Accounting for Derivatives. Ramirez Juan

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      • If, for instance, the underlying assets meet the SPPI criterion, it may be possible to conclude that the non-recourse asset also meets the criterion.

      • If, for example, the non-recourse asset is a vehicle whose only asset is an equity investment, it will not meet the SPPI criterion.

      Principal and interest test. The contractual terms of the tranche itself have only SPPI characteristics.

      Look-through test. The underlying pool of financial instruments:

      contains one or more instruments that meet the SPPI criterion;

      also may contain instruments that:

      reduce the cash flow variability of the instruments under (i) and the combined cash flows meet the SPPI criterion (e.g., interest rate caps and floors, credit protection), or

      align the cash flows of the tranches with the cash flows of the instruments under (i) arising as a result of differences in whether interest rates are fixed or floating or the currency or timing of cash flows.

      Credit risk test. The exposure to credit risk inherent in the tranche is equal to, or lower than, the exposure to credit risk of the underlying pool of financial instruments. The standard states as an example that this condition would be met if, in all circumstances in which the underlying pool of instruments loses 50 % as a result of credit losses, the tranche would lose 50 % or less.

      Example: Tranched issuance

      Suppose that a special-purpose entity (SPE) has bought mortgage assets with a notional amount of USD 800 million and issued three tranched notes (A, B and C) that are contractually linked. All assets in the pool meet the SPPI criterion. The underlying mortgage assets pay fixed rates of interest on a monthly basis. The vehicle holds an interest rate swap that swaps the underlying mortgages monthly fixed interest for 3-month Libor. The weighted average credit spread of the assets in the mortgage pool is 400 basis points.

      • Tranche A pays a quarterly interest of 3-month Libor plus 50 basis points on a principal of USD 300 million.

      • Tranche B pays a quarterly interest of 3-month Libor plus 400 basis points on a principal of USD 200 million.

      • Tranche C pays a quarterly interest of 3-month Libor plus 500 basis points on a principal of USD 100 million.

      If the underlying pool of instruments were to lose 50 % as a result of credit losses, a loss of USD 400 million would arise (=800 million × 50 %), and the effect on the tranches would be as follows:

      • The overcollateralisation would absorb the first USD 200 million losses.

      • Tranche C would lose USD 100 million, representing 100 % of its total principal.

      • Tranche B would lose USD 100 million, representing 50 % of its total principal.

      • Tranche A would not experience any losses.

      In addition to the tranches and the asset pool, the vehicle contains another financial instrument, an interest rate swap, but it only aligns the cash flows of the underlying pool with those of the tranches, and consequently it does not affect the tranches' SPPI eligibility. Whilst all the three tranches meet two of the SPPI conditions (i.e., the underlying mortgage pool meets the SPPI criterion and the tranches pay cash flows that only represent principal and interest), only tranches A and B are eligible for amortised cost recognition, subject to meeting the business model criterion, as a 50 % loss in the underlying asset pool would not cause these tranches to experience losses exceeding 50 % of their principal amounts. As a result, the larger the level of overcollateralisation (i.e., the excess of the underlying pool size relative to the size of the issued tranches), the higher the likelihood of meeting the credit risk test.