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

 

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: 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 


From the IFRS Report Newsletter on the AICPA on February 6, 2014

IASB completes hedge-accounting model
The International Accounting Standards Board has completed its hedge-accounting model to be added to IFRS 9 Financial Instruments. The principles-based standard is intended to reflect risk-management activities more closely in financial statements. Key areas of change include more identifiable risk components, a reduced burden of proving the efficacy of a hedge and changes in accounting for the time value of an option. Financial Director (U.K.) (1/16)

Jensen Comment
Put another way the IASB yielded to pressures to go soft on rules to allow hedge accounting. If you are looking for differences between IFRS versus FASB standards, this is one of the biggest differences in accounting standards. If it intended to disclose more about risk management activities dropping the previous IAS 39 requirement to identify and possibly bifurcating embedded derivatives is a loser. Reduced standards on testing for hedge effectiveness is another huge loser.

Accounting Standard Convergence Dreams Turning Into Divergence Reality in IFRS 9

From the CPA Newsletter on April 3, 2014

Convergence efforts flounder on IFRS 9
The International Accounting Standards Board and the Financial Accounting Standards Board have not been able to come to an agreement on a common financial-instruments accounting standard (that includes accounting for derivative financial instruments and hedging actictivities). Hans Hoogervorst, IASB chairman, said regulators could impose additional disclosures to bridge the gap, but one IASB member opined that the failure to achieve convergence on IFRS 9 was a "terrible disappointment" for global investors. Financial Director (U.K.) (3/5)
http://r.smartbrief.com/resp/fHeJBYbWhBCCfUknCidmwjCicNRoKW?format=standard

Jensen Comment
I blame a lot of this divergence on the unwillingness of the IASB to standup to the EU lawmakers who in turn are unwilling to resist the lobbying efforts of thousands on European banks who want weaker standards for financial instruments and less costly accounting standards to implement, e.g., wanting to avoid the costs of discovering and bifurcating embedded derivative clauses in financial instrument contracts. Aside from ignoring embedded financial instruments risk the milk toast accounting of hedging effectiveness is a real softening of IAS 39 that will soon move into IFRS 9.

Bob Jensen's threads on hedge accounting are at
http://www.trinity.edu/rjensen/caseans/000index.htm


 

ASC = Accounting Standard Codification of the FASB

January 8, 2013 message from Zane Swanson

Another faculty person created a video (link follows)
http://www.screencast.com/t/K8gruSHTv

which introduces the ASC.  This video has potential value at the beginning of the semester to acquaint students with the ASC.  I am thinking about posting the clip to AAA commons.  But, where should it be posted and does this type of thing get posted in multiple interest group areas?

 Any thoughts / suggestions?

Zane Swanson
www.askaref.com a handheld device source of ASC information

Jensen Comment
A disappointment for colleges and students is that access to the Codification database is not free. The FASB does offer deeply discounted prices to colleges but not to individual teachers or students.

There are other access routes that are not free such as the PwC Comperio ---
http://www.pwc.com/gx/en/comperio/index.jhtml

Hi Zane,
 
This is a great video helper for learning how to use the FASB.s Codification database.
 
An enormous disappointment to me is how the Codification omits many, many illustrations in the pre-codification pronouncements that are still available electronically as PDF files. In particular, the best way to learn a very complicated standard like FAS 133 is to study the illustrations in the original FAS 133, FAS 138, etc.
 
The FASB paid a fortune for experts to develop the illustrations in the pre-codification  pronouncements. It's sad that those investments are wasted in the Codification database.
 
What is even worse is that accounting teachers are forgetting to go to the pre-codification pronouncements for wonderful illustrations to use in class and illustrations for CPA exam preparation ---
http://www.fasb.org/jsp/FASB/Page/PreCodSectionPage&cid=1218220137031
 
Sadly the FASB no longer seems to invest as much in illustrations for new pronouncements in the Codification database.

Bob Jensen

 

Examples of great FAS 133 pre-codification illustrations are as follows:

              
[   ] 133ex01a.xls                     12-Jun-2008 03:50  345K  
[   ] 133ex02.doc                      17-Feb-2004 06:00  2.1M  
[   ] 133ex02a.xls                     12-Jun-2008 03:48  279K  
[   ] 133ex03a.xls                     04-Apr-2001 06:45   92K  
[   ] 133ex04a.xls                     12-Jun-2008 03:50  345K  
[TXT] 133ex05.htm                      04-Apr-2001 06:45  371K  
[   ] 133ex05a.xls                     12-Jun-2008 03:49  1.5M  
[TXT] 133ex05aSupplement.htm           26-Mar-2005 13:59   57K  
[   ] 133ex05aSupplement.xls           26-Mar-2005 13:50   32K  
[TXT] 133ex05d.htm                     26-Mar-2005 13:59   56K  
[   ] 133ex06a.xls                     29-Sep-2001 11:43  123K  
[   ] 133ex07a.xls                     08-Mar-2004 16:26  1.2M  
[   ] 133ex08a.xls                     29-Sep-2001 11:43  216K  
[   ] 133ex09a.xls                     12-Jun-2008 03:49   99K  
[   ] 133ex10.doc                      17-Feb-2004 16:37   80K  
[   ] 133ex10a.xls 
[TXT] 133summ.htm                      13-Feb-2004 10:50  121K  
[TXT] 138EXAMPLES.htm                  30-Apr-2004 08:39  355K  
[TXT] 138bench.htm                     07-Dec-2007 05:37  139K  
[   ] 138ex01a.xls                     09-Mar-2001 13:20  1.7M  
[TXT] 138exh01.htm                     09-Mar-2001 13:20   31K  
[TXT] 138exh02.htm                     09-Mar-2001 13:20   65K  
[TXT] 138exh03.htm                     09-Mar-2001 13:20   42K  
[TXT] 138exh04.htm                     09-Mar-2001 13:20  108K  
[TXT] 138exh04a.htm                    09-Mar-2001 13:20  8.2K  
[   ] 138intro.doc                     09-Mar-2001 13:20   95K  
[TXT] 138intro.htm                     09-M

Others --- http://www.cs.trinity.edu/~rjensen/

 

 

Warning 3:  The international standard IAS 39 has been amended many times and continued to be amended. The IASB tends to change paragraph numbers with many of its amendments and directly amends the preceding version of a standard. Hence some of the IAS 39 paragraphs quoted in this glossary may be relocated and/or altered in the latest and greatest version of IAS 39. IAS 39 changes will eventually be contained in IFRS 9.

Warnign 4:  IFRS 9 Anemia

U.S. GAAP Financial Reporting Taxonomy Now Available (2014 Glossary and XBRL)---
http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176163688345 

Bob Jensen's threads on XBRL ---
http://www.trinity.edu/rjensen/XBRLandOLAP.htm

"A Look at the IASB’s Draft of Hedge Accounting Requirements," Deloitte via the CFO Journal, October 19, 2012 ---
http://deloitte.wsj.com/cfo/2012/10/19/a-look-at-the-iasbs-draft-of-hedge-accounting-requirements/

Jensen Comment
This is the most extensive review I've seen of the proposed IFRS 9 departures from IAS 39 in terms of hedge accounting. It covers such things as when a financial instrument can get get hedge accounting previously restricted to derivative financial instruments. Many of the changes are quite technical. The bottom line is that IFRS 9 will allow much more subjective judgment for hedge accounting. In my opinion, this will make financial statements potentially less comparable between companies and thereby destroys to some extent the argument that having global accounting standards increases the comparability in financial reporting.

FAS 133 (as amended a number of times), IAS 39 (as amended a number of times) and IFRS 9 (still being written) are arguably the most difficult accounting standards to teach and apply in practice. The major problems are the technicalities of the accounting added on top of the complicated technicalities of understanding how derivative financial instruments affect financial risks in the management of such risks in both the public and private sectors (e.g., government pension funds use derivatives to manage risks and possibly even speculate).

Deloitte's review does not go far in helping you understand the forthcoming IFRS 9. It goes a long ways in showing you how you're going to have to spend a lot more time and possibly money to understand IFRS 9 before you will ever be able to teach IFRS 9 to students.

The bad news is that hedge accounting will continue to have the worst coverage of all accounting standards in intermediate accounting textbooks.

The good news is that hedge accounting is probably too complicated to ever become a worrisome hurdle in Chartered Accountancy Examinations, CPA examinations, and other certification examinations. Hedge accounting is something you must learn on your own and on the job. IAS 39 was very similar to FAS 133, FAS 133/138 originally had some great illustrations where I learned most of what I know about hedge accounting. Sadly, the FASB eliminated most of those great illustrations when it moved to the Codification database. Boo on the FASB for this! Some of my Excel tutorials on those illustrations can be found in the listing of files at
http://www.cs.trinity.edu/~rjensen/

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

Sadly, I probably will not be updating my tutorials for IFRS 9 --- hey I'm supposed to be retired!

 


References for Comparisons of IFRS versus U.S. GAAP

From Ernst & Young in November 2012
US GAAP versus IFRS: The basics 
While convergence was a high priority for the FASB and the IASB in 2012, differences continue to exist between US GAAP and IFRS. In this guide, we provide an overview by accounting area of where the standards are similar, where differences are commonly found in practice, and how and when certain differences are expected to disappear
http://www.ey.com/Publication/vwLUAssetsAL/IFRSBasics_BB2435_November2012/$FILE/IFRSBasics_BB2435_November2012.pdf

Jensen Comment
This is only a 54-page cocument. I still prefer the somewhat older but much longer PwC document.

Older links to such comparisons:

 

US GAAP versus IFRS: The basics
2011 Edition, 56 Pages
Free from Ernst & Young
http://www.ey.com/Publication/vwLUAssetsAL/IFRSBasics_BB2280_December2011/$FILE/IFRSBasics_BB2280_December2011.pdf

IFRS and US GAAP: Similarities and Differences
2011 Edition, 238 Pages
From PwC
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!

From Deloitte
Comparisons of IFRS With Local GAAPS
http://www.iasplus.com/dttpubs/pubs.htm#compare1109
IFRS and US GAAP
July 2008 Edition, 76 Pages
http://www.iasplus.com/dttpubs/0809ifrsusgaap.pdf

Jensen Comment
At the moment I prefer the PwC reference
My favorite comparison topics (Derivatives and Hedging) begin on Page 158 in the PwC reference
The booklet does a good job listing differences but, in my opinion, overly downplays the importance of these differences. It may well be that IFRS is more restrictive in some areas and less restrictive in other areas to a fault. This is one topical area where IFRS becomes much too subjective such that comparisons of derivatives and hedging activities under IFRS can defeat the main purpose of "standards." The main purpose of an "accounting standard" is to lead to greater comparability of inter-company financial statements. Boo on IFRS in this topical area, especially when it comes to testing hedge effectiveness!

One key quotation is on Page 165

IFRS does not specifically discuss the methodology of applying a critical-terms match in the level of detail included within U.S. GAAP.
Then it goes yatta, yatta, yatta.

Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and more importantly fails to provide "implementation guidance" comparable with the FASB's DIG implementation topics and illustrations.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

It appears that divergence is increasing in FAS 133 versus IAS 39/IFRS 9 in accounting for derivative financial instruments. Most of the differences are caused by the IASB's softening of accounting standards.

From PwC on December 23, 2013

At its December 18 meeting, the FASB made two significant decisions in its financial instruments projects that reduce the likelihood of convergence with the IASB:

 


Both of these decisions diverge from the IASB's approach in their parallel projects, leaving the prospects for convergence in jeopardy.

Jensen Comment
There are other differences, particularly in the IASB's obliterating of bright lines in hedge effectiveness testing --- which is tantamount causing enormous inconsistencies in providing hedge accounting for ineffective hedges.

More at
http://www.pwc.com/us/en/cfodirect/publications/in-brief/2013-50-fasb-fi-project-convergence-not-likely.jhtml?display=/us/en/cfodirect/issues/financial-instruments&j=342137&e=rjensen@trinity.edu&l=616328_HTML&u=14862449&mid=7002454&jb=0

Bob Jensen's threads on accounting for derivative financial instruments and hedging activities ---
http://www.trinity.edu/rjensen/caseans/000index.htm


PwC Dataline: Accounting for centrally cleared derivatives Understanding the accounting implications of Dodd-Frank Title VII (No. 2013-30) --- Click Here 
http://www.pwc.com/us/en/cfodirect/publications/dataline/2013-30-centrally-cleared-derivatives.jhtml?display=/us/en/cfodirect/publications/dataline&j=346566&e=rjensen@trinity.edu&l=621246_HTML&u=15025430&mid=7002454&jb=0

Dodd-Frank Title VII (Dodd-Frank) significantly changed the trading requirements for derivative instruments, such as mandating that certain derivatives be centrally cleared.

A number of financial reporting implementation questions have arisen as companies consider the Dodd-Frank requirements. These include determining fair value of centrally cleared derivatives, accounting for collateral, assessing the impact on hedge accounting, and determining the appropriate presentation (gross versus net).

This Dataline discusses the financial reporting implications of the new requirements, primarily focusing on end-users that trade in the affected derivatives and who do not qualify for the end-user exception.

Continued in article

Bob Jensen's threads on accounting for derivative financial instruments and hedging activities ---
http://www.trinity.edu/rjensen/caseans/000index.htm

 


"IASB Previews New Hedge Accounting Rules," by Emily Chason, CFO Report, September 7, 2012 ---
http://blogs.wsj.com/cfo/2012/09/07/iasb-previews-new-hedge-accounting-rules/?mod=wsjpro_hps_cforeport

The draft is available from the IASB --- Click Here
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Phase-III-Hedge-accounting/Pages/Draft-of-IFRS-General-Hedge-Accounting.aspx 

Jensen Comment
Today I must leave early in the morning to take Erika to Concord for a medical treatment. I've not yet had time to read the above draft in detail. It appears, however, that this draft for IFRS 9 retains changes in IAS 39 that are objectionable to me relative to what I think is better in FAS 33 as amended.

Firstly, the thrust of the IFRS 9 changes will be to add more subjectivity (relative to FAS 133), especially in the area of hedge effectiveness testing. For example, if a farmer has hedges a growing crop of corn, he is likely to do so on the basis of standardized corn quality of corn futures and options trading on the CBOT or CME. It is unlikely that the corn that he ultimately takes to market will have the identical quality moisture content. In addition he will have trucking costs of getting his corn from say South Dakota to the trading market in Chicago. As a result of all this, his hedging contract acquired in June on the CBOT or CME exchange is not likely to be perfectly effective relative to the corn he brings to market in October. Thus there will be hedging ineffectiveness.

The original IAS 39, like FAS 133, had some bright line tests for the degree to which hedge accounting was allowed when there is hedge ineffectiveness. See the slide show illustrations at
www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/06effectiveness.ppt   

There is greater likelihood that in a particular instance of hedge ineffectiveness, the original IAS 39 would result in Client A having identical accounting for the hedge ineffectiveness as Client B. Under the new IFRS 9 this becomes less assured since clients are given considerable subjective judgment in deciding how to deal with hedge ineffectiveness.

Also under FAS 133, embedded derivatives in financial contracts must be evaluated and if the embedded derivative's underlying is not "clearly and closely related" to the underlying in the host contract, the embedded derivatives must be bifurcated and accounted for separately. This leads to a lot of work finding and accounting for embedded derivatives. IFRS 9 will eliminate all that work by not making clients look for embedded derivatives. Hence, the risk that comes from having embedded derivative underlyings not clearly and clossely associated with the underlyings of the host contract can simply be ignored. I don't by into this IFRS 9 bad accounting for the sake of simplification.

I think there are other areas of difference expected differences between IFRS 9 and FAS 133 as amended. Most of the differences lie in the subjectivity allowed in accounting for hedging contracts under IFRS 9 that is not allowed in FAS 133.

September 10, 2012 reply from Bob Jensen

This afternoon received a message from PwC about the IASB's proposed changes to hedge accounting. The PwC reply is consistent with, albeit somewhat more extensive, then my reply that I sent to the AECM early this morning.

The PwC response is at --- Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8Y2HHH&SecNavCode=MSRA-84YH44&ContentType=Content 

Note that the IASB is not really opening up these proposed hedge accounting amendments to comments. Wonder why?

Also note that the proposed IASB's amendments diverge from rather than converge toward U.S. GAAP under FAS 133 as amended. At this point in time I don't think the IASB really cares about convergence of hedge accounting rules.

My quick and dirty response is that the revised hedge accounting standards under IFRS 9 is carte blanche for having two different clients and their auditors account differently for identical hedge accounting transactions because so much subjectivity will be allowed under IFRS 9. We may even have subsidiaries of the same client accounting for identical transactions differently.

Such is the myth of comparability one is supposed to get under principles-based global standards.

Further more, it may challenge auditing Firm X that has one client claiming a hedge is effective when another client would claim the hedge is ineffective. Will auditing Firm X certify divergent accounting for the same hedge. The answer is probably yes these days if both clients are too big to lose.

Bob Jensen

So Much for the Myth That Accounting Standards Are Neutral in Terms of Business Strategy (of course it did not take IFRS 9 to reveal this to us)
"Under New Accounting Standard, CFOs Could Change Hedging Strategies:
Will finance chiefs come under more pressure to adopt hedge accounting — even though it remains entirely optional under the new standard?
"
by Andrew Sawyers
CFO.com, September 12, 2012
http://www3.cfo.com/article/2012/9/gaap-ifrs_hedge-accounting-ias-39-iasb-ifrs-derivatives-80-125-test-hedge-effectiveness 

A new international financial reporting standard (IFRS) on hedge accounting could prompt finance chiefs to change their companies’ hedging strategies under a more accommodating, principles-based regime that requires less testing.

The International Accounting Standards Board (IASB) has been pondering hedge accounting for several years in an effort to find a way to replace the unloved standard IAS 39: so unloved that it’s not part of the package of accounting standards endorsed by the European Commission for listed companies. The standard has made it tough to employ hedge accounting, which can be favorable to companies in certain circumstances.

In a recent podcast, Kush Patel, director in Deloitte’s U.K. IFRS Centre of Excellence, summarized the impact of the new rules: “More hedge-accounting opportunities, less profit and loss volatility — so as you’d expect, this has been well received.”

Under IAS 39, he said, “we saw a lot of companies change the way they manage risk: we saw them reduce the amount of complex, structured derivatives that were being used to hedge and they went for more vanilla instruments that could [qualify for] hedge accounting more easily. Now that IFRS 9 will remove some of these restrictions, I think it’s fair to say risk management could change.”

Andrew Vials, a technical-accounting partner at KPMG, said in a statement, “A company will be able to reflect in its financial statements an outcome that is more consistent with how management assesses and mitigates risks for key inputs into its core business.”

Will CFOs come under more pressure to adopt hedge accounting — even though it remains entirely optional under the new standard? “If hedge accounting becomes easier, there may be more emphasis on them to achieve hedge accounting — so although it’s voluntary, there is an element that they may feel more compelled to do hedge accounting” says Andrew Spooner, lead global IFRS financial-instruments partner at Deloitte.

The final draft of the new hedge-accounting rules was published on September 7 and will be incorporated into the existing IFRS 9 Financial Instruments at the end of the year. The IASB says it’s not seeking comments on this final draft, but is making it available “for information purposes” to allow people to familiarize themselves with it. The new rules will take effect from January 1, 2015, but companies will be allowed to adopt them sooner if they wish.

Spooner and Patel note three main areas in which the new rules are different from the old:

Changes to the instruments that qualify. It’s now easier, for example, to use option contracts without increasing income-statement volatility.

Changes in hedged items. It may not be possible, for example, for a company to hedge the particular type of coffee beans a food company buys. But it could hedge a benchmark coffee price, because it is closely related to the item it would like to hedge. Another change for the better: companies in the euro zone that want to hedge dollar purchases of oil can now more easily hedge the dollar price of the oil, then later hedge the foreign-exchange exposure without the oil-price hedge being deemed ineffective. There are also more favorable rules for hedging against credit risk and inflation.

Changes to the hedge-effectiveness requirements. Under IAS 39, a company could use hedge accounting only if a hedge is “highly effective,” meaning it must be capable of offsetting the risk by a range of 80%–125%. But the 80–125 test has been scrapped to be replaced by a principle-based test that is based on economic relationship: “You have to prove that there is a relationship between the thing you are hedging and the thing you are using,” says Patel. Having gotten rid of the quantitative threshold, there are “more opportunities for companies to reduce the amount of testing they do,” he says. “It’s a welcome change.”

Continued in article

"IASB Previews New Hedge Accounting Rules," by Emily Chason, CFO Report, September 7, 2012 ---
http://blogs.wsj.com/cfo/2012/09/07/iasb-previews-new-hedge-accounting-rules/?mod=wsjpro_hps_cforeport

The PwC response is at --- Click Here
http://cfodirect.pwc.com/CFODirectWeb/Controller.jpf?ContentCode=MSRA-8Y2HHH&SecNavCode=MSRA-84YH44&ContentType=Content 

The draft is available from the IASB --- Click Here
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-Replacement-of-IAS-39-Financial-Instruments-Recognitio/Phase-III-Hedge-accounting/Pages/Draft-of-IFRS-General-Hedge-Accounting.aspx 

Bob Jensen's free tutorials on accounting for derivative financial instruments and hedging activities ---
http://www.trinity.edu/rjensen/caseans/000index.htm


Accounting for Derivative Financial Instruments and Hedging Activities

Hi Patricia,

The bottom line is that accounting authors, like intermediate textbook authors, provide lousy coverage of FAS 133 and IAS 39 because they just do not understand the 1,000+ types of contracts that are being accounted for in those standards. Some finance authors understand the contracts but have never shown an inclination to study the complexities of FAS 133 and IAS 39 (which started out as a virtual clone of FAS 133).

My 2006 Accounting Theory syllabus before I retired can be viewed at http://www.trinity.edu/rjensen/acct5341/acct5341.htm 

There are some great textbooks on derivatives and hedging written by finance professors, but those professors never delved into the complexities of FAS 133 and IAS 39. My favorite book may be out of print at the moment, but this was a required book in my theory course: Derivatives: An Introduction by Robert A Strong, Edition 2 (Thomson South-Western, 2005, ISBN 0-324-27302-9)

Professor Strong's book provides zero about FAS 133 and IAS 39, but my students were first required to understand the contracts that they later had to account for in my course. Strong's coverage is concise and relatively simple.

When first learning about hedging, my Trinity University graduate students and CPE course participants loved an Excel workbook that I made them study at
www.cs.trinity.edu/~rjensen/Calgary/CD/Graphing.xls 
Note the tabs on the bottom that take you to different spreadsheets.

There are some really superficial books written by accounting professors who really never understood derivatives and hedging in finance.

Sadly, much of my tutorial material is spread over hundreds of different links.

However, my dog and pony CD that I used to take on the road such as a training course that I gave for a commodities trading outfit in Calgary can be found at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/  T
his was taken off of the CD that I distributed to each participant in each CPE course, and now I realize that a copyrighted item on the CD should be removed from the Web.

In particular, note the exam material given at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/ 
My students had access to this material before they took my exams.

Note that some of the illustrations and exam answers have changed over time. For example, the exam material on embedded derivatives is still relevant under FASB rules whereas the IASB just waved a magic wand and said that clients no longer have to search for embedded derivatives even though they're not "clearly and closely related" to the underlyings in their host contracts. I think this is a cop out by the IASB.

Links to my tutorials on FAS 133 and IAS 39, including a long history of multimedia, can be found at
http://www.trinity.edu/rjensen/caseans/000index.htm 

Probably the most helpful thing I ever generated was the glossary at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

What made me the most money consulting in this area can be found at
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm 

But the core of what I taught about derivatives and hedge accounting in my accounting theory course can be found in the FAS 133 Excel spreadsheets listed near the top of the document at
http://www.cs.trinity.edu/~rjensen/ 

I also salted my courses with real world illustrations of scandals regarding derivatives instruments contracts, a continuously updated timeline of which is provided at
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds 

Hope this helps. Once again you may want to look at the exam material at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/ExamMaterial/ 

The bottom line is that accounting authors like intermediate textbook authors provide lousy coverage of FAS 133 and IAS 39 because they just do not understand the 1,000+ types of contracts that are being accounted for in those standards. Some finance authors understand the contracts but have never shown an inclination to delve into the complexities of FAS 133 and IAS 39 (which started out as a virtual clone of FAS 133).

Respectfully,
Bob Jensen

 


Question
What could possibly be wrong with mark-to-market accounting for financial instruments and derivative financial instruments?

Hint
It's called "asymmetric accounting" and the topic has been debated over an over again on the AECM (largely by Tom Selling versus Bob Jensen). This is also a topic that I recently recommended that Marc introduce to his "logic" analysis of fair value accounting for financial securities.

"GAAP IS CRAP: THE CASE OF JP MORGAN," by Anthony H. Catanach and J. Edward Ketz, Grumpy Old Accountants Blog, May 31, 2012 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/694

Abraham Briloff complained that sometimes the accounting standard setters do a pathetic job by creating rules that enhance the ability of managers to manage earnings.  At those times, he indicated that GAAP becomes cleverly rigged accounting ploys.  The CRAP acronym is tart, but precise.

David Reilly has written an excellent example of this proposition in his Wall Street Journal article, Heard on the Street: J.P. Morgan, Hedges and ‘Asymmetric Accounting.’”  The issue pivots on the use of portfolio hedging and the “asymmetric accounting” that arises when the portfolio hedge is accounted for by mark-to-mark accounting, and at least some of the hedged items are treated as available for sale securities.  This situation creates a mismatch in the accounting for these items, thereby potentially subjecting an entity to large gains or losses in the derivative, while gains or losses of the hedged items bypass the income statement, and going directly into stockholders’ equity.

David Henry also has a nice essay about this chain of events, entitledJPMorgan Chase Sells $25 Billion in Securities To Offset ‘London Whale’ Losses.”  He quotes former SEC Chief Accountant Lynn Turner who said JP Morgan made two stupid mistakes. They did not comprehend the risks they took with these complex derivatives and they covered half the losses with gains from high income assets that they no longer enjoy.

Jamie Dimon addressed these issues in a corporate conference call on May 10, 2012.  From an edited transcript of this conference call by Thomson Reuters StreetEvents, we read these comments by Mr. Dimon:

Continued in article

Jensen Comment
Below is a reply that I wrote years ago on the AECM



 

If a student asks why FAS 133 had to become so complicated tell them that it's because of the difference between economists and accountants. Economists allow hedging even when hedged items have not been booked by accountants. This causes all sorts of misleading accounting outcomes if hedge accounting relief is not provided for derivative contracts that are hedges rather than speculations.


Students may still ask why FAS 133 became the most complicated accounting standard in the history of the world.


Before FAS 133, companies were getting away with enormous off-balance-sheet-financing (OBSF) with newer types of derivative financial instruments. FAS 80 covered booking of options and futures contracts, but forward contracts and swaps were not booked when they were either speculations or hedges. After interest rate swaps were invented by Wall Street n the 1980s, for example, swap contracting took off like a rocket in worldwide finance. Trillions of dollars in swap debt were being transacted that were not even booked until FAS 133 went into effect in the 1990s.


Originally the FASB envisioned a relatively simple FAS 133. Most derivative financial instruments contracts (forwards, swaps, futures, and options) would be initially booked at fair value (with is zero in most instances except for options) and then reset to changed fair value at least every 90 days. All changes in value would then be booked as current earnings or current losses. Sounds simple except for some dark problems of trying to value some of these contracts.


But then, in the exposure draft period, companies made the FASB aware of an enormous problem that arose because of a difference between economists and accountants. Economists invented hedging contracts without caring at all whether a hedged items were booked or not booked by accountants. For example, the hedged item might be a forecasted transaction by Corp X to issue $100 million in bond debt at spot rates ten months from now. Economists showed Corp X how to hedge the cash flow risk of this unbooked forecasted transaction with a forward contract or swap contract.


Perfect hedges have zero effect on accounting earnings volatility when both the hedged item and its hedging derivative contract are booked by accountants --- such as when existing booked debt is changed from floating rate debt to fixed rate debt with an interest rate swap derivative contract.


Perfect hedges could have an enormous effect on earnings volatility when the hedged item is not booked and the hedging derivative contract is booked. For example, all changes up and down in the fair value of the booked derivative contracts would not be offset in the books by changes in value of the unbooked hedged items even though from an economics standpoint there is no change in economic earnings when changes in value of the booked derivative contract are perfectly offset by changes in value of the unbooked hedged item.


And most hedging circumstances are such that the hedging contract is booked under FAS 133 and the hedged item is not booked such as forecasted purchases of jet fuel by Southwest Airlines over the next two years.

 

Companies that hedged unbooked assets or liabilities would thereby punished with enormous accounting earnings volatility when they hedged economic earnings. The FASB ultimately agreed that this was misleading and thereby introduced hedge accounting relief in FAS 133 by keeping changes in the booked value of hedging contracts out of booked current earnings. For cash flow hedges and foreign currency hedges this is accomplished by using OCI. OCI is not used for fair value hedging, but hedge accounting relief is provided for fair value hedges in other ways. Look up fair value hedging under "Hedge" at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#H-Terms 


Because there are thousands of  types of hedging contracts, FAS 133 became the most complicated standard ever issued by the FASB. It's the only standard that became so complicated that an implementation group (called the DIG) was organized by the FASB  to field implementation questions by auditors and their clients. DIG pronouncements, in turn, became so complicated that at times most accountants could not understand these pronouncements. DIG links are surrounded by red boxes at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 



One of the most difficult aspects of FAS 133 is that hedge accounting relief is allowed only to the extent that hedges are effective. Hedges are seldom perfectly effective in terms of value changes at interim points in time even though they may be perfectly effective when hedges mature. Hedge effectiveness tests have become extremely complicated. FAS 133 still has some bright lines whereas the IASB in IFRS 9 is making hedge effectiveness testing principles based in IFRS 9. That's like giving an alcoholic a case of booze every week.


Thus if a student asks why FAS 133 had to become so complicated tell them that it's because of the difference between economists and accountants. Economists allow hedging even when hedged items have not been booked by accountants. This causes all sorts of misleading accounting outcomes if hedge accounting relief is not provided for derivative contracts that are hedges rather than speculations.


Respectfully,

Bob Jensen

 

 

 


Warning 4:  In 2009, the FASB and the IASB are contemplating huge changes in FAS 133 and IAS 39.

SERIOUS Doubts Over Proposed Changes to FAS 133 and IAS 39

The FASB proposes dubious changes in FAS 133 on Accounting for Derivative Financial Instruments and Hedging Activities while the IASB is studying similar changes in IAS 39. With the SEC currently sitting on the fence in deciding if and when to replace FASB standards with IASB standards, I fully predict that IAS 39 will pretty much follow the revise FAS 133 as it did when IAS 39 was initially adopted, although IAS 39 will continue to have wider coverage of financial instruments in general whereas FAS 133 will narrowly focus on derivative financial instruments and hedge accounting.

When the FASB initially signaled possible revisions for changing hedge accounting rules in FAS 133, a wave of protests from industry hit the fan. The article below is the response of Ira Kawaller who serves on the FASB's Derivatives Implementation Group (DIG) and who is one of the leading consultants on FAS 133 and hedging in general which is his where he has historic roots as a PhD in economics --- http://www.kawaller.com/about.shtml
Ira has written nearly 100 trade articles on FAS 133. I don't think he consults on IAS 39. Ira's home page is at http://www.kawaller.com/about.shtml
Ira also maintains a small hedge fund where he walks the talk about interest rate hedging. However, I'm no expert on hedge funds and will not comment on any particular hedge fund.

I might note in passing for enthusiasts of the new FASB Codification Database for all FASB standards that FAS 133 coverage in the Codification database is relatively sparse. Professionals and students in hedge accounting most likely will have to connect back to original (non-codified) FASB literature. For example, none of the wonderful illustrations in Appendices A and B of FAS 133 are codified. And the extremely helpful, albeit complicated, pronouncements of the FASB's Derivatives Implementation Group (DIG) are excluded from the Codification database --- http://www.fasb.org/derivatives/
Most of the DIG pronouncements are included in context at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
I will never have a lot of respect for the Codification database until it includes much, much more on FAS 133.

Below is a publication in which Dr. Kawaller presents serious doubts regarding revisions to FAS 133 that the FASB is now considering (and the IASB is now considering for IAS 39).

The problem is even more severe for entities with fixed-rate exposures. In this case, there’s a clear disconnect between what swaps are designed to do versus what the FASB requires for hedge accounting.
"Paved With Good Intentions:  The Road to Better Accounting for Hedges," The CPA Journal, August 2009 --- http://www.kawaller.com/pdf/CPA_Paved_w_Good_Intent_Aug_2009.pdf

With 10 years of experience under the current regime of accounting for derivative contracts and hedging transactions, the FASB has determined that it’s time to make some adjustments. Accountants should be wary of the changes. Besides affecting the accounting procedure relating to these instruments and activities, the proposed changes may also seriously impact the manner in which certain derivative hedges are structured— particularly in connection with interest rate risk management activities.

Accounting rules for derivatives and hedging transactions were put forth by the FASB in SFAS 133, Accounting for Derivative Instruments and Hedging Activities. This standard was initially issued in June 1998. It has been amended twice since then, with relatively minor adjustments, but in 2008 the FASB issued a more substantive exposure draft with significant proposed changes. Although the comment period on this exposure draft is over, the project appears to be in limbo. Proposed changes have neither been accepted nor rejected. Further adjustments are likely to be made as the FASB moves to harmonize U.S. accounting guidance with International Financial Reporting Standards (IFRS). When attention turns to derivatives, this latest exposure draft could very likely serve as a starting point. The prospective decisions about the accounting treatment for these derivatives could have a profound impact on the structure and composition of derivatives transactions

The Current Standard SFAS 133 has long been recognized as one of the most complicated accounting standards the FASB has ever issued. A core principle of this standard is that derivative instruments must be recognized on the balance sheet as assets or liabilities at their fair market value. The critical issue, then, is the question of how to handle gains or losses. Should they be reported in current income or elsewhere? Ultimately, SFAS 133 ended up providing different answers for different situations. The “normal” treatment simply requires gains and losses recognized in earnings. This treatment, however, is often problematic for companies that use derivatives for hedging purposes. For such entities, the preferred treatment would recognize gains or losses of derivatives concurrently with the earnings impacts of the items being hedged. The normal accounting treatment generally won’t yield this desired result, but the alternative “hedge accounting” will.

For purposes of this discussion, attention is restricted to the two primary hedge accounting types: cash flow and fair value. For cash flow hedges, the exposure being hedged (i.e., the hedged item) must be an uncertain cash flow, forecasted to occur in a later time period. In these cases, effective gains or losses on derivatives are originally recorded in other comprehensive income (OCI) and later reclassified from OCI to earnings when the hedged item generates its earnings impact. Ineffective results are recorded directly in earnings. In essence, this accounting treatment serves to defer the derivatives’ gains or losses—but only for the portion of the derivatives’ results that are deemed to be effective—thus pairing the earnings recognition for the derivative and the hedged item in a later accounting period.

Continued in article

 

Bob Jensen and Tom Selling have been having an active, to say the least, exchange over hedge accounting where Tom Selling advocates elimination of all hedge accounting (by carrying all derivatives at fair value with changes in value being posted to current earnings). Bob Jensen thinks this is absurd, especially for derivatives that hedge unbooked transactions such as forecasted transactions or unbooked purchase contracts for commodities. Not having hedge accounting causes asymmetric distortions of earnings where the changes in value of the hedging contracts cannot be offset by changes in value of the (unbooked) hedged items. You can read more about our exchanges under the terms "Insurance Contracts" at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#I-Terms
Scroll down to "Insurance Contracts"

 


Message from Ernst & Young on February 10, 2011

To the Point: Hedge accounting - FASB seeks reaction to IASB's proposed model

The FASB is seeking comment on the IASB's December 2010 hedge accounting proposal. The proposed IASB model would significantly change hedge accounting, going well beyond the changes the FASB proposed last year. Notably, the IASB proposes allowing hedges of components of non-financial risk (e.g., commodity risk) and hedges of net positions that share a common risk. Based on the feedback it receives, the FASB will contemplate whether (and how) to incorporate the IASB's ideas into the FASB's hedging model. Comments are due by 25 April 2011.

Reply from Bob Jensen to the AECM on February 10, 2011

The problem in the Academy is that nearly all accounting professors do not understand IAS 39 well enough to even comprehend the awful changes that are being proposed.

I think that the myth that the IASB is trying to make hedge accounting more transparent and less complex is just that --- a myth.

In the message below Ernst & Young does not mention my biggest gripe about the IASB's proposal. Replacing hedge effectiveness guidelines (such as the 80-125 dollar offset guideline in IAS 39) with ambiguities does not constitute simplification. What it really does is complicate both the task of auditing and the task of financial statement analysis.

Ernst & Young does hit hit on two changes below that also greatly complicate auditing and financial statement analysis.
.
The IASB proposed changes are yet another illustration that "the road to hell is paved with good intentions."

The problem in the Academy is that nearly all accounting professors do not understand IAS 39 well enough to even comprehend the awful changes that are being proposed.

Respectfully,
Bob Jensen

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


Differences (Comparisons) between FAS 133 and IAS 39/IFRS 9 --- http://www.trinity.edu/rjensen/caseans/canada.htm

2011 Update

"IFRS and US GAAP: Similarities and Differences" according to PwC (2011 Edition)
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
Note that warnings are given throughout the document that the similarities and differences mentioned in the booklet are not comprehensive of all similarities and differences. The document is, however, a valuable addition to students of FASB versus IASB standard differences and similarities.

It's not easy keeping track of what's changing and how, but this publication can help. Changes for 2011 include:

This continues to be one of PwC's most-read publications, and we are confident the 2011 edition will further your understanding of these issues and potential next steps.

For further exploration of the similarities and differences between IFRS and US GAAP, please also visit our IFRS Video Learning Center.

To request a hard copy of this publication, please contact your PwC engagement team or contact us.

Jensen Comment
My favorite comparison topics (Derivatives and Hedging) begin on Page 158
The booklet does a good job listing differences but, in my opinion, overly downplays the importance of these differences. It may well be that IFRS is more restrictive in some areas and less restrictive in other areas to a fault. This is one topical area where IFRS becomes much too subjective such that comparisons of derivatives and hedging activities under IFRS can defeat the main purpose of "standards." The main purpose of an "accounting standard" is to lead to greater comparability of inter-company financial statements. Boo on IFRS in this topical area, especially when it comes to testing hedge effectiveness!

One key quotation is on Page 165

IFRS does not specifically discuss the methodology of applying a critical-terms match in the level of detail included within U.S. GAAP.
Then it goes yatta, yatta, yatta.

Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and more importantly fails to provide "implementation guidance" comparable with the FASB's DIG implementation topics and illustrations.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

Bob Jensen's threads on accounting standards setting controversies ---
http://www.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

 

 

2010 IASB Exposure Draft

"IASB publishes exposure draft on hedge accounting," IAS Plus, December 9, 2010 ---
http://www.iasplus.com/index.htm

The International Accounting Standards Board (IASB) has published for public comment an exposure draft on the accounting for hedging activities. The exposure draft proposes requirements designed to enable companies to better reflect their risk management activities in their financial statements, and, in turn, help investors to understand the effect of those activities on future cash flows.

The proposed model is principle-based, and is designed to more closely align hedge accounting with risk management activities undertaken by companies when hedging their financial and non-financial risk exposures.

Summary of the ED proposals

  • A new hedge accounting model which combines a management view that aims to use information produced internally for risk management purposes and an accounting view that seeks to address risk management issue of the timing of recognition of gains and losses
  • Look only at whether a risk component can be identified and measured, as opposed to determining what can be hedged by type of item (financial or non-financial)
  • Base qualification for hedge accounting on how entities design hedges for risk management purposes and permit hedging relationships to be adjusted without necessarily stopping and potentially restarting hedge accounting
  • Treat the time value premium of a purchased option as a cost of hedging, which will be presented in other comprehensive income (OCI)
  • Extending the use of hedge accounting to net positions (to improve the link to risk management)
  • A comprehensive set of new disclosures that focus on the risks being hedged, how those risks are being managed and the effect of hedging those risks upon the primary financial statements

The exposure draft forms part of the IASB’s overall project to replace IAS 39 Financial Instruments: Recognition and Measurement, and when its proposals are confirmed they will be incorporated into IFRS 9 Financial Instruments. The exposure draft does not include consideration of portfolio macro hedge accounting which the IASB will continue to discuss.

The exposure draft ED/2010/13 Hedge Accounting is open for comment until 9 March 2011. The IASB intends to finalise and issue the proposals during the first half of 2011.

Click for:

Jensen Comment
Because preparers and auditors complained over the years about the complexity of IAS 39, the IASB in this ED mistakenly assumes that doing away with bright lines in favor of ambiguity reduces complexity. But replacing bright lines with ambiguity in and of itself creates more rather than less complexity. It is analogous to replacing a bright line speed sign reading "20 mph maximum" with "Drive Safely in this School Zone."

For example the ED replaces the bright line 80-125 rule for effectiveness limits of in offset testing of effectiveness with ambiguity about when a hedge of a hedged item should be deemed effective. Similarly, IAS 39 was relatively clear about when portfolios of hedged items could be hedged as a portfolio. The ED creates a very ambiguous term "Group Hedging" that is both ambiguous and takes international hedge accounting further and further away from the U.S. FAS 133 standard that allows portfolio or group hedging in under vastly more limiting and clear cut rules.

Effectiveness testing of purchased options used as hedging instruments is pretty clear cut under FAS 133 and IAS 39. The new IASB ED complicates accounting for the time values of options used for hedging purposes. It introduces the concept of "aligned time value" which will really confuse most auditors and financial analysts.

The net result will be that two different companies are likely to treat many hedging contracts differently when applying hedge accounting under the revised IFRS 9 into which FAS 39 is to be phased into IFRS 9. By introducing greater ambiguity the price will be that comparability between financial statements of different companies will be destroyed or highly uncertain.

I repeat that replacing bright lines with ambiguity may actually increase complexity rather than reduce complexity. The complexity of hedge accounting essentially arises from the immense complexity and variations of hedge accounting contracts. IAS 39 was rooted in FAS 133 which I viewed as a good standard, as amended,  that provided more consisted accounting for derivative financial instruments and hedging activities. The new IAS 39 ED is a move in the wrong direction from FAS 133.

Greater ambiguity is not the solution to dealing with complexity. Ambiguity does eliminate the main problems accountants have with derivatives when the main problems are not really understanding derivatives rather than writing ambiguous accounting standards for complex derivatives contracts.

Bob Jensen's reply to Pat Walter's assertion that the IASB and FASB should just do away with hedge accounting alternatives and post all gains and losses on derivative financial instruments.

Hi Pat,
Can you think of a better way to distinguish between speculating and hedging in financial reporting? There's no distinction if hedge accounting relief is not built into the standards. .

Also making accounting standards simple and easy to understand for auditors should not trump the need for complications in accounting standards. The FASB and IASB have never seriously considered simplifying FAS 133 and IAS 39 to take away special hedge accounting relief altogether. The boards believe that investors will be misinformed by not making a distinction between speculating in derivatives versus managing risk with hedging derivatives. .

Historically, I think the FASB initially did not think that special hedge accounting relief was necessary when FAS 133 was first being formulated. FAS 133 would've been about 50 pages long and no big deal other than some technical problems of measuring derivative financial instrument fair values of customized contracts traded over the counter rather than on exchanges. Hedge accounting made FAS 133 and its amendments extended FAS 133 to over 700 pages long and requires that auditors learn about risk management contracts they never had to understand prior to FAS 133 and IAS 39. .

It took about a NY minute for companies that manage risk by hedging, tens of thousands of companies,to convince the FASB that this was far more than a neutrality issue. What this could do is mask the information content value of eps with with all that was to be gained by bringing derivative financial instruments into the financial statements. .

For example, the genuine value of having eps vary with changes in value of speculative derivative derivative contract investments (e.g., a speculative call option on gold) could be totally obscured by a changes in value of hedging contacts (e.g., a hedging option on gold) simply because the changes in the value of unbooked hedged items could not offset the value changes of their hedging contracts. .

In other words, not having hedge accounting could erase the value of having changed accounting rules for speculators if there is no distinction between hedging and speculating in FAS 133 and IAS 39. .

For this reason neither the FASB nor the IASB have seriously considered doing away with special treatment for hedge accounting even though it greatly complicates the lives of accountants and auditors. .

Your solution of doing away with hedge accounting certainly would make the lives of auditors easier because then they really could sign off on complicated derivatives contracts without truly having to understand those contracts beyond the trouble of finding their fair values. .

Can you think of a better way to distinguish between speculating and hedging in financial reporting?

Bob Jensen

 

Bob Jensen's free tutorials, audio clips, and videos on FAS 133 and IAS 39 are linked at http://www.trinity.edu/rjensen/caseans/000index.htm


Warning 5:  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.

The FASB's Accounting Standard Codification Online Database (FASCOD) --- http://asc.fasb.org/home

I have been using FASCOD regularly, especially Section 815 on accounting for derivative financial instruments and hedging. I find this quite easy to use and appreciate the cross referencing to other standards. It would help in some instances to also reference to the printed standards.

Although there are narrowed-down glossaries for some of the sections like Section 815 (10)(S20), there is also a wonderful "Master Glossary" at http://asc.fasb.org/glossary&nav_type=left_nav#null

When you are into a section's outline, especially note the "Collapse" and "Expand" hot words that let you expand or collapse the outline for a desired level of detail and links to illustrations. Some of the illustrations are new in Section 815. Also there are links to SEC standards and interpretations that have been added to the database.

I did encounter a problem trying to print FASCOD quotations. For some reason, FASCOD pastes as hidden text. I could read it in a MS Word document but not in Print Preview or in printed hard copy. In MS Word I went to Tools, Options, View and clicked on Hidden Text. That did not solve my problem --- not being able to print FASCOD quotations. Then I went to Tools, Options, Print and clicked on Hidden Text. That made my FASCOD quotations appear in both Print Preview and hard copy.

FASB member Tom Linsmeier has been in charge of the FASCOD development. Tom indicates that his team was unaware of the above hidden text problem that some users are having. He says that his team is now looking into why the hidden text printing problem arose in the first place. It may well be that the above problem for some of us will disappear in the future.

Now if we only had such an IASCOD database for international standards. In fairness, the IASB standards, interpretations, exposure drafts, and a glossary can be downloaded into your computer and updated for an annual fee. This database has useful cross referencing and database search features. In many ways it is quite well done. However, it does not slice and dice content into better codification schema.

The IASB has some political correctness issues when it appears to be copying United States GAAP and/or technology. Hopefully the IASB will look at the economics involved in developing FASCOD over four years with over 200 professionals and millions of dollars and decide that the codification schema used by the FASB is suitable, with some tweaking, for the international standards. Of course the actual IASCOD content will be international GAAP rather than U.S. GAAP. It will still be a huge expense to slice and dice international GAAP for purposes of IASCOD. It will also entail a change in delivery. IASCOD will be served up online, whereas the current IASB database of standards, interpretations, exposure drafts, etc. must be downloaded into each user's computer for a fee initially and for annual updates.

The current IASB database can be downloaded from http://www.iasb.org/Home.htm
I find that it is best to leave its red-circle icon as a Startup icon on my computer screen (it could be just a bit smaller). Then it 's very easy to click the database on and off. In some ways the downloaded IASB database is programmed quite cleverly, especially the way it does database search. I give five stars for its search engine.

I hope that the IASB will invest in more illustrations if and when it develops IASCOD. One of the severe weaknesses of the IASB standards is that they cannot compare with the FASB standards in terms of abundant and useful illustrations. This is especially helpful for those of us in education and training. For example, when teaching IAS 39 having very few illustrations, I often run to FAS 133 and its amendments and DIGs for some illustrations. Now I can turn to Section 815 of FASCOD for added illustrations.

A drawback of the current Section 815 FASCOD content is that it does not yet have sliced and diced content of all the Derivative Implementation Group (DIG) pronouncements. Hopefully the DIG's will be added soon to FASCOD.

Bob Jensen

"Framing the Future: A first look at FASB’s GAAP codification, by Bruce Pounder, Journal of Accountancy, May 2008 --- http://www.aicpa.org/pubs/jofa/may2008/fasb_gaap.htm 

In less than a year, FASB’s Accounting Standards Codification will affect the day-to-day work of nearly every CPA who practices, teaches or researches accounting in accordance with U.S. GAAP.

By April 2009, FASB is expected to make the codification the single source of authoritative GAAP, overriding all existing literature. In other words, the codification content—not the original pronouncements from which the content was derived—will be GAAP. And the online codification research system—not books, loose-leaf services or CDs—will be the primary way that accountants access GAAP.

For many historical reasons, GAAP has become a minimally organized collection of many kinds of accounting pronouncements issued by various standard setters over many decades, as well as “widely recognized and prevalent” industry practices that are not the product of any formal standard-setting process. The present components of GAAP vary greatly in format, structure, completeness, authority and accessibility. As a result, practicing CPAs and financial statement preparers who attempt to apply GAAP often find themselves confused and frustrated. Likewise, accounting students frequently struggle to learn GAAP.

If a standard setter were to develop a body of accounting standards from scratch today, those standards presumably would not resemble the challenging jumble that GAAP has become. Rather than start from scratch, FASB has done the next best thing in an attempt to make GAAP more understandable and user-friendly—FASB has sought to simplify the structure of GAAP by codifying it.

In January, FASB released the Accounting Standards Codification for public review and verification. The codification is not merely a new entrant into the market for products and services designed to help CPAs understand and apply GAAP. Rather, the codification completely changes the way that GAAP will be documented, updated, referenced and accessed. It organizes in an entirely new way thousands of existing authoritative financial accounting and reporting standards and delivers the content via an Internet based research system that helps users search and access the material.

One often–overlooked aspect of the codification is that it will eliminate or flatten the GAAP hierarchy. In other words, there will be no more House of GAAP—no tiered structure with varying levels of authority on each floor. Under the codification, there’s no distinction—all standards are uniformly authoritative.

FASB expects that the codification will help mitigate the risk of noncompliance with accounting standards, provide real time updates as standards change and reduce the amount of time and effort required to research accounting issues.

A MAJOR RESTRUCTURING The primary goal of the codification project is not to change GAAP’s content, but rather to organize it in a more useful way. The codification will contain all current, authoritative accounting standards for nongovernmental entities that have been issued by U.S. standard setters, including FASB, FASB’s Emerging Issues Task Force (EITF), and the AICPA Accounting Standards Executive Committee (AcSEC). Certain SEC guidance also is included.

The codification has, for the most part, left standards unchanged. Appendix A of the Notice to Constituents, an overview document on the codification Web site, highlights areas in which FASB is recommending changes to standards to resolve conflicts in GAAP.

As used above, the word “authoritative” refers to GAAP from levels A through D in the current GAAP hierarchy. Undocumented industry practices and documented but-nonauthoritative guidance have been excluded from the codification. Because there are some exceptions regarding what is included in the codification, users are advised to consult FASB’s Notice to Constituents.

The project effectively disassembled each existing authoritative pronouncement and reassembled the pieces, organizing them into approximately 90 topics. Contents in each topic are further organized first by subtopic, then section and finally paragraph. The paragraph level is the only level that contains substantive content; all higher levels in the topical structure exist merely to organize the paragraph-level content.

Continued in article


Bob Jensen's threads on accounting theory and standard setting --- http://www.trinity.edu/rjensen/Theory01.htm

Bob Jensen’s Amendment to the Teaching Note prepared by Smith and Kohlbeck for the following case:  “Accounting for Derivatives and Hedging Activities Comparisons of Cash Flow Versus Fair Value Accounting,” by Pamela A. Smith and Mark J. Kohlbeck
     Issues in Accounting Education, Volume 23, Number 1, February 2008, pp. 103-118
Bob Jensen's Amendment is at http://www.trinity.edu/rjensen/CaseAmendment.htm

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 

For technical details see the following book:
Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization (Wiley Finance) by Janet M. Tavakoli (2008)

Bob Jensen's Web Site

Top of Document

Start of Glossary

| 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 |

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

FASB Accounting  Standards Codification online databaase  --- http://asc.fasb.org/home
Section 815 pertains to FAS 133 --- http://asc.fasb.org/section&trid=2229142&query=Derivative

A Glossary is provided in this Codification database in Section 815 (A20).

Also see the Codification Master Glossary at http://asc.fasb.org/glossary&nav_type=left_nav#null

Timeline of scandals and legislation leading up to FAS 133 and IAS 39 http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

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/


Question
What are hedge funds, especially after Bernie Madoff made them so famous?

When people ask me this question, my initial response is that a hedge fund no longer necessarily has anything to do with financial risk hedging. Rather a hedge fund is merely a "private" investment "club" that does not offer shares to the general public largely because it would then subject itself to more SEC, stock exchange, and other regulators. Having said this, it's pretty darn easy for anybody with sufficient funds to get into such a "private" club. Minimum investments range from $10,000 to $1,000,000 or higher.

Since Bernie Madoff made hedge funds so famous, the public tends to think that a hedge fund is dangerous, fraudulent, and a back street operation that does not play be the rules. Certainly hedge funds emerged in part to avoid being regulated. Sometimes they are risky due to high leverage, but some funds skillfully hedge to manage risk and are much safer than mutual funds. For example, some hedge funds have shrewd hedging strategies to control risk in interest rate and/or foreign currency trading.

Most hedge funds are not fraudulent. In general, however, it's "buyer beware" for hedge fund investors.

I would never invest in a hedge fund that is not audited by a very reliable CPA auditing firm. Not all CPA auditing firms are reliable (Bernie Madoff proved you can engage a fraudulent auditor operating out of a one-room office). Hence, the first step in evaluating a hedge fund is to investigate its auditor. The first step in evaluating an auditor is to determine if the auditing firm is wealthy enough to be a serious third party in law suits if the hedge fund goes belly up.

But the recent multimillion losses of Carnegie Mellon, the University of Pittsburgh, and other university endowment funds that invested in a verry fraudulent hedge fund purportedly audited by Deloitte suggests that the size and reputation of the auditing firm is not, by itself, sufficient protection against a criminal hedge fund (that was supposedly given a clean opinion by Deloitte in financial reports circulated to the victims of the fraud).

When learning about hedge funds, you may want to begin at http://en.wikipedia.org/wiki/Hedge_Fund

"What is a hedge fund and how is it different from a mutual fund?" by Andy Samuels, Business and Finance 101 Examiner, June 10, 2009 --- Click Here
Jim Mahar pointed out this link.

Having migrated away from their namesake, hedge funds no longer  focus primarily on “hedging” (attempting to reduce risk) because hedge funds are now focused almost blindly on one thing: returns.

Having been referred to as “mutual funds for the super rich” by investopedia.com, hedge funds are very similar to mutual funds in that they pool money together from many investors. Hedge funds, like mutual funds, are also managed by a financial professionals, but differ because they are geared toward wealthier individuals.

Hedge funds, unlike mutual funds, employ a wider array of ivesting techniques, which are considered more aggresive. For example, hedge funds often use leverage to amplify their returns (or losses if things go wrong).

The other key difference between hedge funds and mutual funds is the amount of regulation involved. Hedge funds are relatively unregulated because investors in hedge funds are assumed to be more sophisticated investors, who can both afford and understand the potential losses. In fact, U.S. laws require that the majority of investors in the fund are accredited.

Most hedge funds draw in investors because of the trustworthy reputations of the executives of the fund. Word-of-mouth praise and affiliations are often the key to success. Bernie Madoff succeed in luring customers based on two leading factors:  (1) His esteemed reputation on Wall Street and (2) His highly regarded connections in the Jewish community where he drew in most of his victims.

Bob Jensen's threads on frauds are linked at http://www.trinity.edu/rjensen/fraud.htm
In particular see http://www.trinity.edu/rjensen/fraud001.htm
And see http://www.trinity.edu/rjensen/FraudRotten.htm

 

 


"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/ 

 


Bob Jensen's FAS 133 and IAS 39 helpers --- http://www.trinity.edu/rjensen/caseans/000index.htm 

Why there are new rules of accounting for derivative financial instruments and hedge accounting --- See Why!

Bob Jensen's FAS 133,and FAS 138 Cases --- http://www.trinity.edu/rjensen/caseans/000index.htm 

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.

Flow Chart for FAS 133 and IAS 39 Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm 

 

FAS 133 Excel Workbooks Solutions to Examples and Cases --- http://www.cs.trinity.edu/~rjensen/
For example, my Excel wookbook for the Solution to Example 1 in Appendix B of FAS 133 is the file 133ex01a.xls
Note that in many instances, I have expanded upon the FASB examples to make more well-rounded presentation.

Bob Jensen's video tutorials on accounting for derivative financial instruments and hedging activity under FAS 133 and IAS 39 standards --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/ 

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

Flow Chart for FAS 133 Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Flow Chart for IAS 39 Accounting    --- http://www.trinity.edu/rjensen/acct5341/speakers/39flow.htm

Differences between FAS 133 and IAS 39 --- http://www.iasplus.com/country/compare.htm

Intrinsic Value Versus Full Value Hedge Accounting --- http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm 

Canadian Workshop Topics --- http://www.trinity.edu/rjensen/caseans/000indexLinks.htm

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

Illustrations --- See Illustrations 

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 Management:  A Physicists Approach 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 

September 25, 2003 message from editor jda [editor.jda@gmx.de]

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)


JOURNAL OF DERIVATIVES ACCOUNTING 

Hedge Effectiveness Analysis Toolkit
Vol. 1, No. 2 (September 2004) out now!! In this issue issue of JDA, Guy Coughlan, Simon Emery and Johannes Kolb discuss the Hedge Effectiveness Analysis Toolkit, which is JPMorgan’s latest addition to a long list of innovative and cutting-edge risk management solutions. View the Table of Contents @ http://www.worldscinet.com/jda/01/0102/S02198681040102.html


FASB staff posts derivatives compilation of all subsequent changes made to the guidance in the February 10, 2004, edition of the bound codification, Accounting for Derivative Instruments and Hedging Activities (also referred to as the Green Book) --- http://www.fasb.org/derivatives/07-10-06_green_book_changes.pdf

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


In May of 2003, the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133 --- http://www.fasb.org/news/nr043003.shtml 

Norwalk, CT, April 30, 2003—Today the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133.

The new guidance amends Statement 133 for decisions made:

The amendments set forth in Statement 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in Statement 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. Statement 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting.

Effective Dates and Order Information

This Statement is effective for contracts entered into or modified after June 30, 2003, except as stated below and for hedging relationships designated after June 30, 2003. The guidance should be applied prospectively.

The provisions of this Statement that relate to Statement 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. In addition, certain provisions relating to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to existing contracts as well as new contracts entered into after June 30, 2003.

Copies of Statement 149 may be obtained through the FASB Order Department at 800-748-0659 or by placing an order on-line at the FASB website.


SAS 92 auditing standard entitled "Auditing Derivative Instruments, Hedging Activities, and Investments in Securities."  Click Here.


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

Amendment of Statement 133 on Derivative Instruments and Hedging Activities (Exposure Draft)

The News Release reads as follows at http://www.fasb.org/news/nr050102.shtml 

Today the Financial Accounting Standards Board (FASB) issued an Exposure Draft, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Exposure Draft amends Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, to clarify the definition of a derivative. A copy of the Exposure Draft is available on the FASB’s website at www.fasb.org. The comment period concludes on July 1, 2002.

In connection with Statement 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets," the Board addressed issues related to the accounting for beneficial interests in securitized financial assets, such as beneficial interests in securitized credit card receivables. In resolving those issues, the FASB decided that an amendment was needed to clarify the definition of a derivative, as set forth in Statement 133.

The purpose of the Exposure Draft is to improve financial reporting by requiring that financial contracts with comparable characteristics be accounted for in the same way. The Statement would clarify under what circumstances a financial contract—either an option-based or non-option-based contract—with an initial net investment would meet the characteristic of a derivative discussed in paragraph 6(b) of Statement 133. The FASB believes the proposed change will produce more consistent reporting of financial contracts as either derivatives or hybrid financial instruments.

The proposed effective date for the accounting change is the first day of the first fiscal quarter beginning after November 15, 2002, which, for calendar year end companies, will be January 1, 2003.

Bob Jensen's threads on FAS 122 and IAS 39 are at http://www.trinity.edu/rjensen/casea


The FASB staff has prepared a new updated edition of Accounting for Derivative Instruments and Hedging Activities. This essential aid to implementation presents Statement 133 as amended by Statements 137 and 138. Also, it includes the results of the Derivatives Implementation Group (DIG), as cleared by the FASB through December 10, 2001, with cross-references between the issues and the paragraphs of the Statement.

“The staff at the FASB has prepared this publication to bring together in one document the current guidance on accounting for derivatives,” said Kevin Stoklosa, FASB project manager. “To put it simply, it’s a ‘one-stop-shop’ approach that we hope our readers will find easier to use.”

Accounting for Derivative Instruments and Hedging Activities—DC133-2

Prices: $30.00 each copy for Members of the Financial Accounting Foundation, the Accounting Research Association (ARA) of the AICPA, and academics; $37.50 each copy for others.

International Orders: A 50% surcharge will be applied to orders that are shipped overseas, except for shipments made to U.S. possessions, Canada, and Mexico. Please remit in local currency at the current exchange rate.

To order:


FASB staff posts derivatives compilation of all subsequent changes made to the guidance in the February 10, 2004, edition of the bound codification, Accounting for Derivative Instruments and Hedging Activities (also referred to as the Green Book) --- http://www.fasb.org/derivatives/07-10-06_green_book_changes.pdf

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


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 

Flow Chart for FAS 133 and IAS 39 Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Differences between FAS 133 and IAS 39 --- http://www.iasplus.com/country/compare.htm

Intrinsic Value Versus Full Value Hedge Accounting --- http://www.trinity.edu/rjensen/caseans/IntrinsicValue.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.iasplus.com/country/compare.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
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TRADING POST
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Ask Dr. Risk!

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:


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.iasplus.com/country/compare.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.iasplus.com/country/compare.htm

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

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


Derivatives Implementation Group (DIG) 

Hi George,

That depends upon what you mean by "support." If you mean failing to adhere to any FASB standard in the U.S. on a set of audited financial statements, then auditors are sending an open invitation to all creditors and shareholders to contact their tort lawyers --- lawyers always salivate when you mention the magic words "class action lawsuit".

If you mean sending mean-spirited letters to the FASB, then that's all right, because the FASB is open to all communications in what it defines as "due process."

I am a strong advocate of FAS 133 --- corporations got away with hiding enormous risks prior to FAS 133. Could FAS 133/138 and IAS 39 be simplified? Well that's a matter of opinion. The standards will be greatly simplified if your Canadian friends and my U.S. friends support the proposal to book all financial instruments at fair value (as advocated by the JWG and IASB Board Member Mary Barth). But whether this is a simplification is a matter of conjecture since estimation of fair value is a very complex and tedious process for instruments not traded in active and deep markets. In the realm of financial instruments there are many complex financial instruments and derivatives created as custom and unique contracts that are nightmares to value and re-value on a continuing basis. One needs only study how inaccurate the estimated bond yield curves are deriving forward rates. In some cases, we might as well consult astrologers who charge less than Bloomberg and with almost the same degree of error.

My bottom line conclusion: We could simplify the wording of the financial instruments and derivative financial instruments standards by about 95% if we go all the way in adopting fair value accounting for all financial instruments and derivative financial instruments.

But simplifying the wording of the standard does not necessarily simplify the accounting itself and will add a great deal of noise to the measurement of risk. In the U.S., the banking industry is so opposed to fair value accounting that the Amazon river will probably freeze over before the FASB passes what the JWG proposes. See http://www.aba.com/aba/pdf/GR_tax_va6.PDF 

Readers interested in downloading the Joint Working Group IASC Exposure Draft entitled Financial Instruments: Issues Relating to Banks should follow the downloading instructions at http://www.aba.com/aba/pdf/GR_TAX_FairValueAccounting.pdf  
(Trinity University students may find this on J:\courses\acct5341\iasc\jwgfinal.pdf  ).

On December 14, 1999 the FASB issued Exposure Draft 204-B entitled Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value. I'm not sure where you can find this buried document at the moment. 
(Trinity University students can find the document at J:\courses\acct5341\fasb\fvhtm.htm  ).

 

Bob Jensen

-----Original Message----- 
From: glan@UWINDSOR.CA [mailto:glan@UWINDSOR.CA]  
Sent: Monday, February 25, 2002 5:33 PM 
To: AECM@LISTSERV.LOYOLA.EDU 
Subject: Re: Intrinsic Versus Time Value

I have seen the credit to be Paid-in Capital- Stock Options or to Stock Options Outstanding rather than to a liability. It would be interesting to learn more about what the accounting firms stand to gain by not supporting FAS133. 

George Lan

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.iasplus.com/country/compare.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

FAS 133 and IAS 39

Pre-FAS 133

U.S. FAS 133:  All derivatives must be carried on the balance sheet at fair value.  ¶5

Notes from Jensen:  
International:  IAS 39 differs in that it requires fair value adjustments of "all" debt securities, equity securities, and other financial assets except for those whose value cannot be reliably estimated. ¶s 1,5,6, 95, and 96.  There are exceptions where value estimates are unreliable such as in the case of unlisted equity securities (see IAS ¶s 69, 93, and 95).   FAS 133 requires an active market for value estimation of non-trading items.  Under FAS 133, unquoted equity securities are measured at cost subject to an impairment test whether or not value can be estimated reliably by other means. 

FASB requires fair value measurement for all derivatives, including those linked to unquoted equity instruments if they are to be settled in cash but not those to be settled by delivery, which are outside the scope of FAS 133.

There are some exceptions for hybrid instruments as discussed in  IAS 39  ¶ 23c and FAS 133  ¶ 12b.  

Derivatives are reported on the balance sheet on a variety of bases (including fair value, forward value, spot rates, intrinsic value, historical cost) or not recorded at all.

Synthetic (accrual) accounting model for interest-rate swaps is prohibited.

Synthetic (accrual) accounting model is widely used for interest-rate swaps that hedge debt.

Gains and losses on derivative hedging instruments must be recorded in either other comprehensive income or current earnings.  They are not deferred as liabilities or assets.

Note from Jensen
One area of difference between IAS 39 and FAS 133 is that FAS 133 requires that certain gains and losses of hedging instruments be carried in equity (as OCI) whereas IAS 39 provides an option of equity versus current earnings.

Derivative gains and losses for hedges of forecasted transactions and firm commitments are deferred as liabilities or assets on the balance sheet under FAS 52 and FAS 80.

Derivative gains and losses for hedges of forecasted transactions are required to be reported in other comprehensive income (equity), thus causing volatility in equity.

Note from Jensen:
One of the major sources of difference between FAS 133 and IAS 39 concerns embedded derivatives.  In general, net profit or loss will be the same under IAS and FASB Standards, but the balance sheet presentation will be net under IAS and gross under FASB.  See cash flow hedge.

Derivative gains and losses for hedges of forecasted transactions are permitted to be deferred on the balance sheet as assets or liabilities and, as such, do not affect equity.

Hedge accounting is permitted for forward contracts that hedge foreign-currency-denominated forecasted transactions (including intercompany foreign-currency-denominated forecasted transactions).

FAS 52 does not permit hedge accounting for forward contracts that hedge foreign-currency-denominated forecasted transactions.

Some hybrid instruments (i.e., contracts with embedded derivatives), must be bifurcated into their component parts, with the derivative component accounted for separately.

Note from Jensen
IAS 39's definition of a derivative differs in that IAS 39 does not require "net settlement" provisions that are required under FAS 133.

There are some exceptions for hybrid instruments as discussed in  IAS 39  ¶s 23b & 23c;  FAS 133  ¶s 12b & 12c.

Bifurcation of many hybrid instruments is not required under current practice and, therefore, such instruments generally are not bifurcated.

Limited use of written options to hedge is permitted (e.g., when changes in the fair value of the written option offset those of an embedded purchased option).

Current practice generally prohibits hedge accounting for written options.

Hedge accounting is prohibited for a hedge of a portfolio of dissimilar items, and strict requirements exist for hedging a portfolio of "similar" items.

Less stringent guidelines are applied in practice for portfolio hedging.

Demonstration of enterprise or transaction risk reduction is not required -- only the demonstration of a high effectiveness of offset in changes in the fair value of cash flows of the hedging instrument and the hedged. item.

Demonstration of enterprise risk reduction is required for hedge transactions with futures contracts and, by analogy, option contracts.  Demonstration of transaction risk reduction is required for foreign-currency hedges.

The definition of a derivative is broader than in current practice (e.g., it includes commodity-based contracts).

Note from Jensen
IAS 39's definition of a derivative differs in that IAS 39 does not require "net settlement" provisions that are required under FAS 133.

The definition of a derivative excludes certain commodity and other contracts involving nonfinancial assets.

 

Table of Derivatives-Contract Types

Contract

Derivative within the scope
of FAS 133?

Underlying

Notional Amount of
Payment Provision

1.

Equity security

No. An initial net investment is required to purchase a security

-

-

2.

Debt security or loan

No. It requires an initial net investment of the principal amount or (if purchased at a discount or premium) an amount calculated to yield a market rate of interest.

-

-

3.

Regular-way security trade (e.g., trade of a debt or equity security)

No. Such trades are specifically excluded from the scope of FAS 133 (paragraph 10(a)).

-

-

4.

Lease

No. It requires a payment equal to the value of the right to use the property.

-

-

5.

Mortgage-backed security

No. It requires an initial net investment based on market interest rates adjusted for credit quality and prepayment.

-

-

6.

Option to purchase or sell real estate

No, unless it can be net-settled and is exchange-traded.

Price of the real estate

A specified parcel of the real estate

7.

Option to purchase or sell an exchange-traded security

Yes

Price of the security

A specified number of securities

8.

Option to purchase or sell a security not traded on an exchange

No, unless it can be net-settled.

Price of the security

A specified number of securities

9.

Employee stock option

No; for purposes of the issuer's accounting. It is specifically excluded as a derivative by paragraph 11.

-

-

10.

Futures contract

Yes. A clearinghouse (a market mechanism) exists to facilitate net settlement.

Price of a commodity or a financial instrument

A specified quantity or fact amount

11.

Forward contract to purchase or sell securities

No, unless it can be net-settled, or if the securities are readily convertible to cash and the forward contract does not qualify as a "regular way" trade.

Price of a security

A Specified number of securities or a specified principal or face amount

12.

A nonexchange traded forward contract to purchase or sell manufactured goods

No, unless it can be net-settled and neither party owns the goods.

Price of the goods

A specified quantity

13.

A nonexchange traded forward contract to purchase or sell a commodity

No, unless it can be net-settled or the commodity is readily convertible to cash and the purchase is not a "normal purchase."

Price of the commodity

A specified quantity

14.

Interest-rate swap

Yes

An interest rate

A specified amount

15.

Currency swap

Yes. Paragraph 257.

An exchange rate

A specified currency amount

16.

Swaption

Yes. It requires the delivery of a derivative or can be net-settled.

Value of the swap

The notional amount of the swap

17.

Stock-purchase warrant

Yes, for the holder, if the stock is readily convertible to cash. No, for the issuer, if the warrant is classified in stockholders' equity.

Price of the stock

A specified number of shares

18.

Property and casualty insurance contract

No. Specifically excluded.

-

-

19.

Life insurance contract

No. Specifically excluded.

-

-

20.

Financial-quarantee contract -- payment occurs if a specific debtor fails to pay the guaranteed party.

No. Specifically excluded.

-

-

21.

Credit-indexed contract -- payment occurs if a credit index (or the creditworthiness of a specified debtor or debtors) varies in a specified way.

Yes

Credit index or credit rating

A specified payment amount (which may vary, depending on the degree of change, or, which may be fixed)

22.

Royalty agreement

No. It is based on sales of one of the parties, which is an excluded underlying.

-

-

23.

Interest-rate cap

Yes

An interest rate

A specified amount

24.

Interest-rate floor

Yes

An interest rate

A specified amount

25.

Interest-rate collar

Yes

An interest rate

A specified amount

26.

Adjustable-rate loan

No. An initial net investment equal to the principal amount of the loan is required.

-

-

27.

Variable annuity contracts

No. Such contracts require an initial net investment.

-

-

28.

Guaranteed investment contracts

No. Such contracts require an initial net investment.

-

-


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, 2000The 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  

Bob Jensen's Web Site

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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.

One of the things that the FASB has never properly addressed is how to account for hedges of interest rate risk in Available-for-Sale (AFS) securities where gains and losses of both the hedged item and the hedging derivative go to OCI. Based on an old idea from KPMG, I developed my own thoughts on this ---
http://www.trinity.edu/rjensen/CaseAmendment.htm

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.

Available-for-Sale  investments are elaborated upon in March 2003 by the FASB in an exposure draft entitled "Financial Instruments --- Recognition and Measurement," March 2003 --- http://www.cica.ca/multimedia/Download_Library/Standards/Accounting/English/e_FIRec_Mea.pdf 

 

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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 and Paragraphs 375-378 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 on the date the hedging contract is settled 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 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.

 

Two illustrations of basis adjustment taken from http://www.trinity.edu/rjensen/CaseAmendment.htm
Especially note my reasoning under Illustration 2 shown below

Illustration 1

Prices of oil per unit

 

10/31

11/30

12/31

1/31

3/31

Oil Price (Spot)

$35

$40

$38

$44

$46

Forward Price

$36

$41

$39

$44

 

 

Fair Value Hedge of a Firm Commitment

Assume that Warfield makes a deal with an oil supplier to buy 100,000 units of oil for $35 per barrel which is $1 less than the $36 derivatives market forward price on October 31. There can be many reasons such as customer relations and delivery costs that motivate buyers and suppliers to contract for something other than forward prices in a derivatives instruments market exchange and over the counter. Warfield thinks that prices are going to plunge so it hedges the fair value of this firm commitment with a fair value hedge using a forward contract that will settle for the difference between the January 31 spot price and the $35 forward price.

 

Cash Flow Hedge of a Forecasted Transaction
Assume that Warfield has a forecasted transaction to purchase 100,000 units of oil at the January 31 spot rate. In order to hedge cash flow risk, Warfield enters into a forward contract to that will settle for the difference between the January 31 spot price and a $35 forward price.

 

 

Using Jensen Prices

 

 

Date

No Inventory on Hand

Fair Value Hedge of a Firm Commit.

Jensen Solution --- Cash Flow Hedge of Forecasted Trans.

 

Date

Ledger Account

Debit

Credit

Balance

Ledger Account

Debit

Credit

Balance

10/31

No entry for hedge
No inventory on hand

 

 

 

No entry for hedge
No inventory on hand

 

 

 

 

$35 ppb firm commit.
$36 ppb forward price
$35 ppb spot price
100,000 notional
$0 forward contract value

 

 

 

No firm commitment
$36 ppb forward price
$35 ppb spot price
100,000 notional
$0 forward contract value

 

 

 

 

 

 

 

 

 

 

 

 

11/30

Firm commitment

500,000

 

$500,000

OCI or AOCI

0

500,000

($500,000)

 

G/L (I/S)

0

 

$0

G/L (I/S)

 

0

$0

 

Forward contract

 

500,000

($500,000)

Forward contract

500,000

 

$500,000

 

-To adjust the forward contract to fair value with Delta = abs($41-$36)/
             abs($40-$35)

          = 1.0 or 100%
Hence this is a perfect hedge at this point.

 

 

 

-To adjust the forward contract to fair value with Delta = abs($41-$36)/
             abs($40-$35)

          = 1.0 or 100%
Hence this is a perfect hedge at this point.

 

 

 

 

 

 

 

 

 

 

 

 

12/31

Firm commitment

 

200,000

$300,000

OCI or AOCI

200,000

 

($300,000)

 

G/L (I/S)

 

0

$0

G/L (I/S)

0

 

0

 

Forward contract

200,000

 

($300,000)

Forward contract

 

200,000

$300,000

 

-To adjust the forward contract to fair value with Delta = abs($39-$36)/
             abs($38-$35)

          = 1.0 or 100%
Hence hedge accounting is now fully allowed with a perfect cumulative Delta

 

 

 

-To adjust the forward contract to fair value with Delta = abs($39-$36)/
             abs($38-$35)

          = 1.0 or 100%
Hence hedge accounting is now fully allowed with a perfect cumulative Delta

 

 

 

 

 

 

 

 

 

 

 

 

1/31

Firm commitment

500,000

 

$800,000

OCI or AOCI

0

500,000

($800,000)

 

G/L (I/S)

 

 

$0

G/L (I/S)

 

 

 

 

Forward contract

 

500,000

($800,000)

Forward contract

500,000

 

$800,000

 

-To adjust the forward contract fair value for a perfectly effective fair value hedge..

 

 

 

- To adjust the forward contract fair value for a perfectly effective cash flow hedge.

 

 

 

 

 

 

 

 

 

 

 

 

1/31

Forward contract

800,000

 

$0

Forward contract

 

800,000

$0

 

Cash

 

800,000

($800,000)

Cash

800,000

 

$800,000

 

-To record unfavorable settlement of fair value  hedging contract

 

 

 

-To record favorable settlement of cash flow  hedging contract

 

 

 

 

 

 

 

 

 

 

 

 

1/31

Oil inventory

4,400,000

 

$4,400,000

Oil inventory

4,400,000

 

$4,400,000

 

G/L (I/S)

 

900,000

($900,000)

G/L (I/S)

 

0

$0

 

Cash

 

3,500,000

($4,300,000)

Cash

 

4,400,000

($4,000,000)

 

-To record purchase of the oil inventory at the $35 firm commitment price

 

 

 

-To report purchase of the oil inventory at spot price

 

 

 

 

 

 

 

 

 

 

 

 

3/31

Cash

4,600,000

 

$300,000

Cash

4,600,000

 

$600,000

 

Oil inventory

 

4,400,000

$0

Oil inventory

 

4,400,000

$0

 

G/L (I/S)

 

200,000

($1,100,000)

G/L (I/S)

 

200,000

($200,000)

 

-To record the sale of the oil inventory at the spot price

 

 

 

-To record the sale of the oil inventory at the spot price

 

 

 

 

 

 

 

 

 

 

 

 

3/31

G/L (I/S)

800,000

 

$300,000

G/L (I/S)

 

$800,000

($1,000,000)

 

Firm commitment

 

800,000

$0

OCI or AOCI

$800,000

 

$0

 

-This is the basis adjustment that accompanies the sale of all the oil inventory.

 

 

 

-This is the basis adjustment that accompanies the sale of all the oil inventory.

 

 

 

 

Fair Value Hedge Summary (using Jensen’s prices)
+$1,100,000 = March 31 profit without a hedge = $4,600,000 sale on March 31 - $3,500,000 purchase on January 31 at firm commitment price
   +$300,000  = March 31 profit with a hedge = $1,100,000 profit without a hedge - $800,000 loss on fair value hedging contract

A company that wants to hedge fair value of its purchase commitments must be prepared to accept the cash flow risk and loss of opportunity value its firm commitment price is way below the current spot price when the oil is purchased.

Hedging ineffectiveness with the revised prices was greatly eliminated in the second example that did not use the Smith and Kohlbeck prices.

A fair value hedge creates cash flow risk.
A cash flow hedge creates fair value risk.

Basis adjustment for the $800,000 loss on the firm commitment fair value hedge is controversial due to ambiguity in FAS 133 regarding basis adjustment of the Firm Commitment equity account. My way of doing this above is explained under Exhibit 5 shown below.

Cash Flow Hedge Summary (using Jensen’s prices)
+$200,000 = March 31 profit without a hedge = $4,600,000 sale on March 31 - $4,400,000 purchase on January 31
+$1,000,000  = March 31 profit with a hedge = $200,000 profit without a hedge + $800,000 gain on cash flow hedging contract


A company that wants to hedge cash flows of its forecasted transactions must be prepared to accept the fair value risk and loss of opportunity value its decision to pay spot prices.

Hedging ineffectiveness with Jensen’s revised prices was greatly eliminated in the second example that did not use the Smith and Kohlbeck prices. Hedging against cash flow risk of price increases is a good deal when spot prices soar and a bad deal when spot prices plunge.

A fair value hedge creates cash flow risk.
A cash flow hedge creates fair value risk.


The above solution for the cash flow hedge shows the correct way to basis adjust the gain of $800,000 on the hedging contract on the date of sale rather than the date of purchase of the inventory. Smith and Kohlbeck incorrectly basis adjust all cash flow hedges on the date of the hedge settlement. Basis adjustment should be on the date inventory is sold under FAS 133, but under IAS 39 basis should be adjusted when the hedge is settled or dedesignated.

Paragraph 377 of FAS 133 reads as follows:

377. The Board decided to require that the gain or loss on a derivative be reported initially in other comprehensive income and reclassified into earnings when the forecasted transaction affects earnings. That requirement avoids the problems caused by adjusting the basis of an acquired asset or incurred liability and provides the same earnings impact. The approach in this Statement, for example, provides for (a) recognizing the gain or loss on a derivative that hedged a forecasted purchase of a machine in the same periods as the depreciation expense on the machine and (b) recognizing the gain or loss on a derivative that hedged a forecasted purchase of inventory when the cost of that inventory is reflected in cost of sales

 

 

Illustration 2

Instead of buying oil inventory on January 31 at a $35 firm commitment price, suppose the firm purchased the inventory for $35 on October 31 and enters a forward contract to protect the value of the inventory. The hedge accounting is somewhat different for these two types of fair value hedges. The main difference is that for inventory value, the “Firm Commitment” account invented by the FASB is not used for fair value hedge accounting. Instead the accounting for the inventory itself is changed from historical cost to fair value accounting during the hedging period.

 

They are compared below.

 

I will now illustrate hedge accounting using case prices that have more effective hedging outcomes.


Jensen Prices

 

10/31

11/30

12/31

1/31

3/31

Oil Price (Spot)

$35

$40

$38

$44

$46

Forward Price

$37

$41

$40

$44

 

 

Fair Value Hedge of Existing Inventory

Assume buys 100,000 units of oil for $35 per barrel on October 31. Warfield thinks the prices might go down and decides to enter into a forward contract to hedge the fair value of this inventory. The forward contract will settle for the difference between the spot rate on January 31 and $37.

 

Fair Value Hedge of a Firm Commitment

Assume that Warfield makes a deal with an oil supplier to buy 100,000 units of oil for $37 per barrel which is at the $37 derivatives market forward price on October 31. There can be many reasons such as customer relations and delivery costs that motivate buyers and suppliers to contract for something other than forward prices in a derivatives instruments market exchange and over the counter. Warfield thinks that prices are going to plunge so it hedges the fair value of this firm commitment with a fair value hedge using a forward contract that will settle for the difference between the January 31 spot price and the $37 forward price.

 

 

Using Jensen Prices

With Inventory on Hand

With No Inventory on Hand

Date

 

Fair Value Hedge of a Inventory

Fair Value Hedge of a Firm Commitment

 

Date

Ledger Account

Debit

Credit

Balance

Ledger Account

Debit

Credit

Balance

10/31

No entry for forward
Contract

 

 

 

No entry
No inventory on hand

 

 

 

 

$37 ppb forward price
$35 ppb spot price
100,000 notional
$0 forward contract value

 

 

 

$37 ppb firm commit.
$36 ppb forward price
$35 ppb spot price
100,000 notional
$0 forward contract value

 

 

 

 

 

 

 

 

 

 

 

 

10/31

Oil inventory

3,500.000

 

$3,500,000

 

 

 

 

 

Cash

 

3,500,000

($3,500,000)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

11/30

Oil inventory

500,000

 

$4,000,000

Firm commitment

500,000

 

$500,000

 

G/L (I/S)

0

100,000   

($100,000)

G/L (I/S)

 

100,000  

($100,000)

 

Forward contract

 

400,000

($400,000)

Forward contract

 

400,000

($400,000)

 

-To adjust the forward contract to fair value with Delta = abs($41-$37)/
              abs($40-$35)

          = 0.8 or 80%
Hence this is a 80% effective fair value hedge..

 

 

 

- To adjust the forward contract to fair value with Delta = abs($41-$37)/
              abs($40-$35)

          = 0.8 or 80%
Hence this is a 80% effective fair value hedge..

 

 

 

 

 

 

 

 

 

 

 

 

12/31

Oil inventory

 

200,000

$3,800,000

Firm commitment

 

200,000

$300,000

 

G/L (I/S)

100,000

0

$0

G/L (I/S)

100,000

 

$0

 

Forward contract

100,000

 

($300,000)

Forward contract

100,000

 

($300,000)

 

-To adjust the forward contract to fair value with Delta = abs($40-$37)/
             abs($38-$35)

          = 1.0 or 100%
Hence hedge accounting is now fully allowed with a perfect cumulative Delta

 

 

 

-To adjust the forward contract to fair value with Delta = abs($40-$37)/
             abs($38-$35)

          = 1.0 or 100%
Hence hedge accounting is now fully allowed with a perfect cumulative Delta

 

 

 

 

 

 

 

 

 

 

 

 

1/31

Oil inventory

600,000

 

$4,400,000

Firm commitment

100,000

 

$400,000

 

G/L (I/S)

 

500,000

($500,000)

G/L (I/S)

 

 

$0

 

Forward contract

 

100,000

($400,000)

Forward contract

 

100,000

($400,000)

 

-To adjust the forward contract to fair value at a pending $41-$37 unfavorable pending settlement.

 

 

 

- To adjust the forward contract to fair value at a pending $41-$37 unfavorable pending settlement.

 

 

 

 

 

 

 

 

 

 

 

 

1/31

Forward contract

400,000

 

$0

Forward contract

400,000

 

$0

 

Cash

 

400,000

($400,000)

Cash

 

400,000

($400,000)

 

-To record unfavorable settlement of fair value  hedging contract

 

 

 

-To record unfavorable settlement of fair value  hedging contract

 

 

 

 

 

 

 

 

 

 

 

 

1/31

Oil inventory

 

 

$4,400,000

Oil inventory

4,400,000

 

$4,400,000

 

G/L (I/S)

 

0

($500,000)

G/L (I/S)

 

700,000

($700,000)

 

Cash

 

0

($3,900,000)

Cash

 

3,700,000

($4,100,000)

 

-No entry

 

 

 

-To record purchase of the oil inventory at the $37 firm commitment price

 

 

 

 

 

 

 

 

 

 

 

 

3/31

Cash

4,600,000

 

700,000

Cash

4,600,000

 

$500,000

 

Oil inventory

 

4,400,000

$0

Oil inventory

 

4,400,000

$0

 

G/L (I/S)

 

200,000

($700,000)

G/L (I/S)

 

200,000

($900,000)

 

-To record the sale of the oil inventory at the spot price

 

 

 

-To record the sale of the oil inventory at the spot price

 

 

 

 

 

 

 

 

 

 

 

 

3/31

G/L (I/S)

 

 

($700,000)

G/L (I/S)

400,000

 

($500,000)

 

Firm commitment

 

 

 

Firm commitment

 

400,000

$0

 

-This is the basis adjustment is not necessary for inventory on hand.

 

 

 

-This is the basis adjustment that accompanies the sale of all the oil inventory.

 

 

 

 

Fair Value Hedge Summary of Hedging the Fair Value of Inventory
+$1,100,000 = March 31 profit without a hedge = $4,600,000 sale on March 31 - $3,500,000 purchase on October 31
   +$700,000  = March 31 profit with a hedge = $1,100,000 profit without a hedge - $400,000 loss on fair value hedging contract

First it might be noted that hedge accounting is not allowed for commodities that are carried or will be carried at fair value in the ledger accounts. Only inventories maintained at historical cost can get hedge accounting. Oil inventory is normally carried at historical cost except during the hedging period of a fair value hedge under FAS 133 rules.

The main difference between hedging the fair value of inventory and the fair value of a firm commitment is that the “Firm Commitment” account is not used for existing  inventory fair value hedging. Instead existing inventory (the hedged item) normally carried at historical cost is carried at fair value during the hedging period. After the hedge is settled or dedesignated, the company must revert to historical cost valuation of inventories.

A fair value hedge creates cash flow risk of existing inventory.
The can be no cash flow hedge since there is no cash flow risk of existing inventory.

Fair Value Hedge Summary of Hedging the Fair Value of a Firm Commitment
+$900,000 = March 31 profit without a hedge = $4,600,000 sale on March 31 - $3,700,000 purchase on January 31
+$500,000  = March 31 profit with a hedge = $900,000 profit without a hedge - $400,000 loss on fair value hedging contract

The solutions above ignore the time value of money. FAS 133 recommends and in some cases requires that hedge accounting be further complicated with time value of money adjustments.

When inventory is on hand, the effective part of the hedge is carried forward in the Oil Inventory account whose fair value changes offset the changes in value of the hedging contract. That is consistent with Paragraphs 22-24 in FAS 133.

These are two paragraphs from the Fair Value section of Section 815 of the FASB’s Codification database

35-8   The adjustment  of the carrying amount of a hedged asset or liability required by paragraph 815-25-35-1(b) shall be accounted for in the same manner as other components of the carrying amount of that asset or liability. For example, an adjustment of the carrying amount of a hedged asset held for sale (such as inventory) would remain part of the carrying amount of that asset until the asset is sold, at which point the entire carrying amount of the hedged asset would be recognized as the cost of the item sold in determining earnings.

35-9   An adjustment of the carrying amount of a hedged interest-bearing financial instrument shall be amortized to earnings. Amortization shall begin no later than when the hedged item ceases to be adjusted for changes in its fair value attributable to the risk being hedged.

But consider the case of the hedge of the firm commitment when there is no inventory on hand. In this case, the Firm Commitment account absorbs the changes in value of the hedging contract. If the Firm Commitment account is basis adjusted (zeroed out) when the hedge is settled or otherwise terminated, you are not being consistent with the way the hedge settlement is deferred with the inventory is on hand, i.e., until the inventory is sold. The risk being hedged was the change in spot rates and the gain or loss being deferred, in my viewpoint, should be deferred until the purchased inventory is sold so as to be consistent with the hedge accounting when the inventory was on hand when the hedging period commenced.

Hence in the two illustrations above, the ($4,211,111-$3,500,000 = $711,111) change in the value of inventory when the hedge was settled unfavorably on January 31 is deferred from being recognized in current earnings until the inventory is sold on March 31. (The fair value is not hedged between January 31 and March 31 and fair value accounting is not used for the inventory in the unhedged period).

Similarly, when the inventory was not on hand and the fair value of the firm commitment was being hedged, the $711,111 in the Firm Commitment account should not be basis adjusted on January 31. Instead it should be basis adjusted when the inventory is sold since this unfavorable hedge settlement is not buried in the Inventory account like it was when we hedge the fair value of inventory on hand.

Actually, I’ve not been successful in finding examples contrasting these two situations so we have to reason this one through. It seems as though both approaches illustrated above are consistent with each other in deferring the hedge settlement basis adjustment until the inventory is sold. Basis adjusting the Firm Commitment account on January 31 is not consistent with the basis adjustment when we hedged inventory on hand for fair value. This would not be basis adjustment deferral.

It seems to me that my approach is consistent with Paragraph 35-8 above and Paragraphs 22-24 of FAS 133. I’ve been bothered by the sorry way the FASB has explained the accounting for fair value hedging a firm commitment. Of course this is no problem in IAS 39 since basis adjustment always takes place when the hedge is dedesignated or settled.

The Firm Commitment account is always an equity (never an asset or liability) account and is a place to defer the hedge gain or loss to the point of sale for inventory. That’s what basis adjustment deferral is all about. It is just like AOCI in the sense that between the date of the purchase of the inventory and the date of the sale of inventory, the equity account (whether AOCI for cash flow hedges or Firm Commitment for fair value hedges) remains constant until part or all of the inventory is sold. Then basis is adjusted by reclassifying the hedge gain or loss deferral into earnings at the time of the sale.

The purchase price is $35 and the spot price is $44 giving rise to a gain at the time of purchase of $44-$35=$9 per unit or a total gain of $900,000 due to a favorable purchase price. This gain is to be immediately recognized on the date of purchase whether or not we hedge. Commodity inventories are to be booked at fair value on the date of purchase irrespective of the actual purchase price. This has nothing to do with hedging the fair value of the firm commitment.

The question is whether the gain or loss on the hedging derivative should be recognized on the date of the purchase or the date of the sale. In this illustration the hedging derivative lost $800,000 on the date of the purchase of the inventory. The fair value hedge was effective for 89% or $711,111 and ineffective for 11% or $88,889.

Under Smith and Kohlbeck (SK) approach you would basis adjust on January 31 for the full $800,000 hedging derivative loss. Under my approach I would only charge the ineffective $88,889 portion to January 31 earnings and defer the $711,111 effective portion in an equity account (Firm Commitment) until the inventory is sold on March 31.

The issue was never whether to recognize the $900,000 total gain on January 31. Commodity inventories have to be carried at fair value on the date they are purchased even if they are purchased a lower or higher firm commitment price. If the firm commitment price was higher than fair value we certainly would not want to record inventory at above its fair value. The question was never whether to recognize the difference between the firm commitment price and the fair value on the date of purchase and to book this difference in current earnings.

The issue was whether to hit all the hedge derivative loss of $800,000 to earnings on the January 31 date of purchase (SK approach) or to defer the effective portion of the hedging contract’s loss ($711,111) until basis adjustment on the date of the sale (the Jensen approach). I grant you that the FASB does not seem to be clear on this issue for fair value hedges of firm commitments, but it is very clear with respect to deferred basis adjustment for cash flow hedges.

Paragraph 377 of FAS 133 reads as follows:

377. The Board decided to require that the gain or loss on a derivative be reported initially in other comprehensive income and reclassified into earnings when the forecasted transaction affects earnings. That requirement avoids the problems caused by adjusting the basis of an acquired asset or incurred liability and provides the same earnings impact. The approach in this Statement, for example, provides for (a) recognizing the gain or loss on a derivative that hedged a forecasted purchase of a machine in the same periods as the depreciation expense on the machine and (b) recognizing the gain or loss on a derivative that hedged a forecasted purchase of inventory when the cost of that inventory is reflected in cost of sales.

I think my solution is consistent with the above paragraph for fair value hedges vis-à-vis cash flow hedges.

I think my solution is consistent with what happens for a fair value hedge of existing inventory.

I think my solution is consistent with Paragraph 24 (in the Fair Value Hedging Section of FAS 113).

I think my solution is consistent with what companies do in practice when a fair value hedge is dedesignated before maturity. The Firm Commitment equity account is carried forward until the hedged item revenue cycle is completed in whole or in part.

Harris Preferred Capital is carrying forward the hedge settlement until the earnings cycle is completed whether the hedge is desesignated early or settled at maturity.

 You can read the following in the 2005 10-K of the HARRIS PREFERRED CAPITAL CORPORATION ---
http://yahoo.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHTML1?SessionID=bkB8jTdF57B95gG&ID=4306792

 

When hedge accounting is discontinued because a fair value hedge is no longer highly effective, the derivative instrument continues to be recorded on the balance sheet at fair value but the hedged item is no longer adjusted for changes in fair value that are attributable to the hedged risk. The carrying amount of the hedged item, including the basis adjustments from hedge accounting, is accounted for in accordance with applicable generally accepted accounting principles. For a hedged loan, the basis adjustment is amortized over its remaining life. When hedge accounting is discontinued because the hedged item in a fair value hedge no longer meets the definition of a firm commitment, the derivative instrument continues to be recorded on the balance sheet at fair value and any asset or liability that was recorded to recognize the firm commitment is removed from the balance sheet and recognized as a gain or loss in current period earnings. When hedge accounting is discontinued because a cash flow hedge is no longer highly effective, the gain or loss on the derivative that is in accumulated other comprehensive income ("AOCI") remains there until earnings are impacted by the hedged item and the derivative instrument is marked to market through earnings. When hedge accounting is discontinued because it is no longer probable that the forecasted transaction in a cash flow hedge will occur, the gain or loss on the derivative that was in AOCI is recognized immediately in earnings and the derivative instrument is marked to market through earnings. When hedge accounting is discontinued and the derivative remains outstanding, the derivative may be redesignated as a hedging instrument as long as the applicable hedge criteria are met under the terms of the new contract.

Bob Jensen’s illustrations of hedge effectiveness testing can be found using the following links:

 

 

 

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.

With respect to Firm Commitments vs. Forward Contracts, the key distinction is Part b of Paragraph 540 of the original FAS 133 (I have an antique copy of the original FAS 133 Standard.)

Those of us into FAS 133’s finer points have generally assumed a definitional distinction between a “firm commitment” purchase contract to buy a commodity at a contract price versus a forward contract to purchase the commodity at a contracted forward price. The distinction is important, because FAS 133 requires booking a forward contract and adjusting it to fair value at reporting dates if actual physical delivery is not highly likely such that the NPNS exception under Paragraph 10(b) of FAS 133 cannot be assumed to avoid booking.

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

The distinction actually commences with forecasted transactions that include purchase contracts for a fixed notional (such as 100,000 units of fuel) at an uncertain underlying (such as the spot price of fuel on the actual future date of purchase). Such purchase contracts are typically not booked. These forecasted transactions become “firm commitments” if the future purchase price is contracted in advance (such $2.23 per gallon for a future purchase three months later). Firm commitments are typically not booked under FAS 133 rules, but they may be hedged with fair value hedges using derivative financial instruments. Forecasted transactions (with no contracted price) can be hedged with cash flow hedges using derivative contracts.

There is an obscure rule (not FAS 133) that says an allowance for firm commitment loss must be booked for an unhedged firm commitment if highly significant (material) loss is highly probable due to a nose dive in the spot market. But this obscure rule will be ignored here.

One distinction between a firm commitment contract and a forward contract is that a forward contract’s net settlement, if indeed it is net settled, is based on the difference between spot price and forward price at the time of settlement. Net settlement takes the place of penalties for non-delivery of the actual commodity (most traders never want pork bellies dumped in their front lawns). Oil companies typically take deliveries some of the time, but like electric companies these oil companies generally contract for far more product than will ever be physically delivered. Usually this is due to difficulties in predicting peak demand.

A firm commitment is gross settled at the settlement date if no other net settlement clause is contained in the contract. If an oil company does not want a particular shipment of contracted oil, the firm commitment contract is simply passed on to somebody needing oil or somebody willing to offset (book out) a purchase contract with a sales contract. Pipelines apparently have a clearing house for such firm commitment transferals of “paper gallons” that never flow through a pipeline. Interestingly, fuel purchase contracts are typically well in excess (upwards of 100 times) the capacities of the pipelines.  

The contentious FAS 133 booking out problem was settled for electricity companies in FAS 149. But it was not resolved in the same way for other companies. Hence for all other companies the distinction between a firm commitment contract and a forward price contract is crucial.

In some ways the distinction between a firm commitment versus a forward contract may be somewhat artificial. The formal distinction, in my mind, is the existence of a net settlement (spot price-forward price) clause in a forward contract that negates a “significant penalty” clause of a firm commitment contract.

The original FAS 133 (I still have this antique original version) had a glossary that reads as follows in Paragraph 540:

Firm commitment

An agreement with an unrelated party, binding on both parties and
usually legally enforceable, with the following characteristics:

a. The agreement specifies all significant terms, including the
quantity to be exchanged, the fixed price, and the timing of the
transaction. The fixed price may be expressed as a specified
amount of an entity's functional currency or of a foreign
currency. It may also be expressed as a specified interest rate
or specified effective yield.

b. The agreement includes a disincentive for nonperformance that is
sufficiently large to make performance probable.

The key distinction between a firm commitment and a forward contract seems to be Part b above that implies physical delivery backed by a “sufficiently large” penalty if physical delivery is defaulted.  The net settlement (spot-forward) provision of forward contracts generally void Part b penalties even when physical delivery was originally intended.

Firm commitments have greater Part b penalties for physical non-conformance than do forward contracts. But in the case of the pipeline industry, Part b technical provisions in purchase contracts generally are not worrisome because of a market clearing house for such contracts (the highly common practice of booking out such contracts by passing along purchase contracts to parties with sales contracts, or vice versa, that can be booked out) when physical delivery was never intended. For example, in the pipeline hub in question (in Oklahoma) all such “paper gallon” contracts are cleared against each other on the 25th of every month. By “clearing” I mean that “circles” of buyers and sellers are identified such that these parties themselves essentially net out deals. In most cases the deals are probably based upon spot prices, although the clearing house really does not get involved in negotiations between buyers and sellers of these “paper gallons.”

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

See Forward Transaction and Firm Commitment

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)

 

Bob Jensen's Web Site

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| 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 |

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 priceThe 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)
==========================================================================
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.
==========================================================================

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 methodA 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:

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:

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:

 

Transactions

in Lumber

Transactions

in Gold

Date

Accounts

Debit

Credit

Debit

Credit

1/1/x1

Forward

0

 

0

 

        Cash

 

0

 

0

 

 

 

 

Various dates

Forward

100

 

100

 

        OCI

 

100

 

 

       P&L

 

 

 

100

 

 

 

 

7/1/x1

Inventory

400

 

400

 

        Cash

 

400

 

400

 

 

 

 

7/1/x1

Cash

100

 

100

 

        Forward

 

100

 

100

 

 

 

 

7/1/x1

OCI

100

 

 

 

        P&L

 

100

 

 

 

 

 

 

The forward contract was not a FAS 133-allowed cash flow hedge even though it was an economic hedge.  The reason goes back to Paragraph 29d on Page 20 of SFAS 130.

For this same reason, 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 security can be a hedged item, because available-for-sale securities 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.

Held-to-maturity securities may not be hedged for cash flow risk according to Paragraphs 426-431 beginning on Page 190 of FAS 133.  See held-to-maturity.  Suppose a firm has a forecasted transaction to purchase a held-to-maturity bond investment denominated in a foreign currency.  Under SFAS 115, the bond will eventually, after the bond purchase, be adjusted to fair value on each reporting date.  As a result, any hedge of the foreign currency risk exposure to cash flows cannot receive favorable cash flow hedge accounting under FAS 133 rules (as is illustrated in Examples 6 beginning on Page 265 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998).   Before the bond is purchased, its forecasted transaction is not allowed to be a hedged item under Paragraph 29d on Page 20 of FAS 133 since, upon execution of the transaction, the bond "will subsequently be remeasured with changes in fair value ...."  Also see Paragraph 36 on Page 23 of FAS 133.

Even more confusing is Paragraph 29e that requires the cash flow hedge to be on prices or interest rates rather than credit worthiness.  For example, a forecasted sale of a specific asset at a specific price can be hedged for spot price changes under Paragraph 29e.  The forecasted sale's cash flows may not be hedged for the credit worthiness of the intended buyer or buyers.  Example 24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.  Because the bond's coupon payments were indexed to credit rating rather than interest rates, the embedded derivative could not be isolated and accounted for as a cash flow hedge.  See also credit risk swaps.

A  swaption can be a cash flow hedge.   See swaption.

Paragraph 21c on Page 14 and Paragraph 29f on Page 20 of FAS 133 prohibits forecasted cash flows from minority interests in a consolidated subsidiary from being designated as a hedged item in a cash flow hedge.  Reasons are given in Paragraph 472 beginning on Page 206 of FAS 133.  See minority interest.

Cash flow hedges are accounted for in a similar manner but not identical manner in both FAS 133 and IAS 39 (other than the fact that none of the IAS 39 standards define comprehensive income or require that changes in fair value not yet posted to current earnings be classified under comprehensive income in the equity section of a balance sheet):

To the extent that the cash flow hedge is effective, the portion of the gain or loss on the hedging instrument is recognized initially in equity. Subsequently, that amount is included in net profit or loss in the same period or periods during which the hedged item affects net profit or loss (for example, through cost of sales, depreciation, or amortization).

Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm (emphasis added):

IAS 39 Cash Flow Hedge Accounting
For a hedge of a forecasted asset and liability acquisition, the gain or loss on the hedging instrument will adjust the basis (carrying amount) of the acquired asset or liability. The gain or loss on the hedging instrument that is included in the initial measurement of the asset or liability is subsequently included in net profit or loss when the asset or liability affects net profit or loss (such as in the periods that depreciation expense, interest income or expense, or cost of sales is recognised).

FAS 133 Cash Flow Hedge Accounting
For a hedge of a forecasted asset and liability acquisition, the gain or loss on the hedging instrument will remain in equity when the asset or liability is acquired. That gain or loss will subsequently included in net profit or loss in the same period as the asset or liability affects net profit or loss (such as in the periods that depreciation expense, interest income or expense, or cost of sales is recognised). Thus, net profit or loss will be the same under IAS and FASB Standards, but the balance sheet presentation will be net under IAS and gross under FASB.

Cash Flow Hedges Create Fair Value Risk

Cash flow risk commonly arises in forecasted transactions with an unknown value of the underlying.  Interbank rates that banks charge each other is often used for benchmarking in hedge effectiveness testing.  For example, suppose the underlying is a benchmarked interest rate is the ever-popular London Inter-bank Offering Rate (LIBOR) where a firm borrows $1 million for two years at a  fixed rate of 6.41%.  This loan has fair value risk since the amount required to pay the loan off prematurely at the end of any quarter will vary with interest rate movements in the same manner as bond prices move up and down depending upon the spot market of interest rates such as LIBOR.    The loan does not have cash flow risk since the interest rate is locked in at 6.41% (divided by four) for each quarterly interest payment.

The firm can lock in fixed fair value by entering into some type of derivative such as an interest rate swap contract that will pay a variable benchmarked rate that moves up and down with interest rates.  For example, assume the receivable leg of the swap  is fixed at 6.65%.  Each quarter the difference between 6.65% and the current spot rate of LIBOR determines the net settlement of the interest rate swap payment that locks in a fixed return of 6.65% + 2%.  To read more about this particular cash flow hedge and the hedge accounting that is allowed under FAS 133, go to Example 5 in Appendix B of FAS 133 beginning with Paragraph 131.  Bob Jensen elaborates and extends this example with a video and Excel workbook at http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm 

Financial instruments have a notional and an underlying.  For example, an underlying might be a commodity price and the notional is the quantity such as price of corn and the quantity of corn.  An underlying might be an interest rate such as the U.S. Treasury rate of the London Inter-bank Offering Rate and the notional might be the principal such as the $10 million face value of 10,000 bonds having a face value of $1,000 each.

The unhedged investment of $10 million has cash flow risk but no fair value risk.  The hedged investment has no cash flow risk but the subsequent combination of the hedge and the hedged item creates fair value risk.  The fair value of the interest rate swap used as the hedging instrument fluctuates up and down with the current spot rate of LIBOR used in determining the quarterly swap payments.  For example, in Example 5 mentioned above, the swap begins with a zero value but moves up to a fair value of $24,850 a the end of the first quarter, $73,800 at the end of the second quarter, and even drops to a negative ($42,820) after four quarters.

Companies do trillions of dollars worth of cash flow  hedging with interest rate swaps.  Two enormous examples are Fannie Mae and Freddie Mac.  Both of these giant companies hedge millions of dollars of outstanding fixed-rate mortgage investments with interest rate swaps that lock in fair value.  You can read more about their cash flow hedging strategy in their annual reports for Years 2001, 2002, and 2003.  Both companies made headlines for not complying with FAS 133 hedge accounting years.  See http://www.trinity.edu/rjensen/caseans/000index.htm 

 

Fair Value Hedges Create Cash Flow Risk

Fair value risk commonly arises in fore firm commitments with a contracted value of the underlying.  For example, suppose the underlying is a benchmarked interest rate such as the London Inter-bank Offering Rate (LIBOR) where a firm invests $10 million for two years that pays a quarterly return of the spot rate for LIBOR plus 2.25%.  This investment has cash flow risk since the quarterly values of LIBOR are unknown.  The investment does not fair value risk since the value is locked in at $10 million due to the fact that the returns are variable rather than fixed.  

The firm can lock in a fixed return rate by entering into some type of derivative such as an interest rate swap contract that will lock in the current LIBOR forward rate.  For example, assume the payable leg of the swap  is fixed at 6.41%.  Each quarter the difference between 6.41% and the current spot rate of LIBOR determines the net settlement of the interest rate swap payment that will vary with interest rate movements.  To read more about this particular cash flow hedge and the hedge accounting that is allowed under FAS 133, go to Example 2 in Appendix B of FAS 133 beginning with Paragraph 111.  Bob Jensen elaborates and extends this example with a video and Excel workbook at http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm 

The unhedged loan of $1 million has fair value risk but no fair value risk.  The hedged investment has no fair value risk but the subsequent combination of the hedge and the hedged item creates cash flow risk.  If the hedge is perfectly effective,  fair value of the interest rate swap used as the hedging instrument fluctuates exactly to offset any value change in the loan such that the combined value of the loan plus the swap is fixed at $1 million. For example, in Example 2 mentioned above, the swap begins with a zero value but down down to a fair value of a negative liability of )$16,025) when the value of the loan drops to ($998,851) such that the sum of the two values is the constant $1 million.  The swap costs the borrower an outflow of $16,025 at the end of the first quarter to offset the decline in the value of the loan.  

The point here is that a hedge for fair value risk creates cash flow risk.  

Why would a firm want to enter into a fair value hedge that causes cash flow risk?  There can be many reasons, but one is that the borrower may predict that interest rates are going to fall and it would be advantageous to prepay the fixed-rate loan at some point in time before maturity and borrow at anticipated lower rates.  In Example 2 mentioned above, LIBOR dropped to 6.31% in the fourth quarter such at the firm would have to pay $1,001,074 to prepay the loan (e.g., by buying it back in the market).  However, due to the hedge, the interest rate swap would pay $1,074 such that the net cost is only the $1 million locked in fair value fixed by the interest rate swap hedge.

Companies do a somewhat surprising amount of fair value hedging with interest rate swaps.  Two enormous examples are Fannie Mae and Freddie Mac.  Both of these giant companies hedge millions of dollars of outstanding variable rate debt with interest rate swaps that lock in fair value.  Both companies thereby create cash flow risk.  Fannie Mae lost $24 billion in derivatives trading, and much of this was due to fair value hedging.  See "$25 Billion in Derivatives Losses at Fannie Mae" --- http://worldvisionportal.org/WVPforum/viewtopic.php?t=192 

An independent analysis of Fannie's accounts suggests it may have incurred losses on its derivatives trading of $24bn between 2000 and third-quarter 2003. That figure represents nearly all of the $25.1bn used to purchase or settle transactions in that period. Any net losses will eventually have to be recognised on Fannie Mae's balance sheet, depressing future profits.

You can read more about Fannie Mae and Freddie Mac fair value hedging strategy in their annual reports for Years 2001, 2002, and 2003.  Both companies made headlines for not complying with FAS 133 hedge accounting years.  See http://www.trinity.edu/rjensen/caseans/000index.htm

 

 

 

 

DIG issues at http://www.fasb.org/derivatives/  
Section G: Cash Flow Hedges

*Issue G1—Hedging an SAR Obligation (Cleared 02/17/99)

*Issue G2—Hedged Transactions That Arise from Gross Settlement of a Derivative ("All in One" Hedges) (Cleared 03/31/99)

*Issue G3—Discontinuation of a Cash Flow Hedge (Cleared 03/31/99)

*Issue G4—Hedging Voluntary Increases in Interest Credited on an Insurance Contract Liability (Cleared 07/28/99)

*Issue G5—Hedging the Variable Price Component
(Cleared 11/23/99)

Issue G6—Impact of Implementation Issue E1 on Cash Flow Hedges of Market Interest Rate Risk
(Released 11/99)

Issue G7—Measuring the Ineffectiveness of a Cash Flow Hedge of Interest Rate Risk under Paragraph 30(b) When the Shortcut Method is Not Applied
(Released 11/99)

Issue G8—Hedging Interest Rate Risk of Foreign-Currency-Denominated Floating-Rate Debt
(Released 11/99)

See Illustrations  and Ineffectivness.

Cash Flow Statement Presentation

From The Wall Street Journal Accounting Educators' Review on May 9, 2003

TITLE: FASB Rules Derivatives Must Be Part of Financing Cash Flow 
REPORTER: Cassell Bryan-Low 
DATE: May 01, 2003 
PAGE: C4 
LINK: http://online.wsj.com/article/0,,SB105174180092459600,00.html  
TOPICS: Debt, Derivatives, Financial Accounting

SUMMARY: The FASB issued this ruling "in an attempt to crack down" on companies that undertake transactions requiring prepayments by a customer. Some companies have been including those prepayments in cash flows from operations.

QUESTIONS: 

1.) Define financing, investing, and operating cash flows--be specific by referring to authoritative literature for these definitions. Cite your source.

2.) How do financial statement users utilize the three sections of the statement of cash flows to assess a companies financial health? Cite all ways you can think of in which these amounts are used.

3.) Summarize the transaction addressed in the article. Why does the headline define these items as derivatives? What is the support for including the cash flows associated with these transactions in the operating section of the statement of cash flows? What is the argument supporting presenting these cash flows in the financing section?

4.) What is free cash flow? Is this concept defined in authoritative accounting literature? How do financial statement readers use this concept in assessing a company's financial health?

5.) How do the transactions described in this article impact a company's free cash flow? How will they impact free cash flow after implementing the new requirements issued by the FASB?

6.) What does the author mean when he writes of the fact that, because banks such as J.P. Morgan Chase and Citigroup financed delivery of commodities, companies using these transactions, such as Dynegy and Enron, were "able to bury that financing in their trading accounts..."

CBOE =

Chicago Board Options Exchange.  See http://www.cboe.com/    Also see CBOT and CME.

You can find some great tutorials at http://www.cboe.com/education/   For the best educational materials at CBOE, you have to download the Authorware player. But that is free and easy to download.

CBOT =

Chicago Board of TradeSee http://www.cbot.com/   Also see CBOE and CME.

There are a number of Internet sources for options and futures prices ---  http://www.cbot.com/  
For example, look under Quotes and Data, Agricultural Futures.  

You can read about contract specifications by clicking on the tab "Education" and choosing the alternative for "Contract Specifications."  This should take you to http://www.cbot.com/cbot/pub/page/0,3181,21,00.html 

Especially note the definitions at http://cbotdataexchange.if5.com/FeaturesOverview.aspx 

A glossary and tutorials are listed at http://www.cbot.com/cbot/pub/page/0,3181,909,00.html 
The CBOT tutorials hang up quite often when downloading.
The CME tutorials are easier to download and use --- http://www.cme.com/edu/ 
The CME Glossary is at http://www.cme.com/edu/res/glos/index.html 

Also note the FAQs --- http://cbotdataexchange.if5.com/Helpfaq.aspx 

Note that sometimes when you click on "Home" that it does not take you back to the "Real Home" at http://www.cbot.com/ 

Choose the day you are studying this question.  For example, suppose you go to www.cbot.com on January 29, 2004 .  On that day you will find vectors (arrays of prices) called forward prices for futures contracts on commodities such as corn, wheat, etc.  Each price is for a contract having a different expiration date such as contracts settling in March 4, May 4, July 4, etc.  These forward contract prices remain fixed throughout the life of the contract.  Spot prices vary minute to minute and day to day.  The spot price used on the contract date of closing is the settlement price.

The prices you first see listed are the forward prices.  To find spot prices, click on the link called "Charts."  Scroll down to the bottom of the charts page and change the "Month" to "Nearby."  For example, if it currently reads "Mar" for the month, change March to "Nearby."  

At times you will see a Free Historical Data spot price table on the right side of the home page of the CBOT.  You must have a paid subscription to Realtime Services for current spot rates.  A great free foreign exchange (FX) spot rate provider is at http://www.xe.com/ucc/ 

Bob,

The USDA Agricultural Marketing Service provides daily prices for commodities at multiple U.S. locations. Go to: http://www.ams.usda.gov/marketnews.htm . Another place to get cash price data is from Farmers Supply at: www.farmersupply.com .

For LIBOR rates, the following site gives regularly updated LIBOR

rates: http://www.libor-loans.com/libor_rate.html .

I hope that this helps.

Regards,

Fred Seamon
Advisory Economist
Chicago Board of Trade

To find details regarding each futures contract at the CBOT, click on "Futures Contract Specs."  There you will find that each contract is for 5,000 bu. and each tic is 1/4 of a cent which is the increments that traders flash with hand signals in the pit of the trading floor at the CBOT.

You can read more about use of the CBOT at http://www.trinity.edu/rjensen/acct5341/class02.htm 
Note the references at the end of the above document.

CDO Collateralized Debt Obligation = see Credit Derivatives 

Circus =

a hedging combination that entails both an interest rate swap and a foreign currency swap.   As a   single-contract derivative, the circus swap runs into trouble in FAS 133 because it simultaneously hedges a price (or interest rate) risk and foreign currency risk.   Suppose a U.S. company has a trading or available-for-sale portfolio containing a variable rate note receivable in Brazilian reals.   Suppose the company enters into a circus swap that hedges both interest rate and foreign currency risks.  Since SFAS 115 requires that the hedged item (the Brazilian note) be remeasured to fair value at each interest rate date (with foreign currency gains and losses being accounted for under SFAS 52), Paragraph 21c on Page 14 and Paragraph 36 on Page 23 of FAS 133 prohibit the Brazilian note for being the basis of a cash flow hedge.  Paragraph 18 on the top of Page 10 prohibits "separating a compound derivative into components representing different risks .... "  Example 14 beginning on Page 271 illustrates the same problem with a note payable illustration in Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998. 

If the Brazilian note was instead classified as held-to-maturity, the booked value is not remeasured to fair value on each balance sheet date.  That overcomes the Paragraph 21c revaluation objection on Page 14 of FAS 133.  Since the note is not an equity investment, other barriers in Paragraph 21c do not apply.  However, held-to-maturity securities may not be hedged for cash flow risk according to Paragraphs 426-431 beginning on Page 190 of FAS 133.  And Paragraph 18 on Page 10 looms as a lingering barrier.

To circumvent the Paragraph 18 problem of having compound risk hedges in a single contract, the U.S. company could enter into to separate derivative contracts such as an interest rate swap accompanied by an independent forward contract that hedges the foreign currency risk.  Then the issue for a cash flow hedging combination is whether the Brazilian note qualifies as a hedging instrument qualifies under Paragraph 29 rules beginning on Page 20 of FAS 133.  Paragraph 20e bans interest rate hedging if the note is declared held-to-maturity.   Paragraph 20d bans interest rate hedging for a note declared as a trading security under SFAS 115.  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 security can be a hedged item, because available-for-sale securities 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.  Even if this results in accounting for the two derivatives as a cash flow hedge of the Brazilian note, the same cannot be said for a fair value hedge since the forward contract hedging foreign currency risk must be carried at fair value.  Somewhat similar conclusions arise for a foreign currency note payable illustration in Example 15 on Page 272 of Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

One of my students wrote the following case just prior to the issuance of FAS 133:

Brian T. Simmons For his case and case solution entitled ACCOUNTING FOR CIRCUS SWAPS: AN INSTRUCTIONAL CASE click on http://www.resnet.trinity.edu/users/bsimmons/circus/framecase.htm .  He states the following:

This case examines a basic circus swap which involves not only the exchange of floating interest rate for fixed, but also one currency for another. Separation of the effects from both interest rate and foreign currency fluctuations is no simple matter. In fact, no formal accounting pronouncements specifically address this issue. (prior to FAS 133).

The introduction first reviews the history and reasoning of pronouncements leading up to Exposure Draft 162-B. For years, institutions have relied on settlement accounting to record their derivative instruments. With growing concern over the risk of these instruments, however, the SEC and FASB have attempted to increase the detail of disclosure regarding the value and risk of their derivative portfolio. The case provides an example of a hybrid instrument in the form of a circus swap. The case questions review the accounting for these types of instruments under the current settlement accounting guidelines as well as the new fair-value method. Additionally, a simplistic measure of Risk Per Contract (RPC) is developed. By using information that is easy for management to obtain, the likelihood of the benefits of RPC outweighing the costs is greatly enhanced.

Clearly-and-Closely Related Criteria (or Clearly and Closely Related) =

criteria that determine when and when not to treat an embedded derivative as a freestanding contract apart from its host contract.  An embedded derivative that is both deemed to be free standing and is not clearly-and-closely related" must be accounted for separately rather than remain buried in the accounting for the host contract.  Relevant sections of FAS 133 include Paragraphs 304-311 in Pages 150-153 and Paragraphs 443-450 in Pages 196-198.  The FASB reversed its ED 162-B position on compound derivatives.   Examples 12-34 beginning in Paragraph 176 on Page 93 illustrate clearly-and-closely-related criteria in embedded hybrid derivative instruments.  For example, a call option cannot be accounted for separately if it is clearly-and-closely related to to a hybrid instrument that is clearly an equity instrument on a freestanding basis and, thereby, is not subject to FAS 133 rules.  If a prepayment option on a in a variable rate mortgage is based upon an interest rate index, the option is clearly-and-closely related to the host contract and cannot be accounted for separate from its host.  On the other hand, if the option is instead based upon a stock price index such as the Standard and Poors 500 index. the option is no longer clearly-and-closely related to to the host contract.  See hedge.

For example suppose a bond receivable has a variable interest rate with an embedded range floater derivative that specifies a collar of 4% to 8% based upon LIBOR.  The bond holder receives no interest payments in any period where the average LIBOR is outside the collar.  In this case, the range floater embedded option cannot be isolated and accounted for apart from the host bond contract.  The reason is that the option is "clearly-and-closely related" to the interest payments under the host contract (i.e., it can adjust the interest rate).  See Paragraph 12 beginning on Page 7 of FAS 133.

Some debt has a combination of fixed and floating components.  For example, a "fixed-to-floating" rate bond is one that starts out at a fixed rate and at some point (pre-determined or contingent) changes to a variable rate.   This type of bond has a embedded derivative (i.e., a forward component for the variable rate component that adjusts the interest rate in later periods.   Since the forward component is  "clearly-and-closely related"adjustment of interest of the host contract, it cannot be accounted for separately according to Paragraph 12a on Page 7 of FAS 133 (unless conditions in Paragraph 13 apply). 

Illustrations are provided under cap and floater.

See DIG Issue B5 under embedded derivatives.

CME =

Chicago Mercantile ExchangeSee http://www.cme.com   Also see CBOE and CBOT.

Collar=

a hedge that confines risk to a particular range. For example, one form of collar entails buying a call option and selling a put option in such a manner that extreme price variations are hedged from both sides. In Paragraph 181 on Page 95 of FAS 133, a timing collar is discussed.  A collar combines a cap and a floor.  Another example is given in Paragraph 182 beginning on Page 95 of FAS 133. Also see cap and  floater.

Collateralized Debt Obligation (CDO) = see Credit Derivatives 

Collateralized Mortgage Obligation CMO =

a priority claim against collateral used to back mortgage debt. This is considered a derivative financial instrument, because the value is derived from another asset whose value, in turn, varies with global and economic circumstances.

Combination Option = see compound derivatives and option.

Commitment Exposure =

economic exposure arising from the effects of foreign currency fluctuations on the cost curves of competitors. See firm commitment and hedge.

Commodity-Indexed Embedded Derivative =

a derivative embedded in a contract such as an interest bearing note that changes the amount of the payments according to movements of a commodity price index.  When a contract has such a provision, the embedded portion must be separated from the host contract and be accounted for as a derivative according to Paragraph 61i on Page 43 of FAS 133.   This makes embedded commodity indexed derivative accounting different than credit indexed and   inflation indexed embedded derivative accounting rules that do not allow separation from the host contract.  In this regard, credit indexed embedded derivative accounting is more like equity indexed accounting.In this regard, credit indexed embedded derivative accounting is more like equity indexed accounting. See index, equity-indexed, derivative financial instrument and embedded derivatives

In my viewpoint, not all commodity indexed derivatives fail the Paragraph 61i test.  See my Mexcobre Case.

Competitive Exposure =

economic exposure arising from the effects of foreign currency fluctuations on the cost curves of competitors.

Compound Derivatives  =

derivatives that encompass more than one contractual provision such that different risk exposures are hedged in the compound derivative contract.  Paragraph 18 on Pages 9-10 prohibits separation of a compound derivative into components to designate different risks and then use only one or a subset of components as a hedging instrument.  FAS 133, Pages 167-168, Paragraphs 360-361 discusses how the FASB clung to its position on pro rata decomposition in FAS 133 vis-à-vis the earlier Exposure Draft 162-B that also did not allow pro rata decomposition. Further discussion is given in Paragraphs 523-524.  See circus, derivative, embedded derivatives, and option.

Closely related are synthetic instruments arising when multiple financial instruments are synthetically combined into a single instrument, possibly to meet hedge criteria under FAS 133. FAS 133 does not allow synthetic instrument accounting. See Paragraphs 349-350 on Page 164 of FAS 133.  Examples 12-34 beginning in Paragraph 176 on Page 93 illustrate clearly-and-closely-related criteria in embedded hybrid derivative instruments.  These criteria are discussed under hedge.  For a case illustration of a synthetic instrument hedging situation see D.C. Cerf and F.J. Elmy, "Accounting for Derivatives:  The Case Study of a Currency Swap Used to Hedge Foreign Exchange Rate Exposure," Issues in Accounting Education, November 1999, 931-956.

In summary, for hedging purposes, 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 on Page 2 of FAS 133 makes an exception to Paragraph 29a on Page 20 for portfolios of dissimilar assets and liabilities. 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. Reasons 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.  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 at the top of  Page 10 does allow a single derivative to be divided into components  but never with partitioning of  "different risks and designating each component as a hedging instrument."   An example using Dutch guilders versus French francs is given under cash flow hedge.  The problem is troublesome in circuses.

Compound derivative rules do not always apply to compound options such as a combination of put and call options.  Paragraph 28c on Page 19 of FAS 133 highlights these exceptions for written compound options or a combination of a written option and a purchased option.  The test is that for all changes in the underlying, the hedging outcome provides positive cash flows that are never less than the unfavorable cash flows.  See Example 16 beginning on Page 273 of of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

See Structure and Synthetic.

Comprehensive Income or Other Comprehensive Income (OCI) 
Other Comprehensive Income (OCI) and Accumulated OCI (AOCI)

OCI is equal to the change in equity of a business entity during a period from transactions and other events and circumstances from nonowner sources.   Paragraph 5 40 on Page 243 of FAS 133 defines it as follows:

The change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources.   It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners (FASB Concepts Statement No. 6, Elements of Financial Statements, paragraph 70).

Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners (FASB Concepts Statement No. 6, Elements of Financial Statements paragraph 70). The FASB’s ED 162-A proposed a standard on comprehensive income accounting that eventually became a standard in SFAS 130. FAS 133 sought to book financial instrument derivatives without changing net earnings levels prior to issuance of FAS 133. Accordingly, booking of derivative hedgings at fair market value, especially cash flow hedges, entails deferral of earnings in Other Comprehensive Income until cash settlements transpire. Comprehensive income is discussed at various points in FAS 133, notably Paragraphs 46-47, 18c, 127-130, 131-139, 140-143, 144-152, 162-164, 165-172, 173-177, and 338-344.  The acronym AOCI is sometimes used to depict accumulated other comprehensive income. 

The International Accounting Standards Committee (IASC) has not yet defined or required comprehensive statements or the Other Comprehensive Income (OCI) account.  This is especially important since it causes important reproted earnings differences  between IAS 39 versus FAS 133.  Under FAS 133, the OCI account is used for cash flow hedges.  OCI is not used under IAS 39.

See also struggle statement.

OCI and the Accumulated Other Comprehensive Income (AOCI) accounts are used in hedge accounting to keep booked changes in value of cash flow hedges and FX hedges from impacting current earnings to the extent such hedges are deemed effective.  See Hedge Accounting and Ineffectiveness.

Summary of FAS 130

Reporting Comprehensive Income (Issued 6/97)

Summary --- http://www.fasb.org/st/summary/stsum130.shtml 

This Statement establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains, and losses) in a full set of general-purpose financial statements. This Statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial
statement that is displayed with the same prominence as other financial statements. This Statement does not require a specific format for that financial statement but requires that an enterprise display an amount representing total comprehensive income for the period in that financial statement.

This Statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position.

This Statement is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required.

"Watch Out for OCI Accounting,"  April 8, 2002 --- http://www.fas133.com/search/search_article.cfm?page=51&areaid=955 

When Reliant Resources finally released its earnings in mid-March (see TRAS, 2/11/02), it became clear where the company’s FAS 133 hedge accounting went wrong; it’s a mistake other companies should ensure they do not repeat.

While in Reliant’s case, the mistake ended up contributing $134 million to the company’s 2001 net income, had the fair value of the derivatives in question gone the other way, the result would have been more ominous.

In essence, the FAS 133 mistake had to do with four “structured transactions” involving energy forwards which Reliant initially considered cash flow hedges and in retrospect, did not meet the definition.

In particular, the four transactions involved a series of individual forward contracts, mostly off-market (assuming a lower-than-market price initially in return for a higher-than-market price later).

While the combination of forwards was priced at market, the individual contracts were not. Some even involved some prepayment for credit reasons. Still, Reliant chose to account for each forward contract individually as a cash flow hedge set against an underlying transaction.

The real problem was in the initial accounting for the forwards. Under the original accounting, according to Reliant’s 8-K, “the Company recorded each applicable contract in its hedge accounting records on an individual basis, resulting in the recognition of a non-trading derivative asset or liability on the balance sheet with an offsetting entry in accumulated other comprehensive income at inception for each contract.”

Under FAS 133 cash flow hedge rules, however, OCI can only be used to record subsequent changes in the value of a hedging derivative. At inception, the forward should have had a fair value of 0. (Since they were off market, they have a fair value greater or lesser than 0).

Once you begin the hedge accounting with a debit/credit into OCI on day one of the hedge, “you’ve basically introduced a cancer into the balance sheet that will bleed errors into the income statement as the debits and credits get reclassified,” one accounting expert explains.

Under that original accounting, Reliant recorded a net loss in 2001 and ultimately would result in income being recorded for 2002 and 2003 related to these four structured transactions.

In some ways, the accounting did reflect the economics of the transaction, whereby Reliant agreed to sell below market initially in return for being able to sell at higher levels later on. Economically, it wanted to “levelize” what it considered high prices which were unlikely to last.

However, “the recognition of other comprehensive income was in error, because the fair value of each contract in each structure resulted not from changes in the fair value of any anticipated transaction, but rather from the fact that the individual contracts were not at market at inception,” the 8-K explains.

"Preliminary Lessons From Reliant Resources,"  February 27, 2002 --- http://www.fas133.com/search/search_article.cfm?areaid=454&page=51 

While financial hedges retained many of their risk management accounting features under FAS 133 (carry-overs from FAS 52 and FAS 80), in the area of commodity risk management accounting there's been some fundamental changes. It's perhaps an indication of the resulting complexity of the rules that Reliant Resources announced it has made an error in its Q2/Q3 financials, which will necessitate a restatement of earnings.

Earning restatements are bad news in any environment. Against the current backdrop of accounting-transparency debate in the wake of Enron, restatements because of accounting errors look even worse. However, Reliant Resources had to do just that - delay its earning release (so far there's no new release date) because it discovered FAS 133-related errors in its income statement.

The errors, according to the company, result from gas hedges in Q2 and Q3 of 2001. These were previously accounted for as cash flow hedges. Now, the company believes that they do not meet the requirements under FAS 133. This error will affect earning upward of $100 million. Basically, it means that the company now believes that it needs to carry the hedges at fair value, hence reclassifying gains that had been parked in OCI into current income. Reliant says it did not expect to recognize this income until this year and next year (presumably, these were one and two-year hedges).

It's hard to say exactly what happened. That's because the company is saying precious little about what led to its discovery. "Our people are not interested in going into details about the accounting, we're still working it out," says Sandy Fruhman, a PR contact at Reliant. As to when the new figures will be available, Ms. Fruhman says she has not been given a timeframe. "We're eager to get our yearend earnings reported," she notes.

No question about that, since any restatement of earnings (even a revision upward as was the case with Reliant), against the current accounting-focused marketplace, leads to a stock market penalty. The negative market reaction is proof enough that the restatement is not a matter of choice (i.e., earning manipulation). The FASB and the SEC had been previously concerned that some companies might terminate cash flow hedges when they are in a gain position in order to book the gains in income, for instance during years when earnings are down. "I would be surprised if that were the case," noted a partner at a big-five firm. "The market hammered them, so I don't suspect anything 'evil.' My guess is that they were just being honest."

All Reliant is willing to say is that in the course of preparing its annual report, its accounting department came to the conclusion that some of the gas hedges on its books, originally entered into in the second and third quarter of 2001, failed to meet cash flow hedge accounting rules and therefore must be marked to market in income. As a result, Reliant said it expects earnings for the two periods to increase by an amount between $100 million and $130 million. "The restatement, due to a reclassification of several specific transactions, will change the timing of earnings recognition, with the effect that the company will recognize earnings in 2001 that it previously expected to recognize in 2002 and 2003," the company noted.

A quick look at the company's quarterly filings reveals that it held a deferred gain of $495 million (see below) at the end of the third quarter. That's the same amount it disclosed in its Q2 report, and slightly under the Q1 deferred gain.

Contango Swap = the following according to one of my students:

A contango swap is a commodity curve swap, which enables the user to lock in a positive spread between the forward price and the spot price. A producer of a commodity, for example, might pay an amount equal to the 6-month futures contract and receive a floating payment equal to the daily price plus a spread. This enables the commodity producer to lock-in the positive spread and hedge against anticipated backwardation.    Her project on such a swap is as follows:

Debra W. Hutcheson For her case and case solution on Accounting for Commodity and Contango Swaps, click on http://www.resnet.trinity.edu/users/dhutches/project.htm .  She states the following:

This case examines the interplay of a cotton consumer and a cotton producer, both participating in a commodity swap, one of the many commodity-based financial instruments available to users. Each party wants to protect itself from commodity price risk and the cotton swap allows each participating party to "lock-in" a price for 6 million pounds of cotton. One party might lose in the cotton swap and, therefore, must enter into some other derivative alternatives. Additionally, this case examines the requirements for accounting for these contracts under the FASB’s latest exposure draft on accounting for derivatives and the "forward-looking" disclosure required by the SEC.

The term "contango" is also used in futures trading.  It refers to situations in which the spot price is higher than the futures price and converges toward  zero from above the futures price.  In contrast, backwardation arises when the spot price is lower than the futures price, thereby yielding an upward convergence as maturity draws near.  See basis.

Contingent Consideration =

outcomes that have maturities or payouts that depend upon the outcome of a a contingency such as a civil lawsuit.  Contingent consideration in a business combination as defined in Paragraph 78 of APB 16 are excluded (for the issuer) from the scope of FAS 133 under Paragraph 11c on Page 7.  Accounting for this type of transaction remains as originally required for the issuer in APB 16.  Contingent lease rentals based on related sales volume, inflation indexed rentals, and contingent rentals based upon a variable interest rate are also excluded from FAS 133 in Paragraph 61j on Page 43.

Convertible Debt =

a debt contract that has an embedded derivative such as an option to convert the instrument debt into common stock must be viewed as having an embedded option.  When a contract has such a provision, the embedded portion must be separated from the host contract and be accounted for as a derivative according to Paragraph 61k on Page 43 of FAS 133.   See derivative financial instrument and embedded option.

Covered Call and Covered Put  =

simultaneous writing (selling) of a call option coupled with ownership (long position) of the underlying asset.  The written call option is a short position that exposes the call option writer to upside risk.  A covered call transfers upside potential of the long position to the buyer of the call and, thereby, may create more upside price risk than downside price expected benefit.    Paragraph 399 on Page 180 does not allow hedge accounting for covered calls, because the upside potential must be equal to or greater than the downside potential.   In the case of a covered call, the upside risk may exceed the downside potential..   

A covered put entails writing (selling) a put option (long position) coupled with having a short position (e.g., a short sale contract) on the underlying asset.  In the case of a covered put, the downside risk may exceed the downside potential.

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.

Also see option and written option.

Credit Derivative and Credit Risk Swap =

Jensen Comment
Credit derivatives (usually credit default swaps that have a periodic premium paid for and pay periodically for credit insurance) are currently scoped into FAS 133 and IAS 39. I think that this is a mistake. These contracts are really insurance contracts and financial guarantees that should be accounted for as such and not as derivatives scoped into FAS 133 and IAS 39. Be that as it may, these controversial contracts that brought AIG and other Wall Street banks to its knees are accounted for as derivative contracts.

I really don’t think credit derivatives are appropriately accounted for under either FAS 133 or IAS 39. The problem is that the intermediary that brokers an interest rate risk swap can guarantee the interest rate risk swap payments since these swaps are only dealing with payments on the net changes in interest rates with the notionals not being at risk. It seems to me that with credit default swaps, the entire notionals themselves might be at risk and the intermediaries that broker the swaps are not guaranteeing the swap payments equal to complete wipeouts of notionals. Hence, I don’t thinks CDS swaps properly meet the definitions of derivatives since notionals are at risk. It seems to me that CDS contracts should be accounted for as insurance contracts.

This is one of those instances where I think auditors should look at the substance of the transactions rather than rules per se.

 

Credit Default Swap (CDS) at http://en.wikipedia.org/wiki/Credit_default_swap

A credit default swap (CDS) is an instrument to transfer the credit risk of fixed income products. Using technical terms, it is a bilateral contract, in which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. The buyer of a credit swap receives credit protection. The seller 'guarantees' the credit worthiness of the product. In more technical language, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement). Simply, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. For example, a mortgage bank, ABC may have its credit default swaps currently trading at 265 basis points (bp). In other words, the annual cost to insure 10 million euros of its debt would be 265,000 euros. If the same CDS had been trading at 7 bp a year before, it would indicate that markets now view ABC as facing a greater risk of default on its mortgage obligations.

Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events such as a default on a debt obligation. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used to speculate on changes in credit spread.

Credit default swaps are the most widely traded credit derivative product.[1] The typical term of a credit default swap contract is five years, although being an over-the-counter derivative, credit default swaps of almost any maturity can be traded.

"Everything You Wanted to Know about Credit Default Swaps--but Were Never Told," by Peter J. Wallison, RGE, January 25, 2009 ----
Click Here 
Also see http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout

Credit default swaps (CDSs) have been identified in media accounts and by various commentators as sources of risk for the institutions that use them, as potential contributors to systemic risk, and as the underlying reason for the bailouts of Bear Stearns and AIG. These assessments are seriously wide of the mark. They seem to reflect a misunderstanding of how CDSs work and how they contribute to risk management by banks and other intermediaries. In addition, the vigorous market that currently exists for CDSs is a significant source of market-based judgments on the credit conditions of large numbers of companies--information that is not publicly available anywhere else. Although the CDS market can be improved, excessive restrictions on it would create considerably more risk than it would eliminate.

There are so many potential culprits in the current financial crisis that it is difficult to keep them all straight or to assess their relative culpability. Greedy investment banks, incompetent rating agencies, predatory lenders and mortgage brokers--even the entire system of asset securitization--have all been blamed for the current condition of the financial markets. The oddest target, however, is CDSs. Almost every media report and commentary about the collapse of Lehman Brothers in September and the ensuing freeze in the credit markets mentions CDSs as one of the contributing causes, just as similar reports and commentary accompanied the government's decision to rescue Bear Stearns in March and AIG in September. One conventional explanation for the Bear rescue has been that CDSs made the financial markets highly "interconnected." It is in the nature of credit markets to be interconnected, however: that is the way money moves from where it is less useful to where it is most useful, and that is why financial institutions are called "intermediaries." Moreover, there is very little evidence that Bear was bailed out because of its involvement with CDSs--and some good evidence to refute that idea. First, if the government rescued Bear because of CDSs, why did it not also rescue Lehman? If the Treasury Department and the Federal Reserve really believed that Bear had to be rescued because the market was interconnected through CDSs, they would never have allowed Lehman--a much bigger player in CDSs than Bear--to fail. In addition, although Lehman was a major dealer in CDSs--and a borrower on which many CDSs had been written--when it failed there was no discernible effect on its counterparties. Within a month after the Lehman bankruptcy, the swaps in which Lehman was an intermediary dealer were settled bilaterally, and the swaps written on Lehman itself ($72 billion notionally) were settled by the Depository Trust and Clearing Corporation (DTCC). The settlement was completed without incident, with a total cash exchange among all counterparties of $5.2 billion. There is no indication that the Lehman failure caused any systemic risk arising out of its CDS obligations--either as one of the major CDS dealers or as a failed company on which $72 billion in notional CDSs had been written.

Nevertheless, Securities and Exchange Commission (SEC) chairman Christopher Cox was quoted in a recent Washington Post series as telling an SEC roundtable: "The regulatory black hole for credit-default swaps is one of the most significant issues we are confronting in the current credit crisis . . . and requires immediate legislative action. . . . The over-the-counter credit-default swaps market has drawn the world's major financial institutions and others into a tangled web of interconnections where the failure of any one institution might jeopardize the entire financial system." Readers of this Outlook should judge for themselves whether this is even a remotely accurate portrayal of the dangers posed by CDSs.1

The fact that AIG was rescued almost immediately after Lehman's failure led once again to speculation that AIG had written a lot of CDS protection on Lehman and had to be bailed out for that reason. When the DTCC Lehman settlement was completed, however, AIG had to pay only $6.2 million on its Lehman exposure--a rounding error for this huge company. As outlined in a recent Washington Post series on credit risk and discussed below, AIG's exposure was not due to Lehman's failure but rather the result of the use (or misuse) of a credit model that failed to take account of all the risks the firm was taking.2 It is worth mentioning here that faulty credit evaluation on mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) have also been the cause of huge losses to commercial and investment banks. As I argue in this Outlook, there is no substantial difference between making a loan (or buying a portfolio of MBS) and writing protection on any of these assets through a CDS. Faulty credit evaluation in either case will result in losses.

If CDSs did not trigger the rescue of Bear and AIG, what did? The most plausible explanation is that in March, when Bear was about to fail, the international financial markets were very fragile. There was substantial doubt among investors and counterparties about the financial stability and even the solvency of many of the world's major financial institutions. It is likely that the government officials who decided to rescue Bear believed that if a major player like Bear were allowed to fail, there would be a run on other institutions. As Fed chairman Ben Bernanke said at the time, "Under more robust conditions, we might have come to a different decision about Bear Stearns."3 When the markets are in panic mode, every investor and counterparty is on a hair-trigger alert because the first one out the door is likely to be repaid in full while the latecomers will suffer losses. The failure of a large company like Bear in that moblike environment can be responsible for a rush to quality; in a normal market, there would have been a much more muted reaction. For example, when Drexel Burnham failed in 1990, there was nothing like the worldwide shock that ensued after Lehman's collapse, although Drexel was as large a factor in the market at that time as Lehman was before its failure.

After the Lehman bankruptcy, there was a market reaction much like what would have happened if Bear had failed. The markets froze, overnight interbank lending spreads went straight north, and banks stopped lending to one another. In these circumstances, the rescue of AIG was inevitable, although it is likely that the company would have been allowed to fail if the reaction to the Lehman failure had not been so shocking. The Fed's statement on its rescue of AIG pointed to the conditions in the market--not to CDSs or other derivatives--as the reason for its actions: "The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance."4  Indeed, the sensitivity of the markets and the government in September is shown by the reaction of the Treasury and the Fed when the Reserve Fund, a money market mutual fund, "broke the buck"--that is, allowed the value of a share to fall below one dollar. The fund had apparently invested heavily in Lehman commercial paper and thus suffered a loss that the manager could not cover. Treasury moved immediately to guarantee the value of money market fund shares, apparently on fear that the Reserve Fund's losses would trigger a run on all money market funds. Needless to say, money market funds are not "interconnected." The Treasury's action in backing money market mutual funds after Lehman's failure was another response to the market's panic.

So, if CDSs are not responsible for the financial crisis or the need to rescue financial companies, why are they so distrusted? Some observers may simply be drawing a causal connection between the current financial crisis and something new in the financial firmament that they do not fully understand. Misleading references to the large "notional amount" of CDSs outstanding have not helped. This Outlook will outline how CDSs work and explain their value both as risk management devices and market-based sources of credit assessments. It will then review the main complaints about CDSs and explain that most of them are grossly overblown or simply wrong. Improvements can certainly be made in the CDS market, but the current war on this valuable financial innovation makes no sense.

How Credit Default Swaps Work

Figure 1 shows a series of simple CDS transactions. Bank B has bought a $10 million bond from company A, which in CDS parlance is known as "the reference entity." B now has exposure to A. If B does not want to keep this risk--perhaps it believes A's prospects are declining, or perhaps B wants to diversify its assets--it has two choices: sell the bond or transfer the credit risk. For a variety of tax and other reasons, B does not want to sell the bond, but it is able to eliminate most or all of the credit risk of A by entering a CDS. A CDS is nothing more than a contract in which one party (the protection seller) agrees to reimburse another party (the protection buyer) against a default on a financial obligation by a third party (the reference entity). In figure 1, the reference entity is A, the protection buyer is B and the protection seller is C. Although figure 1 shows B purchasing protection against its entire loan to A, it is important to note that B also could have purchased protection for a portion of the principal amount of the $10 million bond. The amount of protection that B purchases is called the "notional amount."

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The CDS market is a dealer market, so transactions take place through dealers, over the counter rather than on an exchange. Accordingly, in purchasing protection against A's default, B's swap is with C, a dealer--one of many, including the world's leading banks, that operate in this market. The structure of the CDS is simple. C agrees to pay $10 million (or whatever notional amount the parties negotiate) if A defaults, and B agrees to make an annual premium payment (usually paid quarterly) to C. The size of this payment or premium will reflect the risk that C believes it is assuming in protecting B against A's default. If A is a good credit, the premium will be small, and correspondingly the premium would be larger when the market perceives greater credit risk in A. Under the typical CDS contract, B is entitled to request collateral from C in order to assure C's performance. As a dealer, C generally aims to keep a matched book. For every risk it takes on, it typically acquires an offsetting hedge. So C enters a CDS with D, and D posts collateral. The transfer of B's risk to C and then to D (and occasionally from D to E and so on) is often described by many CDS critics as a "daisy chain" of obligations, but this description is misleading. Each transaction between counterparties in figure 1 is a separate transaction, so B can look only to C if A defaults, and C must look to D. B will not usually deal directly with E. However, there are now services, such as those of a firm called Trioptima, that are engaged in "compressing" this string of transactions so that the intermediate obligations are "torn up." This reduces outstandings and counterparty risk.

Does this hypothetical string of transactions create any significant new risks that go beyond the risk created when B made its loan to A? In the transaction outlined in figure 1, each of the parties in the chain has two distinct risks--that its counterparty will be unable to perform its obligation either before or after A defaults. If C becomes bankrupt before A defaults, B will have to find a new protection seller; if C defaults after A defaults, B will lose the protection that it sought from the swap. The same is true for C and D if their respective counterparties default. In the CDS market, in which premiums are negotiated based on current views of the risk of A's default, the premium--also known as the spread--for new protection against A's default could be more costly for B, C, and D than the original premium negotiated. Although this might mean a potential loss to any of these parties, it is likely--if the risk of a default by A has been increasing--that the seller of protection will have posted collateral so that each buyer will be able to reimburse itself for the additional premium cost for a new CDS.

It is important at this point to understand how the collateral process works. Either the buyer or the seller in a CDS transaction may be "in the money" at any point--that is, the CDS spread, which is moving with market judgments, may be rising or falling, depending on the market's judgment of the reference entity's credit. At the moment the CDS transaction was entered, the buyer and seller were even, but if the credit of the reference entity begins to decline, the CDS spread will rise, and at that point the buyer is "in the money"--it is paying a lower premium than the risk would warrant. Depending on the terms of the original agreement, the seller then may have to post collateral--or more collateral. But if the reference entity's credit improves--say, its business prospects are better--then the CDS spread will fall and the seller is in the money. In this case, the buyer may have to put up collateral to ensure that it will continue to make the premium payments.

What happens if A defaults? Assuming that there are no other defaults among the parties in figure 1, there is a settlement among the parties, in which E is the ultimate obligor (conceptually, C has paid B, D has paid C, and E has paid D. But if E defaults, D becomes the ultimate payer, and if D defaults, C ends up holding the bag. Of course, D then would have a claim against E or E's bankrupt estate, and the same for C if D defaults. Critics of CDSs argue that this "daisy chain" is an example of interconnections created by CDSs that might in turn create systemic risk as each member of the string of transactions defaults because of the new liability it must assume. But this analysis is superficial. If CDSs did not exist, B would suffer the loss associated with A's default, and there is no reason to believe that the loss would stop with B. B is undoubtedly indebted to others, and its loss on the loan to A might cause B to default on these obligations, just as E's default might have caused D to default on its obligations to C. In other words, the credit markets are already interconnected. With or without CDSs, the failure of a large enough participant can--at least theoretically--send a cascade of losses through this highly interconnected structure. CDSs simply move the risk of that result from B to C, D, or E, but they do not materially increase the risk created when B made its loan to A. No matter how many defaults occur in the series of transactions presented in figure 1, there is still only one $10 million loss. The only question is who ultimately pays it.

The Role of Credit Default Swaps in the Financial Economy

Financial regulators have few resources that will materially reduce risk-taking. They can insist on more capital, which both provides a cushion against losses and a nest egg that management has an incentive to protect, and they can clamp down on innovation, which can always be a source of uncertainty and therefore risk. But beyond that, they are limited to ensuring that banks, securities firms, and insurance companies--to the extent that they are regulated for safety and soundness--carefully review the risks they take and have the records to show for it. The current credit crunch is testimony to the ineffectiveness of regulation. Despite the most comprehensive oversight of any industry, the banking sector is riddled with bad investments and resulting losses. In fact, by creating moral hazard, it is likely that the regulation of banks has reduced the private-sector scrutiny that banks would have received as part of a fully operating system of market discipline.

In light of the consistent failure of traditional regulation, a sophisticated and intelligent regulatory process should now foster risk-management innovations that have been developed by the private sector, especially the derivative instruments that have greater potential to control risk than government oversight. CDSs are one of these instruments, but not the only one. A simple example of effective risk-shifting is the interest rate swap, which--like the CDS--was developed by financial intermediaries looking for ways to manage risk. The documentation for interest rate swaps, as well as for CDSs, was developed by the International Swaps and Derivatives Association (ISDA). Interest rate swaps have been an important and useful risk-management device in the financial markets for at least twenty-five years. The value of an interest rate swap is that it allows financial intermediaries to match their assets and their liabilities and thus to reduce their interest rate risks. Say that a bank has deposits on which it must pay a market or "floating" rate of interest, but it also holds mortgages on which it receives only a fixed monthly interest payment. This is a typical position for a bank--but a risky one. If interest rates rise, it may be forced to pay more interest to its depositors than it is receiving from the mortgages it holds, and thus would suffer losses. Ideally, it would want to trade the fixed rate it receives on its mortgage portfolio for a floating rate that will more closely match what it has to pay its depositors. That way, it is protected against increases in market rates. An interest swap, in which the bank pays a fixed rate to a counterparty and receives a floating rate in return, is the answer; it matches the bank's interest rate receipts to its payment obligations.

But what kind of entity would want to do such a swap? Consider an insurance company that has fixed obligations to pay out a certain sum monthly on the fixed annuities it has written. Insurance companies try to match this obligation with bonds and notes that are the ultimate source of the funds for meeting its fixed obligations, but these do not necessarily yield a fixed return for periods long enough to fully fund its annuity commitments. Instead, they mature well before its annuity obligations expire, and may--if interest rates decline--yield less than it is required to pay out to annuitants. The insurance company, then, would be able to avoid risk with a swap that is the exact mirror image of what the bank needs. Into this picture steps a swap dealer, which arranges a fixed-for-floating interest rate swap between the bank and insurance company. The notional amount can be set at any number--its purpose in an interest rate swap is simply to provide the principal amount on which the interest will be paid--so the parties agree on $100 million. The bank agrees to pay the insurance company a fixed amount--say, 5 percent--on the notional amount of $100 million, and the insurance company agrees to pay the bank a floating rate of interest on the same notional amount. If interest rates rise to 6 percent, the bank is "in the money" and the insurance company pays the bank the 1 percent difference, and, if they fall to 4 percent, the bank pays the insurance company 1 percent.

The important thing to notice about this transaction is that both the bank and the insurance company are better off--both have reduced their risks. The bank now gets a floating payment that assures it of the funds necessary to pay its depositors no matter how high interest rates rise, and the insurance company is better off because it gets a fixed payment from the bank that allows it to pay its annuitants no matter how far interest rates fall. Both parties have hedged their interest rate risk through use of a derivative. The notional amount of interest rate swaps currently outstanding grew to $464.7 trillion by June 30, 2008.5 This is a frighteningly large number, but--as discussed below--its only reality is as the basis on which counterparties are exchanging fixed for floating rates. No one actually owes anyone any portion of this $464.7 trillion. The payment obligations are only interest. The interest rate swap is a classic example of a private-sector mechanism for risk management that could not have been developed or implemented by a regulatory agency. It is also a good way to think about CDSs, which have risk-management characteristics much like interest rate swaps.6 Let's assume that a bank holds a loan to a corporate customer that makes oil field equipment. The bank is receiving a stream of payments on the loan with which it is satisfied, but it concludes as a matter of risk management that it has too much credit exposure to the oil business. If oil prices fall, its loans to the industry may be in jeopardy. One of the objectives of risk management is diversification, but even better is holding uncorrelated assets--that is, assets that do not rise or fall in value or marketability at the same time. Still better, from the risk-management standpoint, are assets that are negatively correlated--that rise in value when the others are falling. For example, a bank would like to hold loans to both an auto manufacturer and an oil company; as oil prices rise, the auto manufacturer becomes weaker but the oil company becomes stronger; other things being equal, the bank's risks are balanced.

Using this strategy, the hypothetical bank we are discussing would like to divest some of its oil industry exposure and instead balance its portfolio with exposure to the risk of, say, auto sales. In a world where CDSs are available, this is easily done. The bank enters a swap with an intermediary CDS dealer in which the dealer promises to reimburse the bank if the oil field services company defaults. The dealer must now find a hedge in the form of a company that is willing to sell protection on the oil services company. A logical protection seller might be an insurance company. The insurance company has substantial outstanding loans on commercial real estate. Taking on the risk of an oil service company would provide needed diversification and could be uncorrelated--or even negatively correlated--with the places where the insurance company's commercial real estate is located. Through this transaction, the bank has reduced or eliminated the credit risk of a loan to the oil industry, but the loan remains on its books and it keeps the oil company's stream of interest and principal payments, as well as its commercial relationship with this client. Now the bank enters another CDS, this time with a hedge fund, in which the bank promises to indemnify the fund against losses on a portfolio of loans to auto dealers. For this protection, the hedge fund makes a monthly payment to the bank (for simplicity, we are disregarding the intermediary dealer). After these two transactions, the bank has somewhat diversified and balanced its portfolio by substituting the credit risk of a portfolio of auto loans for an oil industry loan. Because the portfolio of auto loans may be negatively correlated with the oil industry risks, the bank's portfolio is now likely to be more stable. The insurance company has done the same. Once again, a derivative has operated as an effective risk management tool, reducing the credit risk profile of two financial intermediaries.

It is also important to note that the same risk-management purposes can be served by a bank or any other financial intermediary taking on a risk that diversifies its portfolio, even if it has no relation at all to a reference entity. Because the party writing the protection is paid for assuming the credit risk, the CDS functions in much the same way, from a risk management perspective, as an actual loan. This issue is discussed more fully below in the section on whether CDSs represent "gambling" or "betting."

CDSs also offer an increasingly important window into risk-taking that has not previously existed. In this, CDSs can help both investors and regulators. On November 25, for example, a newswire reported: "Credit default swaps protection generally narrowed Tuesday amid improvement in key spread product markets such as the commercial mortgage-backed securities and asset-backed arena."7 Similarly, on December 10, the interim assistant treasury secretary for financial stability, Neel Kashkari, told the House Financial Services Committee that "one indicator that points to reduced risk of default among financial institutions is the average credit default swap spread for the eight largest U.S. banks, which has declined more than 200 basis points since before Congress passed the [Emergency Economic Stabilization Act]."8

The fact that CDSs are available as an indicator of risk in the financial markets generally, and with respect to particular institutions, is vastly important. Up to now, there has been no generally available, market-based source of credit assessments about financial institutions. Interest rate spreads and stock prices are not as valuable because they are influenced by many factors other than risk-taking and creditworthiness. If properly used, the data on CDS spreads for reference entities can alert regulators to problems at individual banks, securities firms, or insurance companies. Even more important, it can assist investors and creditors in exerting market discipline over financial institutions. In light of the general failure of regulation for controlling risk-taking, the enhancement of market discipline is extremely important. A widening of a reference entity's CDS spread will alert investors that they should investigate risk-taking more fully before advancing funds. Even if CDSs were not important for risk management, the existence of the information generated by the CDS market would alone provide economic justification for allowing this market to operate freely and without restrictions. The importance of this development cannot be overstated. Virtually since their inception, banks have been the repositories of credit information about borrowers. As the securities market grew and public disclosure became more complete, banks lost some of their role as the preferred intermediaries between investors and borrowers; many public companies went to the securities market for credit financing. At the same time, rating agencies began to substitute for credit analysis by some institutional lenders and bond buyers. The growth of CDSs provides for the first time a market-based credit assessment available to all institutional lenders and bond buyers. At a time when the value of rating agencies is being questioned,9 the CDS market offers critical new information to use in credit assessment.

Myths about Credit Default Swaps

Despite these significant benefits, criticism of CDSs is widespread. It is not uncommon to find statements by market observers that CDSs have no economic purpose, create enormous risks for the financial economy, create systemic risks, are little more than irresponsible gambling by market participants, and create hidden liabilities that do not appear in financial statements. Almost all of these claims are either grossly exaggerated or wrong.

Claim: The Notional Amount of CDSs Outstanding Represents a Huge Risk for the World's Financial System. One of the most striking elements associated with credit default swaps is the notional amount outstanding at any one time. As a measure of the growth of CDSs, the aggregate notional amount is of some use, but as a measure of the risk in the market, it is meaningless. Nevertheless, critics of CDS use the aggregate notional amount number to suggest that huge risks are being created in some mysterious way. Shortly after Bear Stearns was rescued, George Soros wrote: "There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45 [trillion]. . . . To put it into perspective, this is about equal to half the total US household wealth."10 This is not putting CDSs "into perspective." Coming from a sophisticated financier, it seems more like a deliberate attempt to mislead. The notional amount of CDSs outstanding--although suitable for scaring people--is not in any sense relevant to the size of the risks associated with CDSs.

Returning again to the hypothetical transaction in figure 1, we can calculate the notional amount that comes out of the reporting of the transaction by the various participants. B reports that it is paying a premium for protection on a notional amount of $10 million (the loan to A), C reports that it has sold protection for this amount, as have D and E and the dealer intermediary between D and E. Thus, the total notional amount arising from this series of transactions is $50 million, or five times the actual potential loss in the event that A defaults. The DTCC recently began publishing data on CDSs from its Trade Information Warehouse, which gathers about 90 percent of all CDS transactions.11 The DTCC's data eliminate the multiple-counting in each swap transaction and report that as of the week ending December 12, what the DTCC calls the "gross notional amount" of CDSs outstanding was $25.6 trillion.12

This amount is many times the actual potential loss on all CDSs outstanding at any time because the protection sold must be reduced by the protection bought. The result is called the net notional amount and has been estimated at 10 percent of the gross notional amount in the market.13 Accordingly, using the gross notional figure reported by the DTCC, we can estimate that the net notional amount is about $2.5 trillion (a total of $2.75 trillion with the additional 10 percent not reported by DTCC), a sum that is a fraction of the figure Soros used. These are not small numbers, of course, but they are far less than the number usually used to describe the total risk in the CDS market. And even these numbers are only "real" if every reference entity were to default and if sellers' recoveries after these defaults were zero.

Claim: CDSs Are Written by or between Parties That Do Not Understand the Risks They Are Assuming. In one sense, this statement is true. There are always lenders who lose money because they do not understand the risk they are assuming, and there are undoubtedly writers of CDS protection who also do not understand the credit risk to which they are exposed. If the statement is meant to communicate the idea that a CDS risk is different from or more complex than a loan (or the acquisition of a portfolio of MBS), however, it is wrong. First, almost all swaps are negotiated through dealers, who serve as the actual counterparties. Dealers typically carry matched books, which means that they hedge their risks by entering offsetting CDSs. To remain in business, they must be sure of the quality of the counterparties they choose. In figure 1, for example, B buys protection from C, a dealer. C then enters a corresponding swap with D, which sells protection to C to cover C's exposure to B. If D does not have a AAA credit rating (and maybe even if it does), it probably has to post collateral to protect C, and C may have to post collateral to assure B that it is protected. In fact, 63 percent of all CDSs--and 65 percent of the dollar exposure--are collateralized,14 precisely because the parties that are paying for protection want to make sure it is there when they need it. In addition, recalling the earlier discussion of counterparties moving in and out of the money, a protection buyer and a protection seller may have obligations to post collateral if the spread on a particular reference entity rises or falls. No institution that enters this market does so lightly.

The AIG case is a good illustration of the CDS process and was covered extensively in the Washington Post series cited above. Initially, AIG's counterparties generally agreed that AIG would not be required to post collateral because it was rated AAA, but when it was downgraded by the rating agencies, it was immediately required by its swap agreements to post collateral. In addition, AIG had written a lot of protection on MBS and CDO portfolios, and, as these declined in value, it was again required by its counterparties to post collateral to cover its increased exposure. When AIG could not do so, it was threatened with bankruptcy, and that is when the Fed stepped in with a rescue. The rescue of AIG, as noted above, had nothing to do with Lehman's failure, but it did have a lot to do with AIG's failure to assess the risks of MBS and CDOs. Does this sound familiar? Of course it does--it is the same problem faced by many banks that also failed to assess properly the risk of these assets. Apparently, AIG relied excessively on a credit risk model that did not adequately account for both the sharp decline in the mortgage market or a downgrade of AIG's credit rating.

This points up a fact that gets too little attention in the discussion of CDSs: that the best analogy for these instruments is an ordinary commercial loan. A seller of protection is taking on virtually the same risk exposure as a lender. It is no more mysterious than that. Successful lending requires expertise in assessing credit--the same skill required for writing CDS protection. AIG, like many banks, misjudged the riskiness of a portfolio of MBS and CDOs. That does not mean that CDSs are any riskier than loans; if AIG, instead of selling protection on various portfolios of MBS and CDOs, had bought the portfolios themselves, there would have been very little commentary other than clucking about the company's poor credit judgment. For some reason, the fact that it did substantially the same thing by selling protection on these instruments through CDSs has caused commentators to see the issue as a problem created by the swaps rather than as a simple example of poor credit assessment.

Recently, in order to eliminate the constant calls for more collateral, the Fed purchased the portfolios of MBS and CDOs on which AIG had written protection. An article in the Wall Street Journal then noted that this was a "blessing" for the banks that had bought protection from AIG. Indeed it was; that is why the banks bought the protection. If AIG had not covered this liability, the banks would have taken these losses. This illustrates another central point about CDSs: one institution's loss is another's gain. The risk was already in the market. It was created when some bank or investment bank borrowed the funds necessary for assembling a portfolio of MBS or CDOs. The fact that AIG was the final counterparty and suffered the loss means that someone else did not. Ultimately, there is only one real risk, represented by the original loan or purchase transaction (in the case of an asset like an MBS portfolio). CDSs, to the extent that they are initiated by parties that are actually exposed to a risk, merely transfer that risk, for a price, to someone else.

A recent article in the Wall Street Journal focused on an instrument called a synthetic CDO and noted that many buyers of these instruments suffered losses because of the meltdown in the U.S. mortgage market.15 Because a CDS is a part of a synthetic CDO, the article once again raised the question of whether protection sellers in the CDS transaction understand the risks they are assuming. However, the writers of the article did not make clear (or failed to understand) that, despite a fancy name and the presence of a CDS, the buyers of these instruments were taking a risk that was essentially identical to investing in a portfolio of loans. In an ordinary CDO, a number of loans are bundled into a pool, and debt instruments are sold to investors backed by the assets in the pool. A CDO, then, is just a generalized term for the same process in which the more familiar MBS are created. The investor in a CDO takes the risk that the instruments in the pool will not lose value or default. In a synthetic CDO, an investor buys a security issued by a special purpose vehicle (SPV) and becomes the seller of protection in a CDS in which the SPV is the protection buyer. The SPV is usually created by a bank that is seeking CDS protection on a portfolio of loans it intends to continue to hold. The SPV uses the cash investment to buy a portfolio of high-quality debt securities. The low yield on the high-quality debt securities is supplemented by the premium on a CDS, and two yields in effect replicate the yield that the investor would have received--and the risk it would have taken--if it had invested in the same portfolio of loans that the bank is holding. Once again, there is no essential difference between investing in the actual loans or investing in the synthetic CDO. The credit risk and the yield are the same.

The Journal story noted that "towns, charities, school districts, pension funds, insurance companies and regional banks" have taken on the risk of these synthetic CDOs and that some have suffered losses as a result of the weakening credit markets. Of course, many (maybe most) have profited from the premiums they have received over time for taking this risk. Two things should be noted at this point. The first is that while synthetic CDOs replicate the risks associated with a portfolio of loans, they are complex investments; there is a question whether they are suitable investments for towns, school districts, and other investors that may not be able properly to evaluate the risks. To the extent that this happened, it would be a violation of the "investor suitability" rules applicable in the United States and any equivalent rules in the countries where these investments were sold. The second point is that the fault in this process was not with the CDSs that were part of the synthetic CDOs, any more than a corporation would be at fault if a bond dealer sold one of its bonds to an investor who could not understand the risks. The role of the CDS is to replicate the risk of owning a portfolio of loans, and the risk they create is not any greater than that.

Writing CDS protection is much the same as making a loan or buying a bond. In order to participate in this market, an institution must have the capability to evaluate credit risk. It is not a market for individuals or even institutions that do not have credit-evaluation skills or access to them. Even institutions with credit-evaluation skills suffer losses on some risks they acquire--as shown by the AIG case--but it is certainly not true that, in general, those institutions that buy and sell CDSs are not aware of the risks they are assuming.

Claim: Transactions between Parties That Have Nothing to Do with the Reference Entity Are Simply Gambling and Have No Independent Value. Because CDSs are much like loans, they can be used to take on the same risk as a loan or a bond. If an institutional investor believes that an issuer will grow stronger over time, it can buy the company's bonds and profit from the strengthening of the issuer's credit position. Alternatively, the investor can sell protection on the same notional amount as the bond--that is, taking on the same exposure without actually buying the bond--and profit in the same way. If the issuer's prospects improve, the CDS rises in value because the premium received is now greater than it would need to be for the lower risk involved. The seller of protection is now "in the money" in the sense that it has an asset that has appreciated in value.

The risk management benefits of CDSs exist independently of whether a lender has any financial interest in a particular reference entity. Thus, the bank that bought protection on its loan to an oil service company could achieve the same risk management purposes--reducing its exposure to the oil industry--by buying protection on an equivalent notional amount of an oil company's outstanding obligations, even though it does not have any direct exposure to the oil company. If the risk is highly correlated with the oil service company's risk, the bank can nearly duplicate the same risk management result. Just as an investor can do this for risk management or hedging purposes, it can also do it as speculation, without having any direct financial interest in the issuer that is the reference entity. Indeed, when a dealer is approached by an institution to buy or sell protection, it is impossible to tell whether the purpose is hedging an existing risk or speculating on the change in the risk profile of the reference entity. Is this simply betting, as some suggest, or does it have a value apart from its value to the two parties involved?

In discussing this subject, it would be useful to avoid the pejorative terms "betting" or "gambling" and use the term "speculation," which more closely approximates what is happening when a party buys or sells protection without any connection to the reference entity involved. Speculation is frequently denounced, while "hedging" is considered good and prudent, yet it is very difficult to tell the difference between the two. Commodity futures have for a long time permitted farmers to protect themselves in the event of a decline in prices when their crop is ready for market. Most people would call this prudent hedging, but what are the investors on the other side of the futures trade doing? In effect, they are selling protection, just like the seller in the CDS transaction. Some observers might call this speculation because the seller of protection to the farmer is speculating (others might call it "gambling" or "betting") that the price will be higher than what he has agreed to pay the farmer. Thus, speculation can have an important role in making markets work.

It may be objected, however, that in hedging or speculation transactions, real things like wheat or loan exposure are involved, while buying or selling CDSs without any connection to the reference entity is different. Consider then puts and calls--options to sell or buy stocks--that are traded regularly on the Chicago Board Options Exchange. These are an accepted part of equity markets and are known as equity derivatives. They can be used for hedging a stock position without selling or buying the stock, or they can be used--without owning the stock--simply to speculate that a stock's price will go up or down. The function of puts and calls is exactly the same as the role played by those who buy or sell CDSs without any connection to a reference entity. The transaction adds to the liquidity and the total information in the market. That is in part why the buying and selling of CDSs provides a continuous, market-based assessment of the credit of a large number of commercial or industrial companies and financial institutions. Some people consider speculation in a security or a commodity to be betting, but economists recognize that this activity provides benefits to a market through added market liquidity and mitigation of bubbles. In the case of CDSs, however, the exogenous benefits of speculation are particularly strong because it provides a market-based credit judgment about the financial position of individual issuers that is not available anywhere else.

Claim: There Is No Way to Know by Looking at a Company's Balance Sheet How Much CDS Exposure It Has Taken On. Exposures to CDS transactions as a protection seller are shown on all balance sheets where that exposure is deemed to be material. The exposure is shown in the aggregate, without listing particular transactions or risks, just as a bank would show its commercial and industrial loans in the aggregate. Normally, parties selling protection have hedged themselves, and it is very unlikely that all, or even most, exposures will result in liability at the same time. So, for the most part, CDS liabilities are carried on balance sheets at somewhere between 1 and 2 percent of their notional amount, reflecting both hedges and the likelihood of losses on a diversified portfolio. Of course, as risks rise or fall, these values are adjusted. The nature of these liabilities is then described in a footnote.

Because CDSs sold or bought by dealers are marked to market every day, it is possible that the risk associated with protecting a counterparty will increase as the financial condition of the reference entity deteriorates. This may require the liability of the protection seller to be written up on its balance sheet, and will almost certainly require more collateral. The opposite is also true. If the reference entity's financial condition markedly improves--perhaps its business prospects are better--the liability on the protection seller's balance sheet will diminish and the collateral requirement could be reduced, eliminated entirely, or moved to the buyer of protection if the seller is now "in the money." This also means that a CDS can move from a liability to an asset on the balance sheet of the buyer or seller, depending on whether the spread on the reference entity has risen (advantage to the buyer) or declined (advantage to the seller) since the CDS was contracted.

Conclusion

Although the Lehman failure demonstrated that the CDS market works well even under severe stress, there are proposals for improvements and reforms. These reforms--including a clearinghouse or an exchange for CDSs and perhaps some additional form of regulation for the CDS market as a whole--are beyond the scope of this Outlook. However, because CDSs and their value are not well understood, there is a serious danger of excessive regulation that will impair the value of CDSs for risk management and credit assessment purposes. As reform proposals take shape, I may revisit this issue in a subsequent Outlook.

Far from creating new or significant risks, CDSs simply move risks that already exist from one place to another. For this reason, they are a major advance in risk management for all financial intermediaries, and restrictions on their use will create more risk in the financial system than it will eliminate. In addition, the vigorous and liquid current market in CDSs provides a market-based reading of the risks of companies that is not available from any other source and that can be of major assistance to regulators, as well as investors and creditors.

 


The Oxford Handbook of Credit Derivatives (Oxford Handbooks)

Customers who have purchased or rated Credit Derivatives: Instruments, Applications, and Pricing (Frank J. Fabozzi Series) by Mark J. Anson PhD CFA might like to know that The Oxford Handbook of Credit Derivatives (Oxford Handbooks) will be released on March 22, 2011.  You can pre-order yours by following the link below.

The Oxford Handbook of Credit Derivatives (Oxford Handbooks)
Alexander Lipton
 
List Price: $150.00
Price: $139.21
 

Actually only $67 at Amazon.


The book looks strong on explaining CDS contrracts but weak on FAS 133 and IAS 9/39 rules for accounting for such contracts.
 
Before buying, readers may want to look up the term "credit derivatives" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

 


"Coming Soon ... Securitization with a New, Improved (and Perhaps Safer) Face,   Knowledge@Wharton, April 2, 2008 ---
http://knowledge.wharton.upenn.edu/article.cfm;jsessionid=a83051431af9532a7261?articleid=1933

 


"FASB Issues FSP Requiring Enhanced Disclosure for Credit Derivative and Financial Guarantee Contracts,"  by Mark Bolton and Shahid Shah, Deloitte Heads Up, September 18, 2008 Vol. 15, Issue 35 --- http://www.iasplus.com/usa/headsup/headsup0809derivativesfsp.pdf

September 18, 2008

Vol. 15, Issue 35

The FASB recently issued FSP FAS 133-1 and FIN 45-4,1 which amends and enhances the disclosure requirements for sellers of credit derivatives (including hybrid instruments that have embedded credit derivatives) and financial guarantees. The new disclosures must be provided for reporting periods (annual or interim) ending after November 15, 2008, although earlier application is encouraged. The FSP also clarifies the effective date of Statement 161.2

The FSP defines a credit derivative as a "derivative instrument (a) in which one or more of its underlyings are related to the credit risk of a specified entity (or a group of entities) or an index based on the credit risk of a group of entities and (b) that exposes the seller to potential loss from credit-risk-related events specified in the contract." In a typical credit derivative contract, one party makes payments to the seller of the derivative and receives a promise from the seller of a payoff if a specified third party or parties default on a specific obligation. Examples of credit derivatives include credit default swaps, credit index products, and credit spread options.

The popularity of these products, coupled with the recent market downturn and the potential liabilities that could arise from these conditions, prompted the FASB to issue this FSP to improve the transparency of disclosures provided by sellers of credit derivatives. Also, because credit derivative contracts are similar to financial guarantee contracts, the FASB decided to make certain conforming amendments to the disclosure requirements for financial guarantees within the scope of Interpretation 45.3

Credit Derivative Disclosures

The FSP amends Statement 1334 to require a seller of credit derivatives, including credit derivatives embedded in hybrid instruments, to provide certain disclosures for each credit derivative (or group of similar credit derivatives) for each statement of financial position presented. These disclosures must be provided even if the likelihood of having to make payments is remote. Required disclosures include:

In This Issue:

• Credit Derivative Disclosures

• Financial Guarantee Disclosures

• Effective Date and Transition

• Effective Date of Statement 161

1 FASB Staff Position No. FAS 133-1 and FIN 45-4, "Disclosures About Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161."

2 FASB Statement No. 161, Disclosures About Derivative Instruments and Hedging Activities.

3 FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.

4 FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.

• The nature of the credit derivative, including:

o The approximate term of the derivative.

o The reason(s) for entering into the derivative.

o The events or circumstances that would require the seller to perform under the derivative.

o The status of the payment/performance risk of the derivative as of the reporting date. This can be based on a recently issued external credit rating or an internal grouping used by the entity to manage risk. (If an internal grouping is used, the entity also must disclose the basis for the grouping and how it is used to manage risk.)

• The maximum potential amount of future payments (undiscounted) the seller could be required to make under the credit derivative contract (or the fact that there is no limit to the maximum potential future payments). If a seller is unable to estimate the maximum potential amount of future payments, it also must disclose the reasons why.

• The fair value of the derivative.

• The nature of any recourse provisions and assets held as collateral or by third parties that the seller can obtain and liquidate to recover all or a portion of the amounts paid under the credit derivative contract.

For hybrid instruments that have embedded credit derivatives, the required disclosures should be provided for the entire hybrid instrument, not just the embedded credit derivative.

Financial Guarantee Disclosures

As noted previously, the FASB did not perceive substantive differences between the risks and rewards of sellers of credit derivatives and those of financial guarantors. With one exception, the disclosures in Interpretation 45 were consistent with the disclosures that will now be required for credit derivatives. To make the disclosures consistent, the FSP amends Interpretation 45 to require guarantors to disclose "the current status of the payment/performance risk of the guarantee."

Effective Date and Transition

Although it is effective for reporting periods ending after November 15, 2008, the FSP requires comparative disclosures only for periods presented that ended after the effective date. Nevertheless, it encourages entities to provide comparative disclosures for earlier periods presented.

Effective Date of Statement 161

After the issuance of Statement 161, some questioned whether its disclosures are required in the annual financial statements for entities with noncalendar year-ends (e.g., March 31, 2009). To address this confusion, the FSP clarifies that the disclosure requirements of Statement 161 are effective for quarterly periods beginning after November 15, 2008, and fiscal years that include those periods. However, in the first fiscal year of adoption, an entity may omit disclosures related to quarterly periods that began on or before November 15, 2008. Early application is encouraged.

Jensen Comment
Credit derivatives (usually credit default swaps that have a periodic premium paid for and pay periodically for credit insurance) are currently scoped into FAS 133 and IAS 39. I think that this is a mistake. These contracts are really insurance contracts and financial guarantees that should be accounted for as such and not as derivatives scoped into FAS 133 and IAS 39. Be that as it may, these controversial contracts that brought AIG and other Wall Street banks to its knees are accounted for as derivative contracts.

I really don’t think credit derivatives are appropriately accounted for under either FAS 133 or IAS 39. The problem is that the intermediary that brokers an interest rate risk swap can guarantee the interest rate risk swap payments since these swaps are only dealing with payments on the net changes in interest rates with the notionals not being at risk. It seems to me that with credit default swaps, the entire notionals themselves might be at risk and the intermediaries that broker the swaps are not guaranteeing the swap payments equal to complete wipeouts of notionals. Hence, I don’t thinks CDS swaps properly meet the definitions of derivatives since notionals are at risk. It seems to me that CDS contracts should be accounted for as insurance contracts.

This is one of those instances where I think auditors should look at the substance of the transactions rather than rules per se.

From the financial rounds blog on December 29, 2008

How Do You Use Credit Default Swaps (CDS) To Create "Synthetic Debt"?

There's been a lot of talk in recent months about "synthetic debt". I just read a pretty good explanation of synthetics in Felix Salmon's column, so I thought I'd give a brief summary of what it is, how it's used, and why.

First off, let's start with Credit Default Swaps (CDS). A CDS has a lot of similarities to an insurance policy on a bond (it's different in that the holder of the CDS needn't own the underlying bond or even suffer a loss if the bond goes into default).

The buyer (holder) of a CDS will make yearly payments (called the "premium"), which is stated in terms of basis points (a basis point is 1/100 of one percent of the notional amount of the underlying bond). The holder of the CDS gets paid if the bond underlying the CDS goes into default or if other stated events occur (like bankruptcy or a restructuring).

So, how do you use a CDS to create a synthetic bond? here's the example from Salmon's column:

Let's assume that IBM 5-year bonds were yielding 150 basis points over treasuries. In addition, Let' s assume an individual (or portfolio manager) wanted to get exposure to these bonds, but didn't think it was a feasible to buy the bonds in the open market (either there weren't any available, or the market was so thin that he's have to pay too high a bid-ask spread). Here's how he could use CDS to accomplish the same thing:
 

·         First, buy $100,000 of 5-year treasuries and hold them as collateral

·         Next, write a 5-year, $100,000 CDS contract

·         he's receive the interest on the treasuries, and would get a 150 basis point annual premium on the CDS
 

So, what does he get from the Treasury plus writing the CDS? If there's no default, the coupons on the Treasury plus the CDS premium will give him the same yearly amount as he would have gotten if he's bought the 5-year IBM bond, And if the IBM bond goes into default, his portfolio value would be the value of the Treasury less what he would have to pay on the CDS (this amount would be the default losses on the IBM bond). So in either case (default or no default), his payoff from the portfolio would be the same payments as if he owned the IBM bond.

So why go through all this trouble? One reason might be that there's not enough liquidity in the market for the preferred security (and you'd get beaten up on the bid-ask spread). Another is that there might not be any bonds available in the maturity you want. The CDS market, on the other hand, is very flexible and extremely liquid.

One thing that's interesting about CDS is that (as I mentioned above), you don't have to hold the underlying asset to either buy or write a CDS. As a result, the notional value of CDS written on a particular security can be multiple times the actual amount of the security available.

I know of at least one hedge fund group that bought CDS as a way of betting against housing-sector stocks (particularly home builders). From what i know, they made a ton of money. But CDS can also be used to hedge default risk on securities you already hold in a portfolio.


To read Salmon's column, click here, and to read more about CDS, click here

 


Questions
What's a financial long bet and how does it win or lose?
What's the distinction between a long bet speculation versus hedge?

From The Wall Street Journal Accounting Weekly Review on April 1, 2011

Hedge Funds Had Bets Against Japan
by: Gregory Zuckerman and Tom Lauricella
Date: Mar 15, 2011 

SUMMARY: The catastrophe in Japan has placed renewed focus on the country's already fragile economy-and brought unexpected profits to investors who have long bet that the nation eventually will be dragged down by its debt problems.

DISCUSSION: 

  1. What is a hedge fund? How is a hedge fund different from mutual funds or individual investing? What type of investor would invest in such funds? What are the risk levels involved with investing in hedge funds?
  2. How did these hedge funds 'bet against Japan'? Why did some investors think it wise to invest this way? How has the earthquake in Japan impacted this type of investment?
  3. What were the issues facing Japan before the earthquake? How has the earthquake changed the situation? What is the long-term outlook for business in the country? What are Japan's borrowing levels? How would this impact investment in the country by businesses? By individuals?

"Hedge Funds Had Bets Against Japan," by: Gregory Zuckerman and Tom Lauricella, The Wall Street Journal, March 15, 2011 ---
http://online.wsj.com/article/SB10001424052748703363904576200990107993916.html?mod=djem_jie_360

The catastrophe in Japan has placed renewed focus on the country's already fragile economy—and brought unexpected profits to investors who have long bet that the nation eventually will be dragged down by its debt problems.

In recent years, a chorus of voices has warned that Japan is facing an inevitable crisis to be brought on by a stagnant economy, a shrinking population and the worst debt profile of any major industrialized country.

Hedge-fund managers from Kyle Bass of Hayman Advisors LP in Dallas to smaller firms like Commonwealth Opportunity Capital have made money since the earthquake on long-held bets on Japan's government and corporate bonds.

Though the economic toll of the earthquake is far from clear, the immediate response in the financial markets has been a decline in stock prices, with the Nikkei Stock Average down 7.8% in two days (including Friday, when the quake hit near the end of the trading day). The price for insuring against a default by Japan on its government debt, a popular way to position for a financial crisis in Japan, has jumped. But in a move that runs counter to the expectations of some long-term Japan bears, the yen has strengthened on expectations that Japanese investors and corporations will be buying yen as they bring money home in coming weeks and months.

The price for insuring $10 million of Japanese sovereign debt for five years in the credit-default-swap market soared to $103,000 on Monday, from $79,000 on Friday, according to data provider Markit.

Reflecting the skepticism about Japan's outlook, even before the disaster, the net notional amount of Japanese debt being insured in the swaps market had surged to $7.4 billion from $4.1 billion a year ago, according to data from the Depository Trust & Clearing Corp. through March 4. The number of contracts outstanding has more than doubled.

Fresh DTCC data are due on Tuesday and will include only the early effects of the earthquake.

Credit-default swaps of many corporate bonds have become even more valuable, rewarding those that bet on them. Among the biggest moves was in Tokyo Electric Power Co., owner of the nuclear-power plants crippled by the earthquake.

Commonwealth Opportunity Capital, a $90 million hedge fund in Los Angeles, made a profit of several million dollars on Tokyo Electric on Monday, from an investment of less than $200,000. The annual cost of protecting $10 million of Tokyo Electric's debt jumped to $240,000 on Monday from $40,700 on Friday.

"Nobody wants bad things to happen to people," said Adam Fisher, who helps run Commonwealth Opportunity Capital. He said the firm has been betting against Japanese corporate bonds for two years. "But it shows how fragile that heavily levered nation is; there's very little margin for error."

Betting against Japan has been a losing proposition for many investors for years. Despite all the debt problems, bond prices have continued to move higher partly because deflation, not inflation, has been the concern. Also, domestic investors own most of the government's debt and have been reluctant to sell.

But now, facing at least a short-term hit to the economy from the earthquake and the likely need to issue more debt to pay for reconstruction efforts, Japan is seeing its problems magnified.

"Japan's choices are very, very bad," said John Mauldin, president of Millennium Wave Advisors. "Japan has an aging population, which is saving less, their savings rate will go negative sometime in the next few years at which point they will have to significantly reduce their spending, increase taxes or print money or some combination of the three.

"In the grand scheme of things, does the earthquake technically move it up further? Yes, but they were already well down the path."

Continued in article

Jensen Comment
Note how long positions on national debt are often a losing proposition unless they are hedges. In hedging situations these gains and losses are offset by gains and losses on the hedged items to the extent that the hedging contracts are effective. For example, a hedge fund might invest in U.S. Treasury bonds paying a fixed rate. There is no cash flow risk on interest payments or repayment of the face value of the bonds. However, there is value risk since the price of these outstanding bonds in the financial markets goes up and down daily. The hedge fund can lock in fixed value by entering into a fair value hedge such as by entering into a plain vanilla interest rate swap in which the fixed-amount interest payments are swapped for variable rate payments. The value of the bonds plus the value of the swap is thereby locked into a fixed value for which there is no value risk. However, when hedging value risk the investor has inevitably taken on cash flow risk. It's impossible to hedge both fair value risk and cash flow risk. Investors must choose between one or the other.

Hedging against debt default entire is an extreme form of fair value hedging and is usually done with a different type of hedging contract. Here the investor is not so much concerned with interim interest payments (or interim changes in value due to shifts in market interest rates) as he/she is concerned with possible default on payback of the entire principal of the debt. In other words it's more like insurance against a creditor declaring bankruptcy to get out of repayment of all or a great portion of debt repayment.

Credit Default Swap --- http://en.wikipedia.org/wiki/Credit_default_swap

A credit default swap (CDS) can almost be thought of as a form of insurance. If a borrower of money does not repay her loan, she "defaults." If a lender has purchased a CDS on that loan from an insurance company, the lender can then use the default as a credit to swap it in exchange for a repayment from an insurance company. However, one does not need to be the lender to profit from this situation. Anyone (usually called a speculator) can purchase a CDS. If a borrower does not repay his loan on time and defaults not only does the lender get paid by the insurance company, but the speculator gets paid as well. It is in the lender's best interest that he gets his money back, either from the borrower, or from the insurance company if the borrower is unable to pay back his loan. However, it is in the speculator's best interest that the borrower never repay his loan and default because that is the only way that the speculator can then take that default, turn it into a credit, and swap it for a cash payment from an insurance company.

A more technical way of looking at it is that a credit default swap (CDS) is a swap contract and agreement in which the protection buyer of the CDS makes a series of payments (often referred to as the CDS "fee" or "spread") to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event. It is a form of reverse trading.

A credit default swap is a bilateral contract between the buyer and seller of protection. The CDS will refer to a "reference entity" or "reference obligor", usually a corporation or government. The reference entity is not a party to the contract. The protection buyer makes quarterly premium payments—the "spread"—to the protection seller. If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction. A default is referred to as a "credit event" and includes such events as failure to pay, restructuring and bankruptcy.[2] Most CDSs are in the $10–$20 million range with maturities between one and 10 years.

A holder of a bond may “buy protection” to hedge its risk of default. In this way, a CDS is similar to credit insurance, although CDS are not similar to or subject to regulations governing casualty or life insurance. Also, investors can buy and sell protection without owning any debt of the reference entity. These “naked credit default swaps” allow traders to speculate on debt issues and the creditworthiness of reference entities. Credit default swaps can be used to create synthetic long and short positions in the reference entity. Naked CDS constitute most of the market in CDS. In addition, credit default swaps can also be used in capital structure arbitrage.

Credit default swaps have existed since the early 1990s, but the market increased tremendously starting in 2003. By the end of 2007, the outstanding amount was $62.2 trillion, falling to $38.6 trillion by the end of 2008.

Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA), although some are tailored to meet specific needs. Credit default swaps have many variations.[2] In addition to the basic, single-name swaps, there are basket default swaps (BDS), index CDS, funded CDS (also called a credit linked notes), as well as loan only credit default swaps (LCDS). In addition to corporations or governments, the reference entity can include a special purpose vehicle issuing asset backed securities.

Credit default swaps are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the trillion dollar size of the market, which could pose a systemic risk to the economy. In March 2010, the DTCC Trade Information Warehouse (see Sources of Market Data) announced it would voluntarily give regulators greater access to its credit default swaps database

Credit Default Swap (CDS)
This is an insurance policy that essentially "guarantees" that if a CDO goes bad due to having turds mixed in chocolates in a diversified portfolio, the "counterparty" who purchased the CDO will recover the value fraudulently invested in turds. On September 30, 2008 Gretchen Morgenson of The New York Times aptly explained that the huge CDO underwriter of CDOs was the insurance firm called AIG. She also explained that the first $85 billion given in bailout money by Hank Paulson to AIG was to pay the counterparties to CDS swaps. She also explained that, unlike its casualty insurance operations, AIG had no capital reserves for paying the counterparties for the the turds they purchased from Wall Street investment banks.

"Your Money at Work, Fixing Others’ Mistakes," by Gretchen Morgenson, The New York Times, September 20, 2008 --- http://www.nytimes.com/2008/09/21/business/21gret.html
Also see "A.I.G., Where Taxpayers’ Dollars Go to Die," The New York Times, March 7, 2009 --- http://www.nytimes.com/2009/03/08/business/08gret.html

What Ms. Morgenson failed to explain, when Paulson eventually gave over $100 billion for AIG's obligations to counterparties in CDS contracts, was who were the counterparties who received those bailout funds. It turns out that most of them were wealthy Arabs and some Asians who we were getting bailed out while Paulson was telling shareholders of WaMu, Lehman Brothers, and Merrill Lynch to eat their turds.

You tube has a lot of videos about a CDS. Go to YouTube and read in the phrase "credit default swap" ---
http://www.youtube.com/results?search_query=Credit+Default+Swaps&search_type=&aq=f
In particular note this video by Paddy Hirsch --- http://www.youtube.com/watch?v=kaui9e_4vXU
Paddy has some other YouTube videos about the financial crisis.

 

Bob Jensen's discussion of accounting rules for credit default swaps can be found under the C-Terms at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Credit default swaps turned into a disaster for AIG and the U.S. Government when black swans flew over in 2008 ---
http://www.trinity.edu/rjensen/2008Bailout.htm

The Commission's Final Report --- http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_full.pdf
(This report is really more of a misleading whitewash of government agencies and Congress relative to the real causes of the subprime disaster.)

Greatest Swindle in the History of the World ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout

Bob Jensen's discussion of accounting rules for credit default swaps can be found under the C-Terms at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

 

 


"Your Money at Work, Fixing Others’ Mistakes," by Gretchen Morgenson, The New York Times, September 20, 2008 --- http://www.nytimes.com/2008/09/21/business/21gret.html

 

What Ms. Morgenson failed to explain, when Paulson eventually gave over $100 billion for AIG's obligations to counterparties in CDS contracts, was who were the counterparties who received those bailout funds. It turns out that most of them were wealthy Arabs and some Asians who we were getting bailed out while Paulson was telling shareholders of WaMu, Lehman Brothers, and Merrill Lynch to eat their turds.

 

You tube has a lot of videos about a CDS. Go to YouTube and read in the phrase "credit default swap" --- http://www.youtube.com/results?search_query=Credit+Default+Swaps&search_type=&aq=f
In particular note this video by Paddy Hirsch --- http://www.youtube.com/watch?v=kaui9e_4vXU
Paddy has some other YouTube videos about the financial crisis.

 


Simoleon Sense Reviews Janet Tavakoli’s Dear Mr. Buffett ---
http://www.simoleonsense.com/simoleon-sense-reviews-janet-tavakolis-dear-mr-buffett/

What’s The Book (Dear Mr. Buffett) About

Dear Mr. Buffett, chronicles the agency problems, poor regulations, and participants which led to the current financial crisis. Janet accomplishes this herculean task by capitalizing on her experiences with derivatives, Wall St, and her relationship with Warren Buffett. One wonders how she managed to pack so much material in such few pages!

Unlike many books which only analyze past events, Dear Mr. Buffett, offers proactive advice for improving financial markets. Janet is clearly very concerned about protecting individual rights, promoting honesty, and enhancing financial integrity. This is exactly the kind of character we should require of our financial leaders.

Business week once called Janet the Cassandra of Credit Derivatives. Without a doubt Janet should have been listened to. I’m confident that from now on she will be.

Closing thoughts

Rather than a complicated book on financial esoterica, Janet has created a simple guide to understanding the current crisis. This book is a must read for all students of finance, economics, and business. If you haven’t read this book, please do so.

Warning –This book is likely to infuriate you, and that’s a good thing! Janet provides indicting evidence and citizens may be tempted to initiate vigilante like witch trials. Please consult with your doctor before taking this financial medication.

Continued in article

September 1, 2009 reply from Rick Lillie [rlillie@CSUSB.EDU]

Hi Bob,

I am reading Dear Mr. Buffett, What an Investor Learns 1,269 Miles from Wall Street, by Janet Tavakoli. I am just about finished with the book. I am thinking about giving a copy of the book to students who perform well in my upper-level financial reporting classes.

I agree with the reviewer’s comments about Tavakoli’s book. Her explanations are clear and concise and do not require expertise in finance or financial derivatives in order to understand what she (or Warren Buffet) says. She explains the underlying problems of the financial meltdown with ease. Tavakoli does not blow you over with “finance BS.” She does in print what Steve Kroft does in the 60 Minutes story.

Tavakoli delivers a unique perspective throughout the book. She looks through the eyes of Warren Buffett and explains issues as Buffett sees them, while peppering the discussion with her experience and perspective.

The reviewer is correct. Tavakoli lets the finance world, along with accountants, attorneys, bankers, Congress, and regulators, have it with both barrels!

Tavakoli’s book is the highlight of my summer reading.

Best wishes,

Rick Lillie

Rick Lillie, MAS, Ed.D., CPA Assistant Professor of Accounting Coordinator - Master of Science in Accountancy (MSA) Program Department of Accounting and Finance College of Business and Public Administration CSU San Bernardino 5500 University Pkwy, JB-547 San Bernardino, CA. 92407-2397

Telephone Numbers: San Bernardino Campus: (909) 537-5726 Palm Desert Campus: (760) 341-2883, Ext. 78158

For technical details see the following book:
Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization (Wiley Finance) by Janet M. Tavakoli (2008)

Financial WMDs (Credit Derivatives) on Sixty Minutes (CBS) on August 30, 2009 ---
http://www.cbsnews.com/video/watch/?id=5274961n&tag=contentBody;housing
The free download will only be available for a short while. I downloaded this video (a little over 5 Mbs) using a free updated version of RealMedia --- Click Here
http://www.real.com/dmm/superpass?pcode=cj&ocode=cj&cpath=aff&rsrc=1275588_10303897_SPLP

 

Steve Kroft examines the complicated financial instruments known as credit default swaps and the central role they are playing in the unfolding economic crisis. The interview features my hero Frank Partnoy. I don't know of anybody who knows derivative securities contracts and frauds better than Frank Partnoy, who once sold these derivatives in bucket shops. You can find links to Partnoy's books and many, many quotations at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

For years I've used the term "bucket shop" in financial securities marketing without realizing that the first bucket shops in the early 20th Century were bought and sold only gambles on stock pricing moves, not the selling of any financial securities. The analogy of a bucket shop would be a room full of bookies selling bets on NFL playoff games.
See "Bucket Shop" at http://en.wikipedia.org/wiki/Bucket_shop_(stock_market)

 

I was not aware how fraudulent the credit derivatives markets had become. I always viewed credit derivatives as an unregulated insurance market for credit protection. But in 2007 and 2008 this market turned into a betting operation more like a rolling crap game on Wall Street.

 

Bob Jensen's Rotten to the Core threads are at http://www.trinity.edu/rjensen/FraudRotten.htm

Bob Jensen's threads on the current economic crisis are at http://www.trinity.edu/rjensen/2008Bailout.htm
For credit derivative problems see http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout

Also see "Credit Derivatives" under the C-Terms at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms

Bob Jensen's free tutorials and videos on how to account for derivatives under FAS 133 and IAS 39 ---
http://www.trinity.edu/rjensen/caseans/000index.htm

Bob Jensen’s threads on accounting for credit default swaps are under the C-Terms at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms

Bob Jensen's threads on CDO accounting are at http://www.trinity.edu/rjensen/theory01.htm#CDO

Bob Jensen's threads on FIN 46 are at http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm

 

 


"Default Swaps: One Boom in the Crunch; Volume Soared in '07 As Woes Worsened; Hedging and Betting," by Serena Ng, The Wall Street Journal, April 16, 2008; Page C2 --- http://online.wsj.com/article/SB120826572928916145.html?mod=todays_us_money_and_investing

The bond market's love affair with credit derivatives continued during the market chaos of 2007, as volumes of instruments such as credit-default swaps surged to new highs.

Credit-default swaps, which are private financial contracts that act as a form of insurance against bond and loan defaults, were written on $62.2 trillion of debt at the end of 2007, according to data from the International Swaps and Derivatives Association, an industry group.

The latest numbers mark a 37% jump from the $45.5 trillion in so-called "notional" values of credit-default swaps in mid-2007, and compare with $34.5 trillion at the end of 2006. The gain indicates that the use of such swaps grew at a faster pace during the credit crunch in the second half of last year, possibly as banks and investors scrambled to protect themselves from possible defaults on mortgage debt and other bonds and loans.

In a credit default swap, one firm makes regular payments to another firm, which agrees to compensate it if a specified bond or loan defaults. Some investors and financial institutions buy these swaps to hedge their debt investments, but many others trade them to make bets on whether default risk is rising or falling. As such, the notional volumes of the contracts far exceed the actual amount of debt on which they are written.

ISDA's survey also found that the notional amount of interest-rate derivatives grew to $382.3 trillion at the end of 2007, up 10% from mid-2007 and 34% from a year earlier. These include interest-rate swaps, where firms exchange fixed interest payments on debt for floating-rate payments.

The market for equity derivatives including options and forward contracts covered $10 trillion in notional volumes at the end of 2007, unchanged from the mid-year but up 39% from a year earlier.

While notional amounts across all the asset classes add up to an eye-popping number of $454.5 trillion, ISDA says the numbers measure derivative activity rather than risk. It estimates that gross credit exposure of the firms that trade derivatives is around $9.8 trillion.

Still, the large volumes have raised concerns about "counterparty risk," or the risk that one or more firms may not be able to make good on their trades and create problems for other firms .

Continued in article

Read about a Credit Default Swap (CDS) at http://en.wikipedia.org/wiki/Credit_default_swap

IAS 39 Paragraph B18 (g) allows some leeway as to whether companies want to account for such contracts as insurance contracts or derivative financial instruments.

FAS 133 Paragraph 59 is somewhat more explicit as to whether or not a credit derivative is scoped into FAS 133.


"The Credit Default Swap," by Richard K. Skora --- http://www.skora.com/default.pdf 

This article shows how risk neutral pricing theory can be applied to price a credit default swap. The price is obtained by explicitly constructing a hedge from the underlying cash market instruments. 

A credit default swap is the most straightforward type of a credit derivative. It is an agreement between two counterparties that allows one counterparty to be “long” a third-party credit risk, and the other counterparty to be “short” the credit risk. Explained another way, one counterparty is selling insurance and the other counterparty is buying insurance against the default of the third party. 

For example, suppose that two counterparties, a market maker and an investor, enter into a two-year credit default swap. They specify what is called the reference asset, which is a particular credit risky bond issued by a third-party corporation or sovereign. For simplicity, let us suppose that the bond has exactly two years’ remaining maturity and is currently trading at par value. 

The market maker agrees to make regular fixed payments (with the same frequency as the reference bond) for two years to the investor. In exchange the market maker has the following right. (For simplicity assume default can occure only at discrete times, namely, at the times the coupon payment is due.) If the third party defaults at any time within that two years, the market maker makes his regular fixed payment to the investor and puts the bond to the investor in exchange for the bond’s par value plus interest. The credit default swap is thus a contingent put – the third party must default before the put is activated. 

In this simple example there is little difference in terms of risk between the credit default swap and the reference bond. Because the swap and the bond have the same maturity, the market maker is effectively short the bond and the investor is long the bond. (In the real world, it is often the case that the bond tenor is longer than the swap tenor. This means that the swap counterparties have exposure to credit risk, but do not have exposure to the full market risk of the

The simplicity of our example helps clarify how the instrument is priced. Pricing the credit default swap involves determining the fixed payments from the market-maker to the investor. In this case it is sufficient to extract the price from the bond market. One does not need to model default or any other complicated credit risk process. To apply risk neutral pricing theory one needs to construct a hedge for the credit default swap. In this simple example, it is sufficient to construct a static hedge. This means the cash instruments are purchased once, and once only, for the life of the credit default swap; they will not have to be sold until the termination of the credit default swap.

The hedge is different for the market maker and investor. If the market-maker were to hedge the credit default swap, then it would need to go long the bond. As illustrated in Figure B, the market-maker borrows money in the funding markets at Libor and uses those funds to purchase the corporate bond, which pays Libor + X basis points. The hedge is paying the market-maker a net cash flow of X basis points.

Continued in the article.


Danger:  What if everybody uses the same formula? 
Banker David Li's computerized financial formula has fueled explosive growth in the credit derivatives market. Now, hundreds of billions of dollars ride on variations of the model every day.  When a credit agency downgraded General Motors Corp.'s debt in May, the auto maker's securities sank. But it wasn't just holders of GM shares and bonds who felt the pain. Like the proverbial flap of a butterfly's wings rippling into a tornado, GM's woes caused hedge funds around the world to lose hundreds of millions of dollars in other investments on behalf of wealthy individuals, institutions like university endowments -- and, via pension funds, regular folk.
Mark Whitehouse, "How a Formula Ignited Market That Burned Some Big Investors:  Credit Derivatives Got a Boost From Clever Pricing Model; Hedge Funds Misused It Inspiration," The Wall Street Journal, September 12, 2005; Page A1 --- http://online.wsj.com/article/0,,SB112649094075137685,00.html?mod=todays_us_page_one


February 7, 2008 question from Miklos A. Vasarhelyi [miklosv@ANDROMEDA.RUTGERS.EDU]

Does anyone understand what this is?
miklos

Jensen Comment
Miklos forwarded interactive graphics video link on monoline insurance --- Click Here

February 7, 2008 reply from J. S. Gangolly [gangolly@CSC.ALBANY.EDU]

Miklos,

Buyers of bonds can insure against default risks by buying policies from monoline insurance companies who service exclusively the capital markets. To protect against default by the monoline on its policy, you buy a credit swap on it from another monoline insurance company (which would be obligated to either buy the bonds at face value or to pay the difference between that and the recovery value in case of default).

When such trades take place, the buyer of the bonds (usually investment banks) have theoretically transferred the risk in bonds, and so can account for the bundle of transactions and recognise "profits".

Apparently, these trades have been very lucrative for banks and so have taken the profits in such transactions over the entire life of the bonds at the consummations of such transactions.

The problem with such accounting for profits is that, if the monoline insurance companies are downgraded, the risk on the bonds reverts to the holder (bank), who must reverse the profits.

The usual culprits in these fancy transactions are investment banks. It is difficult to account for the "profits" because the bonuses paid to the traders on such transactions might have been paid years ago.

What a wonderful fiction we accountants have created wheere profits are not what they seem. Alice in Wonderland pales by comparison.

I should have stuck with my first intended profession (actuary).

Regards,

Jagdish

February 7, 2008 reply from Paul Williams [Paul_Williams@NCSU.EDU]

Jagdish,

Thank you for explaining this. The fault is not entirely ours. Deregulated finance entrepreneurs have invented these complex transactions, which, frankly, can't be accounted for (part of the motivation for their design is precisely because they can't be accounted for). In theory the probability that a bond issuer will default is not altered by these arrangements.

All they do is shift the risk many degrees removed from where it originated. An interesting empirical issue is whether the probability of default does change in the presence of these risk shifting transactions. How does it alter the monitoring of debtors by their creditors when their creditors may not even know they are their creditors?

Do these risk shifting arrangements change the risk? Anyone out there know of any literature that addresses the issue?

February 7, 2008 reply from Bob Jensen

Hi Miklos, Jagdish, Paul, and others,

Actually there’s a very good module (one of the best) on the history of monoline insurance in Wikipedia --- http://en.wikipedia.org/wiki/Monolines  There are excellent references as to when (belatedly) and why monoline insurance companies have been put under review by credit rating agencies.

Credit rating agencies placed the other monoline insurers under review [16]. Credit default swap markets quoted rates for default protection more typical for less than investment grade credits. [17] Structured credit issuance ceased, and many municipal bond issuers spurned bond insurance, as the market was no longer willing to pay the traditional premium for monoline-backed paper[18]. New players such as Warren Buffett's Berkshire Hathaway Assurance entered the market[19]. The illiquidity of the over-the-counter market in default insurance is illustrated by Berkshire taking four years (2003-06) to unwind 26,000 undesirable swap positions in calm market conditions, losing $400m in the process. By January 2008, many municipal and institutional bonds were trading at prices as if they were uninsured, effectively discounting monoline insurance completely. The slow reaction of the ratings agencies in formalising this situation echoed their slow downgrading of sub-prime mortgage debt a year earlier. Commentators such as investor David Einhorn [20] have criticized rating agencies for being slow to act, and even giving monolines undeserved ratings that allowed them to be paid to bless bonds with these ratings, even when the bonds were issued by credits superior to their own.

It has been particularly problematic for investors in municipal bonds.

Bob Jensen

 


"Credit Derivatives Get Spotlight," by Henny Sender, The Wall Street Journal, July 28, 2005; Page C3 --- http://online.wsj.com/article/0,,SB112249648941697806,00.html?mod=todays_us_money_and_investing

A group of finance veterans released its report on financial-markets risk yesterday, highlighting the mixed blessing of credit derivatives, financial instruments that barely existed the last time the markets seized up almost seven years ago.

"The design of these products allows risk to be divided and dispersed among counterparties in new ways, often with embedded leverage," the report of the Counterparty Risk Management Policy Group II states, adding that "transparency as to where and in what form risks are being distributed may be lost as risks are fragmented and dispersed more widely."

Credit-default swaps are at the heart of the credit-derivatives market. They allow players to buy insurance that compensates them in the case of debt defaults. The market enables parties to hedge against company or even country debt, but the market's opacity makes it difficult for regulators and market participants to sort out who is involved in various trades.

The report also notes that credit derivatives can potentially complicate restructurings of the debt of ailing companies and countries. "To the extent primary creditors use the credit-default swap market to dispose of their credit exposure, restructuring in the future may be much more difficult," the report says.

Already, there have been cases where some banks have been accused of triggering defaults after they had already hedged their risk through the credit-derivatives markets. In other cases, when the cost of credit-default protection on a company has risen, market participants have taken that as a harbinger of more troubles to come, making it harder for a company to get financing, and thereby forcing it into a sale or a restructuring.

Continued in article


"Credit Derivatives Survive a Series of Stress Tests As Demand for the Hedging Instruments Grows," by Michael Mackenzie, The Wall Street Journal, January 21, 2003, Page C13 

Having roughly doubled in size in each of the past five years, credit derivatives have lately survived a series of stress tests. Wall Street is hoping that this encourages even broader participation by new investors.

Last year was certainly the year for fallen credit angels, headlined by the default of Argentina and the bankruptcy of Enron Corp. -- the latter was an actively traded name in the credit derivatives market over the past three years. But Wall Street figures that successful negotiation of these credit craters has set the stage for further growth of credit derivatives, such as default swaps, total-return swaps and synthetic collateralized debt obligations.

Some fear that broader participation by inexperienced players raises the risk of big blowups in the credit-derivatives market. Indeed, a few analysts are predicting headlines from such an event this year.

Still, these instruments, once assigned to the fringes of risk management, encountered only a minimum of legal complications in the Enron and Argentine cases.

"Credit derivatives earned their stripes in the aftermath of Enron filing for bankruptcy," said John McEvoy, cofounder of Creditex, a trading platform for credit derivatives. "The market did what it was supposed to do and that has apprised many investors of the value credit derivatives hold for hedging credit risk."

And the continued expansion of the credit-derivatives market derives not just from the perspective of hedging credit risk, but also from investors on the other side of the trade seeking a source of synthetic liquidity.

A credit default swap acts like an insurance position that allows buyers to transfer the risk of defaults or other kinds of credit events, such as debt restructurings, to a selling counterparty, who is paid a premium that is derived from the notional amount of the contract.

In effect, the seller or underwriter of the default swap establishes a synthetic long position in the credit of the company without having to purchase the underlying cash bond.

Investors are increasingly using default swaps to "increase or reduce credit risk without the liquidity constraints of the cash market," said William Cunningham, director of credit strategy at J.P. Morgan Chase in New York.

Indeed, liquidity in credit derivatives has grown so much that two-way activity is often better than that of the notoriously illiquid cash bond market. "We are increasingly seeing the derivative dictate activity in the underlying cash bond," said Mr. McEvoy. "Credit derivatives act as a barometer for the underlying cash market as they concentrate solely upon credit risk."

The growth of credit derivatives has also created better liquidity for less-popular issues as derivatives trading has encouraged greater use of cash bonds for derivatives traders hedging their positions.

It "has created more demand for off-the-run paper," said John Cieslowski, vice president for credit derivatives at Goldman, Sachs & Co. in New York.

Hedge funds have been particularly active users of these instruments. Jeff Devers, president of Palladin Group LP in Maplewood N.J., a hedge fund that seeks to minimize risk and enhance returns from convertible bonds, uses credit derivatives to "isolate credit risk." This way his fund solely takes on the equity exposure of a convertible bond. Mr. Devers expects further growth of credit derivatives to add even more liquidity to the convertible bond market.

Another key development has been the use of synthetic collateralized debt obligation baskets, which are a series of default swaps upon a range of credits bundled together. These credits are divided into tranches that reflect different risk ratings, appealing to the divergent risk appetites of investors.

The two counterparties to a synthetic CDO are either offsetting the credit risk through such trades or are taking exposure to a diverse number of credits that can augment the performance of their underlying portfolios.

Exposure to synthetic CDOs also raises a money manager's level of assets under management and either lowers or raises the level of exposure to a particular credit.

Creditex, which brokers trading between counterparties in CDOs, has been a beneficiary of this growth. "The past year saw many traditional CDO players enter the synthetic CDO market in credit derivatives and this contributed to a substantial rise in market activity," noted Mr. McEvoy.


From The Wall Street Journal Accounting Educators' Review on April 3, 2003

TITLE: Lending Less, "Protecting" More: Desperate for Better Returns, Banks Turn to Credit-Default Swaps 
REPORTER: Henny Sender and Marcus Walker 
DATE: Apr 01, 2003 
PAGE: C13 
LINK: http://online.wsj.com/article/0,,SB104924410648100900,00.html  
TOPICS: Advanced Financial Accounting, Banking, Fair Value Accounting, Financial Analysis, Insurance Industry

SUMMARY: This article describes the implications of banks selling credit-default swap derivatives. Firtch Ratings has concluded in a recent report that banks are adding to their own risk as they use these derivatives to sell insurance agains default by their borrower clients.

QUESTIONS: 1.) Define the term "derivative security" and describe the particular derivative, credit-default swaps, that are discussed in this article.

2.) Why are banks entering into derivatives known as credit-default swaps? Who is buying these derivatives that the bank is selling?

3.) In general, how should these derivative securities be accounted for in the banks' financial statements? What finanicial statement disclosures are required? How have these disclosures provided evidence about the general trends in the banking industry that are discussed in this article?

4.) Explain the following quote from Frank Accetta, an executive director at Morgan Stanley: "Banks are realizing that you can take on the same risk [as the risk associated with making a loan] at more attractive prices by selling protection."

5.) Why do you think the article equates the sale of credit-default swaps with the business of selling insurance? What do you think are the likely pitfalls of a bank undertaking such a transaction as opposed to an insurance company doing so?

6.) What impact have these derivatives had on loan pricing at Deutsche Bank AG? What is a term that is used to describe the types of costs Deutsche Bank is now considering when it decides on a lending rate for a particular borrower?

"Banks' Increasing Use of Swaps May Boost Credit-Risk Exposure, by Henny Sender and Marcus Walker, The Wall Street Journal, April 1, 2003 --- http://online.wsj.com/article/0,,SB104924410648100900,00.html 

When companies default on their debt, banks in the U.S. and Europe increasingly will have to pick up the tab.

That is the conclusion of Fitch Ratings, the credit-rating concern. Desperate for better returns, more banks are turning to the "credit default" markets, a sphere once dominated by insurers. In a recent report, Fitch says the banks -- as they use these derivatives to sell insurance against default by their borrowers -- are adding to their credit risk.

The trend toward selling protection, rather than lending, could well raise borrowing costs for many companies. It also may mean greater risk for banks that increasingly are attracted to the business of selling protection, potentially weakening the financial system as a whole if credit quality remains troubled. One Canadian bank, for example, lent a large sum to WorldCom Inc., which filed for Chapter 11 bankruptcy protection last year. Rather than hedging its loan to the distressed telecom company by buying protection, it increased its exposure by selling protection. The premium it earned by selling insurance, though, fell far short of what it both lost on the loan and had to pay out to the bank on the other side of the credit default swap.

"The whole DNA of banks is changing. The act of lending used to be part of the organic face of the bank," says Frank Accetta, an executive director at Morgan Stanley who works in the loan-portfolio management department. "Nobody used to sit down and calculate the cost of lending. Now banks are realizing that you can take on the same risk at more attractive prices by selling protection."

Despite its youth, the unregulated, informal credit-default swap market has grown sharply to total almost $2 trillion in face value of outstanding contracts, according to estimates from the British Bankers Association, which does the most comprehensive global study of the market. That is up from less than $900 billion just two years ago. (The BBA says the estimate contains a good amount of double counting, but it uses the same method over time and thus its estimates are considered a good measuring stick of relative change in the credit-default swap market.) Usually, banks have primarily bought protection to hedge their lending exposure, while insurers have sold protection. But Fitch's study, as well as banks' own financial statements and anecdotal evidence, shows that banks are becoming more active sellers of protection, thereby altering their risk profiles.

The shift toward selling more protection comes as European and American banks trumpet their reduced credit risk. And it is true that such banks have cut the size of their loan exposures, either by taking smaller slices of loans or selling such loans to other banks. They also have diversified their sources of profit by trying to snare more lucrative investment-banking business and other fee-based activity.

Whether banks lend money or sell insurance protection, the downside is generally similar: The bank takes a hit if a company defaults, cushioned by whatever amount can eventually be recovered. (Though lenders are first in line in bankruptcy court; sellers of such protection are further back in the queue.)

But the upside differs substantially between lenders and sellers of protection. Banks don't generally charge their corporate borrowers much when they make a loan because they hope to get other, more lucrative assignments from the relationship. So if a bank extends $100 million to an industrial client, the bank may pocket $100,000 annually over the life of the loan. By contrast, the credit-default swap market prices corporate risk far more systematically, devoid of relationship issues. So if banks sell $100 million of insurance to protect another party against a default by that same company, the bank can receive, say, $3 million annually in the equivalent of insurance premiums (depending on the company's creditworthiness).

All this comes as the traditional lending business is becoming less lucrative. The credit-derivatives market highlights the degree to which bankers underprice corporate loans, and, as a result, bankers expect the price of such loans to rise.

"We see a change over time in the way loans are priced and structured," says Michael Pohly, head of credit derivatives at Morgan Stanley. "The lending market is becoming more aligned with the rest of the capital markets." In one possible sign of the trend away from traditional lending, the average bank syndicate has dropped from 30 lenders in 1995 to about 17 now, according to data from Loan Pricing Corp.

Some of the biggest players in the market, such as J.P. Morgan Chase & Co., are net sellers of such insurance, according to J.P. Morgan's financial statements. In its annual report, J.P. Morgan notes that the mismatch between its bought and sold positions can be explained by the fact that, while it doesn't always hedge, "the risk positions are largely matched." A spokesman declined to comment.

But smaller German banks, some of them backed by regional governments, are also active sellers, according to Fitch. "Low margins in the domestic market have compelled many German state-guaranteed banks to search for alternative sources of higher yielding assets, such as credit derivatives," the report notes. These include the regional banks Westdeutsche Landesbank, Bayerische Landesbank, Bankgesellschaft Berlin and Landesbank Hessen-Thueringen, according to market participants. The state-owned Landesbanken in particular have been searching for ways to improve their meager profits in time for 2005, when they are due to lose their government support under pressure from the European Union.

Deutsche Bank AG is one of biggest players in the market. It is also among the furthest along in introducing more-rational pricing to reflect the implicit subsidy in making loans. At Deutsche Bank, "loan approvals now are scrutinized for economic shortfall" between what the bank could earn selling protection and what it makes on the loan, says Rajeev Misra, the London-based head of global credit trading.

 

A credit default swap is a form of insurance against default by means of a swap. See Paragraphs 190 and 411d of FAS 133. See Risks.

Somewhat confusing is Paragraph 29e on Page 20 of FAS 133 that requires any cash flow hedge to be on prices or interest rates rather than credit worthiness.  For example, a forecasted sale of a specific asset at a specific price can be hedged for spot price changes under Paragraph 29e.  The forecasted sale's cash flows may not be hedged for the credit worthiness of the intended buyer or buyers.  Example 24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.  Because the bond's coupon payments were indexed to credit rating rather than interest rates, the embedded derivative could not be isolated and accounted for as a cash flow hedge.

One of my students wrote the following case just prior to the issuance of FAS 133:.  John D. Payne's case and case solution entitled A Case Study of Accounting for an Interest Rate Swap and a Credit Derivative appear at http://www.resnet.trinity.edu/users/jpayne/coverpag.htm .  He states the following:

The objective of this case is to provide students with an in-depth examination of a vanilla swap and to introduce students to the accounting for a unique hedging device--a credit derivative. The case is designed to induce students to become familiar with FASB Exposure Draft 162-B and to prepare students to account for a given derivative transaction from the perspective of all parties involved. In 1991, Vandalay Industries borrowed $500,000 from Putty Chemical Bank and simultaneously engaged in an interest rate swap with a counterparty. The goal of the swap was to hedge away the risk that variable rates would increase by agreeing to a fixed-payable, variable-receivable swap, thus hopefully obtaining a lower borrowing cost than if variable rates were used through the life of the loan. In 1992, Putty Chemical Bank entered into a credit derivative with Mr. Pitt Co. in order to eliminate the credit risk that Vandalay would default on repayment of its loan principal to Putty.

Greg Gupton's site is a major convergence point of research on credit risk and credit derivatives --- http://www.credit-deriv.com/crelink.htm 

A good site on credit risk is at http://www.numa.com/ref/volatili.htm   

Example 24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.

Misuses of Credit Derivatives

JP Morgan – whose lawyers must be working overtime – is refuting any wrongdoing over credit default swaps it sold on Argentine sovereign debt to three hedge funds. But the bank failed to win immediate payment of $965 million from the 11 insurers it is suing for outstanding surety bonds.
Christopher Jeffery Editor, March 2, 2002, RiskNews http://www.risknews.net 
Note from Bob Jensen:  The above quotation seems to be Year 2002 Déjà Vu  in terms of all the bad ways investment bankers cheated investors in the 1980s and 1990s.  Read passage from Partnoy's book quoted at http://www.trinity.edu/rjensen/book02q1.htm#022502 

Enron was its own investment bank on many deals, especially in credit derivatives. You can read the following at http://www.trinity.edu/rjensen/fraud.htm 

Selected quotations from "Why Enron Went Bust: Start with arrogance. Add greed, deceit, and financial chicanery. What do you get? A company that wasn't what it was cracked up to be." by Benthany McLean, Fortune Magazine, December 24, 2001, pp. 58-68.

Why Enron Went Bust: Start with arrogance. Add greed, deceit, and financial chicanery. What do you get? A company that wasn't what it was cracked up to be."

In fact , it's next to impossible to find someone outside Enron who agrees with Fasto's contention (that Enron was an energy provider rather than an energy trading company). "They were not an energy company that used trading as part of their strategy, but a company that traded for trading's sake," says Austin Ramzy, research director of Principal Capital Income Investors. "Enron is dominated by pure trading," says one competitor. Indeed, Enron had a reputation for taking more risk than other companies, especially in longer-term contracts, in which there is far less liquidity. "Enron swung for the fences," says another trader. And it's not secret that among non-investment banks, Enron was an active and extremely aggressive player in complex financial instruments such as credi8t derivatives. Because Enron didn't have as strong a balance sheet as the investment banks that dominate that world, it had to offer better prices to get business. "Funky" is a word that is used to describe its trades.

I was particularly impressed, as were all people who phoned in, by the testimony of Scott Cleland (see Tuesday, January 15) and then click on the following link to read his opening remarks to a Senate Committee on December 18. If you think the public accounting profession has an "independence problem," that problem is miniscule relative to an enormous independence problem among financial analysts and investment bankers --- two professions that are literally rotten to the core. Go to http://www.c-span.org/enron/scomm_1218.asp#open 

A portion of Mr. Cleland's testimony is quoted below:

Four, it's common for analysts to have a financial stake in the companies they're covering. That's just like, essentially, allowing athletes to bet on the outcome of the game that they're playing in.

Five, most payments for investment research is routinely commingled in the process with more profitable investment banking and proprietary trading. The problem with this is it effectively means that most research analysts work for the companies and don't work for investors.

Six, credit agencies may have conflicts of interest.

Seven, analysts seeking investment banking tend to be more tolerant of pro-forma accounting and the conflict there is, essentially, the system is allowing companies to tell -- you know, to make up their own accounting. To describe their own financial performance, that no one then can compare objectively with other companies.

Eight, surprise, surprise, companies routinely beat the expectations of a consensus of research analysts that are seeking their investment banking business.

See how banks use/misuse credit derivatives with  tranches.

A Bankers Primer on Credit Derivatives --- http://www.citissb.com/home/Creddriv.pdf 

What are Credit Derivatives?

Credit derivatives have three basic structures: credit default swaps, total return swaps and credit spread options. In a credit default swap, a buyer pays a seller a fixed fee in return for indemnification against losses should a credit event occur. Credit default swaps are used for risk management, capital management and investment management. Buyers of protection reduce credit concentrations or open up credit lines. Buyers may also obtain capital relief, redeploying the capital in more profitable business lines or buying back stock.

Primus Financial Services offers credit derivatives --- http://www.tfibcm.com/news/story/default.asp?734 

Kicking off what analysts are calling a small trend, New York-based Primus Financial Products recently became the first company structured solely to be a swap counterparty, selling protection via credit default swaps. "We're not a dealer, we're not a CDO, and we're not an insurance company," said Chief Executive Officer Tom Jasper. "What we are is a credit derivatives company."

As derivatives are becoming a more and more widely accepted method of transferring risk, it is not surprising that at least two additional companies - both at different stages of development - are following suit. The two are said to be familiar names in the asset-backed market, and the first will likely launch in mid-summer, according to Moody's Investors Service, which, along with Standard & Poor's, has awarded Primus a triple-A counterparty rating. Primus will begin trading in the next few weeks, Jasper said. In the first year of trading, Primus is planning to build a portfolio of about $5.5 billion in single name investment-grade corporate and sovereign credits.

"The plan is to take advantage of what we believe is a pretty efficient capital model and cost model, and to become a very efficient investor in investment-grade risk, using, as the transfer vehicle, the credit default swap," Jasper said. "So we're transferring risk synthetically versus a cash instrument."

Though many of its clients, which could include CDOs, insurance company portfolio managers, hedge funds, banks and other cash investors, might be using PFP to establish hedges, Primus is not incorporating a hedging strategy for its own portfolio, and, only in special situations, will buy credit protection for its exposures. Its triple-A counterparty rating is based primarily on its capital levels, or other resources, being sized to match the expected loss (Moody's) of its referenced obligations.

Also, contrary to some players' initial impressions of the company, Primus doesn't plan to launch any CDOs from its portfolio.

"It's not contemplated that we would securitize the risk that we will take on," Jasper said. "We're very happy to hold the risk to maturity."

March 2002 - Former dealers from Salomon Smith Barney and Bank of America yesterday set up what they claimed to be the first boutique focusing purely on default swap credit derivatives.

Question:
When does a hedge become a speculation?  

Answer:
There are essentially two answers.  Answer 1 is that a speculation arises when the hedge is not perfectly effective in covering that which is hedged such as the current value (fair alue hedge) of the hedged item or the hedged cash flow (cash flow hedge).  Testing for hedge ineffectiveness under FAS 133 and IAS 39 rules is very difficult for auditors.  Answer 2 is that a speculation arises when unsuspected credit risk arises from the settlements themselves such as when dealers who brokered hedge derivatives cannot back the defaults all parties contracted under the derivatives themselves.  Hedges may no longer be hedges!  Answer 2 is even more problematic in this particular down economy.

There is a lot of complaining around the world about need for and technicalities of the U.S. FAS 133 and the international IAS 39 standards on Accounting for Financial Instruments Derivatives and Hedging Activities.  But recent scandals adding to the pile of enormous scandals in derivatives over the past two decades suggest an increased  need for more stringent rather than weakened standards for accounting for derivatives.  The main problem lies in valuation of these derivatives coupled with the possibility that what is a safe hedge is really a risky speculation.  A case in point is Newmont Mining Corporation's Yandal Project in Australia as reported by Steve Maich in "Newmont's Hedge Book Bites Back," on  Page IN1 of the March 4, 2003 edition of Canada's Financial Post --- http://www.financialpost.com/ 

Even by the gold industry's relatively aggressive standards, Yandal's derivatives exposure is stunning.  The unit has 3.4 million ounces of gold committed through hedging contracts that had a market value of negative US$288-million at the end of 2002.

That would be a problem for any major producer, but the situation is particularly dire for Yandal because the development's total proven and provable gold reserves are just 2.1 million ounces.  In other words, the project has, through its hedging contracts, committed to sell 60% more gold than it actually has in the ground.

Making matters worse, the mine's counterparties can require Yandal to settle the contracts in cash, before they come due.  In all, about 2.8 million ounces are subject to these cash termination agreements by 2005, which could cost the company US$223.7-million at current market prices.

With insufficient gold to meet its obligations, and just US$58-million in cash to make up the difference, bankruptcy may be the only option available to Yandal, analysts said.

Comparing Yandal's reserves to its hedging liabilities "suggests that the Yandal assets may be worth more dead than alive," CIBC World Markets analyst Barry Cooper said in a report to clients.

All this is raising even bigger questions about the impact that the Yandal situation might have on the industry's other major hedgers.  Companies such as Canada's Barrick Gold Corp. and Placer Dome Ltd. have lagged the sector's strong rally of the past year, largely because many investors and analysts distrust the companies' derivative portfolios.

One thing that is not stressed hard enough in FAS 133 is the credit risk of the dealers themselves.  The FAS 133 standard and its international IAS 39 counterpart implicitly assume that when speculating or hedging with derivatives, the dealers who broker these contracts are highly credit worthy.  For example, in the case of interest rate swaps it is assumed that the dealer that brokers the swap will stand behind the swapping party and counterparty default risks.  There are now some doubts about this in the present weak economy.

"Derivatives Market a 'Time Bomb':  Buffet," Financial Post, March 4, 2003, Page IN1 --- http://www.financialpost.com/ 
Berkshire chairman warns of risks in shareholder letter --- http://www.berkshirehathaway.com/letters/letters.html 
(The above link is not yet updated for the Year 2002 forthcoming annual Shareholder Letter.)

Billionaire investor Warren Buffett calls derivative contracts "financial weapons of mass destruction, carrying dangers that while now latent are potentially lethal," according to excerpts from his forthcoming annual letter to Berkshire Hathaway Inc. shareholders.

Mr. Buffett, whose company is now seeking to divest of derivatives business tied to its General Re purchase, also worries that substantial credit risk has become concentrated "in the hands of relatively few derivatives dealers."

"Divided on Derivatives Greenspan:  Buffett at Odds on Risks of the Financial Instruments," by John M. Berry, The Washington Post, March 6, 2003, Page E01 --- http://www.washingtonpost.com/wp-dyn/articles/A48287-2003Mar5.html 

The use of derivatives has grown exponentially in recent years. The total value of all unregulated derivatives is estimated to be $127 trillion -- up from $3 trillion 1990. J.P. Morgan Chase & Co. is the world's largest derivatives trader, with contracts on its books totaling more than $27 trillion. Most of those contracts are designed to offset each other, so the actual amount of bank capital at risk is supposed to be a small fraction of that amount.

Previous efforts to increase federal oversight of the derivatives market have failed, including one during the Clinton administration when the industry, with support from Greenspan and other regulators, beat back an effort by Brooksley Born, the chief futures contracts' regulator. Sen. Dianne Feinstein (D-Calif.) has introduced a bill to regulate energy derivatives because of her belief that Enron used them to manipulate prices during the California energy crisis, but no immediate congressional action is expected.

Randall Dodd, director of the Derivatives Study Center, a Washington think tank, said both Buffett and Greenspan are right -- unregulated derivatives are essential tools, but also potentially very risky. Dodd believes more oversight is needed to reduce that inherent risk.

"It's a double-edged sword," he said. "Derivatives are extremely useful for risk management, but they also create a host of new risks that expose the entire economy to potential financial market disruptions."

Buffett has no problem with simpler derivatives, such as futures contracts in commodities that are traded on organized exchanges, which are regulated. For instance, a farmer growing corn can protect himself against a drop in prices before he sells his crop by buying a futures contract that would pay off if the price fell. In essence, derivatives are used to spread the risk of loss to someone else who is willing to take it on -- at a price.

Buffett's concern about more complex derivatives has increased since Berkshire Hathaway purchased General Re Corp., a reinsurance company, with a subsidiary that is a derivatives dealer. Buffett and his partner, Charles T. Munger, judged that business "to be too dangerous."

Because many of the subsidiary's derivatives involve long-term commitments, "it will be a great many years before we are totally out of this operation," Buffett wrote in the letter, which was excerpted on the Fortune magazine Web site. The full text of the letter will be available on Berkshire Hathaway's Web site on Saturday. "In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit."

One derivatives expert said several of General Re's contracts probably involved credit risk swaps with lenders in which General Re had agreed to pay off a loan if a borrower -- perhaps a telecommunications company -- were to default. In testimony last year, Greenspan singled out the case of telecom companies, which had defaulted on a significant portion of about $1 trillion in loans. The defaults, the Fed chairman said, had strained financial markets, but because much of the risk had been "swapped" to others -- such as insurance companies, hedge funds and pension funds -- the defaults did not cause a wave of financial-institution bankruptcies.

"Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands," Buffett acknowledged. "These people believe that derivatives act to stabilize the economy, facilitate trade and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies."

But then Buffett added: "The macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties," some of whom are linked in such a way that many of them could run into problems simultaneously and set off a cascade of defaults.

March 7, 2003 message from Risk Waters Group [RiskWaters@lb.bcentral.com

Alan Greenspan, chairman of the US Federal Reserve, today once again defended the use of derivatives as hedging tools, especially credit derivatives. His comments come in the wake of Warren Buffett's criticism of derivatives as "time bombs" and Peter Carr - recipient of Risk's 2003 quant of the year award this week - saying that in a [hypothetical] argument between quants convinced of the infallibility of their models and derivatives sceptics such as Buffett, he would probably side with Buffett.

But Greenspan, speaking at the Banque de France's symposium on monetary policy, economic cycle and financial dynamics in Paris, said derivatives have become indispensable risk management tools for many of the largest corporations. He said the marriage of derivatives and securitisation techniques in the form of synthetic collateralised debt obligations has broadened the range of investors willing to provide credit protection by pooling and unbundling credit risk through the creation of securities that best fit their preferences for risk and return.

This probably explains why credit derivatives employees reap the highest salaries, with an Asian-based managing director in synthetic structuring at a bulge-bracket firm earning an average basic plus bonus of £1.35 million last year. These were the findings of a first-of-its-kind survey conducted by City of London executive search company Napier Scott. The survey found that most managing directors working in credit derivatives at the top investment banks earn more than £1 million, with synthetic structurers commanding the highest salary levels. Asia-based staff earn 12-15% more than their US counterparts, with UK-based staff not far behind their Asia-based counterparts. Even credit derivatives associates with one or two years' experience earn in excess of £150,000 a year on average at a tier-1 bank.

In more people news, Merrill Lynch has hired four ex-Goldman Sachs bankers for its corporate risk management group focused on Europe, the Middle East and Africa. Roberto Centeno was hired as a director with responsibility for Iberia. Andrea Anselmetti and Luca Pietrangeli, both directors, and Ernesto Mercadente, an associate, will focus on expanding the corporate risk management and foreign exchange business in the Italian region. The corporate risk management group focuses on providing advice and execution for corporate clients, covering all risk management issues, including foreign exchange, interest rate risk and credit risk. All four will report to Patrick Bauné, co-head of Merrill Lynch's global foreign exchange issuer client group, and Damian Chunilal, head of the EMEA issuer client group, and are expected to join within the next two weeks. Merrill also hired Scott Giardina as a director in credit derivatives trading, based in London. He will report to Jon Pliner, managing director of credit trading EMEA, and Neil Walker, managing director of structured credit trading, EMEA. Giardina also joins from Goldman Sachs.

Christopher Jeffery
Editor, RiskNews

www.risknews.net
cjeffery@riskwaters.com

 

April 11, 2003Update on Accounting for Credit Derivatives
April 11, 2003 message from Risk Waters Group [RiskWaters@lb.bcentral.com

Jean-Claude Trichet, governor of the Bank of France, said transparency is essential to prevent a "herd mentality" in the financial market that can create artificial swings in market prices. During a keynote address at the Professional Risk Managers' International Association 2003 European Summit in Paris this week, Trichet called for a "strengthening of market transparency" and the disclosure of "complete and reliable information". He added that "no satisfying disclosure" yet exists for the credit derivatives market-place, and that while a January study by the Bank for International Settlements cast "some light" on this market, "these efforts should be pursued by central banks as well as market participants". Trichet said transparency is not just an issue for investors and savers but a fundamental tenet underpinning anti-cyclicality. "If information is not transparent, behaving as a 'herd' is a natural reaction," Trichet said.

Banks and Credit Derivatives
From Jim Mahar's blog on August 17, 2005

Minton, Stulz, and Williamson have an important look at banks' usage of credit derivatives. The short version? Very few banks are using them! In 2003, only about 6% of banks with over $1B in assets report using this form of derivatives. Consistent with what we have seen on other derivative usage, these banks tend to be much larger than average. Best guess as for the low usage? Transaction costs driven by moral hazard and adverse selection costs.

Slightly longer version of the paper

Minton, Stulz, and Williamson begin by documenting that the credit derivative market (measured by notional principle) has grown in recent years. Regulators (and even Alan Greenspan himself) have claimed that this reduces the risks that banks face. The paper investigates banks' use of credit derivatives and find that as of 2003, few banks were using credit derivatives. Those banks that were using the derivatives tended to be larger and have a greater need for the risk reduction.

In the words of the paper's authors:

"...net buyers of protection have higher levels of risk than other banks: they have lower capital ratios, lower balances of liquid assets, a higher ratio of risk-based assets to total assets, and a higherfraction of non-performing assets than the non-users of credit derivatives."

Why the limited use? Transaction costs undoubtedly play a role. Like in other derivatives "know-how" can be expensive to obtain and this largely fixed cost may explain a portion of the limited use. However, the very nature of credit derivatives also makes them prone to moral hazard and adverse selection costs. (Tried another way, banks typcially know more about the borrowers (and are often in a better position to monitor), than do derivative market participants. This results in less liquidity (higher transaction costs) for the very loans that would make the most sense to hedge.)

Again in the authors' words:

"These adverse selection and moral hazard problems make the market for credit derivatives illiquid for single name protection precisely for the credit risks that banks would often want to hedge with such protection. The positive coefficient estimates on C&I loan and foreign loan shares in a bank’s loan portfolio are consistent with the hypothesis that banks are more likely to hedge with credit derivatives if they have more loans to credits for which the credit derivatives market is more liquid."

So what does this all mean? The conclusion hints that the benefits of credit derivatives may be overstated but apparently the cost of hedging in papers is lower than in the credit derivative market as the paper ends covering both sides of the debate:

"To the extent that credit derivatives make it easier for banks to maximize their value with less capital, they do not increase the soundness of banks as much as their purchases of credit derivatives would imply. However, if credit derivatives enable banks to save capital, they ultimately reduce the cost of loans for bank customers and make banks more competitive with the capital markets for the provision of loans."

Not only are few banks using the derivatives to hedge, the exact loans that the banks would want to hedge are the most expensive to do. This really should not be surprising. What is more surprising is that these costs are so high as to prevent the use of the derivatives. Going forward in time, it will be interesting to see if this remains the case or if as the market develops, new ways evolve to lower the costs which would allow more effective hedging with credit derivatives. Stay Tuned.

Cite:
Minton, Bernadette A, Rene Stulz, and Rohan Williamson.
"How much do banks use credit derivatives to reduce risk?",
Ohio State working paper,
http://www.cob.ohio-state.edu/fin/dice/papers/2005/2005-17.pdf 


From The Wall Street Journal Accounting Weekly Review on June 13, 2008

 

 
SEC, Justice Scrutinize AIG on Swaps Accounting
by Amir Efrati and Liam Pleven
The Wall Street Journal

Jun 06, 2008
Page: C1
Click here to view the full article on WSJ.com ---
http://online.wsj.com/article/SB121271786552550939.html?mod=djem_jiewr_AC
 

TOPICS: Advanced Financial Accounting, Auditing, Derivatives, Fair Value Accounting, Internal Controls, Mark-to-Market Accounting

SUMMARY: The SEC "...is investigating whether insure American International Group Inc. overstated the value of contracts linked to subprime mortgages....At issue is the way the company valued credit default swaps, which are contracts that insure against default of securities, including those backed by subprime mortgages. In February, AIG said its auditor had found a 'material weakness' in its accounting. Largely on swap-related write-downs...AIG has recorded the two largest quarterly losses in its history."

CLASSROOM APPLICATION: Financial reporting for derivatives is at issue in the article; related auditing issues of material weakness in accounting for these contracts also is covered in the main article and the related one.

QUESTIONS: 
1. (Introductory) What are collateralized debt obligations (CDOs)?

2. (Advanced) What are credit default swaps? How are these contracts related to CDOs?

3. (Advanced) Summarize steps in establishing fair values of CDOs and credit default swaps.

4. (Introductory) What is a material weakness in internal control? Does reporting write-downs of such losses as AIG has shown necessarily indicate that a material weakness in internal control over financial reporting has occurred? Support your answer.
 

Reviewed By: Judy Beckman, University of Rhode Island
 

RELATED ARTICLES: 
AIG Posts Record Loss, As Crisis Continues Taking Toll
by Liam Pleven
May 09, 2008
Page: A1
 


"SEC, Justice Scrutinize AIG on Swaps Accounting," by Amir Efrati and Liam Pleven, The Wall Street Journal,  June 6, 2008; Page C1 ---
http://online.wsj.com/article/SB121271786552550939.html?mod=djem_jiewr_AC

The Securities and Exchange Commission is investigating whether insurer American International Group Inc. overstated the value of contracts linked to subprime mortgages, according to people familiar with the matter.

Criminal prosecutors from the Justice Department in Washington and the department's U.S. attorney's office in Brooklyn, New York, have told the SEC they want information the agency is gathering in its AIG investigation, these people said. That means a criminal investigation could follow.

In 2006, AIG, the world's largest insurer, paid $1.6 billion to settle an accounting case. Its stock has been battered because of losses linked to the mortgage market. The earlier probe led to the departure of Chief Executive Officer Maurice R. "Hank" Greenberg.

Officials for AIG, the SEC, the Justice Department and the U.S. attorney's office declined to comment on the new probe. A spokesman for AIG said the company will continue to cooperate in regulatory and governmental reviews on all matters.

At issue is the way the company valued credit default swaps, which are contracts that insure against default of securities, including those backed by subprime mortgages. In February, AIG said its auditor had found a "material weakness" in its accounting.

Largely on swap-related write-downs, which topped $20 billion through the first quarter, AIG has recorded the two largest quarterly losses in its history. That has turned up the heat on management, including CEO Martin Sullivan.

AIG sold credit default swaps to holders of investments called collateralized-debt obligations, or CDOs, backed in part by subprime mortgages. The buyers were protecting their investments in the event of default on the underlying debt. In question is how the CDOs were valued, which drives both the value of the credit default swaps and the amount of collateral AIG must "post," or essentially hand over, to the buyer of the swap to offset the buyer's credit risk.

AIG posted $9.7 billion in collateral related to its swaps, as of April 30, up from $5.3 billion about two months earlier.

Law Blog: Difficulties in Valuation 'Best Defense'

Bob Jensen's threads on CDOs are at
http://www.trinity.edu/rjensen/theory01.htm#CDO

Bob Jensen's timeline of derivative financial instruments scandals and new accounting rules ---
http://www.trinity.edu/rjensen/FraudRotten.htm


Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161
FASB, September 12, 2008 --- http://www.fasb.org/pdf/fsp_fas133-1&fin45-4.pdf


Damocles sword waiting to fall
CDS = Credit Default Swap (or is the Credit Default Sword?)

Financial WMDs (Credit Derivatives) on Sixty Minutes (CBS) on August 30, 2009 ---
http://www.cbsnews.com/video/watch/?id=5274961n&tag=contentBody;housing
I downloaded the video (5,631 Mbs) to http://www.cs.trinity.edu/~rjensen/temp/FinancialWMDs.rv 

Steve Kroft examines the complicated financial instruments known as credit default swaps and the central role they are playing in the unfolding economic crisis. The interview features my hero Frank Partnoy. I don't know of anybody who knows derivative securities contracts and frauds better than Frank Partnoy, who once sold these derivatives in bucket shops. You can find links to Partnoy's books and many, many quotations at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

For years I've used the term "bucket shop" in financial securities marketing without realizing that the first bucket shops in the early 20th Century were bought and sold only gambles on stock pricing moves, not the selling of any financial securities. The analogy of a bucket shop would be a room full of bookies selling bets on NFL playoff games.
See "Bucket Shop" at http://en.wikipedia.org/wiki/Bucket_shop_(stock_market)

I was not aware how fraudulent the credit derivatives markets had become. I always viewed credit derivatives as an unregulated insurance market for credit protection. But in 2007 and 2008 this market turned into a betting operation more like a rolling crap game on Wall Street.

Bob Jensen's Rotten to the Core threads are at http://www.trinity.edu/rjensen/FraudRotten.htm

Bob Jensen's threads on the current economic crisis are at http://www.trinity.edu/rjensen/2008Bailout.htm
For credit derivative problems see http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout

Also see "Credit Derivatives" under the C-Terms at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms

 

"Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults," by David Evans, Bloomberg, May 20, 2008 ---
http://www.bloomberg.com/apps/news?pid=20601109&sid=aCFGw7GYxY14&refer=home

Backshall and his clients aren't the only ones spooked by the prospect of a CDS catastrophe. Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis.

CDSs, which were devised by J.P. Morgan & Co. bankers in the early 1990s to hedge their loan risks, now constitute a sprawling, rapidly growing market that includes contracts protecting $62 trillion in debt.

The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb.

``It is a Damocles sword waiting to fall,'' says Soros, 77, whose new book is called ``The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means'' (PublicAffairs).

``To allow a market of that size to develop without regulatory supervision is really unacceptable,'' Soros says.

`Lumpy Exposures'

The Fed bailout of Bear Stearns on March 17 was motivated, in part, by a desire to keep that sword from falling, says Joseph Mason, a former U.S. Treasury Department economist who's now chair of the banking department at Louisiana State University's E.J. Ourso College of Business.

The Fed was concerned that banks might not have the money to pay CDS counterparties if there were large debt defaults, Mason says.

``The Fed's fear was that they didn't adequately monitor counterparty risk in credit-default swaps -- so they had no idea of where to lend nor where significant lumpy exposures may lie,'' he says.

Those counterparties include none other than JPMorgan itself, the largest seller and buyer of CDSs known to the Office of the Comptroller of the Currency, or OCC.

The Fed negotiated the deal to bail out Bear Stearns by allowing JPMorgan to buy it for $10 a share. The Fed pledged $29 billion to JPMorgan to cover any Bear debts.

`Cast Doubt'

``The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets,'' Fed Chairman Ben S. Bernanke told Congress on April 2. ``It could also have cast doubt on the financial positions of some of Bear Stearns's thousands of counterparties.''

The Fed was worried about the biggest players in the CDS market, Mason says. ``It was a JPMorgan bailout, not a bailout of Bear,'' he says.

JPMorgan spokesman Brian Marchiony declined to comment for this article.

Credit-default swaps are derivatives, meaning they're financial contracts that don't contain any actual assets. Their value is based on the worth of underlying loans and bonds. Swaps are similar to insurance policies -- with two key differences.

Unlike with traditional insurance, no agency monitors the seller of a swap contract to be certain it has the money to cover debt defaults. In addition, swap buyers don't need to actually own the asset they want to protect.

It's as if many investors could buy insurance on the same multimillion-dollar home they didn't own and then collect on its full value if the house burned down.

Bigger Than NYSE

When traders buy swap protection, they're speculating a loan or bond will fail; when they sell swaps, they're betting that a borrower's ability to pay will improve.

The market, which has doubled in size every year since 2000 and is larger in dollar value than the New York Stock Exchange, is controlled by banks like JPMorgan, which act as dealers for buyers and sellers. Swap prices and trade volume aren't publicly posted, so investors have to rely on bids and offers by banks.

Most of the traders are banks; hedge funds, which are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall; and insurance companies. Mutual and pension funds also buy and sell the swaps.

Proponents of CDSs say the devices have been successful because they allow banks to spread the risk of default and enable hedge funds to efficiently speculate on the creditworthiness of companies.

`Seeing the Logic'

The market has grown so large so fast because swaps are often based on an index that includes the debt of scores of companies, says Robert Pickel, chief executive officer of the International Swaps and Derivatives Association.

``Whether you're a hedge fund, bank or some other user, you're increasingly seeing the logic of using these instruments,'' Pickel says, adding he doesn't worry about counterparty risk because banks carefully monitor the strength of investors. ``There have been a very limited number of disputes. The parties understand these products and know how to use them.''

Banks are the largest buyers and sellers of CDSs. New York- based JPMorgan trades the most, with swaps betting on future credit quality of $7.9 trillion in debt, according to the OCC. Citigroup Inc., also in New York, is second, with $3.2 trillion in CDSs.

Goldman Sachs Group Inc. and Morgan Stanley, two New York- based firms whose swap trading isn't tracked by the OCC because they're not commercial banks, are the largest swap counterparties, according to New York-based Fitch Ratings, which doesn't provide dollar amounts.

Untested Until Now

The credit-default-swap market has been untested until now because there's been a steady decline in global default rates in high-yield debt since 2002. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody's Investors Service.

Since then, defaults globally have dropped to 1.5 percent, as of March. The rating companies say the tide is turning on defaults.

Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002. On May 7, Moody's wrote that as the economy weakened, high-yield-debt defaults by companies worldwide would increase fourfold in one year to 6.1 percent by April 2009.

The pressure is building. On May 5, for example, Tropicana Entertainment LLC filed for bankruptcy after the casino owner defaulted on $1.32 billion in debt.

`Complicate the Crisis'

A surge in corporate defaults may leave swap buyers scrambling, many unsuccessfully, to collect hundreds of billions of dollars from their counterparties, says Satyajit Das, a former Citigroup derivatives trader and author of ``Credit Derivatives: CDOs & Structured Credit Products'' (Wiley Finance, 2005).

``This is going to complicate the financial crisis,'' Das says. He expects numerous disputes and lawsuits, as protection buyers battle sellers over the technical definition of default - - this requires proving which bond or loan holders weren't paid -- and the amount of payments due.

``It's going to become extremely messy,'' he says. ``I'm really scared this is going to freeze up the financial system.''

Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, has researched counterparty risk and says it's only a matter of time before the sword begins falling. He says the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $35 billion in defaults.

$150 Billion Loss Estimate

``That's a very conservative estimate,'' he says, adding that his study finds that losses resulting from hedge funds that can't pay their counterparties for defaults could exceed $150 billion.

Hedge funds have sold 31 percent of all CDS protection, according to a February 2007 report by Charlotte, North Carolina-based Bank of America Corp.

Cicione says banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That may not work, he says. Many of the funds won't have the cash to meet the banks' requests, he says.

Sellers of protection aren't required by law to set aside reserves in the CDS market. While banks ask protection sellers to put up some money when making the trade, there are no industry standards, Cicione says.

JPMorgan, in its annual report released in February, said it held $22 billion of credit swap counterparty risk not protected by collateral as of Dec. 31.

`A Major Risk'

``I think there's a major risk of counterparty default from hedge funds,'' Cicione says. ``It's inconceivable that the Fed or any central bank will bail out the hedge funds. If you have a systemic crisis in the hedge fund industry, then of course their banks will take the hit.''

The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.

``It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred,'' the report said. ``It can be difficult even to quantify the amount of risk that has been transferred.''

Counterparty risk can become complicated in a hurry, Das says. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle, Das says.

`Daisy Chain Vortex'

The original purpose of swaps -- to spread a bank's loan risk among a large group of companies -- may be circumvented, he says.

``It creates a huge concentration of risk,'' Das says. ``The risk keeps spinning around and around in this daisy chain like a vortex. There are only six to 10 dealers who sit in the middle of all this. I don't think the regulators have the information that they need to work that out.''

And traders, even the banks that serve as dealers, don't always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDSs, some far more complex than others.

More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company's debt or collateralized debt obligations.

A CDO is an opaque bundle of debt that can be filled with junk bonds, auto loans, credit card liabilities and home mortgages, including subprime debt. Some swaps are made up of even murkier bank inventions -- so-called synthetic CDOs, which are packages of credit-default swaps.

AIG $9.1 Billion Writedown

On May 8, American International Group Inc. wrote down $9.1 billion on the value of its CDS holdings. The world's largest insurer by assets sold credit protection on CDOs that declined in value. In 2007, New York-based AIG reported $11.5 billion in writedowns on CDO credit default swaps.

Michael Greenberger, director of trading and markets at the Commodity Futures Trading Commission from 1997 to 1999, says the Fed is fully aware of the risk banks and the global economy face if CDS holders can't cover their losses.

``Oh, absolutely, there's no doubt about it,'' says Greenberger, who's now a professor at the University of Maryland School of Law in Baltimore. He says swaps were very much on the Fed's mind when Bear Stearns started sliding toward bankruptcy.

``People who were relying on Bear for their own solvency would've started defaulting,'' he says. ``That would've triggered a series of counterparty failures. It was a house of cards.''

Risk Nightmare

It's concerns about that house of cards that have kept Backshall, the California fund adviser, up at night. His worries about a nightmare scenario started in early March. The details of what happened are still fresh in his mind.

It's Monday, March 10, and the market is rife with rumors that Bear Stearns will run out of cash. Some of Backshall's clients have pulled their accounts from Bear; others are considering leaving the bank. Backshall's clients are exposed to Bear in multiple ways: They keep their cash and other accounts at the firm, and they use the bank as their broker for trades. Backshall advises them to spread their assets among various banks.

That same day, Bear CEO Alan Schwartz says publicly, ``There is absolutely no truth to the rumors of liquidity problems.''

Backshall's clients are suspicious. They see other hedge funds pulling their accounts from Bear. In the afternoon after Schwartz's remarks, the cost of protection soars past 600 basis points from 450 before Schwartz's statement.

CEO Didn't Calm Fears

Swaps are priced in basis points, or hundredths of a percentage point. At 600 basis points, a trader would pay $6,000 a year to insure $100,000 of Bear Stearns bonds.

``I don't think his comments did anything to calm fears,'' Backshall says.

The next day, March 11, Securities and Exchange Commission Chairman Christopher Cox says his agency is monitoring Bear Stearns and other securities firms.

``We have a good deal of comfort about the capital cushions at these firms at the moment,'' he says.

Cox's comments are overshadowed by rumors that European financial firms had stopped doing fixed-income trades with Bear, Backshall says.

``Nobody has a clue what's going on,'' he says. Bear swap costs are gyrating between 540 and 665.

For most investors, just getting default-swap prices is a chore. Unlike stock prices, which are readily available because they trade on a public exchange, swap prices are hard to find. Traders looking up prices on the Internet or on private trading systems see information that is hours or days old.

`Terribly Primitive'

Banks send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, Backshall says. For many investors, this system is a headache.

To find the price of a swap on Ford Motor Co. debt, for example, even sophisticated investors might have to search through all of their daily e-mails, he says.

``It's terribly primitive,'' Backshall says. ``The only way you and I could get a level of prices is searching for Ford in our inbox. This is no joke.''

In the past three years, at least two companies have developed software programs that automatically parse an investor's incoming messages, yank out CDS prices and build them into real-time price displays.

The charts show the highest bids and lowest offering prices for hundreds of swaps. Backshall tracks prices he gets from banks using the new software.

`It's Very Hard'

Backshall has been talking with hedge fund managers in New York all week.

``We'd quite frankly been warning them and giving them advice on how to hedge,'' he says of the Bear Stearns crisis and banks overall. ``It's very hard to hedge the counterparty risk. These institutions are thinly capitalized in the best of times.''

The night of Thursday, March 13, Backshall can't sleep. He lies awake worrying about Bear and counterparty risk. The next morning, he arrives at work at 5 a.m., two and a half hours before sunrise.

Through the window of his ninth-floor corner office, he takes a moment to watch the distant flickers of light in the rolling foothills of Mount Diablo. Across the street, he sees the still-dark Walnut Creek train station, about 30 miles (48 kilometers) east of San Francisco.

Backshall, wearing jeans and a blue, button-down shirt, sits at his desk, staring at a pair of the 27-inch (68.6- centimeter) monitors that display swap costs. CDS prices jumped by more than 10-fold in just a year. The numbers show rising fear, he says.

Until early in 2007, the typical price of a credit-default swap tied to the debt of an investment bank like Merrill Lynch & Co., Bear Stearns or Morgan Stanley was 25 basis points.

`Unknowns Are Out There'

If a swap buyer wanted to protect $10 million of assets in the event of a company default, the contract would cost about 0.25 percent of $10 million, or $25,000 a year for a five-year protection contract.

Backshall's screens tell him the cost of buying protection on Bear Stearns debt in the past 24 hours has been moving in a range between 680 and 755 basis points.

``The unknowns are out there,'' Backshall says.

He advises his clients not to buy CDS protection on Bear because the price is too high and the time is wrong. It's too late to buy swaps now, he says.

At 9:13 Friday morning in New York, JPMorgan announces it will loan money to Bear using funds provided by the Federal Reserve. The JPMorgan statement doesn't say how much it will lend; it says it will ``provide secured funding to Bear Stearns, as necessary.''

`Significantly Deteriorated'

Bear CEO Schwartz says his firm's liquidity has ``significantly deteriorated'' during the past 24 hours. Protection quotes drop immediately into the low 500s, as some dealers think a rescue has begun.

That doesn't last long.

``Very quickly, the trading action is swinging violently wider,'' Backshall says. Bear's swap cost jumps to 850 basis points that afternoon, his screen shows. ``When fear gets hold, fundamental analysis goes out the window,'' he says.

In the calmest of times, making reasoned decisions about swap prices is a challenge. Now, it's impossible. Traders don't have access to any company data more recent than Bear's February annual report. Sharp-eyed investors looking through that filing might have spotted a paragraph that's strangely prescient.

``As a result of the global credit crises and the increasingly large numbers of credit defaults, there is a risk that counterparties could fail, shut down, file for bankruptcy or be unable to pay out contracts,'' Bear wrote.

`Material Adverse Effect'

``The failure of a significant number of counterparties or a counterparty that holds a significant amount of credit-default swaps could have a material adverse effect on the broader financial markets,'' the bank wrote.

Even after JPMorgan's Friday morning announcement, the market is alive with rumors. Backshall's clients tell him they've heard some investment banks have stopped accepting trades with Bear Stearns and some money market funds have reduced their short-term holdings of Bear-issued debt.

On Sunday, March 16, the Federal Reserve effectively lifts the sellers of Bear Stearns protection out of their misery. JPMorgan agrees to buy Bear for $2 a share.

While that's devastating news for Bear shareholders -- the stock had traded at $62.30 just a week earlier -- it's the best news imaginable for owners of Bear debt. That's because JPMorgan agreed to cover Bear's liabilities, with the Fed pledging $29 billion to cover Bear's loan obligations.

Turned to Dust

For traders who sold protection on Bear's debt, the bailout is a godsend. Faced with the prospect of having to hand over untold millions to their counterparties just three days earlier, they now have to pay out nothing.

For traders who bought protection swaps just a few days earlier -- when prices were in the 600s to 800s -- the Fed bailout is crushing. Their investments have turned to dust.

On Monday morning, the cost of default protection on Bear plunges to 280. Backshall sits back in his chair and for the first time in two weeks, he can breathe easier.

``No wonder I look so tired all the time,'' he says, finally showing a bit of a smile.

When it bailed out Bear Stearns, the Federal Reserve effectively deputized JPMorgan to monitor the credit-default- swap market, says Edward Kane, a finance professor at Boston College. Because regulators don't know where the risks lie, they're helpless, Kane says.

Default swaps shift the risk from a company's credit to the possibility that a counterparty might fail, says Kane, who's a senior fellow at the Federal Deposit Insurance Corporation's Center for financial Research.

`Off Balance Sheet'

``You've really disguised traditional credit risk, pushed it off balance sheet to its counterparties,'' Kane says. ``And this is not visible to the regulators.''

BNP analyst Cicione says regulators will be hard-pressed to prevent the next potential breakdown in the swaps market.

``Apart from JPMorgan, there aren't many other banks out there capable of doing this,'' he says. ``That's what's worrying us. If there were to be more Bear Stearnses, who would step in and give a helping hand? You can't expect the Fed to run a broker, so someone has to take on assets and obligations.''

Banks have a vested interest in keeping the swaps market opaque, says Das, the former Citigroup banker. As dealers, the banks see a high volume of transactions, giving them an edge over other buyers and sellers.

``Dealers get higher profitability through lack of transparency,'' Das says. ``Since customers don't necessarily know where the market is, you can charge them much wider margins.''

Banks Try to Hedge

Banks try to balance the protection they've sold with credit-default swaps they purchase from others, either on the same companies or indexes. They can also create synthetic CDOs, which are packages of credit-default swaps the banks sell to investors to get themselves protection.

The idea for the banks is to make a profit on each trade and avoid taking on the swap's risk.

``Dealers are just like bookies,'' Kane says. ``Bookies don't want to bet on games. Bookies just want to balance their books. That's why they're called bookies.''

The banks played the role of dealers in the CDO market as well, and the breakdown in that market holds lessons for what could go wrong with CDSs. The CDO market zoomed to $500 billion in sales in 2006, up fivefold from 2001.

Banks found a hungry market for CDOs because they offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating.

CDO Market Dried Up

By the middle of 2007, mortgage defaults in the U.S. began reaching record highs each month. Banks and other companies realized they were holding hundreds of billions in toxic debt. By August 2007, no one would buy CDOs. That newly devised debt market dried up in a matter of months.

In the past year, banks have written off $323 billion from debt, mostly from investments they created.

Now, if corporate defaults increase, as Moody's predicts, another market recently invented by banks -- credit-default swaps -- could come unstuck. Arturo Cifuentes, managing director of R.W. Pressprich & Co., a New York firm that trades derivatives, says he expects a rash of counterparty failures resulting in losses and lawsuits.

``There's a high probability that many people who bought swap protection will wind up in court trying to get their payouts,'' he says. ``If things are collapsing left and right, people will use any trick they can.''

Frank Partnoy, a former derivatives trader and now a securities law professor at the University of San Diego School of Law, says it's high time for the market to let in some sunshine.

Continued in article

"Pressure gauge," The Economist, August 21, 2008 --- http://www.economist.com/finance/displaystory.cfm?story_id=11985964

IN THE weeks before Bear Stearns, a Wall Street bank, collapsed in March, nervous investors scanned not just its share price for a measure of its health, but the price of its credit-default swaps (CDSs), too. These once-obscure instruments, now widely enough followed that they have even earned a mention on an American TV crime series, clearly indicated that the firm’s days were numbered. The five-year CDS spread had more than doubled to 740 basis points (bps), meaning it cost $740,000 to insure $10m of its debt. The higher the spread, the greater the expectation of default.

Once again, CDS spreads on Wall Street banks are pushing higher, having fallen in March after the Federal Reserve extended emergency lending facilities to them. Reportedly one firm, Morgan Stanley, is monitoring its own CDS spreads to assess the market’s perception of its corporate health; if they rise too high, it intends to cut back its lending. Whether the CDS market is accurately assessing the creditworthiness of Lehman Brothers, trading on August 20th at 376 bps, double the level in early May, will be the next test of its worth.

There are some who doubt whether the CDS market is a reliable barometer of financial health. Though its gross value has ballooned in size from $4 trillion in 2003 to over $62 trillion, many of the contracts written on individual companies are thinly traded, lack transparency, and are prone to wild swings.

Recent spikes in CDS spreads on the three largest Icelandic banks are a case in point. In July spreads on Kaupthing and Glitnir rose to levels 35% higher than those observed for Bear Stearns in the days before it was bought out, according to Fitch Solutions, part of the Fitch rating and risk group. But the panic subsided after they released second-quarter earnings. Insiders say CDSs are increasingly used for speculation as well as hedging, which creates distracting “noise” particularly when the markets are as fearful as they have been recently.

On the other hand, although CDS spreads may overshoot, they do not generally stay wrong for long. Moody’s, another rating agency, says that market-implied ratings, such as those provided by CDS spreads, tally loosely with credit ratings 80% of the time. What is more, CDS spreads frequently anticipate ratings changes. Fitch Solutions reckons that the CDS market has anticipated over half of all observed ratings activities on CDS-traded entities as much as three months in advance. Though the magnitude of the moves may at times be unrealistic, the direction is usually at least as good a distress signal as the stock market.


"Credit Default Swap:  The Fed wants to give the blundering rating agencies even more power – this time over derivatives.." The Wall Street Journal, January 3, 2008 --- http://online.wsj.com/article/SB123094475030650613.html?mod=djemEditorialPage

Could the political campaign to blame the financial panic on unregulated derivatives be losing momentum? Let's hope so, because this might save us from making new mistakes in the name of fixing the wrong problems.

We now know that the predicted disaster for credit default swaps (CDS) following the Lehman Brothers bankruptcy never happened. The government also still hasn't explained how AIG's use of CDS to go long on housing would have destroyed the planet. And now the New York Federal Reserve's effort to regulate the CDS market is mired in a turf war. The Securities and Exchange Commission and the Commodity Futures Trading Commission have backed rival efforts in New York and Chicago.

But it is the New York Fed proposal that may pose the most immediate threat to taxpayers, because it is designed to include firms on at least one end of 90% of CDS contracts. After announcing its intention to begin by the end of 2008, the New York branch of the central bank is still awaiting approval from the Fed's Board of Governors to launch a central clearinghouse for CDS trades. Credit default swaps are essentially insurance against an organization defaulting on its debt, and they provide a real-time gauge of credit risk. This has proven particularly valuable because the Fed's method of judging risk -- relying on the ratings agencies S&P, Moody's and Fitch -- has been disastrous for investors.

Under pressure from the New York Fed, nine large CDS dealers -- giants like Goldman Sachs -- agreed to construct a central counterparty, which would backstop and monitor CDS trades. Called The Clearing Corp., it failed to catch on in the marketplace. So the big dealers recently gave an ownership stake to IntercontinentalExchange (ICE). In return, ICE agreed to make this government-created but privately owned institution work.

ICE has given the venture, now called ICE Trust, operational street cred, but the Fed-imposed architecture should still cause taxpayer concern. That's because it takes the widely dispersed risk in the CDS marketplace and attempts to centralize it in one institution. If not structured correctly, it may reward the participating firms with the weakest balance sheets. For this reason, some of the dealers who have resisted a central counterparty because it threatens their profits may now embrace it as a way to socialize their risks. What's more, if it allows these big Wall Street dealers to build an electronic trading platform on top of the central clearinghouse, the big banks could prevent pesky Internet start-ups from threatening their market share.

Here's how the New York Fed's central counterparty would change the market: Right now, CDS trades are conducted over-the-counter as private contracts between two parties. They are reported to the Trade Information Warehouse, so the market has some transparency, but nobody is on the hook besides the two parties to the agreement. This provides an incentive for each party to make an informed judgment on whether the counterparty can be relied upon to pay debts. The buyer of credit protection -- who is paying annual premiums for the right to be compensated if a company defaults on its bonds -- has every reason to study the balance sheet of the seller of a CDS contract.

In the New York Fed's judgment, the recent panic showed there wasn't enough transparency in CDS trades. This claim would have more credibility if the Fed would come clean about AIG. But in any case, the Fed's solution is to force CDS contracts into its central counterparty. There is a virtue here: A particular bank cannot throw out its collateral standards to please one large favored client, because the same standards apply to all participants. The nine large dealers plus perhaps four or five more participating firms would each contribute roughly $100 million to the central counterparty, and they'd have to cough up more money if failures burn through this cash reserve.

However, this system also introduces new risks, because all participants become liable for the potential failure of the weakest members. How does one appropriately judge the credit risk of a participant? ICE Trust and the Fed haven't released details. Sources tell us that participants will need to have a net worth of at least $1 billion, and, more ominously, that the Fed wants a high rating from a major credit-ratings agency as a crucial test of financial health.

If regulators learn nothing else from the housing debacle, they should recognize that their system of anointing certain firms to judge credit risk is structurally flawed and immensely expensive for investors. As Columbia's Charles Calomiris has explained on these pages, one reason the Basel II standards for bank capital failed is because they subcontracted risk assessments to the same ratings agencies that slapped AAA on dodgy mortgage paper.

Unfortunately, the Fed stubbornly refuses to learn this lesson. With its various lending facilities, the Fed continues to demand collateral rated exclusively by S&P, Moody's or Fitch. A rival ratings agency reports that the Fed recently rejected a request from a clearing bank to consider a ratings firm other than the big three.

No doubt ICE Trust has a strong incentive to monitor counterparty credit risk. Our concern is that the Fed's failed policy on credit ratings will increase risks even further if it is allowed to pollute the $30 trillion CDS market. The credit raters have shown they are usually the last to know if a bank is in trouble, yet under a credit-rating seal of approval such a bank could maintain the illusion that all is well. If you have trouble conceiving of such a scenario, reflect on the history of Enron, Bear Stearns, Lehman, Citigroup, the mortgage market, collateralized-debt obligations, etc. Now try to imagine how long it will take the Fed to commit taxpayer dollars if this central counterparty fails.

Any plan that seeks to minimize marketplace risks by concentrating them in one institution deserves skepticism. Relying on ratings from the big three to assess these risks would be an outrage.

Bob Jensen's Primer on Derivatives ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Primer
Also see how AIG and some other Wall Street firms were bailed out of their credit default swaps ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout


"Stanford Research Team Proposes Changes to Credit Default Swaps to Lower Looming Risks of Sovereign Default," MarketWatch, May 15, 2012 ---
http://www.marketwatch.com/story/stanford-research-team-proposes-changes-to-credit-default-swaps-to-lower-looming-risks-of-sovereign-default-2012-05-15

STANFORD, Calif., May 15, 2012 (BUSINESS WIRE) --
STANFORD GRADUATE SCHOOL OF BUSINESS--If you're a bondholder of sovereign debt and think you've covered your risks by purchasing credit default swaps, think again.

According to Darrell Duffie, finance professor from the Stanford Graduate School of Business, and Stanford economics student Mohit Thukral, a flaw within credit default swap (CDS) contracts means that only a small fraction of bondholder losses may be covered in the event of a sovereign debt restructuring.

The flaw is tied to the fact that current CDS contracts only pay buyers of protection based on the price of the sovereign's outstanding bonds, even if the sovereign has just exchanged its legacy bonds for a much smaller amount of new bonds. This CDS payout ignores the additional loss to a bondholder from the effect of this "haircut."

In a recently released research paper, Duffie and Thukral propose tying CDS settlements to the face value of new bonds that is given to bondholders per unit face value of old bonds. The resulting CDS payment approximates actual bondholder losses, allowing for better sovereign default risk management and CDS pricing that more accurately reveals sovereign default risk.

"The current design of credit derivatives is of questionable value for managing the risk of sovereign default, which is a significant issue given the current stresses on the Eurozone," says Duffie. "Unless there is a change in the contract design, such as the one we propose, investors could be left without an effective tool for controlling their exposure to sovereign default, and CDS prices would be unreliable gauges of true default risk."

Furthermore, he explains, if the CDS market is not an effective tool for managing risk, investors may have even more reason to shy away from sovereign bond purchases, leading to unintended consequences for market stability.

Duffie and Thukral, an undergraduate economics major who recently took Duffie's MBA "Debt Markets" class, began their research following the restructuring of Greek sovereign debt in March of this year, when they realized the shortcomings of current CDS contracts. They propose a straightforward redesign of CDS contracts that would allow settlement based on the market value of whatever the sovereign government gives the bondholder in exchange for each old bond; this market value would be determined in a settlement auction.

In practice, a sovereign government may give a package of several financial instruments in exchange for each old bond. Bondholders of Greek debt, for example, received a combination of new bonds, GDP-linked securities, and PSI payment notes that are obligations of the European Financial Stability Facility.

According to Duffie and Thukral's proposal, the redesigned CDS contract would allow settlement based on the market value of the entire exchange package. This would mitigate one of the problems that arose with the Greek debt restructuring; namely, that the protection payment ignored the remainder of the exchange package.

In this way, the team's proposal also provides a mechanism whereby the bond market can digest the complex instruments that may be created in a sovereign debt restructuring. This is important because not all bondholders are well situated to deal with the package of instruments they may receive in a restructuring.

Continued in article

For Bob Jensen's threads on accounting for credit default swaps look under the C-terms at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

 

 

 


Bob Jensen's timeline of derivative financial instruments scandals and new accounting rules --- http://www.trinity.edu/rjensen/FraudRotten.htm

 


Bob Jensen's threads on derivatives scandals can be found at http://www.trinity.edu/rjensen/fraud.htm#DerivativesFraud 

Bob Jensen's helpers, tutorials, glossary, and instructional cases for FAS 133 and IAS 39 are at http://www.trinity.edu/rjensen/caseans/000index.htm 

 

Credit Sensitive Payments =

payments on a debt instrument that vary under an embedded option that adjusts the interest rate on the basis of changed credit rating of the borrower.  Paragraph 61c on Page 41 of FAS 133 defines these payments as clearly-and-closely related such that the embedded derivative cannot be accounted for separately under Paragraph 12 on Page 7.  This makes embedded credit derivative accounting different than commodity indexed and equity indexed embedded derivative accounting rules that require separation from the host contract such as commodity indexed, equity indexed, and inflation indexed embedded derivatives.  In this regard, credit indexed embedded derivative accounting is more like inflation indexed accounting.  See derivative financial instrument and embedded derivatives.

Cross-Currency Hedge = see foreign currency hedge.

Cross Rate =

the exchange rate between two currencies other than the dollar, calculated using the dollar exchange rates of those currencies.

Crude Oil Knock-in Note

a bond that has upside potential on the principal payback contingent upon prices in the crude oil market.  Such a note is illustrated in Example 21 in Paragraph 187 of FAS 133.

CTA = a term with alternate meanings.

Commodity Trading Advisor - One who provides advice on investing in currencies as a separate asset class. Some also act in a separate function as overlay managers, advising on hedging the currency risk in international asset portfolios.

Cumulative Translation Adjustment - An entry in a translated balance sheet in which gains and losses from transactions have been accumulated over a period of years.

Cumulative Dollar Offset = see ineffectiveness.

Currency Swap =

a transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay over time at a predetermined rate that reflects interest payments and possibly amortization of the principal as well. The payment flows are based on fixed interest rates in each currency.    An example of a currency swap in FAS 133 appears in Example 5 Paragraphs 131-139 on Pages 72-76.

Current Rate =

The exchange rate in effect at the relevant-financial-statement date.

 

 

 

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D-Terms

Dedesignation =

a change in status of a designated hedge such that all or a portion of the hedged amounts must be taken into current earnings rather being deferred.  Dedesignation for cash flow hedges is discussed in Paragraph 30 on Page 21 of FAS 133.  If a cash forecasted transaction becomes a firm commitment, its corresponding cash flow hedge must be dedesignated.  Controversies between the FASB's distinction between forecasted transactions versus firm commitments are discussed in Paragraphs 324-325 on Pa