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Proposed Accounting for Derivatives NASACT Audio Conference NASACT Audio Conference June 27, 2007 June 27, 2007
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Page 1: Proposed Accounting for Derivatives NASACT Audio Conference June 27, 2007.

Proposed Accounting for Derivatives

NASACT Audio Conference NASACT Audio Conference June 27, 2007June 27, 2007

Page 2: Proposed Accounting for Derivatives NASACT Audio Conference June 27, 2007.

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Why Is It So Hard?Why Is It So Hard?

Different instruments & countless productsDifferent instruments & countless productsDiscounting, Discounting, present value,present value, yield curve,yield curve, implied implied

forward rate,forward rate, volatility,volatility, option pricing, option pricing, gamma,gamma, theta theta

JargonJargonHedging: offsets versus outcomesHedging: offsets versus outcomesAccounting modelAccounting model Mixed attribute modelMixed attribute model Expected transactions are not recognized in Expected transactions are not recognized in

the accounting modelthe accounting model

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GASB Environment—GASB Environment—Derivative UsersDerivative Users

Pensions and endowments: foreign Pensions and endowments: foreign exchange derivativesexchange derivatives

Utilities and transit agencies: energy Utilities and transit agencies: energy derivativesderivatives

Governments active in debt market: Governments active in debt market: interest rate swapsinterest rate swaps

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Some HistorySome History

Technical Bulletin 94-1, Technical Bulletin 94-1, Disclosures about Disclosures about Derivatives and Similar Debt and Investment Derivatives and Similar Debt and Investment TransactionsTransactions

Statement No. 31, Statement No. 31, Accounting and Financial Accounting and Financial Reporting for Certain Investments and for Reporting for Certain Investments and for External Investment PoolsExternal Investment Pools

Technical Bulletin 2003-1, Technical Bulletin 2003-1, Disclosure Disclosure Requirements for Derivatives Not Reported at Requirements for Derivatives Not Reported at Fair Value on the Statement of Net AssetsFair Value on the Statement of Net Assets

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What is a Derivative for Financial What is a Derivative for Financial Reporting Purposes?Reporting Purposes?

A derivative has:A derivative has:1. One or more reference rates (underlyings) 1. One or more reference rates (underlyings)

and one or more notional amountsand one or more notional amounts

2. Leverage2. Leverage

3. Net settlement3. Net settlement

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Examples of DerivativesExamples of Derivatives

Interest rate swapInterest rate swap Variable-rate to fixed-rateVariable-rate to fixed-rate Fixed-rate to variable-rateFixed-rate to variable-rate

Basis swapBasis swap Exchange payments based on the changes of two Exchange payments based on the changes of two

variable ratesvariable rates

SwaptionSwaption Gives the purchaser of the option the right, but not the Gives the purchaser of the option the right, but not the

obligation, to enter into an interest rate swapobligation, to enter into an interest rate swap

Commodity swapCommodity swap Reduce exposure to a commodity’s price riskReduce exposure to a commodity’s price risk

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Hybrid InstrumentsHybrid Instruments

Hybrid instruments consist of a companion Hybrid instruments consist of a companion instrument (not measured at fair value) and a instrument (not measured at fair value) and a derivative (measured at fair value)derivative (measured at fair value)This is a substance over form issue: A derivative This is a substance over form issue: A derivative should be treated as a derivative regardless of should be treated as a derivative regardless of whether it is a stand-alone instrument or whether it is a stand-alone instrument or included in another instrument, such as a bond, included in another instrument, such as a bond, insurance contract, or a purchase or sale insurance contract, or a purchase or sale contractcontractExample: off-market swap. That is, a swap that Example: off-market swap. That is, a swap that presents a government with an up-front presents a government with an up-front payment.payment.

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Excluded InstrumentsExcluded Instruments

Normal purchases & normal sales Normal purchases & normal sales contractscontracts Commodity (e.g., gas or electricity)Commodity (e.g., gas or electricity) Government intends to and has practice of Government intends to and has practice of

taking delivery or selling the commoditytaking delivery or selling the commodity Quantity is consistent with volume usedQuantity is consistent with volume used

Traditional insurance contractsTraditional insurance contractsTraditional financial guarantee contractsTraditional financial guarantee contractsNon exchange-traded climate contracts, Non exchange-traded climate contracts, liquidated damages, etc.liquidated damages, etc.

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Fair ValueFair Value

Based on either:Based on either:

Market-observed prices orMarket-observed prices or

Models, such as from a Bloomberg Models, such as from a Bloomberg terminalterminal

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Proposed AccountingProposed Accounting

Fair value with hedge accountingFair value with hedge accountingDerivatives would be measured on the Derivatives would be measured on the statement of net assets at fair valuestatement of net assets at fair valueFair value changes would be reported on the Fair value changes would be reported on the “change statement” as investment income“change statement” as investment incomeException: Effective HEDGES!Exception: Effective HEDGES! Changes in fair value of derivative would be reported Changes in fair value of derivative would be reported

on the balance sheet as deferrals—either deferred on the balance sheet as deferrals—either deferred charges or deferred creditscharges or deferred credits

Swap asset, deferred creditSwap asset, deferred credit Swap liability, deferred chargeSwap liability, deferred charge

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Hedge FinancialHedge FinancialStatement PresentationStatement Presentation

Year 1 Year 2Statement of net assets Cash ($6,000) Deferred outflow $5,000 $0 Swap liability $5,000 $0Change statement Interest expenditure/expense $0 $6,000

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Drivers of the Drivers of the Proposed AccountingProposed Accounting

Derivatives should be measured at fair Derivatives should be measured at fair valuevalue

If the derivative instrument is effective, If the derivative instrument is effective, hedge accounting should be appliedhedge accounting should be applied

Effectiveness is determined by using an Effectiveness is determined by using an acceptable method of evaluating hedgesacceptable method of evaluating hedges

If a method subsequently renders hedge If a method subsequently renders hedge ineffective, another method may be usedineffective, another method may be used

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What is a Hedge?What is a Hedge?

Derivative is associated with a hedgeable Derivative is associated with a hedgeable itemitem

The derivative is effective in providing The derivative is effective in providing changes in cash flows or fair values that changes in cash flows or fair values that substantially offset the cash flow or fair substantially offset the cash flow or fair value changes of the hedgeable item value changes of the hedgeable item

No documentation of management’s intentNo documentation of management’s intent

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Hedgeable ItemsHedgeable Items

Single asset or liabilitySingle asset or liabilityGroups of similar assets or liabilities must Groups of similar assets or liabilities must have same risk exposurehave same risk exposureExpected transaction—occurrence should Expected transaction—occurrence should be probable be probable

Transactions within the primary Transactions within the primary government do not qualify for hedge government do not qualify for hedge accountingaccounting

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Methods of Evaluating Methods of Evaluating EffectivenessEffectiveness

Qualitative methodQualitative method Consistent critical terms methodConsistent critical terms method

Quantitative methodsQuantitative methods Synthetic instrument methodSynthetic instrument method Linear regression methodLinear regression method Dollar offset methodDollar offset method Other methodOther method

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Consistent Critical Terms Consistent Critical Terms MethodMethod

Notional and principal amounts should be Notional and principal amounts should be the samethe sameFair value of derivative should be zero at Fair value of derivative should be zero at date of inceptiondate of inceptionBenchmark rates based on the same Benchmark rates based on the same index such as SIFMA to SIFMAindex such as SIFMA to SIFMAAdditional requirements based on whether Additional requirements based on whether it is a: it is a: Fair value hedgeFair value hedge Cash flow hedgeCash flow hedge

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Consistent CriticalConsistent Critical Terms Method Terms Method

Effectiveness must be evaluated every Effectiveness must be evaluated every yearyear

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Consistent CriticalConsistent Critical Terms Method Terms Method

Hedged Hedged Hedging Hedging

Debt Debt DerivativeDerivative

Principal/notionalPrincipal/notional $1,000$1,000 $1,000 $1,000

TermTerm 10 years10 years 10 years 10 years

Payments, EveryPayments, Every 6 months6 months 6 months 6 months

Variable paymentVariable payment SIFMA SIFMA SIFMA SIFMA

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Synthetic Instrument Method Synthetic Instrument Method

Based on notion that the combined cash Based on notion that the combined cash flows of a swap and hedged debt create a flows of a swap and hedged debt create a third instrument—a synthetic fixed-rate third instrument—a synthetic fixed-rate instrumentinstrument

Comes from consistent critical terms Comes from consistent critical terms method, but used when benchmark rates method, but used when benchmark rates are not the same, such as a % of LIBOR are not the same, such as a % of LIBOR swapswap

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Synthetic Instrument Method Synthetic Instrument Method

Uses the rate in the fixed-leg of the swap Uses the rate in the fixed-leg of the swap as the fixed rate. as the fixed rate.

As long as As long as actual actual payments travel within a payments travel within a range of 90% to 111% of the fixed rate, range of 90% to 111% of the fixed rate, the derivative is effective.the derivative is effective. Swap-based hedge use the fixed payment of Swap-based hedge use the fixed payment of

the swapthe swap Commodity hedges use the fixed rate Commodity hedges use the fixed rate

established by the hedgeestablished by the hedge

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Dollar Offset MethodDollar Offset Method

The change in fair values or cash flows The change in fair values or cash flows of the hedging derivative is divided by of the hedging derivative is divided by the same changes of the hedged item. the same changes of the hedged item. The result should be within the range of The result should be within the range of 80 to 125 percent 80 to 125 percent

This method is similar to the economic This method is similar to the economic notion of elasticity notion of elasticity

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Dollar Offset ExampleDollar Offset Example

Fair Value Fair Value

ChangesChanges Change Change

Hedged debtHedged debt $1,000 $1,000

Interest rate swapInterest rate swap (1,150) (1,150)

($1,000/$1,150)($1,000/$1,150) 86.96% 86.96%

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Regression MethodRegression Method

Evaluation of effectiveness should indicate Evaluation of effectiveness should indicate that the hedged item and the hedging that the hedged item and the hedging derivative regress such that:derivative regress such that:

R-squared statistic is at least 0.80R-squared statistic is at least 0.80

F-statistic is at least 95 percent confidence F-statistic is at least 95 percent confidence intervalinterval

Slope coefficient is between –1.25 and –Slope coefficient is between –1.25 and –0.800.80

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Other Evaluation MethodOther Evaluation Method

Method must:Method must:

Be consistent with fair value Be consistent with fair value

Demonstrate that the changes of cash Demonstrate that the changes of cash flows or fair values of the derivative flows or fair values of the derivative substantially offset the changes in cash substantially offset the changes in cash flows or fair value of the hedgeable itemflows or fair value of the hedgeable item

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DisclosuresDisclosures

Similar derivatives may be aggregatedSimilar derivatives may be aggregatedSummary of derivative activity by:Summary of derivative activity by:

1)1) Government activities, business-type Government activities, business-type activities, and fiduciary activitiesactivities, and fiduciary activities

2)2) Then by fair value hedges, cash flow Then by fair value hedges, cash flow hedges, and investment derivativeshedges, and investment derivatives

3)3) Then by type:Then by type:Notional amountNotional amountFair values & changes and where reportedFair values & changes and where reportedFair values & amounts reclassified from hedge to Fair values & amounts reclassified from hedge to investmentinvestment

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DisclosuresDisclosures

Disclosures for Disclosures for HEDGINGHEDGING derivatives derivatives Application of TB-2003 disclosuresApplication of TB-2003 disclosures Significant termsSignificant terms Risks: Credit, Interest Rate, Basis, Termination, Risks: Credit, Interest Rate, Basis, Termination,

Rollover, Market-access, Foreign CurrencyRollover, Market-access, Foreign Currency If an “other evaluation method” is used, the identity of If an “other evaluation method” is used, the identity of

that method and its critical valuesthat method and its critical values

No disclosure of hedge ineffectivenessNo disclosure of hedge ineffectiveness

Disclosures for Disclosures for INVESTMENTINVESTMENT derivatives derivatives Risks: Credit, Interest Rate, Foreign CurrencyRisks: Credit, Interest Rate, Foreign Currency

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DisclosuresDisclosures

Contingencies (e.g., collateral postings)Contingencies (e.g., collateral postings) Fair value of derivatives with featureFair value of derivatives with feature Amount of all potential settlementsAmount of all potential settlements Amounts posted Amounts posted

Hedged debtHedged debt

Synthetic guaranteed investment contractsSynthetic guaranteed investment contracts Description and natureDescription and nature Fair valuesFair values

WrapperWrapper

Underlying investmentsUnderlying investments

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SummarySummary

Derivatives would be reported on the balance Derivatives would be reported on the balance sheet and measured according to their fair sheet and measured according to their fair values. Fair value changes would be reported on values. Fair value changes would be reported on the change statement, provided a derivative is the change statement, provided a derivative is not a hedging derivative.not a hedging derivative.

If a derivative is a hedging derivative, its fair If a derivative is a hedging derivative, its fair value changes would be deferred on the balance value changes would be deferred on the balance sheet until the hedged transaction occurs.sheet until the hedged transaction occurs.

Test effectiveness Test effectiveness

DiscloseDisclose

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Looking ForwardLooking Forward

Exposure Draft on web site by Exposure Draft on web site by June 29, 2007June 29, 2007

Final standard second quarter of 2008Final standard second quarter of 2008

Proposed Standard would be effective for Proposed Standard would be effective for reporting periods reporting periods beginningbeginning after June 15, after June 15, 20092009

RetroactiveRetroactive

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Questions?Questions?Randal Finden—[email protected] site—www.gasb.org

The views expressed in this presentation are those of the The views expressed in this presentation are those of the GASB’s staff. Official positions of the GASB are determined GASB’s staff. Official positions of the GASB are determined only after extensive due process and deliberationonly after extensive due process and deliberation