Trying to qualify for FAS 133 special
accounting is a big undertaking. It’s been eating up
thousands of hours for treasury, accounting, the
controller staff, as well as for bankers, auditors,
consultants and software vendors. That’s because the
rules in FAS 133 are complex, rather different from what
used to be market practice—and far reaching. For
example, FAS 133 defines a lot of commercial contracts
as derivatives, expanding the definition beyond its
traditional bound.
Is it worth
it?
The alternative to working
hard to adopt FAS 133 is to mark to market all
derivative positions in income. That’s easier said than
done, notes Mr. May of Arthur Andersen. While
many companies list mark-to-market as an alternative as
they analyze their derivatives book, and some may even
choose to mark to market some of the positions, most
won’t be able to swallow the volatility impact of taking
the entire derivatives book to income.
“In some cases, it is operational
cost vs. minor volatility decision,” acknowledges Mr.
May. That’s particularly true in simple hedge strategic.
Analysis performed by Mr. May. For example, Mr. May’s
article, To
Designate or Not to Designate? illustrates that
some forward hedges of FX exposure may generate only
minimal volatility if left outside the scope of special
accounting. In such cases, hedge accounting is a
non-issue. But before companies can decide whether the
tradeoff is worth it, they must forecast the potential
volatility effects of marking their derivatives to
market. “It has to be an informed decision,” he
says.
“Everybody likes to talk about it
(marking to market), but at the end of the day, they
will have to report some sort of volatility,” says Mr.
May. “Assuming that you can meet the effectiveness test,
you get at least a portion of the gain/loss ‘deferred.’
That’s better than nothing,”
Certainly some hedge strategies will
never meet the requirements of the effectiveness test,
no matter how liberal the test. In such cases, companies
face a couple of options: They can discontinue the
hedge, which may make plenty of economic sense (just not
FAS 133 sense). Alternatively, they can carry on their
program and find ways to mitigate the volatility impact
of the “non-conforming” hedges.
Risk SAP, Cygnifi, for example, is
working with the Centre of Quantitative Finance (CQF) of
the Imperial College in the UK to develop a way to
minimize residual volatility by optimizing hedges on a
portfolio basis.
While hedges will still have to meet
the relationship criteria of FAS 133, notes Leda Braga,
head of Cygnifi’s valuation service, the tools may be
used to optimize the percentage of underlying being
hedged to mitigate expected volatility. Effie Miskouri,
a researcher with CQF/Cygnifi, has been working to
define effectiveness as a function and put constraints
around the system so that each individual hedge/hedged
item pair still meets FAS 133’s rules and develop an
optimal coverage ratio to minimize resulting
ineffectiveness. Cygnifi is only at the beginning of
this process, but it hopes to have some tools available
in a matter of months (meanwhile, it offers regression,
scenario analysis, variance-reduction and dollar offset
(80-125%) as part of its standard tool kit.
Another way to control the resulting
volatility, Mr. May reports, is to attempt to “insulate”
those non-FAS 133-conforming positions by creating a
portfolio of them and ensuring that (1) together they
naturally offset each other; and (2) if they don’t, put
some derivative hedges against them to “fence off” the
volatility potential – hedging the hedge, if you will.
“You have to be careful that it does not negate the
economic effect of the hedge,” Mr. May cautions. But
this approach may be help hedgers accomplish
economic/risk management goals while containing the
mark-to-market impact of the “ineffective” hedge
portfolio.
It’s easy to think that effectiveness only
really matters when it comes to cash flow hedges—that’s
where the old “deferral” accounting has found a new
incarnation in the form of OCI. But, effectiveness
matters regardless of the hedge-relationship type. “It’s
important for both cash flow and fair value hedges,”
says BofA’s Mr.
Capozzoli.
- In both cases, effectiveness will determine
whether the hedger will get any hedge accounting at
all.
- In both cases, there are hedge strategies
in which it would be important to coincide the
recognition of changes in value of the derivative with
the underlying. “in a cash flow hedge, effectiveness
will determine whether or not gains/losses can be
parked in OCI. In the case of fair value hedges,
effectiveness will determine whether hedgers can
recognize gains or losses in the current period that
otherwise would not.”
Still, not all hedge strategies are created
equal, when it comes to effectiveness testing. Some
strategies are more prone to ineffectiveness than
others. Generally, as long as the hedge and hedged item
match up nicely in terms of duration, reset dates and
currency/benchmark rate, there will be only limited
volatility. Any time basis risk and credit spreads enter
the picture, however, there’s the potential for all
sorts of trouble.
Here are some examples of strategies likely
to cause volatility
headaches:
(1)
Proxy hedges. Proxy hedges introduce a
fair amount of basis risk. And just because the euro is
here does not mean proxy strategies are gone. For
example, Mr. Capozzoli notes that a popular strategy of
late, has been to use the Swiss Franc as a proxy for the
euro since hncredibly strong relationship and the franc
offers a nice IR pick up.” Another possible strategy,
for a euro-functional company would be to use the US
dollar as for a pegged currency, such as the Hong Kong
dollar. While the currencies truly move in tandem,
analysis by Mr. Capozzoli reveals that in the case of
the Swiss franc/euro proxy, the hedge would have failed
the effectiveness test on a dollar-offset basis several
times in recent quarters.
(2) Basis
risk. There are multiple common hedge strategies in
which the hedge and hedged item’s benchmark rate
diverge. Hedging CP is one such example. Another form of
basis risk is credit sector spread. While FAS 133 allows
hedgers to “ignore” credit spreads in some IR hedges
(i.e., hedgers of the risk-free rate), it is only in
cases where the risk being hedged is the benchmark rate.
So CP, again, is a problem since it’s not a benchmark
rate under FAS 133, and CP prices and credit spreads
fluctuate considerably. (For more on CP hedging see, Hedging
CP: The FASB Speaks Out.
(3) Timing
mismatch. Another potential source of
ineffectiveness is any timing mismatch, for example,
reset dates on a swap and an underlying, or a hedge
that’s shorter (or longer) than its underlying (i.e.,
partial term hedging). “There are situations in which
hedgers may be unsure of the maturity of their
exposure,” Mr. Capozzoli
notes.
(4) Finally,
exotic options. While the final word may not be out
on hedge accounting for options, there’s no question that complex options with
multiple benchmarks and components will not, en masse,
qualify for hedge accounting. Still, there may portions
of an exotic option that could be designated as hedges
and receive hedge accounting treatment. “With some
exotic options,” Mr. Capozzoli notes, “you can cut the
option up into components whereas some pieces do not
have to be designated as ineffective by design, (e.g.,
forward equivalent
structures).”
