In 2017 my Website was migrated to
the clouds and reduced in size.
Hence some links below are broken.
One thing to try if a “www” link is broken is to substitute “faculty” for “www”
For example a broken link
http://www.trinity.edu/rjensen/Pictures.htm
can be changed to corrected link
http://faculty.trinity.edu/rjensen/Pictures.htm
However in some cases files had to be removed to reduce the size of my Website
Contact me at rjensen@trinity.edu if
you really need to file that is missing
FAS 133
and IAS 39 Glossary and Transcriptions of Experts
Accounting for Derivative Instruments and Hedging
Activities
Bob Jensen at Trinity University
Warning 1: Many of the links were broken when
the FASB changed all of its links. If a link to a FASB site does not work
, go to the new FASB link and search for the document. The FASB home page
is at http://www.fasb.org/
Warning 2: The DIG documents are not yet available in the
Codification Database, but they can now be accessed at http://www.fasb.org/derivatives/
Over 300 pages of DIG pronouncements can be downloaded from
http://www.fasb.org/derivatives/allissuesp2.pdf
Warning 3: Some of 2018 updates are not factored into the
modules of this document
Kawaller: 2018 Update on Hedge Accounting Rules
---
https://www.cpajournal.com/2018/04/11/update-on-hedge-accounting-rules/
For reference you might link your students to my glossary at
http://faculty.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm
From the IFRS Report Newsletter on the AICPA on February 6, 2014
IASB completes hedge-accounting model
The
International Accounting Standards Board has completed its hedge-accounting
model to be added to IFRS 9 Financial Instruments. The principles-based
standard is intended to reflect risk-management activities more closely in
financial statements. Key areas of change include more identifiable risk
components, a reduced burden of proving the efficacy of a hedge and changes
in accounting for the time value of an option.
Financial Director (U.K.) (1/16)
Jensen Comment
Put another way the IASB yielded to pressures to go soft on rules to allow hedge
accounting. If you are looking for differences between IFRS versus FASB
standards, this is one of the biggest differences in accounting standards. If it
intended to disclose more about risk management activities dropping
the previous IAS 39 requirement to identify and possibly bifurcating embedded
derivatives is a loser. Reduced standards on testing for hedge effectiveness is
another huge loser.
Accounting Standard Convergence Dreams Turning Into Divergence Reality in
IFRS 9
From the CPA Newsletter on April 3, 2014
Convergence efforts flounder on IFRS 9
The
International Accounting Standards Board and the Financial Accounting
Standards Board have not been able to come to an agreement on a common
financial-instruments accounting standard (that includes accounting for
derivative financial instruments and hedging actictivities). Hans
Hoogervorst, IASB chairman, said regulators could impose additional
disclosures to bridge the gap, but one IASB member opined that the failure
to achieve convergence on IFRS 9 was a "terrible disappointment" for global
investors.
Financial Director (U.K.)
(3/5)
http://r.smartbrief.com/resp/fHeJBYbWhBCCfUknCidmwjCicNRoKW?format=standard
Jensen Comment
I blame a lot of this divergence on the unwillingness of the IASB to standup to
the EU lawmakers who in turn are unwilling to resist the lobbying efforts of
thousands on European banks who want weaker standards for financial instruments
and less costly accounting standards to implement, e.g., wanting to avoid the
costs of discovering and bifurcating embedded derivative clauses in financial
instrument contracts. Aside from ignoring embedded financial instruments risk
the milk toast accounting of hedging effectiveness is a real softening of IAS 39
that will soon move into IFRS 9.
Bob Jensen's threads on hedge accounting are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
From the CPA Newsletter on
November 6, 2014
From the IFRS Report Newsletter on the AICPA on February 6, 2014
IASB completes hedge-accounting model
The International Accounting Standards Board has completed its
hedge-accounting model to be added to IFRS 9 Financial Instruments. The
principles-based standard is intended to reflect risk-management activities
more closely in financial statements. Key areas of change include more
identifiable risk components, a reduced burden of proving the efficacy of a
hedge and changes in accounting for the time value of an option.
Financial Director (U.K.) (1/16)
From the CFO Journal's Morning Ledger on February 12, 2014
Companies unclear on EU derivatives rules.
New reporting requirements for over-the-counter derivatives trades
in Europe take effect today, but companies are still uncertain about whether
the regulation applies to them, according to a survey by Chatham Financial.
The European Market Infrastructure Regulation, known as EMIR, requires
European and multinational companies to report over-the-counter and listed
derivatives transactions with an EU-recognized trade repository. To comply,
CFOs will need to report more than 60 data points for each transaction, and
will also need to choose a repository,
Saranya Kapur notes.
They may also decide to contract with a third party or delegate reporting
responsibility to their bank counterparties, if all of their trade
counterparties agree to take on the operational responsibility.
Jensen Comment
The bottom line is that the forthcoming IAS 9 is replete with
"principles-based" subjectivity ---
http://faculty.trinity.edu/rjensen/Theory01.htm#BrightLines
Put another way the IASB yielded to pressures to go soft on rules to allow hedge
accounting. If you are looking for differences between IFRS versus FASB
standards, this is one of the biggest differences in accounting standards. If it
intended to disclose more about risk management activities dropping
the previous IAS 39 requirement to identify and possibly bifurcating embedded
derivatives is a loser. Reduced standards on testing for hedge effectiveness is
another huge loser.
Jensen Comment
Hedge accounting is one of the areas where the IASB departed dramatically from
the very complicated FAS 133 and its subsequent amendments ---
PwC: IFRS and US GAAP:
similarities and differences - 2014 edition (224 pages) ---
Click Here
http://www.pwc.com/us/en/cfodirect/issues/ifrs-adoption-convergence/ifrs-and-us-gaap-similarities-and-differences.jhtml?display=/us/en/cfodirect/issues/accounting-reporting
Table of contents
Importance of being financially bilingual 4
IFRS first-time adoption 7
Revenue recognition 11
Expense recognition—share-based payments 30
Expense recognition—employee benefits 41
Assets—nonfinancial assets 54
Assets—financial assets 80
Liabilities—taxes 102
Liabilities—other 114
Financial liabilities and equity 123
Derivatives and hedging 139
Consolidation 157
Business combinations 177
Other accounting and reporting topics 185
IFRS for small and medium-sized entities 205
FASB/IASB project summary exhibit 209 Noteworthy updates 211
Index 215
Similarities and Differences
- A comparison of IFRS for SMEs and 'full IFRS' ---
http://www.pwc.com/en_GX/gx/ifrs-reporting/pdf/Sims_diffs_IFRS_SMEs.pdf
FASB: Important Differences in
Accounting for Embedded Derivatives in FAS 133 Versus IFRS 9
http://www.iasplus.com/en-us/standards/ifrs-usgaap/embedded-derivatives
ASC = Accounting Standard Codification of the FASB
January 8, 2013 message from Zane Swanson
Another
faculty person created a video (link follows)
http://www.screencast.com/t/K8gruSHTv
which
introduces the ASC. This video has potential value at the beginning of
the semester to acquaint students with the ASC. I am thinking about
posting the clip to AAA commons. But, where should it be posted and
does this type of thing get posted in multiple interest group areas?
Any
thoughts / suggestions?
Zane Swanson
www.askaref.com a handheld device source of
ASC information
Jensen Comment
A disappointment for colleges and students is that access to the Codification
database is not free. The FASB does offer deeply discounted prices to colleges
but not to individual teachers or students.
There are other access routes that are not free such as the PwC Comperio
---
http://www.pwc.com/gx/en/comperio/index.jhtml
Hi Zane,
This is a great video helper for learning
how to use the FASB.s Codification database.
An enormous disappointment to me is how the
Codification omits many, many illustrations in the
pre-codification pronouncements that are still available
electronically as PDF files. In particular, the best way to
learn a very complicated standard like FAS 133 is to study
the illustrations in the original FAS 133, FAS 138, etc.
The FASB paid a fortune for experts to develop
the illustrations in the pre-codification pronouncements. It's
sad that those investments are wasted in the Codification
database.
What is even worse is that accounting teachers are
forgetting to go to the pre-codification pronouncements for
wonderful illustrations to use in class and illustrations for CPA
exam preparation ---
http://www.fasb.org/jsp/FASB/Page/PreCodSectionPage&cid=1218220137031
Sadly the FASB no longer seems to invest as much
in illustrations for new pronouncements in the Codification database.
Bob Jensen
Examples of great FAS 133 pre-codification illustrations are as follows:
133ex01a.xls 12-Jun-2008 03:50 345K
133ex02.doc 17-Feb-2004 06:00 2.1M
133ex02a.xls 12-Jun-2008 03:48 279K
133ex03a.xls 04-Apr-2001 06:45 92K
133ex04a.xls 12-Jun-2008 03:50 345K
133ex05.htm 04-Apr-2001 06:45 371K
133ex05a.xls 12-Jun-2008 03:49 1.5M
133ex05aSupplement.htm 26-Mar-2005 13:59 57K
133ex05aSupplement.xls 26-Mar-2005 13:50 32K
133ex05d.htm 26-Mar-2005 13:59 56K
133ex06a.xls 29-Sep-2001 11:43 123K
133ex07a.xls 08-Mar-2004 16:26 1.2M
133ex08a.xls 29-Sep-2001 11:43 216K
133ex09a.xls 12-Jun-2008 03:49 99K
133ex10.doc 17-Feb-2004 16:37 80K
133ex10a.xls
133summ.htm 13-Feb-2004 10:50 121K
138EXAMPLES.htm 30-Apr-2004 08:39 355K
138bench.htm 07-Dec-2007 05:37 139K
138ex01a.xls 09-Mar-2001 13:20 1.7M
138exh01.htm 09-Mar-2001 13:20 31K
138exh02.htm 09-Mar-2001 13:20 65K
138exh03.htm 09-Mar-2001 13:20 42K
138exh04.htm 09-Mar-2001 13:20 108K
138exh04a.htm 09-Mar-2001 13:20 8.2K
138intro.doc 09-Mar-2001 13:20 95K
138intro.htm 09-M
Others ---
http://www.cs.trinity.edu/~rjensen/
Warning 3: The international standard IAS 39 has been
amended many times and continued to be amended. The IASB tends to change
paragraph numbers with many of its amendments and directly amends the preceding
version of a standard. Hence some of the IAS 39 paragraphs quoted in this
glossary may be relocated and/or altered in the latest and greatest version of
IAS 39. IAS 39 changes will eventually be contained in IFRS 9.
Warnign 4: IFRS 9 Anemia
U.S. GAAP Financial Reporting Taxonomy Now Available (2014 Glossary and
XBRL)---
http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176163688345
Bob Jensen's threads on XBRL ---
http://faculty.trinity.edu/rjensen/XBRLandOLAP.htm
"A Look at the IASB’s Draft of Hedge Accounting Requirements,"
Deloitte via the CFO Journal, October 19, 2012 ---
http://deloitte.wsj.com/cfo/2012/10/19/a-look-at-the-iasbs-draft-of-hedge-accounting-requirements/
Jensen Comment
This is the most extensive review I've seen of the proposed IFRS 9 departures
from IAS 39 in terms of hedge accounting. It covers such things as when a
financial instrument can get get hedge accounting previously restricted to
derivative financial instruments. Many of the changes are quite technical. The
bottom line is that IFRS 9 will allow much more subjective judgment for hedge
accounting. In my opinion, this will make financial statements potentially less
comparable between companies and thereby destroys to some extent the argument
that having global accounting standards increases the comparability in financial
reporting.
FAS 133 (as amended a number of times), IAS 39 (as amended a number of times)
and IFRS 9 (still being written) are arguably the most difficult accounting
standards to teach and apply in practice. The major problems are the
technicalities of the accounting added on top of the complicated technicalities
of understanding how derivative financial instruments affect financial risks in
the management of such risks in both the public and private sectors (e.g.,
government pension funds use derivatives to manage risks and possibly even
speculate).
Deloitte's review does not go far in helping you understand the forthcoming
IFRS 9. It goes a long ways in showing you how you're going to have to spend a
lot more time and possibly money to understand IFRS 9 before you will ever be
able to teach IFRS 9 to students.
The bad news is that hedge accounting will continue to have the worst
coverage of all accounting standards in intermediate accounting textbooks.
The good news is that hedge accounting is probably too complicated to ever
become a worrisome hurdle in Chartered Accountancy Examinations, CPA
examinations, and other certification examinations. Hedge accounting is
something you must learn on your own and on the job. IAS 39 was very similar to
FAS 133, FAS 133/138 originally had some great illustrations where I learned
most of what I know about hedge accounting. Sadly, the FASB eliminated most of
those great illustrations when it moved to the Codification database. Boo on the
FASB for this! Some of my Excel tutorials on those illustrations can be found in
the listing of files at
http://www.cs.trinity.edu/~rjensen/
Also see
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Sadly, I probably will not be updating my tutorials for IFRS 9 --- hey I'm
supposed to be retired!
Bob Jensen's free tutorials on hedge accounting ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
References for Comparisons of IFRS versus U.S. GAAP
From Ernst & Young in November 2012
US GAAP versus IFRS: The basics
While convergence was a high priority for the FASB and the IASB in 2012,
differences continue to exist between US GAAP and IFRS. In this guide, we
provide an overview by accounting area of where the standards are similar, where
differences are commonly found in practice, and how and when certain differences
are expected to disappear
http://www.ey.com/Publication/vwLUAssetsAL/IFRSBasics_BB2435_November2012/$FILE/IFRSBasics_BB2435_November2012.pdf
Jensen Comment
This is only a 54-page cocument. I still prefer the somewhat older but much
longer PwC document.
Older links to such comparisons:
US GAAP versus IFRS: The basics
2011 Edition, 56 Pages
Free from Ernst & Young
http://www.ey.com/Publication/vwLUAssetsAL/IFRSBasics_BB2280_December2011/$FILE/IFRSBasics_BB2280_December2011.pdf
IFRS and US GAAP: Similarities and Differences
2011 Edition, 238 Pages
From PwC
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
From Deloitte
Comparisons of IFRS With Local GAAPS
http://www.iasplus.com/dttpubs/pubs.htm#compare1109
IFRS and US GAAP
July 2008 Edition, 76 Pages
http://www.iasplus.com/dttpubs/0809ifrsusgaap.pdf
Jensen Comment
At the moment I prefer the PwC reference
My favorite comparison topics (Derivatives and
Hedging) begin on Page 158 in the PwC reference
The booklet does a good job listing differences but, in my opinion, overly
downplays the importance of these differences. It may well be that IFRS is more
restrictive in some areas and less restrictive in other areas to a fault. This
is one topical area where IFRS becomes much too subjective such that comparisons
of derivatives and hedging activities under IFRS can defeat the main purpose of
"standards." The main purpose of an "accounting standard" is to lead to greater
comparability of inter-company financial statements. Boo on IFRS in this topical
area, especially when it comes to testing hedge effectiveness!
One key quotation is on Page 165
IFRS does not specifically discuss the
methodology of applying a critical-terms match in the level of detail
included within U.S. GAAP.
Then it goes yatta, yatta, yatta.
Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and
more importantly fails to provide "implementation guidance" comparable with the
FASB's DIG implementation topics and illustrations.
PwC: Download:
IFRS and US GAAP: similarities and differences - 2015 edition
---
http://www.pwc.com/us/en/cfodirect/assets/pdf/accounting-guides/pwc-ifrs-us-gaap-similarities-and-differences-2015.pdf
Bob Jensen's Threads on Controversies in Accounting Standard Setting ---
http://faculty.trinity.edu/rjensen/theory01.htm#MethodsForSetting
Similarities and Differences - A comparison of IFRS for SMEs and 'full IFRS'
---
http://www.pwc.com/en_GX/gx/ifrs-reporting/pdf/Sims_diffs_IFRS_SMEs.pdf
Bob Jensen's threads on accounting for derivative financial instruments
and hedging activities ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
PwC Dataline: Accounting for centrally cleared derivatives Understanding
the accounting implications of Dodd-Frank Title VII (No. 2013-30) ---
Click Here
http://www.pwc.com/us/en/cfodirect/publications/dataline/2013-30-centrally-cleared-derivatives.jhtml?display=/us/en/cfodirect/publications/dataline&j=346566&e=rjensen@trinity.edu&l=621246_HTML&u=15025430&mid=7002454&jb=0
Dodd-Frank Title VII (Dodd-Frank) significantly
changed the trading requirements for derivative instruments, such as
mandating that certain derivatives be centrally cleared.
A number of financial reporting implementation
questions have arisen as companies consider the Dodd-Frank requirements.
These include determining fair value of centrally cleared derivatives,
accounting for collateral, assessing the impact on hedge accounting, and
determining the appropriate presentation (gross versus net).
This Dataline discusses the financial reporting
implications of the new requirements, primarily focusing on end-users that
trade in the affected derivatives and who do not qualify for the end-user
exception.
Continued in article
Bob Jensen's threads on accounting for derivative financial instruments
and hedging activities ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
"IASB Previews New Hedge Accounting Rules," by Emily Chason, CFO
Report, September 7, 2012 ---
http://blogs.wsj.com/cfo/2012/09/07/iasb-previews-new-hedge-accounting-rules/?mod=wsjpro_hps_cforeport
The draft is available from the IASB ---
Click Here
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Phase-III-Hedge-accounting/Pages/Draft-of-IFRS-General-Hedge-Accounting.aspx
Jensen Comment
Today I must leave early in the morning to take Erika to Concord for a medical
treatment. I've not yet had time to read the above draft in detail. It appears,
however, that this draft for IFRS 9 retains changes in IAS 39 that are
objectionable to me relative to what I think is better in FAS 33 as amended.
Firstly, the thrust of the IFRS 9 changes will be to add more subjectivity
(relative to FAS 133), especially in the area of hedge effectiveness testing.
For example, if a farmer has hedges a growing crop of corn, he is likely to do
so on the basis of standardized corn quality of corn futures and options trading
on the CBOT or CME. It is unlikely that the corn that he ultimately takes to
market will have the identical quality moisture content. In addition he will
have trucking costs of getting his corn from say South Dakota to the trading
market in Chicago. As a result of all this, his hedging contract acquired in
June on the CBOT or CME exchange is not likely to be perfectly effective
relative to the corn he brings to market in October. Thus there will be
hedging ineffectiveness.
The original IAS 39, like FAS 133, had some bright line tests for the degree
to which hedge accounting was allowed when there is hedge ineffectiveness. See
the slide show illustrations at
www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/06effectiveness.ppt
There is greater likelihood that in a particular instance of hedge
ineffectiveness, the original IAS 39 would result in Client A having identical
accounting for the hedge ineffectiveness as Client B. Under the new IFRS 9 this
becomes less assured since clients are given considerable subjective judgment in
deciding how to deal with hedge ineffectiveness.
Also under FAS 133, embedded derivatives in financial contracts must be
evaluated and if the embedded derivative's underlying is not "clearly and
closely related" to the underlying in the host contract, the embedded
derivatives must be bifurcated and accounted for separately. This leads to a lot
of work finding and accounting for embedded derivatives. IFRS 9 will eliminate
all that work by not making clients look for embedded derivatives. Hence, the
risk that comes from having embedded derivative underlyings not clearly and
clossely associated with the underlyings of the host contract can simply be
ignored. I don't by into this IFRS 9 bad accounting for the sake of
simplification.
I think there are other areas of difference expected differences between IFRS
9 and FAS 133 as amended. Most of the differences lie in the subjectivity
allowed in accounting for hedging contracts under IFRS 9 that is not allowed in
FAS 133.
September 10, 2012 reply from Bob Jensen
This afternoon received a message from PwC about the IASB's proposed
changes to hedge accounting. The PwC reply is consistent with, albeit
somewhat more extensive, then my reply that I sent to the AECM early this
morning.
The PwC response is at ---
Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8Y2HHH&SecNavCode=MSRA-84YH44&ContentType=Content
Note that the IASB is not really opening up these proposed hedge
accounting amendments to comments. Wonder why?
Also note that the proposed IASB's amendments diverge from rather than
converge toward U.S. GAAP under FAS 133 as amended. At this point in time I
don't think the IASB really cares about convergence of hedge accounting
rules.
My quick and dirty response is that the revised hedge accounting
standards under IFRS 9 is carte blanche for having two different clients and
their auditors account differently for identical hedge accounting
transactions because so much subjectivity will be allowed under IFRS 9. We
may even have subsidiaries of the same client accounting for identical
transactions differently.
Such is the myth of comparability one is supposed to get under
principles-based global standards.
Further more, it may challenge auditing Firm X that has one client
claiming a hedge is effective when another client would claim the hedge is
ineffective. Will auditing Firm X certify divergent accounting for the same
hedge. The answer is probably yes these days if both clients are too big to
lose.
Bob Jensen
So Much for the Myth That Accounting Standards Are Neutral in Terms of
Business Strategy (of course it did not take IFRS 9 to reveal this to us)
"Under New Accounting Standard, CFOs Could Change Hedging Strategies:
Will finance chiefs come under more pressure to adopt hedge accounting — even
though it remains entirely optional under the new standard?"
by Andrew Sawyers
CFO.com, September 12, 2012
http://www3.cfo.com/article/2012/9/gaap-ifrs_hedge-accounting-ias-39-iasb-ifrs-derivatives-80-125-test-hedge-effectiveness
A new international financial reporting standard (IFRS) on hedge
accounting could prompt finance chiefs to change their companies’
hedging strategies under a more accommodating, principles-based regime
that requires less testing.
The International Accounting Standards
Board (IASB) has been pondering hedge accounting for several years in an
effort to find a way to replace the unloved standard IAS 39: so unloved
that it’s not part of the package of accounting standards endorsed by
the European Commission for listed companies. The standard has made it
tough to employ hedge accounting, which can be favorable to companies in
certain circumstances.
In
a recent podcast, Kush Patel, director in
Deloitte’s U.K. IFRS Centre of Excellence, summarized the impact of the
new rules: “More hedge-accounting opportunities,
less profit and loss volatility — so as
you’d expect, this has been well received.”
Under IAS 39, he said, “we saw a lot of companies change the way they
manage risk: we saw them reduce the amount of complex, structured
derivatives that were being used to hedge and they went for more vanilla
instruments that could [qualify for] hedge accounting more easily. Now
that IFRS 9 will remove some of these restrictions, I think it’s fair to
say risk management could change.”
Andrew Vials, a technical-accounting partner at KPMG, said in a
statement, “A company will be able to reflect in its financial
statements an outcome that is
more consistent with how management assesses and mitigates risks
for key inputs into its core business.”
Will CFOs come under more pressure to adopt hedge accounting — even
though it remains entirely optional under the new standard? “If hedge
accounting becomes easier, there may be more emphasis on them to achieve
hedge accounting — so although it’s voluntary, there is an element that
they may feel more compelled to do hedge accounting” says Andrew
Spooner, lead global IFRS financial-instruments partner at Deloitte.
The
final draft of the new hedge-accounting rules
was published on September 7 and will be incorporated into the existing
IFRS 9 Financial Instruments at the end of the year. The IASB
says it’s not seeking comments on this final draft, but is making it
available “for information purposes” to allow people to familiarize
themselves with it. The new rules will take effect from January 1, 2015,
but companies will be allowed to adopt them sooner if they wish.
Spooner and Patel note three main areas in which the new rules are
different from the old:
Changes to the instruments that qualify. It’s now
easier, for example, to use option contracts without increasing
income-statement volatility.
Changes in hedged items. It may not be possible, for
example, for a company to hedge the particular type of coffee beans a
food company buys. But it could hedge a benchmark coffee price, because
it is closely related to the item it would like to hedge. Another change
for the better: companies in the euro zone that want to hedge dollar
purchases of oil can now more easily hedge the dollar price of the oil,
then later hedge the foreign-exchange exposure without the oil-price
hedge being deemed ineffective. There are also more favorable rules for
hedging against credit risk and inflation.
Changes to the hedge-effectiveness requirements.
Under IAS 39, a company could use hedge accounting only if a hedge is
“highly effective,” meaning it must be capable of offsetting the risk by
a range of 80%–125%. But the 80–125 test has been scrapped to be
replaced by a principle-based test that is based on economic
relationship: “You have to prove that there is a relationship between
the thing you are hedging and the thing you are using,” says Patel.
Having gotten rid of the quantitative threshold, there are “more
opportunities for companies to reduce the amount of testing they do,” he
says. “It’s a welcome change.”
Continued in article
"IASB Previews New Hedge Accounting Rules," by Emily Chason, CFO
Report, September 7, 2012 ---
http://blogs.wsj.com/cfo/2012/09/07/iasb-previews-new-hedge-accounting-rules/?mod=wsjpro_hps_cforeport
The PwC response is at ---
Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8Y2HHH&SecNavCode=MSRA-84YH44&ContentType=Content
The draft is available from the IASB ---
Click Here
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Phase-III-Hedge-accounting/Pages/Draft-of-IFRS-General-Hedge-Accounting.aspx
Bob Jensen's free tutorials on accounting for derivative financial
instruments and hedging activities ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Accounting for Derivative Financial Instruments and Hedging Activities
Hi Patricia,
The bottom line is that accounting authors, like intermediate textbook
authors, provide lousy coverage of FAS 133 and IAS 39 because they just do not
understand the 1,000+ types of contracts that are being accounted for in those
standards. Some finance authors understand the contracts but have never shown an
inclination to study the complexities of FAS 133 and IAS 39 (which started out
as a virtual clone of FAS 133).
My 2006 Accounting Theory syllabus before I retired can be viewed at
http://faculty.trinity.edu/rjensen/acct5341/acct5341.htm
There are some great textbooks on derivatives and hedging written by finance
professors, but those professors never delved into the complexities of FAS 133
and IAS 39. My favorite book may be out of print at the moment, but this was a
required book in my theory course: Derivatives: An Introduction by Robert A
Strong, Edition 2 (Thomson South-Western, 2005, ISBN 0-324-27302-9)
Professor Strong's book provides zero about FAS 133 and IAS 39, but my
students were first required to understand the contracts that they later had to
account for in my course. Strong's coverage is concise and relatively simple.
When first learning about hedging, my Trinity University graduate students
and CPE course participants loved an Excel workbook that I made them study at
www.cs.trinity.edu/~rjensen/Calgary/CD/Graphing.xls
Note the tabs on the bottom that take you to different spreadsheets.
There are some really superficial books written by accounting professors who
really never understood derivatives and hedging in finance.
Sadly, much of my tutorial material is spread over hundreds of different
links.
However, my dog and pony CD that I used to take on the road such as a
training course that I gave for a commodities trading outfit in Calgary can be
found at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/ T
his was taken off of the CD that I distributed to each participant in each CPE
course, and now I realize that a copyrighted item on the CD should be removed
from the Web.
In particular, note the exam material given at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/
My students had access to this material before they took my exams.
Note that some of the illustrations and exam answers have changed over time.
For example, the exam material on embedded derivatives is still relevant under
FASB rules whereas the IASB just waved a magic wand and said that clients no
longer have to search for embedded derivatives even though they're not "clearly
and closely related" to the underlyings in their host contracts. I think this is
a cop out by the IASB.
Links to my tutorials on FAS 133 and IAS 39, including a long history of
multimedia, can be found at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Probably the most helpful thing I ever generated was the glossary at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
What made me the most money consulting in this area can be found at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
But the core of what I taught about derivatives and hedge accounting in my
accounting theory course can be found in the FAS 133 Excel spreadsheets listed
near the top of the document at
http://www.cs.trinity.edu/~rjensen/
I also salted my courses with real world illustrations of scandals regarding
derivatives instruments contracts, a continuously updated timeline of which is
provided at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Hope this helps. Once again you may want to look at the exam material at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/
The bottom line is that accounting authors like intermediate textbook authors
provide lousy coverage of FAS 133 and IAS 39 because they just do not understand
the 1,000+ types of contracts that are being accounted for in those standards.
Some finance authors understand the contracts but have never shown an
inclination to delve into the complexities of FAS 133 and IAS 39 (which started
out as a virtual clone of FAS 133).
Respectfully,
Bob Jensen
Question
What could possibly be wrong with mark-to-market accounting for financial
instruments and derivative financial instruments?
Hint
It's called "asymmetric accounting" and the topic has been debated over an over
again on the AECM (largely by Tom Selling versus Bob Jensen). This is also a
topic that I recently recommended that Marc introduce to his "logic" analysis of
fair value accounting for financial securities.
"GAAP IS CRAP: THE CASE OF JP MORGAN," by Anthony H. Catanach and J. Edward
Ketz, Grumpy Old Accountants Blog, May 31, 2012 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/694
Abraham Briloff complained that sometimes the
accounting standard setters do a pathetic job by creating rules that enhance
the ability of managers to manage earnings. At those times, he indicated
that
GAAP becomes cleverly rigged accounting ploys.
The CRAP acronym is tart, but precise.
David Reilly has written an excellent example of
this proposition in his Wall Street Journal article, “Heard
on the Street: J.P. Morgan, Hedges and ‘Asymmetric Accounting.’”
The issue pivots on the use of portfolio hedging and the “asymmetric
accounting” that arises when the portfolio hedge is accounted for by
mark-to-mark accounting, and at least some of the hedged items are treated
as available for sale securities. This situation creates a mismatch in the
accounting for these items, thereby potentially subjecting an entity to
large gains or losses in the derivative, while gains or losses of the hedged
items bypass the income statement, and going directly into stockholders’
equity.
David Henry also has a nice essay about this chain
of events, entitled “JPMorgan
Chase Sells $25 Billion in Securities To Offset ‘London Whale’ Losses.”
He quotes former SEC Chief Accountant Lynn Turner who
said JP Morgan made two stupid mistakes. They did not comprehend the risks
they took with these complex derivatives and they covered half the losses
with gains from high income assets that they no longer enjoy.
Jamie Dimon addressed these issues in a corporate
conference call on May 10, 2012. From an edited transcript of this
conference call by Thomson Reuters StreetEvents, we read these comments by
Mr. Dimon:
Continued in article
Jensen Comment
Below is a reply that I wrote years ago on the AECM
If a student asks why FAS 133 had to become so
complicated tell them that it's because of the difference between
economists and accountants. Economists allow hedging even when hedged
items have not been booked by accountants. This causes all sorts of
misleading accounting outcomes if hedge accounting relief is not
provided for derivative contracts that are hedges rather than
speculations.
Students may still ask why FAS 133 became the most complicated
accounting standard in the history of the world.
Before FAS 133, companies were getting away with enormous
off-balance-sheet-financing (OBSF) with newer types of derivative
financial instruments. FAS 80 covered booking of options and futures
contracts, but forward contracts and swaps were not booked when they
were either speculations or hedges. After interest rate swaps were
invented by Wall Street n the 1980s, for example, swap contracting took
off like a rocket in worldwide finance. Trillions of dollars in swap
debt were being transacted that were not even booked until FAS 133 went
into effect in the 1990s.
Originally the FASB envisioned a relatively simple FAS 133. Most
derivative financial instruments contracts (forwards, swaps, futures,
and options) would be initially booked at fair value (with is zero in
most instances except for options) and then reset to changed fair value
at least every 90 days. All changes in value would then be booked as
current earnings or current losses. Sounds simple except for some dark
problems of trying to value some of these contracts.
But then, in the exposure draft period, companies made the FASB aware of
an enormous problem that arose because of a difference between
economists and accountants. Economists invented hedging contracts
without caring at all whether a hedged items were booked or not booked
by accountants. For example, the hedged item might be a forecasted
transaction by Corp X to issue $100 million in bond debt at spot rates
ten months from now. Economists showed Corp X how to hedge the cash flow
risk of this unbooked forecasted transaction with a forward contract or
swap contract.
Perfect hedges have zero effect on accounting earnings volatility
when both the hedged item and its hedging derivative contract are booked
by accountants --- such as when existing booked debt is changed from
floating rate debt to fixed rate debt with an interest rate swap
derivative contract.
Perfect hedges could have an enormous effect on earnings volatility when
the hedged item is not booked and the hedging derivative contract
is booked. For example, all changes up and down in the fair value of the
booked derivative contracts would not be offset in the books by
changes in value of the unbooked hedged items even though from an
economics standpoint there is no change in economic earnings when
changes in value of the booked derivative contract are perfectly offset
by changes in value of the unbooked hedged item.
And most hedging circumstances are such that the hedging contract is
booked under FAS 133 and the hedged item is not booked such as
forecasted purchases of jet fuel by Southwest Airlines over the next two
years.
Companies that hedged unbooked assets or liabilities would thereby
punished with enormous accounting earnings volatility when they
hedged economic earnings. The FASB ultimately agreed that this was
misleading and thereby introduced hedge accounting relief in FAS 133
by keeping changes in the booked value of hedging contracts out of
booked current earnings. For cash flow hedges and foreign currency
hedges this is accomplished by using OCI. OCI is not used for fair
value hedging, but hedge accounting relief is provided for fair
value hedges in other ways. Look up fair value hedging under "Hedge"
at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#H-Terms
Because there are thousands of types of hedging contracts, FAS 133
became the most complicated standard ever issued by the FASB. It's
the only standard that became so complicated that an implementation
group (called the DIG) was organized by the FASB to field
implementation questions by auditors and their clients. DIG
pronouncements, in turn, became so complicated that at times most
accountants could not understand these pronouncements. DIG links are
surrounded by red boxes at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
One of the most difficult aspects of FAS 133 is that hedge
accounting relief is allowed only to the extent that hedges are
effective. Hedges are seldom perfectly effective in terms of value
changes at interim points in time even though they may be perfectly
effective when hedges mature. Hedge effectiveness tests have become
extremely complicated. FAS 133 still has some bright lines whereas
the IASB in IFRS 9 is making hedge effectiveness testing principles
based in IFRS 9. That's like giving an alcoholic a case of booze
every week.
Thus if a student asks why FAS 133 had to become so complicated tell
them that it's because of the difference between economists and
accountants. Economists allow hedging even when hedged items have
not been booked by accountants. This causes all sorts of misleading
accounting outcomes if hedge accounting relief is not provided for
derivative contracts that are hedges rather than speculations.
Respectfully,
Bob Jensen
Warning 4: In 2009, the FASB and the IASB are
contemplating huge changes in FAS 133 and IAS 39.
SERIOUS Doubts Over Proposed Changes to FAS 133 and IAS 39
The FASB proposes dubious changes in FAS 133 on Accounting for Derivative
Financial Instruments and Hedging Activities while the IASB is studying similar
changes in IAS 39. With the SEC currently sitting on the fence in deciding if
and when to replace FASB standards with IASB standards, I fully predict that IAS
39 will pretty much follow the revise FAS 133 as it did when IAS 39 was
initially adopted, although IAS 39 will continue to have wider coverage of
financial instruments in general whereas FAS 133 will narrowly focus on
derivative financial instruments and hedge accounting.
When the FASB initially signaled possible revisions for changing hedge
accounting rules in FAS 133, a wave of protests from industry hit the fan. The
article below is the response of Ira Kawaller who serves on the FASB's
Derivatives Implementation Group (DIG) and who is one of the leading consultants
on FAS 133 and hedging in general which is his where he has historic roots as a
PhD in economics ---
http://www.kawaller.com/about.shtml
Ira has written nearly 100 trade articles on FAS 133. I don't think he consults
on IAS 39. Ira's home page is at
http://www.kawaller.com/about.shtml
Ira also maintains a small hedge fund where he walks the talk about interest
rate hedging. However, I'm no expert on hedge funds and will not comment on any
particular hedge fund.
I might note in passing for enthusiasts of the new FASB Codification Database
for all FASB standards that FAS 133 coverage in the Codification database is
relatively sparse. Professionals and students in hedge accounting most likely
will have to connect back to original (non-codified) FASB literature. For
example, none of the wonderful illustrations in Appendices A and B of FAS 133
are codified. And the extremely helpful, albeit complicated, pronouncements of
the FASB's Derivatives Implementation Group (DIG) are excluded from the
Codification database ---
http://www.fasb.org/derivatives/
Most of the DIG pronouncements are included in context at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
I will never have a lot of respect for the Codification database until it
includes much, much more on FAS 133.
Below is a publication in which Dr. Kawaller presents serious doubts
regarding revisions to FAS 133 that the FASB is now considering (and the IASB is
now considering for IAS 39).
The problem is even more severe for entities
with fixed-rate exposures. In this case, there’s a clear disconnect between what
swaps are designed to do versus what the FASB requires for hedge accounting.
"Paved With Good Intentions: The Road to Better
Accounting for Hedges," The CPA Journal, August 2009 ---
http://www.kawaller.com/pdf/CPA_Paved_w_Good_Intent_Aug_2009.pdf
With 10 years of
experience under the current regime of accounting for derivative contracts and
hedging transactions, the FASB has determined that it’s time to make some
adjustments. Accountants should be wary of the changes. Besides affecting the
accounting procedure relating to these instruments and activities, the proposed
changes may also seriously impact the manner in which certain derivative hedges
are structured— particularly in connection with interest rate risk management
activities.
Accounting rules for
derivatives and hedging transactions were put forth by the FASB in SFAS 133,
Accounting for Derivative Instruments and Hedging Activities. This standard was
initially issued in June 1998. It has been amended twice since then, with
relatively minor adjustments, but in 2008 the FASB issued a more substantive
exposure draft with significant proposed changes. Although the comment period on
this exposure draft is over, the project appears to be in limbo. Proposed
changes have neither been accepted nor rejected. Further adjustments are likely
to be made as the FASB moves to harmonize U.S. accounting guidance with
International Financial Reporting Standards (IFRS). When attention turns to
derivatives, this latest exposure draft could very likely serve as a starting
point. The prospective decisions about the accounting treatment for these
derivatives could have a profound impact on the structure and composition of
derivatives transactions
The Current Standard SFAS
133 has long been recognized as one of the most complicated accounting standards
the FASB has ever issued. A core principle of this standard is that derivative
instruments must be recognized on the balance sheet as assets or liabilities at
their fair market value. The critical issue, then, is the question of how to
handle gains or losses. Should they be reported in current income or elsewhere?
Ultimately, SFAS 133 ended up providing different answers for different
situations. The “normal” treatment simply requires gains and losses recognized
in earnings. This treatment, however, is often problematic for companies that
use derivatives for hedging purposes. For such entities, the preferred treatment
would recognize gains or losses of derivatives concurrently with the earnings
impacts of the items being hedged. The normal accounting treatment generally
won’t yield this desired result, but the alternative “hedge accounting” will.
For purposes of this
discussion, attention is restricted to the two primary hedge accounting types:
cash flow and fair value. For cash flow hedges, the exposure being hedged (i.e.,
the hedged item) must be an uncertain cash flow, forecasted to occur in a later
time period. In these cases, effective gains or losses on derivatives are
originally recorded in other comprehensive income (OCI) and later reclassified
from OCI to earnings when the hedged item generates its earnings impact.
Ineffective results are recorded directly in earnings. In essence, this
accounting treatment serves to defer the derivatives’ gains or losses—but only
for the portion of the derivatives’ results that are deemed to be effective—thus
pairing the earnings recognition for the derivative and the hedged item in a
later accounting period.
Continued in article
Bob Jensen and Tom Selling have been having an active, to say the least,
exchange over hedge accounting where Tom Selling advocates elimination of all
hedge accounting (by carrying all derivatives at fair value with changes in
value being posted to current earnings). Bob Jensen thinks this is absurd,
especially for derivatives that hedge unbooked transactions such as forecasted
transactions or unbooked purchase contracts for commodities. Not having hedge
accounting causes asymmetric distortions of earnings where the changes in value
of the hedging contracts cannot be offset by changes in value of the (unbooked)
hedged items. You can read more about our exchanges under the terms "Insurance
Contracts" at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#I-Terms
Scroll down to "Insurance Contracts"
Message from Ernst & Young on February 10, 2011
To the Point: Hedge accounting - FASB seeks
reaction to IASB's proposed model
The FASB is seeking comment on the IASB's December
2010 hedge accounting proposal. The proposed IASB model would significantly
change hedge accounting, going well beyond the changes the FASB proposed
last year. Notably, the IASB proposes allowing hedges of components of
non-financial risk (e.g., commodity risk) and hedges of net positions that
share a common risk. Based on the feedback it receives, the FASB will
contemplate whether (and how) to incorporate the IASB's ideas into the
FASB's hedging model. Comments are due by 25 April 2011.
Reply from Bob Jensen to the AECM on February 10, 2011
The problem in the Academy is that nearly all
accounting professors do not understand IAS 39 well enough to even
comprehend the awful changes that are being proposed.
I think that the myth that the IASB is trying to make hedge accounting more
transparent and less complex is just that --- a myth.
In the message below Ernst & Young does not mention my biggest gripe about
the IASB's proposal. Replacing hedge effectiveness guidelines (such as the
80-125 dollar offset guideline in IAS 39) with ambiguities does not
constitute simplification. What it really does is complicate both the task
of auditing and the task of financial statement analysis.
Ernst & Young does hit hit on two changes below that also greatly complicate
auditing and financial statement analysis.
.
The IASB proposed changes are yet another illustration that "the road to
hell is paved with good intentions."
The problem in the Academy is that nearly all accounting professors do not
understand IAS 39 well enough to even comprehend the awful changes that are
being proposed.
Respectfully,
Bob Jensen
Bob Jensen's tutorials on FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Differences
(Comparisons) between FAS
133 and IAS 39/IFRS 9 ---
http://faculty.trinity.edu/rjensen/caseans/canada.htm
2011 Update
"IFRS and US GAAP: Similarities and Differences" according to PwC
(2011 Edition)
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
Note that warnings are given throughout the document that the similarities and
differences mentioned in the booklet are not comprehensive of all similarities
and differences. The document is, however, a valuable addition to students of
FASB versus IASB standard differences and similarities.
It's not easy keeping track of what's changing and
how, but this publication can help. Changes for 2011 include:
- Revised introduction reflecting the current
status, likely next steps, and what companies should be doing now
(see page 2);
- Updated convergence timeline, including
current proposed timing of exposure drafts, deliberations, comment
periods, and final standards
(see page 7);
- More current analysis of the differences
between IFRS and US GAAP -- including an assessment of the impact
embodied within the differences
(starting on page 17); and
- Details incorporating authoritative standards
and interpretive guidance issued through July 31, 2011
(throughout).
This continues to be one of PwC's most-read
publications, and we are confident the 2011 edition will further your
understanding of these issues and potential next steps.
For further exploration of the similarities and
differences between IFRS and US GAAP, please also visit our
IFRS Video Learning Center.
To request a hard copy of this publication, please contact your PwC
engagement team or
contact us.
Jensen Comment
My favorite comparison topics (Derivatives and Hedging) begin on Page 158
The booklet does a good job listing differences but, in my opinion, overly
downplays the importance of these differences. It may well be that IFRS is more
restrictive in some areas and less restrictive in other areas to a fault. This
is one topical area where IFRS becomes much too subjective such that comparisons
of derivatives and hedging activities under IFRS can defeat the main purpose of
"standards." The main purpose of an "accounting standard" is to lead to greater
comparability of inter-company financial statements. Boo on IFRS in this topical
area, especially when it comes to testing hedge effectiveness!
One key quotation is on Page 165
IFRS does not specifically discuss the methodology
of applying a critical-terms match in the level of detail included within
U.S. GAAP.
Then it goes yatta, yatta, yatta.
Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and
more importantly fails to provide "implementation guidance" comparable with the
FASB's DIG implementation topics and illustrations.
I have a
huge beef with the lack of illustrations in IFRS versus the many illustrations
in U.S. GAAP.
I have a
huge beef with the lack of illustrations in IFRS versus the many illustrations
in U.S. GAAP.
I have a huge beef with the lack of illustrations in
IFRS versus the many illustrations in U.S. GAAP.
Bob Jensen's threads on accounting standards setting controversies ---
http://faculty.trinity.edu/rjensen/Theory01.htm#MethodsForSetting
2010 IASB Exposure Draft
"IASB publishes exposure draft on hedge accounting," IAS Plus,
December 9, 2010 ---
http://www.iasplus.com/index.htm
The International Accounting Standards
Board (IASB) has published for public comment an exposure draft on the
accounting for hedging activities. The exposure draft proposes requirements
designed to enable companies to better reflect their risk management
activities in their financial statements, and, in turn, help investors to
understand the effect of those activities on future cash flows.
The proposed model is principle-based,
and is designed to more closely align hedge accounting with risk management
activities undertaken by companies when hedging their financial and
non-financial risk exposures.
Summary of the ED proposals
- A new hedge accounting model which
combines a management view that aims to use information produced
internally for risk management purposes and an accounting view
that seeks to address risk management issue of the timing of
recognition of gains and losses
- Look only at whether a risk component
can be identified and measured, as opposed to determining what
can be hedged by type of item (financial or non-financial)
- Base qualification for hedge
accounting on how entities design hedges for risk management
purposes and permit hedging relationships to be adjusted without
necessarily stopping and potentially restarting hedge accounting
- Treat the time value premium of a
purchased option as a cost of hedging, which will be presented
in other comprehensive income (OCI)
- Extending the use of hedge accounting
to net positions (to improve the link to risk management)
- A comprehensive set of new disclosures
that focus on the risks being hedged, how those risks are being
managed and the effect of hedging those risks upon the primary
financial statements
|
The exposure draft forms part of the
IASB’s
overall project to replace IAS 39 Financial Instruments: Recognition and
Measurement, and when its proposals are
confirmed they will be incorporated into
IFRS 9 Financial Instruments. The exposure
draft does not include consideration of portfolio macro hedge accounting
which the IASB will continue to discuss.
The exposure draft ED/2010/13 Hedge
Accounting is open for comment until 9 March 2011. The IASB intends to
finalise and issue the proposals during the first half of 2011.
Click for:
Jensen Comment
Because preparers and auditors complained over the years about the complexity of
IAS 39, the IASB in this ED mistakenly assumes that doing away with bright lines
in favor of ambiguity reduces complexity. But replacing bright lines with
ambiguity in and of itself creates more rather than less complexity. It is
analogous to replacing a bright line speed sign reading "20 mph maximum" with
"Drive Safely in this School Zone."
For example the ED replaces the bright line 80-125 rule for effectiveness
limits of in offset testing of effectiveness with ambiguity about when a hedge
of a hedged item should be deemed effective. Similarly, IAS 39 was relatively
clear about when portfolios of hedged items could be hedged as a portfolio. The
ED creates a very ambiguous term "Group Hedging" that is both ambiguous and
takes international hedge accounting further and further away from the U.S. FAS
133 standard that allows portfolio or group hedging in under vastly more
limiting and clear cut rules.
Effectiveness testing of purchased options used as hedging instruments is
pretty clear cut under FAS 133 and IAS 39. The new IASB ED complicates
accounting for the time values of options used for hedging purposes. It
introduces the concept of "aligned time value" which will really confuse most
auditors and financial analysts.
The net result will be that two different companies are likely to treat many
hedging contracts differently when applying hedge accounting under the revised
IFRS 9 into which FAS 39 is to be phased into IFRS 9. By introducing greater
ambiguity the price will be that comparability between financial statements of
different companies will be destroyed or highly uncertain.
I repeat that replacing bright lines with ambiguity may actually increase
complexity rather than reduce complexity. The complexity of hedge accounting
essentially arises from the immense complexity and variations of hedge
accounting contracts. IAS 39 was rooted in FAS 133 which I viewed as a good
standard, as amended, that provided more consisted accounting for
derivative financial instruments and hedging activities. The new IAS 39 ED is a
move in the wrong direction from FAS 133.
Greater ambiguity is not the solution to dealing with complexity. Ambiguity
does eliminate the main problems accountants have with derivatives when the main
problems are not really understanding derivatives rather than writing ambiguous
accounting standards for complex derivatives contracts.
Bob Jensen's reply to Pat Walter's assertion that the IASB and FASB should
just do away with hedge accounting alternatives and post all gains and losses on
derivative financial instruments.
Hi Pat,
Can you think of a better way to distinguish between speculating and hedging
in financial reporting? There's no distinction if hedge accounting relief is
not built into the standards. .
Also making accounting standards simple and easy to understand for
auditors should not trump the need for complications in accounting
standards. The FASB and IASB have never seriously considered simplifying FAS
133 and IAS 39 to take away special hedge accounting relief altogether. The
boards believe that investors will be misinformed by not making a
distinction between speculating in derivatives versus managing risk with
hedging derivatives. .
Historically, I think the FASB initially did not think that special hedge
accounting relief was necessary when FAS 133 was first being formulated. FAS
133 would've been about 50 pages long and no big deal other than some
technical problems of measuring derivative financial instrument fair values
of customized contracts traded over the counter rather than on exchanges.
Hedge accounting made FAS 133 and its amendments extended FAS 133 to over
700 pages long and requires that auditors learn about risk management
contracts they never had to understand prior to FAS 133 and IAS 39. .
It took about a NY minute for companies that manage risk by hedging, tens
of thousands of companies,to convince the FASB that this was far more than a
neutrality issue. What this could do is mask the information content value
of eps with with all that was to be gained by bringing derivative financial
instruments into the financial statements. .
For example, the genuine value of having eps vary with changes in value
of speculative derivative derivative contract investments (e.g., a
speculative call option on gold) could be totally obscured by a changes in
value of hedging contacts (e.g., a hedging option on gold) simply because
the changes in the value of unbooked hedged items could not offset the value
changes of their hedging contracts. .
In other words, not having hedge accounting could erase the value of
having changed accounting rules for speculators if there is no distinction
between hedging and speculating in FAS 133 and IAS 39. .
For this reason neither the FASB nor the IASB have seriously considered
doing away with special treatment for hedge accounting even though it
greatly complicates the lives of accountants and auditors. .
Your solution of doing away with hedge accounting certainly would make
the lives of auditors easier because then they really could sign off on
complicated derivatives contracts without truly having to understand those
contracts beyond the trouble of finding their fair values. .
Can you think of a better way to distinguish between speculating and
hedging in financial reporting?
Bob Jensen
Bob Jensen's free tutorials, audio clips, and videos on FAS 133 and IAS 39
are linked at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Warning 5: In February 2008 the FASB for
the first time allowed users free access to its "FASB Accounting Standards
Codification" database. Access will be free for at least one year, although
registration is required for free access. Much, but not all, information in
separate booklets and PDF files may now be accessed much more efficiently as
hypertext in one database. The Glossary below has not been updated for the
Codification Database. Although the database is off to a great start, there is
much information in this Glossary and in the FASB standards that cannot be found
in the Codification Database. You can read the following at
http://asc.fasb.org/asccontent&trid=2273304&nav_type=left_nav
Welcome to the Financial Accounting Standards Board
(FASB) Accounting Standards Codification™ (Codification).
The Codification is the result of a major four-year
project involving over 200 people from multiple entities. The Codification
structure is significantly different from the structure of existing
accounting standards. The Notice to Constituents provides information you
should read to obtain a good understanding of the Codification history,
content, structure, and future consequences.
The FASB's Accounting Standard Codification Online Database (FASCOD) ---
http://asc.fasb.org/home
I have been using FASCOD regularly, especially Section 815 on accounting for
derivative financial instruments and hedging. I find this quite easy to use and
appreciate the cross referencing to other standards. It would help in some
instances to also reference to the printed standards.
Although there are narrowed-down glossaries for some of the sections like
Section 815 (10)(S20), there is also a wonderful "Master Glossary" at
http://asc.fasb.org/glossary&nav_type=left_nav#null
When you are into a section's outline, especially note the "Collapse" and
"Expand" hot words that let you expand or collapse the outline for a desired
level of detail and links to illustrations. Some of the illustrations are new in
Section 815. Also there are links to SEC standards and interpretations that have
been added to the database.
I did encounter a problem trying to print FASCOD
quotations. For some reason, FASCOD pastes as hidden text. I could read it in a
MS Word document but not in Print Preview or in printed hard copy.
In MS Word I went to Tools, Options,
View and clicked on Hidden Text. That did not solve my problem --- not being
able to print FASCOD quotations. Then I went to Tools,
Options, Print and clicked on Hidden Text. That made my FASCOD
quotations appear in both Print Preview and hard copy.
FASB member
Tom Linsmeier
has been in charge of the FASCOD development. Tom indicates that his team was
unaware of the above hidden text problem that some users are having. He says
that his team is now looking into why the hidden text printing problem arose in
the first place. It may well be that the above problem for some of us will
disappear in the future.
Now if we only had such an IASCOD database for international standards. In
fairness, the IASB standards, interpretations, exposure drafts, and a glossary
can be downloaded into your computer and updated for an annual fee. This
database has useful cross referencing and database search features. In many ways
it is quite well done. However, it does not slice and dice content into better
codification schema.
The IASB has some political correctness issues when it appears to be copying
United States GAAP and/or technology. Hopefully the IASB will look at the
economics involved in developing FASCOD over four years with over 200
professionals and millions of dollars and decide that the codification schema
used by the FASB is suitable, with some tweaking, for the international
standards. Of course the actual IASCOD content will be international GAAP rather
than U.S. GAAP. It will still be a huge expense to slice and dice international
GAAP for purposes of IASCOD. It will also entail a change in delivery. IASCOD
will be served up online, whereas the current IASB database of standards,
interpretations, exposure drafts, etc. must be downloaded into each user's
computer for a fee initially and for annual updates.
The current IASB database can be downloaded from
http://www.iasb.org/Home.htm
I find that it is best to leave its red-circle icon as a Startup icon on my
computer screen (it could be just a bit smaller). Then it 's very easy to click
the database on and off. In some ways the downloaded IASB database is programmed
quite cleverly, especially the way it does database search. I give five stars
for its search engine.
I hope that the IASB will invest in more illustrations if and when it
develops IASCOD. One of the severe weaknesses of the IASB standards is that they
cannot compare with the FASB standards in terms of abundant and useful
illustrations. This is especially helpful for those of us in education and
training. For example, when teaching IAS 39 having very few illustrations, I
often run to FAS 133 and its amendments and DIGs for some illustrations. Now I
can turn to Section 815 of FASCOD for added illustrations.
A drawback of the current Section 815 FASCOD content is that it does not yet
have sliced and diced content of all the Derivative Implementation Group (DIG)
pronouncements. Hopefully the DIG's will be added soon to FASCOD.
Bob Jensen
"Framing the Future: A first look at FASB’s GAAP codification, by
Bruce Pounder, Journal of Accountancy, May 2008 ---
http://www.aicpa.org/pubs/jofa/may2008/fasb_gaap.htm
In less than a year, FASB’s Accounting Standards
Codification will affect the day-to-day work of nearly every CPA who
practices, teaches or researches accounting in accordance with U.S. GAAP.
By April 2009, FASB is expected to make the
codification the single source of authoritative GAAP, overriding all
existing literature. In other words, the codification content—not the
original pronouncements from which the content was derived—will be GAAP. And
the online codification research system—not books, loose-leaf services or
CDs—will be the primary way that accountants access GAAP.
For many historical reasons, GAAP has become a
minimally organized collection of many kinds of accounting pronouncements
issued by various standard setters over many decades, as well as “widely
recognized and prevalent” industry practices that are not the product of any
formal standard-setting process. The present components of GAAP vary greatly
in format, structure, completeness, authority and accessibility. As a
result, practicing CPAs and financial statement preparers who attempt to
apply GAAP often find themselves confused and frustrated. Likewise,
accounting students frequently struggle to learn GAAP.
If a standard setter were to develop a body of
accounting standards from scratch today, those standards presumably would
not resemble the challenging jumble that GAAP has become. Rather than start
from scratch, FASB has done the next best thing in an attempt to make GAAP
more understandable and user-friendly—FASB has sought to simplify the
structure of GAAP by codifying it.
In January, FASB released the Accounting Standards
Codification for public review and verification. The codification is not
merely a new entrant into the market for products and services designed to
help CPAs understand and apply GAAP. Rather, the codification completely
changes the way that GAAP will be documented, updated, referenced and
accessed. It organizes in an entirely new way thousands of existing
authoritative financial accounting and reporting standards and delivers the
content via an Internet based research system that helps users search and
access the material.
One often–overlooked aspect of the codification is
that it will eliminate or flatten the GAAP hierarchy. In other words, there
will be no more House of GAAP—no tiered structure with varying levels of
authority on each floor. Under the codification, there’s no distinction—all
standards are uniformly authoritative.
FASB expects that the codification will help
mitigate the risk of noncompliance with accounting standards, provide real
time updates as standards change and reduce the amount of time and effort
required to research accounting issues.
A MAJOR RESTRUCTURING The primary goal of the
codification project is not to change GAAP’s content, but rather to organize
it in a more useful way. The codification will contain all current,
authoritative accounting standards for nongovernmental entities that have
been issued by U.S. standard setters, including FASB, FASB’s Emerging Issues
Task Force (EITF), and the AICPA Accounting Standards Executive Committee (AcSEC).
Certain SEC guidance also is included.
The codification has, for the most part, left
standards unchanged. Appendix A of the Notice to Constituents, an overview
document on the codification Web site, highlights areas in which FASB is
recommending changes to standards to resolve conflicts in GAAP.
As used above, the word “authoritative” refers to
GAAP from levels A through D in the current GAAP hierarchy. Undocumented
industry practices and documented but-nonauthoritative guidance have been
excluded from the codification. Because there are some exceptions regarding
what is included in the codification, users are advised to consult FASB’s
Notice to Constituents.
The project effectively disassembled each existing
authoritative pronouncement and reassembled the pieces, organizing them into
approximately 90 topics. Contents in each topic are further organized first
by subtopic, then section and finally paragraph. The paragraph level is the
only level that contains substantive content; all higher levels in the
topical structure exist merely to organize the paragraph-level content.
Continued in article
Bob Jensen's threads on accounting theory and standard setting ---
http://faculty.trinity.edu/rjensen/Theory01.htm
Bob Jensen’s Amendment to the Teaching Note prepared by Smith and Kohlbeck for
the following case: “Accounting for Derivatives and Hedging Activities
Comparisons of Cash Flow Versus Fair Value Accounting,” by Pamela A. Smith and
Mark J. Kohlbeck
Issues in Accounting Education, Volume 23, Number 1, February 2008,
pp. 103-118
Bob Jensen's Amendment is at
http://faculty.trinity.edu/rjensen/CaseAmendment.htm
The DIG documents are not yet available in the
Codification Database, but they can now be accessed at http://www.fasb.org/derivatives/
Over 300 pages of DIG pronouncements can be
downloaded from http://www.fasb.org/derivatives/allissuesp2.pdf
For technical
details see the following book:
Structured Finance and Collateralized Debt Obligations: New Developments in
Cash and Synthetic Securitization (Wiley Finance) by Janet M. Tavakoli
(2008)
FAS 133
and IAS 39 Glossary and Transcriptions of Experts
Accounting for Derivative Instruments and Hedging
Activities
Bob Jensen at Trinity University
- Unlike many other nations that either did not have national accounting
standards or had weak and incomplete sets of standards, the FASB over the
years produced the best set of accounting standards in the world (although
there is no such thing a perfect set since companies are always writing
contracts to circumvent most any standard). The FASB standards were heavily
rule-based due to the continual battles fought by the FASB in the trenches
of U.S. firms seeking to manage earnings and keep debt of the balance sheet
with ever-increasing contract complexities such as interest rate swaps
invented in the 1980s, SPE ploys, securitization "sales," synthetic leasing,
etc.
- The experiences of those frazzled
executives in charge of reducing risks in the credit derivatives
market are starting to resemble Alice’s adventures in Wonderland.
Alice shrank after drinking a potion, but was then too small to
reach the key to open the door. The cake she ate did make her grow,
but far too much. It was not until she found a mushroom that allowed
her to both grow and shrink that she was able to adjust to the right
size, and enter the beautiful garden. It took an awfully long time,
with quite a number of unpleasant experiences, to get there.
Aline van Duyn, "The adventure never ends in the derivatives
Wonderland," Financial Times, September 11, 2008 ---
Click Here
- While Lehman Brothers was fighting for
its life in the markets today, it was also battling in a Senate
panel's hearing on whether the company and others created a set of
financial products whose primary purpose is to dodge taxes owned on
U.S. stock dividends. The "most compelling" reason for entering into
dividend-related stock swaps are the tax savings, Highbridge Capital
Management Treasury and Finance Director Richard Potapchuk told the
Senate's Permanent Subcommittee on Investigations. Lehman Brothers (nyse:
LEH - news - people ), Morgan Stanley (nyse: MS - news - people )
and Deutsche Bank (nyse: DB - news - people ) are among the
companies behind the products.
Anitia Raghaven, The Tax Dodge Derivative, Forbes, September
11, 2008 ---
Click Here
- What's Right and What's
Wrong With (SPEs), SPVs, and VIEs ---
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm
The FASB's Derivatives and
Hedging Glossary (in the
Accounting Standards Codification Database) ---
http://asc.fasb.org/subtopic&trid=2229141&nav_type=left_nav
Also see the
Codification Master Glossary at
http://asc.fasb.org/glossary&nav_type=left_nav#null
Timeline of scandals
and legislation leading up to FAS 133 and IAS 39
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Bob Jensen's CD ---
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
I'm sharing some old (well relatively old)
accounting theory quiz and exam material that I added to a folder at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
Question
What are hedge funds, especially after Bernie Madoff made them so famous?
When people ask me this question, my initial response is that a hedge fund no
longer necessarily has anything to do with financial risk hedging. Rather a
hedge fund is merely a "private" investment "club" that does not offer shares to
the general public largely because it would then subject itself to more SEC,
stock exchange, and other regulators. Having said this, it's pretty darn easy
for anybody with sufficient funds to get into such a "private" club. Minimum
investments range from $10,000 to $1,000,000 or higher.
Since Bernie Madoff made hedge funds so famous, the public tends to think
that a hedge fund is dangerous, fraudulent, and a back street operation that
does not play be the rules. Certainly hedge funds emerged in part to avoid being
regulated. Sometimes they are risky due to high leverage,
but some funds skillfully hedge to manage risk and are much safer than mutual
funds. For example, some hedge funds have shrewd hedging strategies to
control risk in interest rate and/or foreign currency trading.
Most hedge funds are not fraudulent. In general, however, it's "buyer beware"
for hedge fund investors.
I would never invest in a hedge fund that is not audited by a very reliable
CPA auditing firm. Not all CPA auditing firms are reliable (Bernie Madoff proved
you can engage a fraudulent auditor operating out of a one-room office). Hence,
the first step in evaluating a hedge fund is to investigate its auditor. The
first step in evaluating an auditor is to determine if the auditing firm is
wealthy enough to be a serious third party in law suits if the hedge fund goes
belly up.
But the recent multimillion losses of Carnegie Mellon, the University of
Pittsburgh, and other university endowment funds that invested in a verry
fraudulent hedge fund purportedly audited by Deloitte suggests that the size and
reputation of the auditing firm is not, by itself, sufficient protection against
a criminal hedge fund (that was supposedly given a clean opinion by Deloitte in
financial reports circulated to the victims of the fraud).
When learning about hedge funds, you may want to begin at
http://en.wikipedia.org/wiki/Hedge_Fund
"What is a hedge fund and how is it different from a mutual fund?" by
Andy Samuels, Business and Finance 101 Examiner, June 10, 2009 ---
Click Here
Jim Mahar pointed out this link.
Having migrated away from their namesake, hedge
funds no longer focus primarily on “hedging” (attempting to reduce risk)
because hedge funds are now focused almost blindly on one thing: returns.
Having been referred to as “mutual funds for the
super rich” by
investopedia.com, hedge funds are very similar to
mutual funds in that they pool money together from many investors. Hedge
funds, like
mutual funds, are also managed by a financial
professionals, but differ because they are geared toward wealthier
individuals.
Hedge funds, unlike mutual funds, employ a wider
array of ivesting techniques, which are considered more aggresive. For
example, hedge funds often use
leverage to amplify their returns (or losses if
things go wrong).
The other key difference between hedge funds and
mutual funds is the amount of regulation involved. Hedge funds are
relatively unregulated because investors in hedge funds are assumed to be
more sophisticated investors, who can both afford and understand the
potential losses. In fact, U.S. laws require that the majority of investors
in the fund are
accredited.
Most hedge funds draw in investors because of the trustworthy reputations of
the executives of the fund. Word-of-mouth praise and affiliations are often the
key to success. Bernie Madoff succeed in luring customers based on two leading
factors: (1) His esteemed reputation on Wall Street and (2) His highly
regarded connections in the Jewish community where he drew in most of his
victims.
Bob Jensen's threads on frauds are linked at
http://faculty.trinity.edu/rjensen/fraud.htm
In particular see
http://faculty.trinity.edu/rjensen/fraud001.htm
And see
http://faculty.trinity.edu/rjensen/FraudRotten.htm
"What’s a Couple of Hundred Trillion When You’re Talking Derivatives?"
by Floyd Norris, The New York Times, September 23, 2006 ---
http://www.nytimes.com/2006/09/23/business/23charts.html
Everett McKinley Dirksen, the Senate Republican
leader in the 1950’s, is supposed to have said, “A billion here and a
billion there, and pretty soon you’re talking real money.” What would he
have thought of derivatives today?
The International Swaps and Derivatives
Association, a trade group, reported this week that the outstanding nominal
value of swaps and derivatives at the end of June was $283.2 trillion.
Compare that with the combined gross domestic
product of the United States, the European Union, Canada, Japan and China,
which is about $34 trillion. The total value of all homes in the United
States is about the same amount.
To be sure, notional value is an exaggerated term
as it greatly overstates the amount at risk in many contracts. But the
growth rate is real, and in the fastest-growing area of swaps — credit
default swaps — notional value is closer to the amount at risk, because such
swaps promise to make up the losses if a borrower defaults on the notional
amount.
The value of outstanding credit default swaps
doubles every year — a trend that must eventually stop — and now equals $26
trillion. That is about the same as the total amount of bond debt in the
United States, and corporate debt, on which most credit swaps are traded,
comes to just $5.2 trillion.
The credit derivatives cover the risks of default
by individual companies, and offer insurance against default for bond
indexes and specified bond portfolios.
The growth of the market has forced the swaps and
derivatives association to change the way its credit swaps work. It used to
be that if a company defaulted, the writer of a credit swap would have to
pay par value for the bond he had guaranteed, and could then sell the bond
to reduce his losses.
But in some cases defaults led to bond rallies, as
those who had purchased credit swaps scrambled to get bonds to deliver. Now
traders can choose cash settlements, with the amounts to be paid determined
through auctions.
Until 1997, the association provided separate
numbers on currency and interest rate contracts, but innovations blurred the
distinction between those categories, and now it publishes a combined total.
At the end of June, the figure was $250.8 trillion, up 25 percent over the
previous 12 months.
Growth in that market slowed markedly early in this
decade, as worldwide markets cooled, and there was even one annual decline,
from mid-2000 to mid-2001. But growth picked up in 2002 as economies began
to recover.
The volume outstanding of equity derivatives is
rising by about 30 percent a year, and now totals $5.6 trillion. It could go
farther, with world stock market capitalization now about $41 trillion,
according to Standard & Poor’s.
Robert Pickel, the chief executive of the
association, said that the growth in derivatives enables “more and more
firms to benefit from these risk management tools.” On the other hand, the
situation allows more and more traders to load up on risk if they choose,
and hedge funds have become major derivatives traders.
The combination of large unregulated hedge funds
trading ever larger amounts of unregulated derivatives in nontransparent
markets makes some people nervous. But so far, anyway, little is being done
to change the situation, and nothing devastating has happened to markets.
Continued in article
Jensen Comment
One of the main differences between a "financial instrument" versus a
"derivative financial instrument" is that the notional is generally not at risk
in a "derivative financial instrument." For example if Company C borrows $600
million from Bank B in a financial instrument, the notional amount ($600
million) is at risk immediately after the notional is transferred to Company C.
On the other hand, if Company C and Company D contract for an interest rate swap
on a notional of $600 million using Bank B as an intermediary, the $600 million
notional never changes hands. Only the swap payments for the differences in
interest rates are at risk and these are only a small fraction of the $600
million notional. Sometimes the swap payments are even guaranteed by the
intermediary, thereby eliminating credit risk.
So where's the risk of a derivative financial instrument that caused all the
fuss beginning in the 1980s and led to the most complex accounting standards
ever written (FAS 133 in the U.S. and IAS 39 internationally)?
Often there is little or no risk if the derivative contracts are held to
maturity. The problem is that derivatives are often settled before maturity at
huge gains to one party and huge losses to the counterparty. For example, if
Company C swaps fixed-rate interest payments on $600 million (having current
value risk with no cash flow variation risk) for variable-rate interest payments
on $600 million (having cash flow variation risk but no market value variation
risk), Company C has taken on enormous cash flow risk that may become very large
if interest rates change greatly in a direction not expected by Company C.
If Company C wants to settle its swap contract before
maturity it may have to pay an enormous amount of money to do so either to
counterparty Company D or to some other company who will take the swap off the
hands of Company C. The risk is not the $600 million notional; Rather the risk
is in the shifting value of the swap contract itself which can be huge even if
it is less than the $600 million notional amount.
Perhaps derivative financial instrument risk is even better illustrated by
futures contracts. Futures contracts are traded on organized exchanges such as
the Chicago Board of Trade. If Company A speculates in oil futures on January 1,
there is no exchange of cash on a 100,000 barrel notional that gives Company A
the right to sell oil at a future date (say in one year) at a forward price (say
$100 per barrel) one year from now. As a speculation, Company A has gambled by
hoping to buy 100,000 barrels of oil one year from now for less than $100 per
barrel and sell it for the contracted $100 price.
But futures contracts are unique in that they are net settled in cash each
day over the entire one year contract period. If the spot price of oil is $55 on
January 12 and $60 on January 13, Company A must provide $500,000 =
($60-$55)(100,000 barrels) to the counterparty on January 13 even though the
futures contract itself does not mature until December 31. If Company A has not
hedged its position, its risk can become astounding if oil prices dramatically
rise. Company A's futures contract had zero value on January 1 (futures
contracts rarely have value initially except in the case of options contracts),
but the value of the futures contract may become an enormous asset or an
enormous liability each each day thereafter depending upon oil spot price
movements relative to the forward price ($100) that was contracted.
Hence, derivative contracts may have enormous risks even though the notionals
themselves are not at risk. Prior to FAS 133 these risks were generally not
booked or even disclosed. In the 1980s newer types of derivative contracts
emerged (such as interest rate swaps) in part because it was possible to have
enormous amounts of off-balance-sheet debt that did not even have to be
disclosed, let alone booked, in financial statements. Astounding frauds
transpired that led to huge pressures on the SEC and the FASB to better account
for derivative financial instruments.
Most corporations adopted policies of not speculating in derivatives by
allowing derivatives to be used only to hedge risk. However, such policies are
very misleading since there are two main types of risk --- cash flow risk versus
value risk. It is impossible to simultaneously hedge both
types of risk, and hedging one type increases the risk of the other type.
For example, a company that swaps fixed for floating rate interest payments
increases cash flow risk by eliminating value risk (which it may want if it
plans to settle debt prior to maturity). The counterparty that swaps floating
rate interest payments for fixed rate payments eliminates cash flow risk by
taking on value risk. It is impossible to hedge both cash
flow and value risk simultaneously.
Hence, to say that a corporation has a policy allowing hedging but not
speculating in derivative financial instruments is nonsense. A policy to only
hedge cash flow risk may create enormous value risk. A policy to only hedge
value risk may create enormous cash flow risk.
As the NYT article above points out that derivative financial instruments are
increasingly popular in world commerce. As a result risk exposures have greatly
increased even if all contracts were used for hedging purposes only. The problem
is that a hedge only reduces or eliminates one type of risk at the "cost" of
increasing the other type of risk. Derivative contracts
increase one type or the other type of risk the instant they are signed.
Hedging shifts risk but does not eliminate risk per se.
You can read more about scandals in derivative financial instruments
contracting (such as one company's "trillion dollar bet" that nearly toppled
Wall Street and Enron's derivative scandals) at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
You can download the CD containing my slide shows and videos on how to
account for derivative financial instruments at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
My FAS 133 and IAS 39 Glossary is Below.
Table of Contents
and Links
Bob Jensen's
FAS 133 Glossary on Derivative Financial Instruments and Hedging Activities
Also see a comprehensive
risk and trading glossary at http://risk.ifci.ch/SiteMap.htm
Glossary for the energy industry
--- Also see http://snipurl.com/EnergyGlossary
Related glossaries are listed at
http://faculty.trinity.edu/rjensen/bookbus.htm
Click here for tutorial
links
Risk Glossary ---
http://www.riskglossary.com/
If
you are having trouble finding something try a Google search.
Especially note that you can add terms and phrases at http://www.google.com/advanced_search?hl=en
For example, you can add a phrase in the second cell and individual words in the
top cell. You can fill in both cells
simultaneously to narrow your search.
Also note
that you can seek definitions in Google. In
the top cell type in --- define “phrase” where your phrase can be one word
like “contango” or “backwardation” or a phrase like “asian option”.
It is important to first type in the word “define” without quotation marks.
Second
try a search within the standard itself.
You can find digital versions of FAS 133 by scrolling down at http://www.fasb.org/st/#fas153
DIG text
is can be searched at http://www.fasb.org/derivatives/
Free digital versions of IAS 39 are available but they are difficult to find in
EU law. Fee-based versions are available at http://www.iasb.org/
Bob Jensen's FAS 133 and IAS 39 helpers ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Why there are new rules of accounting for derivative financial instruments
and hedge accounting --- See Why!
Bob Jensen's FAS 133,and FAS 138 Cases ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Examples Illustrating Application of FASB Statement No. 138, Accounting for
Certain Derivative Instruments and Certain Hedging Activities-an amendment of
FASB Statement No. 133 ---
http://www.fasb.org/derivatives/examplespg.shtml
or try clicking here.
Flow Chart for FAS 133 and IAS 39 Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
FAS 133 Excel Workbooks Solutions to Examples and Cases --- http://www.cs.trinity.edu/~rjensen/
For example, my Excel wookbook for the Solution to Example 1 in Appendix B of
FAS 133 is the file 133ex01a.xls
Note that in many instances, I have expanded upon the FASB examples to make more
well-rounded presentation.
Bob Jensen's video tutorials on accounting for derivative
financial instruments and hedging activity under FAS 133 and IAS 39 standards
--- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/
Comparisons of International IAS Versus FASB Standards --- http://www.deloitte.com/dtt/cda/doc/content/pocketiasus.pdf
Flow Chart
for FAS 133 Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Flow Chart
for IAS 39 Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/39flow.htm
Differences between FAS 133 and IAS 39
---
http://www.iasplus.com/country/compare.htm
Intrinsic Value Versus Full Value Hedge Accounting ---
http://faculty.trinity.edu/rjensen/caseans/IntrinsicValue.htm
Canadian Workshop Topics ---
http://faculty.trinity.edu/rjensen/caseans/000indexLinks.htm
Accounting for Executory Contracts Such as Purchase/Sale Commitments and Loan
Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
Illustrations --- See Illustrations
Two Questions
How did Bob Jensen spend his summer vacation?
What can physicists do when they can't find jobs in physics?
Answers
I've spent a great
deal of my summer and my Fall 2004 Semester leave plowing through a book entitled Quantitative Finance and
Risk Management: A Physicists Approach by Jan W. Dash,
(World Scientific Publishing, 2004, ISBN 981-238-712-9)
This is a great book by a good writer.
For a more
introductory warm up I recommend Derivatives: An Introduction by Robert
A Strong, Edition 2 (Thomson South-Western, 2005, ISBN 0-324-27302-9)
And what about
opportunities for physicists?
See "A Geek's Walk on Wall Street," by Peter Coy, Business Week,
November 15, Page 26. This is a review of a book entitled My Life as a
Quant, by Emanuel Derman (Wiley, 2005) --- http://www.businessweek.com/@@x3mnUmYQYMjg7RMA/premium/content/04_46/b3908024_mz005.htm
As one of Wall Street's leading quants, Derman did
throw off some intense gamma radiation. He worked at Goldman from 1985 until
2003 except for one year at Salomon Brothers. At Goldman, he moved from fixed
income to equity derivatives to risk management, becoming a managing director
in 1997. He co-invented a tool for pricing options on Treasury bonds, working
with Goldman colleagues Bill Toy and the late Fischer Black, who co-invented
the Black-Scholes formula for valuing options on stocks. Derman received the
industry's "Financial Engineer of the Year" award in 2000. Now he
directs the financial-engineering program at Columbia University.
Derman failed at what he really wanted, which was to
become an important physicist. He was merely very smart in a field dominated
by geniuses, so he kicked around from one low-paying research job to another.
"At age 16 or 17, I had wanted to be another Einstein," he writes.
"By 1976...I had reached the point where I merely envied the postdoc in
the office next door because he had been invited to give a seminar in
France." His move to Wall Street -- an acknowledgment of failure --
brought him financial rewards beyond the dreams of academic physicists and a
fair measure of satisfaction as well.
In the tradition of the idiosyncratic memoir, My Life
As a Quant is a grab bag of the author's interests. It quotes Schopenhauer and
Goethe while supplying not one but three diagrams of a muon neutrino colliding
with a proton. There is a long section on the brilliant and punctilious
Fischer Black; a glimpse of physicist Richard Feynman; and an embarrassing
encounter with finance giant Robert Merton, who sat next to the author on a
long flight (Derman treated him rudely before realizing who he was).
Derman's mood seems to vary from bemused on good days
to sour on bad ones. The chapter on his postdoc travels is titled "A Sort
of Life"; his brief career at Bell Labs, "In the Penal Colony";
his tenure at Salomon Brothers, "A Severed Head." Pre-IPO Goldman
Sachs comes off as relatively gentle yet stimulating. He writes: "It was
the only place I never secretly hoped would crash and burn."
Continued in the
article
Bob Jensen's threads
(including video tutorials) on derivative financial instruments and the Freddie
and Fannie scandals are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's threads
on the trillions of dollars of worldwide frauds using derivative financial
instruments are at
http://faculty.trinity.edu/rjensen/fraudRotten.htm#DerivativesFrauds
September 25, 2003 message from editor jda [editor.jda@gmx.de]
Dear Professor Bob Jensen,
The Journal of Deivatives Accounting (JDA) is
preparing to publish its first issue and I would be grateful if you could post
the following announcement on your web site.
Regards
Mamouda
Dear Colleagues,
There is a new addition to accounting research
Journals. The Journal of Derivatives Accounting (JDA) is an international
quarterly publication which provides authoritative accounting and finance
literature on issues of financial innovations such as derivatives and their
implications to accounting, finance, tax, standards setting, and corporate
practices. This refereed journal disseminates research results and serves as a
means of communication among academics, standard setters, practitioners, and
market participants.
The first and special issue of the JDA, to appear in
the Winter of 2003, will be dedicated to:
"Stock Options: Developments in Share-Based
Compensation (Accounting, Standards, Tax and Corporate Practice)"
This special issue will consider papers dealing with:
* Analysis of applicable national and international
accounting standards * Convergence between IASB and FASB * Accounting
treatment (Expensing) * Valuation * Corporate and market practice * Design of
stock options * Analysis of the structure of stock options contracts *
Executives pay incentives and performance * Taxation * Management and
Corporate Governance
For more details on how to submit your work to the
journal, please visit http://www.worldscinet.com/jda.html
Sincerely,
The Editorial Board Journal of Derivatives Accounting (JDA)
JOURNAL OF DERIVATIVES ACCOUNTING
Hedge Effectiveness Analysis Toolkit
Vol. 1, No. 2 (September 2004) out now!! In this issue issue of JDA, Guy
Coughlan, Simon Emery and Johannes Kolb discuss the Hedge
Effectiveness Analysis Toolkit, which is JPMorgan’s latest addition to
a long list of innovative and cutting-edge risk management solutions. View the
Table of Contents @ http://www.worldscinet.com/jda/01/0102/S02198681040102.html!
FASB staff posts derivatives compilation of all subsequent changes made to
the guidance in the February 10, 2004, edition of the bound codification,
Accounting for Derivative Instruments and Hedging Activities (also referred to
as the Green Book) ---
http://www.fasb.org/derivatives/07-10-06_green_book_changes.pdf
Bob Jensen's tutorials on accounting for derivative financial instruments are
at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
In May of 2003, the Financial Accounting Standards Board (FASB) issued
Statement No. 149, Amendment of Statement 133 on Derivative Instruments and
Hedging Activities. The Statement amends and clarifies accounting for derivative
instruments, including certain derivative instruments embedded in other
contracts, and for hedging activities under Statement 133 --- http://www.fasb.org/news/nr043003.shtml
Norwalk, CT, April 30, 2003—Today
the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment
of Statement 133 on Derivative Instruments and Hedging Activities. The
Statement amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under Statement 133.
The new guidance amends Statement 133 for decisions
made:
- as part of the Derivatives Implementation Group
process that effectively required amendments to Statement 133,
- in connection with other Board projects dealing
with financial instruments, and
- regarding implementation issues raised in relation
to the application of the definition of a derivative, particularly
regarding the meaning of an “underlying” and the characteristics of a
derivative that contains financing components.
The amendments set forth in Statement 149 improve
financial reporting by requiring that contracts with comparable
characteristics be accounted for similarly. In particular, this Statement
clarifies under what circumstances a contract with an initial net investment
meets the characteristic of a derivative as discussed in Statement 133. In
addition, it clarifies when a derivative contains a financing component that
warrants special reporting in the statement of cash flows. Statement 149
amends certain other existing pronouncements. Those changes will result in
more consistent reporting of contracts that are derivatives in their entirety
or that contain embedded derivatives that warrant separate accounting.
Effective Dates and Order Information
This Statement is effective for contracts entered
into or modified after June 30, 2003, except as stated below and for hedging
relationships designated after June 30, 2003. The guidance should be applied
prospectively.
The provisions of this Statement that relate to
Statement 133 Implementation Issues that have been effective for fiscal
quarters that began prior to June 15, 2003, should continue to be applied in
accordance with their respective effective dates. In addition, certain
provisions relating to forward purchases or sales of when-issued
securities or other securities that do not yet exist, should be applied to
existing contracts as well as new contracts entered into after June 30, 2003.
Copies of Statement 149 may be obtained through the
FASB Order Department at 800-748-0659 or by placing an order on-line
at the FASB website.
SAS 92 auditing standard entitled "Auditing Derivative Instruments,
Hedging Activities, and Investments in Securities." Click
Here.
An
earlier FAS 133
Amendment on the Heels of the Previous (FAS 138) Amendment --- A Mere 104 Pages
Amendment of
Statement 133 on Derivative Instruments and Hedging Activities
(Exposure Draft)
The News Release reads as follows at http://www.fasb.org/news/nr050102.shtml
Today the Financial
Accounting Standards Board (FASB) issued an Exposure Draft, Amendment of
Statement 133 on Derivative Instruments and Hedging Activities. The Exposure
Draft amends Statement No. 133, Accounting for Derivative Instruments and
Hedging Activities, to clarify the definition of a derivative. A copy of the
Exposure Draft is available on the FASB’s website at www.fasb.org. The
comment period concludes on July 1, 2002.
In connection with
Statement 133 Implementation Issue No. D1, "Application of Statement
133 to Beneficial Interests in Securitized Financial Assets," the Board
addressed issues related to the accounting for beneficial interests in
securitized financial assets, such as beneficial interests in securitized
credit card receivables. In resolving those issues, the FASB decided that an
amendment was needed to clarify the definition of a derivative, as set forth
in Statement 133.
The purpose of the
Exposure Draft is to improve financial reporting by requiring that financial
contracts with comparable characteristics be accounted for in the same way.
The Statement would clarify under what circumstances a financial contract—either
an option-based or non-option-based contract—with an initial net
investment would meet the characteristic of a derivative discussed in
paragraph 6(b) of Statement 133. The FASB believes the proposed change will
produce more consistent reporting of financial contracts as either
derivatives or hybrid financial instruments.
The proposed
effective date for the accounting change is the first day of the first
fiscal quarter beginning after November 15, 2002, which, for calendar year
end companies, will be January 1, 2003.
Bob Jensen's threads on FAS 122 and IAS
39 are at
http://faculty.trinity.edu/rjensen/casea
The FASB staff has prepared a new updated edition of Accounting for
Derivative Instruments and Hedging Activities. This essential aid to
implementation presents Statement 133 as amended by Statements 137 and 138.
Also, it includes the results of the Derivatives Implementation Group (DIG), as
cleared by the FASB through December 10, 2001, with cross-references between the
issues and the paragraphs of the Statement.
“The staff at the FASB has prepared this publication to bring together in
one document the current guidance on accounting for derivatives,” said Kevin
Stoklosa, FASB project manager. “To put it simply, it’s a
‘one-stop-shop’ approach that we hope our readers will find easier to
use.”
Accounting for Derivative Instruments and Hedging Activities—DC133-2
Prices: $30.00 each copy for Members of the Financial Accounting
Foundation, the Accounting Research Association (ARA) of the AICPA, and
academics; $37.50 each copy for others.
International Orders: A 50% surcharge will be applied to orders that
are shipped overseas, except for shipments made to U.S. possessions, Canada, and
Mexico. Please remit in local currency at the current exchange rate.
To order:
FASB staff posts derivatives compilation of all subsequent changes made to
the guidance in the February 10, 2004, edition of the bound codification,
Accounting for Derivative Instruments and Hedging Activities (also referred to
as the Green Book) ---
http://www.fasb.org/derivatives/07-10-06_green_book_changes.pdf
Bob Jensen's tutorials on accounting for derivative financial instruments are
at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Derivative
Financial Instruments Frauds ---
http://faculty.trinity.edu/rjensen/fraud.htm
A
Condensed Multimedia Overview With Video and Audio from Experts --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm
A
Longer and More Boring Introduction to FAS 133, FAS 138, and IAS 39 ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Flow Chart for FAS 133 and
IAS 39 Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Differences between FAS 133 and IAS 39
---
http://www.iasplus.com/country/compare.htm
Intrinsic Value Versus Full Value Hedge Accounting ---
http://faculty.trinity.edu/rjensen/caseans/IntrinsicValue.htm
The Devil's Derivatives
Dictionary at http://www.margrabe.com/Devil/DevilF_J.html
To understand more about derivative
financial instruments, I suggest that you begin by going to the file at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Especially note the discussion of the shortcut method at the end of the above
document.
A helpful site on FAS 133 is at http://fas133.com
Differences between FAS 133 and IAS 39 ---
http://www.iasplus.com/country/compare.htm
Auditing Requirements for Derivative Financial
Securities
Auditing Derivative Instruments, Hedging Activities, and Investments in
Securities
http://www.aicpa.org/members/div/auditstd/riasai/sas92.htm
A Nice Summary of SAS 92 is Available Online
(Auditing, Derivative Financial Instruments, Hedging)
SAS 92-New Guidance on Auditing Derivatives and
Securities
by Joe Sanders, Ph.D., CPA and Stan Clark, Ph.D., CPA
http://www.ohioscpa.com/member/publications/Journal/1st2001/page10.asp
Auditors face many challenges in auditing derivatives
and securities. These instruments have become more complex, their use more
common and the accounting requirements to provide fair value information are
expanding. There is also an increasing tendency for entities to use service
organizations to help manage activities involving financial instruments. To
assist auditors with these challenges, the Auditing Standards Board (ASB)
issued SAS 92, Auditing Derivative Instruments, Hedging Activities and
Investments in Securities. The ASB is also currently developing a companion
Audit Guide. SAS 92 supersedes SAS 81, Auditing Investments.
SAS 92 provides a framework for auditors to use in
planning and performing auditing procedures for assertions about all financial
instruments and hedging activities. The Audit Guide will show how to use the
framework provided by the SAS for a variety of practice issues. The purpose of
this article is to summarize and explain some of the more significant aspects
of SAS 92.
Scope SAS 92 applies to:
Derivative instruments, as defined in SFAS 133,
Accounting for Derivative Instruments and Hedging Activity. Hedging activities
which also fall under SFAS 133. Debt and equity securities, as defined in SFAS
115, Accounting for Certain Investments in Debt and Equity Securities. The
auditor should also refer to APB 18, The Equity Method of Accounting for
Investments in Common Stock. Special Skill or Knowledge
SEC Chairman Arthur Levitt, in his speech on renewing
the covenant with investors stated, "I recognize that new financial
instruments, new technologies and even new markets demand more specialized
know-how to effectively audit many of today's companies".1 One of the
first items noted in SAS 92 is that the auditor may need to seek assistance in
planning and performing audit procedures for financial instruments. This
advice is based primarily on the complexity of SFAS 133. Understanding an
entities' information system for derivatives, including work provided by a
service organization, may require the auditor to seek assistance from within
the firm or from an outside expert. SAS 73 provides guidance on using the work
of a specialist.
Inherent Risk Assessment
The inherent risk related to financial instruments is
the susceptibility to a material misstatement, assuming there are no related
controls. Assessing inherent risk for financial instruments, particularly
complex derivatives, can be difficult. To assess inherent risk for financial
instruments, auditors should understand both the economics and business
purpose of the entity's financial activities. Auditors will need to make
inquiries of management to understand how the entity uses financial
instruments and the risks associated with them. SAS 92 provides several
examples of considerations that might affect the auditor's assessment of the
inherent risk for assertions about financial instruments:2
The complexity of the features of the derivative or
security. Whether the transaction that gave rise to the derivative or security
involved the exchange of cash. The entity's experience with derivatives or
securities. Whether the derivative is freestanding or an embedded feature of
an agreement. The evolving nature of derivatives and the applicable generally
accepted accounting principles. Significant reliance on outside parties.
Control Risk Assessment
SAS 92 includes a section on control risk assessment.
Control risk is the risk that a material misstatement could occur and would
not be prevented or detected in a timely manner by an entity's internal
control. Management is responsible for providing direction to financial
activities through clearly stated policies. These policies should be
documented and might include:
Policies regarding the types of instruments and
transactions that may be entered into and for what purposes. Limits for the
maximum allowable exposure to each type of risk, including a list of approved
securities broker-dealers and counterparties to derivative transactions.
Methods for monitoring the financial risks of financial instruments,
particularly derivatives, and the related control procedures. Internal
reporting of exposures, risks and the results of actions taken by management.
Auditors should understand the contents of financial reports received by
management and how they are used. For example, "stop loss" limits
are used to protect against sudden drops in the market value of financial
instruments. These limits require all speculative positions to be closed out
immediately if the unrealized loss on those positions reaches a certain level.
Management reports may include comparisons of stop loss positions and actual
trading positions to the policies set by the board of directors.
The entity's use of a service organization will
require the auditor to gain an understanding of the nature of the service
organization's services, the materiality of the transactions it processes, and
the degree of interaction between its activities and those of the entity. It
may also require the auditor to gain an understanding of the service
organization's controls over the transactions the service organization
processes for it.
Designing Substantive Procedures Based on Risk
Assessments
The auditor should use the assessed levels of
inherent and control risk to determine the acceptable level of detection risk
for assertions about financial instruments and to determine the nature,
timing, and extent of the substantive tests to be performed to detect material
misstatements of the assertions. Substantive procedures should address the
following five categories of assertions included in SAS 31, Evidential Matter:
1. Existence or occurrence. Existence assertions
address whether the derivatives and securities reported in the financial
statements through recognition or disclosure exist at the balance sheet date.
Occurrence assertions address whether changes in derivatives or securities
reported as part of earnings, other comprehensive income, cash flows or
through disclosure occurred. Examples of substantive procedures for existence
or occurrence assertions include:3
Confirmation with the holder of the security,
including securities in electronic form or with the counterparty to the
derivative. Confirmation of settled or unsettled transactions with the
broker-dealer counterparty. Physical inspection of the security or derivative
contract. Inspecting supporting documentation for subsequent realization or
settlement after the end of the reporting period. Performing analytical
procedures. 2. Completeness. Completeness assertions address whether all of
the entity's derivatives and securities are reported in the financial
statements through recognition or disclosure. Since derivatives may involve
only a commitment to perform under a contract and not an initial exchange of
tangible consideration, auditors should not focus exclusively on evidence
relating to cash receipts and disbursements.
3. Rights and obligations. These assertions address
whether the entity has rights and obligations associated with derivatives and
securities reported in the financial statements. For example, are assets
pledged or do side agreements exist that allow the purchaser of a security to
return the security after a specified period of time? Confirming significant
terms with the counterparty to a derivative or the holder of a security would
be a substantive procedure testing assertions about rights and obligations.
4. Valuation. Under SFAS 115 and SFAS 133 many
financial instruments must now be measured at fair value, and fair value
information must be disclosed for most derivatives and securities that are
measured at some other amount.
The auditor should obtain evidence corroborating the
fair value of financial instruments measured or disclosed at fair value. The
method for determining fair value may be specified by generally accepted
accounting principles and may vary depending on the industry in which the
entity operates or the nature of the entity. Such differences may relate to
the consideration of price quotations from inactive markets and significant
liquidity discounts, control premiums, commissions and other costs that would
be incurred to dispose of the financial instrument.
If the derivative or security is valued by the entity
using a valuation model (for example, the Black-Scholes option pricing model),
the auditor should assess the reasonableness and appropriateness of the model.
The auditor should also determine whether the market variables and assumptions
used are reasonable and appropriately supported. Estimates of expected future
cash flows, for example, to determine the fair value of long-term obligations
should be based on reasonable and supportable assumptions.
The method for determining fair value also may vary
depending on the type of asset or liability. For example, the fair value of an
obligation may be determined by discounting expected future cash flows, while
the fair value of an equity security may be its quoted market price. SAS 92
provides guidance on audit evidence that may be used to corroborate these
assertions about fair value.
5. Presentation and disclosure. These assertions
address whether the classification, description and disclosure of derivatives
and securities are in conformity with GAAP. For some derivatives and
securities, GAAP may prescribe presentation and disclosure requirements, for
example:
Certain securities are required to be classified into
categories based on management's intent and ability such as trading,
available-for-sale or held-to-maturity. Changes in the fair value of
derivatives used to hedge depend on whether the derivative is a fair-value
hedge or an expected cash flow hedge, and on the degree of effectiveness of
the hedge. Hedging Transactions
Hedging will require large amounts of documentation
by the client. For starters, the auditor will need to examine the companies'
established policy for risk management. For each derivative, management should
document what risk it is hedging, how it is expected to hedge that risk and
how the effectiveness will be tested. Without documentation, the client will
not be allowed hedge accounting. Auditors will need to gather evidence to
support the initial designation of an instrument as a hedge, the continued
application of hedge accounting and the effectiveness of the hedge.
To satisfy these accounting requirements,
management's policy for financial instrument transactions might also include
the following elements whenever the entity engages in hedging activities:
An assessment of the risks that need to be hedged The
objectives of hedging and the strategy for achieving those objectives. The
methods management will use to measure the effectiveness of the strategy.
Reporting requirements for the monitoring and review of the hedge program.
Impairment Losses
Management's responsibility to determine whether a
decline in fair value is other than temporary is explicitly recognized in SAS
92. The auditor will need to evaluate whether management has considered
relevant information in determining whether other-than-temporary impairment
exists. SAS 92 provides examples of circumstances that indicate an
other-than-temporary impairment condition may exist:4
Management Representations
The auditor must obtain written representations from
management confirming their intent and ability assertions related to
derivatives and securities. For example, the intent and ability to hold a debt
security until it matures or to enter into a forecasted transaction for which
hedge accounting is applied. Appendix B of SAS 85 (AU Sec. 333.17) includes
illustrative representations about derivative and security transactions.
Summary
SAS 92 provides guidance for auditing derivatives and
securities. Accounting requirements related to these instruments, SFAS 115 and
SFAS 133, are very complex and because of their extensive use of fair value
measures require significant use of judgment by the accountant. SAS 92
establishes a framework for auditors to assess whether the entity has complied
with the provisions of SFAS 115 and SFAS 133. However, because of the
subjective nature of many of the requirements of these two standards,
considerable auditor judgment will be required to comply with SAS 92.
Effective Date
This SAS is effective for audits of financial
statements for fiscal years ending on or after June 30, 2001. Early adoption
is permitted.
Keeping Up With Financial Instruments Derivatives
Bob Jensen's CD ---
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
I'm sharing some old (well relatively old)
accounting theory quiz and exam material that I added to a folder at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
You can find some great
tutorials go to CBOE at http://www.cboe.com/education/ .
But these do not help with learning how to account for the derivatives under FAS
133 and IAS 39. The same holds for the CBOT at http://www.cbot.com/cbot/pub/page/0,3181,909,00.html and
the CME at http://www.cme.com/edu/
New York Mercantile Exchange (NYMEX) for energy and metals under
the Education tab at http://www.nymex.com/jsp/index.jsp
Optionetics has some good tutorials with respect to options but these do not
explain options accounting --- http://www.optionetics.com/education/trading.asp
Daniel Oglevee's Course Site --- http://www.cob.ohio-state.edu/fin/autumn2004/723.htm
In 2000, ISDA filed a letter to the Financial Accounting Standards Board
(FASB) urging changes to FAS 133, its derivatives and hedge accounting standard.
ISDA’s letter urged alterations to six areas of the standard: hedging the
risk-free rate; hedging using purchased options; providing hedge accounting for
foreign currency assets and liabilities; extending the exception for normal
purchase and sales; and central treasury netting. The FASB subsequently rejected
changes to purchased option provisions, conceded some on normal purchases and
sales, extending the exception to contracts that implicitly or explicitly permit
net settlement, declined to amend FAS 133 to facilitate partial term hedging and
agreed to consider changing the restrictions on hedge accounting for foreign
currency.
ISDA ®INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.http://www.isda.org/wwa/Retrospective_2000_Master.pdf
A good tutorial on
energy futures and options hedging is given by the New York Mercantile Exchange
(NYMEX) under the Education tab at http://www.nymex.com/jsp/index.jsp
Two Questions
How did Bob Jensen spend his summer vacation?
What can physicists do when they can't find jobs in physics?
Answers
I've spent a great
deal of my summer and my Fall 2004 Semester leave plowing through a book entitled Quantitative Finance and
Risk Managment: A Physicists Approach by Jan W. Dash, by Jan W. Dash
(World Scientific Publishing, 2004, ISBN 981-238-712-9)
This is a great book by a good writer.
For a more
introductory warm up I recommend Derivatives: An Introduction by Robert
A Strong, Edition 2 (Thomson South-Western, 2005, ISBN 0-324-27302-9)
And what about
opportunities for physicists?
See "A Geek's Walk on Wall Street," by Peter Coy, Business Week,
November 15, Page 26. This is a review of a book entitled My Life as a
Quant, by Emanuel Derman (Wiley, 2005) --- http://www.businessweek.com/@@x3mnUmYQYMjg7RMA/premium/content/04_46/b3908024_mz005.htm
As one of Wall Street's leading quants, Derman did
throw off some intense gamma radiation. He worked at Goldman from 1985 until
2003 except for one year at Salomon Brothers. At Goldman, he moved from fixed
income to equity derivatives to risk management, becoming a managing director
in 1997. He co-invented a tool for pricing options on Treasury bonds, working
with Goldman colleagues Bill Toy and the late Fischer Black, who co-invented
the Black-Scholes formula for valuing options on stocks. Derman received the
industry's "Financial Engineer of the Year" award in 2000. Now he
directs the financial-engineering program at Columbia University.
Derman failed at what he really wanted, which was to
become an important physicist. He was merely very smart in a field dominated
by geniuses, so he kicked around from one low-paying research job to another.
"At age 16 or 17, I had wanted to be another Einstein," he writes.
"By 1976...I had reached the point where I merely envied the postdoc in
the office next door because he had been invited to give a seminar in
France." His move to Wall Street -- an acknowledgment of failure --
brought him financial rewards beyond the dreams of academic physicists and a
fair measure of satisfaction as well.
In the tradition of the idiosyncratic memoir, My Life
As a Quant is a grab bag of the author's interests. It quotes Schopenhauer and
Goethe while supplying not one but three diagrams of a muon neutrino colliding
with a proton. There is a long section on the brilliant and punctilious
Fischer Black; a glimpse of physicist Richard Feynman; and an embarrassing
encounter with finance giant Robert Merton, who sat next to the author on a
long flight (Derman treated him rudely before realizing who he was).
Derman's mood seems to vary from bemused on good days
to sour on bad ones. The chapter on his postdoc travels is titled "A Sort
of Life"; his brief career at Bell Labs, "In the Penal Colony";
his tenure at Salomon Brothers, "A Severed Head." Pre-IPO Goldman
Sachs comes off as relatively gentle yet stimulating. He writes: "It was
the only place I never secretly hoped would crash and burn."
Continued in the
article
Bob Jensen's threads
(including video tutorials) on derivative financial instruments and the Freddie
and Fannie scandals are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's threads
on the trillions of dollars of worldwide frauds using derivative financial
instruments are at
http://faculty.trinity.edu/rjensen/fraudRotten.htm#DerivativesFrauds
You can read a great deal about energy derivatives in The Derivatives 'Zine
at http://www.margrabe.com/Energy.html
Other topics include the following:
The Derivatives 'Zine by Dr. Risk
THE WILLIAM MARGRABE GROUP, INC., CONSULTING, PRESENTS |
Ask Dr. Risk!
- Free answers: Dr.
Risk promises any correspondent from a business domain with a website
(e.g., Mack@CSFB.com) at least a
five-minute response to your important question, as soon as he has a
free moment, probably within one month.
- Fast answers:
If you absolutely, positively will have to have an answer overnight, set
up your consulting account, ahead of time, with the William Margrabe
Group, Inc.. Introductory offer: $300 / hour with one-minute
granularity. If we can't provide the answer, we'll refer you to someone
who can. If we can't refer you, we'll inform you fast for free.
- No answers: LDiablo@hotmail.com,
Chris1492@aol.com, BillyG@MSN.com,
and Desperate@Podunk.edu, etc.
can no longer count on even brief answers, unless their questions are
sufficiently intriguing. Sorry.
A question of sufficiently general
interest to make it into the 'Zine, tends to generate a more
comprehensive response. All questions and answers become the property of The
William Margrabe Group, Inc
QUANTITATIVE FINANCE AND RISK MANAGEMENT A Physicist's Approach
by Jan W Dash
This book is designed for scientists and engineers desiring to learn
quantitative finance, and for quantitative analysts and finance graduate
students. Parts will be of interest to research academics --- http://www.worldscientific.com/books/economics/5436.html
804pp |
Pub. date: Jul 2004 |
Contents:
- Introduction, Overview, and Exercise
- Risk Lab (Nuts and Bolts of Risk Management)
- Exotics, Deals, and Case Studies
- Quantitative Risk Management
- Path Integrals, Green Functions, and Options
- The Macro-Micro Model (A Research Topic)
The above sources are not much good about accounting for derivatives under
FAS 133, FAS 138, and IAS 39. For that, go to the following source:
http://faculty.trinity.edu/rjensen/caseans/000index.htm
FAS 133 Tutorial, SmartPros --- http://www.smartpros.com/x33017.xml
FAS 133, the standard
for financial reporting of derivatives and hedging transactions, was adopted
in 1998 by the Financial Accounting Standards Board to resolve inconsistent
previous reporting standards and practices. It went into effect at most U.S.
companies at the beginning of 2001.
Courtesy of Kawaller
& Company, SmartPros presents this FAS 133 tutorial to help you
understand the provisions of the standard. For news pertaining to FAS
133, click on the links to the right in Related Stories.
PwC Tutorial on IAS 39 --- http://www.pwcglobal.com/images/gx/eng/fs/bcm/032403iashedge.pdf
PowerPoint Show Highlighting Some Complaints About IAS 39 and IAS 32 --- http://www.atel.lu/atel/fr/publications/Publications/030524_EACT%20mtg_Milan.ppt
"IAS 32 and IAS 39 Revised: An Overview," Ernst & Young,
February 2004 --- http://www.ey.com/global/download.nsf/International/IAS32-39_Overview_Febr04/$file/IAS32-39_Overview_Febr04.pdf
I shortened the above URL to http://snipurl.com/RevisedIAS32and39
Sharing Professor --- John
Hull (who writes about financial instrument derivatives) --- http://www.rotman.utoronto.ca/~hull/
His great books (not free) are great,
but he also shares (for free) some software and data --- http://www.rotman.utoronto.ca/~hull/
Forwarded by Carl Hubbard on September 12, 2003
I would like to bring to your attention Analysis
of Derivatives for the CFA(r) Program by Don M. Chance, CFA, recently
published this year by the Association for Investment Management and
Research(r). While designed for the CFA program, this publication is a
terrific text for academic derivatives and risk management courses.
The treatment in this volume is intended to
communicate a practical risk management approach to derivatives for the
investment generalist. The topics in the text were determined by a
comprehensive job analysis of investment practitioners worldwide. The
illustrative in-chapter problems and the extensive end-of-chapter questions
and problems serve to reinforce learning and understanding of the material.
We believe that this text responds to the need for a
globally relevant guide to applying derivatives analysis to the investment
process. We hope you will consider adopting Analysis of Derivatives for the
CFA(r) Program for a future course.
Thank you for your attention.
Sincerely,
Helen K. Weaver
Associate
AIMR
656 PAGES
0-935015-93-0
HB 2003
Message from Ira Kawaller on August 4, 2002
Hi Bob,
I posted a new article on the Kawaller & Company
website: “What’s ‘Normal’ in Derivatives Accounting,” originally
published in Financial Executive, July / August 2002. It is most relevant for
financial managers of non-financial companies, who seek to avoid FAS 133
treatment for their purchase and sales contracts. The point of the article is
that this treatment may mask some pertinent risks and opportunities. To view
the article, click on http://www.kawaller.com/pdf/FE.pdf
.
I'd be happy to hear from you if you have any
questions or comments.
Thanks for your consideration.
Ira Kawaller Kawaller & Company, LLC http://www.kawaller.com
kawaller@kawaller.com 717-694-6270
Bob Jensen's documents on derivative financial instruments are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
March 8, 2002 Message from the Risk Waters Group
[RiskWaters@lb.bcentral.com]
ONLINE TRADING
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Thank you.
If you are interested in email messages
regarding financial risk news, you may be interested in contacting:
Christopher Jeffery mailto:cjeffery@riskwaters.com
Editor, RiskNews
http://www.risknews.net
Governmental Disclosure Rules for Derivative Financial
Instruments --- see Disclosure.
The DIG
In the meantime, the FASB formed the FAS 133 Derivatives Implementation Group
(DIG) to help resolve particular implementation questions, especially in areas
where the standard is not clear or allegedly onerous. The FASB's DIG
website (that contains its mission and pronouncements) is at http://www.fasb.org/derivatives/
DIG issues are also summarized (in red borders) at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin.
IAS 138 Implementation Guidance
"Implementation of SFAS 138, Amendments to SFAS 133," The CPA
Journal, November 2001. (With Angela L.J. Huang and John S. Putoubas), pp.
54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm
April 25, 2002 message from Charlie
Stutesman [southwestern.email@swcollege.com]
Dear Professor
Jensen,
In direct contrast to
most trade training derivatives texts which emphasize issues related to the
pricing and hedging of derivatives, this groundbreaking text is designed for
those who want to teach students how to manage derivatives to maximize firm
value through risk management. DERIVATIVES AND RISK MANAGEMENT presents the
crucial tools necessary for executives and future derivatives players to
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* WRITTEN TO
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* MANAGERIAL
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conceptual or mathematical rigor.
We encourage you to
request a complimentary exam copy of DERIVATIVES AND RISK MANAGEMENT (ISBN:
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helped provide generations of learners with a solid foundation and true
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Sincerely,
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Senior Marketing Manager
charlie.stutesman@swlearning.com
IAS 39 Implementation Guidance
Supplement to the
Publication
Accounting for Financial Instruments - Standards, Interpretations, and
Implementation Guidance
http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf
The IASB’s Exposure Draft of the macro hedging compromise is
entitled “Amendments to IAS 39: Recognition
and Measurement Fair Value Hedge Accounting for a Portfolio Hedge of Interest
Rate” and for a short time can be downloaded free from http://www.iasc.org.uk/docs/ed-ias39mh/ed-ias39mh.pdf
See Macro Hedging
Also see Bob Jensen's
Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Hi Patrick,
The term "better" is a loaded
term. One of the main criticisms leveled at IASC standards is that they were too
broad, too permissive, and too toothless to provide comparability between
different corporate annual reports. The IASC (now called IASB) standards only
began ot get respect at IOSCO after they started becoming more like FASB
standards in the sense of having more teeth and specificity.
I think FAS 133 is better than IAS 39
in the sense that FAS 133 gives more guidance on specific types of contracts.
IAS 39 is so vague in places that most users of IAS 39 have to turn to FAS 133
to both understand a type of contract and to find a method of dealing with that
contract. IAS 39 was very limited in terms of examples, but this has been
recitified somewhat (i.e., by a small amount) in a recent publication by the
IASB: Supplement to the Publication Accounting for Financial Instruments -
Standards, Interpretations, and Implementation Guidance http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf
In theory, there are very few
differences between IAS 39 and FAS 133. But this is like saying that there is
very little difference between the Bible and the U.S. Commercial Code. Many
deals may be against what you find in the Bible, but lawyers will find it of
less help in court than the U.S. Commercial Code. I admit saying this with
tongue in cheek, because the IAS 39 is much closer to FAS 133 than the Bible is
to the USCC.
Paul Pacter wrote a nice paper about
differences between IAS 39 and FAS 133. However, such a short paper cannot cover
all differences that arise in practice. The paper is somewhat dated now, but you
can find more recent updates on differences at Differences
between FAS 133 and IAS 39 ---
http://www.iasplus.com/country/compare.htm
Although there are differences between
FAS 133 and IAS 39, I would not make too big a deal out of such differences. IAS
39 was written with one eye upon FAS 133, and the differences are relatively
minor. Paul Pacter's summary of these differences can be downloaded from http://www.iasc.org.uk/cmt/0001.asp?s=490603&sc={65834A68-1562-4CF2-9C09-D1D6BF887A00}&sd=860888892&n=3288
Also note "Comparisons of International IAS Versus FASB Standards"
---
http://www.iasplus.com/country/compare.htm
Hope this helps,
Bob (Robert E.) Jensen Jesse H. Jones
Distinguished Professor of Business Trinity University, San Antonio, TX 78212
Voice: (210) 999-7347 Fax: (210) 999-8134 Email: rjensen@trinity.edu http://faculty.Trinity.edu/rjensen
-----Original
Message-----
From: Patrick Charles [mailto:charlesp@CWDOM.DM]
Sent: Tuesday, February 26, 2002 11:54 AM
To: CPAS-L@LISTSERV.LOYOLA.EDU
Subject: US GAAP Vs IASB
Greetings Everyone
Mr Bolkestein said
the rigid approach of US GAAP could make it easier to hide companies' true
financial situation. "You tick the boxes and out come the answer,"
he said. "Having rules is a good thing, but having rigid rules is not the
best thing.
http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3AHWRLXXC&live=true&tagid=FTDCZE6JFEC&subheading=accountancy
Finally had a chance
to read the US GAAP issue. Robert you mentioned IAS 39, do you have other
examples where US GAAP is a better alternative to IASB, or is this an European
ploy to get the US to adopt IASB?
Cheers
Mr. Patrick Charles charlesp@cwdom.dm
ICQ#6354999
"Education is an
admirable thing, but it is well to remember from time to time that nothing
that is worth knowing can be taught."
Bob
Jensen's Glossary of FAS 133 and IAS 39
Bob Jensen's Overview of FAS 133 (With Audio)
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Interest Rate Swap
Valuation, Forward Rate Derivation, and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments
See
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
FAS 133 flow
chart
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Bob Jensen's
Document on the Missing Parts of FAS 133
Summary
of Key Paragraphs in FAS 133 on Portfolio/Macro Hedging.
Bob
Jensen's Weekly Assignments and Hints Regarding FAS 133
Bob Jensen's Technology Glossary (Includes an Extensive Listing of
Accounting and Finance Glossaries)
ACCT 5341
International Accounting Theories Course Helpers
Yahoo
Finance is Bob Jensen's Favorite Place to learn more about the mechanics and widespread
use of derivative financial instruments. That web site, however, will not help
much with respect to accounting for such instruments under FAS 133.
Bob Jensen's
Mexcobre Case
For a FAS 133 flow chart,
go to
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Internet Links of Possible Interest
Bob Jensen's Transcripts
of Presentations by Experts
PriceWaterhouseCoopers
(PWC) Summary Tables (With Some Notes Added by Bob Jensen)
Derivatives Implementation Group (DIG)
Hi George,
That depends upon what you mean
by "support." If you mean failing to adhere to any FASB
standard in the U.S. on a set of audited financial statements, then
auditors are sending an open invitation to all creditors and
shareholders to contact their tort lawyers --- lawyers always salivate
when you mention the magic words "class action lawsuit".
If you mean sending
mean-spirited letters to the FASB, then that's all right, because the
FASB is open to all communications in what it defines as "due
process."
I am a strong advocate of FAS
133 --- corporations got away with hiding enormous risks prior to FAS
133. Could FAS 133/138 and IAS 39 be simplified? Well that's a matter of
opinion. The standards will be greatly simplified if your Canadian
friends and my U.S. friends support the proposal to book all financial
instruments at fair value (as advocated by the JWG and IASB Board Member
Mary Barth). But whether this is a simplification is a matter of
conjecture since estimation of fair value is a very complex and tedious
process for instruments not traded in active and deep markets. In the
realm of financial instruments there are many complex financial
instruments and derivatives created as custom and unique contracts that
are nightmares to value and re-value on a continuing basis. One needs
only study how inaccurate the estimated bond yield curves are deriving
forward rates. In some cases, we might as well consult astrologers who
charge less than Bloomberg and with almost the same degree of error.
My bottom line conclusion: We
could simplify the wording of the financial instruments and derivative
financial instruments standards by about 95% if we go all the way in
adopting fair value accounting for all financial instruments and
derivative financial instruments.
But simplifying the wording of
the standard does not necessarily simplify the accounting itself and
will add a great deal of noise to the measurement of risk. In the U.S.,
the banking industry is so opposed to fair value accounting that the
Amazon river will probably freeze over before the FASB passes what the
JWG proposes. See http://www.aba.com/aba/pdf/GR_tax_va6.PDF
Readers interested in
downloading the Joint Working Group IASC Exposure Draft entitled
Financial Instruments: Issues Relating to Banks should follow the
downloading instructions at http://www.aba.com/aba/pdf/GR_TAX_FairValueAccounting.pdf
(Trinity University students may find this on J:\courses\acct5341\iasc\jwgfinal.pdf
).
On December 14, 1999 the FASB
issued Exposure Draft 204-B entitled Reporting Financial Instruments and
Certain Related Assets and Liabilities at Fair Value. I'm not sure where
you can find this buried document at the moment.
(Trinity University students can find the document at J:\courses\acct5341\fasb\fvhtm.htm
).
Bob Jensen
-----Original
Message-----
From: glan@UWINDSOR.CA [mailto:glan@UWINDSOR.CA]
Sent: Monday, February 25, 2002 5:33 PM
To: AECM@LISTSERV.LOYOLA.EDU
Subject: Re: Intrinsic Versus Time Value
I have seen
the credit to be Paid-in Capital- Stock Options or to Stock Options
Outstanding rather than to a liability. It would be interesting to
learn more about what the accounting firms stand to gain by not
supporting FAS133.
George Lan
|
For a FAS 133 flow chart,
go to
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Differences between FAS 133 and IAS
39 ---
http://www.iasplus.com/country/compare.htm
Side by Side: IAS 39 Compared with FASB Standards (FAS 133), by Paul Pacter,
as published in Accountancy International Magazine, June 1999 --- http://www.iasc.org.uk/news/cen8_142.htm
Also note "Comparisons of International IAS Versus FASB Standards" ---
http://www.deloitte.com/dtt/cda/doc/content/pocketiasus.pdf
IAS 39 history --- http://www.iasc.org.uk/cmt/0001.asp?s=6941204&sc={CB32B469-886C-4486-86B7-36E49358DDE5}&sd=617116004&n=3306
Limited Revisions to IAS 39, Financial
Instruments: Recognition and Measurement (E66) --- http://www.iasc.org.uk/cmt/0001.asp?s=6941204&sc={CB32B469-886C-4486-86B7-36E49358DDE5}&sd=268256258&n=3222
Recognition and Measurement
(E66)
|
E66,
Proposed Limited Revisions to IAS 39 and Other Related Standards,
proposed the following limited revisions to IAS 39, Financial
Instruments: Recognition and Measurement, and other related Standards:
- changes to require
consistent accounting for purchases and sales of financial assets
using either trade date accounting or settlement date accounting.
IAS 39 currently requires settlement date accounting for sales of
financial assets, but permits both trade date and settlement date
accounting for purchases;
- elimination of the
requirement in IAS 39 for a lender to recognise certain collateral
received from a borrower in its balance sheet;
- improvement of the wording
on impairment recognition;
- changes to require
consistent accounting for temporary investments in equity
securities between IAS 39 and other International Accounting
Standards; and
- elimination of redundant
disclosure requirements for hedges in IAS 32, Financial
Instruments: Disclosure and Presentation.
None of the proposed revisions
represents a change to a fundamental principle in IAS 39. Instead, the
purpose of the proposed changes is primarily to address technical
application issues that have been identified following the approval of
IAS 39 in December 1998. The IASC Board’s assessment is that the
proposed changes will assist enterprises preparing to implement IAS 39
for the first time in 2001 and help ensure a consistent application of
the Standard. No further changes to IAS 39 are contemplated.
|
At its meeting in March 2000, the Board appointed a Committee to develop
implementation guidance on IAS 39, Financial Instruments: Recognition. The
guidance is expected to be published later this year, after public comment, as a
staff guidance document. The IAS 39 Implementation Guidance Committee may refer
some issues either to the SIC or to the Board. http://www.iasc.org.uk/frame/cen2_139.htm
Recommended
Reading
Recommended
Links
Bob
Jensen's Glossary of FAS 133 and IAS 39
A message from Ira Kawaller on January 13, 2002
Hi Bob,
I wanted to alert you to the fact that I posted
another article on the Kawaller and Company website, "The New World Under
FAS 133." It came out in the latest issue of the GARP Review. It deals
with the economics and accounting considerations relating to the use of
cross-currency interest rate swaps. The link below brings you to the paper:
http://www.kawaller.com/pdf/garpswaps.pdf
I also posted a new calendar of events, at
http://www.kawaller.com/schedule/calendar.pdf
To navigate to the links in this email message, click
on them. If that does not work, copy the link and paste it into the address
field of your browser.
Please feel free to contact me if you have any
questions, comments, or suggestions. Thanks for your consideration.
Ira Kawaller kawaller@kawaller.com
http://www.kawaller.com
Bob Jensen's documents on FAS 133, FAS 138, and IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
PriceWaterhouseCoopers (PWC)
Summary Tables
Source: A Guide to
Accounting for Derivative Instruments and Hedging Activities (New York,
Pricewaterhouse Coopers, 1999, pp. 4-5 and pp. 19-22)
Note that the FASB's FAS 133
becomes required for calendar-year companies on January
1, 2001. Early adopters can apply the standard prior to the
required date, but they cannot apply it retroactively. The January
1, 2001 effective date follows postponements from the original starting
date of June 15, 1999 stated in Paragraph 48 on Page 29 of FAS 133.
For fiscal-year companies, the effective date is June
15, 2000. The international counterpart known as the IASC's IAS
39 becomes effective for financial statements for financial years beginning
on the same January 1, 2001. Earlier application permitted for financial
years ending after 15 March 1999.
Note that Bob Jensen has added
notes (in red),
OVERVIEW & EXPECTED
IMPACT of FAS 133 and IAS 39
FAS 133
and IAS 39
|
Pre-FAS 133
|
U.S. FAS 133: All derivatives must be carried on the balance sheet at
fair value.
¶5 Notes from Jensen:
International: IAS 39 differs in that it requires fair value
adjustments of "all" debt securities, equity securities, and
other financial assets except for those whose value cannot be reliably
estimated. ¶s 1,5,6, 95, and 96. There are exceptions
where value estimates are unreliable such as in the case of unlisted
equity securities (see IAS ¶s 69, 93, and 95). FAS 133
requires an active market for value estimation of non-trading items.
Under FAS 133, unquoted equity securities are measured at cost subject to
an impairment test whether or not value can be estimated reliably by other
means.
FASB requires fair value measurement for all derivatives, including those
linked to unquoted equity instruments if they are to be settled in cash
but not those to be settled by delivery, which are outside the scope of FAS 133.
There are some exceptions for hybrid instruments as discussed in IAS
39 ¶ 23c and FAS 133 ¶ 12b.
|
Derivatives are reported on the balance sheet on a variety of bases
(including fair value, forward value, spot rates, intrinsic value, historical cost) or not
recorded at all.
|
Synthetic (accrual) accounting model for interest-rate swaps is
prohibited.
|
Synthetic (accrual) accounting model is widely used for interest-rate
swaps that hedge debt.
|
Gains and losses on derivative hedging instruments must be recorded in
either other comprehensive income or current earnings. They are not deferred as
liabilities or assets.
Note from Jensen
One area of difference between IAS 39 and FAS 133 is that FAS 133 requires that certain gains and losses of hedging instruments be carried
in equity (as OCI) whereas IAS 39
provides an option of equity versus current earnings.
|
Derivative gains and losses for hedges of forecasted transactions and firm
commitments are deferred as liabilities or assets on the balance sheet under FAS 52 and
FAS 80.
|
Derivative gains and losses for hedges of forecasted transactions are
required to be reported in other comprehensive income (equity), thus causing volatility in
equity. Note from Jensen:
One of the major sources of difference between FAS 133
and IAS 39 concerns embedded derivatives. In general,
net profit or loss will be the same under IAS and FASB Standards, but
the balance sheet presentation will be net under IAS and gross under
FASB. See cash flow hedge.
|
Derivative gains and losses for hedges of forecasted transactions are
permitted to be deferred on the balance sheet as assets or liabilities and, as such, do
not affect equity.
|
Hedge accounting is permitted for forward contracts that hedge
foreign-currency-denominated forecasted transactions (including intercompany
foreign-currency-denominated forecasted transactions).
|
FAS 52 does not permit hedge accounting for forward contracts that hedge
foreign-currency-denominated forecasted transactions.
|
Some hybrid instruments (i.e., contracts with embedded derivatives), must
be bifurcated into their component parts, with the derivative component accounted for
separately.
Note from Jensen
IAS 39's definition of a
derivative differs in that IAS 39 does not require "net
settlement" provisions that are required under FAS 133.
There are some exceptions for hybrid instruments as discussed in IAS
39 ¶s 23b & 23c; FAS 133 ¶s 12b & 12c.
|
Bifurcation of many hybrid instruments is not required under current
practice and, therefore, such instruments generally are not bifurcated.
|
Limited use of written options to hedge is permitted (e.g., when changes
in the fair value of the written option offset those of an embedded purchased option).
|
Current practice generally prohibits hedge accounting for written options.
|
Hedge accounting is prohibited for a hedge of a portfolio of dissimilar
items, and strict requirements exist for hedging a portfolio of "similar" items.
|
Less stringent guidelines are applied in practice for portfolio hedging.
|
Demonstration of enterprise or transaction risk reduction is not required
-- only the demonstration of a high effectiveness of offset in changes in the fair value
of cash flows of the hedging instrument and the hedged. item.
|
Demonstration of enterprise risk reduction is required for hedge
transactions with futures contracts and, by analogy, option contracts. Demonstration
of transaction risk reduction is required for foreign-currency hedges.
|
The definition of a derivative is broader than in current practice (e.g.,
it includes commodity-based contracts).
Note from Jensen
IAS 39's definition
of a derivative differs in that IAS 39 does not require "net
settlement" provisions that are required under FAS 133.
|
The definition of a derivative excludes certain commodity and other
contracts involving nonfinancial assets.
|
Table of Derivatives-Contract Types
|
Contract
|
Derivative within the scope
of FAS 133?
|
Underlying
|
Notional Amount of
Payment Provision
|
1.
|
Equity security
|
No. An initial net investment is required to purchase a
security
|
-
|
-
|
2.
|
Debt security or loan
|
No. It requires an initial net investment of the principal
amount or (if purchased at a discount or premium) an amount calculated to yield a market
rate of interest.
|
-
|
-
|
3.
|
Regular-way security trade (e.g., trade of a debt or equity
security)
|
No. Such trades are specifically excluded from the scope of FAS
133 (paragraph 10(a)).
|
-
|
-
|
4.
|
Lease
|
No. It requires a payment equal to the value of the right to
use the property.
|
-
|
-
|
5.
|
Mortgage-backed security
|
No. It requires an initial net investment based on market
interest rates adjusted for credit quality and prepayment.
|
-
|
-
|
6.
|
Option to purchase or sell real estate
|
No, unless it can be net-settled and is exchange-traded.
|
Price of the real estate
|
A specified parcel of the real estate
|
7.
|
Option to purchase or sell an exchange-traded security
|
Yes
|
Price of the security
|
A specified number of securities
|
8.
|
Option to purchase or sell a security not traded on an exchange
|
No, unless it can be net-settled.
|
Price of the security
|
A specified number of securities
|
9.
|
Employee stock option
|
No; for purposes of the issuer's accounting. It is specifically
excluded as a derivative by paragraph 11.
|
-
|
-
|
10.
|
Futures contract
|
Yes. A clearinghouse (a market mechanism) exists to facilitate
net settlement.
|
Price of a commodity or a financial instrument
|
A specified quantity or fact amount
|
11.
|
Forward contract to purchase or sell securities
|
No, unless it can be net-settled, or if the securities are
readily convertible to cash and the forward contract does not qualify as a "regular
way" trade.
|
Price of a security
|
A Specified number of securities or a specified principal or
face amount
|
12.
|
A nonexchange traded forward contract to purchase or sell
manufactured goods
|
No, unless it can be net-settled and neither party owns the
goods.
|
Price of the goods
|
A specified quantity
|
13.
|
A nonexchange traded forward contract to purchase or sell a
commodity
|
No, unless it can be net-settled or the commodity is readily
convertible to cash and the purchase is not a "normal purchase."
|
Price of the commodity
|
A specified quantity
|
14.
|
Interest-rate swap
|
Yes
|
An interest rate
|
A specified amount
|
15.
|
Currency swap
|
Yes. Paragraph 257.
|
An exchange rate
|
A specified currency amount
|
16.
|
Swaption
|
Yes. It requires the delivery of a derivative or can be
net-settled.
|
Value of the swap
|
The notional amount of the swap
|
17.
|
Stock-purchase warrant
|
Yes, for the holder, if the stock is readily convertible to
cash. No, for the issuer, if the warrant is classified in stockholders' equity.
|
Price of the stock
|
A specified number of shares
|
18.
|
Property and casualty insurance contract
|
No. Specifically excluded.
|
-
|
-
|
19.
|
Life insurance contract
|
No. Specifically excluded.
|
-
|
-
|
20.
|
Financial-quarantee contract -- payment occurs if a specific
debtor fails to pay the guaranteed party.
|
No. Specifically excluded.
|
-
|
-
|
21.
|
Credit-indexed contract -- payment occurs if a credit index (or
the creditworthiness of a specified debtor or debtors) varies in a specified way.
|
Yes
|
Credit index or credit rating
|
A specified payment amount (which may vary, depending on the
degree of change, or, which may be fixed)
|
22.
|
Royalty agreement
|
No. It is based on sales of one of the parties, which is an
excluded underlying.
|
-
|
-
|
23.
|
Interest-rate cap
|
Yes
|
An interest rate
|
A specified amount
|
24.
|
Interest-rate floor
|
Yes
|
An interest rate
|
A specified amount
|
25.
|
Interest-rate collar
|
Yes
|
An interest rate
|
A specified amount
|
26.
|
Adjustable-rate loan
|
No. An initial net investment equal to the principal amount of
the loan is required.
|
-
|
-
|
27.
|
Variable annuity contracts
|
No. Such contracts require an initial net investment.
|
-
|
-
|
28.
|
Guaranteed investment contracts
|
No. Such contracts require an initial net investment.
|
-
|
-
|
Other References --- See References
Beginning
of Bob Jensen's FAS 133 and IAS 39 Glossary
Accounting for Derivative
Instruments and Hedging Activities
| A | B | C | D | E | F | G | H | I | J | K | L | M |
| N | O | P | Q | R | S | T | U | V | W | X | Y | Z |
Note that the FASB's FAS 133
becomes required for calendar-year companies on January
1, 2001. Early adopters can apply the standard prior to the
required date, but they cannot apply it retroactively. The January
1, 2001 effective date follows postponements from the original starting
date of June 15, 1999 stated in Paragraph 48 on Page 29 of FAS 133.
For fiscal-year companies, the effective date is June
15, 2000. The international counterpart known as the IASC's IAS
39 becomes effective for financial statements for financial years beginning
on the same January 1, 2001. Earlier application permitted for financial
years ending after 15 March 1999.
For a FAS 133 flow chart,
go to
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
A-Terms
Accounting
Exposure =
a term used in alternate ways. In one
context, accounting exposure depicts foreign exchange exposure that cannot be captured by
the accounting model. In some textbooks accounting exposure is synonymous with translation exposure. See translation exposure.
Also see risks.
Amortization of Basis Adjustments = see basis adjustment.
Anticipated Transaction = see forecasted transaction.
AOCI = accumulated
other comprehensive income. See comprehensive income.
Arbitrage
=
By definition, arbitraging entails investing at zero market (price) risk
coupled with the risk of losing relatively minor transactions costs of getting
into and closing out contracts. There might be other risks.
Especially when dealing in forward contracts, there may be credit risks.
Forward contracts are often private agreements between contracting
individuals. Other arbitraging alternatives such as futures and options
contracts are generally obtained in trading markets such as the Chicago Board of
Trade (CBOT) and the Chicago Board of Options Exchange (CBOE). In markets
like the CBOT or the CBOE, the trading exchanges themselves guarantee payments
such that there is no credit risk in hedging or speculating strategies.
Arbitrage entails a hedging strategy that eliminates all market (price) risk
while, at the same time, has no chance of losing any money and a positive chance
of making a profit. Sometimes the profit is locked in to a fixed amount in
advance. At other times, the profit is unknown, but can never be less than
zero (ignoring transactions costs).
Generally arbitrage opportunities arise when the same item is traded in
different markets where information asymmetries between markets allows
arbitragers with superior information to exploit investors having inferior
information. In perfectly efficient markets, all information is impounded
in prices such that investors who "know more" cannot take advantage of
investors who are not up on the latest scoop. Only in inefficient markets
can there be some differences between prices due to unequal impounding of
information.
FAS 133
says nothing
about arbitrage accounting. Thus it is necessary to drill arbitrage
trans actions down to their basic component contracts such as
forwards, futures, and options.
See derivative financial instruments
and hedge.
You can learn more about
arbitrage from my tutorial on arbitraging at
http://faculty.trinity.edu/rjensen/acct5341/speakers/muppets.htm
You will find the
following definition of arbitrage at http://risk.ifci.ch/00010394.htm
1) Technically, arbitrage consists of
purchasing a commodity or security in one market for immediate sale in another
market (deterministic arbitrage). (2) Popular usage has expanded the meaning of
the term to include any activity which attempts to buy a relatively underpriced
item and sell a similar, relatively overpriced item, expecting to profit when
the prices resume a more appropriate theoretical or historical relationship
(statistical arbitrage). (3) In trading options, convertible securities, and
futures, arbitrage techniques can be applied whenever a strategy involves buying
and selling packages of related instruments. (4) Risk arbitrage applies the
principles of risk offset to mergers and other major corporate developments. The
risk offsetting position(s) do not insulate the investor from certain event
risks (such as termination of a merger agreement or the risk of delay in the
completion of a transaction) so the arbitrage is incomplete. (5) Tax arbitrage
transactions are undertaken to share the benefit of differential tax rates or
circumstances of two or more parties to a transaction. (6) Regulatory arbitrage
transactions are designed to provide indirect access to a market where one party
is denied direct access by law or regulation. (7) Swap- driven arbitrage
transactions are motivated by the comparative advantages which swap
counterparties enjoy in different debt and currency markets. One counterparty
may borrow relatively cheaper in the intermediate- or long-term United States
dollar market while the other may have a comparative advantage in floating rate
sterling. A cross-currency swap can improve both of their positions.
At-the-Money = see option and intrinsic value.
Auditing See SAS
92
Available-for-Sale
(AFS) Security =
is one of three classifications of
securities investments under SFAS 115. Securities designated as "held-to-maturity" need not be revalued for changes in
market value and are maintained at historical cost-based book value. Securities not
deemed as being held-to-maturity securities are adjusted for changes in fair value.
Whether or not the unrealized holding gains or losses affect net income depends upon
whether the securities are classified as trading securities versus available-for-sale
securities. Unrealized holding gains and losses on available-for-sale securities are
deferred in comprehensive income instead of being
posted to current earnings. This is not the case for securities classified as
trading securities rather than trading securities. See FAS 133 Paragraph 13. The three classifications are of
vital importance to cash flow hedge accounting under
FAS 133. See cash flow hedge and held-to-maturity.
Also see equity method
and impairment.
Flow Chart for AFS Hedge Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Classification of an available-for-sale security gives rise to alternative
gain or loss recognition alternatives under international rules. Changes
in the value of an available-for-sale instrument either be included in earnings for the period in which it arises;
or recognized directly in equity, through the statement of changes in equity
( IAS 1 Paragraphs 86-88) until the financial asset is sold, collected or otherwise disposed of,
or until the financial asset is determined to be impaired (see IAS
Paragraphs 117-119), at
which time the cumulative gain or loss previously recognized in equity should be included
in earnings for the period. See IAS 39 Paragraph 103b.
A trading security
(not subject to APB 15 equity method accounting and as defined
in SFAS 115) cannot be a FAS 133 hedged item. That is because
SFAS 115 requires that trading securities be revalued
(like gold) with unrealized holding gains and losses being booked to current
earnings. Conversely, Paragraphs 4c on Page 2, 38 on Page 24, and 479 on Page 209 of
FAS 133 state that a forecasted purchase of an available-for-sale can be a hedged item,
because available-for-sale securities are revalued under SFAS 115 have holding gains and
losses accounted for in comprehensive income rather
than current earnings. Unlike trading securities, available-for-sale securities can
be FAS 133-allowed hedge items. Mention of available-for sale is made in
Paragraphs 4, 18, 23, 36, 38, 49, 52-55, 123, 479-480, and 534 of FAS 133. Held-to-maturity securities can also be FAS 133-allowed hedge
items.
Note that if unrealized gains and
losses are deferred in other comprehensive income, the deferral lasts until the
transactions in the hedged item affect current earnings. This means that OCI may
carry forward on the date hedged securities are purchased and remain on the books until
the securities are sold. This is illustrated in Example 19 on
Page 228 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP
in July 1998). The Example 5.5 illustration on Page 165 notes that hedge
effectiveness need only be assessed for price movements in one direction for put and call
options since these only provide one-way price protection.
Suppose a company expects dividend income
to continue at a fixed rate over the two years in a foreign currency. Suppose the
investment is adjusted to fair market value on each reporting date. Forecasted
dividends may not be firm commitments since there are not
sufficient disincentives for failure to declare a
dividend. A cash flow hedge of the foreign currency risk exposure can be entered
into under Paragraph 4b on Page 2 of FAS 133. Whether or not gains and losses are
posted to other comprehensive income, however, depends
upon whether the securities are classified under SFAS 115 as available-for-sale or as
trading securities. There is no held-to-maturity alternative for equity securities.
One of the things that the FASB has never properly addressed is how to
account for hedges of interest rate risk in Available-for-Sale (AFS)
securities where gains and losses of both the hedged item and the hedging
derivative go to OCI. Based on an old idea from KPMG, I developed my own
thoughts on this ---
http://faculty.trinity.edu/rjensen/CaseAmendment.htm
The difference between a forward exchange rate and a spot rate is not excluded from a fair value hedging relationship for firm
commitments measured in forward rates. However Footnote 22 on Page 68 of
FAS 133 reads as follows:
If the hedged item were a
foreign-currency-denominated available-for-sale security instead of a firm commitment,
Statement 52 would have required its carrying value to be measured using the spot exchange
rate. Therefore, the spot-forward difference would have been recognized immediately in
earnings either because it represented ineffectiveness or because it was excluded from the
assessment of effectiveness.
B-Terms
Backwardation = see basis and contango swap.
Banker Opinions =
Joint Working Group of Banking Associations Financial Instrument Issues
Relating to Banks
- banksjwg.pdf - Discussion Paper
- jwgfinal.pdf - Final Position on Fair Value Accounting
Hi Dr. Jensen!
It is the official site about the Financial
Instruments - Comprehensive Project of the IASC http://www.iasc.org.uk/frame/cen3_112.htm
The site of the IAS Recognition and Measurement Project is: http://www.iasc.org.uk/frame/cen2_139.htm
Your Trinity-Homepages on Derivatives SFAS No. 133 is
my favorite on this subject, espicially the illustrative examples (and the
account simulations).
Currently I am focusing on splitting up hybrid
financial instruments, especially those with embedded optional building
blocks.
The book of Smith/Smithson/Willford (1998) Managing Financial Risk and that
from Das S. (1998) and Walsey J. (1997) provides a good guidance on how these
products are structured.
Best Regard Christian
Basis =
difference between the the current spot
price and the forward (strike) price of a derivative such
as a futures contract or the forward component in an options contract. The basis is negative in normal
backwardation. The basis is is postive in the normal contango.
Various theories exist to explain the two differing convergence patterns.
There are other definitions of basis found in
practice. Some people define basis as the difference between the spot and futures
price. Alternately basis can be viewed as the benefits minus the costs of
holding the hedged spot underlying until the forward or futures
settlement date.
Still another definition of this term is based on the U.S.
tax code where basis is the carrying value of an asset. It is the last definition
that gives rise to the term basis adjustment. See intrinsic value. Also see the terms that use
"basis" that are listed below.
Still another term is the
difference between commodity prices as the difference between physical
locations or product quality grades.
Basis Adjustment
=
the adjustment of the booked value of an asset or
liability as required by SFAS 80 but is no longer allowed for cash flow and foreign
currency hedges under FAS 133 according to Paragraph 31 and Paragraphs 375-378 of FAS 133. Basis adjustment is required for fair value
hedges under Paragraphs 22-24 on Pages 15-16 of FAS 133. An illustration
of amortization of fair value hedge basis adjustments appears in Example 2 beginning in
Paragraph 111 on Page 60 of FAS 133. Also see short-cut method.
The carrying value of a hedging
offset account (OCI, Firm Commitment, or Balance Sheet Item) may be written
off prematurely whenever the hedge becomes severely ineffective.
Under IAS 39, the
carrying value of an effective hedge is written off when the hedge expires or
is dedesignated. See Paragraphs 162 and 163 of IAS 39.
Under FAS 133, the carrying value of
an effective hedge is carried forward until the ultimate disposition of the
hedged item (e.g. inventory sale or depreciation of equipment). See Paragraph
31 of FAS 133.
The FASB decision to ban basis
adjustment on the date the hedging contract is settled is controversial, although the controversy is a tempest in a teapot from the
standpoint of reported net earnings each period. Suppose you are enter into a firm
commitment on 1/1/99 to purchase a building for the amount of yen that you can purchase
for $5 million on 1/1/99. The financial risk is that this commitment requires a
payout in Japanese yen on 7/1/99 such that the building's cost may be higher or lower in
terms of how many yen must be purchased on 7/1/99. To hedge the dollar/yen exchange
rate, you enter into a forward contract that will give you whatever it takes make up the
difference between the yen owed and the yen that $5 million will purchase on 7/1/99.
On 1/1/99 the forward contract has zero value. Six months later, assume that the
forward contract has been value adjusted to $1 million because of the decline in the yen
exchange rate. The offsetting credit is $1 million in OCI if since this was not designated
as a fair value hedge.
To close out the derivative on 7/1/99, you debit cash and
credit the forward contract for $1 million. To basis adjust the cost of
the building, you would debit OCI for $1 million and credit the building fixed asset
account. The building would end up being booked on 7/1/99 for $4 million instead of
its 1/1/99 contracted $5 million. If you did not basis adjust, the credit would stay
in OCI and leave the building booked at a 7/1/99 value of $5 million.
Paragraph 376 on Page 173 of FAS 133 requires that you no longer adjust the basis to $4
million as a result of the foreign currency hedge. Hence depreciation of the
building will be more each year than it would be with basis adjustment.
The controversy stems over how and when to get that $1
million out of OCI and into retained earnings. Under SFAS 80, suppose that
with basis adjustment the impact would have been a reduction of annual depreciation by
$50,000 over the 20-year life of the building. In other words, depreciation
would have been $50,000 less each year smaller $4 million adjusted basis rather than
the $5 million unadjusted basis. One argument against basis adjustment in this
manner is that the company's risk management outcomes become buried in depreciation
expense and are not segregated on the income statement.
Without basis adjustment under FAS 133, you get $50,000
more annual depreciation but identical net earnings because you must amortize the $1
million in OCI over the life of the building. Here we will assume the amortization
is $50,000 per year. Each year a $50,000 debit is made to OCI and a credit is made
to the P&L closing account. When OCI is amortized, investors are
reminded on the income statement that, in this example, a $50,000 per year savings accrued
because the company successfully hedged $1 million in foreign currency risk exposure.
In Paragraph 31 on Page 22 of FAS 133, the amortization
approach is required for this cash flow hedge outcome. You cannot
basis adjust in order to take $50,000 per year lowered depreciation over the life of the
building. But you report the same net earnings as if you had basis
adjusted. In any case, FAS 133 does not allow you to take the entire $1
million into 7/1/99 earnings. Paragraph 376 on Page 173 of FAS 133 elaborates
on this controversy.
What is wrong with the FAS 133 approach, in my viewpoint,
is that it may give the appearance that a company speculated when in fact it merely
locked in a price with a cash flow or foreign currency hedge. The hedge locks in a
price. But the amortization approach (in the case of a long-term asset) or the
write-off at the time of the sale (in the case of inventory) isolates the hedge cash flow
as an expense or revenue as if the company speculated. In the above example, the
company reports $50,000 revenue per year from the forward contract. This could have
been a $50,000 loss if the dollar had declined against the yen between 1/1/99 and
7/1/99. If the $50,000 was buried in depreciation charges, it would seem less likely
that investors are mislead into thinking that the $50,000 per year arose from speculation
in forward contracts. Companies also point out that the amortization approach
greatly adds to record keeping and accounting complexities when there are many such
hedging contracts. Basis adjustment gives virtually the same result with a whole lot
less record keeping.
It should also be noted that to the extent that the hedge
is ineffective, the ineffective portion gets written off to
earnings on the date the asset or liability is acquired. In the above example, any
ineffective portion would have to be declared on 1/199 and never get posted to
OCI. Hence it would never be spread over the life of the building. According to Paragraph 30 of FAS 133, ineffectiveness is to be
defined at the time the hedge is undertaken. Hedging strategy and ineffectiveness
definition with respect to a given hedge defines the extent to which interim adjustments
affect interim earnings.
Click here to view the IASC's Paul Pacter commentary on basis adjustment.
Two illustrations of basis adjustment
taken from
http://faculty.trinity.edu/rjensen/CaseAmendment.htm
Especially note my reasoning under Illustration 2 shown below
Illustration 1
Prices of oil per unit
|
10/31 |
11/30 |
12/31 |
1/31 |
3/31 |
Oil
Price (Spot) |
$35 |
$40 |
$38 |
$44 |
$46 |
Forward Price |
$36 |
$41 |
$39 |
$44 |
|
Fair Value
Hedge of a Firm Commitment
Assume that
Warfield makes a deal with an oil supplier to buy 100,000 units of oil
for $35 per barrel which is $1 less than the $36 derivatives market
forward price on October 31. There can be many reasons such as customer
relations and delivery costs that motivate buyers and suppliers to
contract for something other than forward prices in a derivatives
instruments market exchange and over the counter. Warfield thinks that
prices are going to plunge so it hedges the fair value of this firm
commitment with a fair value hedge using a forward contract that will
settle for the difference between the January 31 spot price and the $35
forward price.
Cash Flow
Hedge of a Forecasted Transaction
Assume that Warfield has a forecasted transaction to purchase 100,000
units of oil at the January 31 spot rate. In order to hedge cash flow
risk, Warfield enters into a forward contract to that will settle for
the difference between the January 31 spot price and a $35 forward
price.
|
Using Jensen Prices |
|
|
Date |
No Inventory on Hand |
Fair Value Hedge of a
Firm Commit. |
Jensen Solution ---
Cash Flow Hedge of Forecasted Trans. |
Date |
Ledger Account |
Debit |
Credit |
Balance |
Ledger Account |
Debit |
Credit |
Balance |
10/31 |
No entry for hedge
No inventory on hand |
|
|
|
No entry for hedge
No inventory on hand |
|
|
|
|
$35 ppb firm commit.
$36 ppb forward price
$35 ppb spot price
100,000 notional
$0 forward contract value |
|
|
|
No firm commitment
$36 ppb forward price
$35 ppb spot price
100,000 notional
$0 forward contract value |
|
|
|
|
|
|
|
|
|
|
|
|
11/30 |
Firm commitment |
500,000 |
|
$500,000 |
OCI
or AOCI |
0 |
500,000 |
($500,000) |
|
G/L (I/S) |
0 |
|
$0 |
G/L
(I/S) |
|
0 |
$0 |
|
Forward contract |
|
500,000 |
($500,000) |
Forward contract |
500,000 |
|
$500,000 |
|
-To
adjust the forward contract to fair value with Delta =
abs($41-$36)/
abs($40-$35)
= 1.0 or 100%
Hence this is a perfect hedge at this point. |
|
|
|
-To
adjust the forward contract to fair value with Delta =
abs($41-$36)/
abs($40-$35)
= 1.0 or 100%
Hence this is a perfect hedge at this point. |
|
|
|
|
|
|
|
|
|
|
|
|
12/31 |
Firm
commitment |
|
200,000 |
$300,000 |
OCI
or AOCI |
200,000 |
|
($300,000) |
|
G/L
(I/S) |
|
0 |
$0 |
G/L
(I/S) |
0 |
|
0 |
|
Forward contract |
200,000 |
|
($300,000) |
Forward contract |
|
200,000 |
$300,000 |
|
-To
adjust the forward contract to fair value with Delta =
abs($39-$36)/
abs($38-$35)
= 1.0 or 100%
Hence hedge accounting is now fully allowed with a perfect
cumulative Delta |
|
|
|
-To
adjust the forward contract to fair value with Delta =
abs($39-$36)/
abs($38-$35)
= 1.0 or 100%
Hence hedge accounting is now fully allowed with a perfect
cumulative Delta |
|
|
|
|
|
|
|
|
|
|
|
|
1/31 |
Firm commitment |
500,000 |
|
$800,000 |
OCI
or AOCI |
0 |
500,000 |
($800,000) |
|
G/L (I/S) |
|
|
$0 |
G/L
(I/S) |
|
|
|
|
Forward contract |
|
500,000 |
($800,000) |
Forward contract |
500,000 |
|
$800,000 |
|
-To
adjust the forward contract fair value for a perfectly effective
fair value hedge.. |
|
|
|
- To
adjust the forward contract fair value for a perfectly effective
cash flow hedge. |
|
|
|
|
|
|
|
|
|
|
|
|
1/31 |
Forward contract |
800,000 |
|
$0 |
Forward contract |
|
800,000 |
$0 |
|
Cash |
|
800,000 |
($800,000) |
Cash |
800,000 |
|
$800,000 |
|
-To
record unfavorable settlement of fair value hedging contract |
|
|
|
-To
record favorable settlement of cash flow hedging contract |
|
|
|
|
|
|
|
|
|
|
|
|
1/31 |
Oil inventory |
4,400,000 |
|
$4,400,000 |
Oil
inventory |
4,400,000 |
|
$4,400,000 |
|
G/L (I/S) |
|
900,000 |
($900,000) |
G/L
(I/S) |
|
0 |
$0 |
|
Cash |
|
3,500,000 |
($4,300,000) |
Cash
|
|
4,400,000 |
($4,000,000) |
|
-To
record purchase of the oil inventory at the $35 firm commitment
price |
|
|
|
-To
report purchase of the oil inventory at spot price |
|
|
|
|
|
|
|
|
|
|
|
|
3/31 |
Cash |
4,600,000 |
|
$300,000 |
Cash |
4,600,000 |
|
$600,000 |
|
Oil inventory |
|
4,400,000 |
$0 |
Oil
inventory |
|
4,400,000 |
$0 |
|
G/L (I/S) |
|
200,000 |
($1,100,000) |
G/L
(I/S) |
|
200,000 |
($200,000) |
|
-To
record the sale of the oil inventory at the spot price |
|
|
|
-To
record the sale of the oil inventory at the spot price |
|
|
|
|
|
|
|
|
|
|
|
|
3/31 |
G/L (I/S) |
800,000 |
|
$300,000 |
G/L
(I/S) |
|
$800,000 |
($1,000,000) |
|
Firm commitment |
|
800,000 |
$0 |
OCI
or AOCI |
$800,000 |
|
$0 |
|
-This
is the basis adjustment that accompanies the sale of all the oil
inventory. |
|
|
|
-This
is the basis adjustment that accompanies the sale of all the oil
inventory. |
|
|
|
Fair Value Hedge Summary (using
Jensen’s prices)
+$1,100,000 = March 31 profit without a hedge = $4,600,000 sale
on March 31 - $3,500,000 purchase on January 31 at firm commitment price
+$300,000 = March 31 profit with a hedge = $1,100,000 profit
without a hedge - $800,000 loss on fair value hedging contract
A company that wants to hedge fair
value of its purchase commitments must be prepared to accept the cash
flow risk and loss of opportunity value its firm commitment price is way
below the current spot price when the oil is purchased.
Hedging ineffectiveness with the
revised prices was greatly eliminated in the second example that did not
use the Smith and Kohlbeck prices.
A fair value hedge creates cash
flow risk.
A cash flow hedge creates fair value risk.
Basis
adjustment for the $800,000 loss on the firm commitment fair value hedge
is controversial due to ambiguity in FAS 133 regarding basis adjustment
of the Firm Commitment equity account. My way of doing this above is
explained under Exhibit 5 shown below.
Cash Flow Hedge Summary (using
Jensen’s prices)
+$200,000 = March 31 profit without a hedge = $4,600,000 sale on
March 31 - $4,400,000 purchase on January 31
+$1,000,000 = March 31 profit with a hedge = $200,000 profit
without a hedge + $800,000 gain on cash flow hedging contract
A company that wants to hedge cash flows of its forecasted transactions
must be prepared to accept the fair value risk and loss of opportunity
value its decision to pay spot prices.
Hedging ineffectiveness with
Jensen’s revised prices was greatly eliminated in the second example
that did not use the Smith and Kohlbeck prices. Hedging against cash
flow risk of price increases is a good deal when spot prices soar and a
bad deal when spot prices plunge.
A fair value hedge creates cash
flow risk.
A cash flow hedge creates fair value risk.
The above solution for the cash flow hedge shows the correct way to
basis adjust the gain of $800,000 on the hedging contract on the date of
sale rather than the date of purchase of the inventory. Smith and
Kohlbeck incorrectly basis adjust all cash flow hedges on the date of
the hedge settlement. Basis adjustment should be on the date inventory
is sold under FAS 133, but under IAS 39 basis should be adjusted when
the hedge is settled or dedesignated.
Paragraph 377
of FAS 133 reads as follows:
377. The Board decided to require that the gain or
loss on a derivative be reported initially in other comprehensive
income and reclassified into earnings when the forecasted
transaction affects earnings. That requirement avoids the problems
caused by adjusting the basis of an acquired asset or incurred
liability and provides the same earnings impact. The approach in
this Statement, for example, provides for (a) recognizing the gain
or loss on a derivative that hedged a forecasted purchase of a
machine in the same periods as the depreciation expense on the
machine and (b) recognizing the gain or loss on a derivative that
hedged a forecasted purchase of inventory when the cost of that
inventory is reflected in cost of sales
|
Illustration 2
Instead of buying oil inventory on
January 31 at a $35 firm commitment price, suppose the firm purchased
the inventory for $35 on October 31 and enters a forward contract to
protect the value of the inventory. The hedge accounting is somewhat
different for these two types of fair value hedges. The main difference
is that for inventory value, the “Firm Commitment” account invented by
the FASB is not used for fair value hedge accounting. Instead the
accounting for the inventory itself is changed from historical cost to
fair value accounting during the hedging period.
They are
compared below.
I will now
illustrate hedge accounting using case prices that have more effective
hedging outcomes.
Jensen Prices
|
10/31 |
11/30 |
12/31 |
1/31 |
3/31 |
Oil
Price (Spot) |
$35 |
$40 |
$38 |
$44 |
$46 |
Forward Price |
$37 |
$41 |
$40 |
$44 |
|
Fair Value
Hedge of Existing Inventory
Assume buys
100,000 units of oil for $35 per barrel on October 31. Warfield thinks
the prices might go down and decides to enter into a forward contract to
hedge the fair value of this inventory. The forward contract will settle
for the difference between the spot rate on January 31 and $37.
Fair Value
Hedge of a Firm Commitment
Assume that
Warfield makes a deal with an oil supplier to buy 100,000 units of oil
for $37 per barrel which is at the $37 derivatives market forward price
on October 31. There can be many reasons such as customer relations and
delivery costs that motivate buyers and suppliers to contract for
something other than forward prices in a derivatives instruments market
exchange and over the counter. Warfield thinks that prices are going to
plunge so it hedges the fair value of this firm commitment with a fair
value hedge using a forward contract that will settle for the difference
between the January 31 spot price and the $37 forward price.
|
Using Jensen Prices |
With Inventory on Hand |
With No Inventory on
Hand |
Date |
|
Fair Value Hedge of a
Inventory |
Fair Value Hedge of a
Firm Commitment |
Date |
Ledger Account |
Debit |
Credit |
Balance |
Ledger Account |
Debit |
Credit |
Balance |
10/31 |
No entry for forward
Contract |
|
|
|
No entry
No inventory on hand |
|
|
|
|
$37 ppb forward price
$35 ppb spot price
100,000 notional
$0 forward contract value |
|
|
|
$37 ppb firm commit.
$36 ppb forward price
$35 ppb spot price
100,000 notional
$0 forward contract value |
|
|
|
|
|
|
|
|
|
|
|
|
10/31 |
Oil
inventory |
3,500.000 |
|
$3,500,000 |
|
|
|
|
|
Cash |
|
3,500,000 |
($3,500,000) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
11/30 |
Oil inventory |
500,000 |
|
$4,000,000 |
Firm
commitment |
500,000 |
|
$500,000 |
|
G/L (I/S) |
0 |
100,000 |
($100,000) |
G/L
(I/S) |
|
100,000 |
($100,000) |
|
Forward contract |
|
400,000 |
($400,000) |
Forward contract |
|
400,000 |
($400,000) |
|
-To
adjust the forward contract to fair value with Delta =
abs($41-$37)/
abs($40-$35)
= 0.8 or 80%
Hence this is a 80% effective fair value hedge.. |
|
|
|
- To
adjust the forward contract to fair value with Delta =
abs($41-$37)/
abs($40-$35)
= 0.8 or 80%
Hence this is a 80% effective fair value hedge.. |
|
|
|
|
|
|
|
|
|
|
|
|
12/31 |
Oil inventory |
|
200,000 |
$3,800,000 |
Firm
commitment |
|
200,000 |
$300,000 |
|
G/L (I/S) |
100,000 |
0 |
$0 |
G/L
(I/S) |
100,000 |
|
$0 |
|
Forward contract |
100,000 |
|
($300,000) |
Forward contract |
100,000 |
|
($300,000) |
|
-To
adjust the forward contract to fair value with Delta =
abs($40-$37)/
abs($38-$35)
= 1.0 or 100%
Hence hedge accounting is now fully allowed with a perfect
cumulative Delta |
|
|
|
-To
adjust the forward contract to fair value with Delta =
abs($40-$37)/
abs($38-$35)
= 1.0 or 100%
Hence hedge accounting is now fully allowed with a perfect
cumulative Delta |
|
|
|
|
|
|
|
|
|
|
|
|
1/31 |
Oil inventory |
600,000 |
|
$4,400,000 |
Firm
commitment |
100,000 |
|
$400,000 |
|
G/L (I/S) |
|
500,000 |
($500,000) |
G/L
(I/S) |
|
|
$0 |
|
Forward contract |
|
100,000 |
($400,000) |
Forward contract |
|
100,000 |
($400,000) |
|
-To
adjust the forward contract to fair value at a pending $41-$37
unfavorable pending settlement. |
|
|
|
- To
adjust the forward contract to fair value at a pending $41-$37
unfavorable pending settlement. |
|
|
|
|
|
|
|
|
|
|
|
|
1/31 |
Forward contract |
400,000 |
|
$0 |
Forward contract |
400,000 |
|
$0 |
|
Cash |
|
400,000 |
($400,000) |
Cash |
|
400,000 |
($400,000) |
|
-To
record unfavorable settlement of fair value hedging contract |
|
|
|
-To
record unfavorable settlement of fair value hedging contract |
|
|
|
|
|
|
|
|
|
|
|
|
1/31 |
Oil inventory |
|
|
$4,400,000 |
Oil
inventory |
4,400,000 |
|
$4,400,000 |
|
G/L (I/S) |
|
0 |
($500,000) |
G/L
(I/S) |
|
700,000 |
($700,000) |
|
Cash |
|
0 |
($3,900,000) |
Cash
|
|
3,700,000 |
($4,100,000) |
|
-No
entry |
|
|
|
-To
record purchase of the oil inventory at the $37 firm commitment
price |
|
|
|
|
|
|
|
|
|
|
|
|
3/31 |
Cash |
4,600,000 |
|
700,000 |
Cash |
4,600,000 |
|
$500,000 |
|
Oil inventory |
|
4,400,000 |
$0 |
Oil
inventory |
|
4,400,000 |
$0 |
|
G/L (I/S) |
|
200,000 |
($700,000) |
G/L
(I/S) |
|
200,000 |
($900,000) |
|
-To
record the sale of the oil inventory at the spot price |
|
|
|
-To
record the sale of the oil inventory at the spot price |
|
|
|
|
|
|
|
|
|
|
|
|
3/31 |
G/L (I/S) |
|
|
($700,000) |
G/L
(I/S) |
400,000 |
|
($500,000) |
|
Firm commitment |
|
|
|
Firm
commitment |
|
400,000 |
$0 |
|
-This
is the basis adjustment is not necessary for inventory on hand. |
|
|
|
-This
is the basis adjustment that accompanies the sale of all the oil
inventory. |
|
|
|
Fair Value Hedge Summary of
Hedging the Fair Value of Inventory
+$1,100,000 = March 31 profit without a hedge = $4,600,000 sale
on March 31 - $3,500,000 purchase on October 31
+$700,000 = March 31 profit with a hedge = $1,100,000 profit
without a hedge - $400,000 loss on fair value hedging contract
First it might be noted that hedge
accounting is not allowed for commodities that are carried or will be
carried at fair value in the ledger accounts. Only inventories
maintained at historical cost can get hedge accounting. Oil inventory is
normally carried at historical cost except during the hedging period of
a fair value hedge under FAS 133 rules.
The main difference between
hedging the fair value of inventory and the fair value of a firm
commitment is that the “Firm Commitment” account is not used for
existing inventory fair value hedging. Instead existing inventory (the
hedged item) normally carried at historical cost is carried at fair
value during the hedging period. After the hedge is settled or
dedesignated, the company must revert to historical cost valuation of
inventories.
A fair value hedge creates cash
flow risk of existing inventory.
The can be no cash flow hedge since there is no cash flow risk of
existing inventory.
Fair Value Hedge Summary of
Hedging the Fair Value of a Firm Commitment
+$900,000 = March 31 profit without a hedge = $4,600,000 sale on
March 31 - $3,700,000 purchase on January 31
+$500,000 = March 31 profit with a hedge = $900,000 profit
without a hedge - $400,000 loss on fair value hedging contract
The solutions
above ignore the time value of money. FAS 133 recommends and in some
cases requires that hedge accounting be further complicated with time
value of money adjustments.
When
inventory is on hand, the effective part of the hedge is carried forward
in the Oil Inventory account whose fair value changes offset the changes
in value of the hedging contract. That is consistent with Paragraphs
22-24 in FAS 133.
These are two
paragraphs from the Fair Value section of Section 815 of the FASB’s
Codification database
35-8 The
adjustment of the carrying amount of a hedged asset or liability
required by paragraph 815-25-35-1(b)
shall be accounted for in the same manner as other components of the
carrying amount of that asset or liability.
For example, an
adjustment of the carrying amount of a hedged asset held for sale (such
as inventory) would remain part of the carrying amount of that asset
until the asset is sold, at which point the entire carrying amount of
the hedged asset would be recognized as the cost of the item sold in
determining earnings.
35-9 An
adjustment of the carrying amount of a hedged interest-bearing
financial instrument
shall be amortized to earnings.
Amortization shall
begin no later than when the hedged item ceases to be adjusted for
changes in its fair value attributable to the risk being hedged.
But consider
the case of the hedge of the firm commitment when there is no inventory
on hand. In this case, the Firm Commitment account absorbs the changes
in value of the hedging contract. If the Firm Commitment account is
basis adjusted (zeroed out) when the hedge is settled or otherwise
terminated, you are not being consistent with the way the hedge
settlement is deferred with the inventory is on hand, i.e., until the
inventory is sold. The risk being hedged was the change in spot rates
and the gain or loss being deferred, in my viewpoint, should be deferred
until the purchased inventory is sold so as to be consistent with the
hedge accounting when the inventory was on hand when the hedging period
commenced.
Hence in the
two illustrations above, the ($4,211,111-$3,500,000 = $711,111) change
in the value of inventory when the hedge was settled unfavorably on
January 31 is deferred from being recognized in current earnings until
the inventory is sold on March 31. (The fair value is not hedged between
January 31 and March 31 and fair value accounting is not used for the
inventory in the unhedged period).
Similarly,
when the inventory was not on hand and the fair value of the firm
commitment was being hedged, the $711,111 in the Firm Commitment account
should not be basis adjusted on January 31. Instead it should be basis
adjusted when the inventory is sold since this unfavorable hedge
settlement is not buried in the Inventory account like it was when we
hedge the fair value of inventory on hand.
Actually,
I’ve not been successful in finding examples contrasting these two
situations so we have to reason this one through. It seems as though
both approaches illustrated above are consistent with each other in
deferring the hedge settlement basis adjustment until the inventory is
sold. Basis adjusting the Firm Commitment account on January 31 is not
consistent with the basis adjustment when we hedged inventory on hand
for fair value. This would not be basis adjustment deferral.
It seems to
me that my approach is consistent with Paragraph 35-8 above and
Paragraphs 22-24 of FAS 133. I’ve been bothered by the sorry way the
FASB has explained the accounting for fair value hedging a firm
commitment. Of course this is no problem in IAS 39 since basis
adjustment always takes place when the hedge is dedesignated or settled.
The Firm
Commitment account is always an equity (never an asset or liability)
account and is a place to defer the hedge gain or loss to the point of
sale for inventory. That’s what basis adjustment deferral is all about.
It is just like AOCI in the sense that between the date of the purchase
of the inventory and the date of the sale of inventory, the equity
account (whether AOCI for cash flow hedges or Firm Commitment for fair
value hedges) remains constant until part or all of the inventory is
sold. Then basis is adjusted by reclassifying the hedge gain or loss
deferral into earnings at the time of the sale.
The purchase
price is $35 and the spot price is $44 giving rise to a gain at the time
of purchase of $44-$35=$9 per unit or a total gain of $900,000 due to a
favorable purchase price. This gain is to be immediately recognized on
the date of purchase whether or not we hedge. Commodity inventories are
to be booked at fair value on the date of purchase irrespective of the
actual purchase price. This has nothing to do with hedging the fair
value of the firm commitment.
The question
is whether the gain or loss on the hedging derivative should be
recognized on the date of the purchase or the date of the sale. In this
illustration the hedging derivative lost $800,000 on the date of the
purchase of the inventory. The fair value hedge was effective for 89% or
$711,111 and ineffective for 11% or $88,889.
Under Smith
and Kohlbeck (SK) approach you would basis adjust on January 31 for the
full $800,000 hedging derivative loss. Under my approach I would only
charge the ineffective $88,889 portion to January 31 earnings and defer
the $711,111 effective portion in an equity account (Firm Commitment)
until the inventory is sold on March 31.
The issue was
never whether to recognize the $900,000 total gain on January 31.
Commodity inventories have to be carried at fair value on the date they
are purchased even if they are purchased a lower or higher firm
commitment price. If the firm commitment price was higher than fair
value we certainly would not want to record inventory at above its fair
value. The question was never whether to recognize the difference
between the firm commitment price and the fair value on the date of
purchase and to book this difference in current earnings.
The issue was
whether to hit all the hedge derivative loss of $800,000 to earnings on
the January 31 date of purchase (SK approach) or to defer the effective
portion of the hedging contract’s loss ($711,111) until basis adjustment
on the date of the sale (the Jensen approach). I grant you that the FASB
does not seem to be clear on this issue for fair value hedges of firm
commitments, but it is very clear with respect to deferred basis
adjustment for cash flow hedges.
Paragraph 377
of FAS 133 reads as follows:
377.
The Board decided to require that the gain or loss on a derivative be
reported initially in other comprehensive income and reclassified into
earnings when the forecasted transaction affects earnings. That
requirement avoids the problems caused by adjusting the basis of an
acquired asset or incurred liability and provides the same earnings
impact. The approach in this Statement, for example, provides for (a)
recognizing the gain or loss on a derivative that hedged a forecasted
purchase of a machine in the same periods as the depreciation expense on
the machine and (b) recognizing the gain or loss on a derivative that
hedged a forecasted purchase of inventory when the cost of that
inventory is reflected in cost of sales.
I think my
solution is consistent with the above paragraph for fair value hedges
vis-à-vis cash flow hedges.
I think my
solution is consistent with what happens for a fair value hedge of
existing inventory.
I think my
solution is consistent with Paragraph 24 (in the Fair Value Hedging
Section of FAS 113).
I think my
solution is consistent with what companies do in practice when a fair
value hedge is dedesignated before maturity. The Firm Commitment equity
account is carried forward until the hedged item revenue cycle is
completed in whole or in part.
Harris
Preferred Capital is carrying forward the hedge settlement until the
earnings cycle is completed whether the hedge is desesignated early or
settled at maturity.
You can read
the following in the 2005 10-K of the HARRIS PREFERRED CAPITAL
CORPORATION ---
http://yahoo.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHTML1?SessionID=bkB8jTdF57B95gG&ID=4306792
When
hedge accounting is discontinued because a fair value hedge is no longer
highly effective, the derivative instrument continues to be recorded on
the balance sheet at fair value but the hedged item is no longer
adjusted for changes in fair value that are attributable to the hedged
risk. The carrying amount of the hedged item, including the basis
adjustments from hedge accounting, is accounted for in accordance with
applicable generally accepted accounting principles. For a hedged loan,
the basis adjustment is amortized over its remaining life. When hedge
accounting is discontinued because the hedged item in a fair value hedge
no longer meets the definition of a firm commitment, the derivative
instrument continues to be recorded on the balance sheet at fair value
and any asset or liability that was recorded to recognize the firm
commitment is removed from the balance sheet and recognized as a gain or
loss in current period earnings. When hedge accounting is discontinued
because a cash flow hedge is no longer highly effective, the gain or
loss on the derivative that is in accumulated other comprehensive income
("AOCI") remains there until earnings are impacted by the hedged item
and the derivative instrument is marked to market through earnings. When
hedge accounting is discontinued because it is no longer probable that
the forecasted transaction in a cash flow hedge will occur, the gain or
loss on the derivative that was in AOCI is recognized immediately in
earnings and the derivative instrument is marked to market through
earnings. When hedge accounting is discontinued and the derivative
remains outstanding, the derivative may be redesignated as a hedging
instrument as long as the applicable hedge criteria are met under the
terms of the new contract.
Bob Jensen’s
illustrations of hedge effectiveness testing can be found using the
following links:
|
Basis Point =
interest rate amount equal to .0001 or 0.01%.
Basis Risk =
risk of financial exposure of a basis difference as defined
under "basis" above. For example in energy hedging there may be location
basis risk due to the differences in location such as the difference
between capacity at a supply terminal and a demand terminal. This risk is
commonly hedged with swaps.
Interest rate basis risk is the
difference arises from a difference between the index of the hedged item
vis-a-vis the exposure risk.
A basis swap is the swapping of one
variable rate for another variable rate for purposes of changing the net
interest rate.
Also see interest rate swap.
Basis Swap = see interest rate swap.
Benchmark = the designated risk being hedged. In FAS
133/138, the term applies to interest rate risk.
From the CFO Journal's Morning Ledger on October
26, 2018
The Financial
Accounting Standards Board on Thursday
expanded the list of U.S. benchmark interest rates
permitted in hedge accounting. The FASB added the
overnight index swap rate based on the Secured Overnight Financing
Rate to its list of eligible benchmark interest rates, reports CFO
Journal's Tatyana Shumsky.
The move comes as global financial regulators are pushing for the
transition away from the scandal-plagued London interbank offered
rate, or Libor. The SOFR, a Treasury repurchase agreement financing
rate, was identified as the preferred alternative to Libor.
The FASB said the accounting standards update will facilitate the
Libor to SOFR transition and give adequate time for companies to
prepare for changes to interest-rate hedging strategies.
In
FAS 133, the FASB did not take into account how interest rate risk is
generally hedged in practice. FAS 133 based the hedging rules
upon hedging of sector spreads for which there are no hedging
instruments in practice. The is one of the main reasons why FAS
138 amendments to FAS 133 were soon issued. Components of
interest rate risk are shown below:
Risk-free rate u(0) =
LIBOR spread l(0)-u(0) =
LIBOR(0) rate l(0) =
Unhedged credit sector spread s(0)-l(0) =
Total systematic interest rate risk s(0) =
Unhedged unsystematic risk v(0)-s(0) =
Full value effective rate v(0) =
Premium (discount) on the debt issue f(0)-v(0)=
Nominal (coupon) rate f(0) =
In FAS 138, the FASB moved away from sector spread hedging and
defined benchmarked interest rate hedging based upon only two allowed
interest rate spreads (i.e., the U.S. Treasury risk-free rate with no
spread or the LIBOR rate with only the LIBOR spread. Sector
spread hedging can no longer receive hedge accounting.
For an extensive numerical example of benchmark hedging, go to http://www.cs.trinity.edu/~rjensen/000overview/138bench.htm
FAS
138 Introduces Benchmarking
Examples Illustrating Application of FASB Statement No. 138,
Accounting for Certain Derivative Instruments and Certain Hedging
Activities-an amendment of FASB Statement No. 133 ---
http://www.fasb.org/derivatives/examplespg.shtml
or try clicking here.
FAS
138 Amendments expand the eligibility of many derivative instrument
hedges to qualify FAS 133/138 hedge. Such qualifications in accounting
treatment that reduces earnings volatility when the derivatives are
adjusted for fair value.
It
is very popular in practice to have a hedging instrument and the
hedged item be based upon two different indices.
In particular, the hedged item may be impacted by credit
factors. For example,
interest rates commonly viewed as having three components noted below:
·
Risk-free
risk that the level of interest rates in risk-free financial
instruments such as U.S. treasury T-bill rates will vary system-side
over time.
·
Credit
sector spread risk that interest rates for particular economic sectors
will vary over and above the risk-free interest rate movements.
For example, when automobiles replaced horses as the primary
means of open road transportation, the horse industry’s credit
worthiness suffered independently of other sectors of the economy.
In more recent times, the dot.com sector’s sector spread has
suffered some setbacks.
·
Unsystematic
spread risk of a particular borrower that varies over and above
risk-free and credit sector spreads.
The credit of a particular firm may move independently of more
system-wide (systematic) risk-free rates and sector spreads.
Suppose
that a hedge only pays at the T-Bill rate for hedged item based on
some variable index having credit components.
FAS 133 prohibited “treasury locks” that hedged only the
risk-free rates but not credit-sector spreads or unsystematic risk.
This was upsetting many firms that commonly hedge with treasury
locks. There is a market
for treasury lock derivatives that is available, whereas hedges for
entire interest rate risk are more difficult to obtain in practice.
It is also common to hedge with London’s LIBOR that has a
spread apart from a risk-free component.
The
DIG confused the issue by allowing both risk-free and credit sector
spread to receive hedge accounting in its DIG Issue E1 ruling.
Paragraph 14 of FAS 138 states the following:
Comments
received by the Board on Implementation Issue E1 indicated (a) that
the concept of market interest rate risk as set forth in Statement 133
differed from the common understanding of interest rate risk by market
participants, (b) that the guidance in the Implementation Issue was
inconsistent with present hedging activities, and (c) that measuring
the change in fair value of the hedged item attributable to changes in
credit sector spreads would be difficult because consistent sector
spread data are not readily available in the market.
In
FAS 138, the board sought to reduce confusion by reducing all
components risk into just two components called “interest rate
risk” and “credit risk.” Credit
risk includes all risk other than the “benchmarked” component in a
hedged item’s index. A
benchmark index can include somewhat more than movements in risk-free
rates. FAS 138 allows the
popular LIBOR hedging rate that is not viewed as being entirely a
risk-free rate. Paragraph
16 introduces the concept of “benchmark interest rate” as follows:
Because
the Board decided to permit a rate that is not fully risk-free to be
the designated risk in a hedge of interest rate risk, it developed the
general notion of benchmark
interest rate to encompass both risk-free rates and rates based on
the LIBOR swap curve in the United States.
FAS
133 thus allows benchmarking on LIBOR.
It is not possible to benchmark on such rates as
commercial paper rates, Fed Fund rates, or FNMA par mortgage rates.
Readers
might then ask what the big deal is since some of the FAS 133 examples
(e.g., Example 5 beginning in Paragraph 133) hedged on the basis of
LIBOR. It is important to
note that in those original examples, the hedging instrument (e.g., a
swap) and the hedged item (e.g., a bond) both used LIBOR in defining a
variable rate? If the
hedging instrument used LIBOR and the hedged item interest rate was
based upon an index poorly correlated with LIBOR, the hedge would not
qualify (prior to FAS 138) for FAS 133 hedge accounting treatment even
though the derivative itself would have to be adjusted for fair value
each quarter. Recall that
LIBOR is a short-term European rate that may not correlate with
various interest indices in the U.S.
FAS 133 now allows a properly benchmarked hedge (e.g., a
swap rate based on LIBOR or T-bills) to hedge an item having
non-benchmarked components.
The
short-cut method of relieving hedge ineffectiveness testing may no
longer be available. Paragraph
23 of FAS 138 states the following:
For
cash flow hedges of an existing variable-rate financial asset or
liability, the designated risk being hedged cannot be the risk of
changes in its cash flows attributable to changes in the benchmark
interest rate if the cash flows of the hedged item are explicitly
based on a different index. In
those situations, because the risk of changes in the benchmark
interest rate (that is, interest rate risk) cannot be the designated
risk being hedged, the shortcut method cannot be applied.
The Board’s decision to require that the index on which the
variable leg of the swap is based match the benchmark interest rate
designated as the interest rate risk being hedged for the hedging
relationship also ensures that the shortcut method is applied only to
interest rate risk hedges. The
Board’s decision precludes use of the shortcut method in situations
in which the cash flows of the hedged item and the hedging instrument
are based on the same index but that index is not the designated
benchmark interest rate. The
Board noted, however, that in some of those situations, an entity
easily could determine that the hedge is perfectly effective.
The shortcut method would be permitted for cash flow hedges in
situations in which the cash flows of the hedged item and the hedging
instrument are based on the same index and that index is the
designated benchmark interest rate.
In
other words, any hedge item that is not based upon only a benchmarked
component will force hedge effectiveness testing at least quarterly.
Thus FAS 138 broadened the scope of qualifying hedges, but it
made the accounting more difficult by forcing more frequent
effectiveness testing.
FAS
138 also permits the hedge derivative to have more risk than the
hedged item. For example,
a LIBOR-based interest rate swap might be used to hedge an AAA
corporate bond or even a note rate based upon T-Bills.
There
are restrictions noted in Paragraph 24 of FAS 138:
This
Statement provides limited guidance on how the change in a hedged
item’s fair value attributable to changes in the designated
benchmark interest rate should be determined.
The Board decided that in calculating the change in the hedged
item’s fair value attributable to changes in the designated
benchmark interest rate, the estimated cash flows used must be based
on all of the contractual cash flows of the entire hedged item.
That guidance does not mandate the use of any one method, but
it precludes the use of a method that excludes some of the hedged
item’s contractual cash flows (such as the portion of interest
payments attributable to the obligor’s credit risk above the
benchmark rate) from the calculation.
The Board concluded that excluding some of the hedged item’s
contractual cash flows would introduce a new approach to bifurcation
of a hedged item that does not currently exist in the Statement 133
hedging model.
The
FASB provides some new examples illustrating the FAS 138 Amendments to
FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html
Example 1 on interest rate benchmarking begins as follows:
Example:
Fair Value Hedge of the LIBOR Swap Rate in a $100 Million A1-Quality
5-Year Fixed-Rate Noncallable Debt On April 3, 20X0, Global Tech
issues at par a $100 million A1-quality 5-year fixed-rate noncallable
debt instrument with an annual 8 percent interest coupon payable
semiannually. On that date, Global Tech enters into a 5-year interest
rate swap based on the LIBOR swap rate and designates it as the
hedging instrument in a fair value hedge of the $100 million
liability. Under the terms of the swap, Global Tech will receive a
fixed interest rate at 8 percent and pay variable interest at LIBOR
plus 78.5 basis points (current LIBOR 6.29%) on a notional amount of
$101,970,000 (semiannual settlement and interest reset dates). A
duration-weighted hedge ratio was used to calculate the notional
amount of the swap necessary to offset the debt's fair value changes
attributable to changes in the LIBOR swap rate.
An
extensive analysis of the above illustration is provided at http://www.cs.trinity.edu/~rjensen/000overview/138bench.htm
Some
DIG Issues Affecting Interest Rate Hedging
Issue
E1—Hedging the Risk-Free Interest Rate
http://www.fasb.org/derivatives/
(Cleared 02/17/99)
Issue E1 heavily influenced FAS 138 as noted above.
*Issue
G6—Impact of Implementation Issue E1 on Cash Flow Hedges of Market
Interest Rate Risk
(Cleared 5/17/00)
With
regard to a cash flow hedge of the variability in interest payments on
an existing floating-rate financial asset or liability, the
distinction in Issue E1 between the risk-free interest rate and credit
sector spreads over the base Treasury rate is not necessarily directly
relevant to assessing whether the cash flow hedging relationship is
effective in achieving offsetting cash flows attributable to the
hedged risk. The effectiveness of a cash flow hedge of the variability
in interest payments on an existing floating-rate financial asset or
liability is affected by the interest rate index on which that
variability is based and the extent to which the hedging instrument
provides offsetting cash flows.
If
the variability of the hedged cash flows of the existing floating-rate
financial asset or liability is based solely on changes
in a floating interest rate index (for example, LIBOR, Fed Funds,
Treasury Bill rates), any changes in credit sector spreads over that
interest rate index for the issuer's particular credit sector should
not be considered in the assessment and measurement of hedge
effectiveness. In addition, any changes in credit sector spreads
inherent in the interest rate index itself do not impact the
assessment and measurement of hedge effectiveness if the cash flows on
both the hedging instrument and the hedged cash flows of the existing
floating-rate financial asset or liability are based on the same
index. However, if the cash flows on the hedging instrument and the
hedged cash flows of the existing floating-rate financial asset or
liability are based on different indices, the basis difference between
those indices would impact the assessment and measurement of hedge
effectiveness.
*Issue
E6—The Shortcut Method and the Provisions That Permit the Debtor or
Creditor to Require Prepayment
http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueg6.html
(Cleared 5/17/00)
An
interest-bearing asset or liability should be considered prepayable
under the provisions of paragraph 68(d) when one party to the contract
has the right to cause the payment of principal prior to the scheduled
payment dates unless (1) the debtor has the right to cause settlement
of the entire contract before its stated maturity at an amount that is
always greater than the then fair value of the contract absent that
right or (2) the creditor has the right to cause settlement of the
entire contract before its stated maturity at an amount that is always
less than the then fair value of the contract absent that right. A
right to cause a contract to be prepaid at its then fair value would
not cause the interest-bearing asset or liability to be considered
prepayable under paragraph 68(d) since that right would have a fair
value of zero at all times and essentially would provide only
liquidity to the holder. Notwithstanding the above, any term, clause,
or other provision in a debt instrument that gives the debtor or
creditor the right to cause prepayment of the debt contingent upon the
occurrence of a specific event related to the debtor's credit
deterioration or other change in the debtor's credit risk (for
example, the debtor's failure to make timely payment, thus making it
delinquent; its failure to meet specific covenant ratios; its
disposition of specific significant assets (such as a factory); a
declaration of cross-default; or a restructuring by the debtor) should
not be considered a prepayment provision under the provisions of
paragraph 68(d). Application of this guidance to specific debt
instruments is provided below.
Issue
E10—Application of the Shortcut Method to Hedges of a Portion of an
Interest-Bearing Asset or Liability (or its Related Interest) or a
Portfolio of Similar Interest-Bearing Assets or Liabilities
http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuee10.html
(Released 4/00)
1.
May the shortcut method be applied to fair value hedges of a
proportion of the principal amount of the interest-bearing asset or
liability if the notional amount of the interest rate swap designated
as the hedging instrument matches the portion of the asset or
liability being hedged, and all other criteria for applying the
shortcut method are satisfied? May the shortcut method similarly be
applied to cash flow hedges of the interest payments on only a portion
of the principal amount of the interest-bearing asset or liability if
the notional amount of the interest rate swap designated as the
hedging instrument matches the principal amount of the portion of the
asset or liability on which the hedged interest payments are based?
[Generally yes was the DIG’s answer.}
2.
May the shortcut method be applied to fair value hedges of
portfolios (or proportions thereof) of similar interest-bearing assets
or liabilities if the notional amount of the interest rate swap
designated as the hedging instrument matches the notional amount of
the aggregate portfolio? May the shortcut method be applied to a cash
flow hedge in which the hedged forecasted transaction is a group of
individual transactions if the notional amount of the interest rate
swap designated as the hedging instrument matches the notional amount
of the aggregate group that comprises the hedged transaction?
[Generally no was the DIG’s answer.}
*Issue
F2—Partial-Term Hedging http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuef2.html
(Cleared 07/28/99)
A
company may not designate a 3-year interest rate swap with a notional
amount equal to the principal amount of its nonamortizing debt as the
hedging instrument in a hedge of the exposure to changes in fair
value, attributable to changes in market interest rates, of the
company’s obligation to make interest payments during the first 3
years of its 10-year fixed-rate debt instrument. There would be no
basis for expecting that the change in that swap’s fair value would
be highly effective in offsetting the change in fair value of the
liability for only the interest payments to be made during the first
three years. Even though under certain circumstances a partial-term
fair value hedge can qualify for hedge accounting under Statement 133,
the provisions of that Statement do not result in reporting a
fixed-rate 10-year borrowing as having been effectively converted into
a 3-year floating-rate and 7-year fixed-rate borrowing as was
previously accomplished under synthetic instrument accounting prior to
Statement 133. Synthetic instrument accounting is no longer acceptable
under Statement 133, as discussed in paragraphs 349 and 350.
*Issue
G7—Measuring the Ineffectiveness of a Cash Flow Hedge under
Paragraph 30(b) When the Shortcut Method is Not Applied
http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueg7.html
(Cleared 5/17/00)
Three
methods for calculating the ineffectiveness of a cash flow hedge that
involves either (a) a receive-floating, pay-fixed interest rate swap
designated as a hedge of the variable interest payments on an existing
floating-rate liability or (b) a receive-fixed, pay-floating interest
rate swap designated as a hedge of the variable interest receipts on
an existing floating-rate asset are discussed below. As noted in the
last section of the response, Method 1 (Change in Variable Cash Flows
Method) may not be used in certain circumstances. Under all three
methods, an entity must consider the risk of default by counterparties
that are obligors with respect to the hedging instrument (the swap) or
hedged transaction, pursuant to the guidance in Statement 133
Implementation Issue No. G10, "Need to Consider Possibility of
Default by the Counterparty to the Hedging Derivative." An
underlying assumption in this Response is that the likelihood of the
obligor not defaulting is assessed as being probable.
Other
DIG issues can be viewed at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html
Also see the following
summary of FAS 138
"Implementation of SFAS 138, Amendments to SFAS 133," The
CPA Journal, November 2001. (With Angela L.J. Huang and John S.
Putoubas), pp. 54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm |
Black-Scholes
Model = see option.
Blockage Factor =
the impact upon financial instrument valuation of
a large dollar amount of items sold in one block. In the case of derivatives,
the FASB decided not to allow discounting of the carrying amount if that amount is to be
purchased or sold in a single block. Some analysts argue that if the items must be
sold in a huge block, the price per unit would be less than marginal price of a single
unit sold by itself. Certain types of instruments may also increase in value due to
blockage. In the case of instruments that carry voting rights, there may be
sufficient "block" of voting rights to influence strategy and control of an
organization (e.g., a 51% block of voting shares or options for voting shares that provide
an option for voting control). If voting power is widely dispersed, less than 51%
may constitute a blockage factor if the "block" is significant enough to
exercise control. The FASB
in SFAS 107does not allow blockage factors to influence the estimation of fair value up or
down. Disallowance of blockage is discussed in FAS 133, Pages 153-154, Paragraphs
312-315. See fair value.
Bookout ---
The term "bookout" can be used in a variety of
contexts such as when firms make a paper transaction in lieu of actual delivery
of a product or service. For an illustration in the power industry, see
the Bonneville Dam illustration under Normal
Purchases Normal Sales
See the DIG C16 resolution under Normal
Purchases Normal Sales
New Guidance on Loans and Revisions to DIG C15 (Bookouts)
Cleared December 19, 2001
http://www.fas133.com/search/search_article.cfm?page=61&areaid=438
Changes in determining how loans will be scoped in
bring guidance closer to the statement itself, as more issues achieve closure.
At its meeting on December 19, the Board agreed to
the staff's recommendation to change its final guidance on the application of
FAS 133 to loans (and other credit arrangements): i.e., when they should be
defined as derivatives for accounting purposes. The Board thus decided to
override C13,"When a Loan Commitment is Included in the Scope of
Statement 133," with broader guidance utilizing FAS 133's
characteristic-based definition of a derivative (in particular, the
net-settlement criteria found in paragraph 9b).
Under this approach, loans and other off-balance
sheet credit arrangements that meet the statement's definition of a derivative
would be scoped in. However, the key to this approach is to be found in the
language the staff has drafted to help apply the FAS 133 definition of a
derivative to such loans/credit arrangements. This language, which we
understand will set a relatively high hurdle for loans to meet the 9b test, is
to be posted on the FASB site soon, and subjected to a 35-day comment period.
[There may be two issues: one to clarify the market mechanism need to qualify
for 9b (net settlement) and a second to address the application of the
derivative definition in accounting of the loan.]
Clarification on the question of MAC clauses (not to
be considered) and asymmetrical accounting for borrower and lender (allowing
borrowers to continue to account for loans deemed derivatives for banks as
loans) as discussed below will also be included in the guidance posted to the
FASB website. Notice will be given that the resulting guidance will be
conditioned on amendments to Statements 65 and 91, which covered prior loan
accounting.
Desperate for closure, the board stresses that this
is essentially the final answer on the subject, and it will primarily consider
comments that help improve the application of the derivative definition test.
Note that this change sets a further precedent for seeking changes to
existing, pre-cleared guidance that go back to the conceptual foundation of
the statement itself.
Another issue of large concern to the electricity
industry was the Board's discussion of further revisions to C15, "Normal
Purchases and Sales Exception for Option-Type Contracts and Forward Contracts
in Electricity." In October, the staff revised C15 to clarify the unique
nature of capacity contracts in the electrical industry and define criteria
under which contracts with certain option features and bookouts can qualify
for the normal purchases and sales exception. The Board has given the final
go- ahead, approving staff revisions which means C15 will be posted in its
final form very soon. We are unclear as to what extent, if at all, these
revisions will differ from the October 10 draft, but interested parties will
want to scrutinize the words carefully.
Loan commitments and FAS 133 Prior to today's
meeting, this issue had been addressed, in part, with C13, "When a Loan
Commitment is Included in the Scope of Statement 133," which was posted
as tentative guidance on the FASB website in January 2001. C13 provided that
(1) loan commitments that relate to the origination or acquisition of mortgage
loans that will be held for resale under Statement 65 must be accounted for as
derivatives under Statement 133 by both the borrower and lender; (2) loan
commitments that relate to the origination or acquisition of mortgage loans
that will be held of investment continue to be accounted for under Statement
65 and (3) commitments that relate to the originations of non-mortgage loans
continue to be accounted for under Statement 91.
However, C13 dealt mainly with mortgage loans, which
would have required FASB to consider extending the guidance in C13 to
non-mortgage loans held for resale.
As an alternative, the staff had recommended the
Board switch gears and use the Statement's broader guidance on defining
derivatives to determine when loans are scoped in, which the Board accepted.
A third and fourth alternative were also presented
but not widely considered. The first of these would have imposed the need for
both parties of a contract to have access to a market mechanism, in order for
the contract to meet the paragraph 9b net settlement criteria. Going down this
route would require a similar decision by the board on this "both
counterparty" requirement for all 9b tests. The second of these
alternatives suggested the Board simply carve out a specific subset of loans
from FAS 133.
In discussing this question, one of the board members
noted how divisive this issues was in the financial services industry, with
constituents coming down almost equally on both sides (see I-bank vs. C-bank
debate). This prevented easy consideration of a carve out, or any guidance,
that drifted away from FAS 133's conceptual fundamentals.
The guidance in C13 (formerly E13) was already
drifting away from the core FAS 133 concepts, but this reflected the Board's
mistaken view that most all loan commitments were clearly not derivatives.
However, C13 arose out of discussions at the DIG (see Item 11-4 discussions
here and here) where DIG members pointed out market mechanisms that could
emerge to facilitate net settlement in loans and how loans with option
features were included in Statement 119 disclosure guidelines.
Moreover, C13 was potentially holding back the
planned move to a fair value model for all financial instruments--a project
discussed later at the meeting. As one of the new board members, Katherine
Schipper, pointed out, going with the alternative to C13 not only provides an
opportunity to fix a flawed approach to loan scope outs, but it brings GAAP
further in the direction of the fair value model toward which the FASB is
moving. Though, other board members, and the staff, said it was not clear
whether more or fewer loans would be likely to be scoped in under the agreed
upon C13 alternative.
Having reached on consensus on the first question
concerning loans, the Board turned to the second and third questions framed by
the staff.
Question 2 dealt with the effect of a subjective
material change clause (Ma clause that may be invoked by the issuer based oive
evaluation of the adverse change-on whethoped into FAS 133. Though not
explicitly stated, this question was posed in order to prevent the insertion
of MAC clauses into credit arrangements merely to trigger a scope exception.
The alternative guidance proposed by the staff dealt
with the degree of control the issuer has over the MAC trigger:
Alternative 1 states that the existence of a
subjective MAC clause always causeso be excluded from the scope of the staff's
proposed guidance.
Alternative 2 would have the loan excluded only if it
is remote that the issuer would invoke the MAC clause.
Alternative 3 would ignore the MAC altogether and not
use it as a consideration in excluding the contract.
The board had no objections to the staff
recommendation to ignore the MAC clause (alternative 3).
The third question arising from the loan discussion
asked if asymmetrical accounting would be allowed for loans falling under the
scope of FAS 133. In other words, a market mechanism might exist for the
issuer (lender), but not the holder (borrower), which would make the contract
a derivative from the former's perspective but not the latter's.
As a pure practical matter, the Board concluded that
asymmetrical accounting would be allowed on an exception basis where the
holder (borrower) does not account for the contract as a derivative--even
where it meets the test for the issuer (lender). Otherwise, borrowers would
have to phone their lenders and ask how they were accounting for the loan in
order to arrive at proper accounting.
With respect to
Firm Commitments vs.
Forward Contracts, the key distinction is Part
b of Paragraph 540 of the original FAS 133 (I have an antique copy of the
original FAS 133 Standard.)
Those of us into
FAS 133’s finer points have generally assumed a definitional distinction between
a “firm commitment” purchase contract to buy a commodity at a contract price
versus a forward contract to purchase the commodity at a contracted forward
price. The distinction is important, because FAS 133 requires booking a forward
contract and adjusting it to fair value at reporting dates if actual physical
delivery is not highly likely such that the NPNS exception under Paragraph 10(b)
of FAS 133 cannot be assumed to avoid booking.
Accounting for Executory Contracts Such as Purchase/Sale Commitments and Loan
Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
The distinction
actually commences with forecasted transactions that include purchase contracts
for a fixed notional (such as 100,000 units of fuel) at an uncertain
underlying (such as the spot price of fuel on the actual future date of
purchase). Such purchase contracts are typically not booked. These forecasted
transactions become “firm commitments” if the future purchase price is
contracted in advance (such $2.23 per gallon for a future purchase three months
later). Firm commitments are typically not booked under FAS 133 rules, but they
may be hedged with fair value hedges using derivative financial instruments.
Forecasted transactions (with no contracted price) can be hedged with cash flow
hedges using derivative contracts.
There is an
obscure rule (not FAS 133) that says an allowance for firm commitment loss must
be booked for an unhedged firm commitment if highly significant (material) loss
is highly probable due to a nose dive in the spot market. But this obscure rule
will be ignored here.
One distinction
between a firm commitment contract and a forward contract is that a forward
contract’s net settlement, if indeed it is net settled, is based on the
difference between spot price and forward price at the time of settlement. Net
settlement takes the place of penalties for non-delivery of the actual commodity
(most traders never want pork bellies dumped in their front lawns). Oil
companies typically take deliveries some of the time, but like electric
companies these oil companies generally contract for far more product than will
ever be physically delivered. Usually this is due to difficulties in
predicting peak demand.
A firm
commitment is gross settled at the settlement date if no other net settlement
clause is contained in the contract. If an oil company does not want a
particular shipment of contracted oil, the firm commitment contract is simply
passed on to somebody needing oil or somebody willing to offset (book out) a
purchase contract with a sales contract. Pipelines
apparently have a clearing house for such firm commitment transferals of
“paper gallons” that never flow through a pipeline. Interestingly, fuel purchase
contracts are typically well in excess (upwards of 100 times) the capacities of
the pipelines.
The contentious
FAS 133 booking out problem was settled for electricity companies in FAS 149.
But it was not resolved in the same way for other companies. Hence for all other
companies the distinction between a firm commitment contract and a forward price
contract is crucial.
In some ways the
distinction between a firm commitment versus a forward contract may be somewhat
artificial. The formal distinction, in my mind, is the existence of a net
settlement (spot price-forward price) clause in a forward contract that negates
a “significant penalty” clause of a firm commitment contract.
The original FAS
133 (I still have this antique original version) had a glossary that reads as
follows in Paragraph 540:
Firm commitment
An agreement with an unrelated party, binding on both parties and
usually legally enforceable, with the following characteristics:
a. The agreement specifies all significant terms, including the
quantity to be exchanged, the fixed price, and the timing of the
transaction. The fixed price may be expressed as a specified
amount of an entity's functional currency or of a foreign
currency. It may also be expressed as a specified interest rate
or specified effective yield.
b. The agreement includes a disincentive for nonperformance that is
sufficiently large to make performance probable.
The key
distinction between a firm commitment and a forward contract seems to be Part b
above that implies physical delivery backed by a “sufficiently large” penalty if
physical delivery is defaulted. The net settlement (spot-forward) provision of
forward contracts generally void Part b penalties even when physical delivery
was originally intended.
Firm commitments
have greater Part b penalties for physical non-conformance than do forward
contracts. But in the case of the pipeline industry, Part b technical provisions
in purchase contracts generally are not worrisome because of a market clearing
house for such contracts (the highly common practice of booking out such
contracts by passing along purchase contracts to parties with sales contracts,
or vice versa, that can be booked out) when physical delivery was never
intended. For example, in the pipeline hub in question (in Oklahoma) all such
“paper gallon” contracts are cleared against each other on the 25th
of every month. By “clearing” I mean that “circles” of buyers and sellers are
identified such that these parties themselves essentially net out deals. In most
cases the deals are probably based upon spot prices, although the clearing house
really does not get involved in negotiations between buyers and sellers of these
“paper gallons.”
Accounting for Executory Contracts Such as Purchase/Sale Commitments and Loan
Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
See
Forward Transaction and
Firm Commitment
Business
Combinations =
contacts for purchases and/or
poolings that require special accounting treatment. In summary, the major exceptions
under FAS 133 for APB Opinion No. 16 are discussed in (FAS 133Paragraph 11c).
Exceptions are not as important
in IAS 39, because fair value adjustments are required of all financial
instruments. However, exceptions or special accounting for derivatives are
discussed in IAS 39 Paragraph 1g --- Also note IAS 22 Paragraphs
65-76)
C-Terms
Call = see option.
CAP
=
a risk bound. For example, a cap writer, in
return for a premium, agrees to limit, or cap, the cap holder's risk associated
with an increase in interest rates. If rates go above a specified interest-rate level (the
strike price or the cap rate), the cap holder is entitled to receive cash
payments equal to the excess of the market rate over the strike price multiplied by the
notional principal amount. Issuers of floating-rate liabilities often purchase caps to
protect against rising interest rates, while retaining the ability to benefit from a
decline in rates. Examples are given in SFAS Paragraphs 182-183 beginning on Page 95 of
FAS 133. Also see Footnote 6 to Paragraph 13 on Page 8 of FAS 133.
The opposite of a cap is termed a floor. A
floor writer, in return for a premium, agrees to limit, or floor, the cap holder's
risk associated with an decrease in interest rates. If rates go below a specified
interest-rate level (the strike price or the floor rate), the floor holder
is entitled to receive cash payments equal to the difference between the market rate over
the strike price multiplied by the notional principal amount. See Footnote 6 to
Paragraph 13 on Page 8 of FAS 133
A collar combines a cap and a floor. In
Paragraph 181 on Page 95 of FAS 133, a timing collar is discussed. Another example
is given in Paragraph 182 beginning on Page 95 of FAS 133. See collar.
Capital Asset Pricing Model (CAPM)
=
a model for valuing a corporation in which
estimated future cash flows are discounted at a rate equal to the firm's weighted average
cost of capital multiplied by the beta, which is a measure of the volatility of a firm's
stock price. The CAPM is a single-index
model and, as such, has enormous structural deficiencies. Alternate approaches and
problems in all approaches are discussed in
http://faculty.trinity.edu/rjensen/149wp/149wp.htm
Also see option pricing theory.
Capacity Risk see Risks
Cash Flow Hedge =
a derivative with a periodic settlement based
upon cash flows such as interest rate changes on variable rate
debt. Major portions of FAS 133 dealing with cash flow hedges include Paragraphs 28-35,
127-130, 131-139, 140-143, 144-152, 153-158, 159-161, 162-164, 371-383, 422-425, 458-473,
and 492-494. See hedge and hedge
accounting. The IASC adopted the same definition of a cash flow
hedge except that the hedge has also to affect reported net
income (See IAS 39 Paragraph 137b).
Flow for Cash Flow Hedge Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
The key
distinction of a cash flow hedge versus a fair
value hedge is that FAS 133 allows deferral of unrealized holding gains and losses on
the revaluation of the derivative to be posted to Other
Comprehensive Income (OCI) rather than current earnings. Paragraph 30 on Page 21 of FAS 133 discusses the posting to OCI.
Paragraph 31 deals with reclassifications from OCI into earnings. Also see derecognition and dedesignation.
In FAS 133, derivative financial instruments
come in three basic types that are listed in Paragraph 4 on Page 2 of FAS 133. One
of these types is described in Section a and Footnote 2 below:
Paragraph 4
on Page 2 of FAS 133.
This Statement standardizes the accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, by requiring that an entity recognize
those items as assets or liabilities in the statement of financial position and measure
them at fair value. If certain conditions are met, an entity may elect to designate a
derivative instrument as follows:
a.
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
or of an unrecognized firm commitment, \2/ that are attributable to a
particular risk (referred to as a fair value hedge)
==========================================================================
Footnote 2
\2/ An unrecognized firm commitment can be viewed as an executory contract that represents
both a right and an obligation. When a previously unrecognized firm commitment that is
designated as a hedged item is accounted for in accordance with this Statement, an asset
or a liability is recognized and reported in the statement of financial position related
to the recognition of the gain or loss on the firm commitment. Consequently, subsequent
references to an asset or a liability in this Statement include a firm commitment.
==========================================================================
With respect to Section a above, a firm
commitment cannot have a cash flow risk exposure because the gain or loss is already
booked. For example, a contract of 10,000 units per month at $200 per unit is
unrecognized and has a cash flow risk exposure if the payments have
not been made. If the payments have been prepaid, that prepayment is
"recognized" and has no further cash flow risk exposure. The booked firm
commitment, however, can have a fair value risk exposure.
Another key distinction is between a forecasted transaction
versus a firm commitment. Firm commitments without any
foreign currency risk cannot have cash flow hedges, because there is no variability in
expected future cash flows (except for credit risks for which cash flow hedges are not
allowed under Paragraph 29e on Page 20, Paragraph 32 on Page
22, and Paragraph 61c on Page 41 of FAS 133 ). Example 9 beginning in
Paragraph 162 on Page 84 of FAS 133 illustrates a forward contract cash flow hedge of a
forecasted series of transactions in a foreign currency. When the forecasted
transactions become accounts receivable, a portion of the value changes in the futures
contract must be taken into current earnings rather than other comprehensive income. Controversies between the
FASB's distinction between forecasted transactions versus firm commitments are discussed
in Paragraphs 324-325 on Page 157 of FAS 133. Firm commitments can have fair value
hedges even though they cannot have cash flow hedges. See Paragraph 20 on Page 11 of
FAS 133.
Cash flow hedges must have the possibility
of affecting net earnings. For example, Paragraph 485 on Page 211 of FAS 133
bans
foreign currency risk hedges of forecasted dividends of foreign subsidiary. The
reason is that these dividends are a wash item and do not affect consolidated
earnings. For reasons and references, see equity method.
A nonderivative instrument, such as a Treasury note, shall not be designated as a hedging
instrument for a cash flow hedge (FAS 133 Paragraph 28d).
Paragraph 40 beginning on Page 25 bans a
forecasted transaction of a subsidiary company from being a hedged item if the parent
company wants to hedge the cash flow on the subsidiary's behalf. However Paragraph
40a allows such cash flow hedging if the parent becomes a party to the hedged item itself,
which can be a contract between the parent and its subsidiary under Paragraph 36b on Page
24 of FAS 133.
Paragraph 399 on Page 180 of
FAS 133 does not
allow covered call strategies that permit an entity to write an
option on an asset that it owns. In a covered call the combined position of the
hedged item and the derivative option is asymmetrical in that exposure to losses is always
greater than potential gains. The option premium, however, is set so that the option
writer certainly does not expect those "remotely possible" losses to occur.
Only when the potential gains are at least equal to potential cash flow losses will
Paragraph 28c on Page 19 of FAS 133 kick in to allow a cash flow hedge under FAS 133.
Also see Paragraph 20c on Page 12. See written
option.
Paragraph 28 beginning on Page 18 of
FAS 133 requires that the hedge be formally documented from the start such that prior contracts
such as options or futures contracts cannot later be declared hedges. (Existing
assets and liabilities can be hedged items, but the hedging instruments must be new and
fully documented at the start of the hedge.) Paragraphs 29c and 29f on Page 20
of FAS 133 require direct cash flow risk exposures rather than earnings exposures such as
a hedge to protect equity-method accounting for an investment under APB 16 rules.
See ineffectiveness.
FAS 133
is silent as to whether a single asset
or liability can be hedged in part (as opposed to a portfolio of items having different
risks). For example, can an interest rate swap be used to hedge the cash flows of
only the last five years of a ten-year note? There seems to be nothing to prevent
this (as is illustrated in Examples 13 and 15 beginning on Page 225 of the Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998).
Paragraph 18 of FAS 133 allows for using only a
portion of a single derivative to hedge an item if, and only if, the selected portion has
the risk exposure of the portion is equal to the risk of the whole derivative. For
example, a four-year interest rate swap designated as hedging a two-year note probably
does not meet the Paragraph 18 test, because the risk exposure in the first two years most
likely is not the same as the risk level in the last two years.
Suppose a company expects dividend income
to continue at a fixed rate over the two years in a foreign currency. Suppose the
investment is adjusted to fair market value on each reporting date. Forecasted
dividends may not be firm commitments since there are not
sufficient disincentives for failure to declare a
dividend. A cash flow hedge of the foreign currency risk exposure can be entered
into under Paragraph 4b on Page 2 of FAS 133. Whether or not gains and losses are
posted to other comprehensive income, however, depends
upon whether the securities are classified under SFAS 115 as available-for-sale or as
trading securities. There is no held-to-maturity alternative for equity securities.
With respect to Paragraph
29a on Page 20 of FAS 133, KPMG notes that if the hedged item is a portfolio of assets or
liabilities based on an index, the hedging instrument cannot use another
index even though the two indices are highly correlated. See Example 7 on Page
222 of the Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.
Accounting for Executory Contracts Such as Purchase/Sale Commitments and
Loan Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
The hedging instrument (e.g., a forecasted
transaction or firm commitment foreign currency hedge) must meet the stringent criteria
for being defined as a derivative financial
instrument under FAS 133. This includes the tests for being clearly-and-closely related. It also includes
strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and
Paragraph 56 on Page 33 of FAS 133 with respect to the host contracts that are being
hedged. Those tests state that if the forecasted "transaction" is in
reality a group or portfolio of individual transactions, all transactions in the group
must bear the same risk exposure within a 10% range discussed in Paragraph 21.
Also see Footnote 9 on Page 13 of FAS 133. The grouping tests are
elaborated upon in the following Paragraphs:
-
Paragraph 21 on Page 13,
-
Paragraph 29 beginning on Page 20,
-
Paragraph 241 on Page 130,
-
Paragraph317 on Page 155,
-
Paragraphs 333-334 beginning on Page 159,
-
Paragraph 432 on Page 192,
-
Paragraph 435 on Page 193,
-
Paragraph 443-450 beginning on Page 196
-
Paragraph 462 on Page 202,
-
Paragraph 477 on Page 208.
The tests can become tricky. For
example, suppose a company has a firm commitment to buy 1,000 units of raw material
per month at a unit price of 5,000DM Deutsche Marks. Can this firm commitment be
designated as a hedged item on a foreign currency risk exposure of 500 units each
month? The answer according to Paragraph 21a's Part (2b) requires that which units
be designated such as the first 500 units or the last 500 unites each month.
A group of variable rate notes indexed in the
same way upon LIBOR can be a hedged item, whereas having different indices such as LIBOR
and U.S. Prime rate underlyings will not qualify. Also,
anticipated purchases cannot be combined with anticipated sales in the same grouping
designated as a forecasted transaction even if they have the same underlying.
Paragraph 477 on Page 208 of FAS 133 makes an exception for a portfolio of differing risk
exposures for financial instruments designated in foreign currencies so not to conflict
with Paragraph 20 of SFAS 52. For more detail see foreign
currency hedge.
Those tests also state that a compound grouping of multiple derivatives (e.g., a
portfolio of options or futures or forward contracts or any combination thereof) is
prohibited from "separating a derivative into either separate proportions
or separate portions and designating any component as a hedging instrument or
designating different components as hedges of different exposures." See
Paragraphs 360-362 beginning on Page 167 of FAS 133. Paragraphs dealing with
compound derivative issues include the following:
-
Paragraph 18 beginning on Page 9,
-
Footnote 13 on Page 29,
-
Paragraphs 360-362 beginning on Page 167,
-
Paragraph 413 on Page 186,
-
Paragraphs 523-524 beginning on Page 225.
Section
c(4) of Paragraph 4 is probably the most confusing condition mentioned in Paragraph 4. It allows hedging under "net investment" criteria under Paragraph 20 of
SFAS 52. The gain or loss is reported in other comprehensive
income as part of the cumulative translation adjustment. This is an exception to
Paragraph 29a on Page 20 of FAS 133. Reasons for the exception are given in
Paragraph 477 on Page 208 of FAS 133:
The net investment in a
foreign operation can be viewed as a portfolio of dissimilar assets and liabilities that
would not meet the criterion in this Statement that the hedged item be a single item or a
group of similar items. Alternatively, it can be viewed as part of the fair value of the
parent's investment account. Under either view, without a specific exception, the net
investment in a foreign operation would not qualify for hedging under this Statement. The
Board decided, however, that it was acceptable to retain the current provisions of
Statement 52 in that area. The Board also notes that, unlike other hedges of portfolios of
dissimilar items, hedge accounting for the net investment in a foreign operation has been
explicitly permitted by the authoritative literature.
For a derivative not designated as a
hedging instrument, the gain or loss is recognized in earnings in the period of
change. Section 4(c) of Paragraph 4 of FAS 133 amends SFAS 52 on Foreign
Currency Translation, to permit special accounting for a hedge of a foreign
currency forecasted transaction with a derivative. For more detail see foreign currency hedge.
Paragraph 42 on Page 26 reads as follows:
.A derivative instrument or a
nonderivative financial instrument that may give rise to a foreign currency transaction
gain or loss under Statement 52 can be designated as hedging the foreign currency exposure
of a net investment in a foreign operation. The gain or loss on a hedging derivative
instrument (or the foreign currency transaction gain or loss on the nonderivative hedging
instrument) that is designated as, and is effective as, an economic hedge of the net
investment in a foreign operation shall be reported in the same manner as a translation
adjustment to the extent it is effective as a hedge. The hedged net investment shall be
accounted for consistent with Statement 52; the provisions of this Statement for
recognizing the gain or loss on assets designated as being hedged in a fair value hedge do
not apply to the hedge of a net investment in a foreign operation.
These Section c(4)
confusions in Paragraph 4 are illustrated in Examples 11-13 beginning on Page 270 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP
in July 1998.
Paragraph 18 on Page 10 does allow a
single derivative to be divided into components provided but never with partitioning
of "different risks and designating each component as a hedging
instrument." For example, suppose
Rippen Company enters into forward contracting with Bank A to sell Dutch guilders and
purchase French francs. The purpose is to hedge two combined unrelated foreign currency
risks from two related companies, one a Holland subsidiary and the other a French
subsidiary. Bank A is independent of all the interrelated companies in this
scenario. If the forward contracting entails one forward contract, it cannot be
partitioned into components having different risks of U.S. dollars against guilders versus
francs.
Paragraph 29d precludes forecasted transactions from being the hedged items in
cash flow hedges if those items, when the transaction is completed, will be remeasured on
each reporting date at fair value with holding gains and losses
taken directly into current earnings (as opposed to comprehensive income). See Paragraph 36 on Page 23 of FAS 133.
Paragraphs 220-231 beginning on Page 123 of
FAS 133
leave little doubt that the FASB
feels "fair value is the most relevant measure for financial instrument and the
only relevant measure for derivative instruments." Allowing gains
and losses from qualified FAS 133-allowed cash flow hedges to be deferred in OCI was more of a political compromise that the FASB
intends for the long-term. But the compromise extends only so far as present
GAAP. It allows OCI deferral on cash flow hedges only if the hedged items are
carried at cost under GAAP. For example, lumber inventory is carried at cost and can
be hedged with OCI deferrals of gains and losses on the derivative instrument such as a
forward contract that hedges the price of lumber. The same cannot be said for gold
inventory.
The forecasted purchase of lumber
inventoried at cost can be a hedged item, but the forecasted purchase of gold or some
other "precious" market commodity cannot qualify for OCI deferral as a hedged
item. The reason is that "precious" items under GAAP are
booked at maintained at market value. For example, suppose a forward contract is entered into on January 1 when
commodity's price is $300 per unit. The "political issue" issue faced by
the FASB is merely a matter of when gains and losses on the derivative contract are posted
to current earnings. If the price goes up to $400 per unit on July 1 when the
commodity is actually purchased, there is a $100 per unit deferred gain on the forward
contract that is transferred from OCI to current
earnings if the commodity is
lumber. If the commodity is "precious" gold, however, the there is no
intervening credit to OCI because of Paragraph 29d on Page 20 of FAS 133.
Illustrative journal entries are shown below:
|
|
Transactions |
in Lumber |
Transactions
|
in Gold |
Date |
Accounts |
Debit |
Credit |
Debit
|
Credit
|
1/1/x1 |
Forward
|
0 |
|
0
|
|
|
Cash
|
|
0
|
|
0
|
|
|
|
|
|
|
Various dates |
Forward
|
100 |
|
100
|
|
|
OCI
|
|
100
|
|
|
|
P&L
|
|
|
|
100
|
|
|
|
|
|
|
7/1/x1 |
Inventory
|
400
|
|
400
|
|
|
Cash
|
|
400
|
|
400
|
|
|
|
|
|
|
7/1/x1 |
Cash
|
100
|
|
100
|
|
|
Forward
|
|
100
|
|
100
|
|
|
|
|
|
|
7/1/x1 |
OCI
|
100
|
|
|
|
|
P&L
|
|
100
|
|
|
|
|
|
|
|
|
The forward contract was
not a FAS 133-allowed cash flow hedge even
though it was an economic hedge. The reason goes back to Paragraph 29d on Page 20 of
SFAS 130.
For this same reason, a trading security (not subject to APB 15 equity method accounting and as defined in SFAS 115) cannot be a
FAS 133 hedged item. That is because SFAS 115 requires that trading securities be revalued (like gold) with unrealized
holding gains and losses being booked to current earnings. Conversely, Paragraphs 4c
on Page 2, 38 on Page 24, and 479 on Page 209 of FAS 133 state that a forecasted purchase
of an available-for-sale security can be a hedged item,
because available-for-sale securities revalued under SFAS 115 have holding gains and
losses accounted for in comprehensive income rather than current earnings. Unlike
trading securities, available-for-sale securities can be FAS 133-allowed hedge items.
Mention of available-for sale is made in Paragraphs 4, 18, 23, 36, 38, 49, 52-55,
123, 479-480, and 534 of FAS 133. Held-to-maturity
securities can also be FAS 133-allowed hedge items.
Held-to-maturity securities
may not be hedged for cash flow risk according to Paragraphs 426-431 beginning on Page 190
of FAS 133. See held-to-maturity.
Suppose a firm has a forecasted transaction to purchase a held-to-maturity bond investment
denominated in a foreign currency. Under SFAS 115, the bond will eventually, after
the bond purchase, be adjusted to fair value on each reporting date. As a result,
any hedge of the foreign currency risk exposure to cash flows cannot receive favorable
cash flow hedge accounting under FAS 133 rules (as is illustrated
in Examples 6 beginning on Page 265 of the Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998). Before the bond is purchased, its forecasted transaction is not
allowed to be a hedged item under Paragraph 29d on Page 20 of FAS 133 since, upon
execution of the transaction, the bond "will subsequently be remeasured with changes
in fair value ...." Also see Paragraph 36 on Page 23 of FAS 133.
Even more confusing is Paragraph 29e
that requires the cash flow hedge to be on prices or interest rates rather than credit
worthiness. For example, a forecasted sale of a specific asset at a specific price
can be hedged for spot price changes under Paragraph 29e. The forecasted sale's cash
flows may not be hedged for the credit worthiness of the intended buyer or buyers. Example
24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.
Because the bond's coupon payments were indexed to credit rating rather than interest
rates, the embedded derivative could not be isolated and accounted for as a cash flow
hedge. See also credit risk swaps.
A swaption can be a cash flow hedge.
See swaption.
Paragraph 21c on Page 14 and Paragraph 29f on
Page 20 of FAS 133 prohibits forecasted cash flows from minority interests in a
consolidated subsidiary from being designated as a hedged item in a cash flow hedge.
Reasons are given in Paragraph 472 beginning on Page 206 of FAS 133. See minority interest.
Cash flow hedges are accounted for in a
similar manner but not identical manner in both FAS 133 and IAS 39 (other
than the fact that none of the IAS 39 standards define comprehensive income or
require that changes in fair value not yet posted to current earnings be
classified under comprehensive income in the equity section of a balance
sheet):
To the extent that the cash flow hedge is effective, the portion of the
gain or loss on the hedging instrument is recognized initially in equity.
Subsequently, that amount is included in net profit or loss in the same period
or periods during which the hedged item affects net profit or loss (for
example, through cost of sales, depreciation, or amortization).
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
(emphasis added):
IAS 39 Cash Flow Hedge Accounting:
For a hedge of a forecasted asset and liability acquisition, the gain
or loss on the hedging instrument will adjust the basis (carrying
amount) of the acquired asset or liability. The gain or loss on the
hedging instrument that is included in the initial measurement of the
asset or liability is subsequently included in net profit or loss when
the asset or liability affects net profit or loss (such as in the
periods that depreciation expense, interest income or expense, or cost
of sales is recognised).
|
FAS 133 Cash Flow Hedge Accounting:
For a hedge of a forecasted asset and liability acquisition, the gain or
loss on the hedging instrument will remain in equity when the asset or
liability is acquired. That gain or loss will subsequently included in
net profit or loss in the same period as the asset or liability affects
net profit or loss (such as in the periods that depreciation expense,
interest income or expense, or cost of sales is recognised). Thus,
net profit or loss will be the same under IAS and FASB Standards, but
the balance sheet presentation will be net under IAS and gross under
FASB.
|
Cash Flow Hedges Create Fair Value Risk
Cash flow risk commonly arises in forecasted transactions with an unknown
value of the underlying. Interbank rates that banks charge each other is
often used for benchmarking in hedge effectiveness testing. For example, suppose the underlying is a
benchmarked interest rate is the ever-popular London Inter-bank Offering Rate (LIBOR)
where a firm borrows $1 million for two years at a fixed rate of
6.41%. This loan has fair value risk since the amount required to pay the
loan off prematurely at the end of any quarter will vary with interest rate
movements in the same manner as bond prices move up and down depending upon the
spot market of interest rates such as LIBOR. The loan does not
have cash flow risk since the interest rate is locked in at 6.41% (divided by
four) for each quarterly interest payment.
The firm can lock in fixed fair value by entering into some type of
derivative such as an interest rate swap contract that will pay a variable
benchmarked rate that moves up and down with interest rates. For example,
assume the receivable leg of the swap is fixed at 6.65%. Each
quarter the difference between 6.65% and the current spot rate of LIBOR
determines the net settlement of the interest rate swap payment that locks in a
fixed return of 6.65% + 2%. To read more about this particular cash flow
hedge and the hedge accounting that is allowed under FAS 133, go to Example 5 in
Appendix B of FAS 133 beginning with Paragraph 131. Bob Jensen elaborates
and extends this example with a video and Excel workbook at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Financial instruments have a notional and an underlying. For example,
an underlying might be a commodity price and the notional is the quantity such
as price of corn and the quantity of corn. An underlying might be an
interest rate such as the U.S. Treasury rate of the London Inter-bank Offering
Rate and the notional might be the principal such as the $10 million face value
of 10,000 bonds having a face value of $1,000 each.
The unhedged investment of $10 million has cash flow risk but no fair value
risk. The hedged investment has no cash flow risk but the subsequent
combination of the hedge and the hedged item creates fair value risk. The
fair value of the interest rate swap used as the hedging instrument fluctuates
up and down with the current spot rate of LIBOR used in determining the
quarterly swap payments. For example, in Example 5 mentioned above, the
swap begins with a zero value but moves up to a fair value of $24,850 a the end
of the first quarter, $73,800 at the end of the second quarter, and even drops
to a negative ($42,820) after four quarters.
Companies do trillions of dollars worth of cash flow hedging with
interest rate swaps. Two enormous examples are Fannie Mae and Freddie
Mac. Both of these giant companies hedge millions of dollars of
outstanding fixed-rate mortgage investments with interest rate swaps that lock
in fair value. You can read more about their cash flow hedging strategy in
their annual reports for Years 2001, 2002, and 2003. Both companies made
headlines for not complying with FAS 133 hedge accounting years. See
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Fair Value Hedges Create Cash Flow Risk
Fair value risk commonly arises in fore firm commitments with a contracted
value of the underlying. For example, suppose the underlying is a
benchmarked interest rate such as the London Inter-bank Offering Rate (LIBOR)
where a firm invests $10 million for two years that pays a quarterly return of
the spot rate for LIBOR plus 2.25%. This investment has cash flow risk
since the quarterly values of LIBOR are unknown. The investment does not
fair value risk since the value is locked in at $10 million due to the fact that
the returns are variable rather than fixed.
The firm can lock in a fixed return rate by entering into some type of
derivative such as an interest rate swap contract that will lock in the current
LIBOR forward rate. For example, assume the payable leg of the swap
is fixed at 6.41%. Each quarter the difference between 6.41% and the
current spot rate of LIBOR determines the net settlement of the interest rate
swap payment that will vary with interest rate movements. To read more
about this particular cash flow hedge and the hedge accounting that is allowed
under FAS 133, go to Example 2 in Appendix B of FAS 133 beginning with Paragraph
111. Bob Jensen elaborates and extends this example with a video and Excel
workbook at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
The unhedged loan of $1 million has fair value risk but no fair value
risk. The hedged investment has no fair value risk but the subsequent
combination of the hedge and the hedged item creates cash flow risk. If
the hedge is perfectly effective, fair value of the interest rate swap
used as the hedging instrument fluctuates exactly to offset any value change in
the loan such that the combined value of the loan plus the swap is fixed at $1
million. For example, in Example 2 mentioned above, the swap begins with a zero
value but down down to a fair value of a negative liability of )$16,025) when
the value of the loan drops to ($998,851) such that the sum of the two values is
the constant $1 million. The swap costs the borrower an outflow of $16,025
at the end of the first quarter to offset the decline in the value of the
loan.
The point here is that a hedge for fair value risk creates cash flow
risk.
Why would a firm want to enter into a fair value hedge that causes cash flow
risk? There can be many reasons, but one is that the borrower may predict
that interest rates are going to fall and it would be advantageous to prepay the
fixed-rate loan at some point in time before maturity and borrow at anticipated
lower rates. In Example 2 mentioned above, LIBOR dropped to 6.31% in the
fourth quarter such at the firm would have to pay $1,001,074 to prepay the loan
(e.g., by buying it back in the market). However, due to the hedge, the
interest rate swap would pay $1,074 such that the net cost is only the $1
million locked in fair value fixed by the interest rate swap hedge.
Companies do a somewhat surprising amount of fair value hedging with interest
rate swaps. Two enormous examples are Fannie Mae and Freddie Mac.
Both of these giant companies hedge millions of dollars of outstanding variable
rate debt with interest rate swaps that lock in fair value. Both companies
thereby create cash flow risk. Fannie Mae lost $24 billion in derivatives
trading, and much of this was due to fair value hedging. See "$25
Billion in Derivatives Losses at Fannie Mae" --- http://worldvisionportal.org/WVPforum/viewtopic.php?t=192
An independent analysis of Fannie's accounts
suggests it may have incurred losses on its derivatives trading of $24bn
between 2000 and third-quarter 2003. That figure represents nearly all of the
$25.1bn used to purchase or settle transactions in that period. Any net losses
will eventually have to be recognised on Fannie Mae's balance sheet,
depressing future profits.
You can read more about Fannie Mae and Freddie Mac fair value hedging
strategy in their annual reports for Years 2001, 2002, and 2003. Both
companies made headlines for not complying with FAS 133 hedge accounting
years. See
http://faculty.trinity.edu/rjensen/caseans/000index.htm
See Illustrations
and Ineffectivness.
Cash Flow Statement
Presentation
From The Wall Street Journal Accounting Educators' Review on May 9,
2003
TITLE: FASB Rules Derivatives Must Be Part of Financing Cash Flow
REPORTER: Cassell Bryan-Low
DATE: May 01, 2003
PAGE: C4
LINK: http://online.wsj.com/article/0,,SB105174180092459600,00.html
TOPICS: Debt, Derivatives, Financial Accounting
SUMMARY: The FASB issued this ruling "in an attempt to crack
down" on companies that undertake transactions requiring prepayments by a
customer. Some companies have been including those prepayments in cash flows
from operations.
QUESTIONS:
1.) Define financing, investing, and operating cash flows--be specific by
referring to authoritative literature for these definitions. Cite your source.
2.) How do financial statement users utilize the three sections of the
statement of cash flows to assess a companies financial health? Cite all ways
you can think of in which these amounts are used.
3.) Summarize the transaction addressed in the article. Why does the
headline define these items as derivatives? What is the support for including
the cash flows associated with these transactions in the operating section of
the statement of cash flows? What is the argument supporting presenting these
cash flows in the financing section?
4.) What is free cash flow? Is this concept defined in authoritative
accounting literature? How do financial statement readers use this concept in
assessing a company's financial health?
5.) How do the transactions described in this article impact a company's
free cash flow? How will they impact free cash flow after implementing the new
requirements issued by the FASB?
6.) What does the author mean when he writes of the fact that, because
banks such as J.P. Morgan Chase and Citigroup financed delivery of
commodities, companies using these transactions, such as Dynegy and Enron,
were "able to bury that financing in their trading accounts..."
CBOE =
Chicago Board Options
Exchange. See http://www.cboe.com/
Also see CBOT and CME.
You can find some great tutorials at http://www.cboe.com/education/
For the best educational materials at
CBOE, you have to download the Authorware player. But that is free and easy to
download.
CBOT =
Chicago Board of Trade.
See http://www.cbot.com/
Also see CBOE and CME.
There are a number of Internet sources for options and
futures prices --- http://www.cbot.com/
For example, look under Quotes and Data, Agricultural Futures.
You can read about contract
specifications by clicking on the tab "Education" and
choosing the alternative for "Contract Specifications." This
should take you to http://www.cbot.com/cbot/pub/page/0,3181,21,00.html
Especially note the definitions at http://cbotdataexchange.if5.com/FeaturesOverview.aspx
A glossary and tutorials are listed at http://www.cbot.com/cbot/pub/page/0,3181,909,00.html
The CBOT tutorials hang up quite often when downloading.
The CME tutorials are easier to download and use --- http://www.cme.com/edu/
The CME Glossary is at http://www.cme.com/edu/res/glos/index.html
Also note the FAQs --- http://cbotdataexchange.if5.com/Helpfaq.aspx
Note that sometimes when you click on
"Home" that it does not take you back to the "Real Home"
at http://www.cbot.com/
Choose
the day you are studying this question. For
example, suppose you go to www.cbot.com on
January 29,
2004
.
On that day you will find vectors (arrays of prices) called forward
prices for futures contracts on commodities such as corn, wheat, etc. Each
price is for a contract having a different expiration date such as contracts
settling in March 4, May 4, July 4, etc.
These forward contract prices remain fixed throughout the life of the
contract. Spot prices vary minute
to minute and day to day. The
spot price used on the contract date of closing is the settlement price.
The
prices you first see listed are the
forward prices.
To find spot
prices,
click on the link called "Charts." Scroll down to the bottom
of the charts page and change the "Month" to "Nearby."
For example, if it currently reads "Mar" for the month, change March
to "Nearby."
At
times you will see a Free Historical Data spot price table on the right side
of the home page of the CBOT. You must have a paid subscription to
Realtime Services for current spot rates. A great free foreign exchange
(FX) spot rate provider is at http://www.xe.com/ucc/
To
find details regarding each futures contract at the CBOT, click on
"Futures Contract Specs." There you will find that each
contract is for
5,000 bu.
and each tic is 1/4 of a cent which is the increments that traders flash with
hand signals in the pit of the trading floor at the CBOT.
You can read more about
use of the CBOT at
http://faculty.trinity.edu/rjensen/acct5341/class02.htm
Note the references at the end of the above document.
CDO Collateralized Debt Obligation = see Credit
Derivatives
Circus =
a hedging combination that entails both an
interest rate swap and a foreign currency swap. As a single-contract derivative, the circus swap runs into trouble in
FAS 133 because it simultaneously hedges a price (or interest rate) risk and foreign currency
risk. Suppose a U.S. company has a trading or
available-for-sale portfolio containing a variable rate note receivable in Brazilian
reals. Suppose the company enters into a circus swap that hedges both interest
rate and foreign currency risks. Since SFAS 115 requires that the hedged item (the
Brazilian note) be remeasured to fair value at each interest rate date (with foreign
currency gains and losses being accounted for under SFAS 52), Paragraph 21c on Page 14 and
Paragraph 36 on Page 23 of FAS 133 prohibit the Brazilian note for being the basis of a
cash flow hedge. Paragraph 18 on the top of Page 10 prohibits "separating a
compound derivative into components representing different risks .... " Example
14 beginning on Page 271 illustrates the same problem with a note payable illustration in Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.
If the Brazilian note was instead
classified as held-to-maturity, the booked value is not
remeasured to fair value on each balance sheet date. That overcomes the Paragraph
21c revaluation objection on Page 14 of FAS 133. Since the note is not an equity
investment, other barriers in Paragraph 21c do not apply. However, held-to-maturity securities may not be hedged for cash flow risk
according to Paragraphs 426-431 beginning on Page 190 of FAS 133. And Paragraph 18
on Page 10 looms as a lingering barrier.
To circumvent the Paragraph 18
problem of having compound risk hedges in a single contract, the U.S. company could enter
into to separate derivative contracts such as an interest rate swap accompanied by an
independent forward contract that hedges the foreign currency risk. Then the issue
for a cash flow hedging combination is whether the Brazilian note qualifies as a hedging
instrument qualifies under Paragraph 29 rules beginning on Page 20 of FAS 133.
Paragraph 20e bans interest rate hedging if the note is declared held-to-maturity. Paragraph
20d bans interest rate hedging for a note declared as a
trading security under SFAS 115. Conversely, Paragraphs 4c
on Page 2, 38 on Page 24, and 479 on Page 209 of FAS 133 state that a forecasted purchase
of an available-for-sale security can be a hedged item,
because available-for-sale securities revalued under SFAS 115 have holding gains and
losses accounted for in comprehensive income rather
than current earnings. Unlike trading securities, available-for-sale securities can
be FAS 133-allowed hedge items. Mention of available-for sale is made in
Paragraphs 4, 18, 23, 36, 38, 49, 52-55, 123, 479-480, and 534 of FAS 133. Even if
this results in accounting for the two derivatives as a cash flow
hedge of the Brazilian note, the same cannot be said for a fair
value hedge since the forward contract hedging foreign currency risk must be carried
at fair value. Somewhat similar conclusions arise for a foreign currency note
payable illustration in Example 15 on Page 272 of Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.
One of my students wrote the following case
just prior to the issuance of FAS 133:
Brian T. Simmons For
his case and case solution entitled ACCOUNTING FOR CIRCUS SWAPS: AN INSTRUCTIONAL
CASE click on http://www.resnet.trinity.edu/users/bsimmons/circus/framecase.htm
. He states the following:
This
case examines a basic circus swap which involves not only the exchange of
floating interest rate for fixed, but also one currency for another.
Separation of the effects from both interest rate and foreign currency
fluctuations is no simple matter. In fact, no formal accounting
pronouncements specifically address this issue. (prior to FAS 133).
The introduction first reviews the history and reasoning of pronouncements
leading up to Exposure Draft 162-B. For years, institutions have relied
on settlement accounting to record their derivative instruments. With
growing concern over the risk of these instruments, however, the SEC and FASB have
attempted to increase the detail of disclosure regarding the value and risk
of their derivative portfolio. The case provides an example of a hybrid
instrument in the form of a circus swap. The case questions review the
accounting for these types of instruments under the current settlement
accounting guidelines as well as the new fair-value method. Additionally, a
simplistic measure of Risk Per Contract (RPC) is developed. By using
information that is easy for management to obtain, the likelihood of the
benefits of RPC outweighing the costs is greatly enhanced.
Clearly-and-Closely
Related Criteria (or Clearly and Closely
Related) =
criteria that determine when and when not
to treat an embedded derivative as a freestanding
contract apart from its host contract. An embedded derivative that is both deemed to
be free standing and is not clearly-and-closely related" must be accounted for
separately rather than remain buried in the accounting for the host contract.
Relevant sections of FAS 133 include Paragraphs 304-311 in Pages 150-153 and Paragraphs
443-450 in Pages 196-198. The FASB reversed its ED 162-B position on compound derivatives.
Examples 12-34 beginning in Paragraph 176 on Page 93 illustrate
clearly-and-closely-related criteria in embedded hybrid derivative instruments. For
example, a call option cannot be accounted for separately if it is clearly-and-closely
related to to a hybrid instrument that is clearly an equity instrument on a freestanding
basis and, thereby, is not subject to FAS 133 rules. If a prepayment option on a in
a variable rate mortgage is based upon an interest rate index, the option is clearly-and-closely related to the host contract
and cannot be accounted for separate from its host. On the other hand, if the option
is instead based upon a stock price index such as the Standard and Poors 500 index. the
option is no longer clearly-and-closely related to to the host contract. See hedge.
For example suppose a bond receivable has a
variable interest rate with an embedded range floater derivative
that specifies a collar of 4% to 8% based upon LIBOR. The bond
holder receives no interest payments in any period where the average LIBOR is outside the
collar. In this case, the range floater embedded option cannot be isolated and
accounted for apart from the host bond contract. The reason is that the option is
"clearly-and-closely related" to the interest payments under the host contract
(i.e., it can adjust the interest rate). See Paragraph 12 beginning on Page 7 of
FAS 133.
Some debt has a combination
of fixed and floating components. For example, a "fixed-to-floating" rate
bond is one that starts out at a fixed rate and at some point (pre-determined or
contingent) changes to a variable rate. This type of bond has a embedded
derivative (i.e., a forward component for the variable rate component
that adjusts the interest rate in later periods. Since the forward component is "clearly-and-closely
related"adjustment of interest of the host
contract, it cannot be accounted for separately according to Paragraph 12a on Page 7 of
FAS 133 (unless conditions in Paragraph 13 apply).
Illustrations are provided under cap
and floater.
See DIG Issue B5 under embedded
derivatives.
CME =
Chicago Mercantile Exchange. See http://www.cme.com
Also see CBOE and CBOT.
Collar=
a hedge that confines risk to a particular range.
For example, one form of collar entails buying a call option and selling a put option in
such a manner that extreme price variations are hedged from both sides. In Paragraph 181
on Page 95 of FAS 133, a timing collar is discussed. A collar combines a cap and a
floor. Another example is given in Paragraph 182 beginning on Page 95 of
FAS 133.
Also see cap and floater.
Collateralized Debt Obligation (CDO) = see
Credit Derivatives
Collateralized Mortgage Obligation CMO =
a priority claim against collateral used to back
mortgage debt. This is considered a derivative financial instrument, because the value is
derived from another asset whose value, in turn, varies with global and economic
circumstances.
Combination Option =
see compound derivatives and option.
Commitment
Exposure =
economic exposure arising from the effects of
foreign currency fluctuations on the cost curves of competitors. See firm commitment and hedge.
Commodity-Indexed
Embedded Derivative =
a derivative embedded in a contract such as
an interest bearing note that changes the amount of the payments according to movements of
a commodity price index. When a contract has
such a provision, the embedded portion must be separated from the host
contract and be accounted for as a derivative according to Paragraph 61i on
Page 43 of FAS 133.
This makes embedded commodity indexed derivative accounting different than credit indexed and inflation
indexed embedded derivative accounting rules that do not allow separation from the host contract. In this regard,
credit indexed embedded derivative accounting is more like equity
indexed accounting.In this regard, credit indexed embedded derivative accounting is more
like equity
indexed accounting. See index, equity-indexed, derivative
financial instrument and embedded derivatives.
In my viewpoint, not all commodity indexed
derivatives fail the Paragraph 61i test. See my
Mexcobre Case.
Competitive
Exposure =
economic exposure arising from the effects of
foreign currency fluctuations on the cost curves of competitors.
Compound
Derivatives =
derivatives that encompass more than one
contractual provision such that different risk exposures are hedged in the compound
derivative contract. Paragraph 18 on Pages 9-10 prohibits separation of a compound
derivative into components to designate different risks and then use only one or a subset
of components as a hedging instrument. FAS 133, Pages 167-168, Paragraphs 360-361
discusses how the FASB
clung to its position on pro rata decomposition in FAS 133 vis-à-vis the earlier
Exposure Draft 162-B that also did not allow pro rata decomposition. Further discussion is
given in Paragraphs 523-524. See circus, derivative,
embedded derivatives, and option.
Closely related are synthetic instruments arising
when multiple financial instruments are synthetically combined into a single instrument,
possibly to meet hedge criteria under FAS 133. FAS 133 does not allow synthetic
instrument accounting. See Paragraphs 349-350 on Page 164 of FAS 133. Examples
12-34 beginning in Paragraph 176 on Page 93 illustrate clearly-and-closely-related
criteria in embedded hybrid derivative instruments. These criteria are discussed
under hedge. For a case illustration of a synthetic instrument
hedging situation see D.C. Cerf and F.J. Elmy, "Accounting for Derivatives: The
Case Study of a Currency Swap Used to Hedge Foreign Exchange Rate Exposure," Issues
in Accounting Education, November 1999, 931-956.
In summary, for hedging purposes, a compound grouping of multiple derivatives (e.g., a
portfolio of options or futures or forward contracts or any combination thereof) is
prohibited from "separating a derivative into either separate proportions
or separate portions and designating any component as a hedging instrument or
designating different components as hedges of different exposures." See
Paragraphs 360-362 beginning on Page 167 of FAS 133. Paragraphs dealing with
compound derivative issues include the following:
-
Paragraph 18 beginning on Page 9,
-
Footnote 13 on Page 29,
-
Paragraphs 360-362 beginning on Page 167,
-
Paragraph 413 on Page 186,
-
Paragraphs 523-524 beginning on Page 225.
Section c(4) of Paragraph 4 on Page
2 of FAS 133 makes an exception to Paragraph 29a on Page 20 for portfolios of dissimilar
assets and liabilities. It allows hedging under "net investment" criteria
under Paragraph 20 of SFAS 52. The gain or loss is reported in other comprehensive income as part of the cumulative translation
adjustment. Reasons are given in Paragraph 477 on Page 208 of FAS 133:
The net investment in a foreign
operation can be viewed as a portfolio of dissimilar assets and liabilities that would not
meet the criterion in this Statement that the hedged item be a single item or a group of
similar items. Alternatively, it can be viewed as part of the fair value of the parent's
investment account. Under either view, without a specific exception, the net investment in
a foreign operation would not qualify for hedging under this Statement. The Board decided,
however, that it was acceptable to retain the current provisions of Statement 52 in that
area. The Board also notes that, unlike other hedges of portfolios of dissimilar items,
hedge accounting for the net investment in a foreign operation has been explicitly
permitted by the authoritative literature.
For a derivative not designated as a hedging instrument,
the gain or loss is recognized in earnings in the period of change. Section 4(c) of
Paragraph 4 of FAS 133 amends SFAS 52 on Foreign Currency Translation, to
permit special accounting for a hedge of a foreign currency forecasted transaction with a
derivative. For more detail see foreign
currency hedge.
Paragraph 42 on Page 26 reads as follows:
.A derivative instrument or a
nonderivative financial instrument that may give rise to a foreign currency transaction
gain or loss under Statement 52 can be designated as hedging the foreign currency exposure
of a net investment in a foreign operation. The gain or loss on a hedging derivative
instrument (or the foreign currency transaction gain or loss on the nonderivative hedging
instrument) that is designated as, and is effective as, an economic hedge of the net
investment in a foreign operation shall be reported in the same manner as a translation
adjustment to the extent it is effective as a hedge. The hedged net investment shall be
accounted for consistent with Statement 52; the provisions of this Statement for
recognizing the gain or loss on assets designated as being hedged in a fair value hedge do
not apply to the hedge of a net investment in a foreign operation.
nonderivative financial instrument that
may give rise to a foreign currency transaction gain or loss under Statement
52 can be designated as hedging the foreign currency exposure of a net
investment in a foreign operation. The gain or loss on a hedging derivative
instrument (or the foreign currency transaction gain or loss on the
nonderivative hedging instrument) that is designated as, and is effective
as, an economic hedge of the net investment in a foreign operation shall be
reported in the same manner as a translation adjustment to the extent it is
effective as a hedge. The hedged net investment shall be accounted for
consistent with Statement 52; the provisions of this Statement for
recognizing the gain or loss on assets designated as being hedged in a fair
value hedge do not apply to the hedge of a net investment in a foreign
operation.
These Section c(4) confusions in
Paragraph 4 are illustrated in Examples 11-13 beginning on Page 270 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP
in July 1998.
Paragraph 18 at the top of Page 10 does
allow a single derivative to be divided into components but never with partitioning
of "different risks and designating each component as a hedging
instrument." An example using Dutch guilders versus French francs is given
under cash flow hedge. The problem is troublesome in circuses.
Compound derivative rules do not always
apply to compound options such as a combination of put and call options. Paragraph 28c on Page 19 of FAS 133
highlights these exceptions for written compound options or a
combination of a written option and a purchased option.
The test is that for all changes in the underlying, the hedging outcome provides positive
cash flows that are never less than the unfavorable cash flows. See Example 16
beginning on Page 273 of of the Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.
See Structure
and Synthetic.
Comprehensive Income or
Other Comprehensive Income (OCI)
Other
Comprehensive Income (OCI) and Accumulated OCI (AOCI)
OCI is equal to the change in equity of a business entity during
a period from transactions and other events and circumstances from nonowner sources.
Paragraph 5 40 on Page 243 of FAS 133 defines it as follows:
The change in equity of a business
enterprise during a period from transactions and other events and circumstances from
nonowner sources. It includes all changes in equity during a period except those
resulting from investments by owners and distributions to owners (FASB Concepts
Statement No. 6, Elements of Financial Statements, paragraph 70).
Comprehensive income includes all changes
in equity during a period except those resulting from investments by owners and
distributions to owners (FASB
Concepts Statement No. 6, Elements of
Financial Statements paragraph 70). The FASB’s ED 162-A proposed a standard on comprehensive income
accounting that eventually became a standard in SFAS 130. FAS 133 sought to
book financial instrument derivatives without changing net earnings levels
prior to issuance of FAS 133. Accordingly, booking of derivative hedgings at
fair market value, especially cash flow hedges, entails deferral of earnings
in Other Comprehensive Income until cash settlements transpire. Comprehensive
income is discussed at various points in FAS 133, notably Paragraphs 46-47,
18c, 127-130, 131-139, 140-143, 144-152, 162-164, 165-172, 173-177, and
338-344. The acronym AOCI is sometimes used to depict accumulated other
comprehensive income.
The International Accounting Standards Committee
(IASC) has not yet defined or required comprehensive statements or the
Other Comprehensive Income (OCI) account. This is especially important since it
causes important reproted earnings differences between IAS
39 versus FAS 133. Under
FAS 133, the OCI account is used for cash flow hedges. OCI is not used under IAS
39.
See also struggle
statement.
OCI and the Accumulated Other Comprehensive Income (AOCI)
accounts are used in hedge accounting to keep booked changes in value of cash
flow hedges and FX hedges from impacting current earnings to the extent such
hedges are deemed effective. See Hedge
Accounting and Ineffectiveness.
Summary of FAS 130
Reporting Comprehensive Income (Issued 6/97)
Summary --- http://www.fasb.org/st/summary/stsum130.shtml
This Statement establishes standards for reporting
and display of comprehensive income and its components (revenues,
expenses, gains, and losses) in a full set of general-purpose financial
statements. This Statement requires that all items that are required to
be recognized under accounting standards as components of comprehensive
income be reported in a financial
statement that is displayed with the same prominence as other financial
statements. This Statement does not require a specific format for that
financial statement but requires that an enterprise display an amount
representing total comprehensive income for the period in that financial
statement.
This Statement requires that an enterprise (a) classify items of other
comprehensive income by their nature in a financial statement and (b)
display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity
section of a statement of financial position.
This Statement is effective for fiscal years beginning after December
15, 1997. Reclassification of financial statements for earlier periods
provided for comparative purposes is required.
"Watch Out for OCI Accounting," April 8, 2002 --- http://www.fas133.com/search/search_article.cfm?page=51&areaid=955
When Reliant Resources finally released its
earnings in mid-March (see TRAS, 2/11/02), it became clear where the
company’s FAS 133 hedge accounting went wrong; it’s a mistake other
companies should ensure they do not repeat.
While in Reliant’s case, the mistake ended up
contributing $134 million to the company’s 2001 net income, had the
fair value of the derivatives in question gone the other way, the result
would have been more ominous.
In essence, the FAS 133 mistake had to do with
four “structured transactions” involving energy forwards which
Reliant initially considered cash flow hedges and in retrospect, did not
meet the definition.
In particular, the four transactions involved a
series of individual forward contracts, mostly off-market (assuming a
lower-than-market price initially in return for a higher-than-market
price later).
While the combination of forwards was priced at
market, the individual contracts were not. Some even involved some
prepayment for credit reasons. Still, Reliant chose to account for each
forward contract individually as a cash flow hedge set against an
underlying transaction.
The real problem was in the initial accounting
for the forwards. Under the original accounting, according to Reliant’s
8-K, “the Company recorded each applicable contract in its hedge
accounting records on an individual basis, resulting in the recognition
of a non-trading derivative asset or liability on the balance sheet with
an offsetting entry in accumulated other comprehensive income at
inception for each contract.”
Under FAS 133 cash flow hedge rules, however,
OCI can only be used to record subsequent changes in the value of a
hedging derivative. At inception, the forward should have had a fair
value of 0. (Since they were off market, they have a fair value greater
or lesser than 0).
Once you begin the hedge accounting with a
debit/credit into OCI on day one of the hedge, “you’ve basically
introduced a cancer into the balance sheet that will bleed errors into
the income statement as the debits and credits get reclassified,” one
accounting expert explains.
Under that original accounting, Reliant
recorded a net loss in 2001 and ultimately would result in income being
recorded for 2002 and 2003 related to these four structured
transactions.
In some ways, the accounting did reflect the
economics of the transaction, whereby Reliant agreed to sell below
market initially in return for being able to sell at higher levels later
on. Economically, it wanted to “levelize” what it considered high
prices which were unlikely to last.
However, “the recognition of other
comprehensive income was in error, because the fair value of each
contract in each structure resulted not from changes in the fair value
of any anticipated transaction, but rather from the fact that the
individual contracts were not at market at inception,” the 8-K
explains.
"Preliminary Lessons From Reliant
Resources," February 27, 2002 --- http://www.fas133.com/search/search_article.cfm?areaid=454&page=51
While financial hedges retained many of their
risk management accounting features under FAS 133 (carry-overs from FAS
52 and FAS 80), in the area of commodity risk management accounting
there's been some fundamental changes. It's perhaps an indication of the
resulting complexity of the rules that Reliant Resources announced it
has made an error in its Q2/Q3 financials, which will necessitate a
restatement of earnings.
Earning restatements are bad news in any
environment. Against the current backdrop of accounting-transparency
debate in the wake of Enron, restatements because of accounting errors
look even worse. However, Reliant Resources had to do just that - delay
its earning release (so far there's no new release date) because it
discovered FAS 133-related errors in its income statement.
The errors, according to the company, result
from gas hedges in Q2 and Q3 of 2001. These were previously accounted
for as cash flow hedges. Now, the company believes that they do not meet
the requirements under FAS 133. This error will affect earning upward of
$100 million. Basically, it means that the company now believes that it
needs to carry the hedges at fair value, hence reclassifying gains that
had been parked in OCI into current income. Reliant says it did not
expect to recognize this income until this year and next year
(presumably, these were one and two-year hedges).
It's hard to say exactly what happened. That's
because the company is saying precious little about what led to its
discovery. "Our people are not interested in going into details
about the accounting, we're still working it out," says Sandy
Fruhman, a PR contact at Reliant. As to when the new figures will be
available, Ms. Fruhman says she has not been given a timeframe.
"We're eager to get our yearend earnings reported," she notes.
No question about that, since any restatement
of earnings (even a revision upward as was the case with Reliant),
against the current accounting-focused marketplace, leads to a stock
market penalty. The negative market reaction is proof enough that the
restatement is not a matter of choice (i.e., earning manipulation). The
FASB and the SEC had been previously concerned that some companies might
terminate cash flow hedges when they are in a gain position in order to
book the gains in income, for instance during years when earnings are
down. "I would be surprised if that were the case," noted a
partner at a big-five firm. "The market hammered them, so I don't
suspect anything 'evil.' My guess is that they were just being
honest."
All Reliant is willing to say is that in the
course of preparing its annual report, its accounting department came to
the conclusion that some of the gas hedges on its books, originally
entered into in the second and third quarter of 2001, failed to meet
cash flow hedge accounting rules and therefore must be marked to market
in income. As a result, Reliant said it expects earnings for the two
periods to increase by an amount between $100 million and $130 million.
"The restatement, due to a reclassification of several specific
transactions, will change the timing of earnings recognition, with the
effect that the company will recognize earnings in 2001 that it
previously expected to recognize in 2002 and 2003," the company
noted.
A quick look at the company's quarterly filings
reveals that it held a deferred gain of $495 million (see below) at the
end of the third quarter. That's the same amount it disclosed in its Q2
report, and slightly under the Q1 deferred gain.
Contango Swap = the following according to one of my students:
A contango swap is a commodity curve swap, which enables
the user to lock in a positive spread between the forward price and the spot price. A
producer of a commodity, for example, might pay an amount equal to the 6-month futures
contract and receive a floating payment equal to the daily price plus a spread. This
enables the commodity producer to lock-in the positive spread and hedge against
anticipated backwardation. Her project on such a swap is as follows:
Debra W. Hutcheson For
her case and case solution on Accounting for Commodity and Contango Swaps,
click on http://www.resnet.trinity.edu/users/dhutches/project.htm
. She states the following:
This
case examines the interplay of a cotton consumer and a cotton producer, both
participating in a commodity swap, one of the many commodity-based financial
instruments available to users. Each party wants to protect itself from
commodity price risk and the cotton swap allows each participating party to
"lock-in" a price for 6 million pounds of cotton. One party might
lose in the cotton swap and, therefore, must enter into some other
derivative alternatives. Additionally, this case examines the requirements
for accounting for these contracts under the FASB’s latest exposure draft
on accounting for derivatives and the "forward-looking" disclosure
required by the SEC.
The term "contango" is also used
in futures trading. It refers to situations in which the spot price is higher than
the futures price and converges toward zero from above the futures price. In
contrast, backwardation arises when the spot price is lower than the futures price,
thereby yielding an upward convergence as maturity draws near. See basis.
Contingent
Consideration =
outcomes that have maturities or payouts that depend upon
the outcome of a a contingency such as a civil lawsuit. Contingent consideration in
a business combination as defined in Paragraph 78 of APB 16 are excluded (for the issuer)
from the scope of FAS 133 under Paragraph 11c on Page 7. Accounting for this type
of transaction remains as originally required for the issuer in APB 16. Contingent
lease rentals based on related sales volume, inflation indexed rentals, and contingent
rentals based upon a variable interest rate are also excluded from FAS 133 in Paragraph
61j on Page 43.
Convertible Debt =
a debt contract that has an embedded
derivative such as an option to convert the instrument debt into common stock must be
viewed as having an embedded option. When a contract has such a provision,
the embedded portion must be separated from the host contract and be accounted for as a
derivative according to Paragraph 61k on Page 43 of FAS 133. See derivative financial instrument and embedded option.
Covered
Call and Covered Put =
simultaneous writing
(selling) of a call option coupled with ownership (long
position) of the underlying asset. The written call option is a
short position that exposes the call option writer to upside risk. A covered call transfers upside
potential of the long position to the buyer of the call and, thereby, may
create more upside price risk than downside price expected benefit. Paragraph 399 on Page 180 does not allow hedge accounting for covered calls,
because the upside potential must be equal to or greater than the downside potential.
In the case of a covered call, the upside risk may exceed the downside
potential..
A covered put entails
writing (selling) a put option (long position) coupled
with having a short position (e.g., a short sale
contract) on the underlying asset. In the case of a covered put, the
downside risk may exceed the downside potential.
Paragraph 399 on Page 180 of
FAS 133 does not
allow covered call strategies that permit an entity to write an
option on an asset that it owns. In a covered call the combined position of
the hedged item and the derivative option is asymmetrical in that exposure to losses is
always greater than potential gains. The option premium, however, is set so that the
option writer certainly does not expect those "remotely possible" losses to
occur. Only when the potential gains are at least equal to potential cash flow
losses will Paragraph 28c on Page 19 of FAS 133 kick in to allow a cash flow hedge under
FAS 133. Also see Paragraph 20c on Page 12.
Also see option and written option.
Credit
Derivative and Credit Risk Swap =
Jensen Comment
Credit derivatives (usually credit default swaps that have a periodic premium
paid for and pay periodically for credit insurance) are currently scoped into
FAS 133 and IAS 39. I think that this is a mistake. These contracts are really
insurance contracts and financial guarantees that should be accounted for as
such and not as derivatives scoped into FAS 133 and IAS 39. Be that as it may,
these controversial contracts that brought AIG and other Wall Street banks to
its knees are accounted for as derivative contracts.
I really don’t think credit derivatives
are appropriately accounted for under either FAS 133 or IAS 39. The problem is
that the intermediary that brokers an interest rate risk swap can guarantee the
interest rate risk swap payments since these swaps are only dealing with
payments on the net changes in interest rates with the
notionals not being at risk. It seems to me that with credit default swaps,
the entire notionals themselves might be
at risk and the intermediaries that broker the swaps are not guaranteeing the
swap payments equal to complete wipeouts of notionals. Hence, I don’t thinks CDS
swaps properly meet the definitions of derivatives since
notionals are at risk. It seems to me that CDS contracts should be accounted
for as insurance contracts.
This is one of those instances where I
think auditors should look at the substance of the transactions rather than
rules per se.
Credit Default Swap (CDS) at
http://en.wikipedia.org/wiki/Credit_default_swap
A credit default
swap (CDS) is an instrument to transfer the credit risk of fixed income
products. Using technical terms, it is a bilateral contract, in which two
counterparties agree to isolate and separately trade the credit risk of at
least one third-party reference entity. The buyer of a credit swap receives
credit protection. The seller 'guarantees' the credit worthiness of the
product. In more technical language, a protection buyer pays a periodic fee
to a protection seller in exchange for a contingent payment by the seller
upon a credit event (such as a default or failure to pay) happening in the
reference entity. When a credit event is triggered, the protection seller
either takes delivery of the defaulted bond for the par value (physical
settlement) or pays the protection buyer the difference between the par
value and recovery value of the bond (cash settlement). Simply, the risk of
default is transferred from the holder of the fixed income security to the
seller of the swap. For example, a mortgage bank, ABC may have its credit
default swaps currently trading at 265 basis points (bp). In other words,
the annual cost to insure 10 million euros of its debt would be 265,000
euros. If the same CDS had been trading at 7 bp a year before, it would
indicate that markets now view ABC as facing a greater risk of default on
its mortgage obligations.
Credit default
swaps resemble an insurance policy, as they can be used by debt owners to
hedge, or insure against credit events such as a default on a debt
obligation. However, because there is no requirement to actually hold any
asset or suffer a loss, credit default swaps can also be used to speculate
on changes in credit spread.
Credit default
swaps are the most widely traded credit derivative product.[1] The typical
term of a credit default swap contract is five years, although being an
over-the-counter derivative, credit default swaps of almost any maturity can
be traded.
"Everything You Wanted to Know about Credit Default Swaps--but Were Never
Told," by Peter J. Wallison, RGE, January 25, 2009 ----
Click Here
Also see
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Credit default swaps
(CDSs) have been identified in media accounts and by
various commentators as sources of risk for the
institutions that use them, as potential contributors to
systemic risk, and as the underlying reason for the
bailouts of Bear Stearns and AIG. These assessments are
seriously wide of the mark. They seem to reflect a
misunderstanding of how CDSs work and how they
contribute to risk management by banks and other
intermediaries. In addition, the vigorous market that
currently exists for CDSs is a significant source of
market-based judgments on the credit conditions of large
numbers of companies--information that is not publicly
available anywhere else. Although the CDS market can be
improved, excessive restrictions on it would create
considerably more risk than it would eliminate.
There are so many
potential culprits in the current financial crisis that
it is difficult to keep them all straight or to assess
their relative culpability. Greedy investment banks,
incompetent rating agencies, predatory lenders and
mortgage brokers--even the entire system of asset
securitization--have all been blamed for the current
condition of the financial markets. The oddest target,
however, is CDSs. Almost every media report and
commentary about the collapse of Lehman Brothers in
September and the ensuing freeze in the credit markets
mentions CDSs as one of the contributing causes, just as
similar reports and commentary accompanied the
government's decision to rescue Bear Stearns in March
and AIG in September. One conventional explanation for
the Bear rescue has been that CDSs made the financial
markets highly "interconnected." It is in the nature of
credit markets to be interconnected, however: that is
the way money moves from where it is less useful to
where it is most useful, and that is why financial
institutions are called "intermediaries." Moreover,
there is very little evidence that Bear was bailed out
because of its involvement with CDSs--and some good
evidence to refute that idea. First, if the government
rescued Bear because of CDSs, why did it not also rescue
Lehman? If the Treasury Department and the Federal
Reserve really believed that Bear had to be rescued
because the market was interconnected through CDSs, they
would never have allowed Lehman--a much bigger player in
CDSs than Bear--to fail. In addition, although Lehman
was a major dealer in CDSs--and a borrower on which many
CDSs had been written--when it failed there was no
discernible effect on its counterparties. Within a month
after the Lehman bankruptcy, the swaps in which Lehman
was an intermediary dealer were settled bilaterally, and
the swaps written on Lehman itself ($72 billion
notionally) were settled by the Depository Trust and
Clearing Corporation (DTCC). The settlement was
completed without incident, with a total cash exchange
among all counterparties of $5.2 billion. There is no
indication that the Lehman failure caused any systemic
risk arising out of its CDS obligations--either as one
of the major CDS dealers or as a failed company on which
$72 billion in notional CDSs had been written.
Nevertheless,
Securities and Exchange Commission (SEC) chairman
Christopher Cox was quoted in a recent Washington
Post series as telling an SEC roundtable: "The
regulatory black hole for credit-default swaps is one of
the most significant issues we are confronting in the
current credit crisis . . . and requires immediate
legislative action. . . . The over-the-counter
credit-default swaps market has drawn the world's major
financial institutions and others into a tangled web of
interconnections where the failure of any one
institution might jeopardize the entire financial
system." Readers of this Outlook should judge
for themselves whether this is even a remotely accurate
portrayal of the dangers posed by CDSs.1
The fact that AIG was
rescued almost immediately after Lehman's failure led
once again to speculation that AIG had written a lot of
CDS protection on Lehman and had to be bailed out for
that reason. When the DTCC Lehman settlement was
completed, however, AIG had to pay only $6.2 million on
its Lehman exposure--a rounding error for this huge
company. As outlined in a recent Washington Post
series on credit risk and discussed below, AIG's
exposure was not due to Lehman's failure but rather the
result of the use (or misuse) of a credit model that
failed to take account of all the risks the firm was
taking.2 It is worth mentioning here that
faulty credit evaluation on mortgage-backed securities (MBS)
and collateralized debt obligations (CDOs) have also
been the cause of huge losses to commercial and
investment banks. As I argue in this Outlook,
there is no substantial difference between making a loan
(or buying a portfolio of MBS) and writing protection on
any of these assets through a CDS. Faulty credit
evaluation in either case will result in losses.
If CDSs did not
trigger the rescue of Bear and AIG, what did? The most
plausible explanation is that in March, when Bear was
about to fail, the international financial markets were
very fragile. There was substantial doubt among
investors and counterparties about the financial
stability and even the solvency of many of the world's
major financial institutions. It is likely that the
government officials who decided to rescue Bear believed
that if a major player like Bear were allowed to fail,
there would be a run on other institutions. As Fed
chairman Ben Bernanke said at the time, "Under more
robust conditions, we might have come to a different
decision about Bear Stearns."3 When the
markets are in panic mode, every investor and
counterparty is on a hair-trigger alert because the
first one out the door is likely to be repaid in full
while the latecomers will suffer losses. The failure of
a large company like Bear in that moblike environment
can be responsible for a rush to quality; in a normal
market, there would have been a much more muted
reaction. For example, when Drexel Burnham failed in
1990, there was nothing like the worldwide shock that
ensued after Lehman's collapse, although Drexel was as
large a factor in the market at that time as Lehman was
before its failure.
After the Lehman
bankruptcy, there was a market reaction much like what
would have happened if Bear had failed. The markets
froze, overnight interbank lending spreads went straight
north, and banks stopped lending to one another. In
these circumstances, the rescue of AIG was inevitable,
although it is likely that the company would have been
allowed to fail if the reaction to the Lehman failure
had not been so shocking. The Fed's statement on its
rescue of AIG pointed to the conditions in the
market--not to CDSs or other derivatives--as the reason
for its actions: "The Board determined that, in current
circumstances, a disorderly failure of AIG could add to
already significant levels of financial market fragility
and lead to substantially higher borrowing costs,
reduced household wealth, and materially weaker economic
performance."4 Indeed, the sensitivity of
the markets and the government in September is shown by
the reaction of the Treasury and the Fed when the
Reserve Fund, a money market mutual fund, "broke the
buck"--that is, allowed the value of a share to fall
below one dollar. The fund had apparently invested
heavily in Lehman commercial paper and thus suffered a
loss that the manager could not cover. Treasury moved
immediately to guarantee the value of money market fund
shares, apparently on fear that the Reserve Fund's
losses would trigger a run on all money market funds.
Needless to say, money market funds are not
"interconnected." The Treasury's action in backing money
market mutual funds after Lehman's failure was another
response to the market's panic.
So, if CDSs are not
responsible for the financial crisis or the need to
rescue financial companies, why are they so distrusted?
Some observers may simply be drawing a causal connection
between the current financial crisis and something new
in the financial firmament that they do not fully
understand. Misleading references to the large "notional
amount" of CDSs outstanding have not helped. This
Outlook will outline how CDSs work and explain
their value both as risk management devices and
market-based sources of credit assessments. It will then
review the main complaints about CDSs and explain that
most of them are grossly overblown or simply wrong.
Improvements can certainly be made in the CDS market,
but the current war on this valuable financial
innovation makes no sense.
How Credit
Default Swaps Work
Figure 1 shows a
series of simple CDS transactions. Bank B has bought a
$10 million bond from company A, which in CDS parlance
is known as "the reference entity." B now has exposure
to A. If B does not want to keep this risk--perhaps it
believes A's prospects are declining, or perhaps B wants
to diversify its assets--it has two choices: sell the
bond or transfer the credit risk. For a variety of tax
and other reasons, B does not want to sell the bond, but
it is able to eliminate most or all of the credit risk
of A by entering a CDS. A CDS is nothing more than a
contract in which one party (the protection seller)
agrees to reimburse another party (the protection buyer)
against a default on a financial obligation by a third
party (the reference entity). In figure 1, the reference
entity is A, the protection buyer is B and the
protection seller is C. Although figure 1 shows B
purchasing protection against its entire loan to A, it
is important to note that B also could have purchased
protection for a portion of the principal amount of the
$10 million bond. The amount of protection that B
purchases is called the "notional amount."
The CDS market is a
dealer market, so transactions take place through
dealers, over the counter rather than on an exchange.
Accordingly, in purchasing protection against A's
default, B's swap is with C, a dealer--one of many,
including the world's leading banks, that operate in
this market. The structure of the CDS is simple. C
agrees to pay $10 million (or whatever notional amount
the parties negotiate) if A defaults, and B agrees to
make an annual premium payment (usually paid quarterly)
to C. The size of this payment or premium will reflect
the risk that C believes it is assuming in protecting B
against A's default. If A is a good credit, the premium
will be small, and correspondingly the premium would be
larger when the market perceives greater credit risk in
A. Under the typical CDS contract, B is entitled to
request collateral from C in order to assure C's
performance. As a dealer, C generally aims to keep a
matched book. For every risk it takes on, it typically
acquires an offsetting hedge. So C enters a CDS with D,
and D posts collateral. The transfer of B's risk to C
and then to D (and occasionally from D to E and so on)
is often described by many CDS critics as a "daisy
chain" of obligations, but this description is
misleading. Each transaction between counterparties in
figure 1 is a separate transaction, so B can look only
to C if A defaults, and C must look to D. B will not
usually deal directly with E. However, there are now
services, such as those of a firm called Trioptima, that
are engaged in "compressing" this string of transactions
so that the intermediate obligations are "torn up." This
reduces outstandings and counterparty risk.
Does this hypothetical
string of transactions create any significant new risks
that go beyond the risk created when B made its loan to
A? In the transaction outlined in figure 1, each of the
parties in the chain has two distinct risks--that its
counterparty will be unable to perform its obligation
either before or after A defaults. If C becomes
bankrupt before A defaults, B will have to find
a new protection seller; if C defaults after A
defaults, B will lose the protection that it sought from
the swap. The same is true for C and D if their
respective counterparties default. In the CDS market, in
which premiums are negotiated based on current views of
the risk of A's default, the premium--also known as the
spread--for new protection against A's default could be
more costly for B, C, and D than the original premium
negotiated. Although this might mean a potential loss to
any of these parties, it is likely--if the risk of a
default by A has been increasing--that the seller of
protection will have posted collateral so that each
buyer will be able to reimburse itself for the
additional premium cost for a new CDS.
It is important at
this point to understand how the collateral process
works. Either the buyer or the seller in a CDS
transaction may be "in the money" at any point--that is,
the CDS spread, which is moving with market judgments,
may be rising or falling, depending on the market's
judgment of the reference entity's credit. At the moment
the CDS transaction was entered, the buyer and seller
were even, but if the credit of the reference entity
begins to decline, the CDS spread will rise, and at that
point the buyer is "in the money"--it is paying a lower
premium than the risk would warrant. Depending on the
terms of the original agreement, the seller then may
have to post collateral--or more collateral. But if the
reference entity's credit improves--say, its business
prospects are better--then the CDS spread will fall and
the seller is in the money. In this case, the buyer may
have to put up collateral to ensure that it will
continue to make the premium payments.
What happens if A
defaults? Assuming that there are no other defaults
among the parties in figure 1, there is a settlement
among the parties, in which E is the ultimate obligor
(conceptually, C has paid B, D has paid C, and E has
paid D. But if E defaults, D becomes the ultimate payer,
and if D defaults, C ends up holding the bag. Of course,
D then would have a claim against E or E's bankrupt
estate, and the same for C if D defaults. Critics of
CDSs argue that this "daisy chain" is an example of
interconnections created by CDSs that might in turn
create systemic risk as each member of the string of
transactions defaults because of the new liability it
must assume. But this analysis is superficial. If CDSs
did not exist, B would suffer the loss associated with
A's default, and there is no reason to believe that the
loss would stop with B. B is undoubtedly indebted to
others, and its loss on the loan to A might cause B to
default on these obligations, just as E's default might
have caused D to default on its obligations to C. In
other words, the credit markets are already
interconnected. With or without CDSs, the failure of a
large enough participant can--at least
theoretically--send a cascade of losses through this
highly interconnected structure. CDSs simply move the
risk of that result from B to C, D, or E, but they do
not materially increase the risk created when B made its
loan to A. No matter how many defaults occur in the
series of transactions presented in figure 1, there is
still only one $10 million loss. The only question is
who ultimately pays it.
The Role of
Credit Default Swaps in the Financial Economy
Financial regulators
have few resources that will materially reduce
risk-taking. They can insist on more capital, which both
provides a cushion against losses and a nest egg that
management has an incentive to protect, and they can
clamp down on innovation, which can always be a source
of uncertainty and therefore risk. But beyond that, they
are limited to ensuring that banks, securities firms,
and insurance companies--to the extent that they are
regulated for safety and soundness--carefully review the
risks they take and have the records to show for it. The
current credit crunch is testimony to the
ineffectiveness of regulation. Despite the most
comprehensive oversight of any industry, the banking
sector is riddled with bad investments and resulting
losses. In fact, by creating moral hazard, it is likely
that the regulation of banks has reduced the
private-sector scrutiny that banks would have received
as part of a fully operating system of market
discipline.
In light of the
consistent failure of traditional regulation, a
sophisticated and intelligent regulatory process should
now foster risk-management innovations that have been
developed by the private sector, especially the
derivative instruments that have greater potential to
control risk than government oversight. CDSs are one of
these instruments, but not the only one. A simple
example of effective risk-shifting is the interest rate
swap, which--like the CDS--was developed by financial
intermediaries looking for ways to manage risk. The
documentation for interest rate swaps, as well as for
CDSs, was developed by the International Swaps and
Derivatives Association (ISDA). Interest rate swaps have
been an important and useful risk-management device in
the financial markets for at least twenty-five years.
The value of an interest rate swap is that it allows
financial intermediaries to match their assets and their
liabilities and thus to reduce their interest rate
risks. Say that a bank has deposits on which it must pay
a market or "floating" rate of interest, but it also
holds mortgages on which it receives only a fixed
monthly interest payment. This is a typical position for
a bank--but a risky one. If interest rates rise, it may
be forced to pay more interest to its depositors than it
is receiving from the mortgages it holds, and thus would
suffer losses. Ideally, it would want to trade the fixed
rate it receives on its mortgage portfolio for a
floating rate that will more closely match what it has
to pay its depositors. That way, it is protected against
increases in market rates. An interest swap, in which
the bank pays a fixed rate to a counterparty and
receives a floating rate in return, is the answer; it
matches the bank's interest rate receipts to its payment
obligations.
But what kind of
entity would want to do such a swap? Consider an
insurance company that has fixed obligations to pay out
a certain sum monthly on the fixed annuities it has
written. Insurance companies try to match this
obligation with bonds and notes that are the ultimate
source of the funds for meeting its fixed obligations,
but these do not necessarily yield a fixed return for
periods long enough to fully fund its annuity
commitments. Instead, they mature well before its
annuity obligations expire, and may--if interest rates
decline--yield less than it is required to pay out to
annuitants. The insurance company, then, would be able
to avoid risk with a swap that is the exact mirror image
of what the bank needs. Into this picture steps a swap
dealer, which arranges a fixed-for-floating interest
rate swap between the bank and insurance company. The
notional amount can be set at any number--its purpose in
an interest rate swap is simply to provide the principal
amount on which the interest will be paid--so the
parties agree on $100 million. The bank agrees to pay
the insurance company a fixed amount--say, 5 percent--on
the notional amount of $100 million, and the insurance
company agrees to pay the bank a floating rate of
interest on the same notional amount. If interest rates
rise to 6 percent, the bank is "in the money" and the
insurance company pays the bank the 1 percent
difference, and, if they fall to 4 percent, the bank
pays the insurance company 1 percent.
The important thing to
notice about this transaction is that both the bank and
the insurance company are better off--both have reduced
their risks. The bank now gets a floating payment that
assures it of the funds necessary to pay its depositors
no matter how high interest rates rise, and the
insurance company is better off because it gets a fixed
payment from the bank that allows it to pay its
annuitants no matter how far interest rates fall. Both
parties have hedged their interest rate risk through use
of a derivative. The notional amount of interest rate
swaps currently outstanding grew to $464.7 trillion by
June 30, 2008.5 This is a frighteningly large
number, but--as discussed below--its only reality is as
the basis on which counterparties are exchanging fixed
for floating rates. No one actually owes anyone any
portion of this $464.7 trillion. The payment obligations
are only interest. The interest rate swap is a classic
example of a private-sector mechanism for risk
management that could not have been developed or
implemented by a regulatory agency. It is also a good
way to think about CDSs, which have risk-management
characteristics much like interest rate swaps.6
Let's assume that a bank holds a loan to a corporate
customer that makes oil field equipment. The bank is
receiving a stream of payments on the loan with which it
is satisfied, but it concludes as a matter of risk
management that it has too much credit exposure to the
oil business. If oil prices fall, its loans to the
industry may be in jeopardy. One of the objectives of
risk management is diversification, but even better is
holding uncorrelated assets--that is, assets that do not
rise or fall in value or marketability at the same time.
Still better, from the risk-management standpoint, are
assets that are negatively correlated--that rise in
value when the others are falling. For example, a bank
would like to hold loans to both an auto manufacturer
and an oil company; as oil prices rise, the auto
manufacturer becomes weaker but the oil company becomes
stronger; other things being equal, the bank's risks are
balanced.
Using this strategy,
the hypothetical bank we are discussing would like to
divest some of its oil industry exposure and instead
balance its portfolio with exposure to the risk of, say,
auto sales. In a world where CDSs are available, this is
easily done. The bank enters a swap with an intermediary
CDS dealer in which the dealer promises to reimburse the
bank if the oil field services company defaults. The
dealer must now find a hedge in the form of a company
that is willing to sell protection on the oil services
company. A logical protection seller might be an
insurance company. The insurance company has substantial
outstanding loans on commercial real estate. Taking on
the risk of an oil service company would provide needed
diversification and could be uncorrelated--or even
negatively correlated--with the places where the
insurance company's commercial real estate is located.
Through this transaction, the bank has reduced or
eliminated the credit risk of a loan to the oil
industry, but the loan remains on its books and it keeps
the oil company's stream of interest and principal
payments, as well as its commercial relationship with
this client. Now the bank enters another CDS, this time
with a hedge fund, in which the bank promises to
indemnify the fund against losses on a portfolio of
loans to auto dealers. For this protection, the hedge
fund makes a monthly payment to the bank (for
simplicity, we are disregarding the intermediary
dealer). After these two transactions, the bank has
somewhat diversified and balanced its portfolio by
substituting the credit risk of a portfolio of auto
loans for an oil industry loan. Because the portfolio of
auto loans may be negatively correlated with the oil
industry risks, the bank's portfolio is now likely to be
more stable. The insurance company has done the same.
Once again, a derivative has operated as an effective
risk management tool, reducing the credit risk profile
of two financial intermediaries.
It is also important
to note that the same risk-management purposes can be
served by a bank or any other financial intermediary
taking on a risk that diversifies its portfolio, even if
it has no relation at all to a reference entity. Because
the party writing the protection is paid for assuming
the credit risk, the CDS functions in much the same way,
from a risk management perspective, as an actual loan.
This issue is discussed more fully below in the section
on whether CDSs represent "gambling" or "betting."
CDSs also offer
an increasingly important window into risk-taking that
has not previously existed. In this, CDSs can help both
investors and regulators. On November 25, for example, a
newswire reported: "Credit default swaps protection
generally narrowed Tuesday amid improvement in key
spread product markets such as the commercial
mortgage-backed securities and asset-backed arena."7
Similarly, on December 10, the interim assistant
treasury secretary for financial stability, Neel
Kashkari, told the House Financial Services Committee
that "one indicator that points to reduced risk of
default among financial institutions is the average
credit default swap spread for the eight largest U.S.
banks, which has declined more than 200 basis points
since before Congress passed the [Emergency Economic
Stabilization Act]."8
The fact that CDSs are
available as an indicator of risk in the financial
markets generally, and with respect to particular
institutions, is vastly important. Up to now, there has
been no generally available, market-based source of
credit assessments about financial institutions.
Interest rate spreads and stock prices are not as
valuable because they are influenced by many factors
other than risk-taking and creditworthiness. If properly
used, the data on CDS spreads for reference entities can
alert regulators to problems at individual banks,
securities firms, or insurance companies. Even more
important, it can assist investors and creditors in
exerting market discipline over financial institutions.
In light of the general failure of regulation for
controlling risk-taking, the enhancement of market
discipline is extremely important. A widening of a
reference entity's CDS spread will alert investors that
they should investigate risk-taking more fully before
advancing funds. Even if CDSs were not important for
risk management, the existence of the information
generated by the CDS market would alone provide economic
justification for allowing this market to operate freely
and without restrictions. The importance of this
development cannot be overstated. Virtually since their
inception, banks have been the repositories of credit
information about borrowers. As the securities market
grew and public disclosure became more complete, banks
lost some of their role as the preferred intermediaries
between investors and borrowers; many public companies
went to the securities market for credit financing. At
the same time, rating agencies began to substitute for
credit analysis by some institutional lenders and bond
buyers. The growth of CDSs provides for the first time a
market-based credit assessment available to all
institutional lenders and bond buyers. At a time when
the value of rating agencies is being questioned,9
the CDS market offers critical new information to use in
credit assessment.
Myths about
Credit Default Swaps
Despite these
significant benefits, criticism of CDSs is widespread.
It is not uncommon to find statements by market
observers that CDSs have no economic purpose, create
enormous risks for the financial economy, create
systemic risks, are little more than irresponsible
gambling by market participants, and create hidden
liabilities that do not appear in financial statements.
Almost all of these claims are either grossly
exaggerated or wrong.
Claim:
The Notional Amount of CDSs Outstanding Represents a
Huge Risk for the World's Financial System.
One of the most striking elements associated with credit
default swaps is the notional amount outstanding at any
one time. As a measure of the growth of CDSs, the
aggregate notional amount is of some use, but as a
measure of the risk in the market, it is meaningless.
Nevertheless, critics of CDS use the aggregate notional
amount number to suggest that huge risks are being
created in some mysterious way. Shortly after Bear
Stearns was rescued, George Soros wrote: "There is an
esoteric financial instrument called credit default
swaps. The notional amount of CDS contracts outstanding
is roughly $45 [trillion]. . . . To put it into
perspective, this is about equal to half the total US
household wealth."10 This is not putting CDSs
"into perspective." Coming from a sophisticated
financier, it seems more like a deliberate attempt to
mislead. The notional amount of CDSs
outstanding--although suitable for scaring people--is
not in any sense relevant to the size of the risks
associated with CDSs.
Returning again
to the hypothetical transaction in figure 1, we can
calculate the notional amount that comes out of the
reporting of the transaction by the various
participants. B reports that it is paying a premium for
protection on a notional amount of $10 million (the loan
to A), C reports that it has sold protection for this
amount, as have D and E and the dealer intermediary
between D and E. Thus, the total notional amount arising
from this series of transactions is $50 million, or five
times the actual potential loss in the event that A
defaults. The DTCC recently began publishing data on
CDSs from its Trade Information Warehouse, which gathers
about 90 percent of all CDS transactions.11
The DTCC's data eliminate the multiple-counting in each
swap transaction and report that as of the week ending
December 12, what the DTCC calls the "gross notional
amount" of CDSs outstanding was $25.6 trillion.12
This amount is many
times the actual potential loss on all CDSs outstanding
at any time because the protection sold must be reduced
by the protection bought. The result is called the net
notional amount and has been estimated at 10 percent of
the gross notional amount in the market.13
Accordingly, using the gross notional figure reported by
the DTCC, we can estimate that the net notional amount
is about $2.5 trillion (a total of $2.75 trillion with
the additional 10 percent not reported by DTCC), a sum
that is a fraction of the figure Soros used. These are
not small numbers, of course, but they are far less than
the number usually used to describe the total risk in
the CDS market. And even these numbers are only "real"
if every reference entity were to default and if
sellers' recoveries after these defaults were zero.
Claim:
CDSs Are Written by or between Parties That Do Not
Understand the Risks They Are Assuming.
In one sense, this statement is true. There are always
lenders who lose money because they do not understand
the risk they are assuming, and there are undoubtedly
writers of CDS protection who also do not understand the
credit risk to which they are exposed. If the statement
is meant to communicate the idea that a CDS risk is
different from or more complex than a loan (or the
acquisition of a portfolio of MBS), however, it is
wrong. First, almost all swaps are negotiated through
dealers, who serve as the actual counterparties. Dealers
typically carry matched books, which means that they
hedge their risks by entering offsetting CDSs. To remain
in business, they must be sure of the quality of the
counterparties they choose. In figure 1, for example, B
buys protection from C, a dealer. C then enters a
corresponding swap with D, which sells protection to C
to cover C's exposure to B. If D does not have a AAA
credit rating (and maybe even if it does), it probably
has to post collateral to protect C, and C may have to
post collateral to assure B that it is protected. In
fact, 63 percent of all CDSs--and 65 percent of the
dollar exposure--are collateralized,14
precisely because the parties that are paying for
protection want to make sure it is there when they need
it. In addition, recalling the earlier discussion of
counterparties moving in and out of the money, a
protection buyer and a protection seller may have
obligations to post collateral if the spread on a
particular reference entity rises or falls. No
institution that enters this market does so lightly.
The AIG case is a good
illustration of the CDS process and was covered
extensively in the Washington Post series cited
above. Initially, AIG's counterparties generally agreed
that AIG would not be required to post collateral
because it was rated AAA, but when it was downgraded by
the rating agencies, it was immediately required by its
swap agreements to post collateral. In addition, AIG had
written a lot of protection on MBS and CDO portfolios,
and, as these declined in value, it was again required
by its counterparties to post collateral to cover its
increased exposure. When AIG could not do so, it was
threatened with bankruptcy, and that is when the Fed
stepped in with a rescue. The rescue of AIG, as noted
above, had nothing to do with Lehman's failure, but it
did have a lot to do with AIG's failure to assess the
risks of MBS and CDOs. Does this sound familiar? Of
course it does--it is the same problem faced by many
banks that also failed to assess properly the risk of
these assets. Apparently, AIG relied excessively on a
credit risk model that did not adequately account for
both the sharp decline in the mortgage market or a
downgrade of AIG's credit rating.
This points up a fact
that gets too little attention in the discussion of CDSs:
that the best analogy for these instruments is an
ordinary commercial loan. A seller of protection is
taking on virtually the same risk exposure as a lender.
It is no more mysterious than that. Successful lending
requires expertise in assessing credit--the same skill
required for writing CDS protection. AIG, like many
banks, misjudged the riskiness of a portfolio of MBS and
CDOs. That does not mean that CDSs are any riskier than
loans; if AIG, instead of selling protection on various
portfolios of MBS and CDOs, had bought the portfolios
themselves, there would have been very little commentary
other than clucking about the company's poor credit
judgment. For some reason, the fact that it did
substantially the same thing by selling protection on
these instruments through CDSs has caused commentators
to see the issue as a problem created by the swaps
rather than as a simple example of poor credit
assessment.
Recently, in order to
eliminate the constant calls for more collateral, the
Fed purchased the portfolios of MBS and CDOs on which
AIG had written protection. An article in the Wall
Street Journal then noted that this was a
"blessing" for the banks that had bought protection from
AIG. Indeed it was; that is why the banks bought the
protection. If AIG had not covered this liability, the
banks would have taken these losses. This illustrates
another central point about CDSs: one institution's loss
is another's gain. The risk was already in the market.
It was created when some bank or investment bank
borrowed the funds necessary for assembling a portfolio
of MBS or CDOs. The fact that AIG was the final
counterparty and suffered the loss means that someone
else did not. Ultimately, there is only one real risk,
represented by the original loan or purchase transaction
(in the case of an asset like an MBS portfolio). CDSs,
to the extent that they are initiated by parties that
are actually exposed to a risk, merely transfer that
risk, for a price, to someone else.
A recent article in
the Wall Street Journal focused on an
instrument called a synthetic CDO and noted that many
buyers of these instruments suffered losses because of
the meltdown in the U.S. mortgage market.15
Because a CDS is a part of a synthetic CDO, the article
once again raised the question of whether protection
sellers in the CDS transaction understand the risks they
are assuming. However, the writers of the article did
not make clear (or failed to understand) that, despite a
fancy name and the presence of a CDS, the buyers of
these instruments were taking a risk that was
essentially identical to investing in a portfolio of
loans. In an ordinary CDO, a number of loans are bundled
into a pool, and debt instruments are sold to investors
backed by the assets in the pool. A CDO, then, is just a
generalized term for the same process in which the more
familiar MBS are created. The investor in a CDO takes
the risk that the instruments in the pool will not lose
value or default. In a synthetic CDO, an investor buys a
security issued by a special purpose vehicle (SPV) and
becomes the seller of protection in a CDS in which the
SPV is the protection buyer. The SPV is usually created
by a bank that is seeking CDS protection on a portfolio
of loans it intends to continue to hold. The SPV uses
the cash investment to buy a portfolio of high-quality
debt securities. The low yield on the high-quality debt
securities is supplemented by the premium on a CDS, and
two yields in effect replicate the yield that the
investor would have received--and the risk it would have
taken--if it had invested in the same portfolio of loans
that the bank is holding. Once again, there is no
essential difference between investing in the actual
loans or investing in the synthetic CDO. The credit risk
and the yield are the same.
The Journal
story noted that "towns, charities, school districts,
pension funds, insurance companies and regional banks"
have taken on the risk of these synthetic CDOs and that
some have suffered losses as a result of the weakening
credit markets. Of course, many (maybe most) have
profited from the premiums they have received over time
for taking this risk. Two things should be noted at this
point. The first is that while synthetic CDOs replicate
the risks associated with a portfolio of loans, they are
complex investments; there is a question whether they
are suitable investments for towns, school districts,
and other investors that may not be able properly to
evaluate the risks. To the extent that this happened, it
would be a violation of the "investor suitability" rules
applicable in the United States and any equivalent rules
in the countries where these investments were sold. The
second point is that the fault in this process was not
with the CDSs that were part of the synthetic CDOs, any
more than a corporation would be at fault if a bond
dealer sold one of its bonds to an investor who could
not understand the risks. The role of the CDS is to
replicate the risk of owning a portfolio of loans, and
the risk they create is not any greater than that.
Writing CDS protection
is much the same as making a loan or buying a bond. In
order to participate in this market, an institution must
have the capability to evaluate credit risk. It is not a
market for individuals or even institutions that do not
have credit-evaluation skills or access to them. Even
institutions with credit-evaluation skills suffer losses
on some risks they acquire--as shown by the AIG
case--but it is certainly not true that, in general,
those institutions that buy and sell CDSs are not aware
of the risks they are assuming.
Claim:
Transactions between Parties That Have Nothing to Do
with the Reference Entity Are Simply Gambling and Have
No Independent Value.
Because CDSs are much like loans, they can be used to
take on the same risk as a loan or a bond. If an
institutional investor believes that an issuer will grow
stronger over time, it can buy the company's bonds and
profit from the strengthening of the issuer's credit
position. Alternatively, the investor can sell
protection on the same notional amount as the bond--that
is, taking on the same exposure without actually buying
the bond--and profit in the same way. If the issuer's
prospects improve, the CDS rises in value because the
premium received is now greater than it would need to be
for the lower risk involved. The seller of protection is
now "in the money" in the sense that it has an asset
that has appreciated in value.
The risk management
benefits of CDSs exist independently of whether a lender
has any financial interest in a particular reference
entity. Thus, the bank that bought protection on its
loan to an oil service company could achieve the same
risk management purposes--reducing its exposure to the
oil industry--by buying protection on an equivalent
notional amount of an oil company's outstanding
obligations, even though it does not have any direct
exposure to the oil company. If the risk is highly
correlated with the oil service company's risk, the bank
can nearly duplicate the same risk management result.
Just as an investor can do this for risk management or
hedging purposes, it can also do it as speculation,
without having any direct financial interest in the
issuer that is the reference entity. Indeed, when a
dealer is approached by an institution to buy or sell
protection, it is impossible to tell whether the purpose
is hedging an existing risk or speculating on the change
in the risk profile of the reference entity. Is this
simply betting, as some suggest, or does it have a value
apart from its value to the two parties involved?
In discussing this
subject, it would be useful to avoid the pejorative
terms "betting" or "gambling" and use the term
"speculation," which more closely approximates what is
happening when a party buys or sells protection without
any connection to the reference entity involved.
Speculation is frequently denounced, while "hedging" is
considered good and prudent, yet it is very difficult to
tell the difference between the two. Commodity futures
have for a long time permitted farmers to protect
themselves in the event of a decline in prices when
their crop is ready for market. Most people would call
this prudent hedging, but what are the investors on the
other side of the futures trade doing? In effect, they
are selling protection, just like the seller in the CDS
transaction. Some observers might call this speculation
because the seller of protection to the farmer is
speculating (others might call it "gambling" or
"betting") that the price will be higher than what he
has agreed to pay the farmer. Thus, speculation can have
an important role in making markets work.
It may be objected,
however, that in hedging or speculation transactions,
real things like wheat or loan exposure are involved,
while buying or selling CDSs without any connection to
the reference entity is different. Consider then puts
and calls--options to sell or buy stocks--that are
traded regularly on the Chicago Board Options Exchange.
These are an accepted part of equity markets and are
known as equity derivatives. They can be used for
hedging a stock position without selling or buying the
stock, or they can be used--without owning the
stock--simply to speculate that a stock's price will go
up or down. The function of puts and calls is exactly
the same as the role played by those who buy or sell
CDSs without any connection to a reference entity. The
transaction adds to the liquidity and the total
information in the market. That is in part why the
buying and selling of CDSs provides a continuous,
market-based assessment of the credit of a large number
of commercial or industrial companies and financial
institutions. Some people consider speculation in a
security or a commodity to be betting, but economists
recognize that this activity provides benefits to a
market through added market liquidity and mitigation of
bubbles. In the case of CDSs, however, the exogenous
benefits of speculation are particularly strong because
it provides a market-based credit judgment about the
financial position of individual issuers that is not
available anywhere else.
Claim:
There Is No Way to Know by Looking at a Company's
Balance Sheet How Much CDS Exposure It Has Taken On.
Exposures to CDS transactions as a protection seller are
shown on all balance sheets where that exposure is
deemed to be material. The exposure is shown in the
aggregate, without listing particular transactions or
risks, just as a bank would show its commercial and
industrial loans in the aggregate. Normally, parties
selling protection have hedged themselves, and it is
very unlikely that all, or even most, exposures will
result in liability at the same time. So, for the most
part, CDS liabilities are carried on balance sheets at
somewhere between 1 and 2 percent of their notional
amount, reflecting both hedges and the likelihood of
losses on a diversified portfolio. Of course, as risks
rise or fall, these values are adjusted. The nature of
these liabilities is then described in a footnote.
Because CDSs sold or
bought by dealers are marked to market every day, it is
possible that the risk associated with protecting a
counterparty will increase as the financial condition of
the reference entity deteriorates. This may require the
liability of the protection seller to be written up on
its balance sheet, and will almost certainly require
more collateral. The opposite is also true. If the
reference entity's financial condition markedly
improves--perhaps its business prospects are better--the
liability on the protection seller's balance sheet will
diminish and the collateral requirement could be
reduced, eliminated entirely, or moved to the buyer of
protection if the seller is now "in the money." This
also means that a CDS can move from a liability to an
asset on the balance sheet of the buyer or seller,
depending on whether the spread on the reference entity
has risen (advantage to the buyer) or declined
(advantage to the seller) since the CDS was contracted.
Conclusion
Although the Lehman
failure demonstrated that the CDS market works well even
under severe stress, there are proposals for
improvements and reforms. These reforms--including a
clearinghouse or an exchange for CDSs and perhaps some
additional form of regulation for the CDS market as a
whole--are beyond the scope of this Outlook.
However, because CDSs and their value are not well
understood, there is a serious danger of excessive
regulation that will impair the value of CDSs for risk
management and credit assessment purposes. As reform
proposals take shape, I may revisit this issue in a
subsequent Outlook.
Far from creating new
or significant risks, CDSs simply move risks that
already exist from one place to another. For this
reason, they are a major advance in risk management for
all financial intermediaries, and restrictions on their
use will create more risk in the financial system than
it will eliminate. In addition, the vigorous and liquid
current market in CDSs provides a market-based reading
of the risks of companies that is not available from any
other source and that can be of major assistance to
regulators, as well as investors and creditors.
|
The Oxford Handbook of Credit
Derivatives (Oxford Handbooks)
Customers who have purchased or rated
Credit Derivatives: Instruments, Applications, and Pricing (Frank J. Fabozzi
Series) by Mark J. Anson PhD CFA might like to know that The Oxford
Handbook of Credit Derivatives (Oxford Handbooks) will be released on March
22, 2011. You can pre-order yours by following the link below.
Actually only $67 at Amazon.
"Coming Soon ... Securitization with a New,
Improved (and Perhaps Safer) Face, Knowledge@Wharton, April
2, 2008 ---
http://knowledge.wharton.upenn.edu/article.cfm;jsessionid=a83051431af9532a7261?articleid=1933
"FASB Issues FSP Requiring Enhanced Disclosure for Credit
Derivative and Financial Guarantee Contracts," by Mark
Bolton and Shahid Shah, Deloitte Heads Up, September 18, 2008
Vol. 15, Issue 35 ---
http://www.iasplus.com/usa/headsup/headsup0809derivativesfsp.pdf
September 18, 2008
Vol. 15, Issue 35
The FASB recently issued FSP FAS
133-1 and FIN 45-4, 1
which amends and enhances the disclosure requirements for
sellers of credit derivatives (including hybrid instruments
that have embedded credit derivatives) and financial
guarantees. The new disclosures must be provided for
reporting periods (annual or interim) ending after November
15, 2008, although earlier application is encouraged. The
FSP also clarifies the effective date of Statement 161.2
The FSP defines a credit derivative
as a "derivative instrument (a) in which one or more of its
underlyings are related to the credit risk of a specified
entity (or a group of entities) or an index based on the
credit risk of a group of entities and (b) that exposes the
seller to potential loss from credit-risk-related events
specified in the contract." In a typical credit derivative
contract, one party makes payments to the seller of the
derivative and receives a promise from the seller of a
payoff if a specified third party or parties default on a
specific obligation. Examples of credit derivatives include
credit default swaps, credit index products, and credit
spread options.
The popularity of these products,
coupled with the recent market downturn and the potential
liabilities that could arise from these conditions, prompted
the FASB to issue this FSP to improve the transparency of
disclosures provided by sellers of credit derivatives. Also,
because credit derivative contracts are similar to financial
guarantee contracts, the FASB decided to make certain
conforming amendments to the disclosure requirements for
financial guarantees within the scope of Interpretation 45. 3
Credit Derivative Disclosures
The FSP amends Statement 133 4
to
require a
seller of credit derivatives,
including credit derivatives embedded in hybrid instruments,
to provide certain disclosures for each credit derivative
(or group of similar credit derivatives) for each statement
of financial position presented. These disclosures must be
provided even if the likelihood of having to make payments
is remote. Required disclosures include:
In This Issue:
• Credit Derivative Disclosures
• Financial Guarantee
Disclosures
• Effective Date and Transition
• Effective Date of Statement
161
1 FASB Staff Position No. FAS
133-1 and FIN 45-4, "Disclosures About Credit
Derivatives and Certain Guarantees: An Amendment of FASB
Statement No. 133 and FASB Interpretation No. 45; and
Clarification of the Effective Date of FASB Statement
No. 161."
2 FASB Statement No. 161,
Disclosures About Derivative Instruments and Hedging
Activities.
3 FASB Interpretation No. 45,
Guarantor’s Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of
Indebtedness of Others.
4 FASB Statement No. 133,
Accounting for Derivative Instruments and Hedging
Activities.
• The nature of the credit
derivative, including:
o The approximate term of the
derivative.
o The reason(s) for entering
into the derivative.
o The events or circumstances
that would require the seller to perform under the
derivative.
o The status of the
payment/performance risk of the derivative as of the
reporting date. This can be based on a recently issued
external credit rating or an internal grouping used by
the entity to manage risk. (If an internal grouping is
used, the entity also must disclose the basis for the
grouping and how it is used to manage risk.)
• The maximum potential amount
of future payments (undiscounted) the seller could be
required to make under the credit derivative contract
(or the fact that there is no limit to the maximum
potential future payments). If a seller is unable to
estimate the maximum potential amount of future
payments, it also must disclose the reasons why.
• The fair value of the
derivative.
• The nature of any recourse
provisions and assets held as collateral or by third
parties that the seller can obtain and liquidate to
recover all or a portion of the amounts paid under the
credit derivative contract.
For hybrid instruments that have
embedded credit derivatives, the required disclosures should
be provided for the entire hybrid instrument, not just the
embedded credit derivative.
Financial Guarantee Disclosures
As noted previously, the FASB did not perceive
substantive differences between the risks and rewards of
sellers of credit derivatives and those of financial
guarantors. With one exception, the disclosures in
Interpretation 45 were consistent with the disclosures that
will now be required for credit derivatives. To make the
disclosures consistent, the FSP amends Interpretation 45 to
require guarantors to disclose "the current status of the
payment/performance risk of the guarantee."
Effective Date and Transition
Although it is effective for reporting periods ending
after November 15, 2008, the FSP requires comparative
disclosures only for periods presented that ended after the
effective date. Nevertheless, it encourages entities to
provide comparative disclosures for earlier periods
presented.
Effective Date of Statement 161
After the issuance of Statement 161, some questioned
whether its disclosures are required in the annual financial
statements for entities with noncalendar year-ends (e.g.,
March 31, 2009). To address this confusion, the FSP
clarifies that the disclosure requirements of Statement 161
are effective for quarterly periods beginning after November
15, 2008, and fiscal years that include those periods.
However, in the first fiscal year of adoption, an entity may
omit disclosures related to quarterly periods that began on
or before November 15, 2008. Early application is
encouraged.
Jensen Comment
Credit derivatives (usually credit default swaps that have a periodic premium
paid for and pay periodically for credit insurance) are currently scoped into
FAS 133 and IAS 39. I think that this is a mistake. These contracts are really
insurance contracts and financial guarantees that should be accounted for as
such and not as derivatives scoped into FAS 133 and IAS 39. Be that as it may,
these controversial contracts that brought AIG and other Wall Street banks to
its knees are accounted for as derivative contracts.
I really don’t think credit derivatives
are appropriately accounted for under either FAS 133 or IAS 39. The problem is
that the intermediary that brokers an interest rate risk swap can guarantee the
interest rate risk swap payments since these swaps are only dealing with
payments on the net changes in interest rates with the
notionals not being at risk. It seems to
me that with credit default swaps, the entire
notionals themselves might be at risk
and the intermediaries that broker the swaps are not guaranteeing the swap
payments equal to complete wipeouts of notionals. Hence, I don’t thinks CDS
swaps properly meet the definitions of derivatives since
notionals are at risk. It seems to me
that CDS contracts should be accounted for as insurance contracts.
This is one of those instances where I
think auditors should look at the substance of the transactions rather than
rules per se.
From the financial rounds blog on December 29,
2008
How Do You Use Credit Default Swaps (CDS) To
Create "Synthetic Debt"?
There's been a lot of talk in recent months about
"synthetic debt". I just read a pretty good explanation of synthetics in Felix
Salmon's column, so I thought I'd give a brief summary of what it is, how it's
used, and why.
First off, let's start with Credit Default Swaps (CDS). A CDS has a lot of
similarities to an insurance policy on a bond (it's different in that the holder
of the CDS needn't own the underlying bond or even suffer a loss if the bond
goes into default).
The buyer (holder) of a CDS will make yearly payments (called the "premium"),
which is stated in terms of basis points (a basis point is 1/100 of one percent
of the notional amount of the underlying bond). The holder of the CDS gets paid
if the bond underlying the CDS goes into default or if other stated events occur
(like bankruptcy or a restructuring).
So, how do you use a CDS to create a synthetic bond? here's the example from
Salmon's column:
Let's assume that IBM 5-year bonds were yielding 150 basis points over
treasuries. In addition, Let' s assume an individual (or portfolio manager)
wanted to get exposure to these bonds, but didn't think it was a feasible to buy
the bonds in the open market (either there weren't any available, or the market
was so thin that he's have to pay too high a bid-ask spread). Here's how he
could use CDS to accomplish the same thing:
·
First, buy
$100,000 of 5-year treasuries and hold them as collateral
·
Next, write a
5-year, $100,000 CDS contract
·
he's receive the
interest on the treasuries, and would get a 150 basis point annual premium on
the CDS
So, what does he get from the Treasury plus writing
the CDS? If there's no default, the coupons on the Treasury plus the CDS premium
will give him the same yearly amount as he would have gotten if he's bought the
5-year IBM bond, And if the IBM bond goes into default, his portfolio value
would be the value of the Treasury less what he would have to pay on the
CDS (this amount would be the default losses on the IBM bond). So in either case
(default or no default), his payoff from the portfolio would be the same
payments as if he owned the IBM bond.
So why go through all this trouble? One reason might be that there's not enough
liquidity in the market for the preferred security (and you'd get beaten up on
the bid-ask spread). Another is that there might not be any bonds available in
the maturity you want. The CDS market, on the other hand, is very flexible and
extremely liquid.
One thing that's interesting about CDS is that (as I mentioned above), you don't
have to hold the underlying asset to either buy or write a CDS. As a result, the
notional value of CDS written on a particular security can be multiple times the
actual amount of the security available.
I know of at least one hedge fund group that bought CDS as a way of betting
against housing-sector stocks (particularly home builders). From what i know,
they made a ton of money. But CDS can also be used to hedge default risk on
securities you already hold in a portfolio.
To read Salmon's column, click
here, and to read more about CDS, click
here
Questions
What's a financial long bet and how does it win or lose?
What's the distinction between a long bet speculation versus hedge?
From The Wall Street Journal Accounting
Weekly Review on April 1, 2011
Hedge Funds Had Bets Against Japan
by: Gregory
Zuckerman and Tom Lauricella
Date: Mar 15, 2011
SUMMARY: The
catastrophe in Japan has placed renewed focus on the country's already
fragile economy-and brought unexpected profits to investors who have long
bet that the nation eventually will be dragged down by its debt problems.
DISCUSSION:
- What is a hedge fund? How is a hedge fund different from mutual
funds or individual investing? What type of investor would invest in
such funds? What are the risk levels involved with investing in hedge
funds?
- How did these hedge funds 'bet against Japan'? Why did some
investors think it wise to invest this way? How has the earthquake in
Japan impacted this type of investment?
- What were the issues facing Japan before the earthquake? How has the
earthquake changed the situation? What is the long-term outlook for
business in the country? What are Japan's borrowing levels? How would
this impact investment in the country by businesses? By individuals?
"Hedge Funds Had Bets Against Japan," by:
Gregory Zuckerman and Tom Lauricella, The Wall Street Journal, March 15, 2011
---
http://online.wsj.com/article/SB10001424052748703363904576200990107993916.html?mod=djem_jie_360
The catastrophe in Japan has
placed renewed focus on the country's already fragile economy—and brought
unexpected profits to investors who have long bet that the nation eventually
will be dragged down by its debt problems.
In recent years, a chorus of
voices has warned that Japan is facing an inevitable crisis to be brought on
by a stagnant economy, a shrinking population and the worst debt profile of
any major industrialized country.
Hedge-fund managers from
Kyle Bass of Hayman Advisors LP in Dallas to smaller firms like Commonwealth
Opportunity Capital have made money since the earthquake on long-held bets
on Japan's government and corporate bonds.
Though the economic toll of
the earthquake is far from clear, the immediate response in the financial
markets has been a decline in stock prices, with the Nikkei Stock Average
down 7.8% in two days (including Friday, when the quake hit near the end of
the trading day). The price for insuring against a default by Japan on its
government debt, a popular way to position for a financial crisis in Japan,
has jumped. But in a move that runs counter to the expectations of some
long-term Japan bears, the yen has strengthened on expectations that
Japanese investors and corporations will be buying yen as they bring money
home in coming weeks and months.
The price for insuring $10
million of Japanese sovereign debt for five years in the credit-default-swap
market soared to $103,000 on Monday, from $79,000 on Friday, according to
data provider Markit.
Reflecting the skepticism
about Japan's outlook, even before the disaster, the net notional amount of
Japanese debt being insured in the swaps market had surged to $7.4 billion
from $4.1 billion a year ago, according to data from the Depository Trust &
Clearing Corp. through March 4. The number of contracts outstanding has more
than doubled.
Fresh DTCC data are due on
Tuesday and will include only the early effects of the earthquake.
Credit-default swaps of many
corporate bonds have become even more valuable, rewarding those that bet on
them. Among the biggest moves was in Tokyo Electric Power Co., owner of the
nuclear-power plants crippled by the earthquake.
Commonwealth Opportunity
Capital, a $90 million hedge fund in Los Angeles, made a profit of several
million dollars on Tokyo Electric on Monday, from an investment of less than
$200,000. The annual cost of protecting $10 million of Tokyo Electric's debt
jumped to $240,000 on Monday from $40,700 on Friday.
"Nobody wants bad things to
happen to people," said Adam Fisher, who helps run Commonwealth Opportunity
Capital. He said the firm has been betting against Japanese corporate bonds
for two years. "But it shows how fragile that heavily levered nation is;
there's very little margin for error."
Betting against Japan has
been a losing proposition for many investors for years. Despite all the debt
problems, bond prices have continued to move higher partly because
deflation, not inflation, has been the concern. Also, domestic investors own
most of the government's debt and have been reluctant to sell.
But now, facing at least a
short-term hit to the economy from the earthquake and the likely need to
issue more debt to pay for reconstruction efforts, Japan is seeing its
problems magnified.
"Japan's choices are very,
very bad," said John Mauldin, president of Millennium Wave Advisors. "Japan
has an aging population, which is saving less, their savings rate will go
negative sometime in the next few years at which point they will have to
significantly reduce their spending, increase taxes or print money or some
combination of the three.
"In the grand scheme of
things, does the earthquake technically move it up further? Yes, but they
were already well down the path."
Continued in article
Jensen Comment
Note how long positions on national debt are often a losing proposition unless
they are hedges. In hedging situations these gains and losses are offset by
gains and losses on the hedged items to the extent that the hedging contracts
are effective. For example, a hedge fund might invest in U.S. Treasury bonds
paying a fixed rate. There is no cash flow risk on interest payments or
repayment of the face value of the bonds. However, there is value risk since the
price of these outstanding bonds in the financial markets goes up and down
daily. The hedge fund can lock in fixed value by entering into a fair value
hedge such as by entering into a plain vanilla interest rate swap in which the
fixed-amount interest payments are swapped for variable rate payments. The value
of the bonds plus the value of the swap is thereby locked into a fixed value for
which there is no value risk. However, when hedging value risk the investor has
inevitably taken on cash flow risk. It's impossible to hedge both fair value
risk and cash flow risk. Investors must choose between one or the other.
Hedging against debt default entire is an
extreme form of fair value hedging and is usually done with a different type of
hedging contract. Here the investor is not so much concerned with interim
interest payments (or interim changes in value due to shifts in market interest
rates) as he/she is concerned with possible default on payback of the entire
principal of the debt. In other words it's more like insurance against a
creditor declaring bankruptcy to get out of repayment of all or a great portion
of debt repayment.
Credit Default Swap ---
http://en.wikipedia.org/wiki/Credit_default_swap
A credit default swap
(CDS) can almost be thought of as a form of insurance. If a borrower of
money does not repay her loan, she "defaults." If a lender has purchased a
CDS on that loan from an insurance company, the lender can then use the
default as a credit to swap it in exchange for a repayment from an insurance
company. However, one does not need to be the lender to profit from this
situation. Anyone (usually called a
speculator) can purchase a CDS. If a borrower does
not repay his loan on time and defaults not only does the lender get paid by
the insurance company, but the speculator gets paid as well. It is in the
lender's best interest that he gets his money back, either from the
borrower, or from the insurance company if the borrower is unable to pay
back his loan. However, it is in the speculator's best interest that the
borrower never repay his loan and default because that is the only way that
the speculator can then take that default, turn it into a credit, and swap
it for a cash payment from an insurance company.
A more technical way
of looking at it is that a credit default swap (CDS) is a
swap contract and agreement in which the
protection buyer of the CDS makes a series of payments (often referred to as
the CDS "fee" or "spread") to the protection seller and, in exchange,
receives a payoff if a credit instrument (typically a
bond or loan) experiences a
credit
event. It is a form of
reverse trading.
A credit default swap
is a bilateral contract between the buyer and seller of protection. The CDS
will refer to a "reference entity" or "reference obligor", usually a
corporation or government. The reference entity is not a party to the
contract. The protection buyer makes quarterly premium payments—the
"spread"—to the protection seller. If the reference entity defaults, the
protection seller pays the buyer the
par value
of the bond in exchange for physical delivery of the
bond, although settlement may also be by cash or auction.
A default is referred to as a "credit
event" and includes such events as failure to pay,
restructuring and bankruptcy.[2]
Most CDSs are in the $10–$20 million range with maturities between one and
10 years.
A holder of a bond may
“buy protection” to hedge its risk of default. In this way, a CDS is similar
to credit insurance, although CDS are not similar to or subject to
regulations governing casualty or life insurance. Also, investors can buy
and sell protection without owning any debt of the reference entity. These
“naked credit default swaps” allow traders to speculate on debt issues and
the creditworthiness of reference entities. Credit default swaps can be used
to create synthetic long and short positions in the reference entity.
Naked CDS constitute most of the market in
CDS.
In addition, credit default swaps can
also be used in capital structure arbitrage.
Credit default swaps have
existed since the early 1990s, but the market increased tremendously
starting in 2003. By the end of 2007, the outstanding amount was
$62.2 trillion, falling to $38.6 trillion by the end of 2008.
Most CDSs are
documented using standard forms promulgated by the
International Swaps and Derivatives Association (ISDA),
although some are tailored to meet specific needs.
Credit default swaps have many variations.[2]
In addition to the basic, single-name swaps, there are basket default swaps
(BDS), index CDS, funded CDS (also called a credit linked notes), as well as
loan only credit default swaps (LCDS). In addition to corporations or
governments, the reference entity can include a special purpose vehicle
issuing
asset backed securities.
Credit default swaps
are not traded on an exchange and there is no required reporting of
transactions to a government agency.
During the
2007-2010 financial crisis the lack of
transparency became a concern to regulators, as was the trillion dollar size
of the market, which could pose a
systemic risk to the economy.
In March 2010, the DTCC Trade
Information Warehouse (see
Sources of Market Data) announced it would
voluntarily give regulators greater access to its credit default swaps
database
Credit Default Swap (CDS)
This is an insurance policy that essentially "guarantees" that if a CDO goes bad
due to having turds mixed in chocolates in a diversified portfolio, the
"counterparty" who purchased the CDO will recover the value fraudulently
invested in turds. On September 30, 2008 Gretchen Morgenson of The New York
Times aptly explained that the huge CDO underwriter of CDOs was the
insurance firm called AIG. She also explained that the first $85 billion given
in bailout money by Hank Paulson to AIG was to pay the counterparties to CDS
swaps. She also explained that, unlike its casualty insurance operations, AIG
had no capital reserves for paying the counterparties for the the turds they
purchased from Wall Street investment banks.
"Your Money at Work, Fixing Others’ Mistakes,"
by Gretchen Morgenson, The New York Times, September 20, 2008 ---
http://www.nytimes.com/2008/09/21/business/21gret.html
Also see "A.I.G., Where Taxpayers’ Dollars Go to Die," The New York Times,
March 7, 2009 ---
http://www.nytimes.com/2009/03/08/business/08gret.html
What Ms. Morgenson failed to explain, when
Paulson eventually gave over $100 billion for AIG's obligations to
counterparties in CDS contracts, was who were the counterparties who received
those bailout funds. It turns out that most of them were wealthy Arabs and some
Asians who we were getting bailed out while Paulson was telling shareholders of
WaMu, Lehman Brothers, and Merrill Lynch to eat their turds.
You tube has a lot of videos about a CDS. Go to
YouTube and read in the phrase "credit default swap" ---
http://www.youtube.com/results?search_query=Credit+Default+Swaps&search_type=&aq=f
In particular note this video by Paddy Hirsch ---
http://www.youtube.com/watch?v=kaui9e_4vXU
Paddy has some other YouTube videos about the financial crisis.
Bob Jensen's discussion of accounting rules
for credit default swaps can be found under the C-Terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Credit default swaps turned into a disaster for
AIG and the U.S. Government when black swans flew over in 2008 ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm
The Commission's Final Report ---
http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_full.pdf
(This report is really more of a misleading whitewash of government agencies and
Congress relative to the real causes of the subprime disaster.)
Greatest Swindle in the History of the World
---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Bob Jensen's discussion of accounting rules
for credit default swaps can be found under the C-Terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
"Your Money at Work, Fixing Others’ Mistakes,"
by Gretchen Morgenson, The New York Times, September 20, 2008 ---
http://www.nytimes.com/2008/09/21/business/21gret.html
What Ms. Morgenson failed to explain, when
Paulson eventually gave over $100 billion for AIG's obligations to
counterparties in CDS contracts, was who were the counterparties who received
those bailout funds. It turns out that most of them were wealthy Arabs and some
Asians who we were getting bailed out while Paulson was telling shareholders of
WaMu, Lehman Brothers, and Merrill Lynch to eat their turds.
You tube has a lot of videos about a CDS. Go to
YouTube and read in the phrase "credit default swap" ---
http://www.youtube.com/results?search_query=Credit+Default+Swaps&search_type=&aq=f
In particular note this video by Paddy Hirsch ---
http://www.youtube.com/watch?v=kaui9e_4vXU
Paddy has some other YouTube videos about the financial crisis.
Simoleon Sense
Reviews Janet Tavakoli’s Dear Mr. Buffett ---
http://www.simoleonsense.com/simoleon-sense-reviews-janet-tavakolis-dear-mr-buffett/
What’s The Book (Dear Mr. Buffett) About
Dear Mr. Buffett,
chronicles the agency problems, poor regulations, and participants which led to
the current financial crisis. Janet accomplishes this herculean task by
capitalizing on her experiences with derivatives, Wall St, and her relationship
with Warren Buffett. One wonders how she managed to pack so much material in
such few pages!
Unlike many books which only analyze past events, Dear Mr.
Buffett, offers proactive advice for improving financial markets. Janet is
clearly very concerned about protecting individual rights, promoting honesty,
and enhancing financial integrity. This is exactly the kind of character we
should require of our financial leaders.
Business week once called Janet the Cassandra of Credit
Derivatives. Without a doubt Janet should have been listened to. I’m confident
that from now on she will be.
Closing thoughts
Rather than a complicated book on financial esoterica, Janet has
created a simple guide to understanding the current crisis. This book is a must
read for all students of finance, economics, and business. If you haven’t read
this book, please do so.
Warning –This book is likely to infuriate you, and that’s a good
thing!
Janet provides indicting evidence and citizens may be tempted to
initiate vigilante like witch trials. Please
consult with your doctor before taking this financial medication.
Continued in article
September 1, 2009 reply from Rick Lillie
[rlillie@CSUSB.EDU]
Hi Bob,
I am reading Dear Mr. Buffett, What an Investor
Learns 1,269 Miles from Wall Street, by Janet Tavakoli. I am just about
finished with the book. I am thinking about giving a copy of the book to
students who perform well in my upper-level financial reporting classes.
I agree with the reviewer’s comments about
Tavakoli’s book. Her explanations are clear and concise and do not require
expertise in finance or financial derivatives in order to understand what
she (or Warren Buffet) says. She explains the underlying problems of the
financial meltdown with ease. Tavakoli does not blow you over with “finance
BS.” She does in print what Steve Kroft does in the 60 Minutes story.
Tavakoli delivers a unique perspective throughout
the book. She looks through the eyes of Warren Buffett and explains issues
as Buffett sees them, while peppering the discussion with her experience and
perspective.
The reviewer is correct. Tavakoli lets the finance
world, along with accountants, attorneys, bankers, Congress, and regulators,
have it with both barrels!
Tavakoli’s book is the highlight of my summer
reading.
Best wishes,
Rick Lillie
Rick Lillie, MAS, Ed.D., CPA Assistant Professor of
Accounting Coordinator - Master of Science in Accountancy (MSA) Program
Department of Accounting and Finance College of Business and Public
Administration CSU San Bernardino 5500 University Pkwy, JB-547 San
Bernardino, CA. 92407-2397
Telephone Numbers: San Bernardino Campus: (909)
537-5726 Palm Desert Campus: (760) 341-2883, Ext. 78158
For technical details see the following
book:
Structured Finance and Collateralized Debt Obligations: New Developments in
Cash and Synthetic Securitization (Wiley Finance) by Janet M. Tavakoli
(2008)
Financial WMDs (Credit Derivatives) on
Sixty Minutes (CBS) on August 30, 2009 ---
http://www.cbsnews.com/video/watch/?id=5274961n&tag=contentBody;housing
The free download will only be available for a short while. I downloaded this
video (a little over 5 Mbs) using a free updated version of RealMedia ---
Click Here
http://www.real.com/dmm/superpass?pcode=cj&ocode=cj&cpath=aff&rsrc=1275588_10303897_SPLP
Steve Kroft examines the complicated
financial instruments known as credit default swaps and the central role they
are playing in the unfolding economic crisis. The interview features my hero
Frank Partnoy. I don't know of anybody who knows derivative securities
contracts and frauds better than Frank Partnoy, who once sold these derivatives
in bucket shops. You can find links to Partnoy's books and many, many quotations
at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
For years I've used the term "bucket shop"
in financial securities marketing without realizing that the first bucket shops
in the early 20th Century were bought and sold only gambles on stock pricing
moves, not the selling of any financial securities. The analogy of a bucket shop
would be a room full of bookies selling bets on NFL playoff games.
See "Bucket Shop" at
http://en.wikipedia.org/wiki/Bucket_shop_(stock_market)
I was not aware how fraudulent the credit
derivatives markets had become. I always viewed credit derivatives as an
unregulated insurance market for credit protection. But in 2007 and 2008 this
market turned into a betting operation more like a rolling crap game on Wall
Street.
Bob Jensen's Rotten to the Core threads
are at
http://faculty.trinity.edu/rjensen/FraudRotten.htm
Bob Jensen's threads on the current
economic crisis are at
http://faculty.trinity.edu/rjensen/2008Bailout.htm
For credit derivative problems see
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Also see "Credit Derivatives" under the
C-Terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms
Bob Jensen's free
tutorials and videos on how to account for derivatives under FAS 133 and IAS 39
---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen’s threads on accounting for credit
default swaps are under the C-Terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms
Bob Jensen's threads on CDO accounting are at
http://faculty.trinity.edu/rjensen/theory01.htm#CDO
Bob Jensen's threads on FIN 46 are at
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm
"Default Swaps: One Boom in the
Crunch; Volume Soared in '07 As Woes Worsened; Hedging and Betting," by
Serena Ng, The Wall Street Journal, April 16, 2008; Page C2 ---
http://online.wsj.com/article/SB120826572928916145.html?mod=todays_us_money_and_investing
The bond market's
love affair with credit derivatives continued during the market chaos of
2007, as volumes of instruments such as credit-default swaps surged to new
highs.
Credit-default
swaps, which are private financial contracts that act as a form of insurance
against bond and loan defaults, were written on $62.2 trillion of debt at
the end of 2007, according to data from the International Swaps and
Derivatives Association, an industry group.
The latest numbers
mark a 37% jump from the $45.5 trillion in so-called "notional" values of
credit-default swaps in mid-2007, and compare with $34.5 trillion at the end
of 2006. The gain indicates that the use of such swaps grew at a faster pace
during the credit crunch in the second half of last year, possibly as banks
and investors scrambled to protect themselves from possible defaults on
mortgage debt and other bonds and loans.
In a credit default
swap, one firm makes regular payments to another firm, which agrees to
compensate it if a specified bond or loan defaults. Some investors and
financial institutions buy these swaps to hedge their debt investments, but
many others trade them to make bets on whether default risk is rising or
falling. As such, the notional volumes of the contracts far exceed the
actual amount of debt on which they are written.
ISDA's survey also
found that the notional amount of interest-rate derivatives grew to $382.3
trillion at the end of 2007, up 10% from mid-2007 and 34% from a year
earlier. These include interest-rate swaps, where firms exchange fixed
interest payments on debt for floating-rate payments.
The market for
equity derivatives including options and forward contracts covered $10
trillion in notional volumes at the end of 2007, unchanged from the mid-year
but up 39% from a year earlier.
While notional
amounts across all the asset classes add up to an eye-popping number of
$454.5 trillion, ISDA says the numbers measure derivative activity rather
than risk. It estimates that gross credit exposure of the firms that trade
derivatives is around $9.8 trillion.
Still, the large
volumes have raised concerns about "counterparty risk," or the risk that one
or more firms may not be able to make good on their trades and create
problems for other firms .
Continued in article
Read about a Credit Default Swap (CDS)
at
http://en.wikipedia.org/wiki/Credit_default_swap
IAS 39 Paragraph
B18 (g) allows some leeway as to whether companies want to account for such
contracts as insurance contracts or derivative financial instruments.
FAS 133 Paragraph 59 is somewhat more
explicit as to whether or not a credit derivative is scoped into FAS 133.
"The Credit Default Swap," by Richard K. Skora --- http://www.skora.com/default.pdf
This article shows how risk neutral pricing theory
can be applied to price a credit default swap. The price is obtained by
explicitly constructing a hedge from the underlying cash market
instruments.
A credit default swap is the most straightforward
type of a credit derivative. It is an agreement between two counterparties
that allows one counterparty to be “long” a third-party credit risk, and
the other counterparty to be “short” the credit risk. Explained another
way, one counterparty is selling insurance and the other counterparty is
buying insurance against the default of the third party.
For example, suppose that two counterparties, a
market maker and an investor, enter into a two-year credit default swap. They
specify what is called the reference asset, which is a particular credit risky
bond issued by a third-party corporation or sovereign. For simplicity, let us
suppose that the bond has exactly two years’ remaining maturity and is
currently trading at par value.
The market maker agrees to make regular fixed
payments (with the same frequency as the reference bond) for two years to the
investor. In exchange the market maker has the following right. (For
simplicity assume default can occure only at discrete times, namely, at the
times the coupon payment is due.) If the third party defaults at any time
within that two years, the market maker makes his regular fixed payment to the
investor and puts the bond to the investor in exchange for the bond’s par
value plus interest. The credit default swap is thus a contingent put – the
third party must default before the put is activated.
In this simple example there is little difference in
terms of risk between the credit default swap and the reference bond. Because
the swap and the bond have the same maturity, the market maker is effectively
short the bond and the investor is long the bond. (In the real world, it is
often the case that the bond tenor is longer than the swap tenor. This means
that the swap counterparties have exposure to credit risk, but do not have
exposure to the full market risk of the
The simplicity of our example helps clarify how the
instrument is priced. Pricing the credit default swap involves determining the
fixed payments from the market-maker to the investor. In this case it is
sufficient to extract the price from the bond market. One does not need to
model default or any other complicated credit risk process. To apply risk
neutral pricing theory one needs to construct a hedge for the credit default
swap. In this simple example, it is sufficient to construct a static hedge.
This means the cash instruments are purchased once, and once only, for the
life of the credit default swap; they will not have to be sold until the
termination of the credit default swap.
The hedge is different for the market maker and
investor. If the market-maker were to hedge the credit default swap, then it
would need to go long the bond. As illustrated in Figure B, the market-maker
borrows money in the funding markets at Libor and uses those funds to purchase
the corporate bond, which pays Libor + X basis points. The hedge is paying the
market-maker a net cash flow of X basis points.
Continued in the article.
Danger: What if everybody uses the same formula?
Banker David Li's computerized financial
formula has fueled explosive growth in the credit derivatives market. Now,
hundreds of billions of dollars ride on variations of the model every day.
When a credit agency downgraded General Motors Corp.'s debt in May, the auto
maker's securities sank. But it wasn't just holders of GM shares and bonds
who felt the pain. Like the proverbial flap of a butterfly's wings rippling
into a tornado, GM's woes caused hedge funds around the world to lose
hundreds of millions of dollars in other investments on behalf of wealthy
individuals, institutions like university endowments -- and, via pension
funds, regular folk.
Mark Whitehouse, "How a Formula Ignited Market That Burned Some Big
Investors: Credit Derivatives Got a Boost From Clever Pricing Model;
Hedge Funds Misused It Inspiration," The Wall Street Journal,
September 12, 2005; Page A1 ---
http://online.wsj.com/article/0,,SB112649094075137685,00.html?mod=todays_us_page_one
February 7, 2008 question from Miklos A. Vasarhelyi
[miklosv@ANDROMEDA.RUTGERS.EDU]
Does anyone understand what this is?
miklos
Jensen Comment
Miklos forwarded interactive graphics video link on monoline insurance ---
Click Here
February 7, 2008 reply from J. S. Gangolly
[gangolly@CSC.ALBANY.EDU]
Miklos,
Buyers of bonds can insure against default
risks by buying policies from monoline insurance companies who service
exclusively the capital markets. To protect against default by the monoline
on its policy, you buy a credit swap on it from another monoline insurance
company (which would be obligated to either buy the bonds at face value or
to pay the difference between that and the recovery value in case of
default).
When such trades take place, the buyer of
the bonds (usually investment banks) have theoretically transferred the risk
in bonds, and so can account for the bundle of transactions and recognise
"profits".
Apparently, these trades have been very
lucrative for banks and so have taken the profits in such transactions over
the entire life of the bonds at the consummations of such transactions.
The problem with such accounting for
profits is that, if the monoline insurance companies are downgraded, the
risk on the bonds reverts to the holder (bank), who must reverse the
profits.
The usual culprits in these fancy
transactions are investment banks. It is difficult to account for the
"profits" because the bonuses paid to the traders on such transactions might
have been paid years ago.
What a wonderful fiction we accountants
have created wheere profits are not what they seem. Alice in Wonderland
pales by comparison.
I should have stuck with my first intended
profession (actuary).
Regards,
Jagdish
February 7, 2008 reply from Paul Williams
[Paul_Williams@NCSU.EDU]
Jagdish,
Thank you for explaining this. The fault
is not entirely ours. Deregulated finance entrepreneurs have invented these
complex transactions, which, frankly, can't be accounted for (part of the
motivation for their design is precisely because they can't be accounted
for). In theory the probability that a bond issuer will default is not
altered by these arrangements.
All they do is shift the risk many degrees
removed from where it originated. An interesting empirical issue is whether
the probability of default does change in the presence of these risk
shifting transactions. How does it alter the monitoring of debtors by their
creditors when their creditors may not even know they are their creditors?
Do these risk shifting arrangements change
the risk? Anyone out there know of any literature that addresses the issue?
February 7, 2008 reply from Bob Jensen
Hi Miklos, Jagdish, Paul, and others,
Actually there’s a very good module (one of the best) on
the history of monoline insurance in Wikipedia ---
http://en.wikipedia.org/wiki/Monolines There are excellent
references as to when (belatedly) and why monoline insurance companies have
been put under review by credit rating agencies.
Credit rating agencies placed the other monoline insurers
under review [16]. Credit default swap markets quoted rates for default
protection more typical for less than investment grade credits. [17]
Structured credit issuance ceased, and many municipal bond issuers spurned
bond insurance, as the market was no longer willing to pay the traditional
premium for monoline-backed paper[18]. New players such as Warren Buffett's
Berkshire Hathaway Assurance entered the market[19]. The illiquidity of the
over-the-counter market in default insurance is illustrated by Berkshire
taking four years (2003-06) to unwind 26,000 undesirable swap positions in
calm market conditions, losing $400m in the process. By January 2008, many
municipal and institutional bonds were trading at prices as if they were
uninsured, effectively discounting monoline insurance completely. The slow
reaction of the ratings agencies in formalising this situation echoed their
slow downgrading of sub-prime mortgage debt a year earlier. Commentators
such as investor David Einhorn [20] have criticized rating agencies for
being slow to act, and even giving monolines undeserved ratings that allowed
them to be paid to bless bonds with these ratings, even when the bonds were
issued by credits superior to their own.
It has been particularly problematic for investors in
municipal bonds.
Bob Jensen
"Credit Derivatives Get Spotlight," by Henny Sender,
The Wall Street Journal, July 28, 2005; Page C3 ---
http://online.wsj.com/article/0,,SB112249648941697806,00.html?mod=todays_us_money_and_investing
A group of finance veterans released its
report on financial-markets risk yesterday, highlighting the mixed blessing
of credit derivatives, financial instruments that barely existed the last
time the markets seized up almost seven years ago.
"The design of these products allows risk
to be divided and dispersed among counterparties in new ways, often with
embedded leverage," the report of the Counterparty Risk Management Policy
Group II states, adding that "transparency as to where and in what form
risks are being distributed may be lost as risks are fragmented and
dispersed more widely."
Credit-default swaps are at the heart of
the credit-derivatives market. They allow players to buy insurance that
compensates them in the case of debt defaults. The market enables parties to
hedge against company or even country debt, but the market's opacity makes
it difficult for regulators and market participants to sort out who is
involved in various trades.
The report also notes that credit
derivatives can potentially complicate restructurings of the debt of ailing
companies and countries. "To the extent primary creditors use the
credit-default swap market to dispose of their credit exposure,
restructuring in the future may be much more difficult," the report says.
Already, there have been cases where some
banks have been accused of triggering defaults after they had already hedged
their risk through the credit-derivatives markets. In other cases, when the
cost of credit-default protection on a company has risen, market
participants have taken that as a harbinger of more troubles to come, making
it harder for a company to get financing, and thereby forcing it into a sale
or a restructuring.
Continued in article
"Credit Derivatives Survive a Series of Stress Tests As Demand for the
Hedging Instruments Grows," by Michael Mackenzie, The Wall Street Journal,
January 21, 2003, Page C13
Having roughly doubled in size in each of the past
five years, credit derivatives have lately survived a series of stress tests.
Wall Street is hoping that this encourages even broader participation by new
investors.
Last year was certainly the year for fallen credit
angels, headlined by the default of Argentina and the bankruptcy of Enron
Corp. -- the latter was an actively traded name in the credit derivatives
market over the past three years. But Wall Street figures that successful
negotiation of these credit craters has set the stage for further growth of
credit derivatives, such as default swaps, total-return swaps and synthetic
collateralized debt obligations.
Some fear that broader participation by inexperienced
players raises the risk of big blowups in the credit-derivatives market.
Indeed, a few analysts are predicting headlines from such an event this year.
Still, these instruments, once assigned to the
fringes of risk management, encountered only a minimum of legal complications
in the Enron and Argentine cases.
"Credit derivatives earned their stripes in the
aftermath of Enron filing for bankruptcy," said John McEvoy, cofounder of
Creditex, a trading platform for credit derivatives. "The market did what
it was supposed to do and that has apprised many investors of the value credit
derivatives hold for hedging credit risk."
And the continued expansion of the credit-derivatives
market derives not just from the perspective of hedging credit risk, but also
from investors on the other side of the trade seeking a source of synthetic
liquidity.
A credit default swap acts like an insurance position
that allows buyers to transfer the risk of defaults or other kinds of credit
events, such as debt restructurings, to a selling counterparty, who is paid a
premium that is derived from the notional amount of the contract.
In effect, the seller or underwriter of the default
swap establishes a synthetic long position in the credit of the company
without having to purchase the underlying cash bond.
Investors are increasingly using default swaps to
"increase or reduce credit risk without the liquidity constraints of the
cash market," said William Cunningham, director of credit strategy at
J.P. Morgan Chase in New York.
Indeed, liquidity in credit derivatives has grown so
much that two-way activity is often better than that of the notoriously
illiquid cash bond market. "We are increasingly seeing the derivative
dictate activity in the underlying cash bond," said Mr. McEvoy.
"Credit derivatives act as a barometer for the underlying cash market as
they concentrate solely upon credit risk."
The growth of credit derivatives has also created
better liquidity for less-popular issues as derivatives trading has encouraged
greater use of cash bonds for derivatives traders hedging their positions.
It "has created more demand for off-the-run
paper," said John Cieslowski, vice president for credit derivatives at
Goldman, Sachs & Co. in New York.
Hedge funds have been particularly active users of
these instruments. Jeff Devers, president of Palladin Group LP in Maplewood
N.J., a hedge fund that seeks to minimize risk and enhance returns from
convertible bonds, uses credit derivatives to "isolate credit risk."
This way his fund solely takes on the equity exposure of a convertible bond.
Mr. Devers expects further growth of credit derivatives to add even more
liquidity to the convertible bond market.
Another key development has been the use of synthetic
collateralized debt obligation baskets, which are a series of default swaps
upon a range of credits bundled together. These credits are divided into
tranches that reflect different risk ratings, appealing to the divergent risk
appetites of investors.
The two counterparties to a synthetic CDO are either
offsetting the credit risk through such trades or are taking exposure to a
diverse number of credits that can augment the performance of their underlying
portfolios.
Exposure to synthetic CDOs also raises a money
manager's level of assets under management and either lowers or raises the
level of exposure to a particular credit.
Creditex, which brokers trading between
counterparties in CDOs, has been a beneficiary of this growth. "The past
year saw many traditional CDO players enter the synthetic CDO market in credit
derivatives and this contributed to a substantial rise in market
activity," noted Mr. McEvoy.
From
The Wall Street Journal
Accounting Educators' Review
on April 3, 2003
TITLE: Lending Less,
"Protecting" More: Desperate for Better Returns, Banks Turn to
Credit-Default Swaps
REPORTER: Henny Sender and Marcus Walker
DATE: Apr 01, 2003
PAGE: C13
LINK: http://online.wsj.com/article/0,,SB104924410648100900,00.html
TOPICS: Advanced Financial Accounting, Banking, Fair Value Accounting,
Financial Analysis, Insurance Industry
SUMMARY: This article describes
the implications of banks selling credit-default swap derivatives.
Firtch Ratings has concluded in a recent report that banks are adding to
their own risk as they use these derivatives to sell insurance agains
default by their borrower clients.
QUESTIONS: 1.) Define the term
"derivative security" and describe the particular derivative,
credit-default swaps, that are discussed in this article.
2.) Why are banks entering into
derivatives known as credit-default swaps? Who is buying these
derivatives that the bank is selling?
3.) In general, how should
these derivative securities be accounted for in the banks' financial
statements? What finanicial statement disclosures are required? How have
these disclosures provided evidence about the general trends in the
banking industry that are discussed in this article?
4.) Explain the following quote
from Frank Accetta, an executive director at Morgan Stanley: "Banks
are realizing that you can take on the same risk [as the risk associated
with making a loan] at more attractive prices by selling
protection."
5.) Why do you think the
article equates the sale of credit-default swaps with the business of
selling insurance? What do you think are the likely pitfalls of a bank
undertaking such a transaction as opposed to an insurance company doing
so?
6.) What impact have these
derivatives had on loan pricing at Deutsche Bank AG? What is a term that
is used to describe the types of costs Deutsche Bank is now considering
when it decides on a lending rate for a particular borrower?
"Banks'
Increasing Use of Swaps May Boost Credit-Risk Exposure, by Henny Sender
and Marcus Walker, The Wall Street Journal, April 1, 2003 --- http://online.wsj.com/article/0,,SB104924410648100900,00.html
When
companies default on their debt, banks in the U.S. and Europe
increasingly will have to pick up the tab.
That
is the conclusion of Fitch Ratings, the credit-rating concern.
Desperate for better returns, more banks are turning to the
"credit default" markets, a sphere once dominated by
insurers. In a recent report, Fitch says the banks -- as they use
these derivatives to sell insurance against default by their borrowers
-- are adding to their credit risk.
The
trend toward selling protection, rather than lending, could well raise
borrowing costs for many companies. It also may mean greater risk for
banks that increasingly are attracted to the business of selling
protection, potentially weakening the financial system as a whole if
credit quality remains troubled. One Canadian bank, for example, lent
a large sum to WorldCom Inc., which filed for Chapter 11 bankruptcy
protection last year. Rather than hedging its loan to the distressed
telecom company by buying protection, it increased its exposure by
selling protection. The premium it earned by selling insurance,
though, fell far short of what it both lost on the loan and had to pay
out to the bank on the other side of the credit default swap.
"The
whole DNA of banks is changing. The act of lending used to be part of
the organic face of the bank," says Frank Accetta, an executive
director at Morgan Stanley who works in the loan-portfolio management
department. "Nobody used to sit down and calculate the cost of
lending. Now banks are realizing that you can take on the same risk at
more attractive prices by selling protection."
Despite
its youth, the unregulated, informal credit-default swap market has
grown sharply to total almost $2 trillion in face value of outstanding
contracts, according to estimates from the British Bankers
Association, which does the most comprehensive global study of the
market. That is up from less than $900 billion just two years ago.
(The BBA says the estimate contains a good amount of double counting,
but it uses the same method over time and thus its estimates are
considered a good measuring stick of relative change in the
credit-default swap market.) Usually, banks have primarily bought
protection to hedge their lending exposure, while insurers have sold
protection. But Fitch's study, as well as banks' own financial
statements and anecdotal evidence, shows that banks are becoming more
active sellers of protection, thereby altering their risk profiles.
The
shift toward selling more protection comes as European and American
banks trumpet their reduced credit risk. And it is true that such
banks have cut the size of their loan exposures, either by taking
smaller slices of loans or selling such loans to other banks. They
also have diversified their sources of profit by trying to snare more
lucrative investment-banking business and other fee-based activity.
Whether
banks lend money or sell insurance protection, the downside is
generally similar: The bank takes a hit if a company defaults,
cushioned by whatever amount can eventually be recovered. (Though
lenders are first in line in bankruptcy court; sellers of such
protection are further back in the queue.)
But
the upside differs substantially between lenders and sellers of
protection. Banks don't generally charge their corporate borrowers
much when they make a loan because they hope to get other, more
lucrative assignments from the relationship. So if a bank extends $100
million to an industrial client, the bank may pocket $100,000 annually
over the life of the loan. By contrast, the credit-default swap market
prices corporate risk far more systematically, devoid of relationship
issues. So if banks sell $100 million of insurance to protect another
party against a default by that same company, the bank can receive,
say, $3 million annually in the equivalent of insurance premiums
(depending on the company's creditworthiness).
All
this comes as the traditional lending business is becoming less
lucrative. The credit-derivatives market highlights the degree to
which bankers underprice corporate loans, and, as a result, bankers
expect the price of such loans to rise.
"We
see a change over time in the way loans are priced and
structured," says Michael Pohly, head of credit derivatives at
Morgan Stanley. "The lending market is becoming more aligned with
the rest of the capital markets." In one possible sign of the
trend away from traditional lending, the average bank syndicate has
dropped from 30 lenders in 1995 to about 17 now, according to data
from Loan Pricing Corp.
Some
of the biggest players in the market, such as J.P.
Morgan Chase & Co., are net sellers of such insurance,
according to J.P. Morgan's financial statements. In its annual report,
J.P. Morgan notes that the mismatch between its bought and sold
positions can be explained by the fact that, while it doesn't always
hedge, "the risk positions are largely matched." A spokesman
declined to comment.
But
smaller German banks, some of them backed by regional governments, are
also active sellers, according to Fitch. "Low margins in the
domestic market have compelled many German state-guaranteed banks to
search for alternative sources of higher yielding assets, such as
credit derivatives," the report notes. These include the regional
banks Westdeutsche Landesbank, Bayerische Landesbank, Bankgesellschaft
Berlin and Landesbank Hessen-Thueringen, according to market
participants. The state-owned Landesbanken in particular have been
searching for ways to improve their meager profits in time for 2005,
when they are due to lose their government support under pressure from
the European Union.
Deutsche
Bank AG is one of biggest players in the market. It is also among
the furthest along in introducing more-rational pricing to reflect the
implicit subsidy in making loans. At Deutsche Bank, "loan
approvals now are scrutinized for economic shortfall" between
what the bank could earn selling protection and what it makes on the
loan, says Rajeev Misra, the London-based head of global credit
trading.
A credit default swap is
a form of insurance against default by means of a
swap. See Paragraphs 190 and 411d of FAS 133. See Risks.
Somewhat confusing is Paragraph 29e on Page
20 of FAS 133 that requires any cash flow hedge to be on prices or interest rates rather
than credit worthiness. For example, a forecasted sale of a specific asset at a
specific price can be hedged for spot price changes under Paragraph 29e. The
forecasted sale's cash flows may not be hedged for the credit worthiness of the intended
buyer or buyers. Example 24 in Paragraph 190 on Page 99 of FAS 133
discusses
a credit-sensitive bond. Because the bond's coupon payments were indexed to credit
rating rather than interest rates, the embedded derivative could not be isolated and
accounted for as a cash flow hedge.
One of my students wrote the following case just
prior to the issuance of FAS 133:. John D. Payne's
case and case solution entitled A Case Study of Accounting for an Interest Rate Swap
and a Credit Derivative appear at http://www.resnet.trinity.edu/users/jpayne/coverpag.htm
. He states the following:
The objective of this case is to
provide students with an in-depth examination of a vanilla swap and to introduce students
to the accounting for a unique hedging device--a credit derivative. The case is designed
to induce students to become familiar with FASB Exposure Draft 162-B and to prepare
students to account for a given derivative transaction from the perspective of all parties
involved. In 1991, Vandalay Industries borrowed $500,000 from Putty Chemical Bank and
simultaneously engaged in an interest rate swap with a counterparty. The goal of the swap
was to hedge away the risk that variable rates would increase by agreeing to a
fixed-payable, variable-receivable swap, thus hopefully obtaining a lower borrowing cost
than if variable rates were used through the life of the loan. In 1992, Putty Chemical
Bank entered into a credit derivative with Mr. Pitt Co. in order to eliminate the credit
risk that Vandalay would default on repayment of its loan principal to Putty.
Greg Gupton's site is a major convergence point of research on
credit risk and credit derivatives --- http://www.credit-deriv.com/crelink.htm
A good site on credit risk
is at http://www.numa.com/ref/volatili.htm
Example 24 in Paragraph 190 on Page 99 of
FAS 133 discusses a credit-sensitive bond.
Misuses of Credit Derivatives
JP Morgan –
whose lawyers must be working overtime – is refuting any wrongdoing over
credit default swaps it sold on Argentine sovereign debt to three hedge funds.
But the bank failed to win immediate payment of $965 million from the 11
insurers it is suing for outstanding surety bonds.
Christopher Jeffery Editor, March 2, 2002, RiskNews http://www.risknews.net
Note from Bob Jensen:
The above quotation seems to be Year 2002 Déjà Vu in terms of all
the bad ways investment bankers cheated investors in the 1980s and 1990s.
Read passage from Partnoy's book quoted at
http://faculty.trinity.edu/rjensen/book02q1.htm#022502
Enron was its own investment
bank on many deals, especially in credit derivatives. You can read the
following at
http://faculty.trinity.edu/rjensen/fraud.htm
Selected quotations from
"Why Enron Went Bust: Start with arrogance. Add greed, deceit,
and financial chicanery. What do you get? A company that wasn't what
it was cracked up to be." by Benthany McLean, Fortune Magazine,
December 24, 2001, pp. 58-68.
Why Enron Went Bust: Start
with arrogance. Add greed, deceit, and financial chicanery. What do
you get? A company that wasn't what it was cracked up to be."
In fact ,
it's next to impossible to find someone outside Enron who agrees
with Fasto's contention (that Enron was an energy provider rather
than an energy trading company). "They were not an energy
company that used trading as part of their strategy, but a company
that traded for trading's sake," says Austin Ramzy, research
director of Principal Capital Income Investors. "Enron is
dominated by pure trading," says one competitor. Indeed, Enron
had a reputation for taking more risk than other companies,
especially in longer-term contracts, in which there is far less
liquidity. "Enron swung for the fences," says another
trader. And it's not secret that among non-investment banks, Enron
was an active and extremely aggressive player in complex financial
instruments such as credi8t derivatives. Because Enron didn't have
as strong a balance sheet as the investment banks that dominate that
world, it had to offer better prices to get business.
"Funky" is a word that is used to describe its trades.
I was particularly impressed,
as were all people who phoned in, by the testimony of Scott Cleland
(see Tuesday, January 15) and then click on the following link to read
his opening remarks to a Senate Committee on December 18. If you think
the public accounting profession has an "independence
problem," that problem is miniscule relative to an enormous
independence problem among financial analysts and investment bankers
--- two professions that are literally rotten to the core. Go to http://www.c-span.org/enron/scomm_1218.asp#open
A portion of Mr. Cleland's
testimony is quoted below:
Four,
it's common for analysts to have a financial stake in the companies
they're covering. That's just like, essentially, allowing athletes
to bet on the outcome of the game that they're playing in.
Five,
most payments for investment research is routinely commingled in the
process with more profitable investment banking and proprietary
trading. The problem with this is it effectively means that most
research analysts work for the companies and don't work for
investors.
Six,
credit agencies may have conflicts of interest.
Seven,
analysts seeking investment banking tend to be more tolerant of
pro-forma accounting and the conflict there is, essentially, the
system is allowing companies to tell -- you know, to make up their
own accounting. To describe their own financial performance, that no
one then can compare objectively with other companies.
Eight,
surprise, surprise, companies routinely beat the expectations of a
consensus of research analysts that are seeking their investment
banking business.
See how banks use/misuse
credit derivatives with tranches.
|
A Bankers Primer on Credit Derivatives
--- http://www.citissb.com/home/Creddriv.pdf
What are
Credit Derivatives?
Credit
derivatives have three basic structures: credit default swaps, total
return swaps and credit spread options. In a credit default swap, a
buyer pays a seller a fixed fee in return for indemnification
against losses should a credit event occur. Credit default swaps are
used for risk management, capital management and investment
management. Buyers of protection reduce credit concentrations or
open up credit lines. Buyers may also obtain capital relief,
redeploying the capital in more profitable business lines or buying
back stock.
Primus Financial Services offers credit derivatives --- http://www.tfibcm.com/news/story/default.asp?734
Kicking off what analysts are calling a small trend,
New York-based Primus Financial Products recently became the first company
structured solely to be a swap counterparty, selling protection via credit
default swaps. "We're not a dealer, we're not a CDO, and we're not an
insurance company," said Chief Executive Officer Tom Jasper. "What
we are is a credit derivatives company."
As derivatives are becoming a more and more widely
accepted method of transferring risk, it is not surprising that at least two
additional companies - both at different stages of development - are following
suit. The two are said to be familiar names in the asset-backed market, and
the first will likely launch in mid-summer, according to Moody's Investors
Service, which, along with Standard & Poor's, has awarded Primus a
triple-A counterparty rating. Primus will begin trading in the next few weeks,
Jasper said. In the first year of trading, Primus is planning to build a
portfolio of about $5.5 billion in single name investment-grade corporate and
sovereign credits.
"The plan is to take advantage of what we
believe is a pretty efficient capital model and cost model, and to become a
very efficient investor in investment-grade risk, using, as the transfer
vehicle, the credit default swap," Jasper said. "So we're
transferring risk synthetically versus a cash instrument."
Though many of its clients, which could include CDOs,
insurance company portfolio managers, hedge funds, banks and other cash
investors, might be using PFP to establish hedges, Primus is not incorporating
a hedging strategy for its own portfolio, and, only in special situations,
will buy credit protection for its exposures. Its triple-A counterparty rating
is based primarily on its capital levels, or other resources, being sized to
match the expected loss (Moody's) of its referenced obligations.
Also, contrary to some players' initial impressions
of the company, Primus doesn't plan to launch any CDOs from its portfolio.
"It's not contemplated that we would securitize
the risk that we will take on," Jasper said. "We're very happy to
hold the risk to maturity."
|
March 2002 - Former dealers from Salomon Smith Barney and Bank
of America yesterday set up what they claimed to be the first boutique focusing
purely on default swap credit derivatives.
Question:
When does a hedge become a speculation?
Answer:
There are essentially two answers. Answer 1
is that a speculation arises when the hedge is not perfectly effective in
covering that which is hedged such as the current value (fair alue hedge) of the
hedged item or the hedged cash flow (cash flow hedge). Testing for
hedge ineffectiveness under FAS 133 and IAS 39 rules is very difficult for
auditors. Answer 2 is that a speculation arises when unsuspected credit
risk arises from the settlements themselves such as when dealers who brokered
hedge derivatives cannot back the defaults all parties contracted under the
derivatives themselves. Hedges may no longer be hedges!
Answer 2 is even more problematic in this particular down economy.
There is a lot of complaining around
the world about need for and technicalities of the U.S. FAS 133 and the
international IAS 39 standards on Accounting for Financial Instruments
Derivatives and Hedging Activities. But recent scandals adding to the pile
of enormous scandals in derivatives over the past two decades suggest an
increased need for more stringent rather than weakened standards for
accounting for derivatives. The main problem lies in valuation of these
derivatives coupled with the possibility that what is a safe hedge is really a
risky speculation. A case in point is Newmont Mining Corporation's Yandal
Project in Australia as reported by Steve Maich in "Newmont's Hedge Book
Bites Back," on Page IN1 of the March 4, 2003 edition of Canada's Financial
Post --- http://www.financialpost.com/
Even by
the gold industry's relatively aggressive standards, Yandal's derivatives
exposure is stunning. The unit has 3.4 million ounces of gold committed
through hedging contracts that had a market value of negative US$288-million
at the end of 2002.
That
would be a problem for any major producer, but the situation is particularly
dire for Yandal because the development's total proven and provable gold
reserves are just 2.1 million ounces. In other words, the project has,
through its hedging contracts, committed to sell 60% more gold than it
actually has in the ground.
Making
matters worse, the mine's counterparties can require Yandal to settle the
contracts in cash, before they come due. In all, about 2.8 million
ounces are subject to these cash termination agreements by 2005, which could
cost the company US$223.7-million at current market prices.
With
insufficient gold to meet its obligations, and just US$58-million in cash to
make up the difference, bankruptcy may be the only option available to Yandal,
analysts said.
Comparing
Yandal's reserves to its hedging liabilities "suggests that the Yandal
assets may be worth more dead than alive," CIBC World Markets analyst
Barry Cooper said in a report to clients.
All this
is raising even bigger questions about the impact that the Yandal situation
might have on the industry's other major hedgers. Companies such as
Canada's Barrick Gold Corp. and Placer Dome Ltd. have lagged
the sector's strong rally of the past year, largely because many investors and
analysts distrust the companies' derivative portfolios.
One thing that is not stressed hard
enough in FAS 133 is the credit risk of the dealers themselves. The FAS
133 standard and its international IAS 39 counterpart implicitly assume that
when speculating or hedging with derivatives, the dealers who broker these
contracts are highly credit worthy. For example, in the case of interest
rate swaps it is assumed that the dealer that brokers the swap will stand behind
the swapping party and counterparty default risks. There are now some
doubts about this in the present weak economy.
"Derivatives Market a 'Time
Bomb': Buffet," Financial Post, March 4, 2003, Page IN1 --- http://www.financialpost.com/
Berkshire chairman warns of risks in shareholder letter --- http://www.berkshirehathaway.com/letters/letters.html
(The above link is not yet updated for the Year 2002 forthcoming annual
Shareholder Letter.)
Billionaire investor
Warren Buffett calls derivative contracts "financial weapons of mass
destruction, carrying dangers that while now latent are potentially
lethal," according to excerpts from his forthcoming annual letter to
Berkshire Hathaway Inc. shareholders.
Mr. Buffett, whose
company is now seeking to divest of derivatives business tied to its General
Re purchase, also worries that substantial credit risk has become concentrated
"in the hands of relatively few derivatives dealers."
"Divided on Derivatives
Greenspan: Buffett at Odds on Risks of the Financial Instruments," by
John M. Berry, The Washington Post, March 6, 2003, Page E01 --- http://www.washingtonpost.com/wp-dyn/articles/A48287-2003Mar5.html
The use of
derivatives has grown exponentially in recent years. The total value of all
unregulated derivatives is estimated to be $127 trillion -- up from $3
trillion 1990. J.P. Morgan Chase & Co. is the world's largest derivatives
trader, with contracts on its books totaling more than $27 trillion. Most of
those contracts are designed to offset each other, so the actual amount of
bank capital at risk is supposed to be a small fraction of that amount.
Previous efforts to increase federal oversight of the derivatives market have
failed, including one during the Clinton administration when the industry,
with support from Greenspan and other regulators, beat back an effort by
Brooksley Born, the chief futures contracts' regulator. Sen. Dianne Feinstein
(D-Calif.) has introduced a bill to regulate energy derivatives because of her
belief that Enron used them to manipulate prices during the California energy
crisis, but no immediate congressional action is expected.
Randall Dodd, director of the Derivatives Study Center, a Washington think
tank, said both Buffett and Greenspan are right -- unregulated derivatives are
essential tools, but also potentially very risky. Dodd believes more oversight
is needed to reduce that inherent risk.
"It's a double-edged sword," he said. "Derivatives are
extremely useful for risk management, but they also create a host of new risks
that expose the entire economy to potential financial market
disruptions."
Buffett has no problem with simpler derivatives, such as futures contracts in
commodities that are traded on organized exchanges, which are regulated. For
instance, a farmer growing corn can protect himself against a drop in prices
before he sells his crop by buying a futures contract that would pay off if
the price fell. In essence, derivatives are used to spread the risk of loss to
someone else who is willing to take it on -- at a price.
Buffett's concern about more complex derivatives has increased since Berkshire
Hathaway purchased General Re Corp., a reinsurance company, with a subsidiary
that is a derivatives dealer. Buffett and his partner, Charles T. Munger,
judged that business "to be too dangerous."
Because many of the subsidiary's derivatives involve long-term commitments,
"it will be a great many years before we are totally out of this
operation," Buffett wrote in the letter, which was excerpted on the
Fortune magazine Web site. The full text of the letter will be available on
Berkshire Hathaway's Web site on Saturday. "In fact, the reinsurance and
derivatives businesses are similar: Like Hell, both are easy to enter and
almost impossible to exit."
One derivatives expert said several of General Re's contracts probably
involved credit risk swaps with lenders in which General Re had agreed to pay
off a loan if a borrower -- perhaps a telecommunications company -- were to
default. In testimony last year, Greenspan singled out the case of telecom
companies, which had defaulted on a significant portion of about $1 trillion
in loans. The defaults, the Fed chairman said, had strained financial markets,
but because much of the risk had been "swapped" to others -- such as
insurance companies, hedge funds and pension funds -- the defaults did not
cause a wave of financial-institution bankruptcies.
"Many people argue that derivatives reduce systemic problems, in that
participants who can't bear certain risks are able to transfer them to
stronger hands," Buffett acknowledged. "These people believe that
derivatives act to stabilize the economy, facilitate trade and eliminate bumps
for individual participants. And, on a micro level, what they say is often
true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives
transactions in order to facilitate certain investment strategies."
But then Buffett added: "The macro picture is dangerous and getting more
so. Large amounts of risk, particularly credit risk, have become concentrated
in the hands of relatively few derivatives dealers, who in addition trade
extensively with one another. The troubles of one could quickly infect the
others. On top of that, these dealers are owed huge amounts by nondealer
counterparties," some of whom are linked in such a way that many of them
could run into problems simultaneously and set off a cascade of defaults.
March 7, 2003 message from Risk
Waters Group [RiskWaters@lb.bcentral.com]
Alan
Greenspan, chairman of the US Federal Reserve, today once again defended
the use of derivatives as hedging tools, especially credit derivatives.
His comments come in the wake of Warren Buffett's criticism of
derivatives as "time bombs" and Peter Carr - recipient of
Risk's 2003 quant of the year award this week - saying that in a
[hypothetical] argument between quants convinced of the infallibility of
their models and derivatives sceptics such as Buffett, he would probably
side with Buffett.
But Greenspan, speaking at the Banque de France's symposium on monetary
policy, economic cycle and financial dynamics in Paris, said derivatives
have become indispensable risk management tools for many of the largest
corporations. He said the marriage of derivatives and securitisation
techniques in the form of synthetic collateralised debt obligations has
broadened the range of investors willing to provide credit protection by
pooling and unbundling credit risk through the creation of securities
that best fit their preferences for risk and return.
This probably
explains why credit derivatives employees reap the highest salaries,
with an Asian-based managing director in synthetic structuring at a
bulge-bracket firm earning an average basic plus bonus of £1.35 million
last year. These were the findings of a first-of-its-kind survey
conducted by City of London executive search company Napier Scott. The
survey found that most managing directors working in credit derivatives
at the top investment banks earn more than £1 million, with synthetic
structurers commanding the highest salary levels. Asia-based staff earn
12-15% more than their US counterparts, with UK-based staff not far
behind their Asia-based counterparts. Even credit derivatives associates
with one or two years' experience earn in excess of £150,000 a year on
average at a tier-1 bank.
In more people
news, Merrill Lynch has hired four ex-Goldman Sachs bankers for its
corporate risk management group focused on Europe, the Middle East and
Africa. Roberto Centeno was hired as a director with responsibility for
Iberia. Andrea Anselmetti and Luca Pietrangeli, both directors, and
Ernesto Mercadente, an associate, will focus on expanding the corporate
risk management and foreign exchange business in the Italian region. The
corporate risk management group focuses on providing advice and
execution for corporate clients, covering all risk management issues,
including foreign exchange, interest rate risk and credit risk. All four
will report to Patrick Bauné, co-head of Merrill Lynch's global foreign
exchange issuer client group, and Damian Chunilal, head of the EMEA
issuer client group, and are expected to join within the next two weeks.
Merrill also hired Scott Giardina as a director in credit derivatives
trading, based in London. He will report to Jon Pliner, managing
director of credit trading EMEA, and Neil Walker, managing director of
structured credit trading, EMEA. Giardina also joins from Goldman Sachs.
Christopher
Jeffery
Editor, RiskNews
www.risknews.net
cjeffery@riskwaters.com
April 11, 2003Update on Accounting for Credit
Derivatives
April 11, 2003 message from Risk Waters Group [RiskWaters@lb.bcentral.com]
Jean-Claude Trichet, governor of the Bank of France,
said transparency is essential to prevent a "herd mentality" in the
financial market that can create artificial swings in market prices. During a
keynote address at the Professional Risk Managers' International Association
2003 European Summit in Paris this week, Trichet called for a
"strengthening of market transparency" and the disclosure of
"complete and reliable information". He added that "no satisfying
disclosure" yet exists for the credit derivatives market-place, and that
while a January study by the Bank for International Settlements cast "some
light" on this market, "these efforts should be pursued by central
banks as well as market participants". Trichet said transparency is not
just an issue for investors and savers but a fundamental tenet underpinning
anti-cyclicality. "If information is not transparent, behaving as a 'herd'
is a natural reaction," Trichet said.
Banks and Credit Derivatives
From Jim Mahar's blog on August 17, 2005
Minton, Stulz, and
Williamson have an important look at banks' usage of credit derivatives. The
short version? Very few banks are using them! In 2003, only about 6% of
banks with over $1B in assets report using this form of derivatives.
Consistent with what we have seen on other derivative usage, these banks
tend to be much larger than average. Best guess as for the low usage?
Transaction costs driven by moral hazard and adverse selection costs.
Slightly longer
version of the paper
Minton, Stulz, and
Williamson begin by documenting that the credit derivative market (measured
by notional principle) has grown in recent years. Regulators (and even Alan
Greenspan himself) have claimed that this reduces the risks that banks face.
The paper investigates banks' use of credit derivatives and find that as of
2003, few banks were using credit derivatives. Those banks that were using
the derivatives tended to be larger and have a greater need for the risk
reduction.
In the words of the
paper's authors:
"...net buyers
of protection have higher levels of risk than other banks: they have
lower capital ratios, lower balances of liquid assets, a higher ratio of
risk-based assets to total assets, and a higherfraction of
non-performing assets than the non-users of credit derivatives."
Why the limited
use? Transaction costs undoubtedly play a role. Like in other derivatives
"know-how" can be expensive to obtain and this largely fixed cost may
explain a portion of the limited use. However, the very nature of credit
derivatives also makes them prone to moral hazard and adverse selection
costs. (Tried another way, banks typcially know more about the borrowers
(and are often in a better position to monitor), than do derivative market
participants. This results in less liquidity (higher transaction costs) for
the very loans that would make the most sense to hedge.)
Again in the
authors' words:
"These adverse
selection and moral hazard problems make the market for credit
derivatives illiquid for single name protection precisely for the credit
risks that banks would often want to hedge with such protection. The
positive coefficient estimates on C&I loan and foreign loan shares in a
bank’s loan portfolio are consistent with the hypothesis that banks are
more likely to hedge with credit derivatives if they have more loans to
credits for which the credit derivatives market is more liquid."
So what does this
all mean? The conclusion hints that the benefits of credit derivatives may
be overstated but apparently the cost of hedging in papers is lower than in
the credit derivative market as the paper ends covering both sides of the
debate:
"To the extent
that credit derivatives make it easier for banks to maximize their value
with less capital, they do not increase the soundness of banks as much
as their purchases of credit derivatives would imply. However, if credit
derivatives enable banks to save capital, they ultimately reduce the
cost of loans for bank customers and make banks more competitive with
the capital markets for the provision of loans."
Not only are few
banks using the derivatives to hedge, the exact loans that the banks would
want to hedge are the most expensive to do. This really should not be
surprising. What is more surprising is that these costs are so high as to
prevent the use of the derivatives. Going forward in time, it will be
interesting to see if this remains the case or if as the market develops,
new ways evolve to lower the costs which would allow more effective hedging
with credit derivatives. Stay Tuned.
Cite:
Minton, Bernadette A, Rene Stulz, and Rohan Williamson.
"How much do banks use credit derivatives to reduce risk?",
Ohio State working paper,
http://www.cob.ohio-state.edu/fin/dice/papers/2005/2005-17.pdf
From The Wall Street Journal Accounting
Weekly Review on June 13, 2008
SEC, Justice Scrutinize AIG on Swaps Accounting
by Amir Efrati
and Liam Pleven
The Wall Street Journal
Jun 06, 2008
Page: C1
Click here to view the full article on WSJ.com ---
http://online.wsj.com/article/SB121271786552550939.html?mod=djem_jiewr_AC
TOPICS: Advanced
Financial Accounting, Auditing, Derivatives, Fair Value
Accounting, Internal Controls, Mark-to-Market Accounting
SUMMARY: The
SEC "...is investigating whether insure American International
Group Inc. overstated the value of contracts linked to subprime
mortgages....At issue is the way the company valued credit
default swaps, which are contracts that insure against default
of securities, including those backed by subprime mortgages. In
February, AIG said its auditor had found a 'material weakness'
in its accounting. Largely on swap-related write-downs...AIG has
recorded the two largest quarterly losses in its history."
CLASSROOM
APPLICATION: Financial reporting for derivatives is at issue
in the article; related auditing issues of material weakness in
accounting for these contracts also is covered in the main
article and the related one.
QUESTIONS:
1. (Introductory) What are collateralized debt
obligations (CDOs)?
2. (Advanced) What are credit default swaps? How are
these contracts related to CDOs?
3. (Advanced) Summarize steps in establishing fair
values of CDOs and credit default swaps.
4. (Introductory) What is a material weakness in
internal control? Does reporting write-downs of such losses as
AIG has shown necessarily indicate that a material weakness in
internal control over financial reporting has occurred? Support
your answer.
Reviewed By: Judy Beckman, University of Rhode Island
RELATED
ARTICLES:
AIG Posts Record Loss, As Crisis Continues Taking Toll
by Liam Pleven
May 09, 2008
Page: A1
|
"SEC, Justice Scrutinize AIG on Swaps
Accounting," by Amir Efrati and Liam Pleven, The Wall Street Journal,
June 6, 2008; Page C1 ---
http://online.wsj.com/article/SB121271786552550939.html?mod=djem_jiewr_AC
The Securities and Exchange
Commission is investigating whether insurer American International Group
Inc. overstated the value of contracts linked to subprime mortgages,
according to people familiar with the matter.
Criminal prosecutors from
the Justice Department in Washington and the department's U.S. attorney's
office in Brooklyn, New York, have told the SEC they want information the
agency is gathering in its AIG investigation, these people said. That means
a criminal investigation could follow.
In 2006, AIG, the world's
largest insurer, paid $1.6 billion to settle an accounting case. Its stock
has been battered because of losses linked to the mortgage market. The
earlier probe led to the departure of Chief Executive Officer Maurice R.
"Hank" Greenberg.
Officials for AIG, the SEC,
the Justice Department and the U.S. attorney's office declined to comment on
the new probe. A spokesman for AIG said the company will continue to
cooperate in regulatory and governmental reviews on all matters.
At issue is the way the
company valued credit default swaps, which are contracts that insure against
default of securities, including those backed by subprime mortgages. In
February, AIG said its auditor had found a "material weakness" in its
accounting.
Largely on swap-related
write-downs, which topped $20 billion through the first quarter, AIG has
recorded the two largest quarterly losses in its history. That has turned up
the heat on management, including CEO Martin Sullivan.
AIG sold credit default
swaps to holders of investments called collateralized-debt obligations, or
CDOs, backed in part by subprime mortgages. The buyers were protecting their
investments in the event of default on the underlying debt. In question is
how the CDOs were valued, which drives both the value of the credit default
swaps and the amount of collateral AIG must "post," or essentially hand
over, to the buyer of the swap to offset the buyer's credit risk.
AIG posted $9.7
billion in collateral related to its swaps, as of April 30, up from $5.3
billion about two months earlier.
Law Blog: Difficulties in Valuation 'Best Defense'
Bob Jensen's threads on CDOs are at
http://faculty.trinity.edu/rjensen/theory01.htm#CDO
Bob Jensen's timeline of derivative
financial instruments scandals and new accounting rules ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm
Disclosures about Credit Derivatives and Certain Guarantees: An
Amendment of FASB Statement No. 133 and FASB Interpretation No. 45;
and Clarification of the Effective Date of FASB Statement No. 161
FASB, September 12, 2008 ---
http://www.fasb.org/pdf/fsp_fas133-1&fin45-4.pdf
Damocles sword
waiting to fall
CDS = Credit Default Swap (or is the Credit Default Sword?)
Financial WMDs (Credit Derivatives) on Sixty Minutes (CBS) on August 30,
2009 ---
http://www.cbsnews.com/video/watch/?id=5274961n&tag=contentBody;housing
I downloaded the video (5,631 Mbs) to
http://www.cs.trinity.edu/~rjensen/temp/FinancialWMDs.rv
Steve Kroft examines the complicated
financial instruments known as credit default swaps and the central role they
are playing in the unfolding economic crisis. The interview features my hero
Frank Partnoy. I don't know of anybody who knows derivative securities
contracts and frauds better than Frank Partnoy, who once sold these derivatives
in bucket shops. You can find links to Partnoy's books and many, many quotations
at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
For years I've used the term "bucket
shop" in financial securities marketing without realizing that the first bucket
shops in the early 20th Century were bought and sold only gambles on stock
pricing moves, not the selling of any financial securities. The analogy of a
bucket shop would be a room full of bookies selling bets on NFL playoff games.
See "Bucket Shop" at
http://en.wikipedia.org/wiki/Bucket_shop_(stock_market)
I was not aware how fraudulent the
credit derivatives markets had become. I always viewed credit derivatives as an
unregulated insurance market for credit protection. But in 2007 and 2008 this
market turned into a betting operation more like a rolling crap game on Wall
Street.
Bob Jensen's Rotten to the Core
threads are at
http://faculty.trinity.edu/rjensen/FraudRotten.htm
Bob Jensen's threads on the current
economic crisis are at
http://faculty.trinity.edu/rjensen/2008Bailout.htm
For credit derivative problems see
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Also see "Credit Derivatives" under
the C-Terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms
"Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults," by David
Evans, Bloomberg, May 20, 2008 ---
http://www.bloomberg.com/apps/news?pid=20601109&sid=aCFGw7GYxY14&refer=home
Backshall and his clients aren't the only
ones spooked by the prospect of a CDS catastrophe. Billionaire investor
George Soros says a chain reaction of failures in the swaps market could
trigger the next global financial crisis.
CDSs, which were devised by J.P. Morgan &
Co. bankers in the early 1990s to hedge their loan risks, now constitute a
sprawling, rapidly growing market that includes contracts protecting $62
trillion in debt.
The market is unregulated, and there are
no public records showing whether sellers have the assets to pay out if a
bond defaults. This so-called counterparty risk is a ticking time bomb.
``It is a Damocles sword waiting to
fall,'' says Soros, 77, whose new book is called ``The New Paradigm for
Financial Markets: The Credit Crisis of 2008 and What It Means'' (PublicAffairs).
``To allow a market of that size to
develop without regulatory supervision is really unacceptable,'' Soros says.
`Lumpy Exposures'
The Fed bailout of Bear Stearns on March
17 was motivated, in part, by a desire to keep that sword from falling, says
Joseph Mason, a former U.S. Treasury Department economist who's now chair of
the banking department at Louisiana State University's E.J. Ourso College of
Business.
The Fed was concerned that banks might not
have the money to pay CDS counterparties if there were large debt defaults,
Mason says.
``The Fed's fear was that they didn't
adequately monitor counterparty risk in credit-default swaps -- so they had
no idea of where to lend nor where significant lumpy exposures may lie,'' he
says.
Those counterparties include none other
than JPMorgan itself, the largest seller and buyer of CDSs known to the
Office of the Comptroller of the Currency, or OCC.
The Fed negotiated the deal to bail out
Bear Stearns by allowing JPMorgan to buy it for $10 a share. The Fed pledged
$29 billion to JPMorgan to cover any Bear debts.
`Cast Doubt'
``The sudden failure of Bear Stearns
likely would have led to a chaotic unwinding of positions in those
markets,'' Fed Chairman Ben S. Bernanke told Congress on April 2. ``It could
also have cast doubt on the financial positions of some of Bear Stearns's
thousands of counterparties.''
The Fed was worried about the biggest
players in the CDS market, Mason says. ``It was a JPMorgan bailout, not a
bailout of Bear,'' he says.
JPMorgan spokesman Brian Marchiony
declined to comment for this article.
Credit-default swaps are derivatives,
meaning they're financial contracts that don't contain any actual assets.
Their value is based on the worth of underlying loans and bonds. Swaps are
similar to insurance policies -- with two key differences.
Unlike with traditional insurance, no
agency monitors the seller of a swap contract to be certain it has the money
to cover debt defaults. In addition, swap buyers don't need to actually own
the asset they want to protect.
It's as if many investors could buy
insurance on the same multimillion-dollar home they didn't own and then
collect on its full value if the house burned down.
Bigger Than NYSE
When traders buy swap protection, they're
speculating a loan or bond will fail; when they sell swaps, they're betting
that a borrower's ability to pay will improve.
The market, which has doubled in size
every year since 2000 and is larger in dollar value than the New York Stock
Exchange, is controlled by banks like JPMorgan, which act as dealers for
buyers and sellers. Swap prices and trade volume aren't publicly posted, so
investors have to rely on bids and offers by banks.
Most of the traders are banks; hedge
funds, which are mostly private pools of capital whose managers participate
substantially in the profits from their speculation on whether the price of
assets will rise or fall; and insurance companies. Mutual and pension funds
also buy and sell the swaps.
Proponents of CDSs say the devices have
been successful because they allow banks to spread the risk of default and
enable hedge funds to efficiently speculate on the creditworthiness of
companies.
`Seeing the Logic'
The market has grown so large so fast
because swaps are often based on an index that includes the debt of scores
of companies, says Robert Pickel, chief executive officer of the
International Swaps and Derivatives Association.
``Whether you're a hedge fund, bank or
some other user, you're increasingly seeing the logic of using these
instruments,'' Pickel says, adding he doesn't worry about counterparty risk
because banks carefully monitor the strength of investors. ``There have been
a very limited number of disputes. The parties understand these products and
know how to use them.''
Banks are the largest buyers and sellers
of CDSs. New York- based JPMorgan trades the most, with swaps betting on
future credit quality of $7.9 trillion in debt, according to the OCC.
Citigroup Inc., also in New York, is second, with $3.2 trillion in CDSs.
Goldman Sachs Group Inc. and Morgan
Stanley, two New York- based firms whose swap trading isn't tracked by the
OCC because they're not commercial banks, are the largest swap
counterparties, according to New York-based Fitch Ratings, which doesn't
provide dollar amounts.
Untested Until Now
The credit-default-swap market has been
untested until now because there's been a steady decline in global default
rates in high-yield debt since 2002. The default rate in January 2002, when
the swap market was valued at $1.5 trillion, was 10.7 percent, according to
Moody's Investors Service.
Since then, defaults globally have dropped
to 1.5 percent, as of March. The rating companies say the tide is turning on
defaults.
Fitch Ratings reported in July 2007 that
40 percent of CDS protection sold worldwide is on companies or securities
that are rated below investment grade, up from 8 percent in 2002. On May 7,
Moody's wrote that as the economy weakened, high-yield-debt defaults by
companies worldwide would increase fourfold in one year to 6.1 percent by
April 2009.
The pressure is building. On May 5, for
example, Tropicana Entertainment LLC filed for bankruptcy after the casino
owner defaulted on $1.32 billion in debt.
`Complicate the Crisis'
A surge in corporate defaults may leave
swap buyers scrambling, many unsuccessfully, to collect hundreds of billions
of dollars from their counterparties, says Satyajit Das, a former Citigroup
derivatives trader and author of ``Credit Derivatives: CDOs & Structured
Credit Products'' (Wiley Finance, 2005).
``This is going to complicate the
financial crisis,'' Das says. He expects numerous disputes and lawsuits, as
protection buyers battle sellers over the technical definition of default -
- this requires proving which bond or loan holders weren't paid -- and the
amount of payments due.
``It's going to become extremely messy,''
he says. ``I'm really scared this is going to freeze up the financial
system.''
Andrea Cicione, a London-based senior
credit strategist at BNP Paribas SA, has researched counterparty risk and
says it's only a matter of time before the sword begins falling. He says the
crisis will likely start with hedge funds that will be unable to pay banks
for contracts tied to at least $35 billion in defaults.
$150 Billion Loss Estimate
``That's a very conservative estimate,''
he says, adding that his study finds that losses resulting from hedge funds
that can't pay their counterparties for defaults could exceed $150 billion.
Hedge funds have sold 31 percent of all
CDS protection, according to a February 2007 report by Charlotte, North
Carolina-based Bank of America Corp.
Cicione says banks will try to pre-empt
this default disaster by demanding hedge funds put up more collateral for
potential losses. That may not work, he says. Many of the funds won't have
the cash to meet the banks' requests, he says.
Sellers of protection aren't required by
law to set aside reserves in the CDS market. While banks ask protection
sellers to put up some money when making the trade, there are no industry
standards, Cicione says.
JPMorgan, in its annual report released in
February, said it held $22 billion of credit swap counterparty risk not
protected by collateral as of Dec. 31.
`A Major Risk'
``I think there's a major risk of
counterparty default from hedge funds,'' Cicione says. ``It's inconceivable
that the Fed or any central bank will bail out the hedge funds. If you have
a systemic crisis in the hedge fund industry, then of course their banks
will take the hit.''
The Joint Forum of the Basel Committee on
Banking Supervision, an international group of banking, insurance and
securities regulators, wrote in April that the trillions of dollars in swaps
traded by hedge funds pose a threat to financial markets around the world.
``It is difficult to develop a clear
picture of which institutions are the ultimate holders of some of the credit
risk transferred,'' the report said. ``It can be difficult even to quantify
the amount of risk that has been transferred.''
Counterparty risk can become complicated
in a hurry, Das says. In a typical CDS deal, a hedge fund will sell
protection to a bank, which will then resell the same protection to another
bank, and such dealing will continue, sometimes in a circle, Das says.
`Daisy Chain Vortex'
The original purpose of swaps -- to spread
a bank's loan risk among a large group of companies -- may be circumvented,
he says.
``It creates a huge concentration of
risk,'' Das says. ``The risk keeps spinning around and around in this daisy
chain like a vortex. There are only six to 10 dealers who sit in the middle
of all this. I don't think the regulators have the information that they
need to work that out.''
And traders, even the banks that serve as
dealers, don't always know exactly what is covered by a credit-default-swap
contract. There are numerous types of CDSs, some far more complex than
others.
More than half of all CDSs cover indexes
of companies and debt securities, such as asset-backed securities, the Basel
committee says. The rest include coverage of a single company's debt or
collateralized debt obligations.
A CDO is an opaque bundle of debt that can
be filled with junk bonds, auto loans, credit card liabilities and home
mortgages, including subprime debt. Some swaps are made up of even murkier
bank inventions -- so-called synthetic CDOs, which are packages of
credit-default swaps.
AIG $9.1 Billion Writedown
On May 8, American International Group
Inc. wrote down $9.1 billion on the value of its CDS holdings. The world's
largest insurer by assets sold credit protection on CDOs that declined in
value. In 2007, New York-based AIG reported $11.5 billion in writedowns on
CDO credit default swaps.
Michael Greenberger, director of trading
and markets at the Commodity Futures Trading Commission from 1997 to 1999,
says the Fed is fully aware of the risk banks and the global economy face if
CDS holders can't cover their losses.
``Oh, absolutely, there's no doubt about
it,'' says Greenberger, who's now a professor at the University of Maryland
School of Law in Baltimore. He says swaps were very much on the Fed's mind
when Bear Stearns started sliding toward bankruptcy.
``People who were relying on Bear for
their own solvency would've started defaulting,'' he says. ``That would've
triggered a series of counterparty failures. It was a house of cards.''
Risk Nightmare
It's concerns about that house of cards
that have kept Backshall, the California fund adviser, up at night. His
worries about a nightmare scenario started in early March. The details of
what happened are still fresh in his mind.
It's Monday, March 10, and the market is
rife with rumors that Bear Stearns will run out of cash. Some of Backshall's
clients have pulled their accounts from Bear; others are considering leaving
the bank. Backshall's clients are exposed to Bear in multiple ways: They
keep their cash and other accounts at the firm, and they use the bank as
their broker for trades. Backshall advises them to spread their assets among
various banks.
That same day, Bear CEO Alan Schwartz says
publicly, ``There is absolutely no truth to the rumors of liquidity
problems.''
Backshall's clients are suspicious. They
see other hedge funds pulling their accounts from Bear. In the afternoon
after Schwartz's remarks, the cost of protection soars past 600 basis points
from 450 before Schwartz's statement.
CEO Didn't Calm Fears
Swaps are priced in basis points, or
hundredths of a percentage point. At 600 basis points, a trader would pay
$6,000 a year to insure $100,000 of Bear Stearns bonds.
``I don't think his comments did anything
to calm fears,'' Backshall says.
The next day, March 11, Securities and
Exchange Commission Chairman Christopher Cox says his agency is monitoring
Bear Stearns and other securities firms.
``We have a good deal of comfort about the
capital cushions at these firms at the moment,'' he says.
Cox's comments are overshadowed by rumors
that European financial firms had stopped doing fixed-income trades with
Bear, Backshall says.
``Nobody has a clue what's going on,'' he
says. Bear swap costs are gyrating between 540 and 665.
For most investors, just getting
default-swap prices is a chore. Unlike stock prices, which are readily
available because they trade on a public exchange, swap prices are hard to
find. Traders looking up prices on the Internet or on private trading
systems see information that is hours or days old.
`Terribly Primitive'
Banks send hedge funds, insurance
companies and other institutional investors e-mails throughout the day with
bid and offer prices, Backshall says. For many investors, this system is a
headache.
To find the price of a swap on Ford Motor
Co. debt, for example, even sophisticated investors might have to search
through all of their daily e-mails, he says.
``It's terribly primitive,'' Backshall
says. ``The only way you and I could get a level of prices is searching for
Ford in our inbox. This is no joke.''
In the past three years, at least two
companies have developed software programs that automatically parse an
investor's incoming messages, yank out CDS prices and build them into
real-time price displays.
The charts show the highest bids and
lowest offering prices for hundreds of swaps. Backshall tracks prices he
gets from banks using the new software.
`It's Very Hard'
Backshall has been talking with hedge fund
managers in New York all week.
``We'd quite frankly been warning them and
giving them advice on how to hedge,'' he says of the Bear Stearns crisis and
banks overall. ``It's very hard to hedge the counterparty risk. These
institutions are thinly capitalized in the best of times.''
The night of Thursday, March 13, Backshall
can't sleep. He lies awake worrying about Bear and counterparty risk. The
next morning, he arrives at work at 5 a.m., two and a half hours before
sunrise.
Through the window of his ninth-floor
corner office, he takes a moment to watch the distant flickers of light in
the rolling foothills of Mount Diablo. Across the street, he sees the
still-dark Walnut Creek train station, about 30 miles (48 kilometers) east
of San Francisco.
Backshall, wearing jeans and a blue,
button-down shirt, sits at his desk, staring at a pair of the 27-inch (68.6-
centimeter) monitors that display swap costs. CDS prices jumped by more than
10-fold in just a year. The numbers show rising fear, he says.
Until early in 2007, the typical price of
a credit-default swap tied to the debt of an investment bank like Merrill
Lynch & Co., Bear Stearns or Morgan Stanley was 25 basis points.
`Unknowns Are Out There'
If a swap buyer wanted to protect $10
million of assets in the event of a company default, the contract would cost
about 0.25 percent of $10 million, or $25,000 a year for a five-year
protection contract.
Backshall's screens tell him the cost of
buying protection on Bear Stearns debt in the past 24 hours has been moving
in a range between 680 and 755 basis points.
``The unknowns are out there,'' Backshall
says.
He advises his clients not to buy CDS
protection on Bear because the price is too high and the time is wrong. It's
too late to buy swaps now, he says.
At 9:13 Friday morning in New York,
JPMorgan announces it will loan money to Bear using funds provided by the
Federal Reserve. The JPMorgan statement doesn't say how much it will lend;
it says it will ``provide secured funding to Bear Stearns, as necessary.''
`Significantly Deteriorated'
Bear CEO Schwartz says his firm's
liquidity has ``significantly deteriorated'' during the past 24 hours.
Protection quotes drop immediately into the low 500s, as some dealers think
a rescue has begun.
That doesn't last long.
``Very quickly, the trading action is
swinging violently wider,'' Backshall says. Bear's swap cost jumps to 850
basis points that afternoon, his screen shows. ``When fear gets hold,
fundamental analysis goes out the window,'' he says.
In the calmest of times, making reasoned
decisions about swap prices is a challenge. Now, it's impossible. Traders
don't have access to any company data more recent than Bear's February
annual report. Sharp-eyed investors looking through that filing might have
spotted a paragraph that's strangely prescient.
``As a result of the global credit crises
and the increasingly large numbers of credit defaults, there is a risk that
counterparties could fail, shut down, file for bankruptcy or be unable to
pay out contracts,'' Bear wrote.
`Material Adverse Effect'
``The failure of a significant number of
counterparties or a counterparty that holds a significant amount of
credit-default swaps could have a material adverse effect on the broader
financial markets,'' the bank wrote.
Even after JPMorgan's Friday morning
announcement, the market is alive with rumors. Backshall's clients tell him
they've heard some investment banks have stopped accepting trades with Bear
Stearns and some money market funds have reduced their short-term holdings
of Bear-issued debt.
On Sunday, March 16, the Federal Reserve
effectively lifts the sellers of Bear Stearns protection out of their
misery. JPMorgan agrees to buy Bear for $2 a share.
While that's devastating news for Bear
shareholders -- the stock had traded at $62.30 just a week earlier -- it's
the best news imaginable for owners of Bear debt. That's because JPMorgan
agreed to cover Bear's liabilities, with the Fed pledging $29 billion to
cover Bear's loan obligations.
Turned to Dust
For traders who sold protection on Bear's
debt, the bailout is a godsend. Faced with the prospect of having to hand
over untold millions to their counterparties just three days earlier, they
now have to pay out nothing.
For traders who bought protection swaps
just a few days earlier -- when prices were in the 600s to 800s -- the Fed
bailout is crushing. Their investments have turned to dust.
On Monday morning, the cost of default
protection on Bear plunges to 280. Backshall sits back in his chair and for
the first time in two weeks, he can breathe easier.
``No wonder I look so tired all the
time,'' he says, finally showing a bit of a smile.
When it bailed out Bear Stearns, the
Federal Reserve effectively deputized JPMorgan to monitor the
credit-default- swap market, says Edward Kane, a finance professor at Boston
College. Because regulators don't know where the risks lie, they're
helpless, Kane says.
Default swaps shift the risk from a
company's credit to the possibility that a counterparty might fail, says
Kane, who's a senior fellow at the Federal Deposit Insurance Corporation's
Center for financial Research.
`Off Balance Sheet'
``You've really disguised traditional
credit risk, pushed it off balance sheet to its counterparties,'' Kane says.
``And this is not visible to the regulators.''
BNP analyst Cicione says regulators will
be hard-pressed to prevent the next potential breakdown in the swaps market.
``Apart from JPMorgan, there aren't many
other banks out there capable of doing this,'' he says. ``That's what's
worrying us. If there were to be more Bear Stearnses, who would step in and
give a helping hand? You can't expect the Fed to run a broker, so someone
has to take on assets and obligations.''
Banks have a vested interest in keeping
the swaps market opaque, says Das, the former Citigroup banker. As dealers,
the banks see a high volume of transactions, giving them an edge over other
buyers and sellers.
``Dealers get higher profitability through
lack of transparency,'' Das says. ``Since customers don't necessarily know
where the market is, you can charge them much wider margins.''
Banks Try to Hedge
Banks try to balance the protection
they've sold with credit-default swaps they purchase from others, either on
the same companies or indexes. They can also create synthetic CDOs, which
are packages of credit-default swaps the banks sell to investors to get
themselves protection.
The idea for the banks is to make a profit
on each trade and avoid taking on the swap's risk.
``Dealers are just like bookies,'' Kane
says. ``Bookies don't want to bet on games. Bookies just want to balance
their books. That's why they're called bookies.''
The banks played the role of dealers in
the CDO market as well, and the breakdown in that market holds lessons for
what could go wrong with CDSs. The CDO market zoomed to $500 billion in
sales in 2006, up fivefold from 2001.
Banks found a hungry market for CDOs
because they offered returns that were sometimes 2-3 percentage points
higher than corporate bonds with the same credit rating.
CDO Market Dried Up
By the middle of 2007, mortgage defaults
in the U.S. began reaching record highs each month. Banks and other
companies realized they were holding hundreds of billions in toxic debt. By
August 2007, no one would buy CDOs. That newly devised debt market dried up
in a matter of months.
In the past year, banks have written off
$323 billion from debt, mostly from investments they created.
Now, if corporate defaults increase, as
Moody's predicts, another market recently invented by banks --
credit-default swaps -- could come unstuck. Arturo Cifuentes, managing
director of R.W. Pressprich & Co., a New York firm that trades derivatives,
says he expects a rash of counterparty failures resulting in losses and
lawsuits.
``There's a high probability that many
people who bought swap protection will wind up in court trying to get their
payouts,'' he says. ``If things are collapsing left and right, people will
use any trick they can.''
Frank Partnoy, a former derivatives trader
and now a securities law professor at the University of San Diego School of
Law, says it's high time for the market to let in some sunshine.
Continued in article
"Pressure gauge," The Economist,
August 21, 2008 ---
http://www.economist.com/finance/displaystory.cfm?story_id=11985964
IN THE weeks before
Bear Stearns, a Wall Street bank, collapsed in March, nervous investors
scanned not just its share price for a measure of its health, but the price
of its credit-default swaps (CDSs), too. These once-obscure instruments, now
widely enough followed that they have even earned a mention on an American
TV crime series, clearly indicated that the firm’s days were numbered. The
five-year CDS spread had more than doubled to 740 basis points (bps),
meaning it cost $740,000 to insure $10m of its debt. The higher the spread,
the greater the expectation of default.
Once again, CDS
spreads on Wall Street banks are pushing higher, having fallen in March
after the Federal Reserve extended emergency lending facilities to them.
Reportedly one firm, Morgan Stanley, is monitoring its own CDS spreads to
assess the market’s perception of its corporate health; if they rise too
high, it intends to cut back its lending. Whether the CDS market is
accurately assessing the creditworthiness of Lehman Brothers, trading on
August 20th at 376 bps, double the level in early May, will be the next test
of its worth.
There are some who
doubt whether the CDS market is a reliable barometer of financial health.
Though its gross value has ballooned in size from $4 trillion in 2003 to
over $62 trillion, many of the contracts written on individual companies are
thinly traded, lack transparency, and are prone to wild swings.
Recent spikes in
CDS spreads on the three largest Icelandic banks are a case in point. In
July spreads on Kaupthing and Glitnir rose to levels 35% higher than those
observed for Bear Stearns in the days before it was bought out, according to
Fitch Solutions, part of the Fitch rating and risk group. But the panic
subsided after they released second-quarter earnings. Insiders say CDSs are
increasingly used for speculation as well as hedging, which creates
distracting “noise” particularly when the markets are as fearful as they
have been recently.
On the other hand,
although CDS spreads may overshoot, they do not generally stay wrong for
long. Moody’s, another rating agency, says that market-implied ratings, such
as those provided by CDS spreads, tally loosely with credit ratings 80% of
the time. What is more, CDS spreads frequently anticipate ratings changes.
Fitch Solutions reckons that the CDS market has anticipated over half of all
observed ratings activities on CDS-traded entities as much as three months
in advance. Though the magnitude of the moves may at times be unrealistic,
the direction is usually at least as good a distress signal as the stock
market.
"Credit Default Swap: The Fed wants to give the
blundering rating agencies even more power – this time over derivatives.."
The Wall Street Journal, January 3, 2008 ---
http://online.wsj.com/article/SB123094475030650613.html?mod=djemEditorialPage
Could the political campaign to blame the
financial panic on unregulated derivatives be losing momentum? Let's hope
so, because this might save us from making new mistakes in the name of
fixing the wrong problems.
We now know that the predicted disaster
for credit default swaps (CDS) following the Lehman Brothers bankruptcy
never happened. The government also still hasn't explained how AIG's use of
CDS to go long on housing would have destroyed the planet. And now the New
York Federal Reserve's effort to regulate the CDS market is mired in a turf
war. The Securities and Exchange Commission and the Commodity Futures
Trading Commission have backed rival efforts in New York and Chicago.
But it is the New York Fed proposal that
may pose the most immediate threat to taxpayers, because it is designed to
include firms on at least one end of 90% of CDS contracts. After announcing
its intention to begin by the end of 2008, the New York branch of the
central bank is still awaiting approval from the Fed's Board of Governors to
launch a central clearinghouse for CDS trades. Credit default swaps are
essentially insurance against an organization defaulting on its debt, and
they provide a real-time gauge of credit risk. This has proven particularly
valuable because the Fed's method of judging risk -- relying on the ratings
agencies S&P, Moody's and Fitch -- has been disastrous for investors.
Under pressure from the New York Fed, nine
large CDS dealers -- giants like Goldman Sachs -- agreed to construct a
central counterparty, which would backstop and monitor CDS trades. Called
The Clearing Corp., it failed to catch on in the marketplace. So the big
dealers recently gave an ownership stake to IntercontinentalExchange (ICE).
In return, ICE agreed to make this government-created but privately owned
institution work.
ICE has given the venture, now called ICE
Trust, operational street cred, but the Fed-imposed architecture should
still cause taxpayer concern. That's because it takes the widely dispersed
risk in the CDS marketplace and attempts to centralize it in one
institution. If not structured correctly, it may reward the participating
firms with the weakest balance sheets. For this reason, some of the dealers
who have resisted a central counterparty because it threatens their profits
may now embrace it as a way to socialize their risks. What's more, if it
allows these big Wall Street dealers to build an electronic trading platform
on top of the central clearinghouse, the big banks could prevent pesky
Internet start-ups from threatening their market share.
Here's how the New York Fed's central
counterparty would change the market: Right now, CDS trades are conducted
over-the-counter as private contracts between two parties. They are reported
to the Trade Information Warehouse, so the market has some transparency, but
nobody is on the hook besides the two parties to the agreement. This
provides an incentive for each party to make an informed judgment on whether
the counterparty can be relied upon to pay debts. The buyer of credit
protection -- who is paying annual premiums for the right to be compensated
if a company defaults on its bonds -- has every reason to study the balance
sheet of the seller of a CDS contract.
In the New York Fed's judgment, the recent
panic showed there wasn't enough transparency in CDS trades. This claim
would have more credibility if the Fed would come clean about AIG. But in
any case, the Fed's solution is to force CDS contracts into its central
counterparty. There is a virtue here: A particular bank cannot throw out its
collateral standards to please one large favored client, because the same
standards apply to all participants. The nine large dealers plus perhaps
four or five more participating firms would each contribute roughly $100
million to the central counterparty, and they'd have to cough up more money
if failures burn through this cash reserve.
However, this system also introduces new
risks, because all participants become liable for the potential failure of
the weakest members. How does one appropriately judge the credit risk of a
participant? ICE Trust and the Fed haven't released details. Sources tell us
that participants will need to have a net worth of at least $1 billion, and,
more ominously, that the Fed wants a high rating from a major credit-ratings
agency as a crucial test of financial health.
If regulators learn nothing else from the
housing debacle, they should recognize that their system of anointing
certain firms to judge credit risk is structurally flawed and immensely
expensive for investors. As Columbia's Charles Calomiris has explained on
these pages, one reason the Basel II standards for bank capital failed is
because they subcontracted risk assessments to the same ratings agencies
that slapped AAA on dodgy mortgage paper.
Unfortunately, the Fed stubbornly refuses
to learn this lesson. With its various lending facilities, the Fed continues
to demand collateral rated exclusively by S&P, Moody's or Fitch. A rival
ratings agency reports that the Fed recently rejected a request from a
clearing bank to consider a ratings firm other than the big three.
No doubt ICE Trust has a strong incentive
to monitor counterparty credit risk. Our concern is that the Fed's failed
policy on credit ratings will increase risks even further if it is allowed
to pollute the $30 trillion CDS market. The credit raters have shown they
are usually the last to know if a bank is in trouble, yet under a
credit-rating seal of approval such a bank could maintain the illusion that
all is well. If you have trouble conceiving of such a scenario, reflect on
the history of Enron, Bear Stearns, Lehman, Citigroup, the mortgage market,
collateralized-debt obligations, etc. Now try to imagine how long it will
take the Fed to commit taxpayer dollars if this central counterparty fails.
Any plan that seeks to minimize
marketplace risks by concentrating them in one institution deserves
skepticism. Relying on ratings from the big three to assess these risks
would be an outrage.
Bob Jensen's Primer on Derivatives ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Primer
Also see how AIG and some other Wall Street firms were bailed out of their
credit default swaps ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
"Stanford Research Team
Proposes Changes to Credit Default Swaps to Lower Looming Risks of Sovereign
Default," MarketWatch, May 15, 2012 ---
http://www.marketwatch.com/story/stanford-research-team-proposes-changes-to-credit-default-swaps-to-lower-looming-risks-of-sovereign-default-2012-05-15
STANFORD,
Calif., May 15, 2012 (BUSINESS WIRE) --
STANFORD GRADUATE SCHOOL OF BUSINESS--If you're a bondholder of sovereign
debt and think you've covered your risks by purchasing credit default swaps,
think again.
According
to Darrell Duffie, finance professor from the Stanford Graduate School of
Business, and Stanford economics student Mohit Thukral, a flaw within credit
default swap (CDS) contracts means that only a small fraction of bondholder
losses may be covered in the event of a sovereign debt restructuring.
The flaw
is tied to the fact that current CDS contracts only pay buyers of protection
based on the price of the sovereign's outstanding bonds, even if the
sovereign has just exchanged its legacy bonds for a much smaller amount of
new bonds. This CDS payout ignores the additional loss to a bondholder from
the effect of this "haircut."
In a
recently released research paper, Duffie and Thukral propose tying CDS
settlements to the face value of new bonds that is given to bondholders per
unit face value of old bonds. The resulting CDS payment approximates actual
bondholder losses, allowing for better sovereign default risk management and
CDS pricing that more accurately reveals sovereign default risk.
"The
current design of credit derivatives is of questionable value for managing
the risk of sovereign default, which is a significant issue given the
current stresses on the Eurozone," says Duffie. "Unless there is a change in
the contract design, such as the one we propose, investors could be left
without an effective tool for controlling their exposure to sovereign
default, and CDS prices would be unreliable gauges of true default risk."
Furthermore, he explains, if the CDS market is not an effective tool for
managing risk, investors may have even more reason to shy away from
sovereign bond purchases, leading to unintended consequences for market
stability.
Duffie and
Thukral, an undergraduate economics major who recently took Duffie's MBA
"Debt Markets" class, began their research following the restructuring of
Greek sovereign debt in March of this year, when they realized the
shortcomings of current CDS contracts. They propose a straightforward
redesign of CDS contracts that would allow settlement based on the market
value of whatever the sovereign government gives the bondholder in exchange
for each old bond; this market value would be determined in a settlement
auction.
In
practice, a sovereign government may give a package of several financial
instruments in exchange for each old bond. Bondholders of Greek debt, for
example, received a combination of new bonds, GDP-linked securities, and PSI
payment notes that are obligations of the European Financial Stability
Facility.
According
to Duffie and Thukral's proposal, the redesigned CDS contract would allow
settlement based on the market value of the entire exchange package. This
would mitigate one of the problems that arose with the Greek debt
restructuring; namely, that the protection payment ignored the remainder of
the exchange package.
In
this way, the team's proposal also provides a mechanism whereby the bond
market can digest the complex instruments that may be created in a sovereign
debt restructuring. This is important because not all bondholders are well
situated to deal with the package of instruments they may receive in a
restructuring.
Continued in article
For Bob Jensen's threads on
accounting for credit default swaps look under the C-terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Bob Jensen's timeline of derivative
financial instruments scandals and new accounting rules ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm
Bob Jensen's threads on derivatives
scandals can be found at
http://faculty.trinity.edu/rjensen/fraud.htm#DerivativesFraud
Bob Jensen's helpers, tutorials,
glossary, and instructional cases for FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Credit
Sensitive Payments =
payments on a
debt instrument that vary under an embedded option that
adjusts the interest rate on the basis of changed credit rating of the
borrower. Paragraph 61c on Page 41 of FAS 133 defines these payments as clearly-and-closely related
such that the embedded derivative cannot be accounted for separately under
Paragraph 12 on Page 7. This makes embedded credit derivative accounting
different than commodity indexed and equity indexed
embedded derivative accounting rules that require separation from the host
contract such as commodity indexed, equity indexed, and inflation indexed
embedded derivatives. In this regard, credit indexed embedded derivative
accounting is more like inflation indexed accounting. See
derivative financial instrument and embedded derivatives.
Cross-Currency Hedge
= see foreign currency hedge.
Cross Rate =
the exchange rate between two currencies other
than the dollar, calculated using the dollar exchange rates of those currencies.
Crude Oil
Knock-in Note =
a bond that has upside potential on the principal
payback contingent upon prices in the crude oil market. Such a note is illustrated
in Example 21 in Paragraph 187 of FAS 133.
CTA = a term with alternate meanings.
Commodity Trading Advisor - One who
provides advice on investing in currencies as a separate asset class. Some also act in a
separate function as overlay managers, advising on hedging the currency risk in
international asset portfolios.
Cumulative Translation Adjustment - An
entry in a translated balance sheet in which gains and losses from transactions have been
accumulated over a period of years.
Cumulative
Dollar Offset = see ineffectiveness.
Currency Swap =
a transaction in which two counterparties
exchange specific amounts of two different currencies at the outset and repay over time at
a predetermined rate that reflects interest payments and possibly amortization of the
principal as well. The payment flows are based on fixed interest rates in each currency.
An example of a currency swap in FAS 133 appears in Example 5 Paragraphs
131-139 on Pages 72-76.
Current Rate =
The exchange rate in effect at the
relevant-financial-statement date.
|
D-Terms
Dedesignation =
a change in status of a designated hedge such
that all or a portion of the hedged amounts must be taken into current earnings rather
being deferred. Dedesignation for cash flow hedges is discussed in Paragraph 30 on
Page 21 of FAS 133. If a cash forecasted
transaction becomes a firm commitment, its corresponding
cash flow hedge must be dedesignated. Controversies between the FASB's distinction
between forecasted transactions versus firm commitments are discussed in Paragraphs
324-325 on Page 157 of FAS 133.
An illustration of dedesignation. is given in
Example 9 in Paragraphs 165-172 on Pages 87-90 of FAS 133. Example 9 illustrates a
forward contract cash flow hedge of a forecasted series of transactions in a foreign
currency. When the forecasted transactions become accounts receivable, a portion of
the value changes in the futures contract must be taken into current earnings rather than
other comprehensive income. Another illustration
of dedesignation. is in Example 7 of FAS 133, pp. 79-80, Paragraphs 144-152. See derecognition and hedge.
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
A financial asset is derecognised if
-
the transferee has the right to sell or
pledge the asset; and
-
the transferor does not have the right to
reacquire the transferred assets. (However, such a right does not
prevent derecognition if either the asset is readily obtainable in
the market or the reacquisition price is fair value at the time of
reacquisition.)
|
FAS 133
In addition to those criteria, FASB requires that the transferred
assets be legally isolated from the transferor even in the event of
the transferor’s bankruptcy.
|
Default Swap = See
Credit Derivatives
Defeasance =
the early extinguishment of debt by
depositing, in risk-free securities, the present value of the interest and principal
payments in an irrevocable trust such that the earnings from the trust will service the
debt and have sufficient funds to eventually extinguish the debt. Exxon invented the
concept in the 1970s. In one instance Exxon captured $132 million of unrealized gain
on $515 million of long-term debt acquired when interest rates were high. The trust
must be entirely under the control of an independent trustee. Defeasance was sometimes
used to remove debt and capture gains when recalling the bonds had relatively high
transaction costs. The FASB allowed defeasance to capture gains and remove
debt from the balance sheet in SFAS 76. However, this was rescinded in SFAS
125. Defeasance can no longer remove debt from the balance sheet or be used to
capture unrecognized gains due to interest rate increases. See derecognition.
Defined-Benefit-Plan = see not-for-profit.
Delivered Floater =
see floater.
Derecognition =
the opposite of recognizing an asset or liability
on the balance sheet. Assets are derecognized when they are sold or abandoned.
Liabilities are derecognized when they are paid or forgiven. Derecognition,
however, can be a more complex issue when rights or obligations are changed in other ways.
Paragraph 26 on Page 17 and Paragraph 491 on Page 213of FAS 133 require that the
fair value of a firm commitment be derecognized when the hedged item no no longer meets
the Paragraph 22 criteria. The concept appears again in Paragraph 49. See dedesignation.
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
A financial asset is derecognised if
-
the transferee has the right to sell or
pledge the asset; and
-
the transferor does not have the right to
reacquire the transferred assets. (However, such a right does not
prevent derecognition if either the asset is readily obtainable in
the market or the reacquisition price is fair value at the time of
reacquisition.)
|
FAS 133
In addition to those criteria, FASB requires that the transferred
assets be legally isolated from the transferor even in the event of
the transferor’s bankruptcy.
|
IAS 39
Guidance in IAS 39 includes the following example. A bank transfers
a loan to another bank, but to preserve the relationship of the
transferor bank with its customer, the acquiring bank is not allowed
to sell or pledge the loan. Although the inability to sell or pledge
would suggest that the transferee has not obtained control, in this
instance the transfer is a sale provided that the transferor does
not have the right or ability to reacquire the transferred asset.
|
FAS 133
While a similar example is not included in FASB Standards, FASB
Standards might be interpreting as prohibiting derecognition by the
transferor bank.
|
Derivative =
A financial instrument whose value is derived
from changes in the value of some underlying asset such as a commodity, a share of stock,
a debt instrument, or a unit of currency. A nice review appears in Myron Scholes'
Nobel lecture that is reprinted as "Derivatives in a Dynamic Environment,"
American Economic Review, June 1998, 350-370. For further elaboration, see derivative financial instrument.
Especially note the terms hedge and disclosure.
Humor: "The
Idiot's Guide to Hedging and Derivatives" ---
http://faculty.trinity.edu/rjensen/fraud033103.htm#Idiot'sGuide
Also see CBOE,
CBOT, and CME for some great tutorials
on derivatives investing and hedging.
Derivative Financial Instrument = =
a
financial instrument that by its terms, at inception or
upon the occurrence of a specified event, provides the
holder (or writer) with the right (or obligation) to
participate in some or all of the price changes of an
underlying (that is, one or more referenced financial
instruments, commodities, or other assets, or other specific
items to which a rate, an
index of
prices, or another market indicator is applied) and does not
require that the holder or writer own or deliver the
underlying. A contract that requires ownership or delivery
of the underlying is a derivative financial instrument if
(a) the underlying is another derivative, (b) a mechanism
exists in the market (such as an organized exchange) to
enter into a closing contract with only a net cash
settlement, or (c) the contract is customarily settled with
only a
net cash payment based on changes in the price of the
underlying. What is most noteworthy about derivative
financial instruments is that in the past two decades, the
global use of derivatives has exploded exponentially to
where the trading in
notional
amounts is in trillions of dollars.
Unlike FAS 133,
IAS 39 makes explicit reference also to an insurance index
or catastrophe loss index and a climatic or geological
condition. Also IAS 39 does
not require net settlement.
Definitions of derivatives
-
IAS 39:
Does not define “net settlement” as
being required to be scoped into IAS 39
as a derivative such as when interest
rate swap payments and receipts are not
net settled into a single payment.
- FAS 133:
Net settlement is an explicit
requirement to be scoped into FAS 133 as
a derivative financial instrument.
-
Implications:
This is not a major difference since IAS
39 scoped out most of what is not net
settled such as Normal Purchases and
Normal Sales (NPNS) and other instances
where physical delivery transpires in
commodities rather than cash
settlements. IAS 39 makes other
concessions to net settlement such as in
deciding whether a "loan
obligation" is a derivative.
The FASB's
Derivatives and Hedging Glossary (in the
Accounting Standards Codification Database) ---
http://asc.fasb.org/subtopic&trid=2229141&nav_type=left_nav
"The Origins of Derivative Instruments," by Stephen G. Cecchetti,
Brandeis University ---
http://people.brandeis.edu/~cecchett/Textbook%20inserts/The%20Origin%20of%20Derivatives.htm
In financial
markets, the term "derivatives" is used to refer to a group of
instruments that derive their value from some underlying commodity or
market. Forwards, futures, swaps and options are all types of
derivative instruments and are widely used for hedging or speculative
purposes. While trading in derivative products has grown tremendously
in recent times, early evidence of these types of instruments can be
traced back to ancient Greece. Aristotle related a story about how the
Greek philosopher Thalus profited handsomely from an option-type
agreement around the 6th century b.c. According to the
story, one-year ahead, Thalus forecast the next olive harvest would be
an exceptionally good one. As a poor philosopher, he did not have many
financial resources at hand. But he used what he had to place a deposit
on the local olive presses. As nobody knew for certain whether the
harvest would be good or bad, Thalus secured the rights to the presses
at a relatively low rate. When the harvest proved to be bountiful, and
so demand for the presses was high, Thalus charged a high price for
their use and reaped a considerable profit
A critical
attribute of Thalus?s arrangement was the fact that its merit did not
depend on his forecast for a good harvest being accurate. The deposit
gave him the right but not the obligation to hire the presses. If the
harvest had failed, his losses were limited to the initial deposit he
paid. Thalus had purchased an option.
There is evidence
that the use of a type of forward contract was prevalent among merchants
in medieval European trade fairs. When trade began to flourish in the 12th
century merchants created a forward contract called a lettre de faire
(letter of the fair). These letters allowed merchants to trade on the
basis of a sample of their goods, thus relieving them of the need to
transport large quantities of merchandise along dangerous routes with no
guarantee of a buyer at the journey?s end. The letter acted as
evidence that the full consignment of the specified commodity was being
held at a warehouse for future delivery. Eventually, the contracts
themselves were traded among the merchants.
The first record
of organized trading in futures comes from 17th century
Japan. Feudal Japanese landlords would ship surplus rice to storage
warehouses in the cities and then issue tickets promising future
delivery of the rice. The tickets represented the right to take
delivery of a certain quantity of rice at a future date at a specified
price. These rice tickets were traded on the Dojima rice market near
Osaka and in 1730. Trading in rice tickets allowed landlords and
merchants to lock the prices at which rice was bought and sold, reducing
the risk they faced. The tickets also provided flexibility. Someone
holding a rice ticket but not a holder of a rice ticket but not wanting
to take delivery could sell it in the market. The rules governing the
trading on the Dojima market were similar to those of modern-day futures
markets.
Moving forward 200
years, Chicago was central to the 19th century development of
futures contracts in the US. As in Japan, the seasonal nature of
agricultural production was the main impetus behind the development of
these financial instruments. Farmers would traditionally bring their
harvest to market once a year in search of buyers creating a seasonal
glut and driving prices to extremely low levels. At other times of
year, shortages would emerge in the urban areas driving prices to
extremely high levels. This cycle was compounded by the fact that
storage facilities in the cities were inadequate and transportation from
rural areas was difficult.
In the early
1800s, forward arrangements began to appear to deal with the risk caused
by market volatility. These were known as ?to arrive? contracts and
involved an agreement between a buyer and seller for the future delivery
of grain. The quantity and grade of the grain would be specified as
well as the delivery date, as well an agreed-upon price. Soon the
contracts themselves began to be traded in anticipation of changes in
the market price of grain. With increases in trading volume increased
came a realization of the benefits of standardization and the need for
an organized exchange. The result, in 1848, was the founding of the
Chicago Board of Trade. Other early exchanges involved in futures
trading in the US included the New York Cotton Exchange, established in
1870, and the New York Coffee Exchange, set up in 1885
Various events in
the early 1970s conspired to spur the development of modern derivatives
markets. There was the collapse of the fixed-exchange rate system
provided the impetus for the trading of foreign-exchange derivatives;
while the theoretical advances of Black and Scholes allowed traders to
compute the price of options so they could buy and sell them. The first
financial futures, seven foreign currency contracts, were traded on the
Chicago Mercantile Exchange in 1972, while the first swap agreements
were executed by the Salomon Brothers in London in 1981. Equity
derivatives, based on underlying stock indices, began to emerge in the
late 1980?s. Today, derivative instruments based on a wide range of
underlying markets are traded globally and complex "exotic" products can
be built to hedge or assume almost any type of risk imaginable.
Definition from Wikipedia
Derivatives are financial instruments
whose value changes in response to the changes in underlying variables. The
main types of derivatives are futures, forwards, options, and swaps.
The main use of derivatives is to reduce
risk for one party. The diverse range of potential underlying assets and
pay-off alternatives leads to a huge range of derivatives contracts
available to be traded in the market. Derivatives can be based on different
types of assets such as commodities, equities (stocks), bonds, interest
rates, exchange rates, or indexes (such as a stock market index, consumer
price index (CPI) — see inflation derivatives — or even an index of weather
conditions, or other derivatives). Their performance can determine both the
amount and the timing of the pay-offs.
Insurance and Hedging
One use of derivatives is as a tool
to transfer
risk by taking the opposite position in the
futures market against the underlying commodity. For example, a wheat farmer
and a wheat miller could enter into a
futures contract to exchange cash for wheat in the
future. Both parties have reduced the risk of the future: the uncertainty of
the price and the availability of wheat.
Speculation and
arbitrage
Speculators may trade with other
speculators as well as with hedgers. In most financial derivatives markets,
the value of speculative trading is far higher than the value of true hedge
trading. As well as outright speculation, derivatives traders may also look
for
arbitrage opportunities between different
derivatives on identical or closely related underlying securities.
In addition to directional plays
(i.e. simply betting on the direction of the underlying security),
speculators can use derivatives to place bets on the
volatility of the underlying security. This
technique is commonly used when speculating with traded options. Speculative
trading in derivatives gained a great deal of notoriety in 1995 when
Nick Leeson, a trader at
Barings Bank, made poor and unauthorized
investments in index futures. Through a combination of poor judgement on his
part, lack of oversight by management, a naive regulatory environment and
unfortunate outside events like the
Kobe earthquake, Leeson incurred a $1.3
billion loss that bankrupted the centuries-old financial institution.
For technical details see the
following book:
Structured Finance and Collateralized Debt Obligations: New Developments in
Cash and Synthetic Securitization (Wiley Finance) by Janet M. Tavakoli
(2008)
Complexities in the Definition of a Derivative Financial Instrument
December 3, 2008 message from David Albrecht
[albrecht@PROFALBRECHT.COM]
Derivatives are contracts to be settled in the
future. They have to be based on an asset, an index or a debt security.
Derivative contracts can be entered into for
hedging purposes or speculative purposes
In the game of monopoly, there are several
instances when there is a need for hedging (also known as insurance).
Frequently, players need to go to jail. The
penalties for going to jail are (1) payment of $50 for getting out of
jail, and (2) payment of any rent on the first turn when emerging from
jail. A trip around the board (40 squares) takes about 5 turns. I have
no idea, over the long run, what is your chance of going to jail at
least once during a trip around the board. My uninformed guess is that
20% of the time you travel around the board you will end up in jail.
Early in the game, before there is much
development of houses and hotels, your cost for going to jail is most
likely only going to be $50. You may pay that immediately in cash, or
you can attempt to roll doubles (a very bad strategy). All books on
strategy for the game of Monopoly recommend paying the $50 and getting
out of jail as quickly as possible if there are still unpurchased
properties available.
I think the expected value or cost of going to
jail in such circumstance is $10. Sometimes you are lucky and never go
to jail, sometimes you are unlucky and go to jail a lot.
Later on in a game when an opponent has built
hotels on St. James, Tennessee and New York (with rents of 900, 900 and
1,000), the cost of going to jail significantly increases when you
consider that eventually you must exit jail and pay rent on any square
upon which you land. For example, your odds of avoiding landing any
orange property are about 65%. It's the 35% that is the killer.
I think that as a sideline, a player could
offer "going to jail"
insurance every time someone reaches Go and
starts a new trip around the board.
As I read the literature on derivatives and
accounting for derivatives, it seems to me that both sides of the
contract qualify as derivatives and therefore need to be accounted for
if each token is an SEC reporting token. The token purchasing the
insurance is hedging, and the token offering the insurance is
speculating. Do I have this right? If an accounting period ends while an
insured token still has a reasonable probability of getting sent to
jail, then the derivative contract must be valued at some estimate of
fair value. Again, do I have this right?
It also seems to me that depending on whether
you are ahead or behind in a game, you might very well wish to offer and
sell to other players an opportunity to make a pre-payment in exchange
for a certain percentage of rent every time someone lands on your house
or hotel, or you might wish to buy into such into either such
arrangement. Aren't both sides of this contract for speculative
purposes? On the other hand, you might want to offer rent discounts that
expire after going around the board once. Again, wouldn't this be
hedging for the party that purchases a rent discount and for speculation
for the party that sells it?
I think also, that options can be built into a
game of monopoly. For example, upon acquiring the final piece of
property that creates a color group monopoly and before making any sort
of building plans, you could offer opponents an option to pay future
rents at a fixed level. Of course, if you don't build enough houses or a
hotel, then the option would not be exercises by the purchasing
opponent, but it would be exercises if you had built enough houses or
hotels.
Of course, all sorts of speculative contracts
could be entered into. For example, you might bet with opponent B that
opponent C will go bankrupt on the current trip around the board. Isn't
this also a derivative contract? It is entered into for speculative
purposes, I presume. Another example would be to speculate (bet) on
whether or not earnings reach a certain dollar amount for the coming
accounting period.
Are there any
December 3m 2008 reply from Bob Jensen
Hi David,
I’ve never heard of
a derivative contract on the net earnings of a company as a whole. The
definition of “net earnings” is generally too complicated and subject to
too many contingencies to get counterparties to agree on such complex
contracts. I don’t think a net earnings hedge of an entire company would
even be eligible for hedge accounting under either the FAS 133 or the
IAS 39 standard.
It is possible to
lock in a profit on a contracted commodity notional by hedging both the
future purchase price and the future selling price in separate
derivative contracts, but this is not the same as net earnings of an
entire firm. More commonly the firm already has a position (even
ownership of the notional itself) and is locking in a profit on a
specific amount of notional.
Derivative contracts
are written on more precise notionals and underlyings such as the price
of a commodity or the default of a debt payment.
You should probably
make your definition of derivatives more precise by defining a notional,
underlying (index), and net settlement (required in FAS 133 for hedge
accounting but not in IAS 39).
The Monopoly Game
could add buying properties with credit (even with accelerated subprime
mortgages) and credit derivative swaps (CDSs). It might also be a way of
adding Black Swan Theory. But the game would probably become too
complicated even for geeks.
What distinguishes
credit derivatives from commodity derivatives is the possibility that
the entire notional may be lost in a credit derivative and the virtual
impossibility that the notional may be lost in a commodity derivative
--- unless the spot price of a commodity like corn, wheat, copper, and
oil drops to zero which is not likely even under the Black Swan Theory.
When Investor I
enters into 40 corn futures contracts with Farmer F, most contracts are
traded with a "net settlement clause" such the notional value of 100,000
bushels of corn "net settles" is never at risk. At settlement time,
Farmer F and Investor I net settle on only the difference between the
current spot price and the contracted future (strike) price. The corn
itself never changes hands in a physical sense in futures markets. If
Investor I really wants corn, he can then buy it at the spot price in
the corn market even though his net price depends how he net settled his
futures contracts in the futures market.
Put more simply,
there are no black swans in most commodity derivative trades, but there
may be black swans in credit derivative trades ---
http://en.wikipedia.org/wiki/Black_swan_theory
There are also quite a few YouTube videos on the Black Swan Theory.
To distinguish
traditional financial securities from derivative financial securities
for my students, I always compared bond sales (financial securities
sales where the notional changes hands on the date of the sale) with
interest rate swaps (derivative financial securities where the notional
changes hands).
When Investor I buys
a bond for a $1 million notional from Debtor D, the risk of repayment is
transferred from I to D the instant the $1 million is transferred to D.
When A and B enter
into an interest rate swap on a $1 million notional, the notional
never changes hands such that the notional itself is never at risk.
Net settlement (usually quarterly throughout the life of the swap) is
based on the difference between the spot rate of interest and the
contracted forward rate. This makes such swaps ideal hedges to convert
variable rate bonds to fixed rate risk and vice versa.
Credit derivative
swaps are not interest rate swaps, and the notional of a credit
derivative swap may be at risk if value of the notional itself drops to
zero --- that black swan.
If you are going to
teach derivatives, the following distinctions between the FAS 133 and
IAS 39 standards should be emphasized, although don't make too much of
the fact that the IAS 39 definition does not require net settlement for
hedge accounting. Most derivatives encountered when applying IAS 39 will
net settle.
*****************************
The terminology related to IAS 39 is very
complicated. Bob Jensen maintains an extensive online glossary of FAS
133 and IAS 39 terminology.
Entries related to IAS 39 are boxed in green, and entries related to DIG
implementation guidelines are blocked in red.
Paragraph 9 of IAS 39 reads, in part, as
follows:
The following
terms are used in this Standard with the meanings specified:
Definition of a derivative |
A
derivative is a financial instrument or other contract
within the scope of this Standard (see Paragraphs 2–7) with all
three of the following characteristics:
(a)
its value changes in response to the change in a specified
interest rate, financial instrument price, commodity price,
foreign exchange rate, index of prices or rates, credit rating
or credit index, or other variable, provided in the case of a
non-financial variable that the variable is not specific to a
party to the contract (sometimes called the 'underlying');
(b)
it requires no initial net investment or an initial net
investment that is smaller than would be required for other
types of contracts that would be expected to have a similar
response to changes in market factors; and
(c)
it is settled at a future date.
|
Later on this definition is elaborated in the
following IAS 39 paragraphs:
AG9 Typical
examples of derivatives are futures and forward, swap and option
contracts. A derivative usually has a notional amount, which is
an amount of currency, a number of shares, a number of units of
weight or volume or other units specified in the contract.
However, a derivative instrument does not require the holder or
writer to invest or receive the notional amount at the inception
of the contract. Alternatively, a derivative could require a
fixed payment or payment of an amount that can change (but not
proportionally with a change in the underlying) as a result of
some future event that is unrelated to a notional amount. For
example, a contract may require a fixed payment of CU1,000 if
six-month LIBOR increases by 100 basis points. Such a contract
is a derivative even though a notional amount is not specified.
AG10 The definition of a
derivative in this Standard includes contracts that are settled
gross by delivery of the underlying item (eg a forward contract
to purchase a fixed rate debt instrument). An entity may have a
contract to buy or sell a non-financial item that can be settled
net in cash or another financial instrument or by exchanging
financial instruments (eg a contract to buy or sell a commodity
at a fixed price at a future date). Such a contract is within
the scope of this Standard unless it was entered into and
continues to be held for the purpose of delivery of a
non-financial item in accordance with the entity's expected
purchase, sale or usage requirements (see Paragraphs 5–7).
AG11 One of the defining
characteristics of a derivative is that it has an initial net
investment that is smaller than would be required for other
types of contracts that would be expected to have a similar
response to changes in market factors. An option contract meets
that definition because the premium is less than the investment
that would be required to obtain the underlying financial
instrument to which the option is linked. A currency swap that
requires an initial exchange of different currencies of equal
fair values meets the definition because it has a zero initial
net investment.
AG12 A regular way purchase
or sale gives rise to a fixed price commitment between trade
date and settlement date that meets the definition of a
derivative. However, because of the short duration of the
commitment it is not recognised as a derivative financial
instrument. Rather, this Standard provides for special
accounting for such regular way contracts (see Paragraphs 38 and
AG53–AG56).
AG12A The definition of a derivative refers
to non-financial variables that are not specific to a party to
the contract. These include an index of earthquake losses in a
particular region and an index of temperatures in a particular
city. Non-financial variables specific to a party to the
contract include the occurrence or non-occurrence of a fire that
damages or destroys an asset of a party to the contract. A
change in the fair value of a non-financial asset is specific to
the owner if the fair value reflects not only changes in market
prices for such assets (a financial variable) but also the
condition of the specific non-financial asset held (a
non-financial variable). For example, if a guarantee of the
residual value of a specific car exposes the guarantor to the
risk of changes in the car's physical condition, the change in
that residual value is specific to the owner of the car.[2]
|
The above definition differs somewhat from the definition of a
derivative financial instrument scoped into FAS 133. The key difference
is in the concept of “net settlement.”
Definitions of derivatives
- IAS 39:
Does not define “net settlement” as being required to be scoped into
IAS 39 as a derivative such as when interest rate swap payments and
receipts are not net settled into a single payment.
- FAS 133:
Net settlement is an explicit requirement to be scoped into FAS 133
as a derivative financial instrument.
Implications: This is not a major difference since IAS 39 scoped out
most of what is not net settled such as Normal Purchases and Normal
Sales (NPNS) and other instances where physical delivery transpires in
commodities rather than cash settlements. Also IAS 39 applies net
settlement as a criterion in scoping a loan commitment into IAS 39.
And in B2 of IAS 39 we find the following
examples of derivatives and examples of derivatives that are not scoped
into IAS 39:
Type of
contract |
Main
pricing-settlement variable (underlying variable) |
Interest rate
swap |
Interest
rates |
Currency swap
(foreign exchange swap) |
Currency
rates |
Commodity
swap |
Commodity
prices |
Equity swap |
Equity prices
(equity of another entity) |
Credit swap |
Credit
rating, credit index or credit price |
Total return
swap |
Total fair
value of the reference asset and interest rates |
Purchased or
written treasury bond option (call or put) |
Interest
rates |
Purchased or
written currency option (call or put) |
Currency
rates |
Purchased or
written commodity option (call or put) |
Commodity
prices |
Purchased or
written stock option (call or put) |
Equity prices
(equity of another entity) |
Interest rate
futures linked to government debt (treasury futures) |
Interest
rates |
Currency
futures |
Currency
rates |
Commodity
futures |
Commodity
prices |
Interest rate
forward linked to government debt (treasury forward) |
Interest
rates |
Currency
forward |
Currency
rates |
Commodity
forward |
Commodity
prices |
Equity
forward |
Equity prices
(equity of another entity) |
The above list is not exhaustive. Any
contract that has an underlying may be a derivative. Weather derivatives
cannot get hedge accounting under FAS 133. They were excluded in the
original version of IAS 39, but an amendment in 2003 made it possible to
get hedge accounting treatment if hedged item does not fall under other
IFRS 4. The above list provides examples of contracts that normally
qualify as derivatives under IAS 39. Moreover, even if an instrument
meets the definition of a derivative contract, special provisions of IAS
39 may apply, for example, if it is a weather derivative (see IAS
39.AG1), a contract to buy or sell a non-financial item such as
commodity (see IAS 39.5 and IAS 39.AG10) or a contract settled in an
entity's own shares (see IAS 32.21–IAS 32.24). Therefore, an entity must
evaluate the contract to determine whether the other characteristics of
a derivative are present and whether special provisions apply.[4]
Share-based employee compensation such as
employee stock options (ESOs) is not scoped into either IAS 39 or FAS
133. Such compensation contracts are scoped in IFRS 2 and IAS 123(R).
A loan obligation is a contract to make or
receive a loan in the future. If it is a firm commitment in the sense of
a specified rate of interest, its accounting depends a great deal
whether or not the loan commitment will net settle due to changes in
market rates of interest. FAS 133 is very clear that loan commitments
that do not net settle are not required to be booked as derivative
financial instruments, although certain problems of conflict between FAS
133 versus FAS 65 had to be resolved in Paragraphs A26-A33 if FAS 149.
Loan commitments that net settle were more
of a problem in IAS 39 since net settlement is not required in the IAS
39 definition of a derivative. However, IAS 39 added a net settlement
condition for loan commitments as follows:
BC15
Loan commitments are firm commitments to provide credit under
pre-specified terms and conditions. In the IAS 39 implementation
guidance process, the question was raised whether a bank's loan
commitments are derivatives accounted for at fair value under
IAS 39. This question arises because a commitment to make a loan
at a specified rate of interest during a fixed period of time
meets the definition of a derivative. In effect, it is a written
option for the potential borrower to obtain a loan at a
specified rate.
BC16 To
simplify the accounting for holders and issuers of loan
commitments, the Board decided to exclude particular loan
commitments from the scope of IAS 39. The effect of the
exclusion is that an entity will not recognise and measure
changes in fair value of these loan commitments that result from
changes in market interest rates or credit spreads. This is
consistent with the measurement of the loan that results if the
holder of the loan commitment exercises its right to obtain
financing, because changes in market interest rates do not
affect the measurement of an asset measured at amortised cost
(assuming it is not designated in a category other than loans
and receivables).
BC17
However, the Board decided that an entity should be permitted to
measure a loan commitment at fair value with changes in fair
value recognised in profit or loss on the basis of designation
at inception of the loan commitment as a financial liability
through profit or loss. This may be appropriate, for example, if
the entity manages risk exposures related to loan commitments on
a fair value basis.
BC18
The Board further decided that a loan commitment should be
excluded from the scope of IAS 39 only if it cannot be settled
net. If the value of a loan commitment can be settled net in
cash or another financial instrument, including when the entity
has a past practice of selling the resulting loan assets shortly
after origination, it is difficult to justify its exclusion from
the requirement in IAS 39 to measure at fair value similar
instruments that meet the definition of a derivative.
BC19
Some comments received on the Exposure Draft disagreed with the
Board's proposal that an entity that has a past practice of
selling the assets resulting from its loan commitments shortly
after origination should apply IAS 39 to all of its loan
commitments. The Board considered this concern and agreed that
the words in the Exposure Draft did not reflect the Board's
intention. Thus, the Board clarified that if an entity has a
past practice of selling the assets resulting from its loan
commitments shortly after origination, it applies IAS 39 only to
its loan commitments in the same class.
BC20
Finally, the Board decided that commitments to provide a loan at
a below-market interest rate should be initially measured at
fair value, and subsequently measured at the higher of (a) the
amount that would be recognised under IAS 37 and (b) the amount
initially recognised less, where appropriate, cumulative
amortisation recognised in accordance with IAS 18 Revenue.
It noted that without such a requirement, liabilities that
result from such commitments might not be recognised in the
balance sheet, because in many cases no cash consideration is
received.
BC20A As
discussed in paragraphs BC21–BC23E, the Board amended IAS 39 in
2005 to address financial guarantee contracts. In making those
amendments, the Board moved the material on loan commitments
from the scope section of the Standard to the section on
subsequent measurement (Paragraph 47(d)). The purpose of this
change was to rationalise the presentation of this material
without making substantive changes.
|
Paragraph BC18
above especially brings IAS 39 closer to FAS 133 with respect to the net
settlement criterion for loan commitments to be derivatives. Paragraph 4
of IAS 39 notes that installment payments are not the same as net
settlements.
If a loan commitment with a locked in rate
of interest net settles and is booked as a derivative financial
instrument, a hedge of this loan commitment cannot get hedge accounting.
However, if the loan commitment does not net settle and is not booked,
then the question of hedge accounting depends upon how the loan
eventually will be carried when it is transacted and booked. If it will
be carried at fair value, then hedge accounting is not allowed for any
derivative that hedges this unbooked loan commitment. If the loan will
be carried at amortized cost, however, fair value hedge accounting is
available for the hedging derivative just as it is for a purchase
commitment of inventory and fixed assets. Cash flow hedging makes no
sense since there is no cash flow risk on a loan commitment that has a
contracted interest rate.
In matters of valuing loan commitments at
fair value, if they meet the net settlement condition of a derivative
and are booked at fair value, a question arises as to fair value
measurement when future servicing rights are embedded in the value of
the loan as is the case for most mortgage loans. A key paragraph of the
SEC’s SAB 105 reads as follows:
Facts:
Bank A enters into a loan commitment with a customer to
originate a mortgage loan at a specified rate. As part of this
written loan commitment, Bank A expects to receive future net
cash flows related to servicing rights from servicing fees
(included in the loan's interest rate or otherwise), late
charges, and other ancillary sources, or from selling the
servicing rights to a third party. If Bank A intends to sell the
mortgage loan after it is funded, pursuant to paragraph 6 of
FASB Statement No. 133, Accounting for Derivative Instruments
and Hedging Activities, as amended by FASB Statement No.
149, Amendment of Statement 133 on Derivative Instruments and
Hedging Activities ("Statement 133"), the written loan
commitment is accounted for as a derivative instrument and
recorded at fair value through earnings (referred to hereafter
as a "derivative loan commitment"). If Bank A does not intend to
sell the mortgage loan after it is funded, the written loan
commitment is not accounted for as a derivative under Statement
133. However, paragraph 7(c) of FASB Statement No. 159, The
Fair Value Option for Financial Assets and Financial Liabilities
("Statement 159"), permits Bank A to record the written loan
commitment at fair value through earnings (referred to hereafter
as a "written loan commitment"). Pursuant to Statement 159, the
fair value measurement for a written loan commitment would
include the expected net future cash flows related to the
associated servicing of the loan.
|
In summary, the
loan commitment must in some instances be booked at fair value and in
other instances it may be booked at fair value under the Fair Value
Option (FVO) in FAS 159. However, FAS 159 makes fair value booking
optional when it is not required under SAB 105, FAS 133, and FAS 149. If
the loan commitment is not booked, the accounting for it would be much
like the accounting for unbooked purchase/sale contracts illustrated by
Bob Jensen.
Additional Considerations
PwC in Comperio
makes the following observation:
SEC Staff Accounting Bulletin
105,
Application of Accounting Principles to Loan Commitments (SAB
105), specifies that in estimating the fair value of loan
commitments that are subject to FAS 133, an entity should
exclude from its calculation the expected future cash flows
related to the associated servicing of the loan. It is unclear
whether the guidance in SAB 105 would also apply to loan
commitments that are not subject to FAS 133 but are eligible for
the FVO under FAS 159. The SEC Staff has requested that an
industry group led by the Mortgage Bankers Association assist in
resolving this issue |
Also consider DIG Issue No. C-13 as amended
by FAS 149. Pursuant to FAS 156, a mortgage banking enterprise may elect
to subsequently measure (BOOKED) servicing assets and servicing
liabilities at fair value with changes in fair value reported in the
period in which they occur. By electing the Fair Value Measurement
Method, the mortgage banking enterprise may simplify its objective for
hedge accounting because the Fair Value Measurement Method requires
income statement recognition of the changes in fair value of those
servicing assets and servicing liabilities, which will potentially
offset the changes in fair value of the derivative instruments in the
same accounting period without designating formal FAS 133 hedging
relationships. The FASB’s Accounting
Standards Codification online database provides useful information
regarding recognition of derivatives. Derecognition of derivatives is
also discussed.
There are occasional differences between IAS
39 and FAS 133 in terms of what types of contracts must be booked as
derivative financial instruments. Some examples of differences and
similarities are listed below:
1.
FAS 133 requires that a
derivative contract have at least one specified notional. IAS 39 makes
some exceptions such as the exception illustrated in AG1 above. However,
in nearly all cases derivatives have at least one specified notional
upon which settlements are based. Paragraph B8 of IAS 39 also allows the
notional to be variable in the case of foreign exchange (FX) hedging and
illustrates this with a derivative settlement based on sales volume.
2.
FAS 133 requires that contract
payments be net settled with only the difference between what is owed
being transmitted in cash. For example, in an interest rate swap, FAS
133 requires that the swap receivable be netted against the swap payable
on each settlement date with only the net difference actually being
transmitted. Paragraph B3 of IAS 39 allows that gross payments be
swapped. There are, however, no cross payments of the notionals
themselves used in calculating the interest payments. The net versus
gross settlement differences in the two standards is generally not very
important. If a derivative is likely to entail physical delivery in
place of cash settlement, it is not scoped into either FAS 133 or IAS
39.
3.
Both standards specify no
initial investment or a very small investment (usually called a premium)
that is nowhere close to the value of the notional of the contract. This
is a main difference between a financial instrument (such as a bond or a
purchase/sale contract) and a derivative financial instrument. The usual
example of a small investment is the premium that is paid by the
purchaser of an option to the writer (seller) of the option, although
there can also be small premiums on other contracts such as interest
rate swaps. Most forward, futures, and swap contracts have no initial
investment and the risks involved are usually much less than the full
value of the entire notional. IAS 39 allows interest rate swap payments
to be prepaid without affecting the “no initial investment” constraint.
Like FAS 133, IAS 39 does not allow for prepayments at the full notional
value of a forward contract.
4.
IAS 39 Paragraph B18 (g)
allows some leeway as to whether companies want to account for credit
default swaps as insurance contracts or derivative financial
instruments. FAS 133 in general is more specific as to what is to be
accounted for as insurance by standards other than FAS 133 relative to
discretion permitted under IAS 39 for insurance-like derivatives.
Although various international standards cover some aspects of
insurance, IFRS 4 is the main standard for insurance accounting
guidelines.
*****************************
[2]
Extracted from IAS 39, Financial Instruments: Recognition and
Measurement. © IASC Foundation.
[4]
Extracted from IAS 39, Guidance on Implementing. © IASC
Foundation.
Bob Jensen
Mr. Buffett, who
has interests in both companies, claimed there was another agenda
(aside from hedging with derivatives). “The
reason many of them do it (invest in derivative contracts)
is that they want to smooth earnings,” he said,
referring to the idea of trying to make quarterly numbers less volatile.
“And I’m not saying there’s anything wrong with that, but that is the
motivation.”
"Derivatives, as Accused by Buffett," by Andrew Ross Sorkin,
The New York Times, March 14, 2011 ---
http://dealbook.nytimes.com/2011/03/14/derivatives-as-accused-by-buffett/?ref=business
Mr. Buffett once
described derivatives as “financial weapons of mass destruction.” Yet
some of his most ardent fans have quietly raised eyebrows at his
pontifications, given that he plays in the opaque market. In the fourth
quarter alone, Berkshire made $222 million on derivatives. TheStreet.com
published a column last spring with the headline: “Warren Buffett Is a
Hypocrite.”
¶His comments, which
were released last month by the financial crisis commission, come as the
government is writing rules for derivatives as part of the Dodd-Frank
financial regulatory overhaul. And the statements could influence the
debate.
¶Mr. Buffett appeared to
backpedal from his oft-quoted line, explaining: “I don’t think they’re
evil per se. It’s just, they, I mean there’s nothing wrong with having a
futures contract or something of the sort. But they do let people engage
in massive mischief.”
¶The problems arise, Mr.
Buffett said, when a bank’s exposure to derivatives balloons to grand
proportions and uninformed investors start using them.
¶It “doesn’t make much
difference if it’s, you know, one guy rolling dice against another, and
they’re doing $5 a throw. But it makes a lot of difference when you get
into big numbers.”
¶What worries him most
is the big financial institutions that have millions of contracts. “If I
look at JPMorgan, I see two trillion in receivables, two trillion in
payables, a trillion and seven netted off on each side and $300 billion
remaining, maybe $200 billion collateralized,” he said, walking through
his thinking. “That’s all fine. But I don’t know what discontinuities
are going to do to those numbers overnight if there’s a major nuclear,
chemical or biological terrorist action that really is disruptive to the
whole financial system.”
¶“Who the hell knows
what happens to those numbers?” he asked. “I think it’s virtually
unmanageable.”
¶Mr. Buffett defended
Berkshire Hathaway’s use of derivatives, arguing that the company
maintains a limited amount. At the time of the interview, the company
had only about 250 derivative contracts. (It’s now down to 203.) “I want
to know every contract, and I can do that with the way we’ve done it.
But I can’t do it with 23,000 that a bunch of traders are putting on.”
¶He noted that when
Berkshire bought General Re in 1998, the reinsurance company had 23,000
derivative contracts. “I could have hired 15 of the smartest people, you
know, math majors, Ph.D.’s. I could have given them carte blanche to
devise any reporting system that would enable me to get my mind around
what exposure that I had, and it wouldn’t have worked,” he said to the
government panel. “Can you imagine 23,000 contracts with 900
institutions all over the world with probably 200 of them names I can’t
pronounce?” Berkshire decided to unwind the derivative deals, incurring
some $400 million in losses.
¶Mr. Buffett said he
used derivatives to capitalize on discrepancies in the market. (That’s
what other investors must think they are doing — just not as
successfully.)
¶Perhaps the most
insightful nugget in the interview was Mr. Buffett’s explanation of why
corporations use derivatives — and why they probably shouldn’t.
¶Many companies, as
diverse as Coca-Cola and Burlington Northern, argue that they employ
derivatives to hedge their risk.
¶The United States-based
Coca-Cola tries to protect against fluctuations in currencies since it
does business around the world. Burlington Northern, the railroad giant,
uses the investments to limit the effect of fuel prices.
¶Mr. Buffett, who has
interests in both companies, claimed there was another agenda. “The
reason many of them do it is that they want to smooth earnings,” he
said, referring to the idea of trying to make quarterly numbers less
volatile. “And I’m not saying there’s anything wrong with that, but that
is the motivation.”
¶The numbers all even
out eventually, he cautioned, so derivatives don’t really make much
difference in the long term.
¶“They’re going to lose
as much on the diesel fuel contracts over time as they make,” he said of
Burlington Northern. “I wouldn’t do it.”
Continued in article
Bob Jensen's threads on creative
accounting, smoothing, and earnings management ---
http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation
Bob Jensen's tutorials on accounting for
derivative financial instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Free derivative financial
instruments document from Ira Kawaller ---
http://www.kawaller.com/
"10 Tenets of Derivatives" (loads
very slow) ---
http://www.kawaller.com/pdf/AFP_10Tenets.pdf
Bob Jensen's tutorials on
accounting for derivative financial instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Paragraph 6 of FAS 133 reads as follows:
. A derivative instrument is a financial instrument
or other contract with all three of the following characteristics:
a. It has (1) one or more underlyings
and (2) one or more notional amounts \3/
or payment provisions or both. Those terms determine the amount of the
settlement or
settlements, and, in some cases, whether or not a settlement is
required. \4/
==========================================================================
\3/ Sometimes other names are used. For example, the
notional amount is called a face amount in some contracts.
\4/ The terms underlying, notional amount, payment
provision, and settlement are intended to include the
plural forms in the remainder of this Statement. Including both the
singular and plural forms used in this paragraph is more accurate but
much more awkward and impairs the readability.
==========================================================================
b. It requires no initial net investment or an initial net investment
that is smaller than would be required for other
types of contracts that would be expected to have a similar response
to changes in market factors.
c. Its terms require or permit net settlement, it can readily be
settled net by a means outside the contract, or it provides for
delivery of an asset that puts the recipient
in a position not substantially different from net settlement.
|
Most derivatives like forward, futures, and swap contracts are acquired at
zero cost such that historical cost accounting is meaningless. The
exception is a purchased/written option where a small premium is paid/received
to buy/sell the option. Thus if the derivative financial instrument
contract is defaulted a few minutes after being transacted there are generally
zero or very small damages. Such is not the case with traditional
non-derivative financial instruments like bonds where the entire notional
amounts (thousands or millions of dollars) change hands initially such that
enormous damages are possible immediately after the notional amounts change
hands. In the case of of a derivative contract, the notional does not
change hands. It is only used to compute a contracted payment such as a
swap payment.
For example, in the year 2004 Wells Fargo Bank sold $63 million in bonds
with an interest rate "derived" from the price of a casino's common
stock price. The interest payments are "derivatives" in one
sense, but the bonds are not derivative financial instruments scoped into FAS
133 due to Condition b in Paragraph 6 quoted above. In the case of
bonds, the bond holders made a $63 million initial investment of the entire
notional amount. If Wells Fargo also entered into an interest rate swap
to lock in a fixed interest rate, the swap contract would be a derivative
financial instrument subject to FAS 133. However, the bonds are not
derivative financial instruments under FAS 133 definitions.
"What Goes On in Vegas Reaches Wall Street: Wells Fargo Sets
Derivatives On Stations Casinos Inc. With $63 Million Bond Offering," by
Joseph T. Hallinan, The Wall Street Journal, June 11, 2004, Page C1
---
Talk about leveraging your bets: Would
you believe a bond whose value is tied to the stock performance of a casino?
In the increasingly complicated world
of financial derivatives, Wells
Fargo & Co. has come up with just such a wrinkle. The San Francisco
bank has issued $63 million in 10-year notes whose return will be determined
not by the actions of Alan Greenspan or the price of Treasury bills but by the
stock price of a Las Vegas casino operator, Station
Casinos Inc. (which isn't involved in issuing the derivatives).
For Wells, which has reported
consistently strong growth in recent years, it means cheap money. Initially,
the bank will pay holders of the note interest at a rate of just 0.25%
annually. Over time, the holders may get more money, depending on the
performance of the stock. So far this year, Station shares have soared about
60%. At 4 p.m. yesterday, Station was down five cents to $48.95 in New York
Stock Exchange composite trading.
Wells said it crafted the unusual deal
after one of its customers -- an institutional investor it declines to name --
approached the bank. The investor wanted exposure to Station's stock without
actually owning it, says Nino S. Fanlo, Wells's treasurer.
The notes are callable by Wells after
three years. When the bonds are cashed, holders may receive 17.6 times the
closing price of the stock, or, if the stock price falls, they are guaranteed
a return of principal. The notes may be resold to other investors. Banks and
others previously have issued notes tied to a stock index or to a basket of
stocks. But the Wells Fargo notes, registered with the Securities and Exchange
Commission, are considered unusual. Wells says this is the first time it has
issued a note tied to the performance of a single stock
Continued in the article
Bob Jensen's threads on accounting for derivative financial instruments
are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
|
Derivative
Financial Instruments Frauds ---
http://faculty.trinity.edu/rjensen/fraud.htm
To understand more about derivative
financial instruments, I suggest that you begin by going to the file at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Especially note the discussion of the shortcut method at the end of the above
document.
The earliest
records of transactions that had features of derivative securities occur around
2000 BC in the Middle East. (Page 338)
Geoffrey Poitras, The Early History of Financial Economics 1478-1776 (Chelten,
UK: Edward Elgar)
http://faculty.trinity.edu/rjensen/book01q3.htm#Poitras
During the Greek and Roman civilizations,
transactions involving elements of derivative securities contracts had evolved
considerably from the sale for consignment process. Markets had been
formalized to the point of having a fixed time and place for trading together
with common barter rules and currency systems. These early markets did
exhibit a practice of contracting for future delivery. (Page 338)
Ibid
Like forward contracts, the use of options contracts
or "privileges" has a long history. (Page 339)
Ibid
The heuristics of an options transaction involves
the payment of a premium to acquire a right to complete a specific trade at a
later date. These types of transactions appear not only in early
commercial activity but also in other areas. For example, an interesting
ancient reference to (sic) options-like transactions can be found in Genesis 29
of the Bible where Laban offers Jacob an option to marry his youngest
daughter Rachel in exchange for seven years labour. (Page 339)
Ibid
What is surprising is that it took over 4000 years
(Until FAS 133 in June of 1998) to finally requiring the booking of
derivatives into the ledger. However, Laban's contract falls outside the
scope of FAS 133 if Rachel cannot readily be converted into cash.
Bob Jensen at http://www.cs.trinity.edu/~rjensen/000overview/mp3/133intro.htm
Derivative financial instruments accounting became a priority
of the SEC, IASC, and FASB after the scandals of the early 1990s. See
"Derivatives Revisited," by Ed McCarthy, Journal of Accountancy, May
2000, pp. 35-43. The online version is at http://www.aicpa.org/pubs/jofa/may2000/mccarthy.htm
Derivatives
debacles have provided some of the past decade’s most devastating
financial headlines. Names such as Long Term Capital Management, Orange
County and Baring Brothers bring to mind situations where derivatives
failed—often miserably (see exhibit 1, below, for details). Several losses
were enormous—an estimated $2 billion for Orange County and $4 billion for
Long Term Capital. Other incidents resulted in highly publicized lawsuits
between derivatives buyers and sellers, such as Procter & Gamble’s
lengthy dispute with Bankers Trust.
Exhibit
1: Derivatives Losses in the 1990s |
Company/Entity |
Amount
of Loss |
Area
of Loss |
Air
Products |
$113,000,000 |
Leverage
and currency swaps. |
Askin
Securities |
$600,000,000 |
Mortgage-backed
securities. |
Baring
Brothers |
$1,240,500,000 |
Options. |
Cargill
(Minnetonka Fund) |
$100,000,000 |
Mortgage
derivatives. |
Codelco
Chile |
$200,000,000 |
Copper
and precious metals futures and forwards. |
Glaxo
Holdings PLC |
$150,000,000 |
Mortgage
derivatives. |
Long
Term Capital Management |
$4,000,000,000 |
Currency
and interest rate derivatives. |
Metallgesellschaft |
$1,340,000,000 |
Energy
derivatives. |
Orange
County |
$2,000,000,000 |
Reverse
repurchase agreements and leveraged structured notes. |
Proctor
& Gamble |
$157,000,000 |
Leveraged
German marks and U.S. dollars spread. |
Source:
Derivatives: Valuable Tool or Wild Beast? by
Brian Kettel. Copyright © 1999 by Global Treasury News
(www.gtnews.com).
Reprinted with permission. |
|
The
causes of these losses varied. Among those frequently cited were traders
working without adequate supervision, pricing models that failed to account
for extreme market movements and market illiquidity. Although derivatives
abuses have been absent from the headlines lately, some incidents still make
news, such as Sweden’s Electrolux AB’s 1999 loss of more than 55 million
German marks (approximately $28 million) due to an employee’s unauthorized
futures trading.
How
Companies Use Derivatives |
Source: 1999
Survey of OTC Derivatives Use and Risk Management Practices
by the Association for Financial Professionals. Copyright © 1999.
|
To see how banks use/misuse derivatives, see
tranches.
Tutorial: Financial
Derivatives in Plain English --- http://www.iol.ie/~aibtreas/derivs-pe/
There are some good examples of hedging and speculating strategies. I
did not, however, see anything on accounting for derivatives under FAS 133 or
IAS 39.
A nonderivative financial instrument fails one or more of the
above tests to qualify as a derivative in FAS 133. Nonderivatives do not
necessarily have to be adjusted to fair value like derivative
instruments. However, they may be used for economic hedges even though
they do not qualify for special hedge accounting under FAS 133.
Exceptions in FAS 133 that afford special hedge accounting treatment for
nonderivative instruments that hedge foreign currency fair value and/or hedge
foreign currency exposures of net investment in a foreign operation. See
FAS Paragraphs 6c, 17d, 18d, 20c, 28d, 37, 39, 40, 42, 44, 45, 246, 247, 255,
264, 293-304, 476, 477, and 479. Also see foreign
currency hedge.
It is important to note that all derivatives in finance may not fall under
the FAS 133 definition. In FAS 133, a derivative must have a notional,
an underlying, and net
settlement. There are other requirements such as a zero or minimal
initial investment as specified in Paragraph 6b and Appendix A Paragraph 57b
of FAS 133 and Paragraph 10b of IAS 39. Examples of derivatives that
are explicitly excluded are discussed in Paragraph 252 on Page 134 of FAS 133. Paragraph 10c of IAS 39 also addresses net
settlement. IASC does not require a net settlement provision in
the definition of a derivative. To meet the criteria for being a
derivative under FAS 133, there must be a net settlement provision.
For a FAS 133 flow
chart, go to
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
There must also be zero or small net investment to meet the definition of a
derivative financial instrument (FAS 133 Paragraphs 6b and Appendix A
Paragraph 57b. Also see IAS 39 IAS 39: Paragraph
10b)
Avoiding derivative
accounting.
In an example of the legalistic nature of the
accounting rules, Manufacturing could have avoided derivative accounting
entirely if the loan and interest rate cap were structured differently. SFAS 133
excludes from its scope certain interest rate caps, floors, and collars that
cannot be classified as either a derivative or an embedded derivative.
Manufacturing could have embedded the interest rate cap in the loan while
failing to meet the criteria of an embedded derivative.
Robert A. Dyson, "Accounting for
Interest-Bearing Instruments as Derivatives and Hedges," The CPA Journal,
http://www.nysscpa.org/cpajournal/2002/0102/features/f014202.htm
Keeping Up With Financial Instruments Derivatives
In 2000, ISDA filed a letter to the Financial Accounting Standards Board
(FASB) urging changes to FAS 133, its derivatives and hedge accounting standard.
ISDA’s letter urged alterations to six areas of the standard: hedging the
risk-free rate; hedging using purchased options; providing hedge accounting for
foreign currency assets and liabilities; extending the exception for normal
purchase and sales; and central treasury netting. The FASB subsequently rejected
changes to purchased option provisions, conceded some on normal purchases and
sales, extending the exception to contracts that implicitly or explicitly permit
net settlement, declined to amend FAS 133 to facilitate partial term hedging and
agreed to consider changing the restrictions on hedge accounting for foreign
currency.
ISDA ®INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.http://www.isda.org/wwa/Retrospective_2000_Master.pdf
You can read a great deal about energy derivatives in The Derivatives 'Zine
at http://www.margrabe.com/Energy.html
Other topics include the following:
The Derivatives 'Zine by Dr. Risk
THE WILLIAM MARGRABE GROUP, INC., CONSULTING, PRESENTS |
Ask Dr. Risk!
- Free answers: Dr.
Risk promises any correspondent from a business domain with a website
(e.g., Mack@CSFB.com) at least a
five-minute response to your important question, as soon as he has a
free moment, probably within one month.
- Fast answers:
If you absolutely, positively will have to have an answer overnight, set
up your consulting account, ahead of time, with the William Margrabe
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- No answers: LDiablo@hotmail.com,
Chris1492@aol.com, BillyG@MSN.com,
and Desperate@Podunk.edu, etc.
can no longer count on even brief answers, unless their questions are
sufficiently intriguing. Sorry.
A question of sufficiently general
interest to make it into the 'Zine, tends to generate a more
comprehensive response. All questions and answers become the property of The
William Margrabe Group, Inc
The above sources are not much good about accounting for derivatives under
FAS 133, FAS 138, and IAS 39. For that, go to the following source:
http://faculty.trinity.edu/rjensen/caseans/000index.htm
March 20, 2002 Message from Ira
Kawaller
Hi Bob,
I just posted a recently published article on how to satisfy the FAS 133 disclosure requirements for interest rate hedges. Although it was originally published by Bank Asset/Liablility Management (March 2000), the content is
applicable to all firms with interest rate exposures -- not just banks.
If you are interested, it is available at
http://www.kawaller.com/pdf/BALMHedges.pdf
You can also find additional information about derivatives, risk management, and FAS 133 in the various articles posted on the Kawaller & Company website:
http://www.kawaller.com
Please feel free to contact me with any questions, comments, or suggestions.
Ira Kawaller
Kawaller & Company, LLC
kawaller@kawaller.com
(718) 694-6270
DIG FAS 133 Implementation Issue A1
--- http://www.fasb.org/derivatives/
QUESTION
If an entity enters into a forward contract that requires the
purchase of 1 share of an unrelated company’s common stock in 1 year
for $110 (the market forward price) and at inception the entity elects
to prepay the contract pursuant to its terms for $105 (the current
price of the share of common stock), does the contract meet the
criterion in paragraph 6(b) related to initial net investment and
therefore meet the definition of a derivative for that entity? If not,
is there an embedded derivative that warrants separate accounting?
RESPONSE
Paragraph 6(b) of Statement 133 specifies that a derivative
requires either no initial net investment or a smaller initial net
investment than would be required for other types of contracts that
would be expected to have a similar response to changes in market
factors. If no prepayment is made at inception, the contract would
meet the criterion in paragraph 6(b) because it does not require an
initial net investment but, rather, contains an unexercised election
to prepay the contract at inception. Paragraph 8 further clarifies
paragraph 6(b) and states that a derivative instrument does not
require an initial net investment in the contract that is equal to the
notional amount or that is determined by applying the notional amount
to the underlying. If the contract gives the entity the option to
"prepay" the contract at a later date during its one-year
term (at $105 or some other specified amount), exercise of that option
would be accounted for as a loan that is repayable at $110 at the end
of the forward contract’s one-year term.
If instead, the entity elects to prepay the contract at inception
for $105, the contract does not meet the definition of a freestanding
derivative. The initial net investment of $105 is equal to the initial
price of the 1 share of stock being purchased under the contract and
therefore is equal to the investment that would be required for other
types of contracts that would be expected to have a similar response
to changes in market factors. However, the entity must assess whether
that nonderivative instrument contains an embedded derivative that,
pursuant to paragraph 12, requires separate accounting as a
derivative. In this example, the prepaid contract is a hybrid
instrument that is composed of a debt instrument (as the host
contract) and an embedded derivative based on equity prices. The host
contract is a debt instrument because the holder has none of the
rights of a shareholder, such as the ability to vote the shares and
receive distributions to shareholders. (See paragraph 60 of Statement
133.) Unless the hybrid instrument is remeasured at fair value with
changes in value recorded in earnings as they occur, the embedded
derivative must be separated from the host contract because the
economic characteristics and risks of a derivative based on equity
prices are not clearly and closely related to a debt host contract,
and a separate instrument with the same terms as the embedded
derivative would be a derivative subject to the requirements of
Statement 133. |
Also see other DIG issues under net settlement.
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
A derivative is a financial instrument—
(a) - whose value changes in response to the
change in a specified interest rate, security price, commodity price,
foreign exchange rate, index of prices or rates, a credit rating or
credit index, or similar variable (sometimes called the
‘underlying’);
(b) - that requires no initial net investment
or little initial net investment relative to other types of contracts
that have a similar response to changes in market conditions; and
(c) - that is settled at a future date.
|
FAS 133
(a) – same as IAS 39
(b) – same as IAS 39
(c) – FASB definition requires that the terms of the derivative
contract require or permit net settlement.
|
FAS 133 Paragraph 408 reads as follows:
The Board recognizes that entities are commonly
exposed to a variety of risks in the course of their activities, including
interest rate, foreign exchange, market price, credit, liquidity, theft,
weather, health, catastrophe, competitive, and business cycle risks. The Exposure
Draft did not propose detailed guidance on what risks could be
designated as being hedged, other than to note in the basis for conclusions
that special hedge accounting for certain risk management transactions, such
as hedges of strategic risk, would be precluded. In redeliberating the issue
of risk, the Board reaffirmed that hedge
accounting cannot be provided for all possible risks
and decided to be more specific about the risks for which hedge accounting
is available.
Various exceptions are dealt with in Paragraph 58 of FAS 133. For
example, Paragraph 58c reads as follows:
Certain contracts that are not traded on an
exchange. A contract that is not traded on an
exchange is not subject to the requirements of this Statement if the
underlying is:
(1) A climatic or
geological variable or other physical variable.
Climatic, geological, and other physical variables include things like the
number of inches of rainfall or snow in a particular area and the severity
of an earthquake as measured by the Richter scale.
(2) The price or value of (a) a nonfinancial asset
of one of the parties to the contract unless that asset is readily
convertible to cash or (b) a nonfinancial liability of one of the parties to
the contract unless that liability requires delivery of an asset that is
readily convertible to cash.
(3) Specified volumes of sales or service revenues
by one of the parties. That exception is intended to apply to contracts with
settlements based on the volume of items sold or services rendered, for
example, royalty agreements. It is not intended to apply to contracts based
on changes in sales or revenues due to changes in market prices.
If a contract's underlying is the combination of
two or more variables, and one or more would not qualify for one of the
exceptions above, the application of this Statement to that contract depends
on the predominant characteristics of the combined variable. The contract is
subject to the requirements of this Statement if the changes in its combined
underlying are highly correlated with changes in one of the component
variables that would not qualify for an exception.
Also see "regular-way"
security trading exceptions in Paragraph 58a if FAS 133. Also note the exception in DIG
C1. Some general DIG exceptions to the scope of FAS 133 are listed
in the "C" category at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html
A nice review of the theory and application (aside from
accounting) of derivative financial instruments appears in Myron Scholes' Nobel lecture that is reprinted as "Derivatives in a
Dynamic Environment," American Economic Review, June 1998, 350-370.
Types of embedded derivative instruments are often indexed debt and
investment contracts such as commodity indexed interest or
principal payments, convertible debt, credit indexed contracts, equity
indexed contracts, and inflation indexed contracts.
By "indexed" it is meant that an uncertain economic event that is measured by an
economic index (e.g., a credit rating index, commodity price index, convertible
debt, or inflation index) defined in the
contract. An equity index might be defined as a
particular index derived from common stock price movements such as the Dow Industrial
Index or the Standard and Poors 500 Index. Derivative instruments may also be futures contracts, forward
contracts, interest rate swaps, foreign currency derivatives, warrants,
forward rate agreements, basis
swaps, and complex combinations of such contracts such as a circus
combination. Interest rate swaps are the most common form of derivatives
in terms of notional amounts. There are Paragraph 6b initial investment size
limitations discussed under the term premium.
Derivatives that are covered by
FAS 133 accounting rules must remeasured to fair value on each balance sheet date. Paragraph
18 on Page 10 of FAS 133 outlines how to account gains and losses on derivative financial
instruments designated for FAS 133 accounting. See hedge
accounting.
FAS 133
does not change the requirement
banning the netting of assets and liabilities in the balance sheet (statement of financial
position) unless there is a right of setoff. This rule goes back to APB 10, Omnibus
Opinion. Hence the aggregate of positive valued derivative financial
instruments cannot be netted against those with negative values. The only exception
would be when there are contractual rights of offset. FAS 133 is silent as to
whether derivatives expiring in the very near future are cash equivalents in the cash flow
statement. KPMG argues against that in terms of SFAS 95 rules. See Example 6
beginning on Page 347 of of the Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.
FAS 133
requires disclosures of hedging gains
and losses by risk type. Paragraph 45 on beginning on Page 27 does require that
aggregate net amounts be reported by type of hedge. Disclosure by market risk
category is required by the SEC.
In this FAS 133 Glossary, there are added
conditions to become a qualified derivative financial instrument under FAS 133
rules.
In certain instances a nonfinancial derivative will also suffice for accounting
under FAS 133 rules. Unless noted otherwise it will be assumed that such
instruments meet the FAS 133 criteria. The formal definition of a derivative
financial instrument for purposes of FAS 133 is given in Paragraph 249 on Page 133.
Such an instrument must have all three of the following attributes:
a.
It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both.
b.
It requires no initial net investment or an initial net investment that is smaller
than would be required for other types of contracts that would be expected to have a
similar response to changes in market factors.
c.
Its terms require or permit net settlement, it can readily be settled net by means outside the contract, or it provides for
delivery of an asset that puts the recipient in a position not substantially different
from net settlement.
Initial investment is an important criterion for
distinguishing a derivative instrument from a nonderivative instrument. See
Paragraph 6b on Page 3 of FAS 133. Paragraph 256 on Page 135 contains the following
example:
A party that wishes to participate
in the changes in the fair value of 10,000 shares of a specific marketable equity security
can, of course, do so by purchasing 10,000 shares of that security. Alternatively,
the party may enter into a forward purchase contract with a notional amount of 10,000
shares of that security and an underlying that is the price of that security. Purchasing
the shares would require an initial investment equal to the current price for 10,000
shares and would result in benefits such as the receipt of dividends (if any) and the
ability to vote the shares. A simple forward contract entered into at the current forward
price for 10,000 shares of the equity instrument would not require an initial investment
equal to the notional amount but would offer the same opportunity to benefit or lose from
changes in the price of that security.
Paragraph 10c of IAS 39 also addresses net
settlement. IASC does not require a net settlement provision in
the definition of a derivative. To meet the criteria for being a
derivative under FAS 133, there must be a net settlement provision.
In FAS 133, derivative financial instruments
come in three basic types that are listed in Paragraph 4 on Page 2 of FAS 133:
Paragraph 4
on Page 2 of FAS 133.
This Statement standardizes the accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, by requiring that an entity recognize
those items as assets or liabilities in the statement of financial position and measure
them at fair value. If certain conditions are met, an entity may elect to designate a
derivative instrument as follows:
a.
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
or of an unrecognized firm commitment, \2/ that are attributable to a
particular risk (referred to as a fair value hedge)
==========================================================================
Footnote 2
\2/ An unrecognized firm commitment can be viewed as an executory contract that represents
both a right and an obligation. When a previously unrecognized firm commitment that is
designated as a hedged item is accounted for in accordance with this Statement, an asset
or a liability is recognized and reported in the statement of financial position related
to the recognition of the gain or loss on the firm commitment. Consequently, subsequent
references to an asset or a liability in this Statement include a firm commitment.
==========================================================================
b.
A hedge of the exposure to variability in the cash flows of a recognized asset or
liability, or of a forecasted transaction, that is attributable to a particular risk
(referred to as a cash flow hedge)
c.
A hedge of the foreign currency exposure of
(1) an unrecognized firm commitment (a foreign currency fair value hedge), (
(2) an available-for-sale
security (a foreign currency fair value hedge),
(3) a forecasted
transaction (a foreign currency cash flow hedge), or
(4) a net investment in a
foreign operation.
With respect to Section a above, a firm
commitment cannot have a cash flow risk exposure because the gain or loss is already
booked. For example, a contract of 10,000 units per month at $200 per unit is
unrecognized and has a cash flow risk exposure if the payments have
not been made. If the payments have been prepaid, that prepayment is
"recognized" and has no further cash flow risk exposure. The booked firm
commitment, however, can have a fair value risk exposure.
With respect to Section c(1) above, firm
commitments can have foreign currency risk exposures if the commitments are not already
recognized. See Paragraph 4 on Page 2 of FAS 133. If the firm commitment is
recognized, it is by definition booked and its loss or gain is already accounted for. For
example, a purchase contract for 10,000 units per month at 100DM Deutsche Marks per unit
is unrecognized and has a foreign currency risk exposure if the
payments have not been made. If the payments have been prepaid, that prepayment is
"recognized" and has no further foreign currency risk exposure. Similar
reasoning applies to trading securities that are excluded in c(2) above since their gains
and losses are already booked. These gains have been deferred in comprehensive income for available-for-sale securities.
Cash flow hedges must have the possibility
of affecting net earnings. For example, Paragraph 485 on Page 211 of FAS 133
bans
foreign currency risk hedges of forecasted dividends of foreign subsidiary. The
reason is that these dividends are a wash item and do not affect consolidated
earnings. For reasons and references, see equity method.
Section c(4) of Paragraph 4 on Page
2 of FAS 133 makes an exception to Paragraph 29a on Page 20 for portfolios of
dissimilar assets and liabilities. It allows hedging under "net
investment" criteria under Paragraph 20 of SFAS 52. The gain or loss is reported in
other comprehensive income as part of the cumulative
translation adjustment. Reasons are given in Paragraph 477 on Page 208 of FAS 133:
The net investment in a foreign
operation can be viewed as a portfolio of dissimilar assets and liabilities that would not
meet the criterion in this Statement that the hedged item be a single item or a group of
similar items. Alternatively, it can be viewed as part of the fair value of the parent's
investment account. Under either view, without a specific exception, the net investment in
a foreign operation would not qualify for hedging under this Statement. The Board decided,
however, that it was acceptable to retain the current provisions of Statement 52 in that
area. The Board also notes that, unlike other hedges of portfolios of dissimilar items,
hedge accounting for the net investment in a foreign operation has been explicitly
permitted by the authoritative literature.
For a derivative not designated as a hedging instrument,
the gain or loss is recognized in earnings in the period of change. Section 4(c) of
Paragraph 4 of FAS 133 amends SFAS 52 on Foreign Currency Translation, to
permit special accounting for a hedge of a foreign currency forecasted transaction with a
derivative. For more detail see foreign
currency hedge.
Paragraph 42 on Page 26 reads as follows:
.A derivative instrument or a
nonderivative financial instrument that may give rise to a foreign currency transaction
gain or loss under Statement 52 can be designated as hedging the foreign currency exposure
of a net investment in a foreign operation. The gain or loss on a hedging derivative
instrument (or the foreign currency transaction gain or loss on the nonderivative hedging
instrument) that is designated as, and is effective as, an economic hedge of the net
investment in a foreign operation shall be reported in the same manner as a translation
adjustment to the extent it is effective as a hedge. The hedged net investment shall be
accounted for consistent with Statement 52; the provisions of this Statement for
recognizing the gain or loss on assets designated as being hedged in a fair value hedge do
not apply to the hedge of a net investment in a foreign operation. nonderivative financial instrument that may give rise to a foreign currency transaction
gain or loss under Statement 52 can be designated as hedging the foreign currency exposure
of a net investment in a foreign operation. The gain or loss on a hedging derivative
instrument (or the foreign currency transaction gain or loss on the nonderivative hedging
instrument) that is designated as, and is effective as, an economic hedge of the net
investment in a foreign operation shall be reported in the same manner as a translation
adjustment to the extent it is effective as a hedge. The hedged net investment shall be
accounted for consistent with Statement 52; the provisions of this Statement for
recognizing the gain or loss on assets designated as being hedged in a fair value hedge do
not apply to the hedge of a net investment in a foreign operation.
These Section c(4) confusions in
Paragraph 4 are illustrated in Examples 11-13 beginning on Page 270 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP
in July 1998.
A more confusing, at least to me, portion of Paragraph 36
reads as follows:
The criterion in paragraph 21(c)(1)
requires that a recognized asset or liability that may give rise to a foreign currency
transaction gain or loss under Statement 52 (such as a foreign-currency-denominated
receivable or payable) not be the hedged item in a foreign currency fair value or cash
flow hedge because it is remeasured with the changes in the carrying amount attributable
to what would be the hedged risk (an exchange rate change) reported currently in
earnings. Similarly, the criterion in paragraph 29(d) requires that the forecasted
acquisition of an asset or the incurrence of a liability that may give rise to a foreign
currency transaction gain or loss under Statement 52 not be the hedged item in a foreign
currency cash flow hedge because, subsequent to acquisition or incurrence, the asset or
liability will be remeasured with changes in the carrying amount attributable to what
would be the hedged risk reported currently in earnings. A foreign currency derivative
instrument that has been entered into with another member of a consolidated group can be a
hedging instrument in the consolidated financial statements only if that other member has
entered into an offsetting contract with an unrelated third party to hedge the exposure it
acquired from issuing the derivative instrument to the affiliate that initiated the hedge.
Investments accounted for under the equity
method cannot be hedged items under FAS 133 accounting for reasons explained under the
term "equity method." Recall that the
magic percentage of equity ownership is 20% of more. Lower ownership share accounted
for under the cost as opposed to equity method can be hedged.
In summary, the major exceptions
under FAS 133 are discussed in the following FAS 133 Paragraphs:
-
Business combinations APB Opinion No. 16
(FAS 133Paragraph 11c)
-
Shareholders' equity (FAS 133 Paragraph 11a)
-
Leases (FAS 133 Paragraph 10f)
-
Employee benefits (SFAS 123 (Paragraph 11b)
-
Insurance contracts (note exceptions in FAS 133 Paragraph 10c)
-
Financial guarantees (note exceptions in FAS 133 Paragraph 10d)
-
Physical indices (FAS 133 Paragraphs 10e, 58c)
-
Regular-way trades
(FAS 133
Paragraphs 10b, 58b)
Accounting for Executory Contracts Such as Purchase/Sale Commitments and
Loan Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
Exceptions are not as
important in IAS 39, because fair value adjustments are required of all
financial instruments. However, exceptions or special accounting for
derivatives are discussed at various places in IAS 39:
-
Business combinations )IAS
39 Paragraph 1g --- Also note IAS 22 Paragraphs 65-76)
-
Shareholders' equity IAS 39 Paragraph 1e)
-
Leases IAS 39 Paragraph 1b)
-
Employee benefits IAS 39 Paragraph 1c)
-
Insurance contracts IAS 39 Paragraph 1d)
-
Financial guarantees IAS 39 Paragraph 1f)
-
Physical indices (IAS 39 Paragraph 1h)
-
Regular-way trades (Not an
explicit exception in IAS 39)
DIG Issue C1 at http://www.fasb.org/derivatives/
QUESTION
If a contract’s payment provision specifies that the issuer will
pay to the holder $10,000,000 if aggregate property damage from all
hurricanes in the state of Florida exceeds $50,000,000 during the year
2001, is the contract included in the scope of Statement 133?
Alternatively, if the contract specifies that the issuer pays the
holder $10,000,000 in the event that a hurricane occurs in Florida in
2001, is the contract included in the scope of Statement 133?
RESPONSE
If the contract contains a payment provision that requires the
issuer to pay to the holder a specified dollar amount based on a
financial variable, the contract is subject to the requirements of
Statement 133. In the first example above, the payment under the
contract occurs if aggregate property damage from a hurricane in the
state of Florida exceeds $50,000,000 during the year 2001. The
contract in that example contains two underlyings — a physical
variable (that is, the occurrence of at least one hurricane) and a
financial variable (that is, aggregate property damage exceeding a
specified or determinable dollar limit of $50,000,000). Because of the
presence of the financial variable as an underlying, the derivative
contract does not qualify for the scope exclusion in paragraph
10(e)(1) of Statement 133.
In contrast, if the contract contains a payment provision that
requires the issuer to pay to the holder a specified dollar amount
that is linked solely to a climatic or other physical variable
(for example, wind velocity or flood-water level), the contract is not
subject to the requirements of Statement 133. In the second example
above, the payment provision is triggered if a hurricane occurs in
Florida in 2001. The underlying in that example is a physical variable
(that is, occurrence of a hurricane). Therefore, the contract
qualifies for the scope exclusion in paragraph 10(e)(1) of Statement
133.
However, if the contract requires a payment only when the holder
incurs a decline in revenue or an increase in expense as a result of
an event (for example, a hurricane) and the amount of the
payoff is solely compensation for the amount of the holder’s loss,
the contract would be a traditional insurance contract that is
excluded from the scope of Statement 133 under paragraph 10(c). |
For a FAS 133 flow
chart, go to
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
See hedge and financial instrument.
Yahoo
Finance is Bob Jensen's Favorite Place to learn more about the mechanics and widespread
use of derivative financial instruments. That web site, however, will not help
much with respect to accounting for such instruments under FAS 133 and IAS
39. Also see CBOE, CBOT, and CME
for some great tutorials on derivatives investing and hedging.
Message from Ira Kawaller on August 4, 2002
Hi Bob,
I posted a new article on the Kawaller & Company
website: “What’s ‘Normal’ in Derivatives Accounting,” originally
published in Financial Executive, July / August 2002. It is most relevant for
financial managers of non-financial companies, who seek to avoid FAS 133
treatment for their purchase and sales contracts. The point of the article is
that this treatment may mask some pertinent risks and opportunities. To view
the article, click on http://www.kawaller.com/pdf/FE.pdf
.
I'd be happy to hear from you if you have any
questions or comments.
Thanks for your consideration.
Ira Kawaller Kawaller & Company, LLC http://www.kawaller.com
kawaller@kawaller.com 717-694-6270
Bob Jensen's documents on derivative financial instruments are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
|
DIG =
the Derivatives Implementation Group established by the FASB
for purposes of helping firms implement FAS 133.
The web site is a http://www.fasb.org/derivatives/
.
The Derivatives Implementation Group is a task
force that was created to assist the FASB in answering questions that
companies will face when they begin implementing Statement 133, Accounting
for Derivative Instruments and Hedging Activities. The FASB’s objective in
forming the group was to establish a mechanism to identify and resolve
significant implementation questions in advance of the implementation of
Statement 133 by many companies.
The role of the Derivatives Implementation Group is
different from that of other task forces previously assembled by the FASB
because it was established to address issues related to a new Statement that
has not yet been implemented by most companies. The responsibilities of the
Derivatives Implementation Group are to identify practice issues that arise
from applying the requirements of Statement 133 and to advise the FASB on
how to resolve those issues. In addition to members of the implementation
group, any constituent or organization may submit questions to be debated by
the group by sending a detailed letter to the group chairman, FASB Vice
Chairman Jim Leisenring. The FASB staff also seeks input from the
implementation group on selected technical inquiries that it resolves.
The model for the Derivatives Implementation Group
is the Emerging Issues Task Force (EITF) with the key difference being that
the Derivatives Implementation Group does not formally vote on issues to
reach a consensus. Instead, it is the responsibility of the Chairman to
identify an agreed-upon resolution that emerges based upon the group’s
debate. Implementation group members are free submit written objections to
any issue where the group reaches an agreed-upon resolution. In instances
where no clear resolution of an issue emerges, the issue may be further
discussed at a future meeting or handled by the FASB staff.
After each meeting of the Derivatives
Implementation Group, the FASB staff has the responsibility of documenting
tentative conclusions reached by the group. Those tentative conclusions are
publicly available on the FASB web site approximately three weeks after a
meeting of the Derivatives Implementation Group. Those conclusions will
remain tentative until they are formally cleared by the FASB and become part
of an FASB staff implementation guide (Q&A). The Board is typically not
asked to formally clear the staff's tentative conclusions at a public Board
meeting until those conclusions have been publicly available on the web site
for at least one month. That delay provides constituents the opportunity to
study those conclusions and submit any comments before the Board considers
formal clearance.
Meetings of the Derivatives Implementation Group
are held at the FASB offices in Norwalk, CT and are open to public
observation. The group will meet bimonthly during 1998 and 1999 when
companies are planning for transition to the new accounting requirements.
The need for meetings of the group in the year 2000 will be assessed at a
later date.
FAS 133 Derivatives
Implementation Group (DIG) Pronouncements (Issues)
Nearly 300 pages of DIG pronouncements as of March 8,
2004 can be downloaded from http://www.fasb.org/derivatives/allissuesp2.pdf
If you click on menu choices (Edit, Find) or the
binoculars icon in your web browser, you can enter the search term DIG to
find various DIG issues in this glossary. These are in tables with red
borders.
Disclosure =
the disclosures of key information in
footnotes, special schedules, or other parts of financial reports. FAS 133 deals with
disclosure at various points, especially in Paragraphs 502-513 on Pages 216-221. An entity that holds or issues derivative instruments (or nonderivative
instruments that are designated and qualify as hedging instruments pursuant to
/FAS 133 Paragraphs
37 and 42) shall disclose its objectives for holding or issuing those instruments, the
context needed to understand those objectives, and its strategies for achieving those
objectives. The description shall distinguish between derivative instruments (and nonderivative
instruments) designated as fair value hedging instruments, derivative instruments
designated as cash flow hedging instruments, derivative (and nonderivative) instruments
designated as hedging instruments for hedges of the foreign currency exposure of a net
investment in a foreign operation, and all other derivatives
(FAS 133 Paragraph 44)
The following must be disclosed if derivatives are used in hedging
relationships (Paragraph 45)
- Risk management policies must be specified, identifying exposures to be
hedged and hedging strategies for managing the associated risks.
- Identification of the type of hedging relationship (i.e., fair value,
cash flow, net investment in foreign operation), if applicable.
- The hedged item must be explicitly identified.
- Ineffective hedge results must be disclosed.
- Any component of the derivatives' results that is excluded from the
hedge effectiveness assessment must be disclosed.
Specific requirements for fair value hedges (Paragraph 45a)
- The place on the income statement where derivative gains or losses are
reported must be disclosed.
- When a firm commitment no longer qualifies as a hedged item, the net
gain or loss recognized in earnings must be disclosed.
Specific requirements for cash flow hedges (Paragraph 45b)
- A description of the conditions that will result in the reclassification
of accumulated other comprehensive income into earnings, and a schedule of
the estimated reclassification expected in the coming 12 months must be
disclosed.
- The maximum length of time over which hedging is anticipated (except for
variable interest rate exposures) must be disclosed.
- Entities must disclose the amount reclassified into earnings as a result
of discontinued cash flow hedges because the forecasted transaction is no
longer probable.
- Specific requirements for hedges of net investments in foreign
operations (Paragraph 45c)
- Entities must disclose the amount of the derivatives' results that is
included in the cumulative translation adjustment during the reporting
period.
Also see
http://www.cs.trinity.edu/~rjensen/Calgary/CD/fasb/sfas161/
Disclosures about Derivative Instruments and Hedging Activities—an amendment
of FASB Statement No. 133
Bob Jensen's FAS 133 and IAS 39 free tutorials are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's FAS 133 and IAS 39 Glossary is at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Bob Jensen's PowerPoint Show on Derivative Financial Instrument Disclosure
Requirements ---
http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/
Under IASC international disclosure rulings,
financial statements should include all of the disclosures required by IAS
32, except that the requirements in IAS 32 for supplementary disclosure of fair values
(IAS 39 Paragraphs 77 and 88) are not applicable to those financial assets and financial
liabilities carried at fair value (Paragraph 166). The following should be included in the disclosures of the enterprise's accounting
policies as part of the disclosure required by IAS 32 Paragraph 47b:
(1) the methods and significant assumptions applied in estimating fair values of financial
assets and financial liabilities that are carried at fair value, separately for
significant classes of financial assets (see IAS 39 Paragraph 46)
2) whether gains and losses arising from changes in the fair value of those
available-for-sale financial assets that are measured at fair value subsequent to initial
recognition are included in net profit or loss for the period or are recognized directly
in equity until the financial asset is disposed of; and
3) for each of the four categories of financial assets defined in paragraph 10, whether
'regular way' purchases of financial assets are accounted for at trade date or settlement
date (see paragraph 30)
(IAS Paragraph 167)
In applying the above paragraph, an enterprise will disclose prepayment rates,
rates of
estimated credit losses, and interest or discount rates
(paragraph 168)
IAS 39 Paragraph 169
With the exception of the previously noted differences, Paragraph 169 is a
long paragraph that requires virtually all disclosures of FAS 133.
The SEC
has more controversial disclosure requirements for derivatives, especially requirements
for quantification of risk. The required disclosures about accounting policies are
specified in new Rule 4-08(n) of Regulation S-X and Item 310 of Regulation S-B. The
required disclosures about market risk exposures are specified in new Item 305 of
Regulation S-K and Item 9A of Form 20-F. See
http://www.sec.gov/divisions/corpfin/guidance/derivfaq.htm
Some SEC rules, which amend Regulation S-X
and Regulation S-K, require the following new market risk disclosures (unless a business
is deemed a small business not subject to market risk disclosure rules and/or unless the
market risks apply to trade accounts recievable or trade accounts payable):
-
detailed disclosures of registrants' accounting
policies for derivative financial instruments and derivative commodity instruments;
-
quantitative and qualitative disclosures outside
the financial statements about market risk information of derivatives and other financial
instruments. The required information includes the fair values of the instruments and
contract terms needed to determine expected cash flows for each of the next five years and
aggregate cash flows thereafter. This information should be categorized by expected
maturity dates. The information should be grouped based on whether the instruments are
held for trading or for other purposes and summarized by market risk category, subdivided
by specific characteristics within a risk category, such as US dollar/German mark and US
dollar/Japanese yen foreign currency exchange risk. The subdivision based on
characteristics should be made to the extent it better reflects the market risk for a
group of instruments.
-
forward-looking information, which includes these
quantitative and qualitative disclosures outside the financial statements.;
-
disclosures about the effects of derivatives on
other positions.
The Rules allow registrants to select one
of the following methods to make their quantitative disclosures for market risk sensitive
instruments:
-
a tabular format --- a presentation of the
terms, fair value, expected principal or transaction cash flows, and other information,
with instruments grouped within risk exposure categories based on common characteristics;
-
a sensitivity analysis --- the
hypothetical loss in earnings, fair values, or cash; (the minumum percentage change seems
to be 10% in Item 3.A of the Instructions to Paragraphs 305a and 305b.)
-
flows resulting from hypothetical changes in rates or
prices;
-
value-at-risk ---
a measure of the potential loss in earnings, fair values, or cash;
-
flows from changes in rates or prices.
A registrant that holds nonderivative
financial instruments that have material amounts of market risk, such as investments,
loans, and deposits, is required to make the qualitative and quantitative disclosures of
market risk, even though the registrant may hold no derivatives.
The new Rules are effective for filings
that include financial statements for fiscal periods ending after June 15, 1997. However,
for registrants that are not banks or thrifts and that have a market capitalization of
$2.5 billion or less on January 28, 1997, the effective date for the quantitative and
qualitative disclosures outside the financial statements about market risk is delayed one
year.
Registrants are required to provide
summarized quantitative market risk information for the preceding fiscal year. They should
explain the reasons for material quantitative changes in market risk exposures between the
current and preceding fiscal years in sufficient detail to enable investors to determine
trends in market risk information.
For a reference on SEC disclosure rules, see T.J.
Linsmeier and N.D. Pearson, "Quantitative Disclosures of Market Risk in the SEC
Release," Accounting Horizons, March 1997, 107-135.
Click here
to view a nice commentary on the SEC financial risk disclosure choices.
Key Disclosure Lessons From FAS 133 Q1 July 6, 2001 By
Nilly Essaides --- http://www.fas133.com/search/search_article.cfm?page=81&areaid=405
A review of 40 10Qs reveals a great diversity
in reporting for Q1/01 as well as some lessons on what constitutes a
useful disclosure. Second quarter 10Q reports will soon begin to hit the
SEC. With them will come Q2/FAS 133 disclosures for most companies. This
next wave of 10Qs will certainly offer insight into the
quarter-by-quarter effects of FAS 133. But judging from the first bunch,
they may leave as much unsaid, as said.
A review of Q1 disclosures in 40 companies’
10Qs reveals great diversity in reporting depth and quality. But perhaps
the clearest revelation is that FAS 133 does not necessarily offer a
clearer picture of a company’s derivatives strategy.
Perhaps the quality of disclosures depends on
whether the company intends to conceal more than it reveals; perhaps,
too, it indicates that MNCs are only at the start of their FAS 133
learning curve. Over time, best practices will hopefully emerge creating
more readable 10Qs.
. . .
What is/isn’t revealed T
his diversity obviously makes it hard to
analyze 10Qs. (Difficult perhaps, but not impossible: FAS133.com is
working on a matrix that would track, on a quarterly basis, various
disclosures and impact on EPS/OCI for large MNCs).
Some trend observations do rise above the
disclosure clutter:
• Effectiveness method. Only one registrant
alluded to the critical terms methodology. No one else provided
information about what effectiveness measures were being used.
• Time value. G20 will make a big
difference for some companies, while having no effect at all for
others. Many pre-G20 10Qs indicate that there is no time value being
recorded in income. Even in cases where some time value was marked to
market in income, the effect was minor.
There are exceptions, however. Microsoft’s
said the following: “...the reduction to income was mostly
attributable to a loss of approximately $300 million reclassified from
OCI for the time value of options and a loss of approximately $250
million reclassified from OCI for derivatives not designated as
hedging instruments.”
• Industry differences: Financial companies
seem to be providing more information about their derivatives than
non-financial MNCs., perhaps because they have more experience with
fair values, have the necessary systems, and tend to have more
non-compliant derivatives. Ditto for commodity companies, which must
now account for many previously “non-derivatives” as derivatives.
• Qualified vs. non-qualified derivatives.
The majority of 10Qs do not list substantial non-compliant
derivatives, but there are some notable exceptions, including some
written calls and non-qualified cross currency swaps or derivatives
that hedge other derivatives.
• Embeddeds. Of all the 10Qs reviewed, only
Lucent mentioned the existence of embeddeds (other than equity options
in convertible bonds). “Lucent’s foreign currency embedded
derivatives consist of sales and purchase contracts with cash flows
indexed to changes in or denominated in a currency that neither party
to the contract uses as [its] functional currency. Changes in the fair
value of these embedded derivatives are recorded in earnings.”
Emerging best practices Of course, what
constitutes good disclosure depends on one's perspective. Good from the
point of view of the investor/analyst means in context and consistent
with some forward-looking information.
Good from the company's standpoint may mean
one of two things:
(1) Clearly communicate the intent and value of
hedges so that gains and losses are understood and not misread; or
(2) Effectively conceals gains and losses on
derivatives so that investors cannot figure out the effect of
derivatives on income.
Perhaps, too, what makes good disclosure will
take time to figure out, as for many of these companies are reporting
FAS 133 info for the first time.
A checklist Still, from the 40 10Qs reviewed
for this article, the following useful hints emerged:
• Divide hedge disclosu3 categories: Fair
value, cash flow and net investment, with a discussion of strategy,
fair values and ineffectiveness total for each category.
• Provide a chart or table summarizing all
derivatives gain/loss, impact on income or OCI
• Include pointers as to where in the
income statement particular derivatives numbers appear, in income and
OCI.
• Listing how market risk exposures would
affect derivatives positions.
Sources of volatility Finally, the Q1s reveal
three sources of OCI/income volatility:
(1) Time value of options (this will
presumably disappear for any hedging options that fall under G20).
(2) Gains/loss on non-qualified derivatives,
either derivatives that do not meet the effectiveness standards or
derivatives that hedge other derivatives. Of course, this does not
mean the derivatives are speculative. There may be as many qualified
derivatives as there are speculative, since those that are
non-qualified ones may be true economic hedges.
(3) Finally, gains/losses on derivatives that
were not accounted for previously as derivatives such as commercial
contracts.
|
CANADA
DISCLOSURE
OF ACCOUNTING POLICIES FOR DERIVATIVE FINANCIAL INSTRUMENTS AND DERIVATIVE
COMMODITY INSTRUMENTS Date Issued: September 5, 2002
http://www.cica.ca/multimedia/Download_Library/Standards/EIC/English//EIC131.pdf
One of my students wrote the following:
Joseph F. Zullo
For his relational database project in Microsoft Access that
disaggregates and then aggregates various types of risk on interest rate swaps,
click on http://www.resnet.trinity.edu/users/jzullo/title.htm
The heart of this project is a relational database. The term
project topic was "suggested aids for using emerging technologies in measuring and
evaluating investment risk." To that end, I created a relational database that is
able to track the use of derivative instruments and assign risk to individual contracts.
The creation of the database is an attempt at dissaggregated reporting.
Theoretically, an investor could access the database through the Internet and compute
custom reports and evaluate individual measures of risk associated with each derivative.
The benefit of dissaggregated reporting lies in the investors ability to perform the
aggregation of relevant data. In todays environment, investors have to rely on
annual financial statements of a company to acquire relevant information. The financial
statements of a company do not always provide a complete picture of the financial
condition of the company. Notably, off-balance sheet items such as derivative financial
instruments do not appear in the body of the financial statements. The FASB and the SEC
have made strides to overcome this reporting deficiency with pronouncements that require
more informational disclosures in the financial statements.
Roger Debreceny wrote the following message on July 31,
1998:
Further to previous discussion on
derivatives:
KPMG
Derivatives and Hedging Handbook
Offers Guidance on New Accounting Standards for Derivatives NEW YORK, July 27 /PRNewswire/
-- A comprehensive Derivatives and Hedging Handbook was published today by KPMG Peat
Marwick LLP, the accounting, tax and consulting firm, in response to the new accounting
standard for derivative instruments and hedging activities issued on June 15, 1998 by the
Financial Accounting Standards Board (FASB).
The FASB issued the new standard (Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging
Activities) to replace the rules that had been in effect since 1984.
"The estimated worldwide amount of derivative
instruments is well above $60 trillion," said Michael A. Conway, partner-in-charge,
KPMG Department of Professional Practice." We developed this handbook because the new
standard is so complex and the potential impact on commercial companies and financial
institutions is enormous.
"Implementing this standard may require changes in
hedging strategies and accounting systems, with possible significant effects on financial
statements," said Conway. "Therefore, we believe its important for
organizations to immediately begin evaluating the impact of the standard on their
operations and financial reporting. This handbook is designed to make that assessment
easier."
The primary author of the handbook, Stephen Swad, KPMG partner, Department of Professional Practice, said
that companies must consider several key issues, including recognizing all derivative
instruments as either assets or liabilities measured at fair value; designating all
hedging relationships anew; measuring transition adjustments that will affect earnings;
and modifying accounting, risk management objectives and strategies, and information
systems to comply with the requirements of the standard. The 425-page publication, the
second in KPMGs handbook series, provides over 100 examples illustrating some of the
complex areas of the standard, and answers possible questions that might arise during
implementation.
KPMGs Web site is: http://www.us.kpmg.com.
March 20, 2002 Message from Ira
Kawaller
Hi Bob,
I just posted a recently published article on how to satisfy the FAS 133 disclosure requirements for interest rate hedges. Although it was originally published by Bank Asset/Liablility Management (March 2000), the content is
applicable to all firms with interest rate exposures -- not just banks.
If you are interested, it is available at
http://www.kawaller.com/pdf/BALMHedges.pdf
You can also find additional information about derivatives, risk management, and FAS 133 in the various articles posted on the Kawaller & Company website:
http://www.kawaller.com
Please feel free to contact me with any questions, comments, or suggestions.
Ira Kawaller
Kawaller & Company, LLC
kawaller@kawaller.com
(718) 694-6270
Inefficiencies in the Information
Thicket
"Inefficiencies in the Information Thicket: A Case Study of Derivative
Disclosures During the Financial Crisis," by Robert P. Bartlett III, Harvard
Law School Forum, May 27, 2010 ---
http://blogs.law.harvard.edu/corpgov/2010/05/27/inefficiencies-in-the-information-thicket/
In the paper,
Inefficiencies in the Information Thicket: A Case Study of Derivative
Disclosures During the Financial Crisis, which was recently made publicly
available on SSRN, I provide an empirical examination of the effect of
enhanced derivative disclosures by examining the disclosure experience of
the monoline insurance industry in 2008. Conventional wisdom concerning the
causes of the Financial Crisis posits that insufficient disclosure
concerning firms’ exposure to complex credit derivatives played a key role
in creating the uncertainty that plagued the financial sector in the fall of
2008. To help avert future financial crises, regulatory proposals aimed at
containing systemic risk have accordingly focused on enhanced derivative
disclosures as a critical reform measure. A central challenge facing these
proposals, however, has been understanding whether enhanced derivative
disclosures can have any meaningful effect given the complexity of credit
derivative transactions.
Like AIG Financial
Products, monoline insurance companies wrote billions of dollars of credit
default swaps on multi-sector CDOs tied to residential home mortgages, but
unlike AIG, their unique status as financial guarantee companies subjected
them to considerable disclosure obligations concerning their individual
credit derivative exposures. As a result, the experience of the monoline
industry during the Financial Crisis provides an ideal setting with which to
test the efficacy of reforms aimed at promoting more elaborate derivative
disclosures.
Overall, the
results of this study indicate that investors in monoline insurers showed
little evidence of using a firm’s derivative disclosures to efficiently
resolve uncertainty about a monoline’s exposure to credit risk. In
particular, analysis of the abnormal returns to Ambac Financial (one of the
largest monoline insurers) surrounding a series of significant, multi-notch
rating downgrades of its insured CDOs reveals no significant stock price
reactions until Ambac itself announced the effect of these downgrades in its
quarterly earnings announcements. Similar analyses of Ambac’s short-selling
data and changes in the cost of insuring Ambac debt securities against
default also confirm the absence of a market reaction following these
downgrade announcements.
Based on a
qualitative examination of how investors process derivative disclosures, to
the extent the complexity of CDOs impeded informational efficiency, it was
most likely due to the generally low salience of individual CDOs as well as
the logistic (although not necessarily analytic) challenge of processing a
CDO’s disclosures. Reform efforts aimed at enhancing derivative disclosures
should accordingly focus on mechanisms to promote the rapid collection and
compilation of disclosed information as well as the psychological processes
by which information obtains salience.
The paper is available for download
from
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1585953
Bob Jensen's tutorials on accounting
for derivative financial instruments and hedging activities ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Illustrations of FAS 133 Disclosures
Adobe Systems’ 10Q
for the second quarter provides a case study in best practices in
FAS 133-related disclosures.
All 10Qs are not made
equal. In the area of FAS 133-related disclosure, that truth is even
more pronounced (see related
item). Indeed, the current diversity in the content and
organization of derivatives disclosures, which in part may reflect
companies’ ambivalence about making this information public, calls
for the emergence of best practices, or disclosure benchmarks.
The lack of uniformity
in disclosure geography and format affect the quality of the
information. It certainly makes it hard for users of financial
statements to reach broad-based conclusions. But perhaps most
important, it opens the door for misinterpretation and exaggeration
of the financial impact of corporate derivatives activities.
What should companies use as a guide? To date, the FAS133.com review
of 10Qs has surfaced five basic benchmarks of best practice in FAS
133 disclosure:
- Divide hedge
disclosure categories: Fair value, cash flow and net investment,
with a discussion of strategy, fair values and ineffectiveness
total for each category.
- Explain risk
management policy/strategy in clear language, providing hedge
activity context.
- Provide a chart or
table summarizing all derivatives gain/loss, impact on income or
OCI.
- Include pointers as
to where in the income statement particular derivatives numbers
appear, in income and OCI.
- List how market risk
exposures would affect derivatives positions.
Some 10Qs contain various
elements of best disclosure. Others are very hard to read. But
perhaps one of the clearest examples of some of the best practices
in FAS 133 disclosure can be found in the second quarter 10Q filed
by Adobe Systems on July 16, 2001.
There are several reasons the
Adobe 10Q represents best practice:
- It presents information in
context. Disclosure of actual figures on derivatives gain/losses
follow clear explanations of risk management strategy and
objectives.
- It highlights strategy
based on hedge objective. The context is presented in a very
organized manner. Risk management activities are segregated
based on their objectives, and the type of exposure being
hedged.
- It summarizes gains/losses
in table. Not only does the table provide figures and how they
affect OCI, but Adobe lists both quarterly, and year to date
information, giving the reader a chance to review the trend.
- It’s in “English.”
Perhaps most important, the disclosures are clearly written,
refraining from jargon and providing simple, “lay man’s”
explanation of risk management activities.
The top-notch disclosure statement represents the product of
treasury’s hard work. “We worked hard on it,” confesses
Barbara Hill, Adobe’s treasurer. Indeed, the language and the
disclosure were the work of the Adobe treasury team, and received
only minor tweaking from the external auditor once complete. “We
tried to spend a lot of effort to make it clear,” she says. Even
at companies where accounting plays a more dominant role, she
cautions, treasury’s input is critical. “You have to have
someone who is trading and understands options, for example, to put
together the disclosures.”
While Adobe reviewed other
companies’ 10Qs and went back to the original standard to ensure
all i's are dotted and t's are crossed, “we came up with the
language in treasury,” Ms. Hill says. In part, Ms. Hill says her
group was so well prepared for the task as a result of several
months’ worth of FAS 133 studying with Helen Kane of Hedgetrackers
(a consultancy).
This approach, Ms. Hill says,
is in line with Adobe’s general approach to communications with
its investors. “It’s part of our philosophy to be as forthcoming
and open in our disclosures.
This straightforward approach
carried tangible benefits, she notes. “You get a reputation for
honesty and integrity, and analysts and investors know that they can
trust your statements.” Overtime, the consistency in reporting
helps build credibility “that’s invaluable over the long
term,” she says. Basically, it helps determine whether investors
and fund managers are interested in investing in the company, or
not.
Perhaps the best part of
the Adobe disclosure is the summary tables (see below). The tables
are Ms. Hill’s idea. “It’s pretty bold,” she admits. She
notes some 10Qs seem to lose the content in the language of FAS 133
(as well as in indeterminable geography, such as including
ineffectiveness in “costs of good sold,” as some MNCs have).
The tables, she says,
“are an offshoot of what I use from a big-pictures standpoint, to
make sure that the numbers I see with regard to FX hedging make
sense. It’s a tool I use internally, which makes it easy for me
(and now investors) to spot problems right away.” Ms. Hill decided
shareholders could benefit from sharing the information, which she
gathers anyway for in-house performance evaluation purposes.
Continued at
http://fas133.com/search/search_article.cfm?areaid=408
AOL-Time Warner's FAS 133-Related Financial
Reporting: Ignoring Interest Rate Exposure?
By Ed Rombach
Link --- http://www.fas133.com/search/search_article.cfm?page=61&areaid=440
Is AOL-Time Warner ignoring
their interest rate exposure, or merely managing it in a way that
avoids disclosure?
As one of the component
companies in the 'Portfolio of 33' we are obliged to focus some
attention on what, at first glance, may be perceived to be AOL-Time
Warner's lack of disclosure into some of the details regarding risk
management under FAS 133 accounting. Is it a fair question to ask why
this company, with a market capitalization of $157 billion and net
debt in excess of $19 billion, would not make use of interest-rate
derivatives of some kind to modify that interest rate exposure?
Or, if they do make use of
interest rate derivatives for risk management purposes, why is there
no mention of it in their quarterly reports, which in accordance with
FAS 133 requires that derivatives used for hedging activities be
recorded at fair value?
These questions are all the more
interesting when we consider the relationship Time Warner has had with
the FASB's DIG: two of its recent assistant controllers were not only
former SEC accountants, but observing and/or regular members of the
DIG: Steve Swad and Pascal Desroches. We should assume, then, that
AOL-TW might serve the financial reporting community as a paragon
example of FAS 133-related financial reporting.
In fairness to AOL-TW, what they left out of recent quarterly reports
they partially made up for in their last annual report for 2000. Under
the heading QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK, for example, it states: America Online is exposed to immaterial
levels of market risk related to changes in foreign currency exchange
rates and interest rates." The bulk of the company's exposure,
per the 10-K, concerns its investment portfolio. "America Online
is exposed to market risk as it relates to changes in the market value
of its investments. America Online invests in equity instruments of
public and private companies for business and strategic purposes, most
of which are Internet and technology companies." Accordingly, the
derivatives used to hedge this exposure get the bulk of the FAS
133-related attention in the company's financial reporting.
But is their interest rate risk
really that immaterial? The third quarter 10Q reports as September 30,
2001, AOL Time Warner had $20.7 billion of debt and $1.5 billion of
cash and cash equivalents for a net debt of $19.2 billion.
Fixed vs. Floating
It's not clear from the financial statements how much of the $19.2
billion outstanding debt is in fixed rate and how much is floating,
but AOL-TW's web site itemizes some twenty six separately issued notes
and debentures mostly by Time Warner and its consolidated
subsidiaries, with remaining maturities of five, ten, twenty and
thirty years (14.36 years on average), with an average coupon of
8.12%. This listing though doesn't provide the amounts issued per
cusip so it is not possible to tell with any precision what the total
amount of fixed rate debt is for the combined companies, and
unfortunately, AOL-Time Warner treasury staff declined to comment on
any of this publicly available information.
The company's 2000 10-K explains
that a Bank Credit Agreement was in place permitting borrowings of up
to $7.5 billion for general business purposes and in support of
commercial paper borrowings of which amounts totaling $6.8 billion had
been drawn down by Time Warner and its consolidated subsidiaries as of
December 31, 2000. By April of 2001, AOL-TW had established a $5
billion commercial paper program allowing the company to issue
commercial paper to investors periodically in maturities of up to 365
days for general corporate purposes including investments, capital
expenditures, repayment of debt and financing acquisitions. However,
it is still not quite clear from the public disclosures just how much
of this program has been utilized to date.
Opportunity risk
Nevertheless, a cursory estimation using a rough metric suggests a
ratio of about 65% to 35% of fixed rate vs. floating rate debt, a
ratio that might be considered less than optimal during a quarter when
the federal reserve cut the fed funds rate by 100 basis points and ten
year swap rates fell by a corresponding amount. Assuming that 65% of
AOL-TW's debt was fixed, at an average maturity of 14 years and at an
average coupon rate of 8.12%, a drop in yields on that debt of 100
basis points implies a fair value change in present value terms of
close to $1.2 billion. Not that they would want to eliminate all of
their fixed rate debt, but if half of it was converted to floating via
fixed to floating swaps, they still would have saved themselves a
significant amount from the lower funding cost. Did that 10K really
say company's exposure to interest rates was immaterial?
More illustrations --- see Illustrations
The Emerging Issues Committee (EIC) of the CICA (Canada) issued
for comment (by July 17, 2002) draft Abstract D21: Disclosure of
Accounting Policies for Derivative Financial Instruments and
Derivative Commodity Instruments.
The Committee reached a consensus that an
enterprise should disclose the accounting policies for derivative
financial instruments and derivative commodity instruments
pursuant to CICA 1505, following the guidance in CICA 3860.48-51.
Disclosures regarding accounting policies
should include descriptions of the accounting policies used for
derivative financial instruments and derivative commodity
instruments and the methods of applying those policies that affect
the determination of financial position, cash flows, or results of
operation. This description should include each of the following
items:
(a) a discussion of each method used to
account for derivative financial instruments and derivative
commodity instruments — fair value method or hedge accounting
methods (i.e., deferral, accrual or settlement methods);
(b) the types of derivative financial instruments and derivative
commodity instruments accounted for under each method;
(c) the criteria required to be met for each hedge accounting
method used, including a discussion of the criteria required to
be met for hedge accounting as set out in AcG-13;
(d) the accounting method used if the criteria for hedge
accounting specified in item (c) are not met;
(e) if applicable to the period, the method used to account for
terminations of derivatives designated as hedges, including the
method used to account for derivative financial instruments and
derivative commodity instruments designated as hedging items, as
when:
(i) the designated hedged item
matures, is sold, is extinguished, or is terminated;
(ii) the hedge is no longer effective;
The Emerging Issues Committee (EIC) of the CICA (Canada) issued for
comment (by July 17, 2002) draft Abstract D21: Disclosure of Accounting
Policies for Derivative Financial Instruments and Derivative Commodity
Instruments.
The Committee reached a consensus that an
enterprise should disclose the accounting policies for derivative
financial instruments and derivative commodity instruments pursuant to
CICA 1505, following the guidance in CICA 3860.48-51.
Disclosures regarding accounting policies
should include descriptions of the accounting policies used for
derivative financial instruments and derivative commodity instruments
and the methods of applying those policies that affect the
determination of financial position, cash flows, or results of
operation. This description should include each of the following
items:
(a) a discussion of each method used to
account for derivative financial instruments and derivative
commodity instruments — fair value method or hedge accounting
methods (i.e., deferral, accrual or settlement methods);
(b) the types of derivative financial instruments and derivative
commodity instruments accounted for under each method;
(c) the criteria required to be met for each hedge accounting method
used, including a discussion of the criteria required to be met for
hedge accounting as set out in AcG-13;
(d) the accounting method used if the criteria for hedge accounting
specified in item (c) are not met;
(e) if applicable to the period, the method used to account for
terminations of derivatives designated as hedges, including the
method used to account for derivative financial instruments and
derivative commodity instruments designated as hedging items, as
when:
(i) the designated hedged item matures,
is sold, is extinguished, or is terminated;
(ii) the hedge is no longer effective;
April 2003
Unlike U.S. business firms, governmental organizations do not
necessarily have to report derivative financial instruments are fair
(mark-to-market) values. However, the Governmental Accounting
Standards Board (GASB) proposed some new disclosure rules for
derivatives, including rules for disclosing more about current values
--- http://www.gasb.org/news/nr040203.html
Governmental
Accounting Standards Board Issues Technical Bulletin To Improve
Disclosures About Derivatives
Norwalk,
CT, April 2, 2003—In
an effort to improve disclosures about the risks associated with
derivative contracts, the Governmental Accounting Standards Board (GASB)
has released for public comment accounting guidance that would provide
more consistent reporting by state and local governments. The proposed
Technical Bulletin, Disclosure Requirements for Derivatives Not
Presented at Fair Value on the Statement of Net Assets, is
designed to increase the public’s understanding of the significance
of derivatives to a government’s net assets and would provide key
information about the potential effects on future cash flows.
While state
and local governments use a vast array of increasingly complex
derivative instruments to manage debt and investments, they also may
be assuming significant risks. Governments must communicate those
risks to financial statement users and the proposed Technical Bulletin
would help clarify existing accounting guidance so that more
consistent disclosures can be made across all governments.
In commenting
on why the GASB believes this issue is so important, GASB Project
Manager, Randal J. Finden, remarked, “The market for derivative
instruments has recently exploded for state and local governments as
current financing needs have changed in connection with a more
constrained budgetary environment. Some derivative contracts may pose
substantial risks, and we want to help governments better disclose
those risks in their financial statements.”
Governments
would be required to disclose the derivative’s objective, its terms,
fair value and risks. The proposed accounting guidance would require
governments to disclose in their financial statements credit risk,
interest rate risk, basis risk, termination risk, rollover risk and
market access risk.
This
Technical Bulletin would be effective for periods ending after June
15, 2003. The proposed
Technical Bulletin is available from the GASB’s website.
Comments on the proposed documents may be made through May 16, 2003.
The proposed Technical Bulletin
can be downloaded from http://www.gasb.org/exp/tb2003-a.pdf
Some of the previous derivative
financial instruments frauds and scandals have centered around
governmental organizations such as the Orange County fraud ---
http://faculty.trinity.edu/rjensen/fraud.htm#DerivativesFraud
Bob
Jensen's documents on
accounting for derivative
financial instruments and
hedging activities are
linked at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
|
|
Discount = see premium.
Disincentives for nonperformance
= see firm commitment.
Dollar Offset
Method =
a computation of the cumulative derivative
hedging gain or loss on the basis of multiple period historical changes in fair value of
the hedging instrument vis-a-vis changes in the fair value of the underlying.
The dollar offset period change ratio is the ratio of the dollar gain or loss of
the hedging instrument divided by the dollar gain or loss of the hedged item. The
cumulative dollar change ratio is the sum of the gains and losses of the hedging
instrument divided by the sum of the gains and losses of the hedged item. See net settlement.
Dynamic
Portfolio Management =
a technique of assessing the risk and managing a
portfolio or group of assets and liabilities. Dynamic management is characterized by
continuous assessment and periodic adjustment of the portfolio components. See the
discussion of macro hedges under hedge. Also see compound derivatives. Also see value at risk (VAR).
See Macro Hedge
E-Terms
Earnings Management
Interest rate swap derivative instruments are widely
used to manage interest rate risk, which is viewed as a perfectly
legitimate use of these hedging instruments. I stumbled on to a
rather interesting doctoral dissertation which finds that firms,
especially banks, use such swaps to manage earnings. The
dissertation from Michigan State University is by Chang Joon Song under
Professor Thomas Linsmeier.
"Are Interest Rate Swaps Used to Manage Banks' Earnings,"
by Chang Joon Song, January 2004 --- http://accounting-net.actg.uic.edu/Department/Songpaper.pdf
This dissertation is quite clever and very well written.
Previous research has shown that loan loss
provisions and security gains and losses are used to manage banks’
net income. However, these income components are reported below banks
largest operating component, net interest income (NII). This study
extends the literature by examining whether banks exploit the
accounting permitted under past and current hedge accounting standards
to manage NII by entering into interest rate swaps. Specifically, I
investigate whether banks enter into receive-fixed/pay-variable swaps
to increase earnings when unmanaged NII is below management’s target
for NII. In addition, I investigate whether banks enter into
receive-variable/pay-fixed swaps to decrease earnings when unmanaged
NII is above management’s target for NII. Swaps-based earnings
management is possible because past and current hedge accounting
standards allow receive-fixed/pay-variable swaps (receivevariable/
pay-fixed) to have known positive (negative) income effects in the
first period of the swap contract. However, entering into swaps for
NII management is not costless, because such swaps change the interest
rate risk position throughout the swap period. Thus, I also examine
whether banks find it cost-beneficial to enter into offsetting swap
positions in the next period to mitigate interest rate risk caused by
entering into earnings management swaps in the current period. Using
546 bank-year observations from 1995 to 2002, I find that swaps are
used to manage NII. However, I do not find evidence that banks
immediately enter into offsetting swap positions in the next period.
In sum, this research demonstrates that banks exploit the accounting
provided under past and current hedge accounting rules to manage NII.
This NII management opportunity will disappear if the FASB implements
full fair value accounting for financial instruments, as foreshadowed
by FAS No. 133.
What is especially interesting is how Song demonstrates that such
earnings management took place before FAS 133 and is still taking place
after FAS 133 required the booking of swaps and adjustment to fair value
on each reporting date. It is also interesting how earnings
management comes at the price of added risk. Other derivative
positions can be used to reduce the risk, but risks arising from such
earnings management cannot be eliminated.
See Gapping and Immunization
See interest rate swap and hedge
Bob Jensen's threads on FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
|
Effectiveness =
see ineffectiveness.
Embedded
Derivatives =
portions of contracts that meet the
definition of a derivative when the entire nonderivative contract cannot be considered a
financial instruments derivative. Types of embedded derivative instruments are often
indexed debt and investment contracts such as commodity indexed interest or principal payments, convertible debt, credit indexed contracts,
equity indexed contracts, and inflation
indexed contracts. Embedded derivatives are discussed in FAS 133, pp. 7-9,
Paragraphs 12-16. Embedded derivatives such as commodity indexed and equity indexed
contracts and convertible debt require separation of the derivative from the host contract
in FAS 133 accounting. In contrast, credit indexed and inflation indexed embedded
derivatives are not separable from the host contract. Also see FAS 133
Paragraphs 51,
60, 61, 176-178, and 293-311. The overall contract is sometimes referred to as a
"hybrid" that contains one or more embedded derivatives. Embedded
derivatives within embedded derivatives generally meet the closely-and-clearly related test and cannot be accounted
for as separate derivatives. The concept of "closely related is
also discussed in IAS 39: paragraph 23a. Rules for
accounting for the host contract after an embedded derivative has be
bifurcated are discussed in SFAS Paragraph
16). If an embedded derivative should bifurcated but the firm cannot
do so for some reason, SFAS 16 requires that the entire contract be treated as
a trading security that is adjusted to fair value at least quarterly with
changes and fair value being charged to current earnings rather than OCI.
See FAS 133 Paragraph 16 and IAS Paragraph 26.
Note that much of the
discussion below has been changed:
"FASB and IASB agree on a three-category financial asset classification
and measurement approach," PwC, May 22, 2012 ---
Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=GBAD-8UJRHU&SecNavCode=MSRA-84YH44&ContentType=Content
. . .
Under their
respective approaches, debt investments (e.g., loans and debt
securities) would be classified based on an individual instrument's
characteristics (as further explained below) and the business strategy
for the portfolio. However, before this week's meeting, the IASB had
defined two categories whereas the FASB had defined three categories.
This week, the IASB agreed to introduce a
third category in which debt investments are measured at fair value with
changes in fair value recognized through other comprehensive income. The
FASB also agreed on a revised definition for this category. As a result,
the categories for debt investments would be broadly defined as follows:
-
Amortized cost – consists of debt
investments where the primary objective is to hold the assets to
collect the contractual cash flows.
- Fair
value with changes in fair value recognized in other comprehensive
income – consists of debt
investments with the primary objective of both holding the assets to
collect contractual cash flows and realizing changes in fair value
through sale. Interest and impairment would be recognized in net
income in a manner consistent with the amortized cost category, and
fair value changes would be recycled from other comprehensive income
to net income when the asset is sold.
- Fair
value with changes in fair value recognized in net income
– consists of debt investments that
either (1) do not meet the instrument characteristics criterion or
(2) meet the instrument characteristics criterion but do not meet
one of the other category definitions (i.e., "the residual
category").
In addition, the FASB agreed to adopt the
IASB requirement for prospective reclassifications between categories
when there is a significant change in business strategy, which is
expected to be "very infrequent."
In previous meetings, the FASB had also
agreed to incorporate the following aspects of the IASB's approach:
-
Instrument characteristics criterion.
The contractual cash flows of the debt
investment must represent
solely payments of principal and interest
in order to be eligible for the
amortized cost or fair value with changes in fair value recognized
in other comprehensive income categories.
-
Bifurcation of hybrid financial instruments.
Separate accounting for financial asset
host contracts and embedded derivatives in hybrid financial assets
would be prohibited; instead the entire hybrid financial asset would
be accounted for as a single instrument. However, hybrid financial
liabilities would continue to be bifurcated.
Continued in article
Jensen Comment
I favor most of these changes, especially changes that use OCI to avoid
fluctuations in current earnings that will never be realized. However, I
think the fact that the FASB's caving in on the issue of not bifurcating
embedded derivatives in hybrid financial assets is absurd since the
financial risks may vary so greatly between the host contract and its
embedded derivatives. And my love of symmetry is appalled at bifurcation of
hybrid liabilities but not hybrid assets is broken hearted.
Paragraph 10 notes that
interest only strips and principal only strips are
not subject to FAS 133 accounting rules under conditions noted in Paragraph 14. In
Paragraph 15, it is noted that embedded foreign currency derivatives "shall not
be separated from the host contract and considered a derivative instrument."
Prepayment options on mortgage loans also do not qualify for accounting under FAS 133
according to Paragraph 293 on Page 146. See compound
derivative and embedded option.
An example is a leveraged gold note that has the amount of
note's principal vary with the price of gold. This type of note can be viewed as
containing a series of embedded commodity (gold) option contracts. These options can
separated out and accounted for as derivatives apart from the host contract under
Paragraph 12 on Page 7 of FAS 133 under the assumption that the price of gold is not
"clearly-and-closely related" to interest
rates.
An equity-linked bear note is another example of a note
with a series of embedded options that can be accounted for as separate derivative
instruments under Paragraph 12 of FAS 133. For example, suppose has 5% coupon bonds
that increase interest rates at certain levels of movement up or down of an index such the
S&P stock price index. The embedded condition that interest rates may move up
based upon an index can qualify as an embedded derivative that can be separated according
to Paragraph 12 on Page 7 of FAS 133 provided the derivative is not clearly-and-closely related. The S&P
index is an equity index that is not clearly-and-closely reated, whereas an interest rate
index such a LIBOR is a clearly-and-closely related index. The host contract (hedged
item) must be an asset or liability that is not itself a derivative instrument.
In this example, the bonds are not derivatives, and the embedded derivatives can be
separated from the host contract under FAS 133 rules. See equity-indexed.
Derivatives cannot be
embedded in other derivatives according to Paragraph 12c on the top of Page 8 of
FAS 133.. For example, an index-amortizing interest rate
swap cannot usually be accounted for as a derivative instrument (pursuant to FAS 133
under Paragraph 12 on Page 7 of FAS 133) when it is a derivative embedded in another
derivative. Suppose a company swaps a variable rate for a fixed rate on a notional
of $10 million. If an embedded derivative in the contract changes the notional to $8
million if LIBOR falls below 6% and $12 million if LIBOR rises above 8%, this
index-amortizing embedded derivative cannot be separated under Paragraph 12 rules.
KPMG states that Paragraph 12 applies only "when a derivative is
embedded in a nonderivative instrument and illustrates this with an index-amortizing
Example 29 beginning on Page 75 of the
Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.
The prior Example 28 and the subsequent Example 30 illustrate index-amortizing embedded
derivatives that qualifies since, in each example, the derivative is embedded in a
nonderivative instrument.
One of the major sources of difference between
FAS 133 and IAS 39 concerns embedded derivatives. There are some exceptions for hybrid instruments as discussed
in IAS 39 Paragraphs 23b and 23c; Also see FAS 133
Paragraphs 12b and 12c.
In summary, bifurcation under FAS 133 is required in the following
examples:
-
Call/Put Debt Option --- If options alter maturity dates, they are clearly and closely related to a debt
instrument that requires principal repayments unless both (1) the debt involves a
substantial premium or discount and (2) the put/call option is only contingently
exercisable. See FAS 133 Paragraph 61d. An example is given
in FAS 133 Paragraph 186. Also see IAS 39 Paragraph
24g.
-
Put/Call Equity Option on Host Equity Instrument --- A put option should
abe separated from the host contract by the issuer of the equity instrument except in
those cases in which the put option is not considered to be a derivative instrument
pursuant to FAS 133 Paragraph 11(a), because it is classified in stockholders' equity. A call
option embedded in the related equity instrument would not be separated from the host
contract by the issuer, but would be otherwise for the holder of the related equity
instrument
See FAS 133 Paragraphs 11a and 61b; IAS 39 Paragraphs 11a, 24a, and
25b.
-
Equity-indexed interest payments --- See FAS 133 Paragraph 61h and an
example given in SFAS Paragraph 185. Also see IAS Paragraph 24d.
-
Option to Extend Debt Maturity --- Variable annuity instruments are generally not subject to
FAS 133 accounting rules except for specific components such as equity-index-based interest
annuity and accumulation period payments discussed in Paragraph 200. Also see IAS Paragraph 24c.
-
Credit-linked Debt --- These are not be separated from the host contract for debt instruments that have the interest
rate reset in the event of (1) default, (2) a change in the debtor's published credit
rating, or (3) a change in the debtor's creditworthiness indicated by a change in its
spread over Treasury bond See Paragraph 61c of FAS 133. An example is
given in SFAS Paragraph 190.. Also see IAS 39 Paragraph 24h.
-
Equity Conversion Feature --- If an option is indexed to the issuer's own stock,
a separate instrument with the same terms would be classified in stockholders' equity
in the statement of financial position, so that the written option is not considered a
derivative instrument. See FAS 133 Paragraph 11a. If a debt
instrument is convertible into a shares of the debtor's common equity stock or another
company's common stock, the conversion option must be separated from the
debt host contract. That accounting applies only to the holder if the debt is
convertible to the debtor's common stock. See FAS 133 Paragraph 61k.
An example is provided in Paragraph 199 of FAS 133. Also see IAS 39
Paragraph 24f.
-
Commodity-linked Notes --- A commodity-related derivative embedded in a commodity-indexed
debt instrument must be separated from the a host contract under FAS 133 Paragraph 61i. Examples are given in
FAS 133 Paragraphs 187
and 188. Also see IAS 39 Paragraph 24e.
Bifurcation under FAS 133 is not allowed in the following
examples:
-
Loan Prepayment Options --- these are not bifurcated. See
Paragraphs 14, 189, and 198 of FAS 133 and Paragraph 25e of IAS 39.
This also included prepayment options embedded in interest-only strips or
principal-only strips that (1) initially resulted from separating the right to receive
contractual cash flows of a financial instrument that, in and of itself, did not contain
an embedded derivative and that (2) does not contain any terms not present in the original
host debt contract (IAS Paragraph 25f)
-
Contingent rentals --- these are not bifurcated. Examples include
Contingent rentals based upon variable interest rates (FAS 133 Paragraph
68j), related sales, inflation bonds (FAS 133 Paragraph 191). There
also is no bifurcation of a lease payment in foreign currency (FAS 133
Paragraph 196), although the derivative should be separated if the lease payments are specified in a currency
unrelated to each party's functional currency. Also see (FAS 133
Paragraph 197). Also see IAS 39 Paragraph 25g.
-
Embedded Cap/Floor --- See FAS 133 Paragraph 183 for reasons why
embedded caps and floors are not bifurcated. See IAS Paragraph
25b.
-
Indexed amortizing note --- See Paragraph 194 in FAS 133. Also
see IAS 39 Paragraph 25h.
-
Inverse Floater --- See Paragraphs 178 and 179 of FAS 133.
Birfurcation depends upon certain circumstances. Inverse
floaters are separated if the embedded derivative could potentially result in the investor's
not recovering substantially all of its initial recorded investment. In addition,
Levered inverse floaters must be separated if there is a possibility of the embedded derivative
increasing the investor's rate of return on the host contract to an amount that is at
least double the initial rate of return on the host contract. Also see
IAS 39 Paragraph 25a.
-
Some Foreign Currency Embedded Derivatives --- Dual Currency Bond
(FAS 133 Paragraph 194) and
Short-Term Loan with a Foreign Currency Option (FAS 133 Paragraph 195) if both the principal payment and the interest payments on the
loan had been payable only in a fixed amount of a specified foreign currency, in which
case remeasurement will be done according to SFAS 52 (refer to paragraph 194).
However, foreign currency options not clearly and closely related to issuing a loan should
be separated (refer to FAS 133 Paragraph 195.) Also see IAS 39
Paragraph 25c.
Update on Embedded Derivatives Bifurcation
FASB: Important Differences in
Accounting for Embedded Derivatives in FAS 133 Versus IFRS 9
http://www.iasplus.com/en-us/standards/ifrs-usgaap/embedded-derivatives
An example of an embedded derivative is the option in a mortgage contract that
allows the borrower to pay off the mortgage before the maturity date of the
mortgage. Most embedded derivatives have underlyings that are “clearly and
closely related” to the underlyings of the host contracts, as is usually the
case with an embedded option to pay off the balance due on a note before its
maturity date. However, there are many instances where embedded options do not
meet the “clearly and closely related” tests of FAS 133. When these tests are
not met, the embedded options must be bifurcated and accounted for as derivative
contracts under FAS 133 and its amendments.
I provide some illustrations of bifurcation in my free FAS 133 examination
materials at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/PracticeQuestions/
Other examination helpers are at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
There have been some recent changes in both the U.S. and international
standards.
First the IASB parted ways with the FASB by not requiring embedded derivative
contracts to be bifurcated for any such embedded derivatives even if the
underlyings are not at all clearly and closely related.
Second, the FASB has now taken a step closer to the IASB by not requiring that
certain credit derivatives be bifurcated even if they are not clearly and
closely related to their host contracts ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=150909
Today, the FASB issued Accounting Standards Update 2010-11, to clarify
the type of embedded credit derivative that is exempt from embedded
derivative bifurcation requirements.
Only one form of embedded credit derivative qualifies for the exemption
one that is related only to the subordination of one financial
instrument to another.
As a result, entities that have contracts containing an embedded credit
derivative feature in a form other than such subordination may need to
separately account for the embedded credit derivative feature.
When the Amendments Are Effective:
An entity must apply the amended guidance as of the beginning of its
first fiscal quarter beginning after June 15, 2010.
The update can be downloaded by clicking
here. |
|
Bob Jensen’s free tutorials and videos on accounting for derivative financial
instruments and hedging activities are linked at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
I call your attention to the IAS Plus summary of the
Notes from the IASB Special Board Meeting
October 6, 2009 ---
http://www.iasplus.com/index.htm
The IASB met for a special meeting relating to the IAS 39 replacement
project. Several Board members including the Chairman, FASB members, and
FASB staff joined the meeting via video link.
Many of these items are especially interesting when teaching IFRS, when
teaching contemporary issues in accountancy, and when teaching about accounting
for derivative financial instruments and hedge accounting (although recent
amendments of IAS 39 have taken this famous/infamous and very complicated standard beyond the scope
of the original IAS 39 and the current FAS 133 in the U.S.)
There are various
items taken up in the October 6 IASB meeting not discussed below. Hence if
you're interested in the entire meeting go to the IASB Special Board Meeting
summary:
October 6, 2009 ---
http://www.iasplus.com/index.htm
One significant difference that will arise between IAS 39 and FAS 133 lies in
the IAS decision to end the requirement of bifurcation of host contracts (such
as mortgage loans) from embedded derivatives (such as the embedded option to pay
the loan off before maturity) when the underlying (such as a LIBOR interest
rate) of the host contract is not "clearly and closely related" to the
underlying of the embedded derivative.
Accounting for embedded derivatives
The Board was presented with the alternative to
eliminate bifurcation of embedded derivatives. Several Board members were
concerned that this decision together with the frozen spread approach
adopted for measurement of financial liabilities would lead to hybrid
instruments with a financial liability as a host not to be valued at fair
value. By implication this means that the derivative part of the hybrid
instruments would be valued at the frozen spread approach and not fair
value. The staff defended this position by arguing that the credit
adjustment to the derivative portion of the hybrid contract would not be
significant. One Board member was particularly concerned about the effect of
this decision on convergence – a point reinforced by a FASB member who
expressed his view that such IASB decision would make convergence in this
area next to impossible.
Nonetheless, the Board narrowly approved the
elimination of bifurcation of financial liabilities as well as financial
assets.
The above decision will lead to fewer derivative financial instruments being
booked under FAS 39 relative to what would be booked under FAS 133. It seems to
me to be politically incorrect to bring about such changes at a time when the
SEC is still wavering to eliminate U.S. GAAP in favor of IASB standards.
What the IASB seems to have ignored is the valuation problems created by
unique (customized) instruments that are not traded in the markets. Suppose
Security AB with a "closely related" embedded Option B is Bond A that is
actively traded with the embedded embedded Option B for paying off the debt
before maturity. Early payoff embedded options are extremely common in bonds
that are actively traded in the securities markets. Usually the embedded options
for early payoff are deemed clearly and closely related under IAS 39 rules such
that the embedded Option B previously did not have to be bifurcated and
accounted for separately as a derivative financial instrument. Market values of
Security AB impound both the value of the security and its embedded
(non-bifurcated) option. Until the IASB changed its position on October 6,
however, embedded options that were not clearly and closely related had to be
bifurcated and accounted for separately.
For example, suppose Security ABXY is Security AB plus embedded Options X and
Y that are not "clearly and closely related" in terms of underlyings.
Further assume Options X and Y can be valued in their own options markets. In
other words there are deep and active markets for valuing Security AB, Option X,
and Option Y. There is no deep and active market for the customized Security
ABXY. Security ABXY is a unique, customized security that is not traded in an
active and deep market.
It is highly unlikely that the total value of Security ABXY is the additive
sum of the values of Security AB plus the value of Option X plus the value of
Option Y. These components of Security ABXY are likely to interact such that
valuation of Security ABXY becomes exceedingly difficult if the embedded Options
X and Y are not bifurcated. In terms of FAS 157, it is no longer possible to
apply the sought-after Level 1 valuation for Security ABXY, even though Level 1
can be applied if the embedded Option X and Options Y were bifurcated.
Alas, throughout history accountants have been very good at naively adding up
components of value that are not truly additive. For example, throughout the
history of accounting firms have added up balance sheet asset values and
reported the sum as the total value of Total Assets when the assets have
interactions (covariances) that are totally ignored in the summation process.
Only when buyers and sellers negotiate for the purchase/sale of the entire
bundle (in mergers and acquisitions) do accountants reveal that, in truth, they
understand that the accounting figure for "Total Assets" on the balance sheet is
sheer nonsense.
|
|
Nothing the FASB has issued with respect to derivatives
makes much sense unless you go outside the FASB literature for basic
terminology, most of which is borrowed from finance. A hybrid instrument
is financial instrument that possesses, in varying combinations,
characteristics of forward contracts, futures contracts, option
contracts, debt instruments, bank depository interests, and other
interests. The host contract may not be a derivative contract but may
have embedded derivatives. See the definition of embedded derivative at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#EmbeddedDerivatives
The problem is that the value of the hybrid (which may be a market
price or transaction price) is often difficult to bifurcate into
component values when the components themselves are not traded on the
market on their own. An excellent paper on how to value some bifurcated
components is provided in "Implementation of an Option
Pricing-Based Bond Valuation Model for Corporate Debt and Its
Components," by M.E. Barth, W.R. Landsman, and R.J. Rendleman, Jr.,
Accounting Horizons, December 2000, pp. 455-480.
Some firms contend that the major problem they are having in
implementing FAS 133 or IAS 39 lies in having to review virtually every
financial instrument in search of embedded derivatives and then trying
to resolve whether bifurcation is required or not required. Many of the
embedded derivatives are so "closely related" that bifurcation
is not required. See "closely related" in
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Also listen to executives and analysts discuss the bifurcation
problem in http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm
Detecting derivatives and embedded derivatives to
account for worldwide (bifurcation)
Bob Jensen
May 6, 2002 message from George Lan
I am trying to read the FASB draft (Questions
and Answers Related to Derivative Financial Instruments Held or
Entered into by a Qualifying Special-Purpose Entity (SPE))
and got stumped right at the beginning. Perhaps someone on the list
can clarify these sentences for me: "Under FASB 133, hybrid
instruments that must be bifurcated contain two components for
accounting purpose-- a derivative financial instrument and a
nonderivative host contract....Hybrid instruments that are not
bifurcated ... are not considered to be derivative instruments."
I am familiar with split accounting (methods of splitting the
financial instrument into its bond and equity components, e.g) and
with most of the common derivative contracts such as futures,
forwards, options, swaps but am ignorant about hybrid instruments and
why they must be or do not have to be bifurcated and would certainly
appreciate some examples and assistance from AECMers.
I am also a little familiar with much of the
derivative jargon, but expressions like "the floor
purchased..." could perhaps be clarified to make the draft easier
to read and understand by a wider audience.
Just a couple of thoughts,
George Lan
University of Windsor
|
DIG Issue B1 --- http://www.fasb.org/derivatives/
QUESTION
An entity (Company A) issues a 5-year "debt" instrument
with a principal amount of $1,000,000 indexed to the stock of an
unrelated publicly traded entity (Company B). At maturity, the holder
of the instrument will receive the principal amount plus any
appreciation or minus any depreciation in the fair value of 10,000
shares of Company B, with changes in fair value measured from the
issuance date of the debt instrument. No separate interest payments
are made. The market price of Company B shares to which the debt
instrument is indexed is $100 per share at the issuance date. The
instrument is not itself a derivative because it requires an initial
net investment equal to the notional amount; however, what is the host
contract and what is the embedded derivative comprising the hybrid
instrument?
RESPONSE
The host contract is a debt instrument because the instrument has a
stated maturity and because the holder has none of the rights of a
shareholder, such as the ability to vote the shares and receive
distributions to shareholders. The embedded derivative is an
equity-based derivative that has as its underlying the fair value of
the stock of Company B. Paragraph 60 states:
...most commonly a financial instrument host contract will not
embody a claim to the residual interest in an entity and, thus, the
economic characteristics and risks of the host contract should be
considered that of a debt instrument. For example, even though the
overall hybrid instrument that provides for repayment of principal may
include a return based on the market price...of XYZ Corporation common
stock, the host contract does not involve any existing or potential
residual interest rights (that is, rights of ownership) and thus would
not be an equity instrument. The host contract would instead be
considered a debt instrument, and the embedded derivative that
incorporates the equity-based return would not be clearly and closely
related to the host contract. Unless the hybrid instrument is
remeasured at fair value with changes in value recorded in earnings as
they occur, the embedded derivative must be separated from the host
contract. As a result of the host instrument being a debt instrument
and the embedded derivative having an equity-based return, the
embedded derivative is not clearly and closely related to the host
contract and must be separated from the host contract and accounted
for as a derivative by both the issuer and the holder of the hybrid
instrument. |
DIG Issue B2 --- http://www.fasb.org/derivatives/
QUESTION
An investor purchases for $10,000,000 a structured note with a face
amount of $10,000,000, a coupon of 8.9 percent, and a term of 10
years. The current market rate for 10-year debt is 7 percent given the
single-A credit quality of the issuer. The terms of the structured
note require that if the interest rate for single-A rated debt has
increased to at least 10 percent at the end of 2 years, the coupon on
the note is reduced to zero, and the investor must purchase from the
issuer for $10,000,000 an additional note with a face amount of
$10,000,000, a zero coupon, and a term of 3.5 years. How does the
criterion in paragraph 13(a) apply to that structured note? Does the
structured note contain an embedded derivative that must be accounted
for separately?
RESPONSE
The structured note contains an embedded derivative that must be
accounted for separately. The requirement that, if interest rates
increase and the derivative is triggered, the investor must purchase
the second $10,000,000 note for an amount in excess of its fair value
(which is about $7,100,000 based on a 10 percent interest rate)
generates a result that is economically equivalent to requiring the
investor to make a cash payment to the issuer for the amount of the
excess. As a result, the cash flows on the original structured note
and the excess purchase price on the second note must be considered in
concert. The cash inflows ($10,000,000 principal and $1,780,000
interest) that will be received by the investor on the original note
must be reduced by the amount ($2,900,000) by which the purchase price
of the second note is in excess of its fair value, resulting in a net
cash inflow ($8,880,000) that is not substantially all of the investor’s
initial net investment on the original note.
As described in paragraph 13(a) of Statement 133, an embedded
derivative in which the underlying is an interest rate or interest
rate index and a host contract that is a debt instrument are
considered to be clearly and closely related unless the hybrid
instrument can contractually be settled in such a way that the
investor would not recover substantially all of its initial recorded
investment. Paragraph 61(a)(1) clarifies that this test would be
conducted by comparing the investor’s undiscounted net cash inflows
over the life of the instrument to the initial recorded investment in
the hybrid instrument. As demonstrated by the scenario above, if a
derivative requires an asset to be purchased for an amount that
exceeds its fair value, the amount of the excess — and not the cash
flows related to the purchased asset — must be considered when
analyzing whether the hybrid instrument can contractually be settled
in such a way that the investor would not recover substantially all of
its initial recorded investment under paragraph 13(a). Whether that
purchased asset is a financial asset or a nonfinancial asset (such as
gold) is not relevant to the treatment of the excess purchase price.
It is noted that requiring the investor to make a cash payment to
the issuer is also economically equivalent to reducing the principal
on the note. The note described in the question above could have been
structured to include terms requiring that the principal of the note
be substantially reduced and the coupon reduced to zero if the
interest rate for single-A rated debt increased to at least 10 percent
at the end of 2 years. That alternative structure would clearly have
required that the embedded derivative be accounted for separately,
because that embedded derivative’s existence would have resulted in
the possibility that the hybrid instrument could contractually be
settled in such a way that the investor would not recover
substantially all of its initial recorded investment. |
DIG Issue B3 --- http://www.fasb.org/derivatives/
QUESTION
Should an investor (creditor) account separately for a put or call
option that is added to a debt instrument by a third party
contemporaneously with or subsequent to the issuance of the debt
instrument?
BACKGROUND
The last two sentences of paragraph 61(d) states, "In certain
unusual situations, a put or call option may have been subsequently
added to a debt instrument in a manner that causes the investor
(creditor) to be exposed to performance risk (default risk) by
different parties for the embedded option and the host debt
instrument, respectively. In those unusual situations, the embedded
option and the host debt instrument are not clearly and closely
related." The references to the "embedded" option in
the previous sentences refer to the added option.
Example 1 presents a transaction that involves the addition of a
call option contemporaneously with or subsequent to the issuance of
debt. Example 2 presents a group of transactions with a similar
overall effect.
Example 1 Company X issues 15-year puttable bonds to an Investment
Banker for $102. The put option may be exercised at the end of five
years. Contemporaneously, the Investment Banker sells the bonds with
an attached call option to Investor A for $100. (The call option is a
written option from the perspective of Investor A and a purchased
option from the perspective of the Investment Banker.) The Investment
Banker also sells to Investor B for $3 the call option purchased from
Investor A on those bonds. The call option has an exercise date that
is the same as the exercise date on the embedded put option. At the
end of five years, if interest rates increase, Investor A would
presumably put the bonds back to Company X, the issuer. If interest
rates decrease, Investor B would presumably call the bonds from
Investor A.
Example 2 Company Y issues 15-year puttable bonds to Investor A for
$102. The put option may be exercised at the end of five years.
Contemporaneously, Company Y purchases a transferable call option on
the bonds from Investor A for $2. Company Y immediately sells that
call option to Investor B for $3. The call option has an exercise date
that is the same as the exercise date of the embedded put option. At
the end of five years, if rates increase, Investor A would presumably
put the bonds back to Company Y, the issuer. If rates decrease,
Investor B would presumably call the bonds from Investor A.
RESPONSE
Yes. A put or call option that is added to a debt instrument by a
third party contemporaneously with or subsequent to the issuance of
the debt instrument should be separately accounted for as a derivative
under Statement 133 by the investor (that is, by the creditor); it
must be reported at fair value with changes in value recognized
currently in earnings unless designated in a qualifying hedging
relationship as a hedging instrument. As a result, in Example 1 above,
the call option that is attached by the Investment Banker is a
separate derivative from the perspective of Investor A. Similarly, the
call option described in Example 2 is a separate freestanding
derivative that also must be reported at fair value with changes in
value recognized currently in earnings unless designated as a hedging
instrument.
The discussion in the last two sentences of paragraph 61(d) that
refers to a put or call option that is added to a debt instrument by a
third party subsequent to its issuance incorrectly uses the phrase
embedded option in referring to that option. An option that is added
or attached to an existing debt instrument by another party results in
the investor having different counterparties for the option and the
debt instrument and, thus, the option should not be considered an
embedded derivative. The notion of an embedded derivative in a hybrid
instrument refers to provisions incorporated into a single contract,
and not to provisions in separate contracts between different
counterparties. Consequently, such added or attached options should
not have been discussed in paragraph 61, which discusses only embedded
derivatives. (When the Board next considers a "technical
corrections" amendment of the accounting literature, the staff
plans to recommend deletion of the last two sentences of paragraph
61(d).) |
DIG Issue B4 --- http://www.fasb.org/derivatives/
QUESTION
Two entities enter into a long-term service contract whereby one
entity (A) agrees to provide a service to the other entity (B), at
market rates over a three-year period. Entity B forecasts it will pay
1,000 kroner to Entity A at the end of the three-year period for all
services rendered under the contract. Entity A's functional currency
is the kroner and Entity B's is the U.S. dollar. In addition to
providing the terms under which the service will be provided, the
contract includes a foreign currency exchange provision. The provision
requires that over the term of the contract, Entity B will pay or
receive an amount equal to the fluctuation in the exchange rate of the
U.S. dollar and the kroner applied to a notional amount of 100,000
kroner (that is, if the U.S. dollar appreciates versus the kroner,
Entity B will pay the appreciation, and if the U.S. dollar depreciates
versus the kroner, Entity B will receive the depreciation). The host
contract is not a derivative and will not be recorded in the financial
statements at market value. For the purpose of applying paragraph 15,
is the embedded foreign currency derivative considered to be clearly
and closely related to the terms of the service contract?
BACKGROUND
Paragraph 12 of Statement 133 requires that an embedded derivative
instrument be separated from the host contract and accounted for as a
derivative instrument pursuant to the Statement if certain criteria
are met. Paragraph 15 provides that an embedded foreign currency
derivative instrument is not to be separated from the host contract
and considered a derivative pursuant to paragraph 12 if the host
contract is not a financial instrument and specifies payments
denominated in either of the following currencies:
The currency of the primary economic environment in which any
substantial party to the contract operates (that is, its functional
currency)
The currency in which the price of the related good or service is
routinely denominated in international commerce.
Paragraph 15 provides the exclusion to paragraph 12 on the basis
that if a host contract is not a financial instrument and it is
denominated in one of the two aforementioned currencies, then the
embedded foreign currency derivative is considered to be clearly and
closely related to the terms of the service contract.
RESPONSE
No, the embedded foreign currency derivative instrument should be
separated from the host and considered a derivative instrument under
paragraph 12.
In paragraph 311, "[t]he Board decided that it was important
that the payments be denominated in the functional currency of at
least one substantial party to the transaction to ensure that the
foreign currency is integral to the arrangement and thus considered to
be clearly and closely related to the terms of the lease." It
follows that the exception provided by paragraph 15 implicitly
requires that the other aspects of the embedded foreign currency
derivative must be clearly and closely related to the host.
In the example discussed above, because the contract is leveraged
by requiring the computation of the payment based on a 100,000 kroner
notional amount, the contract is a hybrid instrument that contains an
embedded derivative — a foreign currency swap with a notional amount
of 99,000 kroner. That embedded derivative is not clearly and closely
related to the host contract and under paragraph 12 of Statement 133
must be recorded separately from the 1,000 kroner contract. Either
party to the contract can designate the bifurcated foreign currency
derivative instrument as a hedging instrument pursuant to Statement
133 if applicable qualifying criteria are met. |
DIG Issue B5 --- http://www.fasb.org/derivatives/
QUESTION
If the terms of a hybrid instrument permit, but do not require, the
investor to settle the hybrid instrument in a manner that causes it
not to recover substantially all of its initial recorded investment,
does the contract satisfy the condition in paragraph 13(a), thereby
causing the embedded derivative to be considered not clearly
and closely related to the host contract?
BACKGROUND
Paragraph 13 of Statement 133 states:
For purposes of applying the provisions of paragraph 12, an
embedded derivative instrument in which the underlying is an interest
rate or interest rate index that alters net interest payments that
otherwise would be paid or received on an interest-bearing host
contract is considered to be clearly and closely related to the host
contract unless either of the following conditions exist:
The hybrid instrument can contractually be settled in such a way
that the investor (holder) would not recover substantially all of its
initial recorded investment.
The embedded derivative could at least double the investor's
initial rate of return on the host contract and could also result in a
rate of return that is at least twice what otherwise would be the
[current] market return for a contract that has the same terms as the
host contract and that involves a debtor with a similar credit
quality. [Footnote omitted.]
Even though the above conditions focus on the investor's rate of
return and the investor's recovery of its investment, the existence of
either of those conditions would result in the embedded derivative
instrument being considered not clearly and closely related to the
host contract by both parties to the hybrid instrument.
Paragraph 61(a) elaborates on the condition in paragraph 13(a) as
follows:
...the embedded derivative contains a provision that (1) permits
any possibility whatsoever that the investor's (or creditor's)
undiscounted net cash inflows over the life of the instrument would
not recover substantially all of its initial recorded investment in
the hybrid instrument under its contractual terms.... RESPONSE
No. The condition in paragraph 13(a) does not apply to a situation
in which the terms of a hybrid instrument permit, but do not require,
the investor to settle the hybrid instrument in a manner that causes
it not to recover substantially all of its initial recorded
investment, assuming that the issuer does not have the contractual
right to demand a settlement that causes the investor not to recover
substantially all of its initial recorded investment. Thus, if the
investor in a 10-year note has the contingent option at the end of
year 2 to put it back to the issuer at its then fair value (based on
its original 10-year term), the condition in paragraph 13(a) would not
be met even though the note's fair value could have declined so much
that, by exercising the option, the investor ends up not recovering
substantially all of its initial recorded investment.
The condition in paragraph 13(a) was intended to apply only to
those situations in which the investor (creditor) could be forced by
the terms of a hybrid instrument to accept settlement at an amount
that causes the investor not to recover substantially all of its
initial recorded investment. For example, assume the investor
purchased from a single-A-rated issuer for $10 million a structured
note with a $10 million principal, a 9.5 percent interest coupon, and
a term of 10 years at a time when the current market rate for 10-year
single-A-rated debt is 7 percent. Assume further that the terms of the
note require that, at the beginning of the third year of its term, the
principal on the note is reduced to $7.1 million and the coupon
interest rate is reduced to zero for the remaining term to maturity if
interest rates for single-A-rated debt have increased to at least 8
percent by that date. That structured note would meet the condition in
paragraph 13(a) for both the issuer and the investor because the
investor could be forced to accept settlement that causes the investor
not to recover substantially all of its initial recorded investment.
That is, if increases in the interest rate for single-A-rated debt
triggers the modification of terms, the investor would receive only $9
million, comprising $1.9 million in interest payments for the first 2
years and $7.1 in principal repayment, thus not recovering
substantially all of its $10 million initial net investment. |
DIG Issue B6 --- http://www.fasb.org/derivatives/
QUESTION
Three methods have been identified for determining the initial
carrying values of the host contract component and the embedded
derivative component of a hybrid instrument:
Estimating the fair value of each individual component of the
hybrid instrument and allocating the basis of the hybrid instrument to
the host instrument and the embedded derivative based on the
proportion of the fair value of each individual component to the
overall fair value of the hybrid (a "relative fair value"
method).
Recording the embedded derivative at fair value and determining the
initial carrying value assigned to the host contract as the difference
between the basis of the hybrid instrument and the fair value of the
embedded derivative (a "with and without" method based on
the fair value of the embedded derivative).
Recording the host contract at fair value and determining the
carrying value assigned to the embedded derivative as the difference
between the basis of the hybrid instrument and the fair value of the
host contract (a "with and without" method based on the fair
value of the host contract).
Because the "relative fair value" method (#1 above)
involves an independent estimation of the fair value of each
component, the sum of the fair values of those components may be
greater or less than the initial basis of the hybrid instrument,
resulting in an initial carrying amount for the embedded derivative
that differs from its fair value. Similarly, the "with and
without" method based on the fair value of the host contract (#3
above) may result in an initial carrying amount for the embedded
derivative that differs from its fair value. Therefore, both of those
methods may result in recognition of an immediate gain or loss upon
reporting the embedded derivative at fair value.
RESPONSE
The allocation method that records the embedded derivative at fair
value and determines the initial carrying value assigned to the host
contract as the difference between the basis of the hybrid instrument
and the fair value of the embedded derivative (#2 above) should be
used to determine the carrying values of the host contract component
and the embedded derivative component of a hybrid instrument when
separate accounting for the embedded derivative is required by
Statement 133.
Statement 133 requires that an embedded derivative that must be
separated from its host contract be measured at fair value. As stated
in paragraph 301 of the basis for conclusions, "…the Board
believes that it should be unusual that an entity would conclude that
it cannot reliably separate an embedded derivative from its host
contract." Once the carrying value of the host contract is
established, it would be accounted for under generally accepted
accounting principles applicable to instruments of that type that do
not contain embedded derivatives. Upon separation from the host
contract, the embedded derivative may be designated as a hedging
instrument, if desired, provided it meets the hedge accounting
criteria.
If the host contract component of the hybrid instrument is reported
at fair value with changes in fair value recognized in earnings or
other comprehensive income, then the sum of the fair values of the
host contract component and the embedded derivative should not exceed
the overall fair value of the hybrid instrument. That is consistent
with the requirement of footnote 13 to paragraph 49, which states, in
part:
"For a compound derivative that has a foreign currency
exchange risk component (such as a foreign currency interest rate
swap), an entity is permitted at the date of initial application to
separate the compound derivative into two parts: the foreign currency
derivative and the remaining derivative. Each of them would thereafter
be accounted for at fair value, with an overall limit that the sum of
their fair values could not exceed the fair value of the compound
derivative." (emphasis added.) While footnote 13 to paragraph 49
addresses separation of a compound derivative upon initial application
of Statement 133, the notion that the sum of the fair values of the
components should not exceed the overall fair value of the combined
instrument is also applicable to hybrid instruments containing a
nonderivative host contract and an embedded derivative. However, in
instances where the hybrid instrument is reported at fair value with
changes in fair value recognized in earnings, paragraph 12(b) would
not be met and therefore separation of the embedded derivative from
the host contract would not be permitted. |
DIG Issue B7 --- http://www.fasb.org/derivatives/
Embedded Derivatives: Variable Annuity Products and Policyholder
Ownership of the Assets
|
DIG Issue B8 --- http://www.fasb.org/derivatives/
QUESTION
How does one determine the host contract in a nontraditional
variable annuity contract (a hybrid instrument)?
BACKGROUND
While traditional variable annuity contracts represent the majority
of contracts sold today by life insurance and other enterprises, those
enterprises have also developed a wide range of variable annuity
contracts with nontraditional features. Nontraditional features of
traditional variable annuity contracts result in a sharing of
investment risk between the issuer and the holder. Nontraditional
variable annuity contracts provide for some sort of minimum guarantee
of the account value at a specified date. This minimum guarantee may
be guaranteed through a minimum accumulation benefit or a guaranteed
account value floor. For example, the floor guarantee might be that,
at a specified anniversary date, the contract holder will be credited
with the greater of (1) the account value, as determined by the
separate account assets, or (2) all deposits that are made, plus three
percent interest compounded annually.
While these nontraditional variable annuity contracts have
distinguishing features, they possess a common characteristic: the
investment risk associated with the assets backing the contract is
shared by the issuer and the policyholder. That is, in contrast to
traditional variable annuity contracts, the investment risk is, by
virtue of the nontraditional product features, allocated between the
two parties and not borne entirely by only one of the parties (the
holder in the case of a traditional variable annuity contract).
Paragraphs 12 and 16 of Statement 133 require that, in certain
circumstances, an embedded derivative is to be accounted for
separately from the host contract as a derivative instrument. An
example illustrating the application of paragraph 12 to insurance
contracts is provided in paragraph 200 of Statement 133. Paragraph
200, second bullet point entitled "Investment Component,"
concludes that the investment component of an insurance contract
backed by investments owned by the insurance company is a debt
instrument because ownership of those investments rests with the
insurance company, noting that the investments are recorded in the
general account of the insurance company. The same bullet point
concludes that the investment component of an insurance contract
backed by assets held in the insurance company's separate account is a
direct investment of the policyholder because the policyholder directs
and owns the investments. (Subsequent to the issuance of Statement
133, some have challenged the assertion that the policyholder
"owns" the investments. The propriety of the conclusions
reached in paragraph 200 relating to traditional variable annuities
has been addressed in Statement 133 Implementation Issue No. B7,
"Embedded Derivatives: Variable Annuity Products and Policyholder
Ownership of the Assets.")
RESPONSE
The FASB staff guidance presented in Statement 133 Implementation
Issue B7 indicates that a traditional variable annuity (as described
in that Issue) contains no embedded derivatives that warrant separate
accounting under Statement 133 even though the insurer, rather than
the policyholder, actually owns the assets.
The host contract in a nontraditional variable annuity contract
would be considered the traditional variable annuity that, as
described in Issue B7, does not contain an embedded derivative that
warrants separate accounting. Nontraditional features (such as a
guaranteed investment return through a minimum accumulation benefits
or a guaranteed account value floor) would be considered embedded
derivatives subject to the requirements of Statement 133. Paragraph 12
of Statement 133, states, in part, that:
Contracts that do not in their entirety meet the definition of a
derivative instrument such as … insurance policies… may contain
"embedded" derivative instruments—implicit or explicit
terms that affect some or all of the cash flows or the value of other
exchanges required by the contract in a manner similar to a derivative
instrument. The effect of embedding a derivative instrument in another
type of contract is that some or all of the cash flows or other
exchanges that otherwise would have been required by the contract,
whether unconditional or contingent upon the occurrence of a specified
event, will be modified based on one or more underlyings. [Emphasis
added; reference omitted.] The economic characteristics and risks of
the investment guarantee and those of the traditional variable annuity
contract would typically be considered to be not clearly and closely
related.
In determining the accounting for other seemingly similar
structures, it would be inappropriate to analogize to the above
guidance due to the unique attributes of nontraditional variable
annuity contracts and the fact that the above guidance, which is based
on Issue B7, can be viewed as an exception for nontraditional variable
annuity contracts issued by insurance companies. |
DIG Issue B9 --- http://www.fasb.org/derivatives/
QUESTION
Are the economic characteristics and risks of the embedded
derivative (market adjusted value prepayment option) in a market value
annuity contract (MVA or the hybrid instrument) clearly and closely
related to the economic characteristics and risks of the host
contract?
BACKGROUND
An MVA accounted for as an investment contract under FASB Statement
No. 97, Accounting and Reporting by Insurance Enterprises for Certain
Long-Duration Contracts and for Realized Gains and Losses from the
Sale of Investments, given its lack of significant mortality risk,
provides for a return of principal plus a fixed rate of return if held
to maturity, or alternatively, a "market adjusted value" if
the surrender option is exercised by the contract holder prior to
maturity. The market adjusted value is typically based on current
interest crediting rates being offered for new MVA purchases. As an
example of how the market adjusted value is calculated at any period
end, the formula typically takes the contractual guaranteed amount
payable at the end of the specified term, including the applicable
guaranteed interest, and discounts that future cash flow to its
present value using rates currently being offered for new MVA
purchases with terms equal to the remaining term to maturity of the
existing MVA. As a result, the market value adjustment may be positive
or negative, depending upon market interest rates at each period end.
In a rising interest rate environment, the market adjustment may be
such that less than substantially all principal is recovered upon
surrender.
The following is an example of an annuity with a fixed return if
held for a specified period or market adjusted value if surrendered
early.
Single premium deposit: $100,000 on 12/31/98
Maturity Date: 12/31/07 (9 yr. term)
Guaranteed Fixed Rate: 7%
Fixed Maturity Value: $183,846 ($100,000 @ 7% compounded for 9
yrs.)
Market Value Adjustment Formula: Discount future fixed maturity
value to present value at surrender date using currently offered
market value annuity rate for the period of time left until maturity.
12/31/99 Valuation Date
(1) Fixed rate account value @7%
(2) Market Adjusted Value
3) Market Value Adjustment |
5%
$107,000
124,434
$ 17,434
======== |
9%
$107,000
92,266
$ (14,734)
======== |
RESPONSE
Yes, the embedded derivative (prepayment option) is
clearly and closely related to the host debt contract.
Paragraph 61(d) provides interpretation of the clearly
and closely related criteria as it applies to debt with put options,
noting that:
Call options (or put options) that can accelerate the
repayment of principal on a debt instrument are considered to be clearly
and closely related to a debt instrument that requires principal
repayments unless both (1) the debt involves a substantial premium or
discount (which is common with zero-coupon bonds) and (2) the put or
call option is only contingently exercisable. Thus, if a substantial
premium or discount is not involved, embedded calls and puts (including
contingent call or put options that are not exercisable unless an event
of default occurs) would not be separated from the host contract. The
terms of MVAs do not include either feature. There is no substantial
premium or discount present in these contracts at inception, and the put
option is exercisable at any time by the contract holder (that is, it is
not "contingently exercisable").
Since the embedded derivative has an underlying that is
an interest rate index and the host contract is a debt instrument, the
MVA contract must be analyzed under the criteria in paragraphs 13 and
61(a) as well. Pursuant to the tentative FASB staff guidance presented
in Statement 133 Implementation Issue No. B5, the condition in paragraph
13(a) was intended to apply only to those situations in which the
investor (creditor) could be forced by the terms of a hybrid instrument
to accept settlement at an amount that causes the investor not to
recover substantially all of its initial recorded investment. That is,
because the investor always has the option to hold the MVA contract to
maturity and receive the fixed rate and the insurance company cannot
force the investor to surrender, the condition in paragraph 13(a) would
not be met (that is, the insurance company does not have the contractual
right to demand surrender and put the investor in a situation of not
recovering substantially all of its initial recorded investment). The
condition in paragraph 13(b) also would not be met in a typical MVA
contract, since there is no leverage feature that would result in twice
the initial and current market rate of return.
Because the criteria in paragraphs 13, 61(a), and 61(d)
are not met, the prepayment option is considered clearly and closely
related to the host debt instrument.
As the above examples demonstrate, the prepayment option
enables the holder simply to cash out of the instrument at fair value at
the surrender date. The prepayment option provides only liquidity to the
holder. The holder receives only the market adjusted value, which is
equal to the fair value of the investment contract at the surrender
date. As such, the prepayment option (the embedded derivative) has a
fair value of zero at all times. |
DIG Issue B10 --- http://www.fasb.org/derivatives/
Embedded Derivatives: Equity-Indexed Life
Insurance Contracts
|
DIG Issue B11 --- http://www.fasb.org/derivatives/
Embedded Derivatives: Volumetric Production Payments
|
DIG Issue B12 --- http://www.fasb.org/derivatives/
Embedded Derivatives in Certificates Issued by Qualifying
Special-Purpose Entities
|
DIG Issue B13 --- http://www.fasb.org/derivatives/
Embedded Derivatives: Accounting for Remarketable Put Bonds
|
DIG Issue B14 --- http://www.fasb.org/derivatives/
Purchase
Contracts with a Selling Price Subject to a Cap and a Floor
(Released 11/99)
|
DIG Issue B15--- http://www.fasb.org/derivatives/
Separate
Accounting for Multiple Derivative Features Embedded in a Single Hybrid
Instrument
(Released 11/99)
|
DIG Issue B16 --- http://www.fasb.org/derivatives/
Calls
and Puts in Debt Instruments
(Released 11/99)
|
DIG Issue K2 at http://www.fasb.org/derivatives/
QUESTION
If a bond includes in its terms at issuance an option feature
that is explicitly transferable independent of the bond and thus
is potentially exercisable by a party other than either the issuer
of the bond (the debtor) or the holder of the bond (the investor),
should the option be considered under Statement 133 as an attached
freestanding option or an embedded option by the writer and the
holder of the option?
BACKGROUND
Certain structured transactions involving the issuance of a
bond incorporate transferable options to call or put the bond. As
such, those options are potentially exercisable by a party other
than the debtor or the investor. For example, certain "put
bond" structures involving three separate parties - the
debtor, the investor, and an investment bank - may incorporate
options that are ultimately held by the investment bank, giving
that party the right to call the bond from the investor. Several
put bond structures involving options that are exercisable by a
party other than the debtor or investor are described in Statement
133 Implementation Issue No. B13, "Accounting for
Remarketable Put Bonds."
RESPONSE
If a bond includes in its terms at issuance an option feature
that is explicitly transferable independent of the bond and thus
is potentially exercisable by a party other than either the issuer
of the bond (the debtor) or the holder of the bond (the investor),
that option should be considered under Statement 133 as an
attached freestanding derivative instrument, rather than an
embedded derivative, by both the writer and the holder of the
option.
For example, a call option that is either transferable by the
debtor to a third party and thus is potentially exercisable by a
party other than the debtor or the original investor based on the
legal agreements governing the debt issuance can result in the
investor having different counterparties for the option and the
original debt instrument. Accordingly, even when incorporated into
the terms of the original debt agreement, such an option may not
be considered an embedded derivative by either the debtor or the
investor because it can be separated from the bond and effectively
sold to a third party. The notion of an embedded derivative, as
discussed in paragraph 12, does not contemplate features that may
be sold or traded separately from the contract in which those
rights and obligations are embedded. Assuming they meet Statement
133’s definition of a derivative, such features must be
considered attached freestanding derivatives rather than embedded
derivatives by both the writer and the current holder.
In addition, Statement 133 Implementation Issue No. B3,
"Investor’s Accounting for a Put or Call Option Attached to
a Debt Instrument Contemporaneously with or Subsequent to Its
Issuance," require that an option that is added or attached
to an existing debt instrument by a third party also results in
the investor having different counterparties for the option and
the debt instrument and, thus, the option should not be considered
an embedded derivative.
An attached freestanding derivative is not an embedded
derivative subject to grandfathering under the transition
provisions of Statement 133. |
FASB: Important Differences in
Accounting for Embedded Derivatives in FAS 133 Versus IFRS 9
http://www.iasplus.com/en-us/standards/ifrs-usgaap/embedded-derivatives
"IASB proposes amendments to clarify the accounting for embedded
derivatives," IASB, December 22, 2008 ---
http://www.iasb.org/Current+Projects/IASB+Projects/Financial+Instruments/Financial+instruments.htm
The International Accounting Standards Board (IASB)
today published for public comment proposals to clarify the accounting
treatment for embedded derivatives.
The proposals respond to requests received from
those taking part in the recent round-table discussions organised by the
IASB and the US Financial Accounting Standards Board (FASB) to clarify the
requirements in IAS 39 Financial Instruments: Recognition and Measurement
and IFRIC 9 Reassessment of Embedded Derivatives.
Participants asked the IASB to act in order to
prevent any diversity in practice developing as a result of the amendments
made to IAS 39 in October 2008 to permit the reclassification of particular
financial assets. The proposals published today would require all embedded
derivatives to be assessed and, if necessary, separately accounted for in
financial statements.
Commenting on the proposals, Sir David Tweedie,
IASB Chairman, said:
* In October 2008, in response to exceptional
circumstances, the IASB amended accounting standards relating to the
reclassification of financial instruments. Issuing that amendment
without normal due process always carried the risk of unintended
consequences, and these proposals seek to clarify the application of
that amendment to embedded derivatives.
The proposals are set out in an exposure draft
Embedded Derivatives, on which the IASB invites comments by 21 January 2009.
The exposure draft is available on the Website from the 'open for comment'
at www.iasb.org .
The Exposure Draft may be temporarily downloaded
from
http://www.iasb.org/NR/rdonlyres/7421736D-6390-4F7B-9F0A-BE4B21CBCABD/0/ED_IFRIC9andIAS391208.pdf
IASB Financial Instruments Projects Page ---
http://www.iasb.org/Current+Projects/IASB+Projects/Financial+Instruments/Financial+instruments.htm
Embedded Option =
an option that is an inseparable part of another
instrument. Most embedded options are conversion features granted to the buyer or early
termination options reserved by the issuer of a security. A call provision of a bond or
note that contractually allows for early extinguishment is an example of an embedded
option. See embedded derivatives and option.
Note that much of the
discussion below is changed with respect to embedded derivatives:
"FASB and IASB agree on a three-category financial asset classification
and measurement approach," PwC, May 22, 2012 ---
Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=GBAD-8UJRHU&SecNavCode=MSRA-84YH44&ContentType=Content
. . .
Under their
respective approaches, debt investments (e.g., loans and debt
securities) would be classified based on an individual instrument's
characteristics (as further explained below) and the business strategy
for the portfolio. However, before this week's meeting, the IASB had
defined two categories whereas the FASB had defined three categories.
This week, the IASB agreed to introduce a
third category in which debt investments are measured at fair value with
changes in fair value recognized through other comprehensive income. The
FASB also agreed on a revised definition for this category. As a result,
the categories for debt investments would be broadly defined as follows:
-
Amortized cost – consists of debt
investments where the primary objective is to hold the assets to
collect the contractual cash flows.
- Fair
value with changes in fair value recognized in other comprehensive
income – consists of debt
investments with the primary objective of both holding the assets to
collect contractual cash flows and realizing changes in fair value
through sale. Interest and impairment would be recognized in net
income in a manner consistent with the amortized cost category, and
fair value changes would be recycled from other comprehensive income
to net income when the asset is sold.
- Fair
value with changes in fair value recognized in net income
– consists of debt investments that
either (1) do not meet the instrument characteristics criterion or
(2) meet the instrument characteristics criterion but do not meet
one of the other category definitions (i.e., "the residual
category").
In addition, the FASB agreed to adopt the
IASB requirement for prospective reclassifications between categories
when there is a significant change in business strategy, which is
expected to be "very infrequent."
In previous meetings, the FASB had also
agreed to incorporate the following aspects of the IASB's approach:
-
Instrument characteristics criterion.
The contractual cash flows of the debt
investment must represent
solely payments of principal and interest
in order to be eligible for the
amortized cost or fair value with changes in fair value recognized
in other comprehensive income categories.
-
Bifurcation of hybrid financial instruments.
Separate accounting for financial asset
host contracts and embedded derivatives in hybrid financial assets
would be prohibited; instead the entire hybrid financial asset would
be accounted for as a single instrument. However, hybrid financial
liabilities would continue to be bifurcated.
Continued in article
Jensen Comment
I favor most of these changes, especially changes that use OCI to avoid
fluctuations in current earnings that will never be realized. However, I
think the fact that the FASB's caving in on the issue of not bifurcating
embedded derivatives in hybrid financial assets is absurd since the
financial risks may vary so greatly between the host contract and its
embedded derivatives. And my love of symmetry is appalled at bifurcation of
hybrid liabilities but not hybrid assets is broken hearted.
Convertible debt can be viewed as a debt instrument with a call option on equity securities of the
issuer. Interest rates on that option are not clearly-and-closely
related. Hence, the embedded option might be accounted for separately under
Paragraph 6 on Page 3 of FAS 133.
DIG Issue K3 at http://www.fasb.org/derivatives/
QUESTION
Should the combinations of purchased and written options described
below be considered for accounting purposes as two separate option
contracts or as a single forward contract:
An embedded (non-transferable) purchased call (put) option and an
embedded (non-transferable) written put (call) option executed
contemporaneously with the same counterparty as part of a single
hybrid instrument?
A freestanding purchased call (put) option and a freestanding or
embedded (non-transferable) written put (call) option that are
executed contemporaneously with the same counterparty at inception but
where the purchased option may be transferred?
A freestanding purchased call (put) option and a freestanding or
embedded (non-transferable) written put (call) option that are
executed contemporaneously with different counterparties at inception?
For the purposes of this question, in all cases, the purchased and
written options have the same terms (strike price, notional amount,
and exercise date) and the same underlying, and neither of the two
options is required to be exercised. The notion of the "same
counterparty" encompasses contracts entered into directly with a
single counterparty and contracts entered into with a single party
that are structured through an intermediary. In addition, consistent
with the conclusion in Statement 133 Implementation Issue No. K2,
"Are Transferable Options Freestanding or Embedded?", an
option incorporated into the terms of a hybrid instrument at inception
that is explicitly transferable should be considered a freestanding,
rather than an embedded, derivative instrument.
RESPONSE
This section provides separate responses for each of the
combinations of options in the Question section.
A combination of an embedded (non-transferable) purchased call
(put) option and an embedded (non-transferable) written put (call)
option in a single hybrid instrument that have the same terms (strike
price, notional amount, and exercise date) and same underlying and
that are entered into contemporaneously with the same counterparty,
should be considered for accounting purposes as a single forward
contract by both parties to the contracts. Those embedded options are
in substance an embedded forward contract because they (a) convey
rights (to the holder) and obligations (to the writer) that are
equivalent from an economic and risk perspective to an embedded
forward contract and (b) cannot be separated from the hybrid
instrument in which they are embedded. Even though neither party is
required to exercise its purchased option, the result of the overall
structure is a hybrid instrument that will likely be redeemed at a
point earlier than its stated maturity. That result is expected by
both the hybrid instrument’s issuer and investor regardless of
whether the embedded feature that triggers the redemption is in the
form of two separate options or a single forward contract. (However,
if either party is required to exercise its purchased
"option" prior to the stated maturity date of the hybrid
instrument, the hybrid instrument should not be viewed for accounting
purposes as containing one or more embedded derivatives. In substance,
the debtor (issuer) and creditor (investor) have agreed to terms that
accelerate the stated maturity of the instrument and the exercise date
of the "option" is essentially the hybrid’s actual
maturity date. As a result, it is inappropriate to characterize the
hybrid instrument as containing two embedded option contracts that are
exercisable only on the actual maturity date or as containing an
embedded forward contract that is a combination of an embedded
purchased call (put) and a written put (call) with the same terms.)
Embedded options in a hybrid instrument that are required to be
considered a single forward contract for accounting purposes as a
result of the guidance contained herein may not be designated
individually as hedged items in a fair value hedge in which the
hedging instrument is a separate, unrelated freestanding option.
Statement 133 does not permit a component of a derivative to be
designated as the hedged item.
A combination of a freestanding purchased call (put) option and a
freestanding or embedded (non-transferable) written put (call) option
that have the same terms and same underlying and are entered into
contemporaneously with the same counterparty at inception should be
considered for accounting purposes as separate option contracts,
rather than a single forward contract, by both parties to the
contracts. Derivatives that are transferable are, by their nature,
separate and distinct contracts. That is consistent with the
conclusion in Issue K2 which states: "…a call option that is
either transferable by the debtor to a third party or that is deemed
to be exercisable by a party other than the debtor or the original
investor based on the legal agreements governing the debt issuance can
result in the investor having different counterparties for the option
and the original debt instrument. Accordingly, even when incorporated
into the terms of the original debt agreement, such an option may not
be considered an embedded derivative by either the debtor or the
investor because it can be separated from the bond and effectively
sold to a third party…."
A combination of a freestanding purchased call (put) option and a
freestanding or embedded (non-transferable) written put (call) option
that have the same terms and same underlying and are entered into
contemporaneously with different counterparties at inception should be
considered for accounting purposes as separate option contracts,
rather than a single forward contract, by both parties to the
contracts. Similarly, a combination of a freestanding written call
(put) option and an embedded (non-transferable) purchased put (call)
option that have the same terms and same underlying and are entered
into contemporaneously with different counterparties at inception
should be considered for accounting purposes as separate option
contracts, rather than a single forward contract, by both parties to
the contracts. Separate purchased and written options with the same
terms but that involve different counterparties convey rights and
obligations that are distinct and do not warrant bundling as a single
forward contract for accounting purposes under Statement 133. |
Question
How should we account for this type of security?
"Liquidity Put Agreement," Sound Capital Management, March
2008 ---
http://www.soundcapital.com/liquidityput.html
Under the terms of a Liquidity Put
Agreement (LPA), the issuer will purchase a portfolio of
Treasury securities which will mature in the amount of the DSRF
requirement and provide interest income each year on a
semi-annual basis. The portfolio will generally consist of two
securities; a premium bond and a discount bond. The amount of
each bond will be determined so as to produce an aggregate
purchase price of par. In essence, the issuer will own a hybrid
long-term Treasury security that pays a semi-annual coupon. If,
during the term of the agreement, the issuer experiences a cash
flow shortage necessitating a draw on the DSRF, the issuer can
put the securities back to the Provider of the LPA and receive a
price of par plus accrued interest. Thus, even if interest rates
rise and the value of the securities fall, the issuer will
always be able to put the securities back to the Provider at
par, eliminating the need to mark the portfolio to market and
cure any deficiencies.
In exchange for this agreement, the
Provider will receive a fee based upon the size of the DSRF.
This fee can be paid either annually out of DSRF interest or
upfront, on a present value basis. If the latter is chosen, the
mixture of securities in the DSRF portfolio can be adjusted so
that the issuer will have no net out of pocket expense and
instead receive a lower rate of return on the DSRF.
If the issuer desires to terminate the
LPA for reasons other than a credit default (e.g., a refunding
or replacement of the DSRF with a surety policy), the issuer may
not exercise the put. Instead, the contract will be terminated
and the issuer will pay to the Provider the present value of the
remaining fees, if any. In the case of a refunding, though, the
issuer can usually transfer the LPA on the DSRF to the refunding
bond issue and only unwind that portion resulting from a
decrease in the DSRF requirement.
On a net basis, LPAs can provide
municipal issuers with yields based on long-term Treasury yields
without the price volatility risk associated with such
securities. Additionally, the LPA provides an issuer the
structuring flexibility to receive an upfront payment
representing the present value of all or a portion of future
investment earnings. Certain issuers may find this structure as
either an alternative funding source or as a means to capture
negative arbitrage in other funds. Because most DSRFs are
subject to arbitrage rebate under current law, any earnings
above the arbitrage yield can be used to offset negative
arbitrage in other funds (e.g., construction fund or capitalized
interest fund).
In summary, LPAs permit the Trustee, on
behalf of the Issuer, to hold a Treasury security with an option
to put the security at par in case of a credit event. The par
put allows the issuer to carry the security at par, eliminating
the need for any mark-up when interest rates move higher.
Continued in article
Jensen Comment
Ignoring for the moment that this is a portfolio and pretending that
it is a single investment contract, I would say that it is a
security investment with an embedded derivative as defined in FAS
133 and IAS 39. The fee becomes a premium of the embedded put option
that in essence is a fair value hedge creating cash flow risk.
Without the option, the investment has no cash flow risk with
a fixed semi-annual coupon and an eventual redemption at par. As
such, however, it has fair value risk if the investment is sold or
settled prematurely at current market value different from the
discounted value of par.
With the embedded put option hedge, the investment has no fair
value risk, but it does have cash flow risk because if interest rate
returns on the instrument and the derivative hedge combined vary
with market interest rates.
One question is whether the embedded derivative must be
bifurcated and accounted for separately. The question is whether its
value changes of the option are perfectly and negatively correlated
with the value of the hedged item. If it were purchased
independently, I would say yes because options market changes in
value are not generally perfectly correlated with hedged item
prices, which is what makes option hedges notoriously ineffective
hedges if settled prematurely. Usually only changes in intrinsic
value can get hedge accounting relief. In this case, however, the
option cannot be sold or settled apart from the host contract. It is
thus perfectly effective as a fair value hedge, and I would say it
does not have to be bifurcated and accounted for separately as a
derivative financial instrument under FAS 133 and IAS 33 rules.
Since the hedged item in reality is a portfolio, the issue of
whether this is a macro hedge must also be considered. The notionals
and the maturity dates of the premium and discount bonds are
identical. The way the two portfolio components interact to produce
an aggregate fixed value (par) subject to fair value risk in this
case. In my opinion this is a homogeneous portfolio that should be
allowed macro hedging using the put option to hedge fair value risk
due to changes in market interest rates..
The combined instrument of two bonds and a put option should be
carried at the discounted value of par less netted against the
discounted value of the premium fees. But in the case of almost any
FAS 133 and IAS 39 puzzle, I'm never 100% certain of my answers to
problems where I've not previously seen an authoritative solution
(like the authoritative solutions in the DIG pronouncements and
Appendices A and B of FAS 133.
My free tutorials on FAS 133 and IAS 39 are linked at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
My FAS 133 and IAS 39 glossary is at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
You can find quite a few interesting problems and answers
about embedded derivatives in my exam material at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/PracticeQuestions/
|
Also see compound
derivative.
Equity Hedging
An equity derivative is a
derivative financial instrument that derives its value in whole or in part
by the value of equity share prices of corporations or other forms of equity
ownership. Being a derivative itself it cannot get hedge accounting
treatment under FAS 133 or IAS 39 because these standards do not allow hedge
accounting for a derivative that hedges another derivative. You can read
about equity derivatives at
http://en.wikipedia.org/wiki/Equity_derivative
"What’s a Couple of Hundred Trillion When You’re Talking Derivatives?"
by Floyd Norris, The New York Times, September 23, 2006 ---
http://www.nytimes.com/2006/09/23/business/23charts.html
The volume outstanding of equity
derivatives is rising by about 30 percent a year, and now totals
$5.6 trillion. It could go farther, with world stock market
capitalization now about $41 trillion, according to Standard &
Poor’s.
FAS 133 and IAS 39 require that
equity derivatives be carried at fair value unless they are intended to not
be net settled, i.e., they will actually be settled by delivery of shares.
There are some exceptions for hybrid instruments as discussed in IAS 39
Paragraph 23c and FAS 133 Paragraph 12b.
One of the main differences between a "financial instrument" versus a
"derivative financial instrument" is that the notional is generally not at
risk in a "derivative financial instrument." For example if Company C
borrows $600 million from Bank B in a financial instrument, the notional
amount ($600 million) is at risk immediately after the notional is
transferred to Company C. On the other hand, if Company C and Company D
contract for an interest rate swap on a notional of $600 million using Bank
B as an intermediary, the $600 million notional never changes hands. Only
the swap payments for the differences in interest rates are at risk and
these are only a small fraction of the $600 million notional. Sometimes the
swap payments are even guaranteed by the intermediary, thereby eliminating
credit risk.
So where's the risk of a derivative financial instrument that caused all
the fuss beginning in the 1980s and led to the most complex accounting
standards ever written (FAS 133 in the U.S. and IAS 39 internationally)?
Often there is little or no risk if the derivative contracts are held to
maturity. The problem is that derivatives are often settled before maturity
at huge gains to one party and huge losses to the counterparty. For example,
if Company C swaps fixed-rate interest payments on $600 million (having
current value risk with no cash flow variation risk) for variable-rate
interest payments on $600 million (having cash flow variation risk but no
market value variation risk), Company C has taken on enormous cash flow risk
that may become very large if interest rates change greatly in a direction
not expected by Company C. If Company C wants to
settle its swap contract before maturity it may have to pay an enormous
amount of money to do so either to counterparty Company D or to some other
company who will take the swap off the hands of Company C. The risk is not
the $600 million notional; Rather the risk is in the shifting value of the
swap contract itself which can be huge even if it is less than the $600
million notional amount.
Perhaps derivative financial instrument risk is even better illustrated
by futures contracts. Futures contracts are traded on organized exchanges
such as the Chicago Board of Trade. If Company A speculates in oil futures
on January 1, there is no exchange of cash on a 100,000 barrel notional that
gives Company A the right to sell oil at a future date (say in one year) at
a forward price (say $100 per barrel) one year from now. As a speculation,
Company A has gambled by hoping to buy 100,000 barrels of oil one year from
now for less than $100 per barrel and sell it for the contracted $100 price.
But futures contracts are unique in that they are net settled in cash
each day over the entire one year contract period. If the spot price of oil
is $55 on January 12 and $60 on January 13, Company A must provide $500,000
= ($60-$55)(100,000 barrels) to the counterparty on January 13 even though
the futures contract itself does not mature until December 31. If Company A
has not hedged its position, its risk can become astounding if oil prices
dramatically rise. Company A's futures contract had zero value on January 1
(futures contracts rarely have value initially except in the case of options
contracts), but the value of the futures contract may become an enormous
asset or an enormous liability each each day thereafter depending upon oil
spot price movements relative to the forward price ($100) that was
contracted.
Hence, derivative contracts may have enormous risks even though the
notionals themselves are not at risk. Prior to FAS 133 these risks were
generally not booked or even disclosed. In the 1980s newer types of
derivative contracts emerged (such as interest rate swaps) in part because
it was possible to have enormous amounts of off-balance-sheet debt that did
not even have to be disclosed, let alone booked, in financial statements.
Astounding frauds transpired that led to huge pressures on the SEC and the
FASB to better account for derivative financial instruments.
Most corporations adopted policies of not speculating in derivatives by
allowing derivatives to be used only to hedge risk. However, such policies
are very misleading since there are two main types of risk --- cash flow
risk versus value risk. It is impossible to
simultaneously hedge both types of risk, and hedging one type increases the
risk of the other type. For example, a company that swaps fixed for
floating rate interest payments increases cash flow risk by eliminating
value risk (which it may want if it plans to settle debt prior to maturity).
The counterparty that swaps floating rate interest payments for fixed rate
payments eliminates cash flow risk by taking on value risk.
It is impossible to hedge both cash flow and value
risk simultaneously.
Hence, to say that a corporation has a policy allowing hedging but not
speculating in derivative financial instruments is nonsense. A policy to
only hedge cash flow risk may create enormous value risk. A policy to only
hedge value risk may create enormous cash flow risk.
As the NYT article above points out that derivative financial instruments
are increasingly popular in world commerce. As a result risk exposures have
greatly increased even if all contracts were used for hedging purposes only.
The problem is that a hedge only reduces or eliminates one type of risk at
the "cost" of increasing the other type of risk.
Derivative contracts increase one type or the other type of risk the instant
they are signed. Hedging shifts risk but does not eliminate risk per se.
You can read more about scandals in derivative financial instruments
contracting (such as one company's "trillion dollar bet" that nearly toppled
Wall Street and Enron's derivative scandals) at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
You can download the CD containing my slide shows and videos on how to
account for derivative financial instruments at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
Old accounting professors have fun thinking back to their days
contemplating the difference between stock splits and stock dividends when
they (as students) were green as grass in intermediate accounting courses.
Always remember that a firm cannot profit from purchasing or selling or
splitting its own shares, or at least that's the chapter and verse of those
old textbooks. Nor can a company get hedge accounting for cash flow and
value risks in its own equity shares under FAS 133 and IAS 39.
Accounting theory is tricky business!
From The Wall Street Journal Accounting Weekly Review on February
29, 2008
IBM Plots Another Share Buyback
by
William M. Bulkeley
The Wall Street Journal
Feb 27, 2008
Page: B2
Click here to view the full article on WSJ.com ---
http://online.wsj.com/article/SB120404278177393945.html?mod=djem_jiewr_AC
TOPICS: Accounting,
Advanced Financial Accounting, Dividends, Stock Price
Effects, Tax Avoidance, Taxation
SUMMARY: IBM "...has spent $46.2 billion the last
five years on repurchasing its shares--a sum equal to
about 30% of its current market capitalization...and
more than twice the $20 billion it spent on acquisitions
during that period." As well, the article refers to
IBM's use of borrowing through a foreign subsidiary for
stock purchases after structuring the transaction to
avoid U.S. taxes on repatriated earnings under IRS
section 367 (b). That technique was known as "Killer B"
and is now prohibited by the IRS.
CLASSROOM APPLICATION: The article covers the range
of issues related to intermediate accounting courses'
discussions of treasury stock and stockholders' equity,
including dividends.
QUESTIONS:
1.) In general, how are stock buybacks, or treasury
stock purchases, accounted for? You may present the
answer to this question in the form of summary journal
entries, with comments.
2.) Refer to IBM's consolidated financial statements for
the year ended December 31, 2007, available at http://www.sec.gov/Archives/edgar/data/51143/000104746908001731/a2181836zex-13.htm
(Alternatively, you may click on the live link to
International Business Machines in the on-line article,
click on SEC filings on the left hand side of the page,
click on the link to the 10-K filed on 02/27/2008,
select the fourth item in the table of submitted
documents (Exhibit 13) and scroll to the financial
statements section beginning on page 58.) What financial
statement shows information about the treasury stock
purchases that IBM has made? Summarize the activity
shown for the years 2005 through 2007 and describe how
that information was used in the article.
3.) How extensive is the amount of IBM's treasury stock
held relative to the shares still outstanding? State
your answer in terms of shares outstanding and dollar
amounts shown in the financial statements. From which
financial statement(s) do you obtain this information?
4.) Has the amount of shares repurchased impacted the
amount of dividends paid to shareholders in the last
three years? In your answer, comment on the point in the
article that IBM increased its dividend 33% last year.
5.) Summarize the reasons given in the article
explaining why IBM has repurchased significant amounts
of its outstanding common stock.
6.) Why do you think that a program of share repurchases
can "speak to strong faith in [IBM's] business model" by
company management? What arguments are made against this
assessment as stated in the article?
7.) What tax implications did IBM integrate into their
share repurchase plans?
8.) Refer again to question 7. Given that the IRS
ultimately disallowed use of the tax plan that IBM
developed in relation to share repurchases, would you
characterize the company's action in undertaking the
plan as tax avoidance or tax evasion? Support your
answer.
Reviewed By: Judy Beckman, University of Rhode Island
|
"IBM Plots Another Share Buyback," by William M. Bulkeley, The Wall
Street Journal, February 27, 2008; Page B2 ---
http://online.wsj.com/article/SB120404278177393945.html?mod=djem_jiewr_AC
International Business Machines Corp. announced
its second $15 billion stock-buyback plan in less than a year, boosting
its share price and igniting a stock-market rally.
The announcement helped convince investors that
IBM, which had a strong fourth quarter, is confident in its strategy and
outlook and believes its stock is underpriced. IBM shares rose $4.30, or
3.9%, to $114.38 in 4 p.m. composite trading on the New York Stock
Exchange, leading a rally that boosted the Dow Jones Industrial Average
by nearly 1%.
Few companies have relied on share buybacks as
much as IBM. The Armonk, N.Y., company has spent $46.2 billion the last
five years on repurchasing its shares -- a sum equal to about 30% of its
current market capitalization, or stock-market value, and more than
twice the $20 billion it spent on acquisitions during that period.
The latest buyback comes as Samuel J. Palmisano
enters his sixth year as chief executive officer. During the early years
of his tenure, IBM went through a rocky period of lowered forecasts and
divestitures of businesses including its disk-drive and
personal-computer units. Until recently, its stock was stuck at less
than its level when Mr. Palmisano took over, while chief rival
Hewlett-Packard Co. has seen a sharp rise in its share price.
IBM's growing profits from an expanded line of
software, steady services business and sales in foreign markets have
helped the company produce a lot of cash. Last year, it reported free
cash flow of $12.4 billion, and it had $16.1 billion in cash at the end
of the year.
IBM said it expects to spend about $12.4
billion of the latest authorized buyback amount during the current year.
Funds will come from operations. It said the reduction in shares will
increase its per-share earnings by five cents to at least $8.25 for the
current year, up at least 16% from 2007. It has forecast $10 to $11 a
share in 2010.
"The willingness to make continued share
buybacks speaks to strong faith in the business model," said Thomas
Smith, an equity analyst with Standard & Poor's who recommends the
stock. Andrew Neff, an analyst with Bear Stearns Cos., said, "We like
where they're positioned, in big markets where they have a compelling
advantage." He said that IBM has been successful in purchasing software
companies and increasing their sales by training its huge sales force to
peddle the programs.
Last year, IBM spent $18.8 billion on stock
buybacks, including a $12.5 billion accelerated share repurchase in May
for which it borrowed money through a foreign subsidiary in order to
avoid U.S. taxes. The Internal Revenue Service prohibited further use of
that technique, which was known as a "Killer B" because it was designed
to circumvent IRS Section 367 (b) covering U.S. tax on repatriated
foreign earnings.
Despite the big gain in IBM shares yesterday,
buybacks don't have a very good recent record of providing superior
returns to shareholders and are sometimes criticized as poor uses of
corporate cash. S&P said that 423 members of the S&P 500-stock index did
buybacks in the 18-month period ended June 30, 2007, but only
one-quarter of them, including IBM, outperformed the S&P index through
Sept. 30. Buybacks reached record-setting levels in the first half of
last year.
Ed Barbini, an IBM spokesman, said the company
isn't stinting on investment in its operations and has increased
spending on research and development in all but one of the past five
years. He noted IBM also has been aggressively purchasing small
companies, especially software makers. The company raised its dividend
33% last year.
Jensen Comment
It might be useful to assign this case to students with two added questions:
- What situations arise when a company may want to hedge cash flow
risk in its own shares?
- What situations arise when a company may want to hedge fair value in
its own shares?
Equity-Indexed
Embedded Derivative =
a contract with payments derived from a common stock price
index such as the Dow Industrial Price Index or
the Standard and Poors 500 Index. For example,when a note's interest payments
has an embedded derivative (e.g., a common stock price option on a particular stock or a
stock index) pegged to equity prices, the embedded portion must be separated from the host
contract and be accounted for as a derivative according to Paragraph 61h on Pages 42-43 of
FAS 133. This makes equity indexed derivative
accounting different than credit indexed and inflation indexed embedded derivative accounting rules that do not allow separation from the host contract. In this regard,
credit-indexed embedded derivative accounting is more like commodity-indexed accounting. An illustration is provided beginning in Paragraph 185 on Page 97 of FAS 133. Also see Paragraph 250 on Page 133 of
FAS 133. FAS 133 does not cover
derivatives in which the equity index is tied only to the firm's on common stock according
to Paragraph 11a beginning on Page 6 of FAS 133. Also see index-amortizing, derivative
financial instrument and embedded derivative.
See DIG Issue B10 under embedded
derivatives.
Equity-Linked Bear Note = see embedded derivatives.
Equity Method =
a naughty word for hedge accounting under
FAS 133.
See Paragraph 29f on Page 20 of FAS 133. Risks of cash
flows, fair value and foreign
currency cannot be hedged for securities accounted for under the equity method under
SFAS 115 except under confusing net investment hedges discussed below. For equity
method accounting, ownership must constitute at least 20% of the outstanding voting
(equity) shares of the security in question. Under the equity method the investment is
adjusted for the owner's share of net earnings irrespective of cash dividends. Since
dividends do not affect earnings, the FASB does not allow cash flow hedges of forecasted
dividends under equity method accounting.
Cash flow hedges must have the possibility
of affecting net earnings. For example, Paragraph 485 on Page 211 of FAS 133
bans
foreign currency risk hedges of forecasted dividends of foreign subsidiary. The
reason is that these dividends are a wash item and do not affect consolidated earnings.
Not allowing equity method investments to be hedged items
is controversial. The FASB defends its decision in Paragraph
455 beginning on Page 200 of FAS 133. This reads as follows:
The Board
decided to retain the prohibition in the Exposure Draft from designating an investment
accounted for by the equity method as a hedged item to avoid conflicts with the existing
accounting requirements for that item. Providing fair value hedge accounting for an equity
method investment conflicts with the notion underlying APB Opinion No. 18, The Equity
Method of Accounting for Investments in Common Stock. Opinion 18 requires an investor
in common stock and corporate joint ventures to apply the equity method of accounting when
the investor has the ability to exercise significant influence over the operating and
financial policies of the investee. Under the equity method of accounting, the investor
generally records its share of the investees earnings or losses from its investment.
It does not account for changes in the price of the common stock, which would become part
of the basis of an equity method investment under fair value hedge accounting. Changes in
the earnings of an equity method investee presumably would affect the fair value of its
common stock. Applying fair value hedge accounting to an equity method investment thus
could result in some amount of double counting of the investors share of the
investees earnings. The Board believes that result would be inappropriate. In
addition to those conceptual issues, the Board was concerned that it would be difficult to
develop a method of implementing fair value hedge accounting, including measuring hedge
ineffectiveness, for equity method investments and that the results of any method would be
difficult to understand. For similar reasons, this Statement also prohibits fair value
hedge accounting for an unrecognized firm commitment to acquire or dispose of an
investment accounted for by the equity method.
Section c(4) of Paragraph 4 is
probably the most confusing condition mentioned in Paragraph 4. It allows hedging
under "net investment" criteria under Paragraph 20 of SFAS 52. The gain or
loss is reported in other comprehensive income as part
of the cumulative translation adjustment. Reasons are given in Paragraph 477 on Page 208
of FAS 133:
The net investment in a foreign
operation can be viewed as a portfolio of dissimilar assets and liabilities that would not
meet the criterion in this Statement that the hedged item be a single item or a group of
similar items. Alternatively, it can be viewed as part of the fair value of the parent's
investment account. Under either view, without a specific exception, the net investment in
a foreign operation would not qualify for hedging under this Statement. The Board decided,
however, that it was acceptable to retain the current provisions of Statement 52 in that
area. The Board also notes that, unlike other hedges of portfolios of dissimilar items,
hedge accounting for the net investment in a foreign operation has been explicitly
permitted by the authoritative literature.
For a derivative not designated as a hedging instrument,
the gain or loss is recognized in earnings in the period of change. Section 4(c) of
Paragraph 4 of FAS 133 amends SFAS 52 on Foreign Currency Translation, to
permit special accounting for a hedge of a foreign currency forecasted transaction with a
derivative. For more detail see foreign
currency hedge.
Paragraph 42 on Page 26 reads as follows:
.A derivative instrument or a
nonderivative financial instrument that may give rise to a foreign currency transaction
gain or loss under Statement 52 can be designated as hedging the foreign currency exposure
of a net investment in a foreign operation. The gain or loss on a hedging derivative
instrument (or the foreign currency transaction gain or loss on the nonderivative hedging
instrument) that is designated as, and is effective as, an economic hedge of the net
investment in a foreign operation shall be reported in the same manner as a translation
adjustment to the extent it is effective as a hedge. The hedged net investment shall be
accounted for consistent with Statement 52; the provisions of this Statement for
recognizing the gain or loss on assets designated as being hedged in a fair value hedge do
not apply to the hedge of a net investment in a foreign operation.
These Section c(4) confusions in
Paragraph 4 are illustrated in Examples 11-13 beginning on Page 270 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP
in July 1998.
A more confusing, at least to me, portion of Paragraph 36
reads as follows:
The criterion in paragraph 21(c)(1)
requires that a recognized asset or liability that may give rise to a foreign currency
transaction gain or loss under Statement 52 (such as a foreign-currency-denominated
receivable or payable) not be the hedged item in a foreign currency fair value or cash
flow hedge because it is remeasured with the changes in the carrying amount attributable
to what would be the hedged risk (an exchange rate change) reported currently in
earnings. Similarly, the criterion in paragraph 29(d) requires that the forecasted
acquisition of an asset or the incurrence of a liability that may give rise to a foreign
currency transaction gain or loss under Statement 52 not be the hedged item in a foreign
currency cash flow hedge because, subsequent to acquisition or incurrence, the asset or
liability will be remeasured with changes in the carrying amount attributable to what
would be the hedged risk reported currently in earnings. A foreign currency derivative
instrument that has been entered into with another member of a consolidated group can be a
hedging instrument in the consolidated financial statements only if that other member has
entered into an offsetting contract with an unrelated third party to hedge the exposure it
acquired from issuing the derivative instrument to the affiliate that initiated the hedge.
Executory Contract
Accounting for Executory Contracts Such as Purchase/Sale Commitments and
Loan Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
Exposed
Net Asset Position =
the excess of assets that are measured or denominated in
foreign currency and translated at the current rate over liabilities that are measured or
denominated in foreign currency and translated at the current rate.
Exposure Draft 162-B =
a part of history in the Financial Accounting
Standards Board leading up to FAS 133. See the Background Information section in
FAS 133, pp. 119-127, Paragraphs 206-231. Especially note Paragraphs 214, 360-384, and
422-194. See FAS 133.
F-Terms
Fair Value =
the estimated best disposal (exit, liquidation)
value in any sale other than a forced sale. It is defined as follows in Paragraph
540 on Page 243 of FAS 133:
The amount at which an asset
(liability) could be bought (incurred) or sold (settled) in a current transaction between
willing parties, that is, other than in a forced or liquidation sale. Quoted market prices
in active markets are the best evidence of fair value and should be used as the basis for
the measurement, if available. If a quoted market price is available, the fair value is
the product of the number of trading units times that market price. If a quoted market
price is not available, the estimate of fair value should be based on the best information
available in the circumstances. The estimate of fair value should consider prices for
similar assets or similar liabilities and the results of valuation techniques to the
extent available in the circumstances. Examples of valuation techniques include the
present value of estimated expected future cash flows using discount rates commensurate
with the risks involved, option- pricing models, matrix pricing, option-adjusted spread
models, and fundamental analysis. Valuation techniques for measuring assets and
liabilities should be consistent with the objective of measuring fair value. Those
techniques should incorporate assumptions that market participants would use in their
estimates of values, future revenues, and future expenses, including assumptions about
interest rates, default, prepayment, and volatility. In measuring forward contracts, such
as foreign currency forward contracts, at fair value by discounting estimated future cash
flows, an entity should base the estimate of future cash flows on the changes in the
forward rate (rather than the spot rate). In measuring financial liabilities and
nonfinancial derivatives that are liabilities at fair value by discounting estimated
future cash flows (or equivalent outflows of other assets), an objective is to use
discount rates at which those liabilities could be settled in an arm's-length transaction.
This is
old news, but it does provide some questions for students to ponder.
The main problem of fair value adjustment is that many ((most?) of the
adjustments cause enormous fluctuations in earnings, assets, and liabilities
that are washed out over time and never realized. The
main advantage is that interim impacts that “might be” realized are
booked. It’s a war between
“might be” versus “might never.” The
war has been waging for over a century with respect to booked assets and two
decades with respect to unbooked derivative instruments, contingencies, and
intangibles.
As you
can see below, the war is not over yet. In
fact it has intensified between corporations (especially banks) versus
standard setters versus members of the academy.
From The Wall Street Journal
Accounting Educators' Review on April 2, 2004
TITLE: As IASB Unveils New Rules,
Dispute With EU Continues
REPORTER: David Reilly
DATE: Mar 31, 2004
PAGE: A2 LINK: http://online.wsj.com/article/0,,SB108067939682469331,00.html
TOPICS: Generally accepted accounting principles, Fair Value Accounting, Insider
trading, International Accounting, International Accounting Standards Board
SUMMARY: Despite controversy with the
European Union (EU), the International Accounting Standards Board (IASB) is
expected to release a final set of international accounting standards. Questions
focus on the role of the IASB, controversy with the EU, and harmonization of the
accounting standards.
QUESTIONS:
1.) What is the role of the IASB? What authority does the IASB have to enforce
standards?
2.) List three reasons that a country
would choose to follow IASB accounting standards. Why has the U.S. not adopted
IASB accounting standards?
3.) Discuss the advantages and
disadvantages of harmonization of accounting standards throughout the world. Why
is it important the IASB reach a resolution with the EU over the disputed
accounting standards?
4.) What is fair value accounting? Why
would fair value accounting make financial statements more volatile? Is
increased volatility a valid argument for not adopting fair value accounting?
Does GAAP in the United States require fair value accounting? Support your
answers.
There are a number of software vendors of FAS 133 valuation
software.
One of the major companies is Financial CAD --- http://www.financialcad.com/
FinancialCAD provides software and services that
support the valuation and risk management of financial securities and
derivatives that is essential for banks, corporate treasuries and asset
management firms. FinancialCAD’s industry standard financial analytics are
a key component in FinancialCAD solutions that are used by over 25,000
professionals in 60 countries.
See software.
What are the
advantages and disadvantages of requiring fair value accounting for all
financial instruments as well as derivative financial instruments?
Advantages:
- Eliminate
arbitrary FAS 115 classifications that can be used by management to
manipulate earnings (which is what Freddie Mac did in 2001 and 1002.
- Reduce problems
of applying FAS 133 in hedge accounting where hedge accounting is now
allowed only when the hedged item is maintained at historical cost.
- Provide a
better snap shot of values and risks at each point in time.
For example, banks now resist fair value accounting because they do
not want to show how investment securities have dropped in value.
Disdvantages:
- Combines fact
and fiction in the sense that unrealized gains and losses due to fair
value adjustments are combined with “real” gains and losses from cash
transactions. Many, if not
most, of the unrealized gains and losses will never be realized in cash.
These are transitory fluctuations that move up and down with
transitory markets. For
example, the value of a $1,000 fixed-rate bond moves up and down with
interest rates when at expiration it will return the $1,000 no matter how
interest rates fluctuated over the life of the bond.
- Sometimes
difficult to value, especially OTC securities.
- Creates
enormous swings in reported earnings and balance sheet values.
"Derivatives
and hedging: An Analyst's Response to US FAS 133," by Frank Will, Corporate
Finance Magazine, June 2002, http://www.corporatefinancemag.com/pdf/122341.pdf
However,
FAS 133 still needs further clarification and improvement as the example of
Fannie Mae shows. Analysts focus more on the economic value of a company
and less on unrealised gains and losses. Much of the FAS 133 volatility in
earnings and in equity does not consistently reflect the economic situation.
This makes it difficult to interpret the figures. Therefore, analysts
welcome the decision of some companies voluntarily to disclose a separate set of
figures excluding the effect of FAS 133.
For
more on Frank Will's analysis of FAS 133, Fair Value Accounting, and Fannie
Mae, go to
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob
Jensen's threads on accounting theory are at
http://faculty.trinity.edu/rjensen/theory.htm
Those
threads dealing with fair value are at
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm
Accounting for Executory Contracts Such as Purchase/Sale Commitments and
Loan Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
From Paul Pacter's IAS Plus on July 13, 2005 ---
http://www.iasplus.com/index.htm
Also see
http://faculty.trinity.edu/rjensen//theory/00overview/IASBFairValueFAQ.pdf
- Why did the Commission
carve out the full fair value option in the original
IAS 39 standard?
- Do prudential supervisors
support IAS 39 FVO as published by the IASB?
- When will the Commission
to adopt the amended standard for the IAS 39 FVO?
- Will companies be able to
apply the amended standard for their 2005 financial
statements?
- Does the amended standard
for IAS 39 FVO meet the EU endorsement criteria?
- What about the
relationship between the fair valuation of own
liabilities under the amended IAS 39 FVO standard
and under Article 42(a) of the Fourth Company Law
Directive?
- Will the Commission now
propose amending Article 42(a) of the Fourth Company
Directive?
- What about the remaining
IAS 39 carve-out relating to certain
|
|
The Financial Accounting Standards Board (FASB) requires estimation
of fair value for many types of financial instruments, including derivative financial
instruments. The main guidelines are spelled out in SFAS 107 and FAS 133 Appendix F Paragraph 540. If a range is estimated for either the amount or the timing of possible cash flows, the
likelihood of possible outcomes shall be considered in determining the best estimate of
future cash flows according to FAS 133 Paragraph 17.
For
related matters under international standards, see IAS 39 Paragraphs 1,5,6,
95-100, and 165. According to the FASB,
fair value is the amount at which an asset (liability) could be bought (incurred) or sold
(settled) in a current transaction between willing parties, that is, other than in a
forced or liquidation sale. Quoted market prices in active markets are the best evidence
of fair value and should be used as the basis for the measurement, if available. If a
quoted market price is available, the fair value is the product of the number of trading
units times that market price. There are some exceptions for hybrid instruments as discussed in
IAS
39 Paragraph 23c and FAS 133 Paragraph 12b.
There are
also exceptions where value estimates are unreliable such as in the case of
unlisted equity securities (see IAS 39 Paragraphs 69, 93, and
95).
If an item is viewed as a financial instrument rather
than inventory, the accounting becomes more complicated under SFAS
115. Traders in financial instruments adjust such instruments to
fair value with all changes in value passing through current earnings.
Business firms who are not deemed to be traders must designate the
instrument as either available-for-sale (AFS) or hold-to-maturity
(HTM). A HTM instrument is maintained at original cost. An
AFS financial instrument must be marked-to-market, but the changes in
value pass through OCI rather than current earnings until the
instrument is actually sold or otherwise expires.
Under international standards, the IASC requires fair value
adjustments for most financial instruments. This has led to strong
reaction from businesses around the world, especially banks. There are
now two major working group documents taking sides for and against
fair value accounting for all financial instruments.
Go to http://www.iasc.org.uk/frame/cen3_112.htm
|
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
All debt securities, equity securities, and other financial assets
that are not held for trading but nonetheless are available for sale
– except those unquoted equity securities whose fair value cannot be
measured reliably by another means are measured at cost subject to an
impairment test.
|
SFAF 133
All debt securities, equity securities, and other financial assets
that are not held for trading but nonetheless are available for sale
– except all unquoted equity securities are measured at cost subject
to an impairment test.
FASB requires fair value measurement for all derivatives, including
those linked to unquoted equity instruments if they are to be settled
in cash but not those to be settled by delivery, which are outside the
scope of 133
|
Paragraph 28 beginning on Page 18 of
FAS 133 requires that the hedge be formally documented from the start such that prior contracts
such as options or futures contracts cannot later be declared hedges. Under
international accounting rules, a hedged item can be a recognized asset or liability, an unrecognized firm
commitment, or a forecasted transaction (IAS 39 Paragraph 127).
If quoted market prices are not available, the
estimate of fair value should be based on the best information available in the
circumstances. The estimate of fair value should consider prices for similar assets and
liabilities and the results of valuation techniques to the extent available in the
circumstances. Examples of valuation techniques include the present value of estimated
expected future cash flows using a discount rate commensurate with the risks involved,
option-pricing models, matrix pricing, option-adjusted spread models, and fundamental
analysis. Valuation techniques for measuring assets and liabilities should be consistent
with the objective of measuring fair value. Those techniques should incorporate
assumptions that market participants would use in their estimates of values, future
revenues, and future expenses, including assumptions about interest rates, default,
prepayment, and volatility.
Under IAS 39 Paragraph 100, under
circumstances when a quoted market price is not available, estimation techniques may be used --- which
include reference to the current market value of another instrument that is substantially
the same, discounted cash flow analysis, and option pricing models. When an enterprise has matching asset and liability positions, it may use mid-market
prices according to IAS 39 Paragraph 99.
In reality, the FASB in FAS 133
and the
IASC in
IAS 39 require continual adjustments of financial instruments derivatives to fair value
without giving much guidance about such matters when the instruments are not traded on
exchange markets or are traded in markets that are too thin to rely upon for value
estimation. Unfortunately, over half of the financial instruments derivative
contracts around the world are customized contracts for which there are no markets for
valuation estimation purposes. The most difficult instruments to value are forward
contracts and interest rate and foreign currency swaps. In my Working Paper 231 I
discuss various approaches for valuation of interest rate swaps. See
http://faculty.trinity.edu/rjensen/231wp/231wp.htm
.
The fair value of foreign currency forward
contracts should be based on the change in the forward rate and should consider the time
value of money. In measuring liabilities at fair value by discounting estimated future
cash flows, an objective is to use discount rates at which those liabilities could be
settled in an arm's-length transaction. Although the FASB does not give very
explicit guidance on estimation of a derivatives fair market value, this topic
appears at many points in FAS 133. See Paragraphs 312-319 and 432-457.See blockage factor and yield curve.
Paragraphs 216 on Page 122 and 220-231
beginning on Page 123 of FAS 133 leave little doubt that the FASB feels "fair
value is the most relevant measure for financial instrument and the only relevant measure
for derivative instruments." This can be disputed, especially when
unrealized gains and value hide operating losses. The December 1998 issue of the Journal
of Accountancy provides an interesting contrast on fair value accounting. On
Pages 12-13 you will find a speech by SEC Chairman Arthur Levitt bemoaning the
increasingly common practice of auditors to allow earnings management. On Page 20
you will find a review of an Eighth Circuit Court of Appeals case in which a firm
prevented the reporting of net losses for 1988 and 1989 by persuading its auditor to allow
reclassification of a large a large hotel as being "for sale" so that it could
revalue historical cost book value to current exit value and record the gain as current
income. Back issues of the Journal of Accountancy are now online at http://www.aicpa.org/pubs/jofa/joaiss.htm
.
The FASB intends eventually to book all financial
instruments at fair value. Jim Leisingring comments about " first shot
in a religious war" in my
tape31.htm.
The IASB also is moving closer and closer to fair value
accounting for all financial instruments for virtually all nations, although it too is
taking that big step in stages. Click here to view Paul
Pacter's commentary on this matter.
See DIG Issue B6 under embedded
derivatives.
At the moment, accounting
standards dictate fair value accounting for derivative financial instruments
but not all financial instruments. However, the entire state of fair
value accounting is in a state of change at the moment with respect to both
U.S. and international accounting standards.
If a purchased item is viewed as an inventory
holding, the basis of accounting is the lower of cost or market for most firms
unless they are classified as securities dealers. In other
words, the inventory balance on the balance sheet does not rise if expected net
realization rises above cost, but this balance is written down if the expected
net realization falls below cost. The one exception, where inventory
balances are marked-to-market for upside and well as downside price movements,
arises when the item in inventory qualifies as a "precious"
commodity (such as gold or platinum) having a readily-determinable market
value. Such commodities as pork bellies, corn, copper, and crude oil, are not
"precious" commodities and must be maintained in inventory at
lower-of-cost-or market.
If an item is viewed as a financial instrument rather than inventory, the
accounting becomes more complicated under SFAS 115. Traders in financial
instruments adjust such instruments to fair value with all changes in value
passing through current earnings. Business firms who are not deemed to be
traders must designate the instrument as either available-for-sale (AFS) or
hold-to-maturity (HTM). A HTM instrument is maintained at original cost. An
AFS financial instrument must be marked-to-market, but the changes in value
pass through OCI rather than current earnings until the instrument is actually
sold or otherwise expires. Under international standards, the IASC requires
fair value adjustments for most financial instruments. This has led to strong
reaction from businesses around the world, especially banks. There are now two
major working group documents taking sides for and against fair value
accounting for all financial instruments.
Go to http://www.iasc.org.uk/frame/cen3_112.htm
- Financial Instruments: Issues Relating to Banks
(strongly argues for
fair value adjustments of financial instruments). The issue date is August
31, 1999.
Trinity University students may view this paper at J:\courses\acct5341\iasc\jwgbaaug.pdf.
Accounting for financial Instruments for Banks (concludes that a
modified form of historical cost is optimal for bank accounting). The issue
date is October 4, 1999.
Trinity University students may view this paper at J:\courses\acct5341\iasc\jwgfinal.pdf
Fair value accounting politics in the revised IAS 39
From Paul Pacter's IAS Plus on July 13, 2005 ---
http://www.iasplus.com/index.htm
- Why did the Commission carve
out the full fair value option in the original IAS 39
standard?
- Do prudential supervisors
support IAS 39 FVO as published by the IASB?
- When will the Commission to
adopt the amended standard for the IAS 39 FVO?
- Will companies be able to
apply the amended standard for their 2005 financial
statements?
- Does the amended standard for
IAS 39 FVO meet the EU endorsement criteria?
- What about the relationship
between the fair valuation of own liabilities under the
amended IAS 39 FVO standard and under Article 42(a) of
the Fourth Company Law Directive?
- Will the Commission now
propose amending Article 42(a) of the Fourth Company
Directive?
- What about the remaining IAS
39 carve-out relating to certain hedge accounting
provisions?
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|
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Teaching Case
Cost Accounting and Inventory Valuation
by Bob Jensen:
Differences Between Mark-to-Market Accounting for Derivative Contracts
Versus Commodity Inventories ---
http://faculty.trinity.edu/rjensen/Mark-to-MarketCorn.htm
"FASB Approves Fair Value Measurement Experiment Using Loan
Commitments," October 2, 2003 --- http://www.fas133.com/search/search_article.cfm?areaid=1384&page=1
The FASB Board agreed to a new project to
clarify FAS 133 guidance on loan commitments accounted for as
derivatives (at fair value). It expects the project to raise issues that
will bring Fair Value accounting near its breaking point.
At its October 1 meeting, the FASB Board agreed
to a new interpretation project to clarify FAS 133 guidance on loan
commitments accounted for as derivatives (at fair value). Loan
commitments contain a witches brew of fair value measurement issues that
the Board’s attempts to resolve will either validate the fair value
model are derail it.
What to do with loans has been a longstanding
issue for FAS 133, since it was discovered that many loan contracts have
derivative-like features that arguably could scope them into FAS 133
accounting. Fitting such loan commitments into the FAS 133 framework was
never fully resolved, other than with guidance specific to the
origination of mortgage loans (see C13). Those held for resale (by
issuers), for example, would be accounted for as derivatives, but those
held for investment purposes would not. While the fall out over Freddie
Mac was not mentioned as a reason to conduct this experiment now, its
influence on matters pertaining to mortgage lending and FAS 133 is hard
to avoid.
To keep this project manageable given
everything else seeking the FASB’s attention, its scope will be
strictly limited to interpretation of how to measure the fair value of
loan committments scoped into FAS 133. It will not seek to resolve the
broader loans as derivatives questions. The primary focus is likely to
be on valuation questions related to issuers of loan commitments
generally falling under the heading of interest rate locks, which
amounts to a written option on a mortgage loan at a set rate (though
another potential project on mortgage servicing rights may be folded in
at a later date).
Specifically the two questions proposed by the
staff are:
1. What information the issuer should use to
determine the fair value of a loan commitment that is accounted for as a
derivative under Statement 133 (as amended), and
2. Whether it is appropriate for a loan
commitment to be recorded as an asset by the issuer of that commitment.
As background, the staff noted that they had
been made aware of a “diversity in practice,” regarding how issuers
chose to fair value their loan commitments. Some market participants
attempted to recognize the future benefit to be derived from the loan,
for example, whereas others exclude such recognition until the option
holder exercises and borrowed. While the latter approach appears
sensible, it may not be "fair value" since so much of the
option's value to the issuer is tied up in the expected loan. There is
also the question of which markets to look to in determining fair value
and what intangibles and indirect costs associated with conversion of
the written option to a loan should be considered in the valuation. And
the valuation method has a direct impact on revenue recognition. The
asset classification question derives from the notion that under current
guidance written options cannot be classified as assets, which among
other things, creates capital constraints on issuers.
"Redefining Fair Value Through New GAAP Measurement
Guidance," July 18, 2003 --- http://www.fas133.com/search/search_article.cfm?page=1&areaid=1338
More Fair Value accounting headaches are coming
soon to a treasury near you, as FASB accelerates its guidance on how to
measure Fair Value in time for “Fair Value M&A.”
“Risk measures are based on Fair Value
metrics and there is not intersection between accounting books and
records and the Fair Value based on risk measurement calculations, so it’s
a completely different set of measures.” -- Gregory J. Parseghian,
Freddie Mac CEO(June 25, 2003 conference call: in response to an analyst
questioning why Freddie’s accounting issue should not call its risk
management into question,)
This statement, in the context of Freddie Mac’s
recent restatements, helps sum up why FASB’s Fair Value Measurement
project is under tremendous pressure to get its measurement guidance
right. If its guidance remains at odds with market practice, as appears
to be the case now with financial institutions’ risk management
measures, then analyst’s questions may be easily (and perhaps
believably) dismissed with statements like this. Unfortunately, someone
still has to figure out how to get the accounting measures right to
comply with GAAP and avoid a restatement headline. In the words of one
of the analysts on the recent Freddie Mac call in considering the Fair
Value accounting challenges for GAAP, regulatory capital and risk
management, “good luck to us all.”
How should GAAP fair value be measured?
In bringing its Fair Value Measurement guidance
into line with its current project, perhaps FASB should consider what
value these measures have if firms elect to make disclosures on
reconciliation between measures used for risk management and GAAP. If
there is no incremental value, then why not just use the risk measures?
And if there is value in the GAAP, what should then be disclosed about
the differences?
But alas, FASB lacks the resources to pursue
fair value disclosure and fair value measurement projects
simultaneously. Thus, the decision at the July 9 Board meeting to shut
down the FAS 107 Amendment project in order to focus FASB’s still
limited resources on measurement. Indeed, the timely logic in this is
that as more of GAAP moves to Fair Value, the Fair Value disclosure
mandate changes significantly. Why seek to capture a moving target now?
Surely, Freddie Mac is thinking the same.
Besides, there is some urgency to the Fair
Value Measurement project, which was just launched in June, since the
Board would like to be able to bring out an Exposure Draft to coincide
with the ED for Business Combinations, which is due out before year-end.
The reason being: The current phase of the Business Combinations project
(Purchase Method Procedures), being undertaken in conjunction with the
IASB, has advanced Fair Value guidance significantly in its
deliberations on applying “accounting’s” evolving Fair Value
concept (i.e., how to measure the “exchange value”) to Purchase
Accounting, of which financial instruments are a mere subcomponent. [If
Fair Value accounting causes such confusion in the derivatives/risk
management arena, much less stock options, you can imagine what is going
to be said to analysts when it gets applied on a much broader basis to
corporate acquisitions.]
Rather than document all the Fair Value
Measurement guidance in the Business Combinations ED, the Board thought
it was more prudent to bring all this together under a separate, new
Standard—which would also put in one place and make consistent,
guidance on Fair Value Measurement that exists elsewhere in the
accounting literature (the IASB’s as well).
"Fair Value Accounting Back in the Spotlight," June 19,
2003 --- http://www.fas133.com/search/search_article.cfm?page=11&areaid=1321
Two items in today’s news point to fair value
accounting and why it’s returning to the spotlight.
The first item is the on-going investigation of
what is behind the Freddie Mac earnings restatements. The second is a
report on efforts by an insurance group led by AIG to derail IASB
efforts at fair value accounting. Both items are part of developing
stories that will soon impact corporates outside of the mortgage finance
and insurance space.
FAS 133 flaws
As the Wall Street Journal is reporting, the
Freddie Mac restatements will be in the billions, stemming from improper
hedge accounting under FAS 133. There was always a greater likelihood
that one of the mortgage finance giants would emerge as the FAS 133 Wall
Street Journal headline, since the task of hedging the risks in mortgage
finance, involving multiple interest, credit and optionality risks is a
tough one, and Fannie and Freddie knew it would be tough to account for
this.
At first, media reports painted as positive the
fact that the Freddie Mac restatements were positive and not negative.
In other words, the gains on the hedges that were deemed non-hedges for
accounting purposes were no longer being deferred. This ignored the
“hedging” notion that these gains were offsetting anticipated losses
in the underlying (e.g. the mortgage paper), which presumably are still
anticipated. The disconnect of hedge from hedged item in the accounting
guidance was always the fundamental flaw in hedge accounting that FAS
133 inadequately addressed, preferring to focus on derivatives. This is
also why it is difficult to glean the impact bringing forward the hedge
gains will have on Freddie Mac’s future earnings.
Broader IASs
Just as Freddie Mac exposes flaws in a limited
fair value approach, the insurance industry is aggressively seeking to
counter acceleration of fair value accounting more broadly. According to
the Wall Street Journal, an insurance group, led by AIG, is actively
opposing international accounting standards (IAS 32/39) and the related
IASB effort to push the fair value concept further into insurance
accounting. These IASB efforts go further than FAS 133 and related FASB
efforts to introduce fair value to a wider scope of accounting:
financial instruments as opposed to just derivatives. Though the IASB
has taken the lead on the fair value drive, FASB is set to follow, which
is why the IASB trends should be followed closely by all concerned with
US GAAP.
Fair value accounting has its flaws, not least
of which is the AIG argument that it introduces meaningless volatility
to earnings statements. However, insurance firms, aside from
broker-dealer banking operators, have as good a shot as any at making
fair value accounting work as a means of giving investors and the
markets a more telling portrait of financial position.
Just as Freddie Mac has revealed how FAS 133
does not go far enough--it’s focus on derivatives has left financial
statement readers in the dark on hedged items--the insurance firm
complaints show how broadening the focus to financial assets and
liabilities is not going to offer an easy solution. But, if accounting
is going to move increasingly toward a fair value model, as its standard
setters plan, they must use the IASB’s insurance market “test” to
prove the model’s practical efficacy. The Exposure Draft of Phase I of
this IASB project is due out in Q3, with a tight implementation
timetable to become effective for EU adoption of IASB standards in 2005.
If fair value accounting cannot be made to work
with insurance firms, it cannot be made to work with non-financial
corporations, and the current course to fair value accounting should be
reversed. Further, by establishing guidelines for accounting for
insurance risk management activities, the IASB effort will help define
accounting for all risk management activities. For example, at its
meeting earlier this week, the IASB discussed the definition of
insurance risk “as risk other than financial risk” (defined by IAS
39), along with other pre-ballot items to become part of the exposure
draft.
This is a high stakes experiment that all
should watch closely for its broader impact, not to mention its
transforming effects on an insurance market already in the midst of a
paradigm shift.
|
Inputs to and
suggestions for fair value estimation are elaborated upon in March 2003
by the FASB in an exposure draft entitled "Financial Instruments
--- Recognition and Measurement," March 2003 --- http://www.cica.ca/multimedia/Download_Library/Standards/Accounting/English/e_FIRec_Mea.pdf
Inputs to valuation techniques
A34
An appropriate technique for estimating the fair value of a particular
financial instrument would incorporate available market information
about the market conditions and other factors that are likely to affect
the instrument’s fair value. The fair value of a financial instrument
will be based on one or more of the following (and perhaps other)
factors:
(a) The time value of money (i.e., interest at the basic or
risk-free rate). Basic interest rates can usually be derived from
observable government bond prices and are often quoted in financial
publications. These rates typically vary with the expected dates of
the projected cash flows along a yield curve of interest rates for
different time horizons. For practical reasons, an entity may use a
well-accepted and readily observable general rate, such as a
LIBOR/swap rate, as the benchmark rate. Since a rate such as LIBOR is
not the basic interest rate, the credit risk adjustment appropriate to
the particular financial instrument would be determined on the basis
of its credit risk in relation to the credit risk in this benchmark
rate. In some countries, the central government’s bonds may carry a
significant credit risk and may not provide a useful, stable benchmark
basic interest rate for instruments denominated in that currency. Some
entities in these countries may have better credit standings and lower
borrowing rates than the central government. In such a case, basic
interest rates may be more appropriately determined by reference to
interest rates for the highest-rated corporate bonds issued in the
currency of that jurisdiction.
(b) Credit risk. The effect on fair value of credit risk (i.e., the
premium over the basic interest rate for credit risk) may be derived
from observ-able market prices for traded corporate bonds of varying
credit quality or from observable interest rates charged by lenders
for loans of various credit ratings.
(c) Foreign currency exchange prices. Active currency exchange
markets exist for most major currencies, and prices are quoted daily
in financial publications.
(d) Commodity prices. There are observable market prices for many
commodities.
(e) Equity prices. Prices (and indexes of prices) of traded equity
securities are readily observable in some markets. Present-value-based
techniques may be used to estimate the current market price of equity
instruments for which there are no observable prices.
(f) Marketability (the return market participants demand to
compensate for the risk that they may not be able to sell an asset or
obtain relief from a liability immediately). In some cases it may be
reasonable to assume that the effects of marketability are included in
the credit risk interest rate premium. In some other cases it may be
reasonable to assume that there has been no significant change in the
marketability of a financial instrument and the effect on the
instrument’s fair value during a reporting period.
(g) Volatility (i.e., the frequency and magnitude of future changes
in price of the financial instrument or other item that is the subject
of an option). Measures of the volatility of actively traded items can
normally be reasonably estimated on the basis of historical market
data.
Relationship between discount rates and projected cash
flows
A35
The present value of projected cash flows may be estimated using a
discount rate adjustment approach or a cash flow adjustment approach,
as appropriate.
A36 Discount rate adjustment approach. Under the discount rate
adjustment approach, the stream of contracted cash flows forms the
basis for the present value computation, and the rate(s) used to
discount those cash flows reflects the uncertainties of the cash
flows. This approach is most readily applied to financial instrument
contracts to receive or pay fixed cash flows at fixed future times
(i.e., instruments for which the only significant uncertainties in
amount and timing of cash flows are caused by credit risk).
A37 The discount rate adjustment approach is consistent with the
manner in which assets and liabilities with contractually specified
cash flows are commonly described (as in “a 12 percent bond”) and
it is useful and well accepted for those instruments. However, because
the discount rate adjustment approach places the emphasis on
determining the interest rate, it is more difficult to apply to
complex financial instruments where cash flows are conditional or
optional, and where there are uncertainties in addition to credit risk
that affect the amount and timing of future cash flows.
A38 Cash flow adjustment approach. Under the cash flow adjustment
approach, the projected cash flows for a financial instrument reflect
the uncertainties in timing and amount (i.e., they are weighted
according to the probability of their occurrence), and adjusted to
reflect the market’s evaluation of the non-diversifiable risk
relating to the uncertainty of those cash flows. The cash flow
adjustment approach has advantages over the discount rate adjustment
approach when an instrument’s cash flows are conditional, optional,
or otherwise particularly uncertain for reasons other than credit
risk.
A39 To illustrate this, suppose that an entity holds a financial
asset such as a derivative that has no specified cash flows and the
entity has estimated that there is a 10 percent probability that it
will receive $100; a 60 percent probability that it will receive $200;
and a 30 percent probability that it will receive $300. Further,
suppose that the cash flows are expected to occur one year from the
measurement date regardless of the amount. The expected cash flow is
then 10 percent of $100 plus 60 percent of $200 plus 30 percent of
$300, which gives a total of $220. The discount rate used to estimate
the instrument’s fair value based on that expected cash flow would
then be the basic (risk-free) rate adjusted for the premium that
market participants would be expected to receive for bearing the
uncertainty of expected cash flows with the same level of risk.
A40 The cash flow adjustment approach also can incorporate
uncertainties with respect to the timing of projected cash flows. For
example, if the cash flow in the previous example was certain to be
$200, and there was a 50 percent chance it would be received in one
year and a 50 percent chance it would be received in three years, the
present value computation would weight those possibilities
accordingly. Because the interest rate for a two-year instrument is
not likely to be the weighted average of the rates for one-year and
three-year instruments, two separate present value computations would
be required. One computation would discount $200 for one year at the
basic interest rate for a one-year instrument and the other would
discount $200 for three years at the basic interest rate for a
three-year instrument. The ultimate result would be determined by
probability-weighting the results of the two computations. Since the
probabilities of each are 50 percent, the fair value would be the sum
of 50 percent of the results of each present value computation, after
adjustment for the estimated effect of any non-diversifiable risk
related to the uncertainty of the timing of the cash flow.
A41 The discount rate adjustment approach would be difficult to
apply in the previous example because it would be difficult to find a
discount rate that would reflect the uncertainties in timing.
|
On December 14, 1999 the FASB issued Exposure Draft 204-B
entitled Reporting Financial Instruments and Certain
Related Assets and Liabilities at Fair Value. This document can be
downloaded from http://www.rutgers.edu/Accounting/raw/fasb/draft/draftpg.html
(Trinity University students can find the document at J:\courses\acct5341\fasb\pvfvalu1.doc
).
"Accounting
for Impaired Assets in Bank Credit Analysis, by Roger B Taillon, New
York (1) 212-438-7400, Standard & Poor's, July 3, 2002 ---
http://www.standardandpoors.com/
Accounting
for impaired assets not only differs markedly from country to country,
it also offers substantial scope for management judgment. The
accounting method prescribed and the judgment exercised in following
that method has a profound impact on bank balance sheets and income
statements. Although not new, accounting for impaired assets probably
remains the biggest accounting-related issue in the credit analysis of
a bank. Whether triggered by systemic crises or by poor lending
practices specific to a single bank, poor asset quality is the most
common fundamental cause of bank failure, although a liquidity crisis
when depositors or lenders begin to suspect the poor asset quality
typically is the proximate cause. Thus, the credit analyst must
understand accounting for impaired assets and attempt to adjust for
differences in order to make more meaningful comparisons between
banks, particularly banks in different countries. For rating purposes,
Standard & Poor's will make these adjustments and generally opt
for the more conservative accounting techniques, given the dangers of
underestimating the extent of (or underreserving for) impaired assets.
The following
major issues must be considered in accounting for impaired assets:
What is the definition of an impaired asset? To what extent is
interest accrued on impaired assets? What is the policy for providing
or reserving against losses on impaired assets? What is the policy for
finally writing off impaired assets?
Even the
terminology of impaired assets differs from system to system. In some
countries, both a contra-asset account used to reduce the accounting
value of the loan portfolio and the income statement item used to
create it are called "loan loss reserves" (or something
similar). In other countries, both items are called
"provisions." To distinguish between the two in its
publications, Standard & Poor's calls the balance sheet item a
"reserve" and the income statement item a
"provision." Thus, in Standard & Poor's terminology, a
provision creates a reserve. When the loan is ultimately judged to be
uncollectable, it is either "written off" directly against
the income statement or "charged off" by reducing a
previously created reserve (although this may also be called a
"write-off"). "Write-backs" refer to the reversal
of a reserve no longer considered necessary, and
"recoveries" refer to the recuperation of all or part of a
previously written-off loan. Types of Impaired Assets Impaired assets
can include loans, loan-related assets such as foreclosed properties,
securities, off-balance-sheet assets such as guarantees receivable, or
in-the-money derivatives. Additionally, there can be off-balance-sheet
commitments that require provisioning, such as guarantees provided or
LOCs payable, where the primary obligor is expected to default, and
commitments to lend to problem borrowers. Securitized assets on which
the bank still bears the risk are also off balance sheet.
In a number
of cases, banks suffering from large amounts of problem loans have
"sold" them to special purpose companies, sometimes called
"bad banks," designed to remove the problem loan portfolios
from the bank's balance sheets and liquidate them. On a few occasions,
these companies have been set up by individual banks; more frequently,
they have been set up by governments following a systemic crisis. In
most cases, these special purpose companies have been funded by the
banks, which also bear all or most of the risk of eventual losses.
Standard & Poor's puts the assets sold to these companies back on
a bank's balance sheet for the purpose of analyzing the amount of a
bank's impaired assets and the adequacy of its reserves.
The loan
portfolio is typically a bank's largest asset category; it is also the
category most likely to suffer impairment. For this reason, knowing
the definition of nonperforming loans (NPLs) is the key first step in
analyzing asset quality. In the U.S., the definition of nonaccrual
loans is standardized as loans that are maintained on a cash basis
because of deterioration in the borrower's financial condition, where
payment in full of principal or interest is not expected and where
principal and interest have been in default for 90 days, unless the
asset is both well-secured and in the process of collection.
Restructured loans (loans restructured for credit reasons at a
below-market interest rate) and "other real estate owned"
(OREO, or properties obtained through or in lieu of foreclosure) must
also be disclosed and are considered nonperforming.
In other
countries, the definition can vary considerably. Nonperforming
consumer loans and residential mortgage loans are typically identified
by aging, but the past-due period necessary for the loan to be
considered nonperforming can vary from as short as 30 days to as long
as 180 days. Some countries and banks define delinquency on a
contractual basis, and others define it on a recency of payments
basis. If delinquency is defined on a recency basis, sometimes only
full payments are counted, and sometimes partial payments are
sufficient to show the loan as performing. In some countries, there
can be different standards for mortgage and other consumer installment
loans, with the mortgage loans being put in nonperforming categories
only after longer periods.
In terms of
corporate loans, in most countries management judgment is the most
important factor in deciding whether a loan is classified as
nonperforming or not. For certain types of loans, such as overdraft
loans, which are very common in some countries such as the U.K.,
management judgment is actually the only possible standard for
determining if the loan is performing or not, since there are no
specific maturities as long as the borrower is within its credit
limit. Deciding just how liberal or conservative management is in
making that judgment is one of the most difficult parts of the
analysis and is generally possible only after extensive discussions.
The Basel
Committee on Banking Supervision proposed a "reference
definition" of a default to be used by banks that plan to use the
"internal ratings-based approach" to the proposed new
capital standards. Under the proposed definition, "a default is
considered to have occurred with regard to a particular obligor when
one or more of the following events has taken place:
The obligor
is unlikely to pay its debt obligations (principal, interest, or fees)
in full; A credit loss event associated with any obligation of the
obligor, such as a charge-off, specific provision, or distressed
restructuring involving the forgiveness or postponement of principal,
interest, or fees; The obligor is past due more than 90 days on any
credit obligation; or The obligor has filed for bankruptcy or similar
protection from creditors." If widely adopted, this definition
would lead to greater standardization between countries, but it still
relies heavily on management judgment.
There are
also differences as to whether a particular loan is considered
nonperforming only when it goes into arrears, or if all loans to that
legal entity are treated as nonperforming. The most conservative
method is to consider all loans to the defaulting entity and loans to
closely related entities as nonperforming. In some countries, only
that portion of a loan that is actually past due is considered
nonperforming. In a few countries, the latter condition is the rule
for mortgage loans, but the entire balance of other loans is
considered nonperforming.
In addition,
restructured loans may or may not be separately disclosed depending on
the country. In many countries, the figures for restructured loans
will not be disclosed, and loans may be reclassified from
nonperforming to performing as soon as they are restructured. In other
countries, they will be reclassified to performing only after they
have met the new terms for a specified period.
Foreclosed
properties are only grouped with NPLs in a few countries, as they are
in the U.S. In most countries, they will not be considered in
management discussions of nonperforming asset (NPA) trends. However,
they frequently are available as a separate category on the balance
sheet or else are disclosed in the footnotes.
Although the
analysis of impaired assets is focused on the loan portfolio (and the
real estate portfolio, to the extent that it represents foreclosed
assets), impaired assets can also be present in the securities
portfolio, including:
Debt
securities either purchased as investments or as loan-equivalents,
which have defaulted; and Debt and equity securities received in
exchange for loans as part of reorganizations or debt restructurings,
or as foreclosed collateral. Equity securities purchased as
investments that declined sharply in value might also be considered
impaired, but would be looked at separately rather than combined with
NPAs.
For
analytical purposes, Standard & Poor's believes a broad definition
of NPAs is appropriate. According to that definition, NPAs should
include:
The full
amount of all loans 90 days or more past due, and any other loans to
the same legal entity; The full amount of all loans to an entity whose
creditworthiness is believed to be impaired to the point where
collection is doubtful, which would typically include any closely
related entities of borrowers that were nonperforming; All loans
restructured at nonmarket rates of interest, even if they are
performing according to the new terms; All foreclosed properties, and
properties received in lieu of foreclosure; Impaired securities as
described above; and Impaired off-balance-sheet assets, including
loans sold to problem asset disposition companies where there is
recourse back to the bank, and nonperforming securitized assets where
the bank retains the risk. To the extent possible, Standard &
Poor's will adjust total NPAs to conform to this broad definition. If
this is not possible, Standard & Poor's will make qualitative
distinctions to recognize the difference in definitions.
Policies on
Accrual of Interest Policies related to the accrual of interest on
NPAs also differ substantially from country to country. The cleanest
method is that which is used currently in most countries, where
interest is not accrued on NPLs. Even there, there are differences as
to whether interest previously accrued but not received is reversed or
capitalized. In addition, the treatment of cash interest received is a
matter of management judgment: typically, it would flow into interest
income if the bank believed it would likely recoup its principal, but
if this were in doubt, it would be used instead to reduce the
principal balance on the bank's books. In other countries, interest
continues to accrue but is fully provisioned. On a bottom-line basis,
this provides the same results as the first policy: net NPAs and net
income are the same as they would be under the nonaccrual method.
However, a number of line items will differ: gross NPAs, reserves on
the balance sheet, gross and net interest income, and loan loss
provisions charged to the income statement will all be higher than
they would be at banks that use the nonaccrual method. Comparisons
between banks in different countries using the two methods will have
to be adjusted to take this into account.
From a credit
analyst's viewpoint, the most pernicious policy is the methodology of
ceasing to accrue interest or provide for it only in those cases where
management believes that collateral on the loan will be insufficient
for it to recover the interest. This is consistent with
"mark-to-market" accounting (which will be covered more
generally in a separate article that will be forthcoming from Standard
& Poor's). This methodology suffers from the following
disadvantages:
It relies
more heavily on valuations of collateral. Even if collateral
valuations are theoretically correct, a bank may have great difficulty
realizing these values. The costs of workout and recovery can be very
high. Unless detailed information is provided on how much interest is
accrued on NPLs, comparisons with banks using more conservative
accounting methods will be impossible. All of these issues concerning
accrual of interest apply to restructured loans and nonperforming debt
securities as well as to identified NPLs. This is particularly true in
restructurings that involve grace periods or extremely low payments in
early years, postponing the day of reckoning where the borrower's true
ability to repay will be tested.
Unfortunately,
it is generally impossible to actually adjust for differences in
accrual policies where provisioning for interest is not done fully.
However, in many cases the balance sheet asset of accrued interest
receivable is available. If this figure grows significantly more
rapidly than that of earning assets (taking into account interest rate
fluctuations) or the liability item of accrued interest payable, it
can be an indication of aggressive accounting.
Policies on
Loan Loss Reserves Loan loss reserving policies also differ
substantially from country to country, and can vary to a greater or
lesser extent among banks within a country. The most conservative
policy is to fully write off or reserve for any identified problem
loans, as well as to establish general reserves for potential future
loan losses that have not yet been identified as problems. In the U.S.
the emphasis has been on writing off problem loans, while in most
other countries the emphasis has been on reserving. The policy itself
is much less important than the adequacy of the amount. Comparison
between NPLs in systems emphasizing charge-offs and NPLs in systems
emphasizing reserving needs must be made net of reserves, however.
The following
factors must be considered in terms of reserves and provisioning:
Are necessary
reserves determined based solely on the number of days past due, on
regulatory or internal loan classification, or (for the larger loans)
on loan-by-loan estimates of loss? To what extent is collateral taken
into account in determining necessary reserves, how is its value
calculated, and are related costs fully taken into account? How does
the percentage coverage of NPLs by reserves compare to regulatory
minimums, historical figures, and that of the bank's peers? Have
reserves been constituted for other impaired assets, such as
securities, and for off-balance-sheet items such as guarantees of debt
of problem clients or commitments to lend to them, and are both the
income-statement and balance sheet figures disclosed? In addition to
(or instead of, if the bank charges off rapidly) "specific"
reserves covering individual problem loans, are there
"general" reserves? If so, how are they calculated? Are
there also "country risk reserves"? How does the tax
treatment of the provisions affect the adequacy of the reserves? Are
loan loss provisions shown only as net, or are both gross new
provisions and write-backs disclosed? Generally, reserves that are
determined based on loan-by-loan analysis for corporate loans are
preferable to those that are determined based on some mechanical
method, assuming they are conservatively estimated. Unfortunately, it
is also more difficult to judge how conservative such reserves are,
although detailed discussions with management can help. From a credit
rating viewpoint, the ideal is probably a situation in which the
reserve on a given loan is the larger of (a) a minimum based on the
number of days past due, or (b) the necessary amount estimated through
detailed analysis.
For consumer
and residential mortgage loans, typically the reserve amount will be
determined through a formula either based on the aging of the
portfolio or on the bank's experience with the particular type of
loan.
Similarly,
from a credit rating viewpoint, one needs to be very skeptical of
taking collateral into account in determining the adequacy of
reserves. There are difficulties in valuing the collateral, with banks
often using valuations assuming "normal" markets when they
are in the midst of a recession with markets falling sharply. There
can be legal and other difficulties in foreclosing, and these
difficulties intensify in bad economic times. Even if banks eventually
can foreclose, substantial costs may be involved that may not have
been fully taken into account in the valuations. Finally, in a bad
market, even if the bank can foreclose, it may be difficult to sell
the collateral.
Provisions
taken against foreclosed assets, impaired securities,
off-balance-sheet items, and the like also must be aggregated with the
loan loss provisions in order to judge the bank's credit track record.
These provisions frequently are included in securities losses or other
expenses, and they may or may not be disclosed in the footnotes.
Write-backs
of provisions are generally (but not always) disclosed separately for
banks that emphasize specific reserves. Sometimes necessary reserves
are added up and then compared to those of the previous period, with
the difference being the loan loss provision, so there are no gross
and write-back figures available. The more robust method calls for
looking at each loan individually, recording new and increased
reserves separately from decreased reserves. The total of the new
reserves and the increases to the reserves is the gross new provision,
and the total of the decreases in reserves is the write-back figure.
These separate figures are usually disclosed in the footnotes. The
loan loss provision shown on the income statement is normally the net
figure, although it is sometimes the gross figure, with write-backs
included in other income. Ideally, specific and general provisions are
disclosed separately. When the information is available, Standard
& Poor's will use net new provisions as the expense item, but it
will analyze the separate components to help evaluate the conservatism
of a bank's reserving policies.
Charge-Off
Policies Charge-off policies are subject to most of the same
considerations as reserving policies. This is true at banks such as
those in the U.S., which are more likely to charge off quickly than
they are to create a specific reserve. In most countries, however, the
issue of when and how much of a loan is actually charged off is much
less important. In these countries, loans are not charged off until:
The borrower has completely gone through the bankruptcy process, or
the bank is nearly certain it will not recover anything for other
reasons; A time period prescribed by regulation has elapsed; The tax
authorities allow them to; or Some combination of the above. Even in
these cases, however, the analyst must be aware of the charge-off
procedures to make more meaningful comparisons of bank loan loss
records: if charge-offs are quick, NPAs will tend to be low compared
to where charge-offs take longer. Loan loss reserves also tend to be
lower at banks where charge-offs are quicker; if not, it is probably a
sign of more conservative accounting.
Tax Treatment
of Impaired Assets Finally, there is the question of tax treatment. In
some countries, banks account for the tax benefits of a loan loss when
the provision is made, even though the loss cannot be taken for tax
purposes until the charge-off is made. Where there is a big delay
between the two and loan loss provisions are increasing more rapidly
than charge-offs, banks can build up large deferred tax assets, which
can amount to a substantial proportion of reported equity. This was
the case for both the Japanese and the Mexican banks in the 1990s.
Analysts had to question when or even whether the banks would actually
be able to realize these future tax benefits, taking into account both
the difficulties in getting charge-offs accepted by tax authorities
and whether profits would be sufficient to use the tax benefits, even
if the charge-offs were allowed. On the other hand, if provisions or
certain types of provisions are not deductible for tax purposes, and
the bank does not immediately account for the deferred tax benefit,
the bank will be able to realize and account for these benefits in the
future. Thus, reserves created without booking the tax benefits can
cover more than their face value of loan losses, if the future
charge-off is tax deductible and the bank has taxable income at the
time the charge-off is made.
Fair Value Exposure Draft
FAS 133 is arguably the most complex, controversial, and tentative
standard ever issued by the FASB. It is not tentative in terms
of required implementation, but it may fade in prominence if and when
the FASB issues its proposed fair value standard for all financial
instruments. The first exposure draft on this even more
controversial proposal is given in Exposure Draft 204-B entitled Reporting
Financial Instruments and Certain Related Assets and Liabilities at
Fair Value.
See updated
information on this at http://www.fasb.org/project/fv_measurement.shtml
Option Pricing : Modeling and
Extracting State-Price Densities A New Methodology by Christian Perkner
ISBN 3-258-06101-7 http://www.haupt.ch/asp/titels.asp?o=f&objectId=3372
The focus
of this book is on the valuation of financial derivatives. A
derivative (e.g. a financial option) can be defined as a contract
promising a payoff that is contingent upon the unknown future state
of a risky security. The goal of this book is to illustrate two
different perspectives of modern option pricing:
Part I: The
normative viewpoint: How does (how should) option pricing theory
arrive at the fair value for such a contingent claim? What are
crucial assumptions? What is the line of argument? How does this
theory (e.g. Black-Scholes) perform in reality?
Part II:
The descriptive viewpoint: How are options truly priced in the
financial markets? What do option prices tell us about the
expectations of market participants? Do investor preferences play a
role in the valuation of a derivative?
To answer
both questions, the author introduces an insightful valuation
framework that consists of five elements. Its central component is
the so called state-price density - a density that represents the
market's valuation of $1 received in various states of the world. It
turns out that the shape of this density is the crucial aspect when
determining the price of an option.
The book
illustrates several techniques allowing the flexible modeling of the
state-price density. Implementation issues are discussed using real
datasets and numerical examples, implications of the various
modeling techniques are analyzed, and results are presented that
significantly improve standard option pricing theory.
Accounting for Executory Contracts Such as Purchase/Sale Commitments and
Loan Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
Also see Option and Option
Pricing Theory
Bob Jensen's threads on valuation
of derivative financial instruments can be found at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
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Fair Value Hedge =
a hedge that bases its periodic settlements on
changes in value of an asset or liability. This type of hedge is most often used for
forecasted purchases or sales. See FAS 133 Paragraphs 20-27,104-110, 111-120, 186,
191-193, 199, 362-370, 422-425, 431-457, and 489-491. The FASB intends to incrementally
move towards fair value accounting for all financial instruments, but the FASB feels that
it is too much of a shock for constituents to abruptly shift to fair value accounting for
all such instruments. See Paragraph 247 on Page 132, Paragraph 331 on Page 159,
Paragraph 335 on Page 160, and Paragraph 321 on Page 156.
The IASC
adopted the same definition of a fair value hedge except that the hedge has also to affect reported net
income (See IAS 39 Paragraph 137a)
Flow Chart for Fair Value Hedge Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Held-to-maturity securities may not be
hedged for fair value risk according to Paragraphs 426-431 beginning on Page 190 of
FAS 133. See held-to-maturity.
In FAS 133, derivative financial instruments
come in three basic types that are listed in Paragraph 4 on Page 2 of FAS 133. One
of these types is described in Section a and Footnote 2 below:
Paragraph 4
on Page 2 of FAS 133.
This Statement standardizes the accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, by requiring that an entity recognize
those items as assets or liabilities in the statement of financial position and measure
them at fair value. If certain conditions are met, an entity may elect to designate a
derivative instrument as follows:
a.
A hedge of the exposure to changes in the fair value of a recognized asset or liability,
or of an unrecognized firm commitment, \2/ that are attributable to a
particular risk (referred to as a fair value hedge)
==========================================================================
Footnote 2
\2/ An unrecognized firm commitment can be viewed as an executory contract that represents
both a right and an obligation. When a previously unrecognized firm commitment that is
designated as a hedged item is accounted for in accordance with this Statement, an asset
or a liability is recognized and reported in the statement of financial position related
to the recognition of the gain or loss on the firm commitment. Consequently, subsequent
references to an asset or a liability in this Statement include a firm commitment.
==========================================================================
With respect to Section a above, a firm
commitment cannot have a cash flow risk exposure because the gain or loss is already
booked. For example, a contract of 10,000 units per month at $200 per unit is
unrecognized and has a cash flow risk exposure if the payments have
not been made. If the payments have been prepaid, that prepayment is
"recognized" and has no further cash flow risk exposure. The booked firm
commitment, however, can have a fair value risk exposure.
Generally assets and liabilities must be
carried on the books at cost (or not be carried at all as unrecognized firm commitments)
in order to host fair value hedges. The hedged item may not be revalued according to
Paragraph 21c on Page 14 of SFAS 113. However,
since GAAP prescribes lower-of-cost-or market write downs (LCM) for certain types of
assets such as inventories and receivables, it makes little sense if LCM assets cannot
also host fair value hedges. Paragraph 336 on Page
160 does not discuss LCM. It is worth noting, however, that Paragraph 336 on Page
160 does not support fair value adjustments of hedged items at the inception of a hedge.
The hedging instrument (e.g., a forecasted
transaction or firm commitment) must meet the stringent criteria for being defined as a derivative financial instrument under
FAS 133.
This includes the tests for being clearly-and-closely
related. It also includes strict tests of Paragraphs 21 beginning on Page 13 ,
29 beginning on Page 20, and Paragraph 56 on Page 33 of FAS 133 with respect to the host
contracts that are being hedged. Those tests state that if the forecasted
"transaction" is in reality a group or portfolio of individual transactions, all
transactions in the group must bear the same risk exposure within a 10% range discussed in
Paragraph 21. Also see Footnote 9 on Page 13 of FAS 133. The grouping
tests are elaborated upon in the following Paragraphs:
-
Paragraph 21 on Page 13,
-
Paragraph 29 beginning on Page 20,
-
Paragraph 241 on Page 130,
-
Paragraph317 on Page 155,
-
Paragraphs 333-334 beginning on Page 159,
-
Paragraph 432 on Page 192,
-
Paragraph 435 on Page 193,
-
Paragraph 443-450 beginning on Page 196
-
Paragraph 462 on Page 202,
-
Paragraph 477 on Page 208.
For example, a group of variable rate notes
indexed in the same way upon LIBOR might qualify, whereas having different indices such as
LIBOR and U.S. Prime rate underlyings will not qualify.
Also, anticipated purchases cannot be combined with anticipated sales in the
same grouping designated as a forecasted transaction even if they have the same underlying. Paragraph 477 on Page 208 of FAS 133
makes
an exception for a portfolio of differing risk exposures for financial instruments
designated in foreign currencies so not to conflict with Paragraph 20 of SFAS 52.
For more detail see cash flow hedge and foreign currency hedge.
Those tests also state that a compound grouping of multiple derivatives (e.g., a
portfolio of options or futures or forward contracts or any combination thereof) is
prohibited from "separating a derivative into either separate proportions
or separate portions and designating any component as a hedging instrument or
designating different components as hedges of different exposures." See
Paragraphs 360-362 beginning on Page 167 of FAS 133. Paragraphs dealing with
compound derivative issues include the following:
-
Paragraph 18 beginning on Page 9,
-
Footnote 13 on Page 29,
-
Paragraphs 360-362 beginning on Page 167,
-
Paragraph 413 on Page 186,
-
Paragraphs 523-524 beginning on Page 225.
Paragraph 18 on Page 10 does allow a single
derivative to be divided into components provided but never with partitioning of
"different risks and designating each component as a hedging instrument."
An example using Dutch guilders versus French francs is given under cash flow hedge.
One question that arises is whether a hedged item
and its hedge may have different maturity dates. Paragraph 18 beginning on Page 9 of
FAS 133 rules out hedges such as interest rate swaps from having a longer maturity than
the hedged item such as a variable rate loan or receivable. On the other hand,
having a shorter maturity is feasible according to KPMG's Example 13 beginning on Page 225
of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP
in July 1998) states the following. A portion of that example reads as follows:
Although the criteria specified
in paragraph 28(a) of the Standard do not address whether a portion of a single
transaction may be identified as a hedged item, we believer that the proportion principles
discussed in fair value hedging model also apply to forecasted transactions.
The difference between a forward exchange rate and a spot rate is not excluded from a fair value hedging relationship for firm
commitments measured in forward rates. However Footnote 22 on Page 68 of
FAS 133 reads as follows:
If the hedged item were a
foreign-currency-denominated available-for-sale security instead of a firm commitment,
Statement 52 would have required its carrying value to be measured using the spot exchange
rate. Therefore, the spot-forward difference would have been recognized immediately in
earnings either because it represented ineffectiveness or because it was excluded from the
assessment of effectiveness.
Paragraph 399 on Page 180 of
FAS 133 does not
allow covered call strategies that permit an entity to write an
option on an asset that it owns. See written option.
As an example of fair
value hedges using interest rate swaps, consider the following excerpt from
the 2002 Boeing Annual Report ---
http://www.boeing.com/companyoffices/financial/finreports/annual/02annualreport/f_ncfs_18.html
Fair value hedges
For derivatives designated as hedges of the
exposure to changes in the fair value of a
recognized asset or liability or a firm
commitment (referred to as fair value hedges),
the gain or loss is recognized in earnings in
the period of change together with the
offsetting loss or gain on the hedged item
attributable to the risk being hedged. The
effect of that accounting is to reflect in
earnings the extent to which the hedge is not
effective in achieving offsetting changes in
fair value.
Interest rate
swaps under which the Company agrees to pay
variable rates of interest are designated as
fair value hedges of fixed-rate debt. The
Company also holds forward-starting interest
rate swap agreements to fix the cost of funding
a firmly committed lease for which payment terms
are determined in advance of funding. This hedge
relationship mitigates the changes in fair value
of the hedged portion of the firm commitment
caused by changes in interest rates. The net
change in fair value of the derivatives and the
hedged items is reported in earnings. For the
year ended December 31, 2002, ineffectiveness
losses of $8 were recorded in interest expense
related to the forward-starting interest rate
swaps. Ineffectiveness was insignificant for the
year ended December 31, 2001.
For the years
ended December 31, 2002 and 2001, $5 and $1 of
gains related to the basis adjustment of certain
terminated interest rate swaps were amortized to
earnings. During 2003, the Company expects to
amortize $8 of gains from the amount recorded in
the basis adjustment of certain terminated fair
value hedge relationships to earnings.
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Accounting for Executory Contracts Such as Purchase/Sale Commitments and
Loan Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
Fair value hedges are accounted for in a
similar manner in both FAS 133 and IAS 39. Paul
Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39 Fair Value Hedge Definition:
a hedge of the exposure to changes in the fair value of a recognised
asset or liability (such as a hedge of exposure to changes in the fair
value of fixed rate debt as a result of changes in interest rates).
However, a hedge of an unrecognised firm
commitment to buy or sell an asset at a fixed price in the
enterprise’s reporting currency is accounted for as a cash flow
hedge
IAS 39 Fair Value Hedge Accounting:
To the extent that the hedge is effective, the gain or loss from
remeasuring the hedging instrument at fair value is recognised
immediately in net profit or loss. At the same time, the corresponding
gain or loss on the hedged item adjusts the carrying amount of the
hedged item and is recognised immediately in net profit or loss.
|
FAS 133 Fair Value Hedge Definition:
Same as IAS 39
...except that a hedge of an unrecognised firm commitment to buy or
sell an asset at a fixed price in the enterprise’s reporting
currency is accounted for as a fair value hedge or a cash flow hedge.
SFAS Fair Value Hedge Accounting:
Same as IAS 39
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a. The gain or loss from remeasuring the hedging instrument at fair value
should be recognized immediately in earnings; and
b. The gain or loss on the hedged item attributable to the hedged risk should adjust the
carrying amount of the hedged item and be recognized immediately in earnings.
c. This applies even if a hedged item is otherwise measured at fair value with changes in
fair value recognized directly in equity under paragraph 103b. It also applies
if the hedged item is otherwise measured at cost.
(IAS 39 Paragraph 153)
See IAS 39 Paragraph 154 for example.
Derivatives cannot
hedge derivatives for accounting purposes -- now or under FASB 133," Bass
said. "Does Dave [Duncan] think his accounting works even under FASB 133?
No way."
Carl Bass, Andersen Auditor in 1999 who asked to be removed from Enron's audit
review responsibilities ---
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm#Bass
The main reasons are given in FAS Paragraph 405. FAS 133 Paragraph
21(2)(c) disallows hedged items to be derivative financial instruments for
accounting purposes, because derivative instruments are carried at fair value
and cannot therefore be hedged items in fair value hedges. Also see
Paragraphs 405-407. Paragraph 472 prohibits derivatives from be
designated hedged items any type of hedge, including cash flow, fair value,
and foreign exchange hedges. The reason is that derivatives under FAS
133 must be adjusted to fair value with the offset going to current
earnings. This is tantamount to the "equity method" referred
to in Paragraph 472. More importantly from the standpoint of Enron
transactions, Paragraphs 230 and 432 prohibit a firm's own equity shares
from being hedged items for accounting purposes. Whenever a firm hedges
the value of its own shares, FAS 133 does not allow hedge accounting
treatment.
Also see hedge and hedge accounting.
Cash Flow Hedges Create Fair Value Risk
Cash flow risk commonly arises in forecasted transactions with an unknown
value of the underlying. Interbank rates that banks charge each other is
often used for benchmarking in hedge effectiveness testing. For example, suppose the underlying is a
benchmarked interest rate is the ever-popular London Inter-bank Offering Rate (LIBOR)
where a firm borrows $1 million for two years at a fixed rate of
6.41%. This loan has fair value risk since the amount required to pay the
loan off prematurely at the end of any quarter will vary with interest rate
movements in the same manner as bond prices move up and down depending upon the
spot market of interest rates such as LIBOR. The loan does not
have cash flow risk since the interest rate is locked in at 6.41% (divided by
four) for each quarterly interest payment.
The firm can lock in fixed fair value by entering into some type of
derivative such as an interest rate swap contract that will pay a variable
benchmarked rate that moves up and down with interest rates. For example,
assume the receivable leg of the swap is fixed at 6.65%. Each
quarter the difference between 6.65% and the current spot rate of LIBOR
determines the net settlement of the interest rate swap payment that locks in a
fixed return of 6.65% + 2%. To read more about this particular cash flow
hedge and the hedge accounting that is allowed under FAS 133, go to Example 5 in
Appendix B of FAS 133 beginning with Paragraph 131. Bob Jensen elaborates
and extends this example with a video and Excel workbook at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Financial instruments have a notional and an underlying. For example,
an underlying might be a commodity price and the notional is the quantity such
as price of corn and the quantity of corn. An underlying might be an
interest rate such as the U.S. Treasury rate of the London Inter-bank Offering
Rate and the notional might be the principal such as the $10 million face value
of 10,000 bonds having a face value of $1,000 each.
The unhedged investment of $10 million has cash flow risk but no fair value
risk. The hedged investment has no cash flow risk but the subsequent
combination of the hedge and the hedged item creates fair value risk. The
fair value of the interest rate swap used as the hedging instrument fluctuates
up and down with the current spot rate of LIBOR used in determining the
quarterly swap payments. For example, in Example 5 mentioned above, the
swap begins with a zero value but moves up to a fair value of $24,850 a the end
of the first quarter, $73,800 at the end of the second quarter, and even drops
to a negative ($42,820) after four quarters.
Companies do trillions of dollars worth of cash flow hedging with
interest rate swaps. Two enormous examples are Fannie Mae and Freddie
Mac. Both of these giant companies hedge millions of dollars of
outstanding fixed-rate mortgage investments with interest rate swaps that lock
in fair value. You can read more about their cash flow hedging strategy in
their annual reports for Years 2001, 2002, and 2003. Both companies made
headlines for not complying with FAS 133 hedge accounting years. See
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Fair Value Hedges Create Cash Flow Risk
Fair value risk commonly arises in fore firm commitments with a contracted
value of the underlying. For example, suppose the underlying is a
benchmarked interest rate such as the London Inter-bank Offering Rate (LIBOR)
where a firm invests $10 million for two years that pays a quarterly return of
the spot rate for LIBOR plus 2.25%. This investment has cash flow risk
since the quarterly values of LIBOR are unknown. The investment does not
fair value risk since the value is locked in at $10 million due to the fact that
the returns are variable rather than fixed.
The firm can lock in a fixed return rate by entering into some type of
derivative such as an interest rate swap contract that will lock in the current
LIBOR forward rate. For example, assume the payable leg of the swap
is fixed at 6.41%. Each quarter the difference between 6.41% and the
current spot rate of LIBOR determines the net settlement of the interest rate
swap payment that will vary with interest rate movements. To read more
about this particular cash flow hedge and the hedge accounting that is allowed
under FAS 133, go to Example 2 in Appendix B of FAS 133 beginning with Paragraph
111. Bob Jensen elaborates and extends this example with a video and Excel
workbook at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
The unhedged loan of $1 million has fair value risk but no fair value
risk. The hedged investment has no fair value risk but the subsequent
combination of the hedge and the hedged item creates cash flow risk. If
the hedge is perfectly effective, fair value of the interest rate swap
used as the hedging instrument fluctuates exactly to offset any value change in
the loan such that the combined value of the loan plus the swap is fixed at $1
million. For example, in Example 2 mentioned above, the swap begins with a zero
value but down down to a fair value of a negative liability of )$16,025) when
the value of the loan drops to ($998,851) such that the sum of the two values is
the constant $1 million. The swap costs the borrower an outflow of $16,025
at the end of the first quarter to offset the decline in the value of the
loan.
The point here is that a hedge for fair value risk creates cash flow
risk.
Why would a firm want to enter into a fair value hedge that causes cash flow
risk? There can be many reasons, but one is that the borrower may predict
that interest rates are going to fall and it would be advantageous to prepay the
fixed-rate loan at some point in time before maturity and borrow at anticipated
lower rates. In Example 2 mentioned above, LIBOR dropped to 6.31% in the
fourth quarter such at the firm would have to pay $1,001,074 to prepay the loan
(e.g., by buying it back in the market). However, due to the hedge, the
interest rate swap would pay $1,074 such that the net cost is only the $1
million locked in fair value fixed by the interest rate swap hedge.
Companies do a somewhat surprising amount of fair value hedging with interest
rate swaps. Two enormous examples are Fannie Mae and Freddie Mac.
Both of these giant companies hedge millions of dollars of outstanding variable
rate debt with interest rate swaps that lock in fair value. Both companies
thereby create cash flow risk. Fannie Mae lost $24 billion in derivatives
trading, and much of this was due to fair value hedging. See "$25
Billion in Derivatives Losses at Fannie Mae" --- http://worldvisionportal.org/WVPforum/viewtopic.php?t=192
An independent analysis of Fannie's accounts
suggests it may have incurred losses on its derivatives trading of $24bn
between 2000 and third-quarter 2003. That figure represents nearly all of the
$25.1bn used to purchase or settle transactions in that period. Any net losses
will eventually have to be recognised on Fannie Mae's balance sheet,
depressing future profits.
You can read more about Fannie Mae and Freddie Mac fair value hedging
strategy in their annual reports for Years 2001, 2002, and 2003. Both
companies made headlines for not complying with FAS 133 hedge accounting
years. See
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Stress Tests: Market Risk, Operational Risk, Liquidity Risk
Stress Test
Risk Glossary Definition
http://www.riskglossary.com/link/stress_testing.htm
Stress testing is a simple form of
scenario analysis. Rather than consider the evolution of risk factors over
several time steps, stress testing considers changes in risk factors over a
single time step. That horizon is usually a single trading day, but stress
testing can be considered over longer horizons—a week, two weeks, a quarter
or even a year. Usually, stress testing is used to assess market risk, and
that is the application this article focuses on. However, any scenario
analysis that employs a single time step may be referred to as a stress
test.
Used for market risk, a single scenario
consists of projected values for applicable risk factors at the end of the
horizon. Based on these values, a portfolio is marked-to-market. The result
is compared with the portfolio's current market value, and the portfolio
loss is calculated as the difference between the two.
Scenarios can be constructed in an ad hoc
manner. If management is concerned about the effect of an inverted yield
curve or a breakdown in a specific correlation, a scenario can be
constructed specifically to assess that eventuality.
Stress testing can also be systematized. A
firm may specify certain fixed scenarios (defined in terms of percent
changes in applicable risk factors) and then perform periodic stress testing
with those scenarios. In this manner, a firm might present stress test
results in its daily risk report. Such stress scenarios may be hypothetical,
perhaps reflecting contingencies that are a recurring concern of management.
They can also be historically based. With that approach, stress scenarios
may reflect the percentage changes in risk factors experienced during
selected historical periods of market turmoil—stock market crashes, currency
devaluations, etc.
Stress testing has much in common with
value-at-risk (VaR). Both assess market risk. Both consider the change in
market risk over a fixed horizon due to changes in specific risk factors.
Indeed, if stress testing is conducted with randomly generated scenarios,
the analysis would not be called stress testing. It would be called a Monte
Carlo VaR measure.
There is some misunderstanding about the
purpose of stress testing. This can be traced to the early literature on VaR
from the mid-1990s. Like any tool, VaR has limitations, and those
limitations were significant with many of the crude VaR implementations of
the day. In light of those limitations, it became customary to recommend
stress testing as a supplement to VaR. The phrase "VaR should always be
supplemented with stress testing" is familiar to practitioners who worked in
financial risk management during that period. Actually, the advice was
dubious. No one ever identified how stress testing addressed the limitations
of VaR measures of the day. For the most part, it didn't.
There was a perception that stress testing
allowed for the analysis of extreme events that VaR didn't address. For
example, if a firms was using one-day 90% USD VaR, results would reflect
losses that might be experienced one day out of ten. What about losses that
might be experienced one day out of 100—or one day out of 1000? On the
surface, stress testing, with its ability to assess arbitrarily extreme
events, seemed well suited to answer such questions. It was not. Although,
stress testing can be used to assess losses under any scenario, it
associates no probabilities with those scenarios. If stress testing
indicates that a firm will lose a billion dollars under one extreme
scenario, it is difficult to make sense out of the result. Is that a
scenario that will occur once every thousand days or once every thousand
years? Given an extreme enough scenario, it is possible to predict ruin for
any portfolio.
Used as a supplement to VaR, stress
testing is primarily useful for offering an intuitive sense of what sorts of
scenarios are causing the VaR to be what it is. In this way, it can be a
nice supplement for VaR.
The one significant shortcoming of VaR
that stress testing does address is sudden changes in historical
correlations. If two currencies have been pegged to one another, they will
exhibit a high historical correlation. A VaR analysis based on that
historical correlation will not address the risk that one of the currencies
may be devalued relative to the other. If this is a scenario that concerns
management, a simple stress test will offer more insights than would, say, a
VaR analysis performed with a modified correlation assumption.
In summary, stress testing can be a nice
supplement for VaR analyses, and many firms use it for that purpose. For
assessing the risk of a breakdown in historical correlations, stress testing
can be valuable. Other than that, as a tool for addressing vaguely defined
limitations of a VaR measure, stress testing is largely a placebo.
There are two categories: Sensitivity Analysis and Scenario
Analysis
Ira Kawaller pulished a paper that talks about liquidity stress testing in
conjunction with FAS 157 valuation definitions
"Watching out for FAS 157: Fair Value Measurement," by Ira Kawaller, Bank
Asset/Liability Management, April 2008 ---
http://www.kawaller.com/pdf/BALMWatchingoutforFAS157.pdf
Also at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/StressTestKawaller.pdf
Liquidity Risk Measurement Techniques and Stress Tests
In the first article in this series
on the considerations to the formulation of a liquidity stress testing
framework, the background to liquidity risk and liquidity stress testing was
presented (see March 2008 BALM). This second article in the series
investigates various stress-testing categories in order to gain a better
understanding of stress testing and how it could be applied in liquidity
risk measurement. The basic liquidity risk measurement techniques are
explored to establish a framework of potential analytical techniques to
apply in the formulation of a liquidity stress testing methodology.
Liquidity Stress Testing. The formulation of a
liquidity stress testing framework requires a clear and decisive
understanding of the stress testing technique applied, exactly what is
stress tested, and the type of analyses conducted. This section will explore
the methods of stress testing that can be applied in the liquidity risk
management process. Furthermore, the types of analyses conducted in
measuring liquidity risk and other considerations that should be
incorporated in the stress testing framework will be discussed.
Categories of Stress Testing.
Generally, stress testing falls in two main categories – sensitivity tests
and scenario tests.
• Sensitivity tests specify financial parameters
that are moved instantaneously by a unitary amount, for example, a 10
percent decline or a 10 basis point increase. This approach is a
hypothetical perspective to potential future changes in the risk factor(s).
Such sensitivity tests lack historical and economic content which limits its
usefulness for longer-term risk management decisions. Sensitivity tests can
also examine historical movements in a number of financial parameters.
Historical movements in parameters can be based on worst case movements over
a set historical period (e.g., the worst change in interest rates, equity
prices and currencies over the past 10 years). Alternatively, actual market
correlations between various factors may be analyzed over a set period of
time to determine the movement in factors that would have resulted in the
largest loss for the current portfolio. In sensitivity stress tests, the
source of the shock is not identified and the time horizon for sensitivity
tests is generally shorter, often
instantaneous, unlike scenario tests.
Italian Banking ---
http://www.c-ebs.org/documents/ABI_CP12.pdf
Stress Tests for Banks ---
http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/StressTestBanks01.htm
Stress Tests for Hedge Funds ---
http://www.cs.trinity.edu/~rjensen/Calgary/CD/FairValue/StressTestHedgeFunds.htm
Slide Show ---
Click Here
"Credit Derivatives Survive a Series of Stress Tests As Demand for the
Hedging Instruments Grows," by Michael Mackenzie, The Wall Street Journal,
January 21, 2003, Page C13
Having roughly doubled in size in each of the past
five years, credit derivatives have lately survived a series of stress tests.
Wall Street is hoping that this encourages even broader participation by new
investors.
Last year was certainly the year for fallen credit
angels, headlined by the default of Argentina and the bankruptcy of Enron
Corp. -- the latter was an actively traded name in the credit derivatives
market over the past three years. But Wall Street figures that successful
negotiation of these credit craters has set the stage for further growth of
credit derivatives, such as default swaps, total-return swaps and synthetic
collateralized debt obligations.
Some fear that broader participation by inexperienced
players raises the risk of big blowups in the credit-derivatives market.
Indeed, a few analysts are predicting headlines from such an event this year.
Still, these instruments, once assigned to the
fringes of risk management, encountered only a minimum of legal complications
in the Enron and Argentine cases.
"Credit derivatives earned their stripes in the
aftermath of Enron filing for bankruptcy," said John McEvoy, cofounder of
Creditex, a trading platform for credit derivatives. "The market did what
it was supposed to do and that has apprised many investors of the value credit
derivatives hold for hedging credit risk."
And the continued expansion of the credit-derivatives
market derives not just from the perspective of hedging credit risk, but also
from investors on the other side of the trade seeking a source of synthetic
liquidity.
A credit default swap acts like an insurance position
that allows buyers to transfer the risk of defaults or other kinds of credit
events, such as debt restructurings, to a selling counterparty, who is paid a
premium that is derived from the notional amount of the contract.
In effect, the seller or underwriter of the default
swap establishes a synthetic long position in the credit of the company
without having to purchase the underlying cash bond.
Investors are increasingly using default swaps to
"increase or reduce credit risk without the liquidity constraints of the
cash market," said William Cunningham, director of credit strategy at
J.P. Morgan Chase in New York.
Indeed, liquidity in credit derivatives has grown so
much that two-way activity is often better than that of the notoriously
illiquid cash bond market. "We are increasingly seeing the derivative
dictate activity in the underlying cash bond," said Mr. McEvoy.
"Credit derivatives act as a barometer for the underlying cash market as
they concentrate solely upon credit risk."
The growth of credit derivatives has also created
better liquidity for less-popular issues as derivatives trading has encouraged
greater use of cash bonds for derivatives traders hedging their positions.
It "has created more demand for off-the-run
paper," said John Cieslowski, vice president for credit derivatives at
Goldman, Sachs & Co. in New York.
Hedge funds have been particularly active users of
these instruments. Jeff Devers, president of Palladin Group LP in Maplewood
N.J., a hedge fund that seeks to minimize risk and enhance returns from
convertible bonds, uses credit derivatives to "isolate credit risk."
This way his fund solely takes on the equity exposure of a convertible bond.
Mr. Devers expects further growth of credit derivatives to add even more
liquidity to the convertible bond market.
Another key development has been the use of synthetic
collateralized debt obligation baskets, which are a series of default swaps
upon a range of credits bundled together. These credits are divided into
tranches that reflect different risk ratings, appealing to the divergent risk
appetites of investors.
The two counterparties to a synthetic CDO are either
offsetting the credit risk through such trades or are taking exposure to a
diverse number of credits that can augment the performance of their underlying
portfolios.
Exposure to synthetic CDOs also raises a money
manager's level of assets under management and either lowers or raises the
level of exposure to a particular credit.
Creditex, which brokers trading between
counterparties in CDOs, has been a beneficiary of this growth. "The past
year saw many traditional CDO players enter the synthetic CDO market in credit
derivatives and this contributed to a substantial rise in market
activity," noted Mr. McEvoy.
To see how banks use/misuse derivatives, see
tranches.
FAS 133 = See SFAS
133
FASB =
See Financial Accounting Standards Board (FASB)
FIN 46
What's Right and What's Wrong With (SPEs),
SPVs, and VIEs ---
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm
Financial Accounting Standards Board
(FASB) =
Financial Accounting Standards Board, P.O. Box 5116, Norwalk, CT 06856-5116. Phone:
203-847-0700 and Fax: 203-849-9714. The web site is at http://www.fasb.org/
. See FAS 133.
On December 14, 1999 the FASB issued Exposure Draft 204-B
entitled Reporting Financial Instruments and Certain
Related Assets and Liabilities at Fair Value. This document can be
downloaded from http://www.fasb.org/derivatives/
(Trinity University students can find the document at J:\courses\acct5341\fasb\pvfvalu1.doc
).
Also
see International Accounting Standards Board (IASB)
and IAS 39
Financial
Instrument =
cash, evidence of an ownership interest in an
entity, or a contract that both:
Imposes on one entity a contractual obligation (1) to
deliver cash or another financial instrument to a second entity or (2) to exchange other
financial instruments on potentially unfavorable terms with the second entity
Conveys to that second entity a contractual right (1)
to receive cash or another financial instrument from the first entity or (2) to exchange
other financial instruments on potentially favorable terms with the first entity.
The definition of financial instrument
includes commodity-based contracts that provide the holder with an option to receive from
the issuer either a financial instrument or a nonfinancial commodity. See derivative financial instrument.
Firm Commitment =
an agreement with an unrelated party,
usually legally enforceable, under which performance is probable because of a sufficiently
large disincentive for nonperformance.
For example,
even though a company expects future dividends from an investment to continue at a fixed
rate, future dividends are not firm commitments unless there are disincentives for failure
to declare dividends. There might be such disincentives in the case of preferred
dividends, but there are no such disincentives for common stock dividends.
Disincentives for nonperformance may not be indirect opportunity gains or losses according
to Paragraph 540 beginning on Page 243 of FAS 133. Paragraph
540 on Page 244 defines a firm commitment as follows:
An agreement with an
unrelated party, binding on both parties and usually legally enforceable, with the
following characteristics:
a. The agreement specifies all significant terms, including the quantity to be exchanged,
the fixed price, and the timing of the transaction. The fixed price may be expressed as a
specified amount of an entity's functional currency or of a foreign currency. It may also
be expressed as a specified interest rate or specified effective yield.
b. The agreement includes a disincentive for nonperformance
that is sufficiently large to make performance probable.
Section b above is judgmental. The best way
to meet this condition is to spell out the penalties for nonperformance in the
contract. But there are many situations where legal recourse is implicit as a matter
of statute or tradition. Must the "agreement disincentives" be
spelled out in each contract? Clearly there are many situations in which
disincentives are implicit in the law. There are many others in which it is not so
much legal as it is economic disincentives requiring laying off of workers, closing down
of plants, negative publicity, etc. Economic disincentives, however, are far more
difficult to use in distinguishing firm commitments from forecasted
transactions.
To my students I like to relate firm commitments and
forecasted transactions to purchase commitments or sales contracts that call
for future delivery. If the contract specifies an exact quantity at a
fixed (firm) price, the commitment is deemed a "firm
commitment." Cash flow is never in doubt with a firm
(fixed-price) commitments and, therefore, a firm commitment cannot be hedged
by a cash flow hedge. For example, suppose Company A enters into a
purchase contract to purchase 10,000 tons of a commodity for $600 per ton in
three months time. This a firm commitment without any doubt about the
cash flows. However, if the price is contracted at "spot
price" in three months, the commitment is no
longer a "firm" commitment. The clause "spot
price" makes this a forecasted
transaction for 10,000 at a future price that can can move up or down from
its current level. It is possible to enter into a cash
flow hedge with a derivative instrument that will lock in price of a
forecasted transaction. In the case of a firm commitment there is no
need for a cash flow hedge.
In the case of a firm commitment the cash flow is fixed but
the value can vary with spot prices. For example, in three months time
the firm commitment cash flow may be ($600)($10,000) = $6,000,000. If
the spot price moves to $500, the cash flow is more than the value of the
commodity at the time of purchase. It is possible, however, to use a
derivative financial instrument to hedge the value at a given level (called a fair
value hedge) such that if the spot rate falls to $500, the hedge will pay
($600-$500)(10,000 tons) = $1,000,000.
In the case of a forecasted transaction at spot rates, the
value stays fixed at ($ spot rate)(10,000 tons). However, the cash flow
accordingly varies. It is possible to enter into a cash flow hedge using
a derivative financial instrument, however, such that the cash flow is fixed a
desired level. In summary either cash flows are fixed and values vary
(i.e., a fixed commitment) or cash flows vary and values are fixed (forecasted
transaction). If hedging takes place, firm commitments are only hedged
with respect to value, whereas forecasted transactions are only hedged as to
cash flow.
I think the FASB really intends that the
disincentives or penalties must be legally specified for each firm commitment to a point
where these specifications will invoke very serious damages after a court in case for any
breach of contract. Section b is probably best interpreted in terms of its
main purpose. The main purpose, I surmise, is to distinguish a firm commitment from
both a forecasted transaction and a common form of purchase contract that is easily broken
with few if any penalties. For example, a newspaper's 80-year agreement to purchase
newsprint from a paper manufacturer might be broken with relatively small damages if the
trees needed for the newsprint have not even been planted. That type of purchase
agreement is not a firm commitment. It would seem, however, that Section b must be a
matter of judgment regarding degrees of "firmness." rather than the mere writing
in of any form of penalty for breach of contract.
Accounting for Executory Contracts Such as Purchase/Sale Commitments and
Loan Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
See DIG
Implementation Issue A5 under net settlement.
Differences between firm commitments versus
forecasted transactions are elaborated upon in
Paragraphs 320-326 beginning on Page 157 of FAS 133.
Respondents did not necessarily agree that the
differences are important. The FASB argues that they are important. As a result, firm commitments do not need cash flow
hedges unless there is foreign currency risk. They may
need fair value hedging since values may vary from committed prices. According to
Paragraph 325, forecasted transactions have fewer rights and obligations vis-a-vis
firm commitments. All significant terms of the exchange should be specified in the
agreement, including the quantity to be exchanged and the fixed price. A forecasted
transaction has no contractual rights and obligations. Firm commitments differ from
long-term purchase commitments. Generally long-term purchase agreements such as agreements
to purchase timber of trees not yet planted or oil not yet pumped from the ground can
usually be broken with a relatively small amount of penalty equal to damages sustained in
the breaking of a contract. A firm commitment usually entails damage awards equal to or
more than the contractual commitment. Hence they are less likely to be broken than
purchase commitments. Firm commitments are discussed at various points in FAS 133.
See Paragraphs 37, 362, 370, 437-442, and 458-462.
Firm commitments can have fair value hedges
even though they cannot have cash flow hedges other than cash flow hedges of foreign
currency risk exposures --- see Paragraph 20 on Page 11 and Paragraph 37 on Page 24 of
FAS 133. They can be contracted in terms of a currency other than the designated
functinal currency. Gains and losses on fair value hedges of firm commitments are
accounted for in current earnings following guidance in Paragraph 39 on Page 25 of
FAS 133. If the firm commitment is recognized, it is by definition booked and its
loss or gain is already accounted for. For example, a purchase contract for 10,000 units
per month at 100DM Deutsche Marks per unit is unrecognized and has a foreign currency risk
exposure if the payments have not been made. If the payments
have been prepaid, that prepayment is "recognized" and has no further foreign
currency risk exposure. See derivative
financial instrument.
With respect
to Firm Commitments vs. Forward
Contracts, the key distinction is Part b of Paragraph 540 of the original
FAS 133 (I have an antique copy of the original FAS 133 Standard.)
Those of us
into FAS 133’s finer points have generally assumed a definitional
distinction between a “firm commitment” purchase contract to buy a commodity
at a contract price versus a forward contract to purchase the commodity at a
contracted forward price. The distinction is important, because FAS 133
requires booking a forward contract and adjusting it to fair value at
reporting dates if actual physical delivery is not highly likely such that
the NPNS exception under Paragraph 10(b) of FAS 133 cannot be assumed to
avoid booking.
The
distinction actually commences with forecasted transactions that include
purchase contracts for a fixed notional (such as 100,000 gallons of fuel) at
an uncertain underlying (such as the spot price of fuel on the actual future
date of purchase). Such purchase contracts are typically not booked. These
forecasted transactions become “firm commitments” if the future purchase
price is contracted in advance (such $2.23 per gallon for a future purchase
three months later). Firm commitments are typically not booked under FAS 133
rules, but they may be hedged with fair value hedges using derivative
financial instruments. Forecasted transactions (with no contracted price)
can be hedged with cash flow hedges using derivative contracts.
There is an
obscure rule (not FAS 133) that says an allowance for firm commitment loss
must be booked for an unhedged firm commitment if highly significant
(material) loss is highly probable due to a nose dive in the spot market.
But this obscure rule will be ignored here.
One
distinction between a firm commitment contract and a forward contract is
that a forward contract’s net settlement, if indeed it is net settled, is
based on the difference between spot price and forward price at the time of
settlement. Net settlement takes the place of penalties for non-delivery of
the actual commodity (most traders never want pork bellies dumped in their
front lawns). Oil companies typically take deliveries some of the time, but
like electric companies these oil companies generally contract for far more
product than will ever be physically delivered. Usually this is due to
difficulties in predicting peak demand.
A firm
commitment is gross settled at the settlement date if no other net
settlement clause is contained in the contract. If an oil company does not
want a particular shipment of contracted oil, the firm commitment contract
is simply passed on to somebody needing oil or somebody willing to offset
(book out) a purchase contract with a sales contract. Pipelines
apparently have a clearing house for such firm commitment transferals
of “paper gallons” that never flow through a pipeline. Interestingly, fuel
purchase contracts are typically well in excess (upwards of 100 times) the
capacities of the pipelines.
The
contentious FAS 133 booking out problem was settled for electricity
companies in FAS 149. But it was not resolved in the same way for other
companies. Hence for all other companies the distinction between a firm
commitment contract and a forward price contract is crucial.
In some ways
the distinction between a firm commitment versus a forward contract may be
somewhat artificial. The formal distinction, in my mind, is the existence of
a net settlement (spot price-forward price) clause in a forward contract
that negates a “significant penalty” clause of a firm commitment contract.
The original
FAS 133 (I still have this antique original version) had a glossary that
reads as follows in Paragraph 540:
Firm commitment
An agreement with an unrelated party, binding on both parties and
usually legally enforceable, with the following characteristics:
a. The agreement specifies all significant terms, including the
quantity to be exchanged, the fixed price, and the timing of the
transaction. The fixed price may be expressed as a specified
amount of an entity's functional currency or of a foreign
currency. It may also be expressed as a specified interest rate
or specified effective yield.
b. The agreement includes a disincentive for nonperformance that is
sufficiently large to make performance probable.
The key
distinction between a firm commitment and a forward contract seems to be
Part b above that implies physical delivery backed by a “sufficiently large”
penalty if physical delivery is defaulted. The net settlement
(spot-forward) provision of forward contracts generally void Part b
penalties even when physical delivery was originally intended.
Firm
commitments have greater Part b penalties for physical non-conformance than
do forward contracts. But in the case of the pipeline industry, Part b
technical provisions in purchase contracts generally are not worrisome
because of a market clearing house for such contracts (the highly common
practice of booking out such contracts by passing along purchase contracts
to parties with sales contracts, or vice versa, that can be booked out) when
physical delivery was never intended. For example, in the pipeline hub in
question (in Oklahoma) all such “paper gallon” contracts are cleared against
each other on the 25th of every month. By “clearing” I mean that
“circles” of buyers and sellers are identified such that these parties
themselves essentially net out deals. In most cases the deals are probably
based upon spot prices, although the clearing house really does not get
involved in negotiations between buyers and sellers of these “paper
gallons.”
See
Bookout and
Forward Transaction
In Paragraph 440 beginning on Page 195 of
FAS 133, the definition of a firm commitment reads the same as is does in Paragraph 540:
An agreement with an unrelated
party, binding on both parties and usually legally enforceable, with the following
characteristics:
a. The agreement specifies
all significant terms, including the quantity to be
exchanged, the fixed price, and the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity's functional currency
or of a foreign
currency. It also may be expressed as a specified interest rate or specified effective
yield.
b. The agreement includes a disincentive for nonperformance that is
sufficiently large to make performance probable.
That definition is based on
the definition of a firm commitment in
Statements 52 and 80.
Paragraph
324 on Page 157 also declares that firm commitments must be fixed-price contracts. Also
see Paragraphs 370, 416, and 432 of FAS 133. Contracts
not having fixed prices are generally not allowed to host fair value hedges. An illustration of a fair value hedge of a firm commitment begins
in Paragraph 121 on Page 67 of FAS 133. Disincentives for nonperformance can be
direct penalties, but they may not be indirect opportunity gains or losses according to
Paragraph 540 beginning on Page 243 of FAS 133.
Some firm commitments are not booked at the time of the
contract. For example, purchase contracts for raw materials are not booked until
title changes hands or prepayment takes place. Unrecognized firm commitments, unlike
recognized firm commitment, are not booked as assets or liabilities. Footnote 2 on
Page 2 of SFAS reads as follows:
An unrecognized firm commitment can
be viewed as an executory contract that represents both a right and an obligation. When a
previously unrecognized firm commitment that is designated as a hedged item is accounted
for in accordance with this Statement, an asset or a liability is recognized and reported
in the statement of financial position related to the recognition of the gain or loss on
the firm commitment. Consequently, subsequent references to an asset or a liability in
this Statement include a firm commitment
Footnote 8 on Page 13 of
FAS 133 notes how
commitments sometimes do and sometimes do not qualify for accounting as firm commitments
for hedges:
A firm commitment that represents
an asset or liability that a specific accounting standard prohibits recognizing (such as a
noncancellable operating lease or an unrecognized mortgage servicing right) may
nevertheless be designated as the hedged item in a fair value hedge. A mortgage banker's
unrecognized "interest rate lock commitment" (IRLC) does not qualify as a firm
commitment (because as an option it does not obligate both parties) and thus is not
eligible for fair value hedge accounting as the hedged item. (However, a mortgage
banker's "forward sale commitments," which are derivatives that lock in the
prices at which the mortgage loans will be sold to investors, may qualify as hedging
instruments in cash flow hedges of the forecasted sales of mortgage loans.)
Sometimes even a firm commitment is not eligible
for hedge accounting. For example, a a firm commitment to acquire equity investment
in a consolidated subsidiary is not eligible under Paragraph 456 on Page 201 of
FAS 133.
Under international rules, a hedged item can be a recognized asset or liability, an unrecognized firm
commitment, or a forecasted transaction (IAS 39 Paragraph 127).
Also
see FAS 133 Paragraph 21a.
A firm commitment must meet
the stringent criteria for being defined as a derivative
financial instrument under FAS 133. This includes the tests for being clearly-and-closely related. It also includes
strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and
Paragraph 56 on Page 33 of FAS 133 with respect to the host contracts that are being
hedged. Those tests state that if the firm "commitment" is in reality a
group or portfolio of individual transactions, all transactions in the group must bear the
same risk exposure within a 10% range discussed in Paragraph 21. Also see
Footnote 9 on Page 13 of FAS 133. The grouping tests are elaborated upon in the
following Paragraphs:
-
Paragraph 21 on Page 13,
-
Paragraph 29 beginning on Page 20,
-
Paragraph 241 on Page 130,
-
Paragraph317 on Page 155,
-
Paragraphs 333-334 beginning on Page 159,
-
Paragraph 432 on Page 192,
-
Paragraph 435 on Page 193,
-
Paragraph 443-450 beginning on Page 196
-
Paragraph 462 on Page 202,
-
Paragraph 477 on Page 208.
For example, a group of variable
rate notes indexed in the same way upon LIBOR might qualify, whereas having different
indices such as LIBOR and U.S. Prime rate underlyings will not
qualify. Also, anticipated purchases cannot be combined with anticipated
sales in the same grouping designated as a forecasted transaction even if they have the
same underlying. Paragraph 477 on Page 208 of
FAS 133 makes an exception for a portfolio of differing risk exposures for financial
instruments designated in foreign currencies so not to conflict with Paragraph 20 of SFAS
52. It allows hedging under "net
investment" criteria under Paragraph 20 of SFAS 52. For
more detail see foreign currency hedge.
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
Fair value hedge definition: a hedge of the exposure to changes in
the fair value of a recognised asset or liability (such as a hedge of
exposure to changes in the fair value of fixed rate debt as a result of
changes in interest rates).
However, a hedge of an unrecognised firm commitment to buy or sell an
asset at a fixed price in the enterprise’s reporting currency is
accounted for as a cash flow hedge
|
FAS 133
Same...
...except that a hedge of an unrecognised firm commitment to buy or
sell an asset at a fixed price in the enterprise’s reporting currency
is accounted for as a fair value hedge or a cash flow hedge.
|
Also see forecasted
transaction and hedge accounting.
|
Fixed-to-Floating = see floater.
Floater =
a variable coupon (nominal) rate that determines
the interim cash flows on bond debt and bond investments. Example 12 in
FAS 133 Paragraph 178 illustrates an inverse floater where the coupon rate varies with changes in
an interest rate index such as the prime rate or LIBOR.
Example 13 in Paragraph 179 illustrates a levered inverse floater that varies indirectly
rather than directly with an index. Example 14 in Paragraph 180
illustrates a delivered floater that has a lagged relation to an index. Example 15
in Paragraph 15 illustrates a range floater with a cash payment based upon the number of
days that the referent index stays with a a pre-established collar (range). Example
16 illustrates a ratchet floater that has an adjustable cap and floor that move in
relation to a referent index such as LIBOR. Example 17 in Paragraph 183 illustrates
a fixed-to-floating floater varies between fixed rate periods versus floating rate
periods.
Much of the concern in
FAS 133 accounting focuses on whether a floater-based embedded option
can be separated from its host. For example suppose a bond receivable has a variable
interest rate with an embedded range floater derivative that specifies a collar of 4% to
8% based upon LIBOR. The bond holder receives no interest
payments in any period where the average LIBOR is outside the collar. In this case,
the range floater embedded option cannot be isolated and accounted for apart from the host
bond contract. The reason is that the option is clearly
and closely related to the interest payments under the host contract (i.e., it can
adjust the interest rate). See Paragraph 12 beginning on Page 7 of FAS 133.
An example of a range floater is provided beginning in Paragraph 181 on Page 95 of
FAS 133.
A ratchet floater pays a floating interest rate with an
adjustable cap and an adjustable floor. The embedded derivatives
must be accounted for separately under Paragraph 12. An example is provided in
Paragraph 182 beginning on Page 95 of FAS 133.
Some debt has a
combination of fixed and floating components. For example, a
"fixed-to-floating" rate bond is one that starts out at a fixed rate and at some
point (pre-determined or contingent) changes to a variable rate. This
type of bond has a embedded derivative (i.e., a forward
component for the variable rate component that adjusts the interest rate in later periods.
Since the forward component is "clearly-and-closely related"adjustment
of interest of the host contract, it cannot be accounted for separately according to
Paragraph 12a on Page 7 of FAS 133 (unless conditions in Paragraph 13 apply). See also Paragraph 21a(2) on Page 14 of
FAS 133. An example of a fixed-to-floating rate debt is provided beginning in Paragraph
183 on Page 196 of FAS 133.
Floor = see cap.
Forecasted
Transaction =
a transaction that is expected, with
high probability, to occur but as to which
there has been no firm commitment. Particularly important is the absence penalties for
breach of contract. Paragraph 540 on Page 245 of FAS 133
defines it as follows:
A transaction that is
expected to occur for which there is no firm commitment. Because no transaction or event
has yet occurred and the transaction or event when it occurs will be at the prevailing
market price, a forecasted transaction does not give an entity any present rights to
future benefits or a present obligation for future sacrifices
To my students I like to
relate firm commitments and forecasted transactions to purchase commitments or
sales contracts that call for future delivery. If the contract specifies
an exact quantity at a fixed (firm) price, the commitment is deemed a "firm
commitment." Cash flow is never in doubt with a firm
(fixed-price) commitments and, therefore, a firm commitment cannot be hedged by
a cash flow hedge. For example, suppose Company A enters into a purchase
contract to purchase 10,000 tons of a commodity for $600 per ton in three months
time. This a firm commitment without any doubt about the cash flows.
However, if the price is contracted at "spot price"
in three months, the commitment is no longer a
"firm" commitment. The clause "spot price"
makes this a forecasted transaction for 10,000 at a future price that can can
move up or down from its current level. It is possible to enter into a cash
flow hedge with a derivative instrument that will lock in price of a
forecasted transaction. In the case of a firm commitment there is no need
for a cash flow hedge.
In the case of a firm
commitment the cash flow is fixed but the value can vary with spot prices.
For example, in three months time the firm commitment cash flow may be
($600)($10,000) = $6,000,000. If the spot price moves to $500, the cash
flow is more than the value of the commodity at the time of purchase. It
is possible, however, to use a derivative financial instrument to hedge the
value at a given level (called a fair value hedge)
such that if the spot rate falls to $500, the hedge will pay ($600-$500)(10,000
tons) = $1,000,000.
In the case of a
forecasted transaction at spot rates, the value stays fixed at ($ spot
rate)(10,000 tons). However, the cash flow accordingly varies. It is
possible to enter into a cash flow hedge using a derivative financial
instrument, however, such that the cash flow is fixed a desired level. In
summary either cash flows are fixed and values vary (i.e., a fixed commitment)
or cash flows vary and values are fixed (forecasted transaction). If
hedging takes place, firm commitments are only hedged with respect to value,
whereas forecasted transactions are only hedged as to cash flow.
Because no transaction or event has
yet occurred and the transaction or event when it occurs will be at the prevailing market
price, a forecasted transaction does not give an entity any present rights to future
benefits or obligations for future sacrifices. Firm commitments differ from
forecasted transactions in terms of legal rights and obligations. A forecasted
transaction has no contractual rights and obligations. Forecasted transactions are
referred to at various points in FAS 133. For example, see FAS 133 Paragraphs 29-35, 93,
358, 463-465, 472-473, and 482-487. A
forecasted transaction, unlike a firm commitment, may need a
cash flow hedge.
Paragraph 29b on Page 20 of
FAS 133 requires that the forecasted transaction be probable. Important in this criterion
would be past sales and purchases transactions. An on-going baking company, for
example, must purchase flour. It does not have to purchase materials for a plant
renovation, however, until management decisions to renovate are firmed up.
Paragraph 325 on Page 157 of
FAS 133 states that even though forecasted transactions may be highly probable, they lack the
rights and obligations of a firm commitment, including unrecognized firm commitments that
are not booked as assets and liabilities.
Forecasted transactions differ from firm commitments in terms of enforcement rights and
obligations. They do not differ in terms of the need for a specific notional and a
specific underlying under Paragraph 440a on Page 195 of FAS 133. Section a of that
paragraph reads as follows:
a. The agreement
specifies all significant terms, including the quantity to be
exchanged, the fixed price, and the timing of the transaction.
The fixed price may be expressed as a specified amount of an entity's functional currency
or of a foreign
currency. It also may be expressed as a specified interest rate or specified effective
yield.
In Paragraph 29c on Page 20 of
FAS 133, the forecasted transaction cannot be with a related party such as a subsidiary or
parent company if it is to qualify as the hedged transaction of a cash
flow hedging derivative. An exception is made in Paragraph 40 on Page 25 for
forecasted intercompany foreign currency-denominated transactions if the conditions on
Page 26 are satisfied. Also see Paragraphs 471 and 487. Paragraph 40 beginning on Page 25 allows such cash flow hedging if the
parent becomes a party to the hedged item itself, which can be a contract between the
parent and its subsidiary under Paragraph 36b on Page 24 of FAS 133. However, a
consolidated group may not apply cash flow hedge accounting as stated in Paragraph 40d on
Page 26.
Cash flow hedges must have the
possibility of affecting net earnings. For example, Paragraph 485 on Page 211 of
FAS 133 bans foreign currency risk hedges of forecasted dividends of foreign
subsidiary. The reason is that these dividends are a wash item and do not affect
consolidated earnings. For reasons and references, see equity
method.
Suppose a company expects dividend
income to continue at a fixed rate over the two years in a foreign currency. Suppose
the investment is adjusted to fair market value on each reporting date. Forecasted
dividends may not be firm commitments since there are not
sufficient disincentives for failure to declare a
dividend. A cash flow hedge of the foreign currency risk exposure can be entered
into under Paragraph 4b on Page 2 of FAS 133. Whether or not gains and losses are
posted to other comprehensive income, however, depends
upon whether the securities are classified under SFAS 115 as available-for-sale or as
trading securities. There is no held-to-maturity alternative for equity securities.
One question that arises is whether a hedged item and its
hedge may have different maturity dates. Paragraph 18 beginning on Page 9 of
FAS 133 rules out hedges such as interest rate swaps from having a longer maturity than the
hedged item such as a variable rate loan or receivable. On the other hand, having a
shorter maturity is feasible according to KPMG's Example 13 beginning on Page 225 of the
Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998) states the
following. A portion of that example reads as follows:
Although the criteria
specified in paragraph 28(a) of the Standard do not address whether a portion of a single
transaction may be identified as a hedged item, we believer that the proportion principles
discussed in fair value hedging model also apply to forecasted transactions.
Paragraph 29d precludes forecasted
transactions from being the hedged items in cash flow hedges
if those items, when the transaction is completed, will be remeasured on each reporting
date at fair value with holding gains and losses taken directly
into current earnings (as opposed to comprehensive income). Also see Paragraph 36 on Page 23 of FAS 133.
Thus, a forecasted purchase of raw material inventory maintained at cost can be a hedged
item, but the forecasted purchase of a trading security not subject to APB 15 equity method accounting and as defined in SFAS 115, cannot be a
hedged item. That is because SFAS 115 requires that trading securities be revalued with
unrealized holding gains and losses being booked to current earnings. Conversely,
the forecasted purchase of an available-for-sale security
can be a hedged item, because available-for-sale securities revalued under SFAS 115 have
holding gains and losses accounted for in comprehensive
income rather than current earnings.
Even more confusing is Paragraph 29e
that requires the cash flow hedge to be on prices rather than credit worthiness. For
example, a forecasted sale of a specific asset at a specific price can be hedged for spot
price changes under Paragraph 29e. The forecasted sale's cash flows may not be
hedged for the credit worthiness of the intended buyer or buyers. Example 24
in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond. Because
the bond's coupon payments were indexed to credit rating rather than interest rates, the
embedded derivative could not be isolated and accounted for as a cash flow hedge.
A forecasted transaction must meet the
stringent criteria for being defined as a derivative
financial instrument under FAS 133. This includes the tests for being clearly-and-closely related. It also includes
strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and
Paragraph 56 on Page 33 of FAS 133 with respect to the host contracts that are being
hedged. Those tests state that if the forecasted "transaction" is in
reality a group or portfolio of individual transactions, all transactions in the group
must bear the same risk exposure within a 10% range discussed in Paragraph 21.
Also see Footnote 9 on Page 13 of FAS 133. The grouping tests are
elaborated upon in the following Paragraphs:
-
Paragraph 21 on Page 13,
-
Paragraph 29 beginning on Page 20,
-
Paragraph 241 on Page 130,
-
Paragraph317 on Page 155,
-
Paragraphs 333-334 beginning on Page 159,
-
Paragraph 432 on Page 192,
-
Paragraph 435 on Page 193,
-
Paragraph 443-450 beginning on Page 196
-
Paragraph 462 on Page 202,
-
Paragraph 477 on Page 208.
For example, a group of variable
rate notes indexed in the same way upon LIBOR might qualify, whereas having different
indices such as LIBOR and U.S. Prime rate underlyings will not
qualify. Also, anticipated purchases cannot be combined with anticipated
sales in the same grouping designated as a forecasted transaction even if they have the
same underlying. Paragraph 477 on Page 208 of FAS 133 makes an exception for a portfolio of
differing risk exposures for financial instruments designated in foreign currencies so not
to conflict with Paragraph 20 of SFAS 52. It allows hedging under "net
investment" criteria under Paragraph 20 of SFAS 52. For more
detail see foreign currency hedge.
Merely meeting the tests of being a
forecasted transaction or a firm commitment does not automatically qualify the item to be
designated a hedge item in a hedging transaction. For example, it cannot be a
forecasted transaction cannot be hedged for cash flows if it is remeasured at fair value
on reporting dates. For example, trading securities under SFAS 115 are remeasured at
fair value with unrealized gains and losses going directly into earnings.
Paragraph 40 beginning on Page 25
bans a forecasted transaction of a subsidiary company from being a hedged item if the
parent company wants to hedge the cash flow on the subsidiary's behalf. However
Paragraph 40a allows such cash flow hedging if the parent becomes a party to the hedged
item itself, which can be a contract between the parent and its subsidiary under Paragraph
36b on Page 24 of FAS 133. Also see Paragraphs 471 and 487.
Paragraph 21c on Page 14 and Paragraph 29f
on Page 20 of FAS 133 prohibits forecasted cash flows from minority interests in a
consolidated subsidiary from being designated as a hedged item in a cash flow hedge. Reasons are given in Paragraph 472
beginning on Page 206 of FAS 133. See minority interest.
Also see firm commitment.
Foreign Currency Financial Statements =
financial statements that employ foreign currency
as the unit of measure.
Foreign
Currency Futures Options = see foreign currency hedge.
Foreign
Currency Hedge =
a hedge that manages risks of variations in
exchange rates for foreign currencies. For example, companies that have firm commitments
to purchase or sell items priced in foreign currencies can hedge against exchange rate
losses between the time of the commitment and the time of the transaction. Major sections
of FAS 133 dealing with such hedges include Paragraphs 36-42, 121-126, 162-175, 194-197,
and 474-487. See currency swap, hedge,
and hedge accounting. The IASC
retained the definition in IAS 21 Paragraph 137c. Held-to-maturity investments carried at amortized cost may be effective hedging
instruments with respect to risks from changes in foreign currency exchange rates
(IAS 39 Paragraph 125). A financial asset or liability whose fair value cannot be reliably measured cannot be a
hedging instrument except in the case of a nonderivative instrument (a) that is
denominated in a foreign currency, (b) that is designated as a hedge of foreign currency
risk, and (c) whose foreign currency component is reliably measurable (IAS
39 Paragraph 126). A nonderivative financial asset or liability may be designated as a
hedging instrument, for hedge accounting purposes, only for a hedge of a foreign currency
risk according to IAS 39 Paragraph 122.
Under IAS 39, foreign currency hedge accounting is
similar to accoutning for cash flow hedges.
(a) the portion of the gain or loss on the hedging instrument that is determined to be an
effective hedge (see IAS Paragraph 142) should be recognized directly in equity through the
statement of changes in equity (see IAS 1, Paragraphs 86-88); and
(b) the ineffective portion should be reported: (1) immediately in earnings if the hedging
instrument is a derivative; or (2) in accordance with Paragraph 19 of IAS 21, in the
limited circumstances in which the hedging instrument is not a derivative
The gain or loss on the hedging instrument relating to the effective portion of the hedge
should be classified in the same manner as the foreign currency translation gain or loss
(IAS Paragraph 164)
Flow Chart for FX Hedge Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
A common type of economic hedge in practice cannot receive
hedge accounting treatment under FAS 133 is called a cross-currency
swap. This is a variant on the standard currency or interest rate swap
in which the interest rate in one currency is fixed, and the interest rate in
the other is floating. The only difference between a traditional interest rate
swap and a currency coupon swap is the combination of the currency and
interest rate features. But the DIG has taken a hard position on
cross-currency swaps that upsets corporations. See http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueh4.html.
Also listen to the audio file CERINO40.mp3 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueh4.html.
Also see circus.
FAS 133 Paragraph 40 reads as follows:
A nonderivative financial instrument shall not be
designated as a hedging instrument in a foreign currency cash flow hedge. A
derivative instrument designated as hedging the foreign currency exposure to
variability in the functional-currency-equivalent cash flows associated with
either a forecasted foreign-currency-denominated transaction (for example, a
forecasted export sale to an unaffiliated entity with the price to be
denominated in a foreign currency) or a forecasted intercompany
foreign-currency-denominated transaction (for example, a forecasted sale to
a foreign subsidiary or a forecasted royalty from a foreign subsidiary)
qualifies for hedge accounting if all of the following criteria are met:
a. The operating unit that has the foreign
currency exposure is a party to the hedging instrument (which can be an
instrument between a parent company and its subsidiary -- refer to FAS 133
Paragraph 36).
b. The hedged transaction is denominated in a
currency other than that unit's functional currency.
c. All of the criteria in FAS 133 Paragraphs 28 and 29
are met, except for the criterion in FAS 133 Paragraph 29c that requires that
the forecasted transaction be with a party external to the reporting
entity.
d. If the hedged transaction is a group of
individual forecasted foreign currency denominated transactions, a
forecasted inflow of a foreign currency and a forecasted outflow of the
foreign currency cannot both be included in the same group.
In FAS 133, derivative financial instruments
come in three basic types that are listed in Paragraph 4 on Page 2 of FAS 133. One
of the types is described in Section c below:
Paragraph 4
on Page 2 of FAS 133.
This Statement standardizes the accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, by requiring that an entity recognize
those items as assets or liabilities in the statement of financial position and measure
them at fair value. If certain conditions are met, an entity may elect to designate a
derivative instrument as follows:
c.
A hedge of the foreign currency exposure of
(1) an unrecognized firm commitment (a foreign currency fair value hedge), (
(2) an available-for-sale
security (a foreign currency fair value hedge),
(3) a forecasted
transaction (a foreign currency cash flow hedge), or
(4) a net investment in a
foreign operation.
With respect to Section c(1) above, firm
commitments can have foreign currency risk exposures if the commitments are not already
recognized. See Paragraph 4 on Page 2 of FAS 133. If the firm commitment is
recognized, it is by definition booked and its loss or gain is already accounted for. For
example, a purchase contract for 10,000 units per month at 100DM Deutsche Marks per unit
is unrecognized and has a foreign currency risk exposure if the
payments have not been made. If the payments have been prepaid, that prepayment is
"recognized" and has no further foreign currency risk exposure. Similar
reasoning applies to trading securities that are excluded in c(2) above since their gains
and losses are already booked. These gains have been deferred in comprehensive income for available-for-sale securities.
An example of a foreign currency hedge is a
contract for foreign currency options on the Philadelphia Exchange. On Page C23 of
the Wall Street Journal on July 22, 1998, blocks of 62,500 Swiss franc
European-style August call options required a payment of 3.58 or $0.0358 per franc plus a
strike price of 63 or $0.6300 bringing the total price up to $0.6658 per franc.
Hence, spot price on July 22 was 66.23 or $0.6623 per franc. Hence, the price need
only rise by more than $0.0035 per franc to be in-the-money. On the Philadelphia
Exchange, options on Swiss francs can only be transacted in blocks of 62,500 francs.
It is also possible to buy options
on foreign currency futures options. A futures call
option gives the owner the right (but not an obligation) to buy the underlying futures
contract at the option contract's strike price. The Chicago Board of Trade deals in
foreign currency futures options.
If the hedged item is a specific portion of an asset/liability (or of a
portfolio of similar assets/liabilities), the hedged item is one of the following:
(1) A percentage of the entire asset/liability
(2) One or more selected contractual cash flows
(3) A put option, a call option, an interest rate cap, or an interest rate floor embedded
in an existing asset/liability that is not an embedded derivative accounted for separately
pursuant to paragraph 12 of the Statement
(4) The residual value in a lessor's net investment in a direct financing or sales-type
lease
If the entire asset/liability is an instrument with variable cash flows, the hedged item
cannot be deemed to be an implicit fixed-to-variable swap perceived to be embedded in a
host contract with fixed cash flows. (FAS 133 Paragraph 21a(2))
The hedged item is not:
(1) an asset or liability that is remeasured with the changes in fair value attributable
to the hedged risk reported currently in earnings (for example, if foreign exchange risk
is hedged, a foreign-currency-denominated asset for which a foreign currency transaction
gain or loss is recognized in earnings), (FAS 133 Paragraph 21c(1)).
Likewise, paragraph 29d prohibits the following transaction from being designated as the
hedged forecasted transaction in a cash flow hedge: the acquisition of an asset or
incurrence of a liability that will subsequently be remeasured with changes in fair value
attributable to the hedged risk reported currently in earnings.
If the forecasted transaction relates to a recognized asset or liability, the asset or
liability is not remeasured with changes in fair value attributable to the hedged risk
reported currently in earnings.)
(2) an investment accounted for by the equity method in accordance with the requirements
of APB Opinion No. 18.
(3) a minority interest in one or more consolidated subsidiaries.
(4) an equity instrument in a consolidated subsidiary.
(5) a firm commitment either to enter into a business combination or to acquire or dispose
of a subsidiary, a minority interest or an equity method investee.
(6) an equity instrument issued by the entity and classified in stockholders' equity in
the statement of financial position (FAS 133 Paragraph 21c).
The following cannot be designated as a hedged item in a foreign currency hedge:
(a) a recognized asset or liability that may give rise to a foreign currency transaction
gain or loss under Statement 52 (such as a foreign-currency-denominated receivable or
payable) either in a fair value hedge or a cash flow hedge.
(b) the forecasted acquisition of an asset or the incurrence of a liability that may give
rise to a foreign currency transaction gain or loss under Statement 52 in a cash flow
hedge
(FAS 133 Paragraph 36).
An available-for-sale equity security can be hedged for changes in the fair value
attributable to changes in foreign currency exchange rates if:
(a) the security is not traded on an exchange on which trades are denominated in the
investor's functional currency.
(b) dividends or other cash flows to holders of the security are all denominated in the
same foreign currency as the currency expected to be received upon sale of the security
(FAS 133 Paragraph 38).
Under Paragraph 42 on Page 26, a financial
instrument that may give rise to foreign currency transaction gains or losses under SFAS
52 can be designated as a hedge against a net investment in a foreign operation (e.g., a
subsidiary, branch, or joint venture). However, such hedges are subject to Paragraph
20 of SFAS 52 criteria rather than FAS 133 criteria. SFAS 52 dictates that that the
gain or loss on the hedging instrument recorded in the SFAS 52-defined currency translation adjustment (CTA) cannot be greater than the
offsetting CTA that arose by translating the foreign entity's financial statements into
the investor's reporting currency. It allows hedging under "net
investment" criteria under Paragraph 20 of SFAS 52. For more detail see cash flow hedge.
FAS 133 does not provide guidance as to which
currencies qualify for an effective hedge. Tandem or cross-currency hedging is permitted for a fair value hedge. For example, if the
Canadian and Australian dollars can be shown to be highly correlated, a forward contract
on one currency can be used as a fair value hedge against a forecasted transaction in the
other currency.
With respect to Paragraph
29a on Page 20 of FAS 133, KPMG notes that if
the hedged item is a portfolio of assets or liabilities based on an index, the hedging
instrument cannot use another index even though the two indices are
highly correlated. See Example 7 on Page 222 of the Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.
Cash flow
hedges must have the possibility of affecting net
earnings. For example, Paragraph 485 on Page 211 of FAS 133 bans foreign currency
risk hedges of forecasted dividends of foreign subsidiary. The reason is that these
dividends are a wash item and do not affect consolidated earnings. For some
complicating factors, however, see equity method.
Paragraph 399 on Page 180 of FAS 133 does not
allow covered call strategies that permit an entity to write an
option on an asset that it owns. In a covered call the combined position of
the hedged item and the derivative option is asymmetrical in that exposure to losses is
always greater than potential gains. The option premium, however, is set so that the
option writer certainly does not expect those "remotely possible" losses to
occur. Only when the potential gains are at least equal to potential cash flow
losses will Paragraph 28c on Page 19 of FAS 133 kick in to allow a cash flow hedge under
FAS 133. Also see Paragraph 20c on Page 12. See written
option.
Foreign currency hedges can be on the basis of
after-tax risk. See tax hedging.
In summary, a derivative instrument or a
nonderivative financial instrument that may give rise to a
foreign currency transaction gain or loss under SFAS 52 can be designated as hedging
the foreign currency exposure of a net investment in a foreign operation (FAS 133 Paragraph 42). A derivative instrument or a
nonderivative financial instrument that may
give rise to a foreign currency transaction gain or loss under SFAS 52 can be
designated as hedging changes in the fair value of an unrecognized firm commitment, or a
specific portion thereof, attributable to foreign currency exchange rates (FAS 133 Paragraph 37). However, such an instrument cannot be
classified as available-for-sale. A derivative instrument can be designated as hedging the changes in the fair value
of an available-for-sale debt security attributable to changes in foreign currency
exchange rates. (See FAS 133 Paragraph 38). Unlike originated loans and receivables, a held-to-maturity investment
cannot be a hedged item with respect to interest-rate risk because designation of an
investment as held-to-maturity involves not accounting for associated changes in interest
rates. However, a held-to-maturity investment can be a hedged item with respect to
risks from changes in foreign currency exchange rates and credit risk
(IAS 39 Paragraph 127).
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
Use of noncash hedging instruments is restricted to exposure to hedges
of any risk of gain or loss from changes in foreign currency exchange
rates arising in fair value hedges, cash flow hedges, or hedges of a
net investment in a foreign operation.
|
FAS 133
Use of noncash hedging instruments is restricted to exposure to hedges
of risk of gain or loss from changes in foreign currency exchange
rates arising in firm commitments or hedges of a net investment in a
foreign operation.
|
Hi Kevin,
How is your talented wife doing these days? Is she still doing any
distance education.
I provide an illustration
related to your question at in the fx01s.xls Excel workbook at
http://www.cs.trinity.edu/~rjensen/mfrFX/FX/
If the hedged item has no
cash flow risk, it has fair value risk. For example, a fixed rate bond
payable has no cash flow risk, but the market price fluctuates
inversely with interest rates. Suppose a firm wants to take advantage
of possible lowering of interest rates possibly buying back its bonds
payable in the future. If the interest rates plunge, it becomes very
expensive to buy back those bonds. The firm can initially, hedge
against a rising buy-back price by hedging the fair value of the bonds
payable. In doing so, however it creates cash flow risk of the
combined hedged item and the hedging derivative (such as an interest
rate swap).
Conversely, if the bonds are
floating rate bonds, there is no market value risk, but there is cash
flow risk. The firm can hedge cash flow risk, but that will create
value risk. You must have one or the other types of risk.
The FASB took all sorts of
flak when FAS 133 did not allow a single hedging derivative to hedge
both interest rate risk and FX risk in the same derivative. You
can listen to one pro complain about the issue prior to FAS 133
at
Audio
of J.C. Mercier, BankBoston MERC30.mp3
Other audio clips are available at http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm
I've not worked the BigWheels
case, but you can read the following in "Implementation of SFAS
138, Amendments to SFAS 133," by Angela L. J. Hwang, Robert E.
Jensen, and John S. Patouhas, The CPA Journal, November 2001,
pp. 54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm
One
important provision of SFAS 138 is that it allows joint hedging of
interest rate risk and foreign exchange (FX) risk in one compound
hedge. SFAS 138 widens the net of qualified FX hedges to include the
following:
Foreign
currency-denominated (FCD) assets or liabilities can be hedged in
fair value or cash flow hedges. However, cash flow hedges of
recognized FCD assets or liabilities are permitted only when all the
variability in the hedged items’ functional currency equivalent
cash flows is reduced to zero. Unrecognized FCD firm commitments can
be hedged in fair value or cash flow hedges. Prior to SFAS 138,
hedge accounting for foreign currency risk exposures was limited to
fair value hedges of unrecognized FCD firm commitments, cash flow
hedges of forecasted FCD transactions, and net investments in FCD
foreign operations.
Example.
FCD items (e.g., a fixed-rate bond in deutsche marks) are subject to
two underlying risks: fair value risk in terms of changes in German
interest rates, and changes in the FX rates (between the deutsche
mark and the U.S. dollar). Before SFAS 138, the debtor would first
hedge the interest rate risk by locking in the combined value of the
bond and swap at a fixed amount in marks with a swap in which
variable interest was received and fixed interest was paid. Then
another derivative contract, such as a forward contract to hedge
against the possible fall of the mark against the dollar, would
hedge the combined FCD value for FX risk. Under SFAS 133, the FCD
debt was remeasured (via the income statement) based on the
prevailing spot rate of exchange and the derivative was marked to
market (also via the income statement). However, these two
adjustments rarely match, creating unintended earnings volatility.
Under the
SFAS 138 amendments, it is now possible to acquire a single compound
derivative to hedge the joint fair value risk of interest rate and
FX movements. One such derivative is a cross-currency interest swap,
which would receive a fixed interest rate in foreign currency and
pay a variable interest rate in domestic currency. SFAS 138 permits
these recognized FCD assets and liabilities to be designated as the
hedged items in fair value or cash flow hedges.
I provide an illustration
related to your question at in the fx01s.xls Excel workbook at
http://www.cs.trinity.edu/~rjensen/mfrFX/FX/
The FASB issued a
cross-currency hedging illustrations that I never have been able to
figure out. It is incomprehensible if you want to derive all of
the numbers in the FX hedging illustrations at http://accounting.rutgers.edu/raw/fasb/derivatives/examplespg.html
Thus far the FASB has not
provided any help in comprehending the above incomprehensible
examples.
Hope this helps a little.
Bob Jensen
-----Original
Message-----
From: Kevin Lightner [mailto:Kevin.Lightner@sdsu.edu]
Sent: Tuesday, February 12, 2002 3:56 PM
To: rjensen@trinity.edu
Subject: Derivatives
Bob
I'm trying
to learn something about derivatives, but am not having a great deal
of success. I was wondering if you could help me with a few items.
Which accounting entries represent the proper accounting for the
combined foreign currency and interest rate swap in the "BigWheels
Case"? Is this swap a "fair-value hedge? Would the entries
and the type of hedge be different if the interest exchange required
BigWheels to exchange fixed dollar payments (at a rate higher than
10%) for the receipt of fixed payments in francs (for the amount
needed to service the 10% franc bond interest payable)? Any help you
can give me would be greatly appreciated. Thanks.
Kevin
Kevin
M. Lightner, Ph.D.
Professor of Accounting School of Accountancy
San Diego State University
Office: SS2427 Phone: 594-3736
Email: Kevin.Lightner@sdsu.edu
|
Also see DIG Issue B4 under embedded
derivatives.
A Message from K Badrinath on January
25, 2002
Dear Mr. Jensen:
To cut a
potentially long introduction short, I am associated with the leading vendor
of treasury software in India, Synergy Log-In Systems Ltd. Shall be glad to
share more on that with you should you be interested.
The reason for
writing this is, while negotiating the minefield called FAS 133, courtesy
your wonderful Glossary on the net, I came across apparantly contradictory
statements under two different heads about whether held-to-maturity
securities can be hedged items:
HELD-TO-MATURITY
Unlike originated loans and receivables, a held-to-maturity investment
cannot be a hedged item with respect to interest-rate risk because
designation of an investment as held-to-maturity involves not accounting for
associated changes in interest rates. However, a held-to-maturity investment
can be a hedged item with respect to risks from changes in foreign currency
exchange rates and credit risk
AVAILABLE-FOR-SALE
Held-to-maturity securities can also be FAS 133-allowed hedge items.
Help!!
K. Badrinath
Hello K. Badrinath,
I think your confusion comes from the fact that FAS 138 amended Paragraph
21(d) as noted below.
Original Paragraph
21(d) .
If the hedged item is all or a portion of a debt security (or a portfolio of
similar debt securities) that is classified as held-to-maturity in
accordance with FASB Statement No. 115, Accounting for Certain Investments
in Debt and Equity Securities, the designated risk being hedged is the risk
of changes in its fair value attributable to changes in the obligor's
creditworthiness or if the hedged item is an option component of a held-to-
maturity security that permits its prepayment, the designated risk being
hedged is the risk of changes in the entire fair value of that option
component. (The designated hedged risk for a held-to-maturity security may
not be the risk of changes in its fair value attributable to changes in
market interest rates or foreign exchange rates. If the hedged item is other
than an option component that permits its prepayment, the designated hedged
risk also may not be the risk of changes in its overall fair value.)
FAS 138 Amendment
of Paragraph 21(d)"
[Hedged Item] If the hedged item is all or a portion of a debt security (or
a portfolio of similar debt securities) that is classified as
held-to-maturity in accordance with FASB Statement No. 115, Accounting for
Certain Investments in Debt and Equity Securities, the designated risk being
hedged is the risk of changes in its fair value attributable to credit risk,
foreign
exchange risk,
or both.
Related paragraph changes are noted
in Appendix B of FAS 138.
Hedge accounting for held-to-maturity
securities under FAS 133 is especially troublesome for me. You can get
hedge accounting treatment for for creditworthiness risk and certain
prepayment option fair value changes, but you cannot get hedge accounting for
interest rate risk. The FASB reasoning is spelled out in Paragraphs
426-431.
Keep in mind, however, that the
derivative used to hedge a held-to-maturity security must be adjusted to fair
value at least every 90 days with changes it its value going to current
earnings.
Hedges of securities classified as
available-for-sale do not take the same beating under FAS 133. Without a
hedge, FAS 115 rules require changes in value of AFS investments to be booked,
but the offset is to OCI rather than current earnings. Paragraph 23 of
FAS 133 reads as follows:
Paragraph 23
If a hedged item is otherwise measured at fair value with changes in fair
value reported in other comprehensive income (such as an available-for-sale
security), the adjustment of the hedged item's carrying amount discussed in
paragraph 22 shall be recognized in earnings rather than in other
comprehensive income in order to offset the gain or loss on the hedging
instrument
Foreign currency risk is somewhat
different under Paragraph 38 for AFS securities.
Some key paragraphs from FAS 133 are
as follows:
Paragraph 54
At the date of initial application, an entity may transfer any held-to-maturity
security into the available-for-sale category or the trading category. An entity
will then be able in the future to designate a security transferred into the
available-for-sale category as the hedged item, or its variable interest
payments as the cash flow hedged transactions, in a hedge of the exposure to
changes in market interest rates, changes in foreign currency exchange rates, or
changes in its overall fair value. (paragraph 21(d) precludes a held-to-
maturity security from being designated as the hedged item in a fair value hedge
of market interest rate risk or the risk of changes in its overall fair value.
paragraph 29(e) similarly precludes the variable cash flows of a
held-to-maturity security from being designated as the hedged transaction in a
cash flow hedge of market interest rate risk.) The unrealized holding gain or
loss on a held-to-maturity security transferred to another category at the date
of initial application shall be reported in net income or accumulated other
comprehensive income consistent with the requirements of paragraphs 15(b) and
15(c) of Statement 115 and reported with the other transition adjustments
discussed in paragraph 52 of this Statement. Such transfers from the
held-to-maturity category at the date of initial adoption shall not call into
question an entity's intent to hold other debt securities to maturity in the
future.
Paragraphs 426-431
Prohibition
against Hedge Accounting for Hedges of Interest Rate Risk of Debt Securities
Classified as Held-to-Maturity
426. This Statement
prohibits hedge accounting for a fair value or cash flow hedge of the
interest rate risk associated with a debt security classified as
held-to-maturity pursuant to Statement 115. During the deliberations that
preceded issuance of Statement 115, the Board considered whether such a debt
security could be designated as being hedged for hedge accounting purposes.
Although the Board's view at that time was that hedging debt securities
classified as held-to-maturity is inconsistent with the basis for that
classification, Statement 115 did not restrict hedge accounting of those
securities because constituents argued that the appropriateness of such
restrictions should be considered in the Board's project on hedging.
427. The Exposure
Draft proposed prohibiting a held-to-maturity debt security from being
designated as a hedged item, regardless of the risk being hedged. The
Exposure Draft explained the Board's belief that designating a derivative as
a hedge of the changes in fair value, or variations in cash flow, of a debt
security that is classified as held-to-maturity contradicts the notion of
that classification. Respondents to the Exposure Draft objected to the
proposed exclusion, asserting the following: (a) hedging a held-to-maturity
security does not conflict with an asserted intent to hold that security to
maturity, (b) a held-to-maturity security contributes to interest rate risk
if it is funded with shorter term liabilities, and (c) prohibiting hedge
accounting for a hedge of a held-to-maturity security is inconsistent with
permitting hedge accounting for other fixed-rate assets and liabilities that
are being held to maturity.
428. The Board
continues to believe that providing hedge accounting for a held-to- maturity
security conflicts with the notion underlying the held-to-maturity
classification in Statement 115 if the risk being hedged is the risk of
changes in the fair value of the entire hedged item or is otherwise related
to interest rate risk. The Board believes an entity's decision to classify a
security as held-to-maturity implies that future decisions about continuing
to hold that security will not be affected by changes in market interest
rates. The decision to classify a security as held-to-maturity is consistent
with the view that a change in fair value or cash flow stemming from a
change in market interest rates is not relevant for that security. In
addition, fair value hedge accounting effectively alters the traditional
income recognition pattern for that debt security by accelerating gains and
losses on the security during the term of the hedge into earnings, with
subsequent amortization of the related premium or discount over the period
until maturity. That accounting changes the measurement attribute of the
security away from amortized historical cost. The Board also notes that the
rollover of a shorter term liability that funds a held-to-maturity security
may be eligible for hedge accounting. The Board therefore decided to
prohibit both a fixed-rate held-to- maturity debt security from being
designated as a hedged item in a fair value hedge and the variable interest
receipts on a variable-rate held-to-maturity security from being designated
as hedged forecasted transactions in a cash flow hedge if the risk being
hedged includes changes in market interest rates.
429. The Board does
not consider it inconsistent to prohibit hedge accounting for a hedge of
market interest rate risk in a held-to-maturity debt security while
permitting it for hedges of other items that an entity may be holding to
maturity. Only held-to-maturity debt securities receive special accounting
(that is, being measured at amortized cost when they otherwise would be
required to be measured at fair value) as a result of an asserted intent to
hold them to maturity.
430. The Board
modified the Exposure Draft to permit hedge accounting for hedges of credit
risk on held-to-maturity debt securities. It decided that hedging the credit
risk of a held-to-maturity debt security is not inconsistent with Statement
115 because that Statement allows a sale or transfer of a held-to-maturity
debt security in response to a significant deterioration in credit quality.
431. Some
respondents to the Task Force Draft said that a hedge of the prepayment risk
in a held-to-maturity debt security should be permitted because it does not
contradict the entity's stated intention to hold the instrument to maturity.
The Board agreed that in designating a security as held-to-maturity, an
entity declares its intention not to voluntarily sell the security as a
result of changes in market interest rates, and "selling" a
security in response to the exercise of a call option is not a voluntary
sale. Accordingly, the Board decided to permit designating the embedded
written prepayment option in a held-to-maturity security as the hedged item.
Although prepayment risk is a subcomponent of market interest rate risk, the
Board notes that prepayments, especially of mortgages, occur for reasons
other than changes in interest rates. The Board therefore does not consider
it inconsistent to permit hedging of prepayment risk but not interest rate
risk in a held-to-maturity security.
Paragraph 533(2)(e)
For securities classified as available-for-sale, all reporting enterprises shall
disclose the aggregate fair value, the total gains for securities with net gains
in accumulated other comprehensive income, and the total losses for securities
with net losses in accumulated other comprehensive income, by major security
type as of each date for which a statement of financial position is presented.
For securities classified as held-to-maturity, all reporting enterprises shall
disclose the aggregate fair value, gross unrecognized holding gains, gross
unrecognized holding losses, the net carrying amount, and the gross gains and
losses in accumulated other comprehensive income for any derivatives that hedged
the forecasted acquisition of the held-to-maturity securities, by major security
type as of each date for which a statement of financial position is presented.
|
Finance Tutorial (of sorts): A Primer on Foreign Exchange
Derivatives
"Of Knock-ins, Knock-outs & KIKOs," by Ranju Sarkar, Business Standard,
April 2, 2008 ---
Click Here
http://www.business-standard.com/common/news_article.php?leftnm=0&subLeft=1&chklogin=N&autono=318661&tab=r
OPTIONS |
|
Option is a contract which gives a buyer a
right, but not an obligation, to buy an underlying/ currency/ stock/
commodities at a pre-determined rate, known as strike price, for
settlement at a future day. The right to buy is called a call
option. The right to sell is called a put option. There are
different types of options. |
|
Knock-out option: An option which
ceases to exist if the knock-out event occurs. A knock out happens
when a particular level is hit (like the Swiss franc touching the
level of 1.10 against the dollar), when the option ceases to exist.
|
|
Knock-in option: An option which
comes into existence if the knock-in event happens. It works exactly
the reverse of a knock-out. In a knock-in, an option comes into
existence if a certain level is hit. |
|
KIKO (knock-in, knock-out): This is
an option with both a knock-in and knock-out. The option kicks in,
or comes alive, if the knock-in is seen. The option ceases to exist
if anytime, pre or post, the knock-in event happening, the knock-out
happens. |
|
One-touch option: When a certain
level (of any currency pair) is hit, a company buying an option gets
a pre-determined pay-off (it could be $10,000, $20,000, or $30,000).
This is how companies made money through derivative deals last year.
|
|
Double-touch option: There are two
levels. If either of the two levels is hit, the company buying an
option will get a pay off. All options require a buyer to pay a
premium. Conversely, sellers of options would receive a premium.
|
|
STRUCTURES |
|
Banks, foreign exchange consultants work
out zero-cost option structures/ strategies for companies so that
they don’t have to pay any premium. To make a zero-cost structure, a
company has to buy some option and sell some option so that the
premium is zero (the premium paid for buying an option is set-off
against the premium received for selling the option). |
|
For instance, when the rupee-dollar parity
is 40.10, an exporter buys a put option at the rate of 39.50, and
sells a call option for 41.00 for delivery of exports at the end of
June, July and August an export commitment of $1 million each month.
By entering into this contract, the best rate the exporter can get
is 41, and the worst rate it can get is 39.50. |
|
If the rupee goes below 39.50, the
exporter will be able to encash its receivables at the rate of
39.50. If the rupee is trading between 39.50 and 41, the exporter
will be able to encash its receivables at the prevailing market
rate. |
|
However, if the rupee is ruling above 41,
it will get its receivables at Rs 41 as he’s locked in that level.
This kind of structure is popular with software companies, who can
realise their receivables in a range (between the best and worst),
unlike in a forward contract where they get locked in at a
particular rate. |
|
Banks also offer, what they call, a 1:2
leveraged option, wherein a company buys some calls, makes some puts
and use a combination of these to create zero-cost strategy for the
company. Companies that have big positions in derivative trades have
been selling KIKOs, or a series of KIKOs and buying one-touch
options and double-touch options. These structures helped companies
make money last year. |
Continued in article
Bob Jensen's links to accounting, finance, and business glossaries ---
http://faculty.trinity.edu/rjensen/Bookbus.htm
Bob Jensen's links to FAS 133 and IAS 39 Accounting for Derivative Financial
Instruments Glossary ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Bob Jensen's FAS 133 and IAS 39 Tutorials on Accounting for Derivative
Financial Instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
IAS 138
Implementation Guidance
Examples Illustrating Application of FASB Statement No. 138, Accounting
for Certain Derivative Instruments and Certain Hedging Activities-an
amendment of FASB Statement No. 133 ---
http://www.fasb.org/derivatives/examplespg.shtml
or try clicking here.
"Implementation of SFAS 138, Amendments to SFAS 133," The
CPA Journal, November 2001. (With Angela L.J. Huang and John S.
Putoubas), pp. 54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm
Hedging of
Foreign Currency– Denominated Items
One
important provision of SFAS 138 is that it allows joint hedging of
interest rate risk and foreign exchange (FX) risk in one compound
hedge. SFAS 138 widens the net of qualified FX hedges to include the
following:
Foreign
currency-denominated (FCD) assets or liabilities can be hedged in
fair value or cash flow hedges. However, cash flow hedges of
recognized FCD assets or liabilities are permitted only when all the
variability in the hedged items’ functional currency equivalent
cash flows is reduced to zero. Unrecognized FCD firm commitments can
be hedged in fair value or cash flow hedges. Prior to SFAS 138,
hedge accounting for foreign currency risk exposures was limited to
fair value hedges of unrecognized FCD firm commitments, cash flow
hedges of forecasted FCD transactions, and net investments in FCD
foreign operations.
Example.
FCD items (e.g., a fixed-rate bond in deutsche marks) are subject to
two underlying risks: fair value risk in terms of changes in German
interest rates, and changes in the FX rates (between the deutsche
mark and the U.S. dollar). Before SFAS 138, the debtor would first
hedge the interest rate risk by locking in the combined value of the
bond and swap at a fixed amount in marks with a swap in which
variable interest was received and fixed interest was paid. Then
another derivative contract, such as a forward contract to hedge
against the possible fall of the mark against the dollar, would
hedge the combined FCD value for FX risk. Under SFAS 133, the FCD
debt was remeasured (via the income statement) based on the
prevailing spot rate of exchange and the derivative was marked to
market (also via the income statement). However, these two
adjustments rarely match, creating unintended earnings volatility.
Under the
SFAS 138 amendments, it is now possible to acquire a single compound
derivative to hedge the joint fair value risk of interest rate and
FX movements. One such derivative is a cross-currency interest swap,
which would receive a fixed interest rate in foreign currency and
pay a variable interest rate in domestic currency. SFAS 138 permits
these recognized FCD assets and liabilities to be designated as the
hedged items in fair value or cash flow hedges.
Intercompany
Exposures
Multinational
corporations enter into many transactions with FX risk exposure. A
centralized treasury center that assesses corporate-wide FX exposure
and hedges the net exposure with a single derivative offers
significant cost savings over subsidiaries acquiring their own
third-party hedges.
Example. A
German subsidiary forecasts sales of DM 5 million from a Japanese
purchaser in the next three months, and a Japanese subsidiary
expects to purchase DM 3 million worth of inventory from a German
supplier in the same period. The net exposure would be a long
position of DM 2 million and the parent company could hedge its risk
by selling a forward contract or buying a put option for DM 2
million.
SFAS 133
discouraged hedge accounting by treasury centers because it required
individual members of a consolidated group to enter individual
offsetting derivative contracts with third parties, which nullifies
the cost savings benefits. The SFAS 138 amendments allow certain
intercompany derivatives that are offset by unrelated third-party
contracts to be designated as the hedging instrument in cash flow
hedges of foreign currency risk in the consolidated financial
statements.
Amendments
to DIG Guidance
SFAS 138
also amends related interpretations issued by the Derivatives
Implementation Group (DIG).
Issue G3:
Discontinuation of a cash flow hedge. SFAS 138 amends the accounting
for discontinued cash flow hedges by requiring that the net
derivative gain or loss from a discontinued cash flow hedge be
reported in accumulated other comprehensive income, unless it is
probable that the forecasted transaction will not occur by the end
of the originally specified time period or within an additional two
months.
Issue H1:
Hedging at the operating unit level. SFAS 138 extends the functional
currency concept of SFAS 52 to foreign currency fair value hedges
and to hedges of the net investment in a foreign operation, in
addition to foreign currency cash flow hedges. It also requires that
the hedged transaction be denominated in a currency other than the
hedging unit’s functional currency.
Issue H2:
Requirement that the unit with the exposure must be a party to the
hedge. The SFAS 138 amendments ensure that the functional currency
concept of SFAS 52 is applied to determine whether hedge accounting
is appropriate for consolidated financial statements. One of two
conditions must be satisfied in order to use hedge accounting:
The
operating unit with the FX exposure must be party to the hedging
instrument; or Another member of the consolidated group is party to
the hedge; this party has the same functional currency as the
operating unit, and there are no intervening subsidiaries with a
different functional currency. Example. A second-tier subsidiary (B)
whose functional currency is the U.S. dollar has a French franc
exposure. A parent company could designate a dollar-franc derivative
as a hedge of a first-tier subsidiary’s (A) exposure, provided
that A’s functional currency is also the dollar.
However, if
A’s functional currency is the Japanese yen, the consolidated
parent company could not designate its dollar-franc derivative as a
hedge of B’s exposure. In this case, the financial statements of B
are first translated into yen before the yen-denominated financial
statements of A are translated into dollars for consolidation. As a
result, there is no direct FX exposure, because A has a different
functional currency than B’s functional currency. Furthermore,
there is no direct exposure to the consolidated parent company.
Issue H5:
Hedging a firm commitment or a fixed-price agreement denominated in
a foreign currency. Unrecognized FCD firm commitments can be
designated as either a fair value or a cash flow hedge. A similar
DIG position for payments due under an available-for-sale debt
security is explicitly permitted by SFAS 138.
What SFAS
138 Did Not Amend
Except for
the confusing and highly limited amendments on intercompany
derivative contracts, SFAS 138 did not change FASB’s stand against
portfolio (macro) hedging. In order to qualify as a SFAS 133/138
hedge, the hedge must, except in unrealistic circumstances, relate
to a specific hedged item in a portfolio rather than a subset of
items. The only exception applies to subsets of items with identical
terms that are nearly fungible. Matching individual hedges against
individual hedged items not only magnifies the accounting costs, but
also contradicts the way many firms view economic hedges. Some have
complained that SFAS 133/138 forces changes in hedging strategies
and risk management practices for accounting reasons that defy
economic sense.
FASB did
not replace SFAS 52, which causes additional complexity when
applying it simultaneously with SFAS 133 and 138. SFAS 138 reduces
the differences between spot and forward rate adjustments, but
difficult issues remain in reconciling the two standards.
Although
FASB requires fair value statements, it provides very little
measurement guidance for customized derivatives that are either not
traded at all or not traded in sufficiently wide markets. Appendix B
of SFAS 133 contains some errors and omissions that were not
addressed by SFAS 138 or other FASB announcements. In particular,
there is no FASB guidance on how swap values were derived in
Examples 2 or 5. Corrections and derivation discussions are
discussed in the following two documents:
“The
Receive Fixed/Pay Variable Interest-Rate Swap in SFAS 133, Example
2, Needs An Explanation: Here It Is,” by Carl M. Hubbard and
Robert E. Jensen, Derivatives Report, November 1999, pp. 6–11
(http://faculty.trinity.edu/rjensen/ caseans/294wp.doc; the Excel
workbook is at www.cs.trinity.edu/~rjensen/ 133ex02a.xls). “An
Explanation of Example 5, Cash Flow Hedge of Variable-Rate Interest
Bearing Asset in SFAS 133,” by Carl M. Hubbard and Robert E.
Jensen, Derivatives Report, April 2000, pp. 8–13 (www.trinity.edu/
rjensen/caseans/133ex05.htm; the Excel workbook is at
www.cs.trinity.edu/ ~rjensen/133ex05a.xls). Derivative instruments
cannot be designated as held-to-maturity items that are not subject
to fair value adjustment. For certain derivatives, this can cause
income volatility that is entirely artificial and will ultimately,
at maturity, cause all previously recognized fair value gains to
wash out against fair value losses. Economic hedges of hedged items
(e.g., bond investments) designated as held-to-maturity items cannot
receive hedge accounting under SFAS 133 even though the hedges must
be booked at fair value. The reason given in Paragraph 29e is that
this hedge is a credit hedge. Fair value hedging of fixed-rate debt
makes little sense since the item will be held to maturity. Cash
flow hedging of variable interest payments will wash out unless the
contract is defaulted. The reasons for not allowing such hedges to
receive SFAS 133 treatment are clear. It is unclear, however, why
the hedges have to be booked to market value if they will be held to
maturity.
|
Foreign
Currency Transactions =
transactions (for example, sales or purchases of
goods or services or loans payable or receivable) whose terms are stated in a currency
other than the entity's functional currency. Foreign
currency risks are discussed extensively in FAS 133. See for example, Paragraphs
71.
Also see DIG Issue B4 under embedded
derivatives.
Foreign
Currency Translation =
the process of expressing amounts denominated or
measured in one currency in terms of another currency by use of the exchange rate between
the two currencies.
Foreign Operation =
an operation whose financial statements are (1)
combined or consolidated with or accounted for on an equity basis in the financial
statements of the reporting enterprise and (2) prepared in a currency other than the
reporting currency of the reporting enterprise.
Forward
Contract or Forward Exchange Contract =
an agreement to exchange at a specified future
date currencies of different countries at a specified rate (forward rate). An example of a
forward contract appears in Example 3 Paragraphs 121-126 beginning on Page 67 of
FAS 133.
See forward transaction.
Forward Exchange Rate Agreement (FXA) =
a forward contract
on exchange rates. A FXA is a forward contract to buy/sell a notional
amount of foreign currency forward at a contracted price. See forward transaction and
forward rate agreement (FRA).
Forward Rate = =
the rate quoted today for delivery of a specific
currency amount at a specific exchange rate on a specific future date.
Forward Rate
Agreement (FRA) =
a forward contract
on interest rates. Loan principals are not exchanged and are used only as notionals to establish forward contract settlements. These are
customized contracts that allow borrowers to hedge future borrowing rates on anticipated
loans in the future. FRA contracts can also be purchased in foreign currencies,
thereby affecting currency exchange and interest rate risk management strategies.
See forward transaction and forward exchange rate agreement (FXA).
Forward
Transaction or Forward Contract =
an agreement to deliver cash, foreign currency,
or some other item at a contracted date in the future. The key distinction between futures
versus forward contracts is that forward contracts are customized and are not traded in
organized markets. Unlike with futures contracts, it is very simple to specify exact terms
such as the exact notional amount and rate to be applied. In the case of a futures
contract, it may be difficult or impossible to find the needed combinations traded in
markets. However, since forward contracts are not traded in markets, their value is often
very difficult to estimate.
Since forward contracts are individually
contracted, often through third party investment banks or brokers, the transactions costs
of a forward contract can be high relative to futures contracts. Matters of settlement
assurances must be contracted since they do not carry the settlement guarantees of futures
contracts.
See FAS 133 Paragraphs 59a, 93, and 100. An
example of a forward contract in FAS 133 appears in Example 3 Paragraphs 121-126 and
Example 10 Paragraphs 165-172.
By way of illustration, currency trading on July
22, 1998 showed the following exchange selling rates among banks in amounts of $1 million
or more:
Wall Street Journal,
07/22/98, Page C23
|
U.S. $ Equivalent
|
Currency per U.S. $
|
Britain
(Pound) Spot |
1.6435
|
.6085
|
1-month forward
|
1.6408
|
.6095
|
3-months
forward
|
1.6352
|
.6115
|
6-months
forward
|
1.6271
|
.6146
|
Canada (Dollar) Spot
|
.6702
|
1.4921
|
1-month forward
|
.6706
|
1.4911
|
3-months
forward
|
.6712
|
1.4898
|
6-months
forward
|
.6720
|
1.4882
|
For example, the spot
rate is such that in $1 million trades or higher, each British pound exchanges into
$1.6435 U.S. dollars. However, a forward exchange contract reduces that amount to
$1.6271 if settled in six months. In practice, forward contracts are tailor-made for
the length or time and amounts to be exchanged. The above rates serve only as
guidelines for negotiation. See futures contract.
FAS 133 leaves out the issue of trade date versus settlement date accounting
and, thereby, excluded forward contracts for regular-way
security trades from the scope of FAS 133 (See Appendix C Paragraph 274).
See DIG Issue A1 under derivative
financial instrument.
See DIG Issues A2 and A3 under net
settlement.
With
respect to Firm Commitments vs. Forward
Contracts, the key distinction is Part b of Paragraph 540 of the original
FAS 133 (I have an antique copy of the original FAS 133 Standard.)
Those
of us into FAS 133’s finer points have generally assumed a definitional
distinction between a “firm commitment” purchase contract to buy a commodity
at a contract price versus a forward contract to purchase the commodity at a
contracted forward price. The distinction is important, because FAS 133
requires booking a forward contract and adjusting it to fair value at
reporting dates if actual physical delivery is not highly likely such that
the NPNS exception under Paragraph 10(b) of FAS 133 cannot be assumed to
avoid booking.
The
distinction actually commences with forecasted transactions that include
purchase contracts for a fixed notional (such as 100,000 gallons of fuel) at
an uncertain underlying (such as the spot price of fuel on the actual future
date of purchase). Such purchase contracts are typically not booked. These
forecasted transactions become “firm commitments” if the future purchase
price is contracted in advance (such $2.23 per gallon for a future purchase
three months later). Firm commitments are typically not booked under FAS 133
rules, but they may be hedged with fair value hedges using derivative
financial instruments. Forecasted transactions (with no contracted price)
can be hedged with cash flow hedges using derivative contracts.
There
is an obscure rule (not FAS 133) that says an allowance for firm commitment
loss must be booked for an unhedged firm commitment if highly significant
(material) loss is highly probable due to a nose dive in the spot market.
But this obscure rule will be ignored here.
One
distinction between a firm commitment contract and a forward contract is
that a forward contract’s net settlement, if indeed it is net settled, is
based on the difference between spot price and forward price at the time of
settlement. Net settlement takes the place of penalties for non-delivery of
the actual commodity (most traders never want pork bellies dumped in their
front lawns). Oil companies typically take deliveries some of the time, but
like electric companies these oil companies generally contract for far more
product than will ever be physically delivered. Usually this is due to
difficulties in predicting peak demand.
A firm
commitment is gross settled at the settlement date if no other net
settlement clause is contained in the contract. If an oil company does not
want a particular shipment of contracted oil, the firm commitment contract
is simply passed on to somebody needing oil or somebody willing to offset
(book out) a purchase contract with a sales contract. Pipelines
apparently have a clearing house for such firm commitment transferals
of “paper gallons” that never flow through a pipeline. Interestingly, fuel
purchase contracts are typically well in excess (upwards of 100 times) the
capacities of the pipelines.
The
contentious FAS 133 booking out problem was settled for electricity
companies in FAS 149. But it was not resolved in the same way for other
companies. Hence for all other companies the distinction between a firm
commitment contract and a forward price contract is crucial.
In
some ways the distinction between a firm commitment versus a forward
contract may be somewhat artificial. The formal distinction, in my mind, is
the existence of a net settlement (spot price-forward price) clause in a
forward contract that negates a “significant penalty” clause of a firm
commitment contract.
The
original FAS 133 (I still have this antique original version) had a glossary
that reads as follows in Paragraph 540:
Firm commitment
An agreement with an unrelated party, binding on both parties and
usually legally enforceable, with the following characteristics:
a. The agreement specifies all significant terms, including the
quantity to be exchanged, the fixed price, and the timing of the
transaction. The fixed price may be expressed as a specified
amount of an entity's functional currency or of a foreign
currency. It may also be expressed as a specified interest rate
or specified effective yield.
b. The agreement includes a disincentive for nonperformance that is
sufficiently large to make performance probable.
The
key distinction between a firm commitment and a forward contract seems to be
Part b above that implies physical delivery backed by a “sufficiently large”
penalty if physical delivery is defaulted. The net settlement
(spot-forward) provision of forward contracts generally void Part b
penalties even when physical delivery was originally intended.
Firm
commitments have greater Part b penalties for physical non-conformance than
do forward contracts. But in the case of the pipeline industry, Part b
technical provisions in purchase contracts generally are not worrisome
because of a market clearing house for such contracts (the highly common
practice of booking out such contracts by passing along purchase contracts
to parties with sales contracts, or vice versa, that can be booked out) when
physical delivery was never intended. For example, in the pipeline hub in
question (in Oklahoma) all such “paper gallon” contracts are cleared against
each other on the 25th of every month. By “clearing” I mean that
“circles” of buyers and sellers are identified such that these parties
themselves essentially net out deals. In most cases the deals are probably
based upon spot prices, although the clearing house really does not get
involved in negotiations between buyers and sellers of these “paper
gallons.”
See
Bookout and
Firm Commitment
Teaching Case from The Wall Street
Journal Accounting Weekly Review on February 25, 2011
For Some, Currency Hedging Is No Gain
by: Dana Mattioli And Chan R. Shoenberger
Feb 19, 2011
Click here to view the full article on WSJ.com
TOPICS: Foreign Currency Exchange Rates, Hedging,
International Accounting
SUMMARY: A
number of companies are finding fees on options, forward and futures
contracts too high-or reporting of hedging gains and losses too
distracting-to justify the benefits of descreased risk expected in 2011.
This assessment, based on recent reduction in worldwide currency volatility,
is leading many to discontinue foreign exchange transaction and translation
hedging activities.
CLASSROOM
APPLICATION: The article is useful to introduce
foreign exchange transactions, foreign currency translation, and hedging
activities.
QUESTIONS:
1. (Advanced) What types of contracts to entities with foreign
operations enter into in order to hedge against fluctuations in currency
values? Specifically describe a contract that a company with foreign sales
may enter into, then describe a contract for companies expecting to make
purchases in foreign currencies.
2. (Introductory) Into which of the above categories do you place
Progress Software Corp., the company described in this article?
3. (Advanced) What are the differences among an option contract, a
forward contract, and a futures contract? Which of these types of contracts
did Progress Software use? What situation led the company to use this
contract?
4. (Introductory) What trade off is Mr. Rick Reidy, Chief Executive
of Progress Software, considering in deciding that he will "hold off this
year" on entering into foreign currency hedging contracts?
5. (Advanced) Explain your understanding of the term "natural
hedges."
6. (Advanced) What is the difference between a foreign currency
transaction gain or loss and a financial statement translation gain or loss?
Why might companies want to stop hedging against translation gains and
losses but continue hedging against transaction gains and losses?
7. (Advanced) What is speculation in foreign currencies? Identify a
company cited in the article that you think is engaging in speculation.
Support your assessment.
Reviewed By: Judy Beckman, University of Rhode Island
"For Some, Currency Hedging Is No
Gain," byDana Mattioli And Chan R. Shoenberger, The Wall Street Journal,
February 19, 2011 ---
http://online.wsj.com/article/SB10001424052748703803904576152442756363116.html?mod=djem_jiewr_AC_domainid
Progress Software
Corp. is walking away from currency hedging, bucking a corporate practice
that became commonplace in the wake of the global financial crisis. "This
year the price is just too high for us," says Chief Executive Rick Reidy.
The Bedford, Mass.,
business-software developer, which gets 60% of its $529 million in annual
revenue outside the U.S., is joining a small minority of multinationals
abandoning or lessening their use of hedging.
Although companies
have hedged currency risks for decades, widespread use began after the
recession stopped the dollar's downward run and unleashed a period of sharp
swings in foreign exchange rates. Companies with global operations rushed to
embrace hedging instruments such as forward contracts, which let them lock
in an exchange rate in the future at a fixed amount, and options, or the
right to buy or sell a currency for a specific price at some future date.
Progress Software
bought a currency option in 2010 after exchange-rate fluctuations the prior
year caused its reported revenue to decline by $30 million. But with such
options, essentially year-long insurance contracts, getting more expensive
and currencies becoming less volatile, Mr. Reidy says he'll hold off this
year.
"We are considering
doing quarterly [contracts] that tend to be more reasonable," he says.
Companies that have
stopped hedging exchange rates say they avoid the costs of hedging, which
can be steep for thinly traded currencies or contracts that lock in rates
for long periods of time. Others, such as Nissan Motor Co., which has a
longstanding no-hedge policy, say diversified global operations, create a
natural hedge by matching revenue to expenses in local currencies.
Autoliv Inc., a
Stockholm-based seatbelt and airbag maker, earlier this month said it would
continue to rely on natural hedges, such as its factories in China. Although
its fourth-quarter European sales were down 6%, to $717 million, primarily
on unfavorable exchange rates, Autoliv doesn't plan on purchasing forward
contacts, a practice it stopped in 2004, Chief Financial Officer Mats
Wallinsays.
Medical-products
maker Becton Dickinson & Co. stopped hedging its so-called translational
exposures—incurred when the company brings foreign currencies back to the
U.S. and converts to dollars—starting in October, although it still hedges
transactions. The cost of options used for currency hedging became too
expensive a few years ago, says Chief Financial Officer David Elkins, and it
began using forward contracts instead.
In its last fiscal
year, Becton reported a roughly $31 million hedging loss compared with a
$100 million hedging gain the prior year. Executives were spending too much
time explaining hedges to investors, Mr. Elkins says. "We want to do away
with that distraction."
Hedging risks are a
growing issue for pharmaceutical investors, says Tony Butler, a managing
director at Barclays Capital, who notes investors have asked him to detail
individual companies' foreign exchange sensitivity. "There was an increasing
discussion of [foreign exchange], away from the fundamentals of the
business," he says.
Going cold turkey
on hedging can lead to wide revenue fluctuations as exchange rates change.
That isn't a great idea, said Jiro Okochi, chief executive of Reval, which
provides software to help companies manage foreign exchange, commodities and
interest rate risks.
Some investors look
for that exposure, says Jeffrey Wallace, managing partner of Greenwich
Treasury Advisors in Boulder, Colo. "The very large companies sometimes say
to their shareholders, 'You bought me because you wanted global risk, and
I'm going to give it to you.'"
For some companies,
a switch away from currency hedging is actually a bet that a currency will
move in a certain direction. Moscow-based Mobile TeleSystems stopped its
currency hedging this year and won't hedge unless the Russian ruble starts
to depreciate, says Alexey Kornya, the company's chief financial officer.
This differs from
the company's strategy in 2009 and 2010, when volatility in the markets led
the company to hedge heavily. About 90% of MTS's revenue is derived in
rubles, but it is also exposed to other currencies in Eastern Europe,
especially Ukraine, Armenia and Uzbekistan.
In 2009, the
telecommunications operator hedged about $1.4 billion of its debt portfolio,
says Mr. Kornya. In 2010, it only hedged $200 million of its U.S. dollar
exposure and the company moved toward financing in rubles rather than
dollars, he says. This year, Mr. Kornya says he doesn't see the need to
hedge yet, but is keeping a close eye on the ruble's value. If the trade
surplus began to diminish and the ruble depreciated, the company would take
hedging actions, he says.
Continued in article
Bob Jensen's tutorials and videos on
accounting for hedging transactions ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Frauds
in Derivatives History
Derivative
Financial Instruments Frauds ---
http://faculty.trinity.edu/rjensen/fraud.htm
Functional
Currency =
the primary currency in which an entity conducts
its operation and generates and expends cash. It is usually the currency of the country in
which the entity is located and the currency in which the books of record are
maintained. See translation adjustment.
Futures Contract =
an exchange-traded contract between a buyer
or seller and the clearinghouse of a futures exchange to buy or sell a standard quantity
and quality of a commodity, financial instrument, or index at a
specified future date and price. Futures contracts commonly require daily settlement
payments (known as the variation margin) for changes in the market price of the contract
and often permit or require a final net cash settlement, rather than an actual purchase or
sale of the underlying asset. Not all futures contracts are financial instruments
derivatives. Futures on commodities, for example, are not necessarily financial
instruments related unless qualifying as hedges of anticipated transactions.
By way of illustration, futures trading on July 29, 1998
showed the following exchange futures contract prices per stipulated contract amounts:
Wall Street
Journal, 07/22/98, Page C20
|
U.S. $ Settlement
|
Contract Amounts
|
Britain
(Pound) Spot |
1.6435
|
|
September 98 futures contract
|
1.6384
|
62,500 British
Pounds
|
December 98 futures contract
|
1.6308
|
62,500
British Pounds
|
July 99 futures contract
|
1.6162
|
62,500 British
Pounds
|
Canada
(Dollar) Spot
|
.6702
|
|
September 98 futures contract
|
.6710
|
100,000 Canadian
Dollars
|
December 98 futures contract
|
.6719
|
100,000
Canadian Dollars
|
March 99 futures contract
|
.6728
|
100,000
Canadian Dollars
|
For example, each 62,500 British pound
contract for July 99 will settle at $1.6162 per pound. Unlike forward contracts, the futures contracts are not customized
for maturities or amounts.
Futures contracts are typically purchased through margin
accounts at brokerage firms. Margin accounts allow for high leveraging due to the
fact that only a small percentage (e.g. 10%) of each contract need be held in cash in the
account. Price movements upward are settled daily and contract holders can cash out
those gains each day in advance of the contract maturities. Similarly, price
movements downward are charged to the margin account daily such that at some point
investors may be required to add more cash to bring the margin account balances up to
minimum balances. Example 7 in FAS 133 Paragraphs 144-152 simplifies the
illustration of 20 futures contracts on corn by not illustrating margin account
trading. In my Excel tutorial of Example 7, however, I added margin account
illustrations. Example 11 in FAS 133 Paragraphs 173-177 illustrate hedging with
pork belly futures contracts.
There are many types of futures contracts
ranging from orange juice to cotton and interest rates. For example, interest rate
futures may be purchased to hedge future borrowing rates, interest
rate strip contracts, and variable rate loans. They
may also be speculations. Futures contracts are traded in block amounts such as
$100,000 each for interest rate futures on U.S. Treasury notes. Trading markets may be
very thin (in terms of numbers of traders and frequency of trades) for certain types of
futures contracts.
Parties include the buyer, seller, and the clearinghouse
of a futures exchange. The contract is to buy or sell a standard quantity and
quality of a commodity, financial instrument, or index at a specified
future date and price. Futures contracts commonly require daily settlement payments (known
as the variation margin) for changes in the market price of the contract and often permit
or require a final net cash settlement, rather than an actual purchase or sale of the
underlying asset. Futures contracts are discussed at various points in FAS 133. See for
example Paragraphs 73-77. See forward transaction
and
foreign currency hedge.
Paragraph 64 on Page 45 of
FAS 133 describes a
futures contract "tailing strategy." Such a strategy entails adjusting the
size or contract amount of the hedge so that cash from reinvestment of daily settlements
(recall that futures price changes are settled daily in margin accounts) do not
distort the hedge effectiveness with reinvestment gains and losses.
Yahoo
Finance is Bob Jensen's Favorite Place to learn more about the mechanics and widespread
use of futures contracts. That web site, however, will not help much with
respect ot accounting for such instruments under FAS 133.
FX = See Foreign
Exchange Contract
G-Terms
Gapping and Immunization
Gapping Risk
Bankers refer to the mismatch between assets and liabilities as
"gapping." The usual cause in banking is borrowing with
short-term obligations and lending at long-term fixed interest rates.
Bank investments such as fixed rate loans tend to have market values that
are negatively correlated with interest rate movements. But the cash
inflows are stable over longer periods of time while the value of money
fluctuates. Short-term obligations tend to have greater cash flow risk
and less market value risk. Banks tend to manage gapping risks in a
variety of ways, but they are generally concerned with managing current
value and earnings stability, and their fair value and earnings management
hedging may put cash flows at risk.
Pension funds are different than banks in that the " gapping" risk
may work in the other direction. The usual cause in pension
funds is borrowing with long-term obligations whose values rise and fall
much more dramatically with interest rate movements than short-term
obligations. Many pension funds have been mismatched in terms of
having debt with 15-year durations and investments with five-year
durations. In the past this arose from a "stupefying
reason." Consultants graded performance against shorter term bond
investment indexes, which is the type of mismanagement that led General
Motors and other corporate pension funds to lose ground in 1995 when their
investments in stocks and bonds were having a banner year. In 1995,
interest rates also fell such that the value of the funds' long-term debt
wiped out the gains on the asset side in terms of current value. Cash
increases from investments had to be set aside to pay off higher amounts of
debt. "Pension liabilities swing upward and downward with
interest rates much more than assets swing upward and downward. See
Robert Lowenstein, "How Pension Funds Lost in Market Book," The
Wall Street Journal, February 1, 1996.
Immunization
Asset and liability duration "gapping" is a major reason why a
newer type of derivative hedging instrument known as the interest rate swap
became immensely popular. Such swaps could be used to
"immunize" pension funds from having huge losses in periods of
interest rate decline. They could also be used to help banks manage
earnings.
See Earnings Management
See interest rate swap and hedge
Gearing = see leverage.
Gold-Linked
Bull Note =
a note with interest rates
indexed to upward movements in gold prices. This is a leveraged form of
investment in gold. It can be viewed as an equivalent of a series of embedded options indexed on on gold price movements. The
derivatives are required to be accounted for separately under Paragraph 12a on Page 7 of
FAS 133. The underlying is the price of gold and the notional is the note's principal amount. There is usually
little or no premium and gold is actively traded in commodity
markets such that conversion to cash is quick and easy. The price of gold is not
deemed to be clearly-and-closely related to any
fixed-rate notes. An example of a gold-linked bull note is provided beginning in
Paragraph 188 on Page 98 of FAS 133.
Governmental Disclosure Rules for Derivative
Financial Instruments = see Disclosure.
Group of Thirty
=
a private and independent, nonprofit body that
examines financial issues, In its July 1993 study Derivatives: Practices and Principles,
the Group of Thirty called for disclosure of information about management's attitude
toward financial risks, how derivatives are used and how risks are controlled, accounting
policies, management's analysis of positions at the balance sheet date and the credit risk
inherent in those positions, and, for dealers, additional information about the extent of
activities in derivatives. Derivatives also were the subject of major studies prepared by
several federal agencies, all of which cited the need for improvements in financial
reporting for derivatives.
|
H-Terms
Hard Currency =
a currency actively traded and easily converted
to other currencies on world markets.
Hedge =
a transaction entered into to manage
(usually reduce) risk exposure to interest rate movements, foreign currency exchange rate
variations, or most any other contractual exposure. The classic example is when a company
has a contract to pay or receive foreign currency in the future. A foreign currency hedge
can lock in the amount such that fluctuations in exchange rates will not give rise to
exchange rate gains or losses. An effective hedge is one in which there is no gain or
loss. An ineffective hedge may give rise to risk of some gain or loss. Effective and
ineffective hedges are discussed at various points in FAS 133. See, for example, major
sections in Paragraphs 17-28, 62-103, 351-383, and 374-383. See dedesignation. and ineffectiveness.
"Why Hedge Interest Rate
Exposures?" by Mary Brooikhart, Bank Asset/Liability Management,
March 2012 ---
http://www.kawaller.com/pdf/BALM-WhyHedgeInterestRateExposures.pdf
Thank you Ira Kawaller for the heads up.
Bob Jensen's free tutorials on
hedging and hedge accounting ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Flow Chart for Hedge Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
The subject of "clearly-and-closely related" is taken
up in FAS 133, Pages 150-153, Paragraphs 304-311 and again in Paragraphs 443-450.. The
closely-related criterion is illustrated in Paragraphs 176-177. Also the FASB reversed its
position on compound derivatives.
Example 11 in Paragraphs 176-177 illustrate clearly-and-closely-related criteria in
embedded hybrid derivative instruments.
See cash flow hedge,
compound derivatives, derecognition,
dedesignation., fair value hedge,
hedge accounting, open position,
tax hedging, and foreign
currency hedge.
Also see Macro
Hedge
Click here to view Professor Linsmeier's commentary on hedging.
LIBOR ---
http://en.wikipedia.org/wiki/Libor
This is Crime, Not Capitalism
"Wall Street con trick," by Ellen Brown, Asia Times, March 24,
2012 ---
http://www.atimes.com/atimes/Global_Economy/NC24Dj05.html
"Far from
reducing risk, derivatives increase risk, often with catastrophic results."
-
Derivatives expert Satyajit Das, Extreme Money (2011)
*****************
Jensen Comment
Derivatives are great contracts to manage risk if their markets are
efficient, fair, and transparent.
They don't reduce risk in most instances because it's impossible in
hedging to reduce risk in most instances. Rather hedging entails
shifting risk. For example, a company that has cash flow risk due to
variable interest rate debt can hedge that cash flow risk. However,
elimination of cash flow risk creates fair value risk. The issue is not
one of reducing risk. Rather it is a shift in risk preferences.
******************
The "toxic culture of greed" on Wall Street was
highlighted again last week, when Greg Smith went public with his
resignation from Goldman Sachs in a scathing oped published in the New York
Times. In other recent eyebrow-raisers, London Interbank Offered Rates (or
LIBOR) - the benchmark interest rates involved in interest rate swaps - were
shown to be manipulated by the banks that would have to pay up; and the
objectivity of the International
Swaps and Derivatives
Association was called into question, when a 50% haircut for creditors was
not declared a "default" requiring counterparties to pay on credit default
swaps on Greek sovereign debt.
Interest rate swaps are less often in the news than credit default swaps,
but they are far more important in terms of revenue, composing fully 82% of
the derivatives trade. In February, JP Morgan Chase revealed that it had
cleared US$1.4 billion in revenue on trading interest rate swaps in 2011,
making them one of the bank's biggest sources of profit. According to the
Bank for International Settlements:
[I]nterest rate
swaps are the largest component of the global OTC derivative market. The
notional amount outstanding as of June 2009 in OTC [over-the-counter]
interest rate swaps was $342 trillion, up from $310 trillion in Dec
2007. The gross market value was $13.9 trillion in June 2009, up from
$6.2 trillion in Dec 2007.
For more than a
decade, banks and insurance companies convinced local governments,
hospitals, universities and other non-profits that interest rate swaps would
lower interest rates on bonds sold for public projects such as roads,
bridges and schools. The swaps were entered into to insure against a rise in
interest rates; but instead, interest rates fell to historically low levels.
This was not a flood, earthquake, or other insurable risk due to
environmental unknowns or "acts of God". It was a deliberate, manipulated
move by the Federal Reserve, acting to save the banks from their own folly
in precipitating the credit crisis of 2008. The banks got into trouble, and
the Federal Reserve and federal government rushed in to bail them out,
rewarding them for their misdeeds at the expense of the taxpayers.
How the swaps were supposed to work was explained by Michael McDonald in a
November 2010 Bloomberg article titled "Wall Street Collects $4 Billion From
Taxpayers as Swaps Backfire":
In an
interest-rate swap, two parties exchange payments on an agreed-upon
amount of principal. Most of the swaps Wall Street sold in the municipal
market required borrowers to issue long-term securities with interest
rates that changed every week or month. The borrowers would then
exchange payments, leaving them paying a fixed-rate to a bank or
insurance company and receiving a variable rate in return. Sometimes
borrowers got lump sums for entering agreements.
Banks and borrowers
were supposed to be paying equal rates: the fat years would balance out the
lean. But the Fed artificially manipulated the rates to the save the banks.
After the credit crisis broke out, borrowers had to continue selling
adjustable-rate securities at auction under the deals. Auction interest
rates soared when bond insurers' ratings were downgraded because of subprime
mortgage losses; but the periodic payments that banks made to borrowers as
part of the swaps plunged because they were linked to benchmarks such as
Federal Reserve lending rates, which were slashed to almost zero.
Continued in article
Bob Jensen's fraud updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
Bob Jensen's tutorials on derivative
financial instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
One of the things that the
FASB has never properly addressed is how to account for hedges of
interest rate risk in Available-for-Sale (AFS) securities where gains
and losses of both the hedged item and the hedging derivative go to OCI.
Based on an old idea from KPMG, I developed my own thoughts on this ---
http://faculty.trinity.edu/rjensen/CaseAmendment.htm
|
FAS 133
permits after-tax hedging of foreign
currency risk and/or market price risk. The hedge must be entered into to reduce
taxes, and the item hedged must be ordinary assets or liabilities in the normal course of
the taxpayer's business.
March 25, 2002 message
from Richard Newmark [richard.newmark@phduh.com]
Bob,
I thought you might be interested in this.
Rick
-------------------------
Richard Newmark
Assistant Professor of Accounting
University of Northern Colorado
Kenneth W. Monfort College of Business
Campus Box 128
Greeley, CO 80639
(970) 351-1213 Office
(801) 858-9335 Fax (free e-mail fax at efax.com)
richard.newmark@PhDuh.com
http://PhDuh.com
IRS
finalizes hedging regs with liberalizations
TD 8985; Reg. § 1.1221-2, Reg. § 1.1256(e)-1
IRS has issued final regs for determining the character of gain or
loss from hedging transactions.
Background. As a result of a '99 law change, capital
assets don't include any hedging transaction clearly identified as
such before the close of the day on which it was acquired,
originated, or entered into. (Code Sec. 1221(a)(7)) Before the
change, IRS had issued final regs in '94 providing ordinary
character treatment for most business hedges. Last year, IRS issued
proposed changes to the hedging regs to reflect the '99 statutory
change (see Weekly Alert ¶ 6 2/1/2001). IRS has now finalized the
regs with various changes, many of which are pro-taxpayer. The regs
apply to transactions entered into after Mar 19, 2002. However, the
Preamble states that IRS won't challenge any transaction entered
into after Dec. 16, '99, and before Mar. 20, 2002, that satisfies
the provisions of either the proposed or final regs.
Hedging
transactions. A hedging transaction is a transaction entered
into by the taxpayer in the normal course of business primarily to
manage risk of interest rate, price changes, or currency
fluctuations with respect to ordinary property, ordinary
obligations, or borrowings of the taxpayer. (Code Sec. 1221(b)(2)(A)(i);
Code Sec. 1221(b)(2)(A)(ii)) A hedging transaction also includes a
transaction to manage such other risks as IRS may prescribe in regs.
(Code Sec. 1221(b)(2)(A)(iii)) IRS has the authority to provide regs
to address nonidentified or improperly identified hedging
transactions (Code Sec. 1221(b)(2)(B)), and hedging transactions
involving related parties. (Code Sec. 1221(b)(3))
Key
changes in final regs. The final regs include the following
changes from the proposed regs.
... Both
the final and the proposed regs provide that they do not apply to
determine the character of gain or loss realized on a section 988
transaction as defined in Code Sec. 988(c)(1) or realized with
respect to any qualified fund as defined in section Code Sec.
988(c)(1)(E)(iii). The proposed regs also provided that their
definition of a hedging transaction would apply for purposes of
certain other international provisions of the Code only to the
extent provided in regs issued under those provisions. This is
eliminated in the final regs because the other references were to
proposed regs and to Code sections for which the relevant regs
have not been issued in final form. The Preamble states that later
regs will specify the extent to which the Reg. § 1.1221-2 hedging
transaction rules will apply for purposes of those other regs and
related Code sections.
...
Several commentators noted that the proposed regs used risk
reduction as the operating standard to implement the risk
management definition of hedging. They found that risk reduction
is too narrow a standard to encompass the intent of Congress,
which defined hedges to include transactions that manage risk of
interest rate, price changes or currency fluctuations. In
response, IRS has restructured the final regs to implement the
risk management standard. No definition of risk management is
provided, but instead, the rules characterize a variety of classes
of transactions as hedging transactions because they manage risk.
(Reg. § 1.1221-2(c)(4); Reg. § 1.1221-2(d))
... The
proposed regs provided that a taxpayer has risk of a particular
type only if it is at risk when all of its operations are
considered. Commentators pointed out that businesses often conduct
risk management on a business unit by business unit basis. In
response, the final regs permit the determination of whether a
transaction manages risk to be made on a business-unit basis
provided that the business unit is within a single entity or
consolidated return group that adopts the single-entity approach.
(Reg. § 1.1221-2(d)(1))
RIA
observation: As a result of the two foregoing changes made
by the final regs, more transactions will qualify as hedging
transactions. This is good for taxpayers because any losses
from the additional transactions qualifying as hedges will be
accorded ordinary treatment.
... In
response to comments, the final regs have been restructured to
separately address interest rate hedges and price hedges. (Reg.
§ 1.1221-2(d)(1)(iv); Reg. § 1.1221-2(d)(2))
... In
response to comments, the final regs provide that a transaction
that converts an interest rate from a fixed rate to a floating
rate or from a floating rate to a fixed rate manages risk. (Reg.
§ 1.1221-2(d)(2))
... The
final regs provide that IRS may identify by future published
guidance specified transactions that are determined not to be
entered into primarily to manage risk. (Reg. § 1.1221-2(d)(5))
... The
proposed regs sought comments on expanding the definition of
hedging transactions to include transactions that manage risks
other than interest rate or price changes, or currency
fluctuations with respect to ordinary property, ordinary
obligations or borrowings of the taxpayer. While comments were
received, the final regs did not make any changes in this area.
However, IRS continues to invite comments on the types of risks
that should be covered, including specific examples of
derivative transactions that may be incorporated into future
guidance, as well as the appropriate timing of inclusion of
gains and losses with respect to such transactions.
...
With respect to the identification requirement, a rule has been
added specifying additional information that must be provided
for a transaction that counteracts a hedging transaction. (Reg.
§ 1.1221-2(f)(3)(v))
RIA
Research References: For hedging transactions, see FTC 2d/FIN ¶
I-6218.01 ; United States Tax Reporter ¶ 12,214.80
|
From The Wall Street Journal Accounting Educators' Review on June 16,
2004
TITLE: Calpine Raises Cash to Pay Debt, Turn Profit
REPORTER: Steven D. Jones
DATE: Jun 15, 2004
PAGE: C3
LINK: http://online.wsj.com/article/0,,SB108724453234036647,00.html
TOPICS: Accounting, Cash Flow, Debt, Early Retirement of Debt, Asset
Disposal
SUMMARY: Calpine Corp. has revealed a plan that will significantly
change its balance sheet and statement of cash flows. Questions focus on
evaluating the plan and the related accounting.
QUESTIONS:
1.) Outline each economic event that is described in the article. For each
event, briefly explain the economic significance of the event.
2.) Assume that Calpine Corp. continues with the plan that is described
in the article. Explain how each component of the plan would impact the
financial statements.
3.) Why would bondholders be concerned about disposing of assets?
4.) What is a hedge? Into what type of hedge transaction did Calpine
Corp. enter? Why did Calpine Corp. enter into the hedge transaction? Is
net income changed by changes in market value of the asset underlying the
hedge transaction? Is net income changed by changes in market value of the
electricity in Calpine's long-term sales contracts? Support your answers.
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
"Outside Audit: Calpine
Takes Basic Approach to Power Game," by Steven D. Jones, The Wall
Street Journal, June 15, 2004, Page C3 --- http://online.wsj.com/article/0,,SB108724453234036647,00.html
Calpine
Corp., one of the main actors in California's long-running energy soap
opera, is working from a script that sounds like it came right out of a
business textbook: raising cash, reducing debt and aiming to put out a
more profitable product.
As any soaps fan knows, however,
plots can turn unexpectedly.
Calpine, based in San Jose, is
raising nearly $1 billion in cash from asset sales, and in the bargain
positioning itself to profit from more volatile electricity prices in
the year ahead.
In a series of deals, including
the sale of a large block of Canadian gas, Calpine will raise cash to
finish power plants and meet obligations for maturing debt and hybrid
securities that begin coming due this fall.
At the same time, the energy
company is reducing how much electricity it has tied up in long-term
supply contracts to 51% of output for the remainder of the year from 65%
a year ago.
The change means that Calpine has
more megawatts to sell on the open market this summer, when consumer
demand is projected to grow 2.5% nationwide and swell as much as 6% in
California
Combined, the moves mean Calpine
is poised to boost cash from asset sales and increase cash flow if
market prices for electricity move higher this summer. Calpine has 88
power plants generating 22,000 megawatts and another 10 plants nearing
completion.
The strategy isn't foolproof:
Those gas reserves are real assets, and thus are a comfort to bond
holders, who may fret at their disposal. Also, if it is a cool summer,
the market price for electricity would understandably suffer, and
Calpine, which had a weak first quarter, would too.
The independent power generator
burned through about $400 million in cash in the first quarter. It had
$1.4 billion in liquidity at the end of the quarter, but it also plans
about $900 million in capital spending and faces two maturing debt
obligations totaling about $570 million in the next two years. In
addition, the first $225 million of a type of hybrid convertible
security that Calpine sold comes due this fall, and many investors are
likely to want to cash out.
Calpine traded at nearly $50 a
share when those hybrid securities were first sold five years ago. At 4
p.m. yesterday in New York Stock Exchange composite trading, it stood at
$3.98, up five cents.
Wall Street and investors are
acutely concerned with how Calpine manages its ready cash, as even the
company notes. "The whole issue on Calpine has been
liquidity," says Bob Kelly, the chief financial officer. "One
way to get that off the table is to build our cash balance."
For Calpine, building cash is in
large part about the difference between fuel costs and the price it
receives for electricity it generates. For example, if it costs Calpine
$35 for the gas to generate a megawatt of electricity that the company
sells for $50, then it earns $15.
Five years ago, when prices and
demand for electricity were high, Calpine prospered by selling long-term
power contracts. To hedge those contracts, the company locked in fixed
gas prices partly by purchasing Canadian gas fields.
Since then, gas prices have
risen, but electricity demand and prices haven't kept pace. Sometimes
Calpine customers, many of them utilities, could come out ahead by
relying on Calpine's fixed-price power, shutting off their own
generating plants and selling their gas for a profit on the open market.
Now Calpine is going back to
customers with an offer to provide the generating capacity only. Or, as
in the earlier example, the utility pays $15 for the generating capacity
and provides the gas at its own expense. While that may appear to be a
small change, it makes a big difference on the balance sheet, because
Calpine no longer needs as much gas in the ground as a long-term hedge.
"Our profit margin doesn't
change," says Mr. Kelly. "We get the capacity value of the
megawatts just the same as we do now, but we have removed the energy
side of the trade so we are long gas. That frees up the opportunity to
sell the gas."
Calpine has 230 billion cubic
feet of natural gas in Alberta on the block. Mr. Kelly estimates the
company paid about $1.25 per thousand cubic feet for that gas and recent
Canadian deals suggest the company could now get $2 per thousand cubic
feet. At that price, Calpine's Alberta gas reserves represent a 60%
return on a three-year investment.
But the deal looks even better
from a balance-sheet perspective, since Calpine intends to pay off some
bank debt and then use most of the proceeds to buy back bonds that are
trading for about 60 cents on the dollar. Put it all together: Calpine
bought gas for $1.25, will sell it for $2 and use the cash to repay
nearly $3 of debt.
"We've doubled our money in
2½ to three years," says Mr. Kelly. "People ought to be
happy."
Yet the enthusiasm on Wall Street
has been restrained. Calpine shares have gained little since the plan
was announced June 10, and its bonds have lost ground, trading down
another 25 cents yesterday.
The tepid response is tied to the
view that the gas on Calpine's balance sheet is a core asset, with some
creditors seeing billions of cubic feet of gas as a cushion against a
hard landing for their bonds.
"That's not the way to look
at it," counters Mr. Kelly. "If anyone is looking at gas as
security on the bonds, then they ought to sell the bonds."
The other key to Calpine's
current restructuring is higher power prices that will spur cash flow,
and for that Calpine could use a heat wave. Consumers weather cold with
natural gas and other sources of energy, but most rely on electrically
powered air conditioners to beat the heat. Too many cool and breezy
days, however, and air conditioners get turned off.
Bob Jensen's threads on
accounting for derivative financial instruments are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
|
Hedge Accounting =
accounting treatment that allows gains and losses
on hedging instruments such as forward contracts and derivatives to be deferred and
recognized when the offsetting gain or loss on the item being hedged is recognized.
Criteria for qualifying as a hedge are discussed in FAS 133 Paragraphs 9-42,
70, 384-431,
432-457,, 458-473, and 488-494. Derivatives qualifying as hedges must continue to meet
hedging criteria for the term of the contracts. Impairment tests are discussed in
Paragraphs 27 on Page 17 and 31-35 on Page 22 of FAS 133. A
nonderivative instrument, such as a Treasury note, shall not be designated as a hedging
instrument for a cash flow hedge (FAS 133 Paragraph 28d). See cash flow hedge, compound
derivatives, disclosure, fair
value hedge, hedge, ineffectiveness,
and foreign currency hedge. Especially note the
term disclosure.
In a nutshell, hedge accounting might be viewed simply as the way changes in
value of a booked derivative financial instrument might be offset against
something other than current earnings.
Many firms are eager to have a hedge qualify for hedge accounting to reduce
earnings fluctuations that arise from changes in derivative instrument values
that do not qualify for hedge accounting.
Flow Chart for Hedge Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Cash flows from a derivative financial instrument such as a
swap are debited or credited to current earnings. However, the change in
the value of a derivative financial instrument may receive special accounting
treatment if that derivative qualifies as a hedge under FAS 133 accounting
rules. If the derivative is not scoped into FAS 133, there is not
requirement under FAS 133 to book the derivative and change its value on the
balance sheet over time (although the derivative such as an insurance
contract) may be booked under other accounting standards). Such
non-scoped derivatives include derivatives having an underlying based upon
sports scores or geological indices (such as rainfall amounts. Other
non-scoped derivatives include regular-way trades, normal purchases and sales,
insurance contracts, financial guarantees, and other derivatives scoped out of
FAS 133 under Paragraph 58,
Changes in value of derivatives that are scoped into FAS 133
(which includes most derivatives commonly used in business) must be charged to
current earnings if they are speculations or economic hedges that do not
qualify for special accounting treatment under FAS 133. For example, an
interest rate swap that is based upon some interest rate index other than the
U.S. Treasury rate or LIBOR will not qualify changes in value of that swap to
receive special hedge accounting treatment under FAS 138 benchmarking
constraints. (See benchmark.).
The swap must nevertheless be booked as a derivative financial instrument and
changes in its value must be charged to current earnings.
If its underlying of the interest rate swap is the U.S.
Treasury rate or LIBOR it would qualify for benchmarked
hedge accounting, and changes in its value would then be charged to other
comprehensive income (OCI) for a qualified cash flow hedge. See cash
flow hedge.
If the hedge qualified as a fair value hedge, hedge accounting
becomes a bit more complex. If the hedged item is a firm commitment for
an unbooked hedged item, the changes in the derivative's value are charged to
an account invented in FAS 133 called "Firm Commitment." If
the hedged item is a booked asset or liability maintained at historical cost,
the accounting for the hedged item is changed from historical cost to fair
value accounting during the hedge period. If the asset (such as gold) or
liability is carried normally at fair value, then no hedge accounting is
allowed and all changes in derivative value are charged to current
earnings. For example, changes in the value of a derivative that hedges
gold are charged to current earnings, whereas the changes in the value of a
derivative hedging a firm commitment to purchase wheat are charged to an
account called "Firm Commitment" and do not affect current earnings
until the derivative is settled. See fair
value hedge.
Hedges of investment securities receive different treatment
depending upon whether the hedged item under FAS 115 is classified as
"trading," "available
for sale," or "held to
maturity." Derivatives hedging investments to be held to
maturity or classified as trading investments cannot receive hedge accounting
treatment. All changes in the the value of derivatives hedging
such securities are charged to current earnings. Changes in the value of
derivatives hedging available for sale (AFS) securities also get charged to
current earnings, but the accounting for the changes in value of the hedged
items get changed in that FAS 115 rules are suspended during the hedging
period for AFS securities. During the hedging period, the changes in
value of AFS hedged items are charged to current earnings rather than Other
Comprehensive Income (OCI). The changes in the value of the derivative
hedging an AFS security, thereby, offsets the changes in the value of the AFS
security itself, and there is no net impact on net earnings to the extent that
the hedge is effective.
Derivatives that are covered by FAS 133 accounting rules must remeasured to fair value on each balance sheet date. Paragraph
18 on Page 10 of FAS 133 outlines how to account gains and losses on derivative financial
instruments designated for FAS 133 accounting. The FASB requires that an entity use that defined method consistently
throughout the hedge period (a) to assess at inception of the hedge and on an ongoing
basis whether it expects the hedging relationship to be highly effective in achieving
offset and (b) to measure the ineffective part of the hedge (FAS 133
Paragraph 62). If the entity identifies an improved method and wants to apply that method prospectively,
it must discontinue the existing hedging relationship and designate the relationship anew
(FAS 133 Paragraph 62).
According to Paragraph 70 of FAS 133, differences in credit
risk do not preclude hedges from being perfectly effective with respect to
price or interest rate risk being hedged.
70. Comparable credit risk at
inception is not a condition for assuming no ineffectiveness even though
actually achieving perfect offset would require that the same discount rate
be used to determine the fair value of the swap and of the hedged item or
hedged transaction. To justify using the same discount rate, the credit risk
related to both parties to the swap as well as to the debtor on the hedged
interest-bearing asset (in a fair value hedge) or the variable-rate asset on
which the interest payments are hedged (in a cash flow hedge) would have to
be the same. However, because that complication is caused by the interaction
of interest rate risk and credit risk, which are not easily separable,
comparable creditworthiness is not considered a necessary condition to
assume no ineffectiveness in a hedge of interest rate risk.
An individual item (specific identification) hedge is a
hedge against a particular underlying, e.g, a foreign currency hedge or fair value hedge
against a firm commitment to purchase a machine such as in Example 1 in FAS 133
Paragraphs 104-110, 432-435, 458, Example 3 in Paragraphs 121-126, and Example 4 in
Paragraphs 127-129. Also see Paragraph 447 on Page 197. A Macro
Hedge is one in which a group of
items or transactions is hedged by one or multiple derivative contracts. There is a gray
zone between an individual item versus a macro hedge. Although portfolio
(macro) hedging is common in finance, FAS 133 and IAS 39 prohibit most macro
hedges. Reasoning is given in Paragraphs 21a and 357-361 of FAS 133.
The hedge must relate to a specific identified and designated risk, and not merely to
overall enterprise business risks, and must ultimately affect the enterprise's net profit
or loss (IAS 39 Paragraph 149). If similar assets or similar
liabilities are aggregated and hedged as a
group, the individual assets or individual liabilities in the group will share the risk
exposure for which they are designated as being hedged. Further, the change in fair
value attributable to the hedged risk for each individual item in the group will be
expected to be approximately proportional to the overall change in fair value attributable
to the hedged risk of the group (IAS Paragraph 132). Under international rules,
the hedged item can be (a) a single asset, liability, firm commitment, or
forecasted transaction or (b) a group of assets, liabilities, firm commitments, or
forecasted transactions with similar risk characteristics (IAS 39 Paragraph 127).
Example:
Example: if the change in fair value of a hedged portfolio attributable to the hedged risk
was 10% during a reporting period, the change in the fair values attributable to the
hedged risk for each item constituting the portfolio should be expected to be within a
range of 9-11%. In contrast, an expectation that the change in fair value
attributable to the hedged risk for individual items in the portfolio would range from
7-13% would be inconsistent with this provision (SFAS Paragraph 21a(1)).
If the hedged item is a financial asset or liability,
a recognized loan servicing right, or a nonfinancial firm commitment with
financial components, the designated risk being hedged is (1) the
risk of changes in the overall fair value of the entire hedged item,
(2) the risk of changes in its fair value attributable to changes in market
interest rates, (3) the risk of changes in its fair value attributable to
changes in the related foreign currency exchange rates (refer to FAS 133 Paragraphs 37 and 38), or (4) the risk of changes in its fair value
attributable to changes in the obligor's creditworthiness. One
controversial issue of frustration to companies was the initial FAS 133
failure to give hedge accounting treatment to interest rate derivatives that only hedge
against the risk-free interest rate portion of a note. This type of
hedge is sometimes called a "treasury
lock." Treasury lock hedges are popular because it is relatively
easy to find a derivative instrument that is marketed for purposes of hedging
interest free rates. Hedging against "fair value of the entire
hedged item" is much more difficult and often requires the acquisition of
a custom derivative that is not traded on exchanges. The Derivative
Instrument Group hung tough on this controversy in E1 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuee1.html
Derivatives cannot
hedge derivatives for accounting purposes -- now or under FASB 133," Bass
said. "Does Dave [Duncan] think his accounting works even under FASB 133?
No way."
Carl Bass, Andersen Auditor in 1999 who asked to be removed from Enron's audit
review responsibilities ---
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm#Bass
The main reasons are given in FAS Paragraph 405. FAS 133 Paragraph
21(2)(c) disallows hedged items to be derivative financial instruments for
accounting purposes, because derivative instruments are carried at fair value
and cannot therefore be hedged items in fair value hedges. Also see
Paragraphs 405-407. Paragraph 472 prohibits derivatives from be
designated hedged items any type of hedge, including cash flow, fair value,
and foreign exchange hedges. The reason is that derivatives under FAS
133 must be adjusted to fair value with the offset going to current
earnings. This is tantamount to the "equity method" referred
to in Paragraph 472. More importantly from the standpoint of Enron
transactions, Paragraphs 230 and 432 prohibit a firm's own equity shares
from being hedged items for accounting purposes. Whenever a firm hedges
the value of its own shares, FAS 133 does not allow hedge accounting
treatment.
QUESTION (In DIG Issue E1)
In a fair value hedge (or cash flow hedge) where
the hedged risk is the change in the fair value (or variability in cash
flows) attributable to market interest rates, may the changes in fair value
(or variability in cash flows) attributable to changes in the risk-free
interest rate be designated as the hedged risk and be the sole focus of the
assessment of hedge effectiveness?
RESPONSE (of the DIG_
No. Changes in the fair value (or variability in
cash flows) attributable to changes in only the risk-free rate cannot be
designated as the hedged risk in a fair value hedge (or cash flow hedge).
Paragraphs 21(f) and 29(h) of Statement 133 permit the designated risk in a
fair value hedge (or cash flow hedge) to be one of the following: (1) risk
of changes in the overall fair value (or cash flows) of the entire hedged
item, (2) risk of changes in the fair value (or cash flows) attributable to
changes in market interest rates, (3) risk of changes in the fair value (or
functional-currency-equivalent cash flows) due to changes in foreign
currency rates, or (4) risk of changes in the fair value (or cash flows) due
to changes in the obligor’s creditworthiness. The term credit risk in
paragraph 21(f) is used to refer only to the risk of changes in fair value
attributable to changes in the obligor’s creditworthiness, which can be
measured by changes in the individual company’s credit rating.
The risk of changes in fair value (or cash flows)
due to changes in market interest rates encompasses the risk of changes in
credit spreads over the base Treasury rate for different classes of credit
ratings. Therefore, if market interest rate risk is designated as the risk
being hedged in either a fair value hedge or a cash flow hedge, that hedge
encompasses both changes in the risk-free rate of interest and changes in
credit spreads over the base Treasury rate for the company’s particular
credit sector (that is, the grouping of entities that share the same credit
rating). The risk of changes in the fair value (or cash flows) attributable
to changes in the risk-free rate of interest is a subcomponent of market
interest rate risk. Statement 133 does not permit designation of a risk that
is a subcomponent of any of the four risks identified in paragraphs 21(f)
and 29(h) in Statement 133 as the risk being hedged. An entity may designate
a contract based on the base Treasury rate (for example, a Treasury note
futures contract) as a cross-hedge of the forecasted issuance of corporate
debt. However, hedge ineffectiveness may occur to the extent that credit
sector spreads change during the hedge period. As a result, in designing a
hedging relationship using a contract based on the base Treasury rate as a
cross-hedge, the risk of changes in credit sector spreads should be
considered in designating the hedged risk.
In IAS 39 Paragraph 128, the IASC took a more conciliatory
position. If a hedged item is a financial asset or liability, it may be a hedged
item with respect to the risks associated with only a portion of its cash flows or fair
value, if effectiveness can be measured. This
conciliatory position does not hold for nonfinancial assets and liabilities
according to IAS 39 Paragraph 129.
Eventually, the FASB also became more
conciliatory. The FASB subsequently issued the FAS 138 amendments to FAS
133 that introduced the concept of "benchmark"
interest rate hedges. Treasury lock hedges can now receive hedge
accounting under FAS 138 even though such accounting was not allowed under the
original version of FAS 133.
If the risk designated as being hedged is not the risk of changes in
overall fair value of the entire hedged item, two or more of the other risks (market
interest rate risk, foreign currency exchange risk, and credit risk) may simultaneously be
designated as being hedged under FAS 133 Paragraph 21f.
In
IAS 39 Paragraph 131, the IASC took a more conciliatory position
when overall fair value risk is an issue. A single hedging instrument may be designated as a hedge of more than one
type of risk provided that: (a) the risks hedged can be clearly identified, (b) the
effectiveness of the hedge can be demonstrated, and (c) it is possible to ensure that
there is a specific designation of the hedging instrument and the different risk positions.
The subject of "clearly-and-closely related" is taken
up in FAS 133, Pages 150-153, Paragraphs 304-311 and again in Paragraphs 443-450.. The
closely-related criterion is illustrated in Paragraphs 176-177. Also the FASB reversed its
position on compound derivatives.
Example 11 in Paragraphs 176-177 illustrate clearly-and-closely-related criteria in
embedded hybrid derivative instruments.
If a hedged item is a nonfinancial asset or liability, it should be
designated as a hedged item either (a) for foreign currency risks or (b) in its entirety
for all risks according to IAS 39 Paragraph 129. If the hedged item is a
nonfinancial asset or liability (other than a
recognized loan servicing right or a nonfinancial firm commitment with financial
components), the designated risk being hedged is the risk of changes in the fair value of
the entire hedged asset or liability (reflecting its actual location if a physical asset).
The price risk of a similar asset in a different location or of a major ingredient
may not be the hedged risk (FAS 133 Paragraph 21e).
If the hedged item is a specific portion of an asset/liability (or of a
portfolio of similar assets/liabilities), the hedged item is one of the following:
(1) A percentage of the entire asset/liability
(2) One or more selected contractual cash flows
(3) A put option, a call option, an interest rate cap, or an interest rate floor embedded
in an existing asset/liability that is not an embedded derivative accounted for separately
pursuant to paragraph 12 of the Statement
(4) The residual value in a lessor's net investment in a direct financing or sales-type
lease
If the entire asset/liability is an instrument with variable cash flows, the hedged item
cannot be deemed to be an implicit fixed-to-variable swap perceived to be embedded in a
host contract with fixed cash flows. (FAS 133 Paragraph 21a(2))
The hedged item is not:
(1) an asset or liability that is remeasured with the changes in fair value attributable
to the hedged risk reported currently in earnings (for example, if foreign exchange risk
is hedged, a foreign-currency-denominated asset for which a foreign currency transaction
gain or loss is recognized in earnings), (FAS 133 Paragraph 21c(1)).
Likewise, paragraph 29d prohibits the following transaction from being designated as the
hedged forecasted transaction in a cash flow hedge: the acquisition of an asset or
incurrence of a liability that will subsequently be remeasured with changes in fair value
attributable to the hedged risk reported currently in earnings. If the forecasted transaction relates to a recognized asset or liability, the asset or
liability is not remeasured with changes in fair value attributable to the hedged risk
reported currently in earnings.)
(2) an investment accounted for by the equity method in accordance with the requirements
of APB Opinion No. 18.
(3) a minority interest in one or more consolidated subsidiaries.
(4) an equity instrument in a consolidated subsidiary.
(5) a firm commitment either to enter into a business combination or to acquire or dispose
of a subsidiary, a minority interest or an equity method investee.
(6) an equity instrument issued by the entity and classified in stockholders' equity in
the statement of financial position (FAS 133 Paragraph 21c).
Paragraph 20 of FAS 133 generally prohibits derivative financial instruments
from being hedged items even though they are commonly used for hedging
instruments.
The following cannot be designated as a hedged item in a foreign currency hedge:
(a) a recognized asset or liability that may give rise to a foreign currency transaction
gain or loss under Statement 52 (such as a foreign-currency-denominated receivable or
payable) either in a fair value hedge or a cash flow hedge.
(b) the forecasted acquisition of an asset or the incurrence of a liability that may give
rise to a foreign currency transaction gain or loss under Statement 52 in a cash flow
hedge
(FAS 133 Paragraph 36). An available-for-sale equity security can be hedged for changes in the fair value
attributable to changes in foreign currency exchange rates if:
(a) the security is not traded on an exchange on which trades are denominated in the
investor's functional currency.
(b) dividends or other cash flows to holders of the security are all denominated in the
same foreign currency as the currency expected to be received upon sale of the security
(FAS 133 Paragraph 38).
A written option is not a hedging instrument unless it is designated as an
offset to a purchased option, including one that is embedded in another financial
instrument, for example, a written option used to hedge callable debt
(IAS 39 Paragraph 124). A purchased option qualifies as a hedging instrument as it has potential gains equal to or
greater than losses and, therefore, has the potential to reduce profit or loss exposure
from changes in fair values or cash flows (IAS 39 Paragraph 124).
Under FASB rules, if a written option is designated as hedging a recognized asset or
liability / the variability in cash flows for a recognized asset or liability, the
combination of the hedged item and the written option provides at least as much potential
for favorable cash flows as exposure to unfavorable cash flows (see FAS 133 Paragraph 20c
or 28c).
Whereas unrealized fair value hedge gains and
losses are accounted for in current earnings, cash flow hedge gains and losses may be
deferred in comprehensive income until derecognition, derecognition, or impairment arise. Impairment in
meeting hedge criteria are discussed in Paragraphs 27, 32, 34-35, 208, 144-152, 447-448,
and 495-498.
Related to impairment are dedesignation., derecognition, and ineffectiveness tests. Impairment tests are discussed in
Paragraphs 31-35 on beginning on Page 22 of FAS 133. Paragraph 31 requires that, in
the case of forecasted net losses of a combined hedged item and its hedging instrument,
accumulated losses in comprehensive income be
transferred to current earnings to the extent of the anticipated settlement loss.
Paragraph 32 beginning on Page 22 of
FAS 133 outlines conditions for discontinuance of hedge accounting and reclassification
requirements. Nothing is said about where reclassifications are to be shown in the
income statement. KPMG argues that these should appear in the operating income
section. See Example 1 on Page 344 of of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP
in July 1998.
Under international standards, IAS 39
has similar impairment provisions.
If there is objective evidence of impairment, and the loss on a financial asset carried at
fair value has been recognized directly in equity in accordance with IAS 39
Paragraph 103b. The cumulative net loss that had been recognized directly in equity should be removed from
equity and recognized in earnings for the period even though the financial asset has not
been derecognized (see IAS 39 Paragraph 117). The amount of the loss that should be removed
from equity and reported in earnings is the difference between its acquisition cost (net
of any principal repayment and amortization) and current fair value (for equity
instruments) or recoverable amount (for debt instruments), less any impairment loss on
that asset previously recognized in earnings. The recoverable amount of a debt
instrument remeasured to fair value is the present value of expected future cash flows
discounted at the current market rate of interest for a similar financial asset
(See IAS 39 Paragraph
118).
If, in a subsequent period, the fair value or recoverable amount of the financial asset
carried at fair value increases and the increase can be objectively related to an event
occurring after the loss was recognized in earnings, the loss should be reversed, with the
amount of the reversal included in earnings for the period (See IAS 39
Paragraph 119).
Fair value hedges are accounted for in a
similar manner in both FAS 133 and IAS 39. Paul Pacter states the
following at http://www.iasc.org.uk/news/cen8_142.htm
(emphasis added):
IAS 39 Fair Value Hedge Definition:
a hedge of the exposure to changes in the fair value of a recognised
asset or liability (such as a hedge of exposure to changes in the fair
value of fixed rate debt as a result of changes in interest rates).
However, a hedge of an unrecognised firm
commitment to buy or sell an asset at a fixed price in the
enterprise’s reporting currency is accounted for as a cash flow
hedge
IAS 39 Fair Value Hedge Accounting:
To the extent that the hedge is effective, the gain or loss from
remeasuring the hedging instrument at fair value is recognised
immediately in net profit or loss. At the same time, the corresponding
gain or loss on the hedged item adjusts the carrying amount of the
hedged item and is recognised immediately in net profit or loss.
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FAS 133 Fair Value Hedge Definition:
Same as IAS 39
...except that a hedge of an unrecognised firm commitment to buy or
sell an asset at a fixed price in the enterprise’s reporting
currency is accounted for as a fair value hedge or a cash flow hedge.
SFAS Fair Value Hedge Accounting:
Same as IAS 39
|
a. The gain or loss from remeasuring the hedging instrument at fair value
should be recognized immediately in earnings; and
b. The gain or loss on the hedged item attributable to the hedged risk should adjust the
carrying amount of the hedged item and be recognized immediately in earnings.
c. This applies even if a hedged item is otherwise measured at fair value with changes in
fair value recognized directly in equity under paragraph 103b. It also applies
if the hedged item is otherwise measured at cost.
(IAS 39 Paragraph 153)
See IAS 39 Paragraph 154 for an example.
Cash flow hedges are accounted for in a
similar manner but not identical manner in both FAS 133 and IAS 39 (other
than the fact that none of the IAS 39 standards define comprehensive income or
require that changes in fair value not yet posted to current earnings be
classified under comprehensive income in the equity section of a balance
sheet):
To the extent that the cash flow hedge is effective, the portion of the
gain or loss on the hedging instrument is recognized initially in equity.
Subsequently, that amount is included in net profit or loss in the same period
or periods during which the hedged item affects net profit or loss (for
example, through cost of sales, depreciation, or amortization).
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
(emphasis added):
IAS 39 Cash Flow Hedge Accounting:
For a hedge of a forecasted asset and liability acquisition, the gain
or loss on the hedging instrument will adjust the basis (carrying
amount) of the acquired asset or liability. The gain or loss on the
hedging instrument that is included in the initial measurement of the
asset or liability is subsequently included in net profit or loss when
the asset or liability affects net profit or loss (such as in the
periods that depreciation expense, interest income or expense, or cost
of sales is recognised).
|
FAS 133 Cash Flow Hedge Accounting:
For a hedge of a forecasted asset and liability acquisition, the gain or
loss on the hedging instrument will remain in equity when the asset or
liability is acquired. That gain or loss will subsequently included in
net profit or loss in the same period as the asset or liability affects
net profit or loss (such as in the periods that depreciation expense,
interest income or expense, or cost of sales is recognised). Thus,
net profit or loss will be the same under IAS and FASB Standards, but
the balance sheet presentation will be net under IAS and gross under
FASB.
|
With respect to net investment un a foreign entity, Paul Pacter states
the following at http://www.iasc.org.uk/news/cen8_142.htm:
IAS 39 Hedge of a
Net Investment in a Foreign Entity:
accounted for same as a cash flow hedge.
|
FAS 133 Hedge of a
Net Investment in a Foreign Entity:
Same as in IAS 39
|
IAS 39
For those financial assets and liabilities that are remeasured to fair
value, an enterprise has a single, enterprise-wide option to either:
(a) recognise the entire adjustment in net
profit or loss for the period; or
(b) recognise in net profit or loss for the
period only those changes in fair value relating to financial assets
and liabilities held for trading, with value changes in non-trading
items reported in equity until the financial asset is sold, at which
time the realised gain or loss is reported in net profit or loss.
|
FAS 133
FASB requires option (b) for all enterprises.
|
March 20 Message from Ira Kawaller
Hi Bob,
I just posted a recently published article on how to satisfy the FAS 133 disclosure requirements for interest rate hedges. Although it was originally published by Bank Asset/Liablility Management (March 2000), the content is
applicable to all firms with interest rate exposures -- not just banks.
If you are interested, it is available at
http://www.kawaller.com/pdf/BALMHedges.pdf
You can also find additional information about derivatives, risk management, and FAS 133 in the various articles posted on the Kawaller & Company website:
http://www.kawaller.com
Please feel free to contact me with any questions, comments, or suggestions.
Ira Kawaller
Kawaller & Company, LLC
kawaller@kawaller.com
(718) 694-6270
Bob Jensen's documents and threads
on FAS 133 are linked at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
The Excel workbook
solutions to examples and cases are on a different server at http://www.cs.trinity.edu/~rjensen/
|
One Feature of the Proposed 2009
Regulation of OTC Derivatives is Insane
OTC Derivatives Should Be Regulated in Some Respects, But They Should Never
Be Standardized
PwC Notes one of the main reasons
(shown in read) at
Click Here
Why should the right balance be struck when it
comes to regulating OTC derivatives?
Some OTC derivatives have been criticized for
contributing to the financial crisis. But new proposals may affect how all
derivatives are traded and designed.
Most financial derivatives have been safely and
prudently used over the years by thousands of companies seeking to manage
specific risks.
OTC derivatives are privately negotiated because
they are often highly customized. They enable businesses to offset nearly
any fi nancial risk exposure, including foreign exchange, interest rate, and
commodity price risks.
Proposals to standardize terms for all OTC
derivatives could inadvertently limit the ability of companies to fully
manage their risks.
Jensen Comment
The reason that it would "limit the ability of companies to fully manage
their risks" is that OTC derivatives are currently very popular hedging
contracts because it is often possible over-the-counter to write customized
hedging contracts that exactly match (in mirror form) the terms of a hedged
item contract or forecasted transaction such that the hedge becomes
perfectly effective over the life of the hedge.
If companies have to hedge with
standardized contracts such as futures and options contracts traded on
organized exchange markets it's either impossible or very difficult to
obtain a perfectly matched and effective hedge. For example, corn futures
are traded in contracts of 25,000 bushels for a given grade of corn. If
Frito Lay wants to hedge a forecasted transaction to purchase 237,000
bushels of corn, it can only perfectly hedge 225,000 bu. with five futures
contracts or 250,000 bu. with six futures contracts. Hence it's impossible
to perfectly hedge 237,000 bu. with standardized contracts.
However, if Frito Lay wants to
perfectly hedge 237,000 bu. of corn it can presently enter into one OTC
forward contract for 237,000 bu. or an OTC options contract for 237,000 bu.
If the hedged item is eventually purchased in the same geographic region as
the hedging contract (such as Chicago), the hedge should be perfectly
effective at all points in time during the contracted hedging period.
If the hedging contract is written
in terms of a Chicago market and the corn is eventually purchased in a
Minneapolis market, then their may be slight hedging ineffectiveness (due
mainly to transportation cost differences between the two markets), but
there is absolutely no mismatch due to quantity (notional) differences.
Why is customization so
important from the standpoint of accounting and auditing?
Under FAS 133 and IAS 39, hedge accounting relief is available only to
the extent hedges are deemed effective. The ineffective portion of value
changes in the hedging contracts must be posted to current earnings, thereby
increasing the volatility of earnings for unrealized value changes of the
hedging contracts.
If new
regulations requiring standardization of OTC derivatives, then the
regulations themselves may dictate that many or most hedging contacts are,
at least in part, ineffective. As a result reported earnings will needlessly
fluctuate to a greater extent due to the regulations rather than because of
economic substance. Dumb! Dumb! Dumb!
In particular, students may want to
refer to the hedge accounting ineffectiveness testing Appendix B Example 7
beginning in Paragraph 144 of FAS 133 and
Appendix A Example 7 beginning in Paragraph 93
of FAS 133. Bob Jensen's extensions and spreadsheet analysis of the
Paragraph 144 illustration are available in Excel worksheet file
133ex07a.xls listed at
http://www.cs.trinity.edu/~rjensen/
Sadly, the FASB left both of these examples, along with the other
outstanding Appendix A and B examples out of its sparse handling of
accounting for derivative financial instruments in its Codification
Database.
In particular, Examples 1
thru 10 in Appendix B of FAS 133 are the best places that I know of to learn
about hedge accounting and effectiveness testing. My extended analysis of
each example can be found in the 133ex01a.xls thru 133ex10a.xls Excel
workbooks at
http://www.cs.trinity.edu/~rjensen/
My students focused heavily on those ten examples to learn about hedge
accounting. They also learned from my videos 133ex05a.wmv and 133ex08a.wmv
files listed at
http://www.cs.trinity.edu/~rjensen/video/acct5341/
Teaching Cases: Hedge Accounting
Scenario 1 versus Scenario 2
Two Teaching Cases Involving Southwest Airlines, Hedging, and Hedge
Accounting Controversies ---
http://faculty.trinity.edu/rjensen/caseans/SouthwestAirlinesQuestions.htm
Bob Jensen's free tutorials and videos for FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
See Illustrations
and Ineffectivness.
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Hedge Fund (an oxymoron)
A pooled investment vehicle
that is privately organised and is administered by professional investment
managers. It is different from another pooled investment fund, the mutual
fund, in that access is available only to wealthy individuals and
institutional managers. Moreover, hedge funds are able to sell securities
short and buy securities on leverage, which is consistent with their
typically short-term and high risk oriented investment strategy, based
primarily on the active use of derivatives and short positions.
OECD --- http://www1.oecd.org/error.htm
Hedge Funds Are Growing: Is This Good or Bad?
When the ratings agencies downgraded General
Motors debt to junk status in early May, a chill shot through the $1
trillion hedge fund industry. How many of these secretive investment
pools for the rich and sophisticated would be caught on the wrong side
of a GM bond bet? In the end, the GM bond bomb was a dud. Hedge funds
were not as exposed as many had thought. But the scare did help fuel the
growing debate about hedge funds. Are they a benefit to the financial
markets, or a menace? Should they be allowed to continue operating in
their free-wheeling style, or should they be reined in by new
requirements, such as a move to make them register as investment
advisors with the Securities and Exchange Commission?
"Hedge Funds Are Growing: Is This Good or Bad?" Knowledge@wharton,
June 2005 ---
http://knowledge.wharton.upenn.edu/index.cfm?fa=viewArticle&id=1225
Question
What are hedge funds, especially after Bernie Madoff made them so famous?
When people ask me this question, my initial
response is that a hedge fund no longer necessarily has anything to do with
financial risk hedging. Rather a hedge fund is merely a "private" investment
"club" that does not offer shares to the general public largely because it
would then subject itself to more SEC, stock exchange, and other regulators.
Having said this, it's pretty darn easy for anybody with sufficient funds to
get into such a "private" club. Minimum investments range from $10,000 to
$1,000,000 or higher.
Since Bernie Madoff made hedge funds so
famous, the public tends to think that a hedge fund is dangerous,
fraudulent, and a back street operation that does not play be the rules.
Certainly hedge funds emerged in part to avoid being regulated. Sometimes
they are risky due to high leverage, but some funds
skillfully hedge to manage risk and are much safer than mutual funds.
For example, some hedge funds have shrewd hedging strategies to control risk
in interest rate and/or foreign currency trading.
Most hedge funds are not fraudulent. In
general, however, it's "buyer beware" for hedge fund investors.
I would never invest in a hedge fund that is
not audited by a very reliable CPA auditing firm. Not all CPA auditing firms
are reliable (Bernie Madoff proved you can engage a fraudulent auditor
operating out of a one-room office). Hence, the first step in evaluating a
hedge fund is to investigate its auditor. The first step in evaluating an
auditor is to determine if the auditing firm is wealthy enough to be a
serious third party in law suits if the hedge fund goes belly up.
But the recent multimillion losses of
Carnegie Mellon, the University of Pittsburgh, and other university
endowment funds that invested in a verry fraudulent hedge fund purportedly
audited by Deloitte suggests that the size and reputation of the auditing
firm is not, by itself, sufficient protection against a criminal hedge fund
(that was supposedly given a clean opinion by Deloitte in financial reports
circulated to the victims of the fraud).
When learning about hedge funds, you may
want to begin at
http://en.wikipedia.org/wiki/Hedge_Fund
"What is a hedge fund and how is it
different from a mutual fund?" by Andy Samuels, Business and Finance
101 Examiner, June 10, 2009 ---
Click Here
Jim Mahar pointed out this link.
Having migrated away
from their namesake, hedge funds no longer focus primarily on “hedging”
(attempting to reduce risk) because hedge funds are now focused almost
blindly on one thing: returns.
Having been
referred to as “mutual funds for the super rich” by
investopedia.com, hedge funds are very similar
to mutual funds in that they pool money together from many investors.
Hedge funds, like
mutual funds, are also managed by a financial
professionals, but differ because they are geared toward wealthier
individuals.
Hedge funds,
unlike mutual funds, employ a wider array of ivesting techniques, which
are considered more aggresive. For example, hedge funds often use
leverage to amplify their returns (or losses
if things go wrong).
The other key
difference between hedge funds and mutual funds is the amount of
regulation involved. Hedge funds are relatively unregulated because
investors in hedge funds are assumed to be more sophisticated investors,
who can both afford and understand the potential losses. In fact, U.S.
laws require that the majority of investors in the fund are
accredited.
Most hedge funds draw in investors because
of the trustworthy reputations of the executives of the fund. Word-of-mouth
praise and affiliations are often the key to success. Bernie Madoff succeed
in luring customers based on two leading factors: (1) His esteemed
reputation on Wall Street and (2) His highly regarded connections in the
Jewish community where he drew in most of his victims.
Bob Jensen's threads on frauds are linked
at
http://faculty.trinity.edu/rjensen/fraud.htm
In particular see
http://faculty.trinity.edu/rjensen/fraud001.htm
And see
http://faculty.trinity.edu/rjensen/FraudRotten.htm
German Chancellor's Call for Global Regulations to Curb Hedge Funds
Germany and the United States are parting company
again, this time over Chancellor Gerhard Schröder's call for international
regulations to govern hedge funds. Treasury Secretary John W. Snow, speaking
here Thursday at the end of a five-country European tour, said the United
States opposed "heavy-handed" curbs on markets. He said that he was not
familiar with the German proposals, but left little doubt about how
Washington would react. "I think we ought to be very careful about
heavy-handed regulation of markets because it stymies financial innovation,"
Mr. Snow said after a news conference here to sum up his visit. Noting that
the Securities and Exchange Commission has proposed that hedge funds be
required to register themselves, he said he preferred the "light touch
rather than the heavy regulatory burden."
Mark Landler, "U.S. Balks at German Chancellor's Call for Global Regulations
to Curb Hedge Funds," The New York Times, June 17, 2005 ---
http://www.nytimes.com/2005/06/17/business/worldbusiness/17hedge.html?
An investing balloon that will one day burst
The numbers are mind-boggling: 15 years ago,
hedge funds managed less than $40 billion. Today, the figure is
approaching $1 trillion. By contrast, assets in mutual funds grew at an
impressive but much slower rate, to $8.1 trillion from $1 trillion, during
the same period. The number of hedge fund firms has also grown - to 3,307
last year, up 74 percent from 1,903 in 1999. During the same period, the
number of funds created - a manager can start more than one fund at a time
- has surged 209 percent, with 1,406 funds introduced in 2004, according
to Hedge Fund Research, based in Chicago.
Jenny Anderson and Riva D. Atlas, "If I Only Had a Hedge Fund,"
The New York Times, The New York Times, March 27, 2005 --- http://www.nytimes.com/2005/03/27/business/yourmoney/27hedge.html
Jensen Comment: The name "hedge fund" seems to imply that
risk is hedged. Nothing could be further from the case. Hedge
funds do not have to hedge risks, Hedge funds should instead be
called private investment clubs. If structured in a certain way they
can avoid SEC oversight.
Remember how the Russian
space program worked in the 1960s? The only flights that got publicized
were the successful ones. Hedge funds are like that. The ones asking
for your money have terrific records. You don't hear about the ones that
blew up. That fact should strongly color your view of hedge funds with
terrific records.
Forbes, January 13, 2005 --- http://snipurl.com/ForbesJan_13
US hedge funds prior to 2005 were exempted from
Securities and Exchange Commission reporting requirements, as well as from
regulatory restrictions concerning leverage or trading strategies. They
now must register with the SEC except under an enormous loophole for funds
that cannot liquidate in less than two years.
The Loophole: Locked-up
funds don't require oversight. That means more risk for investors.
"Hedge Funds Find an Escape Hatch," Business Week,
December 27, 2004, Page 51 ---
Securities
& Exchange Commission Chairman William H. Donaldson recently
accomplished a major feat when he got the agency to pass a controversial
rule forcing hedge fund advisers to register by 2006. Unfortunately,
just weeks after the SEC announced the new rule on Dec. 2, many hedge
fund managers have already figured out a simple way to bypass it.
The easy out is
right on page 23 of the new SEC rule: Any fund that requires investors
to commit their money for more than two years does not have to register
with the SEC. The SEC created that escape hatch to benefit
private-equity firms and venture capitalists, which typically make
long-term investments and have been involved in few SEC enforcement
actions. By contrast, hedge funds, some of which have recently been
charged with defrauding investors, typically have allowed investors to
remove their money at the end of every quarter. Now many are considering
taking advantage of the loophole by locking up customers' money for
years.
Question
Where can you find one of the best definitions of hedge funds and summaries of
alternative hedge fund strategies?
Answer
Where else than Wikipedia ---
http://en.wikipedia.org/wiki/Hedge_fund
The primer below should have been entitled "The
Mutual Fund Scandal for Dummies." It is the best explanation of
what really happened and how mutual funds versus index funds really work.
A
Primer on the Mutual-Fund Scandal --- www.businessweek.com:/print/bwdaily/dnflash/sep2003/nf20030922_7646.htm?db
Stanford University faculty member Eric Zitzewitz, "found
evidence of market timing and late trading across many fund families he
studied."
BusinessWeek Online, September 22, 2003
When
it comes to financial scandal, the mutual-fund industry had always
seemed above the fray. No longer. On Sept. 3, New York Attorney General
Eliot Spitzer kicked off an industry wide probe with allegations that
four prominent fund outfits allowed a hedge fund to trade in and out of
mutual funds in ways that benefited the parent companies at the expense
of their long-term shareholders.
By Sept. 16, Spitzer's office and the Securities & Exchange
Commission had filed criminal and civil charges against a former Bank of
America (BAC ) broker
who allegedly facilitated illegal trading in mutual funds. More fund
companies are being subpoenaed for information about their trading, and
more state and federal regulators are joining the growing investigation.
It's all but certain that more fund firms will be drawn into the
deepening scandal.
Yet this major crisis for the fund industry has failed to inspire much
fury from investors, and it has done little to halt a rising stock
market. Maybe a partial explanation is that the fund companies allegedly
did wrong, and why it hurt shareholders, is difficult to understand. For
anyone who has read widespread coverage of the topic but wanted to
scream, "Explain what the heck is going on," we provide the
following discussion:
Let's start at the beginning. How is a mutual fund set up?
A mutual fund is like any other public company. It has a board of
directors and shareholders. Its business is investing -- in stocks,
bonds, real estate, or other assets -- using whatever strategy is set
out in its prospectus, with money from individual investors. Its
strategy could be to buy, say, small, fast-growing U.S. companies or to
purchase the debt of firms across Europe.
A fund's board hires a portfolio manager as well as an outside firm to
market and distribute the fund to investors. But funds can become big
quickly, and the larger ones operate a bit differently. A
fund-management company (think Fidelity or Vanguard) sets up dozens of
funds, markets them to investors, hires the portfolio managers, and
handles the administrative duties. It makes a profit collecting fees
(usually a percentage of assets under management) from the funds it
manages.
A fund company typically has in place the same board of directors
(including some independent members) for its funds. The board of
directors should be on the lookout for abusive practices by the fund
company, but directors often have too many funds to oversee and may be
too aligned with the company's portfolio managers to provide much
oversight.
This case concerns mutual-fund trading. Does it involve the portfolio
managers?
No, that's not what this case is about. Portfolio managers buy and sell
securities for their funds. But the alleged improper trading has to do
with outside investors buying and selling a fund's shares. Spitzer's
complaint actually concerns the activity of one firm, Canary Capital
Partners, but he alleges the same activity is far more widespread.
Portfolio managers, who are usually compensated based on their funds'
performance and frequently have their own money invested in their funds,
are usually shareholders' greatest defenders against trading practices
that hurt long-term results.
How are mutual funds traded?
Funds can be bought and sold all day. However, unlike stocks, which are
priced throughout the trading day, mutual funds are only priced once a
day, usually at 4 p.m. Eastern Time. At that point the funds' price, or
Net Asset Value (NAV), is determined by adding up the worth of the
securities the fund owns, plus any cash it holds, and dividing that by
the number of shares outstanding.
Buy a fund at 2 p.m. and you'll pay a NAV that is determined two hours
later. Buy a fund at 5 p.m. and you'll pay a price that won't be set
until 4 p.m. the following day. According to Spitzer's complaint, Canary
Capital Partners, a hedge fund, took advantage of the way fund prices
are set to effectively pick the pockets of long-term shareholders.
What's
a hedge fund?
A hedge fund is like a mutual fund in that it buys and sells securities,
is run by a portfolio manager, and tries to make money for its
investors. But hedge funds have a very different structure (they are
actually set up as partnerships) and are almost entirely unregulated,
mostly because they manage money for sophisticated high net-worth
individuals or companies, and have different rules governing when and
how investors can liquidate their positions.
Hedge-fund managers are compensated based on a percentage of profits
(often 20%), so they have a major incentive to take risks, which they
often do. Selling stocks short (a way to bet they will fall in price),
piling on complex financial security derivatives, and using borrowed
money to leverage returns are common strategies.
So exactly what did Canary Capital allegedly do?
According to Spitzer's complaint, Canary (which settled charges, paid
$40 million in fines, but didn't admit or deny guilt), had two
strategies (Spitzer called them "schemes") for making money
trading in mutual funds. The easiest to understand, the most serious,
and clearly illegal is "late trading." The other strategy,
"market timing" is far more common and not illegal, although
clearly unethical.
How does late trading work?
The rule of "forward pricing" prohibits orders placed after 4
p.m. from receiving that day's price. But Canary allegedly established
relationships with a few financial firms, including Bank of America, so
that orders placed after 4 p.m. would still get that day's price. In
return for getting to trade late, Canary placed large investments in
other Bank of America funds, effectively compensating the company for
the privilege of trading late.
The late-trading ability would have allowed Canary to take advantage of
events that occurred after the market closed -- events that would affect
the prices of securities held in a fund's portfolio when the market
opened the next day.
I could use an example.
Here's a hypothetical, simplified one: Let's say the Imaginary Stock
mutual fund has 5% of its assets invested in the stock of XYZ Co. After
the close, XYZ announces earnings that exceed analysts' expectations.
XYZ closed at 4 p.m. at $40 a share but most likely, its price will soar
the next day.
The late trader buys the Imaginary Stock mutual fund at 6 p.m. after the
news is announced, paying an NAV of $15 (that was calculated using the
$40 share price of XYZ). The next day, when XYZ closes at $50, it helps
push the fund's NAV to $15.50. The late trader sells the shares and
pockets the gain. Spitzer says late trading is like "betting today
on yesterday's horse races." You already know the outcome before
you place your winning bet.
How do they turn this into real money? It sounds like small potatoes.
If you did this dozens of times a year in hundreds of funds investing
millions of dollars at a time, it would add up.
What about market-timing? How does that work?
This strategy takes advantage of prices that are already outdated, or
"stale," when a fund's NAV is set. Most often the strategy is
carried out using international funds, in which prices are stale because
the securities closed earlier in a different time zone.
Could you give an example?
Well, let's take the Imaginary International Stock mutual fund. One day,
U.S. markets get a huge boost thanks to positive economic news and the
benchmark Standard & Poor's 500 rises 5%. The market-timer steps in
and buys shares of the international fund at an NAV of $15 at 4 p.m.,
knowing that about 75% of the time, international markets will follow
what happened in the U.S. the previous trading day. Predictably, most of
the time, the international fund rises in price the next day and closes
at an NAV of $15.05. The market-timer then sells the shares, pocketing
the gain.
If market timing isn't illegal, why would Spitzer investigate the
industry for it?
Market timing (and late trading, for that matter) add to a fund's costs,
which are paid by shareholders. This kind of trading activity also
either dilutes long-term profits or magnifies losses depending on
whether the trader is betting the fund will go up or go down. (For a
more detailed example of how market-timing works, see BW Online,
12/11/02, "How
Arbs Can Burn Fund Investors").
Most funds have a stated policy in place (included in the prospectus) of
prohibiting market-timing. They impose redemption fees on investors that
hold a fund less than 180 days. And many prospectuses give fund
companies the right to kick market-timers out of the fund.
Yet Spitzer alleges that fund companies such as Janus (JNS
) and Strong got to reap extra management fees by allowing Canary to do
market-timing trades in return for Canary placing large deposits of
"sticky" assets (funds that are going to stay in one place for
a while) in other funds. That would put it in violation of its fiduciary
duty to act in its shareholders' best interests and mean it has not
conformed to policies laid out in its prospectus.
Spitzer offers this analogy: "Allowing timing is like a casino
saying that it prohibits loaded dice, but then allowing favored gamblers
to use loaded dice, in return for a piece of the action." Janus,
Strong, and the other companies named in Spitzer's complaint have
promised to cooperate with him and are conducting their own internal
investigations of trading practices. Several firms have promised to make
restitution to shareholders if they find such deals cost shareholders
money.
But wouldn't this amount to tiny losses for the shareholders in the
fund?
That depends on how many traders might have used these strategies.
Spitzer believes these practices are widespread and his investigation is
widening to include many more fund companies.
Eric Zitzewitz, an assistant professor of economics at Stanford, has
found evidence of market timing and late trading across many fund
families he studied. His research shows that an investor with $10,000 in
an international fund would have lost an average of $110 to market
timers in 2001 and $5 a year to after-market traders. Average losses in
2003 appear to be at roughly the same level, he says. That may not sound
like much, but in a three-year bear market, when the average investor
was losing hundreds if not thousands of dollars on investments, it's
adding the insult of abused trust to the injury of heavy losses.
What's likely to happen next?
Spitzer and other securities regulators are likely to announce the
alleged involvement of more fund companies. If individual investors
believe fund companies abused their trust, they are likely to call for
more regulation and stiff penalties. Potentially they could pull their
money out of funds en masse, forcing portfolio managers to liquidate
stocks to fund redemptions. That could be very disruptive to financial
markets.
Another possibility is that the stock market continues to rise on the
back of a stronger economy and a jump in corporate profits. Fund
investors might be willing to ignore past losses due to illegal and
unethical trading practices because they're pleased with the current
gains their funds are providing. For now, that's clearly what the
embattled mutual-fund industry hopes will happen.
Invest in Hedge Funds at Your Own
Peril
"Hedge Fund Hoopla Be unafraid; be
very unafraid," The Wall Street Journal, July 1, 2006 ---
http://www.opinionjournal.com/weekend/hottopic/?id=110008598
Politicians are
drawn to piles of unregulated money like, well, politicians to TV
cameras. So it was only a matter of time before Congress took aim at the
$2.4 trillion hedge fund industry.
The Senate
Judiciary Committee held a hedge fund hearing this week, with its star
witness one Gary Aguirre, a former SEC investigator who said superiors
quashed a probe into insider trading at Pequot Capital. Pequot has
vigorously denied the claims, and insider trading is already illegal.
But the ubiquitous Connecticut Attorney General Richard Blumenthal was
nonetheless on hand, in range of TV cameras, to claim that hedge funds
are a "regulatory black hole." The Senators were also very concerned, no
doubt prepping for the day when a few of these pools of private
investment capital go belly up.
So maybe it's
time to step back and recall that we've all been at this cab stand
before. In 1999, a year after Long Term Capital Management blew up, the
President's Working Group on Financial Markets released the results of
its top-to-bottom probe of hedge funds. This was no lightweight body,
containing as it did Alan Greenspan, Robert Rubin and former SEC
Chairman Arthur Levitt. Its findings argued so strongly against meddling
in this source of market liquidity and efficiency that even the Clinton
Administration gave regulation a pass.
The working
group focused on a concern that is often heard today, which is that too
much hedge fund borrowing could lead to systemic market risk. Highly
leveraged investors are always more vulnerable to market shocks. And if
forced to liquidate their often-huge positions, their losses could
cascade throughout the financial system.
But the working
group found that Long Term Capital was unique. The best way to guard
against hedge fund meltdowns is a system in which the counterparties
(bankers, broker-dealers) that lend to or borrow from hedge funds impose
due diligence. In Long Term Capital's case, many counterparties were so
impressed by that giant fund's reputation that they "did not ask
sufficiently tough questions," as Federal Reserve Chairman Ben Bernanke
put it in a speech this May.
Such laxity is
a problem, but the answer isn't necessarily more direct regulation. The
working group recognized that, in the complicated and fast-moving world
of financial derivatives, the best way to guard against future blowups
is to ensure the market itself imposes more discipline. It recommended
that hedge funds provide better disclosure to their counterparties, and
that regulators ensure that counterparties have systems and policies
that identify warning signs and restrain excessive leverage.
The regulators
have since complied, issuing risk-management guidance so bank
supervisors now consider it a primary duty to monitor hedge-fund
dealings. The SEC also stepped up its inspection of broker-dealers. Many
counterparties now require hedge funds to post more collateral to cover
potential exposure. And institutions and regulators are all trying to
improve weak areas--say, understanding the risks in such new financial
products as credit derivatives. For a "black hole," this sure has a lot
of foot traffic.
Hedge funds
offer high returns, but they also take big risks, and some failures are
inevitable. That's especially true when the Fed is raising rates and
credit is getting tighter. But while hedge funds have multiplied since
1999, the funds that have failed have done so with barely a market
ripple. This suggests the Clinton working group's strategy is working.
The Clintonians
also argued that direct hedge fund regulation would have significant
costs, such as reducing the liquidity crucial to robust financial
markets. And in his recent speech, Mr. Bernanke noted how difficult it
would be for any regulator to monitor hedge fund trading strategies that
change rapidly and are enormously complex.
A more recent
complaint about hedge funds is that they are becoming ever more
available to Mom and Pop investors, not merely to the superrich. But a
2003 SEC report found that funds are still dominated by big
institutional investors--pension funds, endowments, and the like. Rich
individuals and families supplied 42% of hedge fund assets, although
that share is declining.
Pension funds
do contain Mom and Pop retirement assets. But the focus of regulators
should be on the pension fund managers for taking a flyer on hedge
funds, not on the funds for taking the money. As for those who claim
hedge funds are run by rogues, the SEC report noted that it could find
"no evidence indicating that hedge funds or their advisers engage
disproportionately in fraudulent activity."
Alas, none of
this common sense stopped the SEC from plunging ahead in 2004 in an
attempt to begin regulating hedge funds. But that attempt was overruled
this month as an illegal power grab by the D.C. Circuit Court of
Appeals, which throws the matter once more into the tender arms of
Congress.
Hedge funds are
easy political targets because they aren't sold to the general public
and aren't well understood. But the regulators at the Fed and Treasury
who are paid to watch the financial system understand that they provide
far more benefits than risks. Congress should tread carefully, if it
treads at all.
You can read about the Long Term
Capital (Trillion Dollar Bet) scandal at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#LTCM
Questions
Do your students know the difference between mutual funds and hedge funds?
Do your students really understand how Ponzi schemes work?
Start with (gasp) Wikipedia.
The Worst Sack Ever on John Elway (former All-Pro Quarterback in the
Mile-High City)
Elway Got Schemered!
Stanford Graduates Should Know Better
"John Elway Invested $15 MILLION With Alleged Ponzi Schemer,"
Huffington Post, October 14, 2010 ---
http://www.huffingtonpost.com/2010/10/14/john-elway-invested-15-mi_n_762663.html
John Elway Invested $15 MILLION With Alleged Ponzi
Schemer
diggfacebook Twitter stumble reddit del.ico.us
What's Your Reaction? .Amazing Inspiring Funny Scary Hot Crazy Important
Weird Read More: Elway 15 Million, John Elway, Mitchell Pierce, Ponzi
Scheme, Sean Michael Mueller, Sean Mueller, Denver News 10 views Get Denver
Alerts Email Comments 17 DENVER — Former Denver Broncos quarterback John
Elway and his business partner gave $15 million to a hedge-fund manager now
accused of running a Ponzi scheme.
The Denver Post reported Thursday that Elway and
Mitchell Pierce filed a motion saying they wired the money to Sean Michael
Mueller in March. They said Mueller agreed to hold the money in trust until
they agreed on where it would be invested.
A state investigator says 65 people invested $71
million with Mueller's company over 10 years and it only had $9.5 million in
assets in April and $45 million in liabilities.
Elway's filing asks that the court put their claims
ahead of others so they can collect their money first. His lawyer declined
to comment.
Jensen Comment
It's hard to feel sorry for rich people who play in games without rules (hedge
funds)
Better to play in games with rules and stand behind 325 lb linemen with missing
teeth, BO, and noses that look like corkscrews.
Bob Jensen's fraud updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
Bob Jensen's threads on Hedge Funds
are under the H-term at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Note that hedge funds may have nothing to do with hedging.
Bob Jensen's threads on Ponzi
schemes are at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#Ponzi
From The Wall Street Journal Accounting Weekly Review on
September 9, 2005
TITLE: Lifting the Curtains on Hedge-Fund Window Dressing
REPORTER: Jesse Eisinger
DATE: Jul 09, 2005
PAGE: C1
LINK:
http://online.wsj.com/article/0,,SB112605873549333575,00.html
TOPICS: Advanced Financial Accounting, Investments, Auditing
SUMMARY: Eisinger analyzes stock price jumps on August 31 and argues that
the phenomena may be indicative of window-dressing at one particular hedge
fund.
QUESTIONS:
1.) What are the three types of investment portfolios identified in the
accounting literature? What type of investment portfolio is discussed in
this article?
2.) Describe the accounting for the three types of investment portfolios.
What is the biggest difference in the accounting practices' effect on
reported profits?
3.) Define the term "window dressing." How does that issue relate to
using market values for financial reporting and to their impact on
performance shown in the income statement?
4.) Suppose you are an auditor for the hedge-fund identified in this
article. How would you assess the potential impact of these issues on your
audit procedures? Would you react to the information published? Identify all
steps you might take both in your audit steps within the hedge-fund and any
external steps you might consider.
Reviewed By: Judy Beckman, University of Rhode Island
|
Hedged Item --- See Hedge
Accounting
Held-to-Maturity
(HTM) =
is one of three classifications of securities
investments under SFAS 115. Securities designated as "held-to-maturity"
need not be revalued for changes in market value and are maintained at historical
cost-based book value. Securities not deemed as being held-to-maturity securities
are adjusted for changes in fair value. Whether or not the unrealized holding gains
or losses affect net income depends upon whether these are classified as trading securities versus available-for-sale securities.
Holding gains and losses on available-for-sale securities are deferred in
comprehensive income instead of being posted to current earnings. The three
classifications are of vital importance to cash flow hedge
accounting under FAS 133.
Flow Chart for HTM Hedge Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
The distinction is important under
FAS 133, because
held-to-maturity securities need not be revalued in interim periods with unrealized gains
and losses going to current earnings (for trading investments) or comprehensive income (for available-for-sale
investments). The FASB clung to its disallowance of either cash flow or fair value
hedge accounting under FAS 133 for held-to-maturity investments.
Held-to-maturity securities may not be hedged for cash flow risk according to
Paragraphs 426-431 beginning on Page 190 of FAS 133. Suppose a firm has a
forecasted transaction to purchase a held-to-maturity bond investment denominated in a
foreign currency. Under SFAS 115, the bond will eventually, after the bond purchase, be
adjusted to fair value on each reporting date. As a result, any hedge of the foreign
currency risk exposure to cash flows cannot receive favorable cash flow hedge accounting
under FAS 133 rules (as is illustrated in Example 6 beginning on Page 265 of the
Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998. Before the
bond is purchased, its forecasted transaction is not allowed to be a cash flow hedged item
under Paragraph 29d on Page 20 of FAS 133 since, upon execution of the transaction, the
bond "will subsequently be remeasured with changes in fair value. Also see Paragraph
36 on Page 23 of FAS 133. Similar international rulings apply under IAS
39. Unlike originated loans and receivables, a held-to-maturity investment
cannot be a hedged item with respect to interest-rate risk because designation of an
investment as held-to-maturity involves not accounting for associated changes in interest
rates. However, a held-to-maturity investment can be a hedged item with respect to
risks from changes in foreign currency exchange rates and credit risk
(IAS 39 Paragraph 127).
FAS 133 Paragraph 21d reads as follows:
If the hedged item is all or a portion of a
debt security (or a portfolio of similar debt securities) that is classified
as held-to-maturity in accordance with FASB Statement No. 115, Accounting for
Certain Investments in Debt and Equity Securities, the designated risk being
hedged is the risk of changes in its fair value attributable to changes in the
obligor's creditworthiness or if the hedged item is an option component of a
held-to- maturity security that permits its prepayment, the designated risk
being hedged is the risk of changes in the entire fair value of that option
component. (The designated hedged risk for a held-to-maturity security may not
be the risk of changes in its fair value attributable to changes in market
interest rates or foreign exchange rates. If the hedged item is other than an
option component that permits its prepayment, the designated hedged risk also
may not be the risk of changes in its overall fair value.)
Paragraph 428 beginning
on Page 190 of FAS 133 reads as follows (where the "Board" is the FASB):
The
Board continues to believe that providing hedge accounting for a held-to-
maturity security conflicts with the notion underlying the held-to-maturity
classification in Statement 115 if the risk being hedged is the risk of
changes in the fair value of the entire hedged item or is otherwise related
to interest rate risk. The Board believes an entity's decision to classify a
security as held-to-maturity implies that future decisions about continuing
to hold that security will not be affected by changes in market interest
rates. The decision to classify a security as held-to-maturity is consistent
with the view that a change in fair value or cash flow stemming from a
change in market interest rates is not relevant for that security. In
addition, fair value hedge accounting effectively alters the traditional
income recognition pattern for that debt security by accelerating gains and
losses on the security during the term of the hedge into earnings, with
subsequent amortization of the related premium or discount over the period
until maturity. That accounting changes the measurement attribute of the
security away from amortized historical cost. The Board also notes that the
rollover of a shorter term liability that funds a held-to-maturity security
may be eligible for hedge accounting. The Board therefore decided to
prohibit both a fixed-rate held-to- maturity debt security from being
designated as a hedged item in a fair value hedge and the variable interest
receipts on a variable-rate held-to-maturity security from being designated
as hedged forecasted transactions in a cash flow hedge if the risk being
hedged includes changes in market
interest rates.
|
Paul Pacter states
the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
If an enterprise is prohibited from classifying financial assets as
held-to-maturity because it has actually sold some such assets before
maturity, that prohibition expires at the end of the second financial
year following the premature sales.
|
FAS 133
FASB standard is silent as to whether or when such
"tainting" is ever cured.
|
A Message from K Badrinath on January
25, 2002
Dear Mr. Jensen:
To cut a potentially
long introduction short, I am associated with the leading vendor of treasury
software in India, Synergy Log-In Systems Ltd. Shall be glad to share more on
that with you should you be interested.
The reason for
writing this is, while negotiating the minefield called FAS 133, courtesy your
wonderful Glossary on the net, I came across apparantly contradictory
statements under two different heads about whether held-to-maturity securities
can be hedged items:
HELD-TO-MATURITY
Unlike originated loans and receivables, a held-to-maturity investment cannot
be a hedged item with respect to interest-rate risk because designation of an
investment as held-to-maturity involves not accounting for associated changes
in interest rates. However, a held-to-maturity investment can be a hedged item
with respect to risks from changes in foreign currency exchange rates and
credit risk
AVAILABLE-FOR-SALE
Held-to-maturity securities can also be FAS 133-allowed hedge items.
Help!!
K. Badrinath
Hello K. Badrinath,
I think your confusion comes from the fact that FAS 138 amended Paragraph
21(d) as noted below.
Original Paragraph
21(d) .
If the hedged item is all or a portion of a debt security (or a portfolio of
similar debt securities) that is classified as held-to-maturity in accordance
with FASB Statement No. 115, Accounting for Certain Investments in Debt and
Equity Securities, the designated risk being hedged is the risk of changes in
its fair value attributable to changes in the obligor's creditworthiness or if
the hedged item is an option component of a held-to- maturity security that
permits its prepayment, the designated risk being hedged is the risk of
changes in the entire fair value of that option component. (The designated
hedged risk for a held-to-maturity security may not be the risk of changes in
its fair value attributable to changes in market interest rates or foreign
exchange rates. If the hedged item is other than an option component that
permits its prepayment, the designated hedged risk also may not be the risk of
changes in its overall fair value.)
FAS 138 Amendment of
Paragraph 21(d)"
[Hedged Item] If the hedged item is all or a portion of a debt security (or a
portfolio of similar debt securities) that is classified as held-to-maturity
in accordance with FASB Statement No. 115, Accounting for Certain Investments
in Debt and Equity Securities, the designated risk being hedged is the risk of
changes in its fair value attributable to credit risk, foreign
exchange risk,
or both.
Related paragraph changes are noted in
Appendix B of FAS 138.
Hedge accounting for held-to-maturity
securities under FAS 133 is especially troublesome for me. You can get
hedge accounting treatment for for creditworthiness risk and certain prepayment
option fair value changes, but you cannot get hedge accounting for interest rate
risk. The FASB reasoning is spelled out in Paragraphs 426-431.
Keep in mind, however, that the
derivative used to hedge a held-to-maturity security must be adjusted to fair
value at least every 90 days with changes it its value going to current
earnings.
Hedges of securities classified as
available-for-sale do not take the same beating under FAS 133. Without a
hedge, FAS 115 rules require changes in value of AFS investments to be booked,
but the offset is to OCI rather than current earnings. Paragraph 23 of FAS
133 reads as follows:
Paragraph 23
If a hedged item is otherwise measured at fair value with changes in fair
value reported in other comprehensive income (such as an available-for-sale
security), the adjustment of the hedged item's carrying amount discussed in
paragraph 22 shall be recognized in earnings rather than in other
comprehensive income in order to offset the gain or loss on the hedging
instrument
Foreign currency risk is somewhat
different under Paragraph 38 for AFS securities.
Some key paragraphs from FAS 133 are as
follows:
Paragraph 54
At the date of initial application, an entity may transfer any held-to-maturity
security into the available-for-sale category or the trading category. An entity
will then be able in the future to designate a security transferred into the
available-for-sale category as the hedged item, or its variable interest
payments as the cash flow hedged transactions, in a hedge of the exposure to
changes in market interest rates, changes in foreign currency exchange rates, or
changes in its overall fair value. (paragraph 21(d) precludes a held-to-
maturity security from being designated as the hedged item in a fair value hedge
of market interest rate risk or the risk of changes in its overall fair value.
paragraph 29(e) similarly precludes the variable cash flows of a
held-to-maturity security from being designated as the hedged transaction in a
cash flow hedge of market interest rate risk.) The unrealized holding gain or
loss on a held-to-maturity security transferred to another category at the date
of initial application shall be reported in net income or accumulated other
comprehensive income consistent with the requirements of paragraphs 15(b) and
15(c) of Statement 115 and reported with the other transition adjustments
discussed in paragraph 52 of this Statement. Such transfers from the
held-to-maturity category at the date of initial adoption shall not call into
question an entity's intent to hold other debt securities to maturity in the
future.
Paragraphs 426-431
Prohibition
against Hedge Accounting for Hedges of Interest Rate Risk of Debt Securities
Classified as Held-to-Maturity
426. This Statement
prohibits hedge accounting for a fair value or cash flow hedge of the interest
rate risk associated with a debt security classified as held-to-maturity
pursuant to Statement 115. During the deliberations that preceded issuance of
Statement 115, the Board considered whether such a debt security could be
designated as being hedged for hedge accounting purposes. Although the Board's
view at that time was that hedging debt securities classified as
held-to-maturity is inconsistent with the basis for that classification,
Statement 115 did not restrict hedge accounting of those securities because
constituents argued that the appropriateness of such restrictions should be
considered in the Board's project on hedging.
427. The Exposure
Draft proposed prohibiting a held-to-maturity debt security from being
designated as a hedged item, regardless of the risk being hedged. The Exposure
Draft explained the Board's belief that designating a derivative as a hedge of
the changes in fair value, or variations in cash flow, of a debt security that
is classified as held-to-maturity contradicts the notion of that
classification. Respondents to the Exposure Draft objected to the proposed
exclusion, asserting the following: (a) hedging a held-to-maturity security
does not conflict with an asserted intent to hold that security to maturity,
(b) a held-to-maturity security contributes to interest rate risk if it is
funded with shorter term liabilities, and (c) prohibiting hedge accounting for
a hedge of a held-to-maturity security is inconsistent with permitting hedge
accounting for other fixed-rate assets and liabilities that are being held to
maturity.
428. The Board
continues to believe that providing hedge accounting for a held-to- maturity
security conflicts with the notion underlying the held-to-maturity
classification in Statement 115 if the risk being hedged is the risk of
changes in the fair value of the entire hedged item or is otherwise related to
interest rate risk. The Board believes an entity's decision to classify a
security as held-to-maturity implies that future decisions about continuing to
hold that security will not be affected by changes in market interest rates.
The decision to classify a security as held-to-maturity is consistent with the
view that a change in fair value or cash flow stemming from a change in market
interest rates is not relevant for that security. In addition, fair value
hedge accounting effectively alters the traditional income recognition pattern
for that debt security by accelerating gains and losses on the security during
the term of the hedge into earnings, with subsequent amortization of the
related premium or discount over the period until maturity. That accounting
changes the measurement attribute of the security away from amortized
historical cost. The Board also notes that the rollover of a shorter term
liability that funds a held-to-maturity security may be eligible for hedge
accounting. The Board therefore decided to prohibit both a fixed-rate held-to-
maturity debt security from being designated as a hedged item in a fair value
hedge and the variable interest receipts on a variable-rate held-to-maturity
security from being designated as hedged forecasted transactions in a cash
flow hedge if the risk being hedged includes changes in market interest rates.
429. The Board does
not consider it inconsistent to prohibit hedge accounting for a hedge of
market interest rate risk in a held-to-maturity debt security while permitting
it for hedges of other items that an entity may be holding to maturity. Only
held-to-maturity debt securities receive special accounting (that is, being
measured at amortized cost when they otherwise would be required to be
measured at fair value) as a result of an asserted intent to hold them to
maturity.
430. The Board
modified the Exposure Draft to permit hedge accounting for hedges of credit
risk on held-to-maturity debt securities. It decided that hedging the credit
risk of a held-to-maturity debt security is not inconsistent with Statement
115 because that Statement allows a sale or transfer of a held-to-maturity
debt security in response to a significant deterioration in credit quality.
431. Some respondents
to the Task Force Draft said that a hedge of the prepayment risk in a
held-to-maturity debt security should be permitted because it does not
contradict the entity's stated intention to hold the instrument to maturity.
The Board agreed that in designating a security as held-to-maturity, an entity
declares its intention not to voluntarily sell the security as a result of
changes in market interest rates, and "selling" a security in
response to the exercise of a call option is not a voluntary sale.
Accordingly, the Board decided to permit designating the embedded written
prepayment option in a held-to-maturity security as the hedged item. Although
prepayment risk is a subcomponent of market interest rate risk, the Board
notes that prepayments, especially of mortgages, occur for reasons other than
changes in interest rates. The Board therefore does not consider it
inconsistent to permit hedging of prepayment risk but not interest rate risk
in a held-to-maturity security.
Paragraph 533(2)(e)
For securities classified as available-for-sale, all reporting enterprises shall
disclose the aggregate fair value, the total gains for securities with net gains
in accumulated other comprehensive income, and the total losses for securities
with net losses in accumulated other comprehensive income, by major security
type as of each date for which a statement of financial position is presented.
For securities classified as held-to-maturity, all reporting enterprises shall
disclose the aggregate fair value, gross unrecognized holding gains, gross
unrecognized holding losses, the net carrying amount, and the gross gains and
losses in accumulated other comprehensive income for any derivatives that hedged
the forecasted acquisition of the held-to-maturity securities, by major security
type as of each date for which a statement of financial position is presented
|
Held-to-maturity investments as defined in March 2003 by the FASB in an
exposure draft entitled "Financial Instruments --- Recognition and
Measurement," March 2003 --- http://www.cica.ca/multimedia/Download_Library/Standards/Accounting/English/e_FIRec_Mea.pdf
.20
An entity does not have a positive intention to hold to maturity a
financial asset with a fixed maturity when any one of the following
conditions is met: (a) the entity intends to hold the financial asset
for an undefined period; (b) the entity stands ready to sell the
financial asset (other than when a situation arises that is
non-recurring and could not have been reasonably anticipated by the
entity) in response to changes in market interest rates or risks,
liquidity needs, changes in the availability of, and the yield on,
alternative investments, changes in financing sources and terms, or
changes in foreign currency risk; or (c) the issuer has a right to
settle the financial asset at an amount significantly below its
amortized cost.
.21
A debt security with a variable interest rate can satisfy the criteria
for a held-to-maturity investment. Most equity securities cannot be
held-to-maturity investments either because they have an indefinite life
(such as common shares) or because the amounts the holder may receive
can vary in a manner that is not predetermined (such as for share
options, warrants, and rights). With respect to the definition of
held-to-maturity investments, fixed or determinable payments and fixed
maturity means a contractual arrangement that defines the amounts and
dates of payments to the holder, such as interest and principal
payments. A significant risk of non-payment does not preclude
classification of a financial asset as held to maturity as long as its
contractual payments are fixed or determinable and the other criteria
for that classification are met. When the terms of a perpetual debt
instrument provide for interest payments for an indefinite period, the
instrument cannot be classified as held to maturity because there is no
maturity date.
.22
The criteria for classification as a held-to-maturity investment are met
for a financial instrument that is callable by the issuer when the
holder intends and is able to hold it until it is called or until
maturity and the holder would recover substantially all of its carrying
amount. The call option of the issuer, if exercised, simply accelerates
the asset’s maturity. However, when the financial asset is callable on
a basis that would result in the holder not recovering substantially all
of its carrying amount, the financial asset is not classified as held to
maturity. The entity considers any premium paid and any capitalized
transaction costs in determining whether the carrying amount would be
substantially recovered.
.23
A financial asset that is puttable (the holder has the right to require
that the issuer repay or redeem the financial asset before maturity) is
classified as a held-to-maturity investment only when the holder has the
positive intention and ability to hold it until maturity.
.24
An entity does not classify any financial assets as held to maturity
when the entity has, during the current financial year or during the two
preceding financial years, sold or reclassified more than an
insignificant amount of held-to-maturity investments before maturity
(more than insignificant in relation to the total amount of
held-to-maturity investments), other than sales or reclassifications
that: (a) are so close to maturity or the financial asset’s call date
(for example, less than three months before maturity) that changes in
the market rate of interest would not have had a significant effect on
the financial asset’s fair value; (b) occur after the entity has
already collected substantially all of the financial asset’s principal
outstanding at acquisition (at least 85 percent) through scheduled
payments or prepayments; or (c) are due to an isolated event that is
beyond the entity’s control, is non-recurring and could not have been
reasonably anticipated by the entity. Whenever sales or
reclassifications of more than an insignificant amount of
held-to-maturity investments do not meet any of the conditions in
(a)-(c), any remaining held-to-maturity investments should be
reclassified as available for sale.
.25 Fair value is a more
appropriate measure for most financial assets than amortized cost. The
held-to-maturity classification is an exception, but only when the
entity has a positive intention and the ability to hold the investment
to maturity. When an entity’s actions have cast doubt on its intention
and ability to hold such investments to maturity, paragraph 3855.24
precludes the use of the exception for a reasonable period of
time.
.26
A “disaster scenario” that is extremely remote, such as a run on a
bank or a similar situation affecting an insurance company, is not
something that is assessed by an entity in deciding whether it has the
positive intention and ability to hold an investment to maturity.
.27
Sales before maturity could satisfy the condition in paragraph 3855.24
— and therefore not raise a question about the entity’s intention to
hold other investments to maturity — when they are due to any of the
following:
(a) A significant
deterioration in the issuer’s creditworthiness. For example, a sale
following a downgrade in a credit rating by an external rating agency
would not necessarily raise a question about the entity’s intention
to hold other investments to maturity when the downgrade provides
evidence of a significant deterioration in the issuer’s
creditworthiness judged by reference to the credit rating at initial
recognition. Similarly, when an enterprise uses internal ratings for
assessing exposures, changes in those internal ratings may help to
identify issuers for which there has been a significant deterioration
in creditworthiness, provided the entity’s approach to assigning
internal ratings and changes in those ratings give a consistent,
reliable, and objective measure of the credit quality of the issuers.
When there is evidence that a financial asset is impaired (see
paragraph 3855.A44), the deterioration in creditworthiness often is
regarded as significant.
(b) A change in tax law that
eliminates or significantly reduces the tax exempt status of interest
on the held-to-maturity investment (but not a change in tax law that
revises the marginal tax rates applicable to interest income).
(c) A major business
combination or major disposal (such as sale of a segment) that
necessitates the sale or transfer of held-to-maturity investments to
maintain the entity’s existing interest rate risk position or credit
risk policy (although the business combination itself is an event
within the entity’s control, the changes to its investment portfolio
to maintain an interest rate risk position or credit risk policy may
be consequential rather than anticipated).
(d) A change in statutory or
regulatory requirements significantly modifying either what
constitutes a permissible investment or the maximum level of
particular types of investments, thereby causing an entity to dispose
of a held-to-maturity investment.
(e) A significant increase in
the industry’s regulatory capital requirements that requires the
entity to downsize by selling held-to-maturity investments.
(f) A significant increase in
the risk weights of held-to-maturity investments used for regulatory
risk-based capital purposes that requires the entity to sell
held-to-maturity investments.
.28 An entity does not have a
demonstrated ability to hold to maturity an investment in a financial
asset with a fixed maturity when either of the following conditions is
met: (a) it does not have the financial resources available to continue
to finance the investment until maturity; or (b) it is subject to an
existing legal or other constraint that could frustrate its intention to
hold the financial asset to maturity (however, an issuer’s call option
does not necessarily frustrate an entity’s intention to hold a
financial asset to maturity — see paragraph 3855.22).
.29 Circumstances other than
those described in paragraphs 3855.20-.28 can indicate that an entity
does not have a positive intention or the ability to hold an investment
to maturity.
.30 An entity assesses its
intention and ability to hold its held-to-maturity investments to
maturity not only when those financial assets are initially recognized
but also at each subsequent balance sheet date.
|
Historical Rate =
the foreign-exchange rate that prevailed when a
foreign-currency asset or liability was first acquired or incurred.
Hybrid Contract =
financial instrument that
possesses, in varying combinations, characteristics of forward contracts,
futures contracts, option contracts, debt instruments, bank depository
interests, and other interests. See embedded derivatives.
Nothing the FASB has issued with respect to derivatives makes much sense
unless you go outside the FASB literature for basic terminology, most of which
is borrowed from finance. A hybrid instrument is financial instrument that
possesses, in varying combinations, characteristics of forward contracts,
futures contracts, option contracts, debt instruments, bank depository
interests, and other interests. The host contract may not be a derivative
contract but may have embedded derivatives. See the definition of embedded
derivative at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#EmbeddedDerivatives
The problem is that the value of the hybrid (which may be a market price or
transaction price) is often difficult to bifurcate into component values when
the components themselves are not traded on the market on their own. An
excellent paper on how to value some bifurcated components is provided in
"Implementation of an Option Pricing-Based Bond Valuation Model for
Corporate Debt and Its Components," by M.E. Barth, W.R. Landsman, and R.J.
Rendleman, Jr., Accounting Horizons, December 2000, pp. 455-480.
Some firms contend that the major problem they are having in implementing FAS
133 or IAS 39 lies in having to review virtually every financial instrument in
search of embedded derivatives and then trying to resolve whether bifurcation is
required or not required. Many of the embedded derivatives are so "closely
related" that bifurcation is not required. See "closely related"
in
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Also listen to executives and analysts discuss the bifurcation problem in http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm
Detecting derivatives and embedded derivatives to account for
worldwide (bifurcation)
Bob Jensen
May 6, 2002 message from George Lan
I am trying to read the FASB draft (Questions and
Answers Related to Derivative Financial Instruments Held or Entered into by a
Qualifying Special-Purpose Entity (SPE)) and got stumped right at
the beginning. Perhaps someone on the list can clarify these sentences for me:
"Under FASB 133, hybrid instruments that must be bifurcated contain two
components for accounting purpose-- a derivative financial instrument and a
nonderivative host contract....Hybrid instruments that are not bifurcated ...
are not considered to be derivative instruments." I am familiar with
split accounting (methods of splitting the financial instrument into its bond
and equity components, e.g) and with most of the common derivative contracts
such as futures, forwards, options, swaps but am ignorant about hybrid
instruments and why they must be or do not have to be bifurcated and would
certainly appreciate some examples and assistance from AECMers.
I am also a little familiar with much of the
derivative jargon, but expressions like "the floor purchased..."
could perhaps be clarified to make the draft easier to read and understand by
a wider audience.
Just a couple of thoughts,
George Lan
University of Windsor
I-Terms
IAS 39 = see International
Accounting Standards Committee.
IASB/IASC = see International
Accounting Standards Committee.
IFAC = see International
Federation of Accountants Committee.
Illustrations
(Selected)
Bob Jensen's illustrations ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
FAS 133 trips up Fanny Mae and Freddie Mac ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
FAS 133 trips up Reliant Resources --- See Comprehensive
Income
Ineffective Hedges at Wells Fargo --- See Ineffectiveness
Horizon --- see Risk Metrics
Disclosure illustrations --- See Disclosure
Impairment = see hedge accounting.
Index (Indices) =
is a term used in FAS 133
to usually refer to
the underlying (e.g a commodity price, LIBOR, or a foreign currency exchange rate) of a
derivative contract. By "indexed" it is meant that an uncertain economic
event that is measured by an economic index (e.g., a credit
rating index, commodity price index, convertible debt, equity index,
or inflation index) defined in the contract. An equity index might be defined as a particular index derived from
common stock price movements such as the Dow Industrial Index or the Standard and Poors
500 Index. FAS 133 explicitly does not allow some indices such as natural
indices (e.g., average rainfall) and contingency
consideration indices (e.g., lawsuit outcomes, sales levels, and contingent rentals)
under Paragraphs 11c and 61)
Paragraph 252 on Page 134 of
FAS 133 mentions that the FASB considered expanding the underlying to include all derivatives
based on physical variables such as rainfall levels, sports scores, physical condition of
an asset, etc., but this was rejected unless the derivative itself is exchange
traded. For example, a swap payment based upon a football score is not subject to
FAS 133 rules. An option that pays damages based upon the bushels of corn damaged
by hail is subject to insurance accounting rules (SFAS 60) rather than FAS 133. A
option or swap payment based upon market prices or interest rates must be accounted for by
FAS 133 rules. However, if derivative itself is exchange traded, then it is covered
by FAS 133 even if it is based on a physical variable that becomes exchange traded.
See derivative, inflation
indexed, LIBOR, and underlying.
Unlike FAS 133, IAS 39 makes explicit
reference also to an insurance index or catastrophe loss index and a climatic or
geological condition.
The following Section c in Paragraph 65 on
Page 45 of FAS 133 is of interest with respect to a premium paid for a forward or futures
contract:
c. Either the change in the discount or
premium on the forward contract is excluded from the assessment of effectiveness and included directly in earnings pursuant to
Paragraph 63 or the change in expected cash flows on the forecasted transaction is based
on the forward price for the commodity.
KPMG notes that if the
hedged item is a portfolio of assets or liabilities based on an index, the hedging
instrument cannot use another index even though the two indices are
highly correlated. See Example 7 on Page 222 of the Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.
See DIG Issue B10 under embedded
derivatives.
See equity-indexed
and index amortizing.
Index-Amortizing
=
a changing interest
rate based upon some index such as LIBOR.
For example, an index-amortizing interest rate swap cannot usually be accounted for as a
derivative instrument (pursuant to FAS 133 under Paragraph 12 on Page 7 of FAS 133) when
it is a derivative embedded in another
derivative. Suppose a company swaps a variable rate for a fixed rate on a notional
of $10 million. If an embedded derivative in the contract changes the notional to $8
million if LIBOR falls below 6% and $12 million if LIBOR rises above 8%, this
index-amortizing embedded derivative cannot be separated under Paragraph 12 rules.
KPMG states that Paragraph 12 applies only "when a derivative is
embedded in a nonderivative instrument and illustrates this with an index-amortizing
Example 29 beginning on Page 75 of the Derivatives
and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.
The prior Example 28 and the subsequent Example 30 illustrate index-amortizing embedded
derivatives that qualifies since, in each example, the derivative is embedded in a
nonderivative instrument. See equity-indexed.
Ineffectiveness =
degree ex ante to which a hedge fails to meet its goals in protecting against risk (i.e., degree
to which the hedge fails to correlate perfectly with the underlying
value changes or forecasted transaction prices.
According to Paragraphs 20 on Page 11 and 30 on Page 21 of FAS 133, ineffectiveness is to
be defined ex ante at the time the hedge is undertaken. Hedging strategy
and ineffectiveness definition with respect to a given hedge defines the extent to which
interim adjustments affect interim earnings. Hedge effectiveness requirements and
accounting are summarized in Paragraphs 62-103 beginning on Page 44 of FAS 133. An
illustration of intrinsic value versus time value accounting is given in Example 9 of
FAS 133,
Pages 84-86, Paragraphs 162-164. In Example 9, the definition of ineffectiveness in
terms of changes in intrinsic value of a call option results in
changes in intrinsic value each period being posted to other comprehensive income rather
than earnings. In Examples 1-8 in Paragraphs 104-161, designations as to fair value
versus cash flow hedging affects the journal entries. See hedge
and hedge accounting.
One means of documenting hedge effectiveness is
to compare the cumulative
dollar offset defined as the cumulative value
over a succession of periods (e.g., quarters) in which the cumulative gains and losses of
the derivative instrument are compared with the cumulative gains and losses in value of
the hedged item. n assessing the effectiveness of a hedge, an enterprise will generally
need to consider the time value of money according to FAS 133 Paragraph 64
and IAS 39 Paragraph 152.
"Hedge Effectiveness Testing Revisited," by Ira Kawaller and Paul
Koch, Journal of Derivatives, September 2013 ---
http://kawaller.com/hedge-effectiveness-testing-revisited/?utm_source=September+20%2C+2013&utm_campaign=9%2F10%2F13&utm_medium=email
Jensen Comment
One of the areas where the IASB and FASB have diverged is in the area of hedge
effectiveness testing. The IASB plays loosey-goosey on this one with the
so-called principles-based standard that will roll along when IAS 9 comes into
play. To me this means that one company's effective hedge is ineffective in
another company.
The IASB is tougher on the shortcut method and does not allow the shortcut
method for interest rate swap hedge effectiveness testing.
The FASB still has a rules-based effectiveness testing standard, but there is
more looseness allowed in such tests than I would like. Kawaller and Koch have
renewed our focus on hedge effectiveness testing that that can greatly affect
partitioning huge amounts of derivatives instruments gains and losses between
OCI and current earnings.
Teaching Case
Cost Accounting and Inventory Valuation
by Bob Jensen:
Differences Between Mark-to-Market Accounting for Derivative Contracts Versus
Commodity Inventories ---
http://faculty.trinity.edu/rjensen/Mark-to-MarketCorn.htm
"FASB Proposed Modifications to Hedge Accounting: Good Thing, Bad Thing,
or Just a Thing?* by Tom Selling, The Accounting Onion, August 22,
2016 ---
http://accountingonion.com/2016/08/fasb-proposed-modifications-to-hedge-accounting-good-thing-bad-thing-or-just-a-thing.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+typepad%2Ftheaccountingonion+%28The+Accounting+Onion%29
If we don’t destroy ourselves first, we will someday discover intelligent
life on another planet. But when we do, the chances are about one in a
billion that we’ll find hedge accounting standards more complex than our
own.
Now would also be as good a time as any to peel the onion on hedge
accounting since the FASB has recently reached a
consensus on a
revisions to rules that have been in place since the issuance of
SFAS 133 in
1998.
The Basics
At the risk of oversimplifying, the FASB addressed three problems in SFAS
133:
First,
there was the problem of accounting for derivatives, which without
additional guidance would be measured at historic cost. Historic cost
accounting is always suboptimal, but it is especially problematic
when it comes to derivatives. Consider, for example, a financial
institution with $9 billion in liabilities covered by $10 billion of assets.
Next, assume that said financial institution enters into a (near) cashless
interest rate swap with a notional amount of $10 billion — or a credit
default swap, or a commodities future contract. Basically, it enters into
any kind of financial derivative contract, I don’t care which.
All accounting measurement conventions applied to this derivative would
produce a net value of (near) zero at inception because the present value of
the contract’s receivable leg would be (nearly) equal to its payable leg.
But, should the “underlying” of the contract (e.g., an interest rate, a
commodity price, a credit rating) change even a
tiny bit, there will
be a large change in the fair value of the derivative contract — owing to
its relatively large national amount .
You don’t need to be a derivatives expert to figure out what’s going on
here: derivative contracts are the soft underbelly of historic cost
accounting. Failure to recognize the economic effects of the market risks
from being a party to a derivative contract renders the entire endeavor of
accounting for entities like this hypothetical financial institution an
utter sham. Consequently, the FASB correctly decided that interests in
derivative contracts must be, without exception, measured at fair value.
First problem solved. But, it creates two additional and related problems,
which I will call Problems 2a and 2b:
Problem 2a is
how to deal with the irony that if a company were to enter into a derivative
contract reduce a source of risk — i.e., reducing the volatility of future
enterprise value — then marking a derivative to market through net income
could be expected to increase the volatility of future net income.
This could be the case if GAAP requires that the item creating the risk in
the first place (e.g., a commodity held as inventory or a fixed-rate
mortgage loan) is measured at historic cost.
Problem 2a was addressed in SFAS 133 by the so-called “fair value hedge
accounting” treatment if the source of the risk is the change in the fair
value of a recognized asset, liability, or “firm commitment.” The issuer may
elect to offset the gain/loss recognized in income on the derivative
with an offsetting change to the hedged item.
Fair value hedging might seem like a reasonable accounting treatment, but
there are a number questionable aspects to it. Two of these are:
Inconsistencies in measurement
— Assets, liabilities and firm commitments that happen to be linked with a
derivative in fair value hedge accounting are measured one way, and unlinked
items are measured another way. Moreover, an added source of inconsistency
exists since “special” hedge accounting is optional. For example, both
Kellogg and
General Mills report
that they hedge their commodities positions with derivatives. But Kellogg
uses hedge accounting and General Mills doesn’t. Obviously, this is not
helpful when trying to analyze the differences in their gross margins.
Arbitrary measurement
— The measurement of the assets and liabilities in the hedging relationship
are neither historic cost nor fair value. They are something in between —
what former FASB member Tom Linsmeier dubbed “mutt accounting.” This is not
much different than the insane numbers generated by the FASB’s treatment of
foreign subsidiaries set forth in
SFAS 52, and
which I described in a
recent post as
one of the worst and most divisive accounting standards ever written. One
of the reasons I was particularly harsh in my assessment of SFAS 52 is
because I don’t think that the SFAS 133 fair value hedge accounting
provisions would have been at all palatable (or even considered) if SFAS 52
had not opened up a Pandora’s box of arbitrary accounting measurements.
(And, as we will see later in this post, it also legitimized the concept of
dirty surplus — euphemistically termed “other comprehensive income).
Problem 2b
is that if a company were to enter into a derivative contract for the
purposes of risk reduction, but the risk was not a recognized asset,
liability or firm commitment, then marking the derivative to market through
net income would again increase the volatility of future net income.
However, fair value hedging would not be an effective solution since there
is no recognized hedged item on which the offsetting changes could be lumped
into.
The solution to Problem 2b that the FASB came up with is known as “cash flow
hedging.” It temporarily parks the portions of the gains/losses on marking
the derivative to market that are actually “effective” (more on that term
later) as a hedge in Accumulated Other Comprehensive Income (AOCI). When the
risk being hedged actually hits the income statement, the appropriate
offsetting amounts in AOCI are transferred to net income.
Are you with me so far? These are just the first layers of the onion. I
still have to tell you about additional provisions that can make hedge
accounting very difficult to pull off in practice. Many of these details
Continued in article
August 22, 2016 reply from Bob Jensen
Hi Tom,
In the past your alternatives for derivatives contract accounting
did not distinguish between speculation and hedging with those contracts.
Until you show me an a derivatives contract accounting alternative that does
so I will prefer FAS 133 or IFRS 9. Simply appealing to "full disclosure" is
a cop out since annual reports with over a million footnotes are not
practical.
Your statement that General Mills hedges with derivatives without applying
FAS 133 is misleading. General Mills applies FAS 133 in a backhanded way. I
do not think that any company can simply ignore FAS 133 for derivative
contracts scoped into FAS 133. Here's what General Mills says about using
hedge accounting ---
http://sec.edgar-online.com/general-mills-inc/8-k-current-report-filing/2008/09/17/section10.aspx
Regardless of designation for accounting purposes, we (at General Mills)
believe all of our commodity hedges are economic hedges of our risk
exposures, and as a result we consider these derivatives to be hedges for
purposes of measuring segment operating performance. Thus, these gains and
losses are reported in unallocated corporate expenses outside of segment
operating results
until such time that the exposure we are hedging affects earnings.
At that time we reclassify the hedge gain or loss from unallocated corporate
expenses to segment operating profit, allowing our operating segments to
realize the economic effects of the hedge
without experiencing any resulting mark-to-market volatility,
which remains in unallocated corporate expenses. We no longer have any open
commodity derivatives previously accounted for as cash flow hedges.
Continued in article
Note that General Mills is trying to exclude those
mark-to-market earning fictions
I've talked about in our past debates.
From what I can tell I pretty much go along with the proposed 2016 revisions
in FAS 133 even though I hate some of the previous revisions in IFRS 9. You
seem to think that commodity prices in Chicago can be used satisfactorily
for all commodity inventories. The fact of the matter is that for most
commodities there's a huge difference between commodities held as local
inventory hundreds or thousands of miles from Chicago and the CBOT, CBT,
CBOT, or CME prices in Chicago. Having grown up on an Iowa farm I'm well
aware that the commodities we stored on the farm should not have been valued
at Chicago exchange prices. Firstly, our inventories on the farm differed
greatly in quality from the Chicago exchange standards.
We (on our Iowa farm) held these inventories sometimes because the local
elevator did not want our lower quality inventories. Instead we either fed
our crops to our own livestock or sold them to nearby feeders who would buy
these inventories at serious price discounts. Today's corn farmers are often
selling corn to nearby livestock containment feeding operations for the same
reasons.
Secondly the Chicago exchange prices were quite different from local prices
due to future shipping costs. If you look at the original FAS 133 Appendix
illustrations of hedge ineffectiveness you will find that almost all those
illustrations for commodities focused on hedge ineffectiveness due to
shipping cost ---
http://www.cs.trinity.edu/rjensen/000overview/mp3/000ineff.htm
(Note that the FASB Codification does not include the Appendix illustrations
that were in the original FAS 133 hard copy standard.)
Teaching Case
Cost Accounting and Inventory Valuation
by Bob Jensen:
Differences Between Mark-to-Market Accounting for Derivative Contracts
Versus Commodity Inventories ---
http://faculty.trinity.edu/rjensen/Mark-to-MarketCorn.htm
August 22, 2016 reply from Tom Selling
Bob,
My responses to your
concerns are indented, below:
You wrote: In the past
your alternatives for derivatives contract accounting did not distinguish
between speculation and hedging with those contracts. Until you show me an a
derivatives contract accounting alternative that does so I will prefer FAS
133 or IFRS 9.
Under extant GAAP,
you can: (1) hold a freestanding derivative; (2) “hedge" and apply hedge
accounting, or (3) “hedge" and not apply hedge accounting. I put “hedge”
in quotes, because the FASB has not defined “hedge.” You say you are
happy with SFAS 133 even though it does not, as you demand of me,
distinguish between (1) and (3). That’s because the FASB no longer
defines a “hedge.” Indeed, the whole purpose of SFAS 133 was to supply a
hedge accounting solution without having to actually consider the
difference between hedging and speculation.
You wrote: Simply
appealing to "full disclosure" is a cop out since annual reports with over a
million footnotes are not practical.
I did nothing of the
sort. I would prefer disclosures that allow an analyst to unwind hedge
accounting if they think it is a stupidity (as I do), but it is not a
necessary condition. I want all commodities and financial instruments to be
measured the same way. After that, feel free to screw up the income
statement as much as you please.
You wrote: Your
statement that General Mills hedges with derivatives without applying FAS
133 is misleading. General Mills applies FAS 133 in a backhanded way. I do
not think that any company can simply ignore FAS 133 for derivative
contracts scoped into FAS 133. Here's what General Mills says about using
hedge accounting —
Bob, please be careful
when you use the term misleading. I regard your use of the term very much
like the way you took offense when you thought Zafar called you a liar.
Surely, you can think of a more respectful and appropriate term than
“misleading" … perhaps, “inaccurate”?
That said, I provided a
link to a 10-K. It reads in relevant part as follows:
“We use derivatives
to manage our exposure to changes in commodity prices. We do not perform
the assessments required to achieve hedge accounting for commodity
derivative positions. Accordingly, the changes in the values of these
derivatives are recorded currently in cost of sales in our Consolidated
Statements of Earnings.”
It appear that you
provide a link to an 8-K, which I have not read. As best as I can tell, you
describe GM’s presentation of segment disclosures (where departures from
GAAP are permitted). That’s a far cry from the consolidated financial
statements.
You wrote: From what I
can tell I pretty much go along with the proposed 2016 revisions in FAS 133
even though I hate some of the previous revisions in IFRS 9. You seem to
think that commodity prices in Chicago can be used satisfactorily for all
commodity inventories. The fact of the matter is that for most commodities
there's a huge difference between commodities held as local inventory
hundreds or thousands of miles from Chicago and the CBOT, CBT, CBOT, or CME
prices in Chicago. Having grown up on an Iowa farm I'm well aware that the
commodities we stored on the farm should not have been valued at Chicago
exchange prices. Firstly, our inventories on the farm differed greatly in
quality from the Chicago exchange standards.
Again, “perfection is
the enemy of the good,” even for your family farm. Do you mean to tell me
that your parent’s actually gave a hoot about the historic cost of your corn
after it was harvested? When they asked themselves, “how did we do?” is that
what they talked about?
If you are going to
provide examples of practical barriers, I suggest you use public companies.
And, don’t try to tell me that Kellogg and GM don’t know the current values
of their commodity inventories on a daily basis.
Best,
Tom
August 23, 2016 reply from Bob Jensen
Hi Tom,
You miss the point when you say that our farm's distant (from Chicago) less
than top quality corn would not be valued at Chicago exchange prices.
That's my whole point.
When you hedge most often it will be done with net settlement derivative
contracts priced at Chicago exchange prices. This is what gives rise to
hedging ineffectiveness because your local inventory valuation differs from
the Chicago exchange pricing in your hedging contracts. See the definition
of "ineffectiveness" under the "I" letter at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Therefore, the
extent your hedges are ineffective you are speculating and not hedging
due to those differences in prices between your inventory valuation and
Chicago exchange price valuation of your hedging contracts. To the
extent hedges are effective then you are hedging and should choose to
not show earnings fluctuations to the
extent the hedges are effective (ala General Mills).
To the extent hedges are ineffective you are
speculating and should post the ineffective portion to retained earnings.
The FASB does have a definition of a derivative contract, and I elaborate on
it at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Click on "D" and then scroll down.
For the definition of a hedging contract click on "H" and scroll down.
The IASB's definition differs somewhat from the FASB's definition of a
derivative. Where it gets even messier is in the definitions of derivatives
for macro hedges. A "macro" contract hedges a portfolio with multiple types
of risks with a hedging instrument that only hedges one of those risks. An
exception now allowed under FAS 138 (that amended FAS 133) is a
cross-currency hedge that hedges both FX risk and interest rate (price) risk
simultaneously using one hedging instrument. The IASB and FASB departed when
it comes to accounting for some (very limited) types of macro hedges.
Any USA company that has derivative contracts under the FASB's definition
had better consult its attorneys and auditors before deciding to depart from
FAS 133 and its amendments.
Are you trying to tell us that, unlike in its 8K discussion of derivative
contracts, that General Mills has what the FASB calls derivatives contracts
in its 10K that it elects not to account
for under FAS 133 rules? I really, really doubt that!
One piece of information in the 8K is that General Mills does
not hedge cash flows. If it did so it
would abide by FAS 133 rules or worry about lawsuits.
To the extent that General Mills does have fair value hedging contracts
meeting the FASB definition it does have to resort to FAS 133 for accounting
purposes. An to the extent it acquires other types of hedging contracts
(like cash flow hedges) meeting the FAS 133 definition it will resort to FAS
133 accounting whether in an 8K or a 10K.
If you find an exception in the General Mills 10K please let us and the
auditors and the SEC know about it.
And my parents cared about the historic cost of corn. For one thing this
affected taxes. Secondly when the great scorer comes to write against your
aggregate lifetime profit the aggregate "cash in" versus the aggregate "cash
out" is what determined how good you were as a farmer (adjusted of course
when you butchered your own livestock to eat). All the
unrealized commodity value ups and downs
were fictions --- like it says in the General Mills 8K
that you conveniently selected only part of to quote from my longer
quotation.
Of course my parents looked at current fair values of their inventories.
They even made decisions based on changes in values. But they did that in a
two-column set of financial statements rather than confine themselves to one
fair value column containing fiction accounting
August 23. 2016 reply from Tom Selling
Bob,
We are talking past
each other. I don’t even think you read what I write, even though I
specifically address each of your points. Just for one example, I did not
state that the FASB doesn’t have a definition of a derivative; I stated that
it does not have a definition of “hedge” apart from what “hedge accounting”
is.
This is my last word on
this subject.
Best,
Tom
August 23, 2016 reply from Bob Jensen
FAS 133 does not scope in weather derivatives mostly because the underlying
(e.g., cumulative rainfall for the months of July and August) are not exchange
traded like commodity price underlyings.
ASC 815-45 provides guidance on the financial accounting and reporting for
weather derivatives
ASC 815-45 provides guidance on the financial accounting and reporting for
weather derivatives.
Teaching Cases: Hedge
Accounting Scenario 1 versus Scenario 2
Two Teaching Cases Involving Southwest Airlines, Hedging, and Hedge
Accounting Controversies ---
http://faculty.trinity.edu/rjensen/caseans/SouthwestAirlinesQuestions.htm
Short Summary
"Hedge Effectiveness: The Wild Card in Accounting for Derivatives,"
by Ira C. Kawaller ---
http://www.kawaller.com/pdf/AFP-Hedge Effectiveness.pdf
Also see
http://www.cs.trinity.edu/~rjensen/Calgary/CD/HedgeEffectiveness.pdf
Neither the FASB nor the IASC specify a single method for either assessing
whether a hedge is expected to be highly effective or measuring hedge ineffectiveness.
Tests of hedge effectiveness should be
conducted at least quarterly and on financial statement dates. The appropriateness of a given method can depend on the nature of the risk being
hedged and the type of hedging instrument used. See FAS 133 Appendix A,
Paragraph 62 and IAS 39 Paragraph 151.
Wells Fargo: The Sunny Side of Hedge
Ineffectiveness
By Ed Rombach
Link --- http://www.fas133.com/search/search_article.cfm?page=61&areaid=439
How Wells Fargo's hedge
selection benefits from current climate.
Recent media coverage of
deflationary indicators like the recent CPI announcement of -.3% in
October has prompted some analysts to differentiate between
"bad" deflation caused by monetary policy mistakes and
"good" deflation attributable to increases in labor
productivity. Similarly, when it comes to risk management as practiced
in accordance with FAS 133, a case can be made for differentiating
between "bad" and "good" hedge ineffectiveness.
Since the beginning of the year, with the most aggressive Federal
Reserve rate cutting in memory, financial institutions involved in
mortgage originations, securitization and retention of mortgage
servicing rights (MRS) have been consistently the most prone to
reporting significant hedge ineffectiveness. As the Fed cut the over
night funds rate another 100 basis points during the third quarter,
Wells Fargo & Co, which is included in the Portfolio of '33' took
the prize for hedge ineffectiveness - the good kind.
Specifically, Wells Fargo recognized a gain of $320 million for the
third quarter in non-interest income, representing the ineffective
portion of fair value hedges of mortgage servicing rights. This excess
hedging gain boosted quarterly EPS by $.19 to $.68, accounting for over
23% of third quarter earnings. If only hedge ineffectiveness was always
so kind.
How did Wells Fargo manage to rack
up such robust fair value hedging gains relative to their mortgage
servicing rights? Did they over hedge, or did the actual prepayment
speed of home mortgage re-financing turn out to be less than
anticipated? Perhaps it was a little bit of both.
Wells Fargos's third quarter 10Q
provides some insights about their hedging methodology, indicating that
the ineffectiveness windfall was primarily related to yield curve and
basis spread changes that impacted favorably on the derivative hedges
relative to the hedged exposures in the volatile interest rate
environment.
Divergent spread movement
Subsequent, to June 30 and especially after the September 11 attacks,
swap spreads were volatile but generally tended to narrow in the falling
interest rate environment, as ten-year swap spreads narrowed from 90
basis points on 7/2/01 to 63 basis points on 9/28/01. If the bank had
used Treasury instruments to hedge the prepayment risk on its MRS assets
instead of LIBOR based products, the hedges would have under performed.
However, Wells Fargo's third quarter 10Q discloses that the company uses
a variety of derivatives to hedge the fair value of their MSR portfolio
including futures, floors, forwards, swaps and options indexed to LIBOR.
The yield curve steepens
Moreover, the yield curve continued to steepen during the third quarter
with the yield spread between ten and thirty year Treasuries widening
from 33 basis points out to 88 basis points while the spread between
10yr and 30yr LIBOR swap rates widened from 28 basis points to 65 basis
points. Since the ten-year maturity is the duration of choice for
mortgage hedgers, it follows that these hedges would have out performed
hedges with longer durations.
In connection with this, the
company reported that all the components of each derivative instrument's
gain or loss used for hedging mortgage servicing rights were included in
the measurement of hedge ineffectiveness and was reflected in the
statement of income. However, time decay (theta) and the volatility
components (vega) pertaining to changes in time value of options were
excluded in the assessment of hedge effectiveness. As of September 30,
2001, all designated hedges continued to qualify as fair value hedges.
In addition, all components of each derivative instrument's gain or loss
used to convert long term fixed rate debt into floating rate debt were
also included in the assessment of hedge effectiveness.
There was also some of the bad kind of hedge ineffectiveness which
showed up in Wells Fargo's cash flow hedges which include futures
contracts and mandatory forward contracts, including options on futures
and forward contracts, all of which are used to hedge the forecasted
sale of its mortgage loans. During the third quarter the company
recognized a net loss of $54 million (-$.03 per share), accounting for
ineffectiveness of these hedges, all component gains and losses of which
were included in the assessment of hedge effectiveness.
It would appear that this hedge
ineffectiveness was the flip side of the coin of the ineffectiveness on
the fair value hedges because the futures contracts most commonly used
to hedge this kind of pipeline risk are ten year Treasury note futures
which would have tended to under-performed relative to the value of the
mortgage loans, given the steepening of the yield curve and the general
spread widening of mortgage rates relative to treasuries.
For example, ten year constant
maturity treasury yields fell 86 basis points, from 5.44% on 7/5/01 to
4.58% on 9/27/01 in contrast to the Freddie Mac weekly survey of
mortgage rates reports average 30-year fixed rate mortgages at 7.19% on
7/05/01 or a spread of 1.75% over the ten-year constant maturity
treasury rates, vs. average fixed mortgage rates of 6.72% on 9/27/01 or
a spread of 2.14% over ten-year treasury rates.
The net impact of the $320 million
of excess gains in the fair value hedges vs. net losses of $54 million
in the cash value hedges weighs in at a net hedge ineffectiveness of
$271 million or almost $.16 (16 cents) per share courtesy of a Federal
Reserve policy cutting interest rates with a vengeance. However, the
unprecedented interest rate volatility of this period could well turn
this quarter's ineffectiveness windfall into next quarter's shortfall.
Risk managers should at least be able to take some comfort though from
the fact that the fed can't lower interest rates below zero percent. |
A Great Article!
"A Consistent Approach to Measuring Hedge Effectiveness," by
Bernard Lee, Financial Engineering News --- http://www.fenews.com/fen14/hedge.html
Another Great Article With Formulas
"Complying with FAS 133 Accounting Solutions in Finance KIT," Trema, http://www.trema.com/finance_online/7/2/FAS133_FK.html?7
During the past year Trema has worked with clients,
partners and consulting firms to ensure that all Finance KIT users will be FAS
133 compliant by Summer 2000, when the new U.S. accounting standards come into
effect. In Finance Line 3/99, Ms. Mona Henriksson, Director of Trema (EMEA),
addressed the widespread implications the FAS 133 accounting procedures will
have on the financial industry (see ‘Living Up to FAS 133’ in Finance Line
3/99). Now, in this issue, Ms. Marjon van den Broek, Vice President, Knowledge
Center – Trema (Americas), addresses specific FAS 133 requirements and their
corresponding functionality in Finance KIT.
See software
One Feature of the Proposed
Regulation of OTC Derivatives is Insane
OTC Derivatives Should Be Regulated in Some Respects, But They Should Never Be
Standardized
PwC Notes one of the main reasons
(shown in read) at
Click Here
Why should the right balance be struck when it comes
to regulating OTC derivatives?
Some OTC derivatives have been criticized for
contributing to the financial crisis. But new proposals may affect how all
derivatives are traded and designed.
Most financial derivatives have been safely and
prudently used over the years by thousands of companies seeking to manage
specific risks.
OTC derivatives are privately negotiated because they
are often highly customized. They enable businesses to offset nearly any fi
nancial risk exposure, including foreign exchange, interest rate, and commodity
price risks.
Proposals to standardize terms for all OTC derivatives
could inadvertently limit the ability of companies to fully manage their risks.
Jensen Comment
The reason that it would "limit the ability of companies to fully manage their
risks" is that OTC derivatives are currently very popular hedging contracts
because it is often possible over-the-counter to write customized hedging
contracts that exactly match (in mirror form) the terms of a hedged item
contract or forecasted transaction such that the hedge becomes perfectly
effective over the life of the hedge.
If companies have to hedge with
standardized contracts such as futures and options contracts traded on organized
exchange markets it's either impossible or very difficult to obtain a perfectly
matched and effective hedge. For example, corn futures are traded in contracts
of 25,000 bushels for a given grade of corn. If Frito Lay wants to hedge a
forecasted transaction to purchase 237,000 bushels of corn, it can only
perfectly hedge 225,000 bu. with five futures contracts or 250,000 bu. with six
futures contracts. Hence it's impossible to perfectly hedge 237,000 bu. with
standardized contracts.
However, if Frito Lay wants to
perfectly hedge 237,000 bu. of corn it can presently enter into one OTC forward
contract for 237,000 bu. or an OTC options contract for 237,000 bu. If the
hedged item is eventually purchased in the same geographic region as the hedging
contract (such as Chicago), the hedge should be perfectly effective at all
points in time during the contracted hedging period.
If the hedging contract is written in
terms of a Chicago market and the corn is eventually purchased in a Minneapolis
market, then their may be slight hedging ineffectiveness (due mainly to
transportation cost differences between the two markets), but there is
absolutely no mismatch due to quantity (notional) differences.
Why is customization so important
from the standpoint of accounting and auditing?
Under FAS 133 and IAS 39, hedge accounting relief is available only to the
extent hedges are deemed effective. The ineffective portion of value changes in
the hedging contracts must be posted to current earnings, thereby increasing the
volatility of earnings for unrealized value changes of the hedging contracts.
If new
regulations requiring standardization of OTC derivatives, then the regulations
themselves may dictate that many or most hedging contacts are, at least in part,
ineffective. As a result reported earnings will needlessly fluctuate to a
greater extent due to the regulations rather than because of economic substance.
Dumb! Dumb! Dumb!
In particular, students may want to
refer to the hedge accounting ineffectiveness testing Appendix B Example 7
beginning in Paragraph 144 of FAS 133 and
Appendix A Example 7 beginning in Paragraph 93 of
FAS 133. Bob Jensen's extensions and spreadsheet analysis of the Paragraph 144
illustration are available in Excel worksheet file
133ex07a.xls listed at
http://www.cs.trinity.edu/~rjensen/
Sadly, the FASB left both of these examples, along with the other outstanding
Appendix A and B examples out of its sparse handling of accounting for
derivative financial instruments in its Codification Database.
In particular, Examples 1 thru 10
in Appendix B of FAS 133 are the best places that I know of to learn about hedge
accounting and effectiveness testing. My extended analysis of each example can
be found in the 133ex01a.xls thru 133ex10a.xls Excel workbooks at
http://www.cs.trinity.edu/~rjensen/
My students focused heavily on those ten examples to learn about hedge
accounting. They also learned from my videos 133ex05a.wmv and 133ex08a.wmv files
listed at
http://www.cs.trinity.edu/~rjensen/video/acct5341/
Teaching Cases: Hedge Accounting
Scenario 1 versus Scenario 2
Two Teaching Cases Involving Southwest Airlines, Hedging, and Hedge
Accounting Controversies ---
http://faculty.trinity.edu/rjensen/caseans/SouthwestAirlinesQuestions.htm
Bob Jensen's free tutorials and videos for FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
A number of common effectiveness testing criteria used when implementing FAS
133 include the following from Quantitative Risk Management, Inc. --- http://www.qrm.com/products/mb/Rmbupdate.htm
To provide the maximum flexibility in testing hedge
effectiveness, we now offer the following methods:
- Dollar Offset (DO) calculates the ratio of dollar change in
profit/loss for hedge and hedged item
- Relative Dollar Offset (RDO) calculates the ratio of dollar
change in net position to the initial MTM value of hedged item
- Variability Reduction Measure (VarRM) calculates the ratio of
the squared dollar changes in net position to the squared dollar
changes in hedged item
- Ordinary Least Square (OLS) measures the linear relationship
between the dollar changes in hedged item and hedge. OLS
calculates the coefficient of determination (R2) and the slope
coefficient (ß) for effectiveness measure and accounts for the
historical performance
- Least Absolute Deviation (LAD) is similar to OLS, but employs
median regression analysis to calculate R2 and ß.
|
"Hedging with Swaps: When Shortcut Accounting Can’t be
Applied," by Ira G. Kawaller, Bank Asset/Liability Management, June 2003
--- http://www.kawaller.com/pdf/BALM_Hedging_with_Swaps.pdf
For bank asset/liability management, when
using derivatives, “hedge accounting” treatment is an imperative. It assures
that gains or losses associated with hedging instruments will contribute to
earnings simultaneously with the risks being hedged. Otherwise – i.e., without
hedge accounting – these two effects will likely impact earnings in different
accounting periods, resulting in an elevated level of income volatility that
obscures the risk management objectives of the hedging entity.
For most managers with interest rate
exposures, the desired treatment can be assured if appropriately tailored swaps
contracts serve as the hedging instrument. Under these conditions, entities may
apply the “Shortcut” treatment, which essentially guarantees that the
accounting results will reflect the intended economics of the hedge and that no
unintended income effects will occur. For example, synthetic fixed rate debt
(created by issuing variable rate debt and swapping to fixed), would generate
interest expenses on the income statement that would be indistinguishable from
that which would arise from traditional fixed rate funding. Synthetic instrument
accounting is persevered with the shortcut treatment. Qualifying for the
shortcut treatment also has another benefit of obviating the need for any
effectiveness testing, thereby eliminating an administrative burden and reducing
some measure of the associated hedge documentation obligation.
See Shortcut Method
Great Document
"HEAT Technical Document: A Consistent Framework for Assessing Hedge
Effectiveness Under IAS 39 and FAS 133," JPMorgan, April 24, 2003 ---
http://www.jpmorgan.com/cm/BlobServer?blobtable=Document&blobcol=urlblob&blobkey=name&blobheader=application/pdf&blobwhere=jpmorgan/investbk/heat_techdoc_2Apr03.pdf
I shortened the above URL to http://snipurl.com/JPMorganIAS39
Chapter 1. Introduction
1.1 The accounting background
1.2 Implications for corporate hedging
1.3 What is HEAT?
1.4 How this document is organised
1.5 Terminology
Chapter 2. Intuition behind hedge
effectiveness
2.1 Defining hedge effectiveness
2.2 The concept of the 'perfect hedge'
2.3 Evaluating effectiveness
2.4 Calculating hedge effectiveness in economic terms
2.5 Summary
Chapter 3. Principles of hedge effectiveness
under IAS 39 and FAS 133
3.1 Effectiveness principles and the
concept of the 'perfect hedge'
3.2 Assessing hedge effectiveness
3.3 Methods for testing effectiveness
3.4 Ineffectiveness measurement and recognition
3.5 Summary
Chapter 4. Practical issues surrounding
hedge effectiveness testing
4.1 Example 1: The 'perfect' fair value
interest-rate hedge for a bond
4.2 Example 2: The 'perfect' fair value interest-rate hedge
with payment frequency mismatches
4.3 Example 3: The 'perfect' fair value interest-rate hedge
with issuer credit spread
4.4 Results of different types of effectiveness tests
4.5 Discussion: Lessons for effectiveness tests
Chapter 5. HEAT: A consistent framework for
hedge effectiveness testing
5.1 Overview of the HEAT framework
5.2 Methodologies for hedge effectiveness
5.3 The Ideal Designated Risk Hedge (IDRH)
5.4 Alternative 'types' of effectiveness tests
5.5 Example: Hedging currency risk
5.6 Impact of hedges without hedge accounting
5.7 Summary
References
Appendix
Glossary of working definitions
Also see Software
Minimum value and Paragraph 63 of FAS 133
The minimum value of an American option is zero or its intrinsic value since it
can be exercised at any time. The same cannot be said for a European
option that has to be held to maturity. If the underlying is the price of
corn, then the minimum value of an option on corn is either zero or the current
spot price of corn minus the discounted risk-free present value of the strike
price. In other words if the option cannot be exercised early, discount
the present value of the strike price from the date of expiration and compare it
with the current spot price. If the difference is positive, this is the
minimum value. It can hypothetically be the minimum value of an American
option, but in an efficient market the current price of an American option will
not sell below its risk free present value.
Of course the value may actually be greater due to volatility that adds value
above the risk-free discount rate. In other words, it is risk or
volatility that adds value over and above a risk free alternative to investing.
However, it is possible but not all that common to exclude volatility from risk
assessment as explained in Sub-paragraph b of Paragraph 63 of FAS 133 quoted
below.
a. If the effectiveness of a hedge with an option
contract is assessed based on changes in the option's intrinsic value, the
change in the time value of the contract would be excluded from the
assessment of hedge effectiveness.
b. If the effectiveness of a hedge with an option
contract is assessed based on changes in the option's minimum value, that
is, its intrinsic value plus the effect of discounting, the change in the
volatility value of the contract would be excluded from the assessment of
hedge effectiveness.
c. If the effectiveness of a hedge with a forward
or futures contract is assessed based on changes in fair value attributable
to changes in spot prices, the change in the fair value of the contract
related to the changes in the difference between the spot price and the
forward or futures price would be excluded from the assessment of hedge
effectiveness.
TIME VALUE / VOLATILITY VALUE
Time value is the option premium less intrinsic value
Intrinsic value is the beneficial difference between the strike price
and the price of the underlying
Volatility value is the option premium less the minimum value
Minimum value is present value of the beneficial difference between
the strike price and the price of the underlying
FEATURES OF OPTIONS
Intrinsic Value: Difference between the strike price and the
underlying price, if beneficial; otherwise zero
Time Value: Sensitive to time and volatility; equals zero at
expiration
Sub-paragraph b(c) of Paragraph 63 of FAS 133
c. If the effectiveness of a hedge with a forward or futures contract
is assessed based on changes in fair value
attributable to changes in spot prices, the change in the
fair value of the contract related to the changes in the difference
between the spot price and the forward or futures price would be
excluded from the assessment of hedge effectiveness.
Sub-paragraph b(a) of Paragraph 63 of FAS 133
a. If the effectiveness of a hedge with an option contract is
assessed based on changes in the option's
intrinsic value, the change in the time value of the contract
would be excluded from the assessment of hedge effectiveness.
Sub-paragraph b(b) of Paragraph 63 of FAS 133
b. If the effectiveness of a hedge with an option contract is
assessed based on changes in the option's minimum
value, that is, its intrinsic value plus the effect of
discounting, the change in the volatility value
of the contract would be excluded from the assessment of hedge
effectiveness .
Minimum Value
If the underlying is the price of corn, then the minimum value of
an option on corn is either zero or the current spot price of corn
minus the discounted risk-free present value of the strike price.
In other words if the option cannot be exercised early, discount the
present value of the strike price from the date of expiration and
compare it with the current spot price. If the difference is
positive, this is the minimum value. It can hypothetically be
the minimum value of an American option, but in an efficient market
the current price of an American option will not sell below its risk
free present value.
Minimum (Risk Free) Versus Intrinsic Value
European Call Option
X = Exercise (Strike) Price in n
periods after current time
P = Current Price (Underlying) of Commodity
I = P-X>0 is the intrinsic value using the
current spot price if the option is in the money
M = is the minimum value at the
current time
M>I if the option if the intrinsic value I
is greater than zero.
X = $20 Exercise (Strike) Price and Minimum
Value
M = $10.741
n = 1 year with risk-free rate r = 0.08
P (Low) = $10 with PV(Low) = $9.259
P = $20 such that the intrinsic value now is
I = P-X = $10.
Borrow P(Low), and Buy at $20 = $9.259+10.741 =
PV(Low)+M
If the ultimate price is low at $10 after one
year, pay off loan at P(Low)=$10 by selling at the
commodity at $10. If we also sold a option for
M=$10.741,
ultimately our profit would be zero from the stock
purchase and option sale. If the actual option
value is anything other than M=$10.741, it would
be possible to arbitrage a risk free gain or loss.
|
Minimum Versus Intrinsic Value
American Call Option
X = Exercise (Strike) Price in n periods after
current time
P = Current Price (Underlying) of Commodity
I = P-X>0 is the intrinsic value using the current spot
price if the option is in the money
M = 0 is the minimum value since option can be exercised at
any time if the option’s value is less than intrinsic
value I.
Value of option exceeds M and I due to volatility value |
|
The point here is that options are certain to be effective in
hedging intrinsic value, but are uncertain in terms of hedging time value at all
interim points of time prior to expiration. As a result, accounting
standards require that effectiveness for hedge accounting be tested at each
point in time when options are adjusted to fair value carrying amounts in the
books even though ultimate effectiveness is certain. Potential gains from
options are uncertain prior to expiration. Potential gains or losses from
other types of derivative contracts are uncertain both before expiration and on
the date of expiration.
Paragraph 69 of FAS 133 reads as follows [also
see (IAS 39 Paragraph 152)]:
The fixed rate on a hedged item need not exactly
match the fixed rate on a swap designated as a fair value hedge. Nor does the
variable rate on an interest-bearing asset or liability need to be the same as
the variable rate on a swap designated as a cash flow hedge. A swap's fair
value comes from its net settlements. The fixed and variable rates on a swap
can be changed without affecting the net settlement if both are changed by the
same amount. That is, a swap with a payment based on LIBOR and a receipt based
on a fixed rate of 5 percent has the same net settlements and fair value as a
swap with a payment based on LIBOR plus 1 percent and a receipt based on a
fixed rate of 6 percent.
Paragraph 10c of IAS 39 also addresses net
settlement. IASC does not require a net settlement provision in
the definition of a derivative. To meet the criteria for being a
derivative under FAS 133, there must be a net settlement provision.
The following Section c in Paragraph 65
of FAS 133 is of interest with respect to a premium paid for a forward or futures contract:
c. Either the change in the discount or premium on the forward contract is excluded from the assessment of
effectiveness and included directly in earnings pursuant to Paragraph 63 or the change in
expected cash flows on the forecasted transaction is based on the forward price for the
commodity.
Paragraph 146 of IAS 39 reads
as follows:
146. A hedge is normally regarded as
highly effective if, at inception and throughout the life of the hedge, the
enterprise can expect changes in the fair value or cash flows of the hedged
item to be almost fully offset by the changes in the fair value or cash
flows of the hedging instrument, and actual results are within a range of 80
per cent to 125 per cent. For example, if the loss on the hedging instrument
is 120 and the gain on the cash instrument is 100, offset can be measured by
120/100, which is 120 per cent, or by 100/120, which is 83 per cent. The
enterprise will conclude that the hedge is highly effective.
Delta ratio D
= (D option value)/ D
hedged item value)
range [.80 < D <
1.25] or [80% < D% <
125%] (FAS 133 Paragraph 85)
Delta-neutral strategies are discussed at various points (e.g., FAS 133 Paragraphs 85, 86, 87, and 89)
A hedge is normally regarded as highly effective if, at inception and
throughout the life of the hedge, the enterprise can expect changes in the fair value or
cash flows of the hedged item to be almost fully offset by the changes in the fair value
or cash flows of the hedging instrument, and actual results are within a range of
80-125%
(IAS 39 Paragraph 146). The FASB requires that an entity define at the time it designates a
hedging relationship the method it will use to assess the hedge's effectiveness in
achieving offsetting changes in fair value or offsetting cash flows attributable to the
risk being hedged (FAS 133 Paragraph 62). In defining how hedge effectiveness will be assessed, an entity must specify whether it
will include in that assessment all of the gain or loss on a hedging instrument. The
Statement permits (but does not require) an entity to exclude all or a part of the hedging
instrument's time value from the assessment of hedge effectiveness. (FAS 133 Paragraph 63).
Hedge ineffectiveness would result from the following circumstances, among
others:
a) difference between the basis of the hedging instrument and the hedged item or hedged
transaction, to the extent that those bases do not move in tandem.
b) differences in critical terms of the hedging instrument and hedged item or hedged
transaction, such as differences in notional amounts, maturities, quantity, location, or
delivery dates.
c) part of the change in the fair value of a derivative is attributable to a change in the
counterparty's creditworthiness (FAS 133 Paragraph 66).
"A New Twist To Dollar Offset," by Louis
Schleifer Senior Product Manager, SunGard Treasury Systems --- http://www.fas133.com/search/search_article.cfm?page=11&areaid=392
The dollar-offset method of assessing FAS 133 effectiveness is
inarguably the simplest approach available. By all accounts, it is
also the one most commonly offered by system vendors and, as
anecdotal evidence suggests, most commonly used by corporate
hedgers. However, the basic dollar offset method has one serious
drawback, namely its sensitivity to small price changes. Lou
Schleifer, of SunGard Treasury Systems, argues that this flaw
should not necessarily force companies to turn to alternative,
statistical methods. Rather, he has developed an algorithm that
modifies the dollar-offset method so as to filter-out the noise
associated with small price changes.
Introduction The dollar offset is inarguably the most
straightforward way to approach the assessment of retrospective
and prospective effectiveness under FAS 133. But this simplicity
does not come “free of charge.”
In particular, the original dollar offset approach reacts
aggressively to small changes in prices, creating the potential
for unwarranted noise and potential ineffectiveness. Apparently
some companies and vendors are using this as a reason to abandon
dollar offset entirely, in favor of statistical measures. But, it
may be worthwhile to modify the dollar offset instead, and thereby
retain some of its advantages (e.g., simplicity and its reliance
on existing pricing data), while at the same time eliminating the
possibility that immaterial price moves will trigger an
ineffective result.
This sort of approach, when discussed and determined with
senior management and the company’s auditors, could be used to
illustrate the hedging company’s risk management approach, and
could be codified into its assessment of effectiveness, in a
manner consistent with FAS 133.
Simple, but… The simplicity of the dollar offset method is
immediately evident in its definition (Equation 1):
Dollar Offset = [Change in Fair Value of Hedge] / [Change in
Fair Value of Hedged Item]
In addition to its simplicity, the dollar-offset method has
some other key advantages, including the following:
It relies upon calculations—namely change in fair value
calculations—that are already a required part of FAS133
Accounting. It relies upon data—namely Fair Values of the Hedge
and of the Hedged Item—that must already be captured for FAS 133
accounting; it does not rely upon externally supplied, historical
data series, as many statistical methods do. It is similar to a
hedge ratio calculation., but one based on observed-market values
instead of projected-future-market values (for retrospective
effectiveness, that is), It is sensitive to mismatches in size
between the hedge and the hedged item, unlike most statistical
methods. It can be easily duplicated. Unfortunately, though, there
is one serious flaw with this algorithm: It exhibits unwarranted
behavior when market rates stay relatively static, and therefore
prices change very little over the period in question.
In this situation, intuition tells us that the price changes
observed are financially immaterial—because of their relatively
small size—and represent nothing more than statistical noise
from an otherwise-perfect hedging relationship. As a result, one
would certainly expect to have the effectiveness algorithm—whatever
form it might take—return a result very close to 100 percent, as
this represents a perfect value of retrospective/prospective
effectiveness.
But this is not the case for dollar offset. As both the
numerator and denominator in equation 1 (see above) approach zero,
it is not too hard to see that their ratio can vary widely unless
they coincidentally happen to approach zero in lockstep (a very
unlikely occurrence indeed).
Rebuilding dollar offset from the ground up It seems that the
standard reaction to this state of affairs has been to abandon the
dollar-offset approach altogether, and find a different
calculation (e.g., regression-analysis, or another statistical
method). But there is an alternative, with some mathematical care
(and flair), it is possible to fix the dollar offset algorithm to
ensure that it behaves properly all of the time—even when the
observed price changes are miniscule.
To this end, consider the concept of allowing the hedger to
mathematically quantify his/her definition of financial
immateriality (or “noise”) via a noise-threshold parameter. In
other words, hedgers could determine, mathematically, the level at
which price changes constitute a material change in fair value.
Once this is done, the new-and-improved dollar-offset algorithm
(see below) can compare the actual changes in fair value to the
hedger’s noise-threshold in order to see how relevant these
price changes really are in computing FAS 133
retrospective/prospective effectiveness. Depending upon the result
of this comparison, the new algorithm’s behavior can be split
into one of three possible regimes:
· Regime #1—Small Changes: The observed price changes are
small compared to the user-defined noise-threshold, so the new
algorithm should return a result very close to 100 percent (i.e.,
perfect effectiveness).
· Regime #2—Transition Period: The observed price changes
are on the order of the user-defined noise-threshold, so the new
algorithm should give a result somewhere between what it would
give for Regimes #1 and #3.
· Regime #3—Large Changes: The observed price changes are
large compared to the user-defined noise-threshold, and so the new
algorithm should return a result very close to the dollar-offset
algorithm (see equation 1, above).
To better quantify the concepts just introduced, the following
definitions are made:
DFV {Financial Instrument} = Change in Fair Value of the
specified Financial Instrument over the accounting period in
question. NTN = user-defined value of Noise Threshold (Normalized
value), quoted in basis points. This can be any positive, integral
value. This variable lets the user quantitatively define his level
of financial materiality. MP = Magnitude of the Prices of the
financial instruments being considered. We will define this in
greater detail below. NTA = Noise Threshold (Absolute value),
computed as follows (Equation 2): NTA = MP * (NTN / 10,000)
Defining MP
As one can see from equation 2, above, MP measures the size of
the financial instruments included in a hedging relationship. As a
first approximation, one would probably think to define this size
as the notional amount of the hedges (or the hedged item). But
this is too primitive since it misses the impact that instrument
tenor/characteristics and market rates have on defining the fair
value. So, as a better approximation to measuring size, one might
rather think to take the fair value of the hedges.
Unfortunately, this alternative is even worse. To see why,
consider that each leg of an at-market $10 million notional
Interest-Rate Swap will probably have a fair value somewhere in
the ballpark range of $1 million to $5 million, but these values
perfectly offset each other to result in a net fair value of zero.
This exact—or almost-exact—offsetting of two large fair values
is typical of many derivatives, including IR Swaps, CCIR Swaps,
and FX Forwards.
The ideal approximation to measuring “size” could well be
the present-value of one leg of the derivative. However, consider
the complications that this definition would entail should a
hedging relationship chance to have many derivatives moving into
and out of it over time: This measure of size would have to be
computed on one leg of each one of these derivatives, and then be
prorated for the time that the respective derivative actually
resided in the hedging relationship.
The best compromise is to look to the hedged item. More
specifically, consider using the present-value of only that
portion of the hedged item’s cash flows that are being hedged
with the derivative. This should serve as a good first-order
approximation to the present-value of one leg of the hedging
instrument, without too much computational aggravation. Here is
how to do this:
For an IR Swap: MP = Present-Value of the coupons only on the
hedged item For CCIR Swap: MP = Present-Value of all cash flows on
the hedged item For FX Forward or FX Option: MP = Present-Value of
the foreign-currency leg only of the hedged item Looking Good With
these definitions in place, the stage is now set for the “first
take” on a new dollar offset algorithm. For purposes of
comparison, the reader should recall the definition of the
standard dollar offset algorithm, reiterated here with the new
nomenclature introduced above (Equation 3):
Dollar Offset = DFV {Hedge} / DFV {Hedged-Item}
Contrast the above with the new, single-variable, dollar-offset
algorithm, presented below (and developed by William Lipp [w.b.lipp@ieee.org],
an independent consultant hired by SunGard):
Lipp Modulated Dollar Offset (Equation 4)=
[DFV{Hedge} + NTA] / [DFV{Hedged-Item} + NTA]
Technical Note: An implicit assumption inherent in equation (4)
is that all three variables involved are nonnegative. We can
assure this by taking the absolute value of each variable prior to
invoking the equation. Of course, even before taking this step we
must check to ensure that DFV{Hedge} and DFV{Hedged-Item} have
opposite signs. If they don’t, then there’s no point to even
calculating effectiveness, as we have added to our risk, not
hedged it. In this case, we would simply return with an error
condition (e.g., Effectiveness = 0). Note that in the “Small
Changes” regime, the ratio in equation approaches
NTA / NTA = 1 = 100%
Moreover, in the “Large Changes” regime, the ratio
approaches
DFV {Hedge} / DFV {Hedged-Item}
…which is nothing more than the standard dollar offset, as
given in equation 3. [Equation 4 is currently supported in STS’s
GTM DAS module (“GTM”=“Global Treasury Management”, and
“DAS”=“Derivative Accounting System”).]
During the Transition Period, meanwhile, equation 4 exhibits a
smooth transition between these two regimes. To get a better feel
for the behavior of Lipp’s method, consider Figure 1: The graph
therein illustrates the case of a hypothetical hedging
relationship that satisfies the following criteria across a large
range of possible changes in fair value (from miniscule to
gargantuan):
DFV{Hedge}= 2 *DFV {Hedged-Item},
From the above, it is easy to see that:
Dollar Offset = 2 = 200%
In other words, the hypothetical hedger, in this case
inexplicably used exactly twice as much hedging vehicle as was
required to properly hedge the underlying risk. Although this
would be an egregious mistake were it actually to occur,
nevertheless, it represents an excellent test for Lipp’s method,
since it poses this question: At what range of price changes
should the algorithm first begin to notice this over-hedging?
Figure 1 plots three examples of equation 4, each with a
distinct value of NTN. Viewing these graphs from left-to-right,
the corresponding values of NTN are 10, 500, and 15,000.
The first important observation is that each of these curves
makes a very smooth transition between the Small Changes regime
(where effectiveness is close to 100 percent) and the Large
Changes regime (where effectiveness is close to 200 percent).
But the second observation is that the user now has a “degree-of-freedom”
to play with when defining this curve: The parameter NTN allows
the hedger to define at what level of price changes he wants the
transition to take place. [We note that the X-Axis in Figure 1
gives a new measure of the size of the observed price changes;
this measure is defined below in equation 5.]
And Looking Even Better If one had to find fault with the Lipp
method (equation 4), it might be the following: Although it does
give the user control over defining the onset of the transition
between the two regimes, it doesn’t give him any control over
how fast the transition occurs. The solution is to introduce a
second user-controlled variable into equation 4, as well as an
additional variable that is required by the calculation:
· ST: The speed of the transition, as defined by the user.
Must be a decimal value that is strictly greater than -1.
· MDP: The Magnitude of the observed Price Changes. This is
defined as follows (Equation 5):
MDP = [DFV {Hedge} ^ 2 + DFV {Hedged-Item} ^ 2 ] ^ (1/2)
Make sure not to confuse MP with MDP: The former is a measure
of the size of the instruments contained in our hedging
relationship, whereas the latter is a measure of the size of the
price changes of these same instruments over a period of time.
With these new variables in place, it is now posble to transform
Lipp’s algorithm into a full-fledged, two-variable modification
to the standard dollar offset algorithm. The result (a
modification to Lipp’s algorithm discovered by the author) is:
Schleifer-Lipp Modulated Dollar Offset (Equation 6)=
[DFV {Hedge} * (MDP/ NTA) ^ ST + NTA ] / [DFV {Hedged-Item} * (MDP/
NTA) ^ ST + NTA ]
The only qualification to be made on this result is the
following (Equation 7):
ST > -1
Note: Equation 6 is currently supported in STS’s GTM DAS
module.
Technical Note:
The same proviso that was made on equation (4) is equally
applicable here: namely, we must take the absolute value of the
same three variables that appeared in equation (4), prior to
invoking equation (6). But, once again, we wouldn’t even bother
to use equation (6) if we first saw that DFV{Hedge} and DFV{Hedged-Item}
had the same sign. In this case, we would simply return with an
error condition (e.g., Effectiveness = 0).
If one sets ST = 0 in equation 6, the algorithm obviously
degenerates to equation (4), the first approach at modifying
dollar offset. Given this relationship between the equations, it
should come as no surprise that equation 6 also allows the user to
“place” the transition via the parameter NTN--just as was
possible in equation 4—for any permissible value of ST.
However, should the user choose to start trying non-zero values
of ST in equation 6, he will quickly see that doing so gives him a
new, surprising measure of control over the shape of the
transition period.
As a first observation, if one starts with a value of ST = 0
and begins increasing it, the transition period will start to
shrink—i.e., it will be compressed into continually smaller
intervals along the X-axis. This is the same as saying that the
Small Changes regime and the Large Changes regime begin to
converge on each other. In fact, as ST continues to increase
without bound, the Transition period starts to disappear
completely, as equation (6) mathematically approaches the
discontinuous curve that satisfies these constraints:
If MDP < NTA, Then Effectiveness = 100%
If MDP > NTA, Then Effectiveness = Dollar Offset, as
computed via equation 1
For the second observation, note that if one starts with a
value of ST = 0 and begins to decrease it towards the value of –1,
the transition period will start to lengthen. This is equivalent
to saying that the Small Changes and Large Changes regimes start
receding from each other. But there is no value to actually
setting ST = -1, as doing so in equation 6 results in an
expression that is independent of NTA. This means the graph would
be independent of the size of the price changes observed, and
would therefore be perfectly flat!
Figure 2 aptly illustrates these effects by starting with a
graph of equation 6 that has NTN = 500 and ST = 0. Next, it varies
the values of ST while keeping NTN fixed. As ST is successively
increased to 0.6 and 4.0, the reader can see that the transition
period becomes successively shorter/steeper. Then, as ST is
successively decreased to –0.55 and –0.75, it is clear that
the transition period become successively longer/flatter. In
essence, the parameter ST represents a second “degree-of-freedom”
that is available to the user in equation 6.
Mission Accomplished
The Schleifer-Lipp Modulated Dollar Offset represents the
culmination of the present research effort to enhance the simple
dollar-offset algorithm. Although it is not as simple as dollar
offset, it should be considerably easier to understand than most
statistical methods.
Moreover, as noted in the introduction, it relies upon the fair
values and change-in-fair-values that must already be captured for
performing FAS 133 earnings calculations. Perhaps best of all,
though, is the ease with which one can duplicate equation 6 in a
spreadsheet and test it out on real financial instruments, to get
a feel for what it would predict in real-life situations.
With equation 6 and the two user-definable parameters—NTN and
ST —a hedging corporation should be able to get just about any
type of transition-behavior desired. Of course, just because one
can physically set the noise threshold--NTN--at astronomical
levels and thereby guarantee perpetual effectiveness doesn't
entitle anyone to actually get away with it!
Moreover, it is quite clear that doing so would never even be
in the corporation's best interest, as it is tantamount to denying
that any economic ineffectiveness exists--a serious impediment to
dealing with such ineffectiveness when it actually occurs (and it
will occur!).
The benefit provided by the algorithm is simply this: Instead
of looking far-and-wide at the myriad approaches to measuring
effectiveness—each with its advantages and disadvantages, and
many of which are computationally intensive and mathematically
esoteric—the hedging corporation should be able to convince both
its management and auditors of the reasonableness and practicality
of the approach discussed herein.
This means that the only remaining issue is to hammer out—with
the approval of both management and auditors—the actual values
of the parameters NTN and ST that will be used in equation 6. Once
this is done, these values can be hardwired in the system. And at
that point, the system will be relying upon an effectiveness
algorithm that the hedger, his management, and his auditors can
all understand and defend. |
A bit of a review is provided at
http://www.cfoeurope.com/displayStory.cfm/1736487
Alternative approaches to testing hedge effectiveness under SFAS
No. 133 ---
http://www.allbusiness.com/accounting/methods-standards/209328-1.html
A Listing
of Some Hedge Accounting Restatements for 2005 (see Page 3 of the online
version)
"Lost in the Maze Problems with hedge accounting caused a wave of restatements
in 2005: Are FASB's rules too hard to follow, or are companies simply too
lax?" by Linda Corman, CFO Magazine, May 2005 ---
http://www.cfo.com/article.cfm/6874855/1/c_8435337
Alternative approaches to testing hedge effectiveness under SFAS No. 133 ---
http://www.allbusiness.com/accounting/methods-standards/209328-1.html
Selected IAS 39 Paragraphs on Valuation and
Testing for Hedge Effectiveness
144. There is normally a single fair
value measure for a hedging instrument in its entirety, and the factors
that cause changes in fair value are co-dependent. Thus a hedging
relationship is designated by an enterprise for a hedging instrument in
its entirety. The only exceptions permitted are (a) splitting the
intrinsic value and the time value of an option and designating only the
change in the intrinsic value of an option as the hedging instrument,
while the remaining component of the option (its time value) is excluded
and (b) splitting the interest element and the spot price on a forward.
Those exceptions recognize that the intrinsic value of the option and the
premium on the forward generally can be measured separately. A dynamic
hedging strategy that assesses both the intrinsic and the time value of an
option can qualify for hedge accounting.
145. A proportion of the entire hedging
instrument, such as 50 per cent of the notional amount, may be designated
in a hedging relationship. However, a hedging relationship may not be
designated for only a portion of the time period in which a hedging
instrument is outstanding.
Assessing
Hedge Effectiveness
146. A hedge is normally regarded as highly
effective if, at inception and throughout the life of the hedge, the
enterprise can expect changes in the fair value or cash flows of the
hedged item to be almost fully offset by the changes in the fair value or
cash flows of the hedging instrument, and actual results are within a
range of 80 per cent to 125 per cent. For example, if the loss on the
hedging instrument is 120 and the gain on the cash instrument is 100,
offset can be measured by 120/100, which is 120 per cent, or by 100/120,
which is 83 per cent. The enterprise will conclude that the hedge is
highly effective.
147. The method an enterprise adopts for
assessing hedge effectiveness will depend on its risk management strategy.
In some cases, an enterprise will adopt different methods for different
types of hedges. If the principal terms of the hedging instrument and of
the entire hedged asset or liability or hedged forecasted transaction are
the same, the changes in fair value and cash flows attributable to the
risk being hedged offset fully, both when the hedge is entered into and
thereafter until completion. For instance, an interest rate swap is likely
to be an effective hedge if the notional and principal amounts, term,
repricing dates, dates of interest and principal receipts and payments,
and basis for measuring interest rates are the same for the hedging
instrument and the hedged item.
148. On the other hand, sometimes the hedging
instrument will offset the hedged risk only partially. For instance, a
hedge would not be fully effective if the hedging instrument and hedged
item are denominated in different currencies and the two do not move in
tandem. Also, a hedge of interest rate risk using a derivative would not
be fully effective if part of the change in the fair value of the
derivative is due to the counterparty's credit risk.
149. To qualify for special hedge accounting, the
hedge must relate to a specific identified and designated risk, and not
merely to overall enterprise business risks, and must ultimately affect
the enterprise's net profit or loss. A hedge of the risk of obsolescence
of a physical asset or the risk of expropriation of property by a
government would not be eligible for hedge accounting; effectiveness
cannot be measured since those risks are not measurable reliably.
150. An equity method investment cannot be a
hedged item in a fair value hedge because the equity method recognizes the
investor's share of the associate's accrued net profit or loss, rather
than fair value changes, in net profit or loss. If it were a hedged item,
it would be adjusted for both fair value changes and profit and loss
accruals - which would result in double counting because the fair value
changes include the profit and loss accruals. For a similar reason, an
investment in a consolidated subsidiary cannot be a hedged item in a fair
value hedge because consolidation recognizes the parent's share of the
subsidiary's accrued net profit or loss, rather than fair value changes,
in net profit or loss. A hedge of a net investment in a foreign subsidiary
is different. There is no double counting because it is a hedge of the
foreign currency exposure, not a fair value hedge of the change in the
value of the investment.
151. This Standard does not specify a single
method for assessing hedge effectiveness. An enterprise's documentation of
its hedging strategy will include its procedures for assessing
effectiveness. Those procedures will state whether the assessment will
include all of the gain or loss on a hedging instrument or whether the
instrument's time value will be excluded. Effectiveness is assessed, at a
minimum, at the time an enterprise prepares its annual or interim
financial report. If the critical terms of the hedging instrument and the
entire hedged asset or liability (as opposed to selected cash flows) or
hedged forecasted transaction are the same, an enterprise could conclude
that changes in fair value or cash flows attributable to the risk being
hedged are expected to completely offset at inception and on an ongoing
basis. For example, an entity may assume that a hedge of a forecasted
purchase of a commodity with a forward contract will be highly effective
and that there will be no ineffectiveness to be recognized in net profit
or loss if:
(a) the forward contract is for purchase of the same quantity of the same
commodity at the same time and location as the hedged forecasted purchase;
(b) the fair value of the forward contract at inception is zero; and
(c) either the change in the discount or premium on the forward contract
is excluded from the assessment of effectiveness and included directly in
net profit or loss or the change in expected cash flows on the forecasted
transaction is based on the forward price for the commodity.
152. In assessing the effectiveness of a hedge,
an enterprise will generally need to consider the time value of money. The
fixed rate on a hedged item need not exactly match the fixed rate on a
swap designated as a fair value hedge. Nor does the variable rate on an
interest-bearing asset or liability need to be the same as the variable
rate on a swap designated as a cash flow hedge. A swap's fair value comes
from its net settlements. The fixed and variable rates on a swap can be
changed without affecting the net settlement if both are changed by the
same amount. Update in 2012
"IASB Previews New Hedge Accounting Rules," by Emily Chason, CFO
Report, September 7, 2012 ---
http://blogs.wsj.com/cfo/2012/09/07/iasb-previews-new-hedge-accounting-rules/?mod=wsjpro_hps_cforeport
The draft is available from the IASB ---
Click Here
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Phase-III-Hedge-accounting/Pages/Draft-of-IFRS-General-Hedge-Accounting.aspx
Jensen Comment
Today I must leave early in the morning to take Erika to Concord for a medical
treatment. I've not yet had time to read the above draft in detail. It appears,
however, that this draft for IFRS 9 retains changes in IAS 39 that are
objectionable to me relative to what I think is better in FAS 33 as amended.
Firstly, the thrust of the IFRS 9 changes will be to add more subjectivity
(relative to FAS 133), especially in the area of hedge effectiveness testing.
For example, if a farmer has hedges a growing crop of corn, he is likely to do
so on the basis of standardized corn quality of corn futures and options trading
on the CBOT or CME. It is unlikely that the corn that he ultimately takes to
market will have the identical quality moisture content. In addition he will
have trucking costs of getting his corn from say South Dakota to the trading
market in Chicago. As a result of all this, his hedging contract acquired in
June on the CBOT or CME exchange is not likely to be perfectly effective
relative to the corn he brings to market in October. Thus there will be
hedging ineffectiveness.
The original IAS 39, like FAS 133, had some bright line tests for the degree
to which hedge accounting was allowed when there is hedge ineffectiveness. See
the slide show illustrations at
www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/06effectiveness.ppt
There is greater likelihood that in a particular instance of hedge
ineffectiveness, the original IAS 39 would result in Client A having identical
accounting for the hedge ineffectiveness as Client B. Under the new IFRS 9 this
becomes less assured since clients are given considerable subjective judgment in
deciding how to deal with hedge ineffectiveness.
Also under FAS 133, embedded derivatives in financial contracts must be
evaluated and if the embedded derivative's underlying is not "clearly and
closely related" to the underlying in the host contract, the embedded
derivatives must be bifurcated and accounted for separately. This leads to a lot
of work finding and accounting for embedded derivatives. IFRS 9 will eliminate
all that work by not making clients look for embedded derivatives. Hence, the
risk that comes from having embedded derivative underlyings not clearly and
clossely associated with the underlyings of the host contract can simply be
ignored. I don't by into this IFRS 9 bad accounting for the sake of
simplification.
I think there are other areas of difference expected differences between IFRS
9 and FAS 133 as amended. Most of the differences lie in the subjectivity
allowed in accounting for hedging contracts under IFRS 9 that is not allowed in
FAS 133.
September 10, 2012 reply from Bob Jensen
This afternoon received a message from PwC about the IASB's proposed
changes to hedge accounting. The PwC reply is consistent with, albeit
somewhat more extensive, then my reply that I sent to the AECM early this
morning.
The PwC response is at ---
Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8Y2HHH&SecNavCode=MSRA-84YH44&ContentType=Content
Note that the IASB is not really opening up these proposed hedge
accounting amendments to comments. Wonder why?
Also note that the proposed IASB's amendments diverge from rather than
converge toward U.S. GAAP under FAS 133 as amended. At this point in time I
don't think the IASB really cares about convergence of hedge accounting
rules.
My quick and dirty response is that the revised hedge accounting
standards under IFRS 9 is carte blanche for having two different clients and
their auditors account differently for identical hedge accounting
transactions because so much subjectivity will be allowed under IFRS 9. We
may even have subsidiaries of the same client accounting for identical
transactions differently.
Such is the myth of comparability one is supposed to get under
principles-based global standards.
Further more, it may challenge auditing Firm X that has one client
claiming a hedge is effective when another client would claim the hedge is
ineffective. Will auditing Firm X certify divergent accounting for the same
hedge. The answer is probably yes these days if both clients are too big to
lose.
Bob Jensen
So Much for the Myth That Accounting Standards Are Neutral in Terms of
Business Strategy (of course it did not take IFRS 9 to reveal this to us)
"Under New Accounting Standard, CFOs Could Change Hedging Strategies:
Will finance chiefs come under more pressure to adopt hedge accounting —
even though it remains entirely optional under the new standard?"
by Andrew Sawyers
CFO.com, September 12, 2012
http://www3.cfo.com/article/2012/9/gaap-ifrs_hedge-accounting-ias-39-iasb-ifrs-derivatives-80-125-test-hedge-effectiveness
A new international financial reporting standard (IFRS) on hedge
accounting could prompt finance chiefs to change their companies’
hedging strategies under a more accommodating, principles-based
regime that requires less testing. The International Accounting
Standards Board (IASB) has been pondering hedge accounting for
several years in an effort to find a way to replace the unloved
standard IAS 39: so unloved that it’s not part of the package of
accounting standards endorsed by the European Commission for listed
companies. The standard has made it tough to employ hedge
accounting, which can be favorable to companies in certain
circumstances.
In
a recent podcast, Kush Patel, director in
Deloitte’s U.K. IFRS Centre of Excellence, summarized the impact of
the new rules: “More hedge-accounting opportunities,
less profit and loss volatility —
so as you’d expect, this has been well received.”
Under IAS 39, he said, “we saw a lot of companies change the way
they manage risk: we saw them reduce the amount of complex,
structured derivatives that were being used to hedge and they went
for more vanilla instruments that could [qualify for] hedge
accounting more easily. Now that IFRS 9 will remove some of these
restrictions, I think it’s fair to say risk management could
change.”
Andrew Vials, a technical-accounting partner at KPMG, said in a
statement, “A company will be able to reflect in its financial
statements an outcome that is
more consistent with how management assesses and mitigates risks
for key inputs into its core business.”
Will CFOs come under more pressure to adopt hedge accounting —
even though it remains entirely optional under the new standard? “If
hedge accounting becomes easier, there may be more emphasis on them
to achieve hedge accounting — so although it’s voluntary, there is
an element that they may feel more compelled to do hedge accounting”
says Andrew Spooner, lead global IFRS financial-instruments partner
at Deloitte.
The
final draft of the new hedge-accounting rules
was published on September 7 and will be
incorporated into the existing IFRS 9 Financial Instruments
at the end of the year. The IASB says it’s not seeking comments on
this final draft, but is making it available “for information
purposes” to allow people to familiarize themselves with it. The new
rules will take effect from January 1, 2015, but companies will be
allowed to adopt them sooner if they wish.
Spooner and Patel note three main areas in which the new rules
are different from the old:
Changes to the instruments that qualify. It’s
now easier, for example, to use option contracts without increasing
income-statement volatility.
Changes in hedged items. It may not be possible,
for example, for a company to hedge the particular type of coffee
beans a food company buys. But it could hedge a benchmark coffee
price, because it is closely related to the item it would like to
hedge. Another change for the better: companies in the euro zone
that want to hedge dollar purchases of oil can now more easily hedge
the dollar price of the oil, then later hedge the foreign-exchange
exposure without the oil-price hedge being deemed ineffective. There
are also more favorable rules for hedging against credit risk and
inflation.
Changes to the hedge-effectiveness requirements.
Under IAS 39, a company could use hedge accounting only if a hedge
is “highly effective,” meaning it must be capable of offsetting the
risk by a range of 80%–125%. But the 80–125 test has been scrapped
to be replaced by a principle-based test that is based on economic
relationship: “You have to prove that there is a relationship
between the thing you are hedging and the thing you are using,” says
Patel. Having gotten rid of the quantitative threshold, there are
“more opportunities for companies to reduce the amount of testing
they do,” he says. “It’s a welcome change.”
Continued in article
"IASB Previews New Hedge Accounting Rules," by Emily Chason, CFO
Report, September 7, 2012 ---
http://blogs.wsj.com/cfo/2012/09/07/iasb-previews-new-hedge-accounting-rules/?mod=wsjpro_hps_cforeport
The PwC response is at ---
Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8Y2HHH&SecNavCode=MSRA-84YH44&ContentType=Content
The draft is available from the IASB ---
Click Here
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Phase-III-Hedge-accounting/Pages/Draft-of-IFRS-General-Hedge-Accounting.aspx
Bob Jensen's free tutorials on accounting for derivative financial
instruments and hedging activities ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
|
Hedge Accounting
Ira has a new posting for those of you into hedge scholarship, research, and
hedge accounting ---
http://www.kawaller.com/pdf/AFP_ExpectTheUnexpected.pdf
Bob Jensen's 06Effectiveness.ppt PowerPoint file on
effectiveness accounting for hedging instruments is included in the dog and pony
show listing at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/
It saddens me that the IASB appears to be watering down effectiveness testing as
IAS 39 is folded into IAS 9. It's just more and more principled-based mush.
June
29, 2001 |
By Ed Rombach and Nilly Essaides
Link --- http://www.fas133.com/search/search_article.cfm?page=81&areaid=404
The biggest question mark of FAS
133 remains its impact on EPS and stock price. While it’s
still early days on FAS 133 reporting (see FAS
133’s Impact on Earnings), there are some clues in
Q1/10Q as to what FAS 133 reveals (or does not; see Earnings
Analysis: What FAS 133 Does Not Show).
In a recent exchange of information between
two fund managers on an internet chat room, one responded
quite viscerally to published derivatives losses at GE and
AIG. “You were right to shed yourself from GE, AIG
etc.,” he wrote. “GE is highly questionable and
overvalued and their derivatives book has significant
exposure, took a $1.2 billion loss recently, probably more
to come [sic]. AIG loves ‘toxic waste’ as well.”
This reaction came despite GE’s
explanation that its first quarter, $1.2bn loss will be
mainly offset by changes in floating-rate interest costs.
Perhaps more telling, however, is the
fact that this fund manager appears to be in the minority.
Overall, the market shrugged off the reported loss. On the
day of the 10Q release (4/19/01), GE’s stock closed at
$48.51. It weakened slightly for the next few days, before
resuming its uptrend and peaking at $53.40 on 5/21/01.
Further drilling into GE’s headline
derivatives losses reveals that the overall loss was
comprised of smaller charges, with the biggest component
being a one-time transition charge at adoption. Further, the
effects of FAS 133’s reporting on GE’s financials can be
separated into two:
(1) FAS 133
impact on income:
·
Fair-value hedge losses of
$503 million in the quarter ending March 31.
·
An additional $53 million in losses net of
taxes reclassified to earnings from shareholders equity (OCI).
·
A $68 million gain in hedges of net investment
that did not qualify for effectiveness (most likely
derivative or cash positions that do not qualify for hedge
accounting under FAS 133, and recorded in “interest and
other financial charges).
(2) FAS 133 impact on Equity/OCI:
·
A transition adjustment loss of $827 million.
·
A $64 million derivative gain attributable to
hedges of net foreign investments that met the effectiveness
measure (in a separate equity component related to currency
translation adjustments).
Importantly, GE’s first quarter
derivative returns contained an insignificant $3 million
negative charge for ineffective hedges of future cash flow
(i.e., cash flow hedges). Also, it included a $1 million
negative charge for “amounts excluded from the measure of
effectiveness,” or derivatives that do not qualify as
hedges under FAS 133. The combined amount is less than three
one hundredths of one cent per share net effect on earnings.
The bottom line: Of the
reported $1.2 billion in losses, the largest portion was
related to the one-time transition adjustment. Another $503
million was a loss offset by gains on the underling I/R
position. The actual losses attributable to ineffectiveness
or derivatives that must be marked to market in income –
the sort of hit to income analysts and treasurers have
feared—totaled $4 million, and are immaterial at best.
Why is GE disclosing this
information? It may be that GE wants to make sure that
it is meticulous in its presentation, leaving no stone
unturned. It may also be making a point with regard to the
efficacy of its hedging. Further, and perhaps most
important, GE is laying out the “base line” for future
analysis of its FAS 133 reports. Of course, if future
quarters produce massive swings in these numbers, analysts
would surely take notice.
|
|
FEDERATION
BANCAIRE DE L'UNION EUROPEENNE Provides a great free document on macro
hedging with references to IAS 39. The article also discusses
prospective and retrospective effectiveness testing.
"MACRO
HEDGING OF INTEREST RATE RISK," April 4, 2003 --- http://www.fbe.be/pdf/Macro%20Hedging%20of%20Interest%20Rate%20Risk.pdf
Trinity Students may access this article at J:\courses\acct5341\ResearchFiles\00macroHedging.pdf
Macro hedging is the hedging of a portfolio of
assets and liabilities for the same type of risk. This differs from
hedging a single instrument or a number of the same type of assets (or
liabilities) as there is risk offsetting between the assets and
liabilities within the portfolio.
This form of hedging occurs not at a
theoretical ‘consolidated Group’ level, but at an operational level,
where individual assets and liabilities in the portfolio can be clearly
identified. Within one banking group, several macro hedge portfolios for
different activities may be separately managed at an operational level.
. . .
I.C Hedging the ‘Net Position’
Building a portfolio requires aggregating the necessary information
(data) of all assets and liabilities that share the same risk to be
hedged. Although systems differ, there is general agreement that the
hedging process involves identification of notional amounts and
repricing dates. As the economic risks of some financial instruments
differ from their contractual terms, they have to be modelled to reflect
their true economic effect on interest rate risk management. They are
therefore included based on their behaviouralized repricing dates
(statistical observations of customer behaviour) rather than their
contractual repricing dates. These types of contracts include for
example demand deposits, some (often regulated) saving accounts and
prepayable loans.
The notional amounts of these assets and
liabilities in the portfolio are then allocated to defined repricing
buckets. Based on this allocation, the mismatch between assets and
liabilities in each repricing bucket is derived, which is the net
position.
For each net position, the company can decide
whether it wants to hedge it fully or a portion of it. The extent of
hedging to be undertaken is determined by the interest rate risk
management strategy and is therefore a management decision as mentioned
earlier in Section I.A.
See macro hedge.
Ira Kawaller explains that the common 80/25 rule
described above is not statistically correct. See "The
80/125 Problem," Derivatives Strategy, March 2001
Flow Chart for FAS 133 and
IAS 39 Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Differences between FAS 133 and IAS 39
---
http://faculty.trinity.edu/rjensen/caseans/canada.htm
Intrinsic Value Versus Full Value Hedge Accounting ---
http://faculty.trinity.edu/rjensen/caseans/IntrinsicValue.htm
The above document discusses Delta hedging
Vendors of Effectiveness Tests
The table below summarizes what some
different software vendors say their systems can do for effectiveness
analysis. It is based on the responses to our FAS133.com
Show-Me survey and Addendum section.
Vendor/Product
|
Does
the System support actual and prospective testing?
|
What
methodologies are supported?
|
Alterna
Technologies Group Inc.
Auros
|
Yes
|
Dollar
offset/ratio for both prospective and actual effectives.
Additional
effectiveness testing methods are being added. The sequence of
implementing additional calculation methods is determined along with
our customers.
|
Selkirk
Financial Technologies, Inc.
Treasury
Manager™
|
Yes
|
Dollar
offset/ratio for both prospective and actual.
Additional
methods are available with results calculated externally.
|
FXpress
Corp.
FXpress™
|
Yes
|
Dollar
offset/ratio for both prospective and actual (cumulative or period by
period). Projected rate scenarios can be saved and used for
prospective effectiveness testing. Additional statistical methods for
prospective effectiveness will be supported in a future update
|
INNSINC
Futrak
2000
|
Yes
|
Dollar
offset/ratio for both. (Futrak® 2000 uses the Change in Variable Cash
Flow Method (see Method 1 - Statement 133 Implementation Issue No. G7)
|
SunGard
Treasury Systems
GTM
|
Yes
|
At
present, users have the choice of six different methodologies. The
first two are periodic and cumulative dollar offset. The other four
are proprietary and meant to address the shortcomings of dollar
offset.
|
Integrity
Treasury Solutions
integra-T
|
Yes
|
Index
correlation and regression: verifying that coefficient of correlation
is greater than 0.9 or a user specified value and/or verifying that
the R-square of a linear regression is greater than 0.8 or user
specified value.
Ratio
Test: verifying that the gain/loss on derivative and the hedged risk
are offsetting and the ratio of their magnitudes are within the
80-125% range or other user specified range.
Short
Cut Method: Validation of terms prescribed by the standard.
Critical
Terms Matching: Validation of terms that verify an assumption of
"No Ineffectiveness" for hedges that don't qualify for the
Shortcut Method (e.g. FX hedges)
|
Open
Link Financial
Endur/Findur
|
Yes
|
Endur
and Findur are fully integrated trading and risk management systems.
Accordingly, we support rolling VaR (monte carlo and/or parametric),
Duration, Simulation and Scenario Shock (what-if), Delta Value, etc.
for the calculation oustomize effectiveness calculations. All
necessary data is stored in the database and can be used with the FAS
Analyzer to determine effectiveness
|
FinancialCAD®
Corporation
The
Perfect Hedge (formerly fincad.com)
|
Yes
|
Prospective
method supported is a variance reduction method.
Retrospective
method supported is dollar offset/ratio.
|
SunGard
Treasury Systems
Quantum
|
Yes
|
The
System supports dollar offset and regression.
|
SAP
CFM
|
Only
actual (no prospective).
|
Dollar
offset/raio, based on spot values, cash flow differences forward, cash
flow differences forward discounted/ all either using clean values
(i.e. taking interest accruals into account) or not, FX option
intrinsic value based on spot rates, option intrinsic value based on
forward rates, option intrinsic value based on forward discounted
rates, present value (clean price or nonclean), benchmark (again,
clean or not).
|
Principia
Partners
Principia
Analytic Systems (PAS)
|
Yes
|
Method
is dependent on the needs of the client; the system can handle a wide
variety of methods including retrospective hedge analysis, dollar
offset, etc.
|
XRT
Treasury
Workstation (TWS) and Globe$
|
Yes
|
Dollar
offset/ratio for both. (System supports ability select effectiveness
testing and valuation using spot-spot or forward-forward methods.)
|
Trema
Treasury Management
Finance
Kit
|
Yes
|
Dollar
offset. Or, for prospective effectiveness, the system can run reports
to show that the critical terms match (for relevant cases, e.g. FX
risk hedge with forward), or we can take a hedge relationship and run
it through simulation. For example, for a FX risk hedge, we can
simulate the effect of FX rate change +/-5% (or any user-defined
range) and the system returns the calculated values for both the hedge
and the hedged item at selected intervals (...-1%, -0.5%, +0.5%,
+1%...), allowing us to prove that the values will offset each other.
Similarly, we can simulate the effect of e.g. Libor change on the
future values of IRS hedge and hedged debt instrument.
|
Reval.com
|
Yes
|
Dollar
offset method, on the basis of: Spot, Forward, Intrinsic Value,
Minimum Value and Full Fair Market Value Method. Can support
effectiveness testing using user defined and performed regression
methodologies.
|
Wall
Street Systems
Wall
Street Systems®
|
Yes
|
The
dollar offset method for prospective and actual effectives. For
prospective, the application calculates the present value (PV) of all
future cash flows as well as maintains the historical change in actual
values. For retrospective assessment, the user has the chose to elect
to compare the actual change in values, actual change in floating leg
cash flow values, and even the actual change in the fixed leg cash
flows. For prospective assessment the application uses the PV of the
future cash flows.
|
Also see risk metrics and software.
JOURNAL OF DERIVATIVES ACCOUNTING
Hedge Effectiveness Analysis Toolkit
Vol. 1, No. 2 (September 2004) out now!! In this issue issue of JDA, Guy
Coughlan, Simon Emery and Johannes Kolb discuss the Hedge
Effectiveness Analysis Toolkit, which is JPMorgan’s latest
addition to a long list of innovative and cutting-edge risk management
solutions. View the Table of Contents @ http://www.worldscinet.com/jda/01/0102/S02198681040102.html!
October 11, 2002 message from Ira [kawaller@lb.bcentral.com]
If you, your
colleagues, or your customers have hedge effectiveness testing requirements
under FAS 133, and you're having difficulty designing regression tests for
this purpose, this article (co-authored with my friend and client, Reva
Steinberg of BDO Seidman, and originally published in "AFPExchage")should
be of interest:
http://www.kawaller.com/pdf/AFP_Regression.pdf
Otherwise... never
mind.
In either case, visit
the Kawaller & Company website to find other articles/information dealing
with a host of issues relating to derivatives.
I hope you'll find
this material to be useful and would welcome your questions, comments, or
suggestions.
Ira Kawaller
Kawaller & Company, LLC
http://www.kawaller.com
kawaller@kawaller.com
(718)694-6270
For interest rate swaps, especially note the section of Short-Cut
Method for Interest Rate Swaps.
See further paragraphs 73-103 for illustrations of assessing effectiveness and measuring
ineffectiveness:
Example 1: Fair Value Hedge of Natural Gas Inventory with Futures Contracts
(FAS 133 Paragraphs
73-77)
Example 2: Fair Value Hedge of Tire Inventory with a Forward Contract
(FAS 133 Paragraphs 78-80)
Example 3: Fair Value Hedge of Growing Wheat with Futures Contracts
(FAS 133 Paragraphs 81-84)
Example 4: Fair Value Hedge of Equity Securities with Option Contracts
(FAS 133 Paragraphs 85-87)
Example 5: Fair Value Hedge of a Treasury Bond with a Put Option Contract
(FAS 133 Paragraphs 88-90)
Example 6: Fair Value Hedge of an Embedded Purchased Option with a Written Option
(FAS 133 Paragraphs 91-92)
Example 7: Cash Flow Hedge of a Forecasted Purchase of Inventory with a Forward Contract
(FAS 133 Paragraphs 93-97)
Example 8: Cash Flow Hedge with a Basis Swap
(FAS 133 Paragraphs 98-99)
Example 9: Cash Flow Hedge of Forecasted Sale with a Forward Contract
(FAS 133 Paragraphs 100-101)
Example 10: Attempted Hedge of a Forecasted Sale with a Written Call Option
(FAS 133 Paragraphs 102-103)
My understanding
is that the “long haul” method is any situation where the stringent tests for
shortcut method do not hold. Thus tests for ineffectiveness must be conducted at
each reset date. This is problematic for swaps and options especially since the
market for the hedged item entails a different set of buyers than the market for
the hedging instrument, thereby increasing the likelihood of ineffectiveness.
I do not have a
spreadsheet illustration of ineffectiveness testing for interest rate swaps, but
the tests I assume are the same as those tests used for other hedges. Some
analysts assume that the “long haul” method applies to regression tests (as
opposed to dollar offset), and regression tests (unlike dollar offset tests)
cannot be applied retrospectively. See “Shortcut Method” at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#S-Terms
Also see
http://www.accountingweb.com/cgi-bin/item.cgi?id=101227&d=815&h=817&f=816&dateformat=%25o%20%25B%20%25Y
|
DIG Issue E7 at http://www.fasb.org/derivatives/
Title: Hedging—General: Methodologies to Assess Effectiveness of
Fair Value and Cash Flow Hedges
Paragraph references: 20(b), 22, 28(b), 62, 86, 87
Date released: November 1999
QUESTION
Since Statement 133 provides an entity with flexibility in choosing
the method it will use in assessing hedge effectiveness, must an entity
use a dollar-offset approach in assessing effectiveness?
BACKGROUND
Paragraph 20(b) of Statement 133 states, in part:
Both at inception of the [fair value] hedge and on an ongoing basis,
the hedging relationship is expected to be highly effective in achieving
offsetting changes in fair value attributable to the hedged risk during
the period that the hedge is designated. An assessment of effectiveness
is required whenever financial statements or earnings are reported, and
at least every three months. Paragraph 28(b) indicates a similar
requirement that the hedging relationship be expected to be highly
effective in achieving offsetting changes in cash flows attributable to
the hedged risk during the period that the hedge is designated.
Paragraph 22 of Statement 133 states, in part:
The measurement of hedge ineffectiveness for a particular hedging
relationship shall be consistent with the entity’s risk management
strategy and the method of assessing hedge effectiveness that was
documented at the inception of the hedging relationship, as discussed in
paragraph 20(a). Nevertheless, the amount of hedge ineffectiveness
recognized in earnings is based on the extent to which exact offset is
not achieved. Paragraph 62 emphasizes that each entity must "define
at the time it designates a hedging relationship the method it will use
to assess the hedge’s effectiveness in achieving offsetting changes in
fair value or offsetting cash flows attributable to the risk being
hedged." It also states, "This Statement does not specify a
single method for either assessing whether a hedge is expected to be
highly effective or measuring hedge ineffectiveness."
RESPONSE
No. Statement 133 requires an entity to consider hedge effectiveness
in two different ways-in prospective considerations and in retrospective
evaluations.
Prospective considerations. Upon designation of a hedging
relationship (as well as on an ongoing basis), the entity must be able
to justify an expectation that the relationship will be highly effective
over future periods in achieving offsetting changes in fair value or
cash flows. That expectation, which is forward-looking, can be based
upon regression or other statistical analysis of past changes in fair
values or cash flows as well as on other relevant information.
Retrospective evaluations. At least quarterly, the hedging entity
must determine whether the hedging relationship has been highly
effective in having achieved offsetting changes in fair value or cash
flows through the date of the periodic assessment. That assessment can
be based upon regression or other statistical analysis of past changes
in fair values or cash flows as well as on other relevant information.
If an entity elects at the inception of a hedging relationship to
utilize the same regression analysis approach for both prospective
considerations and retrospective evaluations of assessing effectiveness,
then during the term of that hedging relationship those regression
analysis calculations should generally incorporate the same number of
data points. Electing to utilize a regression or other statistical
analysis approach instead of a dollar-offset approach to perform
retrospective evaluations of assessing hedge effectiveness may affect
whether an entity can apply hedge accounting for the current assessment
period as discussed below.
Paragraph 62 requires that at the time an entity designates a hedging
relationship, it must define and document the method it will use to
assess the hedge’s effectiveness. That paragraph also states that
ordinarily "an entity should assess effectiveness for similar
hedges in a similar manner; use of different methods for similar hedges
should be justified." Furthermore, it requires that an entity use
that defined and documented methodology consistently throughout the
period of the hedge. If an entity elects at the inception of a hedging
relationship to utilize a regression analysis approach for prospective
considerations of assessing effectiveness and the dollar-offset method
to perform retrospective evaluations of assessing effectiveness, then
that entity must abide by the results of that methodology as long as
that hedging relationship remains designated. Thus, in its retrospective
evaluation, an entity might conclude that, under a dollar-offset
approach, a designated hedging relationship does not qualify for hedge
accounting for the period just ended, but that the hedging relationship
may continue because, under a regression analysis approach, there is an
expectation that the relationship will be highly effective in achieving
offsetting changes in fair value or cash flows in future periods. In its
retrospective evaluation, if that entity concludes that, under a
dollar-offset approach, the hedging relationship has not been highly
effective in having achieved offsetting changes in fair value or cash
flows, hedge accounting may not be applied in the current period.
Whenever a hedging relationship fails to qualify for hedge accounting in
a certain assessment period, the overall change in fair value of the
derivative for that current period is recognized in earnings (not
reported in other comprehensive income for a cash flow hedge) and the
change in fair value of the hedged item would not be recognized in
earnings for that period (for a fair value hedge).
If an entity elects at the inception of a hedging relationship to
utilize a regression analysis (or other statistical analysis) approach
for either prospective considerations or retrospective evaluations of
assessing effectiveness, then that entity must periodically update its
regression analysis (or other statistical analysis). For example, if
there is significant ineffectiveness measured and recognized in earnings
for a hedging relationship, which is calculated each assessment period,
the regression analysis should be rerun to determine whether the
expectation of high effectiveness is still valid. As long as an entity
reruns its regression analysis and determines that the hedging
relationship is still expected to be highly effective, then it can
continue to apply hedge accounting without interruption.
In all instances, the actual measurement of hedge ineffectiveness to
be recognized in earnings each reporting period is based on the extent
to which exact offset is not achieved as specified in paragraph 22 of
Statement 133 (for fair value hedges) or paragraph 30 (for cash flow
hedges). That requirement applies even if a regression or other
statistical analysis approach for both prospective considerations and
retrospective evaluations of assessing effectiveness supports an
expectation that the hedging relationship will be highly effective and
demonstrates that it has been highly effective, respectively.
The application of a regression or other statistical analysis
approach to assessing effectiveness is complex. Those methodologies
require appropriate interpretation and understanding of the statistical
inferences. |
DIG Issue F5 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuef5.html
Basing the Expectation of Highly Effective Offset on a Shorter Period
Than the Life of the Derivative
(Cleared 11/23/99) |
Inflation
Indexed Embedded Derivative =
an embedded derivative that alters payments
on the basis of an inflation index. Paragraph 61b on
Page 41 of FAS 133 defines these payments as clearly-and-closely
related such that the embedded derivative cannot be accounted for separately under
Paragraph 12 on Page 7. This makes embedded inflation indexed derivative accounting different
than commodity indexed and equity
indexed embedded derivative accounting rules that require separation from the host
contract such as commodity indexed, equity indexed, and inflation indexed embedded
derivatives. In this regard, credit indexed embedded derivative accounting is more
like credit indexed derivative accounting. See
derivative financial instrument and embedded derivatives.
Initial Investment = see premium.
Insurance
Contracts =
a complex set of contracts to manage future
casualty risks. Contracts manage financial instrument risks are not insurance
contracts under FAS 133. In general, insurance contracts are covered by prior FASB standards rather
than FAS 133. However, the FASB did take steps to discourage the interpretation of
derivative contracts as insurance contracts just to avoid FAS 133. Important sections of
FAS 133 dealing with insurance include Paragraphs 10 and 277-283.
Note the exception in DIG
C1.
Bob Jensen's July 2, 2009 message to Tom
Selling
Hi Tom,
I
define insurance as risk management via actuary science. Actuaries only deal
with data that has persistent and reliable linkage of the past with the
future --- historical data that can be objectively extrapolated to future
loss risks. Before using the term "insurance," think of whether there are
actuary tables for the item you are calling insurance. Insurance companies
then offer contracts that will spread actuary-determined risk among buyers
subjected to such risks.
Hedging with derivative financial instruments scoped into FAS 133 never, at
least virtually never, entails contracts for which there are actuarial
tables that estimate risks. There is a huge gray zone between insurance and
derivatives such as weather derivatives for which there are actuary tables.
But these gray zone derivatives are not scoped into FAS 133 or IAS 39. There
is also a gray zone of derivatives in wagering such as wagers on sporting
events. These are not scoped into FAS 133.
Another indirect difference between insurance and derivatives entails how
risk is managed and spread. With derivatives risk is managed between two
parties --- the party and the counterparty to a derivative contract. The
contracts can be, and often are, over-the-counter derivatives that are not
traded on any exchange. With insurance risk is managed by spreading the risk
among all buyers of a virtually identical contracts such as home and auto
insurance sold by a particular company that is spreading the potential loss
coverage among all buyers of the insurance.
If a Farmer A contracts with his Neighbor B such that the Neighbor B
agrees to reimburse Farmer A for weather-related damage to crops, this is
not insurance as I define insurance. I think the term "insurance" should be
restricted to instances where there are many buyers of protection who are
spreading the risk with the actuarially-determined risk to the entire set of
buyers. There are no actuarial tables for just Farmer A's plot of land.
There are actuarial tables for hail, wind, fire, and flood damage for the
entire state of Iowa.
June 30 and July 31, 2009 replies by Tom Selling and BOB JENSEN
Hi, Bob:
All of my responses you
will be in italics, below.
Tom Selling
Bob Jensen
What you are really arguing is that accounting for most derivatives should
not distinguish “asymmetric-booking” hedging derivative contracts
from speculation derivative contracts. I argue that failure to
distinguish between hedging and speculation is very, very, very, very
misleading to investors. I do not think FAS 133 is an “abject failure.”
Quite to the contrary (except in the case of credit derivatives).
Tom Selling
What is your evidence that failure to distinguish between hedging and
speculation is misleading to investors? My own anecdotal evidence is that
investors reverse engineer the effect of hedge accounting, to the extent
they can, on reported income by transferring hedging gains and losses from
OCI to net income. That's because investors believe that management is
hedging its bonuses and not shareholder value.
Bob Jensen
My evidence is that millions of sole proprietorships extensively hedge
prices and interest rates, including a huge proportion of farmers in the
United States. Sole proprietors constitute the depth of derivatives markets.
a sole proprietor has no disconnect between shareholder value and his/her
compensation. and yet sole proprietors hedge all the time. many often
speculate as well, but there is a huge difference in the financial risk
between hedging and speculating (USING
THE FINANCE DEFINITION OF HEDGING RATHER THAN TOM SELLING'S AMBIGUOUS
DEFINITION).
a sole proprietor has access to all accounting records of the business.
investors do not have access and rely on accountants and auditors to keep
them informed according to gaap.
and what’s to say that there’s always a disconnect between matching
compensation versus shareholder value? sure there are lots of instances
where managers have taken advantage of agency powers, but if this were true
of virtually all corporations there would no longer be outside passive
investors in corporations. you can fool some of the people some of the time,
but not all the investors all of the time.
a subset of the evidence on executive compensation and shareholder value is
given at
http://snipurl.com/execcomp01
if managers are willing to cheat on hedging AT THE EXPENSE OF SHAREHOLDERS,
they’re most likely WANTING to cheat on every other opportunity, thereby
making accounting standard setting as futile for many other standards other
than hedge accounting in fas 133.
I AM NOT SO CYNICAL ABOUT MOST MANAGERS. IF YOU’RE CORRECT, FINANCIAL
MARKETS WILL COLLAPSE.
Fas 133 is wonderful in that it allows the balance sheet to carry
derivatives and current fair value and keeps the changes in value out of
current earnings if changes in hedged item booked value cannot be used to
offset the one-sided, ASYMMETRICAL changes in derivative value caused by not
booking the hedged items.
YOU SEEM TO AVOID THE FOLLOWING WEAKNESS IN YOUR ARGUMENT:
your argument has a huge inconsistency. there is no change in current
earnings for effective hedges of booked items MAINTAINED AT FAIR VALUE. but
if the hedged items are not booked, the change in current earnings can be
enormous simply because the perfectly offsetting change in value of the
hedged item is not booked. somehow this inconsistency does not seem to
bother you.
IN FACT, WHEN ACCOUNTING FOR HISTORICAL COST INVENTORIES THAT HAVE A FAIR
VALUE HEDGE, FAS 133 REQUIRES THAT, DURING THE HEDGING PERIOD, WE DEPART
FROM HISTORICAL COST ACCOUNTING SO THAT FAIR VALUE CHANGES OF THE INVENTORY
CAN OFFSET FAIR VALUE CHANGES IN THE HEDGING DERIVATIVE. THIS IS NOT
POSSIBLE, HOWEVER, WHEN THE HEDGED ITEMS ARE NOT BOOKED SUCH AS IN THE CASE
OF FORECASTED TRANSACTIONS THAT ARE HEDGED ITEMS.
some of your claims that hedging is speculation would make finance
professors shake their heads BECAUSE THEY HAVE A MORE PRECISE DEFINITION OF
SPECULATION VERSUS HEDGING. Please examine the spreadsheet that i use in my
hedge accounting workshops. the spreadsheet is called “hedges” in the
graphing.xls workbook at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
Tom Selling
As for symmetric versus asymmetric booking, the FAS 133 solution (fair value
hedging) is to completely screw up the balance sheet by recording
inconsistent amounts based on ridiculous hypotheticals. I am a balance
sheet guy: get the balance sheet as right as possible at a reasonable cost;
derive accounting income from selected changes in assets and liabilities.
bob jensen
i don’t understand your argument. all derivatives scoped into fas 133 are
carried on the balance sheet at fair value whether or not the hedged items
are booked.
nOTHING IS being
“screwed up” on the balance sheet!
the debate between
us concerns the income statement impacts of hedging versus speculating.
Bob Jensen
I have to say I disagree entirely about “derivatives” being the cause of
misleading financial reporting. The current economic crisis was heavily
caused by AIG’s credit derivatives that were essentially undercapitalized
insurance contracts. Credit derivatives should’ve been regulated like
insurance contracts and not FAS 133 derivatives. Credit derivatives should
never have been scoped into FAS 133.
Tom Selling
You will never end up with a coherent set of accounting rules that are based
on distinctions such as hedging versus speculation, or even hedging versus
insurance. Getting back to the example of Southwest Airlines, the fact that
they used options to manage their future fuel costs when they thought that
options were "cheap" enough just reinforces my view that they were
speculating, and they happened to end up being a winner. Perhaps, in
contrast to other airlines, Southwest had some free cash flow that they
could use to speculate because they were able to engineer for themselves a
lower cost structure than their competitor. But, that doesn't change my
view they were speculating. Try this example: if I were to incessantly
fiddle with the amount of flood insurance on my house based on long-range
weather forecasts, that, too, would be speculating-- notwithstanding the
fact that the contract I am doing it with is nominally an 'insurance
contract.'
Bob Jensen
i would not accept this argument from a sophomore tom. the issue of hedging
is often to lock in a price today rather than speculate on what the price
will be in the future. that’s “hedging” of cash flow! IT IS NOT SPECULATION
as defined in finance textbooks (USING
THE FINANCE DEFINITION OF HEDGING RATHER THAN TOM SELLING'S AMBIGUOUS
DEFINITION).
you are trying to
CONFUSE the definition of cash flow “speculation.” cash flow speculation
in derivatives means that by definition you have unknown cash flows due to
FUTURE price or rate changes.
in contrast, cash
flow hedging means locking in a price or rate. you are not
distinguishing between locking in a contracted price versus speculating on a
future priceS.
if you have no cash
flow risk you MUST have value risk. such is life!
fas 133 makes it very clear that if you have no cash flow risk, you MUST
LIVE WITH value risk. and if you have no value risk, you have cash flow
risk. rules for hedge accounting exist for both types of hedging in fas 133.
I KNOW YOU LIKE TO
THINK THAT A LOCKED IN PRICE DUE TO A HEDGE IS A TYPE OF "SPECULATION," BUT
THIS IS NOT HOW "SPECULATION" IS DEFINED IN FINANCE. I DOUBT THAT HAVING
DEFINITIONS FOR "LOCKED-IN PRICE SPECULATION" VERSUS "FUTURES PRICE
SPECULATION" WILL ADD MUCH TO THE EFFICIENCY OF OUR ARGUMENT BASED IN THE
FINANCE DEFINITIONS OF A CASH FLOW "HEDGE" VERSUS "SPECULATION,"
i think what you are
really confusing in your argument is the distinction between cash flow risk
and value risk. These two financial risks are more certain than love and
marriage. you must have one (type of risk) without the other (type of risk).
and the fas 133 rules are different for hedges of value versus hedges of
cash flow.
Tom Selling
In short, where you see derivatives and insurance contracts, I only see
contracts whose ultimate consequences are contingent on uncertain future
events. They should all be fair value with changes going to earnings.
Bob Jensen
there’s a huge difference between hedging and insurance.
insurance companies charge to spread risk. for example, SUPPOSE an insurance
company sells hail insurance in iowa, it’s ACTUARILY "certain" that all
crops in iowa will not be destRoyed by hail in one summer. but we can’t be
certain what small pockets of iowa farmers will have their crops destroyed
BY HAIL. hence most iowa farmers buy hail insurance, thereby spreading the
risk among those who will and those who won’t have hail damage TO CROPS IN
IOWA. insurance companies are required by law to have sufficient capital to
pay all claims under actuarial probabilities OF HAIL LOSSES.
however, when an
iowa farmer buys an option in april that locks in the price of his corn crop
in THE october HARVEST, this is not spreading the risk among all iowa
farmers. perhaps he buys the option directly from his neighbor who decides
to speculate on the price of october corn and get an option premium to boot.
this is a cash flow risk transfer but is not the same as spreading the risk
of hail damage among all iowa farmers
there’s a huge
difference between insurance and hedging contracts in that virtually all
insurance contracts rely on actuarial science. life expectancy, hail, fire,
wind, floods can be estimated with much greater scientific precision than
the price of oil 18 months into the future. actuarial estimation is not
without error, but actuaries won’t touch commodity pricing and interest
rate pricing where historical extrapolations are virtually impossible.
One reason private
insurance companies CAN sell hail insurance and not flood insurance to iowa
farmers is that highland farmers are almost assured of not having floods but
no farmer in iowa is assured of not having hail damage.
without
forcing all iowa farmers to buy flood insurance. the government had to put
taxpayer money into flood coverage of lowlanders. this was not the case of
FOR hail, FIRE, AND WIND DAMAGE risk.
one reason private
insurance companies would not sell earthquake insurance is that actuary
science for earthquakes is lousy. we can predict where earthquakes are
likely to hit, but science is extremely unreliable when it comes to
predicting what century.
fas 133 does
recognize that there are many similarities between insurance and hedging in
some context. these are discussed in paragraph 283 of fas 133. BUT THE
DEFINITIONS OF INSURANCE VERSUS HEDGING ARE QUITE different IN FAS 133.
ONE PLACE THE FASB
SCREWED UP in fas 133 IS IN NOT RECOGNIZING THAT CREDIT DERIVATIVES ARE MORE
LIKE INSURANCE THAN commodity HEDGING. not making aig have capital reserves
for credit derivatives was a huge, huge mistake. those cash reserves most
likely would not have covered the subprime mortgage implosion that destroyed
value of almost all cdo bonds, but at least there would have been some
capital backing and some regulation of wild west credit derivatives of aig.
Bob Jensen
The issue in your post concerns derivatives apart from credit derivatives,
derivatives that are so very popular in managing financial risk, especially
commodity price risk and interest rate fluctuation risk. Before FAS 119 and
FAS 133 it was the wild west of off-balance sheet financing with undisclosed
swaps and forward contracts, although we did have better accounting for
futures contracts because they clear for cash each day. Scandals were
soaring, in large measure, due to failure of the FASB to monitor the
explosion in derivatives frauds. Arthur Levitt once told the Chairman of the
FASB that the FASB’s three biggest problems, before FAS 133, were
1-derivatives, 2-derivatives, and 3-derivatives ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Tom Selling
The way I see the basic problem that FAS 133 did fix was to require fair
value for all contracts within its scope. Prior to that, a $10 billion
interest rate swap could stay off the balance sheet no matter how far
interest rates strayed. As you pointed out in a previous e-mail, the hedge
accounting provisions in FAS 133 were a concession to special interests. I
could be wrong, but I don't recall a single investor group pounding the
table and insisting that there be 2000 pages of rules to permit managers to
smooth their income.
Bob Jensen
ACTUALLY THE FASB INITIALLY DID NOT WANT TO MAKE ANY EARNINGS IMPACT
CONCESSIONS FOR HEDGE ACCOUNTING. THE ORIGINAL FASB THOUGHT WAS TO DO JUST
AS YOU SAY AND BOOK ALL DERIVATIVES AT FAIR VALUE WITHOUT 2,000 PAGES OF
ADDED HEDGE ACCOUNTING RULES.
THE HEDGE ACCOUNTING
RULES CAME ABOUT BECAUSE COMPANIES JUMPED ON THE FASB FOR “PUNISHING”
HEDGING COMPANIES BY CREATING ENORMOUS UNREALIZED EARNINGS VOLATILITY IN
INTERIM PERIODS THAT WOULD NEVER BE REALIZED WHEN HEDGES WERE SETTLED AT
MATURITY DATES.
WITHOUT HEDGE
ACCOUNTING, COMPANIES GO PUNISHED FOR HEDGING AS IF THEY WERE SPECULATING
WHEN THEY ARE HEDGING (USING THE FINANCE DEFINITION OF HEDGING RATHER THAN
TOM SELLING'S AMBIGUOUS DEFINITION). I KNOW YOU LIKE TO THINK THAT A LOCKED
IN PRICE DUE TO A HEDGE IS A TYPE OF "SPECULATION," BUT THIS IS NOT HOW
"SPECULATION" IS DEFINED IN FINANCE. I DOUBT THAT HAVING DEFINITIONS FOR
"LOCKED-IN PRICE SPECULATION" VERSUS "FUTURES PRICE SPECULATION" WILL ADD
MUCH TO THE EFFICIENCY OF OUR ARGUMENT BASED IN THE FINANCE DEFINITIONS OF A
CASH FLOW "HEDGE" VERSUS "SPECULATION,"
IT’S UNFAIR TO EQUATE
CONCESSIONS TO SPECIAL INTEREST GROUPS TO HEDGE ACCOUNTING RULES IN FAS 133.
I FIND THE ARGUMENTS FOR HEDGE ACCOUNTING VERY COMPELLING SINCE IN MOST
INSTANCES OF HEDGING THE FLUCTUATIONS IN UNREALIZED VALUE CHANGES WASH OUT
FOR HEDGE CONTRACTS THAT ARE SETTLED AT MATURITY DATES. IT WAS THE ARGUMENTS
THAT WERE COMPELLING RATHER THAN POLITICAL CONCESSIONS TO SPECIAL INTEREST
GROUPS. THE SIMPLE ARGUMENT WAS THAT BY LOCKING IN PRICES OR PROFITS
COMPANIES WERE BEING PUNISHED AS IF THEY WERE SPECULATING (I DISCUSS YOUR
CONFUSED DEFINITION OF “SPECULATION” ELSEWHERE IN THIS MESSAGE.)
prior to fas 133,
companies were learning that it was very easy to keep debt off the balance
sheet with interest rate swaps. there is ample evidence of the explosion of
this as companies shifted from managing risk with treasury bills to managing
risk with swaps.
there were many
scandals due, in large measure, to bad accounting for derivatives prior to
fas 133 ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
of course lack of regulation of the derivatives markets themselves was an
even bigger problem.
Bob Jensen
When you respond to my post please take up the issue of purchase contracts
and non-contracted forecasted transactions since these account for the
overwhelming majority of “asymmetric-booking” derivatives contracts hedges
being reported today. Then show me how booking changes in value of a hedging
contract as current earnings makes sense when the changes in value of the
hedged item are not, and should not, be booked.
Tom Selling
I already took up that question. One of the points I was trying to make in
the OilCo case is that hedge accounting, while designed to reduce the
volatility of reported earnings, often increases the volatility of economic
earnings. That's why OilCo's stock price went down as oil prices went up.
Let me try state it in terms of a manufacturer of a commodity product that
contains a significant amount of copper. Changes in market prices of the
end product can be expected to be highly correlated with changes in the
price of copper. Therefore, a natural hedge is already in place for the
risk that copper prices will rise in the future. If you add a forward
contract to purchase copper to the firm's investment portfolio, then you are
actually adding to economic volatility instead of subtracting from it. (I
trust you don't need a numerical example, but I could provide one if you
want it.) If you add an at-the-money option to purchase copper, you are
destroying value by paying a premium for what is essentially an insurance
contract on a long run risk that doesn't exist.
I think the fundamental
difference between our positions, Bob, is that you believe that management
is acting to maximize (long-run) shareholder value, and I (and perhaps the
like Leslie Kren), more cynically believe that management is acting to
lock-in their short-run, earnings-based compensation. The 'special hedge
accounting' provisions of FAS 133 is just one tool that they have for doing
so. And as icing on the cake because of its incredible complexity, it lines
the pockets of 'advisors', financial intermediaries, auditors, and even
educators like you and me.
Bob Jensen
OPTION VALUE = INTRINSIC VALUE + TIME VALUE
YOU ARE
INSULTING THE INTELLIGENCE OF FINANCE PROFESSORS WHO WOULD SHAKE THEIR HEADS
WHEN READING: “ If you add an
at-the-money option to purchase copper, you are destroying value by paying a
premium for what is essentially an insurance contract on a long run risk
that doesn't exist.”
THERE IS LONG RUN RISK
THAT THE FUTURE PRICE WILL GO UP OR DOWN. WHEN YOU BUY AN OPTION AT THE
MONEY, THERE IS NO INTRINSIC VALUE BY DEFINITION. BUT THE REASON THE
PRICE(PREMIUM) OF THE OPTION IS NOT ZERO IS THAT IT HAS TIME VALUE
DUE TO THAT CONTRACTED INTERVAL OF TIME IT HAS TO GO INTO THE MONEY. CASH
FLOW HEDGING WITH AN OPTION IS NOT “INSURANCE CONTRACTING” AS DEFINED IN FAS
133. THIS IS A HEDGE THAT LOCKS IN A PURCHASE OR SALES PRICE AT THE STRIKE
PRICE SUCH THAT IT IS NOT NECESSARY IN THE FUTURE TO GAMBLE ON AN UNKNOWN
FUTURE PRICE.
a subset of the evidence on executive compensation and shareholder value is
given at
http://snipurl.com/execcomp01
if managers are willing to cheat on hedging AT THE EXPENSE OF SHAREHOLDERS,
they’re most likely WILLING to cheat on every other opportunity, thereby
making accounting standard setting as futile for many other standards other
than hedge accounting in fas 133.
Bob Jensen
Then show me how this asymmetric-booking reporting of changes in value of a
hedging contract not offset in current earnings by changes in the value of
the item it hedges provides meaningful information to investors, especially
since the majority of such hedging contracts are carried to maturity and all
the interim changes in their value are never realized in cash.
Tom Selling
Just because it may not be recognized in cash, that doesn't mean
changes in value are not relevant to investors. I suppose that's an
empirical question. But I should also add that by your comment, may I infer
that you are also in favor of maintaining a held-to-maturity category for
marketable debt securities? If so, then we have a lot more important things
to talk about than just hedge accounting! Him him him him him him him
Bob Jensen
I AM A STRONG ADVOCATE OF HTM ACCOUNTING SIMPLY TO KEEP PERFORMANCE FICTION
OUT OF THE FINANCIAL STATEMENTS. THIS IS ESPECIALLY THE CASE WHERE THERE ARE
PROHIBITIVE TRANSACTIONS COSTS FROM EARLY SETTLEMENTS. MY ARGUMENTS HERE ARE
MY CRITICISMS OF EXIT VALUE AT
http://faculty.trinity.edu/rjensen/theory01.htm#FairValue
THE IASB IMPOSES
GREATER PENALTIES FOR VIOLATORS OF HTM DECLARATIONS THAN DOES THE FASB, BUT
AUDITORS ARE WARNED TO HOLD CLIENTS TO HTM DECLARATIONS.
Bob Jensen
Show me why this asymmetric-booking of changes in value of hedging contracts
versus non-reporting of offsetting changes in the value of the unbooked
hedged item benefits investors. Show me how the failure to distinguish
earnings changes from derivative contract speculations from earnings changes
from derivative hedging benefits investors.
Tom Selling
Hedging and speculation is a question of intent, and I don't believe they
can be reliably separated. To this I would add that transaction
hedging in FAS 133 is really not economic hedging. In order to make the
distinction between hedging and speculation auditable, FAS 133 prohibits
macro hedges. Thus, managers claim that the hedges that actually enter into
in order to get the income smoothing they need are actually less efficient
(i.e., riskier) than if they were permitted to have hedge accounting for
macro hedges.
Bob Jensen
once again you are confusing cash flow hedging from value hedging. i covered
this above.
Bob Jensen
What you are really arguing is that accounting for such derivatives should
not distinguish hedging derivative contracts from speculation derivative
contracts. I argue that failure to distinguish between hedging and
speculation is very, very, very, very misleading to investors.
Derivative contracts are
now the most popular vehicles for managing risk. They are extremely
important for managing risk. I think FAS 133 and IAS 39 can be improved, but
failure to distinguish hedging derivative contracts from speculations in
terms of the booking of value changes of these derivatives will be an
enormous loss to users of financial statements.
Tom Selling
Empirical question. See above.
Bob Jensen
The biggest complaint I get from academe is that professors mostly just
don’t understand FAS 133 and IAS 39. I think this says more about professors
than it does about the accounting. In fairness, to understand these two
standards accounting professors have to learn a lot more about finance than
they ever wanted to know. For example, they have to learn about contango
swaps and other forms of relatively complex hedging contracts used in
financial risk management.
Tom Selling
I can't speak for other accounting professors who may choose to remain
ignorant of the details of FAS 133. I think it's a question of incentives.
But, I think I know FAS 133 pretty well (although surely not as well as
you), and certainly well enough to have an informed opinion. I don't think
FAS 133 stinks because it is too difficult to learn. It stinks because,
contrary to what you believe, I think that managers game the system and in
the process are destroying shareholder value, and even our economy.
Bob Jensen
Finance professors, in turn, have to
learn a whole lot more about accounting than they ever wanted to know. For
example, they have to learn the rationale behind not booking purchase
contracts and the issue of damage settlements that may run close to 100% of
notionals for executed contracts and less than 1% of notionals for executory
purchase contracts. And hedged forecasted transactions that are not even
written into contracts are other unbooked balls of wax that can be hedged.
Tom Selling
I can't speak for finance professors either, but my very loose impression is
that they will make the simplifying assumption that accounting doesn't
matter. In other words, the contract between shareholders and management is
efficient in the sense that managers cannot gain by gaming the accounting
rules. Ha Ha Ha.
Bob Jensen
IF WHAT YOU SAY IS TRUE THAT VIRTUALLY ALL MANAGERS OUR OUT TO SCREW
INVESTORS, THEN CAPITALISM AS WE KNOW IT IS DOOMED. IT IS SERIOUSLY
CHALLENGED AT THE MOMENT, AND MAYBE WE WILL TURN ALL OF OUR LARGE
CORPORATIONS OVER TO THE GOVERNMENT THAT NEVER SCREWS ANYBODY. WHY DIDN’T WE
THINK OF THIS BEFORE. THE SOVIET UNION HAD IT RIGHT ALL ALONG.
a subset of the evidence on executive compensation and shareholder value is
given at
http://snipurl.com/execcomp01
if managers are willing to cheat on hedging AT THE EXPENSE OF SHAREHOLDERS,
they’re most likely WantING to cheat on every other opportunity, thereby
making accounting standard setting as futile for many other standards other
than hedge accounting in fas 133. I AM NOT SO CYNICAL ABOUT MOST MANAGERS.
IF YOU’RE CORRECT, FINANCIAL MARKETS WILL COLLAPSE.
“Accounting Doesn’t
Matter”
once again this is a sophomore statement. although i’m often critical that
individual financial reporting events studies are not replicated, the
thousands of such studies combined point to the importance of events,
especially earnings announcements, on investor behavior. only sophomores in
finance would make a claim that “accounting does not matter.”
There may be a better way
to distinguish earnings changes arising from speculation derivative
contracts versus hedging derivative contracts, but the FAS 133 approach at
the moment is the best I can think of until you have that “aha” moment that
will render FAS 133 hedge accounting meaningless.
Bob Jensen
I anxiously await your “aha” moment Tom as long as you distinguish booked
from unbooked hedged items.
Tom Selling
I like FAS 159 as a temporary measure, despite the inconsistencies it
creates—they are no worse than FAS 133’s inconsistencies.
Offsetting changes in
the value of unbooked hedged items are to the totality of our grossly
inadequate accounting standards as a flea is to Seabiscuit's rear end.
Here's the best I can do: change the name of the balance sheet to "statement
of recognized assets and liabilities"; change the name of the income
statement to "statement of recognized revenues, expenses, gains and
losses." At least that way, readers will have a better idea of what
accountants are feeding them.
Bob Jensen
fas 159 says absolutely nothing about a fair value option for unbooked
contracts and forecasted transactions other than it does not allow fair
value booking for these anticipated (often contracted) transactions
And I certainly
would not make fair value accounting for derivatives an option under fasb
standards.
hence fas 159 is of
no help at all in accounting for hedging contracts of hedged items that are
not booked.
Thanks,
Bob Jensen
Interest Only
Strip =
a contract that calls for cash settlement based upon the
interest but not the principal of a note. Except in certain conditions, interest-only and
principal only strips are not covered in FAS 133. See Paragraphs 14 and 310. See futures contract.
Interest Rate
Swap =
a transaction in which two parties exchange
interest payment streams of differing character based on an underlying principal amount.
This is the most common form of hedging risk using financial instruments derivatives. The
most typical interest rate swaps entail swapping fixed rates for variable
rates and vice versa. A basis swap is the swapping of one
variable rate for another variable rate for purposes of changing the net interest rate.
Basis swaps are discussed in Paragraph 28d on Page 19 and Paragraphs 391-395 on Pages
178-179 of FAS 133. A basis swap arises when one variable rate index
(e.g., LIBOR) is swapped for another index (e.g., a U.S Prime rate). Basis risk arises when the hedging index differs from the index of
the exposed risk. Interest rate swaps are illustrated in Example 2 paragraphs
111-120, Example 5 Paragraphs 131-139, Example 8 Paragraphs 153-161, and other examples in
Paragraphs 178-186. See FAS 133 Paragraph 68 for the exact conditions that have to be met if an entity is to assume no
ineffectiveness in a hedging relationship of interest rate risk involving an
interest-bearing asset/liability and an interest rate swap.
See yield curve, swaption,
currency swap, notional, underlying, swap, legal settlement rate, and [Loan
+ Swap] rate. Also see basis
adjustment and short-cut
method for interest rate swaps.
Interest Rate Swaps were
invented in 2001 ---
http://en.wikipedia.org/wiki/Interest_rate_swap
These derivative financial
instruments are essentially portfolios of forward contracts swapping
interest payments (usually fixed versus variable rate payments) were
not even required to be disclosed in financial statements of banks
and other corporations since there were no accounting rules for
forward contracts. In a few years interest rate swaps became popular
worldwide for both managing cash and for achieving off-balance-sheet
financing ---
http://en.wikipedia.org/wiki/Off-balance-sheet
Valuation and Pricing of Interest Rate
Swaps
From Risk News on November 14, 2003
A surge in interest rate swaps transactions helped the
global over-the-counter (OTC) derivatives market to grow by 20% during the first
half of this year, according to figures released this week by the Bank for
International Settlements (BIS). The BIS said the total notional amount of all
OTC contracts outstanding at the end of June was $169.7 trillion, up from $141.7
trillion at the end of December. Gross market values for these contracts rose by
24% to $7.9 trillion. There was growth in all risk categories except gold,
according to the BIS’s semi-annual report into OTC market activity. The report
highlighted the continued growth in interest rate swaps, by far the largest
single group of OTC products with $95 trillion in notional amounts outstanding.
Interest rate contracts represented 56% of all market risk categories. Foreign
exchange derivatives also grew strongly, with notionals up 20% on the previous
six months. Currency options rose by 42%. The BIS said the forex derivatives
market had never before shown more than single-figure growth in the time it has
been collecting statistics. But the growth in OTC contracts failed to match the
pace set in the regulated market. Exchange-traded derivatives grew by 61% in
notional amounts outstanding during the first half of 2003, the report said.
An excellent summary about why interest rate swaps have
become so popular is provided by Green Interest Rate Swap Management at http://home.earthlink.net/~green/whatisan.htm
One question that arises is whether a hedged item
and its hedge may have different maturity dates. Paragraph 18 beginning on Page 9 of
FAS 133 rules out hedges such as interest rate swaps from having a longer maturity than
the hedged item such as a variable rate loan or receivable. On the other hand,
having a shorter maturity is feasible according to KPMG's Example 13 beginning on Page 225
of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP
in July 1998) states the following. A portion of that example reads as follows:
Although the criteria specified
in paragraph 28(a) of the Standard do not address whether a portion of a single
transaction may be identified as a hedged item, we believer that the proportion principles
discussed in fair value hedging model also apply to forecasted transactions.
LIBOR ---
http://en.wikipedia.org/wiki/LIBOR
Note that LIBOR is a global index used in hundreds of millions of contracts
around the world as an underlying for interest rate movements. Nobody ever
argued that LIBOR was as risk free as the U.S. Treasury Rate, but globally the
U.S. Treasury rate paled relative to LIBOR as a market index for interest rates,
especially hundreds of trillions of dollars in interest rate swaps.
Hence when LIBOR becomes manipulated by
traders it affects worldwide settlements. This is why pension funds of small
U.S. towns, labor unions, and banks of all sizes are now suing Barclays and the
other U.K banks that allegedly manipulated the LIBOR market rates for their own
personal agenda.
"Lies, Damn Lies and Libor:
Call it one more improvisation in 'too big to fail' crisis management," by
Holman W. Jenkins Jr., The Wall Street Journal, July 6, 2012 ---
http://professional.wsj.com/article/SB10001424052702304141204577510490732163260.html?mod=djemEditorialPage_t&mg=reno64-wsj
Ignore the man
behind the curtain, said the Wizard of Oz. That advice doesn't pay in the
latest scandal of the century, over manipulation of Libor, or the London
Interbank Offered Rate. The mess is one more proof of the failing wizardry
of the First World's monetary-cum-banking arrangements.
Libor is a
reference point for interest rates on everything from auto loans and
mortgages to commercial credit and complex derivatives. Major world banks
are accused of artificially suppressing their claimed Libor rates during the
2007-08 financial crisis to hide an erosion of trust in each other.
Did the Bank of
England or other regulators encourage and abet this manipulation of a global
financial indicator?
We are talking
about TBTF banks—too big to fail banks. Banks that, by definition, become
suspect only when creditors begin to wonder if regulators might seize them
and impose losses selectively on creditors. Their overseers could not have
failed to notice that interbank liquidity was drying up and the banks
nevertheless were reporting Libor rates that suggested all was well. The
now-famous nudging phone call from the Bank of England's Paul Tucker to
Barclays's Bob Diamond came many months after Libor manipulation had already
been aired in the press and in meetings on both sides of the Atlantic. That
call was meant to convey the British establishment's concern about
Barclays's too-high Libor submissions.
Let's not kid
ourselves about something else: Central banks everywhere at the time were
fighting collapsing confidence by cutting rates to stimulate retail lending.
Their efforts would have been thwarted if Libor flew up on panic about the
solvency of the major banks.
Of all the
questionably legal improvisations regulators resorted to during the crisis,
then, the Libor fudge appears to be just one more. Regulators everywhere
gamed their own capital standards to keep banks afloat. The Fed's bailout of
AIG, an insurance company, hardly bears close examination. And who can
forget J.P. Morgan's last-minute decision to pay Bear Stearns shareholders
$10 a share, rather than the $2 mandated by Treasury Secretary Hank Paulson,
to avoid a legal test of the Fed-orchestrated takeover? Even today, the
European Central Bank continues to extend its mandate in dubious ways to
fight the euro crisis.
There has been
little legal blowback from any of this, but apparently there will be a great
deal of blowback from the Libor fudge. Barclays has paid $453 million in
fines. Half its top management has resigned. A dozen banks—including Credit
Suisse, Deutsche Bank, Citigroup and J.P. Morgan Chase—remain under
investigation. Private litigants are lining up even as officialdom seemingly
intends to wash its hands of its own role.
Yet the larger
lesson isn't that bankers are moral scum, badder than the rest of us. The
Libor scandal is another testimony (as if more were needed) of just how
lacking in rational design most human institutions inevitably are.
Libor was flawed by
the assumption that the banks setting it would always be seen as top-drawer
credit risks. The Basel capital-adequacy rules were flawed because they
incentivized banks to overproduce "safe" assets, like Greek bonds and U.S.
mortgages. The ratings process was flawed eight ways from Sunday, including
the fact that many fiduciaries, under law, were required to invest in
securities blessed by the rating agencies.
Some Barclays
emails imply that traders, even before the crisis, sought to influence the
bank's Libor submissions for profit-seeking reasons. This is puzzling and
may amount to empty chest thumping. Barclays's "submitters" wouldn't seem in
a position to move Libor in ways of great use to traders. Sixteen banks are
polled to set Libor and any outlying results are thrown out. Plus each
bank's name and submission are published daily. But let's ask: Instead of
trying to manipulate Libor in a crisis, what would have been a more
straightforward way of dealing with its exposed flaws, considering the many
trillions in outstanding credit tied to Libor?
Continued in article
Bob Jensen's threads on interest
rate swaps and LIBOR ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Search for LIBOR or swap.
"Why Hedge Interest Rate Exposures?"
by Mary Brooikhart, Bank Asset/Liability Management, March 2012 ---
http://www.kawaller.com/pdf/BALM-WhyHedgeInterestRateExposures.pdf
Thank you Ira Kawaller for the heads up.
Bob Jensen's free tutorials on hedging
and hedge accounting ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
LIBOR ---
http://en.wikipedia.org/wiki/Libor
This is Crime, Not Capitalism
"Wall Street con trick," by Ellen Brown, Asia Times, March 24,
2012 ---
http://www.atimes.com/atimes/Global_Economy/NC24Dj05.html
"Far from
reducing risk, derivatives increase risk, often with catastrophic results."
-
Derivatives expert Satyajit Das, Extreme Money (2011)
*****************
Jensen Comment
Derivatives are great contracts to manage risk if their markets are
efficient, fair, and transparent.
They don't reduce risk in most instances because it's impossible in
hedging to reduce risk in most instances. Rather hedging entails
shifting risk. For example, a company that has cash flow risk due to
variable interest rate debt can hedge that cash flow risk. However,
elimination of cash flow risk creates fair value risk. The issue is not
one of reducing risk. Rather it is a shift in risk preferences.
******************
The "toxic culture of greed" on Wall Street was
highlighted again last week, when Greg Smith went public with his
resignation from Goldman Sachs in a scathing oped published in the New York
Times. In other recent eyebrow-raisers, London Interbank Offered Rates (or
LIBOR) - the benchmark interest rates involved in interest rate swaps - were
shown to be manipulated by the banks that would have to pay up; and the
objectivity of the International
Swaps and Derivatives
Association was called into question, when a 50% haircut for creditors was
not declared a "default" requiring counterparties to pay on credit default
swaps on Greek sovereign debt.
Interest rate swaps are less often in the news than credit default swaps,
but they are far more important in terms of revenue, composing fully 82% of
the derivatives trade. In February, JP Morgan Chase revealed that it had
cleared US$1.4 billion in revenue on trading interest rate swaps in 2011,
making them one of the bank's biggest sources of profit. According to the
Bank for International Settlements:
[I]nterest rate
swaps are the largest component of the global OTC derivative market. The
notional amount outstanding as of June 2009 in OTC [over-the-counter]
interest rate swaps was $342 trillion, up from $310 trillion in Dec
2007. The gross market value was $13.9 trillion in June 2009, up from
$6.2 trillion in Dec 2007.
For more than a
decade, banks and insurance companies convinced local governments,
hospitals, universities and other non-profits that interest rate swaps would
lower interest rates on bonds sold for public projects such as roads,
bridges and schools. The swaps were entered into to insure against a rise in
interest rates; but instead, interest rates fell to historically low levels.
This was not a flood, earthquake, or other insurable risk due to
environmental unknowns or "acts of God". It was a deliberate, manipulated
move by the Federal Reserve, acting to save the banks from their own folly
in precipitating the credit crisis of 2008. The banks got into trouble, and
the Federal Reserve and federal government rushed in to bail them out,
rewarding them for their misdeeds at the expense of the taxpayers.
How the swaps were supposed to work was explained by Michael McDonald in a
November 2010 Bloomberg article titled "Wall Street Collects $4 Billion From
Taxpayers as Swaps Backfire":
In an
interest-rate swap, two parties exchange payments on an agreed-upon
amount of principal. Most of the swaps Wall Street sold in the municipal
market required borrowers to issue long-term securities with interest
rates that changed every week or month. The borrowers would then
exchange payments, leaving them paying a fixed-rate to a bank or
insurance company and receiving a variable rate in return. Sometimes
borrowers got lump sums for entering agreements.
Banks and borrowers
were supposed to be paying equal rates: the fat years would balance out the
lean. But the Fed artificially manipulated the rates to the save the banks.
After the credit crisis broke out, borrowers had to continue selling
adjustable-rate securities at auction under the deals. Auction interest
rates soared when bond insurers' ratings were downgraded because of subprime
mortgage losses; but the periodic payments that banks made to borrowers as
part of the swaps plunged because they were linked to benchmarks such as
Federal Reserve lending rates, which were slashed to almost zero.
Continued in article
Bob Jensen's fraud updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
Bob Jensen's tutorials on derivative
financial instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Hi Ray
About all I have on file for this old Sears interest rate swap example is the
really old document at
http://faculty.trinity.edu/rjensen/231wp/231wp.htm
As I recall, my sources for the Sears swap were personal messages. I don't
recall any published sources.
A current Google search disclosed the following links:
http://my.dreamwiz.com/stoneq/articles/orgloss.htm
http://www.nysscpa.org/cpajournal/1995/OCT95/f341095.htm
Hope this helps!
Bob Jensen
-----Original Message-----
From: Ray Eason [mailto:rayeason2@hotmail.com]
Sent: Thursday, March 25, 2004 6:41 AM
To: Jensen, Robert Subject: <<student request>>
Hi, Bob...
I am an MBA candidate in Boston working on a one page
summary of the Sears Roebuck $257MM swap loss in 1994. I came across your name
from Working Paper 231 on the web. I wondered if you might be able to suggest
a reference or two in regards to swap losses at Sears in the 1994 timeframe.
What tool do you use to query historical information on derivative debacles in
your research?
Warmest Regards -Ray
:Ray Eason ::
Harvard MBA 2004 :: www.geocities.com/oxford96
Interest rate swap derivative instruments are widely used to manage interest
rate risk, which is viewed as a perfectly legitimate use of these hedging
instruments. I stumbled on to a rather interesting doctoral dissertation
which finds that firms, especially banks, use such swaps to manage
earnings. The dissertation from Michigan State University is by Chang Joon
Song under the direction of Professor Thomas Linsmeier.
"Are Interest Rate Swaps Used to Manage Banks' Earnings," by Chang
Joon Song, January 2004 --- http://accounting-net.actg.uic.edu/Department/Songpaper.pdf
This dissertation is quite clever and very well written.
Previous research has shown that loan loss provisions
and security gains and losses are used to manage banks’ net income. However,
these income components are reported below banks largest operating component,
net interest income (NII). This study extends the literature by examining
whether banks exploit the accounting permitted under past and current hedge
accounting standards to manage NII by entering into interest rate swaps.
Specifically, I investigate whether banks enter into
receive-fixed/pay-variable swaps to increase earnings when unmanaged NII is
below management’s target for NII. In addition, I investigate whether banks
enter into receive-variable/pay-fixed swaps to decrease earnings when
unmanaged NII is above management’s target for NII. Swaps-based earnings
management is possible because past and current hedge accounting standards
allow receive-fixed/pay-variable swaps (receivevariable/ pay-fixed) to have
known positive (negative) income effects in the first period of the swap
contract. However, entering into swaps for NII management is not costless,
because such swaps change the interest rate risk position throughout the swap
period. Thus, I also examine whether banks find it cost-beneficial to enter
into offsetting swap positions in the next period to mitigate interest rate
risk caused by entering into earnings management swaps in the current period.
Using 546 bank-year observations from 1995 to 2002, I find that swaps are used
to manage NII. However, I do not find evidence that banks immediately enter
into offsetting swap positions in the next period. In sum, this research
demonstrates that banks exploit the accounting provided under past and current
hedge accounting rules to manage NII. This NII management opportunity will
disappear if the FASB implements full fair value accounting for financial
instruments, as foreshadowed by FAS No. 133.
What is especially interesting is how Song demonstrates that such earnings
management took place before FAS 133 and is still taking place after FAS 133
required the booking of swaps and adjustment to fair value on each reporting
date. It is also interesting how earnings management comes at the price of
added risk. Other derivative positions can be used to reduce the risk, but
risks arising from such earnings management cannot be eliminated.
Avoiding derivative accounting.
In an example of the legalistic nature of the
accounting rules, Manufacturing could have avoided derivative accounting
entirely if the loan and interest rate cap were structured differently. SFAS 133
excludes from its scope certain interest rate caps, floors, and collars that
cannot be classified as either a derivative or an embedded derivative.
Manufacturing could have embedded the interest rate cap in the loan while
failing to meet the criteria of an embedded derivative.
Robert A. Dyson, "Accounting for
Interest-Bearing Instruments as Derivatives and Hedges," The CPA Journal,
http://www.nysscpa.org/cpajournal/2002/0102/features/f014202.htm
To my accounting theory students:
I probably won't examine you on this one, but you might find it of interest.
Karen Richardson, "Swapping Rates to Save on Debt ...
Maybe: Rice Financial Products Offers Cities, States Deal Rife With
Benefits, Risks," The Wall Street Journal, March 15, 2005;
Page C3 --- http://online.wsj.com/article/0,,SB111083206224878924,00.html?mod=todays_us_money_and_investing
Officials in Durham, N.C., hope that a financial
transaction with a private New York firm will save the city millions of
dollars on its municipal debt.
But some say the deal -- an interest-rate swap with a
formula that multiplies the city's potential savings as well as its potential
losses -- may contain costly risk.
"They're entering into a gamble where they
believe they're going to win more money than they're going to lose," says
Robert Whaley, professor of finance and a derivatives expert at Duke
University in Durham. "It's just speculation."
The Synthetic Fixed-Rate Refinancing Swap, as it is
known, was created by Rice Financial Products Co., which has sold such deals
in at least five states. It would work like this in Durham: On existing debt
of $103 million, Durham would pay Rice Financial a still-to-be negotiated
fixed interest rate over 15 years while Rice Financial would pay Durham a rate
that is about 0.9 percentage point greater, plus a so-called adjustment
factor. Rice Financial has said the deal could save the city $8 million.
"This proposal is so complex ... that I don't
know that there are 30 or 40 people in this entire state who can fully
comprehend it," says Eugene Brown, a Durham city councilman who has been
lobbying against the swap.
"What you really want to focus on is the all-in
cost of funds," says Donald Rice, founder and chief executive of Rice
Financial.
The adjustment factor is based on a combination of
the Bond Market Association (BMA) benchmark index rate for tax-exempt bonds
and the taxable London interbank offered rate, or Libor. Supply and demand,
credit risk, tax policy, interest rates and different maturities can result in
unpredictable swings in that relationship. "Understanding the dynamics of
how these two rates behave in relationship to one another is not an easy
task," says Prof. Whaley
The formula effectively "magnifies both
potential benefits and risks" by 1.54 times, according to an analysis of
the swap structure by Public Financial Management in Philadelphia, Durham's
financial adviser. The firm approved the deal but recommended that the city
budget the expected savings conservatively.
Rice Financial made an "unsolicited
proposal" to Durham City in August after it sold a similar swap to Durham
County, says Kenneth Pennoyer, the city's director of finance. Prior to
meeting with Rice Financial, he says, the city hadn't been contemplating any
sort of swap because most of its bonds outstanding pay a fixed interest rate.
"There's a potential savings for the city, and I
think that's a worthwhile goal in itself," Mr. Pennoyer says. He is
confident that a final city-council vote April 18 will approve the deal since
a commission of the state treasurer has approved it and Standard & Poor's
Ratings Services recently gave it its highest rating for this type of
transaction.
Mr. Rice is a Harvard Business School graduate who
started structuring municipal interest-rate swaps at Merrill Lynch & Co.
nearly 20 years ago. He says his company has executed more than $20 billion in
swaps since its establishment in 1994. "There may be a circumstance where
our transaction causes dis-savings, but it requires a substantial market move
... one that's unparalleled," says Mr. Rice.
Interest-rate swaps aren't new to the municipal-bond
markets, but their use has grown over the past three years. As interest rates
fell to record lows, municipal issuers were looking for ways to trim costs
without issuing more bonds. But with interest rates rising, fixed-rate issuers
betting on a formula involving two floating rates and a multiplier effect
seems imprudent to some.
"Often the political pressures are such that ...
when [potential benefits] are couched in terms of 'savings,' the risk is that
people are doing things they don't understand," says Mike Marz, vice
chairman of First Southwest Co. in Dallas. First Southwest has advised North
Carolina finance officials against using the Rice Financial swap.
Mr. Rice declined to discuss his company's
compensation from the swaps, except to say that issuers' financial advisers
were responsible for negotiating rates that were "fair value" in the
market. On average, municipal-swap deals generate fees of 0.05% to 0.10% of
the deal for bankers. Durham City's Mr. Pennoyer said Rice Financial's
compensation on the $103 million swap was in the ballpark of about $800,000,
or 0.8%.
In 2003 the West Basin Municipal Water District in
California sued its financial adviser, P.G. Corbin & Co., in California
state court, alleging it gave faulty advice in deeming a Rice Financial swap
in 2001 a "fair market transaction."
A spokesman for West Basin said he didn't know the
status of the case. Lawyers representing P.G. Corbin didn't return phone calls
seeking comment.
Separately, this month a West Basin official was
sentenced in U.S. court in California to two years in prison for extorting
$25,000 from a consultant at M.R. Beal & Co., then a partner of Rice
Financial, to steer the water district's debt-refinancing contract in Rice
Financial's favor.
"The well-publicized events among certain of
West Basin's board members are unfortunate," Mr. Rice said.
"Nonetheless, we are pleased with the products and services we have
provided West Basin over the years and value them as a customer."
From The Wall Street Journal Accounting Weekly Review on March
18, 2005
TITLE: Swapping Rates to Save on Debt...Maybe
REPORTER: Karen Richardson
DATE: Mar 14, 2005
PAGE: C3
LINK: http://online.wsj.com/article/0,,SB111083206224878924,00.html
TOPICS: Advanced Financial Accounting, Derivatives, Governmental Accounting
SUMMARY: The city of Durham, NC., has entered into an unusual interest rate
swap created by Rice Financial Products, Co. A Duke university finance
professor, Robert Whaley, describes the transaction as speculative.
QUESTIONS:
1.) What are the features of a standard interest rate swap? What is unusual
about the interest rate swap discussed in this article?
2.) Why might a governmental entity want to engage in an interest rate swap
transaction? Answer this question with reference to the current state of
interest rates and the terms of the Durham, N.C. debt described in the article.
3.) Why does Duke University Professor of Finance Robert Whaley call this
transaction "just speculation"?
4.) How does the assessment that this interest rate swap is speculative
potentially affect the accounting for the swap?
Reviewed By: Judy Beckman, University of Rhode Island
The practice of selling high risk derivative instruments
products just goes on and on in spite of the enormous scandals of the past ---
http://faculty.trinity.edu/rjensen/fraudrotten.htm#DerivativesFrauds
Particularly important is understanding Examples 2 and 5 of
Appendix B of FAS 133 and how to value interest rate swaps ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
See Gapping and Immunization
See Earnings Management
Bob Jensen's threads on FAS 133 and IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
|
DIG Issue A9 --- http://www.fasb.org/derivatives/
QUESTION
How does Statement 133 affect the accounting for a prepaid interest
rate swap contract, that is, an interest rate swap contract for which
the fixed leg has been prepaid (at a discounted amount)?
BACKGROUND AND DESCRIPTION OF TRANSACTION
In lieu of obtaining a pay-fixed, receive-variable interest rate
swap that is settled net each quarter, an entity may choose to enter
into a "prepaid interest rate swap" contract that obligates
the counterparty to make quarterly payments to the entity for the
variable leg and for which the entity pays the present value of the
fixed leg of the swap at the inception of the contract. Different
structures can be used for a prepaid interest rate swap contract,
although the amount and timing of the cash flows under the different
structures are the same, which makes the different structures of
contract terms identical economically. For example, rather than
entering into a 2-year pay-fixed, receive-variable swap with a
$10,000,000 notional amount, a fixed interest rate of 6.65 percent,
and a variable interest rate of 3-month US$ LIBOR (that is, the swap
terms in Example 5 of Statement 133), an entity can effectively
accomplish a prepaid swap by entering into a contract under either of
the following structures.
Structure 1
The entity pays $1,228,179 to enter into a prepaid interest rate swap
contract that requires the counterparty to make quarterly payments
based on a $10,000,000 notional amount and an annual interest rate
equal to 3-month US$ LIBOR. The amount of $1,228,179 is the present
value of the 8 quarterly payments of $166,250, based on the implied
spot rate for each of the 8 payment dates under the assumed initial
yield curve in that example.
Structure 2
The entity pays $1,228,179 to enter into a structured note
("contract") with a principal amount of $1,228,179 and loan
payments based on a formula equal to 8.142 times 3-month US$ LIBOR.
(Note that 8.142 = 10,000,000 / 1,228,179.) Under the structured note,
there is no repayment of the principal amount at the end of the
two-year term. Rather, repayment of the $1,228,179 principal amount is
incorporated into the 8quarterly payments and, thus, is dependent on
interest rates.
RESPONSE
The prepaid interest rate swap contract (accomplished under either
structure) is a derivative instrument because it meets the criteria in
paragraph 6 and related paragraphs of Statement 133. Accordingly, the
prepaid interest rate swap (accomplished under either structure) must
be accounted for as a derivative instrument and reported at fair
value. Even though both structures involve a lending activity related
to the prepayment of the fixed leg, the prepaid interest rate swap
cannot be separated into a debt host contract and an embedded
derivative because Statement 133 does not permit such bifurcation of a
contract that, in its entirety, meets the definition of a derivative.
Discussion of Structure 1
The prepaid interest rate swap in Structure 1 has an underlying
(three-month US$ LIBOR) and a notional amount (refer to paragraph
6(a)). The prepaid interest rate swap requires an initial investment
($1,228,179) that is smaller than would be required for other types of
contracts that would be expected to have a similar response to changes
in market factors, such as an 8-times impact for changes in LIBOR when
applied to the initial investment (refer to paragraph 6(b)). (Note
that the reference to "8 times" is based on the ratio of the
notional amount to the initial investment: 10,000,000 / 1,228,179 =
8.142.) In this example, the initial investment of $1,228,179 is
smaller than an investment of $10,000,000 to purchase a note with a
$10,000,000 notional amount and a variable interest rate of 3-month
US$LIBOR-an instrument that provides the same cash flow response to
changes in LIBOR as the prepaid interest rate swap.
Under the prepaid swap in Structure 1, neither party is required to
deliver an asset that is associated with the underlying or that has a
principal amount, stated amount, face value, number of shares, or
other denomination that is equal to the notional amount (or the
notional amount plus a premium or minus a discount) (refer to
paragraphs 6(c) and 9(a)).
Discussion of Structure 2
The contract in Structure 2 has an underlying (three-month US$ LIBOR)
and a notional amount (refer to paragraph 6(a)). The contract requires
an initial investment that is smaller than would be required for other
types of contracts that would be expected to have a similar response
to changes in market factors, such as an eight-times impact for
changes in US$ LIBOR (refer to paragraph 6(b)). The fact that the
contract under Structure 2 involves an initial investment equal to the
stated notional of $1,228,179 is not an impediment to satisfying the
criterion in paragraph 6(b), even though paragraph 8 states, "A
derivative instrument does not require an initial net investment in
the contract that is equal to the notional amount (or the notional
amount plus a premium or minus a discount) or that is determined by
applying the notional amount to the underlying." The observation
in paragraph 8 focuses on those contracts that do not involve
leverage. When a contract involves leverage, its notional amount is
effectively the stated notional times the multiplication factor that
represents the leverage. The contract in Structure 2 is highly
leveraged, resulting in an impact that is over eight times as great as
simply applying the stated notional amount to the underlying. Thus,
its initial investment is smaller than would be required for other
types of contracts that would be expected to have a similar response
to changes in market factors-the criterion in paragraph 6(b). (Note
that even a contract with a much lower leverage factor than that
illustrated in the above example would meet the criterion in paragraph
6(b).) The guidance in this issue is considered to be consistent with
Statement 133 Implementation Issue No. A1, "Initial Net
Investment," in which a required initial investment of $105 (to
prepay a 1-year forward contract with a $110 strike price) is
considered not to meet the criterion in paragraph 6(b).
Under the contract in Structure 2, neither party is required to
deliver an asset that is associated with the underlying or that has a
principal amount, stated amount, face value, number of shares, or
other denomination that is equal to the notional amount (or the
notional amount plus a premium or minus a discount) (refer to
paragraphs 6(c) and 9(a)). Although the investor may surrender
(deliver) the evidence of indebtedness (the structured note) to the
issuer at maturity, the stated amount of the note ($1,228,179) is not
equal to the actual notional amount ($10,000,000). |
March 20, 2002 Message from Ira
Kawaller
Hi Bob,
I just posted a recently published article on how to satisfy the FAS 133 disclosure requirements for interest rate hedges. Although it was originally published by Bank Asset/Liablility Management (March 2000), the content is
applicable to all firms with interest rate exposures -- not just banks.
If you are interested, it is available at
http://www.kawaller.com/pdf/BALMHedges.pdf
You can also find additional information about derivatives, risk management, and FAS 133 in the various articles posted on the Kawaller & Company website:
http://www.kawaller.com
Please feel free to contact me with any questions, comments, or suggestions.
Ira Kawaller
Kawaller & Company, LLC
kawaller@kawaller.com
(718) 694-6270
|
International Accounting Standards
Board (Committee) (IASB) =
An organization headquartered in London
that has be charged with developing international accounting standards. The charge
is given by 140 public accounting bodies (such as the AICPA in the United States) in 101
countries seeking harmonization of accounting standards. In recent years, IASC
standards have more clout due to widespread requiring of IASC standards by worldwide stock
exchanges for cross-border listings of securities. For a discussion of the IASC's
history and struggles to develop its own IAS 39
"Financial Instruments: Recognition and Measurement" standard that is somewhat
like, but much less complex, than FAS 133,
see my pacter.htm file. Initially, the
IASC was going to adopt FAS 133. Later it commenced work on developing its own
standard. In reality, however, the IASC requirements are very close to FAS 133. Also see IFAC. The web site of the IASC is at http://www.iasc.org.uk .
You can read
about the history of the IASB at
http://www.iasb.org/About+Us/About+the+Foundation/History.htm
Also see the
Timeline at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Click here to view Paul Pacter's commentary on the IASC.
---
http://faculty.trinity.edu/rjensen/acct5341/speakers/pacter.htm
Note
that the differences between IAS 39 and FAS 133 are highlighted at
http://faculty.trinity.edu/rjensen/acct5341/speakers/pacter.htm#SFAS133diffs1
.
The for-free IASC comparison study of IAS 39 versus FAS 133 (by Paul
Pacter) at http://www.iasc.org.uk/news/cen8_142.htm
The non-free FASB comparison study of all standards entitled The IASC-U.S.
Comparison Project: A Report on the Similarities and Differences between IASC
Standards and U.S. GAAP
SECOND EDITION, (October 1999) at http://stores.yahoo.com/fasbpubs/publications.html
In 1999 the Joint Working Group of the Banking
Associations sharply rebuffed the IAS 39 fair value accounting in two white
papers that can be downloaded from http://www.iasc.org.uk/frame/cen3_112.htm.
Also see the Financial Accounting Standards Board (FASB)
and the International Federation of Accountants Committee (IFAC).
Side by Side: IAS 39 Compared with FASB Standards (FAS 133), by Paul Pacter,
as published in Accountancy International Magazine, June 1999 --- http://www.iasc.org.uk/news/cen8_142.htm
Also note "Comparisons of International IAS Versus FASB Standards" ---
http://www.deloitte.com/dtt/cda/doc/content/pocketiasus.pdf
IAS 39 Implementation Guidance
Supplement to the
Publication
Accounting for Financial Instruments - Standards, Interpretations, and
Implementation Guidance
http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf
PowerPoint Show Highlighting Some Complaints About IAS 39 and IAS 32 --- http://www.atel.lu/atel/fr/publications/Publications/030524_EACT%20mtg_Milan.ppt
Fair value accounting politics in the revised
IAS 39
From Paul Pacter's IAS Plus on July 13, 2005 ---
http://www.iasplus.com/index.htm
- Why did the Commission
carve out the full fair value option in the original
IAS 39 standard?
- Do prudential supervisors
support IAS 39 FVO as published by the IASB?
- When will the Commission
to adopt the amended standard for the IAS 39 FVO?
- Will companies be able to
apply the amended standard for their 2005 financial
statements?
- Does the amended standard
for IAS 39 FVO meet the EU endorsement criteria?
- What about the
relationship between the fair valuation of own
liabilities under the amended IAS 39 FVO standard
and under Article 42(a) of the Fourth Company Law
Directive?
- Will the Commission now
propose amending Article 42(a) of the Fourth Company
Directive?
- What about the remaining
IAS 39 carve-out relating to certain hedge
accounting provisions?
|
|
It's
a Shame: Europeans follow rather than learn from Enron's lead on how to
hide risk with unbooked derivatives
"Europe Closer to Adopting Uniform Accounting Rules," by Floyd
Norris, The New York Times, November 22, 2004
The European Commission has formally adopted an
emasculated accounting standard for derivatives, leaving it up to banks to
decide whether they will fully comply with international rules aimed at
preventing financial institutions from hiding losses.
The vote on Friday was a victory for banks, mostly
but not all from France. They had opposed
the accounting rule, voicing concerns that it would lead to volatility in
reported profits and balance sheet values.
Even with the decision to change the rule, the
European Union moved closer to a system of having all companies follow
similar accounting standards beginning in 2005. Until now, each country has
had its own rules, which have varied both in details and in how well they
were enforced. Many companies are expected to report significant changes in
profits under the rules.
The derivatives rule, known as International
Accounting Standard 39, is similar to, but less restrictive than, an
American rule that has been in force for several years. In an attempt to win
European Commission approval, the International Accounting Standards Board
watered down the rule in ways that would let companies keep most of the
volatility away from their income statement. But that was not enough to
satisfy some banks, which complained that the standard would still lead to
lower or more volatile valuations that could alarm investors.
. . .
In announcing the decision, the commission rejected
what it said were criticisms "that the relaxation of the hedge
accounting provisions make the standard 'seriously deficient' and 'not
credible.' " It said that the rule, even with the changes, was "a
significant step forward" because no current European accounting rule
"contains any hedge accounting provisions" at all.
Continued in the article
Differences
(Comparisons) between FAS
133 and IAS 39/IFRS 9 ---
http://faculty.trinity.edu/rjensen/caseans/canada.htm
2011 Update
"IFRS and US GAAP: Similarities and Differences" according to PwC
(2011 Edition)
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
Note that warnings are given throughout the document that the similarities and
differences mentioned in the booklet are not comprehensive of all similarities
and differences. The document is, however, a valuable addition to students of
FASB versus IASB standard differences and similarities.
It's not easy keeping track of what's changing and
how, but this publication can help. Changes for 2011 include:
- Revised introduction reflecting the current
status, likely next steps, and what companies should be doing now
(see page 2);
- Updated convergence timeline, including
current proposed timing of exposure drafts, deliberations, comment
periods, and final standards
(see page 7);
- More current analysis of the differences
between IFRS and US GAAP -- including an assessment of the impact
embodied within the differences
(starting on page 17); and
- Details incorporating authoritative standards
and interpretive guidance issued through July 31, 2011
(throughout).
This continues to be one of PwC's most-read
publications, and we are confident the 2011 edition will further your
understanding of these issues and potential next steps.
For further exploration of the similarities and
differences between IFRS and US GAAP, please also visit our
IFRS Video Learning Center.
To request a hard copy of this publication, please contact your PwC
engagement team or
contact us.
Jensen Comment
My favorite comparison topics (Derivatives and Hedging) begin on Page 158
The booklet does a good job listing differences but, in my opinion, overly
downplays the importance of these differences. It may well be that IFRS is more
restrictive in some areas and less restrictive in other areas to a fault. This
is one topical area where IFRS becomes much too subjective such that comparisons
of derivatives and hedging activities under IFRS can defeat the main purpose of
"standards." The main purpose of an "accounting standard" is to lead to greater
comparability of inter-company financial statements. Boo on IFRS in this topical
area, especially when it comes to testing hedge effectiveness!
One key quotation is on Page 165
IFRS does not specifically discuss the methodology
of applying a critical-terms match in the level of detail included within
U.S. GAAP.
Then it goes yatta, yatta, yatta.
Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and
more importantly fails to provide "implementation guidance" comparable with the
FASB's DIG implementation topics and illustrations.
I have a
huge beef with the lack of illustrations in IFRS versus the many illustrations
in U.S. GAAP.
I have a
huge beef with the lack of illustrations in IFRS versus the many illustrations
in U.S. GAAP.
I have a huge beef with the lack of illustrations in
IFRS versus the many illustrations in U.S. GAAP.
Bob Jensen's threads on accounting standards setting controversies ---
http://faculty.trinity.edu/rjensen/Theory01.htm#MethodsForSetting
2014 Update
Accounting Standard Convergence Dreams Turning Into Divergence Reality in
IFRS 9
From the CPA Newsletter on April 3, 2014
Convergence efforts flounder on IFRS 9
The
International Accounting Standards Board and the Financial Accounting
Standards Board have not been able to come to an agreement on a common
financial-instruments accounting standard (that includes accounting for
derivative financial instruments and hedging actictivities). Hans
Hoogervorst, IASB chairman, said regulators could impose additional
disclosures to bridge the gap, but one IASB member opined that the
failure to achieve convergence on IFRS 9 was a "terrible disappointment"
for global investors.
Financial Director (U.K.) (3/5)
http://r.smartbrief.com/resp/fHeJBYbWhBCCfUknCidmwjCicNRoKW?format=standard
Jensen Comment
I blame a lot of this divergence on the unwillingness of the IASB to standup
to the EU lawmakers who in turn are unwilling to resist the lobbying efforts
of thousands on European banks who want weaker standards for financial
instruments and less costly accounting standards to implement, e.g., wanting
to avoid the costs of discovering and bifurcating embedded derivative
clauses in financial instrument contracts. Aside from ignoring embedded
financial instruments risk the milk toast accounting of hedging
effectiveness is a real softening of IAS 39 that will soon move into IFRS 9.
The IASB is sets global accounting standards but is still heavily
dependent upon EU lawmakers for funding
From the CPA Newsletter on April 3, 2014
EU approves funding for accounting bodies with strings attached
The European Parliament approved
funding for the International Financial Reporting Standards Foundation
and other accounting standards groups, but imposed conditions requiring
regular updates on recommended reforms.
Compliance Week/Global Glimpses blog
(3/19),
The Telegraph (London) (tiered subscription model)
(3/15)
http://r.smartbrief.com/resp/fHeJBYbWhBCCfUkxCidmwjCicNRZjj?format=standard
Bob Jensen's threads on hedge accounting are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
"IAS 32 and IAS 39 Revised: An Overview," Ernst & Young,
February 2004 --- http://www.ey.com/global/download.nsf/International/IAS32-39_Overview_Febr04/$file/IAS32-39_Overview_Febr04.pdf
I shortened the above URL to http://snipurl.com/RevisedIAS32and39
Also see Bob Jensen's
Interest Rate Swap Valuation, Forward Rate Derivation, and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Differences between FAS 133 and
IAS 39 ---
http://faculty.trinity.edu/rjensen/caseans/canada.htm
Also see Macro
Hedge
|
This is
old news, but it does provide some questions for students to ponder.
The main problem of fair value adjustment is that many ((most?) of the
adjustments cause enormous fluctuations in earnings, assets, and liabilities
that are washed out over time and never realized. The
main advantage is that interim impacts that “might be” realized are booked.
It’s a war between “might be” versus “might never.”
The war has been waging for over a century with respect to booked assets
and two decades with respect to unbooked derivative instruments, contingencies,
and intangibles.
As you can
see below, the war is not over yet. In
fact it has intensified between corporations (especially banks) versus standard
setters versus members of the academy.
From The Wall Street Journal
Accounting Educators' Review on April 2, 2004
TITLE: As IASB Unveils New Rules,
Dispute With EU Continues
REPORTER: David Reilly
DATE: Mar 31, 2004
PAGE: A2 LINK: http://online.wsj.com/article/0,,SB108067939682469331,00.html
TOPICS: Generally accepted accounting principles, Fair Value Accounting, Insider
trading, International Accounting, International Accounting Standards Board
SUMMARY: Despite controversy with the
European Union (EU), the International Accounting Standards Board (IASB) is
expected to release a final set of international accounting standards. Questions
focus on the role of the IASB, controversy with the EU, and harmonization of the
accounting standards.
QUESTIONS:
1.) What is the role of the IASB? What authority does the IASB have to enforce
standards?
2.) List three reasons that a country
would choose to follow IASB accounting standards. Why has the U.S. not adopted
IASB accounting standards?
3.) Discuss the advantages and
disadvantages of harmonization of accounting standards throughout the world. Why
is it important the IASB reach a resolution with the EU over the disputed
accounting standards?
4.) What is fair value accounting? Why
would fair value accounting make financial statements more volatile? Is
increased volatility a valid argument for not adopting fair value accounting?
Does GAAP in the United States require fair value accounting? Support your
answers.
Reviewed By: Judy Beckman, University
of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
Bob
Jensen's threads on these controversial standards are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob
Jensen's threads on accounting theory are at
http://faculty.trinity.edu/rjensen/theory.htm
Those
threads dealing with fair value are at
http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm
June 7, 2004 Update
"EU Body Fails to Bar Bank Accounting Rule," The Wall Street
Journal, June 7, 2004, Page A18
A European Commission advisory group failed Friday to
block an accounting rule proposed by the International Accounting Standards
Board governing how banks treat complex accounting instruments on their balance
sheets.
The European Financial Reporting Advisory Council's 11
members voted 6-5 against recommending the new accounitng standard to the
commission but the vote fell short of the two-thirds margin required to
recommend rejections of the new rule.
European banks have opposed portions of the disputed
accounting standard known as FAS 39, because they say requirements to used
market prices to value certain financial instruments will cause unnecessary
volatility in their financial statements.
Continued in the article
GAAP Differences in Your
Pocket: IAS and US GAAP
http://www.deloitte.com/dtt/cda/doc/content/pocketiasus.pdf
Topic |
IAS
39 from the IASB |
FAS
133 from the FASB |
Change in value of
non-trading investment |
Recognize either in
net profit or loss or in equity (with recycling).
May be changed in IAS 39 Amendments. |
Recognize in equity
(with recycling). |
Accounting for
hedges of a firm commitment |
Cash flow hedge.
May be changed in IAS 39 Amendments. |
Fair value hedge. |
Use of partial-term
hedges |
Allowed. |
Prohibited. |
Effect of selling
investments classified as held-to-maturity |
Prohibited from
using held-to- maturity classification for the next two years. |
Prohibited from
using held-to- maturity classification (no two year limit). |
Use of "basis
adjustment" |
Gain/loss on hedging
instrument that had been reported in equity becomes an adjustment of the
carrying amount of the asset.
May be changed in IAS 39 Amendments. |
Gain/loss on hedging
instrument that had been reported in equity remains in equity and is
amortized over the same period as the asset. |
Derecognition
of financial assets |
No "isolation
in bankruptcy" test.
May be changed in IAS 39 Amendments.
May be changed in IAS 39 Amendments. |
Derecognition
prohibited unless the transferred asset is beyond the reach of the
transferor even in bankruptcy. |
Subsequent reversal
of an impairment loss |
Required, if certain
criteria are met
May be changed in IAS 39 Amendments. |
Prohibited. |
Use of
"Qualifying SPEs" |
Prohibited. |
Allowed. |
Differences between FAS 133 and IAS 39 ---
http://faculty.trinity.edu/rjensen/caseans/canada.htm
There are also some major differences in between FAS 133 versus IAS 39 with
respect to macro hedging.
See Macro Hedge
IAS 39 history --- http://www.iasc.org.uk/cmt/0001.asp?s=6941204&sc={CB32B469-886C-4486-86B7-36E49358DDE5}&sd=617116004&n=3306
Limited Revisions to IAS 39, Financial
Instruments: Recognition and Measurement (E66) --- http://www.iasc.org.uk/cmt/0001.asp?s=6941204&sc={CB32B469-886C-4486-86B7-36E49358DDE5}&sd=268256258&n=3222
Recognition and Measurement
(E66)
|
E66,
Proposed Limited Revisions to IAS 39 and Other Related Standards,
proposed the following limited revisions to IAS 39, Financial
Instruments: Recognition and Measurement, and other related Standards:
- changes to require
consistent accounting for purchases and sales of financial assets
using either trade date accounting or settlement date accounting.
IAS 39 currently requires settlement date accounting for sales of
financial assets, but permits both trade date and settlement date
accounting for purchases;
- elimination of the
requirement in IAS 39 for a lender to recognise certain collateral
received from a borrower in its balance sheet;
- improvement of the wording
on impairment recognition;
- changes to require
consistent accounting for temporary investments in equity
securities between IAS 39 and other International Accounting
Standards; and
- elimination of redundant
disclosure requirements for hedges in IAS 32, Financial
Instruments: Disclosure and Presentation.
None of the proposed revisions
represents a change to a fundamental principle in IAS 39. Instead, the
purpose of the proposed changes is primarily to address technical
application issues that have been identified following the approval of
IAS 39 in December 1998. The IASC Board’s assessment is that the
proposed changes will assist enterprises preparing to implement IAS 39
for the first time in 2001 and help ensure a consistent application of
the Standard. No further changes to IAS 39 are contemplated.
|
Hi Patrick,
The term "better" is a loaded
term. One of the main criticisms leveled at IASC standards is that they were too
broad, too permissive, and too toothless to provide comparability between
different corporate annual reports. The IASC (now called IASB) standards only
began ot get respect at IOSCO after they started becoming more like FASB
standards in the sense of having more teeth and specificity.
I think FAS 133 is better than IAS 39
in the sense that FAS 133 gives more guidance on specific types of contracts.
IAS 39 is so vague in places that most users of IAS 39 have to turn to FAS 133
to both understand a type of contract and to find a method of dealing with that
contract. IAS 39 was very limited in terms of examples, but this has been
recitified somewhat (i.e., by a small amount) in a recent publication by the
IASB: Supplement to the Publication Accounting for Financial Instruments -
Standards, Interpretations, and Implementation Guidance http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf
In theory, there are very few
differences between IAS 39 and FAS 133. But this is like saying that there is
very little difference between the Bible and the U.S. Commercial Code. Many
deals may be against what you find in the Bible, but lawyers will find it of
less help in court than the U.S. Commercial Code. I admit saying this with
tongue in cheek, because the IAS 39 is much closer to FAS 133 than the Bible is
to the USCC.
Paul Pacter wrote a nice paper about
differences between IAS 39 and FAS 133. However, such a short paper cannot cover
all differences that arise in practice. One of the differences that I have to
repeatedly warn my students about is the fact that OCI is generally converted to
current earnings when the derivative hedging contract is settled on a cash flow
hedge (this conversion is usually called basis adjustment). For example, if I
hedge a forecasted purchase of inventory, I will use OCI during the cash flow
hedging period, but when I buy the inventory, IAS 39 says to covert the OCI to
current earnings. (Actually, IAS standards do not admit to an "Other
Comprehensive Income" (OCI) account, but they recommend what is tantamount
to using OCI in the equity section of the balance sheet.)
Under FAS 133, basis adjustment is not
permitted under many circumstances when derivatives are settled. In the example
above, FAS 133 requires that OCI be carried forward after the inventory is
purchased and the derivative is settled. OCI is subsequently converted to
earnings in a piecemeal fashion. For example, if 20% of the inventory is sold,
20% of the OCI balance at the time the derivative is settled is then converted
to current earnings. I call this deferred basis adjustment under FAS 133. This
is also true of a cash flow hedge of AFS investment. OCI is carried forward
until the investment is sold.
Although there are differences between
FAS 133 and IAS 39, I would not make too big a deal out of such differences. IAS
39 was written with one eye upon FAS 133, and the differences are relatively
minor. Paul Pacter's summary of these differences can be downloaded from http://www.iasc.org.uk/cmt/0001.asp?s=490603&sc={65834A68-1562-4CF2-9C09-D1D6BF887A00}&sd=860888892&n=3288
Hope this helps,
Bob (Robert E.) Jensen Jesse H. Jones
Distinguished Professor of Business Trinity University, San Antonio, TX 78212
Voice: (210) 999-7347 Fax: (210) 999-8134 Email: rjensen@trinity.edu http://faculty.Trinity.edu/rjensen
-----Original
Message-----
From: Patrick Charles [mailto:charlesp@CWDOM.DM]
Sent: Tuesday, February 26, 2002 11:54 AM
To: CPAS-L@LISTSERV.LOYOLA.EDU
Subject: US GAAP Vs IASB
Greetings Everyone
Mr Bolkestein said
the rigid approach of US GAAP could make it easier to hide companies' true
financial situation. "You tick the boxes and out come the answer,"
he said. "Having rules is a good thing, but having rigid rules is not the
best thing.
http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3AHWRLXXC&live=true&tagid=FTDCZE6JFEC&subheading=accountancy
Finally had a chance
to read the US GAAP issue. Robert you mentioned IAS 39, do you have other
examples where US GAAP is a better alternative to IASB, or is this an European
ploy to get the US to adopt IASB?
Cheers
Mr. Patrick Charles
charlesp@cwdom.dm ICQ#6354999
"Education is an
admirable thing, but it is well to remember from time to time that nothing
that is worth knowing can be taught."
International Federation of Accountants
Committee (IFAC) =
An organization charged with dealing
with matters of concern in 140 public accounting bodies in 110 countries. Relations
with the IASC are briefly discussed by Paul Pacter in my pacter.htm
file. Although the IFAC appoints some members to the IASC, standard setting
responsibilities are now the responsibility of the IASC rather than the IFAC. The
IFAC deals more directly with international auditing standards and education/training
requirements of public accountants around the world. Also see IASC.
The IFAC web site is at http://www.ifac.org/
Click
here to view Paul Pacter's commentary on the IFAC.
In-the-Money = see option and intrinsic value.
Intrinsic Value =
the difference between the spot
price and the forward strike price of the underlying in an option
contract. Intrinsic value is an expected future value. Intrinsic
(future) value minus current (present) value of the option is called time value.
Hence, intrinsic value has two components. One is the known current value. The
other component is time value that is generally unknown ex ante. For example,
the suppose the value of an option having no credit risk is $10 on the exchange
market. If a commodity's price is $93 and the forward (strike) price of a call
option is $90, the intrinsic value of the option is $3. The difference between the
total option's current price ($10) and intrinsic value is a time value of $7 = $10
-$3. One way to think about time value is to think about opportunities for an option
to increase its intrinsic value. If an option is about to expire, there is very
little time left for the spot price of the underlying (e.g., commodity price) to
increase. Time value of an option declines as the option approaches its expiration
date. In other words, intrinsic value converges toward total value as the option
matures. If there is a great deal of time left before the option expires, there is
more opportunity for the underlying to increase in value. Hence time value is higher
for options having longer-term expiration dates. Also see basis.
An illustration of intrinsic value versus time
value accounting is given in Example 9 of FAS 133, Pages 84-86, Paragraphs
162-164. I found the FASB presentation in Paragraph 162 somewhat confusing.
You may want to look at my Example 9 tutorial on this illustration. You may obtain
the link and password by contacting me at rjensen@trinity.edu. Call options are illustrated in Example 9 of
FAS 133 in Paragraphs 162-164. An option is "in-the-money" if the holder would
benefit from exercising it now. A call option is in-the-money if the
strike price (the exercise price) is below the current market
price of the underlying asset; a put option is in-the-money if the strike price is
above the market price. Intrinsic value is equal to the
difference between the strike price and the market price. An option is
"out-of-the-money" if the holder would not benefit from exercising it now. A
call option is out-of-the-money if the strike price is above the current market price of
the underlying asset; a put option is out-of-the-money if the strike price is below the
market price. The key distinction between contracts versus
futures/forward contracts is that an option is
purchased up front and the buyer has a right but not an obligation to execute the option
in the future, In other words, the most the option buyer can lose is the option price. In
the case of forwards and futures, there is an obligation to perform in the future. The writer (seller) of an option, however, has an obligation to
perform if the option is exercised by the buyer. FAS 133 rules for purchased options are
much different than for written options. For rules regarding written options see
Paragraphs 396-401 on Pages 179-181 of FAS 133. Exposure Draft 162-B would not
allow hedge accounting for written options. FAS 133 relaxed the rules for written
options under certain circumstances explained in Paragraphs 396-401.
The partitioning of an option's value
between intrinsic and time value partitions is important subsequent to the
purchase of an option. On the acquisition date, the option is recorded
at the premium (purchase price) the paid.
Subsequent to the purchase date, the option is marked to fair value equal to
subsequent changes in quoted premiums. If the
option qualifies as a cash flow hedge of a forecasted transaction, changes
in the time value of the option are debited or credited to current
earnings. Changes in the intrinsic value, however, are posted to comprehensive
income (OCI). See the CapIT Corporation and FloorIT
Corporation cases at
http://faculty.trinity.edu/rjensen/acct5341/133cases/000index.htm.
Google gave me the following
definitions on February 1, 2004
Definitions of Intrinsic Value on the Web:
A measure of the value of an option or a warrant if immediately
exercised. The amount by which the current price for the underlying
commodity or futures contract is above the strike price of a call
option or below the strike price of a put option for the commodity or
futures contract.
www.cftc.gov/opa/brochures/opaglossary.htm
The amount by which an option is in-the-money. The intrinsic value
is the difference between the exercise/strike price and the price of
the underlying security.
www.exchange-handbook.co.uk/glossary.cfm
That portion of a warrant, right or call option's price that
represents the amount by which the market price of the underlying
security exceeds the price at which the warrant, right or call option
may be exercised. The intrinsic value of a put is calculated as the
amount by which the underlying security's market value is below the
price at which the put option can be exercised.
www.bmoinvestorline.com/EducationCentre/i.html
If the option is in-the-money (see above), the intrinsic value of
the option is the difference between the current price of the
underlying stock and the option strike price.
www.optiondigest.com/stock-option-glossary.htm
The value of an option if it were to expire immediately with the
underlying stock at its current price; the amount by which an option
is in-the-money. For call options, this is the difference between the
stock price and the striking price, if that difference is a positive
number, or zero otherwise. For put options it is the difference
between the striking price and the stock price, if that difference is
positive, and zero otherwise. See also In-the-Money, Time Value
Premium and Parity.
www.cboe.com/LearnCenter/glossary_g-l.asp
The amount by which an option is in-the-money. An option which is
not in-the-money has no intrinsic value. For calls, intrinsic value
equals the difference between the underlying futures price and the
option s strike price. For puts, intrinsic value equals the option s
strike price minus the underlying futures price. Intrinsic value is
never less than zero.
www.energybuyer.org/glossraryGK.htm
For in-the-money call and put options, the difference between the
strike price and the underlying futures price.
futures.tradingcharts.com/glossary/d-i.html
The underlying value of a business separate from its market value
or stock price. In fundamental analysis, the analyst will take into
account both the quantitative and qualitative aspects of a company's
performance. The quantitative aspect is the use of financial ratios
such as earnings, revenue, etc., while the qualitative perspective
involves consideration of the company's management strength. Based on
such analysis, the fundamental analyst will make a forecast of future
earnings and prospects for the company to arrive at an intrinsic value
of its shares. The intrinsic value of a share can be at odds with its
stock market price, indicating that the company is either overvalued
or undervalued by the market. BACK TO TOP
university.smartmoney.com/glossary/index.cfm
The difference between an in the money option strike price and the
current market price of a share of the underlying security.
www.schaeffersresearch.com/option/glossary.asp
The absolute value of the in-the-money amount; that is, the amount
that would be realized if an in-the-money option were exercised.
www.nfa.futures.org/basic/glossary.asp
For call options: The amount the market price of the underlying
security is above the option’s strike price. Eg, an IBM call option
with a strike price of 100 with IBM stock at 110, has an intrinsic
value of 10 & is “in-the-money.” If IBM were at 95, the call
option would have no intrinsic value & would be
“out-of-the-money.” If IBM were at 100, there would still be no
intrinsic value, but the option would be “at-the-money.” For put
options: The amount the market price of the underlying security is
below the option’s strike price. Eg, a Xerox put with a strike price
of 35 with Xerox at 30, has an intrinsic value of 5. If Xerox were at
35 or higher, the put option would have no intrinsic value. See also
Premium, Strike Price & Time Value.
www.hsletter.com/Tutorial_GlossaryB.html
the value of an option measured by the difference between the
strike price and the market price of the underlying futures contract
when the option is "in-the-money."
www.cigtrading.com/glossary.htm
The amount by which an option is in the money.
www.ndmarketmanager.org/education/glossary.html
Value of the option if it were exercised and in the money.
www.agr.gc.ca/policy/risk/course/english/gls1e.html
exists when the exercise price of a call option is below (or of a
put option is above) the current market price of the underlying
security.
www.asset-analysis.com/glossary/glo_026.html
The excess of the market value of the underlying stock over the
striking price of the option for a call, or the excess of the striking
price of the option over the market value of the underlying stock for
a put.
www.yourinvestmentclub.com/dictionary.htm
Historic or other value of an item that means it must be retained
and preserved in its original form - the value that the item has
beyond the recorded information contained in it.
www.alia.org.au/~wsmith/glossary.htm
The amount by which an option is in-the-money. See In-the-Money
Option.
www.goldseek.com/101/glossary.shtml
The amount by which an option is in-the-money. See In-the-Money
Option
www.thepitmaster.com/otherresources/glossary.htm
A call option's intrinsic value is equal to the number of points
the underlying contract exceeds the strike price of the option.. An
option premium will never be less than the option's intrinsic value.
www.gtfutures.com/glossary.htm
The dollar amount of the difference between the exercise price of
an option and the current cash value of the underlying security.
Intrinsic value and time value are the two components of an option
premium, or price.
www.calton.com/definiti.htm
This refers to the difference between an in-the-money call/put and
the strike price.
www.forexdirectory.net/opgloss.html
A form of judgement that takes into account all the values present
in the system, an holistic valuation or fitness measurement of the
whole.
www.calresco.org/glossary.htm
The value of an option were it to be exercised. Only in-the-money
options have intrinsic value.
www.fdic.gov/regulations/trust/trust/glos.html
The amount by which an option is in-the-money. An option having
intrinsic value. A call option is in-the-money if its strike price is
below the current price of the underlying futures contract. A put
option is in-the-money if its strike price is above the current price
of the underlying futures contract.
www.ag-tradingfloor.com/education/glossary.asp
|
Minimum value and Paragraph 63 of FAS 133
The minimum value of an American option is zero or its intrinsic value since it
can be exercised at any time. The same cannot be said for a European
option that has to be held to maturity. If the underlying is the price of
corn, then the minimum value of an option on corn is either zero or the current
spot price of corn minus the discounted risk-free present value of the strike
price. In other words if the option cannot be exercised early, discount
the present value of the strike price from the date of expiration and compare it
with the current spot price. If the difference is positive, this is the
minimum value. It can hypothetically be the minimum value of an American
option, but in an efficient market the current price of an American option will
not sell below its risk free present value.
Of course the value may actually be greater due to volatility that adds value
above the risk-free discount rate. In other words, it is risk or
volatility that adds value over and above a risk free alternative to investing.
However, it is possible but not all that common to exclude volatility from risk
assessment as explained in Sub-paragraph b of Paragraph 63 of FAS 133 quoted
below.
a. If the effectiveness of a hedge with an option
contract is assessed based on changes in the option's intrinsic value, the
change in the time value of the contract would be excluded from the
assessment of hedge effectiveness.
b. If the effectiveness of a hedge with an option
contract is assessed based on changes in the option's minimum value, that
is, its intrinsic value plus the effect of discounting, the change in the
volatility value of the contract would be excluded from the assessment of
hedge effectiveness.
c. If the effectiveness of a hedge with a forward
or futures contract is assessed based on changes in fair value attributable
to changes in spot prices, the change in the fair value of the contract
related to the changes in the difference between the spot price and the
forward or futures price would be excluded from the assessment of hedge
effectiveness.
The point here is that options are certain to be effective in
hedging intrinsic value, but are uncertain in terms of hedging time value at all
interim points of time prior to expiration. As a result, accounting
standards require that effectiveness for hedge accounting be tested at each
point in time when options are adjusted to fair value carrying amounts in the
books even though ultimate effectiveness is certain. Potential gains from
options are uncertain prior to expiration. Potential gains or losses from
other types of derivative contracts are uncertain both before expiration and on
the date of expiration.
Flow Chart for FAS 133 and
IAS 39 Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Differences between FAS 133 and IAS 39
---
http://faculty.trinity.edu/rjensen/caseans/canada.htm
Intrinsic Value Versus Full Value Hedge Accounting ---
http://faculty.trinity.edu/rjensen/caseans/IntrinsicValue.htm
Inverse Floater = see floater.
|
J-Terms
K-Terms
L-Terms
Leaps =
long term derivatives, usually long term options.
Legal
Settlement Rate =
the internal rate of return that discounts
estimated future interest rate swap cash flows back down to a time t value equal to future
swap receipts discounted at the swap receivable rate minus the swap payables discounted at
the swap payable rate. This is a term invented by Bob Jensen in Working Paper 231 at
http://faculty.trinity.edu/rjensen/231wp/231wp.htm
.
Leverage =
an investment position subject to a multiplier
impact on returns. For example, for a relatively low price, say $500, an investor
can purchase a call option on 100 shares of stock that in effect accrues all the benefits
of rising prices on those share as if the investor owned those shares at a price of , say,
$5,000. Similarly, a leveraged position can be obtained on a put option that
benefits the option holder in the case of falling prices. In England and some other
nations, the term "gearing" means the same thing as leverage.
Another example is a leveraged gold note that
pays no interest and has the amount of principal vary with the price of gold. This
is discussed under the term embedded derivative.
Leveraged Gold Note =
see embedded derivative.
Levered Inverse Floater = see floater.
LIBOR =
the London InterBank Offering Rate interest rate
at which banks borrow in London. The rate is commonly used as an index
in floating rate contracts, interest rate swaps, and other contracts based upon interest
rate fluctuations.
LIBOR ---
http://en.wikipedia.org/wiki/Libor
Note that LIBOR is a global index used in hundreds of millions of contracts
around the world as an underlying for interest rate movements. Nobody ever
argued that LIBOR was as risk free as the U.S. Treasury Rate, but globally
the U.S. Treasury rate paled relative to LIBOR as a market index for
interest rates, especially hundreds of trillions of dollars in interest rate
swaps.
Hence when LIBOR becomes
manipulated by traders it affects worldwide settlements. This is why pension
funds of small U.S. towns, labor unions, and banks of all sizes are now
suing Barclays and the other U.K banks that allegedly manipulated the LIBOR
market rates for their own personal agenda.
"Why LIBOR Manipulation Poses an
Ongoing Risk: A finance professor explains what it will take to fix
the problem," by Darrell Duffie, Stanford University Graduate School of
Business, September 2014 ---
Click Here
http://www.gsb.stanford.edu/news/headlines/darrell-duffie-why-libor-manipulation-poses-ongoing-risk?utm_source=Stanford+Business+Re%3AThink&utm_campaign=154e75cce1-Stanford_Business_Re_Think_Issue_46_9_21_2014&utm_medium=email&utm_term=0_0b5214e34b-154e75cce1-70265733&ct=t%28Stanford_Business_Re_Think_Issue_46_9_21_2014%29
"Lies, Damn Lies and Libor:
Call it one more improvisation in 'too big to fail' crisis management,"
by Holman W. Jenkins Jr., The Wall Street Journal, July 6, 2012 ---
http://professional.wsj.com/article/SB10001424052702304141204577510490732163260.html?mod=djemEditorialPage_t&mg=reno64-wsj
Ignore the man
behind the curtain, said the Wizard of Oz. That advice doesn't pay in
the latest scandal of the century, over manipulation of Libor, or the
London Interbank Offered Rate. The mess is one more proof of the failing
wizardry of the First World's monetary-cum-banking arrangements.
Libor is a
reference point for interest rates on everything from auto loans and
mortgages to commercial credit and complex derivatives. Major world
banks are accused of artificially suppressing their claimed Libor rates
during the 2007-08 financial crisis to hide an erosion of trust in each
other.
Did the Bank of
England or other regulators encourage and abet this manipulation of a
global financial indicator?
We are talking
about TBTF banks—too big to fail banks. Banks that, by definition,
become suspect only when creditors begin to wonder if regulators might
seize them and impose losses selectively on creditors. Their overseers
could not have failed to notice that interbank liquidity was drying up
and the banks nevertheless were reporting Libor rates that suggested all
was well. The now-famous nudging phone call from the Bank of England's
Paul Tucker to Barclays's Bob Diamond came many months after Libor
manipulation had already been aired in the press and in meetings on both
sides of the Atlantic. That call was meant to convey the British
establishment's concern about Barclays's too-high Libor submissions.
Let's not kid
ourselves about something else: Central banks everywhere at the time
were fighting collapsing confidence by cutting rates to stimulate retail
lending. Their efforts would have been thwarted if Libor flew up on
panic about the solvency of the major banks.
Of all the
questionably legal improvisations regulators resorted to during the
crisis, then, the Libor fudge appears to be just one more. Regulators
everywhere gamed their own capital standards to keep banks afloat. The
Fed's bailout of AIG, an insurance company, hardly bears close
examination. And who can forget J.P. Morgan's last-minute decision to
pay Bear Stearns shareholders $10 a share, rather than the $2 mandated
by Treasury Secretary Hank Paulson, to avoid a legal test of the
Fed-orchestrated takeover? Even today, the European Central Bank
continues to extend its mandate in dubious ways to fight the euro
crisis.
There has been
little legal blowback from any of this, but apparently there will be a
great deal of blowback from the Libor fudge. Barclays has paid $453
million in fines. Half its top management has resigned. A dozen
banks—including Credit Suisse, Deutsche Bank, Citigroup and J.P. Morgan
Chase—remain under investigation. Private litigants are lining up even
as officialdom seemingly intends to wash its hands of its own role.
Yet the larger
lesson isn't that bankers are moral scum, badder than the rest of us.
The Libor scandal is another testimony (as if more were needed) of just
how lacking in rational design most human institutions inevitably are.
Libor was
flawed by the assumption that the banks setting it would always be seen
as top-drawer credit risks. The Basel capital-adequacy rules were flawed
because they incentivized banks to overproduce "safe" assets, like Greek
bonds and U.S. mortgages. The ratings process was flawed eight ways from
Sunday, including the fact that many fiduciaries, under law, were
required to invest in securities blessed by the rating agencies.
Some Barclays
emails imply that traders, even before the crisis, sought to influence
the bank's Libor submissions for profit-seeking reasons. This is
puzzling and may amount to empty chest thumping. Barclays's "submitters"
wouldn't seem in a position to move Libor in ways of great use to
traders. Sixteen banks are polled to set Libor and any outlying results
are thrown out. Plus each bank's name and submission are published
daily. But let's ask: Instead of trying to manipulate Libor in a crisis,
what would have been a more straightforward way of dealing with its
exposed flaws, considering the many trillions in outstanding credit tied
to Libor?
Continued in article
Bob Jensen's threads on interest
rate swaps and LIBOR ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Search for LIBOR or swap.
Liquidity Stress Test
See
Stress Test
LME =
London Mercantile Exchange. See spot rate.
Loan Commitments
Accounting for Executory Contracts Such as Purchase/Sale Commitments and
Loan Commitments ---
http://faculty.trinity.edu/rjensen/TheoryOnFirmCommitments.htm
Also ee
Fair Value
Loan + Swap Rate
=
an underlying notional loan rate (e.g., the interest rate
on bonds payable) plus the difference between the swap receivable rate minus the swap
payable rate. This is a term invented by Bob Jensen in Working Paper 231 at
http://faculty.trinity.edu/rjensen/231wp/231wp.htm
.
Loan Obligation
A
loan obligation is a contract to make a loan in the future. If it is a firm
commitment in the sense of a specified rate of interest, its accounting
depends a great deal whether or not the loan commitment will net settle due
to changes in market rates of interest. FAS 133 is very clear that loan
commitments that do not net settle are not required to be booked as
derivative financial instruments, although certain problems of conflict
between FAS 133 versus FAS 65.had to be resolved in Paragraphs A26-A33 if
FAS 149.
Loan commitments that net settle were
more of a problem in IAS 39 since net settlement is not required in the IAS
39 definition of a derivative. However, IAS 39 added a net settlement
condition for loan commitments as follows:
BC15 Loan commitments
are firm commitments to provide credit under pre-specified terms and
conditions. In the IAS 39 implementation guidance process, the
question was raised whether a bank's loan commitments are
derivatives accounted for at fair value under IAS 39. This question
arises because a commitment to make a loan at a specified rate of
interest during a fixed period of time meets the definition of a
derivative. In effect, it is a written option for the potential
borrower to obtain a loan at a specified rate.
BC16 To simplify the
accounting for holders and issuers of loan commitments, the Board
decided to exclude particular loan commitments from the scope of IAS
39. The effect of the exclusion is that an entity will not recognise
and measure changes in fair value of these loan commitments that
result from changes in market interest rates or credit spreads. This
is consistent with the measurement of the loan that results if the
holder of the loan commitment exercises its right to obtain
financing, because changes in market interest rates do not affect
the measurement of an asset measured at amortised cost (assuming it
is not designated in a category other than loans and receivables).
BC17 However, the Board
decided that an entity should be permitted to measure a loan
commitment at fair value with changes in fair value recognised in
profit or loss on the basis of designation at inception of the loan
commitment as a financial liability through profit or loss. This may
be appropriate, for example, if the entity manages risk exposures
related to loan commitments on a fair value basis.
BC18 The Board further
decided that a loan commitment should be excluded from the scope of
IAS 39 only if it cannot be settled net. If the value of a loan
commitment can be settled net in cash or another financial
instrument, including when the entity has a past practice of selling
the resulting loan assets shortly after origination, it is difficult
to justify its exclusion from the requirement in IAS 39 to measure
at fair value similar instruments that meet the definition of a
derivative.
BC19 Some comments
received on the Exposure Draft disagreed with the Board's proposal
that an entity that has a past practice of selling the assets
resulting from its loan commitments shortly after origination should
apply IAS 39 to all of its loan commitments. The Board considered
this concern and agreed that the words in the Exposure Draft did not
reflect the Board's intention. Thus, the Board clarified that if an
entity has a past practice of selling the assets resulting from its
loan commitments shortly after origination, it applies IAS 39 only
to its loan commitments in the same class.
BC20 Finally, the Board
decided that commitments to provide a loan at a below-market
interest rate should be initially measured at fair value, and
subsequently measured at the higher of (a) the amount that would be
recognised under IAS 37 and (b) the amount initially recognised
less, where appropriate, cumulative amortisation recognised in
accordance with IAS 18 Revenue. It noted that without such a
requirement, liabilities that result from such commitments might not
be recognised in the balance sheet, because in many cases no cash
consideration is received.
BC20A As discussed in
paragraphs BC21–BC23E, the Board amended IAS 39 in 2005 to address
financial guarantee contracts. In making those amendments, the Board
moved the material on loan commitments from the scope section of the
Standard to the section on subsequent measurement (Paragraph 47(d)).
The purpose of this change was to rationalise the presentation of
this material without making substantive changes.
|
Paragraph BC18 above
especially brings IAS 39 closer to FAS 133 with respect to the net
settlement criterion for loan commitments to be derivatives.
If a loan commitment
net settles and is booked as a derivative financial instrument, a hedge of
this loan commitment cannot get hedge accounting. However, if the loan
commitment does not net settle and is not booked, then the question of hedge
accounting depends upon how the loan eventually will be carried when it is
transacted and booked. If it will be carried at fair value, then hedge
accounting is not allowed for any derivative that hedges this unbooked loan
commitment. If the loan will be carried at amortized cost, however, hedge
accounting is available for the hedging derivative just as it is for a
purchase commitment of inventory and fixed assets.
In matters of valuing
loan commitments at fair value if they meet the net settlement condition of
a derivative and are booked at fair value, a question arises as to fair
value measurement when future servicing rights are embedded in the value of
the loan, as is the case for most mortgage loans. A key paragraph of the
SEC’s SAB 105 reads as follows:
Facts: Bank A enters into a
loan commitment with a customer to originate a mortgage loan at a
specified rate. As part of this written loan commitment, Bank A
expects to receive future net cash flows related to servicing rights
from servicing fees (included in the loan's interest rate or
otherwise), late charges, and other ancillary sources, or from
selling the servicing rights to a third party. If Bank A intends to
sell the mortgage loan after it is funded, pursuant to paragraph 6
of FASB Statement No. 133, Accounting for Derivative Instruments
and Hedging Activities, as amended by FASB Statement No. 149,
Amendment of Statement 133 on Derivative Instruments and Hedging
Activities ("Statement 133"), the written loan commitment is
accounted for as a derivative instrument and recorded at fair value
through earnings (referred to hereafter as a "derivative loan
commitment"). If Bank A does not intend to sell the mortgage loan
after it is funded, the written loan commitment is not accounted for
as a derivative under Statement 133. However, paragraph 7(c) of FASB
Statement No. 159, The Fair Value Option for Financial Assets and
Financial Liabilities ("Statement 159"), permits Bank A to
record the written loan commitment at fair value through earnings
(referred to hereafter as a "written loan commitment"). Pursuant to
Statement 159, the fair value measurement for a written loan
commitment would include the expected net future cash flows related
to the associated servicing of the loan. |
In summary, the
loan commitment must in some instances be booked at fair value and in other
instances it may be booked at fair value under the Fair Value Option (FVO)
in FAS 159. However, FAS 159 makes fair value booking optional when it is
not required under SAB 105, FAS 133, and FAS 149.If the loan commitment is
not booked, the accounting for it would be much like the accounting for
unbooked purchase/sale contracts illustrated by Bob Jensen at
---
ttp://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/answers/WeeklyAssignments/quiz0107a.xls
Additional
Considerations
PwC in Comperio
makes the following observation:
SEC Staff Accounting Bulletin
105, Application of Accounting Principles to Loan Commitments (SAB
105), specifies that in estimating the fair value of loan
commitments that are subject to FAS 133, an entity should exclude
from its calculation the expected future cash flows related to the
associated servicing of the loan. It is unclear whether the guidance
in SAB 105 would also apply to loan commitments that are not subject
to FAS 133 but are eligible for the FVO under FAS 159. The SEC Staff
has requested that an industry group led by the Mortgage Bankers
Association assist in resolving this issue |
Also
consider DIG Issue No. C-13 as amended by FAS 149. Pursuant to FAS 156, a
mortgage banking enterprise may elect to subsequently measure (BOOKED)
servicing assets and servicing liabilities at fair value with changes in
fair value reported in the period in which they occur. By electing the Fair
Value Measurement Method, the mortgage banking enterprise may simplify its
objective for hedge accounting because the Fair Value Measurement Method
requires income statement recognition of the changes in fair value of those
servicing assets and servicing liabilities, which will potentially offset
the changes in fair value of the derivative instruments in the same
accounting period without designating formal FAS 133 hedging relationships.
The FASB’s Accounting Standards Codification online database provides
useful information regarding recognition of derivatives. Derecognition of
derivatives is also discussed
Local Currency =
currency of a particular country being referred to; the
reporting currency of a domestic or foreign operation being referred to in context.
Long =
Ownership of an investment position, security, or
instrument such that rising market prices will benefit the owner. This is also known
as a long position. For example, the purchase of a call option
is a long position because the owner of the call option goes in the money with rising
prices. See also short.
Long-Haul Method ---
see Shortcut Method under the
S-Terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#S-Terms
Long Term Capital Management (LTCM)
Fund =
the best known of the investment
funds that failed using scientific formulas for hedging with derivatives. The firm
was run by 25 scholars who received Ph.Ds in economics and were heavily influenced by the
options pricing theories of Nobel Prize winning economists Robert C. Merton and Myron S.
Scholes. In November of 1998, the largest and best known investment banking
and brokerage houses in New York had to dig deep into their own pockets to keep the fund
from a failure that would have shaken financial markets around the world. See Options Pricing Theory and Black-Scholes
Model.
|
M-Terms
Macro Hedge = the hedging of a portfolio of items such as
loans rather than the hedging of each item within the portfolio. In some
cases, the hedge is a net hedge of the value of the portfolio's asset items less
the value of the portfolio's liability items.
In general, FAS 133 does not allow a macro hedge accounting of a
non-homogeneous portfolio. Net hedging also does not qualify for hedge
accounting.
. The FASB’s blanket refusal
to allow hedge accounting for macro hedges of non-homogeneous portfolios and
hedges of more than one type of risk runs counter to both theory and practice.
For example, it is extremely common for financial instruments such as
loans to have combined interest rate risk and prepayment risk that arises from
embedded options to settle before a maturity date.
If multiple-risk items are being hedged for only one type of risk,
usually price or interest rate risk, changes in the market value of the
hedging derivative that hedges only one type of risk may not match changes in
the market value of the hedged item whose value changes are impacted by
multiple risks. The hedge of the
price risk may be perfectly effective when in fact the FAS 133 mandated
comparisons of the changes in hedged item and hedging instrument values make
it appear to be an ineffective hedge that does not qualify for hedge
accounting.
Put in another way, suppose the hedged item is an apple whose value is
impacted by both the market price of apples and a significant likelihood that
the apple will rot before being sold. The
hedging derivative (say an apple price swap contract) is only impacted by
changes in apple prices and is not subject to rotting before a contracted
maturity date. Changes in the swap’s
value may be highly ineffective in hedging the value change of any apple that
becomes prematurely rotten. The
same can be said about the hedge of a loan investment if the loan is paid off
prematurely. Varying prepayment
risks on loans held by banks typically prevent loan portfolios from being
sufficiently homogeneous for purposes of macro hedging of interest rate risks
under FAS 133 and IAS 39.
FAS 133 and IAS 39 rules require, except in rare instances, a separate
hedging contract for each investment loan in a portfolio of hundreds or
thousands of loans. Obtaining
favorable hedge accounting under the rules becomes extremely impractical for
firms holding large portfolios. The way that banks hedge loan interest rates
in practice is to macro hedge an entire portfolio of loans grouped into time
periods based upon expected repayment dates rather than contracted maturities.
This is analogous to hedging a warehouse full of apples grouped
according to expected sales dates rather than expected dates of being too
rotten to sell. In the
U.S.
, banks and other business firms tried unsuccessfully allow for greater
flexibility in FAS 133 macro hedging rules that do not require individual item
hedging contracts.
Individual item hedges that seldom take place for many types of
transactions where financial risk is managed on a macro basis for portfolios
of transactions. Banks just do not
hedge each individual loan just as grocers do not hedge individual apples.
The major macro hedging controversy boils down to the following
controversies:
1.
Individual item hedging is sometimes as absurdly impractical as
writing a forward contract for each apple held in a grocery chain’s
inventory.
2.
Not allowing multiple types of risk to be hedged with one
hedging instrument fails to take into account that the two or more risks may
be highly correlated. The market
value of a fixed-rate loan is greatly impacted by both risk of interest rate
movements and risk of prepayment which, in turn, is also correlated with
interest rate movements. The two
risks are neither independent nor additive.
3.
Businesses badly want accounting rules changed to allow macro
hedge accounting for portfolios of assets and liabilities rather than
individual items. The also want
hedge accounting for “netting” hedges in portfolios contain both assets
and liabilities. Managers often
hedge net values even though netting is not allowed in the current hedge
accounting standards.
It may be possible for
firms to provide online supplementary pivot tables for investor dynamic
analyses of hedges much like Microsoft provides online “What if” pivot
tables to supplement
Macro hedging problem --- using a single hedge of a portfolio of securities
having multiple financial risks
"IASB seeks improvement for macro hedging accounting," by Ken Tysiac,
Journal of Accountancy, April 17, 2014 ---
http://www.journalofaccountancy.com/News/20149975.htm
Jensen Comment
FAS 133 denied hedge accounting for portfolios or securities having more than
one type of financial risk. For example, a portfolio of mortgage investments or
liabilities might have securities with differing maturity dates, different
interest rates, different currencies, different embedded payoff options, etc.
FAS 138 became somewhat of an exception after the FASB learned that it was
common to hedge a given security called a "cross currency" security having both
interest rate risk and foreign currency risk. FAS 133 overturned the FAS 133 ban
on simultaneous hedging of a given security's simultaneous risk of interest rate
fluctuation and FX fluctuation. However, the cross currency hedging instrument
itself must simultaneously hedge both risks. There are cross currency hedging
instruments in the financial world that do so.
The FASB, however, has never allowed hedge accounting for portfolios of
securities unless all components of the portfolio have the same risks such as
the same fixed or variable interest rates, the same maturity dates, the same
foreign exchange risk, etc. Such portfolios almost never exist in the financial
world.
Now the IASB is somehow miraculously trying to provide hedge accounting for
heterogeneous portfolios. All I can say is good luck!
Although there has been considerable convergence of IASB and FASB standards,
the accounting for derivative financial instruments and hedge accounting has
been marked by increased divergence as the IASB
tries to make marshmallows out of complicated hedge accounting rules that once
existed in IAS 39.
One thing is set in stone. If a portfolio has more than one type of financial
risk, a hedging instrument that does not hedge all those risks simultaneiously
is not a hedging instrument in the financial world. It may one day be one in the
fantasyland of the IASB obsessed with principles-based standards having no
bright lines.
Macro hedging problem --- using a single hedge of a portfolio of securities
having multiple financial risks
"IASB seeks improvement for macro hedging accounting," by Ken Tysiac,
Journal of Accountancy, April 17, 2014 ---
http://www.journalofaccountancy.com/News/20149975.htm
Jensen Comment
FAS 133 denied hedge accounting for portfolios or securities having more than
one type of financial risk. For example, a portfolio of mortgage investments or
liabilities might have securities with differing maturity dates, different
interest rates, different currencies, different embedded payoff options, etc.
FAS 138 became somewhat of an exception after the FASB learned that it was
common to hedge a given security called a "cross currency" security having both
interest rate risk and foreign currency risk. FAS 133 overturned the FAS 133 ban
on simultaneous hedging of a given security's simultaneous risk of interest rate
fluctuation and FX fluctuation. However, the cross currency hedging instrument
itself must simultaneously hedge both risks. There are cross currency hedging
instruments in the financial world that do so.
The FASB, however, has never allowed hedge accounting for portfolios of
securities unless all components of the portfolio have the same risks such as
the same fixed or variable interest rates, the same maturity dates, the same
foreign exchange risk, etc. Such portfolios almost never exist in the financial
world.
Now the IASB is somehow miraculously trying to provide hedge accounting for
heterogeneous portfolios. All I can say is good luck!
Although there has been considerable convergence of IASB and FASB standards,
the accounting for derivative financial instruments and hedge accounting has
been marked by increased divergence as the IASB
tries to make marshmallows out of complicated hedge accounting rules that once
existed in IAS 39.
One thing is set in stone. If a portfolio has more than one type of financial
risk, a hedging instrument that does not hedge all those risks simultaneiously
is not a hedging instrument in the financial world. It may one day be one in the
fantasyland of the IASB obsessed with principles-based standards having no
bright lines.
Volcker Rule Won't Allow Banks to Use 'Portfolio Hedging' ---
http://online.wsj.com/news/articles/SB10001424052702303722104579238622934171230?mod=djemCFO_h
Bob Jensen's helpers for learning about accounting for derivative
financial instruments and hedge accounting ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Jensen Comment
FAS 133 has never allowed macro hedge accounting relief for hedged portfolios
except when all financial risks of components in the portfolio are identical
(read that as almost never). For example, if mortgage loans in a hedged
portfolio have different interest rates and maturity dates the risks are
heterogeneous. In fact the risks differ fundamentally since the collateral
of any one mortgage differs from the collateral of any other mortgage.
Put in another way, suppose the hedged
item is an apple whose value is impacted by both the market price of apples and
a significant likelihood that the apple will rot before being sold. The hedging
derivative (say an apple price swap contract) is only impacted by changes in
apple prices and is not subject to rotting before a contracted maturity date.
Changes in the swap's value may be highly ineffective in hedging the value
change of any apple that becomes prematurely rotten. The same can be said about
the hedge of a loan investment if the loan is paid off prematurely. Varying
prepayment risks on loans held by banks typically prevent loan portfolios from
being sufficiently homogeneous for purposes of macro hedging of interest rate
risks under FAS 133 and IAS 39.
Note that KPMG was fired from the firm's biggest audit
in history (Fannie Mae) largely because KPMG allowed hedge accounting of some
portfolios in the largest earnings management fraud in history engineered by
Fannie Mae's CEO Franklin Raines who wanted his earnings-based bonus.
"Fannie Mae Enron?" Editorial in The
Wall Street Journal
October 4, 2004; Page A16
For
years, mortgage giant Fannie Mae has produced smoothly growing earnings. And
for years, observers have wondered how Fannie could manage its inherently
risky portfolio without a whiff of volatility. Now, thanks to Fannie's
regulator, we know the answer. The company was cooking the books. Big time.
We've
looked closely at the 211-page report issued by the Office of Federal
Housing Enterprise Oversight (Ofheo), and the details are more troubling
than even the recent headlines. The magnitude of Fannie's machinations is
stunning, and in two key areas in particular they deserve to be better
understood. By improperly delaying the recognition of income, it created a
cookie jar of reserves. And by improperly classifying certain derivatives,
it was able to spread out losses over many years instead of recognizing them
immediately.
In
the cookie-jar ploy, Fannie set aside an artificially large cash reserve.
And -- presto -- in any quarter its managers could reach into that jar to
compensate for poor results or add to it to dampen good ones. This ploy,
according to Ofheo, gave Fannie "inordinate flexibility" in reporting the
amount of income or expenses over reporting periods.
This
flexibility also gave Fannie the ability to manipulate earnings to hit --
within pennies -- target numbers for executive bonuses. Ofheo details an
example from 1998, the year the Russian financial crisis sent interest rates
tumbling. Lower rates caused a lot of mortgage holders to prepay their
existing home mortgages. And Fannie was suddenly facing an estimated expense
of $400 million.
Well,
in its wisdom, Fannie decided to recognize only $200 million, deferring the
other half. That allowed Fannie's executives -- whose bonus plan is linked
to earnings-per-share -- to meet the target for maximum bonus payouts. The
target EPS for maximum payout was $3.23 and Fannie reported exactly . . .
$3.2309. This bull's-eye was worth $1.932 million to then-CEO James Johnson,
$1.19 million to then-CEO-designate Franklin Raines, and $779,625 to
then-Vice Chairman Jamie Gorelick.
That
same year Fannie installed software that allowed management to produce
multiple scenarios under different assumptions that, according to a Fannie
executive, "strengthens the earnings management that is necessary when
dealing with a volatile book of business." Over the years, Fannie designed
and added software that allowed it to assess the impact of recognizing
income or expense on securities and loans. This practice fits with a Fannie
corporate culture that the report says considered volatility "artificial"
and measures of precision "spurious."
This
disturbing culture was apparent in Fannie's manipulation of its derivative
accounting. Fannie runs a giant derivative book in an attempt to hedge its
massive exposure to interest-rate risk. Derivatives must be
marked-to-market, carried on the balance sheet at fair value. The problem is
that changes in fair-value can cause some nasty volatility in earnings.
So,
Fannie decided to classify a huge amount of its derivatives as hedging
transactions, thereby avoiding any impact on earnings. (And we mean huge: In
December 2003, Fan's derivatives had a notional value of $1.04 trillion of
which only a notional $43 million was not classified in hedging
relationships.) This misapplication continued when Fannie closed out
positions. The company did not record the fair-value changes in earnings,
but only in Accumulated Other Comprehensive Income (AOCI) where losses can
be amortized over a long period.
Fannie had some $12.2 billion in deferred losses in the AOCI balance at
year-end 2003. If this amount must be reclassified into retained earnings,
it might punish Fannie's earnings for various periods over the past three
years, leaving its capital well below what is required by regulators.
In
all, the Ofheo report notes, "The misapplications of GAAP are not limited
occurrences, but appear to be pervasive . . . [and] raise serious doubts as
to the validity of previously reported financial results, as well as
adequacy of regulatory capital, management supervision and overall safety
and soundness. . . ." In an agreement reached with Ofheo last week, Fannie
promised to change the methods involved in both the cookie-jar and
derivative accounting and to change its compensation "to avoid any
inappropriate incentives."
But
we don't think this goes nearly far enough for a company whose executives
have for years derided anyone who raised a doubt about either its accounting
or its growing risk profile. At a minimum these executives are not the sort
anyone would want running the U.S. Treasury under John Kerry. With the
Justice Department already starting a criminal probe, we find it hard to
comprehend that the Fannie board still believes that investors can trust its
management team.
Fannie Mae isn't an ordinary company and this isn't a run-of-the-mill
accounting scandal. The U.S. government had no financial stake in the
failure of Enron or WorldCom. But because of Fannie's implicit subsidy from
the federal government, taxpayers are on the hook if its capital cushion is
insufficient to absorb big losses. Private profit, public risk. That's quite
a confidence game -- and it's time to call it.
Also note that FAS 133 and
IAS 39 do not prevent portfolio hedging --- only the ability to get hedge
accounting relief for portfolio hedges. The Volker Rule is much more
restrictive regarding permission of the banks to hedge portfolios.
Revisions to IAS 39 allow portfolio hedging under limited circumstances.
"Volcker Rule Won't Allow Banks to Use 'Portfolio Hedging'," by Scott
Patterson and Justin Baer, The Wall Street Journal, December 4, 2013 ---
http://online.wsj.com/news/articles/SB10001424052702303722104579238622934171230?mod=djemCFO_h
In a defeat for Wall Street, the "Volcker rule"
won't allow banks to enter trades designed to protect against losses held in
a broad portfolio of assets, according to people familiar with the rule.
The practice, known as portfolio hedging, has
become a focal point of regulators drafting the rule, a controversial plank
of the 2010 Dodd-Frank financial law that seeks to prevent banks from
putting their own capital at risk in pursuit of trading profits.
The rule, named after former Federal Reserve
Chairman Paul Volcker, is expected to be approved next week, ending a
three-year period of regulatory uncertainty for some of the securities
industry's most-profitable businesses.
But it won't contain language permitting portfolio
hedging, which has been "expunged" from earlier drafts of the rule,
according to a person familiar with the matter. Regulators decided to remove
portfolio hedging from the rule after J.P. Morgan Chase JPM +0.58% & Co.
disclosed billions of dollars in losses from its so-called London whale
trades in 2012.
The bank initially described the trades as a
portfolio hedge. Now, it is likely other Wall Street firms also will end up
paying for J.P. Morgan's slip-up. Regulators, in response to the J.P. Morgan
disclosure, pushed to write a rule that would ensure banks couldn't engage
in such trades.
The move will come as a blow to banks, which
lobbied regulators to keep language allowing portfolio hedging in the rule.
Banks often hedge to offset the risks that accompany trading with clients.
Sometimes, though, there is no perfect counterweight to those clients'
trades. Banks look to portfolio hedging to manage a broader array of risks.
A recent version of the Volcker rule, reviewed by
The Wall Street Journal, defined hedging activity as "designed to reduce or
otherwise significantly mitigate…one or more identifiable risks."
What hedges don't do, regulators wrote, is "give
rise…to any significant new or additional risk that is not itself hedged
contemporaneously." The excerpt reviewed by the Journal didn't mention
portfolio hedging.
Continued in article
Macro Hedging is Probably the Main Weakness of FAS
133, and Fannie Mae is Taking it in the Fanny
The bottom line is that both the FASB and the IASB
must someday soon take another look at how the real world hedges portfolios
rather than individual securities. The problem is complex, but the problem
has come to roost in Fannie Mae's $1 trillion in hedging contracts. How
the SEC acts may well override the FASB. How the SEC acts may be a
vindication or a damnation for Fannie Mae and Fannie's auditor KPMG who let
Fannie violate the rules of IAS 133.
You can read more about macro hedges at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#M-Terms
On October 4, 2004 the main editorial in The Wall
Street Journal presented a scathing attack on Fannie Mae (and outside
auditor KPMG by implication) for simply ignoring FAS 133 explicit rules for
testing hedging effectiveness and improperly keeping over $1 billion in hedging
gains and losses in AOCI (accumulated other comprehensive income) rather than
current earnings.
"Fannie Mae Enron?"
Editorial in The Wall Street Journal
October 4, 2004; Page A16
For years, mortgage giant Fannie Mae
has produced smoothly growing earnings. And for years, observers have wondered
how Fannie could manage its inherently risky portfolio without a whiff of
volatility. Now, thanks to Fannie's regulator, we know the answer. The company
was cooking the books. Big time.
We've looked closely at the 211-page
report issued by the Office of Federal Housing Enterprise Oversight (Ofheo),
and the details are more troubling than even the recent headlines. The
magnitude of Fannie's machinations is stunning, and in two key areas in
particular they deserve to be better understood. By improperly delaying the
recognition of income, it created a cookie jar of reserves. And by improperly
classifying certain derivatives, it was able to spread out losses over many
years instead of recognizing them immediately.
In the cookie-jar ploy, Fannie set
aside an artificially large cash reserve. And -- presto -- in any quarter its
managers could reach into that jar to compensate for poor results or add to it
to dampen good ones. This ploy, according to Ofheo, gave Fannie
"inordinate flexibility" in reporting the amount of income or
expenses over reporting periods.
This flexibility also gave Fannie the
ability to manipulate earnings to hit -- within pennies -- target numbers for
executive bonuses. Ofheo details an example from 1998, the year the Russian
financial crisis sent interest rates tumbling. Lower rates caused a lot of
mortgage holders to prepay their existing home mortgages. And Fannie was
suddenly facing an estimated expense of $400 million.
Well, in its wisdom, Fannie decided to
recognize only $200 million, deferring the other half. That allowed Fannie's
executives -- whose bonus plan is linked to earnings-per-share -- to meet the
target for maximum bonus payouts. The target EPS for maximum payout was $3.23
and Fannie reported exactly . . . $3.2309. This bull's-eye was worth $1.932
million to then-CEO James Johnson, $1.19 million to then-CEO-designate
Franklin Raines, and $779,625 to then-Vice Chairman Jamie Gorelick.
That same year Fannie installed
software that allowed management to produce multiple scenarios under different
assumptions that, according to a Fannie executive, "strengthens the
earnings management that is necessary when dealing with a volatile book of
business." Over the years, Fannie designed and added software that
allowed it to assess the impact of recognizing income or expense on securities
and loans. This practice fits with a Fannie corporate culture that the report
says considered volatility "artificial" and measures of precision
"spurious."
This disturbing culture was apparent in
Fannie's manipulation of its derivative accounting. Fannie runs a giant
derivative book in an attempt to hedge its massive exposure to interest-rate
risk. Derivatives must be marked-to-market, carried on the balance sheet at
fair value. The problem is that changes in fair-value can cause some nasty
volatility in earnings.
So, Fannie decided to classify a huge
amount of its derivatives as hedging transactions, thereby avoiding any impact
on earnings. (And we mean huge: In December 2003, Fan's derivatives had a
notional value of $1.04 trillion of which only a notional $43 million was not
classified in hedging relationships.) This misapplication continued when
Fannie closed out positions. The company did not record the fair-value changes
in earnings, but only in Accumulated Other Comprehensive Income (AOCI) where
losses can be amortized over a long period.
Fannie had some $12.2 billion in
deferred losses in the AOCI balance at year-end 2003. If this amount must be
reclassified into retained earnings, it might punish Fannie's earnings for
various periods over the past three years, leaving its capital well below what
is required by regulators.
In all, the Ofheo report notes,
"The misapplications of GAAP are not limited occurrences, but appear to
be pervasive . . . [and] raise serious doubts as to the validity of previously
reported financial results, as well as adequacy of regulatory capital,
management supervision and overall safety and soundness. . . ." In an
agreement reached with Ofheo last week, Fannie promised to change the methods
involved in both the cookie-jar and derivative accounting and to change its
compensation "to avoid any inappropriate incentives."
But we don't think this goes nearly far
enough for a company whose executives have for years derided anyone who raised
a doubt about either its accounting or its growing risk profile. At a minimum
these executives are not the sort anyone would want running the U.S. Treasury
under John Kerry. With the Justice Department already starting a criminal
probe, we find it hard to comprehend that the Fannie board still believes that
investors can trust its management team.
Fannie Mae isn't an ordinary company
and this isn't a run-of-the-mill accounting scandal. The U.S. government had
no financial stake in the failure of Enron or WorldCom. But because of
Fannie's implicit subsidy from the federal government, taxpayers are on the
hook if its capital cushion is insufficient to absorb big losses. Private
profit, public risk. That's quite a confidence game -- and it's time to call
it.
FAS 133 (and IAS 39) do not deal well with macro (portfolio) hedges in that
hedge accounting is denied unless all of the securities in a portfolio are
identical in terms of the risk being hedged. IAS 39 was recently amended
(largely for political rather than theory reasons) to allow for macro hedges of
interest rate risk when the maturity dates or possible early payoff dates are
not identical. But the IAS 39 amendment is only a very small step
toward solving a very large problem. Companies like Fannie Mae and Freddie
Mac find it impractical (actually impossible) to hedge individual securities (or
homogeneous portfolios) as required under FAS 133.
The large problem is that when non-homogeneous portfolios are being hedged
for only one of several risks, there can be a huge mismatch in terms of value
changes of the portfolio versus value change of the hedging derivatives.
When writing the hedge accounting standards, standard setters took a
conservative approach that virtually denies hedge accounting for non-homogeneous
portfolios. This long been known as the "macro hedging" problem
of FAS 133. By denying hedge accounting to financial institutions with
large non-homogeneous portfolios, those institutions are going to show huge
fluctuations in net earnings by having to mark-to-market all macro hedging
derivatives with offsetting value changes being charged to current earnings
rather than some offset such as AOIC for cash flow hedges or the macro portfolio
itself for fair value hedges.
One of the better media articles about this
controversial problem is the following article by Michael MacKenzie. What
MacKenzie does is explain just how Fannie Mae covers her fanny with macro
hedging strategy that really is not eligible for hedge accounting under FAS
133. However, the problem is with FAS 133.
:"Sometimes
the Wrong 'Notion': Lender Fannie Mae Used A Too-Simple Standard For
Its Complex Portfolio," by Michael MacKenzie, The Wall Street Journal, October
5, 2004, Page C3
Lender Fannie Mae Used A Too-Simple Standard For Its
Complex Portfolio
What exactly did Fannie
Mae do wrong?
Much has been made of the accounting
improprieties alleged by Fannie's regulator, the Office of Federal Housing
Enterprise Oversight.
Some investors may even be aware the
matter centers on the mortgage giant's $1 trillion "notional"
portfolio of derivatives -- notional being the Wall Street way of saying that
that is how much those options and other derivatives are worth on paper.
But understanding exactly what is
supposed to be wrong with Fannie's handling of these instruments takes some
doing. Herewith, an effort to touch on what's what -- a notion of the problems
with that notional amount, if you will.
Ofheo alleges that, in order to keep
its earnings steady, Fannie used the wrong accounting standards for these
derivatives, classifying them under complex (to put it mildly) requirements
laid out by the Financial Accounting Standards Board's rule 133, or FAS 133.
For most companies using derivatives,
FAS 133 has clear advantages, helping to smooth out reported income. However,
accounting experts say FAS 133 works best for companies that follow relatively
simple hedging programs, whereas Fannie Mae's huge cash needs and giant
portfolio requires constant fine-tuning as market rates change.
A Fannie spokesman last week declined
to comment on the issue of hedge accounting for derivatives, but Fannie Mae
has maintained that it uses derivatives to manage its balance sheet of debt
and mortgage assets and doesn't take outright speculative positions. It also
uses swaps -- derivatives that generally are agreements to exchange fixed- and
floating-rate payments -- to protect its mortgage assets against large swings
in rates.
Under FAS 133, if
a swap is being used to hedge risk against another item on the balance sheet,
special hedge accounting is applied to any gains and losses that result from
the use of the swap. Within the application of this accounting there are two
separate classifications: fair-value hedges and cash-flow hedges.
Fannie's fair-value hedges generally
aim to get fixed-rate payments by agreeing to pay a counterparty floating
interest rates, the idea being to offset the risk of homeowners refinancing
their mortgages for lower rates. Any gain or loss, along with that of the
asset or liability being hedged, is supposed to go straight into earnings as
income. In other words, if the swap loses money but is being applied against a
mortgage that has risen in value, the gain and loss cancel each other out,
which actually smoothes the company's income.
Cash-flow hedges, on the other hand,
generally involve Fannie entering an agreement to pay fixed rates in order to
get floating-rates. The profit or loss on these hedges don't immediately flow
to earnings. Instead, they go into the balance sheet under a line called
accumulated other comprehensive income, or AOCI, and are allocated into
earnings over time, a process known as amortization.
Ofheo claims that instead of
terminating swaps and amortizing gains and losses over the life of the
original asset or liability that the swap was used to hedge, Fannie Mae had
been entering swap transactions that offset each other and keeping both the
swaps under the hedge classifications. That was a no-go, the regulator says.
"The major risk facing Fannie is
that by tainting a certain portion of the portfolio with redesignations and
improper documentation, it may well lose hedge accounting for the whole
derivatives portfolio," said Gerald Lucas, a bond strategist at Banc of
America Securities in New York.
The bottom line is that both the FASB
and the IASB must someday soon take another look at how the real world hedges
portfolios rather than individual securities. The problem is complex, but
the problem has come to roost in Fannie Mae's $1 trillion in hedging
contracts. How the SEC acts may well override the FASB. How the SEC
acts may be a vindication or a damnation for Fannie Mae and Fannie's auditor
KPMG who let Fannie violate the rules of IAS 133.
Bob Jensen's threads on macro hedging are at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#M-Terms
Bob Jensen's threads on the Fannie Mae and Freddie Mac
scandals are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's threads on KPMG scandals are at
http://faculty.trinity.edu/rjensen/fraud.htm#KPMG
The vexing problem of macro hedging
in FAS 133 is still a vexing problem
It was a huge problem for Fannie Mae
"Hedging Portfolios," by Ira Kawaller,
Bank Asset/Liability Management, May 2003 ---
http://www.kawaller.com/pdf/BALM_Hedging_Portfolios.pdf
So what’s the
problem? In all likelihood, the intended hedged items would be either a
collection of assets or a group of interest expenses, which means that
FAS133’s requirements pertaining to portfolio hedges would have to be
satisfied. And these requirements happen to be especially restrictive.
Here’s what the standard says, in paragraph 21.a.(1):
“The changes in
fair value attributable to the hedged risk for each individual item in a
hedged portfolio must be expected to respond in a generally
proportionate manner to the overall change in fair value of the
aggregate portfolio attributable to the hedged risk. That is, if the
change in fair value of a hedged portfolio attributable to the hedged
risk was 10 per cent during a reporting period, the change in the fair
values attributable to the hedged risk for each item constituting the
portfolio should be expected to be within a fairly narrow range, such as
9 percent to 11 percent. In contrast, an expectation that the change in
fair value attributable to the hedged risk for individual items in the
portfolio would range from 7 percent to 13 percent would be inconsistent
with this provision.”
It should be clear
that the components making up the hedged item would have to be quite
homogeneous to satisfy this threshold. There may be an “out,” however, in
that FAS 133 allows for hedging relationships to be defined where a portion
of the derivative serves as the hedging instrument. Thus, instead of hedging
a portfolio of assets, the institution might be better served by hedging
selected components of the portfolio individually (i.e., mini-portfolios),
and devising an allocation algorithm to determine the appropriate portion of
the derivative to be assigned to each component hedged item.
This work-around
may still be problematic in that the various hedging relationships may not
all be satisfied using the same hedge effectiveness test, so the solution
may end up being quite cumbersome. Moreover, with a portfolio considered to
be the hedged item, one might ordinarily expect to realize some benefit of
diversification – where the effect of the hedge “over-performing” with
respect to some portion of the portfolio would be balanced by some
“underperforming” with respect to other portions. If hedging
mini-portfolios, however, the effectiveness assessment must still be carried
out for each designated hedge, individually. That is, even if the hedges
perform well in the aggregate, if individual hedges fail the effectiveness
assessment criteria, hedge accounting would not be permitted for those
failing hedge relationships.
It should be
understood that, assuming the aggregate portfolio can be broken down to a
workable set of mini-portfolios, each qualifying for hedge accounting,
there’s nothing that requires separate derivatives for each hedging
relationship. Rather, portions of a single derivative might be applicable
for all of the hedging relationships.
Admittedly, the
above solution would likely be less than satisfying for hedgers with large,
very diverse portfolios. Thankfully, though, those banks still have the
option to hedge the other side of the balance sheet. That is, instead of
seeking to address their net interest margin exposure by reducing the
duration of the bank’s assets, the bank could seek to increase the duration
of its liabilities. Attacking the problem from this perspective may require
change in mind-set, but at least by doing so, the bank gets to apply cash
flow hedge accounting, thereby avoiding the income volatility that would
otherwise occur – either because the bank chose not to hedge at all, or
because it did hedge its assets, but failed to qualify for fair value hedge
accounting.
Continued in article
FEDERATION
BANCAIRE DE L'UNION EUROPEENNE Provides a great free document on macro hedging
with references to IAS 39. The article also discusses prospective and
retrospective effectiveness testing. See
Ineffectiveness.
"MACRO
HEDGING OF INTEREST RATE RISK," April 4, 2003 --- http://www.fbe.be/pdf/Macro%20Hedging%20of%20Interest%20Rate%20Risk.pdf
Trinity Students may access this article at
J:\courses\acct5341\ResearchFiles\00macroHedging.pdf
Macro hedging is the hedging of a portfolio of assets
and liabilities for the same type of risk. This differs from hedging a single
instrument or a number of the same type of assets (or liabilities) as there is
risk offsetting between the assets and liabilities within the portfolio.
This form of hedging occurs not at a theoretical ‘consolidated
Group’ level, but at an operational level, where individual assets and
liabilities in the portfolio can be clearly identified. Within one banking
group, several macro hedge portfolios for different activities may be
separately managed at an operational level.
. . .
I.C Hedging the ‘Net Position’
Building a portfolio requires aggregating the necessary information (data) of
all assets and liabilities that share the same risk to be hedged. Although
systems differ, there is general agreement that the hedging process involves
identification of notional amounts and repricing dates. As the economic risks
of some financial instruments differ from their contractual terms, they have
to be modelled to reflect their true economic effect on interest rate risk
management. They are therefore included based on their behaviouralized
repricing dates (statistical observations of customer behaviour) rather than
their contractual repricing dates. These types of contracts include for
example demand deposits, some (often regulated) saving accounts and prepayable
loans.
The notional amounts of these assets and liabilities
in the portfolio are then allocated to defined repricing buckets. Based on
this allocation, the mismatch between assets and liabilities in each repricing
bucket is derived, which is the net position.
For each net position, the company can decide whether
it wants to hedge it fully or a portion of it. The extent of hedging to be
undertaken is determined by the interest rate risk management strategy and is
therefore a management decision as mentioned earlier in Section I.A.
The FAS133 Compliance Module Wall Street Systems --- http://www.wallstreetsystems.com/fas133/news-compl.htm
"FAS 133’s bias against macro hedging, its focus on
individual hedges, and its demanding detailed disclosure will generate
a quarterly calculation nightmare for many companies."
--Jeff Wallace, Greenwich Treasury Advisors, LLC
In June of 1998, The Financial Accounting Standards Board released
Statement Number 133. This statement revised accounting and reporting
standards for derivative instruments. It requires that banks and
corporations classify derivatives as either assets or liabilities and
that these instruments be measured at "fair value".
The accounting steps necessary to bring a bank or a corporation
into compliance with Statement 133 are substantial. Exposures must be
linked to hedges, instruments must be fairly valued, and the results
must be appropriately posted. Following this inventory and accounting
process, firms must report hedge effectiveness. The reporting
requirements under this statement require full documentation of
objectives and policies and require a variety of reporting summaries
in various formats.
The process of identifying derivatives in itself presents
substantial complexities. The definition of a derivative is broad and
includes instruments such as insurance policies, production contracts,
procurement contracts and other "non-financial" obligations.
Because of the complexities of inventory, accounting, and reporting
associated with compliance to Statement 133, the Financial Accounting
Standards Board delayed implementation of this standard believing that
neither system developers nor treasuries would be ready to handle
these new requirements.
Wall Street Systems is in the business of creating enterprise-wide
client/server front to back treasury solutions for the largest banks
and corporations in the world. This product, The Wall Street System,
integrates all geographies, all financial products, all credit and
market risk controls, and all accounting, confirmation, and cash
management processes into a single, global, real-time, 24/7 system.
Because of the strength of this straight-through processing system,
and because The Wall Street System has long offered the capability to
capture exposures and perform fair market valuations of derivative
transactions, Wall Street Systems was able to offer a fully
functioning FAS133 Module to its customers in advance of the original
FAS 133 implementation date.
The Wall Street Systems FAS 133 Module reports hedge gains and
losses at fair market value each day. The hedge tracking and linking
feature packages exposures and hedge transactions together and
automatically adjusts earnings and Other Comprehensive Income (OCI)
accounts. The module also creates all reports and documentation
required by FAS 133.
The key features of The Wall Street System FAS 133 Module are:
Fair Market Valuation Exposures and derivatives are
marked-to-market and compared through hedge effectiveness ratios Hedge
Profile Database and Query Each hedge package is stored by date.
Closing values, changes in value, and effectiveness ratios are
preserved in the database. Automatic Linking and Tracking Trades and
the underlying exposures are linked to a hedge profile. The profile
categorizes the hedge by type and includes hedge objectives, valuation
method, risk management policy and transaction details. The hedge
profile is linked to the documentation. The combination forms a hedge
"package" that drives all FAS 133 events. Cash Flow OCI
Adjusting Automatic examination of the P&L status of each hedge
package at the close of business each day. Automatic adjustment of OCI
and P&L accounts. Automatic posting of derivatives fair market
values to earnings with the effective portion of the hedge
reclassified into OCI Audit Capability Time series database keeps
copies of each hedge package status at the close of each day. There is
a full audit query capability imbedded in the database. Forecasting
The System can generate a P&L forecast from the OCI account that
covers the next 12 months.
The comprehensive functionality of the Wall Street System FAS 133
Module is achieved through the application of straight through
processing on a global scale with a system that covers the front,
middle and back office.
Treasurers will have difficulty with FAS 133 compliance if the
treasury runs on a "best of breed" model rather than a
global STP model. In the best of breed model, trading, risk management
and accounting functions are distributed across a mix of systems that
share information with varying degrees of efficiency. For this model
to work, each resident system must capture relevant FAS 133
information to its database and have the capacity to share that
information with all other member systems. This requires a high degree
of flawless data exchange and systems integration, features not
normally associated with the best of breed solution. A fragmented
treasury desktop makes it extraordinarily difficult to manage hedge
relationships from front to back.
The Wall Street System, being a single global system for 24/7
treasury operations faces none of these data exchange obstacles. Hedge
package information is shared easily, stored safely, and posted
correctly.
The Wall Street System is ready now with a 100% compliant FAS 133
Module
|
IASB Finalises Macro Hedging Amendments to IAS 39 March 31, 2004 --- http://www.iasb.org/news/index.asp?showPageContent=no&xml=10_120_25_31032004_31032005.htm
The International Accounting Standards Board (IASB)
issued an Amendment to IAS 39 Financial Instruments: Recognition and
Measurement on Fair Value Hedge Accounting for a Portfolio Hedge of Interest
Rate Risk. The amendments simplify the implementation of IAS 39 by enabling
fair value hedge accounting to be used more readily for a portfolio hedge of
interest rate risk (sometimes referred to as a macro hedge) than under
previous versions of IAS 39.
The publication of this amendment is a direct response to concerns expressed
by the banking community about the potential difficulty of implementing the
requirements of IAS 39. Many constituents had sought fair value hedge
accounting treatment for portfolio hedging strategies, which was not
previously permitted under IAS 39. In the light of these concerns, the IASB
launched intensive discussions with representatives of the banking industry
to determine whether a way could be found within the existing principles of
IAS 39 to allow fair value hedge accounting treatment to be applied to a
macro hedge.
The publication of this amendment means that macro hedging will be part of
the IASB’s set of standards to be adopted in 2005. The IASB notes that
discussions will continue on another aspect of IAS 39, namely an additional
hedging methodology and the balance sheet presentation of certain
hedges—issues of particular concern to some banking institutions.
Furthermore, in April, the IASB will publish a proposed limited amendment to
restrict the existing fair value option in response to concerns raised by
banking supervisory authorities.
With today’s publication of the macro-hedging amendment, the IASB
announced its intention to set up an international working party to examine
the fundamentals of IAS 39 with a view to replacing the standard in due
course. (A similar working party will be established on the IASB’s
long-term insurance project.) The financial instruments working party will
assist in improving, simplifying and ultimately replacing IAS 39 and examine
broader questions regarding the application and extent of fair-value
accounting—a topic on which the IASB has not reached any conclusion.
Although any major revision of IAS 39 may take several years to complete,
the IASB is willing to revise IAS 39 and IFRS 4 Insurance Contracts
in the short term in the light of any immediate solutions arising from the
working parties’ discussions. The IASB plans to announce details of these
two working parties in the coming weeks.
Introducing the amendment to IAS 39, Sir David Tweedie, IASB Chairman,
commented:
This amendment is a further step in our project to
ease the implementation of IAS 39 for the thousands of companies required
to implement international standards in 2005 and those companies already
using IFRSs. The IASB has made it clear that any amendments must be within
the basic principles of hedge accounting contained in IAS 39, but that we
will work within those principles to simplify the application of the
standard. This amendment does not mark the end of the Board’s work on
the subject of financial instruments. The Board remains open to all
suggestions for improvement of the standard and is taking active steps in
both the immediate future and in the medium term to that end.
The primary means of publishing International
Financial Reporting Standards is by electronic format through the IASB’s
subscriber Website. Subscribers are able to access the amendment published
today through “online services”. Those wishing to subscribe should
contact:
IASCF Publications Department, 30 Cannon Street,
London EC4M 6XH, United Kingdom.
Tel: +44 (0)20 7332 2730, Fax: +44 (0)20 7332 2749,
email: publications@iasb.org Web: www.iasb.org.
Printed copies of Amendment to IAS 39 Financial Instruments: Recognition and
Measurement: Fair Value Hedge Accounting for a Portfolio Hedge of
Interest Rate Risk (ISBN 1-904230-58-X) will be available shortly, at £15
each including postage, from IASCF Publications Department.
To the IASB’s
dismay in the summer of 2004, certain key aspects of FAS 133 incorporated in
the international IAS 39 standard have riled European banks and other EU
businesses to a point where, for the first time, there was a serious political
movement underway in
Europe
to veto acceptance of a portion of an IASB standard in the EU.
A news article in the August 21, 2003 edition of The
Wall Street Journal on Page C5 reads as follows:
This
accounting battle centers on the IASB's insistence that derivatives should be
valued at their fair value, rather than at cost, which is generally immaterial
or even zero and is often how European companies treat them. Banks have argued
that the outcome of the IASB's plan would be unnecessary volatility in their
earnings and net worth, a point echoed by Mr. Chirac.
IASB
Vice Chairman Tom Jones argued that the current system merely pretends that
the earnings volatility doesn't exist. Trying to smooth earnings is what got
Freddie Mac into trouble in the U.S., he said.
"Bank
results in
Europe
are a fiction: No volatility, and derivatives are
nonexistent (at least appearing to be nonexistent in financial
statements)," he said.
The
new IASB proposal (compromise) would now make it easier for banks to lump
bundles of securities or loans together and hedge a fraction of the overall
risk, a process known in the industry as macro hedging. This isn't allowed in the U.S., which requires (in FAS 133) companies to
show the individual items being hedged. The original IASB draft had taken
a similar stance.
But
the body didn't give in on two other bones of contention: when banks should
take a charge to earnings because hedge strategies are ineffective and whether
banks can include money deposited in bank accounts that is available on demand
in accounting for their hedges. The IASB argues that the money has to be
treated for accounting purposes as if it could all be withdrawn the next day,
although that doesn't happen in practice. It also argues that its concessions
on macro hedging should help the banks accomplish similar results, and its
board members have shown little willingness to budge.
The IASB’s Exposure Draft of the macro hedging compromise is entitled
“Amendments to IAS 39: Recognition
and Measurement Fair Value Hedge Accounting for a Portfolio Hedge of Interest
Rate” and for a short time can be downloaded free from http://www.iasc.org.uk/docs/ed-ias39mh/ed-ias39mh.pdf
It should be noted that this compromise does not apply to cash flow
hedging or other types of hedging other than interest rate hedges.
It’s highly unfortunate that the proposed macro hedging compromise of
IAS 39 mentioned above puts the IASB international standard on a somewhat
non-divergent course with the FASB/SEC in the
United States
. The FASB currently shows
no interest to date in compromising FAS 133 with respect to macro hedging,
although the complaints of the European companies apply to U.S. firms as well.
Two paragraphs from FAS 133 from the FASB are quoted below:
Paragraph
448.
The Board (FASB) considered alternative approaches that would require
amortizing the hedge accounting adjustments to earnings based on the
average holding period, average maturity or duration of the items in the
hedged portfolio, or in some other manner that would not allocate
adjustments to the individual items in the hedged portfolio. The Board
rejected those approaches because determining the carrying amount for an
individual item when it is (a) impaired or (b) sold, settled, or otherwise
removed from the hedged portfolio would ignore its related hedge
accounting adjustment, if any. Additionally, it was not clear how those
approaches would work for certain portfolios, such as a portfolio of
equity securities.
Paragraph 449.
Advocates of macro hedging generally believe that it is a more effective
and efficient way of managing an entity's risk than hedging on an
individual-item basis. Macro hedging seems to imply a notion of
entity-wide risk reduction. The Board also believes that permitting hedge
accounting for a portfolio of dissimilar items would be appropriate only
if risk were required to be assessed on an entity-wide basis. As discussed
in paragraph 357, the Board decided not to
include entity-wide risk reduction as a criterion for hedge accounting.
Paragraph 21(a)(1)
1) If similar assets or similar liabilities are aggregated and hedged as a
portfolio, the individual assets or individual liabilities must share the risk
exposure for which they are designated as being hedged. The change in fair value
attributable to the hedged risk for each individual item in a hedged portfolio
must be expected to respond in a generally proportionate manner to the overall
change in fair value of the aggregate portfolio attributable to the hedged risk.
That is, if the change in fair value of a hedged portfolio attributable to the
hedged risk was 10 percent during a reporting period, the change in the fair
values attributable to the hedged risk for each item constituting the portfolio
should be expected to be within a fairly narrow range, such as 9 percent to 11
percent. In contrast, an expectation that the change in fair value attributable
to the hedged risk for individual items in the portfolio would range from 7
percent to 13 percent would be inconsistent with this provision. In aggregating
loans in a portfolio to be hedged, an entity may choose to consider some of the
following characteristics, as appropriate: loan type, loan size, nature and
location of collateral, interest rate type (fixed or variable) and the coupon
interest rate (if fixed), scheduled maturity, prepayment history of the loans
(if seasoned), and expected prepayment performance in varying interest rate
scenarios. See Footnote 9
==========================================================================
Footnote 9
Mortgage bankers and other servicers of financial assets that designate a
hedged portfolio by aggregating servicing rights within one or more risk strata
used under paragraph 37(g) of Statement 125 would not necessarily comply with
the requirement in this paragraph for portfolios of similar assets. The risk
stratum under paragraph 37(g) of Statement 125 can be based on any predominant
risk characteristic, including date of origination or geographic location.
Improper Use of Hedge Accounting for
Portfolios In a Manner Not Allowed in FAS 133: The Case Study of Freddie
Mac ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm#FreddieMac
Also see see hedge and compound derivatives.
Bob Jensen's Year 2004 leave proposal ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/leave2004.htm
Earnings Management
Interest rate swap
derivative instruments are widely used to
manage interest rate risk, which is viewed
as a perfectly legitimate use of these
hedging instruments. I stumbled on to a
rather interesting doctoral dissertation
which finds that firms, especially banks,
use such swaps to manage earnings. The
dissertation from Michigan State University
is by Chang Joon Song under Professor Thomas
Linsmeier. "Are Interest Rate Swaps Used
to Manage Banks' Earnings," by Chang Joon
Song, January 2004 ---
http://accounting-net.actg.uic.edu/Department/Songpaper.pdf
This dissertation is quite clever and
very well written.
Previous
research has shown that loan loss
provisions and security gains and losses
are used to manage banks’ net income.
However, these income components are
reported below banks largest operating
component, net interest income (NII).
This study extends the literature by
examining whether banks exploit the
accounting permitted under past and
current hedge accounting standards to
manage NII by entering into interest
rate swaps. Specifically, I investigate
whether banks enter into
receive-fixed/pay-variable swaps to
increase earnings when unmanaged NII is
below management’s target for NII. In
addition, I investigate whether banks
enter into receive-variable/pay-fixed
swaps to decrease earnings when
unmanaged NII is above management’s
target for NII. Swaps-based earnings
management is possible because past and
current hedge accounting standards allow
receive-fixed/pay-variable swaps (receivevariable/
pay-fixed) to have known positive
(negative) income effects in the first
period of the swap contract. However,
entering into swaps for NII management
is not costless, because such swaps
change the interest rate risk position
throughout the swap period. Thus, I also
examine whether banks find it
cost-beneficial to enter into offsetting
swap positions in the next period to
mitigate interest rate risk caused by
entering into earnings management swaps
in the current period. Using 546
bank-year observations from 1995 to
2002, I find that swaps are used to
manage NII. However, I do not find
evidence that banks immediately enter
into offsetting swap positions in the
next period. In sum, this research
demonstrates that banks exploit the
accounting provided under past and
current hedge accounting rules to manage
NII. This NII management opportunity
will disappear if the FASB implements
full fair value accounting for financial
instruments, as foreshadowed by FAS No.
133.
What is especially interesting is how
Song demonstrates that such earnings
management took place before FAS 133 and is
still taking place after FAS 133 required
the booking of swaps and adjustment to fair
value on each reporting date. It is also
interesting how earnings management comes at
the price of added risk. Other derivative
positions can be used to reduce the risk,
but risks arising from such earnings
management cannot be eliminated.
See Gapping and
Immunization
See interest
rate swap and hedge
Bob Jensen's threads on FAS 133 and
IAS 39 are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm |
|
|
Macro Macro Hedge of Enterprise Risk
"KPMG Strategists Describe Benefits of Effective Risk Management," SmartPros,
February 9, 2004 --- http://www.smartpros.com/x42423.xml
Two senior executives of KPMG LLP have authored a new
business guide to help corporate leaders and boards of directors develop and
implement effective risk-management strategies.
Risk: From the CEO and Board Perspective, Mary Pat
McCarthy and Tim Flynn, offers insights on how to confront and control risk.
The book describes how to best shape an organization's structure to assess and
manage risk in ways that will maximize shareholder value, and determine how
closely risk management should be integrated into business, operational and
financial planning.
According to McCarthy, risk management is no longer
just a defensive measure. "There are positive rewards to risk
management," she said. "Implemented properly, sound risk assessments
and responses can have a significant impact on a company's reputation and
bottom line, and enhance shareholder value and transparency."
The book advocates taking a holistic view on risk.
According to Flynn, risk management must now extend well beyond traditional
financial and insurable hazards to encompass a wide variety of strategic,
operational, reputation, regulatory and information risks. "Businesses
who take a holistic view of risks and their interdependencies, can be more
agile and adept at responding to them," Flynn said.
In addition to the thought leadership of McCarthy,
Flynn and other KPMG professionals, the book draws on the experiences of top
executives from Microsoft, Hewlett-Packard, Viacom, Sprint and Motorola.
Chief among the strategies suggested for developing
sound risk management is the separate and independent management of the
process of reporting, measuring and controlling risks from those who generate
them. "Just as an independent board, audit committee and auditor are
critical to effective corporate governance, an independent risk-management
function is essential to effective operations," said McCarthy.
Risk: From the CEO and Board Perspective is available
in hardcover, priced at $27.95.
Mark To Market =
to revalue securities at prevailing market prices or, in
the case of some exotic derivatives, estimated fair value. See fair
value.
Minimum Value
Intrinsic value adjusted by time value of money to exercise
date. See Intrinsic Value and Valuation
of Options
Minority
Interest =
the part-owner of a subsidiary corporation
that is controlled by another parent company. Paragraph 21c on Page 14 and Paragraph
29f on Page 20 of FAS 133 prohibits forecasted cash flows from minority interests in a
consolidated subsidiary from being designated as a hedged item in a cash flow hedge. Reasons are given in Paragraph 472
beginning on Page 206 of FAS 133.
Monetary Items =
obligations to pay or rights to receive a fixed
number of currency units in the future.
Monoline Insurance =
See
Credit Derivatives
MTM =
Mark-To-Market See fair
value
|
N-Terms
Net Investment =
Statement 133 Implementation Issue No. A1
Title: |
Definition of a
Derivative: Initial Net Investment |
Paragraph
references: |
6(b), 8, 12,
57(b), 255–258 |
Date cleared by
Board: |
June 23, 1999 |
Date latest
revision posted to website: |
March 14, 2006 |
Affected by: |
FASB Statements
No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities,
and No. 155, Accounting for Certain Hybrid
Financial Instruments
(Revised February 16, 2006) |
QUESTION
If an entity enters into a forward contract that
requires the purchase of 1 share of an unrelated
company's common stock in 1 year for $110 (the market
forward price) and at inception the entity elects to
prepay the contract pursuant to its terms for $105 (the
current price of the share of common stock), does the
contract meet the criterion in paragraph 6(b) related to
initial net investment and therefore meet the definition
of a derivative for that entity? If not, is there an
embedded derivative that warrants separate accounting?
RESPONSE
Paragraph 6(b) of Statement 133 specifies that a
derivative requires either no initial net investment or
a smaller initial net investment than would be required
for other types of contracts that would be expected to
have a similar response to changes in market factors. If
no prepayment is made at inception, the contract would
meet the criterion in paragraph 6(b) because it does not
require an initial net investment but, rather, contains
an unexercised election to prepay the contract at
inception. Paragraph 8 further clarifies paragraph 6(b)
and states that a derivative instrument does not require
an initial net investment in the contract that is equal
to the notional amount or that is determined by applying
the notional amount to the underlying. If the contract
gives the entity the option to "prepay" the contract at
a later date during its 1-year term (at $105 or some
other specified amount), exercise of that option would
be accounted for as a loan that is repayable at $110 at
the end of the forward contract's one-year term.
If, instead, the entity elects to prepay the contract
at inception for $105, the contract does not meet the
definition of a freestanding derivative. Paragraph 8, as
amended, indicates that if the initial net investment of
the contract (after adjustment for the time value of
money) is less, by more than a nominal amount, than the
initial net investment that would be commensurate with
the amount that would be exchanged to acquire the asset
related to the underlying, the characteristic in
paragraph 6(b) is met. The initial net investment of
$105 is equal to the initial price of the 1 share of
stock being purchased under the contract and therefore
is equal to the investment that would be required for
other types of contracts that would be expected to have
a similar response to changes in market factors. That
is, the initial net investment is equal to the amount
that would be exchanged to acquire the asset related to
the underlying.
However, the entity must assess whether that
nonderivative instrument contains an embedded derivative
that, pursuant to paragraph 12, requires separate
accounting as a derivative unless a fair value election
is made pursuant to Statement 155. (Note that Statement
155 was issued in February 2006 and allows for a fair
value election for hybrid financial instruments that
otherwise would require bifurcation. Hybrid financial
instruments that are elected to be accounted for in
their entirety at fair value cannot be used as a hedging
instrument in a Statement 133 hedging relationship.) In
this example, the prepaid contract is a hybrid
instrument that is composed of a debt instrument as the
host contract (that is, a loan that is repayable at $110
at the end of the forward contract’s 1-year term) and an
embedded derivative based on equity prices. The host
contract is a debt instrument because the holder has
none of the rights of a shareholder, such as the ability
to vote the shares and receive distributions to
shareholders. (Refer to paragraph 60 of Statement 133.)
Unless the hybrid instrument is remeasured at fair value
with changes in value recorded in earnings as they
occur, the embedded derivative must be separated from
the host contract because the economic characteristics
and risks of a derivative based on equity prices are not
clearly and closely related to a debt host contract, and
a separate instrument with the same terms as the
embedded derivative would be a derivative subject to the
requirements of Statement 133.
The above response has been authored by the FASB
staff and represents the staff's views, although the
Board has discussed the above response at a public
meeting and chosen not to object to dissemination of
that response. Official positions of the FASB are
determined only after extensive due process and
deliberation.
|
|
|
January 2008 Summary of the International Financial Reporting
Interpretations Committee
IASPlus ---
http://www.iasplus.com/index.htm
March 6, 2008
At the
January 2008 IFRIC meeting, the IFRIC
discussed the comments received on its
Draft Interpretation
D22 Hedges
of a Net Investment in a Foreign Operation.
As a result of the deliberations, the staff
was asked to provide a comprehensive example
to confirm some of the principles underlying
the draft Interpretation.
The principles the
staff tried to demonstrate were:
- The same risk
can be hedged only once in the group
- The amount of
net investment to be hedged cannot be
duplicated
- A parent
entity can hedge a net investment it
holds indirectly
- Where the
hedging instrument is held has no effect
on hedge effectiveness
- The
consolidation method (direct vs.
indirect) does not affect hedge
effectiveness
- The nature of
the hedging instrument (cash instrument
or derivative) has no effect on hedge
effectiveness
The staff presented
various scenarios of net investment hedges
involving cash instruments or derivatives to
illustrate the principles. The examples
contained the necessary calculations and
journal entries in detail.
One IFRIC member
noted that the examples are meant to prove
the principles, as the spreadsheets were set
up using those principles.
The IFRIC discussed
some points using the spreadsheets in depth.
Method of
consolidation
Some IFRIC members
were particularly concerned with the
assumption that the direct method of
consolidation is the correct one and other
methods must be adjusted to result in the
same figures as the direct method. The
chairman told IFRIC members that the
Interpretation does not prescribe any method
of consolidation but reflects the standards
as currently applicable. The staff noted
that the question does not deal with the
consolidation procedure itself but with
effectiveness testing.
Overhedging and
hedging the same risk twice
It was also
confirmed that an entity cannot hedge the
same risk twice, and some
designations/designated amounts would not be
valid as they would result in overhedging.
One member noted that this would normally
not occur in practice as it would also make
no sense to overhedge from an economic
perspective.
Location of the
hedging instrument
Some IFRIC members
highlighted that the method of consolidation
could affect the amounts recognised if the
hedging instrument is not held within the
(sub-)group containing the hedged item (that
is, the net investment).
Recycling
The discussion then
switched to the issue of recycling once the
net investment or the entity containing the
hedging instrument is disposed of. It was
noted that this could lead to practical
implications and complications, as the
amounts in the respective foreign currency
translation reserve must be identifiable to
allow the correct timing of recycling that
results from assuming IAS 39 overrides IAS
21 when it comes to hedge accounting. Some
members expressed concerns over the
theoretical foundation and the practical
application of this approach. The chairman
noted that it would not be in the scope of
this Interpretation to provide guidance on
this issue as this would be a general hedge
accounting issue. Some members still did not
seem to be convinced.
The IFRIC continued
its debate on the issues of the method of
consolidation and recycling. While there
seemed to be agreement that the
Interpretation should not prescribe the
method of consolidation, some members asked
the staff to include words as a caveat to
remind entities that they would have to
track the amounts in the foreign currency
translation reserve relating to hedge
accounting, which could be challenging in
large and complex group structures. One
member also cited possible transitional
issues. Another IFRIC member believed
implementing the IFRIC approach correctly
could be a huge task for some entities.
The IFRIC also
discussed which examples should go into the
final Interpretation as illustrative
examples, but did not make a final decision.
The staff was also asked to align the
example that currently is contained in the
draft Interpretation.
Other issues
raised by commentators
The staff also
asked the Board to confirm its preliminary
conclusions on certain issues raised by
commentators to the draft Interpretation.
Could a parent
entity apply hedge accounting in its
separate financial statements? How should
the hedged amounts be accounted for?
Yes, but that would
be a different type of hedge (for example, a
fair value hedge). No further clarification
is required.
The IFRIC agreed.
How should an
entity account for the ineffectiveness
resulting from a decrease in a net
investment value during the term of hedge?
All ineffectiveness
will be recognised in profit or loss. No
exception exists for net investment hedges.
Such an ex post overhedge would
result in ineffectiveness. No further
clarification is required.
The IFRIC agreed.
Should the
transitional requirements be clarified?
Some commentators
asked for clarification on the transitional
provision with regard to applying the
Interpretation prospectively. The staff
proposed to amend the transitional paragraph
as follows:
"...when first
applying the Interpretation. If an
entity had designated a transaction as a
hedge of a net investment but the hedge
does not meet the conditions for hedge
accounting in this Interpretation, the
entity shall apply IAS 39 to discontinue
prospectively that hedge accounting."
The IFRIC agreed.
Is an
intra-group loan defined by IAS 21 paragraph
15 in the scope of this interpretation?
Could such an intra-group loan be a part of
the net investment?
Yes, this is
obvious from the Standard. No further
clarification is required.
The IFRIC agreed,
however one member questioned if this really
was the question the commentator asked as it
was so obvious.
Does a hedge
relationship designated at a lower group
level require hedge documentation also at
the higher group levels in order for the
lower level hedge to qualify for hedge
accounting at any higher level?
The IFRIC had a
lengthy discussion on this issue, notably if
an entity would be required at a higher
level to 'unhedge', that is, explicitly
state that it does not want to continue
hedge accounting coming from a lower level
in the group.
The IFRIC finally
agreed that this is out of the scope of this
interpretation as it would be general
guidance on how to document hedging
relationships. Accordingly, the IFRIC agreed
with the staff recommendation not to provide
further clarification.
Should the
interpretation include the reason the
hedging instruments may not be held by the
foreign operation that is being hedged?
No, as this is
would allow the net investment to hedge
itself as the instrument is part of the net
investment.
The IFRIC agreed.
Then the staff
asked the IFRIC whether it agreed with the
staff view that the following questions are
addressed by the examples presented. One
member expressed concerns as the examples
would not be contained in the final
Interpretation.
- How should an
entity account for various fact patterns
such as:
- a foreign
operation is held jointly by two
intermediate parents with different
currencies
- a
combination of instruments is held
by one or several entities within
the group to hedge one exposure
- Parent A
holds subsidiaries B (100%) and C
(70%) and B holds 30% of C,
could B's 30% interest qualify as
part of the hedged item in A's
consolidated financial statements?
- Should the
interpretation indicate that the
location of hedging instrument should
have no effect on the amounts actually
deferred in equity as an effective
hedge?
- Should the
interpretation further clarify possible
differences in the amounts of the
foreign currency translation reserve
caused by the method of the
consolidation?
The IFRIC agreed
not to address these issues in the final
Interpretation.
Way forward
The staff was asked
to amend the draft Interpretation in the
light of this meeting's discussions and
integrate selected examples. The staff will
return at the May IFRIC meeting with a new
draft of the Interpretation for clearance by
IFRIC. |
|
|
|
Also see
derivative financial instrument and
cash flow hedge.
Net Settlement =
a contract provision that allows for netting out
payables and receivables in terms of cash or items that can be readily converted to cash
in an established market. Net settlement criteria for FAS 133 are not satisfied if
an asset such as land or a liability such as a personal note can be delivered to satisfy
the contractual obligation. In swaps where items are swapped, it must be possible to
net out the swap obligations and transfer only the net difference in cash. Details
of net settlements are discussed in SFAS 13 Paragraphs 6c, 9, and 57c. According to Paragraphs
10 and 275-276, "regular-way security trades" are contracts with no net
settlement provisions and not market mechanism to facilitate net settlements.
Paragraph 10c of IAS 39 also addresses net
settlement. IASC does not require a net settlement provision in
the definition of a derivative.
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
A derivative is a financial instrument—
(a) - whose value changes in
response to the change in a specified interest rate, security price,
commodity price, foreign exchange rate, index of prices or rates, a
credit rating or credit index, or similar variable (sometimes called
the ‘underlying’);
(b) - that requires no initial net investment
or little initial net investment relative to other types of contracts
that have a similar response to changes in market conditions; and
(c) - that is settled at a future date.
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FAS 133
(a) – same as IAS 39
(b) – same as IAS 39
(c) – FASB definition requires that the terms of the
derivative contract require or permit net settlement.
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To meet the criteria for being a
derivative under FAS 133, there must be a net settlement provision.
The
issue in a regular-way trade arises because of differences between trading dates and
settlement dates. Paragraph 294 on Page 141 of FAS 133 states the following:
Requiring that all forward contracts for purchases and
sales of financial instruments that are readily convertible to cash be accounted for as
derivatives would effectively require settlement date accounting for all such
transactions. Resolving the issue of trade date versus settlement date accounting was not
an objective of the project that led to this Statement. Therefore, the Board decided to
explicitly exclude forward contracts for "regular-way" trades from the scope of
this Statement.
For example, the forward sale requiring delivery
of a mortgaged-backed security is a regular-way trade if delivery of these types of
securities normally take 30 days or 60 days. Paragraph 10 excudes regular-way,
normal purchases, and normal sales. Also see Paragraphs 57c, 274, and 259-266. See
also dollar offset method and transition settlements.
FAS 133 leaves out the issue of trade date versus settlement date accounting
and, thereby, excluded forward contracts for regular-way security trades from the scope of
FAS 133 (See Appendix C Paragraph 274).
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
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IAS 39
If an enterprise has a contractual obligation that it can settle
either by paying out a financial assets or its own equity securities,
and if the number of equity securities required to settle the
obligation varies with changes in their fair value so that the total
fair value of the equity securities paid always equals the amount of
the contractual obligation, the obligation should be accounted for as
a financial liability, not as equity.
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FAS 133
FASB standards do not require that such an obligation be classified as
a liability.
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DIG Implementation Issue A3 --- http://www.fasb.org/derivatives/
QUESTION
Does the liquidity of the market for a group of contract affect the
determination of whether under paragraph 9(b) there is a market
mechanism that facilitates net settlement under paragraph 9(b)? For
example, assume a company contemporaneously enters into 500 futures
contracts, each of which requires delivery of 100 shares of an
exchange-traded equity security on the same date. The contracts fail
to meet the criterion in paragraph 9(a) because delivery of an asset
related to the underlying is required. The futures contracts trade on
an exchange, which constitutes a market mechanism under which the
company can be relieved of its rights and obligations under the
futures contracts. However, the quantity of futures contracts held by
the company cannot be rapidly absorbed in their entirety without
significantly affecting the quoted price of the contracts.
RESPONSE
No. The lack of a liquid market for the group of contracts does not
affect the determination of whether under paragraph 9(b) there is a
market mechanism that facilitates net settlement because the test in
paragraph 9(b) focuses on a singular contract. The exchange offers a
ready opportunity to sell each contract, thereby providing relief of
the rights and obligations under each contract.
Paragraph 57(c)(2) elaborates on the phrase market mechanism
that facilitate net settlement and states that "any
institutional arrangement or other agreement that enables either party
to be relieved of all rights and obligations under the contract and to
liquidate its net position without incurring a significant transaction
cost is considered net settlement." The possible reduction in
price due to selling a large futures position is not considered to be
a transaction cost under that paragraph.
Whether the number of shares deliverable under the group of futures
contracts exceeds the amount of shares that could rapidly be absorbed
by the market without significantly affecting the price is not
relevant to applying the criterion in paragraph 9(b). |
DIG Implementation Issue A5 --- http://www.fasb.org/derivatives/
QUESTION
Does a contract contain a net settlement provision under paragraphs
9(a) and 57(c)(1) if it contains both (a) a variable penalty for
nonperformance based on changes in the price of the items that are the
subject of the contract and (b) a fixed incremental penalty for
nonperformance that is sufficiently large to make the possibility of
net settlement remote?
BACKGROUND
Certain contracts may require payment of (a) a variable penalty for
nonperformance based on changes in the price of the items that are the
subject of the contract and (b) an incremental penalty for
nonperformance stated as a fixed amount or fixed amount per unit. The
contract may or may not characterize the incremental payment upon
nonperformance as a penalty.
Paragraph 57(c)(1) elaborates on the criterion in paragraph 6(c)
regarding whether the terms of a contract require or permit net
settlement which is discussed in paragraph 9(a). Paragraph 57(c)(1)
states:
Its terms implicitly or explicitly require or permit net
settlement. For example, a penalty for nonperformance in a purchase
order is a net settlement provision if the amount of the penalty is
based on changes in the price of the items that are the subject of the
contract. Net settlement may be made in cash or by delivery of any
other asset, whether or not it is readily convertible to cash. A fixed
penalty for nonperformance is not a net settlement provision. RESPONSE
No. A contract that contains a variable penalty for nonperformance
based on changes in the price of the items that are the subject of the
contract does not contain a net settlement provision under paragraphs
9(a) and 57(c)(1) if it also contains an incremental penalty of a
fixed amount (or fixed amount per unit) that would be expected to be
significant enough at all dates during the remaining term of the
contract to make the possibility of nonperformance remote. If a
contract includes such a provision, it effectively requires
performance, that is, requires the party to deliver an asset that is
associated with the underlying. Thus, the contract does not meet the
criterion for net settlement under paragraphs 9(a) and 57(c)(1) of
Statement 133. The assessment of the fixed incremental penalty in the
manner described above should be performed only at the contract's
inception.
The magnitude of the fixed incremental penalty should be assessed
on a standalone basis as a disincentive for nonperformance, not in
relation to the overall penalty. |
DIG Implementation Issue A7 --- http://www.fasb.org/derivatives/
QUESTION
Does the existence of a contractual requirement that one party
obtain the other's permission to assign rights or obligations to a
third party under a contract, in and of itself, preclude a contract
from meeting the definition of a derivative because it would not
possess the net settlement characteristic described in paragraph 9(b)
of Statement 133 as a market mechanism?
For the purposes of this question, assume that (1) if the contract
did not contain an assignment clause, an established market mechanism
that facilitates net settlement outside the contract exists, (2) the
contract does not satisfy the criteria for net settlement under the
provisions of paragraph 9(a), (3) the asset that is required to be
delivered under the contract is readily convertible to cash as
described under paragraph 9(c), and (4) the contract would qualify for
the normal purchases and sales exception under paragraph 10(b) if it
is considered not to possess the net settlement characteristic
described in paragraph 9(b).
BACKGROUND
Some commodity contracts contain a provision that allows one or
both parties to a contract to assign its rights or obligations to a
third party only after obtaining permission from the counterparty.
Under the assignment clause addressed in this issue, permission shall
not be unreasonably withheld. The primary purpose of an assignment
clause is to ensure that the non-assigning counterparty is not unduly
exposed to credit or performance risk if the assigning counterparty is
relieved of all of its rights and obligations under the contract.
Accordingly, a counterparty could withhold consent only in limited
circumstances, such as when the contract would be assigned to a third
party assignee that has a history of defaulting on its obligations or
has a lower credit rating than the assignor.
Paragraph 9(b) of Statement 133 indicates that the net settlement
characteristic of the definition of a derivative may be satisfied if
"One of the parties is required to deliver an asset of the type
described in paragraph 9(a), but there is a market mechanism that
facilitates net settlement, for example, an exchange that offers a
ready opportunity to sell the contract or to enter into an offsetting
contract." Paragraph 57(c) of Statement 133 elaborates on that
notion. It states:
...a contract that meets any one of the following criteria has the
characteristic described as net settlement [in paragraph
9(b)]….(2) There is an established market mechanism that
facilitates net settlement outside the contract. The term market
mechanism is to be interpreted broadly. Any institutional
arrangement or other agreement that enables either party to be
relieved of all rights and obligations under the contract and to
liquidate its net position without incurring a significant
transaction cost is considered net settlement. [Emphasis added.]
RESPONSE
No. The existence of an assignment clause does not, in and of
itself, preclude the contract from possessing the net settlement
characteristic described in paragraph 9(b) as a market mechanism. Once
the determination is made that a market mechanism that facilitates net
settlement outside of the contract exists, then an assessment of the
substance of the assignment clause is required in order to determine
whether that assignment clause precludes a party from being relieved
of all rights and obligations under the contract through that existing
market mechanism. Although permission to assign the contract shall not
be unreasonably withheld by the counterparty in accordance with the
terms of the contract, the assignment feature cannot be viewed simply
as a formality because it may be invoked at any time to prevent the
non-assigning party from being exposed to unacceptable credit or
performance risk. Accordingly, the existence of the assignment clause
may or may not permit a party from being relieved of its rights and
obligations under the contract.
If it is remote that the counterparty will withhold
permission to assign the contract, the mere existence of the clause
should not preclude the contract from possessing the net settlement
characteristic described in paragraph 9(b) as a market mechanism. Such
a determination requires assessing whether a sufficient number of
acceptable potential assignees exist in the marketplace such that
assignment of the contract would not result in imposing unacceptable
credit risk or performance risk on the non-assigning party.
Consideration should be given to past counterparty and industry
practices regarding whether permission to be relieved of all rights
and obligations under similar contracts has previously been withheld.
However, if it is reasonably possible or probable that
the counterparty will withhold permission to assign the contract, the
contract is precluded from possessing the net settlement
characteristic described in paragraph 9(b) as a market mechanism. In
that circumstance, even if the asset under the contract were readily
convertible to cash as described under paragraph 9(c), the contract
could qualify for the normal purchases and normal sales exception
under paragraph 10(b) because there is no net settlement provision in
the contract and no market mechanism that facilitates net settlement
exists (as described in paragraphs 9(a) and 9(b)). |
DIG Implementation Issue A8 --- http://www.fasb.org/derivatives/
QUESTION
Does an asymmetrical default provision, which provides the
defaulting party only the obligation to compensate its counterparty's
loss but not the right to demand any gain from its counterparty, give
a commodity forward contract the characteristic of net settlement
under paragraph 9(a) of Statement 133?
BACKGROUND
Paragraph 6(c) of Statement 133 describes the following derivative
characteristic:
Its terms require or permit net settlement, it can readily be
settled net by a means outside the contract, or it provides for
delivery of an asset that puts the recipient in a position not
substantially different from net settlement.
Paragraph 9(a) provides the following additional guidance regarding
the derivative characteristic in paragraph 6(c):
Neither party is required to deliver an asset that is associated
with the underlying or that has a principal amount, stated amount,
face value, number of shares, or other denomination that is equal to
the notional amount (or the notional amount plus a premium or minus
a discount).
Paragraph 57(c) and related subparagraph (1) provide the following
additional guidance regarding the derivative characteristic in
paragraphs 6(c) and 9(a):
A contract that meets any one of the following criteria has the
characteristic described as net settlement:
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Its terms implicitly or explicitly require or permit net
settlement. For example, a penalty for nonperformance in a
purchase order is a net settlement provision if the amount of
the penalty is based on changes in the price of the items that
are the subject of the contract. Net settlement may be made in
cash or by delivery of any other asset, whether or not it is
readily convertible to cash. A fixed penalty for nonperformance
is not a net settlement provision.
Many commodity forward contracts contain default provisions that
require the defaulting party (the party that fails to make or take
physical delivery of the commodity) to reimburse the nondefaulting
party for any loss incurred as illustrated in the following examples:
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If the buyer under the forward contract (Buyer) defaults (that
is, does not take physical delivery of the commodity), the seller
under that contract (Seller) will have to find another buyer in
the market to take delivery. If the price received by Seller in
the market is less than the contract price, Seller incurs a loss
equal to the quantity of the commodity that would have been
delivered under the forward contract multiplied by the difference
between the contract price and the current market price. Buyer
must pay Seller a penalty for nonperformance equal to that loss.
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If Seller defaults (that is, does not deliver the commodity
physically), Buyer will have to find another seller in the market.
If the price paid by Buyer in the market is more than the contract
price, Seller must pay Buyer a penalty for nonperformance equal to
the quantity of the commodity that would have been delivered under
the forward contract multiplied by the difference between the
contract price and the current market price.
For example, Buyer agreed to purchase 100 units of a commodity from
Seller at $1.00 per unit:
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Assume Buyer defaults on the forward contract by not taking
delivery and Seller must sell the 100 units in the market at the
prevailing market price of $.75 per unit. To compensate Seller for
the loss incurred due to Buyer's default, Buyer must pay Seller a
penalty of $25.00 (that is, 100 units × ($1.00 – $.75)).
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Similarly, assume that Seller defaults and Buyer must buy the
100 units it needs in the market at the prevailing market price of
$1.30 per unit. To compensate Buyer for the loss incurred due to
Seller's default, Seller must pay Buyer a penalty of $30.00 (that
is, 100 units × ($1.30 – $1.00)).
Note that an asymmetrical default provision is designed to
compensate the nondefaulting party for a loss incurred. The defaulting
party cannot demand payment from the nondefaulting party to realize
the changes in market price that would be favorable to the defaulting
party if the contract were honored. Under the forward contract in the
example, if Buyer defaults when the market price is $1.10, Seller will
be able to sell the units of the commodity into the market at $1.10
and realize a $10.00 greater gain than it would have under the
contract. In that circumstance, the defaulting Buyer is not required
to pay a penalty for nonperformance to Seller, nor is Seller required
to pass the $10.00 extra gain to the defaulting Buyer. Similarly, if
Seller defaults when the market price is $0.80, Buyer will be able to
buy the units of the commodity in the market and pay $20.00 less than
under the contract. In that circumstance, the defaulting Seller is not
required to pay a penalty for nonperformance to Buyer, nor is Buyer
required to pass the $20.00 savings on to the defaulting Seller.
RESPONSE
No. A nonperformance penalty provision that requires the defaulting
party to compensate the nondefaulting party for any loss incurred but
does not allow the defaulting party to receive the effect of favorable
price changes (herein referred to as an asymmetrical default
provision) does not give a commodity forward contract the
characteristic described as net settlement under paragraph 9(a) of
Statement 133.
A derivative instrument can be described, in part, as allowing the
holder to participate in the changes in an underlying without actually
making or taking delivery of the asset related to that underlying. In
a forward contract with only an asymmetrical default provision,
neither Buyer nor Seller can realize the benefits of changes in the
price of the commodity through default on the contract. That is, Buyer
cannot realize favorable changes in the intrinsic value of the forward
contract except (a) by taking delivery of the physical commodity or
(b) in the event of default by Seller, which is an event beyond the
control of Buyer. Similarly, Seller cannot realize favorable changes
in the intrinsic value of the forward contract except (a) by making
delivery of the physical commodity or (b) in the event of default by
Buyer, which is an event beyond the control of Seller. However, if
there was a pattern of using the asymmetrical default provisions as a
means to net settle certain kinds of an entity's commodity purchase or
sales contracts, that behavior would indicate that the asymmetrical
default provision would give those kinds of commodity contracts the
characteristic described as net settlement under paragraph 9(a).
In contrast, a contract that permits only one party to elect net
settlement of the contract (by default or otherwise), and thus
participate in either favorable changes only or both favorable
and unfavorable price changes in the underlying, meets the derivative
characteristic described in paragraph 6(c) and discussed in paragraph
9(a) for all parties to that contract. Such a default provision allows
one party to elect net settlement of the contract under any pricing
circumstance and consequently does not require delivery of an asset
that is associated with the underlying. That default provision differs
from the asymmetrical default provision in the above example contract
since it is not limited to compensating only the nondefaulting party
for a loss incurred and is not solely within the control of the
defaulting party.
If the commodity forward contract does not have the characteristic
of net settlement under paragraphs 9(a) and 9(b) but has the
characteristic of net settlement under paragraph 9(c) because it
requires delivery of a commodity that is readily convertible to cash,
the commodity forward contract may nevertheless be eligible to qualify
for the normal purchases and normal sales exception in paragraph 10(b)
and if so, would not be subject to the accounting requirements of
Statement 133 for the party to whom it is a normal purchase or normal
sale. |
DIG Implementation Issue A10 --- http://www.fasb.org/derivatives/
Title: Definition of a Derivative: Assets That Are Readily
Convertible to Cash
Paragraph references: 6(c), 9(c), Footnote 5 (to paragraph 9), 265
Date released: November 1999
QUESTION
Is an asset considered readily convertible to cash, as that phrase
is used in paragraph 9(c), if the net amount of cash that would be
received from a sale in an active market is not the equivalent amount
of cash that an entity would typically have received under a net
settlement provision? The net amount of cash that would be received
from a sale in an active market may be impacted by various factors,
such as sales commissions and costs to transport the asset (such as a
commodity) to the delivery location specified for that active market.
BACKGROUND
Paragraph 9(c) of Statement 133 provides that a contract that
requires delivery of the assets associated with the underlying has the
characteristic of net settlement if those assets are readily
convertible to cash. Footnote 5 to that paragraph makes explicit
reference to the use of the phrase readily convertible to cash in
paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and
Measurement in Financial Statements of Business Enterprises.
This issue addresses whether a contract has the net settlement
characteristic described in paragraph 9(c). This issue presumes there
is no net settlement provision in the contract and no market mechanism
that facilitates net settlement that would cause the contract to meet
the criteria in paragraphs 9(a) and 9(b). A contract that is a
derivative solely because it has the net settlement characteristic
described in paragraph 9(c) (since the asset to be delivered under the
contract is readily convertible to cash) may yet qualify for the
normal purchases and normal sales exception under paragraph 10(b) or
the other exclusions provided in paragraph 10.
RESPONSE
It depends. An asset can be considered to be readily convertible to
cash, as that phrase is used in paragraph 9(c), only if the net amount
of cash that would be received from a sale in an active market is not
significantly less than the amount an entity would typically have
received under a net settlement provision. The net amount that would
be received upon sale need not be equal to the amount typically
received under a net settlement provision.
Paragraph 6(c) of Statement 133 defines net settlement, in part, as
“…or it provides for delivery of an asset that puts the recipient
in a position not substantially different from net settlement”
(emphasis added). The basis for conclusions also comments in paragraph
265 that “…the parties generally should be indifferent as to
whether they exchange cash or the assets associated with the
underlying,” although the term indifferent was not intended to imply
an approximate equivalence between net settlement and proceeds from
sale in an active market. Based on the foregoing Statement 133
references, if an entity determines that the estimated costs that
would be incurred to immediately convert the asset to cash are not
significant, then receipt of that asset puts the entity in a position
not substantially different from net settlement. Therefore, an entity
must evaluate, in part, the significance of the estimated costs of
converting the asset to cash in determining whether those assets are
considered to be readily convertible to cash. For purposes of
assessing significance of such costs, an entity should consider those
estimated conversion costs to be significant only if they are 10
percent or more of the gross sales proceeds (based on the spot price
at the inception of the contract) that would be received from the sale
of those assets in the closest or most economical active market. The
assessment of the significance of those conversion costs should be
performed only at inception of the contract. |
See also DIG Issue A9 under interest
rate swap
|
Normal Purchases and Normal Sales (NPNS)
A portion of Paragraph 8 in FAS 133 reads as follows:
b. Normal purchases and normal
sales. Normal purchases and normal sales
are contracts with no net settlement provision and no market mechanism
to facilitate net settlement (as described
in paragraphs 9(a) and 9(b)). They provide for the purchase or sale of
something other than a financial instrument or derivative instrument
that will be delivered in quantities expected to be used or sold by the
reporting entity over a reasonable period in the normal course of
business.
A portion of Paragraph 58 of FAS 133 reads as
follows:
b. Normal purchases and normal
sales.
The exception in paragraph 10(b) applies only to a contract that
requires future delivery of assets (other than financial instruments or
derivative instruments) that are readily convertible to cash and only if
there is no market mechanism to facilitate net settlement outside the
contract. To qualify for the exception, a contract's terms also must be
consistent with the terms of an entity's normal purchases or normal
sales, that is, the quantity purchased or sold must be reasonable in
relation to the entity's business needs. Determining whether or not the
terms are consistent will require judgment. In making those judgments,
an entity should consider all relevant factors, such as
(1) the quantities provided under
the contract and the entity's need for the related assets,
(2) the locations to which delivery of the items will be made,
(3) the period of time between entering into the contract and delivery,
and
(4) the entity's prior practices with regard to such contracts.
Evidence such as past trends,
expected future demand, other contracts for delivery of similar items,
an entity's and industry's customs for acquiring and storing the related
commodities, and an entity's operating locations should help in
identifying contracts that qualify as normal purchases or normal sales.
Paragraphs 271 and 272 of FAS 133 read as follows:
271. The Board decided that contracts that
require delivery of nonfinancial assets that are readily convertible
to cash need not be accounted for as derivative instruments under this
Statement if the assets constitute normal purchases or normal sales of
the reporting entity unless those contracts can readily be settled
net. The Board believes contracts for the acquisition of assets in
quantities that the entity expects to use or sell over a reasonable
period in the normal course of business are not unlike binding
purchase orders or other similar contracts to which this Statement
does not apply. The Board notes that the normal purchases and normal
sales exemption is necessary only for contracts based on assets that
are readily convertible to cash.
272. The Board understands that the normal
purchases and normal sales provision sometimes will result in
different parties to a contract reaching different conclusions about
whether the contract is required to be accounted for as a derivative
instrument. For example, the contract may be for ordinary sales by one
party (and therefore not a derivative instrument) but not for ordinary
purchases by the counterparty (and therefore a derivative instrument).
The Board considered requiring both parties to account for a contract
as a derivative instrument if the purchases or sales by either party
were other than ordinary in the normal course of business. However,
that approach would have required that one party to the contract
determine the circumstances of the other party to that same contract.
Although the Board believes that the accounting by both parties to a
contract generally should be symmetrical, it decided that symmetry
would be impractical in this instance and that a potential
asymmetrical result is acceptable.
IAS 138 Implementation Guidance
"Implementation of SFAS 138, Amendments to SFAS 133," The
CPA Journal, November 2001. (With Angela L.J. Huang and John S.
Putoubas), pp. 54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm
The normal purchases and normal sales
exception is expanded to certain commodity contracts. The risk that
can be hedged in an interest rate hedge is redefined. Recognized
foreign currency-denominated assets and liabilities may be hedged with
a single cross-currency compound hedge. Net hedging of certain
intercompany derivatives may be designated as cash flow hedges of
foreign currency risk. Normal Purchases and Normal Sales Exception
In their normal course of business, companies
that consume or produce commodities often enter contracts to
physically deliver nonfinancial assets, such as electricity, natural
gas, oil, aluminum, wheat, or corn. Although these physical contracts
are typically settled by the delivery of the commodity, they often
include cash settlement provisions in case one party does not deliver
or accept delivery of the goods, although these provisions are not
intended as derivatives. Historically, the accounting principles for
executory contracts applied to physical contracts.
FASB decided contracts that permit but do not
require settlement by delivery of a commodity are often used
interchangeably with other derivatives and present similar risks;
therefore, they should be considered derivatives. As a result, the “normal
purchases and normal sales” exception in paragraph 10(b) of SFAS 133
did not apply to these commodities contracts because they could be
settled at net or liquidated through a market mechanism that would
facilitate net settlement. Normal purchases and sales provide
commodities that the reporting entity would use or sell in a
reasonable period of time during the normal course of business.
In response to concerns that SFAS 133
inappropriately classified such physical contracts as derivatives,
SFAS 138 amends paragraph 10(b) by expanding the normal purchases and
normal sales exception to contracts that contain net settlement
provisions if it is probable (at inception and throughout the term of
the individual contract) that the contract will not settle at net and
will result in physical delivery. The entity must document this
conclusion. While this amendment will affect many forward contracts,
exchange-traded futures that require periodic cash settlements do not
qualify for the exception.
A portion of Paragraph 4 of FAS 138 reads as follows:
4. Statement 133 is amended as follows:
Amendment Related to Normal Purchases and
Normal Sales
a. Paragraph 10(b) of FAS 133 is replaced by
the following:
Normal purchases and normal sales. Normal
purchases and normal sales are contracts that provide for the purchase
or sale of something other than a
financial instrument or derivative instrument that
will be delivered in quantities expected to be used or sold by the
reporting entity over a reasonable period in the normal course of
business. However, contracts that have a price based on an underlying
that is not clearly and closely related to the asset being sold or
purchased (such as a price in a contract for the sale of a grain
commodity based in part on changes in the S&P index) or that are
denominated in a foreign currency that meets neither of the criteria
in paragraphs 15(a) and 15(b) shall not be considered normal purchases
and normal sales. Contracts that contain net settlement provisions as
described in paragraphs 9(a) and 9(b) may qualify for the normal
purchases and normal sales exception if
it is probable at inception and throughout the term of the individual
contract that the contract will not settle net and will result in
physical delivery. Net settlement (as
described in paragraphs 9(a) and 9(b)) of contracts in a group of
contracts similarly designated as normal purchases and normal sales
would call into question the classification of all such contracts as
normal purchases or normal sales. Contracts
that require cash settlements of gains or losses or are otherwise
settled net on a periodic basis, including individual contracts that
are part of a series of sequential contracts intended to accomplish
ultimate acquisition or sale of a commodity, do not qualify for this
exception. For contracts that qualify for
the normal purchases and normal sales exception, the entity shall
document the basis for concluding that it is probable that the
contract will result in physical delivery. The documentation
requirements can be applied either to groups of similarly designated
contracts or to each individual contract.
DIG Implementation Issue A2 --- http://www.fasb.org/derivatives/
Statement 133 Implementation Issue No. A2,
"Existence of a Market Mechanism That Facilitates Net
Settlement," was rescinded upon the clearance of Statement 133
Implementation Issue No. A21, "Existence of an Established Market
Mechanism That Facilitates Net Settlement under Paragraph 9(b),"
which was posted on April 10, 2002
QUESTION
Two entities enter into a commodity forward
contract that requires delivery and is not exchange-traded; however,
there are brokers who stand ready to buy and sell the commodity
contracts. Either entity can be relieved of its obligation to make (or
right to accept) delivery of the commodity and its right to receive
(or obligation to make) payment under the contract by arranging for a
broker to make or accept delivery and paying the broker a commission
plus any difference between the contract price and the current market
price of the commodity. The commission paid to the broker is not
significant. Based on those facts, is the criterion for net settlement
in paragraph 6(c) satisfied because of the existence of a market
mechanism that facilitates net settlement as described in paragraph
9(b)?
RESPONSE
Yes. The criterion for net settlement would be
satisfied because the entity can be relieved of its rights and
obligations under the contract without incurring a substantial fee due
to its arrangement with a broker. Paragraph 57(c)(2) states that the
term market mechanism is to be interpreted broadly, and any
institutional arrangement or side agreement that enables either party
to be relieved of all rights and obligations under the contract and to
liquidate its net position without incurring a significant transaction
cost is considered net settlement. The fact that brokers stand ready
to relieve entities of their rights and obligations under a particular
type of contract indicates that a market mechanism that facilitates
net settlement exists for that type of contract.
In contrast, if the arrangement between the
entity and the broker (a) is simply an agreement whereby the broker
will make (or accept) delivery on behalf of an entity and (b) does not
relieve the entity of its rights and obligations under the contract,
the arrangement does not constitute a market mechanism that
facilitates net settlement under paragraph 9(b) and the criterion for
net settlement in paragraph 6(c) is not satisfied.
|
|
A
message concerning Normal
Purchases and Normal Sales (NPNS)
I
received a very long message and received permission to quote the message below
regarding the Normal Purchases and Normal Sales (NPNS) amendment in FAS 138::
Hello
Professor Jensen,
Great
website! However, I have to disagree with your comment regarding the issue of
NPNS.
I
work for the Bonneville Power Administration (Bonneville), a federal based
Electric Wholesale Power Marketer, we sell the output from the 29 federally
owned dams on the Columbia and Snake River system in the Pacific Northwest.
I am the project manager for Bonneville responsible for implementing FAS
133. More on Bonneville at the end
of this email - postscript.
Regarding
the NPNS issue: This
issue is of big concern to the Energy industry as it relates to our normal sales
and purchases activities. I am most
familiar with the Electric Utility
industry and the sales and
delivery practices that are prevalent throughout the industry.
I would argue that Bonneville was
much better off under the original statement para 10 (b) because the statement
was silent on the practice I describe below referred to as "Bookouts".
Specifically,
in the electric utility industry it is necessary and is considered best utility
and business practice to perform a type of transaction called a
"Bookout"
whereby several transactions with the same Counterparty in the same month - a
purchase and a sale - are offset and
not scheduled for physical delivery.
For example, Bonneville may sell forward 200 MWs for the month of August
2000 in January 2000 based on our most current hydro forecasts and subsequently
in May 2000 our most current forecasts now show a deficit and we have to
purchase 200 MWs for the same month to cover our obligations.
We may from time to time find ourselves with both purchases and sales
with the same counterparty in the same month at the same delivery location.
Just prior to delivery, we look at our schedule and try and match up
transactions --- the "Bookout" procedure.
This
"Bookout" procedure is common in the electric utility industry as a
scheduling convenience when two utilities happen to have offsetting
transactions. If this procedure is not used, both counterparties
incur transmission costs in order to make deliveries to each other. The
Bookout procedure avoids the energy scheduling process (an administrative burden
as well) which would trigger payment of transmission costs.
We do not plan for this event or know in advance what we will bookout and
we do not "Bookout" to capture a margin.
Rather, we find ourselves in this situation because of our inventory
management constraints, maintenance schedules, and dependency on factors outside
our control such as the weather and streamflows or environmental constraints
placed upon us by other federal agencies or federal courts.
We
lobbied
the FASB and the DIG to clarify and revise the NPNS language to allow for this
practice, but the FASB position was very restrictive -- if you do not deliver
then it is considered net settled.
It seems to me and other industry participants that bookouts do not fit
into the net settlement definition as it was described and intended in FAS 133.
Rather it is a utility best practice that results in no physical delivery.
In addition, when we bookout the cash settling is done at the agreed upon
contract prices - not at the market pricing.
We would argue that the Board's original intent was to capture net
settlement mechanisms that require "market" settlement.
Unfortunately, the FASB made their decision about a practice without
doing more homework on the nature of the transaction.
I understand the pressures the
FASB was under to get the statement amended and implemented.
Unfortunately, the industry participants and practitioners are left to
deal with the Board's end product.
The final 138 was not clear in its guidance either as it relates to these
types of transactions and what this meant to our "similar" contracts
that we want to qualify for NPNS. I
continue, along with our auditors, to hold discussions with FASB staff.
What
I am afraid may happen is that because of the "One size fits all approach
by the FASB", Bonneville and
other regulated utilities will be forced into adopting a FV accounting approach
on transactions that are simple sales and purchases.
Applying mark to market treatment to these transactions is more
misleading to the financial statement reader not clearer - the original intent
of 133. I believe the
interpretation of the final written words by individuals unfamiliar with the
Energy industry is driving us into misleading and confusing presentation.
Any
advice or encouragement you can provide would be appreciated.
We adopt October 1 and I have a deadline to meet and I still do not have
final clear and convincing guidance. I
am ahead of most folks on this issue since we do have an earlier adoption date
than most utilities. Thanks for
your time. This is a complex issue
and I apologize for the length of this email and I imagine I still have not
described the issues in the most succinct and clear fashion.
Regards,
Sanford
Menashe
Project Manager, FAS 133
Bonneville Power Administration
phone: 503-230-3570
email: smmenashe@bpa.gov
Postscript:
About
Bonneville Power Administration:
Bonneville
is a federal agency under the Department of Energy, which was established over
60 years ago to market power from 29 federal dams and one non-federal nuclear
plant in the Pacific Northwest. BPA’s energy sales are governed by federal
legislation (e.g. the Northwest Power Act) and other regional mandates to
maintain the benefits of power sales for the Pacific Northwest region and to
manage its environmental and safety obligations relative to operating the
federal hydroelectric system. Its primary objective is to provide low-cost
electricity to the region by offering cost-based rates for its power and
transmission services to eligible publicly owned and investor-owned utilities in
the Pacific Northwest (including Oregon, Washington, Idaho, western Montana and
small parts of Wyoming, Nevada, Utah, California and eastern Montana).
Sanford
Menashe, Manager, FAS 133 Project.
Project
Manager, FAS 133
Bonneville Power Administration
phone: 503-230-3570
email: smmenashe@bpa.gov
Email:
smmenashe@bpa.gov
Updates in September 2001 and March
2003:
The DIG addressed Mr. Menasche's concerns, especially in Dig Issue C16. But this did not go far enough to satisfy energy
firms with respect to bookouts.
Statement 133 Implementation Issue No. C16
Title: Scope Exceptions: Applying the Normal Purchases and Normal
Sales Exception to Contracts That Combine a Forward Contract and a
Purchased Option Contract
May 1, 2003
Affected by: FASB Statement No. 149,
Amendment of Statement 133 on Derivative Instruments and Hedging
Activities
(Revised March 26, 2003)
QUESTION
If a purchased option that would, if exercised, require delivery of
the related asset at an established price under the contract is combined
with a forward contract in a single supply contract and that single
supply contract meets the definition of a derivative, is that single
supply contract eligible to qualify for the normal purchases and normal
sales exception in paragraph 10(b)?
BACKGROUND
Some utilities and independent power producers (also called IPPs)
have fuel supply contracts that require delivery of a contractual
minimum quantity of fuel at a fixed price and have an option that
permits the holder to take specified additional amounts of fuel at the
same fixed price at various times. Essentially, that option to take more
fuel is a purchased option that is combined with the forward contract in
a single supply contract. Typically, the option to take additional fuel
is built into the contract to ensure that the buyer has a supply of fuel
in order to produce the electricity during peak demands; however, the
buyer may have the ability to sell to third parties the additional fuel
purchased through exercise of the purchased option. Due to the
difficulty in estimating peak electricity load and thus the amount of
fuel needed to generate the required electricity, those fuel supply
contracts are common in the electric utility industry (though similar
supply contracts may exist in other industries). Those fuel supply
contracts are not requirements contracts that are addressed in Statement
133 Implementation Issue No. A6, "Notional Amounts of Commodity
Contracts."
Many of those contracts meet the definition of a derivative because
they have a notional amount and an underlying, require
no or a smaller initial net investment, and provide for net settlement (for
example, through their default provisions or by requiring delivery of an
asset that is readily convertible to cash). For purposes of applying
Statement 133 to contracts that meet the definition of a derivative, it
is necessary to determine whether the fuel supply contract qualifies for
the normal purchases and normal sales exception, whether bifurcation of
the option is permitted if it does not qualify for the normal purchases
and normal sales exception, or whether the entire contract is accounted
for as a derivative.
Statement 133 Implementation Issue No. C15, "Normal Purchases
and Normal Sales Exception for Certain Option-Type Contracts and Forward
Contracts in Electricity," indicates that power purchase or sales
agreements (including combinations of a forward contract and an option
contract) that meet the criteria in that Implementation Issue qualify
for the normal purchases and normal sales exception in paragraph 10(b).
Although the above background information discusses utilities and
independent power producers, this Implementation Issue applies to all
entities that enter into contracts that combine a forward contract and a
purchased option contract, not just to utilities and independent power
producers.
RESPONSE
The inclusion of a purchased option that would, if exercised, require
delivery of the related asset at an established price under the contract
within the single supply contract that meets the definition of a
derivative disqualifies the entire derivative fuel supply contract from
being eligible to qualify for the normal purchases and normal sales
exception in paragraph 10(b) except as provided in paragraph 10(b)(4) of
Statement 133, as amended, and Implementation Issue C15 with respect to
certain power purchase or sales agreements. Statement 133 Implementation
Issue No. C10, “Can Option Contracts and Forward Contracts with
Optionality Features Qualify for the Normal Purchases and Normal Sales
Exception,” states? “Option contracts only contingently provide for
such purchase or sale since exercise of the option contract is not
assured. Thus, in accordance with paragraph 10(b)(2) of Statement 133,
as amended, freestanding option contracts (including in-the-money
options contracts) are not eligible to qualify for the normal purchases
and normal sales exception.” Paragraph 10(b)(3) of Statement 133, as
amended, and Implementation Issue C10 further indicate that forward
contracts with embedded optionality can qualify for the normal purchases
and normal sales exception only if the embedded optionality (such as
price caps) does not affect the quantity to be delivered. The fuel
supply contract cannot qualify for the normal purchases and normal sales
exception because of the optionality regarding the quantity of fuel to
be delivered under the contract.
An entity is not permitted to bifurcate the forward contract
component and the option contract component of a fuel supply contract
that in its entirety meets the definition of a derivative and then
assert that the forward contract component is eligible to qualify for
the normal purchases and normal sales exception. Paragraph 18 indicates
that an entity is prohibited from separating a compound derivative in
components representing different risks. (The provisions of paragraph 12
require that certain derivatives that are embedded in non-derivative
hybrid instruments must be split out from the host contract and
accounted for separately as a derivative; however, paragraph 12 does not
apply to a contract that meets the definition of a derivative in its
entirety.)
An entity may wish to enter into two separate contracts—a forward
contract and an option contract—that economically achieve the same
results as the single derivative contract described in the background
section and determine whether the exception in paragraph 10(b) applies
to the separate forward contract.
Similar to the option contracts discussed in Implementation Issue
C10, this Issue addresses option components that would require delivery
of the related asset at an established price under the contract. If the
option component does not provide any benefit to the holder beyond the
assurance of a guaranteed supply of the underlying commodity for use in
the normal course of business and that option component only
permits the holder to purchase additional quantities at the market price
at the date of delivery (that is, that option component will always have
a fair value of zero), that option component would not require delivery
of the related asset at an established price under the contract.
If an entity’s single supply contract included at its inception
both a forward contract and an option contract and, in subsequent
renegotiations, that contract is negated and replaced by two separate
contracts (a forward contract for a specific quantity that will be
purchased and an option contract for additional quantities whose
purchase is conditional upon exercise of the option), the new forward
contract would be eligible to qualify for the normal purchases and
normal sales exception under paragraph 10(b), whereas the new option
contract would not be eligible for that exception. From the inception of
that new separate option contract, it would be accounted for under
Statement 133. However, the guidance in this Implementation Issue would
not retroactively affect the accounting for the combination derivative
contract that was negated prior to the effective date of this
Implementation Issue.
If on the effective date of this Implementation Issue, an entity was
party to a combination derivative contract that included both a forward
contract and an option contract but the entity had not been accounting
for that derivative contract under Statement 133 because it had
documented an asserted compliance with paragraph 10(b), that combination
derivative contract would be reported at its fair value on the effective
date of this Implementation Issue, with the offsetting entry recorded in
current period earnings. The combination derivative contract cannot be
bifurcated into a forward contract that would have been eligible to
qualify for the normal purchases and normal sales exception and an
option contract.
EFFECTIVE DATE
The effective date of the implementation guidance in this Issue for
each reporting entity is the first day of its second fiscal quarter
beginning after October 10, 2001, the date that the Board-cleared
guidance was posted on the FASB website. The revisions made on March 26,
2003, do not affect the effective date.
|
"FASB Clears DIG Issues But Refuses Electricity Exception," March
23, 2001 --- http://www.fas133.com/search/search_article.cfm?areaid=369&page=111
FASB Clears DIG Issues But Refuses Electricity
Exception The FASB Board cleared 22 DIG issues and discussed one
electricity-related item at its March 21, 2001 meeting.
Electricity options. The only other FAS 133-related
issue discussed at the FASB’s meeting relates to electricity option
contracts (DIG Agenda Item 14-3, (Normal Purchases and Sales Exception in the
Electric Industry for Capacity Contracts Including Contracts that May Have
Some Characteristics of Purchased and Written Options).
In general, notes Kevin Stoklosa, project manager
with the FASB Staff, Issue C10 says that options do not qualify for the normal
purchases and sales exemption of FAS 133.
However, because of the uniqueness of electricity
contracts (they are regulated, the “goods” cannot be stored, etc.) the
Board has received a request to make an exception for electricity option
contracts. However, he says, the Board declined to offer such a special
exception.
Book outs. Item 14-12, regarding book out contracts
and their normal purchases and sales exception implications was not discussed;
however, Mr. Stoklosa says he expects that the Staff’s tentative guidance
will be posted shortly. In essence, he says, as long as a contract is subject
to “being booked out,” it does not qualify for the exception. That’s
because the book out option precludes the company from making the presumption
at inception that it will most likely take delivery. “That’s particularly
true when they don’t have control over the book out,” he notes.
See Bookout
Not-for-Profit
=
a reporting entity that does not compute
net income as a separate caption. This includes most governmental, educational, and
charitable organizations. Many health care entities are also nonprofit, although in
recent years many of those have become profit enterprises. Gains and losses on a
hedging or nonhedging derivative instrument is to be accounted for as a change in net
assets of not-for-profit entities according to Paragraph 43 on Pages 26-27 of FAS 133.
These entities may not use cash flow hedges. Similar accounting rules apply
to a defined benefit pension
plan.
Notional =
the quantity that,
when multiplied by the underlying index (e.g., price
or interest rate), is used to determine the net
settlement of a derivative
financial instrument.. For example, on the Chicago Board of Trade (CBOT),
futures contracts for corn are defined in terms of 25,000-bushel
contracts. Four contracts on corn would, therefore, have a notional of
100,000 bushels.
A notional cannot be a
contingent amount except under the DIG issue A6 conditons noted below. For example, the notional cannot be specified as the
Year 2004 corn production amount on the Ralph Jones Family Farm. The
notional must be defined in terms of something other than a sports or
geological condition such a an amount of crop dependent upon rainfall over the
growing season. See Derivative
Financial Instrument.
The notional may be the
principal on a loan (e.g. bonds payable) whose
interest rate is swapped in an interest rate swap contract. For example,
the notional on 10,000 bonds having a face value of $1,000 is $10,000,000. The "notional rate" is the
current interest rate on the notional loan. FAS 133 on Page 3, Paragraph 6 defines a
notional as "a number of currency units, shares, bushels, pounds, or other units
specified in the contract." The settlement of a derivative instrument with a notional
amount is determined by the interaction of that notional amount with the underlying.
." Also see Paragraphs 250-258. Go to the term underlying.
Fixed payment is required as a result of some future event unrelated to a
notional amount. Paragraphs 10a and 13 of IAS 39. Payment provision specifies a fixed or determinable settlement to be made
if the underlying behaves in a specified manner. (FAS 133 Paragraphs 6a, 7 & 5 of
FAS 133.)
There were some very sticky questions raised in DIG Issue A6 about
commodity contracts where the number of items are not specified. See http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuea6.html
One of my students, Erin Welch, wrote the following based
upon DIG Issue A6
Question: How does the lack of
specification of a fixed number of units of a commodity to be bought or sold
affect whether a commodity contract has a notional amount?
Specifically, does each of the illustrative contracts below have a
notional amount as discussed in paragraph 6(a) to meet Statement 133’s
definition of a derivative instrument?”
|
NOTIONAL
SPECIFICATION
|
DOES
IT QUALIFY AS A NOTIONAL UNDER FAS 133?
|
WHY
OR WHY NOT?
|
As
many units as required to satisfy the buyer’s actual needs during the
contract period.
|
It
depends.
|
Yes,
if the contract contains explicit provisions that support the
calculation of a determinable amount reflecting the buyer’s needs.
|
Only
as many units as needed to satisfy its needs up to a maximum of 100
units.
|
It
depends.
|
Same
as previous provision except that the notional cannot exceed 100 units
|
A
minimum of 60 units and as many units needed to satisfy its actual needs
in excess of 60 units.
|
Yes.
|
A
contract that specifies a minimum number of units always as a notional
amount at least equal to that minimum amount.
Only that portion of the contract with a determinable notional
amount would be accounted for as a derivative instrument.
|
A
minimum of 60 units and as many units needed to satisfy its actual needs
in excess of 60 units up to a maximum of 100 units.
|
Yes.
|
Same
as previous provision except that the notional cannot exceed 100 units.
|
NYMEX
=
New York Mercantile Exchange (NYMEX) for Energy and Metals --- http://www.nymex.com/jsp/index.jsp
O-Terms
OCI = see comprehensive income.
Open
Interest
The total number of futures or options
contracts of a given commodity that have not yet been offset by an opposite
futures or option transaction nor fulfilled by delivery of the commodity or
option exercise. Each open transaction has a buyer and a seller, but for
calculation of open interest, only one side of the contract is counted.
See futures contract.
Open Position =
a financial risk that is not hedged. See hedge.
Option =
a contract that gives the purchaser the right to
buy or sell an asset (such as a unit of foreign currency) at a specified price within a
specified time period. A call option gives the holder the right to buy the underlying
asset; a put option gives the holder the right to sell it. The price of the option
is called a premium. Singular options or a combination of
options can be designated as hedges according to Paragraph 20c on Page 12 of FAS 133.
For example, an interest rate collar combination of a put and
call options or circus combinations may qualify as hedges unless a
net premium is received giving rise to written option
complications.
Call options are illustrated in Example 9 of
FAS 133 in Paragraphs 162-164. An option is "in-the-money" if the holder would
benefit from exercising it now. A call option is in-the-money if the
strike price (the exercise price) is below the current market
price of the underlying asset; a put option is in-the-money if the strike price is
above the market price. Intrinsic value is equal to the
difference between the strike price and the market price. An option is
"out-of-the-money" if the holder would not benefit from exercising it now. A
call option is out-of-the-money if the strike price is above the current market price of
the underlying asset; a put option is out-of-the-money if the strike price is below the
market price. The key distinction between contracts versus
futures/forward contracts is that an option is
purchased up front and the buyer has a right but not an obligation to execute the option
in the future, In other words, the most the option buyer can lose is the option price. In
the case of forwards and futures, there is an obligation to perform in the future. The writer (seller) of an option, however, has an obligation to
perform if the option is exercised by the buyer. FAS 133 rules for purchased options are
much different than for written options. For rules regarding written options see
Paragraphs 396-401 on Pages 179-181 of FAS 133. Exposure Draft 162-B would not
allow hedge accounting for written options. FAS 133 relaxed the rules for written
options under certain circumstances explained in Paragraphs 396-401.
The partitioning of an option's value
between intrinsic and time value partitions is important subsequent to the
purchase of an option. On the acquisition date, the option is recorded
at the premium (purchase price) the paid.
Subsequent to the purchase date, the option is marked to fair value equal to
subsequent changes in quoted premiums. If the
option qualifies as a cash flow hedge of a forecasted transaction, changes
in the time value of the option are debited or credited to current
earnings. Changes in the intrinsic value, however, are posted to comprehensive
income (OCI). See the CapIT Corporation and FloorIT
Corporation cases at
http://faculty.trinity.edu/rjensen/acct5341/133cases/000index.htm.
Paragraph 399 on Page 180 of
FAS 133 does not
allow covered call strategies that permit an entity to write an
option on an asset that it owns. In a covered call the combined position of
the hedged item and the derivative option is asymmetrical in that exposure to losses is
always greater than potential gains. The option premium, however, is set so that the
option writer certainly does not expect those "remotely possible" losses to
occur. Only when the potential gains are at least equal to potential cash flow
losses will Paragraph 28c on Page 19 of FAS 133 kick in to allow a cash flow hedge under
FAS 133. Also see Paragraph 20c on Page 12.
Options are referred to extensively in
FAS 133.
See for example Paragraphs 60-61, 85-88, 102, 188., and 284. For a discussion of
combination options, see compound derivatives.
Also see intrinsic value, swaption,
range forward, covered call, and written option.
By way of illustration of interest rate options,
suppose a September Eurodollar call option has a strike price of 9550 basis points
(95.50%) that nets out an option interest rate strike price of 100% - 95.50% =
4.50%. Adding a 0.10 option premium to this nets out to 100% - 95.50% - 0.10%
= 4.40%. Interest rate call options are used to hedge against falling
interest rates. The cost of each basis point is $25 such that with a 0.10 option
premium, the cost of the September call option is (10 basis points)($25) = $250.
Settlements are in cash and no actual transfer of securities take place if the purchaser
of the option chooses to exercise the call option. Suppose that the call option had
been used to hedge a Eurodollar futures contract that settled in September for 9500.
The fall in interest rates by 50 basis points is hedged by the rise in the call option by
an equivalent amount.
A written option is not a hedging instrument unless it is designated as an
offset to a purchased option, including one that is embedded in another financial
instrument, for example, a written option used to hedge callable debt
(FAS 133 Paragraph 124). A purchased option qualifies as a hedging instrument as it has potential gains equal to or
greater than losses and, therefore, has the potential to reduce profit or loss exposure
from changes in fair values or cash flows (IAS 39 Paragraph 124).
Under FASB rules, if a written option is designated as hedging a recognized asset or
liability / the variability in cash flows for a recognized asset or liability, the
combination of the hedged item and the written option provides at least as much potential
for favorable cash flows as exposure to unfavorable cash flows (see FAS 133 Paragraph 20c
or 28c).
For a discussion of option valuation, go to Valuation
of Options
Yahoo
Finance is Bob Jensen's Favorite Place to learn more about the mechanics and widespread
use of options. That web site, however, will not help much with respect
to accounting for such instruments under FAS 133. Also
see CBOE, CBOT, and CME
for some great tutorials on options investing and hedging.
Question
What is the main advantage and main disadvantage of speculating or hedging with
purchased options?
Main Advantage
The main advantage of purchased options is that the total loss is bounded by the
premium paid initially. In the case of other derivatives like forwards, futures,
swaps, and written options, the risks are generally not bounded unless they are
bounded by other hedging contracts. Strategies thereby become more complicated.
Main Disadvantage
The main disadvantage is the cost (premium) that must be paid initially for
purchased options. Most other alternatives have no up front premiums although
premiums can be written into more complex OTC alternatives.
Question
What are reverse convertible securities?
"Simple options thrive in risky
world - SuperDerivatives," by Toni Vorobyova, Reuters, February 8,
2012 ---
http://uk.reuters.com/article/2012/02/08/uk-superderivatives-idUKLNE81701V20120208
Investors want
simple derivative products to cushion the pain of stock market losses and
have turned their back on complex, custom-built products which were earning
a fortune for investment banks, the head of equities at a leading
derivatives pricing firm said.
The collapse
of Lehman Brothers - the largest bankruptcy in U.S. history which left the
bank facing billions of dollars in derivatives claims - has burnt many
investors, choking off demand for more complex options, according to Mikael
Benguigui, head of equities at SuperDerivatives.
Such trends
were last week acknowledged by Deutsche Bank (DBKGn.DE),
which noted lower revenue for equity derivatives sales
and trading compared with 2010 as a result of what it said was a more
challenging environment and lower client activity.
"The market has
changed completely. Banks are not willing to take on risk. There is a
general consensus in the market now to avoid going into too-complex,
too-exotic options," Benguigui said.
"What we see is
that people are pricing fairly simple structured products, fairly
commoditised products. It's not what we saw five or six years ago when every
month banks were inventing a new product."
The pace of growth
in the equity derivatives market has slumped from the 33 percent seen in
2007 - before the 2008 collapse of Lehman - to 9 percent in 2011, according
to data from the World Federation of Exchanges. Within that, stock index
options are the most popular category and are enjoying the strongest growth.
The timeframe
on such products has also shrunk: five-year options are popular, but banks
are reluctant to take on the risk of offering products for seven years or
longer. This is in contrast to pre-crisis days, when they would quote for 12
years or more, Benguigui, a derivatives veteran who also worked at Citi (C.N)
and JPMorgan (JPM.N),
said.
"The feedback from
the investment banking side is that a lot of them are struggling. We are
coming back to less complicated options and less complicated strategy, so
it's more plain vanilla. And plain vanilla means less room for margin - it's
more liquid, it's easy to put banks into competition," he said.
NO BIG UPSIDE
SuperDerivatives
offers equity derivatives pricing tools - from a live platform to a one-off
portfolio valuation service - to banks, hedge funds, asset managers,
custodians and hedge fund administrators in more than 60 countries.
Among the most
popular are so-called reverse convertible securities, which are linked to an
underlying stock or index and offer a high coupon.
Upon maturity, if
the value of the stock or index is above a certain level, the holder gets
back the full investment. Otherwise, they get a pre-agreed number of shares.
Such a product
ensures a steady relatively high return, in exchange for which investors
give up their right to benefit from any unexpected surge in a share price.
"The big upside -
no one really believes in it. There might be moderate upside, but they are
happy to have a fixed coupon. Moderate downside can happen and they don't
want to suffer on that, so they are happy to have the investment back. If
they are completely wrong and something really bad happens, it's no worse
than being long the stock from day one," Benguigui said.
"This sort of
super-easy product has big, big flows in the UK and also in Switzerland."
Regulation is key
to regaining investor confidence in a market where many found themselves
unable to exit positions as the global financial crisis unfurled.
"Right now, every
regulatory body is pushing for more transparency, better liquidity. They are
asking the buy side to be more independent by using a platform where you can
price everything independently," Benguigui said.
"When the market
changes like this, the volume is going to come back. But ... investment
banks are not going to be allowed to do what they did before in terms of
taking risk or playing with the capital. I don't think we are going to see
huge volumes again on complex instruments where banks were making fortunes."
Links to my tutorials on derivative financial instruments, including a long history of
multimedia, can be found at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
"Of Knock-ins, Knock-outs & KIKOs," by
Ranju Sarkar, Business Standard, April 2, 2008 ---
Click Here
http://www.business-standard.com/common/news_article.php?leftnm=0&subLeft=1&chklogin=N&autono=318661&tab=r
OPTIONS
|
|
Option is
a contract which gives a buyer a right, but not an obligation, to
buy an underlying/ currency/ stock/ commodities at a pre-determined
rate, known as strike price, for settlement at a future day. The
right to buy is called a call option. The right to sell is called a
put option. There are different types of options. |
|
Knock-out option: An option which ceases to exist if the
knock-out event occurs. A knock out happens when a particular level
is hit (like the Swiss franc touching the level of 1.10 against the
dollar), when the option ceases to exist. |
|
Knock-in option: An option which comes into existence if the
knock-in event happens. It works exactly the reverse of a knock-out.
In a knock-in, an option comes into existence if a certain level is
hit. |
|
KIKO
(knock-in, knock-out): This is an option with both a knock-in
and knock-out. The option kicks in, or comes alive, if the knock-in
is seen. The option ceases to exist if anytime, pre or post, the
knock-in event happening, the knock-out happens. |
|
One-touch option: When a certain level (of any currency pair) is
hit, a company buying an option gets a pre-determined pay-off (it
could be $10,000, $20,000, or $30,000). This is how companies made
money through derivative deals last year. |
|
Double-touch option: There are two levels. If either of the two
levels is hit, the company buying an option will get a pay off. All
options require a buyer to pay a premium. Conversely, sellers of
options would receive a premium. |
|
STRUCTURES |
|
Banks,
foreign exchange consultants work out zero-cost option structures/
strategies for companies so that they don’t have to pay any premium.
To make a zero-cost structure, a company has to buy some option and
sell some option so that the premium is zero (the premium paid for
buying an option is set-off against the premium received for selling
the option). |
|
For
instance, when the rupee-dollar parity is 40.10, an exporter buys a
put option at the rate of 39.50, and sells a call option for 41.00
for delivery of exports at the end of June, July and August an
export commitment of $1 million each month. By entering into this
contract, the best rate the exporter can get is 41, and the worst
rate it can get is 39.50. |
|
If the
rupee goes below 39.50, the exporter will be able to encash its
receivables at the rate of 39.50. If the rupee is trading between
39.50 and 41, the exporter will be able to encash its receivables at
the prevailing market rate. |
|
However,
if the rupee is ruling above 41, it will get its receivables at Rs
41 as he’s locked in that level. This kind of structure is popular
with software companies, who can realise their receivables in a
range (between the best and worst), unlike in a forward contract
where they get locked in at a particular rate. |
|
Banks also
offer, what they call, a 1:2 leveraged option, wherein a company
buys some calls, makes some puts and use a combination of these to
create zero-cost strategy for the company. Companies that have big
positions in derivative trades have been selling KIKOs, or a series
of KIKOs and buying one-touch options and double-touch options.
These structures helped companies make money last year. |
Continued in article
Bob Jensen's links to accounting,
finance, and business glossaries ---
http://faculty.trinity.edu/rjensen/Bookbus.htm
Bob Jensen's links to FAS 133 and IAS
39 Accounting for Derivative Financial Instruments Glossary ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Bob Jensen's FAS 133 and IAS 39
Tutorials on Accounting for Derivative Financial Instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
"IAS 32
Financial Instruments: Presentation — Put options written over non-controlling
interests," IAS Plus, January 17, 2012 ---
http://www.iasplus.com/ifric/1201.htm#ias32
Throughout 2010 and
2011, the Committee considered a request for guidance on how an entity
should account for changes in the carrying amount of a financial liability
for a put option, written over shares held by a non-controlling interest
shareholder (NCI put), in the consolidated financial statements of a parent
entity. The request is the result of perceived diversity in accounting for
the subsequent measurement of the financial liability that is recognised for
those NCI puts. The issue arises because of potential inconsistencies
between the requirements for measuring financial liabilities and the
requirements for accounting for transactions with owners in their capacity
as owners, whereby some believe that subsequent changes in the liability
that is recognised for the NCI put should be recognised in profit or loss
while others believe the change in the liability should be recognised in
equity.
Given that the IASB
rejected the Committee's initial recommendation for a possible scope
exclusion to IAS 32 Financial Instruments: Presentation for put options
written over the non-controlling interest in the consolidated financial
statements of a group, the Committee considered possible paths forward on
this project.
The Committee was
directed by the IASB to specifically consider whether changes in the
measurement of the NCI put should be recognised in profit or loss or equity
and whether the scope of the recognition decision should be applied only to
NCI puts or extended to include both NCI puts and NCI forwards. While the
Committee was asked to consider these two focused questions, they quickly
expanded the scope of the discussion by considering broader concerns
surrounding the project including the counterintuitive result of recognising
a 'gross' liability when reflecting subsequent changes in the liability in
profit or loss (as opposed to reflection on a 'net' basis), the treatment of
the purchase of a NCI put with variable consideration and the timing of
transaction recognition; acknowledging that these were the same concerns
expressed when they made their initial recommendation to the IASB to exclude
from the scope of IAS 32 put options written over the non-controlling
interest in the consolidated financial statements of a group.
One Committee
member expressed a preference that application guidance be drafted which
specifies that paragraph 30 of IAS 27 Consolidated and Separate Financial
Statements does not apply to NCI puts because the change in ownership
interest has not yet occurred. Put another way, only transactions with
owners are recognised in equity, and remeasuring an NCI put is not a
transaction with an owner (thus should be reflected in profit or loss).
Paragraph 30 in IAS 27 is describing a circumstance in which the controlling
shareholder's and the non-controlling interest shareholder's relative
ownership of the subsidiary changes, and this is not the case when the NCI
put is remeasured. This was seen as a clarification of the literature for
subsequent measurement (to avoid diversity), albeit without addressing some
of the larger issues in the Committee's minds.
Many Committee
members supported the view expressed by this Committee member. However,
other Committee members continued to express concerns over the scope of this
decision in resolving underlying concerns previously discussed by the
Committee.
When put to a vote,
the Committee elected to move forward with the application guidance
proposal. However, the Committee asked the staff to consider certain issues
offline including any potential knock-on implication to the consolidation
analysis, specific principle concerns raised by Committee members (including
accounting for the premium on warrants, accounting for the debit side of the
transaction in IAS 32 and when to derecognise the non-controlling interest)
and whether the above application guidance recommendation should be included
in the body of IAS 27 as an amendment or interpretation or as application
guidance.
Bob Jensen's threads on accounting for derivative financial instruments
---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Option
Pricing Theory =
a theory that is too complex to define in
this glossary. Options pricing theory (OPT) is sometimes called an options pricing
model (OPM). The general idea is that an investment at any level of risk, including
an investment that is not traded on the open market, can be valued by a portfolio of
investments that are traded on exchanges. A good review is provided by Robert
Merton in "Applications of Option-Pricing Theory: Twenty Five Years
Later," American Economic Review, June 1998, 323-349. Closely related is
Arbitrage Pricing Theory (APT). OPT and APT in theory overcome many of the
limitations of CAPM. However, they have problems of their own
that I attempted to touch upon in
http://faculty.trinity.edu/rjensen/149wp/149wp.htm
See Long Term Capital Management (LTCM) Fund.
Option Pricing : Modeling and
Extracting State-Price Densities A New Methodology by Christian Perkner
ISBN 3-258-06101-7 http://www.haupt.ch/asp/titels.asp?o=f&objectId=3372
The focus of this
book is on the valuation of financial derivatives. A derivative (e.g. a
financial option) can be defined as a contract promising a payoff that is
contingent upon the unknown future state of a risky security. The goal of
this book is to illustrate two different perspectives of modern option
pricing:
Part I: The
normative viewpoint: How does (how should) option pricing theory arrive at
the fair value for such a contingent claim? What are crucial assumptions?
What is the line of argument? How does this theory (e.g. Black-Scholes)
perform in reality?
Part II: The
descriptive viewpoint: How are options truly priced in the financial
markets? What do option prices tell us about the expectations of market
participants? Do investor preferences play a role in the valuation of a
derivative?
To answer both
questions, the author introduces an insightful valuation framework that
consists of five elements. Its central component is the so called
state-price density - a density that represents the market's valuation of $1
received in various states of the world. It turns out that the shape of this
density is the crucial aspect when determining the price of an option.
The book
illustrates several techniques allowing the flexible modeling of the
state-price density. Implementation issues are discussed using real datasets
and numerical examples, implications of the various modeling techniques are
analyzed, and results are presented that significantly improve standard
option pricing theory.
DOES A ROSS ECONOMY LUNCH REALLY COST
AS MUCH AS
HIRSHLEIFER CUISINE COMPLETE WITH sm2
DESSERT?
Bob Jensen's unpublished Working Paper 149 ---
http://faculty.trinity.edu/rjensen/149wp/149wp.htm
Bob Jensen's threads on valuation
of derivative financial instruments can be found at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Other Comprehensive Income (OCI)
= (see Comprehensive Income)
Out-of-the-Money = see option and intrinsic value.
Overlay Program
=
a program designed to reduce the currency risk in an
international asset portfolio.
|
P-Terms
Participating
Strategy =
a combination of a purchased option and a written
option, with the written option on a smaller foreign currency amount.
Portfolio Hedging =
see Macro Hedge and Dynamic
Portfolio management.
Also see my summary of key paragraphs
in FAS 133 on portfolio/macro hedging.
Premium =
the price paid/received to enter into
certain types of derivative contracts. For example, the price paid to enter into a
futures contract, forward contract, interest rate swap, warrant, or option is called the
premium. In the case of exchange-traded contracts (e.g., options, futures, and
futures options), there is generally a premium. In custom-contract derivatives
(e.g., forward contracts, forward rate agreements, swaps and some embedded options),
however, it is common to not have any premium paid by one party to the other party.
There may be legal fees and brokerage costs, but these are not part of the premium and are
accounted for separately. If they are very small relative to both the underlying and the premium, they are often posted to current
earnings. However, in theory the brokerage fees, legal fees, and premium
should be amortized against future settlements of the derivative instrument.
Paragraphs 6b on Page 3 and 57b on Page 35
of FAS 133 require that the for any FAS 133
derivative instrument, the premium itself
must be "smaller than would be required for other types of contracts that would be
expected to have a similar response to changes in market factors." This
condition is ambiguous. However, this rules out short sale contracts that carry an
implicit requirement to own or purchase and resell an entire asset rather than having a
cash settlement.
For a derivative not designated as a hedging instrument,
the gain or loss is recognized in earnings in the period of change. Section 4(c) of
Paragraph 4 of FAS 133 amends SFAS 52 on Foreign Currency Translation, to
permit special accounting for a hedge of a foreign currency forecasted transaction with a
derivative
Paragraph 42 on Page 26 of FAS 133
reads as follows:
.A derivative instrument or a
nonderivative financial instrument that may give rise to a foreign currency transaction
gain or loss under Statement 52 can be designated as hedging the foreign currency exposure
of a net investment in a foreign operation. The gain or loss on a hedging derivative
instrument (or the foreign currency transaction gain or loss on the nonderivative hedging
instrument) that is designated as, and is effective as, an economic hedge of the net
investment in a foreign operation shall be reported in the same manner as a translation
adjustment to the extent it is effective as a hedge. The hedged net investment shall be
accounted for consistent with Statement 52; the provisions of this Statement for
recognizing the gain or loss on assets designated as being hedged in a fair value hedge do
not apply to the hedge of a net investment in a foreign operation.
nonderivative financial instrument that may give rise to a foreign currency transaction
gain or loss under Statement 52 can be designated as hedging the foreign currency exposure
of a net investment in a foreign operation. The gain or loss on a hedging derivative
instrument (or the foreign currency transaction gain or loss on the nonderivative hedging
instrument) that is designated as, and is effective as, an economic hedge of the net
investment in a foreign operation shall be reported in the same manner as a translation
adjustment to the extent it is effective as a hedge. The hedged net investment shall be
accounted for consistent with Statement 52; the provisions of this Statement for
recognizing the gain or loss on assets designated as being hedged in a fair value hedge do
not apply to the hedge of a net investment in a foreign operation.
These Section c(4) confusions in
Paragraph 4 are illustrated in Examples 11-13 beginning on Page 270 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP
in July 1998.
Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
Transaction costs are included in the initial measurement of all
financial instruments.
|
FAS 133
FASB does not address transaction costs. Such costs can be included in
or excluded in initial measurement of financial instruments.
|
Principal Only Strip = =
a contract that calls for cash settlement for the
principal but not the interest of a note. See embedded derivatives. Except in certain
conditions, interest-only and principal only strips are not covered in FAS 133. See
Paragraphs 14 and 310.
Put =
see option.
|
Q-Terms
R-Terms
Range Floater = see floater.
Range Forward =
a combination of a purchased option and a written
option on equal amounts of currency with a "range" between the strike prices.
The premium on the written option offsets the premium on the purchased option. See option.
Ratchet Floater = see floater.
Regular-Way
Security Trade = see net settlement.
References
Introductory
References --- See Introductory
References
Note the book entitled PRICING DERIVATIVE SECURITIES, by
T W Epps (University of Virginia, USA) The book is published by World
Scientific --- http://www.worldscibooks.com/economics/4415.html
Contents:
- Preliminaries:
- Introduction and Overview
- Mathematical Preparation
- Tools for Continuous-Time Models
- Pricing Theory:
- Dynamics-Free Pricing
- Pricing Under Bernoulli Dynamics
- Black-Scholes Dynamics
- American Options and 'Exotics'
- Models with Uncertain Volatility
- Discontinuous Processes
- Interest-Rate Dynamics
- Computational Methods:
- Simulation
- Solving PDEs Numerically
- Programs
- Computer
Programs
- Errata
Essentials of Energy Risk Management --- http://www.rigzone.com/store/product.asp?p_id=1048&c_id=46
Publisher: Paradigm Strategy
Group Item Number: 100-1048
Also see http://snipurl.com/EnergyGlossary
March 5, 2004 message
from editor jda [editor.jda@gmx.de]
Journal of Derivatives Accounting
(JDA)
First Issue on "Stock Options:
Development in Share-Based Compensation" You can downloand Papers online (http://www.worldscinet.com/jda/jda.shtml)
The second issue deals with Hedging
Theory and Practice in Risk Management and Trading (Financial instruments and
strategies, Impact of accounting rules and taxation). The titles of forthcoming
papers for the second issue are also shown.
For subscription information follow the
following link
(http://www.worldscinet.com/jda/mkt/order_information.shtml)
Mamouda Mbemap Ph.D
Editor In Chief
Vol. 1, No. 1 (March 2004)
LETTER
FROM THE EDITOR
Articles
ACCOUNTING
FOR EMPLOYEE STOCK OPTIONS: A PRACTICAL APPROACH TO HANDLING THE VALUATION
ISSUES
JOHN HULL and ALAN WHITE
RISK-AVERSE
EXECUTIVES, MULTIPLE COMMON RISKS, AND THE EFFICIENCY AND INCENTIVES OF
INDEXED EXECUTIVE STOCK OPTIONS
SHANE A. JOHNSON and YISONG S. TIAN
STOCK
OPTIONS AND MANAGERIAL INCENTIVES TO INVEST
TOM NOHEL and STEVEN TODD
CEO
COMPENSATION, INCENTIVES, AND GOVERNANCE IN NEW ENTERPRISE FIRMS
LERONG HE and MARTIN J. CONYON
EVIDENCE
ON VOLUNTARY DISCLOSURES OF DERIVATIVES USAGE BY LARGE US COMPANIES
RAJ AGGARWAL and BETTY J. SIMKINS
THE
EFFECT OF TAXES ON THE TIMING OF STOCK OPTION EXERCISE
STEVEN BALSAM and RICHARD GIFFORD
THE
VALUE AND INCENTIVES OF OPTION-BASED COMPENSATION IN DANISH LISTED
COMPANIES
KEN L. BECHMANN and PETER LØCHTE JØRGENSEN
Industry Perspective
AN
INTRODUCTION TO US TAX ASPECTS OF EXECUTIVE/EMPLOYEE COMPENSATION WITH A
STOCK OPTION FOCUS
STEWART KARLINSKY and JAMES KROCHKA
Book Review
Book
Review: AN INTRODUCTION TO EXECUTIVE COMPENSATION
Steve Balsam
|
Forthcoming
Papers |
Vol. 1 No. 2
- Does Allowing Alternative
Hedge Designation Affect Financial Statement Comparability?
Arlette C. Wilson and Ronald L. Clark
- Alternative Hedge Accounting
Treatments for Foreign Exchange Forwards
Ira G. Kawaller and Walter R. Teets
- Divergent FAS-133 and IAS 39
Interest Rate Risk Hedge Effectiveness: Problem and Remedies
Jim Bodurtha
- Interest Rate Swap Prices,
Fair Values, and FAS 133
Donald Smith
- Optimal Hedging with
Cumulative Prospect Theory
Darren Frechette and Jon Tuthill
- Hedging, Operating Leverage,
and Abandonment Options
Keith Wong
- Hedging Against Neutral and
Non-Neutral Shock: Theory and Evidence
Marcello Spano
- Pricing S&P 500 Index
Options under Stochastic Volatility with the Indirect Inference Method
Jinghong Shu and Jin E. Zhang
- Structural Relationships
between Semiannual and Annual Swaps Rates
D.K. Malhotra, Mukesh Chaudhry and Vivek Bhargava
- Valuing and Hedging American
Options under Time-Varying Volatility
In Joon Kim
- The Introduction of
Derivatives Reporting in the UK: A Content Analysis of FRS 13
Disclosures
T. Dunne, C. Helliar, D. Power, C. Mallin, K. Ow-Yong and L. Moir
|
March 23, 2004 message from Heather MacMaster [southwestern.email@thomsonlearning.com]
The second edition of Derivatives: An Introduction
by Robert Strong will be available in July for your fall classes.
One of the briefest texts on the market, Robert
Strong's ability to explain the intuition behind the math and show students
how derivatives are actually used has made this course much more tangible and
easier to understand.
The second edition has expanded its coverage of Real
Options, with more discussion of option strategies than the typical survey
course text. Also integrated throughout the text are rich examples to show how
it may be appropriate to use several types of Derivative Options at once, or
both futures and options at the same time.
This text illustrates real-world uses of derivatives.
Distinctive features of this applied approach include:
"Derivatives Today" Boxes: Real-life,
derivative situations provide students with an opportunity to consider issues
they may encounter in the marketplace. "Trading Strategy" Boxes:
These stimulating trading scenarios illustrate various methods in which
speculators or investors use options in ways that most existing texts do not
cover. Finally, in clear and concise prose, Strong focuses on the practical.
Since the text includes more institutional detail than competing texts, users
can connect theory to practice! Also to maintain student interest and
applicablity, Strong sparks interest by using many institutional anecdotes,
including trading mechanics, market folklore, and contemporary examples of
derivatives use and misuse.
Be sure to click below to reserve your complimentary
copy when the book publishes in July…
[Link Deleted]
Sincerely,
Heather MacMaster
Marketing Manager
Thomson South-Western
Bob Jensen's threads
on derivatives accounting are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Related Party Transaction =
a transaction between related
entities that may not act independently of one another. For example, a
forecasted transaction between a parent company and its subsidiary or between subsidiaries
having a common parent is a related party transaction. Related party forecasted
transactions cannot be designated for cash flow hedges according to Paragraph 29c on Page
20 of FAS 133. The one exception is for a foreign currency risk exposure in a
currency other than than the functional currency and
other criteria listed in Paragraph 40 on Pages 25-26. Also see
Paragraphs 471 and 487.
Cash flow hedges must have the possibility
of affecting net earnings. For example, Paragraph 485 on Page 211 of FAS 133
bans
foreign currency risk hedges of forecasted dividends of foreign subsidiary. The
reason is that these dividends are a wash item and do not affect consolidated
earnings. For reasons and references, see equity method.
.
Reporting
Currency =
the currency in which an enterprise prepares its
financial statements.
Risk
=
=
the various types of financial risks, including
market price risk, market interest rate risk,
foreign exchange risk, and credit
risk.
These are discussed in FAS 133, Pages 184-186. FAS 133 does not take up such things as
tax rate swaps and credit swaps. Mention is given to nonfinancial assets and liabilities
in Paragraphs 416-421. Other risks are mentioned in Paragraph 408. Only three
types of risks can receive hedge accounting treatment under FAS 133. For details
see derivative financial instruments.
Some industries have
their own types of risk. For example, the energy industry has location
basis risk and transportation capacity risk. Location basis risk is
the differences in prices between two locations such as the supply terminal
and the demand terminal. Transportation capacity
risk is the risk of having too much or too little hauling or
distribution capacity between to terminals.
Execution risk is the
time delay between one transaction (such as closure of a purchase contract)
and another transaction (such as closure of a sales contract).
Held-to-maturity securities may not be
hedged for cash flow risk according to Paragraphs 426-431 beginning on Page 190 of
FAS 133. See held-to-maturity.
Firm commitments can have foreign currency
risk exposures if the commitments are not already recognized. See Paragraph 4
on Page 2 of FAS 133. If the firm commitment is recognized, it is by definition booked
and its loss or gain is already accounted for. For example, a purchase contract for 10,000
units per month at 100DM Deutsche Marks per unit is unrecognized and has a foreign
currency risk exposure if the payments have not been made. If
the payments have been prepaid, that prepayment is "recognized" and has no
further foreign currency risk exposure. See derivative
financial instrument.
A good site dealing with
credit risk is at http://www.numa.com/ref/volatili.htm
For more on the topic of risk measurement and disclosure,
see disclosure.
Risk Glossary ---
http://www.riskglossary.com/
Assessment
of Risk: Peeling Apart the Data on Derivatives --- http://www.kawaller.com/pdf/Am_Banker_Assessing_Risk.pdf
Risk
Metrics and Risk Stress Testing
Risk metrics
are quantitative measures of risk of some sort or another. For example
Value-at-Risk (VAR) metrics are designed to measure outcomes in worst case
scenarios --- see Value-at-Risk.
VAR is related to risk "stress
testing." Freddie Mac was an innovator in risk stress testing ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm#FreddieMac
There are a number of software vendors of FAS 133 risk analysis
software.
One of the major companies is FinancialCAD --- http://www.financialcad.com/
FinancialCAD provides software and services that
support the valuation and risk management of financial securities and
derivatives that is essential for banks, corporate treasuries and asset
management firms. FinancialCAD’s industry standard financial analytics are a
key component in FinancialCAD solutions that are used by over 25,000
professionals in 60 countries.
Also see Risk, Software, and
Ineffectiveness.
"A Web-Based Risk Tool," August 12, 2003 --- http://www.fas133.com/search/search_article.cfm?page=1&areaid=1353
The experiences (and resulting systems/processes)
that banks have developed, in order to deal with Basel I and Basel II are of
relevance to corporate treasurers today, as they attempt to manage the new,
compliance/control requirement of Sarbanes-Oxley as well as broader scruitiny
of earnings/results.
With this in mind, its useful to review how banks
have handled the challenge, and are planning to utilize their know-how in the
area of system and process management.
Case in point: Horizon
JPMorgan was in the right place at the right time
with RiskMetrics (since spun off) to help firms deal with derivatives-related
rules for disclosure and controls (value at risk).
Now as the disclosure and control focus has
broadened, the bank wants to be there again with Horizon, its web-based tool
for internal risk control and self-assessment.
Horizon appears tailor-made for the internal control
rules mandated by Sarbanes-Oxley, especially if firms go beyond basic
compliance to implement enterprise risk management frameworks, such as those
suggested by the new COSO draft.
It is also in line with Basel II’s qualitative
measurement prescriptions for operational risk management, which suggests
corporates seeking internal control guidance have another source of best
practice recommendations to draw upon.
Indeed, compliance is all about risk management. “If
you look at Basel II or Sarbanes-Oxley, the point of the regulations is for
firms to better manage risk,” notes Craig Spielmann, VP and Executive in
charge of Horizon for JPMorgan Treasury Services. He notes, the aim is to
create transparency for shareholders that senior people are identifying the
firm’s key risks, showing what they are doing to mitigate these, and when
these mitigation efforts are to be in place. “It’s about how effective you
are at risk management, as much as about how you are managing risk.”
Self-assessment is an important measure of risk management effectiveness.
Operational risk process automation
Horizon, like RiskMetrics, was born out of an
internal bank tool to help JP Morgan assess operational risk across its
businesses. It is also one of many operational risk tools out there oriented
toward banks, or internally developed by banks, seeking to comply with Basel
II’s internal ratings based approach (IRB)-- in particular the Advanced
Measurement Approaches-- in order to reduce their regulatory capital
requirements.
Control and risk self-assessment is a key component
of the qualitative measurement requirements for operational risk under Basel
II. These involve among other things:
(1) a review of risk management process goals;
(2) a review of the controls/procedures to meet these
goals; and
(3) specification of corrective actions required and
follow-up on implementation of such actions. This is the area of focus for
Horizon.
Horizon uses the traffic light approach to
self-assessment, common with internal control cum operational risk/enterprise
risk applications offered by audit firms and consultancies, calling upon users
to select their risk concern according to red (most dangerous), yellow, green,
blue (not applicable).
However, where it seeks to differentiate itself from
traditional internal audit tools is its orientation toward risk management
ideals: effective, on-going risk mitigation in support of business goals.
Clearly, though, traditional internal audit tools are moving in the same
direction, guided by the new COSO draft, following the banks’ lead in their
approaches to operational risk management.
According to Barry Macklin, head of Operational Risk
Analytics/Financial Risk for JPMorgan’s Treasury & Securities Services
(T&SS) business, Horizon helps to not only automate the operational risk
and control self-assessment process but also provides opportunities to share
risk expertise and best practices across T&SS’ global operations (with
locations in 39 countries globally, with 14,500 employees).
Mr. Macklin was an early Horizon adopter outside JP
Morgan: his group within Chase was in negotiation to purchase the product when
the merger with JP Morgan was announced.
Part of its appeal from his initial customer
perspective was that it provided an automated solution taking a paper-based
process and putting it on the bank’s intranet. It also has built-in
algorithms to calculate a “score” for comparative purposes, based on how
each risk is weighed (with the traffic light).
By automating the data-collection and “scoring”
process, Mr. Macklin notes, senior risk and business managers have much more
time to focus on analysis: “We are spending more time analyzing risks than
compiling data”.
The automation facilitates continuous
self-improvement of control processes, and sharing of best practices and
improves the ability to monitor and resolve action items. For example, for a
particular risk, he may see that one unit indicates that a process has good
controls while another unit with a similar process in another location needs
to enhance controls. Risk and business managers can now delve into how to
ensure the procedures are effectively applied globally.
According to Mr. Macklin, the first step for his
group was to sit down with the internal and external auditors, business
managers, operational risk managers, and identify key processes.
“We then made sure we had the right operational
process, with all the key risks and control procedures identified and then
populated the risk and control procedures on the Horizon application. Business
Managers were integral in the development of the Horizon templates. They know
how their business processes work, and clearly take ownership. This team
effort creates a great process,” Mr. Macklin notes. General Audit also
leverages the risk assessment templates and utilizes Horizon to record their
recommendations.
These risk assessment and compliance process items
are reviewed formally twice each year, along with continuous assessment of
review triggers such as an acquisition or business relocation, which prompt
immediate review of the templates. The self-assessment process also supports
Management’s annual affirmation of the control environment as required by
FDICIA.
The content for these self-assessment templates is
key to this or any such application. A fact that highlights how adaptable bank
operational risk applications like Horizon can be to any number of situations,
including non-bank risks.
Mr. Spielmann cites an example related to a business
acquisition as follows: For any new business acquired, a customized template
can be developed on Horizon, identifying key business risks and control
procedures. An assessment can be performed to determine opportunities for
improvement and develop action plans with accountable parties and resolution
time frames in the early stages of integrating the acquired business. The
results can then be evaluated on a continuing basis to ensure timely
remediation.
A corporation looking to manage risks specific to its
business, notes Mr. Spielmann, could go through a similar process with senior
management and the Board to construct a template for Horizon to conduct this
sort of self-assessment. The latest version of Horizon has been optimized for
Sarbanes-Oxley internal control compliance with this in mind.
RiskMetrics, a different approach
This, however, is corporate use of RiskMetrics in
reverse. What made JPMorgan’s RiskMetrics so popular for corporates seeking
to follow bank practice on value at risk disclosures for derivatives was that
JPMorgan provided easily accessible, name brand data sets. These they could
download and plug into their own spreadsheets or internal applications,
creating a quick fix to comply with new SEC rules.
Here corporates are getting an application, but
limited content. Indeed, they have to develop the templates to collect the
data on their own. There is no quick fix for Sarbanes-Oxley.
Horizon competes not only with other bank and
non-bank operational risk management applications, but also countless
internally developed self-assessment/scorecard spreadsheets (e-mailed) or
web-based database applications which provide less elegant solutions.
Corporates should consider the cost/benefit of applications such as Horizon
before they build their own web applications.
With the stakes so much higher, name brand
off-the-shelf solutions might provide more comfort than internally developed
applications, especially for Corporate Boards and shareholders. In today’s
environment controls to prevent reputational risk and ensuring effective
Corporate Governance standards are applied is certainly something Corporate
Boards would be interested in. This clearly presents new opportunities to
market the Horizon application.
Looking forward JPMorgan Chase is developing a
process that will integrate the key Operational Risk Management tools they
currently utilize, such as: Horizon self-assessment, operational loss data
collection, capital allocation and key risk indicators. Says Macklin, “Integrating
these tools will further enhance and link the firm’s operational risk
analysis, monitoring and reporting capabilities, which we believe will
positively impact results.”
"Risk Systems, Integrate! July 15, 2002 --- http://www.fas133.com/search/search_article.cfm?page=1&areaid=467
FAS 133 and other factors spark a flurry of “asset
expansion” among risk management software vendors.
Treasurers are increasingly adamant that they want a
single, integrated system to handle all of their risks. The impetus for this
change is multifold (see here). However, both system vendors and treasurers
agree that FAS 133 has a lot to do with convincing risk managers and
accountants that they need to handle risk management and its accounting-entry
consequences in a single platform.
In recent weeks, FXpress, Reval and Kiodex announced
plans to expand their asset classes and offer a soup-to-nuts system for risk
management. This is great news for treasurers looking for a solution that
allows them to view risk, manage it, and account for it centrally, yet one
which comes with a less-than-a-million-dollar price tag. “Right now,”
notes Dino Ewing, CFO of Reval, “there’s not that much in between that and
spreadsheets.”
What’s new and what’s not?
FXpress launched the integration flurry with its
unveiling of a commodity module, as well as plans for interest rate,
investment and ultimately, an equity-risk module in 2003.
Reval, which has handled FX and interest rates as
well as related FAS 133 accounting via its newly named HedgeRX™
hedge-management solution, now covers metals, energy and commodities as part
of its most recent release.
Kiodex, a web-services energy risk
management/accounting platform (see IT, 2/25/02), is expanding to cover FX
first. “We plan to introduce more asset classes aggressively in 2003,”
reports Co-Founder and President, Raj Mahajan.
These recent converts to the integration mantra
follow in the footsteps of others such as Open Link on the high end, and
INSSINC on the affordable side. “We have always chosen the integrated route,”
explains Elie Zabal, president and CEO of INSSINC. Yet Mr. Zabal and others
agree that this flare-up in asset-class expansion signals a change: The market
is coming around to understanding that handling risk in one system is key,
whether or not execution continues to occur in separate functions.
Says Kiodex’s Mr. Mahajan: “Our vision has been
to generate a report for chief financial officers that breaks down the
corporation’s exposure to price risk by asset class.” Such a holistic view
is critical, if companies want to avoid “nasty” surprises (e.g., Ford’s
$1 billion write down). “The first step is identifying the exposure across
asset classes” he says. “Next, treasury should be able to quantify/analyze
the risk and produce a single report which makes risk transparent while
allowing treasury to mitigate exposures, taking into account correlations
among asset classes.”
Granted, many companies handle financial and
non-financial risks in separate departments. Yet an integrated system makes
sense precisely because of this ongoing separation of duties, as companies
come under increased pressure to comply with regulatory requirements, and
ensure internal compliance with hedging/trading policies. “FAS 133 brought
this issue front and center,” notes Mr. Zabal. “Whether you are hedging
corn or electricity, the policies, controls and accounting trail should be the
same.”
Remote access, centralized data
Reval and Kiodex offer an added twist—an ASP model
(available from INSSINC as well). The upshot is quicker implementation and an
ideal platform for capturing live data dynamically, and allowing multiple,
remote access points. Certainly, client/server systems can accommodate this,
but implementation can takes months, compared to days with the newer
technologies.
Such rapid implementation and lower price tags have a
“price” too—less control over the IT environment. Interestingly, Reval
reports that clients who have been offered the intranet option have opted for
the outsourced solution 100 percent of the time. The reason, says Mr. Ewing,
is cost and maintenance.
ASP or not, the integrated model opens doors.
Customers want a single solution and vendors need to be able to offer one, Mr.
Zabal says, if they are to make sales. FXpress, Reval and Kiodex all report
that existing users have asked them to round out their offerings. The key is
to offer an integrated solution at an affordable price that can be quickly
implemented. Often, the latter is more important. “Would technology save us
some time and money?” comments one treasurer, “Yes, but in the immediate
term,” he says, “I cannot afford to lose staff time to lengthy and painful
implementations.”
Which end is first?
One issue for treasurers to consider is whether the
system’s origins matter. Both Reval (originally financial) and Kiodex
(originally commodity) agree it’s fair to say that moving from commodity to
financial risk is an easier route, since commodity markets and instruments are
typically more complex. Does this give systems with commodity origins an edge?
Other issues treasurers may wish to consider as they
evaluate newly integrated solutions include: (1) Can one system truly handle
all asset classes effectively (and affordably)? (2) Does the underlying
platform (ASP vs. client server) matter, and if so, how? (3) How about the
global support structure of smaller or newer vendors?
There are two superpowers
in the world today in my opinion. There’s the United States and there’s
Moody’s Bond Rating Service. The United States can destroy you by dropping
bombs, and Moody’s can destroy you by down grading your bonds. And believe me,
it’s not clear sometimes who’s more powerful. The most that we can
safely assert about the evolutionary process underlying market equilibrium is
that harmful heuristics, like harmful mutations in nature, will die out.
Martin Miller, Debt and Taxes as quoted by Frank Partnoy, "The Siskel and
Ebert of Financial Matters: Two Thumbs Down for Credit Reporting
Agencies," Washington University Law Quarterly, Volume 77, No. 3,
1999 ---
http://faculty.trinity.edu/rjensen/FraudRottenPartnoyWULawReview.htm
Related to risk metrics are the ratings given firms
and securities by rating agencies. These agencies were especially
criticized in the accounting and finance scandals for their close ties and less
than objective ratings of firms like Enron. Frank Partnoy is especially
critical of the lack of integrity of rating agencies. Several references
written by Partnoy are shown below:
Senate Testimony by Frank Partnoy ---
http://faculty.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony
Article by Frank Partnoy
"The Siskel and Ebert of Financial Matters: Two Thumbs Down for the
Credit Reporting Agencies" (Washington University Law Quarterly,
Volume 77, No. 3, 1999) --- http://ls.wustl.edu/WULQ/
Also see
http://faculty.trinity.edu/rjensen/FraudRottenPartnoyWULawReview.htm
Books by Frank Partnoy
- FIASCO: The Inside Story of a Wall Street Trader
- FIASCO: Blood in the Water on Wall Street
- FIASCO: Blut an den weißen Westen der Wall Street Broker.
- FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance
- Infectious Greed : How Deceit and Risk Corrupted the Financial
Markets
- Codicia Contagiosa
"An End to the Exclusive Rating Franchise? June 16, 2003, by Joseph Neu
--- http://www.fas133.com/search/search_article.cfm?page=1&areaid=1318
Treasurers’ love-hate relationship with credit
rating agencies is something we have followed with interest of late (see
3/24/03). In part, this is because it is easy to be sympathetic with the
treasurers’ argument that the rating process is way too subjective relative
to its potential impact on a corporation’s financial wellbeing. But this
begs the question: What is the more objective alternative?
Defining treasury’s interests ahead of change. We
aren’t the only ones who have taken an increasing interest in the role of
rating agencies of late. In the wake of the corporate scandals in the US, and
the “lagging” nature of credit rating indications, the SEC has been
mandated by Sarbanes-Oxley to revisit the role of rating agencies, the state
of regulatory scrutiny over them and, most especially, the special status that
it grants a few rating agencies (i.e., NRSROs) to provide regulatory
benchmarks.
In its latest effort, the SEC has issued a concept
letter, asking for public comments on related questions (see here).
All this makes now an opportune time for treasurers
to consider the current rating processes, as executed by the rating agencies,
and weigh the potential alternatives to determine what sort of process they
might like to see, and who other than the current NRSROs they would like to
rate them. Given the potential for change at hand, now is the time to make
your voices heard.
And by no means should this call to action be limited
to treasurers in the US. As we’ve noted, the Americanization of capital
markets globally have made obtaining a rating (and managing a rating agency
relationship) increasingly critical abroad. Indeed, the Association for
Corporate Treasurers (ACT) in the UK held a recent conference on the subject,
aptly titled Rating Agencies: Prophet’s, Judges or Mere Mortals? There, as
elsewhere, treasurers expressed the desire for greater transparency in the
rating process. They also want more reliance on replicable quantitative
analysis that could be used to help them manage their rating.
Ideally, were there a standard analytical model, it
could be embedded into a risk management application to help treasury track a
shadow rating. This, in turn, could help treasurers determine how different
actions might impact that rating.
An opportunity for broker-dealers. That the ACT
conference was sponsored by Merrill Lynch may be telling as well. Could
broker-dealers find a way to break into the seemingly lucrative franchise
enjoyed by Moody’s and S&P? If not in the US, then perhaps they can
abroad, where the concept of NRSRO is not as well established.
One scenario treasurers (and the SEC) should
consider, therefore, is what if broker-dealers offered credit “rating”
services?
At first, this might appear to make the rating
management game more like that played with equity analysts. This used to mean
talking analysts into the right quarterly earnings (or non-earnings) targets
(with influence from the investment banking business offered), and managing
EPS (or proforma results) accordingly. But, given the current scrutiny of
broker-dealer analysts’ objectivity, it is hard to see how they would be
allowed to expand the business of using their analysts on the credit side to
assign buy/sell signals on debt.
Their opening to this market, however, could come in
the form of their own internal risk models, which the SEC is considering
allowing broker-dealers to use as an alternative to NRSRO ratings to help
determine capital charges on debt securities.
If a broker-dealer is holding your paper for whatever
reason, wouldn’t you want to know how their model “rating” compared to
the rating agencies’ (and why shouldn’t you know)?
Risk analytics vs. rating analyst. To some extent,
this information will find its way to the market. After all, the models
broker-dealers employ to determine internal capital charges are not all that
different from those they use to price credit risk for external use (e.g., for
credit derivatives). The models could also be used to help fund managers
optimize portfolios from a risk management perspective and sell them paper
with the right risk profile to fill the gaps.
At some point, the markets must be allowed to
determine how best to utilize traditional credit ratings in conjunction with
emerging credit risk-assessment provided by analytical models, without
regulatory favoritism. Risk modeling and analytics have advanced quite a bit
in the last decade, which is why the rating agencies themselves have developed
(or acquired) model-based risk analytics capabilities in parallel to
traditional rating services. Both approaches should be considered by
treasurers—and both should held to objective standards by regulators.
Also see software.
|
S-Terms
SAS 92
Auditing Requirements for Derivative
Financial Securities
Auditing Derivative Instruments, Hedging Activities, and Investments in
Securities
http://www.aicpa.org/members/div/auditstd/riasai/sas92.htm
A Nice Summary of SAS 92 is Available Online
(Auditing, Derivative Financial Instruments, Hedging)
SAS 92-New Guidance on Auditing Derivatives
and Securities
by Joe Sanders, Ph.D., CPA and Stan Clark, Ph.D., CPA
http://www.ohioscpa.com/member/publications/Journal/1st2001/page10.asp
Auditors face many challenges in auditing
derivatives and securities. These instruments have become more
complex, their use more common and the accounting requirements to
provide fair value information are expanding. There is also an
increasing tendency for entities to use service organizations to help
manage activities involving financial instruments. To assist auditors
with these challenges, the Auditing Standards Board (ASB) issued SAS
92, Auditing Derivative Instruments, Hedging Activities and
Investments in Securities. The ASB is also currently developing a
companion Audit Guide. SAS 92 supersedes SAS 81, Auditing Investments.
SAS 92 provides a framework for auditors to
use in planning and performing auditing procedures for assertions
about all financial instruments and hedging activities. The Audit
Guide will show how to use the framework provided by the SAS for a
variety of practice issues. The purpose of this article is to
summarize and explain some of the more significant aspects of SAS 92.
Scope SAS 92 applies to:
Derivative instruments, as defined in SFAS
133, Accounting for Derivative Instruments and Hedging Activity.
Hedging activities which also fall under SFAS 133. Debt and equity
securities, as defined in SFAS 115, Accounting for Certain Investments
in Debt and Equity Securities. The auditor should also refer to APB
18, The Equity Method of Accounting for Investments in Common Stock.
Special Skill or Knowledge
SEC Chairman Arthur Levitt, in his speech on
renewing the covenant with investors stated, "I recognize that
new financial instruments, new technologies and even new markets
demand more specialized know-how to effectively audit many of today's
companies".1 One of the first items noted in SAS 92 is that the
auditor may need to seek assistance in planning and performing audit
procedures for financial instruments. This advice is based primarily
on the complexity of SFAS 133. Understanding an entities' information
system for derivatives, including work provided by a service
organization, may require the auditor to seek assistance from within
the firm or from an outside expert. SAS 73 provides guidance on using
the work of a specialist.
Inherent Risk Assessment
The inherent risk related to financial
instruments is the susceptibility to a material misstatement, assuming
there are no related controls. Assessing inherent risk for financial
instruments, particularly complex derivatives, can be difficult. To
assess inherent risk for financial instruments, auditors should
understand both the economics and business purpose of the entity's
financial activities. Auditors will need to make inquiries of
management to understand how the entity uses financial instruments and
the risks associated with them. SAS 92 provides several examples of
considerations that might affect the auditor's assessment of the
inherent risk for assertions about financial instruments:2
The complexity of the features of the
derivative or security. Whether the transaction that gave rise to the
derivative or security involved the exchange of cash. The entity's
experience with derivatives or securities. Whether the derivative is
freestanding or an embedded feature of an agreement. The evolving
nature of derivatives and the applicable generally accepted accounting
principles. Significant reliance on outside parties. Control Risk
Assessment
SAS 92 includes a section on control risk
assessment. Control risk is the risk that a material misstatement
could occur and would not be prevented or detected in a timely manner
by an entity's internal control. Management is responsible for
providing direction to financial activities through clearly stated
policies. These policies should be documented and might include:
Policies regarding the types of instruments
and transactions that may be entered into and for what purposes.
Limits for the maximum allowable exposure to each type of risk,
including a list of approved securities broker-dealers and
counterparties to derivative transactions. Methods for monitoring the
financial risks of financial instruments, particularly derivatives,
and the related control procedures. Internal reporting of exposures,
risks and the results of actions taken by management. Auditors should
understand the contents of financial reports received by management
and how they are used. For example, "stop loss" limits are
used to protect against sudden drops in the market value of financial
instruments. These limits require all speculative positions to be
closed out immediately if the unrealized loss on those positions
reaches a certain level. Management reports may include comparisons of
stop loss positions and actual trading positions to the policies set
by the board of directors.
The entity's use of a service organization
will require the auditor to gain an understanding of the nature of the
service organization's services, the materiality of the transactions
it processes, and the degree of interaction between its activities and
those of the entity. It may also require the auditor to gain an
understanding of the service organization's controls over the
transactions the service organization processes for it.
Designing Substantive Procedures Based on
Risk Assessments
The auditor should use the assessed levels of
inherent and control risk to determine the acceptable level of
detection risk for assertions about financial instruments and to
determine the nature, timing, and extent of the substantive tests to
be performed to detect material misstatements of the assertions.
Substantive procedures should address the following five categories of
assertions included in SAS 31, Evidential Matter:
1. Existence or occurrence. Existence
assertions address whether the derivatives and securities reported in
the financial statements through recognition or disclosure exist at
the balance sheet date. Occurrence assertions address whether changes
in derivatives or securities reported as part of earnings, other
comprehensive income, cash flows or through disclosure occurred.
Examples of substantive procedures for existence or occurrence
assertions include:3
Confirmation with the holder of the security,
including securities in electronic form or with the counterparty to
the derivative. Confirmation of settled or unsettled transactions with
the broker-dealer counterparty. Physical inspection of the security or
derivative contract. Inspecting supporting documentation for
subsequent realization or settlement after the end of the reporting
period. Performing analytical procedures. 2. Completeness.
Completeness assertions address whether all of the entity's
derivatives and securities are reported in the financial statements
through recognition or disclosure. Since derivatives may involve only
a commitment to perform under a contract and not an initial exchange
of tangible consideration, auditors should not focus exclusively on
evidence relating to cash receipts and disbursements.
3. Rights and obligations. These assertions
address whether the entity has rights and obligations associated with
derivatives and securities reported in the financial statements. For
example, are assets pledged or do side agreements exist that allow the
purchaser of a security to return the security after a specified
period of time? Confirming significant terms with the counterparty to
a derivative or the holder of a security would be a substantive
procedure testing assertions about rights and obligations.
4. Valuation. Under SFAS 115 and SFAS 133
many financial instruments must now be measured at fair value, and
fair value information must be disclosed for most derivatives and
securities that are measured at some other amount.
The auditor should obtain evidence
corroborating the fair value of financial instruments measured or
disclosed at fair value. The method for determining fair value may be
specified by generally accepted accounting principles and may vary
depending on the industry in which the entity operates or the nature
of the entity. Such differences may relate to the consideration of
price quotations from inactive markets and significant liquidity
discounts, control premiums, commissions and other costs that would be
incurred to dispose of the financial instrument.
If the derivative or security is valued by
the entity using a valuation model (for example, the Black-Scholes
option pricing model), the auditor should assess the reasonableness
and appropriateness of the model. The auditor should also determine
whether the market variables and assumptions used are reasonable and
appropriately supported. Estimates of expected future cash flows, for
example, to determine the fair value of long-term obligations should
be based on reasonable and supportable assumptions.
The method for determining fair value also
may vary depending on the type of asset or liability. For example, the
fair value of an obligation may be determined by discounting expected
future cash flows, while the fair value of an equity security may be
its quoted market price. SAS 92 provides guidance on audit evidence
that may be used to corroborate these assertions about fair value.
5. Presentation and disclosure. These
assertions address whether the classification, description and
disclosure of derivatives and securities are in conformity with GAAP.
For some derivatives and securities, GAAP may prescribe presentation
and disclosure requirements, for example:
Certain securities are required to be
classified into categories based on management's intent and ability
such as trading, available-for-sale or held-to-maturity. Changes in
the fair value of derivatives used to hedge depend on whether the
derivative is a fair-value hedge or an expected cash flow hedge, and
on the degree of effectiveness of the hedge. Hedging Transactions
Hedging will require large amounts of
documentation by the client. For starters, the auditor will need to
examine the companies' established policy for risk management. For
each derivative, management should document what risk it is hedging,
how it is expected to hedge that risk and how the effectiveness will
be tested. Without documentation, the client will not be allowed hedge
accounting. Auditors will need to gather evidence to support the
initial designation of an instrument as a hedge, the continued
application of hedge accounting and the effectiveness of the hedge.
To satisfy these accounting requirements,
management's policy for financial instrument transactions might also
include the following elements whenever the entity engages in hedging
activities:
An assessment of the risks that need to be
hedged The objectives of hedging and the strategy for achieving those
objectives. The methods management will use to measure the
effectiveness of the strategy. Reporting requirements for the
monitoring and review of the hedge program. Impairment Losses
Management's responsibility to determine
whether a decline in fair value is other than temporary is explicitly
recognized in SAS 92. The auditor will need to evaluate whether
management has considered relevant information in determining whether
other-than-temporary impairment exists. SAS 92 provides examples of
circumstances that indicate an other-than-temporary impairment
condition may exist:4
Management Representations
The auditor must obtain written
representations from management confirming their intent and ability
assertions related to derivatives and securities. For example, the
intent and ability to hold a debt security until it matures or to
enter into a forecasted transaction for which hedge accounting is
applied. Appendix B of SAS 85 (AU Sec. 333.17) includes illustrative
representations about derivative and security transactions.
Summary
SAS 92 provides guidance for auditing
derivatives and securities. Accounting requirements related to these
instruments, SFAS 115 and SFAS 133, are very complex and because of
their extensive use of fair value measures require significant use of
judgment by the accountant. SAS 92 establishes a framework for
auditors to assess whether the entity has complied with the provisions
of SFAS 115 and SFAS 133. However, because of the subjective nature of
many of the requirements of these two standards, considerable auditor
judgment will be required to comply with SAS 92.
Effective Date
This SAS is effective for audits of financial
statements for fiscal years ending on or after June 30, 2001. Early
adoption is permitted.
Settlement Date =
the date at which a payable is paid or a
receivable is collected.
Paul Pacter notes the following at http://www.iasc.org.uk/news/cen8_142.htm
IAS 39
An enterprise will recognise normal purchases of securities in the
market place either at trade date or settlement date. If settlement
date accounting is used, IAS 39 requires recognition of certain value
changes between trade and settlement dates so that the income
statement effects are the same for all enterprises.
|
FAS 133
FASB does not address trade date vs. settlement date. Value change
between trade and settlements dates may be included in or excluded
from measurement of net income.
|
SFAS 133 =
a standard issued by the Financial Accounting
Standards Board (FASB)
in June 1998. You can read more about FAS 133 and other FASB standards
at http://www.fasb.org l.
Note that the FASB's FAS 133 becomes required
for calendar-year companies on January 1, 2001.
Early adopters can apply the standard prior to the required date, but they
cannot apply it retroactively. The January 1, 2001 effective date
follows postponements from the original starting date of June 15, 1999
stated in Paragraph 48 on Page 29 of FAS 133. For fiscal-year
companies, the effective date is June 15, 2000.
The international counterpart known as the IASC's IAS 39
becomes effective for financial statements for financial years beginning on
the same January 1, 2001. Earlier application permitted for financial
years ending after March 15, 1999.
The
FASB staff has prepared a new updated edition of Accounting for
Derivative Instruments and Hedging Activities. This essential aid to
implementation presents Statement 133 as amended by Statements 137 and
138. Also, it includes the results of the Derivatives Implementation
Group (DIG), as cleared by the FASB through December 10, 2001, with
cross-references between the issues and the paragraphs of the Statement.
“The staff at the FASB has prepared this publication to bring
together in one document the current guidance on accounting for
derivatives,” said Kevin Stoklosa, FASB project manager. “To put it
simply, it’s a ‘one-stop-shop’ approach that we hope our readers
will find easier to use.”
Accounting for Derivative Instruments and Hedging Activities—DC133-2
Prices: $30.00 each copy for Members of the Financial
Accounting Foundation, the Accounting Research Association (ARA) of the
AICPA, and academics; $37.50 each copy for others.
International Orders: A 50% surcharge will be applied to
orders that are shipped overseas, except for shipments made to U.S.
possessions, Canada, and Mexico. Please remit in local currency at the
current exchange rate.
To order:
|
In May of 2003, the Financial Accounting Standards Board (FASB) issued
Statement No. 149, Amendment of Statement 133 on Derivative Instruments and
Hedging Activities. The Statement amends and clarifies accounting for derivative
instruments, including certain derivative instruments embedded in other
contracts, and for hedging activities under Statement 133 --- http://www.fasb.org/news/nr043003.shtml
Norwalk, CT, April 30, 2003—Today
the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment
of Statement 133 on Derivative Instruments and Hedging Activities. The
Statement amends and clarifies accounting for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities under Statement 133.
The new guidance amends Statement 133 for decisions
made:
- as part of the Derivatives Implementation Group
process that effectively required amendments to Statement 133,
- in connection with other Board projects dealing
with financial instruments, and
- regarding implementation issues raised in relation
to the application of the definition of a derivative, particularly
regarding the meaning of an “underlying” and the characteristics of a
derivative that contains financing components.
The amendments set forth in Statement 149 improve
financial reporting by requiring that contracts with comparable
characteristics be accounted for similarly. In particular, this Statement
clarifies under what circumstances a contract with an initial net investment
meets the characteristic of a derivative as discussed in Statement 133. In
addition, it clarifies when a derivative contains a financing component that
warrants special reporting in the statement of cash flows. Statement 149
amends certain other existing pronouncements. Those changes will result in
more consistent reporting of contracts that are derivatives in their entirety
or that contain embedded derivatives that warrant separate accounting.
Effective Dates and Order Information
This Statement is effective for contracts entered
into or modified after June 30, 2003, except as stated below and for hedging
relationships designated after June 30, 2003. The guidance should be applied
prospectively.
The provisions of this Statement that relate to
Statement 133 Implementation Issues that have been effective for fiscal
quarters that began prior to June 15, 2003, should continue to be applied in
accordance with their respective effective dates. In addition, certain
provisions relating to forward purchases or sales of when-issued
securities or other securities that do not yet exist, should be applied to
existing contracts as well as new contracts entered into after June 30, 2003.
Copies of Statement 149 may be obtained through the
FASB Order Department at 800-748-0659 or by placing an order on-line
at the FASB website.
The FASB created a special Derivatives Implementation Group
(DIG). Some general DIG exceptions to
the scope of FAS 133 are listed in the "C" category at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html
The FASB has a CD-ROM course at http://www.rutgers.edu/Accounting/raw/fasb/
The FASB's Derivatives Implementation Group website is at http://www.rutgers.edu/Accounting/raw/fasb/digsum.html
FAS 133
replaces the Exposure Draft publication Number 162-B, June 1996 .
The International Accounting Standards Committee (IASC) later came out with IAS 39 which is similar to but less detailed
than FAS 133.
Differences
(Comparisons) between FAS
133 and IAS 39/IFRS 9 ---
http://faculty.trinity.edu/rjensen/caseans/canada.htm
2011 Update
"IFRS and US GAAP: Similarities and Differences" according to PwC
(2011 Edition)
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
Note that warnings are given throughout the document that the similarities and
differences mentioned in the booklet are not comprehensive of all similarities
and differences. The document is, however, a valuable addition to students of
FASB versus IASB standard differences and similarities.
It's not easy keeping track of what's changing and
how, but this publication can help. Changes for 2011 include:
- Revised introduction reflecting the current
status, likely next steps, and what companies should be doing now
(see page 2);
- Updated convergence timeline, including
current proposed timing of exposure drafts, deliberations, comment
periods, and final standards
(see page 7);
- More current analysis of the differences
between IFRS and US GAAP -- including an assessment of the impact
embodied within the differences
(starting on page 17); and
- Details incorporating authoritative standards
and interpretive guidance issued through July 31, 2011
(throughout).
This continues to be one of PwC's most-read
publications, and we are confident the 2011 edition will further your
understanding of these issues and potential next steps.
For further exploration of the similarities and
differences between IFRS and US GAAP, please also visit our
IFRS Video Learning Center.
To request a hard copy of this publication, please contact your PwC
engagement team or
contact us.
Jensen Comment
My favorite comparison topics (Derivatives and Hedging) begin on Page 158
The booklet does a good job listing differences but, in my opinion, overly
downplays the importance of these differences. It may well be that IFRS is more
restrictive in some areas and less restrictive in other areas to a fault. This
is one topical area where IFRS becomes much too subjective such that comparisons
of derivatives and hedging activities under IFRS can defeat the main purpose of
"standards." The main purpose of an "accounting standard" is to lead to greater
comparability of inter-company financial statements. Boo on IFRS in this topical
area, especially when it comes to testing hedge effectiveness!
One key quotation is on Page 165
IFRS does not specifically discuss the methodology
of applying a critical-terms match in the level of detail included within
U.S. GAAP.
Then it goes yatta, yatta, yatta.
Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and
more importantly fails to provide "implementation guidance" comparable with the
FASB's DIG implementation topics and illustrations.
I have a
huge beef with the lack of illustrations in IFRS versus the many illustrations
in U.S. GAAP.
I have a
huge beef with the lack of illustrations in IFRS versus the many illustrations
in U.S. GAAP.
I have a huge beef with the lack of illustrations in
IFRS versus the many illustrations in U.S. GAAP.
Bob Jensen's threads on accounting standards setting controversies ---
http://faculty.trinity.edu/rjensen/Theory01.htm#MethodsForSetting
The FASB address is Financial Accounting Standards Board, P.O. Box 5116,
Norwalk, CT 06856-5116. Phone: 203-847-0700 and Fax: 203-849-9714. The web site is
at http://www.rutgers.edu/Accounting/raw/fasb/
The for-free IASC comparison study of IAS 39 versus FAS 133 (by Paul
Pacter) at http://www.iasc.org.uk/news/cen8_142.htm
The non-free FASB comparison study of all standards entitled The IASC-U.S.
Comparison Project: A Report on the Similarities and Differences between IASC
Standards and U.S. GAAP
SECOND EDITION, (October 1999) at http://www.rutgers.edu/Accounting/raw/fasb/IASC/iascus2d.html
You can read more about the
FAS 133 history in my transcriptions listed in the Table of Contents
of this document. Also see disclosure.
For a FAS 133 flow
chart, go to
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Why There Are New Rules for
Accounting for Derivative Financial Instruments
What is the thinking behind the need for FAS 133?
What was the problem with hedge accounting prior to FAS 133?
The new FAS
133 standard entitled Accounting
for Derivative Financial Instruments
and Hedging Activities was released in 1998 after an Exposure
Draft 162-B circulated for two years around the U.S. and a temporary FAS
119 standard required disclosures in footnotes while FAS 133 was being
written. It was followed soon thereafter by IAS 39 that imposed
similar requirements for international reporting and CICA 39 for Canadian
reporting of the same types of derivative instruments. These and the
similar new standards in some other nations differ only in minor
ways.
What was new in all of these standards was that derivative
financial instruments have to be booked initially at fair value and then
adjusted to fair value on all reporting dates, especially for quarterly
and annual audited financial statements released to the public. Most
derivatives, other than options and futures contracts covered by FAS 80,
were not booked or even disclosed in financial reports prior to these
newer standards. The really problematic derivatives were forward
contracts and swaps. Swaps were not even invented until the early
1980s, and firms were not reporting enormous risks and
off-balance-sheet-financing as swaps and forward contracts exploded in
popularity in the late 1980s and early 1990s. For example, companies
that formerly managed cash with Treasury Bills, shifted to interest rate
swaps for managing interest rate risk on trillions of dollars.
Futures contracts were accounted for pretty well under FAS
80 since these contracts settle in cash frequently (usually daily) prior
to expiration. Options contracts were not accounted for well at all
since only the initial cost (premium) was booked and amortized over the
life of each option. The problem was that the booked value of the
option was generally small and irrelevant relative to the much larger fair
value of the option.
In the early 1990s, enormous frauds using derivative
financial instruments were coming to light. Both governmental (e.g.,
Orange County) and corporate (e.g., Proctor and Gamble) scandals revealed
how investment banks were writing misleading and immensely complicated
derivative contracts to dupe organizations out of billions of
dollars. Many of the scandals are in derivative financial
instruments are documented at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
In particular, note Frank Partnoy's truly sickening revelations of
intentional frauds perpetrated by virtually all the world's leading
investment banks.
Paragraphs 212 and 213 of FAS 133 read as follows at http://www.fasb.org/st/index.shtml#fas150
212. Concern has grown about the
accounting and disclosure requirements for derivatives and hedging
activities as the extent of use and the complexity of derivatives and
hedging activities have rapidly increased in recent years. Changes in
global financial markets and related financial innovations have led to
the development of new derivatives used to manage exposures to risk,
including interest rate, foreign exchange, price, and credit risks. Many
believe that accounting standards have not kept pace with those changes.
Derivatives can be useful risk management tools, and some believe that
the inadequacy of financial reporting may have discouraged their use by
contributing to an atmosphere of uncertainty. Concern about inadequate
financial reporting also was heightened by the publicity surrounding
large derivative losses at a few companies. As a result, the Securities
and Exchange Commission, members of Congress, and others urged the Board
to deal expeditiously with reporting problems in this area. For example,
a report of the General Accounting Office prepared for Congress in 1994
recommended, among other things, that the FASB "proceed
expeditiously to develop and issue an exposure draft that provides
comprehensive, consistent accounting rules for derivative products. . .
." \30/ In addition, some users of financial statements asked for
improved disclosures and accounting for derivatives and hedging. For
example, one of the recommendations in the December 1994 report
published by the AICPA Special Committee on Financial Reporting,
Improving Business Reporting-A Customer Focus, was to address the
disclosures and accounting for innovative financial instruments.
213. Because of the urgency of improved financial information about
derivatives and related activities, the Board decided, in December 1993,
to redirect some of its efforts toward enhanced disclosures
and, in October 1994, issued FASB
Statement No. 119, Disclosure about Derivative Financial
Instruments and Fair Value of Financial Instruments. This
Statement supersedes Statement 119.
Even when the derivative contracts are used for economic
hedges, the risk exposures prior to expiration of the hedge can be huge
since many hedges are highly ineffective prior to expiration of the
derivative contracts. What makes derivative financial instruments
unique relative to other financial instruments is that derivatives
customarily have either zero initial cost (e.g., for forwards, futures and
swap contracts) or exceedingly small initial premiums for options.
Hence the traditional historical cost accounting standards were
meaningless for derivative instruments. For FAS 133, the Financial
Accounting Standards Board (FASB) decided to require continuous fair
market value booking and adjustments (commonly called Mark-To-Market (MTM)
adjustments.
What the FASB wanted was to simply adjust derivatives to
fair value as assets or liabilities and to charge current earnings with
the incremental unrealized gains or losses. All hell broke loose,
however, when this was proposed to the business community, because such
adjustments sometimes resulted in enormous fluctuations of reported
earnings. These fluctuations were especially troublesome in theory
and in practice for firms who were only using derivatives to hedge
risk. Unless there was some way to adjust hedging derivatives to
fair value without impacting current earnings, firms who hedged were
actually going to look more risky than if they were not hedging risk.
This forced the FASB, the IASB, and other standard setters
to adopt hedge accounting relief in the newer standards that require that
derivative financial instruments be carried at fair value. What
might have been a relatively simple FAS 133 thus exploded to way over 500
paragraphs of technical jargon and complex accounting rules like the world
as ever known. At the time I am writing this in February 2004, most
European nations have agreed to implement all IAS standards in January of
2005 except for IAS 39 which business firms in Europe refuse to accept at
this juncture. FAS 133 has been in effect in the U.S. since Year
2000 and has caused enormous confusion and reporting errors, most notable
of which is Freddie Mac ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm#FreddieMac
The new standards also create immense problems for
auditors, some of which are dealt with in SAS 92.
Auditing Derivative Instruments, Hedging Activities,
and Investments in Securities
http://www.aicpa.org/members/div/auditstd/riasai/sas92.htm
Hedge accounting affords companies opportunities to book
and adjust derivative financial instruments to fair value at all
times. However, many business firms are upset because the required
hedge effectiveness tests cause them to
lose part or all their hedge accounting.
Short =
Ownership of an investment position, security, or
instrument such that falling market prices will benefit the owner. This is also
known as a short position. For example, the purchase of a put
option is a short position because the owner of the put option goes in the money with
falling prices. A short position may also arise when investor incurs rights
and obligations that mirror the risk-return characteristics of another investor's asset
position such that a change in value in opposite directions to that asset position.
See also long.
Short sales do not meet Paragraph 6b, Page 3, definition
of a FAS 133 derivative instrument if they require a significant initial investment premium. Footnote 18 on Page 39 and Paragraph 290 on Page 145
leave the door partly ajar for declaring short sales to be derivative instruments and qualify as fair value hedges. Paragraph 20, however, does not allow
nonderivative instruments to be fair value hedges.
Short sales of borrowed security hedges do not meet the Paragraphs 6b and 8 criteria to
qualify as derivative hedging instruments. Short sales of borrowed securities are
defined, in Paragraph 59d on Page 39 of FAS 133, in terms of having at least one of the
following activities:
(1) Selling a security (by
the short seller to the purchaser)
(2) Borrowing a security (by the short seller from the lender)
(3) Delivering the borrowed security (by the short seller to the purchaser)
(4) Purchasing a security (by the short seller from the market)
(5) Delivering the purchased security (by the short seller to the lender).
Those five activities involve three separate contracts. A contract
that distinguishes a short sale involves activities (2) and (5), borrowing a security
and replacing it by delivering an identical security. Such a contract has two of the three
characteristics of a derivative instrument. The settlement is based on an
underlying (the price of the security) and a notional amount (the face amount of the
security or the number of shares),and the settlement is made by delivery of a security
that is readily convertible to cash. However, the other characteristic, little or
no initial net investment, is not present. The borrowed security is the lender's
initial net investment in the contract. Consequently, the contract relating to activities
(2) and (5) is not a derivative instrument. The other two contracts (one for
activities (1) and (3) and the other for activity (4)) are routine and do not
generally involve derivative instruments. However, if a forward purchase or sale is
involved, and the contract does not qualify for the exception in paragraph 10(a),
it is subject to the requirements of this Statement.
In Paragraph 290 on Page 145 of
FAS 133,
the FASB wavered on certain types of contracts as follows:
Several respondents to the Exposure
Draft asked the Board for specific guidance about whether some contracts meet the
definition of a derivative instrument, including sales of securities not yet owned
("short sales"), take-or-pay contracts, and contracts
with liquidating damages or other termination clauses. The Board cannot definitively state
whether those types of contracts will always (or never) meet the definition because their
terms and related customary practices vary.
Gradient Analytics Forensic
Accounting Firm ---
http://www.gradientanalytics.com/
Gradient Analytics, Inc., founded in 1996 by Don Vickrey and Carr Bettis
as Camelback Research Alliance, Inc. in Scottsdale, Arizona. Gradient
Analytics is an independent equity research company ---
http://investing.businessweek.com/research/stocks/private/snapshot.asp?privcapId=11517448
"There
is no question these transactions should be a red flag for investors,"
says Carr Bettis, the co-founder of forensic accounting firm Gradient
Analytics and co-author of a recent study on hedging. "The evidence is
pretty compelling that hedges tend to be used before bad news hits the
market." Bettis' research found that in the year after executives and
directors had engaged in hedging, their company's stock often dropped
markedly. He also found evidence of an increase in financial
restatements and shareholder lawsuits during the same period. Executives
at MCI, Enron, ImClone (IMCL), Krispy Kreme—companies that suffered some
of the great stock melt-downs of the last decade—hedged their shares.
"Some CEOs Are Selling Their Companies Short," by Jane Saseen,
Business Week, February 25, 2010 ---
http://www.businessweek.com/magazine/content/10_10/b4169044647894.htm?campaign_id=magazine_related
Thanks to Jim Mahar for the heads up.
For
investors in Switch & Data Facilities (SDXC), a telecom services
startup, 2008 was a wild year. From a low of 8.60 in mid-March,
shares more than doubled, to 18.17 three months later. Further gains
seemed likely in late July when CEO Keith Olsen boosted the guidance
he had given Wall Street analysts. But with revenue growth slowing
even as debt payments and other costs jumped, Switch & Data was in
the red by yearend. By November 2008, the shares had fallen to 4.21.
One
shareholder avoided much of that drop: the CEO. On June 19, the day
the stock peaked, Olsen contracted with an investment bank to hedge
150,000 shares—a quarter of his stock in the company—against losses
if the price fell below 18. As part of the complex maneuver, he
agreed to sell his shares to the bank one year later and got an
advance of $2.2 million. Olsen, who disclosed his hedging in public
filings, declined to comment for this story.
Hedges are
ways to contain losses if a stock declines, while still keeping some
upside potential if the price keeps rising (see table for a full
explanation). It's a strategy anyone in the market can employ. But
the way hedging is done by CEOs, directors, and other senior
executives may deprive investors of clues about impending problems
at companies. Many grant executives stock as compensation largely
because they want them to have a stake in the company's success or
failure. Investors routinely follow insiders' sales and purchases of
company stock as a gauge of a corporation's prospects. Hedging,
though, reduces an executive's exposure to stock price drops in a
way that investors have a hard time detecting. The complex
transactions are structured so that executives still technically own
the shares. And though some really big hedges get noticed at the
time they are made, disclosures of hedging are often vague or buried
deep in the footnotes of obscure public filings.
"There is
no question these transactions should be a red flag for investors,"
says Carr Bettis, the co-founder of forensic accounting firm
Gradient Analytics and co-author of a recent study on hedging. "The
evidence is pretty compelling that hedges tend to be used before bad
news hits the market." Bettis' research found that in the year after
executives and directors had engaged in hedging, their company's
stock often dropped markedly. He also found evidence of an increase
in financial restatements and shareholder lawsuits during the same
period. Executives at MCI, Enron, ImClone (IMCL), Krispy Kreme—companies
that suffered some of the great stock melt-downs of the last
decade—hedged their shares.
Some 107
instances of executive hedging were reported to the Securities &
Exchange Commission in 2009, up from a decade low of 48 in 2007,
according to Bettis, and regulators are beginning to scrutinize the
transactions. Kenneth Feinberg, the U.S. Treasury pay czar, has
banned executives from hedging at the banks and automakers that
received government bailouts. "We wanted to make sure they couldn't
undercut the links we created between compensation and long-term
performance," says Feinberg. If executives at the companies could
hedge their stock, he adds, "they wouldn't have to worry about how
[the stock] does."
In 2000 and
2001, billionaire Philip Anschutz hedged shares of two companies in
which he held major stakes, Union Pacific (UNP) and Anadarko
Petroleum (APC). Shorting stock is typically done as part of a
hedging strategy. In Anschutz's case, the bank that arranged the
deal, Donaldson, Lufkin & Jenrette (now part of Credit Suisse
Group), shorted Anschutz's own shares rather than borrowing shares
in the market to short. That was a common technique until tax
authorities cracked down on it in 2006. In a case pending before
U.S. Tax Court in Washington, the IRS is arguing that Anschutz's
deals were effectively stock sales rather than hedges, and is
seeking $143.6 million in capital gains taxes. Tax lawyers are
watching the case because they say many other executives who early
in the decade allowed their own shares to be shorted the way
Anschutz did are now being audited. If the IRS wins its case, these
hedgers could face big tax bills earlier than expected. Anschutz
disputes the IRS's argument and would not comment for this story.
There are
plenty of reasons a senior executive would hedge if he thought his
company's stock was going to slide. In one type of hedge, called a
prepaid variable forward contract, he can get a cash advance of up
to 85% for shares he agrees to sell eventually to an investment
bank. Because he still technically owns the shares, the IRS doesn't
consider a hedge a sale so long as the bank doesn't short the
executive's own shares. So the executive need not pay capital gains
taxes until the hedge expires. Meanwhile, he can still vote the
shares and collect dividends.
U.S.
executive hedging first took off in Silicon Valley during the
dot-com era, when transactions averaged around 290 a year.
Investment banks—Morgan Stanley (MS), Goldman Sachs (GS), JPMorgan
Chase (JPM), and Citigroup (C)—rushed to provide hedge services. "I
don't know of a bank that doesn't have a department doing this,"
says Mark Leeds, a tax lawyer with Greenberg Traurig. By mid-decade,
he adds, transactions worth several billion had likely been sold.
The hedge business helps the banks cement ties with top executives,
which comes in handy when a bank is pitching other services. And the
banks reap rich fees.
SUSPECT
CORRELATIONS
Bettis and his co-authors examined 2,010 hedging transactions
reported in filings by 1,181 executives at 911 firms between 1996
and 2006. In the year preceding executives' hedges, their companies'
shares outpaced the market anywhere from 17% to 31% on average,
depending on the type of hedge used, according to Bettis' analysis,
which was completed last year. After the executives hedged, it's a
different story. Shares in companies where the CEOs, directors, and
other top executives had hedged using a variable forward sale lagged
the market by 16.2%, on average. Those where a collar, another
popular hedging transaction, had been used fell behind by 25%.
Roughly 11%
of the companies where an executive used a collar had to restate
financials within two years of the hedge transaction; comparable
companies where no hedging occurred had half as many restatements,
Bettis says. Some 11% of the firms that let their executives buy a
variable forward contract faced securities-related suits within a
year, double the number at companies that didn't hedge. "The poor
performance following hedging suggests a number of these trades are
potentially based on privileged information," argues Bettis. The
trades "appear to be tied to events that were known or could
reasonably have been anticipated by the executives," he adds.
SEC
officials say executives who hedge fall under the same rules as
those who sell their stock. If an executive were to use a hedge to
protect himself against losses at a time when he possessed specific
material information that the company's performance had stumbled or
was about to, that could potentially bring an insider trading
charge. But SEC spokesman John Heine says the agency has never
pursued an insider trading case against an executive following a
hedge.
Missed
earnings in the wake of a hedge appear common, Bettis' research
shows. Chattem Chairman and CEO Alexander Guerry placed a hedge on
60,000 shares of the Chattanooga (Tenn.)-based maker of Gold Bond
foot powder,
Continued in article
Jensen Comment
Note that FAS 133 does not scope in accounting for short sales.
Bob Jensen's tutorials on
accounting for derivative financial instruments and hedge accounting ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Short-Cut
Method for Interest Rate Swaps
=
steps to computing interest accruals and
amortization adjustments for interest rate swaps that have no ineffectiveness.
The main attractiveness of the shortcut it that for interest rate
swaps, quarterly testing for hedge ineffectiveness is not required.
Whenever possible, firms seek to use the shortcut method. For interest rate swap cash flow hedges the short-cut method steps are listed in Paragraph 132 on
Pages 72-73 of FAS 133. For fair value hedges, see Paragraph 114 on Page 62 of
FAS 133. See FAS 133 Paragraph 68 for the exact conditions that have to be met if an entity is to assume no
ineffectiveness in a hedging relationship of interest rate risk involving an
interest-bearing asset/liability and an interest rate swap. Also see interest rate swaps,
transition accounting, and basis adjustment.
My understanding is that the “long haul” method is any
situation where the stringent tests for shortcut method do not hold. Thus
tests for ineffectiveness must be conducted at each reset date. This is
problematic for swaps and options especially since the market for the hedged
item entails a different set of buyers than the market for the hedging
instrument, thereby increasing the likelihood of ineffectiveness.
I do not have a spreadsheet illustration of ineffectiveness
testing for interest rate swaps, but the tests I assume are the same as
those tests used for other hedges. Some analysts assume that the “long haul”
method applies to regression tests (as opposed to dollar offset), and
regression tests (unlike dollar offset tests) cannot be applied
retrospectively. See “Ineffectiveness” at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#I-Terms
"Proposed Guidance on Applying the “Shortcut Method”
of Hedge Accounting," KPMG's Defining Issues, July 2007 ---
http://www.kpmg.com/aci/docs/DI 07_24 Shortcut Method.pdf
Also see
http://www.cs.trinity.edu/~rjensen/Calgary/CD/fasb/ShortcutMethodFromKPMG.pdf
Also see
http://www.accountingweb.com/cgi-bin/item.cgi?id=101227&d=815&h=817&f=816&dateformat=%25o%20%25B%20%25Y
The Financial Accounting Standards Board has issued proposed Statement 133
Implementation Issue No. E23, "Issues Involving the Application of the
Shortcut Method under Paragraph 68." This proposal provides guidance on
certain practices involved in the application of one technique for
determining hedge accounting, commonly referred to as the shortcut method.
Designed to promote consistency in the practice of determining when an
entity qualifies for the shortcut method, the proposal also provides
investors and others with better information about how the shortcut method
affects a company's financial statements.
FASB News Release, July 24, 2007 ---
http://www.fasb.org/news/nr072407.shtml
If the critical terms of the hedging instrument and the entire hedged
asset/liability or hedged forecasted transaction are the same, an enterprise could
conclude that changes in fair value or cash flows attributable to the risk being hedged
are expected to completely offset at inception and on an ongoing basis.
For example, an entity may assume that a hedge of a forecasted purchase of a commodity
with a forward contract will be highly effective and that there will be no ineffectiveness
to be recognized in net profit or loss if:
(a) the forward contract is for purchase of the same quantity of the same commodity at the
same time and location as the hedged forecasted purchase.
(b) the fair value of the forward contract at inception is zero.
(c) either the change in the discount or premium on the forward contract is excluded from
the assessment of effectiveness and included directly in net profit or loss or the change
in expected cash flows on the forecasted transaction is based on the forward price for the
commodity
(IAS 39 Paragraph 151)
(FAS 133 Paragraph 65)
|
DIG Issue E4 at http://www.fasb.org/derivatives/
QUESTIONS
Can the shortcut method be applied if most but not all of the
applicable conditions in paragraph 68 are met?
Can that shortcut method be applied to hedging relationships that
involve hedging instruments other than interest rate swaps or that
involve hedged risks other than market interest rate risk?
Can the shortcut method be applied to a fair value hedge of a
callable interest-bearing debt instrument if the hedging interest rate
swap has matching call provisions?
BACKGROUND
The conditions for assuming no ineffectiveness and thus being able
to apply the shortcut method are listed in paragraph 68, which states
in part:
An entity may assume no ineffectiveness in a hedging relationship
of interest rate risk involving an interest-bearing asset or liability
and an interest rate swap if all of the applicable conditions in the
following list are met.... Paragraphs 114 and 132 discuss the steps to
be used in applying the shortcut method to Examples 2 and 5,
respectively.
RESPONSE
Question 1 No. The shortcut method can be applied only if all of
the applicable conditions in paragraph 68 are met. That is, all the
conditions applicable to fair value hedges must be met to apply the
shortcut method to a fair value hedge and all the conditions
applicable to cash flow hedges must be met to apply the shortcut
method to a cash flow hedge. A hedging relationship cannot qualify for
application of the shortcut method based on an assumption of no
ineffectiveness justified by applying other criteria.
Given the potential for not recognizing hedge ineffectiveness in
earnings under the shortcut method, Statement 133 intentionally limits
its application only to hedging relationships that meet each and every
applicable condition in paragraph 68. Thus, if the interest rate swap
at the inception of the hedging relationship has a positive or
negative fair value, the shortcut method cannot be used even if all
the other conditions are met. (See condition 68(b).) Similarly,
because a callable financial instrument is prepayable, the shortcut
method cannot be applied to a debt instrument that contains an
embedded call option (unless the hedging interest rate swap in a fair
value hedge contains a mirror-image call option, as discussed in
Question 3). (See condition 68(d).) The verb match is used in the
specified conditions in paragraph 68 to mean be exactly the same or
correspond exactly.
Question 2 No. Because paragraph 68 specifies only a hedging
relationship that involves only an interest rate swap as the hedging
instrument, the shortcut method cannot be applied to relationships
hedging interest rate risk that involve hedging instruments other than
interest rate swaps. Similarly, the shortcut method described in
paragraphs 114 and 132 cannot be applied to hedging relationships that
involve hedged risks other than the risk of changes in fair value (or
cash flows) attributable to changes in market interest rates. However,
the inability to apply the shortcut method to a hedging relationship
does not suggest that that relationship must result in some
ineffectiveness. Paragraph 65 points out a situation in which a
hedging relationship involving a commodities forward contract would be
considered to result in no ineffectiveness.
Question 3 An entity is not precluded from applying the shortcut
method to a fair value hedging relationship of interest rate risk
involving an interest-bearing asset or liability that is prepayable
due to an embedded call option provided that the hedging interest rate
swap contains an embedded mirror-image call option. The call option
embedded in the swap is considered a mirror image of the call option
embedded in the hedged item if (a) the terms of the two call options
match exactly (including matching maturities, related notional
amounts, timing and frequency of payments, and dates on which the
instruments may be called) and (b) the entity is the writer of one
call option and the holder (or purchaser) of the other call option.
Similarly, an entity is not precluded from applying the shortcut
method to a fair value hedging relationship of interest rate risk
involving an interest-bearing asset or liability that is prepayable
due to an embedded put option provided the hedging interest rate swap
contains an embedded mirror-image put option.
General Comments Statement 133 acknowledges in paragraph 70 that a
hedging relationship that meets all of the applicable conditions in
paragraph 68 may nevertheless involve some ineffectiveness
(notwithstanding the supposed “assumption of no ineffectiveness”).
Yet Statement 133 permits application of the shortcut method, which
does not recognize such ineffectiveness currently in earnings. For
example, the change in the fair value of an interest rate swap may not
offset the change in the fair value of a fixed-rate receivable
attributable to the hedged risk (resulting in hedge ineffectiveness)
due to either (a) a change in the creditworthiness of the counterparty
on the swap or (b) a change in the credit spread over the base
Treasury rate for the debtor’s particular credit sector (sometimes
referred to as a change in the sector spread). Although an expectation
of such hedge ineffectiveness potentially could either (a) preclude
fair value hedge accounting at inception or (b) trigger current
recognition in earnings under regular fair value hedge accounting, the
shortcut method masks that ineffectiveness and does not require its
current recognition in earnings. In fact, the shortcut method does not
even require that the change in the fair value of the hedged
fixed-rate receivable attributable to the hedged risk be calculated.
Although a hedging relationship may not qualify for the shortcut
method, the application of regular fair value hedge accounting may
nevertheless result in recognizing no ineffectiveness. For example, an
analysis of the characteristics of the hedged item and the hedging
derivative may, in some circumstances, cause an entity’s calculation
of the change in the hedged item’s fair value attributable to the
hedged risk to be an amount that is equal and offsetting to the change
in the derivative’s fair value. In those circumstances, because
there is no ineffectiveness that needs to be reported, the result of
the fair value hedge accounting would be the same as under the
shortcut method.
At its July 28, 1999 meeting, the Board reached the above answer to
Question 3. Absent that, the staff would have been able to provide
only the answer that because a callable financial instrument is
prepayable, the shortcut method cannot be applied to a callable debt
instrument even if the hedging interest rate swap has a matching call
provision. The Board noted that, in developing the provisions in
paragraph 68(d), it had not focused on situations in which the hedging
interest rate swap contains a mirror-image call provision and, had it
focused on the situation described above, it would have arrived at the
above guidance. |
Derivatives
Implementation Group
Title: Transition Provisions: Use of the Shortcut Method in the
Transition Adjustment and Upon Initial Adoption
Paragraph references: 48, 52, 68
Date released: November 1999
QUESTIONS
For a hedging relationship that existed prior to the initial adoption
of Statement 133 and that would have met the requirements for the
shortcut method in paragraph 68 at the inception of that pre-existing
hedging relationship, may the transition adjustment upon initial
adoption be calculated as though the shortcut method had been applied
since the inception of that hedging relationship?
In deciding whether the shortcut method can be applied prospectively
from the initial adoption of Statement 133 to a designated hedging
relationship that is the continuation of a pre-existing hedging
relationship, should the requirements of paragraph 68(b) (that the
derivative has a zero fair value) be based on the swap's fair value at
the inception of the pre-existing hedging relationship rather than at
the inception of the hedging relationship newly designated under
Statement 133 upon its initial adoption?
RESPONSES
Question 1 Yes. For a hedging relationship that involves an interest
rate swap designated as the hedging instrument, that existed prior to
the initial adoption of Statement 133, and that would have met the
requirements for the shortcut method in paragraph 68 at the inception of
that pre-existing hedging relationship, an entity may choose to
calculate the transition adjustment upon initial adoption either (a)
pursuant to the provisions of paragraph 52, as discussed in Statement
133 Implementation Issue No. J8, "Adjusting the Hedged Item's
Carrying Amount for the Transition Adjustment related to a
Fair-Value-Type Hedging Relationship," or (b) as though the
shortcut method had been applied since the inception of that hedging
relationship, as discussed below. Under either approach, the interest
rate swap would be recognized in the statement of financial position as
either an asset or liability measured at fair value.
If the previous hedging relationship was a fair-value-type hedge, the
difference between the swap's previous carrying amount and its fair
value would be included in the transition adjustment and recorded as a
cumulative-effect-type adjustment of net income. The hedged item's
carrying amount would be adjusted to the amount that it would have been
had the shortcut method for a fair value hedge of interest rate risk
been applied from the inception of that pre-existing hedging
relationship; that adjustment would be recorded as a
cumulative-effect-type adjustment of net income.
If the previous hedging relationship was a cash-flow-type hedge, the
difference between the swap's previous carrying amount and its fair
value would be included in the transition adjustment and allocated
between a cumulative-effect-type adjustment of other comprehensive
income and a cumulative-effect-type adjustment of net income, as
follows. The cumulative-effect-type adjustment of other comprehensive
income would be the amount necessary to adjust the balance of other
comprehensive income to the amount that it would have been related to
that swap on the date of initial adoption had the shortcut method been
applied from the inception of the pre-existing hedging relationship. The
remainder, if any, of the transition adjustment would be recorded as a
cumulative-effect-type adjustment of net income.
Question 2 Yes. In deciding whether the shortcut method can be
applied prospectively from the initial adoption of Statement 133 to a
designated hedging relationship that is the continuation of a
pre-existing hedging relationship, the requirements of paragraph 68(b)
(requiring that the derivative has a zero fair value) should be based on
the swap's fair value at the inception of the pre-existing hedging
relationship rather than at the inception of the hedging relationship
newly designated under Statement 133 upon its initial adoption. However,
if the hedging relationship that is designated upon adoption of
Statement 133 is not the continuation of a pre-existing hedging
relationship (that is, not the same hedging instrument and same hedged
item or transaction), then the decision regarding whether the shortcut
method can be applied prospectively from the initial adoption of
Statement 133 should be based on the fair value of the swap at the date
of initial adoption. |
Question
What's your opinion regarding the Shortcut Method allowed in FAS 133 but not
in IAS 39?
If companies meet the strict tests for the Shortcut Method in FAS 133, they
can avoid period-to-period hedge effectiveness testing for interest rate
swaps. The FASB is now considering changing these tests. I would prefer that
the FASB eliminate the Shortcut Method entirely.
October 4, 2007 message from Attorney XXXXX
Bob Jensen:
As your website(s) keep coming up as an
"authority" in the subject area of FAS 133, you might want to pre-date
(September 21, 2007) and submit to FASB any comment letter of substance on
DIG Implementation Issue E23 - revising the cash-flows short-cut method per
website invitation:
http://www.fasb.org/
New—FASB Issues Proposal to Clarify the
"Shortcut Method" of Hedge Accounting (Posted: 07/24/07) News Release
Although I submitted "late," mine was still
"accepted" and posted as #35 on the list - http://www.fasb.org/ocl/fasb-getletters.php?project=ISSUE-E23
I'm also hoping Ira Kawaller of
www.kawaller.com also submits something as
both his and your names keep coming up on Google-searches on the subject.
I'm only an independent consultant working on
a project, and as such, I submitted a single-issue item snafu I've been
experiencing in the general area - perhaps yours could be more extensive.
Second message on October 5, 2007
Ira, Bob, et. al.:
In addition to potential late submissions
on the FASB website (below original e-mail), do either of you know of,
or can suggest any, commercial software to set-in-place and track a
plain vanilla Cash-Flows Macro Interest Rate Swap showing the long-haul
method?
I'm consulting at a sub-prime mortgage
management firm and they want to roll-up $1/2 Billion of their variable
debt to a single fixed-interest cash-flow hedge - as a Macro Interest
Rate Swap. While they already have a counter-party whose software they
might be using, but I'm sort-of shopping-around for them as well.
Due to the uncertainties surrounding the
short-cut method, we're going long-haul (at this point!). As the verdict
is pending on the short-cut method (see Morgan Stanley's E23 Comment -
http://www.fasb.org/ocl/ISSUE-E23/51580.pdf
where they "ceased" all their short cut hedge
programs, as well as KPMG's, where even-if short-cut is used, long-haul
would still be needed to track ineffectiveness -
http://www.fasb.org/ocl/ISSUE-E23/51585.pdf ),
and since it's only a "basic" cash-flows
interest-rate swap, we figure on moving ahead and using the long-haul
method to track the entirety of it.
I know we can't have our cake and eat it
too - i.e. once a "fixed" rate is established by the hedge, it too can
"sink" in the market, where we can't simultaneously hedge the cash-flows
risk and the fair-value risk of the completed hedge - but I'll leave
that to the macro-economists to figure-out.
Suggestions or comments welcome - please
feel free to forward to others who might be able to help, even
commercial vendors, so I know what prices the long-haul tracking will
cost (I know! I know! - it'll probably be more costly than the
ineffectiveness that's being tracked anyway - but we're just trying to
play-by-the-rules in an uncertain regulatory environment!).
Regards,
XXXXX
October 7, 2007 reply from Bob Jensen
Hi Albert,
I’m not sure I
can add much more to the Shortcut method that the FASB has not already
considered. Actually, I would like to do away with the Shortcut method since
it applied only to interest rate swaps and does not conform to IAS 39.
Your request
for information about software inspired me to update my somewhat neglected
module on software under the S-terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#S-Terms
(Scroll down to “Software.”
I discuss ineffectiveness
testing under the I-terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#I-Terms
A bit of a review is provided at
http://www.cfoeurope.com/displayStory.cfm/1736487
Alternative approaches to testing hedge
effectiveness under SFAS No. 133 ---
http://www.allbusiness.com/accounting/methods-standards/209328-1.html
A Listing of Some Hedge Accounting Restatements
for 2005 (see Page 3 of the online version)
"Lost in the
Maze Problems with hedge accounting caused a wave of restatements in 2005:
Are FASB's rules too hard to follow, or are companies simply too lax?" by
Linda Corman, CFO Magazine, May 2005 ---
http://www.cfo.com/article.cfm/6874855/1/c_8435337
Alternative approaches to testing hedge
effectiveness under SFAS No. 133 ---
http://www.allbusiness.com/accounting/methods-standards/209328-1.html
Derivatives One has some basic free tools ---
http://www.derivativesone.com/kb/hedge_effectiveness.aspx
There are a number of commercial vendors of FAS
133 and IAS 39 compliance software. A sampling is shown below:
FinancialCAD ---
http://www.financialcad.com/
FinancialCAD provides software and services
that support the valuation and risk management of financial securities and
derivatives that is essential for banks, corporate treasuries and asset
management firms. FinancialCAD’s industry standard financial analytics are a
key component in FinancialCAD solutions that are used by over 25,000
professionals in 60 countries.
Also see
http://www.cfo.com/article.cfm/3002428/c_3046496
COMSOL ---
http://www.comsol-online.com/content.php?si=317&id=134
INNSINC ---
http://www.inssinc.com/?issadsrc=google&gclid=CO38pY7f_I4CFTaoGgodgyqT2w
FUTRAK workstation offers all of the features
necessary to significantly reduce the time required to manage your hedging
activities, provide management with all the control tools necessary to
comply with SarbOx 404, satisfy auditors with documentary evidence needed to
justify your company's use of derivative hedge accounting, and eliminate
earnings volatility.
Also see
http://www.bobsguide.com/guide/news/21544.html
Hedge Trackers ---
http://www.hedgetrackers.com/whatweoffer/toolsandsoftware.htm
TPG Software ---
http://www.tpgsoftware.com/CustServiceCenter/Docs/Windows/DerivativeGenius_files/DerivativeGenius.htm
MBRM ---
http://www.mbrm.com/
Allegro (especially good for energy companies)
---
http://www.allegrodev.com/solutions_app_riskMgmt.asp?c=positions
Sunguard Bancware ---
http://www.sungard.com/bancware/menus/brochures/bancwarealmbrochure.pdf
Treasury Compliance ---
http://www.fas133.com/search/search_article.cfm?page=11&areaid=362
October 8, 2007 reply from IRA KAWALLER
[kawaller@kawaller.com]
Jensen Note: Ira has been a member of the FASB's Derivative Implementation
Group (DIG) since its inception.
Bob -
I’m a bit surprised that you favor disallowing
shortcut.
I don’t have a problem with that perspective
for cash flow hedges, but I do for fair value hedges.
The problem for FV hedges is that long haul
doesn’t work. Over the life of fixed rate debt – typically issued at par and
being redeemed at par, the change in FV over the life of the debt is zero.
The results of a swap, on the other hand will be whatever the sum of the
cash flows happens to be – but certainly not zero. The only way FV hedges
can work is if you ignore swap settlements, but that’s crazy. The fact is,
swaps don’t offset the changes in the FV of the debt they’re used to hedge
unless the swaps are sized on a duration basis. That’s what bond portfolio
managers do, but it’s not what corporate treasurers do. For hedges that are
designed to synthesize variable rate debt, a one-to-one sizing is
appropriate, but unless you use shortcut, there’s little chance that you’ll
be able to pass retrospective effectiveness tests.
Hope all is well.
Ira Kawaller
718-694-6270
www.kawaller.com
Bob Jensen's threads on the Shortcut Method are under the S-terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#S-Terms
(Scroll down to "Shortcut Method")
Bob Jensen's FAS 133 and IAS 39 tutorials are at the following two sites:
http://faculty.trinity.edu/rjensen/caseans/000index.htm
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
I still say do away with the Shortcut Method until the IASB allows it in IAS
39.
Of course banks and other corporations in the U.S. would hit the ceiling
May 6, 2005 message from Dennis Beresford
[dberesfo@terry.uga.edu]
Bob,
I just finished listening to the GE web cast and it
is fascinating. It's interesting to listen to the company's explanations of
what happened and to the analysts' questions. The web cast is available at:
http://phx.corporate-ir.net/phoenix.zhtml?c=118676&p=irol-eventdetails&EventId=1062945&WebCastId=443224&StreamId=533758
although these things usually get removed after a
month or so. They also said that they would post a transcript of the web
cast later today.
Denny
May 6, 2005 reply from Bob Jensen
Hi Denny,
I enjoyed part of the Webcast and appreciated the fact that the analysis
of why GE is restating its financial statements came near the beginning of
the Webcast. I thought the explanation was direct and very clear.
The restatement tends to make a FAS 133 mountain out of an economic mole
hill.
Scholars interested in the Shortcut Method for Interest Rate Swaps will
find this GE Webcast interesting. FAS 133 makes a huge exception for having
to test for hedge effectiveness of interest rate swaps. This is important,
because typical tests of effectiveness such as the dollar offset test will
often fail quarter to quarter for such swaps. Not having to test for
effectiveness helps to avoid having to declare swap hedges ineffective when,
in my viewpoint, they are perfectly effective over the life of the swap.
GE executives decided after the fact that they thought they were eligible
for the Short Cut Method on some swaps that technically violated one SCM
test. The impact is rather small and not a big deal even though GE is going
to restate its financial statements to the tune of about $300 million.
The important point for academics and practitioners is to learn why GE
decided they did not meet the SCM tests outlined under "Short Cut Method for
Interest Rate Swaps" in my glossary at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#S-Terms
The important point for standard setters is to learn that this is yet
another technicality in an accounting rule that has absolutely no impact on
the actual economic performance or cash flows of a company. I think standard
setters have to become more creative in distinguishing cash/economic
outcomes versus fluctuations in financial performance that are transitory
and have no ultimate impact on cash/economic performance.
This earnings restatement by GE due to derivatives is much less complex
than the macro hedging complications of Fannie Mae and Freddie Mac ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm#FannieMae
Bob Jensen
"Hedging with Swaps: When Shortcut Accounting Can’t be
Applied," by Ira G. Kawaller, Bank Asset/Liability Management, June 2003
--- http://www.kawaller.com/pdf/BALM_Hedging_with_Swaps.pdf
For bank asset/liability management, when
using derivatives, “hedge accounting” treatment is an imperative. It assures
that gains or losses associated with hedging instruments will contribute to
earnings simultaneously with the risks being hedged. Otherwise – i.e., without
hedge accounting – these two effects will likely impact earnings in different
accounting periods, resulting in an elevated level of income volatility that
obscures the risk management objectives of the hedging entity.
For most managers with interest rate
exposures, the desired treatment can be assured if appropriately tailored swaps
contracts serve as the hedging instrument. Under these conditions, entities may
apply the “Shortcut” treatment, which essentially guarantees that the
accounting results will reflect the intended economics of the hedge and that no
unintended income effects will occur. For example, synthetic fixed rate debt
(created by issuing variable rate debt and swapping to fixed), would generate
interest expenses on the income statement that would be indistinguishable from
that which would arise from traditional fixed rate funding. Synthetic instrument
accounting is persevered with the shortcut treatment. Qualifying for the
shortcut treatment also has another benefit of obviating the need for any
effectiveness testing, thereby eliminating an administrative burden and reducing
some measure of the associated hedge documentation obligation.
See Ineffectiveness and Software
Hi Donna,
If your client uses variable rate debt
as the hedged item, there is cash flow risk and you can hedge this with an
interest rate swap. If the hedge and the hedged item are both based on LIBOR,
you have eliminated interest rate risk of the combined cash flows and should
qualify for the shortcut method as explained in Paragraph 132 of FAS 133. In
fact, your example is a lot like Example 5 of Appendix B that begins in
Paragraph 131. You can read my discussion of Example 5 at http://www.cs.trinity.edu/~rjensen/133ex05.htm
The Example 5 Excel workbook solution
is at http://www.cs.trinity.edu/~rjensen/133ex05.xls
Note in my Excel workbook above how
complicated the derivation of fair values of interest rate swaps can become. You
have to go to Bloomberg terminals and derive swap (yield) curves. One advantage
of the shortcut method is that it allows you to assume that the value of the
hedge exactly offsets the value of the hedged item. If the hedged item is easier
to value (e.g., if there is a daily market price on the bonds), then you have
saved yourself a lot of time and expense of valuing the swap and testing for
hedge ineffectiveness.
Whenever possible, interest rate hedges
are designed to qualify for the shortcut method.
You can read more about this under my
definition of "Yield Curve" at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
For a better understanding about how
FAS 138 impacts upon FAS 133 in this regard, go to the definitions of
"benchmarking" at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#B-Terms
Hope this helps!
Bob (Robert E.) Jensen Jesse H. Jones
Distinguished Professor of Business Trinity University, San Antonio, TX 78212
Voice: (210) 999-7347 Fax: (210) 999-8134 Email: rjensen@trinity.edu http://faculty.Trinity.edu/rjensen
-----Original
Message-----
From: Donna Jones [mailto:djones@tssllp.com]
Sent: Friday, February 15, 2002 12:46 PM
To: rjensen@trinity.edu Subject: FAS133
I am wrestling with
the requirements of FAS133 as it relates to a client of mine. It is probably a
simple case, if there is such a thing, and deals with an interest rate swap.
The client has debt through industrial development bonds with a variable rate
based on LIBOR. They entered into a swap agreement to fix the interest rate
though final maturity of the bonds. This would qualify as a cash flow hedge, I
think. The counter party to the agreement has valued the agreement (a market
to market value) at year end. I assume I will set this up as a liability (who
knew 2 1/2 years ago rates would fall this low) through accumulated other
comprehensive income.
My confusion is
related to assessing the hedge effectiveness. It appears that this is
imperative to qualify for hedge accounting and determine the ineffective
portion of the hedge. I am not sure how to document this assessment. If the
hedge meets the requirements for the shortcut method of accounting, does this
ease the assessment documentation requirements? Would this mean that there
would never be an ineffective portion and all changes in the FMV of the hedge
would be posted through accumulated other comprehensive income? Basically,
they have posted interest paid on the swap agreement through interest expense.
I would appreciate
your advice on this case. The information I found on your website was
extensive but the requirements are extremely confusing to me. Unfortunately, I
am the first partner in my firm to tackle this issue. Please let me know if
you need more details of the agreement.
Thank you,
Donna Jones
Thomas, Stout &
Stuart LLP
PO Box 2220 Burlington, NC 27216
Phone: (336)226-7343 Fax: (336)229-4204 http://tssllp.com/
Hi Again Donna,
In this added message to you, I am going to feature a quote from a
fascinating book by Frank Partnoy. I also want to point you to an
important paper by Ira Kawaller. But before doing so, I am going to give
you more background that you ever hoped for or perhaps even want.
My purpose is to give your more background on the Shortcut Method and to
demonstrate why it is so important for your clients to qualify for the Shortcut
Method whenever possible. You can read the following definition in my glossary
at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#S-Terms
Shortcut
Method = steps to computing interest accruals and
amortization adjustments for interest rate swaps that have no ineffectiveness.
The main attractiveness of the shortcut it that for interest rate swaps,
quarterly testing for hedge ineffectiveness is not required. Whenever
possible, firms seek to use the shortcut method. For interest rate swap
cash flow hedges the short-cut method steps are listed in Paragraph 132 on Pages
72-73 of FAS 133. For fair value hedges, see Paragraph 114 on Page 62 of
FAS 133. See FAS 133 Paragraph 68 for the exact conditions
that have to be met if an entity is to assume no ineffectiveness in a hedging
relationship of interest rate risk involving an interest-bearing asset/liability
and an interest rate swap.
I will digress now and explain the background of FAS 133. FAS
133 arose because of the spectacular increase in the popularity of
certain types of derivative instruments, particularly interest rate
swaps (that hedge fair values or cash flows) and cross-currency swaps
for interest rates and foreign exchange (FX) risk. In the case of
both interest rate swaps and cross-currency swaps of interest rate risk,
the FASB goofed in the original FAS 133. In the case of interest
rates, the goof was to assume that firms hedge sector spreads rather
than benchmarked rates. In the case of cross-currency swaps, the
goof was to not allow for simultaneous hedging of both interest rate
risk and FX risk in the same swap derivative contract. This was
rectified in FAS 138 that you can read about at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm
Except for futures contracts (that settle for cash daily), there was
no fair value accounting for financial instruments derivatives prior to
FAS 133 in the U.S. and IAS 39 internationally. Most derivatives
like forward contracts and swaps were not booked at all until maturity
when cash settlements took place. FAS 133/138 requires booking of
most derivatives and subsequent adjustment of the carrying values
of the derivatives to fair value at least every 90 days.
Originally, the FASB wanted to book changes in derivative value to
current earnings even though such changes are not realized until cash
settlements take place. If that became the required accounting
treatment, FAS 133 would have been about 20 simple paragraphs, and there
would have been no need for the FAS 138 amendments of FAS 133.
However, corporate America complained loudly that this simplistic
treatment of changes in derivative instrument fair value would lead to
reporting asymmetries for hedging contracts that are highly
misleading. Their point was well taken in theory. If the
hedged item (such as bonds payable) remained at historical cost and the
hedging contract (such as an interest rate swap) was carried at current
fair value, the changes in the hedge's fair value would create extreme
volatility in earnings. Furthermore, such changes in earnings are
unrealized and might be perfectly offset by unbooked changes in value of
the hedged item. Accounting reality
would, thereby, be far removed from economic reality in the case of
effective hedges.
The FASB listened to its constituencies and decided to lessen the
impact of unrealized changes in hedging contract values on current
earnings per share. Doing so added over 500 paragraphs to FAS 133
plus the added paragraphs in the FAS 138 amendments to FAS 133. It
left us with the most complex and convoluted standard in the history of
accountancy.
Now I will outline at the key issues of hedging ineffectiveness in
FAS 133:
1.
Hedge accounting is primarily of interest to your clients because it
allows changes in the fair value of a derivative hedge to be offset by
something other than current earnings. In the case of cash flow
hedges and FX hedges, the offset is usually to Other Comprehensive
Income (OCI). In the case of fair value hedges, the offset is
either to an account called "Firm Commitment" for unbooked
purchase commitments or the hedged item itself for booked assets or
liabilities. In the latter case, the historical cost rule of
accounting for the hedged item is suspended in favor of fair value
accounting for the booked hedged item during the hedging period, after
which the accounting reverts back to historical cost. You can
read more about this by looking up such terms as "cash flow
hedge," "fair value hedge," and "foreign currency
hedge" in my glossary at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm
2.
Not all economic hedges qualify for hedge accounting, in which case
the changes in value of the hedge contract impact directly upon
current earnings. Your clients will nearly always want to have
their hedges qualify for hedge accounting under FAS 133/138.
They will, thereby, avoid the volatility of current earnings caused by
fair value adjustments of derivative contracts (other than futures
contracts).
3.
FAS 133 requires, except in the case of the Shortcut Method, testing
of hedge effectiveness at the time the derivative instruments are
adjusted for changes in fair value. To the extent that a hedge
is deemed ineffective, the ineffective portion must be charged to
current earnings rather than to the permitted offsets such as OCI,
Firm Commitment, or the fair value offset debit or credit to the
hedged item itself. Testing for effectiveness can be a very
complicated process and is highly inaccurate (as you will see in
Partnoy's passage quoted below). The importance of qualifying
for the Shortcut Method is stressed in a paper by Ira Kawaller cited
below.
4.
Testing for hedge effectiveness of interest rate swaps is perhaps the
most complicated aspect of any hedge accounting under FAS 133.
Appendix A of FAS 133 is devoted to issues of effectiveness testing
(although that appendix does not delve into the more complex issues of
hedge effectiveness testing of interest rate swaps). Testing for
interest rate swap hedge effectiveness requires an understanding of
yield curves known as swap curves and an understanding of how to
derive forward prices from spot prices on such curves. You can
read (and possibly weep) more about how this process works at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
5.
Testing for hedge effectiveness of interest rate swaps is a highly
inaccurate process that may give rise to hedge ineffectiveness simply
due to the inaccuracy of valuing the interest rate swap (at least
every 90 days) relative to the valuing of the hedged item itself (say
a bond) that may be valued with great accuracy because it is traded on
the open market. In other words, the
hedged item (e.g., a bond) can be valued with great accuracy whereas
its hedge (the interest rate swap) is a customized derivative contract
that is not traded in the open market and can only be valued with
great inaccuracy.
6.
The importance of the Shortcut Method (which
only applies to qualified interest rate swap hedges) is that hedge
effectiveness does not have to be tested when the swap is adjusted to
fair value. This avoids the tedium of having to go to
Bloomberg terminals and derive the swaps curves. More
importantly, it avoids the inaccuracy of these swaps curves in valuing
the swap. This, in turn, avoids having to book hedge
ineffectiveness to current earnings when, in fact, the ineffectiveness
is fiction arising only from inaccuracies in estimation of swap (yield
curves).
Now let me quote from a truly fascinating book that I am reading at the
moment (perhaps one of the most valued books that I have ever read in my life).
Passage from Fiasco: The Inside Story of a Wall
Street Trader,
by Frank Partnoy (New York: Penguin Books, 1999, ISBN 0 14
02.7879 6, pp. 56-58)
In a clever but somewhat dubious marketing pitch
for PERLS, DPG salemen often bragged that the investor's
"downside risk was limited to the initial
investment." These words appeared as boilerplate
throughout Morgan Stnley's marketing documents and almost always
generated snickers from the salesmen. One of the ironic
selling points of PERLS --- and many other derivatives my group
later sold --- was that the most a buyer could lose was
everything
(Note from Jensen: The buyer would not lose
everything in the case of a hedge rather than a speculation).
. . .
Some PERLS buyers had no idea that the bet they were making
by buying PERLS typically was a bet against a set of
"forward yield curves." (Note from
Jensen: In the case of an interest rate swap, these are
called swap curves.) Forward yield curves are a basic,
but crucial, concept in selling derivatives. The most
simple "yield curve" is the curve that describes
government bond yields for various maturities. Usually the
curve slopes upward because as the maturity of a government bond
increases, its yield also increases. You can think about
this curve in terms of a bank Certificate of Deposit. Your
are likely to get a higher rate with a five-year CD than with a
one-year CD. A yield curve is simply a graph of interest
rates of different maturities.
There are many different kinds of yield curves. The
"coupon curve" plots the yields of government coupon
bonds of varying maturities. The "zero curve"
plots the yields of zero coupon government bonds of varying
maturities (more about zero coupon bonds, also known as Strips
later in the book). The coupon and zero curves are
elementary, and you can find the quotes that make up these
curves every day in the business section of most
newspapers. The Wall Street Journal also includes a
summary of daily trading activity in such bonds in its Credit
Markets column.
Note from Bob Jensen: The most
important part of this passage begins now:
But the most important yield curve to derivatives salesmen is
one you won't find in the financial pages --- the forward yield
curve, or "forward curve," Actually, there are
many forward curves, but all are based on the same idea. A
forward curve is like a time machine: it tells you what
the market is "predicting" the current yield curve
will look like at the same forward in time.
Embedded in the current yield curve are forward curves for
various forward times. For example, the "one-year
forward curve" tells you what the current yield curve is
predicting the same curve will look like in one year. The
"two-year forward curve" tells you what the current
yield curve is predicting the same curve will look like in two
years.
The yield curve isn't really predicting changes in the way an
astrologer or palm reader might, and as
a time machine, a forward curve is not very accurate.
If it were, derivatives traders would be even richer than they
already are. Instead, the yield curve's predictions arise almost
like magic but not quite, out of arbitrage --- so called
riskless trades to capture price differences between bonds ---
in an active, liquid bond market.
Continued on Page 58 of the book.
|
The important point is that the value of the
interest rate swap derivative contract (the hedge) is usually an
"inaccurate" estimate, whereas the value of the hedged item
(e.g., a bond) may be highly accurate. If the hedge qualifies for
the Shortcut Method under FAS 133, then the need to use such inaccurate
value estimates in hedge effectiveness testing is avoided. The
value change in the hedge can be assumed to be perfectly correlated
(that is negatively correlated) with the value change in the hedged
item. Changes in value of the hedge thereby are assumed to
perfectly offset changes in the value of the hedged item in the case of
a fair value hedge.
For students seeking to learn more about derivatives and hedges,
there are some important free papers by Ira Kawaller at http://www.kawaller.com/articles.htm
. Several of the more important papers related to the topic at
hand are noted below:
- "Yield
Curve Implications of Interest Rate Hedges," A
Chicago Mercantile Exchange Strategy Paper. Originally
published as "Hedge Interest Rates Now. . . Before It's Too
Late," Journal of Derivatives, Spring 1998
- "The
New World Under FAS 133 – (Strategies Involving Cross-Currency
Interest Rate Swap Contracts)," GARP Review,
December 2001/January 2002
- "FAS
133: System Worries," Bank Asset/Liability Management,
May 2001.
- "The
Impact of FAS 133 on the Risk Management Practices of End Users of
Derivatives," Association for Financial Professionals,
May 2001
- "The
New World Under FAS 133 – (Strategies Involving Cross-Currency
Interest Rate Swap Contracts)," GARP Review,
December 2001/January 2002
Differences between tax and FAS 133 accounting are discussed in the
following paper by Ira Kawaller and John Ensminger:
"The Fallout
from FAS 133," (With John Ensminger), Regulation (The CATO
Review of Business and Government), Vol. 23, No. 4, 2000.
With respect to the Shortcut Method, I want to call your attention to
the following December 2000 message from Ira:
Hi Bob,
I
wanted to alert you to the fact that I've added a new article to my
site, " The Impact of FAS 133 Accounting Rules on the
Market for Swaps, " which just came out in the latest issue of
AFP Express. It deals with the consequences of not qualifying for
the shortcut treatment
when interest rate swaps are used in fair value hedges. (It's
not pretty.)
,
I'd be
happy to hear from you.
Ira
Kawaller & Company, LLC
(718) 694-6270
kawaller@idt.net
www.kawaller.com
A Passage From "Impact
of Accounting Rules on the Market for Swaps,"
by Ira Kawaller, Derivatives Quarterly, Spring 2001
HEDGING
WITH INTEREST RATE SWAPS
Applying these rules to
interest rate risks requires an understanding that both fair
value hedge accounting and cash flow hedging will be used,
depending on the nature of the interest rate exposure.
Specifically, if the intention is to manage the risk of
uncertain interest expenses or revenues associated with a
variable-rate debt security, then cash flow treatment is
appropriate. If the intention is to manage the risk associated
with a fixed-rate security, on the other hand, fair value hedge
treatment is required.
Consider two examples.
In a case where an investor holds the fixed-rate security as an
asset, the fair value hedge treatment may be reasonable and
intuitive. After all, the hedger’s objective is to safeguard
its value. Locking in some value for this security is perfectly
consistent with the fair value hedge approach.
In contrast, however,
the hedger who issues fixed-rate debt and decides to swap from
fixed to floating reflects a different kind of thinking. The
objective of this hedge is not to offset present value effects,
but to generate prospective cash flows that, when consolidated
with the debt’s coupon payments, will result in a total
interest expense that replicates the outcome of a variable-rate
loan.
It is well known that
interest rate swaps generate precisely this set of cash flows,
which suggests that cash flow hedging rules should be followed.
But this is not the case. When the hedged item is a
fixed-rate security, the FASB has mandated that fair value
accounting is the only applicable accounting treatment.
Unfortunately, in many cases, this requirement will foster an
accounting result that is at odds with the economics of the
transactions. This seeming ineffectiveness is a consequence of
the requirement to use fair value hedge accounting. It does not
result from the hedge being inappropriate or badly designed.
The shortcut method
will circumvent this problem. Qualifying to use shortcut
treatment, however, requires that the features of the swap
(i.e., the notional amount, payment and reset dates, and rate
conventions) match precisely to those of the debt being hedged.
If they do, the change in the carrying amount of the hedged item
is set equal to the gains or losses on the swap, net of swap
accruals, rather than to the change in the value of the bond due
to the risk being hedged. Thus, the resulting accounting under
the shortcut method replicates the current "synthetic
instrument" accounting. Without
the shortcut, you get something else.
MEASURING HEDGE
INEFFECTIVENESS
To get a better idea of
how serious failing to qualify for the shortcut treatment can
be, consider the FASB’s own example,* in which a hedger issues
five-year, fixed-rate debt. The debt has a par value of $100,000
and a coupon rate of 10%. The hedging instrument is a five-year
swap, receiving 7% fixed and paying LIBOR. The risk being hedged
is the benchmark LIBOR-based swap rate. The example
assumes a flat yield curve, which simplifies the calculations.
According to the
FASB’s calculations, a 50-basis point change in the
LIBOR-based swap rate will foster a change in the fair value of
the swap of $1,675. If the hedger elects, and qualifies for, the
shortcut method, the $1,675 would be used for both the swap and
the adjustment to the carrying amount of the debt. These two
contributions to earnings would be exactly offsetting, so that
the ultimate effect on earnings would distill to interest
accruals of the debt and the swap, respectively. The synthetic
instrument outcome would be realized, where the effective
interest rate would be LIBOR plus 3%. (The 3% spread over LIBOR
comes from the difference between the 10% fixed rate on the debt
versus the 7% fixed rate on the swap.) Without the election of
the shortcut method, the swap would generate the same income
consequences as above, but the adjustment to earnings from the
hedged item’s response to the change in the LIBOR-based swap
rate would be different—$1,568 instead of $1,675. This
seemingly small difference of $107 is misleading, however.
On a yield basis, this discrepancy translates to an interest
rate effect of 43 basis points, i.e.
0 43% =
[107/100 000] X [360/90]
So the question is: If
a company is considering swapping from fixed- to floating-rate
debt, and the result could end up being 43 basis points—or
more—away from the intended outcome, will that company still
go ahead with the hedge? For the many (possibly the vast
majority of ) potential swappers, this magnitude of uncertainty
will be unacceptable and the answer will be no. The recourse
will be to take whatever steps are necessary to ensure that the
prospective hedge will qualify for the shortcut method.
GOOD NEWS
The good news is that
if entities do qualify for the shortcut treatment, the
requirement to document that the hedge will be highly effective
becomes moot. The act of qualifying ensures effectiveness. The
bad news is that the criteria for qualifying are restrictive.
The underlying debt securities have to be "typical,"
presumably lacking bells and whistles that may have served to
reduce costs for issuers in the past.
Thus, for those firms
with "atypical" debt on their balance sheet, either as
assets or liabilities, for which the shortcut method is
prohibited, the perfectly functioning interest rate swap will no
longer work. And for those cases where the debt security
qualifies but the terms of the associated swap do not match up
properly, firms will likely want to trade out of their existing
swap positions and enter into swaps that do qualify for shortcut
treatment. In the longer run, the appetite for anything but
plain vanilla swaps may all but disappear if concerns about
potential income volatility come to dominate in the decision
about which hedging strategy or tool to employ.
Continued at http://www.kawaller.com/pdf/Impact.pdf
|
|
Short Sale = see short.
Soft Currency =
a currency that depreciates rapidly because-use
of the country's high inflation rate. Soft currencies are less actively traded on world
markets than hard currencies and are often subject to strict controls by the country's
central bank.
Software
A bit of a review is provided at
http://www.cfoeurope.com/displayStory.cfm/1736487
Alternative approaches to testing hedge effectiveness under SFAS
No. 133 ---
http://www.allbusiness.com/accounting/methods-standards/209328-1.html
A Listing
of Some Hedge Accounting Restatements for 2005 (see Page 3 of the online
version)
"Lost in the Maze Problems with hedge accounting caused a wave of restatements
in 2005: Are FASB's rules too hard to follow, or are companies simply too
lax?" by Linda Corman, CFO Magazine, May 2005 ---
http://www.cfo.com/article.cfm/6874855/1/c_8435337
Alternative approaches to testing hedge effectiveness under SFAS No. 133 ---
http://www.allbusiness.com/accounting/methods-standards/209328-1.html
Derivatives One has some basic free tools ---
http://www.derivativesone.com/kb/hedge_effectiveness.aspx
There are a number of commercial vendors of FAS 133 and IAS 39 compliance software.
A sampling is shown below:
FinancialCAD --- http://www.financialcad.com/
FinancialCAD provides software and services that
support the valuation and risk management of financial securities and
derivatives that is essential for banks, corporate treasuries and asset
management firms. FinancialCAD’s industry standard financial analytics are a
key component in FinancialCAD solutions that are used by over 25,000
professionals in 60 countries.
Also see
http://www.cfo.com/article.cfm/3002428/c_3046496
COMSOL ---
http://www.comsol-online.com/content.php?si=317&id=134
INNSINC ---
http://www.inssinc.com/?issadsrc=google&gclid=CO38pY7f_I4CFTaoGgodgyqT2w
FUTRAK workstation offers all of the
features necessary to significantly reduce the time required to manage your
hedging activities, provide management with all the control tools necessary
to comply with SarbOx 404, satisfy auditors with documentary evidence needed
to justify your company's use of derivative hedge accounting, and eliminate
earnings volatility.
Also see
http://www.bobsguide.com/guide/news/21544.html
Hedge Trackers ---
http://www.hedgetrackers.com/whatweoffer/toolsandsoftware.htm
TPG Software ---
http://www.tpgsoftware.com/CustServiceCenter/Docs/Windows/DerivativeGenius_files/DerivativeGenius.htm
MBRM ---
http://www.mbrm.com/
Allegro (especially good for energy companies) ---
http://www.allegrodev.com/solutions_app_riskMgmt.asp?c=positions
Sunguard Bancware ---
http://www.sungard.com/bancware/menus/brochures/bancwarealmbrochure.pdf
Treasury Compliance ---
http://www.fas133.com/search/search_article.cfm?page=11&areaid=362
"What’s a “big” system? February 20, 2001, by
Nilly Essaides --- http://www.fas133.com/search/search_article.cfm?page=11&areaid=362
Looking for a “big” system to solve your FAS 133 and risk
management needs? You may be looking in the wrong place, depending on
your definition of “big.”
The term “big” and “small” have been commonly used in
describing software applications. But what does it really mean? Does big
mean complex or fully integrated? Does small mean cheap or simple?
It used to be that “big” meant expensive systems requiring an
army of on site consultants to help implement and configure. The bigger
the price tag, it seemed, the bigger the system. But is price tag still
the determining factor? With new web technologies and risk management
accounting requirements, the definition of size may be irrelevant or at
least in a state of flux.
As the dust settles on the vendor universe in our FAS 133 System
Survey it appears that some expensive systems, and some very inexpensive
ones may both fall into the “big” category. The key: Being able to
track the hedge through the FAS 133 hedge accounting process,
dynamically and with a clear audit trail.
The compliance process
Compliance with FAS 133 is an ongoing process, with four distinct
elements:
(1) Calculating fair value. Step one in the compliance process is
valuation of hedges and underlying exposures. While some companies have
had their own pricing capability for some time, many others have relied
on banks and other providers for that information. With FAS 133 now a
reality, companies with anything more than a handful of derivatives are
better off having their own fair value (hence system and pricing feed)
capacity. (Although the FASB has not prescribed a particular fair-value
model—leaving that up to the market and auditors’ discretion. That
means that some companies may be able to continue relying on the values
provided by the banks’ monthly swap ticket, for example.)
(2) Performing effectiveness testing. For companies deciding to go
for special accounting, the core of FAS 133 is the effectiveness test.
It’s important to remember hedge accounting is an option that some
companies may choose to forego. “Quite a few of our large European
clients have opted not to do hedge accounting,” reports Ritta Kuusela,
accounting product manager with software vendor Trema. “They just
decided that it’s too much hassle.” The same is true with some large
US MNCs as well.
However, that said, companies that want special accounting will need
to run the hedge and underlying through some rigorous testing. FAS 133
not prescribe exactly what sort of test companies must use. The standard
(and consequent DIG/FASB guidance) requires two types of tests: One for
measuring prospective effectiveness or the likelihood of highly
effective offset of fair value, and the other, an ongoing measure of
actual, dollar offset. Our survey shows a certain common threat among
the various tests offered by compliant systems, but the jury is still
out on the “best” test. Some outsiders, like fixed income specialist
Andrew Kalotay of Andrew Kalotay Associates Inc., maintain that it’s
critical that companies identify a test that works for risk management
and accounting purposes. Some of the accounting-focused testing, he
cautions, may result in non-effective hedges and hits to the income
statement.
(3) Making the accounting entries – Finally, there’s the need to
make the actual G/L entries that correspond to the results of the
effectiveness test and fair value models. These entries are tedious and
confusing and a challenge that perhaps can be only alleviated using an
integrated system approach. We’ve addressed these issues at length
with our FAS 133 System Readiness Survey.
(4) Documentation, documentation, documentation. However, underlying
all three compliance process elements is the constant need for
documentation. Companies need to document compliance from day 1 of the
hedge, through effectiveness testing as well as any changes in the risk
management activity.
“Documentation does not mean a long and verbose document about your
hedge policy,” explains Elie Zabal, CEO of software vendor Inssinc,
whose product Futrak 2000 provided perhaps the most extensive “documentation”
back up among our early-bird respondents to the FAS 133 system survey.
Rather, he says, “it’s the ability to dynamically track your hedges.”
For example, what happens when treasury decides to terminate a hedge,
unexpectedly? The system needs to know to generate a memo, noting the
hedge was terminated, while keeping OCI gain/loss in OCI until the
underlying exposure is recognized, which could be months later. “The
real issue is being able to prove what you did, that what you are doing
is correct and that you are not manipulating earnings.”
While FAS 133 has no restrictions on terminating hedges, it is
sensitive to any attempts to manipulate income numbers. In addition,
notes Brian Ferguson of Open Link Financial, systems must be able to
track component hedges or components of a hedged portfolio and make the
necessary entries to OCI and income, and produce the reports.
Indeed, this latter phase of the compliance process may be the most
taxing. “Effectiveness and mark-to-market are the simplest components,”
argues Mr. Zabal. He notes that mark-to-market values for hedgers need
only be derived once a quarter under FAS 133. Plus, there are no precise
requirements as to the “quality” of that number and its precision
(i.e., the type of fair value methodology/model hedgers should use).
“Fair value for traders operating with razor-thin margins is one
thing; fair value for periodic accounting evaluations is another.
Companies with a handful of hedges may simply rely on their banks for
this quarterly valuation,” he says. “I would not trade on this
value, but it’s sufficient for fair valuing..” However, you would
still need a system to track and document effectiveness, generate
journal entries and recognize AOCI at the right time. “That,” says
Mr. Zabal, “no bank can do for you.” As to more active hedgers –
they probably already have ways to price their instruments, and if they
don’t they should.
Meeting the process challenges So how can you tell a big system from
a small one? As far as FAS 133 is concerned, big systems are the ones
that truly allow you to continue your hedging business undisturbethe
system creates the audit trail that the auditors and the SEC will need
to see. That means being able to terminate hedges, hedge portfolios,
etc., while the system keeps track of OCI values and entries, and
generates the necessary memos regarding hedge activity.
In addition, look for a system that gives you more than just
compliance, but allows you to improve the risk management culture, for
example one that includes an effectiveness test that offers real insight
into the chances that your hedge will remain effective throughout its
life. |
The FAS133 Compliance Module Wall Street Systems --- http://www.wallstreetsystems.com/fas133/news-compl.htm
"FAS 133’s bias against macro hedging, its focus on individual
hedges, and its demanding detailed disclosure will generate a quarterly
calculation nightmare for many companies."
--Jeff Wallace, Greenwich Treasury Advisors, LLC
In June of 1998, The Financial Accounting Standards Board released
Statement Number 133. This statement revised accounting and reporting
standards for derivative instruments. It requires that banks and
corporations classify derivatives as either assets or liabilities and
that these instruments be measured at "fair value".
The accounting steps necessary to bring a bank or a corporation into
compliance with Statement 133 are substantial. Exposures must be linked
to hedges, instruments must be fairly valued, and the results must be
appropriately posted. Following this inventory and accounting process,
firms must report hedge effectiveness. The reporting requirements under
this statement require full documentation of objectives and policies and
require a variety of reporting summaries in various formats.
The process of identifying derivatives in itself presents substantial
complexities. The definition of a derivative is broad and includes
instruments such as insurance policies, production contracts,
procurement contracts and other "non-financial" obligations.
Because of the complexities of inventory, accounting, and reporting
associated with compliance to Statement 133, the Financial Accounting
Standards Board delayed implementation of this standard believing that
neither system developers nor treasuries would be ready to handle these
new requirements.
Wall Street Systems is in the business of creating enterprise-wide
client/server front to back treasury solutions for the largest banks and
corporations in the world. This product, The Wall Street System,
integrates all geographies, all financial products, all credit and
market risk controls, and all accounting, confirmation, and cash
management processes into a single, global, real-time, 24/7 system.
Because of the strength of this straight-through processing system,
and because The Wall Street System has long offered the capability to
capture exposures and perform fair market valuations of derivative
transactions, Wall Street Systems was able to offer a fully functioning
FAS133 Module to its customers in advance of the original FAS 133
implementation date.
The Wall Street Systems FAS 133 Module reports hedge gains and losses
at fair market value each day. The hedge tracking and linking feature
packages exposures and hedge transactions together and automatically
adjusts earnings and Other Comprehensive Income (OCI) accounts. The
module also creates all reports and documentation required by FAS 133.
The key features of The Wall Street System FAS 133 Module are:
Fair Market Valuation Exposures and derivatives are marked-to-market
and compared through hedge effectiveness ratios Hedge Profile Database
and Query Each hedge package is stored by date. Closing values, changes
in value, and effectiveness ratios are preserved in the database.
Automatic Linking and Tracking Trades and the underlying exposures are
linked to a hedge profile. The profile categorizes the hedge by type and
includes hedge objectives, valuation method, risk management policy and
transaction details. The hedge profile is linked to the documentation.
The combination forms a hedge "package" that drives all FAS
133 events. Cash Flow OCI Adjusting Automatic examination of the P&L
status of each hedge package at the close of business each day.
Automatic adjustment of OCI and P&L accounts. Automatic posting of
derivatives fair market values to earnings with the effective portion of
the hedge reclassified into OCI Audit Capability Time series database
keeps copies of each hedge package status at the close of each day.
There is a full audit query capability imbedded in the database.
Forecasting The System can generate a P&L forecast from the OCI
account that covers the next 12 months.
The comprehensive functionality of the Wall Street System FAS 133
Module is achieved through the application of straight through
processing on a global scale with a system that covers the front, middle
and back office.
Treasurers will have difficulty with FAS 133 compliance if the
treasury runs on a "best of breed" model rather than a global
STP model. In the best of breed model, trading, risk management and
accounting functions are distributed across a mix of systems that share
information with varying degrees of efficiency. For this model to work,
each resident system must capture relevant FAS 133 information to its
database and have the capacity to share that information with all other
member systems. This requires a high degree of flawless data exchange
and systems integration, features not normally associated with the best
of breed solution. A fragmented treasury desktop makes it
extraordinarily difficult to manage hedge relationships from front to
back.
The Wall Street System, being a single global system for 24/7
treasury operations faces none of these data exchange obstacles. Hedge
package information is shared easily, stored safely, and posted
correctly.
The Wall Street System is ready now with a 100% compliant FAS 133
Module
FAS 133, IAS 39 and the importance of integrated treasury systems as
discussed by Keith Bergman Of Wall Street Systems --- http://www.wallstreetsystems.com/fas133/news-risk-mag.htm
The long awaited Financial Accounting Standards Board's (FASB)
Statement of Financial Accounting Standard No. 133 (FAS 133) takes
effect for all publically traded companies beginning with the first
fiscal period after June 15th, 2000. This requires all derivatives to be
fair valued with the change in value recorded on the balance sheet and
in earnings. The statement also requires disclosure and documentation
for all hedging activities.
In the past companies have done little to recognize the fair value of
derivative contracts. Premiums were amortized, discounts were accreted,
and interest was accrued. Now both exposures and hedging instruments
must be fair valued and measured against each other to assure hedge
validity. This assessment and proof of effectiveness must be provided
quarterly at a minimum.
The board's objective is to disclose the market risk potential of
derivative contracts. The Security Exchange Commission has supported
this change ever since Procter & Gamble and American Greetings
incurred substantial losses as a result of derivatives trading activity.
Marking derivatives to market provides investors with a more accurate
picture of a company's current financial position. The result of this
approach is that company earnings are subjected to market volatility.
FAS 133 moves the board closer to their final objective of fair valuing
the entire balance sheet.
Best-of-Breed solutions are no longer feasible. Some firms are at a
disadvantage because they have installed individual systems that provide
specific functionality for specific purposes. These best of breed
solutions individually focus on activities like cash management, debt
issuance, and trading of foreign exchange, options, and swap contracts.
These systems, by their nature, do not share information.
However, these best of breed solutions create an onerous FAS 133
compliance burden. The statement requires integration between exposures
and hedging instruments in order to properly generate the appropriate
accounting entries.
For example, cash management systems will have to fair value foreign
currency cash forecasts on a forward rate NPV basis similar to a foreign
exchange contract. Foreign exchange systems that deferred forward points
in the past will have to mark-to-markets the foreign exchange contract
and record the full value and change in value in both the balance sheet
and in earnings. Then, in order to reduce the resulting income statement
volatility, the effective portion of the hedge, the lesser of the
absolute value maintained within the two separate systems, must be
recorded in Other Comprehensive Income (OCI) leaving the ineffective
portion in Earnings. This requires integration. Otherwise, the FAS 133
requirements will not be met.
Integrated systems such as the Wall Street System are filling the
void. Treasurers are looking for straight-forward deal capture and
position tracking systems that provide real time p&l and can also
determine how much is at risk and how much to hedge in order to comply
with FAS 133. Integrated treasury management systems such as the Wall
Street System do not have the gaps that exist in best-of-breed
solutions. They also provide the only possible way of continuing to
hedge portfolios in a macro sense under the restricted and limited scope
of "Portfolio Hedging".
Macro Hedging under FAS 133 In the past and even today, treasurers
and risk managers have managed to establish macro-hedging strategies
designed to reduce risk. These strategies involve hedging overall net
positions or partial positions and are performed for an economic reason.
FAS 133 completely eliminate the macro hedging approach.
The statement is the accountants attempt to record economic reality
within an accounting framework.
As a result, the statement requires tracking of earnings volatility.
The offsetting effects of macro hedges are no longer recognized. The
board has decided that hedge accounting will only apply if the hedge
proves to be effective. Otherwise, only the change in value of the
derivative gets recorded in earnings with little or no offset. The board
had defined effectiveness to be similar to FAS 80's definition of
"highly correlated" ratio of 80% - 120%. Managers are required
to provide proof that prospectively the hedge is going to remain valid
and retrospectively that the hedge was valid. Recently, the board
allowed managers to used regression analysis and statistical correlation
as proof instead of using the "Dollar Offset Ratio Method".
Macro hedging interest risk under the FAS 133 can only be performed
within the limited framework of "Portfolio Hedging".
"Portfolio Hedging" allows like positions, not netted
positions, to be hedged with an offsetting hedging instrument, usually a
derivative. The concept is that the change in value of each individual
exposure component in the portfolio cannot change by less than or
greater than 90% - 110% of the overall change in value of the portfolio.
If any one component falls outside of the range, then the entire
portfolio does not comply.
Portfolio Hedging Illustration
Exposure Hedging Instrument Total value = 150 Total value = 160
Dollar Offset Ratio (150/160) = 93.75%
Individual Exposure Values Last Period This Period % Change 1. 45 50
90.00% 2. 72 75 96.00% 3. 23 25 92.00% ______ ______ ______ 140 150
93.33%
Note: the combination of the dollar offset ratio being within the
required range and the individual components being within the required
range qualifies the hedge for hedge accounting.
Without an integrated system it is nearly impossible to hedge using
the "Portfolio Hedging" concept because isolated systems
cannot keep track of the packaged transactions.
Special accounting and documentation FAS 133 requires additional
accounting for all three types of hedges. For Cash Flow hedges, since
fair value of the forecasted cash flow or variable rate instrument is
not recorded, the effective portion of the hedge can be removed from
earnings and placed within the equity section of the balance sheet. In
order to determine the effective portion, the system must calculate the
change in value for both the exposure and hedging instrument. The lesser
of the absolute values is placed in Other Comprehensive Income (OCI).
The system must determine the exact amount to be removed from earnings.
Fair Value hedges require the recording of the exposures change in value
in order to offset the earnings effect from the hedging instrument. Net
Investment hedges require the effective portion to be recorded within
Cumulative Translation Adjustment account instead of earnings. Here
again, full system integration is required.
Other Comprehensive Income Calculation and Posting Illustration
Derivative Hedged Item Lesser Earnings Period Cum Period Cum Absolute
OCI Period Change Change Change Change Cum Chg Change Balence Change
Balence 1. 100 100 (96) (96) 96 194 32 96 96 4 4 2. 94 194 (101) (197)
198 194 (4) 0 3. (162) 32 160 (37) (162) 32 0 0
Documentation also poses a challenge if data is distributed among
isolated systems. The statement requires that information be documented
on a per hedge basis. Information regarding the details of the
individual transactions must be disclosed. For those without an
integrated treasury, documentation will be an onerous manual task.
International Accounting Standard 39 The technology issues raised by
FAS 133 will not remain exclusive to the United States for long.
International Accounting Standard (IAS) 39, Financial Instruments:
Recognition and Measurement, Europe's version of FAS 133, 125, 115, and
114, is on its way with the effective date on or after 1 January 2001.
Early evaluation of that standard suggests that it will be at least as
rigorous as FAS 133. IAS 39 goes beyond the issue of hedge accounting to
require that all financial assets and liabilities must be initially
measured at cost. For derivatives and traded assets and liabilities, an
additional adjustment is required to record the instrument's fair market
value. IAS 39 provides the choice of placing the change in value
entirely within earnings or within the equity section of the balance
sheet. However, the statement only allows the non-traded portion of the
financial instrument to be placed within the equity section of the
balance sheet. Since all derivatives are considered trading instruments,
the entire change in value must be placed within earnings. Unlike FAS
133, IAS 39 allows financial assets and liabilities to be used as valid
hedging instruments for hedging of foreign currency risk. FAS 133 only
allows this for hedging a net investment in a foreign currency. Like FAS
133, hedge accounting is permitted under IAS 39 as long as the hedge is
clearly defined, measurable, and effective.
Wall Street System's Approach At Wall Street Systems, we have kept
both FAS 133 and IAS 39 in mind when developing our compliance product.
As a provider of a fully integrated treasury solution, we have been able
to leverage the advantage of complete integration into a product that
totally complies with both the FAS 133 and IAS 39 standards. With a
system that, by its very nature, posts changes in derivative values for
traders and management across the entire treasury operation, we have the
necessary system architecture in place to allow us to develop a product
that would meet the standards. The regulatory and operational
environment will grow more complex over time. Technology planning must
incorporate this assumption and turn toward effective integration
strategies to meet the challenges ahead.
|
For other software see fair value, Ineffectiveness,
and Risk Metrics )
Special Purpose Entities (SPE
Accounting and FIN 46)
What's Right and What's Wrong With (SPEs),
SPVs, and VIEs ---
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm
Spot Price or Spot Rate =
the current market price of a commodity or the
current market rate for interest or foreign exchange conversions. Importance of spot
prices or spot rates appears in nearly every SFAS example. For instance see
Example 10 Paragraphs 165-172.. Also see intrinsic value,
Tom/Next and yield curve.
Stock
Appreciation Right = =
a form of employee compensation that gives cash
or stock to employees based upon a contractual formula pegged to the change in common
stock price.
Stop-loss/Take-profit =
a strategy under which a company asks a dealer to buy or
sell a currency if and when a particular rate is reached. Assuming the willingness and
reliability of the dealer, it can be an inexpensive alternative to an option.
Stress Test
See
Stress Test
Strike Price =
the exercise price of an option. This is a key
component in measuring an option's intrinsic value.
See option .
Strip =
see interest-only
strip, principal-only strip, and embedded derivatives.
Structure =
The term "structure" is ambiguous until placed in a
particular context. In one context a "structured note" is a derivative
financial instrument or combination of such instruments whose value is based on
an "underlying" index. It may also refer to using a swap to change the
cash flows of a financial instrument. It can be a synthetic substitute for a
financial instrument that is not a derivative. In another context,
"structured" may mean something else entirely. Structured financing
may, in one context, refer to financing based upon anticipated cash flows rather
than current value of an asset or collateral. See Compound Derivatives and Synthetic.
With the credit markets convulsing and
merger activity slowing, what, pray tell, is the fate of law-firm associates who
serve the titans of Wall Street? For sure, the most vulnerable are lawyers in
so-called structured-finance practices. These are attorneys involved in the
process of packaging assets such as mortgages, auto loans or credit-card debt
into securities. But will layoffs creep into other practice areas as well?
Peter Lattman, "Structured Finance Proves To Be a Vulnerable Area," The Wall
Street Journal, January 16, 2008; Page B17 ---
http://online.wsj.com/article/SB120045941678994161.html?mod=todays_us_marketplace
For technical details see the following
book:
Structured Finance and Collateralized Debt Obligations: New Developments in
Cash and Synthetic Securitization (Wiley Finance) by Janet M. Tavakoli
(2008)
Finance Tutorial (of sorts): A Primer on Foreign Exchange
Derivatives
"Of Knock-ins, Knock-outs & KIKOs," by Ranju Sarkar, Business Standard,
April 2, 2008 ---
Click Here
http://www.business-standard.com/common/news_article.php?leftnm=0&subLeft=1&chklogin=N&autono=318661&tab=r
OPTIONS |
|
Option is a contract which gives a buyer a
right, but not an obligation, to buy an underlying/ currency/ stock/
commodities at a pre-determined rate, known as strike price, for
settlement at a future day. The right to buy is called a call
option. The right to sell is called a put option. There are
different types of options. |
|
Knock-out option: An option which
ceases to exist if the knock-out event occurs. A knock out happens
when a particular level is hit (like the Swiss franc touching the
level of 1.10 against the dollar), when the option ceases to exist.
|
|
Knock-in option: An option which
comes into existence if the knock-in event happens. It works exactly
the reverse of a knock-out. In a knock-in, an option comes into
existence if a certain level is hit. |
|
KIKO (knock-in, knock-out): This is
an option with both a knock-in and knock-out. The option kicks in,
or comes alive, if the knock-in is seen. The option ceases to exist
if anytime, pre or post, the knock-in event happening, the knock-out
happens. |
|
One-touch option: When a certain
level (of any currency pair) is hit, a company buying an option gets
a pre-determined pay-off (it could be $10,000, $20,000, or $30,000).
This is how companies made money through derivative deals last year.
|
|
Double-touch option: There are two
levels. If either of the two levels is hit, the company buying an
option will get a pay off. All options require a buyer to pay a
premium. Conversely, sellers of options would receive a premium.
|
|
STRUCTURES |
|
Banks, foreign exchange consultants work
out zero-cost option structures/ strategies for companies so that
they don’t have to pay any premium. To make a zero-cost structure, a
company has to buy some option and sell some option so that the
premium is zero (the premium paid for buying an option is set-off
against the premium received for selling the option). |
|
For instance, when the rupee-dollar parity
is 40.10, an exporter buys a put option at the rate of 39.50, and
sells a call option for 41.00 for delivery of exports at the end of
June, July and August an export commitment of $1 million each month.
By entering into this contract, the best rate the exporter can get
is 41, and the worst rate it can get is 39.50. |
|
If the rupee goes below 39.50, the
exporter will be able to encash its receivables at the rate of
39.50. If the rupee is trading between 39.50 and 41, the exporter
will be able to encash its receivables at the prevailing market
rate. |
|
However, if the rupee is ruling above 41,
it will get its receivables at Rs 41 as he’s locked in that level.
This kind of structure is popular with software companies, who can
realise their receivables in a range (between the best and worst),
unlike in a forward contract where they get locked in at a
particular rate. |
|
Banks also offer, what they call, a 1:2
leveraged option, wherein a company buys some calls, makes some puts
and use a combination of these to create zero-cost strategy for the
company. Companies that have big positions in derivative trades have
been selling KIKOs, or a series of KIKOs and buying one-touch
options and double-touch options. These structures helped companies
make money last year. |
Continued in article
Bob Jensen's links to accounting, finance, and business glossaries ---
http://faculty.trinity.edu/rjensen/Bookbus.htm
Bob Jensen's links to FAS 133 and IAS 39 Accounting for Derivative Financial
Instruments Glossary ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Bob Jensen's FAS 133 and IAS 39 Tutorials on Accounting for Derivative
Financial Instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Struggle
Statement =
a statement of unrecognized gains and losses that
do not impact upon the derivation of net income. The term is used in England where
struggle statements are used in place of disclosing unrecognized gains and losses in
equity statements or comprehensive income disclosures pursuant with SFAS 130. The
IASC permits struggle statement disclosures of unrecognized cash flow hedge gains and
losses, whereas the FASB in the United States requires the use of comprehensive income
accounting. Paul Pacter briefly refers to the struggle statement in my pacter.htm file. See comprehensive income.
Click here to view Paul Pacter's commentary on
the struggle statement.
Swap =
an agreement in which two parties exchange
payments over a period of time. The purpose is normally to transform debt payments from
one interest rate base to another, for example, from fixed to floating or from one
currency to another. See swaption, currency
swap, contango swap, earnings
management, and interest
rate swap .
Swaption =
an option on a swap. Swaptions are usually interest rate options used to hedge
long-term debt. When a company has an interest rate swap, a swaption can be used to
close out the swap. A swaption can also be used to enter into an interest rate
swap. The majority are European options in terms of
settlements. Swaptions may be cash flow hedges, including written swaptions (i.e. a written option on a swap). Paragraph 20c on Page 12 makes
it possible for a swaption to qualify as a fair value hedge under the following
circumstances:
If a written option is
designated as hedging a recognized asset or liability, the combination of the hedged item
and the written option provides at least as much potential for gains as a result of a
favorable change in the fair value of the combined instruments as exposure to losses from
an unfavorable change in their combined fair value. That test is met if all possible
percentage favorable changes in the underlying (from zero percent to 100 percent) would
provide at least as much gain as the loss that would be incurred from an unfavorable
change in the underlying of the same percentage.
One of my students defines the following
types of swaptions:
call swaption - type of swaption giving the
owner the right to enter into a swap where he receives fixed and pays floating
callable swap - type of swaption in which the fixed payer has the right, but not the
obligation, to terminate the swap on or
before a scheduled maturity date
expiration date - date by which the option must be exercised
extendible swap - type of swaption in which the counterparties have the right to extend
the swap beyond its stated maturity date as per an agreed upon schedule
put swaption - type of swaption giving the owner the right to enter into a swap where he
receives floating and pays fixed
putable swap - type of swaption in which the variable payer has the right, but not the
obligation, to terminate the swap on or before a scheduled maturity date
Her entire project is linked below:
Suzanne M. Winegar For
her case and case solution entitled Understanding swaptions: A case study click
on http://www.resnet.trinity.edu/users/swinegar/swaption.htm
. She writes as follows:
The objective of this case is to
provide an example of a company that purchases an interest rate swaption in order to hedge
the variability of its interest payments. Swaptions are a type of derivative financial
instrument for which there are no accounting standards or guidelines. This case explains
one method that could be used to account for swaptions and mark them to market. In order
to mark the swaptions to market, this case uses the Black-Scholes Model to determine the
fair value of the swaption. The case presents a series of questions dealing with valuation
and accounting issues, and ends with a discussion of the risk involved in using swaption
derivatives.
Swaption Valuation
Start
here ---
http://en.wikipedia.org/wiki/Swaption#Valuation
Especially note the link at
http://en.wikipedia.org/wiki/Volatility_smile#Implied_volatility_surface
More
details are provided at
http://helecon3.hkkk.fi/pdf/diss/a238.pdf
Some books and papers by
Ira Kawaller may be of interest:
http://www.amazon.com/Fixed-Income-Synthetic-Assets-Strategies-Professionals/dp/product-description/0471551627
http://www.sheshunoff.com/ideanet/index.php?itemid=237
Also see
http://search.barnesandnoble.com/The-Complete-Guide-to-Option-Pricing-Formulas/Espen-Gaarder-Haug/e/9780071389976
And
http://books.google.com/books?id=IRW7uu0flG0C&pg=PA202&lpg=PA202&dq=Swaptions+"Kawaller"&source=bl&ots=Nw1ws8w_16&sig=vPAYQ8LguC8mGEH_fsN02p7rJlA&hl=en&ei=kK-OSrDpG4jLlAeNruW1DA&sa=X&oi=book_result&ct=result&resnum=10#v=onepage&q=Swaptions
"Kawaller"&f=false
Synthetic Instrument =
the artificial creation of
an asset using combinations of other assets. For example, call option or a put
option (which amounts to a synthetic long stock), or a long put option and a
short call option (a synthetic short stock). In the area of futures
contracts, a synthetic long futures position is created by combining a
long call option and a short put option for the same expiration date and the
same strike price. A synthetic short futures is created by combining a long put
and a short call with the same expiration date and the same strike
price. See Compound Derivatives and "Structure."
For technical details see the
following book:
Structured Finance and Collateralized Debt Obligations: New Developments
in Cash and Synthetic Securitization (Wiley Finance) by Janet M.
Tavakoli (2008) |
T-Terms
Tailing Strategy = see futures contract.
Take-or-Pay
A form of contracting commonly used for
off-balance sheet financing. Three or more credit-worthy companies form a joint
venture in which no single company has voting control and does not have to bring the joint
venture into its consolidated financial statements. The joint venture is able to
borrow enormous amounts of capital because of purchase contracts with its owners to
"take the product" such as crude oil produced or "pay" for the product
whether it is taken or not. When the "product" is a pipeline distribution
service rather than a physical product per se, the contracts are generally called
"through put" contracts. The FASB wavered on taking specific action on
such contracts in FAS 133. For details see short.
Tandem Hedge = see foreign currency hedge.
Tax Accounting for
Derivatives
Accounting Tax Rules for Derivatives --- http://www.investmentbooks.com/tek9.asp?pg=products&specific=joongngrm
by Mark J.P. Anson
Publisher's Price: $150
ISBN#: 1883249694
Catalog #: B14982W
Convergence
of Tax and Book Accounting for Derivatives --- http://www.kawaller.com/pdf/HedgeWorld.pdf
Tax Goal of Derivatives
From The Wall Street Journal Accounting Weekly
Review on July 27, 2007
IRS Probes Tax Goal of Derivatives
by Anita Raghavan
The Wall Street Journal
Jul 19, 2007
Page: C1
Click here to view the full article on WSJ.com
---
http://online.wsj.com/article/SB118480967033571172.html?mod=djem_jiewr_ac
TOPICS: Tax Evasion,
Tax Havens, Tax Regulations, Taxation, Accounting, Advanced
Financial Accounting, Derivatives, Personal Taxation, Tax
Avoidance
SUMMARY: "The IRS
has sent requests to Citigroup and Lehman Brothers asking for
information about derivatives trades made with hedge-fund
clients." Offshore investors, including U.S. hedge funds with
offshore locations, will undertake derivative transactions with
names such as "Yield Enhancement," "Dividend Arbitrage," and
"Tax Efficiency." The transactions allow a non-holder of a stock
to purchase a derivative through which the investor will receive
appreciation on an underlying stock, much as a call option will
generate, plus a cash payment equal to a dividend distribution
on that stock. As in a call option, the purchaser pays a fee,
but potentially may avoid significant taxation. In order to
provide the U.S. tax rules in this area, the article quotes a
KPMG memorandum to its professionals alerting them to the IRS
scrutiny."'The United States generally imposes U.S. withholding
taxes on dividends paid by U.S. corporations to foreign
taxpayers...but it does not impose U.S. withholding tax on
foreign source income paid to foreign persons...KPMG say net
income paid to a foreign person is 'generally treated as foreign
source income and, thus, exempt from U.S. withholding tax." On
the other hand, another IRS guideline, Notice 97-66, would
indicate taxation of a foreign person is required if the
derivative transaction is deemed to merely substitute for a
securities lending transaction.
QUESTIONS:
1.) Define the term derivative. Explain how the transactions
described in this article meet the definition of a derivative
security.
2.) The IRS is questioning the business purpose of these
derivative securities other than tax motivations. How could
these transactions provide a valid business purpose or financial
interest for each party to the transaction? (Hint: think of a
call option as an analogy, identifying the value to the buyer
and the seller of the option.)
3.) How are these derivatives possibly used to reduce tax
liabilities? In your answer, comment on the worldwide location
of the recipient of payouts from these derivative securities.
4.) What are the tax rules precluding use of these derivatives
merely to avoid paying taxes? How do these rules rely on
establishing the intent of undertaking transactions in these
derivative securities? (You may refer solely to descriptions in
the article to answer this question.)
5.) How do the names of these derivative securities indicate
that they may be undertaken merely to avoid paying taxes?
Reviewed By: Judy Beckman,
University of Rhode Island
|
Bob Jensen's free FAS 133 and IAS 39 tutorials (including videos) are
linked at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Tax Hedging =
|
FAS 133
permits after-tax hedging of foreign
currency risk and/or market price risk. The hedge must be entered into to reduce
taxes, and the item hedged must be ordinary assets or liabilities in the normal course of
the taxpayer's business.
March 25, 2002 message
from Richard Newmark [richard.newmark@phduh.com]
Bob,
I thought you might be interested in this.
Rick
-------------------------
Richard Newmark
Assistant Professor of Accounting
University of Northern Colorado
Kenneth W. Monfort College of Business
Campus Box 128
Greeley, CO 80639
(970) 351-1213 Office
(801) 858-9335 Fax (free e-mail fax at efax.com)
richard.newmark@PhDuh.com
http://PhDuh.com
IRS
finalizes hedging regs with liberalizations
TD 8985; Reg. § 1.1221-2, Reg. § 1.1256(e)-1
IRS has issued final regs for determining the character of gain or
loss from hedging transactions.
Background. As a result of a '99 law change, capital
assets don't include any hedging transaction clearly identified as
such before the close of the day on which it was acquired, originated,
or entered into. (Code Sec. 1221(a)(7)) Before the change, IRS had
issued final regs in '94 providing ordinary character treatment for
most business hedges. Last year, IRS issued proposed changes to the
hedging regs to reflect the '99 statutory change (see Weekly Alert ¶
6 2/1/2001). IRS has now finalized the regs with various changes, many
of which are pro-taxpayer. The regs apply to transactions entered into
after Mar 19, 2002. However, the Preamble states that IRS won't
challenge any transaction entered into after Dec. 16, '99, and before
Mar. 20, 2002, that satisfies the provisions of either the proposed or
final regs.
Hedging
transactions. A hedging transaction is a transaction entered
into by the taxpayer in the normal course of business primarily to
manage risk of interest rate, price changes, or currency fluctuations
with respect to ordinary property, ordinary obligations, or borrowings
of the taxpayer. (Code Sec. 1221(b)(2)(A)(i); Code Sec. 1221(b)(2)(A)(ii))
A hedging transaction also includes a transaction to manage such other
risks as IRS may prescribe in regs. (Code Sec. 1221(b)(2)(A)(iii)) IRS
has the authority to provide regs to address nonidentified or
improperly identified hedging transactions (Code Sec. 1221(b)(2)(B)),
and hedging transactions involving related parties. (Code Sec.
1221(b)(3))
Key
changes in final regs. The final regs include the following
changes from the proposed regs.
... Both
the final and the proposed regs provide that they do not apply to
determine the character of gain or loss realized on a section 988
transaction as defined in Code Sec. 988(c)(1) or realized with
respect to any qualified fund as defined in section Code Sec.
988(c)(1)(E)(iii). The proposed regs also provided that their
definition of a hedging transaction would apply for purposes of
certain other international provisions of the Code only to the
extent provided in regs issued under those provisions. This is
eliminated in the final regs because the other references were to
proposed regs and to Code sections for which the relevant regs have
not been issued in final form. The Preamble states that later regs
will specify the extent to which the Reg. § 1.1221-2 hedging
transaction rules will apply for purposes of those other regs and
related Code sections.
... Several
commentators noted that the proposed regs used risk reduction as the
operating standard to implement the risk management definition of
hedging. They found that risk reduction is too narrow a standard to
encompass the intent of Congress, which defined hedges to include
transactions that manage risk of interest rate, price changes or
currency fluctuations. In response, IRS has restructured the final
regs to implement the risk management standard. No definition of
risk management is provided, but instead, the rules characterize a
variety of classes of transactions as hedging transactions because
they manage risk. (Reg. § 1.1221-2(c)(4); Reg. § 1.1221-2(d))
... The
proposed regs provided that a taxpayer has risk of a particular type
only if it is at risk when all of its operations are considered.
Commentators pointed out that businesses often conduct risk
management on a business unit by business unit basis. In response,
the final regs permit the determination of whether a transaction
manages risk to be made on a business-unit basis provided that the
business unit is within a single entity or consolidated return group
that adopts the single-entity approach. (Reg. § 1.1221-2(d)(1))
RIA
observation: As a result of the two foregoing changes made
by the final regs, more transactions will qualify as hedging
transactions. This is good for taxpayers because any losses from
the additional transactions qualifying as hedges will be
accorded ordinary treatment.
... In
response to comments, the final regs have been restructured to
separately address interest rate hedges and price hedges. (Reg. §
1.1221-2(d)(1)(iv); Reg. § 1.1221-2(d)(2))
... In
response to comments, the final regs provide that a transaction
that converts an interest rate from a fixed rate to a floating
rate or from a floating rate to a fixed rate manages risk. (Reg.
§ 1.1221-2(d)(2))
... The
final regs provide that IRS may identify by future published
guidance specified transactions that are determined not to be
entered into primarily to manage risk. (Reg. § 1.1221-2(d)(5))
... The
proposed regs sought comments on expanding the definition of
hedging transactions to include transactions that manage risks
other than interest rate or price changes, or currency
fluctuations with respect to ordinary property, ordinary
obligations or borrowings of the taxpayer. While comments were
received, the final regs did not make any changes in this area.
However, IRS continues to invite comments on the types of risks
that should be covered, including specific examples of derivative
transactions that may be incorporated into future guidance, as
well as the appropriate timing of inclusion of gains and losses
with respect to such transactions.
... With
respect to the identification requirement, a rule has been added
specifying additional information that must be provided for a
transaction that counteracts a hedging transaction. (Reg. §
1.1221-2(f)(3)(v))
RIA
Research References: For hedging transactions, see FTC 2d/FIN ¶
I-6218.01 ; United States Tax Reporter ¶ 12,214.80
See hedge.
|
Tax Rate Swap =
a swap of tax rates. One of my students wrote the
following case just prior to the issuance of FAS 133:
Jennifer K. Robinson
For her case and case solution entitled TAX RATE SWAPS click on http://www.resnet.trinity.edu/users/jrobinso/Jensen.html
. She states the following:
This case examines an unusual
type of derivative called a tax rate swap and its accounting treatment. Tax rate
swaps are rare due to the relatively stable nature of tax rates in most nations. In
certain circumstances, however, they can provide an effective means for one company to
"lock-in" its current tax rate while another company speculates that that rate
will change in its favor. Examination of this case should provide an introduction to the
workings of a tax rate swap, as well as the suggested accounting treatment for such a
transaction. (Note: It is important to know that tax rate swaps, described in this paper,
and tax swaps are very different.)
Term Structure = =
yield patterns in
which returns of future cash flows are not necessarily discounted at the same interest
rates. Yield curves may have increasing or decreasing
yield rates over time. However, it much more common for the rates yields to increase
over time. Theories vary as to why. One theory known as expectations theory
based on the assumption that borrowers form long-term expectations and then choose a
rollover strategy if short-term rates are less than long-term expectations and vice
versa. Lenders form their own expectations. Expectations theory postulates
that long-term interest rates are a geometric average of expected short term interest
rates. Liquidity preference theory postulates that investors add a liquidity
preference premium on longer-term investments that gives rise to an upward sloping yield
curve. Liquidity preference theory is not consistent with the averaging process
assumed in expectations theory. Market segmentation theory is yet another theory
used to explain term structures. That theory postulates that the supply and demand
for money is affected by market segments' demands for short term money that in turn
affects the cost of coaxing short term lenders into making longer commitments.
Whatever the reasons, yield vary with the time to maturity, and this
relationship of yield to time is known as term structure of interest rates. See yield curve.
Time Value of an Option = see intrinsic value.
Tom/Next =
tomorrow next, a spot foreign exchange quotation for
settlement the next business day rather than in the usual two business days. Rates for
"tom/next" quotations are adjusted on a present-value basis.
|
Tranches
Tricks with
Derivatives to Hide Rather Than Manage Risk: What is a tranche?
"DEBT TRICKS: Covering Their
Assets," Fortune Magazine, March 4, 2002, by Julie Creswell --- http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=206542
So you think you escaped Global Crossing and Enron? Surprise! Banking's
dastardly debt trick may leave you vulnerable.
For all the talk of
what banks have done wrong lately (huge write-downs! swelling bad debt!),
they've also done something right: passed the buck.
Turns out it's not
just lenders like J.P. Morgan Chase and Citigroup that are on the line for
billions in loans to now-bankrupt entities such as Enron and Global
Crossing; it's a host of hedge funds, insurance companies, and even
retirement plans that bought slickly repackaged debt from them. While these
complicated "credit derivatives" helped banks sidestep even bigger
losses and possibly prevented systemic stress on the banking system by
diffusing liabilities, unwitting investors may soon be in for a rude
awakening. "One way or the other, somebody is sitting on a huge amount
of risk," says Doug Noland, financial market strategist at David W.
Tice & Associates. Indeed, federal banking regulators are increasing
scrutiny of moves that push risky transactions off bank balance sheets,
while the SEC is looking into PNC Financial for its debt-repackaging
dealings. Though only the first repercussions of the credit-derivative
fallout have been felt, "there's going to be a huge problem,"
predicts Noland. "Something's going to blow up."
Here's why: One
of the more common hedges banks used is called a collateralized-debt
obligation, or CDO, a bundle of around 50 corporate loans that is sliced and
diced into pieces called tranches. In theory, the resulting product is akin
to a mutual fund--one or two defaults don't taint the whole batch. Each
tranche carries a degree of risk, from investment grade to--in trader's
parlance--"toxic waste." That's why safety-conscious insurance
companies and pension funds snapped up the higher-rated, lower-yielding
tranches, while hedge funds and investors seeking higher returns bought the
riskier tiers.
Banks love
transforming loans into these derivatives because they don't have to reserve
as much capital on their balance sheets, which frees up more money for new
loans. CDOs are fairly new, but they're the fastest-growing fixed-income
sector. In the past five years the market has swelled from a few billion
dollars to more than $500 billion. When all goes as planned, investors love
CDOs too--they get a steady stream of interest payments.
But this time
around everything didn't go as planned. Banks started ramping up CDO sales
in the late 1990s when default and bankruptcy rates were at historic lows;
that persuaded less experienced investors to bite. Banks "became very
good at using financial engineering to make credit risk more palatable to
the end buyer," says Charles Peabody, a banking analyst at brokerage
firm Ventana Capital. "But that risk just doesn't disappear." The
sharp increase in defaults--from telecom startups to Kmart--caught buyers
off guard, thus throwing CDOs into downgrades and losses. American Express'
financial advisors group learned that lesson the hard way: It bought a batch
of CDOs in 1997 to juice returns and last summer was forced to take an $860
million charge related to that ill-fated purchase. Furthermore, "there
is a certain lack of transparency" in some types of CDOs, explains
Mitchell Lench, senior director of European CDOs for Fitch Ratings.
Investors "know the ratings, the industries, and the amount of exposure
they have to the industries, but after that, it's kind of a guessing
game."
As the aftermath of
the credit-derivatives game unfolds, expect to see some angry players.
Bob Jensen's
threads on derivatives financial instruments frauds are at
http://faculty.trinity.edu/rjensen/fraud.htm#DerivativesFraud
|
Trading Security =
see available-for-sale security and held-to-maturity.
Flow Chart for Trading Hedge Accounting ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Transaction =
a particular kind of external event, namely, an external
event involving transfer of something of value (future economic benefit) between two (or
more) entities. The transaction may be an exchange in which each participant both receives
and sacrifices value, such as purchases or sales of goods or services; or the transaction
may be a nonreciprocal transfer in which an entity incurs a liability or transfers an
asset to another entity (or receives an asset or cancellation of a liability) without
directly receiving (or giving) value in exchange (FASB Concepts Statement
6, paragraph 137).
Internal cost allocations or events within a consolidated
reporting entity are not transactions. Internal cost allocations include depreciation and
cost of sales. Events within a consolidated reporting entity include intercompany
dividends and sales.
Transaction Date =
the date at which a transaction (for example, a sale or
purchase of merchandise or services) is recorded in a reporting entity's accounting
records.
Transaction
Exposure =
exposure of a transaction denominated in a foreign
currency to changes in the exchange rate between when it is agreed to and when it is
settled.
Transition Adjustments
= see transition settlements.
Transition Accounting =
accounting rules in the transition period prior full
adoption of FAS 133 or IAS 39. FAS 133 Paragraph 48 dictates that FAS 133
accounting shall not be applied retroactively to financial statements
of prior periods. The accounting for any gains and losses on derivative instruments that arose prior to the
initial application of the Statement and that were previously added to the carrying amount
of recognized hedged assets or liabilities is not affected by this Statement. Those
gains and losses shall not be included in the transition adjustment (FAS 133 Paragraph 49).
At the date of initial application, an entity shall recognize all
freestanding derivative instruments (as opposed to embedded derivatives) in the statement
of financial position as either assets or liabilities and measure them at fair value
pursuant to FAS 133 Paragraph 17. The difference between a derivative's previous carrying
amount and its fair value shall be reported as a transition adjustment, as discussed in
FAS 133 Paragraph 52. The entity also shall recognize offsetting gains and losses on hedged
assets, liabilities, and firm commitments by adjusting their carrying amounts at that
date, as discussed in FAS 133 Paragraph 52b. See FAS 133 Paragraphs
49,
50 and 51 for adjustments relating to separating an embedded derivative
instrument separated from its host contract in conjunction with the initial application of
this FAS 133. Any gains or losses on derivative instruments reported in other comprehensive income at
the date of initial application because the derivative instruments were hedging the fair
value exposure of available-for-sale securities also shall be reported as transition
adjustments; the offsetting losses and gains on the securities shall be accounted pursuant
to FAS 133 Paragraph 5. See FAS 133 Paragraph 49.
In contrast, the derivative instrument hedging the variable cash flow exposure of a
forecasted transaction related to an available-for-sale security shall remain in
accumulated other comprehensive income and shall not be reported as a transition
adjustment (FAS 133 Paragraph 49). If a derivative instrument had been hedging the variable cash flow exposure of a
forecasted transaction related to an available-for-sale security that is transferred into
the trading category at the date of initial application and the entity had reported a gain
or loss on that derivative instrument in other comprehensive income (consistent with
Paragraph 115 of Statement 115), the entity also shall reclassify those derivative gains
and losses into earnings (but not report them as part of the cumulative-effect-type
adjustment for the transition adjustments (FAS 133 Paragraph 55).
Any gains or losses on derivative instruments that are reported
independently as deferred gains or losses in the statement of financial position at the
date of initial application shall be derecognized from that statement; that derecognition
also shall be reported as transition adjustment as indicated in SFAS
Paragraph 52 (FAS 133 Paragraph 49). The transition adjustment for the derivative instrument that had been designated in a
hedging relationship that addressed the fair value exposure of an asset, a liability, or a
firm commitment shall be reported as a cumulative-effect-type adjustment of net income.
Concurrently, any difference between the hedged item's fair value and its carrying amount
shall be recognized as an adjustment of the hedged item's carrying amount at the date of
initial application, but only to the extent of an offsetting transition adjustment for the
derivative.
The adjustment of the hedged item's carrying amount shall also be reported as a
cumulative-effect-type adjustment of net income The transition adjustment related to the gain or loss reported in accumulated other
comprehensive income on a derivative instrument that hedged an available-for-sale
security, together with the loss or gain on the related security (to the extent of an
offsetting transition adjustment for the derivative instrument), shall be reclassified to
earnings as a cumulative-effect-type adjustment of both net income and accumulated other
comprehensive income (FAS 133 Paragraph 52b).
See FAS 133 Paragraphs 52a and 52c for how the transition adjustment relating to (1) a derivative
instrument that had been designated in a hedging relationship that addressed the variable
cash flow exposure of a forecasted transaction and (2) a derivative instrument that had
been designated in multiple hedging relationships that addressed both the fair value
exposure of an asset or a liability and the variable cash flow exposure of a forecasted
transaction respectively should be reported. Other transition adjustments not encompassed by
FAS 133 Paragraphs 52(a), 52(b) and 52(c) shall be
reported as part of the cumulative-effect-type adjustment of net income (FAS 133 Paragraph 52d. Note that any transition adjustment reported as a cumulative-effect-type adjustment of
accumulated other comprehensive income shall be subsequently reclassified into earnings in
a manner consistent with FAS 133 Paragraph 31. (FAS 133 Paragraph 53)
In November 1999, the DIG gave in on
this dispute in terms of DIG
Issue No. J9 entitled
"Transition Provisions: Use of the Shortcut Method in the
Transition Adjustment and Upon Initial Adoption." Now the
shortcut method is available without having zero value at the transition
date.
|
Derivatives
Implementation Group
Title: Transition Provisions: Use of the Shortcut Method in the
Transition Adjustment and Upon Initial Adoption
Paragraph references: 48, 52, 68
Date released: November 1999
QUESTIONS
For a hedging relationship that existed prior to the initial adoption
of Statement 133 and that would have met the requirements for the
shortcut method in paragraph 68 at the inception of that pre-existing
hedging relationship, may the transition adjustment upon initial
adoption be calculated as though the shortcut method had been applied
since the inception of that hedging relationship?
In deciding whether the shortcut method can be applied prospectively
from the initial adoption of Statement 133 to a designated hedging
relationship that is the continuation of a pre-existing hedging
relationship, should the requirements of paragraph 68(b) (that the
derivative has a zero fair value) be based on the swap's fair value at
the inception of the pre-existing hedging relationship rather than at
the inception of the hedging relationship newly designated under
Statement 133 upon its initial adoption?
RESPONSES
Question 1 Yes. For a hedging relationship that involves an interest
rate swap designated as the hedging instrument, that existed prior to
the initial adoption of Statement 133, and that would have met the
requirements for the shortcut method in paragraph 68 at the inception of
that pre-existing hedging relationship, an entity may choose to
calculate the transition adjustment upon initial adoption either (a)
pursuant to the provisions of paragraph 52, as discussed in Statement
133 Implementation Issue No. J8, "Adjusting the Hedged Item's
Carrying Amount for the Transition Adjustment related to a
Fair-Value-Type Hedging Relationship," or (b) as though the
shortcut method had been applied since the inception of that hedging
relationship, as discussed below. Under either approach, the interest
rate swap would be recognized in the statement of financial position as
either an asset or liability measured at fair value.
If the previous hedging relationship was a fair-value-type hedge, the
difference between the swap's previous carrying amount and its fair
value would be included in the transition adjustment and recorded as a
cumulative-effect-type adjustment of net income. The hedged item's
carrying amount would be adjusted to the amount that it would have been
had the shortcut method for a fair value hedge of interest rate risk
been applied from the inception of that pre-existing hedging
relationship; that adjustment would be recorded as a
cumulative-effect-type adjustment of net income.
If the previous hedging relationship was a cash-flow-type hedge, the
difference between the swap's previous carrying amount and its fair
value would be included in the transition adjustment and allocated
between a cumulative-effect-type adjustment of other comprehensive
income and a cumulative-effect-type adjustment of net income, as
follows. The cumulative-effect-type adjustment of other comprehensive
income would be the amount necessary to adjust the balance of other
comprehensive income to the amount that it would have been related to
that swap on the date of initial adoption had the shortcut method been
applied from the inception of the pre-existing hedging relationship. The
remainder, if any, of the transition adjustment would be recorded as a
cumulative-effect-type adjustment of net income.
Question 2 Yes. In deciding whether the shortcut method can be
applied prospectively from the initial adoption of Statement 133 to a
designated hedging relationship that is the continuation of a
pre-existing hedging relationship, the requirements of paragraph 68(b)
(requiring that the derivative has a zero fair value) should be based on
the swap's fair value at the inception of the pre-existing hedging
relationship rather than at the inception of the hedging relationship
newly designated under Statement 133 upon its initial adoption. However,
if the hedging relationship that is designated upon adoption of
Statement 133 is not the continuation of a pre-existing hedging
relationship (that is, not the same hedging instrument and same hedged
item or transaction), then the decision regarding whether the shortcut
method can be applied prospectively from the initial adoption of
Statement 133 should be based on the fair value of the swap at the date
of initial adoption. |
The international rules of the IASC for derecognition, measurement and hedge accounting policies
followed in financial statements for periods prior to the effective date of this Standard
should not be reversed and, therefore, those financial statements should not be restated
(IAS 39 Paragraph 172a). Transactions entered into before the beginning of the financial year in which this
Standard is initially applied should not be retrospectively designated as hedges
(IAS 39 Paragraph 172g). If a securitization, transfer, or other derecognition transaction was entered into prior
to the beginning of the financial year in which this Standard is initially applied, the
accounting for that transaction should not be retrospectively changed to conform to the
requirements of IAS 39 (Paragraph 172h). At the beginning of the financial year in which this Standard is initially
applied, an enterprise should recognize all derivatives in its balance sheet as either
assets or liabilities and should measure them at fair value (except for a derivative that
is linked to and that must be settled by delivery of an unquoted entity instrument whose
fair value cannot be measured reliably)
(IAS 39 Paragraph 172c).
At the beginning of the financial year in which IAS
39 is initially
applied, any balance sheet positions in fair value hedges of existing assets and
liabilities should be accounted for by adjusting their carrying amounts to reflect the
fair value of the hedging instrument (IAS 39 Paragraph 172e). At the beginning of the financial year in which this Standard is initially applied, an
enterprise should classify a financial instrument as equity or as a liability in
accordance with Paragraph 11 of IAS 39. (See IAS 39 Paragraph 172i).
|
U-Terms
Underlying =
that which "underlies a settlement
transaction formula." FAS 133 on Page 3, Paragraph 6 defines it as a
"specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rate, or other variable. An underlying may be a
price or rate of an asset or liability but is not the asset or liability
itself." An underlying component by itself does not determine the net
settlement. According to Paragraph 252 on Page 133, settlement is to be based upon
the interaction between movements of underlying and notional values. See
Paragraphs 57a and Paragraphs 250-258 of FAS 133. Also see the the terms premium, underlying, and notional.
The underlying may not
be the index (e.g., price or interest rate) of a unique asset whose value may
be determined by negotiation. For example, even though though used car
prices have "Blue Book" suggested price ranges, each used car is too
unique to have its value determined by any market-wide price index. No
used car is sufficiently like another used car, and each used car is a unique
asset. Similarly, a quality grade of a given grain such as corn must fit
the quality grade of that grain traded on futures markets in order for
the futures commodity price to be an underlying. If the grain has a
unique quality, then its price cannot be an underlying under FAS 133 the
definition of a derivative instrument.
The underlying man may
not be a price that any particular buyer or seller or small group of buyers
and sellers can influence. For example, if the Hunt brothers from Ft.
Worth, Texas had succeeded (as they once tried) in cornering the market on
high grade silver, that silver could no longer be an underlying in terms a
derivative financial instrument under FAS 133. Underlying prices must be
established in competitive markets that are wide and deep. For example,
FAS 133 frequently mentions a "unique metal." By this it is
meant that the metal's price cannot be an underlying.
Paragraph 252 on Page 134 of
FAS 133 mentions that the FASB considered expanding the underlying to include all derivatives
based on physical variables such as rainfall levels, sports scores, physical condition of
an asset, etc., but this was rejected unless the derivative itself is exchange
traded. For example, a swap payment based upon a football score is not subject to
FAS 133 rules. An option that pays damages based upon the bushels of corn damaged
by hail is subject to insurance accounting rules (SFAS 60) rather than FAS 133. A
option or swap payment based upon market prices or interest rates must be accounted for by
FAS 133 rules. However, if derivative itself is exchange traded, then it is covered
by FAS 133 even if it is based on a physical variable that becomes exchange traded.
For examples see cap
and floater.
Most derivatives like forward, futures, and swap contracts are acquired at
zero cost such that historical cost accounting is meaningless. The
exception is a purchased/written option where a small premium is paid/received
to buy/sell the option. Thus if the derivative financial instrument
contract is defaulted a few minutes after being transacted there are generally
zero or very small damages. Such is not the case with traditional
non-derivative financial instruments like bonds where the entire notional
amounts (thousands or millions of dollars) change hands initially such that
enormous damages are possible immediately after the notional amounts change
hands. In the case of of a derivative contract, the notional does not
change hands. It is only used to compute a contracted payment such as a
swap payment.
For example, in the year 2004 Wells Fargo Bank sold $63 million in bonds
with an interest rate "derived" from the price of a casino's common
stock price. The interest payments are "derivatives" in one
sense, but the bonds are not derivative financial instruments scoped into FAS
133 due to Condition b in Paragraph 6 quoted above. In the case of
bonds, the bond holders made a $63 million initial investment of the entire
notional amount. If Wells Fargo also entered into an interest rate swap
to lock in a fixed interest rate, the swap contract would be a derivative
financial instrument subject to FAS 133. However, the bonds are not
derivative financial instruments under FAS 133 definitions.
For elaboration on the above example, see Derivative
Financial Instruments.
|
V-Terms
Valuation
IVSC = International Valuation Standards Council ---
http://www.ivsc.org/
The IVSC is now addressing the very, very difficult problem of valuing
certain types of derivative financial instruments ---
http://www.ivsc.org/news/nr/2012/nr120227.html
One of the major problems is that many derivatives
instruments contracts are customized unique contracts that are not exchange
traded, including forward contracts and most swaps contracts (portfolios of
forward contracts).
Bob Jensen's threads on how to value interest rate swaps ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Note the book entitled PRICING DERIVATIVE SECURITIES, by
T W Epps (University of Virginia, USA) The book is published by World
Scientific ---
http://www.worldscibooks.com/economics/4415.html
Contents:
- Preliminaries:
- Introduction and Overview
- Mathematical Preparation
- Tools for Continuous-Time Models
- Pricing Theory:
- Dynamics-Free Pricing
- Pricing Under Bernoulli Dynamics
- Black-Scholes Dynamics
- American Options and 'Exotics'
- Models with Uncertain Volatility
- Discontinuous Processes
- Interest-Rate Dynamics
- Computational Methods:
- Simulation
- Solving PDEs Numerically
- Programs
- Computer
Programs
- Errata
Bob Jensen's threads on fair value accounting ---
http://faculty.trinity.edu/rjensen/Theory02.htm#FairValue
PwC Dataline: Accounting for centrally cleared derivatives Understanding
the accounting implications of Dodd-Frank Title VII (No. 2013-30) ---
Click Here
http://www.pwc.com/us/en/cfodirect/publications/dataline/2013-30-centrally-cleared-derivatives.jhtml?display=/us/en/cfodirect/publications/dataline&j=346566&e=rjensen@trinity.edu&l=621246_HTML&u=15025430&mid=7002454&jb=0
Dodd-Frank Title VII (Dodd-Frank) significantly
changed the trading requirements for derivative instruments, such as
mandating that certain derivatives be centrally cleared.
A number of financial reporting implementation
questions have arisen as companies consider the Dodd-Frank requirements.
These include determining fair value of centrally cleared derivatives,
accounting for collateral, assessing the impact on hedge accounting, and
determining the appropriate presentation (gross versus net).
This Dataline discusses the financial reporting
implications of the new requirements, primarily focusing on end-users that
trade in the affected derivatives and who do not qualify for the end-user
exception.
Continued in article
Bob Jensen's threads on accounting for derivative financial instruments
and hedging activities ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Valuation of Options
Valuation calculators are provided at http://www.numa.com/derivs/ref/calculat/calculat.htm
Most discussions of option valuation focus on the Black-Scholes
model. Jerry Marlowe provides a nice tutorial at http://www.optionanimation.com/
Options are valued in a variety of
ways. At the web URL http://207.87.27.10/forbes/97/0616/5912218a.htm , Forbes
Magazine provides an interesting overview on
valuing options. If options are purchased on organized exchanges then there are
market values. However, trading in certain kinds of options may be thin such that
market prices are not solid indicators of value. Many options are custom contracts
that are not traded on exchanges. These can be valued in various models, the best
known of which are variations of the binomial option pricing model and the
Black-Scholes
model. Variations arise regarding such factors as type of option (e.g., European
versus American) and degree to which underlying assumptions (e.g., normal distribution)
are deemed reasonable. More troublesome are such assumptions as transactions costs,
no taxes, a constant risk free interest rate, a continuous market for the underlying with
no jumps in prices, and other assumptions such as the distribution of asset returns being
log-normal. Fortunately these models are quite robust in terms of departures
from the assumptions. Online and downloading calculators for the
Black-Scholes
model are linked below:
Various free versions http://www.numa.com/links/online-c.htm
Enter "Option Value
Calculator" in the exact phrase box at http://www.google.com/advanced_search?hl=en
Premium = f (IV, time, vol , r)
Intrinsic value (IV)
Time to expiration (time)
Expected volatility (vol )
Interest rates (r)
Miniumum Value = Intrinsic value adjusted by time value of money
to expiration date.
-
Minimum value and Paragraph 63 of FAS 133
The minimum value of an American option is zero or its intrinsic value since
it can be exercised at any time. The same cannot be said for a
European option that has to be held to maturity. If the underlying is
the price of corn, then the minimum value of an option on corn is either
zero or the current spot price of corn minus the discounted risk-free
present value of the strike price. In other words if the option cannot
be exercised early, discount the present value of the strike price from the
date of expiration and compare it with the current spot price. If the
difference is positive, this is the minimum value. It can
hypothetically be the minimum value of an American option, but in an
efficient market the current price of an American option will not sell below
its risk free present value.
Of course the value may actually be greater due to volatility that adds
value above the risk-free discount rate. In other words, it is risk or
volatility that adds value over and above a risk free alternative to
investing. However, it is possible but not all that common to exclude
volatility from risk assessment as explained in Sub-paragraph b of Paragraph
63 of FAS 133 quoted below.
a. If the effectiveness of a hedge with an option
contract is assessed based on changes in the option's intrinsic value, the
change in the time value of the contract would be excluded from the
assessment of hedge effectiveness.
b. If the effectiveness of a hedge with an option
contract is assessed based on changes in the option's minimum value, that
is, its intrinsic value plus the effect of discounting, the change in the
volatility value of the contract would be excluded from the assessment of
hedge effectiveness.
c. If the effectiveness of a hedge with a forward
or futures contract is assessed based on changes in fair value attributable
to changes in spot prices, the change in the fair value of the contract
related to the changes in the difference between the spot price and the
forward or futures price would be excluded from the assessment of hedge
effectiveness.
The point here is that options are certain to be effective in
hedging intrinsic value, but are uncertain in terms of hedging time value at all
interim points of time prior to expiration. As a result, accounting
standards require that effectiveness for hedge accounting be tested at each
point in time when options are adjusted to fair value carrying amounts in the
books even though ultimate effectiveness is certain. Potential gains from
options are uncertain prior to expiration. Potential gains or losses from
other types of derivative contracts are uncertain both before expiration and on
the date of expiration.
Minimum Value (Shout Option Condition) --- http://quantlib.org/html/a01285.html
A shout option is an option where the
holder has the right to lock in a minimum value for the payoff at one (shout)
time during the option's life. The minimum value is the option's intrinsic
value at the shout time.
Paragraph 63(b) allows for effectiveness testing
based upon minimum value where appropriate. When the derivative hedging
instrument is an option and hedge effectiveness is stated initially to be based
upon changes in an option's minimum value (intrinsic value adjusted for
discounting), the volatility of the option may be excluded from effectiveness
tests. The minimum value model, as opposed to other valuation models like
the Black-Scholes model, is based on one’s willingness to buy an at-the-money
shout option on a share of stock with the right to defer payment of the exercise
price until the end of the option’s term. The model has the advantage of
simplicity but does not capture the effect of share price volatility. A
shout option is an option where the holder has the right to lock in a minimum
value for the payoff at one (shout) time during the option's life. The minimum
value is the option's intrinsic value at the shout time.
Delta-neutral strategies are discussed at various points in FAS
133 (e.g., ¶85, ¶86, ¶87, and ¶89). Delta-neutral implies that the option
value does not change for relatively small changes in hedged item value. Many
hedge strategies are delta-neutral such that ineffectiveness arises only for
relative large changes in the value of the hedged item itself.
Illustration of Option Valuation
I like the discussion of option valuation quoted below from
Professor Brad DeLong --- http://econ161.berkeley.edu/Teaching_Folder/BA_130_F96/BAonethirty20.html
Options:
- Chicago Board of Trade Options Exchange was
founded in 1973; an immediate success.
- Buy options (if you are a firm) to offset
idiosyncratic risk that may lead to financial distress.
- Buy options (if you are an individual) if you need
psychiatric help.
- Options pricing theory also helps value growth
opportunities. "Disguised" options.
Calls, Puts, and Shares:
- A call option gives its owner the
right to buy stock at a specified exercise or strike price on or before a
specified exercise date. European options--only on the particular date;
American options--on or before that date.
- A put option gives its owner the
right to sell stock at a specified exercise or strike price on or before a
specified exercise date. European options--only on the particular date;
American options--on or before that date.
Intel Options Prices in July 1995;
Stock Trading at $65 a Share
Exercise Date
|
Exercise Price
|
Price of Put
|
Price of Call
|
10/95
|
$65
|
$6.25
|
$4.625
|
1/96
|
$65
|
$8
|
$5.875
|
1/96
|
$70
|
$5.875
|
$8.5
|
Value of call at expiration = max(price of share -
exercise price, 0)
Value of put at expiration = max(exercise price -
price of share, 0)
Bachelier diagrams//payoffs to owners/payoffs to
writers
[buy call, invest PV of exercise price in safe asset]
has the same payoff as [buy put, buy share]
V[call] + PV[exercise price] = V[put]+[share price]
[buy call, sell put] has the same payoff as [buy
share, borrow PV of exercise price]
Synthetic Option:
Buy put = buy call + sell share + invest PV of
exercise price
Bankruptcy as shareholders' exercise of a put option
What determines option values?
Value of call is less than share price; value of call
is greater than payoff if exercised immediately
- When the stock is worthless, the option is
worthless
- When the stock price is very large, option price
approaches stock price minus PV of exercise price. [thus the value of an
option increases with the rate of interest and the time to
maturity]--buying on credit
- The option price exceeds its minimum value--higher
by an amount that depends on the variance
Why DCF Doesn't Work for Options:
Because the riskiness of an option changes every time
the stock price moves.
Valuing Options:
Price options by constructing a synthetic option.
Suppose we have our $65 Intel stock, and buy a call
option with a strike price of $65 and an expiration date six months from now.
r of 5% per year. If Intel stock can only (a) fall by 20% to $52 or rise by
25% to $81.25, then
Option value = 0 in bad case; $16.25 in good case.
Spread=5/9 spread of stock price. Suppose you bought 5/9 of a share and
borrowed the PV of 5/9 of a share in the bad case from the bank--borrow
$28.18, the PV of $28.89.
Then you have the same payoffs as the option. Value
of 5/9 of a share today is $36.11, minus $28.18 = $7.93. We have just valued
our option. The number of shares to replicate the spread from an option is the
hedge ratio or option delta. (If the option sells for more than
$7.93, you have a money machine by selling options and covering.
Value of put option--option delta = -4/9; payoff =
+$13 in low state; = 0 in high state; sell 4/9 of a share and lend out $35.23
(collect $36.11 in six months). $35.23 - 4/9 x $65 = $6.34.
V[call] + PV[exercise price] = V[put]+[share price]
$7.93 +$65/1.025 = $6.34 + $65
Selected IAS 39 Paragraphs on Valuation and
Testing for Hedge Effectiveness
144. There is normally a single fair
value measure for a hedging instrument in its entirety, and the factors
that cause changes in fair value are co-dependent. Thus a hedging
relationship is designated by an enterprise for a hedging instrument in
its entirety. The only exceptions permitted are (a) splitting the
intrinsic value and the time value of an option and designating only the
change in the intrinsic value of an option as the hedging instrument,
while the remaining component of the option (its time value) is excluded
and (b) splitting the interest element and the spot price on a forward.
Those exceptions recognize that the intrinsic value of the option and the
premium on the forward generally can be measured separately. A dynamic
hedging strategy that assesses both the intrinsic and the time value of an
option can qualify for hedge accounting.
145. A proportion of the entire hedging
instrument, such as 50 per cent of the notional amount, may be designated
in a hedging relationship. However, a hedging relationship may not be
designated for only a portion of the time period in which a hedging
instrument is outstanding.
Assessing
Hedge Effectiveness
146. A hedge is normally regarded as highly
effective if, at inception and throughout the life of the hedge, the
enterprise can expect changes in the fair value or cash flows of the
hedged item to be almost fully offset by the changes in the fair value or
cash flows of the hedging instrument, and actual results are within a
range of 80 per cent to 125 per cent. For example, if the loss on the
hedging instrument is 120 and the gain on the cash instrument is 100,
offset can be measured by 120/100, which is 120 per cent, or by 100/120,
which is 83 per cent. The enterprise will conclude that the hedge is
highly effective.
147. The method an enterprise adopts for
assessing hedge effectiveness will depend on its risk management strategy.
In some cases, an enterprise will adopt different methods for different
types of hedges. If the principal terms of the hedging instrument and of
the entire hedged asset or liability or hedged forecasted transaction are
the same, the changes in fair value and cash flows attributable to the
risk being hedged offset fully, both when the hedge is entered into and
thereafter until completion. For instance, an interest rate swap is likely
to be an effective hedge if the notional and principal amounts, term,
repricing dates, dates of interest and principal receipts and payments,
and basis for measuring interest rates are the same for the hedging
instrument and the hedged item.
148. On the other hand, sometimes the hedging
instrument will offset the hedged risk only partially. For instance, a
hedge would not be fully effective if the hedging instrument and hedged
item are denominated in different currencies and the two do not move in
tandem. Also, a hedge of interest rate risk using a derivative would not
be fully effective if part of the change in the fair value of the
derivative is due to the counterparty's credit risk.
149. To qualify for special hedge accounting, the
hedge must relate to a specific identified and designated risk, and not
merely to overall enterprise business risks, and must ultimately affect
the enterprise's net profit or loss. A hedge of the risk of obsolescence
of a physical asset or the risk of expropriation of property by a
government would not be eligible for hedge accounting; effectiveness
cannot be measured since those risks are not measurable reliably.
150. An equity method investment cannot be a
hedged item in a fair value hedge because the equity method recognizes the
investor's share of the associate's accrued net profit or loss, rather
than fair value changes, in net profit or loss. If it were a hedged item,
it would be adjusted for both fair value changes and profit and loss
accruals - which would result in double counting because the fair value
changes include the profit and loss accruals. For a similar reason, an
investment in a consolidated subsidiary cannot be a hedged item in a fair
value hedge because consolidation recognizes the parent's share of the
subsidiary's accrued net profit or loss, rather than fair value changes,
in net profit or loss. A hedge of a net investment in a foreign subsidiary
is different. There is no double counting because it is a hedge of the
foreign currency exposure, not a fair value hedge of the change in the
value of the investment.
151. This Standard does not specify a single
method for assessing hedge effectiveness. An enterprise's documentation of
its hedging strategy will include its procedures for assessing
effectiveness. Those procedures will state whether the assessment will
include all of the gain or loss on a hedging instrument or whether the
instrument's time value will be excluded. Effectiveness is assessed, at a
minimum, at the time an enterprise prepares its annual or interim
financial report. If the critical terms of the hedging instrument and the
entire hedged asset or liability (as opposed to selected cash flows) or
hedged forecasted transaction are the same, an enterprise could conclude
that changes in fair value or cash flows attributable to the risk being
hedged are expected to completely offset at inception and on an ongoing
basis. For example, an entity may assume that a hedge of a forecasted
purchase of a commodity with a forward contract will be highly effective
and that there will be no ineffectiveness to be recognized in net profit
or loss if:
(a) the forward contract is for purchase of the same quantity of the same
commodity at the same time and location as the hedged forecasted purchase;
(b) the fair value of the forward contract at inception is zero; and
(c) either the change in the discount or premium on the forward contract
is excluded from the assessment of effectiveness and included directly in
net profit or loss or the change in expected cash flows on the forecasted
transaction is based on the forward price for the commodity.
152. In assessing the effectiveness of a hedge,
an enterprise will generally need to consider the time value of money. The
fixed rate on a hedged item need not exactly match the fixed rate on a
swap designated as a fair value hedge. Nor does the variable rate on an
interest-bearing asset or liability need to be the same as the variable
rate on a swap designated as a cash flow hedge. A swap's fair value comes
from its net settlements. The fixed and variable rates on a swap can be
changed without affecting the net settlement if both are changed by the
same amount. |
Valuation of Swaps ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
Value at Risk
(VaR) =
various mathematical models for performing
probability analysis of market risk. See dynamic
portfolio Management. VAR references include the following:
VAR disclosures are one of
the alternatives allows under SEC Rule 4-08. See Disclosure.
Click here to
view a commentary on VAR by Walter Teets.
There are some
VAR working papers at http://www.gloriamundi.org/var/wps.html
This is an
excellent Value at Risk document ---> http://www.gloriamundi.org/
All About VaR http://www.gloriamundi.org/
Financial risk managers can find value-at-risk book reviews, discussion
groups, answers to frequently asked questions, news and presentations here, as
well as articles such as “An Irreverent Guide to Value-at-Risk” and “Stress
Testing by Large Financial Institutions: Current Practice and Aggregation
Issues.”
See Risk Metrics
VAR is related to risk "stress testing."
Freddie Mac was an innovator in risk stress testing ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm#FreddieMac
The Value at Risk (VaR) Model of Investment Risk ---
http://en.wikipedia.org/wiki/VaR
Too-Fat Tails Lead to All Sorts of Troubles in Life
The Value at Risk (VaR) Model of Investment Risk ---
http://en.wikipedia.org/wiki/VaR
"In Plato's cave," The Economist, January 24, 2009,
pp. 10-14 ---
http://www.economist.com/specialreports/displaystory.cfm?story_id=12957753
...
Almost as damaging is the hash that
banks have made of “value-at-risk” (VAR) calculations, a measure of the
potential losses of a portfolio. This is supposed to show whether banks
and other financial outfits are being safely run. Regulators use VAR
calculations to work out how much capital banks need to put aside for a
rainy day. But the calculations are flawed.
The mistake was to turn a blind eye to
what is known as “tail risk”. Think of the banks’ range of possible
daily losses and gains as a distribution. Most of the time you gain a
little or lose a little. Occasionally you gain or lose a lot. Very
rarely you win or lose a fortune. If you plot these daily movements on a
graph, you get the familiar bell-shaped curve of a normal distribution
(see chart 4). Typically, a VAR calculation cuts the line at, say, 98%
or 99%, and takes that as its measure of extreme losses.
Tail spin However, although the normal
distribution closely matches the real world in the middle of the curve,
where most of the gains or losses lie, it does not work well at the
extreme edges, or “tails”. In markets extreme events are surprisingly
common—their tails are “fat”. Benoît Mandelbrot, the mathematician who
invented fractal theory, calculated that if the Dow Jones Industrial
Average followed a normal distribution, it should have moved by more
than 3.4% on 58 days between 1916 and 2003; in fact it did so 1,001
times. It should have moved by more than 4.5% on six days; it did so on
366. It should have moved by more than 7% only once in every 300,000
years; in the 20th century it did so 48 times.
In Mr Mandelbrot’s terms the market
should have been “mildly” unstable. Instead it was “wildly” unstable.
Financial markets are plagued not by “black swans”—seemingly
inconceivable events that come up very occasionally—but by vicious
snow-white swans that come along a lot more often than expected.
This puts VAR in a quandary. On the
one hand, you cannot observe the tails of the VAR curve by studying
extreme events, because extreme events are rare by definition. On the
other you cannot deduce very much about the frequency of rare extreme
events from the shape of the curve in the middle. Mathematically, the
two are almost decoupled.
The drawback of failing to measure the
tail beyond 99% is that it could leave out some reasonably common but
devastating losses. VAR, in other words, is good at predicting small
day-to-day losses in the heart of the distribution, but hopeless at
predicting severe losses that are much rarer—arguably those that should
worry you most.
When David Viniar, chief financial
officer of Goldman Sachs, told the Financial Times in 2007 that the bank
had seen “25-standard-deviation moves several days in a row”, he was
saying that the markets were at the extreme tail of their distribution.
The centre of their models did not begin to predict that the tails would
move so violently. He meant to show how unstable the markets were. But
he also showed how wrong the models were.
Modern finance may well be making the
tails fatter, says Daron Acemoglu, an economist at MIT. When you trade
away all sorts of specific risk, in foreign exchange, interest rates and
so forth, you make your portfolio seem safer. But you are in fact
swapping everyday risk for the exceptional risk that the worst will
happen and your insurer will fail—as AIG did. Even as the predictable
centre of the distribution appears less risky, the unobserved tail risk
has grown. Your traders and managers will look as if they are earning
good returns on lower risk when part of the true risk is hidden. They
will want to be paid for their skill when in fact their risk-weighted
returns may have fallen.
Edmund Phelps, who won the Nobel prize
for economics in 2006, is highly critical of today’s financial services.
“Risk-assessment and risk-management models were never well founded,” he
says. “There was a mystique to the idea that market participants knew
the price to put on this or that risk. But it is impossible to imagine
that such a complex system could be understood in such detail and with
such amazing correctness…the requirements for information…have gone
beyond our abilities to gather it.”
Every trading strategy draws upon a
model, even if it is not expressed in mathematical symbols. But Mr
Phelps believes that mathematics can take you only so far. There is a
big role for judgment and intuition, things that managers are supposed
to provide. Why have they failed?
"In Defense Of Value At Risk (VaR) And Other Risk Management Methods,"
by Suna Reyent, Seeking Alpha, January 19, 2009 ---
http://seekingalpha.com/article/115339-defending-var-but-you-still-need-common-sense
In the beginning of the month, New York
Times Magazine published an article by Joe Nocera called “Risk
Mismanagement” that created quite a stir in the blogosphere and beyond.
Despite the watering-down of certain aspects related to risk management
tools, as well as the diversity with which these tools are applied practice,
the article was a success because of the buzz it created as well as the
ensuing debate.
The article portrays a debate over value
at risk methodology between well-known practitioners of VAR and the critics
of the methodology led by Nassim Taleb. It is hard not to get carried away
with Mr. Taleb’s tabloid-like descriptions of VAR as a “fraud” and its
practitioners as “intellectual charlatans.”
I love how the debate is construed. The
premise is that value at risk and other valuation models (such as Black-Scholes)
assume normal distribution of asset returns. Okay, they do that in their
most primitive forms, but let’s just accept the oversimplification as a fact
for a moment because the debate would hardly exist in this simplistic form
if we didn’t go along with the show here.
This is where our hero Mr. Taleb, an
experienced options trader no less, emerges to the public mainstream to
inform all of us ignorant folks that asset returns do not follow a normal
distribution! The horror! The painful realization that this stuff continues
to be taught in business schools! All that wasted class time learning
statistics!
It is fair to say that this assumption
will mislead naïve market participants about the nature of their risk
exposures as “Black Swan” events happen a lot more frequently than suggested
by Gaussian distributions. The problem is, almost anyone in finance already
knows that asset prices are not normally distributed, and many practitioners
build models or apply extensions to existing ones in order to take this into
consideration.
I decided to give a little background on
value at risk in order to get the points across that I feel strongly about.
Since I teach VAR in the classroom as part of a risk management curriculum,
I feel it is best to give some preliminary information.
A Primer On Value At Risk
Depending on the confidence interval
chosen, value at risk, in its simplest form, exists of applying a one-sided
test to figure out the loss that a portfolio may weather in a given time
period. For instance, a 95% daily VAR of ten million dollars indicates that
a portfolio is likely to lose at most that amount of money 95% of the time,
or once a month assuming 20 trading days in a given month. At the same time,
it displays the LEAST amount of money that the portfolio can lose 5% of the
time. I appreciated it when Mr. Nocera mentioned this in his article
prepared for general readership. As VAR is unable to tell us about what kind
of a loss we should expect in that tail of 5%, the limitation of this metric
if taken as gospel becomes apparent even to the untrained eye.
More on the tail risk later. But first, I
would like to talk about three established ways of calculating value at risk
for one asset and analyze the current risk management crisis within this
framework:
Analytical VAR – “Misunderestimating”
Risks
Otherwise known as variance-covariance
method of calculating the value at risk, this is the well-known method of
calculating VAR and the easiest one to apply. It assumes a normal
distribution of returns. All it takes to calculate VAR is a standard
deviation, which represents the “volatility” of the asset as well as a mean,
which is the expected return on the same asset.
This is the VAR that Mr. Taleb seems to
conveniently focus on, because it will indeed underestimate the risk at the
tails of a negatively skewed or a leptokurtic distribution.
Stock markets in general exhibit negative
skewness, which means that the distribution of returns will exhibit a long
tail (a few extreme losses) to the left side. They also exhibit
leptokurtosis, which means that both tails of the distribution are fatter
than implied by normal distribution.
So we could go nuts over how wrong the
normal distribution assumption is, and apparently people do. But we should
also be very concerned over how sensitive this measure is to the standard
deviation as well the mean, both of which are subject to change as markets
change especially in the light of the current crisis.
Historical VAR – Good As Long As Future
Resembles Past
This method does not need any assumptions
about the distribution of returns and is certainly superior to analytical
VAR because it is not parametric. The more data there is, the better the
measurement. Historical data will exhibit characteristics such as skewness
or kurtosis as long as the asset itself exhibits these qualities as well.
Assuming 250 trading days in a given year,
in order to measure the 95% daily VAR you need to rank the returns from
worst to best and pick the greatest return among those that correspond to
the bottom 5% of returns. So the worst 12th return (or you could interpolate
between the 12th and13th worst return, since 250 divided by 20 is 12.5, but
since VAR itself is an approximation, why bother?) will tell you the maximum
percentage loss 95% percent of the time, or the minimum percentage loss 5%
of the time. Multiply the loss by your portfolio value and you get the neat
VAR value in terms of dollars.
Moreover, the majority of investment
houses use historical VAR as the basis for measurement as it is a clear
improvement over the analytical VAR. You do not need return assumptions or
standard deviation values to come up with this value.
Historical VAR calculations replace
parametric assumptions with historical data. This means that if you had
positions in mortgage derivative securities and started the year 2007 with
models that were built around data of the previous two years encompassing
the “peaceful” periods of 2005 and 2006, you would soon be awakened to a
world where your VAR measures no longer reflected the reality of the
marketplace. Note that such limitations of VAR as an all-encompassing risk
measure were visible to any professional who understood risk management
models as well as the limitations of historical data that went into them.
As Mr. Nocera’s article conveys, this is
precisely what Goldman Sachs (GS) did. When it became obvious that the
mortgage markets had changed in fundamental ways and aggressive positions in
these securities started bringing in gigantic losses (as opposed to reaping
the usual gigantic profits on the back of the ever-rising housing market),
the team decided to limit its risk exposure by “getting closer to home.”
I don’t think the article conveys what
“getting closer to home” really means. Let me use day trading as an example
here. In day trading terms, this means that when your positions start
showing huge losses at the end of the day, you accept “defeat” and take your
losses as opposed to trying to ride them in the hope that the market will
come around. So instead of wishing for market to make a comeback to recoup
losses, you close out your open positions, take your losses and go home.
Then you go back to the drawing board to strategize for the next day given
the new reality of the marketplace.
Of course, looking retrospectively, the
decision to limit exposure and take losses as opposed to trying to ride them
in the expectation of a housing market turnaround has been the right
decision to make. However, as we have seen with many other bubbles, managers
do not have the incentive to make the sound trading decisions, nor do they
have the incentive to listen to their risk managers as long as they get a
huge piece of profits made during the ride and the taxpayer ends up holding
the bag when the market finally blows up.
We have seen this movie over and over
again. What surprises me is the heavy blame put on models for not reflecting
“reality,” whereas those in charge knew that the mortgage bubble was
collapsing, they had many opportunities to get rid of their huge exposures
to the derivatives securities, but they chose not to do it most likely
because of expectations of a market turn around. This is trading 101. If you
try to ride your losses, you may make comebacks, but you will eventually
blow up.
Now the next episode features critics who
tell us that the “models” have been faulty and wrong. Hence the conclusion
that value at risk is an erroneous and misleading measure, not to mention a
“fraud.”
Ladies and gentleman, we found the “fraud”
haunting the trading floor on the street, and it is not a human being: Shame
on you, VAR and other risk management tools! Of course, we can blame the car
manufacturers for the accident: the car’s faulty speedometer, or its lack of
an apparatus to show us the bumps on the road ahead. But why is the culture
that is reticent to blame the drunk driver who was clearly intoxicated with
the thrill of making green?
These “models” are as guilty as the
“accounting” that was used with a sleight of hand to conceal what was really
going on behind the curtains during the Enron debacle and others. Of course,
given the mathematical complexities of models, the quantitative brainpower
needed to understand some of them, and the assumptions required in creating
a map of your territory, there is more of an opportunity to either blame the
models or to pretend that you didn’t understand them when things turned
sour.
As I ventured with this essay, hoping to
make my points within the value at risk framework featured in textbooks, I
will move on to the third methodology used in calculating the measure.
Monte Carlo Simulation – Anything Goes,
But More Of An Art Than Science
Monte Carlo Simulation is especially
useful in calculating risk exposures of assets that have either little
historical data or whose historical data is rendered irrelevant due to
changing economic conditions that affect both the price of securities and
the way these securities interact with each other in a portfolio. Also,
historical returns of assets with asymmetric payoffs or returns of
derivative securities that interact with variables such as interest rates,
housing prices, and the like will not reflect the future when factors that
influence the return of the security change as the economic climate shifts.
Continued in article
Bob Jensen's threads on VaR are at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#VaR
Bob Jensen's threads on the banking crisis ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm
Question
What is cookie jar accounting and why is it generally a bad thing in financial
reporting?
Answer
Cookie jar is more formally known as earnings reserve accounting where
management manipulates the timings of earnings and expenses usually to smooth
reported earnings and prevent shocks up and down in the perceived stability of
the company. European companies in the past notoriously put deferred earnings in
"cookie jars" so as to picture themselves as solid by covering bad times with
deferrals out of the cookie jar that mitigate the bad news and vice versa for
good times. The problem with too much in the way of a good time (in terms of
financial reporting) is that accelerated growth rates in one year cannot
generally be maintained every year and it may be a bad thing, in the eyes of
management, to have investors expecting high rates of growth in revenues and
earnings every year.
What's wrong with cookie jar reporting is that it allows management wide
latitude in discretionary reporting that is a major concern to both investors
and standard setters. Accounting reports become obsolete when they mix stale
cookies from the cookie jar with fresh sweets and lemon balls of the current
period.
Also see
http://en.wikipedia.org/wiki/Cookie_jar_accounting
You can read more about FAS 106 at
http://www.fasb.org/st/index.shtml
Scroll down to FAS 106 on "Employers' Accounting for Postretirement Benefits
Other Than Pensions"
"On the Impossibility of
Measuring Model Risk," Sandrew, February 18, 2010 ---
http://sandrew.tumblr.com/post/397168410/on-the-impossibility-of-measuring-model-risk
Thank you Francine for the heads up.
This week
The Economist
poked a little fun at the quants:
JPMorgan
Chase holds $3 billion of “model-uncertainty reserves” to cover
mishaps caused by quants who have been too clever by half. If you
can make provisions for bad loans, why not bad maths too?
And in
response to this revelation, Francine McKenna
wondered how the auditors could have
signed-off on the models:
If you need
$3 billion of “model reserves” how [does] PwC attest to [the] models
underlying valuations, estimates and reserves?
It’s worth
noting that these model-uncertainty reserves not only comply with GAAP,
but are mandated by it. So in response to Ms. McKenna’s concern, there
is in fact a “GAAP for that.”
FAS 157
Par. C16: This Statement clarifies that the measurements should be
adjusted for risk, that is, the amount market participants would
demand because of the risk (uncertainty) inherent in a particular
valuation technique used to measure fair value (such as a pricing
model) and/or the risk inherent in the inputs to the valuation
technique (a risk premium notion). Accordingly, a measurement (for
example, a “mark-to-model” measurement) that does not include an
adjustment for risk would not represent a fair value measurement if
market participants would include one in pricing the related asset
or liability. [Emphasis mine.]
OK, so now we
understand why banks have to measure model risk, but how
do you do it? Well, if you’re being honest, you don’t. Model risk is
impossible to measure. Here’s why.
Pricing
Models as Interpolation
First, it’s
important to understand what a pricing model is and why they are used.
Pricing models are used for two purposes: valuation (that is, to come up
with fair values for instruments that do not have directly observed
prices—e.g. OTC derivatives) and risk management (that is, to measure
the sensitivities of instruments to particular risks for the purpose of
managing an overall book). Let’s put aside for now the risk management
purpose and focus on the valuation.
The majority of
OTC positions are not “marked-to-model” in any meaningful sense of that
term. Yes, there are pricing models used to value them, but they’re
not the scary kind of marks that skeptics rightly call
“mark-to-make-believe.” Most of the time, the pricing model is simply
a fancy (and sometimes expensive) tool to interpolate between observed
market prices.
Let’s say I
have an interest rate swap. I can observe the market prices (rates of
various maturities) and as long as my swap is within the range of my
observations, then my pricing model is calibrated to market. The only
modeling I’ve done is to build a rate curve based on observed inputs and
used this curve to discount the contractual cash flows of the swap.
This is simply a robust way to interpolate the value of my swap from
observed quotes on similar instruments (i.e. other swaps). Now this is
obviously a very simple example, but this model-as-interpolation view
can also be said of more complicated, but traded, instruments like
synthetic index CDOs.
What’s this
have to do with model risk? When models are calibrated to observed
market prices, and hence where the model is used an interpolation tool,
the model risk is (pretty much) already captured by the model. This is
true even if the model is “wrong”. If the model calibrates to market,
it already reflects the market’s view of the model risk—at least with
respect to the observed instruments to which it’s calibrated. I should
add that even if you’re interpolating between observed prices, you might
have residual model risk—how much residual risk (which could be
significant) depends on the granularity of observed data, among other
things.
True
Mark-to-Model Positions and Why Model Risk is Immeasurable
But wait. If
most positions are marked to prices interpolated between observed
quotes, what about the rest? Here’s where we get into the true
mark-to-model issues, and where model risk is most prevalent.
Thankfully, these are easy enough to identify on a balance sheet. They
are anything noted as a “level 3” fair value measure—i.e. instruments
where the value significantly depends on the model itself and on the
unobservable inputs or parameters thereto. Think of a CDO-squared or a
bespoke synthetic CDO.
I promised I’d
get to the point about the impossibility of measuring model risk, so
here it is:
-
<!--[if !supportLists]-->Model
risk is the risk that you’re using the wrong model.
-
<!--[if !supportLists]--><!--[endif]-->The
space of possible models is infinite. That is, there are an
infinite number of models to choose from, including those not yet
discovered.
-
<!--[if !supportLists]-->No
one knows what the right model is. If you knew which model was the
right one, you’d already be using it. Even if most market
participants agree on a model today, they might discover a better
model tomorrow, or simply decide that no model is sufficient to
assess the risks (this has happened).
-
<!--[if !supportLists]-->Judgments
about the amount of model risk are necessarily qualitative. The
best I could hope for would be to say that this model feels
more certain than that one.
-
<!--[if !supportLists]--><!--[endif]-->Model
risk is recursive. Even if I could quantify the level of model
risk, what model would I use to measure the impact of that model
risk on fair value? Where are the models of model risk? Even if
they existed, those model risk models have model risk, no?
That $3B
Model-Uncertainty Reserve
If model risk
is immeasurable, where did JPMorgan’s $3B come from and what does it
mean? As to where it came from, I don’t know the specifics, but I
suspect they’ve either: (a) shocked the unobservable model inputs by
some arbitrary amount and taken the worst of the lot or (b) run some
“shadow models” (i.e. run the same positions through multiple known
models) and taken the worst of the lot. Either way, the result is
arbitrary. So as to what it means: not much. At best, it gives us some
insight into the subjective judgments of JPMorgan management with
respect to the quality of their models. So yeah, not much at all.
Bob Jensen's threads on cookie
jar accounting are at
See below
February 19, 2010 reply from Bob
Jensen
Hi Francine,
The Sandrew article is really terrific (thanks for the
heads up) ---
http://sandrew.tumblr.com/post/397168410/on-the-impossibility-of-measuring-model-risk
As to the cookie jar question, I think it reduces to an
issue of whether the bad quant reserves are used primarily to smooth
income in the same sense as cookie jar reserves are traditionally used
to smooth income. Or are the bad quant reserves more like bad debt
reserves that are used for better matching under the matching concept
where timing of cost write offs better matches revenues with expenses
incurred to generate those revenues.
To me, the Allowance for Bad Quants seems to me to be a
bit more like the Allowance for Bad Debts, but I’ve not really taken
time to study this question in detail.
A great example of cookie jar accounting, aside from the
classic examples allowed in Switzerland, is Tom Selling’s General Motors
example ---
See belowBob
Jensen
How to use VaR, ETL in Excel
Estimating Risk Measures
I wish I could retroactively
require an article to be read! If I could, this would be
it for my Portfolio class (Fin422).
Writing in
Financial Engineering News,
Kevin Dowd explains how to use
Excel to calculate VAR and other risk measures. This
will be VERY HELPFUL in class!!!
For instance: "To estimate the daily VaR at, say, the 99
percent confidence level, we can use Excel’s Large
command, which gives the kth largest value in an array.
Thus, if our data are an array called “losses,” we can
take the VaR to be the eleventh largest loss out of
1,000. (We choose the eleventh largest loss as our VaR
because the confidence level implies that one percent of
losses – 10 losses – should exceed the VaR.) The
estimated VaR is given by the Excel command
“=Large(losses,11)”."
good stuff! Read it!!!
From Jim Mahar's blog on May 23, 2005 ---
http://financeprofessorblog.blogspot.com/
Bob Jensen's threads on VAR are under the V-terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#V-Terms
VAR disclosures are
one of the alternatives allows under SEC Rule 4-08
Here is a Good Summary of Various Forms of Business Risk
---
http://www.erisk.com/portal/Resources/resources_archive.asp
Variable Interest Entities (VIE Accounting and
FIN 46)
What's Right and What's Wrong With (SPEs),
SPVs, and VIEs ---
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm
Variable Rate =
a rate that varies
over time as opposed to a fixed rate. The term is commonly used in FAS 133
to refer
to debt contracts with interest that vary from period to period rather than stay fixed at
a contractual rate. Firms sometimes issue notes and bonds at variable rates in order
to get a lower rate than fixed rates available to them in the capital market. The
variable rate is usually based upon some index such as the U.S. prime
rate or the English LIBOR.
Some debt has a
combination of fixed and floating components. For example, a
"fixed-to-floating" rate bond is one that starts out at a fixed rate and at some
point (pre-determined or contingent) changes to a variable rate. This type of bond
has a embedded derivative (i.e., a forward component
for the variable rate component that adjusts the interest rate in later periods.
Since the forward component is clearly-and-closely related adjustment of interest of
the host contract, it cannot be accounted for separately according to Paragraphs 12a and
13 of FAS 133 (unless conditions listed in Paragraph 13 apply).
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W-Terms
Warrants =
options that typically are attached to other financial
instruments such as bonds. Warrants, like options, give the holders' rights into the
future but not obligations. There are a wide variety of warrant types including the
following:
Cross-Currency Warrants
Currency Exchange Warrants (CEWs)
Debt with Springing Warrants
Detachable Warrants
Emerging Market Warrants
Equity Index Warrants
Eurowarrants
Ex-Warrants
Foreign Stock Index Options, Warrants, and Futures
Income Warrants
Index Warrants
Long Bond Yield Decrease Warrants (Turbos)
Money Back Options or Warrants
nonDetachable Warrants
Samurai Warrants
Secondary Warrants
Springing Warrants
Synthetic Warrants
Third Party Warrants
Window Warrants
Yield Curve Flattening Warrants
Weather = See Derivative
Financial Instruments
Written Option =
an option written by an
"option writer" who sells options collateralized by a portfolio of securities or
other performance bonds. Typically a written option is more than a mere "right"
in that it requires contractual performance based upon another party's right to force
performance. The issue with most written options is not whether they are covered by
FAS 133 rules. The issue is whether they will be allowed to be designated as cash flow
hedges. Written options are referred to at various points in FAS 133. For example,
see Paragraphs 20c, 28c, 91-92 (Example 6), 199, and 396-401.. For rules regarding written
options see Paragraphs 396-401 on Pages 179-181 of FAS 133. Exposure Draft 162-B
would not allow hedge accounting for written options. FAS 133 relaxed the rules for
written options under certain circumstances explained in Paragraphs 396-401. Note
that written options may only hedge recorded assets and liabilities. They may not be
used to hedge forecasted purchase and sales transactions.
Paragraph 399 on Page 180 of
FAS 133 does not
allow covered call strategies that permit an entity to write an
option on an asset that it owns.
A written option is not a hedging instrument unless it is designated as an
offset to a purchased option, including one that is embedded in another financial
instrument, for example, a written option used to hedge callable debt
(FAS 133 Paragraph 124).
A purchased option qualifies as a hedging instrument as it has potential gains equal to or
greater than losses and, therefore, has the potential to reduce profit or loss exposure
from changes in fair values or cash flows (FAS 133 Paragraph 124).
Under FASB rules, if a written option is designated as hedging a recognized asset or
liability / the variability in cash flows for a recognized asset or liability, the
combination of the hedged item and the written option provides at least as much potential
for favorable cash flows as exposure to unfavorable cash flows (see FAS 133 Paragraph 20c
or 28c).
A Case for Writing (rather than purchasing) Options
The Money Tree by Ronald Groenke and Wade Keller. Now
I must confess, the reason I started this is because the authors are
subscribers to the newsletter, but it has turned out to be a interesting look
at selling calls on stocks that you already own. It is written as a novel, yet
is full of financial strategies and terms. I am still not 100% convinced that
opportunity costs are completely considered but definitely worth the time! I
will let you know more when I finish it.
From TheFinanceProfessor on March 24, 2002. See http://www.amazon.com/exec/obidos/ASIN/0967412811/finpapers/104-9378365-5272442
See option, swaption, and covered call.
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X-Terms
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