• Impact of hedge effectiveness
• Effectiveness concepts
• Hedgeable risks
• Factors that may cause ineffectiveness
• Effectiveness assessment
• Measurement and valuation considerations
• Other issues and considerations

• Earnings
• Budgeting and forecasting
• Risk management strategies
• Instruments and transactions used to manage risk
• Systems and operations

• Knowledge and skill requirements of personnel in risk management and related finance/accounting positions
• Services/support that dealers provide customers
• Financial disclosures - ineffectiveness is a required disclosure

• There must be an expectation that the derivative will be highly effective in achieving fair value or cash flow offset
• Both at inception and on an ongoing basis
• Without this expectation hedge accounting is not allowed
• Effectiveness must be assessed whenever financial statements or earnings are reported, and at least every three months

• Same meaning as "high correlation" under SFAS 80, Accounting for Futures Contracts
• Hedging instrument provides offset of 80% to 125% of the change in fair value or cash flows of the hedged item
• R-squared of .80 or higher

• For certain hedging relationships, when the critical terms of the hedging instrument and the hedged item are the same, it is not necessary to perform detailed hedge effectiveness analysis
• 100% effectiveness can be assumed
• All applicable conditions of the shortcut method must be met in order to qualify

Required Conditions

• Swap notional matches the principal of the hedged item
• Fair value of the swap at inception is zero
• Net settlement formula for the swap is the same for each settlement period
• The hedged interest bearing asset or liability is not prepayable
• No unusual terms that may cause ineffectiveness
• Conditions applicable to fair value hedges
  --  Expiration date of the swap matches the maturity date of the interest-bearing asset or liability
  --  No floor or ceiling embedded in the interest rate swap
  --  The variable interest rate of the swap reprices frequently, i.e., at least every 3 to 6 months
• Conditions applicable to cash flow hedges
  --  All interest receipts or payments on the variable-rate asset or liability, during the term of the
       swap, designated as being hedged
  --  Any cap or floor on the variable-rate asset or liability is offset by a comparable cap or floor on the
       variable rate of the swap
  --  The repricing dates of the swap match those of the variable-rate asset or liability
  --  The index on the variable rate of the swap matches the index on the variable-rate asset or liability

• Changes in overall fair value (i.e., all risks)
• Changes in market interest rates
  --  Hedging the risk-free rate or index
• Changes in foreign currency exchange rates
• Changes in the obligor's creditworthiness
  --  Hedging credit risk

Example - Fair Value Hedge

• ABC issues five-year fixed-rate debt - $100 million principal
• ABC enters into a five-year receive fixed / pay variable swap - $100 million notional
• Swap is designated as a hedge of changes in fair value due to changes in market interest rates
• Transaction does not qualify for the shortcut method
• Five year treasury note trades at 6.00%
• Debt issued at par w/coupon of 8.00% - 200bps spread to treasury
• ABC's credit sector is trading at 7.75% - 175bps spread to treasury

End of year-one

• ABC's credit rating is unchanged
• Treasury note trades at 6.75% - increase of 75 bps
• ABC's debt is trading at 8.75% - 200bps spread to treasury (no change in spread)
• ABC's credit sector is trading at 8.25% - 150bps spread to treasury (decrease of 25bps)

GENERAL LEDGER ENTRIES (000's)

[ledger entries go here]

• Cash flows of the entire hedged item (i.e., purchase or sales price)
• Changes in market interest rates
  --  Hedging the risk-free rate or index
• Changes in foreign currency exchange rates
• Changes in the obligor's creditworthiness

Example - Cash Flow Hedge

Beginning of year-one

• ABC intends to issue $100 million of five-year fixed rate debt at the beginning of year-two
• ABC enters into a forward starting pay fixed / receive 3-month LIBOR interest rate swap
• Swap is designated as a hedge of the market interest rate risk associated with the forecasted issuance of debt
• Swap starts at the beginning of year-two, has a five-year term and $100 million notional
• ABC's debt currently trades at a 100bps spread to treasury
• ABC's credit sector is currently trading at a 75bps spread to treasury
• One year forward rate for five-year treasury notes is 6.00%
• 3 month LIBOR is at 5.00%

Beginning of year-two

• ABC's credit rating is unchanged
• Five-year treasury note trades at 7.00%
• 3-month LIBOR is at 6.00%
• ABC issues debt with a 7.00% coupon to yield 8.00%
• ABC's credit sector is trading at 7.60% - 60bps spread to treasury (decrease of 15bps)

GENERAL LEDGER ENTRIES (000's)

[ledger entries go here]

• Unrecognized firm commitment
• Changes in cash flow of a forecasted foreign currency transaction
• Net investment in a foreign operation

• A risk cannot be hedged more than once
• A subcomponent of a defined risk cannot be designated as the hedged item, for example:
  -- Prepayment risk is not a hedgeable risk unless it is in the form of an embedded option, i.e., call
      option embedded in debt
  --  Interest rate index

• Principal/notional amounts
• Term/maturity
• Rate basis
• Rate reset dates
  Cash receipt/payment dates
• Prepayment terms
• Cross hedge
• Delivery location
• Embedded option
• Change in credit sector spread

• Method must be defined at the time of designation
• SFAS 133 does not require or specify methods of assessment
• Similar hedging strategies should use similar methods of assessing effectiveness

• Period-to-period offset
• Cumulative offset
• Rolling time period correlation
• DIG Issue F5, Basing the Expectation of Highly Effective Offset on a Shorter Period Than the Life of the Derivative

• $100,000 of fixed rate debt
• Five-year receive fixed / pay variable swap - $100,000 notional
• Transaction does not qualify for the shortcut method

• $100,000 of fixed rate debt
• Five-year receive fixed / pay variable swap - $100,000 notional
• Transaction does not qualify for the shortcut method

• Fair value hedge
  --  The difference between the change in fair value of the hedged item and the hedging instrument
       is always recognized in earnings
• Cash flow hedge
  --  Ineffectiveness is recognized only when the cumulative gain or loss on the derivative hedging
       instrument exceeds the cumulative change in the expected future cash flows on the hedged
       forecasted transaction
  --  Cumulative test - SFAS 133, ¶30 and ¶140

• Under SFAS 133 time value may be excluded from the assessment of effectiveness for transactions where only the intrinsic value provides offset
• Changes in time value, when excluded from the effectiveness assessment, are recognized through earnings

• Fair value hedge
  --  Discontinue recognizing changes in fair value of the hedged item
  --  Begin amortization of the basis adjustment
  --  Continue recognizing changes in fair value of the hedging instrument through earnings
  --  Hedge of a firm commitment
• Cash flow hedge
  --  The net gain or loss included in other comprehensive income (OCI) will remain in OCI and
       be recognized as the hedged forecasted transaction impacts earnings
  --  If the forecasted transaction is no longer expected to occur, then the amount reported in
       OCI must be recognized in current earnings
• Whenever hedge accounting is discontinued, future changes in the fair value of the derivative that was designated as the hedging instrument are recognized in earnings

• Hypothetical derivative
• Forward vs. spot rates
  --  Either may be used to assess effectiveness
  --  Derivative fair value based on forward rates
• Proportion (applies to derivative) vs. portion (applies to hedged item)
• Special rules for written options
• Combination of derivatives

• Portfolio hedging - fair value
  --  Hedged items must share the same risk exposure for which they are hedged
  --  Hedged items must respond proportionately to the change in fair value of the total portfolio
  --  Criteria are difficult to meet for financial instruments
• Portfolio hedging - cash flow
  --  Forecasted transactions included in the portfolio must share the same risk exposure for which
       they are hedged
• Partial term hedging
  --  Allowable under SFAS 133
  --  Unlikely to achieve the desired economic effect for fair value hedges

• Why doesn't a swap qualify as an effective hedging instrument in a partial term fair value hedge?
  
  Example
  --  ABC issues $100,000 of five-year fixed rate debt - 10.00% coupon
  --  ABC enters into a three-year receive fixed / pay 3-mo LIBOR swap
  --  At the end of year-one interest rates increase 200bps

• Prepayment option
• Delta-neutral hedging
  --  Allowable under SFAS 133
• Hedge of one derivative with another
  --  Precluded under SFAS 133