Derivative Instruments: Futures, Forwards, Options, Swaps, and Other Derivative Instruments
18.01 The following section provides a discussion about the economic uses of derivative instruments and hedging activities. Refer to FASB Accounting Standards Codification (ASC) 815, Derivatives and Hedging, for accounting guidance on these topics.
18.02 The derivative instruments addressed in this chapter, which include futures, forwards, swaps, and option contracts, as well as other financial contracts with similar characteristics, have become important financial management tools for banks and savings institutions. These instruments collectively are referred to in this chapter as derivative instruments, which are defined for accounting purposes in paragraphs 83–139 of FASB ASC 815-10-15. This chapter provides background information on basic contracts, risks, and other general considerations to provide a context for related accounting and auditing guidance.
18.03 This chapter focuses on end uses of derivatives, rather than on the broader range of activities that includes the marketing of derivatives to others. Some banks and savings institutions, primarily large commercial banks, act as market makers or dealers in derivatives that are not traded under uniform rules through an organized exchange. The primary goals of those activities are to make a market and earn income on the difference between the bid and offer prices. Although the nature of the transactions often causes individual exposures to offset each other, such activities may be subject to different permutations of risks and different accounting, auditing, and regulatory considerations.
18.04 The AICPA Audit Guide Special Considerations in Auditing Financial Instruments provides background information about financial instruments and discussion of audit considerations relating to financial instruments.
Risks Inherent in Derivatives
18.05 Risks inherent in derivatives, such as credit risk, market risk, legal risk, and control risk, are the same as risks inherent in other types of financial instruments. However, derivatives have unique risks because derivative transactions are designed to create price exposure, and thereby transfer risk, by having their value determined — or derived — from the value of an underlying commodity, security, index, rate, or event. Unlike other financial instruments, derivatives generally do not involve the transfer of a title or principle, require little or no considerations to be exchanged at inception, and as such can be thought of as creating pure price exposure by linking their value to a notional amount (that is, principle of the underlying item). These characteristics give rise to potential risks and rewards substantially greater than the amounts recognized in the statement of financial position. Also, many derivatives are less liquid and have values that are more volatile than those of other financial instruments, potentially alternating between positive and negative values in a short period of time.
18.06 Given these features, a derivative's risks can be difficult to segregate because the interaction of such risks may be complex. This complexity is increased (a) when two or more basic derivatives are used in combination, (b) by the difficulty of valuing complex derivatives, and (c) by the volatile nature of markets for some derivatives. The economic interaction between an institution's position in derivatives and that institution's other on- or off-balance-sheet positions (whether assets or liabilities) is an important determinant of the total risk associated with an institution's derivatives use. Risk assessment, therefore, involves consideration of the specific instrument and its interaction with other on- and off-balance-sheet portfolios and activities. No list of risk characteristics exists that can cover all those complex interactions, but a discussion of the basic risk characteristics associated with derivatives follows.
18.07 Counterparty credit risk of derivative instruments is the risk that the counterparty to a transaction could default or deteriorate in creditworthiness before the final settlement of a transaction’s cash flows. Counterparty credit risk creates a bilateral risk of loss because the market value of a transaction can be positive or negative to either counterparty. For example, if a derivative instrument is in an unrealized gain position to the holder, and the counterparty enters bankruptcy, it is unlikely that the holder would be able to collect the unrealized value of the derivative from the bankrupt counterparty. Conversely, if the derivative instrument is in an unrealized loss position to the holder and the holder experienced financial difficulties, it is possible that the counterparty would not recover the unrealized value of the contract.
18.08 Entities often quantify this risk of loss based upon the derivative's replacement cost — that is, the fair value of an identical contract. Master netting agreements and collateral maintenance provisions are some of the ways that financial institutions and other derivative counterparties seek to reduce counterparty credit risk. Requirements that participants settle or collateralize changes in the value of their positions can mitigate the credit risk associated with many derivatives. Such settlement or collateralization requirements, which are typically based on the change in the value of a position, or group of positions, may occur daily or when the change exceeds a threshold, as governed by the rules of the exchange (for exchange traded derivatives) or through credit support annex agreements of each party’s International Swaps and Derivatives Association master contracts.
18.09 Settlement risk is the related exposure that a counterparty may fail to perform under a contract after the institution has delivered funds or assets according to its obligations under the contract. Settlement risk relates almost solely to over-the-counter (OTC) derivative contracts (that is, nonexchange-traded derivatives). Institutions can reduce settlement risk through master netting agreements, which allows the parties to set off all their related payable and receivable positions at settlement.
18.10 Concentration risk broadly defines the sensitivity of the entity to an excessive concentration of exposure to specific counterparties, industry sectors, geographical locations, or individual transactions; the concept also extends to the degree of anticipated positive correlation in the behavior of such variables under stressed economic conditions.
18.11 Market risk relates broadly to economic losses due to adverse changes in the fair value of the derivative. Related risks include price risk, basis risk, and liquidity risk. Price risk relates to changes in the level of prices due to changes in (a) interest rates, (b) foreign exchange rates, or (c) other factors that relate to market volatilities of the rate, index, or price underlying the derivative. Basis risk relates to the differing effect market forces have on the performance or value of two or more distinct underlyings, possibly in instruments used in combination (see the discussion of hedging that follows). Liquidity risk relates to changes in the ability to sell, dispose of, or close out the derivative, thus affecting its value. This may be due to a lack of sufficient contracts or willing counterparties. Valuation or model risk is the risk associated with the imperfection and subjectivity of models and the related assumptions used to value derivatives.
18.12 Legal risk relates to losses due to a legal or regulatory action that invalidates or otherwise precludes performance by the institution or its counterparty under the terms of the contract or related netting arrangements. Such risk could arise, for example, from insufficient documentation for the contract, an inability to enforce a netting arrangement in bankruptcy, adverse changes in tax laws, or statutes that prohibit entities (such as certain state and local governmental entities) from investing in certain types of financial instruments.
18.13 Control risk relates to losses that result from the failure (or absence) of controls to prevent or detect problems (such as human error, fraud, or system failure) that hinder an institution from achieving its operational, financial reporting, or compliance objectives. Such failure could result, for instance, from unauthorized trading in derivative instruments or in an institution’s failing to understand a contract's economic characteristics, all of which could impact published financial information or compliance with applicable contracts, laws, or regulations. Failure to understand the derivatives used may lead to inadequate design of controls over their use.
Types of Derivatives
18.14 Paragraphs 83–139 of FASB ASC 815-10-15 define the term derivative instrument.
18.15 A key feature of derivatives, as defined in this chapter, is that resulting cash flows are decided by reference to an underlying, such as the following:
a. Rates, indexes (which measure changes in specified markets), or other independently observable factors
b. The value of underlying positions in the following:
i. Financial instruments such as government securities, equity instruments (such as common stock), or foreign currencies
ii. Commodities such as corn, gold bullion, or oil
iii. Other derivatives
c. The occurrence or nonoccurrence of a specified event
18.16 Derivatives can generally be described as either forward-based or option-based or combinations of the two. A traditional forward contract obligates one party to buy and another counterparty to sell an underlying financial instrument, foreign currency, or commodity at a future date at an agreed-upon price. Thus, a forward-based derivative (examples are futures, forward, and swap contracts) is a two-sided contract in that each party potentially has a favorable or unfavorable outcome resulting from changes in the value of the underlying position or the amount of the underlying reference factor. A traditional option contract provides one party that pays a premium (the option holder) with a right, but not an obligation, to buy (call options) or sell (put options) an underlying financial instrument, foreign currency, or commodity at an agreed-upon price on or before a predetermined date. The counterparty (the option writer) is obligated to sell (buy) the underlying position if the option holder exercises the right. Thus, an option-based derivative (examples are option contracts, interest rate caps, interest-rate floors, and swaptions) is one-sided in the sense that, in the event the right is exercised, only the holder can have a favorable outcome (or the loss is limited to any premium paid) and the writer can have only an unfavorable outcome reduced by any premium received. If market conditions would result in an unfavorable outcome for the holder, the holder will allow the right to expire unexercised. The expiration of the option contract results in a neutral outcome for both parties (except for any premium paid to the writer by the holder). Although there are a variety of derivatives, they generally are variants or combinations of these two types of contracts.
18.17 Derivatives also are either exchange-traded or traded OTC. Institutions and dealers trade futures, certain option, and other standardized contracts under uniform rules through an organized exchange. Most of the risk inherent in such exchange-traded derivatives relates to market risk rather than to credit risk. OTC derivatives are privately traded instruments (primarily swap, option, and forward contracts) customized to meet specific needs and for which the counterparty is not an organized exchange. As a result, although OTC derivatives are more flexible, they potentially involve higher credit and liquidity risk.
18.18 A description of the basic contracts and variations follows.
18.19 Forward contracts are contracts negotiated between two parties to purchase and sell a specified quantity of a financial instrument, foreign currency, or commodity at a price specified at origination of the contract, with delivery and settlement at a specified future date. Forward contracts are not traded on exchanges and, accordingly, may be less liquid and generally involve more credit and liquidity risk than futures contracts.
18.20 Forward-rate agreements, which are widely used to manage interest rate risk (IRR), are forward contracts that specify a reference interest rate and an agreed-upon interest rate (one to be paid and one to be received) on an assumed deposit until a specified future date (the settlement date). The assumed deposit is also known as a notional amount. The term of the assumed deposit may begin at a future date; for example, the contract period may be for 6 months, commencing in 3 months. At the settlement date, the seller of the forward-rate agreement pays the buyer if interest calculated at the reference rate is higher than that calculated at the agreed-upon rate; conversely, the buyer pays the seller if interest calculated at the agreed-upon rate is higher than that calculated at the reference rate. Treasury rate locks are a type of forward-rate agreement where the settlement is based upon the price movements of a particular reference U.S. Treasury issuance rather than to a deposit. Examples of such reference instruments would be the current on-the-run 10-year U.S. Treasury security or possibly the Committee on Uniform Security Identification Procedures identifier of a particular U.S. Treasury issuance.
18.21 Futures contracts are forward-based contracts to make or take delivery of a specified financial instrument, foreign currency, or commodity at a specified future date or during a specified period at a specified price or yield. Futures are standardized contracts traded on an organized exchange. The deliverable financial instruments underlying interest-rate futures contracts are specified investment-grade financial instruments, such as U.S. Treasury securities or mortgage-backed securities (MBSs). Foreign-currency futures contracts involve specified deliverable amounts of a particular foreign currency. The deliverable products under commodities futures contracts are specified amounts and grades of commodities, such as oil, gold bullion, or coffee.
18.22 Active markets exist for many financial and commodities futures contracts. Active markets provide a mechanism by which entities may transfer their exposures to price risk to other parties. Those parties may, in turn, be trying to manage their own financial risks or achieve gains through speculation. Recognized exchanges, such as the International Monetary Market (a division of the Chicago Mercantile Exchange) or the Chicago Board of Trade, establish conditions governing transactions in futures contracts. U.S. Treasury bond (interest-rate) futures contracts are the most widely traded financial futures contracts. To ensure an orderly market, the exchanges specify maximum daily price fluctuations for each type of contract. If the change in price from the previous day's close reaches a specified limit, no trades at a higher or lower price are allowed. Consequently, trading in the contract is stopped until buy orders and sell orders can be matched either within the daily price limits or on the next business day. Such limits may affect liquidity and thereby hinder the effectiveness of futures contracts used as hedges.
18.23 Brokers require both buyers and sellers of futures contracts to deposit assets (such as cash, government securities, or letters of credit) with a broker. Such assets represent the initial margin (which is a good-faith deposit) at the time the contract is initiated. The brokers mark open positions to market daily and either call for additional assets to be maintained on deposit when losses are experienced (a margin call) or credit customers' accounts when gains are experienced. This daily margin adjustment is called variation margin. Variation margin payments generally must be settled daily in cash or acceptable collateral, thus reducing credit risk. The broker returns the initial margin when the futures contract is closed out or the counterparty delivers the underlying financial instrument according to the terms of the contract.
18.24 Delivery of the commodity or financial instrument underlying futures contracts occurs infrequently, as contracts usually are closed out before maturity. This close-out process involves the participants entering a futures contract that is equal and opposite to a currently held futures contract. This provides the participant with equal and opposite positions and obligations and eliminates any subsequent market movements from affecting the net asset or obligation during the remaining lives of the futures contracts.
18.25 Swap contracts are forward-based contracts in which two parties agree to swap streams of payments over a specified period. The payment streams are based on an agreed-upon (or notional) principal amount. The term notional is used because swap contracts generally involve no exchange of principal at either inception or maturity. Rather, the notional amount serves as a basis for calculation of the payment streams to be exchanged. Many swap contracts are not exchange-traded; however, certain types of interest rate, currency, and credit default swaps are required to be executed on an exchange or swap execution facility and settled through a clearinghouse. These execution and clearing requirements are the result of regulations and are applicable depending on the nature and size of the parties in the transaction. OTC swaps are generally tailored to the needs of the parties and thus often have unique terms; accordingly, they are not as liquid as futures contracts and may lack the credit protection provided by regulated exchanges. The failure by a counterparty to make payments under a swap contract usually results in an economic loss to an institution only if the underlying prices (for example, interest rates or foreign exchange rates) have moved in an adverse direction (that is, in the direction that the swap contract was intended to protect against). The economic loss corresponds to the cost to replace the swap contract. That cost would be the present value of any discounted net cash inflows that the swap contract would have generated over its term.
18.26 Interest-rate swaps are the most prevalent type of swap contract. One party generally agrees to make periodic payments, which are fixed at the outset of the swap contract. The counterparty agrees to make variable payments based on a market interest rate (index rate). Swap contracts allow institutions to achieve net payments similar to those that would be achieved if the institution actually changed the interest rate of designated assets or liabilities (the underlying cash position) from floating to fixed rate or vice versa.
18.27 Interest-rate swap contracts are considered a flexible means of managing IRR. Because swap contracts are customized for institutions, terms may be longer than futures contracts, which generally have delivery dates from three months to three years. Swap contract documentation usually is standardized and transactions can be concluded quickly, making it possible to rapidly take action against anticipated interest-rate movements.
18.28 Interest-rate swap contracts normally run to maturity. However, there may be circumstances that eliminate an institution's need for the swap contract before maturity. In such instances, an institution may cancel contracts, sell its position, or enter an offsetting swap contract.
18.29 In some swap contracts, the timing of payments varies. For example, in an interest-rate swap contract, one party might pay interest quarterly while the counterparty pays interest semiannually. An added element of credit risk exists for the quarterly payer because of the risk that the semiannual payer may default. Here, the economic loss equals the lost quarterly payment and the cost of replacing the swap contract.
18.30 Many entities enter legally enforceable master netting agreements that may reduce total credit risk. Upon default by an applicable counterparty, the agreements provide that entities may set off (for settlement purposes) all their related payable and receivable derivative contract positions.
18.31 Foreign-currency swaps (sometimes called cross-currency exchange agreements) are used to fix (for example, in U.S. dollar terms) the value of foreign exchange transactions that will occur in the future. Foreign-currency swap contracts are also used to transfer a stream of cash flows denominated in a particular currency or currencies into another currency or currencies. Basic features of foreign-currency swap contracts include the following:
• The principal amount is usually exchanged at the initiation of the swap contract.
• Periodic interest payments are made based on the outstanding principal amounts at the respective interest rates agreed to at inception.
• The principal amount is usually re-exchanged at the maturity date of the swap contract.
18.32 In fixed-rate-currency swaps, two counterparties exchange fixed-rate interest in one currency for fixed-rate interest in another currency. Currency coupon or cross-currency interest-rate swap contracts combine the features of an interest-rate swap contract and a fixed-rate-currency swap contract. That is, the counterparties exchange fixed-rate interest in one currency for floating-rate interest in another currency.
18.33 Basis swaps are a variation on interest-rate swap contracts where both rates are variable but are tied to different index rates. For example, one party's rate may be indexed to three-month London Interbank Offered Rate (LIBOR) while the other party's rate is indexed to six-month LIBOR.
18.34 Equity swaps, also known as total return swaps, are contracts in which the counterparties exchange a series of cash payments based on (a) an equity index and (b) a fixed or floating interest rate on a notional principal amount. Equity swap contracts typically are tied to a stock index, but sometimes they relate to a particular stock or a defined basket of stocks. One party (the equity payer) pays the counterparty (the equity receiver) an amount equal to the increase in the stock index at regular intervals specified in the contract. Conversely, the equity receiver must pay the equity payer if the stock index declines. The counterparties generally make quarterly payments. Whatever the index performance, the party designated as the equity receiver may also receive an amount representing dividends paid by the companies making up the index during the period.
18.35 The equity payer, on a floating-rate equity swap contract, typically receives LIBOR (plus or minus a spread) on the notional principal amount defined in the equity swap contract. This notional principal amount is based on the underlying equity index value at the contract's inception. The notional principal amount is adjusted at each payment date to reflect the settlement of the equity gain or loss. The floating rate is also reset on the periodic payment dates. A fixed-rate equity swap contract is essentially the same, except that the interest rate is fixed for the term of the contract.
18.36 Commodity swaps are contracts in which the counterparties agree to exchange cash flows based on the difference between an agreed-upon, fixed price and a price that varies with changes in a specified commodity index, as applied to an agreed-upon quantity of the underlying commodity.
18.37 In mortgage swaps, two counterparties exchange contractual payments designed to replicate the net cash flows of a portfolio of MBSs financed by short term floating-rate funds. For example, mortgage swaps enable an institution to finance mortgage securities at a rate tied to a floating-rate index below LIBOR on a guaranteed, multiyear basis. Mortgage swaps have been described as being similar to an amortizing interest-rate swap (rather than one with a fixed notional principal amount) with a long term forward commitment to purchase MBSs. In a typical mortgage swap transaction, an investor contracts with a third party to receive cash flows based on a generic class of MBSs over a specified period in exchange for the payment of interest at a rate typically based on LIBOR. The payments are made as if there were an underlying notional pool of mortgage securities. Payments are exchanged on a monthly basis. The cash flows received by the investor are derived not only from the fixed coupon on the generic class of securities but also, to the extent that the coupon is above or below par, from the benefit or loss implicit to the discount or premium. The notional amount of the mortgage swap is adjusted monthly, based on the amortization and prepayment experience of the generic class of MBSs.
18.38 The contract may require the investor either to take physical delivery of mortgages at a predetermined price (for example, a percentage of the par amount of mortgages remaining in the pool) when the contract expires or to settle in cash for the difference between the predetermined price of the mortgages and their fair value as determined by the dealer.
18.39 Overnight index swaps are swap contracts where the floating rate is based upon the geometric average of the overnight rates for the period. The overnight index swap rate is an interest rate representative of the amount of interest paid on funds deposited for one day, such as posted collateral. It is becoming more common to see overnight index swap rates used in the pricing of swaps where collateral is required to be posted to reduce counterparty nonperformance risks.
18.40 Option contracts are traded on an exchange or OTC (that is, they are negotiated between two parties). Option contracts allow, but do not require, the holder (or purchaser) to buy (call) or sell (put) a specific or standard commodity, or financial or equity instrument, at a specified price during a specified period (an American option), at a specified date (a European option), or dates (a Bermudian option). Furthermore, certain option contracts may involve cash settlements based on changes in specified indexes, such as stock indexes. Again, the principal difference between option contracts and either futures or forward contracts are that an option contract does not require the holder to exercise the option, whereas performance under a futures or forward contract is mandatory.
18.41 At the inception of an option contract, the holder typically pays a fee, which is called a premium, to the writer (or seller) of the option. The premium includes 2 components of value: the intrinsic value and the time value. The intrinsic value of a call option is the excess, if any, of the market price of the item underlying the option contract over the price specified in the option contract (the strike price or the exercise price). The intrinsic value of a put is the excess, if any, of the option contract's strike price over the market price of the item underlying the option contract. The intrinsic value of an option cannot be less than zero. The other component of the premium's value is the time value. The time value reflects the probability that the price of the underlying item will move above the strike price (for a call) or below the strike price (for a put) during the exercise period. For example, suppose an entity owned a call option that granted it the right to purchase a given stock at $50 per share. If the price of the underlying stock is $50, then the intrinsic value of the option is $0. If the price of the stock rises to $55 per share, then the intrinsic value is $5 because the entity can purchase for $50 an asset that has a market value of $55. If the market value of the shares drops to $45 per share, then the option will not be exercised; it has an intrinsic value of $0.
18.42 The advantage of option contracts held is that they can be used to either mitigate downside price risk or to permit upside profit potential. This is because the loss on a purchased option contract is limited to the amount paid for the option contract. Profit on written option contracts is limited to the premium received but the loss potential is unlimited because the writer is obligated to settle at the strike price if the option is exercised.
18.43 Option contracts are frequently processed through a clearinghouse that guarantees the writer's performance under the contract. This reduces credit risk, much like organized exchanges reduce credit risk for futures contracts. Thus, such option contracts are primarily subject to market risk. However, for option contracts that are not processed through the clearinghouse, the holder may have significant credit and liquidity risks.
18.44 Different option contracts can be combined to transfer risks from one entity to another. Examples of such option-based derivatives are caps, floors, collars, and swaptions (an option to enter a swap).
18.45 Interest-rate caps are contracts in which the cap writer, in return for a premium, agrees to limit, or cap, the cap holder's risk associated with an increase in interest rates for a certain period of time. If rates go above a specified interest-rate level (the strike price or the cap rate), the cap holder is entitled to receive cash payments equal to the excess of the market rate over the strike rate multiplied by the notional amount. Issuers of floating-rate liabilities often purchase caps to protect against rising interest rates while retaining the ability to benefit from a decline in rates.
18.46 Because a cap is an option-based contract, the cap holder has the right but not the obligation to exercise the option. If rates move down, the cap holder has lost only the premium paid. Because caps are not exchange-traded, however, they expose the cap holder to credit risk because the cap writer could fail to fulfill its obligations to the cap holder.
18.47 A cap writer has virtually unlimited risk resulting from increases in interest rates above the cap rate. However, the cap writer's premium may potentially provide an attractive return.
18.48 Interest-rate floors are similar to interest-rate caps. Interest-rate floors are contracts in which the floor writer, in return for a premium, agrees to limit the risk associated with a decline in interest rates based on a notional amount for a certain period of time. If rates fall below an agreed rate, the floor holder will receive cash payments from the floor writer equal to the difference between the market rate and an agreed rate multiplied by the notional amount. Floor contracts allow floating-rate lenders to limit the risk associated with a decline in interest rates while benefiting from an increase in rates. As with interest-rate caps, the floor holder is exposed to credit risk because the floor writer could fail to fulfill its obligations.
18.49 Interest-rate collars combine a cap and a floor (one held and one written). Interest-rate collars enable an institution with a floating-rate contract to lock into a predetermined interest-rate range.
18.50 Swaptions are option contracts to enter into an interest-rate swap contract at some future date or to cancel an existing swap contract in the future. As such, a swaption contract may act as a floor or a cap for an existing swap contract or be used as an option to enter, close out, or extend a swap contract in the future.
18.51 Various contracts may need to be evaluated as possible derivatives including warrants, the embedded conversion feature in convertible debt or convertible preferred stock, and other embedded derivatives that may or may not require bifurcation. Warrants generally meet the definition of a derivative and should be accounted for as such unless they meet the exception criteria in paragraphs 74–75 of FASB ASC 815-10-15 (see also FASB ASC 815-40 for additional information). Features embedded in contracts or agreements may require separate accounting as a derivative, and complex pricing structures may increase the complexity of the assumptions used in estimating the fair value of a derivative. Warrants and embedded derivatives are less likely to be identified by management as requiring derivative treatment, which increases the inherent risk for certain assertions. For example, an option to convert the principal outstanding under a loan agreement into equity securities is less likely to be identified for valuation and disclosure considerations if it is a clause in a loan agreement than if it is a freestanding agreement. Similarly, a structured note may include a provision for payments related to changes in a stock index or commodities prices that requires separate accounting. Certain embedded interest structures also require separate accounting. FASB ASC 815 requires bifurcation (separation) of embedded derivatives from host contracts if (a) the economic characteristics and risks of the embedded derivative are not clearly and closely related to those of the host, (b) a separate instrument with the same terms as the embedded derivative would be a derivative instrument subject to the requirements of FASB ASC 815-15, and (c) the hybrid instrument is not currently measured at fair value through profit or loss. For additional information on the scope of embedded derivatives guidance and evaluating embedded derivatives for bifurcation, see FASB ASC 815-15-15 and FASB ASC 815-15-25, respectively.
18.52 Credit derivatives are derivatives based on an index, basket of reference entities, or single name reference entity where settlement is determined by the credit performance of the reference entity. The writer of a credit derivative receives a premium (either paid up front or over the life of the contract) as compensation for an obligation to make a payment should a defined credit event occur on the underlying referenced obligation(s). Credit events may include bankruptcy, failure to pay, decline in credit rating, or repudiation. These instruments may be used by financial institutions to reduce or modify the credit exposure of their loan or investment portfolios. Credit derivatives should not be confused with financial guarantee contracts as described in FASB ASC 815-10-15-58, which are not derivatives. Credit derivatives differ from financial guarantees in that credit derivatives require settlement regardless of whether the holder has suffered a loss based on the underlying referenced obligation(s), whereas a settlement under a financial guarantee contract is based on loss suffered by the holder. A letter of credit is an example of a financial guarantee contract.
Uses of Derivatives to Alter Risk
18.53 Financial market participants have created a large variety of derivatives. Not only are there basic contracts, but there are variants tailored to add, subtract, multiply, or divide the related risk and reward characteristics and thereby satisfy specific risk objectives of the parties to the transactions. Such innovation has been driven by the users' desire to cope with (or attempt to take advantage of) market volatility in foreign exchange rates, interest rates, and other market prices; deregulation; tax law changes; and other broad economic or business factors. An institution may attempt to alter such risks (a) at a general level (that is, the overall risk exposures faced by the institution), (b) at the level of specific portfolios of assets or liabilities, or (c) narrowly to a specific asset, liability, or anticipated transaction. Uses of derivatives to alter risks range from uses that help mitigate or control volatile risk exposures (activities that include the idea of taking defensive action against risk through hedging) to uses that increase exposures to risk and, by that, the potential rewards (the idea of offensive action, often considered as trading or speculation).
18.54 Speculation. Speculation involves the objective of profiting by entering into an exposed position. That is, assuming risk in exchange for the opportunity to profit from anticipated market movements. A speculator believes that the cash market price of an underlying commodity, financial instrument, or index will change so that the derivative produces net cash inflows or can be closed out in the future at a profit. By simultaneously buying the relatively cheaper item and selling the relatively more expensive item, speculation serves a key function in the financial markets by eliminating price differences and works to keep markets and their prices efficient. See discussion of the Volcker Rule prohibiting banks from propriety trading for their own account in paragraphs 1.48 and 18.77–.78 of this guide.
18.55 Risk management. Most institutions that use derivatives do so to increase or decrease risks associated with existing or anticipated on- or off-balance-sheet transactions, not for speculation. Institutions often manage financial risks both generally (through management of the overall mix of financial assets and liabilities) and specifically (through hedges of specific risks or transactions). Risk managers typically look at the mix of the institution’s interest-based assets and liabilities and attempt to economically hedge those instruments where right of setoff exists. Any excess or shortfalls in the economic hedges may then be offset by looking to derivatives and other financial instruments to achieve the degree of offset necessary to insulate the institution from movements in market interest rates.
18.56 Some entities continually analyze and manage financial assets and liabilities based on their payment streams and interest rates, the timing of their maturities, and their sensitivity to actual or potential changes in market prices or interest rates. Such activities fall under the broad definition of asset/liability management. Some institutions enter into derivatives to help manage and select their total exposure to IRR. Institutions also enter into derivatives to convert the cash flow pattern and market risk profile of assets and liabilities. Those instruments can be used in the institution's asset/liability management activities to synthetically alter the interest income and expense flows of certain assets or liabilities. For example, an institution can convert the cash flow pattern and market risk profile of floating-rate debt to those of fixed-rate debt by entering an interest-rate swap contract. (Note that synthetic instrument accounting is prohibited by FASB ASC 815-10-25-4).
18.57 Hedging connotes a risk alteration activity to protect against the risk of adverse price movements on certain of an institution's assets, liabilities, or anticipated transactions. A hedge is a defensive strategy. It is used to avoid or reduce risk by creating a relationship by which losses on certain positions (assets, liabilities, or anticipated transactions) are expected to be counterbalanced in whole or in part by gains on separate positions in another market. For example, an institution may want to attempt to fix the value of an asset, the sales price of some portion of its future production, the rate of exchange for payments to its suppliers, or the interest rates of existing or an anticipated issuance of debt. Derivatives may be designated as accounting hedges, as discussed further in the “Accounting and Financial Reporting” section of this chapter. Derivatives not designated as accounting hedges either because they do not qualify for specialized hedge accounting, or by management choice, but held to offset a risk are commonly referred to as economic hedges. If not held for an accounting or economic hedge, and if unrelated to transactions with customers and others (for instance, a bank may underwrite floating rate debt and also enter into a fixed to floating rate swap with the same customer or compensate employees with derivative instruments), the use of a derivative is generally considered speculative.
18.58 The use of various financial instruments to reduce certain risks results in the hedger assuming a different set of risks. Effective control and management of risks through hedging, usually depends on a thorough understanding of the market risks associated with the financial instrument that is part of the hedging program.
18.59 Basis risk is an important risk encountered with most hedging contracts. As introduced previously, basis is the difference between the cash market price of the instrument or other position being hedged and the price of the related hedging contract. The institution is subject to the risk that the basis will change while the hedging contract is open (that is, the price correlation will not be perfect). Changes in basis can occur continually and may be significant. Changes in basis can occur even if the position underlying the hedging contract is the same as the position being hedged. However, entities often enter a hedging contract, such as a futures contract, on a position that is different from the position being hedged. Such cross-hedging increases the basis risk.
18.60 As cash market prices change, the prices of related hedging contracts change, but not necessarily to the same degree. Correlation is the degree to which hedging contract prices reflect the price movement in the cash market. The higher the correlation between changes in the cash market price and the hedging contract's price, the higher the precision with which the hedging contract will offset the price changes of the position being hedged (that is, less basis risk).
18.61 Gains or losses on the hedge position will not exactly offset the exposed cash market positions when the basis changes. The institution might enter a hedge when (a) it is perceived that the risk of a change in basis is lower than the risk associated with the cash market price exposure or (b) there is the ability to monitor the basis and to adjust the hedge position in response to basis changes.
18.62 Basis changes occur in response to many factors. Among them are (a) economic conditions, (b) supply and demand for the position being hedged, (c) liquidity of the cash market and the futures market for the instrument, (d) the credit rating of the cash instrument, and (e) the maturity of the instrument being hedged as compared with the instrument represented in the hedging contract. A discussion of how these factors affect basis is beyond the scope of this chapter. However, convergence — a significant contributor to a change in the basis over time — warrants mention.
18.63 Convergence is the shrinking of the basis between the hedging contract's price and the cash market price as the contract delivery date approaches. The hedging contract's price includes an element related to the time value up to the expiration of the contract. Convergence results from the delivery feature of hedging contracts that encourages the price of an expiring contract to equal the price of the deliverable cash market instrument on the day that the contract expires. As the delivery day approaches, prices generally fluctuate less and less from the cash market prices because the effect of expectations related to time is diminishing.
18.64 The correlation factor represents the potential effectiveness of hedging a cash market instrument with a contract where the deliverable financial instrument differs from the cash market instrument. The correlation factor generally is determined by regression analysis or another method of technical analysis of market behavior. When a high degree of positive correlation has historically existed between the hedging instrument price and the cash market price of the instrument being hedged, the risk of price variance associated with a cross-hedge is expected to be lower than the risk of not being hedged. Institutions usually employ the correlation factor to analyze cross-hedging risk at the inception of the hedge, while actual changes in the relative values of the hedge instrument and the hedged item usually are employed throughout the hedge period to measure correlation.
Variations on Basic Derivatives
18.65 Some derivatives combine two or more basic contracts and thereby the risk and reward characteristics of several different products. Written options and other variations embedded in certain derivative and non-derivative contracts can magnify interest-rate and other risks assumed by the institution as end user. Included may be variations affecting the term, notional amount, interest rate, or specified payments. These variations have the potential to produce higher cash inflows or outflows than similar instruments that do not contain the option feature. This follows the general rule that the greater the potential return, the higher the risk.
18.66 Some swap contracts involve the institution’s writing of options that the counterparty issuer may exercise if certain changes occur in the index rate or under other specified circumstances. As with most option contracts (and allowing for the effect of the premium paid for the contract) the holder of the option (here, the counterparty) has a potentially favorable (or neutral) outcome, while the writer of the option (here, the institution) has a potentially unfavorable (or neutral) outcome if the option is exercised. For example, the counterparty will exercise an option to sell securities to the institution at a specified price only when that price exceeds the current market prices. Accordingly, the institution must analyze such contracts carefully to understand the nature of the derivative and how it will work under various interest-rate and other conditions.
18.67 Other variations. Other variations built into derivatives may necessitate certain actions be taken by the institution or may result in changes in terms if specified events or conditions occur. For example, such variations might involve
• increases or decreases in the notional amount based on certain changes in interest rates;
• increases or decreases in interest rates based on a multiplier (that is, leverage);
• additional payments as a result of specified conditions; and
• a settlement payment based upon the expiration of a contract.
18.68 Some swap contracts magnify changes in the specified index rate by tying floating payments to an exponent of the index rate over a specified denominator. The risks of this variation, a contract with embedded leverage terms, are similar to the risks posed by written options. Consider a contract that specifies the floating rate as 3-month LIBOR squared and divided by 5 percent. Assume that 3-month LIBOR is 5 percent at inception. If 3-month LIBOR were to climb 5 basis points to 5.05 percent, the increase would be magnified. The floating rate would increase 10 basis points to approximately 5.10 percent (5.05 percent squared and divided by 5 percent). Thus, at this level of interest rates, an increase of 1 basis point in the index rate for the contract would result in an increase of 2 basis points in the contractual rate — in other words, 1 basis point on twice the stated notional amount.
18.69 Finally, the notional principal amount of certain swap contracts changes with changes in the rate to which the floating payments are indexed. These are called index amortizing swaps. For example, the notional principal amount may decrease when interest rates decline. Thus, the floating-rate payer would lose some of the benefit of declining interest rates but would not get a corresponding benefit if interest rates increase.
18.70 Banking Circular 277, Risk Management of Financial Derivatives, issued by the Office of the Comptroller of the Currency (OCC), addresses banks' risk management of derivatives and sets forth best practices and procedures for managing risk. Bulletin OCC 94-31, Risk Management of Financial Derivatives Q & A’s, answers commonly asked questions about Banking Circular 277. Through Bulletin OCC 2014-8, End-User Derivatives and Trading Activities: Comptroller’s Handbook Supplemental Examination Procedures, the OCC issued supplemental exam procedures applicable to banks that are active end users of derivatives or that have significant trading activity. The Board of Governors of the Federal Reserve System (Federal Reserve) issued supervisory concerns on trust preferred stock that has been hedged with an interest rate derivative contract that is asymmetrical with regard to deferral terms in Supervision and Regulation (SR) letter 02-10, Derivative Contracts Hedging Trust Preferred Stock. The FDIC issued guidance for its examiners in Financial Institution Letter (FIL)-62-96, Credit Derivatives, and FIL-45-98, Investment Activities. Derivatives: Practice and Principles and related appendices, published by the Global Derivatives Study Group in 1993, also recommends a set of sound risk management practices for dealers and end-users of derivatives. Readers can access the guidance from any of the respective agencies’ websites.
18.71 Intercompany transactions and performance of services between two or more U.S. Bank legal vehicles and all their affiliates must be conducted in compliance with the applicable statutory and regulatory requirements of Sections 23A–23B of the Federal Reserve Act (Banks and Banking, U.S. Code 12, Section 371c and 371c–1) and Regulation W (Title 12 U.S. Code of Federal Regulations [CFR] Part 223) of the Federal Reserve Act. Derivative transactions are subject to the market terms requirement of Section 23B. Accordingly, each institution would price, and require collateral in, derivative transactions with affiliates in a way that is at least as favorable to the institution as the way the institution would price, or require collateral in, a derivative transaction with comparable unaffiliated counterparties. Credit derivatives that are the functional equivalent of a guarantee are also subjected to Section 23A, and the Federal Reserve Board suggests that other derivative transactions that are the functional equivalent of a loan might be subject to the requirements of Section 23A, depending on facts and circumstances. Regulation W also requires the bank to have policies and procedures in place to manage the credit exposure arising from derivatives with affiliates in a safe and sound manner (see 12 CFR 223.33[b]).
18.72 The Federal Financial Institutions Examination Council’s (FFIEC’s) Advisory on Interest Rate Risk Management, issued in January 2010,2 reminds institutions of supervisory expectations of sound practices for managing IRR. This advisory reiterates the importance of effective corporate governance, policies and procedures, risk measuring and monitoring systems, stress testing, and internal control related to the IRR exposures of depository institutions. It also clarifies elements of existing guidance and describes some IRR management techniques used by effective risk managers. For the complete text of the advisory, see the FFIEC’s website at www.ffiec.gov.
18.73 On March 22, 2010, the OCC, the Federal Reserve, and the FDIC (collectively, the federal banking agencies), along with the Office of Thrift Supervision (prior to its transfer of powers to the OCC, the Federal Reserve, and the FDIC),3 and the National Credit Union Administration issued Interagency Policy Statement on Funding and Liquidity Risk Management. The policy statement summarizes the principles of sound liquidity risk management that the agencies have issued in the past and, when appropriate, supplements them with the Principles for Sound Liquidity Risk Management and Supervision issued by the Basel Committee on Banking Supervision in September 2008. This policy statement emphasizes supervisory expectations for all depository institutions including banks, thrifts, and credit unions.
18.74 Policies on funding and liquidity risk management should clearly articulate a liquidity risk tolerance that is appropriate for the business strategy of the institution considering its complexity, business mix, liquidity risk profile, and its role in the financial system. Policies should also contain provisions for documenting and periodically reviewing assumptions used in liquidity projections. Policy guidelines should employ both quantitative targets and qualitative guidelines. For example, these measurements, limits, and guidelines may be specified in terms of the measures and conditions mentioned in the policy statement, as applicable to derivatives (for example, contingent liability exposures such as unfunded loan commitments, lines of credit supporting asset sales or securitizations, and collateral requirements for derivative transactions and various types of secured lending; or exposures of material activities, such as securitization, derivatives, trading, transaction processing, and international activities, to broad systemic and adverse financial market events. This is most applicable to institutions with complex and sophisticated liquidity risk profiles).
18.75 In response to the increased risk for model management, the OCC and the Federal Reserve jointly developed and issued Supervisory Guidance on Model Risk Management, which was released as Bulletin OCC 2011-12, Sound Practices for Model Risk Management: Supervisory Guidance on Model Risk Management, and SR letter 11-7, Guidance on Model Risk Management, in April 2011. The guidance replaces Bulletin OCC 2000-16, Risk Modeling: Model Validation. Although model validation remains at the core of the guidance, the broader scope of model risk management encompasses model development, implementation, and use, as well as governance and controls related to models. All banks and savings and loan holding companies should ensure that internal policies and procedures are consistent with the risk management principles and supervisory expectations contained in this guidance. For further information, readers can access the supervisory guidance from either the OCC website at www.occ.gov or the Federal Reserve website at www.federalreserve.gov.
18.76 In June 2011, the federal banking agencies issued Interagency Supervisory Guidance on Counterparty Credit Risk. The guidance clarifies supervisory expectations and sound practices for an effective counterparty credit risk management framework. The guidance emphasizes that banks should use appropriate reporting metrics and limits systems, have well-developed and comprehensive stress testing, and maintain systems that facilitate measurement and aggregation of counterparty credit risk throughout the organization. The guidance is intended for banks with significant derivatives portfolios. Banks with limited derivatives exposure, particularly noncomplex exposures that are typical for community banks (such as embedded caps and floors on assets or liabilities, forward agreements to sell mortgages, or simple interest rate swaps) should apply this guidance as appropriate. Banks using derivatives that are more complex or those with significant noncomplex derivatives exposure should refer to the guidance for applicable risk management principles and practices. Readers can access the guidance from any of the federal banking agencies’ websites.
18.77 In January 2014, the OCC, the Federal Reserve, the FDIC, and the SEC published a final rule, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With, Hedge Funds and Private Equity Funds, implementing Section 13 of the Bank Holding Company Act, which was added by Section 619 (commonly referred to as the Volcker Rule) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (see additional discussion in chapter 1, “Industry Overview — Banks and Savings Institutions,” of this guide). National banks (other than certain limited-purpose trust banks), federal savings associations, and federal branches and agencies of foreign banks are required to fully conform their activities and investments to the requirements of the final regulations by the end of the conformance period, which the Federal Reserve extended to July 21, 2015.
18.78 The final regulations
• prohibit banks from engaging in short-term proprietary trading of certain securities, derivatives commodity futures, and options on these instruments for their own accounts.
• impose limits on banks’ investments in, and other relationships with, hedge funds and private equity funds.
• provide exemptions for certain activities, including market-making-related activities, underwriting, risk-mitigating hedging, trading in government obligations, insurance company activities, and organizing and offering hedge funds and private equity funds.
• clarify that certain activities are not prohibited, including acting as agent, broker, or custodian.
• scale compliance requirements based on the size of the bank and the scope of the activities. Larger banks are required to establish detailed compliance programs and their CEOs must attest to the OCC that the bank’s programs are reasonably designed to achieve compliance with the final regulations. Smaller banks engaged in modest activities are subject to a simplified compliance program.
18.79 FASB ASC 815-10-05-4 requires that an entity recognize derivative instruments, including certain derivative instruments embedded in other contracts as assets or liabilities, in the statement of financial position and measure them at fair value. If certain conditions are met, an entity may elect, under FASB ASC 815, to designate a derivative instrument in any one of the following ways:
a. A hedge of the exposure to changes in the fair value of a recognized asset or liability, or an unrecognized firm commitment that is attributable to a particular risk (referred to as a fair value hedge)
b. A hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk (referred to as a cash flow hedge)
c. A hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment (a foreign currency fair value hedge), an available-for-sale security (a foreign currency fair value hedge), or a forecasted transaction (a foreign currency cash flow hedge)
18.80 FASB ASC 820-10-20 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Paragraphs 5 and 5A of FASB ASC 820-10-35 state that a fair value measurement assumes that the transaction to sell the asset or transfer the liability takes place either in the principal market for the asset or liability or, in the absence of a principal market, in the most advantageous market for the asset or liability. The FASB ASC glossary defines the principal market as the market with the greatest volume and level of activity for the asset or liability. A reporting entity need not undertake an exhaustive search of all possible markets to identify the principal market or, in the absence of a principal market, the most advantageous market, but it should take into account all information that is reasonably available. In the absence of evidence to the contrary, the market in which the reporting entity normally would enter into a transaction to sell the asset or to transfer the liability is presumed to be the principal market or, in the absence of a principal market, the most advantageous market. If the market in which the transaction takes place is different from the principal market (or most advantageous market), the transaction price might not represent the fair value of an asset or liability at initial recognition as stated in FASB ASC 820-10-30-3A(d). Under FASB ASC 820-10-35-53, when relevant observable inputs are not otherwise available, the use of unobservable data to measure fair value is permitted. Unobservable inputs should reflect assumptions that market participants would use when pricing the asset or liability including assumptions about risk. See chapter 20, “Fair Value,” of this guide and FASB ASC 820, Fair Value Measurement, for additional information.
18.81 The specific criteria for qualifying for hedge accounting vary depending on the type of hedge. (FASB ASC 815-20-25 sets forth criteria that must be met for designated hedging instruments and hedged items or transactions to qualify for fair value hedge accounting, cash flow hedge accounting, and accounting for a hedge of a net investment in a foreign operation.) FASB ASC 815-20-25-3 prescribes requirements for designation and documentation of the hedge at inception for cash flow and fair value hedges. One aspect of qualification should include an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged, as stated in FASB ASC 815-10-10-1(d). To meet the documentation requirement applicable to fair value, cash flow, and net investment hedges, at the inception of the hedge, management must designate the derivative as a hedge and contemporaneously formally document the hedging relationship, including identification of all of the following as stated in FASB ASC 815-20-25-3(b):
• The hedging relationship.
• The entity’s risk management objective and strategy for undertaking the hedge, including identification of all of the following:
— The hedging instrument.
— The hedged item or transaction.
— The nature of the risk being hedged.
— The method that will be used on an ongoing basis to retrospectively and prospectively assess the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value (if a fair value hedge) or hedged transaction’s variability in cash flows (if a cash flow hedge) attributable to the hedged risk. There should be a reasonable basis for how the entity plans to assess the hedging instrument’s effectiveness.
— The method that will be used to measure hedge ineffectiveness (including those situations in which the change in fair value method as described in paragraphs 31–32 of FASB ASC 815-30-35 will be used).
— If the entity is hedging foreign currency risk on an after-tax basis, that the assessment of the effectiveness, including the calculation of ineffectiveness, will be on an after-tax basis (rather than on a pretax basis).
Considerations for Private Companies That Elect to Use Standards as Issued by the Private Company Council
FASB ASC 815 also allows the use of the simplified hedge accounting approach to account for swaps that are entered into for the purpose of economically converting a variable-rate borrowing into a fixed-rate borrowing. The approach may be applied to all entities, except for public business entities and not-for-profit entities as defined in the FASB ASC glossary, employee benefit plans within the scope of FASB ASC 960 through FASB ASC 965 on plan accounting, and financial institutions. As described in FASB ASC 942-320-50-1, the term financial institutions includes banks, savings and loan associations, savings banks, credit unions, finance companies, and insurance entities. Because mortgage companies do not fall under the financial institutions exclusion, mortgage companies that are not public business entities would be permitted to follow the simplified hedge accounting approach. Under this approach, the income statement charge for interest expense will be similar to the amount that would result if the entity had directly entered into a fixed-rate borrowing instead of a variable-rate borrowing and a receive-variable, pay-fixed interest rate swap. Alternatively, that entity may continue to follow the current guidance in FASB ASC 815.
The simplified hedge accounting approach provides entities within its scope with a practical expedient to qualify for cash flow hedge accounting under FASB ASC 815. Under this approach, an entity may assume no ineffectiveness for qualifying swaps designated in a hedging relationship under FASB ASC 815. This approach can be applied to a cash flow hedge of a variable-rate borrowing with a receive-variable, pay-fixed interest rate swap provided all of the following criteria are met:
• Both the variable rate on the swap and the borrowing are based on the same index and reset period (for example, both the swap and borrowing are based on one-month LIBOR or both the swap and borrowing are based on three-month LIBOR). In complying with this condition, an entity is not limited to benchmark interest rates described in FASB ASC 815-20-25-6A.
• The terms of the swap are typical (in other words, the swap is what is generally considered to be a “plain-vanilla” swap), and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap.
• The repricing and settlement dates for the swap and the borrowing match or differ by no more than a few days.
• The swap’s fair value at inception (that is, at the time the derivative was executed to hedge the IRR of the borrowing) is at or near zero.
• The notional amount of the swap matches the principal amount of the borrowing being hedged. In complying with this condition, the amount of the borrowing being hedged may be less than the total principal amount of the borrowing.
• All interest payments occurring on the borrowing during the term of the swap (or the effective term of the swap underlying the forward starting swap) are designated as hedged whether in total or in proportion to the principal amount of the borrowing being hedged.
Under the simplified hedge accounting approach, an entity that qualifies for the accounting alternative has the option to measure the designated swap at settlement value instead of fair value. The primary difference between settlement value and fair value is that nonperformance risk is not considered in determining settlement value. One approach for estimating the receive-variable, pay-fixed interest rate swap’s settlement value is to perform a present value calculation of the swap’s remaining estimated cash flows using a valuation technique that is not adjusted for nonperformance risk.
Under the simplified hedge accounting approach, documentation required by FASB ASC 815-20-25-3 to qualify for hedge accounting must be completed by the date on which the first annual financial statements are available to be issued after hedge inception rather than concurrently at hedge inception. Because FASB ASC 815 permits election of hedge accounting on a swap-by-swap basis, an entity that qualifies for the accounting alternative can elect to apply this approach to any qualifying swap, whether existing at the date of adoption of this approach or entered into after that date. In determining whether an existing swap otherwise meets all of the requirements for applying this approach at adoption, the criterion that the swap’s fair value at the time of the application of this approach is at or near zero does not need to be considered as long as the swap’s fair value was at or near zero at the time the swap was entered into.
All other requirements in FASB ASC 815 for cash flow hedge accounting apply for the simplified hedge accounting approach. In addition, the current disclosure requirements in FASB ASC 815 and 820 on fair value measurement continue to apply for a swap accounted for under the simplified hedge accounting approach. In providing those disclosures, amounts recorded at settlement value may be used in place of fair value wherever applicable with amounts disclosed at settlement value subject to all of the same disclosure requirements as amounts disclosed at fair value. Any amounts disclosed at settlement value should be clearly stated as such and disclosed separately from amounts disclosed at fair value.
For the purpose of evaluating whether FASB ASC 825, Financial Instruments, disclosures about the fair value of financial instruments are required, a swap recorded under the simplified hedge accounting approach is not considered a derivative instrument under FASB ASC 815.
18.82 Items (c) and (d) in FASB ASC 815-20-25-3 also include additional documentation requirements applicable specifically to either fair value hedges or cash flows hedges. Paragraphs 4–72 of FASB ASC 815-20-25 address eligibility criteria for hedged items and transactions.
18.83 FASB ASC 815-10-35-2 states that the accounting for changes in the fair value (that is, gains and losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, if so, the reason for holding it.
18.84 Companies typically receive periodic fair value reporting from the counterparty. These fair values may or may not conform to the requirements of FASB ASC 820. As such, additional consideration of these values may be warranted. See chapter 20 of this guide for additional information regarding fair value measurements and disclosures.
18.85 Guarantees. According to FASB ASC 460-10-25-1, a guarantee that is accounted for as a derivative instrument at fair value under FASB ASC 815 is not subject to the recognition provisions of FASB ASC 460, Guarantees. The contingent aspect of the guarantee should be accounted for in accordance with FASB ASC 450-20 unless the guarantee is accounted for as a derivative under FASB ASC 815, according to FASB ASC 460-10-35-4.
18.86 In accordance with FASB ASC 460-10-50-1, the loss contingency disclosures required by FASB ASC 460-10-50 apply to guarantees, including guarantees that are outside the scope of FASB ASC 460-10-15-4 (such as a guarantee accounted for as derivative instruments at fair value under FASB ASC 815); however, this guidance does not apply to guarantees or indemnifications excluded from the scope of FASB ASC 450, Contingencies, as described in FASB ASC 460-10-15-7(a). According to FASB ASC 460-10-50-5(c), the disclosure requirements of FASB ASC 460-10-50 do not eliminate or affect the disclosure requirements in the disclosure sections of FASB ASC 815, which apply to guarantees that are accounted for as derivatives.
18.87 Offsetting. Paragraphs 1–2 of FASB ASC 210-20-05 state that it is a general principle of accounting that the offsetting of assets and liabilities in the balance sheet is improper except where a right of setoff exists. The general principle that the offsetting of assets and liabilities is improper except where a right of setoff exists is usually thought of in the context of unconditional receivables from and payables to another party. The general principle also applies to conditional amounts recognized for contracts under which the amounts to be received or paid or items to be exchanged in the future depend on future interest rates, future exchange rates, future commodity prices, or other factors. The FASB ASC glossary defines right of setoff as a debtor's legal right, by contract or otherwise, to discharge all or a portion of the debt owed to another party by applying against the debt an amount that the other party owes to the debtor. FASB ASC 210-20-45-1 specifies what conditions must be met to have that right. FASB ASC 210-20-45-9 states that the phrase enforceable at law encompasses the idea that the right of setoff should be upheld in bankruptcy.
18.88 Paragraphs 1–7 of FASB ASC 815-10-45 address offsetting certain amounts related to derivative instruments. For purposes of this guidance, derivative instruments include those that meet the definition of a derivative instrument but are not included in the scope of FASB ASC 815-10. None of the provisions in FASB ASC 815-10 support netting a hedging derivative's asset (or liability) position against the hedged liability (or asset) position in the balance sheet. Unless the conditions in FASB ASC 210-20-45-1 are met, the fair value of derivative instruments in a loss position should not be offset against the fair value of derivative instruments in a gain position. Similarly, amounts recognized as accrued receivables should not be offset against amounts recognized as accrued payables unless a right of setoff exists. Without regard to the condition in FASB ASC 210-20-45-1(c), a reporting entity may offset fair value amounts recognized for derivative instruments and fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from derivative instrument(s) recognized at fair value executed with the same counterparty under the same master netting arrangement. Regardless of whether or not instruments have been netted for presentation in the statement of financial position, FASB ASC 815-10-50-4B requires derivative instruments to be reported gross within the footnote disclosures.
18.89 FASB ASC 230-10-45-27 states that cash flows from a derivative instrument that is accounted for as a fair value hedge or cash flow hedge may be classified in the same category as the cash flows from the items being hedged provided that the derivative instrument does not include an other-than-insignificant financing element at inception, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments (that is, the forward points in an at-the-money forward contract) and that the accounting policy is disclosed. If the derivative instrument includes an other-than insignificant financing element at inception, all cash inflows and outflows of the derivative instrument should be considered cash flows from financing activities by the borrower. If for any reason hedge accounting for an instrument that hedged an identifiable transaction or event is discontinued, then any cash flows after the date of discontinuance should be classified consistent with the nature of the instrument.
18.90 SEC Market Risk Disclosure Rules.5 Item 305 of Regulation S-K requires entities filing with the SEC to disclose certain information about market risk. In general, the rule
a. requires quantitative and qualitative disclosures about market risk inherent in derivatives and other financial instruments outside the financial statements; and
b. provides a reminder to registrants to supplement existing disclosures about financial instruments, commodity positions, firm commitments, and other forecasted transactions with related disclosures about derivatives.
18.91 SEC Management's Discussion and Analysis (MD&A) Requirements.6 Item 303 of Regulation S-K requires institutions to discuss, in their MD&A, any known trends or any known demands, commitments, events or uncertainties that the institution reasonably expects to have a material favorable or unfavorable impact on their results of operations, liquidity, and capital resources.
18.92 Written loan commitments. In accordance with FASB ASC 815-10-15-71, loan commitments that relate to the origination of mortgage loans that will be held for sale, as discussed in FASB ASC 948-310-25-3, should be accounted for, by the issuer of the loan commitment, as derivative instruments at fair value. Recording a written loan commitment at its initial fair value may result in the recognition in an initial asset and gain, or an initial liability and loss.
18.93 Consistent with the guidance in FASB ASC 860-50 and FASB ASC 825-10, the SEC’s Codification of Staff Accounting Bulletins topic 5DD, “Written Loan Commitments Recorded at Fair Value Through Earnings,” states the expected net future cash flows related to the associated servicing of a loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. The expected net future cash flows should be determined in the same manner that the fair value of a recognized servicing asset or liability is measured under FASB ASC 860-50. However, as discussed in FASB ASC 860-50-25-1, a separate and distinct servicing asset or liability is not recognized for accounting purposes until the servicing rights have been contractually separated from the underlying loan by sale or securitization of the loan with servicing retained.
18.94 The preceding guidance should be applied irrespective of whether the resulting loan is intended to be sold servicing released or servicing retained.
Financial Statement Disclosures
18.95 According to FASB ASC 815-10-50-1, an entity with derivative instruments (or non-derivative instruments that are designated and qualify as hedging instruments pursuant to paragraphs 58 and 66 of FASB ASC 815-20-25) should disclose information to enable users of the financial statements to understand all of the following:
• How and why an entity uses derivative instruments (or such non-derivative instruments)
• How derivative instruments (or such non-derivative instruments) and related hedged items are accounted for under FASB ASC 815
• How derivative instruments (or such non-derivative instruments) and related hedged items affect an entity’s financial position, financial performance, and cash flows
18.96 Paragraphs 4A–4F of FASB ASC 815-10-50 require certain quantitative disclosures about fair value amounts of and gains and losses on derivative instruments.
18.97 FASB ASC 815-10-50-4K requires certain disclosures about credit derivatives and hybrid instruments (for example, a credit-linked note) that have embedded credit derivatives to enable users of financial statements to assess their potential effect on the entity's financial position, financial performance, and cash flows. These disclosures, however, do not apply to an embedded derivative feature related to the transfer of credit risk that is only in the form of subordination of one financial instrument to another as described in FASB ASC 815-15-15-9.
18.98 FASB ASC 815-10-50-5 provides additional information to consider related to qualitative disclosures. Qualitative disclosures about an entity’s objectives and strategies for using derivative instruments (and non-derivative instruments that are designated and qualify as hedging instruments pursuant to FASB ASC 815-20-25-58 and FASB ASC 815-20-25-66) may be more meaningful if such objectives and strategies are described in the context of an entity’s overall risk exposures relating to IRR, foreign exchange risk, commodity price risk, credit risk, and equity price risk. Those additional qualitative disclosures, if made, should include a discussion of those exposures even though the entity does not manage some of those exposures by using derivative instruments. An entity is encouraged, but not required, to provide such additional qualitative disclosures about those risks and how they are managed.
18.99 As stated in FASB ASC 825-10-50-20, except as indicated in FASB ASC 825-10-50-22, an entity should disclose all significant concentrations of credit risk arising from all financial instruments, whether from an individual counterparty or groups of counterparties. Throughout paragraphs 20–21 of FASB ASC 825-10-50, the term financial instruments includes derivative instruments accounted for under FASB ASC 815. Group concentrations of credit risk exist if a number of counterparties are engaged in similar activities and have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions.
18.100 FASB ASC 210-20-50 requires enhanced disclosures about financial instruments and derivative instruments that are either offset in accordance with FASB ASC 210-20-45 or FASB ASC 815-10-45 or subject to an enforceable master netting arrangement or similar agreement (irrespective of whether they are offset in accordance with the aforementioned FASB ASC sections). Further discussion on the scope of and specific disclosures required by FASB ASC 210-20-50 can be found beginning in paragraph 14.40 of this guide.
18.101 AU-C section 501, Audit Evidence—Specific Considerations for Selected Items,8 addresses specific considerations by the auditor in obtaining sufficient appropriate audit evidence, in accordance with AU-C section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained; AU-C section 500, Audit Evidence; and other relevant AU-C sections regarding, among other considerations, certain aspects of investments in securities and derivative instruments in an audit of financial statements. In addition, the companion AICPA Audit Guide Special Considerations in Auditing Financial Instruments provides background information about financial instruments and discussion of audit considerations relating to financial instruments. The suggested auditing procedures contained in the guide do not increase or otherwise modify the auditor’s responsibilities described in AU-C section 501. Rather, the suggested procedures in the guide are intended to clarify and illustrate the application of the requirements of AU-C section 501. In addition, AU-C section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures, addresses the auditor’s responsibilities relating to accounting estimates, including fair value accounting estimates and related disclosures, in an audit of financial statements. Specifically, it expands on how AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement; AU-C section 330; and other relevant AU-C sections are to be applied with regard to accounting estimates. It also includes requirements and guidance related to misstatements of individual accounting estimates and indicators of possible management bias.
Considerations for Audits Performed in Accordance With PCAOB Standards9
PCAOB Staff Audit Practice Alert No. 2, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists (PCAOB Staff Guidance, sec. 400.02),10 provides guidance on auditors' responsibilities for auditing fair value measurements of financial instruments and when using the work of specialists under the existing standards of the PCAOB. This alert is focused on specific matters that are likely to increase audit risk related to the fair value of financial instruments in a rapidly changing economic environment. This practice alert highlights certain requirements in the auditing standards related to fair value measurements and disclosures in the financial statements and certain aspects of GAAP that are particularly relevant to the current economic environment.
PCAOB Staff Audit Practice Alert No. 4, Auditor Considerations Regarding Fair Value Measurements, Disclosures, and Other-Than-Temporary Impairments (PCAOB Staff Guidance, sec. 400.04), informs auditors about potential implications of the recent guidance on reviews of interim financial information and annual audits. This alert addresses the following topics: (a) reviews of interim financial information (reviews); (b) audits of financial statements, including integrated audits; (c) disclosures; and (d) auditor reporting considerations.