CBIZ MHM Presentation - Interest Rate Derivatives

7/31/2019 CBIZ MHM Presentation - Interest Rate Derivatives

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Basic Topics in Interest Rate Derivatives

By Timothy Woods, CPA, MBA

CBIZ MHM WebinarMay 21, 2009


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Presentation Overview

Most Common Interest Rate Derivatives

Interest Rate Swaps

Interest Rate Cap Agreements

Risk Characteristics Pros and Cons of each

Accounting and Reporting

Valuation

CBIZ MHM, LLC Services

Questions


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Interest Rate Swaps

Most common is a plain vanilla interest rate swap where: A Company agrees to pay cash flows equal to interest at a

predetermined fixed rate on a stated notional principal for a

stated period and, in return, the Company receives interest at afloating rate on the same notional principal for the same period

of time.

Company can be the fixed rate payer and the floating ratereceiver or vice versa.


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Interest Rate Swaps

For Example: Company XYZ has outstanding $10,000,000 of non-amortizing

variable rate debt for which interest payments are due on a

quarterly basis. The note accrues interest at the 3 month LondonInterbank Offered Rate (LIBOR) plus 5% and matures via a

bullet payment in 5 years.

In this case, in order to hedge the Companys interest rate risk,the Company would enter into a 5 year interest rate swap for a

notional amount of $10,000,000 at a current swap rate (fixed

rate) of 2.60% (as of April 30, 2009).


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Interest Rate Swaps

Example, contd: The Company would pay the fixed rate of 2.6% on the $10,000,000

notional amount on a quarterly basis and would receive the 3 month

LIBOR rate on a quarterly basis. The LIBOR received is set a quarter

prior to payment so the payment is made 3 months in arrears.Accordingly, the Company knows 3 months in advance what the

payment will be.

Payments are settled on a net basis so if the 3 month LIBOR is greaterthan 2.6% then the Company will receive a payment.

Therefore, the Company has effectively turned its variable rate debt into

fixed rate debt with an effective interest rate of 7.6% (2.6% fixed + 5%

spread).


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Interest Rate Swaps

Example contd:

FIXED RATE PAYMENT = $10,000,000 * .026 / 4 = $65,000

VARIABLE RATE PAYMENT = $10,000,000 * 3 MONTH LIBOR

(3.0%) or .030 / 4 = $75,000

THEREFORE COMPANY RECEIVES:

$75,000 - $65,000 = $10,000 AT QUARTERLY SETTLEMENT.

THE FIXED RATE PAYMENT WILL BE $65,000 AT EACH

SETTLEMENT

THE VARIABLE RATE PAYMENT IS THE MOVING COMPONENT

AS THE THREE MONTH LIBOR WILL CHANGE.


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Interest Rate Cap Agreement

An interest rate cap is an option that provides a payoffwhen a specified interest rate above a certain level (the

cap rate). The specified rate is a floating rate that is set

periodically.


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Interest Rate Caps -Terms

Interest rate caps can be described by a term sheet Maturity (for example - 5 years)

Notional amount (usually set equal to borrowed amount)

Strike price (sometimes called the protection level)

Frequency (how many payments per year)

Payments per year times maturity tells you how many caplets

Basis (how youre going to count days)

Underlying rate (usually LIBOR of some maturity)


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Interest Rate Cap

For Example:

Company XYZ has outstanding $10,000,000 of non-amortizing variable rate debt

for which interest payments are due on a quarterly basis. The note accrues

interest at the 3 month LIBOR plus 5% and matures via a bullet payment in 5

years.

In this case, in order to hedge the Companys interest rate risk, the Company

would purchase a 5 year interest rate cap agreement for a notional amount of

$10,000,000 which has a cap rate of 2.6% (for example) and designated

maturities of 3 months. For purposes of this example, the purchase price is

$200,000 for the interest rate cap agreement.

Therefore, given that the Company purchased an interest rate cap agreement

with a term of 5 years and quarterly settlements, the interest rate cap agreement

is comprised of 20 individual cap agreements, or caplets, that are settled on a

quarterly basis. As with the interest rate swap, the cap rate is set 3 months priorto settlement and as such, the settlement amount is know 3 months in advance.


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Interest Rate Cap

For Example, contd: With an interest rate cap, the Company that purchased the cap

agreement will only receive a payment if the 3 month LIBOR closes

above the cap rate. At no time will the Company be required to pay

additional funds at any of the caplet settlements.

For example, if the 3 month LIBOR rate closes at 3%, the Company will

receive a payment equal to (3% - 2.6%) *10,000,000 / 4 = $10,000.

Therefore, the Company has ensured that the effective rate of its debtwill not go above 7.6% (LIBOR of 2.6%, the cap rate, plus the 5%

margin on the underlying debt). However, the Companys effective rate

can go as low as the market will take it; which as we will see, is not the

situation with the interest rate swap.


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Risk Characteristics

Risk Characteristics of Interest Rate Swaps:

As we discussed before, the swap rate is the fixed rate of

interest that the receiver (variable rate payer) demands in

exchange for the uncertainty of having to pay the short term 3

month LIBOR (floating rate) over the term of the swap.

Therefore, at the time that the interest rate swap is entered, the

total present value of the fixed rate payments to be received

(made) is equal to the expected value of the variable rate

payments to be made (received). As such, at the date the swap

is entered the value of the swap is $0, which is why there is no

purchase price for the swap (without commissions).


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Interest rate swaps involve two primary risks: 1) interest rate risk

and 2) credit, or counterparty, risk.

Interest Rate Risk:

When a Company enters into an interest rate swap for purposes of riskmanagement, they are stating that they are comfortable with the effective interestrate that has been set as a result of entering into the swap.

Therefore, because actual interest rate movements do not always matchexpectations, from the standalone viewpoint of the swap only, swaps entailinterest rate risk. For example, the variable rate receiver will profit if interest rates

rise and will lose if interest rates fall and vice versa for the fixed rate receiver. However, when viewed in conjunction with the cash flows of the underlying debt

being hedged, the variable rate receiver has effectively locked in the hedgedinterest rate at the time the swap was entered into as the any fluctuations in thevariable rate being received will be offset by the variable rate being paid on theunderlying debt and the Company is effectively left with the fixed rate + themargin on the underlying debt.


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While we will get into the accounting for interest rate swaps later in the webinar, it is

important to note that interest rate swaps are marked to market at each reportingdate; that is, they are recorded at estimated fair value, with the change either being

reported in earnings or through other comprehensive income. Therefore, depending

upon whether the Company designates the interest rate swap as a hedge under

SFAS 133 or as an investment, the change in fair value could have a material effect

on the Companys earnings, even though the Company has effectively locked in thesame interest rate over the period of the interest rate swap.

For example, if the Company has not designated hedge accounting and as the

variable rate payer under an interest rate swap, interest rates drop by a large amount,

the value of the interest rate swap will be significantly decreased such that theCompany will need to record the change in fair value through earnings. However, the

Company does not get an offset to the drop in fair value of the swap by reducing the

value of its debt. Therefore, Companies must keep this is mind before they enter into

interest rate swaps and make the determination of whether hedge accounting will be

utilized (note there are specific and stringent criteria to qualify for hedge accounting).


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Credit, or Counterparty, Risk

Swaps are also subject to the counterpartys credit risk: the

chance that the other party in the contract will default on its

responsibility. Although this risk is very low banks that deal in

LIBOR and interest rate swaps generally have very high credit

ratings of double-A or above it is still higher than that of a risk-

free U.S. Treasury bond.


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Risk Characteristics - Caps

Interest rate caps are option products, and as such,share certain common characteristics with all options:

An upfront premium is required to purchase a cap.

The value of a cap depends upon the variability of interest rates;that is, the projected volatility of interest rates, over the life of thecap.

The longer the maturity of the cap, the more expensive.

A cap provides insurance against higher interest rates.

The fartherout-of-the-moneya cap is, that is, the higher the caprate, the cheaper it will be.


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Risk Characteristics - Caps

As stated before, the only value at risk with an interest rate cap is

the premium paid for the cap agreement.

The value of the interest rate cap agreement will increase with

increases in interest rates and will decrease with decreases in

interest rates. All other aspects of the value of the interest rate cap are the same

as for other types of options:

Increase in interest rate volatility increases the value of the interest ratecap

Increase in term, increases the value of the interest rate cap

Increase in cap rate, decreases the value of the interest rate cap

And vice versa


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Pros and Cons Interest Rate Swaps

PROS

No upfront cash outlay

Effective hedging vehicle

Locks in an effective rate

CONS

No upside participation (no gain from decline or rise in interest rates)

Mark to Market accounting can have large effect on net income

Credit, non-performance risk


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Pros and Cons Interest Rate Caps

PROS

Effective interest rate risk hedging vehicle with participation in gainsfrom decrease in interest rates.

Can only lose premium paid, cannot go to below zero (re: no liability

treatment) Caps interest rate

CONS

Upfront cash outlay

Mark to Market accounting can have large effect on net incomealthough losses only to the extent premium paid.

Credit, non-performance risk


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Primary accounting guidance comes from SFAS 133,Accounting for Derivatives and Hedging Activities.

Primary issue is the treatment of the gains or losses

resulting from the adjustment of the derivatives carryingvalue to fair value.

Hedge accounting: gain or loss from the derivative

impacts earnings in the same period as the gain or lossresulting from underlying exposure being hedged.


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If Company does not elect to use hedge accounting

under SFAS 133 for its interest rate swaps and/or caps,

the change in the fair value of the derivatives is

recognized in earnings during the period of the change.


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Accounting and Reporting Hedge Accounting

However, if the Company wishes to elect hedge accounting, they must

first meet the following criteria:

1) The Determination of the Nature of the Hedged Risk

While there are three different types of exposures to hedge (fair value

exposure, cash flow exposure, and the exposure to changes in thevalue of a net investment in a foreign operation), for purposes of thiswebinar we are referring to HEDGES OF CASH FLOW EXPOSURE,which is defined as a cash flow hedge.

Accordingly, the Company declares the interest rate swaps and orcaps to be hedges of the variability in the Companys future interestrate payments related to its variable rate debt.

In order for this to be a valid cash flow hedge, the Company must be

able to properly forecast the cash flows being hedged, the transactionsmust be probable, and must be with a party external to the reportingentity.


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2) In addition to the preceding, the Company must have Hedge

Documentation prepared at the inception of hedge and mustinclude:

Identification of the hedging instrument.

Identification of the hedged risk. Risk management objective and strategy for undertaking the hedge.

Documentation supporting managements expectation that the hedgewill be effective.

Procedure to be followed for measuring hedge effectiveness.

WITHOUT THE PRECEEDING, HEDGE ACCOUNTING CANNOT BE

UTILIZED AND ALL CHANGES IN FV WILL BE RECOGNIZED INEARNINGS.


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3) As noted in the documentation requirement, the Company must

document that the derivative will be highly effective in hedging the

variability in the forecasted cash flows related to its debt service

requirements. Furthermore, the Company must measure the

effectiveness of the cash flow hedge at each reporting date.

Must be highly effective to continue to use hedge accounting.


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The company must select a method to measure the portion

of the change in the value of the derivative intended to

offset changes in the hedged exposure and to evaluate

hedge effectiveness:

1) at the inception of the hedge and

2) on an ongoing basis while the hedge is in place.


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In measuring the effectiveness of a cash flow hedge, the

Company must measure the correlation of the expected

(hedged) result and the actual result (difference should

be minimal for an effective hedge).

In terms of a fair value hedge, the Company must

measure the correlation of the change in fair value of the

hedged item and the change in fair value of thederivative being utilized in the hedge.


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Hedge Effectiveness Example:

In terms of the interest rate swap and cap examples that we discussed, we

would need to measure the effectiveness of the swap or cap to properly

hedge the interest rate risk that we are hedging. In terms of the swap, we

entered into the hedge with the goal of locking in an effective rate of 7.6%.Accordingly, we would need to calculate the actual interest rate at the

reporting date and compare this to the 7.6%.

However, if we determine a portion of the interest rate swap to be ineffective

(for example, if we paid off a portion of the underlying debt and the notional

amount of the swap is now greater than the underlying debt being hedged),

that portion of the change in fair value of the swap that is deemed to be

ineffective must be recognized in earnings.


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If Company does not elect to use hedge accounting

under SFAS 133 for its interest rate swaps and/or caps,

the change in the fair value of the derivatives is

recognized in earnings during the period of the change.


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Hedge Accounting

Provided that the Company meets the burden of SFAS

133 and can properly implement hedge accounting, the

changes in the fair value of the derivative (interest rate

swap and/or cap) are deferred in accumulated other

comprehensive income (AOCI) until the forecastedtransaction being hedged is recognized in earnings. At

that point, that portion of the hedge that is deferred in

AOCI is transferred from AOCI to earnings andrecognized in the same category as the underlying item

being hedged; in this case, interest expense.


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Reporting

While it is outside of the scope of this webinar, the disclosure

requirements for derivatives and hedged activities changed as a

result of SFAS 161, Disclosures about Derivative Instruments and

Hedging Activities an Amendment of SFAS 133, which was

effective January 1, 2009.

In addition, SFAS 157, Fair Value Measurements, which was

effective for financial assets and liabilities on January 1, 2008,

requires certain disclosures as to the nature of the fair valuemeasurements of derivatives in the context of the SFAS 157 fair

value hierarchy (re level 1,2 or 3).


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Valuation

As just noted, SFAS 157, provides a fair value hierarchy under

which among other items, derivatives, must be measured anddisclosed.

Given that interest rate swaps and caps into which your companies

will enter will not be able to be valued by obtaining market quotes,the fair values must be estimated via cash flow and option pricingmodels.

Typically, your banker will provide a statement of the fair value ofthese instruments, however, if considered material in relation to yourfinancial statements, your auditors will need to audit that value and itis rare that the banker will provide them access to their pricingmodels as they are deemed to be proprietary.


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Valuation

Therefore, in the situation of a non-publicly traded entity,

the auditor maybe able to estimate the value of the

interest rate swap and/or cap for the Company, in the

context of auditing the confirmation received from the

bank. However, auditors cannot derive the valuation

assumptions for management.


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Valuation Interest Rate Swaps

Interest rate swaps are valued by taking the net presentvalue of the estimated cash flows over the life of theswap.

Given that the fixed rate payments are known, thevariable rate payments must be estimated.

The future variable rate payments can be estimated by extractingthe forward rates for the variable rate and using these as ourestimates of the variable rate that will be in effect at settlement.

By definition, a forward interest rate is the interest rate for afuture period of time that is implied by the interest rates

prevailing in the market today.


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Valuation Forward Rates

Forward Rates example

Forward rates are derived from the current rates in the market forexample:

3 month LIBOR = 2%

6 month LIBOR = 4% The implied 3 month LIBOR rate from the 4th 6th month is 6%.

This is because if an investor can invest $1,000 for 3 months @ 2% andcan invest for 6 months @ 4% then the sum of the three month periods

must be equivalent to the 6 month return of 4%. Therefore: the investor earns $20 for the 6 months at 4%, and earns $5

for the 3 months at 2%, then he must earn $15 for the second threemonths which is equivalent to a rate of 6%.

This is the logic being forward rates and how they are determined fromthe yield curve for the underlying base rate


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Valuation Interest Rate Swaps

Example1 2 3 4 5 6 7 8 9 10 11

Swap Rate: 2.60% Annualized Period Present

3 Month LIBOR 3 Month LIBOR Payer Receiver Value of

Total Period Notional Forward Forward Fixed Floating Net Discount NetDate Days Days Principal Rate Rate Cash Flow Cash Flow Cash Flow Factor Cash Flow

12/31/2008 $10,000,000

3/31/2009 90.00 90.00 $10,000,000 2.0000% 0.5000% ($64,110) $50,000 ($14,109.59) 0.99502 ($14,039)6/30/2009 181.00 91.00 $10,000,000 2.2500% 0.5625% ($64,822) $56,250 ($8,571.92) 0.98946 ($8,482)

9/30/2009 273.00 92.00 $10,000,000 2.5000% 0.6250% ($65,534) $62,500 ($3,034.25) 0.98331 ($2,984)12/31/2009 365.00 92.00 $10,000,000 2.7500% 0.6875% ($65,534) $68,750 $3,215.75 0.97660 $3,141

($22,364)

Therefore, based upon the following swap terms:

Notional Amount: $10,000,000

Swap Rate: 2.60%

Fixed Rate Payer: XYZ Company & Floating Rate Receiver Floating Rate Payer: ABC Bank & Fixed Rate Receiver

Settlement Every 3 months

Floating Rate: 3 month LIBORMaturity; 12/31/2009

The value of the interest rate swap to XYZ Bank, that is using the swap to hedge its 10,000,000 variable rate debt is ($22,364)

Which would be recorded as follows as of 12/31/08: AOCI $22,364ST Derivative Liability ($22,364)


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Valuation Interest Rate Cap

Given that interest rate caps are options, we must usean option pricing model to estimate the fair value thereof.

The most widely used option pricing model for interest

rate caps is a derivation of the Black Scholes OptionPricing model, called the Black Option Pricing model.


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Valuation Interest Rate Caps

While going through the math that is behind the valuation

of an interest rate cap using the Black Model is beyond

the scope of this webinar, we will touch upon the

variables that must be input / estimated for the Black

Model.


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flag = "caplet" for pricing European call options on interest rates

X = option strike price (e.g. 2.6%)

ndays = the number of days in the protection period ( = life of option)basis = the number of days used in the forward market for quoting interest rates

( e.g., 360 days or 365 days)

ep = length of the exposure period (also called the reset period), measured in

years (e.g., 0.5 yrs, or 2.75 yrs, etc.)

z = the continously compounded zero coupon rate over the exposure period

f = the forward rate over the protection (or reset period) periodVol = volatility of the forward interest rate

For example, suppose we want to cap the interest rate on a 182 day loan taken out

in 6 months. The six-month forward rate embedded in the yield curve today is 8% and

Exposure Period

t=0 t= 6

Protection

Period

t = 1 year

f =z=

Life of


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1 2 3 4 5 6 7 8 9 10 11 12 13 14

X ndays basis ep z f VolNotional: $10,000,000 # of Days # of Days (Reset zero Forward Volatility

Base Rate: 3 month LIBOR Option In In Fwrd Period) Rate for Rate for 3 mn LIBOR Value

Life of Strike Protection Market Exposure Exposure Protection Forward Caplet of

Period From To Days Caplet Price Period Quotes Period (yrs) Period (yrs) Period (yrs) Rate Price Caplet

31-Dec-08 31-Mar-09 90.00 0.3 2.60% 90.0 360.0 2.00% 60.00%

1 1-Apr-09 30-Jun-09 90.00 0.5 2.60% 90.0 360.0 0.3 2.25% 2.25% 60.00% 0.0003628 $3,6282 1-Jul-09 30-Sep-09 91.00 0.8 2.60% 91.0 360.0 0.5 2.38% 2.50% 60.00% 0.0009437 $9,437

3 1-Oct-09 31-Dec-09 91.00 1.0 2.60% 91.0 360.0 0.8 2.50% 2.75% 60.00% 0.0015457 $15,457

$28,522

Therefore, in this example, the Company has purchased an interest rate cap for a period

of 1 year, with 3 remaining settlements. The notional amount is $10,000,000 and the cap rate is $2.60%.

Given the forward rate curve as of 12/31/08 (hypothetical not actual), and an estimated volatiltiy

of the 3 month LIBOR of 60%, the total value of the entire interest rate cap agreement is $28,522


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Derivatives - Taxation

While this webinar is not specifically coming from the income tax

perspective, generally derivatives and hedging activities becometaxable events upon the realization of gains and losses (i.e. theunrealized gains and losses from mark to market of derivatives arenot taxable events).

Generally, for Federal income tax purposes, the cost basis of optionpremiums are amortized over the life of the option to expense.

However, as always, you should consult your tax advisor prior to

entering into any derivatives or hedging transactions.


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Interest Rate Swaps Current Market Rate

Given the decrease in interest rates experienced over the past year,

the current index for swap rates is very low from a historicalperspective.

Current swap rate (www.federalreserve.gov) 5/18/09 Fixed for 3

month LIBOR 1 yr = .85%

2 yr = 1.25%

3 yr = 1.74%

4 yr = 2.14%

5 yr = 2.44%

7 yr = 2.88%

10 yr = 3.22%


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CBIZ MHM, LLC

We are available to consult with you in terms of your

current, projected, and/or desired implementation of aninterest rate risk hedging program.

Accounting and Reporting (disclosures)

Effectiveness testing

Valuation

Structuring

Sensitivity Analyses


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