Accounting for Derivative Financial Instruments and Hedging
Activities
Bob Jensen at Trinity University
My FAS 133 and IAS 39 Glossary and Transcriptions of Experts Accounting for Derivative Instruments and Hedging Activities --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Derivative
Financial Instruments Frauds ---
http://www.trinity.edu/rjensen/fraud.htm
A
Condensed Multimedia Overview With Video and Audio from Experts --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm
This file has video and audio clips of experts!
A
Longer and More Boring Introduction to FAS 133, FAS 138, and IAS 39 --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133intro.htm
This file has audio clips of experts!
My introduction to FAS 138 (Amendments to FAS 133) and some key DIG issues at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm
I have a draft paper entitled "The Theory of Interest Rate Swap Overhedging"
at http://www.trinity.edu/rjensen/315wp/315wp.htm
This is a very rough start on developing this
theory. I would appreciate any feedback you can give on this paper.
My SFAS 133 and IAS 39 Glossary and Transcriptions of Experts
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
When I first began reading a novel about derivatives, two paragraphs in the Preface really caught my attention. They seem to apply more so today in the aftermath of Enron's trading disasters. Those paragraphs written in 1997 read as follows::
Derivatives have become the largest market in the world. The size of the derivatives market, estimated at $55 trillion in 1996, is double the value of all U.S. stocks and more than ten times the entire U.S. national debt. Meanwhile, derivative losses continue to multiply.
Of course, plenty of firms made money on derivatives, including Morgan Stanley, and the firm's derivatives group is thriving, even as derivatives purchases lick their wounds. Some clients tired of having their faces ripped off or being blown up, and business declined briefly in 1995 and 1996. Many of us quit during this period, some leaving for less brutish firms.
(Continued on Page 15)
Frank Partnoy in FIASCO: The Inside Story of a Wall Street Trader (New York: Penguin Putnam, 1997, ISBN 0 14 02 7879 6)
We have been following the transition of public accountants from the most trusted profession in the United States to one of the least trusted. It is interesting how this transition is taking place amidst a somewhat similar transition in investment banking and securities trading in general. The following quotation from the above Preface may really open your eyes:
From 1993 to 1995, I (Frank Parnoy) sold derivatives on Wall Street. During that time, the seventy or so people I worked with in the derivatives group at Morgan Stanley in New York, London, and Tokyo generated total fees of about $1 billion --- an average of almost $15 million a person. We were arguably the most profitable group of people in the world.
My group was the biggest moneymaker at the firm by far. Morgan Stanley is the oldest and most prestigious of the top investment banks, and the derivatives group was the engine that drove Morgan Stanley. The $1 billion we made was enough to pay the salaries of most of the firm's ten thousand worldwide employees, with plenty left for us. The managers in my group received millions and millions in bonuses; even our lowest level employees had six-figure incomes. An many of us, including me, were still in our twenties.
How did we make so much money? In part, it was because we were smart. I worked with the greatest minds in the derivatives business. We mastered the complexities of modern finance, and it is no coincidence that we were called "rocket scientists." (Page 15)
This is the part that indirectly relates to the changing business model of public accountants.
This was not the Morgan Stanley of yore. In the 1920s, the white-shoe (in auditing that would be black-shoe) investment bank developed a reputation for gentility and was renowned for fresh flowers and fine furniture (recall that Arthur Andersen offices featured those magnificent wooden doors), an elegant partners' dining room, and conservative business practices. The firm's credo was "First class business in a first class way."
However, during the banking heyday of the 1980s, the firm faced intense competition from other banks and slipped from its number one spot. In response, Morgan Stanley's partners shifted their focus from prestige to profits --- and thereby transformed the firm. (Emphasis added) Morgan Stanley had swapped its fine heritage for slick sales-and-trading operation --- and made a lot more money.
Other banks --- including First Boston, where I worked before I joined Morgan Stanley --- could not match Morgan Stanley's aggressive sales tactics. By every measure, the firm had been recast. The flowers were gone. The furniture was Formica. Busy managers ingested lunch, if at all, at a crowded donut stand jammed between two hallways along the trading floor. Aggressive business practices inspired a new credo: "First class business in a second class way." After decades of politesse, there were savages at Morgan Stanley."
(Continued on Page 14 of the book cited above).
Added notes from Bob Jensen
I was sitting in Times Square (where I was Program Director for the 1994 American Accounting Association Annual Meetings in the Marriott Marquis Hotel) and captured an address by the Chairman of the Financial Accounting Standards Board (Denny Beresford) quoting that until 1993 he thought derivatives were "something a person his age took when prunes did not quite do the job." You can hear my MP3 recording of Denny's remarks (along with related and free audio and video clips) at http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm#Introduction
Bob Jensen's overviews of accounting for derivative financial instruments, including cases and case solutions, can be found at the following two links:
Bob Jensen's threads on derivatives frauds can be found at http://www.trinity.edu/rjensen/fraud.htm#DerivativesFraud
How the professions of financial analysis and investment banking became rotten to the core is elaborated upon at http://www.trinity.edu/rjensen/fraud.htm#Cleland
Bob Jensen's spreadsheets on my KPMG workshop cases. Open the 0000KPMG folder at http://www.cs.trinity.edu/~rjensen/
New and Revised Already!
FAS 133 Hedge Accounting Ineffectiveness Testing Short Cases --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/000ineff.htm
The above document was specially prepared for my Year 2000 KPMG Workshops that I
am conducting with Ira Kawaller in Chicago October 12-13, New York City November
2-3, and Las Vegas November 30-December 1. Persons interested in attending
these workshops may contact Lysle Hollenbeck at [lhollenbeck@kpmg.com]
If you previously downloaded the Excel workbook copy of my three "short" cases on testing for hedge ineffectiveness using futures (Case B7), Forwards (Case A7), and foreign currency forward contracts (Case A1), please download a fresh copy from by downloading the Excel Workbook 133ex07a.xls file. This file has been temporarily removed so that my students may temporarily not access the answers. If you are not one of my students, you may contact me for a the solution file at rjensen@trinity.edu .
There may be other corrections and additions after the rest of you give me feedback. One reason I really love the Internet is that people using my cases point out their flaws and shortcomings. Robert Steeindt pointed out that in my Case A1 the spot and forward prices did not converge at maturity for Nation 2 foreign currency. I fixed this. There was also confusion over the DELTA(t) definitions. I added commentaries and made some corrections.
Case B7 features a a hedge effectiveness test based upon DELTA(t) defined as the absolute value of the change in futures prices divided by the change in spot prices of corn.
Case A7 features a a hedge effectiveness test based upon DELTA(t) defined as the absolute value of the change in forward prices of Columbian coffee divided by the change in forward prices of Brazilian coffee.
Case A1 features a a hedge effectiveness test based upon DELTA(t) defined as the absolute value of the change spot prices of Nation 2 currency divided by the change spot prices of Nation 1 currency. Since spot prices are used, Paragraph 63(c ) is invoked where effectiveness testing excludes the difference between forward and spot prices.
Case A1 also adds a test for hedge ineffectiveness materiality. Hedge accounting in Case A1 is denied only when the hedge ineffectiveness is material in dollar amount as well as violates the 0.80-1.25 Rule for DELTA(t).
Note in particular that I have some relatively short (relatively short in terms of the cases listed below) that expand upon FAS 133 Appendix A Problem 7 versus Appendix B Problem 7. You can proceed directly to those short cases by downloading the Excel Workbook 133ex07a.xls file at http://www.cs.trinity.edu/~rjensen/ This file has been temporarily removed so that my students may temporarily not access the answers. If you are not one of my students, you may contact me for a the solution file at rjensen@trinity.edu .
In that same workbook, I extended a KPMG example on foreign currency hedging of an equipment purchase. Whereas KPMG assumed perfect hedge effectiveness, I added examples of both immaterial and material hedge ineffectiveness. Go to my 133ex07a.xls file at http://www.cs.trinity.edu/~rjensen/
I have also improved by Excel Workbook expansions of Appendix B Examples 9 and 10. These are in files 133ex09.xls and 133ex10.xls files that can be downloaded from http://www.cs.trinity.edu/~rjensen/
New!
Warning: If you downloaded the following case and/or its accompanying Excel Workbook prior to August 22, please discard those files and download the updated files. Both the case and the Excel Workbook contained some serious errors that (hopefully) have been corrected.
I am sharing my latest working draft of a case entitled FAS 138 Benchmark Interest Value-Locked Debt Accounting Case. This is accompanied by a rather complicated Excel workbook. The link to everything is now available at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138bench.htm. However, the way I keep revising both the case and the worksheet, it is probably best to wait until I make an announcement that I am at last happy with my work (that I mistakenly posted before it made sense.)
One feature of the case is a focus on accounting for hedge ineffectiveness. In addition to the familiar 0.80-1.25 DELTA(t) Rule, I introduce a parameter for hedge amount ineffectiveness. Testing for ineffectiveness significance only on the 0.80-1.25 rule ignores hedge materiality. I propose a joint test for materiality and significance. If C(t) depicts the carrying value of the debt, A(t) depicts the current discount/premium amortization, and I(t) depicts the present value of the the index rate present values as specified in FAS 138, most firms want economic hedges to qualify for FAS 138 hedge accounting in order to adjust carrying value of the debt by [I(t)-I(t-1)] to offset the booking of changes in hedge (e.g., swap) values required under FAS 133. Suppose -V(0) proceeds are received when the debt is issued for a market rate liability of V(0).
With No Qualifying Hedge or a Hedge that Combines Ineffectiveness Materiality and Significance in Terms of the 0.80-1.25 Rule for DELTA(t).
C(t)= C(t-1)+A(t)
= V(0)-[V(0)+SA(t) to date]
With A Qualifying Hedge or a Hedge that Combines Ineffectiveness Immateriality and Insignificance in Terms of the 0.80-1.25 Rule for DELTA(t).
C(t)= C(t-1)+A(t)+[I(t)-I(t-1)]
= V(0)-[V(0)+SA(t) to date]+[I(t)-I(t-1)]
A long last I think I have my Excel Workbook hedge ineffectiveness Materiality and Significance tests working in the Excel Workbook accompanying my originally error-bound case at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138bench.htm.
One question never addressed by standard setters is what do do about hedge ineffectiveness that is material in amount but also has a DELTA(t) ratio falling within the 0.80-1.25 Rule bounds. In my case, I do not deny hedge accounting in those outcomes, although the reason has me staring at the wall and wondering why.
I apologize for my confusions passed along to students and faculty in early versions of this case that were released before being fixed up. In addition I apologize that even without the Excel Workbook, the case is over 70 pages long. That also makes me stare at the wall and wonder why.
I am sharing the first draft of Working Paper 288 entitled Overhedging Foreign Currencies With a Swap: The FAS 133 Controversy. At this point the HTML version is merely a pasting of one spreadsheet from the 288wp.xls Excel workbook. I suggest that interested readers download the Excel workbook. You can obtain download information from http://www.cs.trinity.edu/~rjensen/288wp.htm
I would really appreciate feedback on this case. I went out on a limb and need more assurance that I am on the right track in this controversy.
I am sharing the first draft of Working Paper 287 entitled Underhedging Foreign Currencies With a Swap: The FAS 133 Controversy. At this point the HTML version is merely a pasting of one spreadsheet from the 288wp.xls Excel workbook. I suggest that interested readers download the Excel workbook. You can obtain download information from http://www.cs.trinity.edu/~rjensen/287wp.htm
I would really appreciate feedback on this case. I went out on a limb and need more assurance that I am on the right track in this controversy.
It is probably best to begin with Examples 1-10 in Appendix B of FAS 133. Then I would like them to read the following two documents about Examples 2 and 5:
http://www.trinity.edu/rjensen/caseans/294wp.doc
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex02a.xls
http://www.trinity.edu/rjensen/caseans/133ex05.htm
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex05a.xls
This above files have been temporarily removed so that my students may temporarily not access the answers. If you are not one of my students, you may contact me for a the solution files at rjensen@trinity.edu .
The links to five cases on hedging strategies and accounting under new rules for accounting for derivative financial instruments and hedging activities are as follows:
MarginWHEW Bank Case (interest rate profit hedging with 30 Eurodollar
futures contracts)
http://www.trinity.edu/rjensen/caseans/285case.htm
The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/285wp/285wp.xls
Margin OOPS Bank Case (interest rate profit hedging with 75 Eurodollar futures
contracts)
http://www.trinity.edu/rjensen/caseans/285case.htm
You can access the MarginOOPS Bank Case with buttons at the bottom of the screen.
The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/286wp/286wp.xls
CapIT Corporation Case (interest rate caps with Eurodollar interest rate
put options taken from the Wall Street Journal)
http://www.trinity.edu/rjensen/caseans/ccase.htm
The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/283wp/283wp.xls
FloorIT Bank Case (interest rate floors with Eurodollar interest rate call
options taken from the Wall Street Journal)
http://www.trinity.edu/rjensen/caseans/ccase.htm
You can access the FloorIT Bank Case with buttons at the bottom of the
screen.
The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/284wp/284wp.xls
Mexcobre Case (a complex international hedging case involving a copper price
swap)
http://www.trinity.edu/rjensen/caseans/133sp.htm
The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/mexcobre/133spans.xls
Big Wheels Cross-Currency Swap Case, Student Project by Rachel Grant,
Accounting 5341, Trinity University, Spring 2000
http://www.trinity.edu/rjensen/acct5341/projects/sp2000/grant/StartPage.htm
The Hubbard and Jensen paper on Example 5 of FAS 133 (that points out some errors in the Example 5) can be downloaded as follows:
http://www.trinity.edu/rjensen/caseans/133ex05.htm
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex05a.xls
The Hubbard and Jensen explanation of Example 2 of FAS 133 can be downloaded as follows:
http://www.trinity.edu/rjensen/caseans/294wp.doc
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex02a.xls
Readers may want to download one or more of my Excel files linked at http://www.cs.trinity.edu/~rjensen/13300tut.htm
Some solution files have been temporarily removed so that my students may temporarily not access the answers. In particular, my Excel spreadsheets for FAS 133 Appendix B Examples 1-10 have temporarily been removed. If you are not one of my students, you may contact me for a the solution files at rjensen@trinity.edu .
I wrote a document (screen play? short story? tutorial? case?) that is a takeoff on the Muppets. It is entitled "Clyde Gives Brother Hat a Lesson in Arbitrage" and can be found at http://www.trinity.edu/rjensen/acct5341/speakers/muppets.htm
Readers may also want to download the excellent FAS 133 cases by Teets and Uhl at http://www.gonzaga.edu/faculty/teets/index0.html
A listing of various solution files can be found at http://www.cs.trinity.edu/~rjensen/
These include my spreadsheet extensions of the FAS 133 examples. For
example, file names for some of these examples are as follows:
Excel Spreadsheet Example | File Name |
FAS 133 Example 01 | 133ex0a1.xls |
FAS 133 Example 02 | 133ex02a.xls |
FAS 133 Example 03 | 133ex03a.xls |
FAS 133 Example 04 | 133ex04a.xls |
FAS 133 Example 05 | 133ex0a5.xls |
FAS 133 Example 06 | 133ex06a.xls |
FAS 133 Example 07 | 133ex07a.xls |
FAS 133 Example 08 | 133ex08a.xls |
FAS 133 Example 09 | 133ex09a.xls |
FAS 133 Example 10 | 133ex10a.xls |
Others are available |
Instructions are given at http://www.cs.trinity.edu/~rjensen/13300tut.htm
Some solution files have been temporarily removed so that my students may temporarily not access the answers. In particular, my Excel spreadsheets for FAS 133 Appendix B Examples 1-10 have temporarily been removed. If you are not one of my students, you may contact me for a the solution files at rjensen@trinity.edu .
My course syllabus, helpers, and assignments --- http://www.trinity.edu/rjensen/acct5341/index.htm
Recommended Tutorials on Derivative Financial Instruments (but not about FAS 133 or IAS 39)
You might start at http://www.finpipe.com/derivatives.htm.
Then you can try Financial
Derivatives in Plain English --- http://www.iol.ie/~aibtreas/derivs-pe/
For details on products and how they work in practice, I like the following tutorial/education websites:
CBOE --- http://www.cboe.com/education/
CBOT --- http://www.cbot.com/ourproducts/index.html
CME --- http://www.cme.com/educational/index.html
Recommended Tutorials on FAS 133
One of the best documents the FASB generated for FAS 133
implementation is called "summary of Derivative Types." This
document also explains how to value certain types. It can be
downloaded free from at http://www.rutgers.edu/Accounting/raw/fasb/derivsum.exe
The Appendix B examples in FAS 133. You can also
download Excel worksheet tutorials on the first 10 examples in files
133ex01a.xls through 133ex10.xls at http://www.cs.trinity.edu/~rjensen/
Instructions are given at http://www.cs.trinity.edu/~rjensen/13300tut.htm
Bob Jensen's cases indexed at http://www.trinity.edu/rjensen/caseans/000index.htm
The FASB's CD-ROM Self-Study CPE Training Course and
Research Tool http://www.rutgers.edu/Accounting/raw/fasb/CDROM133.html
The FASB provides some
new examples illustrating the FAS 138 Amendments to FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html
Implementation Guidelines on IAS 39 --- http://www.iasc.org.uk/frame/cen2_139.htm
The excellent tutorials entitled Introductory Cases on
Accounting for Derivative Instruments and Hedging Activities by Walter
R. Teets and Robert Uhl available free from http://www.gonzaga.edu/faculty/teets/index0.html.
Recommended Glossaries
Bob Jensen's FAS 133 Glossary on Derivative Financial Instruments and Hedging Activities
Also see comprehensive risk and trading glossaries such as the ones listed below that provide broader coverage of derivatives instruments terminology but almost nothing in terms of FAS 133, FAS 138, and IAS39: