How To Hedge With An Interest Rate Swap

Transcription

1 The accounting rules governing derivatives are covered in FASB Accounting Standards Codification ( FASB ASC ) Topic 815 Derivatives and Hedging. Derivatives must be measured and reported at fair value. Changes in market interest rates will affect the fair value of the derivative thus potentially creating volatility in earnings. A credit union that enters into a derivative contract can manage this volatility in one of two ways - it can elect hedge accounting, or it can elect fair value accounting for the financial asset or liability being hedged. Each choice has advantages and disadvantages which we detail below. We begin with fair value hedge accounting. We next contrast fair value hedge accounting with the election of fair value for the financial instrument. Finally, we walk through cash flow hedge accounting. Our hedge accounting discussion includes specific examples to achieve the desired outcome of less income statement volatility. Hedge accounting is done under one of two methods - the fair value method or the cash flow method. Under the fair value method, the gain or loss on the hedging instrument (the derivative), as well as the gain or loss on the hedged item, are recognized in current earnings. With cash flow hedges, the effective portion of the hedge is reported in other comprehensive income while the ineffective portion is reported in current earnings. To qualify for hedge accounting, the hedge must be "effective". Effectiveness is a measure of how closely the change in the value of the derivative matched the change in the value of the financial instrument being hedged. The type of hedge accounting selected depends on the nature of the item being hedged. Fair value hedges are used for existing financial assets and liabilities. For example, a credit union that wants to hedge against the decrease in the fair value of a fixed rate loan rate loan portfolio due to increases in market interest rates, can enter into a fair value hedge. One alternative is to enter into an interest rate swap agreement in which the credit unions pays a fixed rate of interest and receives a floating rate of interest. If market interest rates increase, the fair value of the loans will decrease and the fair value of the swap will increase. The change in each will run through the income statement. By way of contrast, cash flow hedges are used for forecasted transactions or to hedge against changes in floating rate cash flows on existing financial assets or liabilities. For example, let's assume that a credit union wants to hedge against an increase in the cost of its floating non-maturity deposits. It can enter into an interest rate swap in which it pays fixed and receives floating. In this case, the credit union will designate the transaction as a cash flow hedge. It is hedging against an increase in the forecasted payments to its members.

2 WW Risk Management notes that hedge accounting is elective and is specific. FAS ASC 815 is intended to prevent achieving hedge accounting results when using macro-hedges. Hedge Documentation Hedge accounting requires formal designation and documentation at inception. Thus, before a credit union enters into a derivatives transaction it must detail its objective and strategy for the hedge, including the: Hedging instrument to be used - the derivative (interest rate swap, interest rate floor, etc.) Hedged item or transaction- the financial asset or liability being hedged Nature of the risk being hedged - interest rate risk Method that will be used to retrospectively and prospectively measure the hedge's effectiveness Method that will be used to measure hedge ineffectiveness Benchmark interest rate being hedged WW Risk Management notes that eligible benchmark interest rates under FAS ASC 815 include only: United States Treasury rates Federal Funds effective swap rate LIBOR In addition for cash flow hedges, a credit union must provide the following information about forecasted transactions: Date on which transaction will occur Specific nature of asset or liability Quantity of the forecasted transaction Hedging Instrument The NCUA rules authorize credit unions to use the following derivatives only: Interest rate swaps An agreement to exchange future payments of interest on a notional amount at specific times and for a specific time period Interest rate caps A contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate rises above the level specified in the contract Interest rate floors A contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate falls below the level specified in the contract 2

3 Basis swaps An agreement between two parties in which the parties make periodic payments to each other based on floating rate indices multiplied by a notional amount Treasury note futures A U.S. Treasury note financial contract that obligates the buyer to take delivery of Treasury notes (or the seller to deliver Treasury notes) at a predetermined future date and price. Futures contracts are standardized to facilitate trading on an exchange For GAAP, a derivative instrument is defined as a financial instrument or other contract with all of the following characteristics: Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required: o One or more underlyings o One or more notional amounts or payment provisions, or both. Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. Net settlement. The contract can be settled net by any of the following means: o Its terms implicitly or explicitly require or permit net settlement. o It can readily be settled net by a means outside the contract. o It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. 1 WW Risk Management believes all of the derivatives permitted by the NCUA meet the definition of a derivative under GAAP. NCUA Derivatives Limits Once an eligible federal credit union thoroughly understands the risks it wants to hedge, the hedge instruments it plans to use, and the accounting implications related to hedge accounting, it can seek approval from the NCUA to undertake a derivatives program. A credit union's approval request must include a: Demonstration on how derivatives function within the credit union s interest rate risk management mitigation plan Demonstration on how the credit union will control and manage the derivatives process from a resources and systems perspective 1 FAS ASC

4 After the NCUA grants derivative authority, a credit union operates for one year under entry limits. Thereafter, standard limits apply. The limits relate to permissible notional amounts and fair value losses. The notional amount limitation takes into account the type of derivative and the time to maturity. The notional amount functions as a prospective limit while the fair value loss limit accounts for the credit union's actual experience. The fair value loss limit is calculated by summing the fair values of the credit union's outstanding derivatives. WW Risk Management notes that while gains on derivative contracts can offset losses on other derivative contracts, the credit union does not include the change in the value of the hedged item(s) in the calculation. The fair value loss limits are 15% of net worth under the entry limits, and 25% of net worth under the standard limits. The Weighted Average Remaining Maturity Notional (WARMN) limits are set at 65% of net worth under the entry limits and 100% of net worth under the standard limits. The calculation is shown below. Step #1 Gross Adjust Factor Product National (Percent) Step #2 Adjusted Notional Step #3 WARM Options (Caps) Current notional 33 33% of current notional Time remaining to maturity Options (Floors) Current notional 33 33% of current notional Time remaining to maturity Swaps Current notional % of current notional Time remaining to maturity Futures Contract size % of contract size Underlying contract Sum = Total adjusted notional Sum = Overall WARM WARMN = Adjusted notional *(WARM/10) WW Risk Management notes that the calculation is cumulative and a credit union cannot net offsetting derivatives transactions when making the calculation. Hedged item Under hedge accounting, a credit union must identify the item to be hedged. We believe that the hedged item will generally be an existing financial asset or liability or the floating rate payments on an existing financial asset or liability. Nature of the Risk Being Hedged WW Risk Management believes that the risk being hedged through the use of these derivative instruments is interest rate risk. 4

5 Hedge Effectiveness We believe determining hedge effectiveness is the by far the most complex part of FAS ASC 815. To qualify for hedge accounting, the hedging relationship, both at inception of the hedge and on an ongoing basis, shall be expected to be highly effective in achieving either of the following: Offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated (if a fair value hedge) Offsetting cash flows attributable to the hedged risk during the term of the hedge (if a cash flow hedge) Hedge effectiveness can be measured using a dollar offset approach or statistical methodologies. The dollar-offset method compares the changes in the fair value or cash flow of the hedged item and the derivative. The following table reflects an example of the dollar-offset method which compares the change in fair value of an interest rate swap to a group of investments held AFS. Market Rate Net Swap Change in Change in Change From Swap Fair Swap Investments Dollar Effective Month Inception Payment Value Fair Value Fair Value Offset % (y / n) Mo. 0 0 bps 0 Mo bps (68,950) (166,293) (166,293) 140, % yes Mo bps (71,327) (214,920) (48,627) 65, % no Mo bps (73,705) (371,804) (156,884) 150, % yes Mo bps (71,488) (181,349) 190,455 (140,757) 135.3% no Mo bps (62,835) 437, ,538 (625,865) 98.8% yes Total (348,305) 437,189 (410,361) 106.5% yes The dollar-offset method can be applied either period by period (which cannot exceed 3 months) or cumulatively. For a perfect hedge, the change in the value of the derivative exactly offsets the change in the value of the hedged item. Therefore, the ratio of the cumulative sum of the periodic changes in the value of the derivative and the cumulative sum of the periodic changes in the value of the hedged item would equal one in a perfect hedge (after multiplying the ratio by negative one to adjust for the two sums having opposite signs in a hedging relationship). Of course, not all hedges will be perfect. FAS ASC 815 does not specify the precise percentage range that would be considered highly effective under the dollar offset method. In practice, most believe that a dollar offset range of 80% to 125% would be considered to be highly effective. For example, assume the fair value of the asset being hedged declines by $100,000. To be considered highly effective, the fair value of the hedge would have to increase by at $80,000 and no more than $125,000. In this case, we can see the benefit of measuring the changes on a cumulative basis, because while the hedge results are outside the 80% to 125% limits in months 2 and 4, the hedge is within the limits when measured for all time periods. Electing to utilize a regression or other statistical analysis approach instead of a dollar-offset approach to perform the assessment of hedge effectiveness may permit a credit union to apply hedge accounting for the current period, even though from a dollar-offset approach the hedge appears to be ineffective. To the extent the analysis shows the hedging relationship will be highly effective in offsetting changes in fair 5

6 value or cash flows in future periods, the credit union can continue to apply hedge accounting even though the hedging relationship was ineffective for the reporting period being evaluated. WW Risk Management notes that the statistical approaches can be complex to implement and require multiple observation periods. In our experience, the regression analysis must include the following elements: It must have a minimum of 30 observations The credit union must examine the relationship between the changes in the value of the hedged item and the derivative It must have a time horizon that coincides with, or is less than, the time horizon of the hedge relationship The credit union must consider whether the data should be regressed on value changes or value levels in order to avoid distortion The credit union must review the distribution of the error terms and consider autocorrelation The regression produces an R-squared that exceeds a pre-specified level such as 0.80 The hedge ratio of the hedging relationship must correspond to beta (the slope of the regression line) The standard error of the estimate is used to calculate reliability using the t-statistic The t-test is passed for the regression coefficient at a 95% confidence level The y-intercept is considered as part of the analysis The regression results are related to the actual hedge and compared to the dollar offset results As an example, an R-squared analysis can be performed by examining actual dividend or deposits rates and a benchmark interest rate such as 1-month LIBOR Mo LIBOR Line Fit Plot 1.40 Dividend Rate Div. Rate Predicted Div. Rate Mo LIBOR In this example, the R-squared result was.82. Since the R-squared result exceeds the predetermined.80 threshold for determining effectiveness, the hedge is considered to be effective. 6

7 WW Risk Management notes that the simpler dollar-offset method can be used when the potential changes in the fair value of the derivative would be less material (e.g. relatively small notional amount and/or relatively short term). Conversely, a credit union could benefit by undertaking the more complex statistical method when the changes in the dollar amount of the derivative could be material. A credit union shall consider hedge effectiveness in two different ways in prospective considerations (expectation it will be effective) and in retrospective evaluations (was it effective): Prospective considerations. The credit union's expectation "that the relationship will be highly effective over future periods in achieving offsetting changes in fair value or cash flows, which is forward-looking, can be based on regression or other statistical analysis of past changes in fair values or cash flows as well as on other relevant information. The standard requires that the prospective assessment of hedge effectiveness consider all reasonably possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied. The prospective assessment shall not be limited only to the likely or expected changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument or the hedged items. Generally, the process of formulating an expectation regarding the effectiveness of a proposed hedging relationship involves a probability-weighted analysis of the possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument and the hedged items for the hedge period. Therefore, a probable future change in fair value will be more heavily weighted than a reasonably possible future change. That calculation technique is consistent with the definition of the term expected cash flow in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements." 2 Retrospective evaluations. "An assessment of effectiveness shall be performed whenever financial statements or earnings are reported, and at least every three months. The credit union must determine if the hedging relationship has been highly effective in having achieved offsetting changes in fair value or cash flows. The assessment can be made using a statistical or dollar-offset approach. If a credit union intends to use the dollar-offset approach to perform retrospective evaluations, it may choose either a period-by-period approach or a cumulative approach in designating how effectiveness of a fair value hedge or of a cash flow hedge will be assessed, depending on the nature of the hedge." 3 If the hedge accounting is not or no longer deemed to be effective then the hedge accounting must be discontinued prospectively. 2 FAS ASC a 3 FAS ASC b 7

8 Hedge Ineffectiveness for Income Statement Purposes Hedge ineffectiveness for income statement purposes is measured by the dollar-offset method. For fair value hedges, hedge ineffectiveness flows through the income statement based on any difference between the change in the value of the derivative and the change in the value of the hedged item. In a cash flow hedge, ineffectiveness must be separately measured and recorded on the income statement. WW Risk Management notes that if the change in the fair value of the derivative exceeds the present value of the hedged cash flows, the difference is accounted for as ineffectiveness and recorded in the income statement. Conversely, if the present value of the cash flows exceeds the change in the fair value of the derivative, no ineffectiveness is assumed to have occurred. Short-Cut Method for Interest Rate Swaps WW Risk Management notes that entities can assume no ineffectiveness an interest rate swap in two instances. First, a private company that enters into a pay fixed, receive floating interest rate swap can assume no ineffectiveness. This exemption from hedge accounting does not apply to financial institutions. Second, all companies, including financial institutions, can examine a swap to determine if it can be accounted for under the Short-Cut Method. In order to conclude no hedge ineffectiveness in a hedge with an interest rate swap, the swap must meet all of the following conditions: Notional amount of swap matches principal amount of item being hedged Fair value of the swap is zero at inception (WW Risk Management notes that for purposes of determining zero a credit union can ignore bid/ask spread at inception, commissions and other transaction costs) Formula for computing net settlements remains the same throughout the swap - specifically o Fixed rate remains the same o Variable rate index does not change Interest bearing asset or liability is not pre-payable o Unless the prepayment is due to an embedded call (put) option and the swap has a mirror option call (put) option - options must match exactly Index on which the variable rate leg is based matches the benchmark interest rate designated as the interest rate risk being hedged 4 WW Risk Management believes that in many cases credit unions will not be able to use the short-cut method. For example, we do not believe a credit union can use the short-cut method when hedging its loan portfolio, because the borrower can prepay (call) the loans at any time without incurring a penalty, and the NCUA permitted swaps do not allow for a mirroring put feature. Moreover, many investments can be prepaid without penalty and would thus also not qualify for short-cut treatment. If a credit union loses its short-cut treatment, it loses hedge accounting. Therefore, even in situations when it can be used, we do not recommend it. We believe it is better to account for swaps under the long-haul method recognizing that swaps that would qualify for the short-cut method should easily pass the effectiveness testing - referred to in the industry as "easy pass". 4 FAS ASC

9 Given the recent rule changes for private companies, we believe one potential strategy for credit unions could be to offer floating rate loans to its member business loan customers and then refer those which want a fixed rate of interest to a swap provider. The borrower can enter into a pay fixed, receive floating interest rate swap. The advantages for the borrower are that it can assume no ineffectiveness under the private company rules and thus avoid effectiveness testing and it can pay a fixed rate of interest on its borrowing. The advantage for the credit union is that it can effectively provide a loan with a fixed rate of interest and avoid the intricacies of hedge accounting, having referred the swap transaction to a third party. Critical Terms Match A credit union can also assume no hedge ineffectiveness if the critical items of the hedging instrument and of the entire hedged asset or liability, or hedged forecasted transaction are the same. WW Risk Management notes that this assumption is more commonly made for cash flow hedges and is very rarely made for fair value hedges. Critical terms include the notional amount, the underlying, maturity date, etc. In addition, the change in the expected cash flows for hedged item and the hedging instrument are based on the same interest rate. Fair Value Hedges A credit union may designate a derivative instrument as hedging the exposure to changes in the fair value of an asset or a liability or an identified portion thereof (hedged item) that is attributable to a particular risk if all applicable criteria below are met: The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or a portfolio of similar liabilities (or a specific portion thereof). In this circumstance, if similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or liabilities shall share the risk exposure - generally proportionate change in fair value If the specific portion of an asset or liability, then the hedged items is one of the following: o A percentage of the entire asset or liability o One or more selected contractual cash flows, including one or more individual interest payments during a selected portion of the term of a debt instrument (such as the portion of the asset or liability representing the present value of the interest payments in the first two years of a four-year debt instrument) o A put option or call option (including an interest rate cap or price cap or an interest rate floor or price floor) embedded in an existing asset or liability that is not an embedded derivative accounted for separately The hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings 9

10 If the hedged item is a financial asset or liability, or a recognized loan servicing right, the designated risk being hedged is any of the following: o The risk of changes in the overall fair value of the entire hedged item o The risk of changes in its fair value attributable to changes in the designated benchmark interest rate (referred to as interest rate risk) o The risk of changes in its fair value attributable to both of the following (referred to as credit risk): Changes in the obligor s creditworthiness Changes in the spread over the benchmark interest rate with respect to the hedged item s credit sector at inception of the hedge 5. The similar asset or liability criteria has given pause to many considering a fair value hedge. The guidance provides more detail on similarity and whether the individual assets or individual liabilities within a portfolio in a fair value hedge shall share the risk exposure for which they are designated as being hedged. "If the change in fair value of a hedged portfolio attributable to the hedged risk was 10 percent during a reporting period, the change in the fair values attributable to the hedged risk for each item constituting the portfolio should be expected to be within a fairly narrow range, such as 9 percent to 11 percent. In contrast, an expectation that the change in fair value attributable to the hedged risk for individual items in the portfolio would range from 7 percent to 13 percent would be inconsistent with the requirement in that paragraph." 6 We note that in aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate: a. Loan type b. Loan size c. Nature and location of collateral d. Interest rate type (fixed or variable) e. Coupon interest rate (if fixed) f. Scheduled maturity g. Prepayment history of the loans (if seasoned) h. Expected prepayment performance in varying interest rate scenarios. 7 5 FAS ASC slightly abridged 6 FAS ASC FAS ASC

11 Other Items to Consider WW Risk Management notes that credit unions considering a fair value hedge should also be aware of several other items: A fair value hedge cannot be used to hedge interest rate risk on held-to-maturity securities. If a fair value hedge is used to hedge interest rate risk on available-for-sale securities then the change in the value of the hedged item runs through the income statement instead of through OCI. A partial-term hedge of a fixed rate financial instrument using a shorter-term, notionally matched swap will generally not "be effective" (e.g. hedging a 30-year loan with a 3-year swap). In Appendix A, we give two examples of a fair value hedge technique. The first example is the "portfolio method" in which a portfolio of similar fixed rate single family loans is hedged with a pay fixed, receive floating interest rate swap. The second example is the purchase of an interest rate cap. Elect Fair Value Fair value hedge accounting is obviously restrictive and complex. It requires that hedged items be similar and the long-haul method involves detailed analysis and documentation. To avoid these limitations and complications, a credit union could simply elect to account for the financial instrument at fair value. For example, it could elect to account for a portion of its fixed rate loans at fair value and enter into a pay fixed, receive floating interest rate swap. If market interest rates increase, the value of the loans would decrease as the value of the interest swap increased. This alternative avoids all of the complications of hedge accounting. That said, we urge credit unions contemplating this option to consider the following disadvantages: The hedge accounting election can be terminated at any time while the fair value election is irrevocable. Nearly all of the change in the value of interest rate swap over time will be due to changes in market interest rates (provided the counterparty remains financially strong), while the fair value of the loans will be affected by changes in interest rate and credit conditions. Thus, the fair value of a loan could decrease if the borrower's FICO drops even if market interest rates remain the same. A fair value hedge by way of contrast can be limited to the change in the benchmark interest rate only. The credit union will need to develop systems to estimate the fair value of the loans over their entire lives. We note that the change in fair value due to changes in credit risk can be minimized by selecting borrowers with excellent credit and low loan-to-value ratios. WW Risk Management can help with accounting if a credit union opts to value select financial instruments at fair value as we have already developed robust fair value models in connection with our fair value line of business. 11

12 Cash Flow Hedges The final alternative for managing income statement volatility is a cash flow hedge. A credit union may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with either of the following: Payments on an existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt or liabilities) A forecasted transaction (such as a forecasted purchase or sale). A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met: The forecasted transaction is specifically identified as either of the following: o A single transaction o A group of individual transactions that share the same risk exposure for which they are designated as being hedged. A forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction The occurrence of the forecasted transaction is probable The forecasted transaction meets both of the following conditions: o It is a transaction with a party external to the reporting entity o It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be re-measured with changes in fair value attributable to the hedged risk reported currently in earnings If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not remeasured with changes in fair value attributable to the hedged risk reported currently in earnings If the hedged transaction is the forecasted purchase or sale of a financial asset or liability (or the interest payments on that financial asset or liability) or the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is any of the following: o The risk of overall changes in the hedged cash flows related to the asset or liability, such as those relating to all changes in the purchase price or sales price o The risk of changes in its cash flows attributable to changes in the designated benchmark interest rate (referred to as interest rate risk) o The risk of changes in its cash flows attributable to all of the following (referred to as credit risk): i. Default ii. Changes in the obligor s creditworthiness iii. Changes in the spread over the benchmark interest rate with respect to the related financial asset s or liability s credit sector at inception of the hedge. 8 8 FAS ASC slightly abridged 12

13 WW Risk Management notes that the prohibition against using the cash flows arising from an asset or liability that is measured at fair value as the hedged item would, for example, preclude a credit union from designating the cash flows on securities that are held for trading as the hedged item because the change in their fair values runs through the income statement. On the other hand, a credit union could designate cash flows on available for sale securities as the hedged item because the change in fair value runs through other comprehensive income and not through the income statement. In Appendix B, we give two examples of cash flow hedge techniques. The first is the "first payments method" in which payments on money market accounts are hedged with the pay fixed, receive floating interest rate swap. The second is the purchase of an interest rate cap. Conclusion WW Risk Management believes the use of derivatives can be a very effective way to manage the risk of rising interest rates in today's environment. WW Risk Management can be of service in the following ways. We can: Work with you to identify the optimal derivative(s) to be used given your credit union's ALM profile. Work with you to amend your ALM policies to allow for the use of derivatives. Work with you to draft derivatives policies and procedures that ensure you have the proper internal controls in place and that meet all of the NCUA requirements regarding the use of derivatives. Provide estimates of ongoing fair value for loans, investments, and liabilities which you have elected to account for at fair value. We can also help you with the initial selection. For those electing hedge accounting, we can: o Develop the appropriate interest rate hedge and hedging item(s) to be used given your credit union's ALM profile. o Work with you to identify the item(s) to be hedged and the nature of the risk being hedged o Ensure you are able to achieve hedge accounting - including prospective and retrospective effectiveness testing on a dollar offset or statistical basis 13

14 Appendix A - Examples of Fair Value Hedges Portfolio Method Our example is the use of the portfolio method in which a pay fixed, receive floating interest rate swap is used to hedge against the change in the fair value of a portfolio of fixed rate single family mortgages. The precise details can be found in ASC through 178. We believe it is particularly relevant for credit unions, because the swap in the example matches a swap contract eligible under the new rules. We note that the key here is that the credit union will de-designate portions of the swap if loans prepay a rate faster than envisioned at the time the credit union entered into the swap transaction. In the example, we assume the following: Hedging item used - pay fixed receive floating interest rate swap with a fair value of zero at inception Hedged item - portfolio of fixed rate single family mortgage loans Nature of the risk being hedged - interest rate risk defined as the change in the fair value of the mortgage loan portfolio in relation to the change in benchmark interest rate (LIBOR) The portfolio of loans meets the similar assets criteria In this case, we are assuming that the stated maturity of the interest rate swap is consistent with the stated maturities of the loans. The notional amount of the interest rate swap amortizes based on a schedule that is expected to approximate the principal repayments of the loans (excluding prepayments). There is no optionality included in the interest rate swap. As part of its documented risk management strategy associated with this hedging relationship, on a quarterly basis, the credit union intends to do both of the following: a. Assess effectiveness of the existing hedging relationship for the past three-month period b. Consider possible changes in value of the hedging derivative and the hedged item over the next three months in deciding whether it has an expectation that the hedging relationship will continue to be highly effective at achieving offsetting changes in fair value. The credit union's portfolio of loans satisfies the requirements of paragraph FAS ASC (b)(1) regarding the grouping of similar assets, because the portfolio of loans has been defined in a restrictive manner and the credit union determined, by calculation, that each of the loans contained in the portfolio is expected to react in a generally proportionate manner to changes in the benchmark interest rate. Even though a certain portion of the loans may prepay, each loan still may be considered to have the same exposure to prepayment risk because each loan has a similar prepayment option. When aggregating loans in a portfolio, an entity is permitted to consider, among other things, prepayment history of the loans (if seasoned) and expected prepayment performance in varying interest rate scenarios. 14

15 The credit union's documented hedging strategy meets the requirements of paragraph for a prospective assessment of effectiveness provided the entity established that the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated. Paragraph (a) explains that a probable future change in fair value will be more heavily weighted than a reasonably possible future change. For example, the credit union could assign a probability weighting to each possible future change in value of the hedged portfolio. Depending on the level of market interest rates and the expected prepayment rates for the types of loans in the hedged portfolio, the credit union may reach a conclusion that the change in fair value of the swap will be highly effective at offsetting the change in the value of the portfolio of loans, inclusive of the prepayment option. As a result of this analysis, management would conclude that hedge accounting is permitted for the hedging relationship for the next three-month period; however, any ineffectiveness related to the current period must be reflected currently in earnings. That is, management is required to assess the effectiveness of the existing hedging relationship for the past three-month period. The amount of ineffectiveness related to the current period will be the difference between the change in fair value of the swap (which could have a notional amount different than the hedged portfolio due to curtailments and prepayments) and the change in fair value of the existing hedged portfolio. If necessary, the notional amount of the swap in excess of the portfolio balance at the end of each three-month period must be de-designated and a new hedging relationship designated (with a smaller percentage of the swap as the hedging instrument) going forward to allow high effectiveness to continue in the future. WW Risk Management notes that the dedesignation process might have to be very dynamic if loans are continually prepaying and portions of the hedge may have to be de-designated multiple times throughout the quarter. Following is an example. Amortizing Market Rate Net Swap Change in 15 Year Change in De-designation Hedge Change From Swap Fair Swap Loan Pool Loan Portfolio Dollar Effective Notional Month Notional Amt Inception Payment Value Fair Value Unpaid Bal. Value Offset % (y / n) Amount Mo. 0 50,000,000 0 bps 0 50,000,000 Mo. 1 49,796, bps (104,527) (251,261) (251,261) 49,571, , % yes Mo. 2 49,592,968 +5bps (97,316) 372, ,586 49,017,968 (508,479) 122.6% yes Mo. 3 49,388, bps (94,853) 639, ,718 48,632,600 (301,068) 88.6% yes 755,834 Total (296,696) 639,043 (552,447) 115.7% yes 755,834 In this case, the hedge has been effective for the first 3 months. The credit union will de-designate $755,834 of the hedge for the next three months as it undertakes it prospective effectiveness testing. Changes in the fair value of the de-designated portion will therefore not have an offset in the income statement going forward. 15

16 Purchase of an interest rate cap Our second example is the purchase of an interest rate cap to hedge against the decline in the price of a portfolio of $100 million 10-year treasury notes, which the credit union is holding in its available-for-sale inventory. In the example, we assume the following: Hedging item used - in-the-money interest rate cap Hedged item - $100 million 10-year US Treasury note portfolio Nature of the risk being hedged - interest rate risk, defined as the decrease in the fair value of the note in relation to the change in benchmark interest rate - US Treasury Rate The cap provides only against increases in interest rates and is thus considered "one sided". To achieve hedge accounting, the cash inflows from the cap must be highly effective in offsetting the decrease in the fair value of the treasury security portfolio. At inception, the value of an option, such as a cap, consists of time value (including volatility) and intrinsic value. The intrinsic value is zero until the option is in-themoney. The time value changes in value as the volatility of the value of the underlying changes and generally decays as a the option approaches its expiration date. FAS ASC provides that "In defining how hedge effective will be assessed, a credit union shall specify whether it will include in that assessment all of the gain or loss on a hedging instrument. An entity may exclude all or part of the hedging instrument's time value from the assessment of hedge effectiveness as follows: a. If the effectiveness of a hedge with an option is assessed based on changes in the option's intrinsic value, the change in the time value of the option would be excluded from the assessment of hedge effectiveness. b. If the effectiveness of a hedge with an option is assessed based on changes in the option's minimum value, that is, its intrinsic value plus the effect of discounting, the change in the volatility value of the contract shall be excluded from the assessment of hedge effectiveness. c. An entity may exclude any of the following components of the change in an option's time value from the assessment of hedge effectiveness: 1. The portion of the change in time value attributable to the passage of time (theta) 2. The portion of the change in time value attributable to changes due to volatility (vega) 3. The portion of the change in time value attributable to changes due to interest rates (rho) d. If the effectiveness of a hedge with a forward contract or futures contract is assessed based on changes in fair value attributable to changes in spot prices, the change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price shall be excluded from the assessment of hedge effectiveness." 16

17 In this example, we are using a one-sided option in a fair value hedge. Only the increase in the intrinsic value of the cap will offset the decrease in the value of the US Treasury securities portfolio if interest rates increase. The effectiveness testing will be based on the changes in the intrinsic value and the time value changes in the cap will be considered to be ineffective and recorded in the income statement. WW Risk Management notes that the cap premium is not amortized. Instead, the change in the fair value of the cap is measured and run through the income statement each reporting period. WW Risk Management further notes that "When a purchased option is designated as a hedging instrument in a cash flow hedge, an entity shall not define only limited parameters for the risk exposure designated as being hedged that would include the time value component of that option. An entity cannot arbitrarily exclude some portion of an option s intrinsic value from the hedge effectiveness assessment simply through an articulation of the risk exposure definition." 9 Following is an example of dollar-offset test comparing the change in the intrinsic value of the interest rate cap to the change in value of a US Treasury security. As shown by the example below, the change in time value is assumed to be ineffective for this hedge, excluded from the effectiveness test and runs through the income statement. PV Initial PV Updated Change in Change in PV Initial PV Updated Change in Intrinsic Intrinsic PV Intrinsic Treasury Dollar Time Time PV Time Value Value Value Security Value Offset % Effective? Value Value Value 5,513,076 6,566,932 1,053,856 (1,142,384) 92.25% yes 3,732,098 3,625,143 (106,955) Ineffective Appendix B - Examples of Cash Flow Hedges First Payments Method Our first example of a cash flow hedge is the use of the first payments method in which a pay fixed, receive floating interest rate swap is used to hedge against the risk of increasing interest rates for a credit union's money market share accounts. The technique is based on FAS ASC paragraphs 33A through 33F which address hedging against the risk of decreasing payments on a floating rate loan portfolio. We believe the method is analogous because the member can withdraw its shares at any time with no prepayment penalty just as a borrower could prepay its loan. The technique is used to ensure that the credit union can conclude the forecasted transaction is probable because it is not trying to forecast which specific member will be paid. We further note that FAS ASC B specifically permits this technique to be used for financial liabilities. We believe this hedging technique has several advantages over a fair value hedge when considering the "portfolio" of money market share accounts. First, cash flow hedges are not subject to the similar portfolio restriction. Second, because a cash flow hedge includes forecasted transactions, the fact a member withdraws funds does not create problems with effectiveness testing, because the hedge can be applied to other members' share accounts. Third, a cash flow hedge does not require a static portfolio of 9 FAS ASC

18 money market accounts thus avoiding the de-designation process described in our portfolio method fair value hedge example. In our cash flow hedge example, we assume the following: Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception Hedged item - payments on the $50 million of the credit union's money market share accounts Nature of the risk being hedged - variability in cash flows on its quarterly interest payments on $50 million principal of money market share accounts. The credit union has calculated that its historical re-pricing beta for the account is 0.50 compared to changes in 60-day LIBOR. It further determines that the weighted average life for the accounts is 3 years. It enters into a 3-year LIBOR-based interest rate swap that provides for quarterly net settlements based on the paying a fixed interest rate on a $25 million notional amount and receiving 60-day LIBOR based on a $25 million notional amount. The credit union identifies the hedged forecasted transactions as the first payments made during each 4 week period that begins 1 week before each quarterly payment due date on the swap over the next 3 years that, in aggregate for each quarter, are divided payments on $50 million of money market share accounts. The hedged forecasted transactions in this case are described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction. Provided that the credit union determines it is probable that it will continue to make interest payments on at least $50 million principal of its then existing money market share accounts, it can conclude that the hedged forecasted transactions in the documented cash flow hedging relationships are probable of occurring. The credit union cannot assume no ineffectiveness in such a hedging relationship as described in paragraph FAS ASC because the hedging relationship does not involve directly hedging a floating benchmark interest rate. FAS ASC (d) (3) prohibits an entity from designating interest rate risk as the hedged risk if the cash flows of the hedged transaction are explicitly based on an index different from the benchmark interest rates permitted. WW Risk Management notes that a credit union could designate interest rate as the hedged item in a cash flow hedge of the issuance of fixed rate certificates of deposit. Thus, it will have to assess hedge effectiveness under the long-haul method. Ineffectiveness can be measured in one of three ways: Change in variable cash flows method - discussed below Hypothetical derivative method Change in fair value method 18

19 Method One - Change in variable cash flows method The change-in-variable-cash-flows method is described in FAS ASC paragraphs 16 through Hedge ineffectiveness is based on a comparison of the following items: a. The variable leg of the interest rate swap, and b. The hedged variable-rate cash flows on the asset or liability. 18. The change-in-variable-cash-flows method is consistent with the cash flow hedge objective of effectively offsetting the changes in the hedged cash flows attributable to the hedged risk. The method is based on the premise that only the floating-rate component of the interest rate swap provides the cash flow hedge, and any change in the interest rate swap s fair value attributable to the fixed-rate leg is not relevant to the variability of the hedged interest payments (receipts) on the floating-rate liability (asset). 19. Under this method, the interest rate swap designated as the hedging instrument would be recorded at fair value on the balance sheet. The calculation of ineffectiveness involves a comparison of the following amounts: a. The present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap b. The present value of the cumulative change in the expected future interest cash flows on the variable-rate asset or liability. 20. Because the focus of a cash flow hedge is on whether the hedging relationship achieves offsetting changes in cash flows, if the variability of the hedged cash flows of the variable-rate asset or liability is based solely on changes in a variable-rate index, the present value of the cumulative changes in expected future cash flows on both the variable-rate leg of the interest rate swap and the variable-rate asset or liability shall be calculated using the discount rates applicable to determining the fair value of the interest rate swap. 21. If hedge ineffectiveness exists, accumulated other comprehensive income shall be adjusted to a balance that reflects the difference between the overall change in fair value of the interest rate swap since the inception of the hedging relationship and the amount of ineffectiveness that shall be recorded in earnings. 19

20 The following table illustrates the application of the change-in-variable-cash-flows method. This table reflects a comparison of the change in the present value of the variable leg swap cash flows to the change in the present value of money market share / deposit payments. At Inception Testing After Initial Quarter Expected Present Expected Present Present Present Ineffective Swap Variable Value of Share Value of Value of Value of Portion of Payment Receipts Variable Leg Payments Share Pmts Variable Leg Share Pmts the Hedge Year 1, Quarter 1 12,094 12,088 12,094 12,088 Year 1, Quarter 2 14,328 14,312 14,328 14,312 23,680 22,552 Year 1, Quarter 3 15,396 15,371 15,396 15,371 24,723 23,546 Year 1, Quarter 4 19,259 19,212 19,259 19,212 28,546 27,187 Year 2, Quarter 1 25,647 25,558 25,647 25,558 34,865 33,205 Year 2, Quarter 2 38,106 37,916 38,106 37,916 47,179 44,932 Year 2, Quarter 3 52,796 52,422 52,796 52,422 61,622 58,688 Year 2, Quarter 4 69,886 69,198 69,886 69,198 78,314 74,584 Year 3, Quarter 1 89,047 87,857 89,047 87,857 96,864 92,251 Year 3, Quarter 2 106, , , , , ,823 Year 3, Quarter 3 123, , , , , ,518 Year 3, Quarter 4 140, , , , , , , , , , , ,124 37,306 In our example, the hedge has been, and is expected to be, highly effective in offsetting the increase in the dividend share payments. The ratio of the present value of the variable leg to the present value of the share payments over the term of the swap is 105%. WW Risk Management notes that for this hedge to be effective, the credit union will have to continually change its dividend rate on money market shares in response to the changes in 60-day LIBOR. Purchase of an interest rate cap In this example, a credit union purchases an interest rate cap to use to hedge against the risk of increasing interest rates on the credit union's floating rate Federal Home Loan Bank advances. In the example, we assume the following: Hedging item used - out-of-the-money interest rate cap Hedged item - payments on variable rate payments of the credit union's $50 million Federal Home Loan Bank advances Nature of the risk being hedged - increase in the cost of quarterly interest payments on its $50 million Federal Home Loan Bank advances when the 3 month LIBOR rate associated with this particular advance exceeds 3.00%. The cap provides only against increases in interest rates and is thus considered "one-sided". To achieve hedge accounting, the cash inflows from the cap must be highly effective in offsetting the increase in the cost of the payments for the FHLB advances. Unlike our fair value hedge cap example, in this case, the credit union can run the entire change in the value of the cap (intrinsic and time value) through other 20