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NOTES ON RISK, HEDGING, AND

HEDGE ACCOUNTING [FAS 133,


IAS -39]

TRIB

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OUTLINE
• RISK
• HEDGING
• ACCOUNTING RECAP
• OCI vs. EARNINGS
• HEDGE ACCOUNTING
• EFFECTIVENES
• HEDGE DESIGNATION PROCESS
• QUESTIONS!!!
• EXAMPLES
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RISK-DEFINITION/TYPE/MEASUREMENT
• DEFINITION: Risk is potential of loss in the value of your position
due to the adverse movement of a market variable / or a future
event [market variable/an event].

An Example – Commodity Coffee. Starbucks vs. Coffee producer in


Nigeria

• TYPE OF RISK: Because of your position: 1.upside, 2.downside, or


both

• MEASUREMENT: Volatility of the variable- Standard Deviation - if


it’s market variable
Probability of the event taking place – if it’s an event

* Market variable -> market risk, event of default by counter party – credit risk
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HEDGING-1
• Definition: Activity that enables one to
guard against potential of loss in the value
in the future due to adverse change in the
variable
• Example: Starbucks again
Question???
Due to its business activity (position)
Starbuck is exposed to –[TYPE]- risk
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HEDGING-2
POSSIBLE SOLUTION!! - Long a Forward or Future
Suppose we long a forward

Risk Risk

Profile Profile
K Coffee Price K Coffee Price

Risk profile of Starbucks (a) Risk profile of Forward (b)

Risk
Profile
K Coffee Price

Risk profile of combined 5


position (a+b)
HEDGING-3
ANOTHER POSSIBLE SOLUTION!!
Long a Call Option at Strike price K

Risk Risk

Profile Profile
K Coffee Price K Coffee Price

Risk profile of Starbucks (a) Risk profile of Call Option (b)

Risk Recall the


Profile
K Pay-Off of the
Coffee Price
Put Option
Risk profile of combined 6
position (a+b)
ACCOUNTING RECAP -1
Dividend, Expense, Asset and Losses (DEAL) accounts increase in value when
debited and decrease when credited, whereas Gains, Income, Revenues, Liability
and Stockholder's (Owner's) equity (GIRLS) accounts decrease in value when
debited and increase when credited.

Debit/credit
Account Debit Credit
Assets ? ?
Expenses ? ?
Liabilities ? ?
Shareholder Equity ? ?
Revenue ? ?

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ACCOUNTING RECAP -2
VALUATION METHODS – (1)ACCRUAL (HISTORICAL)

(2)MTM (FMV)

DOUBLE ENTRY [T-ACCOUNTS]


Every transaction will have double entry – also called as T accounting [a credit entry in one account, and a
debit entry in other account]. Following are some examples.
Note in T-accounts debits are shown on left and credits are shown on right

Example: Sell the goods worth $1000 in cash


T- Account entries will be as follows:

Cash in hand [Account] Inventory [Account]

Debit
$1000 Credit Goods
worth $1000

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OCI vs. EARNINGS
FAS 133
• Derivatives are reported in balance sheet as an asset or liability @ MTM. Hedge A/C
• Change in the value of derivative to be reported in earnings;
- potential to bring the volatility in current earnings [due to leverage effect].
• For some cases the gains or losses in the value of the derivatives can be reported
under OCI.

Earnings is operating income (P&L Statement)


• Performance measure for an equity or market analyst- less volatility is preferred

So, what is OCI?

OCI is other comprehensive income a subsection of equity section of balance sheet.

For some cases gains and losses on derivatives can be parked in OCI, Good for
corporate treasuries.

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DERIVATIVE ACCOUNTING Purpose of
Derivative

Trading
Hedging

Type of Hedged
Instrument

-Floating-rate assets
-Floating-rate liabilities
-Fixed-rate assets
-Forecasted commodity
-Fixed-rate liabilities
transactions -Foreign currency firm
-Firm commitments
-FX-Denominated forecasted commitments
-FX-denominated debt and
third party or intercompany
AFS securities
transactions

-MTM on B/S
-Looses and Gains
Cash Flow Fair Value Net Investment
are reported in
Hedge Hedge Hedge
Earnings

-MTM on B/S
-The effective portion of the gain or loss on a -MTM on B/S -MTM on B/S
derivative instrument designated and
-The gain or loss on a derivative instrument -The gain or loss on the hedging derivative or
qualifying as a cash flow hedging instrument
designated and qualifying as a fair value nonderivative instrument in a hedge of a
shall be reported as a component of other
comprehensive income (outside earnings) hedging instrument as well as the offsetting foreign-currency-denominated firm
and reclassified into earnings in the same loss or gain on the hedged item commitment and the offsetting loss or
period or periods during which the hedged attributable to the hedged risk shall be gain on the hedged firm commitment shall
forecasted transaction affects earnings. The recognized currently in earnings in the be recognized currently in earnings in
remaining gain or loss on the derivative same accounting period the same accounting period
instrument, if any, shall be recognized 10
currently in earnings
HEDGE ACCOUNTING
RISKS WE ARE HEDGING VS. HEDGE TYPE

-Change in the Fair value of the Fair Value


Hedge
hedged item

-Variability in the cash flow of


forecasted (expected) transaction Cash Flow
Hedge
-Foreign Currency Exposure
• Unrecognized foreign currency
denominated firm commitment
• FX denominated Available for sale
Net Investment
Security
Hedge
•Forecasted FX denominated
transaction
•Net investment in foreign operation/
foreign currency firm commitments 11
EFFECTIVENESS-1
• WHAT IS EFFECTIVENESS?

• Goals of effectiveness process:


1.) to assess the effectiveness [yes/no, e.g. ratio test ], and
2.) to measure the ineffectiveness

How you assess or measure?


Compare MTM of Hedge Instrument to MTR (mark to risk) calculation of
Hedged item

Why?
MTM captures all the risks; MTR measures the designated risk
Mark to risk is the relevant change- how much of this is being hedged by
hedging instrument (ineffectiveness)
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EFFECTIVENESS-2
One can specify what part of the MTM change in hedge
instrument will be used for effective assessment
Example:
Option: one can choose change in intrinsic value, min
value, or fair value
Forward, Future: one can use change in FV due to change
in spot prices

Total change in Portion Used to Portion not used to assess


Derivative value = assess + the effectiveness; report
(Hedge Inst.) the effectiveness in earnings

Effective Portion;
+ Ineffective Portion;
Report in OCI
report in earnings
(CF and NIF) 13
EFFECTIVENESS-3
• MTR (Mark to Risk) calculation of Hedged Item
- Capture change in value due to designated
risk[s] only
- MTR methods
- Spot Undiscounted
- Spot Discounted
- Forward
- Forward Undiscounted

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EFFECTIVENESS-4
• TYPE OF EFFECTIVENESS TEST
-Prospective
-Retrospective

• Frequency of the effectiveness tests


- Min (three months, financial statement
reporting time)
- Check the effectiveness over the period of
designation: Type – cumulative or periodic
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EFFECTIVENESS-5
• Hedge Effectiveness assessment/measurement
methods
(1.) Critical terms comparison
(2.) Dollar offset method
(3.) Regression Analysis
.8<=EFF RATIO<=1.25

Dollar Offset Method


(a.) Hypothetical derivative
(b.) The benchmark Rate
(c.) Sensitivity Analysis

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HEDGE DESIGNATION PROCESS FLOW
STEP-1:Document the following: Documentation
description of Hedge, Hedge relationship,
risk management Objective, Hedge Type, Part
Designation date, De-desig. date

STEP-2:LINK- Hedged item (exposure which STEP-2B:-List Hedged item. , which includes
STEP-2A:-List Hedge Instru. , which includes
is exposed to one or more than one type Trade desc, proportion, partial from to date,
Trade desc, proportion, partial from to date,
of the designated risk) to Risk Designation, How MTR will be calculated (for
Hedge method (if CF or NIF), How effectiveness
Hedging Instrument (instrument eg forward Discounted etc), OCI adj Freq,
will be calculated [for option( int,min, FV),
which hedges the selected risk)
for forw or fut change due to spot or all incl

STEP-1A:Based on Hedged item


Select Hedge Type

Fair Value Hedge Cash Flow Hedge Net Investment Hedge

STEP-3: Select Effectiveness assessment method both prospective and retrospective,


Assessment type cumulative or periodic, frequency of assessment

STEP-4: Publish OCI release schedule, IF APPLICABLE


(Fair value Hedge doest require this) Accounting
Part
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