CFH: Cap/Floor Used as a Hedging Transaction

 

Valuation and Effectiveness Test

As part of the effectiveness test, the system determines the sum of the intrinsic values of each caplet on the valuation key date. The intrinsic value of a caplet is found by subtracting the strike amount from the value of the interest flow. (If the result is negative, the system sets it automatically to zero.) The value is translated using the forward rate and is then discounted.

This result is then compared with the change in value of the underlying transaction. The change in value is determined by subtracting the strike amount from the interest flows of the exposure, translating the amount with the forward rate, and then discounting it. If this results in a negative value, it is also set to zero.

Floors are calculated in the same way. For caps and floors, the system runs a foreign currency valuation and security valuation.

If the hedging relationship is 100% effective, the total effect is recognized in equity without affecting profit and loss.

If the underlying transaction and the hedging transaction (interest rate swap) are concluded in local currency, the total effect comprises only the interest rate effect. If a foreign currency is involved, the total effect comprises the interest rate and foreign currency effects. The system cannot manage these effects separately in the effectiveness test.

If an effective hedging relationship is not 100% effective, the system differentiates between the following two scenarios:

  • If the change in value of the hedging transaction is greater than the change in value of the hedged item, the foreign currency effect is posted proportionately to the profit and loss account.

  • If the change in value of the hedging transaction is less than the change in value of the hedged item, the hedging transaction value is posted to equity and not recognized in profit and loss.

    Note Note

    Alternatively, you can use a hypothetical derivative in the effectiveness test.

    End of the note.
Creating a Hedging Relationship

To create a hedging relationship, proceed as follows:

  1. On the SAP Easy Access screen, choose Start of the navigation path Treasury and Risk Management Next navigation step Hedge Management and Accounting Next navigation step Hedge Accounting for Exposures Next navigation step Hedging Relationships Next navigation step Hedge Plan End of the navigation path (THMEX).

  2.   Specify Interest Rate Risk as the risk category.

    If the Single Hedged Item indicator is set, the system assigns all the loaded exposures (an interest rate instrument or the interest payment in a transaction) to only one hedged item. We recommend setting this indicator if you want to hedge multiple interest payments for an interest rate instrument using a cap or floor.

  3. Once the underlying transaction has been uploaded, Liabilities or Financial Assets are displayed under the Transaction Category, and Position or Cash Flow are displayed under Transaction Activity. You can also select the underlying transaction manually.

  4. Choose the Hedged Item tab page and select the hedge category Cash Flow Hedge.

  5. On the Hedging Relationship tab page, specify the interest rate swap that you entered as the hedging instrument.

  6. Select the hedge strategy 103 CF Forward Discounted, Cumulated.

Selecting the Hedge Strategy

We recommend that you use the hedge strategy 103 CF Forward Discounted, Cumulated delivered as standard in Customizing with the calculation type 103.

If you decide to use a different hedge strategy, this strategy must use a calculation type based on calculation category 003 Cash Flow Differences, Forward Rate Discounted and on Cash Flow Determination Method 2 (FAS133: DIG G7 method 1).

Customizing Settings

  • In Customizing for the Transaction Manager the product types 62C (Int. Rate Swap: Hedge Accounting) and 61D (FLOOR Hedge Accounting) are delivered with the standard system. To select these, choose Start of the navigation path OTC Derivatives Next navigation step Transaction Management Next navigation step Product Types Next navigation step Define Product Types End of the navigation path.

  • These product types are assigned to the position management procedure 3000 (Derivatives: Mark-to-Market as Hedging Instr., Hedge Acc.). This setting is made in Customizing for the Transaction Manager under Start of the navigation path Accounting Next navigation step Settings for Position Management Next navigation step Assign Position Management Procedure End of the navigation path.

See also:

Hypothetical and Perfect Derivative

Cash Flow Hedge (CFH) to Hedge Interest Rate Risk