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With rates at historically low levels, reporting entities may want to consider either initiating or expanding hedging strategies. U.S. generally accepted accounting principles requires all interest rate swaps to be recorded at fair value in the financial statements, with the presentation of the change in fair value dependent on the election and application of the hedge accounting requirements. During this webinar, learn more about the application and accounting of interest rate swaps from Mayer Hoffman McCann’s experts.

Join us for this course that will focus on:

Interest rate swap basics — strategies and solutions

The application of ASC 815 to interest rate swaps as cash flow and fair value hedges

Common pitfalls and concerns

Reporting and disclosure requirements

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- 1. EXECUTIVE EDUCATION SERIES:Understanding Interest Rate DerivativesPresented by:Shareholders Tim Woods,Mike Loritz and James ComitoMay 9, 2013
- 2. 2#MHMwebinar To view this webinar in full screen mode, click on viewoptions in the upper right hand corner. Click the Support tab for technical assistance. If you have a question during the presentation, please usethe Q&A feature at the bottom of your screen.Before We Get Started…
- 3. 3#MHMwebinar This webinar is eligible forCPE credit. To receive credit,you will need to answerperiodic polling questionsthroughout the webinar. External participants willreceive their CPE certificatevia email immediatelyfollowing the webinar.CPE Credit
- 4. 4#MHMwebinarThe information in this Executive Education Seriescourse is a brief summary and may not include all thedetails relevant to your situation.Please contact your MHM service provider to furtherdiscuss the impact on your financial statements.Disclaimer
- 5. 5#MHMwebinarToday’s PresentersMike Loritz, CPAShareholder913.234.1226 | mloritz@cbiz.comMike has 17 years of experience in public accounting with diversified financialcompanies and other service based companies, including banking, broker/dealer,investment companies, and other diversified companies ranging from audits ofpublic entities in the Fortune 100 to small private entities. He is a member ofMHMs Professional Standards Group, providing accounting knowledgeleadership in the areas of derivative financial instruments, investment securities,share-based compensation, fair value, revenue recognition and others.Tim Woods, CPAShareholder720.200.7043 | twoods@cbiz.comA member of MHM’s Professional Standards Group, Tim is a subject matterexpert for derivatives and hedge accounting. He also has extensive experiencein leasing transactions, fair value, stock-based compensation, and complex debtand equity transactions. Tim has worked in public accounting, consulting, andprivate industry for the past 20 years, focusing on outsourced CFO consultingand financial statement audits for small and mid size privately held companies.He has extensive experience in accounting for business combinations andvariable interest entities, as well as with issues in leasing, revenue recognition,and foreign exchange.
- 6. 6#MHMwebinarToday’s PresentersJames Comito, CPAShareholder858.795.2029 | jcomito@cbiz.comA member of MHM’s Professional Standards Group, James has expertise in allaspects of revenue recognition, business combinations, impairment of goodwilland other intangible assets, accounting for stock-based compensation,accounting for equity and debt instruments and other accounting issues.Additionally, he has significant experience with a variety of other regulatory andcorporate governance issues pertaining to publicly traded companies, includingall aspects of internal control. In addition, James frequently speaks onaccounting and auditing matters at various events for MHM.
- 7. 7#MHMwebinarToday’s Agenda123Interest Rate Risk – Risk ManagementHedge AccountingValuation & Fair Value Issues
- 8. RISK MANAGEMENT
- 9. 9#MHMwebinarCommon Types of DerivativesOption-BasedInterest rate cap or floorPut or call option (equity)CurrencyForwardAgreementsForward RateForeign exchangeCommodityFuture AgreementsEquityCurrencyCommoditySwapsInterest rateCurrencyCommodityCredit DefaultForward Based
- 10. 10#MHMwebinarMost common is a plain vanilla interest rate swap where: A Company agrees to pay cash flows equal to interest at apredetermined fixed rate on a stated notional principal for astated period and, in return, the Company receives interestat a floating rate on the same notional principal for the sameperiod of time. Company can be the fixed rate payer and the floating ratereceiver or vice versa.Interest Rate Swaps
- 11. 11#MHMwebinarFor example: Company XYZ has outstanding $10,000,000 of non-amortizing variable rate debt for which interest paymentsare due on a quarterly basis. The note accrues interest atthe 3 month London Interbank Offered Rate (“LIBOR”) plus5% and matures via a bullet payment in 5 years. In this case, in order to hedge the Company’s interest raterisk, the Company would enter into a 5 year interest rateswap for a notional amount of $10,000,000 at a swap rate(fixed rate) of 1.50%.Interest Rate Swaps
- 12. 12#MHMwebinar Example cont’d: The Company would pay the fixed rate of 1.5% on the $10,000,000notional amount on a quarterly basis and would receive the 3 monthLIBOR rate on a quarterly basis. The LIBOR received is set a quarterprior to payment so the payment is made 3 months in arrears.Accordingly, the Company knows 3 months in advance what thepayment will be. Payments are settled on a net basis so if the 3 month LIBOR isgreater than 1.5% then the Company will receive a payment. Therefore, the Company has effectively turned its variable rate debtinto fixed rate debt with an effective interest rate of 6.5% (1.5% fixed+ 5% spread).Interest Rate Swaps
- 13. 13#MHMwebinar Example cont’d: FIXED RATE PAYMENT = $10,000,000 * .015 / 4 = $37,500 VARIABLE RATE PAYMENT = $10,000,000 * 3 MONTHLIBOR (3.0%) or .03 / 4 = $75,000 THEREFORE COMPANY RECEIVES: $75,000 - $37,500 = $37,500 AT QUARTERLY SETTLEMENT.THE FIXED RATE PAYMENT WILL BE $37,500 AT EACHSETTLEMENT THE VARIABLE RATE PAYMENT IS THE MOVING COMPONENTAS THE THREE MONTH LIBOR WILL CHANGE.Interest Rate Swaps
- 14. 14#MHMwebinarAn interest rate capis an option thatprovides a payoffwhen a specifiedinterest rateincreases above acertain level (the caprate). The specifiedrate is a floating ratethat is setperiodically.Interest Rate Cap Agreement
- 15. 15#MHMwebinarInterest rate caps can be described by a “term sheet”Interest Rate Caps – TermsMaturity (for example - 5 years)Notional amount (usually set equal to borrowed amount)Strike price (sometimes called the protection level)Frequency (how many payments per year)• Payments per year times maturity tells you how many capletsBasis (how you’re going to count days)Underlying rate (usually LIBOR of some maturity)
- 16. 16#MHMwebinar For Example: Company XYZ has outstanding $10,000,000 of non-amortizing variable rate debt forwhich interest payments are due on a quarterly basis. The note accrues interest at the3 month LIBOR plus 5% and matures via a bullet payment in 5 years. In this case, in order to hedge the Company’s interest rate risk, the Company wouldpurchase a 5 year interest rate cap agreement for a notional amount of $10,000,000which has a cap rate of 1.5% (for example) and designated maturities of 3 months. Forpurposes of this example, the purchase price is $200,000 for the interest rate capagreement. Therefore, given that the Company purchased an interest rate cap agreement with aterm of 5 years and quarterly settlements, the interest rate cap agreement iscomprised of 20 individual cap agreements, or “caplets”, that are settled on a quarterlybasis. As with the interest rate swap, the cap rate is set 3 months prior to settlementand as such, the settlement amount is known 3 months in advance.Interest Rate Cap
- 17. 17#MHMwebinar For Example cont’d: With an interest rate cap, the Company that purchased the cap agreementwill only receive a payment if the 3 month LIBOR closes above the cap rate.At no time will the Company be required to pay additional funds at any of thecaplet settlements. For example, if the 3 month LIBOR rate closes at 3%, the Company willreceive a payment equal to (3% - 1.5%) *10,000,000 / 4 = $37,500. Therefore, the Company has ensured that the effective rate of its debt willnot go above 6.5% (LIBOR of 1.5%, the cap rate, plus the 5% margin on theunderlying debt). However, the Company’s effective rate can go as low asthe market will take it, which is not the situation with the interest rate swap.Interest Rate Cap
- 18. 18#MHMwebinar The swap rate is the fixed rate of interest that the receiver(variable rate payer) demands in exchange for the uncertaintyof having to pay the short-term 3 month LIBOR (floating rate)over the term of the swap. Therefore, at the time that the interest rate swap is entered,the total present value of the fixed rate payments to bereceived (made) is equal to theexpected value of the variablerate payments to be made(received). As such, at the date theswap is entered the value of theswap is $0, which is why there is nopurchase price for the swap(without commissions).Risk Characteristics of Interest Rate Swaps
- 19. 19#MHMwebinar1) interestrate risk2) credit, orcounterparty,riskRisk Characteristics of Interest Rate SwapsTwo primary risks:Interest Rate Risk:• When a company enters into an interest rate swap for purposes of risk management,they are stating that they are comfortable with the effective interest rate that has beenset as a result of entering into the swap.• From the standalone viewpoint of the swap only, swaps entail interest rate risk.• However, when viewed in conjunction with the cash flows of the underlying debt beinghedged, the variable rate receiver has effectively locked in the hedged interest rate atthe time the swap was entered into as the any fluctuations in the variable rate beingreceived will be offset by the variable rate being paid on the underlying debt and theCompany is effectively left with the fixed rate + the margin on the underlying debt.
- 20. 20#MHMwebinarCredit, or Counterparty, RiskSwaps are also subject to thecounterparty’s credit risk: thechance that the other party inthe contract will default on itsresponsibility.• Banks that deal in LIBORand interest rate swapsgenerally have very highcredit ratings of double-A orabove – It is still higher thanthat of a risk-free U.S.Treasury bond.
- 21. 21#MHMwebinarPros• No upfront cash outlay• Effective hedgingvehicle• Locks in an effectiverateCons• No upside participation• Mark to Marketaccounting can havelarge effect on netincome• Credit, non-performance riskPros and Cons – Interest Rate Swaps
- 22. 22#MHMwebinarAn upfront premium isrequired to purchase acap.The value of a capdepends upon thevariability of interest rates;that is, the projectedvolatility of interest rates,over the life of the cap.The longer the maturity ofthe cap, the moreexpensive.A cap provides “insurance”against higher interestrates.The farther out-of-the-money a cap is, that is, thehigher the cap rate, thecheaper it will be. Interest rate caps are option products, and as such,share certain common characteristics with all options:Risk Characteristics – Caps
- 23. 23#MHMwebinar• The only value at risk with an interestrate cap is the premium paid for thecap agreement.• The value of the interest rate capagreement will increase withincreases in interest rates and willdecrease with decreases in interestrates.• All other aspects of the value of theinterest rate cap are the same as forother types of options: Increase in interest rate volatility increasesthe value of the interest rate cap Increase in term, increases the value of theinterest rate cap Increase in cap rate, decreases the value ofthe interest rate cap And vice versaRisk Characteristics – Caps
- 24. 24#MHMwebinarPros• Effective interest raterisk hedging vehiclewith participation ingains from decrease ininterest rates.• Can only losepremium paid, cannotgo to below zero (re:no liability treatment)• Caps interest rateCons• Upfront cash outlay• Mark to Marketaccounting can havelarge effect on netincome although lossesonly to the extentpremium paid.• Credit, non-performanceriskPros and Cons – Interest Rate Caps
- 25. HEDGE ACCOUNTING
- 26. 26#MHMwebinar? From an economicstandpoint, hedging is usingderivative instruments to offsetrisks (or volatility) that arepresent in a company’sbusiness model in order tomaintain a predictableoutcome.• Fair value: maintain the fairvalue of an item• Cash flow: achievepredictable cash flows From an accountingstandpoint, there are specificcriteria that must be met prior toa company’s implementation ofhedge accountingWhat is Hedging?
- 27. 27#MHMwebinar Derivatives that are accounted for as freestanding arerecorded at fair value at each reporting date with thechange recorded in earnings. Derivatives that are accounted for as hedging instrumentsare also recorded at fair value; however, the accountingfor the impact to earnings is based upon the type ofhedge that has been implemented. Regardless of whether hedge accounting is utilized, ALLderivatives are recorded on the balance sheet at theirestimated fair value.What is Hedging?
- 28. 28#MHMwebinarFair value hedge - Economic purpose isto enter into a derivative instrument whose changes infair value directly offset the changes in fair value of thehedged item (i.e. item has fixed cash flows).Foreign currency hedge - If thehedged item is denominated in a foreign currency, thenan entity may designate the hedge as either of theabove or a net investment hedge.What is Hedging?Cash flow hedge - Economic purpose isto enter into a derivative instrument whose gains andlosses on settlement directly offset the losses andgains incurred upon settlement of the transactionbeing hedged.
- 29. 29#MHMwebinarFair value hedgeIn a fair value hedge the gain or loss on a derivative instrumentdesignated and qualifying as a fair value hedging instrument aswell as the offsetting loss or gain on the hedged itemattributable to the hedged risk are recognized currently inearnings in the same accounting period.Intent is to convert a fixed cash flow instrument with a variable fairvalue to a fixed fair value.EXAMPLE: FIXED RATE DEBTSpecial treatment = Hedged ItemTypes of Hedging
- 30. 30#MHMwebinarTypes of HedgingCash Flow HedgeIn a cash flow hedge, the effective portionof the gain or loss on a derivativeinstrument designated and qualifying as acash flow hedging instrument shall bereported as a component of othercomprehensive income (outside ofearnings) and reclassified into earnings inthe same period or periods during whichthe hedged forecasted transaction affectsearnings.Any portion of the derivative instrument thatis designated as a cash flow hedge that isdetermined to be ineffective should berecognized in earnings immediately.Intent is to convert a variable cashflow instrument to a predictable setof cash flows.
- 31. 31#MHMwebinarContains explicit guidance regarding the application of hedgeaccounting models, including documentation and effectivenessassessment requirements. One of the fundamentalrequirements of ASC 815 is that formal documentation beprepared at inception of a hedging relationship.Stresses the need for the documentation to beprepared contemporaneously with the designation ofthe hedging relationship.ASC815ASC815Hedging is a Privilege, Not a Right!Formal Documentation Under ASC 815Hedge Documentation
- 32. 32#MHMwebinarYou can replacethis text withyour own text.Keep the textshort and simpleYou can replacethis text withyour own text.Keep the textshort and simpleHedgingrelationshipDocumentation must include:Hedge Documentation• Identification of the hedging instrument• Identification of the hedged item or forecastedtransaction(s)• Identification of how the hedging instrument’seffectiveness in offsetting the exposure tochanges in the hedged item’s fair value (fairvalue hedge) or the hedged transaction’svariability in cash flows (cash flow hedge)attributable to the hedged risk will beassessed.• How ineffectiveness will be measuredEntity’s risk managementobjective and strategy forundertaking the hedge
- 33. 33#MHMwebinar Both at the inception of the hedgeand on an ongoing basis, thehedging relationship is expected tobe highly effective in achieving Offsetting changes in the fair value attributableto the hedged risk during the period that thehedge is designated (in the case of a fair valuehedge) or Offsetting cash flows attributable to the hedgedrisk during the term of the hedge (in the case ofa cash flow hedge). An assessment of effectiveness isrequired whenever financialstatements or earnings are reported;at least every three months.Hedge Documentation –Effectiveness Assessment
- 34. 34#MHMwebinarSample Company XX (Company) intends to enter into a transactionwith Counterparty A (Counterparty) as part of the Company’soverall risk management policies and intends to designate aninterest rate swap as a hedge of the exposure to changes in cashflows resulting from changes in interest rates associated with theCompany’s variable rate debt.Cash Flow Example - Documentation
- 35. 35#MHMwebinarRisk Management Objective The Company’s risk management objective is to reduce exposure to thevariability in cash flows (interest payments) associated with changes in the3 month LIBOR benchmark interest rate on $10 million of outstandingprincipal of the Company’s note payable to Bank A. The Company intendsto hedge its exposure to changes in the benchmark interest rate by enteringinto a pay fixed, received variable (3 month LIBOR) interest rate swap. Thevariable leg of the swap is intended to offset changes in the cash flowsattributable to changes in the 3 month LIBOR benchmark interest rate.Cash Flow Example - Documentation
- 36. 36#MHMwebinarHedged Item The Company is hedging the changes in cash flows, associated withchanges in the 3 month LIBOR rate only, on the monthly variable rateinterest payments beginning on January 1st, 2011 and the 1st of eachmonth thereafter on the Company’s $10 million in outstanding debt withBank A. Based on the Company’s internal evaluation, the future interestpayments associated with the outstanding debt with Bank A areassessed as probable of occurring as the debt is not callable by thelender and the Company intends for the debt to remain outstandingthroughout the hedged period (maturity). Additionally, we haveassessed the counterparty credit risk and determined that the likelihoodthe counterparty would default on any payments due under thecontractual terms of the hedging instrument is not probable (ASC 815-20-35-15).Cash Flow Example - Documentation
- 37. 37#MHMwebinarHedged Item Therefore, the Company has elected to ignore the impact of changes inthe counterparty credit risk as well as the Company’s non-performancerisk in the assessment of effectiveness and ineffectiveness. As a result,changes in the fair value of the hedging instrument related tocounterparty credit risk and non-performance risk will be included as acomponent of accumulated other comprehensive income (AOCI) untilthe hedged cash flows impact earnings.Hedging Instrument The hedging instrument is the pay fixed, received variable interest rateswap with Counterparty A.Cash Flow Example - Documentation
- 38. 38#MHMwebinarEffectiveness Assessment: The Company will perform the initial and on-going effectivenessassessment through a regression analysis of the monthly changein the actual interest rate swap and a perfectly effectivehypothetical (PEH) swap designed to entirely offset the changesin cash flows as a result of changes in the 3 month LIBOR. Theregression analysis will use a minimum of 60 monthly data points(length of the hedging relationship) prior to the hedgingrelationship. When correlating the actual swap value to the perfectly effectivehypothetical derivative instrument, the R2, or coefficient ofdetermination, which is the R, or coefficient of correlation,squared, should be equal to or greater than 0.8. The R2 factorshould be greater than (0.8) and less than or equal to 1.25 inorder to be considered highly effective.Cash Flow Example - Documentation
- 39. 39#MHMwebinarEffectiveness Assessment: Additionally, the Company will update the assessment ofthe probability of the hedged cash flows occurring and theassessment of counterparty and non-performance creditrisk on a quarterly basis. To the extent the hedged cashflows remain probable of occurring, and counterpartydefault is not probable, the Company will exclude theimpact of changes in counterparty credit risk from thevaluation of the perfectly hypothetical derivative and actualderivative for purposes of the effectiveness andineffectiveness testing.Cash Flow Example - Documentation
- 40. 40#MHMwebinarIneffectiveness Assessment: The Company will use the cumulative dollar-offset method toassess the ineffectiveness on a quarterly basis. The Companywill compare the change in the value of the actual interest rateswap with the change in the fair value of the perfectly effectivehypothetical swap (a swap assuming the same critical terms asthe hedged item). The actual interest rate swap will be recordedat the credit adjusted fair value on the balance sheet with anoffsetting entry to other comprehensive income. The amount of ineffectiveness to be recorded equals the lesser ofthe cumulative change in the fair value of the actual interest rateswap or the cumulative change in the fair value of the perfectlyeffective hypothetical swapCash Flow Example - Documentation
- 41. VALUATION ISSUES
- 42. 42#MHMwebinarASC 820, provides a fair value hierarchy under which amongother items, derivatives, must be measured and disclosed.Given that interest rate swaps and caps into which yourcompanies will enter will not be able to be valued by obtainingmarket quotes, the fair values must be estimated via cash flowand option pricing models.Typically, your banker will provide a statement of the fair valueof these instruments, however, if considered material in relationto your financial statements, your auditors will need to audit thatvalue and it is rare that the banker will provide them access totheir pricing models as they are typically deemed to beproprietary.Valuation
- 43. 43#MHMwebinarTherefore, in the situation of a non-publicly traded entity, the auditor maybe able to estimate the value of theinterest rate swap and/or cap for theCompany, in the context of auditingthe confirmation received from thebank. However, auditors cannotderive the valuation assumptions formanagement.Valuation
- 44. 44#MHMwebinarValuation – Interest Rate SwapsInterest rate swaps arevalued by taking the netpresent value of theestimated cash flowsover the life of the swap.Given that the fixed ratepayments are known, the variablerate payments must be estimated.• The future variable rate payments canbe estimated by extracting theforward rates for the variable rate andusing these as our estimates of thevariable rate that will be in effect atsettlement.• By definition, a forward interest rate isthe interest rate for a future period oftime that is implied by the interestrates prevailing in the market today.
- 45. 46#MHMwebinar1 2 3 4 5 6 7 8 9 10 11Swap Rate: 2.60% Annualized Period Present3 Month LIBOR 3 Month LIBOR Payer Receiver Value ofTotal Period Notional Forward Forward Fixed Floating Net Discount NetDate Days Days Principal Rate Rate Cash Flow Cash Flow Cash Flow Factor Cash Flow12/31/2012 $10,000,0003/31/2013 90.00 90.00 $10,000,000 2.0000% 0.5000% ($64,110) $50,000 ($14,110) 0.99502 ($14,039)6/30/2013 181.00 91.00 $10,000,000 2.2500% 0.5625% ($64,822) $56,250 ($8,572) 0.98946 ($8,482)9/30/2013 273.00 92.00 $10,000,000 2.5000% 0.6250% ($65,534) $62,500 ($3,034) 0.98331 ($2,984)12/31/2013 365.00 92.00 $10,000,000 2.7500% 0.6875% ($65,534) $68,750 $3,216 0.97660 $3,141($22,364)Therefore, based upon the following swap terms:Notional Amount: $10,000,000Swap Rate: 2.60%Fixed Rate Payer: XYZ Company & Floating Rate ReceiverFloating Rate Payer: ABC Bank & Fixed Rate ReceiverSettlement: Every 3 monthsFloating Rate: 3 month LIBORMaturity: 12/31/2013The value of the interest rate swap to XYZ Company is as follows: ($22,364)Which would be recorded as follows as of 12/31/12, assuminghedge accounting has not been elected: Unrealized loss - derivatives $22,364ST Derivative Liability $22,364Valuation – Interest Rate Swaps – NO CVAExample
- 46. 47#MHMwebinarAs stated before, over the counter derivatives (not actively traded),must have the counterparty valuation adjustment (CVA) factored intofair valuation estimate of the derivative. With interest rate swaps, theCVA is representative of the credit risk of the counterparty. Forinterest rate swaps, as there are 2 parties, there are 2 CVA factors: 1for the bank and 1 for the counterparty (although for swaps withprojected net cash flows that are either all outflows or all inflows, theCVA for the party paying the cash flows is the only applicable CVA).The CVA is the rate that represents the credit risk of the counterpartyand is added to the risk free rate to calculate the applicable discountfactor for each projected net cash flow over the life of the interestrate swap.Valuation – Counterparty Valuation Adjustment
- 47. 48#MHMwebinarValuation – Interest Rate Swaps – with CVAExample1 2 3 4 5 6 7 8 9 10 11Swap Rate: 2.60%CVA XYZ Co 2.00% Fixed payer Annualized Period PresentCVA ABC Bank 1.00% Floating payer 3 Month LIBOR 3 Month LIBOR Payer Receiver Value ofTotal Period Notional Forward Forward Fixed Floating Net Discount NetDate Days Days Principal Rate Rate Cash Flow Cash Flow Cash Flow Factor Cash Flow12/31/2012 $10,000,0003/31/2013 90.00 90.00 $10,000,000 2.0000% 0.5000% ($64,110) $50,000 ($14,110) 0.99038 ($13,974)6/30/2013 181.00 91.00 $10,000,000 2.2500% 0.5625% ($64,822) $56,250 ($8,572) 0.97957 ($8,397)9/30/2013 273.00 92.00 $10,000,000 2.5000% 0.6250% ($65,534) $62,500 ($3,034) 0.96761 ($2,936)12/31/2013 365.00 92.00 $10,000,000 2.7500% 0.6875% ($65,534) $68,750 $3,216 0.96386 $3,100($22,207)Therefore, based upon the following swap terms: Valuation w/o CVA factor ($22,364)CVA $157Notional Amount: $10,000,000Swap Rate: 2.60%Fixed Rate Payer: XYZ Company & Floating Rate ReceiverFloating Rate Payer: ABC Bank & Fixed Rate ReceiverSettlement: Every 3 monthsFloating Rate: 3 month LIBORMaturity: 12/31/2013The value of the interest rate swap to XYZ Company is as follows: ($22,207)Which would be recorded as follows as of 12/31/12, assuminghedge accounting has not been elected: Unrealized loss - derivatives $22,207ST Derivative Liability $22,207
- 48. 49#MHMwebinar Given that interest rate caps are options, we must usean option pricing model to estimate the fair valuethereof. The most widely used option pricing model for interestrate caps is a derivation of the Black Scholes OptionPricing model, called the Black option pricing model.Valuation — Interest Rate Swaps
- 49. 50#MHMwebinar While going through the math that is behind thevaluation of an interest rate cap using the Black Modelis beyond the scope of this webinar, we will touch uponthe variables that must be input / estimated for theBlack Model.Valuation — Interest Rate Swaps
- 50. 51#MHMwebinarflag = "caplet" for pricing European call options on interest ratesX = option strike price (e.g. 2.6%)ndays = the number of days in the protection period ( = life of option)basis = the number of days used in the forward market for quoting interest rates( e.g., 360 days or 365 days)ep = length of the exposure period (also called the reset period), measured inyears (e.g., 0.5 yrs, or 2.75 yrs, etc.)z = the continously compounded zero coupon rate over the exposure periodf = the forward rate over the protection (or reset period) periodVol = volatility of the forward interest rateExposure Periodt=0 t= 6ProtectionPeriodt = 1 yearf =z=Life ofValuation – Interest Rate Caps
- 51. 52#MHMwebinar1 2 3 4 5 6 7 8 9 10 11 12 13 14X ndays basis ep z f VolNotional: $10,000,000 # of Days # of Days (Reset zero Forward VolatilityBase Rate: 3 month LIBOR Option In In Fwrd Period) Rate for Rate for 3 mn LIBOR ValueLife of Strike Protection Market Exposure Exposure Protection Forward Caplet ofPeriod From To Days Caplet Price Period Quotes Period (yrs) Period (yrs) Period (yrs) Rate Price Caplet31-Dec-12 31-Mar-13 90.00 0.3 2.60% 90.0 360.0 2.00% 60.00%1 1-Apr-13 30-Jun-13 90.00 0.5 2.60% 90.0 360.0 0.3 2.25% 2.25% 60.00% 0.0003628 $3,6282 1-Jul-13 30-Sep-13 91.00 0.8 2.60% 91.0 360.0 0.5 2.38% 2.50% 60.00% 0.0009437 $9,4373 1-Oct-13 31-Dec-13 91.00 1.0 2.60% 91.0 360.0 0.8 2.50% 2.75% 60.00% 0.0015457 $15,457$28,522Therefore, in this example, the Company has purchased an interest rate cap for a periodof 1 year, with 3 remaining settlements. The notional amount is $10,000,000 and the cap rate is 2.60%.Given the forward rate curve as of 12/31/12 (hypothetical not actual), and an estimated volatiltiyof the 3 month LIBOR of 60%, the total value of the entire interest rate cap agreement is $28,522Valuation – Interest Rate Caps
- 52. 53#MHMwebinar As we can see from the example, the most importantvariables that are input into the Black model are asfollows: Forward curve – 3 month LIBOR – obtained from observedmarket rates as of the valuation date Volatility for the underlying, in this case the 3 month LIBORrate – volatility is an estimate which as with any estimates,needs to be that amount that we most expect to occur in thefuture. This can be obtained from historical data representingthe actual volatility that has occurred over a period consistentwith the term of the interest rate cap agreement. Or volatilitycan be estimated using the implied volatility in the valuations ofsimilar actively traded instruments.Interest Rate Caps - Volatility
- 53. 54#MHMwebinar Futures contracts are actively traded instruments in the marketplace oncertain regulated exchanges. Futures contracts allow the buyer (seller) to purchase (sell) a statednotional amount of a certain commodity, currency, financial instrument,etc… at a stated price over a designated period of time. Futures contracts may be entered and exited at anytime during the life ofthe futures contract provided that the buyer (seller) is willing to accept a netsettlement of the value of the futures contract, and not physical settlement(receipt of the actual underlying). The prices of futures contracts are based on the current spot price and canbe estimated from the spot price using the risk free rate, the dividend orstated interest rate on the underlying (if any), costs of storage, andconvenience cost.Futures Contracts
- 54. 55#MHMwebinarTherefore, using the following formulae, the value of a futures contract canbe derived from the current spot price of the underlying and compared tothe actual future price to identify any opportunities in the marketplace:Futures ContractsFutures prices with:T = Time to maturityS = Current Spot price of Underlyingr = risk free rate for TI = Known income provided by underlyingq = Known convenience income or yieldc = costs of carrying the commoditye = 2.71828^ = to the power ofF = Se^rT Provides no incomeF = (S - I)e^rT Provides income with present value = IF = Se^(r-q)T Provides yield = to q%F = Se^(r+c)T Cost to maintain = c%
- 55. 56#MHMwebinarEXAMPLE – value of futures contractFutures ContractsFutures prices with: VARIABLES FOR CONTRACTT = Time to maturity 1S = Current Spot price of Underlying $1,578.00 GOLD - 1 ozr = risk free rate for T 0.13%I = Known income provided by underlying 0q = Known convenience income or yield 0c = costs of carrying the commodity 0e = 2.71828 2.71828^ = to the power ofACTUAL per CME $1,588.00F = Se^rT Provides no income $1,580.05 = 1580*(2.71828)^(.0013*1)F = (S - I)e^rT Provides income with present value = IF = Se^(r-q)T Provides yield = to q%F = Se^(r+c)T Cost to maintain (storage) = c%
- 56. 57#MHMwebinarForward Contracts• Therefore, although forward contracts may imposeexplicit times for settlement (e.g. at the maturity ofthe contract), the formula for calculating the valueof a forward contract is the same as the formula forcalculating the value of a futures contract, exceptfor one difference – CREDIT RISK• Given that futures contracts are traded onorganized exchanges, the requirement for initialand maintenance margin limits the credit riskassociated with these contracts and, as such, creditrisk is generally not considered in the valuation offutures contracts.• However, assuming that a forward contract meetsthe definition of a derivative, and if the underlying isconsistent with the underlying of an actively tradedfutures contract, it is likely that this is the case, theholder of the forward contract must take intoaccount the credit risk of the counterparty, whendetermining the value of the forward contract. Thatis, the CVA must be added to r when discountingthe value of the contract.NOTE: you must take into account thepresence of credit enhancements whenvaluing the contract. e.g. collateral,letters of credit, guarantees, masternetting arrangements, etc…
- 57. 58#MHMwebinar Options on Futures and Forward contracts have the same properties as options on anyfinancial asset (e.g. stocks) and can, provided that the options are European, that is,they can only be exercised at maturity of the contract (or at a certain date) be valuedusing the Black Scholes Option Pricing Model (or a derivation thereof, the Black model). Therefore, a European call and put option can be valued using the following formulae:Options on Futures and Forward ContractsBlack Scholes Option Pricing Model for Futures Contracts:EXAMPLE:c = e^-rT[F*N(d1) - K*N(d2)] call = $1.05p = e^-rT[K*N(-d2) - F*N(-d1)] put = $3.35whereN(d) N(-d)d1 =[ln(F/K) + σ^2*T/2] / σ*SQRT(T) 0.072169 N(d1) = 0.528766 0.471234d2 =[ln(F/K) - σ^2*T/2] / σ*SQRT(T) = d1 - σ*SQRT(T) -0.07217 N(d2) = 0.471234 0.528766EXAMPLE: PUT - CALL PARITY, requires that:European call and put option on an oil futures contract c + Ke^-rT = p + Fe^-rtT = 0.333333 Time to expirationF = 60 Current Futures price We can use put-call parity to findK = 60 Exercise price mispriced options in the market.r = 0.09 Risk free rateσ = 0.25 Volatility of Oil Futures Contracte = 2.71828
- 58. 59#MHMwebinarWe can also calculate the values of options on futurescontracts using lattice based models (binomial andtrinomial models) and simulation.However, this is beyondthe scope of this webinar.Options on Futures and Forward Contracts
- 59. 60#MHMwebinar Given the decrease in interest rates experienced over the past year, thecurrent index for swap rates is very low from a historical perspective. Current swap rate (www.federalreserve.gov)4/5/13 – Fixed for 3 month LIBORInterest Rate Swaps – Current Market RateCurrent swap rate(www.federalreserve.gov)4/5/13 – Fixed for 3 month LIBOR1 year .32%2 year .37%3 year .48%4 year .65%5 year .87%7 year 1.33%10 year 1.87%
- 60. 61The requisitehedge accountingdocumentationMaintenance ofhedge accounting- Effectiveness testing,ineffectiveness- Additional transactionsAccounting andreporting(disclosures)Valuation Structuring andrisk managementSensitivityanalysesCBIZ & Mayer Hoffman McCann P.C.MHM’s Derivatives Assistance Group
- 61. 62#MHMwebinarIf You Enjoyed This Webinar… Join us for these related EES courses: 8/1: Commodity Hedging – A Risk Management Tool AgainstPrice Volatility of Commodities 10/10: Hedge Accounting – What is it? And is Now theTime?
- 62. 63#MHMwebinarQuestions?
- 63. 64#MHMwebinarToday’s PresentersMike Loritz, CPAShareholder913.234.1226 | mloritz@cbiz.comMike has 17 years of experience in public accounting with diversified financialcompanies and other service based companies, including banking, broker/dealer,investment companies, and other diversified companies ranging from audits ofpublic entities in the Fortune 100 to small private entities. He is a member ofMHMs Professional Standards Group, providing accounting knowledgeleadership in the areas of derivative financial instruments, investment securities,share-based compensation, fair value, revenue recognition and others.Tim Woods, CPAShareholder720.200.7043 | twoods@cbiz.comA member of MHM’s Professional Standards Group, Tim is a subject matterexpert for derivatives and hedge accounting. He also has extensive experiencein leasing transactions, fair value, stock-based compensation, and complex debtand equity transactions. Tim has worked in public accounting, consulting, andprivate industry for the past 20 years, focusing on outsourced CFO consultingand financial statement audits for small and mid size privately held companies.He has extensive experience in accounting for business combinations andvariable interest entities, as well as with issues in leasing, revenue recognition,and foreign exchange.
- 64. 65#MHMwebinarToday’s PresentersJames Comito, CPAShareholder858.795.2029 | jcomito@cbiz.comA member of MHM’s Professional Standards Group, James has expertise in allaspects of revenue recognition, business combinations, impairment of goodwilland other intangible assets, accounting for stock-based compensation,accounting for equity and debt instruments and other accounting issues.Additionally, he has significant experience with a variety of other regulatory andcorporate governance issues pertaining to publicly traded companies, includingall aspects of internal control. In addition, James frequently speaks onaccounting and auditing matters at various events for MHM.
- 65. 66#MHMwebinarConnect with Mayer Hoffman McCannlinkedin.com/company/mayer-hoffman-mccann-p.c.@mhm_pcyoutube.com/mayerhoffmanmccanngplus.to/mhmpcblog.mhm-pc.comslideshare.net/mhmpcfacebook.com/mhmpc

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