The Financial Accounting Standards Board's proposed standard will hit some derivatives markets particularly hard. But in the long run, the gains may offset the losses.

By Nilly Ostro-Landau

The derivatives world has been awaiting the release of the Financial Accounting Standards Board's exposure draft on derivatives accounting with bated breath-and with good reason. In this highly structured marketplace, accounting treatment often determines which products flourish and which die a slow lingering death.

Thus far, nobody is letting out a sigh of relief.

There is, in fact, plenty of bad news in the proposed standard: derivatives end-users are likely to see increased volatility in their earnings and comprehensive income/equity. The proposal effectively kills synthetic accounting for swaps, bans certain leveraged and accrual-based structures, and provides uneven and inconsistent treatment of some instruments. It also requires more sophisticated pricing models for end-users and annihilates exchange-traded rollover strategies for hedging long-term risk.

But there's some good news as well: the exposure draft gives a green light to hedging expected transactions and a vote of confidence to combination options. It will help make valuations of derivatives exposures more transparent. And, after years of confusion, it outlines clearer, more comprehensive treatment of derivatives that is likely to focus more attention on risk management than ever before.

Raising glasses

Optimists believe the long-term prospects look rosy. They admit the market could take a short-term hit because of the confusion over new comprehensive income numbers and the need for more sophisticated valuation systems. But in the long run they believe the increased flexibility allowed by the proposed standard and its comprehensive nature are likely to increase trading volume in hedge instruments.

The biggest cheers are coming from beleaguered accountants who have spent years leading their clients through a thicket of contradictory FASB hedging pronouncements. "The exposure draft is the first comprehensive statement on derivatives," notes Bob Sullivan, lead partner of Price Waterhouse's capital markets and treasury practice. As a result, companies that may have shied away from some more sophisticated practices-fearing unfavorable accounting treatment-may now be more inclined to give these practices a second look.

Others are particularly happy about the green light for hedging of anticipated transactions. In the past, companies struggled to find appropriate ways to protect expected cash flows. FAS No. 52, which covers currency hedges, allowed only hedges of firm commitments. FAS No. 80, which originally applied to commodities but later expanded to cover other financial risks, allowed such hedges, but only with options. Then, in 1992, the SEC threw the forecasted transaction hedge market into more of a quandary when it barred the use of option combinations (designed to reduce premium cost) for hedging of anticipated risk.

The new standard resolves the issue in two ways. First, it offers a clear definition of an anticipated transaction. Second, it allows the use of options combinations and forwards to hedge such risks.

The industry is also upbeat about the heightened emphasis on risk management policies and procedures that are designed to clearly separate hedgers from speculative traders. Companies will now be forced to sort out their internal risk controls and corporate policies in greater detail-and chances are that more will end up protecting their currency and interest rate exposures in an organized and ongoing fashion. "The exposure draft should actually increase the use of derivative instruments sold by banks because it increases the focus on risk management," argues Peter Marshall, senior associate at Emcor Risk Management Consulting, an Irvington, New York­based consultancy specializing in financial risk management.

The flip side of this clear-cut distinction between a hedge and a speculative position is that banks will have to be more careful about the instruments they recommend. Nobody will be able to sell Libor squared swaps as a hedge, for instance. "It's got to put a lot of pressure on banks to ensure they are selling appropriate instruments," says Marshall.

Serious fears

Not everyone is so optimistic. Some bankers are expressing serious concern that the proposed standard will hurt their business. "This is clearly not good for the market," says Chip Goodrich, managing director at Deutschebank in London. "The feeling in the industry is that the exposure draft will discourage hedging by end-users, because of the restrictive nature of some of the requirements."

Yves Leysen, head of marketing for Credit Suisse Financial Products for the Americas, is equally cautious. "I am very worried," he says, "that it's going to reduce the potential and use of derivatives to exploit inefficiencies in the capital markets." Leysen is mostly concerned that accounting treatment will encourage users to choose cash instruments over derivative instruments even when the latter make more economic sense. Although a floating rate bond issue and a fixed rate issue swapped into a floating rate obligation may have the same risk profile, they will be treated differently under the standard. While it may make more sense to issue a bullet and swap it, the accounting treatment of the swap will be less favorable, as changes in the value will have to be marked to market, creating earnings volatility. He's also concerned that forcing investors to match the duration of both hedge and exposure will discourage them from taking advantage of profitable arbitrage opportunities-for example, swapping a leg of a long-term debt deal when rates shift suddenly.

Pessimists believe that although FASB has clarified permitted activity, it will make some transactions like vanilla swaps unnecessarily difficult. "FASB has done a reasonable job of trying to accommodate most prudent hedging activity," says James Mountain, partner, capital markets at Deloitte & Touche. "The problem is that the accounting has become more difficult and complicated."

Here's a rundown of how markets will be positively or negative affected.

BUSTED:

1. Off-balance-sheet swaps. "If adopted as proposed, the exposure draft will make the accounting for swaps much more complicated," says Mountain. Before the new rules, swaps were off-balance-sheet items, with only the quarterly exchange of interest reflected in the bottom line. Now swaps will become, like all other derivatives, on-balance-sheet items and will have to be marked to market at their fair market value.

Since a swap's market value (which also reflects counterparty risk) will show up on the books, any mismatch between the value of the hedge instrument and the underlying exposure will result in volatility in earnings or equity. Take, for example, a swap in which the two sides of a transaction are perfectly matched, with gains on one side offsetting losses on the other. If the credit quality of a counterparty drops, the gap between hedge and exposure will create earnings volatility, since one side will no longer perfectly offset the other, leading to realized gains/losses. For banks, the latter is of utmost importance since they are already highly leveraged. (See box on page 29.)

There's another problem with swap accounting. One of the most controversial changes proposed by the board creates a serious inconsistency in the treatment of certain swaps. A floating rate debt issue swapped into fixed will be treated as a cash flow hedge; thus gains and losses will work their way into comprehensive income. However, a fixed rate bond issue swapped into a floating rate obligation will be accounted for as a fair value hedge, with any mismatched gains or losses instantly hitting the bottom line.

Swaps will also be adversely effected by a requirement that hedge and risk have similar maturities. In the past a company would issue 10-year debt and swap, say, only the first three years of that bond deal to take advantage of the favorable interest rate environment. Under the new rules this partial swap will not be eligible for hedge accounting. "It takes away a lot of flexibility companies had in the past," says Price Waterhouse's Sullivan.

2. Short-dated futures. The same maturity-matching requirement is causing quite a stir in the halls of the CBOT and the Merc. Concerned about rollover risk, FASB has mandated that a hedge must be "on or about" the maturity of the underlying exposure. The rule essentially kills any chance of deferral accounting for hedging of long-term risks with short-dated instruments, the bread and butter of the futures exchanges. "The rollover issue is of most concern," says Ira Kawaller, senior vice president and head of the New York office of the Chicago Mercantile Exchange.

The upshot of this ban is that companies will be more likely to use structured OTC hedges instead of short-term futures. "You are creating an accounting and reporting bias against the contracts that are the most liquid and have the least degree of credit concerns," points out Joseph Erickson, partner in charge of KPMG Peat Marwick's risk strategy, and former FASB fellow. "Whereas structured instruments are appropriate for certain risk management situations," he says, "an institution should not feel compelled to choose an instrument based on an accounting bias rather than economics."

3. Leveraged transactions/structured notes. It comes as no surprise that leveraged derivatives got a big-time snub by the board. In fact, FASB went further than denying the use of these as hedge instruments. It broadened the concept to include structured notes and other non-derivative transactions with option-like embedded features. FASB defined those as debt issues that are linked to an underlying index "in a manner that multiplies or otherwise exacerbates the effect of changes in that index."

Examples include:

1. A debt instrument with a stated coupon that under slated condition multiplies changes in LIBOR by an amount greater than the face value of the contract.

2. A debt instrument with an amount payable at maturity that is determined by the difference between two reference exchange rates multiplied by the face value of the note, and a multiplication factor greater than one.

3. A debt instrument with a stated coupon that varies depending on the number of days the designated index falls within an established range.

Callable debt is not included in this prohibition since it does not involve any multiplication or exacerbation. Neither are step-up notes, since the step-up coupon is predetermined from the start and does not involve multiplication. But certain accrual and index-linked structures with embedded options certainly do. In the future, investors interested in buying a particular exposure profile may have to buy the options themselves instead of being served up a ready-made product by an issuer.

BOOSTED:

1. Option combos (for example, range forwards). Perhaps the best news coming out of the proposed standard is the green light for use of option combinations. In the past, hedgers seeking to reduce their all-in cost for protecting anticipated risks were prohibited from using option combinations. Under the proposed rules, written options are eligible for hedge accounting as long as they don't result in net premium paid, and combinations of puts and calls can now be used to hedge current and anticipated exposures. "There's a perception that written options are out, but that is not the case," says Emcor's Marshall. The Board was very precise in its definition: a written option is only one that results in net debit.

The rebirth of complex options strategies is music to the ears of corporates and dealers. Previously, "it was very unclear to people whether option combinations were acceptable," says Marshall. Option desks are likely to be in hot demand now that the accounting treatment is crystal clear.

The only caveat here is that there's a chance inventive derivatives pros will structure new option combos that fit FASB's bill-net premium paid-at the expense of the fair value of the various individual components. Dealers can potentially tweak implied volatility measures, for example, to come up with the right numbers. In such a case, the onus would be on end-users to value each building block separately, at market rates, to gauge whether they are getting the fair price for their combination structure.

2. OTC/tailored forwards. Forwards, in particular currency forwards, are likely to get a double shot in the arm. First, as short-dated futures lose their appeal, they will likely be replaced with forwards that allow end-users to match duration of hedge and exposure more precisely. A four-month forward will get more favorable treatment than a three-month future, if the underlying exposure dictates such maturity. Also, corporates can now hedge anticipated risk with forwards. Before, this practice was a no-no under FAS No. 52. "There will be more use of short-dated forwards," predicts Bob Herz, national director of accounting and SEC services at Coopers & Lybrand, and member of FASB's emerging issues task force.

Regardless of which instrument end-users choose, they will certainly have to update their valuation systems to meet the new standard's requirements for fair value disclosure and accounting. Previously end-users could value the hedge once a year (for disclosure purposes) at historical cost. Now all derivatives must be marked to market and their fair value presented. "That's a dramatic change," says Price Waterhouse's Sullivan. "And it creates the practical issue of implementing new systems, since most are currently cost based."

The impact of new systems requirement varies. For software vendors it's a dream come true. Companies will be clamoring for more sophisticated programs-and will have to bear the administrative and financial cost of replacing existing models. Banks, already in possession of adequate in-house systems, may find a new fee-generating business in "lending" their pricing expertise to clients.

At least initially, banks will have to provide additional pricing services to their corporate customers. For example, they may have to value their options and forwards portfolio every three months to help comply with the standard. Ultimately, users will have to purchase their own and develop the financial acumen necessary for accurately pricing each instrument.

Gray horizon

All immediate conclusions about the ultimate impact of FASB's proposed derivatives accounting standard are premature. "It's a little hard to predict what the results would be until you have the final rule," says KPMG's Erickson. The comment period for the draft, which was issued June 20, extends till October 11. If approved, the standard would become effective for fiscal years beginning after December 15, 1997.

Not everybody believes the new proposal spells disaster for the exchanges. Jeff Wallace, a treasury consultant based in Greenwich, Connecticut, believes the increased focus on hedging, combined with the use of combination options and more upscale valuation systems, will eventually boost the exchange's direct hedging business. "The increased sophistication of users, particularly for P&L hedging, is going to convince many that going to the exchanges makes a lot of economic sense," he says. Wallace sees end-users bidding out different components of complex structures, and eventually using offsetting puts and calls on the exchange to create range forwards without credit and liquidity concerns. "Obviously the Merc will not see immediate surges, but over time, end-users will have to give more serious thought to the supposed advantages of OTC products," he says.

Dealers, meanwhile, will simply devise new structures that benefit from the increased flexibility, particularly on the option side of the market. "My position," says Jean-Marie Barreau, senior vice president in charge of equity derivatives sales at Société Générale, "is that I am neutral." The list of pros and cons is long and whether one side outweighs the other is a matter of perception. "Ultimately, the draft will create new opportunities to create even better products," says one dealer. "We'll all have just to be more creative."

The proposed changes in swap accounting affect every swap user. But financial institutions-by far the largest users of swaps-are likely to bear the brunt of the change. "The bankers are very upset," concedes Coopers & Lybrand's Herz.

Their concerns are not entirely unwarranted. The way the new accounting for swaps works, all swaps will be on balance sheet and marked to market to reflect changes in their value. While dealers have been marking their books for market for some time, some have maintained separate accounts for hedging purposes. Now those too will hit the P&L.

Pulling the leverage

The way the new swap accounting works, any mismatch between the hedge instrument and the underlying risk will be funneled to either current earnings, for fair value hedges, or comprehensive income-essentially equity-for cash flow hedges. Such a mismatch can be the result of basis risk, or even a change in the credit quality of the counterparty. Either way, the result is potential volatility in the income statement.

"Unlike corporates-which can have a 2:1 leverage or less-most banks are highly leveraged," says Sullivan of Price Waterhouse. Hence changes in their equity account may prove disastrous. They may even spark "retaliatory" action by bank regulators such as demands for higher capital reserves.

But Deloitte & Touche's Mountain cautions that the impact of these new changes may be overblown. "Large banks have been keeping the bulk of their swaps on balance sheet and marked to market for some time now," he says. "Many financial institutions are already-as dealers-marking their swap books to market." However, Sullivan disagrees. "Banks have hedge portfolios and trading portfolios of swaps," he says. "And they account for those separately."

One possible outcome is a greater inclination to use Eurodollar strips as hedges, now that both swaps and futures strips will be marked to market. In the past many users preferred swaps. However, futures strips, says Edward Rombach, derivatives specialist at Technical Data in Boston, "work just as well, offer no liquidity or credit concerns, and often, depending on the convexity bias inherent in the swap rate/Eurodollar strip return profile, make more economic sense."

There are two key elements in the proposal that represent a departure from the "old-style" deferral accounting standard for hedgers:

1. All derivatives will be measured at their fair (liquidation) market value.

2. All derivatives and their impact will be reflected in the financial statement.

The draft generally breaks hedging into two categories:

• Fair value hedges-hedges of existing assets/liability and firm commitments; and
• Cash flow hedges-hedges of anticipated transactions and net investment in subs.

While both groups will now be on balance sheet and disclosed at fair market value, there's a difference in their accounting treatment. Fair value hedges will be marked to market and worked through current earnings, whereas gains and losses on cash flow hedges will essentially be deferred into a new part of the equity account called comprehensive income. The latter is a whole new concept introduced in a separate exposure draft.

Under the new rules, comprehensive income is defined as the change in equity of a business entity during a period due to transactions and other events and circumstances from non-owner sources. This means all changes except those resulting from investment by owners and distribution to owners. Though not unlike the old "equity," the new comprehensive income statement provides for a very detailed breakdown of unrealized gains and losses. It will render transparent hedging instruments and exposures, and changes in value that some experts consider "paper" gains and losses.

Reading the new statements

If hedge instrument and underlying exposure are perfectly matched, the new standard is unlikely to cause any increase in actual earnings volatility. However, when the two move out of tandem, problems ensue. In the past, hedge accounting allowed end-users to defer the unrealized gains and losses. In the future, the discrepancies on fair value hedges will hit the P&L instantly, and discrepancies on cash flow hedges will show up as swings in comprehensive income (or equity). Hence the market's concern.

To a great degree, the impact on hedging activity will be determined by the way stock market analysts decide to interpret the new "comprehensive income" portion of the financial statement. "The potential earnings volatility could potentially mislead users of financial statements," worries Deutschebank's Goodrich.

He is not alone. Adds Deloitte & Touche's Mountain, "There is certainly a possibility that readers of financial statements will migrate from their focus on current earnings to comprehensive income, which includes various interim measures (for example, unrealized gains and losses) that will fluctuate with the market."

Seeking: analyst education

At this point very few Wall Street analysts are even aware that comprehensive income is in the works. "I talked to a number of analysts, some of whom hadn't even heard of the exposure drafts," reveals a concerned Leysen of CSFP. "Without some further education, it will be very difficult for analysts to interpret the new earnings statements."

"Investment banks are yet to begin the process of education," says Lang Gibson, a consultant at Farrell Capital Management in Greenwich, Connecticut, "and there's a danger here. If analysts are educated with a misconception of accounting versus economic value, they may really lead investors astray."

By Heike Wipperfurth

On July 16 NationsBank held a telephone conference call allowing clients to ask some experts about the implications of FASB's exposure draft on accounting for derivatives.

On the call were NationsBank vice president and risk management advisor Dave Napolo and senior vice president Bonnie Masterman, as well as partner Bob Sullivan and senior manager Lee Dixon of Price Waterhouse.

One client asked how to report transactions that take place between member firms of a consolidated group. Specifically, his U.S. company sells a product to a Japanese company which sells the product to a third party and remits the net yen revenues back to the U.S. company. The experts assured him that under the new rules, his company can place forward contracts to hedge its open sale to its customer-as long as the functional currency is U.S. dollars.

But suppose a U.S. company has an English subsidiary that manufactures a product and sells it to another subsidiary in France. Qu'est-ce qui se passe-what happens? For one thing, the French subsidiary can hedge the sale to its customers because its functional currency is the French franc. In addition, the English subsidiary is allowed to hedge its intercompany sales to the French subsidiary as long as its sale is Sterling dominated. Confusing? "Essentially, FASB granted hedge accounting for intercompany transactions when the company that sells the product or purchases the product from a third party has economic risk," complained one expert. But, added the expert, FASB also took some privileges away. Under the new rules, companies are no longer allowed to hedge their subsidiaries' forecasts of dividends or royalty allocations.

Another corporate asked whether a company that has bought contracts anticipating, say, a sale taking place in a year, has to change its cash flow hedging to fair value hedging once the company has moved to a firm commitment. The answer: yes. At that point the firm has to record the item in the new category of "comprehensive income," which will reflect if there are any changes taking place in the value of the firm commitment.

What about a company with a subsidiary that borrows its debt and then swaps yen-denominated debt into Australian dollars? The answer is that it can use hedge accounting if it swaps the interest and the currency simultaneously, or if it conducts the currency swap first and the interest swap later-and vice versa.

Another manager wanted to know whether a firm has to report a derivative that has moved against the firm and has become a liability. According to the experts the answer is yes. They gave an example: a company's $10 million debt increases to $10.5 million. The company buys a swap for the $500,000. Under the new rules it has to report an asset of $500,000 and a debt of $10.5 million.

What about a firm that makes a commitment to buy a machine? Where does it record the decrease or increase in its obligation? The answer: if a firm buys a machine for $100 in deutsche marks and enters into a forward contract, and that contract increases to $105 because of a change in the exchange rate, it has to record a liability for that contract and a $5 asset for the forward contract.

One treasurer wanted to know whether his firm will be able to continue its practice of aggregating its exposure to FX and outstanding debt in a pooled approach and offsetting that risk with a hedge pool. According to the experts, under hedge accounting only what is considered an "item" can be hedged. However, FASB allows a company to hedge items that it calls "similar," meaning that they might share such likenesses as expected payoff levels. What does FASB have in mind? According to the experts, whether those payoffs take place within a month, a quarter or six months is left to the imagination. "But," said the experts, "people may be in a 'within-a-month' kind of activity and maybe 'within-a-quarter' for some transactions."