Credit Derivatives Accounting HVB Group

Global Markets ResearchEuro Credit Strategy

Credit Derivatives SpecialApril 25, 2005

CREDIT DERIVATIVES ACCOUNTING:

©HVB Corporates & Markets, Global Markets Research.See second to last page for disclaimer.

A member of HVB Group

. . . THE INS AND OUTS

In the aftermath of our Credit Derivatives Special publications, which mainlyfocus on the mechanism of basic and more exotic credit derivatives and theirapplication in practice, we now take a more operational view. Thetremendous growth of credit markets, accompanied by a variety of severalnew instruments (e.g. iTraxx products), raises operational questions likeaccounting and regulatory issues that have to be resolved before enteringthe market. In the following, we provide guidance with regard toInternational Accounting Standards (IAS/IFRS), as these have becomemandatory for listed companies as of January 1, 2005.

n Introduction to IAS 39: European accounting rules are currently subject tosignificant changes. Consequently, we provide an introduction to basicprovisions that deal with financial instruments, which incorporate a lion’s shareof credit derivatives. However, many credit derivatives are accounted for asfinancial guaranty contracts in accordance with IAS 37 or IFRS 4, whichprovides a “back door” for many major instruments.

C D S A C C O U N T I N G I S N O T A S S T R A I G H T F O R W A R D A S O N E W O U L D E X P E C T

IAS 37 / IFRS 4 “financial guaranty”

IAS

39 “

der

ivat

ive”

Is the CDSused for trading

purposes?

Is the CDS basedon “standard”credit events?

Protectionbuyer

position?

Hedging anexisting credit risk

exposure?

YES

YES

YES

YES

NO

NO

NO

NO

Source: HVB Global Markets Research

n Accounting consequences for basic and exotic credit derivatives: The mainsection of this paper focuses on applying the discussed accounting rules to creditderivatives, particularly credit default swaps (CDS), total return swaps (TRS),credit linked notes (CLN), and the iTraxx product family. We show that there is agood chance to avoid fair value accounting for many of these instruments,depending on their respective field of application. In addition, we provideguidance for third generation credit derivatives.

ContentsIntroduction________________2

Modus Operandi __________2An Introduction to IAS 39____3

The Scope of IAS 39________3Categories of FinancialInstruments _______________4Measurement _____________6Recognition andDerecognition____________10Embedded Derivatives ____11Hedge Accounting________12

Credit Default Swaps _______15Instrument Description____15Accounting Consequences _16

Total Return Swaps ________18Instrument Description____18Accounting Consequences _18

Credit Linked Notes ________20Instrument Description____20Accounting Consequences _21

iTraxx Products ____________22Instrument Description____22Accounting Consequences _22

Other Instruments _________24

AuthorMichael Zaiser+49 89 378-13229

BloombergHVCA

Internetwww.hvb.de/valuepilot

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Credit Derivatives Special - Credit Derivatives Accounting:April 25, 2005


INTRODUCTION

Credit derivatives pose severalchallenges with regard tooperational questions

The tremendous growth of credit markets witnessed over the last few yearsbrings numerous challenges for market players. As a consequence, theintroduction of several new products, e.g. products based on iTraxx indices,raises operational questions related to accounting and regulatory issues.This Credit Derivatives Special focuses on how to deal with credit derivativeinstruments from an accounting perspective, particularly with regard toInternational Accounting Standards (IAS). At a later date, we will publish asimilar paper that will address regulatory affairs.

IAS (or IFRS) have been putinto legislation

European accounting rules are currently subject to significant changes. Before2001, each country had its own accounting standards. For example, Germancompanies had to comply with provisions of the Handelsgesetzbuch (HGB),which provides a rough framework for the preparation of a financial statement,including the balance sheet and the income statement. In the course ofEuropean harmonization of accounting rules, International AccountingStandards (IAS), alternatively called International Financial Reporting Standards(IFRS), have been developed to achieve comparability across Europeancompanies. In the meantime, the vast majority of these rules have been made apart of legislation for public companies.

It is merely a matter of timeuntil the trinity of accountingrules in Germany will beabolished

However, German companies are still obliged to prepare individual financialstatements according to German-GAAP (HGB) and tax laws as well. In our view,it is merely a matter of time until the trinity of accounting rules will beabolished. Against this background, we focus primarily on IAS rather than onGerman-GAAP.

MODUS OPERANDI

This report is designed to meetthe needs of beginners as wellas of accounting aficionados

From January 1, 2005, all listed companies in the European Union have toprepare their financial statements in accordance with IAS/IFRS. This reportis designed to meet the needs of beginners as well as of accountingaficionados. It is structured as follows:

IAS 39 is of major importancefor credit derivatives, ...

... but not exhaustively

The first part gives a compressed overview with regard to basic accountingprinciples of International Accounting Standard 39, which is of majorimportance for credit derivatives accounting. However, as we will see, IAS 39does not exhaustively cover the topic, as several exceptions with regard to“financial guaranty contracts” (or “insurance contracts”) are made. Hence,making reference to the related accounting standards (IFRS 4 for insurancecontracts and IAS 37 for financial guaranty contracts) is inevitable.

Subsequently, we provideguidance for major creditderivatives contracts

Subsequently, the accounting rules are applied to major credit derivativescontracts, particularly credit default swaps (CDS), total return swaps (TRS),credit linked notes (CLN), and the iTraxx product family. In addition, we provideadditional guidance with regard to more exotic products, including suchinstruments like options on CDO tranches.

ABS deals are not covered It should be noted that this paper does not cover an important category of creditderivatives, namely asset backed securities.

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AN INTRODUCTION TO IAS 39

We focus on the fundamentalprinciples

In order to facilitate an understanding of the topic of financial instrumentsaccounting, we focus on the fundamental principles. We provide anintroduction to basic provisions of the International Accounting Standard39: “Financial Instruments: Recognition and Measurement”. However, thereare many specific issues and exceptions to these principles, which areignored for simplicity’s sake.

THE SCOPE OF IAS 39

IAS 32 and 39 deal with“financial instruments”

IAS 39 deals with the accounting of so-called “financial instruments”. However,IAS 39 is not the only standard that addresses this topic. In fact, IAS 39 can onlybe applied in combination with International Accounting Standard 32:“Financial Instruments: Disclose and Presentation”, which includesprovisions particularly concerning the notes of an entity’s financial statement.Accordingly, we will resort to certain definitions and provisions once in a while.It must be noted that both standards IAS 32 and 39 have to be applied at thesame time for periods beginning on or after January 1, 2005 or earlier [IAS39.103].

In the course of theendorsement, the standardsmay be adjusted

The International Accounting Standards Board (IASB), the standard setter, is anon-profit organization that developed these standards with the objective toprovide generally accepted accounting principles for the European Union andbeyond. However, the European Union and its member states have to put thesestandards into legislation before they become mandatory. In the course of thisprocess, called the endorsement, the standards may be subject to changes whichis mainly attributable to the influence of certain lobbies. We will highlight thesediscrepancies if they are important in respect to credit derivatives accounting.

What are “financialinstruments” according to IAS32 and 39?

According to IAS 32.11, a financial instrument is “any contract that gives rise toa financial asset of one entity and a financial liability or equity instrument ofanother entity.” In addition, IAS 32 and 39 differentiate between differentcategories of financial instruments, namely financial assets, financial liabilitiesand some contracts to buy or sell non-financial items [IAS 39.1] (the latter is notwithin the our field of interest).

A backdoor for “financialguarantee contracts”

However, it is not an easy task to distinguish financial assets and liabilitiescovered by the IAS 39 from those addressed by other standards. One importantexception is the area of so-called “financial guaranty contracts” (including lettersof credit and other credit default contracts) [IAS 39.2 (f)]. If such contracts“provide for specified payments to be made to reimburse the holder for a loss itincurs because a specified debtor fails to make payment when due under theoriginal or modified terms of a debt instrument”, International AccountingStandard 37: “Provisions, Contingent Liabilities and Contingent Assets”applies. Hence, this rule basically provides a back door for credit default swapsand similar products. We will return to this point later as it enables creditinvestors to avoid fair value accounting for particular credit products. In themeantime, the IASB introduced a new standard that deals with “insurancecontracts” (IFRS 4), which also encompasses financial guaranties. Hence, IFRS 4currently applies instead of IAS 37, however with no substantial change withregard to their accounting treatment.

Fair value accounting pervadesthe International Accounting

This leads to the primary goal of the standard. International AccountingStandards (IAS) aim at showing the entity’s assets and liabilities at “fair value”

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Standards ...

... but there are exceptions

on the balance sheet as far as possible (“fair value accounting”). With respect tofinancial instruments, this means that all (financial) contracts within the scopeof IAS 39 have to be disclosed on the balance sheet, even for derivatives, whichis in contrast to German-GAAP (HGB) where derivatives are basically treated asoff-balance contracts due to their conditional characteristic. However, there isno rule without exceptions. Hence, it needs more than 400 pages to clarify theseexceptions and to deal with the problems arising from them.

CATEGORIES OF F INANCIAL INSTRUMENTS

IAS 39 defines four differentcategories of financialinstruments, ...

... which unfortunately are notexhaustive

IAS 39 defines four different categories of financial instruments to capture themost common exceptions with regard to fair value accounting. As we will seelater, these categories are not exhaustive due to the fact that the standardprovides additional rules for the so-called “hedge accounting” which facilitates aspecial treatment of specific instruments irrespective of their original category.The following diagram provides an overview concerning these categories.

T H E F O U R C A T E G O R I E S O F F I N A N C I A L I N S T R U M E N T S

At Fair Value through Profit or Loss (aFVtPL)

(1) short-term selling/repurchasing(2) part of a portfolio with evidence of short-term profit-taking(3) derivatives

Held for trading Designated as aFVtPL• designated by the entity upon initial recognition

Held-to-Maturity Investments (HtM)• only for non-derivatives financial assets with fixed or determinable payments and fixed maturity• entity has the positive intention and ability to hold to maturity

Loans and Receivables (LaR)• non-derivative financial assets with fixed or determinable payments• not quoted in an active market

Available-for-Sale Financial Assets (AfS)• non-derivative financial assets• category


The allocation is not self-evident

The allocation of financial instruments to these categories is not self-evident, asthe user typically has several options. However, the attribution of a financialinstrument to one of these categories should be done according to the purpose ofthe respective contract.

Any financial asset or liabilitycan be classified as aFVtPL

The category “at fair value through profit or loss” (aFVtPL) complies the bestwith the goal of fair value accounting, as we will see later. Hence, IAS 39 allowsfor the designation of any financial asset or liability as aFVtPL. However, onehas to designate the respective instrument at initial recognition [IAS 39.9],which is an irrevocable act [IAS 39.50]. Unfortunately, the fair value option iscurrently unavailable for financial liabilities due to partial endorsement of thestandard. For financial assets, the application of the “fair value option” is notrestricted.

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HtM is a restrictive category ...

... due to the fact that fairvalue accounting does notapply

Held-to-maturity investments require fixed or determinable payments with afixed maturity date [IAS 39.9]. While cash bond investments typically fulfill theseconditions, stock purchases cannot be allocated to this category due to a missingmaturity date. In fact, the HtM category is a restrictive one, as it requires theability and intention of the entity to hold to maturity. Any material violation ofthis provision leads to a punishment in a way that the entity is no longer allowedto use the category for three years. The idea of this category is to save the entityfrom fair value accounting for these instruments, as fair value changes duringthe remaining lifetime are not of interest from an economical perspective.Hence, fair value accounting does not apply.

IAS 39 abstains from fair valueaccounting for “loans andreceivables”

The same applies for “loans and receivables”, where IAS 39 abstains from fairvalue accounting due to a lack of market prices. In practice, this means thatloans and receivables are disclosed on the balance sheet at amortized cost.

The rest of the pack belongs to“available for sale”

Any financial instrument that does not qualify for the categories HtM and LaRand is not designated for aFVtPL is automatically designated as “available forsale”.

“Derivatives” always belong toaFVtPL, ...

... but the concept is somewhatmore restrictive

As highlighted in the diagram above, derivatives are automatically designated as“held for trading”, and hence included in aFVtPL with the exception of thoseinstruments that qualify for hedge accounting. However, “derivatives” in anaccounting context have an alternative meaning compared to market vernacular.Usually, derivatives refer to financial instruments that are subject to the risk ofother asset classes in a way that their payoff/value depends on thevaluation/price of another financial instrument. For IAS 39, the term“derivatives” refers to financial instruments which additionally meet thefollowing criteria [IAS 39.9]:

– No initial net investment (e.g. swaps, future or forward contracts) or an initialnet investment that is smaller than would be required for other types ofcontracts that would be expected to have a similar response to changes inmarket factors (e.g. options, leveraged products)

– Settlement at a future date

Credit Linked Notes are not“derivatives” in accountingterms

Hence, the IAS 39 term “derivative” is somewhat more restrictive compared toan economic point of view. For example, structured products like regular creditlinked notes do in fact have a comparable “net investment level” as a directbond investment in the respective name. Hence, such contracts cannot bedesignated as “derivatives”, although the market value of such a contract islinked to a non-issuer-related credit risk.

Not every case is covered bythe four categories

As stated above, IAS 39 primarily deals with financial assets and financialliabilities. However, while all four categories basically have to be considered forthe asset side, only one category applies for the liability side of the balancesheet. Although this seems insufficient, the following paragraph provides analternative for financial liabilities, which is not covered by the four categoriesstated above.

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MEASUREMENT

We focus on the fundamentalprinciples that pervade IAS 39

Typically one would discuss the topic of recognition and derecognitionbefore delving into measurement aspects. However, as the measurement ofa financial instrument is closely related to the four categories introducedbefore, we postpone the recognition issue for the time being. Let us assumethat a financial instrument is recognized on the balance sheet when boughtor incurred, and derecognized when it is sold or redeemed.

Talking about measurementraises the following questions

When talking about measurement, one has to differentiate between the followingquestions:

(1) What is the value to be disclosed on the balance sheet when initiallyrecognized? (Initial Measurement)

(2) What is the value to be disclosed on the balance sheet subsequently, i.e.after initial recognition, but not before derecognition? (SubsequentMeasurement)

(3) What has to be done once the financial asset or liability has beenderecognized?

Initial Measurement …

… always at fair value

The first question is easiest to answer. At initial recognition, i.e. at the time thefinancial asset is bought or one has incurred the financial liability, the asset orliability is measured at fair value [IAS 39.43]. Transaction costs that are directlyattributable to the acquisition or issue of the financial asset or liability are addedif the instrument does not belong to the category “aFVtPL” (cf. diagram below).

What is fair value? Although this seems straightforward, it is important to know what IAS 39understands as “fair value”. IAS 39 defines the fair value as “the amount forwhich an asset could be exchanged, or liability settled, between knowledgeable,willing parties in an arm’s length transaction”. In the context of InitialMeasurement, this simply means that we have to take the actual transactionprice [IAS 39.AG71]. However, determining the fair value at a later date can bequite tough. We will return to this point later on.

So what’s the deal? Hence, acquiring a bond or stock simply requires putting the price paid on thebalance sheet, for example. Entering into a swap contract, e.g. a plain-vanillainterest rate swap, typically involves no upfront payment. In this case, thecarrying amount is zero at initiation and the instrument neither enters the assetside nor the liabilities side. Option-style contracts (calls, puts, caps, floors,swaptions, etc.) typically feature a premium payment at initiation, whichrepresents the value of the option. In case one buys an option, the premium paidenters the balance sheet as an asset, while writing an option involvespassivating a liability that amounts to the premium received.

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B A S I C M E A S U R E M E N T C O N S I D E R A T I O N S U N D E R I A S 3 9

Assets Liabilities

Financial Assets aFVtPL

ð Initially: Fair Value [IAS 39.43]ð Subsequently: Fair Value [IAS 39.46]

Held-to-Maturity

ð Initially: Fair Value + Transact. C. [IAS 39.43]ð Subsequently: Amortized Cost [IAS 39.46(b)]

Loans and Receivables

ð Initially: Fair Value + Transact. C. [IAS 39.43]ð Subsequently: Amortized Cost [IAS 39.46(a)]

Available-for-Sale

ð Initially: Fair Value + Transact. C. [IAS 39.43]ð Subsequently: Fair Value, but no P&L effect

Financial Liabilities aFVtPL

ð Initially: Fair Value [IAS 39.43]ð Subsequently: Fair Value [IAS 39.47(a)]

Other Financial Liabilities

ð Initially: Fair Value + Transact. C. [IAS 39.43]ð Subsequently: Amortized Cost [IAS 39.47]


Fair value accounting ...

... versus amortized cost

However, Initial Measurement is of minor importance, as it describes thebalance sheet effect for just a moment, whereas Subsequent Measurement dealswith the impact on (a) the balance sheet and (b) the income statement in thecourse of time. With regard to the balance sheet, one has to differentiatebetween the fair value approach and the measurement at amortized cost.Financial assets “aFVtPL” and “Available-for-Sale” items are disclosed at fairvalue, while “Held-to-Maturity” investments and “Loans and Receivables” aresubject to the so-called effective interest method which accompaniesmeasurement at amortized cost (cf. diagram above)

Fair value approach revisited First of all, we have to return to the issue of determining the fair value of afinancial instrument. As the expression “the amount for which an asset could beexchanged, or liability settled, between knowledgeable, willing parties in anarm’s length transaction” does not hold water, IAS 39 [IAS 39.AG69-AG82]provides detailed guidance for implementing the fair value approach. A majorconclusion is: As long as there is a published price quotation (market pricequoted by an exchange, dealer, broker, etc.) available, one should take this asthe fair value [IAS 39.AG71]. Otherwise, one has to use a valuation technique inorder to establish a fair value [IAS 39.AG74]. Basically, the followingpossibilities are available:

– Recent arm’s length market transaction between knowledgeable, willingparties

– Reference to the current fair value of another instrument that is substantiallythe same

– Discounted cash flow analysis

– Option pricing models

If one of these techniques is commonly used by market participants and provedvalid in the past, one should take that technique [IAS 39.AG74].

AfS fair value changes do notaffect the income statement ...

Although fair value accounting applies for both “aFVtPL” items and “Available-for-Sale” assets, there is a substantial difference between both categories with

8




regard to the effect on the income statement. As the expression“... through profitor loss” suggests, fair value changes for “aFVtPL” items do not only lead to anadjustment of their carrying amount on the balance sheet, but also immediatelyaffects the income statement [IAS 39.55(a)]. AfS items, however, do notautomatically entail a P&L effect from unrealized profits [IAS 39.55(b)]. In fact,gains and losses arising from a change in fair value are basically recognized inequity, through the so-called “statement of changes in equity”. This is a veryspecial item in equity, which does not belong to the income statement and isoften referred to as “AfS reserve”.

... except for impairment losses However, there is no rule without an exception! In case of so-called impairmentlosses, the entity is obliged to recognize the loss in the income statement [IAS39.67]. Possible reasons for an impairment are [IAS 39.59]:

– Significant financial difficulty of the issuer or obligor

– Breach of a contract (default, delinquency) with regard to interest or principalpayments

– Bankruptcy or restructuring is becoming probable

– Measurable decrease in estimated future cash flows

It should be added that a downgrade of an issuer’s credit rating is basically notsufficient for impairment [IAS 39.60]. For an equity instrument, a significant orprolonged decline in the fair value below its cost is also objective evidence ofimpairment [IAS 39.61].

Reversal of impairment losses...

... only for debt instruments

If, in a subsequent period, the fair value of the instrument increases due to “anevent occurring after the impairment loss was recognized in profit or loss, theimpairment loss shall be reversed, with the amount of the reversal recognized inprofit or loss” [IAS 39.70]. Unfortunately, this provision only holds for debtinstruments. Fair value gains for equity instruments in the aftermath of animpairment are recognized in the “AfS reserve” [IAS 39.69].

Measuring a financialinstrument at amortized cost ...

... via the effective interestmethod

In a second step, we now delve into the topic of measuring a financialinstrument at amortized cost. As we already pointed out, the carrying amount ofa financial instrument when initially recognized equals the amount spent orreceived for it. However, abiding by this amount until the financial instrument isdue or sold/redeemed is not self-evident. For an equity instrument, it makessense to keep the carrying amount up over time. On the other hand, debtinstruments are typically redeemed at par value (100) but they are bought/soldabove or below par. Hence, one needs an approach to distribute the premium ordiscount over time. Previous German-GAAP (HGB) solve this problem byestablishing a deferred item on the balance sheet at initial recognition anddissolving it proportionately until maturity. However, IAS 39 does not permitsuch an approach, but dictates the “effective interest method” (EIM) instead.

An example for the EIM In the following, we introduce the concept by means of an example. Let usassume that an entity purchases a government bond with a notional amount ofEUR 100,000, a yearly coupon of 6% and five years until maturity at a price of95.9. The first step is to calculate the effective interest rate of this fixed incomeinvestment. Please note that the effective interest rate is the internal rate ofreturn, i.e. that uniform discount rate which generates the current market price.In the present case, applying a numerical procedure provides an effectiveinterest rate of 7%. Please refer to the left table below for details.

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P A Y M E N T S T R U C T U R E A N D I N T E R N A L R A T E O F R E T U R N

Year Cash flow Discount factor Present value

1 6,000 1/1.07 5,6072 6,000 1/1.072 5,241

3 6,000 1/1.073 5,8984 6,000 1/1.074 4,577

5 106,000 1/1.075 75,577Amortized cost at the beginning of year 1 95,900


C A R R Y I N G A M O U N T A N D I N T E R E S T I N C O M E ( I A S 3 9 )

Year Carrying amount(start of period)

Carrying amount(end of period)

Interestincome

1 95,900.00 96,613.00 6,713.00

2 96,613.00 97,375.91 6,762.913 97,375.91 98,192.22 6,816.31

4 98,192.22 99,065.68 6,873.465 99,065.68 100,000.00 6,934.32

Sum 34,100.00


The interest income iscalculated based on the initialinternal rate of return ...

The left table shows the development of the carrying amount until maturity ofthe bond. At initial recognition, the carrying amount equals the purchase price.The effective interest method now presumes that the investment provides aconstant interest income in accordance with the initial internal rate of return.Hence, the interest income for year 1 amounts to

6,713 EUR7.00%95,900 EUR =× .

... and not on actual cash flows However, as there is only a cash inflow of EUR 6,000 during this period, thedifference of EUR 713 has to be assigned to a value increase of the position,leading us to a carrying amount at the end of year 1 of

96,613 EUR713 EUR95,900 EUR =+

The carrying amount and theinterest income increase by theinitial rate of return

The carrying amount at the end of the period also acts as the carrying amountfor the start of the next period. For period 2 and afterwards, the procedure isrepeated for the respective new carrying amount. For example, the interestincome of 7% is then calculated based on the new carrying amount of EUR96,613. In fact, the carrying amount and the interest income are subject to ay-o-y increase of 7%, the initial rate of return.

Impairment provisions alsoapply to HtM and LaR

Applying the effective interest method as demonstrated above is just the regularcase. As for AfS assets, there are impairment provisions for HtM and LaR assetsas well [IAS 39.63]. If there is objective evidence for impairment, the differencebetween the asset’s carrying amount and its present value is recognized in profitor loss. The entity may choose between (a) the reduction of the carrying amountand (b) the use of an allowance account. IAS 39.65 states that if the impairmentloss decreases afterwards, the impairment loss shall be reversed with theamount of the reversal recognized in profit or loss.

IAS 39 suffers from the mixedmodel approach

In a nutshell, IAS 39 is characterized by a mixed measurement approach, i.e.some financial instruments are recognized at fair value, while others aredisclosed at (amortized) cost. The attribution of a financial instrument to one ofthese categories is primarily driven by the purpose of the item within thecompany.

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RECOGNIT ION AND DERECOGNIT ION

Side issues may arise whichquestion the recognition orderecognition of a financialinstrument

Finally, we deal with recognition and derecognition. In the precedingparagraph, we dealt with measurement issues, presuming that therecognition of the respective financial instrument has already taken place. Itseems rather straightforward to assume the recognition of a financial assetas soon as it is acquired and the contract is settled. However, side issuesmay arise which question the recognition or derecognition of a financialinstrument in practice. Hence, we give a short overview of basic IAS 39guidance with regard to this subject.

Initial recognition isstraightforward

The initial recognition of a financial asset or liability is straightforward. IAS39.14 uses the expression “the entity becomes a party to the contractualprovisions of the instrument.” In the context of “regular way purchases”(meaning: spot transactions), the entity even has the choice of using “trade dayaccounting” (date that an entity commits itself to purchase or sell an asset) or“settlement day accounting” (date that an asset is delivered to or by an entity)[IAS 39.38]. However, the method should be chosen consistently for allpurchases and sales [IAS 39.AG53].

Derecognition of a financialasset

On the other hand, derecognition provisions for financial assets are extensive.First of all, it is clear that a financial asset has to be derecognized when therights to the asset’s cash flows expire [IAS 39.17(a)]. However, there is anotherpossibility: the transfer of the financial asset [IAS 39.17(b)]. “Transferring” of anasset means that one (1) transfers the contractual rights to receive the cashflows of the financial asset, or (2) assumes a contractual obligation to pay thecash flows to one or more recipients [IAS 39.18]. In addition, derecognition ofthe asset requires that the entity transfers “substantially all the risks andrewards of ownership” [IAS 39.20(a)]. This is evaluated by comparing theentity’s exposure, before and after the transfer, with the variability in theamounts and timing of the net cash flows of the transferred asset [IAS 39.21].

Derecognition of a financialliability

Derecognition rules for financial liabilities are comparatively easy to implement.Such an instrument is removed from the balance sheet when it is extinguished,i.e. the obligation specified in the contract is discharged, cancelled, or expired[IAS 39.39].

Derecognition leads to a P&Leffect for the respectiveinstrument

Last but not least, it should be noted that if a financial instrument is removedfrom the balance sheet because of derecognition, the difference between thecarrying amount and the consideration received or paid is recognized in profitor loss [IAS 39.26 and IAS 39.41]. In case an AfS reserve has been built up for afinancial asset over time, the balance sheet item has to be dissolved andrecognized in P&L.

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EMBEDDED DER IVAT IVES

Structured products entail apossible obfuscation ofleveraged exposure to non-related asset classes

The market for structured products has recently experienced tremendousgrowth. Against this background, the financial statement of companiesinvesting in these products may feature significant leveraged exposure tonon-related asset classes (e.g. equity and credit). Given that thesecompanies classify hybrid instruments as HtM or even as LaR (e.g.structured promissory loans as “Schuldscheindarlehen”), the financial riskwould not be identifiable for the reader of the financial statement. Hence,the standard setter introduced specific rules that clarify how to cope withthis kind of instrument.

Hybrid products are dividedinto ...

The basic idea of the “embedded derivatives” concept is to divide structured orhybrid products into

... a host contract and... – a host contract (typically a fixed-income security) and

... an embedded derivative – an embedded derivative [IAS 39.10].

The valuation and payout of the embedded derivative is subject to a specifiedinterest rate, financial instrument price, commodity price, foreign exchangerate, index of prices or rates, credit rating or credit index, or other variable.

Not every embedded derivativehas to be separated from itshost contract

Not every embedded derivative has to be separated from its host contract! Aseparation is mandatory if (a) the risk of the embedded derivative is not “closelyrelated” to the host contract, (b) the embedded derivative would meet thedefinition of a derivative, and (c) the hybrid instrument is not measured at fairvalue with changes in fair value recognized in profit or loss [IAS 39.11]. Pleaserefer to the following diagram for an overview.

T H E D E C I S I O N T R E E F O R S E P A R A T I N G E M B E D D E D D E R I V A T I V E S

Is the risk of theembedded derivativeclosely related to the

host contract? [IAS 39.11(a)]

YES

NO

Is the embeddedderivative actually a“derivative” in line

with IAS 39? [IAS 39.11(b)]

NO

YES

Is the hybridinstrument measured

at fair value andrecognized in p&l?

[IAS 39.11(c)]

YES

NO

Separation ofembedded

derivative ismandatory

No separation of embedded derivative


What does “closely related”risk mean?

The term “closely related” refers to the risk sources of the host contract and theembedded derivative. Typically, the host contract is a fixed-income security(fixed coupon bond, floater, zero coupon bond). Risk sources related to thatproduct are interest rate risk and the issuer’s credit risk. If the embeddedderivative is driven by other risk sources (equity risk, other credit risk than theissuer’s, etc.) or has leveraged exposure, the embedded derivative’s risk is not“closely related” to the host contract. The following list gives a few examples ofsuch hybrid products:

– convertibles

– notes that are linked to commodity or equity prices

– credit linked notes

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The host contract keeps theinstrument’s category, ...

... while the embeddedderivative will be disclosedaFVtPL

What are the consequences of a separation? IAS 39 stipulates that the hostcontract is accounted for in accordance with the hybrid instrument’s originalcategory. For example, if the hybrid product is classified HtM, the host contract– should be a fixed-income instrument – will also be treated as a HtM contract[IAS 39.11]. On the other hand, the embedded derivative will be recognizedaFVtPL as it can be interpreted as a “derivative” in line with IAS 39. If novaluation tools are available, one can determine the fair value of the embeddedderivative as the difference between the fair value of the hybrid instrument andthe fair value of the host contract [IAS 39.13].

The “fair value” option In practice, it is difficult and time-consuming for companies to separate theembedded derivative as shown above. However, the introduction of the “fairvalue option” in December 2003, which allows the entity to designate eachsingle financial instrument to disclose it aFVtPL without the duty to perform aseparation procedure, provides a basis to avoid embedded derivativesseparation. Nevertheless, one has to accept the effect of fair value changes in theP&L in this case.

HEDGE ACCOUNT ING

The mixed measurement modelmay cause P&L asymmetries

As noted in the measurement paragraph, a major characteristic of IAS 39 isthe mixed measurement approach, as fair value and cost accounting forfinancial instruments apply simultaneously. In a hedging context, this maylead to inappropriate results, as the hedged item may be recognized atamortized cost while the hedging instrument (e.g. a derivative) is disclosedaFVtPL. In order to avoid P&L asymmetries, IAS 39 provides rules thatfacilitate a valid reproduction of economically-driven hedging relationships[IAS 39.71 et sqq.], called hedge accounting.

Basic concepts of hedgeaccounting

In the following, we give a short overview of basic terms and concepts of hedgeaccounting:

B A S I C T E R M S A N D C O N C E P T S O F H E D G E A C C O U N T I N G

Concept Source ExplanationHedged item IAS 39.9;

IAS 39.78An asset, liability, firm commitment (forward contract), highlyprobable transaction or net investment in a foreign operation,involving a risk of changes in fair value or future cash flows

Hedging instrument IAS 39.9;IAS 39.72

A derivative whose fair value or cash flows are expected tooffset changes in the fair value or cash flows of a designatedhedged item

Hedge effectiveness IAS 39.9 The degree to which changes in the fair value or cash flows ofthe hedged item that are attributable to a hedged risk areoffset by changes in the fair value or cash flows of the hedginginstrument

Fair value hedge IAS 39.86(a) A hedge of the exposure to changes in fair value of arecognized asset or liability, etc., that is attributable to aparticular risk and could affect profit or loss

Cash flow hedge IAS 39.86(b) A hedge of the exposure to variability in cash flows that is (1)attributable to a particular risk associated with a recognizedasset or liability or a highly probable forecast transaction and(2) could affect P&L


The fair value hedge ... IAS 39 provides three types of hedging relationships. The idea of a “fair valuehedge” is to compensate the hedged item’s fair value changes by means of fair

13




value changes of the respective hedging instrument. Ideally, fair value changesfor both instruments have opposite algebraic signs but the same absoluteamount. When setting up a fair value hedge, one has not only to designate thehedged item and the hedging instrument, but also specify the particular risk thataffects the fair value of both financial instruments. Any recognized financialasset or liability or an unrecognized firm commitment can be utilized as ahedged item. The left diagram below shows a typical situation: The company haspurchased a bond with a fixed coupon (hedged item) and wants to hedge theinterest rate risk by entering into a payer swap (pay coupon, receive floatingleg). The funding position is shown for the sake of completeness and is not partof the hedging relationship.

A T Y P I C A L F A I R V A L U E H E D G E A T Y P I C A L C A S H F L O W H E D G E

Assets Liabilities

fixed-coupon bonde.g. coupon 5%, maturity 5 years

payer swap

specifications:• pay 5% p.a.• receive float• maturity 5 years

funding positione.g. 3M-Euribor + Spread

5% p.a.

5% p.a.

3M-Euribor + Spread

3M-€+ Spread

Assets Liabilities

floating rate notee.g. floater 3M-Euribor, maturity 5years

receiver swap

specifications:• pay float• receive 5% p.a.• maturity 5 years

funding positione.g. 5% p.a.

5% p.a.

3M-€ + Spread

5% p.a.3M-€ + Spread


... and its consequences in caseit proves effective

In case the fair value hedge proves effective (which seems clear for the exampleabove), IAS 39 stipulates the following accounting rules for the hedged item andthe hedging instrument:

– The fair value change of the hedged item which is attributable to the hedgedrisk is used to adjust the carrying amount of the hedged item andsimultaneously recognized in P&L [IAS 39.89(b)]

– As the hedging instrument (a derivative) is already disclosed aFVtPL, nothingchanges [IAS 39.89(a)].

This results in an avoidance of a P&L disavowal, which would otherwise beattributable to the hedged risk. A fair value hedge approach is only indicatedwhen the hedged item is categorized as HtM, LaR or AfS.

The cash flow hedge ... The “cash flow hedge” is an alternative approach, which is covered by IAS 39provisions. It aims at eliminating or reducing the exposure to variability in cashflows. These future cash flows may be variable cash flows from alreadyrecognized assets or liabilities (e.g. floaters), but also from “highly probableforecast transactions” [IAS 39.86(b)]. The right diagram above shows a typicalsituation: The company has purchased a floating rate note (hedged item) andwants to hedge the risk of unstable future interest income by entering into areceiver swap (receive fixed coupon, pay floating leg). The company’s fundingposition involves fixed coupon payments and is only shown for the sake ofcompleteness.

... and its consequences In case the cash flow hedge proves effective (which seems clear for the exampleabove), IAS 39 stipulates the following accounting rules for the hedged item andthe hedging instrument:

– The portion of the hedging instrument’s fair value change which is

14




determined to be an effective hedge is recognized directly in equity throughthe statement of changes in equity (the so-called “cash flow hedge reserve”).On the other hand, the ineffective portion, if there is any, is recognized in P&L[IAS 39.95].

– The hedged item, if it is already recognized, is treated in accordance with itsoriginal category.

Apparently, the consequences of an effective cash flow hedge differ substantiallyfrom those for a fair value hedge. An effective fair value hedge leads to a P&Lrecognition for both hedged item and hedging instrument. In contrast, anefficient cash flow hedge involves no P&L effect due to changed fair values;mark-to-market changes of the hedging instrument are put on a “parkingposition” similar to the AfS reserve.

The hedge of a net investmentin a foreign operation

There is also a third hedge accounting approach, namely the “hedge of a netinvestment in a foreign operation”. We ignore this topic due to the fact that it isnot related to our focus on credit derivatives.

Several conditions must be metto apply hedge accounting

As hedge accounting facilitates to deviate from basic measurement rules, onehas to fulfill several conditions before applying these degrees of freedom:

– The hedging relationship has to be formally designed at initiation (hedgeditem, hedging instrument, hedged risk) and requires documentation (riskmanagement objective and strategy) [IAS 39.71 and IAS 39.88(a)].

– Hedged item and hedging instrument must involve external counterparties[IAS 39.73].

– The hedging instrument shall not be a net written option, i.e. a net premium,if any, is received [IAS 39.77].

– The hedge is expected to be highly effective in achieving offsetting changes infair value or cash flows attributable to the hedged risk [IAS 39.88(b)].

– The effectiveness of the hedge can be reliably measured and is assessed on anongoing basis [IAS 39.88(d),(e)].

15




CREDIT DEFAULT SWAPS

Accounting CDS in accordancewith IAS is not asstraightforward as expected

Credit default swaps represent the most important product group within thecredit derivatives universe in terms of turnover and volume. In addition,CDS contracts act as basic building blocks for more complex creditderivatives. Against this background, accounting for credit default swapsseems to be rather straightforward. However, as we will see below, this is afalse conclusion.

INSTRUMENT DESCR IPT ION

CDS allow for the transfer ofcredit risk

Credit default swaps (CDS) are bilateral OTC-traded contracts. Such a contractenables the protection buyer to exclusively transfer the credit risk of a specifiedreference obligation (a loan or a bond) to his counterparty, the protection seller,for a limited timeframe (typically 1Y, 3Y, 5Y, 7Y, or 10Y). In return, theprotection buyer has to pay a “premium” on a regular (typically quarterly) basis.Basically, other types of periods (e.g. yearly) or one-off premium payments arefeasible, but not market standard.

M E C H A N I S M O F A C R E D I T D E F A U L T S W A P

common risk factor

(2a) delivers ref. obligation

protection buyer“premium” payments

(spread)

(1) cash settlement payment

protection seller

typically a loan or bondsubject to default risk

reference obligation

(2b) pays par value (100)

activitiy (no default)

activitiy in case of a default


The CDS payoff is event-driven The CDS is dissolved prior to maturity if a credit event, as prespecified in thecontract, occurs. As the documentation usually is based on the 2003 ISDA CreditDerivatives Definitions, the following credit events apply:

– Bankruptcy, i.e., the company becomes insolvent or is unable to pay itsdebts; protection for creditors applies via filing for bankruptcy

– Failure to pay, i.e., an amount of at least USD 1 mn is due considering agrace period

– Restructuring, i.e., an adverse change in debt obligations which amount to atleast USD 10 mn

In case of a credit event, the contract is settled either (1) by cash settlement or(2) by physical settlement (cf. diagram above). The latter largely established asmarket standard. For details regarding CDS contracts, please refer to ourCredit Derivatives Special “CDS: Mechanism, Pricing & Application”.

16




ACCOUNT ING CONSEQUENCES

Is the CDS contract covered byIAS 39 or not?

Irrespective of the CDS position taken (protection buyer or seller), one has toassess if the contract is covered by IAS 39, as the guaranty character isapparent. As already stated, particular “financial guaranty contracts” are subjectto IAS 37 (or IFRS 4), according to IAS 39.2(f) and IAS 39.3. Such contracts areexcluded from the scope of IAS 39, if the contract provides “for specifiedpayments to be made to reimburse the holder for a loss it incurs because aspecified debtor fails to make payment when due under the original or modifiedterms of a debt instrument.” This particularly means that the followingconditions have to be met:

– In case of a default, the protection buyer must incur a loss in the referenceobligation. Obviously, this means that he is required to have the obligation inhis portfolio.

– The payoff profile of the CDS must be qualified to make up the loss of the debtinstrument.

– The CDS contract has to provide a reimbursement if, and only if, the specifieddebtor “fails to make payment when due”.

No one will be able to verifythe first condition for aprotection seller in practice

Apparently, the first aspect seems inapplicable from the perspective of aprotection seller, as one has to know if the counterparty possesses the referenceobligation. In practice, no external auditor will be able verify this condition forlong credit positions.

In practice, credit events otherthan(1) bankruptcy,(2) failure to pay, and(3) restructuringautomatically lead to IAS 39accounting

With regard to the last two prerequisites, there are different views. For example,Auerbach and Klotzbach from KPMG recently stated that the inclusion of“restructuring” as a credit event does not comply with these conditions. Hence,this would mean that practically all CDS contracts are recognized in accordancewith IAS 39. However, there are other opinions as well, which currently seem tobe confirmed as best practice, that all three mentioned credit events(bankruptcy, failure to pay, restructuring) fulfill the required conditions. On theother hand, credit events like obligation acceleration, obligation default, andrepudiation/moratorium are not accepted. Hence, the inclusion of such creditevents would automatically lead to a “derivatives” accounting in accordancewith IAS 39. In a nutshell, the only possibility to avoid IAS 39 becoming effectivefor CDS accounting is to refrain from additional credit events that are non-market standard.

Protection buyers need to havea (economically motivated)hedging relationship in orderto avoid IAS 39 accounting

In case of a short credit position (protection buyer), the CDS should be used tohedge already existing credit risk exposure (loan or cash bond). In our view, it isnot necessary that the hedge leads to a reduction of risk-weighted assets. If thehedge makes sense from an economic point of view (e.g. same obligor butdifferent reference loans/bonds, different reference entities but same economicrisk due to a letter of comfort or a profit-pooling contract), IAS 37 (or IFRS 4)applies.

Trading CDS are always“derivatives” in terms of IAS 39

In any case, conducting trading activities, i.e. entering into a CDS contract inorder to realize short-term profits attributable to spread changes, does notreflect the nature of financial guaranties. Hence, trading positions should alwaysbe accounted for in accordance with IAS 39.

Consult your external auditorabout CDS

The following decision tree summarizes the crucial aspects pointed out above.However, we recommend to consult an external auditor in order to get clearguidance with regard to credit default swaps.

17




C R E D I T D E F A U L T S W A P S : I A S 3 7 O R I A S 3 9 ?

IAS 37 / IFRS 4 “financial guaranty”

IAS

39 “

der

ivat

ive”

Is the CDSused for trading

purposes?

Is the CDS basedon “standard”credit events?

Protectionbuyer

position?

Hedging anexisting credit risk

exposure?

YES

YES

YES

YES

NO

NO

NO

NO


Consequences for CDS as“financial guaranties”

After having resolved whether the CDS contract is a “derivative” or a “financialguaranty”, one has to apply the respective accounting rules. In case of afinancial guaranty, the CDS establishes a contingent liability (protection seller)or a contingent claim/collateral (protection buyer). Basically, both items are notshown on the balance sheet as long as the default case is outside the range ofvision [IAS 37.31 et sqq.]. However, the contingent claim/collateral has to betaken into account in case of impairment for the hedged loan or bond. If thepotential loss can be retrieved by the CDS contract, an impairment is notnecessary. A contingent liability may entail reserves in case the respective creditexposure experiences a dramatic deterioration.

Consequences for CDS as“derivatives”

As already stated, “derivatives” in line with the IAS 39 definition are categorizedas “aFVtPL”, i.e. their fair value is disclosed on the balance sheet and fair valuechanges are recognized in the income statement. It should be noted that theinitial present value is zero and may become positive (asset) or negative(liability) afterwards, depending on the market spread development.

Is the regular “premium”payment an option premium?

What about the ongoing premium payments? One could argue that the“premium” is an option premium with deferred payment dates. This seemsreasonable, as the default case is detrimental to just one counterparty, namelythe protection seller. However, this is not the usual interpretation of a creditdefault “swap”: the premium leg is swapped for the default leg. Hence, thepremium payments are accounted for as interest payment, which calls foraccrual accounting and recognizing the premium as interest income.

18




TOTAL RETURN SWAPS

The importance of TRS hasdeclined compared to CDS

Total return swaps belong to the basic credit derivative structures, althoughtheir importance has declined against the background of the massive growthof credit default swap products. Nevertheless, we give a short abstract of itsmechanism and show possible accounting consequences.


A TRS allows for transferringmarket and credit risk

Total return swaps (TRS) are bilateral OTC-traded contracts where one party(protection buyer) agrees to pay the other the “total return” (particularly couponpayments, fair value changes) of a defined reference obligation (a loan or bond),usually in return for receiving a stream of Libor or Euribor based cash flows. Infact, it enables the protection buyer to transfer both the underlying’s market andcredit risk to the protection seller. The floating leg of the contract reflects that nofunding is required for the protection seller to obtain the risks and rewards ofthe reference obligation.

M E C H A N I S M O F A T O T A L R E T U R N S W A P

common risk factor

protection buyerbond coupon

positive fair value change

protection seller



floating rate (e.g. 3M-Euribor)± spread

bond

cou

pon

negative fair value change

definitive payment (no default)

conditional payment



IAS 39 applies Applying the accounting provisions for “financial guaranty contracts” (IAS 37) isout of the question, as the contract provides for payments that go beyond areimbursement of credit-related losses.

A derecognition issue:Is the underlying asset“transferred” to the protectionseller?

However, there is a recognition/derecognition issue, which has to be taken intoaccount. From an economic perspective, the protection buyer transfers all risksand rewards of the underlying asset to his counterparty. But is this “transfer” inline with IAS 39.17 et sqq., which would lead to a derecognition of theunderlying asset in the protection buyer’s balance sheet? Apparently, theprotection buyer “retains the contractual rights to receive the cash flows of thefinancial asset, but assumes a contractual obligation to pay the cash flows to oneor more recipients” [IAS 39.18(b)]. IAS 39.19 stipulates additional conditionsthat have to be met in order to achieve derecognition, namely:

– The protection buyer has no obligation to pay amounts to the eventualrecipient unless it collects equivalent amounts from the original asset [IAS39.19(a)].

19




– The protection buyer is prohibited by the terms of the transfer contract fromselling or pledging the original asset [IAS 39.19(b)].

– The protection buyer has an obligation to remit any cash flows it collects onbehalf of the eventual recipients without material delay, i.e. no reinvestmentof such cash flows should be possible [IAS 39.19(c)].

The protection seller typicallycannot be kept from selling orpledging the asset

In our view, the first and the third conditions can be easily met by respectivelegal definitions of the TRS contract. However, the protection seller typicallycannot be kept from selling or pledging the original asset by means of the totalreturn swap. Hence, we anticipate that a “transfer” in line with IAS 39.17 et sqq.has not taken place. A derecognition of the underlying asset does not come intoquestion.

Fair value accounting for totalreturn swaps

Accordingly, the TRS is accounted for as a regular “derivative” contract in linewith IAS 39. Hence, the fair value (can be either positive or negative) isdisclosed on the balance sheet and fair value changes are recognized in theincome statement. Interest cash flows (bond coupon and refinancing leg) of thecontract call for accrual accounting, while compensation payments due to fairvalue changes are directly recognized in the income statement.

Selling the asset and retrievingall returns via a TRS ...

... justifies no derecognition ofthe asset

There is another case that should be considered [IAS 39.AG40(o) and IAS39.AG51(o)]. Let’s assume that a company sells a financial asset to acounterparty and enters into a TRS with the same party to retrieve all cash flowsand fair value changes. In such a case, derecognition of the asset is prohibiteddue to the fact that the company “retains substantially all the risks and rewardsof ownership of the financial asset” [IAS 39.20(b)]. The total return swap is justa legal contract that facilitates the maintenance of the economic property.Hence, no separate disclosure of the TRS contract is required.

20




CREDIT LINKED NOTES

Credit linked notes are subjectto “embedded derivatives”provisions

Credit linked notes belong to the class of hybrid products, as their payoff isrelated to credit risk that is not (exclusively) issuer-related. Against thisbackground, IAS 39 provisions with regard to embedded derivatives comeinto play. Hence, accounting consequences are mainly determined by thechosen asset category.


A CLN is a combined positioncomprising a regular bond anda protection seller CDS

A credit linked note (CLN) is a funded asset which is subject to credit risk of areference obligation (entity) that does not correspond to the issuer’s credit risk.The note issuer typically pays an enhanced coupon to the investor for taking onthe additional credit risk. If the reference entity defaults, then the noteholderreceives the recovery price of the reference obligation in lieu of its par value(market standard). Alternatively, the CLN issuer might deliver the referenceobligation. Hence, a CLN is simply a combined position comprising (1) a regularbond investment and (2) a protection seller position in a CDS.

M E C H A N I S M O F A C R E D I T L I N K E D N O T E

common risk factor

CLN issuer

par value (100)

CLN investor



floating rate (e.g. 3M-Euribor)+ credit spread

recovery valueof the reference obligation

activity (no default)

activity in case of a default


More complex structures ... It should be noted that there are more complex structures available as well, forexample:

– Leveraged CLNs: The notional amount of the embedded credit default swap isa multiple of the notes’ notional amount. Physical settlement applies if a creditevent occurs.

– First-to-default CLNs: Same as a regular CLN, but subject to the first defaultevent within a basket of various reference entities.

– Spread widening note: Includes a protection buyer CDS instead of a protectionseller position, which leads to negative spread.

... and promissory loans arepossible

Many more structures are possible. Such a hybrid structure may also be“issued” as a promissory loan (“Schuldscheindarlehen”).

21





An embedded credit derivativein a host debt instrument is not“closely related”

A regular credit linked note is subject to IAS 39 provisions concerningembedded derivatives. IAS 39.AG30(h) states that “credit derivatives that areembedded in a host debt instrument and allow one party to transfer the creditrisk of a particular reference asset to another party are not closely related to thehost debt instrument.”

The separation decision issolely contingent on thechosen category for theinstrument

However, this does not automatically lead to a separation of the embeddedderivative, as two additional criteria have to be met. The second condition,namely that the embedded derivative is in line with the “derivative” definition ofIAS 39, is out of the question in practice. Hence, the separation decision is solelydependent on the chosen asset category. In case of HtM or LaR (in case of apromissory loan), the embedded credit derivative has to be separated anddisclosed at fair value, while fair value changes are recognized directly in P&L.AfS credit linked notes have to be split up as well, accompanied by recognizingfair value changes that are attributable to the embedded credit derivative in theincome statement instead of the AfS reserve. Only an “aFVtPL” categorizationprevents the entity from separating the embedded derivative.

Same applies to the CLN issuer But how about the accounting consequences for the issuer? The results basicallyremain unchanged, although there are only two categories available for theliabilities side. Hence, “other financial liabilities” are subject to a separation ofthe embedded credit derivative.

The December 2003 version ofIAS 39 provides opportunitiesto avoid the separation

As mentioned before, splitting up a CLN into a host contract and an embeddedderivative is an annoying procedure in practice. In addition, fair valueaccounting for the embedded derivative contributes to P&L volatility due tomarket changes. However, the December 2003 version of IAS 39 providesopportunities to avoid the separation of the embedded derivative:

(1) Exercise the “fair valueoption”

– The International Accounting Standards Board (IASB) introduced the “fairvalue option” which enables the entity to designate each single financialinstrument to disclose aFVtPL. Hence, the duty to perform the separation ofthe embedded credit derivative is circumvented.

(2) Implement hedgeaccounting (for CLN issuers)

– The fair value option is currently unavailable for financial liabilities due to thepartial endorsement of the standard. Thus, the only possibility for CLN issuersto avoid a separation is to implement a hedge accounting approach. Werecommend to perform a fair value or cash flow hedge, which requires anappropriate hedging instrument contracted with an external counterparty.For instance, a single-name CDS contract would satisfy hedging the credit riskof a regular CLN.

(3) Issues the CLN from the“trading book”

– In place of implementing a hedge accounting approach, one could issue theCLN from the “trading book”, if applicable. Hence, the category “aFVtPL”applies without the obligation to separate the embedded derivative.

22




ITRAXX PRODUCTS

The iTraxx product familyachieved great popularity sinceits introduction in June 2004

Since its introduction in June 2004, the iTraxx product family has achievedgreat popularity, as it offers diversified access to credit exposure. In fact,the iTraxx Europe Benchmark index has become the most liquid instrumentwithin the credit universe, accompanied by extremely narrow bid-offerspreads. In the following, we provide an insight into the various indices andproducts with regard to their accounting treatment.


The iTraxx family is based onthree main indices ...

... and comprises severalproduct categories andmaturities

The iTraxx family is based on three different main indices or baskets, which areshown in the upper part of the diagram below. Please note that the iTraxxEurope Corporate is an obsolete index due to a lack of demand. Various productcategories and maturities are available, depending on the structure of therespective indices, including index swaps, first-to-default baskets andstandardized CDO tranches. Credit linked notes relating to the iTraxx universeare currently of minor importance. Please refer to our Credit DerivativesSpecial “DJ iTraxx: Credit at its best!” for details regarding the mechanismof these products.

T H E I T R A X X I N D E X A N D P R O D U C T F A M I L Y – A N O V E R V I E W

iTraxx Benchmark• 125 Investment Grade names with stipulated sectoral structure and high CDS liquidity• equally weighted names (0.8% each)

iTraxx Crossover• 35 High Yield names with high CDS liquidity• equally weighted names (2.86% each)

iTraxx Corporate• incorporates the biggest issuers of the DJ iBoxx EUR Corporates Index (curr. 53 names)• weightings in accordance with duration value

HiVol• includes 30 out of 125 names with the highest CDS spread

CDO tranches

Sectors- Non-Financials (100)- Financials Senior (25)- Financials Sub (25)- TMT (20)- Autos (10)- Industrials (20)- Consumers (30)- Energy (20)

first-to-default contracts

iTra

xx p

rodu

cts

iTra

xx in

dice

s

index swaps (CDS-style)

credit linked notes (funded)



Each product category isdiscussed separately

In the following, we will discuss the accounting consequences for each productcategory within the iTraxx universe separately. As iTraxx index swaps are ofmajor importance and also act as the basis for more sophisticated iTraxxproducts, we will start with this product group.

iTraxx index swaps are similarto regular CDS contracts

Index swaps are based on a basket of reference entities (or obligations) withstatic weightings. Like regular CDS contracts, they are settled physically in casea credit event occurs. Bankruptcy, failure to pay, and restructuring are taken as

23




credit events in accordance with the European CDS market standard.

Is IAS 37 applicable? Hence, one could argue that their treatment in accounting terms should besimilar to regular CDS contracts, particularly with regard to a possiblerecognition as “financial guaranty contracts”. However, IAS 39.3 states thatfinancial guaranty contracts are subject to IAS 39 if they provide for payments tobe made in response to changes in a “credit index”. In our view, this provision isnot applicable to iTraxx index swaps, because they are not based on a “creditindex”. The gain or loss of an iTraxx index swap position is solely based on realeconomic actions, namely credit events of constituents in the respective basket.In addition, an iTraxx index swap can be understood as an additive aggregationof regular CDS contracts.

Accounting rules for CDS arealso applicable to iTraxx indexswaps ...

In a nutshell, we are convinced that the IAS 39.3 provision cannot be applied toiTraxx index swaps. Hence, accounting consequences drawn with regard to CDScontracts can be transferred to iTraxx index swaps. Protection buyers willindeed have difficulties to prove an economic hedge of default risk. For theiTraxx Europe Benchmark index swap, one would need all 125 reference assetson the balance sheet to achieve an accounting treatment under the terms of IAS37 (or IFRS 4).

... and even FTD baskets andCDO tranches

When considering iTraxx FTD baskets or CDO tranches, it seems self-evident todesignate these as “derivatives” in accordance with IAS 39. However, we see agood chance to transfer the CDS considerations to these products. As statedbefore, the underlying is not a “credit index”, but a portfolio of regular CDScontracts. Admittedly, FTD baskets and CDO tranches are complex products, butthey still rely on credit events reflecting losses that arise “because a specifieddebtor fails to make payment when due” [IAS 39.2(f)]. The non-linearity ofpayoff profiles for these instruments is, in our view, an aspect that is notrelevant for assessing “financial guaranty contracts”. However, we recommendto consult the external auditor in order to get a clear guidance with regard tothese “exotics”.

Credit spread options definitelyare IAS 39 “derivatives”

Few market makers also provide quotes for credit spread options with iTraxxindex swaps as underlying. In contrast to FTD baskets and CDO tranches, theunderlying is the quoted spread of the index swap (“credit index”), but not theeconomic default risk of the reference entities. Hence, credit spread optionscannot be designated as “financial guarantee contracts”, and hence have to beaccounted for as “derivatives” in line with IAS 39. They have to be disclosed atfair value on the balance sheet, while fair value changes have to be directlyrecognized in the income statement.

24




OTHER INSTRUMENTS OF INTEREST

A brief guidance for moreexotic credit derivativesstructures

Besides the products presented in the preceding sections, the creditderivatives market created several exotic structures over the last few years.Despite the fact that these are only of minor importance, we provide a list togive a brief guidance with regard to International Accounting Standards. Itshould be noted that the list is not exhaustive. In case of doubt, werecommend to apply IAS 39, i.e. fair value accounting for the respectiveinstrument.

A N O N - E X H A U S T I V E L I S T F O R M O R E E X O T I C C R E D I T D E R I V A T I V E S

Product Description IAS accountingDigital Credit Default Swap (DDS) Similar to CDS except that the recovery value is fixed at the start

of the trade. This specification avoids the complicatedmechanism to determine the recovery rate for cash settlement.

IAS 39 “derivative” [IAS 39.9]

Recovery Default Swap (RDS) A forward contract with regard to the recovery rate. In case of adefault, the actual recovery rate is compared to the stipulatedrecovery rate in the contract to determine a compensationpayment (can be either positive or negative).


Equity Default Swap Actually no credit derivative, but an equity derivative (a far-out-of-the-money put option with barrier)


Rating-triggered CDS Similar to CDS except that the default event is defined in terms ofrating classes.


Constant Maturity Credit DefaultSwaps (CMCDS)

Similar to CDS except that the spread level of the premium leg isregularly adjusted in accordance with market levels

IAS 7 / IFRS 4 cannot be ruled out,although instrument is typicallyused to implement a spread view

Options on CDO tranches and FTDbaskets

Option contract which allows the buyer to enter into a CDOtranche or FTD basket



25



©HVB Corporates & Markets, Global Markets Research.

DISCLAIMERPlease note

Key 1: Bayerische Hypo- und Vereinsbank AG and/or a company affiliated with it pursuant to § 15 AktG (German stock-company act) owns atleast 1% of the capital stock of the company.

Key 2: Bayerische Hypo- und Vereinsbank AG and/or a company affiliated with it pursuant to § 15 AktG (German stock-company act)belonged to a syndicate that in the last five years prior to publication of this analysis has acquired securities of the company.

Key 3: Bayerische Hypo- und Vereinsbank AG acts as stabilizing manager or sponsor, e.g. as designated sponsor of the analyzed securities onthe stock exchange or the open market on the basis of an agreement with the company.

Key 4: Bayerische Hypo- und Vereinsbank AG and/or a company affiliated with it pursuant to § 15 AktG (German stock-company act) hold ashort position of at least 1% of the capital stock of the analyzed company at the end of the month prior to the date on which theanalysis was compiled.

Company - Key:

Bayerische Hypo- und Vereinsbank AG and companies affiliated with it pursuant to § 15 AktG (German stock-company act) regularly tradeshares of the analyzed company.

Disclaimer:

Our recommendations are based on public information that we consider to be reliable but for which we assume no liability especially withregard to its completeness and accuracy. We reserve the right to change the views expressed here at any time and without advance notice. Theinvestment possibilities discussed in this report may not be suitable for certain investors depending on their specific investment target or timehorizon or in the context of their overall financial situation. This report is provided for general information purposes only and cannot be a substitutefor obtaining independent advice. Please contact your bank’s investment advisor. Provision of this information shall not be construed as constituting anoffer to enter into a consulting agreement.

Please note that the provision of investment services may be restricted in certain jurisdictions. You are required to acquaint yourself with anylocal laws and restrictions on the usage and the availability of any services described therein. The information is not intended for distributionto or use by any person or entity in any jurisdiction or country where such distribution would be contrary to local law or regulations.

Notice to UK residents:

This report is intended for clients of Bayerische Hypo- und Vereinsbank AG who are market counterparties or intermediate customers (both asdefined by the Financial Services Authority (“FSA”) and is not intended for use by any other person, in particular, private customers asdefined by the rules of FSA. This report does not constitute a solicitation to buy or an offer to sell any securities. The information in thispublication is based on carefully selected sources believed to be reliable, but we do not make any representation that it is accurate orcomplete. Any opinions herein reflect our judgement at this date and are subject to change without notice.

We and/or other members of Bayerische Hypo- und Vereinsbank Group may take a long or short position and buy or sell securities mentionedin this publication. We and/or members of Bayerische Hypo- und Vereinsbank Group may act as investment bankers and/or commercialbankers for issuers of securities mentioned, be represented on the board of such issuers and/or engage in “market making” of such securities.The Bank and its affiliates may also, from time to time, have a consulting relationship with a company being reported upon.

The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectivesand financial position. Private investors should obtain the advice of their banker/broker about the investments concerned prior to makingthem.

Bayerische Hypo- und Vereinsbank AG, London branch, is regulated by FSA for the conduct of designated investment business in the UK.

Notice to US residents:

The information contained in this report is intended solely for institutional clients of Bayerische Hypo- und Vereinsbank AG, New York Branch(“HypoVereinsbank”) and HVB Capital Markets, Inc. (“HVB Capital” and, together with HypoVereinsbank, “HVB”) in the United States, andmay not be used or relied upon by any other person for any purpose. Such information is provided for informational purposes only and doesnot constitute a solicitation to buy or an offer to sell any securities under the Securities Act of 1933, as amended, or under any other U.S.federal or state securities laws, rules or regulations. Investments in securities discussed herein may be unsuitable for investors, depending ontheir specific investment objectives, risk tolerance and financial position.

In jurisdictions where HVB is not registered or licensed to trade in securities, commodities or other financial products, any transaction may beeffected only in accordance with applicable laws and legislation, which may vary from jurisdiction to jurisdiction and may require that atransaction be made in accordance with applicable exemptions from registration or licensing requirements.

All information contained herein is based on carefully selected sources believed to be reliable, but HVB makes no representations as to itsaccuracy or completeness. Any opinions contained herein reflect HVB’s judgement as of the original date of publication, without regard tothe date on which you may receive such information, and are subject to change without notice.

HVB may have issued other reports that are inconsistent with, and reach different conclusions from, the information presented in this report.Those reports reflect the different assumptions, views and analytical methods of the analysts who prepared them. Past performance shouldnot be taken as an indication or guarantee of further performance, and no representation or warranty, express or implied, is made regardingfuture performance.

HVB and any HVB affiliate may, with respect to any securities discussed herein: (a) take a long or short position and buy or sell such securities;(b) act as investment and/or commercial bankers for issuers of such securities; (c) engage in market-making for such securities; (d) serve on theboard of any issuer of such securities; and (e) act as a paid consultant or adviser to any issuer.

The information contained in this report may include forward-looking statements within the meaning of U.S. federal securities laws that aresubject to risks and uncertainties. Factors that could cause a company’s actual results and financial condition to differ from its expectationsinclude, without limitation: political uncertainty, changes in economic conditions that adversely affect the level of demand for the company’sproducts or services, changes in foreign exchange markets, changes in international and domestic financial markets, competitiveenvironments and other factors relating to the foregoing.

All forward-looking statements contained in this report are qualified in their entirety by this cautionary statement.

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©HVB Corporates & Markets, Global Markets Research.

CONTACTSGlobal Head of Research

Thorsten Weinelt, CFAManaging Director+49 89 [email protected]

FX/FI & FX/FI Derivatives Strategy

Michael Rottmann, Head+49 89 378-15121

Kornelius Purps, FI-Strategy+49 89 378-12753

Herbert Sellier, Technical Analysis+49 89 378-18024

Herbert Stocker, Technical Analysis+49 89 378-14305

Armin Mekelburg, FX-Analysis+49 89 378-14307

Dr. Stefan Kolek, EEMEA Strategy+49 89 378-12495

Frauke David, EEMEA Strategy+49 89 378-13247

Credit & Credit Derivatives Strategy

Dr. Jochen Felsenheimer, Head+49 89 378-18188

Dr. Philip GisdakisQuantitative Credit Strategy+49 89 378-13228

Michael ZaiserCredit Strategy+49 89 378-13229

Covered Bond & Agency Research

Bernd Volk, CFA, Covered Bonds+49 89 378-18133

Florian Hillenbrand, Covered Bonds+49 89 378-12961

Valentina Stadler, Sub-Sovereigns & Agencies+49 89 378-16296

Securitization Research

Helge Münkel+49 89 378-11294

High Grade Research*

Luis Maglanoc, CFA, HeadFinancials+49 89 378-12708

Franz RudolfInsurance, Financial Services+49 89 378-12449

Stephan HaberTelecoms, Media, Technology+49 89 378-15192

Dr. Sven KreitmairAutomobiles & Parts, Industrial G&S,Aerospace & Defense+49 89 378-13246

Carmen HummelFood & Beverage, Personal & Household Goods,Retail, Travel & Leisure+49 89 378-12252

Christian KleindienstUtilities, Oil & Gas+49 89 378-12650

High Yield* & EEMEA Credit Research

Dr. Felix Fischer, CFA, HeadGeneral Industries, Construction & Materials, Tobacco+49 89 378-15449

Jochen SchlachterChemicals, Healthcare+49 89 378-13212

Jana ArndtBasic Resources+49 89 378-13211

Dusan Meszaros, EEMEA Credit+43 [email protected]

* Crossover credits are covered by the respective high-grade sector analyst

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Credit Derivatives Accounting HVB Group

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