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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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.

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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

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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)

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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.

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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.)

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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

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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

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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!