Nasar Zamir, Director of Congruent; explores why it’s so important to have trusted experts advise on financial risk handling
Derivative instruments – financial risk and disclosure
Most financial directors will be aware of the fair-value treatment of derivatives required by modern accounting standards, particularly with the introduction of FRS 102 (mandatory for periods commencing on or after 1 January 2016).
This ‘fair-value’ treatment has been well understood by the banks for many years, by developing and implementing sophisticated models for valuation and risk modelling of derivative instruments, in order to assist their knowledge of the financial risks inherent in their ‘book’ of these products.
However, the end users of derivative products (either corporate or non-sophisticated financial institutions) typically do not have the skills, knowledge or expertise to value or model the risks of their holdings of derivative instruments. Instead, they are forced to rely on their product provider or accountant to provide them with a basic level of information to satisfy disclosure and financial reporting requirements.
Expert insight can pay dividends
An expert in the handling of complex financial instruments can provide valuable insight. For instance, derivative products that are used primarily for hedging (as opposed to trading or for speculative purposes) may qualify for hedge accounting treatment either on a fair-value or cash-flow basis. This reduces the volatility of earnings, given that the new accounting standards require the fair-value treatment of these financial instruments.
The hidden danger of secondary risk
In some cases, even though the principal or primary risks (e.g. market risks) may be understood by the end user, these instruments usually tend to exhibit additional or secondary risks.
The real danger is that these risks are not often understood and this may have a significant financial impact on the business. Even for relatively ‘vanilla’ interest rate derivative products (e.g. an interest rate swap) the secondary or additional risks may suddenly manifest themselves due to credit deterioration of the counterparty as was experienced during the financial crisis.
This can have serious consequences for a business if they don’t have an independent expert on board to help mitigate such risks before they occur.
Understanding contingent risk
Contingent risks arise in derivative contracts as a result of some internal or external event affecting the hedged or hedging item e.g. refinancing of a loan or default of the hedging counterparty.
Consider the case of an interest rate derivative contract that is hedging a bank loan and qualifies for cash-flow hedge accounting treatment. There is no impact on the profit or loss at the reporting date if both instruments remain on the balance sheet.
The fair-value of the derivative contract attributable to the hedged risk, is taken in the cash flow hedge reserve shown within other comprehensive income. However, if the loan is repaid early and the hedging contract remains open at the reporting date, this reserve will need to be recycled through the profit and loss account.
This is not an unusual position for a business that has an on-going requirement to manage the balance sheet according to its particular requirements.
This contingent risk i.e. a statistical measure of the ‘maximum loss’, can be measured with interest rate modelling techniques that provide some insight into the magnitude of this risk at the outset. Such advanced modelling techniques are typically used by banks to measure the counterparty exposure, allowing the bank to determine the replacement cost in the event of the customer default.
The real cause for concern is that this contingent risk is not well understood by smaller businesses, as evidenced by the redress programme introduced by the FCA that instructed the major UK banks to compensate qualifying customers for mis-sold derivative contracts. The programme revealed that the main customer complaint was the contingent risk or “break cost” inherent in these contracts was not adequately explained by the bank.
Here, in explaining and managing the complexities of contingent risk, the true value of a trusted expert and advisor is revealed.
Seeking expert advice on risk disclosure
As most financial directors are already aware, the FRS 102 accounting standards require businesses to provide a certain degree of disclosure in their financial statements, including the new strategic report that details principal risks and uncertainties.
This assists users in evaluating the connection between financial instruments and the final performance of the business. It also enables them to assess the nature of risks arising from the use of financial instruments and how the business seeks to mitigate them.
When it comes to the nature and extent of risks arising from financial instruments, the disclosure requirements include qualitative and quantitative disclosures on exposures to each separate class of risk: credit risk, liquidity risk, and market risk, including sensitivity analyses.
The latest FRS 102 standard requires that for each market risk that the business is exposed to, it should disclose what would be the effect on profit or loss and on equity for a change in the relevant risk variable.
Yet again, the analysis of these risks (particularly secondary risks and contingent risks) requires specialist technical assistance from financial modelling experts, who can assist not only with the quantitative aspects but also with the qualitative description required for these disclosures.
Nasar Zamir is director of Congruent, financial risk advisers specialising in dealing with complex financial products.