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Financial Reporting for Derivatives and Risk Management Activities Thomas J. LinsmeierUniversity of Illinois AAA Annual Meeting August 16, 1998

Workshop Topics Common types of derivatives Risk management activities New financial reporting standards FASB Statement 133 SEC Financial Reporting Release 48 At end session at 10:30 a.m. tomorrow Illustrative examples Evaluation of Statement 133 2

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. 3

Common Derivatives Forwards / Futures Options Swaps Hybrids / Embedded derivatives 4

Forward / Future Contracts Obligate one party to buy and another party to sel an underlying instrument or commodity at a future date Now Future Date Instrument or Commodity Cash Long Short Market Cash Market Price Instrument or Forward Commodity Market Long Short Agree to Terms Forward Price 5

Options Options provide the holder the right, but not the obligation, to buy or sel the underlying instrument or commodity at a predetermined price cal ed the strike or exercise price Options normal y are in the form of a Cal or a Put Cal s enable the holder to buy the underlying instrument or commodity at the strike price Puts enable the holder to sel the underlying instrument or commodity at the strike price Require up front payment or premium 6

Payoff Profiles of Purchased Puts and Calls Purchased Call ayoff P Price of Exercise Price underlying instrument Purchased Put ayoff P Price of underlying Exercise Price instrument 7

Swaps Two parties exchange recurring payments Similar to series of forward contracts Interest rate swaps most common 8

Plain-Vanil a Interest Rate Swap Floating Rate (LIBOR) X Notional Principal Fixed-Rate Fixed-Rate Payer Receiver Fixed Rate of 6.75% X Notional Principal Note: LIBOR is London Interbank Offered Rate 9

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 10

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 11

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 12

How Are Derivatives Used? Risk management (hedging) Commodity price risk Interest rate risk Foreign currency price risk Speculation 13

Commodity Price Risk Cost of mining gold: $350 per pounce Current gold spot price: $400 per ounce Gold reserves sufficient for ten years of production Company exposed to risk of decreases in future prices of gold Cash flow exposure forecasted transaction 14

Original Exposure Profit Upside 50 potential Downside Risk 3 50 400 Gold price Gold Production Cost Loss 15

Risk Management Tool: Short Forward Profit 0 400 Gold price Current forward price Loss 16

Net Position: $50 Profit Locked in Profit Net Position 50 350 400 Gold Sho price rt Fo Original Exposure rward Loss 17

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 LIBOR Cash flow exposure existing liability 18

Exposure at EachInterest Payment Date Interest Expense Risk of increase $7 Million (.07 x $100. million) Potential decrease 0 7% LIBOR 19

Risk Management Tool: Interest Rate Swap Company with Bank or Other Exposure Intermediary Receive Floating Rate (LIBOR) X Notional Principal Fixed-Rate Fixed-Rate Payer Receiver Pay 7.00% Fixed Rate X Notional Principal 20

Risk Management Tool: Interest Rate Swap Pay Fixed Rate of 7%, Receive LIBOR Net $7 Million (.07 x $100 Million) O Outflow utfl on Swap ows from Swap 0 7 %Ne LIBOR I g n a fl t o iv w e s O fr u o t m flo S w w s a = p 21 Net

Net Position atEach Interest Payment Date Net Interest Expense Original Interest Expense Net Interest Expense $7 Million Out S fl w ow ap s from 0 7% Nega I t n iv fl e o w O s u f tf r l o ow m s S = wap 22

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) 23

Foreign Currency Price Risk US Company commits to purchase machinery from a French manufacturer Payment of 10 mil ion French francs (FF) to be made six months from now Currently $US/FF exchange rate $.20 per FF US Company is exposed to risk of increases in the $US price of a FF Fair value exposure firm commitment 24

Original Exposure Cost (in $US) Risk of Increased $US Cost $2 Million ($.20/FF x FF10 Million) 0 .20 $US Price of a FF Current Exchange Rate 25

Risk Management Tool: Purchased Cal Option Payoff in $US .25 $US price Exercise of a FF price Strategic Issues: Company believes the price of a FF may go down Company does not want to pay more than $2.5 mil ion for 26 machinery.

Net Cost of Machinery Cost (in $US) original exposure $2.5 million NET COST $2 million 0 .20 .25 O $US price ption p of a FF ayoff Option payoff functionsas a reduction in cost 27

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 dif erent from speculation? 28

Speculating with Derivatives A manufacturing company anticipates that a certain commodity wil soon drop in price. To exploit this belief, the company sel s 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 29

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 31

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 of set ing changes in fair values or cash flows 32 for the risk being hedged

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 33

Why Al ow Hedge Accounting? To resolve recognition and measurement anomalies These anomalies cause earnings effects in different periods for hedging instrument and hedged item 34

Common Reporting Issues: Qualifying Hedges Documentation requirements Effectiveness and ineffectiveness General disclosure requirements Specific accounting and disclosure rules fair value, cash flow, foreign currency hedges Hedge termination Impairment 35

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 ef ectiveness wil be assessed 36

Required Documentation Example of Cash Flow Hedge of Note Purchase On 1/1/x1, XYZ purchases a cal option on 5 year treasury notes as a hedging instrument in a cash flow hedge of a forecasted $100 mil ion 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 ef ectiveness measurement, the cal premium is excluded from the test. The cal option notional amount and forecasted note amount match. 37

Effectiveness (Paragraphs 20 and 28) Ef ectiveness is defined as the derivative instrument s ability to generate of set ing 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 ef ective Ef ectiveness is measured at inception and must be assessed whenever earnings are reported (at least quarterly) Ef ectiveness measures intended to be similar to high correlation in Statement 80 38

Example of Highly Effective Fair Value Hedge $5.0 $3.8 $4.0$3.0$2.0 Fair value change $1.0 $0.4 fixed-rate debt $- Fair value change $(1.0) $(0.4) receive-fixed $(2.0) interest rate swap $(3.0)$(4.0) $(3.8) $(5.0) 6/30/x1 12/31/x1 39

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 40

Effectiveness Implications If the highly ef ectiveness test is failed, the entire hedge does not qualify for special accounting If the highly ef ectiveness test is met, some inef ectiveness may occur and a portion of the derivative gain or loss may be recorded through earnings Inef ectiveness is recorded dif erently in cash flow and fair value hedges, depending on the hedging relationship 41

Ineffectiveness (Paragraphs 22 and 30) Items included in the effectiveness test that may generate ineffectiveness include: Dif erent value of hedged item and notional principal Dif erent maturity or repricing dates Dif erent underlying interest rate basis e.g. LIBOR versus Prime Currency dif erences Credit dif erences 42

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. 43

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 at ributable 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 ef ective hedge Effective gain or loss adjusts basis of hedged item 44

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 45

Disclosure Requirements: Fair Value Hedges (Paragraph 45(a)) Net gain or loss recognized in earnings during the reporting period representing: hedge inef ectiveness the component of the derivatives gain or loss excluded from the assessment of hedge ef ectiveness where the net gain or loss is reported The amount of net gain or loss is recognized in earnings when a hedged firm commitment no longer qualifies as a fair value hedge. 46

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 of set by the cash flows of the hedging instrument. Key Aspects: Forecasted transactions or balance sheet items with variable cash flows qualify Ef ective gain or loss to OCI Earnings recognition matches hedged item Inef ective gain or loss may be recorded in earnings 47

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 48

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 49

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 wil 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 wil not occur 50

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 permit ed Carry forward most of the ideas in Statement 52 Hedge of net investment in sub Use of nonderivative instrument Some expansion of hedge accounting particularly for forecasted transactions 51

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 52

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 53

Implementation Issues What qualifies as a derivative instrument, including embedded derivatives? See Paragraphs 6 16, Appendix A, Section1, and Appendix E What qualifies as a hedged item? See Paragraphs 21 and 29 and Appendix C 54

Implementation Issues (continued) Assessment of hedge effectiveness See Appendix A, Section 2 Transition provisions See Paragraphs 48 56 and Appendix B, Section 3 55

Il ustrative Examples Fair value hedge Cash flow hedge Appendix B, Section 1 56

Definition of a Fair Value Hedge A fair value hedge is a hedge of the $5.0 $3.8 $4.0 exposure to a $3.0 Fair value change in fair value $2.0 change: fixed- of a recognized $1.0 $0.4 rate debt asset $- Fair value or liability or of $(1.0) $(0.4) change: receive- $(2.0) fixed interest rate an unrecognized $(3.0) swap firm commitment $(4.0) $(3.8) attributable to a $(5.0) 6/30/x1 12/31/x1 particular risk. 57

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. 58

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 59

DEFINITION OF A FIRM COMMITMENT A 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 usual y legal y enforceable Probable 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) 60

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. Of set ing gains/losses on hedged items are recognized in earnings and adjust the carrying amount of those items. 61

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.62

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.) 63

STATEMENT 133 CRITERIA:Items Not Qualifying For Hedge Accounting Transactions not affecting earnings do not qualify for hedge accounting, such as: Projected purchases of treasury stock Intercompany 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 64

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 65

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 wil be on 6/30/x1. Therefore, on 1/1/x1, XYZ enters into a forward contract to sel 10,000 units of titanium at the current forward rate of $310 per unit. Hedge ef ectiveness is based on changes in the 6/30/x1 forward price of titanium. 66

Example: Fair Value Hedge of Firm Commitment Fwd Rate for Fair Fair Value Spot 6/30 Value of Firm Date Rate Maturity of Fwd 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 67

Example: Fair Value Hedge of Firm Commitment Journal entries at 3/31/x1: Forward contract 128,079 Gain on forward contract 128,079 To record change in fair value of forward contract Loss on firm commitment 128,079 Firm commitment 128,079 To record change in fair value of firm commitment 68

Example: Fair Value Hedge of Firm Commitment Journal entries at 6/30/x1: Forward contract 121,921 Gain on forward contract 121,921 To record change in fair value of forward contract Loss on firm commitment 121,921 Firm commitment 121,921 To record change in fair value of firm commitment ($121,921 = $250,000 less $128,079) 69

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 set lement of forward contract 70

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 250,000 Titanium 250,000 To derecognize the firm commitment and adjust the carrying amount of the titanium purchase 71

Cash Flow Hedge A cash flow hedge is a hedging 4 3 .3 5 relationship where 2 .8 5 3 the variability of Ca sh the hedged item s 2 out flow ,LI BOR de bt cash flows are Ca sh flow. of set by the cash 1 0 .1 5 pa y-fix e d flows of the 0 ra t e sw a p hedging -0 .3 5 instrument. -1 72

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 73

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 74

STATEMENT 133 CRITERIA: Eligible Forecasted Transaction The eligible forecasted transaction must be: A single transaction or a group of individual transactions Probable to occur With a third party external to the reporting entity and present an exposure to variations in cash flows for the hedged risk that could af ect reported earnings 75

STATEMENT 133 CRITERIA: Ineligible Forecasted Transaction The fol owing items do not qualify for hedging: Items subject to remeasurement with changes in value at ributable 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 companys interest in a consolidated subsidiary or an equity method investment 76

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 inef ective portions of hedge may be recognized in earnings Is change in derivative less than change in hedged item? Amounts in OCI shal be reclassified to earnings when the hedged item af ects earnings 77

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 original y were acquired for $1 mil ion). On the first day of period 1, ABC enters into Derivative Z to sel 100,000 bushels at $1.1 mil ion 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 inef ectiveness because al 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 mil ion. 78

Example: Cash Flow Hedge of Forecasted Inventory Sale Journal entries at end of period 1: Derivative Z 25,000 OCI 25,000 To record Derivative Z at fair value Cash 25,000 Derivative Z 25,000 To record set lement of Derivative Z 79

Example: Cash Flow Hedge of Forecasted Inventory Sale Journal entries at end of period 1: Cash 1,075,000 Revenue 1,075,000 COGS 1,000,000 Inventory 1,000,000 To record inventory sale OCI 25,000 Earnings 25,000 To reclassify amount in OCI to earnings upon inventory sale 80

Example: Cash Flow Hedge of Forecasted Inventory Sale Forecasted cash flows: $1,100,000 Actual cash flows: Derivative $25,000 Sale of inventory $1,075,000 $1,100,000 Variability of cash flows is offset by derivative 81

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 82

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 83

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 84

Disadvantages of Statement 133 Extremely complex standard For fair value hedges, hybrid nature of measurement attribute for hedged item Promotes risk management at transaction level Promotes derivatives as only hedging instrument 85

A Look to the Future Is hedge accounting warranted? Risk management also involves taking a view. which is similar to speculation Fair value all financial instruments Discontinuation of cash flow hedges of forecasted transactions? 86

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! 87