Accounting for Interest Rate DerivativesFAS ASC 815FAS ASC 815

Presented byPresented by Frank Wilary and Douglas Winn

M 1 2014May 1, 2014

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• Describe hedge accounting and provide examples

Add h d ff ti t ti• Address hedge effectiveness testing

• Define hedge ineffectiveness – testing vs. bookkeepingbookkeeping

• Provide alternative to hedge accounting

• We will briefly revisit certain items from our prior• We will briefly revisit certain items from our prior webinar on the rule itself

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Derivatives must be accounted for and reported pat fair value

Three options to decrease resulting income statement volatility:1. Fair Value Hedge Accounting

2 F i V l A ti2. Fair Value Accounting

3. Cash Flow Hedge Accounting

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Two types of hedge accountingTwo types of hedge accounting

1. Fair value hedge

Ch i f i l f th h d i i t tChange in fair value of the hedging instrument runs through the income statement, along with the change in the fair value of the item being hedged – used for existing financial assets and liabilitiesfinancial assets and liabilities

2. Cash flow hedge

“Eff ti ” ti f th h d i t d i Oth“Effective” portion of the hedge is reported in Other Comprehensive Income, while the ineffective portion is reported in current earnings – used for forecasted transactions or variable payments on existing financial

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transactions or variable payments on existing financial assets and liabilities

Type of accounting depends on the item being hedged –Credit Union enters into a Pay Fixed, Receive Floating

Interest Rate SwapFair Value Hedge Example:Fair Value Hedge Example:CU wants to hedge against the decrease in fair value of a fixed rate loan portfolio

defines hedge as change in benchmark interest rateIf b h k i t t t i f i l f th l ill d d thIf benchmark interest rate increases, fair value of the loans will decrease, and the

fair value of the swap will increase. Change in each runs through the income statement

Cash Flow Hedge Example:Cash Flow Hedge Example:CU wants to hedge against increase in cost of its floating non-maturity deposits.Defines hedge as risk of an increase in the forecasted payments to its members.

Eff ti ti ill th h OCI

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Effective portion will run through OCI

Formal designation and documentation grequired at inception

The CU’s objective and strategy for the hedge must include:j gy g

• The hedging instrument – the derivative (interest rate swap, interest rate floor, interest rate cap, etc.)

• The hedged item or transaction – the asset or liability being hedged

• The nature of the risk being hedged – interest rate risk

• The method that will be used to retrospectively and prospectively• The method that will be used to retrospectively and prospectively measure the hedge’s effectiveness

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• The method that will be used to measure hedge ineffectiveness

• Benchmark interest rate being hedged

Eligible benchmark rates are:Treasury ratesFederal funds effective swap rateLIBORLIBOR

In addition, for cash flow hedges the following information about forecasted transactions must be provided:

Date on which transaction will occurSpecific nature of asset or liabilityQuantity of the forecasted transaction

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Quantity of the forecasted transaction

NCUA authorizes credit unions to use only the following derivatives:NCUA authorizes credit unions to use only the following derivatives:• Interest Rate Swaps

An agreement to exchange future payments of interest on a notional amount at specific times and for a specific time periodnotional amount at specific times and for a specific time period

• Interest Rate CapsA contract based on a reference interest rate for payment toA contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate rises above the level specified in the contract

• Interest Rate Floors• Interest Rate FloorsA contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate falls below the l l ifi d i th t t

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level specified in the contract

• Basis SwapsAn agreement between two parties in which the parties make periodic payments to each other based on floating rate indices multiplied by a notional amount

• Treasury Note futuresA U.S. Treasury note financial contract that obligates the buyer t t k d li f T t ( th ll t d lito take delivery of Treasury notes (or the seller to deliver Treasury notes) at a predetermined future date and price. Futures contracts are standardized to facilitate trading on an exchangeexchange

Note: Wilary Winn Risk Management believes all of the derivatives permitted by the NCUA meet the definition of a derivative

d GAAP

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under GAAP.

N ti l A t Li it• Notional Amount Limito Takes into account type of derivative, time to maturity and net

worth

• Fair Value Loss Limito Loss limit does not include hedge benefit – measures the g

derivatives only

o Limit is based on net aggregate loss of derivatives and net worth Entry Standardworth Entry

LimitsStandard

LimitsTotal fair value 15 25Weighted average remaining maturity - notional 65 100

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Cannot net offsetting transaction – calculation is cumulative

St #1 G Adj t F tProduct

Step #1 Gross National

Adjust Factor (Percent) Step #2 Adjusted Notional Step #3 WARM

Options (Caps) Current notional 33 33% of current notional Time remaining to maturityOptions (Floors) Current notional 33 33% of current notional Time remaining to maturitySwaps Current notional 100 100% of current notional Time remaining to maturityFutures Contract size 100 100% of contract size Underlying contract

WARMN = Adjusted notional * (WARM/10)

y gSum = Total adjusted notional Sum = Overall WARM

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To qualify for hedge accounting, the hedging relationship q y g g, g g p(both at inception of the hedge and on an ongoing basis), shall be expected to be highly effective in achieving either of the following:achieving either of the following:

• Offsetting changes in fair value attributable to the hedged risk during the period that the hedge ishedged risk during the period that the hedge is designated - a fair value hedge

• Offsetting cash flows attributable to the hedged risk during the term of the hedge - a cash flow hedge

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Hedge Effectiveness can be measured in two ways:1. Dollar-offset approach

• Compares changes in fair value or cash flow of the hedged item and the derivativederivative

• Can be applied period by period (cannot be less than 3 months) or cumulatively

M t b li d ll ff t f 80% 125% ld b id d• Most believe a dollar offset range of 80%-125% would be considered highly effective

2. Statistical methodologies• May permit a CU to continue to use hedge accounting for the current

period even though the dollar-offset approach appears ineffective

• Complex to implement and requires multiple observation periods

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Complex to implement and requires multiple observation periods

Dollar-Offset Approach Example$50 MM pay fixed / receive floating 5-year interest rate swapHedged item – a group of fixed rate investments held AFS

Market Rate Net Swap Change in Change inChange From Swap Fair Swap Investments Dollar Effective

Month Inception Payment Value Fair Value Fair Value Offset % (y / n)M 0 0 b 0Mo. 0 0 bps 0Mo. 1 -10 bps (68,950) (166,293) (166,293) 140,579 118.3% yesMo. 2 -15 bps (71,327) (214,920) (48,627) 65,425 74.3% noMo. 3 -25 bps (73,705) (371,804) (156,884) 150,257 104.4% yesMo. 4 -20 bps (71,488) (181,349) 190,455 (140,757) 135.3% noMo. 5 +5 bps (62,835) 437,189 618,538 (625,865) 98.8% yesTotal (348,305) 437,189 (410,361) 106.5% yes

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Statistical Approaches – Regression AnalysisStatistical Approaches Regression Analysis• Minimum of 30 observations

• Must consider changes in the value of the derivative and gthe hedged item

• Time horizon must coincide or be less than the time horizon of the hedge relationshipof the hedge relationship

• Must consider whether to regress value changes or value levels

• Must review distribution of error terms

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Statistical Approaches – Regression Analysis ContinuedStatistical Approaches Regression Analysis Continued• R-squared result must exceed a pre-specified level (e.g. 0.80)

• Hedge relationship must correspond to beta (the slope of the g p p ( pregression line)

• Standard error must be used to calculate the reliability using the t statisticthe t statistic

• T-test must be passed at a 95% confidence level

• Must consider y-intercepty p

• Must compare results to dollar offset results

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Statistical Approach Example – R-squared Analysis Hedged item – floating dividend rate on money market shares

1Mo LIBOR Line Fit Plot

1.20

1.40

1.60

ate

1 Mo LIBOR Line Fit  Plot

0.40

0.60

0.80

1.00

Divide

nd  Ra

Div. Rate

PredictedDiv Rate

0.00

0.20

0.00 1.00 2.00 3.00 4.00 5.00 6.00

1 Mo LIBOR

Predicted Div. Rate

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Polling Question #1

If you have performed effectiveness testing in the past, what method did you use?

Dollar offset

Regression analysis

Other statistical method

Have not performed effectiveness testing

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p g

A credit union shall consider hedge effectiveness in twoA credit union shall consider hedge effectiveness in two different ways:

1. Prospective Considerationsp

2. Retrospective Evaluations

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Prospective Considerationsp• Can be based on regression or other statistical analysis of past

changes in fair values or cash flows as well as on other relevant informationinformation

• Shall consider all reasonably possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of th d i ti i t t d th h d d it f th i d dthe derivative instrument and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied

• Not be limited only to the likely or expected changes in fair value (if a fair value hedge) or in fair value or cash flow (if a cash flow hedge)

• Generally involves a probability-weighted analysis – consistent with

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y p y g yFASB Concepts Statement No. 7

Retrospective Considerationsp• An assessment of effectiveness shall be performed whenever

financial statements or earnings are reported, and at least every three monthsthree months

• Can be based on dollar offset or statistical approaches• Dollar-offset measurement can be for period or cumulative• Statistical methods must be similar period to period (e.g. same

number of data points)

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What if the hedge is not or no longer effective?g gThe hedge accounting is discontinued prospectively, resulting in

potential income statement volatility as the derivative is marked to market with no offset to the hedged itemmarket with no offset to the hedged item

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Hedge ineffectiveness is measured by the g yDollar-offset method

Fair Value Hedge:Hedge ineffectiveness flows through the income statement based on any difference between the change in the value of the derivative and the change in value of the hedged item

Cash Flow Hedge:Ineffectiveness must be separately measured and recorded on the income statement. If the fair value of the derivative changes by more than the present value of hedged cash flows, the difference is the ineffective amount. If the fair value of the hedged cash flows changes b th th h i th f i l f th d i ti th

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by more than the change in the fair value of the derivative then no ineffectiveness

Entities can assume no ineffectiveness in an interest rate swap in two instances:

1. A private company that enters into a pay fixed, receive floating interest rate swap (this exemption does not apply to financial institutions)

2 A swap can be examined to determine if it can be2. A swap can be examined to determine if it can be accounted for under the Short-Cut Method (this applies to all companies, including financial institutions)

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To conclude no hedge ineffectiveness in a hedge with an g ginterest rate swap, all of the following conditions must be met:

• Notional amount of swap matches principal amount of item being hedged

• Fair value of the swap is zero at inceptionFair value of the swap is zero at inception

Note: For the purposed of determining zero: can ignore bid/ask spread at inception, commissions, and other transaction costscosts

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• Formula for computing net settlements remains the same throughout ththe swap

− Fixed rate remains the same− Variable rate index does not change

• Interest bearing asset or liability is not pre-payable− Unless the prepayment is due to an embedded call (put) option and

the swap has a mirror option call (put) option - options must mach exactlyexactly

− Because the NCUA does not allow a credit union to enter into a swap with this feature, we believe a swap involving loans that can be prepaid will not qualify for the short-cut methodp p q y

• Index on which the variable rate leg is based matches the benchmark interest rate designated as the interest rate being hedged

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• WW Risk Management does not recommend the short-cut method, b if f il tbecause if you fail, you cannot reassess.

• We recommend that a credit union account for the swap using the long-haul method, recognizing that swaps that would qualify for the short-cut method will easily pass the effectiveness testing

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As asset or liability is eligible for designation as a hedged item in a fair value hedge if all of the following criteria are met:

• The hedged item is specifically identified as either all or a specific• The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitmentThe hedged item presents an exposure to changes in fair value• The hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings

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• The hedged item is a single asset or liability (or a specific portion th f) i tf li f i il t i il li biliti (thereof) or is a portfolio of similar assets or similar liabilities (or a specific portion thereof)

o If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or liabilities shall share the risk exposure –generally proportionate change in fair value

o If the specific portion of an asset or liability then one or more selected contractual cash flows including one or more individual interest paymentscontractual cash flows, including one or more individual interest payments during a selected portion of the term of a debt instrument (such as the portion of the asset or liability representing the present value of the interest payments in the first two years of a four-year debt instrument).

o A put option or call option (including an interest rate cap or price cap or an interest rate floor or price floor) embedded in an existing asset or liability that is not an embedded derivative accounted for separately

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• If the hedged item is a financial asset or liability or a recognized loan i i i ht th d i t d i k b i h d d i f thservicing right, the designated risk being hedged is any of the

following: o The risk of changes in the overall fair value of the entire hedged item

Th i k f h i it f i l tt ib t bl t h i tho The risk of changes in its fair value attributable to changes in the designated benchmark interest rate (referred to as interest rate risk)

o The risk of changes in its fair value attributable to both of the following (referred to as credit risk):(referred to as credit risk):

• Changes in the obligor’s creditworthiness • Changes in the spread over the benchmark interest rate with

respect to the hedged item’s credit sector at inception of the hedgerespect to the hedged item s credit sector at inception of the hedge

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Change in fair value for each item in the portfolio must be within a fairly narrow range – such as 9 to 11%. On the other hand, a range of 7 to 13% would not meet the similar portfolio requirementsimilar portfolio requirement

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In aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate:

a Loan typea. Loan type b. Loan size c. Nature and location of collateral d. Interest rate type (fixed or variable) e. Coupon interest rate (if fixed) f. Scheduled maturity yg. Prepayment history of the loans (if seasoned) h. Expected prepayment performance in varying interest rate scenarios

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Credit unions considering a fair value hedge should be aware of the following:

• Fair value hedge cannot be used to hedge interest rate risk on held-to-maturity securitiesto maturity securities

• If a fair value hedge is used to hedge interest rate risk on available-for- sale securities then the change in the value of the hedged item runs through the income statement and not through OCIruns through the income statement and not through OCI

• A partial-term hedge of a fixed rate financial instrument using a shorter-term, notionally matched swap will generally not "be effective" (e g hedging a 30-year loan with a 3-year swap)effective (e.g. hedging a 30 year loan with a 3 year swap)

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Fair value hedge accounting is restrictive and complex, and a CU could elect to account for the financial instrument at fair value in order to avoid these complications and limitations. However, fair value election has severallimitations. However, fair value election has several disadvantages:

• Hedge-accounting election can be terminated at any time, while the f i l l ti i i blfair value election is irrevocable

• Nearly all of the change in value of an interest rate derivative over time will be due to changes in the market interest rates, while fair

l f th l ill b ff t d b h i i t t t dvalue of the loans will be affected by changes in interest rate and credit conditions

• The CU will need to develop systems to estimate the fair value of l th i ti li

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loans over their entire lives

We recommend that if a credit union elects to account for loans at fair value, that it:

• Select high credit borrowers to minimize the change in value arising from deterioration of the borrower’s credit or the widening out offrom deterioration of the borrower s credit or the widening out of credit spreads

W t th t h t i l t ti t th f iWe note that we have systems in place to estimate the fair value of loans over their entire lives

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Fixed Rate Mortgage Fair Value ExampleFixed Rate Mortgage FICO Score Range LTV Range

Avg FICO Avg LTV WAC CPR % CRR % CDR % Severity %

Discount Rate

Fair Value %

780+ under 50% 806 30% 4.2% 9.9% 9.9% 0.0% 0.0% 4.0% 100.3%780+ 50% - 75% 800 62% 4.1% 9.4% 9.3% 0.0% 10.0% 4.2% 99.2%780+ 75% - 100% 800 86% 4.7% 9.8% 9.8% 0.0% 15.0% 4.4% 100.6%780+ 803 48% 4.3% 9.8% 9.7% 0.0% 5.2% 4.1% 100.0%

720 - 779 under 50% 756 34% 4.0% 10.2% 9.8% 0.1% 0.0% 3.8% 100.4%720 - 779 50% - 75% 755 62% 4.3% 9.8% 9.7% 0.1% 10.0% 4.2% 99.5%720 779 75% 100% 752 86% 4 7% 9 6% 9 5% 0 1% 15 0% 4 4% 100 2%720 - 779 75% - 100% 752 86% 4.7% 9.6% 9.5% 0.1% 15.0% 4.4% 100.2%720 - 779 755 58% 4.3% 9.9% 9.7% 0.1% 7.7% 4.1% 100.0%

660 - 719 under 50% 694 35% 4.3% 8.6% 8.4% 0.2% 0.0% 4.1% 100.4%660 - 719 50% - 75% 693 63% 4.6% 8.7% 8.4% 0.3% 10.0% 4.7% 98.4%660 - 719 75% - 100% 697 87% 4.8% 6.3% 5.7% 0.6% 15.0% 5.8% 90.7%% % % % % % % % % %660 - 719 694 62% 4.6% 8.0% 7.6% 0.3% 8.5% 4.9% 96.8%

620 - 659 under 50% 641 36% 4.9% 8.3% 7.3% 1.0% 0.0% 4.4% 101.1%620 - 659 50% - 75% 641 63% 4.9% 8.4% 7.3% 1.1% 10.0% 5.3% 95.4%620 - 659 75% - 100% 641 87% 5.0% 7.5% 5.2% 2.3% 15.0% 7.4% 80.5%

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620 - 659 641 62% 5.0% 8.1% 6.7% 1.4% 8.4% 5.6% 92.9%

An entity may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with either of the following:may be associated with either of the following:

• Payments on an existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt or variable rate liabilities share accounts)rate liabilities – share accounts)

• A forecasted transaction (such as a forecasted purchase or sale)

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A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following criteria are met:

A f t d t ti i ifi ll id tifi d ith• A forecasted transaction is specifically identified as either:

a. A single transaction

b A group of individual transactions that share the same risk exposureb. A group of individual transactions that share the same risk exposure for which they are designated as being hedged. A forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction.

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• The occurrence of the forecasted transaction is probable.

• The forecasted transactions meets both of the following conditions:o It is a transaction with a party external to the reporting entity

It t t i ti i h fl f th h d d i ko It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings

• The forecasted transaction is not the acquisition of an asset or i f li bilit th t ill b tl b d ithincurrence of a liability that will subsequently be re-measured with changes in fair value attributable to the hedged risk reported currently in earnings.

• If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not re-measured with changes in fair value attributable to the hedged risk reported currently in earnings.

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Polling Question #2

If you considering the use of derivatives which types areIf you considering the use of derivatives, which types are you considering (select all that apply)?

Swapp

Cap

FloorFloor

Treasury futures

Have not decided yet

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Have not decided yet

• If the hedged transaction is the variable cash inflow or outflow of an i ti fi i l t li bilit th d i t d i k b i h d d iexisting financial asset or liability, the designated risk being hedged is

any of the following:o The risk of overall changes in the hedged cash flows related to the asset

or liability such as those relating to all changes in the purchase price oror liability, such as those relating to all changes in the purchase price or sales price

o The risk of changes in its cash flows attributable to changes in the designated benchmark interest rate (referred to as interest rate risk)designated benchmark interest rate (referred to as interest rate risk)

o The risk of changes in its cash flows attributable to all of the following (referred to as credit risk):

i. Default ii. Changes in the obligor’s creditworthiness iii. Changes in the spread over the benchmark interest rate with respect to the related financial asset’s or liability’s credit sector at inception of the hedge

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inception of the hedge.

Fair Value Hedges• Portfolio Method using an interest rate swap• Purchase of an interest rate capCash Flow Hedges• First Payments Method using an interest rate swap

Method 1: Change in variable cash flows we will show exampleMethod 1: Change in variable cash flows – we will show exampleMethod 2: Hypothetical derivativeMethod 3: Change in fair value

• Purchase of an interest rate cap

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A pay fixed, receive floating interest rate swap is used to hedge against the change in the fair value of a portfolio of fixed rate single family mortgages

• Hedging item used pay fixed receive floating interest rate swap• Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception

• Hedged item - portfolio of fixed rate single family mortgage loansN t f th i k b i h d d i t t t i k d fi d th• Nature of the risk being hedged - interest rate risk defined as the change in the fair value of the mortgage loan portfolio in relation to the change in benchmark interest rate (LIBOR)Th tf li f l t th i il t it i• The portfolio of loans meets the similar assets criteria

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A pay fixed, receive floating interest rate swap is used to hedge against the change in the fair value of a portfolio of fixed rate single family mortgages

• Stated maturity of swap is consistent with the stated maturities of the• Stated maturity of swap is consistent with the stated maturities of the loans

• Swap amortizes on a schedule that equates to scheduled amortization of the loansamortization of the loans

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As part of its documented risk management strategy associated with this hedging relationship, on a quarterly basis, the credit union intends to do both of the following:

• Assess effectiveness of the existing hedging relationship for the past three-Assess effectiveness of the existing hedging relationship for the past threemonth period.

• Consider possible changes in value of the hedging derivative and the hedged item over the next three months in deciding whether it has an expectation that the hedging relationship will continue to be highly effective at achieving offsetting changes in fair value.

Loans can prepay – credit union considers prepayment risk of the tf li i it ti t tiportfolio in its prospective testing

If loans prepay faster than expected resulting in an over-hedge – credit union de-designates a portion of the swap for the next three month

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period

Portfolio Method Examplep$50 MM amortizing 15 year pay fixed / receive floating interest rate swap

Hedged item – a pool of 15-year fixed rate loans

Market Amortizing Rate Change in Change in

Hedge Change Net Swap Swap 15 Year Loan De-designationNotional From Swap Fair Fair Loan Pool Portfolio Dollar Effective Notional

Month Amt Inception Payment Value Value Unpaid Bal Value Offset % (y / n) AmountMonth Amt Inception Payment Value Value Unpaid Bal. Value Offset % (y / n) AmountMo. 0 50,000,000   0 bps 0 50,000,000  Mo. 1 49,796,823   ‐10 bps (104,527) (251,261) (251,261)   49,571,823   257,100     97.7% yesMo. 2 49,592,968   +5bps (97,316)    372,325   623,586     49,017,968   (508,479)   122.6% yesMo. 3 49,388,434   +10 bps (94,853)    639,043   266,718     48,632,600   (301,068)   88.6% yes 755,834               

Total (296,696) 639,043     (552,447)   115.7% yes 755,834               

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An interest rate cap is purchased to hedge against the decline in the price of a $100 million 10-year treasury note, which the credit union is holding in its available-for-sale inventory.sale inventory.

• Hedging item used - in-the-money interest rate cap• Hedged item - $100 million 10-year treasury note

N t f th i k b i h d d i t t t i k d fi d th• Nature of the risk being hedged - interest rate risk defined as the change in the fair value of the note in relation to the change in benchmark interest rate - US treasury rate

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Interest Rate Cap Example$100 MM semi ann al 10 ear ith a cap strike price of 2 78%$100 MM semi-annual 10-year with a cap strike price of 2.78%

Semi-annual Cap Reset Intrinsic Time TotalPayment Notional Strike Rate PV PV PV

1 100,000,000 2.78 0.38 - 6 6 2 100,000,000 2.78 0.62 - 1,152 1,152 , , , ,3 100,000,000 2.78 1.16 - 41,076 41,076 4 100,000,000 2.78 1.71 - 102,498 102,498 5 100,000,000 2.78 2.25 - 248,452 248,452 6 100,000,000 2.78 2.60 - 305,261 305,261 7 100,000,000 2.78 2.96 85,322 346,940 432,263 8 100,000,000 2.78 3.17 183,518 310,580 494,098 9 100,000,000 2.78 3.50 330,635 288,690 619,325

10 100,000,000 2.78 3.55 350,355 242,014 592,369 11 100,000,000 2.78 3.81 456,079 227,892 683,972 12 100,000,000 2.78 3.79 431,534 223,278 654,812 13 100 000 000 2 78 3 99 518 408 222 005 740 41313 100,000,000 2.78 3.99 518,408 222,005 740,413 14 100,000,000 2.78 3.96 485,731 192,042 677,773 15 100,000,000 2.78 4.11 545,324 189,797 735,121 16 100,000,000 2.78 4.05 506,228 197,983 704,211 17 100,000,000 2.78 4.17 543,733 197,474 741,208 18 100 000 000 2 78 4 15 526 343 198 058 724 401

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18 100,000,000 2.78 4.15 526,343 198,058 724,401 19 100,000,000 2.78 4.24 549,865 196,899 746,764

Total 5,513,076 3,732,098 9,245,174

Interest Rate Cap Example$100 MM semi ann al cap ith a strike price of 2 78%$100 MM semi-annual cap with a strike price of 2.78%

Hedged item – 10-year Treasury note

PV Initial PV Updated Change in Change in PV Initial PV Updated Change inIntrinsic Intrinsic PV Intrinsic Treasury Dollar Time Time PV Time

Value Value Value Security Value Offset % Effective ? Value Value Value

5,513,076 6,566,932 1,053,856 (1,142,384) 92.25% yes 3,732,098 3,625,143 (106,955) Ineffective

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A pay fixed, receive floating interest rate swap is used to hedge against the risk of increasing interest rates for a credit union's money market share accounts

• Hedging item used pay fixed receive floating interest rate swap• Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception

• Hedged item - payments on the $50 million of the credit union's money market share accountsmoney market share accounts

• Nature of the risk being hedged - variability in cash flows on its quarterly interest payments on $50 million principal of money market share accountsshare accounts

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A pay fixed, receive floating interest rate swap is used to hedge against the risk of increasing interest rates for a credit union's money market share accounts

• Re pricing beta is 0 50 compared with 60 day LIBOR and money• Re-pricing beta is 0.50 compared with 60-day LIBOR and money market accounts have an estimated life of 3 years

• Credit union enters into a 3-year 60-day LIBOR swap with a notional amount of $25 million and quarterly settlementsamount of $25 million and quarterly settlements

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Credit Union must perform effectiveness testing. To be effective, changes in money market rates must closely track changes in LIBOR. Effectiveness testing cannot be based on the changes in LIBOR only – must considerbased on the changes in LIBOR only must consider actual payments made because the dividend rate is not the risk free rate

Ineffectiveness can be measured in one of three ways:• Change in variable cash flows method – we will show

an example• Hypothetical derivative method

Change in fair al e method

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• Change in fair value method

• Hedge ineffectiveness is based on a comparison of:• Variable leg of the interest rate swap• Hedged variable-rate cash flows on the money market account

• Based on the premise that only the floating-rate component of the p y g pinterest rate swap provides the cash flow hedge

• The interest rate swap is recorded at fair value on the balance sheet. The calculation of ineffectiveness involves a comparison of the pfollowing amounts:

a. The present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap g pb. The present value of the cumulative change in the expected future interest cash flows on the variable-rate asset or liability

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• If the variability of the hedged cash flows of the variable-rate asset or li bilit i b d l l h i i bl t i d thliability is based solely on changes in a variable-rate index, the present value of the cumulative changes in expected future cash flows shall be calculated using the discount rates applicable to determining the fair value of the interest rate swapdetermining the fair value of the interest rate swap

• Hedge ineffectiveness results when the present value of the l ti h fl th d th t l f thcumulative cash flows on the swap exceed the present value of the

cumulative cash flows of the designated money market accounts. Conversely, there is no ineffectiveness if the PV of the designated money market payments exceed the PV of the swap (FAS ASC 815money market payments exceed the PV of the swap (FAS ASC 815-30-35-3(b)

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Change in Variable Cash Flow Method Example$25 MM 3-year pay fixed / receive floating interest rate swap$25 MM 3 year pay fixed / receive floating interest rate swap

Hedged item – variability in cash flows on its quarterly interest payments on $50 million principal of money market share accounts

E d P E d P P P I ff iAt Inception Testing After Initial Quarter

Expected Present Expected Present Present Present IneffectiveSwap Variable Value of Share Value of Value of Value of Portion of

Payment Receipts Variable Leg Payments Share Pmts Variable Leg Share Pmts the HedgeYear 1, Quarter 1 12,094 12,088 12,094 12,088 Year 1, Quarter 2 14,328 14,312 14,328 14,312 23,680 22,552 Year 1, Quarter 3 15,396 15,371 15,396 15,371 24,723 23,546 Year 1, Quarter 4 19,259 19,212 19,259 19,212 28,546 27,187 Year 2, Quarter 1 25,647 25,558 25,647 25,558 34,865 33,205 Year 2, Quarter 2 38,106 37,916 38,106 37,916 47,179 44,932 Year 2, Quarter 3 52,796 52,422 52,796 52,422 61,622 58,688 Year 2, Quarter 4 69,886 69,198 69,886 69,198 78,314 74,584 Year 3, Quarter 1 89,047 87,857 89,047 87,857 96,864 92,251 Year 3, Quarter 2 106,193 104,331 106,193 104,331 113,215 107,823 Year 3, Quarter 3 123,719 120,952 123,719 120,952 129,694 123,518 Year 3, Quarter 4 140,036 136,141 140,036 136,141 144,729 137,837

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706,506 695,359 706,506 695,359 783,430 746,124 37,306

Credit union purchases an interest rate cap to hedge against the risk of adverse extreme marketplace interest rate changes on the credit union's floating rate Federal Home Loan Bank advances.Home Loan Bank advances.

• Hedging item used – out-of-the-money interest rate capH d d it d t k t l i t t t h• Hedged item – adverse extreme market place interest rate changes related to its variable rate payments on the credit union's $50 million Federal Home Loan Bank advancesN t f th i k b i h d d i bilit i h fl th• Nature of the risk being hedged - variability in cash flows on the quarterly interest payments on its $50 million Federal Home Loan Bank advances

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Interest Rate Cap Example$50 MM 3-year quarterly with an out of the money strike price of 3.00%

Hedged item – 3-month LIBOR interest rate changes above 3.00%Quarterly Cap Reset Intrinsic Time TotalQuarterly Cap Reset Intrinsic Time Total

Period Notional Strike Rate PV PV PV1 50,000,000 3.00 0.24 0 0 02 50,000,000 3.00 0.25 0 3 3 3 50,000,000 3.00 0.27 0 4 4 4 50,000,000 3.00 0.33 0 154 154 5 50,000,000 3.00 0.45 0 59 59 6 50,000,000 3.00 0.65 0 735 735 7 50,000,000 3.00 0.89 0 4,216 4,216 8 50,000,000 3.00 1.18 0 13,257 13,257 9 50,000,000 3.00 1.47 0 12,363 12,363

10 50,000,000 3.00 1.75 0 23,970 23,970 11 50,000,000 3.00 2.03 0 40,364 40,364 12 50,000,000 3.00 2.27 0 58,180 58,180

Total 0 153,305 153,305

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Total 0 153,305 153,305

Interest Rate Cap Example$50 MM 3-year quarterly with an out of the money strike price of 3 00%$50 MM 3 year quarterly with an out of the money strike price of 3.00%

Hedged item – 3-month LIBOR interest rate changes above 3.00%Perfectly matched resets, indices and terms – fair value includes time & intrinsic value

Fair Value Change in Fair ValuePeriod -100 0 100 -100 0 100

0 18,484 153,305 531,600 (134,821) - 378,295 1 17,238 151,891 525,075 (1,246) (1,414) (6,525) 2 15,992 150,477 518,551 (1,246) (1,414) (6,525) 3 15 662 151 302 508 403 (330) 825 (10 148)

g

3 15,662 151,302 508,403 (330) 825 (10,148) 4 18,713 157,094 501,459 3,051 5,791 (6,944) 5 24,709 167,364 496,234 5,995 10,270 (5,225) 6 19,243 151,734 452,803 (5,465) (15,630) (43,431) 7 16,250 137,599 406,047 (2,994) (14,135) (46,756) 8 16 953 125 736 355 709 703 (11 863) (50 339)8 16,953 125,736 355,709 703 (11,863) (50,339) 9 20,391 114,157 299,916 3,437 (11,579) (55,792)

10 9,207 68,393 196,038 (11,184) (45,764) (103,878) 11 1,926 27,964 96,224 (7,281) (40,429) (99,814) 12 - - 33,953 (1,926) (27,964) (62,271)

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(153,305) (153,305) (119,352)

Call Report References• Other Assets,32–d Non-Trading Derivatives Assets, net• Liabilities, 7 Non-Trading Derivative Liabilities, net• Schedule D: Pages 20-24Schedule D: Pages 20 24

Risk Based Capital• AOCI not included in capital so no regulatory benefit for cash flow

hedge

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• Identify the optimal derivative(s) to be used given your credit union's ALM filALM profile

• Work with you to amend your ALM policies to allow for the use of derivatives

• Work with you to draft derivatives policies and procedures that ensure you have the proper internal controls in place and that you meet all of the NCUA requirements regarding the use of derivatives

• We can provide estimates of ongoing fair value for loans, investments, and liabilities which you have elected to account for at fair value. We can also help you with the initial selection of the items

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• For those electing hedge accounting we can:– Develop the appropriate interest rate hedge and hedging item(s)

to be used given your credit union's ALM profile– Work with you to identify the item(s) to be hedged and the nature y y ( ) g

of the risk being hedged– Ensure you are able to achieve hedge accounting - including

prospective and retrospective effectiveness testing on a dollar p p p goffset or statistical basis

– Provide you with the journal entries needed to report hedging activities

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Services and Contact Information

Asset Liability Management, Derivatives and Private Label MBS/CMOs:Frank Wilary fwilary@wilwinn.comy y@

Mergers and Acquisitions, Fair Value Footnotes, ASC 310-30, and TDRs:Brenda Lidke blidke@wilwinn.com

Mortgage Servicing Rights and Mortgage Banking Derivatives:Eric Nokken enokken@wilwinn.com

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Wilary Winn Risk Management LLCFirst National Bank Building

332 Minnesota Street, Suite W1750Saint Paul, MN 55101Saint Paul, MN 55101

651-224-1200

www.wilwinn.com

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