Warning 1:  Many of the links were broken when the FASB changed all of its links.  If a link to a FASB site does not work , go to the new FASB link and search for the document.  The FASB home page is at http://www.fasb.org/ 

Warning 2:  In February 2008 the FASB for the first time allowed users free access to its "FASB Accounting Standards Codification" database. Access will be free for at least one year, although registration is required for free access. Much, but not all, information in separate booklets and PDF files may now be accessed much more efficiently as hypertext in one database. The Glossary below has not been updated for the Codification Database. Although the database is off to a great start, there is much information in this Glossary and in the FASB standards that cannot be found in the Codification Database. You can read the following at http://asc.fasb.org/asccontent&trid=2273304&nav_type=left_nav

Welcome to the Financial Accounting Standards Board (FASB) Accounting Standards Codification™ (Codification).

The Codification is the result of a major four-year project involving over 200 people from multiple entities. The Codification structure is significantly different from the structure of existing accounting standards. The Notice to Constituents provides information you should read to obtain a good understanding of the Codification history, content, structure, and future consequences.

Click here to view the Notice to Constituents (Adobe Acrobat format).

The DIG documents are not yet available in the Codification Database, but they can now be accessed at  http://www.fasb.org/derivatives/ 
Over 300 pages of  DIG pronouncements can be downloaded from  http://www.fasb.org/derivatives/allissuesp2.pdf 

FAS 133 and IAS 39 Glossary and Transcriptions of Experts
Accounting for Derivative Instruments and Hedging Activities
Bob Jensen at Trinity University

The FASB's Derivatives and Hedging Glossary (in the Accounting Standards Codification Database) ---
http://asc.fasb.org/subtopic&trid=2229141&nav_type=left_nav

Bob Jensen's CD --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/

I'm sharing some old (well relatively old) accounting theory quiz and exam material that I added to a folder at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

"What’s a Couple of Hundred Trillion When You’re Talking Derivatives?" by Floyd Norris, The New York Times, September 23, 2006 --- http://www.nytimes.com/2006/09/23/business/23charts.html

Everett McKinley Dirksen, the Senate Republican leader in the 1950’s, is supposed to have said, “A billion here and a billion there, and pretty soon you’re talking real money.” What would he have thought of derivatives today?

The International Swaps and Derivatives Association, a trade group, reported this week that the outstanding nominal value of swaps and derivatives at the end of June was $283.2 trillion.

Compare that with the combined gross domestic product of the United States, the European Union, Canada, Japan and China, which is about $34 trillion. The total value of all homes in the United States is about the same amount.

To be sure, notional value is an exaggerated term as it greatly overstates the amount at risk in many contracts. But the growth rate is real, and in the fastest-growing area of swaps — credit default swaps — notional value is closer to the amount at risk, because such swaps promise to make up the losses if a borrower defaults on the notional amount.

The value of outstanding credit default swaps doubles every year — a trend that must eventually stop — and now equals $26 trillion. That is about the same as the total amount of bond debt in the United States, and corporate debt, on which most credit swaps are traded, comes to just $5.2 trillion.

The credit derivatives cover the risks of default by individual companies, and offer insurance against default for bond indexes and specified bond portfolios.

The growth of the market has forced the swaps and derivatives association to change the way its credit swaps work. It used to be that if a company defaulted, the writer of a credit swap would have to pay par value for the bond he had guaranteed, and could then sell the bond to reduce his losses.

But in some cases defaults led to bond rallies, as those who had purchased credit swaps scrambled to get bonds to deliver. Now traders can choose cash settlements, with the amounts to be paid determined through auctions.

Until 1997, the association provided separate numbers on currency and interest rate contracts, but innovations blurred the distinction between those categories, and now it publishes a combined total. At the end of June, the figure was $250.8 trillion, up 25 percent over the previous 12 months.

Growth in that market slowed markedly early in this decade, as worldwide markets cooled, and there was even one annual decline, from mid-2000 to mid-2001. But growth picked up in 2002 as economies began to recover.

The volume outstanding of equity derivatives is rising by about 30 percent a year, and now totals $5.6 trillion. It could go farther, with world stock market capitalization now about $41 trillion, according to Standard & Poor’s.

Robert Pickel, the chief executive of the association, said that the growth in derivatives enables “more and more firms to benefit from these risk management tools.” On the other hand, the situation allows more and more traders to load up on risk if they choose, and hedge funds have become major derivatives traders.

The combination of large unregulated hedge funds trading ever larger amounts of unregulated derivatives in nontransparent markets makes some people nervous. But so far, anyway, little is being done to change the situation, and nothing devastating has happened to markets.

Continued in article

Jensen Comment
One of the main differences between a "financial instrument" versus a "derivative financial instrument" is that the notional is generally not at risk in a "derivative financial instrument." For example if Company C borrows $600 million from Bank B in a financial instrument, the notional amount ($600 million) is at risk immediately after the notional is transferred to Company C. On the other hand, if Company C and Company D contract for an interest rate swap on a notional of $600 million using Bank B as an intermediary, the $600 million notional never changes hands. Only the swap payments for the differences in interest rates are at risk and these are only a small fraction of the $600 million notional. Sometimes the swap payments are even guaranteed by the intermediary, thereby eliminating credit risk.

So where's the risk of a derivative financial instrument that caused all the fuss beginning in the 1980s and led to the most complex accounting standards ever written (FAS 133 in the U.S. and IAS 39 internationally)?

Often there is little or no risk if the derivative contracts are held to maturity. The problem is that derivatives are often settled before maturity at huge gains to one party and huge losses to the counterparty. For example, if Company C swaps fixed-rate interest payments on $600 million (having current value risk with no cash flow variation risk) for variable-rate interest payments on $600 million (having cash flow variation risk but no market value variation risk), Company C has taken on enormous cash flow risk that may become very large if interest rates change greatly in a direction not expected by Company C. If Company C wants to settle its swap contract before maturity it may have to pay an enormous amount of money to do so either to counterparty Company D or to some other company who will take the swap off the hands of Company C. The risk is not the $600 million notional; Rather the risk is in the shifting value of the swap contract itself which can be huge even if it is less than the $600 million notional amount.

Perhaps derivative financial instrument risk is even better illustrated by futures contracts. Futures contracts are traded on organized exchanges such as the Chicago Board of Trade. If Company A speculates in oil futures on January 1, there is no exchange of cash on a 100,000 barrel notional that gives Company A the right to sell oil at a future date (say in one year) at a forward price (say $100 per barrel) one year from now. As a speculation, Company A has gambled by hoping to buy 100,000 barrels of oil one year from now for less than $100 per barrel and sell it for the contracted $100 price.

But futures contracts are unique in that they are net settled in cash each day over the entire one year contract period. If the spot price of oil is $55 on January 12 and $60 on January 13, Company A must provide $500,000 = ($60-$55)(100,000 barrels) to the counterparty on January 13 even though the futures contract itself does not mature until December 31. If Company A has not hedged its position, its risk can become astounding if oil prices dramatically rise. Company A's futures contract had zero value on January 1 (futures contracts rarely have value initially except in the case of options contracts), but the value of the futures contract may become an enormous asset or an enormous liability each each day thereafter depending upon oil spot price movements relative to the forward price ($100) that was contracted.

Hence, derivative contracts may have enormous risks even though the notionals themselves are not at risk. Prior to FAS 133 these risks were generally not booked or even disclosed. In the 1980s newer types of derivative contracts emerged (such as interest rate swaps) in part because it was possible to have enormous amounts of off-balance-sheet debt that did not even have to be disclosed, let alone booked, in financial statements. Astounding frauds transpired that led to huge pressures on the SEC and the FASB to better account for derivative financial instruments.

Most corporations adopted policies of not speculating in derivatives by allowing derivatives to be used only to hedge risk. However, such policies are very misleading since there are two main types of risk --- cash flow risk versus value risk. It is impossible to simultaneously hedge both types of risk, and hedging one type increases the risk of the other type. For example, a company that swaps fixed for floating rate interest payments increases cash flow risk by eliminating value risk (which it may want if it plans to settle debt prior to maturity). The counterparty that swaps floating rate interest payments for fixed rate payments eliminates cash flow risk by taking on value risk. It is impossible to hedge both cash flow and value risk simultaneously.

Hence, to say that a corporation has a policy allowing hedging but not speculating in derivative financial instruments is nonsense. A policy to only hedge cash flow risk may create enormous value risk. A policy to only hedge value risk may create enormous cash flow risk.

As the NYT article above points out that derivative financial instruments are increasingly popular in world commerce. As a result risk exposures have greatly increased even if all contracts were used for hedging purposes only. The problem is that a hedge only reduces or eliminates one type of risk at the "cost" of increasing the other type of risk. Derivative contracts increase one type or the other type of risk the instant they are signed.  Hedging shifts risk but does not eliminate risk per se.

You can read more about scandals in derivative financial instruments contracting (such as one company's "trillion dollar bet" that nearly toppled Wall Street and Enron's derivative scandals) at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

You can download the CD containing my slide shows and videos on how to account for derivative financial instruments at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

My FAS 133 and IAS 39 Glossary is Below.

Table of Contents and Links

Bob Jensen's FAS 133 Glossary on Derivative Financial Instruments and Hedging Activities

          Also see a comprehensive risk and trading glossary at http://risk.ifci.ch/SiteMap.htm

Glossary for the energy industry --- Also see http://snipurl.com/EnergyGlossary  

Related glossaries are listed at http://www.trinity.edu/rjensen/bookbus.htm 

Click here for tutorial links 

Risk Glossary --- http://www.riskglossary.com/

If you are having trouble finding something try a Google search.  Especially note that you can add terms and phrases at http://www.google.com/advanced_search?hl=en
For example, you can add a phrase in the second cell and individual words in the top cell.  You can fill in both cells simultaneously to narrow your search.

Also note that you can seek definitions in Google.  In the top cell type in --- define “phrase” where your phrase can be one word like “contango” or “backwardation” or a phrase like “asian option”.
It is important to first type in the word “define” without quotation marks.

Second try a search within the standard itself.  
You can find digital versions of FAS 133 by scrolling down at http://www.fasb.org/st/#fas153 
DIG text is can be searched at http://www.fasb.org/derivatives/ 
Free digital versions of IAS 39 are available but they are difficult to find in EU law.  Fee-based versions are available at http://www.iasb.org/ 

Illustrations --- See Illustrations 

Dear Professor Bob Jensen,

The Journal of Deivatives Accounting (JDA) is preparing to publish its first issue and I would be grateful if you could post the following announcement on your web site.

Regards

Mamouda

Dear Colleagues,

There is a new addition to accounting research Journals. The Journal of Derivatives Accounting (JDA) is an international quarterly publication which provides authoritative accounting and finance literature on issues of financial innovations such as derivatives and their implications to accounting, finance, tax, standards setting, and corporate practices. This refereed journal disseminates research results and serves as a means of communication among academics, standard setters, practitioners, and market participants.

The first and special issue of the JDA, to appear in the Winter of 2003, will be dedicated to:

"Stock Options: Developments in Share-Based Compensation (Accounting, Standards, Tax and Corporate Practice)"

This special issue will consider papers dealing with:

* Analysis of applicable national and international accounting standards * Convergence between IASB and FASB * Accounting treatment (Expensing) * Valuation * Corporate and market practice * Design of stock options * Analysis of the structure of stock options contracts * Executives pay incentives and performance * Taxation * Management and Corporate Governance

For more details on how to submit your work to the journal, please visit http://www.worldscinet.com/jda.html 

Sincerely,
The Editorial Board Journal of Derivatives Accounting (JDA)

An earlier FAS 133 Amendment on the Heels of the Previous (FAS 138) Amendment --- A Mere 104 Pages

Derivative Financial Instruments Frauds --- 
http://www.trinity.edu/rjensen/fraud.htm

A Condensed Multimedia Overview With Video and Audio from Experts --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm 

A Longer and More Boring Introduction to FAS 133, FAS 138, and IAS 39 --- http://www.trinity.edu/rjensen/caseans/000index.htm 

The Devil's Derivatives Dictionary at http://www.margrabe.com/Devil/DevilF_J.html 

To understand more about derivative financial instruments, I suggest that you begin by going to the file at 
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm  
Especially note the discussion of the shortcut method at the end of the above document.

A helpful site on FAS 133 is at http://fas133.com 

Differences between FAS 133 and IAS 39 --- http://www.trinity.edu/rjensen/caseans/canada.htm 

Auditing Requirements for Derivative Financial Securities
Auditing Derivative Instruments, Hedging Activities, and Investments in Securities
http://www.aicpa.org/members/div/auditstd/riasai/sas92.htm 

A Nice Summary of SAS 92 is Available Online (Auditing, Derivative Financial Instruments, Hedging)

SAS 92-New Guidance on Auditing Derivatives and Securities
by Joe Sanders, Ph.D., CPA and Stan Clark, Ph.D., CPA 
http://www.ohioscpa.com/member/publications/Journal/1st2001/page10.asp  

Auditors face many challenges in auditing derivatives and securities. These instruments have become more complex, their use more common and the accounting requirements to provide fair value information are expanding. There is also an increasing tendency for entities to use service organizations to help manage activities involving financial instruments. To assist auditors with these challenges, the Auditing Standards Board (ASB) issued SAS 92, Auditing Derivative Instruments, Hedging Activities and Investments in Securities. The ASB is also currently developing a companion Audit Guide. SAS 92 supersedes SAS 81, Auditing Investments.

SAS 92 provides a framework for auditors to use in planning and performing auditing procedures for assertions about all financial instruments and hedging activities. The Audit Guide will show how to use the framework provided by the SAS for a variety of practice issues. The purpose of this article is to summarize and explain some of the more significant aspects of SAS 92.

Scope SAS 92 applies to:

Derivative instruments, as defined in SFAS 133, Accounting for Derivative Instruments and Hedging Activity. Hedging activities which also fall under SFAS 133. Debt and equity securities, as defined in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. The auditor should also refer to APB 18, The Equity Method of Accounting for Investments in Common Stock. Special Skill or Knowledge

SEC Chairman Arthur Levitt, in his speech on renewing the covenant with investors stated, "I recognize that new financial instruments, new technologies and even new markets demand more specialized know-how to effectively audit many of today's companies".1 One of the first items noted in SAS 92 is that the auditor may need to seek assistance in planning and performing audit procedures for financial instruments. This advice is based primarily on the complexity of SFAS 133. Understanding an entities' information system for derivatives, including work provided by a service organization, may require the auditor to seek assistance from within the firm or from an outside expert. SAS 73 provides guidance on using the work of a specialist.

Inherent Risk Assessment

The inherent risk related to financial instruments is the susceptibility to a material misstatement, assuming there are no related controls. Assessing inherent risk for financial instruments, particularly complex derivatives, can be difficult. To assess inherent risk for financial instruments, auditors should understand both the economics and business purpose of the entity's financial activities. Auditors will need to make inquiries of management to understand how the entity uses financial instruments and the risks associated with them. SAS 92 provides several examples of considerations that might affect the auditor's assessment of the inherent risk for assertions about financial instruments:2

The complexity of the features of the derivative or security. Whether the transaction that gave rise to the derivative or security involved the exchange of cash. The entity's experience with derivatives or securities. Whether the derivative is freestanding or an embedded feature of an agreement. The evolving nature of derivatives and the applicable generally accepted accounting principles. Significant reliance on outside parties. Control Risk Assessment

SAS 92 includes a section on control risk assessment. Control risk is the risk that a material misstatement could occur and would not be prevented or detected in a timely manner by an entity's internal control. Management is responsible for providing direction to financial activities through clearly stated policies. These policies should be documented and might include:

Policies regarding the types of instruments and transactions that may be entered into and for what purposes. Limits for the maximum allowable exposure to each type of risk, including a list of approved securities broker-dealers and counterparties to derivative transactions. Methods for monitoring the financial risks of financial instruments, particularly derivatives, and the related control procedures. Internal reporting of exposures, risks and the results of actions taken by management. Auditors should understand the contents of financial reports received by management and how they are used. For example, "stop loss" limits are used to protect against sudden drops in the market value of financial instruments. These limits require all speculative positions to be closed out immediately if the unrealized loss on those positions reaches a certain level. Management reports may include comparisons of stop loss positions and actual trading positions to the policies set by the board of directors.

The entity's use of a service organization will require the auditor to gain an understanding of the nature of the service organization's services, the materiality of the transactions it processes, and the degree of interaction between its activities and those of the entity. It may also require the auditor to gain an understanding of the service organization's controls over the transactions the service organization processes for it.

Designing Substantive Procedures Based on Risk Assessments

The auditor should use the assessed levels of inherent and control risk to determine the acceptable level of detection risk for assertions about financial instruments and to determine the nature, timing, and extent of the substantive tests to be performed to detect material misstatements of the assertions. Substantive procedures should address the following five categories of assertions included in SAS 31, Evidential Matter:

1. Existence or occurrence. Existence assertions address whether the derivatives and securities reported in the financial statements through recognition or disclosure exist at the balance sheet date. Occurrence assertions address whether changes in derivatives or securities reported as part of earnings, other comprehensive income, cash flows or through disclosure occurred. Examples of substantive procedures for existence or occurrence assertions include:3

Confirmation with the holder of the security, including securities in electronic form or with the counterparty to the derivative. Confirmation of settled or unsettled transactions with the broker-dealer counterparty. Physical inspection of the security or derivative contract. Inspecting supporting documentation for subsequent realization or settlement after the end of the reporting period. Performing analytical procedures. 2. Completeness. Completeness assertions address whether all of the entity's derivatives and securities are reported in the financial statements through recognition or disclosure. Since derivatives may involve only a commitment to perform under a contract and not an initial exchange of tangible consideration, auditors should not focus exclusively on evidence relating to cash receipts and disbursements.

3. Rights and obligations. These assertions address whether the entity has rights and obligations associated with derivatives and securities reported in the financial statements. For example, are assets pledged or do side agreements exist that allow the purchaser of a security to return the security after a specified period of time? Confirming significant terms with the counterparty to a derivative or the holder of a security would be a substantive procedure testing assertions about rights and obligations.

4. Valuation. Under SFAS 115 and SFAS 133 many financial instruments must now be measured at fair value, and fair value information must be disclosed for most derivatives and securities that are measured at some other amount.

The auditor should obtain evidence corroborating the fair value of financial instruments measured or disclosed at fair value. The method for determining fair value may be specified by generally accepted accounting principles and may vary depending on the industry in which the entity operates or the nature of the entity. Such differences may relate to the consideration of price quotations from inactive markets and significant liquidity discounts, control premiums, commissions and other costs that would be incurred to dispose of the financial instrument.

If the derivative or security is valued by the entity using a valuation model (for example, the Black-Scholes option pricing model), the auditor should assess the reasonableness and appropriateness of the model. The auditor should also determine whether the market variables and assumptions used are reasonable and appropriately supported. Estimates of expected future cash flows, for example, to determine the fair value of long-term obligations should be based on reasonable and supportable assumptions.

The method for determining fair value also may vary depending on the type of asset or liability. For example, the fair value of an obligation may be determined by discounting expected future cash flows, while the fair value of an equity security may be its quoted market price. SAS 92 provides guidance on audit evidence that may be used to corroborate these assertions about fair value.

5. Presentation and disclosure. These assertions address whether the classification, description and disclosure of derivatives and securities are in conformity with GAAP. For some derivatives and securities, GAAP may prescribe presentation and disclosure requirements, for example:

Certain securities are required to be classified into categories based on management's intent and ability such as trading, available-for-sale or held-to-maturity. Changes in the fair value of derivatives used to hedge depend on whether the derivative is a fair-value hedge or an expected cash flow hedge, and on the degree of effectiveness of the hedge. Hedging Transactions

Hedging will require large amounts of documentation by the client. For starters, the auditor will need to examine the companies' established policy for risk management. For each derivative, management should document what risk it is hedging, how it is expected to hedge that risk and how the effectiveness will be tested. Without documentation, the client will not be allowed hedge accounting. Auditors will need to gather evidence to support the initial designation of an instrument as a hedge, the continued application of hedge accounting and the effectiveness of the hedge.

To satisfy these accounting requirements, management's policy for financial instrument transactions might also include the following elements whenever the entity engages in hedging activities:

An assessment of the risks that need to be hedged The objectives of hedging and the strategy for achieving those objectives. The methods management will use to measure the effectiveness of the strategy. Reporting requirements for the monitoring and review of the hedge program. Impairment Losses

Management's responsibility to determine whether a decline in fair value is other than temporary is explicitly recognized in SAS 92. The auditor will need to evaluate whether management has considered relevant information in determining whether other-than-temporary impairment exists. SAS 92 provides examples of circumstances that indicate an other-than-temporary impairment condition may exist:4

Management Representations

The auditor must obtain written representations from management confirming their intent and ability assertions related to derivatives and securities. For example, the intent and ability to hold a debt security until it matures or to enter into a forecasted transaction for which hedge accounting is applied. Appendix B of SAS 85 (AU Sec. 333.17) includes illustrative representations about derivative and security transactions.

Summary

SAS 92 provides guidance for auditing derivatives and securities. Accounting requirements related to these instruments, SFAS 115 and SFAS 133, are very complex and because of their extensive use of fair value measures require significant use of judgment by the accountant. SAS 92 establishes a framework for auditors to assess whether the entity has complied with the provisions of SFAS 115 and SFAS 133. However, because of the subjective nature of many of the requirements of these two standards, considerable auditor judgment will be required to comply with SAS 92.

Effective Date

This SAS is effective for audits of financial statements for fiscal years ending on or after June 30, 2001. Early adoption is permitted.

 

Keeping Up With Financial Instruments Derivatives

Bob Jensen's CD --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/

I'm sharing some old (well relatively old) accounting theory quiz and exam material that I added to a folder at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

You can find some great tutorials go to CBOE at http://www.cboe.com/education/ .   But these do not help with learning how to account for the derivatives under FAS 133 and IAS 39.  The same holds for the CBOT at http://www.cbot.com/cbot/pub/page/0,3181,909,00.html  and the CME at http://www.cme.com/edu/ 

New York Mercantile Exchange (NYMEX) for energy and metals under the Education tab at http://www.nymex.com/jsp/index.jsp 

Optionetics has some good tutorials with respect to options but these do not explain options accounting --- http://www.optionetics.com/education/trading.asp 

Daniel Oglevee's Course Site --- http://www.cob.ohio-state.edu/fin/autumn2004/723.htm 

In 2000, ISDA filed a letter to the Financial Accounting Standards Board (FASB) urging changes to FAS 133, its derivatives and hedge accounting standard. ISDA’s letter urged alterations to six areas of the standard: hedging the risk-free rate; hedging using purchased options; providing hedge accounting for foreign currency assets and liabilities; extending the exception for normal purchase and sales; and central treasury netting. The FASB subsequently rejected changes to purchased option provisions, conceded some on normal purchases and sales, extending the exception to contracts that implicitly or explicitly permit net settlement, declined to amend FAS 133 to facilitate partial term hedging and agreed to consider changing the restrictions on hedge accounting for foreign currency. 
ISDA ®INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.http://www.isda.org/wwa/Retrospective_2000_Master.pdf  

A good tutorial on energy futures and options hedging is given by the New York Mercantile Exchange (NYMEX) under the Education tab at http://www.nymex.com/jsp/index.jsp 

Two Questions
How did Bob Jensen spend his summer vacation?
What can physicists do when they can't find jobs in physics?

Answers

I've spent a great deal of my summer and my Fall 2004 Semester leave plowing through a book entitled Quantitative Finance and Risk Managment:  A Physicists Approach by Jan W. Dash, by Jan W. Dash (World Scientific Publishing, 2004, ISBN 981-238-712-9)
This is a great book by a good writer.

For a more introductory warm up I recommend Derivatives:  An Introduction by Robert A Strong, Edition 2 (Thomson South-Western, 2005, ISBN 0-324-27302-9)

And what about opportunities for physicists?
See "A Geek's Walk on Wall Street," by Peter Coy, Business Week, November 15, Page 26.  This is a review of a book entitled My Life as a Quant, by Emanuel Derman (Wiley, 2005) --- http://www.businessweek.com/@@x3mnUmYQYMjg7RMA/premium/content/04_46/b3908024_mz005.htm 

As one of Wall Street's leading quants, Derman did throw off some intense gamma radiation. He worked at Goldman from 1985 until 2003 except for one year at Salomon Brothers. At Goldman, he moved from fixed income to equity derivatives to risk management, becoming a managing director in 1997. He co-invented a tool for pricing options on Treasury bonds, working with Goldman colleagues Bill Toy and the late Fischer Black, who co-invented the Black-Scholes formula for valuing options on stocks. Derman received the industry's "Financial Engineer of the Year" award in 2000. Now he directs the financial-engineering program at Columbia University.

Derman failed at what he really wanted, which was to become an important physicist. He was merely very smart in a field dominated by geniuses, so he kicked around from one low-paying research job to another. "At age 16 or 17, I had wanted to be another Einstein," he writes. "By 1976...I had reached the point where I merely envied the postdoc in the office next door because he had been invited to give a seminar in France." His move to Wall Street -- an acknowledgment of failure -- brought him financial rewards beyond the dreams of academic physicists and a fair measure of satisfaction as well.

In the tradition of the idiosyncratic memoir, My Life As a Quant is a grab bag of the author's interests. It quotes Schopenhauer and Goethe while supplying not one but three diagrams of a muon neutrino colliding with a proton. There is a long section on the brilliant and punctilious Fischer Black; a glimpse of physicist Richard Feynman; and an embarrassing encounter with finance giant Robert Merton, who sat next to the author on a long flight (Derman treated him rudely before realizing who he was).

Derman's mood seems to vary from bemused on good days to sour on bad ones. The chapter on his postdoc travels is titled "A Sort of Life"; his brief career at Bell Labs, "In the Penal Colony"; his tenure at Salomon Brothers, "A Severed Head." Pre-IPO Goldman Sachs comes off as relatively gentle yet stimulating. He writes: "It was the only place I never secretly hoped would crash and burn."

Continued in the article

Bob Jensen's threads (including video tutorials) on derivative financial instruments and the Freddie and Fannie scandals are at http://www.trinity.edu/rjensen/caseans/000index.htm 

Bob Jensen's threads on the trillions of dollars of worldwide frauds using derivative financial instruments are at http://www.trinity.edu/rjensen/fraudRotten.htm#DerivativesFrauds 

 

You can read a great deal about energy derivatives in The Derivatives 'Zine at http://www.margrabe.com/Energy.html 
Other topics include the following:

The Derivatives 'Zine by Dr. Risk THE WILLIAM MARGRABE GROUP, INC., CONSULTING, PRESENTS

Home ABOUT CONTACT SEARCH LINKS DICTIONARY ACCOUNTING & FAS 133 BIG APPLET ASK DR. RISK! CREDIT RISK CREDIT DP CURRENCY ENERGY EQUITY FIXED INCOME TRADING POST PERSONAL IF ONLY ... DEAL MARKET RISK MODEL RISK BOOKSHELF MATH APPENDIX JAVA JOBS! CALENDAR HUMOR GAMES DEVIL'S DD

Ask Dr. Risk!

• Free answers: Dr. Risk promises any correspondent from a business domain with a website (e.g., Mack@CSFB.com) at least a five-minute response to your important question, as soon as he has a free moment, probably within one month. 
• Fast answers: If you absolutely, positively will have to have an answer overnight, set up your consulting account, ahead of time, with the William Margrabe Group, Inc.. Introductory offer: $300 / hour with one-minute granularity. If we can't provide the answer, we'll refer you to someone who can. If we can't refer you, we'll inform you fast for free.
• No answers: LDiablo@hotmail.com, Chris1492@aol.com, BillyG@MSN.com, and Desperate@Podunk.edu, etc. can no longer count on even brief answers, unless their questions are sufficiently intriguing. Sorry. 

A question of sufficiently general interest to make it into the 'Zine, tends to generate a more comprehensive response. All questions and answers become the property of The William Margrabe Group, Inc

QUANTITATIVE FINANCE AND RISK MANAGEMENT A Physicist's Approach
by Jan W Dash

This book is designed for scientists and engineers desiring to learn quantitative finance, and for quantitative analysts and finance graduate students. Parts will be of interest to research academics --- http://www.worldscientific.com/books/economics/5436.html 

804pp	Pub. date: Jul 2004
ISBN 981-238-712-9	US$98 / £73

Contents:

• Introduction, Overview, and Exercise
• Risk Lab (Nuts and Bolts of Risk Management)
• Exotics, Deals, and Case Studies
• Quantitative Risk Management
• Path Integrals, Green Functions, and Options
• The Macro-Micro Model (A Research Topic)

The above sources are not much good about accounting for derivatives under FAS 133, FAS 138, and IAS 39.  For that, go to the following source:

http://www.trinity.edu/rjensen/caseans/000index.htm 

FAS 133 Tutorial, SmartPros --- http://www.smartpros.com/x33017.xml 

FAS 133, the standard for financial reporting of derivatives and hedging transactions, was adopted in 1998 by the Financial Accounting Standards Board to resolve inconsistent previous reporting standards and practices. It went into effect at most U.S. companies at the beginning of 2001.

Courtesy of Kawaller & Company, SmartPros presents this FAS 133 tutorial to help you understand the provisions of the standard. For news pertaining to FAS 133, click on the links to the right in Related Stories.

PwC Tutorial on IAS 39 --- http://www.pwcglobal.com/images/gx/eng/fs/bcm/032403iashedge.pdf 

PowerPoint Show Highlighting Some Complaints About IAS 39 and IAS 32 --- http://www.atel.lu/atel/fr/publications/Publications/030524_EACT%20mtg_Milan.ppt 

"IAS 32 and IAS 39 Revised:  An Overview," Ernst & Young, February 2004  --- http://www.ey.com/global/download.nsf/International/IAS32-39_Overview_Febr04/$file/IAS32-39_Overview_Febr04.pdf 
I shortened the above URL to http://snipurl.com/RevisedIAS32and39 

Sharing Professor  --- John Hull (who writes about financial instrument derivatives) --- http://www.rotman.utoronto.ca/~hull/

His great books (not free) are great, but he also shares (for free) some software and data --- http://www.rotman.utoronto.ca/~hull/

Options, Futures, and Other Derivatives, 5th Edition  Fundamentals of Futures and Options Markets, 4th Edition

Forwarded by Carl Hubbard on September 12, 2003

I would like to bring to your attention Analysis of Derivatives for the CFA(r) Program by Don M. Chance, CFA, recently published this year by the Association for Investment Management and Research(r). While designed for the CFA program, this publication is a terrific text for academic derivatives and risk management courses.

The treatment in this volume is intended to communicate a practical risk management approach to derivatives for the investment generalist. The topics in the text were determined by a comprehensive job analysis of investment practitioners worldwide. The illustrative in-chapter problems and the extensive end-of-chapter questions and problems serve to reinforce learning and understanding of the material.

We believe that this text responds to the need for a globally relevant guide to applying derivatives analysis to the investment process. We hope you will consider adopting Analysis of Derivatives for the CFA(r) Program for a future course.

Thank you for your attention.

Sincerely,

Helen K. Weaver
Associate
AIMR

656 PAGES
0-935015-93-0 
HB 2003

Message from Ira Kawaller on August 4, 2002

Hi Bob,

I posted a new article on the Kawaller & Company website: “What’s ‘Normal’ in Derivatives Accounting,” originally published in Financial Executive, July / August 2002. It is most relevant for financial managers of non-financial companies, who seek to avoid FAS 133 treatment for their purchase and sales contracts. The point of the article is that this treatment may mask some pertinent risks and opportunities. To view the article, click on http://www.kawaller.com/pdf/FE.pdf  .

I'd be happy to hear from you if you have any questions or comments.

Thanks for your consideration.

Ira Kawaller Kawaller & Company, LLC http://www.kawaller.com 

kawaller@kawaller.com 717-694-6270

Bob Jensen's documents on derivative financial instruments are at http://www.trinity.edu/rjensen/caseans/000index.htm 

March 8, 2002 Message from the Risk Waters Group [RiskWaters@lb.bcentral.com] 

ONLINE TRADING TRAINING NOW AVAILABLE (Investments, Finance, Derivatives) … 
‘Introduction to Trading Room Technology’ from Waters Training. A low-cost, Web-based training solution for financial professionals. Go at your own pace, travel nowhere, and learn about the core trading processes and key technology issues from your own desktop. For more information, go to http://www.waters-training.com  to find out more. Lastly, if you have any colleagues, training managers or business associates who would be interested in this new product, please forward them this message. 
Thank you.

If you are interested in email messages regarding financial risk news, you may be interested in contacting:

Christopher Jeffery  mailto:cjeffery@riskwaters.com 
Editor, RiskNews
http://www.risknews.net 

Governmental Disclosure Rules for Derivative Financial Instruments ---  see Disclosure.

The DIG
In the meantime, the FASB formed the FAS 133 Derivatives Implementation Group (DIG) to help resolve particular implementation questions, especially in areas where the standard is not clear or allegedly onerous.  The FASB's DIG website (that contains its mission and pronouncements) is at http://www.fasb.org/derivatives/  DIG issues are also summarized (in red borders) at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin.

IAS 138 Implementation Guidance
"Implementation of SFAS 138, Amendments to SFAS 133," The CPA Journal, November 2001. (With Angela L.J. Huang and John S. Putoubas), pp. 54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm

April 25, 2002 message from Charlie Stutesman [southwestern.email@swcollege.com] 

Dear Professor Jensen,

In direct contrast to most trade training derivatives texts which emphasize issues related to the pricing and hedging of derivatives, this groundbreaking text is designed for those who want to teach students how to manage derivatives to maximize firm value through risk management. DERIVATIVES AND RISK MANAGEMENT presents the crucial tools necessary for executives and future derivatives players to effectively hedge with derivatives in order to protect firms from losses.

* WRITTEN TO EMPHASIZE THE ROLE OF MANAGERS: Managers will use derivatives to maximize firm value as opposed to traders who may use derivatives to speculate.

* MANAGERIAL APPLICATION BOXES: Preparing users to meet the challenges of today's business decisions, real-world applications bring chapter concepts to life.

* TECHNICAL BOXES: Concepts presented within the chapters are taken to a higher level of conceptual or mathematical rigor.

We encourage you to request a complimentary exam copy of DERIVATIVES AND RISK MANAGEMENT (ISBN: 0-538-86101-0) by Stulz. Simply reply to this message, contact your South-Western, Thomson Learning representative, call the Thomson Learning Academic Resource Center at 1-800-423-0563, or go to:

http://esampling.thomsonlearning.com/s1.asp?Rid=1+JWA+1719&SC=2SCF2262 

South-Western has helped provide generations of learners with a solid foundation and true understanding of finance. Now more than ever, follow the proven leader into a new century with relevant, comprehensive, and up-to-date finance products and information.

Sincerely,

Charlie Stutesman 
Senior Marketing Manager 
charlie.stutesman@swlearning.com 

IAS 39 Implementation Guidance

Supplement to the Publication
Accounting for Financial Instruments - Standards, Interpretations, and Implementation Guidance
http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf

The IASB’s Exposure Draft of the macro hedging compromise is entitled “Amendments to IAS 39:  Recognition and Measurement Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate” and for a short time can be downloaded free from http://www.iasc.org.uk/docs/ed-ias39mh/ed-ias39mh.pdf
See Macro Hedging 

Also see Bob Jensen's Interest Rate Swap Valuation, Forward Rate Derivation,  and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments --- http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm 

Hi Patrick,

The term "better" is a loaded term. One of the main criticisms leveled at IASC standards is that they were too broad, too permissive, and too toothless to provide comparability between different corporate annual reports. The IASC (now called IASB) standards only began ot get respect at IOSCO after they started becoming more like FASB standards in the sense of having more teeth and specificity.

I think FAS 133 is better than IAS 39 in the sense that FAS 133 gives more guidance on specific types of contracts. IAS 39 is so vague in places that most users of IAS 39 have to turn to FAS 133 to both understand a type of contract and to find a method of dealing with that contract. IAS 39 was very limited in terms of examples, but this has been recitified somewhat (i.e., by a small amount) in a recent publication by the IASB: Supplement to the Publication Accounting for Financial Instruments - Standards, Interpretations, and Implementation Guidance http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf 

In theory, there are very few differences between IAS 39 and FAS 133. But this is like saying that there is very little difference between the Bible and the U.S. Commercial Code. Many deals may be against what you find in the Bible, but lawyers will find it of less help in court than the U.S. Commercial Code. I admit saying this with tongue in cheek, because the IAS 39 is much closer to FAS 133 than the Bible is to the USCC.

Paul Pacter wrote a nice paper about differences between IAS 39 and FAS 133. However, such a short paper cannot cover all differences that arise in practice. The paper is somewhat dated now, but you can find more recent updates on differences at Differences between FAS 133 and IAS 39 --- http://www.trinity.edu/rjensen/caseans/canada.htm  

Although there are differences between FAS 133 and IAS 39, I would not make too big a deal out of such differences. IAS 39 was written with one eye upon FAS 133, and the differences are relatively minor. Paul Pacter's summary of these differences can be downloaded from http://www.iasc.org.uk/cmt/0001.asp?s=490603&sc={65834A68-1562-4CF2-9C09-D1D6BF887A00}&sd=860888892&n=3288 

Also note "Comparisons of International IAS Versus FASB Standards" --- http://www.deloitte.com/dtt/cda/doc/content/pocketiasus.pdf

Hope this helps,

Bob (Robert E.) Jensen Jesse H. Jones Distinguished Professor of Business Trinity University, San Antonio, TX 78212 Voice: (210) 999-7347 Fax: (210) 999-8134 Email: rjensen@trinity.edu http://www.trinity.edu/rjensen 

-----Original Message----- 
From: Patrick Charles [mailto:charlesp@CWDOM.DM]  
Sent: Tuesday, February 26, 2002 11:54 AM 
To: CPAS-L@LISTSERV.LOYOLA.EDU 
Subject: US GAAP Vs IASB

Greetings Everyone

Mr Bolkestein said the rigid approach of US GAAP could make it easier to hide companies' true financial situation. "You tick the boxes and out come the answer," he said. "Having rules is a good thing, but having rigid rules is not the best thing.

http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3AHWRLXXC&live=true&tagid=FTDCZE6JFEC&subheading=accountancy

Finally had a chance to read the US GAAP issue. Robert you mentioned IAS 39, do you have other examples where US GAAP is a better alternative to IASB, or is this an European ploy to get the US to adopt IASB?

Cheers

Mr. Patrick Charles charlesp@cwdom.dm  ICQ#6354999

"Education is an admirable thing, but it is well to remember from time to time that nothing that is worth knowing can be taught."

Bob Jensen's Glossary of FAS 133 and IAS 39

Bob Jensen's Overview of FAS 133 (With Audio) http://www.trinity.edu/rjensen/caseans/000index.htm 

Interest Rate Swap Valuation, Forward Rate Derivation,  and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments 
See http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

FAS 133 flow chart  http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Bob Jensen's Document on the Missing Parts of FAS 133

Summary of Key Paragraphs in FAS 133 on Portfolio/Macro Hedging.

Bob Jensen's Weekly Assignments and Hints Regarding FAS 133

Bob Jensen's Technology Glossary (Includes an Extensive Listing of Accounting and Finance Glossaries)

ACCT 5341 International Accounting Theories Course Helpers

Yahoo Finance is Bob Jensen's Favorite Place to learn more about the mechanics and widespread use of derivative financial instruments.  That web site, however, will not help much with respect to accounting for such instruments under FAS 133.

Bob Jensen's Mexcobre Case

For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm 

Internet Links of Possible Interest

Bob Jensen's Transcripts of Presentations by Experts

• The web address for my multimedia overview of FAS 133 can be found at http://www.cs.trinity.edu/~rjensen/000overview/133suma.htm. 
  

• James Leisenring from the Financial Accounting Standards Board
  Stephen Swad from KPMG Peat Marwick LLP
  
  

• James Leisenring from the Financial Accounting Standards Board
  Lynn Turner from the Securities and Exchange Commission
  
  

• Paul Pacter from the International Accounting Standards Committee
  
  

• Walter Teets from Gonzaga University
  
  

PriceWaterhouseCoopers (PWC) Summary Tables (With Some Notes Added by Bob Jensen) 

Derivatives Implementation Group (DIG) 

For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm 

Differences between FAS 133 and IAS 39 --- http://www.trinity.edu/rjensen/caseans/canada.htm

Side by Side: IAS 39 Compared with FASB Standards (FAS 133), by Paul Pacter, as published in Accountancy International Magazine, June 1999 --- http://www.iasc.org.uk/news/cen8_142.htm 
Also note "Comparisons of International IAS Versus FASB Standards" --- http://www.deloitte.com/dtt/cda/doc/content/pocketiasus.pdf

IAS 39 history --- http://www.iasc.org.uk/cmt/0001.asp?s=6941204&sc={CB32B469-886C-4486-86B7-36E49358DDE5}&sd=617116004&n=3306 

Limited Revisions to IAS 39, Financial Instruments: Recognition and Measurement (E66) --- http://www.iasc.org.uk/cmt/0001.asp?s=6941204&sc={CB32B469-886C-4486-86B7-36E49358DDE5}&sd=268256258&n=3222

Recognition and Measurement (E66)

E66, Proposed Limited Revisions to IAS 39 and Other Related Standards, proposed the following limited revisions to IAS 39, Financial Instruments: Recognition and Measurement, and other related Standards: changes to require consistent accounting for purchases and sales of financial assets using either trade date accounting or settlement date accounting. IAS 39 currently requires settlement date accounting for sales of financial assets, but permits both trade date and settlement date accounting for purchases; elimination of the requirement in IAS 39 for a lender to recognise certain collateral received from a borrower in its balance sheet; improvement of the wording on impairment recognition; changes to require consistent accounting for temporary investments in equity securities between IAS 39 and other International Accounting Standards; and elimination of redundant disclosure requirements for hedges in IAS 32, Financial Instruments: Disclosure and Presentation. None of the proposed revisions represents a change to a fundamental principle in IAS 39. Instead, the purpose of the proposed changes is primarily to address technical application issues that have been identified following the approval of IAS 39 in December 1998. The IASC Board’s assessment is that the proposed changes will assist enterprises preparing to implement IAS 39 for the first time in 2001 and help ensure a consistent application of the Standard. No further changes to IAS 39 are contemplated.

At its meeting in March 2000, the Board appointed a Committee to develop implementation guidance on IAS 39, Financial Instruments: Recognition. The guidance is expected to be published later this year, after public comment, as a staff guidance document. The IAS 39 Implementation Guidance Committee may refer some issues either to the SIC or to the Board.  http://www.iasc.org.uk/frame/cen2_139.htm

Recommended Reading

Recommended Links

Bob Jensen's Glossary of FAS 133 and IAS 39

A message from Ira Kawaller on January 13, 2002

Hi Bob,

I wanted to alert you to the fact that I posted another article on the Kawaller and Company website, "The New World Under FAS 133." It came out in the latest issue of the GARP Review. It deals with the economics and accounting considerations relating to the use of cross-currency interest rate swaps. The link below brings you to the paper:

http://www.kawaller.com/pdf/garpswaps.pdf

I also posted a new calendar of events, at

http://www.kawaller.com/schedule/calendar.pdf

To navigate to the links in this email message, click on them. If that does not work, copy the link and paste it into the address field of your browser.

Please feel free to contact me if you have any questions, comments, or suggestions. Thanks for your consideration.

Ira Kawaller kawaller@kawaller.com 
http://www.kawaller.com

Bob Jensen's documents on FAS 133, FAS 138, and IAS 39 are at http://www.trinity.edu/rjensen/caseans/000index.htm 

PriceWaterhouseCoopers (PWC) Summary Tables

Source:  A Guide to Accounting for Derivative Instruments and Hedging Activities (New York, Pricewaterhouse Coopers, 1999, pp. 4-5 and pp. 19-22)  

Note that the FASB's FAS 133 becomes required for calendar-year companies on January 1, 2001.  Early adopters can apply the standard prior to the required date, but they cannot apply it retroactively.   The January 1, 2001 effective date follows  postponements from the original starting date of June 15, 1999 stated in Paragraph 48 on Page 29 of FAS 133.   For fiscal-year companies, the effective date is June 15, 2000.  The international counterpart known as the IASC's IAS 39 becomes effective for financial statements for financial years beginning on the same January 1, 2001.  Earlier application permitted for financial years ending after 15 March 1999.  

Note that Bob Jensen has added notes (in red),

OVERVIEW & EXPECTED IMPACT of FAS 133 and IAS 39

Table of Derivatives-Contract Types

Other References --- See References 

Beginning of Bob Jensen's FAS 133 and IAS 39 Glossary
Accounting for Derivative Instruments and Hedging Activities

| A | B | C | D | E | F | G | H | I | J | K | L | M |
| N | O | P | Q | R | S | T | U | V | W | X | Y | Z |

Note that the FASB's FAS 133 becomes required for calendar-year companies on January 1, 2001.  Early adopters can apply the standard prior to the required date, but they cannot apply it retroactively.   The January 1, 2001 effective date follows  postponements from the original starting date of June 15, 1999 stated in Paragraph 48 on Page 29 of FAS 133.   For fiscal-year companies, the effective date is June 15, 2000.  The international counterpart known as the IASC's IAS 39 becomes effective for financial statements for financial years beginning on the same January 1, 2001.  Earlier application permitted for financial years ending after 15 March 1999. 

For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm  

A-Terms

Accounting Exposure =

a term used in alternate ways. In one context, accounting exposure depicts foreign exchange exposure that cannot be captured by the accounting model. In some textbooks accounting exposure is synonymous with translation exposure. See translation exposure.  Also see risks.

Amortization of Basis Adjustments = see basis adjustment.

Anticipated Transaction = see forecasted transaction.

AOCI = accumulated other comprehensive income.  See comprehensive income.

Arbitrage = 

By definition, arbitraging entails investing at zero market (price) risk coupled with the risk of losing relatively minor transactions costs of getting into and closing out contracts.  There might be other risks.  Especially when dealing in forward contracts, there may be credit risks.  Forward contracts are often private agreements between contracting individuals.  Other arbitraging alternatives such as futures and options contracts are generally obtained in trading markets such as the Chicago Board of Trade (CBOT) and the Chicago Board of Options Exchange (CBOE).  In markets like the CBOT or the CBOE, the trading exchanges themselves guarantee payments such that there is no credit risk in hedging or speculating strategies.  Arbitrage entails a hedging strategy that eliminates all market (price) risk while, at the same time, has no chance of losing any money and a positive chance of making a profit.  Sometimes the profit is locked in to a fixed amount in advance.  At other times, the profit is unknown, but can never be less than zero (ignoring transactions costs).

Generally arbitrage opportunities arise when the same item is traded in different markets where information asymmetries between markets allows arbitragers with superior information to exploit investors having inferior information.  In perfectly efficient markets, all information is impounded in prices such that investors who "know more" cannot take advantage of investors who are not up on the latest scoop.  Only in inefficient markets can there be some differences between prices due to unequal impounding of information.

FAS 133 says nothing about arbitrage accounting.  Thus it is necessary to drill arbitrage trans actions down to their basic component contracts such as forwards, futures, and options.  See derivative financial instruments and hedge.

You can learn more about arbitrage from my tutorial on arbitraging at http://www.trinity.edu/rjensen/acct5341/speakers/muppets.htm 

You will find the following definition of arbitrage at http://risk.ifci.ch/00010394.htm 

1) Technically, arbitrage consists of purchasing a commodity or security in one market for immediate sale in another market (deterministic arbitrage). (2) Popular usage has expanded the meaning of the term to include any activity which attempts to buy a relatively underpriced item and sell a similar, relatively overpriced item, expecting to profit when the prices resume a more appropriate theoretical or historical relationship (statistical arbitrage). (3) In trading options, convertible securities, and futures, arbitrage techniques can be applied whenever a strategy involves buying and selling packages of related instruments. (4) Risk arbitrage applies the principles of risk offset to mergers and other major corporate developments. The risk offsetting position(s) do not insulate the investor from certain event risks (such as termination of a merger agreement or the risk of delay in the completion of a transaction) so the arbitrage is incomplete. (5) Tax arbitrage transactions are undertaken to share the benefit of differential tax rates or circumstances of two or more parties to a transaction. (6) Regulatory arbitrage transactions are designed to provide indirect access to a market where one party is denied direct access by law or regulation. (7) Swap- driven arbitrage transactions are motivated by the comparative advantages which swap counterparties enjoy in different debt and currency markets. One counterparty may borrow relatively cheaper in the intermediate- or long-term United States dollar market while the other may have a comparative advantage in floating rate sterling. A cross-currency swap can improve both of their positions. 

At-the-Money = see option and intrinsic value.

Auditing See SAS 92

Available-for-Sale (AFS) Security =

is one of three classifications of securities investments under SFAS 115.  Securities designated as "held-to-maturity" need not be revalued for changes in market value and are maintained at historical cost-based book value.  Securities not deemed as being held-to-maturity securities are adjusted for changes in fair value.  Whether or not the unrealized holding gains or losses affect net income depends upon whether the securities are classified as trading securities versus available-for-sale securities.  Unrealized holding gains and losses on available-for-sale securities are deferred in comprehensive income instead of being posted to current earnings.  This is not the case for securities classified as trading securities rather than trading securities.  See FAS 133 Paragraph 13.  The three classifications are of vital importance to cash flow hedge accounting under FAS 133.  See cash flow hedge and held-to-maturity.   Also see equity method and impairment.

Flow Chart for AFS Hedge Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm 

Classification of an available-for-sale security gives rise to alternative gain or loss recognition alternatives under international rules.  Changes in the value of an available-for-sale instrument either be included in earnings for the period in which it arises; or recognized directly in equity, through the statement of changes in equity ( IAS 1 Paragraphs 86-88) until the financial asset is sold, collected or otherwise disposed of, or until the financial asset is determined to be impaired (see IAS Paragraphs 117-119), at which time the cumulative gain or loss previously recognized in equity should be included in earnings for the period.  See IAS 39 Paragraph 103b.

A trading security (not subject to APB 15 equity method accounting and as defined in SFAS 115) cannot be a FAS 133 hedged item.  That is because SFAS 115 requires that trading securities be revalued (like gold) with unrealized holding gains and losses being booked to current earnings.  Conversely, Paragraphs 4c on Page 2, 38 on Page 24, and 479 on Page 209 of FAS 133 state that a forecasted purchase of an available-for-sale can be a hedged item, because available-for-sale securities are revalued under SFAS 115 have holding gains and losses accounted for in comprehensive income rather than current earnings.  Unlike trading securities, available-for-sale securities can be FAS 133-allowed hedge items.   Mention of available-for sale is made in Paragraphs 4, 18, 23, 36, 38, 49, 52-55, 123, 479-480, and 534 of FAS 133.  Held-to-maturity securities can also be FAS 133-allowed hedge items.

Note that if unrealized gains and losses are deferred in other comprehensive income, the deferral lasts until the transactions in the hedged item affect current earnings.  This means that OCI may carry forward on the date hedged securities are purchased and remain on the books until the securities are sold.  This is illustrated in Example 19 on Page 228 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998).  The Example 5.5 illustration on Page 165 notes that hedge effectiveness need only be assessed for price movements in one direction for put and call options since these only provide one-way price protection.

Suppose a company expects dividend income to continue at a fixed rate over the two years in a foreign currency.  Suppose the investment is adjusted to fair market value on each reporting date.  Forecasted dividends may not be firm commitments since there are not sufficient disincentives for failure to declare a dividend.  A cash flow hedge of the foreign currency risk exposure can be entered into under Paragraph 4b on Page 2 of FAS 133.  Whether or not gains and losses are posted to other comprehensive income, however, depends upon whether the securities are classified under SFAS 115 as available-for-sale or as trading securities.   There is no held-to-maturity alternative for equity securities.

The difference between a forward exchange rate and a spot rate is not excluded from a fair value hedging relationship for firm commitments measured in forward rates.  However Footnote 22 on Page 68 of FAS 133 reads as follows:

If the hedged item were a foreign-currency-denominated available-for-sale security instead of a firm commitment, Statement 52 would have required its carrying value to be measured using the spot exchange rate. Therefore, the spot-forward difference would have been recognized immediately in earnings either because it represented ineffectiveness or because it was excluded from the assessment of effectiveness.

B-Terms

Backwardation = see basis and contango swap.

Banker Opinions = 

Joint Working Group of Banking Associations Financial Instrument Issues Relating to Banks

- banksjwg.pdf - Discussion Paper 
- jwgfinal.pdf - Final Position on Fair Value Accounting

Hi Dr. Jensen!

It is the official site about the Financial Instruments - Comprehensive Project of the IASC http://www.iasc.org.uk/frame/cen3_112.htm  The site of the IAS Recognition and Measurement Project is: http://www.iasc.org.uk/frame/cen2_139.htm 

Your Trinity-Homepages on Derivatives SFAS No. 133 is my favorite on this subject, espicially the illustrative examples (and the account simulations).

Currently I am focusing on splitting up hybrid financial instruments, especially those with embedded optional building blocks. The book of Smith/Smithson/Willford (1998) Managing Financial Risk and that from Das S. (1998) and Walsey J. (1997) provides a good guidance on how these products are structured.

Best Regard Christian

Basis =

difference between the the current spot price and the forward (strike) price of a derivative such as a futures contract or the forward component  in an options contract.     The basis is negative in normal backwardation.  The basis is is postive in the normal contango.  Various theories exist to explain the two differing convergence patterns. 

There are other definitions of basis found in practice.  Some people define basis as the difference between the spot and futures price.  Alternately basis can be viewed as the benefits minus the costs of  holding the hedged spot underlying until the forward or futures settlement date. 

Still another definition of this term is based on the U.S. tax code where basis is the carrying value of an asset.  It is the last definition that gives rise to the term basis adjustment.  See intrinsic value.  Also see the terms that use "basis" that are listed below.

Still another term is the difference between commodity prices as the difference between physical locations or product quality grades.

Basis Adjustment =

the adjustment of the booked value of an asset or liability as required by SFAS 80 but is no longer allowed for cash flow and foreign currency hedges under FAS 133 according to Paragraph 31 on Page 22 and Paragraphs 375-378 on Pages 172-173 of FAS 133.    Basis adjustment is required for fair value hedges under Paragraphs 22-24 on Pages 15-16 of FAS 133.   An illustration of amortization of fair value hedge basis adjustments appears in Example 2 beginning in Paragraph 111 on Page 60 of FAS 133.   Also see short-cut method.

The carrying value of a hedging offset account (OCI, Firm Commitment, or Balance Sheet Item) may be written off prematurely whenever the hedge becomes severely ineffective.

Under IAS 39, the carrying value of an effective hedge is written off when the hedge expires or is dedesignated. See Paragraphs 162 and 163 of IAS 39.

Under FAS 133, the carrying value of an effective hedge is carried forward until the ultimate disposition of the hedged item (e.g. inventory sale or depreciation of equipment). See Paragraph 31 of FAS 133.

The FASB decision to ban basis adjustment for cash flow hedges is controversial, although the controversy is a tempest in a teapot from the standpoint of reported net earnings each period.  Suppose you are enter into a firm commitment on 1/1/99 to purchase a building for the amount of yen that you can purchase for $5 million on 1/1/99.  The financial risk is that this commitment requires a payout in Japanese yen on 7/1/99 such that the building's cost may be higher or lower in terms of how many yen must be purchased on 7/1/99.   To hedge the dollar/yen exchange rate, you enter into a forward contract that will give you whatever it takes make up the difference between the yen owed and the yen that $5 million will purchase on 7/1/99.  On 1/1/99 the forward contract has zero value.  Six months later, assume that the forward contract has been value adjusted to $1 million because of the decline in the yen exchange rate. The offsetting credit is $1 million in OCI if since this was not designated as a fair value hedge. 

To close out the derivative on 7/1/99, you debit cash and credit the forward contract for $1 million.    To basis adjust the cost of the building, you would debit OCI for $1 million and credit the building fixed asset account.   The building would end up being booked on 7/1/99 for $4 million instead of its 1/1/99 contracted $5 million.  If you did not basis adjust, the credit would stay in OCI and leave the building booked at a 7/1/99 value of $5 million.   Paragraph 376 on Page 173 of FAS 133 requires that you no longer adjust the basis to $4 million as a result of the foreign currency hedge.   Hence depreciation of the building will be more each year than it would be with basis adjustment. 

The controversy stems over how and when to get that $1 million out of  OCI and into retained earnings.  Under SFAS 80, suppose that with basis adjustment the impact would have been a reduction of annual depreciation by $50,000 over the 20-year life of the building.  In other words,  depreciation would have been $50,000  less each year smaller $4 million adjusted basis rather than the $5 million unadjusted basis.   One argument against basis adjustment in this manner is that the company's risk management outcomes become buried in depreciation expense and are not segregated on the income statement.

Without basis adjustment under FAS 133, you get $50,000 more annual depreciation but identical net earnings because you must amortize the $1 million in OCI over the life of the building.  Here we will assume the amortization is $50,000 per year.  Each year a $50,000 debit is made to OCI and a credit is made to the P&L closing account. When OCI is amortized, investors are reminded on the income statement that, in this example, a $50,000 per year savings accrued because the company successfully hedged $1 million in foreign currency risk exposure.

In Paragraph 31 on Page 22 of FAS 133, the amortization approach is required for this cash flow hedge outcome. You cannot basis adjust in order to take $50,000 per year lowered depreciation over the life of the building.  But you report the same net earnings as if you had basis adjusted.   In any case, FAS 133 does not allow you to take the entire $1 million into 7/1/99 earnings.  Paragraph 376 on Page 173 of FAS 133  elaborates on this controversy. 

What is wrong with the FAS 133 approach, in my viewpoint, is that it may give the appearance that a company  speculated when in fact it merely locked in a price with a cash flow or foreign currency hedge.  The hedge locks in a price.  But the amortization approach (in the case of a long-term asset) or the write-off at the time of the sale (in the case of inventory) isolates the hedge cash flow as an expense or revenue as if the company speculated.   In the above example, the company reports $50,000 revenue per year from the forward contract.  This could have been a $50,000 loss if the dollar had declined against the yen between 1/1/99 and 7/1/99.  If the $50,000 was buried in depreciation charges, it would seem less likely that investors are mislead into thinking that the $50,000 per year arose from speculation in forward contracts.  Companies also point out that the amortization approach greatly adds to record keeping and accounting complexities when there are many such hedging contracts.  Basis adjustment gives virtually the same result with a whole lot less record keeping.

It should also be noted that to the extent that the hedge is ineffective, the ineffective portion gets written off to earnings on the date the asset or liability is acquired.  In the above example, any ineffective portion would have to be declared on 1/199 and never get posted to OCI.   Hence it would never be spread over the life of the building.  According to Paragraph 30 on Page 21 of FAS 133, ineffectiveness is to be defined at the time the hedge is undertaken.  Hedging strategy and ineffectiveness definition with respect to a given hedge defines the extent to which interim adjustments affect interim earnings.

Click here to view the IASC's Paul Pacter commentary on basis adjustment.

Basis Point =

interest rate amount equal to .0001 or 0.01%.

Basis Risk = 

risk of financial exposure of a basis difference as defined under "basis" above.  For example in energy hedging there may be location basis risk due to the differences in location such as the difference between capacity at a supply terminal and a demand terminal.  This risk is commonly hedged with swaps.

Interest rate basis risk is the difference arises from a difference between the index of the hedged item vis-a-vis the exposure risk.  

A basis swap is the swapping of one variable rate for another variable rate for purposes of changing the net interest rate.

Also see interest rate swap.

Basis Swap = see interest rate swap.

Benchmark = the designated risk being hedged.  In FAS 133/138, the term applies to interest rate risk.

In FAS 133, the FASB did not take into account how interest rate risk is generally hedged in practice.  FAS 133 based the hedging rules upon hedging of sector spreads for which there are no hedging instruments in practice.  The is one of the main reasons why FAS 138 amendments to FAS 133 were soon issued.  Components of interest rate risk are shown below: Risk-free rate u(0) =  LIBOR spread l(0)-u(0) =  LIBOR(0) rate l(0) =  Unhedged credit sector spread s(0)-l(0) =  Total systematic interest rate risk s(0) =  Unhedged unsystematic risk v(0)-s(0) =  Full value effective rate v(0) =  Premium (discount) on the debt issue f(0)-v(0)=  Nominal (coupon) rate f(0) =  In FAS 138, the FASB moved away from sector spread hedging and defined benchmarked interest rate hedging based upon only two allowed interest rate spreads (i.e., the U.S. Treasury risk-free rate with no spread or the LIBOR rate with only the LIBOR spread.  Sector spread hedging can no longer receive hedge accounting. For an extensive numerical example of benchmark hedging, go to http://www.cs.trinity.edu/~rjensen/000overview/138bench.htm  FAS 138 Introduces Benchmarking Examples Illustrating Application of FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities-an amendment of FASB Statement No. 133 --- http://www.fasb.org/derivatives/examplespg.shtml or try clicking here. FAS 138 Amendments expand the eligibility of many derivative instrument hedges to qualify FAS 133/138 hedge. Such qualifications in accounting treatment that reduces earnings volatility when the derivatives are adjusted for fair value.  It is very popular in practice to have a hedging instrument and the hedged item be based upon two different indices.  In particular, the hedged item may be impacted by credit factors.  For example, interest rates commonly viewed as having three components noted below: ·        Risk-free risk that the level of interest rates in risk-free financial instruments such as U.S. treasury T-bill rates will vary system-side over time. ·        Credit sector spread risk that interest rates for particular economic sectors will vary over and above the risk-free interest rate movements.  For example, when automobiles replaced horses as the primary means of open road transportation, the horse industry’s credit worthiness suffered independently of other sectors of the economy.  In more recent times, the dot.com sector’s sector spread has suffered some setbacks. ·        Unsystematic spread risk of a particular borrower that varies over and above risk-free and credit sector spreads.  The credit of a particular firm may move independently of more system-wide (systematic) risk-free rates and sector spreads. Suppose that a hedge only pays at the T-Bill rate for hedged item based on some variable index having credit components.  FAS 133 prohibited “treasury locks” that hedged only the risk-free rates but not credit-sector spreads or unsystematic risk.  This was upsetting many firms that commonly hedge with treasury locks.  There is a market for treasury lock derivatives that is available, whereas hedges for entire interest rate risk are more difficult to obtain in practice.  It is also common to hedge with London’s LIBOR that has a spread apart from a risk-free component. The DIG confused the issue by allowing both risk-free and credit sector spread to receive hedge accounting in its DIG Issue E1 ruling.  Paragraph 14 of FAS 138 states the following: Comments received by the Board on Implementation Issue E1 indicated (a) that the concept of market interest rate risk as set forth in Statement 133 differed from the common understanding of interest rate risk by market participants, (b) that the guidance in the Implementation Issue was inconsistent with present hedging activities, and (c) that measuring the change in fair value of the hedged item attributable to changes in credit sector spreads would be difficult because consistent sector spread data are not readily available in the market.  In FAS 138, the board sought to reduce confusion by reducing all components risk into just two components called “interest rate risk” and “credit risk.”  Credit risk includes all risk other than the “benchmarked” component in a hedged item’s index.  A benchmark index can include somewhat more than movements in risk-free rates.  FAS 138 allows the popular LIBOR hedging rate that is not viewed as being entirely a risk-free rate.  Paragraph 16 introduces the concept of “benchmark interest rate” as follows: Because the Board decided to permit a rate that is not fully risk-free to be the designated risk in a hedge of interest rate risk, it developed the general notion of benchmark interest rate to encompass both risk-free rates and rates based on the LIBOR swap curve in the United States. FAS 133 thus allows benchmarking on LIBOR.  It is not possible to benchmark on such rates as commercial paper rates, Fed Fund rates, or FNMA par mortgage rates. Readers might then ask what the big deal is since some of the FAS 133 examples (e.g., Example 5 beginning in Paragraph 133) hedged on the basis of LIBOR.  It is important to note that in those original examples, the hedging instrument (e.g., a swap) and the hedged item (e.g., a bond) both used LIBOR in defining a variable rate?  If the hedging instrument used LIBOR and the hedged item interest rate was based upon an index poorly correlated with LIBOR, the hedge would not qualify (prior to FAS 138) for FAS 133 hedge accounting treatment even though the derivative itself would have to be adjusted for fair value each quarter.  Recall that LIBOR is a short-term European rate that may not correlate with various interest indices in the U.S.  FAS 133 now allows a properly benchmarked hedge (e.g., a swap rate based on LIBOR or T-bills) to hedge an item having non-benchmarked components. The short-cut method of relieving hedge ineffectiveness testing may no longer be available.  Paragraph 23 of FAS 138 states the following: For cash flow hedges of an existing variable-rate financial asset or liability, the designated risk being hedged cannot be the risk of changes in its cash flows attributable to changes in the benchmark interest rate if the cash flows of the hedged item are explicitly based on a different index.  In those situations, because the risk of changes in the benchmark interest rate (that is, interest rate risk) cannot be the designated risk being hedged, the shortcut method cannot be applied.  The Board’s decision to require that the index on which the variable leg of the swap is based match the benchmark interest rate designated as the interest rate risk being hedged for the hedging relationship also ensures that the shortcut method is applied only to interest rate risk hedges.  The Board’s decision precludes use of the shortcut method in situations in which the cash flows of the hedged item and the hedging instrument are based on the same index but that index is not the designated benchmark interest rate.  The Board noted, however, that in some of those situations, an entity easily could determine that the hedge is perfectly effective.  The shortcut method would be permitted for cash flow hedges in situations in which the cash flows of the hedged item and the hedging instrument are based on the same index and that index is the designated benchmark interest rate. In other words, any hedge item that is not based upon only a benchmarked component will force hedge effectiveness testing at least quarterly.  Thus FAS 138 broadened the scope of qualifying hedges, but it made the accounting more difficult by forcing more frequent effectiveness testing. FAS 138 also permits the hedge derivative to have more risk than the hedged item.  For example, a LIBOR-based interest rate swap might be used to hedge an AAA corporate bond or even a note rate based upon T-Bills. There are restrictions noted in Paragraph 24 of FAS 138: This Statement provides limited guidance on how the change in a hedged item’s fair value attributable to changes in the designated benchmark interest rate should be determined.  The Board decided that in calculating the change in the hedged item’s fair value attributable to changes in the designated benchmark interest rate, the estimated cash flows used must be based on all of the contractual cash flows of the entire hedged item.  That guidance does not mandate the use of any one method, but it precludes the use of a method that excludes some of the hedged item’s contractual cash flows (such as the portion of interest payments attributable to the obligor’s credit risk above the benchmark rate) from the calculation.  The Board concluded that excluding some of the hedged item’s contractual cash flows would introduce a new approach to bifurcation of a hedged item that does not currently exist in the Statement 133 hedging model. The FASB provides some new examples illustrating the FAS 138 Amendments to FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html Example 1 on interest rate benchmarking begins as follows: Example: Fair Value Hedge of the LIBOR Swap Rate in a $100 Million A1-Quality 5-Year Fixed-Rate Noncallable Debt On April 3, 20X0, Global Tech issues at par a $100 million A1-quality 5-year fixed-rate noncallable debt instrument with an annual 8 percent interest coupon payable semiannually. On that date, Global Tech enters into a 5-year interest rate swap based on the LIBOR swap rate and designates it as the hedging instrument in a fair value hedge of the $100 million liability. Under the terms of the swap, Global Tech will receive a fixed interest rate at 8 percent and pay variable interest at LIBOR plus 78.5 basis points (current LIBOR 6.29%) on a notional amount of $101,970,000 (semiannual settlement and interest reset dates). A duration-weighted hedge ratio was used to calculate the notional amount of the swap necessary to offset the debt's fair value changes attributable to changes in the LIBOR swap rate. An extensive analysis of the above illustration is provided at http://www.cs.trinity.edu/~rjensen/000overview/138bench.htm Some DIG Issues Affecting Interest Rate Hedging Issue E1—Hedging the Risk-Free Interest Rate http://www.fasb.org/derivatives/ (Cleared 02/17/99) Issue E1 heavily influenced FAS 138 as noted above. *Issue G6—Impact of Implementation Issue E1 on Cash Flow Hedges of Market Interest Rate Risk (Cleared 5/17/00) With regard to a cash flow hedge of the variability in interest payments on an existing floating-rate financial asset or liability, the distinction in Issue E1 between the risk-free interest rate and credit sector spreads over the base Treasury rate is not necessarily directly relevant to assessing whether the cash flow hedging relationship is effective in achieving offsetting cash flows attributable to the hedged risk. The effectiveness of a cash flow hedge of the variability in interest payments on an existing floating-rate financial asset or liability is affected by the interest rate index on which that variability is based and the extent to which the hedging instrument provides offsetting cash flows. If the variability of the hedged cash flows of the existing floating-rate financial asset or liability is based solely on changes in a floating interest rate index (for example, LIBOR, Fed Funds, Treasury Bill rates), any changes in credit sector spreads over that interest rate index for the issuer's particular credit sector should not be considered in the assessment and measurement of hedge effectiveness. In addition, any changes in credit sector spreads inherent in the interest rate index itself do not impact the assessment and measurement of hedge effectiveness if the cash flows on both the hedging instrument and the hedged cash flows of the existing floating-rate financial asset or liability are based on the same index. However, if the cash flows on the hedging instrument and the hedged cash flows of the existing floating-rate financial asset or liability are based on different indices, the basis difference between those indices would impact the assessment and measurement of hedge effectiveness. *Issue E6—The Shortcut Method and the Provisions That Permit the Debtor or Creditor to Require Prepayment  http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueg6.html (Cleared 5/17/00) An interest-bearing asset or liability should be considered prepayable under the provisions of paragraph 68(d) when one party to the contract has the right to cause the payment of principal prior to the scheduled payment dates unless (1) the debtor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always greater than the then fair value of the contract absent that right or (2) the creditor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always less than the then fair value of the contract absent that right. A right to cause a contract to be prepaid at its then fair value would not cause the interest-bearing asset or liability to be considered prepayable under paragraph 68(d) since that right would have a fair value of zero at all times and essentially would provide only liquidity to the holder. Notwithstanding the above, any term, clause, or other provision in a debt instrument that gives the debtor or creditor the right to cause prepayment of the debt contingent upon the occurrence of a specific event related to the debtor's credit deterioration or other change in the debtor's credit risk (for example, the debtor's failure to make timely payment, thus making it delinquent; its failure to meet specific covenant ratios; its disposition of specific significant assets (such as a factory); a declaration of cross-default; or a restructuring by the debtor) should not be considered a prepayment provision under the provisions of paragraph 68(d). Application of this guidance to specific debt instruments is provided below. Issue E10—Application of the Shortcut Method to Hedges of a Portion of an Interest-Bearing Asset or Liability (or its Related Interest) or a Portfolio of Similar Interest-Bearing Assets or Liabilities   http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuee10.html (Released 4/00) 1.        May the shortcut method be applied to fair value hedges of a proportion of the principal amount of the interest-bearing asset or liability if the notional amount of the interest rate swap designated as the hedging instrument matches the portion of the asset or liability being hedged, and all other criteria for applying the shortcut method are satisfied? May the shortcut method similarly be applied to cash flow hedges of the interest payments on only a portion of the principal amount of the interest-bearing asset or liability if the notional amount of the interest rate swap designated as the hedging instrument matches the principal amount of the portion of the asset or liability on which the hedged interest payments are based? [Generally yes was the DIG’s answer.} 2.        May the shortcut method be applied to fair value hedges of portfolios (or proportions thereof) of similar interest-bearing assets or liabilities if the notional amount of the interest rate swap designated as the hedging instrument matches the notional amount of the aggregate portfolio? May the shortcut method be applied to a cash flow hedge in which the hedged forecasted transaction is a group of individual transactions if the notional amount of the interest rate swap designated as the hedging instrument matches the notional amount of the aggregate group that comprises the hedged transaction?  [Generally no was the DIG’s answer.} *Issue F2—Partial-Term Hedging  http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuef2.html (Cleared 07/28/99) A company may not designate a 3-year interest rate swap with a notional amount equal to the principal amount of its nonamortizing debt as the hedging instrument in a hedge of the exposure to changes in fair value, attributable to changes in market interest rates, of the company’s obligation to make interest payments during the first 3 years of its 10-year fixed-rate debt instrument. There would be no basis for expecting that the change in that swap’s fair value would be highly effective in offsetting the change in fair value of the liability for only the interest payments to be made during the first three years. Even though under certain circumstances a partial-term fair value hedge can qualify for hedge accounting under Statement 133, the provisions of that Statement do not result in reporting a fixed-rate 10-year borrowing as having been effectively converted into a 3-year floating-rate and 7-year fixed-rate borrowing as was previously accomplished under synthetic instrument accounting prior to Statement 133. Synthetic instrument accounting is no longer acceptable under Statement 133, as discussed in paragraphs 349 and 350. *Issue G7—Measuring the Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method is Not Applied http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueg7.html (Cleared 5/17/00) Three methods for calculating the ineffectiveness of a cash flow hedge that involves either (a) a receive-floating, pay-fixed interest rate swap designated as a hedge of the variable interest payments on an existing floating-rate liability or (b) a receive-fixed, pay-floating interest rate swap designated as a hedge of the variable interest receipts on an existing floating-rate asset are discussed below. As noted in the last section of the response, Method 1 (Change in Variable Cash Flows Method) may not be used in certain circumstances. Under all three methods, an entity must consider the risk of default by counterparties that are obligors with respect to the hedging instrument (the swap) or hedged transaction, pursuant to the guidance in Statement 133 Implementation Issue No. G10, "Need to Consider Possibility of Default by the Counterparty to the Hedging Derivative." An underlying assumption in this Response is that the likelihood of the obligor not defaulting is assessed as being probable. Other DIG issues can be viewed at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html Also see the following summary of FAS 138 "Implementation of SFAS 138, Amendments to SFAS 133," The CPA Journal, November 2001. (With Angela L.J. Huang and John S. Putoubas), pp. 54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm

Black-Scholes Model = see option.

Blockage Factor =

the impact upon financial instrument valuation of a large dollar amount of  items sold in one block.  In the case of derivatives, the FASB decided not to allow discounting of the carrying amount if that amount is to be purchased or sold in a single block.  Some analysts argue that if the items must be sold in a huge block, the price per unit would be less than marginal price of a single unit sold by itself.  Certain types of instruments may also increase in value due to blockage.  In the case of instruments that carry voting rights, there may be sufficient "block" of voting rights to influence strategy and control of an organization (e.g., a 51% block of voting shares or options for voting shares that provide an option for voting control).  If voting power is widely dispersed, less than 51% may constitute a blockage factor if the "block" is significant enough to exercise control. The FASB in SFAS 107does not allow blockage factors to influence the estimation of fair value up or down.  Disallowance of blockage is discussed in FAS 133, Pages 153-154, Paragraphs 312-315. See fair value.

Bookout --- 

The term "bookout" can be used in a variety of contexts such as when firms make a paper transaction in lieu of actual delivery of a product or service.  For an illustration in the power industry, see the Bonneville Dam illustration  under Normal Purchases Normal Sales 
See the DIG C16 resolution under Normal Purchases Normal Sales 

New Guidance on Loans and Revisions to DIG C15 (Bookouts) 
Cleared December 19, 2001 
 http://www.fas133.com/search/search_article.cfm?page=61&areaid=438  

Changes in determining how loans will be scoped in bring guidance closer to the statement itself, as more issues achieve closure.

At its meeting on December 19, the Board agreed to the staff's recommendation to change its final guidance on the application of FAS 133 to loans (and other credit arrangements): i.e., when they should be defined as derivatives for accounting purposes. The Board thus decided to override C13,"When a Loan Commitment is Included in the Scope of Statement 133," with broader guidance utilizing FAS 133's characteristic-based definition of a derivative (in particular, the net-settlement criteria found in paragraph 9b).

Under this approach, loans and other off-balance sheet credit arrangements that meet the statement's definition of a derivative would be scoped in. However, the key to this approach is to be found in the language the staff has drafted to help apply the FAS 133 definition of a derivative to such loans/credit arrangements. This language, which we understand will set a relatively high hurdle for loans to meet the 9b test, is to be posted on the FASB site soon, and subjected to a 35-day comment period. [There may be two issues: one to clarify the market mechanism need to qualify for 9b (net settlement) and a second to address the application of the derivative definition in accounting of the loan.]

Clarification on the question of MAC clauses (not to be considered) and asymmetrical accounting for borrower and lender (allowing borrowers to continue to account for loans deemed derivatives for banks as loans) as discussed below will also be included in the guidance posted to the FASB website. Notice will be given that the resulting guidance will be conditioned on amendments to Statements 65 and 91, which covered prior loan accounting.

Desperate for closure, the board stresses that this is essentially the final answer on the subject, and it will primarily consider comments that help improve the application of the derivative definition test. Note that this change sets a further precedent for seeking changes to existing, pre-cleared guidance that go back to the conceptual foundation of the statement itself.

Another issue of large concern to the electricity industry was the Board's discussion of further revisions to C15, "Normal Purchases and Sales Exception for Option-Type Contracts and Forward Contracts in Electricity." In October, the staff revised C15 to clarify the unique nature of capacity contracts in the electrical industry and define criteria under which contracts with certain option features and bookouts can qualify for the normal purchases and sales exception. The Board has given the final go- ahead, approving staff revisions which means C15 will be posted in its final form very soon. We are unclear as to what extent, if at all, these revisions will differ from the October 10 draft, but interested parties will want to scrutinize the words carefully.

Loan commitments and FAS 133 Prior to today's meeting, this issue had been addressed, in part, with C13, "When a Loan Commitment is Included in the Scope of Statement 133," which was posted as tentative guidance on the FASB website in January 2001. C13 provided that (1) loan commitments that relate to the origination or acquisition of mortgage loans that will be held for resale under Statement 65 must be accounted for as derivatives under Statement 133 by both the borrower and lender; (2) loan commitments that relate to the origination or acquisition of mortgage loans that will be held of investment continue to be accounted for under Statement 65 and (3) commitments that relate to the originations of non-mortgage loans continue to be accounted for under Statement 91.

However, C13 dealt mainly with mortgage loans, which would have required FASB to consider extending the guidance in C13 to non-mortgage loans held for resale.

As an alternative, the staff had recommended the Board switch gears and use the Statement's broader guidance on defining derivatives to determine when loans are scoped in, which the Board accepted.

A third and fourth alternative were also presented but not widely considered. The first of these would have imposed the need for both parties of a contract to have access to a market mechanism, in order for the contract to meet the paragraph 9b net settlement criteria. Going down this route would require a similar decision by the board on this "both counterparty" requirement for all 9b tests. The second of these alternatives suggested the Board simply carve out a specific subset of loans from FAS 133.

In discussing this question, one of the board members noted how divisive this issues was in the financial services industry, with constituents coming down almost equally on both sides (see I-bank vs. C-bank debate). This prevented easy consideration of a carve out, or any guidance, that drifted away from FAS 133's conceptual fundamentals.

The guidance in C13 (formerly E13) was already drifting away from the core FAS 133 concepts, but this reflected the Board's mistaken view that most all loan commitments were clearly not derivatives. However, C13 arose out of discussions at the DIG (see Item 11-4 discussions here and here) where DIG members pointed out market mechanisms that could emerge to facilitate net settlement in loans and how loans with option features were included in Statement 119 disclosure guidelines.

Moreover, C13 was potentially holding back the planned move to a fair value model for all financial instruments--a project discussed later at the meeting. As one of the new board members, Katherine Schipper, pointed out, going with the alternative to C13 not only provides an opportunity to fix a flawed approach to loan scope outs, but it brings GAAP further in the direction of the fair value model toward which the FASB is moving. Though, other board members, and the staff, said it was not clear whether more or fewer loans would be likely to be scoped in under the agreed upon C13 alternative.

Having reached on consensus on the first question concerning loans, the Board turned to the second and third questions framed by the staff.

Question 2 dealt with the effect of a subjective material change clause (Ma clause that may be invoked by the issuer based oive evaluation of the adverse change-on whethoped into FAS 133. Though not explicitly stated, this question was posed in order to prevent the insertion of MAC clauses into credit arrangements merely to trigger a scope exception.

The alternative guidance proposed by the staff dealt with the degree of control the issuer has over the MAC trigger:

Alternative 1 states that the existence of a subjective MAC clause always causeso be excluded from the scope of the staff's proposed guidance.

Alternative 2 would have the loan excluded only if it is remote that the issuer would invoke the MAC clause.

Alternative 3 would ignore the MAC altogether and not use it as a consideration in excluding the contract.

The board had no objections to the staff recommendation to ignore the MAC clause (alternative 3).

The third question arising from the loan discussion asked if asymmetrical accounting would be allowed for loans falling under the scope of FAS 133. In other words, a market mechanism might exist for the issuer (lender), but not the holder (borrower), which would make the contract a derivative from the former's perspective but not the latter's.

As a pure practical matter, the Board concluded that asymmetrical accounting would be allowed on an exception basis where the holder (borrower) does not account for the contract as a derivative--even where it meets the test for the issuer (lender). Otherwise, borrowers would have to phone their lenders and ask how they were accounting for the loan in order to arrive at proper accounting.

Business Combinations =

contacts for purchases and/or poolings that require special accounting treatment.  In summary, the major exceptions under FAS 133 for APB Opinion No. 16 are discussed in (FAS 133Paragraph 11c).  

Exceptions are not as important in IAS 39, because fair value adjustments are required of all financial instruments.  However, exceptions or special accounting for derivatives are discussed in IAS 39 Paragraph 1g --- Also note  IAS 22 Paragraphs 65-76)

C-Terms

Call = see option.

CAP =

a risk bound.  For example, a cap writer, in return for a premium, agrees to limit, or cap, the cap holder's risk associated with an increase in interest rates. If rates go above a specified interest-rate level (the strike price or the cap rate), the cap holder is entitled to receive cash payments equal to the excess of the market rate over the strike price multiplied by the notional principal amount. Issuers of floating-rate liabilities often purchase caps to protect against rising interest rates, while retaining the ability to benefit from a decline in rates. Examples are given in SFAS Paragraphs 182-183 beginning on Page 95 of FAS 133.  Also see Footnote 6 to Paragraph 13 on Page 8 of FAS 133.

The opposite of a cap is termed a floor.  A floor writer, in return for a premium, agrees to limit, or floor, the cap holder's risk associated with an decrease in interest rates. If rates go below a specified interest-rate level (the strike price or the floor rate), the floor holder is entitled to receive cash payments equal to the difference between the market rate over the strike price multiplied by the notional principal amount.  See Footnote 6 to Paragraph 13 on Page 8 of FAS 133

A collar combines a cap and a floor.  In Paragraph 181 on Page 95 of FAS 133, a timing collar is discussed.  Another example is given in Paragraph 182 beginning on Page 95 of FAS 133.  See collar.

Capital Asset Pricing Model (CAPM) =

a model for valuing a corporation in which estimated future cash flows are discounted at a rate equal to the firm's weighted average cost of capital multiplied by the beta, which is a measure of the volatility of a firm's stock price.  The CAPM is a single-index model and, as such, has enormous structural deficiencies.  Alternate approaches and problems in all approaches are discussed in http://www.trinity.edu/rjensen/149wp/149wp.htm    Also see option pricing theory.

Capacity Risk see Risks

Cash Flow Hedge =

a derivative with a periodic settlement based upon cash flows such as interest rate changes on variable rate debt. Major portions of FAS 133 dealing with cash flow hedges include Paragraphs 28-35, 127-130, 131-139, 140-143, 144-152, 153-158, 159-161, 162-164, 371-383, 422-425, 458-473, and 492-494.   See hedge and hedge accounting.  The IASC adopted the same definition of a cash flow hedge except that the hedge has also to affect reported net income (See IAS 39 Paragraph 137b).

Flow for Cash Flow Hedge Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm 

The key distinction of a cash flow hedge versus a fair value hedge is that FAS 133 allows deferral of unrealized holding gains and losses on the revaluation of the derivative to be posted to Other Comprehensive Income (OCI) rather than current earnings.  Paragraph 30 on Page 21 of FAS 133 discusses the posting to OCI. Paragraph 31 deals with reclassifications from OCI into earnings. Also see derecognition and dedesignation.

In FAS 133, derivative financial instruments come in three basic types that are listed in Paragraph 4 on Page 2 of FAS 133.  One of these types is described in Section a and Footnote 2 below:

Paragraph 4 on Page 2 of FAS 133.
This Statement standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the statement of financial position and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument as follows:

a.
A hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, \2/ that are attributable to a particular risk (referred to as a fair value hedge)
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Footnote 2
\2/ An unrecognized firm commitment can be viewed as an executory contract that represents both a right and an obligation. When a previously unrecognized firm commitment that is designated as a hedged item is accounted for in accordance with this Statement, an asset or a liability is recognized and reported in the statement of financial position related to the recognition of the gain or loss on the firm commitment. Consequently, subsequent references to an asset or a liability in this Statement include a firm commitment.
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With respect to Section a above, a firm commitment cannot have a cash flow risk exposure because the gain or loss is already booked.  For example, a contract of 10,000 units per month at $200 per unit is unrecognized and has a cash flow risk exposure if the payments have not been made. If the payments have been prepaid, that prepayment is "recognized" and has no further cash flow risk exposure. The booked firm commitment, however, can have a fair value risk exposure.

Another key distinction is between a forecasted transaction versus a firm commitment.  Firm commitments without any foreign currency risk cannot have cash flow hedges, because there is no variability in expected future cash flows (except for credit risks for which cash flow hedges are not allowed under Paragraph 29e on Page 20, Paragraph 32 on Page 22,  and Paragraph 61c on Page 41 of FAS 133 ).  Example 9 beginning in Paragraph 162 on Page 84 of FAS 133 illustrates a forward contract cash flow hedge of a forecasted series of transactions in a foreign currency.  When the forecasted transactions become accounts receivable, a portion of the value changes in the futures contract must be taken into current earnings rather than other comprehensive income.  Controversies between the FASB's distinction between forecasted transactions versus firm commitments are discussed in Paragraphs 324-325 on Page 157 of FAS 133.  Firm commitments can have fair value hedges even though they cannot have cash flow hedges.  See Paragraph 20 on Page 11 of FAS 133.  

Cash flow hedges must have the possibility of affecting net earnings.  For example, Paragraph 485 on Page 211 of FAS 133 bans foreign currency risk hedges of forecasted dividends of foreign subsidiary.  The reason is that these dividends are a wash item and do not affect consolidated earnings.  For reasons and references, see equity method.  A nonderivative instrument, such as a Treasury note, shall not be designated as a hedging instrument for a cash flow hedge (FAS 133 Paragraph 28d). 

Paragraph 40 beginning on Page 25 bans a forecasted transaction of a subsidiary company from being a hedged item if the parent company wants to hedge the cash flow on the subsidiary's behalf.  However Paragraph 40a allows such cash flow hedging if the parent becomes a party to the hedged item itself, which can be a contract between the parent and its subsidiary under Paragraph 36b on Page 24 of FAS 133.

Paragraph 399 on Page 180 of FAS 133 does not allow covered call strategies that permit an entity to write an option on an asset that it owns.  In a covered call the combined position of the hedged item and the derivative option is asymmetrical in that exposure to losses is always greater than potential gains.  The option premium, however, is set so that the option writer certainly does not expect those "remotely possible" losses to occur.   Only when the potential gains are at least equal to potential cash flow losses will Paragraph 28c on Page 19 of FAS 133 kick in to allow a cash flow hedge under FAS 133.   Also see Paragraph 20c on Page 12.  See written option.

Paragraph 28 beginning on Page 18 of FAS 133 requires that the hedge be formally documented from the start such that prior contracts such as options or futures contracts cannot later be declared hedges.  (Existing assets and liabilities can be hedged items, but the hedging instruments must be new and fully documented at the start of the hedge.)   Paragraphs 29c and 29f on Page 20 of FAS 133 require direct cash flow risk exposures rather than earnings exposures such as a hedge to protect equity-method accounting for an investment under APB 16 rules.   See ineffectiveness.

FAS 133 is silent as to whether a single asset or liability can be hedged in part (as opposed to a portfolio of items having different risks).  For example, can an interest rate swap be used to hedge the cash flows of only the last five years of a ten-year note?  There seems to be nothing to prevent this (as is illustrated in Examples 13 and 15 beginning on Page 225 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998).

Paragraph 18 of FAS 133 allows for using only a portion of a single derivative to hedge an item if, and only if, the selected portion has the risk exposure of the portion is equal to the risk of the whole derivative.  For example, a four-year interest rate swap designated as hedging a two-year note probably does not meet the Paragraph 18 test, because the risk exposure in the first two years most likely is not the same as the risk level in the last two years.

Suppose a company expects dividend income to continue at a fixed rate over the two years in a foreign currency.  Suppose the investment is adjusted to fair market value on each reporting date.  Forecasted dividends may not be firm commitments since there are not sufficient disincentives for failure to declare a dividend.  A cash flow hedge of the foreign currency risk exposure can be entered into under Paragraph 4b on Page 2 of FAS 133.  Whether or not gains and losses are posted to other comprehensive income, however, depends upon whether the securities are classified under SFAS 115 as available-for-sale or as trading securities.   There is no held-to-maturity alternative for equity securities.

With respect to Paragraph 29a on Page 20 of FAS 133, KPMG notes that if the hedged item is a portfolio of assets or liabilities based on an index, the hedging instrument cannot use another index even though the two indices are highly correlated.  See Example 7 on Page 222 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

Accounting for Executory Contracts Such as Purchase/Sale Commitments and Loan Commitments ---
http://www.trinity.edu/rjensen/TheoryOnFirmCommitments.htm

The hedging instrument  (e.g., a forecasted transaction or firm commitment foreign currency hedge) must meet the stringent criteria for being defined as a derivative financial instrument under FAS 133.  This includes the tests for being clearly-and-closely related.  It also includes strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and Paragraph 56 on Page 33 of FAS 133 with respect to the host contracts that are being hedged.  Those tests state that if the forecasted "transaction" is in reality a group or portfolio of individual transactions, all transactions in the group must bear the same risk exposure within a 10% range discussed in Paragraph 21.    Also see Footnote 9 on Page 13 of FAS 133.  The grouping tests are elaborated upon in the following Paragraphs:

• Paragraph 21 on Page 13,

• Paragraph 29 beginning on Page 20,

• Paragraph 241 on Page 130,

• Paragraph317 on Page 155,

• Paragraphs 333-334 beginning on Page 159,

• Paragraph 432 on Page 192,

• Paragraph 435 on Page 193,

• Paragraph 443-450 beginning on Page 196

• Paragraph 462 on Page 202,

• Paragraph 477 on Page 208.

The tests can become tricky.  For example, suppose a company has a firm commitment to buy 1,000 units of raw material per month at a unit price of 5,000DM Deutsche Marks. Can this firm commitment be designated as a hedged item on a foreign currency risk exposure of 500 units each month?  The answer according to Paragraph 21a's Part (2b) requires that which units be designated such as the first 500 units or the last 500 unites each month.

A group of variable rate notes indexed in the same way upon LIBOR can be a hedged item, whereas having different indices such as LIBOR and U.S. Prime rate underlyings will not qualify.  Also, anticipated purchases cannot be combined with anticipated sales in the same grouping designated as a forecasted transaction even if they have the same underlying.   Paragraph 477 on Page 208 of FAS 133 makes an exception for a portfolio of differing risk exposures for financial instruments designated in foreign currencies so not to conflict with Paragraph 20 of SFAS 52.  For more detail see foreign currency hedge.

Those tests also state that a compound grouping of multiple derivatives (e.g., a portfolio of options or futures or forward contracts or any combination thereof) is prohibited from "separating a derivative into either separate proportions or separate portions and designating any component as a hedging instrument or designating different components as hedges of different exposures."   See Paragraphs 360-362 beginning on Page 167 of FAS 133.  Paragraphs dealing with compound derivative issues include the following:

• Paragraph 18 beginning on Page 9,

• Footnote 13 on Page 29,

• Paragraphs 360-362 beginning on Page 167,

• Paragraph 413 on Page 186,

• Paragraphs 523-524 beginning on Page 225.

Section c(4) of Paragraph 4 is probably the most confusing condition mentioned in Paragraph 4. It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52.  The gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment. This is an exception to Paragraph 29a on Page 20 of FAS 133.  Reasons for the exception are given in Paragraph 477 on Page 208 of FAS 133:

The net investment in a foreign operation can be viewed as a portfolio of dissimilar assets and liabilities that would not meet the criterion in this Statement that the hedged item be a single item or a group of similar items. Alternatively, it can be viewed as part of the fair value of the parent's investment account. Under either view, without a specific exception, the net investment in a foreign operation would not qualify for hedging under this Statement. The Board decided, however, that it was acceptable to retain the current provisions of Statement 52 in that area. The Board also notes that, unlike other hedges of portfolios of dissimilar items, hedge accounting for the net investment in a foreign operation has been explicitly permitted by the authoritative literature.

For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.  Section 4(c) of Paragraph 4 of FAS 133 amends SFAS 52 on Foreign Currency Translation, to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative.  For more detail see foreign currency hedge.

Paragraph 42 on Page 26 reads as follows:

.A derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss under Statement 52 can be designated as hedging the foreign currency exposure of a net investment in a foreign operation. The gain or loss on a hedging derivative instrument (or the foreign currency transaction gain or loss on the nonderivative hedging instrument) that is designated as, and is effective as, an economic hedge of the net investment in a foreign operation shall be reported in the same manner as a translation adjustment to the extent it is effective as a hedge. The hedged net investment shall be accounted for consistent with Statement 52; the provisions of this Statement for recognizing the gain or loss on assets designated as being hedged in a fair value hedge do not apply to the hedge of a net investment in a foreign operation. 

These Section c(4) confusions in Paragraph 4 are illustrated in Examples 11-13 beginning on Page 270 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

Paragraph 18 on Page 10 does allow a single derivative to be divided into components provided but never with partitioning of  "different risks and designating each component as a hedging instrument."  For example, suppose Rippen Company enters into forward contracting with Bank A to sell Dutch guilders and purchase French francs. The purpose is to hedge two combined unrelated foreign currency risks from two related companies, one a Holland subsidiary and the other a French subsidiary. Bank A is independent of all the interrelated companies in this scenario.  If the forward contracting entails one forward contract, it cannot be partitioned into components having different risks of U.S. dollars against guilders versus francs.

Paragraph 29d precludes forecasted transactions from being the hedged items in cash flow hedges if those items, when the transaction is completed, will be remeasured on each reporting date at fair value with holding gains and losses taken directly into current earnings (as opposed to comprehensive income).  See Paragraph 36 on Page 23 of FAS 133.  Paragraphs 220-231 beginning on Page 123 of FAS 133 leave little doubt that the FASB feels "fair value is the most relevant measure for financial instrument and the only relevant measure for derivative instruments."    Allowing gains and losses from qualified FAS 133-allowed cash flow hedges to be deferred in OCI was more of a political compromise that the FASB intends for the long-term.  But the compromise extends only so far as present GAAP.  It allows OCI deferral on cash flow hedges only if the hedged items are carried at cost under GAAP.  For example, lumber inventory is carried at cost and can be hedged with OCI deferrals of gains and losses on the derivative instrument such as a forward contract that hedges the price of lumber.  The same cannot be said for gold inventory.

The forecasted purchase of lumber inventoried at cost can be a hedged item, but the forecasted purchase of gold or some other "precious" market commodity cannot qualify for OCI deferral as a hedged item.   The reason is that  "precious" items under GAAP are booked at maintained at market value.  For example, suppose a forward contract is entered into on January 1 when commodity's price is $300 per unit.  The "political issue" issue faced by the FASB is merely a matter of when gains and losses on the derivative contract are posted to current earnings.  If the price goes up to $400 per unit on July 1 when the commodity is actually purchased, there is a $100 per unit deferred gain on the forward contract that is transferred from OCI to current earnings if the commodity is lumber.  If the commodity is "precious" gold, however, the there is no intervening credit to OCI because of Paragraph 29d on Page 20 of FAS 133.  Illustrative journal entries are shown below: