Bob Jensen's Transcript of a Prisentation by Tom Linsmeier

A Presentation by Professor Linsmeier
as Videotaped by Bob Jensen

Bob Jensen at Trinity University

Understanding everything that has to go on, especially with SFAS 133. See mine's getting a little dog-eared. This document is about as complex as anything I've seen the FASB issue. And what I'd like to do today is give you an introduction to derivatives, then introduce to you in an overview the new financial reporting standards related to derivatives. There are two and the one we are going to concentrate on today is Statement 133 (SFAS 133) from the FASB. The other one (SEC Financial Reporting Release 48) comprises the disclosure rules from the SEC.

If you want to know more about the disclosure rules that the SEC issued in the last year's time period, you can attend a session tomorrow morning, at 10:30, at which I and some of my colleagues are speaking about the SEC market risk disclosure rules and outlining a research program that I've developed as a consequence in being involved with market risk in the SEC. So we will bypass that today, Financial Reporting #48, but, if you are interested in that there is a full session tomorrow on that topic.

You'll find that after I give you verbal summary of SFAS 133, you won't be very comfortable. So it's going to be important to give you some in the beginning a lot of examples as to what might be happening in the accounting for cash flow hedge and a fair value hedge. And we will spend some time going through simplified two basic examples of that accounting.

And finally, I'll give you an evaluation of what I think the strengths and weaknesses of SFAS 133 are in conclusion. That's the road map for today.

I can get going pretty much on derivatives. People tell me I have to be quiet at times. What I want is to serve you. I can stand up here and talk at you for a long time. But, I don't know what level of expertise I have in the room. I assume it varies from people that don't understand derivatives much at all to people that have some penetrating questions. I'd like you to interrupt me throughout this session. I thought very hard trying to make this an active learning session. But there's so much background that by the time you can actively learn, or move forward on this, it would've been me for three-quarters of the hour anyhow and then I would've been out of time. So I want you to be able to intervene and ask questions whenever you feel it's necessary.

To start, you each should have a copy of the slides, and before you ask, it's on my last slide. And before you ask if you want this in electronic form, I've got an e-mail address on the very last slide, so that at the end, you can send it to me next week and I'm more than willing to share it with those slides.

Part of my objective of putting this together was to provide materials for you to bring it to the classroom. So, if you want those slides, they're free for the taking.

Derivative

A generic term used to describe a wide variety of financial and commodity instruments whose value depends on or is derived from the value of an underlying asset/liability, reference rate, or index.

Let's start with what are derivatives? This is not the FASB's definition of what a derivative is. The FASBs definition in SFAS 133 goes on for about six or seven pages and has three appendices describing the definition. So just to start more generically, what is a generic definition for a derivative? It is it's a word used to describe a wide variety of primarily financial and commodity instruments. We'll find other sorts of instruments also as a underlying. They are financial and commodity instruments whose values are derived from an underlying rate, price, index those sorts of things. Now if you are not very familiar with derivatives, that might not help you.

That might not give you a very good picture of what a derivative is. So let's go through and talk about what some of the common derivatives are, and talk about their key characteristics.

Common derivatives include forwards and futures. These are basically the same things --- it depends on whether they're exchange traded or not --- whether they are called a forward (non-exchange traded) or a future (exchange traded).

So those two contracts (forward vs futures) are going to differ primarily on dimensions of liquidity risk and credit risk. By being exchange traded, the movements in underlying rate are priced at what would cause one party to lose, and another party to win, when it's traded on the exchange. You have to, as the losing party in a price change that gets big enough has to on a daily basis, put up the loss in cash (in a futures transaction). (Futures contracts) minimize credit risk problems, the risk of somebody defaulting, and (forward contracts) minimize liquidity risk. The cash that is available to the party that's going to win but that's the only difference in concept and obviously and I'll talk about this more. One of the reasons why you have a forward contract, versus a futures contract, is how unique the contract is. (Forward contracts can be customized.) We'll talk about that a little bit more. A unique contract is not going to be traded on an exchange, because other people are not going to want to participate, are not going to want to participate, in that trade. So you can have forwards or futures.

We'll also talk about options. And I'll want to convince you by the end, that the option is the underlying fundamental derivative. Everything else is a combination of options (or forwards or futures).

So you would think of options as the basic derivative. Swaps, we are going to see, are a series of forward contracts, and we move to hybrid or embedded derivatives and if anybody followed some of the catastrophic loss 94 or 95, there are some pretty weird derivatives out there. Things like wedding band derivatives. Now what's that going to be? We got some very complex derivatives, but all they are, they're basic forms of derivatives, options, forwards or futures embedded in something else and sometimes being leveraged.

What do I mean by leveraged? If the price changes and underlying interest rate index changes by 100 basis points, the "put" the term, the term in the contract that says as the change in the underlying flows are leveraged by a factor of 103. So 103 times the change is what the effect is on the cash flows.

That's what happened to Proctor and Gamble when they lost $57 million dollars on one contract. They had a leveraged derivative that took a minor change, and blew up on them.

So those are the common derivatives, at least an introduction in words. Let's look at them in more detail through some graphical representations. A forward or future is a lot like what we do in normal cash market. A forward and futures contract obligates one party to buy and another party to sell an underlying instrument, that's a key term in derivatives, an underlying. But it doesn't have to be imposing, an underlying instrument or commodity at a future date and price.

Just think about buying an automobile. That's really a derivative contract, because most of the time we don't go in and buy that day. We go when we decide instead of price with that automobile dealership where there might be time that goes elapsed between the time you buy it and the time it's delivered.

And there is a price risk, isn't there in that time period? You contracted to buy that automobile several days in the future. And yet if the price did change in that time period, if it went up, the buyer wins. If it went down, the buyer loses, and the seller wins.

That's not unlike what a forward or a future contract is. So we can think of first the normal cash market, when we buy or exchange in cash now and get the product back now; as their normal exchange mechanism and now let's introduce some derivatives' terms. The party that's going to get what's being contracted for is going to be long in that item. And those that are going to give up the automobile, the dealer is going to be short in that item. But in the normal contract in a cash market, it's going to happen today.

All that happens in a forward or a future setting is that we agree to the terms today to do the same thing sometimes in the future. It's a forward or future contract. Now, you are all familiar with the very common forward on futures contract. It's called a variable rate mortgage. Now what's true and what we are going to see in these particular settings, what's true about a forward contract?

If you set it at the money; that is if we contract to buy something in the future at the price we think it's going to be at the future. Taking the present value out of that amount, weren't neither party in the exchange to a forward or future is going to exchange cash up front. Because we've gotten equal expectations and we're equally likely to win on that contract as to lose on that contract. And that's the key distinguishing features I want you to pick up about a forward and futures. No particular up-front premium. There will be a transaction cost for writing the contract, but no other premium up-front if it's purchased at the money.

Suppose we think that gold will still be worth $400 an ounce several days from now, ok, several days or months from now, when we have a forecasted values. (e.g., I predict one value and you predict another value.) We decide to do a future's contract on gold; neither of us are going to have to provide cash to each other. Because we are going to be in agreement that that's the reasonable transaction price for that. And each of us can win and lose. So, no transaction, no premium, ok, in this contract. Both parties have the opportunity to win and lose.

Let's go back to that variable rate mortgage. Remember we say that a derivative is an item that value is derived based on an underlying price rate or index? Think about the variable rate mortgage. The cash flow that you paid in a variable rate mortgage are derived based on underlying index that's specified in the contract. Now that could be called a derivative contract.

If we said that, and the bank and yourself in buying the home, set the mortgage rate in that index in that contract; if it was On Market, and if you look at an interest rate yield curve, interest rates are lowered short term, longer long-term for inflation effects. But you have a yield curve that's what mortgages contracted On-Market, there's no extra price paid by the mortgagor or the mortgagee in that process.

Now, the FASB is going to work real hard at deciding --- I can find a derivative in almost anything. The FASB members are going to work real hard in SFAS 133 to build tiny walls around what they think are going to be derivatives and needed to be contracted as a derivative versus those that are not (subject to SFAS 133). Because any normal purchases order is a forward contract. And if it's for normal items, if it's in a company, the FASB is going to say we already have accounting for normal operating items in a purchase contract and we don't want to get into derivatives in that area and they are going to divide those off. But that's a forward and a future contract. The forward futures contract you can either decide to buy the instrument at the specified price or you can decide to sell the instrument at the specified price at a future date.

It's an artificial thing that you and I probably can punch through very easily, one of those paper-thin walls.

Options. Options are a different nature. Options provide the holder one of the parties, one of the sides of the contract the right but not the obligation to either buy or sell an underlying item, instrument or commodity at a pre-determined price in the contracted derivative terms that the "strike" price or at "exercise" price.

Options

Options provide the holder the right, but not the obligation, to buy or sell the underlying instrument or commodity at a predetermined price called the "strike" or "exercise" price

Options normally are in the form of a "Call" or a "Put"

Calls - enable the holder to buy the underlying instrument or commodity at the strike price

Puts - enable the holder to sell the underlying instrument or commodity at the strike price

Require "up-front" payment or "premium"

Well, what should I pick up first in that definition? One party has the right either not to make any money, or to win. That's what we are going to see here in an option or in the writer of the --- that's the one that buys the option. The other one, the writer of the option, is either going to not lose any money or lose money--unsure of whole sentence.

The two parties (buyer of the option versus the writer of the option) that contracted is pre-determined an option, one party could lose and one party can win, depending on the exercise price of the option. So let's think about that automobile again. Let's say I contracted to buy a Camaro for $25,000 on a forward (contract). And the price went up and I have --- I am the holder of the right of the option to buy it for $25,000 (when the current price may be $26,000).

What happens in that setting if the price goes up in a production period, let's say 30 days, to $26,000. I exercise my option to buy it at $25,000. Now if it went down to $24,000, my option's useless. I'd be pretty stupid to buy it at $25,000 if I can get it at $24,000 on the regular market.

So your option's going to give you the right to win. The writer of the option is possibly going to lose. The buyer of the option is possibly going to win (although it is certain that the buyer will lose the premium paid for the option). Now obviously, in equilibrium we don't do that for any cost. If I have the right to win and you have the right to lose, we are going to have to agree on what the potential expected value that win or loss might be.

You know what this sounds like? Sounds to me like insurance. What do we do with insurance? We pay a premium up front and what is that premium based on? Based on in all actuality, what on average what we might expect to lose in that setting. And we buy that option, so that minimizes our outside loss. So we guarantee that loss to be the premium, don't we? Because we are giving that up.

That's nature of what an option's like. Options are the form of a call. The "call" allow you to buy something, to gain the right. Or a "put", that's the right to sell something. So you can have a "call" option or a "put" option. Do you long in a position or short in a position? But in equilibrium, it's going to have an up-front payment for the expected value of the potential loss or gain is, in contract with the two parties.

And so the writers of the options are betting that they are not going to lose as much as we expected and the holder of the option is hoping that in the end that they are not over-paying --- that their losses in actuality would've been larger in that setting. But if there is no price change at all, if there's no price change at all in the underlying, the holder of the option threw away some money. So there's a risk there for the person that buys the option. So that's an option.

Options have this common sort of hockey stick pay-off function. You were just looking at just purchased options, those that have by the options or the right to win or lose. A purchased-call option gives you the right to buy a commodity at that exercise price. So how are you going to win by holding that option? You are going to win if the price goes up and you get to buy it more cheaply. So that the pay-off arises and if you can buy it at the exercise price, rather than having to do it at the actual market price. That's the pay-off per purchase call when you're buying. No, if the actual price is below the exercise price, the value of that option is zero.

Opposite for purchase put. Purchase put gives you the right to sell something at the exercise price. So what's happening here is that you can sell them at this price and the actual price is below, you win in that option. If you can sell it at a higher price, no pay-off at the other side.

Now, what I have up here is what we would see is the purchase of the holder of the right and the options pay-off function. What's going to be the writer of the options pay-off function? It's going to be the opposite, if that party wins this one's going to lose. There's going to be no loss of --- you can end up putting on the other side a different option that has this sort of features. But note if I put an option that has that sort of features, that line that goes together, if I put a written option and a purchase option's together, that line becomes something that you can win, lose at, both parties --- that becomes a forward contract.

So you put together a written option, with a purchase option, certain combinations and you can make a combination of options a forward.

Question/Comment. If you look at an option then as, really, it could be a hedge. If you don't want to play in that ball game, you don't want to expose yourself to the risk or you can look to have option that is speculation?

Tom. You can look at every derivative as both the hedge and speculation. I hope to convince you of that by the end of the day.

Tom. Yes, yes, yes! Every derivative choice requires that you take a view. What are you doing? Let's say that you've got fixed-rate debt and you want to swap it to variable. Why do you swap it to variable? Because you think interest rates are going to go down. You are saying you are hedging your exposures against interest rates going down, because if it goes down in variable you pay less.

What if they go up? Means that you forward a contract. You lose. How is that any different than betting on interest rates? You have to take the view when you do a forward contract. Flip it around.

Question/Comment. Suppose that you have a variable and you don't want to expose yourself to something that changes in the interest rate so you swap it to the fixed. Isn't that a hedge?

Tom. It is also a hedge when taking a view. What happens if you switch the fix and you've got a debt? You win if it goes up, you lose if it goes down. It's the opposite direction every time, the opposite direction between a fair value hedge and a cash flow hedge.

Comment. I guess I must have meant the hedge is that --- I view the hedge as --- I just don't want to play in the ballpark. I'll give up the right to win and the right to lose. I just --- what do you do though, when you're trading a derivative? You're betting that the interest rates are going to go one way or the other to your advantage. No, as I think that in some cases you're not betting whether --- you're betting that it may change but the direction of the change is not as important to you as the fact that it may change.

I'm talking about the point of view of your foreign currency. Because we have a small company that just doesn't feel like they have the expertise to play in that ballpark. So they just abstract themselves from that [unsure]. Whether they win or lose depending on how the currency rates change; that they will win or lose.

Tom. But not your value of cash flow that are symmetric in foreign currencies. Translation gains and losses versus transactions gains and losses in an earnings setting. It will tell you, you are going to win or lose at every bet that you take.

Tom. Well, what I want to convince you is you are always exposed to risk. If we got out of risk, we make companies treasure [bills--unsure] and I don't think any of us want to pay for the buying of treasury [bills--ditto].

There's going to be risk. In a derivatives [unsure] reshape the risk that you're exposed to, but you can win or lose. Whether you call it hedging or speculation. Almost any time.

Question/Comment. Tom would it be fair to say that when you are talking about winning or losing, it's almost relative to counterparty.

Tom. I think it's relative to a counterparty, but it's also relative with what your reasonable exposure was. And we will get to that in a moment. I've got some examples. It's going to change win or losing relative to what you have before the derivative. Yes.

Tom. Right, the purchase price --- when the purchase price is below the exercise price you can make money, when you're the holder of the "put" option.

Swaps. Basis "swaps". Here two parties are exchanging cash flow payments. If you think that any of you know about swaps, you're switching variable rate interest payments for fixed rate interest payments, right? The common sort of stock that you hear about, two parties are exchanging recurring payments.

Swap

Two parties exchange recurring payments

Similar to series of forward contracts

Interest-rate swaps most common

In a sense, it's a series of forward contracts. Because that's every, let's say interest payment day, depending on how floating rates changed vis-a-vis the fixed rate. One party's going to win, one party's going to lose. And if you set the swap on the yield curve in an interest rate environment, the up-front premium is zero again.

So a swap just happens to be a similar to a series of forward contracts. Interest rate swaps are the ones that are the most common. So look at the structure of plain vanilla interest rate swap, why call it plain vanilla? Because there's no embedded thing in there to blow up on you.

Here the structure. I don't know about these labels as being definitive. The fixed ratepayer or the fixed rate receiver could be the variable ratepayer or the fixed rate receiver; you could change things around. Well, we've got two parties in the contract. And one of the parties is going to be paying the other party a cash flow similar to interest and a fixed rate.

Now let's say that the contractual fixed rate for interest over this term-structure, this term to maturity is 6.75%. We call that multiplied by a notional principal. That's a terminology in derivatives that's different. It's not --- a notional principal is a principal that's really not going to exchange hands. You think about debt, a real principal is somebody who lends you the actual cash and there's interest rate payment of the principal.

On a notional principal, it's the defining amount that helps you define the amount of the underlying --- of the cash flow in the contract but it never changes hands. It's just a definitional term in terms of how you come up with the magnitude of the cash flow.

We've got a fixed-rate payer, paying the receiver of the fixed-rate, a fixed-rate on equivalent principle. And we have the other person paying a variable rate in return. Most common variable rate, a common variable rate is called LIBOR, which is The London Inter-Bank Offer Rate the rate at which banks are willing to exchange to money. Inter-bank offer rate, ok, at that price.

And so we have that sort of contract. This is a series of forward contracts. This party's going to win and if interest rates go down, because they are going to have the higher fixed-rate from the start of the contract. This party's going to win if interest rates go up, because they are going to be getting that higher variable rate. And what we are starting at is an equilibrium that the fixed and variables are equilibrium in the term structure and so nobody's going to win or lose [unsure of word]. It'll depend on how interest rates change over time. Series of forward contracts.

Now what is the importance of forwards, futures, swaps and options? First of all there is instruments that involve in the exchange of cash flows. They can be used to alter existing cash flows and because of that, very easily by the way, because of that they are going to comprise what we are going to call the basic risk management tools.

Importance of Forwards, Futures
Swaps and Options

Instruments that involve the exchange of cash flows

Can be used to alter existing cash flows

Comprise the basic risk management tools

They arose; they started --- we started seeing many more derivatives after Nixon took us off the Brentwood Accord. And if you look at a time series history of volatility in interest rates, foreign currency exchange rates and commodity rates; what we'll see if this is past time and this is the future, and this is early 1970's, it was taken off. When we went off, when the Brentwood Accord were broken and there was no longer a [pegged--unsure] exchange rate to the US dollar, you'll see volatility going like this; very tight, and then start bouncing around in all of those particular rates.

Now the Brentwood Accord would explain currency rates and interest rates. It won't explain commodity prices but remember we had OPEC in the mid-1970's, so that kind of dampened the variability and that broke apart when the oil prices started really getting volatile.

And so what we saw was in the mid-1970's is that underlying fundamental changes in the economics in our world economy. We no longer had to be experts in just our operating risks, but there were other sorts of risk that begun to explode. And that change in the variability and the dawning of the Black ScholesOption Pricing Model, that actually allowed us to price those changes caused us in combination to see an explosion in derivative instruments. To manage the cash flow variability that arises or fair value variability that arose that affected business ability to make money.

Question/Comment. I think I understand better that some of the entries. It can clearly see that with cash flows that the transactions a conventional kind of hedging planning. Do I have to considered any other entries at any other time with these derivatives? Or do I simply then rely on the FASB's pronouncement that at the end that I simply [tape faded].

Tom. So let's think about cash flows and fair values. The way I learned to think about that is that all that cash flow risk is [unclear] fair value. What is fair value? It's the present value of a series of cash flows today. So it takes account for all the cash flows. And the cash flow risk is not all the cash flows, it's the ---

Tom. What we are going to see is a fundamental building block of entries. The fundamental statement of SFAS 133 is get derivatives on the balance sheet at fair value, which represents the present value of future cash flow.

Question/Comment. So no matter what kind of [unclear], I just wait until the end of the year and take advantage of [unclear]?

Tom. What we are going to end up seeing is there's going to be a lot of work that’s going to go on if we say that derivatives meets very constructive and tight rules to say that it's related to something else. And you are going to have to do a lot of things during the year. And we will talk about all the things you've got to do. It's not just disclosure; one of the huge costs will be documentation. And we will get to that as soon as we start describing SFAS 133.

Hybrid instruments are embedded derivatives. I want you to realize that these are --- that simple derivatives are the fundamental building blocks of these complex structures. So when you see something called a structure note; all it is, is a note with an embedded option or swap in it. So the fundamental derivatives we talked about are the ones that comprise all other more complex derivatives.

A complex swap is a plain vanilla swap with an embedded option or leverage feature. And that is what happened with Proctor and Gamble. They wrote a swap that said that the worry was on the part of Banker's Trust that wrote that swap --- was that the yield curve was going --- the short-term was going to go up faster than the long-term. And so they wrote a swap that said we will have a normal swap, but in fact if there's a twist in the yield curve, we don't want to be held accountable for that on the Banker's Trust side. You are going to be accountable and that twist times 103 or times 97, I can't remember exactly what the leverage feature is; what's going to define the change in interest rates.

And it's exactly what happened in a very short time period after that swap was written. And people could say, what's the likelihood of that? Well I would suggest to you that Banker's Trust thought that the likelihood was pretty high, you can write that into the contract. And so people anticipated that and so they had an embedded sort of leverage feature in that contract that caused it to be an exploding problem swap for Proctor and Gamble.

So let's talk about managing risk with derivatives. We are going to find in SFAS 133 that there's this magical belief that the only way you can manage risk is with derivatives. The only way you can hedge accounting is with derivatives. But think about it. If you've got fixed-rate assets, debt securities as assets; how can you assure you're not going to be interest rate sensitive in a fixed rate exposure? They're the identical fixed rate liability over there.

When interest rates go up [on one--unsure], when they go up on the fixed rate --- you're going to lose on the asset or gain on the liability. That's going to be a perfect hedge of the fair value differences. And we are not going to see that we are going to be using anything but derivatives in that hedging process. And that's a little bit problematic for me for SFAS 133. It gets us thinking that the only way that you can manage risk is with derivatives.

But when we manage risk with derivatives, why use derivatives? They are low cost, they are very easy to get into, and you can transact them at very speedily. So they are going to be very easy things to get into. A forward or future contract, what's it going to cost you up front? The transaction cost to write the contract. No premium up front, because you [unsure] to likely to win or lose. It's not going to be costly to you. So it's going to be low cost and you can do it relatively quickly. If it's a futures contract, it's exchange traded. A future's contract is one in which you are going to have a lot of people interested in that contract so you can get to be on the exchange; corn futures, gold futures, those sort of things.

But if you want to write a forward contract on buying a pink polka-dotted Cadillac, you're probably not going to find a lot of demand on that on the outside market. You are going to have to do that privately. And that contract is not going to trade, that will be a forward rather than a future. But what you can do here is --- manage risks very quickly.

Managing Risk With Derivatives

Low cost, ease, and speed of transacting make derivatives attractive for managing risk

Different derivatives provide means of adjusting the timing, amount, and variability of cash flows / fair values

Ideal for both hedging and speculation

Different derivative products provide means of adjusting either the timing, the amount, or the variability of cash flows or fair values. When I was talking to Charlie, I look at those two as a continual. Cash flows is just isolating on the cash flows in a short term period, where fair values is the cash flows over the whole contract that we think about in a present value sort of sense. These are going to be ideal for both hedging and speculation.

Tom. It's a good question, isn't it? She asked why would any company want leveraged features in their derivatives? What Proctor and Gamble --- what had some effect on Proctor and Gamble, was they went out and wanted to lower their cost of financing by at least 50-60 basis points. Kathy, do you remember --- some amount --- 50-60 basis points, ok?

And how do you get that? How do you get a lower cost of financing in a equilibrium market? You take away some of the risk of the person that's lending to you. And so, to take on the risk of getting a lower 50-60 basis points decrease in their funding cost, by the way, the treasurer was receiving bonuses in lowering their basis points in their borrowing. They take on some risks.

Now they took on a risk that was huge. That the effective interest rates went from a normal amount to way HUGE and we are talking about way down [unclear]. I can't remember, but we're talking HUGE, ok? 119%, something like that. Some unbelievable amount if they would've continued in the contract. They settled out at a 56-57 million-dollar loss before taxes.

So how are derivatives used? They're used for risk management in the FASBs terminology we are going to call that hedging; and they're also used as speculative instruments. And as I will try to convince you some over time the line between those two categories for me is rather fuzzy, as to what is one and what is the other.

How Are Derivatives Used?

Risk management (hedging)

Commodity price risk

Interest rate risk

Foreign currency price risk

Speculation

I'm going to go through three ways in which derivatives can be used to manage original risk exposure. To sort of build off of what Tom is concerned was to [enlighten that a little more--unsure of phrase]. I'm going to go through a commodity risk example, an interest rate risk example, and a foreign currency price risk example. Those are good examples because derivatives are commonly in those rates or prices. And they're the key sorts of risks that are embedded with SFAS 133. Yes.

Question/Comment. Getting back to this fuzziness between hedging and speculation. Simply, does this statement continue the old practice in allowing management to contract the derivative [unclear] and not to designate it as a hedge, creating a speculative contract?

Tom. We'll see when we get to there, the basic fundamental issues. You put the derivatives on the balance sheet at fair value, with changes in those fair values going into earnings. Earnings is just a key term to me, that's not comprehensive income, earnings. Unless they meet very special criterion and then they can have special accounting. Not for the derivative, per se; not in a balance sheet; but for either a hedged item or what we do with the income in the income statement in certain derivatives.

Tom. Well, say more than designation. Meet the criterion, have it be deemed a qualifying hedge. You are going to see a lot of criterion here.

How are derivatives used? Let's look at a commodity price risk example. Let's say we've got a cost of mining gold at $350 per ounce, so we've to gold in the ground, it's not mined yet. But we think it's going to cost us $350 per ounce to mine it from past history. The current spot price is $400 per ounce. So that's what we expect to be able to sell it at today, that means we expect a $50 profit today. We have a lot of gold reserves. There's no doubt that we will be able to sell gold in the future. You've got ten years worth of reserves in the ground.

Commodity Price Risk

Cost of mining gold: $350 per pounce

Current gold spot price: $400 per ounce

Gold reserves sufficient for ten years of production

Company exposed to risk of decreases in future prices of gold

Cash flow exposure (forecasted transaction)

The company at this point in time is exposed to a decrease in the future rates of gold prices. They're going to lose if those go down, before they get it out of the ground and sell it. In the FASB's terminology, SFAS 133 terminology, this is a cash flow exposure. What is the cash flow and this could be the [trouble--unsure]. Why is it this [equal--unsure] fair value exposure to inventory? We don't have inventory. We don't have it in sellable form. This is a cash flow exposure, which suggests that the revenues, the future cash flows of revenues, are at risk. That's a cash flow exposure of what they are going to call a forecasted transaction. A transacted, the expected sale of gold in the future.

So we get back to that notion when we get into 133, hopefully that will help you a little bit. Tom, here's your original exposures. What's the original exposure of this company? Gold price of 400, with an expected production price of 350, their profit is 50. They have an exposure if the gold price goes down. If it goes down, that profit's going to go down. So there's down side risk from this point down on the curve.

There's upside potential if the gold price goes up. So right now they're exposure. Their original exposure is exposed to both up-price movements and down-price movements. Downward they are gong to lose, upward they are going to win, but they've got a full complete exposure to both sides of the movement. Yes.

Question/Comment. If they had --- if they entered into a contract to provide gold at a fixed price, a fixed amount and a fixed price; then do we change it to a fair value?

Tom. No, no it's always going to be a cash flow hedge if you don't have a hedged item on the balance sheet to have fair value. That's the distinction. Right now we don't have gold inventory on the balance sheet. We have gold reserves.

Tom. We don't have a firm commitment here to sell it. There's no contracting party that's willing to buy it.

Tom. Sure, then you can go the other way, exactly. But, no what happens there, it becomes a fixed contract if you have price, day, time. You have a price, ok. You're no longer exposed to this upward and downward movement. Cash flow hedge, here you are. And that's the difference in what we would see in the original exposure. The original exposure would look different on a fair value versus a cash flow hedge.

Question/Comment. Instead of taking the value of the future gold, why not hedge the value of the gold deposit?

Tom. Because it's very hard to write a derivatives' contract that would be effective for the gold deposit. Because you don't really know how much it's really going to cost to get it out. And that's why the FASB will not allow you, doesn't think in SFAS 133 that you can hedge the value of the gold in the ground. Because you are not going to be able to find the derivatives contract who's underlying changes very well. With that actual gold, until it's in more common form to know what the price is…

Tom. Yes, but it's very much more mined-specific than ounce-common, and that's the issue. There's a forecasted transaction we expect to be happening in the future with the sales price is in sellable form. Now, I'm not tell you…

Question continued. There's a fine line there [again, too faded to understand]

Tom. There may be a fine dividing line, but the FASB also addressed it in SFAS 133 that oil in the ground is not something your problems' going to have an effective hedge on.

Question/Comment. [Faded] is that contracts on book or is that unrecognized firm commitment?

Tom. When you use the word firm commitment, it's unrecognized. Synonymous to being unrecognized. So you can also have a fair value hedge of an exiting asset or liability.

Now what might they do on this setting? They might want to make sure that they get the $50 profit. What would be the easiest way to do that? What are they worried about here? They are worried about price going down. It's the only thing they're worried about. Price going down, they want to at least --- they want to get to 50.

And their view might be going into this derivative's contract; we're worried that prices are going to go down. If they are worried that the price is going up, it would be really stupid to do anything. Because even if you did an option in that setting, you'd be paying the premium that would be negative cash out flow. So if you think for sure prices are going up, you want to stay with the original exposure.

But here they have a view that prices might go down, and to protect themselves in that view at that least cost, they go under a forwards or futures contract. Because there is no up-front [cost for that--unsure]. What do they do? They go under a forward contract that allows them to sell short, sell gold at $400 in the future. So price goes down and they only sell at the real gold that comes out of the ground, they sell it at $375; but they're guaranteed to be able to sell it at $400. They make themselves whole because the derivatives contract is going to be worth $25.

So they sell the gold forward short, which says that if the price of the gold goes below $400, they are going to get a pay-off dollar for dollar below that $400 amount. But if price goes up, they just lost by doing this. Did they take a view? Yes, they took a view. Because this contract is a pretty stupid contract if prices go up. Because they capped that up-size potential. Yes, they are hedging the right to downsize exposure, but they've created risk of not being able to participate in up-side price movement.

And that's not much different than going into a normal derivative contract, or a normal investment of any type. You might win; you might lose. And they are changing their win and lose position by getting into this short forward contract. What happened to the short forward contract? We put the two series of cash flow diagrams together, they cross very nicely and in that position they locked into a $50 profit on any gold they sold forward.

Interest Rate Risk

Company issued a $100 million floating rate note with interest payments based on LIBOR

Interest expense: LIBOR X $100 Million

LIBOR currently is 7%

Company exposed to risk of increases in LIBOR

Cash flow exposure

let's say a company issued a $100 million floating rate so there's no fair value exposure is there, in a floating rate note? It's always coming back to the principle. They've got a company issued on $100 million floating rate note with interest rate based --- interest payments based on LIBOR. It's going to be LIBOR times $100 million in their interest payment in the floating rate note. It's the note payable. LIBOR is currently 7%. LIBOR goes up, not a good thing for this company. Got to pay higher interest.

So the company is exposed to risk in the increases in LIBOR. And this is the cash flow exposure. Because there's no change in fair value ever on a variable rate note. Because as that changes, the discount rate changes and you get back to the principle amount all the time.

So this is a cash flow exposure that your actual interest cash flows are going to change based on LIBOR. By definition they will change based on LIBOR, and in the SFAS 133 terminology, that's a cash flow exposure of an existing liability. We are going to see those cash flow exposures of forecasted transactions in existing liabilities as an existing liability. And I wanted to put this one up here because most of you will read 133, they say almost say, everything's a forecasted transaction.

They sort of gloss over the fact, they don't emphasize that there's cash flow exposures of existing liabilities. Because when they tell you forecasted transactions unlike my response to firm commitment, firm commitments are guaranteed to be unrecognized. They sort of try to scoop in cash flow exposures of existing liabilities and assets as if they are just like forecasted transactions. They don't maintain the definition's as nicely. So watch that when you read the 270-page ton called SFAS 133.

What's the exposure at each interest payment date? Well here, right now, LIBOR was 7%, so their interest is $7 million on this particular $100 million contract. What's the exposure? If LIBOR goes up there's a risk of increase in interest payments; LIBOR goes down, they win. Looks sort of like a forward contract, doesn't it? The original exposure looks like a forward contract. Things go one way we win, things go the other way, and we lose.

But what we might be worried about is this risk of increase. And so we don't want to be exposed to variable rate increase, so what we could use to hedge that exposure is a swap. An interest rate swap that has the same notional principal amount as the debt of $100 million. Note what happens in this. Here's the company with the exposure; they want to become a fixed-rate payer. They are a variable ratepayer right now, aren't they? They are paying variable out.

How am I going to make myself a fixed-rate payer? I'm paying variable out; the swap would work to have them paid variable to me. That would net me back to zero, right? And I would have to pay fixed-out on the swap. So one leg of the contract of this swap, the received floating rate to this company with the exposure negates what they are already doing on the cash outflow for interest and the [pay-leg--unsure] at fixed-rate, swaps changes the variable rate to a fixed-rate contract. And that's how they are going to hedge the exposure.

Question/Comment. In this case Tom, does the fixed-rate receiver, do they generally work on a transaction cost basis for their --- they attempt to be brokered…

Tom. The banker or any other mediator can make money two ways. One way they can make money is jump on the transaction [cost--unsure] to swap which is really low for a [pay-leg--unsure of phrase] swap, but they can make money on writing that contract. But if all they wanted to do was make money on writing that contract, they are going to have to negate their risks in this setting. Or they could make money by leaving themselves [bare--unsure] on this contract and really this person, the fixed-rate payer is believing interest rates are going to go up, the banker could be believing that interest rates are going down. And if the yield curves an equilibrium that's likely can go either way.

So they are going to make money on transactions cost and the banker and the mediator are going to have to decide whether they leave themselves bare there. If they are going to take it back, they are going to speculate themselves or they are going to have to go out and do their contracts that hedge that exposure. And a lot of times people ask questions where did the other side go in Proctor and Gamble, or in Orange County, etc… How come we didn't see it some place else? Because the bank and other intermediaries laid off their risks all over the economy. The only conversation that I was part of about Proctor and Gamble they would've taken them hundreds of millions of dollars of contracts to be able to undo what was happening there. But Banker's Trust probably hedged some of their risks there and so that loss or gain was spread over many parts in the process.

Question/Comment. Did you ever finance transaction? Is it the case where the [unclear] variable rates contract and turn them around [unclear]?

Tom. It can depend on their view, whenever they need protection. A lot of times companies will --- if you look at really borrowing almost all of them are fixed rate. Because for some reason there's lower transaction cost in fixed-rates. But if you really want a variable, what you do is issue fixed and you go right away to variable.

But others sometimes companies can lay this on at other instances. The problem that we have in the process here is that if you entered an option in a swap, you write the option; in other words, you are giving someone the right to [unclear] benefits and you get an up-front premium on that. The way we have accounting now, people can buy income that way. Because the swap accounting didn't disentangle the option and so there were representation fellows the FCC by sellers of derivatives that half-of the swap market --- and the swap market at the something like 20-30 trillion level was by up-front income. The earnings managed were buying swaps.

So that timing differences is going --- that timing issue couldn't go away now. So we may end up seeing that when they lay on swaps, it would be different than they are now. Because if it were for earnings management purposes to bring yourself into whatever your target is, it would be more frequent that it wouldn't be at the start than at other times.

Now that was just a representation of somebody who after the fact; when I talked to [Moore--unsure of spelling], he said that was pretty stupid of me to say that at the SEC wasn't it? Yes, it seemed kind of dumb to be saying that and I would suspect that he was exaggerating at the 50% level. But if it's even 10%, that's a lot, that's a lot. Yes, Bill.

Question/Comment. Question is that they enter into a fixed rate transaction costs or [lower--unsure]. And then enter into a swap.

Question/Comment. Would that work just because the swap involved notional amounts?

Tom. I don't know why the transaction costs and swaps are lower, but they really --- in competition got to be like 1 or 2 basis points. That's about ---

Questions continued. Because I was thinking on that well --- is if your transaction costs meaning you couldn't conceivably have [greater--unsure] transaction costs because you were entering into two transactions.

Tom. Well, obviously it would not make sense I know unless the net was less.

Question/Comment. The only thing I can think if is because the swap involves a notional amount is that the [guarantee--unsure] of the party is not providing the cash, it's just ---

Tom. I don't know the answer but it's going to involve [equity--unsure of spelling] risk, credit risk, a whole bunch of different risk factors that must be different in that setting. And so you might be right. But I don't know, but I have not empirical evidence as to what it is that causes the swaps to be cheaper than that fixed-rate --- variable rate debt originally.

Tom. So what are we going to do in this setting? If we're worried about movement, we already talked about the swap; here's what one of the cash flows in the swap will look like. Remember we --- just showed you the original exposure that told you that the outflows would go up if rates went up.

So if rates went up here in this setting in the swap setting; you are going to have outflows from the swap if the rates go down. Because you are going to become a fixed-rate payer at what was it, 7%, right at 7%, when the other persons' --- the leg you are going to get is less than 7% you [end--unsure] that outflows. You are going to settle that swap at an outflow to you.

But if prices go --- if interests rates go up, the net on the swap is --- you are going to have a net inflow. That's going to lower your outflows. And I had to draw this graph this way because my first original exposure graph was what the outflow was. So that's why this graph is depicted as it is.

What's the net position? After laying on the swap, here's the original exposure. Interest rate is going up. [IRA--unsure] payments haven't been paid. By swapping from variable to fixed, I'm going to lower that when we go above 7%. The net is, as you know, that we're paying a fixed interest rate.

Now is that hedging? Is that speculation? What is the outcome of the activity? The idea was, to think about reducing funding costs. Let's think about that more. Reducing funding costs of derivatives. Swapping from floating to fix like we just saw, reduced funding costs only if rates increase. If rates decrease, you're stuck at 7, not the lower rate.

Reduce Funding Costs With Derivatives

Swapping floating-rate cash flows to fixed-rate reduces funding costs only if rates increase

Swapping fixed-rate cash flows to floating-rate reduces funding costs if rates decrease

Funding costs reduced by "expressing a view" (i.e., by betting on movements in future interest rates)

Swapping from fixed to floating reduces funding cost if rates decrease. So by being either in a variable rate exposure or a fixed-rate exposure, you changed your original exposure, Tom, that was direction, from one or the other. But the move that you want to be here, the decision that you're going to do is, you're betting on changes what directions interest rates are going to change in doing that hedging strategy. When you use a forward or a future in that setting, you're betting that it makes sense. That interest rates are going to go one way and it's going to do the right thing for you.

If they go the other way, you've made a bad move. That sounds to me almost like speculating. What do you do with speculating? You buy an instrument; you hope it goes up. If not, if it goes down you made a bad choice. It's fuzzy to me as to what we're saying is the difference between risk management and speculation. That's why I think of everything as taking a view; in changing your original exposure to a different exposure.

Question/Comment. Would you explain to me [several years ago--not sure] that one motivation for borrowing [total--unsure] then swapping fixed, is it because of the [legitimacy--unsure] in capital [unclear]? You could borrow floating [unclear].

Tom. Which has to suggest that there is some sort of friction in the market or that you can arbitrage away that difference, right? You should be able to do it. I just don't know what the friction is that would suggest that we're equilibrium and it makes sense in costs. I do know though, that the more I thought about derivatives, the more there are underlying issues that cause those instruments not to be the same. And we have to start thinking about what those risks are, and they may not be market risks. They may not be changes --- exposure to market rates or prices. But they might be equity risks, they might be credit risks, they might be legal risks. There's a whole cornucopia of risks that we ought to think about and people are expert at writing derivatives' contracts to reflect those risks.

You know I haven't thought about this setting enough or have convinced myself what it is. But there is possible in a lot of settings that when you say cheese you know, there's an opportunity for arbitrage here there's a miss-pricing going on --- then there might not be a miss-pricing. There might be. But we've seen instances of where there's miss-pricing across the world derivatives' markets, that people get very good at making money on that really rapidly. So people are picking up on the abilities. If there are some frictions, they are not risk-based or not equilibrium correct, making some up. Obviously there should be some contracts out there where that isn't obvious, and yet people haven't exploited it.

But the one area I'd be pretty convinced that people would've thought about is borrowing and swapping. When that happens enough times and I think there was an arbitrage opportunity, people would've done that.

Suppose a company commits to purchase machinery from a manufacturer --- a French manufacturer, sometimes in the future. The payment is for 10 million French Francs to be made six months from now. So it's something in the future. Currently you can get a US Dollar --- the US Dollar-French Franc exchange rate is 20 cents US Dollar for every French Franc.

Foreign Currency Price Risk

US Company commits to purchase machinery from a French manufacturer

Payment of 10 million French francs (FF) to be made six months from now

Currently $US/FF exchange rate $.20 per FF

US Company is exposed to risk of increases in the $US price of a FF

Fair value exposure (firm commitment)

So right now the contract says we buy this machine in dollars at 10 million dollars. That's what we expect there. The company's exposed to risk of increases in the price of a US Dollar for French Franc. Exchange rate goes up above 20; they are going to have to pay more six months from now. So that's their price exposure.

In SFAS 133 notion is a fair value exposure of a firm commitment, assuming that his purchase --- you know the contract, you know the quantity, you know the amount, you know the timing. Its all there in my description. And there's a legal and forcible contract available through the firm commitment.

But this is a fair value exposure of a firm commitment. It’s a firm commitment because it's not an existing asset or liability yet. It will become one. It's a fully executory contract that we don't recognize that asset yet until some party performs, normally. So there's the commitment, you've got a contract to buy the asset in the future, but we don't normally put that on the books when you've got a contract. So that's why this is a firm commitment. I'll buy this six months from now for you.

Tom. Nothing's been delivered and you haven't paid anything. You've just got a contract to agree to buy something in the future.

Tom. To agree to buy; that's good, the impression's good because we need to make that clear what this is. We just agreed that six months from now that we are willing to buy this thing at that price.

Tom. Six months from now and the six months from now are also [unclear]. Yes.

Tom. You ask --- well what is the cash flow [--- revenue or --unclear]. What is the fair value? The total amount of the present value of the effected cash flows. What are we going to do in accounting when we buy this thing? Put it on the books as an asset. What's our exposure? That asset, the fair value of that asset's going to change from 20 to 2 million dollars.

Tom. Yes it is definitional but this is a fair value hedge. You fair value the asset liability, not cash. And I know cash is an asset.

Comment. You say fair value represents future cash flows. In here is everything in this contract is already determined [unclear] cash flow hedge ---

Tom. And this gets back to what I said to Charlie. Before I think the difference between [cash-book--unsure] and fair value if you look [unclear] bookkeeping, if we hedge the value all of the cash flows --- fair value. And if you're only doing a part of it, for a certain period of time and there's more, [hence it be more--not sure] like cash flows.

Now I don't know if that --- I'm not that all [sure--unclear] as whether that's definitive for everything, but I think that works. Here we're doing all of it.

Question/Comment. Isn't this Tom, based on FASBs decision to recognize certain executive [not sure] contracts when there are derivatives involved?

Tom. Yes, we are going to find out that this non-recognition that we don't normally see.

Tom. Remember there is a distinction, but there is also a cash flow hedge of existing assets or liabilities too. So all cash flow hedges aren't forecasted transactions. So that's the difference I think, what you choose to call your hedge. What you decide to hedge. You can make your choice. In some respects, you can make your choice whether it's the total present value of the sum or it's part of it.

Question/Comment. I do have a question about that one swap having a [unclear]. Seems to me that would be fair value [unclear].

Tom. Well, no because think about the fair value of the variable rate note [on bond--unclear]. Does that ever change with rate change? There's no cash flow --- there is no fair value to support that because it's fixed.

Tom. That's right. But principal counter-acts to get the same total fair value at all time.

Comment. That's kind of a special case having some liability that cannot [be of--unsure] fair value.

Tom. Cannot be a fair value hedge. Cannot be because there's no fair value exposure there. So we really have to get to the essence. No, every time I start to hear [as I cover an--unsure] original exposure and I drew on the diagram what are exposures. You know outside the potential [unclear] where is the variability? And some instruments can be both cash flows in fair value [depending on whether you're looking at--unclear] or hold. Otherwise, it's not possible at all. Either of fair value or cash flow. That's truly one or the other. Fixed rate debt is fair value exposed. Variable rate debt, cash flows.

Question/Comment. If the main product goes down because the exchange rates different, that would be a cash flow exposure, wouldn't it?

Tom. Yes, now they actually talk about this on 133. So [it's in the right implication for--unclear] changes in foreign currency rates on ---

Tom. That's right and they will talk about that, that it's very difficult to say that a derivative can hedge that effectively. Because there's too many links in the channel to know how that change in foreign currency exchange rates really flow through your operating activities. But we know that the US Dollar - Japanese Yen exchange rate changes that's going to add implications for the ability to Japanese automakers to sell automobiles here. Probably not much on our ability because we don't get into that. But you know there will be some implications [unclear] in their operating, in their ability to supply demand here. But the linkage between the changes in the rating and what's going to happen there are so far reaching and there's so many steps for it, they suggest that you can't hedge that for the derivatives. You can get special accounting, you can hedge it with a derivative by choice, but you have to treat that as if it's an unhedged position for accounting book.

Tom. No. And we are going to end up seeing that they worked real hard on putting the Chinese wall up that I'm talking about around what is a derivative and what is the exposure that you can have. They limit both. That's what makes this very complicated.

Tom. Here's our exposure. Right now the exchange rate is $ .20 --- US price of a French Franc is $ .20. If that goes up, you will have to pay more six months from now, because we didn't set the price. We set the price in Francs but not in Dollars. So you have to pay more in dollars to get this thing. Obviously if it goes down, we win.

What's this company's thinking about; this company is going to be a little bit more sophisticated. They are not going to wipe out this whole exposure. They are going to say, let's think about these strategic issues. The company believes the price of the French Franc might go down, it might go down. They actually think that's a possibility. They are not just worried about it going up, they think it might go down and they don't want to take out the possibility of the gain, the lower cost, if it goes down.

So they are not going to use a forward or a future. And they are not all that concerned about having to pay 2.5 million for this asset. They are concerned if they have to pay more. So they are not worried about all increases, just increases above a certain amount. Sounds like they are going to buy insurance, right? They buy an option; their hedging instrument is going to be an option.

That option says it's going to be a call option, which says that they can buy that machine --- they can buy it. Not the machine, they can buy the French Francs at $ .25, guaranteed you can buy it at $ .25, per French Francs. And so if it goes above $ .25, for every cent it goes up, they are going to get a cent back, which will negate that increase. But there's the hockey stick pay-off function for that particular contract.

It's going to be the net cost of the machinery in this setting. It's going to be a little bit more complicated. Remember our original exposure was they paid the price whatever it was per French Franc, up and down. The pay-off function on the option is, I just inverted it. Remember this was an outflow and the hockey stick, the upper, was the inflow we got. So I ended up coming over here at $ .25 and here's the inflow that counter-acts the outflow and so what they are going to pay is --- if price goes down, they are going to receive all the benefits of the price going down. But if it goes up above $ .25 per French Franc, it's capped.

But where is the risk now here? It's not the downward price movements it's great. It's not the upper price movement, above $ .25. The risk [unclear]. The risk is that it stays at 20 or 21 or 22, 23 or 24. Because what did they do in that setting? If they didn't change their exposure there but they paid an up-front premium for the cost of the expected exposure change. And so where they are going to lose or make a bad decision is in that little range. They changed their original exposure.

Question/Comment. Cost of premium is that capitalized on the after --- [unclear]

Tom. Up-front it's the time value; we are going to call it the time value of the option. But it's going to go on the option account. That's going to be the up-front cost of the option.

Question/Comment. So why do you say it's a bad decision only in that little range? Isn't it a bad decision anytime the price falls?

Tom. That's true, you're right. You're absolutely right, you're absolutely right.

Speculation with derivatives, speculation primarily the domain of the viewers and sophisticated traders is what the idea was. It's primarily their domain that's where we think speculation occurs. I would venture to guess a lot of the corporate that got caught in 1994 we very, very seriously think about some of their options --- some of their derivatives they invested in as also being speculative.

Speculation With Derivatives

Speculation primarily domain of dealers and sophisticated traders

Speculative trading based on investors’ views of future market movements

Using interest rate swaps to reduce funding costs also requires "expressing a view" (i.e. form of speculation)

Query: Is risk management much different from speculation?

Comment. I have a comment as to what you think their motives are at the CEO level for these speculative derivatives.

Tom. Well for a lot of the catastrophic losses that we saw in '94 and '95, the CEO had no idea that is was going on. There was not a good set of risk management policies and procedures or what was being represented to them as we were in very plain vanilla instruments. So a lot of what has happened is some internal controls have been placed within companies that define what the risk management policies and procedures are and many corporate now have a rule--plain vanilla. None of this embedded sort of stuff.

So, it's not clear to me that the CEO knew, or the CEO understood. Even if they knew, that they understood what was going on. And some of the comments in the press were, if the CEO really knew what was happening, understood, this would not have happened.

Tom. No, I think this was others talking, others talking. Obviously they CEO's that got caught are not good people to [go--unclear] get truthful responses as to their level of knowledge. So there has been some internal control developments that has been going on in setting what they wanted to be doing. But I told you that Proctor and Gamble's motivation for the treasurer was to reduce funding costs because the compensations --- his compensation contract was tied to that.

Question/Comment. You think that was a fairly typical background [too faded]?

Tom. It was --- there were --- that was not a-typical at that time period. I think people realized that there was a really perverse incentive placed on that person that got companies in trouble and I don't --- I'm pretty sure that things have been re-contracted over time.

Question/Comment. Do you think placement of stock in that [unclear] top-level executives trying to pretend to be better than they are by ---

Tom. Oh, I place a lot of theory in the notion that derivatives can be used for earnings management purposes and for helping managers with their compensation by getting them in perfect --- in ranges that makes sense. There's a whole series of theories as to why firms getting into derivatives I'll be talking about at 10:30 tomorrow. But the only empirical evidence solid is while compensation contracts and maybe hedging your investments are indeed activities. You try to deal with internal financing rather than with external financing.

But there is not a lot of empirical evidence other than maybe managers using these internally for their own compensation benefits. The question on the outside is does the investor want them to do that? Does the investor want a company to be in derivatives? Why wouldn't the investor invest in their own derivatives and hedge their own risks in the portfolio? Yes.

Question/Comment. What would the answer be on that last question about the machine? What would be the cost on the machine?

Tom. It depends on whatever the dollar price for French Franc was when it came out. In the accounting you're talking about?

Question/Comment. Yes, you capitalize [that it comes out a difference. We are going to capitalize in there--unsure of whole phrase]

Tom. You are going to capitalize at $ .22. Whatever the fair value of that machine is. The machine's going out on that fair value. You are going to also end up having some counter accounting for that particular transaction in the derivative's contract that will settle things out. So that the net implications for the company in cash flow is to cap it at 25. But the machine is going out at fair value.

Question/Comment. I want to go back to [debits and credits here--unsure]. When you record that machine's purchase ---

Tom. Let's save the debits and credits until I get some examples where I've got debits and credits for you. Right now all I want you to think about is exposures and what could be managed and what's happening in those exposures. I'd --- we could end up doing those entries and there will be a series of entries over a series of dates and we've got some examples later. Not on this exact study, but you'll see how on a fair value hedge things work out [unclear].

Tom. Remember this is a commitment, so you are not going to record the machine until it's purchased. And you are going to record it at fair value. In the [acquired--unsure] time period, you've got the derivatives on the books. With this price going up and down, as the price changes and as you net that out, the cash flows' going to be capped at 25 --- at $ .25.

Tom. You are going to record the option in your derivative contract. And you are going to settle the derivative at the purchase date. So when you settle it, it's going to be in the money or out of the money. If it's in the money, you're going to end up taking it off at value. And ending up having a gain that ends up a lot --- you're going to take it off. And is going to --- well it depends if its an asset or a liability. What position --- well it can only be an asset. It can only be an asset if it's not.

Question/Comment. Let me attach a number to this. Suppose you purchase the price of the French Franc is $ .30. [Unclear] you are going to have a $500,000 gain or option. Would you recognize the earnings immediately? [Unclear]. Isn't it --- recognized ---?

Tom. Because it's a fair value hedge, you are not going to --- one of the key things when you get to SFAS 133 is we don't end up basis adjusting anything. We don't end up taking the implications of a value change in the derivative and putting it into the attached contract. We view this as a company purchasing machine, a comparability basis; you want the machine to go on at what it was worth when you purchased it. Whether or not you have the derivative and have the derivative implication in the derivatives account.

So we are not going to end up having basis adjustment any longer. Now that was possible in the past. But there's a work here to say what measurement attribute are you recording these things at? And whether we can make it more consistent. We're still going to have problems with that and I'll talk about that later.

Tom. Well, that's right, and we're no longer thinking about that. We're going back to more what we think about is, separate transactions are counted for separately and we [aggregate--unclear] them through into the income statement; their implications separately. But the net effects are all there in the income statement and separately in the balance sheet.

We are not tying them together and doing any aggregation and linkage together on the face and one line account. We are doing them separately.

Question/Comment. What if the French Franc price of the machine drops? Are the value of the French Franc [unclear]. Are you still going to be recording the machine at fair value?

Question/Comment. Even if the French manufacturers install the machine as opposed to the now [unclear] for only 900,000 Francs ---

Tom. You already have a firm commitment for the price. You don't get to re-contract that.

Question/Comment. That's historical that cost based on current fair value of Francs. That's not the fair value of the machine. If you bought the machine now for 900,000 Francs, $ .30 equals $7 million dollars, not $3 million dollars.

Tom. The fair value of the transaction price is what it is you pay for it when you agree to pay for it. It's what you're willing to contract it at, to exchange it for. Yes. There are impairment issues. You can still have impairment tests after the fact. But the transaction price is what we account for.

Question/Comment. I guess I'm probably still in 52, but if the value went up to 30 million based on the exchange price and we had a firm commitment to buy it at 22 ---

Tom. We don't have a firm commitment to buy it at 22. We have a firm commitment to buy it for 10 million Francs. That's the firm commitment. That price can change because we are going to have to do it in Dollars because our functional currency is Dollars. The 10 million is not changing. The firm commitment is for amount, quantity, and timing.

Tom. With the fair value hedge, you are going to recognize it in the settlement of the contract as the contract's settled. So that net cash implications are you bought it for whatever the net was, cash implication. The machinery is going to be on the books at its fair value. And its transaction price, if we want to move from risks in changes on that amount. We'll see that as we move on.

Speculation, we've already talked about that. The domain of dealers and sophisticated traders speculative trading based on investor's views of future market rates or movement, using interest rate swaps. The hedge or risk in a debt is also expressing a view in market rates movements. The question I ask you is, is risk management much different from speculation?

It's going to come down to this fundamental issue, one of the four cornerstones of SFAS 133 is, we should have special accounting in a risk management setting. And I think we ought to step back and think about whether this is really uniquely different than speculation. We're working really hard at special accounting here. And we're putting together about as complex a statement as I've ever seen. This thing's, what, 200 and something pages long, and they put it on thin pages to fool us. It's not normal thickness pages for the FASB. To make it look smaller.

Do we need to work that hard at coming up with special accounting, if really what it is, is not much different than speculation, it's just changing your exposures. Should we work so hard and make our heads hurt so much as to how things are going to be tied together in this process? I don't know. I'm not answering that question, but we're working awful hard at coming up with a specialized model.

No, a company --- manufacturing company can speculate with derivatives. Here this manufacturing company anticipates that a certain commodity will soon drop in price. This business has nothing to do with the commodity --- nothing to do with this commodity. They are not in business with this commodity. But they think it's going to drop in price. They think they have an expertise in guessing at gold price movements.

Speculating With Derivatives

A manufacturing company anticipates that a certain commodity will soon drop in price.

To exploit this belief, the company sells the commodity for forward (or future) delivery at a price reflecting the current market consensus

If the price does decline, the company can buy the commodity in the spot market and deliver it against the forward contract

Profit = Forward price - spot price

So what they do, they decide --- they decide they are going to try to make some money on that knowledge. So they go out and exploit this [lead--not sure]; the company sells the commodity forward for future delivery at a price reflecting the current market consensus. They thing it's going to sell for 400. The market thinks it's going to sell for 400 and they think it's going to go down. So they buy it and decide to sell it forward for 400. If the price does decline and the company goes out on a [date at that time--unsure of phrase] and buys the products at 350; it turns around and sells it for 400 and makes $50 with the difference between the forward and the spot rates. Companies can do that.

You might actually want the company to do that if we think that they have some comparative advantage of being able to know about these markets. I certainly like to know that when I buy the company. That they're not only doing their operating risks but they're doing these sorts of things so that's the way you can speculate.

But is that much difference from the gold example I just told you? If gold now is their business, if they had to decide whether they wanted a $50 profit margin or not, is it much different? I think for sure that we would say that's speculation. If they're Sears & Roebuck and they're going into commodity gold futures, I don't know. What I want to leave you with as we go to break, and after break we will come back, we'll do SFAS 133.

What we are going to do for the rest of the time here is talk about FASB's SFAS 133. Give you an overview of its guidance, and then go through some examples and give you an evaluation. The compass there is so to say that this is something there that we might need some steering through.

Why do we have a change? Why the change in SFAS 133? Well first of all, the quantity and variety of derivatives is increasing. If you go from 1990 to 1997, the number of [OTC--unsure] contracts sent --- we increased 10 times the amount and the notional amounts of [OTC--ditto] contracts and derivatives in '97 projected were 30 trillion dollars. This is not a small market. So the amount and variety of derivatives is increasing greatly.

SFAS 133: Why the Change?

Quantity and variety of derivatives is increasing

Accounting conventions and standards are outdated, incomplete, and inconsistent

The resulting financial statements are not transparent

Going into SFAS 133, the accounting model for derivatives was inconsistent, incomplete, and outdated. Inconsistent in that it didn't address all types of derivatives. Inconsistent also in that 180 said; look at enterprise risk reduction. 52 looked at a transaction's basis level. We had a lot of inconsistencies across the two primary Documents 52 and 80. Or even the same sort of derivative instruments, and it was incomplete. Didn't address also a derivative instrument. So when I was at the SEC, it became bloody obvious that by analogy, people can do almost anything. Unless it was exactly a future's contract under 80, or it was exactly something in 52. People, even people trying to do a good job had difficulty.

And then we know that there are incentives not to try to do a good job. And so we have broken accounting models that made the results of a derivative in the financial statements not transparent. And the example that I just wanted to give that related to what we were taking about previously, previously in 52 you actually took the derivative gain or loss and did a basis adjustment on that asset that we were buying. And so the implications of making the choice to hedge it was not transparent to anybody on the outside. And the same company making the wrong call all the time, nobody knew the right call. There was no separation, there's no idea of getting any notion as to how well these risk management activities or these speculative activities are for a company in terms of ascertaining whether you want the [unclear]. We had little or no transparency; derivatives are not on the balance sheet prior to 133. Except maybe an option premium. And they are not in all settings.

What are the four cornerstone decisions of SFAS 133? And I think these are --- this is the place to start if you want to try and understand this statement. These are where the board started from there are four fundamental decision, the cornerstone decisions.

SFAS 133: Four Cornerstone Decisions

Derivatives are contracts that create rights and obligations that meet the definition of assets and liabilities

Fair value is the only relevant measure for derivatives

Only assets & liabilities should be on balance sheet

Special hedge accounting should be provided, but should be limited to transactions involving offsetting changes in fair values or cash flows for the risk being hedged

First of all, derivatives are contracts that create rights or obligations that meet the definition of an asset or a liability in Concept 6, and therefore should be recognized on the financial statements. Now the problems with that statement is that it might have already been true, but if we did it at an historical cost measurement attribute, what would you put a forward or a future on it to contract it? [Day--unsure] zero.

And so that leads to the second fundamental cornerstone, fair value is the only reasonable measurement attribute for derivatives. The risk or loss of gain or loss isn't there at the start on a forward or a future, it arises at the rate of price changes occur over time. And if we are going to pick up with consequences [of those are--unsure of phrase], we need a fair value derivatives or there's not going to be on a financial statement on the face of the balance sheet. So that's the second one.

Thirdly, they will say we only want assets and liabilities on the balance sheets. Remember the old concepts under --- what was it --- 52 or 80 that we could defer a gain or loss and call it an asset or liability. The board decided that really stunk. That's not something we want to be doing, is deferring gain or loss. For a loss, you call it an asset. How could a loss possibly be an asset? How can a gain be a liability, in a deferral notion? They decided when we go about setting up this accounting model; we are not going to have anything that is just a deferred gain or loss on the balance sheets.

Now that doesn't mean that certain measurement attributes and [assets--unsure] like a firm commitment, that the deferred gain or loss is not going to be the amount that we put the asset or liability in the book. But they say a firm commitment is a potential asset or liability. So they're kind of [unsure] here. They say they don't want a deferred gain or loss. They are really very special with today, that they don't want any assets or liabilities. But they're still going to fall back in this compromise to come up with this complicated model; that we want a firm commitment saying we are going to measure the firm commitment in a deferred gain or loss. Amount.

Finally they did decide; and remember I was trying to set you up here to wonder should we really have special accounting? Should we really have hedge accounting? Because of its nature, what's the difference between speculation and risk management? But they did decide that special accounting should be provided. Frankly, they had no political ability to get rid of it. We are going to see that they'd like to get rid of cash flows exposures and they had not political ability to get rid of cash flows hedges.

So they decided that special hedge accounting should be provided, but limited to transactions involving offsetting changes in either fair values of the derivative in the hedged item, or the cash flow exposure; offsetting changes in fair values or cash flows. And they are going to work real hard, they are going to work really hard that if the offset is ineffective, that the ineffective portion gets measured.

So we are not going to presume that it’s a perfect hedge. That the extent that it's not perfect, they are going to want to be able to try to make that flow through earnings. And they can almost do it until we came to the cash flow --- one of the cash flow hedge exposure anomalies, and I will talk about that in a bit. They couldn't get all the way there.

What are the key aspects? If I had to summarize 133 in a short presentation, I would say that. But you will see that, that doesn't have a lot of explanatory power. Overall that's what they decided on 133. All derivatives are at fair value on the balance sheet. And special accounting might arise, special accounting for the change in the value of the derivatives designated in a qualifying items, in either fair value hedges, cash flow hedges (most often thought of as in terms of forecasted transactions), and foreign currency hedges.

SFAS 133: Key Aspects

All derivatives are at fair value on the balance sheet

Special accounting for the change in value of derivatives designated and qualifying in:

Fair value hedges

Cash flow (forecasted transaction) hedges

Foreign currency hedges

Don't be deceived that foreign currency hedges are different than cash flow or fair value hedges, they are not. They are examples of cash flow, fair value hedges. They put them separately because they didn't want to destroy Statement 52. We are going to find that every foreign currency hedge is an example of a fair value or a cash flow hedge, even a hedge of a net investment in a foreign sub, because that is going to be the fair value exposure in the transaction gain or loss.

So this is just a special category to help them in putting together the literature. They are going to deep 52 in place, 80's gone. But they are going to keep 52 as is; though there is not a lot said about hedge accounting in 52.

Why allow hedge accounting? Remember I told you the controversial choice is the fourth plane. Why allow it? You know, if we start thinking about all the problems in our accounting model, almost all of them that we struggle with now are either have to do with consolidating together entities or combinations, or certain recognition in measurement anomalies because we account for parts as parts, right? We account for line items; we don't look at it as a whole all the time.

Why Allow Hedge Accounting?

To resolve recognition and measurement anomalies

These anomalies cause earnings effects in different periods for hedging instrument and hedged item

And the effort is we are going to have some potential recognition in measurement anomalies. And what I mean by that is those anomalies in the balance sheet in terms of what we recognize and what we measure them. Since we're primarily an asset liability point of view; we are going to cause anomalies in the earnings effects as to when the earnings effects of hedged items in hedging instruments falter earnings.

Hedging instruments being the derivatives, hedged items being the items whose exposure are being hedged. And so there's a problem and most of this happens with the mixed, a mixed attribute model, where certain items are fair value if those changes in fair values currently going through earnings, where other items might be at different attributes; historical cost, lower cost, or market. Where the timing of those changes are not as contemporaneous and don't fall through earnings at the same time.

So all special accounting is, is an effort that if we think we can link together hedging items and hedged instruments. If we think we can link them together, that we are going to work to get the earnings is something that you want to listen to when I say earnings. That means our old net income. From that beyond earnings we have the other comprehensive income items to go to comprehensive income. We are going to make a distinction. And it's going to go to earnings together. To be able to have some of them go to earnings together, we are going to park the implications of the cash flow hedge in other comprehensive income until the hedged items effects [go up to--unsure] earnings. And then we are going to get the gain or loss on the hedging instrument earnings at the same time. That's how we are going to work at that.

So this is the resolve recognition and measurement anomaly. Why did I say recognition anomalies? What I just described is a measurement anomaly. The firm commitment notion is a recognition anomaly. People would actually say that a firm commitment in some respects is an asset or liability. We've just decided not to recognize it when it's fully executory or both parties' parts yet. Because an asset says future benefits under the control of the entity based on past transactions. That's true of all firm commitments. But we don't recognize it until one party --- one party does something on the side of the contract. The forward represents that as a recognition anomaly within SFAS 133.

Common Reporting Issues: Qualifying Hedges

Documentation requirements

Effectiveness and ineffectiveness

General disclosure requirements

Specific accounting and disclosure rules

fair value,