Best Practices For Your Hedge Program from Hedge Trackers, LLC

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  • 1. Best Practices For YourHedge Program Helen Kane: Founder & President 6/15/2011
  • 2. Agenda Introduction Hedging Definition Exposure Identification Instruments Hedge Relationships Execution Accounting Valuation Disclosures Performance Reporting © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 3. Introduction – Helen Kane Founder and President of Hedge Trackers Hedge Trackers, LLC provides practical, solutions to exposure management and hedge accounting challenges Direct experience implementing hedge programs and outsourcing derivative accounting for global corporations for over a decade © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 4. Services Currency Risk • Consulting: hedge program implementation and accounting • Outsourcing: derivative accounting AcappellaFX (SAAS) derivative accounting Interest Rate Risk • Consulting: derivative accounting • Outsourcing: derivative accounting Commodity Risk • Consulting: derivative accounting • Outsourcing: derivative accounting © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 5. HedgeHedging versus trading • Hedging: using derivatives to • Limit risk on existing exposures • Exchange less desirable risk for more desirable risk • Floating interest rate for fixed interest rates • Euro cash inflows for USD cash inflows • Floating commodity purchase prices for fixed • Trading: using derivatives to • Create profits from market movements © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 6. Exposure Identification Requirement to identify and quantify market risk exposures that impact normal business operations • Economic Exposure – Exposure to market risk that impact the company’s cash flows • Accounting Exposure – Exposures reflected in company financial statements by application of GAAP – May/may not be economic © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 7. Exposure Identification – Best Practices Document exposure trail through P&L, BS and Cash Flow statement on detail basis Centralize exposure identification/ collection /data mining • Technical, focused resource(s) • Identify entity short/long and net global position Identify opportunities to naturally hedge Centralize exposure location(s) when viable © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 8. Exposure Identification – Best Practices Network • Reach into operations to develop data sources • Exchange data with FP&A • Share – Make hedge information valuable to operations © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 9. Exposure Identification – Controls Ensure that exposures identified for hedging are economic • Validate currency exposures with cash • Shadow balances • Intercompany tax structures • USD held in Foreign Functional Subs • Monitor the quality of data submissions • Anticipated transactions © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 10. InstrumentsForward/futures/swap contracts are used in hedging • To lock in (fix) fluctuating values Use forward to fix USD value of JPY anticipated costs or payables Use interest rate swap to fix % paid on revolver debt • To return a fixed value to floating at market Use futures to return gold held in inventory to market price until sold © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 11. InstrumentsPlain vanilla options are used in hedging • To insure against costs rising Use option to protect LIBOR based interest payments on debt from exceeding X% Use option to protect natural gas costs in manufacturing plant from exceeding X per MMBtu • To insure against revenue values dropping Use option to protect USD value of EUR revenue from dropping below X © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 12. Instruments – Best Practices Increase corporate trader “sophistication” Align instrument tenor with expected cash flows Evaluate instrument types for “Special Hedge Accounting” qualification Inform accounting organization when new derivatives contemplated Train management to understand that losing money on “hedge” is generally good news for the business © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 13. Contrast Current Practice with Proposed PracticeCurrent Practice8M month * 12 months = 96M © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 14. Contrast Current Practice with Proposed PracticeProposed ProgramEUR2-4M a month, EUR8M outstanding each month © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 15. Instruments – Controls Ensure accounting has ability to reliably value the instruments Credit effecting of derivatives greatly increasing difficulty of valuations Segregate trading from confirmation and accounting Appropriate signature authority and disclosures when financing derivative purchases (participating forwards) © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 16. Hedge Relationship – Best Practices Solid understanding of how underlying transaction is executed/priced and how flows through financial statements Ensure that instrument type is appropriate to meet hedge objective • Effectiveness testing – contemplate economic (not just accounting) effectiveness • Match tenor to risk profile • Notional hedged annually closely reflects exposure transactions (not balances) for the year © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 17. Hedge Relationship – ControlsInstrument notional < exposure• Monitoring of hedged item vis a vis derivative(s) • Reflected change in hedge when underlying exposure changes • Capture when exposure changes and rates that govern that change © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 18. Trade ExecutionCounterparty business model: buy low, sell highCounterparties execute trades with varying credit arrangements • Virtually no credit risk • exchange • broker (bilateral posting of collateral) • Credit relationship: increasing ISDA language with unilateral or bilateral credit calls • banks • banks with broker/trading firm intermediary • broker © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 19. Execution – Best PracticesPricing of derivatives reflects • Sophistication of buyer • Complexity of structure (transparency) • Access to pricing information • Transaction size • Access to the market • Liquidity (depth of market, market drama)• Accounting responsibility understands derivative and hedge relationship © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 20. Execution - Controls Pricing visibility Authorized Instrument Authorized Trader Authorized Counterparty Confirms sent directly to accounting responsibility © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 21. AccountingAll derivatives require • Identification • Fair Valued • Recorded as asset/liability (few scope exceptions) • Special hedge accounting supported by qualification of hedged item and appropriate documentation • Inception & ongoing basis • Disclosure © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 22. Accounting – Best PracticesAre all derivatives on the books at fair value • Independent valuations Use market models and inputs Beware of inefficient markets (prices) at year end Contemplate own & counterparty credit in valuation • Understand what they mean • Understand the source © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 23. Accounting – Best PracticesValuations • Understand inputs and sources • Monitor markets for changes in valuation approachesCredit effect derivatives • discounting current position, • discounting possible future positions © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 24. CDS Rates - 2010 © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 25. 3M vs 1M LIBOR – 2010 © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 26. Accounting – Best PracticesProcess to identify “operational derivatives” • Electricity/Natural Gas • 3rd Currency contractsDetailed mapping of hedged item transit through the financial statements © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 27. Accounting – Best PracticesSpecial Hedge Accounting • Detail description of hedged item per derivative • Evaluation of all sources of ineffectiveness in testing protocols • R2, Bslope, T-test, analysis of y-intercept • Like item analysis • Details on measurement approaches • Scenario analysis © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 28. Accounting – ControlsEducation and sophistication in accounting to provide appropriate and effective oversightDirect receipt of confirmationsValidation of valuationsMonitor values in OCI • Record of effectiveness testing • Probability assessment • Calculations: measurement of ineffectiveness • Timing of reclassification to income © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 29. DisclosuresRequirement to provide quantitative and qualitative disclosures about the hedge program. Why and how hedging How accounting for hedges and how monitoring their effectiveness “Tabular requirements” Information about the volume of trades and trade activity © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 30. Disclosures – Best PracticesDevelop data capture and processes for translation of quantitative derivative disclosuresClearly discuss sources of exposure to company and expectations of hedge program © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 31. Disclosures - ControlsRoll forward of OCI information related to cash flow hedgesDistinguish between cash/non-cash timing of derivative and hedge items © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 32. Performance ReportingReporting on the economic effectiveness of the hedge program against economic objectives • Distinct from accounting effectiveness • Performance against net • Meeting budget rate • Delivering margin rate • Addresses objectives © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 33. Performance Reporting – Best Practices Take the mystery out of hedge results Provide consistent and easy to understand metrics and scorecards (graphs improve communication with Sr. Management) Align the objective with performance reporting © 2010 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  • 34. Questions www.hedgetrackers.com 408.350.8580Silicon Valley | Chicago | Los Angeles
  • 35. Answers hkane@hedgetrackers.com Hedge Trackers, LLCSilicon Valley, Chicago, Los Angeles (408) 350-8580 www.hedgetrackers.com