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Financial Instrument Hedging Strategies and Issues June 8, 2000

Financial Instrument Hedging Strategies and Issues June 8, 2000. John Woods Arthur Andersen LLP. Session Objectives. Overview Key Changes Introduced by 133 Impact on Common Risk Management Techniques Effectiveness Concerns Miscellaneous. 1. Overview - “Cornerstones” of Statement 133.

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Financial Instrument Hedging Strategies and Issues June 8, 2000

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  1. Financial Instrument Hedging Strategies and IssuesJune 8, 2000 John Woods Arthur Andersen LLP

  2. Session Objectives • Overview • Key Changes Introduced by 133 • Impact on Common Risk Management Techniques • Effectiveness Concerns • Miscellaneous 1

  3. Overview - “Cornerstones” of Statement 133 • Derivatives are assets or liabilities • Fair value is the measure • High hurdle for hedge accounting • Designation and effectiveness are key 2

  4. Overview - “Natural State” of Derivatives • Report derivatives at fair value • Report all changes in value currently in earnings • Hedge accounting criteria provide only exception • Allows matching of derivative and hedged item 3

  5. Overview - Definition • Underlying • Notional or Payment Provision • No, or minimal initial investment • Net settlement permitted or required Results in some financial instruments being classified as derivatives for the first time (e.g. forward purchase commitments) 4

  6. Overview - What Derivatives Are Not: • Regular way securities trades • Normal purchases/sales of nonfinancial items • Traditional insurance contracts (Some financial guarantees) • Derivatives that impede sales accounting (SFAS 125) • IO and PO strips • Contracts indexed to Company’s own stock (EITF 96-13) • Classified in equity • Stock-based compensation • Contracts related to contingent consideration in business combinations (APB 16) 5

  7. Overview - Universe 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) Certain FX-Denominated Receivables and Payables FX-Denominated AFS Securities or Firm Commitments Certain FX-Denominated Receivables and Payables Net Investments in Foreign Operations 6

  8. Overview - Hedge Accounting Criteria • Designate and formally document hedge at inception • Hedged item • Hedging instrument • Risk being hedged • Effectiveness must be: • Expected • Experienced • Measured • Reported 7

  9. Key Changes - Hedging Instrument • Cannot use cash instruments (unless using certain Fx strategies) • Cannot receive hedge accounting in consolidated financial statements for intercompany derivatives (FASB E6) • Limited eligibility for written options 8

  10. Key Changes - Hedged Item • Prohibitions (see rules) • Interest rate risk on HTM security • Dividends on trust preferred securities classified as minority interests • Equity investments in unconsolidated subs • Company’s own equity instruments • Transactions with stockholders (dividends, purchases of stock) • Items carried at fair value (trading securities, demand deposits) • Partial-term hedging for fair value hedges • Synthetic-accounting 9

  11. Key Changes - Hedged Item • Grouped items must share “same risk exposure” and additionally, for fair value hedges, must exhibit proportionate changes in fair value compared to overall group, for example: • Forecasted interest payments within a specified time period on several 3-month LIBOR debt instruments • Fair value changes of individual loans in a loan portfolio 10

  12. Key Changes - Risk Being Hedged • Benchmark interest-rate risk (LIBOR curve, Treasury curve) • Credit risk • Foreign currency exchange rate risk • All risks (entire change in fair value or cash flows) 11

  13. Key Changes - Risk Being Hedged • Benchmark interest-rate risk (LIBOR curve, Treasury curve) • Credit risk 12

  14. Key Changes - Risk Being Hedged Components of an Overall Interest Rate US Treasury Rate Overall interest rate minus Credit risk equals 7% 2% 5% 13

  15. Key Changes - Risk Being Hedged Components of an Overall Interest Rate Overall interest rate LIBOR Swap Rate minus Credit risk equals 1% 7% 6% 14

  16. Key Changes - Risk Being Hedged - Cash Flow Hedge Specific Observations • Cannot hedge benchmark if variable-rate instrument is indexed to something other than benchmark • Can designate benchmark (LIBOR) hedge of debt indexed to LIBOR • CANNOT designate benchmark (LIBOR) hedge of debt indexed to Fed funds But… hedge accounting (with ineffectiveness reported currently in earnings) okay if highly effective as measured by all cash flows 15

  17. Key Changes - Existing Hedging Activities at Risk • Synthetic Instrument Hedging • Mortgage banking • Pipeline • MSRs • Hedging heterogeneous portfolios • Use of derivatives with option-related features to hedge an item without offsetting option characteristics • Cap of existing floating debt or forecasted rollover of debt • Indexed-amortizing vehicles • Basis swaps 16

  18. Key Changes - Hedging Instrument • Can use two or more derivatives in combination • Receive-LIBOR-pay-Prime plus receive-Prime-pay-fixed swap equals receive-LIBOR-pay-fixed swap • Can pro-rate derivative (but not by risk) • 50% of a 100mm notional swap is okay • First three years of a five year swap NOT okay • Can use embedded derivatives that have been bifurcated 17

  19. Key Changes - Swaps as Written Options • Written options rarely qualify as hedging instruments • Fair value hedge involving monetization of call in callable debt Nonoption derivative + written option = written option • Cancelable, extendible, index-amortizing, accreting, written cap or floor, written swaptions • Can’t bifurcate written optionality (¶18) • Mark to fair value through earnings 18

  20. Effectiveness - Achieving Hedge Accounting Assessing Effectiveness (FASB E7) 1. Expecting high effectiveness at hedge inception 2. Observing whether high effectiveness has occurred 3. Expecting effectiveness prospectively each quarter 4. Measure ineffectiveness to be reported in earnings 19

  21. Effectiveness - Achieving Hedge Accounting Assessing Effectiveness (FASB E7) 1. Expecting high effectiveness at hedge inception 2. Observing whether high effectiveness has occurred 3. Expecting effectiveness prospectively each quarter 4. Measure ineffectiveness to be reported in earnings Steps 1 through 3 may involve statistical methods (such as regression analysis) 20

  22. Effectiveness - Achieving Hedge Accounting Assessing Effectiveness (FASB E7) 1. Expecting high effectiveness at hedge inception 2. Observing whether high effectiveness has occurred 3. Expecting effectiveness prospectively each quarter 4. Measure ineffectiveness to be reported in earnings Step 4 must be based on “dollar offset” (see paragraph 30 for cash flow hedges) 21

  23. Effectiveness - Shortcut Method • Interest-rate swaps only (FASB E4) • If terms of swap and hedged item match • Assume perfect effectiveness prospectively • Swap change is proxy for hedged item change • Very restrictive • Must meet all criteria (¶68) • Materiality is not an out 22

  24. Effectiveness - Shortcut Method General Conditions • Swap notional = hedged item’s principal (FASB E10) • $50 swap hedging $50 debt • 50% of $100 swap hedging $50 debt • $25 swap hedging $25 of $50 debt • Hedged item is not prepayable (FASB E6 and FAS 139) • Prepayable if one party can cause principal payment before scheduled date, unless: • Debtor can trigger at an amount > FV, or • Creditor can trigger at an amount < FV 23

  25. Effectiveness - Shortcut Method General Conditions, continued • Fair value of swap at swap/hedge inception is zero • Financing element (FASB A9) • Fair value at initial application (FASB J8) • Net settlement formula is constant • Stub period not a problem (DIG Agenda Item 11-7) • No other terms create ineffectiveness (catch-all) 24

  26. Effectiveness - Shortcut Method Fair Value Hedge Conditions • Swap Expiration matches instrument maturity • No floor or cap on swaps floating leg • Interval between repricing dates on swap floating leg are at least 3 to 6 months or less 25

  27. Effectiveness - Shortcut Method Cash Flow Hedge Conditions • No floor or cap on floating leg unless matched • Swap and hedged item repricing dates match • Underlying on floating leg and debt match • “Match” = “exactly the same” or “correspond exactly” (FASB E4) • No “out” for quantitative materiality • All interest amounts during swap term are hedged • Stub period not a problem (DIG Agenda Item 11-7) 26

  28. Miscellaneous-Embedded Derivatives Derivatives embedded in hybrid contracts • Split out embedded derivative if • Hybrid contract isn’t at fair value in earnings • Not clearly and closely related economically • Would separately meet definition of derivative • Answer generally applies to issuer and investor • However, answers not always symmetrical 27

  29. Is the contract carried at fair value through earnings? Would it be a derivative if it were freestanding? Is it clearly and closely related to the host contract? No Yes No Apply Statement 133 Yes No Yes Do Not Apply Statement 133 Miscellaneous-Embedded Derivatives Application 28

  30. Miscellaneous -Embedded Derivatives: Clearly and Closely Related? Some embedded derivatives exempted: • Interest rates always clearly and closely related • To inflation • To changes in creditworthiness • Most interest-only and principal-only securities • Prepayment features of servicing rights • Interest-rate caps and floors in interest bearing instruments • Puts and calls that accelerate principal payments • Principal, interest, or both in foreign currency 29

  31. SFAS 133 Transition Steps • Designate and document all hedges anew • Bifurcate hybrid instruments post 12/31/98 • Recognize all derivatives at fair value • Fair value hedges • Cash flow hedges • Non-hedge designation • Adjustment impact determined by previous hedge relationship • Fair value hedge • Cash value hedge 30

  32. SFAS 133 Transition Steps Transition Impact on Current Fair Value Hedges • FV hedge of assets, liabilities or firm commitments • Recognize fair value adjustments of derivative in income (cumulative - net of tax) • Recognize hedged item fair value adjustment (up to derivative fair value adjustment) in income Transition Impact on Current Cash Flow Hedges • CF hedge of forecasted transaction (cumulative - net to tax) • Report impact in OCI 31

  33. SFAS 133 Transition Steps • SFAS 115 Reclassifications • A one-time reclass of HTM securities to AFS or trading is allowed • HTM reclass must be to trading if sold within same quarter of reclass (EITF Topic D-73) 32

  34. Topics Scope Valuation Documentation New Processes Identify all derivatives Identify derivatives embedded in other host contracts, like equity options embedded in investments in convertible debt Value derivatives and related hedged items, or portions thereof, on date of initial application (for example, 1/1/01) and at inception of each hedge, at hedge termination, and quarterly Formally document hedge objectives and strategy, including hedged items, hedging instrument and risk being hedged Formally designate derivatives hedges on date of initial application (for example, 1/1/01) and at inception of each hedge Miscellaneous - Operational issues 33

  35. Topics Effectiveness Bifurcation Recording Disclosure New Processes Perform tests of effectiveness of each hedge at inception and at least quarterly. Bifurcate certain transactions containing embedded derivatives into derivative and non-derivative components. Value and account for components separately. Mark derivatives and some hedged items to fair value on the balance sheet each reporting period. Record deferred gains or losses on cash flow hedges into and out of other comprehensive income. Capture and record ineffectiveness of cash flow hedges in earnings. Quantify and disclose the impact of adopting FAS 133 in current year financial statements Miscellaneous - Operational issues 34

  36. www.arm.arthurandersen.com 35

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