Treatment of Interest on IndexedLinked Debt Instruments

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Treatment of Interest on Indexed-Linked Debt
Instruments
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• Two papers
• Instruments indexed to foreign currency
• Separate discussion option to treat it as
  denominated in that currency.
• Instruments indexed to something else (e.g., CPI,
  share prices, oil price)
• Issues are how the indexation amounts are
• classified as interest or revaluation and
• allocated over the life of the instrument.

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Index-linked securities in the SNA
7.104. Index linked securities are financial
instruments for which the amounts of the coupon
payments (interest) and/or the principal
outstanding are linked to a general price index,
a specific price index or an exchange rate
index.  When the coupon payments are index
linked, the full amounts of such payments are
treated as interest receivable or payable, in the
same way as the interest receivable and payable
on any other security paying a contractually
agreed variable income. When the value of the
principal is index linked, the difference between
the eventual redemption price and the issue price
is treated as interest accruing over the life of
the asset in the same way as for a security whose
redemption price is fixed in advance. In
practice, the change in the value of the
principal outstanding between the beginning and
end of a particular accounting period due to the
movement in the relevant index may be treated as
interest accruing in that period, in addition to
any interest due for payment in that period. ...
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Issues

• Redemption value is not known
• Implication value of interest before redemption
  is unclear.
• It is argued that some indexation (such as to
  stock prices, oil prices, gold prices) combines
  motives for both interest income and holding
  gains.
• Interest is the return for putting financial
  resources at disposal of another entity.
• Holding gains/losses effect of index value
  fluctuations.

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Issues

• Are negative values of interest
  payable/receivable acceptable or meaningful, when
  general interest rates are positive?
• Or are such fluctuations an indication that the
  value is driven by revaluation factors rather
  than being a return for supplying financial
  resources?
• Business accounting does not have the
  interest/holding gain distinction.

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1993 SNA Approach

• Keeping the 1993 SNA unchanged for the concept of
  interest and not allowing revisions of interest
  accruals (when the coupons are index-linked, the
  full amounts paid as coupons, after indexation,
  are accrued as interest and when the value of
  the principal is index-linked the difference
  between the actual redemption value and the issue
  price is treated as interest accruing over the
  life of the instrument (paragraph 7.104)). For
  determining interest accruing in an accounting
  period, the movement in the relevant index during
  the period is used to determine interest accruing
  in that period, without revising them later.

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1993 SNA Approach
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1993 SNA Approach

• Comments
• Interest is volatile due to movements in index.
• Revaluations are due to changes in market
  expectations about future path of the index. It
  could arise also from market interest rate
  changes or credit ratings (in this example, these
  were assumed unchanged).
• Revaluations cancel out over life of instrument.

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1993 SNA with revision/s

• Keeping the 1993 SNA unchanged for the concept of
  interest, and accepting revisions of interest
  accruals that will be determined in each
  accounting period either
• (a) by using the movement in the relevant index
  in each accounting period and revising interest
  when actual redemption value is known, or
• (b) by using the most recent observation of the
  relevant index and revising interest
  continuously.

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1993 SNA with one final revision
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1993 SNA with regular revisions
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1993 SNA with revision/s

• Comments
• The total interest accrued over the life of the
  instrument is the same with that in the 1993 SNA
  approach.
• The allocation over the life is different.
• Revaluations cancel out over the life of the
  instrument.
• The issue is whether it is desirable to revise
  interest accruals
• when actual cash flows are know at the
  redemption.
• on a regular basis using the latest information
  (on the index).

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Modified debtor approach

• Clarifying or changing the 1993 SNA for defining
  interest on index-linked instruments by fixing
  the rate of interest at the time of issue, and
  treating any deviation of the index from the
  expected path as holding gains/losses.
• AEG discussion in December 2004 was helpful this
  option had previously been ruled out of
  consideration.

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Modified debtor approach
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Modified debtor approach

• Comments
• Interest accruals are calculated using the
  expected yield-to-maturity (YTM) at issue.
• Interest for the life of instrument may not be
  equal to the difference between issue price and
  redemption value.
• Revaluations may not cancel out over the life of
  the instrument (equal to the difference between
  expected and actual redemption value).

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Embedded derivative approach

• Clarifying or changing the 1993 SNA for defining
  interest by regarding indexed-linked instruments
  as effectively including derivative contracts.
  This is similar to previous approach. However,
  interest is imputed based on a similar instrument
  that is not indexed and the value of the embedded
  derivative reflects the deviation (of the imputed
  interest) from actual movements in the relevant
  index.

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Embedded derivative approachStandard bond
component
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Embedded derivative approachDerivative component
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Embedded derivative approach

• Comments
• Interest accruals are imputed based on similar
  instruments that are not indexed. Effectively,
  for the debtor approach, this means using the
  expected YTM at issue.
• Derivative reflects the deviation of imputed
  interest from actual movements of the relevant
  index.
• The standard bond component may also have
  revaluation if market interest rate changes.
  Then, it becomes difficult how to disentangle
  revaluations due to change in index or due to
  market interest rates.

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Discussion point

• Which alternative, among the four presented in
  the Executive Summary, do the members prefer?
• (a) 1993 SNA approach as it is?
• (b) 1993 SNA with revisions
• when actual redemption value is known?
• using the most recent observation?
• (c) Modified debtor approach?
• (d) Embedded derivative approach?

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• BOPCOM discussion
• Evenly divided between (a) and (c).
• Conclusion to keep the status quo i.e., option
  (a) - in the absence of a consensus for change.

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