DERIVATIONS® DEMYSTIFYING RISK MANAGEMENT SOLUTIONS

VOLUME NO. 20

REVISIONS TO ACCOUNTING THE CHALLENGE RULES REOPENS DOOR TO DERIVATIVES IN CROSS-BORDER The global nature of the capital markets allows many companies to capture lower costs of FINANCING funds and greater market liquidity by raising capital outside their country of domicile. However, the full benefits of cheaper funding can only be realized if there is an Recent revisions to the new U.S. deri- economically viable, and financial statement friendly, method to convert foreign currency vatives accounting rules make it possible cash flows back into the company's functional currency. for U.S. GAAP issuers to again use cross- Long-term cross-currency interest rate swaps are a proven technique for addressing this currency interest rate swaps in global problem. They allow financing to be raised in the most efficient market, carry over the funding strategies. The changes restore financing advantages (cost, covenants, and rate character) from the source to the target financial statement hedge treatment for a currency, and eliminate currency risk on a cash-flow-neutral basis. widely used tool that enables borrowers to New U.S. accounting rules for derivatives and hedging activity have changed the financial access low cost capital across the world. statement impact of cross-currency interest rate swaps. The rules require mark-to-market treatment for derivative contracts, unless certain stringent hedge accounting rules are met, in which case deferral accounting is allowed. As initially written, the new rules excluded almost all cross-currency swaps from meeting hedge accounting guidelines. However, recent revisions now permit appropriately constructed transactions to qualify for hedge accounting. This allows all of the economic benefits of cross-currency swaps to be realized, while minimizing negative financial statement impact.

FAS 133 Background In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). FAS 133 was formally amended by FAS 138, and informally interpreted through discussions of the Derivative Implementation Group (DIG). The original rules, the amendment, and the interpretations collectively redefine hedge accounting practices, including the identification of hedgeable risks, designation and effectiveness, and accounting recognition and measurement. The fundamental principle of FAS 133 is that all derivative contracts are assets or liabilities that must be recorded on the balance sheet at fair value, with any changes in the fair value recognized in earnings unless specific hedge criteria are met. Changes in value of derivatives that do not qualify under the hedge accounting rules are always recorded in current period earnings. If a transaction qualifies under the hedge accounting rules of FAS 133, a company is allowed to offset the income statement impact of the change in fair value of the derivative.

Hedging Cross-Border Funding To account for a cross-currency swap prior to the adoption of FAS 133, a company recorded interest expense at the rate paid on the functional currency leg of the swap. Changes in the value of the currency component of the swap were deferred and recorded as an offset to translation gains or losses on the debt. This hedge accounting treatment applied to foreign currency borrowings swapped back to the issuer's domestic currency. DEMYSTIFYING RISK MANAGEMENT SOLUTIONS

CONTINUED Under the original version of the FAS 133 rules, cross-currency interest rate swaps were not accorded hedge accounting treatment. The impact of this was to prevent borrowers from raising capital abroad for use domestically. Under the revised rules, a cross-currency interest rate swap is accounted for as a fair value or cash flow hedge, depending on the character of the target debt, as illustrated below.

Where fair value hedge accounting is applied, changes in the value of the derivative, and changes in the value of the hedged, foreign-denominated debt are recorded in current earnings. To the extent that the changes offset each other, there is no net income statement impact. Where cash flow hedge accounting is applied, changes in the value of the derivative that are deemed effective are deferred into equity, and recognized in income, to offset interest and currency translation effects on the hedged, foreign currency debt.

Case Study U.S. companies regularly make use of cross-border funding through bond issues in offshore markets. The example on the next page illustrates the economic and financial statement impacts of cross-border funding under the new U.S. accounting rules. A U.S. company can borrow USD domestically at T+1.50% (6.90% currently) fixed for 10 years. As an alternative, the company can issue 10 year Euro-denominated notes in London at a rate of 5.80% for 10 years. Since the borrower's objective is to raise USD, a cross-currency swap is used to convert the Euro-denominated notes to dollars. In the swap, the company agrees to receive a fixed Euro interest rate equal to the coupon on underlying issue, and pay a USD fixed rate of 6.65%. This represents a 25 basis point saving compared to issuing direct in the domestic U.S. market. In addition to the periodic exchange of interest payments, the swap incorporates an initial exchange of principal. The company delivers the Euro proceeds of the issue, and receives dollars with the exchange rate set at the spot rate on the date of issue. The company also agrees to a re-exchange of principal at maturity of the swap, using the Euros it receives in the re-exchange to redeem the bond issue, and delivering dollars to the swap counterparty at exactly the same rate used in the initial exchange. DEMYSTIFYING RISK MANAGEMENT SOLUTIONS

CONTINUED

If the company issues EUR100MM in notes when the exchange rate is USD .90/EUR, it will deliver EUR100M and receive USD90M through the swap. At maturity, the flows are reversed.

Economics: The cross-currency swap produces USD90M of new financing for the company at a saving of .25%, compared to direct USD issuance. The swap allows the company to draw on a pool of advantageously-priced capital outside its home market, broaden its investor base, and preserve its access to domestic capital sources for future use.

Accounting: The cross-currency swap qualifies under FAS 133 as a cash flow hedge of the forecasted U.S. dollar equivalent of the Euro cash flows that are associated with the interest payments on the Euro debt issue. The swap is not eligible for short-cut treatment (only single currency interest rate swaps qualify), but can be expected to be highly effective, provided the key terms of the derivative are properly structured and closely matched to those of the bond issue it hedges.

Because this is a cash flow hedge, financial statement effectiveness is calculated through the preparation of an Other Comprehensive Income (OCI) table. This table compares the cumulative change in the market value of the hedging derivative to the cumulative change in market value of the hedged asset or liability. The lesser of the absolute values of these two amounts is deemed to be the effective portion of the hedge gains or losses, and is recorded in OCI, a component of the equity section of the Balance Sheet. Changes in the value of the derivative hedge that are greater than or lesser than the value of the underlying asset or liability, represent ineffectiveness. An excess would be recorded in current earnings. If changes in the value of the derivative are less than the changes in value of the hedged cash flows, the shortfall is not recorded in current earnings.

Under the cash flow hedge methodology, the effective gains and losses recorded in OCI are recognized into income on a pro-rata basis, in each time period that the company makes USD payments on the debt issuance.

This treatment is appropriate as long as the hedge relationship meets the overall 80% - 125% effectiveness band required by the statement. DEMYSTIFYING RISK MANAGEMENT SOLUTIONS

CONTINUED Operational: To facilitate the preparation of the OCI table, and the measurement of effectiveness, companies need to value both the underlying liability and the derivative. The valuations are used to populate the OCI table, and as evidence of the highly-effective correlation of the hedging relationship. Although valuation of the derivative is a relatively straightforward matter (i.e. quotes from the swap counterparty are easily obtained), valuation of the underlying liability may be more complicated, depending on the nature of the instrument. On this topic, FAS 133 allows for alternative methodologies to provide the issuer more flexibility (i.e. other than quotes from financial intermediaries).

SUMMARY

Companies prefer to fund in the most efficient (lowest cost) market available to them. In some cases, the best alternative is to raise foreign currency funds, either through issuing debt in the name of the parent organization in a foreign country, or by issuing debt in the name of the foreign subsidiary, in that subsidiary's country of domicile. The amended rules of FAS 133 now allow the use of cross-currency interest rate swaps when hedging either type of foreign currency debt issuance. This allows a company to take advantage of the lower cost of funds available when funding in foreign currencies, and then use a cross- currency interest rate swap to convert the foreign cash flows back to their functional currency. While there are administrative issues involved in utilizing the cash flow hedge accounting model under FAS 133, the extra administrative effort is offset by potentially significant savings arising from tapping into low-cost sources of capital.

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