Accounting for Derivative Financial Instruments and Hedging Activities
Bob Jensen’s home page is at http://www.trinity.edu/rjensen/
Robert (Bob) Jensen
Emeritus Accounting Professor From Trinity University
190 Sunset Hill Road
Sugar Hill, NH 03586
Phone: 603-823-8482
email:
rjensen@trinity.edu
Derivative Financial Instrument Frauds ---
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Off line ---
Click Here
Bob Jensen’s FAS 133-IAS 39 Tutorials ---
http://www.trinity.edu/rjensen/caseans/000index.htm
Off line ---
Click
Here
Bob Jensen’s Free CD ---
http://www.cs.trinity.edu/~rjensen/Calgary/CD/
Off line ---
CD B#CDbookmarkookmark
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
Off line ---
Click Here
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!
Off line ---
133summ.htm
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!
Off line ---
133intro.htm
Video Tutorials on Accounting for Derivative Financial Instruments and
Hedging Activities per FAS 133 in the U.S. and IAS 39 internationally ---
http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/
Off line --- 133summ.htm
Flow Chart for FAS 133
and IAS 39 Accounting ---
http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Off line ---
133flow.htm
Differences between FAS 133 and IAS 39 ---
http://www.trinity.edu/rjensen/caseans/canada.htm
Off line ---
Canada.htm
Intrinsic Value Versus Full Value Hedge Accounting ---
http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm
Off line ---
IntrinsicValue.htm
Derivative Financial Instruments Frauds ---
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Off line ---
133summ.htm
FAS 133 Trips Up Fannie Mae
Off line ---
000index.htm
Hedging Paradox:
In finance, there is no way to cover your Fannie without exposing your
Fannie somewhere else.
Gypsy Rose Lee would've said her fan (hedge) can only cover one Fannie cheek at
a time.
Off line ---
000index.htm
Freddie Mac Paves the Way With Risk Stress Tests and Then Fails on Macro Hedge
Accounting
Yield Burning Frauds
Off line ---
000index.htm
Introduction to FAS 138 (Amendments to FAS 133) and some key DIG issues at
http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm
Off line ---
138intro.htm
Canadian Workshop Topics ---
http://www.trinity.edu/rjensen/caseans/000indexLinks.htm
Off line ---
000indexLinks.htm
Tutorials and Helpers ---
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Tutorials
Off line ---
133glosf.htm#Tutorials
”Testing and Accounting for Hedge Ineffectiveness Under FAS 133, by Angela L.J. Huang and Robert E. Jensen, Derivatives Report, February 2003, pp. 1-10. http://www.riahome.com/estore/detail.asp?ID=TDVN
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.
Off line ---
315wp.htm
This is a Good Summary of Various Forms of Business Risk --- http://www.erisk.com/portal/Resources/resources_archive.asp
1. Enterprise Risk Management
2. Credit Risk
3. Market Risk
4. Operational Risk
5. Business Risk
6. Other Types of Risk?
Video Tutorials on Accounting for Derivative Financial Instruments and
Hedging Activities per FAS 133 in the U.S. and IAS 39 internationally ---
http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/
My SFAS 133 and IAS 39 Glossary and Transcriptions of Experts
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Off line ---
Click Here
Some Other Helpers for Accountants and Accounting Educators
Helpers for Accounting Educators ---
http://www.trinity.edu/rjensen/default3.htm
Off line ---
default3.htm
Accounting Theory ---
http://www.trinity.edu/rjensen/theory.htm
Off line ---
theory.htm
XBRL and XML ---
http://www.trinity.edu/rjensen/XBRLandOLAP.htm
Off line ---
XBRLandOLAP.htm
Electronic Commerce ---
http://www.trinity.edu/rjensen/ecommerce.htm
The name of the game is derivatives!
Will your
bonus for last year come anywhere close to $9 million?
Global commercial banks are expected to award bumper bonuses in the next three
months, following a pattern set by the US investment banks in December. Forex
dealers anticipate year-on-year increases of up to 50% in their annual packages,
on the back of a highly lucrative year in foreign exchange as major and emerging
markets currencies went haywire. An unusually active fourth quarter in
particular boosted many traders' profit and loss accounts as they wound down for
year-end, sending up bonus expectations accordingly. Goldman Sachs, Merrill
Lynch, Morgan Stanley and Lehman Brothers were among the banks that announced
their bonus payouts in December. Peers at rival banks reported that forex
dealers at Morgan Stanley saw average year-on-year rises of 20%, while the very
top staff in foreign exchange and derivatives may have seen as much as $9
million each. "This type of figure is not inconceivable at the top three or four
banks," said one head of foreign exchange at a US bank in New York.
RiskNews Weekly on January 9, 2004
An Illustration of FAS 133 Implementation and Hedging Complexities
The bookkeeping error in which Fannie Mae failed to book $1.1 billion in derivative financial statements was reported as a computer error when implementing a new FAS 149 set of amendments to FAS 133 at Fannie Mae. The explanation is plausible, the importance of this error were probably overblown by the media.
However, Fannie May's otherwise impeccable attempts to implement FAS 133 and its amendments illustrate what a complicated mess we are in today when implementing FAS 133 issued by the Financial Accounting Standards Board (FASB). The same can be said about its IAS 39 counterpart issued by the International Accounting Standards Board (IASB). These two standards and their various amendments are widely criticized and have tended to create more confusion than help among investors, analysts, accountants, banks, and other corporations.
A large part of the confusion that exists centers around the public perception of hedging. Hedging suggests elimination of risks that are hedged. In fact, however, hedging is merely a transfer from one type of risk to another type of risk. Before getting into this, however, let's review the Fannie Mae example of a really solid effort to implement FAS 133 and its amendments.
What is Fannie Mae? --- Federal National Mortgage Association --- http://www.primecoastmortgage.com/Fannie_Mae.htm
The role of Fannie Mae and the
secondary mortgage market in housing finance
Fannie Mae plays a vital role in financing mortgages and increasing
homeownership opportunities for more Americans. A privatization success story,
Fannie Mae began in 1938 as an agency of the federal government, created to
bring stability to the U.S. housing market. In 1968, Fannie Mae became a
privately-owned and - managed corporation. At that time, the U.S. Congress
rechartered Fannie Mae as a private company, mandating that it operate with
private capital on a self-sustaining basis to enhance the flow of funds through
the secondary market to American home buyers.
Fannie Mae operates exclusively in the secondary mortgage market - providing support to mortgage lending institutions in the primary market. Lenders who originate loans in the primary mortgage market may either hold the loans in their portfolios or sell them in the secondary mortgage market. By selling their loans in the secondary market, lenders are able to obtain additional funds with which to make more loans to home buyers.
The secondary mortgage market helps accomplish the following important housing objectives:
Fannie Mae's impact on
housing needs
Fannie Mae is the nation's largest investor in home mortgages today. The
corporation has provided home financing for over 32 million American families
since its creation in 1938. Fannie Mae currently owns in its portfolio, or holds
in trust for investors, one out of every five mortgages in the United States.
In 1994, Fannie Mae announced its Trillion Dollar Commitment to provide $1 trillion by the year 2000 to finance homes for over 10 million families most in need. This targeted housing finance initiative is serving families with incomes below the median for their area, minorities and new immigrants, families who live in central cities and distressed communities, and people with special housing needs.
Through its Trillion Dollar Commitment, Fannie Mae provides renters in America the information they need to buy homes, develops specialized products and services to break down arbitrary barriers to getting home mortgages, and focuses on eliminating lending discrimination in the housing finance industry.
Fannie Mae's homepage is at http://www.fanniemae.com/index.jhtml
Fannie Mae FAQs --- http://www.fanniemae.com/faq/index.jhtml?p=FAQ
Statement from the CEO of Fannie Mae Regarding FAS 133 Reporting Prior to the October 29, 2003 Adverse News Report --- http://www.fanniemae.com/ceoanswers/derivativesaccounting.jhtml
Why do you have confidence that you have done your
derivative accounting properly?
First, Fannie Mae filed fully audited financial statements
with the SEC when we filed our Form 10 and Form 10-K on March 31, 2003. And as
part of the registration process, the SEC reviewed our financial disclosures and
critical accounting policies. As CEO of an SEC-registered company, I personally
certified that our financial statements are accurate, as did our Chief Financial
Officer, Tim Howard. Further, on May 14, 2003, Fannie Mae filed its Form 10-Q
and will file all required SEC reports going forward.
More specifically, years before the FAS 133 accounting
practices pertaining to derivatives were adopted, we worked closely with the
Financial Accounting Standards Board (FASB) to make sure we understood how the
new requirements would apply to our business. We then made substantial
investments in additional accounting staff and new systems to track our
derivatives transactions, given the unique challenges of these transactions. For
example, we need to match up each derivative transaction -- one by one -- with
the liability that we use the derivative to hedge.
Let me walk through how we account for our derivatives:
It is because of our disciplined approach to accounting that
we have experienced such large swings in our GAAP income over the past two
years. In our use of derivatives, we look to execute the most efficient hedge
for the business -- we don't approach our hedging with a specific accounting
result in mind. We fully disclose the accounting implications of our decisions,
and each quarter we report to investors both our core business earnings and our
GAAP earnings, and reconcile the two.
To date, of the 14 housing GSEs (including the 12 Federal
Home Loan Banks), Fannie Mae is the only one to have filed its fully audited --
and management certified -- financial statements with the SEC. The fully
independent Audit Committee of our Board of Directors oversees our internal
auditor, outside auditor, and our financial reporting. That gives us additional
confidence in our financial statements, and should give investors confidence
too.
Fannie Mae provides a
comparison of our GAAP results to our non-GAAP financial measures.
In May of 2003, the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133 --- http://www.fasb.org/news/nr043003.shtml
Norwalk, CT, April 30, 2003—Today the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133.
The new guidance amends Statement 133 for decisions made:
The amendments set forth in Statement 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in Statement 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. Statement 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting.
October 1, 2003 Accounting Tutorial Provided to the Public by Fannie Mae --- http://www.fanniemae.com/ir/accountingtutorial.jhtml
This virtual presentation is copyrighted material of Fannie Mae. No recording, broadcast, or other distribution of this virtual presentation, or any part of the virtual presentation, is permitted without Fannie Mae's permission. Your participation in this virtual presentation implies your consent.
October 29, 2003 Error Announcement: FAS 133/149 Trips Up Fannie Mae
Statement by Jayne Shontell Fannie Mae Senior Vice President, Investor Relations October 30, 2003 --- http://www.fanniemae.com/ir/issues/financial/103003.jhtml
As you know, yesterday Fannie Mae filed a Form 8-K/A with the SEC amending our third quarter press release to correct computational errors in that release. There were honest mistakes made in a spreadsheet used in the implementation of a new accounting standard.
As we also reported, we discovered the errors in the course of the standard review in preparation of the company's financial statements to be included in Form 10-Q for the third quarter, and were primarily made in conjunction with the implementation of FAS 149.
The bottom line is that the correction has no impact on our income statement, but resulted in increases to unrealized gains on securities, accumulated other comprehensive income, and total shareholder equity (of $1.279 billion, $1.136 billion, and $1.136 billion, respectively).
I would like to explain what happened yesterday regarding the release of the information.
We were preparing to file the Form 8-K/A as required, and to ensure the maximum disclosure, we also were preparing to issue a press release with a statement announcing the filing. We contacted the business service we use to distribute press releases to inform the service what we planned to do once the documents were finalized. Before we even sent the business service the documents to be disclosed, the service -- on its own and without our prior knowledge or authorization -- put forth a statement, attributed to Fannie Mae, "killing" our previously issued October 16 press release. Shortly thereafter, our stock began to trade down. We proceeded to file the 8-K/A and issued our statement as soon as we could.
Let me reiterate that the correction had to do with a computational error in performing complicated calculations required in the implementation of FAS 149.
FAS 149 was issued in April. It required Fannie Mae to mark to market the majority of mortgage commitments we had made, which were previously not part of our financial statements. The new requirement was effective July 1. In adopting a new accounting standard in a short period of time, Fannie Mae had to put in place a system and process to capture all open commitments and mark them to market. To implement this standard, Fannie Mae utilized information from its internal, automated systems in conjunction with spreadsheets that made additional calculations necessary under the new rule. Fannie Mae is already in the process of updating its automated systems to account for the mortgage commitments under FAS 149.
Our accounting team discovered the errors in the normal course of preparing our financial statements for inclusion in our 10-Q. They immediately notified management and our independent auditor, KPMG. Management in turn notified the Audit Committee of the Fannie Mae Board of Directors and our regulator.
We continue to be proud of our accounting processes and controls. Far from being a failure of our accounting system, this event demonstrates that our accounting processes and controls work as they should. While we would have obviously preferred the error did not occur in the October 16 press release, we are pleased that the error was corrected before we file our financial statements in our 10-Q.
October 31, 2003 Quotation from The Wall Street Journal
Fannie Mae had previously argued that it had a
far better lock on its accounting than Freddie Mac, hoping to cast itself as a
more responsible and sophisticated operation that didn't need much more
scrutiny. Fannie Mae went so far as to hold an accounting "tutorial" earlier
this month to explain derivatives accounting to investors, analysts and
reporters. Yet it was in derivatives accounting that its stumble came.
Patrick Bartta and John D Mckinnon (See below)
Note from Bob Jensen
You can read Fannie Mae's Derivatives Accounting Tutorial at
http://www.fanniemae.com/ir/pdf/tutorial10012003.pdf
"Fannie Mae Made $1.1 Billion Error In Its Accounting: Understatement of Equity Renews Calls For Oversight of Two Mortgage Giants," by Patrick Bartta and John D. McKinnon, The Wall Street Journal, October 31, 2003 --- http://online.wsj.com/article/0,,SB10674573311089700-search,00.html?collection=wsjie%2F30day&vql_string=Freddie%3Cin%3E%28article%2Dbody%29
Fannie Mae, the mortgage-financing giant already facing a crescendo of criticism about its financial oversight, said it miscalculated the value of its mortgage commitments, forcing it to make a $1.1 billion restatement of its stockholder equity.
The government-chartered company, which bills itself as the world's largest nonbank financial institution, released a revised third-quarter financial statement Wednesday correcting what it called "computational errors" that appeared when the results were first reported earlier this month. The restated figures were higher and didn't alter the company's profit, which was $2.67 billion in the third quarter, up 168% from a year earlier.
But the episode instantly reinforced fears that Fannie Mae and its smaller sibling Freddie Mac lack the necessary skills to operate their massive and complex businesses, which some investors, rivals and political critics worry could pose risk to the nation's financial system if not properly managed. Though the companies are not formally backed by a government guarantee, investors generally assume the government would step in to bail the companies out in an emergency, given their critical importance to the housing and broader financial markets.
Spreads between most Fannie Mae debt issues and comparable Treasury securities widened Wednesday. Investors pummeled the stock after the news was announced, though the stock recovered some ground by the end of the day. In 4 p.m. New York Stock exchange composite trading, Fannie Mae's shares were down 2.4% at $73.10.
Lawmakers and Treasury officials were already debating whether to tighten oversight of Fannie and Freddie after Freddie Mac disclosed its own accounting problems earlier this year. Freddie Mac's problems, which involved understating income by at least $4.5 billion, led to a major management shake-up, including the ouster of two chief executive officers. Freddie Mac used financial transactions to shift excess earnings into the future and mask the company's volatility.
Both companies "have a credibility problem, and this only makes it worse," said James Bianco, president of Bianco Research LLC, a Chicago-based investment-research firm who has been critical of the two companies. He said it highlights how too few people have a firm grasp on Fannie Mae's arcane accounting and overall financial position, even as Wall Street analysts continue to tout the company's stock. "Investors look at this stuff, throw their arms up in the air [and say], 'We don't understand this stuff, you don't understand this stuff, and the companies don't understand this stuff, but it doesn't matter, because the government is going to back it anyway.' "
Fannie Mae had previously argued that it had a far better lock on its accounting than Freddie Mac, hoping to cast itself as a more responsible and sophisticated operation that didn't need much more scrutiny. Fannie Mae went so far as to hold an accounting "tutorial" earlier this month to explain derivatives accounting to investors, analysts and reporters. Yet it was in derivatives accounting that its stumble came.
Continued in the article.
Question
How can failure to book derivatives fair value of $1.1 billion not have any
impact on earnings? If this is the case, what's the big sweat over failure to
book the derivatives?
Answer (I include the FAS 149
amendments of FAS 133 as being part and parcel to FAS 133 itself.)
If the unbooked $1.1 fair value of the derivatives had instead been properly
booked according to FAS133/IAS39 rules, the balance sheet assets and liabilities
would change by $1.1 billion. If these derivatives had been speculations or did
not otherwise qualify for special hedge accounting treatment under FAS133/IAS39
rules, they would have impacted earnings by $1.1 billion. But these derivatives
were apparently hedges, and Fannie Mae tries to imply that its accounting error
is no big sweat. The CEO of Fannie Mae asserts that derivatives are used
primarily for two purposes:
... we use derivatives primarily for two
purposes: as substitutes for notes and bonds we issue in the debt markets and to
hedge against fluctuations in interest rates on planned debt issuances.
Statement from the CEO of Fannie Mae Regarding FAS 133 Reporting Prior to
the October 29, 2003 Adverse News Report ---
http://www.fanniemae.com/ceoanswers/derivativesaccounting.jhtml
First I might note that when derivatives are used as substitutes for debt issuances, their changes in value would affect current earnings to the extent that they are not used for hedging purposes under FAS 133 rules. However, I seriously doubt that Fannie Mae is allowed to speculate using derivatives? As "hedges against fluctuations in interest rates" their changes in value would not affect current earnings to the extent that the hedges are effective. The reason is that FAS 133 provides complex ways to avoid earnings impacts of changes in value of hedging derivatives. This is complex in the sense how it is done varies with cash flow hedges versus fair value hedges of booked hedge items versus fair value hedges of unbooked hedge items such as "planned debt issuances." In the case of forecasted transactions like "planned debt issuances," the hedges are most likely cash flow hedges of interest rate risk in forecasted transactions much like Example 5 in Appendix B of FAS 133. See my video of Example 5:
Video Tutorial: Accounting for Interest Rate Swap Hedges and Valuation of
Swaps ---
030FAS133InterestRateSwapAccounting.wmv ---
http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/
Choose file 030FAS133InterestRateSwap.wmv
So where's the big sweat in FAS 133 and IAS reporting rules as they stand today?
The big sweat is that there are two types of hedges other than foreign currency hedges. One type is a cash flow hedge and the other type is a fair value hedge. What people often fail to realize is that you can't be hedged both ways. If a company has cash flow risk and hedges that risk, it creates fair value risk. If a company has fair value risk and hedges that risk, it creates cash flow risk. If Fannie Mae hedged interest rate cash flow risk, then it created fair value risk on the combined fair value of its hedged items and hedging instruments. If it hedged fair value, it created cash flow risk.
If Fannie Mae's erroneously unbooked derivatives qualified for special hedge accounting under FAS133/IAS39 rules, then the offset to changes in booked fair value would bypass earnings. The ineffective portion of the hedge does impact current earnings. However, since Fannie Mae primarily hedges interest rate movements (probably with interest rate swaps), the hedges most likely qualified for "The Shortcut Method" under FAS 133 (see Paragraph 132) and would be deemed to be perfectly effective at the beginning of the hedge.
Hence Fannie Mae most likely is correct in contending that its failure to book the $1.1 billion in derivatives under FAS 133 would not have impacted earnings provided both the hedges and the hedged items were carried to maturity. The risk in not booking the derivatives (in terms of earnings) lies in the likely case that the hedged items and the hedges might not be carried to maturity. Failure to book the $1.1 billion hides the enormous risk of a hit on earnings if customers pay off loans early (as is likely the case if interest rates drop) or that Fannie Mae sells the loans before maturity (as is common with Fannie Mae).
From The Wall Street Journal Accounting Educators' Reviews on November 7, 2003
TITLE: Fannie Mae Makes $1.1 Billion Error in Its Accounting
REPORTER: Patrick Barta and John D. McKinnon
DATE: Oct 30, 2003
PAGE: A1
LINK:
http://online.wsj.com/article/0,,SB10674573311089700,00.html
TOPICS: Advanced Financial Accounting, Audit Report, Auditing, Derivatives, Fair
Value Accounting, Hedging
SUMMARY: Fannie Mae made an error in applying the new FAS149 requirements to mark loan commitments to market, in accordance with derivative accounting under FAS 133, that was required to be implemented in 3rd quarter reporting. Fannie Mae argues that this was not a systemic problem, but merely resulted from human error in manual systems that are being used temporarily in order to implement the new requirement quickly.
QUESTIONS:
1.) The first paragraph describes the changes from revising their third quarter
financial statements as a "restatement of stockholder equity"and the second
paragraph indicates that "the restated figures...didn't alter the company's
profit..." How is it possible to change total stockholders' equity and not
affect net income? What measure of reported performance do you think was
affected by this change? Support your answer and include definitions of
appropriate terms in doing so.
2.) Cite statements from the article which characterize the reaction to Fannie Mae's announcement of the accounting error. Why has the reaction been so negative even though the impact of the accounting error on stockholders' equity was positive?
3.) At the end of the article, the author indicates that the problem giving rise to this restatement was "tied in part to an obscure accounting provision, known as Financial Accounting Standard No. 149." What is the subject of that standard? Do you think it is "obscure"? What do you think makes the popular business press use this description?
4.) The author describes the loan commitments that are the subject of this accounting error near the end of the article. What provision in FAS 49 requires that these commitments be marked to market value "and hence record any unrealized changes in value of those commitments despite whatever price the company agrees to pay for the loans"? What type of accounting treatment for such commitments could result in an impact on stockholders' equity, but not net income, as is the case at hand?
5.) The impact on stockholders' equity was positive--an unrealized gain on the value of the loan commitments undertaken by Fannie Mae. What does that say about the terms of these loan commitment contracts?
6.) Suppose you are an auditor and Fannie Mae is your client. What impact does this problem have on your plans for the year-end audit? Do you have any responsibility associated with the problematic third quarter report, even if that report was labeled "unaudited"?
Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University
Reviewed By: Kimberly Dunn, Florida Atlantic University
--- RELATED ARTICLES ---
TITLE: Review & Outlook: Fannie's Black Box
REPORTER: WSJ Editors
PAGE: A12
ISSUE: Oct 31, 2003
LINK:
http://online.wsj.com/article/0,,SB106755988050523700,00.html
| . 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) Margin OOPS Bank Case (interest rate profit hedging with 75
Eurodollar futures contracts) CapIT Corporation Case (interest rate caps with Eurodollar interest
rate put options taken from the Wall Street
Journal) FloorIT Bank Case (interest rate floors with Eurodollar interest rate
call options taken from the Wall Street Journal) Mexcobre Case (a complex international hedging case involving a
copper price swap) Big Wheels Cross-Currency Swap Case, Student Project by Rachel Grant,
Accounting 5341, Trinity University, Spring 2000 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 Hubbard and Jensen explanation of Example 2 of FAS 133 can be downloaded as follows:
http://www.trinity.edu/rjensen/caseans/294wp.doc 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/
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/ 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/ · 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:
·
http://risk.ifci.ch/SiteMap.htm · http://www.margrabe.com/Dictionary.html
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Interest Rate Swap
Valuation, Forward Rate Derivation, and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments
Bob Jensen at Trinity University
Short-Cut Method for Interest Rate Swaps
Yield Curve and Forward Rate Calculations
Example 5 from Appendix B of FAS 133
Excerpts from the IAS 39 November 2001 Implementation and Guidance Supplement
Casting out on the Internet often results in a catch
Concept of Fair Value --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#FairValue
Note the book entitled PRICING DERIVATIVE SECURITIES, by T W Epps (University of Virginia, USA) The book is published by World Scientific --- http://www.worldscibooks.com/economics/4415.html
Contents:
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Yield Curve and Forward Rate Calculations
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Yield Curve Definition = the graphical relationship between yield and time of maturity of debt or investments in financial instruments. In the case of interest rate swaps, yield curves are also called swaps curves. Forward yield (or swaps) curves are used to value many types of derivative financial instruments. If time is plotted on the abscissa, the yield is usually upward sloping due to term structure of interest rates. Term structure is an empirically observed phenomenon that yields vary with dates to maturity. FAS 133 refers to yield curves at various points such as in Paragraphs 112 and 319. The Board also referred to by analogy at various points such as in Paragraphs 162 and 428. Financial service firms obtain yield curves by plotting the yields of default-free coupon bonds in a given currency against maturity or duration. Yields on debt instruments of lower quality are expressed in terms of a spread relative to the default-free yield curve. Paragraph 112 of SFAS 113 refers to the "zero-coupon method." This method is based upon the term structure of spot default-free zero coupon rates. The interest rate for a specific forward period calculated from the incremental period return in adjacent instruments. A very interesting web site on swaps curves is at http://www.clev.frb.org/research/JAN96ET/yiecur.htm#1b In the introductory Paragraph 111 of FAS 133, the Example 2 begins with the assumption of a flat yield curve. A yield curve is the graphic or numeric presentation of bond equivalent yields to maturity on debt that is identical in every aspect except time to maturity. In developing a yield curve, default risk and liquidity, for example, are the same for every security whose yield is included in the yield curve. Thus yields on U. S. Treasury issues are normally used to plot yield curves. The relationship between yields and time to maturity is often referred to as the term structure of interest rates. As explained by the expectations hypothesis of the term structure of interest rates, the typical yield curve increases at a decreasing rate relative to maturity. That is, in normal economic conditions short-term rates are somewhat lower than longer-term rates. In a recession with deflation or disinflation, the entire yield curve shifts downward as interest rates generally fall and rotates indicating that short-term rates have fallen to much lower levels than long-term rates. In an economic expansion accompanied by inflation, interest rates tend to rise and yield curves shift upward and rotate indicating that short-term rates have increased more than long-term rates. The different shapes of the yield curve described above complicate the calculation of the present value of an interest rate swap and require the calculation and application of implied forward rates to discount future fixed rate obligations and principal to the present value. Fortunately Example 2 assumes that a flat yield curve prevails at all levels of interest rates. A flat yield curve means that as interest rates rise and fall, short-term and long-term rates move together in lock step, and future cash flows are all discounted at the same current discount rate. A yield curve is the graphic or numeric presentation of bond equivalent yields to maturity on debt that is identical in every aspect except time to maturity. In developing a yield curve, default risk and liquidity, for example, are the same for every security whose yield is included in the yield curve. Thus yields on U. S. Treasury issues are normally used to plot Treasury yield curves. The relationship between yields and time to maturity is often referred to as the term structure of interest rates. Similarly, an unknown set of estimated LIBOR yield curves underlie the FASB swap valuations calculated in all FAS 133/138 illustrations. The FASB has never really explained how swaps are to be valued even though they must be adjusted to fair value at least every three months. Other than providing the assumption that the yields in the yield curves are zero-coupon rates, the FASB offers no information that would allow us to derive the yield curves or calculate the swap values in Examples 2 and 5 in Appendix B of FAS 133 and in other examples using FAS 138 rules. The typical yield curve gradually increases relative to years to maturity. That is, historically, short-term rates are somewhat lower than longer-term rates. In a recession with deflation or disinflation the entire yield curve shifts downward as interest rates generally fall and rotates counter-clockwise indicating that short-term rates have fallen to much lower levels than long-term rates. In rapid economic expansion accompanied by inflation, interest rates tend to rise and yield curves shift upward and rotate clockwise indicating that short-term rates have increased more than long-term rates. The different shapes of the yield curve described above complicate the calculation of the present value of an interest rate swap and require the calculation and application of implied forward rates to calculate future expected swap cash flows. Example 2 in Appendix B of FAS 133 assumed that a flat yield curve prevails at all levels of interest rates. A flat yield curve means that as interest rates rise and fall, short-term and long-term rates move together in lock step, and future cash flows are all discounted at the same current discount rate. The cash flows and values in the Appendix B Example 5, however, are developed from the prevailing upward sloping yield curve at each reset date. The accompanying Excel workbook used the tool Goal Seek in Excel to derive upward sloping yield curves and swap values at the reset dates that generated the $4,016,000 swap value used in the FASB's Example 1 of Section 1 of the FAS 138 examples at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html. Yield curves are typically computed on the basis of a forward calculated in the following manner using the y(t) yield curve values: ForwardRate(t) = [1 + y(t)]t/[1 + y(t-1)]t-1 – 1 The ForwardRate(t) is the forward rate for time period t, y(t) is the multi-period yield that spans t periods, and y(t-1) is the yield for an investment of t-1 periods --- for example, if 6.5% is y(t) and 6.0% is y(t-1). Thus, Fo |