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SFAS 133 Implementation
Identifying Derivatives
Marjorie Marker
(May 25, 2000)
© 2000 Arthur Andersen All rights reserved.
Session Objectives
•
Identify derivatives as redefined by FAS 133
•
Explain valuing freestanding and embedded derivatives
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Derivative Instruments as Redefined by FAS 133
•
Key Characteristics
– Underlying and notional amount/payment provisions
– Little or no initial net investment
– Net settlement
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Key Characteristics:
Underlying and notional amount/payment provisions
Change in Underlying
X
Notional Amount/Payment
Provisions
=
Settlement
Amount
Settlement Amount
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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
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
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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
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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
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Items Excluded 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)
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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
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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
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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
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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
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Accounting for Embedded Derivatives:
Is Bifurcation Required?
Bifurcation: To B or Not to B?
Yes
No
“Clearly
and closely
related”?
Yes
No
Feature is
a derivative?
No
Stop. Do not bifurcate.
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Yes
Bifurcate
Hybrid at
FV through
earnings?
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
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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...
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Types of Statement 133 Hedges
Fixed-Rate Assets
Fixed-Rate Liabilities
Firm Commitments
Floating-Rate Assets
Floating-Rate Liabilities
Forecasted Transactions
Cash
Flow
Hedges
FX-Denominated
Forecasted Transactions
(Third Party or Intercompany)
Fair
Value
Hedges
Foreign
Currency
Hedges
FX-Denominated
AFS Securities or
Firm Commitments
Net Investments in Foreign Operations
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Accounting for FAS 133 Derivatives
Fair Value Hedges
Measurement of Derivative
Change in Fair Value*
1
Measurement of Hedged Item
Gain in Loss Attributable to
Risk Being Hedged†
Earnings
1
* Hedge ineffectiveness (forward points or time value)
always is reported currently in earnings.
† Pre-existing
gains or losses are unaffected.
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Accounting for FAS 133 Derivatives
Fair 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
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Accounting for FAS 133 Derivatives
Cash Flow Hedges
Measurement of Derivative
Change in Fair Value*
Equity†
1
2
Measurement of Hedged Item
Earning Effects
Earnings
2
(interest, cost of sales, depreciation)
* 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.
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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
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Accounting for FAS 133 Derivatives
Net Investment Hedges
Measurement of Derivative
Foreign Currency
Transaction Gain or Loss
1
Measurement of Net Investment
Foreign Currency
Transaction Gains and Losses
Equity†
1
† Display
in “other comprehensive income” as part of
the cumulative translation adjustment.
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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
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Valuation of Free-Standing
and Embedded Derivatives
Jitendra D. Sharma
(May 25, 2000)
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
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Embedded Derivatives -The Bifurcation Decision in Three Steps
Yes
No
“Clearly
and closely
related”?
Yes
No
Feature is
a derivative?
No
Stop. Do not bifurcate.
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Yes
Bifurcate
Hybrid at
FV through
earnings?
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
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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
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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
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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
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Market-Based Derivatives
Examples
Instrument Type
Futures
Options
Money Market / Depos
X
X
X
X
X
X
X
X
X
X
X
X
X
Interest Rate
Currency
U.S. Treasury Bills,
Notes and Bonds
Equity
Commodities
Index
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Options Forwards
on Futures
X
X
X
X
X
X
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Swaps
X
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
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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
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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
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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
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