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SFAS 133 Implementation Identifying Derivatives

SFAS 133 Implementation Identifying Derivatives. Marjorie Marker (May 25, 2000). Session Objectives. Identify derivatives as redefined by FAS 133 Explain valuing freestanding and embedded derivatives. Derivative Instruments as Redefined by FAS 133. Key Characteristics

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SFAS 133 Implementation Identifying Derivatives

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  1. SFAS 133 ImplementationIdentifying Derivatives Marjorie Marker (May 25, 2000) © 2000 Arthur Andersen All rights reserved.

  2. Session Objectives • Identify derivatives as redefined by FAS 133 • Explain valuing freestanding and embedded derivatives © 2000 Arthur Andersen All rights reserved.

  3. Derivative Instruments as Redefined by FAS 133 • Key Characteristics • Underlying and notional amount/payment provisions • Little or no initial net investment • Net settlement © 2000 Arthur Andersen All rights reserved.

  4. Change in Underlying X Notional Amount/Payment Provisions = Settlement Amount Equals item market price : Stock price Commodity price Foreign currency Interest rate These are: Basis for computation Number of shares, principal amount, units, barrels, kilowatts, etc. Payment provisions specify a fixed or determinable amount based on the behavior of the derivative: Knock-in and Knock-out options Key Characteristics:Underlying and notional amount/payment provisions Settlement Amount © 2000 Arthur Andersen All rights reserved.

  5. Key Characteristic:Little or No Initial Net Investment • Underlying ownership is NOT necessary to participate in risks and rewards • Option premium or forward discount may require a small payment © 2000 Arthur Andersen All rights reserved.

  6. Key Characteristic:Net Settlement This consists of: • Explicit or implicit cash settlement provision: • Net settlements under an interest rate swap • A “Market mechanism” that covers rights and obligations: • Exchange-traded futures contract • Broker Market • Delivery of item readily convertible to cash: • Forward contract to deliver a marketable equity security © 2000 Arthur Andersen All rights reserved.

  7. Items Excluded from FAS 133 Derivatives Based on Paragraph 10 and various FASB Staff Interpretations, the following are specifically excluded from being treated as FAS 133 Derivatives: 1)“Regular-way” security trades • Delivery of a security within 3-day settlement period set by the market _ When-issued, and TBA securities if: • No other way to purchase or sell • Will settle within shortest period for security 2) Normal Purchases and Sales • Proposed Amendment will make this exception available to most commodity contracts where physical delivery is probable even if contract can be net cash settlement © 2000 Arthur Andersen All rights reserved.

  8. ItemsExcluded from FAS 133 Derivatives (cont.) 3) Certain insurance contracts • Where underlying is an identifiable insurable event (other than a price change) such as: • Traditional life • Traditional property and casualty 4) Certain financial guarantee contracts • Where beneficiary must hold guaranteed asset for life of contract (FASB C7) • Where payments reimburse loss incurred on default (NOT changes on creditworthiness) © 2000 Arthur Andersen All rights reserved.

  9. Items Excluded from FAS 133 Derivatives (cont.) 5) Contracts not traded on an exchange with underlyings based on: • Climatic or geological variables • The price or value of nonfinancial assets or obligations • Specified sales revenues or volumes of sales 6) Derivatives that defeat sale accounting • Call on financial assets in a secured borrowing • Residual value guarantee in sale of assets subject to an operating lease © 2000 Arthur Andersen All rights reserved.

  10. Items Excluded from FAS 133 Derivatives (cont.) 7) When classification and underlying is the equity of the issuer as in: • Certain EITF 96-13 contracts • Stock compensation • Contingent consideration © 2000 Arthur Andersen All rights reserved.

  11. Embedded Derivatives - Definitions Hybrid Contract: Contracts that contain derivative-like features but that are not derivatives themselves. • Embedded Features: • Features in a Hybrid Contract affecting cash flows or value of other exchanges similar to that of a derivative • Host Contract: • What would be left if the Embedded Features were not in the Hybrid Contract © 2000 Arthur Andersen All rights reserved.

  12. Examples of Embedded Derivatives • Callable debt • Call on interest rates • Convertible debt held as investment • Equity option • Commodity or S&P linked notes issued or held • Commodity or S&P option or forward • Indexed amortizing notes • Conditional prepayment options based on specific interest rate index • Levered inverse floaters • Leveraged embedded interest rate swaps © 2000 Arthur Andersen All rights reserved.

  13. Accounting for Embedded Derivatives:Is Bifurcation Required? Bifurcation: To B or Not to B? Hybrid at FV through earnings? “Clearly and closely related”? Feature is a derivative? Bifurcate No No Yes Yes Yes No Stop. Do not bifurcate. © 2000 Arthur Andersen All rights reserved.

  14. Accounting for Embedded Derivatives Measuring the Embedded Derivative • Only one derivative is bifurcated (simple or compound) • Determine fair value of embedded derivative, remaining carrying amount of hybrid allocated to host contract • If embedded forward, should be bifurcated so that it has zero fair value at bifurcation (may need to recharacterize terms) • If embedded option, bifurcate according to stated terms © 2000 Arthur Andersen All rights reserved.

  15. The FASB’s “Natural State” of Derivatives • Derivatives are assets or liabilities reported at fair value • Changes in fair value are reported currently in earnings Only departure from this accounting is when all hedge accounting criteria are met... © 2000 Arthur Andersen All rights reserved.

  16. Types of Statement 133 Hedges Fixed-Rate Assets Fixed-Rate Liabilities Firm Commitments Floating-Rate Assets Floating-Rate Liabilities Forecasted Transactions Cash Flow Hedges Fair Value Hedges Foreign Currency Hedges FX-Denominated Forecasted Transactions (Third Party or Intercompany) FX-Denominated AFS Securities or Firm Commitments Net Investments in Foreign Operations © 2000 Arthur Andersen All rights reserved.

  17. Accounting for FAS 133 Derivatives Fair Value Hedges Earnings Measurement of Derivative Change in Fair Value* 1 Measurement of Hedged Item Gain in Loss Attributable to Risk Being Hedged† 1 * Hedge ineffectiveness (forward points or time value)always is reported currently in earnings. † Pre-existing gains or losses are unaffected. © 2000 Arthur Andersen All rights reserved.

  18. Accounting for FAS 133 DerivativesFair Value Hedges (cont.) Examples: • Fixed rate debt held or issued swapped to floating • Purchased put to hedge equity price risk on available for sale equity security • FX hedge of firm commitment to buy equipment from foreign manufacturer © 2000 Arthur Andersen All rights reserved.

  19. Accounting for FAS 133 Derivatives Cash Flow Hedges Measurement of Derivative Change in Fair Value* Equity† 1 2 Measurement of Hedged Item Earnings Earning Effects (interest, cost of sales, depreciation) 2 * Hedge ineffectiveness (forward points or time value)always is reported currently in earnings. † Display in other comprehensive income (OCI). If transaction is no longer probable, recognize immediately in earnings. © 2000 Arthur Andersen All rights reserved.

  20. Accounting for FAS 133 Derivatives Cash Flow Hedges (cont.) Examples: • Hedge of probable issuance of fixed rate debt • Swapping floating rate debt to fixed • Hedging FX risk in foreign sales or purchases • Hedging floating rate debt with a purchased cap • Hedging commodity risk in future inventory purchase with futures © 2000 Arthur Andersen All rights reserved.

  21. Accounting for FAS 133 Derivatives Net Investment Hedges Equity† Measurement of Derivative Foreign Currency Transaction Gain or Loss 1 Measurement of Net Investment Foreign Currency Transaction Gains and Losses 1 † Display in “other comprehensive income” as part of the cumulative translation adjustment. © 2000 Arthur Andersen All rights reserved.

  22. Accounting for FAS 133 Derivatives Net Investment Hedges Foreign Currency: • Change in fair value of foreign currency derivative recorded in the Cumulative Translation Adjustment (OCI) • Ineffectiveness, if any, through earnings • If using cross currency interest rate swaps • Receive-fixed-functional, pay-fixed-foreign • Receive-floating-functional, pay-floating-foreign • All others do not qualify • Awaiting clarification on determining hedge ineffectiveness © 2000 Arthur Andersen All rights reserved.

  23. Valuation of Free-Standing and Embedded Derivatives Jitendra D. Sharma (May 25, 2000)

  24. Getting to Valuation • Embedded Derivatives and Bifurcation • Core element of FAS 133 • Important for Hedging and Effectiveness exercises • Need to Answer Whether Derivative is Free-standing or Embedded • If free-standing, proceed to valuation • If embedded, proceed to bifurcation decision © 2000 Arthur Andersen All rights reserved.

  25. Embedded Derivatives --The Bifurcation Decision in Three Steps Hybrid at FV through earnings? “Clearly and closely related”? Feature is a derivative? Bifurcate No No Yes Yes Yes No Stop. Do not bifurcate. © 2000 Arthur Andersen All rights reserved.

  26. Embedded Derivatives -- Bifurcating a Hybrid Contract “(1) - (2) = (3)” (1) Hybrid Contract • Contracts that contain derivative-like features but that are not derivatives themselves (2) Embedded Features • Features in a Hybrid Contract affecting cash flows or value of other exchanges similar to that of a derivative (3) Host Contract • What would be left if the Embedded Features were not in the Hybrid Contract © 2000 Arthur Andersen All rights reserved.

  27. Embedded Derivatives – Bifurcation Example 1 • Callable bond -- Issuer can repurchase the bond • Predetermined price • At some time in the future • Holder of bond has sold call option to the issuer • Hybrid Contract: Callable Debt • Contracts that contain derivative-like features but that are not derivatives themselves • Embedded Features: Call Option on Interest Rates • Features in a Hybrid Contract affecting cash flows or value of other exchanges similar to that of a derivative • Host Contract: Noncallable Debt • What would be left if the Embedded Features were not in the Hybrid Contract © 2000 Arthur Andersen All rights reserved.

  28. Embedded Derivatives – Bifurcation Example 1, continued • Hybrid Contract: Callable Debt • Widely Traded -- Multiple price sources • Illiquid -- Value cash flows, discounted at credit-specific discount curve • Embedded Features: Call Option on Interest Rates • Widely Traded -- Option pricing models • Illiquid -- Proxy valuation using static models • Host Contract: Noncallable Debt • Comparable debt -- similar amount, terms and credit rating © 2000 Arthur Andersen All rights reserved.

  29. Embedded Derivatives – Bifurcation Example 2 • Convertible bond -- Holder has right to exchange debt for equity • Predetermined exchange ratio • At certain time(s) in the future • The convertible bond is often callable by the issuer • Call provision allows issuer to “force” conversion into equity at earlier time than holders may otherwise choose • If interest rates are constant and call provisions are ignored, then • Convertible debt is similar to straight debt plus call warrants • Hybrid Contract: Convertible Debt • Contracts that contain derivative-like features but that are not derivatives themselves • Embedded Features: Call Option on Equity • Features in a Hybrid Contract affecting cash flows or value of other exchanges similar to that of a derivative • Host Contract: Plain Vanilla Debt • What would be left if the Embedded Features were not in the Hybrid Contract © 2000 Arthur Andersen All rights reserved.

  30. Market-Based DerivativesExamples Instrument Type Futures Options Options Forwards Swaps on Futures Money Market / Depos X X X X X Interest Rate X X Currency X X X U.S. Treasury Bills, X X X Notes and Bonds Equity X Commodities X X X Index X X X © 2000 Arthur Andersen All rights reserved.

  31. Broker Quotations Versus Modeling • Depends on Nature of Derivative • Many Futures, Options and Options on Futures are market-quoted • Internal Models • Greater control and validation of external quotes • Introduces model risk • Should be independently validated, prior to use • Front Office versus Independent Risk Management • Valuation independence (regulators require) • Check and balance system © 2000 Arthur Andersen All rights reserved.

  32. Liquidity and Blockage • Lack of Market Liquidity • e.g. Only one broker or market maker for instrument • e.g. Little or no demand for instrument • Position Blockage • Size of position (say, you hold 80% of outstanding) • May move the market substantially upon liquidation • FAS 133 does not allow adjustments for blockage Either condition may result in the conclusion that the instrument is NOT a derivative © 2000 Arthur Andersen All rights reserved.

  33. Valuing Complex or Privately Placed Derivatives • Use agreed-upon terms • e.g. ISDA Master Agreement • Can use standard models or specific software • Wide range available (Microsoft Excel add-ins to dedicated systems) • Isolate risks being hedged • If hedging, must isolate specific risk(s) being hedged • Measuring correlation • Important to testing hedge effectiveness • Statistical correlation or dollar offset methods © 2000 Arthur Andersen All rights reserved.

  34. For Further Information, Contact: Jitendra D. Sharma, Partner, Financial and Commodity Risk Consulting (212) 708-4536 OR Dilip S. Kumar, Partner, Financial and Commodity Risk Consulting (212) 708-6292 AT Arthur Andersen LLP 1345 Avenue of the Americas New York, NY 10105 © 2000 Arthur Andersen All rights reserved.

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