1. 3-1 Forwards and Futures Go To Bob Jensen’s Flow Chart http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

2. 3-2 TRANSACTION MARKETS Spot or Cash:Immediate exchange of property for payment Forward:Later exchange of property for payment, t terms fixed today Futures:Like forwards, but...

3. 3-3 Price setting mechanisms for deferred value dates Totally flexible in terms of timing and size of transactions Negotiated on a principal-to-principal basis Introduce credit risk exposure to counterparties for profitable positions FORWARD CONTRACTS

4. 3-4 Price setting mechanisms for deferred value dates Designed with specific value dates and fixed contract sizes Exchange traded, with bids and offers provided by exchange members Daily cash settlements insure against the risk of counter-party defaults FUTURES CONTRACTS

5. 3-5 FINANCIAL INTEGRITY Variation Margin:One day’s gain or loss of the futures position (#contracts  price change  multiplier) Initial Margin:Good faith deposit or collateral Maintenance Level:Minimum below which account cannot fall

6. 3-6 CUSTOMER PERFORMANCE BONDS Alternative Qualifying Instruments U.S. currency and Government securities Bank letters of credit GNMA pass-throughs Selected Brady bonds Selected sovereign securities NYSE, AMEX, S&P500 and S&PMidCap stocks Selected mutual funds

7. 3-7 Forecasted Transactions Versus Firm Commitments Forecasted transactions that are highly probable with a known notional and cash flow risk from an unknown spot price or rate Firm commitments that are contracted with a specified notional and transaction price that eliminates cash flow risk but creates value risk equal to the difference between spot versus contracted price or rate

8. 3-8 Accounting for Forecasted Transactions Versus Firm Commitments Forecasted transactions are not booked or even disclosed under present accounting standards. Firm commitments (more generally known as purchase commitments in the case of purchases) are to be disclosed but are not to be booked unless a significant loss anticipated. Then conservatism in dictates booking an anticipated loss reserve that is much like an allowance for warranty or bad debt expense.

9. 3-9 Examples 1 and 4 FAS 133 Appendix B Fair Value vs. Cash Flow Hedges See 133ex01a.xls at http://www.cs.trinity.edu/~rjensen/ http://www.cs.trinity.edu/~rjensen/

10. 3-10 Delta Ratio Effectiveness Testing 80%<Delta<125% Bounds Paragraph 146 in IAS 39 A hedge is normally regarded as highly effective if, at inception and throughout the life of the hedge, the enterprise can expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument, and actual results are within a range of 80 per cent to 125 per cent. For example, if the loss on the hedging instrument is 120 and the gain on the cash instrument is 100, offset can be measured by 120/100, which is 120 per cent, or by 100/120, which is 83 per cent. The enterprise will conclude that the hedge is highly effective.

11. 3-11 Example 4 from FAS 133 Paragraph 128 With 100% Delta Effectiveness Forecasted Transaction Inventory Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $25,000 $25,000 = Change in Hedged Item Value $25,000 = Change in Hedge Contract Value Delta = 1.00 or 100%

12. 3-12 Example 4 from FAS 133 Paragraph 128 With 100% Delta Effectiveness Forecasted Transaction Inventory Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $25,000 Debit Credit Jan. 31 Forward Contract 25,000 P&L 0 OCI 25,000 For cash flow hedges, adjust hedging derivative to fair value and offset to OCI to the extent of hedge effectiveness.

13. 3-13 Example 4 from FAS 133 Paragraph 128 With 90% Delta Effectiveness Forecasted Transaction Inventory Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $22,500 $25,000 = Change in Hedged Item Value $22,500 = Change in Hedge Contract Value Delta = 0.90 or 90%

14. 3-14 Example 4 from FAS 133 Paragraph 128 With 90% Delta Effectiveness Forecasted Transaction Inventory Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $22,500 Debit Credit Jan. 31 Forward Contract 22,500 P&L 2,500 OCI 25,000 Hedge accounting is allowed only to the degree of effectiveness if Delta is within 80%-125% range.

15. 3-15 Example 4 from FAS 133 Paragraph 128 With 75% Delta Effectiveness Forecasted Transaction Inventory Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $18,750 $25,000 = Change in Hedged Item Value $18,750 = Change in Hedge Contract Value Delta = 0.75 or 75%

16. 3-16 Example 4 from FAS 133 Paragraph 128 With 75% Delta Effectiveness Forecasted Transaction Inventory Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $18,750 Debit Credit Jan. 31 Forward Contract 18,750 P&L 18,750 OCI 0 When the hedge effectiveness lies outside the 80%-125% range, hedge accounting is not allowed.

17. 3-17 Example 4 Modified As Follows Forecasted Transaction Inventory Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $18,750 Feb. 28 $1,025,000 $0 $25,000 Mar. 31 $1,050,000 $1,050,000 $50,000 Suppose the inventory is purchased on March 31. Suppose the inventory is sold on April 30 for $1,100,000.

18. 3-18 Example 4 Modified February 28 Adjustment of Forward Contract Forecasted Transaction Inventory Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $18,750 Feb. 28 $1,025,000 $0 $25,000 Debit Credit Bal. Feb. 28 Forward Contract 6,250 25,000 P&L 18,750 0 OCI 25,000 25,000 Hedge effectiveness can be initially designated as being tested on a cumulative basis.

19. 3-19 Example 4 Modified March 31 Adjustment of Forward Contract Forecasted Transaction Inventory Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Feb. 28 $1,025,000 $0 $25,000 Mar. 31 $1,050,000 $1,050,000 $50,000 Debit Credit Bal. Mar. 31 Forward Contract 25,000 50,000 P&L 0 0 OCI 25,000 50,000 The forward contract is settled for $50,000 in cash to offset the increase to $1,050,000 of the hedged item’s price. FAS 133 says carry forward OCI balance until inventory is sold. IAS 39 has an OCI basis adjustment on March 31, unlike FAS 133.

20. 3-20 Example 4 Modified March 31 Purchase of Inventory Debit Credit Bal. Mar. 31 Cash 50,000 50,000 Forward contract 50,000 0 Mar. 31 Inventory 1,050,000 1,050,000 Cash 1,050,000 (1,000,000) Under IAS 39, there will also be an entry to close the $50,000 in OCI to P&L. Under FAS 133, there will be no such basis adjustment until the inventory is sold.

21. 3-21 Example 4 from FAS 133 Paragraph 128 April 30 Basis Adjustment of OCI Forecasted Transaction Inventory Cash Flow Sales Book Hedge Date Amount Value Value Jan. 01 $0 $0 $0 Apr. 30 $1,100,000 $1,050,000 $0 Debit Credit Bal. Apr. 30 OCI 50,000 0 P&L 50,000 (50,000) The sales profit of $1.1 million less $1.05 million is $50,000 without hedging. With a cash flow hedge, retained earnings is increased by another $50,000 that locked in inventory value at $1 million.

22. 3-22 Basis Adjustment Alternatives The carrying value of a hedging offset account (OCI, Firm Commitment, or Balance Sheet Item) may be written off prematurely whenever the hedge becomes severely ineffective. Under IAS 39, the carrying value of an effective hedge is written off when the hedge expires or is dedesignated. See Paragraphs 162 and 163 of IAS 39. Under FAS 133, the carrying value of an effective hedge is carried forward until the ultimate disposition of the hedged item (e.g. inventory sale or depreciation of equipment). See Paragraph 31 of FAS 133.

23. 3-23 Example 4 Modified April 30 Sale of Inventory Debit Credit Bal. Apr. 30 P&L (CGS) 1,050,000 1,000,000 Inventory 1,050,000 0 Apr. 30 Cash 1,100,000 100,000 P&L (Sales) 1,100,000 (100,000) The sales profit of $1.1 million less $1.05 million is $50,000 without hedging. With a cash flow hedge, retained earnings is increased by another $50,000 that locked in inventory value at $1 million.

24. 3-24 Cash Flow Hedge of a Precious Metal or Any Hedged Item to be Carried at Value Forecasted Transaction Gold Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $22,500 $25,000 = Change in Hedged Item Value $22,500 = Change in Hedge Contract Value Delta = 0.90 or 90%

25. 3-25 Cash Flow Hedge of a Precious Metal or Any Hedged Item to be Carried at Value Forecasted Transaction Gold Cash Flow Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $1,025,000 $0 $22,500 Debit Credit Jan. 31 Forward Contract 22,500 P&L 22,500 OCI 0 Paragraph 29(d) of FAS 133 prohibits the hedged item to be any item that is or will be carried on the books at fair value after acquisition.

26. 3-26 New Example New Example Coming Up

27. 3-27 Firm Commitment with Contracted Price With 100% Delta Effectiveness Firm Commitment Inventory Fair Value Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $975,000 $0 $25,000 -$25,000 = Change in Value of Hedged Item $25,000 = Change in Value of Hedge Contract Delta = 1.00 = 100%

28. 3-28 Firm Commitment with Contracted Price With 100% Delta Effectiveness Firm Commitment Inventory Fair Value Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $975,000 $0 $25,000 Debit Credit Jan. 31 Forward contract 25,000 P&L 0 Firm commitment 25,000 For firm commitments, the fair value hedge is adjusted to full value with the effective portion to firm commitment.

29. 3-29 Firm Commitment with Contracted Price With 90% Delta Effectiveness Firm Commitment Inventory Fair Value Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $975,000 $0 $22,500 Debit Credit Jan. 31 Forward contract 22,500 P&L 2,500 Firm commitment 25,000 Hedge accounting is allowed only to the degree of effectiveness if Delta is within 80%-125% range.

30. 3-30 Firm Commitment with Contracted Price With 75% Delta Effectiveness Firm Commitment Inventory Fair Value Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $0 $0 Jan. 31 $975,000 $975,000 $18,750 Debit Credit Jan. 31 Forward contract 18,750 P&L 18,750 Firm commitment 0 When the hedge effectiveness lies outside the 80%-125% range, hedge accounting is not allowed.

31. 3-31 New Example New Example Coming Up

32. 3-32 Example 1 from FAS 133 Paragraph 105 With 100% Delta Effectiveness Inventory on Hand Inventory Fair Value Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $1,000,000 $0 Jan. 31 $975,000 $975,000 $25,000 Debit Credit Jan. 31 Forward contract 25,000 P&L 0 Inventory 25,000 When the hedged item is already booked at historical cost, change its accounting to fair value during hedging period.

33. 3-33 Example 1 from FAS 133 Paragraph 105 With 90% Delta Effectiveness Inventory on Hand Inventory Fair Value Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $1,000,000 $0 Jan. 31 $ 975,000 $ 975,000 $22,500 Debit Credit Jan. 31 Forward contract 22,500 P&L 2,500 Inventory 25,000 Hedge accounting is allowed only to the degree of effectiveness if Delta is within 80%-125% range.

34. 3-34 Example 1 from FAS 133 Paragraph 105 With 75% Delta Effectiveness Inventory on Hand Inventory Fair Value Entry Book Hedge Date Value Value Value Jan. 01 $1,000,000 $1,000,000 $0 Jan. 31 $975,000 1,000,000 (no change) $18,750 Debit Credit Jan. 31 Forward contract 18,750 P&L 18,750 When the hedge effectiveness lies outside the 80%-125% range, hedge accounting is not allowed.

35. 3-35 Cumulative Dollar Offset Hedging Actually is More Complicated See 133ex07a.xls at http://www.cs.trinity.edu/~rjensen/ http://www.cs.trinity.edu/~rjensen/

36. 3-36 Forward Versus Futures Contracts Quotations from Walter Teets September 7, 2000 email message to Bob Jensen The error in our case is simply that the futures values (due to changes in either spot or futures prices) shouldn't be present valued, since there is daily settling up. But the (change in) values of the anticipated cash flows of the hedged item should be present valued, because there is usually no periodic settling of the cash flows associated with the hedged item. The change to the case is minor; the major point of the futures case is to show exclusion of the change in the difference between future and spot price from the determination of effectiveness. Present valuing the cash flow associated with the anticipated transaction, while not present valuing the futures (change in) value adds additional ineffectiveness to the hedging relation. Walter Teets at Gonzaga University

37. 3-37 KPMG Example 4.2 Cumulative Dollar Offset

38. 3-38 New Example New Example Coming Up

39. 3-39 Fair Value FX Hedging Example 3 from FAS 133 Paragraph 121 Example 3 illustrates a firm commitment to purchase a machine on May 2 for 270,000Dfl Dutch guilders which exposes the firm to both a fair value risk and a foreign exchange (FX) risk. MNO enters a forward contract FX fair value hedge in which this company enters elects to hedge the 270,000Dfl with equivalent 240,000DM in German marks that it apparently had on hand on February 3. Although the example hedges in German DM currency, the firm declares this a fair value hedge of the firm commitment in U.S. dollars. To the extent of hedge effectiveness, the account Firm Commitment is used to offset changes in the value of the forward contract during the hedging period.

40. 3-40 Cash Flow FX Hedging Example 10 from FAS 133 Paragraph 165 Example 10 illustrates DEF Company’s hedging of foreign currency risk of on three expected installments of 1,000,000DM German marks. As a cash flow hedge, other comprehensive income is used to offset changes in the value of the hedging forward contract to the extent that the contract is effective in hedging FX risk. But the effectiveness tests are very complicated as explained in Paragraph 169

41. 3-41 Cash Flow FX Hedging Example 10 from FAS 133 Paragraph 169 169. As each royalty is earned, DEF recognizes a receivable and royalty income. The forecasted transaction (the earning of royalty income) has occurred. The receivable is an asset, not a forecasted transaction, and is not eligible for cash flow hedge accounting. Nor is it eligible for fair value hedge accounting of the foreign exchange risk because changes in the receivable's fair value due to exchange rate changes are recognized immediately in earnings. (paragraph 21(c) prohibits hedge accounting in that situation.) Consequently, DEF will dedesignate a proportion of the forward contract corresponding to the earned royalty. As the royalty is recognized in earnings and each proportion of the derivative is dedesignated, the related derivative gain or loss in accumulated other comprehensive income is reclassified into earnings. After that date, any gain or loss on the dedesignated proportion of the derivative and any transaction loss or gain on the royalty receivable will be recognized in earnings and will substantially offset each other.

42. 3-42 Example 10 in FAS 133 Appendix B Cash Flow Hedging of FX Risk See 133ex10.doc at http://www.cs.trinity.edu/~rjensen/ http://www.cs.trinity.edu/~rjensen/ See 133ex10a.xls at http://www.cs.trinity.edu/~rjensen/ http://www.cs.trinity.edu/~rjensen/

43. 3-43 FORWARD/FUTURES PRICING Expense of holding (financing, storage, insurance, etc.) less income generated from spot Spot Price + Cost of Carry Futures/Forward Price Basis = +/-(Futures - Spot)

44. 3-44 BASIS AND CONVERGENCE F e = S e Price Time F O S O

45. 3-45 SPECULATIVE TRADES Outright positions Basis trades / arbitrage Calendar spreads Inter-market spreads - TEDs, LEDs, BEDs, NOBs, etc.

46. 3-46 Rounding error Cross-market (spread) risk Mismatching value dates (basis risk) Timing of variation settlement cashflows FUTURES HEDGING Sources of Uncertainty

47. 3-47 TIMING CONSIDERATION Problem: Futures results are realized daily, the effect on the exposure occurs in a deferred period Solution: Tail the hedge to generate the present value of the desired price effects Time Daily Futures Results... 0t Hedge Value Date

48. 3-48 Tailing Futures Hedges/Tailing Spreads http://www.kawaller.com/pdf/tails.pdf An untailed hedge ignores the difference between the time futures gains or losses are realized and the time the price effects on the associated cash market exposures are realized. A tailed hedge, on the other hand, takes these timing considerations into consideration. Put another way, an untailed hedge ignores the effects of financing costs or investment returns associated with daily variation margin settlements of futures contracts; a tailed hedge these effects.

49. 3-49 Tailing Futures Hedges/Tailing Spreads http://www.kawaller.com/pdf/tails.pdf While tailed hedges should be recognized as more perfect from an economic perspective, untailed hedges have the advantage of offering the appearance of a better offset from an accounting point of view when deferral accounting methods are employed. Moreover, maintaining a correctly tailed hedge position requires an ongoing adjustment of the hedge position, while untailed hedges need no analogous adjustments.

50. 3-50 Tailing Futures Hedges/Tailing Spreads http://www.kawaller.com/pdf/tails.pdf Importantly, the correct number of contracts for this latter case will tend to increase as the passage of time erodes the difference between present values and future values. Ultimately, by the time the hedge value date is reached, the discounted present value will converge to the $500 amount. Thus, over time the required hedge will gradually rise to twenty contracts. This second case is an example of a tailed hedge, where the tail is the number of contracts needed to adjust for this present valuing effect.

51. 3-51 MARK-TO-MARKET VALUATIONS Forward Contracts MV =Market Value F(i) = Forward Price at time i r = Zero coupon rate (to forward value date) d = Days to the forward value date n =Compounding periods to forward value date MV = (1+ r) d 360 F(t+1) - F(t) = (1+r) n

52. 3-52 Complexities of Paragraph 63(c) of FAS 133 See KPMG 1A Sheet in 133ex07a.xls at http://www.cs.trinity.edu/~rjensen/ http://www.cs.trinity.edu/~rjensen/ 63(c). If the effectiveness of a hedge with a forward or futures contract is assessed based on changes in fair value attributable to changes in spot prices, the change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price would be excluded from the assessment of hedge effectiveness.

53. 3-53 CASE 3 - Firm Commitment Hedged with Forward Contract On 9/30/2001, GlobalTechCo, a U.S. company issues a purchase order to a foreign supplier for equipment to be delivered and paid for at 3/31/2002. The terms of the agreement meet the criteria for a firm commitment. The price is denominated in the foreign currency— FC10,000,000. The company simultaneously enters into a forward- exchange contract, which matures 3/31/2002, in order to receive FC10,000,000 and pay U.S. $6,600,000.

54. 3-54 Forward Rates Spot Ratesfor 3/31/2002 9/30/2001FC1 = $0.65FC1 = $0.66 12/31/2001 FC1 = $0.67FC1 = $0.69 3/31/2002FC1 = $0.69FC1 = $0.69 CASE 3 - Firm Commitment Hedged with Forward Contract

55. 3-55 CASE 3 - Firm Commitment Hedged with Forward Contract The entity documents the following: – Effectiveness will be measured by (a) comparing the change in the fair value of the forward contract attributable to changes in spot rates with (b) the changes in the fair value of the firm commitment attributable to changes in the spot rates – The spot-forward difference will be excluded from the assessment of effectiveness and recorded through earnings

56. 3-56 CASE 3 - Firm Commitment Hedged with Forward Contract The following demonstrates the journal entries to record this hedge under Statement 133: At 9/30/2001, no entry is recorded under Statement 133 because a cash payment is not made and the contract has a zero value.

57. 3-57 Entries recorded at 12/31/2001 Forward contract295,567 Earnings 295,567 To record the forward contract fair value (present value at a 6% discount rate of ((.69 –.66) x FC10 million); includes both effective portion of hedge and ineffectiveness due to changes in the forward rate. Earnings 197,044 Firm commitment 197,044 To record the change in the fair value of the foreign-currency component of the firm commitment attributable to the change in spot rates ((.65 –.67) x FC10 million), discounted at 6%. CASE 3 - Firm Commitment Hedged with Forward Contract

58. 3-58 Entries recorded at 3/31/2002 Forward contract4,433 Earnings 4,433 To record time value change as there was no change in the forward rate (assumption for illustrative purposes only). Earnings202,956 Firm commitment 202,956 To record the change in the fair value of the foreign-currency component of the firm commitment attributable to the change in spot rates ((.65 –.69) x FC10 million) – 197,044 CASE 3 - Firm Commitment Hedged with Forward Contract

59. 3-59 3/31/2002 (continued) Cash 300,000 Forward contract 300,000 To record cash receipt upon maturity of forward contract Equipment6,500,000 Firm commitment 400,000 Cash6,900,000 To record purchase of equipment CASE 3 - Firm Commitment Hedged with Forward Contract

60. 3-60 CASE 4 – Example 7 from Appendix B of FASB Statement 133 Designation and Discontinuance of a Cash Flow of the Forecasted Purchase of Inventory