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Financial Reporting for Derivatives and Risk Management Activities
Thomas J. LinsmeierUniversity of Illinois
AAA Annual MeetingAugust 16, 1998
2
Workshop Topics
Common types of derivativesRisk management activitiesNew financial reporting standards
FASB Statement 133 SEC Financial Reporting Release 48
Attend session at 10:30 a.m. tomorrow
Illustrative examplesEvaluation of Statement 133
3
What Are Derivatives?
“Derivatives”--
A generic term used to describe a wide variety of financial and commodity instruments whose value depends on or is derived from the value of an underlying asset/liability, reference rate, or index.
4
Common Derivatives
Forwards / FuturesOptionsSwapsHybrids / Embedded derivatives
5
Long ShortCashMarket
Long ShortForwardMarket Agree to Terms
CashMarket Price
Now
Forward Price
Future Date
Instrument orCommodity
Forward / Future Contracts
Obligate one party to buy and another party to sell an underlying instrument or commodity at a future date
Instrument or Commodity
6
Options
Options provide the holder the right, but not the obligation, to buy or sell the underlying instrument or commodity at a predetermined price called the “strike” or “exercise” price
Options normally are in the form of a “Call” or a “Put” Calls - enable the holder to buy the underlying
instrument or commodity at the strike price Puts - enable the holder to sell the underlying
instrument or commodity at the strike price Require “up-front” payment or “premium”
7
Purchased Call
Purchased Put
Exercise Price
Price ofunderlying instrument
Pay
off
Payoff Profiles of Purchased Puts and Calls
Price ofunderlying instrumentExercise Price
Pay
off
8
Swaps
Two parties exchange recurring payments
Similar to series of forward contractsInterest-rate swaps most common
9
Note: LIBOR is London Interbank Offered Rate
Fixed-RatePayer
Fixed-RateReceiver
Floating Rate(LIBOR)
X Notional Principal
Fixed Rate of 6.75%
X Notional Principal
“Plain-Vanilla” Interest Rate Swap
10
Importance of Forwards, Futures, Swaps, and Options
Instruments that involve the exchange
of cash flows
Can be used to alter existing cash flows
Comprise the basic risk management
tools
11
Hybrid Instruments: Embedded Derivatives
Simple derivatives are the fundamental building blocks of these complex structures
Structured note: Note with embedded option or swap
Complex swap: “Plain vanilla” swap with embedded options or leverage features
12
Managing Risks with Derivatives
Low cost, ease, and speed of transacting make derivatives attractive for managing risk
Different derivatives provide means of adjusting the timing, amount, and variability of cash flows / fair values
Ideal for both hedging and speculation
13
How Are Derivatives Used?
Risk management (hedging) Commodity price risk Interest rate risk Foreign currency price risk
Speculation
14
Commodity Price Risk
Cost of mining gold: $350 per pounceCurrent gold spot price: $400 per
ounceGold reserves sufficient for ten years of
productionCompany exposed to risk of decreases
in future prices of goldCash flow exposure
forecasted transaction
15
Original Exposure
GoldProduction
Cost
Upside
potentia
l
Downs
ide R
isk50
400
Gold price
Profit
Loss
350
16
400 Gold price
0
Risk Management Tool: Short Forward
Currentforward
price
Profit
Loss
17
Origin
al Exp
osure
Net Position
Short Forward
Net Position: $50 Profit “Locked in”
50
400350 Gold price
Profit
Loss
18
Interest Rate Risk
Company issued a $100 million floating rate note with interest payments based on LIBOR
Interest expense: LIBOR X $100 Million
LIBOR currently is 7%Company exposed to risk of increases
in LIBORCash flow exposure
existing liability
19
InterestExpense
$7 Million
(.07 x $100. million)
0 7% LIBOR
Risk of
increa
se
Potenti
al
decre
ase
Exposure at EachInterest Payment Date
20
Fixed-RatePayer
Company with Exposure
Bank or Other IntermediaryReceive Floating Rate
(LIBOR) XNotional Principal
Pay 7.00%Fixed Rate X
Notional Principal
Risk Management Tool: Interest Rate Swap
Fixed-RateReceiver
21
$7 Million (.07 x $100 Million)
0 7 %
Net
NetOutflowon Swap
Negative Outflows =
Inflows from Swap
Outflows from Swap
Risk Management Tool: Interest Rate Swap
Pay Fixed Rate of 7%, Receive LIBOR
LIBOR
22
$7 Million
NetInterestExpense
Net Interest Expense
0 7%Negative Outflows =
Inflows from Swap
Outflows from
Swap
Original
Interest E
xpense
Net Position atEach Interest Payment Date
23
Reducing Funding Costs With Derivatives
Swapping floating-rate cash flows to fixed-rate reduces funding costs only if rates increase
Swapping fixed-rate cash flows to floating-rate reduces funding costs if rates decrease
Funding costs reduced by “expressing a view” (i.e., by betting on movements in future interest rates)
24
Foreign Currency Price Risk
US Company commits to purchase machinery from a French manufacturer
Payment of 10 million French francs (FF) to be made six months from now
Currently $US/FF exchange rate $.20 per FFUS Company is exposed to risk of increases
in the $US price of a FFFair value exposure
firm commitment
25
Cost(in $US)
0 .20
Risk of In
creased $US Cost
$2 Million($.20/FF x FF10
Million)
$US Price of a FF
CurrentExchange Rate
Original Exposure
26
.25Exercise
price
$US price of a FF
Payoffin $US
Risk Management Tool: Purchased Call Option
Strategic Issues: Company believes the price of a FF may go down Company does not want to pay more than $2.5 million
for machinery.
27
.25.20
Option payoff functionsas a reduction in cost
Option payoff
$2.5 million NET COST
0
original exposure
Net Cost of Machinery
Cost(in $US)
$2 million
$US price of a FF
28
Speculation with Derivatives
Speculation primarily domain of dealers and sophisticated traders
Speculative trading based on investors’ views of future market movements
Using interest rate swaps to reduce funding costs also requires “expressing a view” (i.e. form of speculation)
Query: Is risk management much different from speculation?
29
Speculating with Derivatives
A manufacturing company anticipates that a certain commodity will soon drop in price.
To exploit this belief, the company sells the commodity for forward (or future) delivery at a price reflecting the current market consensus
If the price does decline, the company can buy the commodity in the spot market and deliver it against the forward contract
Profit = Forward price - spot price
30
FASB Statement 133*
“Accounting for Derivative Instruments and Hedging Activities”
* Portions of the FASB's, "A Review of Statement 133-Accounting for Derivative Instruments and Hedging Activities," copyright 1998 by the Financial Accounting Standards Board, Norwalk, Connecticut 06856, are included by permission.
31
Statement 133: Why The Change?
Quantity and variety of derivatives is increasing
Accounting conventions and standards are outdated, incomplete, and inconsistent
The resulting financial statements are not transparent
32
Four Cornerstone Decisions of Statement 133
Derivatives are contracts that create rights and obligations that meet the definition of assets and liabilities
Fair value is the only relevant measure for derivatives
Only assets & liabilities should be on balance sheet
Special hedge accounting should be provided, but should be limited to transactions involving offsetting changes in fair values or cash flows for the risk being hedged
33
Statement 133: Key Aspects
All derivatives are at fair value on the balance sheet
Special accounting for the change in value of derivatives designated and qualifying in: Fair value hedges Cash flow (forecasted transaction) hedges Foreign currency hedges
34
Why Allow Hedge Accounting?
To resolve recognition and measurement anomalies
These anomalies cause earnings effects in different periods for hedging instrument and hedged item
35
Common Reporting Issues: Qualifying Hedges
Documentation requirementsEffectiveness and ineffectivenessGeneral disclosure requirementsSpecific accounting and disclosure rules
fair value, cash flow, foreign currency hedges
Hedge terminationImpairment
36
Documentation Requirements(Paragraphs 20(a), 28(a))
Formal documentation is required at the inception of the hedge and must include: Identification of the hedging instrument
and the hedged item The nature of the risk being hedged The risk management objective/strategy How effectiveness will be assessed
37
Required Documentation - Example of Cash Flow Hedge of Note Purchase
On 1/1/x1, XYZ purchases a call option on 5-year treasury notes as a hedging instrument in a cash flow hedge of a forecasted $100 million 5-year treasury note purchase at 12/31/x1
XYZ designates the decreases in cash flows related to decreasing interest rates as the hedged risk
For effectiveness measurement, the call premium is excluded from the test. The call option notional amount and forecasted note amount match.
38
Effectiveness (Paragraphs 20 and 28)
Effectiveness is defined as the derivative instrument’s ability to generate offsetting changes in the fair value or cash flows of the the hedged item. Key aspects: For both fair value and cash flow hedges, the
hedge is expected to be highly effective Effectiveness is measured at inception and
must be assessed whenever earnings are reported (at least quarterly)
Effectiveness measures intended to be similar to “high correlation” in Statement 80
39
Example of Highly Effective Fair Value Hedge
$3.8
$(0.4)
$(3.8)
$0.4
$(5.0)
$(4.0)
$(3.0)
$(2.0)
$(1.0)
$-
$1.0
$2.0
$3.0
$4.0
$5.0
Fair value change- fixed-rate debt
Fair value change- receive-fixedinterest rate swap
6/30/x1 12/31/x1
40
Hedge Effectiveness Test
An item may be excluded from the effectiveness test because it does not provide offsetting cash flows, such as an option’s time value (time value is the amount paid for the option, excluding payments for intrinsic value)
An item may be included in the effectiveness test, but may generate ineffectiveness
41
Effectiveness Implications
If the highly effectiveness test is failed, the entire hedge does not qualify for special accounting
If the highly effectiveness test is met, some ineffectiveness may occur and a portion of the derivative gain or loss may be recorded through earnings
Ineffectiveness is recorded differently in cash flow and fair value hedges, depending on the hedging relationship
42
Ineffectiveness (Paragraphs 22 and 30)
Items included in the effectiveness test that may generate ineffectiveness include: Different value of hedged item and notional
principal Different maturity or repricing dates Different underlying interest rate basis e.g.
LIBOR versus Prime Currency differences Credit differences
43
General Disclosure Requirements (Paragraph 44)
For all derivative instruments that qualify as hedging instruments, the entity shall disclose for each type of hedge the: Objectives for holding derivatives Context needed to understand those
objectives Strategies for achieving those objectives Entity’s risk management policy Description of the items or transactions
that are being hedged.
44
Accounting for Fair Value Hedges (Paragraphs 20-27)
A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk. Key aspects: Assets or liabilities exposed to price risk Change in value of hedged item and hedging
instrument recorded in earnings Result is matching for effective hedge Effective gain or loss adjusts basis of hedged item
45
Board Views - Fair Value Hedges
Fair value hedging is reasonable because the hedged item is a firm commitment or an asset or a liability
Offsetting fair value changes of the hedged item and the hedging instrument through earnings provides a natural offset
46
Disclosure Requirements: Fair Value Hedges (Paragraph 45(a))
Net gain or loss recognized in earnings during the reporting period representing: hedge ineffectiveness the component of the derivatives gain or
loss excluded from the assessment of hedge effectiveness
where the net gain or loss is reportedThe amount of net gain or loss is recognized
in earnings when a hedged firm commitment no longer qualifies as a fair value hedge.
47
Accounting for Cash Flow Hedges (Paragraphs 28-35)
A cash flow hedge is a hedging relationship where the variability of the hedged item’s cash flows is offset by the cash flows of the hedging instrument. Key Aspects: Forecasted transactions or balance sheet
items with variable cash flows qualify Effective gain or loss to OCI Earnings recognition matches hedged item Ineffective gain or loss may be recorded in
earnings
48
Board Views - Cash Flow Hedges
Board decided to permit cash flow hedge accounting as an accommodation to constituents
Because the hedged forecasted transaction is not recorded on the books, derivative gains and losses are deferred in other comprehensive income (OCI), adding a layer of complexity
49
Board Views - Cash Flow Hedges (continued)
Gains and losses on derivative contracts do not represent future economic sacrifices (liabilities) or benefits (assets)
Deferring gains or losses on derivatives as a separate component of OCI, rather than as a separate asset or liability, avoids conceptual difficulties and increases visibility for cash flow hedge transactions
50
Disclosure Requirements: Cash Flow Hedges (Paragraph 45(b))
Net gain or loss recognized in earnings during the reporting period
Description of transactions or other events that will result in reclassification of gains and losses deferred in accumulated OCI into earnings within next 12 months
Maximum length of time entity is hedging forecasted transaction variable cash flows
Discontinued hedge gains and losses because it is probable forecasted transaction will not occur
51
Accounting for Currency Hedges (Paragraphs 36-42)
Board intended to increase the consistency of hedge accounting guidance by broadening the scope of eligible foreign currency hedges. Key aspects: Cash flow and fair value hedges permitted Carry forward most of the ideas in
Statement 52Hedge of net investment in sub Use of nonderivative instrument
Some expansion of hedge accounting particularly for forecasted transactions
52
Accounting for Hedge Termination (Paragraph 25)
Terminate hedge accounting prospectively when: eligibility of qualification criteria not met derivative expires, is sold, terminated or
exercised hedge designation is removed
53
Impairment Issues (Paragraph 27)
Hedged item is still subject to impairment reviews
Apply after basis of hedged item is adjusted for changes in fair value or cash flows
Fair value of hedging instrument is not considered
54
Implementation Issues
What qualifies as a derivative instrument, including embedded derivatives? See Paragraphs 6-16, Appendix A,
Section1, and Appendix EWhat qualifies as a hedged item?
See Paragraphs 21 and 29 and Appendix C
55
Implementation Issues (continued)
Assessment of hedge effectiveness See Appendix A, Section 2
Transition provisions See Paragraphs 48-56 and Appendix B,
Section 3
56
Illustrative Examples
Fair value hedgeCash flow hedgeAppendix B, Section 1
57
Definition of a Fair Value Hedge
A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk.
$3.8
$(0.4)
$(3.8)
$0.4
$(5.0)
$(4.0)
$(3.0)
$(2.0)
$(1.0)
$-
$1.0
$2.0
$3.0
$4.0
$5.0
Fair valuechange: fixed-rate debt
Fair valuechange: receive-fixed interest rateswap
6/30/x1 12/31/x1
58
DEFINITION OF FAIR VALUE
Fair value is defined as the amount at which an asset (or liability) can be bought (or incurred) or sold (or settled) in a current transaction between willing parties, other than in a forced or liquidation sale. Quoted market prices are the best indicator. In the absence of quoted prices, use other
valuation techniques.
59
DEFINITION OF A RECOGNIZED ASSET OR LIABILITY
A recognized asset or liability is defined as an asset or liability recorded on the balance sheet (i.e., not a future transaction or an unrecorded intangible asset).
Hedgeable assets or liabilities include: Available-for-sale securities Commodity-type inventory Fixed-rate loan obligations
60
DEFINITION OF A FIRM COMMITMENTA firm commitment has the
characteristics of an asset or liability and must be:
Specific as to price, quantity, and timing With an unrelated party, binding on both parties
and usually legally enforceableProbable due to significant disincentive for
nonperformance
Example: Agreement with an unrelated party to purchase five machines (a fixed quantity) for $500 per machine (a fixed price) in six months (fixed timing)
61
Fair Value Hedge Accounting
Key concepts:Derivatives are always recorded on the
balance sheet at fair value. The change in a derivative’s fair value is
always recognized in earnings. Offsetting gains/losses on hedged items
are recognized in earnings and adjust the carrying amount of those items.
62
STATEMENT 133 CRITERIA:Hedgeable Items
Changes in fair value of the following items can be hedged:
Financial assets or liabilities (four specific risks can be hedged)
Non-financial assets or liabilities (the only risk that can be hedged is the risk of changes in fair value of the entire hedged asset or liability)
Note: Assets or liabilities already measured at fair value through earnings, such as trading securities, cannot be hedged items.
63
STATEMENT 133 CRITERIA: Risks That Can Be Hedged
For financial assets or liabilities, the hedged risk can be the risk of changes in fair value : Of the entire hedged item Due to market interest rates Due to foreign currency exchange rates Due to an obligor’s creditworthiness
Note: Prepayment risk cannot be the hedged risk. (However, the option component of a prepayable instrument can be designated as the hedged item.)
64
Transactions not affecting earnings do not qualify for hedge accounting, such as:
STATEMENT 133 CRITERIA:Items Not Qualifying For Hedge Accounting
Projected purchases of treasury stockIntercompany transactions (except foreign
currency)Anticipated stock issuances in relation to a
stock option plan for which no compensation expense is recognized for changes in stock price
65
STATEMENT 133 CRITERIA:Items Not Qualifying For Hedge Accounting (continued)
Other exclusions: Equity method investments Minority interests in consolidated subsidiaries Equity investments in consolidated
subsidiaries Firm commitments to enter into business
combinations An equity instrument issued by the entity and
recorded in stockholders equity
66
Example: Fair Value Hedge of Firm Commitment
XYZ manufactures titanium products. Its titanium supplier requires a 6-month firm commitment. On 1/1/x1, XYZ enters into a firm commitment with its supplier to buy 10,000 units of titanium at the current forward rate of $310 per unit on 6/30/x1.
XYZ wants to purchase and record the titanium at whatever the market price will be on 6/30/x1. Therefore, on 1/1/x1, XYZ enters into a forward contract to sell 10,000 units of titanium at the current forward rate of $310 per unit.
Hedge effectiveness is based on changes in the 6/30/x1 forward price of titanium.
67
Example: Fair Value Hedge of Firm Commitment
DateSpotRate
FwdRate for
6/30Maturity
FairValue
of Fwd
Fair Valueof Firm
Commitment
January 1 $300 $310 $0 $0
March 31 $292 $297 $128,079 ($128,079)
June 30 $285 N/A $250,000 ($250,000)
$128,709 = (310 - 297) * 10,000, present valued at 6% for 3 months
$250,000 = (310 - 285) * 10,000
68
Example: Fair Value Hedge of Firm Commitment
Journal entries at 3/31/x1:Forward contract 128,079
Gain on forward contract 128,079To record change in fair value of forward contract
Loss on firm commitment 128,079Firm commitment 128,079
To record change in fair value of firm commitment
69
Example: Fair Value Hedge of Firm Commitment
Journal entries at 6/30/x1:Forward contract 121,921
Gain on forward contract 121,921To record change in fair value of forward contract
Loss on firm commitment 121,921Firm commitment 121,921
To record change in fair value of firm commitment
($121,921 = $250,000 less $128,079)
70
Example: Fair Value Hedge of Firm Commitment
Journal entries at June 30 (con’t):Cash 250,000
Forward contract 250,000
To record cash receipt upon settlement of forward contract
71
Example: Fair Value Hedge of Firm Commitment
Journal entries at June 30 (con’t):Titanium 3,100,000
Cash 3,100,000 To record purchase of titanium at contracted
rate
Firm Commitment 250,000Titanium 250,000
To derecognize the firm commitment and adjust the carrying amount of the titanium purchase
72
Cash Flow Hedge
A cash flow hedge is a hedging relationship where the variability of the hedged item’s cash flows are offset by the cash flows of the hedging instrument.
2.853.35
0.15
-0.35-1
0
1
2
3
4
Cashoutflow,LIBOR debt
Cash flow,pay-fixedrate swap
73
Statement 133 Criteria: Hedgeable Items
Cash flow hedge provisions allow an entity to designate a derivative instrument as a hedge of the exposure to variability attributable to specific risks in the cash flows of: A recognized asset or liability such as a
variable-rate bond A forecasted transaction such as an
anticipated issuance of a fixed-rate debt
74
Statement 133 Criteria: Financial Asset and Financial Liability Hedgeable Risks
For forecasted purchase or sale of a financial asset or liability, hedgeable cash flow risks include: Changes in the cash flows relating to the
purchase or sale of the entire asset or liability
Changes in market interest rates Changes in the obligor’s creditworthiness
75
STATEMENT 133 CRITERIA: Eligible Forecasted Transaction
The eligible forecasted transaction must be:
A single transaction or a group of individual transactions
Probable to occurWith a third party external to the reporting
entity and present an exposure to variations in cash flows for the hedged risk that could affect reported earnings
76
STATEMENT 133 CRITERIA: Ineligible Forecasted Transaction
The following items do not qualify for hedging: Items subject to remeasurement with
changes in value attributable to the hedged risk reported currently in earnings
Interest rate risk of the forecasted purchase or sale of a held-to-maturity security
Forecasted business combinations subject to Opinion 16 or related to a parent company's interest in a consolidated subsidiary or an equity-method investment
77
STATEMENT 133 CRITERIA: Earnings Recognition
An entity’s risk management strategy may exclude a component of a derivative’s change in fair value This amount is recognized currently in earnings
Other ineffective portions of hedge may be recognized in earnings Is change in derivative less than change in
hedged item?
Amounts in OCI shall be reclassified to earnings when the hedged item affects earnings
78
Example: Cash Flow Hedge of Forecasted Inventory Sale
ABC designated the risk being hedged as its cash flows related to a forecasted sale of 100,000 bushels of Commodity A at the end of period 1 (the bushels originally were acquired for $1 million).
On the first day of period 1, ABC enters into Derivative Z to sell 100,000 bushels at $1.1 million at the end of period 1. At hedge inception, the derivative is at-the-money (i.e., its fair value was zero).
Hedge has no ineffectiveness because all terms of the forecasted sale and the derivative match.
At the end of period 1, Derivative Z has a fair value of $25,000 and the 100,000 bushels of Commodity A were sold for $1.075 million.
79
Example: Cash Flow Hedge of Forecasted Inventory Sale
Journal entries at end of period 1:Derivative Z 25,000
OCI 25,000To record Derivative Z at fair value
Cash 25,000Derivative Z 25,000
To record settlement of Derivative Z
80
Example: Cash Flow Hedge of Forecasted Inventory Sale
Journal entries at end of period 1:Cash 1,075,000
Revenue 1,075,000COGS 1,000,000
Inventory 1,000,000To record inventory sale
OCI 25,000Earnings 25,000
To reclassify amount in OCI to earnings upon inventory sale
81
Example: Cash Flow Hedge of Forecasted Inventory Sale
Forecasted cash flows: $1,100,000
Actual cash flows:Derivative $25,000Sale of inventory $1,075,000
$1,100,000Variability of cash flows is offset by
derivative
82
Advanced Topics
Accounting (1) for the ineffective portion of a hedge and (2) for fair value and cash flow hedges when swaps are the hedging instrument See Appendix B, Section1
Accounting for foreign currency risk in the net investment in a subsidiary See FASB Statement 52
83
Advanced Topics (continued)
Application of the clearly and closely related criterion to determine the existence of embedded derivatives See Appendix B, Section 2
Hedging of a portfolio of similar assets or similar liabilities See Paragraph 21(a)(1) and Appendix C
84
Advantages of Statement 133
A clear improvement over existing practice
Increases transparency of derivatives in financial statements
Provides a complete and consistent accounting model for all types of derivatives and hedging activities
Guidance is consistent with the Conceptual Framework
85
Disadvantages of Statement 133
Extremely complex standardFor fair value hedges, hybrid nature
of measurement attribute for hedged item
Promotes risk management at transaction level
Promotes derivatives as only hedging instrument
86
A Look to the Future
Is hedge accounting warranted? Risk management also involves “taking
a view”, which is similar to speculationFair value all financial instrumentsDiscontinuation of cash flow hedges
of forecasted transactions?
87
Closing Remarks
For electronic copies of the slides for use in classroom presentations at a college or university, please contact me at linsmeie@uiuc.edu
Thanks for your attention!
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