Accounting and Financial Reporting for Derivative Instruments

1. Accounting and Financial Reporting for Derivative Instruments

2. Derivatives Notional amounts outstanding, 1987-present $683.7 trillion in June 2008 Source: International Swaps and Derivatives Association, Inc., 2008

3. Types of Derivatives that Accountants Encounter % of notional amounts outstanding – as of June 2008 – Source Bank for International Settlements

4. Executive Summary of GASB Statement No. 53 • Complex statement that: • Defines derivatives and exclusions. • Presents requirements for recognition and measurement of derivatives. • Describes and calculates hedge accounting, efficient and inefficient hedge accounting. • Contains a full set of examples and note disclosures, as well as transition guidance. • Supersedes Technical Bulletin 2003-1. • Amends pieces of Statement Nos. 7, 23, 25, 31, 40 and 43.

5. Executive Summary of GASB Statement No. 53 • What is a derivative? • It is a contract that has settlement factors which could be • one or more reference rates. • notional amounts. • payment provisions or any combination. • It has leverage. • It can be settled net.

6. Executive Summary of GASB Statement No. 53 • What are settlement factors? • Reference Rate – an interest rate, security price, commodity price, exchange rate, other variables. • Notional Amount(s) – the face amount of the contract, which includes the number of units, shares, bushels, pounds, etc.

7. Executive Summary of GASB Statement No. 53 • Requirements of the statement: • Derivatives should be reported on the statement of net assets at fair value except for synthetic guaranteed investment contracts. • Unless hedging derivative, changes in fair values are part of investment revenue in statement of activities, changes, etc. • If hedging, then changes are deferred inflows or outflows. • If hedged derivative is terminated, P&L event.

8. Executive Summary of GASB Statement No. 53 • How to measure fair value: • Market price if there is a market. • Discounted expected cash flows. • One of a number of different pricing models and methods. • IF using a pricing service and the method to calculate is NOT disclosed by the service, then management must make an assessment of propriety based on the information received.

9. Executive Summary of GASB Statement No. 53 • Termination occurs when: • Hedging derivative not effective. • Government becomes exposed to adverse changes in fair values or cash flows. • Hedged asset or liability is sold or retired, refunded or defeased. • Derivative is terminated. • Forward transaction occurs (e.g., sale of bonds or purchase of commodity). • Reporting – investment revenue, balance sheet activity caption “increase (decrease) upon hedge termination.”

10. What is a hedge? • A hedgeis a contract entered into to reduce some form of risk in cash flows or fair values. • Hedges that accomplish the goal of reducing risk as expected are commonly referred to as effective.

11. What is a hedge? • It must be associated with a hedgeable item • Asset, liability, expected transaction (swaption, forward, etc.) • Notional amount = principal amount. • Derivative is in the same fund as hedgeable item. • Term or time period is consistent between derivative and hedgeable item. • It is effective in reducing the risk.

12. How to evaluate effectiveness? • Initial year: • If terms of derivative (years, amounts, rates) are consistent with debt, asset etc., then automatically effective – known as consistent critical terms. • If inconsistent, then at least one of many quantitative methods must be used. • Subsequent years: • Use the same method as first year, but can use other method. • Evaluation of effectiveness is done by measuring cash flows or overall changes in fair values.

13. How to evaluate effectiveness? • Quantitative methods include: • Synthetic instrument method (combine debt cash flows and derivative to create a third item). • Dollar offset method (measure changes in expected cash flows). • Regression analysis method (statistical relationship between debt and derivative changes). • Can use other quantitative methods.

14. Synthetic instrument method Dollar Offset Regression analysis Synthetic rate should be within 90% - 111% of fixed rate. Derivative cash flows 80% - 125% of debt. R2 (measure of the proportion of the variance in a dependent variable about its mean that can be explained by changes in the independent variable.) must be ≥ 0.80. F-statistic (confidence level) must have 95% confidence. Corridor must be80% - 125% of debt. Effectiveness Corridors

15. Note Disclosure • Summary table of information: • Organized by governmental, BTA, fiduciary funds: • Subdivisions for hedging derivatives and investment derivatives. • Within each category – aggregate information by type (received fixed swaps, pay fixed swaps, swaptions, caps, basis swaps, futures, etc.).

16. Example 1 -- Calculating Effectiveness • Assumptions: • Auction rate bonds issued for $100MM on 7/1/xx. Bonds mature 6/30/x4. • Semiannual coupons reset weekly. • On 7/1/xx, the government enters into a $100MM, notional, pay fixed, receive variable swap that terminates 6/30/x4. FMV at 7/1/xx=$0. • Semiannual variable payment reset weekly. • The variable payment is 49.96% of LIBOR + 78 basis points. • The fixed payment is 3.58782%.

17. Step 1 – Diagram the transaction Fixed pay 3.57872% Government Counterparty Variable receive – 49.96% of LIBOR + 78bps Auction rate paid Note that the actual synthetic rate paid will vary depending on the difference between the auction rate paid and the variable rate received. Bondholders

18. Step 2 -- Calculate the cash flows and values

19. Step 3 -- Divide and measure From Assumptions Since these are between 90 and 111%, then derivative is effective – changes reflected only in statement of net assets.

20. Journal Entries – HIGHLY SIMPLIFIED – Year 1

21. Journal Entries – HIGHLY SIMPLIFIED – Year 2

22. Journal Entries – HIGHLY SIMPLIFIED – Year 4 (final year)

23. What if the swap terminates? • What if in the 3rd year, the state passes a change in taxes that causes the swap to no longer be effective? What happens? • Assume the same facts in the previous illustration.

24. Step 2 -- Spreadsheet the cash flows and values Way out of corridor (2.81% ÷ 3.58% = 78.49%)

25. What if the swap terminates? • In year 4 • Change in fair value now a component of investment income / expense. • Any deferred outflows / inflows also become a component of investment income / expense (no more statement of net assets account).

26. Example 2 – A Swaption • Assumptions: • A state enters into a swaption with an investment bank; the bank has the right, but not the obligation, to force the state to enter into a pay-fixed, variable rate swap in the future. • The state receives an up-front payment of $11,016,200 on 7/1 of year 0. • The fixed rate the state receives is above the market rate - 5.5%. • The 2-year forward rate is 3%. • The variable rate is SIFMA. • The notional amount is $100 million. • The swap may have a volatility of up to 30%. • At year 1, the one year forward rate is 2.85%. • At year 2, the rate is 2.80%. • The day after year 2, the bank exercises its option; the rate continues to be 2.80%.

27. Example 2 – A Swaption Fair value is calculated by taking the net present value of the cash flows at 3%. Fair value of the derivative is the swaption, less the borrowing. The change in fair value is the current year’s less the previous year’s fair value.

28. Example 2 – A Swaption The beginning balance is the original fair value of the borrowing. The interest accrual is the beginning fair value x 3% x (180/360). The swap payments are after the exercise date. Ending balance = beginning + interest – payments. The $1,250,000 starts in 2½ years until maturity.

29. Example 2 -- A Swaption

30. Statement of Net Assets Presentation for Swaption and Swap Not supposed to foot unless counting statement of activities

31. Statement of Net Assets Presentation for Swaption and Swap Not supposed to foot unless counting statement of net assets

32. Journal Entries – HIGHLY SIMPLIFIED

33. Journal Entries – HIGHLY SIMPLIFIED

34. Journal Entries – HIGHLY SIMPLIFIED

35. Note Disclosure • Summary table of information • Information includes: • Notional amounts. • Changes in fair value and where it is reported in the financial statements. • Fair values at the end of the year. • Reclassifications from hedging to investment derivatives during the period. • Deferral amounts in investment revenue. • Can be narrative if small number of contacts.

36. Note Disclosure • Narratives include: • Objectives of derivatives. • Terms of derivatives include: • Notional amounts. • Reference rates, indexes, etc. • Any embedded options (caps, floors collars). • Date of contract and termination or maturity. • Any cash paid or received. • TB 2003-1 risks (credit, interest rate, basis, termination, rollover, market access, foreign currency).

37. Note Disclosure • Other: • Hedged debt: follow GASB 38, disclose net cash flows. • If using other quantitative method identify any notable features of the method. • Investment derivatives: • TB 2003-1 disclosures along with GASB 40 disclosures.

38. Note Disclosure – June 30, Year 1

39. Disclosure • After table, note the following: • Terms not in table. • How fair values were calculated. • Risks and ratings of counterparties. • Contingencies on derivatives. • Table of all payments and hedged debt.

40. Disclosure – 2nd table

41. Transition • For financial statements for periods BEGINNING AFTER June 15, 2009. • Retroactive application for all periods presented. • Perform hedge effectiveness evaluation as of the END of the CURRENT PERIOD ONLY. If effective now, assume effective as of the beginning of the contract.

42. Other items included in the Statement • Huge (11 page) glossary. • 12 robust illustrations: • Consistent critical terms. • Interest rate swaps – synthetic method. • Interest rate swaps – terminations due to market conditions. • Regression analysis. • Dollar offset method.

43. Other items included in the Statement • 12 robust illustrations (continued): • Swaptions. • Full set of note disclosures. • Flowchart of hedge effectiveness decisions. • Codification instructions. • Still to Come – Implementation Guide – Watch for it in 2009!

44. Questions? Contact Information: Eric S. Berman, CPA Deputy Comptroller Commonwealth of Massachusetts Eric.berman@state.ma.us 617-973-2602