The document provides an overview of financial operations, specifically focusing on transaction types such as buy-sell and borrow-lend, along with their life cycles and cash flows. It categorizes financial markets into underlying, derivatives, and structured products, highlighting their roles and characteristics. Additionally, the document explains Forex trading, including deal types like outright and FX swaps, emphasizing the nature of currency transactions and the pricing mechanisms involved.

1. IB Operations
Background Reading Material
March 2010
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Transaction Types: Buy-Sell and Borrow-Lend
Based on the nature of flows between the two parties, we can classify transactions into buy-
sell and borrow transactions (there are two more types, swap and option, discussed later)
Buy-Sell Transaction
• One flow is in a financial asset and the other is in money: it is exchange of an asset for
money.
• The exchange occurs simultaneously at a point of time called settlement date.
• The two sides of the transaction are called buy and sell; and the two parties, buyer and
seller.
Borrow-Lend Transaction
• Both flows are in money: it is exchange of money for money.
• To make the exchange meaningful, the exchange cannot be simultaneous but split over
a period of time, marked by start date and end date.
• The two sides of the transaction are called borrow and lend; and the two parties,
borrower and lender.
The amount of money on end date must include the amount on start date plus an additional
amount, representing the “rent” on money for the period. This rent is called interest, which
represents the “time-value” of money. The following exhibit shows the two types of
transactions and their flows.
Buy-Sell Transaction
BUYER
SELLER
asset money
Settlement Date
Exchange at a point of time
Borrow-Lend Transaction
BORROWER
LENDER
money money
Start Date End Date
Exchange over a period of time
time time

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Transaction Life Cycle
The transaction life cycle consists of many stages, but the important among them are trade
and settlement.
The trade part precedes settlement part and consists of both parties negotiating and
agreeing on the terms of trade, which consist of the following features.
For buy-sell transaction: identification of the asset, quantity, price, and settlement date.
For borrow-lend transaction: amount of money, interest rate, and period of borrowing
specified by start date and end date.
The settlement part occurs after the trade part and involves executing the terms of trade:
exchange of asset for money on settlement date (for buy-sell trades) or payment and
repayment of money on start date and end date, respectively (for borrow-lend trades).
If the settlement date or start date is the same as trade date, it is called “T+0” settlement,
the zero indicating that there is no gap between trade date and settlement date/start date.
For most trades, however, there is a delay between them, and settlement date/start is on first
business day (T+1) or second business day (T+2) or even third business day (T+3) following the
trade date.
Besides the trade and settlement stages, there are many other stages in the trade life
cycle: validation/review/repair, documentation, confirmation, pre-settlement confirmation,
accounting, reconciliation, margining, market-to-market, etc.
Trade Cash Flows Types
Any financial instrument is, in the final analysis, is a bundle of cash flows. Based on the type of
cash flows, we give it a name (e.g. equity, bond, forex, etc). Each cash flow is described by its
three attributes: occurrence, timing and amount.
• occurrence: whether it will occur; qualified as certain (i.e. it will surely occur) or
uncertain (i.e. its occurrence is conditionally on the occurrence of a specified event)
• timing: when it will occur; qualified as certain (i.e. its timing is known) or uncertain
(i.e. its timing is not known at inception)
• amount: how much it will be; qualified as certain (i.e. its amount is known) or
uncertain (i.e. its amount is not known at inception)
Based on the combination of attributes, we categorize cash flows into fixed, floating and
contingent. If the cash flow is fixed, all the three attributes are certain: it will occur, and its
timing and amount are known at inception. If the cash flow is floating, its occurrence and
timing are certain and known, but its amount is not known at inception: it will be known only
in future. If the cash flow is uncertain, its occurrence is uncertain because it is conditional on
the occurrence of a specified event. If it occurs, its timing and amount may be certain (known
in advance) or uncertain (not known in advance but known only in future). The following
exhibit summarizes the properties of three cash flow types.

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Types of Cash Flows
Type Occurrence Timing Amount
Fixed Certain Certain Certain
Floating Certain Certain Certain
Contingent Uncertain Uncertain/Certain Uncertain/Certain
Financial Markets
Market is the mechanism which brings the two sides of the trade (i.e. buyer/sell,
borrower/lender) together and enables business between them in the form of a transaction.
At the first level, we can classify financial markets into three types: underlying markets,
derivatives markets and structured products.
Underlying Markets
The underlying markets are the fundamental and most important markets because the other
two markets are derived from them. The underlying markets have the following qualifying
features.
• They are independent
• The prices in these markets are determined by demand-supply forces
• The price and value are frequently different: price is set by the demand-supply forces in
the market while the value is subjectively perceived by each market participant.
• To accurately and consistently forecast the price is impossible
The underlying markets are used for consumption and investment, and can be grouped into
money, bond, equity and forex markets. The first two are also called debt or fixed-income
securities markets, and are money trades. The last two are asset trades.
Money and Bond Markets
Together called debt or fixed-income securities (FIS) markets, they involve borrowing are
lending of money: they are money transactions. The difference between the two markets is the
period of borrowing/lending. In money market, the period is less than one year; and in bond
market, it is one year or more.
It may be noted that we may create a “paper” or “security” to channel the money
borrowing as “buy” or “sell” of that security. The essence, however, is money borrowing or
lending between the two parties.

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Equity Market
Trades in equity market are buy-sell trades, the asset being the ownership of a business, which
is exchanged for money. Equity and debt markets together are called capital markets, which
are the source of finance for businesses.
Forex Market
Forex trades are buy-sell trades, like in equity market. It consists of exchanging one brand of
money for another. Of the two, one serves as a financial asset and the other as money. The
following exhibit summarizes the nature of transactions in the four underlying markets.
Underlying Markets
Market Transaction
Type
Market Sides Remark
Money Borrow-lend Borrow, Lend Money exchanged for money for a period
of less than one year
Bond Borrow-lend Borrow, Lend Money exchanged for money for a period
of one year or more
Equity Buy-sell Buy, Sell Money exchanged for ownership of
business
Forex Buy-sell Buy, Sell One brand of money exchanged for
another
Derivatives Market
Derivatives market, unlike underlying market, are not independent but derived (and hence the
name “derivative”) from underlying market. The underlying market is the object and the
derivative market is the shadow, so to speak. To be qualified as a financial derivative, the
International Accounting Standard #39 (IAS 39) stipulates the following criteria.
• Value of derivative is linked in some way to the value of underlying, rather than
determined by demand-supply forces directly
• The derivative trade must settle on a future date
• At inception, the derivative requires no cash outlay or a fraction of trade value
Each underlying market (i.e. money, bond, equity and forex) has its counterpart in
derivatives (e.g. money derivatives, bond derivatives, etc.). Derivative instruments exist on
non-financial underlyings such as commodities, energy, power, weather, freight, etc. They also
exist on non-physical underlyings such as credit, which does not exist separately but in
association with money transactions. Derivatives are used for different purposes than

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underlyings. Whereas underlying assets are used for investment and consumption, derivatives
are used for risk management.
Structured Products
Structured products, like derivatives, are not independent but derived from other assets. The
can be further classified into two types: securitization products and “bespoke” or hybrid
products.
The securitization products are derived by combining different underlying assets from bond
or money markets. The process consists of pooling assets of same class but different character,
grading, and blending to create new assets backed by the underlying. Examples of such
synthetic assets are mortgage-backed securities (MBS), asset-backed securities (ABS) and
collateralized debt obligations (CDO).
The “bespoke” or hybrid assets are derived by combing a bond and a derivative asset on
equity, forex or commodity. The hybrid assets will now have the features of bond and the other
asset class, offering the fixed cash flows of bond and floating cash flows of equity, forex or
commodity. The following exhibit summarizes the financial markets.
DEBT EQUITY
SECURITIZATION
products
BESPOKE or HYBRID
instruments
Money trades
Asset trades
Structured
Products Markets
Derivatives Markets
Underlying Markets
CAPITAL FOREX
BONDMONEY
MONEY
DERIVATIVES
BOND
DERIVATIVES
EQUITY
DERIVATIVES
FOREX
DERIVATIVES

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The table below summarizes the features of underlying, derivative and structured products
markets.
Feature Underlying Derivative Structured Product
Independent? Yes No (derived) No (derived)
Role Investment Risk management Investment
Pricing Demand-supply Arbitrage Arbitrage
Forex Trade: Currency Pair
Every forex transaction is a currency pair, and the forex price (or rate) is the price of one
currency in terms of the other currency.
We can compare the three types of exchange: barter, money and forex. In barter, it is
exchange of one goods (or services) for another goods (or services). In money, it is exchanges
of goods (or services) for money. In forex, it is exchange of one brand of money for another
brand of money.
Type Exchange
Barter Goods versus goods
Money Goods versus money
Forex Money versus money
Base Currency and Quoting Currency
Of the two currencies in the pair, one is called the base currency (BC) and the other, the
quoting currency (QC).
Base currency is the currency that is priced: it is bought and sold like a commodity
(hence the name “commodity currency”) and ceases to act in the traditional role of money.
Quoting currency is the currency that prices the base currency, and is thus acting in the role of
money. What is quoted in the market as forex price (or rate) is the price of base currency in
units of quoting currency. This statement always holds in all “quotation styles” (explained
later) and must be memorized.
Forex Price = Price of BC in QC
The amount of BC is fixed (usually at one unit) and the amount of QC naturally varies
as the market price varies over time. Accordingly, BC and QC are also called “constant/fixed
amount currency” and “variable amount currency”, respectively.
ISO / SWIFT Codes
International Organization for Standardization (ISO) has given three-letter alpha code for every
currency in their ISO 4217 standard. The first two letters are the country code defined by ISO in
their standard ISO 3166, and the third letter is usually (but not always) taken from the first
letter in the currency name.
Country Currency ISO Code
United Kingdom pound GBP
European Union euro EUR
United States dollar USD
Switzerland franc CHF
Japan yen JPY
India rupee INR
China renminbi CNY
South Africa rand ZAR

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FX Deal Types
All forex deals are classified into two types: outright and FX swap. Every forex transaction is
analyzed with respect to two risk parameters: exposure (or position) and mismatch (or gap).
Outright Deal
An outright transaction involves buying or selling a currency. Since the forex trade is an
exchange of two currencies, it is simultaneously buying a currency and selling an equivalent
amount of another currency. The following examples illustrate the outright deals.
Deal #1: Bought EUR 1 million on EUR/USD currency pair @ 1.5665 value date spot
Deal #2: Sold JPY 500 million on USD/JPY currency pair @ 104.00 value date spot
In the deals, only one currency (“deal currency”) amount and the price are specified.
The other currency (“derived currency”) amount has to be derived by ‘crossing’ the deal
currency amount with the deal price.
In deal #1, the deal currency is base currency. The deal price in all cases is the price of
base currency (here EUR) in terms of quoting currency (here USD). Accordingly, the price here
implies that EUR 1 = USD 1.5665 or EUR 1 million is equal to USD 1.5665 million. The ‘crossing’
here means multiplication of deal currency with deal price.
In deal #2, the deal currency is quoting currency. It is a market practice that deal
currency can be either base currency or quoting currency. If the requirement is to buy or sell a
specific amount of quoting currency, then the action will be specified in that currency. The
deal price implies that USD 1 = JPY 104.00, so that JPY 500 million will be equivalent to 500 /
104.00 = USD 4.789272 million. The ‘crossing’ here means division of deal currency amount by
deal price.
To sum up, the outright deal always involves a bought currency and a sold currency.
The amount of one of them and the price is specified. The amount of the other currency is
derived by ‘crossing’ the deal amount with the price. The ‘crossing’ is multiplication or
division, depending on whether the deal currency is base currency or quoting currency,
respectively.
Deal Currency = Base Currency
Derived Currency Amount = Deal Currency Amount ×××× Price
Deal Currency = Quoting Currency
Derived Currency amount = Deal Currency Amount / Price

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FX Swap Deal
FX swap is different from another product of similar name called currency swap. FX swap was
called simply “swap” earlier. In the early 1980s, another instrument was invented, which was
called “currency swap”. To make the distinction between the two, the traditional “swap” is
now called FX swap and the new instrument is called currency swap.
FX swap consists of simultaneous purchase and sale of same currency on the same
currency pair for the same amount but for different value dates. The value dates must be
necessarily different because without such a condition, the buy and sell will square up each
other, leaving no transaction in existence. The following example illustrates the FX swap.
Leg #1: Bought EUR 1 million on EUR/USD currency pair @ price1 value date spot
Leg #2: Sold EUR 1 million on EUR/USD currency pair @ price2 value date 1-month
The above are not two independent transactions but two legs of one transaction. The
leg that settles first is called the near leg and the other leg is called the far leg. The near leg is
always written first. Accordingly, we distinguish two kinds of FX swaps: buy-sell (B−S) and sell-
buy (S−B) swaps. In B−S swap, the market side of the near leg is buy and that of far leg is sell;
and the converse for S−B swap.
The legs have the same deal currency and amount, same currency pair, but different
value dates. The only trade parameter we have not considered is the price for two legs. We
cannot put any restriction such as “same” or “different” on the prices of two legs because that
is market-driven. All combinations are possible: the buy price may be more than, less than or
equal to the sell price. If the buy price is less than the sell price, does it mean profit? And loss,
when the buy price is more than the sell price? And if they are the same, what is motive in
doing such a transaction? Let us examine the cash flows from the swap transaction illustrated
above. We consider that Party A has executed the above swap with Party B. For the Party A, it
is a B−S swap in EUR and S−B swap in USD for equivalent amount; and the converse for the
Party B.
Party A
Time
Near Date Far Date
Party B
EUR USD EUR USD

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For a moment, ignore the USD cash flows and consider only the EUR cash flows? What is
this transaction? It is obviously a money transaction in EUR with Party A as borrower and Party
B as lender. Consider now only the USD cash flows and ignore the EUR cash flows. It is now a
USD money transaction with Party A as lender and Party B as borrower. Consider now the flows
only on the near date, and ignore the far date cash flows. The transaction now is a forex
transaction in EUR/USD currency pair with Party A as EUR buyer/USD seller; and party B as EUR
seller/USD buyer. Consider now the flows only on the far date, and ignore the near date cash
flows. The transaction is again a forex transaction in EUR/USD currency pair with Party A as
EUR seller/USD buyer; and party B as EUR buyer/USD seller. Consider all flows together: it is a
B−S swap in EUR (or S−B swap in USD) for Party A; and S−B swap in EUR (or B−S swap in USD) for
Party B. FX swap is thus essentially a combination of borrowing and lending in two difference
currencies.
Perspective Party A Party B
EUR cash flows EUR Borrower EUR Lender
USD cash flows USD Lender USD Borrower
Near date cash flows EUR buyer/USD seller EUR seller/USD buyer
Far date cash flows EUR seller/USD buyer EUR buyer/USD seller
Entirety FX swap: B−S in EUR or S−B in USD FX swap: S−B in EUR or B−S in USD
We can see from the above that two money trades are combined into a single package
called FX swap. The currency lent is secured by the currency borrowed or vice versa. FX swap is
similar to the repo/reverse repo trade in money market. Whereas repo/reverse repo is
exchange of money for a security (and hence a collateralized money lending or securities
lending), FX swap is exchange of two currencies (or two brands of money). On the near date,
the rate of exchange between the currencies is linked to the prevailing market price. On the
far date, the same amounts of currencies are re-exchanged along with the two interest
amounts. The two interest amounts are converted into quoted currency and clubbed with the
principal amount to derive the price for far leg.

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Risks
At a trade level, we can identify the four sources of risk: counterparty, instrument market, and
the entity itself. With respect to counterparty, there are three risks: settlement risk, credit
risk and counterparty credit risk.
Settlement Risk
Settlement risk arises in buy-sell trades: whenever there is an exchange of two flows between
the parties. It refers to the possibility that one party fulfils his obligation while the other fails.
For example, buyer delivers money but the seller fails to delivery the asset; or seller delivers
the asset but the buyer does not pay money. Settlement risk is faced by each party on the
other. The loss amount is called credit exposure, which is equal to the transaction amount.
Settlement risk is much more enhanced in forex trades because the settlement involves
two different business centers that are separately in time zones. The delay between the legs of
the settlement can be as long as 13 hours such as the case in USD/JPY trades. Settlement risk
is lowered or eliminated by following means.
• Delivery-versus-Payment (DvP) form of settlement: this is practiced usually for
sovereign bonds
• Netting and Clearing: this is practiced in most markets
• Trade guarantee by a third party: this is practiced in all derivatives exchanges
• Continuous linked settlement (CLS): this is practiced in forex market
Credit Risk
Credit risk arises in borrow-lend trades. It refers to the possibility that the borrower may not
repay the amount due. Unlike settlement risk, credit risk is faced only by lender against the
borrower, not the other way. The size of risk (or credit exposure) is the amount under default.
Credit risk is probably the oldest financial risk since money borrowing existed in
Sumerian Civilization (circa 3000 BC). The most prominent form of mitigating credit risk is
collateral and margin: money is lent against collateral and the amount lent is less than the
current value of collateral.
Note that the settlement risk in buy-sell trades will transform finally into credit risk,
but we use different terms because settlement risk is faced by both parties and arises only on

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settlement date, while credit risk faced by only one party (namely, the lender) and arises
during the entire period.
Counterparty Credit Risk
Counterparty credit risk arises in all OTC derivative trades. One of the defining features of
derivatives is that the settlement is postponed to a future date (as in forward, futures, option)
or settlement occurs over many dates in future (as in swaps).
If the counterparty fails to fulfill his obligations in settlement, the other counterparty
will not lose the entire value of trade because he, too, withholds his obligations. However, the
non-defaulting party has to replace the contract with another in the market at the prevailing
prices/rates. The loss suffered in replacement, due to change in the market price/rate, is the
size of counterparty credit risk.
Counterparty credit risk arises between trade date and settlement date of the
derivative. On settlement date, the same risk transforms itself as settlement risk if the
underlying is an asset or credit risk or price risk if the underlying is money. For this reason, it is
also called pre-settlement risk.
The following exhibit summarizes the settlement risk (in asset trades), credit risk (in
money trades) and counterparty credit risk (in derivative trades).
UNDERLYING TRADE
DERIVATIVE TRADE
T = Trade (negotiation of trade terms)
S = Settlement (exchange of asset and money)
Time
T S
T+0, T+1, T+2 or T+3
more than T+2 or T+3
ST

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In exchange-traded derivatives, there is no credit risk because of trade guarantee from
a third party called Clearing Corporation. In OTC derivatives market, the counterparty credit
risk is mitigated by incorporating certain legal covenants in the “master agreement” with the
counterparty. The standard legal provisions are:
• Margining: each party posting a fraction of contract value with a third party; or the
weaker party posting with the stronger party.
• Mark-to-market: change in the value of contract is settled before trade settlement
• Mandatory early termination: if a certain specified event (defined in the master
agreement as “events of default” and “termination events”) occurs on a party, the
other party has the right to prematurely terminate all outstanding contracts at the
prevailing market prices/rates
SR
CR
Legend
UNDERLYING MARKETS
time
Trade Date Settlement Date (T+2)
SR in asset trades
CR in money trades
DERIVATIVE MARKETS
time
Trade Date Settlement Date (more than T+2)
if underlying is asset trade
if underlying is money trade
CCR
SR Settlement Risk CR Credit Risk CCR Counterparty Credit Risk

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• Optional early termination (a.k.a. “mutual termination”): each party has the right to
prematurely terminate all outstanding contracts at the prevailing market prices/rates
at specified times in future. The difference between mandatory and early terminations
is that the former is the cure and the latter is the prevention.
• Close-out netting: during mandatory or early termination, all outstanding contracts are
netted out for their replacement cost, and only the net amount is settled in
termination.
The following exhibit summarizes the profile of three risks from counterparty.
Risk Who Faces? Size of Risk Mitigation
Settlement Risk Each Trade amount DvP, trade guarantee, netting
& clearing, CLS
Credit Risk only Lender Default amount Collateral, margin
Counterparty
Credit risk
Each Replacement cost trade guarantee, margining,
mark-to-market, mandatory
and early termination, close-
out netting
Two Concepts in Risk Identification: Exposure/Position and Mismatch/Gap
Exposure (a.k.a. Position)
Exposure (or position in FX traders’ lingo) defines the price risk (a.k.a. market risk) in a forex
trade. What we mean by risk is the uncertainty about future return, which could be positive or
negative. The popular names for positive and negative returns are profit and loss, respectively.
For example, if we buy EUR on EUR/USD currency pair, there will be either profit or
loss in future, respectively, if the price rises or falls. We say we have a position or are exposed
to price risk or market risk. When we buy a currency, we say we have long or overbought
exposure; and when we sell it, we have short or oversold exposure. When there is no exposure,
we say square. Since every forex trade involves two currencies with opposite market sides (i.e.
buy one and sell the other), the exposure arises simultaneously in two currencies in a
complementary way: overbought in one currency and oversold in the other for equivalent
amount. If there is exposure in only one currency, it is profit/loss and not exposure. The
following deals illustrate the exposure and profit/loss.
Deal #1: Bought EUR 100 on EUR/USD currency pair @ 1.5665
The deal above results in an overbought exposure for EUR 100 and oversold exposure
for USD 156.65. If the rate goes up subsequently, it results in profit; and if the rate goes down,

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it results in loss. Let us assume that we have contracted the second trade subsequently as
follows.
Deal #2: Sold EUR 100 on EUR/USD currency pair @ 1.5765
The second trade creates an oversold exposure for EUR 100, which will exactly offset
the existing overbought exposure, leaving a square exposure in EUR. In USD, the second trade
creates overbought exposure for USD 157.65, which will eliminate the existing oversold
exposure of USD 156.65, leaving a net overbought exposure of USD 1. Since exposure by
definition arises in two currencies and in a complementary way, the single exposure in USD
must be considered profit/loss from the two trades. If the exposure in one currency is
overbought, it is inflow and thus profit; if oversold, it is outflow and hence loss.
Outright trades create new exposure, and if the new exposure is complementary to an
existing exposure, they eliminate the existing exposure. FX swap trades involve simultaneous
buying and selling of same currency and amount on the same currency pair; and therefore do
not create any new exposure, but leave the existing exposure unchanged.
Mismatch (a.k.a. Gap)
Mismatch (or gap in traders’ lingo) refers to the cash balances in currencies. The cash balance
in a currency can be surplus, deficit or square. Whereas the surplus requires lending and
deficit requires borrowing, the square situation is the ideal state. Unlike exposure, mismatch is
computed for each day at the closing, because the day is the unit of accounting.
When we buy a currency, there will be cash inflow or surplus in that currency.
Similarly, when we sell it, there will be cash outflow or deficit. Since forex trade always
involves buying one currency and selling another of equivalent value, mismatch arises
simultaneously in two currencies: surplus in one and deficit in another for equivalent value.
Whenever there is an exposure, it necessarily follows that there will be a mismatch. Outright
trades create exposure and therefore create mismatch. FX swaps do not create exposure but
create mismatch because the buying and selling are for different value dates. The better way
to understand the concepts of exposure and mismatch is by analyzing the cash flows.
Cash Flow Analysis
Analyzing the cash flows is always fool-proof because every product, however complicated, will
be ultimately translated into a set of cash flows. The cash flows are shown in a table: row
represents the date of cash flow; and the column, the type of cash flow. Different columns
represent different flows in assets.

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Each transaction is split into a pair of flowsan inflow and an outflowand each flow is
mapped to the two-dimensional grid.
For example, consider the 3-month forward sale transaction on a stock at the price of 100 for
quantity of 5. The flows are: (1) outflow of 5 units of stock; and (2) inflow of 500 units of
currency, both occurring at 3-month. Thus, the flows occur in the same row but in different
columns. Similarly, consider the money transaction of borrowing Rs 100 from spot to 1-month
at the rate of 12% pa. The flows are: (1) inflow of Rs 100 on spot; and (2) an outflow of Rs 101
(representing principal and interest) at 1-month. The flows occur in the same column but in
different rows.
The two-dimensional grid above is not merely a map of cash flows. Its format indicates two
parameters of risk identification: mismatch and exposure.
Mismatch impacts the cash position, and is qualified as surplus or deficit. In terms of cash
flows, mismatch is defined as the sum of cash flows at a specific date (i.e. a date) for each
type of cash flow (i.e. a column). If the sum is positive we have “surplus”; and if it is negative,
we have deficit.
Exposure is what exposes us to risk from price movements, and is qualified as long (a.k.a.
overbought) or short (a.k.a. oversold). In terms of cash flows, exposure is defined as sum of
cash flows on all dates for each column. If the sum if positive, we are “long”; and if it is
negative, we are “short” in that type of cash flow.
Rs Stock Remark
Spot +100 Money trade – initial borrowing
1-month –101 Money trade – Repayment
3-month +500 –5 Forward purchase
General Note
Buy/sell trades occur as two flows in the same row
but different columns
Money trades occur as two flows in the same column
but different rows
ISDA Documentation
Financial contracts in money, bond, equity and forex markets are sufficiently covered by
securities laws and economic legislation. For OTC derivatives, however, there is no such
specific legislation because the products are new, complex, and have provisions that are not
explicitly provided by the existing securities laws.

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Accordingly, the International Swaps and Derivatives Association (ISDA), an association of
banks and dealers in OTC derivatives, has come out with a model set of documentation that is
the foundation for governing the relationships between parties in OTC derivative trades.
Architecture of ISDA Documentation
ISDA Documentation consists of three elements: Master Agreement (MA), Schedule to Master
Agreement (SCH), and Trade Confirmation (CNF).
Master Agreement
Master Agreement (MA) is the body of ISDA documentation. The following are the features
about MA.
• It contains standard and legal terms; and it does not contain economic terms or terms
specific to a particular trade
• MA applies to all trades that are contracted in future between the same parties
• MA has no expiry: it remains in force until one of the parties revokes it
• MA is a boilerplate document: it is the same wording throughout the words and
between any two parties to the MA
• MA is drafted in such a way that some provisions will always apply, while others will
apply only if they are specifically elected elsewhere in documentation (e.g. SCH, which
is explained below)
Schedule
Schedule (SCH) is an attachment to the MA. Its purpose is to make the MA flexible and tailor-
made to the counterparty.
Since all counterparties are not the same in terms of credit quality, financial strength, etc,
we would like to deal with them differently. We can affect such counterparty-specific
documentation in two ways. First, negotiate the MA provisions separately for each counterpart
so that each MA between a pair is unique. Second, make the MA a boilerplate document; and
make it counterparty-specific by electing, deleting or modifying some of the provisions in the
SCH. The second method is efficient and elegant; and is the method adopted by ISDA.
Thus, the purpose of SCH is to elect, delete and modify the MA provisions so that the
universal standard template of MA is made counterparty-specific and flexible. For this reason,
the parties that enter into ISDA MA will spend considerable time in negotiating the terms of
SCH.

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Confirmation
Trade confirmation (CNF) is the third element in the documentation. It differs from MA and
SCH in two important ways.
• Whereas the MA and SCH contain the general and legal terms, the CNF contains the
trade-specific economic terms
• MA and SCH apply to all trades, past and future, and are executed once; CNF applies
only to a particular trade, and must be exchanged for each trade.
Single Agreement and Resolution of Inconsistency
For the purpose of legal interpretation, the MA, SCH and CNF will constitute a single
agreement. It should be noted that the provisions of MA and SCH applies to all trades, but the
provisions of CNF will apply to a specific trade. Since three different documents reference the
same trade, it is possible that there is a conflict in the provisions. For example, MA sanctions a
particular provision, which is reversed by SCH, but is reinstated by CNF. In such cases, the
following order of precedence will resolve the inconsistencies in the different parts of
documentation.
• Conflict between MA and SCH
SCH will prevail over MA, because SCH is specifically negotiated whereas the MA is a
boilerplate: if SCH is in conflict with the MA, then the parties want it that way and
provided for it in the SCH
• Conflict between SCH and CNF; or between MA and CNF
CNF will prevail over SCH or MA, because CNF is drafted after SCH and MA, and applies
only to a particular trade.
Key Provisions of MA
ISDA has come out with MA in 1992 in two versions: local currency single jurisdiction and multi-
currency cross-border. Based on the subsequent events (e.g. Russian bank moratorium,
liquidation of Hong Kong-based dealer-broker, Peregrine, market disruption in the wake of
9/11 terrorist act, etc), ISDA had revised the MA in 2002. The following are the key provisions
of 2002 MA.
• Payments Netting
Automatic netting applies for payments and receipts falling due on the same date in the
same currency and from the same trade. The parties may extend the scope of payment
netting to multiple trades falling due on the same day in the same currency by specifically

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electing that “Multiple Transaction Payment Netting” shall apply in the SCH; and specifying
the starting date for such netting.
• Withholding Tax
Withholding tax is the tax imposed by a country on foreigners on the interest income and
capital gains earned in that country. The MA provides that the payer has the right to
deduct it from the amount due. If the payer is subsequently taxed, then the payee must
reimburse the payer for the amount of deduction.
• Events of Default (EoD)
Most OTC derivative trades have a life of 5 – 10 years (and up to 50 years in some cases).
Each party is naturally concerned about the financial soundness of the counterparty during
the life of the trade. The MA provides that if one party suffers deterioration in financial
standing, the other party has a right to prematurely terminate all the outstanding trades
(called “Early Termination”, which is discussed below). It is a mechanism to mitigate the
counterparty credit risk. The deterioration in financial standing is defined in terms of
“Events of Default” (EoD). The MA defines the following events to be the EoD.
o Failure to Pay (money) or Deliver (security), unless remedied within a local
business day (the grace period was three days in 1992 MA but was reduced to one
day in 2002 MA)
o Bankruptcy: The launch of bankruptcy proceedings by the party itself or the
regulator will constitute an EoD without waiting for formal declaration. When the
proceedings are instituted by others, it will be an EoD unless it is dismissed within
15 days (reduced from 30 days in 1992 MA). Bankruptcy applies to the
counterparty, its “Credit Support Provider” or the “Specified Entity” (both
described later).
o Breach or Repudiation of Agreement: if the counterparty disaffirms, disclaims,
repudiates or rejects, in whole or part, or challenges the validity of MA or a
transaction covered by it, it will be an EoD, unless remedied within 15 local
business days (reduced from 30 days in 1992 MA)
o Credit Support Default: credit support refers to providing collateral by the
counterparty or another party (called the “Credit Support Provider”) on behalf of
the counterparty. Credit support default covers expiry, failing, terminating or
ceasing of credit support document. The 2002 MA extends it to cases where the
expiry or failure happens in respect of security interest granted under credit
support document; and to repudiation of credit support document by the

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counterparty, its Credit Support Provider, or an entity empowered to act on behalf
of them.
o Cross Default: It is a provision that enables the non-defaulting party to declare that
an amount has become prematurely due (called “acceleration default”) because of
actual default on another trade (which is “payment default”). Cross default is
subject to a Threshold Amount, which is computed by summing the acceleration
default and payment default.
o Default under a Specified Transaction: it is triggered when the counterparty party,
its Credit Support Provider or its Specified Entity defaults on or disaffirms its
obligations in relation to certain types of financial markets transactions ("Specified
Transactions") with the other party or one of its Specified Entities, regardless of
documentation under which the transaction is documented. The 2002 MA covers
repos, securities lending, and credit derivatives. The definition of “specified
transaction” now covers any new types of transactions that may become common
place in the future, which should negate the need to amend the definition of
"Specified Transaction" in the future. The default in respect of a "Specified
Transaction" must result in acceleration or early termination of all transactions
under documentation applicable to the Specified Transaction. This has been
included to avoid the situation, where a failure to deliver, say, under a single repo
(which failure may not be credit related) could lead to an Event of Default under
the ISDA document. Under the new wording, a failure in respect of, in our
example, one repo, would lead to an Event of Default only if that failure led to a
general default with respect to all applicable repo transactions. This amendment
was made particularly because defaults under repo or securities lending
transactions are not necessarily indicative of the creditworthiness of the
counterparty, but may be a result of isolated difficulties in delivery. Failures of
these kinds tend to be relatively common in repo and securities lending
transactions and should not result in the close-out of all the transactions
documented under the master agreement.
o Merger without Assumption of Obligations
• Termination Events
Termination Events (TE) are similar to but different from Events of Default; and are
another tool to mitigate counterparty credit risk. The following are considered the
termination events.
o Illegality

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Illegality is the situation in which it becomes impossible or illegal to make or
receive payment or delivery due to an event or circumstances other than any
action caused by the party or its credit support provider.
o Tax Event Upon Merger
o Credit Event Upon Merger
Merger results in lower credit standing of the party, its credit support provider or
its specified entity.
o Force Majeure
It is incorporated in 2002 MA and is similar to Illegality and specific to the
particular office affected. The difference between Illegality and Force Majeure is
that the latter requires that only the cause is out of control but will also apply if it
could not be prevented after reasonable effort.
The difference between TE and EoD is in the scope their applicability and the source of
their origin. On the occurrence of EoD, the non-defaulting party can early-terminate all
outstanding trades; and on the occurrence of termination event, the early termination
applies only to the affected trades. The origin of EoD is internal (e.g. business distress,
bankruptcy, etc) but the origin of termination events is external (e.g. changes in
regulations, tax, etc).
• Hierarchy of Events
If an event is capable being an Event of Default and a Termination Event, then it should be
construed as an Event of Default; and if an event is capable being an Illegality and Force
Majeure event, then it should be construed as an Illegality.
• Early Termination
On the occurrence of Event of Default, the non-defaulting party has the right to terminate
all outstanding trades with the defaulting party. On the occurrence of Termination Event,
the parties may transfer the rights and obligations to another office or chose early
termination but only for the affected trades.
The procedure for early termination is to value the trades at the prevailing market
prices and net off the amounts from all trades (called “cross netting”) and make a single
claim. The 1992 MA provided two methods of valuation: Market Quotation method (based
on liquidated damages) and Loss method (based on un-liquidated damages). The 2002 MA
replaced the two methods with a single method called Close-out Amount, under which the
determining party will calculate the amount in "commercially reasonable" manner based on

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quotations from one or more third parties, market data or internal data. The change is
motivated by practical difficulties experienced. Market Quotation method requires
obtaining quotes of early-terminated transactions, which typically tend to be off-market
trades at the time of termination. In times of market stress and volatility, it may not be
possible to obtain quotes for off-market trades. This was particularly evident in energy
derivatives in the wake of Enron bankruptcy. Even if such quotes are obtained, they may be
influenced and of questionable commercial value. The Loss method involves generating the
appropriate value for the early-terminated transactions by developing price curves from
the current market quotes to compute the loss on early termination. This is tedious and has
legal uncertainty.
• Single Office or Multi-Office Party
The parties need to specify whether the MA will cover the particular office or all offices of
the parties. If stated to be a multi-office party, then the same MA will cover all the
specified offices of the party.
• Notify Address
Under ISDA documentation, the CNF is not addressed to the office that is a party to the
trade. It is addressed to a nodal office specified in the MA. This is in contrast to trades in
cash markets where the CNF is always addressed to the office that is the party to the
transaction.
Credit Support Agreement
In addition to the MA-SCH-CNF structure of the legal documentation, there may be optional
Credit Support Agreement (CSA) between the parties. The CSA is to collateralize the trades
between the two parties. The collateral under the CSA is arranged either by the counterparty
directly or, on his behalf, by a third party called Credit Support Provider. In general, whenever
the counterparty is subsidiary of a well-known parent, the parent will act as Credit Support
Provider for the subsidiary. The CSA specifies the following.
• Mark-to-market interval
It specifies the interval at which all outstanding trades between the parties are valued at
the prevailing market rates. On such valuation, the trade will typically have a positive
value for one party and negative value for the other. The party with a negative mark-to-
market value should post the collateral with the other party for the amount of negative
mark-to-market value.
• Collateral Type

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It specifies whether the collateral should be in cash or a security. If security, it will further
specify a list of acceptable securities along with the haircut (which is mark-down value
applied on the market value of the security). For example, the acceptable securities are all
index stock with a hair cut of 20%. The counterparty offers an eligible security whose
market value is USD 1 million. For the purpose of collateralization, the value of the offered
security is computed as:
Market Value / (1 + haircut) = 1,000,000 / 1.20 = 833,333.33
• Collateralization Type
It specifies whether each party should post collateral (two-way collateralization) or only
one of the specified party should post collateral (one-way collateralization) whenever a
party faces negative mark-to-market value. For example, if collateralization applies to only
Party B, then whenever the Party B faces negative mark-to-market value, he should post
the collateral to Party A; but Party A will not post any collateral to Party B whenever Party
A faces negative mark-to-market value.
ISDA Definitions
Besides the MA, SCH and CNF, ISDA has also published various “Definitions”, which describe the
technical terms used in derivatives documentation, particularly in the CNF. Describing each
technical term and market practice in a precise legal language will make the CNF to be very
long (“long form” CNF) and its preparation tedious. The solution to this problem is to use the
technical terms without explaining them in CNF, but make a reference to the particular ISDA
Definitions document for an explanation of them. This makes the CNF to be short (“short form”
CNF) and its preparation fast. ISDA has so far published nine different Definitions documents
for different derivatives.
Structure of the CNF
The CNF documents the trade-specific economic terms of the trade. It is always addressed to
the nodal office of the party as specified in the SCH, and not to the office that executed the
trade. The CNF has the following structured format.
• It makes a reference to the date of MA that will govern the relationship of the parties. It
also makes a reference to the particular “ISDA Definitions” that will govern the definitions
of technical terms used in the CNF. Any word beginning with a capital letter should be
understood in the way it was defined in the specified ISDA Definitions document.
• The next section documents the economic terms of the trade: date, amount, etc. The
description of economic terms in OTC derivatives is different from cash market trades in
two ways. First, there are a series of payments (rather than one or two) spread over 5 – 20

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years. Instead of describing them as a complete schedule of dates and amount, it is the
practice to specify them parametrically using few parameters. Second, in most trades, the
amounts payable on future dates are not known in advance, but linked to specified market
variables prevailing at the time of payment. Therefore, the procedure to determine
amount, rather than the amount, is documented.
• The next section specifies the “standard settlement instructions” (SSI). Certain info of the
trade (e.g. account particulars, contact details, etc) do not change from trade to trade but
remain the same. Such data are called “static data” and are stored separately. For all
trades, a call is made on “static data” and it is blended with the trade-specific information
in the CNF.
• The next section specifies the names of offices that are parties to the trade. Note that the
CNF is not addressed to the office that has executed the trade. Rather, it is addressed to
the nodal office where the documentation is centralized. Only by looking in this section,
we will know the offices of both parties that have executed the trade.
The last section specifies who the “Calculation Agent” is. As we stated earlier, the CNF
specifies the procedure to compute the payment amounts rather than directly specifying the
amount. Therefore, there is a need to periodically apply the procedure on market rates and
compute the payment amounts. One of the two parties (or even a third party) will act as
Calculation Agent to compute the amounts.
Day Count Fraction
Since the interest is always quoted as rate for year and the period of borrowing/lending is
usually other than a year, we need to convert the period into year fraction, which is called day
count basis in money and bond markets, day count fraction in OTC derivatives market and
simply basis by traders. The ‘basis’ here is different from the ‘basis” in futures market where it
refers to the difference between current spot price and current price of the futures contract.
Day count basis is expressed as a fraction. The numerator indicates the method of counting the
number of days between the start date and the end date of the period; and the denominator
indicates the total number of days in a year or ‘full coupon period’. There are different
conventions, which can be classified into the following four categories.
Actual / constant

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For the numerator, count the actual number of days in the given period; and for the
denominator, assume constant number of days in a year. The conventions in this category are:
Actual/365 Fixed and Actual/360.
Actual / Actual
For the numerator, count the actual number of days in the given period; and for the
denominator, count the actual number of calendar days in a year or full coupon period. The
conventions in this category are: Actual/Actual-ISDA, Actual/Actual-AFB and Actual/Actual-
ISMA.
30 / 360 (or 360 / 360)
This category assumes that the year consists of 12 months, each of which has exactly 30 days.
In other words, for the numerator, count the number of days in the given period by assuming
that every completed month has 30 days; and for the denominator, assume a constant of 360.
The conventions in this category are: 30E/360, 30/360, 30/360 German, 30/360 SIA, 30A/360,
30E+/360 and 30/360 Italian.
Others
All other conventions that do not fit into any of the three categories above are grouped in this
category. The conventions in this category are: Actual/365 Japan and Actual/365 Sterling.
Note on Accrual Days
It is the convention in all markets (except the 30/360 Italian method) to include the first day of
the period and exclude the last day of the period for interest accrual. For example, in the
period from 30-April-2006 to 05-May-2006, there is one day in April and four days in May. In the
30/360 Italian method, both the start date and end date of the period are counted.
In contrast to the above practice, most software utilities exclude the first day and include
the last day. As long as one of them is included and the other is excluded, they will result in
the same result except in Actual/Actual-ISDA convention, as explained later.
Actual/365 Fixed
Count the actual number of days in the given period and divide it by the constant of 365
regardless of leap or non-leap year.
In the earlier days, it was called simply ‘Actual/365’. However, the 2000 Definitions of ISDA
documentation defined “Actual/365” in a different way. To avoid confusion, what used to be
simply ‘Actual/365’ in the earlier days is now renamed as ‘Actual/365 Fixed’, particularly in
ISDA documentation. This method is used money markets of UK and all Asia-Pacific countries

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except Indonesia. In India, all financial transactions except dirty price calculations for
government securities.
Example: Accrual period is from 25-Jan-2005 to 03-Feb-2005. There are seven days in January
2005 (including Jan 25) and two days in February 2005 (excluding Feb 03), and the basis is
(7+2)/365 = 0.024657534.
Actual/360
Count the actual number of days in the given period and divide it by a constant of 360. This is
widely followed in most money markets, including those in the US and Europe. It is sometimes
called “money market basis.”
Example: Accrual period is from 25-Jan-2005 to 03-Feb-2005. There are seven days in January
2005 (including Jan 25) and two days in February 2005 (excluding Feb 03), and the basis is
(7+2)/365 = 0.025.
For a given interest rate, the Actual/360 convention will always results in higher interest
amount than the Actual/365 Fixed convention because of its lower denominator and the same
numerator. We can transform the interest rate in A/365F basis to its equivalent rate in A/360
basis or vice versa using the following formula.
A/365F from A/360:
Rate (A/365F) =Rate (A/360) × 365 / 360
A/360 from A/365F:
Rate (A/360) =Rate (A/365F) × 360 / 365
Actual / Actual-ISDA (a.k.a. Actual/365 in ISDA documentation)
In ISDA 2000 Definitions, it is also designated as ‘Actual/365’. Since there is already a method
named ‘Actual/365’ in practice, which is different from Actual/Actual, the former is now
called ‘Actual/365 Fixed’.
The basis is computed as follows. If the entire period falls in a non-leap year, count the
actual number of days in the period and divide them by 365. If the entire period falls in a leap
year, count the actual number of days in the period and divide them by 366. If the period falls
partly in leap year and partly in non-leap year, then divide the period is divided into two sub-
periods, each for leap and non-leap portions. The actual number of days for each sub-period is
computed separately. The days in leap part are divided by 366 and those in non-leap part by
365, and the resulting fractions are summed.

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Example: Accrual period is from 27-Dec-2004 to 05-Jan-2005. Since the period falls partly in
leap year (i.e. 2004) and partly in non-leap year, we will have to divide it into two sub-periods.
Leap sub-period consists of five days (i.e. Dec 27, 28, 29, 30, 31)
Non-leap sub-period consists of four days (i.e. Jan 1, 2, 3, 4)
Day count basis = (5 / 366) + (4 / 365)
= 0.013661202 + 0.010958904 = 0.024620106
Note on border date between two sub-periods
For working out the sub-periods in a spreadsheet, the border date between the sub-periods
should be set as January 01 rather than December 31. In the above example, the sub-periods
should be December 27, 2004 to January 01, 2005 and January 01, 2005 to January 05, 2005.
The reason for choosing the first day of next calendar year (rather than the last day of same
calendar year) is that the spreadsheets exclude the start date and include the end date,
whereas the market convention is to include the start date and exclude the end date.
Actual / Actual – AFB (a.k.a. Actual / Actual Euro, 365 – 366, Actual / 365-366)
The leap year is identified by the occurrence of February 29 in the accrual period, rather than
by the calendar year. If February 29 occurs in the accrual period, the actual number of days in
the period is divided by 366. If February 29 does not occur, then the actual number of days in
the period is divided by 365, though it may fall in a leap calendar year.
For bonds that pay semi-annual coupon, interest may over-accrue or under-accrue in one
period relative to the coupon payment, but the difference will be always nullified in the next
coupon period.
Example: Accrual period is from 15-Jan-2008 to 15-Feb-2008. Since there is 29 February in the
period, the denominator of 365 is used, despite the period completely falling in leap year.
If the period is longer than one year, it is divided into full year, starting backward from the
end date, and keeping the irregular period (“stub”) at the beginning. When counting backward,
if the end date is February 28, then the full year is counted back to the February 28 of previous
calendar year except when February 29 exists, in which case, February 29 will be used.
Actual / Actual – ICMA (a.k.a. Actual / Actual – Bond, Actual / Actual)
This convention differs from all other conventions in its definition of the denominator. The
denominator is the ‘full coupon period’ rather than year; and the number of actual days in the
full coupon period is multiplied by the number of coupons in a year.

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This convention is defined by ICMA rules Section 250 Rule 251 (iii) and applies to all USD-
denominated straight and convertible Eurobonds issued after December 1998. The US
treasuries, UK gilts (after 1998) and all EUR-denominated bonds follow this convention. Outside
ISDA documentation, when the convention is stated to be simply “Actual/Actual”, this
convention can be safely assumed.
Example: Accrual period is from 01-Nov-2003 to 01-May-2004 (which is the full coupon period).
Actual / Actual – ISDA: (61 / 365) + (121 / 366) = 0.49772438.
Actual / Actual – AFB: (182 / 366) = 0.49726776.
Actual / Actual – ICMA:(182 / (182 * 2) = 0.5.
The Actual / Actual – ICMA convention can raise more issues when dealing with irregular
(“stub”) calculation periods. ICMA has recommended that irregular periods should be avoided.
30E/360 (a.k.a. Eurobond basis, AIBD basis, 30/360 ISMA, 30/360 Special German, 30S/360)
If the day of either start date or end date is 31, it is arbitrarily set to 30. It is followed in
Eurobond and many domestic European bond markets. After the day of start date and end date
are shortened when required, the period as year fraction is computed as:
[360 × (Y2 − Y1) + 30 × (M2 − M1) + (D2 − D1)] / 360
where Y, M and D are the year, month and day, respectively; and 1 and 2 refer to the start
date and end date, respectively.
Example: Accrual period is from 31-Dec-2004 to 25-Jan-2005. The day of the start date, being
31, needs to be shortened to 30, while the day of the end date requires no adjustment. After
the adjustment, the Y2, Y1, M2, M1, D2 and D1 are 2005, 2004, 1, 12, 25 and 30, respectively.
[360 × (2005 − 2004) + 30 × (1 − 12) + (25 − 30)] / 360 = 25/360 (or 0.069444)
Association of International Bond Dealers (AIBD) is a body that formulates rules on issuance,
trading and settlement of Eurobonds. It was renamed as International Securities Market
Association (ISMA) in 1991. In July 2005, there was a merger between ISMA and International
Primary Market Association (IPMA), and the merged entity is now named as International
Capital Market Association (ICMA). Please see their website www.icma-group.org
30/360 (a.k.a. bond basis, 30/360 US Muni, 360/360)
It differs from 30E/360 in the following way. While the shortening of the day of the start date
is automatic, the shortening of the day of the end date is conditional. The following is the
procedure.

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If the day of the start date is 31, then shorten it to 30 (i.e. automatic, like in 30E/360)
If the day of the end date is 31, shorten it to 30 only if the day of the start date is 30.
Otherwise (i.e. day of the start date is 29 or less), do not shorten it.
After adjusting the day of the start date and end date as above, use the equation given
under 30E/360 convention to compute the period as year fraction. This is the method by
Municipal Securities Rulemaking Board (MSRB) in their rule G-33 for the US Municipal Bonds.
30E/360 (ISDA)
It is similar to 30E/360 convention with the following additional adjustment. If the day of the
start date is the last day of February (i.e. 29 in leap year and 28 in non-leap year), it is
changed to 30. Similar lengthening of the last day of February to 30 is applied to the day of the
end date, unless the day of the end date is the maturity day of the instrument (called
Termination Date in ISDA documentation). In other words, if the instrument begins has
semiannual payments on the last day of February and August and expires on 28 February 2009,
the every payment period is considered to end on 30 February except the last payment date,
which ends on 28 February 2009.
30A/360 (a.k.a. 30/360 NASD, 30/360 PSA, 30/360 BMA)
It is similar to 30/360 SIA except that the lengthening of day is applied to the start date but
not to the end date. Thus,
If the day of the start date is 31, it is shortened to 30; and if it is the last day of February (i.e.
29 in leap years and 28 in non-leap years), it is lengthened to 30.
If the day of the end date is 31, then shorten it to 30 only if the day of the start date is 30.
Otherwise, do not shorten it.
Note on 30/360 conventions
They were originally invented to ease manual calculations. Though they did ease manual
calculations, they are internally inconsistent. For example, the length of coupon period (a) may
not always be equal to the sum of accrual days (b) and the days remaining to the next coupon
date (c). For this reason, the b should never be computed directly but always derived as (a – c).
Actual/365 Sterling (a.k.a. Actual/365 L, Actual/Actual – Basic)
The denominator is 365 if the payment date falls in a non-leap year; and 366 if it falls in a leap
year. It is used for GBP floating rate notes.

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Actual/365 Japan
The denominator is a constant of 365. The numerator, though referred to as “actual”, does not
involve counting the actual days. If there is no February 29 in the period, we take the actual
number of days for the numerator; if it exists, then take the actual number of days and deduct
one from them. For the denominator, use the constant of 365.
What happens when the start date or end date is 29 February and the other date is
adjacent calendar day? For example, you borrow a loan from the bank on 29-Feb-2004 and
repay it on 01-Mar-2004. Will bank charge interest for “zero” day? No. In such case, the
numerator is treated as 1.
Microsoft Excel Function for Day Count Basis
=YEARFRAC(StartDate, EndDate, basis) supports of five types of day count basis. Its input
values must be specified as follows.
StartDate and EndDate inputs must be provided through: (1) link to the cells where their values
are stored; (2) using =DATE (yyyy, mm, dd) function; or (3) as text, but must be within double
quotes and in the format the Excel/Windows is set.
Basis is a value from the following list:
0 for 30A/360
1 for Actual/Actual-ICMA
2 for Actual/360
3 for Actual/365
4 for 30E/360
The Excel’s output for Actual/Actual-ICMA is not always reliable. It always assumes
annual frequency for payment and projects a quasi coupon date from the start date, and
positions it after the end date.
ISDA Template for Trade Confirmation of Interest Rate Swap
The Trade Confirmation, which is an important document in legal documentation, has to be
drawn in conformity with the ISDA template. ISDA has standardized the terminology. It is
important to use the ISDA terminology since it has legal implications. The following table maps
the front office terminology to ISDA terminology.
Front Office Terminology ISDA Terminology
Start Date Effective Date
End Date Termination Date
Payer Fixed-rate (or Fixed Amount) Payer

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Receiver Floating-rate (or Floating Amount) Payer
Day Count Basis Day Count Fraction
Business Day Adjustment Business Day Convention
Holiday Calendar Business Days
Benchmark Floating Rate Option
Tenor of Benchmark Designated Maturity
Note that ISDA names both the parties as “payers”: one is a payer of fixed amount and the
other, the payer of floating amount.
ISDA template for OTC derivatives is uniform for most products. It has the following
structure.
Opening Para: It makes reference to the: (a) names of the parties to the swap; and (b) the
reference to the 2000 ISDA Definitions for interest rate derivatives.
Section 1: makes a reference to the date of ISDA Master Agreement between the parties.
Section 2: contains the “economic” details of the trade and consist of the following.
(1) Notional: must consist of the three-letter ISO code for currency and the amount in full
(not abbreviated as MM or M).
(2) Trade Date
(3) Effective Date
(4) Termination Date along with the Business Day Convention. If the latter is not specified,
then the fallback value in ISDA Definitions (which is “no adjustment applies)
(5) Fixed Amount: it specifies the details of fixed-rate leg of swap, and consists of
specifying the following information separately.
a. Fixed Amount Payer: name of the party paying fixed-rate
b. Period End Date with Business Day Convention: they are specified only if they
are different from Payment Dates
c. Payment Dates with Business Day Convention: they are usually described
parametrically rather than as a list
d. Rate: interest rate applicable to the fixed-rate leg of swap. It is not necessary
to mention explicitly as “percentage per annum” since it is so defined in ISDA
Definitions

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e. Business Days: name of the center for considering holidays and Business Day
Convention.
f. Day Count Fraction
(6) Floating Amount: it specifies the details of floating-rate leg of the swap, and consists
of the following information separately.
a. Floating Amount Payer: name of the party paying floating-rate
b. Period End Date with Business Day Convention: they are specified only if they
are different from Payment Dates
c. Payment Dates with Business Day Convention: they are usually described
parametrically rather than as a list
d. Floating Rate Option: the benchmark applicable to the floating-rate leg. It
consists of three parts: (a) ISO code of the currency (e.g. USD, INR, etc) (b)
name of the benchmark (e.g. LIBOR, MIBOR, etc.); and (c) name of the provider
of rate (e.g. BBA, FIMMDA). If the provider is not specified, then the name of
Reference Banks will be specified; or it is left to the Calculation Agent.
Whatever it is, the relevant details or procedure must be specified.
e. Designated Maturity: it is the tenor of Floating Rate Option.
f. Spread: Spread, if any, to be loaded on to the Floating Rate Option for
computing the interest amount. The spread may be applicable or inapplicable.
If inapplicable, the word “zero” or “none” is indicated. If applicable, it is
stated as a number (in which case it is understood as percentage per annum) or
explicitly as “basis points”. If the spread is negative, it is explicitly stated as
“minus.”
g. Reset Dates: list of dates on which the interest rate is to be reset. They are not
specified as a complete list, but linked to a specified date in the Calculation
Period. (e.g. the first day in the Calculation Period)
h. Fixing Dates: the date on which the Floating Rate Option is obtained for each
Reset Period. Usually, they are not stated and understood to be the second
business day before the Reset Date. They need to be specified only if the Fixing
Dates are positioned otherwise.
i. Payment Date Business Days: name of he business center to determine holidays
and adjusting the Payment Dates

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j. Reset Date Business Days: name of he business center to determine holidays
and adjusting the Reset Dates. If the fixing center for the Floating Rate Option
and settlement center for the currency are different, then both centers are
named.
k. Compounding: it specifies whether the compounding is applicable or not.
Compounding is applicable when the payment frequency is less than reset
frequency.
Section 3: gives information about the account details of both parties (called “static data”). It
includes the account number and the name of correspondent banks, SWIFT code, etc.
Section 4: specifies the names of offices of the counterpart for correspondence on the trade.
Section 5: specifies the name of the Calculation Agent, who will be responsible for obtaining
the rate fixings and advising the interest amount payable by both the parties. The Schedule to
ISDA Master Agreement usually specifies which of the parties will act as Calculation Agent.
However, Trade Confirmation may specify a different party than mentioned in the Schedule,
and what is written in the Trade Confirmation will prevail. The Calculation Agent can be also a
third party, in which case the Trade Confirmation will specify who will pay for the services of
the third party acting as Calculation Agent.
Section 6: makes a reference to the standard disclaimers.
ISDA Template for Trade Confirmation of FX Option
The trade confirmation for FX option will document the following.
Buyer
Name of the option buyer
Seller
Name of the option seller/writer
Expiry Date and Time
It defines the date and time in the location of option expiry. It consists of the following
three: Date, Time and Cut Name. The last is a scheme with pre-defined time at a
specified business center. For example, the following are the some of the schemes and
their description.
Scheme Description

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Comex 2:30pm New York
ECB 1:30pm London
New York 10:00am New York
SilverLondon 12:15pm London
Exercise Style
It takes the value from the pre-defined list of: American, Bermuda and European
FX Option Premium
It specifies the premium exchange for a single option or option strategy. For zero-cost
option strategies, this is not applicable. When applicable, it has the following
parameters.
Payer: Name of the payer
Receiver: Name of the receiver
Premium Amount: specified as a combination of SWIFT code for currency and
amount, and represents the currency amount of premium
Premium Settlement Date: the date on which the premium amount is settled
Premium Quote: this is optional and for information only. When specified, it
consists of the following parameters.
Premium Value: specified as number, which is either percentage or an
explicit amount
Premium Quote Basis: it takes the value from the following pre-defined
list: percentage of call currency amount, percentage of call currency
amount, call currency per put currency or put currency per call
currency
Value Date
It specifies the date when the currencies are exchanged if the option is exercised by its
buyer.
Cash Settlement Terms
This is applicable only when the settlement method is “cash settlement”. When
applicable, it is specified with the following parameters.

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Settlement Currency: SWIFT code of the currency in which the option is settled
Fixing: It is specified with the following parameters: primary rate source,
secondary rate source (optional), fixing time (reference to the business center
and time) and fixing date.
Put Currency Amount
Must be specified as a combination of SWIFT code for the currency and its numerical
amount, and is the currency amount with right to sell
Call Currency Amount
Must be specified as a combination of SWIFT code for the currency and its numerical
amount, and is the currency amount with right to buy
FX Strike Price
It consists of the following two parameters.
Rate: The rate of exchange between the two currencies. It must be specified
with the following parameter.
Strike Quote Basis: It takes the value from the following pre-defined list: put
currency per call currency and call currency per put currency.

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Hedge Accounting
Financial Instruments: Classification
Besides qualifying financial instruments into types as specified in the previous section, IAS 39
also requires that they should be classified into one of the following five categories.
Loans and receivables (LR)
Assets with fixed or determinable payments, have fixed maturity, not actively quoted in the
market, and are not intended to be sold in the short term. Qualifying assets that intended to
be sold in the short term should be classified in HFT; qualifying assets actively quoted in the
market should be classified in HTM; and qualifying assets for which all of the initial investment
may not be recoverable for reasons other than credit deterioration must be classified as AFS.
Held to maturity (HTM)
Assets with fixed or determinable payments and must have fixed maturity; there must be
positive intention and ability to hold them to maturity, and such intention and ability is
assessed at each balance sheet date; and do not meet the definition of LR. This definition
makes preference shares and ordinary shares ineligible to be classified as HTM in usual
circumstances.
The category should be used sparingly. If the items in this category are sold or reclassified
except for irrelevant portion or in exceptional circumstances, then the category cannot be
used for a period of two years. Further, “hedge accounting” (described later) cannot be
applied to the items in this category.
Held at fair value through profit and loss (FVTPL)
It consists of items from two streams:
Held for trading (HFT)
Financial asset or liability held for short term or part of the portfolio where there is an
actual short term profit taking; or derivative asset or liability, including separated
embedded derivatives, except those derivatives that are designated as hedging
instruments.
Measured at fair value or “fair value option” (FVO)

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Any financial asset or liability that is designated as held at fair value. Such designation is a
one-time election on initial recognition and irrevocable, and the asset stays in this
category until sold, matures or extinguished. If fair value of an item cannot be reliably
measured, then it cannot be designated as FVPTL at initiation.
Though IAS 39 allows designating both financial asset and liability to be FVPTL on the
above conditions, banking regulators do not allow it in all cases. For example, European
Union forbids banks from such designation for liabilities.
Available for sale (AFS)
All assets that do not fit into any of the above categories and any non-derivative financial
asset recognized as AFS at initial recognition.
Non-trading liabilities (NTL)
Other liabilities (note that financial liabilities can be classified only in FVTPL or NTL)
Financial Instruments: Measurement
Financial assets and liabilities are measured separately at initial recognition and in subsequent
periods.
Measurement at initial recognition
The general principle is that all financial assets and liabilities must be measured at their
initial cost on initial recognition. For items in FVTPL, transaction costs (e.g. brokerage,
commission, etc) are separated from the initial cost and are taken into income. For items that
are not FVTPL, transaction costs are included in the initial cost.
Measurement in subsequent periods
The accounting treatment for measuring in subsequent periods takes into account the change
in the value, and is made consistent with the category, de described below.
Category Accounting Treatment
LR Measured at amortized cost
HTM Measured at amortized cost
FVTPL Measured at fair value and changes in fair value are brought into income
(see Note 1 below)
AFS Measured at fair value and changes in fair value at brought into equity,

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unless impaired or sold, in which case the cumulative gain/loss previously
recognized in equity is recognized in income for the period (see Note 1
below)
However, interest is recorded in income (see Note 2 below)
NTL Measured at amortized cost
Note 1
If the fair value cannot be reliably measured, then the items are measured at cost. However,
such circumstances should be limited and reserved only for unquoted equity instruments and
derivatives on them and only when valuation methodology results in a wide range of fair value.
It should be noted that private equity investments do not come under FAS 133/IAS 39.
Note 2
Interest from an AFS asset must be recorded at the effective yield (i.e. internal rate of return,
which is also called yield-to-maturity in bond market) after including transaction costs. The
difference between fair value and amortized cost should be brought into equity as gain/loss.
For monetary AFS assets (e.g. bonds), the foreign currency gain/loss rising from translation of
amortized cost should be brought into the income.
The AFS assets that are equity are not considered monetary assets, and therefore the foreign
currency translation gain/loss should be recorded in equity, unless the foreign currency risk is
hedged (when it will come under hedge accounting)
Note that participating interests (e.g. investments in associates whose accounts are brought in
consolidated financial statements) are outside the scope of FAS 133/IAS 39.
Hedge Accounting
Hedging is the processes of eliminating specified risks from items (called “hedged items”) by
transacting in certain instruments (called “hedging instruments”) that offset the gain/loss from
hedged items. Under FAS 133/IAS 39, all derivatives must be recognized in balance sheet at fair
value. This leads to a problem when the hedged exposure is either not yet recorded in balance
sheet (because it is a forecast transaction) or recorded in balance sheet but not at fair value.
The situation creates a mismatch in the sense that gain/loss on derivative are not offset by the
complementary gain/loss from hedged exposure. Hedge accounting is introduced to manage
such mismatch in the timing of offsetting gain/loss from hedging instrument and hedged

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exposure. To be eligible for hedge accounting, the following “hedge documentation” criteria
must be satisfied.
Identification of hedged item and hedging instrument
Identification of type of hedge
Identification of risk that is hedged and risk management strategy
hedge effectiveness criteria, which consists of:
o Prospective hedge effectiveness (“Will the hedge be effective?”)
o Retrospective hedge effectiveness (“Has the hedge been effective?”)
o Method to test hedge effectiveness
Hedged Items
They can be:
Asset
Liability
Firm commitment
Highly probable forecast transaction
Net investment in a foreign operation (i.e. having a subsidiary, branch or associate
whose functional currency of operation is different from that of the entity) that is
exposed to risk of change in fair value or future cash flow.
The following cannot be designated as hedged items.
• Intra-group items (because the inter-company transactions affect only the entity’s
financial statements and not the consolidated financial statements of the group). The
exceptions to this are monetary items (i.e. payable or receivable between two
subsidiaries) or highly probable forecast transactions. They can be considered hedged
items in consolidated financial statements provided they are denominated in a
currency other than the functional currency of the entity entering into that transaction
and the currency risk will affect the consolidated profit or loss.
• Overall business risks (because they cannot be identified and measured)
• Assets in HTM category for interest rate risk or prepayment risk (because hedging them
will be inconsistent with the objectives of HTM category). However, they can be
hedged for currency risk and credit risk
• Derivatives, except written options which can hedge purchased option

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• Net exposure of a portfolio of assets or liabilities (because hedge effectives requires
measuring the changes in fair value or cash flows of a hedged item or a group of similar
item). However, note that though the net exposure does not qualify to be a hedged
exposure, part of the underlying exposure in the portfolio can be hedged. For example,
a company has export receivable of EUR 500,000 and import payable of EUR 200,000. It
designates an the net amount of EUR 300,000 as hedged item, which is acceptable
because the hedged item is considered a part of the EUR 500,000 receivable.
• Own equity (because it does not expose the entity to any risk). A forecast dividend
cannot be a hedged item because distributions to equity holders are directly debited to
equity and therefore do not impact P/L.
• Non-financial assets or liabilities can be hedged items only for all risks or for currency
risk alone. For example, Indian vegetable oil extracting company purchasing soy bean
futures priced in US dollar can hedge: (1) commodity price risk plus currency risk; or
(2) currency risk. It cannot hedge commodity price risk alone, until hedge effectiveness
is proved (explained later).
The eligible hedged items can be hedged fully or partially. For example, consider a 7-year
fixed-rate loan in AFS or FVTPL category. This can be hedged as follows.
• For all cash flows (i.e. fixed interest payments) on the entire fair value
• For all cash flows on 50% of the fair value
• For all cash flows due to specific risk (e.g. risk-free rate)
• For 50% of cash flows due to specific risk (e.g. risk-free rate)
• For specific risk (e.g. currency rate) for principal alone
• For specific risk (e.g. currency rate) for interest alone
Hedging Instruments
Hedging instruments are generally derivatives. However, even non-derivative financial assets or
liabilities can be designated as hedging instruments for currency provided they meet the test of
hedge effectiveness (explained later). Examples of such cases are foreign currency loans or
deposits.
All derivatives except written options, which are carried at fair value, can be hedging
instruments provided it is designated for the entirety of its maturity. A written option cannot
be a hedging instrument except for a purchased option. The following actions are permissible
for hedging.

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• Part of the hedging instrument can be hedge, but not part of its life
• One derivative can be designated as hedge for multiple risks
• Two or more derivatives, in full or part amount, can jointly be designated as hedging
instrument. However, if the combination includes written and purchased options, it
cannot be a hedging instrument if there is net written option or net premium received.
• A combination of derivative and non-derivative can be designated as hedging
instrument only for currency risk
Types of Hedge Accounting
Hedge accounting classifies hedges into fair value hedge, cash flow hedge, and net investment
hedge for foreign operations.
Fair Value Hedge (FVH):
It must satisfy the following criteria.
• The hedged item must be a recognized asset, liability or an unrecognized firm
commitment
• Their prices/rates (or quantity in case of firm commitments) are fixed so that
subsequent changes in their market prices will affect their fair value
In other words, the derivative hedges against the change in fair value.
Cash Flow Hedge (CFH):
It must satisfy the following criteria.
• The hedged item is an existing asset or liability with variable future cash flows; or a
highly probable forecast transaction
• Their prices/rates are not fixed so that subsequent changes in their market prices will
affect their value
Thus, the derivative fixes the price/rate of cash flows and reduces their variability
Net Investment Hedge (NIH):
It is similar to CFH except that applies to net investment in foreign operations (e.g. subsidiary,
branch, etc, located outside the home country) and therefore is a hedge against currency risk.
It allows matching foreign currency gains/losses from derivative or liability against revaluation
of net investment in foreign operations. This type of hedge accounting is not available for the
stand-alone accounts of the parent company if the overseas subsidiaries are not equity-
accounted. In such cases, FVH should be applied to the net investment.
Forecast transactions are always under CFH and firm commitments are generally under FVH.
The exception to this principle is the currency risk of a firm commitment, which can be either

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CFH or FVH. Annex I summarizes the various exposures and the hedge types that can be
associated with them.
Nature of Risk and Risk Management Strategy
The entity must document the nature of risk being hedged: that is, whether it is currency risk,
interest rate risk, credit risk, etc. The nature of risk being hedged must also be consistent with
the overall documented policies on risk management.
Hedge Effectiveness
FAS 133/IAS 39 requires that, to qualify for hedge accounting, the hedging instrument must be
effective in hedge. The standard does not specify the procedure to test hedge effectiveness,
but rather requires that the entity should specify the method to assess hedge effectiveness at
the inception; and apply it consistently for the duration of the hedge. Mathematical or
statistical techniques like ratio analysis, regression analysis, etc can be used. The method
chosen must be consistent with the risk management strategy and objective (explained below)
and applied consistently to all similar hedges unless different methods are explicitly justified.
Hedges cannot be designated or documented retrospectively.
The test for hedge effectiveness must be both prospective (“Will it be effective?”) and
retrospective (“Has it been effective?”). The prospective test must be proved at the inception.
Hedge effectiveness cannot be assumed even if the terms of hedging instrument and hedged
item are the same. It must be assessed and measured, because hedge ineffectiveness may arise
from changes in the liquidity, counterparty credit risk, etc. For the retrospective test,
hedge must be assessed and the effectiveness must be within 80 – 125% range, and the
assessment must be on each balance sheet date and on dates the interim financial statements
are prepared.
To ensure hedge effectiveness, the following are permitted.
• Hedge ratios: the ratio is permitted instead of one-to-one. For example, if the hedging
instrument changes in value by only 90% of unit change in hedged item, then the
amount of hedging instrument can be: 100 / 90 = 111% of the amount of hedged item.
• Retrospective test for effectiveness is permitted on period-by-period or cumulative
basis
• In measuring effectiveness, time value of the derivative price can be separated from its
intrinsic-value, and only the latter can be considered for the hedge relationship. The
time-value will then be considered the ineffective part of the hedge, and the change in
fair value will be shown in P&L.

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• Designating only a portion of total risk: only certain risks can be designated as hedged
while others remain un-hedged. For example, a BBB-rated company can enter into an
interest rate swap with LIBOR benchmark (which reflects the credit quality of AA-rated
banks) and designate the portion of risk related to LIBOR and excluded the changes in
the fair value of the hedged item due to its own credit quality.
Accounting for FVH
Change in the fair value of both hedging instrument and hedged item are recognized as
gain/loss in income, thus offsetting each other. These criteria are applicable even if the
hedged item is in AFS so that its changes in fair value are measured in equity. They also apply
to the hedged items that are measured at cost.
For unrecognized firm commitments, the subsequent cumulative change in fair value
attributable to hedged risk is recognized as asset or liability in the balance sheet with a
corresponding gain or loss in P/L. The change in fair value of hedging instrument is also
recognized in P/L. The initial recognition of asset or liability to which the firm commitment
relates: the initial carrying amount of asset or liability that results from fulfilling the firm
commitment is adjusted to include the cumulative change in the fair value of the firm
commitment attributable to the hedged risk that was recognized in balance sheet.
Example
The company raises a 5Y fixed-rate debt for INR 100M with a fixed rate of 8%, and hedges it
through a 5Y interest rate swap under which it pays floating rate and receives the fixed rate of
6.5%. The difference between the fixed-rate of swap and the fixed-rate of debt is 150 basis
points, which represents the credit spread on the company’s debt. The company designates the
swap as fair value hedge, and leaves the credit spread un-hedged.
The following table shows the fair value of debt and changes in the fair value of swap on
different dates.
Issue Date Reporting Date #1 Reporting Date #2
Debt (100) (107) (105)
Swap 0 7 5
The following will be the journal entries for the example above.
On Issue Date

44. IB Operations Background Reading
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Issuance of debt is recorded, but no entries for swap since its fair value at inception is zero.
Dr. Cash for 100
Cr. Debt for 100
On Reporting Date #1
Swap has acquired positive value and the debt has correspondingly acquired negative value.
Entries are passed for change in the fair value for both.
Dr. Swap for 7
Cr. P/L for 7
Dr. P/L for 7
Cr. Debt for 7
There is no impact on P/L because the changes in fair value are offsetting.
On Reporting Date #2
Swap has acquired positive value and the debt has correspondingly acquired negative value.
Entries are passed for change in the fair value for both.
Dr. P/L for 2
Cr. Swap for 2
Dr. Debt for 2
Cr. P/L for 2
Because the credit risk is not hedged, the carrying amount of debt in balance sheet does
not represent the full fair value but was a hybrid of amortized cost and changes in fair value
due to movements in interest rates alone. If the company has not elected to start amortizing
the hedging gain/loss while the hedge was outstanding, the adjustment would have remained
as part of debt instrument until it was extinguished or no longer hedged. If hedge accounting
ceased prior to the debt being extinguished, the fair value adjustment of debt would have
been amortized as yield adjustment over the expected remaining life of debt (which is
explained later).
Example
On 15-Sep-05, an Indian company has realized its export receivable for USD 1M. The spot
rate is USD/INR is 45. However, the company does not convert USD into INR because it has
a firm commitment to pay USD 1M on 15-Mar-06. It keeps the export proceeds in an EEFC
account, and designates it as hedge for the firm commitment of USD payable. The
company’s balance sheet date is 31-Dec-05. The forex rates on various dates are as follows.

45. IB Operations Background Reading
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31-Dec-05 (Balance Sheet Date): 46
15-Mar-06 (Settlement Date): 44
The following are the journal entries.
On 15-Sep-05
The deposit is recorded at the spot rate of 45 for an amount of INR 45M. However, no
entries are passed for change in fair value since the firm commitment is not yet recognized.
On 31-Dec-05
The changes in the fair value of deposit and firm commitment are recognized in income
statement. The latter is also recognized as liability in the balance sheet.
Dr. Deposit for INR 1M
Cr. P/L for INR 1M
Dr. P/L for INR 1M
Cr. Exposure for INR 1M
On 15-Mar-06
The changes in the fair value of import payable since 31-Dec-05 is recognized (which is a
profit of INR 2M).
Dr. Exposure for INR 2M
Cr. P/L for INR 2M
The amount for the import payable on this date is INR 44M; and there is an amount of INR
1M against the exposure so far, which is added to the actual payment. In other words, the
final price of the import payable will be the same as the rate prevailing on the hedge date
of 15-Sep-05.
Accounting for CFH
Changes in the fair value of derivative are measured and decomposed into “effective portion”
and “ineffective portion” (which is the time value of derivatives). The effective portion is
deferred into a separate reserve in equity, and the ineffective portion is recognized
immediately in profit or loss. The effective portion is moved out of equity and into profit or
loss in the period the hedged items affects the income.
The amount deferred in equity is limited to the lesser of the absolute amount of:
• Cumulative gain/loss on hedging instrument since the inception of hedge

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• Present-value of cumulative change in the fair value of the expected future cash flows
of the hedged item since the inception of hedge.
Notice that if the former is less than the latter, the cash flow hedge is under-hedged, but it
does not affect the P/L. In other words, the hedge ineffectiveness is not captured in P/L. This
is in contrast to the situation in FVH where the hedge ineffectiveness from both over-hedge
and under-hedge is reflected in profit or loss. The following example illustrates the different
situations.
Changes in fair value Entries Comment
Future cash flows: (100)
Hedging instrument: 90
Hedging instrument: 90
Equity: 90
P/L: 0
Under-hedge
No effect on P/L
Future cash flows: 100
Hedging instrument: (110)
Hedging instrument: 110
Equity: 100
P/L: 10
Over-hedge
P/L affected
Future cash flows: (50)
Hedging instrument: 100
Hedging instrument: 100
Equity: 0
P/L: 100
Hedge ineffective
Does not qualify for
hedge accounting
If the derivative is contracted at market price (which implies its fair value is zero), no
journal entry occurs on trade date. However, if the derivative is contracted at off-market price,
then its fair value will not be zero, and the non-zero fair value must be recorded in equity.
CFH for forecast transactions must be highly probable and is an exposure to variations in
cash flow that will affect profit or loss. If the gain/loss from hedging instrument deferred in
equity subsequently results in recognition of a non-financial asset or liability, the entity can
chose two options, as follows, for accounting it.
• Reclassification: reclassify the gain/loss into profit or loss in the same period the
asset/liability affects profit or loss
• Basis adjustment: adjust the carry amount of asset or liability with the associated
gain/loss deferred in the equity. In this route, the gain/loss from hedging
instrument will affect profit or loss when the non-financial item is sold or
depreciated.
In the Example of the previous section, the company used CFH instead of FVH, and the
company’s policy is not to “basis-adjust” non-financial items in CFH. Whether basis-adjusted
(i.e. firm commitment is fair-value-hedged) or not (i.e. firm commitment is cash-flow-hedged

47. IB Operations Background Reading
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without basis adjustment), the net impact on P/L of either CFH or FVH is the same. For CFH,
whether the entity basis-adjusts a non-financial item the forecast purchase of which has been
cash-flow-hedged, or chooses to recycle hedging gain/loss deferred in equity, the net impact
on P/L is the same.
Example
An Indian company has an export order for EUR 4M and enters into a forward sale of EUR.
On the date of forward sale contract
No journal entries since derivative is contracted at fair value and hence has zero value
On the interim reporting date
EUR weakened and the forward sale resulted in positive value of INR 100,000. The change
in fair value is taken into equity
Dr. Forward Sale for INR 100,000
Cr. Equity for INR 100,000
On balance sheet date
EUR weakened further, resulting in a further profit of INR 10,000
Dr. Forward for INR 10,000
Cr. Equity for INR 10,000
On the settlement date of hedged item (the EUR/INR = 50)
Sale
Dr. Cash for INR 20 Cr
Cr. Sales for INR 20 Cr
Settlement of forward
Dr. Cash INR 110,000
Cr. Forward INR 110,000
Re-cycle cumulative gain/loss from equity to P/L
Dr. Equity INR 110,000
Cr. Sales INR 110,000
(Note: we have not discounted the change in fair value of forward for simplicity)
Discontinuation of Hedge Accounting
Hedge accounting must be discontinued in the following cases.

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• Hedging instrument expires or is sold, terminated or exercised; or
• Hedge no longer meets the effectiveness test
• Forecast transaction is no longer highly probable
• Entity declares the hedge to be discontinued. In such cases, the entity may designate
new instrument as hedge provided the new hedging instrument meets the hedge
criteria
In all cases of hedge discontinuation, the cumulative gain/loss on hedging instrument
deferred in equity so far will have to be immediately recognized in profit/loss. However, if the
discontinued hedge is a CFH for a forecast transaction, the accumulated gain/loss can continue
to be deferred in equity if the forecast transaction is still expected to occur (though no longer
highly probable).
Journal Entries for Interest Rate Swap
The IRS may be a trading or hedge transaction, and its market side may pay (i.e. pay fixed and
receive floating) or receive (i.e. receive fixed and pay float), giving a four possible situations:
(1) Trading – Pay (2) Trading – Receive (3) Hedge – Pay (4) Hedge – Receive. The accounting
entries are separately described for each of them.
(1) Trading – Pay (i.e. pay fixed and receive floating)
(A) On Effective Date
Book the memo item for the Notional.
Dr. IRS (Trading) Receive Floating A/c (for Notional)
Cr. IRS (Trading) Pay Fixed A/c (for Notional)
(B) On every interest Settlement Date during swap life
Interest amount is accounted separately for floating and fixed sides of the swap; and
the difference between them is accounted for as the balancing item, as illustrated
below.
(i) Net interest amount is a payment
Dr. IRS (Trading) Interest (Fixed) A/c (for fixed-rate amount)
Cr. IRS (Trading) Interest (Floating) A/c (for floating-rate amount)
Cr. Counterparty/Branch Clearing A/c (for the balance amount)
(ii) Net interest amount is a receipt
Dr. IRS (Trading) Interest (Fixed) A/c (for fixed-rate amount)
Dr. Counterparty/Branch Clearing A/c (for the balance amount)
Cr. IRS (Trading) Interest (Floating) A/c (for floating-rate amount)
(C) On Termination Date
Interest amount for the last calculation period will be settled as described in the
previous section. In addition, the original memo item will have to reversed, as follows.
Dr. IRS (Trading) Pay Fixed A/c (for Notional)
Cr. IRS (Trading) Receive Floating A/c (for Notional)
(D) On Cancellation / Early Termination
On the date of cancellation/early termination, three sets of accounting entries will
have to be passed. First, the interest accrued (for both sides) from the last calculation
period end date to cancellation date. The procedure for them is as described in section
(1)(B). Second, the reversal of memo item, which shall be in accordance with the
procedure described in section (1)(C). The third set relates to the gain or loss resulting
from cancellation/early termination of the contract, for which the following entries
will be posted.
(i) Cancellation results in gain/receipt
Dr. Counterparty/Branch Clearing A/c (for receipt)
Cr. IRS (Trading) Gain A/c (for receipt)

49. IB Operations Background Reading
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(ii) Cancellation results in loss/payment
Dr. Counterparty/Branch Clearing A/c (for payment)
Cr. IRS (Trading) Gain A/c (for payment)
(E) On Revaluation Date
(i) Revaluation results in gain
Dr. IRS (Trading) Unrealized Gain on Revaluation A/c (for gain)
Cr. IRS (Trading) Revaluation Gain A/c
(ii) Revaluation results in loss
Dr. IRS (Trading) Revaluation Loss A/c (for loss)
Cr. IRS (Trading) Un-crystallized loss A/c (for loss)
The above entries will have to be reversed at the beginning of next business day.
(F) On Balance Sheet Date
Interest accrual (separately for each side of swap) is to be computed from last
calculation period end date to balance sheet date, and the following entries need to be
passed.
For the accrued payment (i.e. fixed-rate amount)
Dr. IRS (Trading) Interest (Fixed) A/c
Cr. IRS (Trading) Interest (Fixed) Payable A/c
For the accrued receipt (i.e. floating-rate amount)
Dr. IRS (Trading) Interest (Floating) Receivable A/c
Cr. IRS (Trading) Interest (Floating) A/c
Both the set of entries will have to be reversed at the beginning of the next business
day.
(G) Fee Paid or Received
(i) Fee is payable
Dr. Commission A/c (for fee amount)
Cr. Counterparty A/c (for fee amount)
(ii) Fee is receivable
Dr. Counterparty A/c (for fee amount)
Cr. Commission A/c (for fee amount)
If the IRS is struck at off-market-rates, the difference between market rate and
contract rate is settled separately as “Other Payments” either on Trade Date or
subsequently. In such cases, the entry may be posted in the control register if its
settlement date is other than Trade Date; and, more important, the amount should be
accounted for in Interest on IRS (Trading) A/c rather than Commission A/c. The reason
is that the amount represents the interest amount rather than service cost.
(2) Trading – Receive (i.e. receive fixed and pay floating)
(A) On Effective Date
Book the memo item for the Notional.
Dr. IRS (Trading) Receive Fixed A/c (for Notional)
Cr. IRS (Trading) Pay Floating A/c (for Notional)
(B) On every interest Settlement Date during swap life
Interest amount is accounted separately for floating and fixed sides of the swap; and
the difference between them is accounted for as the balancing item, as illustrated
below.
(i) Net interest amount is a payment
Dr. Interest (Floating) on IRS (Trading) A/c (for floating-rate amount)
Cr. Interest (Fixed) on IRS (Trading) A/c (for fixed-rate amount)
Cr. Counterparty/Branch Clearing A/c (for the balance amount)
(ii) Net interest amount is a receipt
Dr. Interest (Floating) on IRS (Trading) A/c (for floating-rate amount)
Dr. Counterparty/Branch Clearing A/c (for the balance amount)
Cr. Interest (Fixed) on IRS (Trading) A/c (for fixed-rate amount)
(C) On Termination Date

50. IB Operations Background Reading
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Interest amount for the last calculation period will be settled as described in the
previous section. In addition, the original memo item will have to reversed, as follows.
Dr. IRS (Trading) Pay Floating A/c (for Notional)
Cr. IRS (Trading) Receive Fixed A/c (for Notional)
(D) On Cancellation / Early Termination
On the date of cancellation/early termination, three sets of accounting entries will
have to be passed. First, the interest accrued (for both sides) from the last calculation
period end date to cancellation date. The procedure for them is as described in section
(2)(B). Second, the reversal of memo item, which shall be in accordance with the
procedure described in section (2)(C). The third set relates to the gain or loss resulting
from cancellation/early termination of the contract, for which the entries will be
passed as described in sections (1)(D)(i) and (ii).
(E) On Revaluation Date
As described in section (1)(E).
(F) On Balance Sheet Date
Interest accrual (separately for each side of swap) is to be computed from last
calculation period end date to balance sheet date, and the following entries need to be
passed.
For the accrued payment (i.e. floating-rate amount)
Dr. Interest (Floating) on IRS (Trading) A/c
Cr. Interest (Floating) Payable on IRS (Trading) A/c
For the accrued receipt (i.e. floating-rate amount)
Dr. Interest (Fixed) Receivable on IRS (Trading) A/c
Cr. Interest (Fixed) on IRS (Trading) A/c
Both the set of entries will have to be reversed at the beginning of the next business
day.
(G) Fee Payable/Receivable
As described in section (1)(G)
(3) Hedging – Pay (i.e. pay fixed and receive floating)
(A) On Effective Date
Book the memo item for the Notional.
Dr. IRS (Hedge) Receive Floating A/c (for Notional)
Cr. IRS (Hedge) Pay Fixed A/c (for Notional)
(B) On every interest Settlement Date during swap life
Interest amount is accounted separately for floating and fixed sides of the swap; and
the difference between them is accounted for as the balancing item, as illustrated
below.
(i) Net interest amount is a payment
Dr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount)
Cr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount)
Cr. Counterparty/Branch Clearing A/c (for the balance amount)
(ii) Net interest amount is a receipt
Dr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount)
Dr. Counterparty/Branch Clearing A/c (for the balance amount)
Cr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount)
(C) On Termination Date
Interest amount for the last calculation period will be settled as described in the
previous section. In addition, the original memo item will have to reversed, as follows.
Dr. IRS (Hedge) Pay Fixed A/c (for Notional)
Cr. IRS (Hedge) Receive Floating A/c (for Notional)
(D) On Cancellation / Early Termination
On the date of cancellation/early termination, three sets of accounting entries will
have to be passed. First, the interest accrued (for both sides) from the last
calculation period end date to cancellation date. The procedure for them is as
described in section (3)(B). Second, the reversal of memo item, which shall be in

51. IB Operations Background Reading
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accordance with the procedure described in section (3)(C). The third set relates to
the gain or loss resulting from cancellation/early termination of the contract,
which has to be amortized over the life of remaining maturity of swap or the life of
hedged exposure, whichever is shorter, as follows.
Amortization entries (at daily, weekly, monthly or quarterly interals)
(i) Amount is gain/receipt
Dr. Interest on IRS (Hedge) Received in Advance A/c (for gain)
Cr. Interest on IRS (Hedge) A/c (for gain)
(ii) Amount is loss/payment
Dr. Interest on IRS (Hedge) A/c (for loss)
Cr. Interest on IRS (Hedge) Paid in Advance A/c (for loss)
(E) On Balance Sheet Date
Interest accrual (separately for each side of swap) is to be computed from last
calculation period end date to balance sheet date, and the following entries need to be
passed.
For the accrued payment (i.e. fixed-rate amount)
Dr. Interest (Fixed) on IRS (Hedge) A/c
Cr. Interest (Fixed) Payable on IRS (Hedge) A/c
For the accrued receipt (i.e. floating-rate amount)
Dr. Interest (Floating) Receivable on IRS (Hedge) A/c
Cr. Interest (Floating) on IRS (Hedge) A/c
Both the set of entries will have to be reversed at the beginning of the next business
day.
Besides the accounting entries for the interest amount, the swap will have to be
marked-to-the-market (MtM), and the resulting MtM gain or loss should be adjusted to
the market value of the underlying hedged exposure. If the revaluation of underlying
hedged exposure is reversed at the beginning of next business day, then the adjusted
MtM gain or loss from swap should be reversed at the beginning of next business day,
too.
(F) Fee payable or receivable
The amount will have to be amortized over the life of the swap. For details, see the
“Amortization Entries” in section (3)(D).
(G) Re-designation of Hedge
Re-designation of hedge means that a swap is taken off the hedge book; it may be (but
not necessarily) substituted with another swap; the swap remains and the underlying
exposure is substituted with another exposure; or a combination of them. The following
entries are recommended for various events in the re-designation of hedge
(i) Swap is taken off the hedge
(a) Reverse the memo items as described in section (3)(C)
(b) Provision for the interest accrual, as described in section (3)(E)
(c) Mark-to-market (MtM) of the swap, and amortize the MtM gain or loss over the
remaining life of swap or the life of hedged exposure, whichever is shorter. For
details, see the “Amortization Entries” in section (3)(D).
(ii) New swap replaces the old swap for hedge
Follow the procedure applicable for new IRS (Hedge)
(iii) Underlying exposure is substituted with another exposure
Both the hedge and the hedged underlying exposure are marked to the market; he
offsetting MtM entry adjustments are treated as the amount paid or received for
hedging the new underlying exposure; and such amount should be amortized over
the maturity of swap or underlying exposure, whichever is shorter. For details, see
the “Amortization Entries” in section (3)(D).
(4) Hedging – Receive (i.e. receive fixed and pay floating)
(A) On Effective Date
Book the memo item for the Notional.
Dr. IRS (Hedge) Receive Fixed A/c (for Notional)

52. IB Operations Background Reading
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Cr. IRS (Hedge) Pay Floating A/c (for Notional)
(B) On every interest Settlement Date during swap life
Interest amount is accounted separately for floating and fixed sides of the swap; and
the difference between them is accounted for as the balancing item, as illustrated
below.
(i) Net interest amount is a payment
Dr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount)
Cr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount)
Cr. Counterparty/Branch Clearing A/c (for the balance amount)
(ii) Net interest amount is a receipt
Dr. Interest (Floating) on IRS (Hedge) A/c (for floating-rate amount)
Dr. Counterparty/Branch Clearing A/c (for the balance amount)
Cr. Interest (Fixed) on IRS (Hedge) A/c (for fixed-rate amount)
(C) On Termination Date
Interest amount for the last calculation period will be settled as described in the
previous section. In addition, the original memo item will have to reversed, as follows.
Dr. IRS (Hedge) Pay Floating A/c (for Notional)
Cr. IRS (Hedge) Receive Fixed A/c (for Notional)
(D) On Cancellation / Early Termination
On the date of cancellation/early termination, three sets of accounting entries will
have to be passed. First, the interest accrued (for both sides) from the last
calculation period end date to cancellation date. The procedure for them is as
described in section (4)(B). Second, the reversal of memo item, which shall be in
accordance with the procedure described in section (4)(C). The third set relates to
the gain or loss resulting from cancellation/early termination of the contract,
which has to be amortized over the life of remaining maturity of swap or the life of
hedged exposure, whichever is shorter. For details, see the “Amortization Entries”
in section (3)(D).
(E) On Balance Sheet Date
Interest accrual (separately for each side of swap) is to be computed from last
calculation period end date to balance sheet date, and the following entries need to be
passed.
For the accrued payment (i.e. floating-rate amount)
Dr. Interest (Floating) on IRS (Hedge) A/c
Cr. Interest (Floating) Payable on IRS (Hedge) A/c
For the accrued receipt (i.e. fixed-rate amount)
Dr. Interest (Fixed) Receivable on IRS (Hedge) A/c
Cr. Interest (Fixed) on IRS (Hedge) A/c
Both the set of entries will have to be reversed at the beginning of the next business
day.
Besides the accounting entries for the interest amount, the swap will have to be
marked-to-the-market (MtM), and the resulting MtM gain or loss should be adjusted to
the market value of the underlying hedged exposure. If the revaluation of underlying
hedged exposure is reversed at the beginning of next business day, then the adjusted
MtM gain or loss from swap should be reversed at the beginning of next business day,
too.
(F) Fee payable or receivable
The amount will have to be amortized over the life of the swap. For details, see the
“Amortization Entries” in section (3)(D).
(G) Re-designation of Hedge
Re-designation of hedge means that a swap is taken off the hedge book; it may be (but
not necessarily) substituted with another swap; the swap remains and the underlying
exposure is substituted with another exposure; or a combination of them. The following
entries are recommended for various events in the re-designation of hedge
(i) Swap is taken off the hedge

53. IB Operations Background Reading
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(a) Reverse the memo items as described in section (4)(C)
(b) Provision for the interest accrual, as described in section (4)(E)
(c) Mark-to-market (MtM) of the swap, and amortize the MtM gain or loss over the
remaining life of swap or the life of hedged exposure, whichever is shorter. For
details, see the “Amortization Entries” in section (3)(D).
(ii) New swap replaces the old swap for hedge
Follow the procedure applicable for new IRS (Hedge)
(iii) Underlying exposure is substituted with another exposure
Both the hedge and the hedged underlying exposure are marked to the market; he
offsetting MtM entry adjustments are treated as the amount paid or received for
hedging the new underlying exposure; and such amount should be amortized over the
maturity of swap or underlying exposure, whichever is shorter. For details, see the
“Amortization Entries” in section (3)(D).
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