Risk Hedeging Accounting Public Latest

NOTES ON RISK, HEDGING, AND HEDGE ACCOUNTING [FAS 133, IAS -39]

TRIB 1

OUTLINE • • • • • • • • •

RISK HEDGING ACCOUNTING RECAP OCI vs. EARNINGS HEDGE ACCOUNTING EFFECTIVENES HEDGE DESIGNATION PROCESS QUESTIONS!!! EXAMPLES 2

RISK-DEFINITION/TYPE/MEASUREMENT •

DEFINITION: Risk is potential of loss in the value of your position due to the adverse movement of a market variable / or a future event [market variable/an event]. An Example – Commodity Coffee. Starbucks vs. Coffee producer in Nigeria

•

TYPE OF RISK: Because of your position: 1.upside, 2.downside, or both

•

MEASUREMENT: Volatility of the variable- Standard Deviation - if it’s market variable Probability of the event taking place – if it’s an event

* Market variable -> market risk, event of default by counter party – credit risk

3

HEDGING-1 • Definition: Activity that enables one to guard against potential of loss in the value in the future due to adverse change in the variable • Example: Starbucks again Question??? Due to its business activity (position) Starbuck is exposed to –[TYPE]- risk 4

HEDGING-2 POSSIBLE SOLUTION!! - Long a Forward or Future

Suppose we long a forward Risk

Risk Profile

Profile

K

K

Coffee Price

Risk profile of Starbucks (a)

Coffee Price

Risk profile of Forward (b)

Risk Profile

K

Coffee Price

Risk profile of combined position (a+b)

5

HEDGING-3 ANOTHER POSSIBLE SOLUTION!! Long a Call Option at Strike price K

Risk

Risk Profile

Profile

K

K

Coffee Price

Risk profile of Starbucks (a)

Risk profile of Call Option (b)

Risk Profile

Coffee Price

K

Coffee Price

Risk profile of combined position (a+b)

Recall the Pay-Off of the Put Option 6

ACCOUNTING RECAP -1 Dividend, Expense, Asset and Losses (DEAL) accounts increase in value when debited and decrease when credited, whereas Gains, Income, Revenues, Liability and Stockholder's (Owner's) equity (GIRLS) accounts decrease in value when debited and increase when credited. Debit/credit Account

Debit Credit

Assets

?

?

Expenses

?

?

Liabilities

?

?

Shareholder Equity ?

?

Revenue

?

?

7

ACCOUNTING RECAP -2 VALUATION METHODS –

(1)ACCRUAL (HISTORICAL) (2)MTM (FMV)

DOUBLE ENTRY [T-ACCOUNTS] Every transaction will have double entry – also called as T accounting [a credit entry in one account, and a debit entry in other account]. Following are some examples. Note in T-accounts debits are shown on left and credits are shown on right

Example: Sell the goods worth $1000 in cash T- Account entries will be as follows:

Cash in hand [Account] Debit $1000

Inventory [Account] Credit Goods worth $1000

8

OCI vs. EARNINGS FAS 133 Hedge A/C • Derivatives are reported in balance sheet as an asset or liability @ MTM. • Change in the value of derivative to be reported in earnings; - potential to bring the volatility in current earnings [due to leverage effect]. • For some cases the gains or losses in the value of the derivatives can be reported under OCI. Earnings is operating income (P&L Statement) • Performance measure for an equity or market analyst- less volatility is preferred So, what is OCI? OCI is other comprehensive income a subsection of equity section of balance sheet. For some cases gains and losses on derivatives can be parked in OCI, Good for corporate treasuries.

9

DERIVATIVE ACCOUNTING

Purpose of Derivative

Trading

Hedging

Type of Hedged Instrument -Floating-rate assets -Floating-rate liabilities -Forecasted commodity transactions -FX-Denominated forecasted third party or intercompany transactions

Cash Flow Hedge

-Fixed-rate assets -Fixed-rate liabilities -Firm commitments -FX-denominated debt and AFS securities

-Foreign currency firm commitments

Fair Value Hedge

Net Investment Hedge

-MTM on B/S -Looses and Gains are reported in Earnings

-MTM on B/S -The effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedging instrument shall be reported as a component of other comprehensive income (outside earnings) and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings. The remaining gain or loss on the derivative instrument, if any, shall be recognized currently in earnings

-MTM on B/S -The gain or loss on a derivative instrument designated and qualifying as a fair value hedging instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk shall be recognized currently in earnings in the same accounting period

-MTM on B/S -The gain or loss on the hedging derivative or nonderivative instrument in a hedge of a foreign-currency-denominated firm commitment and the offsetting loss or gain on the hedged firm commitment shall be recognized currently in earnings in the same accounting period

10

HEDGE ACCOUNTING RISKS WE ARE HEDGING

-Change in the Fair value of the hedged item

VS.

HEDGE TYPE

Fair Value Hedge

-Variability in the cash flow of forecasted (expected) transaction

Cash Flow Hedge

-Foreign Currency Exposure • Unrecognized foreign currency denominated firm commitment • FX denominated Available for sale Security •Forecasted FX denominated transaction •Net investment in foreign operation/ foreign currency firm commitments

Net Investment Hedge

11

EFFECTIVENESS-1 •

WHAT IS EFFECTIVENESS?

•

Goals of effectiveness process: 1.) to assess the effectiveness [yes/no, e.g. ratio test ], and 2.) to measure the ineffectiveness

How you assess or measure? Compare MTM of Hedge Instrument to MTR (mark to risk) calculation of Hedged item Why? MTM captures all the risks; MTR measures the designated risk Mark to risk is the relevant change- how much of this is being hedged by hedging instrument (ineffectiveness) 12

EFFECTIVENESS-2 One can specify what part of the MTM change in hedge instrument will be used for effective assessment Example: Option: one can choose change in intrinsic value, min value, or fair value Forward, Future: one can use change in FV due to change in spot prices Total change in Derivative value (Hedge Inst.)

=

Portion Used to assess the effectiveness

Effective Portion; Report in OCI (CF and NIF)

+

+

Portion not used to assess the effectiveness; report in earnings

Ineffective Portion; report in earnings 13

EFFECTIVENESS-3 • MTR (Mark to Risk) calculation of Hedged Item - Capture change in value due to designated risk[s] only - MTR methods -

Spot Undiscounted Spot Discounted Forward Forward Undiscounted

14

EFFECTIVENESS-4 • TYPE OF EFFECTIVENESS TEST -Prospective -Retrospective • Frequency of the effectiveness tests - Min (three months, financial statement reporting time) - Check the effectiveness over the period of designation: Type – cumulative or periodic 15

EFFECTIVENESS-5 • Hedge Effectiveness assessment/measurement methods (1.) Critical terms comparison (2.) Dollar offset method (3.) Regression Analysis .8<=EFF RATIO<=1.25

Dollar Offset Method (a.) Hypothetical derivative (b.) The benchmark Rate (c.) Sensitivity Analysis

16

HEDGE DESIGNATION PROCESS FLOW Documentation Part

STEP-1:Document the following: description of Hedge, Hedge relationship, risk management Objective, Hedge Type, Designation date, De-desig. date

STEP-2A:-List Hedge Instru. , which includes Trade desc, proportion, partial from to date, Hedge method (if CF or NIF), How effectiveness will be calculated [for option( int,min, FV), for forw or fut change due to spot or all incl

STEP-2:LINK- Hedged item (exposure which is exposed to one or more than one type of the designated risk) to Hedging Instrument (instrument which hedges the selected risk)

STEP-2B:-List Hedged item. , which includes Trade desc, proportion, partial from to date, Risk Designation, How MTR will be calculated (for eg forward Discounted etc), OCI adj Freq,

STEP-1A:Based on Hedged item Select Hedge Type

Fair Value Hedge

Cash Flow Hedge

Net Investment Hedge

STEP-3: Select Effectiveness assessment method both prospective and retrospective, Assessment type cumulative or periodic, frequency of assessment

STEP-4: Publish OCI release schedule, IF APPLICABLE (Fair value Hedge doest require this)

Accounting Part 17