Credit Derivatives Accounting HVB Group

Global Markets Research Euro Credit Strategy
Credit Derivatives Special

April 25, 2005
CREDIT DERIVATIVES ACCOUNTING:

Contents Introduction________________2 Modus Operandi __________2 An Introduction to IAS 39 ____3 The Scope of IAS 39________3 Categories of Financial Instruments _______________4 Measurement _____________6 Recognition and Derecognition____________10 Embedded Derivatives ____11 Hedge Accounting________12 Credit Default Swaps _______15 Instrument Description ____15 Accounting Consequences _16 Total Return Swaps ________18 Instrument Description ____18 Accounting Consequences _18 Credit Linked Notes ________20 Instrument Description ____20 Accounting Consequences _21 iTraxx Products ____________22 Instrument Description ____22 Accounting Consequences _22 Other Instruments _________24
... THE INS AND OUTS

In the aftermath of our Credit Derivatives Special publications, which mainly focus on the mechanism of basic and more exotic credit derivatives and their application in practice, we now take a more operational view. The tremendous growth of credit markets, accompanied by a variety of several new instruments (e.g. iTraxx products), raises operational questions like accounting and regulatory issues that have to be resolved before entering the market. In the following, we provide guidance with regard to International Accounting Standards (IAS/IFRS), as these have become mandatory for listed companies as of January 1, 2005. n Introduction to IAS 39: European accounting rules are currently subject to significant changes. Consequently, we provide an introduction to basic provisions that deal with financial instruments, which incorporate a lions share of credit derivatives. However, many credit derivatives are accounted for as financial guaranty contracts in accordance with IAS 37 or IFRS 4, which provides a back door for many major instruments.
CDS ACCOUNTING IS NOT AS STRAIGHTFORWARD AS ONE WOULD EXPECT
Is the CDS used for trading purposes?

NO
YES
Is the CDS based on standard credit events?

YES
NO
Protection buyer position?

NO
YES
Hedging an existing credit risk exposure?

YES
NO
IAS 37 / IFRS 4 financial guaranty

Source: HVB Global Markets Research
Author Michael Zaiser +49 89 378-13229 Bloomberg HVCA Internet www.hvb.de/valuepilot
n Accounting consequences for basic and exotic credit derivatives: The main section of this paper focuses on applying the discussed accounting rules to credit derivatives, particularly credit default swaps (CDS), total return swaps (TRS), credit linked notes (CLN), and the iTraxx product family. We show that there is a good chance to avoid fair value accounting for many of these instruments, depending on their respective field of application. In addition, we provide guidance for third generation credit derivatives.
HVB Corporates & Markets, Global Markets Research. See second to last page for disclaimer.
IAS 39 derivative
A member of HVB Group
Credit Derivatives Special - Credit Derivatives Accounting:

April 25, 2005
INTRODUCTION
Credit derivatives pose several challenges with regard to operational questions
The tremendous growth of credit markets witnessed over the last few years brings numerous challenges for market players. As a consequence, the introduction 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 derivative instruments from an accounting perspective, particularly with regard to International Accounting Standards (IAS). At a later date, we will publish a similar paper that will address regulatory affairs. European accounting rules are currently subject to significant changes. Before 2001, each country had its own accounting standards. For example, German companies 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 of European harmonization of accounting rules, International Accounting Standards (IAS), alternatively called International Financial Reporting Standards (IFRS), have been developed to achieve comparability across European companies. In the meantime, the vast majority of these rules have been made a part of legislation for public companies. However, German companies are still obliged to prepare individual financial statements 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 be abolished. Against this background, we focus primarily on IAS rather than on German-GAAP.
IAS (or IFRS) have been put into legislation
It is merely a matter of time until the trinity of accounting rules in Germany will be abolished
MODUS OPERANDI
This report is designed to meet the needs of beginners as well as of accounting aficionados
From January 1, 2005, all listed companies in the European Union have to prepare their financial statements in accordance with IAS/IFRS. This report is designed to meet the needs of beginners as well as of accounting aficionados. It is structured as follows: The first part gives a compressed overview with regard to basic accounting principles of International Accounting Standard 39, which is of major importance for credit derivatives accounting. However, as we will see, IAS 39 does 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 insurance contracts and IAS 37 for financial guaranty contracts) is inevitable. Subsequently, the accounting rules are applied to major credit derivatives contracts, particularly credit default swaps (CDS), total return swaps (TRS), credit linked notes (CLN), and the iTraxx product family. In addition, we provide additional guidance with regard to more exotic products, including such instruments like options on CDO tranches. It should be noted that this paper does not cover an important category of credit derivatives, namely asset backed securities.
IAS 39 is of major importance for credit derivatives, ...
... but not exhaustively
Subsequently, we provide guidance for major credit derivatives contracts
ABS deals are not covered

April 25, 2005
AN INTRODUCTION TO IAS 39
We focus on the fundamental principles
In order to facilitate an understanding of the topic of financial instruments accounting, we focus on the fundamental principles. We provide an introduction to basic provisions of the International Accounting Standard 39: Financial Instruments: Recognition and Measurement. However, there are many specific issues and exceptions to these principles, which are ignored for simplicitys 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 only be applied in combination with International Accounting Standard 32: Financial Instruments: Disclose and Presentation, which includes provisions particularly concerning the notes of an entitys 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 the same time for periods beginning on or after January 1, 2005 or earlier [IAS 39.103]. The International Accounting Standards Board (IASB), the standard setter, is a non-profit organization that developed these standards with the objective to provide generally accepted accounting principles for the European Union and beyond. However, the European Union and its member states have to put these standards into legislation before they become mandatory. In the course of this process, called the endorsement, the standards may be subject to changes which is mainly attributable to the influence of certain lobbies. We will highlight these discrepancies if they are important in respect to credit derivatives accounting. According to IAS 32.11, a financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. In addition, IAS 32 and 39 differentiate between different categories of financial instruments, namely financial assets, financial liabilities and some contracts to buy or sell non-financial items [IAS 39.1] (the latter is not within the our field of interest). However, it is not an easy task to distinguish financial assets and liabilities covered by the IAS 39 from those addressed by other standards. One important exception is the area of so-called financial guaranty contracts (including letters of 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 it incurs because a specified debtor fails to make payment when due under the original or modified terms of a debt instrument, International Accounting Standard 37: Provisions, Contingent Liabilities and Contingent Assets applies. Hence, this rule basically provides a back door for credit default swaps and similar products. We will return to this point later as it enables credit investors to avoid fair value accounting for particular credit products. In the meantime, the IASB introduced a new standard that deals with insurance contracts (IFRS 4), which also encompasses financial guaranties. Hence, IFRS 4 currently applies instead of IAS 37, however with no substantial change with regard to their accounting treatment. This leads to the primary goal of the standard. International Accounting Standards (IAS) aim at showing the entitys assets and liabilities at fair value
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In the course of the endorsement, the standards may be adjusted
What are financial instruments according to IAS 32 and 39?
A backdoor for financial guarantee contracts
Fair value accounting pervades the International Accounting

April 25, 2005 Standards ...
... but there are exceptions
on the balance sheet as far as possible (fair value accounting). With respect to financial instruments, this means that all (financial) contracts within the scope of IAS 39 have to be disclosed on the balance sheet, even for derivatives, which is in contrast to German-GAAP (HGB) where derivatives are basically treated as off-balance contracts due to their conditional characteristic. However, there is no rule without exceptions. Hence, it needs more than 400 pages to clarify these exceptions and to deal with the problems arising from them.
CATEGORIES OF FINANCIAL INSTRUMENTS

IAS 39 defines four different categories of financial instruments, ...
... which unfortunately are not exhaustive
IAS 39 defines four different categories of financial instruments to capture the most common exceptions with regard to fair value accounting. As we will see later, these categories are not exhaustive due to the fact that the standard provides additional rules for the so-called hedge accounting which facilitates a special treatment of specific instruments irrespective of their original category. The following diagram provides an overview concerning these categories.
THE FOUR CATEGORIES OF FINANCIAL INSTRUMENTS
At Fair Value through Profit or Loss (aFVtPL)

Held for trading
(1)
Designated as aFVtPL
designated by the entity upon initial recognition
short-term selling/repurchasing (2) part of a portfolio with evidence of short-term profit-taking (3) derivatives
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 selfevident
The allocation of financial instruments to these categories is not self-evident, as the user typically has several options. However, the attribution of a financial instrument to one of these categories should be done according to the purpose of the respective contract. The category at fair value through profit or loss (aFVtPL) complies the best with the goal of fair value accounting, as we will see later. Hence, IAS 39 allows for the designation of any financial asset or liability as aFVtPL. However, one has to designate the respective instrument at initial recognition [IAS 39.9], which is an irrevocable act [IAS 39.50]. Unfortunately, the fair value option is currently unavailable for financial liabilities due to partial endorsement of the standard. For financial assets, the application of the fair value option is not restricted.
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Any financial asset or liability can be classified as aFVtPL

April 25, 2005 HtM is a restrictive category ...
... due to the fact that fair value accounting does not apply
Held-to-maturity investments require fixed or determinable payments with a fixed maturity date [IAS 39.9]. While cash bond investments typically fulfill these conditions, stock purchases cannot be allocated to this category due to a missing maturity date. In fact, the HtM category is a restrictive one, as it requires the ability and intention of the entity to hold to maturity. Any material violation of this provision leads to a punishment in a way that the entity is no longer allowed to use the category for three years. The idea of this category is to save the entity from fair value accounting for these instruments, as fair value changes during the remaining lifetime are not of interest from an economical perspective. Hence, fair value accounting does not apply. The same applies for loans and receivables, where IAS 39 abstains from fair value accounting due to a lack of market prices. In practice, this means that loans and receivables are disclosed on the balance sheet at amortized cost. Any financial instrument that does not qualify for the categories HtM and LaR and is not designated for aFVtPL is automatically designated as available for sale. As highlighted in the diagram above, derivatives are automatically designated as held for trading, and hence included in aFVtPL with the exception of those instruments that qualify for hedge accounting. However, derivatives in an accounting context have an alternative meaning compared to market vernacular. Usually, derivatives refer to financial instruments that are subject to the risk of other asset classes in a way that their payoff/value depends on the valuation/price of another financial instrument. For IAS 39, the term derivatives refers to financial instruments which additionally meet the following criteria [IAS 39.9]: No initial net investment (e.g. swaps, future or forward contracts) or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors (e.g. options, leveraged products) Settlement at a future date
IAS 39 abstains from fair value accounting for loans and receivables The rest of the pack belongs to available for sale
Derivatives always belong to aFVtPL, ...
... but the concept is somewhat more restrictive
Credit Linked Notes are not derivatives in accounting terms
Hence, the IAS 39 term derivative is somewhat more restrictive compared to an economic point of view. For example, structured products like regular credit linked notes do in fact have a comparable net investment level as a direct bond investment in the respective name. Hence, such contracts cannot be designated as derivatives, although the market value of such a contract is linked to a non-issuer-related credit risk. As stated above, IAS 39 primarily deals with financial assets and financial liabilities. However, while all four categories basically have to be considered for the asset side, only one category applies for the liability side of the balance sheet. Although this seems insufficient, the following paragraph provides an alternative for financial liabilities, which is not covered by the four categories stated above.
Not every case is covered by the four categories

April 25, 2005
MEASUREMENT
We focus on the fundamental principles that pervade IAS 39
Typically one would discuss the topic of recognition and derecognition before delving into measurement aspects. However, as the measurement of a financial instrument is closely related to the four categories introduced before, we postpone the recognition issue for the time being. Let us assume that a financial instrument is recognized on the balance sheet when bought or incurred, and derecognized when it is sold or redeemed. When talking about measurement, one has to differentiate between the following questions: (1) What is the value to be disclosed on the balance sheet when initially recognized? (Initial Measurement) (2) What is the value to be disclosed on the balance sheet subsequently, i.e. after initial recognition, but not before derecognition? (Subsequent Measurement) (3) What has to be done once the financial asset or liability has been derecognized?
Talking about measurement raises the following questions
Initial Measurement always at fair value
The first question is easiest to answer. At initial recognition, i.e. at the time the financial asset is bought or one has incurred the financial liability, the asset or liability is measured at fair value [IAS 39.43]. Transaction costs that are directly attributable to the acquisition or issue of the financial asset or liability are added if the instrument does not belong to the category aFVtPL (cf. diagram below). Although this seems straightforward, it is important to know what IAS 39 understands as fair value. IAS 39 defines the fair value as the amount for which an asset could be exchanged, or liability settled, between knowledgeable, willing parties in an arms length transaction. In the context of Initial Measurement, this simply means that we have to take the actual transaction price [IAS 39.AG71]. However, determining the fair value at a later date can be quite tough. We will return to this point later on. Hence, acquiring a bond or stock simply requires putting the price paid on the balance sheet, for example. Entering into a swap contract, e.g. a plain-vanilla interest rate swap, typically involves no upfront payment. In this case, the carrying amount is zero at initiation and the instrument neither enters the asset side nor the liabilities side. Option-style contracts (calls, puts, caps, floors, swaptions, etc.) typically feature a premium payment at initiation, which represents the value of the option. In case one buys an option, the premium paid enters the balance sheet as an asset, while writing an option involves passivating a liability that amounts to the premium received.
What is fair value?
So whats the deal?

April 25, 2005 BASIC MEASUREMENT CONSIDERATIONS UNDER IAS 39
Assets
Financial Assets aFVtPL
Initially: Fair Value [IAS 39.43] Subsequently: Fair Value [IAS 39.46]
Liabilities
Financial Liabilities aFVtPL
Initially: Fair Value [IAS 39.43] Subsequently: Fair Value [IAS 39.47(a)]
Held-to-Maturity
Initially: Fair Value + Transact. C. [IAS 39.43] Subsequently: Amortized Cost [IAS 39.46(b)]
Other Financial Liabilities

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

Initially: Fair Value + Transact. C. [IAS 39.43] Subsequently: Amortized Cost [IAS 39.46(a)]
Available-for-Sale
Initially: Fair Value + Transact. C. [IAS 39.43] Subsequently: Fair Value, but no P&L effect
Fair value accounting ...
... versus amortized cost
However, Initial Measurement is of minor importance, as it describes the balance sheet effect for just a moment, whereas Subsequent Measurement deals with the impact on (a) the balance sheet and (b) the income statement in the course of time. With regard to the balance sheet, one has to differentiate between the fair value approach and the measurement at amortized cost. Financial assets aFVtPL and Available-for-Sale items are disclosed at fair value, while Held-to-Maturity investments and Loans and Receivables are subject to the so-called effective interest method which accompanies measurement at amortized cost (cf. diagram above) First of all, we have to return to the issue of determining the fair value of a financial instrument. As the expression the amount for which an asset could be exchanged, or liability settled, between knowledgeable, willing parties in an arms length transaction does not hold water, IAS 39 [IAS 39.AG69-AG82] provides detailed guidance for implementing the fair value approach. A major conclusion is: As long as there is a published price quotation (market price quoted by an exchange, dealer, broker, etc.) available, one should take this as the fair value [IAS 39.AG71]. Otherwise, one has to use a valuation technique in order to establish a fair value [IAS 39.AG74]. Basically, the following possibilities are available: Recent arms length market transaction between knowledgeable, willing parties Reference to the current fair value of another instrument that is substantially the same Discounted cash flow analysis Option pricing models If one of these techniques is commonly used by market participants and proved valid in the past, one should take that technique [IAS 39.AG74].
Fair value approach revisited
AfS fair value changes do not affect the income statement ...
Although fair value accounting applies for both aFVtPL items and Availablefor-Sale assets, there is a substantial difference between both categories with
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April 25, 2005
regard to the effect on the income statement. As the expression... through profit or loss suggests, fair value changes for aFVtPL items do not only lead to an adjustment of their carrying amount on the balance sheet, but also immediately affects the income statement [IAS 39.55(a)]. AfS items, however, do not automatically 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 in equity, through the so-called statement of changes in equity. This is a very special item in equity, which does not belong to the income statement and is often referred to as AfS reserve.
... except for impairment losses
However, there is no rule without an exception! In case of so-called impairment losses, the entity is obliged to recognize the loss in the income statement [IAS 39.67]. 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 principal payments Bankruptcy or restructuring is becoming probable Measurable decrease in estimated future cash flows It should be added that a downgrade of an issuers credit rating is basically not sufficient for impairment [IAS 39.60]. For an equity instrument, a significant or prolonged decline in the fair value below its cost is also objective evidence of impairment [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 an event occurring after the impairment loss was recognized in profit or loss, the impairment loss shall be reversed, with the amount of the reversal recognized in profit or loss [IAS 39.70]. Unfortunately, this provision only holds for debt instruments. Fair value gains for equity instruments in the aftermath of an impairment are recognized in the AfS reserve [IAS 39.69]. In a second step, we now delve into the topic of measuring a financial instrument at amortized cost. As we already pointed out, the carrying amount of a financial instrument when initially recognized equals the amount spent or received for it. However, abiding by this amount until the financial instrument is due or sold/redeemed is not self-evident. For an equity instrument, it makes sense to keep the carrying amount up over time. On the other hand, debt instruments are typically redeemed at par value (100) but they are bought/sold above or below par. Hence, one needs an approach to distribute the premium or discount over time. Previous German-GAAP (HGB) solve this problem by establishing a deferred item on the balance sheet at initial recognition and dissolving it proportionately until maturity. However, IAS 39 does not permit such an approach, but dictates the effective interest method (EIM) instead. In the following, we introduce the concept by means of an example. Let us assume that an entity purchases a government bond with a notional amount of EUR 100,000, a yearly coupon of 6% and five years until maturity at a price of 95.9. The first step is to calculate the effective interest rate of this fixed income investment. Please note that the effective interest rate is the internal rate of return, i.e. that uniform discount rate which generates the current market price. In the present case, applying a numerical procedure provides an effective interest rate of 7%. Please refer to the left table below for details.
Measuring a financial instrument at amortized cost ...
... via the effective interest method An example for the EIM

April 25, 2005
PAYMENT STRUCTURE AND INTERNAL RATE OF RETURN Year 1 2 3 4 5 Cash flow 6,000 6,000 6,000 6,000 106,000 Discount factor 1/1.07 1/1.072 1/1.07 1/1.07 1/1.07
3 4 5
CARRYING AMOUNT AND INTEREST INCOME (IAS 39) Year 1 2 3 4 5 Sum

Present value 5,607 5,241 5,898 4,577 75,577 95,900
Carrying amount Carrying amount (start of period) (end of period) 95,900.00 96,613.00 97,375.91 98,192.22 99,065.68 96,613.00 97,375.91 98,192.22 99,065.68 100,000.00
Interest income 6,713.00 6,762.91 6,816.31 6,873.46 6,934.32 34,100.00
Amortized cost at the beginning of year 1

The interest income is calculated based on the initial internal rate of return ...
The left table shows the development of the carrying amount until maturity of the bond. At initial recognition, the carrying amount equals the purchase price. The effective interest method now presumes that the investment provides a constant interest income in accordance with the initial internal rate of return. Hence, the interest income for year 1 amounts to
EUR 95,900 7.00% = EUR 6,713 .
... and not on actual cash flows
However, as there is only a cash inflow of EUR 6,000 during this period, the difference 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
EUR 95,900 + EUR 713 = EUR 96,613
The carrying amount and the interest income increase by the initial rate of return
The carrying amount at the end of the period also acts as the carrying amount for the start of the next period. For period 2 and afterwards, the procedure is repeated for the respective new carrying amount. For example, the interest income of 7% is then calculated based on the new carrying amount of EUR 96,613. In fact, the carrying amount and the interest income are subject to a y-o-y increase of 7%, the initial rate of return. Applying the effective interest method as demonstrated above is just the regular case. As for AfS assets, there are impairment provisions for HtM and LaR assets as well [IAS 39.63]. If there is objective evidence for impairment, the difference between the assets carrying amount and its present value is recognized in profit or loss. The entity may choose between (a) the reduction of the carrying amount and (b) the use of an allowance account. IAS 39.65 states that if the impairment loss decreases afterwards, the impairment loss shall be reversed with the amount of the reversal recognized in profit or loss. In a nutshell, IAS 39 is characterized by a mixed measurement approach, i.e. some financial instruments are recognized at fair value, while others are disclosed at (amortized) cost. The attribution of a financial instrument to one of these categories is primarily driven by the purpose of the item within the company.
Impairment provisions also apply to HtM and LaR
IAS 39 suffers from the mixed model approach
HVB Corporates & Markets, Global Markets Research. 9 See second to last page for disclaimer.

April 25, 2005
RECOGNITION AND DERECOGNITION

Side issues may arise which question the recognition or derecognition of a financial instrument
Finally, we deal with recognition and derecognition. In the preceding paragraph, we dealt with measurement issues, presuming that the recognition of the respective financial instrument has already taken place. It seems rather straightforward to assume the recognition of a financial asset as soon as it is acquired and the contract is settled. However, side issues may arise which question the recognition or derecognition of a financial instrument in practice. Hence, we give a short overview of basic IAS 39 guidance with regard to this subject. The initial recognition of a financial asset or liability is straightforward. IAS 39.14 uses the expression the entity becomes a party to the contractual provisions of the instrument. In the context of regular way purchases (meaning: spot transactions), the entity even has the choice of using trade day accounting (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 all purchases and sales [IAS 39.AG53]. 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 the rights to the assets cash flows expire [IAS 39.17(a)]. However, there is another possibility: the transfer of the financial asset [IAS 39.17(b)]. Transferring of an asset means that one (1) transfers the contractual rights to receive the cash flows of the financial asset, or (2) assumes a contractual obligation to pay the cash flows to one or more recipients [IAS 39.18]. In addition, derecognition of the asset requires that the entity transfers substantially all the risks and rewards of ownership [IAS 39.20(a)]. This is evaluated by comparing the entitys exposure, before and after the transfer, with the variability in the amounts and timing of the net cash flows of the transferred asset [IAS 39.21]. 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]. Last but not least, it should be noted that if a financial instrument is removed from the balance sheet because of derecognition, the difference between the carrying amount and the consideration received or paid is recognized in profit or loss [IAS 39.26 and IAS 39.41]. In case an AfS reserve has been built up for a financial asset over time, the balance sheet item has to be dissolved and recognized in P&L.
Initial recognition is straightforward
Derecognition of a financial asset
Derecognition of a financial liability
Derecognition leads to a P&L effect for the respective instrument
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April 25, 2005
EMBEDDED DERIVATIVES
Structured products entail a possible obfuscation of leveraged exposure to nonrelated asset classes
The market for structured products has recently experienced tremendous growth. Against this background, the financial statement of companies investing in these products may feature significant leveraged exposure to non-related asset classes (e.g. equity and credit). Given that these companies classify hybrid instruments as HtM or even as LaR (e.g. structured promissory loans as Schuldscheindarlehen), the financial risk would not be identifiable for the reader of the financial statement. Hence, the standard setter introduced specific rules that clarify how to cope with this kind of instrument. The basic idea of the embedded derivatives concept is to divide structured or hybrid products into a host contract (typically a fixed-income security) and an embedded derivative [IAS 39.10]. The valuation and payout of the embedded derivative is subject to a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable.
Hybrid products are divided into ... ... a host contract and... ... an embedded derivative
Not every embedded derivative has to be separated from its host contract
Not every embedded derivative has to be separated from its host contract! A separation is mandatory if (a) the risk of the embedded derivative is not closely related to the host contract, (b) the embedded derivative would meet the definition of a derivative, and (c) the hybrid instrument is not measured at fair value with changes in fair value recognized in profit or loss [IAS 39.11]. Please refer to the following diagram for an overview.
THE DECISION TREE FOR SEPARATING EMBEDDED DERIVATIVES
Is the risk of the embedded derivative closely related to the host contract? [IAS 39.11(a)] Is the embedded derivative actually a derivative in line with IAS 39? [IAS 39.11(b)] Is the hybrid instrument measured at fair value and recognized in p&l? [IAS 39.11(c)]
NO
YES
NO
Separation of embedded derivative is mandatory
YES
NO
YES
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 the embedded derivative. Typically, the host contract is a fixed-income security (fixed coupon bond, floater, zero coupon bond). Risk sources related to that product are interest rate risk and the issuers credit risk. If the embedded derivative is driven by other risk sources (equity risk, other credit risk than the issuers, etc.) or has leveraged exposure, the embedded derivatives risk is not closely related to the host contract. The following list gives a few examples of such hybrid products: convertibles notes that are linked to commodity or equity prices credit linked notes
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April 25, 2005 The host contract keeps the instruments category, ...
... while the embedded derivative will be disclosed aFVtPL
What are the consequences of a separation? IAS 39 stipulates that the host contract is accounted for in accordance with the hybrid instruments original category. 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 recognized aFVtPL as it can be interpreted as a derivative in line with IAS 39. If no valuation tools are available, one can determine the fair value of the embedded derivative as the difference between the fair value of the hybrid instrument and the fair value of the host contract [IAS 39.13]. In practice, it is difficult and time-consuming for companies to separate the embedded derivative as shown above. However, the introduction of the fair value option in December 2003, which allows the entity to designate each single financial instrument to disclose it aFVtPL without the duty to perform a separation procedure, provides a basis to avoid embedded derivatives separation. Nevertheless, one has to accept the effect of fair value changes in the P&L in this case.
The fair value option
HEDGE ACCOUNTING
The mixed measurement model may cause P&L asymmetries
As noted in the measurement paragraph, a major characteristic of IAS 39 is the mixed measurement approach, as fair value and cost accounting for financial instruments apply simultaneously. In a hedging context, this may lead to inappropriate results, as the hedged item may be recognized at amortized cost while the hedging instrument (e.g. a derivative) is disclosed aFVtPL. In order to avoid P&L asymmetries, IAS 39 provides rules that facilitate a valid reproduction of economically-driven hedging relationships [IAS 39.71 et sqq.], called hedge accounting. In the following, we give a short overview of basic terms and concepts of hedge accounting:
BASIC TERMS AND CONCEPTS OF HEDGE ACCOUNTING Concept Hedged item Source IAS 39.9; IAS 39.78 Explanation An asset, liability, firm commitment (forward contract), highly probable transaction or net investment in a foreign operation, involving a risk of changes in fair value or future cash flows A derivative whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedged item 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 A hedge of the exposure to changes in fair value of a recognized asset or liability, etc., that is attributable to a particular risk and could affect profit or loss A hedge of the exposure to variability in cash flows that is (1) attributable to a particular risk associated with a recognized asset or liability or a highly probable forecast transaction and (2) could affect P&L
Basic concepts of hedge accounting
Hedging instrument IAS 39.9; IAS 39.72 Hedge effectiveness IAS 39.9
Fair value hedge
IAS 39.86(a)
Cash flow hedge
IAS 39.86(b)
The fair value hedge ...
IAS 39 provides three types of hedging relationships. The idea of a fair value hedge is to compensate the hedged items fair value changes by means of fair
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April 25, 2005
value changes of the respective hedging instrument. Ideally, fair value changes for both instruments have opposite algebraic signs but the same absolute amount. When setting up a fair value hedge, one has not only to designate the hedged item and the hedging instrument, but also specify the particular risk that affects the fair value of both financial instruments. Any recognized financial asset or liability or an unrecognized firm commitment can be utilized as a hedged item. The left diagram below shows a typical situation: The company has purchased a bond with a fixed coupon (hedged item) and wants to hedge the interest rate risk by entering into a payer swap (pay coupon, receive floating leg). The funding position is shown for the sake of completeness and is not part of the hedging relationship.
A TYPICAL FAIR VALUE HEDGE
Assets
5% p.a.
A TYPICAL CASH FLOW HEDGE

Liabilities
funding position
e.g. 3M-Euribor + Spread 3M- + Spread
Assets
3M- + Spread
Liabilities
funding position
e.g. 5% p.a. 5% p.a.
fixed-coupon bond
e.g. coupon 5%, maturity 5 years
floating rate note

e.g. floater 3M-Euribor, maturity 5 years 3M- + Spread
payer swap
specifications: pay 5% p.a. receive float maturity 5 years
5% p.a. 3M-Euribor + Spread
receiver swap
specifications: pay float receive 5% p.a. maturity 5 years
5% p.a.
... and its consequences in case it proves effective
In case the fair value hedge proves effective (which seems clear for the example above), IAS 39 stipulates the following accounting rules for the hedged item and the hedging instrument: The fair value change of the hedged item which is attributable to the hedged risk is used to adjust the carrying amount of the hedged item and simultaneously recognized in P&L [IAS 39.89(b)] As the hedging instrument (a derivative) is already disclosed aFVtPL, nothing changes [IAS 39.89(a)]. This results in an avoidance of a P&L disavowal, which would otherwise be attributable to the hedged risk. A fair value hedge approach is only indicated when 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 39 provisions. It aims at eliminating or reducing the exposure to variability in cash flows. These future cash flows may be variable cash flows from already recognized assets or liabilities (e.g. floaters), but also from highly probable forecast transactions [IAS 39.86(b)]. The right diagram above shows a typical situation: The company has purchased a floating rate note (hedged item) and wants to hedge the risk of unstable future interest income by entering into a receiver swap (receive fixed coupon, pay floating leg). The companys funding position involves fixed coupon payments and is only shown for the sake of completeness. In case the cash flow hedge proves effective (which seems clear for the example above), IAS 39 stipulates the following accounting rules for the hedged item and the hedging instrument: The portion of the hedging instruments fair value change which is
... and its consequences
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April 25, 2005
determined to be an effective hedge is recognized directly in equity through the 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 its original category. Apparently, the consequences of an effective cash flow hedge differ substantially from those for a fair value hedge. An effective fair value hedge leads to a P&L recognition for both hedged item and hedging instrument. In contrast, an efficient 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 parking position similar to the AfS reserve.
The hedge of a net investment in a foreign operation
There is also a third hedge accounting approach, namely the hedge of a net investment in a foreign operation. We ignore this topic due to the fact that it is not related to our focus on credit derivatives. As hedge accounting facilitates to deviate from basic measurement rules, one has to fulfill several conditions before applying these degrees of freedom: The hedging relationship has to be formally designed at initiation (hedged item, hedging instrument, hedged risk) and requires documentation (risk management 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 in fair 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 an ongoing basis [IAS 39.88(d),(e)].
Several conditions must be met to apply hedge accounting
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CREDIT DEFAULT SWAPS

Accounting CDS in accordance with IAS is not as straightforward as expected
Credit default swaps represent the most important product group within the credit derivatives universe in terms of turnover and volume. In addition, CDS contracts act as basic building blocks for more complex credit derivatives. Against this background, accounting for credit default swaps seems to be rather straightforward. However, as we will see below, this is a false conclusion.
INSTRUMENT DESCRIPTION
CDS allow for the transfer of credit risk
Credit default swaps (CDS) are bilateral OTC-traded contracts. Such a contract enables the protection buyer to exclusively transfer the credit risk of a specified reference 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, the protection 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 are feasible, but not market standard.
MECHANISM OF A CREDIT DEFAULT SWAP
common payments risk factor premium protection buyer

(spread) (1) cash settlement payment
(2a) delivers ref. obligation
protection seller
(2b) pays par value (100)
reference obligation
typically a loan or bond subject to default risk 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 the contract, occurs. As the documentation usually is based on the 2003 ISDA Credit Derivatives Definitions, the following credit events apply: Bankruptcy, i.e., the company becomes insolvent or is unable to pay its debts; protection for creditors applies via filing for bankruptcy Failure to pay, i.e., an amount of at least USD 1 mn is due considering a grace period Restructuring, i.e., an adverse change in debt obligations which amount to at least 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 as market standard. For details regarding CDS contracts, please refer to our Credit Derivatives Special CDS: Mechanism, Pricing & Application.
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ACCOUNTING CONSEQUENCES
Is the CDS contract covered by IAS 39 or not?
Irrespective of the CDS position taken (protection buyer or seller), one has to assess if the contract is covered by IAS 39, as the guaranty character is apparent. As already stated, particular financial guaranty contracts are subject to IAS 37 (or IFRS 4), according to IAS 39.2(f) and IAS 39.3. Such contracts are excluded from the scope of IAS 39, if the contract provides for specified payments to be made to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due under the original or modified terms of a debt instrument. This particularly means that the following conditions have to be met: In case of a default, the protection buyer must incur a loss in the reference obligation. Obviously, this means that he is required to have the obligation in his portfolio. The payoff profile of the CDS must be qualified to make up the loss of the debt instrument. The CDS contract has to provide a reimbursement if, and only if, the specified debtor fails to make payment when due.
No one will be able to verify the first condition for a protection seller in practice
Apparently, the first aspect seems inapplicable from the perspective of a protection seller, as one has to know if the counterparty possesses the reference obligation. In practice, no external auditor will be able verify this condition for long credit positions. 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 accordance with IAS 39. However, there are other opinions as well, which currently seem to be confirmed as best practice, that all three mentioned credit events (bankruptcy, failure to pay, restructuring) fulfill the required conditions. On the other hand, credit events like obligation acceleration, obligation default, and repudiation/moratorium are not accepted. Hence, the inclusion of such credit events would automatically lead to a derivatives accounting in accordance with IAS 39. In a nutshell, the only possibility to avoid IAS 39 becoming effective for CDS accounting is to refrain from additional credit events that are nonmarket standard. In case of a short credit position (protection buyer), the CDS should be used to hedge already existing credit risk exposure (loan or cash bond). In our view, it is not necessary that the hedge leads to a reduction of risk-weighted assets. If the hedge makes sense from an economic point of view (e.g. same obligor but different reference loans/bonds, different reference entities but same economic risk due to a letter of comfort or a profit-pooling contract), IAS 37 (or IFRS 4) applies. In any case, conducting trading activities, i.e. entering into a CDS contract in order to realize short-term profits attributable to spread changes, does not reflect the nature of financial guaranties. Hence, trading positions should always be accounted for in accordance with IAS 39. The following decision tree summarizes the crucial aspects pointed out above. However, we recommend to consult an external auditor in order to get clear guidance with regard to credit default swaps.
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In practice, credit events other than (1) bankruptcy, (2) failure to pay, and (3) restructuring automatically lead to IAS 39 accounting
Protection buyers need to have a (economically motivated) hedging relationship in order to avoid IAS 39 accounting
Trading CDS are always derivatives in terms of IAS 39
Consult your external auditor about CDS

April 25, 2005 CREDIT DEFAULT SWAPS: IAS 37 OR IAS 39?
Is the CDS used for trading purposes?

NO
YES
Is the CDS based on standard credit events?

YES
NO
Protection buyer position?

NO
YES
Hedging an existing credit risk exposure?

YES
NO
IAS 37 / IFRS 4 financial guaranty

Consequences for CDS as financial guaranties
After having resolved whether the CDS contract is a derivative or a financial guaranty, one has to apply the respective accounting rules. In case of a financial guaranty, the CDS establishes a contingent liability (protection seller) or a contingent claim/collateral (protection buyer). Basically, both items are not shown on the balance sheet as long as the default case is outside the range of vision [IAS 37.31 et sqq.]. However, the contingent claim/collateral has to be taken into account in case of impairment for the hedged loan or bond. If the potential loss can be retrieved by the CDS contract, an impairment is not necessary. A contingent liability may entail reserves in case the respective credit exposure experiences a dramatic deterioration. As already stated, derivatives in line with the IAS 39 definition are categorized as aFVtPL, i.e. their fair value is disclosed on the balance sheet and fair value changes are recognized in the income statement. It should be noted that the initial present value is zero and may become positive (asset) or negative (liability) afterwards, depending on the market spread development. What about the ongoing premium payments? One could argue that the premium is an option premium with deferred payment dates. This seems reasonable, as the default case is detrimental to just one counterparty, namely the protection seller. However, this is not the usual interpretation of a credit default swap: the premium leg is swapped for the default leg. Hence, the premium payments are accounted for as interest payment, which calls for accrual accounting and recognizing the premium as interest income.
Consequences for CDS as derivatives
Is the regular premium payment an option premium?
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April 25, 2005
TOTAL RETURN SWAPS

The importance of TRS has declined compared to CDS
Total return swaps belong to the basic credit derivative structures, although their importance has declined against the background of the massive growth of credit default swap products. Nevertheless, we give a short abstract of its mechanism and show possible accounting consequences.
A TRS allows for transferring market 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 coupon payments, 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. In fact, it enables the protection buyer to transfer both the underlyings market and credit risk to the protection seller. The floating leg of the contract reflects that no funding is required for the protection seller to obtain the risks and rewards of the reference obligation.
MECHANISM OF A TOTAL RETURN SWAP
common risk factor bond coupon protection buyer

bond coupon floating rate (e.g. 3M-Euribor) spread positive fair value change negative fair value change
protection seller
typically a loan or bond subject to default risk definitive payment (no default) conditional payment
IAS 39 applies
Applying the accounting provisions for financial guaranty contracts (IAS 37) is out of the question, as the contract provides for payments that go beyond a reimbursement of credit-related losses. However, there is a recognition/derecognition issue, which has to be taken into account. From an economic perspective, the protection buyer transfers all risks and rewards of the underlying asset to his counterparty. But is this transfer in line with IAS 39.17 et sqq., which would lead to a derecognition of the underlying asset in the protection buyers balance sheet? Apparently, the protection buyer retains the contractual rights to receive the cash flows of the financial asset, but assumes a contractual obligation to pay the cash flows to one or more recipients [IAS 39.18(b)]. IAS 39.19 stipulates additional conditions that have to be met in order to achieve derecognition, namely: The protection buyer has no obligation to pay amounts to the eventual recipient unless it collects equivalent amounts from the original asset [IAS 39.19(a)].
A derecognition issue: Is the underlying asset transferred to the protection seller?
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April 25, 2005
The protection buyer is prohibited by the terms of the transfer contract from selling or pledging the original asset [IAS 39.19(b)]. The protection buyer has an obligation to remit any cash flows it collects on behalf of the eventual recipients without material delay, i.e. no reinvestment of such cash flows should be possible [IAS 39.19(c)].
The protection seller typically cannot be kept from selling or pledging the asset
In our view, the first and the third conditions can be easily met by respective legal definitions of the TRS contract. However, the protection seller typically cannot be kept from selling or pledging the original asset by means of the total return 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 into question. Accordingly, the TRS is accounted for as a regular derivative contract in line with IAS 39. Hence, the fair value (can be either positive or negative) is disclosed on the balance sheet and fair value changes are recognized in the income statement. Interest cash flows (bond coupon and refinancing leg) of the contract call for accrual accounting, while compensation payments due to fair value changes are directly recognized in the income statement. There is another case that should be considered [IAS 39.AG40(o) and IAS 39.AG51(o)]. Lets assume that a company sells a financial asset to a counterparty and enters into a TRS with the same party to retrieve all cash flows and fair value changes. In such a case, derecognition of the asset is prohibited due to the fact that the company retains substantially all the risks and rewards of ownership of the financial asset [IAS 39.20(b)]. The total return swap is just a legal contract that facilitates the maintenance of the economic property. Hence, no separate disclosure of the TRS contract is required.
Fair value accounting for total return swaps
Selling the asset and retrieving all returns via a TRS ...
... justifies no derecognition of the asset
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CREDIT LINKED NOTES

Credit linked notes are subject to embedded derivatives provisions
Credit linked notes belong to the class of hybrid products, as their payoff is related to credit risk that is not (exclusively) issuer-related. Against this background, IAS 39 provisions with regard to embedded derivatives come into play. Hence, accounting consequences are mainly determined by the chosen asset category.
A CLN is a combined position comprising a regular bond and a protection seller CDS
A credit linked note (CLN) is a funded asset which is subject to credit risk of a reference obligation (entity) that does not correspond to the issuers credit risk. The note issuer typically pays an enhanced coupon to the investor for taking on the additional credit risk. If the reference entity defaults, then the noteholder receives the recovery price of the reference obligation in lieu of its par value (market standard). Alternatively, the CLN issuer might deliver the reference obligation. Hence, a CLN is simply a combined position comprising (1) a regular bond investment and (2) a protection seller position in a CDS.
MECHANISM OF A CREDIT LINKED NOTE
floating rate (e.g. 3M-Euribor) + credit spread par value (100) recovery value of the reference obligation
common risk factor CLN investor
CLN issuer
typically a loan or bond subject to default risk 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, for example: Leveraged CLNs: The notional amount of the embedded credit default swap is a multiple of the notes notional amount. Physical settlement applies if a credit event occurs. First-to-default CLNs: Same as a regular CLN, but subject to the first default event within a basket of various reference entities. Spread widening note: Includes a protection buyer CDS instead of a protection seller position, which leads to negative spread.
... and promissory loans are possible
Many more structures are possible. Such a hybrid structure may also be issued as a promissory loan (Schuldscheindarlehen).
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An embedded credit derivative in a host debt instrument is not closely related
A regular credit linked note is subject to IAS 39 provisions concerning embedded derivatives. IAS 39.AG30(h) states that credit derivatives that are embedded in a host debt instrument and allow one party to transfer the credit risk of a particular reference asset to another party are not closely related to the host debt instrument. However, this does not automatically lead to a separation of the embedded derivative, as two additional criteria have to be met. The second condition, namely that the embedded derivative is in line with the derivative definition of IAS 39, is out of the question in practice. Hence, the separation decision is solely dependent on the chosen asset category. In case of HtM or LaR (in case of a promissory loan), the embedded credit derivative has to be separated and disclosed 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 recognizing fair value changes that are attributable to the embedded credit derivative in the income statement instead of the AfS reserve. Only an aFVtPL categorization prevents the entity from separating the embedded derivative. But how about the accounting consequences for the issuer? The results basically remain unchanged, although there are only two categories available for the liabilities side. Hence, other financial liabilities are subject to a separation of the embedded credit derivative. As mentioned before, splitting up a CLN into a host contract and an embedded derivative is an annoying procedure in practice. In addition, fair value accounting for the embedded derivative contributes to P&L volatility due to market changes. However, the December 2003 version of IAS 39 provides opportunities to avoid the separation of the embedded derivative: The International Accounting Standards Board (IASB) introduced the fair value option which enables the entity to designate each single financial instrument to disclose aFVtPL. Hence, the duty to perform the separation of the embedded credit derivative is circumvented. The fair value option is currently unavailable for financial liabilities due to the partial endorsement of the standard. Thus, the only possibility for CLN issuers to avoid a separation is to implement a hedge accounting approach. We recommend to perform a fair value or cash flow hedge, which requires an appropriate hedging instrument contracted with an external counterparty. For instance, a single-name CDS contract would satisfy hedging the credit risk of a regular CLN. In place of implementing a hedge accounting approach, one could issue the CLN from the trading book, if applicable. Hence, the category aFVtPL applies without the obligation to separate the embedded derivative.
The separation decision is solely contingent on the chosen category for the instrument
Same applies to the CLN issuer
The December 2003 version of IAS 39 provides opportunities to avoid the separation
(1) Exercise the fair value option
(2) Implement hedge accounting (for CLN issuers)
(3) Issues the CLN from the trading book
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ITRAXX PRODUCTS
The iTraxx product family achieved great popularity since its introduction in June 2004
Since its introduction in June 2004, the iTraxx product family has achieved great popularity, as it offers diversified access to credit exposure. In fact, the iTraxx Europe Benchmark index has become the most liquid instrument within the credit universe, accompanied by extremely narrow bid-offer spreads. In the following, we provide an insight into the various indices and products with regard to their accounting treatment.
The iTraxx family is based on three main indices ...
... and comprises several product categories and maturities
The iTraxx family is based on three different main indices or baskets, which are shown in the upper part of the diagram below. Please note that the iTraxx Europe Corporate is an obsolete index due to a lack of demand. Various product categories and maturities are available, depending on the structure of the respective indices, including index swaps, first-to-default baskets and standardized CDO tranches. Credit linked notes relating to the iTraxx universe are currently of minor importance. Please refer to our Credit Derivatives Special DJ iTraxx: Credit at its best! for details regarding the mechanism of these products.
THE ITRAXX INDEX AND PRODUCT FAMILY AN OVERVIEW
iTraxx Benchmark iTraxx indices

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
Sectors
- Non-Financials (100) - Financials Senior (25) - Financials Sub (25) - TMT (20) - Autos (10) - Industrials (20) - Consumers (30) - Energy (20)
index swaps (CDS-style) iTraxx products credit linked notes (funded) first-to-default contracts CDO tranches
Each product category is discussed separately
In the following, we will discuss the accounting consequences for each product category within the iTraxx universe separately. As iTraxx index swaps are of major importance and also act as the basis for more sophisticated iTraxx products, we will start with this product group. Index swaps are based on a basket of reference entities (or obligations) with static weightings. Like regular CDS contracts, they are settled physically in case a credit event occurs. Bankruptcy, failure to pay, and restructuring are taken as
iTraxx index swaps are similar to regular CDS contracts
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April 25, 2005
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 be similar to regular CDS contracts, particularly with regard to a possible recognition as financial guaranty contracts. However, IAS 39.3 states that financial guaranty contracts are subject to IAS 39 if they provide for payments to be made in response to changes in a credit index. In our view, this provision is not applicable to iTraxx index swaps, because they are not based on a credit index. The gain or loss of an iTraxx index swap position is solely based on real economic actions, namely credit events of constituents in the respective basket. In addition, an iTraxx index swap can be understood as an additive aggregation of regular CDS contracts. In a nutshell, we are convinced that the IAS 39.3 provision cannot be applied to iTraxx index swaps. Hence, accounting consequences drawn with regard to CDS contracts can be transferred to iTraxx index swaps. Protection buyers will indeed have difficulties to prove an economic hedge of default risk. For the iTraxx Europe Benchmark index swap, one would need all 125 reference assets on the balance sheet to achieve an accounting treatment under the terms of IAS 37 (or IFRS 4). When considering iTraxx FTD baskets or CDO tranches, it seems self-evident to designate these as derivatives in accordance with IAS 39. However, we see a good chance to transfer the CDS considerations to these products. As stated before, the underlying is not a credit index, but a portfolio of regular CDS contracts. Admittedly, FTD baskets and CDO tranches are complex products, but they still rely on credit events reflecting losses that arise because a specified debtor fails to make payment when due [IAS 39.2(f)]. The non-linearity of payoff profiles for these instruments is, in our view, an aspect that is not relevant for assessing financial guaranty contracts. However, we recommend to consult the external auditor in order to get a clear guidance with regard to these exotics. Few market makers also provide quotes for credit spread options with iTraxx index swaps as underlying. In contrast to FTD baskets and CDO tranches, the underlying is the quoted spread of the index swap (credit index), but not the economic default risk of the reference entities. Hence, credit spread options cannot be designated as financial guarantee contracts, and hence have to be accounted for as derivatives in line with IAS 39. They have to be disclosed at fair value on the balance sheet, while fair value changes have to be directly recognized in the income statement.
Accounting rules for CDS are also applicable to iTraxx index swaps ...
... and even FTD baskets and CDO tranches
Credit spread options definitely are IAS 39 derivatives
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April 25, 2005
OTHER INSTRUMENTS OF INTEREST

A brief guidance for more exotic credit derivatives structures
Besides the products presented in the preceding sections, the credit derivatives market created several exotic structures over the last few years. Despite the fact that these are only of minor importance, we provide a list to give a brief guidance with regard to International Accounting Standards. It should be noted that the list is not exhaustive. In case of doubt, we recommend to apply IAS 39, i.e. fair value accounting for the respective instrument.
A NON-EXHAUSTIVE LIST FOR MORE EXOTIC CREDIT DERIVATIVES Product Digital Credit Default Swap (DDS) Description Similar to CDS except that the recovery value is fixed at the start of the trade. This specification avoids the complicated mechanism to determine the recovery rate for cash settlement. A forward contract with regard to the recovery rate. In case of a default, the actual recovery rate is compared to the stipulated recovery rate in the contract to determine a compensation payment (can be either positive or negative). Actually no credit derivative, but an equity derivative (a far-outof-the-money put option with barrier) IAS accounting IAS 39 derivative [IAS 39.9]
Recovery Default Swap (RDS)
IAS 39 derivative [IAS 39.9]
Equity Default Swap Rating-triggered CDS Constant Maturity Credit Default Swaps (CMCDS)
IAS 39 derivative [IAS 39.9]
Similar to CDS except that the default event is defined in terms of IAS 39 derivative [IAS 39.9] rating classes. Similar to CDS except that the spread level of the premium leg is regularly adjusted in accordance with market levels IAS 7 / IFRS 4 cannot be ruled out, although instrument is typically used to implement a spread view IAS 39 derivative [IAS 39.9]
Options on CDO tranches and FTD Option contract which allows the buyer to enter into a CDO baskets tranche or FTD basket
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DISCLAIMER
Please note Key 1: Bayerische Hypo- und Vereinsbank AG and/or a company affiliated with it pursuant to 15 AktG (German stock-company act) owns at least 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 on the 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 a short 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 the analysis was compiled. 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April 25, 2005
CONTACTS
Global Head of Research Thorsten Weinelt, CFA Managing Director +49 89 378-15110 thorsten.weinelt@hvb.de 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 Gisdakis Quantitative Credit Strategy +49 89 378-13228 Michael Zaiser Credit 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 Mnkel +49 89 378-11294 Publication Address Bayerische Hypo- und Vereinsbank AG HVB Corporates & Markets Global Markets Research Arabellastrasse 12 D-81925 Munich Telephone +49 89 378-12759 Facsimile +49 89 378-16237 Bloomberg HVBR Internet www.hvb.de/valuepilot
* Crossover credits are covered by the respective high-grade sector analyst
High Grade Research* Luis Maglanoc, CFA, Head Financials +49 89 378-12708 Franz Rudolf Insurance, Financial Services +49 89 378-12449 Stephan Haber Telecoms, Media, Technology +49 89 378-15192 Dr. Sven Kreitmair Automobiles & Parts, Industrial G&S, Aerospace & Defense +49 89 378-13246 Carmen Hummel Food & Beverage, Personal & Household Goods, Retail, Travel & Leisure +49 89 378-12252 Christian Kleindienst Utilities, Oil & Gas +49 89 378-12650 High Yield* & EEMEA Credit Research Dr. Felix Fischer, CFA, Head General Industries, Construction & Materials, Tobacco +49 89 378-15449 Jochen Schlachter Chemicals, Healthcare +49 89 378-13212 Jana Arndt Basic Resources +49 89 378-13211 Dusan Meszaros, EEMEA Credit +43 50505-82350 dusan.meszaros@BA-CA.com
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