Transcript Foundations

Forwards and Futures
Go To Bob Jensen’s Flow Chart
http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm
3-1
TRANSACTION MARKETS
3-2
•
Spot or Cash: Immediate exchange of
property for payment
•
Forward:
Later exchange of
property for payment, t
terms fixed today
•
Futures:
Like forwards, but...
FORWARD CONTRACTS
3-3
•
Price setting mechanisms for deferred
value dates
•
Totally flexible in terms of timing and size
of transactions
•
Negotiated on a principal-to-principal
basis
•
Introduce credit risk exposure to
counterparties for profitable positions
FUTURES CONTRACTS
• Price setting mechanisms for deferred
value dates
• Designed with specific value dates and
fixed contract sizes
• Exchange traded, with bids and offers
provided by exchange members
• Daily cash settlements insure against the
risk of counter-party defaults
3-4
FINANCIAL INTEGRITY
3-5
•
Variation Margin:
•
Initial Margin:
Good faith deposit or
collateral
•
Maintenance Level:
Minimum below which
account cannot fall
One day’s gain or loss
of the futures position
(#contracts  price change  multiplier)
CUSTOMER PERFORMANCE BONDS
Alternative Qualifying Instruments
•
•
•
•
•
•
•
3-6
U.S. currency and Government securities
Bank letters of credit
GNMA pass-throughs
Selected Brady bonds
Selected sovereign securities
NYSE, AMEX, S&P500 and S&PMidCap
stocks
Selected mutual funds
Forecasted Transactions Versus
Firm Commitments
Forecasted transactions that are highly probable
with a known notional and cash flow risk from
an unknown spot price or rate
Firm commitments that are contracted with a
specified notional and transaction price that
eliminates cash flow risk but creates value risk
equal to the difference between spot versus
contracted price or rate
3-7
Accounting for Forecasted Transactions
Versus Firm Commitments
Forecasted transactions are not booked or even
disclosed under present accounting standards.
Firm commitments (more generally known as
purchase commitments in the case of
purchases) are to be disclosed but are not to be
booked unless a significant loss anticipated.
Then conservatism in dictates booking an
anticipated loss reserve that is much like an
allowance for warranty or bad debt expense.
3-8
Examples 1 and 4 FAS 133 Appendix B
Fair Value vs. Cash Flow Hedges
See 133ex01a.xls at
http://www.cs.trinity.edu/~rjensen/
3-9
Delta Ratio Effectiveness Testing
80%<Delta<125% Bounds
Paragraph 146 in IAS 39
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.
3-10
Example 4 from FAS 133 Paragraph 128
With 100% Delta Effectiveness
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$1,025,000
Inventory
Book
Value
$0
$0
Cash Flow
Hedge
Value
$0
$25,000
$25,000 = Change in Hedged Item Value
$25,000 = Change in Hedge Contract Value
Delta = 1.00 or 100%
3-11
Example 4 from FAS 133 Paragraph 128
With 100% Delta Effectiveness
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$1,025,000
Jan. 31
Inventory
Book
Value
$0
$0
Forward Contract
P&L
OCI
Cash Flow
Hedge
Value
$0
$25,000
Debit
25,000
0
Credit
25,000
For cash flow hedges, adjust hedging derivative to fair value and offset to
OCI to the extent of hedge effectiveness.
3-12
Example 4 from FAS 133 Paragraph 128
With 90% Delta Effectiveness
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$1,025,000
Inventory
Book
Value
$0
$0
Cash Flow
Hedge
Value
$0
$22,500
$25,000 = Change in Hedged Item Value
$22,500 = Change in Hedge Contract Value
Delta = 0.90 or 90%
3-13
Example 4 from FAS 133 Paragraph 128
With 90% Delta Effectiveness
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$1,025,000
Jan. 31
Inventory
Book
Value
$0
$0
Forward Contract
P&L
OCI
Cash Flow
Hedge
Value
$0
$22,500
Debit
22,500
2,500
Credit
25,000
Hedge accounting is allowed only to the degree of effectiveness if Delta is
within 80%-125% range.
3-14
Example 4 from FAS 133 Paragraph 128
With 75% Delta Effectiveness
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$1,025,000
Inventory
Book
Value
$0
$0
Cash Flow
Hedge
Value
$0
$18,750
$25,000 = Change in Hedged Item Value
$18,750 = Change in Hedge Contract Value
Delta = 0.75 or 75%
3-15
Example 4 from FAS 133 Paragraph 128
With 75% Delta Effectiveness
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$1,025,000
Jan. 31
Inventory
Book
Value
$0
$0
Forward Contract
P&L
OCI
Cash Flow
Hedge
Value
$0
$18,750
Debit
18,750
Credit
18,750
0
When the hedge effectiveness lies outside the 80%-125% range, hedge
accounting is not allowed.
3-16
Example 4 Modified As Follows
Forecasted Transaction
Entry
Inventory
Book
Cash Flow
Hedge
Date
Jan. 01
Jan. 31
Feb. 28
Mar. 31
Value
$0
$0
$0
$1,050,000
Value
$0
$18,750
$25,000
$50,000
Value
$1,000,000
$1,025,000
$1,025,000
$1,050,000
Suppose the inventory is purchased on March 31.
Suppose the inventory is sold on April 30 for $1,100,000.
3-17
Example 4 Modified
February 28 Adjustment of Forward Contract
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$1,025,000
Feb. 28
$1,025,000
Inventory
Book
Value
$0
$0
$0
Cash Flow
Hedge
Value
$0
$18,750
$25,000
Debit Credit
Feb. 28 Forward Contract 6,250
P&L
18,750
OCI
25,000
Bal.
25,000
0
25,000
Hedge effectiveness can be initially designated as being tested on a
cumulative basis.
3-18
Example 4 Modified
March 31 Adjustment of Forward Contract
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Feb. 28
$1,025,000
Mar. 31
$1,050,000
Inventory
Book
Value
$0
$0
$1,050,000
Mar. 31 Forward Contract
P&L
OCI
Cash Flow
Hedge
Value
$0
$25,000
$50,000
Debit Credit
25,000
0
25,000
Bal.
50,000
0
50,000
The forward contract is settled for $50,000 in cash to offset the increase
to $1,050,000 of the hedged item’s price. FAS 133 says carry
forward OCI balance until inventory is sold. IAS 39 has an OCI
basis adjustment on March 31, unlike FAS 133.
3-19
Example 4 Modified
March 31 Purchase of Inventory
Debit Credit
Mar. 31 Cash
50,000
Forward contract
50,000
Mar. 31 Inventory
Cash
Bal.
50,000
0
1,050,000
1,050,000
1,050,000 (1,000,000)
Under IAS 39, there will also be an entry to close the
$50,000 in OCI to P&L. Under FAS 133, there will be no
such basis adjustment until the inventory is sold.
3-20
Example 4 from FAS 133 Paragraph 128
April 30 Basis Adjustment of OCI
Forecasted Transaction
Sales
Date
Jan. 01
Apr. 30
Apr. 30
Amount
$0
$1,100,000
Inventory
Book
Value
$0
$1,050,000
Debit
50,000
OCI
P&L
Cash Flow
Hedge
Value
$0
$0
Credit
Bal.
0
50,000 (50,000)
The sales profit of $1.1 million less $1.05 million is $50,000 without
hedging. With a cash flow hedge, retained earnings is increased by
another $50,000 that locked in inventory value at $1 million.
3-21
Basis Adjustment Alternatives
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.
3-22
Example 4 Modified
April 30 Sale of Inventory
Apr. 30 P&L (CGS)
Inventory
Debit Credit
Bal.
1,050,000
1,050,000
1,000,000
0
Apr. 30 Cash
1,100,000
100,000
P&L (Sales)
1,100,000
(100,000)
The sales profit of $1.1 million less $1.05 million is $50,000
without hedging. With a cash flow hedge, retained earnings
is increased by another $50,000 that locked in inventory
value at $1 million.
3-23
Cash Flow Hedge of a Precious Metal
or Any Hedged Item to be Carried at Value
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$1,025,000
Gold
Book
Value
$0
$0
Cash Flow
Hedge
Value
$0
$22,500
$25,000 = Change in Hedged Item Value
$22,500 = Change in Hedge Contract Value
Delta = 0.90 or 90%
3-24
Cash Flow Hedge of a Precious Metal
or Any Hedged Item to be Carried at Value
Forecasted Transaction
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$1,025,000
Jan. 31
Gold
Book
Value
$0
$0
Forward Contract
P&L
OCI
Cash Flow
Hedge
Value
$0
$22,500
Debit
22,500
Credit
22,500
0
Paragraph 29(d) of FAS 133 prohibits the hedged item to be any item that is
or will be carried on the books at fair value after acquisition.
3-25
New Example
New Example Coming Up
3-26
Firm Commitment with Contracted Price
With 100% Delta Effectiveness
Firm Commitment
Entry
Date
Jan. 01
Jan. 31
Value
$1,000,000
$975,000
Inventory
Book
Value
$0
$0
Fair Value
Hedge
Value
$0
$25,000
-$25,000 = Change in Value of Hedged Item
$25,000 = Change in Value of Hedge Contract
Delta = 1.00 = 100%
3-27
Firm Commitment with Contracted Price
With 100% Delta Effectiveness
Firm Commitment
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$975,000
Jan. 31
Inventory
Book
Value
$0
$0
Fair Value
Hedge
Value
$0
$25,000
Debit
Forward contract 25,000
P&L
0
Firm commitment
Credit
25,000
For firm commitments, the fair value hedge is adjusted to full value with
the effective portion to firm commitment.
3-28
Firm Commitment with Contracted Price
With 90% Delta Effectiveness
Firm Commitment
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$975,000
Jan. 31
Inventory
Book
Value
$0
$0
Fair Value
Hedge
Value
$0
$22,500
Debit
Forward contract
22,500
P&L
2,500
Firm commitment
Credit
25,000
Hedge accounting is allowed only to the degree of effectiveness if Delta is
within 80%-125% range.
3-29
Firm Commitment with Contracted Price
With 75% Delta Effectiveness
Firm Commitment
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$975,000
Jan. 31
Inventory
Book
Value
$0
$975,000
Forward contract
P&L
Firm commitment
Fair Value
Hedge
Value
$0
$18,750
Debit
18,750
Credit
18,750
0
When the hedge effectiveness lies outside the 80%-125% range,
hedge accounting is not allowed.
3-30
New Example
New Example Coming Up
3-31
Example 1 from FAS 133 Paragraph 105
With 100% Delta Effectiveness
Inventory on Hand
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$975,000
Jan. 31
Inventory
Book
Value
$1,000,000
$975,000
Forward contract
P&L
Inventory
Fair Value
Hedge
Value
$0
$25,000
Debit
25,000
0
Credit
25,000
When the hedged item is already booked at historical cost, change
its accounting to fair value during hedging period.
3-32
Example 1 from FAS 133 Paragraph 105
With 90% Delta Effectiveness
Inventory on Hand
Entry
Date
Value
Jan. 01
$1,000,000
Jan. 31
$ 975,000
Jan. 31
Inventory
Book
Value
$1,000,000
$ 975,000
Forward contract
P&L
Inventory
Fair Value
Hedge
Value
$0
$22,500
Debit
22,500
2,500
Credit
25,000
Hedge accounting is allowed only to the degree of effectiveness if
Delta is within 80%-125% range.
3-33
Example 1 from FAS 133 Paragraph 105
With 75% Delta Effectiveness
Inventory on Hand
Entry
Date
Jan. 01
Jan. 31
Fair Value
Hedge
Value
Value
$1,000,000
$0
1,000,000 (no change) $18,750
Debit
Credit
Jan. 31 Forward contract
18,750
P&L
18,750
When the hedge effectiveness lies outside the 80%-125% range,
hedge accounting is not allowed.
3-34
Value
$1,000,000
$975,000
Inventory
Book
Cumulative Dollar Offset Hedging
Actually is More Complicated
See 133ex07a.xls at
http://www.cs.trinity.edu/~rjensen/
3-35
Forward Versus Futures Contracts
Quotations from Walter Teets
September 7, 2000 email message to Bob Jensen
The error in our case is simply that the futures values (due to changes
in either spot or futures prices) shouldn't be present valued, since
there is daily settling up. But the (change in) values of the anticipated
cash flows of the hedged item should be present valued, because there
is usually no periodic settling of the cash flows associated with the
hedged item. The change to the case is minor; the major point of the
futures case is to show exclusion of the change in the difference between
future and spot price from the determination of effectiveness. Present
valuing the cash flow associated with the anticipated transaction, while
not present valuing the futures (change in) value adds additional
ineffectiveness to the hedging relation.
Walter
Teets at Gonzaga University
3-36
KPMG Example 4.2
Cumulative Dollar Offset
Derivative
Hedge Item
Period
Cumulative
Hedging Inst.
Gain (Loss) Change Ratio Change Ratio
Gain (Loss)
$100
25
(20)
(5)
25
3-37
$ (90)
(21)
27
4
(22)
111%
119%
74%
125%
114%
111%
113%
125%
125%
123%
New Example
New Example Coming Up
3-38
Fair Value FX Hedging
Example 3 from FAS 133 Paragraph 121
Example 3 illustrates a firm commitment to purchase a machine on May
2 for 270,000Dfl Dutch guilders which exposes the firm to both a fair
value risk and a foreign exchange (FX) risk.
MNO enters a forward contract FX fair value hedge in which this
company enters elects to hedge the 270,000Dfl with equivalent
240,000DM in German marks that it apparently had on hand on February
3.
Although the example hedges in German DM currency, the firm declares
this a fair value hedge of the firm commitment in U.S. dollars.
To the extent of hedge effectiveness, the account Firm Commitment is
used to offset changes in the value of the forward contract during the
3-39
hedging period.
Cash Flow FX Hedging
Example 10 from FAS 133 Paragraph 165
Example 10 illustrates DEF Company’s hedging of foreign currency risk
of on three expected installments of 1,000,000DM German marks.
As a cash flow hedge, other comprehensive income is used to offset
changes in the value of the hedging forward contract to the extent that
the contract is effective in hedging FX risk.
But the effectiveness tests are very complicated as explained in
Paragraph 169
3-40
Cash Flow FX Hedging
Example 10 from FAS 133 Paragraph 169
169. As each royalty is earned, DEF recognizes a receivable and royalty income. The
forecasted transaction (the earning of royalty income) has occurred. The receivable is an
asset, not a forecasted transaction, and is not eligible for cash flow hedge accounting.
Nor is it eligible for fair value hedge accounting of the foreign exchange risk because
changes in the receivable's fair value due to exchange rate changes are recognized
immediately in earnings. (paragraph 21(c) prohibits hedge accounting in that
situation.) Consequently, DEF will dedesignate a proportion of the forward contract
corresponding to the earned royalty. As the royalty is recognized in earnings and each
proportion of the derivative is dedesignated, the related derivative gain or loss in
accumulated other comprehensive income is reclassified into earnings. After that date,
any gain or loss on the dedesignated proportion of the derivative and any transaction
loss or gain on the royalty receivable will be recognized in earnings and will
substantially offset each other.
3-41
Example 10 in FAS 133 Appendix B
Cash Flow Hedging of FX Risk
See 133ex10.doc at
http://www.cs.trinity.edu/~rjensen/
See 133ex10a.xls at
http://www.cs.trinity.edu/~rjensen/
3-42
FORWARD/FUTURES PRICING
Spot Price
+ Cost of Carry
Expense of holding (financing,
storage, insurance, etc.) less
income generated from spot
Futures/Forward Price
Basis = +/-(Futures - Spot)
3-43
BASIS AND CONVERGENCE
Price
F =S
e
e
F
O
S
O
Time
3-44
SPECULATIVE TRADES
3-45
•
Outright positions
•
Basis trades / arbitrage
•
Calendar spreads
•
Inter-market spreads
- TEDs, LEDs, BEDs, NOBs, etc.
FUTURES HEDGING
Sources of Uncertainty
3-46
•
Rounding error
•
Cross-market (spread) risk
•
Mismatching value dates (basis risk)
•
Timing of variation settlement cashflows
TIMING CONSIDERATION
Problem: Futures results are realized daily, the
effect on the exposure occurs in a deferred period
Daily
Futures
Results
0
...
Hedge
Value
Date
Time
t
Solution: Tail the hedge to generate the present
value of the desired price effects
3-47
Tailing Futures Hedges/Tailing Spreads
http://www.kawaller.com/pdf/tails.pdf
An untailed hedge ignores the difference between the time
futures gains or losses are realized and the time the price
effects on the associated cash market exposures are
realized. A tailed hedge, on the other hand, takes these
timing considerations into consideration. Put another way,
an untailed hedge ignores the effects of financing costs or
investment returns associated with daily variation margin
settlements of futures contracts; a tailed hedge these
effects.
3-48
Tailing Futures Hedges/Tailing Spreads
http://www.kawaller.com/pdf/tails.pdf
While tailed hedges should be recognized as more perfect
from an economic perspective, untailed hedges have the
advantage of offering the appearance of a better offset
from an accounting point of view when deferral
accounting methods are employed. Moreover, maintaining
a correctly tailed hedge position requires an ongoing
adjustment of the hedge position, while untailed hedges
need no analogous adjustments.
3-49
Tailing Futures Hedges/Tailing Spreads
http://www.kawaller.com/pdf/tails.pdf
Importantly, the correct number of contracts for this latter case will tend to increase
as the passage of time erodes the difference between present values and future
values.
Ultimately, by the time the hedge value date is reached, the discounted present
value will converge to the $500 amount. Thus, over time the required hedge will
gradually rise to twenty contracts. This second case is an example of a tailed hedge,
where the tail is the number of contracts needed to adjust for this present valuing
effect.
3-50
MARK-TO-MARKET VALUATIONS
Forward Contracts
MV =
MV =
F(i) =
r=
d=
n=
3-51
F(t+1) - F(t)
d
(1+
r)
360
=
F(t+1) - F(t)
(1+r)n
Market Value
Forward Price at time i
Zero coupon rate (to forward value date)
Days to the forward value date
Compounding periods to forward value date
Complexities of Paragraph 63(c)
of FAS 133
See KPMG 1A Sheet in 133ex07a.xls at
http://www.cs.trinity.edu/~rjensen/
63(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.
3-52
CASE 3 - Firm Commitment Hedged with
Forward Contract
•
On 9/30/2001, GlobalTechCo, a U.S. company issues a
purchase order to a foreign supplier for equipment to
be delivered and paid for at 3/31/2002. The terms of
the agreement meet the criteria for a firm
commitment.
•
The price is denominated in the foreign currency—
FC10,000,000.
•
The company simultaneously enters into a forwardexchange contract, which matures 3/31/2002, in order
to receive FC10,000,000 and pay U.S. $6,600,000.
3-53
CASE 3 - Firm Commitment Hedged with
Forward Contract
Forward Rates
Spot Rates for 3/31/2002
9/30/2001
FC1 = $0.65
FC1 = $0.66
12/31/2001
FC1 = $0.67
FC1 = $0.69
3/31/2002
FC1 = $0.69
FC1 = $0.69
3-54
CASE 3 - Firm Commitment Hedged with
Forward Contract
The entity documents the following:
– Effectiveness will be measured by (a) comparing
the change in the fair value of the forward
contract attributable to changes in spot rates
with (b) the changes in the fair value of the firm
commitment attributable to changes in the spot
rates
– The spot-forward difference will be excluded
from the assessment of effectiveness and
recorded through earnings
3-55
CASE 3 - Firm Commitment Hedged with
Forward Contract
The following demonstrates the journal entries to
record this hedge under Statement 133:
At 9/30/2001, no entry is recorded under
Statement 133 because a cash payment is not
made and the contract has a zero value.
3-56
CASE 3 - Firm Commitment Hedged with
Forward Contract
Entries recorded at 12/31/2001
Forward contract
Earnings
295,567
295,567
To record the forward contract fair value (present value at a 6%
discount rate of ((.69 – .66) x FC10 million); includes both
effective portion of hedge and ineffectiveness due to changes in
the forward rate.
Earnings
Firm commitment
197,044
197,044
To record the change in the fair value of the foreign-currency
component of the firm commitment attributable to the change in
spot rates ((.65 – .67) x FC10 million), discounted at 6%.
3-57
CASE 3 - Firm Commitment Hedged with
Forward Contract
Entries recorded at 3/31/2002
Forward contract
Earnings
4,433
4,433
To record time value change as there was no change in the
forward rate (assumption for illustrative purposes only).
Earnings
Firm commitment
202,956
202,956
To record the change in the fair value of the foreign-currency
component of the firm commitment attributable to the change in
spot rates ((.65 – .69) x FC10 million) – 197,044
3-58
CASE 3 - Firm Commitment Hedged with
Forward Contract
3/31/2002 (continued)
Cash
300,000
Forward contract
300,000
To record cash receipt upon maturity of forward contract
Equipment
Firm commitment
Cash
6,500,000
400,000
To record purchase of equipment
3-59
6,900,000
CASE 4 – Example 7 from Appendix B of
FASB Statement 133
• Designation and Discontinuance of a
Cash Flow of the Forecasted Purchase
of Inventory
3-60