Derivatives and Hedging - Mayer Hoffman McCann PC

MHM Executive Education Series:MHM Executive Education Series:Derivatives and Hedging

Presented by:Presented by:Mike Loritz and Tim Woods

August 16, 2012

Agenda

• Basics - Overview of the definition of a derivative• Identification and accounting for embedded derivative

instrumentsinstruments• Requirements for the application of hedge accounting

and common hedging strategies– Cash flow hedges– Fair value hedges– Net investment hedgeNet investment hedge

• Common valuation issues associated with certain derivative instruments

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What is a Derivative? – Characteristics of Derivatives

A derivative financial instrument is an instrument whose value is dependent on or derived from the value of an underlying asset reference rate or index Derivatives haveunderlying asset, reference rate, or index. Derivatives have the following characteristics:

– One or more underlyings– One or more notional amounts (or payment provisions)– Little or no net investment– Net settlement provisions (or market mechanism to facilitate net et sett e e t p o s o s (o a et ec a s to ac tate et

settlement)

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Underlying– The underlying is the variable that, along with the notional

amount and or payment provisions determines the settlement ofamount and or payment provisions, determines the settlement of the derivative.

– Examples of the underlying are:• A security price or index (e g in a stock option the underlying is the• A security price or index (e.g. in a stock option the underlying is the

price of the stock)• An interest rate (e.g. in an interest rate derivative = LIBOR)• A commodity price (e g in a futures contract = price of oil)A commodity price (e.g. in a futures contract = price of oil)• An exchange rate (e.g. in a FOREX contract = USD/EUROS)

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Notional Amount– The notional amount is the number of units of the derivative

contract.– Examples of the notional amount are:

• 10,000 stock options (e.g. in a stock option the notional amount is the number of options, or shares upon exercise)p , p )

• $1,000,000 (e.g. in an interest rate swap, the notional amount is the amount of the currency that is being swapped into either a variable or fixed interest rate)

• 40,000 barrels of oil (e.g. in a futures contract for oil, the notional amount is the total amount of the commodity)

• $1,000,000 (e.g. in a FOREX contract, the notional amount is the amount that is being exchanged for another currency)

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amount that is being exchanged for another currency)


Initial Net Investment– Many derivative instruments require no initial net investment

(e.g. interest rate swaps, futures contracts, forward contracts, ( g p , , ,etc…)

– However, certain derivative contracts require an initial net investment as compensation for one or both of the following:p g

• Time value (e.g. premium on an option)• Terms that are more or less favorable than market conditions (e.g. a

premium on a stock option with an exercise price that is less than the current market price of the stock)

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Net Settlement– Net settlement allows the parties to a derivative contract to settle

the contract at its net value rather than the value based upon its pnotional terms.

– A contract meets the definition of net settlement if it can be settled in any of the following ways:

• Net settled under its contract terms• Net settled through a market mechanism (e.g. in the stock option example, if

the stock option could not be net settled, provided that a liquid market mechanism exists that will put the holder in substantially the same positionmechanism exists that will put the holder in substantially the same position as net settlement, then net settlement is presumed to exist)

• Net settlement by delivery of derivative instrument or asset that is readily convertible to cash

f

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This is an important factor when considering embedded derivatives in private company equity securities and contracts

settled in (or potentially settled in) an entities own shares.


Payment Provision– A payment provision specifies a fixed or determinable settlement

to be made if the underlying behaves in a specified manner. y g p– For example, a derivative instrument might require a specified

payment if a referenced interest rate (underlying) settles at an amount that is greater than 5%.g

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Derivatives – Basic Principles

• Derivatives can be assets or liabilities!!– Limited exceptions – i.e. can a purchased option be a liability?

• All derivatives are recorded on the balance sheet at fair value.

• Specialized accounting may apply if a transaction qualifies for hedge accounting and the proper election is made.ade– Documentation requirements must be met.– Quarterly analysis required. (certain limited exceptions)

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Derivatives – Scope Exceptions to Topic 815The following contracts are not subject to the requirements of derivativeThe following contracts are not subject to the requirements of derivative accounting:

– Regular way trades– Normal purchases and normal sales (if elected)– Certain insurance contracts– Financial guarantee contracts– Certain contracts that are not traded on an exchange– Derivatives that serve as impediments to sales accounting

Investments in life insurance– Investments in life insurance– Certain investment contracts– Most loan commitments

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– Leases– Registration payment arrangements

Continued - Scope Exceptions to Topic 815

The following contracts issued or held by a reporting entity are not subject to the requirements of derivative accounting:

• Contracts issued or held by that reporting entity that are both 1) indexed in its own stock and 2) classified in stockholders’ equityits own stock and 2) classified in stockholders equity.

• Contracts issued by the entity that are subject to Share Based Compensation guidance.

• Contacts issued by the entity as contingent consideration from a business bi ticombination.

• Forward contracts that require settlement by the reporting entity’s delivery of cash in exchange for the acquisition of a fixed number of its equity shares.

The above exceptions do not apply to the counterparty in thoseThe above exceptions do not apply to the counterparty in those contracts. In addition, a contract that an entity either can or must settle by issuing its own equity instruments but that is indexed in part or in full to something other than its own stock can be a derivative, in which case it would be accounted for as an asset or liability

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case it would be accounted for as an asset or liability.

Embedded Derivatives

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A component of a hybrid contract that is embedded in a non-derivative instrument (“host contract”) that modifies the cash flows or the value of other exchanges required by a contract, in a manner similar to a derivative. The embedded feature must bemanner similar to a derivative. The embedded feature must be separated from the host contract and accounted for as a derivative if:

a free standing instrument with same terms as the embedded derivative meets the ASC 815 definition of aembedded derivative meets the ASC 815 definition of a derivative, and

the economic characteristics/risks of the embedded derivative are not “clearly and closely related” to the economic characteristics of the host contracteconomic characteristics of the host contract.

The hybrid contract is not subject to re-measurement at fair value under GAAP.

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Embedded Derivatives – Identification

• A Hybrid instrument contains terms that affect some or all of the cash flows under the contractin a manner similar to a derivative financial i t tinstrument.– Typically the embedded derivative will alter the cash

flows as compared to a similar contract without the same feature(s).feature(s).

• If the fair value of the Hybrid instrument is different than the fair value of the same instrument without the embedded feature, it most likely is the result of a change in the potential or actual cash flows.

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Embedded Derivatives - Sources

A f b dd d d i ti lt fA common source of embedded derivatives result from financing transactions, including:

– Convertible debtConvertible debt• conversion and any redemption features must be analyzed

– Preferred securities d ti d th f t ( t ll t )• redemption and other features (puts, calls, etc)

• PIK dividends and contingent dividend increases– Non-detachable Warrants (detachable warrants are (

considered freestanding) • settled in an entity’s own stock??

– Foreign Currency Transactions

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– Foreign Currency Transactions

Derivatives – Scope Exceptions

Scope exceptions specific to embedded derivatives:a. Normal purchases and normal sales contracts

b. Unsettled foreign currency transactions

Pl i ill i i i htc. Plain-vanilla servicing rights

d. Features involving certain aspects of credit risk (subordination)

e. Features involving certain currencies

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g


Foreign Currency Scope Exceptions– Unsettled foreign currency transactions (including financial

instruments) are not considered embedded derivatives if theyinstruments) are not considered embedded derivatives if they are accounted for under ASC 830-20

– An embedded foreign currency derivative within a non-financial host contract is not bifurcated if it requires paymenthost contract is not bifurcated if it requires payment denominated in:

• The functional currency of any substantial party• The currency in which the price of the good/service is routinely• The currency in which the price of the good/service is routinely

denominated in international markets• The local currency of either substantial party• The currency used by a substantial party as if it were functional

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The currency used by a substantial party as if it were functional (i.e. highly inflationary economy)


Is the contact carried at fair

Would it be a Is it clearly and closel related

Bifurcate

carried at fair value through earnings?

derivative if it was freestanding?

closely related to the host contract?

e

No Yes No

No

Do Not Bifurcate

YesNo

Yes

Do Not Bifurcate

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Clearly & Closely Related

Generally, an embedded derivative whose fair value is commonly associated with the fair value of the host contract is clearly and closely relatedcontract is clearly and closely related

– Equity features are typically clearly and closely related to an equity host

• conversion option in preferred stock• conversion option in preferred stock– Generally, debt features that only alter the amount of interest

payments made on the host contract are considered “clearly and closely related ”closely related.

• Variable rate debt• Prepayment provisions

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• Purchase Contract – Floor and cap on the price of the asset is clearly/closely

relatedrelated

• Equity Host– A put option on the equity securities is NOT clearly/closely

related

• Leases– Inflation indexed rentals are clearly/closely related– Contingent rentals are clearly/closely related

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Interest Rate Underlyings (ASC 815-15-25-26) An embedded derivative in which the only underlying is an interest rate or interest rate index(such as an interest rate cap or an interest ( prate collar) that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract that is considered a debt instrument is considered to be clearly and closely related to the host contract unless either of the following conditions exists• The hybrid instrument can contractually be settled in such a way that

the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment.

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Interest Rate Underlying’s (ASC 815-15-25-26) The embedded derivative meets both of the following conditions:conditions:

– There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the hostleast double the investor’s initial rate of return on the host.

– For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled the embedded derivative would at the same time resultdoubled, the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return for a contract that has the same terms

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terms.


If an embedded feature is required to be bifurcated:

• Record full fair value of the embedded derivative(s) on theRecord full fair value of the embedded derivative(s) on the balance sheet and allocate remaining value to the host contract/instrument.

• Account for the host contract under the applicable accounting standardsaccounting standards

• Account for the embedded feature(s) in accordance with ASC 815• Can be “freestanding”• Can be a hedging instrument

• If the fair value of the embedded cannot be reliably determined, the Host contract together with the embedded derivative (Hybrid) must be accounted for at fair value

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derivative (Hybrid) must be accounted for at fair value


Example:

ABC Company issues preferred stock that allows the holder theABC Company issues preferred stock that allows the holder the option to put the stock back to ABC Company for an amount equal to the outstanding par plus dividends payable after a period of 5 years from the issuance date. The preferred stock pays interest of 12% annuallypays interest of 12% annually.

Is the embedded put feature considered clearly and closely related to the host contract?closely related to the host contract?

What if the instrument had an embedded conversion f t ?

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feature?


Analysis:

Host Contact: The preferred stock instrumentHost Contact: The preferred stock instrument

Embedded Derivative – Put Right:Underlying: Benchmark Interest Rates– Underlying: Benchmark Interest Rates

– Notional: Par Value – Preferred Stock– Net Settlement: Assume Yes– Initial Investment: NoInitial Investment: No

Since the preferred stock in this instance is more akin to a debt instrument than an equity instrument

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q y(ASC 815-15-25-17), the put feature would be

considered clearly and closely related.


Example:

ABC Company issues fixed rate debt at a par value of $100 andABC Company issues fixed rate debt at a par value of $100 and a maturity of 10 years. The debt is callable by ABC Company at any date after issuance at a rate of 105 for the first 5 years and at par thereafter.

Is the embedded call feature considered clearly and closely related to the host contract?

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Analysis:

Host Contact: The debt instrumentHost Contact: The debt instrument

Embedded Derivative – Call Option:Underlying: Benchmark Interest Rates– Underlying: Benchmark Interest Rates

– Notional: Par Value – Debt– Net Settlement: Yes– Initial Investment: NoInitial Investment: No

Since the instrument could not be settled such that the investor would lose their investment and the call option has

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ponly a single interest rate underlying (DIG B39), the call option would be considered clearly and closely related.

Hedge Accounting

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What is Hedging?

• From an economic standpoint, hedging is using derivative instruments (or potentially other vehicles) to offset risks (or volatility) that are present in a company’soffset risks (or volatility) that are present in a company s business model in order to maintain a predictable outcome.– Fair value: maintain the fair value of an item– Cash flow: achieve predictable cash flows

• From an accounting standpoint, there are specific criteria that must be met prior to a company’s implementation of h d ti

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hedge accounting.

What is Hedging?• Derivatives that are accounted for as freestanding are recorded at• Derivatives that are accounted for as freestanding are recorded at

fair value at each reporting date with the change recorded in earnings.

• Provided that the requisite hedging criteria are met derivatives that• Provided that the requisite hedging criteria are met, derivatives that are accounted for as hedging instruments are also recorded at fair value; however, the accounting for the impact to earnings is based upon the type of hedge that has been implemented.upon the type of hedge that has been implemented.

• Regardless of whether hedge accounting is utilized, ALL derivatives are recorded on the balance sheet at their estimated fair value.

• For accounting purposes there are generally 3 types of hedges:• For accounting purposes, there are generally 3 types of hedges:– Fair value hedge– Cash flow hedge

Foreign currency hedge

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– Foreign currency hedge

What is Hedging?• Fair value hedge• Fair value hedge –

Economic purpose is to enter into a derivative instrument whose changes in fair value directly offset the changes in fair value of the hedged item I e item has fixed cash flowshedged item. I.e. item has fixed cash flows.

• Cash flow hedge –Economic purpose is to enter into a derivative instrument whose

i d l ttl t di tl ff t th l d igains and losses on settlement directly offset the losses and gains incurred upon settlement of the transaction being hedged.

• Foreign currency hedge –If the hedged item is denominated in a foreign currency, then an entity may designate the hedge as either 1) a fair value hedge of that item, 2) a cash-flow hedge of that item, or 3) a hedge of a net in estment in a foreign operation

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investment in a foreign operation.

Types of Hedging

F i l h dFair value hedge– In a fair value hedge the gain or loss on a derivative

instrument designated and qualifying as a fair value g q y ghedging instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized currently in earnings in the same accounting periodaccounting period.

Intent is to convert a fixed cash flow instrument with a variable fair value to a fixed fair value.

EXAMPLE: FIXED RATE DEBTS i l t t t H d d It

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Special treatment = Hedged Item

Types of Hedging

Cash Flow Hedge– In a cash flow hedge, the effective portion of the gain or loss on

a derivative instrument designated and qualifying as a cash flowa derivative instrument designated and qualifying as a cash flow hedging instrument shall be reported as a component of other comprehensive income (outside of earnings) and reclassified into earnings in the same period or periods during which the g p p ghedged forecasted transaction affects earnings.

– Any portion of the derivative instrument that is designated as a cash flow hedge that is determined to be ineffective should be grecognized in earnings immediately.

Intent is to convert a variable cash flow instrument to a

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Intent is to convert a variable cash flow instrument to a predictable set of cash flows.

Types of Hedging

Cash Flow Hedge

EXAMPLES VARIABLE RATE DEBT FORECASTEDEXAMPLES: VARIABLE RATE DEBT, FORECASTED SALES & PURCHASES

Special Accounting Treatment:The Unrealized Gain/Loss on the hedgingThe Unrealized Gain/Loss on the hedging

instrument

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Types of Hedging

Foreign Currency Hedge– Foreign currency hedges designated as either fair

l h d h fl h d t d fvalue hedges or cash-flow hedges are accounted for in the same manner as regular fair value and cash flow hedges.

– A derivative instrument or a non-derivative financial instrument that may give rise to a foreign currency transaction gain or loss can be designated as hedgingtransaction gain or loss can be designated as hedging the foreign currency exposure of a net investment in a foreign operation.

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Types of Hedging

Foreign Currency Hedge– The gain or loss on a hedging derivative instrument

( th f i t ti i l(or the foreign currency transaction gain or loss on the non-derivative hedging instrument) that is designated as, and is effective as, an economic hedge of the net investment in a foreign operation shall be reported in the same manner as a translation adjustment to the extent it is effective as a hedgeadjustment to the extent it is effective as a hedge.

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Types of Hedging

Foreign Currency Hedge

Example: A US domiciled company with foreign operations wishes toExample: A US domiciled company with foreign operations wishes to decrease the potential volatility to equity as a result of the currency translation adjustment. The company could enter into a foreign currency derivative (i.e. option, currency swap, forward, etc.) to hedgecurrency derivative (i.e. option, currency swap, forward, etc.) to hedge the volatility. This is similar to a fair value hedge.

Special Accounting TreatmentSpecial Accounting TreatmentThe unrealized gain/loss on the hedging instrument is recorded as a

component of the currency translation adjustment

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Hedge Documentation

Formal Documentation Under ASC 815• ASC 815 contains explicit guidance regarding the

application of hedge accounting models includingapplication of hedge accounting models, including documentation and effectiveness assessment requirements. One of the fundamental requirements of ASC 815 is that formal documentation be prepared at inception of a hedging relationship.

• ASC 815 stresses the need for the documentation toASC 815 stresses the need for the documentation to be prepared contemporaneously with the designation of the hedging relationship.

Hedging is a Privilege, Not a Right!

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Hedge Documentation

Documentation must include:– Hedging relationship

Entity’s risk management objective and strategy for undertaking– Entity s risk management objective and strategy for undertaking the hedge, including:

• Identification of the hedging instrument• Identification of the hedged item or forecasted transaction(s)• Identification of the hedged item or forecasted transaction(s)• Identification of how the hedging instrument’s effectiveness in

offsetting the exposure to changes in the hedged item’s fair value (fair value hedge) or the hedged transaction’s variability in cash ( g ) g yflows (cash flow hedge) attributable to the hedged risk will be assessed.

• How ineffectiveness will be measured

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Hedge Documentation

Eff ti A tEffectiveness Assessment:– Both at the inception of the hedge and on an ongoing basis, the

hedging relationship is expected to be highly effective in achieving

• Offsetting changes in the fair value attributable to the hedged risk during the period that the hedge is designated (in the case of a fair

l h d )value hedge) or • Offsetting cash flows attributable to the hedged risk during the term

of the hedge (in the case of a cash flow hedge).An assessment of effectiveness is required whenever financial– An assessment of effectiveness is required whenever financial statements or earnings are reported; at least every three months.

– All assessments of effectiveness must be consistent with the originally documented risk management strategy for that

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originally documented risk management strategy for that particular hedging relationship.

Hedge Documentation

• In measuring the effectiveness of a cash flow hedge, the Company must measure the correlation of the expected (hedged) result and the actual result (difference should be minimal for an effective (hedge).

• In terms of a fair value hedge, the Company must measure the correlation of the change in fair value of the hedged item and the change in fair value of the derivative being utilized in the hedge.

A t t d b f th t i it ti i hi h th C• As stated before, there are certain situations in which the Company can utilize the critical terms match method, provided that the requisite criteria are met, and can therefore presume that no-i ff ti i t

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ineffectiveness exists.

Cash Flow Example

Sample Company XX (Company) intends to enter into a transaction with Counterparty A (Counterparty) as part of the Company’s overall risk management policies and intends toCompany s overall risk management policies and intends to designate an interest rate swap as a hedge of the exposure to changes in cash flows resulting from changes in interest rates associated with the Company’s variable rate debt.

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Cash Flow Example

Risk Management Objective The Company’s risk management objective is to reduce exposure to th i bilit i h fl (i t t t ) i t d iththe variability in cash flows (interest payments) associated with changes in the 3 month LIBOR benchmark interest rate on $10 million of outstanding principal of the Company’s note payable to Bank A. The Company intends to hedge its exposure to changes in the benchmark interest rate by entering into a pay fixed, received variable (3 month LIBOR) interest rate swap. The variable leg of the swap is intended to offset changes in the cash flows attributable to changes in the 3 month LIBOR benchmark interest rate.

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Cash Flow Example

Hedged Item The Company is hedging the changes in cash flows, associated with changes in the 3 month LIBOR rate only on the monthly variable ratechanges in the 3 month LIBOR rate only, on the monthly variable rate interest payments beginning on January 1st, 2011 and the 1st of each month thereafter on the Company’s $10 million in outstanding debt with Bank A.Bank A. Based on the Company’s internal evaluation, the future interest payments associated with the outstanding debt with Bank A are assessed as probable of occurring as the debt is not callable by the assessed as p obab e o occu g as t e debt s ot ca ab e by t elender and the Company intends for the debt to remain outstanding throughout the hedged period (maturity). Additionally, we have assessed the counterparty credit risk and determined that the likelihood

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the counterparty would default on any payments due under the contractual terms of the hedging instrument is not probable (ASC 815-20-35-15).

Cash Flow Example

Hedged Item Therefore, the Company has elected to ignore the impact of changes in the counterparty credit risk as well as the Company’s non-performancethe counterparty credit risk as well as the Company s non-performance risk in the assessment of effectiveness and ineffectiveness. As a result, changes in the fair value of the hedging instrument related to counterparty credit risk and non-performance risk will be included as acounterparty credit risk and non performance risk will be included as a component of accumulated other comprehensive income (AOCI) until the hedged cash flows impact earnings.

Hedging InstrumentThe hedging instrument is the pay fixed, received variable interest rate swap with Counterparty A

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swap with Counterparty A.

Interest Rate Swaps

Effectiveness Assessment: The Company will perform the initial and on-going effectiveness

t th h i l i f th thl h i thassessment through a regression analysis of the monthly change in the actual interest rate swap and a perfectly effective hypothetical (PEH) swap designed to entirely offset the changes in cash flows as a result of changes in the 3 month LIBOR The regression analysis will use aof changes in the 3 month LIBOR. The regression analysis will use a minimum of 60 monthly data points (length of the hedging relationship) prior to the hedging relationship. When correlating the actual swap value to the perfectly effectiveWhen correlating the actual swap value to the perfectly effective hypothetical derivative instrument, the R2, or coefficient of determination, which is the R, or coefficient of correlation, squared, should be equal to or greater than 0.8 . The R2 factor should be greatershould be equal to or greater than 0.8 . The R2 factor should be greater than (0.8) and less than or equal to 1.25 in order to be considered highly effective.

Cash Flow Example

Effectiveness Assessment: Additionally, the Company will update the assessment of the probability f th h d d h fl i d th t f t tof the hedged cash flows occurring and the assessment of counterparty

and non-performance credit risk on a quarterly basis. To the extent the hedged cash flows remain probable of occurring, and counterparty default is not probable the Company will exclude the impact ofdefault is not probable, the Company will exclude the impact of changes in counterparty credit risk from the valuation of the perfectly hypothetical derivative and actual derivative for purposes of the effectiveness and ineffectiveness testing.effectiveness and ineffectiveness testing.

Cash Flow Example

IneffectivenessThe Company will use the cumulative dollar-offset method to assess the ineffectiveness on a quarterly basis. The Company will compare the q y p y pchange in the value of the actual interest rate swap with the change in the fair value of the perfectly effective hypothetical swap (a swap assuming the same critical terms as the hedged item). The actual interest rate swap will be recorded at the credit adjusted fair value on the balance sheet with an offsetting entry to other comprehensive income. The amount of ineffectiveness to be recorded equals the lesser of the cumulative change in the fair value of the actual interest rate swap or the cumulative change in the fair value of the perfectly effective h th ti l

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hypothetical swap.

Net Investment Hedge

• Designation of a net investment in a foreign operation as a hedged item would be is the same as designating a group of dissimilar assets and liabilities as the hedged item which isdissimilar assets and liabilities as the hedged item, which is not permitted for a fair value or cash flow hedge.

• However, ASC Topic 830 previously permitted hedge accounting for net investments and practice in this area wasaccounting for net investments and practice in this area was well established.

• A net investment in a foreign operation includes incorporated and unincorporated business structures such as subsidiaries, divisions, branches, VIE’s, and investments accounted for by the equity method.

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Eff ti T tiEffectiveness TestingEffectiveness and ineffectiveness should be measured based on the beginning balance of the net investment at the beginning of g g g gthe hedging period. • Offsetting amounts to be included in the CTA for the hedging

instrument and the translation of the net investment may notinstrument and the translation of the net investment may not equal.

• An entity may designate a foreign currency derivative with a ti l f 1 000 000 E h d f it t i t t inotional of 1,000,000 Euro as a hedge of its net investment in

a European subsidiary with an equal balance of 1,000,000 Euro. The effectiveness and ineffectiveness assessments will b b d th ti l if th t i t t f ll

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be based on the same notional even if the net investment falls below 1,000,000 Euro during the 3 month period.


DIG Issue No. H8, "Measuring the Amount of Ineffectiveness in a Net Investment Hedge,“ addresses how ineffectiveness that must be recognized in earnings shall be measuredmust be recognized in earnings shall be measured

– May be forward or spot rates– Forward Rates: If the notional amount of the derivative

d i t d h d l th ti f th tdesignated as a hedge equals the portion of the net investment designated as being hedged, generally all changes in fair value of the derivative should be reported in CTA. In that case, no hedge ineffectiveness would be recognized in earnings.

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SEC Letter – May 11, 2012

• Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Act) establishes a new framework for regulatory and supervisory oversight of the over-the-g y p y gcounter (OTC) derivatives market.

• This could result in the novation of contracts underlying certain designated hedge transactions which would effect acertain designated hedge transactions, which would effect a change in the counterparties to the contract.

• The SEC would not object to a conclusion that the original derivative contract has not been terminated in certainderivative contract has not been terminated in certain circumstances in which a novation of a bilateral OTC derivative contract to a central counterparty "on the same fi i l t " i t dfinancial terms" is executed.

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Valuation Issues

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Valuation

• Topic 820, provides a fair value hierarchy under which among other items, derivatives, must be measured and disclosed.

• Given that interest rate swaps and caps into generally will not be• Given that interest rate swaps and caps into generally will not be valued by obtaining market quotes, the fair values must be estimated via cash flow and option pricing models.

• Typically, your client’s banker will provide a statement of the fair value of these instruments, however, if considered material in relation to the financial statements, as auditors, we will need to audit th t l d it i th t th b k ill id t th ithat value and it is rare that the banker will provide us access to their pricing models as they are deemed to be proprietary.

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Valuation – Interest Rate Swaps

• Interest rate swaps are valued by taking the net present value of the estimated cash flows over the life of the swapswap.

• Given that the fixed rate payments are known, the variable rate payments must be estimatedvariable rate payments must be estimated.

– The future variable rate payments can be estimated by extracting the forward rates for the variable rate and using these as our estimates of the variable rate that will be in effect at settlement.

– By definition, a forward interest rate is the interest rate for a future period of time that is implied by the interest rates

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p p yprevailing in the market today.

Valuation – Forward Rates

• Forward Rates – Example– Forward rates are derived from the current rates in the market – for

example:example:– 3 month LIBOR = 2%– 6 month LIBOR = 4%– The implied 3 month LIBOR rate from the 4th – 6th month is 6%. – This is because if an investor can invest $1,000 for 3 months @ 2% and

can invest for 6 months @ 4% then the sum of the three month periods t b i l t t th 6 th t f 4%must be equivalent to the 6 month return of 4%.

– Therefore: the investor earns $20 for the 6 months at 4%, and earns $5 for the 3 months at 2%, then he must earn $15 for the second three months which is equivalent to a rate of 6%

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months which is equivalent to a rate of 6%.– This is the logic being forward rates and how they are determined from

the yield curve for the underlying base rate

Valuation – Interest Rate Swaps

E lExample1 2 3 4 5 6 7 8 9 10 11

Swap Rate: 2.60% Annualized Period Present3 Month LIBOR 3 Month LIBOR Payer Receiver Value of

Total Period Notional Forward Forward Fixed Floating Net Discount NetgDate Days Days Principal Rate Rate Cash Flow Cash Flow Cash Flow Factor Cash Flow

12/31/2008 $10,000,0003/31/2009 90.00 90.00 $10,000,000 2.0000% 0.5000% ($64,110) $50,000 ($14,109.59) 0.99502 ($14,039)6/30/2009 181.00 91.00 $10,000,000 2.2500% 0.5625% ($64,822) $56,250 ($8,571.92) 0.98946 ($8,482)9/30/2009 273.00 92.00 $10,000,000 2.5000% 0.6250% ($65,534) $62,500 ($3,034.25) 0.98331 ($2,984)

12/31/2009 365.00 92.00 $10,000,000 2.7500% 0.6875% ($65,534) $68,750 $3,215.75 0.97660 $3,141( )($22,364)

Therefore, based upon the following swap terms:

Notional Amount: $10,000,000Swap Rate: 2.60%Fixed Rate Payer: XYZ Company & Floating Rate Receivery p y gFloating Rate Payer: ABC Bank & Fixed Rate ReceiverSettlement Every 3 monthsFloating Rate: 3 month LIBORMaturity; 12/31/2009

The value of the interest rate swap to XYZ Bank, that is using the swap to hedge its 10,000,000 variable rate debt is ($22,364)

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g g ( , )Which would be recorded as follows as of 12/31/08: AOCI $22,364

ST Derivative Liability ($22,364)

Valuation – Interest Rate Cap

• Given that interest rate caps are options, we must use an option pricing model to estimate the fair value thereof.

• The most widely used option pricing model for interest rate caps is a derivation of the Black Scholes Option Pricing model called the Black option pricing modelPricing model, called the Black option pricing model.

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Valuation – Interest Rate Caps

• While going through the math that is behind the valuation of an interest rate cap using the Black Model is beyond th f thi bi ill t h ththe scope of this webinar, we will touch upon the variables that must be input / estimated for the Black Model.Model.

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flag = "caplet" for pricing European call options on interest ratesX = option strike price (e.g. 2.6%)ndays = the number of days in the protection period ( = life of option)basis = the number of days used in the forward market for quoting interest rates

( e.g., 360 days or 365 days)ep = length of the exposure period (also called the reset period), measured in

years (e.g., 0.5 yrs, or 2.75 yrs, etc.)z = the continously compounded zero coupon rate over the exposure periodf = the forward rate over the protection (or reset period) periodVol = volatility of the forward interest rate

For example, suppose we want to cap the interest rate on a 182 day loan taken outin 6 months. The six-month forward rate embedded in the yield curve today is 8% and

P t ti

f = z=

Exposure Period

t=0 t= 6

Protection Period

t = 1 year

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Life of


1 2 3 4 5 6 7 8 9 10 11 12 13 14

X ndays basis ep z f VolNotional: $10,000,000 # of Days # of Days (Reset zero Forward VolatilityBase Rate: 3 month LIBOR Option In In Fwrd Period) Rate for Rate for 3 mn LIBOR ValueBase Rate: 3 month LIBOR Option In In Fwrd Period) Rate for Rate for 3 mn LIBOR Value

Life of Strike Protection Market Exposure Exposure Protection Forward Caplet ofPeriod From To Days Caplet Price Period Quotes Period (yrs) Period (yrs) Period (yrs) Rate Price Caplet

31-Dec-08 31-Mar-09 90.00 0.3 2.60% 90.0 360.0 2.00% 60.00%1 1-Apr-09 30-Jun-09 90.00 0.5 2.60% 90.0 360.0 0.3 2.25% 2.25% 60.00% 0.0003628 $3,6282 1-Jul-09 30-Sep-09 91 00 0 8 2 60% 91 0 360 0 0 5 2 38% 2 50% 60 00% 0 0009437 $9 4372 1-Jul-09 30-Sep-09 91.00 0.8 2.60% 91.0 360.0 0.5 2.38% 2.50% 60.00% 0.0009437 $9,4373 1-Oct-09 31-Dec-09 91.00 1.0 2.60% 91.0 360.0 0.8 2.50% 2.75% 60.00% 0.0015457 $15,457

$28,522

Therefore, in this example, the Company has purchased an interest rate cap for a periodof 1 year, with 3 remaining settlements. The notional amount is $10,000,000 and the cap rate is $2.60%.Given the forward rate curve as of 12/31/08 (hypothetical not actual), and an estimated volatiltiyof the 3 month LIBOR of 60%, the total value of the entire interest rate cap agreement is $28,522

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Futures versus Forwards• Futures contracts are traded on organized exchangesFutures contracts are traded on organized exchanges

and the terms for each contract are standardized. – For example, 1 futures contract of West Texas

Intermediate (WTI) Light Sweet Crude has the following specifications:

• It is for 1 000 barrels• It is for 1,000 barrels• Quoted in US Dollars and Cents• Contract matures at the close of business on the

3rd business day prior to the 25th calendar day of the month preceding the delivery month.C t t li t d f ll th• Contracts are listed for all months

• Contracts are listed are listed for 9 years forward

Futures versus Forwards

• Futures contracts require a buyer or seller to put up an initial amount of margin as required by the exchange based on the notional dollar amount of the transactionbased on the notional dollar amount of the transaction.

• On a daily basis the value of the futures account is market to market with the buyer or seller potentially y p yneeding to put up additional margin if their has been losses in the account that are not covered by the current margin in the accountmargin in the account.

• If this margin is not put up, the positions in the account will be liquidated to cover the margin call.

• Futures can be physically settled or net settled.

Futures versus Forwards• While futures are traded on organized exchanges, forward contracts

are traded in what is known as the “over the counter or OTC”are traded in what is known as the over the counter or OTC market.

• The OTC market is a computer linked network of dealers who do not physically meet. p y y

• Trades in the OTC market are typically much larger than trades in the exchange traded market.

• A key advantage to the OTC market is that the terms of the forward y gcontracts do not have to be specified by the exchange; that is, they can be tailored to the needs and wants of the transacting parties.

• The disadvantage is the credit risk involved in the transaction. With futures contracts the margin required and the monitoring thereoffutures contracts, the margin required and the monitoring thereof ensures proper settlement. With OTC contracts there is a risk that the counterparty will not perform. This is the very reason for the requirement for margin for exchange traded futures, to ensure that traders do not walk away from their commitmentstraders do not walk away from their commitments.

Credit risk – Forward Contracts

• Credit risk has traditionally been a feature of the OTC markets as there is always a chance that the party to the other side of the OTC trade will defaultother side of the OTC trade will default.

• Interestingly, the OTC market has started requiring a concept called collateralization which is essentially the p ysame as a margin agreement; positions are marked to market on a daily basis and the loser must post additional collateraladditional collateral.

FUTURES VS. FORWARDSFORWARDS FUTURESFORWARDS FUTURESPrivate Contract between two parties Traded on an exchange

Not standardized Standardized ContractVery flexible Rigid

Settled at end of contract Settled daily (MTM)

Delivery or final cash settlement Contract is usually closedDelivery or final cash settlement Contract is usually closedprior to maturity

Some credit risk Virt all no credit riskSome credit risk Virtually no credit risk

Valuation Issues for Derivatives

In accordance with ASC 815, those financial instruments that meet the requirements for derivative accounting, must be market to market through earnings (unless hedgebe market to market through earnings (unless hedge accounting is utilized).

Accordingly, we will know discuss some of the issues that must be considered in the determination of the value of derivativesderivatives.


First, what are the most common derivative instruments that we come across in our business activities:

1) Futures contracts for commodities – metals, energy, agricultural

2) Futures contracts for foreign exchange2) Futures contracts for foreign exchange 3) Forward contracts for commodities and foreign exchange4) Interest rate swaps5) Forward contracts for foreign exchange5) Forward contracts for foreign exchange6) And of course, call and put option on all of the above


As we discussed before, futures contracts are traded on organized exchanges and are therefore quite simple to value as they are considered level 1 securities for purposesvalue as they are considered level 1 securities for purposes of the fair value hierarchy.

However, forward contracts are not traded on an organized exchange and as such, we must look to their level 1 counterparts for an indication of value Accordingly forwardcounterparts for an indication of value. Accordingly, forward contracts with an underlying that is actively traded, are level 2 securities.


Valuation issues for Forward Contracts

The key to ensuring that a forward contract is properly valued is to ensure that the forward contract is read in detail and that are terms of the derivative are properlydetail and that are terms of the derivative are properly understood. Financial engineering has made the OTC market very creative in its development of derivative products Accordingly we must understand all of the termsproducts. Accordingly, we must understand all of the terms, included how the derivatives are priced and settled, how they mature, requirements for collateral, etc….


Valuation issues for Forward ContractsAfter thoroughly examining the contract, we must identify th d l i t th f d t t hi h ill t lik lthe underlying to the forward contract which will most likely be actively traded in the futures market.Upon identifying the underlying, we must then identifyingUpon identifying the underlying, we must then identifying the price that is most applicable to the forward contract and the settlement date (s) therefore.


Once we have the estimated cash flows for the forward contract, we must then assess the credit risk of the applicable counterparties and calculate the credit riskapplicable counterparties and calculate the credit risk adjusted discount rate such that we can properly discount the estimated future settlements to arrive at the estimated fair value of the derivative as of the reporting date.


An example of this is as follows:A company has entered into a forward contract with ABC bank to sell 1,000,000 pounds of copper at $3.50 on September 30, 2012.

Given that copper is an actively traded commodity, we can look to the futures market as of June 30, 2012, the valuation date, to observe the price of the underlying for which the September 2012 copper futuresprice of the underlying for which the September 2012 copper futures contract closed at $3.40 on 6/30/12.

Therefore, the undiscounted value of this contract is $100,000. However as this cash flow is to occur in 3 months the Company mustHowever, as this cash flow is to occur in 3 months, the Company must discount this amount at the credit risk adjusted rate of the counterparty which is estimated at 4%. Accordingly, the estimated fair value of the contract as of June 30, 2012 is $99,024.contract as of June 30, 2012 is $99,024.

Therefore, the estimated fair value of this level 2 derivative is $99,024 as of June 30, 2012.


The most common derivative the we come across is that of the interest rate swap. Furthermore, most of these interest rate swaps have an underlying that is either the 1 or 3 month LIBORis either the 1 or 3 month LIBOR. Given the interest rate environment over the past 4-5 years, the fixed rate payer, variable rate receiver interest rate swaps have resulted in, at times, large losses, and therefore liabilities on the balance sheets of th fi d tthe fixed rate payers. However, in the valuation of these interest rate swaps, companies often miss the requisite counterparty valuation adjustment (or CVA), which is an adjustment to the discount rate being utilized for the credit j grisk of the fixed rate payer. This adjustment has the effect of reducing the liability being reported by the fixed rate payer, and, as such, is often viewed as counter intuitive.However the adjustment is required as it is representative of what aHowever, the adjustment is required, as it is representative of what a willing buyer would pay for the future cash flows represented by the interest rate swap and the credit risk of the fixed rate payer must be taken into account in this valuation.


It should be noted that upon entering into an interest rate swap, or any at market priced derivative, the value of the derivative at that date should be $0derivative at that date should be $0.


Down Round Protection:We often see Companies that have issued securities with down round protection; that is, if the Company issues another security in the future at a price that is lower than the security that was formerly issued, then that price is reduced to the new lower price.If these securities that have down round protection are classified as pderivatives (re bifurcated call options on convertible debt, standalone warrants, etc…); the down round protection feature is not properly valued using a standalone Black Scholes option pricing model.In fact, the SEC does not allow the standalone Black Scholes option pricing model to value these derivatives, but requires a binomial or lattice based model to value the derivatives.


Down Round Protection:The reason that the Black Scholes Model does not yield a

l f ti ith d d t ti i dproper value for options with down round protection is due to the fact that the BSM is a closed ended model; that is, it does not take into account the probability of a down round p yfinancing, and therefore a reduced exercise price. The volatility factor in the model works on the changes in the stock price NOT the exercise price of the optionstock price, NOT the exercise price of the option.

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Down Round Protection:While the preferred method of valuing optionality with down

d t ti i th h th f l tti b dround protection is through the use of a lattice based or simulation model, we have seen instances of valuations where a probability weighted Black Scholes Model Matrix is p y gutilized, wherein a probability is assigned to the down round and the related price at which the round occurs. The resulting value is a probability weighted Black Scholesresulting value is a probability weighted Black ScholesModel.

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Down Round Protection:That said, as auditors and financial professionals, we

d th f lifi d l ti i li t hrecommend the use of a qualified valuation specialist when valuing financial instruments with down round protection.

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Speaker BiographyMichael Loritz CPAMichael Loritz, CPA

Shareholder, Mayer Hoffman McCann P.C.

913.234.1226

[email protected]

Mike has 15 years of public accounting experience with financial and service basedcompanies, including the engineering and construction industry. He is a member of theMHM's Professional Standards Group, providing accounting knowledge leadership in theareas of derivative financial instruments, share-based compensation, fair value, leasing,p grevenue recognition and others.

Mike's experience includes over 14 years with a Big Four firm where he was responsiblefor client service for large and small SEC filers and non-public entities audit/accountingfor client service for large and small SEC filers and non-public entities, audit/accountingtechnical expertise and training instruction and delivery.

Speaker BiographyTim Woods CPATim Woods, CPA

Shareholder, Mayer Hoffman McCann P.C.

720.200.7000

[email protected]

A member of MHM’s Professional Standards Group, Tim is a subject matter expert for derivatives and hedge accounting. He also has extensive experience in leasing transactions, fair value, stock-based compensation and complex debt & equity transactions. Tim's experience includes five years at a Big Four firm and five years as a Controller and CFO for companies in the financial services industry.

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Derivatives and Hedging - Mayer Hoffman McCann PC

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