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March 17, 2000

FAS 133 Amendments


Last call for comments

Table of Contents
Overview ............................2
Hedging the Benchmark
Interest Rate.......................2
Hedging Recognized Foreign
Currency Denominated
Instruments ........................4
Net Hedges of Intercompany
Derivatives..........................4
Normal Sales and Normal
Purchases Exception ..........4
Shortcut Method Extended 5
Conclusion..........................5

John F. Tierney
(212) 469 6795
john.tierney@db.com

David Folkerts-Landau
Managing Director, Head of
Global Markets Research

The Financial Accounting Standards Board (FASB) has issued for public
comment several amendments to FAS 133. They address issues that
have arisen as corporations prepare for FAS 133.

The comment period ends April 2. We urge corporations to review the


amendments, and to make their views known to the FASB, especially
if they have further constructive ideas on how to improve the FAS 133
framework. This is the last opportunity people will have to influence
the final standard before it goes into effect.

A key amendment would permit corporations to hedge the risk-free


rate or a benchmark rate instead of the market rate. This would
significantly reduce the level of hedge ineffectiveness that is reported
in earnings, and give corporations the ability to hedge credit spreads.

We recommend the specified benchmark rate (LIBOR/swaps curve)


be broadened. Ideally corporations should be able to choose the
benchmark(s) that make the most business sense.

Another amendment eases the restriction on hedging FX exposures,


by permitting corporations to hedge cross currency exposures using
compound interest rate/FX derivatives. But the proposed approach
would not eliminate the FAS 133 spot / forward differential. We would
prefer to see an approach that eliminates this problem, but we
concede the FASB is unlikely to make such a change.

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FAS 133 Amendments

Permit a net hedging of intercompany exposures only


for certain cash flow hedges of FX exposures. All
other intercompany hedges would have to be offset
with outside parties on a transaction by transaction
basis. The FASB has been dead set against portfolio
type hedges throughout the FAS 133 deliberation
process. We disagree with this position but we see
little chance that they will relent further on this issue.

Broadens the scope of contracts to purchase and sell


goods and services in the normal course of business
without running afoul of FAS 133. Under the original
FAS 133 guidance, contracts with net settlement
provisions were deemed to be derivatives. The
amendment would permit net settlement provisions
for business contracts to sell or purchase goods and
services as long as it was probable that the contract
would be settled through physical rather than net
settlement. This change will allow many business
and industries to avoid having to redraft standard
contracts to avoid FAS 133.

Formalizes a number of changes made through the


Derivative Implementation Group. In particular, the
shortcut method would be extended to include
swaptions as long as the embedded option
component mirrors an embedded purchased option in
the underlying hedged position.

Overview
The Financial Accounting Standards Board has issued a
proposed amendment to FAS 133 that would make
several changes that will be welcomed by most
corporations. The FASBs willingness to consider and
propose these amendments is a major concession on
their part.
The amendments are out for a public comment period
that ends April 2. We urge all corporations and
businesses affected by FAS 133 to review these
amendments, and to make their views known to the
FASB. This is the final opportunity to make changes to
FAS 133 before it goes into effect in June. We would
note that while the FASB is unlikely to make any further
major changes to either FAS 133 or the amendments
there is still room to air constructive comments and time
for the FASB to consider and perhaps implement them.
In this report, we review and critique the proposed
amendments, and provide our views on how several of
them could be further modified yet still conform to the
basic model of FAS 133 (a key decision criterion for the
FASB).
In summary the amendments:

Permit corporations to hedge either the risk free or


benchmark rate, as opposed to the market rate of a
position (loan, security, outstanding debt). The goal is
to better reflect how corporations hedge market
interest rates. For US hedgers the benchmark rate is
narrowly defined to be LIBOR/swaps, while for nonUS dollar exposures the guidance is more general.
We recommend that the amendment be changed so
that corporations can designate the benchmark rates
they plan to use as part of their derivatives policy.
This would ensure a consistent framework across US
dollar and non-US dollar exposures and provide
flexibility for corporations to construct hedges that
make business sense.
Permit cross currency hedges of FX exposures. The
goal is to allow corporations to accomplish with a
single compound derivative what they would need to
do in two steps under the present version of FAS
133. The bottom line is that this change will not fix
the spot/forward differential that arises from the
interaction of FAS 52 and 133. We would like to see a
solution in which the spot / forward differential is
eliminated but unfortunately we do not think further
concessions on this issue are likely.

March 17, 2000

Hedging the Benchmark Interest Rate


The proposed amendment on hedging the benchmark
interest rate provides significantly more flexibility to
hedge different risk exposures, and should be welcomed
by most people. Our major area of concern is that the
definition of the benchmark interest rate for US investors
is too narrow.
In the original statement, FAS 133 permitted hedgers to
designate one or more risk exposures as the risk being
hedged. These included changes in fair value attributable
to market price risk (i.e., change in the entire price of the
hedged item), market interest rates, FX risk, and default
risk. Market interest rates was defined to be the risk free
rate plus the credit spread for the hedged position (i.e., its
coupon or yield), and default risk referred to changes in
price due to default or documented change in credit
worthiness (e.g., a rating agency downgrade).
One problem with this approach is that most people
hedge with instruments such as Treasury futures or Eurodollar futures or LIBOR/swaps, which can give rise to
basis risk and hedge ineffectiveness. Under the original
FAS 133 model, the basis risk from, for example, hedging
a corporate bond with swaps or Treasury-based

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March 17, 2000

FAS 133 Amendments

derivatives would show up as hedge ineffectiveness and


earnings volatility (in a fair value hedge) unless the hedge
qualifies for the shortcut method.1 We think a key issue
for many people was not earnings volatility per se, but the
prospect that a high degree of basis risk could lead to the
hedge being deemed ineffective, and hedge accounting
being disallowed. In this scenario, the derivative would
be marked to market through earnings, with no offset
from the hedged position (in a fair value hedge) or no
buffer from using other comprehensive income (for cash
flow hedges).2
To address this problem, corporations requested that the
designated hedgeable risk exposures be modified to
better reflect how most hedging strategies work in
practice. The FASB agreed to permit changes in fair value
/ cash flow attributable to changes in either the risk-free
rate or a benchmark rate to be designated as the hedged
risk exposure. The FASB also permitted changes in the
credit spread to be a hedgeable risk exposure. For
purposes of the FAS 133 amendment the credit spread is
the difference between the coupon or yield on the
hedged position and the risk-free or benchmark rate. A
key implication of this amendment is that changes in
credit spreads due to factors other than a default or
downgrade can be hedged using credit derivatives.
For example, if a 5-year fixed rate high yield bond is
hedged with a 5-year off-market swap (a fair value hedge
that does not qualify for the shortcut method) changes in
the fair value of the swap would be reflected on the
balance sheet and in earnings, and the hedged bond
1

Under the so-called shortcut method, if the hedging instrument is


an interest rate swap that meets certain criteria, then perfect hedge
effectiveness can be assumed. To qualify for the shortcut method,
the swap must have a fair value of zero at inception, the notional
amount of the swap must match the hedged position, the hedged
position is not prepayable, and for a fair value hedge the term of the
swap matches the maturity of the hedged position. Under this
approach changes in the fair value or cash flows of the swap are
offset by an equal change in the carrying value or cash flows on the
hedged position regardless of the actual performance of the hedged
position for fair value hedges, and the swap is zero at inception (no
fee paid or received).
2
To qualify for hedge accounting under FAS 133, the derivative
(among other things) must be highly effective at offsetting changes
in market value or cash flow on the hedged position. FAS 133 does
not explicitly define highly effective, but it is widely understood that
the 80% - 125% correlation test used currently will continue to be
the standard for judging effectiveness when FAS 133 goes into
effect. Under FAS 133 even if the hedge is highly effective and
qualifies for hedge accounting any hedge ineffectiveness must be
recognized in earnings even if the hedge is deemed to be highly
effective over time. If the hedge is considered no longer highly
effective, then hedge accounting treatment may be disallowed. If
the hedge remains in place, then earnings volatility will rise
significantly because the accounting will reflect the mark to market
volatility of a naked derivative rather than the economics of the
hedging strategy.

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would be revalued with respect to changes in the swap,


with the change reflected in earnings. If during this
period, the credit spread on the hedged bond also
widened 50 bp, this would not be reflected in either the
carrying value of the bond or earnings. In effect, the
hedge would be highly or perfectly effective by
construction. In addition, a credit derivative could be used
to hedge the credit spread.
Without this amendment, corporations had a strong
incentive to structure hedges so they qualified for the
short cut method. This amendment will effectively
extend the hedge effectiveness benefits associated with
the shortcut method to a broader range of derivatives,
including Treasury based derivatives and off-market
swaps, although the bookkeeping will probably not be
quite as straightforward as the shortcut method.
One key point that corporations should focus on is that
the amendment defines the risk-free rate and benchmark
rate for US based hedgers very narrowly as the US
Treasury curve and LIBOR/swaps, respectively. Other
benchmarks such as commercial paper rates or fed funds
are not eligible. Thus if a corporation hedges the
benchmark rate using a CP based derivative there would
be basis risk. Outside of the US the amendment would
provide some discretion for hedgers to select the risk free
rate and/or benchmark rate appropriate for a given
country and financial market.
We are concerned that the guidance on this issue is both
overly specific for hedges of US exposures and too open
ended for non-US exposures. In the US, there are a
variety of benchmark interest rate in addition to the
swaps curve. If the goal (as stated in the amendment) is
to better reflect actual hedging practices then
corporations should be able to exercise some discretion
in selecting benchmark rates for hedging purposes.
For hedges of non-US exposures, we think there is some
risk that the accounting profession may take a very
conservative or inconsistent approach to defining specific
risk free and benchmark rates for different countries. For
example, in Europe there are now two LIBOR type
benchmarks for the Euro. One is Euribor, which is priced
through the European Banking Federation and the other is
Euro-LIBOR, which is priced in London. Would both
EURIBOR and Euro-LIBOR be acceptable benchmark
rates? Or would some accountants insist that only
London based benchmarks be used since FAS 133 only
explicitly sanctions a London based benchmark for the
US?
While we appreciate the FASBs concerns about not
wanting to open the door to an anything-goes approach to

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FAS 133 Amendments

selecting benchmarks, we think it would be appropriate to


allow corporations to define benchmark rates for hedging
purposes as part of an overall derivatives and FAS 133
policy statement.
For example, FAS 133 provides
corporations with latitude to define how they measure
hedge effectiveness; the key point is that the policy is
applied consistently. We think a similar approach would
be acceptable for defining benchmark rates for hedging
purposes.

Hedging Recognized Foreign Currency


Denominated Instruments
A significant sore spot for many multinationals has been
the treatment of hedges of FX exposures under FAS 133.
These include foreign denominated debt or foreign
denominated securities positions.
FAS 133 retains
guidance from FAS 52 that requires FX positions to be
translated to the corporations function currency based on
spot rates, with gains/losses recognized in earnings.3 But
FAS 133 also requires that derivatives be marked to
market at fair value, i.e., reflecting forward rates. The FX
exposure does not qualify for hedge accounting per se
under FAS 133 because it is already marked to market
through earnings. The idea is that since both the FX
exposure and an FX derivative used as a hedge are
marked to market through earnings, there is a built-in
hedge. But the requirements of FAS 133 give rise to a
spot / forward differential.
For example, under FAS 133 a cross currency exposure
(such as a fixed rate Euro-denominated debt issuance by
a company whose function currency is the US dollar)
would have to be done in two steps to obtain partial
hedge accounting and minimize earnings volatility. The
Euro fixed rate would be swapped to floating (a fair value
hedge) and a FX basis swap would be used to offset the
FAS 52 Euro to dollar translation risk. The basis swap is
marked at fair value (i.e., based on forward rates) while
the FAS 52 translation is based on the spot rate, giving
rise to the spot/forward differential. A compound hedge
could not be used because FAS 133 does not permit
compound derivatives to be bifurcated for hedge
accounting purposes.
The amendment retains the substance of the accounting
described above, but it permits corporations to
accomplish this through a single compound derivative
rather than two derivative transactions. In effect, the
hedged position in the example above would be adjusted
in two stages to reflect first the interest rate component

March 17, 2000

(based on fair value) then the FX component (based on


spot rates). The compound derivative would be marked
to fair value. The impact on earnings would be the same
as above.
We would much rather see a situation where both sides
of these types of FX hedges are marked to fair value.
This would eliminate the spot/forward differential and be
consistent with the hedge accounting model of FAS 133.
But we concede that this change is unlikely to happen, at
least as a result of the amendment process.

Net Hedges of Intercompany


Derivatives
FAS 133 requires a transaction by transaction approach to
hedge accounting. There is little leeway to do macro or
portfolio hedges and obtain hedge accounting treatment.
The FASB took this approach for intercompany hedges.
Generally speaking to obtain hedge accounting for an
intercompany hedge, there must be a offsetting hedge
with an outside party.
Even in cases where all
intercompany hedging is coordinated or conducted
through a central treasury office intercompany hedges
cannot be hedged on a net basis.
The amendment provides a limited ability to hedge certain
intercompany FX exposures on a net basis. Specifically
cash flow hedges of forecasted transactions can be offset
on a net basis for each currency. These would include
forecasted borrowings or planned purchases. It would
not include hedges related to recognized foreign currency
denominated instruments.

Normal Sales and Normal Purchases


Exception
FAS 133 lays out specific criteria to determine whether a
contract meets the definition of a derivative. In particular,
if a contract provides for net settlement or there is a
market mechanism to facilitate net settlement in lieu of
physical delivery, then it is a derivative and subject to the
mark to market requirements of FAS 133. For example, if
a contract to sell corn can be settled either by delivering
corn or as a net cash payment reflecting the change in
the value of the contract then it may be considered a
derivative.
FAS 133 does provide a carveout for contracts that
represent normal sales and normal purchases of things
other than financial instruments or derivatives. As long as
there is no net settlement provision or related market

See Statement of Financial Accounting Standard No. 52, Foreign


Currency Translation.

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March 17, 2000

FAS 133 Amendments

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mechanism, the contract will not be considered a


derivative.
In the amendment process, the FASB decided to extend
the carveout to certain contracts that provide net
settlement features. The contract must be for delivery of
nonfinancial assets for use in the normal course of
business, and it must be highly probable that the contract
will be settled through physical delivery.
The goal of this amendment is to provide many
businesses with leeway to continue using existing
contracts for sales and purchases of goods and services
that also include net settlement provisions. In many
cases these contracts represent long-established
business practices in different industries, and rewriting
contracts to avoid FAS 133 issues clearly would have
been burdensome. But it is unlikely that this change will
provide much room to recast de facto derivative contracts
as normal business contracts. The language in the
amendment makes it clear that exercising a net settle
provision could call into question whether the contract is
a derivative, and we expect the accounting profession
(and SEC) will be on the watch for these situations.

Shortcut Method Extended


The amendments formalize a DIG decision to permit the
short cut method for hedges of securities with embedded
options (e.g., a callable bond). To qualify the option
embedded in the hedging swaption must mirror the
option embedded in the hedged position. See footnote 2
for a summary of the shortcut method.

Conclusion
Again, we urge corporations to review the amendments,
and to provide comments to the FASB on additional
changes they would like to see. We acknowledge the
likelihood of significant changes or concessions are small
at this point in the process. But we would argue that the
comment period is a nothing ventured nothing gained
opportunity to let the FASB know about implementation
issues and constructive ideas to resolve them.

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