Cash Flow Hedge Basics, Interest Rate Swap Valuations & Foreign Currency Topics. Presented By: Ruth Hardie & Jim Shepard

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1 Cash Flow Hedge Basics, Interest Rate Swap Valuations & Foreign Currency Topics Presented By: Ruth Hardie & Jim Shepard

2 Agenda CNH vs. CNY: ASC 830 & ASC 815 Implications Valuing an Interest Rate Swap under ASC 820 Economic Hedging: Using Net Investment Hedges to Fix Economic Imbalances Basics of Cash Flow Hedge Accounting

3 CNH vs. CNY and ASC 830 & 815

4 CNH vs. CNY and (Yuan & Renminbi) Renminbi (People s Currency) vs. Yuan (Round Object) CNY: On-Shore Chinese Currency Market Not readily convertible outside China USD Peg Maintained and Regulated by Government CNH: Off-Shore (Hong Kong) Chinese Currency Market Deliverable Market (Exchange CCY for CNH and Vice Versa) Price driven by private supply/demand but tracks CNY closely

5 CNH vs. CNY & ASC 830 For years companies have used CNY as their BSR ASC 830 (FAS 52) Says In the absence of unusual circumstances, the exchange rate applicable to conversion of a currency for purposes of dividend remittances shall be used to translate foreign currency statements.

6 CNH vs. CNY & ASC 830 If Multiple Rates Existed FASB Concluded: The Dividend/Cash Conversion Rate- is more meaningful than any other rate because cash flows to the reporting enterprise from the foreign entity can be converted at only that rate, and realization of a net investment in a foreign entity will ultimately be in the form of cash flows from that entity.

7 CNH vs. CNY & ASC 830 So what s the best BSR? CNY or CNH? Before you answer let s look at ASC 815 implications

8 CNH vs. CNY & ASC 815

9 CNH vs. CNY & ASC 815 Assume CNY is the BSR Hedging with Deliverable CNH Forward Contract Non-designated (BS) hedges protect against large movements

10 CNH vs. CNY & ASC 815 But What about Hedge Accounting? Can I use a CNH Hedge against a CNY Exposure? Why not, they move together right? Under ASC 815 One Must Prove Effectiveness Interestingly CNH/EUR vs. CNY/EUR works well CNY/USD vs. CNH/USD does not work well Changes are not Correlated Due to the Peg

11 CNH vs. CNY: Spot Changes R² =

12 Conclusion Align Currencies if Taking Hedge Accounting Hypo and Derivative cannot be Assumed to be the Same Take a Fresh Look into your Balance Sheet Rate Setting Methodology We have heard that the markets may combine into a single market at some point

13 Interest Rate Swap Valuation

14 Interest Rate Swap A contract where participants agree to exchange interest payments in the future. A typical interest rate swap has one party paying a fixed rate and the other party paying a variable rate. No out-of-pocket costs for a vanilla interest rate swap Hedgers use IR Swaps to exchange one rate type for another

15 Vanilla IR Swap Mechanics 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed interest on $10M A pays B fixed interest on $10M A pays B fixed interest on $10M A pays B fixed interest on $10M A receives 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M

16 Net Impact of Swap Trade) The red arrows represent Fixed payments to the counterparty The black arrows represent predicted LIBOR payments to the Company

17 Swap and Debt Combined 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed interest on $10M & pays C 3M LIBOR interest on $10M A pays B fixed interest on $10M & pays C 3M LIBOR interest on $10M A pays B fixed interest on $10M & pays C 3M LIBOR interest on $10M A pays B fixed interest on $10M & pays C 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M A receives 3M LIBOR interest on $10M

18 Net Impact Swap & Debt (ignoring credit spread) 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays fixed interest on $10M A pays fixed interest on $10M A pays fixed interest on $10M A pays fixed interest on $10M

19 Credit Valuation Adjustment Static Method Most common PV all projected cash flows using counterparty credit when in asset position & Company credit when in liability position Potential Method More complicated, requires a modeling system & uses both counterparty and Company credit 19

20 Fair Value of Inception Fixed Pmts Variable Pmts Net Pmts 31-Mar , , , Jun , , , Sep , , , Dec , , , Mar , , , Jun , , , Sep , , , Dec , , , Mar , , , Jun , , , Sep , , , Dec , , , Mar , , , Jun , , , Sep , , , Dec , , , Mar , , , Total -6,027, ,027,

21 Fair Value Changes due to time 21

22 Economic Hedging with Net Investment Hedges

23 To Hedge or Not to Hedge? Common Scenario Cash builds over time at LC subs Holding LC cash is risky economically (USD Value) Holding USD cash creates accounting risk (P&L) Treasuries must decide how to mitigate both risks to benefit stakeholders 23

24 Uneconomic Balance Sheet Hedge If company holds LC cash Re-measurement of the LC balance is not required Accounting risk is mitigated (P&L) LC cash remains an economic risk to company Cash balances in USD value fluctuate with offset to equity Accounting risk mitigated but economic risk remains 24

25 Uneconomic Balance Sheet Hedge If LC company holds USD cash The re-measurement of the USD balance is reported on P&L Companies want to protect P&L so USD balance is hedged (synthetically converted to local currency) to mitigate the P&L exposure USD balances are then translated back into USD with changes reported in Equity Accounting risk mitigated at the expense of creating economic risk 25

26 Hedging USD is Un-Economic USD Hedge: P&L CR 100K Hedge USD CASH Translates to USD CTA: CR 100K 26 USD CASH in Bank USD Re-Measures to Local P&L: DR 100K

27 Solves FX but not the Economics USD Hedge: P&L CR 100K Hedge USD CASH Translates to USD CTA: CR 100K 27 USD CASH in Bank USD Re-Measures to Local P&L: DR 100K

28 Dilemma Company forced to chose between: A hedge of a non-economic risk (speculating?) or Not hedge and explain to analysts that the P&L volatility is not economic 28

29 Solution Restore economics to a corporation s hedge program by addressing both the accounting and the economics In addition, the cost of hedging and the notional amount of outstanding hedges will be greatly reduced 29

30 Solution Mechanics Hedge the USD exposure as part of a standard balance sheet hedge program Restore economics by entering into an offsetting Net Investment of Foreign Operations hedge* Notional amount of the hedge cannot exceed foreign net monetary asset/liability position of the foreign subsidiary *Simultaneously trade the long and short positions as a swap to eliminate buy-sell spreads 30

31 Restoration Swap Optics Balance Sheet Hedge Restoration Swap P&L: CR 100K Translates to USD CTA: CR 100K Net Investment Hedge Restoration Swap CTA: DR 100K 31 USD CASH in Bank USD Re-Measures to Local P&L: DR 100K

32 Results of Restoration Swap P&L volatility addressed Derivatives no longer creating exposures Cost of hedging reduced Economic exposure hedged 32

33 Hedge Accounting Basics

34 The Hedger s Problem Period Period 1 2 Total Exposure Derivative (31) (31) P&L (31) 30 (1) 34

35 Cash Flow Hedging Cash Flow Exposures: Variable rate assets or liabilities Anticipated transactions Sales COGS Future fixed rate debt issuance

36 The Hedger s CF Solution Cash Flow Hedge Period Period 1 2 Total Exposure Derivative (31) (31) P&L (31) 30 (1) 36

37 The Hedger s CF Solution Ineffectiveness Period Period 1 2 Total Exposure Derivative (1) (30) (31) P&L (1) 0 (1) 37

38 Cash Flow Hedges The effective portion of derivative s gain/loss is reported in other comprehensive income (OCI); the ineffective portion is reported in earnings

39 Cash Flow Hedges Qualifying Criteria At inception, formal documentation of hedge relationship, entity s risk management objective and strategy, including the risk being hedged and how effectiveness will be measured At inception and ongoing, relationship must be expected to be highly effective in achieving offset consistent with risk management strategy

40 Cash Flow Hedges Qualifying Criteria Hedged Item A single transaction or series of individual transactions sharing the same exposure The forecasted transaction is probable and is a transaction with an external party (FX has exception) Transaction described with sufficient specificity

41 Derivative Terminated Early Hedged Item still exists or anticipated: Hedge activity recorded prior to termination is not impacted OCI from period when last effective will remain and be released as hedged item impacts earnings

42 Exposure Terminated Early Hedged Item no longer possible All accumulated OCI from prior period impacts earnings If derivative remains outstanding, subsequent changes impact earnings, unless re-designated

43 Thank You

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