Derivatives: Practical Issues in Implementing the Standard Eric S. Berman, MSA, CPA Deputy Comptroller Commonwealth of Massachusetts June 27, 2007.

Derivatives:Practical Issues in Implementing the Standard

Eric S. Berman, MSA, CPADeputy Comptroller Commonwealth of MassachusettsJune 27, 2007

One Investor’s View

Charlie [Munger, Buffett's partner in managing Berkshire Hathaway] and I are of one mind in how we feel about derivatives and the trading activities that go with them:

We view them as time bombs, both for the parties that deal in them and the economic system.

Additional Buffetisms

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem--at a price, you will easily find an obliging counterparty.

Additional Buffetisms

Like Hell, [derivatives] are easy to enter and almost impossible to exit. In [derivatives], once you write a contract--which may require a large payment decades later--you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.

Agenda for Today

Common Definitions Types of Derivatives Preparers and

Auditors Encounter Why Do Derivatives? - Hedging

What Are Derivatives?

A Derivative is an instrument (financial or otherwise) whose value depends on the value of an underlying variable.

What does it mean to you?

What is the point of entering into a Derivative contract?

Derivatives in other words

The definition of a derivative itself is a financial instrument or other contract with all three of the following characteristics:

It has (i) one or more reference rates and (ii) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.

Derivatives in other words

It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts expected to have a similar response to changes in market factors.

Derivatives in other words

Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Derivatives Notional amounts outstanding, 1987-present

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

Bil

lio

ns

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Source: International Swaps and Derivatives Association, Inc., 2007

$327.3 trillion in 2006

Common Definitions to Know

Underlyings are the unrelated assets that are used to gauge the value of the derivative.

The value of the derivative is the value of the underlying times a notional quantity.

The notional rate is the current, floating interest rate applied to bonds

Common Definitions to Know

A hedge is a contract entered into to reduce some form of risk.

Hedges that accomplish the goal of reducing risk as expected are commonly referred to as effective.

Common Definitions to Know

A cap is where parties enter into an agreement in exchange for a premium in order to limit interest rate risk. Can you describe a

common cap? Cashflow hedges use

cash inflows based on periodic interest rates

Collars limit interest rate exposure to a specified range in the contract.

Common Definitions to Know

Compound derivatives are where an entity enters into multiple derivatives within the same contract. Synthetic Derivatives

Credit derivatives or risk swaps are contracts where two parties join to insure a third party’s debt issuance.

A currency swap is where parties exchange specific amounts of foreign currencies at the time of contract and repay each other at specified intervals and at rates based on fixed interest rates in each currency.

Common Definitions to Know

Fair value hedge – A derivative instrument that offsets fair value changes in hedgable items

Forward - A forward contract gives the owner the right and obligation to buy a specified asset on a specified date at a specified price. The seller of the forward contract has the right

and obligation to sell the asset on the date for the price.

Common Definitions to Know

Forwards – Continued Generally, no money changes hands on the

origination date of the forward contract. However, collateral may be demanded. Delivery options may exist concerning

the quality of the asset the quantity of the asset the delivery date the delivery location.

If your position has value, you face the risk that your counterparty will default.

Common Definitions to Know

Floater is another term for variable rate interest debt

Future - An option to purchase or sell a commodity, instrument, asset, liability, index or other item at a specific time in the future.

Interest Rate Swap Swaption

Types of Derivatives that Accountants Encounter

10%6%

10%

2%

2%

70%

Foreign Exchange Contracts Interest Rate Contracts

Equity - Linked Contracts Commodity Contracts

Credit Default Swaps Other

% of notional amounts outstanding – as of June 2006 – Source Bank for International Settlements

Types of Derivatives that Preparers and Auditors Encounter

Swaps The MOST prevalent derivative in the

market A swap is an agreement between

counter-parties to exchange cash flows at specified future times according to pre-specified conditions.

A swap is equivalent to a coupon-bearing asset plus a coupon-bearing liability. The coupons might be fixed or floating.

Types of Derivatives that Preparers and Auditors Encounter

Swaps – Example An Investment Bank agrees to pay a fixed

payment and receive a floating payment, from a Government.

Investment Bank is the fixed rate payer-floating rate receiver (the “pay-fixed” party).

Government is the fixed rate receiver-floating rate payer (the “receive-fixed” party).

Typically, there is no initial exchange of principal (i.e., no cash flow at the initiation of the swap).

Plain Vanilla Swap

On 3/1/xx, an agreement is struck wherein for the next 3 years, every six months, Investment Bank receives from Government, a payment on a notional principal of $100 million, based on the 6 month LIBOR rate. Investment Bank makes a fixed payment on the same notional principal to Government, based on a rate of 5.75% per annum.

You need to know the fixed rate. You need to know the variable (floating) rate. You need to know notional principal. Note that 6-month LIBOR at origination is R0 =

5.36%. The next two slides illustrate the cash flows.

Each actual payment (“difference check”) equals the difference between the interest rates times NP times #days between payments over 360, or #days/365.

The time “t” variable cash flow is typically based on the time t-1 (this period minus 1) floating interest rate.

Thus, the first floating cash flow, based on the rate, R0, is known: it is 5.36%.

All subsequent floating cash flows are random variables as of time zero (but always known one period in advance).

RR R

0R 1R~

2R~

3R~

0

Multiply each “R” by NP times #days between payments over 360

(or use a 365-day year)R

How to Calculate the swap

---------Millions of Dollars---------

LIBOR FLOATING FIXED Net

Date Rate Cash Flow Cash Flow Cash Flow

Mar.1, 200x 5.36%

Sept. 1, 200x 5.4% +2.68 –2.875 –0.195

Mar.1, 200y 5.1% +2.70 –2.875 –0.175

Sept. 1, 200y 5.2% +2.05 –2.875 -0.825

Mar.1, 200z 5.3% +2.60 –2.875 -0.275

Sept. 1, 200z 5.4% +2.15 –2.875 -0.725

Mar.1, 20aa 5.1% +2.70 –2.875 - 0.175

The Cash Flows to Investment Bank from Government

A Closer Look at the Cash Flows on September 1, 200x

Floating Payment: Based on the 6-month LIBOR rate that existed on

March 1, 200x: 5.36%. ($100,000,000)(0.0536)(1/2) = +$2,680,000.

Fixed Payment: Based on 5.75% rate. ($100,000,000)(0.0575)(1/2) = -$2,875,000.

Net Cash Flow: -$195,000.

“Plain Vanilla” Swap involving a government that issues bonds

Why did this government enter into this transaction???

INVESTMENT BANK

GOVERNMENT

BONDHOLDER

5.75%

6 month

LIBOR 5.36%5.75%

PaysReceives

Pays

Receives

What Preparers need to worry about

Similar items already being done for 2003-1 Fair values of Derivatives need to be as

of Statement of Net Assets date If derivatives are tied to Business Type

Activities – good idea to segregate swap revenues from debt expense

Non-debt related derivatives may be out there

What Preparers need to worry about

Disclosure Items Summary of activity during the period

by category: fair value hedges, cash flow hedges and investments

Within category, segregate by type (swaps, caps, swaptions, futures, etc.)

Similar disclosure to TB 2003-1

Evel Knievel’s Foray into Derivatives and Hedging – September 8, 1974

Why Do Derivatives?

How did Evel Hedge Risk? Two ways to view Risk

Some Investors want to Increase risk to increase potential return

Some Issuers want to decrease risk to fix costs

The Goals of Risk

Financial goal – reduce the variability of cash flows, though can never eliminate it Prices are volatile!

Governments are Generally Risk Averse

Reasoning: Managers are risk averse – why? Bondholders are risk averse – why? Stakeholders (i.e., employees, suppliers,

customers) are risk averse – why? So, a reduction in risk should benefit

everyone. Plus, a decrease in volatility implies a

lower cost of finance, and therefore, an increase in net assets.

Risk aversion: a willingness to pay a premium to reduce risk exposure.

4 Basic Risks Hedging Attempts to Cure

Market Risk (including prices and interest rates)

Credit Risk Probability of default Depth of exposure Method of recovery (cure)

Basis Risk (a.k.a. “spread”) Rollover or termination risk

Key to Hedge Success – Is it Effective?

Hedge effectiveness is somewhat in the eye of the beholder, but can be calculated

The opposite of an effective hedge is???

Keys to Effectiveness

General requirements are the following: Management intends and documents its

strategy to reduce risk Offsetting occurs consistently If cash flow hedge, highly probable Measurement can reasonably occur Measurement is ongoing and

effectiveness is determined throughout the financial reporting period

Keys to Effectiveness

Methods to evaluate include Qualitative

Are terms in debt and derivative consistent (consistent critical terms method)

Quantitative Methods Synthetic instruments method Dollar offset method Regression analysis method

What Preparers Need to Worry About - Hedges

Hedge Effectiveness Calculation Disclosure

Why hedge was entered into Terms

Notional Amounts, Rates, Terms, Options and cash paid or received

Risks (Similar to TB-2003-1) Method for determining effectiveness

However, Hedges have Risks

However, Hedges have Risks