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Further on Derivatives

A number of readers have asked for further information on the mysterious ‘derivatives’ that our Council is carrying on its books, and that have the ability over time to create substantial (in the millions!) losses or gains dependent on interest rate movements. They are complicated, and I suspect that few people understand the full ramification for organisations that enter into them.

The following is my compilation of extracts from a paper written by Steve Baker and presented to the Audit Committee on 3 February 2009 by the Leadership Team. This was provided to me by Steve yesterday.

A ‘derivative’ is defined as a financial instrument or other contract with all three of the following characteristics:

1.           Its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract,

2.           It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, and

3.           It is settled at a future date.

Derivatives are classified as “At fair value through profit or loss”. These derivatives are initially measured at cost, which will usually be fair value at the time. Subsequent revaluations to be fair value (mark-to-market).

Changes in fair value of derivatives are required to be recognised in the Statement of Financial Performance (except for derivatives designated as hedges where the organisation elects to adopt hedge accounting)

There are two ways in which hedging instruments can be accounted for in Council reports. 

1.           Non-Hedge Accounting Method

2.           Hedge Accounting Method 

Council currently has interest rate swaps, swaptions, and foreign exchange contracts (which are hedging instruments) in place.

Swaps will have a 'real' cashflow impact on Council as they will form the basis of the interest paid on the portion of debt they cover, be it higher or lower than the interest cost Council would otherwise have had to pay. The anticipated interest cost from swaps is factored into Councils Interest rate budgets. Where as swaptions provide Council with the opportunity to protect itself from upwards movements in interest rates for a predetermined period of time where it could choose to exercise that option at any time within the timeframe specified within the option. Swaptions may or may not attract a premium payment. 

 The value of these instruments has to be included in the balance sheet (statement of financial   position).  Every year after they have been introduced, they have to be valued and any movements in value must be accounted for.

Under the non-hedge accounting method – these movements in valuation will be recorded in the Statement of Financial Performance. As such any movements in valuation will be reflected in the net operating surplus of Council in each year.

These ‘revaluations’ are not cash transactions so will not require funding in the conventional sense.  They will not affect the incidence of rates set and therefore will not directly touch ratepayers pockets.  In fact the adoption of hedge accounting would increase administration costs which would need to be recovered from the ratepayer.

The future value of the derivatives can be difficult to predict and therefore can lead to volatility in profitability. Under the Liability Management Policy Section 9.0 all financial instruments are fair valued (marked-to-market) on a consistent basis, at least six monthly for treasury management and accounting purposes. 

The decision to enter into the derivative market was made on the basis of the well foundered assumption at the time that interest rates were on the rise, and that many of TCDC’s loans would incur substantial interest increases when they were rolled, and because long term (over 3 years) loans were almost impossible to secure at the time, the Council was at some considerable risk, and that risk has increased exponentially as its borrowing has increased over the last two years.

I asked Steve at the same time as he passed on the above to provide me with an explanation as to just how Asia Pacific (now apparently absorbed by Price Waterhouse) valued the instrument at each six-monthly re-valuation. Also, just how projections were arrived at for the year ahead for incorporation into the Annual Plan? Specifically, just how this figure has gone from negative $151k to $934k in the 2013/13 forecast?

Steve opted to refer my enquiry to Price Waterhouse, in order to “ensure we use the correct terminology” for the answers. I will pass these answers on just as soon as they received.

I am not undertaking this enquiry in any way as a witch-hunt – rather in an attempt to establish some clarity. It is always easy to be wise after the event, and Council at the time honestly believed that the advice it was receiving was sound and that entering into the instrument was warranted. The fact that interest rates took a dive in late 2008 when the  OCR went from 8.25 to 5% between July and January), and now hangs around 2.25% speaks for itself and could not have been predicted – it came as a shock to the entire market, let alone our Council. There is no doubt that it has been an expensive exercise.

The net result is that quite apart from the current liability projection of $934k, the Non-current liability line shows an increase from $1,416k to $3,856k. I have no doubt that this is realistic, but the Price Waterhouse explanation will be nevertheless be extremely interesting. It will be particularly interesting to understand just how they value the increase in liability resulting from the proposed increase in borrowing of some $9.7m. It seems that at some stage interest rates will rise, and Steve Baker’s “zero-sum” exercise come to a conclusion.    

My criticism is that there is insufficient explanation of a number of items in the Financial Statements – some of which have a substantial effect on the final outcome, including the Derivatives. I mention another as an example - the line item ‘Intangible Assets’ has gone from $6.481m to $8.514 without any explanation – again, not good enough!

Anyone who can throw further light on this situation is welcome to comment.

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Reader Comments (1)

Is the jargon an attempt to make understanding so difficult that the perpetrators are left alone to get on with their job without interference by elected members.? Or is this obfuscation to hide a profligate use of ratepayers cash to avoid accountability? You may understand this Bill but I'm at a lose(bedazzled)..

May 4, 2013 | Unregistered CommenterPeter H Wood,

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