ipsas 29—financial instruments: recognition and measurement - IFAC

FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT
Also, for the purpose of this illustration, assume that the following quarterly-period
term structure of interest rates using quarterly compounding exists at the inception of
the hedge.
Yield curve at inception – (beginning of period 1)
Forward periods 1 2 3 4 5
Spot rates 3.75% 4.50% 5.50% 6.00% 6.25%
Forward rates 3.75% 5.25% 7.51% 7.50% 7.25%
The one-period forward rates are computed on the basis of spot rates for the
applicable maturities. For example, the current forward rate for Period 2 calculated
using the formula above is equal to [1.0450 2 /1.0375] – 1 = 5.25 percent. The current
one-period forward rate for Period 2 is different from the current spot rate for Period
2, since the spot rate is an interest rate from the beginning of Period 1 (spot) to the
end of Period 2, while the forward rate is an interest rate from the beginning of
Period 2 to the end of Period 2.
Hedged Item
In this example, the entity expects to issue a CU100,000 one-year debt instrument in
three months with quarterly interest payments. The entity is exposed to interest rate
increases and would like to eliminate the effect on cash flows of interest rate changes
that may happen before the forecast transaction takes place. If that risk is eliminated,
the entity would obtain an interest rate on its debt issue that is equal to the one-year
forward coupon rate currently available in the marketplace in three months. That
forward coupon rate, which is different from the forward (spot) rate, is 6.86 percent,
computed from the term structure of interest rates shown above. It is the market rate
of interest that exists at the inception of the hedge, given the terms of the forecast
debt instrument. It results in the fair value of the debt being equal to par at its issue.
At the inception of the hedging relationship, the expected cash flows of the debt
instrument can be calculated on the basis of the existing term structure of interest rates.
For this purpose, it is assumed that interest rates do not change and that the debt would be
issued at 6.86 percent at the beginning of Period 2. In this case, the cash flows and fair
value of the debt instrument would be as follows at the beginning of Period 2.
Issue of Fixed Rate Debt
Beginning of period 2 - No rate changes (spot based on forward rates)
Total
Original forward periods 1 2 3 4 5
Remaining periods 1 2 3 4
Spot rates 5.25% 6.38% 6.75%
Forward rates 5.25% 7.51% 7.50%
IPSAS 29 IMPLEMENTATION GUIDANCE 1234
6.88
%
7.25
%