36

Accounting for Derivatives

Under the structure depicted, the borrower effectively achieves funding at Euribor plus
50 bps. Note that all the GBP cash flows have to be fully synchronised to eliminate the GBP
exposure. Chapter 6 includes several examples of CCSs and their pricing mechanics.
2.3.2 IAS 39 Accounting Implications
Cross-currency swaps are the most basic instruments to hedge foreign currency denominated
liabilities. In general, CCSs do not imply a major challenge from IAS 39 viewpoint. As
mentioned for interest rate swaps, there are two particular points that are worth noting: firstly,
the need to define hedge relationships involving CCS in such a way that eligibility for hedge
accounting is maximised, and secondly, the need to exclude the interest accrual amounts when
calculating CCS fair value changes.
In a hedge accounting context, a CCS is often linked to a specific foreign currency denominated liability. The market value of a CCS and its related liability are typically determined
using different yield curves. Normally, the market values a liability using a yield curve that
incorporates the issuers credit spread, while CCSs are valued excluding the issuers credit
spread from the yield curve. As a result the interest rate sensitivities of a liability and its related CCS can be significantly different, endangering the eligibility for hedge accounting of a
well-constructed hedge. When the liability and the CCS rate sensitivities are notably different,
it is suggested that one defines the hedge relationship as the hedge of interest rate and FX risk
only (i.e., excluding other risks, such as credit risk).
Often valuation dates fall within interest periods. The inclusion or exclusion of accrued
interest in the valuation of a CCS can make a huge difference. The solution to this problem
is to exclude interest accrual amounts when calculating a CCS fair value. The exclusion is
especially important to make consistent fair value comparisons of liabilities and CCS with
different interest periods. The exclusion is also needed to avoid double counting the interest
income or expense related to a CCS, as the income or expense associated with a cash flow is
apportioned into the periods to which it relates. Chapter 6 includes detailed computations of
the interest accruals of CCSs.
In addition to hedging foreign currency denominated liabilities, CCSs are used to hedge the
FX exposure of net investments in foreign operations. For this type of hedge, IAS 39 sets a
special type of hedge accounting, called net investment hedge. When designated as hedging
instruments of net investment hedges, some aspects of the accounting treatment of CCSs are
still unclear. This is particularly the case of CCSs in which the entity pays a fixed interest rate
in the leg denominated in the groups functional currency leg. This accounting uncertainty is
covered in more detail in Chapter 4.

2.4 STANDARD (VANILLA) OPTIONS

2.4.1 Product Description
In general there are two types of options: standard options and exotic options. The standard,
options, also called vanilla options or just options, are the most basic option instruments.
Unlike the terms of most exotic options, the terms of a standard option (e.g., nominal, strike,
expiry date, etc) are known at its inception. There are two types of standard options:
Call options. A call gives the buyer the right, but not the obligation, to buy a specific amount
of an underlying at a predetermined price on or before a specific future date.