Private & Confidential

Valuation of Hedging
Instruments held by Tata Sons
Private Limited

August 2019
Table of Contents

Your Duff & Phelps contacts for any questions Title Page
relating to this document are:
1. Introduction to Hedging Instruments 3
Umakanta Panigrahi 2. Cost of Hedge 9
Managing Director
Tel +91 22 6623 1002 3. Valuation of Financial Instruments 16
Umakanta.Panigrahi@duffandphelps.com 4. Other Essential Factors 26

Deepak Panda
Director
Tel +91 22 6623 1020
Deepak.Panda@duffandphelps.com

Jash Shah
Associate Vice President
Tel +91 22 6623 1008
Jash.Shah@duffandphelps.com

2
1.
Introduction to Hedging
Instruments
Hedge Accounting

What is Hedge Accounting ?

 The objective of hedge accounting is to represent, in the financial statements, the effect of risk
management activities that use financial instruments to manage exposures arising from particular risks
that could affect profit or loss (P&L) or other comprehensive income (OCI).

 In simple terms, hedge accounting is a technique that modifies the normal basis for recognizing gains and
losses (or income and expenses) on associated hedging instruments and hedged items, so that both are
recognized in P&L (or OCI) in the same accounting period.

 This eliminates or reduces the volatility in the statement of profit and loss that otherwise would arise if the
hedged item and the hedging instrument were accounted for separately under Ind AS.

Why Hedge Accounting

 Ind AS 109 requires all derivative instruments to be classified and measured as Fair Value through Profit
or Loss a/c (“FVTPL”), giving rise to volatility in profit and loss on each reporting date until maturity of the
instrument.
 For instance, consider a forecast purchase of material in foreign currency which is hedged using a
forward contract. Since the underlying hedged item is a forecast purchase in foreign currency, it does not
affect the statement of profit and loss until the actual transaction occurs, i.e. until the material is
delivered.
 If company elects not to apply the hedge accounting principles in Ind AS 109, the accounting mismatch in
the timing of the impact on the statement of profit and loss will remain.

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Impact of Hedging on Cashflows

Without Hedging With Hedging

Foreign Currency Borrowing Foreign Currency Borrowing

No Cashflow Fluctuation

Principle Principle
Interest Payment Interest Payment
Repayment Repayment

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Impact of Hedge Accounting on Financial Statements

Impact of Hedge
Accounting

• Affects Income Highly volatile on

Ordinary Financial account of changes in
Statement or
macro economic
Instruments • Other Comprehensive factors like interest
Income Statement rate, forex rate, etc.

Eliminates / Reduces
• Affects Income Volatility on account
Financial of the instruments and
Statement or
Instruments under changes in macro
• Other Comprehensive economic factors like
Hedge Accounting
Income Statement interest rate, forex
rate, etc.

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Types of Hedging Instrument

Hedging Instruments

Hedging instrument refers to all the financial instruments used by an investor aiming to offset the potential
changes in the fair value or cash flows of their hedged items.

A forward contract is a customized contract between two parties to buy or sell an

Forward Contract asset at a specified price on a future date. These contracts are always traded over-
the-counter where the transacting parties are known.

A futures contract is a contract between two parties to buy or sell an asset at a

Futures Contract specified price on a future date. These contracts are always exchange traded where
transacting parties are unknown. .

An options contract is an agreement between two parties to facilitate a potential

transaction on the underlying security at a preset price, referred to as the strike
Option Contract
price, prior to the expiration date. There are primarily two types of option contracts –
Call Option and Put Option.

A financial swap is a derivative contract where one party exchanges or "swaps" the
cash flows or value of one asset for another. For example, a company paying a
Swap Contract variable rate of interest may swap its interest payments with another company that
will then pay the first company a fixed rate. Three types of Swap Contracts are
Cross Currency Interest Rate Swaps, Coupon Only Swap and Principle only Swap

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Type of Swap Contracts

Types of Swap Contracts

Cross Currency Coupon Only Principle

Interest Rate Swap Swap Only Swap

Only Only
Principle Interest
Interest Principle
Exchange Exchange
Exchange Exchange

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 2.
Cost of Hedge

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Cost of Hedging (1/4)

Cost of Hedging

Forward Contract
• As per Ind AS 109, an entity must assess the type of hedge on the basis of the nature of the hedged item,
regardless of whether the hedging relationship is a cash flow hedge or a fair value hedge.
• The forward element of a forward contract must account for the changes as the change in time value in
OCI while only the intrinsic value of the forward contract is recorded as the hedging instrument in P&L.
• Time value amount will be removed from OCI and recognized in P&L, either over the period of the hedge
if, the hedge is time related or when the hedged transaction affects P&L, if the hedge is transaction
related.

Swap Contract
• IAS 39 did not prescribe specific accounting criteria for currency basis spreads.
• Ind AS 109 states that a hypothetical derivative cannot include features that do not exist in the hedged
item. It clarifies that a hypothetical derivative cannot simply impute a charge for exchanging different
currencies.
• Under Ind AS 109, where an entity separates the foreign currency basis spread from a financial
instrument and excludes it from the designation of that financial instrument as the hedging instrument, the
entity can account for the changes in the currency basis spread in the OCI which can be further
amortized to the P&L either over the period of the hedge if the hedge is time related or when the hedged
transaction affects P&L.

This ‘cost of hedging’ accounting treatment is optional rather than mandatory. This additional
approach helps to reduce volatility in P&L as compared to the accounting under IAS 39

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Cost of Hedging (2/4)

Forward Contract

Forward element of forward

Change in Spot Rate
contract

Designated to Hedge
Cost of Hedging
Accounting

Duff & Phelps 11

Cost of Hedging (3/4)

Swap Contract

Foreign exchange Fluctuations in Interest

Fluctuations Rate

Designated to Hedge Balancing Figure FCBS

Accounting

Designated to Hedge
Cost of Hedging
Accounting

Foreign Currency Basis Spread (FCBS)

Used in the valuation of cross currency swap instruments, it is

FCBS
the liquidity premium of one currency over the other that is Interest Rate
adjusted to the floating rate of one of the legs of the swap Interest Excluding
contract. FCBS

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Cost of Hedging (4/4)

Accounting for Foreign Currency Basis Spread as per Accounting Standards

Ind AS - 39 Ind AS - 109

Financial
No foreign currency basis spread Adjustment Cost of Hedge
Instrument 13
prescribed

Changes attributable
Changes attributable
to Other
to Statement of
Comprehensive
Profit and Loss
Income

Duff & Phelps 13

Hedge Effectiveness

Hedge Effectiveness

 Hedge effectiveness is defined as the extent to which changes in the fair value or cash flows of the
hedging instrument offset changes in the fair value or cash flows of the hedged item.

 Hedge effectiveness testing can be prospective or retrospective in nature.

 Prospective test is a forward looking evaluation of effectiveness of hedging instrument in offsetting

changes in fair value of cashflow of the hedged item.

 Retrospective test is a backward looking evaluation of effectiveness of hedging instrument in offsetting

changes in fair value of cashflow of the hedged item as of the designated or reporting date.

Hypothetical Derivative

Hypothetical Derivative Perfect Hedge to Hedged Item

14
Hedge Ratio

Hedge Ratio

• The hedge ratio is the relationship between the quantity of

the hedging instrument and the quantity of the hedged item
in terms of their relative weighting. Hedging Instrument
Hedge Ratio =
• Ind 109 requires that the hedge ratio used for hedge Hedged Item
accounting purposes should be the same as that used for
risk management purposes.
0% = No Hedge
• A hedge ratio is the ratio of exposure to a hedging < 100% = Under - Hedged
instrument to the value of the hedged asset. 100% = Perfect Hedge
> 100% = Over - Hedged
• A ratio 100% means that the position is fully hedged and a
ratio of 0% means it is not hedged at all.

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 3.
Valuation of Financial Instruments

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Valuation of Forward Contracts (1/3)

Valuation of Forward Contract

Value of forward contract Change in value of forward contract

Vfwd = MTMd * Nusd ∆Vfwd = ( Sv - S ) * Nv / Sv

Where,
MTMd = (Fe – F) / [(1+r)^n]

Where,

Vfwd = Value of forward contract as of the valuation date Nusd = Notional amount of forward contract in USD
MTMd = Discounted Mark to Market Gain / Loss Sv = Spot Rate as of the Valuation date
Fe = Estimated USD / INR forward rate as of the valuation date S = USD/INR Spot rate as of trade date
F = Forward USD / INR rate as per the contract Nv = Notional amount of contract (USD)
r = Discount Rate (Indian Risk Free Rate)
n = Discount Period
∆Vfwd = Change in Fair Value attributable to spot exchange rate (USD)

Duff & Phelps 17

Valuation of Forward Contracts (2/3)

Valuation Methodology – Forward Contracts

1. Determining the Spot and Forward Terms of the Contract

currency rate of the contract

2. Determining the estimated

forward currency rate as of the Source: Bloomberg Database
valuation date

3. Arriving at unit undiscounted gain / Undiscounted Gain / Loss

loss as of the valuation date = Estimated Forward Rate –
Contractual Forward Rate

4. Discounting the undiscounted gain

/ loss to the valuation date using Source: Bloomberg Database
the Indian Risk Free Rate

5. Determining the value of contract Total Gain / Loss = Discounted Gain /

Loss * Notional Value of
contract

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Valuation of Forward Contracts (3/3)

Valuation Inputs – Forward Contracts

Bloomberg Forward Rate Estimate Bloomberg Estimate of Value of forward

Bloomberg USD/INR Spot Rate

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Valuation of Swap Contracts (1/5)

Valuation of Cross Currency Interest Rate Swaps (CCIRS)

INR - Fixed Leg USD - Floating Leg

1. Determine fixed Interest cashflow and
Principle exchange as of accrual date.
2. Discount the cash flows to the valuation
date using adjusted ICVS (23) rates to
arrive at the present value of total
cashflows.
n=T
Vsf1 =[ ∑ (( Pf1(n) + If1(n))/(1+r1(n))^n) ] / S
n=t
1. Determine variable Interest cash flow using
appropriate adjusted reset rate as Libor
rate plus spread, and Principle exchange
cash flows as of the accrual date.
2. Discount the cash flows to the valuation
date using adjusted ICVS (68) rates to
arrive at the present value of total
cashflows.
n=T
Vsf2 = ∑ (( Pf2(n) + If2(n))/(1+r2(n))^n)
n=t

Vs = Vsf1 – Vsf2
Where,

Vs = Fair Value of swap Pf2 = Principle Payment in USD

Vsf1 = Present Value of fixed leg of swap If2 = Interest Payment in USD
Vsf2 = Present Value of variable leg of swap r1 = ICVS 23 discount rates
Pf1 = Principle Payment in INR r2 = ICVS 68 discount rates
If1 = Interest Payment in INR S = USD/INR Spot rate as of valuation date

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Valuation of Swap Contracts (2/5)

Valuation of Cross Coupon Only Swaps (COS)

INR - Fixed Leg USD - Floating Leg

1. Determine fixed Interest cashflow as of the 1. Determine variable Interest cash flow using
accrual date. appropriate adjusted reset rate as Libor
rate plus spread, as of the accrual date.
2. Discount the cash flows to the valuation
date using adjusted ICVS (23) rates to 2. Discount the cash flows to the valuation
arrive at the present value of total date using adjusted ICVS (68) rates to
cashflows. arrive at the present value of total
cashflows.

n=T n=T
Vsf1 =[ ∑ ( If1(n) / (1+r1(n))^n ) ] / S Vsf2 = ∑ ( If2(n) / (1+r2(n) )^n)
n=t n=t

Vs = Vsf1 – Vsf2
Where,

Vs = Fair Value of swap If2 = Interest Payment in USD

Vsf1 = Present Value of fixed leg of swap r1 = ICVS 23 discount rates
Vsf2 = Present Value of variable leg of swap r2 = ICVS 68 discount rates
If1 = Interest Payment in INR S = USD/INR Spot rate as of valuation date

Duff & Phelps 21

Valuation of Swap Contracts (3/5)

Valuation of Principle Only Swaps (POS)

INR - Fixed Leg USD - Floating Leg

1. Determine fixed Interest cashflow and 1. Determine Principle exchange cash flows
Principle exchange as of the accrual date. as of the accrual date.
The fixed interest component is attributable
2. Discount the cash flows to the valuation
to risk associated to foreign exchange rate
date using adjusted ICVS (68) rates to
fluctuations.
arrive at the present value of total
2. Discount the cash flows to the valuation date cashflows.
using adjusted ICVS (23) rates to arrive at
the present value of total cashflows.
n=T n=T
Vsf1 =[ ∑ ((Pf1(n) + If1(n) ) / ( 1+r1(n) )^n) ] / S Vsf2 = ∑ (( Pf2(n ))/( 1+r2(n) )^n )
n=t n=t

Vs = Vsf1 – Vsf2
Where,

Vs = Fair Value of swap Pf2 = Principle Payment in USD

Vsf1 = Present Value of fixed leg of swap r1 = ICVS 23 discount rates
Vsf2 = Present Value of variable leg of swap r2 = ICVS 68 discount rates
Pf1 = Principle Payment in INR S = USD/INR Spot rate as of valuation date
If1 = Interest Payment in INR

Duff & Phelps 22

Valuation of Swap Contracts (4/5)

Valuation Methodology – Swap Instruments

USD Cashflow - Reset Rates derived from

1. Estimating cash flows based on Bloomberg database
the terms of the contract
INR Cashflow - Terms of the Contract

2. Deriving discount factors based USD – ICVS 23 Curve

Source:
on the prevailing interest rates to
Bloomberg
value each leg and discounting it INR – ICVS 68 Curve Database

3. Arriving at the concluded Fair Vs = [Vinr / USD/INRspot ] – Vusd

value of CCIRS

Forex Sensitivity
4. Sensitivity analysis
Interest Rate Sensitivity

Duff & Phelps 23

Valuation of Swap Contracts (5/5)

Valuation Inputs – Swap Instruments

Bloomberg Reset Rate Estimates Bloomberg USD/INR Spot Rate

ICVS – 68 Curve ICVS – 23 Curve

Duff & Phelps 24

Factors affecting value – BNP CCIRS (Expiry 15 Oct 2022)

-
0 -
Value of swap as of
(1,000,000) Jan 31, 2019

(2,000,000)
(2,202,315)

(2,394,768)
(3,000,000) Change due to decrease
in maturity

(4,000,000)
(577,520)

(5,000,000) (2,649,943)
Change due to decrease
in Interest rate both USD
& INR
(6,000,000)

(7,000,000)
Change due to exchange
rate
(8,000,000)
(7,824,546)

(9,000,000)

Value of swap as
of March 31, 2019

Duff & Phelps 25

 4.
Other Essential Factors

Duff & Phelps

Risk Mitigation

Risks Covered through Hedging Instrument

Rebalancing Risk

Hedge Ratio
Credit Risk

Economic Risk Currency Risk

Duff & Phelps 27

Sensitivity Analysis

Hedging Effectiveness

Economic Risk Currency Risk

Interest Rate Sensitivity Currency Sensitivity

LIBOR + 0% USD/INR Spot

- 1% +1%
LIBOR – 1% LIBOR + 1%
- 5% +5%

Duff & Phelps 28

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