Derivatives and Hedging. Mike Loritz and Tim Woods

Transcription

1 MHM Executive Education Series: Derivatives and Hedging Presented by: Mike Loritz and Tim Woods August 16, 2012

2 Agenda Basics - Overview of the definition of a derivative Identification and accounting for embedded derivative instruments Requirements for the application of hedge accounting and common hedging strategies Cash flow hedges Fair value hedges Net investment hedge Common valuation issues associated with certain derivative instruments 2

3 What is a Derivative? Characteristics of Derivatives A derivative financial instrument is an instrument whose value is dependent on or derived from the value of an underlying asset, reference rate, or index. Derivatives have the following characteristics: One or more underlyings One or more notional amounts (or payment provisions) Little or no net investment Net settlement e e t provisions o s (or market mechanism to facilitate net settlement) 3

4 What is a Derivative? Characteristics of Derivatives Underlying The underlying is the variable that, along with the notional amount and or payment provisions, determines the settlement of the derivative. Examples of the underlying are: A security price or index (e.g. in a stock option the underlying is the price of the stock) An interest rate (e.g. in an interest rate derivative = LIBOR) A commodity price (e.g. in a futures contract = price of oil) An exchange rate (e.g. in a FOREX contract = USD/EUROS) 4

5 What is a Derivative? Characteristics of Derivatives Notional Amount The notional amount is the number of units of the derivative contract. Examples of the notional amount are: 10,000 stock options (e.g. in a stock option the notional amount is the number of options, or shares upon exercise) $1,000,000 (e.g. in an interest rate swap, the notional amount is the amount of the currency that is being swapped into either a variable or fixed interest rate) 40,000 barrels of oil (e.g. in a futures contract for oil, the notional amount is the total amount of the commodity) $1,000,000 (e.g. in a FOREX contract, the notional amount is the amount that is being exchanged for another currency) 5

6 What is a Derivative? Characteristics of Derivatives Initial Net Investment Many derivative instruments require no initial net investment (e.g. interest rate swaps, futures contracts, forward contracts, etc ) However, certain derivative contracts require an initial net investment as compensation for one or both of the following: Time value (e.g. premium on an option) Terms that are more or less favorable than market conditions (e.g. a premium on a stock option with an exercise price that is less than the current market price of the stock) 6

7 What is a Derivative? Characteristics of Derivatives Net Settlement Net settlement allows the parties to a derivative contract to settle the contract at its net value rather than the value based upon its notional terms. A contract meets the definition of net settlement if it can be settled in any of the following ways: Net settled under its contract terms Net settled through a market mechanism (e.g. in the stock option example, if the stock option could not be net settled, provided that a liquid market mechanism exists that will put the holder in substantially the same position as net settlement, then net settlement is presumed to exist) Net settlement by delivery of derivative instrument or asset that is readily convertible to cash This is an important factor when considering embedded derivatives in private company equity securities and contracts settled in (or potentially settled in) an entities own shares. 7

8 What is a Derivative? Characteristics of Derivatives Payment Provision A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner. For example, a derivative instrument might require a specified payment if a referenced interest rate (underlying) settles at an amount that is greater than 5%. 8

9 Derivatives Basic Principles Derivatives can be assets or liabilities!! Limited exceptions i.e. can a purchased option be a liability? All derivatives are recorded on the balance sheet at fair value. Specialized accounting may apply if a transaction qualifies for hedge accounting and the proper election is made. Documentation requirements must be met. Quarterly analysis required. (certain limited exceptions) 9

10 Derivatives Scope Exceptions to Topic 815 The following contracts are not subject to the requirements of derivative accounting: Regular way trades Normal purchases and normal sales (if elected) Certain insurance contracts Financial guarantee contracts Certain contracts that are not traded on an exchange Derivatives that serve as impediments to sales accounting Investments in life insurance Certain investment contracts Most loan commitments Leases Registration payment arrangements 10

11 Continued - Scope Exceptions to Topic 815 The following contracts issued or held by a reporting entity are not subject to the requirements of derivative accounting: Contracts issued or held by that reporting entity that are both 1) indexed in its own stock and 2) classified in stockholders equity. Contracts issued by the entity that are subject to Share Based Compensation guidance. Contacts issued by the entity as contingent consideration from a business combination. Forward contracts that require settlement by the reporting entity s delivery of cash in exchange for the acquisition of a fixed number of its equity shares. The above exceptions do not apply to the counterparty in those contracts. In addition, a contract that an entity either can or must settle by issuing its own equity instruments but that is indexed in part or in full to something other than its own stock can be a derivative, in which case it would be accounted for as an asset or liability. 11

12 Embedded Derivatives 12

13 Embedded Derivatives A component of a hybrid contract that is embedded in a nonderivative instrument ( host contract ) that modifies the cash flows or the value of other exchanges required by a contract, in a manner similar to a derivative. The embedded feature must be separated from the host contract and accounted for as a derivative if: a free standing instrument with same terms as the embedded derivative meets the ASC 815 definition of a derivative, and the economic characteristics/risks of the embedded derivative are not clearly and closely related to the economic characteristics of the host contract. The hybrid contract is not subject to re-measurement at fair value under GAAP. 13

14 Embedded Derivatives Identification A Hybrid instrument contains terms that affect some or all of the cash flows under the contract in a manner similar to a derivative financial instrument. t Typically the embedded derivative will alter the cash flows as compared to a similar contract without the same feature(s). If the fair value of the Hybrid instrument is different than the fair value of the same instrument without the embedded feature, it most likely is the result of a change in the potential or actual cash flows. 14

15 Embedded Derivatives - Sources A common source of embedded d derivatives result from financing transactions, including: Convertible debt conversion and any redemption features must be analyzed Preferred securities redemption and other features (puts, calls, etc) PIK dividends and contingent dividend increases Non-detachable Warrants (detachable warrants are considered freestanding) settled in an entity s own stock?? Foreign Currency Transactions 15

16 Derivatives Scope Exceptions Scope exceptions specific to embedded derivatives: a. Normal purchases and normal sales contracts b. Unsettled foreign currency transactions c. Plain-vanilla ill servicing i rights d. Features involving certain aspects of credit risk (subordination) e. Features involving certain currencies 16

17 Embedded Derivatives Foreign Currency Scope Exceptions Unsettled foreign currency transactions (including financial instruments) are not considered embedded derivatives if they are accounted for under ASC An embedded foreign currency derivative within a non-financial host contract is not bifurcated if it requires payment denominated in: The functional currency of any substantial party The currency in which the price of the good/service is routinely denominated in international markets The local currency of either substantial party The currency used by a substantial party as if it were functional (i.e. highly inflationary economy) 17

18 Embedded Derivatives Is the contact carried at fair value through earnings? Would it be a derivative if it was freestanding? Is it clearly and closely related to the host contract? No Yes No Bifurcate Yes No Yes Do Not Bifurcate 18

19 Clearly & Closely Related Generally, an embedded derivative whose fair value is commonly associated with the fair value of the host contract is clearly and closely related Equity features are typically clearly and closely related to an equity host conversion option in preferred stock Generally, debt features that only alter the amount of interest payments made on the host contract are considered clearly and closely related. Variable rate debt Prepayment provisions 19

20 Clearly & Closely Related Purchase Contract Floor and cap on the price of the asset is clearly/closely related Equity Host A put option on the equity securities is NOT clearly/closely related Leases Inflation indexed rentals are clearly/closely related Contingent rentals are clearly/closely related 20

21 Clearly & Closely Related Interest Rate Underlyings (ASC ) An embedded derivative in which the only underlying is an interest rate or interest rate index(such as an interest rate cap or an interest rate collar) that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract that is considered a debt instrument is considered to be clearly and closely related to the host contract unless either of the following conditions exists The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment. 21

22 Clearly & Closely Related Interest Rate Underlying s (ASC ) The embedded derivative meets both of the following conditions: There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor s initial rate of return on the host. For any of the possible interest rate scenarios under which the investor s initial rate of return on the host contract would be doubled, the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return for a contract that has the same terms. 22

23 Embedded Derivatives If an embedded feature is required to be bifurcated: Record full fair value of the embedded derivative(s) on the balance sheet and allocate remaining value to the host contract/instrument. Account for the host contract under the applicable accounting standards Account for the embedded feature(s) in accordance with ASC 815 Can be freestanding Can be a hedging instrument If the fair value of the embedded cannot be reliably determined, the Host contract together with the embedded derivative (Hybrid) must be accounted for at fair value 23

24 Embedded Derivatives Example: ABC Company issues preferred stock that allows the holder the option to put the stock back to ABC Company for an amount equal to the outstanding par plus dividends payable after a period of 5 years from the issuance date. The preferred stock pays interest of 12% annually. Is the embedded put feature considered clearly and closely related to the host contract? What if the instrument had an embedded conversion feature? 24

25 Embedded Derivatives Analysis: Host Contact: The preferred stock instrument Embedded Derivative Put Right: Underlying: Benchmark Interest Rates Notional: Par Value Preferred Stock Net Settlement: Assume Yes Initial Investment: No Since the preferred stock in this instance is more akin to a debt instrument than an equity instrument (ASC ), the put feature would be considered clearly and closely related. 25

26 Embedded Derivatives Example: ABC Company issues fixed rate debt at a par value of $100 and a maturity of 10 years. The debt is callable by ABC Company at any date after issuance at a rate of 105 for the first 5 years and at par thereafter. Is the embedded call feature considered clearly and closely related to the host contract? 26

27 Embedded Derivatives Analysis: Host Contact: The debt instrument Embedded Derivative Call Option: Underlying: Benchmark Interest Rates Notional: Par Value Debt Net Settlement: Yes Initial Investment: No Since the instrument could not be settled such that the investor would lose their investment and the call option has only a single interest rate underlying (DIG B39), the call option would be considered clearly and closely related. 27

28 Hedge Accounting 28

29 What is Hedging? From an economic standpoint, hedging is using derivative instruments (or potentially other vehicles) to offset risks (or volatility) that are present in a company s business model in order to maintain a predictable outcome. Fair value: maintain the fair value of an item Cash flow: achieve predictable cash flows From an accounting standpoint, there are specific criteria that must be met prior to a company s implementation of hedge accounting. 29

30 What is Hedging? Derivatives that are accounted for as freestanding are recorded at fair value at each reporting date with the change recorded in earnings. Provided that the requisite hedging criteria are met, derivatives that are accounted for as hedging instruments are also recorded at fair value; however, the accounting for the impact to earnings is based upon the type of hedge that has been implemented. Regardless of whether hedge accounting is utilized, ALL derivatives are recorded on the balance sheet at their estimated fair value. For accounting purposes, there are generally 3 types of hedges: Fair value hedge Cash flow hedge Foreign currency hedge 30

31 What is Hedging? Fair value hedge Economic purpose is to enter into a derivative instrument whose changes in fair value directly offset the changes in fair value of the hedged item. I.e. item has fixed cash flows. Cash flow hedge Economic purpose is to enter into a derivative instrument whose gains and losses on settlement t directly offset the losses and gains incurred upon settlement of the transaction being hedged. Foreign currency hedge If the hedged item is denominated in a foreign currency, then an entity may designate the hedge as either 1) a fair value hedge of that item, 2) a cash-flow hedge of that item, or 3) a hedge of a net investment in a foreign operation. 31

32 Types of Hedging Fair value hedge In a fair value hedge the gain or loss on a derivative instrument designated and qualifying as a fair value hedging instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized currently in earnings in the same accounting period. Intent is to convert a fixed cash flow instrument with a variable fair value to a fixed fair value. EXAMPLE: FIXED RATE DEBT Special treatment t t = Hedged d Item 32

33 Types of Hedging Cash Flow Hedge In a cash flow hedge, the effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedging instrument shall be reported as a component of other comprehensive income (outside of earnings) and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings. Any portion of the derivative instrument that is designated as a cash flow hedge that is determined to be ineffective should be recognized in earnings immediately. Intent is to convert a variable cash flow instrument to a predictable set of cash flows. 33

34 Types of Hedging Cash Flow Hedge EXAMPLES: VARIABLE RATE DEBT, FORECASTED SALES & PURCHASES Special Accounting Treatment: The Unrealized Gain/Loss on the hedging instrument 34

35 Types of Hedging Foreign Currency Hedge Foreign currency hedges designated as either fair value hedges or cash-flow hedges are accounted for in the same manner as regular fair value and cash flow hedges. A derivative instrument or a non-derivative financial instrument that may give rise to a foreign currency transaction gain or loss can be designated as hedging the foreign currency exposure of a net investment in a foreign operation. 35

36 Types of Hedging Foreign Currency Hedge The gain or loss on a hedging derivative instrument (or the foreign currency transaction ti gain or loss on the non-derivative hedging instrument) that is designated as, and is effective as, an economic hedge of the net investment in a foreign operation shall be reported in the same manner as a translation adjustment to the extent it is effective as a hedge. 36

37 Types of Hedging Foreign Currency Hedge Example: A US domiciled company with foreign operations wishes to decrease the potential volatility to equity as a result of the currency translation adjustment. The company could enter into a foreign currency derivative (i.e. option, currency swap, forward, etc.) to hedge the volatility. This is similar to a fair value hedge. Special Accounting Treatment The unrealized gain/loss on the hedging instrument is recorded as a component of the currency translation adjustment 37

38 Hedge Documentation Formal Documentation Under ASC 815 ASC 815 contains explicit guidance regarding the application of hedge accounting models, including documentation and effectiveness assessment requirements. One of the fundamental requirements of ASC 815 is that formal documentation be prepared at inception of a hedging relationship. ASC 815 stresses the need for the documentation to be prepared contemporaneously with the designation of the hedging relationship. Hedging is a Privilege, Not a Right! 38

39 Hedge Documentation Documentation must include: Hedging relationship Entity s risk management objective and strategy for undertaking the hedge, including: Identification of the hedging instrument Identification of the hedged item or forecasted transaction(s) Identification of how the hedging instrument s effectiveness in offsetting the exposure to changes in the hedged item s fair value (fair value hedge) or the hedged transaction s variability in cash flows (cash flow hedge) attributable to the hedged risk will be assessed. How ineffectiveness will be measured 39

40 Hedge Documentation Effectiveness Assessment: Both at the inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving Offsetting changes in the fair value attributable to the hedged risk during the period that the hedge is designated (in the case of a fair value hedge) or Offsetting cash flows attributable to the hedged risk during the term of the hedge (in the case of a cash flow hedge). An assessment of effectiveness is required whenever financial statements or earnings are reported; at least every three months. All assessments of effectiveness must be consistent with the originally documented risk management strategy for that particular hedging relationship. 40

41 Hedge Documentation In measuring the effectiveness of a cash flow hedge, the Company must measure the correlation of the expected (hedged) result and the actual result (difference should be minimal for an effective hedge). In terms of a fair value hedge, the Company must measure the correlation of the change in fair value of the hedged item and the change in fair value of the derivative being utilized in the hedge. As stated t before, there are certain situations ti in which h the Company can utilize the critical terms match method, provided that the requisite criteria are met, and can therefore presume that no- ineffectiveness exists. 41

42 Cash Flow Example Sample Company XX (Company) intends to enter into a transaction with Counterparty A (Counterparty) as part of the Company s overall risk management policies and intends to designate an interest rate swap as a hedge of the exposure to changes in cash flows resulting from changes in interest rates associated with the Company s variable rate debt. 42

43 Cash Flow Example Risk Management Objective The Company s risk management objective is to reduce exposure to the variability in cash flows (interest t payments) associated with changes in the 3 month LIBOR benchmark interest rate on $10 million of outstanding principal of the Company s note payable to Bank A. The Company intends to hedge its exposure to changes in the benchmark interest rate by entering into a pay fixed, received variable (3 month LIBOR) interest rate swap. The variable leg of the swap is intended to offset changes in the cash flows attributable to changes in the 3 month LIBOR benchmark interest rate. 43

44 Cash Flow Example Hedged Item The Company is hedging the changes in cash flows, associated with changes in the 3 month LIBOR rate only, on the monthly variable rate interest payments beginning on January 1st, 2011 and the 1st of each month thereafter on the Company s $10 million in outstanding debt with Bank A. Based on the Company s internal evaluation, the future interest payments associated with the outstanding debt with Bank A are assessed as probable of occurring as the debt is not callable ab by the lender and the Company intends for the debt to remain outstanding throughout the hedged period (maturity). Additionally, we have assessed the counterparty credit risk and determined that the likelihood the counterparty would default on any payments due under the contractual terms of the hedging instrument is not probable (ASC ). 44

45 Cash Flow Example Hedged Item Therefore, the Company has elected to ignore the impact of changes in the counterparty credit risk as well as the Company s non-performance risk in the assessment of effectiveness and ineffectiveness. As a result, changes in the fair value of the hedging instrument related to counterparty credit risk and non-performance risk will be included as a component of accumulated other comprehensive income (AOCI) until the hedged cash flows impact earnings. Hedging Instrument The hedging instrument is the pay fixed, received variable interest rate swap with Counterparty A. 45

46 Interest Rate Swaps Effectiveness Assessment: The Company will perform the initial and on-going effectiveness assessment through h a regression analysis of the monthly change in the actual interest rate swap and a perfectly effective hypothetical (PEH) swap designed to entirely offset the changes in cash flows as a result of changes in the 3 month LIBOR. The regression analysis will use a minimum of 60 monthly data points (length of the hedging relationship) prior to the hedging relationship. When correlating the actual swap value to the perfectly effective hypothetical derivative instrument, the R2, or coefficient of determination, which is the R, or coefficient of correlation, squared, should be equal to or greater than 0.8. The R2 factor should be greater than (0.8) and less than or equal to 1.25 in order to be considered highly effective.

47 Cash Flow Example Effectiveness Assessment: Additionally, the Company will update the assessment of the probability of fthe hedged dcash hflows occurring and dthe assessment of counterparty t and non-performance credit risk on a quarterly basis. To the extent the hedged cash flows remain probable of occurring, and counterparty default is not probable, the Company will exclude the impact of changes in counterparty credit risk from the valuation of the perfectly hypothetical derivative and actual derivative for purposes of the effectiveness and ineffectiveness testing.

48 Cash Flow Example Ineffectiveness The Company will use the cumulative dollar-offset method to assess the ineffectiveness on a quarterly basis. The Company will compare the change in the value of the actual interest rate swap with the change in the fair value of the perfectly effective hypothetical swap (a swap assuming the same critical terms as the hedged item). The actual interest rate swap will be recorded at the credit adjusted fair value on the balance sheet with an offsetting entry to other comprehensive income. The amount of ineffectiveness to be recorded equals the lesser of the cumulative change in the fair value of the actual interest rate swap or the cumulative change in the fair value of the perfectly effective hypothetical ti swap. 48

49 Net Investment Hedge Designation of a net investment in a foreign operation as a hedged item would be is the same as designating a group of dissimilar assets and liabilities as the hedged item, which is not permitted for a fair value or cash flow hedge. However, ASC Topic 830 previously permitted hedge accounting for net investments and practice in this area was well established. A net investment in a foreign operation includes incorporated and unincorporated business structures such as subsidiaries, divisions, branches, VIE s, and investments accounted for by the equity method. 49

50 Net Investment Hedge Effectiveness Testing Effectiveness and ineffectiveness should be measured based on the beginning g balance of the net investment at the beginning g of the hedging period. Offsetting amounts to be included in the CTA for the hedging instrument and the translation of the net investment may not equal. An entity may designate a foreign currency derivative with a notional of 1,000,000 Euro as a hedge of its net investment t in a European subsidiary with an equal balance of 1,000,000 Euro. The effectiveness and ineffectiveness assessments will be based on the same notional even if the net investment t falls below 1,000,000 Euro during the 3 month period. 50

51 Net Investment Hedge DIG Issue No. H8, "Measuring the Amount of Ineffectiveness in a Net Investment Hedge, addresses how ineffectiveness that must be recognized in earnings shall be measured May be forward or spot rates Forward Rates: If the notional amount of the derivative designated d as a hedge equals the portion of the net investment designated as being hedged, generally all changes in fair value of the derivative should be reported in CTA. In that case, no hedge ineffectiveness would be recognized in earnings. 51

52 SEC Letter May 11, 2012 Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Act) establishes a new framework for regulatory and supervisory oversight of the over-the- counter (OTC) derivatives market. This could result in the novation of contracts underlying certain designated hedge transactions, which would effect a change in the counterparties to the contract. The SEC would not object to a conclusion that the original derivative contract has not been terminated in certain circumstances in which a novation of a bilateral OTC derivative contract to a central counterparty "on the same financial i terms" is executed. 52

53 Valuation Issues 53

54 Valuation Topic 820, provides a fair value hierarchy under which among other items, derivatives, must be measured and disclosed. Given that interest rate swaps and caps into generally will not be valued by obtaining market quotes, the fair values must be estimated via cash flow and option pricing models. Typically, your client s banker will provide a statement of the fair value of these instruments, however, if considered material in relation to the financial statements, as auditors, we will need to audit that t value and it is rare that t the banker will provide us access to their pricing models as they are deemed to be proprietary. 54

55 Valuation Interest Rate Swaps Interest rate swaps are valued by taking the net present value of the estimated cash flows over the life of the swap. Given that the fixed rate payments are known, the variable rate payments must be estimated. The future variable rate payments can be estimated by extracting the forward rates for the variable rate and using these as our estimates of the variable rate that will be in effect at settlement. By definition, a forward interest rate is the interest rate for a future period of time that is implied by the interest rates prevailing in the market today. 55

56 Valuation Forward Rates Forward Rates Example Forward rates are derived from the current rates in the market for example: 3 month LIBOR = 2% 6 month LIBOR = 4% The implied 3 month LIBOR rate from the 4 th 6 th month is 6%. This is because if an investor can invest $1,000 for 3 2% and can invest for 6 4% then the sum of the three month periods must tbe equivalent tto the 6 month return of f4% 4%. Therefore: the investor earns $20 for the 6 months at 4%, and earns $5 for the 3 months at 2%, then he must earn $15 for the second three months which is equivalent to a rate of 6%. This is the logic being forward rates and how they are determined from the yield curve for the underlying base rate 56

57 Valuation Interest Rate Swaps Example Swap Rate: 2.60% Annualized Period Present 3 Month LIBOR 3 Month LIBOR Payer Receiver Value of Total Period Notional Forward Forward Fixed Floating Net Discount Net Date Days Days Principal Rate Rate Cash Flow Cash Flow Cash Flow Factor Cash Flow 12/31/2008 $10,000,000 3/31/ $10,000, % % ($64,110) $50,000 ($14,109.59) ($14,039) 6/30/ $10,000, % % ($64,822) $56,250 ($8,571.92) ($8,482) 9/30/ $10,000, % % ($65,534) $62,500 ($3,034.25) ($2,984) 12/31/ $10,000, % % ($65,534) $68,750 $3, $3,141 ($22,364) Therefore, based upon the following swap terms: Notional Amount: $10,000,000 Swap Rate: 2.60% Fixed Rate Payer: XYZ Company & Floating Rate Receiver Floating Rate Payer: ABC Bank & Fixed Rate Receiver Settlement Every 3 months Floating Rate: 3 month LIBOR Maturity; 12/31/2009 The value of the interest rate swap to XYZ Bank, that is using the swap to hedge its 10,000,000 variable rate debt is ($22,364) Which would be recorded as follows as of 12/31/08: AOCI $22,364 ST Derivative Liability ($22,364) 57

58 Valuation Interest Rate Cap Given that interest rate caps are options, we must use an option pricing model to estimate the fair value thereof. The most widely used option pricing model for interest rate caps is a derivation of the Black Scholes Option Pricing model, called the Black option pricing model. 58

59 Valuation Interest Rate Caps While going through the math that is behind the valuation of an interest rate cap using the Black Model is beyond the scope of this webinar, we will touch upon the variables that must be input / estimated for the Black Model. 59

60 Valuation Interest Rate Caps flag = "caplet" for pricing European call options on interest rates X = option strike price (e.g. 2.6%) ndays = the number of days in the protection period ( = life of option) basis = the number of days used in the forward market for quoting interest rates ( e.g., 360 days or 365 days) ep = length of the exposure period (also called the reset period), measured in years (e.g., 0.5 yrs, or 2.75 yrs, etc.) z = the continously compounded zero coupon rate over the exposure period f = the forward rate over the protection (or reset period) period Vol = volatility of the forward interest rate For example, suppose we want to cap the interest rate on a 182 day loan taken out in 6 months. The six-month forward rate embedded in the yield curve today is 8% and z= f = Exposure Period Protection ti Period t=0 t= 6 t = 1 year Life of 60

61 Valuation Interest Rate Caps X ndays basis ep z f Vol Notional: $10,000,000 # of Days # of Days (Reset zero Forward Volatility Base Rate: 3monthLIBOR Option In In Fwrd Period) Rate for Rate for 3mnLIBOR Value Life of Strike Protection Market Exposure Exposure Protection Forward Caplet of Period From To Days Caplet Price Period Quotes Period (yrs) Period (yrs) Period (yrs) Rate Price Caplet 31-Dec Mar % % 60.00% 1 1-Apr Jun % % 2.25% 60.00% $3, Jul Sep % 2.60% % 250% 2.50% 60.00% 00% $9, Oct Dec % % 2.75% 60.00% $15,457 Therefore, in this example, the Company has purchased an interest rate cap for a period of 1 year, with 3 remaining settlements. The notional amount is $10,000,000 and the cap rate is $2.60%. Given the forward rate curve as of 12/31/08 (hypothetical not actual), and an estimated volatiltiy of the 3 month LIBOR of 60%, the total value of the entire interest rate cap agreement is $28,522 $28,522 61

62 Futures versus Forwards Futures contracts are traded on organized exchanges and the terms for each contract are standardized. For example, 1 futures contract of West Texas Intermediate (WTI) Light Sweet Crude has the following specifications: It is for 1,000 barrels Quoted in US Dollars and Cents Contract matures at the close of business on the 3 rd business day prior to the 25 th calendar day of the month preceding the delivery month. Contracts t are listed for all months Contracts are listed are listed for 9 years forward

63 Futures versus Forwards Futures contracts require a buyer or seller to put up an initial amount of margin as required by the exchange based on the notional dollar amount of the transaction. On a daily basis the value of the futures account is market to market with the buyer or seller potentially needing to put up additional margin if their has been losses in the account that are not covered by the current margin in the account. If this margin is not put up, the positions in the account will be liquidated to cover the margin call. Futures can be physically settled or net settled.

64 Futures versus Forwards While futures are traded on organized exchanges, forward contracts are traded in what is known as the over the counter or OTC market. The OTC market is a computer linked network of dealers who do not physically y meet. Trades in the OTC market are typically much larger than trades in the exchange traded market. A key advantage to the OTC market is that the terms of the forward contracts do not have to be specified by the exchange; that is, they can be tailored to the needs and wants of the transacting parties. The disadvantage is the credit risk involved in the transaction. With futures contracts, the margin required and the monitoring thereof ensures proper settlement. With OTC contracts there is a risk that the counterparty will not perform. This is the very reason for the requirement for margin for exchange traded futures, to ensure that traders do not walk away from their commitments.

65 Credit risk Forward Contracts Credit risk has traditionally been a feature of the OTC markets as there is always a chance that the party to the other side of the OTC trade will default. Interestingly, the OTC market has started requiring a concept called collateralization which is essentially the same as a margin agreement; positions are marked to market on a daily basis and the loser must post additional collateral.

66 FUTURES VS. FORWARDS FORWARDS Private Contract between two parties FUTURES Traded on an exchange Not standardized Very flexible Standardized Contract Rigid Settled at end of contract Settled daily (MTM) Delivery or final cash settlement Contract is usually closed prior to maturity Some credit risk Virtually no credit risk

67 Valuation Issues for Derivatives In accordance with ASC 815, those financial instruments that meet the requirements for derivative accounting, must be market to market through earnings (unless hedge accounting is utilized). Accordingly, we will know discuss some of the issues that must be considered in the determination of the value of derivatives.

68 Valuation Issues for Derivatives First, what are the most common derivative instruments that we come across in our business activities: 1) Futures contracts for commodities metals, energy, agricultural 2) Futures contracts for foreign exchange 3) Forward contracts for commodities and foreign exchange 4) Interest rate swaps 5) Forward contracts for foreign exchange 6) And of course, call and put option on all of the above

69 Valuation Issues for Derivatives As we discussed before, futures contracts are traded on organized exchanges and are therefore quite simple to value as they are considered level 1 securities for purposes of the fair value hierarchy. However, forward contracts are not traded on an organized exchange and as such, we must look to their level 1 counterparts for an indication of value. Accordingly, forward contracts with an underlying that is actively traded, are level 2 securities.

70 Valuation Issues for Derivatives Valuation issues for Forward Contracts The key to ensuring that a forward contract is properly valued is to ensure that the forward contract is read in detail and that are terms of the derivative are properly understood. Financial engineering has made the OTC market very creative in its development of derivative products. Accordingly, we must understand all of the terms, included how the derivatives are priced and settled, how they mature, requirements for collateral, etc.

71 Valuation Issues for Derivatives Valuation issues for Forward Contracts After thoroughly examining the contract, we must identify the underlying to the forward contract t which h will most likely l be actively traded in the futures market. Upon identifying the underlying, we must then identifying the price that is most applicable to the forward contract and the settlement date (s) therefore.

72 Valuation Issues for Derivatives Once we have the estimated cash flows for the forward contract, we must then assess the credit risk of the applicable counterparties and calculate the credit risk adjusted discount rate such that we can properly discount the estimated future settlements to arrive at the estimated fair value of the derivative as of the reporting date.

73 Valuation Issues for Derivatives An example of this is as follows: A company has entered into a forward contract with ABC bank to sell 1,000,000 pounds of copper at $3.50 on September 30, Given that copper is an actively traded commodity, we can look to the futures market as of June 30, 2012, the valuation date, to observe the price of the underlying for which the September 2012 copper futures contract closed at $3.40 on 6/30/12. Therefore, the undiscounted value of this contract is $100,000. However, as this cash flow is to occur in 3 months, the Company must discount this amount at the credit risk adjusted rate of the counterparty which is estimated at 4%. Accordingly, the estimated fair value of the contract as of June 30, 2012 is $99,024. Therefore, the estimated fair value of this level 2 derivative is $99,024 as of June 30, 2012.

74 Valuation Issues for Derivatives The most common derivative the we come across is that of the interest rate swap. Furthermore, most of these interest rate swaps have an underlying that is either the 1 or 3 month LIBOR. Given the interest rate environment over the past 4-5 years, the fixed rate payer, variable rate receiver interest rate swaps have resulted in, at times, large losses, and therefore liabilities on the balance sheets of the fixed rate payers. However, in the valuation of these interest rate swaps, companies often miss the requisite counterparty valuation adjustment (or CVA), which is an adjustment to the discount rate being utilized for the credit risk of the fixed rate payer. This adjustment has the effect of reducing the liability being reported by the fixed rate payer, and, as such, is often viewed as counter intuitive. However, the adjustment is required, as it is representative of what a willing buyer would pay for the future cash flows represented by the interest rate swap and the credit risk of the fixed rate payer must be taken into account in this valuation.

75 Valuation Issues for Derivatives It should be noted that upon entering into an interest rate swap, or any at market priced derivative, the value of the derivative at that date should be $0.

76 Valuation Issues for Derivatives Down Round Protection: We often see Companies that have issued securities with down round protection; that is, if the Company issues another security in the future at a price that is lower than the security that was formerly issued, then that price is reduced to the new lower price. If these securities that have down round protection are classified as derivatives (re bifurcated call options on convertible debt, standalone warrants, etc ); the down round protection feature is not properly valued using a standalone Black Scholes option pricing model. In fact, the SEC does not allow the standalone Black Scholes option pricing model to value these derivatives, but requires a binomial or lattice based model to value the derivatives.

77 Valuation Issues for Derivatives Down Round Protection: The reason that the Black Scholes Model does not yield a proper value for options with down round protection ti is due to the fact that the BSM is a closed ended model; that is, it does not take into account the probability of a down round financing, and therefore a reduced exercise price. The volatility factor in the model works on the changes in the stock price, NOT the exercise price of the option. 77

78 Valuation Issues for Derivatives Down Round Protection: While the preferred method of valuing optionality with down round protection ti is through h the use of a lattice based or simulation model, we have seen instances of valuations where a probability weighted Black Scholes Model Matrix is utilized, wherein a probability is assigned to the down round and the related price at which the round occurs. The resulting value is a probability weighted Black Scholes Model. 78

79 Valuation Issues for Derivatives Down Round Protection: That said, as auditors and financial professionals, we recommend the use of a qualified valuation specialist when valuing financial instruments with down round protection. 79

80 Speaker Biography Michael Loritz, CPA Shareholder, Mayer Hoffman McCann P.C Mike has 15 years of public accounting experience with financial and service based companies, including the engineering and construction industry. He is a member of the MHM's Professional Standards Group, providing accounting knowledge leadership in the areas of derivative financial instruments, share-based compensation, fair value, leasing, revenue recognition and others. Mike's experience includes over 14 years with a Big Four firm where he was responsible for client service for large and small SEC filers and non-public entities, audit/accounting technical expertise and training instruction and delivery.

81 Speaker Biography Tim Woods, CPA Shareholder, Mayer Hoffman McCann P.C A member of MHM s Professional Standards Group, Tim is a subject matter expert for derivatives and hedge accounting. He also has extensive experience in leasing transactions, fair value, stock-based compensation and complex debt & equity transactions. Tim's experience includes five years at a Big Four firm and five years as a Controller and CFO for companies in the financial services industry.

82 Questions?