Part 6: Use of derivatives
Our expectations and overall findings
6.1
We expected that:
- the derivatives used by NZDMO would be those most appropriate for hedging or managing the relevant financial exposure;
- a robust and standard procedure would be in place for seeking approval from the Minster of Finance to transact in new derivatives; and
- Minister of Finance approval and the delegated authority chain from the NZDMO Treasurer to the Head of Portfolio Management and from the Head of Portfolio Management to the Portfolio Managers would be complete.
6.2
We found that:
- the derivatives transacted by NZDMO were generally appropriate given both the exposure and risk-averse management approach;
- most derivative instruments have been approved for use by NZDMO for a number of years;
- the authority to transact derivatives was sound; and
- while a formal limit (as to the term) exists for the Portfolio Managers to transact swaps, there was no limit for other approved derivatives. We consider this treatment inconsistent.
6.3
We concluded that the use and types of derivatives used by NZDMO are appropriate and consistent with its policy and risk management framework.
Background
6.4
NZDMO splits its management activities between the strategic and tactical portfolios. Within each of these portfolios are a number of sub-portfolios that are structured to monitor and report upon the various activities undertaken.
6.5
The strategic portfolio mainly contains domestic New Zealand dollar debt and assets. In terms of derivative activities, interest rate swaps are transacted with banks to ensure compliance with NZDMO’s debt management principles. Interest rate swaps are also undertaken in order to hedge borrowing arrangements with some NZDMO clients. Such borrowers also enter into fixed (floating) to floating (fixed) interest rate swaps to manage the duration of their own portfolios. These exposures are then hedged with banks.
6.6
Currency and foreign exchange swaps are transacted in the market to obtain foreign currency cash. They thereby create foreign currency liabilities, for investment purposes (for example, into mortgage-backed securities), and to extend foreign currency advances to the IMF.
6.7
Unlike the strategic portfolio, the tactical portfolio mainly contains foreign currency liabilities and assets. Liabilities are matched to the assets such that the market value of the portfolio is immunised against changes in both interest and exchange rates within predetermined risk tolerances (for example, the VaR limit). NZDMO books the spot and forward foreign currency transactions with Crown entities and departments to this portfolio.
6.8
Foreign currency spot transactions are used to exchange one currency for another, generally New Zealand dollars into a foreign currency, where foreign currency obligations are due or forecast. Foreign currency swaps are used to manage timing changes in foreign currency obligations. These transactions are hedged with similar but off setting transactions, together with foreign currency investments and interest rate futures contracts as required.
6.9
Foreign currency loans advanced to the RBNZ, for foreign currency reserve purposes, are booked to this portfolio. This requires the conversion of New Zealand dollar proceeds to foreign currency through currency and foreign exchange swaps in order to fund and create foreign currency loans. The alternative course of action would be to fund reserves from foreign currency borrowing. This was not as costeff ective at the time of our audit. Foreign currency swaps are also used to hedge the translation hedge requirement of the New Zealand Superannuation Fund (NZSF). Currency and asset swaps are used to manage, in an asset and liability management sense, the prevailing foreign currency debt portfolio and associated assets and thereby add value to the Crown.
6.10
The total number of derivative transactions (foreign exchange spot and forwards, currency swaps, interest rate swaps, and futures contracts) increased in each of the three years to the point in the 2006 year where it almost equalled all other transactions combined. This is shown in Figure 10. This is primarily because of an increase in the number of foreign exchange transactions, which reflects both an increase in the number of Crown entities and departments serviced by NZDMO and the nature of their requirements (the NZSF in particular).
Figure 10
NZDMO transaction volumes (2001/02 to 2005/06)
Source: KPMG
Appropriateness
6.11
NZDMO’s 2005/06 Annual Performance Report states that foreign exchange derivative transactions have practically doubled over the course of that year largely because of transactions undertaken with the NZSF. A substantial proportion of these transactions are foreign exchange swaps (FX swaps). For the year up to and including October 2006, the notional value of the FX swap business transacted with the NZSF averaged $3,700 million a month and increased by $83 million a month.
Valuations
6.12
NZDMO values all its positions (both strategic and tactical portfolios) on a daily basis. However, it currently does this using three diff erent valuation methodologies depending on the type of reporting the valuations are being incorporated into.
End-of-day reporting
6.13
For daily reporting purposes, NZDMO values the interest rate component of its derivatives using a valuation curve that is derived as the swap curve less 12.5 basis points. NZDMO selected the 12.5 basis point margin adjustment because it considers it provides a fair representation of both NZDMO’s borrowing costs and the credit standing of its pool of assets. This curve is used to value both derivatives as well as physical securities (such as bonds). The use of this adjusted swap curve may give rise to a valuation error on individual positions. We have not sought to quantify the effect of this on a portfolio-wide basis.
6.14
For the end-of-day reporting, the foreign currency component of derivatives is valued using FX mid rates taken at 3.00p.m., and financial futures are valued at closing market prices.
External financial reporting under New Zealand generally accepted accounting practice
6.15
NZDMO uses derivatives for hedging purposes rather than trading. Therefore, it is not required to include them on its Statement of Financial Position at fair value under GAAP.1 Instead, the financial effect of the derivatives is currently recorded in the financial statements as the underlying transactions occur. Information as to the fair value of derivatives is disclosed by NZDMO in schedules in the Treasury’s Annual Report.
6.16
For external financial reporting, NZDMO values the interest rate component of its derivatives using the swap curve adjusted for the contractual spread of the deal. Futures and the foreign currency component of derivatives are valued as for end-of-day reporting.
6.17
The external financial audits of NZDMO’s financial statements have found the financial instrument valuations to be not materially misstated.
6.18
The Government is currently in transition to reporting under NZ IFRS. Accordingly, the financial year ending 30 June 2007 will be last set of financial statements prepared under GAAP.
External reporting under New Zealand equivalents to International Financial Reporting Standards
6.19
As part of the transition to NZ IFRS, NZDMO will first prepare financial statements under NZ IFRS principles for the financial year ending 30 June 2007 (for comparative purposes).
6.20
Under NZ IFRS, NZDMO will be required to include the fair value of all derivative instruments, in its Statement of Financial Position. Changes in the fair values will be reported through the Statement of Financial Performance. For non-derivative instruments, the accounting treatment (fair value or modified historical cost) will depend on whether the position is part of a portfolio that is managed on a fair value basis (for example, the tactical portfolio).
6.21
Under NZ IFRS, the valuation methodologies used for derivatives do not change. The key valuation change is in the valuation of physical securities. Where these were previously valued off the swap curve, the swap curve used in each valuation will be adjusted for the credit spread attaching to that instrument.
6.22
NZDMO’s derivative valuations prepared under NZ IFRS principles have been assessed as part of the 2006/07 financial audit of NZDMO. The financial auditor has concluded that these valuations were not materially misstated.
6.23
Best practice is that all positions should be marked-to-market daily, based on the appropriate yield curves and credit spreads. This practice also assists in maintaining the control environment. For example, it helps to ensure that transactions are dealt at market rates, and that profits and losses are calculated accurately.
6.24
We understand that NZDMO proposes to use the valuation methodologies developed for NZ IFRS for its management reporting. We endorse this approach, as it would represent better practice and should ensure consistency between the results reported in management reports and reporting in the financial statements.
1: What is included in the financial statements is any initial premium paid for the derivative, amortised across the life of the contract, contractual cash flows incurred (such as accrued interest or exchanges of principal cash flows), and any FX revaluation gains or losses on foreign currency balances. Futures settle daily and so are recorded at fair value. The valuation of a cross-currency swap is aff ected by both FX and interest rates. Therefore, NZDMO’s financial statements include the initial principal cash flows that were exchanged by the counterparties and accrued interest. Additionally, changes in value relating to FX rate movements aff ecting the value of foreign currency principal balances payable and receivable are also recorded. However, the financial statements do not include value changes related to movements in interest rates.