Fas 133 Cash Flow Hedges Exposures With Uncertain Timing
- 1. FAS 133 Effectiveness Assessment FX Exposures with Uncertain Timing
- 2. Discussion Items Introduction Wrong Practice – Cash Flow Hedges using Option Contracts DIG Issue G20 DIG Issue G16 Suggested Future Steps 1
- 3. Introduction Presentation discusses treatment of cash flow hedges using purchased options of anticipated exposures (foreign currency capital expenditures, raw material purchases, revenue inflows, etc. ) where timing of exposure is not known precisely. Many companies erroneously apply DIG Issue G20 to hedges of cash flow whose timing is uncertain: Assume that critical terms of exposure and option hedge matches completely Defer entire change in fair value of option contract hedging these exposures to expiry of option Expense time value (option premium) only at expiry. Above approach may not be completely correct for exposures whose timing is uncertain since companies do not know precisely when these exposures may be realized. What they do know is a specific time period within which such payments can happen. To hedge such exposures appropriately, companies should apply DIG Issue G16 to option hedges of cash flow whose timing is uncertain: Document and calculate effectiveness based only on intrinsic value of exposure and option hedge calculated using spot rates Expense difference in market value of option hedge because of difference in forward rates and spot rates through P&L on a periodic basis. 1
- 4. Wrong Practice Cash Flow Hedges using Options Companies hedge exposures with uncertain timing (capital expenditures, vendor payments, etc.) using option contracts and assume critical terms match for effectiveness assessment and measurement. Companies do not know precise dates for when such exposures will be realized. Exposure and hedge relationship is usually documented as follows: Underlying Exposure : The underlying exposures are some number of payments to be made on specific dates (even though specific dates are unknown when documentation is prepared) Specifics of Derivative : This exposure will be hedged with option contracts expiring on date of each payment . Hedge Effectiveness : Evaluated by measuring: First XX of exposure on specific date with XX option contract maturing on same date. Effectiveness will be assessed prospectively and retrospectively by assuming critical terms match. Effectiveness will be measured by dividing the change in fair value of exposure to change in fair value of hedge. If the ratio is between 80% and 120%, the hedge will be considered highly effective. In this situation, Effectiveness cannot be assessed properly because one of the critical terms (maturity) does not match between exposure and option hedge. Effectiveness cannot be measured using full fair value because one does not know what forward rate needs to be applied to the exposure. 2
- 5. DIG Issue G20 The following is a summary of DIG Issue G20 cleared by FASB on June 27, 2002. This issues discusses: Assessing and Measuring the Effectiveness of a Purchased Option Used in a Cash Flow Hedge. According to the FASB, in order for the hedging relationship to be considered perfectly effective, the following conditions need to be met: Critical terms of the hedging instrument match the related terms of the hedged forecasted transaction Strike price of the hedging option matches the specified level beyond which the exposure is being hedged Hedging instrument’s inflows (outflows) at its maturity date completely offset the change in the hedged transaction’s cash flows for the risk being hedged Hedging instrument can be exercised only on a single date – its contractual maturity date. As a result: Only if the critical terms of the exposure and hedge match at the outset, we can conclude that the hedging relationship is perfectly effective. Then, we can record all changes in the option’s fair value (including changes in time value) to OCI – thus expensing time value only at maturity. If the above four conditions are not met, one needs to perform long haul effectiveness testing each period and recognize the change in the value of the derivative that does not offset the change in the value of the exposure (changes in time value) from one period to next in earnings … no critical terms match can be assumed. 3
- 6. DIG Issue G16 This issue was cleared by FASB on March 21, 2001 and discusses: Cash Flow Hedge: Designating the Hedged Forecasted Transaction When Its Timing Involves Some Uncertainty within a Range. According to this, for a forecasted transaction whose timing involves some uncertainty within a range, that range could be documented as the “ originally specified time period ” provided that the hedged transaction is described with sufficient specificity in the documentation. As long as it remains probable that the forecasted transaction will occur by the end of the originally specified time period of the overall project, cash flow hedge accounting for that hedging relationship will continue. As per paragraph 63 in the FAS 133 statement, one can measure effectiveness based on (a) the option’s intrinsic value, (b) its minimum value (that is, the discounted intrinsic value), or (c) the total fair value (intrinsic value + time value) of the hedge. The problem with using (b) and (c) in measuring effectiveness is we do not know the discount rate or the forward rate for the time at which the actual payment is going to be made, hence it is not possible to discount the intrinsic value, nor is it possible to calculate the fair value of the exposure using forward rates. Hence, companies should assess effectiveness for such hedges by using method (a) and calculate the intrinsic value of the hedge based on spot rates, and then compare the change in intrinsic value of the hedge to the change in value of exposure calculated using spot rates. One advantage of using this method is that we do not need to know the exact timing of the exposure. But, if we use the above method, we need to calculate the difference between the fair value of the hedge and the intrinsic value at the spot rate (labeled usually as time value though it also contains some vega), and expense changes in this value monthly to the P&L. 4
- 7. Suggested Future Steps In order to be fully compliant with FAS 133, companies should do the following: Change the way for documenting Underlying Exposure, the Specifics of the Derivative and Effectiveness Assessment and Measurement cash flow hedges of exposures whose timing is uncertain Document that such exposures will happen within a specified time period instead of indicating that such exposures will be realized on a specific date. Indicate that derivative is hedging an exposure that can happen within a specified time period, and not on an exact date. Do not assume critical terms match for such hedges. Instead, perform long haul effectiveness assessment and measurement. Assess prospective and retrospective effectiveness for such hedges using regression or scenario analysis. Measure effectiveness for such hedges using intrinsic values calculated using spot rates as they are easily identifiable. Expense changes in time value for such hedges (market value of derivative minus intrinsic value calculated as change in value of derivative due to change in spot rates) to P&L each measurement period. 5