12.1.1 Inflation Market Participants

Inflation markets attract a diverse group of participants. In general, these participants can be categorised as inflation payers or receivers (see Figure 12.1).

12.1.2 Measuring Inflation from Indices

Any inflation-linked instrument needs a reference measure of inflation – a so-called inflation index. This subsection explains what an inflation figure represents and how it is measured from inflation indices.

A (retail) inflation index tries to measure the price of a representative basket of consumer goods and services in a specific country. Every month officials in that country publish a new index level, based on the prices of a basket encompassing hundreds of components. The components of inflation indices and their weights vary from country to country, and include transportation, food and non-alcoholic beverages, clothing and footwear, education, restaurants and hotels, alcohol and tobacco, housing and household goods.

Whilst housing represents one of the largest sources of expenditure for most people, it is much harder to observe than other areas of the index that are directly purchased. For example, the housing component of the UK's Retail Price Index (RPI) tries to incorporate all costs incurred by a homeowner, from mortgage costs to depreciation and council tax.

In itself the level of an inflation index is meaningless, unless it is compared with a previous level. When the price levels of two dates of the same inflation index are compared, a measurement of the increase (or decrease) of the prices in that economy between the two dates is obtained (what is commonly termed as inflation).

A base date is chosen at which the value of the index is set to, say, 100. An index value represents the value of the underlying basket at a point in time (i.e., a certain month/year) assuming that the basket was worth 100 on the base date.

Suppose that the levels of an inflation index associated with March 20X0 and March 20X1 were 130.15 and 135.66, respectively. The annualised inflation rate between those two periods was therefore 4.23% (=135.66/130.15 – 1).

Suppose further that the officials in the country to which the inflation index related reported an inflation figure related for April 20X1 of 4.05%. The published value of the index corresponding to April 20X1 was 136.12 (=135.66 × (1 + 4.05%/12)).

In general, the change in purchasing power between times 0 and t is given by Index_t/Index₀, where Index_t is the value of the index at time t and Index₀ is its value at time 0.

12.1.3 Main Inflation Indices

In this subsection I briefly describe the most important inflation indices.

12.1.4 Components of a Bond Yield and the Fisher Equation

The value of a debt instrument is driven by its associated yield, which for a currency is a function of the term to maturity of the instrument. Normally for an issuer and a currency, the longer the term to maturity, the higher the yield. The yield of a debt instrument has a number of components (see Figure 12.2) :

• A credit risk premium that takes into account the creditworthiness of the issuer. Normally, longer-term maturities are viewed to have more credit risk than shorter-term maturities.
• A liquidity risk premium that takes into account how deep the market is for the debt instrument. Normally, longer-term maturities are viewed to have more liquidity risk than shorter-term maturities.
• A nominal interest rate which represents a risk-free rate adjusted for expectations and risks related to future inflation during the term of the debt instrument. In theory all bonds of all issuers with the same term to maturity and denominated in the same currency have an identical nominal interest rate.

In turn, a nominal interest rate can be broken down into two parts:

• A real interest rate which represents the interest rate in an economy after the effects of inflation have been removed.
• A breakeven inflation component. The breakeven inflation represents the expected inflation during the term of the bond and a premium that compensates investors for the risk of potential changes in inflation expectations.

The Fischer Equation

Because the yield and the sum of the credit risk premium and the liquidity premium of a bond can be directly observed from active markets (e.g., independent quotes may be obtained in the market for credit derivatives), nominal interest rates can be inferred. An interesting debate within the economic community concerns whether real interest rates can be reliably determined. The Fisher equation provides a relationship between nominal interest rates, real interest rates and inflation:

This formula can be approximated as:

where n is the nominal interest rate, r is the real interest rate, and i represents inflation expectations and inflation risk premium.

12.1.5 Breakeven Inflation

As noted previously, the breakeven inflation rate (BEI) in a bond's yield represents the sum of the expected inflation and the inflation risk premium, two components of nominal yields that on their own are not always easily quantifiable. Assuming an inflation risk premium much lower than the expected inflation, a BEI provides a rough measure of inflation expectations.

Assuming an inflation-linked bond (ILB) and a comparable fixed rate bond of the same issuer and liquidity, the BEI equals the difference between the yields of these bonds. If actual inflation is greater than breakeven inflation, the ILB is likely to outperform the fixed rate bond. If actual inflation is lower than breakeven inflation, the fixed rate bond is likely to outperform the ILB. In other words, breakeven inflation is the future inflation rate required for an ILB to achieve the same return as a comparable fixed rate bond, if held to maturity. Thus, investors who wish to take a view on the path of inflation have a choice. If they believe that inflation will be higher than the level priced in by the market, they will sell fixed rate bonds and buy ILBs. If lower, they will do the opposite.

12.3.1 Zero-Coupon Inflation Swaps

Zero-coupon inflation swaps are simple structures that account for a large proportion of the inflation derivatives market, due to their simplicity. These swaps provide a direct measurement of breakeven inflation.

A zero-coupon inflation swap is an agreement between two counterparties in which one party agrees to pay an inflation-linked flow versus a fixed amount, for a given notional amount and period of time. The only cash flows in a zero-coupon swap are paid at maturity (see Figure 12.5): a compounded fixed amount

where X% is the market quoted zero-coupon rate, representing the expected average annual inflation rate over the period, and t is the number of years to maturity; and a realised inflation amount

where IndexFinal and IndexInitial are jointly defined by the payment date, start date and the lag, which is the number of months between the payment date and the month in which IndexFinal is observed. For example, if the payment date is in May, and the lag is 3 months, then IndexFinal is for the month of February.

The following table provides an example of the main terms in a 5-year zero-coupon inflation swap:

Party A received the fixed amount and paid the inflation amount. The fixed rate was 2.50%, representing the expected annual inflation over the 5-year period. A realised annual inflation rate lower than 2.50%, would result in A receiving a settlement amount at maturity. ­Conversely, a realised annual inflation rate higher than 2.50% would result in A paying a settlement amount at maturity. The position of B was the opposite of that of A. Party A probably had inflation-linked revenues and through the zero-coupon inflation swap it was protecting itself against an annual European inflation rate lower than 2.50% over the next 5 years, while not benefiting from a potential rise in such inflation above 2.50%. Zero-coupon inflation swaps are also interesting for investors (like B) looking to protect an investment over a certain period against rising inflation rates.

Suppose that the HICP level corresponding to August 20X7 was 285.3. The settlement amount on 1 November 20X7 was calculated as follows: A was due to receive EUR 13,140,821.29 (=100 mn × ((1 + 2.50%)⁵ – 1)) from B, while A was due to pay EUR 21,663,113.01 (=100 mn × (285.3/234.5 – 1)) to B. Therefore, A paid to B the difference, EUR 8,522,291.72 (=21,663,113.01 – 13,140,821.29), as shown in Figure 12.6.

It is important to note that the accreting nature of zero-coupon inflation swaps heightens credit exposure, in the absence of other credit risk mitigants like a collateralised ISDA agreement. In our previous numerical example, A was expected to pay to B over EUR 8.5 million, a substantial amount relative to the notional amount.

12.3.2 Non-cumulative Periodic Inflation Swaps

A periodic inflation swap is an agreement between two counterparties in which one party agrees to periodically swap fixed payments (or floating payments linked to Libor/Euribor rates) for floating payments linked to an inflation rate, for a given notional amount and period of time.

In a non-cumulative periodic inflation swap the notional is not adjusted and as a result the periodic cash flows are calculated over the initial notional (see Figure 12.7), as follows. One party to the swap periodically pays a fixed amount (or a Euribor/Libor based amount)

where X% is a fixed rate, representing the expected average annual inflation rate over the life of the swap. The other party to the swap periodically pays the realised inflation amount during the interest period

where Indext is the inflation index corresponding to the end date of the interest period (taking into account the time lag between such date and the month in which the inflation index is observed) and Indext–1 is the inflation index corresponding to the end date of the previous interest period.

The following table provides an example of the main terms of a 5-year non-cumulative inflation swap with a 3% fixed rate and a notional amount.

The following table provides a numerical example of the inflation swap settlement amounts, from party A's perspective, based on an assumed scenario of the inflation index (amounts in EUR millions). Because each year the annual inflation was larger than the 3% fixed rate, A received each year a settlement amount that represented the excess of the annual inflation relative to the 3% fixed rate (see Figure 12.8).

12.3.3 Cumulative Periodic Inflation Swaps

In a cumulative inflation swap the notional on the inflation leg is adjusted and as a result the periodic cash flows are calculated over the initial notional (see Figure 12.9). A cumulative inflation swap is equivalent to a string of zero-coupon inflation swaps, as follows. One party to the swap periodically pays a fixed amount (or a Euribor/Libor based amount):

where X% is a fixed rate. The other party periodically pays the realised inflation amount during the interest period:

where Indext is the inflation index corresponding to the end date of the interest period (taking into account the time lag between such date and the month in which the inflation index is observed) and IndexInitial is the inflation index corresponding to the effective date (taking into account the corresponding time lag).

The following table provides an example of the main terms in a 5-year cumulative inflation swap with a 3% fixed rate.

The following table provides a numerical example of the inflation swap settlement amounts, from party A's perspective, based on an assumed scenario of the inflation index (amounts in EUR millions). Because each year the annual inflation was higher than the 3% fixed rate, A received each year a settlement amount that represented the excess of the cumulative annual inflation relative to the 3% fixed rate (see Figure 12.10). The compounding effect amplified the difference over time, resulting in an increasing settlement amount.

12.3.4 Inflation Caps and Floors

Besides swaps, options can also be traded on inflation indices. An inflation cap is an option (or a string of options, called caplets) that provides a cash flow equal to the difference between inflation and a pre-agreed strike rate if this difference is positive. An inflation floor is an option (or a string of options, called floorlets) that provides a cash flow equal to the difference between a pre-agreed strike rate and inflation if this difference is positive. Caps and floors play a natural role in hedges of an interval of inflation exposures. For instance, a floor on the ­principal is often included in inflation-linked bonds in order to protect investors against ­deflation and/or low inflation rates.

Periodic Inflation Caps and Floors

In a periodic inflation cap (floor) the buyer is protected periodically against inflation exceeding (underperforming) a certain level, the cap rate (floor rate). A cap (floor) that has more than one exercise date is a combination of several single options called caplets (floorlets). The following table summarises the main terms of a 3-year 4% inflation cap that protected the buyer against an annual inflation rate above 4% (see Figure 12.11). For the protection, party A paid on 1 November 20X2 a EUR 210,000 premium.

Annual inflation cap terms
Trade date	28 October 20X2
Effective date	1 November 20X2
End date	1 November 20X5 (3 years)
Notional	EUR 100 million
Buyer	Party A
Up-front premium	Party A pays 0.21% of the notional (i.e., EUR 210,000) on the Effective date
Party B pays	Notional × max[(Indext/Indext–1) – (1+4.00%), 0)]
Party B payment dates	Every 1 November from, and including, 1 November 20X3 up to, and including, the end date
Index	HICPxT for the eurozone, non-revised, published by Eurostat. For information purposes only, this index is published on Bloomberg page CPTFEMU<Index>
Indext–1	Indext corresponding to the party B previous payment date Indext–1 for the party B first payment date was set at 234.5 (HICP ­corresponding to the month of August 20X2)
Indext	HICP corresponding to the month of August of the year of the party B payment date

The following table provides an example of the payoffs under the cap. In this example the year-on-year inflation for the first year was 4.733% (=245.6/234.5 – 1), and, as a result, the excess of the annual inflation over 4% was 0.733%. Thus, on 1 November 20X3 party B paid EUR 733,000 (i.e., the 0.733% excess inflation over the EUR 100 million notional) to party A. During the second year, annual inflation was 3.094% (=253.2/245.6 – 1), below 4%, and therefore A did not receive any compensation under the cap. During the third year, annual inflation was 6.003% (=268.4/253.2 – 1) exceeding 4%, and thus A received EUR 2,003,000 in compensation.

	1-Nov-X3	1-Nov-X4	1-Nov-X5
Indext	245.6	253.2	268.4
Indext–1	234.5	245.6	253.2
Indext/Indext–1	1.04733	1.03094	1.06003 (1)
max(Indext/Indext–1 – 1.04 , 0)	0.733%	0%	2.003% (2)
Party B payment (EUR)	733,000	-0-	2,003,000 (3)

Notes:

(1) 268.4/253.2

(2) Maximum of (1.06003 – 1.04) and zero

(3) 2.003% × 100,000,000

12.4.1 Hybrid Instruments

Suppose that ABC is Germany-based company with the EUR as its functional (and presentation) currency. ABC issued inflation-linked debt denominated in EUR in which payments of principal and interest are linked to an inflation index. The inflation link is not leveraged and the principal is protected.

Recall from Section 1.6 that when a financial liability encompasses a combination of a host contract and an embedded derivative (a “hybrid instrument”), the issuer needs to assess whether the embedded derivative should be accounted for separately. IFRS 9 does not require the separation of the embedded derivative (see 1.7):

1. If the derivative does not qualify as a derivative if it were free-standing. In our example, the inflation-linked feature qualified as a derivative if it was separated from the liability; or
2. If the host contract is accounted for at fair value, with changes in fair value recorded in profit and loss. In our example, the host contract was recognised at amortised cost; or
3. If the economic characteristics and risks of the embedded derivative are closely related to those of the host contract. This was the key element affecting the assessment. Let us take a look to different inflation underlyings:
   • European CPI. This inflation index is the one commonly used in the EUR currency economic environment. Therefore there was no need to separate (the instrument was treated as a liability in its entirety).
   • German CPI. Same conclusion as for the European CPI if a sufficiently high correlation can be demonstrated between European and German inflation.
   • British RPI. The inflation index relates to a different economic environment. Thus, ABC would need to split the bond into a host contract and a derivative.

In our example, the bond was principal protected. IFRS 9 does not address whether an inflation-linked bond not requiring separation must be principal protected to be eligible for amortised cost recognition. A prolonged deflationary economy may cause a principal unprotected bond to be redeemed below its initial nominal amount, and the accounting community regards the bond as having cash flows that are solely payments of principal and interest on the principal outstanding.

Also, in our example the inflation adjustment was not leveraged. Imagine that instead the adjustment each year was for three times the CPI. In this case, the embedded inflation derivative would be accounted for separately. However, it is less clear whether the separation is the three-times adjustment or just the leveraged part (i.e., a two-times adjustment). However, it is generally understood that splitting the embedded derivative into two derivatives is not generally permitted under IFRS 9, and as a result, the full inflation adjustment (i.e., three times CPI) should be separated.

12.4.2 Hedging Inflation as a Risk Component

Can the inflation component (or “risk portion”) of a fixed or variable interest rate ­instrument be designated as the risk being hedged in a hedging relationship? Whilst the main requirement is that the portion of a risk has to be identifiable and separately ­measurable, answering this question may require careful judgement of relevant facts and circumstances.

In principle, inflation may only be hedged when changes in inflation constitute a contractually specified portion of cash flows of a recognised financial instrument. This may be the case where an entity acquires or issues inflation-linked debt. In such circumstances, the entity has a cash flow exposure to changes in future inflation that may be cash flow hedged.

In principle, an entity is not permitted to designate an inflation component which is not contractually specified. For example, IFRS 9 does not deem separately identifiably and reliably measurable the inflation component of issued or acquired fixed rate debt in a fair value hedge. However, for financial instruments, IFRS 9 introduces a rebuttable presumption, meaning that there are limited cases under which it is possible to identify a risk component for inflation and designate that inflation component in a hedging relationship, even though the inflation component is not contractually specified. The assessment is based on the particular circumstances in the related debt market. The following is taken from the application guidance of IFRS 9 (B6.3.14):

For example, an entity issues debt in an environment in which inflation-linked bonds have a volume and term structure that results in a sufficiently liquid market that allows constructing a term structure of zero-coupon real interest rates. This means that for the respective currency, inflation is a relevant factor that is separately considered by the debt markets. In those circumstances the inflation risk component could be determined by discounting the cash flows of the hedged debt instrument using the term structure of zero-coupon real interest rates (i.e., in a manner similar to how a risk-free (nominal) interest rate component can be determined).

In the case of eurozone countries, IFRS 9 does not provide guidance on whether the analysis of inflation as eligible risk component has to be done by analysing the inflation market of the country or the overall inflation for the currency. In my opinion, when a bond is denominated in EUR, the relevant market structure for inflation should be eurozone inflation.

12.5.1 Background

Imagine that in 20X0, ABC – a British toll road operator – signed a 15-year contract with the British government to operate from 1 January 20X1 a highway that had just been constructed. Although both parties to the contract expected their collaboration to last 15 years, every 5 years the British government had the right to renegotiate the ­contract if the quality of maintenance of the highway was considered to be below a certain standard.

The contract established a cash cost price per vehicle of GBP 4.00 for the calendar year 20X1. The contract included a price adjustment mechanism that provided customers with a fixed “real” price. The price that ABC charged vehicles travelling through its highway was adjusted every 1 January to incorporate the most recent yearly inflation using the British RPI. For example, as shown in Figure 12.12, the price for the year 20X2 would be set by taking the price set for year 20X0 (GBP 4.00) and adjusting it for the inflation rate from October 20X0 to October 20X1. Assuming that the levels of the RPI corresponding to October 20X0 and October 20X1 were 134.1 and 139.8 respectively, implying a 4.28% annualised inflation rate, the price for the year 20X2 would be GBP 4.17 (=4.00 × (1 + 139.8/134.1)).

By far the largest item affecting ABC's costs was financing expense, which stemmed from interest payments under a 15-year fixed rate loan. Because the revenues were linked to inflation while costs were fixed, ABC hedged the mismatch by entering into a 4-year inflation-linked swap (ILS) with the following terms:

Under the ILS, each year ABC paid the realised inflation and received a fixed rate of 3.71%, accrued since the effective date (see Figure 12.13). Thus, on a notional of GBP 146 million and assuming a constant amount of traffic, ABC locked in revenues growing at a 3.71% annual rate. The GBP 146 million notional represented the expected revenues for the year 20X1 (i.e., 36.5 million vehicles times GBP 4.00). Whilst ABC was exposed to a lower than expected volume of traffic, it concluded that 36.5 million vehicles was a reliable estimate.

12.5.2 Hedging Relationship Documentation

ABC designated the ILS as the hedging instrument in a cash flow hedging relationship of a string of four highly expected cash flows. In order to justify the high probability of occurrence of the cash flows ABC produced an analysis in which it substantiated that traffic of 36.5 ­million vehicles was a conservative estimate and described the pricing mechanism formalised under the contract with the British authorities.

12.5.3 Hedge Effectiveness Assessment – Hypothetical Derivative

Although the cash flows take place almost evenly during the year, for assessment purposes they will be grouped into one flow taking place at the end of the year. Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of a hypothetical derivative. The terms of the hypothetical derivative – an ILS with nil fair value at the start of the hedging relationship – reflected the terms of the hedged item. The terms of the hypothetical derivative were identical to those of the hedging instrument except the counterparty to ILS which was assumed to be credit risk-free and a fixed rate of 3.70%.

Note that the fixed rate of the hypothetical derivative (3.70%) was different from that of the hedging instrument (3.71%) due to the absence of CVA in the hypothetical derivative (the counterparty to the hypothetical derivative was assumed to be credit risk-free).

Changes in the fair value of the hedging instrument will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in the cash flow hedge reserve of OCI. The accumulated amount in equity will be reclassified to profit or loss in the same period during which the hedged expected future cash flow affects profit or loss, adjusting the sales amount.
• The ineffective part of the gain or loss on the hedging instrument will be recognised immediately in profit or loss.

Hedge effectiveness will be assessed prospectively at hedging relationship inception, on an ongoing basis at each reporting date and upon occurrence of a significant change in the ­circumstances affecting the hedge effectiveness requirements.

The hedging relationship will qualify for hedge accounting only if all the following ­criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a string of highly expected forecast transactions ­exposing the entity's profit or loss to fair value risk and is reliably measurable. The hedging ­instrument is eligible as it is a derivative and it does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging ­relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if all the following requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that ­economic relationship.
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis. The assessment will be complemented by a quantitative assessment using the scenario analysis method for one scenario in which the expected inflation rates will be calculated by shifting the expected inflation rates prevailing on the assessment date by +2%, and the change in fair value of both the hypothetical derivative and the hedging instrument compared.

12.5.4 Hedge Effectiveness Assessment Performed at Start of the Hedging Relationship

ABC performed an effectiveness assessment on 1 January 20X1, the start date of the hedging relationship, which was documented as follows.

The hedging relationship was considered effective as all the following requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the qualitative assessment performed supported by a quantitative analysis, the entity concluded that the change in fair value of the hedged item was expected to be ­substantially offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that ­economic relationship as the credit ratings of both the entity and XYZ Bank were considered ­sufficiently strong.
3. The 1:1 hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

Due to the fact that the main terms of the hedging instrument and those of the expected cash flow closely matched and the low credit risk exposure to the counterparty of the ILS contract, it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions. This conclusion was supported by a quantitative assessment, which consisted of one scenario analysis performed as follows. The expected inflation rates on the assessment date were simulated by shifting on a parallel basis the expected inflation rates prevailing on the assessment date by +2%. As shown in the table below, the change in fair value of the hedged item was expected to largely be offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.

The hedge ratio was set at 1:1, resulting from the GBP 146 million quantity of hedged item that the entity actually hedged and the GBP 146 million quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

The following sources of ineffectiveness were identified: a change in the estimated cash flows below the hedged notional, a substantial deterioration of the creditworthiness of the counterparty to the ILS and changes in the agreement with the British government.

ABC also performed an effectiveness assessment on each reporting date, yielding very similar results, which have been omitted to avoid unnecessary repetition.

12.5.5 Fair Valuations of the ILS and the Hypothetical Derivative

The following table details the fair valuation of the hedging instrument on 1 January 20X1:

Notes:

(1) Discount factor, between 31-Jan-X1 (valuation date) and the cash flow date ­calculated using the GBP Libor curve

(2) Expected inflation rate from previous year's October to October of the year of the cash flow. For example, 4.22% was the expected inflation rate from October 20X0 to October 20X1

(3) The level of the British RPI index assuming a level of 134.1 for the month of ­October 20X0. For example, 139.8 = 134.1 × (1 + 4.22%), rounded to one ­decimal place

(4) <GBP 146 mn> × (Previous RPI/Current RPI − 1). For example, <6,206,000> = <146 mn> × (139.8/134.1 − 1)

(5) GBP 146 mn × [(1+3.71%)Years − 1], where Years was the number of calendar years since the effective date (31 December 20X1). For example, 11,034,000 = 146 mn × [(1+3.71%)2 – 1]

(6) Inflation leg cash flow + Fixed leg cash flow. For example, <789,000> = <6,206,000> + 5,417,000

(7) Settlement amount × Discount factor. For example, <708,000> = <789,000> × 0.8972

The following table details the fair valuation of the hedging instrument on 31 December 20X1:

(*) RPI corresponding to October 20X1 was 139.8

The following table details the fair valuation of the hedging instrument on 31 December 20X2:

(*) RPI corresponding to October 20X2 was 145.0

The following table details the fair valuation of the hedging instrument on 31 December 20X3:

(*) RPI corresponding to October 20X3 was 148.0

The following table details the fair valuation of the hedging instrument on 31 December 20X4:

(*) RPI corresponding to October 20X4 was 150.7

The fair valuation of the hypothetical derivative was similar to that of the hedging instrument. The only differences were the fixed leg cash flows (which were computed based on a 3.70% fixed rate) and the absence of CVA (DVA remained present).

The following table summarises the fair values of the hedging instrument and the hypothetical derivative at each relevant date:

The ineffective part of the change in fair value of the hedging instrument was the excess of its cumulative change in fair value over that of the hypothetical derivative. The effective and ineffective parts of the period change in fair value of the ILS were the following (see Section 5.5.6 for an explanation of the calculations):

The following table summarises the settlement amounts under the ILS:

The following table summarises the revenues generated by ABC, assuming that the actual annual traffic was exactly 36.5 million vehicles:

12.5.6 Accounting Entries

Suppose that ABC reported financially every 31 December.

1. Accounting entries on 1 January 20X1

   No entries were required as the fair value of the swap was nil on trade date.

2. Accounting entries on 31 December 20X1

   ABC recognised GBP 146 million revenues for the year, which were received in cash. The change in fair value of the ILS produced a GBP 1,087,000 loss, fully deemed to be effective and recorded in the cash flow hedge reserve of OCI.

3. Accounting entries on 31 December 20X2

   ABC recognised GBP 152,205,000 revenues for the year, which were received in cash. ABC paid GBP 789,000 under the ILS and adjusted the revenues figure. The change in fair value of the ILS produced a GBP 593,000 gain, fully deemed to be effective and recorded in the cash flow hedge reserve of OCI.

4. Accounting entries on 31 December 20X3ABC recognised GBP 157,863,000 revenues for the year, which were received in cash. ABC paid GBP 833,000 under the ILS and adjusted the revenues figure. The change in fair value of the ILS produced a GBP 6,040,000 gain, of which GBP 5,990,000 was deemed to be effective and recorded in the cash flow hedge reserve of OCI, while GBP 50,000 was considered to be ineffective and recorded in profit or loss.
5. Accounting entries on 31 December 20X4

   ABC recognised GBP 161,111,000 revenues for the year, which were received in cash. ABC received GBP 1,727,000 under the ILS and adjusted the revenues figure. The change in fair value of the ILS produced a GBP 851,000 loss, of which GBP <841,000> was deemed to be effective and recorded in the cash flow hedge reserve of OCI, while GBP <10,000> was considered to be ineffective and recorded in profit or loss.

6. Accounting entries on 31 December 20X5

   ABC recognised GBP 164,068,000 revenues for the year, which were received in cash. ABC received GBP 4,829,000 under the ILS and adjusted the revenues figure. The change in fair value of the ILS produced a GBP 4,695,000 loss, of which GBP <4,655,000> was deemed to be effective and recorded in the cash flow hedge reserve of OCI, while GBP <40,000> was considered to be ineffective and recorded in profit or loss.

12.5.7 Concluding Remarks

The objective of the hedge was to generate revenues, assuming a constant 36.5 million annual traffic, growing at a rate of 3.71%. The following table details the target revenues:

(*) 4.000 × (1 + 3.70%)^Years, where Years was the number of years elapsed since 31-Dec-X1. For example, 4.302 = 4.000 × (1 + 3.70%)²

The hedge worked very well, each year almost reaching the target revenues. The following table compares the realised revenues (the sum of the traffic revenues generated plus the ILS settlement amounts) with the target revenues:

In our example, ABC reported financially on an annual basis and the amounts under the ILS were settled coinciding with the reporting. In practice, it is likely that both reporting periods differ and accruals of the ILS settlement amounts need to be calculated. It is crucial to exclude accrual amounts when fair valuing an ILS to avoid double counting.

ABC was exposed to a lower than expected traffic, having concluded that 36.5 million vehicles was a sufficiently conservative estimate. If the British economy experienced a prolonged recession causing traffic figures to be below the hedged figure, ABC would be overhedged and ineffectiveness would be present, potentially adding volatility to the entity's profit or loss.

The ILS term was relatively short compared to the agreement. Normally ABC would have hedged a term coinciding with the term of the fixed finance. If for example the debt has a 15-year maturity, ABC would have taken out a 15-year ILS. However, the existence of the 5-year break clause in the agreement may have prevented the entity from applying hedge accounting for a term longer than 5 years.