CASE STUDY

Hedge optimization with IAS 39

Hedging is an important tool in designing risk management strategies and has been one of the hottest implementation topics in finance for the last decades. Moreover, it is highly considered in the IFRS and IAS standards as it is one of the main topics addressed in their published documentations.
Ioannis Akkizidis Consultant, IRIS Integrated Risk Management AG that may occur in another investment. Hedging is one of the main topics addressed by the documentation of the International Financial Reporting Standards (IFRS) and the International Accounting Standard (IAS 32 & 39). IAS 39 provides specific definitions on the recognition and measurement of hedging instruments and hedged items used in the hedge relationship. On the other hand, IAS 32 contains disclosure requirements, which are both narrative and numerical, and covers, among others, the policies governing risk management and hedging activities. According to this standard, an entity shall describe its financial risk management objectives and policies, including hedging policies. For the financial instruments that are applied, the entity has to provide information about the associated risks including the managements rationale for hedging the risk exposures (Figure 1).

edging in finance is about offsetting the relation between the financial hedging instruments and hedged items. In the real market environment this hedge relation is dynamically changing and thus has to be adjusted, by defining and modifying their contribution, to keep their offsetting effective, robust and stable to a desirable level. While this is trivial when the number of the potential hedged items and hedging instruments is small, it is quite complex when there are a lot of potential contracts for a hedge relation. A solution is to define their optimal amount in order to offset their hedge relation. This optimization is performed by using derivative-based mathematical optimization algorithms as well as linguistic rule-base optimization techniques. Both approaches are driven by objective (target) functions that consider the changes in their volatilities referring to hedged items and hedging instruments. Moreover, all possible constraints in reference to the homogeneity, ex-ante effectiveness, and maximum hedge percentage also play an important role and thus are considered in applying the hedge optimization approaches described in this article.

IFRS
derivative-based optimization Hedging Recognitions Measurements Disclosures rule-based optimization

IAS32

IAS39

IFRS / IAS 32 & 39 and hedging

Hedging in finance is an investment in an offsetting position aimed at reducing the risk ensuing from adverse price movements

optimally offsetting hedge relation

Figure 1: IFRS IAS /32 /39 and Hedge Optimization

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IAS 32
IAS 32 Financial Instruments: Disclosure and Presentation was issued in December 2003 and is applicable for annual periods beginning on or after 1 January 2005. IAS 32 is intended to enhance financial statement users understanding of the significance of financial instruments to an entitys financial position, performance and cash flows. It prescribes requirements for the presentation of financial instruments and identifies information that should be disclosed about them. IAS 32 applies to all types of financial instruments except: those interests in subsidiaries, associates and joint ventures that are consolidated, or are accounted for using the equity method or proportionate consolidation in accordance with IAS 27 Consolidated and Separate Financial Statements, IAS 28 Investment in Associates or IAS 31 Interests in Joint Ventures; employers rights and obligations under employee benefit plans (IAS 19 Employee Benefits); contracts for contingent consideration in a business combination (IFRS 3 Business Combinations); insurance contract as defined by IFRS 4 Insurance Contracts; financial instruments that are within the scope of IFRS 4 Insurance Contracts because they contain a discretionary participation feature; and financial instruments, contracts and obligations under share-based payment transactions (IFRS 2 Share Based Payment). Financial assets and financial liabilities are offset when and only when there is a legally enforceable right to set off and the entity intends to settle on a net basis. IAS 32 requires disclosure about factors that affect the amount, timing and certainty of an entitys future cash flows relating to financial instruments and the accounting policies applied to those instruments. It also requires disclosure about the nature and extent of an entitys use of financial instruments, the business purposes they serve, the risks associated with them, and managements policies for controlling those risks. The principles in IAS 32 complement the principles for recognising and measuring financial assets and financial liabilities in IAS 39 Financial Instruments: Recognition and Measurement.

Summary of IAS 32
Financial instruments are classified, from the perspective of the issuer, as financial assets, financial liabilities and equity instruments. Compound financial instruments may contain both a liability and an equity component. Interest, dividends, losses and gains relating to financial liabilities are recognised as income or expense in profit or loss. Distributions to holders of equity instruments are debited directly to equity, net of any related income tax benefit.

(Source : IASB, Web Summaries Financial Instruments: Disclosure and Presentation)

Hedging is an integral part of risk management. It is considered as one of the most advanced strategic tools for minimizing the risk exposure in a portfolio while still allowing profit to be gained from the investment activities. This is however not the case in a full or total hedge. Here, we seek to neutralize the risk of an investment by engaging in a number of offsetting contracts such that potential gains and losses cancel each other out. A hedge portfolios focus is not on whether the market as a whole goes up or down in value; what really matters are the volatilities and the corresponding adaptation of the contribution of the hedge group elements. A hedge group consists of both hedging instruments and hedged items linked together to form a hedge relationship. According to the IFRS/IAS, a hedging instrument is a designated derivative or for a hedge of foreign exchange risks a non-derivative financial asset or liability, whose fair value or cash flows are expected to offset

changes in the fair value or cash flows of a designated hedged item in the same hedge. On the other hand, a hedged item is an asset, a liability, a firm commitment, a highly probable forecast transaction or a net investment in a foreign operation that (a) exposes the entity to a risk of changes in fair value or future cash flows and (b) is designated as being hedged by hedging instruments from the same hedge. In the categories of hedges, a fair value hedge is a hedge of the exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment or an identified portion of such an asset, liability or firm commitment that is attributable to a particular risk and could affect profit or loss. Based on the same standards definitions, hedge effectiveness is the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument. Therefore, hedge effec-

tiveness measures the ability to offset the hedging instruments with the hedged items, whereby in hedging this has to reach the optimal level.

Hedge optimization and its strategies

In hedging the main target is to synchronize the volatilities between the hedged items and hedging instruments. The first step can be achieved by selecting the hedging instruments that are offsetting the hedged items and vice versa. In the real market environment a hedge relationship is dynamically changing, as volatilities may change independent of each other - making adjustments necessary. In dynamic hedge optimization the target is to optimally modify the contribution of hedging instruments and hedged items and to adjust this effectively according to their offsetting capabilities keeping the hedge relationship stable. Note that the offsetting is defined as regards the effects on profit or loss of changes in the fair value of

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the hedging instruments and the hedged items, given certain constraints. In hedge optimization the main driver for dynamically selecting the offsetting hedging instruments and hedged items is the magnitude of the volatilities/changes in reference to changes in fair values and amortized cost of a financial asset or liability. The constrained optimization techniques are driven by objective functions that are required to move towards a minimum or maximum point through an iterative process. The constraints that have to be considered refer to hedge homogeneity, ex-ante effectiveness, and a predefined hedge percentage in the offsetting relation. The strategy of the hedge optimization can be based on: The optimal selection of the most effective hedging instruments that are offsetting the risk exposure of the hedged items; The optimal selection of the hedged items that can be hedged by the available hedging instruments.

Constraints: Homogeneity Ex-ante Effectiveness Hedge Percentage

Optimal Hedging Derivative & Rule Based

Optimisation Techniques

Volatilities / Changes Fair Values / FV Amortized Cost / AC Dynamic Simulation (Hedging Instruments & Hedging Items)
Figure 2: Pyramid representing the layout for designing the hedge optimization algorithmic strategy

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The two hedge optimization strategies mentioned above are based on bottom-up approaches, where the evaluation of the individual volatilities grants the ability to define the contribution of the hedge instruments and the participation of the hedged items in the hedge relationship. When such a strategy is applied, a one-to-one hedge relational analysis is used to minimize the objective function. However, such a strategy may be time-consuming in proportion to the number of the hedge instruments/ items used in the hedge relationship. Alternatively, overall volatilities may be employed to measure and offset the hedge relationship. By employing such an approach, the objective function may not be minimized to a desirable level. However, the algorithm reaches the (local) minimum point faster and thus the approach is quite suitable, when the number of hedging instruments and/or hedged items is significantly large. Finally, applying both the abovementioned approaches in parallel could be an alternative for defining the optimal contribution of the hedging instruments, as well as the optimal amount of hedged items that should contribute in offsetting the hedge relationship. Although this combined approach is more sophisticated, it however requires a large amount of computation and iteration steps to reach the optimal solution. ART
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How to optimize the hedge?

To implement all of the abovementioned hedge optimization approaches described, different optimization techniques and methodologies are employed. These include derivative-based optimization techniques, where differentiation functions are the drivers toward the optimal levels. Furthermore, strategic optimal rule-based techniques are also employed, where expert knowledge is put down on paper to design the hedge strategies. Nonlinear functions are used to express the linguistic terms mathematically and quantify the optimal hedge relation.

Hedging built on derivativebased optimization techniques

In hedge analysis, derivative-based mathematical optimization techniques are applied to optimally offset the hedge relationship. Offsetting the relationship implies that the volatilities of the hedging instru-

Francis-Olivier Brunet, Arbre, ink and acrylic on paper (21 x 14 cm).

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ments and hedged items should equal that of the opposite relationship. This brings to the fore the hedge duration: the first derivative of the hedge relationship. The transition of this hedge duration is defined by the second derivative of the hedge relationship. This is the hedge convexity. The two main drivers of the objective function used in hedge optimization are the cost and the direction functions towards the optimum. The latter refers to the hedge convexity, whereas the former refers to the hedge duration. In hedge optimization the aim is to synchronize the volatilities of the selected hedging instruments and hedged items and vice versa. Thus, the exposure to the relative changes in movements in fair values and amortized cost is small. In this case, for the hedge duration, the hedge participation is adequately offsetting the overall portfolio. Moreover, the variation of this hedge synchronization should also have a low degree, and the adjustment of the overall portfolio that is driven by the hedge convexity, is well performed. This is as regards the (updated) hedge participation and the offsetting process, implying that the overall portfolio has a high level of stability. Note that by using derivative-based optimization techniques the solution may only be in the area of the local minimum. However, by starting with the constraint of effectiveness i.e., [0.8 - 1.25], defined in IFRS / IAS 39, this issue may be resolved, as the optimization algorithm searches in the area where the global minimum is. degrees of optimal contribution in regard to the existing offsetting volatility. Similar to the aim in derivative-based approaches, the objective in rule-based hedge optimization is to define through rules the optimal contribution of items in the offsetting hedge relationship considering the volatilities of the hedging instruments and hedged items. This is achieved by defining if-then rules so as to follow in terms of the propositions the offsetting volatilities/ changes for the two types of hedges. Let us define the following two fuzzy linguistic rules, referring to the contribution of hedging instruments for offsetting the hedged items: Rule I: if the offsetting volatility of a hedging instrument to the volatility of hedged items has a low degree, then the contribution of the instrument is low Rule II: if the offsetting volatility of a hedging instrument to the volatility of the hedged items has a high degree, then the contribution of the instrument is high

Hedging based on rule-based optimization techniques

Hedge optimization can also be based on optimal linguistic rule-based techniques defined by experts for designing hedging strategies. The rules are expressed in linguistic terms and are driven by nonlinear relational functions expressed as membership functions. These measure the actual

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IAS 39
IAS 39 Financial Instruments: Recognition and Measurement was issued in December 2003 and is applicable for annual periods beginning on or after 1 January 2005. IAS 39 prescribes principles for recognising and measuring all types of financial instruments except: those interests in subsidiaries, associates and joint ventures that are consolidated, or are accounted for using the equity method or proportionate consolidation in accordance with IAS 27 Consolidated and Separate Financial Statements, IAS 28 Investment in Associates or IAS 31 Interests in Joint Ventures; rights and obligations under leases (IAS 17 Leases). However: lease receivables recognised by a lessor are subject to the derecognition and impairment provisions of IAS 39; finance lease payables recognised by a lessee are subject to the derecognition provisions of IAS 39; and derivatives that are embedded in leases are subject to the embedded derivatives provisions of IAS 39. employers rights and obligations under employee benefit plans (IAS 19 Employee Benefits); financial instruments issued by the entity that meet the definition of an equity instrument in IAS 32 (including options and warrants). rights and obligations under an insurance contracts as defined by IFRS 4 Insurance Contracts, and under a contract that is within IFRS 4 because it contains a discretionary participation feature. However, IAS 39 applies to derivatives embedded in such a contract; contracts for contingent consideration in a business combination (IFRS 3 Business Combinations); contracts between an acquirer and a vendor in a business combination to buy or sell an acquiree at a future date; loan commitments that cannot be settled net in cash or another financial instrument (except those that are designated as financial liabilities at fair value through profit or loss); and financial instruments, contracts and obligations under share-based payment transactions (IFRS 2 Share Based Payment), except certain contracts to buy or sell a non-financial item as noted below. IAS 39 applies to those contracts to buy or sell a non-financial item that can be settled net in cash or another financial instrument, or by exchanging financial instruments, as if the contracts were financial instruments. However, IAS 39 does not apply to any such contracts that were entered into and continue to be held for the purpose of the receipt or delivery of a nonfinancial item in accordance with the entitys expected purchase, sale or usage requirements. Available-for-sale financial assets: Non-derivative financial assets that do not fall within any of the other categories. The unrealised movements in fair value are recognised in equity until disposal or sale, at which time, those unrealised movements from prior periods are recognised in profit or loss. If there is objective evidence that a financial asset is impaired, the carrying amount of the asset is reduced and an impairment loss is recognised. A financial asset carried at amortised cost is not carried at more than the present value of estimated future cash flows. An impairment loss on an available-for-sale asset that reduces the carrying amount below acquisition cost is recognised in profit or loss. Hedge accounting IAS 39 provides for two kinds of hedge accounting, recognising that entities commonly hedge both the possibility of changes in cash flows (ie a cash flow hedge) and the possibility of changes in fair value (ie a fair value hedge). Strict conditions must be met before hedge accounting is applied: There is formal designation and documentation of a hedge at inception. The hedge is expected to be highly effective (ie the hedging instrument is expected to almost fully offset changes in fair value or cash flows of the hedged item that are attributable to the hedged risk). Any forecast transaction being hedged is highly probable. Hedge effectiveness is reliably measurable (ie the fair value or cash flows of the hedged item and the fair value of the hedging instrument can be reliably measured). The hedge must be assessed on an ongoing basis and be highly effective. When a fair value hedge exists, the fair value movements on the hedging instrument and the corresponding fair value movements on the hedged item are recognised in profit or loss. When a cash flow hedge exists, the fair value movements, on the part of the hedging instrument that is effective, are recognised in equity until such time as the hedged item affects profit or loss. Any ineffective portion of the fair value movement on the hedging instrument is recognised in profit or loss. Embedded derivatives IAS 39 requires derivatives that are embedded in non-derivative contracts to be accounted for separately at fair value through profit or loss.

Summary of IAS 39
Recognition and derecognition A financial asset or liability is recognised when the entity becomes a party to the instrument contract. A financial liability is derecognised when the liability is extinguished. A financial asset is derecognised when, and only when: the contractual rights to the cash flows from the asset expire; or the entity transfers substantially all the risks and rewards of ownership of the asset; or the entity transfers the asset, while retaining some of the risks and rewards of ownership, but no longer has control of the asset (ie the transferee has the ability to sell the asset). The risks and rewards retained are recognised as an asset. Measurement Financial assets and liabilities are initially recognised at fair value. Subsequent measurement depends on how the financial instrument is categorised:

At amortised cost using the effective interest method

Held-to-maturity investments: non-derivative financial assets with fixed or determinable payments and maturity that the entity has the positive intention and ability to hold to maturity. Loans and receivables: non-derivative financial assets with fixed or determinable payments that are not quoted in an active market. Financial liabilities that are not held for trading and not designated at fair value through profit or loss.

At fair value

At fair value through profit or loss: Financial asset or liability that is classified as held for trading, is a derivative or has been designated by the entity at inception as at fair value through profit or loss.

(Source : Web Summaries IAS 39: Financial Instruments: Recognition and Measurement)

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Note that the contribution refers to the hedging instrument and a hedged item used for offsetting the hedge relation. These fuzzy rules that include linguistic terms such as low and high are determined based on fuzzy set theory. Based on this theory a hedging instrument and a hedged item may have low as well as high offsetting volatilities of different degrees. This is defined through nonlinear functions that represent the linguistic terms such as low, medium and high. Therefore, their contribution for offsetting the hedge is defined accordingly. duces the corresponding Fair Values (FV) and Amortized Cost (AC) that actually reflects the future volumes of profit and loss (P&L). Consequently, from the abovementioned simulated values, the volatilities/ changes for both hedging instruments and hedging items are used to define their corresponding offsetting relations in reference to each other. These degrees of relations are used as elementary inputs to drive the optimization techniques (hedge optimizer) described in the sections above. Constraints referring to the homogeneity, ex-ante effectiveness, and the maximum hedge percentage are also considered in the optimization process. If the optimal solution is aligned with these constraints, their values are used to set the hedge contribution in the offsetting of volatilities. The process continues via new dynamic simulations to evaluate the optimal contribution at different re-hedging times.

Remarks
The main problem in hedging analysis is how to optimally assign already existing contracts of hedged items and hedging instruments to an offsetting hedge relationship. The complexity of the hedge balance problem arises when the number and types of different hedging instruments and hedge items increases. When this is the case, constrained optimization techniques and methodologies can be employed to optimally offset the hedged items and/or hedging instruments as described in this article. By using optimization techniques in hedging, the objective is to offset the volatilities of the hedging instruments and hedged items by determining their optimal contribution to the hedge relationship. This can be done by selecting the contribution of the hedging instruments that are offsetting the volatility of the hedged item. On

Putting everything together

The main methodological process for hedge optimization is constructed by a series of steps as illustrated in Figure 2. The first step is to define the values of both hedging instruments and hedged items based on dynamic simulation. The simulation pro-

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the other hand, this offsetting can be driven by optimally determining those items that could be hedged by offsetting their volatility to the available hedging instruments. Additionally, the overall volatilities of both hedging instruments and hedged items could be considered. In both cases the offsetting relation of the hedge volatilities are used in different ways, as fully explained in this article. Two different types of methodological approaches for hedge optimization are proposed; namely, derivative-based and rulebased optimization techniques. Derivativebased optimization methods are straightforward algorithmic techniques that have low application complexity and an optimization process that is well understood. A main advantage of such a method is that the resulting optimal values can be reasonably explained through the applied optimization analytical process. On the other hand, derivative-based optimization techniques are designed through analytical mathematical functions that steer the objective function(s). Such techniques may drive the solution to the local minimum of the objective function as opposed to the global minimum. By applying linguistic rules for hedge optimization, the offsetting strategy is designed using a similar way as the human experts think, increasing therefore their robustness to a high degree. The linguistic rule-based expressions are simple mathematical equations and thus they allow fast and uncomplicated design of the proposed hedge solutions, where previous knowledge on solved or unsolved cases may not be fully available. Moreover, using such techniques, rapid prototyping of the hedge strategies can be implemented, because their design is only based on the expert knowledge and thus an immediate commencement of the implementation can be made. As a result, such solutions minimize the cost of design and implementation. Finally and more importantly, significant benefit in applying this approach is the transparency of the solutions based on linguistic rules that are easy to understand and modify. However, such techniques are mainly dependent on the designers expert knowledge. A knowledgeable designer will produce more efficient rules. As a rule of thumb, a relatively small number of rules should be defined. Furthermore, the rules should be kept simple and comprehensible to everyone. I.A.

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