Back-to-Back Swap Strategy

A fairly common strategy for regional and community banks is to offer variable rate funding to their commercial clients and simultaneously arrange an interest rate swap to affect a synthetic fixed rate loan. Typically, these banks also arrange coincident, offsetting swaps with independent derivatives dealers. In this way, the banks are able to add to their bottom line without introducing any duration risk to their overall portfolio, while at the same time satisfying their customer’s funding preferences. For the trade to be reasonable and appropriate, the strategy would have to compensate the bank appropriately for bearing the counterparty credit risk associated with the swaps.

The strategy is commonly known as a back-to-back swap strategy. We assume the transaction is driven by the customer’s desire for term funding, while the bank prefers variable funding. Interest rate swaps can serve to allow both parties to satisfy their respective objectives. Moreover, the swaps can be engineered to generate an up-front cash flow to the benefit of the bank in an amount that serves to accelerate earnings that the bank realizes. This process will be demonstrated by the example.

The strategy requires three components: (1) A variable rate loan extended to a bank customer, (2) an interest rate swap between the bank and the customer (the bank customer pays fixed; the bank pays floating), and (3) an interest rate swap between the bank and a derivative dealer (dealer pays variable; the bank pays fixed). For illustrative purposes, we summarize features of an assumed example:

Variable Rate Loan

  • Principal amount of customer’s variable interest exposure: $10 million
  • Customer’s variable interest rate benchmark: 3 month LIBOR
  • Customer’s variable Interest rate exposure start date: April 1, 2016
  • Customer’s variable Interest rate exposure end date: January 3, 2017
  • Interest paid on the first business day after each quarter-end

The Customer/Bank Swap (Customer Pays Fixed; Bank Pays Variable)

  • Swap notional: $10 million
  • Variable interest rate benchmark: 3 month LIBOR
  • Start date: April 1, 2016
  • End date: January 3, 2017
  • Settlements made on the first business day following each quarter-end

The Bank/Dealer Swap (Bank Pays Fixed; Dealer Pays Variable)

  • Swap notional: $10 million
  • Variable interest rate benchmark: 3 month LIBOR
  • Start date: April 1, 2016
  • End date: January 3, 2017
  • Settlements made on the first business day following each quarter-end

Note the equivalency of the principal and notional amounts, the fact that all start and end dates are in common, and the reliance on the same variable interest rate benchmark for the various components of the trade.

The bank effectively trades the two swaps simultaneously. We start with the consideration of the two, respective at-market swaps – i.e., swaps that have a starting value of zero, where the fixed rates are determined in a manner that reflects the credit quality of the counterparties to the contract. For the purposes of the example, we assume that the at-market fixed rate for the bank/dealer swap is 0.75%, and the at-market fixed rate on the customer/bank swap is 40 basis points higher, or 1.15%.

As a practical matter, the bank will generally dictate the fixed rate on the customer/bank swap. Appreciating that the credit risk associated with lending to the customer is (or should) be reflected in the spread over LIBOR that’s specified by the loan agreement, the assumed 40 basis point differential between the two fixed rates in this example represents the compensation that the bank would require in connection with the incremental credit risk associated with fixed rate funding versus floating rate funding. The higher fixed rate on the customer/bank swap (relative to the bank/dealer swap is also justified given that the bank customer would likely have an inferior credit rating relative the bank. On that basis, the fixed rate that the customer pays on a pay fixed/receive variable swap should be higher than the fixed rate that the bank would pay on a similarly constructed swap. In any case, baring default, the bank would end up earning this difference between these two fixed interest rates through the term of the swaps.

An alternative structure allows the bank to accelerate earnings recognition under this strategy by altering the terms of the bank/dealer swap. Specifically, the fixed rate on the bank/dealer swap could be adjusted upward from 0.75% to the same 1.15% rate that applies to the other swap, with a compensating day-one cash flow paid by the dealer to the bank in an amount that reflects the present value of the incrementally higher fixed interest payment that the dealer would receive. For the purposed of the example, we assume that present value effect to be $34,000.

The accounting for this strategy requires both swaps to be recorded on the balance sheet by the bank at their respective fair market values, with changes in values posted to earnings. The earnings effect includes swap settlements, as well as these mark-to-market adjustments. Note that because total swap results (mark-to-market changes plus settlements) are reported in earnings, swap accruals need not be specifically identified or independently accounted for. In fact, any explicit journal entries relating to swap accrual would foster a double counting if the total swaps’ results are otherwise correctly recorded.

Recall that at the time of the trade, the customer/bank swap is transacted with no initial net investment (i.e., no day-one settlement), such that no journal entry arises for that transaction on the trade date. On the other hand, a day-one settlement does occur from dealer to the bank for having marked up the fixed leg of their swap to mirror the customer/bank swap’s fixed rate. When the dealer makes a day-one settlement (typically paid T+2) to the bank, the correct journal entry is a debit of cash and a credit to the derivative account in the amount of the settlement. Our example assumes a day-one settlement of $34,000 (equal to the present value of the incremental 40 basis points). Thus, with the receipt of the cash, the bank/dealer swap is a liability worth $34,000 from the perspective of the bank and an asset of the same value from the perspective of the dealer. Following this initial settlement, both swaps would be marked-to-market through income. From the bank’s perspective, one of the swaps would be an asset; the other a liability.

As the fixed rates on both swaps have been set equal to each other, after that day-one settlement on the bank/dealer swap, all the following cash flows of the two respective swaps over the life of the transaction will be equal and opposite. That is, any subsequent settlements from the customer to the bank (or vice versa) would be a perfect offset to the settlements between the bank and the dealer. Despite these perfect offsets, however, the two respective swap valuations won’t be exactly equal because of credit quality concerns. In other words, the two swaps will not have identical balance sheet carrying values. (They’re likely to be quite close, but they won’t be the same.)

Differences will arise as a consequence of credit considerations. That is, the derivative carrying values on the balance sheet must reflect credit qualities of the counterparties. Different counterparties will serve to generate different valuations, and these valuation discrepancies will foster earnings effect through the transaction horizons. In any case, though, these ongoing earnings impacts notwithstanding, the aggregate realized earnings will sum precisely to the value of the day-one settlement amount.

The prospective income volatility of this strategy could be avoided if both of the swaps were fully collateralized, with daily variation margin adjustments. In that situation, typical valuation conventions would price the two swaps identically with no credit adjustments, thus obviating the income volatility after the first accounting period. Typically, however, commercial borrowers are generally not subject to such daily variation margin requirements, and it’s likely that these customers would be resistant to accommodating to such margining practices.

The following table contains the required data needed to generate all the associated journal entries for the back-to-back swaps. It presumes that the two respective valuations differ in each period due to the different credit qualities of the counterparty pairs for the respective swaps. The respective earnings of each of these swaps, period by period, is the combined effects of changes in swap values plus (or minus) any settlements received (or paid) subsequent to the initial trade date. Swap accrual amounts are fully reflected in the swaps’ fair values and hence the change in fair values, so no other explicit accrual adjustments are necessary or appropriate. Put another way, with the accrual amounts reflected in the carrying value calculations, the impact of the settlements is explicitly realized in the reporting interval in which those settlements occur.

Critical Journal Entry Data

As stated above, the Combined Earnings is the sum of both Total Swap Results, which, in this example grosses up to an aggregate earnings of $34,000 over the full term of the strategy (i.e., $33,000 – $100 + $600 +$400 + $100 = $34,000) – an amount that is identical to the initial settlement on the Bank/Dealer Swap. Critically, by engineering of the bank/dealer swap to provide for an initial day-one cash flow to the benefit of the bank, the bank is able to accelerate the earnings recognition under the strategy, realizing the lion’s share of this earnings in the first reporting period (ending 3/31/16, in this example). After that first period, some earnings volatility arises, again, as a consequence of the differences in the two swap valuations due to credit considerations.

The associated journal entries for this transaction follow:

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Interest Rate Swaps: Economics and Accounting

Despite the aura of complexity and exotica for the uninitiated, interest rate swaps may be one of the most straight forward and accessible tools in the risk management arsenal. Although these tools can be used for other purposes, the most ubiquitous application is the textbook strategy of converting variable interest rate exposures to fixed, or vice versa, using plain vanilla interest rate swaps. These strategies have proven to be extremely useful to financial managers in commercial enterprises, across the board.

For corporate managers, the predominant application of interest rate swaps applies to variable rate funding, where the use of an interest rate swap synthetically creates fixed rate debt and thereby stabilizes interest expenses. Applying hedge accounting to this strategy dampens the volatility of reported earnings that would otherwise occur had the variable rate debt remained unhedged. For banks, on the other hand, because interest rate exposures are present on both sides of the balance sheet, the use of swaps tends to be a bit more balanced – sometimes fostering the need to swap from fixed-to-floating, other times in the reverse direction – typically with the objective of harmonizing the exposures on both sides of the balance sheet thereby minimizing the interest rate gap.

Economically, the intent of all of these swap applications is to change the nature of future cash flows, irrespective of whether the objective is to swap from fixed-to-floating or floating-to-fixed. Accounting authorities, however, see these strategies as distinct, depending on which way the swap is employed. For hedges designed to swap from floating-to-fixed, cash flow hedge accounting is required to reflect the intended strategy. On the other hand, for hedges that swap from fixed-to-floating, fair value hedge accounting is required.

For typical variable interest rate hedges, perfect hedges can generally be arranged to swap from variable to fixed by (a) setting the notional of the swap equal to the principal of the asset or liability being hedged, (b) matching the reference interest rate of the variable leg of the swap to the variable interest rate being hedged, with the same frequency and reset date schedules and assuring the use of a common set of conventions for both settlement calculations, and (d) arranging the fixed rate on the swap so as to assure that no initial settlement occurs coincidently or immediately following the swap’s trade execution.

With such a swap in place, hedge gains or losses would be considered to be perfectly effective, whereby the hedge results would be initially recorded in other comprehensive income and subsequently reclassified to earnings coincidently with the earnings recognition of the variable interest rate exposures being hedged. The combined earnings of the original variable rate interest amounts plus the reclassified swap earnings would replicate the earnings of a fixed rate asset or liability. Thus, the economic objective of swapping from floating-to-fixed would be reflected in the resulting reported earnings. Critically, any swap construction other than that perfect construction described above would yield somewhat different results – both economically and accounting-wise.

The accounting process for fair value hedges is totally different. For fair value hedges, all of the derivative’s gains or losses – realized and unrealized (i.e., settlements and changes in present values) – would be reported in current income; but besides this treatment for the derivative, fair value hedging also requires making an adjustment to the carrying value of the hedged item (i.e., the fixed rate asset or liability being hedged). In this case, however, the accounting and economics are harmonized only if the carrying value adjustment for the hedged item offsets all of the swap’s earnings effects except for the swap settlements adjusted for accruals. Under current guidance, the only way to achieve this outcome in the general case would be for the hedging entity to qualify for and apply a special accounting treatment called the shortcut treatment. Under this treatment, the adjustment to the carrying value of the hedge item is a plug amount that serves to yield the “correct” accounting outcome. That is, the carrying value adjustment is set equal and opposite to the swap’s total results (i.e., settlements plus mark-to-market effects) net of settlements adjusted for accruals.

Qualifying for shortcut on fair value hedges requires structuring the swap with the following features: (a) the hedging derivative’s notional amount equals the principal of the hedged item, (b) the start and end dates are equal for the swap and the hedged item, and (c), the frequency of the variable interest resets on the swap is no longer than a six- month interval. If shortcut is not applied, fair value hedging calls for a process called the long haul method, whereby the change in the carrying value of the hedged item must be determined analytically; and shortcut and long haul accounting results will typically differ.

This difference between these the two accounting outcomes may very well be remedied with a widely-anticipated amendment to the hedge accounting rules expected to be ratified later this year. The current disparity arises because guidance presently requires using two different discount curves for the swap’s valuations and the adjustment to the carrying value of the hedged item. With the revised rules, that guidance appears likely to be revised, such that a common set of discount rates would apply to both sides off the hedge relationship. This change would assure that for a properly constructed hedge, the value associated with any given benchmark rate change would be identical for the two sides of a hedge relationship. Thus, without specifically saying so, this change would have the effect of causing the long haul method and shortcut to yield identical accounting results – again, presuming the hedging derivative is properly constructed.

An additional expected rule change is the proscription on hedging for only a portion of the time to the maturity of a fixed rate asset liability. Current guidance for the shortcut treatment requires that the swap and the hedged item have common maturity (or expiration) dates. This requirement appears likely to be relaxed, allowing, for example, for swapping from fixed-to-floating on, say, the first three years of a five-year asset or liability. Under the revised guidance, this strategy would still deliver an accounting result that reflects the intended economics, while under current guidance, this outcome is virtually impossible to achieve.

While these expected changes still require a formal sign-off by the FASB before they become GAAP, it seems like a good bet that they’ll be included in the next round of amendments with the dual benefit of adding greater flexibility to hedgers’ risk management capabilities and greater harmony between accounting and economics.

Although the comments thus far have assumed that the asset or liability being hedged under a fair value hedge is a “standard” fixed rate instrument. In fact, the guidance allows for the shortcut treatment when hedging assets or liabilities with embedded cancellation options, but only if the swap is constructed with mirror image termination provisions. That is, to qualify for shortcut with such hedges, if either side of the hedge relationship is terminated early, the hedger must be able to seamlessly affect the termination of the other side with no prospect of realizing any unintended windfall or penalty.

A further constraint is that the termination options on the two sides of the hedge relationship must be treated similarly. For example, if the hedged item were pre-payable debt, with the prepayment option fully reflected in the price of the debt, the price of the early cancellation feature of the swap would have to be fully reflected in the specified fixed rate of the swap. In other words, for the “right” accounting to be realized, the cancelation option on the swap couldn’t be arranged with an initial cash settlement unless parallel treatment applied to the hedged item’s early termination option.

As a final comment, this article started by focusing attention to the most widely used swap strategies – swapping from fixed-to-floating or vice versa. With either of these objectives in mind, the process of engineering perfect hedges should generally be straightforward; and properly designed hedges should end up with compatible accounting – i.e., recognized earnings impacts that reflect the intended economic objective. An alternative swap application strategy applies, however, for portfolio managers who generally look for ways to protect against value changes, but who really don’t care all that much about altering future cash flows. While the more traditional textbook application effectively seeks to offset the risk of changes in a benchmark interest rate (i.e., the benchmark rate that pertains to the swap), this alternative strategy has a slightly different objective. It calls for offsetting the full price effect of the asset or liability being hedged.

It should be understood that this second strategy is different from the first, and it requires a different hedge construction. That is, when hedging the entire price risk of an asset or liability, the hedger should strive to set the interest rate sensitivity of the hedging derivative to be equal and opposite to that of the hedge item. In general, this construction would require a notional amount of the hedged that would not be equal to the principal amount of the hedge item, where the appropriate hedge ratio would have to be determined analytically, on a case by case basis. Moreover, this type of hedge would likely require dynamic adjustments as the respective interest rate sensitivities of the hedged item and the derivative should not be expected to remain in balance throughout the intended hedge horizon; and with each hedge adjustment, a true-up of the accounting would be required. That is, a new carrying value adjustment would have to be performed reach and every time the size of the hedge is adjusted to reflect the most recent hedge position prior to the adjustment.

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Thinking Ahead: Adjusting Hedge Coverage as the Market Changes

Key Takeaways:

  • Whenever market expectations become widely accepted by economic actors, those expectations get reflected in the prices of derivative contracts.
  • A wholly distinct class of companies have an exposure to the risk of falling interest rates. The market essentially pays these companies to hedge their exposures, as opposed to exacting a cost.
  • Any hedging decision should be forward-looking, asking what could happen in the future with a fully unhedged exposure. Unfortunately, in a world with uncertainty, that’s a difficult judgment to make.

The thing about risk is that it keeps changing. Whether it’s due to ever-evolving macroeconomic conditions or firm-specific developments, a firm’s capacity to cope with change is anything but static. This realization justifies an ongoing process of evaluating and adjusting hedge coverage as time passes or as material price adjustments arise.

The market challenge

One of the tricky aspects underlying the determination of how much to hedge is that whenever market expectations become widely accepted by economic actors, those expectations get reflected in the prices of derivative contracts. For example, when everyone is convinced that interest rates are poised to rise, the cost of hedging against rising interest rates incorporates these expected rate increases. The more dramatic the expected price change, the higher the cost to hedge that risk.

At the time of writing this article, for instance, the consensus view is that interest rates are expected to rise by about 10 basis points per quarter, for the next two years, with LIBOR projected to reach about 2.00 percent by the end of 2018. Those expectations are built into prices for interest rate swaps and other interest rate derivatives (e.g., caps, floors, collars and futures contracts). For hedgers exposed to rising interest rates, then, putting a hedge in place today generally means accepting rate increases that are currently widely anticipated. Put another way, those expectations foster a hedging cost.

A wholly distinct class of companies operate with exactly the opposite risk concerns—i.e., having an exposure to the risk of falling interest rates. These firms would be cash-rich companies—or more likely financial institutions—that earn interest revenues. For such firms, consensus expectations of higher interest rates actually serve as a hedge inducement in that derivatives pricing allows these firms to lock in more attractive (i.e., higher) interest rates than those currently available, as reflected by spot market conditions. In effect, the market is paying these companies to hedge their exposures, as opposed to exacting a cost. These opportunities arise when consensus expectations assess the proposed hedged risk to be a low probability event, but just because the risk is deemed to be unlikely doesn’t mean that it should be ignored. Rather, this set up may present a particularly opportune time to hedge.

The vast majority of nonfinancial treasury departments face the risk of higher, rather than lower interest rates, so this consideration may not be particularly meaningful. The concept might be more applicable, however, in connection with raw material or commodity purchases and sales. With these products, nonfinancial businesses more evenly divide between suppliers and demanders, where suppliers face the risk of lower prices while demanders bear the risk of higher prices.

Futures prices

Whether derivatives favor one side of the market or the other can be inferred from the configuration of futures prices. Futures contracts are readily available for a wide array of basic commodities, and they serve as the building blocks for virtually all over-the-counter derivatives instruments (e.g., swaps, caps, floors, collars, etc.). Futures prices are readily accessible on the website of the CME Group (formerly the Chicago Mercantile Exchange), the exchange that hosts trading for the vast majority of U.S. commodity contracts. By looking at the configuration of futures prices, one can readily determine whether you happen to be on the side that pays for hedging or the side that gets paid for hedging.

A listing of their most active contracts is shown in the accompanying table.

Energy
Crude Oil (WTI)
Natural Gas
Gasoline
No. 2 Fuel Oil
Crude Oil (Brent)
FX
EUR/USD
JPY/USD
GBP/USD
AUD/USD
CAD/USD
MXN/USD
CHF/USD
Agriculture
Corn
Soybeans
Chicago SRW Wheat
Soybean Oil
Live Cattle
KC HRW Wheat
Lean Hogs
Metals
Gold
Copper
Silver
Platinum
Palladium

With the exception of the currency contracts (FX), most futures contract prices will typically be said to be in contango. This term simply means that prices for more distant valuation dates move higher and higher, as you extend out in time. This pricing configuration thus tends to favor the suppliers (i.e., sellers) of these commodities, as it allows these firms to lock in more attractive prices for future sales than the firm can realize today. While this situation is fairly typical, it’s not always in effect. That is, sometimes, futures prices will be lower for more distant months, which would favor demanders (i.e., purchasers). Futures prices would be said to be in backwardation in those situations; and backwardation favors the demanders.

Foreign exchange rates are another story. For the currencies of countries with developed capital markets, forward pricing is determined by covered interest arbitrage, which causes the forward prices of foreign currencies (i.e., non-USD) to be at a premium to spot prices whenever U.S. interest rates are higher than foreign interest rates, and vice versa; but these conditions change over time. As of this writing, forward prices for euros are at a premium to spot prices, while forward prices for Mexican pesos are at a discount to spot prices. Thus, under these conditions, U.S. exporters to the eurozone enjoy the benefit of forward pricing, while importers from the eurozone would be subject to somewhat of a forward pricing penalty. These characterizations would be reversed with counterparties to U.S./Mexican trade. Here, the U.S. importers would have the hedging advantage, while the U.S. exporters would bear the penalty.

Critically, whether futures prices are in contango or backwardation is certainly a consideration, but in most cases, it shouldn’t be overriding. That is, even if the pricing of futures—and hence all related derivatives—are adverse for a given entity, this consideration needs to be balanced by the risk for which hedging is being considered. In other words, even if the cost of hedging may seem high, the consequence of not hedging might be far greater. The decision to hedge or not to hedge is one that requires assessing the trade-off of bearing known cost, today, to preclude the prospect of a far greater cost in the future.

In the normal situation, if there is one, most hedgers will tend to view forward price premiums or discounts as being minor relative to magnitudes of prospective price changes, such that the incremental cost or benefit discussed above would be seen as acceptable. Occasionally, however, hedges can appear to be either overly cheap or overly expensive. And, presumably, if and when such judgments can be made, they should reasonably influence the decision to hedge, or, more specifically, the determination of how much to hedge.

Looking ahead

Ultimately, any hedging decision should be forward-looking, asking what could happen in the future with a fully unhedged exposure. Unfortunately, in a world with uncertainty, that’s a difficult judgment to make, as one can never be sure if most recently observed price changes will be extended or reversed. In any case, independent of these expectations, to the extent that unacceptable prospective outcomes are recognized to be possible, derivatives can be used to mitigate these risks. Critically, the decision to hedge needn’t be all-or-nothing. Rather, hedges can be phased in and out, as the perceptions of risk and hedging costs vary. But you have to pay attention.

My own sensibilities lead me to prefer making periodic reassessments of hedge coverage, augmented by reassessments whenever unanticipated price adjustments arise that challenge previously held expectations. Additionally, I favor reliance on a rules-based process for determining how hedge coverage should be adjusted, as opposed to reliance on purely subjective judgements of any group or individual. By rules-based, I’m suggesting the use of objective criteria for deciding on how much to adjust hedge coverage. Incorporating such practices adds discipline to the hedging process and reduces the chances that ill-considered transactions will be consummated just when market conditions are most volatile.

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Dual Focus: Hedging Programs Need to Focus on Both Sides of the Income Statement

A mix of analytics and judgment is required when devising a hedging program to manage financial risk.

To frame the issue, we start with an appreciation that virtually all companies are in a spread business, where profit (i.e., the spread) equals the difference between revenues and costs; and the economic objective would be to maximize that spread, possibly subject to a variety of constraints. More pointedly, a hedging program that focusses on only one side of the income statement may actually add to overall economic risk, as opposed to mitigating it.

Maximizing the spread
To illustrate our concern, we start by considering two distinct extreme situations. For simplicity, we assume the costs are dominated by a particular good or commodity; and, similarly, revenues are associated with a particular finished good.

In the first instance, we assume that the inputs and outputs are closely related, where the costs of the inputs are immediately passed through to the customer. In this case, the company essentially bears no market risk, and thus the need for any derivatives-related hedging activity is obviated. Moreover, if the firm chooses to hedge either costs or revenues but not both, those hedges would serve to introduce market risk where none pre-existed. For example, profitability would be adversely affected if the expense outflow is stabilized via a hedging strategy but then revenues end up declining.

In the second instance, we assume prices of inputs and outputs to be distinct. Changes in input prices would have an inverse effect on the spread (i.e., profits), while changes in output prices would have a direct effect; but revenues and expenses are largely seen as being independent of each other. Assuming the availability of hedging derivatives relating to the major components of both revenues and expenses, the firm could protect profitability by hedging both revenues and expenses, independently.

With these two extremes understood, we now consider somewhat of a middle ground: In this case, we do not have viable derivative markets relating to inputs and outputs, respectively; but, instead, a common underlying commodity applies to both expenses and revenues. To hedge overall profitability, we would need to protect against price increases for the inputs, while simultaneously protecting against price decreases for the final sales. If both hedges involve the same derivative contract, the appropriate hedge position would be the net of these two component hedges.

In the general case, some analytics would be required to measure the respective price sensitivity of inputs and outputs to the underlying commodity associated with the derivative; and we shouldn’t necessarily expect those sensitivities to be the same. In the vernacular of the market place, the input hedges and the output hedges would have distinct hedge ratios.

Hedge horizon
With this orientation, the next concern is the length of the hedge horizon. How far out should the hedges extend? Practically speaking, we are likely to be constrained by the durations of viable hedging instruments. But more significantly, we would want to assure that we are operating on income and expenses in parallel. That is, we would like to control input costs through the horizon that our revenues are controlled, and vice versa. Put another way if we lock up input prices for an extended term, but we do nothing to control finished goods prices, we would be introducing considerable risk to the enterprise. Thus, it should be clear that the risk-averse firm with contracted revenues over, say, a three-year horizon, would seek to hedge its input costs over that same three years. Alternatively, the firm with a fixed price contract for inputs would seek to hedge its associated final sales, again, for a common term.

In thinking about the business in this way, it’s important to recognize that some “fixed” prices are fixed by convention, as opposed to being contractually fixed. That is, the institutional nature of the market may be such that, in some cases, prices are sticky and hence should be thought of as fixed; or, alternatively, companies may voluntarily offer their goods or services at a given price for some time horizon. In effect, these companies have committed to fixed prices for some segment of their exposures, for some term; and thus, to operate in a manner consistent with this discussion, they would reduce their overall enterprise risk by hedging a commensurate portion of their exposure(s) on the other side of their income statement.

Clearly, firms may enter smaller hedge positions, but in so doing, those firms should realize that they’re effectively transitioning from an orientation that seeks to manage their overall profitability to some alternative business objective that bears greater risk. In so doing, they may end up enhancing their profits, but perhaps not. In an ideal world, the management discussion and analysis (MD&A) presented in financial disclosures should offer clues (if not clarity) about where the firm in question stands on this spectrum of how they manage profitability risk – i.e. how much or little parallelism the company imposes on their income and expense exposures. Unfortunately, discerning that information remains a challenge.

Implications for corporates
The orientation suggested above is one that is generally embraced by financial intermediaries – institutions like banks and insurance companies that carry both financial assets and financial liabilities on their balance sheets, where their spread is widely referred to as their “net interest margin.” The concept is equally valid, however, for myriad non-financial companies. In particular, any company that is heavily reliant on commodities can (should?) be thinking about their profits as the spread between their revenues and their costs. And just as banks manage their net interest margin using derivatives, so, too, can non-financial businesses use derivatives to manage their profitability.

Especially good candidates for this way of thinking are companies tied to agricultural markets, mining companies, energy producers, and even some companies where the costs and revenue streams seem less obvious — like airlines or clothing manufacturers. If your company is actively using derivatives to manage market price risk on only one side of the income statement, those hedges may actually be introducing risk, as opposed to mitigating it – a situation that may be more common than you might think; but one that may be relatively easy to address.

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* Robert Brooks, Ph.D., CFA is the Wallace D. Malone, Jr. Endowed Chair of Financial Management at the University of Alabama; and Ira Kawaller, Ph.D. is the president of Kawaller & Co., a boutique consulting company that specializes in services relating to derivative instruments.

Accommodating to Loan Customers’ Preferences

Whether borrowing or lending, virtually every prospective market participant confronts the choice between fixed-rate financing or variable-rate financing. And the way the world typically works today, practitioners are forced to pick one or the other. Given the opportunity, however, a large population of players would likely opt for a middle ground. That is, rather than committing to a fully fixed-rate instrument or a fully variable-rate instrument, a “half-and-half structure” would be an attractive alternative. Moreover, once that door is open, it should be clear that virtually any mix of fixed and floating (e.g., 25 percent fixed-rate and 75 percent floating rate, or vice versa) would be possible. Such a mixed-rate construct is easily engineered with the use of interest rate swaps.

To illustrate the idea more concretely, consider the issue from the perspective of the banker who wants to arrange a half-and-half loan (i.e., half fixed-rate; half variable-rate) for a prospective borrower. The banker could satisfy this borrower in a number of ways:

  1. The banker could structure the loan where the interest payment is calculated as if the loan were a combination of two loans, each for 50 percent of the desired principal amount. One component would base its contribution to interest expense on a stipulated fixed-interest rate, while the interest rate on from the second component would be reset periodically, based on an observable variable interest rate (e.g., LIBOR).
  2. The banker could offer variable-rate financing and simultaneously enter into an interest rate swap with the borrower, where the notional of the swap is half of the principal on the loan, and the bank customer (i.e., the borrower) pays fixed and receives variable on the swap.
  3. The banker could offer fixed-rate financing and simultaneously structure a different interest rate swap with the borrower. As with the prior swap, the notional of this swap would be half of the principal on the loan; but in this case the borrower pays variable and receives fixed on the swap.

To the extent that the bank preferred to avoid bearing the swaps’ exposures in these last two alternatives, the bank could easily offset that risk by entering into offsetting swaps with a third party – i.e., a different swap dealer. More likely than not, these back-to-back swaps would have identical accrual periods and settlement dates, a common floating interest rate, but the two fixed interest rates would likely be slightly different, allowing the bank to realize incremental income through the lives of the swaps, commensurate with the difference between the two fixed interest rates.

All of three of these designs listed above result in cash flows that mimic those of the half-and-half loan structure; but the accounting differs under each of these designs and, potentially, the company’s resulting reported earnings could differ, as well.

From the borrower’s perspective, the first design would undoubtedly be the easiest. In this case, barring application of the fair value option, the loan would be carried on the balance sheet of both the bank and the customer at its outstanding principal value, and the interest revenue/expense would simply be the combined interest settlements of the two components of the loan. With such a loan design, the bank might (or might not) opt to use derivatives to over-ride the original debt’s duration and interest rate exposures, but the bank’s action in this regard would be totally irrelevant from the perspective of the borrower.

The second alternative design permits two different accounting treatments: a) cash flow hedge accounting or (b) no special hedge accounting treatment (i.e., regular derivatives accounting). Hedge accounting’s appeal is that it allows the economics of the hedge – or a close approximation — to be transparently represented in the company’s income statement. This presentation is likely to be important to public companies, but less so for privately-held firms. That is, private companies might not care all that much about reported income, as long as the hedge construction results in the desired cash flows. Those cashflows, however, would be determined by the way the hedge is constructed, which is totally separate and apart from any accounting considerations. Firms thus have the discretion to apply hedge accounting or not, balancing the seemingly improved income statement presentation with the perceived hassle of qualifying for that treatment. Importantly, qualifying for hedge accounting isn’t trivial, but it’s do-able.

With cash flow hedge accounting, a perfectly constructed hedge would generate reported interest expense in an amount that would be identical to that reported under the first design, but the borrower would also record unrealized hedge gains or losses in other comprehensive income. Without this hedge accounting treatment (i.e., regular derivatives accounting), both the swap settlements and the swap’s mark-to-market gains or losses (i.e., unrealized swap results) would be recorded in the company’s reported earnings, most likely as interest expense. These two alternative earnings outcomes — with hedge accounting versus without — would likely be dramatically different.

While the borrower under this second funding strategy starts with floating-rate debt and then swaps half of that debt to fixed, the borrower employing the third design starts with fixed-rate borrowing and then swaps half of that fixed-rate debt to floating. The second and third designs are sort of reverse images of each other. The same ultimate cash flows occur, but once again, the accounting is distinct. As with the second alternative, the borrowing entity can apply hedge accounting, or not; but in this case, the hedge accounting would be fair value hedge accounting, as opposed to cash flow hedge accounting.

Whereas cash flow hedge accounting generally defers unrealized hedge gains or losses, with fair value hedging these unrealized results are reported in earnings; but fair value hedging also requires the carrying values of the fixed rate debt being hedged to be adjusted to reflect the price effects of the risk being hedged, with the changes in the carrying values reflected in current income. In a perfect world, the unrealized swap results and the debt’s carrying value adjustment would be largely offsetting, in such a way as to replicate the earnings outcome of the first design. This outcome happens to be assured if shortcut hedge accounting is applied, but this treatment, though permitted by GAAP, is frequently discouraged by auditing firms. Without reliance on the shortcut methods, firms may still apply what has become known as the long haul fair value method; but this method will likely result in realizing some measure of ineffective earnings – a prospect that probably makes this last design the least attractive of the three, unless the reported earnings impact is of little concern.

[For a more detailed discussion of the various accounting treatments for derivatives, see http://www.kawaller.com/accounting-treatments/.]

As a final consideration, it’s worth pointing out that whenever either party of the financing has the capacity to terminate prior to the natural maturity, the appropriate hedge might not be quite as obvious as it is when these options aren’t present. Still, even with loan early-termination provisions, bankers would be able to engineer a variety of hedge constructions that would foster a mix of fixed and floating rate interest payments. Some such hedges might end up generating fixed versus floating rate proportions in the financing that might not be entirely predictable or consistent throughout the terms of the loans, but the hedge would nonetheless offer an alternative to the extreme of the fully fixed- or fully floating-financing alternatives; and in all likelihood, these hybrid designs would be preferred by at least some portion of commercial borrowers.

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Hedging with Off-Market Swaps

Companies that have LIBOR-based bank debt can use swaps to lock in a fixed rate, thereby synthetically converting their floating-rate debt to fixed-rate debt. However, in order to have financial statements reflect this intended outcome, companies would need to qualify for, and apply, special hedge accounting.

For perfect hedges, where the accrual periods, reset dates and settlement dates on the swap are identical to those of the bank debt, and where the notional amount of the swap is at or below the outstanding principal on the loan, hedge accounting results in reported earnings that are identical to those shown with traditional fixed rate funding. On the other hand, without hedge accounting, all unrealized gains or losses of the swap are accelerated through current income, thereby fostering a reported interest expense on the income statement that would look anything but stable.

For most entities seeking to transform their variable rate debt in this way, it’s pretty easy to arrange the perfect swap simply by setting the terms of the swap in the manner described above. Sometimes, though, stuff happens, and companies may find that they want (or need) to modify their hedges prior to their swap’s stated end-date. Often these adjustments come in response to changes in the planning horizon that might be motivated by any number of considerations. For whatever reason, the original swap may no longer be consistent with the hedger’s preferences and a modification would seem to be appropriate.

It’s not uncommon for companies in this situation to find themselves trying to replace a swap that is in a liability position. In this situation, liquidation of the swap would require paying an amount equal to the swap’s liability value. Assuming the company did not have the cash (or liquid assets) on hand, it could either borrow the required funds or, perhaps more typically, it could enter into an off-market swap with the new swap counterparty.

Unfortunately, the way the hedge accounting rules work, replacing one swap for another means ending one designated hedging relationship and starting another. And with this re-designation, it’s likely that some measure of ineffective earnings will be reported in earnings. Specifically, FASB requires measuring hedge ineffectiveness for a swap by comparing its results to that of a hypothetical derivative—a swap that perfectly offsets the risk being hedge, but with one critical caveat: The hypothetical swap must have a present value equal to zero when the hedge is designated. Thus, any off-market replacement swap wouldn’t be able to be considered to be perfectly effective from an accounting perspective—even if the new swap and the original swap have identical terms.

A hedge-relationship example
One might be tempted to think that, whatever this ineffectiveness might be, it couldn’t have a material effect. But you might be surprised. Consider the following example: We assume the hedge relationship starts on 6/30, with an actual derivative that has notional of $10 million and a liability value of $397,661. The swap has quarterly settlements, with two years remaining, as reflected in Table 1. Variable cash flows derive from resetting three-month LIBOR, quarterly, and the fixed rate on the swap is 2.1106 percent. The differences in the value of the fixed cashflows simply reflect different numbers of days in the various quarters.

Table 1: Cashflows for the Actual Derivative

Over the life of this swap, the projected reported earnings may be calculated by adding (a) the change in the swap’s present value over the holding period (from a liability value of $397,661 at the start to a zero value at the end) to (b) the sum of the settlements. Mathematically,

Earnings = the change in the swap’s present value + settlements
or
Earnings = ($0 – (-$396,661)) + (-$400,290) = -$2,629

Table 2 shows an analogous presentation, but this time for the hypothetical derivative (i.e., the derivative covering the same accrual periods and notional value, but having a fixed rate that forces the present value of the swap to a value of zero when the hedge is newly designated.)

Table 2: Cashflows for the Hypothetical Derivative

In this case, using the same math, the projected earnings for the hypothetical derivative over its life would be $150. That is,

Earnings = ($0 – $0) + $150 = $150

Thus, we see a difference between the actual derivative’s earnings and those of the hypothetical derivative—a difference of $2,779 (= $150 – $2,629). Importantly, this difference would apply for any set of LIBORs that might develop, as in all cases, the payments received will be identical for the actual and the hypothetical derivative—irrespective of the values of LIBOR that may happen to arise. That is, the second columns of the two tables will always be identical, under any progression of LIBORs.

Violate traditional boundaries?
The disparity between the two results is problematic in that it would seem to violate the traditional boundaries of a dollar offset ratio test. In other words, -$2,629 ÷ 150 = -17.5. That’s well outside the boundary conditions required to qualify as an effective hedge (i.e., 80 percent to 125 percent). But this out-of-bounds result is more of a reflection of the limitations of a dollar offset calculation being used as a means of effectiveness testing than anything else. A better test would compare this disparity to the notional value of the swap—$10 million—and appreciate that the difference represents less than 0.03 percent if the notional, or an amount that would account about 1.4 basis points a year for each of the remaining two years.

While this minor disparity in the effective fixed rate, ex post, relative to its ex ante anticipated fixed rate would likely justify the assessment that the hedge will perform quite satisfactorily over the entire hedge horizon, this conclusion won’t necessarily hold in the short run. Under current accounting rules, swapping from fixed to floating with an off-market swap could end up introducing unintended and undesirable earnings volatility quarter by quarter—an outcome that is particularly discomfiting since the hedger would be trying to avoid income volatility by entering into the swap in the first place. At the heart of the issue is the fact the actual and hypothetical swaps have different interest rate sensitivities, and the difference will give rise to different quarterly price changes.

A common metric used to quantify interest rate sensitivities is the dollar value of a basis point (DV01), which estimates a swap’s price change arising from a 1 basis point shift in interest rates. And when the DV01s are different for the actual and hypothetical derivative, ineffective earnings may result. Critically, the amount of this ineffective result can’t be known in advance, as it would be directly related to the magnitude of the rate change.

A further consideration is that differences in DV01s don’t necessarily mean ineffective earnings will result, as ineffective earnings occur only when the gain or loss of the actual derivative exceeds that of the hypothetical. Thus, if it happens the hypothetical derivative’s DV01 is larger than the actual derivative’s DV01, the difference would not be expected to impact reported earnings. On the other hand, if the actual derivative’s DV01 is the larger, ineffective earnings would be expected. And, again, the bigger the rate change, the bigger the prospective ineffective earnings. As time passes, though, both DV01s will tend to fall as will the difference between the two. Thus, as the swap’s maturity gets closer, the potential ineffective earnings impacts would likely decline, quarter by quarter.

Even better news is that this ineffective earnings impact may be eliminated with an expected revision to hedge accounting rules. FASB has released an exposure draft, suggesting an important change to cash flow hedge accounting treatment, whereby entities would no longer be required to post ineffective hedge results to current earnings. It’s not clear exactly when this rule may go into effect, but it’s something to look forward to.

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Perspectives on the Proposed Accounting Update for Derivatives and Hedging

For those who’ve struggled with the challenges of applying hedge accounting rules, FASB has proposed some adjustments to their accounting standard, which, for some, might be a source of relief. Exactly when revised rules will go into effect is still unclear, but it’s possible that companies could adopt the new rules – once officially released — as early as the start of their following fiscal year.

The proposed revisions are offered in an exposure draft that was issued on September 8, 2016. As is common practice, FASB solicits public comment before the rules are finalized, with the comment period ending November 22, 2016. The proposed adjustments are largely viewed as an attempt to liberalize the hedge accounting prerequisites, and in some cases to actually simplify the accounting. That said, for some portion of reporting entities, little may change.
In my judgement, the most significant proposed change pertains to accounting rules for cash flow hedges. Cash flow hedges are the most common types of hedges, relevant to the broadest class of derivatives hedgers. (Cash flow hedges address risks of uncertain forecasted transactions; fair value hedges address the price risk of recognized assets, liabilities, or firm commitments.) Current rules for cash flow hedges require segmenting hedge results between their effective and ineffective pieces. Ineffective results are immediately posted to current earnings, while effective results first go to other comprehensive income (OCI) and later are reclassified to earnings concurrently with the earnings recognition of their associated hedged items.

While existing hedgers have clearly accommodated to the current standard, it wasn’t necessarily easy. The determination of the effective/ineffective split hasn’t always been obvious, and considerable time and effort may have been expended to develop methodologies for making these measurements. Changing the accounting treatment at this point would necessarily impose some minor conversion costs for current hedges; but for new hedgers, this change would likely represent a significant simplification. It’s also worth noting that for perfect hedge relationships – not uncommon for many interest rate swap hedges where structuring perfect hedges is a fairly straightforward proposition – the same journal entries would arise, before and after.

A corollary of this rule change would be that it obviates the need to measure ineffectiveness. Critically, FASB differentiates between assessing effectiveness (or effectiveness testing) and measuring ineffectiveness. To qualify for hedge accounting, hedgers still need to demonstrate that hedges will be “highly effective” in offsetting the risks being hedged (i.e., they still need to perform effectiveness tests); and while this “highly effective” threshold has not been modified, the proposed guidance offers more flexibility, particularly in connection with retrospective effectiveness testing. However, to the extent that current effectiveness testing methods are working, in this observer’s opinion, most hedgers will simply continue what they are doing. The new proposal doesn’t necessarily mandate a change.

In any case, under the proposed guidance, ineffective and effective hedge results would not be differentiated, and the combined value would be posted to OCI. Additionally, the timing of the subsequent reclassification will be unchanged from current practice. While the proposed rule change is a clear step toward simplicity, it would require wide-scale system changes in legacy accounting systems.

Although the anticipated modifications obviate the need to measure hedge ineffectiveness, the same is not true for “excluded items.” In assessing hedge effectiveness for futures and forward contracts, hedgers may exclude the effect of forward points in their effectiveness tests. Similarly, for option hedges (including caps, floors, and collars), hedgers may exclude the effects of changes in option time values, again, in connection with assessing hedge effectiveness. Making either election in connection with effectiveness testing, however, continues to force these respective excluded values to be reported in current earnings, as opposed to allowing them to be deferred through OCI. (This treatment is a carry-over from current practice.) Whereas disclosure requirements hadn’t necessarily distinguished between ineffective results and excluded results, that distinction is now critical for meeting the accounting requirements.

One of the most significant of the proposed changes won’t directly apply to banks, but it would apply to their customers who use commodity derivatives. Currently, most commodity hedges involve an inherent basis risk because hedging entities generally use derivatives that reference some industry-standard price for hedging their commodity price risk, and those industry-standard prices typically differ from the prices paid or received for commodities as a function of quality or location differences. Economically, these hedges should perform well as long as the prices paid or received for the commodity are highly correlated with the derivative’s industry-standard price, but if these two price series don’t move in lock-step (literally), hedges won’t generate perfect offsets, thereby giving rise to hedge ineffectiveness and possibly threatening the capacity to apply hedge accounting, altogether.

Under the proposed rules, hedgers may be able to hedge components of their commodity price risk – as opposed to the entire, all-in price, which is the current requirement. Unfortunately, the proposed change may not be as liberalizing as one might hope. To hedge a component of commodity price risk, that component must be “contractually specified” in the purchase or sales agreement. If not, commodity hedgers would be stuck with the status quo. To the extent that pricing with reference to an industry-standard price becomes more common, the prospect of failing hedge effectiveness tests and thus disallowing hedge accounting will likely be diminished; but the way many commodity purchase and sale contracts are currently drafted, this provision simply wouldn’t apply. Bankers would be advised to alert their customers as to this pending change, so they might be able to adjust their contractual arrangements, accordingly.

FASB is also expanding the categories of “hedge-able” risks in the realm of interest rates. Under current rules pertaining to interest rate exposures, hedgers can designate entire fair value or cash flow exposures as hedged items, or they can specify risks associated with specific benchmark interest rates: Risk-free (i.e., government) rates, fed funds, LIBOR, and LIBOR and OIS swap rates. Besides expanding this list to include SIFMA as a benchmark rate, FASB is also proposing allowing any contracted rate index to be an eligible hedged item, analogous to their approach to commodity hedging. This adjustment certainly makes sense, but it’s likely to be relevant for only a small segment of the hedging community.

Finally, my candidate for the most substantive change being offered has to do with fair value hedges where interest rate swaps are used to convert from fixed cash flows to floating. Under this treatment, the total gain or loss of a swap is recorded in current income – both realized (i.e., settlements) and unrealized (i.e., the change in the swap’s present value). Additionally, the carrying value of the hedged item is adjusted to reflect the change in the value of the hedged item due to the hedge risk; and this change, too, is reflected in current income. When entities fail to qualify for the shortcut treatment, they are forced to calculate the required change in the carrying value of the hedged item using the “long haul method.” Under current rules, this method requires using different discount rates in connection with calculations for the swap versus the hedged item; and the consequence of this requirement is that the long haul method will almost inevitably foster unintended ineffective earnings outcomes. This ineffectiveness, however, isn’t real. It’s simply an artifact of the accounting rules – rules that FASB appears ready discard.

Under the new proposal, hedgers who use interest rate swaps to hedge the benchmark interest rate in fair value hedging situations will end up with an accounting result with zero ineffectiveness – i.e., the same outcome that would be realized under the shortcut treatment without explicitly declaring that treatment. The critical caveat is that the fixed interest rate on the debt being hedged must be greater than or equal to the swap’s fixed rate as of the hedge’s inception date. Otherwise, hedgers would be required to address the full fair value effects, rather than just benchmark rate effects, as the risk being hedged; and some ineffectiveness would likely still arise. This adjustment would be a major improvement, and it can’t happen too soon!

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Derivatives’ Valuations: Assessing Alternative Methodologies

In the olden days, there were basically two types of derivatives: those that were not reported on balance sheets (like swaps and forward contracts) and those that were (like option contracts). With the release of Financial Accounting Statement (FAS) No. 133 in 1998 (“Accounting for Derivatives and Hedging Transactions”), which later came to be known as Topic 815 in the Accounting Standard Codification (ASC), all derivatives had to be recorded on balance sheets at their fair market value. For swaps and forwards, this starting value is typically zero, but this value adjusts with changing market conditions and the passage of time. Thus, most swaps and forwards become apparent on the balance sheet subsequent to their initial trade date, as they achieve non-zero values.

Prior to FAS 133, many holders of these kinds of derivatives didn’t necessarily worry about the value of these derivatives, as long as they had confidence that they would perform as advertised, e.g., that swaps would convert future cash flows from fixed to floating or vice versa, and that forwards would lock in prospective prices. In any case, the new accounting rules forced derivatives users to report the market values of these derivatives on the balance sheet, for the first time.

The idea of valuing a derivative is reasonably straightforward, but the devil is in the details. The first concern is the notion of fair value. In fact, it’s harder to agree on what this term means than you might think, in that value is really in the eye of the beholder. Some are willing to pay higher prices than others for the same good or commodity, so what’s fair to one might not be fair to another. Clearly, for balance sheet presentation purposes, FASB doesn’t want us to think about fair value in such a subjective way. Rather, the carrying value should be a reflection of market (rather than individual) sensibilities.

For some goods or commodities, where a formalized market mechanism exists that publicly displays bids and offers, market prices are transparent. Those

bids and offers are market prices, and balance sheet carrying values should reflect those prices. Generally, the exit price for derivative positions should be the price at which derivatives are recorded on the balance sheet, which may be derived from the bid or the offer, depending on whether the instrument under consideration is carried as an asset or liability, but mid-market pricing is an acceptable practice in most cases. Another convention is to look at the value of the latest transaction and assume it to have been freely negotiated between the parties, without duress. Of course, market conditions can change abruptly, and last-sale prices won’t necessarily reflect market conditions anytime subsequent to that last transfer. Thus, the farther back in time we have to search for a last trade, the less confident we should be in that valuation. Furthermore, whether this last price was a fulfillment of a bid or offer price is typically ignored.

Bigger problems
Much bigger problems arise when prices are not readily transparent. In those instances, reporting entities are forced to use models to value derivative positions. In this effort, the mathematical and technological sophistication in use today may instill a false sense of the level of precision attributable to these estimates. Models provide estimates of fair value and those estimates are only as good as the models themselves or the models’ inputs that underlie those valuations.

The conceptual starting point for valuing a derivative is an appreciation that the fair value should be a reflection of the present value of expected future cash flows. Put another way, one can calculate the present value of expected future cash flows and use this calculated value as the estimate of the contract’s fair value. Thus, fair value and present value have come to be tantamount to the same thing. In making this calculation, two challenges are present: (1) How should future cash flows be estimated, and (2) what are the appropriate interest rates that should be used for discounting purposes?

For most swaps and forward contracts, one can usually observe forward prices or else infer them from objectively observed market data, making the first calculation nearly trivial. For option contracts, on the other hand, expected future cash flows have to reflect a probabilistic assessment of prospective spot prices—an exercise that ultimately relies on assuming some estimated price volatility throughout the term of the derivative being valued.

The discounting issue is also fraught. Fair value should reflect the credit quality of the counterparties to the contracts, both in terms of what would be correct, economically, and what’s required for balance sheet presentation by statute. But practice divides in terms of the methodology to apply to get there. Two methods currently are used. Both methods typically start with the derivation of forward prices or the identification of forward curves, but after that, the two methods take different approaches with respect to addressing credit risk. The more intuitive approach uses the standard discounted cash flow (DCF) analysis, applying discount rates that reflect the risk premiums applicable to the owing party, cash flow by cash flow.

Thus, this “risk-adjusted DCF” approach uses up to three yield curves: a forward curve (or a set of forward prices) used to generate the expected cash flows and yield curves pertaining to any party of the contract with any obligation to pay. These yield curves are necessary to derive the risk- adjusted discount rates that would be used, cash flow by cash flow. Either or both parties may have this obligation. For example if Party A has the obligation to pay the first cash flow, Party A’s discount rate would be used for discounting that first cash flow. And if Party B had the obligation to pay the second cash flow, Party B’s discount rate would be used to discount the second cash flow, etc.

Alternative methodology
The alternative methodology takes credit conditions into account by employing a two-step process. Under this approach we first value the derivative by discounting expected future cash flows using a proxy for “risk free” discount rates, and then we make a separate credit valuation adjustment to this original, risk-free valuation. Practice derives these risk free discount rate proxies from the yield curve of overnight indexed swaps (OIS), which reflect spot and forward overnight fed funds rates.

Although this second method is widely adopted, it requires firm-specific data relating to the trading parties and explicit assumptions about probabilities of default and expected recovery rates. Often, these data are simply unavailable. As a result, those who use these methods are forced to base their valuations on their best guesses of various inputs or else relying on data from some other institution deemed to be similar. Moreover, the second method generally derives some inputs from the market for credit default swaps. Even if these instruments are traded for the parties of the derivative contract, those credit default swaps may be associated with maturities other than the maturity of the derivative under consideration. Regardless, under his method of valuation, we’re forced to use what we have.

While presented as distinct approaches, in an ideal world both approaches should generate the same values. That is, risk-adjusted interest rates should reflect assumed probabilities of default and recovery rates; and similarly, probabilities of default and recovery rates should be consistent with some set of risk-adjusted discount rates. Thus, to the extent that the different methodologies yield different values, the differences can likely be ascribed to the inconsistency of available data sets. Thus, when disparities of valuations are found, it’s not clear which approach, if either, would necessarily be the better point of departure. That said, the risk-adjusted discounted cash flow approach has the clear advantage of being the more accessible and intuitive method of the two.

Thus far, discussion has focused on valuing a single derivative. But what if that derivative is one of many covered by a master netting agreement? Does that agreement justify an alternative approach? It’s possible. It may be reasonable to value a portfolio of contracts that fall under the jurisdiction of a single master netting agreement as if those resulting cash flows derived from a single contract. As before, the valuation could reasonably be made using either of the above described methodologies. Clearly, though, the value of any component of that portfolio would likely differ from the valuation assuming it been priced individually. On the other hand, if the parties have the exibility to liquidate individual contracts, it the sum of exit prices of the individual contracts might seem to be the more appropriate carrying value for balance sheet presentation purposes.

A second challenge deals with collateral considerations. The valuation methods discussed above presume that the swap under consideration had been transacted in the absence of any requirement relating to collateral adjustments between the parties of the swap. In fact, such collateral adjustments are frequently required under the International Swap Dealers Association’s credit support agreement. This feature typically requires the losing party to pledge collateral to the winning party, when specified valuation threshold conditions are satisfied. And when derivatives positions are fully collateralized, the need for a credit valuation adjustment is obviated. In this situation, practice has evolved to value contracts by discounting future cash flows with risk-free discount rates.

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Hedging Loan Commitments

The process of originating new loans involves issuing loan commitments that define the critical terms of the loan, giving the prospective borrower the option to take down the debt within a specified time frame. Thus, in fact, by issuing a commitment, the bank is extending a put option to the prospective borrower. That is, the loan commitment grants the prospective borrower the right, but not the obligation, to sell an asset (i.e., the loan) to the bank. Differentiating this put option from most other options is the fact that this option is granted seemingly for free. While some banks normally charge an application fee, this fee typically reflects some administrative cost, rather than any amount that would be reflective of the fair value of the option, based on standard modeling considerations.

Upon granting this commitment, the bank faces three alternative outcomes:

  1. The loan is taken down, and the bank maintains ownership of the loan, realizing a return on that asset over the course of its holding period.
  2. The loan is taken down, but instead of holding the loan, the bank elects to sell it in the secondary market. The gain or loss on the asset during any holding period would reflect the difference between the final sales price and the original acquisition price (i.e., the starting balance on the loan).
  3. The prospective borrower elects to walk away, and the loan is never consummated. In this case, no gain or loss is realized, save any overhead or administrative costs not covered by the commitment fee.

Suppose the bank expects the first of these three alternatives to be the case in question. In this situation, the loan would have to be financed with some liability, and the bank would realize some associated net interest margin. Given the fact that the interest rate on the loan is dictated by the terms of the commitment, the resulting net interest margin would bear interest rate risk if the outstanding balances and maturities of the funding failed to match those of the loan. That risk could be mitigated, however, using derivatives.

With this orientation, the bank would typically seek to hedge all or a portion of the uncertain funding costs that would be expected to arise during the period for which the loan’s yield was fixed. The choice of the type of derivative instrument that would be used would depend on the extent of the desired coverage, the nature of the funding instruments that were expected to be used, and the particular hedge objective. Most banks will tend to rely on swaps or futures to lock in interest rates; but they might also enter into caps or collars to constrain effective funding rates to some predetermined range of funding rates, rather than fixing those costs, outright.

Regardless of the hedge objective, in most cases the notional amounts of the derivative would adjust through its term to reflect the anticipated progression of the outstanding loan balances throughout the life of the loan. For instance, if the outstanding balance on the loan were expected to decline over its holding period, the associated funding amounts would be structured to decline, commensurately. Given that, to the extent that the loan may have embedded prepayment options that make these outstanding balance projections uncertain, the hedging derivative might end up being too small or too large relative to the originally targeted coverage amount, depending on the direction of the forecasting error. If and when material deviations become evident, a modification to the hedge would be justified, which could mean substituting a new derivative contract for the original, or else adding a new derivative to affect a marginal adjustment.

If the bank expected to sell the loan in the secondary market (i.e., alternative 2, above), a different hedge orientation would likely apply. In this case the hedge would probably be designed to address the uncertainty associated with the sales price of the loan. If the loan(s) could be well -specified, the bank might be able to enter into forward contracts to set prospective sales prices and thus create perfect hedges that would lock in known gains or losses. A more general hedging approach could apply, however, if such forward contracts were unavailable in derivatives’ market place. In this case, the bank would measure the interest rate sensitivity of the loan (i.e., the loan’s duration) and pair it with a derivative position having an equal but opposite sensitivity. The presumption underlying this construction, though, is that the interest rates for the loan and the asset underlying the derivative will move comparably – i.e., approximately one-for-one. If not, the notional size of the derivative would have to be adjusted to compensate for any expected deviation from this one-for-one relationship.

For both the first and second of the possible outcomes, the bank can pretty well assure profitable outcomes if the loan terms and the terms and structure of the hedging derivate are arranged simultaneously. Typically, though, that kind of coordination is impractical. More likely, the hedge would be executed sometime after the commitment is issued. Best practices would then set the terms of the commitment in a manner that reflects the prevailing derivatives market conditions but allows for the possibility that, upon execution, the hedging derivative reflect a higher cost than were in effect as of the commitment’s issue date. In other words, the bank would address this execution risk – or try to – by requiring an incrementally higher yield on the loan, hoping that the resulting terms would still be acceptable by the prospective borrower.

It should be clear that if the bank executes a derivative but the prospective borrower fails to take down the loan, the derivative will inevitably end up have some value; but without a loan origination, there will be no offset. The problem only arises in one market scenario, however. That is, in a rising interest rate environment, the derivative would likely show a gain. Having no offset would be fine. On the other hand, with declining interest rates, the derivative would likely lose. In that case, what had been intended as a hedge would turn out to be a naked, losing derivative position.

The bank could seek to address this asymmetry issue in either of two ways. Probably the most typical approach would be to hedge a notional exposure that reflects the expected take down amount. This approach may make the most sense when the bank is working with a portfolio of commitments, where, based on history and market conditions, the bank is able to make a reasonable estimation as to the percentages of the commitments that will convert to loans. With a 95 percent expectation, the notional size of the derivative would be scaled down to 95 percent of the commitment balance amounts.

The size of the hedge would then have to be adjusted once the actual takedown outcome is determined. Implicitly, this approach involves at least some unavoidable mismatch, given that the ultimate takedown percentage can’t be known with certainty until it’s too late.

The second approach uses caps or purchased options as the hedging contract (as opposed to swaps or futures contracts). Irrespective of whether the orientation is to hedge the loan’s associated funding costs or to hedge the intended sale of the loan, the bank still assumes that the loan will be taken down and matches the notional amounts of the derivative position to the expected loan through time. Although derivative losses with this hedge would still have no offset when the loan isn’t taken down, in this case the derivative’s losses would be bounded. By the end of the term of the commitment, if the loan isn’t taken down the derivative should be liquidated. On the other hand, if the loan is taken down, the bank would have the option to leave the original hedge in place, or to liquidate it and replace it with another derivative that would deliver an alternative hedge objective.

As is always the case when using derivatives, hedgers have the ongoing capacity to adjust their hedge positions as market conditions and/or risk appetites evolve. Hedging loan commitments is no exception.

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Hedging the Hedge: How Treasurers Can Decide How Much to Hedge

Suppose you expected gold prices to rise, and you decided to speculate by buying gold futures contracts. Higher prices would generate profits; lower prices, losses. Saying things could get worse before they get better translates to saying that the gold futures price could go down before it goes up. In fact, four possible scenarios could play out:

  • You buy the futures and (eureka!) you really did call it right. The price rises from that entry (and break-even) price. Presumably, at some higher price, your bullish sentiment erodes, as you come to believe that the price has gone as high as you can reasonably expect; and you liquidate at a profit.
  • Subsequent to buying the futures contracts, the futures prices rises, but you end up waiting too long. The futures price retreats, and your unrealized profits erode.
  • After buying the futures, contrary to your expectations, the futures price moves lower. Even so, you maintain your bullish sensibilities. In this case, the price drop allows you to buy more contracts and build a more substantial speculative position. The added positions serve to lower your effective break-even price. Subsequently, you turn out to have been correct in your market view; and the gold futures price moves higher. You’re able to liquidate your position at a profit.
  • You buy a futures contract, and the price moves lower… and lower still. At some point you realize that you blew it. Your original bullish orientation was a bad forecast, and you have to pay the piper.

All along the way, irrespective of the price moves, the attentive trader is (or should be) evaluating whether the original price forecasts still holds. Even if the originally expected direction of the price change still holds, material variations in the price – either up or down – could likely influence the strength of your conviction vis a vis that forecast, justifying making an adjustment the size of the position, if not a determination that the trade should be liquidated, altogether.

Successful trading requires operating on somewhat of a knife’s edge. Too frequent adjustments could result in whipsaw trading losses from entering and exiting positions due to noise, as opposed to meaning full price change information. Too frequent adjustments could also foster the realization of losses prematurely, foreclosing the opportunity to recoup those losses when adverse price changes self-correct. Similarly, closing winning positions too soon could preclude realizing more generous gains if the beneficial price movements were to continue. The other side of the coin is that too infrequent adjustments could also be a problem. They could result in realizing losses in excess of true risk tolerance or, alternatively, giving back some or all profit that might have been realized with an earlier trade termination. Finding the right balance is the trader’s challenge.

The trading orientation presented above might have some value to hedgers, as well—albeit with some caveats.

A hedging example

Consider the example of a U.S. importer, expecting to make €20 million purchases per month from European suppliers over the coming 12 months. In considering how much of this exposure to hedge, one could argue that taking no hedge position would be suited for the entity that was confident that the exchange rate was poised to move favorably, while hedging 100 percent of the exposure would go with an expectation that an adverse exchange rate move (ignoring the hedge) was a virtual certainty. With that perspective, the firm might reasonably opt to hedge 50 percent of the exposure—i.e., €10 million of purchases per month—by buying 12 forward contracts, each for €10 million, with one contract maturing in each of the coming 12 months. Effectively, half of the exposure would be hedged, and the other have would remain exposed to market risk.

This 50/50 starting position might have particular appeal to those entities that claim no particular expertise or confidence in forecasting market moves; but even so, it deserves further scrutiny. It’s not for everyone. In particular, a large segment of hedging entities will favor more certainty—i.e., lower earnings volatility, all else being equal—achievable by hedging a larger portion of any original exposure. Choosing the coverage ratio of any hedge, however, is a business judgment that must be made by each hedging entity, individually, balancing a variety of competing considerations, including sensibilities as to the likely distribution of prospective price changes of the unhedged exposure, the tolerance for uncertainty of outcomes, and some sense or expectation as to how peer group companies are likely to cover their exposures. Taking a hedging position that’s markedly at odds with peer group practice potentially could make your company out-perform when hedges generate profits, but that same coverage ratio could cause under-performance when hedging derivatives generate losses.

The traders’ orientation presented above might also suggest that it would be reasonable to adjust the hedge over time, as prices change. Just like the trader, the hedger is confronted by the dilemma as to whether any observed price change is indicative of a trend that will continue or an effect that will more likely be reversed. New pricing information assimilated by the hedger could cause a revision in the strength of conviction of the original forecast, or even a reversal of the direction of the expected price change. With that updated assessment, it would make as much sense for the hedger to adjust the portion of the exposure being hedged as it does for the trader to adjust the size of his or her speculative position. That said, for the entity that steadfastly refuses to impose any judgment about future price trends, the strategy that persistently applies a hedge that covers 50 percent of any exposure would be both logical and consistent.

Regardless of the particular degree of hedge coverage selected, again, taking cues from the traders’ orientation, it’s a reasonable question as to whether that hedge should be executed as a single transaction, or over time. A single trade execution yields certainty as to the effective starting price of the aggregate hedge position, while the phase-in approach introduces a path-dependent set of derivative transactions with some inherent uncertainty. This dynamic effort may succeed in generating a more attractive outcome, but maybe it won’t. That tactical decision—placing a hedge in full or phasing in a hedging position over time—is one that deserves consideration. Under some market conditions, the dynamic approach may seem more promising than others; and in those cases it may be a prudent business decision to try for it.

No right answer

These tactical considerations aside, one of the most challenging aspects about implementing a hedging program is figuring out how much to hedge. Is 50 percent coverage the right amount? Should it be 30 percent? Should it be 80 percent? Unfortunately, there’s no right answer to this question, which makes it hard for management teams to coalesce on a course of action. Moreover, whatever the degree of hedge coverage chosen, it’s easy to take a retrospective look and realize that the firm would have enjoyed a better outcome (i.e., higher profits) at one or the other extreme—hedging nothing, or hedging everything, depending on which way prices happened to have moved. With that retrospective perspective, literally any intermediate hedge coverage ratio would be wrong. Unfortunately, as wrong-headed as this perspective is, it’s immobilizing. The fear of second-guessing often leads decision makers to do nothing, which boils down to chronically leaving their exposures unhedged. This posture reflects a critical error in way the performance of derivatives is assessed.

The benefit of using derivatives shouldn’t be measured by the profit that they generate, but rather by the possible trouble that they can reliably avoid. To the extent that these contracts preclude unacceptable outcomes from being realized, they should be deemed to be effective, irrespective of the profit or loss that they may end up generating. The challenge for the hedging entity, then, is devising and carrying out disciplined policies and procedures that assure the implementation of a level of hedge coverage that appropriately responds to the changing economic conditions facing the company and the company’s associated risk tolerances, on an ongoing basis.

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Designing a Proper Hedge: Theory versus Practice (Abstract)

Determining the hedge ratio based on the slope coefficient of a regression on price changes suffers from several critical shortcomings. First, it is difficult to assemble a properly constructed data set. Second, results vary depending on the length of the change interval. Third, the resulting ex post effective prices realized under this approach are wholly uncertain, ex ante. We show that when the hedge ratio is determined with reference to a regression on the respective price levels, rather than price changes, the resulting hedge ratio solution is superior in that none of these shortcomings apply.

You can find the full paper at the Wiley Online Library:
http://onlinelibrary.wiley.com/doi/10.1111/jfir.12091/abstract

For many hedgers, determining the size of the hedging position may be trivial. For example, when hedging a foreign exchange exposure of €20 million, the hedger would naturally apply a €20 million notional-size derivative. Similarly, hedging 10 million MMBTUs of natural gas would normally require a derivative having a notional of 10 million MMBTUs. Such intuition applies, however, only when the underlying to the derivative is identical to the hedged item. In a cross hedge, where the respective assets are distinct, an analytical solution is required. For example, when no viable jet fuel derivative contract is available, hedgers seek to identify a closely correlated oil-based commodity for which a derivative is available, but in this situation a one-to-one hedge construction would likely be inappropriate. Typically, the size of a cross hedge of this nature would be determined using regression analysis; but in performing this exercise, the design of that regression is critical.

In fact, because of hedge accounting requirements, this issue is central to the sizing of virtually any commodity hedge for which hedge accounting is intended. Under FASB’s hedge accounting rules, hedges should be engineered to offset the exposure’s entire price change for any commodity exposure – not just the price changes associated with some industry-standard price. This requirement should motivate the hedger to view their hedges as cross hedges and assess whether one-to-one hedge ratios should still be applied.

The article challenges conventional wisdom as to the form of the regression. Specifically, the traditional text book solution performs a regression using price change series for the hedged item and the hedging derivative, respectively. We argue that that price change specification has some serious problems and that in the vast majority of hedging situations a regression performed using price levels will have superior properties.

Nuances of Novation: Hedge Accounting Considerations

In August 2015, the Financial Accounting Standards Board (FASB) issued an exposure draft relating to the accounting for derivatives and hedging transactions, focusing on the situation where derivative contacts are novated – that is, where “ownership” of one of the parties to the derivative is transferred to a third party. The exposure draft reads “… a change in the counterparty to a derivative instrument that has been designated as the hedging instrument in an existing hedging relationship would not, in and of itself, be considered a termination of the derivative instrument.” (See ASC 815-25-40-1A.) As might reasonably be expected, all respondents to the FASB’s request for comments favored this adjustment.

More recently, in December 2015, the Board announced a tentative decision with the release of Emerging Issues Task Force (EITF) Issue No. 15-D, which relates to this question. This tentative decision, if ratified, appears to clear the way for the uninterrupted application of hedge accounting following novation of the hedging derivative. The opinion would seem to allow the reporting entity to “look through” any transformation of cash flows that may arise as a consequence of the novation, allowing for hedge effectiveness to be evaluated on the basis of the original design of the pre-novated derivative.

For some novation circumstances, this decision reflects an accounting determination that happens to be in conflict with the change in economics that arises as a consequence of the novation.

Financial professionals should appreciate that two distinct types of novation may arise. In the simpler case, a new legal entity steps into the shoes of an original party to the derivative, but all of the cash flow obligations set forth by the original derivative contract are unaffected. In this case, because the economics of the transaction are unchanged by the novation, it’s reasonable and appropriate that any measure of ineffectiveness should be unaffected. In contrast, when the novation of a contract fosters a change in cash flow obligations from the pre-novation design, irrespective of any accounting accommodations, the economic outcome of the novated derivative will differ from that which otherwise would have occurred under the prior (pre-novation) treatment.

With the novation of a traditional, bi-lateral over the counter derivative to a clearing platform, the cash flow obligations originally dictated under the pre-cleared instrument design would be over-ridden by daily variation margin settlements required by the clearing institution. These daily settlements effectively accelerate payments for unrealized gains and losses. Critically, though, the daily settlements with the clearing entity also include a price alignment interest (PAI) component as part of the variation margin amount. PAI serve to compensate the party bearing the liability in amounts intended to replicate the (potential) interest income foregone as a consequence of having to put up cash commensurate with the unrealized loss on the contract. This PAI component of the variation margin, however, is an undifferentiated aspect of the derivative’s gain or loss.

The fact that the economics are altered under this type of novation is incontrovertible. Consider, for example a cleared swap versus its precursor — a standard (not-cleared) OTC swap; and assume both start at market (i.e., with an initial value equal to zero). For the cleared swap, the gain or loss over the life of the contract will be the sum of all of the daily variation settlement amounts, inclusive of PAIs. For traditional (non-cleared) OTC contracts, the life-time gains or losses will simply be the sum of its settlements. These two outcomes won’t be the same.

[See Kawaller, “The Evolution of Over-The- Counter Derivatives and Associated Accounting Concerns,” Bank Asset/Liability Management, January 2015 for a more complete discussion of these issues.]

Despite the change in the economics of this type of novated derivative, under the proposed accounting guidance, reporting entities will still be able to continue hedge accounting without re-designation. Moreover, the proposed EITF guidance goes further by seeming to allow reporting entities to measure ineffectiveness based on the pre-novated critical terms, which, in reality, won’t generally apply. Again, original cash flow obligations would be over-ridden or replaced by the daily variation margin adjustments.

A related concern still begs for a clarification from FASB. That is, “What is the correct balance sheet carrying value for cleared swaps that require daily variation margin settlements?” At the heart of this question is a determination as to whether variation margin adjustments are collateral or, instead, settlements against value. If one characterizes variation margin as “cash collateral,” the seemingly correct carrying value of the derivative would be an asset or liability value that would be determined on the basis of the present value of anticipated cash flows, independent from any current or anticipated collateral considerations – i.e., the pre-novated value of the derivative. With this treatment, receipt or payment of the cash collateral variation margin presumably would be reflected in cash balances, with a compensating, associated payable or receivable.

On the other hand, if the variation margin is deemed to be a settlement against the value of the cleared derivative, the offset to these cash flows would be to the derivative, itself, identically to the way settlements offset typical payables or receivables. This treatment nets the variation settlements from the derivatives carrying value, each and every day.

It should be clear that the former treatment balloons the balance sheet relative to the latter treatment. Put another way, when variation margin is treated as collateral, the balance sheet either double counts assets and imposes a compensating payable, or it double counts liabilities and imposes a compensating receivable.

To be fair, even those who characterize variation margin as collateral may end up with the same balance sheet carrying value as those who see variation margin as settlements against derivatives’ values, provided they make an election to show their derivatives on their balance sheet net the cash collateral settlements. Thus, a discrepancy only applies to those who view variation margin as collateral and decline this netting election.

At this point, accounting practice is divided. Some entities treat variation margin as collateral; others treat it as settlements against derivatives’ values. In all likelihood, the presence of the PAI component of the variation margin is the source of the lack of consensus of the accounting treatment. When non-cash collateral is pledged under the terms of the ISDA credit support agreement, the pledger (i.e., the losing derivative counterparty) still owns the collateral, and the pledger enjoys the benefit of any interest that the collateral might generate. The PAI was designed essentially to mimic this economic result – i.e., to allow the posting party of “cash collateral” to earn interest income on their posted amounts.

Still, characterizing variation margin as collateral doesn’t make it so. The pledging of collateral is a temporary condition that would be “un-done” or reversed, assuming the successful satisfaction of the contract’s obligation, but variation margin settlements don’t work that way. With cleared swaps, variation margin supersedes the originally stipulated cash flow obligations, and parties of the transaction should have no expectation that those variation margin settlements will necessarily revert to the original payer. These considerations notwithstanding, for the present, the FASB has not taken a position on this issue, leaving it to the reporting entities and their auditors to make the determination as to which orientation they deem to be more appropriate.

The choice could have significant implications, depending on the magnitude of the derivative positions. Different balance sheet presentations will necessarily yield different measures for traditional financial ratios, such as returns on assets and debt/equity ratios. Additionally, regulatory capital requirements could be calculated differently under these two alternative reporting regimes – a consideration that might be paramount in management’s consideration of the alternatives.

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Saving Money When Banks Offer ‘Chooser Options’

Many companies with variable-rate funding look to derivatives to transform their variable interest-rate exposures to synthetic fixed-rate debt. And while the interest rate swap is the derivative of choice, alternative contract designs warrant consideration.

In all cases, we start by examining the terms of the variable rate debt. An economically perfect hedge may be possible if we can find a derivative with a variable interest rate that matches the variable interest rate on the funding. This matching, however, requires not only a common variable interest rate on the financing and the swap, but also common accrual periods, rate-reset timing and day-count and payment conventions. In such cases, the variable cash flows of the debt and the swap will perfectly cancel, and the swap’s fixed cash flow obligations survive. Importantly, if the debt imposes a spread over, or under, the variable interest rate common to the debt and the swap, this spread survives as well. Thus, the effective interest rate realized, post-hedge, would be the fixed rate of the swap, plus or minus any spread over or under the variable interest rate common to both the debt and the swap.

Economically perfect hedges—where the effective post-hedge interest rate is predictable, with certainty—are easy to construct when the variable interest rate on the debt is one that commonly serves as the interest rate on the variable leg of a standard, fixed-float interest rate swap. Most common among these situations are the pairing of LIBOR-based bank debt and Fixed-versus-LIBOR swaps. An example is depicted in Figure 1, reflecting the case of a borrower that hedges an exposure to three-month LIBOR funding, plus a spread. The arrows point in the direction of the required cash flows. The display demonstrates how the swap synthetically synthesizes fixed rate funding at an effective rate equal to the swap’s fixed rate, plus the original spread over the LIBOR funding.

figure 1

Many LIBOR-based bank loan agreements provide borrowers with a “chooser option,” permitting the borrower to choose the variable interest rate from a set of set of alternatives—say, one-month LIBOR, three-month LIBOR, or six-month LIBOR. Critically, however, fixed rates quoted on swaps with different variable reset frequencies won’t necessarily be the same. For instance, the fixed rate for fixed-versus-one-month LIBOR swap may not be equal to the fixed rate for a fixed-versus-three-month LIBOR swap.

Thus, assuming the bank applies the same spread to all of the available LIBOR reset maturity choices, the best choice would be the swap having the lowest fixed rate; and that swap selection would then dictate the choice of the reset maturity/frequency on the debt. For instance, assume the fixed rate on a fixed verses one-month LIBOR spread is 2.25 percent, while the fixed rate on the fixed versus three-month LIBOR swap is 2.35 percent. Also, assume the bank imposes the same spread over LIBOR for both reset maturities. Thus, choosing the fixed versus one-month LIBOR swap and funding on the basis of one-month LIBOR would save 10 basis points per year during the hedge horizon, relative to trading the fixed versus three-month LIBOR swap and funding with three-month LIBOR.

Once a swap is designed and executed, changing the debt’s reset election from the original selection would necessarily introduce some uncertainty, as the variable rate on the debt and the variable rate on the swap may no longer match. In that situation, the effective rate realized can no longer be expected to be the swap’s fixed rate plus or minus that bank-imposed spread over/under LIBOR. Rather, the resulting effective interest rate would be subject to variability as a consequence of unequal changes in the two respective variable interest rates. Thus, in order to continue to achieve a known effective fixed rate after electing to change the reset maturity and frequency of the debt, the swap contract must be adjusted, as well, to re-establish the required matching.

Changing conditions
What if conditions change? Suppose the market favored the three-month swap (and hence funding on the basis of three-month LIBOR) at the start of the hedge. Then, suppose market conditions changed, such that if a new swap were to be put in place today, the preferred choice would be, say, fixed versus one-month LIBOR. Economically, the sharp-pencil decision would be to exit the starting swap and replace it with a new swap, again, selecting the swap with the lowest fixed rate and switching the variable reset maturity accordingly.

In transitioning to this new hedge, however, the devil is in the details. With the new swap in place, the effective fixed rate that would be realized over the remaining horizon of the swap would be the fixed rate on the new swap adjusted by the prorated retirement value of the original swap not reflected in prior earnings. The liquidation price of the original swap will be critically important to this outcome and, unfortunately, such liquidation prices are often dictated by the dealer in a way that may be disadvantageous to the hedging entity.

A better way to proceed would be to maintain the original swap and overlay a basis swap, thereby making the hedging derivative the two swaps combined (i.e., the original swap plus the basis swap). A basis swap involves two variable cash-flow obligations. This solution is illustrated in Figure 2. We assume the borrowing entity (i.e., the hedger) originally entered into and hedged a variable rate debt tied to three-month LIBOR plus a spread. Subsequently, the hedger saw an opportunity to reduce funding costs by replacing the three-month LIBOR funding with one-month LIBOR funding and coincidently adjusting the derivative.

figure 2

In this case, the basis swap requires the hedger to pay three-month LIBOR and receive one-month LIBOR, plus a basis, such that when all the cash flows of the original swap and the basis swap are combined, all LIBOR-based cash flows are fully offset. The ending effective fixed rate is (a) the spread over LIBOR charged by the lender, plus (b) the fixed rate on the original swap, less (c) the basis received under the basis swap. It should be clear that the size of the basis in the basis swap is all that one would need to examine, in order to assess whether the terms available in the market at any given time would warrant electing to exercise a chooser option and how much of a savings would result.

Note that the display assumes that the original swap and the basis swap are entered into with two distinct counterparties. In fact, the original swap dealer could amend the original contract to explicitly reset the variable rate to the replacement LIBOR maturity and to lower the fixed rate on the contact by the amount of the basis swap’s basis. In effect, this amended swap terminates the original swap and replaces it with a new swap of precisely the same market value.

With any adjustment to any hedge relationship, if continuance of hedge accounting is desired, new hedge documentation is needed. The revised hedged item would become the interest payments based on the newly chosen reset rate and payment frequency, and the hedging derivative would be the replacement swap (or swaps combined). Assuming the original hedge received hedge accounting treatment, at the point of redesignation, some accumulated other comprehensive income (AOCI) would have been generated by the original swap, and this amount would have to be reclassified to earnings over the term of the original hedge horizon. The effective funding costs post-redesignation would thus be comprised of (a) the debt’s variable funding costs, (b) earnings from the replacement hedge, and (c) earnings from the reclassification of the original swap’s ending AOCI.

Economically this combined result would be expected to translate to the original swap’s fixed rate, less the basis on the basis swap. However, the accounting result may differ somewhat from period to period due to an accounting rule. This rule forces entities that hedge with swaps to measure hedge ineffectiveness by comparing the performance of their actual hedges with those of a hypothetical swap that has a zero value as of the hedge designation date.

Unless we replace the original swap with a new at-market (zero net present value) swap, we face the prospect of having to record some measure of ineffectiveness in current income—or not. Gains or losses of any amended hedging derivative won’t be the same as the gains or losses of the hypothetical derivative. However, the difference only affects earnings when the actual derivative’s results exceed those of the hypothetical derivative, i.e., the excess of actual hedge gains (losses) over hypothetical hedge gains (losses).

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The Two Faces of Market Risk

When bankers confront the issue of market risk, they might have either of two approaches in mind. In both, the concern deals with the impact of prospective changes in interest rates. However, two dimensions pertain to this concern: (1) the immediate impact of an interest rate change and (2) the impact over time. Put another way, a change in interest rates will have in instantaneous effect on position market values and thus the aggregate value of the firm. It will also influence future earnings that will be realized over the remaining life of the bank’s portfolio items. To appropriately evaluate the efficacy of any hedging program, we need to know which of these concerns the hedge is attempting to address.

Evaluation Hedging Programs. Consider the case of a fairly traditional bank portfolio consisting of longer-duration assets and shorter-duration liabilities. For now, assume a buy and hold orientation, whereby maturing assets and liabilities will be replaced, but only upon their expiration at their natural maturity dates. Further, consider each asset to be funded by an associated collection of one or more liabilities. Given the maturity mismatch of these asset/liability pairings, a rise in interest rates will adversely affect net interest margin associated with existing assets, but the resulting net interest margin for any replacement assets and associated liabilities will be uncertain.

It should also be clear that, as longer duration assets have greater interest rate sensitivity than shorter duration liabilities, higher interest rates will foster a lower aggregate market value for the existing portfolio. This price impact will be transitory for the starting portfolio, however, as the component financial instruments will necessarily settle to predetermined maturity values – as long as they do not default. Of course, the transitory nature of the impact on the firm’s aggregate market value is dependent on holding portfolio components until their natural maturity dates. And while it may make sense to be vigilant in seeking to substitute better performing assets or liabilities when such opportunities present themselves, in so doing, the firm transitions from positioning with a known outcome to one of an unknown outcome, effectively introducing a new component of market risk into the mix. Put another way, the expectation of improving the resulting net interest margin is one that may not end up being fulfilled.

Altering Your Bank’s Risk Profile. In any case, to the extent that banks may wish to alter their market risk profile, the alternatives are (a) to restructure the portfolio, or (b) to use derivative instruments to achieve an analogous result, synthetically. Generally, the former tends to be cumbersome and time-consuming, while the latter allows for a more efficient and immediate adjustment. In using derivatives, however, two distinct hedging objectives might be pursued. One objective could be to seek to mitigate the effects of an interest rate perturbation on portfolio values (i.e., the value- oriented approach), and a second objective could be to focus on prospective net interest margins (i.e., the income-oriented approach). To rephrase, the first would serve to stabilize the market value of the bank’s portfolio without necessarily affecting the accrual schedules of the portfolio components, while the second addresses prospective contributions to earnings, without particular consideration of market value changes. The two hedging objectives would likely call for different hedge constructions.

Mitigating Changes in Portfolio Values. With the objective of mitigating changes in portfolio values, the typical approach determines the aggregate interest rate sensitivity of the portfolio and then overlays a derivative position designed to foster a lesser sensitivity of the portfolio and the derivative position, combined, relative to the starting asset/ liability portfolio. The presumption underlying this approach is that the bank can correctly measure and monitor interest rate sensitivities of their assets and liabilities, as well as those of their derivative positions. With this capability, the bank can target and achieve virtually any degree of price exposure of its choosing.

With a focus on prospective net interest margin, the hedge would be designed to synthetically extend the maturities of liabilities or, alternatively, to shrink the maturities of assets. In either case, the hedge would serve to adjust the bank’s gap position. This hedge process is complicated for institutions that hold positions with early termination features, such as prepayable loans, where existence of prepayment options fosters the need to make assumptions about the expected schedule of prospective early terminations as a prerequisite for determining appropriate hedge positions.

To the extent that those assumptions are incorrect, the selected hedge positions might turn out to be too large or too small, depending on the direction of the error. In most situations, however, when the objective is to mitigate some existing risk, as opposed to fully eliminating it, this level of imprecision would likely fall within acceptable performance ranges.

It should be appreciated that the hedge construction that derives from this earnings-oriented hedging approach can typically serve to reduce the interest rate sensitivity of the bank as a whole – consistent with the outcome of the previously discussed duration based hedging. Even so, the two respective hedge designs should not be expected to be the same. That is, the duration of the derivative used to affect a synthetic adjustment to asset or liability maturities would likely have a duration that would differ, at least somewhat, from the duration of a derivative intending to fully offset the price effect of an interest rate perturbation on some asset or liability. Moreover, any number of hedge constructions could be orchestrated to yield comparable durations. However, more likely than not, the alternative earnings-oriented hedging would generally involve a more constrained set of hedge choices.

How Much Market Risk to Mitigate. Importantly, whichever approach is taken (value-oriented or income-oriented), hedging positions should not be static. As time passes, assets and liabilities will expire or will be eliminated from the portfolio and replaced. As a consequence, the bank’s exposure will change; and so, too, might the bank’s risk appetite. Thus, on an ongoing basis, best practice calls for revisiting the question of how much market risk to mitigate. This reassessment deserves to be made both on a periodic basis and also in response to any significant market adjustment.

For both types of hedges to be reflected in the bank’s financial statements in a manner consistent with the associated hedging objective, special hedge accounting would be needed. For the value-oriented hedge, fair value hedge accounting would be the appropriate treatment. Here, the hedger would most likely identify particular assets having an aggregate duration measure equal to that which the bank would want to neutralize. Under certain conditions, a single derivative might serve to hedge this collection of assets, or else at the individual, assets or smaller subsets of assets would require their own hedging relationships, pairing specific assets with specific derivatives or portions of a derivative.

In fair value hedges, balance sheet carrying values of the assets being hedged would be adjusted to reflect the value changes due to the interest rate changes that occurred throughout the hedging horizon. Under hedge accounting, those changes would be reflected in the income statement. Additionally, gains or losses of the hedging derivative, realized and/or unrealized, would also be recorded as earnings in the income statement. With a well-functioning hedge, these two earnings effects should be roughly offsetting.

For the income-oriented approach, the accounting treatment would depend on whether the hedge was conceived as intending to shorten the maturity of the bank’s assets or lengthen the maturity of the bank’s liabilities.

In the former case, fair value hedging would apply with essentially the same approach as that detailed above; and in the latter case, cash flow hedge accounting would apply. With cash flow hedging, the hedger would have to evaluate the hedge results and make a determination as to the portion of those hedge gains or losses that would be considered to be effective versus the portion that would be considered to be ineffective.

Effective results would initially be reflected in other comprehensive income, and later reclassified to earnings in the accounting period associated with the earnings impacts being hedged. The ineffective hedge results, on the other hand, would be recorded in earnings on a current basis. In this case, for well- functioning hedges, ineffective earnings amounts should be inconsequential if not immaterial; but regardless of materiality, the application of hedge accounting requires rigorous compliance with the dictates of the accounting procedures specified in section 815 of the Accounting Standard Codification.

The Application of Hedge Accounting. Critically, hedge accounting is permissible only when stringent prerequisite conditions are satisfied, including the drafting of detailed hedge documentation and devising and satisfying prospective and retrospective effectiveness tests. Given the repetitive nature of most hedging programs, though, addressing these requirements tends to be a one-time concern in that the initial documentation can usually be replicated with little or no adjustments when similar hedges are initiated.

Failure to satisfy these qualifying conditions for hedge accounting would force the default accounting treatment, where derivative gains or losses, realized and unrealized, would have to be reported in current earnings. Under this treatment, the intent of the hedge would not be reflected in the bank’s financial statements, and management would likely have to address analysts’ concerns about the more exaggerated level of earnings volatility that would likely result relative to the hedge accounting outcome.

Final Thoughts. Having presented these two alternative risk management orientations – one relating to the immediate interest rate effects and the other relating to interest rate effects that will accrue over time – the question remains as to which approach is better. Different bank asset/liability managers with different priorities may make different judgments, but my own preference is for the earnings-oriented approach, which I think lends itself to greater precision, discipline, and predictability.

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Implementing a Hedging Program: Building a Dashboard

Whether in the realm of interest rates, currencies, or commodities, traditional hedging programs start with some pre-existing exposure and then overlays a derivative position intending to transfer some or all of the undesirable risk exposure to a third party. Alternatively, from another perspective, derivatives mitigate risk by constraining the effects of some critical price or rate change. With varying degrees of precision depending on the circumstances, futures, forwards and swaps serve to “lock in” prices that would otherwise be subject to price variability; and purchased options, caps, and floors, generally serve to impose a boundary condition (i.e., a worst case effective price/rate) for the source of the risk exposure, but at the same time allowing for the possibility of more attractive outcomes. Clearly, other types of derivatives or derivative constructions could also be used, but these designs (futures, forwards, swaps, and purchased options) are the most basic.

Trade-offs are inescapable with derivatives. They force you to give up one thing to get another. For instance, when hedging with futures, forwards, or swaps, no initial payment is required to initiate the contract, but users have to be willing to forgo the benefit of advantageous price moves in order to be protected from adverse moves. When buying options, caps, or floors, on the other hand, users have to be willing to bear up-front payments in the form of option premiums to secure the prospective benefits, appreciating that some or all of option premiums will be realized costs, irrespective of whether those instruments subsequently payoff or not.

Entering into any hedging contract requires a secondary determination beyond simply recognizing which price change direction would be adverse. That is, when locking in a price, the anticipated effective price (post hedge) is critical. It’s not enough to lock in any price. For hedging to be desirable or appropriate, the price that the market allows you to lock in has to be an acceptable price. Prospective buyers wouldn’t want to look in a price that is “too high,” and prospective sellers wouldn’t want to lock in a price that is “too low.” (The same applies for interest rate payers or interest rate receivers.) Similarly, if using a purchased option, cap or floor, that contract would have to be “cheap enough.” Put another way, at some sufficiently high premium, the protection gained wouldn’t be worth the price paid.

The preference for futures, forwards, or swaps over options because the former contracts require no initial up-front expense should be recognized to be shortsighted – at least to some extent. Using the nomenclature of economists, futures, forwards, and swaps inherently bear opportunity costs, reflecting the fact that users must forgo the effects of a beneficial price moves. These opportunity costs would be unknown at the start of the contract, but they could end up being considerable if and when the price of the exposure being hedged moves sharply beneficially. In contrast, for option, caps, and floors, maximum costs are explicitly known at the start of the hedge, equal to the premiums paid. With this foundation, it should be clear that the choice between using futures, forwards, or swaps on one hand, and options, caps or floors, on the other, should compare potential opportunity costs of the former with known upfront premium amounts of the later.

So when is a fixed price “acceptable” and when is an option price “cheap enough?” Unfortunately, these judgments involve some subjectivity. That subjectivity notwithstanding, for futures, forwards, and swaps, the choice for the prospective hedger distills to choosing between taking the fixed price dictated by that contract or maintaining the exposure and hoping that the unhedged prices will end up yielding a better outcome. Clearly, different players with different risk tolerances and different market expectations will make different choices under the same market conditions.

For entities evaluating the purchase of options, caps, and floors, the alternatives are to bear the unprotected risk and hope prices won’t move (too) adversely, or to pay some known premium to offset the effects of prices rising above or below a critical threshold. With options, caps, and floor, though, choices abound, in that you can structure a hedge with any budget in mind, recognizing that paying a higher premium expands the range of prices for which protection will apply. Put another way, the cheaper the option the greater the price risk born by the hedging entity.

Entering into a hedge is, in effect, a pricing decision; but so, too, is the decision not to enter a hedge. Not hedging implies a judgment that the expected unhedged outcome is expected to be preferred to that which would arise if a hedge were in place. From that perspective, a chronic posture of not hedging known exposures would seem to be an abrogation of fiduciary responsibility. Surely, some situations must occur from time to time, where the terms of hedging derivatives are particularly advantageous, but you have to assess the markets on an ongoing basis to see if and when those circumstances arise.

Several observations:

  1. Hedging should not be thought of as an “all-or-nothing” proposition. The more attractive the fixed price of a derivative or the price of the option, the more desirable the hedge. Thus, it may be reasonable to hedge larger portions of risk exposures with more attractive derivative pricing, and a smaller portions with less attractive derivatives pricing. Moreover, the degree of hedge coverage deserves to be reconsidered on an ongoing basis as time passes and as market conditions change. Hedging entities should be comfortable about taking a partial coverage as a starting posture, with the idea of adjusting that coverage (upward or downward) over time.
  2. Forward prices are reflected in the pricing of all derivatives, and they are what they are. Thus, there’s no way to “recoup” any seeming adverse difference from today’s spot price. The only thing a derivative can do is protect from further adverse price changes than those already reflected in the derivative’s starting price.
  3. The relationship between spot and forward prices may provide a seeming advantage to one side of the market relative to the other. For example, when forward prices are markedly higher than spot prices, prospective sellers are able to lock in seemingly high sales prices; and conversely, when forward prices are markedly lower than spot prices, prospective buyers can lock in seemingly low purchase prices. Forward prices at comparable levels to current, spot prices would thus seem to offer a fairly neutral setting for hedgers, favoring neither buyers nor sellers.

With this third bullet point in mind, the following table shows a dashboard for a variety of interest rates and commodities, showing their spot prices at the near the end of September 2015, with a comparison of swap fixed rates for the 12 months of 2016 (reflective of forward rates throughout that year), and a value for their respective December 2016 forward prices. The presentation is designed to provide a snapshot showing the consensus view of anticipated prices or interest rate both over the coming year as well as by the end of 2016.

Spot price/Rate (End of September 2015) 1-yr. Forward Starting Swap Fixed Rate December 2016 Forward Price Comments
3-Month LIBOR 0.43% 0.60% 0.93% Favors lenders
Fed Funds 0.14% 0.37% 0.64% Favors lenders
Crude Oil $45.64/bbl. $49.10/bbl. $50.89/bbl Favors sellers
Natural Gas $2.59/MMBTU $2.87/MMBTU $3.19/MMBTU Favors sellers
Corn $3.89/bu. $4.07/bu. $4.12/bu. Favors sellers
Soybeans $8.84/bu. $8.92/bu. $8.90/bu. Favors sellers
Iron Ore $56.43/MT $42.42/MT $40.53/MT Favors buyers
Live Cattle $1.29/lb. $1.28/lb. $1.27/lb. Favors Buyers/Neutral

The two interest rates shown (3 month LIBOR and Fed Funds) reflect the capacity to lock in higher interest rates for future exposures, thereby favoring enterprises that earn (as opposed to pay) these respective interest rates. Crude oil, natural gas, corn, and soybean derivatives allow for locking in higher prices for future exposures, thereby favoring sellers of these products. On the other hand, iron ore forward prices allow for locking in lower prices for deferred periods, favoring purchasers; and while the same is technically true for live cattle, in this case the deviations are quite small.

Just because forward prices may favor one side of the market over another doesn’t mean that the disadvantaged side should necessarily shun hedging. Other considerations may certainly over-ride, and hedging from this seemingly disadvantaged starting point may still be the better choice, given that market conditions could very well deteriorate further. On the other hand, when the starting conditions favor hedging, the market stands ready to reward you for hedging; and it would be shortsighted to operate under a policy that chronically disregards these market incentives. Maintaining a dashboard may be a first step toward avoiding this pitfall.

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Good News on the Derivatives Accounting Front

Key Highlights

  • Under the proposed changes, hedgers would be allowed up to three months from the derivatives’ transaction dates to define and satisfy effectiveness tests.
  • Under the revised approach for cash flow hedges, the distinction between effective versus ineffective earnings would be ignored— at least as far as journal entries are concerned.
  • The only downside to the proposed changes is that FASB still seems committed to relying on the concept of “offsets” in considering hedge effectiveness.

Giant Steps
After years of benign neglect, it appears that the Financial Accounting Standards Board (FASB) is ready to reconsider the accounting treatment for derivative contracts. In June, the FASB made a variety of tentative decisions, which, unless modified, will critically impact a sizable portion of commercial enterprises that use derivatives for hedging purposes. The prospective changes will simplify accounting processes and generally serve to improve the alignment of the accounting with the economics underlying derivatives transactions.

The critical adjustments relate to hedge accounting—the allowable treatment for qualifying transactions whereby derivatives’ gains or losses are reported in the same accounting period as the earnings impacts of the associated hedged items. By pairing these results in a common accounting period, this treatment reflects the economic intent of the hedge.

While hedge accounting is an elective treatment, it requires satisfying a variety of prerequisite conditions. Among the current prerequisites is the requirement to document the hedging relationship in a very specific way, including the specification of prospective and retrospective hedge effectiveness testing methodologies. This documentation must be correct and complete as of the derivative transaction date if hedge accounting is to be applied from the start. Under the proposed changes, hedgers would be allowed up to three months from the derivatives’ transactions dates to define and satisfy these tests. Clearly for first-time hedgers, this adjustment will make the application of hedge accounting a lot easier.

Cash flow hedges
Presuming hedge accounting is authorized, one of the most significant changes will apply to cash flow hedges,which are hedges that relate to risks associated with uncertain, forecasted transactions. Under the current procedures, before any journal entries can be made, hedge results must be evaluated to determine the portion of gains or losses deemed to be effective versus ineffective. Effective results are initially reported in other comprehensive income (OCI) and later reclassified to earnings, concurrently with the recognition of the earnings effects of the item(s) being hedged. Ineffective results are not deferred but instead are posted directly to earnings.

The effective/ineffective assessment requires an evaluation of the cumulative hedge performance, and it is also asymmetric. That is, cumulative ineffective earnings arise only in the situation when the hedge gains or losses are too large relative to the gains or losses that a perfect hedge would have yielded. Thus, if hedges “under- perform,” ineffective earnings are deemed to be zero.

With the proposed changes, the FASB will be taking a dramatic leap. Under the revised approach, as long as the entity qualifies for cash flow hedge accounting, the distinction between effective versus ineffective earnings would be ignored—at least as far as journal entries are concerned. All hedge results would be posted to OCI and subsequently reclassified to earnings, again timed to coincide with the earnings recognition for the hedged item. Thus, to the extent that any ineffectiveness arises, it will show up in earning only when the reclassification occurs and not throughout the hedging horizon as is the case under current guidance. This adjustment should foster some lesser income volatility during the hedge period than we have experienced under the current regime.

A further advantage to this revision is that it eliminates the prospects of two entities using the same derivative and posting different earnings outcomes as a consequence of employing different methodologies for how they each measure ineffectiveness. Under the proposed rules, both entities will post identical earnings impacts when they hold the same derivative position(s).

At this point, although it would seem that we no longer need to worry about ineffective versus effective hedge results as far as journal entries are concerned, the measurement of these effects will still be necessary in order to satisfy disclosure requirements. Although it might be reasonable to expect ineffective results to be immaterial in the vast majority of cases, auditors would presumably expect this immateriality to be demonstrated. Thus, while we won’t have to measure effective and ineffective results for journal entries, we’d still have to perform that analysis to comply with disclosure requirements.

Commodity hedging concerns
Of particular concern to commodity hedgers is the requirement that stipulates (currently) that the hedged item must be defined as the full price effect of any commodity exposure. This requirement is likely to be liberalized. Specifically, if the full price being hedged expressly references some component price, that component price may be deemed to be the risk being hedged. A large portion of commodity purchases and sales are structured in this way, where the price references an industry standard price (or a benchmark price), plus or minus a basis.

Under the proposed rules that benchmark price can be defined to be the hedged item. This adjustment could be profoundly important in that it will likely expand the capacity to apply hedge accounting to many enterprises that have had difficulty passing effectiveness test (or simply declined to try) due to the volatility associated with basis conditions. This change has been long-awaited and will likely be widely appreciated.

An analogous liberalization appears to be in store for interest rate hedges. In this sector, hedgers have always enjoyed the capacity to hedge benchmark rate exposures (as opposed to the full interest rate exposures) for most interest rate situations, but benchmark rates have been limited to LIBORs, LIBOR-based swap rates, Treasury rates, or Fed Funds rates. The new rules would expand allowable benchmark rates to include SIFMA (Securities Industry and Financial Markets Association Municipal Swap Index). They would also allow the ability to designate any contractual index (e.g., Prime—not just benchmark rates) as the risk being hedged.

Two other changes affecting fair value hedges of interest rate exposures—i.e., hedges of fixed rate exposures—are also worth noting, in connection with:

  • For fair value interest rate hedges, derivative results are recorded in earnings coincidently with changes in the value of the hedged item due to the risk being hedged. The FASB now appears ready to allow entities to value the adjustment to the carrying value of the hedged item using the same discount factors as those used to value the hedging derivative. With this change, the long haul method yields an identical adjustment to the carrying value of the hedged item as does the shortcut method, thereby obviating the need for shortcut, altogether. This change assures an accounting outcome for an interest swap hedge that is consistent with the intended economic objective
    of swapping from fixed-to-floating
  • Partial-term hedging would be permitted for fair value hedges, whereby entities could qualify for hedge accounting when swapping from fixed-to-floating over a shorter span than the full maturity off the instrument being hedged. Allowing hedge accounting in this situation is an improvement in that it permits the harmonization of the economics and the accounting for this strategy, where otherwise, the two were at odds.

Dramatic improvement
The proposed rules are a dramatic improvement over the current guidance. They will make it easier to qualify for and apply hedge accounting, and they’ll also simplify the required processing procedures.

Don’t expect these changes to be effective anytime real soon, but it looks like they’re on their way. At this point, a formal process is required before any changes in the current guidance will apply. The FASB staff needs to prepare an Accounting Standards Update to amend Topic 815, with a proposed transition plan; the public will have an opportunity to comment; and then the FASB will ultimately accept, reject, or modify the guidance. My own experience suggests that the proposed changes will be warmly received by those who attend to these kinds of issues, and it seems likely that virtually all of the substantive adjustments thus far suggested will be adopted.

What’s Not in the Proposal?

Besides covering what the proposed changes would do, it may be useful to explore what they’ve failed to do. In fact, the only substantive reservation I have with respect to the proposed adjustments is the FASB still seems committed to relying on the concept of “offsets” in considering hedge effectiveness.

Both practitioners and academics have long believed this con- cept to be seriously flawed. In the vast majority of situations, high correlation between the price levels associated with the exposure and those underlying the derivative should serve a sufficient basis for expecting hedges to perform well over the long run or over repetitive applications. This statement, however, is not the same as asserting that such situations will reliably result in dollar offset calculations that fall between the traditional 80 percent to 125 percent bounds. In fact, numerous studies have demonstrated that even with data samples with very highly correlated price levels, the 80 percent to 125 percent boundary conditions are often violated with a seemingly high frequency (often approaching 50 percent of the periods in the sample).

Dollar offset ratios often blow up in periods of low volatility when nothing much is happening. With highly correlated price level, you can reasonably assume that dollar offsets to fall within the prescribed 80 percent to 125 percent range with sustained price moves, but all bets are off if you artificially constrain time periods to too limited horizons or periods in which price changes revert to zero. This current offset orientation ends up denying hedge accounting for too many entities that are pursuing reason- able and responsible hedging strategies.

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Synthetic Debt, Repos, and Dollar Rolls

Most financial professionals recognize that forward contracts are price-fixing mechanisms that allow buyers or sellers to set the price of some reference asset for some prospective, future value date. Perhaps less well-understood is the fact that forwards also offer the capacity to affect synthetic short term borrowings or, alternatively, synthetic short term investments.

Using gold as a prototypical example, consider the owner of gold who simultaneously sells 100 ounces of gold and buys back that same volume of gold with a forward purchase contract having a forward value date one year later. It should be clear that these combined transactions will serve to generate cash for the one-year interval between the original sale and the subsequent repurchase, i.e., a one-year synthetic debt. Assuming the spot sales price for gold is $1,000 per ounce and the forward purchase price is $1,050, this pair of trades affects a synthetic borrowing with an effective cost of 5 percent (=1,050/1,000 – 1).

From the counterparty’s perspective, the same transactions would serve to synthesize an asset, i.e., a synthetic loan, earning 5 percent. In the case of gold, forward prices are determined with direct consideration of these respective implied borrowing/lending rates. That is, gold arbitrageurs will buy spot gold and sell in the futures (or forward) market when the yield on this combined purchase/sale exceeds that firm’s financing costs; and similarly, they will do the opposite—sell spot gold and buy in the futures market—when the implied rate is below their alternative borrowing costs.

This cash-and-carry arbitrage is common in precious metals markets and a variety of other commodity markets where the commodity is storable. It should be clear that the precise nature of the underlying good can be anything for which forward contracts can be negotiated, at least in theory. The prevailing spot/futures pricing may make the yields associated with such synthetic borrowing/lending unattractive, but the design is nonetheless do-able.

This concept underlies a very widely used financing practice known as the repo market. A repo or repurchase agreement is typically constructed where an interest bearing security substitutes for the gold used in the prior example. Despite the terminology, however, no sale or repurchase actually transpires with repo transactions. Repos are not synthetic debt. They are just a particular form of secured real debt, where the reference security serves as collateral for a debt. The lender on the other side of the repo transaction would be said to be entering into a reverse repo transaction.

Under the repo contract design, instead of actually selling the security and buying it back later, the borrower maintains ownership of the security but pledges it as collateral for the duration of the borrowing. At maturity, when the debt is repaid, authority over the collateral reverts to the borrower. Repos also typically incorporate a haircut, where the outstanding balance on the loan will generally be for an amount less than the full market value of the security. For instance, a 5 percent haircut would mean that $100 of collateral would be required to secure $95 of debt.

Most financial professionals recognize that forward contracts are price-fixing mechanisms that allow buyers or sellers to set the price of some reference asset for some prospective, future value date. Perhaps less well-understood is the fact that forwards also offer the capacity to affect synthetic short term borrowings or, alternatively, synthetic short term investments.

In contrast to real debt, synthetic debt is engineered by pairing a true sale and a forward purchase of that same (or substantially similar) asset, allowing the full market value of the reference asset to be accessed by the borrower for a temporary period. Thus, the concept of a haircut just does not apply. Moreover, in contrast to the repo situation, where the interest generated by the reference asset is maintained by the borrower throughout the financing term, with a true sales and repurchase, the interest on the reference security moves to the lender at the time of the sale and then reverts to the buyer with the repurchase.

Mortgage Dollar Roll Transactions. One active category of synthetic debt is called a mortgage dollar roll transaction. The same design as described above applies but, with dollar rolls the reference asset is an Agency such as the U.S. government insured mortgage backed security (MBS), and a to-be-announced (TBA) contract serves as the requisite forward contract. TBAs are, in essence, forward contracts that specify the character of a given MBS (i.e., the issuer, coupon rate, maturity, par amount, price, and forward delivery date). The specific MBS delivered under the contract will not be identified, however, until two days prior to delivery. This delivery process conveys an embedded option that allows the TBA seller to deliver the cheapest-to-deliver underlying asset. As a consequence, yields on TBAs will be somewhat inflated, relative to cash MBA securities, to compensate the TBA buyer for this effect.

No sale or repurchase actually transpires with repo transactions. Repos are not synthetic debt. They are just a particular form of secured real debt, where the reference security serves as collateral for a debt.

In fact, dollar rolls may be confusing because the term is commonly used in connection with two distinct practices, and only one of these designs happens to be a financing. The non-financing dollar roll starts with an entity buying a TBA. Then, subsequent to delivery under this contract, the dollar roll is simply the act of liquidating this starting TBA and replacing it with another TBA with a more deferred value date. The price differential between these two TBAs is referred to as the price drop. Given the starting long TBA position, it would make sense to roll if the price drop were sufficiently generous, i.e., if the more deferred TBA were cheap enough. This strategy stands to make or lose on the basis of the price changes of the respective TBS that are traded, but it never generates cash in amounts that correspond to the notional values of the TBAs. Hence, considering this strategy to be a financing would be inappropriate. Again, we only construct synthetic debt when the transaction involves the sale of a physical instrument.

Accounting Treatments. Despite the economic differences between repos and synthetic debt, the accounting treatments for both are quite similar, provided the following transpire:

  • the sale and repurchase contracts in the synthetic debt transaction are entered into in contemplation of each other, and
  • the repurchase contract serves to allow the borrowing entity to regain control of the originally sold asset or a substantially similar asset.

Despite the economic differences between repos and synthetic debt, the accounting treatments for both are quite similar.

In other words some degree of substitution is allowable
for the collateral. Such a substitution necessarily arises with bone fide dollar roll financings, as the originally sold MBS would likely not qualify as the cheapest to deliver MBS.

The correct journal entry at the start of both real and synthetic financing transactions is debit cash/credit debt; interest expenses are reflected on an accrual basis; and finally, with the repayment of the debt (or the repurchase of the security), the debt account would be closed, and cash credited. Accounting for synthetic debt in this way may satisfy the accounting rules, but it distorts the economics of the trade. That is, this treatment leaves the sold asset on the balance sheet when, in fact, it has been transferred to another party. Synthetic debt thus inflates the balance sheet relative to real debt.

Financing Rates. Because of the different treatment of the interest on the reference security for the repo versus the synthetic debt, the two respective financing rates are not directly comparable. Besides the explicit financing rate inferred by spot and forward pricing in the synthetic debt, the synthetic borrower also gives up the income on the reference asset. Economists label this cost an opportunity cost, and failure to consider it would understate the true cost of this kind of financing. Besides this issue, the fact that the delivered asset under the TBA contract would be the cheapest to deliver, the true market value of this security might be different from the prescribed repurchase price, thereby introducing some degree of uncertainty for financing under the dollar roll strategy, while the cost of borrowing under a repo transaction is explicitly stated and will be realized, baring default.

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Tactical Considerations of Hedging Currency Exposures

Tactical Considerations of Hedging Currency Exposures

Key Insights

  • Traders may offer valuable lessons to hedgers.
  • Hedgers should consider a hedging process that requires terminating losing hedges before their natural termination dates.
  • If an organization understands the nature of its exposures and their hedges, outcomes should be reasonably predictable.

It’s not easy to forecast foreign exchange rates. Sometimes large exchange rate moves are abruptly reversed, and sometimes, after relatively brief pauses, the trend reemerges. Moreover, prices frequently stutter and change direction in a seemingly random manner, often with non-trivial counter movements during trends that may persist for years.

Speculative currency traders, for the most part, live and die on the basis of how well they can anticipate—or react to—imminent market moves. Their ability to forecast, however, may not be paramount. Often, the source of their income derives largely from their trading rules that serve to limit their losses. If you pick the market direction correctly only half of the time but you earn more on your winners than you lose on your losers, you’ll be a successful trader. Of course, you need to have sufficient capital to trade another day, following losing episodes that inevitably will occur.

Hedgers generally have a somewhat different orientation. Rather than being concerned about minor market gyrations, they’re typically willing to bear some variability of exchange rates while seeking to mitigate the effects of more substantial market moves. That said, the traders’ orientation may still offer valuable lessons to hedging entities. After all, it would seem hard to justify a hedging strategy that doesn’t presume the ability to earn positive expected returns for derivative positions—not necessarily for every hedging instance, but certainly overtime. Unfortunately, given the volatile nature of currency markets, it may be overly optimistic to expect to realize those positive returns without the benefit of some kind of a disciplined trade execution plan.

This perspective suggests that hedgers may want to consider a hedging process that requires terminating losing hedges before their natural termination dates. For example, consider a U.S. importer who buys from a European supplier with payments to be made in Euros. Assume further that the hedger initiates a hedge of 50 percent of
its Euro exposure by buying Euros in the forward market at a price of $1.1500 per Euro. In this instance, the company is still exposed to the risk of a stronger (i.e., more expensive) Euro, relative to the U.S. dollar; but 50 percent of the risk (as well as 50 percent of the beneficial opportunity of a weakening Euro) has been eliminated by this hedge.

With the predilection of limiting hedge losses, one tactical approach might be for the hedger to decrease the hedge coverage by liquidating portions of the starting hedge position as the exchange rate falls—i.e., as the hedge positions generate losses. For example, for each drop in the exchange rate of, say, $0.0100, a fifth of the initial hedge position could be liquidated. In that way, the entire hedge would be terminated if and when the exchange rates were to fall below $1.1000 per Euro. This hedger would clearly lose on these hedge positions, but at least those losses would be constrained, and throughout the process, the degree of exposure to the beneficial rate change would be increasing (i.e., improving).

A logical extension of this plan might be to increase hedge coverage when hedges are winning—presuming the starting point were less than 100 percent of the existing risk is initially hedged. Returning to the starting 50 percent hedge coverage in our initial example, this entity might want to increase the hedge coverage in increments of 10 percent of the exposure with each $0.0100 increase in the exchange rate. In this way, if and when the exchange rate rises above $1.2000, the hedging entity would be fully hedged and protected from any further strengthening of the Euro. Clearly, at this point, with the exposure fully hedged any further accumulation of forward contracts beyond that coverage would have to be considered as speculative trade, as opposed to being a hedge.

A problematic approach?
This approach is not without its problems. Note that under the adjustment process just described, the firm would be buying and selling Euros forward at pre-determined price points. Given the way currency markets trade, however—often gapping from one level to the next— there’s no guaranty that these trades can be executed at desired levels. As a result, the outcome from the hedge may not be realized with the level of precision that might be desired. Additionally, under this approach, the hedging entity would be buying Euros forward as the exchange rate rises and selling forward as the exchange rate falls. Thus, if the thresholds for making these exit/enter adjustments to the hedge position are too narrow and exchange rates gyrate within a confined trading range, adjustments to the hedge position would have the hedger buying high and selling low, thus fostering trading losses that would be largely independent of any meaningful adjustment to exchange rates. And finally, with the termination of a hedge in response to loses on that derivative, the entity would again be exposed to any subsequent adverse market move unless or until a new hedge is applied.

These realities notwithstanding, it’s important not to lose the forest for the trees. Although this approach could yield hedge losses from the adjustment process that may end up being unrelated to the realized market move for the exchange rate being hedge, these losses would likely arise in periods of relatively low volatility; and most likely, the losses would be relatively minor. On the other hand if a truly sustained market move were to arise, this approach would likely be successful in constraining adverse earnings impacts while at the same time allowing for possibly substantial beneficial earnings impacts to be realized if the exchange rate moved beneficially.

The careful reader might realize that this strategy would be expected to perform much like a purchased call on Euros. That is, with a long call, the hedger can be assured that a worst case (maximum) exchange rate equal to the call’s strike price has been established, with the allowance to enjoy a lower (cheaper) exchange rate if spot Euro exchange rates remain lower than that critical maximum. In fact, traders typically understand that the dynamic approach presented above synthetically replicates a call option in that both deliver the asymmetric outcome of limited risk with unbounded opportunity. For the actual call, however, the cost of the strategy is explicitly known, up front—i.e., the price required to buy the option. For the dynamic strategy, on the other hand, neither the costs nor this effective worst case outcome can be known with certainty at the onset of the strategy. Both would depend on the path of exchange rates during the hedging process. Sometimes the dynamic strategy will deliver a better result; sometimes the purchased call option will be better.

The decision of whether to hedge and how much to hedge is anything but win-win. You look like a hero if, when hedged, you experience an adverse exchange rate move and your hedge delivers a profitable offset. On the other hand, if that risk doesn’t come to fruition, the hedge will generate a loss—a loss that might, in retrospect, seem to have been avoidable. Still, if an organization understands the nature of its exposures and their hedges, outcomes should be reasonably predictable. That is, hedges should reliably constrain effective costs and prices (post hedge) to be within acceptable ranges. Of course, what is deemed to be acceptable is an individual business judgment. But the point is, prospective hedge losses for any given hedge, by themselves, are really beside the point.

Complicating the calculus in the hedging decision is the fact that companies are often compared to their peers. Differences in performance between a company that hedges and a peer that doesn’t would be inconsequential if exchange rates stay steady. But with a substantial exchange rate move, the difference could be considerable. And, perhaps as often as not, the company that hedges a larger portion of its risk may end up with the less attractive earnings outcome. The hope and expectation would have to be that the disciplined risk management orientation will prove to be more profitable, over time.

Unfortunately, whether or not stock valuations will appropriately reflect the idiosyncratic hedge processing practices that each company pursues is an open question. Ultimately, it falls to the management to explain their hedging program in the firm’s disclosers in a way that allows the investment community to evaluate whether the hedging program is, in fact, disciplined, or if it is ad hoc.

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Accounting for Commodity Hedges: Hypothetically Speaking

American companies that hedge commodity purchases and sales almost always suffer from basis risk—the risk that changes in cash prices paid or received for commodities being hedged will differ from the price changes that underlie hedging derivatives.

This risk arises because, typically, available derivative contracts reference some “industry standard” commodity price, where the quality of that reference asset and/or its delivery location differ from the firm-specific price risk being hedged. For well-functioning hedges, these two respective prices need not be identical, but they should be highly correlated.

Many companies understand basis risk and are prepared to accept it. They’re comfortable substituting the risk of changes in the basis for the broader, market risk that they associate with the industry standard commodity price changes. Put another way, companies often tend to view their cash price exposure as being composed of an industry standard price risk coupled with a basis risk. The derivative is expected to hedge the lion’s share of that combined risk.

Unfortunately, in the United States, the accounting authorities have a different orientation. Under U.S. GAAP, cash flow hedge accounting is generally the preferred accounting treatment relating to hedges of prospective purchases or sales. This treatment reflects the intended economics of the hedge by deferring the earnings recognition of the effective portion of a hedging derivative’s results until earnings are recognized for the purchases or sales being hedged.

Key Insights
To qualify for hedge accounting, derivative gains or losses must be highly effective in offsetting the full cash price changes of the purchases or sales being hedged—not just the “industry standard” price change.

The “hypothetical derivative” is a conceptual construct that would generate a perfect hedge offset.

Ineffective earnings are recognized in earnings only when cumulative gains (or losses) from the actual derivative exceed those that would have been generated by the hypothetical derivative.

In order to qualify for hedge accounting treatment, the hedging entity must expect the derivative to be “highly effective” in offsetting the risk being hedged. Ineffectiveness derives from a comparison of the derivative’s gains or losses to the losses or gains associated with the full cash price change of the commodity being hedged—not just the industry standard price change. When these two prices move differently, the hedge either under-performs or over-performs relative to the cash price risk being hedged. If the imbalance is sufficiently large, then hedge accounting could be disallowed.

Defining hypothetical derivatives
To determine the appropriate division between effective versus ineffective hedge results, many companies rely on the concept of a hypothetical derivative—a derivative that, if it could be traded, would perfectly offset the risk being hedged. Ideally then, commodity hedgers would likely seek to execute a perfectly tailored hedging derivative that expressly referenced that firm’s specific cash prices. Typically, however, most derivative dealers wouldn’t be willing to trade such a contract. Rather, they’d offer contracts that reference an industry standard price. The perfect hedge, then, is not one that generally can be traded. It is commonly referred to as the hypothetical derivative, and its settlement amounts are thus … hypothetical.

In any case, the results that would have been generated by trading a hypothetical derivative may be compared to those of the derivative that is actually traded (i.e., the actual derivative) to generate the measure of hedge ineffectiveness needed to properly satisfy the accounting requirements. More specifically, this comparison requires an assessment of cumulative gains or losses, and ineffectiveness fosters an earnings impact only if the actual derivative over-performs relative to the hypothetical. That is, ineffective earnings are recognized in earnings only when actual gains (or losses) exceed hypothetical gains (or losses).

In the typical case, hypothetical derivatives will follow the same form as their associated actual derivatives. For example, if the actual derivative is a forward contract, the hypothetical contract would also be a forward contract. If the actual is an option contract, then the hypothetical would be an option. If the actual is a swap, then the hypothetical would be a swap. In each case, though, beyond knowing the type of instrument, we also need to define that instrument’s critical features—forward (or futures) prices for hypothetical forwards (or futures), strike prices for hypothetical options, or fixed prices for hypothetical swaps. These critical features can be deduced by applying a transforming equation to the associated feature(s) of the related actual derivative. The precise methodology for making these transformations, however, is left to the discretion of those doing the hedging.

While no unique methodology for making these transformations is prescribed by generally accepted accounting principles (GAAP), the terms of the hypothetical derivative should be documented up front. Otherwise, the discipline to assure that the accounting treatment is not being manipulated would be lost. How, then, do we devise this transformation? Ultimately, the transformation should reflect the nature of the relationship between the cash prices of the hedged item and the prices of the industry standard commodity underlying the hedging derivative.

One solution is to apply regression analysis, where we’d strive to discern a linear relationship between the cash price being hedged (C) and the price that underlies the hedging derivative (D):

C = a x D + b

where estimates for the values for the slope (a)and intercept (b) would be estimated by the regression analysis.

Assuming this equation is a valid representation of the relationship between these two variables, we apply this equation to transform the features of the actual derivative to get the associated parameters for the hypothetical derivative.

For example, suppose the actual derivative is a commodity swap with a fixed price of $4.50 per unit. The resulting regression equation is C= 0.9 x D + 0.25. Plugging the swap’s $4.50 fixed price as the D value in the regression equation yields a price of $4.30 (=0.9 x $4.50 + 0.25), which would be the presumed fixed price for the hypothetical derivative.

Alternatively, if the hedging derivative happened to be an option with a strike price of $4.50, that same approach would dictate that the strike price on the hypothetical option should be $4.30. Clearly, any result would be dependent on the data set used for the analysis.

It’s important to realize that, ultimately, it is the earnings impact from the actual derivative that will be realized in earnings.

Hypothetical case
A second approach for setting the critical terms of the hypothetical derivative would be to adjust the actual derivative’s critical price by some spread or differential. To illustrate, consider the case where a company’s basis ranged from a low of $0.05 to a high of $0.40. With this history,

it would seem reasonable to set the transforming spread somewhere between these extremes. Any number of methods could be used, however, to determine this mid-range value. For instance, the company might simply set the spread to the mean of the basis over the latest two or three years, or the median, or some other alternative weighting scheme of past basis values.

Under both methodologies, the objective is to define a hypothetical derivative that reflects an outcome that we expect to be able to realize. Importantly, this objective is only a target; it’s not something that we can necessarily achieve. In other words, if we define a fixed rate for the hypothetical swap to be, say, $4.30, we should expect the hedge (using an actual swap having a fixed rate of $4.50) to end up locking in an all-in fixed price of (about) $4.30. Similarly, if the strike price on a hypothetical cap is $4.30, we should expect to end up constraining our all-in purchase prices to no more than (also roughly) $4.30.

It should be clear that different entities will end up defining different hypothetical derivatives for situations where their actual derivatives are identical. As a consequence, those two entities, having identical derivative outcomes (for their actual derivatives) may very well end up with different measures of ineffectiveness, and thus different earnings results and different AOCI values. Put another way, GAAP as currently written does not foster a unique accounting result for companies using the same derivative, hedging the same risk.

That said, it’s important to realize that, ultimately, it is the earnings impact from the actual derivative that will be realized in earnings. That amount is unaffected by the design of the hypothetical derivative. The hypothetical instrument might likely impact the timing of when actual gains and losses generated by the actual derivative are recognized in earnings, but not the amount.

By whatever method selected, once the terms of the hypothetical derivative have been set, subsequent valuations for these hypothetical derivatives would likely be found by repeating the transformation technique to generate subsequent hypothetical forward prices, as time goes by. At each quarter-end, either an updated regression would
be performed, or an updated spread would be calculated. These revised results would then be used to transform the (observable) forward prices of the actual derivative to (unobservable) forward prices for the hypothetical derivative. Those transformed forward prices would serve as the critical inputs for (re)valuing the hypothetical derivative. Regardless of the methodology chosen, when devising the hypothetical derivative’s new forward prices, it would be reasonable and appropriate to apply the same conventions as far as observations and frequencies used in connection with the way the critical terms of the hypothetical derivative were devised. In that way, the methodology will reflect any changes in the relationship between the cash prices and the prices underlying the derivative, as those changes become apparent.

The good news is that the accounting guidance offers considerable flexibility to hedging entities, allowing hedgers to devise hypothetical derivatives in a manner that seems most workable. The bad news is that this flexibility translates to a lack of consistency. Different companies hedging virtually the same risks with the same derivatives may end up with dramatically different earnings representations. This lack of consistency is inherent in any hedging application that relies on the use of hypothetical derivatives, but it is especially severe in commodity hedging situations due to the requirement that hedgers must seek to address their entire price risk, inclusive of basis risk.

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Comparing Hedge Accounting Under GAAP and IFRS 9

Key Insights

  • IFRS 9 is more compact and offers less prescriptive guidance than U.S. GAAP.
  • IFRS 9 is more liberal than U.S. GAAP in allowing for component hedging in the commodity sector and in the elimination of retrospective effectiveness testing.
  • The two standards differ in their treatments of forward points and option time values.

This past July, the International Accounting Standards Board (IASB) released a new accounting standard—IFRS 9. While not applicable to U.S. domiciled companies, many international companies apply the international standard in some jurisdictions and U.S. GAAP in others. This article highlights some of the more significant features of the international standard that differ from the U.S. rules.

“The main difference between IFRS 9 and U.S. GAAP has to do with allowances for companies to apply hedge accounting in connection with risk components.”

The big picture
Conceptually, U.S. GAAP and IFRS 9 share a common foundation:

  1. Derivatives are assets or liabilities, carried on the balance sheet at their current market value.
  2. Derivatives’ gains or losses generally are recognized in earnings on a current basis, but special hedge accounting can override this treatment when prerequisite conditions are satisfied.
  3. Three distinct types of special hedge accounting might apply—fair value hedge accounting, cash flow hedge accounting, and hedge accounting for hedges of net investments in foreign operations. In both jurisdictions, hedge accounting serves to allow earnings recognition from the hedging derivative coincidently with the earnings effects relating to the exposures being hedged.

Hedging differences
The main difference between IFRS 9 and U.S. GAAP has to do with allowances for companies to apply hedge accounting in connection with risk components. In the United States, the capacity to hedge risk components applies only for interest rate exposures, where, in many circumstances, U.S. reporting entities may designate “benchmark interest rate” changes as the risk being hedged. The international standard breaks with the U.S. by allowing benchmark hedging for commodities as well as interest rates. Thus, under IFRS 9, if a commodity price is tied to a benchmark price and if the derivative also depends on this benchmark price, the hedge would be expected to perform with zero ineffectiveness.

A nuance of the IFRS 9 rules for hedging price components, however, is that this eligibility is restricted o components that represent something less than the full price risk facing the firm. This requirement would preclude component hedging in situations where the full price exposure reflects some benchmark price less an incremental difference. In this case, the hedging entity would likely opt to designate the full price risk as the risk being hedged. Note, however, that if the differential to the benchmark price is constant throughout the life of the hedge, this restriction has no real impact. That is, if the full price relating to the exposure being hedged were equal to a benchmark price minus a constant differential, the hedge of the full price effects would yield a perfect hedge outcome. In other words, the allowance to hedge a component risk in this case would be unnecessary. On the other hand, if that differential varies over time, those operating under the international standard might be forced to terminate hedge accounting if and when the variable basis conditions dominate relative to changes in benchmark prices, i.e., the same situation that U.S. reporting entities face for all of their commodity hedges.

Effectiveness testing
A prerequisite for hedge accounting for both standards is that hedges have to be expected to offset the risk being hedged— either changes in fair value for fair value hedges or changes in cash flows for cash flow hedges. Failure to achieve a sufficiently close offset would preclude the application of hedge accounting. In the U.S. GAAP, the offset must be “highly effective,” which, in practice, is taken to mean that the ratio of the hedge results to the gains or losses on the hedged item should fall within the boundaries of 80 percent to125 percent.

The international standard is much less prescriptive, requiring only that the hedging entity demonstrate that “an economic relationship exists” between the hedged item and the hedging derivative, whereby the two components of the hedge relationship are expected to move inversely to each other. Additionally, the international standard appears to take a somewhat more flexible approach in that it allows the assessment of effectiveness assessment to be based on the companies risk management analysis or information, i.e., the work that companies do to satisfy their internal requirements that justify that the hedge would likely meet the company’ risk management objectives.

U.S. GAAP requires prospective effectiveness tests to be repeated at least on a quarterly basis. The international standard, on the other hand, requires a prospective test at the start of the hedge relationship and on an ongoing basis; but “ongoing” is not defined. A more substantive difference exists, however, in connection with retrospective effectiveness testing—an assessment of effectiveness pertaining to the hedge performance of the hedge relationship in question. Retrospective testing is required under U.S. GAAP, but no retrospective requirement is stipulated in IFRS 9.

The lack of a retrospective effectiveness testing requirement under IFRS 9 undoubtedly will allow for a more liberal application of hedge accounting under the international standard. In the U.S., failing a retrospective test precludes hedge accounting in that period. In contrast, under the same performance, hedge accounting would still be applied under IFRS 9, as long as the seemingly poor hedge performance in the period past is not seen to be reflective of a genuine change in the economics of the hedge, and the prospective assessment continues to be satisfied.

Accounting for cash-flow hedges
Under U.S. GAAP, effective cash-flow hedge results are posted to AOCI and reclassified to earnings coincidently with the earnings recognition for the associated hedged item; and the process of closing out AOCI to earnings is called reclassification. It works somewhat differently for IFRS 9. First, IFRS 9 has a unique treatment of forward points and time value effects. Beyond that, under IFRS 9, the deferred effective gains or losses (excluding forward point or time value effects) are posted to a cash-flow hedge reserve account—analogous to AOCI in U.S. GAAP.

The timing of when the hedge reserve account is closed out under IFRS 9 may differ from the AOCI reclassification date under the U.S. standard, and the geography may also be different. Specifically, for an IFRS 9 cash flow hedge, if the hedge item is a purchase or sale of some good or commodity, the offset to the closing out the hedge reserve account is to the line item pertaining to the hedged item, per se. In such a case, IFRS 9 explicitly states that this close-out is not to be considered a reclassification. (The standard is silent as to what it should be called.) In contrast, for an interest rate hedge, closing out the cash flow hedge reserve would be a reclassification to an earnings account (e.g., interest income or interest expense)—identically to the U.S. treatment.

Accounting for forward points and option time values
Under both standards, hedgers have the flexibility to choose whether to exclude forward points and/or option ime values from their assessment of hedge effectiveness. If excluded, though, the U.S. standard requires gains or losses of those excluded components of hedge results to be recognized in earnings on a current basis. This requirement has no earnings impact for fair value hedges, as those effects are recorded in earnings, anyway. In cash flow hedges, however, the rules serve to preclude time value or forward point effects from being deferred.

Under U.S. GAAP, hedging entities that would prefer to defer all or most of these components of the derivatives’ results would opt not to exclude forward points or time values. In these instances, effectiveness is generally measured by comparing actual derivative result to those of a hypothetical derivative, allowing for the possibility of the full derivative gain or loss being deferred through AOCI if the actual and hypothetical forwards or options are identical to their respective hypothetical counterparts. Excess gain or loss of the actual derivative relative to its associated hypothetical, however, would be recognized in earnings as ineffectiveness. Any amounts initially recorded in AOCI amounts would subsequently be reclassified to earnings coincidently with the date of the earnings impact of the hedged item.

The accounting process for forward points and option time values is somewhat different under IFRS 9. Under this standard, a separate AOCI account is created for results associated with forward points and option time values (as distinct from the cash flow hedge reserve account), and gains and losses of those components are posted to that separate account. The hedging entity is required to apply a “rational” amortizing methodology for reversing those amounts out of that account and into earnings, but no specific method is prescribed. The accumulated amount in this account is ultimately closed out at some point. Depending on the nature of the hedged item, the offset to the journal entry to close this account would either be (a) an adjustment to the cost basis of the hedged item at the time of the transaction—not necessarily an earnings recognition date, (b) an amortization during the term of the hedge horizon, or (c) an adjustment to earnings in the case of an interest rate hedge, during the horizon where the hedged item affects earnings.

This separate equity account (distinct from the cash flow hedging reserve) is also used in connection with the hedges that employ forward contracts, in connection with the associated forward points. Treatment for forward points follows analogously to that of option time value changes.

Discontinuing hedge accounting
Under U.S. GAAP, hedge accounting is an elective that can be instituted at will—assuming all prerequisites are satisfied—and it can be discontinued at will, as well. IFRS 9 seemingly restricts this option to terminate hedge accounting prior to the hedge naturally terminating when the derivative expires or when the exposure no longer exists. It appears, however, that the international standard provides somewhat of a loophole.

The international standard takes pains to distinguish strategies from objectives. Strategies reflect how the entity manages its risk. Objectives, on the other hand, reflect the anticipated outcome that the company would hope to achieve from hedging. In the context of this discussion, early termination of hedge accounting may be able to be achieved by stipulating additional qualifying criteria in the hedge documentation within the discussion of the hedge strategy and objectives that, if not satisfied, would necessarily preclude application of hedge accounting.

IFRS 9 is more compact and offers less prescriptive guidance than U.S. GAAP. However, IFRS 9 bears close resemblance to its U.S. precursor, and it can be categorized as more liberal in allowing for component hedging in the commodity sector and in a total elimination of retrospective effectiveness testing.

The most important differences deal with risk components and time values and forward points. IFRS 9 requires the use of a special equity account for current market changes in these components of hedge results. Amounts in this special account subsequently get closed out of this account on some amortized schedule, subject to some discretion on the part of the reporting entity. This feature of the international standard alters the timing of earnings recognition associated with forward points and time values in a way that likely resulting in a smoother earnings pre- sentation than that which would occur under the U.S. standard.

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