Hedge Management in TRM

Hedge Management in SAP Treasuryand Risk Management

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1. Hedge Accounting Overview2. Qualifying Criteria for Hedge Accounting3. Effectiveness Training4. SAP Hedge Management – Key Concepts5. SAP Hedge Management – Process6. Key Customizing Settings

Agenda

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IAS 39 and FAS 133... a new accounting guideline concerning derivativeinstruments and hedging activities:

IAS 39 / FAS 133 standardizes accounting for derivativeIAS 39 / FAS 133 standardizes accounting for derivativeinstruments by requiring thatinstruments by requiring that

all derivatives have to be reported on the balance sheetall derivatives have to be valuated at their fair value

Hedge Accounting can be applied for qualifying items

IAS39/FAS 133 - Overview

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Solution:Derivatives have to be accounted on the balance sheet.Special hedge accounting allowed if criterias like effectiveness are met

Solution:Derivatives have to be accounted on the balance sheet.Special hedge accounting allowed if criterias like effectiveness are met

Problem prior to IAS 39/FAS 133:If derivatives are off-balance sheet items, the earnings risk - for non-hedgingderivatives or not effectively hedging derivatives - is not measured.Enormous „surprise factor“.

Problem prior to IAS 39/FAS 133:If derivatives are off-balance sheet items, the earnings risk - for non-hedgingderivatives or not effectively hedging derivatives - is not measured.Enormous „surprise factor“.

Hedging:Hedging of an open risk position by building an offsetting position, so thatgains and losses from the open underlying transaction (hedged item) and thehedging transaction cancel each other out

Hedging:Hedging of an open risk position by building an offsetting position, so thatgains and losses from the open underlying transaction (hedged item) and thehedging transaction cancel each other out

Accounting for Derivatives:Why Hedge Accounting?

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Hedge Exposures

Forecasted transactions are expected future cash flows that are notrecorded in the balance sheet and are not related to a certain contract.Example: forecasted sale.

Unrecognized firm commitments are contractual obligations or liabilities tothird parties. All important parameters such as quantity and price arefixed.Example: sales order/sales contract.

Recognized assets and liabilities - Financial assets and liabilities, e.g. bonds.As of FAS 138 receivables and payables can also be designated ashedged items.

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Cash flow hedge:

Hedging of balance sheet exposures, or offorecasted transactions, against fluctuations infuture cash flows

Fair value hedge:

Hedging of balance sheet exposures, or of unrecognizedfirm commitments, against fluctuations in their fair value

Hedge categories:Fair value hedgeCash flow hedgeNet investment in aforeign subsidiary

Hedge Categories I

Hedge of a net investment:

Hedging of net investments recorded on the balance sheetagainst value fluctuations due to exchange rate fluctuations

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Transaction/Exposure:fair value of a recognized asset/liab.fair value of an unrecognized firm commitment

Accounting Treatment:recognize the change in fair value of derivatives in

balance sheet against earningsrecognize the change in fair value of the hedged

item against earningseffective portion is offset and any ineffectiveness is

recorded in earnings (net effect on earnings)

Risk factors :priceinterest rateexchange rate risk

Hedge Categories II


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Transaction/Exposure:variability in future cash flows of recogn. asset/liab.variability in future cash flows of forecasted

transact.

Risk factors :priceinterest rateexchange rate risk

Hedge Categories III


Accounting Treatment:effective portion is recorded on a cumulative basis in

Other Comprehensive Income (OCI) or equitythe ineffective portion is recorded in current P/Lno adjustments of the hedged item is recordedOCI-balance is reclassified as hedged item affects

earnings

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Exposure:Investment in a foreign subsidiary (differentfunctional currency)

Risk factors :exchange rate risk

Hedge Categories IV


Accounting Treatment:effective portion is recorded on a cumulative basis in

CTA or equitythe ineffective portion is recorded in current P/Lno adjustments of the hedged item is recordedOCI-balance is reclassified as hedged item affects

earnings

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Agenda

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Qualifying Criteria

Identification of hedged item (underlying exposure)Identification of hedging instruments (derivatives)Identification of nature of risk being hedgedDocumentation of how the hedging instrument´s effectiveness in offsetting valuechanges in the hedged item will be assessed.

Determine the algorithm (method) used for assessing effectivenessDetermine the components of the derivative´s value change that is included in thesubsequent effectiveness assessment

Derivative needs to be linked with the exposure in a hedging relationshipEffectiveness testing

IAS 39/ FAS 133 requires that certain criteria be met for alltypes of hedges in order for them to qualify for hedgeaccounting:

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Agenda

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Effectiveness Testing - Fundamentals

The effectiveness of a hedging relationship is a measure of how well aderivative protects against the underlying risk (exposure).

Effectiveness is measured through the “effectiveness ratio”. Theeffectiveness ratio has to fall within a certain range in order for thehedging relationship to be considered ‘highly effective’. Only then canhedge accounting take place.

A hedging relationship has to be considered effective at inception of thehedge as well as on an ongoing basis.

An effectiveness test has to be carried out at every balance sheet date,and at least every 3 months.

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There are two kinds of effectiveness tests:

prospective test (is the hedging relationship expected to continue to be highlyeffective in the future?)retrospective test (has the hedging relationship been effective in the past period orperiods?)

Balance sheet date

Retrospective test Prospective test

time

Prospective vs. Retrospective

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For calculation of the value changes, different methods may be used depending onthe derivative and on the hedge category:

Fair value changes

Changes in cash flows, based on spot rates or forward rates

Changes of intrinsic value for options

Changes of a value of a hypothetical derivate

Regression analysis

Note that components of value changes may be excluded, e.g. the time value ofoptions.

For calculating the effectiveness ratio, a period-to-period approach or acumulative approach may be used.

Calculation Methods

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In the case of a perfect hedge, a hedge may qualify for the

shortcut method for interest-rate hedgesthe ‘matching of critical terms‘ method for FX hedges *

In both cases, no effectiveness test is needed, and perfect effectiveness isassumed. This means that

all fair value changes of the derivative are posted to OCI/Equity directly (cash flowhedges)all fair value changes of the derivative are posted to P/L, and the same amount isposted to P/L for the underlying exposure (fair value hedge)

Effectiveness Testing - When it is not needed (US-GAAP)

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Agenda

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SAP Treasury and Risk ManagementSAP Treasury and Risk Management

PortfolioAnalyzer

Credit RiskAnalyzer

Market RiskAnalyzer

Transaction Manager

FX Debt Sec.Der.MM

ExposureManagement

Hedge Management/ Accounting

Hedge Management - Architecture

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Hedge CategoriesFair value hedge

Hedging InstrumentsFX swap, FX forwardFRAInterest rate swapCross currency interest rate swapOther Product Types (e.g. Futures) are in planning status

Effectiveness Calculation MethodsNet Present Value Method / Dollar offset Method¹Hypothetical Derivative Method (has to be generated manually)Benchmark MethodRegression Analysis (in planning status)

Scope of SAP‘s Hedge Management

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Hedge CategoriesCash flow hedge

Hedging InstrumentsFX swap, FX forward, FX options (plain vanilla and average rate), CollarFRA, CAP, FLOORInterest rate swapCross currency interest rate swapOther Product Types are in planning status

Effectiveness Calculation MethodsNet Present Value Method / Dollar offset Method ¹Cash Flow MethodHypothetical Derivative MethodRegression Analysis (in planning status)


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Hedge CategoriesNet Investment hedge

Hedging InstrumentsMoney Market InstrumentsForward Exchange TransactionsFX and Cross Currency Swaps (note 967104 for ERP2004/ERP2005)FX Options (note 967104 for ERP2004/ERP2005)

Effectiveness Calculation MethodsNet Present Value MethodCash Flow MethodSpot MethodForward Method / All critical Terms match(note 967104 for ERP2004/ERP2005)


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Hedged Items

Hedged Items are ExposuresFrom a manual entryUpload from Money Market InstrumentsUpload from Risk ObjectsUpload from FX-Exposure ManagementGeneration from FX Forwards (or from a rollover or premature settlement of an FX-Forward)

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Effectiveness Testing - Process

Balancesheet date

time

Start date of theHedging Relationship

Is the HedgingRelationshipexpected to behighly effective inthe future?

1. Run theprospectiveeffectiveassessment toprove if thehedgingrelationship isexpected to behighly effective.

Was the HedgingRelationship highlyeffective in the past?

2. Run the retrospectiveeffective assessment toprove the pasteffectiveness of thehedging relationship.

3. If the assessment hasshown an effectivehedging relationship,run the EffectiveMeasurement todetermine the exactamount to be posted toOCI/Equity or P/L.

Is the HedgingRelationshipexpected to behighly effective inthe future?

4. Run the prospectiveeffectiveassessment toprove if the hedgingrelationship isexpected tocontinue to behighly effective.

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Integration into the accounting

Classification of the valuation resultsEffective portionIneffective portionFree standing portionTime value

Reclassification when exposure hits earningManual reclassificationAutomatic distribution over a user defined time intervalPartial reclassification (if exposure changes or is overhedged)

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Valuation: posting logic with FAS133/IAS39

FX - Balance Sheet Account

1 Delta NPV

OCI/Equity - Distribution Account

1 Delta NPV

3 Effective portion

4 Ineffectiveportion

0,000,00

2

5

Free-standingportion

Delta time value

P/L

4 Ineffective portion

2

5

Free-standingportion

Delta time value

OCI/Equity3 Effective portion

[ ]

[ ]

Distribution

1. Determine derivative‘s fair value

2. Determine value of any free-standing portion of the derivative

3. Determine OCI/ Equity target balance and amount to be posten toOCI/Equity

4. Post remainder of clearing OCI/Equity distribution account to P/L

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Expiration and Reclassification

When? Hedge accounting ceases prospectively when any of the following occurs:• hedge fails an effectiveness test;• the hedged item is sold or settled;

• the hedging instrument is sold, terminated or exercised;• management decides to revoke the designation; or• for a hedge of a forecasted transaction, the forecasted transaction is nolonger highly probable.¹

In customizing you can define, what should happen with the hedge relationship in thecase of infectivity – to dissolve or to dedesignate.²

How? Manually (reclassify all or parts of the equity capital balances at once or one-offthe part of it) or automatically (reclassify over multiple periods on a linear basis).

What happens with the hedging instrument? As in IAS 39: All future fair valuechanges in a derivative hedging instrument are recognized in the income statement.Future changes in the fair value of any non-derivative hedging instrument are accountedfor as they would be without hedge accounting.

What happens with the hedged item? Future changes in the fair value of the hedgeditem are accounted for as they would be without hedge accounting.

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Agenda

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Hedge Management – Steps

Hedging Relationship - You use this function to comply with the accounting rules for derivativefinancial instruments and hedging relationships, according to FAS 133 / IAS 39.

Exposure Management - The exposure management function enables you to manage yourforeign currency exposures and transfer them to hedge management.

The first step in Hedge Management is to create a Hedge Plan..Here, you can summarize exposures according to specific criteria.Remember that each transaction carries only one Risk Category.The transaction category defines the nature of the underlying exposure to behedged, such as a firm commitment.The transaction activity refines the category, indicating, for example, whether thedeal is a sale or a purchase.

As a next step the effectiveness test should assure the effectiveness of the HedgingRelationship. In case of effectiveness Hedge Accounting according to FAS 133 / IAS 39may take place.

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To define Exposure and the Hedge Plan manually

To define Exposure and the Hedge Plan via upload of the Exposure from theExposure Management

Define Exposure and the Hedge Plan via upload of the Exposure through anRisk Object from another application or External Sources

Define Exposure and the Hedge Plan via the Hedge Instrument

Define Exposure via upload from a Money Market Instrument

I. Possibilities to define Exposure/Hedge Plans

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1. Define Exposure and the Hedge Plan manually(THMEX)

Define hedge plan:IDdescriptionstart dateend daterisk category

You can groupexposuresaccording tospecific criteria byusing differenthedge plans.

Define Hedge Plan

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1. Define Exposure and the Hedge Plan manually(THMEX)

Create exposure:transactioncategorytransactionactivitytransaction IDnominal amounttransaction

currency.

Define Exposure

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2. Define Exposure and the Hedge Plan via uploadof Exposure from Exposure Management (TEM20)

Prerequisites:

enter a rawExposures

generate Versionscarry out

Exposure Analysis

After you havecarried out theexposure analysis,you can go on with

transfer theExposure to HedgeManagement

Transfer the Exposure to Hedge Management

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2. Define Exposure and the Hedge Plan via uploadof Exposure from Exposure Management (THMEX)

Display assigned Exposures

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3. Define Exposure and the Hedge Plan via uploadof the Exposure through an Risk Object (THMRO)

Import Data into acentral repository(Risk Object) usingExternal DataTransfer (EDT)functionality

carry out ‚RiskObject/HedgeManagement‘synchronizationreport

scan the RiskObject repository

capture allexposuresidentified as HedgeManagementrelevant

Excel

R/3 Modules

BW Planning

EDT

EDT

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Laye

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Obj

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synchro-nization

HedgeManagement

Load Foreign Currency Exposure

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Create Hedge Instrument with Product Type for Hedge Accounting

Define Hedge Category:• Fair value hedge• Cash flow hedge• Net investment hedge

Target Hedge Ratio could not bechanged in the deal but in theHedge Plan

You can create your Hedge Planand define your Exposure and theHedged Item directly in theTransaction. Alternatively atransaction could be assigned toan existing Hedge Plan

Define Exposure with Category:• Forecasted Transaction• Firm Commitment• Financial Asset

Choose Hedge Strategy forhedging relationship (depended onHedge Category)

4. Define Exposure and the Hedge Plan via theHedge Instrument (FTR_CREATE)

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5. Define Exposure via upload from a MoneyMarket Instrument (THMEX)

Create a hedgeplan :

Risk Category –Interest Rate Risk

Upload interest rate exposures from money market instruments

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5. Define Exposure via upload from a MoneyMarket Instrument (THMMM)

Enter your selection criteria in the following entry fields:Company CodeHedge PlanTransaction

Fixed interest exposures are imported to hedgemanagement as fair value hedges, and variable interestexposures as cash flow hedges.

This function does not import charges or flows fordiscounts or premiums. The upload is restricted tofunctional currency cash flows.

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You use the Hedgetab to enter theunderlying hedgingcategory according toFAS 133 / IAS 39(Hedge Accounting).Using the hedgingtarget ratio, you candefine a target valueto be hedged (inpercent) according toyour risk guidelines.In contrast to anexposure, a hedgeditem refers to aspecific valuationarea. Use the ChangeValuation Areafunction to create thehedged item inanother valuationarea.

II. Define Hedged Item (THMEX)

Define Hedged Item

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III. Define Hedging Relationship (THMEX)

At the HedgingRelationship tab,you enter theHedgeInstrument (DealNumber fromTransactionManager) and thevolume that is tobe used to hedgethe object.

Define Hedging Relationship

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IV. Define and determine the Net Present Value(THM30 and TPM60)

Before the first Valuation you have to define the Net Present Value on InceptionDate as well as the Net Present Value on the current Valuation Date. For everycoming valuation you have to determine the Net Present Value again.

Define Net Present Value Save Net Present Value

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V. Simulate the Effectiveness Test (Prospective)(THM80)

If you want to carry out a prospectiveeffectiveness test in our system, youwill need a market data scenario. Theuser create scenarios, whichrepresent market situations youconsider to be possible or probable(for example, a high interest ratescenario with an inverted yield curve).You can also use historical marketdata.

The field Horizon could be appropriateused for the prospective effective test.This date is the later evaluation time,on which all market data is read (e.g.forward rates, if the horizon is in thefuture) and on which interest isdiscounted in accordance with all cashflows.

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Monitoring Effectiveness

VI. Simulate the Effectiveness Test (retrospective)(THMEX)

This EffectivenessMeasurement calculation willbe processed automaticallyduring the valuation run. Itdetermines the exact amountto be posted to OCI/Equity orP/L and stores the results.

As a next step youcould manually runthe EffectivenessTest for yourvaluation date tohave a look at theresults.

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VII. Run the Valuation (TPM1)

Execute Valuation

Posting Log

Distribution of Profit/Loss

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VIII. Have a quick look on the Account Balances(THM81)

The total value of the derivative is noted into equity.

At every balance sheet date during the maturity term you run the valuationprocess incl. NPV Determination and Effectiveness Testing and the valuesresulting from these activities are automatically distributed. After each valuationyou can see the results in this report.

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Post Derived Flows

IX. Expiration of hedging relationship (TBB1 undTPM18)

Before the Hedging Relationship could be expired please settle the transaction ofthe Hedging Instrument and post the flows including the derived flows (the status ofthe Hedging Relationship change to ‘dedesignated’)

Post Flows

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X. Hedge Plan Expiration (THM12)

With the Hedge Plan Expiration (emphasize fact that OCI/Equity is reclassified when exposureexpires (affects earnings), not when derivative expires) the Hedging relationship get the status‘dissolved’.

Distribution of Profit/Loss

The ExposureExpiration (THM10) isalso possible. Itdissolves all thehedging relationshipsthat are assigned toexpired exposures.

Posting Log

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XI. Reclassification (manual) (THM54)

This report allows the user to reclassifymanually all or parts of the equitycapital balances of the selected hedgingrelationship(s). You can reclassify gainsand losses entered in the equity capitalaccount as expense or revenue (OCI toP/L).

The partial reclassification is alsopossible. Here are only 12.000,00EUR of the whole 12.220,49 EURentered in equity reclassified.

Distribution of Profit and Loss

Posting Log

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XI. Reclassification (automatic) (THM58)

In contrast to manual reclassification, the automaticreclassification is used, if the asset item have to betransferred to the profit and loss statement overmultiple periods. You determine the period for thehedge item (in THMEX) using the parameters Start ofReclassification and End of Reclassification. Overthis period, the automatic equity reclassificationfunction transfers the equity from the hedgingrelationship to the profit and loss statement on alinear basis.

The status of the Hedging Relationship have to be„dedesignated“.

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XII. Retrace the Hedging Relationship(THMEX)

With the ‘History’ button you getthe overview about the changesand valuations, as well as aboutthe status of the HedgingRelationship.

You could also have a look at thedetail log of every effectivenesstest, including stored assessmentand measurement logs.

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XIII. Document the Hedging Relationship(THMEX)

Press button ‘Documentation’ to displaythe hedge documentation.

Hedge Documentation IFRS and US GAAP require keyinformation about the hedgingrelationships to be formallydocumented prior to hedgeaccounting treatment being applied.Failure to establish thisdocumentation will mean hedgeaccounting cannot be adoptedregardless of how effective the hedgeactually is in offsetting risk.

Hedge documentation requirementsare:

Risk management objective andstrategy

Identification of the hedginginstrument

The related hedged item ortransaction

The nature of the risk being hedgedHow the entity will assess the

hedging instrument’s effectiveness

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There is the information about theHedging Relationship included hedgeitem, hedge plan, designatedexposures, effectivenessassessment, risk managementobjectives, risk category and hedgestrategy.Also Notes on the Hedged Item, theHedge Plan or the HedgingRelationship are printed on thedocumentation and are a free Textfield.

XIV. Document the Hedging Relationship

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Reports I

Hedging Relationship per Derivative (THM83)This report shows the derivatives and the exposures they are hedged. It isthus possible to report on the derivatives that are hedging/are not hedgingexposures, and where hedge capacities remain.

Hedge Plan Overview (THM82)This report shows all hedge plans matching the selection criteria in a treestructure (company code – hedge plan - hedge – exposure – hedgingtransaction).

Effectiveness Test Report (THM80)By using the combined effectiveness assessment and measurement report,hedge effectiveness can be calculated at any point during the lifetime of thehedging relationship, and can be used for simulation purposes, e.g. „what-if“scenarios.

OCI/Equity Balance Overview Report (THM81)This report provides the OCI/Equity and P&L balance for derivatives and theirhedging relationships as of the selected date.

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Reports II

Retrospective Effectiveness Assessment: Dissolve IneffectiveHedging Relationships (THM52)This reports allows the user to dissolve all or a selection of hedgingrelationships that have been ineffective in the period just ended.

Prospective Effectiveness Assessment (THM50)The Prospective Effectiveness Assessment lets the user record, for ahedging relationship or several hedging relationships and for a given date,whether it is expected to be effective in the future. This data is manuallyentered; double-clicking on the „effective“ column in the report marks ahedging relationship as not being effective prospectively.

Exposure Expiration Report (THM10)This report enables you to monitor the expiration of the exposure you haveselected. It dissolves all the hedging relationships that are assigned toexpired exposures (this includes reclassification of OCI in cash flowhedges).²

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Reports III

Manual OCI/Equity Reclassification (THM54)This report allows the user to manually reclassify all or parts of the OCIbalances of the selected hedging relationships.

Prematurely reclassified OCI/Equity (THM84)This report shows all OCI balances that have been reclassified prematurely, i.e. before the underlying exposure affected earnings, or was scheduled to affectearnings. It thus provides the exception reporting required.

Change Documents for Hedge Management (THM85)This reports enables you to display every new entry and data change in hedgemanagement. The selection can be restricted to specific hedge plans, hedgingitems, versions of hedging relationships, and exposures. The time period andthe name of the last person who changed the selection can also be specified.

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Agenda

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Gain/Loss Handling

This indicator controlshow gains and lossesare handled¹.

In the IMG maintenanceof rate valuationprocedures for foreignexchangetransactions, the field'Gain/Loss Handling'have to be indicated.Otherwise you cannotperform any hedgeaccounting fortransactionswhose positionmanagement procedureallows a valuation ofthis type.

For all the hedging instruments set the indicator to ‚HedgeAccounting (Hedging Instrument)‘, for FX Transactions see the note967019. Is it about MM Transactions, which operate as Exposureswithin the Fair Value Hedge, set the indicator to ‚Hedge Accounting(Hedged Item)‘ (note 1003790).

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Valuation area-dependent settings for HedgeAccounting

In this step you can define whether you want the hedge relationship which isregarded as ineffective in the future to be dissolved or dedesignated. Dissolvingor dedesignating hedge relationships means ending the relationship between aderivative financial instrument and a hedge item. When you dissolve a hedgerelationship any OCI balances that exist are cleared against P&L, whereas thisdoes not happen in the case of dedesignation.

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Define Calculation Types

The calculation categories represent the fundamentalunderlying methods of assessing and measuringeffectiveness of hedging relationships, e.g. Cash flowdifferences forward discounted or Cash flowdifferences spot value (with interest accrual).

Set this indicator if the hypothetical derivativerepresents a perfect derivative in accordance with G7in the Derivatives Implementation Group (DIG).

The price/NPV type determines which of the storedNPVs for the hedging instrument (OTC transaction)and the hedged item should be used in theeffectiveness test.

The offset calculation category specifies how valuesare looked at, on a period-to-period or ona cumulative basis.

In Risk Management the evaluation type controls theassignment of financial instruments to the respectivemarket prices (e.g. currency rates, yield curves,security prices, ...) and calculation methods.

You use the transition speed to influence thetransition area between the area in which the noisethreshold value dominates and the area in which itdoes not play a role. The greater the transition speed,the smaller the transition area.

With this parameter you determine the amount atwhich fluctuations in value are not considered to berelevant for the valuation of hedging relationships.

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Thank you!

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Hedge Management in TRM

Documents

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hedge accounting overview2

hedge accounting3

sap hedge management

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balance sheet exposures

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fair valuehedge accounting