© 2000 Arthur Andersen All rights reserved. SFAS 133 Implementation Evaluating Hedging Strategies Financial and Commodity Risk Consulting David M. Johnson, James J. Rozsypal June 1, 2000

3 © 2000 Arthur Andersen All rights reserved. Evaluating Hedging Strategies Objectives: Identify the changes introduced by FAS 133 on accounting for commodity contracts Describe hedging with FX contracts Identify implementation challenges Describe measuring and evaluating correlation List macro and complex hedge strategies

SFAS No. 133 Commodity contracts

5 © 2000 Arthur Andersen All rights reserved. Definition of a derivative is expanded Statement 133’s derivative definition includes: –Certain commodity contracts that require physical settlement –Certain derivatives embedded in non-derivative contracts

6 © 2000 Arthur Andersen All rights reserved. A derivative possesses three characteristics Underlying and notional amount or payment provision Little or no initial net investment Net settlement or equivalent

7 © 2000 Arthur Andersen All rights reserved. DIG issue A6 - notional amounts of commodity contracts Do contracts that do not specify a fixed amount have a notional amount? –Examples Requirements contracts Min contracts Max contracts Min and max contracts

8 © 2000 Arthur Andersen All rights reserved. DIG issue A6 - notional amounts of commodity contracts (cont.) Tentative conclusion: –Yes, if the contract contains explicit provisions that support the calculation of a determinable amount A minimum quantity can be a notional amount Determine the notional amount based on the contract’s settlement and default provisions –Notional amount could fluctuate over time

9 © 2000 Arthur Andersen All rights reserved. Three ways to have the characteristic of net settlement Contract requires or permits net settlement Market mechanism exits that facilitates net settlement Asset to be delivered is “readily convertible to cash”

10 © 2000 Arthur Andersen All rights reserved. DIG issue A8 - net settlement provision Is a one-sided default provision a net settlement provision? No, it must be two-sided (symmetrical) One-sided default provision does not allow the defaulting party to participate in favorable changes in the price of the underlying

11 © 2000 Arthur Andersen All rights reserved. DIG issue A2 - market mechanism Does the fact that brokers stand ready to buy and sell a commodity forward contract that requires physical delivery and is not exchange- traded indicate the existence of a market mechanism that facilitates net settlement? Yes, because either party can be relieved of its rights and obligations under the contract without incurring a substantial fee due to its arrangement with a broker.

12 © 2000 Arthur Andersen All rights reserved. DIG issue A3 - market mechanism Does the liquidity of the market for a group of contracts affect the determination of whether there is a market mechanism that facilitates net settlement? No. The test for market mechanism that facilitates net settlement focuses on a singular contract.

13 © 2000 Arthur Andersen All rights reserved. DIG issue A7 - market mechanism Does an assignment consent clause preclude the existence of a market mechanism for net settlement? Tentative conclusion: –Maybe. Must assess the consent clause to determine the likelihood that the counterparty will withhold permission to assign the contract –Assessment based on credit and performance risk of potential assignees

14 © 2000 Arthur Andersen All rights reserved. DIG issue A10 - readily convertible to cash Is an asset readily convertible to cash if significant costs would be incurred to convert the asset to cash? No. If the conversion costs are 10 percent or more of the gross sales proceeds, the cost is significant. This assessment is performed only once - at inception of the contract.

15 © 2000 Arthur Andersen All rights reserved. Exception to the definition affecting commodity contracts Normal purchases and sales of nonfinancial items –Quantities expected to be used in a reasonable period in the normal course of business –Allow exception for contracts that implicitly or explicitly permit net settlement if it is probable that the contract will not settle net and will result in physical delivery –Net settlement of similar contracts should be rare –An individual contract in a sequential series of contracts and offsetting contracts that ultimately results in physical delivery will not qualify for the normal purchases or sales exception

16 © 2000 Arthur Andersen All rights reserved. DIG Issue G2 - A derivative that is expected to be settled gross can be designated as a cash flow hedge of a forecasted transaction that occurs upon gross settlement of the derivative itself. Useful if requirements for the “normal sales” exception cannot be met for the firm commitment All-in-one hedges

17 © 2000 Arthur Andersen All rights reserved. Hedging of anticipated commodity transactions Follow cash flow hedging model Hedge of the variability of the forecasted transaction’s future cash flows Changes in fair value of hedging instrument recorded in other comprehensive income (OCI) Reclassify amounts in OCI to earnings when the forecasted transaction affects earnings

Hedging with foreign currency contracts

19 © 2000 Arthur Andersen All rights reserved. Eligible Eligible Hedged Item Hedging Instrument Fair Value Hedge –Beginning Balance Only Net Investment in a Foreign Operation Forecasted Intercompany Transaction Forecasted Transaction AFS Securities* Unrecognized Firm Commitments Derivative or Cash Instrument Derivative Instrument Only Derivative or Cash Instrument Three types of foreign currency hedges Cash Flow Hedge *Equity securities have certain restrictions Net Investment Hedge

20 © 2000 Arthur Andersen All rights reserved. Net investment hedges A hedge of the net investment in a foreign operation due to changes in foreign exchange rates Hedging instrument can be either a derivative or a foreign currency denominated cash instrument

21 © 2000 Arthur Andersen All rights reserved. Accounting for net investment hedges Record changes in fair value of hedging instrument in other comprehensive income (OCI) as part of the cumulative translation adjustment

22 © 2000 Arthur Andersen All rights reserved. Hedged Item Derivative Change in fair value of derivative Foreign Currency Translation Gains and Losses Cumulative Translation Adjustment Accounting for net investment hedges (cont.)

Implementation challenges

24 © 2000 Arthur Andersen All rights reserved. Implementation challenges The following common risk management practices may now get different accounting or will now have unique restraints –Portfolio hedging –Asset optimization strategies –Certain FX transactions –Partial term vs. proportionate hedging

25 © 2000 Arthur Andersen All rights reserved. Portfolio hedging Individual assets, liabilities, firm commitments or forecasted transactions must share the risk exposure for which they are designated as being hedged Change in fair value of each item in portfolio must be proportionate to change in fair value of portfolio (+/-2%) Requirement facilitates allocation of portfolio’s fair value to individual items in portfolio that are sold/settled

26 © 2000 Arthur Andersen All rights reserved. Asset Optimization AssetSell BuySellBuySell Buy Sell BuySellBuySell Optimization ActivityAsset Activity

27 © 2000 Arthur Andersen All rights reserved. Partial term vs. proportionate hedging A percentage of the asset or liability for full term is allowed One or more contractual cash flows Fair value hedge accounting for a percentage of an asset or liability for only a part of the term is not permitted

28 © 2000 Arthur Andersen All rights reserved. Accounting for intercompany FX hedge transactions Consolidated statements –Intercompany derivatives may be used as a hedging instrument for cash flow hedges of fx risk if the following conditions are met: Subsidiary with exposure is a party to the hedge Parent enters into offsetting contract with 3rd party Separate company statements –Subsidiaries may qualify for hedge accounting in separate statements if: They are a party to the hedging instrument This applies even if the counterparty is the parent

Measuring and evaluating effectiveness

30 © 2000 Arthur Andersen All rights reserved. What is hedge effectiveness? The hedging instrument’s ability to offset changes in the hedged item’s fair value or cash flows related to the risk hedged

31 © 2000 Arthur Andersen All rights reserved. Hedge effectiveness criteria Hedge must be expected to be “highly effective” at achieving offsetting changes in fair values or cash flows –Inception –On-going An assessment of effectiveness is required whenever earnings are reported and at least quarterly

32 © 2000 Arthur Andersen All rights reserved. What does the term “highly effective” mean? Not specifically defined Intended to be similar to “high correlation” in SFAS 80 Interpreted to mean a dollar offset ratio of 0.80 to 1.25

33 © 2000 Arthur Andersen All rights reserved. What is the offset ratio? Offset ratio = change in fair value of the hedging instrument  inverse change in fair value or cash flows of the hedged item (related to the risk hedged) – Hedge is perfectly effective –Between 0.80 and Hedge is “highly effective” – than Hedge does not qualify

34 © 2000 Arthur Andersen All rights reserved. DIG Issue E8: Assessing effectiveness using dollar offset In periodically assessing hedge effectiveness retrospectively under a dollar offset approach, should the dollar offset be evaluated on a period-by-period basis or on a cumulative basis (from inception of the hedge)? Either method is appropriate for retrospective evaluations, but all of the following must be performed –Document method to be used at inception of hedge –Assess effectiveness for similar hedges in a similar manner –For period-by-period election, period cannot exceed three months

35 © 2000 Arthur Andersen All rights reserved. DIG issue G9: Assuming no ineffectiveness If the critical terms of a hedging instrument and the hedged forecasted transaction are the same, what type of assessment and documentation of hedge effectiveness are required? “Shortcut method” not available (DIG E4) Must continue to document expectation of effectiveness If shown at inception that critical terms of hedged item and hedging instrument are the same, subsequent assessments can be performed by verifying and documenting whether critical terms have changed.

36 © 2000 Arthur Andersen All rights reserved. Pricing issues impacting derivatives valuation Blockage factors –A premium or discount based on the relative size of the position held, such as a large proportion of the total trading units of an instrument –Statement 133 prohibits the use of a blockage factor because it would lessen the reliability and comparability of reported estimates of fair value Point of delivery –i.e., basis –must be considered in defining the hedge item

Macro and complex hedge strategies

38 © 2000 Arthur Andersen All rights reserved. Commodity caps and floors DIG Issue B-14 Floors and caps on a commodity price are “clearly and closely related” to a host commodity contract Relevant only to commodity contracts that do not meet derivative definition

39 © 2000 Arthur Andersen All rights reserved. Volumetric production payments DIG Issue B-11 Do embedded derivative provisions apply to volumetric production payments for which the quantity of the commodity that will be delivered is reliably determinable? Yes. Volumetric production payment is effectively a debt instrument with an embedded commodity forward. –Bifurcate embedded derivative –Applies to all parties to the contract –Potential cash flow hedge –Normal purchases and sales exception may apply

40 © 2000 Arthur Andersen All rights reserved. Risk hedged must be specifically identified Described with sufficient specificity so that when transaction occurs, it is clear whether the transaction is the hedged transaction First 50 mbbl of production during the month NOT 50% of total production during the month

41 © 2000 Arthur Andersen All rights reserved. Questions and answers Questions?