RiskMarket RiskFAS 157: Bad Credit & Ineffective Hedges?

FAS 157: Bad Credit & Ineffective Hedges?

The Statement of Financial Accounting Standard (SFAS) 157, the Financial Accounting Standards Board’s (FASB’s) standard that is effective for calendar year-end companies starting 1 January 2008, centrally defines ‘fair value’. The FASB’s intention in ratifying this standard is to consolidate all definitions of fair value referenced in accounting literature and create one clear definition that is applicable to all other standards.

The scope of the ruling is fairly wide and will affect entities that are currently required to fair value instruments (both financial and non-financial) in their financial statements. SFAS157 will have a substantial impact on derivative users currently complying with the hedge accounting rules under SFAS 133.

The New Definition of Fair Value

FAS 157 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’. Although this definition seems fairly straightforward and intuitive at first glance, in practice it will significantly affect companies’ financial statements. One of the major reasons for this is that entities will now need to consider their own credit rating in determining fair value when an instrument is a liability.

For derivative users, this will mean that an instrument can switch from being an asset and a liability depending on market moves, and tracking this and applying the proper credit curve (entity’s own if the derivative is a liability and counterparty’s if the derivative is an asset) will pose unique challenges in its own right.

Not only will entities need to consider credit for valuation purposes, they will now need to consider credit for purposes of hedge accounting as well. Most corporates – already reeling from the complex rules of hedge accounting as promulgated under SFAS 133 – will now have to contend with even more complexity in terms of assessment and measurement in their hedging relationships.

FAS 133 and FAS 157

Evaluating credit risk should not be a new concept under FAS 133; however, it will come as a fairly big surprise to most end users of derivatives. According to DIG G10, ‘an entity must consider the likelihood of the counterparty’s compliance with the contractual terms of the hedging derivative that require the counterparty to make payments.’

Although entities should be monitoring counterparty credit risk with respect to derivatives, few if any are currently monitoring this on a quantitative level. FAS 157 will now force entities to not only actively monitor counterparty credit risk but their own credit risk as well. Consider the following example of a typical fair value hedge to see how FAS 157 will introduce another layer of complexity:

Figure 1: Fair Value Hedge Example

For the above example, if one were to assess and measure ineffectiveness using a historical simulation regression methodology without considering the effects of FAS 157, one would get the following results:

Figure 2

Regression Result R-SQ Slope Net P&L
3/1/2005 0.99998228 -0.99986  
3/31/2005 0.999981225 -0.99976 -16,822.75
4/29/2005 0.999979851 -0.99979 -2,795.33
5/31/2005 0.999983028 -0.99948 15,095.25
6/30/2005 0.999967457 -0.99996 -16,291.50
7/29/2005 0.999972923 -1.00002 620.38
8/31/2005 0.999959623 -0.99955 27,083.63
9/30/2005 0.999957878 -0.99919 -13,473.23
10/31/2005 0.999957713 -0.99888 -17,334.67
11/30/2005 0.999944787 -0.99879 -116,306.62
12/30/2005 0.999939187 -0.99898 -22,185.88
1/31/2006 0.999937794 -0.99886 -7,560.11
2/28/2006 0.999932709 -0.99888 17,490.42
3/31/2006 0.999898071 -0.99792 -21,193.83
4/28/2006 0.999898378 -0.99799 -2,911.36
5/31/2006 0.999903736 -0.9979 16,613.18
6/30/2006 0.999891504 -0.99809 -29,217.65
7/31/2006 0.999874003 -0.99808 16,895.41
8/31/2006 0.999876312 -0.99729 25,364.07
9/29/2006 0.999877895 -0.9972 -1,496.49
10/31/2006 0.999883721 -0.99612 -3,585.95
11/30/2006 0.99989208 -0.99589 1,713.10
12/29/2006 0.999896555 -0.99583 -3,762.64
1/31/2007 0.999902652 -0.99513 -812.53
2/28/2007 0.999907463 -0.99525 4,682.01
3/30/2007 0.999907509 -0.99525 466.49
4/30/2007 0.999906496 -0.99552 -6,567.33
5/31/2007 0.999904175 -0.99512 719.64
6/29/2007 0.999896967 -0.99532 -2,860.60
SUM     $(158,398.89)

It is evident that this relationship is a highly effective relationship given that both the R-Sq and Slope measures are fairly close to 1.00 and -1.00 respectively. Also, the net earnings impact on a cumulative basis of US$-95,372.84 is fairly small considering the notional amounts involved in this relationship.

Now let us consider this relationship post-FAS 157. Since entities will now have to include the change in value of the credit component in valuing their derivatives, we get the following results if we discount the swap at Libor + 200 bps if it is in a liability position (assume this represents the credit spread for a BBB+ rated entity) to the reporting entity and at Libor + 50 bps if the swap is in an asset position to the reporting entity (assume this represents the credit spread over Libor of the bank). We get the following results:

Figure 3

Regression Result R-SQ Slope Net P&L
3/1/2005 0.999785 -0.90918  
3/31/2005 0.999789 -0.90907 -105,061.77
4/29/2005 0.999776 -0.90945 247,369.46
5/31/2005 0.999774 -0.90911 227,339.08
6/30/2005 0.999828 -0.91883 42,515.43
7/29/2005 0.99985 -1.91829 -246,238.68
8/31/2005 0.999809 -0.91771 232,281.14
9/30/2005 0.99978 -0.91648 -241,302.58
10/31/2005 0.999779 -0.91547 -202,581.50
11/30/2005 0.999807 -0.91502 -108,988.00
12/30/2005 0.999807 -0.91511 85,860.27
1/31/2006 0.999759 -0.9141 -105,768.32
2/28/2006 0.999747 -0.91393 17,239.88
3/31/2006 0.999538 -0.91357 -83,652.15
4/28/2006 0.999524 -0.91396 -39,971.66
5/31/2006 0.999487 -0.91437 4,843.04
6/30/2006 0.999467 -0.91435 -23,674.80
7/31/2006 0.999191 -0.91639 39,850.57
8/31/2006 0.999097 -0.91958 74,842.44
9/29/2006 0.999016 -0.92058 13,606.39
10/31/2006 0.998962 -0.91901 3,688.89
11/30/2006 0.99898 -0.91886 128,753.20
12/29/2006 0.999052 -0.91895 -133,260.61
1/31/2007 0.998983 -0.91881 -25,216.50
2/28/2007 0.998846 -0.9218 37,832.68
3/30/2007 0.998846 -0.92183 -11,552.77
4/30/2007 0.998815 -0.92212 -1,735.13
5/31/2007 0.998615 -0.92836 -40,001.41
6/29/2007 0.998678 -0.9327 -34,881.18
SUM     $(247,864.59)

Observing the results, one can see that the relationship using derivative fair values as prescribed under FAS 157 (that is adjusting values of derivatives for credit risk) leads to an ineffective hedge as well as a 56% increase in cumulative earnings volatility.

The reason for this increase in volatility and decrease in effectiveness may be attributed to the nature of the risk being hedged. In this case, the risk being hedged is the change in value of the hedged item attributable to alterations in just the changes in the benchmark interest risk (assuming the benchmark is Libor). This means that the changes in the value of the swap due to changes in Libor are offset by marking the changes in the bond to risk. Or, in other words, the cashflows of the bond are discounted using Libor flat (the benchmark interest rate) whereas the projected cashflows of the swap are valued either at Libor + 200 if the swap is a liability to the entity or at Libor + 50 if the swap is an asset to the entity.

This mismatch in the curves being used to discount the values of the bond and the swap give rise to the ‘ineffectiveness’ and cause the P&L volatility. The above example is just one illustration of how entities currently following FAS 133 hedge accounting will have to deal with even more complexity when valuing the credit component of the derivative.

If fair value interest rate hedgers find that applying FAS 157 fair values to effectiveness assessments as required by FAS 133 rules make their hedges ineffective, they can turn to FAS 159, which will allow for both the hedged item and hedging instrument to be carried at fair value on the balance sheet. This will automatically remove the assessment and measurement requirements of FAS 133 by providing a natural offset to the change in the value of the derivative, as both values (derivative and underlying hedged item) will flow through to earnings and offset. Although this might sound like the cure, credit will still need to be included when valuing both items and the two might not necessarily be correlated.

The FAS 159 approach will also require companies to value their own credit on a periodic basis and disclose this, which most companies will be hesitant to do especially if credit ratings are declining. Paradoxically, this will lead to large gains being taken and vice versa if credit ratings are improving. Therefore, FAS 159 might not necessarily be the panacea that it seems to be at first glance and companies may be better served by applying the rules of FAS 133.

For cashflow hedgers, there isn’t such an option (yet). To see how the credit issue might affect cash flow currency hedgers, consider the following example:

Figure 4

The fair values of this derivative are shown below both pre and post-157. Though it might seem odd to currency hedgers to consider discounting at Libor + a spread, this is what FAS 157 will force corporates to do.

Figure 5

Date Pre-157 Post-157 Difference Difference
1/4/2006 22,015.00 22,015,00 0.00% $ –
1/31/2006 (1,066,200.00) (1,049,110,00) 1.63% $17,090.00
2/28/2006 73,344.00 73,344.00 0.00% $ –
3/31/2006 799,864.00 799,864.00 0.00% $-
4/28/2006 (3,382,964.00) (3,334,390.00) -1.46% $48,574.00
5/31/2006 (5,575,442.00) (5,517,875.00) -1.04% $57,567.00
6/30/2006 (4,618,434.00) (4,571,601.00) -1.02% $46,833.00
7/31/2006 (5,451,420.00) (5,410,410.00) -0.76% $41,010.00
8/31/2006 (7,008,477.00) (6,952,031.00) -0.18% $56,446.00
9/30/2006 (5,725,760.00) (5,692,339.00) -0.59% $33,421.00
10/30/2006 (7,238,004.00) (7,208,521.00) -0.41% $29,483.00
11/30/2006 (10,181,201.00) (10,162,083.00) -0.19% $19,188.00
12/31/2006 (9,768,301.00) (9,766,141.00) -0.02% $2,160.00
SUM       $351,702.00

In this case, since the counterparty’s credit is represented by the swap curve, the value of the FX forward when it is an asset to the reporting entity is the same both pre- and post-157. However, the value of the derivative if it is in a liability position has been discounted at Libor + 200 bps in this example. The difference pre- and post- in this example is an increase of US$351,702. Depending on the paragraph 30(b) rule this difference may end up in earnings as ineffectiveness.

Conclusion

From the examples listed in this article, it is clear to see that credit spreads would have a large impact on valuations, as well as assessment and measurement calculations that are required by SFAS 133. This will come as a surprise to most derivative end users as most companies don’t value derivatives based on credit curves presently and making this change will require new or substantial enhancements to existing systems and valuation processes.

This will also force corporates to actively monitor both their own credit ratings as well as the credit ratings of their counterparties and recalibrate their valuation systems to be able to apply this when fair valuing instruments.

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