Proposed Accounting for Derivatives NASACT Audio Conference June 27, 2007

2 2 Why Is It So Hard? Different instruments & countless products Discounting, present value, yield curve, implied forward rate, volatility, option pricing, gamma, theta Jargon Hedging: offsets versus outcomes Accounting model Mixed attribute model Mixed attribute model Expected transactions are not recognized in the accounting model Expected transactions are not recognized in the accounting model

3 3 GASB Environment Derivative Users Pensions and endowments: foreign exchange derivatives Utilities and transit agencies: energy derivatives Governments active in debt market: interest rate swaps

4 4 Some History Technical Bulletin 94-1, Disclosures about Derivatives and Similar Debt and Investment Transactions Statement No. 31, Accounting and Financial Reporting for Certain Investments and for External Investment Pools Technical Bulletin , Disclosure Requirements for Derivatives Not Reported at Fair Value on the Statement of Net Assets

5 5 What is a Derivative for Financial Reporting Purposes? A derivative has: 1. One or more reference rates (underlyings) and one or more notional amounts 2. Leverage 3. Net settlement

6 6 Examples of Derivatives Interest rate swap Variable-rate to fixed-rate Variable-rate to fixed-rate Fixed-rate to variable-rate Fixed-rate to variable-rate Basis swap Exchange payments based on the changes of two variable rates Exchange payments based on the changes of two variable ratesSwaption Gives the purchaser of the option the right, but not the obligation, to enter into an interest rate swap Gives the purchaser of the option the right, but not the obligation, to enter into an interest rate swap Commodity swap Reduce exposure to a commoditys price risk Reduce exposure to a commoditys price risk

7 7 Hybrid Instruments Hybrid instruments consist of a companion instrument (not measured at fair value) and a derivative (measured at fair value) This is a substance over form issue: A derivative should be treated as a derivative regardless of whether it is a stand-alone instrument or included in another instrument, such as a bond, insurance contract, or a purchase or sale contract Example: off-market swap. That is, a swap that presents a government with an up-front payment.

8 8 Excluded Instruments Normal purchases & normal sales contracts Commodity (e.g., gas or electricity) Commodity (e.g., gas or electricity) Government intends to and has practice of taking delivery or selling the commodity Government intends to and has practice of taking delivery or selling the commodity Quantity is consistent with volume used Quantity is consistent with volume used Traditional insurance contracts Traditional financial guarantee contracts Non exchange-traded climate contracts, liquidated damages, etc.

9 9 Fair Value Based on either: Market-observed prices or Models, such as from a Bloomberg terminal

10 Cash Flow Hedge Swap counterparty State or local government Variable-rate bond holders Variable-rate coupon payments Variable payment received: 67% of 1-month LIBOR Fixed payment %

11 Proposed Accounting Fair value with hedge accounting Derivatives would be measured on the statement of net assets at fair value Fair value changes would be reported on the change statement as investment income Exception: Effective HEDGES! Changes in fair value of derivative would be reported on the balance sheet as deferralseither deferred charges or deferred credits Changes in fair value of derivative would be reported on the balance sheet as deferralseither deferred charges or deferred credits Swap asset, deferred credit Swap asset, deferred credit Swap liability, deferred charge Swap liability, deferred charge

12 Hedge Financial Statement Presentation

13 Drivers of the Proposed Accounting Derivatives should be measured at fair value If the derivative instrument is effective, hedge accounting should be applied Effectiveness is determined by using an acceptable method of evaluating hedges If a method subsequently renders hedge ineffective, another method may be used

14 What is a Hedge? Derivative is associated with a hedgeable item The derivative is effective in providing changes in cash flows or fair values that substantially offset the cash flow or fair value changes of the hedgeable item No documentation of managements intent

15 Hedgeable Items Single asset or liability Groups of similar assets or liabilities must have same risk exposure Expected transactionoccurrence should be probable Transactions within the primary government do not qualify for hedge accounting

16 Methods of Evaluating Effectiveness Qualitative method Consistent critical terms method Consistent critical terms method Quantitative methods Synthetic instrument method Synthetic instrument method Linear regression method Linear regression method Dollar offset method Dollar offset method Other method Other method

17 Consistent Critical Terms Method Notional and principal amounts should be the same Fair value of derivative should be zero at date of inception Benchmark rates based on the same index such as SIFMA to SIFMA Additional requirements based on whether it is a: Fair value hedge Fair value hedge Cash flow hedge Cash flow hedge

18 Consistent Critical Terms Method Effectiveness must be evaluated every year

19 Consistent Critical Terms Method Hedged Hedging Hedged Hedging Debt Derivative Debt Derivative Principal/notional$1,000 $1,000 Term10 years 10 years Payments, Every6 months 6 months Variable payment SIFMA SIFMA

20 Synthetic Instrument Method Based on notion that the combined cash flows of a swap and hedged debt create a third instrumenta synthetic fixed-rate instrument Comes from consistent critical terms method, but used when benchmark rates are not the same, such as a % of LIBOR swap

21 Synthetic Instrument Method Uses the rate in the fixed-leg of the swap as the fixed rate. As long as actual payments travel within a range of 90% to 111% of the fixed rate, the derivative is effective. Swap-based hedge use the fixed payment of the swap Swap-based hedge use the fixed payment of the swap Commodity hedges use the fixed rate established by the hedge Commodity hedges use the fixed rate established by the hedge

22 Dollar Offset Method The change in fair values or cash flows of the hedging derivative is divided by the same changes of the hedged item. The result should be within the range of 80 to 125 percent This method is similar to the economic notion of elasticity

23 Dollar Offset Example Fair Value Fair Value Changes Change Hedged debt $1,000 Interest rate swap (1,150) ($1,000/$1,150) 86.96% ($1,000/$1,150) 86.96%

24 Regression Method Evaluation of effectiveness should indicate that the hedged item and the hedging derivative regress such that: R-squared statistic is at least 0.80 F-statistic is at least 95 percent confidence interval Slope coefficient is between –1.25 and – 0.80

25 Other Evaluation Method Method must: Be consistent with fair value Demonstrate that the changes of cash flows or fair values of the derivative substantially offset the changes in cash flows or fair value of the hedgeable item

26 Disclosures Similar derivatives may be aggregated Summary of derivative activity by: 1)Government activities, business-type activities, and fiduciary activities 2)Then by fair value hedges, cash flow hedges, and investment derivatives 3)Then by type: Notional amount Fair values & changes and where reported Fair values & amounts reclassified from hedge to investment

27 Disclosures Disclosures for HEDGING derivatives Application of TB-2003 disclosures Application of TB-2003 disclosures Significant terms Significant terms Risks: Credit, Interest Rate, Basis, Termination, Rollover, Market-access, Foreign Currency Risks: Credit, Interest Rate, Basis, Termination, Rollover, Market-access, Foreign Currency If an other evaluation method is used, the identity of that method and its critical values If an other evaluation method is used, the identity of that method and its critical values No disclosure of hedge ineffectiveness Disclosures for INVESTMENT derivatives Risks: Credit, Interest Rate, Foreign Currency Risks: Credit, Interest Rate, Foreign Currency

28 Disclosures Contingencies (e.g., collateral postings) Fair value of derivatives with feature Fair value of derivatives with feature Amount of all potential settlements Amount of all potential settlements Amounts posted Amounts posted Hedged debt Synthetic guaranteed investment contracts Description and nature Description and nature Fair values Fair valuesWrapper Underlying investments

29 Summary Derivatives would be reported on the balance sheet and measured according to their fair values. Fair value changes would be reported on the change statement, provided a derivative is not a hedging derivative. If a derivative is a hedging derivative, its fair value changes would be deferred on the balance sheet until the hedged transaction occurs. Test effectiveness Disclose

30 Looking Forward Exposure Draft on web site by June 29, 2007 Final standard second quarter of 2008 Proposed Standard would be effective for reporting periods beginning after June 15, 2009 Retroactive

31 Questions? Randal Finden Web sitewww.gasb.org The views expressed in this presentation are those of the GASBs staff. Official positions of the GASB are determined only after extensive due process and deliberation