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Session 7 Derivatives and Hedging

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Session 7 Derivatives and Hedging 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,
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