Interest Rate Fair Value Hedges

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1 Interest Rate Fair Value Hedges Managing the Basis Adjustment By: Peter Seward, Vice President of Product Strategy, Reval April 15, 2009 CONTENT Executive Summary Introduction The Problem The Solution Effective Yield Amortization Conclusion

Strategy, Reval April 15, 2009 CONTENT Executive Summary

2 Executive summary Accurate accounting for a fair value hedge over the life cycle of a debt instrument requires an understanding of fair value basis adjustment calculations and how to ensure it is clearedout by maturity of designation of a fair value hedge. This paper explains the basis adjustment and methods for ensuring that it is fully amortized of the life of a hedge. Introduction There s no short cut to managing the basis adjustment for interest rate fair value hedges. The longhaul method for fair value interest rate hedges requires hedgers to assess the effectiveness of changes in a receive-fixed for pay-floating interest rate swap and the designated risk of fixed rate debt. The designated risk is either the full fair value (para 21(e) of FAS 133), or fair value changes, to changes in the benchmark LIBOR rate (para 21(f)(2) of FAS 133). Reval calls the designated portion of the hedged instrument the mark-to-risk (MTR), i.e. that part of the debt that is hedged. If a hedge is assessed as being effective then the periodic change in the derivative is offset by the periodic change in the MTR. This offset is known as the basis adjustment. In accounting terms, the derivative is marked to profit and loss as an unrealized gain/loss with a contra entry to a balance sheet asset/liability account. At issuance the principal of the debt would have been booked at par to a balance sheet liability account and cash. Assuming the hedge is assessed as being effective each period, the balance sheet liability account will be adjusted by the periodic change in the MTR (basis adjustment) with a contra entry to the profit and loss unrealized gain/loss account, and so on. Life seems simple! About the author Peter Seward is the Vice President of product strategy at Reval and is responsible for the strategic direction of the Webbased SaaS offering, Reval, and Reval s outsourced valuation service, Reval Center. He has established Reval s outsourced hedge accounting service, which has grown exponentially, and has also written Reval s IAS 39, IFRS 7 and FAS 161 Doctors. Peter has over 15 years experience with financial services software in Asia Pacific, Europe and North America. Prior to Reval, Peter was a Sales Engineer at Principia Partners and has also worked for Integrity Treasury Systems in both Sydney and Chicago as an Implementation Consultant and Custom Development Project Manager and Rabobank Australia in Sydney as Manager of Treasury Systems. He holds a Bachelor of Science in Mathematics and Economics from the University of Western Australia.. The author can be reached at: peter.seward@reval.com Reval.com, Inc. All Rights Reserved 2

Introduction There s no short cut to managing the basis adjustment for interest rate fair value hedges.

3 When maturity is reached and the swap and debt mature, the swap fair value will be zero and debt fair will be par. If the swap had an initial fair value of zero then the cumulative change in unrealized gains will be zero. Since the debt is going to be paid off at par, and the liability extinguished, we would hope that the cumulative basis adjustment will also be zero. But will it be? The short answer is, probably not! The Problem To see this, consider the starting and ending values of the MTR (and not the debt). The ending value is par and the starting value will be the amount calculated at the inception of the hedge. Note that this is not the historical cost of the debt (par) at which the liability was booked. It is simply a starting value from which we calculated periodic changes in the MTR. This MTR is calculated by discounting the hedged cashflows using a risk-free zero curve. Corporate debt is always issued at a spread to the risk-free curve, so it would be expected that the full fair value including credit is greater than par, and the fair value excluding credit would be close to par. In either case it is not guaranteed to be par, so the final cumulative basis adjustment will not be zero. As the debt is being terminated, the liability account will be cleared and will no longer be accounted for. The fact that we have cumulative basis adjustment in the liability account will therefore make no sense. The situation is clearer with a late hedge (debt that has been in place for some time). Very clearly the starting MTR would not be expected to be par as LIBOR rates and corporate credit would have moved from the time of issuance. The swap, on the other hand, will start at zero and end at zero. In this case the cumulative basis adjustment will not be zero. If the hedge falls out of effectiveness on a monthly basis, and a corporate reports quarterly, auditors may allow the hedge relationship to continue with only periods where it was effective being adjusted. This will also result in the cumulative basis adjustment being non-zero at maturity. Again the situation appears with an early termination or prepayment of debt. About Reval Reval is a leading, global Software-as-a-Service (SaaS) provider of comprehensive and integrated Treasury and Risk Management (TRM) solutions. Our cloud-based software and related offerings enable enterprises to better manage cash, liquidity and financial risk, and includes specialized capabilities to account for and report on complex financial instruments and hedging activities. The scope and timeliness of the data and analytics we provide allow chief financial officers, treasurers and finance managers to operate more confidently in an increasingly complex and volatile global business environment. Using Reval, companies can optimize treasury and risk management activities across the enterprise for greater operational efficiency, security, control and compliance. Founded in 1999, Reval is headquartered in New York with regional centers across North America, EMEA and Asia Pacific. For more information, visit or info@reval.com Reval.com, Inc. All Rights Reserved 3

Since the debt is going to be paid off at par, and the liability extinguished, we would hope that the cumulative basis adjustment will also be zero. But will it be? The short answer is, probably not!

4 The early de-designation of a fair value hedge relationship where debt is not repaid is a separate situation where accumulated basis adjustments are amortized over the remaining life of the debt. The Solution The obvious solution is to clear the total basis adjustment by maturity of a hedge relationship. There are at least two ways to do this: Either make sure the MTR is the same at maturity as it was at designation (finish where you start), or make sure all of the adjustments made over the life of the hedge are reversed out (cover your tracks). Choosing the second method (cover your tracks) has the extra benefit of not needing to know where the MTR started; therefore, it has applicability in more of the situations described above. This method is implemented in straight line and effective yield versions. Straight Line Amortization Reval does the following: After the second period of basis amortization, Reval sums the cumulative basis adjustment to the end of the prior period and then amortizes this amount in the next period in proportion to the remaining number of periods expected in the hedge relationship. For example, assume the debt will run for 10 periods: 2009 Reval.com, Inc. All Rights Reserved 4

There are at least two ways to do this: Either make sure the MTR is the same at maturity as it was at designation (finish where you start), or make sure all of the adjustments made over the life of

5 The amount of 2.11 in Period 5 is calculated as follows: Add the periodic changes in MTR from Periods 1 to 4 [ =- 16]. To this add the sum of the prior Basis Adjustment Amortizations [ =3.36]. This gives = This is the amount that needs to be amortized. As there were six periods left at the start of Period 5, the Basis Amortization Adjustment for this period is (-12.64)/6 = 2.11 (rounded). The sign is reversed as the needs to be reversed out. This calculation is repeated each period until the last. In the last period, in addition to this calculation, the final periodic change in MTR is also reversed out. Effective Yield Amortization In this method, from the second period onwards, all prior period basis adjustments are summed and added to the face value of the debt. This amount is expressed as a clean price per 100 and a yield to maturity implied from the cashflows. At each period-end the debt is then priced at the beginning and end of the period at the same yield. The difference is the periodic basis adjustment amortization. In the next period, the process is repeated again; a yield is implied and priced at the start and at the end of the period, the difference being the amortization for the period. The result is close to that for the straight-line method. In the final period, a cleanup occurs, so that the total basis adjustment is zero over the life of the hedge. Conclusion The quantitative and risk aspects of hedge accounting must always be consistent with the accounting requirements. A thorough understanding of both is required to ensure hedge accounting solutions meet front and middle office requirements Reval.com, Inc. All Rights Reserved 5

As there were six periods left at the start of Period 5, the Basis Amortization Adjustment for this period is (-12.64)/6 = 2.11 (rounded). The sign is reversed as the -12.64 needs to be reversed out.

Interaction of FAS 157 with FAS 133:

Interaction of FAS 157 with FAS 133: The Second Wave By: Peter Seward, Vice President, Product Strategy, Reval June 2, 2009 CONTENT Executive Summary Introduction FAS 157 Fair Valuations Impact on FAS