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**Accounting for Interest Rate Derivatives FAS ASC 815**

Presented by Frank Wilary and Douglas Winn October 20, 2014

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**Frank Wilary, Principal and Co-founder**

Mr. Wilary has over twenty years of diversified experience in the financial services industry. Areas of expertise include asset-liability management, capital markets, asset-backed securitization, derivatives and information systems. Mr. Wilary's primary responsibility is to lead the firm’s asset liability management and non-Agency MBS business lines. Prior to co-founding Wilary Winn, Mr. Wilary held senior positions in treasury, capital markets, accounting, finance and systems within two organizations.

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**Douglas Winn, President and Co-Founder**

Mr. Winn co-founded Wilary Winn in the summer of 2003 and his primary responsibility is to set the firm's strategic direction. Since inception, Wilary Winn has grown rapidly and currently has more than 375 clients located in 47 states and the District of Columbia. Wilary Winn’s clients include community banks, 43 of which are publicly traded, and credit unions, including 26 of the top 100. Mr. Winn is a nationally recognized expert regarding the accounting and regulatory rules for financial institutions and has recently led seminars on the subject for many of the country's largest public accounting firms, the AICPA, the FDIC, and the NCUA.

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**Overall Agenda NCUA rule How derivatives can reduce IRR**

Requirements Limits Application process How derivatives can reduce IRR “Hedge accounting” Can be very complex Elective Permitted derivatives are “vanilla”

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**Agenda – The New Rule Eligibility Permitted derivatives Limits**

Hedging example Alternatives for managing IRR Counterparties and margining Policies and internal controls Required reporting Application process

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**Agenda – Hedge Accounting**

Describe hedge accounting and provide examples Address hedge effectiveness testing Define hedge ineffectiveness – testing vs. bookkeeping Provide alternative to hedge accounting

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Why Now? Changes in interest rates over one-year time periods from 1955 to 2008 30% of the time periods experienced changes of interest rates of over 200 bps 16% of the time periods experienced changes of interest rates of over 300 bps. 9% of the time periods experienced changes of interest rates of over 400 bps Source: FDIC Supervisory Insights, Winter 2009

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Who is Eligible Federal Credit Unions with more than $250 million in total assets Must have CAMEL 3 or better Must have management CAMEL of 2 or better Credit unions with less than $250 million can apply to NCUA field director for authority

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Hedging Instruments NCUA authorizes credit unions to use only the following derivatives: Interest Rate Swaps An agreement to exchange future payments of interest on a notional amount at specific times and for a specific time period Interest Rate Caps A contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate rises above the level specified in the contract Interest Rate Floors A contract, based on a reference interest rate, for payment to the purchaser when the reference interest rate falls below the level specified in the contract

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Hedging Instruments NCUA authorizes credit unions to use only the following derivatives: Basis Swaps An agreement between two parties in which the parties make periodic payments to each other based on floating rate indices multiplied by a notional amount Treasury Note Futures A U.S. Treasury note financial contract that obligates the buyer to take delivery of Treasury notes (or the seller to deliver Treasury notes) at a predetermined future date and price. Futures contracts are standardized to facilitate trading on an exchange Note: Wilary Winn Risk Management believes all of the derivatives permitted by the NCUA meet the definition of a derivative under GAAP.

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Other Restrictions Swaps, caps, and floors can be amortizing and include a forward start date (90 day maximum) Amortization cannot be linked to another financial instrument – e.g. a reference pool of mortgage loans Treasury futures are limited to notes (maturity of 10 years or less) Derivatives cannot be leveraged

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**Other Restrictions Must be based on domestic interest rates (LIBOR)**

Must be denominated in U.S. Dollars Maximum maturity is 15 years (except for Treasury Futures) Must meet the definition of derivative under GAAP

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**Economic Considerations**

OTC swaps pricing varies considerably Consider engaging independent third party advisor that can obtain multiple bids We also recommend having an advisor help with the purchase of interest rate caps and floors Treasury futures are exchange traded Pricing is the same for everyone Must post collateral

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**Derivatives Limits Notional Amount Fair Value Loss Limit**

Takes into account type of derivative, time to maturity and net worth Fair Value Loss Limit Loss limit does not include hedge benefit – measures the derivatives only Limit is based on net aggregate loss of derivatives and net worth

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**Weighted Average Remaining Maturity Notional**

Cannot net offsetting transaction – calculation is cumulative WARMN = Adjusted notional * (WARM/10)

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Hedging Example 2-Year Interest Rate Swap – Pay Fixed, Receive Floating Entry Limit Calculations

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Hedging Example 5-Year Interest Rate Swap – Pay Fixed, Receive Floating Entry Limit Calculations

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**Balance Sheet & 2 Year Net Interest Income Projection**

Hedging Example Balance Sheet & 2 Year Net Interest Income Projection

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Hedging Example 2-Year Interest Rate Swap – Pay Fixed, Receive Floating Base Case Swap Cash Flows on $50 MM Notional

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**2 Year Net Interest Income Projection with Swap**

Hedging Example 2 Year Net Interest Income Projection with Swap

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**Hedging Alternatives Originate floating-rate loan products**

Purchase floating-rate securities Sell long-term fixed rate assets Purchase of short-term assets Increased use of share certificates – longer term with higher early withdrawal penalties

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**Counterparty Agreements, Collateral, and Margining**

Can have exchange traded, centrally cleared, or non-cleared derivatives Exchange traded and cleared: Comply with Commodity Futures Trading Commission Rules Dealers must be CFTC registrants Comply with margining rules set by futures commission merchant Non-cleared derivatives: Must have ISDA master service agreement Must have minimum daily margining of $250,000 Marginal collateral can include only cash, US Treasuries, GSE debt, GSE residential MBS

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**Counterparty Agreements, Collateral, and Margining**

Must have systems in place to manage collateral and margining requirements System must include posting, tracking, valuing and reporting of collateral Must assess liquidity needs in light of margining requirements

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**Operational Support Required Experience and Competencies**

Board – must receive derivatives training – updated annually Senior Executive Officers must understand, approve, and provide oversight Qualified Derivatives Personnel Must understand ALM, including use of derivatives Must know how to evaluate counterparty, collateral and margining risks Must understand accounting and financial reporting in accordance with GAAP

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**External Service Providers**

Can use ESPs, provided ESP: Is not a counterparty Is not a principal or agent in the derivatives transactions Does not have discretionary authority to execute trades CU must be capable of overseeing ESP ESP’s role must be documented ESP cannot conduct ALM or liquidity risk management in lieu of credit union

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Internal Controls Transaction support - must identify transaction and show how it will be effective Internal controls review – must perform review for 2 years (internal audit or external auditor) Financial statement audit – must have financial statement audit performed Must have written processes in place including schematic (flow chart or organization chart) Must have appropriate segregation of duties Must have legal review of derivatives contracts Must have written policies and procedures

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**Elements of a Derivatives Policy**

Key participants Participants’ responsibilities and internal controls - including who is permitted to enter into derivatives transaction Objective of hedge and nature of risk being hedged Hedge period Authority for implementation of the derivatives program Purpose and implementation guidelines Permissible derivative instruments Hedge limits Hedge designations Hedge effectiveness Reporting requirements

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**Derivatives Reporting Requirements**

Quarterly board reports Monthly reporting to senior executives and ALCO, if applicable. At a minimum, the reports must show: Any areas of noncompliance Comparison to internal limits Itemization of individual positions and current fair values with comparison to NCUA limits NEV calculations with and without derivatives Evaluation of effectiveness in mitigating IRR Evaluation of “hedge accounting”

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**Credit Unions Must Apply for Authority to Use Derivatives**

Demonstrate how derivatives will mitigate IRR Detail derivatives the CU intends to use and why Have policies in place Detail how credit union will acquire appropriate resources, controls and systems to implement sound program Specify how ESPs will be used Address margining and collateral Describe how it will meet GAAP

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**Credit Unions Must Apply for Authority to Use Derivatives**

Cannot enter into derivative transactions until approved Entry limits when approved Standard limits apply after CU has been using derivatives for one year and NCUA has not voiced any safety and soundness concerns Pilot program participants must be fully compliant within 12 months

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**Accounting for Derivatives**

Derivatives must be accounted for and reported at fair value Three options to decrease resulting income statement volatility: Fair Value Hedge Accounting Fair Value Accounting Cash Flow Hedge Accounting

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**Accounting for Derivatives**

Two types of hedge accounting 1. Fair value hedge Change in fair value of the hedging instrument runs through the income statement, along with the change in the fair value of the item being hedged – used for existing financial assets and liabilities Cash flow hedge “Effective” portion of the hedge is reported in Other Comprehensive Income, while the ineffective portion is reported in current earnings – used for forecasted transactions or variable payments on existing financial assets and liabilities

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**Accounting for Derivatives**

Type of accounting depends on the item being hedged – Credit Union enters into a Pay Fixed, Receive Floating Interest Rate Swap Fair Value Hedge Example: CU wants to hedge against the decrease in fair value of a fixed rate loan portfolio defines hedge as change in benchmark interest rate If benchmark interest rate increases, fair value of the loans will decrease, and the fair value of the swap will increase. Change in each runs through the income statement Cash Flow Hedge Example: CU wants to hedge against increase in dividend payments on CD accounts as they renew Defines hedge as risk of an increase in the forecasted payments to its members. Effective portion will run through OCI

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Hedge Documentation Formal designation and documentation required at inception The CU’s objective and strategy for the hedge must include ( b 2): The hedging instrument – the derivative (interest rate swap, interest rate floor, interest rate cap, etc.) The hedged item or transaction – the asset or liability being hedged The nature of the risk being hedged – interest rate risk The method that will be used to retrospectively and prospectively measure the hedge’s effectiveness

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Hedge Documentation The method that will be used to measure hedge ineffectiveness Benchmark interest rate being hedged Eligible benchmark rates are ( A): Treasury rates Federal funds effective swap rate LIBOR

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**Hedge Documentation Fair Value Hedge**

Can hedge the change in fair value of an entire or a portion of an asset or liability ( ) Cash Flow Hedge – Variability in Expected Future Cash Flows Related to: An existing recognized asset or liability (such as all or certain future interest payments on variable rate debt) A forecasted transaction (such as a forecasted purchase or sale) ( )

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Hedge Effectiveness To qualify for hedge accounting, the hedging relationship (both at inception of the hedge and on an ongoing basis), shall be expected to be highly effective in achieving either of the following ( ): Offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated - a fair value hedge Offsetting cash flows attributable to the hedged risk during the term of the hedge - a cash flow hedge

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**Hedge Effectiveness Hedge Effectiveness can be measured in two ways:**

1. Dollar-offset approach ( a) Compares changes in fair value or cash flow of the hedged item and the derivative Can be applied period by period (cannot be less than 3 months) or cumulatively Most believe a dollar offset range of 80%-125% would be considered highly effective Statistical methodologies May permit a CU to continue to use hedge accounting for the current period even though the dollar-offset approach appears ineffective ( ) Complex to implement and requires multiple observation periods

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**Hedge Effectiveness: Dollar-Offset Approach Example**

$50 MM pay fixed / receive floating 5-year interest rate swap Hedged item – a group of fixed rate investments held AFS

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**Hedge Effectiveness: Statistical Approaches**

Regression Analysis Minimum of 30 observations Must consider changes in the value of the derivative and the hedged item Time horizon must coincide or be less than the time horizon of the hedge relationship Must consider whether to regress value changes or value levels Must review distribution of error terms EY Derivatives and Hedging, October

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**Hedge Effectiveness: Statistical Approaches**

Regression Analysis continued R-squared result must exceed a pre-specified level (e.g ) Hedge relationship must correspond to beta (the slope of the regression line) Standard error must be used to calculate the reliability using the t statistic T-test must be passed at a 95% confidence level Must consider y-intercept Must compare results to dollar offset results EY Derivatives and Hedging, October

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**Hedge Effectiveness: Statistical Approaches**

R-squared Analysis Hedged item – floating dividend rate on money market shares

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Hedge Effectives A credit union shall consider hedge effectiveness in two different ways: 1. Prospective Considerations 2. Retrospective Evaluations

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**Hedge Effectiveness Prospective Considerations (815-20-25-79a)**

Can be based on regression or other statistical analysis of past changes in fair values or cash flows as well as on other relevant information Shall consider all reasonably possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied Not be limited only to the likely or expected changes in fair value (if a fair value hedge) or in fair value or cash flow (if a cash flow hedge) Generally involves a probability-weighted analysis – consistent with FASB Concepts Statement No. 7

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**Hedge Effectiveness Retrospective Considerations (815-20-25-79a)**

An assessment of effectiveness shall be performed whenever financial statements or earnings are reported, and at least every three months Can be based on dollar offset or statistical approaches Dollar-offset measurement can be for period or cumulative Statistical methods must be similar period to period (e.g. same number of data points)

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**Hedge Effectiveness Other Considerations for Cash Flow Hedges**

Effectiveness testing for a cash flow hedge involving an interest rate swap can be done using one of three methods: Change in variable cash flows method ( through 24) Hypothetical derivative method ( through 30) Change in fair value method ( through 32) We will show examples of each later on in the presentation

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**What if the Hedge is No Longer Effective?**

The hedge accounting is discontinued prospectively, resulting in potential income statement volatility as the derivative is marked to market with no offset to the hedged item (fair value hedge and cash flow hedge ) Fair value adjustments for fixed rate financial instruments related to fair value hedges are recognized prospectively using the effective interest rate method when hedge accounting is discontinued ( ) Cash flow hedge - the net gain or loss remains in AOCI unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period plus a 2 month extension ( )

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**Hedge Ineffectiveness**

Hedge ineffectiveness is measured by the Dollar-offset method Fair Value Hedge: Hedge ineffectiveness flows through the income statement based on any difference between the change in the value of the derivative and the change in value of the hedged item ( b) Cash Flow Hedge: Ineffectiveness must be separately measured and recorded on the income statement. If the fair value of the derivative changes by more than the present value of hedged cash flows, the difference is the ineffective amount. If the fair value of the hedged cash flows changes by more than the change in the fair value of the derivative then no ineffectiveness ( c)

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Short-Cut Method Entities can assume no ineffectiveness in an interest rate swap in two instances: A private company that enters into a pay fixed, receive floating interest rate swap (this exemption does not apply to financial institutions) ( B) A swap can be examined to determine if it can be accounted for under the Short-Cut Method (this applies to all companies, including financial institutions)

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Short-Cut Method To conclude no hedge ineffectiveness in a hedge with an interest rate swap, all of the following conditions must be met for both fair value and cash flow hedges ( ): Notional amount of swap matches principal amount of item being hedged Fair value of the swap is zero at inception Note: For the purposed of determining zero: can ignore bid/ask spread at inception, commissions, and other transaction costs

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Short-Cut Method d) Formula for computing net settlements remains the same throughout the swap Fixed rate remains the same Variable rate index does not change e) Interest bearing asset or liability is not pre-payable Unless the prepayment is due to an embedded call (put) option and the swap has a mirror option call (put) option - options must mach exactly Because the NCUA does not allow a credit union to enter into a swap with this feature, we believe a swap involving loans that can be prepaid will not qualify for the short-cut method f) Index on which the variable rate leg is based matches the benchmark interest rate designated as the interest rate being hedged

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Short-Cut Method WW Risk Management does not recommend the short-cut method, because if you fail, you cannot reassess. We recommend that a credit union account for the swap using the long-haul method, recognizing that swaps that would qualify for the short-cut method will easily pass the effectiveness testing

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**Fair Value Hedges - Eligibility**

As asset or liability is eligible for designation as a hedged item in a fair value hedge if all of the following criteria are met: The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment ( a) The hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings ( c)

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**Fair Value Hedges - Eligibility**

The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or similar liabilities (or a specific portion thereof) ( b) If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or liabilities shall share the risk exposure – generally proportionate change in fair value If the specific portion of an asset or liability then the hedged item is one of the following: One or more selected contractual cash flows, including one or more individual interest payments during a selected portion of the term of a debt instrument (such as the portion of the asset or liability representing the present value of the interest payments in the first two years of a four-year debt instrument). A put option or call option (including an interest rate cap or price cap or an interest rate floor or price floor) embedded in an existing asset or liability that is not an embedded derivative accounted for separately

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**Fair Value Hedges - Eligibility**

If the hedged item is a financial asset or liability or a recognized loan servicing right, the designated risk being hedged is any of the following ( f): The risk of changes in the overall fair value of the entire hedged item The risk of changes in its fair value attributable to changes in the designated benchmark interest rate (referred to as interest rate risk) The risk of changes in its fair value attributable to both of the following (referred to as credit risk): Changes in the obligor’s creditworthiness Changes in the spread over the benchmark interest rate with respect to the hedged item’s credit sector at inception of the hedge

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Fair Value Hedges Change in fair value for each item in the portfolio must be within a fairly narrow range – such as 9 to 11%. On the other hand, a range of 7 to 13% would not meet the similar portfolio requirement ( )

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Fair Value Hedges In aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate ( ): a. Loan type b. Loan size c. Nature and location of collateral d. Interest rate type (fixed or variable) e. Coupon interest rate (if fixed) f. Scheduled maturity g. Prepayment history of the loans (if seasoned) h. Expected prepayment performance in varying interest rate scenarios

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**Fair Value Hedges Non-performance risk**

Credit valuation adjustments (CVAs) Counterparty risk Credit union non-performance risk – implied EY For derivatives such as swaps the CVAs adjustments can swing from party to party as each entity comes into / goes out of the money

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Fair Value Hedges Credit unions considering a fair value hedge should be aware of the following: Fair value hedge cannot be used to hedge interest rate risk on held-to-maturity securities ( c 2) If a fair value hedge is used to hedge interest rate risk on available-for- sale securities then the change in the value of the hedged item runs through the income statement and not through OCI A partial-term hedge of a fixed rate financial instrument using a shorter-term, notionally matched swap will generally not "be effective" (e.g. hedging a 30-year loan with a 3-year swap)

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**Fair Value Hedges vs. Fair Value Accounting**

Fair value hedge accounting is restrictive and complex, and a CU could elect to account for the financial instrument at fair value in order to avoid these complications and limitations. However, fair value election has several disadvantages: Hedge-accounting election can be terminated at any time, while the fair value election is irrevocable Nearly all of the change in value of an interest rate derivative over time will be due to changes in the market interest rates, while fair value of the loans will be affected by changes in interest rate and credit conditions The CU will need to develop systems to estimate the fair value of loans over their entire lives

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**Fair Value Hedges vs. Fair Value Accounting**

We recommend that if a credit union elects to account for loans at fair value, that it: Select high credit borrowers to minimize the change in value arising from deterioration of the borrower’s credit or the widening out of credit spreads We note that we have systems in place to estimate the fair value of loans over their entire lives

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**Fair Value Hedges vs. Fair Value Accounting**

Fixed Rate Mortgage Fair Value Example

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**Cash Flow Hedges - Eligibility**

An entity may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with either of the following ( ): Payments on an existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt or variable rate liabilities – share accounts) A forecasted transaction (such as a forecasted purchase or sale)

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**Cash Flow Hedges - Eligibility**

A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following criteria are met ( ): a) A forecasted transaction is specifically identified as either: A single transaction A group of individual transactions that share the same risk exposure for which they are designated as being hedged. A forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction.

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**Cash Flow Hedges - Eligibility**

b) The occurrence of the forecasted transaction is probable. c) The forecasted transactions meets both of the following conditions: It is a transaction with a party external to the reporting entity It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings d) The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be re-measured with changes in fair value attributable to the hedged risk reported currently in earnings. e) If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not re-measured with changes in fair value attributable to the hedged risk reported currently in earnings.

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**Cash Flow Hedges - Eligibility**

f) If the hedged transaction is the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is any of the following: The risk of overall changes in the hedged cash flows related to the asset or liability, such as those relating to all changes in the purchase price or sales price 2. The risk of changes in its cash flows attributable to changes in the designated benchmark interest rate (referred to as interest rate risk) 3. The risk of changes in its cash flows attributable to all of the following (referred to as credit risk): i. Default ii. Changes in the obligor’s creditworthiness iii. Changes in the spread over the benchmark interest rate with respect to the related financial asset’s or liability’s credit sector at inception of the hedge.

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**Cash Flow Hedge Accounting**

Accounting for cash flows AOCI reclassified into earnings in the same period that the in which the forecasted transaction affects earnings

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**Hedge Accounting Examples**

Fair Value of the Derivative Interest Rate Swap Interest Rate Cap Cash Flow Hedges Rollover of FHLB Advances – hypothetical derivatives method Rollover of Share CDs – change in variable cash flows method Rollover of Share CDs – change in fair value method Money Market Share Accounts – change in variable cash flows Fair Value Hedge Loan Portfolio Method Forgo Hedge Accounting Fair Value Option for loan portfolio

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**Fair Value of Derivatives**

$50 MM 3-year pay fixed / receive floating interest rate swap At inception and without the credit valuation adjustment (CVA), the fair value of the swap is zero.

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**Fair Value of Derivatives**

$50 MM 3-year pay fixed / receive floating interest rate swap Credit valuation adjustment (CVA) is applied to the discount rate on both legs of the swap to determine fair value

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**Fair Value of Derivatives**

$50 MM 3-year pay fixed / receive floating interest rate swap Fair value of the swap changes as interest rates move and with the passage of time

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**Fair Value of Derivatives**

$25 MM 5-year interest rate cap with a 3.50% strike price Since the cap strike price of 3.50% exceeds the anticipated forward rate in all periods, this cap is out-of-the-money at inception.

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**Fair Value of Derivatives**

$25 MM 5-year interest rate cap with a 3.50% strike price Fair value of the interest rate cap changes as interest rates move and with the passage of time

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**Hedge Accounting Examples**

Cash Flow Hedges – Using Interest Rate Swaps Rollover of FHLB Advances Analogous to hedging commercial paper ( though 05-9) Hypothetical derivatives method no ineffectiveness Rollover of CDs Change in variable cash flows method with ineffectiveness ( ) Change in fair value method with ineffectiveness ( ) Money Market Share Accounts – First Payments Method Change in variable cash flows method with ineffectiveness

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**Hedge Accounting Examples**

Non-performance Risk for Cash Flow Hedges Using Interest Rate Swaps The discount rate used for the change in variable cash flows method and the hypothetical derivative method is the rate applicable to determining the fair value of the swap ( ). This means that the non-performance risk of the swap counterparty would be applied to the swap and the hedged item cash flows so it would not in itself result in effectiveness. Issue arises if default of counterparty is “probable”. Non-performance risk can result in effectiveness using the change in fair value method ( )

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**Cash Flow Hedge Example: Rollover of Existing Debt**

A pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows on rollovers of the credit union's FHLB advances Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception Hedged item – forecasted quarterly issuances of fixed rate FHLB advances (rollovers) Nature of the risk being hedged - variability in cash flows in the interest element of the final cash flows at maturity attributable to changes in the LIBOR swap rate – benchmark interest rate

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**Cash Flow Hedge Example: Rollover of Existing Debt**

Critical terms Notional amount of the swap and FHLB advance match at $50 MM Fixed rate on the swap is the same throughout the term and the variable rate equals LIBOR Index on the swap’s variable interest rate leg matches the benchmark interest rate designated as the risk being hedged (3 month LIBOR) No interest payments beyond the term of the swap are designated as hedged No caps or floors on the variable interest rate leg and no embedded optionality in the FHLB advance Swap and borrowings re-price on the same day Determination that the it is probable that the swap counterparty will not default on its obligations

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**Cash Flow Hedge Example: Rollover of Existing Debt**

Credit Union must perform effectiveness testing. Effectiveness testing can be based on the changes in LIBOR only – because the borrowing is fixed rate and based on the risk free rate. Hedge of benchmark interest rate. Ineffectiveness will measured using the change in hypothetical derivatives method.

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**Cash Flow Hedge Example: Hypothetical Derivatives Method**

Hedge ineffectiveness based on a comparison of the following amounts: a. The change in fair value of the actual interest rate swap designated as the hedging instrument b. The change in fair value of a hypothetical interest rate swap having terms that identically match the critical terms of the floating-rate asset or liability, including all of the following: 1. The same notional amount 2. The same repricing dates 3. The same index (that is, the index on which the hypothetical interest rate swap’s variable rate is based matches the index on which the asset or liability’s variable rate is based) 4. Mirror image caps and floors 5. A zero fair value at the inception of the hedging relationship

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**Cash Flow Hedge Example: Hypothetical Derivatives Method**

Short-Cut Method Cash Flow Hedge ( ) a. All interest receipts or payments on the variable-rate asset or liability during the term of the interest rate swap are designated as hedged. No interest payments beyond the term of the interest rate swap are designated as hedged. c. Either of the following conditions is met: 1. There is no floor or cap on the variable interest rate of the interest rate swap. The variable-rate asset or liability has a floor or cap and the interest rate swap has a floor or cap on the variable interest rate that is comparable to the floor or cap on the variable-rate asset or liability.

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**Cash Flow Hedge Example: Hypothetical Derivatives Method**

The repricing dates of the variable-rate asset or liability and the hedging instrument occur on the same dates and be calculated the same way (that is, both shall be either prospective or retrospective). For cash flow hedges of the interest payments on only a portion of the principal amount of the interest-bearing asset or liability, the notional amount of the interest rate swap designated as the hedging instrument (see paragraph [a]) matches the principal amount of the portion of the asset or liability on which the hedged interest payments are based. For a cash flow hedge in which the hedged forecasted transaction is a group of individual transactions (as permitted by paragraph [a]), if both of the following criteria are met: Notional amount of swap equals total of individual transactions Remaining short cut criteria are also met

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**Cash Flow Hedge Example: Hypothetical Derivatives Method**

Essentially the hypothetical derivatives method needs to satisfy all of the criteria of the short-cut method with the exception of ASC (e) relating to prepayment which was written for “fair value” hedges.

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**Cash Flow Hedge Example: Hypothetical Derivatives Method**

Cumulative change in the fair value of the actual swap will be compared to the cumulative change in the fair value of the hypothetical swap Critical terms of the hypothetical swap match hedged transactions (i.e. the FHLB borrowings) and will thus be expected to be “highly effective” and perfectly offset the hedged cash flows Change in fair value of the perfect hypothetical swap will be regarded as a proxy for the present value of the cumulative change in expected cash flows on the FHLB borrowings ( ) Use dollar offset method to measure effectiveness

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**Cash Flow Hedge Example: Hypothetical Derivatives Method**

A $50 MM 3-year pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows on rollovers the credit union's FHLB advances

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**Cash Flow Hedge Example: Hypothetical Derivatives Method**

Retrospective effectiveness testing - $50 MM 3-year pay fixed, receive floating interest rate swap that hedges against the risk of increases in interest rate- related cash flows on rollovers the credit union's FHLB advances - interest rates increase 50 basis points after 1st Quarter

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**Cash Flow Hedge Example: Hypothetical Derivatives Method**

First Quarter Interest expense $153,706 Cash To record fixed payment $ 29,311 To record receipt of floating End of First Quarter - Rates Increase .50% Derivative Asset $ 792,709 Other Comprehensive Income To record change in swap's fair value after Q 1 payment

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**Cash Flow Hedge Example: Hypothetical Derivatives Method**

Note there is no need to amortize OCI because we are recording the cash flows from the swap as interest expense and other changes to fair value to OCI with an offset to derivative asset or derivative liability. The fair value of the swap will revert back to zero over time as it reaches maturity.

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**Cash Flow Hedge Example: Rollover of Existing Debt**

A pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows on reissuances of the credit union's share certificates Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception Hedged item – forecasted quarterly re-issuances of fixed rate share certificates Nature of the risk being hedged - variability in cash flows arising from reissuances of share certificates

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**Cash Flow Hedge Example: Rollover of Existing Debt**

Critical terms Notional amount of the swap and share certificates match at $50 MM Fixed rate on the swap is the same throughout the term and the variable rate equals LIBOR No interest payments beyond the term of the swap are designated as hedged Swap and CDs re-price on the same day Determination that the it is probable that the swap counterparty will not default on its obligations

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**Cash Flow Hedge Example: Change in Variables Cash Flow Method**

Credit Union must perform effectiveness testing. To be effective, changes in certificates of deposit must closely track changes in LIBOR. Effectiveness testing could be based on the changes in LIBOR only – as a benchmark interest rate. In this example, we will test using the rate on the CDs. Ineffectiveness will measured using the change in variable cash flows method.

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**Change in Variables Cash Flow Method**

Hedge ineffectiveness is based on a comparison of: Variable leg of the interest rate swap Hedged variable-rate cash flows on the share certificates Based on the premise that only the floating-rate component of the interest rate swap provides the cash flow hedge The interest rate swap is recorded at fair value on the balance sheet. The calculation of ineffectiveness involves a comparison of the following amounts: a. The present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap b. The present value of the cumulative change in the expected future interest cash flows on the CDs

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**Change in Variables Cash Flow Method**

Hedge ineffectiveness results when the present value of the cumulative cash flows on the swap exceed the present value of the cumulative cash flows of the designated share certificate accounts. Conversely, there is no ineffectiveness if the PV of the designated share certificate payments exceed the PV of the swap (FAS ASC (b))

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**Change in Variables Cash Flow Method**

A $50 MM 3-year pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows on rollovers the credit union's share certificates At inception hedge value is $0. LIBOR rates increase 25 basis points after 1 quarter.

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**Change in Variables Cash Flow Method**

A $50 MM 3-year pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows on rollovers the credit union's share certificates $310,706 is the effective portion of the hedge. $27,017 is ineffective.

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**Change in Variable Cash Flows Method**

Interest Expense $ 124,395 Cash Record net payments on swap Derivative Asset $ 459,906 Interest Income $ 27,017 OCI $ 432,889 Record fair value of swap and ineffective portion

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**Change in Fair Value Method**

Ineffectiveness based on a calculation that compares: Present value of the cumulative change in expected variable cash flows that are designated as the hedged items Cumulative change in the fair value of the interest rate swap designated as the hedging instrument Non-performance risk could result in some ineffectiveness using this technique because while the credit valuation adjustment would affect end of period cash flows as in methods 1 and 2 – it would also affect the beginning of the period cash flows for the swap as part of its determination of fair value

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**Change in Fair Value Method**

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**Cash Flow Hedge: Change in Fair Value Method**

Interest Expense $ 124,395 Cash Record net payments on swap Derivative Asset $ 459,906 Interest Income $ 24,805 OCI $ 435,101 Record fair value of swap and ineffective portion

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**Cash Flow Hedge: First Payments Method**

A pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows for a credit union's money market share accounts Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception Hedged item - payments on the $50 million of the credit union's money market share accounts Nature of the risk being hedged - variability in cash flows on its quarterly interest payments on $50 million principal of money market share accounts

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**Cash Flow Hedge: First Payments Method**

A pay fixed, receive floating interest rate swap is used to hedge against the risk of increasing interest rates for a credit union's money market share accounts Re-pricing beta is 0.50 compared with 60-day LIBOR and money market accounts have an estimated life of 3 years Credit union enters into a 3-year 60-day LIBOR swap with a notional amount of $25 million and quarterly settlements

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**Cash Flow Hedge Example: Change in Variables Cash Flow Method**

Credit Union must perform effectiveness testing. To be effective, changes in dividends on money market shares must closely track changes in LIBOR. Effectiveness testing cannot be based on the changes in LIBOR only – must consider actual payments made because the dividend rate is variable and is not explicitly based on a benchmark interest rate ( (d)(3)) . Ineffectiveness will measured using the change in variable cash flows method.

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**Change in Variable Cash Flow Method Example**

$25 MM 3-year pay fixed / receive floating interest rate swap Hedged item – variability in cash flows on its quarterly interest payments on $50 million principal of money market share accounts Fair value of the interest rate swap after 1 quarter and an increase in LIBOR interest rates of 15 basis points.

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**Change in Variable Cash Flow Method Example**

$25 MM 3-year pay fixed / receive floating interest rate swap Hedged item – variability in cash flows on its quarterly interest payments on $50 million principal of money market share accounts

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**Change in Variable Cash Flows Method**

Derivative Asset $147,289 Interest Income $37,306 OCI $109,983

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**Hedge Accounting Examples**

Fair Value Hedge Portfolio Method using an interest rate swap For sake of simplicity we will ignore CVAs Forgo Hedge Accounting Loan portfolio – fair value option Purchase of an interest rate cap

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**Fair Value Hedge Example: Portfolio Method**

A pay fixed, receive floating interest rate swap is used to hedge against the change in the fair value of a portfolio of fixed rate single family mortgages Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception Hedged item - portfolio of fixed rate single family mortgage loans Nature of the risk being hedged - interest rate risk defined as the change in the fair value of the mortgage loan portfolio in relation to the change in benchmark interest rate (LIBOR) The portfolio of loans meets the similar assets criteria

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**Fair Value Hedge Example: Portfolio Method**

A pay fixed, receive floating interest rate swap is used to hedge against the change in the fair value of a portfolio of fixed rate single family mortgages Stated maturity of swap is consistent with the stated maturities of the loans Swap amortizes on a schedule that equates to scheduled amortization of the loans

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**Fair Value Hedge Example: Portfolio Method**

As part of its documented risk management strategy associated with this hedging relationship, on a quarterly basis, the credit union intends to do both of the following: Assess effectiveness of the existing hedging relationship for the past three-month period. Consider possible changes in value of the hedging derivative and the hedged item over the next three months in deciding whether it has an expectation that the hedging relationship will continue to be highly effective at achieving offsetting changes in fair value. Loans can prepay – credit union considers prepayment risk of the portfolio in its prospective testing If loans prepay faster than expected resulting in an over-hedge – credit union de-designates a portion of the swap for the next three month period

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**Fair Value Hedge Example: Portfolio Method**

$50 MM amortizing 15 year pay fixed / receive floating interest rate swap Hedged item – a pool of 15-year fixed rate loans

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**Fair Value Hedge Example: Portfolio Method**

Month 1 Interest expense 104,527 Cash Non-interest income 251,261 Derivative liability Residential real estate loans 257,100 Month 2 Interest expense 97,316 Cash Derivative liability 251,261 Derivative asset 372,325 Non-interest income 623,586 508,479 Residential real estate loans Month 3 Interest expense 94,583 Cash Derivative asset 266,718 Non-interest income 301,068 Residential real estate loans

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**Fair Value Election Accounting**

Fixed Rate Mortgage Fair Value Example

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**Fair Value Election Accounting**

Example with Default and Interest Rate Shock

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**Fair Value Election a Non-interest expense (interest rate) $ 1,065,609**

$ 1,065,609 Non-interest expense (credit) $ ,113 Residential real estate loans $ 1,109,722

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**Purchase of Interest Rate Cap**

An interest rate cap is purchased to hedge against the decline in the price of a $100 million 10-year treasury note, which the credit union is holding in its available-for-sale inventory. Forgo hedge accounting

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**Purchase of Interest Rate Cap**

The value of a cap has two components – intrinsic and time. When measuring effectiveness of an option credit union can include all of its gain or loss or it may exclude all or part of the time value as follows ( ): Assess on intrinsic value only Assess on present value intrinsic value only Exclude any of the time value elements: Passage of time (theta) Volatility (vega) Change in interest rates (rho)

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**Interest Rate Cap Example**

$100 MM quarterly 5-year with a cap strike price of 2.75%

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**Interest Rate Cap Example**

Horizon analysis with interest rate shocks

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**Other Considerations Call Report References Risk Based Capital**

Other Assets,32–d Non-Trading Derivatives Assets, net Liabilities, 7 Non-Trading Derivative Liabilities, net Schedule D: Pages 20-24 Risk Based Capital AOCI not included in capital so no regulatory benefit for cash flow hedge

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How We Can Help Identify the optimal derivative(s) to be used given your credit union's ALM profile Work with you to amend your ALM policies to allow for the use of derivatives Work with you to draft derivatives policies and procedures that ensure you have the proper internal controls in place and that you meet all of the NCUA requirements regarding the use of derivatives We can provide estimates of ongoing fair value for loans, investments, and liabilities which you have elected to account for at fair value. We can also help you with the initial selection of the items

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**How We Can Help For those electing hedge accounting we can:**

Develop the appropriate interest rate hedge and hedging item(s) to be used given your credit union's ALM profile Work with you to identify the item(s) to be hedged and the nature of the risk being hedged Ensure you are able to achieve hedge accounting - including prospective and retrospective effectiveness testing on a dollar offset or statistical basis Provide you with the journal entries needed to report hedging activities

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Wilary Winn Resources

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**Wilary Winn Risk Management**

Wilary Winn Risk Management LLC First National Bank Building 332 Minnesota Street, Suite W1750 Saint Paul, MN

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**Wilary Winn Risk Management**

Services and Contact Information Asset Liability Management, Derivatives and Private Label MBS/CMOs: Frank Wilary Mergers and Acquisitions, Fair Value Footnotes, ASC , and TDRs: Brenda Lidke Mortgage Servicing Rights and Mortgage Banking Derivatives: Eric Nokken

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Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter Ten Derivative Securities Markets.

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter Ten Derivative Securities Markets.

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