Hedging Interest-Rate Risk: A Primer in Instruments. & Accounting. September 29, Presented by: Ruth Hardie
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1 Hedging Interest-Rate Risk: A Primer in Instruments September 29, 2015 & Accounting Presented by: Ruth Hardie
2 Hedge Trackers, LLC Integrated Derivative Management Interest Rate, Foreign Currency and Commodities Consulting Exposures to hedge accounting Outsourcing Valuations, testing, journal entries and disclosures Software & Analytics Capella, Global Exposure Report, RTZ Training Series of 2.5 hour in-depth trainings ASC 815 and ASC 830 Series of 1 hour webinars Customized training 2
3 Agenda Instrument Basics Interest Rate Swaps Interest Rate Caps Hedgeable Risks Cash Flow Fair Value Hedge Accounting Cash Flow Fair Value Effectiveness Testing Basics 3
4 Instrument Basics 4
5 Derivative Defined Financial instrument or other contract with all of the following characteristics: One or more notional amounts (quantity) One or more underlying (price or rate) Requires little or no initial net investment AND Terms require or permit net settlement or can be readily settled outside of contract ASC to
6 Four Cornerstone Concepts 1. Derivative instruments represent rights or obligations that meet definition of asset or a liability 2. Fair Value is only relevant measure for derivative instrument 3. Only instruments that are assets and liabilities will be on financial statements as such 4. Hedge accounting is special accounting for qualifying transactions only a) The gain or loss on a derivative instrument not designatedas a ASC 815 hedging instrument shall be recognized currently in earnings 6
7 Symmetrical Contracts -Swaps A contract where participants agree to exchange interest payments in the future. Company A enters into an interest rate swap contract where it receives 3M LIBOR and pays a fixed rate on a contractual notional amountforafixedterm. Generally, there is no out-of-pocket cost for entering into a swap 7
8 Swap Construction 8
9 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 9
10 Net Impact of Swap Trade Date) The red arrows represent Fixed payments to the counterparty The black arrows represent predicted LIBOR payments to the Company 10
11 Asymmetrical Contracts -Options Cap: A contract where the counterparty pays the buyer when the LIBOR index exceeds the strike rate. Floor: A contract where the counterparty pays the buyer when the LIBOR index is below the strike rate. Caps & floors typically have periodic settlements (caplets & floorlets) Purchase 3% LIBOR cap where Company A receives max[3m LIBOR-3%, 0], in exchange for premium paid at inception quarterly over the next two years Purchase 1% LIBOR floor where Company A receives max [1%-3M LIBOR, 0] in exchange for premium paid at inception quarterly over the next two years In both cases, ultimate interest expense is uncertain. 11
![Caps & floors typically have periodic settlements (caplets & floorlets) Purchase 3% LIBOR cap where Company A receives max[3m LIBOR-3%, 0], in exchange for premium](/docs-images/41/3831487/images/page_11.jpg "paid at inception quarterly over the next two years Purchase 1% LIBOR floor where Company A receives max [1%-3M LIBOR, 0] in exchange for premium paid at inception")
12 Cap Construction Cap Strike 12
13 Vanilla IR Cap Mechanics 12/31/X0 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed Premium A receives 3M LIBOR interest > 1% on $10M A receives 3M LIBOR interest > 1% on $10M A receives 3M LIBOR interest > 1% on $10M A receives 3M LIBOR interest > 1% on $10M 13
14 Net Impact of Cap Trade Date) The red arrows represent premium paid to the counterparty The black arrows represent predicted LIBOR payments to the Company 14
15 Hedgeable Risks 15
16 Hedging IR Risk Opportunity to hedge benchmark IR in US is limited to LIBOR, OIS* or Treasury Rates No longer a restriction on using different benchmark rates for similar hedges *Effective July 17,
17 Cash Flow Hedged Items Exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, attributable to a particular risk Most Common: Less Common: Variable rate debt Variable rate assets Term loans Revolvers Construction loans Future issuance of: Bond Fixed rate debt Commercial Paper 17
18 Fair Value Hedged Items Exposure to changes in the fair value of a recognized asset or liability, attributable to a particular risk Most common: Fixed rate debt Less common: Fixed rate asset* * Community banks hedge fixed rate assets (loans) 18
19 Hedge Accounting 19
20 Cash Flow Hedges Hedges exposure to variability in cash flows attributable to a particular risk of a recorded asset or liability, or a forecasted transaction The effective portion of derivative s gain/loss is reported in other comprehensive income (OCI); the ineffective portion is reported in earnings, subject to the provisions in ASC b OCI is adjusted to reflect the lesser of the cumulative gain or loss on the derivative or the cumulative change in expected future cash flows of the hedged item Earnings are impacted to the extent the hedge is not effective (for overhedges only) 20
21 Cash Flow Hedge Derivative Valuation book to balance sheet Effective Portion Balance Sheet (OCI) Ineffective Portion Income Statement 21
22 Cash Flow Hedges Qualifying Criteria Hedging Instrument: 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 Non derivative instruments, e.g. treasury notes, do not qualify Written options generally do not qualify for hedge accounting, except in very limited circumstances (only when hedging an embedded purchase option) 22
23 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 Can hedge change in cash flows due to the benchmark interest, credit risk, fx risk, or entire change in cash flow 23
24 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 24
25 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 25
26 Net Impact Swap & Debt 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 26
27 Vanilla IR Cap Mechanics 12/31/X0 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed Premium A receives 3M LIBOR interest > 1% on $10M A receives 3M LIBOR interest > 1% on $10M A receives 3M LIBOR interest > 1% on $10M A receives 3M LIBOR interest > 1% on $10M 27
28 Debt and Cap Combined 12/31/X0 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed A pays C 3M LIBOR A pays C 3M LIBOR A pays C 3M LIBOR A pays C 3M LIBOR Premium interest on $10M interest on $10M interest on $10M interest on $10M A receives 3M LIBOR interest > 1% on $10M A receives 3M LIBOR interest > 1% on $10M A receives 3M LIBOR interest > 1% on $10M A receives 3M LIBOR interest > 1% on $10M 28
29 Net Impact Cap & Debt 12/31/X0 3/31/X0 6/30/X0 9/30/X0 12/31/X0 A pays B fixed A pays C 3M LIBOR A pays C 3M LIBOR A pays C 3M LIBOR A pays C 3M LIBOR Premium <=1% on $10M <=1% on $10M <=1% on $10M <=1% on $10M 29
30 IR Hedge Relationships: Floating Rate Debt/Asset Interest on Debt Deriv -FMV Total Period 1 Period 2 Total 5 Cash 7 12 Flow (4) (6) (10) (7) (3) (13) (1) (5) 04 (1) Ineffectiveness 30
31 Fair Value Hedges Hedges the exposure to a change in fair value of a recognized asset, liability, firm commitment or an identified portion thereof, attributable to a particular risk Typical designatedrisk hedged is the benchmark (LIBOR) interest rate Gain/loss on derivative is recognized in earnings Gain/loss on hedged item, attributable to the risk being hedged, adjusts the carrying amount of the hedged item and is also recognized in earnings Earnings are impacted to the extent the hedge is ineffective 31
32 Fair Value Hedge Derivatives Income Statement Hedged Items 32
33 Fair Value Requirements ASC : In calculating the change in the hedged item s fair value attributable to changes in the benchmark interest rate (see paragraph (f)(2)), the estimated cash flows used in calculating fair value shall be based on all of the contractual cash flows of the entire hedged item. Excluding some of the hedged item s contractual cash flows (for example, the portion of the interest coupon in excess of the benchmark interest rate) from the calculation is not permitted 33
34 Fair Value Hedges Qualifying Criteria Hedging Instrument: At inception, formal documentation of hedge relationship, 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 Instruments that do not meet the definition of a derivative, e.g. treasury notes, can not be used for hedging Written options generally do not qualify for hedge accounting, except in very limited circumstances (only when hedging an embedded purchased option) 34
35 Fair Value Hedges Qualifying Criteria Hedged Item: Specifically identified portion of an asset, liability, or firm commitment A single asset or liability, or pool of similar assets or liabilities, or portion thereof, if all hedged items are expected to move within the same narrow range (+/-10% is OK; +/-30% is not) If hedging a financial asset or liability, can hedge the benchmark interest rate, credit risk, fx risk, or the entire change in fair value 35
36 Fair Value of Fixed Rate Debt (9,600,000) Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 (9,800,000) (10,000,000) (10,200,000) (10,400,000) (10,600,000) (10,800,000) 36
37 Fair Value of Swap 37
38 Swap and Debt Fair Value 38
39 Combined Fair Value 39
40 Ineffectiveness 40
41 IR Hedge Relationships: Fixed Rate Debt/Asset FV of asset Deriv -FV Total Fair Value Period 1 Period 2 Total 12 (5) 7 (13) 7 (6) (1) 2 (1) Ineffectiveness 41
42 Effectiveness Testing 42
43 What is Highly Effective? When the change in value of the derivative offsets 80% to 125% of the change in value of the hedged item. May assess effectiveness using one of the following methods (guidance does not specify particular methods to use) : Regression Analysis Dollar offset / ratio method Shortcut Similar hedges should be tested in a similar way. 43
44 Regression Testing Specify data Specify test points (prefer 30) to reflect derivative tenor Last 60 days, daily Last year, weekly Last 3 years monthly Last 10 years quarterly 44
45 Regression Testing Specify measurements R 2,beta slope, f-stat Specify effective results R 2 =>.80 Beta Slope =>.80 AND <= 1.25 Significance F <.05 Rounded to what level , %,
46 Regression Results Interpretations of measurements R2 are the points close enough to the line? Beta slope how close is the correlation to 1:1? Significance F probability that the results of the regression are random 46
47 08/20/15 Derivative Hedged Item Derivative Change Hedged Item Change Value date Curve Date Period to Period Change 8/20/2015 7/31/ , , (19,157.85) (18,854.58) 8/20/2015 6/30/ , , (115,923.31) (115,615.48) 8/20/2015 5/31/2015 1,114, ,112, , , /20/2015 4/30/2015 1,047, ,046, , , /20/2015 3/31/ , , (334,916.52) (335,492.44) 8/20/2015 2/28/2015 1,280, ,278, , , /20/2015 1/31/ , , (513,525.94) (510,882.53) 8/20/ /31/2014 1,344, ,340, , , /20/ /30/2014 1,166, ,165, (100,910.51) (101,070.30) 8/20/ /31/2014 1,267, ,266, (199,517.14) (193,684.86) 8/20/2015 9/30/2014 1,467, ,460, , , /20/2015 8/31/2014 1,458, ,456, (67,413.11) (68,039.20) 8/20/2015 7/31/2014 1,526, ,524, , , /20/2015 6/30/2014 1,006, ,005, (67,526.26) (66,382.98) 8/20/2015 5/31/2014 1,074, ,072, (107,236.77) (109,135.89) 8/20/2015 4/30/2014 1,181, ,181, (42,179.75) (40,917.51) 8/20/2015 3/31/2014 1,223, ,222, , , /20/2015 2/28/ , , , , /20/2015 1/31/ , , (145,748.76) (146,739.78) 8/20/ /31/2013 1,037, ,040, , , /20/ /30/ , , , , /20/ /31/ , , (61,969.85) (62,782.56) 8/20/2015 9/30/ , , (748,395.18) (739,869.56) 8/20/2015 8/31/2013 1,359, ,355, , , /20/2015 7/31/ , , , , /20/2015 6/30/ , , , , /20/2015 5/31/ , , , , /20/2015 4/30/ , , (21,582.35) (21,165.47) 8/20/2015 3/31/ , , (8,060.05) (8,071.79) 8/20/2015 2/28/ , , , , /20/2015 1/31/ , , , , /20/ /31/ , , , , /20/ /30/ , ,
48 Slope Slope Standard Error R2 F-Stat Significance F Observations ,
49 Dollar Offset Ratio of: Change in FMV of Derivative Divided by Change in FMV of Hedged Item Specify Effective Results Between.80 and
50 Short Cut Method The guidance has a shortcut for certain interest rate swaps that hedge a recognized interest-bearing asset or liability (ASC ) In effect, the hedger may accrue interest at the combined synthetic rate created by the interest rate swap The shortcut method assumes that changes in the fair value of the swap equal changes in the fair value of the instrument or cash flows hedged The hedger avoids making the calculations necessary to determine hedge effectiveness 50
51 Questions? Silicon Valley Chicago New York 51
52 Answers!
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