GE CAPITAL

GE CAPITAL

OVERVIEW OF HEDGING

Management of Market-Related Risks

**Example risks:**
Interest rate movements Foreign currency movements Changes in equity prices Changes in commodity prices

**Example hedging instruments:**
Swaps Forwards Options Futures Other (including non-derivatives)

**Hedge Accounting**
Cash flow hedge accounting is used to hedge variability in cash flows associated with: Recognized assets and liabilities with variable terms; or Forecasted transactions
Fair value hedge accounting is used to hedge an entity's exposure to changes in fair value, attributable to a particular risk, relating to: Recognized assets or liabilities with fixed terms; or Unrecognized firm commitments
Hedging of a net investment in a foreign operation continues to be allowed

**Qualifying Hedge Criteria**
Formal documentation of the hedging relationship, its objectives and strategy, and its effectiveness
The hedging relationship must be expected to be highly effective at inception and on an ongoing basis
There are special rules for using written options and basis swaps as hedging instruments

**Formal Documentation**
At inception, must document: Hedging relationship Risk management objective and strategy Identification of instrument and hedged item Nature of risk Method of assessing effectiveness
Additional documentation required for: 1. Firm commitment: reasonable method of recognizing adjustments in earnings 2. Forecasted transaction: transaction specifics (timing, nature, amount, price) evidence supporting management's assertion that the transaction is probable

**Items Not Receiving Hedge Accounting**
FAS 133 does not allow hedge accounting for the following items: Net income hedging Items that are marked-to-market through income (except foreign currency denominated transactions) Equity method investments Equity in a consolidated subsidiary Business combinations Non-financial assets/liabilities - the designated risk being hedged must be the risk of changes in the FV of the entire asset/liability

**Effectiveness**
In order to maintain hedge accounting, the hedged item and hedging instrument must be highly effective
However, any ineffectiveness must be taken to earnings (with one exception - discussed later)
Process for measuring effectiveness is not set by the standard

**Subsequent Assessment**
Ongoing: Evaluate at least quarterly Cumulative versus period methodologies Statistical techniques may be appropriate/used
If an improved measurement method is identified then: Must terminate and re-designate hedge relationships Apply prospectively
If high effectiveness ceases: May re-designate new hedging relationship prospectively; or Hedge accounting discontinued prospectively

**Sources of Ineffectiveness**
Derivative	Principal & notional amounts	Hedged Item
Derivative	Counterparty creditworthiness	Hedged Item
Derivative	Term or maturity	Hedged Item
Derivative	Fair value at inception and repricing dates	Hedged Item
Derivative	Cash receipts or payment dates	Hedged Item
Derivative	Underlying basis (e.g., LIBOR versus Prime)	Hedged Item

**Examples - Little Ineffectiveness**
Utilization of an IRS to synthetically alter fixed rate debt to a floating rate obligation
Utilization of FX forwards/swaps on foreign currency denominated transactions (e.g., foreign denominated debt)

**Short-Cut Method**
Available when key terms of an interest rate swap and hedged items meet certain conditions
Accounting model: Assume perfectly effective No requirement to reassess effectiveness
Short-cut method may not be used for hedges of risks other than interest rate risk (e.g. foreign currency risk)

**Short Cut Method Criteria**
All: Notional amount matches principal FV of swap at inception is zero Net settlements computed in same way Hedged item is not prepayable (except for embedded calls that have mirrored puts in the swap) The index on the variable leg of the swap matches the benchmark interest rate designated as the hedged item Other terms are typical
Cash Flow Hedges All cash flows are designated as hedged No floor/cap on the swap unless hedged item has floor/cap Repricing dates of the swap must match hedged item
Fair Value Hedges Expiration dates match No floor or ceiling Re-pricing internals frequent

**Components of Derivatives**
Forward contract Spot price Interest (time value) Carrying costs
Option Intrinsic value Time value Interest Volatility value
Market arbitrage effects

Excluded Component of the
Derivative's Gain/Loss
Only specified components may be excluded: For option contracts Intrinsic value: Time value can be excluded Minimum value (intrinsic + discounting): Volatility value can be excluded For a Forward or Futures Contract Spot prices: Difference between spot and forward/futures price can be excluded
Excluded Portion is Included in Earnings Based on Its Changes in Fair Value

**Examples**
Equity securities hedging - options Typically use only intrinsic value to assess effectiveness; therefore, time value will be recognized in income each period
Foreign currency denominated variable rate debt hedged using short-term forwards Management may decide not to apply hedge accounting for these instruments given their short tenor
FX hedging - swap/forward Management must determine whether to assess effectiveness based on spot or forward rate
FX hedging - option DIG currently reviewing this issue; tentative indications appear to require the use of spot FX rate in determining the intrinsic value of an option

**Other Effectiveness Considerations**
Pools of items Loans with similar interest and maturities FX exposures
Multiple hedging instruments (combination of options and swaps)
Dynamic hedging Mortgage servicing rights Interest only strips and other prepayable financial instruments

**Effectiveness: Comments**
A hedge must be highly effective at inception and on an ongoing basis
Effectiveness will be measured at the end of each quarter
Evaluation of effectiveness must be consistent with the entity's risk management strategy
Even though a hedge may be highly effective, the income statement may still contain hedge ineffectiveness
Currently, there is no definitive method of evaluating hedge effectiveness

**Termination of Hedging Relationship**
Prospectively, mark-to-market derivative through earnings
For cash flow accounting, amount in OCI is evaluated for removal based on the forecasted transaction (or future cash settlement) (i.e., if the forecasted transaction remains probable, the amount will remain in OCI until the transaction occurs)
For fair value accounting, previous basis adjustments are accounted for based on the underlying item (i.e., if the hedged item was a loan, the adjusted basis (discount/premium) would be amortized to earnings consistent with current accounting for discounts/premiums on loans)

INTRODUCTION AND OVERVIEW

FAS 133 SEMINAR
June 19-21, 2000

**SFAS 133 Seminar**
Schedule
Breaks
Lunch
Other administrative matters

**Agenda**
Why FASB changed the rules
New definition of derivatives
New criteria to qualify for hedge accounting
How does it affect me?
What should I be concerned about?
What should I do next?

**Why the Change?**
Existing Model was: Incomplete Inconsistent Not Transparent Difficult to Apply

**Development of New Accounting Model**
Derivatives Are Assets or Liabilities	The Only Relevant Measure for Derivatives is Fair Value
Only Assets and Liabilities Should be Recorded As Such	Special Hedge Accounting for Qualified Transactions

**Hedging Activities**
Fair Value Fixed Rate Assets/Liabilities Firm Commitments
Cash Flow Variable Rate Assets/Liabilities Forecasted Transactions
Foreign Currency Firm Commitments Forecasted Transactions Net Investments
Significant Paradigm Shift from Old Accounting

**Hedging Activities - Fair Value**
Fair Value Hedge Provides Protection Against Changes in Value Caused by Fixed Rates or Prices
Accounting Model	Measurement of Derivative Change in Fair Value	Earnings
Accounting Model	Measurement of Hedged Item Offsetting Gain or Loss Attributable to Risk Being Hedged	Earnings

**Hedging Activities - Cash Flow**
Cash Flow Hedge Provides Protection Against Changes in Cash Flows Caused by Variable Rates or Prices
Accounting Model	Measurement of Derivative Change in Fair Value	Effective	OCI (Equity) (1)
Accounting Model	(1) Based on Timing of Earnings Impact of Hedged Item (interest, cost of sales, depreciation)	Ineffective	Earnings

**Hedging Activities - Foreign Currency**
Foreign Currency
FAS 52 Still Largely Applicable
Hedge Accounting Was Limited to: Fair Value Hedge of Unrecognized Firm Commitments Cash Flow Hedge of Forecasted Transactions Net Investment in Foreign Operations
Amendment Expanded Range of F/X Hedges

**How Does It Affect Me?**
Financial Statements Earnings Volatility Volatility in Recorded Assets and Liabilities
Implementation Issues Inventory Derivatives Assess Impact Develop Systems Revise Strategies

**Corporate Treasury**
Uses Derivatives To Convert Interest Rate And/or FX Risk to Counterparty Credit Risk
Reduce Funding Costs By About $70 Million (Pre-Tax) Per Year
Board Policy Treasury Executes All Derivatives in GECC AAA Counterparty Rating for 5 Years+ AA Rating For < 5 Years Downgrade Language Below A-
Derivatives Provide Flexibility and Lower Cost Of Funding

**GECS' CORPORATE FUNDING OPERATION**
Current Strategy	FASB 133 Strategy	Principal Amount 12/31/98($MM)	Incremental Cost Per Annum Basis Points/$MM	Impact of Funding Strategy
US Funding
Issue US Commercial Paper & Swap to Fixed USD Fixed Foreign Currency Debt Swapped to Fixed USD Floating Foreign Currency Debt Swapped to Fixed USD	Issue Fixed USD Debt Issue Fixed USD Debt Issue Fixed USD Debt	$11,884 $ 9,100 $ 2,334	10 bp/$17 15 bp/$14 5 bp/$1	USID Fixed Rate Notes Multiple Currencies Floating Rate Notes Multiple Currencies	Fixed Rate Notes - USD Fixed Rate Notes -USD Fixed Rate Notes - USD
Foreign Currency Funding
Synthetic Floating Foreign Debt Swapped to Fixed Foreign Currency Fixed Foreign Currency 1 Debt Swapped to Floating Foreign Currency	Issued Fixed Foreign Debt Issue Floating Foreign 2 Debt	$18,678 $ 8,654	10 bp/$19 10 bp/$9	Fixed/Floating Notes Multiple Currencies Fixed Rate Notes Multiple Currencies	Fixed Rate Notes-Single Currency Floating Rate Notes-Single Currency
SFAS 133 Reduces Funding Alternatives And Flexibility

**Derivatives Portfolio ($159 Billion)**
Reduction of Funding Costs Matched Funding Swaps (Eliminate Interest Rate Risk) USD Portfolio $12.9 Non-USD Portfolio 19.7 Funding USD Floating 3.0 USD Fixed 18.0 Non-USD Floating 20.3 Non-USD Floating (via FX) 23.4 TOTAL $97.3	Exposure Management Mortgage Services $21.4 (Hedge Prepayment Risk) GEFA (Insurance Business) 10.0 (Hedge Portfolio Investments) Other Business Hedges 23.0 Other (Net Investment) 7.0 TOTAL $61.4
Derivatives Are Used For Exposure Management, As Well As Reducing Funding Costs

**Overview of FAS 133 cont.**
OTC Shares Ownership
OTC Business Business Business OTC
Define Measure Analyze Design Verify
Project Objectives------>	Project Planning/ Management	Process Implementation ------>	Transition to Process Owners
Dedicated Team Focused on Specific DMADV Goals Technical Interpretation with FASB & GE Create Center of Excellence at Corp. Treasury	Complete GECS Project Implementation Plan/Timeline Inform Businesses; Create Awareness of Paradigm Shift in Accounting, Systems and Hedging Strategies	Monitor Earnings Volatility, Rate Shock, Accuracy & Cycle Time CTQs Measure Defects (e.g., Derivatives Treated Improperly On New Systems, Unidentified Embedded Derivatives)	Ensure Business Process Management Activities Are In Place Institutionalize Policies & Procedures Used for Hedging Activities and to Identify/ Account for New Derivatives
Project Evolving Real Time...Success Is Critical

**What Do We Go From Here?**
Use Quiz as your guide Train Your Personnel Locally If you Have, Continue to Sit Down with GM and other Business Leaders; If you haven't, Let Them Know Where You Stand in Detail Review your Implementation Plan and Data Submissions w/GM, MF Meet Key Milestones, Deliverables

**Key Takeaways**
How The New Accounting Model Works It Affects Your Business--In The Pocket Why Your Involvement Is Needed GECS-wide DMADV Project Where We Go From Here

DIG Issues/Amendments
SFAS 133
An Overview of the Amendment of
SFAS 133 (SFAS 138)

Self-Imposed Criteria
For the FASB's Amendment Project
No conflict with or modifications to the basic model of SFAS 133
No delay in the effective date of the standard
Implementation efforts would be eased for a large number of constituents

Principal Provisions of the Amendment
(SFAS 138)
Hedged of interest rate risk
Hedges of foreign exchange risk
Central treasury
Normal purchase/sale exception

Other Revisions Considered and
Rejected by the FASB
Enrique, I plan to add a short list of other significant areas constituents asked be amended but the Board decided not to. I don't think it will take more than a few minutes to briefly summarize.

**Hedges of Interest Rate Risk**
"Market interest rate risk" *has been replaced* with the concept of interest rate risk: *From* the risk free rate (US Treasury) plus "sector" risk To a benchmark interest rate - LIBOR swap rate or US Treasury rate
More difficult to hedge credit risk since sector spread is part of credit risk
Benchmark interest rate being hedged must be: Specifically identified as part of designation Documented at inception of the relationship Ordinarily the same benchmark rate for similar hedges
To qualify for the short cut method, the index on which the variable leg of the swap is based must MATCH the benchmark rate designated as the risk being hedged

**Fair Value Interest Rate Hedges**
Use of a LIBOR based swap to hedge the change in fair value due to LIBOR changes of even highly rated (AAA) debt instruments is now permitted
The change in the hedged item's fair value attributable to changes in the benchmark interest rate: Must be based upon the contractual cash flows of the entire hedge item Excluding some of these cash flows (e.g., the portion of the interest coupon in excess of the benchmark interest rate) is not permitted No required discount rate given; therefore, an entity may use the benchmark interest rate or the hedged item's coupon rate (adjusted for changes to benchmark) as the discount rate.

**Cash Flow Interest Rate Hedges**
Entity is permitted to use: (1) a LIBOR based instrument to hedge the change in cash flows of a variable rate instrument that resets based on the US Treasury or (2) a Treasury based instrument to hedge the change in cash flows of a variable rate instrument that resets based on LIBOR
The designated risk being hedged for a variable rate financial asset or liability (either existing or forecasted) can NOT be the benchmark interest rate if the cash flows of the hedged transaction are explicitly based on a different index (e.g., Prime).
Instead, an entity may be able to designate the overall changes in cash flows as the hedged risk and not just interest rate risk

**Foreign Currency Hedges**
Foreign-currency-denominated (FCD) asset or liability can be hedged in fair value or cash flow hedge
Unrecognized FCD firm commitments also can be hedged in fair value or cash flow hedge
Cash flow hedging of a recognized FCD asset or liability is permitted only when ALL the variability in the hedged item's functional currency equivalent cash flows is fixed

Benefits of the Revised Foreign
Currency Provisions
Revisions permit hedge accounting where, previously, only "natural hedging" was permitted Minimizes the spot/forward difference created by SFAS 133 while Retaining the concepts of marking-to-spot the asset or liability under SFAS 52 and marking-to-market the derivative under SFAS 133

**Foreign Currency Fair Value Hedges**
Provisions for hedging AFS Securities remain substantially unchanged
Hedging other recognized assets or liabilities that give rise to FX transaction gains or losses Adjust the FCD asset or liability for interest changes in the foreign currency (presuming interest-rate risk is also hedged) Then mark-to-spot the adjusted FCD asset or liability

**Foreign Currency Cash Flow Hedges**
Report the change in fair value of derivatives deemed effective (including the forward premium in OCI.
Release to earnings amount equal to mark-to-spot adjustment of asset or liability. Release to earnings remaining amount (forward premium) as yield adjustment over time.

**Foreign Currency Hedge Illustration**
Debt terms	Fixed-rate foreign currency denominated debt Variable-rate, foreign-currency denominated debt Foreign currency trade payable
Hedge Objective	Reduce foreign currency and interest rate risk Fix variability of principal and interest payments due to FX and interest Fix variability due to foreign currency risk
Derivative	Cross currency interest swap (receive fixed interest rate in FC, pay variable interest rate in US$) or an FX forward and an interest rate swap Cross currency interest swap (receive variable interest rate in FC, pay fixed interest rate in US$) or an FX forward and an interest rate swap FX forward or currency swap (receive fixed interest rate in FC, pay fixed interest rate in US$)
Result	US$ variable rate interest pay out and US$ fixed principal US$ fixed interest rate pay out and US$ fixed principal US$ fixed rate interest pay out and US$ fixed principal
Approach	Fair value hedge of FX and interest Cash flow hedge of FX and interest Cash flow or fair value hedge of FX

**Central Treasury**
Hedging with intercompany derivative ALLEGEDLY simplified
Intercompany foreign currency derivatives would be permitted to be designated as cash flow hedges (in the consolidated financial statements) of the following: Forecasted borrowings Purchases or sales Unrecognized firm commitments
Only if those intercompany derivatives are offset by third party derivatives on a net bases
"Net hedging" not extended to: Any other cash flow hedge or fair value hedges of foreign currency risk (e.g., fair value or cash flow hedges of recognized foreign currency denominated assets or net investment in foreign operations), or Hedges of any other risk such as interest rates
Central treasury must act as a pass-through entity: Must enter into third-party contracts to offset, on a net basis for each foreign currency The foreign exchange risk arising from multiple internal derivatives AND the derivative contract with the unrelated third party must general equal or closely approximating gains and losses when compared with the aggregate or net losses and gains generated by the intercompany derivative contracts
Due to concerns regarding macro-hedging, central treasury (or Issuing Affiliate): Must track exposures and document linkage of all derivatives Cannot alter or terminate third-party contracts unless Hedging Affiliate initiates action Must reassess compliance with all requirements if the internal derivative is modified or de-designated as a hedge
Can only combine exposure from internal contracts that involve the same currency and mature within the same 31-day period
Offsetting net third-party contract must: Offset the aggregate or net exposure to that currency Mature within the same 31-day period Be entered into within 3 business days after the designation of internal contracts as hedging instruments

**Normal Purchases and Normal Sales**
Normal purchase/sale exception expanded to include: Contracts that permit net settlement (9a) Contracts that have a market mechanism to facilitate net settlement (9b)
Entity must determine that it is probable at inception and throughout the term that the contract will *not* be settled net AND will result in physical settlement (intent based)
Contracts that do not qualify for the exception: Those requiring cash settlement or otherwise settling periodically (e.g., futures contracts) Those having a price based on an underlying not clearly and closely related to asset sold or purchased, such as: Contracts denominated in a foreign currency that is not the currency of the counterparty or the currency such transactions are routinely stated Purchase contract with final price determined by reference to the S&P index An individual contract that will settle net if it is part of a series of sequential contracts intended to accomplish ultimate acquisition or sale of a commodity (e.g., sale of electricity through grids)

**DIG Issues Incorporated Into the SFAS 138**
DIG Issue G3, "Discontinuation of a Cash Flow Hedge": Gain or loss continues to be reported in OCI unless it is probable that the forecasted transaction will not occur by the originally specified time period or within an additional two month period Extenuating circumstances resulting in the continued reporting in OCI beyond that two-month period: Should be rare Must be beyond the control of the reporting entity
DIG Issue H2, "Requirements That the Unit With the Exposure Must Be Party to the Hedge": For consolidated financial statements, either: Operating unit that has the FX exposure must be party to the hedging instrument, or Another member of the consolidated group is party to the hedge and: That other member has the same functional currency as the operating unit There are no intervening subsidiaries with a different functional currency
DIG Issue H5, "Hedging a Firm Commitment or a Fixed-Price Agreement Denominated in a Foreign Currency": Unrecognized foreign-currency-denominated firm commitment can be designated in either a fair value or a cash flow hedge Earlier position reaching the same conclusion for payments due under an AFS debt security (by analogizing to this issue), is explicitly permitted by SFAS 138

**Method of Assessing Hedge Effectiveness**
Changes in intrinsic value of the stock option will be compared to changes in stock prices below $95. Changes in time value will be excluded from assessment of effectiveness: they will be reflected directly in net income.

**FAIR VALUE HEDGE with PUT OPTIONS**
	9/30/X1	12/31/X1	3/31/X1
JCN shares (100,000 shares) JCN per share	$1,050,000 $105	$940,000 $94	$900,000 $90
Put options (100,000 options) Put options each Intrinsic value Time Value	$14,500 $1.45 $0 $1.45	$36,700 $3.67 $1.00 $2.67	$50,000 $5.00 $5.00 $0
Volatility Risk-free rate Dividend Yield	20% 5% 0%	20% 5% 0%	$20% 5% 0%

Definition, Scope and
Embedded Derivatives

**Characteristics of a "Derivative"**
FAS 133 introduces a broad characteristics-based definition: Underlying and (1) Notional Amount or (2) Payment Provision Little or no initial investment Net settlement provisions
Major change in existing practice

**Accounting for Derivatives (A Refresher)**
Derivatives are carried on the balance sheet at FV with offset to the income statement unless restrictive hedge accounting criteria are met
If hedge accounting criteria are met, accounting for the offset will be driven by the hedge accounting model used (cash flow, fair value or net investment in a foreign affiliate)
Even with hedge accounting, ineffective portion affects earnings (increased P&L volatility)

**Excluded from Scope of FAS 133**
Regular Securities Trades Normal Purchases and Sales (e.g., inventory) Certain Insurance Contracts Certain Financial Guarantees Equity Contracts Certain Non-Exchange Contracts Contracts that Serve as an Impediment to Sale Accounting

**Identifying Derivatives Subject to FAS 133**
Forwards, futures, options and swaps will continue to be derivatives
Other contracts may be derivatives subject to FAS 133 depending on the characteristics of the contract
Provisions to look for in contracts: Terms indicating a notional amount/payment provision (minimum take provisions; liquidated damages clauses; etc.); "requirements-only" contracts do not contain a notional amount Terms indicating net settlement (see previous slide)

**Net Settlement**
The net settlement criterion is met if: Net settlement required or permitted by the contract (transfer of cash or other assets): OR Net settlement by a market mechanism outside the contract (e.g., commodity futures); OR Delivery of a derivative or an asset readily convertible to cash

**Derivative Examples**
Warrants Critical criteria to be evaluated is net settlement Public co. warrants will typically be derivatives unless: Significant restrictions exist Volumes at which the warrants can be exercised result in public stock not being readily convertible to cash Private co. warrants may not be derivatives; depends on whether net settlement provisions are contained in the document or a market mechanism exists (look out for put options and special arrangements with investment bankers)
Financial Guarantees Are the payment provisions based on losses associated with insurable events? Payments in response to changes in an underlying are most often derivatives, NOT financial guarantees Payments in response to a downgrade in debtor's credit rating Payments to a conduit/SPE (inverse floaters) resulting from changes in interest rate or similar circumstances
Guarantee and reimbursement (G&R) agreements: Common requirement for transactions involving fixed rate assets used to fund with CP (e.g., through Edison) 3rd Party provides an interest rate swap with a notional amount that varies with outstanding balance of assets Business provides a G&R agreement directly with the swap counterparty assuming from the swap party the risk of variability of repayment (prepayments, etc.) G&R is a derivative contract under SFAS 133 and will rarely (if ever) qualify for hedge accounting

**Selected DIG Discussions Impacting Warrants**
DIG Issue A2 "Existence of a Market Mechanism That Facilitates Net Settlement
DIG Issue A3 "Impact of Market Liquidity on the Existence of a Market Mechanism"
Agenda Item 10-2 "Derivative Treatment of Stock Purchase Warrant for Temporarily Restricted Stock
Future Agenda Item. "Designation of a Stock Purchase Warrant as an All-In-One Cash Flow Hedge"

Slide #11 G&R Agreement Illustration AND
Slide #10 Definition, Scope and Embedded Derivatives GO HERE

**SFAS 133 Requires Separate Accounting When...**
Embedded features meet the definition of a derivative
Hybrid instrument (i.e., the overall instrument) is not measured at fair value with the effect in earnings
Economic characteristics and risks of embedded derivative are not clearly and closely related to host contract
Requires Detailed Understanding of Contract Provisions; Little Doubt that Some "Sleepers" Still Exist

**"Clearly and Closely Related"**
Value of Host Contract	Driven By	Underlying Index
Debt instrument		Interest rates Prepayment terms Inflation rates Creditworthiness
Equity instrument		Equity of issuer
Lease instrument		Inflation rates Interest rates Expected revenues

"Clearly and Closely Related" - Further
Rules for Interest Bearing Contracts
Instruments which change one interest rate to another (e.g., variable rate debt) are generally viewed as clearly and closely related BUT, if it is possible for the investor: Not to recover substantially all of its initial recorded investment; OR Receive at least double investors initial rate of return on host contract; OR Result in a rate of return at least twice the market return for a similar contract ...Then not clearly and closely related

**Effect of Separation**
Account for "host contract" under existing accounting principles;
Account for the embedded derivative in accordance with this Statement - thus can be a hedging instrument
Inability to separate embedded derivative from contract results in fair value treatment for the entire instrument and forfeiture of ability to qualify as a hedging instrument

**Examples - Embedded Derivatives**
I/O strips Even though we may not recover substantially all of our initial net investment under terms of contract, they may be excluded from the standard if: The I/O initially resulted from separating the rights to receive contractual cash flows from a financial instrument that did not contain an embedded derivative The I/O incorporates terms that were not present in the original financial instrument from which the I/O was created Note that some I/O's: Are excluded from SFAS 133 (as noted above) Are, in their entirety, derivatives subject to SFAS 133 Contain embedded derivatives that must be bifurcated

**I/O Strips and Other BIs (DIG B12)**
Must first determine whether the Beneficial Interest (BI) is in the form of debt or equity DIG did not provide guidance in this area Should consider EITF Issue 89-4, "Accounting for Purchased Investment in a Collateralized Mortgage Obligation or in a Mortgage-Backed IO Certificate"
If BI is in the form of debt, there is an embedded derivative if it incorporates a return other than interest rates

QSPE's Assets	BIs	Embedded?
Example 1: SPE Holds a fixed-rate and an interest rate swap	BIs provide a guaranteed return of principal, a stated interest rate, and potential for an equity-based upside	No
Example 2: SPE Holds a Treasury Bills and an equity-linked option	BIs provide a variable return based on LIBOR	Yes
Example 3: SPE Holds a FC-denominated variable-rate bond and a FC interest rate swap	BIs provide a fixed interest-rate return denominate in the investors' functional currency	No

Consider the following examples (in all cases the BI is deemed to be debt) A qualifying SPE holds fixed-rate corporate bonds (7 percent coupon rate) and a pay-fixed (at 7 percent), receive-variable (LIBOR) interest rate swap. An investor purchases a beneficial interest issued by the qualifying SPE that has an interest rate based on LIBOR. A qualifying SPE holds Treasury bills and an equity option linked to XYZ Company stock. An investor purchases a beneficial interest issued by the qualifying SPE that provides a guaranteed return of the principal invested, a stated fixed interest rate, and the potential for upside based on the performance of XYZ Company stock. A qualifying SPE holds EURO-denominated variable-rate corporate bonds and a pay-floating-EURO and receive-fixed-U.S. dollar foreign currency interest rate swap. Assume that the notional amount of the swap matches the principal amount of the corporate bonds, that its repricing dates match those of the bonds, and that the index on which the swap's variable rate is based matches the index on which the bonds' variable rate is based. An investor purchases a beneficial interest issued by the qualifying SPE that is denominated in U.S. dollars and has a fixed interest rate.

**Examples - Embedded Derivatives**
Lease contract host Payments indexed to a foreign currency (not a currency of either party to the lease) Payments indexed to stock indexes/prices Payments indexed to other non-interest/credit related provisions
Insurance contract host Payments based on equity indexes/prices Payments based on industry-wide indices rather than losses for which counterparty has an interest "Dual trigger" are a source of continued confusion
Special rules for variable annuities A traditional variable annuity is excluded from the provisions of #133. The definition of a "traditional variable annuity" are set forth in DIG issue B7
Mandatorily deliverable debt indexed to equity: Can require delivery of shares, net cash settlement, or provide for a settlement option Ultimate repayment of debt instrument is indexed to market price of the stock Can be structured in a variety of ways. For embedded derivative to qualify as a hedge it must be a: Forward contract, or Purchased option, or Net purchased option
Not Required to be Separated from Host Contract Floating rate notes Range floating rate notes Ratchet floating rate notes Floating to fixed rate notes Index amortizing notes Credit sensitive bonds Inflation-indexed bonds Callable or putable bonds Disaster bonds linked to assets of the holder Participating mortgages Required to be Separated from Host Contract Inverse floating rate debt (if no floor) Leveraged inverse floating rate notes Other equity indexed notes Commodity indexed notes Disaster bonds not linked to specific insurable losses U.S. dollar notes with embedded currency options Certain convertible debt Extendible bonds at non-market rates

Hedging: Effectiveness &
Concept of Similar Items

Overview of Hedging

**Objective of Hedging Activities**
Management of Market-Related Risks
Example risks: Interest rate movements Foreign currency movements Changes in equity prices Changes in commodity prices
Example hedging instruments: Swaps Forwards Options Futures Other (including non-derivatives)

**Hedge Accounting**
Cash flow hedge accounting is used to hedge variability in cash flows associated with: Recognized assets and liabilities with variable terms; or Forecasted transactions
Fair value hedge accounting is used to hedge an entity's exposure to changes in fair value, attributable to a particular risk, relating to: Recognized assets or liabilities with fixed terms; or Unrecognized firm commitments
Hedging of a net investment in a foreign operation continues to be allowed

**Qualifying Hedge Criteria**
Formal documentation of the hedging relationship, its objectives and strategy, and its effectiveness
The hedging relationship must be expected to be highly effective at inception and on an ongoing basis
There are special rules for using written options and basis swaps as hedging instruments

**Formal Documentation**
At inception, must document: Hedging relationship Risk management objective and strategy Identification of instrument and hedged item Nature of risk Method of assessing effectiveness
Additional documentation required for: Firm Commitment: reasonable method of recognizing adjustments in earnings Forecasted transaction: transaction specifics (timing, nature, amount, price) evidence supporting management's assertion that the transaction is probable

**Items Not Receiving Hedge Accounting**
FAS 133 does not allow hedge accounting for the following items: Net income hedging Items that are marked-to market through income (except foreign currency denominated transactions) Equity method investments Equity in a consolidated subsidiary Business combinations Non-financial assets/liabilities - the designated risk being hedged must be the risk of changes in the FV of the entire asset/liability

**Effectiveness**
In order to maintain hedge accounting, the hedged item and hedging instrument must be highly effective However, any ineffectiveness must be taken to earnings (with one exception - discussed later) Process for measuring effectiveness is not set by the standard

**Subsequent Assessment**
Ongoing: Evaluate at least quarterly Cumulative versus period methodologies Statistical techniques may be appropriate/used
If an improved measurement method is identified then: Must terminate and re-designate hedge relationships Apply prospectively
If high effectiveness ceases: May re-designate new hedging relationship prospectively; or Hedge accounting discontinued prospectively

**Sources of Ineffectiveness**
Derivative	Principal & notional amounts	Hedged Item
Derivative	Counterparty creditworthiness	Hedged Item
Derivative	Term or maturity	Hedged Item
Derivative	Fair value at inception and re-pricing dates	Hedged Item
Derivative	Cash receipts or payment dates	Hedged Item
Derivative	Underlying basis (e.g., LIBOR versus Prime)	Hedged Item

Examples - Little Ineffectiveness
Utilization of an IRS to synthetically alter fixed rate debt to a floating rate obligation
Utilization of FX forwards/swaps on foreign currency denominated transactions (e.g., foreign denominated debt)

**Short-Cut Method**
Available when key terms of an interest rate swap and hedged items meets certain conditions
Accounting model: Assume perfectly effective No requirement to reassess effectiveness
Short-cut method may not be used for hedges of risks other than interest rate risk (e.g., foreign currency risk)

**Short Cut Method Criteria**
All: Notional amount matches principal FV of swap at inception is zero Net settlements computed in same way Hedged item is not prepayable (except for embedded calls that have mirrored puts in the swap) The index on the variable leg of the swap matches the benchmark interest rate designated as the hedged item Other terms are typical
Cash Flow Hedges All cash flows are designated as hedged No floor/cap on the swap unless hedged item has floor/cap Repricing dates of the swap must match hedged item
Fair Value Hedges Expiration dates match No floor or ceiling Re-pricing intervals frequent

**Components of Derivatives**
Forward contract Spot price Interest (time value) Carrying costs
Option Intrinsic value Time value Interest Volatility value
Market arbitrage effects

Excluded Component of the
Derivative's Gain/Loss
Only specified components may be excluded:
For option contracts Intrinsic value: Time value can be excluded Minimum value (intrinsic + discounting): Volatility value can be excluded
For a Forward or Futures Contract Spot prices: Difference between spot and forward/futures price can be excluded
Excluded Portion is Included in Earnings Based on Its Changes in Fair Value

**Examples**
Equity securities hedging - options Typically use only intrinsic value to assess effectiveness; therefore, time value will be recognized in income each period
Foreign currency denominated variable rate debt hedged using short-term forwards Management may decide not to apply hedge accounting for these instruments given their short tenor
FX hedging - swap/forward Management must determine whether to assess effectiveness based on spot or forward rate
FX hedging - option DIG currently reviewing this issue; tentative indications appear to require the use of spot FX rate in determining the intrinsic value of an option

**Other Effectiveness Considerations**
Pools of items Loans with similar interest rates and maturities FX exposures
Multiple hedging instruments (combination of options and swaps)
Dynamic hedging Mortgage servicing rights Interest only strips and other prepayable financial instruments

**Effectiveness: Comments**
A hedge must be highly effective at inception and on an ongoing basis
Effectiveness will be measured at the end of each quarter
Evaluation of effectiveness must be consistent with the entity's risk management strategy
Even though a hedge may be highly effective, the income statement may still contain hedge ineffectiveness
Currently, there is no definitive method of evaluating hedge effectiveness

**Termination of Hedging Relationship**
Prospectively, mark-to-market derivative through earnings
For cash flow accounting, amount in OCI is evaluated for removal based on the forecasted transaction (or future cash settlement) (i.e., if the forecasted transaction remains probable, the amount will remain in OCI until the transaction occurs)
For fair value accounting, previous basis adjustments are accounted for based on the underlying item (i.e., if the hedged item was a loan, the adjusted basis (discount/premium) would be amortized to earnings consistent with current accounting for discounts/premiums on loans)

Fair Value Hedging:
GE Examples

Fair Value Hedge

**Agenda**
Definition
Accounting Model Under SFAS 133
Firm Commitments
Examples
Short-Cut Method

**Definition**
Fair value hedge provides protection against changes in value caused by fixed terms, rates, or prices
Example Exposures Fixed Rate Assets Fixed Rate Liabilities Firm Commitments
Swap Fixed Floating	Debt Fixed

**Accounting Model**
Derivative recorded at fair value through earnings
Hedged item's carrying amount adjusted for changes in fair value attributable to hedged risk for all the contractual cash of the entire hedged item.
Movement in derivative and underlying may not be equal (difference = ineffectiveness)
Hedge ineffectiveness recorded in current earnings
Measurement of Derivative Change in Fair Value	+	Earnings
Measurement of Hedge Item Offsetting Gain or Loss Attributable to Risk Being Hedged for all Contractual Cash Flows	-

**Example - Fixed Rate Debt**
Company issued 5 year term debt with interest payments fixed at 7%. Debt proceeds used to fund variable rate assets. Company wishes to convert fixed rate debt to variable rate Enters 5 year interest rate swap to receive 7% and pay LIBOR + 2%
SWAP 7% Fixed LIBOR + 2%	DEBT 7% Fixed
What Would You Designate as the Hedged Item?
Pre-Amendment: The overall change in fair value of the hedged item for changes in "market interest rate risk". Post-Amendment: The change in fair value of the hedged item for changes in the LIBOR (benchmark) interest rate component of the hedged item.
Post-Amendment Provisions Should Reduce Potential Volatility.
How Do You Calculate Ineffectiveness?
Change in the FV of the Derivative Less: Pre-Amendment: Changes in FV of the Hedged Item only for Changes in "Market Interest Rate Risk"
Ineffectiveness will result from changes in the non-customer specific credit spread on the hedged item
Change in the FV of the Derivative Less: Post-Amendment: Change in FV of Hedged Item for Changes in the LIBOR (or Benchmark) Interest Rate Component.
Ineffectiveness will result from differences between the credit spread in the hedged item and the derivative contract.

Example - Fixed Rate Debt
Pre-Amendment
Change in Interest Rates
Type of Instrument Interest Rate Swap Hedged Debt Obligation	Change in Fair Value 6 (10)	Recorded in Earnings		Not Recorded
Change in FV of hedged debt obligation due to change in: Market interest rates (8) Customer specific credit spread (2) Total change in FV (10)			Derivative	Underlying
		Measurement	MTM	MTM
		Recognition	I/S	I/S
Change in Interest Rates
Type of Instrument Interest Rate Swap Hedged Debt Obligation	Change in Fair Value 6 (10)	Recorded in Earnings (6) 8*		Not Recorded - 2**
Ineffectiveness of 2 *Impact due to change in customer credit risk

Example - Fixed Rate Debt
Post-Amendment
	Derivative	Underlying
Measurement
Recognition
Change in Interest Rates
Type of Instrument Interest Rate Swap Hedged Debt Obligation	Change in Fair Value 6 (10)	Recorded in Earnings	Not Recorded
Change in FV of hedged debt obligation due to change in: Libor benchmark interest rate (5.5) Total credit spread (4.5) Total change in FV (10)			Derivative	Underlying
		Measurement	MTM	MTM
		Recognition	I/S	I/S
Change in Interest Rates
Type of Instrument Interest Rate Swap Hedged Debt Obligation	Change in Fair Value 6 (10)	Recorded in Earnings (6) 5.5*		Not Recorded - 4.5**
Ineffectiveness of (0.5) *Impact due to change in total credit risk

**Firm Commitment Requirements**
Contract Specifies all significant terms including price, quantity and timing With an unrelated party, binding on both parties and usually legally enforceable Significant disincentive for non performance
"Firm Commitments" and "Forecasted Transactions" NOT Interchangeable & subject to different accounting model
Significant Disincentive for Non-Performance DIG Issue F-3
Legal jurisdiction that governs the agreement provides remedies for default equivalent to the damages suffered in the event of non performance	=	Significant Disincentive for Non-Performance

**Qualifying Criteria**
For non financial asset/liability hedged risk must be entire change in FV E.G. Chocolate bar - cocoa - butter - milk	Cocoa Derivative can be used to hedge chocolate bar if highly effective
For financial asset/liability can hedge separate risk components of market price risk EURO Bond - default (credit) risk - interest rate risk - foreign exchange risk
The following items are prohibited Hedged item presents an exposure to earnings Transactions involving certain equity investments or instruments Certain Other Characteristics Special rules for Held to Maturity Debt Securities Written options See Appendix A for further details

**Short Cut Method**
Available when key terms of an interest rate swap and hedged items meet certain conditions
Accounting model: Assume perfectly effective No requirement to reassess effectiveness

**Short Cut Method Criteria**
ALL:
Notional amount matches principal
FV of swap at inception is zero
Net settlements computed in same way
Hedged item is not prepayable
Other terms are typical
Expiration dates match
No floor or ceiling
Re-pricing intervals frequent

**Sources of ineffectiveness**
Notional amount does not match
FV of swap at inception is not zero
Net settlements computed in different way
Hedged item is prepayable
Expiration dates do not match
Floor or ceiling exists
Re-pricing intervals infrequent
Differing credit spread in swap and hedged item

EXAMPLES

**Case 1**
D. Brain and Company: Accounting for Interest Rate Swaps in a Horizontal Yield Curve Environment
Existing Financial Instrument Fixed Rate Debt - $1,000,000 principal - 3 year maturity - 8% annual payments - LIBOR benchmark	Risk Management Objective Eliminate changes in fair value of fixed-rate debt; enter into interest rate swap
Hedging Derivative Receive-fixed, pay-variable interest rate swap 8% fixed-rate LIBOR variable-rate $1,000,000 notional Annual payments on December 31 3 year maturity	Specific Risk Being Hedged Changes in fair value of fixed-rate debt due to changes in the 3 year LIBOR benchmark rate
Method of Assessing Hedge Effectiveness Critical terms match Swap qualifies for the short-cut method May assume no ineffectiveness	End of Year 1 Swap value: Present value of ordinary annuity, +20,000, 2 years, 6% = 36,668 Dr. Swap Receivable for 36,668 Cr. Gain on Swap for 36,668 Dr. Loss on B/P for 36,668 Cr. Bonds Payable for 36,668

**Case 2**
W. Ielusic Cigar Company: Accounting for Options Hedging Equity Securities
Existing Financial Instrument 10,000 Shares of W. Ielusic Cigar (WIC) Current value $105 per share Accounted for in AFS	Risk Management Objective Lock in gain on sale to at least $95 per share, no management of position
Hedging Derivative 10,000 purchased put options	Specific Risk Being Hedged Changes in the fair value of WIC stock below $95 per chare due to change in equity prices

Method of Assessing
Hedge Effectiveness
Changes in intrinsic value of the stock option will be compared to changes in stock prices below $95. Changes in time value will be excluded from assessment of effectiveness: they will be reflected directly in net income.

FAIR VALUE HEDGE with PUT OPTIONS

**12/31/X1 Journal Entries**
Purchased Options 22,200 G. on Hedging Ops 10,000 Gain on Options 12,200 (Split gain in effective, ineffective; not required for correct I/S impact) Loss on Securities 10,000 OCI 100,000 AFS Securities 110,000 (Only 10,000 of 110,000 hedged)

**3/31/X2 Entries**
Purchased Options 13,400 Loss on Options 26,600 G. on Hedging Ops 40,000 (Break gain into effective, ineffective; not required) Cash 950,000 Purchased Options 50,000 AFS Securities 900,000

**3/31/X2 Journal Entries**
Loss on Sale (AFS) 50,000 Reclass. Adj. 50,000 (Since hedging started, 50,000 loss on unhedged portion of AOCI deferred in AOCI; now realized)

**Summary**
Fair value hedge provides protection against changes in value caused by fixed terms, rates or prices
SFAS 133 Accounting Model Derivative recorded at fair value through earnings Hedged item's carrying amount adjusted for changes in fair value attributable to hedged risk Hedge ineffectiveness recorded in current earnings Shortcut method for interest rate swaps available in certain cases

Cash Flow Hedging:

Cash Flow Hedge

**Agenda**
What Is A Cash Flow Hedge
Accounting Model Under SFAS 133
Forecasted Transactions
Case Study

**What Is a Cash Flow Hedge?**
A cash flow hedge provides protection against exposure to fluctuations in the cash flows associated with a hedged item caused by variable rates, terms or prices.
Sample Exposures Commercial paper used to fund fixed-rate assets SFG's variable price oil and gas production Forecasted sales of loans by Mortgage Services
How a typical cash flow hedge works	SWAP Floating Fixed	DEBIT Floating

**Accounting Model**
Derivative measured at fair and recognized as an asset/liability
Hedged item's carrying amount remains unchanged
Change in FV of derivative is compared to change in future cash flows (or PV of future cash flows)
Difference may go either to OCI or current earnings
Measurement of Derivative Change in Fair Value Amounts are subsequently transferred out of Accumulated Other Comprehensive Income (OCI) as the hedged item impacts income (interest, cost of sales, depreciation).	Effective Ineffective	Recognition OCI (Equity)
		(1)
		Earnings

**Forecasted Transaction**
Plan Single transaction or group of related transactions Probable to occur Must be with an external party Must expose an entity to variable Cash Flow which could affect earnings
"Firm Commitments" and "Forecasted Transactions" NOT interchangeable & subject to different accounting model

**Case 1**
Joe's Computer Company: Cash Flow Hedge Accounting for an Interest Rate Swap in a Horizontal Yield Curve Environment
Existing Financial Instrument Variable Rate Investment - $1,000,000 principal - 3 year maturity - LIBOR annual receipts	Risk Management Objective Eliminate cash flow variability of interest receipts on variable-rate investment; enter into interest rate swap
Hedging Derivative Receive-fixed, pay-variable interest rate swap - 8% fixed-rate - LIBOR variable-rate - $1,000,000 notional - Annual payments on December 31 - 3 year maturity	Specific Risk Being Hedged Changes in cash inflows from variable-rate investment due to changes in market interest rates
Method of Assessing Hedge Effectiveness Critical terms match Swap qualifies for the short-cut method May assume no ineffectiveness	Swap Pricing/Assumptions Determine expected variable interest rate Determine expected net interest payments/receipts Discount to present value Horizontal yield curve: Means current interest rate is expected to persist into future Expected payments/receipts constant Discount rate same for all maturities

**Timeline: Swap Interest Rate Dynamics**
Swap receive-fixed rate always 8% Beginning of year 1: current LIBOR 8% Expected LIBOR at EOY 1, 2, 3: ?? Expected net CF, EOY 1, 2, 3: ?? Swap receive-fixed rate always 8% Beginning of year 1: current LIBOR 8% Expected LIBOR at EOY 1, 2, 3: 8% Expected net CF, EOY 1, 2, 3: ?? Swap receive-fixed rate always 8% Beginning of year 1: current LIBOR 8% Expected LIBOR at EOY 1, 2: 8% Expected net CF, EOY, 1, 2, 3: -0- Swap receive-fixed rate always 8% Beginning of year 1: current LIBOR 8% Expected LIBOR at EOY 1, 2: 8% Expected CF, EOY 1, 2, 3: -0- EOY 1, BOY 2: current LIBOR 6% Expected LIBOR at EOY 2, 3: ?? Expected net CF, EOY 2, 3: ?? Swap receive-fixed rate always 8% Beginning of year 1: current LIBOR 8% Expected LIBOR at EOY 1, 2: 8% Expected net CF, EOY 1, 2, 3: -0- EOY 1, BOY 2: current LIBOR 6% Expected LIBOR at EOY 2, 3: 6% Expected net CF, EOY 2, 3: ?? Swap receive-fixed rate always 8% Beginning of year 1: current LIBOR 8% Expected LIBOR at EOY 1, 2: 8% Expected net CF, EOY 1, 2, 3: -0- EOY 1, BOY 2: current LIBOR 6% Expected LIBOR at EOY 2, 3: 6% Expected net CF, EOY 2, 3: +$20,000 Swap receive-fixed rate always 8% Beginning of year 1: current LIBOR 8% Expected LIBOR at EOY 1, 2: 8% Expected net CF, EOY 1, 2, 3: -0- EOY 1, BOY 2: current LIBOR 6% Expected LIBOR at EOY 2: 6% Expected net CF, EOY 2, 3: +$20,000 EOY 2, BOY 3: current LIBOR 10% Expected net CF, EOY 3: ?? Swap receive-fixed rate always 8% Beginning of year 1: current LIBOR 8% Expected LIBOR at EOY 1, 2: 8% Expected net CF, EOY 1, 2, 3: -0- EOY 1, BOY 2: current LIBOR 6% Expected LIBOR at EOY 2: 6% Expected net CF, EOY 2, 3: +$20,000 EOY 2, BOY 3: current LIBOR 10% Net CF, EOY 3: -$20,000

**End of Year 1**
Swap value: Present value of ordinary annuity, +20,000, 2 years, 6% = 36,668 Swap Receivable 36,668 OCI 36,668 (Record FV of cash flow hedge swap) CF Hedge Other Income: -0- OCI: $36,668

**End of Year 2**
Record Interest Earned on Swap Swap Receivable 2,200 OCI 2,200 Receive payment on swap Cash 20,000 Swap Receivable 20,000 Interest revenue on investment is hedged item affecting income; reclassify OCI Reclass. adj. 20,000 Interest Revenue 20,000 Swap value: Present value of ordinary annuity, -20,000, 1 year, 10% = ($18,182) OCI 37,050 Swap Payable 18,182 Swap Receivable 18,868 (Record FV of CF hedge swap) CF Hedge Other Income: -0- OCI: $(??????)

**End of Year 3**
No new types of journal entries CF Hedge other income: -0- OCI: ??????

**Summary**
A cash flow hedge provides protection against exposure to *fluctuations in the cash flows associated with a hedged item* caused by variable rates, terms or prices.
SFAS 133 Accounting Model Derivative measured at fair and recognized as an asset/liability Hedged item's carrying amount remains unchanged Change in FV of derivative is compared to change in future cash flows (or PV of future cash flows) Difference may go either to OCI or current earnings

F/X

Hedging Foreign Currency Exposure

**Agenda**
Brief history concerning the FX section of SFAS 133
Review of FX provisions prior to amendment by SFAS 138
Overview of revised FX hedge accounting
Fair value FX hedging
Cash flow FX hedging
Hedging net investments in foreign operations

**Brief History**
Basic idea was to avoid reinventing the wheel: Preserve the basic elements of SFAS 52 Expand the "hedging provisions" of SFAS 52 to address forecasted transactions Ensure the fundamentals of the D&H document were followed
These objectives led to certain frustrating "anomalies"

**Basic Principles of SFAS 52**
Functional Currency: "An entity's functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash."
Translation of foreign currency statements
Foreign currency transactions: Transaction gains or losses generally included in net income Specific transaction gains or losses excluded from net income: Hedges of net investments in a foreign entity Long-term intercompany foreign currency transactions Gains or losses on transactions (including FX forwards) intended to hedge a foreign currency firm commitment

**The *Initial* Impacts of SFAS 133**
All derivative instruments recognized and measured at fair value
Recognized assets and liabilities giving rise to foreign currency transaction gains or losses under SFAS 52 could not be hedged.
Nonderivative instruments giving rise to transaction gains or losses could be designated as hedging instruments (but only for hedges of FX firm commitments and net investments in foreign operations)
Hedges for forecasted transactions were permitted
SFAS 133 initially provided for some "subtle" yet significant changes to the accounting model for FX exposures

Eligible Hedge Accounting Was
More Limited Prior to SFAS 138
A fair value hedge of a foreign-currency-denominated: (1) firm commitment (excludes intercompany) or (2) available-for-sale security (debt and certain equity securities)
A cash flow hedge of a foreign-currency-denominated (1) forecasted transaction (including intercompany), (2) unrecognized firm commitment, or (3) AFS debt security
A hedge of a net investment in a foreign operation (similar to existing approach under SFAS 52)
"Natural hedging" was a significant part of SFAS 133 prior to the recent amendment

**FX Hedging Subsequent to SFAS 138**
Proposed amendment removes the preclusion from hedging recognized assets or liabilities that give rise to foreign currency transaction gains or losses Reduces (but will not always eliminate) P&L volatility Permits hedging with certain compound derivatives (e.g., one that alters both interest rate and currency characteristics)
Issues remain regarding hedges of net investments of foreign operations.

Revised Fair Value and
Cash Flow Hedging
Hedged Item	Fair Value Hedge	Cash Flow Hedge
Forecasted FX denominated (FXD) transactions
Forecasted intercompany transactions
Unrecognized FXD firm commitment
Recognized fixed-rate FXD asset or liability	¹	¹
Recognized AFS equity security
Recognized variable-rate FXD asset or liability	¹	¹
Ability to designate as a fair value hedge or a cash flow hedge depends on whether the resulting cash flows are totally fixed

**General Prerequisites to FX Hedge Accounting**
Must meet general requirements for fair value or cash flow hedging
Hedged transaction is denominated in a currency other than the hedging unit's functional currency
Operating Unit that has the FX exposure must either: - Be party to the hedging instrument - Benefit from a hedge designated by another member of the consolidated group that has the same functional currency as the operating unit
If a unit other than the operating unit designates the hedge: - The operating unit will not obtain hedge accounting in its stand-alone financial statements - There may be no intervening subsidiaries with a different functional currency from the operating unit

**Example 1: Illustrating FX Fair Value Hedge Accounting**
GECC (functional currency being the US Dollar), on January 3, 200X, borrows 100 million fixed-rate Euro (EUR) at a yield to maturity of 5.68 percent. The loan has a term of 5 years and pays an annual coupon of 5.68 percent. This yield at inception is equivalent to Euribor plus 0.52 percent or (on a swapped basis) to USD LIBOR plus 0.536 percent. Also on January 3, 200X, GECC enters into a 5-year cross-currency swap in which it will receive fixed EUR at a rate of 5.68 percent on EUR 100 million and pay floating USD at USD LIBOR plus 0.536 percent on USD 102 million. There will be a final exchange of principal on maturity of the contract. Both the debt and the swap will pay coupons annually on December 31. The company designates the cross-currency swap as a fair value hedge of the changes in the fair value of the loan due to both interest and exchange rates.

**Fair Value Hedges of FXD AFS Debt Securities**
Entire change in fair value (including changes from FX) of an FXD AFS debt security is generally included in OCI
If the FXD AFS debt security is designated as a hedged item in a fair value hedge: - Changes in fair value of the derivative included currently in earnings - Changes in fair value of the AFS debt security attributable to FX is also reported currently in earnings
If the FXD AFS debt security is designated as a hedged item in a cash flow hedge (Fixed rate FXD swapped to Fixed rate functional currency denominated): - Changes in fair value of the derivative included in OCI - Changes in fair value of the AFS debt security attributable to FX remains reported currently in OCI - Changes in fair value of the derivative are removed from OCI into earnings as the interest income is recognized on the FXD AFS debt security

**Fair Value Hedges of AFS Equity Securities**
To qualify for hedge accounting, the equity security must expose the unit to FX risk: - Security is not traded in the investor's functional currency - Dividends (if any) on the security are all denominated in the same foreign currency expected to be realized upon sale
If the FXD AFS debt security is designated as a hedged item: - Changes in the fair value of the derivative included currently in earnings - Changes in fair value of the AFS equity security attributable to FX is also reported currently in earnings

Additional Provisions for FX
Cash Flow Hedges
If the forecasted transaction is a group of individual forecasted FXD transactions, a forecasted inflow and a forecasted outflow of foreign currency cannot both be included in the same group
If the hedged item is a recognized FXD asset or liability, ALL variability in the hedged item's functional-currency-equivalent cash flows must be eliminated (including variability other than FX exposures)
Internal derivatives can be used in hedging certain cash flow exposures (details to be discussed later in the presentation)

Example 2: Illustrating FX Cash Flow
Hedge Accounting
On July 1, 1999, GECC, (USD functional currency entity) issues a zero-coupon debt instrument with a notional amount of FC154,766.79 for FC96,098.00. The interest rate implicit in the debt is 10 percent. The debt will mature on June 30, 2004. GECC enters into a forward contract to buy FC154,766.79 in 5 years at the forward rate of 1.090148194 (USD cost $168,718.74) and designates the forward contract as a hedge of the variability of the USD functional currency equivalent cash flows on the debt. Because the currency, notional amount, and maturity of the debt and the forward contract match, GECC concludes that no ineffectiveness will result. The USD interest rate implicit in the forward contract is 11.028 percent.

Hedging Net Investment in
Foreign Operations
What once seemed to be the more *friendly* part of SFAS 133 has become a frustration
On the surface: - Changes in fair value of the hedging derivative or non-derivative are included in CTA - Ineffectiveness recognized currently in earnings

Determining Ineffectiveness in a Net
Investment Hedge
Ineffectiveness is caused by the following (DIG Issue H8): - The notional amount of the hedging instrument being different from the hedged net investment - The hedging instrument is denominated in a different currency from the hedged net investment - Use of multiple underlyings: certain derivatives with multiple underlyings can be used for hedged accounting: Pay floating-rate, receive floating-rate cross currency interest rate swaps Pay fixed-rate, receive fixed-rate cross currency interest rate swaps
Ineffectiveness in a net investment hedge is measured: - By comparing the changes in fair value of the hedging instrument with changes in the fair value of a hypothetical forward contact with appropriate terms and the same maturity as the actual hedging instrument (if hedging with a derivative) Transaction gains or losses arising from a non-derivative with the same "notional" amount denominated in the same currency as the hedged item - If the net of tax approach is used, the "hypothetical" hedging instruments are adjusted for the appropriate tax rate

Assessing Effectiveness of Net Investment
Hedges (DIG Issue H7)
Assuming the beginning balance (or specified portion thereof) of the net investment is documented as the basis for assessing hedge effectiveness: - Effectiveness is assessed each time financial statements or earnings are reported and, at least, every three months - An entity is not required to redesignate hedging relationships more frequently that that, even when a significant transaction occurs (e.g., a dividend) in the interim period

**Problems With Net Investment Hedging**
Problem 1 for GECC: - DIG determined (DIG Issue H8) that the "perfect" net investment hedge is an appropriate FXD forward - GECC cannot choose to designate only the intrinsic value changes in the forward contract for assessing effectiveness - Therefore, the entire "effective" change in the fair value of the forward is included in CTA, resulting in: Interest expense that is not properly reflective of rates in the foreign denominated environment Gains or losses ("hedge costs") inappropriately pent up in OCI
Problem 2 for GECC: - DIG determined (DIG Issue H10) that the combination of FXD debt and a derivative cannot, in tandem, be used to hedge a net investment - Consider the following example: GECC Operating Sub requires Japanese Yen (JPY) funding GECC Treasury determines the most cost effective funding strategy is for Treasury to borrow in Euros and swap the Euros to JPY - Could move the Euro borrowing and related FX swap to a JPY functional currency entity

**Using Internal Derivatives in FX Hedges**
SFAS 138 introduces the concepts of: - A Hedging Affiliate: Party in a consolidated group that has a FX exposure that is being hedged. In the GECC environment it might be an operating entity that has originated or acquired an asset denominated in a foreign currency - Issuing Affiliate: Party in a consolidated group that has issued an intercompany derivative to the Hedging Affiliate. In the GECC environment this would most likely be GECC treasury
Hedges using internal derivatives survive in consolidation only: - For specified FX cash flow exposures - If, from the perspective of the Hedging Affiliate, the relevant conditions (paragraph 40) for foreign currency cash flow hedge accounting is satisfied - If the Issuing affiliate, either: Enters into a derivative contract with an unrelated third-party to offset the exposure resulting from the internal derivative The provisions for offsetting net exposures (paragraph 40B of SFAS 138) have been met

Use of Non-derivative Financial Instruments
as F/X Hedging Instruments
Permitted to hedge fair value of foreign-currency denominated firm commitments	} 1
Permitted to hedge net investment in foreign operation
Cannot be used to hedge recognized assets or liabilities or forecasted transactions (Reversal of EITF Issues 96-15 & 97-7)
1 These continue to be the only two circumstances under SFAS 133 in which nonderivative instruments qualify for hedge accounting (nonderivative instrument used is marked to spot rates, not market value)

Potential Advantage of Using a
Nonderivative to Hedge a Net Investment
Consider the following facts - GECC has a foreign operation with yen functional currency - GECC Treasury decides to "hedge" that net investment by funding it operations in Japanese Yen (JPY)
Hedging with a non derivative vs. using a derivative (assume no ineffectiveness)
FCD CASH INSTRUMENTS MAY PROVIDE HEDGING SOLUTIONS BUT AT AN ADDED COST

**Summary**
Provisions of SFAS 52 still applicable
Hedge accounting limited expanded by SFAS 138 to include recognized assets or liabilities that give rise to FX transaction gains and losses
Approaches to cash flow and fair value hedges generally apply; however, there are a number of special rules that apply only to FX