DIG issues at http://www.fasb.org/derivatives/   Section G: Cash Flow Hedges *Issue G1—Hedging an SAR Obligation (Cleared 02/17/99) *Issue G2—Hedged Transactions That Arise from Gross Settlement of a Derivative ("All in One" Hedges) (Cleared 03/31/99) *Issue G3—Discontinuation of a Cash Flow Hedge (Cleared 03/31/99) *Issue G4—Hedging Voluntary Increases in Interest Credited on an Insurance Contract Liability (Cleared 07/28/99) *Issue G5—Hedging the Variable Price Component (Cleared 11/23/99) Issue G6—Impact of Implementation Issue E1 on Cash Flow Hedges of Market Interest Rate Risk (Released 11/99) Issue G7—Measuring the Ineffectiveness of a Cash Flow Hedge of Interest Rate Risk under Paragraph 30(b) When the Shortcut Method is Not Applied (Released 11/99) Issue G8—Hedging Interest Rate Risk of Foreign-Currency-Denominated Floating-Rate Debt (Released 11/99)

See Illustrations  and Ineffectivness.

Cash Flow Statement Presentation

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

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

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

QUESTIONS: 

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

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

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

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

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

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

CBOE =

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

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

CBOT =

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

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

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

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

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

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

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

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

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

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

Bob, The USDA Agricultural Marketing Service provides daily prices for commodities at multiple U.S. locations. Go to: http://www.ams.usda.gov/marketnews.htm . Another place to get cash price data is from Farmers Supply at: www.farmersupply.com . For LIBOR rates, the following site gives regularly updated LIBOR rates: http://www.libor-loans.com/libor_rate.html . I hope that this helps. Regards, Fred Seamon Advisory Economist Chicago Board of Trade

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

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

CDO Collateralized Debt Obligation = see Credit Derivatives 

Circus =

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

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

To circumvent the Paragraph 18 problem of having compound risk hedges in a single contract, the U.S. company could enter into to separate derivative contracts such as an interest rate swap accompanied by an independent forward contract that hedges the foreign currency risk.  Then the issue for a cash flow hedging combination is whether the Brazilian note qualifies as a hedging instrument qualifies under Paragraph 29 rules beginning on Page 20 of FAS 133.  Paragraph 20e bans interest rate hedging if the note is declared held-to-maturity.   Paragraph 20d bans interest rate hedging for a note declared as a trading security under SFAS 115.  Conversely, Paragraphs 4c on Page 2, 38 on Page 24, and 479 on Page 209 of FAS 133 state that a forecasted purchase of an available-for-sale security can be a hedged item, because available-for-sale securities revalued under SFAS 115 have holding gains and losses accounted for in comprehensive income rather than current earnings.  Unlike trading securities, available-for-sale securities can be FAS 133-allowed hedge items.   Mention of available-for sale is made in Paragraphs 4, 18, 23, 36, 38, 49, 52-55, 123, 479-480, and 534 of FAS 133.  Even if this results in accounting for the two derivatives as a cash flow hedge of the Brazilian note, the same cannot be said for a fair value hedge since the forward contract hedging foreign currency risk must be carried at fair value.  Somewhat similar conclusions arise for a foreign currency note payable illustration in Example 15 on Page 272 of Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

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

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

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

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

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

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

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

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

Illustrations are provided under cap and floater.

See DIG Issue B5 under embedded derivatives.

CME =

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

Collar=

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

Collateralized Debt Obligation (CDO) = see Credit Derivatives 

Collateralized Mortgage Obligation CMO =

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

Combination Option = see compound derivatives and option.

Commitment Exposure =

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

Commodity-Indexed Embedded Derivative =

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

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

Competitive Exposure =

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

Compound Derivatives  =

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

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

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

• Paragraph 18 beginning on Page 9,

• Footnote 13 on Page 29,

• Paragraphs 360-362 beginning on Page 167,

• Paragraph 413 on Page 186,

• Paragraphs 523-524 beginning on Page 225.

Section c(4) of Paragraph 4 on Page 2 of FAS 133 makes an exception to Paragraph 29a on Page 20 for portfolios of dissimilar assets and liabilities. It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52.  The gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment. Reasons are given in Paragraph 477 on Page 208 of FAS 133:

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

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

Paragraph 42 on Page 26 reads as follows:

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

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

Paragraph 18 at the top of  Page 10 does allow a single derivative to be divided into components  but never with partitioning of  "different risks and designating each component as a hedging instrument."   An example using Dutch guilders versus French francs is given under cash flow hedge.  The problem is troublesome in circuses.

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

See Structure and Synthetic.

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

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

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

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

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

See also struggle statement.

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

Summary of FAS 130

Reporting Comprehensive Income (Issued 6/97)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Contingent Consideration =

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

Convertible Debt =

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

Covered Call and Covered Put  =

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

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

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

Also see option and written option.

Credit Derivative and Credit Risk Swap =

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

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

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

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

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

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

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

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

Continued in the article.

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

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

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

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

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

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

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

Continued in article

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Misuses of Credit Derivatives

JP Morgan – whose lawyers must be working overtime – is refuting any wrongdoing over credit default swaps it sold on Argentine sovereign debt to three hedge funds. But the bank failed to win immediate payment of $965 million from the 11 insurers it is suing for outstanding surety bonds. Christopher Jeffery Editor, March 2, 2002, RiskNews http://www.risknews.net  Note from Bob Jensen:  The above quotation seems to be Year 2002 Déjà Vu  in terms of all the bad ways investment bankers cheated investors in the 1980s and 1990s.  Read passage from Partnoy's book quoted at http://www.trinity.edu/rjensen/book02q1.htm#022502  Enron was its own investment bank on many deals, especially in credit derivatives. You can read the following at http://www.trinity.edu/rjensen/fraud.htm  Selected quotations from "Why Enron Went Bust: Start with arrogance. Add greed, deceit, and financial chicanery. What do you get? A company that wasn't what it was cracked up to be." by Benthany McLean, Fortune Magazine, December 24, 2001, pp. 58-68. Why Enron Went Bust: Start with arrogance. Add greed, deceit, and financial chicanery. What do you get? A company that wasn't what it was cracked up to be." In fact , it's next to impossible to find someone outside Enron who agrees with Fasto's contention (that Enron was an energy provider rather than an energy trading company). "They were not an energy company that used trading as part of their strategy, but a company that traded for trading's sake," says Austin Ramzy, research director of Principal Capital Income Investors. "Enron is dominated by pure trading," says one competitor. Indeed, Enron had a reputation for taking more risk than other companies, especially in longer-term contracts, in which there is far less liquidity. "Enron swung for the fences," says another trader. And it's not secret that among non-investment banks, Enron was an active and extremely aggressive player in complex financial instruments such as credi8t derivatives. Because Enron didn't have as strong a balance sheet as the investment banks that dominate that world, it had to offer better prices to get business. "Funky" is a word that is used to describe its trades. I was particularly impressed, as were all people who phoned in, by the testimony of Scott Cleland (see Tuesday, January 15) and then click on the following link to read his opening remarks to a Senate Committee on December 18. If you think the public accounting profession has an "independence problem," that problem is miniscule relative to an enormous independence problem among financial analysts and investment bankers --- two professions that are literally rotten to the core. Go to http://www.c-span.org/enron/scomm_1218.asp#open  A portion of Mr. Cleland's testimony is quoted below: Four, it's common for analysts to have a financial stake in the companies they're covering. That's just like, essentially, allowing athletes to bet on the outcome of the game that they're playing in. Five, most payments for investment research is routinely commingled in the process with more profitable investment banking and proprietary trading. The problem with this is it effectively means that most research analysts work for the companies and don't work for investors. Six, credit agencies may have conflicts of interest. Seven, analysts seeking investment banking tend to be more tolerant of pro-forma accounting and the conflict there is, essentially, the system is allowing companies to tell -- you know, to make up their own accounting. To describe their own financial performance, that no one then can compare objectively with other companies. Eight, surprise, surprise, companies routinely beat the expectations of a consensus of research analysts that are seeking their investment banking business. See how banks use/misuse credit derivatives with  tranches.

A Bankers Primer on Credit Derivatives --- http://www.citissb.com/home/Creddriv.pdf  What are Credit Derivatives? Credit derivatives have three basic structures: credit default swaps, total return swaps and credit spread options. In a credit default swap, a buyer pays a seller a fixed fee in return for indemnification against losses should a credit event occur. Credit default swaps are used for risk management, capital management and investment management. Buyers of protection reduce credit concentrations or open up credit lines. Buyers may also obtain capital relief, redeploying the capital in more profitable business lines or buying back stock. Primus Financial Services offers credit derivatives --- http://www.tfibcm.com/news/story/default.asp?734  Kicking off what analysts are calling a small trend, New York-based Primus Financial Products recently became the first company structured solely to be a swap counterparty, selling protection via credit default swaps. "We're not a dealer, we're not a CDO, and we're not an insurance company," said Chief Executive Officer Tom Jasper. "What we are is a credit derivatives company." As derivatives are becoming a more and more widely accepted method of transferring risk, it is not surprising that at least two additional companies - both at different stages of development - are following suit. The two are said to be familiar names in the asset-backed market, and the first will likely launch in mid-summer, according to Moody's Investors Service, which, along with Standard & Poor's, has awarded Primus a triple-A counterparty rating. Primus will begin trading in the next few weeks, Jasper said. In the first year of trading, Primus is planning to build a portfolio of about $5.5 billion in single name investment-grade corporate and sovereign credits. "The plan is to take advantage of what we believe is a pretty efficient capital model and cost model, and to become a very efficient investor in investment-grade risk, using, as the transfer vehicle, the credit default swap," Jasper said. "So we're transferring risk synthetically versus a cash instrument." Though many of its clients, which could include CDOs, insurance company portfolio managers, hedge funds, banks and other cash investors, might be using PFP to establish hedges, Primus is not incorporating a hedging strategy for its own portfolio, and, only in special situations, will buy credit protection for its exposures. Its triple-A counterparty rating is based primarily on its capital levels, or other resources, being sized to match the expected loss (Moody's) of its referenced obligations. Also, contrary to some players' initial impressions of the company, Primus doesn't plan to launch any CDOs from its portfolio. "It's not contemplated that we would securitize the risk that we will take on," Jasper said. "We're very happy to hold the risk to maturity."

March 2002 - Former dealers from Salomon Smith Barney and Bank of America yesterday set up what they claimed to be the first boutique focusing purely on default swap credit derivatives.

Question:
When does a hedge become a speculation?  

Answer:
There are essentially two answers.  Answer 1 is that a speculation arises when the hedge is not perfectly effective in covering that which is hedged such as the current value (fair alue hedge) of the hedged item or the hedged cash flow (cash flow hedge).  Testing for hedge ineffectiveness under FAS 133 and IAS 39 rules is very difficult for auditors.  Answer 2 is that a speculation arises when unsuspected credit risk arises from the settlements themselves such as when dealers who brokered hedge derivatives cannot back the defaults all parties contracted under the derivatives themselves.  Hedges may no longer be hedges!  Answer 2 is even more problematic in this particular down economy.

There is a lot of complaining around the world about need for and technicalities of the U.S. FAS 133 and the international IAS 39 standards on Accounting for Financial Instruments Derivatives and Hedging Activities.  But recent scandals adding to the pile of enormous scandals in derivatives over the past two decades suggest an increased  need for more stringent rather than weakened standards for accounting for derivatives.  The main problem lies in valuation of these derivatives coupled with the possibility that what is a safe hedge is really a risky speculation.  A case in point is Newmont Mining Corporation's Yandal Project in Australia as reported by Steve Maich in "Newmont's Hedge Book Bites Back," on  Page IN1 of the March 4, 2003 edition of Canada's Financial Post --- http://www.financialpost.com/ 

Even by the gold industry's relatively aggressive standards, Yandal's derivatives exposure is stunning.  The unit has 3.4 million ounces of gold committed through hedging contracts that had a market value of negative US$288-million at the end of 2002.

That would be a problem for any major producer, but the situation is particularly dire for Yandal because the development's total proven and provable gold reserves are just 2.1 million ounces.  In other words, the project has, through its hedging contracts, committed to sell 60% more gold than it actually has in the ground.

Making matters worse, the mine's counterparties can require Yandal to settle the contracts in cash, before they come due.  In all, about 2.8 million ounces are subject to these cash termination agreements by 2005, which could cost the company US$223.7-million at current market prices.

With insufficient gold to meet its obligations, and just US$58-million in cash to make up the difference, bankruptcy may be the only option available to Yandal, analysts said.

Comparing Yandal's reserves to its hedging liabilities "suggests that the Yandal assets may be worth more dead than alive," CIBC World Markets analyst Barry Cooper said in a report to clients.

All this is raising even bigger questions about the impact that the Yandal situation might have on the industry's other major hedgers.  Companies such as Canada's Barrick Gold Corp. and Placer Dome Ltd. have lagged the sector's strong rally of the past year, largely because many investors and analysts distrust the companies' derivative portfolios.

One thing that is not stressed hard enough in FAS 133 is the credit risk of the dealers themselves.  The FAS 133 standard and its international IAS 39 counterpart implicitly assume that when speculating or hedging with derivatives, the dealers who broker these contracts are highly credit worthy.  For example, in the case of interest rate swaps it is assumed that the dealer that brokers the swap will stand behind the swapping party and counterparty default risks.  There are now some doubts about this in the present weak economy.

"Derivatives Market a 'Time Bomb':  Buffet," Financial Post, March 4, 2003, Page IN1 --- http://www.financialpost.com/ 
Berkshire chairman warns of risks in shareholder letter --- http://www.berkshirehathaway.com/letters/letters.html 
(The above link is not yet updated for the Year 2002 forthcoming annual Shareholder Letter.)

Billionaire investor Warren Buffett calls derivative contracts "financial weapons of mass destruction, carrying dangers that while now latent are potentially lethal," according to excerpts from his forthcoming annual letter to Berkshire Hathaway Inc. shareholders.

Mr. Buffett, whose company is now seeking to divest of derivatives business tied to its General Re purchase, also worries that substantial credit risk has become concentrated "in the hands of relatively few derivatives dealers."

"Divided on Derivatives Greenspan:  Buffett at Odds on Risks of the Financial Instruments," by John M. Berry, The Washington Post, March 6, 2003, Page E01 --- http://www.washingtonpost.com/wp-dyn/articles/A48287-2003Mar5.html 

The use of derivatives has grown exponentially in recent years. The total value of all unregulated derivatives is estimated to be $127 trillion -- up from $3 trillion 1990. J.P. Morgan Chase & Co. is the world's largest derivatives trader, with contracts on its books totaling more than $27 trillion. Most of those contracts are designed to offset each other, so the actual amount of bank capital at risk is supposed to be a small fraction of that amount.

Previous efforts to increase federal oversight of the derivatives market have failed, including one during the Clinton administration when the industry, with support from Greenspan and other regulators, beat back an effort by Brooksley Born, the chief futures contracts' regulator. Sen. Dianne Feinstein (D-Calif.) has introduced a bill to regulate energy derivatives because of her belief that Enron used them to manipulate prices during the California energy crisis, but no immediate congressional action is expected.

Randall Dodd, director of the Derivatives Study Center, a Washington think tank, said both Buffett and Greenspan are right -- unregulated derivatives are essential tools, but also potentially very risky. Dodd believes more oversight is needed to reduce that inherent risk.

"It's a double-edged sword," he said. "Derivatives are extremely useful for risk management, but they also create a host of new risks that expose the entire economy to potential financial market disruptions."

Buffett has no problem with simpler derivatives, such as futures contracts in commodities that are traded on organized exchanges, which are regulated. For instance, a farmer growing corn can protect himself against a drop in prices before he sells his crop by buying a futures contract that would pay off if the price fell. In essence, derivatives are used to spread the risk of loss to someone else who is willing to take it on -- at a price.

Buffett's concern about more complex derivatives has increased since Berkshire Hathaway purchased General Re Corp., a reinsurance company, with a subsidiary that is a derivatives dealer. Buffett and his partner, Charles T. Munger, judged that business "to be too dangerous."

Because many of the subsidiary's derivatives involve long-term commitments, "it will be a great many years before we are totally out of this operation," Buffett wrote in the letter, which was excerpted on the Fortune magazine Web site. The full text of the letter will be available on Berkshire Hathaway's Web site on Saturday. "In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit."

One derivatives expert said several of General Re's contracts probably involved credit risk swaps with lenders in which General Re had agreed to pay off a loan if a borrower -- perhaps a telecommunications company -- were to default. In testimony last year, Greenspan singled out the case of telecom companies, which had defaulted on a significant portion of about $1 trillion in loans. The defaults, the Fed chairman said, had strained financial markets, but because much of the risk had been "swapped" to others -- such as insurance companies, hedge funds and pension funds -- the defaults did not cause a wave of financial-institution bankruptcies.

"Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands," Buffett acknowledged. "These people believe that derivatives act to stabilize the economy, facilitate trade and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies."

But then Buffett added: "The macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties," some of whom are linked in such a way that many of them could run into problems simultaneously and set off a cascade of defaults.

March 7, 2003 message from Risk Waters Group [RiskWaters@lb.bcentral.com] 

Alan Greenspan, chairman of the US Federal Reserve, today once again defended the use of derivatives as hedging tools, especially credit derivatives. His comments come in the wake of Warren Buffett's criticism of derivatives as "time bombs" and Peter Carr - recipient of Risk's 2003 quant of the year award this week - saying that in a [hypothetical] argument between quants convinced of the infallibility of their models and derivatives sceptics such as Buffett, he would probably side with Buffett.

But Greenspan, speaking at the Banque de France's symposium on monetary policy, economic cycle and financial dynamics in Paris, said derivatives have become indispensable risk management tools for many of the largest corporations. He said the marriage of derivatives and securitisation techniques in the form of synthetic collateralised debt obligations has broadened the range of investors willing to provide credit protection by pooling and unbundling credit risk through the creation of securities that best fit their preferences for risk and return.

This probably explains why credit derivatives employees reap the highest salaries, with an Asian-based managing director in synthetic structuring at a bulge-bracket firm earning an average basic plus bonus of £1.35 million last year. These were the findings of a first-of-its-kind survey conducted by City of London executive search company Napier Scott. The survey found that most managing directors working in credit derivatives at the top investment banks earn more than £1 million, with synthetic structurers commanding the highest salary levels. Asia-based staff earn 12-15% more than their US counterparts, with UK-based staff not far behind their Asia-based counterparts. Even credit derivatives associates with one or two years' experience earn in excess of £150,000 a year on average at a tier-1 bank.

In more people news, Merrill Lynch has hired four ex-Goldman Sachs bankers for its corporate risk management group focused on Europe, the Middle East and Africa. Roberto Centeno was hired as a director with responsibility for Iberia. Andrea Anselmetti and Luca Pietrangeli, both directors, and Ernesto Mercadente, an associate, will focus on expanding the corporate risk management and foreign exchange business in the Italian region. The corporate risk management group focuses on providing advice and execution for corporate clients, covering all risk management issues, including foreign exchange, interest rate risk and credit risk. All four will report to Patrick Bauné, co-head of Merrill Lynch's global foreign exchange issuer client group, and Damian Chunilal, head of the EMEA issuer client group, and are expected to join within the next two weeks. Merrill also hired Scott Giardina as a director in credit derivatives trading, based in London. He will report to Jon Pliner, managing director of credit trading EMEA, and Neil Walker, managing director of structured credit trading, EMEA. Giardina also joins from Goldman Sachs.

Christopher Jeffery
Editor, RiskNews
www.risknews.net
cjeffery@riskwaters.com

 

April 11, 2003Update on Accounting for Credit Derivatives
April 11, 2003 message from Risk Waters Group [RiskWaters@lb.bcentral.com] 

Jean-Claude Trichet, governor of the Bank of France, said transparency is essential to prevent a "herd mentality" in the financial market that can create artificial swings in market prices. During a keynote address at the Professional Risk Managers' International Association 2003 European Summit in Paris this week, Trichet called for a "strengthening of market transparency" and the disclosure of "complete and reliable information". He added that "no satisfying disclosure" yet exists for the credit derivatives market-place, and that while a January study by the Bank for International Settlements cast "some light" on this market, "these efforts should be pursued by central banks as well as market participants". Trichet said transparency is not just an issue for investors and savers but a fundamental tenet underpinning anti-cyclicality. "If information is not transparent, behaving as a 'herd' is a natural reaction," Trichet said.

Banks and Credit Derivatives
From Jim Mahar's blog on August 17, 2005

Minton, Stulz, and Williamson have an important look at banks' usage of credit derivatives. The short version? Very few banks are using them! In 2003, only about 6% of banks with over $1B in assets report using this form of derivatives. Consistent with what we have seen on other derivative usage, these banks tend to be much larger than average. Best guess as for the low usage? Transaction costs driven by moral hazard and adverse selection costs.

Slightly longer version of the paper

Minton, Stulz, and Williamson begin by documenting that the credit derivative market (measured by notional principle) has grown in recent years. Regulators (and even Alan Greenspan himself) have claimed that this reduces the risks that banks face. The paper investigates banks' use of credit derivatives and find that as of 2003, few banks were using credit derivatives. Those banks that were using the derivatives tended to be larger and have a greater need for the risk reduction.

In the words of the paper's authors:

"...net buyers of protection have higher levels of risk than other banks: they have lower capital ratios, lower balances of liquid assets, a higher ratio of risk-based assets to total assets, and a higherfraction of non-performing assets than the non-users of credit derivatives."

Why the limited use? Transaction costs undoubtedly play a role. Like in other derivatives "know-how" can be expensive to obtain and this largely fixed cost may explain a portion of the limited use. However, the very nature of credit derivatives also makes them prone to moral hazard and adverse selection costs. (Tried another way, banks typcially know more about the borrowers (and are often in a better position to monitor), than do derivative market participants. This results in less liquidity (higher transaction costs) for the very loans that would make the most sense to hedge.)

Again in the authors' words:

"These adverse selection and moral hazard problems make the market for credit derivatives illiquid for single name protection precisely for the credit risks that banks would often want to hedge with such protection. The positive coefficient estimates on C&I loan and foreign loan shares in a bank’s loan portfolio are consistent with the hypothesis that banks are more likely to hedge with credit derivatives if they have more loans to credits for which the credit derivatives market is more liquid."

So what does this all mean? The conclusion hints that the benefits of credit derivatives may be overstated but apparently the cost of hedging in papers is lower than in the credit derivative market as the paper ends covering both sides of the debate:

"To the extent that credit derivatives make it easier for banks to maximize their value with less capital, they do not increase the soundness of banks as much as their purchases of credit derivatives would imply. However, if credit derivatives enable banks to save capital, they ultimately reduce the cost of loans for bank customers and make banks more competitive with the capital markets for the provision of loans."

Not only are few banks using the derivatives to hedge, the exact loans that the banks would want to hedge are the most expensive to do. This really should not be surprising. What is more surprising is that these costs are so high as to prevent the use of the derivatives. Going forward in time, it will be interesting to see if this remains the case or if as the market develops, new ways evolve to lower the costs which would allow more effective hedging with credit derivatives. Stay Tuned.

Cite:
Minton, Bernadette A, Rene Stulz, and Rohan Williamson.
"How much do banks use credit derivatives to reduce risk?",
Ohio State working paper,
http://www.cob.ohio-state.edu/fin/dice/papers/2005/2005-17.pdf 

Bob Jensen's threads on derivatives scandals can be found at http://www.trinity.edu/rjensen/fraud.htm#DerivativesFraud 

Bob Jensen's helpers, tutorials, glossary, and instructional cases for FAS 133 and IAS 39 are at http://www.trinity.edu/rjensen/caseans/000index.htm 

Credit Sensitive Payments =

payments on a debt instrument that vary under an embedded option that adjusts the interest rate on the basis of changed credit rating of the borrower.  Paragraph 61c on Page 41 of FAS 133 defines these payments as clearly-and-closely related such that the embedded derivative cannot be accounted for separately under Paragraph 12 on Page 7.  This makes embedded credit derivative accounting different than commodity indexed and equity indexed embedded derivative accounting rules that require separation from the host contract such as commodity indexed, equity indexed, and inflation indexed embedded derivatives.  In this regard, credit indexed embedded derivative accounting is more like inflation indexed accounting.  See derivative financial instrument and embedded derivatives.

Cross-Currency Hedge = see foreign currency hedge.

Cross Rate =

the exchange rate between two currencies other than the dollar, calculated using the dollar exchange rates of those currencies.

Crude Oil Knock-in Note = 

a bond that has upside potential on the principal payback contingent upon prices in the crude oil market.  Such a note is illustrated in Example 21 in Paragraph 187 of FAS 133.

CTA = a term with alternate meanings.

Commodity Trading Advisor - One who provides advice on investing in currencies as a separate asset class. Some also act in a separate function as overlay managers, advising on hedging the currency risk in international asset portfolios.

Cumulative Translation Adjustment - An entry in a translated balance sheet in which gains and losses from transactions have been accumulated over a period of years.

Cumulative Dollar Offset = see ineffectiveness.

Currency Swap =

a transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay over time at a predetermined rate that reflects interest payments and possibly amortization of the principal as well. The payment flows are based on fixed interest rates in each currency.    An example of a currency swap in FAS 133 appears in Example 5 Paragraphs 131-139 on Pages 72-76.

Current Rate =

The exchange rate in effect at the relevant-financial-statement date.

Bob Jensen's Web Site

Top of Document

Start of Glossary

The problem is that the value of the hybrid (which may be a market price or transaction price) is often difficult to bifurcate into component values when the components themselves are not traded on the market on their own. An excellent paper on how to value some bifurcated components is provided in "Implementation of an Option Pricing-Based Bond Valuation Model for Corporate Debt and Its Components," by M.E. Barth, W.R. Landsman, and R.J. Rendleman, Jr., Accounting Horizons, December 2000, pp. 455-480.

Some firms contend that the major problem they are having in implementing FAS 133 or IAS 39 lies in having to review virtually every financial instrument in search of embedded derivatives and then trying to resolve whether bifurcation is required or not required. Many of the embedded derivatives are so "closely related" that bifurcation is not required. See "closely related" in http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

Also listen to executives and analysts discuss the bifurcation problem in http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm 

Detecting derivatives and embedded derivatives to account for worldwide (bifurcation)

• Audio of J.C. Mercier from BankBoston MERC20.mp3
• Some companies may not be aware that they have derivatives --- Jim Rozsypal  ROZSY04.mp3 
• Audio of Martin Klein from Lehman Brothers  KLEIN20.mp3  
• Audio of Martin Klein and Jin Chang from Lehman Brothers  KLCHANG1.mp3 
• The litmus test --- Audio of Jin Chang from Lehman Brothers  CHANG10.mp3
• Roger Pearson Says Find Them and Be Consistent  CARBR04.mp 
  

Bob Jensen

May 6, 2002 message from George Lan

I am trying to read the FASB draft (Questions and Answers Related to Derivative Financial Instruments Held or Entered into by a Qualifying Special-Purpose Entity (SPE))  and got stumped right at the beginning. Perhaps someone on the list can clarify these sentences for me: "Under FASB 133, hybrid instruments that must be bifurcated contain two components for accounting purpose-- a derivative financial instrument and a nonderivative host contract....Hybrid instruments that are not bifurcated ... are not considered to be derivative instruments." I am familiar with split accounting (methods of splitting the financial instrument into its bond and equity components, e.g) and with most of the common derivative contracts such as futures, forwards, options, swaps but am ignorant about hybrid instruments and why they must be or do not have to be bifurcated and would certainly appreciate some examples and assistance from AECMers.

I am also a little familiar with much of the derivative jargon, but expressions like "the floor purchased..." could perhaps be clarified to make the draft easier to read and understand by a wider audience.

Just a couple of thoughts,

George Lan 
University of Windsor

DIG Issue B1 --- http://www.fasb.org/derivatives/ 
QUESTION

An entity (Company A) issues a 5-year "debt" instrument with a principal amount of $1,000,000 indexed to the stock of an unrelated publicly traded entity (Company B). At maturity, the holder of the instrument will receive the principal amount plus any appreciation or minus any depreciation in the fair value of 10,000 shares of Company B, with changes in fair value measured from the issuance date of the debt instrument. No separate interest payments are made. The market price of Company B shares to which the debt instrument is indexed is $100 per share at the issuance date. The instrument is not itself a derivative because it requires an initial net investment equal to the notional amount; however, what is the host contract and what is the embedded derivative comprising the hybrid instrument?

RESPONSE

The host contract is a debt instrument because the instrument has a stated maturity and because the holder has none of the rights of a shareholder, such as the ability to vote the shares and receive distributions to shareholders. The embedded derivative is an equity-based derivative that has as its underlying the fair value of the stock of Company B. Paragraph 60 states:

...most commonly a financial instrument host contract will not embody a claim to the residual interest in an entity and, thus, the economic characteristics and risks of the host contract should be considered that of a debt instrument. For example, even though the overall hybrid instrument that provides for repayment of principal may include a return based on the market price...of XYZ Corporation common stock, the host contract does not involve any existing or potential residual interest rights (that is, rights of ownership) and thus would not be an equity instrument. The host contract would instead be considered a debt instrument, and the embedded derivative that incorporates the equity-based return would not be clearly and closely related to the host contract. Unless the hybrid instrument is remeasured at fair value with changes in value recorded in earnings as they occur, the embedded derivative must be separated from the host contract. As a result of the host instrument being a debt instrument and the embedded derivative having an equity-based return, the embedded derivative is not clearly and closely related to the host contract and must be separated from the host contract and accounted for as a derivative by both the issuer and the holder of the hybrid instrument.

DIG Issue B2 --- http://www.fasb.org/derivatives/ 
QUESTION

An investor purchases for $10,000,000 a structured note with a face amount of $10,000,000, a coupon of 8.9 percent, and a term of 10 years. The current market rate for 10-year debt is 7 percent given the single-A credit quality of the issuer. The terms of the structured note require that if the interest rate for single-A rated debt has increased to at least 10 percent at the end of 2 years, the coupon on the note is reduced to zero, and the investor must purchase from the issuer for $10,000,000 an additional note with a face amount of $10,000,000, a zero coupon, and a term of 3.5 years. How does the criterion in paragraph 13(a) apply to that structured note? Does the structured note contain an embedded derivative that must be accounted for separately?

RESPONSE

The structured note contains an embedded derivative that must be accounted for separately. The requirement that, if interest rates increase and the derivative is triggered, the investor must purchase the second $10,000,000 note for an amount in excess of its fair value (which is about $7,100,000 based on a 10 percent interest rate) generates a result that is economically equivalent to requiring the investor to make a cash payment to the issuer for the amount of the excess. As a result, the cash flows on the original structured note and the excess purchase price on the second note must be considered in concert. The cash inflows ($10,000,000 principal and $1,780,000 interest) that will be received by the investor on the original note must be reduced by the amount ($2,900,000) by which the purchase price of the second note is in excess of its fair value, resulting in a net cash inflow ($8,880,000) that is not substantially all of the investor’s initial net investment on the original note.

As described in paragraph 13(a) of Statement 133, an embedded derivative in which the underlying is an interest rate or interest rate index and a host contract that is a debt instrument are considered to be clearly and closely related unless the hybrid instrument can contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment. Paragraph 61(a)(1) clarifies that this test would be conducted by comparing the investor’s undiscounted net cash inflows over the life of the instrument to the initial recorded investment in the hybrid instrument. As demonstrated by the scenario above, if a derivative requires an asset to be purchased for an amount that exceeds its fair value, the amount of the excess — and not the cash flows related to the purchased asset — must be considered when analyzing whether the hybrid instrument can contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment under paragraph 13(a). Whether that purchased asset is a financial asset or a nonfinancial asset (such as gold) is not relevant to the treatment of the excess purchase price.

It is noted that requiring the investor to make a cash payment to the issuer is also economically equivalent to reducing the principal on the note. The note described in the question above could have been structured to include terms requiring that the principal of the note be substantially reduced and the coupon reduced to zero if the interest rate for single-A rated debt increased to at least 10 percent at the end of 2 years. That alternative structure would clearly have required that the embedded derivative be accounted for separately, because that embedded derivative’s existence would have resulted in the possibility that the hybrid instrument could contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment.

DIG Issue B3 --- http://www.fasb.org/derivatives/ 
QUESTION

Should an investor (creditor) account separately for a put or call option that is added to a debt instrument by a third party contemporaneously with or subsequent to the issuance of the debt instrument?

BACKGROUND

The last two sentences of paragraph 61(d) states, "In certain unusual situations, a put or call option may have been subsequently added to a debt instrument in a manner that causes the investor (creditor) to be exposed to performance risk (default risk) by different parties for the embedded option and the host debt instrument, respectively. In those unusual situations, the embedded option and the host debt instrument are not clearly and closely related." The references to the "embedded" option in the previous sentences refer to the added option.

Example 1 presents a transaction that involves the addition of a call option contemporaneously with or subsequent to the issuance of debt. Example 2 presents a group of transactions with a similar overall effect.

Example 1 Company X issues 15-year puttable bonds to an Investment Banker for $102. The put option may be exercised at the end of five years. Contemporaneously, the Investment Banker sells the bonds with an attached call option to Investor A for $100. (The call option is a written option from the perspective of Investor A and a purchased option from the perspective of the Investment Banker.) The Investment Banker also sells to Investor B for $3 the call option purchased from Investor A on those bonds. The call option has an exercise date that is the same as the exercise date on the embedded put option. At the end of five years, if interest rates increase, Investor A would presumably put the bonds back to Company X, the issuer. If interest rates decrease, Investor B would presumably call the bonds from Investor A.

Example 2 Company Y issues 15-year puttable bonds to Investor A for $102. The put option may be exercised at the end of five years. Contemporaneously, Company Y purchases a transferable call option on the bonds from Investor A for $2. Company Y immediately sells that call option to Investor B for $3. The call option has an exercise date that is the same as the exercise date of the embedded put option. At the end of five years, if rates increase, Investor A would presumably put the bonds back to Company Y, the issuer. If rates decrease, Investor B would presumably call the bonds from Investor A.

RESPONSE

Yes. A put or call option that is added to a debt instrument by a third party contemporaneously with or subsequent to the issuance of the debt instrument should be separately accounted for as a derivative under Statement 133 by the investor (that is, by the creditor); it must be reported at fair value with changes in value recognized currently in earnings unless designated in a qualifying hedging relationship as a hedging instrument. As a result, in Example 1 above, the call option that is attached by the Investment Banker is a separate derivative from the perspective of Investor A. Similarly, the call option described in Example 2 is a separate freestanding derivative that also must be reported at fair value with changes in value recognized currently in earnings unless designated as a hedging instrument.

The discussion in the last two sentences of paragraph 61(d) that refers to a put or call option that is added to a debt instrument by a third party subsequent to its issuance incorrectly uses the phrase embedded option in referring to that option. An option that is added or attached to an existing debt instrument by another party results in the investor having different counterparties for the option and the debt instrument and, thus, the option should not be considered an embedded derivative. The notion of an embedded derivative in a hybrid instrument refers to provisions incorporated into a single contract, and not to provisions in separate contracts between different counterparties. Consequently, such added or attached options should not have been discussed in paragraph 61, which discusses only embedded derivatives. (When the Board next considers a "technical corrections" amendment of the accounting literature, the staff plans to recommend deletion of the last two sentences of paragraph 61(d).)

DIG Issue B4 --- http://www.fasb.org/derivatives/ 

QUESTION

Two entities enter into a long-term service contract whereby one entity (A) agrees to provide a service to the other entity (B), at market rates over a three-year period. Entity B forecasts it will pay 1,000 kroner to Entity A at the end of the three-year period for all services rendered under the contract. Entity A's functional currency is the kroner and Entity B's is the U.S. dollar. In addition to providing the terms under which the service will be provided, the contract includes a foreign currency exchange provision. The provision requires that over the term of the contract, Entity B will pay or receive an amount equal to the fluctuation in the exchange rate of the U.S. dollar and the kroner applied to a notional amount of 100,000 kroner (that is, if the U.S. dollar appreciates versus the kroner, Entity B will pay the appreciation, and if the U.S. dollar depreciates versus the kroner, Entity B will receive the depreciation). The host contract is not a derivative and will not be recorded in the financial statements at market value. For the purpose of applying paragraph 15, is the embedded foreign currency derivative considered to be clearly and closely related to the terms of the service contract?

BACKGROUND

Paragraph 12 of Statement 133 requires that an embedded derivative instrument be separated from the host contract and accounted for as a derivative instrument pursuant to the Statement if certain criteria are met. Paragraph 15 provides that an embedded foreign currency derivative instrument is not to be separated from the host contract and considered a derivative pursuant to paragraph 12 if the host contract is not a financial instrument and specifies payments denominated in either of the following currencies:

The currency of the primary economic environment in which any substantial party to the contract operates (that is, its functional currency)

The currency in which the price of the related good or service is routinely denominated in international commerce.

Paragraph 15 provides the exclusion to paragraph 12 on the basis that if a host contract is not a financial instrument and it is denominated in one of the two aforementioned currencies, then the embedded foreign currency derivative is considered to be clearly and closely related to the terms of the service contract.

RESPONSE

No, the embedded foreign currency derivative instrument should be separated from the host and considered a derivative instrument under paragraph 12.

In paragraph 311, "[t]he Board decided that it was important that the payments be denominated in the functional currency of at least one substantial party to the transaction to ensure that the foreign currency is integral to the arrangement and thus considered to be clearly and closely related to the terms of the lease." It follows that the exception provided by paragraph 15 implicitly requires that the other aspects of the embedded foreign currency derivative must be clearly and closely related to the host.

In the example discussed above, because the contract is leveraged by requiring the computation of the payment based on a 100,000 kroner notional amount, the contract is a hybrid instrument that contains an embedded derivative — a foreign currency swap with a notional amount of 99,000 kroner. That embedded derivative is not clearly and closely related to the host contract and under paragraph 12 of Statement 133 must be recorded separately from the 1,000 kroner contract. Either party to the contract can designate the bifurcated foreign currency derivative instrument as a hedging instrument pursuant to Statement 133 if applicable qualifying criteria are met.

DIG Issue B5 --- http://www.fasb.org/derivatives/ 
QUESTION

If the terms of a hybrid instrument permit, but do not require, the investor to settle the hybrid instrument in a manner that causes it not to recover substantially all of its initial recorded investment, does the contract satisfy the condition in paragraph 13(a), thereby causing the embedded derivative to be considered not clearly and closely related to the host contract?

BACKGROUND

Paragraph 13 of Statement 133 states:

For purposes of applying the provisions of paragraph 12, an embedded derivative instrument in which the underlying is an interest rate or interest rate index that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract is considered to be clearly and closely related to the host contract unless either of the following conditions exist:

The hybrid instrument can contractually be settled in such a way that the investor (holder) would not recover substantially all of its initial recorded investment.

The embedded derivative could at least double the investor's initial rate of return on the host contract and could also result in a rate of return that is at least twice what otherwise would be the [current] market return for a contract that has the same terms as the host contract and that involves a debtor with a similar credit quality. [Footnote omitted.]

Even though the above conditions focus on the investor's rate of return and the investor's recovery of its investment, the existence of either of those conditions would result in the embedded derivative instrument being considered not clearly and closely related to the host contract by both parties to the hybrid instrument.

Paragraph 61(a) elaborates on the condition in paragraph 13(a) as follows:

...the embedded derivative contains a provision that (1) permits any possibility whatsoever that the investor's (or creditor's) undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms.... RESPONSE

No. The condition in paragraph 13(a) does not apply to a situation in which the terms of a hybrid instrument permit, but do not require, the investor to settle the hybrid instrument in a manner that causes it not to recover substantially all of its initial recorded investment, assuming that the issuer does not have the contractual right to demand a settlement that causes the investor not to recover substantially all of its initial recorded investment. Thus, if the investor in a 10-year note has the contingent option at the end of year 2 to put it back to the issuer at its then fair value (based on its original 10-year term), the condition in paragraph 13(a) would not be met even though the note's fair value could have declined so much that, by exercising the option, the investor ends up not recovering substantially all of its initial recorded investment.

The condition in paragraph 13(a) was intended to apply only to those situations in which the investor (creditor) could be forced by the terms of a hybrid instrument to accept settlement at an amount that causes the investor not to recover substantially all of its initial recorded investment. For example, assume the investor purchased from a single-A-rated issuer for $10 million a structured note with a $10 million principal, a 9.5 percent interest coupon, and a term of 10 years at a time when the current market rate for 10-year single-A-rated debt is 7 percent. Assume further that the terms of the note require that, at the beginning of the third year of its term, the principal on the note is reduced to $7.1 million and the coupon interest rate is reduced to zero for the remaining term to maturity if interest rates for single-A-rated debt have increased to at least 8 percent by that date. That structured note would meet the condition in paragraph 13(a) for both the issuer and the investor because the investor could be forced to accept settlement that causes the investor not to recover substantially all of its initial recorded investment. That is, if increases in the interest rate for single-A-rated debt triggers the modification of terms, the investor would receive only $9 million, comprising $1.9 million in interest payments for the first 2 years and $7.1 in principal repayment, thus not recovering substantially all of its $10 million initial net investment.

DIG Issue B6 --- http://www.fasb.org/derivatives/ 
QUESTION

Three methods have been identified for determining the initial carrying values of the host contract component and the embedded derivative component of a hybrid instrument:

Estimating the fair value of each individual component of the hybrid instrument and allocating the basis of the hybrid instrument to the host instrument and the embedded derivative based on the proportion of the fair value of each individual component to the overall fair value of the hybrid (a "relative fair value" method).

Recording the embedded derivative at fair value and determining the initial carrying value assigned to the host contract as the difference between the basis of the hybrid instrument and the fair value of the embedded derivative (a "with and without" method based on the fair value of the embedded derivative).

Recording the host contract at fair value and determining the carrying value assigned to the embedded derivative as the difference between the basis of the hybrid instrument and the fair value of the host contract (a "with and without" method based on the fair value of the host contract).

Because the "relative fair value" method (#1 above) involves an independent estimation of the fair value of each component, the sum of the fair values of those components may be greater or less than the initial basis of the hybrid instrument, resulting in an initial carrying amount for the embedded derivative that differs from its fair value. Similarly, the "with and without" method based on the fair value of the host contract (#3 above) may result in an initial carrying amount for the embedded derivative that differs from its fair value. Therefore, both of those methods may result in recognition of an immediate gain or loss upon reporting the embedded derivative at fair value.

RESPONSE

The allocation method that records the embedded derivative at fair value and determines the initial carrying value assigned to the host contract as the difference between the basis of the hybrid instrument and the fair value of the embedded derivative (#2 above) should be used to determine the carrying values of the host contract component and the embedded derivative component of a hybrid instrument when separate accounting for the embedded derivative is required by Statement 133.

Statement 133 requires that an embedded derivative that must be separated from its host contract be measured at fair value. As stated in paragraph 301 of the basis for conclusions, "…the Board believes that it should be unusual that an entity would conclude that it cannot reliably separate an embedded derivative from its host contract." Once the carrying value of the host contract is established, it would be accounted for under generally accepted accounting principles applicable to instruments of that type that do not contain embedded derivatives. Upon separation from the host contract, the embedded derivative may be designated as a hedging instrument, if desired, provided it meets the hedge accounting criteria.

If the host contract component of the hybrid instrument is reported at fair value with changes in fair value recognized in earnings or other comprehensive income, then the sum of the fair values of the host contract component and the embedded derivative should not exceed the overall fair value of the hybrid instrument. That is consistent with the requirement of footnote 13 to paragraph 49, which states, in part:

"For a compound derivative that has a foreign currency exchange risk component (such as a foreign currency interest rate swap), an entity is permitted at the date of initial application to separate the compound derivative into two parts: the foreign currency derivative and the remaining derivative. Each of them would thereafter be accounted for at fair value, with an overall limit that the sum of their fair values could not exceed the fair value of the compound derivative." (emphasis added.) While footnote 13 to paragraph 49 addresses separation of a compound derivative upon initial application of Statement 133, the notion that the sum of the fair values of the components should not exceed the overall fair value of the combined instrument is also applicable to hybrid instruments containing a nonderivative host contract and an embedded derivative. However, in instances where the hybrid instrument is reported at fair value with changes in fair value recognized in earnings, paragraph 12(b) would not be met and therefore separation of the embedded derivative from the host contract would not be permitted.

DIG Issue B7 --- http://www.fasb.org/derivatives/ 
Embedded Derivatives: Variable Annuity Products and Policyholder Ownership of the Assets

DIG Issue B8 --- http://www.fasb.org/derivatives/ 
QUESTION

How does one determine the host contract in a nontraditional variable annuity contract (a hybrid instrument)?

BACKGROUND

While traditional variable annuity contracts represent the majority of contracts sold today by life insurance and other enterprises, those enterprises have also developed a wide range of variable annuity contracts with nontraditional features. Nontraditional features of traditional variable annuity contracts result in a sharing of investment risk between the issuer and the holder. Nontraditional variable annuity contracts provide for some sort of minimum guarantee of the account value at a specified date. This minimum guarantee may be guaranteed through a minimum accumulation benefit or a guaranteed account value floor. For example, the floor guarantee might be that, at a specified anniversary date, the contract holder will be credited with the greater of (1) the account value, as determined by the separate account assets, or (2) all deposits that are made, plus three percent interest compounded annually.

While these nontraditional variable annuity contracts have distinguishing features, they possess a common characteristic: the investment risk associated with the assets backing the contract is shared by the issuer and the policyholder. That is, in contrast to traditional variable annuity contracts, the investment risk is, by virtue of the nontraditional product features, allocated between the two parties and not borne entirely by only one of the parties (the holder in the case of a traditional variable annuity contract).

Paragraphs 12 and 16 of Statement 133 require that, in certain circumstances, an embedded derivative is to be accounted for separately from the host contract as a derivative instrument. An example illustrating the application of paragraph 12 to insurance contracts is provided in paragraph 200 of Statement 133. Paragraph 200, second bullet point entitled "Investment Component," concludes that the investment component of an insurance contract backed by investments owned by the insurance company is a debt instrument because ownership of those investments rests with the insurance company, noting that the investments are recorded in the general account of the insurance company. The same bullet point concludes that the investment component of an insurance contract backed by assets held in the insurance company's separate account is a direct investment of the policyholder because the policyholder directs and owns the investments. (Subsequent to the issuance of Statement 133, some have challenged the assertion that the policyholder "owns" the investments. The propriety of the conclusions reached in paragraph 200 relating to traditional variable annuities has been addressed in Statement 133 Implementation Issue No. B7, "Embedded Derivatives: Variable Annuity Products and Policyholder Ownership of the Assets.")

RESPONSE

The FASB staff guidance presented in Statement 133 Implementation Issue B7 indicates that a traditional variable annuity (as described in that Issue) contains no embedded derivatives that warrant separate accounting under Statement 133 even though the insurer, rather than the policyholder, actually owns the assets.

The host contract in a nontraditional variable annuity contract would be considered the traditional variable annuity that, as described in Issue B7, does not contain an embedded derivative that warrants separate accounting. Nontraditional features (such as a guaranteed investment return through a minimum accumulation benefits or a guaranteed account value floor) would be considered embedded derivatives subject to the requirements of Statement 133. Paragraph 12 of Statement 133, states, in part, that:

Contracts that do not in their entirety meet the definition of a derivative instrument such as … insurance policies… may contain "embedded" derivative instruments—implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument. The effect of embedding a derivative instrument in another type of contract is that some or all of the cash flows or other exchanges that otherwise would have been required by the contract, whether unconditional or contingent upon the occurrence of a specified event, will be modified based on one or more underlyings. [Emphasis added; reference omitted.] The economic characteristics and risks of the investment guarantee and those of the traditional variable annuity contract would typically be considered to be not clearly and closely related.

In determining the accounting for other seemingly similar structures, it would be inappropriate to analogize to the above guidance due to the unique attributes of nontraditional variable annuity contracts and the fact that the above guidance, which is based on Issue B7, can be viewed as an exception for nontraditional variable annuity contracts issued by insurance companies.

DIG Issue B9 --- http://www.fasb.org/derivatives/ 
QUESTION

Are the economic characteristics and risks of the embedded derivative (market adjusted value prepayment option) in a market value annuity contract (MVA or the hybrid instrument) clearly and closely related to the economic characteristics and risks of the host contract?

BACKGROUND

An MVA accounted for as an investment contract under FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, given its lack of significant mortality risk, provides for a return of principal plus a fixed rate of return if held to maturity, or alternatively, a "market adjusted value" if the surrender option is exercised by the contract holder prior to maturity. The market adjusted value is typically based on current interest crediting rates being offered for new MVA purchases. As an example of how the market adjusted value is calculated at any period end, the formula typically takes the contractual guaranteed amount payable at the end of the specified term, including the applicable guaranteed interest, and discounts that future cash flow to its present value using rates currently being offered for new MVA purchases with terms equal to the remaining term to maturity of the existing MVA. As a result, the market value adjustment may be positive or negative, depending upon market interest rates at each period end. In a rising interest rate environment, the market adjustment may be such that less than substantially all principal is recovered upon surrender.

The following is an example of an annuity with a fixed return if held for a specified period or market adjusted value if surrendered early.

Single premium deposit: $100,000 on 12/31/98

Maturity Date: 12/31/07 (9 yr. term)

Guaranteed Fixed Rate: 7%

Fixed Maturity Value: $183,846 ($100,000 @ 7% compounded for 9 yrs.)

Market Value Adjustment Formula: Discount future fixed maturity value to present value at surrender date using currently offered market value annuity rate for the period of time left until maturity.

RESPONSE

Yes, the embedded derivative (prepayment option) is clearly and closely related to the host debt contract.

Paragraph 61(d) provides interpretation of the clearly and closely related criteria as it applies to debt with put options, noting that:

Call options (or put options) that can accelerate the repayment of principal on a debt instrument are considered to be clearly and closely related to a debt instrument that requires principal repayments unless both (1) the debt involves a substantial premium or discount (which is common with zero-coupon bonds) and (2) the put or call option is only contingently exercisable. Thus, if a substantial premium or discount is not involved, embedded calls and puts (including contingent call or put options that are not exercisable unless an event of default occurs) would not be separated from the host contract. The terms of MVAs do not include either feature. There is no substantial premium or discount present in these contracts at inception, and the put option is exercisable at any time by the contract holder (that is, it is not "contingently exercisable").

Since the embedded derivative has an underlying that is an interest rate index and the host contract is a debt instrument, the MVA contract must be analyzed under the criteria in paragraphs 13 and 61(a) as well. Pursuant to the tentative FASB staff guidance presented in Statement 133 Implementation Issue No. B5, the condition in paragraph 13(a) was intended to apply only to those situations in which the investor (creditor) could be forced by the terms of a hybrid instrument to accept settlement at an amount that causes the investor not to recover substantially all of its initial recorded investment. That is, because the investor always has the option to hold the MVA contract to maturity and receive the fixed rate and the insurance company cannot force the investor to surrender, the condition in paragraph 13(a) would not be met (that is, the insurance company does not have the contractual right to demand surrender and put the investor in a situation of not recovering substantially all of its initial recorded investment). The condition in paragraph 13(b) also would not be met in a typical MVA contract, since there is no leverage feature that would result in twice the initial and current market rate of return.

Because the criteria in paragraphs 13, 61(a), and 61(d) are not met, the prepayment option is considered clearly and closely related to the host debt instrument.

As the above examples demonstrate, the prepayment option enables the holder simply to cash out of the instrument at fair value at the surrender date. The prepayment option provides only liquidity to the holder. The holder receives only the market adjusted value, which is equal to the fair value of the investment contract at the surrender date. As such, the prepayment option (the embedded derivative) has a fair value of zero at all times.

DIG Issue B10 --- http://www.fasb.org/derivatives/ 
Embedded Derivatives: Equity-Indexed Life Insurance Contracts

DIG Issue B11 --- http://www.fasb.org/derivatives/ 
Embedded Derivatives: Volumetric Production Payments

DIG Issue B12 --- http://www.fasb.org/derivatives/ 
Embedded Derivatives in Certificates Issued by Qualifying Special-Purpose Entities

DIG Issue B13 --- http://www.fasb.org/derivatives/ 
Embedded Derivatives: Accounting for Remarketable Put Bonds

DIG Issue K2 at http://www.fasb.org/derivatives/ 
QUESTION

If a bond includes in its terms at issuance an option feature that is explicitly transferable independent of the bond and thus is potentially exercisable by a party other than either the issuer of the bond (the debtor) or the holder of the bond (the investor), should the option be considered under Statement 133 as an attached freestanding option or an embedded option by the writer and the holder of the option?

BACKGROUND

Certain structured transactions involving the issuance of a bond incorporate transferable options to call or put the bond. As such, those options are potentially exercisable by a party other than the debtor or the investor. For example, certain "put bond" structures involving three separate parties - the debtor, the investor, and an investment bank - may incorporate options that are ultimately held by the investment bank, giving that party the right to call the bond from the investor. Several put bond structures involving options that are exercisable by a party other than the debtor or investor are described in Statement 133 Implementation Issue No. B13, "Accounting for Remarketable Put Bonds."

RESPONSE

If a bond includes in its terms at issuance an option feature that is explicitly transferable independent of the bond and thus is potentially exercisable by a party other than either the issuer of the bond (the debtor) or the holder of the bond (the investor), that option should be considered under Statement 133 as an attached freestanding derivative instrument, rather than an embedded derivative, by both the writer and the holder of the option.

For example, a call option that is either transferable by the debtor to a third party and thus is potentially exercisable by a party other than the debtor or the original investor based on the legal agreements governing the debt issuance can result in the investor having different counterparties for the option and the original debt instrument. Accordingly, even when incorporated into the terms of the original debt agreement, such an option may not be considered an embedded derivative by either the debtor or the investor because it can be separated from the bond and effectively sold to a third party. The notion of an embedded derivative, as discussed in paragraph 12, does not contemplate features that may be sold or traded separately from the contract in which those rights and obligations are embedded. Assuming they meet Statement 133’s definition of a derivative, such features must be considered attached freestanding derivatives rather than embedded derivatives by both the writer and the current holder.

In addition, Statement 133 Implementation Issue No. B3, "Investor’s Accounting for a Put or Call Option Attached to a Debt Instrument Contemporaneously with or Subsequent to Its Issuance," require that an option that is added or attached to an existing debt instrument by a third party also results in the investor having different counterparties for the option and the debt instrument and, thus, the option should not be considered an embedded derivative.

An attached freestanding derivative is not an embedded derivative subject to grandfathering under the transition provisions of Statement 133.

DIG Issue K3 at http://www.fasb.org/derivatives/ 
QUESTION

Should the combinations of purchased and written options described below be considered for accounting purposes as two separate option contracts or as a single forward contract:

An embedded (non-transferable) purchased call (put) option and an embedded (non-transferable) written put (call) option executed contemporaneously with the same counterparty as part of a single hybrid instrument?

A freestanding purchased call (put) option and a freestanding or embedded (non-transferable) written put (call) option that are executed contemporaneously with the same counterparty at inception but where the purchased option may be transferred?

A freestanding purchased call (put) option and a freestanding or embedded (non-transferable) written put (call) option that are executed contemporaneously with different counterparties at inception?

For the purposes of this question, in all cases, the purchased and written options have the same terms (strike price, notional amount, and exercise date) and the same underlying, and neither of the two options is required to be exercised. The notion of the "same counterparty" encompasses contracts entered into directly with a single counterparty and contracts entered into with a single party that are structured through an intermediary. In addition, consistent with the conclusion in Statement 133 Implementation Issue No. K2, "Are Transferable Options Freestanding or Embedded?", an option incorporated into the terms of a hybrid instrument at inception that is explicitly transferable should be considered a freestanding, rather than an embedded, derivative instrument.

RESPONSE

This section provides separate responses for each of the combinations of options in the Question section.

A combination of an embedded (non-transferable) purchased call (put) option and an embedded (non-transferable) written put (call) option in a single hybrid instrument that have the same terms (strike price, notional amount, and exercise date) and same underlying and that are entered into contemporaneously with the same counterparty, should be considered for accounting purposes as a single forward contract by both parties to the contracts. Those embedded options are in substance an embedded forward contract because they (a) convey rights (to the holder) and obligations (to the writer) that are equivalent from an economic and risk perspective to an embedded forward contract and (b) cannot be separated from the hybrid instrument in which they are embedded. Even though neither party is required to exercise its purchased option, the result of the overall structure is a hybrid instrument that will likely be redeemed at a point earlier than its stated maturity. That result is expected by both the hybrid instrument’s issuer and investor regardless of whether the embedded feature that triggers the redemption is in the form of two separate options or a single forward contract. (However, if either party is required to exercise its purchased "option" prior to the stated maturity date of the hybrid instrument, the hybrid instrument should not be viewed for accounting purposes as containing one or more embedded derivatives. In substance, the debtor (issuer) and creditor (investor) have agreed to terms that accelerate the stated maturity of the instrument and the exercise date of the "option" is essentially the hybrid’s actual maturity date. As a result, it is inappropriate to characterize the hybrid instrument as containing two embedded option contracts that are exercisable only on the actual maturity date or as containing an embedded forward contract that is a combination of an embedded purchased call (put) and a written put (call) with the same terms.)

Embedded options in a hybrid instrument that are required to be considered a single forward contract for accounting purposes as a result of the guidance contained herein may not be designated individually as hedged items in a fair value hedge in which the hedging instrument is a separate, unrelated freestanding option. Statement 133 does not permit a component of a derivative to be designated as the hedged item.

A combination of a freestanding purchased call (put) option and a freestanding or embedded (non-transferable) written put (call) option that have the same terms and same underlying and are entered into contemporaneously with the same counterparty at inception should be considered for accounting purposes as separate option contracts, rather than a single forward contract, by both parties to the contracts. Derivatives that are transferable are, by their nature, separate and distinct contracts. That is consistent with the conclusion in Issue K2 which states: "…a call option that is either transferable by the debtor to a third party or that is deemed to be exercisable by a party other than the debtor or the original investor based on the legal agreements governing the debt issuance can result in the investor having different counterparties for the option and the original debt instrument. Accordingly, even when incorporated into the terms of the original debt agreement, such an option may not be considered an embedded derivative by either the debtor or the investor because it can be separated from the bond and effectively sold to a third party…."

A combination of a freestanding purchased call (put) option and a freestanding or embedded (non-transferable) written put (call) option that have the same terms and same underlying and are entered into contemporaneously with different counterparties at inception should be considered for accounting purposes as separate option contracts, rather than a single forward contract, by both parties to the contracts. Similarly, a combination of a freestanding written call (put) option and an embedded (non-transferable) purchased put (call) option that have the same terms and same underlying and are entered into contemporaneously with different counterparties at inception should be considered for accounting purposes as separate option contracts, rather than a single forward contract, by both parties to the contracts. Separate purchased and written options with the same terms but that involve different counterparties convey rights and obligations that are distinct and do not warrant bundling as a single forward contract for accounting purposes under Statement 133.

Bob Jensen's Web Site

Top of Document

Start of Glossary