Enterprise Risk Management
Responsibilities of Senior Management
•  Senior management is ultimately responsible
for all organizational activities
•  For risk management, here is a summary:
–  Establish written policies
–  Define roles and responsibilities
–  Identify acceptable strategies
–  Ensure that personnel are qualified
–  Ensure that control systems are in place
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Managing Risk Exposures
•  Access Volatility
–  More is better, when we’re dealing with options
•  Limit Downside
–  Privilege
–  But not obligation
•  Optimal Exercise
–  Best time
–  Best price
FASB has recognized difficulties of reporting
derivatives positions
•  Difficult even for simple situations involving exchangetraded contracts
•  1998, FASB established the Derivatives Implementation
Group (DIG) to develop mechanisms for resolving
difficulties in implementing Statement 133, Accounting
for Derivative Instruments and Hedging Activities
•  Model for the DIG is the Emerging Issues Task Force
–  except that the members of the DIG do not vote in order to reach
concensus
–  Chair has responsibility for formulating resolutions of the group
based upon the debate that occurs during the meetings
–  individual members are then free to submit formal objections if
desired
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What to Disclose
•  In reporting the value of any option or hedge
the list must cover:
–  clear identification of the underlying assets and the stochastic
processes that generate their values
–  clear description of the relationship among the underlying
assets involved in the option or hedge
•  for example, the ratio of the current price of the input relative to the
current price of the output in the case of an option to exchange one asset
for another
–  estimate of the length of time available for the option to be
exercised
•  this may be a matter of physical limitations
•  or how long it will take before competitors get the option
–  for hedges, the effectiveness must be assessed
Key Aspects of FAS 133
•  All derivatives are reported at fair value on the
balance sheet
•  Changes in fair value for derivatives not
designated and qualifying in a hedging
relationship are recorded in earnings
•  Special accounting is provided for the change
in value of derivatives designated and
qualifying as:
–  Fair Value Hedge
–  Cash Flow Hedge
–  Foreign Currency Hedge
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Fair Value Hedge
•  A fair value hedge is a hedge of the exposure to a
change in the
–  fair value of a recognized asset or liability
•  attributable to a particular risk
–  or of an unrecognized firm commitment
•  attributable to a particular risk
•  Key aspects:
–  Hedged item is exposed to price risk
–  Changes in fair value of hedged item and hedging instrument
are recorded in earnings
–  Basis of hedged item is adjusted by the change in value
–  So, earnings reflect the extent to which the hedge is not
effective in achieving offsetting changes in fair value
Cash Flow Hedge
•  A cash flow hedge is a hedging relationship
where the variability of the hedged item's cash
flows is offset by the cash flows of the hedging
instrument.
•  Key aspects:
–  Hedged item is a forecasted transaction or balance
sheet item with variable cash flows
–  Effective gain or loss reported in OCI (other
comprehensive income)
–  Earnings recognition matches hedged transaction
–  So, the ineffective portion of the gain or loss is
reported in earnings immediately
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Foreign Currency Hedge
•  The Board intended to increase the consistency
of hedge accounting guidance by broadening
the scope of eligible foreign currency hedges.
•  Key aspects:
–  Includes hedges of cash flows, fair value, and net
investments in foreign operations
–  Permits limited use of non-derivative instruments
–  Expands hedge accounting, particularly for
•  forecasted transactions
•  inter-company transactions
•  and tandem currency hedges
An Entity that Elects Hedge
Accounting
•  Required to establish at the inception of the
hedge the method it will use for assessing the
effectiveness of the hedging derivative and
•  The measurement approach for determining
the ineffective aspect of the hedge.
•  Those methods must be consistent with the
entity's approach to managing risk
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Hedge Effectiveness Depends Upon
•  Comparability
•  Timing
•  Tax treatment
Comparability
•  How closely does the underlying in the
derivative match the asset or liability to
be hedged?
•  Partial hedges do not have perfect
matches, but the underlying is correlated
with the hedge target
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Timing
•  How closely does the expiration in the
derivative match the maturity of the asset
or liability to be hedged?
•  Partial hedges do not have perfect
matches, but the expiration or the
derivative is close to the maturity of the
hedge target
Tax Treatment
•  How closely does the tax treatment of the
derivative match the tax treatment of the
asset or liability to be hedged?
•  Partial hedges do not have perfect
matches, but the tax differential can be
absorbed without serious harm
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