefore not between a pre-trade risk management function divorced from hedge accounting and a post-trade hedge accounting function divorced from risk management, but between (i) a pre-trade decision-making process, where discretionary decisions can still be made with regard to both risk management and hedge accounting, and (ii) a post-trade decision-making process, which is almost entirely governed by the risk management decisions and hedge accounting set-up decided before the trade was executed. In this article, we would like to share with you four of the risk management and hedge accounting considerations that went into the set-up of our post-trade hedge accounting framework, with the hope that some of those insights could help you optimise your own post-trade set-up.
First consideration: Should you account for your derivatives as fair value hedges or as cash flow hedges? The answer depends in part on the sort of flows you are trying to hedge. This is because fair value hedge accounting can only be applied to firm commitments (i.e., to committed sales or purchase transactions with third parties). However, because cash flow hedge accounting can be applied to most sorts of flows whereas fair value hedge accounting cannot, we and many of the companies we benchmarked have preferred to deny ourselves the opportunity to use fair value hedge accounting. This has enabled us to keep our hedge accounting set-up as simple as possible (one rule for all) in addition to aligning us with the forecasts most experts make with regard to the disappearance of fair value hedge accounting as an option within the revised international hedge accounting standards.
Second consideration: Which portion of your forward contract should you designate as a hedging instrument for the purpose of hedge accounting? The question may sound odd, especially if one assumes that hedging instruments cannot be split for such purpose, which is an incorrect assumption. Within a forward contract, one may distinguish between the spot component of the instrument and the forward points component. The valuation of the spot component measures the FX gains or losses made on the volatility of the spot rate between inception and the date at which the derivative is valued whereas the valuation of the forward points tries to quantify everything else, i.e., both (i) the impact of the change in forward points between inception date and valuation date and (ii) the time value of money with which one must discount the value of a derivative on its maturity date to get to its present value today. The usefulness of such distinction is that since the time value of money is located entirely in the forward points, the non-inclusion of these forward points in the hedge designation allows the hedge thus designated to remain effective as long as there is no overhedging. Maturities of hedged items can change, roll over of hedges can occur: all these changes will impact the forward points, not the spot component of the derivative.