Session 7 Derivatives and Hedging
Risk management background
Derivatives
Hedging
Hedge ineffectiveness
FAS 133 and related GAAP (all in ASC Section 815)
Analysis of derivatives and hedging
163 Extant Proposals to Change Hedge Accounting
In May 2010, the FASB issued Proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities (“the proposed ASU”)
Simpler than but reasonably consistent with FAS 133
Somewhat easier to obtain hedge accounting
Hedge accounting obscures volatility less
After putting the project on the back burner, the FASB began redeliberating the proposed ASU in February 2015
Summary of deliberations through March 23, 2016 is available on FASB website
FASB currently plans to issue an exposure draft in 2016Q3
164 Extant Proposals to Change Hedge Accounting (2)
In November 2013, the IASB issued new, bank-friendlier hedge accounting rules in IFRS 9 (replacing rules in IAS 39)
Provides more flexibility to define the hedged item than either IAS 39 or FAS 133: groups of positions (including derivatives), net positions (including net nil positions), risk layers (including last layers)
Also provides more flexibility to define the hedge than IAS 39 or FAS 133: non-derivative/cash instruments classified at fair value through profit and loss
Treats certain types of hedge ineffectiveness (e.g., option time value) as a cost of hedging to be amortized into income over time
Hedge accounting allowed if economic hedging relationship exists consistent with firm’s risk management strategy; no quantitative threshold need be met
The IASB has an ongoing project to allow “macro” hedging of open portfolios; issued discussion paper in April 2014 but does not appear to 165 have made much progress since then Derivatives
Under FAS 133 (ASC 815), the payoffs on a derivative depend on
the notional amount of one or more underlyings
principal amount
physical quantity
one or more prices
interest rates, exchange rates, commodity prices...
credit indices, credit ratings, indicators of default, indices or indicators of catastrophes...
Example: interest-rate swaps
166 Derivatives (2)
Derivatives generally do not transfer the underlying
derivatives usually can be thought of as the net of two positions
under FAS 133, derivatives must settle net or a market mechanism must exist to allow net settlement
helps to explain why the FASB decided in FAS 149 that interest rate lock commitments on mortgages intended to be held for sale are derivatives but other loan commitments are not
167 Derivatives (3)
Derivatives usually have zero or small initial value relative to their notional amounts and thus risk
under FAS 149, the value of a derivative must be less than its notional amount by more than a nominal amount
motivated by prepaid forwards and swaps
derivatives’ small initial value makes them ideal for either hedging or speculation
reduce counterparty risk and liquidity requirements compared to instruments with the same risk but higher value
168 Derivatives (4)
Main types of simple derivatives
forwards and futures
options
swaps
Complex derivatives are combinations of simple derivatives or incorporate leverage or other factors
169 Forwards and Futures
Obligate one party to buy and another party to sell something at a future date
Can be used for two-sided hedging of long or short positions (or speculation)
170 Purchased Forward
payoff
slope=notional amount of underlying
0 spot price
forward price
0 171 Options
Purchaser obtains the right to buy (call) or sell (put) the underlying to the seller (writer) at the strike price over a specified term
Purchaser pays writer a premium
options have initial value
like an insurance contract
Can be used for one-sided hedging of long or short positions (or speculation)
172 Purchased Call Option
net of premium value or payoff value payoff=“intrinsic value”
time value
0 spot price -premium
strike price 0
173 Options (2)
Purchased Written
Call Long Short
Put Short Long
174 Swaps
Exchange of recurring payments between 2 parties
like a series of forwards contracts with lower transactions costs
Most common form is the “plain vanilla” interest rate swap: one party pays fixed and receives floating and the other the opposite
175 Plain Vanilla Receive-Fixed, Pay- Floating Interest-Rate Swap
value
sum of undiscounted fixed interest receipts
0 sum of value of underlying undiscounted fixed-rate asset fixed cash principal and notional interest principal of receipts (r=0) swap
0 (r=∞) 176 Interest-Rate Swaps
Plain vanilla interest-rate Rec swaps can be used to Floating fixe convert fixed-rate Asset floa exposure exposures to floating or Rec Fixed floati vice-versa fix
177 Hedging
Hedging is taking positions that counterbalance the risk of existing exposures
Question is what is the risk of existing exposures
fair value volatility
cash flow volatility
FAS 133 allows for both of these inconsistent definitions of risk, making it difficult to distinguish hedging from speculation
lowering cash flow volatility implies raising fair value volatility and vice-versa
correct definition of risk is fair value volatility for most financial institutions 178 Hedge Ineffectiveness
Hedge ineffectiveness results from a mismatch of hedged item and hedge, which could arise from
different notional amounts, terms, or basis
behavioral (prepayment, core deposit) or other hard to model factors
notion of “model book”
counterparty risk
In practice, a hedge is deemed overall effective if the change in the value or cash flows of the hedge is within 80- 125% of the change in the value or cash flows of the hedged item
“dollar offset” vs. statistical methods 179 designated overall effective derivatives hedges qualify for hedge Accounting for Derivatives and Hedging
Accounting for derivatives and hedging is governed by FAS 133 (1998) and two follow-on standards: FAS 138 (2000), and FAS 149 (2003)
There is also voluminous implementation guidance in Derivatives Implementation Group (DIG) issues
The primary required disclosures for derivatives and hedging are in FAS 133, FAS 161 (2008), and FSP FAS 133-1 and FIN 45-4
All the above is in ASC Section 815
The proposed ASU would simplify this GAAP and make it easier for firms to obtain hedge accounting
180 FAS 133 and Derivatives
Defines derivatives narrowly, as described on slides 4-6
Requires derivatives embedded in other instruments to be unembedded if they are not “clearly and closely related” to the host instrument and the host instrument is not fair valued on balance sheet with gains and losses recorded in income under GAAP
Accounting Standards Update 2010-11: subordination does not yield an embedded credit derivative
Requires that all derivatives be fair valued gross of hedged items on the balance sheet
yields big balance sheets compared to prior “synthetic instrument” accounting 181 derivatives usually are netted against hedged items on the income FIN 39 and Net Presentation of Derivatives Covered by Master Netting Agreements
FIN 39 allows but does not require net balance sheet presentation of offsetting derivatives that exhibit the legal right of setoff and the intent to set off
FIN 39 deems this right and intent to be conveyed by standard master netting agreements
In contrast, IFRS generally requires gross presentation of offsetting derivatives even when a master netting agreement exists
This yields the largest differences between balance sheets under U.S. GAAP versus IFRS
ASU 2011-11 requires disclosures of the amount of netting and of firms’ choice not to net when the legal right of setoff exists, allowing reconciliation of these differences 182 FAS 133 and Hedge Accounting
Hedge accounting, in its various forms, involves accounting consistently for the hedge and the hedged item, at least on the income statement
FAS 133 allows hedge accounting only for designated hedges of specific documented exposures using derivatives
FASB is concerned about documentation of hedge and ongoing assessment of hedge effectiveness
183 FAS 133 and Hedge Accounting (2)
FAS 133’s restriction of hedges to derivatives implies that most economic hedging cannot qualify for hedge accounting
In contrast, the November 2013 IASB hedge accounting rules in IFRS 9 allow non-derivative hedges and other features of hedging relationships that capture more economic hedging (see slide 4)
184 FAS 133 and Hedge Accounting (3)
FAS 133 requires the effectiveness of each hedge to be evaluated each accounting period and hedge accounting discontinued if the hedge ceases to be effective
Exception to periodic (“long haul”) hedge effectiveness testing
paragraph 65 of FAS 133 (the “matched terms” method): the critical terms of the hedging instrument and the entire hedged asset, liability, or forecasted transaction are the same
paragraph 68 of FAS 133 (the “shortcut” method): contains many criteria for hedges of (possibly benchmark) interest rate risk using interest rate swaps
The proposed ASU would require qualitative assessment of hedge effectiveness at initiation and subsequently only if 185 FAS 133 and Hedge Accounting (4)
FAS 133 allowing hedge accounting only for hedges of specific exposures yields two significant problems
an effective hedge of a specific exposure may not be an effective hedge of the bank’s net exposure
an effective hedge of banks’ net exposure may not be an effective hedge of any specific exposure
Example: A bank holds $50 of three-year fixed-rate assets, $50 of three-year floating-rate assets, and $100 of three- year fixed-rate liabilities
Q: what is its net exposure? What type of swap would hedge its net exposure?
Q: what type of swaps would qualify for hedge accounting for its individual exposures? 186 FAS 133 and Hedge Accounting (5)
Allows two models of hedge accounting
fair value hedge accounting
cash flow hedge accounting
Requires that gains and losses from hedge ineffectiveness be recognized immediately in net income in most circumstances
exceptions: ignore ineffectiveness for
cash flow under-hedges (the proposed ASU would eliminate, although the FASB appears to have backed off this proposal)
basis risk in hedges of benchmark interest rates under FAS 138
187 Fair Value Hedge Accounting
Applies to hedges of on-balance sheet assets or liabilities or off-balance sheet firm commitments whose fair values vary
examples: fixed-rate assets or liabilities, MSRs, take-or-pay contracts...
In some cases, can hedge specific risks within these exposures (e.g., interest rate risk)
the proposed ASU would retain
188 Fair Value Hedge Accounting (2)
For overall effective fair value hedges
The hedged item
is valued at its normal basis plus the change in the fair value attributable to the hedged risk since the inception of the hedge (to the extent that this change is not already reflected in its normal basis) and
unrealized gains and losses are recorded in income
Examples: HTM securities, AFS securities
The hedge is fair valued on the balance sheet with unrealized gains and losses recorded in income
This is normal accounting for derivatives
Income on the hedge and hedged item offset for the effective portion of the hedge but not for the ineffective portion of the hedge 189 Cash Flow Hedge Accounting
Applies to hedges of on-balance sheet assets or liabilities or off-balance sheet forecasted transactions whose cash flows vary
examples: floating-rate assets or liabilities, forecasted purchases of assets or issuances of debt...
Q: is a forecasted transaction an exposure?
In some cases, can hedge specific risks within these exposures (e.g., interest rate risk)
the proposed ASU would retain
190 Cash Flow Hedge Accounting (2)
For overall effective cash flow hedges, the hedge is fair valued on the balance sheet with gains and losses initially recorded in accumulated other comprehensive income (AOCI) and subsequently reversed to smooth the income effect of the hedged item
E.g., cash flows on interest-rate swaps smooth interest revenue on floating-rate hedged items
For other derivatives (e.g., forwards and futures…see Derivatives Problem 4), the income statement effect usually occurs in one shot
Gains and losses that occur during an accounting period that are reversed later in the same accounting period may appear to bypass AOCI and go straight to net income 191 Cash Flow Hedge Accounting (3)
Gains and losses associated with hedge ineffectiveness are recognized immediately in net income for overhedges but not for underhedges
An overhedge (underhedge) means the absolute cumulative change in the value of the hedge is greater (less) than necessary to offset the cumulative change in the expected future cash flows on the hedged item
the proposed ASU would recognize hedge ineffectiveness for cash flow underhedges, although the FASB appears to have backed off this proposal
192 Example: Fair Value vs. Cash Flow Hedge Accounting
Assume a bank holds
$100 of floating-rate assets paying interest each year at the current market interest rate (CIBOR) and principal in 3 years
CIBOR: 10% end year 0, 12% end year 1, 11% end year 2
$90 of fixed-rate debt paying interest each year at a 10% rate and principal in 3 years
debt experiences gain of $3.04 when CIBOR changes to 12% and a loss of $.8 when CIBOR changes to 11%
$95 notional principal receive fixed (10%)-pay floating (CIBOR) interest rate swap
swap experiences loss of $3.21 when CIBOR changes to 12% and a gain of $.84 when CIBOR changes to 11%
swap can be designated as cash flow hedge of floating-rate assets or fair value hedge of fixed-rate liabilities 193 Example (2)
If swap is designated as cash flow under-hedge of floating- rate assets Year 1Year 2Year 3 interest revenue on assets 10 12 11 interest expense on debt 9 9 9 interest revenue on swap 0 (1.9) (.95) net income 1 1.1 1.05 accumulated OCI (3.21) (.86) 0
Swap smoothes 95% of the variation in interest revenue on
the floating-rate assets 194 Q h ld th l l ti h if th h d ti l Example (3)
If swap is designated as fair value over-hedge of fixed-rate debt and fair value interest is used Year 1Year 2Year 3 interest revenue on assets 10 12 11 interest expense on debt 9 10.44 9.81 interest expense on swap 0 .39 .09 gain on debt 3.04 (.8) 0 gain on swap (3.21) .84 0 net income .83 1.21 1.1
195 Example (4)
Comparison of hedge accounting methods Year 1 Year 2 Year 3 Cash flow hedge of floating-rate loans net interest income=net income 1 1.1 1.05 owners’ equity 7.79 11.25 13.15 Fair value hedge of fixed-rate debt net interest income 1 1.17 1.1 net income .83 1.21 1.1 owners’ equity 10.83 12.04 13.15 Q: What changes if interest is calculated on a amortized cost basis for the debt and as the cash flow for the swap in fair value hedge accounting?
196 Example (5)
Summary
cash flow hedge accounting
yields excessive smoothing of net income
ignores ineffectiveness associated with under-hedging
yields excessive volatility in owners’ equity
fair value hedge accounting
records gains and losses in periods they occur
yields correct net income and owners’ equity for hedging relationship (not necessarily for firm though)
197 Required Disclosures
Firm must disclose
its objectives and strategy for risk management
for fair value and cash flow hedges separately, the net gain or loss included in net income due to hedge ineffectiveness from following sources
exclusion from the test for hedge ineffectiveness
hedge ineffectiveness
because it is probable that hedged forecasted transaction will not occur
where gains and losses from hedge ineffectiveness appear in the income statement
198 Required Disclosures (2)
for cash flow hedges
the change in accumulated OCI during period due to
gains and losses on hedge
reclassification into net income
how much accumulated OCI will be reclassified into net income over the next year and why
maximum tenor of cash flow hedges
199 Required Disclosures (3)
FAS 161 expanded FAS 133’s disclosure requirements. Firms have to disclose information about derivatives distinguishing
fair value versus cash flow hedges
derivatives used for other risk management purposes (economic hedges)
derivatives used for other purposes (nonhedges)
for some disclosures, nonhedge derivatives can be aggregated with the trading portfolio
FAS 161’s required disclosures
firms’ risk management objectives by primary type of risk (e.g., interest rate, credit…)
qualitative disclosures of overall exposures by type of risk are 200 encouraged but not required Required Disclosures (4)
FAS 161’s required disclosures (continued)
tables indicating
gross fair values of derivative assets and liabilities with no offsetting (even if the legal right of setoff applies) and where they are located on balance sheet
gains and losses recorded in net income and where they are located on income statement
gains and losses on fair value hedged items must also be disclosed
gains and losses recorded in OCI and reclassified from AOCI to net income and where they are located on income statement
for derivative liabilities with credit contingent features
the nature of those features
fair value
the fair value of assets that are posted as collateral 201 the additional fair value of assets that would have to be posted or Required Disclosures (5)
FSP FAS 133-1 and FIN 45-4 requires disclosures about written credit derivatives
Nature, terms, trigger events
Maximum future payments (ignoring collateral and third-party recourse)
Fair value
Collateral and third-party recourse
202 Analysis of Derivatives and Hedging
First assess the bank’s economic hedging using its derivatives and market risk disclosures
characterize the bank’s net exposure pre-derivatives
nature, magnitude, term
assess how the bank uses derivatives to modify this net exposure
is bank hedging or speculating?
is the bank attempting to reduce fair value or cash flow volatility?
is hedge one-sided or two-sided?
are the amounts, sensitivities, and tenors of the derivatives reasonable?
assess the threats to hedge effectiveness
basis risk, non-linearity, unknown exposure
203 Analysis of Derivatives and Hedging (2)
Then ask how accounting describes the bank’s economic hedging using derivatives
do its economic hedges qualify as accounting hedges?
if so, are they fair value hedges or cash flow hedges?
what are the limitations of the accounting?
204 Takeaways
FAS 133, 138, 149, and 161 are limited, evolutionary standards
partly fair value accounting for hedging relationships is superimposed on largely amortized cost accounting for traditional exposures
two inconsistent models of hedge accounting
The burden is on users of financial reports to understand
bank’s pre-derivatives exposures
banks’ modification of these exposures using derivatives
how banks’ derivatives use is captured by the accounting
Significantly improved disclosures of derivatives, hedge
ineffectiveness, and market risk usually provide sufficient 205 information either to develop such an understanding or to Conclusions
We hope these discussions and exercises increase your ability to analyze and understand accounting practices for banks and other financial institutions.
Good luck!
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