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Derivatives – challenges with GASB 53 P2F2 Financial Forum

28 October 2014

Derivatives – challenges with GASB 53 Page 1 1409-1315414

Disclaimer

► The views expressed by presenter(s) are not necessarily those of Ernst & Young LLP.

► These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.


Objectives

► Identify the characteristics of a derivative instrument ► Understand the methods of evaluating hedge effectiveness ► Understand the events that lead to the termination of hedge

accounting ► Identify the financial reporting requirements for derivative instruments


Background Derivatives – challenges with GASB 53


Why governments hedge


Characteristics of a derivative instrument

► Governmental Accounting Standards Board (GASB) 53, Accounting and Financial Reporting for Derivative Instruments, became effective for financial statements for periods beginning after 15 June 2009.

► It was first implemented for governments with 30 June 2010 year-ends.

► It’s been more than four years since first implemented. What are governments still struggling with?



Derivative instrument

Settlement factors

Leverage Net settlement


Scope of standard

What’s in? ► Swaps ► Futures ► Forwards ► Options (cap, floor, collar) ► Swaption (option to enter into

a swap)


Scope of standard

What’s out? ► Normal purchases, normal sales contracts ► Insurance contracts accounted for under

GASB 10 ► Certain financial guarantee contracts ► Certain contracts that are not exchange

traded ► Loan commitments For derivative instruments reported in financial statements prepared using the current financial resources measurement focus, GASB 53 should not be applied


Evaluating hedge effectiveness



Two types of hedges:

Fair value Cash flow



Fair value hedge: Cash flow hedge:

► Address risks that arise due to variable prices or rates

► Manage risks by eliminating variable or market fluctuations to which the cash flows of the associated item are subject: ► Most hedges undertaken

by governments are cash flow hedges.

► Pay-fixed, receive-variable interest rate swap

► Address risks of changes in fair values of items that have prices or rates that are fixed or known

► Manage risks by “unlocking” fixed prices and rates, thereby allowing item to be valued as if it had current market rate/price

► Pay-variable, receive-fixed interest rate swap



Four methods to evaluate effectiveness:

Consistent critical terms

Synthetic instrument

Dollar-offset Regression



1. Consistent critical terms: ► Evaluates effectiveness with qualitative considerations ► Same characteristics:

► Notional amount/quantity ► Zero fair value ► Net settlement ► Reference rate/benchmark rate ► Payments occurring over same period of time ► No floor or cap ► Time interval reference rate ► Rate reset days ► Payment dates ► Delivery location



2. Synthetic instrument: ► Combining the hedgeable item and the potential hedging derivative

instrument to simulate a third synthetic instrument ► Limited to cash flow hedges in which the hedgeable items are interest

bearing and carry a variable rate ► Effective if the actual synthetic rate is substantially fixed

(90% to 111%)



Synthetic instrument example

Counterparty Government

Bondholders

Pay fixed 5%

Receive variable 50% LIBOR + 80 bp Pay variable auction

rate


Synthetic instrument example (continued)


Counterparty Government

Bondholders

Pay fixed 5%

Receive variable 50% LIBOR + 80 bp Pay variable

auction rate

Fixed rate 5.00%

(Receive variable rate) -4.55%

Net payment 0.45%

Pay variable on bonds 4.30%

Synthetic rate 4.75%

Synthetic rate/fixed rate 4.75%/5.00% 95.00%

Effective



3. Dollar-offset: ► Compares the changes in expected cash flows or fair values of the

potential hedging derivative instrument with the changes in expected cash flows or fair values of the hedgeable item

► Effective if within a range of 80% to 125%



Dollar-offset example: ► In March 2014, the government

enters into a supply contract for the purchase of natural gas of 100,000 MMBTUs in December 2014 at the Chicago Citygate spot price.

► Government enters into forward purchase contract for natural gas of 100,000 MMBTUs in December 2014. Government will pay fixed price of $10.00 per MMBTU and receive the spot rate at Henry Hub.



Dollar-offset example (continued)

Effective

March 2014

30 June 2014

Chicago Citygate December forward price $ 10.05 $ 10.57 Henry Hub December forward price 10.00 10.46

March 2014

30 June 2014 Change

Expected cash flow Chicago Citygate $ (5,000) $ (57,000) $ (52,000) Expected cash flow Harry Hub – (46,000) (46,000)

$ (52,000) $ (46,000) = 113%



4. Regression: ► Consider the statistical relationship between the cash flows or fair

values of the potential hedging derivative instrument and the hedgeable item. The changes in cash flows or fair values of the potential hedging derivative instrument substantially offset the changes in cash flows or fair values of the hedgeable item if all of the following criteria are met: ► The R-squared of the regression analysis is at least 0.80. ► The F-statistic calculated for the regression model demonstrates that the

model is significant using a 95% confidence interval. ► The regression coefficient for the slope is between -1.25 and -0.80.


What are the pros and cons?

Method Pros Cons Consistent critical terms Easy to implement Little flexibility

Synthetic instruments Relatively easy to implement In differing rate environments, could fall out of range

Dollar offset Conceptually easy to implement (hypothetical “perfect” trade)

Unpredictable and subjective if hedging and hedged rates do not move in tandem

Regression analysis Favorite among Accounting Standards Codification (ASC) 815

Relatively harder to implement; needs statistical knowledge and proper number of data points


Hybrid instruments

Embedded derivative instrument: ► Call option in a bond ► Cap or floor in a sale or purchase contract ► Interest rate swap in a debt instrument

Companion Instrument (debt, lease, insurance contract)

Derivative instrument


+


Termination of hedge accounting



Hedge accounting should cease to be applied if: ► The hedging derivative instrument is no longer effective. ► The likelihood that a hedged expected transaction will occur is no

longer probable. ► The hedged asset or liability, such as a hedged bond, is sold or retired

but not reported as a current refunding or advanced refunding resulting in a defeasance of debt.

► The hedging derivative instrument is terminated (exception, GASB 64). ► A current refunding or advanced refunding resulting in the defeasance

of the hedged debt is executed. ► The hedged expected transaction occurs, such as the purchase of an

energy commodity or the sale of bonds.

Renegotiating or amending a critical term of a hedging derivative instrument terminates hedge accounting.



Financial reporting at termination: ► The balance in the deferral account should be reported on the flow of

resources statement within the investment revenue classification. ► If reported separately within investment revenue, the removal of the

balance in the deferral account should be captioned increase (decrease) upon hedge termination.

Reapply hedge accounting? ► Hedge accounting should not be reapplied to that hedging

relationship. ► A derivative instrument from a terminated hedge, however, may be

employed as a hedging derivative instrument in a new hedge.


Financial reporting and disclosures


Financial reporting requirements for derivative instruments

Financial reporting – recognition and measurement

Investment derivative Hedging derivative

Recorded at fair value with changes in fair value reported within the investment revenue classification on the flow of resources statement

Economic resource method

Recorded at fair value with changes in fair values reported as either deferred inflows or deferred outflows in the statement of net assets

Economic resource method


Disclosures for derivative instruments

Summary disclosures

► Organized by governmental activities, business-type activities and fiduciary funds

Information should then be divided into the following categories:

► Hedging derivative instruments (distinguishing between fair value hedges and cash flow hedges)

► Investment derivative instruments

► Within each category, derivative instruments should be aggregated by type (examples include receive-fixed swaps, pay-fixed swaps, swaptions, rate caps, basis swaps or futures contracts).

Information to be presented: ► Notional amount

► Fair value and changes in fair value during the reporting period and where those changes in fair value are reported

► Fair value based on other than quoted market prices, with the methods and significant assumptions used to estimate those fair values disclosed

► Fair values and deferral amount of derivative instruments reclassified from a hedging derivative instrument to an investment derivative instrument



Hedging derivative instrument disclosures: ► Objectives ► Terms:

► Notional amount ► Reference rate ► Embedded options, caps, floors or collars ► Date entered into and date scheduled to terminate ► Amount of cash paid or received when entered into



Hedging derivative instrument disclosures (continued): ► Risks:

► Credit ► Interest rate ► Basis risk ► Termination risk ► Rollover risk ► Market-access risk



Investment derivative instrument disclosures: ► Risks:

► Credit risk ► Interest rate risk ► Foreign currency risk



Other disclosures: ► Contingent features:

► Existence and nature of contingent features and the circumstances in which the features could be triggered

► Fair value of derivative instruments that contain those features ► Fair value of assets required to be posted as collateral ► Amount of collateral posted

► Hybrid instruments: ► Disclosures of the companion instrument should be consistent with disclosures

required of similar transactions, for example, disclosures for debt instruments.

► Synthetic guaranteed investment contracts (SGIC): ► For SGIC that is fully benefit-responsive:

► Description ► Fair value


Appendix A Characteristics of a derivative instrument



Definition of a derivative instrument: ► Settlement factors:

► One or more reference rates ► One or more notional amounts, payment provisions, or both

► Leverage: ► Requires no initial net investment ► An initial net investment that is smaller than would be required for other

types of contracts that would be expected to have a similar response to changes in market factors

► Net settlement: ► Its terms require or permit net settlement.


Settlement factors Reference rates

► The price or index of a security or commodity

► An interest rate or interest rate index

► A foreign exchange rate or index ► A measure of creditworthiness

(e.g., Moody’s rating) ► An insurance index or catastrophe

loss index: ► A climatic or geological condition

(temperature, earthquake severity, or rainfall)


Settlement factors Notional amount

► A number of: ► Currency units ► Shares ► Bushels ► Pounds ► Other units

(Applied to the underlying to determine settlement – price X no. of shares)


No initial net investment (or a small value)

► A derivative requires either: ► No initial net investment ► An initial net investment (after adjustment for the time value of money) that

is less, by more than a nominal amount, than the initial net investment that would be commensurate with the amount that would be exchanged to acquire the asset (or incur the obligation) related to the underlying

► Some derivative instruments require an initial net investment as compensation for the time value of an option or for terms that are more or less favorable than market conditions.

► It does not require initial net investment of the notional amount.


Net settlement – three ways to meet requirement

1. Net settlement by terms of the contract itself (cash or other assets) 2. Net settlement by market mechanism 3. Delivery of a derivative or an asset that is readily convertible to cash

(such as actively traded/liquid securities, commodities and foreign currencies)


Appendix B Regression approaches


Evaluating hedge effectiveness Three potential regression approaches

1. Settlement: ► Settlement date remains the same for all data points. ► Tenor (duration) changes (one-month forward price, two-month

forward price)

Price

Date


Evaluating hedge effectiveness Three potential regression approaches 2. Declining maturity: ► Gradually removes the time value factor just as we would expect to

happen as the derivative approaches maturity

Price

Date


Evaluating hedge effectiveness Three potential regression approaches

3. Constant maturity: ► The current terms of the hedge are treated as static. ► Forward curve tenor remains the same – always 12-month forward

spot price.

Price

Date


Appendix C Hybrid instruments



Hybrid instruments: ► The companion instrument is not measured at fair value. ► A separate instrument with the same terms would meet the definition

of a derivative instrument. ► The economic characteristics and risks of the derivative instrument are

not closely related to the economic characteristics and risks of the companion instrument: ► Up-front payment with off-market terms ► Written option that is in the money ► Inconsistent reference rate ► Potential negative yield ► Leverage yield



Accounting for hybrid instruments

GASB 53 Standard applicable to companion instrument (debt, lease, insurance)

Embedded derivative instrument Companion instrument +



Up-front payment with off-market terms (valuation): ► Fixed swap rate is the break-even rate that sets the present value of

the fixed payments equal to the present value of the expected floating rate, e.g., London Interbank Offered Rate (LIBOR) payments: ► Price or value of a swap = present value of fixed leg – present value of

floating leg ► Price of an at-the-market swap = 0

► An off-market swap has value to one party and requires an up-front cash payment to compensate for the off-market rate



Up-front payment with off-market terms (interest rate swap): ► Embedded derivative instrument is measured first. ► Remaining balance is affiliated to the value of the debt.

At-the-market swap Above-market portion treated as debt

Embedded derivative instrument Companion instrument +



Challenge – association with new hedgeable item ► Issue: The swap is now off-market and the fair value (FV) of the derivative does not equal the

balance in the deferral account (previous changes were recorded in investment revenue). ► Two approaches:

► See GASB Q&A Illustrations 5.2 – Other Illustrations: Off-Market Swap

“Hybrid” instrument approach

Straight-line amortization over the life of the swap

► At-the-market swap treated as the

potential hedging derivative instrument

► Above-market portion treated as a borrowing

► Amortized over life of the swap

► Compute a reconciling difference so that the FV of the swap ending balance and the deferral ending balance align correctly

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