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CBIZ & MHM Executive Education Series™

Co-Sponsored by Abacus Valuation and Risk Management Inc.

Strategies and Pitfalls for Hedging with Interest Rate Swaps Mike Loritz of MHM Greg Vermeychuk and Tom McGourn of Abacus Valuation and Risk Management Inc. March 24 & April 11, 2017

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About CBIZ & MHM

• Together, CBIZ & MHM are a Top Ten accounting provider • Offices in most major markets • Tax, audit and attest and advisory services • Over 2,900 professionals nationwide

A member of Kreston International A global network of independent

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MHM (Mayer Hoffman McCann P.C.) is an independent CPA firm that provides audit, review and attest services, and works closely with CBIZ, a business consulting, tax and financial services provider. CBIZ and MHM are members of Kreston International Limited, a global network of independent accounting firms.

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Before We Get Started…

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CPE Credit

This webinar is eligible for CPE credit. To receive credit, you will need to answer periodic participation markers throughout the webinar. External participants will receive their CPE certificate via email immediately following the webinar.

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Disclaimer

The information in this Executive Education Series course is a brief summary and may not include all

the details relevant to your situation.

Please contact your service provider to further discuss the impact on your business.

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Presenters

Mike has 18 years of experience in public accounting with diversified

financial companies and other service based companies, including

banking, broker/dealer, investment companies, and other diversified

companies ranging from audits of public entities in the Fortune 100 to

small private entities.

He is a member of MHM's Professional Standards Group, providing

accounting knowledge leadership in the areas of derivative financial

instruments, financial instruments, share-based compensation, fair

value, revenue recognition and others.

913.234.1226 • mloritz@cbiz.com

MIKE LORITZ, CPA MHM Shareholder

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Presenters

Tom McGourn is a co-Owner and Principal Consultant at Abacus

Valuation and Risk Management Inc. Previous to this, he was a portfolio

manager for several proprietary derivatives trading firms on the floors

of the Philadelphia and American Stock Exchanges. He successfully

transitioned from the trading floor to Senior Vice President of Write

Capital Management, LLC, responsible for the daily management of an

equity option overlay strategy on a portfolio in excess of $300 million.

Tom has held various positions as Portfolio Manager, Equity Option

Specialist and Head Specialist Clerk for trading companies. Tom holds a

B.A. in Economics with a concentration in Accounting and Finance from

Rutgers University in New Jersey. He is a Chartered Financial Analyst

(CFA). Tom has served on the Philadelphia Stock Exchange’s Rules and

Admission committees and is an active member of the CFA Institute.

Through the CFA Society of Philadelphia, he is the founder of a Member

to Member Derivatives Discussions Group and is a member of its

Education Committee.

THOMAS McGOURN Principal Consultant,

Abacus

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Presenters

Greg Vermeychuk is co-Owner and Principal Consultant of Abacus Valuation and Risk Management Inc. He has extensive experience in the valuation of swaps, options, futures and structured products. He has over 30 years of experience in university teaching and research, mathematical modeling and simulation of complex dynamical systems, optimization of closely coupled systems, large program and financial management. He served as a Consultant to the RAND Corporation of Santa Monica, CA, where he developed and conducted strategic simulations for the Department of Defense. While employed by a major specialty chemical producer and defense contractor, Dr. Vermeychuk devised and implemented a hedging program to stabilize the cost of an agriculturally derived raw material.

After leaving corporate life, Dr. Vermeychuk founded, built and sold two successful companies in the specialty chemical sector. Dr. Vermeychuk holds a BS in Chemical Engineering from Carnegie-Mellon University, and a PhD in Chemical Engineering with a concentration in Applied Mathematics from Princeton University, where he was a National Science Foundation Fellow and a Wallace Memorial Fellow in Engineering. He is also a Chartered Alternative Investment Analyst (CAIA) and a Financial Risk Manager (FRM).

GREG VERMEYCHUK Principal Consultant,

Abacus

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HEDGE ACCOUNTING

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What is Hedging?

• From an economic standpoint; • Hedging is using derivative instruments to offset risks

(or volatility, as defined as variability in economic results) that are present in an entity’s business model.

• From an accounting standpoint; • There are specific criteria that must be met prior to a

company’s implementation of hedge accounting.

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What is Hedging?

• Derivatives that are accounted for as investments are recorded at fair value and marked to market at each reporting date with the change recorded in earnings.

• Provided that the requisite hedging criteria are met, derivatives that are accounted for as hedges are also recorded at fair value; however, the accounting for the derivatives is based upon the type of hedge that has been implemented.

• It should be noted that regardless of whether hedge accounting is utilized, ALL derivatives are recorded on the balance sheet at their estimated fair value.

• For accounting purposes, there are generally 3 types of hedges: • Fair value hedge • Cash flow hedge • Foreign currency hedge

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What is Hedging?

• Fair value hedge – Economic purpose is to enter into a derivative instrument whose changes in fair value directly offset the changes in fair value of the hedged item.

• Cash flow hedge – Economic purpose is to enter into a derivative

instrument whose gains and losses on settlement directly offset the losses and gains incurred upon settlement of the transaction being hedged. The Company is hedging the forecasted transactions that are highly expected to occur in the future.

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What is Hedging?

Cash flow hedge • In a cash flow hedge, the effective portion of the gain or loss

on a derivative instrument designated and qualifying as a cash flow hedging instrument shall be reported as a component of other comprehensive income (outside of earnings) and • The gain/loss is then reclassified into earnings in the same period

or periods during which the hedged forecasted transaction affects earnings.

• Any portion of the derivative instrument that is designated as a cash flow hedge that is determined to be ineffective should be recognized in earnings immediately.

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Requirements for utilization of hedge accounting

An entity may designate a derivative instrument as a fair value, cash flow, or foreign currency hedge if:

• At the inception of the hedge, there is formal documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge, including: • Identification of the hedging instrument • Identification of the hedged item or forecasted transaction(s) • Identification of how the hedging instrument’s effectiveness in

offsetting the exposure to changes in the hedged item’s fair value (fair value hedge) or the hedged transaction’s variability in cash flows (cash flow hedge) attributable to the hedged risk will be assessed. There must be a reasonable basis for how the entity plans to assess the hedging instrument’s effectiveness.

• And:

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Requirements for utilization of hedge accounting

• Both at the inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving • A) offsetting changes in the fair value attributable to the hedged

risk during the period that the hedge is designated (in the case of a fair value hedge) or

• B) offsetting cash flows attributable to the hedged risk during the term of the hedge (in the case of a cash flow hedge).

• An assessment of effectiveness is required whenever financial statements or earnings are reported; at least every three months.

• All assessments of effectiveness must be consistent with the originally documented risk management strategy for that particular hedging relationship.

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A CLOSER LOOK AT DERIVATIVES AND HEDGING

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Derivatives for Responsible Users

• Derivatives are in common, widespread use. Stock Options, Grain Futures, Financial Futures and Options, etc.

• A derivative is any financial instrument whose value is dependent (derived from) the value of another instrument.

• The underlying instrument can be just about anything. • Structure can range from very simple to super-complex. • Traded either on Exchanges and Over The Counter • Two classes of use:

o Hedging = Limitation of risk inherent in a position in the underlying. o Speculation = An outright bet based upon a view of the market.

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Two Characteristics Make Derivatives Both Useful and Dangerous

• Leverage: A large amount of underlying is controlled with a small initial deposit. Both GAINS and LOSSES are magnified.

• Volatility: Prices of derivatives generally move over a wider percentage range than prices of the underlying instrument or commodity.

• The combination can lead to large and rapid losses for the careless or uninformed.

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Hedging with Derivatives = Insurance

• Any Asset or Liability carries Market Risk.

o Physical Commodities: Risk of falling market prices.

o Bonds: Market value moves inversely to interest rates.

o Payables and/or receivables in foreign currency: Dollar value fluctuates up and down with the exchange rate.

o Floating Rate Debt: When interest rate goes up, more cash is required to service the debt.

• A Derivative Position whose value moves an equal amount in an opposite direction can be set up for little or no cost. This is insurance protection. This is hedging.

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Synthetic Purchase or Sale with Futures or Forwards

• Problem: You need 25,000 lb. of high grade copper at the end of July 2017. The price is $2.6243 per lb. today. You want to lock in your price against market fluctuations for budgetary and quotation purposes.

• Solution: You buy a July 2015 futures contract on the Chicago Mercantile Exchange which specifies delivery of 25,000 lb. for $2.6400 per lb. This price is now locked in. It requires $3,100 to maintain the contract.

• The futures contract expires on July 28. On that date, the futures price = the spot price. Gain (Loss) on the futures contract = (Loss) Gain on the physical transaction. You pay $2.64, no more, no less.

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Conversion of Floating Rate to Fixed Rate Debt

• Problem: You are a privately held company with a BB credit rating. You need a 5-year, $10,000,000 loan. You cannot go to the bond market, so you get a floating rate loan from a New York bank. The terms call for an interest payment every 6 months at LIBOR + 160 basis points. Principal is due at loan maturity. At the inception of the loan, the LIBOR rate is 1.42%, so your interest rate for the first six months is 3.020% and the payment is $151,000. You do not know what the LIBOR will be in 6 months, so you do not know what your interest payment will be.

• Solution: You obtain a “pay-fixed-receive-floating” interest rate swap with 6 month resets at flat LIBOR. Your swap dealer quotes the 5-year swap rate at 2.060%. The swap requires no up-front payment. Every six months, you receive a payment of (LIBOR / 2) x $10,000,000. You pay the bank the amount you receive from the swap plus (0.0120/2) x 10 Mil. = $60,000. You pay the swap counterparty (0.02060/2) x 10 Mil. = $103,000. Your fixed semi-annual payment requirement is $60,000 + $103,000 = $163,000. This never increases. Your effective interest rate is 3.260%.

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Conversion of Floating Rate to Fixed Rate Debt

• The conversion of floating interest rate to fixed has both a cost and a benefit. If the LIBOR goes above 2.060% in the next five years, you will still pay the fixed amount originally specified in the swap agreement.

• If the LIBOR rate remains below 2.060% or declines over the next five years, you will have paid out more in interest than you would have under the original floating rate terms.

• Under the fixed rate regime, you are assured of a maximum interest rate that you will pay, plus the rate is fixed and predictable. This is good for planning and budgeting.

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How a Simple Interest Rate Swap Works

Illustration Courtesy of Wikipedia®

A borrows floating LIBOR + 150 bp B borrows fixed at 8.50%

A converts from floating to fixed, B converts from fixed to floating.

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A Look at Interest Rates

6 month LIBOR vs. Time – Source: Bloomberg

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How Banks Make Money on Swaps

Illustration Courtesy of Wikipedia®

The bank takes a cut of 15 bp from each side for a profit of 30 bp total.

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How Swaps are Priced - I

• Floating leg is flat LIBOR by convention. • When banks borrow, they borrow from other banks. LIBOR is the

rate. • We must specify the start date, end date, and reset frequency. • Swap is priced (fixed leg rate) to have ZERO present value at start

date. • Once the swap starts, the value changes along with interest rates.

• Yield curves: all based on LIBOR

• Zero Curve: Yield of a zero-coupon bond traded today. • Forward Curve: Rate for X months, starting Y months in the future. • Swap Curve: Rate which makes a swap for Y months with resets every X

months have Zero Net Present Value today. • Each may be derived from any other.

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Example of a Yield Curve

USD Sovereign STRIPS: 6/30/2016 and 1/03/2017 Source: Bloomberg

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How Swaps are Priced - II

• Calculate floating leg cash flows at reset dates using the LIBOR forward rates.

• Discount floating leg cash flows back to contract date. • Set up fixed leg cash flows at all reset dates as a function of the fixed rate

(swap rate). • Discount fixed leg cash flows back to contract date using “risk-free" rate.

• Set fixed rate (swap rate) so that NPV of the swap is ZERO at contract date.

• The swap rate then depends upon the term of the swap and the LIBOR

forward curve. • Before the financial crisis of 2007-2008, both the fixed and floating leg cash

flows were discounted using the same LIBOR forward rates used to calculate the floating leg cash flows.

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How Swaps are Priced – Dual Curve Discounting

The TED Spread – 3 mo LIBOR over 13 wk T-Bill

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Dual Curve Discounting

• Since the Crisis, LIBOR is not considered as a proxy for a “risk-free” rate.

• It is now common practice to use LIBOR to calculate cash flows, and discount with the Overnight Indexed Swap (OIS) rate.

• The OIS rate at any time is the fixed rate of a swap which resets daily at the overnight Sovereign rate. In the USA, this is the Effective Federal Funds Rate.

• In other countries and for other currencies, the analogous overnight Sovereign rate is used.

• Swaps are the most prevalent form of derivative. They are highly liquid and rates are quoted continuously by services such as Bloomberg.

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Selected Interest Rates

0.00000

0.20000

0.40000

0.60000

0.80000

1.00000

1.20000

1.40000

1.60000

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00

Selected Interest Rates 9/30/2016

USD 6mo LIBOR

USD SA 30/360 Swap

USD OIS Zero

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Risks of Swaps

• Swaps are OTC products. The guarantee of payment depends upon the credit quality of the counterparty.

• Swaps are less risky than a loan or a bond. The notional value (principal) never changes hands. Maximum risk is for one periodic payment. In the event of default, the swap terminates.

• The value of the swap is zero at inception. However, the value may become positive or negative over time, depending on the evolution of interest rates.

• Swaps may be traded in the secondary market. It is important to be able to mark a swap properly.

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Swaps and Accounting

• Swap Accounting is governed by ASC Topic 815 “Derivatives and Hedging”.

• Swaps may be used as either CASH FLOW or FAIR VALUE hedges. • If a swap is categorized as “Highly Effective” under ASC 815, any gain

(loss) in the value of the swap is recorded under Other Comprehensive Income (OCI).

• The easiest way to insure that a swap is “Highly Effective” is to design it so that it fits the “Critical Terms Matching” requirement, and is eligible for the “shortcut method.” The use of “Hedge Accounting” is beneficial to all concerned.

• Critical Terms: • Benchmark Interest Rate • Life of the swap vs life of the hedged item (loan, bond, etc.) • Reset frequency and reset dates. These should match perfectly. • Notional Value

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33

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Swap Pitfalls to Avoid

0.0000

0.2000

0.4000

0.6000

0.8000

1.0000

1.2000

1.4000

1.6000 USD LIBOR

US0006M

US0003M

US0001M

Mismatch of Reset Frequency between the Hedged Item and the Swap 10bp x $10,000,000 x 5 years = $50,000

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Another Swap Pitfall

• Leading or lagging reset dates compared to the hedged item.

• Volatility of LIBOR rates in 2016: • 3mo 12.6% • 6mo 11.4%

• In one month, the 3mo rate moved as much as 14 bp. • In one month, the 6mo rate moved as much as 22 bp.

• During periods of rising or falling rates, it is necessary

for reset dates and frequencies to match in order to guarantee hedge effectiveness.

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Real World Mismatch

• Loan: $264 Million, LIBOR + 250, Resets on 5/3 and 11/3 • Swap: $110 Million, Pays Flat LIBOR, Resets on 9/30 and 3/30

Actual and Projected USD 6mo LIBOR

Curve Date 5/3/2016 9/30/2016 11/3/2016 3/30/2017 5/3/2017 9/30/2017 11/3/2017

5/3/2016 0.90415% 1.05300% 1.16730% 1.26470% 9/30/2016 1.23363% 1.24170% 1.26360% 1.27260% 1.31190% 1.31170% 11/3/2016 1.25656% 1.28375% 1.36313%

Difference of 2.3 bp x $110 Million for 6 months = $11,500 In 2016, the Difference could have been up to 22 bp.

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Key Takeaways

• Interest rate swaps are a powerful and effective tool to reduce risk. • Stabilize cash flows by converting floating rates to fixed. • Stabilize fair values by converting fixed rates to floating.

• Verify your net present value at inception. It should always be zero.

• Shop around for OTC instruments. Pricing may vary. • Simplify your accounting by using Critical Terms Matching. • Avoid mismatches in reset dates and frequencies.

• They complicate your accounting. • They could cost you a lot of money.

• Derivatives are valuable and useful tools – IF you know how to

use them.

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How Abacus Can Help You

• We know swaps, options, futures and other derivatives. • We have experience in both valuation and trading. • We know ASC 815 and how to apply it. • We can design an effective hedging program for you. • We can advise you on how to manage your financial risks. • We can evaluate the proposals of banks and other OTC dealers. • We can set up and manage a customized program for you.

• The Client has full ownership of all assets in the program. • There is full disclosure of all positions, gains and losses.

• We work in the best interests of the Client at all times.

We invite you to visit our website: www.abacusvalrisk.com

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Thank you for your time and attention. We welcome your questions.

Please contact us:

tom@abacusvalrisk.com greg@abacusvalrisk.com

Thank You!

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