Effectiveness Issues

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Effectiveness Issues
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ACCOUNTING EFFECTIVENESS

• Fair value hedges
• Derivatives should offset the changes in fair
  value of the hedged item attributable to the
  hedged risk
• Cash flow hedges
• Derivatives should offset cash flows of the
  hedged item attributable to the hedged risk

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EXCLUDABLE HEDGE RESULTS

• Changes in forward points
• Assessment based on changes in spot prices or
  forward prices
• Changes in the time value of options
• Assessment based on intrinsic value
• Changes in the options volatility value
• Assessment based on an options minimum value

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SPOT/FORWARD PRICES
Price
Forward
Spot
Time
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Forward Versus Futures ContractsQuotations from
Walter Teets
September 7, 2000 email message to Bob JensenThe
error in our case is simply that the futures
values (due to changes in either spot or futures
prices) shouldn't be present valued, since there
is daily settling up. But the (change in) values
of the anticipated cash flows of the hedged item
should be present valued, because there is
usually no periodic settling of the cash flows
associated with the hedged item. The change to
the case is minor the major point of the futures
case is to show exclusion of the change in the
difference between future and spot price from the
determination of effectiveness. Present valuing
the cash flow associated with the anticipated
transaction, while not present valuing the
futures (change in) value adds additional
ineffectiveness to the hedging relation. Walter
Teets at Gonzaga University

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KPMG Example 4.2Cumulative Dollar Offset
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Future Values Must Be Discounted

• If forward values are used to estimate current
  values, FAS 133 and IAS 39 require that these be
  discounted backwards to the current dates.
• See http//www.trinity.edu/rjensen/acct5341/speak
  ers/133glosf.htmYieldCurve

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TIME VALUE / VOLATILITY VALUE

• Time value is the option premium less intrinsic
  value
• Intrinsic value is the beneficial difference
  between the strike price and the price of the
  underlying
• Volatility value is the option premium less the
  minimum value
• Minimum value is present value of the beneficial
  difference between the strike price and the price
  of the underlying

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FEATURES OF OPTIONS
Option Value Intrinsic Value Time Value

• Intrinsic Value Difference between the strike
  price and the underlying price, if
  beneficial otherwise zeroz
• Time Value Sensitive to time and
  volatility equals zero at expiration

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Sub-paragraph b(c) of Paragraph 63 of FAS 133

• c. If the effectiveness of a hedge with a forward
  or futures contract is assessed based on changes
  in fair value attributable to changes in spot
  prices, the change in the fair value of the
  contract related to the changes in the difference
  between the spot price and the forward or futures
  price would be excluded from the assessment of
  hedge effectiveness.

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Sub-paragraph b(a) of Paragraph 63 of FAS 133

• a. If the effectiveness of a hedge with an option
  contract is assessed based on changes in the
  option's intrinsic value, the change in the time
  value of the contract would be excluded from the
  assessment of hedge effectiveness.

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Sub-paragraph b(b) of Paragraph 63 of FAS 133

• b. If the effectiveness of a hedge with an option
  contract is assessed based on changes in the
  option's minimum value, that is, its intrinsic
  value plus the effect of discounting, the change
  in the volatility value of the contract would be
  excluded from the assessment of hedge
  effectiveness.

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THE IMPACT OF VOLATILITY
A
B
Price
Price
P
P
Time
Time
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Minimum Value
Option Value Risk Free Value Volatility Value

• If the underlying is the price of corn, then the
  minimum value of an option on corn is either zero
  or the current spot price of corn minus the
  discounted risk-free present value of the strike
  price.  In other words if the option cannot be
  exercised early, discount the present value of
  the strike price from the date of expiration and
  compare it with the current spot price.  If the
  difference is positive, this is the minimum
  value.  It can hypothetically be the minimum
  value of an American option, but in an efficient
  market the current price of an American option
  will not sell below its risk free present value.

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INTRINSIC VALUE / MINIMUM VALUE
Option Price
Minimum Value
Strike Price
Intrinsic Value
Underlying Price
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Minimum (Risk Free) Versus Intrinsic
ValueEuropean Call Option

• X Exercise Price in n periods after current
  time
• P Current Price (Underlying) of Commodity
• I P-Xgt0 is the intrinsic value using the
  current spot price if the option is in the money
• M P-X/(1r)n is the minimum value at the
  current time
• MgtI if the option if the intrinsic value I is
  greater than zeroValue of Option exceeds
  minimum M due to volatility value

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INTRINSIC VALUE / MINIMUM VALUE
Option Price
Minimum Value
Strike Price
Intrinsic Value
Underlying Price
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Minimum Versus Intrinsic ValueAmerican Call
Option

• X Exercise Price in n periods after current
  time
• P Current Price (Underlying) of Commodity
• I P-Xgt0 is the intrinsic value using the
  current spot price if the option is in the money
• M 0 is the minimum value since option can be
  exercised at any time if the
  options value is less than intrinsic value
  I.Value of option exceeds M and I due to
  volatility value

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Selected IAS 39 Paragraph Excerpts

• 146.  80ltDeltalt125 Guideline.
• 147. Assessing hedge effectiveness will depend on
  its risk management strategy.
• 148. Sometimes the hedging instrument will offset
  the hedged risk only partially.
• 149. The hedge must relate to a specific
  identified and designated risk, and not merely to
  overall enterprise business risks, and must
  ultimately affect the enterprise's net profit or
  loss.
• 150. An equity method investment cannot be a
  hedged item in a fair value hedge because the
  equity method recognizes the investor's share of
  the associate's accrued net profit or loss,
  rather than fair value changes, in net profit or
  loss. If it were a hedged item, it would be
  adjusted for both fair value changes and profit
  and loss accruals - which would result in double
  counting because the fair value changes include
  the profit and loss accruals. For a similar
  reason, an investment in a consolidated
  subsidiary cannot be a hedged item in a fair
  value hedge because consolidation recognizes the
  parent's share of the subsidiary's accrued net
  profit or loss, rather than fair value changes,
  in net profit or loss. A hedge of a net
  investment in a foreign subsidiary is different.
  There is no double counting because it is a hedge
  of the foreign currency exposure, not a fair
  value hedge of the change in the value of the
  investment.
• 151. This Standard does not specify a single
  method for assessing hedge effectiveness.
• 152. In assessing the effectiveness of a hedge,
  an enterprise will generally need to consider the
  time value of money.

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FAS Effectiveness Testing --- http//www.qrm.com/p
roducts/mb/Rmbupdate.htm

• Dollar Offset (DO) calculates the ratio of dollar
  change in profit/loss for hedge and hedged item
• Relative Dollar Offset (RDO) calculates the ratio
  of dollar change in net position to the initial
  MTM value of hedged item
• Variability Reduction Measure (VarRM) calculates
  the ratio of the squared dollar changes in net
  position to the squared dollar changes in hedged
  item
• Ordinary Least Square (OLS) measures the linear
  relationship between the dollar changes in hedged
  item and hedge. OLS calculates the coefficient of
  determination (R2) and the slope coefficient (ß)
  for effectiveness measure and accounts for the
  historical performance
• Least Absolute Deviation (LAD) is similar to OLS,
  but employs median regression analysis to
  calculate R2 and ß.

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Regression Versus Offset Effectiveness Tests
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EXCLUDABLE ITEMS
Premium 5 Strike 50 PV(Strike) 49
Volatility Value 5 5 5 4 3 2 1
Time Value 5 5 5 5 4 3 2
Intrinsic Value 0 0 0 0 1 2 3
Minimum Value 0 0 0 1 2 3 4
Spot 47 48 49 50 51 52 53
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LONG OPTION HEDGES

• Fair value hedges
• Mark-to-market of the option will generally be
  smaller than exposures contribution to earnings
• Cash flow hedges
• Changes in intrinsic values of options go to
  other comprehensive income to the extent
  effective
• Remaining changes in option prices goes to
  current income

Bounded by the magnitude of the exposures
price changes
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GENERAL RECOMMENDATIONS

• For most static option hedges Exclude time
  value from hedge effectiveness considerations
• For most fair value hedges Exclude forward
  points from hedge effectiveness considerations
• For non-interest rate cash flow hedges Assess
  effectiveness based on comparisons of forward
  prices

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THE RISK BEING HEDGED

• For non-interest rate exposures
• Entities must identify their firm-specific
  exposures as hedged items
• Differences between firm-specific prices and
  hedging instruments underlying variables will
  foster income volatility
• Pre-qualifying hedge effectiveness documentation
  is required for all cross-hedges

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Sub-paragraph b(c) of Paragraph 63 of FAS 133

• c. If the effectiveness of a hedge with a forward
  or futures contract is assessed based on changes
  in fair value attributable to changes in spot
  prices, the change in the fair value of the
  contract related to the changes in the difference
  between the spot price and the forward or futures
  price would be excluded from the assessment of
  hedge effectiveness.

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Example 6 from Appendix B of FAS 133
At the beginning of period 1, XYZ Company enters
into a qualifying cash flow hedge of a
transaction forecasted to occur early in period
6. XYZ's documented policy is to assess hedge
effectiveness by comparing the changes in present
value of the expected future cash flows on the
forecasted transaction to all of the hedging
derivative's gain or loss (that is, no time value
component will be excluded as discussed in
paragraph 63). In this hedging relationship, XYZ
has designated changes in cash flows related to
the forecasted transaction attributable to any
cause as the hedged risk.
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Example 6 in Appendix B of FAS 133From File
133ex06a.xls
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HEDGEABLE INTEREST RATE RISKS

• Overall fair value effects
• Fair value changes due to changes in a benchmark
  interest rate (i.e., the risk-free rate or the
  LIBOR-based swap rate)
• Fair value changes due to interest rate effects
  associated with credit quality and/or rating
  changes
• Fair value changes due to foreign exchange rate
  changes

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FAIR VALUE INTEREST RATE HEDGES

• The benchmark interest rate will likely be the
  predominant selection for the hedged item
• The shortcut method is only applicable for
  interest rate swaps if all the criteria of s 68
  and 69 are met
• Fair value hedges that dont qualify for shortcut
  may have considerable unintended income effects

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FLOATING FIXED RATE DEBT

• Originally issue fixed rate debt
• Maturity - 2 quarters
• Rate - 8 (fixed)
• Enter swap
• Receive 6 fixed pay 3-mo LIBOR
• At start, 3-month LIBOR 5
• After 3 months, LIBOR increases to 9

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SWAPS MARK-TO-MARKET VALUE

• At start -
• End of Q1 -
• End of Q2 -

MV 0
MV 0 ?MV 7,335
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SHORTCUT CALCULATIONS
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LOANS MARK-TO-MARKET VALUE

• At start -
• End of Q1 -
• End of Q2 -

MV 1,000,000
MV 0 ?MV 7,299
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NON-SHORTCUT CALCULATIONS
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PERSPECTIVES ON INEFFECTIVENSS
Impact of 50 basis point fall in interest rates
on 1 million par bonds semi-annual compounding
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NON-SHORTCUT PROCEDURES

• Identify appropriate benchmark security
• Determine rate change on benchmark security over
  the hedge period
• Calculate present values of the hedged item (PV)
  using original discount rates adjusted by the
  amount of the benchmark rate change
• The basis adjustment on the hedged item (going to
  earnings) is the difference between PV and the
  original present value

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NON-SHORTCUT EXAMPLE

• Hedged item 5-year Corporate debt
• Hedging deriviative 5-year swap
• Hedging objective Offset changes in the
  LIBOR-based swap rate

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ALTERNATIVE BENCHMARK RATE CHANGES

• Use the change in 5-year swap rates
• Use the change in 4 3/4-year swap rates
• Use the difference between the 5-year swap rate
  at the start vs. a 4 3/4-year swap rate at the
  end
• Use the difference between the forward 4 3/4-year
  swap rate at the start vs. a spot 4 3/4-year rate
  at the end

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FAIR VALUE HEDGING KEY POINTS

• Ideally, all contributions to earnings -- other
  than accruals -- will be entirely offsetting
• The ideal outcome is achieved if the shortcut
  method is employed
• If the shortcut method is not used, differences
  between the swaps fixed rate and the hedged
  items fixed rate will generate income effects

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USING REGRESSION

• Should the regression use price levels or price
  changes?
• What is the proper frequency of the observations?
• Can overlapping samples be used?
• Is measuring correlation sufficient?

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PERFECTLY CORRELATED CHANGES
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AN ALTERNATIVE TO REGRESSION

• Given time series of price changes for both the
  derivative and the hedged item, generate a
  frequency distribution for the combined results
• Assign a threshold value and a level of
  confidence for high effectiveness (e.g., the
  combined results must be smaller than 2 of the
  initial value of the hedged item in 95 of the
  observations)

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CAVEATS

• Price changes of the hedged item should reflect
  only the effect of the risk being hedged
• Price changes of the hedging derivative should
  not included excluded items
• Price changes of fixed income securities should
  appropriately reflect aging of the security
• In general, interest accruals (on both debt and
  swaps) should not be included in price change
  measures

Relevant only for fair value hedges
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Shortcut Method conditions applicable to both
fair value hedges and cash flow hedges

• The notional amount of the swap matches the
  principal amount of the interest-bearing asset or
  liability being hedged. 
• If the hedging instrument is solely an interest
  rate swap, the fair value of the swap at its
  inception is zero.  There are other applicable
  conditions if the instrument is a compound
  derivative composed of an interest rate swap and
  an option. 
• The formula for computing net settlements under
  the interest rate swap is the same for each net
  settlement.  (That is, the fixed rate is the same
  throughout the term, and the variable rate is
  based on the same index and includes the same
  constant adjustment or no adjustment.) 
• The interest-bearing asset or liability is not
  prepayable, unless the asset or liability is
  prepayable solely due to an embedded option and
  the hedging instrument is a compound derivative
  composed of an interest rate swap and an
  option. 

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Shortcut Method conditions applicable to both
fair value hedges and cash flow hedges

• The index on which the variable rate is based
  matches the benchmark interest rate designated as
  the interest rate risk being hedged for that
  hedging relationship. 
• Any other terms in the interest-bearing financial
  instruments or interest rate swaps are typical of
  those instruments and do not invalidate the
  assumption of no ineffectiveness.
• Conditions applicable to fair value hedges only
• The expiration date of the swap matches the
  maturity date of the interest-bearing asset or
  liability. 
• There is no floor or cap on the variable interest
  rate of the swap. 
• The interval between repricings of the variable
  interest rate in the swap is frequent enough to
  justify an assumption that the variable payment
  or receipt is at a market rate (generally three
  to six months or less).

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Shortcut Method conditions applicable to both
fair value hedges and cash flow hedges

• The index on which the variable rate is based
  matches the benchmark interest rate designated as
  the interest rate risk being hedged for that
  hedging relationship. 
• Any other terms in the interest-bearing financial
  instruments or interest rate swaps are typical of
  those instruments and do not invalidate the
  assumption of no ineffectiveness.
• Conditions applicable to fair value hedges only
• The expiration date of the swap matches the
  maturity date of the interest-bearing asset or
  liability. 
• There is no floor or cap on the variable interest
  rate of the swap. 
• The interval between repricings of the variable
  interest rate in the swap is frequent enough to
  justify an assumption that the variable payment
  or receipt is at a market rate (generally three
  to six months or less).

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Shortcut Method conditions applicable to only to
cash flow hedges

•  
• The expiration date of the swap matches the
  maturity date of the interest-bearing asset or
  liability. 
• There is no floor or cap on the variable interest
  rate of the swap. 
• The interval between repricings of the variable
  interest rate in the swap is frequent enough to
  justify an assumption that the variable payment
  or receipt is at a market rate (generally three
  to six months or less).

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Shortcut Method conditions applicable to only to
fair value hedges

• All interest receipts or payments on the
  variable-rate asset or liability during the term
  of the swap are designated as hedged, and no
  interest payments beyond the term of the swap are
  designated as hedged. 
• There is no floor or cap on the variable interest
  rate of the swap unless the variable-rate asset
  or liability has a floor or cap.  In that case,
  the swap must have a floor or cap on the variable
  interest rate that is comparable to the floor or
  cap on the variable-rate asset or liability. 
  (For this purpose, comparable does not
  necessarily mean equal.  For example, if a swap's
  variable rate is LIBOR and an asset's variable
  rate is LIBOR plus 2 percent, a 10 percent cap on
  the swap would be comparable to a 12 percent cap
  on the asset.) 
• The repricing dates match those of the
  variable-rate asset or liability.