ISDA / GARP
Overview and Implications of FAS 133
Presented by
Ira G. Kawaller
Kawaller & Company, LLC
(718)-694-6270
kawaller@idt.net
www.kawaller.com
The accompanying presentation has been compiled by Ira G. Kawaller for general information purposes.
Examples are hypothetical, used for explanatory purposes only. Although every attempt has been made to
ensure the accuracy of the information, Mr. Kawaller assumes no responsibility for any errors or omissions.
KAWALLER
& Company, LLC
INSTRUCTOR PROFILE
Before founding Kawaller and Company, Ira
Kawaller held positions with the Chicago Mercantile
Exchange, J. Aron & Company, AT&T, and the Board of
Governors of the Federal Reserve System
Mr. Kawaller is currently a member of the Financial
Accounting Standards Board’s Derivatives
Implementation Group (DIG). In prior years he was a
trustee of both the Futures Industry Institute and the
Securities Industry Institute and a member of the board
of directors of the International Association of Financial
Engineers.
Mr. Kawaller received a Ph.D. in economics from
Purdue University and has held adjunct professorships at
Columbia University and Polytechnic University.
KAWALLER
& Company, LLC
FASB 133 - FOUNDATIONS
• Qualifying derivatives must be recorded as
assets or liabilities on the balance sheet,
measured at fair value
• Special hedge accounting may apply in
restrictive situations
• Hedges must be expected to be “highly
effective” in offsetting changes in fair values or
changes in forecasted cash flows
KAWALLER
& Company, LLC
FASB 133 - KEY ISSUES
•
•
Identification
Hedge qualifications
•
Valuation
KAWALLER
& Company, LLC
DERIVATIVE DEFINITION
•
A derivative is a contract with all three of the
following characteristics
– An underlying and either a notional amount or a
–
–
•
•
payment provision or both
At most, a relatively small initial net investment
Net settlement or its equivalent
Derivatives may be freestanding or be embedded in
other (“host”) contracts
A number of exclusions exist
KAWALLER
& Company, LLC
EXEMPTED DERIVATIVES
•
•
•
•
•
Normal purchases and normal sales
•
Derivatives based on sales or revenues of one
of the parties
“Regular-way” security trades
Traditional insurance contracts
Most financial guarantee contracts
OTC contracts with certain underlyings (e.g.,
climatic, physical, or geologic variables)
KAWALLER
& Company, LLC
EXEMPTED DERIVATIVES
•
Derivatives that are an impediment to sales
accounting
•
Instruments indexed to an entity’s own stock
and classified in stockholders’ equity
•
Stock-based compensation covered by
Statement 123 (issuer only)
•
Contingent consideration in a business
combination (purchaser only)
KAWALLER
& Company, LLC
NEW ACCOUNTING FOR DERIVATIVES*
• Speculative:
- Mark derivatives to market
- Post results to current income
• Fair value hedges of recognized assets,
liabilities, and firm commitments:
- Mark-to-market both (a) the derivative
and (b) the exposure relating to the risk
being hedged
- Post both to current income
*Effective for all fiscal years beginning after June 15, 2000
KAWALLER
& Company, LLC
ACCOUNTING TREATMENT (Con’t)
• Cashflow hedges of uncertain forecasted
transactions:
– “Effective” hedge results are initially
recorded in other comprehensive income
– “Ineffective” results go to current income
– Allocations must be based on cumulative
outcomes
– OCI is reclassified to income coincidentally
with the hedged item’s income effects
KAWALLER
& Company, LLC
ALLOCATING CASH FLOW RESULTS
Derivative
Exposure
Period
Cum
Period
Cum
Lesser
Per. Change Change Change Change Cum
100
100
(96)
(96)
1
96
2
3
4
5
94
(162)
(101)
30
194
32
(69)
(39)
(101)
160
103
(32)
(197)
(37)
66
34
194
32
(66)
(34)
OCI
96
194-96
=98
32-194
=(162)
(66)-32
=(98)
(34)-(66)
=32
Inc.
4
(4)
0
(3)
(2)
KAWALLER
& Company, LLC
ACCOUNTING TREATMENT (Con’t)
• Net investments in foreign operations:
– Consistent with current FAS52 treatment
– Effective hedge results are posted to
translation account
– Ineffective hedge results go to earnings
– Forward points no longer allocated ratably
KAWALLER
& Company, LLC
Effectiveness Considerations
KAWALLER
& Company, LLC
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
KAWALLER
& Company, LLC
CRITICAL CONSIDERATIONS
•
Dollar offset ratio calculations may be used to
pass the “highly effective” criteria
0.8  -1 
Gain (Loss) on the Derivative
Gain (Loss) on the Hedged Item  1.2
•
Calculations may rely on period-by-period or
cumulative analysis
•
Income allocations for cash flow hedges must
be based on cumulative results
KAWALLER
& Company, LLC
SPOT/FORWARD PRICES
Price
Forward
Spot
Time
KAWALLER
& Company, LLC
“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 option’s volatility value
– Assessment based on an option’s minimum
value
KAWALLER
& Company, LLC
CRITICAL CONSIDERATIONS
•
If dollar offset justifies hedge accounting but
the 0.8 - 1.2 range is violated, no hedge
accounting is permitted for the period
•
If an alternative statistical analysis justifies
hedge accounting, hedge accounting rules will
apply even if the 0.8 - 1.2 range is violated
•
If the 0.8 - 1.2 range is violated, a new analysis
is required to qualify for subsequent periods
KAWALLER
& Company, LLC
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?
KAWALLER
& Company, LLC
PRICE LEVELS VS. CHANGES
Prices
Levels are uncorrelated; changes are perfectly correlated
Time
P1
P2
KAWALLER
& Company, LLC
Prices
HIGHLY CORRELATED PRICES
Time
P1
P2
KAWALLER
& Company, LLC
GUIDING PRINCIPLES
•
To assess effectiveness over a given time span
(e.g., quarterly) price changes should be that
same length (e.g., quarterly)
•
Correlations using price levels may be
indicative of long term effectiveness, but not
over a single period
•
Paragraph 75 implies that high correlation of
price levels is sufficient
KAWALLER
& Company, LLC
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 include “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
KAWALLER
& Company, LLC
Required Disclosures
KAWALLER
& Company, LLC
REQUIRED DISCLOSURES
•
Discussion relating to the rationale and
objectives of derivatives positions -- whether
for hedging or not
•
If hedges, identification of hedge type (i.e., fair
value, cash flow, hedge of a net investment in
foreign operation)
KAWALLER
& Company, LLC
REQUIRED DISCLOSURES
•
The amount of ineffectiveness recognized in
earnings
•
The derivative results excluded from hedge
effectiveness considerations
•
Description of where derivative results are
reported
KAWALLER
& Company, LLC
REQUIRED DISCLOSURES
•
Cashflow hedges
– Description of transactions and estimated
–
–
amounts to be reclassified from OCI over the
coming 12 months
Maximum time for which the hedge will be
maintained
Reclassified OCI due to discontinuing hedges
because the forecasted event in the required
time frame
KAWALLER
& Company, LLC
REQUIRED DISCLOSURES
•
Fair value
– Net gain or loss recognized in earnings when
hedges of firm commitments no longer qualify
for fair value treatment
•
Hedges of net investments in foreign
operations
– Amount included in cumulative translation
adjustments
KAWALLER
& Company, LLC
FINDING HELP
Selected Articles Posted on www.kawaller.com
•
•
•
•
•
Implementing FAS 133: From Theory to
practice
Futures Versus Forwards: Implications of
FAS 133
Meeting the “Highly Effective Expectation”
Criterion for Hedge Accounting
The 80/125 Problem
Partial-Term Hedging
KAWALLER
& Company, LLC
K
AWALLER
& COMPANY, LLC
www.kawaller.com
PHONE
EMAIL
718-694-6270
kawaller@idt.net