0
Derivatives: Practical Issues in Implementing the Standard Eric S. Berman, MSA, CPA Deputy Comptroller  Commonwealth of Ma...
One Investor’s View <ul><li>Charlie [Munger, Buffett's partner in managing Berkshire Hathaway] and I are of one mind in ho...
Additional Buffetisms <ul><li>The range of derivatives contracts is limited only by the imagination of man (or sometimes, ...
Additional Buffetisms <ul><li>Like Hell , [derivatives] are easy to enter and almost impossible to exit. In [derivatives],...
Agenda for Today <ul><li>Common Definitions </li></ul><ul><li>Types of Derivatives Preparers and Auditors Encounter </li><...
What Are Derivatives? <ul><li>A Derivative is an instrument (financial or otherwise) whose value depends on the value of a...
Derivatives in other words <ul><li>The definition of a  derivative  itself is a financial instrument or other contract wit...
Derivatives in other words <ul><li>It requires  no initial net investment  or an initial net investment that is  smaller t...
Derivatives in other words <ul><li>Its terms require or permit  net settlement , it can readily be settled net by a means ...
Derivatives Notional amounts outstanding, 1987-present Source: International Swaps and Derivatives Association, Inc., 2007...
Common Definitions to Know <ul><li>Underlyings  are the unrelated assets that are used to gauge the value of the derivativ...
Common Definitions to Know <ul><li>A  hedge   is a contract entered into to reduce some form of risk. </li></ul><ul><li>He...
Common Definitions to Know <ul><li>A  cap  is where parties enter into an agreement in exchange for a premium in order to ...
Common Definitions to Know <ul><li>Compound derivatives  are where an entity enters into multiple derivatives within the s...
Common Definitions to Know <ul><li>Fair value hedge  – A derivative instrument that offsets fair value changes in hedgable...
Common Definitions to Know <ul><li>Forwards – Continued </li></ul><ul><ul><li>Generally, no money changes hands on the ori...
Common Definitions to Know <ul><li>Floater  is another term for variable rate interest debt </li></ul><ul><li>Future  - An...
Types of Derivatives that Accountants Encounter % of notional amounts outstanding – as of June 2006 –  Source Bank for Int...
Types of Derivatives that Preparers and Auditors Encounter <ul><li>Swaps </li></ul><ul><ul><li>The MOST prevalent derivati...
Types of Derivatives that Preparers and Auditors Encounter <ul><li>Swaps – Example </li></ul><ul><ul><li>An Investment Ban...
Plain Vanilla Swap <ul><li>On 3/1/xx, an agreement is struck wherein for the next 3 years, every six months, Investment Ba...
How to Calculate the swap <ul><li>Each actual payment (“difference check”) equals the difference between the interest rate...
The Cash Flows to Investment Bank from Government ---------Millions of Dollars--------- LIBOR FLOATING  FIXED  Net Date Ra...
A Closer Look at the Cash Flows on September 1, 200x <ul><li>Floating Payment: </li></ul><ul><ul><li>Based on the 6-month ...
“ Plain Vanilla” Swap involving a government that issues bonds Why did this government enter into this transaction??? INVE...
What Preparers need to worry about <ul><li>Similar items already being done for 2003-1 </li></ul><ul><ul><li>Fair values o...
What Preparers need to worry about <ul><li>Disclosure Items </li></ul><ul><ul><li>Summary of activity during the period by...
Evel Knievel’s Foray into Derivatives and Hedging – September 8, 1974
Why Do Derivatives? <ul><li>How did Evel Hedge Risk? </li></ul><ul><li>Two ways to view Risk </li></ul><ul><ul><li>Some In...
The Goals of Risk <ul><li>Financial goal – reduce the variability of cash flows, though can never eliminate it </li></ul><...
Governments are Generally Risk Averse <ul><li>Reasoning: </li></ul><ul><ul><li>Managers are  risk averse – why? </li></ul>...
4 Basic Risks Hedging Attempts to Cure <ul><li>Market Risk (including prices and interest rates) </li></ul><ul><li>Credit ...
Key to Hedge Success – Is it Effective? <ul><li>Hedge effectiveness is somewhat in the eye of the beholder, but can be cal...
Keys to Effectiveness <ul><li>General requirements are the following: </li></ul><ul><ul><li>Management  intends  and  docu...
Keys to Effectiveness <ul><li>Methods to evaluate include </li></ul><ul><ul><li>Qualitative </li></ul></ul><ul><ul><ul><li...
What Preparers Need to Worry About - Hedges <ul><li>Hedge Effectiveness Calculation </li></ul><ul><li>Disclosure </li></ul...
However, Hedges have Risks
However, Hedges have Risks
Upcoming SlideShare
Loading in...5
×

PPT

1,794

Published on

0 Comments
1 Like
Statistics
Notes
  • Be the first to comment

No Downloads
Views
Total Views
1,794
On Slideshare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
Downloads
30
Comments
0
Likes
1
Embeds 0
No embeds

No notes for slide
  • From his shareholders letter – March 8, 2002
  • Underlying variable - could be interest rates, CPI, the price of gold, weather, oil prices - anything
  • Underlyings are also known as reference rates. Reference rates can be: a. A security price or security price index b. A commodity price or commodity price index c. An interest rate or interest rate index d. A credit rating or credit index e. An exchange rate or exchange rate index f. An insurance index or catastrophe loss index g. A climatic or geological condition (such as temperature, earthquake severity, or rainfall), another physical variable, or a related index. A reference rate also may be any variable whose changes are observable or otherwise objectively verifiable. Frequent reference rate cited is the London Interbank Offered Rate or LIBOR or the Bond Market Association Rate (BMA) The notional amount is the number of currency units, shares, bushels, pounds, or other units specified in the derivative instrument. The notional amount multiplied by the reference rate produces the derivative instrument’s variable payment.
  • Net investment is also known as leverage
  • Net settlement means that a government or counterparty may end its rights or obligations under a contract by receiving or making, respectively, one payment for only the changes in value that have occurred since entering the derivative. For example, a government enters into a forward contract with a supplier to purchase in 6 months a certain quantity of natural gas that has a fair value of $5,000. Six months later, that quantity of natural gas has a value of $7,000. With a gross settlement, the government would make a payment of $5,000 and receive $7,000 of natural gas. With a net settlement the supplier would make a settlement payment to the government of $2,000. In that case, the government would not take delivery of the natural gas.
  • Again - Underlyings may be the value of a commodity, currency, common stock, price, interest rate or other index. For example, the notional on 5,000 bonds with a face value of US$1,000 each is US$5,000,000.
  • Effective Hedges are commonly described as having cash flows that offset between 80 and 120% of related indebtedness’ cash flow. Hedges are deemed effective under GASB’s rules if: The hedging instrument is a derivative instrument, referred to as a hedging derivative instrument (further described in paragraph 22). b. The hedging derivative instrument is associated with a hedgeable item. (Hedgeable items are further described in paragraph 26–26.) Association is established by consideration of the facts and circumstances of the potential hedge including whether: (1) The notional amount of the derivative instrument is consistent with the principal amountof the issued debt or the quantity of the commodity. (2) The derivative instrument will be reported in the same fund as the hedgeable item. (3) The term of the derivative instrument is consistent with the term of the hedgeable item. c. The hedge is effective (further described in paragraphs 27–42). Hedges can be between a government and a component unit, but not WITHIN a government (e.g. between a city and a city utility department.)
  • This is a common derivative that homeowners participate in, knowing little about what they have just entered into. A homeowner with a variable interest rate mortgage may have terms in the mortgage note limiting their variable interest rate to say 12% while the current variable interest rate may be 4.65% for a five-year adjustable rate mortgage. For example, to contain variable rate interest, an issuer may enter into a contract to pay a minimum of 4%, varying to a maximum of 12%, thereby also using a cap and a floor .
  • For example, an entity may have entered into an interest rate swap with an embedded equity option to hedge outstanding debt with an embedded equity feature, such as a bond whose principal amount increases with specified percentage increases in the S&amp;P 500 index. Compound derivatives may also be hybrid derivatives or synthetic derivatives . For example, using a swap in conjunction with a variable rate debit issuance derives a synthetic fixed rate. Credit Derivatives - One party sells insurance while another party buys the seller’s insurance against the default of the debt issuer. For example, suppose that two counterparties, a market maker and an investor, enter into a two-year credit default swap
  • For example, a government may establish a fair value hedge by entering a futures contract to hedge its commitment to purchase fuel in the future at a fixed price . If fuel prices fall, gains from this futures contract would provide payments to the government, reducing the net cost of the commodity to the government. Likewise, a government may establish a fair value hedge by entering into an interest rate swap to hedge interest rate risk associated with its fixed-rate debt. If interest rates fall, gains from the swap would provide payments to the government, reducing net interest costs.
  • Interest rate swaps are probably the most common type of derivative. A debt issuer exchanges an interest payment stream with another debt issuer based on an underlying principal balance. These can be swapping variable rate payments for fixed rate payments or vice versa. A swaption is an option on a swap. These are rights to enter into swap agreements either currently, or in the future, in exchange for a premium. They may be put swaptions, where the owner of the swaption has the right to pay fixed rates and receive floating rates, or a call swaption, which is the opposite. They may be callable or putable, with a right to sell or buy before the maturity date.
  • Foreign exchange includes currencies and forwards Interest rates include forward rates, options and swaps – Swaps by far the most prevalent -56% of all derivatives Equities are linked to stocks, mainly stock options Commodities include gold options and other – mainly oil, crops etc. Credit defaults are insurance risk contracts Foreign exchange and interest rate contracts are the most
  • Drawing a swap is the easiest way to understand this – see that the government is making about 0.4% on the deal The LIBOR is among the most common of benchmark interest rate indexes used to make adjustments to adjustable rate debt
  • Parachute Ramp arched upward Large contingent of mechanics and other crew Betters were on both sides – could he make it – maybe not? Evel decreased risk by using a parachute and a crew, increased risk by using rocket fuel The jump, on Sept. 8, 1974, was nearly a total disaster. Crowds rioted the previous night because of excessive beer and concession prices. The parachute accidentally deployed when the Sky-Cycle was launched, and strong headwinds blew Knievel back into the canyon where he crashed, 600 feet below, just a few feet from the swirling waters of the river. Twelve thousand people trampled restraining fences to try to get to the edge of the canyon and see what had happened. Miraculously, Evel Knievel walked away with only minor injuries. Also of course playing into the derivative was that Richard Nixon was pardoned by Gerald Ford that day, further enhancing the distrust of government!
  • Market risk is the chance that the price of an underlying asset or liability will go up or down in a given period or, indirectly, that there will be no exchange available to accept the underlying asset or liability if there is a need for it to be sold. Ultimately, these changes affect the fair market value of debt or assets as reported or the cashflows of the entity. This risk of non-exchange is sometimes termed “exchange risk”. Credit risk is the probability that the value of the underlying asset or liability will change if the parties to a transaction fail to meet their own obligations. There are three components of credit risk: the probability of default; the depth of exposure and the method of recovery; or cure. In governmental debt issuances that this author has entered into in the course of his career, credit risk of the debt issuances was mitigated by securing the debt with a related underlying loan obligation’s worth. The loans financed by the debt were further secured by the ability to intercept municipal aid payments from the state government to the municipality if there was ever a default. This intercept would occur in a matter of hours, thereby affording the debt holder an amount of risk equal to the risk that the state will not act to cure the default. Furthermore, a debt service reserve fund backed these bonds ranging from one-third to one-half of the outstanding principal. The debt service reserve fund was invested in over-collateralised guaranteed investment contracts, with maturities that aligned to the bond principal maturity dates. Because of the ability to intercept the value of the debt service reserve fund and the breadth of the program of debt issuance, these particular bonds are afforded the highest credit ratings. Basis risk is defined as the “spread” between the price of the asset or obligation in the future and the price that the derivative contract is based upon today. Basis risk arises because the value of the underlying asset or liability is based on a different index or set of assumptions than the related derivative. This is especially prevalent in long-term contracts. In a contract to sell grain three months from now, a farmer will enter into an agreement to sell at a price estimated for that commodity in 90 days. The differential between that price and today is basis risk. Rollover or termination risk. These risks occur when a derivative contract matures before an underlying debt instrument matures and a new derivative hedge cannot be entered into at similar terms. At the point of maturity or termination, a payment may also have to ensue between the debt issuer and the counterparty. Should the derivative terminate early, a large payment usually occurs between either party, depending on the agreement due to the spread between interest rates at termination and interest rates assumed when the contract was entered into. Standard termination events are usually written into derivative contracts, including failure to pay and bankruptcy. It is preferable that the ability to terminate is held at the party issuing the debt, not at the counterparty, as the debt issuer would then control more of the derivative’s destiny.
  • Hedge effectiveness generally falls in the range of 90 to 111%. For example, if the loss on the hedging instrument is 110 and the gain on the cash instrument is 100, offset can be measured by 110/100, which is 110%, or by 100/110, which is 91%. The enterprise will conclude that the hedge is highly effective. A hedge is ineffective if the issuer cannot predict the cashflows from the hedge. Dollar offset method allows 80-125%
  • Intent includes identification of hedging instrument, the hedged item or transaction, nature of risk being hedged, how management will assess the risk effectiveness – e.g. changes in fair value or cash flows
  • Terms – is principal = to notional amount at inception? Is fair value of swap = 0? Is formula the same in computing values throughout the swap? Are indexes used to evaluate the same? Fair value hedges can’t have a prepayable asset or liability associated with it. Expiration dates have to be the same. No floors or caps can be used. For cash flow hedges, interest receipts / payments OK to be shorter than the life of the debt / asset. No floors or caps can be used as they limit cash flows. Repricing dates are approximately the same as on the underlying debt or asset. Synthetic instruments method – hedged item + derivative are combined to create a third synthetic instrument- e.g. synthetic fixed rate. In these cases, all items apply, but repricings must be at least every 90 days. Dollar offset method – (fair value from current period less the prior period) ÷ (fair value from current period less the prior period) should be between 80 and 125% (wider than most effective hedges) Regression analysis method – use statistical regression to measure cash flow likeness – must use 95% confidence that cash flows are within 80 to 125%
  • Source: Banque de France – Special issue on hedge funds – April 2007
  • Transcript of "PPT"

    1. 1. Derivatives: Practical Issues in Implementing the Standard Eric S. Berman, MSA, CPA Deputy Comptroller Commonwealth of Massachusetts June 27, 2007
    2. 2. One Investor’s View <ul><li>Charlie [Munger, Buffett's partner in managing Berkshire Hathaway] and I are of one mind in how we feel about derivatives and the trading activities that go with them: </li></ul><ul><li>We view them as time bombs, both for the parties that deal in them and the economic system. </li></ul>
    3. 3. Additional Buffetisms <ul><li>The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem-- at a price, you will easily find an obliging counterparty. </li></ul>
    4. 4. Additional Buffetisms <ul><li>Like Hell , [derivatives] are easy to enter and almost impossible to exit. In [derivatives], once you write a contract--which may require a large payment decades later--you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability. </li></ul>
    5. 5. Agenda for Today <ul><li>Common Definitions </li></ul><ul><li>Types of Derivatives Preparers and Auditors Encounter </li></ul><ul><li>Why Do Derivatives? - Hedging </li></ul>
    6. 6. What Are Derivatives? <ul><li>A Derivative is an instrument (financial or otherwise) whose value depends on the value of an underlying variable. </li></ul><ul><li>What does it mean to you? </li></ul><ul><li>What is the point of entering into a Derivative contract? </li></ul>
    7. 7. Derivatives in other words <ul><li>The definition of a derivative itself is a financial instrument or other contract with all three of the following characteristics: </li></ul><ul><li>It has (i) one or more reference rates and (ii) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required. </li></ul>
    8. 8. Derivatives in other words <ul><li>It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts expected to have a similar response to changes in market factors. </li></ul>
    9. 9. Derivatives in other words <ul><li>Its terms require or permit net settlement , it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. </li></ul>
    10. 10. Derivatives Notional amounts outstanding, 1987-present Source: International Swaps and Derivatives Association, Inc., 2007 $327.3 trillion in 2006
    11. 11. Common Definitions to Know <ul><li>Underlyings are the unrelated assets that are used to gauge the value of the derivative. </li></ul><ul><li>The value of the derivative is the value of the underlying times a notional quantity. </li></ul><ul><li>The notional rate is the current, floating interest rate applied to bonds </li></ul>
    12. 12. Common Definitions to Know <ul><li>A hedge is a contract entered into to reduce some form of risk. </li></ul><ul><li>Hedges that accomplish the goal of reducing risk as expected are commonly referred to as effective . </li></ul>
    13. 13. Common Definitions to Know <ul><li>A cap is where parties enter into an agreement in exchange for a premium in order to limit interest rate risk. </li></ul><ul><ul><li>Can you describe a common cap? </li></ul></ul><ul><li>Cashflow hedges use cash inflows based on periodic interest rates </li></ul><ul><li>Collars limit interest rate exposure to a specified range in the contract. </li></ul>
    14. 14. Common Definitions to Know <ul><li>Compound derivatives are where an entity enters into multiple derivatives within the same contract. </li></ul><ul><ul><li>Synthetic Derivatives </li></ul></ul><ul><li>Credit derivatives or risk swaps are contracts where two parties join to insure a third party’s debt issuance. </li></ul><ul><li>A currency swap is where parties exchange specific amounts of foreign currencies at the time of contract and repay each other at specified intervals and at rates based on fixed interest rates in each currency. </li></ul>
    15. 15. Common Definitions to Know <ul><li>Fair value hedge – A derivative instrument that offsets fair value changes in hedgable items </li></ul><ul><li>Forward - A forward contract gives the owner the right and obligation to buy a specified asset on a specified date at a specified price. </li></ul><ul><ul><li>The seller of the forward contract has the right and obligation to sell the asset on the date for the price. </li></ul></ul>
    16. 16. Common Definitions to Know <ul><li>Forwards – Continued </li></ul><ul><ul><li>Generally, no money changes hands on the origination date of the forward contract. </li></ul></ul><ul><ul><li>However, collateral may be demanded. </li></ul></ul><ul><ul><li>Delivery options may exist concerning </li></ul></ul><ul><ul><ul><li>the quality of the asset </li></ul></ul></ul><ul><ul><ul><li>the quantity of the asset </li></ul></ul></ul><ul><ul><ul><li>the delivery date </li></ul></ul></ul><ul><ul><ul><li>the delivery location. </li></ul></ul></ul><ul><ul><li>If your position has value, you face the risk that your counterparty will default. </li></ul></ul>
    17. 17. Common Definitions to Know <ul><li>Floater is another term for variable rate interest debt </li></ul><ul><li>Future - An option to purchase or sell a commodity, instrument, asset, liability, index or other item at a specific time in the future. </li></ul><ul><li>Interest Rate Swap </li></ul><ul><li>Swaption </li></ul>
    18. 18. Types of Derivatives that Accountants Encounter % of notional amounts outstanding – as of June 2006 – Source Bank for International Settlements
    19. 19. Types of Derivatives that Preparers and Auditors Encounter <ul><li>Swaps </li></ul><ul><ul><li>The MOST prevalent derivative in the market </li></ul></ul><ul><ul><li>A swap is an agreement between counter-parties to exchange cash flows at specified future times according to pre-specified conditions. </li></ul></ul><ul><ul><li>A swap is equivalent to a coupon-bearing asset plus a coupon-bearing liability. The coupons might be fixed or floating. </li></ul></ul>
    20. 20. Types of Derivatives that Preparers and Auditors Encounter <ul><li>Swaps – Example </li></ul><ul><ul><li>An Investment Bank agrees to pay a fixed payment and receive a floating payment, from a Government. </li></ul></ul><ul><ul><ul><li>Investment Bank is the fixed rate payer-floating rate receiver (the “pay-fixed” party). </li></ul></ul></ul><ul><ul><ul><li>Government is the fixed rate receiver-floating rate payer (the “receive-fixed” party). </li></ul></ul></ul><ul><ul><li>Typically, there is no initial exchange of principal (i.e., no cash flow at the initiation of the swap). </li></ul></ul>
    21. 21. Plain Vanilla Swap <ul><li>On 3/1/xx, an agreement is struck wherein for the next 3 years, every six months, Investment Bank receives from Government, a payment on a notional principal of $100 million, based on the 6 month LIBOR rate. Investment Bank makes a fixed payment on the same notional principal to Government, based on a rate of 5.75% per annum. </li></ul><ul><li>You need to know the fixed rate. </li></ul><ul><li>You need to know the variable (floating) rate. </li></ul><ul><li>You need to know notional principal. </li></ul><ul><li>Note that 6-month LIBOR at origination is R 0 = 5.36%. </li></ul><ul><li>The next two slides illustrate the cash flows. </li></ul>
    22. 22. How to Calculate the swap <ul><li>Each actual payment (“difference check”) equals the difference between the interest rates times NP times #days between payments over 360, or #days/365. </li></ul><ul><li>The time “t” variable cash flow is typically based on the time t-1 (this period minus 1) floating interest rate. </li></ul><ul><li>Thus, the first floating cash flow, based on the rate, R 0 , is known: it is 5.36%. </li></ul><ul><li>All subsequent floating cash flows are random variables as of time zero (but always known one period in advance). </li></ul>0 Multiply each “R” by NP times #days between payments over 360 (or use a 365-day year)
    23. 23. The Cash Flows to Investment Bank from Government ---------Millions of Dollars--------- LIBOR FLOATING FIXED Net Date Rate Cash Flow Cash Flow Cash Flow Mar.1, 200x 5.36% Sept. 1, 200x 5.4% +2.68 – 2.875 – 0.195 Mar.1, 200y 5.1% +2.70 – 2.875 – 0.175 Sept. 1, 200y 5.2% +2.05 – 2.875 -0.825 Mar.1, 200z 5.3% +2.60 – 2.875 -0.275 Sept. 1, 200z 5.4% +2.15 – 2.875 -0.725 Mar.1, 20aa 5.1% +2.70 – 2.875 - 0.175
    24. 24. A Closer Look at the Cash Flows on September 1, 200x <ul><li>Floating Payment: </li></ul><ul><ul><li>Based on the 6-month LIBOR rate that existed on March 1, 200x: 5.36%. </li></ul></ul><ul><ul><li>($100,000,000)(0.0536)(1/2) = +$2,680,000. </li></ul></ul><ul><li>Fixed Payment: </li></ul><ul><ul><li>Based on 5.75% rate. </li></ul></ul><ul><ul><li>($100,000,000)(0.0575)(1/2) = -$2,875,000. </li></ul></ul><ul><li>Net Cash Flow: -$195,000. </li></ul>
    25. 25. “ Plain Vanilla” Swap involving a government that issues bonds Why did this government enter into this transaction??? INVESTMENT BANK GOVERNMENT BONDHOLDER 5.75% 6 month LIBOR 5.36% 5.75% Pays Receives Pays Receives
    26. 26. What Preparers need to worry about <ul><li>Similar items already being done for 2003-1 </li></ul><ul><ul><li>Fair values of Derivatives need to be as of Statement of Net Assets date </li></ul></ul><ul><ul><li>If derivatives are tied to Business Type Activities – good idea to segregate swap revenues from debt expense </li></ul></ul><ul><ul><li>Non-debt related derivatives may be out there </li></ul></ul>
    27. 27. What Preparers need to worry about <ul><li>Disclosure Items </li></ul><ul><ul><li>Summary of activity during the period by category: fair value hedges, cash flow hedges and investments </li></ul></ul><ul><ul><ul><li>Within category, segregate by type (swaps, caps, swaptions, futures, etc.) </li></ul></ul></ul><ul><ul><ul><li>Similar disclosure to TB 2003-1 </li></ul></ul></ul>
    28. 28. Evel Knievel’s Foray into Derivatives and Hedging – September 8, 1974
    29. 29. Why Do Derivatives? <ul><li>How did Evel Hedge Risk? </li></ul><ul><li>Two ways to view Risk </li></ul><ul><ul><li>Some Investors want to Increase risk to increase potential return </li></ul></ul><ul><ul><li>Some Issuers want to decrease risk to fix costs </li></ul></ul>
    30. 30. The Goals of Risk <ul><li>Financial goal – reduce the variability of cash flows, though can never eliminate it </li></ul><ul><ul><li>Prices are volatile! </li></ul></ul>
    31. 31. Governments are Generally Risk Averse <ul><li>Reasoning: </li></ul><ul><ul><li>Managers are risk averse – why? </li></ul></ul><ul><ul><li>Bondholders are risk averse – why? </li></ul></ul><ul><ul><li>Stakeholders (i.e., employees, suppliers, customers) are risk averse – why? </li></ul></ul><ul><li>So, a reduction in risk should benefit everyone. </li></ul><ul><li>Plus, a decrease in volatility implies a lower cost of finance, and therefore, an increase in net assets. </li></ul><ul><li>Risk aversion: a willingness to pay a premium to reduce risk exposure. </li></ul>
    32. 32. 4 Basic Risks Hedging Attempts to Cure <ul><li>Market Risk (including prices and interest rates) </li></ul><ul><li>Credit Risk </li></ul><ul><ul><li>Probability of default </li></ul></ul><ul><ul><li>Depth of exposure </li></ul></ul><ul><ul><li>Method of recovery (cure) </li></ul></ul><ul><li>Basis Risk (a.k.a. “spread”) </li></ul><ul><li>Rollover or termination risk </li></ul>
    33. 33. Key to Hedge Success – Is it Effective? <ul><li>Hedge effectiveness is somewhat in the eye of the beholder, but can be calculated </li></ul><ul><li>The opposite of an effective hedge is??? </li></ul>
    34. 34. Keys to Effectiveness <ul><li>General requirements are the following: </li></ul><ul><ul><li>Management intends and documents its strategy to reduce risk </li></ul></ul><ul><ul><li>Offsetting occurs consistently </li></ul></ul><ul><ul><li>If cash flow hedge, highly probable </li></ul></ul><ul><ul><li>Measurement can reasonably occur </li></ul></ul><ul><ul><li>Measurement is ongoing and effectiveness is determined throughout the financial reporting period </li></ul></ul>
    35. 35. Keys to Effectiveness <ul><li>Methods to evaluate include </li></ul><ul><ul><li>Qualitative </li></ul></ul><ul><ul><ul><li>Are terms in debt and derivative consistent ( consistent critical terms method) </li></ul></ul></ul><ul><ul><li>Quantitative Methods </li></ul></ul><ul><ul><ul><li>Synthetic instruments method </li></ul></ul></ul><ul><ul><ul><li>Dollar offset method </li></ul></ul></ul><ul><ul><ul><li>Regression analysis method </li></ul></ul></ul>
    36. 36. What Preparers Need to Worry About - Hedges <ul><li>Hedge Effectiveness Calculation </li></ul><ul><li>Disclosure </li></ul><ul><ul><li>Why hedge was entered into </li></ul></ul><ul><ul><li>Terms </li></ul></ul><ul><ul><ul><li>Notional Amounts, Rates, Terms, Options and cash paid or received </li></ul></ul></ul><ul><ul><li>Risks (Similar to TB-2003-1) </li></ul></ul><ul><ul><li>Method for determining effectiveness </li></ul></ul>
    37. 37. However, Hedges have Risks
    38. 38. However, Hedges have Risks
    1. A particular slide catching your eye?

      Clipping is a handy way to collect important slides you want to go back to later.

    ×