Contents Foreword Introduction Preface Acknowledgments Chapter 1: Fixed Income Securities—Theory Learning Objectives Fixed Income Securities in General Basics of the Bond Market Definition of Financial Instruments Categories of Financial Instruments—An Overview Questions Chapter 2: Fixed Income Securities—Fair Value through Profit or Loss Learning Objectives Meaning and Definition of Fixed Income Securities Classification of Debt Securities as “Fair Value through Profit or Loss” Accounting for Fixed Income Securities Trade Life Cycle for Fixed Income Securities—Fair Value through Profit or Loss Corporate Action Additional Events in the Trade Life Cycle Complete Solution to the Illustration FX Revaluation and FX Translation Process Distinction between Capital Gain and Currency Gain Illustration 1: Investment in Bonds held for Trading Purposes Solution to Illustration 1: Investment in Bonds held for Trading Purposes Problem 1: Investment in Bonds (Trading) in Foreign Currency (AUD) Accounting Entries in Functional Currency Summary Questions Chapter 3: Fixed Income Securities—Available-for-Sale Learning Objectives Basic Understanding of Available-for-Sale (AFS) Accounting for Fixed Income Securities Classified as Availablefor-Sale Option to Designate a Financial Asset at Fair Value through Profit or Loss Accounting for Fixed Income Securities Trade Life Cycle for Fixed Income Securities—Available-forSale FX Translation on Available-for-Sale Securities Impairment of Available-for-Sale Fixed Income Securities Bonds Classified as Available-for-Sale—Complete Solution to the Illustration Problem 1—Bonds Held as Available-for-Sale in USD FX Revaluation and FX Translation process Accounting Entries in Functional Currency—USD Summary Questions Chapter 4: Fixed Income Securities—Held-to-Maturity Learning Objectives Meaning of Securities Classified as Held-to-Maturity (HTM) Exceptions to the Rule for Classification as Held-to-Maturity Effective Interest Rate Accounting for Securities Classified as Held-to-Maturity Trade Life Cycle for Fixed Income Securities—Held-to-Maturity Illustration of Bonds Held-to-Maturity—Complete Solution Problem—2: Bonds Held as Held-to-Maturity in BRL (Foreign Currency) Solution to Problem—2: Bonds Held as Held-to-Maturity in BRL (Foreign Currency) Accounting Entries in Functional Currency—Problem 2—USD Summary Questions Chapter 5: Presentation, Disclosures & Reclassification Learning Objectives Relevant Accounting Standards General Disclosure as per IFRS A Significance of Financial Instruments for Financial Position and Performance Statement of Comprehensive Income Other Disclosures B Qualitative Disclosures C Quantitative Disclosures Amendments to IAS 39 & IFRS (October 2008) Reclassification as per IFRS Presentation of Financial Instruments Summary Exercise Chapter 6: Interest Rate Derivatives—Theory Learning Objectives Derivatives in a Financial Instrument Definition of Derivatives as per Accounting Standards Accounting Standards for Interest Rate Derivatives Differences between US GAAP and IFRS Over-the-Counter Contracts Exchange-Traded Derivative Contracts Benefits of Interest Rate Derivatives International Swaps and Derivatives Association (ISDA) Types of Interest Rate Derivatives Hedged or Hedging Instrument—Status of Various Financial Instruments Summary Exercise Chapter 7: Interest Rate Swaps—Receive Fixed Pay Floating Learning Objectives Meaning of Interest Rate Swap Definition of a Derivative Accounting for Interest Rate Swaps The Trade Life Cycle for Interest Rate Swaps Receive Fixed & Pay Floating—Illustration Complete Solution to Illustration 1: Interest Rate Swap—Receive Fixed Pay Floating Problem1: Interest Rate Swap—Receive Fixed Pay Floating Solution to Problem 1: Interest Rate Swap—Receive Fixed Pay Floating Summary Questions Chapter 8: Interest Rate Swaps—Pay Fixed Receive Floating Learning Objectives Meaning of Receive Floating and Pay Fixed Type of Interest Rate Swap Accounting Standards The Trade Life Cycle for Interest Rate Swaps Pay Fixed and Receive Floating—Illustration Complete Solution to Illustration 1: Interest Rate Swap—Receive Floating Pay Fixed Pay Fixed to Receive Floating—USD Solution Summary Questions Chapter 9: Interest Rate Caps Learning Objectives Interest Rate Caps—Description of the Product Accounting for interest rate caps The Trade Life Cycle for Interest Rate Caps Interest Rate Cap Instrument—An Illustration Complete Solution to the Illustration—Interest Rate Cap Problem 1: Interest Rate Cap—Pay Solution to Problem 1: Interest Rate Cap—Pay Problem 2: Interest Rate Cap—Pay Solution to Problem 2: Interest Rate Cap—Pay Accounting Entries in Functional Currency Problem 3: Interest Rate Cap—Receive Solution to Problem 3: Interest Rate Cap—Receive Problem 4: Interest Rate Cap—Receive Solution to Problem 4: Interest Rate Cap—Receive Problem 5: Interest Rate Cap—Receive Solution to Problem 5: Interest Rate Cap—Receive Accounting Entries in Functional Currency Summary Questions Chapter 10: Interest Rate Floors Learning Objectives Interest Rate Floors—Description of the Product Accounting for Interest Rate Floors The Trade Life Cycle for Interest Rate Floors Interest Rate Floor Instrument—An Illustration Complete Solution to Illustration Problem 1: Interest Rate Floor—Sale of Floor Instrument Solution to Problem 1: Interest Rate Floor Problem 2: Interest Rate Floor Solution to Problem 2: Interest Rate Floor Journal Entries in Functional Currency Problem 2: Interest Rate Floor Illustration: IRD Floor—Receive Comprehensive Solution to Illustration Problem 1: Interest Rate Floor (Receive) Solution to Problem 1: Interest Rate Floor (Receive) Problem 2: Interest Rate Floor (Receive) Solution to Problem 2: Interest Rate Floor (Receive) Accounting Entries in Functional Currency Problem 2: Interest Rate Floor (Receive) Summary Questions Chapter 11: Interest Rate Collar Learning Objectives Meaning of Interest Rate Collar Collar or Reverse Collar as a Hedging Instrument Accounting for Interest Rate Collar The Trade Life Cycle for an Interest Rate Collar Interest Rate Collar Instrument—An Illustration Complete Solution to the Illustration—Interest Rate Collar Problem 1: Interest Rate Collar Solution to Problem Entries in Functional Currency Meaning of Interest Rate Reverse Collar Accounting for Interest Rate Reverse Collar The Trade Life Cycle for Interest Rate Reverse Collar Problem 1: Reverse Collar Solution to Problem 1: Reverse Collar Problem 2: Reverse Collar Solution to Problem 2: Reverse Collar Entries in Functional Currency Summary Questions Chapter 12: Cross-Currency Swaps (XCCY Swaps) Learning Objectives A Meaning of Cross-Currency Swaps (XCCY Swaps) Accounting for Cross-Currency Swaps The Trade Life Cycle for Cross-Currency Swaps Complete Solution to Illustration 1: Cross Currency Interest Rate Swap—USD/GBP Accounting Entries in Functional Currency Problem 1: Cross Currency Interest Rate Swap—USD/EUR Accounting Entries in Functional Currency Summary Questions Bibliography Index SUMMARY Currency swaps are over-the-counter derivatives, and are similar to interest rate swaps covered already in this volume except that in a cross-currency swap the principal amounts are in different currencies and unlike interest rate swaps, cross-currency swaps can involve the exchange of the principal Even where there is no exchange of principal, the counterparties are subject to the foreign exchange rate fluctuation during the substance of the trade The tenure of a cross-currency swap typically ranges from one to fifteen years Cross-currency swaps are suitable for entities that have a loan commitment denominated in one currency, while the revenues generated by the entity are denominated in a different currency, resulting in a currency mismatch between the currency of the loan and the currency of revenues A Cross-currency interest rate swaps allow an entity to switch its loan from one currency to another A Cross-currency interest rate swaps enable an entity to manage foreign currency exposures The entity can use money it receives in one currency to pay off its loans in another currency with a cross-currency swap Since a cross-currency swap is basically an interest rate swap, all the risks associated with an interest rate swap in terms of interest rates exist in this instrument The single important reason for entering into a cross-currency swap is to manage foreign exchange exposure This also becomes a huge risk if not managed properly As cross currency swaps involve exchange risk on the principal, the credit risk associated with these types of transactions is substantially greater than with interest rate swaps An important purpose of a cross-currency interest rate swap is to effectively reduce the cost of borrowing by the principle of comparative cost advantage viz to procure debt by borrowing at the best available rate regardless of the currency and then swapping for a debt in the desired currency using a back-to-back-loan The second important purpose of a cross-currency swap is to hedge against exchange rate fluctuations Unlike interest rate swaps there may be an exchange of principal taking place during the purchase and at maturity of the swap If there is no principal exchange then the entry will only be a contingent and an off balance sheet For an actual principal exchange, the respective entries for money transfers will be recorded The net present value of the trade at the time of entering into the contract is also known as the upfront fee on the trade The present value of the pay leg and the receive leg is computed separately and discounted back based on the yield curve of the respective currencies to arrive at the net present value of the contract At the end of every valuation date the fair value of the cross-currency interest rate swap contract is ascertained and the swap contract is marked-to-market to reflect the net present value of the contract The value of the swap is computed based on the expected cash inflows and cash outflows on the remaining period of the life of the contract and discounted based on the yield curve of the respective currency The foreign exchange rate fluctuation between the two currencies is also factored into while arriving at the net present value Being a derivative instrument, an interest rate cross-currency swap per se qualifies to be a hedging instrument It should be noted that in a cross currency swap the risk reward is symmetric and can be more or less compared to an equity futures position A cross-currency interest rate swap instrument can be used to hedge primarily interest rate risk as well as foreign exchange risk QUESTIONS Theory questions What is a cross-currency swap and how is it different from an interest rate swap? Enumerate the features of an interest rate cross-currency swap What are the benefits of a cross-currency interest rate swap? What are the major risks associated with a cross-currency interest rate swap? What are the three types of cross-currency interest rate swaps? Can a cross-currency interest rate swap be designated as a hedging instrument? Enumerate the significant events in the trade life cycle of a cross-currency interest rate swap “The termination fee in any cross-currency interest rate swap includes the fx gain or loss on the position.” Elucidate Objective questions Cross-currency swaps are an effective solution to long-term: a) Interest rate hedging needs b) Currency hedging needs c) Market hedging needs d) None of the above Tenure of cross-currency swap ranges from one to years a) b) 10 c) 15 d) 20 Cross currency swaps are suitable for who has loans denominated in one currency, while its revenues are denominated in a different currency a) Government b) Private c) Corporate d) None of the above Cross-currency interest-rate swaps allow the firm to switch its _ from one currency to another a) Bond b) Equity c) Loan d) None of the above Different types of risk involved in cross-currency swaps are a) Interest rate risk b) Credit risk c) Currency risk d) All of the above A cross-currency swap transaction is recorded as a) A profit or loss item b) A balance sheet item c) An off balance sheet item d) None of the above In a cross-currency swap the interest is prefixed for the next quarter based on the a) Market rate b) Exchange rate c) Benchmark rate d) None of the above The net present value of the trade at the time of entering into the contract is also known as the on the trade a) Premium b) Discount c) Leverage d) None of the above Journal questions Cross-currency swap—problem USD—EUR Prepare Journal entries, general ledgers, trial balance, income statement, and balance sheet Cross-currency swap—problem USD—GBP Prepare Journal entries, general ledgers, trial balance, income statement, and balance sheet Cross-currency swap—problem USD—CAD Prepare Journal entries, general ledgers, trial balance, income statement, and balance sheet Bibliography Accounting Standards Accounting Standards issued by the Financial Accounting Standards Board (FASB) Accounting Standards issued by the International Accounting Standards Board (IASB) Epstein, Barry Interpretation and Application of Generally Accepted Accounting Principles 2009 Edition (New Jersey: John Wiley & Sons, Inc., 2009) Epstein, Barry Interpretation and Application of International Financial Reporting Standards 2009 Edition (New Jersey: John Wiley & Sons, Inc., 2009) Ernst & Young International GAAP 2010 under International Financial Reporting Standards 2010 Edition (New Delhi: Wiley India Pvt Ltd.) PriceWaterhouseCoopers LLP Manual of Accounting—Financial instruments 2010 2010 Edition (New Delhi: CCH India, Wolters Kluwer (India) Private Limited) Deloitte Touch Tohmatsu India Private Limited iGAAP—Financial Reporting Standards in India Including a Comparison with IFRS 2010 Edition (New Delhi: CCH India, Wolters Kluwer (India) Private Limited, New Delhi) Financial Instruments Sanguiuolo, Rosemarie & Siedman, Leslie Financial Instruments—A Comprehensive Guide to Accounting and Reporting 2007 Edition (Chicago: CCH, 2007) Ramirez, Juan Accounting for Derivatives—Advanced Hedging under IFRS 2007 Edition (John Wiley & Sons Ltd., England, 2007) Fixed Income Securities Fabozzi, Frank J The Handbook of Fixed Income Securities 2005 Edition (New York: McGrawHill, 2005) Index A Accrued interest Accrued interest purchased Amortization Amortized cost Asset Available-for-sale B Back-to-back-loan Bankruptcy Bearer certificates Benchmark Benchmark interest rates Bond coupon Bond holder Bond maturity Bond pricing Bonds C Callable debt Call feature Call risk Cap component Cap strike Carrying cost Collateralized mortgage obligation Commercial paper Commodities Commodity forward Commodity futures Commodity prices Consummated FX translation Contraction risk Corporate action Corporate bonds Counterparty Coupon accrual Coupon receipt Credit derivatives Credit limit Credit swap Cross currency swaps Currency forward Currency futures Currency rates D Debt security Derecognition Derivative pricing Deterioration “Dirty price” Discounted cash flow Duration E Early amortization risk Equity futures Equity index futures Equity instruments Equity shares Equity swap Expenses Extension risk F Face value Federal agency securities FIFO Financial instruments Fixed-for-floating Fixed income securities Fixed interest Floating rate notes Floor component Floor rate Foreign currency Foreign exchange risk Forward contracts Forward rate agreement Functional currency FX revaluation FX-swap FX translation H Hedge Hedge accounting Hedge ineffectiveness Held-to-maturity I Impaired bonds Impairment of bonds Impairment of securities Inception Income Inflation risk Interest Interest rate cap Interest rate collar Interest rate floor Interest rate reverse collar Interest rate swap Internal rate of return International Swaps and Derivatives Association (ISDA) Investment Issuer L Lease contracts Legislative risk Liability LIFO Liquidity risk Loan Loans and receivables M Market risk Mark-to-market Monetary items Mortgage- and asset-backed securities Municipal bonds N Non-monetary items O Option pricing Other comprehensive income Over-the-counter (OTC) P Payer swaption Perpetual debt instrument Premium Prepayment risk Presentation currency Principal Put feature Puttable debt Q Quantitative data R Real estate mortgage investment Receiver swaption Redemption Reference rate Refundable Regulatory risk Reinvestment risk Reporting period Reset date Retail mortgage S Sensitivity analysis Settlement Short term money market Spot exchange rate Spot foreign exchange Spot rate Sunk cost Swaption T T-bills Termination fee Timing risk Total return swap Trade life cycle Transient FX translation U Unrealized gain/loss Unwind Upfront fee Upward movements US GAAP V Valuation date Variable Variable interest rate instrument Volatility W Written option Y Yield to call Yield to maturity Z Zero coupon bonds ... Para 1 1A) Available -for- sale Available -for- sale financial assets are those non-derivative financial assets that are designated as available -for- sale or are not classified as: Loans and receivables;... Cycle for Fixed Income Securities? ??Available-forSale FX Translation on Available -for- Sale Securities Impairment of Available -for- Sale Fixed Income Securities Bonds Classified as Available -for- Sale—Complete... actual interest rate; valuation entries on valuation date; and termination of the trade and accounting for termination fee are all covered An illustration gives the accounting aspects of an interest