Introduction

Purposes of this Case

Case Questions

Student Questions

Excel Workbook

Exhibit 1 
FAS 138 Benchmark Interest Value-Locked Debt Accounting Case: Definitions of Basic Symbols --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/138exh01.htm    with a local link 138exh01.htm

Exhibit 2 
FAS 133/138 Benchmark Interest Value-Locked Debt Accounting Case: Example 2 from Appendix B in Paragraphs 111-120 --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/138exh02.htm  with a local link 138exh02.htm

Exhibit 3 
FAS 138 Benchmark Interest Value-Locked Debt Accounting Case: The FASB's Example 1 on Benchmarked Interest Accounting --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/138exh03.htm with a local link 138exh03.htm

Exhibit 4 
FAS 138 Benchmark Interest Value-Locked Debt Accounting Case: Glossary of Key Terms --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/138exh04.htm  with a local link 138exh04.htm

Working Paper 291

FAS 138 Benchmark Interest Value-Locked Debt Accounting Case

Bob Jensen at Trinity University

Comments received by the Board on Implementation Issue E1 indicated (a) that the concept of market interest rate risk as set forth in Statement 133 differed from the common understanding of interest rate risk by market participants, (b) that the guidance in the Implementation Issue was inconsistent with present hedging activities, and (c) that measuring the change in fair value of the hedged item attributable to changes in credit sector spreads would be difficult because consistent sector spread data are not readily available in the market. 
As quoted from Paragraph 14 of FAS 138

DIG E1 --- Must hedge the entire transaction --- no Treasury-lock of portions 

• Audio of James J. Rozsypal, Partner in Arthur Andersen  ROZSY50.mp3

• Audio on this BIG DIG Credit Spread Issue  ROZSY.52.mp3

• Going before DIG again ---  the $900 million dollar hit on earnings ROZSY54.mp3

• Sector spread issues amount to the same problem ROZSY56.mp3  

• Audio of Jin Chang from Lehman Brothers CHANG20.mp3

The FASB listened to complaints about treasury lock hedging and proposed allowing treasury locks in FAS 138 amendments to FAS 133 released on June 15, 2000.
See "Benchmark Interest Rates" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#B-Terms

It should be noted at the start that this case is accompanied by an Excel Workbook that is essential to understanding the case.  I suggest that you click "Yes" to enable the macros and "No" to the prompt concerning automatic links.  The Excel Workbook can be downloaded from the following link:

Excel Workbook:  http://www.cs.trinity.edu/~rjensen/000overview/mp3/138ex01a.xls 
Note:  It is best to choose the option to save this as an Excel file and then open it in
Excel rather than view it in your browser's screen where Excel's functionality is weakened.

In June of 1998, the Financial Accounting Standards Board (FASB) issued FAS 133.  This may also be referred to as SFAS 133.  This is the most difficult standard ever issued by the FASB and the only standard to date for which the FASB formed an implementation group called the Derivatives Implementation Group (DIG).  It is undoubtedly the most expensive standard to implement by many firms and a standard that probably has generated an exceptional amount of controversy among both public accounting firms and their clients.  Troubles in implementing FAS 133 prompted the FASB to extend the implementation deadline to January 1, 2001 for calendar-year reporting clients.  Because of some of the most severe cases taken up by the DIG, the FASB issued a new FAS 138 standard with the sole purpose of amending some paragraphs in FAS 133.  The term FAS 133 in this case will refer to the original June 1998 version and FAS 133/138 will refer to the June 2000 amended version.

Readers seeking introductory background on FAS 133/138 are referred to the following websites:

Introduction and Cases:  http://www.cs.trinity.edu/~rjensen/caseans/000index.htm 

Glossary:  http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

A short glossary is contained in Exhibit 4

This case and several to follow was inspired by a series of FAS 138 examples provided free by the FASB at the following website:

FAS 138 Examples:  http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html 

These examples as written are confusing to experts and students alike.  After some discussions with technical staff at the FASB, it became evident that these examples were outsourced to prominent security analysis firms who began with Step A using some market valuation computer such as a Bloomberg Terminal.  The examples then proceeded From Step A to Step H without explaining Steps B-I and without ever extending the examples to Steps J-Z.  The basic purpose of this case is to fill in Steps B-I and add Step J (for Jensen) in a manner of speaking.  More specifically the broad purposes of this case are as follows:

Purpose 1:
Definitions of symbols used are given in  Exhibit 1 of this case. One purpose of this case is to clarify the concept of credit sector spread versus  risk-free U.S. Treasury rate u(t), LIBOR-rate l(t), and systematic s(t) rate components of full market v(t) rates of debt.  Corresponding "values" to which debt can be adjusted are U(t), L(t), S(t) and V(t) respectively.  Companies that have public debt may be partitioned credit risk "sectors" such as AAA, AA, and BBB by firms that rate credit worthiness with small number of discrete credit sector designations..  However, if there are over 1,000 firms in the same credit sector such as BBB, the borrowing market (effective) rates are not all the same theoretical "systematic" or "sector" rate s(t) for the system of firms in that sector.  Instead, firms in the same sector have borrowing rates v(t) that vary from s(t) due to unsystematic, firm-specific credit risk such as when Firestone's v(t) borrowing rates increased due to a massive recall of Firestone tires.  In FAS 133, the FASB only allowed "fair value" hedging of a V(0) full value derived from a v(0) market rate at time t=0.  The v(0) borrowing rate was assumed by the FASB to be the sum of the risk-free rate plus a credit sector spread.  However, when hedging the v(0), there really is no market for hedges apart from having some "insurance" hedge that factors in unsystematic as well as systematic risk.  What is explained in this case is that, in theory, full hedged item value V(0) corresponding to a v(0) rate for a particular firm cannot be hedged without "insuring" unsystematic risk that is customized insurance for only one firm rather than for a "system" of firms.  The original FAS 133 naively assumed that firms hedge V(0) and naively called this risk-free plus credit sector risk.  Hedge accounting for debt value became further messed up in DIG Implementation Issues E1 and G6.   These issues are described and linked in the big Glossary linked at the top of Exhibit 4. I repeat the original quote at the start of this case: 

Comments received by the Board on Implementation Issue E1 indicated (a) that the concept of market interest rate risk as set forth in Statement 133 differed from the common understanding of interest rate risk by market participants, (b) that the guidance in the Implementation Issue was inconsistent with present hedging activities, and (c) that measuring the change in fair value of the hedged item attributable to changes in credit sector spreads would be difficult because consistent sector spread data are not readily available in the market. 
As quoted from Paragraph 14 of FAS 138

FAS 138 introduced the concept of "benchmark" value hedging in which only an interest rate component such as a u(0) risk-free rate or a l(0) LIBOR rate can be hedged in addition to the full v(0) rate.  A risk-free hedge of a U(0) component is called a Treasury lock.  The hedge of a L(0) component of total value can be called  LIBOR lock.  FAS 133 did not permit Treasury of LIBOR lock hedging that only became permitted after the June 2000 amendments in FAS 138.  It is now possible to find a hedging contract that hedges a benchmarked value I(0) where I(0) can be designated in advance as U(0), L(0), or V(0) depending upon the index used in the hedging contract.  In reality, hedges of V(0) full values are rare.  Hedges of U0) or L(0) are very common.  A major purpose of this case is to show how the FAS 138 benchmark hedges really work and emphasize that it is very misleading to say that hedged items (e.g., debt) are adjusted to "fair values" in value-lock hedge accounting.  The difference between fair value V(0) and benchmarked I(0) is not hedged under Treasury-lock and LIBOR-lock hedges.

Purpose 2:
To explain more precisely why two of the seven Board members to dissented as documented following Paragraph 25 in FAS 138.  The major reason is that benchmark value-lock hedging is a departure from the "fair value" hedging implicit throughout FAS 133 for value-lock hedges.  One of the dissenters recently declared at a meeting that it is now possible to LIBOR-lock fixed rate debt value that does not even have a L(0) LIBOR value component.

Purpose 3
To explain how interest rate swap hedges are to be valued at W(t) ex ante for either value-lock or cash flow hedges.  The accompanying Excel Workbook to this case goes into considerable detail in showing students how ex ante swap values are derived from yield (swap) curves.  The "Main Case" spreadsheet assumes typical nonlinear rising yield curves and the "133Example2" spreadsheet illustrates linear yield curves having no term structure effects.  Interested readers should click on the button in the Case spreadsheet button that is labeled "Swap Valuation Calculations."  Readers should also note the Yield (Swap) Curve definition in Exhibit 4 of this case.

Purpose 4
To explain how "Amortization of Basis Adjustments" are computed even though they are somewhat confusing in value-lock hedge accounting.  These were illustrated in Paragraph 117 of FAS 133 without any explanation of how to derive them or what they mean.  The accompanying Excel Workbook to this case goes into considerable detail in showing students how to compute and journalize basis adjustments.   Interested readers should go to the "Main Case" and "133Example2"  spreadsheet buttons labeled "Summary Accounting Tables."  It is important to also make certain that the basis amortization parameter is "1" rather than "0" if they want to see the basis amortization journal entries.  Readers should also note the "Amortization of Basis Adjustments" definition in Exhibit 4 of this case.

Purpose 5
To explain how journal entries are formed for each example in the case.   Journal entries are given in the accompanying Excel Workbook to the case.  Interested readers should click on the button labeled "Journal Entries."

Purpose 6
To explain how solutions vary with different parameters defined in Exhibit 1 of this case. Readers are allowed to choose from "Pre-set Examples" or create their own examples by clicking on the button labeled "Make Up Your Own Examples."

Purpose 7
To explain how value-lock hedges are computed and accounted for under FAS 133/138 rules.  This is the main advantage of the accompanying Excel Workbook to the case.  Readers can click on a cell and then examine the formulas to see how each number is derived.  This is probably the main purpose of this case.

Purpose 8
To explain in considerable detail how an interest rate value-lock hedge works.  This is described in some detail in Exhibit 2.  The formulas and sensitivity analysis options are given in the Excel Workbook. 

Purpose 9
To illustrate the well known 0.80-1.25 Rule that sets a tolerance band for DELTA(t) ineffectiveness ratios.  Also, this case introduces a materiality bound parameter as an ineffectiveness materiality test in this case.  It will be argued and illustrated that allowing a company to have hedge accounting privileges should depend upon a combination of significance of the observed DELTA(t) in terms of falling between 0.80 and 1.25 and the materiality of the ineffectiveness.  The accompanying Excel Workbook applies both significance and materiality tests jointly.

Purpose 10
To give students a better understanding of why derivative instruments are booked at "values" and adjusted to new values at least every three months whereas financial instruments are generally carried at historical costs and are not carried at "values" except in certain exceptions such as those in FAS 115.

In either the "Main Case" or "133Example2" spreadsheet, the pre-set Example 00 and Example 01 differ only in the journal entries for "Amortization of Basis Adjustments."  These two examples only differ in the Journal Entries section of the spreadsheet.  Recall that parameters are defined in Exhibit 1 of this case.  The inspiration for Examples 00 and 01 was Example 2 in Appendix B of Section 1 of the FASB's FAS 133 examples in Paragraphs 111-120.  Portions of Example 2 from the FASB can be seen in Exhibit 2 of this case.  The derivations of the infamous Paragraph 117 table are derived near the bottom of the "133Example2" spreadsheet.  The example is extended to an ineffective case illustration.

Recall that parameters are defined in Exhibit 1 of this case.  The inspiration for Examples 00 and 01 in the "Main Case" spreadsheet was Example 1 of Section 1 of the FASB's FAS 138 examples (a web link to those examples was given at the beginning of this document). The FASB Example 1 is extended considerably in the spreadsheet.  This is a somewhat difficult example since it deals with duration hedge ratios and DELTA ratio adjustments.   The complete Example 1 from the FASB can be seen in Exhibit 3 of this case.

When you read the FASB's version in the tables below, note that the Exhibit 1 definitions are as follows in the "Main Case" spreadsheet::

In Exhibit 3 of this case, it can be seen that the FASB only did a partial accounting of an interim accrual period t=0.5 rather than present a complete example that carries through for t=1 through t=10 interest payment periods.  For Period 0.5, the FASB tosses in a hedge (swap) value of W(0.5)=$4,016,000 without any explanation of how to derive that swap value.  The FASB does, to its credit, show how to derive the benchmarked hedged item (debt) value ($96,224,380).  In Period 0.5, the hedged item is adjusted from its starting value of C(0)=($100,000,000) by a debit of the following amount:

   I(0.5) = L(0.5) =     ($96,224,380)
 -I(0) =C(0)         = -($100,000,000)
  I(0)-I(0.5)         =       $ 3,775,620

In Examples 00 and 01 of the "Main Case" spreadsheet, I will depart from the FASB when booking the initial swap value.  The FASB assumed that W(0)=$0 when in reality, imprecision in the hedge ratio resulted in a starting hedge value of a W(0)=($240,380) liability.  The FASB recorded this liability in the t=0.5 journal entry.  I recorded it at t=0.  In terms of the  Exhibit 1 parameters, we thus start out with the following t=0.5 outcomes:

Of course, if Global Tech had chosen i(t) to be a Treasury-locked benchmark value instead of a LIBOR-locked benchmark value, the outcomes would have been different.  The outcomes might also have been different under the original FAS 133 required s(t) "fair value" hedge.  The only way the above example would qualify for that would be to assume that LIBOR accounts for all the credit sector spread of Global Tech.  This is an unrealistic assumption in most instances. 

Now it is time to elaborate on the definitions of this case and of the concepts in FAS 133/138 with regard to a value-lock hedge.  The Case Questions provided with brief answers.  The Student Questions are intended to be initially provided without answers so that students can seek their own answers.

Case Question 01
Why do firms have a difficult time hedging full V(0) value corresponding to the effective rate v(0) that includes both systematic and unsystematic interest rate risk?  What in particular gave them troubles in getting FAS 133 hedge accounting for economic hedges based upon a market index such as LIBOR?  How did FAS 138 change the value locks based upon u(0) risk-free and l(0) LIBOR rates?  Note especially Examples 01 and 04 in the "Main Case" spreadsheet.

Answer:
The main problem in hedging V(0) is that there is no convenient interest rate index that for either v(t) full value or s(t) systematic value.  When an economic hedge was written in a popular index such as LIBOR, there was too much ineffectiveness in hedging v(0) to reap the benefits of hedge accounting under the original FAS 133 that allowed only hedging of V(0) at the full effective rate v(0).  

The term "systematic" debt value was never used by the FASB in FAS 133 or DIG Issues E1 at and G6.  However, the term "credit sector" was used, which begs the question as to what constitutes  "sector."  Presumably, a sector is the subset of all firms having a given credit rating such as AAA or BBB by debt rating companies.  The term "systematic debt value" or S(t) in this case refers to all "systematic" interest rate risk components of the full market value V(t) of the hedged item (debt).  The stem "system" means that the risk applies to all firms in a given sector of the economy (e.g., all BBB firms) as opposed to "unsystematic" interest rate risk components that apply to only a single firm apart from all other firms in that credit sector's "system" of firms.  Suppose that Company Cautious and Company Chancey are both in the BBB credit sector.  Company Cautious firm has a somewhat higher credit rating due to negative unsystematic risk components such as its low debt/equity ratio and a lengthy history of paying all debts on time.  Whatever the reason, Company Chancey has a lower credit rating due to higher unsystematic risk perceived in the market.  Company Chancey is the Example 04 company in the Excel spreadsheet.

Since the swap rate is the sum of the Treasury yield and the swap spread, a well-known statistical rule breaks its volatility into three components:

Swap Rate Variance = Treasury Yield Variance
                                    + Swap Spread Variance
                                    + 2 * Covariance of Treasury Yield and Swap Spread

For purposes of this case, the illustrations will ignore the covariance components so that the illustrated components are additive.

Suppose that for a given face amount of noncallable fixed-rate debt, the U.S. Treasury would have to pay a risk-free u(0) rate to borrow funds.  If Companies Cautious and Chancey are in the same credit sector and had zero unsystematic risk, they would have to pay a s(0) rate for a credit sector spread of s(0)-u(0).  In reality, each must pay its own v(0) effective rate at t=0, where the unsystematic risk component is v(0)-s(0).  Suppose both firms negotiate the same hedge swap based upon a swap curve i(t) index benchmarked to LIBOR(t).  Further, assume the following risk components of interest rate risk at t=0:

Based upon present values of the $4,000,000 semi-annual interest payments and the repayment of $100 million at maturity, the various present values at t=0 are as follows:

This example differs from the FASB example only in that the effective rates differ from the nominal rates and a premium or discount on the bond issue is illustrated.  If the face liability at maturity is F=($100,000,000), the interest payments of $4,000,000 semi-annually are identical for both companies.  But the companies would record initial carrying liabilities of the following based upon present values of the debt cash flows at the differing 0.03155 versus 0.4125 v(0) rates that have differing unsystematic risks:

V(0) = ($107,151,338) PV for 10 periods at v(0)= 0.03155 for Company Cautious
V(0) =   ($98,992,418) PV for 10 periods at v(0)=0.04125 for Company Chancey

If the borrowing rates are truly different (as in the case of Cautious and Chancey) the only way to really hedge full V(0) value is to find some form of "insurance" against unsystematic, firm-specific risk apart from systematic risk of a "system" of firms in the same credit sector.  For example, if Company Cautious has 10 oil wells in 10 countries, it is less risky ceteris paribus than Company Cautious having one oil well even if both companies are in the BBB credit sector.

Recall that symbols are defined in Exhibit 1.  The carrying values differ because Company Cautious received more funds due to its lower unsystematic risk.  Suppose that each company declared a FAS 138 benchmark hedge based upon LIBOR.  Further, assume that LIBOR increased from 6.29% at t=1 to 7.29% at t=0.5.  Since the i(t) benchmark is LIBOR, we have a change of i(0.5)-i(0)=+0.0100.  If there is no discount or premium amortization in this interim accrual period where there is no interest payment due at t=0.5, the changed carrying values would be as follows:

Firms generally do not enter into full value "insurance-type" hedges since where no v(t) market indexes exist upon which to negotiate interest rate swaps.   And there are no s(t) credit sector hedge indexes.   Swaps in practice are hedged with various public indexes such as LIBOR that did not account for full value or credit sector interest rate risk.  In FAS 138, the FASB finally allowed hedge accounting based upon Treasury-locks based upon the u(t) U.S. Treasury rate or the l(t) based upon the popular US$ LIBOR rate for which yield (swap) curves are available for purposes of deriving W(t) swap values.  One more time, an important quotation from FAS 138 reads is repeated below:

Comments received by the Board on Implementation Issue E1 indicated (a) that the concept of market interest rate risk as set forth in Statement 133 differed from the common understanding of interest rate risk by market participants, (b) that the guidance in the Implementation Issue was inconsistent with present hedging activities, and (c) that measuring the change in fair value of the hedged item attributable to changes in credit sector spreads would be difficult because consistent sector spread data are not readily available in the market. 
As quoted from Paragraph 14 of FAS 138

Case Question 02
Why do firms want economic hedges of fixed-rate debt to qualify for FAS 133/138 hedge accounting?  What was the accounting before FAS 133, after FAS 133, and after FAS 133/138?

Answer
The "problem" emphasized over and over by firms is that FAS 133/138 requires the booking of derivative hedges at full market value.  In the above FASB's illustration above, the carrying value of the swap had to be booked at a liability of W(0.5)=($4,106,000).  If the swap does not qualify as a hedge, FAS 133/138 nevertheless still requires booking of the liability at this full current value at t=0.5.  Without hedge accounting, the debt is not adjusted for any type of value changes and remains at amortized historical cost.  

If the derivative qualifies for hedge accounting, the impact of booking the derivative at value is somewhat offset by booking the hedged item in a value-locked I(t-1)-I(t) value changes.  In terms of  Exhibit 1 notation, the carrying values are as follows where C(t) is the debt carrying value, A(t) is the discount/premium amortization, and I(t) is the present value of all remaining cash flows under the debt contract:

With No Qualifying Hedge or a Hedge that Combines Ineffectiveness Materiality and Significance in Terms of the 0.80-1.25 Rule for DELTA(t). 

C(t)= C(t-1)+A(t)  
      = V(0)-[V(0)+SA(t) to date]

With A Qualifying Hedge or a Hedge that Combines Ineffectiveness Immateriality and Insignificance in Terms of the 0.80-1.25 Rule for DELTA(t). 

C(t)= C(t-1)+A(t)+[I(t)-I(t-1)]  (
      = V(0)-[V(0)+SA(t) to date]+[I(t)-I(t-1)]  (It's the last term that firms want in hedge accounting!)

That hedge accounting adjustment of the hedged item's carrying value by [I(t-1)-I(t)] in a perfect hedge exactly offsets the change in earnings caused by booking the Y(t-1)-Y(t) change in hedge (swap) values.  If the hedge is somewhat less than perfect, the W(t-1)-W(t) changes in swap value are still offset by approximately the same changes in booked hedged item (debt) value changes under FAS 133/138 hedge accounting.  The booking of [I(t-1)-I(t)] tends to cause less volatility in reported earnings if the economic hedge also qualifies for hedge accounting under FAS 133/138.  This is dramatized (in the audio clip below) as a significant problem (before the passage of FAS 138) for firms who qualified for hedge accounting under the original FAS 133's 0.80-1.25 ineffectiveness tolerance rule but those adjustments to carrying value of debt were not sufficient to reduce earnings volatility.  Click on the link below to hear James J. Rozsypal of Arthur Andersen dramatize the impact on earnings before FAS 138 saved the day for his clients (to hear the clip, your computer must be able to play MP3 audio files):

The accounting was as follows under three different phases of rules for value-lock hedges of fixed rate, noncallable debt:

Keep in mind that W(t) swap values are not the same under different i(t) indexes upon which the yield (swap) curves are based.  Also keep in mind that FAS 138 made it possible to extend I(t) benchmarked hedged item (debt) value to U(t) and L(t) values rather than only allow S(t) value changes that were hard to define.

Prior to FAS 133, there were no FASB standards that covered interest rate swaps.  These were only invented in the mid-1980s, and it took a while for the FASB and the SEC to ponder rule changes.  One of the reasons for the rule changes was the explosion of interest rate swaps as both speculations and hedging instruments.  They are often more convenient and less costly than hedging with options, futures, and forward contracts.

Case Question 03
Why did the FASB back away from requiring that firms only hedge full V(0) instead of U(0), L(0), or U(0) value?  Why might such a problem disappear in the distant future?

Answer:
The FASB would love to have all debt instruments carried at full V(t) value and has proposed this in an exposure draft that would require full value accounting for all financial instruments.  The December 13, 1999 Exposure Draft 204-B is entitled Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value at http://www.rutgers.edu/Accounting/raw/fasb/draft/draftpg.html 

The problem is that companies, especially financial institutions, do not want to book all their financial instruments at full value.  The impact on earnings would be explosive and there would be greatly increased volatility of reported income in many firms.

The FASB, however, saw no justification in allowing selective full value adjustments of only hedged financial instruments.  The main objection in the case of a value-lock hedge of debt is that the V(t-1)-V(t) changes in full value may have little or no offset to changes in W(t-1)-W(t) hedges based upon some ex ante market index for which yield (swap) curves are published.  It would be less troublesome if debtors could obtain hedges that exactly offset V(t-1)-V(t) full value changes, but such hedges are not common in financial markets.  In reality, such hedges would be more like unsystematic risk insurance than interest rate hedges.  

Case Question 04
What is hedge ineffectiveness?  How is it accounted for under FAS 133/138?  What is the .80-1.25 Rule for any DELTA(t) ineffectiveness ratio?  How is this combined with a DELTA(t) error intolerance parameter concocted by Bob Jensen for the Excel Workbook to be used as a materiality test in this case? 

Answer
First of all let me repeat the following with respect to hedge accounting for an interest rate swap based upon an ex ante benchmark i(t) index such as LIBOR(t).  When a particular i(t) is observed ex post at time t, it is possible to also define an ex post I(t) present values of all remaining cash flows.  

If the derivative qualifies for hedge accounting, the impact of booking the derivative at value is somewhat offset by booking the hedged item in a value-locked I(t-1)-I(t) value changes.  In terms of  Exhibit 1 notation, the carrying values are as follows where C(t) is the debt carrying value, A(t) is the discount/premium amortization, and I(t) is the present value of all remaining cash flows under the debt contract:

With No Qualifying Hedge or a Hedge that Combines Ineffectiveness Materiality and Significance in Terms of the 0.80-1.25 Rule for DELTA(t). 

C(t)= C(t-1)+A(t)  (
      = V(0)-[V(0)+SA(t) to date]

With A Qualifying Hedge or a Hedge that Combines Ineffectiveness Immateriality and Insignificance in Terms of the 0.80-1.25 Rule for DELTA(t). 

C(t)= C(t-1)+A(t)+[I(t)-I(t-1)]  (
      = V(0)-[V(0)+SA(t) to date]+[I(t)-I(t-1)]  (It's the last term that firms want in hedge accounting!)

One question never addressed by standard setters is what do do about hedge ineffectiveness that is material in amount but also has a DELTA(t) ratio falling within the 0.80-1.25 Rule bounds.  In my case, I do not deny hedge accounting in those outcomes, although the reason has me staring at the wall and wondering why.

It should be noted that the FASB does not provide a rule for measuring ineffectiveness of a hedge or specify tests for detection and correction of hedge ineffectiveness.  The main rules set in FAS 133/138 include a rule that management define in advance how ineffectiveness will be measured and that it be tested at least every three months.  Also, the FASB requires that pre-defined significant ineffectiveness be booked to current earnings.  In this case I will define the level of ineffectiveness as follows using Exhibit 1 notation:

Hedge Ineffectiveness = [W(t)-W(t-1)]+[I(t)-I(t-1)] 
                                  = [Change in Hedge Value] + [Change in Hedged Item Value]
(Note that the change in hedge value will have different sign than the change in the value of the hedged item.)

Hedge ineffectiveness in a fixed-rate debt value-lock hedge arises whenever the value change in the hedged item is not perfectly offset by a value change in the carrying value of the hedge contract.  In Exhibit 1 notation, the hedge is perfectly effective whenever W(t)-W(t-1)=I(t-1)-I(t).  Hedges are frequently not perfectly effective since the hedged item I(t) value is based upon ex post i(t) values and the hedge W(t) values are based upon ex ante yield (swap) curve estimates of future forward rates.  Since an interest rate swap is in reality a portfolio of multiple forward contracts, difference in ex post versus ex ante valuations are common.

Although firms are free to define ineffectiveness and ineffectiveness tests, it is necessary to define ineffectiveness at the start of a hedging contract and consistently test the degree of ineffectiveness at least every three months under FAS 133/138 rules.  It is common to use the FASB's suggested (but not required) 0.80-1.25 Rule for DELTA(t) as defined in Exhibit 1.  (If you listened to the above audio clip by James J. Rozsypal, you heard him mention this rule.)  If that rule is the client's chosen ineffectiveness rule, then any ineffectiveness violating that rule must be booked to current earnings.  This increases earnings volatility under qualifying but ineffective hedges.  In this case, a hedge outcome for a particular DELTA(t) outcome will be deemed "Significant" if it falls outside the 0.80 lower bound or the 1.25 upper bound.  It will be "Insignificant" if it falls within those bounds.

In the "Main Case" spreadsheet, the 0.80-1.25 rule for DELTA(t) is only one of the tests for booking ineffectiveness.  The other is a materiality tolerance bounding the level of ineffectiveness.   For example, the change value of a hedge is $10 and the change in value of the hedged item is ($2), the hedge ratio is DELTA(t)=-$10/($2) = 5.0.  However, relative to a debt proceeds of, say, $100 million, the ineffectiveness of $8=$10-$2 involved is too small to make a difference in spite of the high DELTA(t).  In the "Main Case" spreadsheet, the ineffectiveness materiality tolerance of ineffectiveness is set at 

Lower Materiality Bound = 0.0005*($100,000,000) = ($50,000)
Upper materiality Bound = 0.0005* $100,000,000 =    $50,000

When the amount of hedge ineffectiveness falls outside the materiality bounds it will be deemed "Material."  If it falls within those bounds it will be deemed "Immaterial" for the Period t in question.  

The amount of ineffectiveness is always debited or credited to current earnings.  If ineffectiveness is deemed both "Significant" and "Material" in joint combination, however, the company is to be denied hedge accounting treatment for the Period t when these violations arise.  Although ineffectiveness must be tested at least every three months, in the "Main Case" spreadsheet examples, such testing will only be illustrated on a semi-annual basis.  It should also be noted that in any period where ineffectiveness is both "Significant" and "Material," the company must question whether hedge accounting should be denied for all future periods of the hedge.  Certainly, hedge accounting is not allowed in the period in question.  The main implication of this is that the C(t) carrying value cannot be adjusted by the [I(t)-I(t-1)] change in benchmark values.

If the ineffectiveness lies outside the bound, then the DELTA(t) ratio is calculated at the levels shown in the "Main Case" spreadsheet in Cells Y174:Y193.  For Example 3 in that spreadsheet, the outcomes are as follows:

Although FAS 133 does not set strict requirements for booking hedge ineffectiveness, are there some periods where the hedge seems to exceed what many firms recommend for hedge effectiveness?  In particular, discuss this in terms of the 0.80-1.25 rule that most public accounting firms are using to assess DELTA(t) ratios.  For Period 7 ending on 10/02/03 with a DELTA(7) of 1.341, show the journal entries without booking the ineffectiveness versus booking of ineffectiveness.

The following is an outcome summary for  Period 7 ending on 10/02/03 for Example 3 in the "Main Case" spreadsheet:

Example 03, Period 7
Swaps Are Valued Based on Ex Ante Forward Rates in Period 7 
     Swap Value at the End of Period 7 = W(7) =  ($1,419,508)
     Swap Value at the End of Period 6 = W(6) = -($1,674,235)  
     Change in Swap Value      =  W(7) - W(6) =    $   254,727

Index Present Value is Based on Ex Post Spot i(t) Rates in Period 7
     Index Value at the End of Period 7  = I(7)  = ($98,820,872) 
     Index Value at the End of Period 6 = I(6)  = ($98,630,913)  
     Change in Index Present Value = I(7)-I(6) =   ($  189,959)

 $254,727+($189,959) =  $64,768 ineffectiveness lies above the upper materiality bound of $50,000

DELTA(7) = -$254,727/($189,959) = 1.341  which lies outside the 1.25 upper DELTA(t) bound 

Hence the $64,768 ineffectiveness is jointly material and significant.  The C(7) carrying value cannot be adjusted by the ($189,159) change in index value.

In Period 8, the following outcomes can be observed for Example 03 in the "Main Case" spreadsheet:

Example 03, Period 8
Swaps Are Valued Based on Ex Ante Forward Rates in Period 8
     Swap Value at the End of Period 8 = W(8) =  ($1,049,188)
     Swap Value at the End of Period 7 = W(7) = -($1,419,508)  
     Change in Swap Value =  W(8)-W(7)         =   ($   370,320)

Index Present Value is Based on Ex Post Spot i(t) Rates in Period 7
     Index Value at the End of Period 8  = I(8)  =  ($99,221,137) 
     Index Value at the End of Period 7  = I(7)  =  ($98,820,872)  
     Change in Index Present Value = I(8)-I(7) =      $  400,265

  ($370,320)+ $400,265 =  $29,945 ineffectiveness is beneath the materiality upper bound of $50,000

DELTA(8) = -($370,320)/$400,265 = 0.925, which lies within the 0.80-1.25 Rule bounds

The ineffectiveness of $29,945 is neither material nor significant.  Hence, the Period 8 hedged item C(7) carrying value can be fully adjusted by the $400,265 change in benchmark value in Example 03.

Case Question 05
What is the shortcut rule for interest rate swaps?

Answer
The shortcut rule is discussed near the bottom of Exhibit 1 of this case.  Suppose a particular value-lock hedge is a fortunate hedge that will always be perfectly effective, because for all periods it is known that Y(t-1)-Y(t)=I(t)-I(t-1) and that W(t)=Y(t).  Then the shortcut method can be elected in advance, and it is no longer necessary for the firm to test for ineffectiveness every three months.  Actually the hedge may not be perfect, but it might be demonstrated that any imperfection is completely immaterial across the aggregate life of the hedge.

In the Excel Workbook accompanying this case, perfect (shortcut) hedges can be compared with imperfect benchmarked value-lock hedges.  A shortcut hedge, because it is always assumed to be a  perfect hedge with swap value changes exactly offsetting debt value adjustments.  The shortcut method optimally  minimizes the impact on earnings of FAS 133/138 requirements that derivative instruments hedges be carried at full W(t) or V(t) value.

Case Question 06
What is basis risk?  Why was basis risk a huge reason that two of the seven Board members dissented in the passage of FAS 133?

Answer
Basis risk is briefly defined in Exhibit 1 of this case.  Immediately following Paragraph 25 of FAS 138, the dissents of two FASB members is summarized as follows (with emphasis added in red by Bob Jensen):

Case Question 07
Why does the FASB adamantly refuse to allow hedge accounting for the strategic management of risk over multiple hedged items?  For example, many firms lump multiple debt instruments into a portfolio and then manage risk of the entire portfolio rather than for items. 

Answer
It is extremely common to manage portfolios of hedged items or even the financial risks of an entire enterprise.  A number of key audio clips on this matter are linked below:

The main opposition to portfolio hedging arises from the fact that there may be "hidden risks," particularly when debt items having greatly different maturities are lumped into one value-locked portfolio. 

FAS 133 Paragraphs 443-450 (with Bob Jensen's highlights in red)

443. This Statement retains the provision from the Exposure Draft that prohibits a portfolio of dissimilar items from being designated as a hedged item. Many respondents said that hedge accounting should be extended to hedges of portfolios of dissimilar items (often called macro hedges) because macro hedging is an effective and efficient way to manage risk. To qualify for designation as a hedged item on an aggregate rather than individual basis, the Exposure Draft would have required that individual items in a portfolio of similar assets or liabilities be expected to respond to changes in a market variable in an equivalent way. The Exposure Draft also included a list of specific characteristics to be considered in determining whether items were sufficiently similar to qualify for hedging as a portfolio. Respondents said that, taken together, the list of characteristics and the "equivalent way" requirement would have meant that individual items could qualify as "similar" only if they were virtually identical.

444. To deal with the concerns of respondents, the Board modified the Exposure Draft in two ways. First, the Board deleted the requirement that the value of all items in a portfolio respond in an equivalent way to changes in a market variable. Instead, this Statement requires that the items in a portfolio share the risk exposure for which they are designated as being hedged and that the fair values of individual items attributable to the hedged risk be expected to respond proportionately to the total change in fair value of the hedged portfolio. The Board intends proportionately to be interpreted strictly, but the term does not mean identically. For example, a group of assets would not be considered to respond proportionately to a change in interest rates if a 100-basis-point increase in interest rates is expected to result in percentage decreases in the fair values of the individual items ranging from 7 percent to 13 percent. However, percentage decreases within a range of 9 percent to 11 percent could be considered proportionate if that change in interest rates reduced the fair value of the portfolio by 10 percent.

445. The second way in which the Board modified the Exposure Draft was to delete the requirement to consider all specified risk characteristics of the items in a portfolio. The Board considered completely deleting the list of risk characteristics included in the Exposure Draft, and the Task Force Draft did not include that list. However, respondents to that draft asked for additional guidance on how to determine whether individual assets or liabilities qualify as "similar." In response to those requests, the Board decided to reinstate the list of characteristics from the Exposure Draft. The Board intends the list to be only an indication of factors that an entity may find helpful.

446. Those two changes are consistent with other changes to the Exposure Draft to focus on the risk being hedged and to rely on management to define how effectiveness will be assessed. It is the responsibility of management to appropriately assess the similarity of hedged items and to determine whether the derivative and a group of hedged items will be highly effective at achieving offset. Those changes to the Exposure Draft do not, however, permit aggregation of dissimilar items. Although the Board recognizes that certain entities are increasingly disposed toward managing specific risks within portfolios of assets and liabilities, it decided to retain the prohibition of hedge accounting for a hedge of a portfolio of dissimilar items for the reasons discussed in the following SFAS 133 Paragraphs.

447. Hedge accounting adjustments that result from application of this Statement must be allocated to individual items in a hedged portfolio to determine the carrying amount of an individual item in various circumstances, including (a) upon sale or settlement of the item (to compute the gain or loss), (b) upon discontinuance of a hedging relationship (to determine the new carrying amount that will be the basis for subsequent accounting), and (c) when other generally accepted accounting principles require assessing that item for impairment. The Board decided that a hedge accounting approach that adjusts the basis of the hedged item could not accommodate a portfolio of dissimilar items (macro hedging) because of the difficulties of allocating hedge accounting adjustments to dissimilar hedged items. It would be difficult, if not impossible, to allocate derivative gains and losses to a group of items if their values respond differently (both in direction and in amount) to a change in the risk being hedged, such as market interest rate risk. For example, some components of a portfolio of dissimilar items may increase in value while other components decrease in value as a result of a given price change. Those allocation difficulties are exacerbated if the items to be hedged represent different exposures, that is, a fair value risk and a cash flow risk, because a single exposure to risk must be chosen to provide a basis on which to allocate a net amount to multiple hedged items.

448. The Board considered alternative approaches that would require amortizing the hedge accounting adjustments to earnings based on the average holding period, average maturity or duration of the items in the hedged portfolio, or in some other manner that would not allocate adjustments to the individual items in the hedged portfolio. The Board rejected those approaches because determining the carrying amount for an individual item when it is (a) impaired or (b) sold, settled, or otherwise removed from the hedged portfolio would ignore its related hedge accounting adjustment, if any. Additionally, it was not clear how those approaches would work for certain portfolios, such as a portfolio of equity securities.

449. Advocates of macro hedging generally believe that it is a more effective and efficient way of managing an entity's risk than hedging on an individual-item basis. Macro hedging seems to imply a notion of entity-wide risk reduction. The Board also believes that permitting hedge accounting for a portfolio of dissimilar items would be appropriate only if risk were required to be assessed on an entity-wide basis. As discussed in SFAS 133 Paragraph 357, the Board decided not to include entity-wide risk reduction as a criterion for hedge accounting.

450. Although this Statement does not accommodate designating a portfolio of dissimilar items as a hedged item, the Board believes that its requirements are consistent with (a) the hedge accounting guidance that was in Statements 52 and 80, (b) what the Board generally understands to have been current practice in accounting for hedges not addressed by those Statements, and (c) what has been required by the SEC staff. The Board's ultimate goal of requiring that all financial instruments be measured at fair value when the conceptual and measurement issues are resolved would better accommodate risk management for those items on a portfolio basis. Measuring all financial instruments at fair value with all gains or losses recognized in earnings would, without accounting complexity, faithfully represent the results of operations of entities using sophisticated risk management techniques for hedging on a portfolio basis

In the Student Question section, it is assumed that students have carefully examined the Excel Workbook.  This case is accompanied by an Excel Workbook that is essential to understanding the case.  I suggest that you click "Yes" to enable the macros and "No" to the prompt concerning automatic links.  The Excel workbook can be downloaded from the following link:

Excel Workbook:  http://www.cs.trinity.edu/~rjensen/000overview/mp3/138ex01a.xls

Student Question 01
Why was there a great need for FAS 133?  Answer both for derivatives in general and for interest rate swaps in particular.

Hint 1:  The audio and video clips below may help in answering this question.

Hint 2:  You may want to look of the definition of a Derivative Financial Instrument in Exhibit 4.

Answer

Prior to FAS 133 there were no accounting standards for various types of derivatives contracts such as interest rate swaps, swaps in general, forward contracts, and many types of futures and options contracts not covered in previous standards such as FAS 80 and FAS 52.  One of the problems was that standard setters around the world (e.g., the FASB and the IASC) were caught unsuspecting in the late 1980s as derivative contracts exploded in popularity in a matter of a few years.  For example, interest rate swaps were invented in the mid-80s and exploded in popularity worldwide to where trillions of dollars were being contracted..

Without accounting standards, the traditional accounting practice to emerge for derivative contracts was cash flow (settlement) accounting that mixed very badly with accrual accounting for non-derivative contracts.  Drawbacks included the following:

1. Derivative financial instruments met the definitions of assets and liabilities under the FASB's Statements of Financial Concepts but were not booked as assets and liabilities.  This was particularly problematic for enormous liabilities that were not booked.  In some cases there were scandals (such as those mentioned in the above audio and video clips) where companies had enormous risks that were neither disclosed nor booked.
   
   
2. Cash flow accounting is problematic in that management can often manipulate the timings of cash flows to create misleading patters of reported earnings such as "doubling up" collections in a particular period.
   
   
3. There was no differentiation between reporting derivatives that were huge speculations versus derivatives that were simply hedges to financial risk exposures of hedged items.

The FASB provides a much more elaborate justification in a lengthy Appendix C of FAS 133 in Paragraphs 206-504..  Key paragraphs include Paragraphs 210-212

210. 
The Board began deliberating issues relating to derivatives and hedging activities in January 1992. From then until June 1996, the Board held 100 public meetings to discuss various issues and proposed accounting approaches, including 74 Board meetings, 10 meetings with members of the Financial Accounting Standards Advisory Council, 7 meetings with members of the Financial Instruments Task Force and its subgroup on hedging, and 9 meetings with outside representatives. In addition, individual Board members and staff visited numerous companies in a variety of fields and participated in meetings with different representational groups, both nationally and internationally, to explore how different entities manage risk and how those risk management activities should be accounted for.

211. 
In June 1993, the Board issued a report, "A Report on Deliberations, Including Tentative Conclusions on Certain Issues, related to Accounting for Hedging and Other Risk-adjusting Activities." That report included background information about the Board's deliberations and some tentative conclusions on accounting for derivatives and hedging activities. It also solicited comments from constituents and provided the basis for two public meetings in September 1993.

212. 
Concern has grown about the accounting and disclosure requirements for derivatives and hedging activities as the extent of use and the complexity of derivatives and hedging activities have rapidly increased in recent years. Changes in global financial markets and related financial innovations have led to the development of new derivatives used to manage exposures to risk, including interest rate, foreign exchange, price, and credit risks. Many believe that accounting standards have not kept pace with those changes. Derivatives can be useful risk management tools, and some believe that the inadequacy of financial reporting may have discouraged their use by contributing to an atmosphere of uncertainty. Concern about inadequate financial reporting also was heightened by the publicity surrounding large derivative losses at a few companies. As a result, the Securities and Exchange Commission, members of Congress, and others urged the Board to deal expeditiously with reporting problems in this area. For example, a report of the General Accounting Office prepared for Congress in 1994 recommended, among other things, that the FASB "proceed expeditiously to develop and issue an exposure draft that provides comprehensive, consistent accounting rules for derivative products. . . ." \30/ In addition, some users of financial statements asked for improved disclosures and accounting for derivatives and hedging. For example, one of the recommendations in the December 1994 report published by the AICPA Special Committee on Financial Reporting, Improving Business Reporting-A Customer Focus, was to address the disclosures and accounting for innovative financial instruments.
==========================================================================

\30/ United States General Accounting Office, Report to Congressional Requesters, Financial Derivatives: Actions Needed to Protect the
Financial System, May 1994, 16.

Student Question 02
If the FASB wanted to book derivative financial instruments, why couldn't the FASB require historical cost accounting to be more consistent with financial instrument accounting in general that is based on historical cost except in certain exceptions such as those specified in FAS 115?  Why were derivatives required to be booked at "fair values" and adjusted to new fair values at least every three months?  In particular, address the controversy of what value to adjust a hedged item (e.g., debt) to under value-lock hedge accounting.  Why did two FASB members dissent and claim that the FAS 138 Amendments to FAS 133 were a step backward?

Answer

The basic problem with historical cost for derivatives accounting is that derivatives virtually have no "cost."  When a firm issues bonds for $100 million the "cost" is $100 million and the firm is liable for at least $100 million in the event of backing out prior to maturity.  When a firm as a $100 million notional on an interest rate swap, the "cost" is zero and there are almost no damages early on if the firm backs out of the swap prior to maturity.  There is zero cost in futures and forwards contracts at the date the obligations commence.  There is only nominal (premium) costs for options that are very small relative to the risks and rewards involved.

Since costs are virtually zero for a derivative contract even though the potential gains and losses are immense (unless offset by hedging instruments).  Hence the FASB decided that the only alternative was some type of "fair value" accounting.  Being called "fair value" accounting, it became necessary to adjust the values frequently.  The FASB arbitrarily chose every three months as the maximum lapse allowed before adjusting to current fair values.

One problem is that "fair value" is an elusive concept.  To investors, fair value is the V(t) of a hedged item value that includes all systematic and unsystematic risks and is the market value if the hedged item (e.g., bonds).  Similarly, fair value of a derivative is a market value if the derivative is traded in the open markets.  One advantage of most derivative contracts is that there is almost no unsystematic risk.  Performance under such contracts as futures and options are guaranteed by the exchanges on which they are traded.  Performance of forward contracts and interest rate swaps are often guaranteed by the banks that broker the contracts.  

Adjusting hedged items to "fair value" is particularly problematic under both FAS 133 and FAS 138.  In the minds of investors, investments carried at "fair value" are generally visualized by investors as V(t) market values that are impacted by both systematic and unsystematic risk components.  The FASB, however, never considered "fair value" in FAS 133 to include unsystematic risk components.  FAS 133 envisioned "fair value" to be full S(t) systematic value apart from unsystematic risk. The DIG Issue E1 illustrated how committed the FASB was to "fair value" than embodied all credit sector systematic risk.  The problem was that it was almost impossible to objectively determine S(t) value apart from total V(t) market value.  

FAS 138 introduced the concept of benchmarked interest rates whose yield curves are available in the financial markets.  FAS 133 basically became a step backward in terms of "fair value."  Now hedged items can be carried at U(t) risk-free adjusted values or L(t) LIBOR-adjusted values.  Not all FASB Board members agreed with this step backward, but the FASB still managed to pass FAS 133.

Student Question 03
In either both the "Main Case" or the "133Example2" spreadsheets, compare the outcomes of Example 00 with Example 05.  You may initially compare these two examples in the Summary Answer Tables.  Note in particular how the a company that has no cash flow risk in fixed-rate debt must take on cash flow risk in order to hedge (lock in) debt value.  Why would a debtor want to take on cash flow risk in order to fix the total value of a hedged item (e.g., debt) plus a hedge (e.g., a swap)?

Answer

There can be various reasons.  One of the most common reasons is that the debtor anticipates a drop a change in the i(t) interest rates and wants to "cash in" on the forecasted changed rates if what is perceived as a "good deal" can be negotiated in obtaining a swap or other derivative instrument.  However, the FAS 133/138 requirements force the debtor to book the swap value at fair value at least every three months.  However, if the firm has debt that can be a "hedged item" for the swap as a hedge that can receive hedge accounting under FAS 133/138, the basis of accounting for the hedged item (e.g., debt) can be changed from historical cost to a value-adjusted carrying value based upon changes in the I(t-1)-I(t) present value differences using the ex post i(t-1) and i(t)  index rates in place of the historical v(0) rate for each period.  

If the hedge is perfectly effective, then any W(t-1)-W(t) change in hedge value will be perfectly offset by a change in the I(t-1)-I(t) compnent of hedged item value.  The result is to eliminate fluctuations in earnings caused by booking the W(t) hedge values under FAS 133/138 rules.

Student Question 04
In terms of the Exhibit 1 definitions, what parameter changes can change swap cash flows.  For example, can the ex ante yield (swap) curve parameters directly affect swap cash flows?  Do the W(t) swap values affect swap cash flows?

Answer

Recall in Exhibit 1 that the swap cash flow is X(t)=[-F(0)*H(0)]*[r(0)-i(t)-p(0)]

The only parameter changes that will affect swap cash flows are the F(0)*H(0) swap notional, ex post i(t) index, the r(t) swap receivable leg rate, and the p(t) component of the i(t)+p(t) swap payable leg rate.  In this case, it has been assumed that r(t)=r(0) and p(t)=p(0).  Hence, the only parameter that both changes over time and affects swap cash flow is the ex post benchmark interest index i(t).

All other parameters in Exhibit 1 have no direct bearing on the swap cash flow.  In theory, the swap cash flow pattern ex post may move in the opposite direction of swap value (at least for a short period of time).  The reason is that cash flows are based upon past i(t) values and W(t) swap values are based upon forward i(t) rates.

Student Question 05
In the FASB's original Example 2 of Appendix B, a p(t)=0.00 increment applies for every repricing period of the swap.  This means the ABC Company has a swap receivable rate of (1/4)(0.0641) and a swap payable rate of [i(t)+0.0000] each period that translates to an APR=D*[i(t)+0.0000].  How much cash did the ABC Company receive from or payout to the counterparty of the t=0 through t=8 repricing periods of the swap?  What is the answer when D*p(t)=-0.10?  What if D*p(t)=0.10?

Hint:  In the "133Example2" spreadsheet, the answers can be found in Examples 01 and 05 for the D*p(t)=0.00 and D*p(t)=-0.10 parameters.  For the D*p(t)=0.10 parameter, students may first choose Example 01 and then customize the D*p(t) parameter expressed in an APR rate.

Answer

The original FASB Example 2 had D*p(t)=0.00 that resulted the swap's losing a total of ($12,225) in order to lock in a debt+swap value of $1,000,000 no matter what the change in the i(t) interest rate during the life of the swap.

Student Question 06
Is there a difference between how a X(t) swap's cash flow impacts earnings versus a W(t)-W(t-1)change in an interest rate swap hedge value and I(t-1)-I(t) components of hedged item value?  What happens if a swap is not perfectly effective as a hedge.  Answer for both cash flow hedges and benchmarked value-lock hedges?   

Answer

In a value-lock hedge, changes in value of both the value of the hedge and the swap cash flow affect current earnings.  The change in swap value, however, ideally offsets the change in hedged item value to mitigate the impact of value changes on earnings if the hedge qualifies for hedge accounting.

In cash flow hedge accounting, the changes in swap value are charged to OCI and swap cash flows are charged to current earnings.  You can compare value-lock versus cash-lock hedge accounting by comparing Paragraph 117 in Example 2 with Paragraph 137 in Example 5 of FAS 133.

Hedge ineffectiveness is charged to earnings under both types of swaps if it violates the ineffectiveness tolerances set by management at the start of the hedge contract.  Ineffectiveness within those tolerances can be ignored and need not be booked.

Student Question 07
In the "Main Case" spreadsheet, the tolerance for DELTA(t) ratios can be changed.  Higher values of this will tend to adjust "insignificant" hedge ineffectiveness ratios from there computed values back to 1.00.  For example, the change value of a hedge is $10 and the change in value of the hedged item is ($2), the hedge ratio is DELTA(t)=-$10/($2) = 5.0.  However, relative to a debt proceeds of, say, $100 million, the ineffectiveness involved is too small to make a difference in spite of the high DELTA(t).  In the "Main Case" spreadsheet, the DELTA(t) tolerance is initially set at a level of 

Lower Tolerance Bound = 0.0005*($100,000,000) = ($50,000)
Upper Tolerance Bound = 0.0005* $100,000,000 =    $50,000

Whenever the change in swap value plus the change in debt value (they have opposite signs) is nonzero, there is hedge ineffectiveness.  However, when this sum is less than the tolerance bound, the DELTA(t) is adjusted to 1.00 in the spreadsheet so that there will be no ineffectiveness adjustment.

Recall the outcome summary for  Period 7 ending on 10/02/03 for Example 3 in the "Main Case" spreadsheet:

Swaps Are Valued Based on Ex Ante Forward Rates in Period 7: 
     Swap Value at the End of Period 7 = W(7) =  ($1,419,508)
     Swap Value at the End of Period 6 = W(6) = -($1,674,235)  
     Change in Swap Value  =        W(7)-W(6) =    $   254,727

The LIBOR index Ex Post Current i(t) Rates in Period 7 lead to the following:
     Present Value at the End of Period 7    = I(7) = ($98,820,872)
     Present Value at the End of Period 6    = I(6) = ($98,630,913) without adjustment
     Change in Benchmark Debt Value = I(7)-I(6) =   ($  189,959)

 $254,727+($189,959) =  $64,768 ineffectiveness lies above the upper materiality bound of $50,000

DELTA(7) = -$254,727/($189,959) = 1.341 lies above the 1.25 upper bound.

Hence in Period 7, hedge ineffectiveness of $64,768 is deemed both material in amount and significant in terms of the popular 0.80-1.25 Rule for DELTA(t).

Questions:

1. What is the reason behind the hedge ineffectiveness in this case and why might management be upset by not being allowed hedge accounting for Period 7?
   
   
2. How would you journalize (book) this value-lock ineffectiveness under a rule that derivative instruments are to be carried at their W(t) fair values?  Keep in mind that the FASB does not prescribe one single way to define or test ineffectiveness?
   
   
3. How might the ineffectiveness adjustment help financial statement analysts get a better picture of Global Tech?
   
   
4. What is the journal entry for Period 7 under the shortcut method if a perfect (shortcut) value-lock hedge could have been negotiated?
   
   
5. What is the journal entry for Period 7 if hedge accounting is not permitted such that the economic hedge is accounted for as a speculation and the hedged item (debt) is carried at amortized historical cost?  In Example 3 of the Excel Workbook, there is no discount or premium to amortize.

Hint:  In the FASB's Exhibit 3 start to this illustration, the hedge at Time 0 begins at 
            Hedged V(0) + W(0) value lock = ($100,240,380

Answers

Management might be upset by increased variability of earnings whenever hedge accounting is not allowed because of hedge ineffectiveness that is both material and significant.  In this case earnings increases when hedge accounting is not allowed.  This is because the $254,727 increase in swap value is credited to interest expense without being reduced by a $189,959 change in benchmarked interest value.

The reason behind this ineffectiveness is that the FAS 133/138 rule for hedge accounting is that the carrying value of the debt under a qualifying value-lock hedge is the Present Value of the remaining payment (three payments remaining in this case) and the payoff of the principal at the ex post i(7) index rate which for D=2 in this case happens to be i(7)=(1/2)*0.07647)=.035734 in Period 7.  That present value is C(7)=($98,820,872) using an ex post rate of 3.5734%.  However, the Period 7 swap value of W(7)=($1,419,508) using the forward ex ante rates of the i(t) yield (swap) curve.  The swap is perfectly effective only when ex post and ex ante rates coincide to where W(7)-W(6)=I(6)-I(7).  That condition is violated in this case by $64,768.

The bottom line in Period 7 is that the hedge exceeded the ineffectiveness bounds under the 0.80-1.25 Rule and was significant under the ($50,000) to $50,000 materiality tolerance set initially for the case.  Since the DELTA(7)=1.341, the change in swap value exceeded the change in debt value.  The amount of ineffectiveness is the difference in the unbooked and booked ineffectiveness debt values above:

Unbooked ineffectiveness carrying value of the debt C(7) =  ($97,239,262)
Booked ineffectiveness carrying value of the debt     C(7) = -($97,364,453)
Unbooked, accumulated ineffectiveness                           =    $     125,191

In this particular case, earnings went up due to ineffectiveness.  What management and investors are likely to be more concerned with is the impact of booking ineffectiveness does to income volatility both up and down..   Although the impact of an ineffectiveness adjustment to earnings is favorable in this particular Period 7 illustration, the point is made to investors that booking ineffectiveness leads to greater earnings volatility.  What goes up must come down and vice versa since the net impact of all the valuation adjustments across the entire hedging period (five years in this example) add up to zero.  Large adjustments in one direction must be offset by large adjustments in the other direction at some future point in time.

If Global Tech had been able to elect the shortcut method, there would never be any ineffectiveness to book.  The journal entry for Period 7 under the shortcut method is as follows:

Without hedge accounting, the swap is a speculation and the debt is carried at amortized historical cost under FAS 133/138 rules.  The Period 7 entry is as follows:

The above outcome illustrates why companies have a strong incentive to qualify for hedge accounting if they have a value-locked economic hedge.  Treating the hedge as a speculation tends to have a much greater impact on earnings volatility than with any form of hedge accounting that tends to offset hedge value changes with debt value adjustments that are not allowed if the hedge is accounted for as a speculation.

I plan to add more student questions about swap valuation procedures and that pesky Amortization of Basis Adjustments account that is more confusing than it is worth in value-locked hedges that qualify for hedge accounting under FAS 133/138