Transcript Foundations - Trinity University

Effectiveness Issues
6-0
ACCOUNTING EFFECTIVENESS
6-1
•
Fair value hedges
– Derivatives should offset the changes in fair
value of the hedged item attributable to the
hedged risk
•
Cash flow hedges
– Derivatives should offset cash flows of the
hedged item attributable to the hedged risk
“EXCLUDABLE” HEDGE RESULTS
6-2
•
Changes in forward points
– Assessment based on changes in spot prices
or forward prices
•
Changes in the time value of options
– Assessment based on intrinsic value
•
Changes in the option’s volatility value
– Assessment based on an option’s minimum
value
SPOT/FORWARD PRICES
Price
Forward
Spot
Time
6-3
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
6-4
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
6-5
$ (90)
(21)
27
4
(22)
111%
119%
74%
125%
114%
111%
113%
125%
125%
123%
Future Values Must Be Discounted
•
If forward values are used to estimate current
values, FAS 133 and IAS 39 require that these
be discounted backwards to the current dates.
•
See
http://www.trinity.edu/rjensen/acct53
41/speakers/133glosf.htm#YieldCurve
6-6
TIME VALUE / VOLATILITY VALUE
•
Time value is the option premium less intrinsic
value
– Intrinsic value is the beneficial difference
between the strike price and the price of the
underlying
•
Volatility value is the option premium less the
minimum value
– Minimum value is present value of the
beneficial difference between the strike price
and the price of the underlying
6-7
FEATURES OF OPTIONS
Option Value = Intrinsic Value + Time Value
6-8
• Intrinsic Value:
Difference between the strike
price and the underlying
price, if beneficial;
otherwise zeroz
• Time Value:
Sensitive to time and
volatility; equals zero at
expiration
Sub-paragraph b(c) of Paragraph 63 of FAS
133
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.
6-9
Sub-paragraph b(a) of Paragraph 63 of FAS
133
a. If the effectiveness of a hedge with an
option contract is assessed based on
changes in the option's intrinsic value,
the change in the time value of the
contract would be excluded from the
assessment of hedge effectiveness.
6-10
Sub-paragraph b(b) of Paragraph 63 of FAS
133
b. If the effectiveness of a hedge with an
option contract is assessed based on
changes in the option's minimum value,
that is, its intrinsic value plus the effect
of discounting, the change in the
volatility value of the contract would be
excluded from the assessment of hedge
effectiveness.
6-11
THE IMPACT OF VOLATILITY
A
B
Price
Price
P*
P*
Time
6-12
Time
Minimum Value
Option Value = Risk Free Value + Volatility Value
If the underlying is the price of corn, then the minimum value of
an option on corn is either zero or the current spot price of
corn minus the discounted risk-free present value of the
strike price. In other words if the option cannot be exercised
early, discount the present value of the strike price from the
date of expiration and compare it with the current spot
price. If the difference is positive, this is the minimum
value. It can hypothetically be the minimum value of an
American option, but in an efficient market the current price
of an American option will not sell below its risk free present
value.
6-13
INTRINSIC VALUE / MINIMUM VALUE
Option
Price
Strike
Price
Minimum
Value
Intrinsic
Value
Underlying
Price
6-14
Minimum (Risk Free) Versus Intrinsic Value
European Call Option
•
•
X = Exercise Price in n periods after current time
P = Current Price (Underlying) of Commodity
•
I = P-X>0 is the intrinsic value using the current spot price if the
option is in the money
•
M = P-[X/(1+r)n] is the minimum value at the current time
•
M>I if the option if the intrinsic value I is greater than zero
Value of Option exceeds minimum M due to volatility value
6-15
INTRINSIC VALUE / MINIMUM VALUE
Option
Price
Strike
Price
Minimum
Value
Intrinsic
Value
Underlying
Price
6-16
Minimum Versus Intrinsic Value
American Call Option
•
•
X = Exercise Price in n periods after current time
P = Current Price (Underlying) of Commodity
•
I = P-X>0 is the intrinsic value using the current spot price if the
option is in the money
•
M = 0 is the minimum value since option can be exercised at any
time if the option’s value is less than intrinsic value I.
Value of option exceeds M and I due to volatility value
6-17
Selected IAS 39 Paragraph Excerpts
•
•
•
•
•
•
•
146. 80%<Delta<125% Guideline.
147. Assessing hedge effectiveness will depend on its risk management strategy.
148. Sometimes the hedging instrument will offset the hedged risk only partially.
149. The hedge must relate to a specific identified and designated risk, and not merely to overall enterprise business
risks, and must ultimately affect the enterprise's net profit or loss.
150. An equity method investment cannot be a hedged item in a fair value hedge because the equity method
recognizes the investor's share of the associate's accrued net profit or loss, rather than fair value changes, in net
profit or loss. If it were a hedged item, it would be adjusted for both fair value changes and profit and loss accruals which would result in double counting because the fair value changes include the profit and loss accruals. For a
similar reason, an investment in a consolidated subsidiary cannot be a hedged item in a fair value hedge because
consolidation recognizes the parent's share of the subsidiary's accrued net profit or loss, rather than fair value
changes, in net profit or loss. A hedge of a net investment in a foreign subsidiary is different. There is no double
counting because it is a hedge of the foreign currency exposure, not a fair value hedge of the change in the value of
the investment.
151. This Standard does not specify a single method for assessing hedge effectiveness.
152. In assessing the effectiveness of a hedge, an enterprise will generally need to consider the time value of money.
6-18
FAS Effectiveness Testing --http://www.qrm.com/products/mb/Rmbupdate.htm
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•
•
•
•
Dollar Offset (DO) calculates the ratio of dollar change in profit/loss for hedge
and hedged item
Relative Dollar Offset (RDO) calculates the ratio of dollar change in net position
to the initial MTM value of hedged item
Variability Reduction Measure (VarRM) calculates the ratio of the squared dollar
changes in net position to the squared dollar changes in hedged item
Ordinary Least Square (OLS) measures the linear relationship between the dollar
changes in hedged item and hedge. OLS calculates the coefficient of
determination (R2) and the slope coefficient (ß) for effectiveness measure and
accounts for the historical performance
Least Absolute Deviation (LAD) is similar to OLS, but employs median
regression analysis to calculate R2 and ß.
6-19
Regression Versus Offset Effectiveness Tests
6-20
“EXCLUDABLE ITEMS”
Premium = 5 ; Strike = 50 ; PV(Strike) = 49
6-21
Spot
Intrinsic
Value
Time
Value
Minimum
Value
Volatility
Value
47
48
49
50
51
52
53
0
0
0
0
1
2
3
5
5
5
5
4
3
2
0
0
0
1
2
3
4
5
5
5
4
3
2
1
LONG OPTION HEDGES
•
Fair value hedges
– Mark-to-market of the option will generally be
smaller than exposure’s contribution to
earnings
•
Cash flow hedges
– Changes in intrinsic values of options go to
–
other comprehensive income to the extent
effective*
Remaining changes in option prices goes to
current income
* Bounded by the magnitude of the exposures’ price changes
6-22
GENERAL RECOMMENDATIONS
6-23
•
For most static option hedges: Exclude time
value from hedge effectiveness considerations
•
For most fair value hedges: Exclude forward
points from hedge effectiveness considerations
•
For non-interest rate cash flow hedges: Assess
effectiveness based on comparisons of forward
prices
“THE RISK BEING HEDGED”
•
For non-interest rate exposures
– Entities must identify their firm-specific
exposures as hedged items
– Differences between firm-specific prices
and hedging instruments’ underlying
variables will foster income volatility
– Pre-qualifying hedge effectiveness
documentation is required for all crosshedges
6-24
Sub-paragraph b(c) of Paragraph 63 of FAS
133
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.
6-25
Example 6 from Appendix B of FAS 133
At the beginning of period 1, XYZ Company enters into a
qualifying cash flow hedge of a transaction forecasted to occur
early in period 6. XYZ's documented policy is to assess
hedge effectiveness by comparing the changes in present
value of the expected future cash flows on the forecasted
transaction to all of the hedging derivative's gain or loss
(that is, no time value component will be excluded as
discussed in paragraph 63). In this hedging relationship, XYZ
has designated changes in cash flows related to the forecasted
transaction attributable to any cause as the hedged risk.
6-26
Example 6 in Appendix B of FAS 133
From File 133ex06a.xls
6-27
“HEDGEABLE” INTEREST RATE RISKS
•
•
•
•
6-28
Overall fair value effects
Fair value changes due to changes in a
benchmark interest rate (i.e., the risk-free rate
or the LIBOR-based swap rate)
Fair value changes due to interest rate effects
associated with credit quality and/or rating
changes
Fair value changes due to foreign exchange
rate changes
FAIR VALUE INTEREST RATE HEDGES
6-29
•
The benchmark interest rate will likely be the
predominant selection for the hedged item
•
The shortcut method is only applicable for
interest rate swaps if all the criteria of ¶’s 68
and 69 are met
•
Fair value hedges that don’t qualify for
shortcut may have considerable unintended
income effects
FLOATING FIXED RATE DEBT
6-30
•
Originally issue fixed rate debt
– Maturity - 2 quarters
– Rate - 8% (fixed)
•
Enter swap
– Receive 6% fixed; pay 3-mo LIBOR
•
At start, 3-month LIBOR = 5%
•
After 3 months, LIBOR increases to 9%
SWAP’S MARK-TO-MARKET VALUE
• At start MV = 0
• End of Q1 MV = 1,000,000  (-.03/4) = -7,335 ; MV = -7,335
(1+.09/4)
• End of Q2 MV = 0 ; MV = +7,335
6-31
SHORTCUT CALCULATIONS
Loan Accruals
Swap Accruals
Swap’s M-T-M
Loan’s M-T-M
Effect on Earnings
6-32
End of Q1
-20,000
+2,500
-7,335
+7,335
End of Q2
-20,000
-7,500
+7,335
-7,335
-17,500
(7%)
-27,500
(11%)
LOAN’S MARK-TO-MARKET VALUE
• At start MV = 1,000,000
• End of Q1 MV = 1,000,000 (1+.08/4) = 992,701 ; MV = -7,299
(1+.11/4)
• End of Q2 MV = 0 ; MV = +7,299
6-33
NON-SHORTCUT CALCULATIONS
Loan Accruals
Swap Accruals
Swap’s M-T-M
Loan’s M-T-M
Effect on Earnings
6-34
End of Q1
-20,000
+2,500
-7,335
+7,299
End of Q2
-20,000
-7,500
+7,335
-7,299
-17,536
(7.01%)
-27,464
(10.99%)
PERSPECTIVES ON INEFFECTIVENSS
Impact of 50 basis point fall in interest rates on
$1 million par bonds; semi-annual compounding
6-35
6%-Coupon
9%-Coupon
Difference
1-Yr
$4,801
$4,698
$103 (4 b.p.)
5-Yr
$21,600
$20,027
$1,573 (63 b.p.)
10-Yr
$38,068
$33,236 $4,832 (193 b.p.)
NON-SHORTCUT PROCEDURES
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•
•
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6-36
Identify appropriate benchmark security
Determine rate change on benchmark security
over the hedge period
Calculate present values of the hedged item
(PV*) using original discount rates adjusted
by the amount of the benchmark rate change
The basis adjustment on the hedged item
(going to earnings) is the difference between
PV* and the original present value
NON-SHORTCUT EXAMPLE
6-37
•
Hedged item: 5-year Corporate debt
•
Hedging deriviative: 5-year swap
•
Hedging objective: Offset changes in the
LIBOR-based swap rate
ALTERNATIVE BENCHMARK RATE CHANGES
6-38
•
•
•
Use the change in 5-year swap rates
•
Use the difference between the forward 4 3/4year swap rate at the start vs. a spot 4 3/4-year
rate at the end
Use the change in 4 3/4-year swap rates
Use the difference between the 5-year swap
rate at the start vs. a 4 3/4-year swap rate at
the end
FAIR VALUE HEDGING KEY POINTS
6-39
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Ideally, all contributions to earnings -- other
than accruals -- will be entirely offsetting
•
The ideal outcome is achieved if the shortcut
method is employed
•
If the shortcut method is not used, differences
between the swap’s fixed rate and the hedged
item’s fixed rate will generate income effects
USING REGRESSION
6-40
•
Should the regression use price levels or price
changes?
•
What is the proper frequency of the
observations?
•
Can overlapping samples be used?
•
Is measuring correlation sufficient?
PERFECTLY CORRELATED CHANGES
50
Prices
40
30
20
10
0
-10
Time
Series1
6-41
Series2
AN ALTERNATIVE TO REGRESSION
•
•
6-42
Given time series of price changes for both the
derivative and the hedged item, generate a
frequency distribution for the combined
results
Assign a threshold value and a level of
confidence for “high effectiveness” (e.g., the
combined results must be smaller than 2% of
the initial value of the hedged item in 95% of
the observations)
CAVEATS
•
•
•
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Price changes of the hedged item should reflect
only the effect of the risk being hedged
Price changes of the hedging derivative should
not included “excluded items”
Price changes of fixed income securities should
appropriately reflect “aging” of the security*
In general, interest accruals (on both debt and
swaps) should not be included in price change
measures
*Relevant only for fair value hedges
6-43
Shortcut Method conditions applicable to both
fair value hedges and cash flow hedges
•
The notional amount of the swap matches the principal amount of the
interest-bearing asset or liability being hedged.
•
If the hedging instrument is solely an interest rate swap, the fair value of the
swap at its inception is zero. There are other applicable conditions if the
instrument is a compound derivative composed of an interest rate swap and
an option.
•
The formula for computing net settlements under the interest rate swap is
the same for each net settlement. (That is, the fixed rate is the same
throughout the term, and the variable rate is based on the same index and
includes the same constant adjustment or no adjustment.)
•
The interest-bearing asset or liability is not prepayable, unless the asset or
liability is prepayable solely due to an embedded option and the hedging
instrument is a compound derivative composed of an interest rate swap and
an option.
6-44
Shortcut Method conditions applicable to both
fair value hedges and cash flow hedges
•
The index on which the variable rate is based matches the benchmark
interest rate designated as the interest rate risk being hedged for that
hedging relationship.
•
Any other terms in the interest-bearing financial instruments or interest
rate swaps are typical of those instruments and do not invalidate the
assumption of no ineffectiveness.
Conditions applicable to fair value hedges only
The expiration date of the swap matches the maturity date of the interestbearing asset or liability.
•
•
•
There is no floor or cap on the variable interest rate of the swap.
•
The interval between repricings of the variable interest rate in the swap is
frequent enough to justify an assumption that the variable payment or
receipt is at a market rate (generally three to six months or less).
6-45
Shortcut Method conditions applicable to both
fair value hedges and cash flow hedges
•
The index on which the variable rate is based matches the benchmark
interest rate designated as the interest rate risk being hedged for that
hedging relationship.
•
Any other terms in the interest-bearing financial instruments or interest
rate swaps are typical of those instruments and do not invalidate the
assumption of no ineffectiveness.
Conditions applicable to fair value hedges only
The expiration date of the swap matches the maturity date of the interestbearing asset or liability.
•
•
•
There is no floor or cap on the variable interest rate of the swap.
•
The interval between repricings of the variable interest rate in the swap is
frequent enough to justify an assumption that the variable payment or
receipt is at a market rate (generally three to six months or less).
6-46
Shortcut Method conditions applicable
to only to cash flow hedges
•
The expiration date of the swap matches the maturity
date of the interest-bearing asset or liability.
•
There is no floor or cap on the variable interest rate
of the swap.
•
The interval between repricings of the variable
interest rate in the swap is frequent enough to justify
an assumption that the variable payment or receipt is
at a market rate (generally three to six months or
less).
6-47
Shortcut Method conditions applicable
to only to fair value hedges
•
All interest receipts or payments on the variable-rate asset or liability
during the term of the swap are designated as hedged, and no interest
payments beyond the term of the swap are designated as hedged.
•
There is no floor or cap on the variable interest rate of the swap unless the
variable-rate asset or liability has a floor or cap. In that case, the swap
must have a floor or cap on the variable interest rate that is comparable to
the floor or cap on the variable-rate asset or liability. (For this purpose,
comparable does not necessarily mean equal. For example, if a swap's
variable rate is LIBOR and an asset's variable rate is LIBOR plus 2
percent, a 10 percent cap on the swap would be comparable to a 12 percent
cap on the asset.)
•
The repricing dates match those of the variable-rate asset or liability.
6-48