Derivate floor

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Jonny
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Joined: 22 May 2020, 11:09

Derivate floor

Post by Jonny »

Hi
How can I estimate, at inception, the fair value of a financial Gas Power Purchase Agreement designated as hedging instrument with a mechanism of floating price with a floor?

The company A sells and produces gas and has signed with Company B the contract.

Company A pays a discount of 10% on the market price in exchange of a floor of 60 euro/cm for 50mc produced in a year.

If the average market price of the year is 70 Company A pays 7 euro/mc to Company B as 70-7=63 is higher than 60
If the average market price of the year is 65 Company A pays 5 euro/mc to Company B as 65-6,5= 58,5 is lower than 60.
If the average market price of the year is 58 Company B pays 2 euro/mc to Company a 58+2 is equal to the floor.

At inception the average forward price is 68 euro/mc.

Is the Fv of the derivate 340 euro (6,8 euro x 50mc)? How do I have to treat it?

Thanks
pub_acco
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Re: Derivate floor

Post by pub_acco »

Under normal orderly transactions, the fair value of a derivative is supposed to be zero at inception unless you pay/receive a premium; otherwise, parties wouldn't reach an agreement. This is the case though only when both parties can reasonably evaluate the fair value of a contract....
DJP
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Re: Derivate floor

Post by DJP »

I am not sure if I clearly understand your derivative.

In any case, a floor is protection that you buy. Either it is a purchased put option in case you are long on the underlying, or a purchased call option in case you are short on the underlying.

In order to calculate its fair value, you will have to use an appropriate methodology (Black-Scholes most likely in this case).

The accounting depends on whether you are applying hedge accounting or not. Assuming that you are not, and given that you are buying protection, the initial entries will be DR Derivatives XXX; CR Cash XXX. Then at each reporting date you will have to calculate the fair value of the derivative and any fair value change shall be recognised in P&L.

Hope this helps.
pub_acco
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Re: Derivate floor

Post by pub_acco »

It's a swap contract so perhaps the Black-Scholes isn't the directly relevant model, though I can't name an appropriate model for floors. Anyway, it's beyond the scope of accounting....
DJP
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Re: Derivate floor

Post by DJP »

Why do you say this is a swap?

The scenario is not very well described, but it looks like a floor to me.
pub_acco
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Re: Derivate floor

Post by pub_acco »

You're right, DJP. The OP's description isn't clear and ot seems to imply an option-like instrument. I just assumed it without thinking a lot because a normal interest rate floor has multiple coupon dates and looks just like a swap or a series of European options.
Jonny
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Joined: 22 May 2020, 11:09

Re: Derivate floor

Post by Jonny »

Hi thanks for your help. It is a option. The company A is not paying at inception but paying the discount on the forward market price. We are thinking to estimate the fv of the option at inception considering the volatility. The difference with zero should be posted in p&l as day 1 gain or loss.
The change of fv will be posted as CFH reserve. Does this make sense?
Thanks
pub_acco
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Re: Derivate floor

Post by pub_acco »

To be honest, I have no idea how to price this "option" in a closed form. Average market prices don't random-walk, which breaks the Black-Scholes' assumption. And, the premium seems variable depending on the magnitude of the average market price.

Anyway, you have to analyze the day 1 gain/loss very carefully. The fair value at inception is supposed to be zero if economically rational parties reach an agreement. Day 1 gain/loss might suggest: (i) there is another agreement between parties that compensates the gain/loss, (ii) one party scams the other, and/or (iii) both parties are simply stupid. (i) might be recognized as a separate asset or liability. (ii) and (iii) might be unrelated to the fair value of the hedged item so they might be recognized immediately in profit or loss as a ineffective portion of cash flow hedges.
DJP
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Re: Derivate floor

Post by DJP »

Jonny, can you please try to explain this arrangement in a clearer way? There should be no day-1 loss, so your proposed accounting treatment is not correct. And you can only book fair value changes in OCI if you are applying hedge accounting.
Jonny
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Joined: 22 May 2020, 11:09

Re: Derivate floor

Post by Jonny »

We expect a gain or loss at inception because it is difficult that the fv it is zero. We experienced it with a different structured Ppa (Swap) that the fv at inception was not zero. In the auditor’s ( big 4) opinion the gain or loss has to be always posted in p&l when applying hedge accounting.
DJP
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Re: Derivate floor

Post by DJP »

It makes sense that you have a value different from zero because this is an option. You are buying protection. But in order to advice on the accounting you need to explain the scenario and product clearly.
pub_acco
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Re: Derivate floor

Post by pub_acco »

I think it is possible to defer the day 1 gain/loss as a cost of hedging under IFRS 9 (time value of options) if the gain/loss really represents a deferred option premium.
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