4/9/2018

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Derivatives - New Rules for Hedging Programs

SoCal EXPO, May 10, 2018 Glenn Suarez, Director, Client Services

Service Overview

Software: CapellaFX for Trade Management, Compliance, and Analytics

• Hedge Accounting & SEC Disclosures

• System of record for all FX transactions

• Reconcile to Zero – Performance reporting

Outsourcing: Accounting/Compliance for FX, IR and Commodities

• Documentation • Derivative valuations • GAAP compliant journal entries

• Effectiveness testing • Audit support • Disclosure Tables • SOC I

Consulting: Establish Hedge Programs & Best Practices for Foreign Currency, Interest Rate, and Commodities

• Cash Flow • Fair Value • Net Investment (FX) • Re-measurement (FX)

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AGENDA

• Hedge accounting basics • Overview of the changes that impact

hedging programs • Risks eligible to be hedged • Effectiveness Testing • Measurement • Accounting • Elections

• Adoption Considerations • Attractive Hedging Strategies • Q & A

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What is hedge accounting?

• Hedging is the process of mitigating risks • Can mitigate by entering into derivatives in accordance

with risk management objectives • Derivatives are recorded at fair value with changes

reporting in earnings • Hedge accounting aligns the timing and geography of the

derivative and the forecasted transactions • To qualify organization must complete documentation and

prove a highly effective offset through quantitative testing

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The Hedger’s Dilemma

Exposure 30 30

Derivative (30) (30)

P&L (30) 30 (0)

Period Period

1 2 Total

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Hedge Basics — Objectives

Exposure 30 30

Derivative (30) (30)

P&L (30) 30 (0)

Period Period Result

1 2 of Hedge

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Hedge Basics — Objectives

Exposure 30 30

Derivative (30) (30)

P&L (30) 30 (0)

Period Period Result

1 2 of Hedge

Fair Value Hedge

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Benefits of Special Hedge Accounting

• Timing – Aligns earnings impact of derivative and hedged item

• Geography – Permits alignment of reporting impact of derivative with

hedged item

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Hedge Accounting Designations

• Non-Designated Hedge • Fair Value Hedge

– Firm Commitments – Fixed rate debt swapped to floating – Inventory on the Books

• Cash Flow Hedge – Anticipated Purchases/Sales – Floating rate debt swapped to fixed

• Net Investment Hedge

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Key Themes in the Update

• Align accounting requirements with corporate risk management principles

• Make hedge accounting under GAAP easier, reduce non-GAAP reporting related to derivative activity

• Make more items hedg-eable, require less ongoing administration

• Reduce situations where de/redesignation of a hedge is required

• Incorporation of some IFRS 9 elements

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Eligible Risks – What can you hedge?

Hedged Items – Cash Flow

• Current requirement to hedge total variability in cash flows of purchases and sales of nonfinancial assets (e.g. commodities , commodity based products) has been relaxed under ASU 2017-12

• Basis differentials (e.g. location, grade) between hedge and hedged item complicate hedge accounting currently

• Contractually specified component of forecasted purchases or sales of nonfinancial assets is eligible to be hedged

• Creates symmetry in hedging models for financial and nonfinancial transactions

Can still hedge total variability in cash flows if you like

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Eligible Risks – Nonfinancial Items

Variability in total cash flows or overall changes in fair value

Existing Guidance

Variability in total cash flows or overall changes in fair value OR Variability in a contractually specific component*

New Guidance

Hedged Item

Hedged Item

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* Can be hedged for a period that extends beyond the contract’s term

Hedged Items – Cash Flow

• Contractually Specified Component

• “An index or price explicitly referenced in an agreement to purchase or sell a nonfinancial asset other than an index or price calculated or measured solely by reference to an entity’s own operations”

• “The definition of a contractually specified component is considered to be met if the component is explicitly referenced in agreements that support the price at which a nonfinancial asset will be purchased or sold”

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Hedged Items – Cash Flow

• Contractually Specified Component

• Can be hedged for a period that extends beyond the contract’s term, or for a not yet existing contract if entity expects to satisfy the contractually-specified-component requirements

• If there is a change in the contractually specified component, entity can reassess whether the contractually specified component continues to qualify as designated hedged risk

• No automatic de-designation is required

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Eligible Risks – Interest Rate

Any Contractually Specified Rate

US Treasury Libor Swap Rate Overnight Index Swap Rate (OIS) SIFMA (Securities Industry and Financial Markets Association)

Variable Rate

Fixed Rate

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• Benchmark component of fixed rate

• Partial term hedging

• Last of layer (mortgages)

• Pre-payable consideration

• SIFMA

• Back-up test for shortcut treatment

Hedged Items – Fair Value (IR)

Increased ability to define hedged interest rate risk such that it is well matched to plain vanilla hedging instruments

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Effectiveness Testing and Ineffectiveness

Measurement

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Hedge Effectiveness – Current Rules

• Current rules require contemporaneous preparation of hedge documentation, including effectiveness tests

• Quantification of ineffective portion of a highly effective hedge (typically immaterial)

• Ability to exclude portions of derivative gains and losses from effectiveness assessment, and report directly in income on a fair value basis • Forward points on FX forward contracts, option premiums

• Critical terms match approach implies matched to the day

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Hedge Effectiveness – New Rules

• Requirements have been relaxed with respect to:

• Timing of effectiveness test

• Amount of quantitative work required

• Components that may be excluded from effectiveness testing and reporting methodology

• Reporting hedge ineffectiveness

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Critical Terms Match

• Critical terms match (CTM)

• Within a 31 day period or fiscal month

• Could impact dual purpose hedgers and hedge periods greater than a month (FX only)

• What happens when facts and circumstances change?

• Define a quantitative test at inception of hedge relationship

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Effectiveness Testing

• Quantitative Test Required for Prospective Assessment – 2 Day Rule of Thumb Replaced by End of Quarter – Control issue: insure tests are complete by quarter end

• Qualitative Test Permitted for Retrospective Assessments – If Relationship Changes – Quantitative/Qualitative

815-20-25-3

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Time Value - Excluding from Effectiveness Assessment

Option Premiums Forward Points

Option Premiums Forward Points Cross Currency Basis Spreads

Current GAAP

Amended GAAP

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Measurement • Ineffectiveness as a concept is eliminated

• No more measuring, no more reporting

• Fair value hedges will still have an earnings impact

• Consider whether hedging total variability in cash flows may be attractive (as opposed to component hedging), in light of the elimination of hedge ineffectiveness

• Excluded items may be amortized using a rational basis

• Can continue to use mark to market as a policy election

815-30-35-3 & 815-20-25-83(A)

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Accounting

Accounting

• As long as you pass your ongoing effectiveness assessment……

• Quantitative or Qualitative

• Mark to market the derivative, record any excluded items in income, the rest goes to OCI (CF hedges)

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Recognition of Excluded Components

Mark-to-Market • Measured at fair value • Changes recognized in earnings

Current GAAP

Amended GAAP

Mark-to-Market • Measured at fair value • Changes recognized in earnings

Amortization • Systematic and rational approach

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Derivative Accounting

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• Elect where effective, ineffective, and excluded derivative gains/losses will be recorded for cash flow and fair value hedges

• Cash Flow - Record ineffectiveness in P&L

• Derivative impact reclass to same line item as hedged item(s) for CF & FV*

• Excluded portion of CF/FV hedges follow hedge item

* Exceptions – line items not specified

• Cash flow hedged items probable NOT to occur

• OCI reclass to P&L timing mirrors hedged item

• Less flexibility on where to record impacts of excluded components

• Excluded Component of net investment hedge can be recorded per documentation

• Voluntary de-designation still permitted

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Documentation

• 2 Day Completion Convention Remains

• Additional time for effectiveness testing

• Must Specify Quantitative or Qualitative Assessment

• Consider regular quantitative testing if you are regularly hedging

• Although Not Measuring for Effectiveness…

– Hedged Item Specificity & Expected Dates Required

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Disclosures

• Ineffectiveness No Longer Required • Balance Sheet Tables Remain (including offset tables) • Addition to P&L Table

• Include total amounts recorded in income statement line items that contain hedge impacts

• All Qualitative Disclosures Remain • All Other Quantitative Disclosures Remain

– OCI Released in Next 12 months – Indications of Size and Frequency of Trading Etc.

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Adoption and Elections

Adoption - Dates

• Guidance ASU 2017-12 issued in August

• Mandatory adoption for public companies – fiscal years beginning after December 15, 2018

• All others – fiscal years beginning after December 15, 2019

• Early adoption permitted – if an interim period – any adjustments shall be reflected as of the beginning of the fiscal year that includes the interim period (i.e. 1/1/17 for calendar year companies)

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Adoption - Considerations • One Time Elections

• To move to qualitative testing

• To designate the hedged risk as variability in cash flows attributable to changes in contractually specified component on a cash flow hedge

• Add backup test for shortcut

• Hedge benchmark component of coupons

• Change excluded treatment from fair value to amortization

• Can have some TV exclude hedges that MTM points through income, and some that amortize, at the same time

• De-designation/re-designation required to move from exclude time value to include

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Early Adoption?

• Strong incentive to early adopt, especially if new to hedging, due to the decreased administration under new rules

• Very little you have to change to adopt the new standard; can largely keep existing strategies intact

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Early Adopters - Incentives

• Commodity hedges

• Take advantage of contractual component hedging

• Regressions may still need to be run, but likely to pass, and no hedge ineffectiveness will be booked

• Interest Rate hedges

• Eliminate hedge ineffectiveness

• Floored debt hedged by un-floored swaps

• Fair value hedges with large credit component in coupon

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Early Adopters - Incentives • Foreign Exchange Hedges

• Eliminate ineffectiveness (though typically immaterial)

• Move from time value exclude approach to time value include

• Ask auditors if existing time value exclude hedges can be allowed to run off, while entering into new hedges using time value include approach

• Can also amortize excluded forward points, but may be more incentive to change to include forward points in effectiveness assessment

• Cross currency swaps

• Take advantage of ability to recognize interest as accrued, with remainder of swap fair value not impacting earnings, based new provisions in guidance relating to systematic and rational amortization of excluded components

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• US and European interest rate differentials have motivated the use of cross currency swaps designated as either net investment hedges or hedges of nonfunctional currency denominated loans

• Strategies allow for reduction in interest expense based on rate differential

• Net Investment Hedges: Amortization methodologies may treat reporting of accrued interest differential in income, with all other parts of currency swap fair value reported in OCI/CTA, as a systematic and rational method of recognizing excluded components in income

• Subject to interpretation

• With only interest accruals/payments reported in income, and no other fair value components, clean accounting outcome under new guidance with no MTM noise in P&L

Attractive Strategies under ASU 2017-12

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Cash Flow Hedge

IR Swap

Net Investment Hedge

Term Loan XYZ Inc. CC Swap

XYZ Limited

EUR Net Assets

EUR Fixed

USD Fixed

USD FloatUSD Fixed

USD Float

• Historically low interest rate environment has resulted in lenders including minimum LIBOR interest rates (typically 0% in variable rate credit facilities)

• If these floors are not mirrored in hedging swaps, hedge ineffectiveness results under current GAAP

• New rules motivate early adoption for these unfloored swaps against floored debt

• Regressions generally pass (expected to continue with expected LIBOR rate path)

• No ineffectiveness needs to be booked

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y = 0.8853x - 1882.2R² = 0.9944

Attractive Strategies under ASU 2017-12

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• Last –of-Layer hedging approach may allow for hedging mortgage/prepayable assets, which is problematic under current hedge accounting rules

• FASB is revisiting guidance, to determine whether multiple layers of a portfolio can be hedged

• Not clear if you can designate Swaps 2 and 3 in diagram

• Treatment of basis adjustments for hedged items in last of layer designation also being revisited

Attractive Strategies under ASU 2017-12

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-

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

140,000,000

07/2

017

06/2

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05/2

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03/2

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02/2

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01/2

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12/2

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11/2

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09/2

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08/2

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07/2

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06/2

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05/2

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02/2

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01/2

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12/2

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11/2

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10/2

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09/2

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08/2

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07/2

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03/2

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02/2

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01/2

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12/2

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11/2

046

Swap 3

Swap 2

Swap 1

Closed Portfolio #1 Balance

Adoption - Factors to Consider

• Option premiums can be amortized

• FX options: can expense option over life of trade, or all at once end of trade

• Interest Rate Caps: can amortize premium straight-line (time value excluded), or expense based on caplet schedule (time value included)(back loaded)

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$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

$800,000

$900,000

$1,000,000

Cumulative Premium Expensed(TV Exclude - Straight Line)

Cumulative Premium Expensed(TV Include - Caplet)

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• Review current program to determine to how capitalize on new accounting rules

• Treatment of time value, strategies which generate hedge ineffectiveness, net investment hedges

• Revisit commodity hedging and potential to apply contractual component approach

• Adopt new guidance if establishing a hedge program

• Financial institutions – consider various new opportunities to manage balance sheet risk

• Last of layer, partial term hedging etc.

• Reduced hedge accounting complexity, but more decisions to be made

Summary – How to Benefit from ASU 2017-12

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Q&A

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THANK YOU

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gsuarez@hedgetrackers.com

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Contact Me

Glenn Suarez, CFA

Director, Client Services

Contact Us

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