Transcript Financial Reporting for Derivatives and Risk Management

Financial Reporting for
Derivatives and Risk
Management Activities
Thomas J. Linsmeier
University of Illinois
AAA Annual Meeting
August 16, 1998
Workshop Topics
Common types of derivatives
Risk management activities
New financial reporting standards
FASB Statement 133
SEC Financial Reporting Release 48
Attend session at 10:30 a.m. tomorrow
Illustrative examples
Evaluation of Statement 133
2
What Are Derivatives?
“Derivatives”-A generic term used to describe a wide
variety of financial and commodity
instruments whose value depends on or is
derived from the value of an underlying
asset/liability, reference rate, or index.
3
Common Derivatives
Forwards / Futures
Options
Swaps
Hybrids / Embedded derivatives
4
Forward / Future Contracts
Obligate one party to buy and another party to sell an
underlying instrument or commodity at a future date
Future Date
Now
Instrument or
Commodity
Cash
Market
Forward
Market
Long
Short
Cash
Market Price
Instrument or
Commodity
Agree to Terms
Long
Short
Forward Price
5
Options
 Options provide the holder the right, but not the
obligation, to buy or sell the underlying
instrument or commodity at a predetermined
price called the “strike” or “exercise” price
 Options normally are in the form of a “Call” or a
“Put”
Calls - enable the holder to buy the underlying
instrument or commodity at the strike price
Puts - enable the holder to sell the underlying
instrument or commodity at the strike price
 Require “up-front” payment or “premium”
6
Payoff Profiles of Purchased
Puts and Calls
Payoff
Purchased Call
Exercise Price
Price of
underlying
instrument
Payoff
Purchased Put
Exercise Price
Price of
underlying
instrument
7
Swaps
Two parties exchange recurring payments
Similar to series of forward contracts
Interest-rate swaps most common
8
“Plain-Vanilla” Interest Rate
Swap
Floating Rate
(LIBOR)
X Notional Principal
Fixed-Rate
Receiver
Fixed-Rate
Payer
Fixed Rate
of 6.75%
X Notional
Principal
Note: LIBOR is London Interbank Offered Rate
9
Importance of Forwards,
Futures, Swaps, and Options
Instruments that involve the exchange of
cash flows
Can be used to alter existing cash flows
Comprise the basic risk management tools
10
Hybrid Instruments:
Embedded Derivatives
Simple derivatives are the fundamental
building blocks of these complex
structures
Structured note: Note with embedded
option or swap
Complex swap: “Plain vanilla” swap with
embedded options or leverage features
11
Managing Risks with
Derivatives
Low cost, ease, and speed of transacting
make derivatives attractive for managing
risk
Different derivatives provide means of
adjusting the timing, amount, and
variability of cash flows / fair values
Ideal for both hedging and speculation
12
How Are Derivatives Used?
Risk management (hedging)
Commodity price risk
Interest rate risk
Foreign currency price risk
Speculation
13
Commodity Price Risk
Cost of mining gold: $350 per pounce
Current gold spot price: $400 per ounce
Gold reserves sufficient for ten years of
production
Company exposed to risk of decreases in
future prices of gold
Cash flow exposure
forecasted transaction
14
Original Exposure
Profit
50
350
Gold
Production
Cost
Loss
400
Gold price
15
Risk Management Tool:
Short Forward
Profit
0
Loss
400
Current
forward
price
Gold
price
16
Net Position:
$50 Profit “Locked in”
Profit
Net Position
50
350
400
Gold price
Loss
17
Interest Rate Risk
Company issued a $100 million floating
rate note with interest payments based on
LIBOR
Interest expense: LIBOR X $100 Million
LIBOR currently is 7%
Company exposed to risk of increases in
LIBOR
Cash flow exposure
existing liability
18
Exposure at Each
Interest Payment Date
Interest
Expense
$7 Million
(.07 x $100. million)
0
7% LIBOR
19
Risk Management Tool:
Interest Rate Swap
Company with
Exposure
Receive Floating Rate
(LIBOR) X
Notional Principal
Bank or Other
Intermediary
Fixed-Rate
Receiver
Fixed-Rate
Payer
Pay 7.00%
Fixed Rate X
Notional Principal
20
Risk Management Tool:
Interest Rate Swap
Pay Fixed Rate of 7%, Receive LIBOR
Net
$7 Million (.07 x $100 Million)
Outflow
on Swap
0
Net
7%
LIBOR
21
Net Position at
Each Interest Payment Date
Net
Interest
Expense
Net Interest
Expense
$7 Million
0
7%
22
Reducing Funding Costs With
Derivatives
Swapping floating-rate cash flows to
fixed-rate reduces funding costs only if
rates increase
Swapping fixed-rate cash flows to
floating-rate reduces funding costs if rates
decrease
Funding costs reduced by “expressing a
view” (i.e., by betting on movements in
future interest rates)
23
Foreign Currency Price Risk
US Company commits to purchase machinery
from a French manufacturer
Payment of 10 million French francs (FF) to be
made six months from now
Currently $US/FF exchange rate $.20 per FF
US Company is exposed to risk of increases in
the $US price of a FF
Fair value exposure
firm commitment
24
Original Exposure
Cost
(in $US)
$2 Million
($.20/FF x FF10
Million)
0
.20
$US Price
of a FF
Current
Exchange Rate
25
Risk Management Tool:
Purchased Call Option
Payoff
in $US
.25
Exercise
price
$US price
of a FF
Strategic Issues:
 Company believes the price of a FF may go down
 Company does not want to pay more than $2.5 million for
26
machinery.
Net Cost of Machinery
Cost
(in $US)
NET COST
$2.5 million
$2 million
0
.20
.25
$US price
of a FF
Option payoff functions
as a reduction in cost
27
Speculation with Derivatives
Speculation primarily domain of dealers and
sophisticated traders
Speculative trading based on investors’ views of
future market movements
Using interest rate swaps to reduce funding
costs also requires “expressing a view” (i.e.
form of speculation)
Query: Is risk management much different from
speculation?
28
Speculating with Derivatives
A manufacturing company anticipates that a
certain commodity will soon drop in price.
To exploit this belief, the company sells the
commodity for forward (or future) delivery at a
price reflecting the current market consensus
If the price does decline, the company can buy
the commodity in the spot market and deliver it
against the forward contract
Profit = Forward price - spot price
29
FASB Statement 133*
“Accounting for
Derivative Instruments
and
Hedging Activities”
* Portions of the FASB's, "A Review of Statement 133-Accounting for Derivative Instruments
and Hedging Activities," copyright 1998 by the Financial Accounting Standards Board,
Norwalk, Connecticut 06856, are included by permission.
30
Statement 133: Why The
Change?
Quantity and variety of derivatives is
increasing
Accounting conventions and standards are
outdated, incomplete, and inconsistent
The resulting financial statements are not
transparent
31
Four Cornerstone
Decisions of Statement 133
Derivatives are contracts that create rights and
obligations that meet the definition of assets
and liabilities
Fair value is the only relevant measure for
derivatives
Only assets & liabilities should be on balance
sheet
Special hedge accounting should be provided,
but should be limited to transactions involving
offsetting changes in fair values or cash flows
for the risk being hedged
32
Statement 133: Key Aspects
All derivatives are at fair value on the
balance sheet
Special accounting for the change in value
of derivatives designated and qualifying
in:
Fair value hedges
Cash flow (forecasted transaction) hedges
Foreign currency hedges
33
Why Allow Hedge Accounting?
To resolve recognition and measurement
anomalies
These anomalies cause earnings effects in
different periods for hedging instrument
and hedged item
34
Common Reporting Issues:
Qualifying Hedges
Documentation requirements
Effectiveness and ineffectiveness
General disclosure requirements
Specific accounting and disclosure rules
fair value, cash flow, foreign currency hedges
Hedge termination
Impairment
35
Documentation Requirements
(Paragraphs 20(a), 28(a))
Formal documentation is required at the
inception of the hedge and must include:
Identification of the hedging instrument and
the hedged item
The nature of the risk being hedged
The risk management objective/strategy
How effectiveness will be assessed
36
Required Documentation - Example of
Cash Flow Hedge of Note Purchase
On 1/1/x1, XYZ purchases a call option on 5year treasury notes as a hedging instrument in
a cash flow hedge of a forecasted $100 million
5-year treasury note purchase at 12/31/x1
XYZ designates the decreases in cash flows
related to decreasing interest rates as the
hedged risk
For effectiveness measurement, the call
premium is excluded from the test. The call
option notional amount and forecasted note
amount match.
37
Effectiveness (Paragraphs 20
and 28)
Effectiveness is defined as the derivative
instrument’s ability to generate offsetting
changes in the fair value or cash flows of the the
hedged item. Key aspects:
For both fair value and cash flow hedges, the hedge is
expected to be highly effective
Effectiveness is measured at inception and must be
assessed whenever earnings are reported (at least
quarterly)
Effectiveness measures intended to be similar to “high
correlation” in Statement 80
38
Example of Highly Effective
Fair Value Hedge
$5.0
$4.0
$3.0
$3.8
$2.0
$0.4
$1.0
$$(1.0)
$(0.4)
$(2.0)
$(3.0)
$(4.0)
$(5.0)
Fair value change
- fixed-rate debt
Fair value change
- receive-fixed
interest rate swap
$(3.8)
6/30/x1
12/31/x1
39
Hedge Effectiveness Test
An item may be excluded from the
effectiveness test because it does not
provide offsetting cash flows, such as an
option’s time value (time value is the
amount paid for the option, excluding
payments for intrinsic value)
An item may be included in the
effectiveness test, but may generate
ineffectiveness
40
Effectiveness Implications
If the highly effectiveness test is failed, the
entire hedge does not qualify for special
accounting
If the highly effectiveness test is met, some
ineffectiveness may occur and a portion of the
derivative gain or loss may be recorded through
earnings
Ineffectiveness is recorded differently in cash
flow and fair value hedges, depending on the
hedging relationship
41
Ineffectiveness (Paragraphs 22
and 30)
Items included in the effectiveness test that
may generate ineffectiveness include:
Different value of hedged item and notional
principal
Different maturity or repricing dates
Different underlying interest rate basis e.g.
LIBOR versus Prime
Currency differences
Credit differences
42
General Disclosure
Requirements (Paragraph 44)
For all derivative instruments that qualify as
hedging instruments, the entity shall
disclose for each type of hedge the:
Objectives for holding derivatives
Context needed to understand those
objectives
Strategies for achieving those objectives
Entity’s risk management policy
Description of the items or transactions that
are being hedged.
43
Accounting for Fair Value
Hedges (Paragraphs 20-27)
A fair value hedge is a hedge of the exposure to
a change in fair value of a recognized asset or
liability or of an unrecognized firm commitment
attributable to a particular risk. Key aspects:
Assets or liabilities exposed to price risk
Change in value of hedged item and hedging
instrument recorded in earnings
Result is matching for effective hedge
Effective gain or loss adjusts basis of hedged item
44
Board Views - Fair Value
Hedges
Fair value hedging is reasonable because
the hedged item is a firm commitment or
an asset or a liability
Offsetting fair value changes of the
hedged item and the hedging instrument
through earnings provides a natural offset
45
Disclosure Requirements: Fair
Value Hedges (Paragraph 45(a))
Net gain or loss recognized in earnings during
the reporting period representing:
hedge ineffectiveness
the component of the derivatives gain or loss
excluded from the assessment of hedge
effectiveness
where the net gain or loss is reported
The amount of net gain or loss is recognized in
earnings when a hedged firm commitment no
longer qualifies as a fair value hedge.
46
Accounting for Cash Flow
Hedges (Paragraphs 28-35)
A cash flow hedge is a hedging relationship
where the variability of the hedged item’s cash
flows is offset by the cash flows of the hedging
instrument. Key Aspects:
Forecasted transactions or balance sheet
items with variable cash flows qualify
Effective gain or loss to OCI
Earnings recognition matches hedged item
Ineffective gain or loss may be recorded in
earnings
47
Board Views - Cash Flow
Hedges
Board decided to permit cash flow hedge
accounting as an accommodation to
constituents
Because the hedged forecasted
transaction is not recorded on the books,
derivative gains and losses are deferred in
other comprehensive income (OCI),
adding a layer of complexity
48
Board Views - Cash Flow
Hedges (continued)
Gains and losses on derivative contracts
do not represent future economic
sacrifices (liabilities) or benefits (assets)
Deferring gains or losses on derivatives as
a separate component of OCI, rather than
as a separate asset or liability, avoids
conceptual difficulties and increases
visibility for cash flow hedge transactions
49
Disclosure Requirements: Cash
Flow Hedges (Paragraph 45(b))
Net gain or loss recognized in earnings during
the reporting period
Description of transactions or other events that
will result in reclassification of gains and losses
deferred in accumulated OCI into earnings
within next 12 months
Maximum length of time entity is hedging
forecasted transaction variable cash flows
Discontinued hedge gains and losses because it
is probable forecasted transaction will not occur
50
Accounting for Currency
Hedges (Paragraphs 36-42)
Board intended to increase the consistency of
hedge accounting guidance by broadening the
scope of eligible foreign currency hedges. Key
aspects:
Cash flow and fair value hedges permitted
Carry forward most of the ideas in Statement
52
Hedge of net investment in sub
Use of nonderivative instrument
Some expansion of hedge accounting
particularly for forecasted transactions
51
Accounting for Hedge
Termination (Paragraph 25)
Terminate hedge accounting prospectively
when:
eligibility of qualification criteria not met
derivative expires, is sold, terminated or
exercised
hedge designation is removed
52
Impairment Issues (Paragraph
27)
Hedged item is still subject to impairment
reviews
Apply after basis of hedged item is
adjusted for changes in fair value or cash
flows
Fair value of hedging instrument is not
considered
53
Implementation Issues
What qualifies as a derivative instrument,
including embedded derivatives?
See Paragraphs 6-16, Appendix A, Section1,
and Appendix E
What qualifies as a hedged item?
See Paragraphs 21 and 29 and Appendix C
54
Implementation Issues
(continued)
Assessment of hedge effectiveness
See Appendix A, Section 2
Transition provisions
See Paragraphs 48-56 and Appendix B,
Section 3
55
Illustrative Examples
Fair value hedge
Cash flow hedge
Appendix B, Section 1
56
Definition of a Fair Value
Hedge
A fair value hedge
is a hedge of the
exposure to a
change in fair value
of a recognized
asset
or liability or of
an unrecognized
firm commitment
attributable to a
particular risk.
$5.0
$4.0
$3.8
$3.0
$2.0
$1.0
$0.4
$$(1.0)
$(0.4)
$(2.0)
$(3.0)
$(4.0)
$(5.0)
Fair value
change: fixedrate debt
Fair value
change: receivefixed interest rate
swap
$(3.8)
6/30/x1
12/31/x1
57
DEFINITION OF FAIR VALUE
Fair value is defined as the amount at which
an asset (or liability) can be bought (or
incurred) or sold (or settled) in a current
transaction between willing parties, other
than in a forced or liquidation sale.
Quoted market prices are the best indicator.
In the absence of quoted prices, use other
valuation techniques.
58
DEFINITION OF A RECOGNIZED
ASSET OR LIABILITY
A recognized asset or liability is defined as
an asset or liability recorded on the
balance sheet (i.e., not a future
transaction or an unrecorded intangible
asset).
Hedgeable assets or liabilities include:
 Available-for-sale securities
 Commodity-type inventory
 Fixed-rate loan obligations
59
DEFINITION OF A FIRM
COMMITMENT
A firm commitment has the characteristics
of an asset or liability and must be:
Specific as to price, quantity, and timing
With an unrelated party, binding on both parties
and usually legally enforceable
Probable due to significant disincentive for
nonperformance
Example: Agreement with an unrelated
party to purchase five machines (a fixed
quantity) for $500 per machine (a fixed
price) in six months (fixed timing)
60
Fair Value Hedge Accounting
Key concepts:
Derivatives are always recorded on the balance
sheet at fair value.
The change in a derivative’s fair value is always
recognized in earnings.
Offsetting gains/losses on hedged items are
recognized in earnings and adjust the carrying
amount of those items.
61
STATEMENT 133 CRITERIA:
Hedgeable Items
Changes in fair value of the following items
can be hedged:
Financial assets or liabilities (four specific risks
can be hedged)
Non-financial assets or liabilities (the only risk
that can be hedged is the risk of changes in fair
value of the entire hedged asset or liability)
Note: Assets or liabilities already measured
at fair value through earnings, such as
trading securities, cannot be hedged items.
62
STATEMENT 133 CRITERIA:
Risks That Can Be Hedged
For financial assets or liabilities, the hedged risk
can be the risk of changes in fair value :
Of the entire hedged item
Due to market interest rates
Due to foreign currency exchange rates
Due to an obligor’s creditworthiness
Note: Prepayment risk cannot be the hedged
risk. (However, the option component of a
prepayable instrument can be designated as the
hedged item.)
63
STATEMENT 133 CRITERIA:
Items Not Qualifying For Hedge
Accounting
Transactions not affecting earnings do not
qualify for hedge accounting, such as:
Projected purchases of treasury stock
Intercompany transactions (except foreign
currency)
Anticipated stock issuances in relation to a stock
option plan for which no compensation expense
is recognized for changes in stock price
64
STATEMENT 133 CRITERIA:
Items Not Qualifying For Hedge
Accounting (continued)
Other exclusions:
Equity method investments
Minority interests in consolidated subsidiaries
Equity investments in consolidated
subsidiaries
Firm commitments to enter into business
combinations
An equity instrument issued by the entity and
recorded in stockholders equity
65
Example: Fair Value Hedge of
Firm Commitment
 XYZ manufactures titanium products. Its titanium
supplier requires a 6-month firm commitment. On
1/1/x1, XYZ enters into a firm commitment with its
supplier to buy 10,000 units of titanium at the current
forward rate of $310 per unit on 6/30/x1.
 XYZ wants to purchase and record the titanium at
whatever the market price will be on 6/30/x1.
Therefore, on 1/1/x1, XYZ enters into a forward contract
to sell 10,000 units of titanium at the current forward
rate of $310 per unit.
 Hedge effectiveness is based on changes in the 6/30/x1
forward price of titanium.
66
Example: Fair Value Hedge of Firm
Commitment
Date
Spot
Rate
Fwd
Rate for
6/30
Maturity
Fair
Value
of Fwd
Fair Value
of Firm
Commitment
January 1
$300
$310
$0
$0
March 31
$292
$297
$128,079
($128,079)
June 30
$285
N/A
$250,000
($250,000)
$128,709 = (310 - 297) * 10,000, present valued at 6% for 3 months
$250,000 = (310 - 285) * 10,000
67
Example: Fair Value Hedge of
Firm Commitment
Journal entries at 3/31/x1:
Forward contract
Gain on forward contract
128,079
128,079
To record change in fair value of forward contract
Loss on firm commitment
Firm commitment
128,079
128,079
To record change in fair value of firm commitment
68
Example: Fair Value Hedge of
Firm Commitment
Journal entries at 6/30/x1:
Forward contract
Gain on forward contract
121,921
121,921
To record change in fair value of forward contract
Loss on firm commitment
Firm commitment
121,921
121,921
To record change in fair value of firm commitment
($121,921 = $250,000 less $128,079)
69
Example: Fair Value Hedge of
Firm Commitment
Journal entries at June 30 (con’t):
Cash
250,000
Forward contract
250,000
To record cash receipt upon settlement of
forward contract
70
Example: Fair Value Hedge of
Firm Commitment
Journal entries at June 30 (con’t):
Titanium
3,100,000
Cash
3,100,000
To record purchase of titanium at contracted rate
Firm Commitment
Titanium
250,000
250,000
To derecognize the firm commitment and adjust
the carrying amount of the titanium purchase
71
Cash Flow Hedge
A cash flow hedge
is a hedging
relationship where
the variability of
the hedged item’s
cash flows are
offset by the cash
flows of the
hedging
instrument.
4
3
3.35
2.85
Cash
outflow,
LIBOR debt
2
1
Cash flow,
pay-fixed
rate swap
0.15
0
-1
-0.35
72
Statement 133 Criteria:
Hedgeable Items
Cash flow hedge provisions allow an
entity to designate a derivative instrument
as a hedge of the exposure to variability
attributable to specific risks in the cash
flows of:
A recognized asset or liability such as a
variable-rate bond
A forecasted transaction such as an
anticipated issuance of a fixed-rate debt
73
Statement 133 Criteria:
Financial Asset and Financial Liability
Hedgeable Risks
For forecasted purchase or sale of a
financial asset or liability, hedgeable cash
flow risks include:
Changes in the cash flows relating to the
purchase or sale of the entire asset or liability
Changes in market interest rates
Changes in the obligor’s creditworthiness
74
STATEMENT 133 CRITERIA:
Eligible Forecasted Transaction
The eligible forecasted transaction must be:
A single transaction or a group of individual
transactions
Probable to occur
With a third party external to the reporting entity
and present an exposure to variations in cash
flows for the hedged risk that could affect
reported earnings
75
STATEMENT 133 CRITERIA:
Ineligible Forecasted Transaction
The following items do not qualify for hedging:
Items subject to remeasurement with changes in
value attributable to the hedged risk reported
currently in earnings
Interest rate risk of the forecasted purchase or
sale of a held-to-maturity security
Forecasted business combinations subject to
Opinion 16 or related to a parent company's
interest in a consolidated subsidiary or an
equity-method investment
76
STATEMENT 133 CRITERIA:
Earnings Recognition
An entity’s risk management strategy may
exclude a component of a derivative’s change in
fair value
This amount is recognized currently in earnings
Other ineffective portions of hedge may be
recognized in earnings
Is change in derivative less than change in hedged
item?
Amounts in OCI shall be reclassified to earnings
when the hedged item affects earnings
77
Example: Cash Flow Hedge of
Forecasted Inventory Sale
 ABC designated the risk being hedged as its cash flows
related to a forecasted sale of 100,000 bushels of
Commodity A at the end of period 1 (the bushels
originally were acquired for $1 million).
 On the first day of period 1, ABC enters into Derivative Z
to sell 100,000 bushels at $1.1 million at the end of
period 1. At hedge inception, the derivative is at-themoney (i.e., its fair value was zero).
 Hedge has no ineffectiveness because all terms of the
forecasted sale and the derivative match.
 At the end of period 1, Derivative Z has a fair value of
$25,000 and the 100,000 bushels of Commodity A were
78
sold for $1.075 million.
Example: Cash Flow Hedge of
Forecasted Inventory Sale
Journal entries at end of period 1:
Derivative Z
25,000
OCI
25,000
To record Derivative Z at fair value
Cash
25,000
Derivative Z
25,000
To record settlement of Derivative Z
79
Example: Cash Flow Hedge of
Forecasted Inventory Sale
Journal entries at end of period 1:
Cash
1,075,000
Revenue
1,075,000
COGS
1,000,000
Inventory
1,000,000
To record inventory sale
OCI
25,000
Earnings
25,000
To reclassify amount in OCI to earnings upon inventory
sale
80
Example: Cash Flow Hedge of
Forecasted Inventory Sale
Forecasted cash flows:
Actual cash flows:
Derivative
Sale of inventory
$1,100,000
$25,000
$1,075,000
$1,100,000
Variability of cash flows is offset by
derivative
81
Advanced Topics
Accounting (1) for the ineffective portion
of a hedge and (2) for fair value and cash
flow hedges when swaps are the hedging
instrument
See Appendix B, Section1
Accounting for foreign currency risk in the
net investment in a subsidiary
See FASB Statement 52
82
Advanced Topics (continued)
Application of the clearly and closely
related criterion to determine the
existence of embedded derivatives
See Appendix B, Section 2
Hedging of a portfolio of similar assets or
similar liabilities
See Paragraph 21(a)(1) and Appendix C
83
Advantages of Statement 133
A clear improvement over existing
practice
Increases transparency of derivatives in
financial statements
Provides a complete and consistent
accounting model for all types of
derivatives and hedging activities
Guidance is consistent with the
Conceptual Framework
84
Disadvantages of Statement
133
Extremely complex standard
For fair value hedges, hybrid nature of
measurement attribute for hedged item
Promotes risk management at transaction
level
Promotes derivatives as only hedging
instrument
85
A Look to the Future
Is hedge accounting warranted?
Risk management also involves “taking a
view”, which is similar to speculation
Fair value all financial instruments
Discontinuation of cash flow hedges of
forecasted transactions?
86
Closing Remarks
For electronic copies of the slides for use
in classroom presentations at a college or
university, please contact me at
[email protected]
Thanks for your attention!
87