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Accounting & Disclosure

Favorable Accounting for Fair-Value Hedges

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December 16, 2016

Case Study: Eris Standards hedge accounting includes fair value hedges.

Accounting-MoneySeeking to crack the assumption that only over-the-counter swaps are eligible for hedge accounting treatment, Eris Exchange and R.J. O’Brien (RJO) have released a second case study demonstrating that swap futures can receive the favorable accounting treatment not only for cash-flow but also fair-value hedges.

The firms released a case study in October showing that Eris’s Standards swap futures (http://www.itreasurer.com/Eris-Standards-Could-Help-Mitigate-Swap-Cost-Hike.aspx), which unlike traditional swaps can last the duration of the underlying exposure, are eligible for hedge accounting treatment and will be far less costly than OTC swaps as new margin rules take effect. Furthermore, changes to accounting guidelines now in the works will make applying hedge accounting to those derivatives operationally less burdensome.

Cash-flow hedges are used to hedge uncertain cash flows in the future, such as the coupon on a bond that a corporate plans to issue. Fair-value hedges are used to hedge the changing values of assets or liabilities due to factors such as rising interest rates. For example, a bank that has issued $1 billion in 5-year bonds knows its future cash flows, but may want to hedge against a fall in interest rates, which would drive up the fair value of the liability.

“The bank would enter a fair value hedge and designate an interest rate swap or an Eris position as a fair value hedge for that debt issue on its books,” said Geoff Sharp, managing director at Eris Exchange. “So the company can put on a fair-value hedge, designating a swap or Eris position as a fair value hedge for the debt deal on its books.”

RJO executives note they’ve sought to persuade derivative end-users of the merits of swap futures for several years now. However, they have faced reluctance from market participants who habitually use OTC swaps and are concerned about the inability to match terms of a standard futures contract with those of the underlying asset or liability. GFM Solutions Group, which RJO’s Fixed Income Group hired to conduct the accounting studies focused on Eris Swap Futures, has found that the “ineffectiveness” resulting from that mismatch is negligible.

“Historically, Standard contracts have not meshed well with company objectives where they want to match all critical terms of hedges with those of the exposures,” said Charles Brobst, managing partner at GFM Solutions Group. “So in the past, companies were wary of using standardized contracts out of concern that they would not be able to take advantage of simplifications afforded them under the hedge accounting standard. That doesn’t need to be the case.”

GFM found in its studies that the ineffectiveness resulting from applying Standard futures contracts as cash flow hedges amounted to less than 0.025% in any given period, and as fair value hedges to less than 0.2%. That ineffectiveness will be reported in earnings for cash flow hedges and fair value hedges.

Proposed amendments to the hedge accounting standard, nearing completion, should significantly simplify the accounting process for swap futures both for cash flow and fair-value hedge accounting. Today, derivative end-users must first establish that a cash-flow hedge will be effective and then regularly assess and measure its effectiveness. Under one of the proposed amendments, Mr. Brobst noted that the cash-flow hedge will require an initial assessment to establish effectiveness, acknowledging that the terms are not identical but that the contract will effectively offset the underlying exposure’s changes in value. Then changes in the hedge’s value will be recorded as if they are effective, requiring only qualitative assessments that critical terms of the underlying exposure have not changed.

There are also proposed changes that will favorably impact the effectiveness of Standard contracts used as fair value hedges. Mr. Brobst added that end-users should make an investment upfront in establishing a strong foundation for a hedge designation, sufficiently supported by regression or another form of analysis.

In terms of cost, the largest firms began complying with new margin in October and other market players will be subject them to over the next few years. Those rules apply margin to over-the-counter (OTC) swaps for the first time ever, using 10-day value-at-risk (VaR) methodology. Cleared swaps must apply five-day VaR, and exchange-traded futures such as Eris’s Standards swap futures only two-day VaR, representing significant savings over the OTC hedging instruments corporates have traditional used.

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