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Monday
Jul022018

Derivatives, Interest Rate 'Swaps,' & 'Hedging'

Long-time readers will be aware of the skepticism I have expressed in the past regard to the ability of our Council (and it is not alone in this regard!), to handle ‘derivatives’ in the form of interest rate swaps on forward borrowing up to five years out. There is a stated intent in the Council policy to “avoid speculation,” but such is inherent with every decision.  

I was alarmed at a recent Council meeting to hear Corporate Services Manager - Karl Dudley, indicate that it would be necessary to increase the current provision for loss on derivatives from $300k to $400k, and maybe more to year-end on 30 June.

I decided to investigate the current and ‘rolling’ state of the derivative account, and was referred to the Annual Reports from 2010 onwards, though figures from 2006 to 2009 were provided covering the period from when the account first went into deficit in 2008.

On further analysis of the Notes to the Accounts, it appears that the annual deficits (and some gains!) recorded by Price-Waterhouse Cooper who have been retained to provide an independent six-monthly valuation of the 'paper,' or 'swaps' had accumulated from a $447k gain in 2005 to a total $4.57m deficit by 30 June 2017.

This is not a ‘cash’ figure as the Finance Manager hastened to assure me, and therefore not recorded in the Council’s Profit & Loss account. Of course, the $4.57m is only relevant when those who hold the swaps decide to ‘cash-up’ and demand repayment along with the outstanding debt, though Council is substantially protected by varying maturity dates. Nevertheless, the upper echelon of Council will naturally be concerned that the figure does not ‘blow-out’ at any time resulting from adverse movements in interest rates, or for any other reason.

While interest rates remain low, the holders of the instruments are encouraged to ‘roll-over’ their ‘paper.’ Should Council decide, or be forced to ‘crystallize’ its position for whatever reason, the $4.5m (or whatever amount at the particular time) contingent liability would have to be settled, and then it would appear in our Council’s Profit & Loss account. It can theoretically extend well out into the future, but it always remains a risk.

Council was persuaded in 2007 to enter the market to offset the effects of predicted imminent interest rate increases. These never eventuated, and hence the current deficit. Interest rate increases can still occur quite quickly, and may well do so during the term of the current Government – thus the term ‘hedging.’ The reduction in the accumulated deficit from $6.4m in 2016 to $4.6m in 2017 exemplifies this volatility, and risks inherent in the practice.

Here is the extract from the 2017 Annual Report that explains the policy as it has been applied since the outset. Readers should be aware of the policy and its implications.

Accounting policy 

Derivative financial instruments are used to manage exposure to interest rate risks arising from the Council's financing activities. In accordance with its treasury policy, the Council does not hold or issue derivative financial instruments for trading purposes. 

Derivative financial instruments are initially measured at fair value on the contract date, and are re-measured to their fair value at each balance date. The fair value of interest rate swap contracts is determined by reference to market values for similar instruments. Any gains or losses arising from changes in fair value are recognised in the surplus or deficit. 

Derivatives embedded in other financial instruments or other non-financial host contracts are treated as separate derivatives when their risks and characteristics are not closely related to those of the host contract and the host contract is not carried at fair value with unrealised gains or losses reported in the surplus or deficit. 

The portion of the fair value of an interest rate derivative that is expected to be realised within 12 months of balance date is classified as current, with the remaining portion classified as non-current. 

The Council has elected not to apply hedge accounting to its derivative financial instruments. 

 

Breakdown of derivative financial instruments and further information

 

 

2017

Actual

$000's

         2016

Actua

$000'

Current liability portion

Interest rate swaps                                                                                                      1,303

 

1,269

Total current liability portion

1,303

1,269

Non-current liability portion

Interest rate swaps                                                                                                      3,265

 

5,138

Total non-current liabilities portion

3,265

5,138

Total derivative financial instrument liabilities

4,568

6,407

 

Fair value of interest rate swaps

The fair values of interest rate swaps have been determined by calculating the expected cash flows under the terms of the swaps and discounting these values to their present value. The inputs into the valuation model are from independently sourced market parameters such as interest rate yield curves. Most market parameters are implied from instrument prices. 

Information about interest rate swaps 

 

The notional principal amounts of the outstanding interest rate swap contracts for the Council were $50.5 million (2016: $50.5 million). $10 million of these interest rate swaps have start dates after year-end and are in line with forecasted borrowing requirements. At 30 June 2017, the fixed interest rates of the outstanding interest rate swaps varied from 4.17% to 6.10% (2016: 4.17% to 6.10%).

 

 


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Reader Comments (2)

Bill
As I am not a 'finance' person, can you please explain what this gooble-de-gook actually means?

For example: "...Derivative financial instruments are used to manage exposure to interest rate risks..."
"...Derivative financial instruments are initially measured at fair value on the contract date, and are re-measured to their fair value at each balance date. …" Derivatives embedded in other financial instruments or other non-financial host contracts are treated as separate derivatives when their risks and characteristics are not closely related to those of the host contract and the host contract is not carried at fair value with unrealised gains or losses reported in the surplus or deficit. …"

Oh gosh - look at that - I can't understand most of the article.....am I alone in this?

July 4, 2018 | Unregistered CommenterRussell

Most people prefer not to go there Russell for precisely this reason. It is as if the wording has been deliberately obfuscated precisely to put people off from investigating just what on earth is going on.
I have been fascinated ever since the first visit to Council of a merchant bank 'smarty pants' in 2007 to explain it all in these terms to a bunch of incredulous councilors who simply did not have a clue what he was talking about, but who were prepared to follow the then CFO into the bright new world of derivatives - it was happening everywhere at that time, but most were simply 'hedging' against future interest rate increases - a relatively simple process.
The problem is that once into derivatives, it is much harder to get out - hence here we are in 2018 with what is fortunately only a $4.5m deficit - it could have been much higher. As for it not being a "cash loss" - well you know what I think about that - delusional! Remember that the PwC involvement is simply to 'track' the deficit, and the figure arrived at is buried in the Notes to the Accounts where few readers would venture.
It is important that the 'roll-over' deficit needs to be tracked from year to year by others outside the Castle walls, and that we are not put off by either councilors or staff who I suspect simply hope that it stays hidden until they 'pass the baton.'

July 5, 2018 | Registered CommenterBill Barclay

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