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Accounting for Interest Rate Derivatives November 2014

Wilary Winn Risk Management LLC – All rights reserved

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WW Risk Management notes that hedge accounting is elective and is specific. FAS ASC 815 is intended to prevent achieving hedge accounting results when using macro-hedges. Hedge Documentation Hedge accounting requires formal designation and documentation at inception. Thus, before a credit union enters into a derivatives transaction it must detail its objective and strategy for the hedge, including the1:

Hedging instrument to be used - the derivative (interest rate swap, interest rate floor, etc.)

Hedged item or transaction - the financial asset or liability being hedged

Nature of the risk being hedged - interest rate risk

Method that will be used to retrospectively and prospectively measure the hedge's effectiveness

Method that will be used to measure hedge ineffectiveness

Benchmark interest rate being hedged WW Risk Management notes that eligible benchmark interest rates under FAS ASC 815 include only2:

United States Treasury rates

Federal Funds effective swap rate

LIBOR

Hedging Instrument The NCUA rules authorize credit unions to use the following derivatives only:

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

1 FAS ASC 815‐20‐25‐3b 2 2 FAS ASC 815‐20‐25‐6A



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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

For GAAP, a derivative instrument is defined as a financial instrument or other contract with all of the following characteristics:3

Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:

o One or more underlyings o One or more notional amounts or payment provisions, or both.

Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.

Net settlement. The contract can be settled net by any of the following means: o Its terms implicitly or explicitly require or permit net settlement. o It can readily be settled net by a means outside the contract. o It provides for delivery of an asset that puts the recipient in a position not substantially

different from net settlement. WW Risk Management believes all of the derivatives permitted by the NCUA meet the definition of a derivative under GAAP.

NCUA Derivatives Limits Once an eligible federal credit union thoroughly understands the risks it wants to hedge, the hedge instruments it plans to use, and the accounting implications related to hedge accounting, it can seek approval from the NCUA to undertake a derivatives program. A credit union's approval request must include a:

Demonstration on how derivatives function within the credit union’s interest rate risk management mitigation plan

Demonstration on how the credit union will control and manage the derivatives process from a resources and systems perspective

3 FAS ASC 815‐10‐15‐83



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After the NCUA grants derivative authority, a credit union operates for one year under entry limits. Thereafter, standard limits apply. The limits relate to permissible notional amounts and fair value losses. The notional amount limitation takes into account the type of derivative and the time to maturity. The notional amount functions as a prospective limit while the fair value loss limit accounts for the credit union's actual experience. The fair value loss limit is calculated by summing the fair values of the credit union's outstanding derivatives. WW Risk Management notes that while gains on derivative contracts can offset losses on other derivative contracts, the credit union does not include the change in the value of the hedged item(s) in the calculation. The fair value loss limits are 15% of net worth under the entry limits, and 25% of net worth under the standard limits. The Weighted Average Remaining Maturity Notional (WARMN) limits are set at 65% of net worth under the entry limits and 100% of net worth under the standard limits. The calculation is shown below.

WARMN = Adjusted notional *(WARM/10) WW Risk Management notes that the calculation is cumulative and a credit union cannot net offsetting derivatives transactions when making the calculation. Hedged item Under hedge accounting, a credit union must identify the item to be hedged. We believe that the hedged item will generally be an existing financial asset or liability or the variable cash flows on an existing financial asset or liability. Nature of the Risk Being Hedged WW Risk Management believes that the risk being hedged through the use of these derivative instruments is interest rate risk.

ProductStep #1 Gross

NationalAdjust Factor

(Percent) Step #2 Adjusted Notional Step #3 WARMOptions (Caps) Current notional 33 33% of current notional Time remaining to maturityOptions (Floors) Current notional 33 33% of current notional Time remaining to maturitySwaps Current notional 100 100% of current notional Time remaining to maturityFutures Contract size 100 100% of contract size Underlying contract

Sum = Total adjusted notional Sum = Overall WARM



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Hedge Effectiveness We believe determining hedge effectiveness is the by far the most complex part of FAS ASC 815. 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 (if a fair value hedge)

Offsetting cash flows attributable to the hedged risk during the term of the hedge (if a cash flow hedge)

Hedge effectiveness can be measured using a dollar offset approach or statistical methodologies. The dollar-offset method compares the changes in the fair value or cash flow of the hedged item and the derivative. The following table reflects an example of the dollar-offset method which compares the change in fair value of an interest rate swap to a group of investments held AFS.

The dollar-offset method can be applied either period by period (which cannot be less than 3 months) or cumulatively. For a perfect hedge, the change in the value of the derivative exactly offsets the change in the value of the hedged item. Therefore, the ratio of the cumulative sum of the periodic changes in the value of the derivative and the cumulative sum of the periodic changes in the value of the hedged item would equal one in a perfect hedge (after multiplying the ratio by negative one to adjust for the two sums having opposite signs in a hedging relationship). Of course, not all hedges will be perfect. FAS ASC 815 does not specify the precise percentage range that would be considered highly effective under the dollar offset method. In practice, most believe that a dollar offset range of 80% to 125% would be considered to be highly effective. For example, assume the fair value of the asset being hedged declines by $100,000. To be considered highly effective, the fair value of the hedge would have to increase by at $80,000 and no more than $125,000. In this case, we can see the benefit of measuring the changes on a cumulative basis, because while the hedge results are outside the 80% to 125% limits in months 2 and 4, the hedge is within the limits when measured for all time periods.

Electing to utilize a regression or other statistical analysis approach instead of a dollar-offset approach to perform the assessment of hedge effectiveness may permit a credit union to apply hedge accounting for the current period, even though from a dollar-offset approach the hedge appears to be ineffective. To the extent the analysis shows the hedging relationship will be highly effective in offsetting changes in fair

Market Rate Net Swap Change in Change inChange From Swap Fair Swap Investments Dollar Effective

Month Inception Payment Value Fair Value Fair Value Offset % (y / n)Mo. 0 0 bps 0

Mo. 1 -10 bps (68,950) (166,293) (166,293) 140,579 118.3% yes

Mo. 2 -15 bps (71,327) (214,920) (48,627) 65,425 74.3% no

Mo. 3 -25 bps (73,705) (371,804) (156,884) 150,257 104.4% yes

Mo. 4 -20 bps (71,488) (181,349) 190,455 (140,757) 135.3% no

Mo. 5 +5 bps (62,835) 437,189 618,538 (625,865) 98.8% yes

Total (348,305) 437,189 (410,361) 106.5% yes



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value or cash flows in future periods, the credit union can continue to apply hedge accounting even though the hedging relationship was ineffective for the reporting period being evaluated. WW Risk Management notes that the statistical approaches can be complex to implement and require multiple observation periods. In our experience, the regression analysis must include the following elements:

It must have a minimum of 30 observations

The credit union must examine the relationship between the changes in the value of the hedged item and the derivative

It must have a time horizon that coincides with, or is less than, the time horizon of the hedge relationship

The credit union must consider whether the data should be regressed on value changes or value levels in order to avoid distortion

The credit union must review the distribution of the error terms and consider autocorrelation

The regression produces an R-squared that exceeds a pre-specified level such as 0.80

The hedge ratio of the hedging relationship must correspond to beta (the slope of the regression line)

The standard error of the estimate is used to calculate reliability using the t-statistic

The t-test is passed for the regression coefficient at a 95% confidence level

The y-intercept is considered as part of the analysis

The regression results are related to the actual hedge and compared to the dollar offset results As an example, an R-squared analysis can be performed by examining actual dividend or deposits rates and a benchmark interest rate such as 1-month LIBOR.

In this example, the R-squared result was .82. Since the R-squared result exceeds the predetermined .80 threshold for determining effectiveness, the hedge is considered to be effective.

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WW Risk Management notes that the simpler dollar-offset method can be used when the potential changes in the fair value of the derivative would be less material (e.g. relatively small notional amount and/or relatively short term). Conversely, a credit union could benefit by undertaking the more complex statistical method when the changes in the dollar amount of the derivative could be material. A credit union shall consider hedge effectiveness in two different ways—in prospective considerations (expectation it will be effective) and in retrospective evaluations (was it effective): Prospective considerations. The credit union's expectation "that the relationship will be highly effective over future periods in achieving offsetting changes in fair value or cash flows, which is forward-looking, 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. The standard requires that the prospective assessment of hedge effectiveness 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. The prospective assessment shall not be limited only to the likely or expected 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 or the hedged items. Generally, the process of formulating an expectation regarding the effectiveness of a proposed hedging relationship involves a probability-weighted analysis of the 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 hedge period. Therefore, a probable future change in fair value will be more heavily weighted than a reasonably possible future change. That calculation technique is consistent with the definition of the term expected cash flow in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements."4 Retrospective evaluations. "An assessment of effectiveness shall be performed whenever financial statements or earnings are reported, and at least every three months. The credit union must determine if the hedging relationship has been highly effective in having achieved offsetting changes in fair value or cash flows. The assessment can be made using a statistical or dollar-offset approach. If a credit union intends to use the dollar-offset approach to perform retrospective evaluations, it may choose either a period-by-period approach or a cumulative approach in designating how effectiveness of a fair value hedge or of a cash flow hedge will be assessed, depending on the nature of the hedge."5 If the hedge accounting is not or no longer deemed to be effective then the hedge accounting must be discontinued prospectively. For more details, see what if the hedge is no longer effective paragraphs in the discussion of fair value and cash flow hedges.

4 FAS ASC 815‐20‐25‐79 a 5 FAS ASC 815‐20‐25‐79 b



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Hedge Ineffectiveness for Income Statement Purposes Hedge ineffectiveness for income statement purposes is measured by the dollar-offset method. For fair value hedges, hedge ineffectiveness flows through the income statement based on any difference between the change in the value of the derivative and the change in the value of the hedged item. In a cash flow hedge, ineffectiveness must be separately measured and recorded on the income statement.6 WW Risk Management notes that if the change in the fair value of the derivative exceeds the present value of the hedged cash flows, the difference is accounted for as ineffectiveness and recorded in the income statement. Conversely, if the present value of the cash flows exceeds the change in the fair value of the derivative, no ineffectiveness is assumed to have occurred.7 Short-Cut Method for Interest Rate Swaps WW Risk Management notes that entities can assume no ineffectiveness an interest rate swap in two instances. First, a private company that enters into a pay fixed, receive floating interest rate swap can assume no ineffectiveness. This exemption from hedge accounting does not apply to financial institutions. Second, all companies, including financial institutions, can examine a swap to determine if it can be accounted for under the Short-Cut Method. In order to conclude no hedge ineffectiveness in a hedge with an interest rate swap, the swap must meet all of the following conditions8:

Notional amount of swap matches principal amount of item being hedged

Fair value of the swap is zero at inception (WW Risk Management notes that for purposes of determining zero a credit union can ignore bid/ask spread at inception, commissions and other transaction costs)

Formula for computing net settlements remains the same throughout the swap - specifically o Fixed rate remains the same o Variable rate index does not change

Interest bearing asset or liability is not pre-payable o Unless the prepayment is due to an embedded call (put) option and the swap has a mirror

option call (put) option - options must match exactly

Index on which the variable rate leg is based matches the benchmark interest rate designated as the interest rate risk being hedged

WW Risk Management believes that in many cases credit unions will not be able to use the short-cut method. For example, we do not believe a credit union can use the short-cut method when hedging its loan portfolio, because the borrower can prepay (call) the loans at any time without incurring a penalty, and the NCUA permitted swaps do not allow for a mirroring put feature. Moreover, many investments can be prepaid without penalty and would thus also not qualify for short-cut treatment. If a credit union loses its short-cut treatment, it loses hedge accounting. Therefore, even in situations when it can be used, we do not recommend it. We believe it is better to account for swaps under the long-haul method recognizing that swaps that would qualify for the short-cut method should easily pass the effectiveness testing - referred to in the industry as "easy pass". 6 FAS ASC 815‐20‐35‐1b 7 FAS ASC 815‐20‐35‐1c 8 FAS ASC 815‐20‐25‐104



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Given the recent rule changes for private companies, we believe one potential strategy for credit unions could be to offer floating rate loans to its member business loan customers and then refer those which want a fixed rate of interest to a swap provider. The borrower can enter into a pay fixed, receive floating interest rate swap. The advantages for the borrower are that it can assume no ineffectiveness under the private company rules and thus avoid effectiveness testing and it can pay a fixed rate of interest on its borrowing. The advantage for the credit union is that it can effectively provide a loan with a fixed rate of interest and avoid the intricacies of hedge accounting, having referred the swap transaction to a third party. Critical Terms Match A credit union can also assume no hedge ineffectiveness if the critical items of the hedging instrument and of the entire hedged asset or liability, or hedged forecasted transaction are the same. WW Risk Management notes that this assumption is more commonly made for cash flow hedges and is very rarely made for fair value hedges. Critical terms include the notional amount, the underlying, maturity date, etc. In addition, the change in the expected cash flows for hedged item and the hedging instrument are based on the same interest rate. WW Risk Management recommends that credit unions forgo the use of this technique because if the terms changed for some reason during the life of the derivative contract, a credit union would prospectively lose hedge accounting. We recommend instead the long-haul method again assuming “easy-pass”. Fair Value Hedges A credit union may designate a derivative instrument as hedging the exposure to changes in the fair value of an asset or a liability or an identified portion thereof (hedged item) that is attributable to a particular risk if all applicable criteria below 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

The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or a portfolio of similar liabilities (or a specific portion thereof). In this circumstance, 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 items is one of the following: o A percentage of the entire asset or liability o 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)

o 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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The hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings

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:

o The risk of changes in the overall fair value of the entire hedged item o The risk of changes in its fair value attributable to changes in the designated benchmark

interest rate (referred to as interest rate risk) o 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 hedge9. The similar asset or liability criteria has given pause to many considering a fair value hedge. The guidance provides more detail on similarity and whether the individual assets or individual liabilities within a portfolio in a fair value hedge shall share the risk exposure for which they are designated as being hedged. "If the change in fair value of a hedged portfolio attributable to the hedged risk was 10 percent during a reporting period, the change in the fair values attributable to the hedged risk for each item constituting the portfolio should be expected to be within a fairly narrow range, such as 9 percent to 11 percent. In contrast, an expectation that the change in fair value attributable to the hedged risk for individual items in the portfolio would range from 7 percent to 13 percent would be inconsistent with the requirement in that paragraph."10 We note that in aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate11:

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.

9 FAS ASC 815‐20‐25‐12 slightly abridged 10 FAS ASC 815‐20‐55‐14 11 FAS ASC 815‐20‐55‐15



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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 adjustments to the hedged item. The existing fair value adjustments related to fixed rate financial instruments are recognized prospectively using the effective interest rate method when hedge accounting is discontinued.12 Other Items to Consider WW Risk Management notes that credit unions considering a fair value hedge should also be aware of several other items:

A fair value hedge cannot be used to hedge interest rate risk on held-to-maturity securities.13

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 instead of 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).

WW Risk Management further notes that the non-performance risk of the counterparties must be taken into account when determining the fair value of the derivative. This is done using credit valuation adjustments (“CVAs”). We note that the CVAs can swing from party to party for derivatives such as interest rate swaps as each party “comes into or goes out of the money”. We show examples of this calculation in Appendix A. In Appendix B, we give an example of a fair value hedge technique - the "portfolio method" in which a portfolio of similar fixed rate single family loans is hedged with a pay fixed, receive floating interest rate swap. Elect Fair Value Fair value hedge accounting is obviously restrictive and complex. It requires that hedged items be similar and the long-haul method involves detailed analysis and documentation. To avoid these limitations and complications, a credit union could simply elect to account for the financial instrument at fair value. For example, it could elect to account for a portion of its fixed rate loans at fair value and enter into a pay fixed, receive floating interest rate swap. If market interest rates increase, the value of the loans would decrease as the value of the interest swap increased. This alternative avoids all of the complications of hedge accounting. That said, we urge credit unions contemplating this option to consider the following disadvantages:

The hedge accounting election can be terminated at any time while the fair value election is irrevocable.

12 FAS ASC 815‐25‐35‐9 13 FAS ASC 815‐20‐25‐43 c2



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Nearly all of the change in the value of interest rate swap over time will be due to changes in market interest rates (provided the counterparty remains financially strong), while the fair value of the loans will be affected by changes in interest rate and credit conditions. Thus, the fair value of a loan could decrease if the borrower's FICO drops even if market interest rates remain the same. A fair value hedge by way of contrast can be limited to the change in the benchmark interest rate only.

The credit union will need to develop systems to estimate the fair value of the loans over their entire lives.

We note that the change in fair value due to changes in credit risk can be minimized by selecting borrowers with excellent credit and low loan-to-value ratios. WW Risk Management can help with accounting if a credit union opts to value select financial instruments at fair value as we have already developed robust fair value models in connection with our fair value line of business. We provide an example of electing fair value in Appendix C. Cash Flow Hedges The final alternative for managing income statement volatility is a cash flow hedge. A credit union 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 liabilities)

A forecasted transaction (such as a forecasted purchase or sale). A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following additional criteria are met14:

The forecasted transaction is specifically identified as either of the following: o A single transaction o 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

The occurrence of the forecasted transaction is probable The forecasted transaction meets both of the following conditions:

o It is a transaction with a party external to the reporting entity o It presents an exposure to variations in cash flows for the hedged risk that could affect

reported earnings

14 FAS ASC 815‐20‐25‐15 slightly abridged



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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

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

If the hedged transaction is the forecasted purchase or sale of a financial asset or liability (or the interest payments on that financial asset or liability) or the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is any of the following:

o 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

o The risk of changes in its cash flows attributable to changes in the designated benchmark interest rate (referred to as interest rate risk)

o 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.

In addition for cash flow hedges, a credit union must provide the following information about forecasted transactions:

Date on which transaction will occur

Specific nature of asset or liability

Quantity of the forecasted transaction

WW Risk Management notes that the prohibition against using the cash flows arising from an asset or liability that is measured at fair value as the hedged item would, for example, preclude a credit union from designating the cash flows on securities that are held for trading as the hedged item because the change in their fair values runs through the income statement. On the other hand, a credit union could designate cash flows on available for sale securities as the hedged item because the change in fair value runs through other comprehensive income and not through the income statement. We further note that effectiveness testing for interest rate swaps can be done using one of three methods:

1. Change in variable cash flows method15 2. Hypothetical derivatives method16 3. Change in fair value method17

15 FAS ASC 815‐30‐35‐16 through 24 16 FAS ASC 815‐30‐35‐25 through 30 17 FAS ASC 815‐30‐35‐31 through 32



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Non-performance Risk for Cash Flow Hedges Using Interest Rate Swaps WW Risk Management notes that 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 (815-30-35-20). 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. The only potential issue here is a default of counterparty becomes “probable”. However, non-performance risk can result in effectiveness using the change in fair value method (815-30-35-17). 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 adjustments to the hedged item. The existing balance remains in OCI until the end of the hedge period 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).18 In Appendix D, we give four examples of cash flow hedge techniques all related to interest rate swaps:

1. Rollover of FHLB advances – hypothetical derivatives method 2. Rollover of share CDs – change in variable cash flows method 3. Rollover of share CDs – change in fair value method 4. Money market advances – change in variable cash flows method

Conclusion WW Risk Management believes the use of derivatives can be a very effective way to manage the risk of rising interest rates in today's environment. WW Risk Management can be of service in the following ways. We can:

Work with you to 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 meet all of the NCUA requirements regarding the use of derivatives.

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.

For those electing hedge accounting, we can: o Develop the appropriate interest rate hedge and hedging item(s) to be used given your

credit union's ALM profile. o Work with you to identify the item(s) to be hedged and the nature of the risk being

hedged 18 FAS ASC 815‐30‐40‐4



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o Ensure you are able to achieve hedge accounting - including prospective and retrospective effectiveness testing on a dollar offset or statistical basis



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Appendix A – Calculating the Fair Value of the Derivative In our first example, we are assuming that a credit union has entered into a pay fixed, receive floating swap with a notional amount of $50 million and a 3-year term. The present value of the swap at inception is zero.

WW Risk Management notes that the non-performance risk of the counterparties must be taken into account when determining the fair value of the derivative. This is done using credit valuation adjustments (“CVAs”). We note that the CVAs can swing from party to party for derivatives such as interest rate swaps as each party “comes into or goes out of the money”. In our simplified example, we assume that the credit union counterparty is more creditworthy than the credit union. The CVA for the credit union is thus 2% compared to the 1% for the swap counterparty. The fair value of the swap at inception including the non-performance risk $18,951.

Pay Receive Net Present

Quarter Days Fixed Floating Payments Value1 90 (153,706) 29,311 (124,395) (124,318)

2 91 (155,414) 32,702 (122,713) (122,556)

3 89 (151,998) 46,322 (105,676) (105,442)

4 90 (153,706) 72,157 (81,549) (81,248)

5 90 (153,706) 101,353 (52,353) (52,053)

6 90 (153,706) 131,620 (22,086) (21,901)

7 90 (153,706) 162,603 8,896 8,793

8 90 (153,706) 195,117 41,411 40,766

9 90 (153,706) 227,693 73,987 72,500

10 90 (153,706) 261,209 107,503 104,796

11 90 (153,706) 287,054 133,347 129,231

12 90 (153,706) 310,982 157,276 151,433

Total (1,844,475) 1,858,124 13,649 -

Pay Discount Discounted Receive Discount Discounted Fair Value

Quarter Days Fixed w/ 2% CVA Pay Fixed Leg Floating w/ 1% CVA Rcv Float Leg with CVA1 90 (153,706) 0.9944 (152,852) 29,311 0.9969 29,221 (123,631)

2 91 (155,414) 0.9888 (153,673) 32,702 0.9938 32,498 (121,176)

3 89 (151,998) 0.9830 (149,419) 46,322 0.9904 45,877 (103,541)

4 90 (153,706) 0.9767 (150,130) 72,157 0.9865 71,184 (78,947)

5 90 (153,706) 0.9699 (149,083) 101,353 0.9821 99,535 (49,548)

6 90 (153,706) 0.9626 (147,953) 131,620 0.9770 128,599 (19,354)

7 90 (153,706) 0.9547 (146,742) 162,603 0.9715 157,961 11,219

8 90 (153,706) 0.9463 (145,448) 195,117 0.9653 188,342 42,895

9 90 (153,706) 0.9373 (144,071) 227,693 0.9585 218,247 74,176

10 90 (153,706) 0.9278 (142,613) 261,209 0.9512 248,454 105,841

11 90 (153,706) 0.9180 (141,098) 287,054 0.9434 270,805 129,707

12 90 (153,706) 0.9078 (139,532) 310,982 0.9352 290,843 151,311

Total (1,844,475) (1,762,615) 1,858,124 1,781,566 18,951



17

We note that the non-performance risk adjustments discussed above do not mean the swap is ineligible under the NCUA rules. The rule is based on the value of the swap at inception without the non-performance risk adjustments. We further note that the fair value of the swap changes as interest rates move and with the passage of time.

Appendix B - Example of Fair Value Hedge Portfolio Method Our example is the use of the portfolio method in which 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. The precise details can be found in ASC 815-20-25-174 through 178. We believe it is particularly relevant for credit unions, because the swap in the example matches a swap contract eligible under the new rules. We note that the key here is that the credit union will de-designate portions of the swap if loans prepay a rate faster than envisioned at the time the credit union entered into the swap transaction. In the example, we assume the following:

Hedging item used - pay fixed receive floating interest rate amortizing swap with a notional amount of $50 million and fair value of zero at inception

Hedged item – a $50 million 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 In this case, we are assuming that the stated maturity of the interest rate swap is consistent with the stated maturities of the loans. The notional amount of the interest rate swap amortizes based on a schedule that is expected to approximate the principal repayments of the loans (excluding prepayments). There is no optionality included in the interest rate swap. 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:

a. Assess effectiveness of the existing hedging relationship for the past three-month period

Time -100 Base 100 200 300Inception (1,494,219) - 1,445,935 2,845,187 4,199,400

1 Year Out (758,735) 353,620 1,443,606 2,511,784 3,558,698

2 Years Out (111,723) 506,549 1,118,512 1,724,262 2,323,891



18

b. 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.

The credit union's portfolio of loans satisfies the requirements of paragraph FAS ASC 815-20-25-12(b)(1) regarding the grouping of similar assets, because the portfolio of loans has been defined in a restrictive manner and the credit union determined, by calculation, that each of the loans contained in the portfolio is expected to react in a generally proportionate manner to changes in the benchmark interest rate. Even though a certain portion of the loans may prepay, each loan still may be considered to have the same exposure to prepayment risk because each loan has a similar prepayment option. When aggregating loans in a portfolio, an entity is permitted to consider, among other things, prepayment history of the loans (if seasoned) and expected prepayment performance in varying interest rate scenarios. The credit union's documented hedging strategy meets the requirements of paragraph 815-20-25-75 for a prospective assessment of effectiveness provided the entity established that the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated. Paragraph 815-20-25-79(a) explains that a probable future change in fair value will be more heavily weighted than a reasonably possible future change. For example, the credit union could assign a probability weighting to each possible future change in value of the hedged portfolio. Depending on the level of market interest rates and the expected prepayment rates for the types of loans in the hedged portfolio, the credit union may reach a conclusion that the change in fair value of the swap will be highly effective at offsetting the change in the value of the portfolio of loans, inclusive of the prepayment option. As a result of this analysis, management would conclude that hedge accounting is permitted for the hedging relationship for the next three-month period; however, any ineffectiveness related to the current period must be reflected currently in earnings. That is, management is required to assess the effectiveness of the existing hedging relationship for the past three-month period. The amount of ineffectiveness related to the current period will be the difference between the change in fair value of the swap (which could have a notional amount different than the hedged portfolio due to curtailments and prepayments) and the change in fair value of the existing hedged portfolio. If necessary, the notional amount of the swap in excess of the portfolio balance at the end of each three-month period must be de-designated and a new hedging relationship designated (with a smaller percentage of the swap as the hedging instrument) going forward to allow high effectiveness to continue in the future. WW Risk Management notes that the de-designation process might have to be very dynamic if loans are continually prepaying and portions of the hedge may have to be de-designated multiple times throughout the quarter. Following is an example.



19

In this case, the hedge has been effective for the first 3 months. The credit union will de-designate $755,834 of the hedge for the next three months as it undertakes it prospective effectiveness testing. Changes in the fair value of the de-designated portion will therefore not have an offset in the income statement going forward. We note that for purpose of simplifying our example, we have ignored non-performance risk. The journal entries used to record the transaction are as follows:

Appendix C - Elect Fair Value In this example, we have assumed that a credit union has elected to forgo the rigors of hedge accounting and has instead elected to account for a portion of its fixed rate loan portfolio at fair value in order to offset the changes in the fair value of a derivative. The table below shoes the estimated fair values of the loans by FICO score and estimated loan-to-value.

Amortizing Market Rate Net Swap Change in 15 Year Change in De-designationHedge Change From Swap Fair Swap Loan Pool Loan Portfolio Dollar Effective Notional

Month Notional Amt Inception Payment Value Fair Value Unpaid Bal. Value Offset % (y / n) AmountMo. 0 50,000,000 0 bps 0 50,000,000 Mo. 1 49,796,823 ‐10 bps (104,527) (251,261) (251,261) 49,571,823 257,100 97.7% yesMo. 2 49,592,968 +5bps (97,316) 372,325 623,586 49,017,968 (508,479) 122.6% yesMo. 3 49,388,434 +10 bps (94,853) 639,043 266,718 48,632,600 (301,068) 88.6% yes 755,834

Total (296,696) 639,043 (552,447) 115.7% yes 755,834

Interest expense 104,527

Cash 104,527

Non‐interest income 251,261

Derivative liability 251,261

Residential real estate loans 257,100


Month 1Interest expense 97,316

Cash 97,316

Derivative liabilty 251,261

Derivative asset 372,325




Month 2

Interest expense 94,583

Cash 94,583

Derivative asset 266,718




Month 3



20

In order to minimize the effect of the change in the fair value of the loan portfolio as a result of changes in the credit component, the credit union limits the loans for which it will elect fair value to those above 720. The following table shows the change in fair value resulting from a 2 percent increase in interest rates. It shows that essentially all of the change in fair value in the 780+ portion of the portfolio is due to the increase in rates. Additionally, nearly all of the change in the 720-779 band is due to the increase in interest rates – 9% change compared to the overall decrease of 9.1%.

Appendix D - Examples of Cash Flow Hedges In Appendix C, we give four examples of cash flow hedge techniques all related to interest rate swaps:

1. Rollover of FHLB advances – hypothetical derivatives method 2. Rollover of share CDs – change in variable cash flows method

Fixed Rate Mortgage LTV Principal Avg Avg Discount FairFICO Score Range Range Balance FICO LTV WAC CPR % CRR % CDR % Severity% Rate Value %

780+ under 50% 1,000,000 821 32% 4.6% 11.5% 11.5% 0.0% 0.0% 4.2% 101.4%780+ 50% - 75% 1,000,000 809 60% 4.4% 10.1% 9.5% 0.0% 10.0% 4.3% 100.1%780+ 75% - 100% 1,000,000 780 79% 4.5% 8.8% 6.6% 0.0% 15.0% 4.3% 100.6%780+ 3,000,000 815 42% 4.6% 11.0% 10.7% 0.0% 12.2% 4.2% 100.9%

720 - 779 under 50% 1,000,000 762 25% 4.4% 10.7% 10.7% 0.1% 0.0% 4.2% 100.4%720 - 779 50% - 75% 1,000,000 757 59% 4.5% 11.1% 11.1% 0.1% 10.0% 4.3% 100.9%720 - 779 75% - 100% 1,000,000 747 77% 4.4% 8.7% 8.6% 0.1% 15.0% 4.3% 101.0%720 - 779 3,000,000 756 54% 4.5% 10.6% 10.5% 0.1% 9.1% 4.2% 100.8%

660 - 719 under 50% 1,000,000 687 15% 4.7% 8.6% 8.4% 0.2% 0.0% 4.4% 101.1%660 - 719 50% - 75% 1,000,000 688 60% 4.4% 8.6% 8.4% 0.2% 10.0% 4.6% 98.9%660 - 719 75% - 100% 1,000,000 687 79% 4.2% 6.9% 6.6% 0.3% 15.0% 5.4% 92.5%660 - 719 3,000,000 688 63% 4.4% 7.8% 7.6% 0.3% 12.6% 5.0% 96.2%

620 - 659 under 50% 1,000,000 648 42% 5.0% 8.3% 7.3% 1.0% 0.0% 4.6% 102.2%620 - 659 50% - 75% 1,000,000 630 66% 4.6% 8.5% 7.3% 1.3% 10.0% 4.9% 97.0%620 - 659 75% - 100% 1,000,000 630 78% 4.3% 8.0% 6.0% 2.1% 15.0% 6.3% 86.1%620 - 659 3,000,000 632 67% 4.6% 8.4% 6.9% 1.5% 11.4% 5.2% 94.6%

Change in Base Shock Change in Total ChangeFixed Rate Mortgage LTV Avg Avg Base Shock Fair Discount Discount Fair in Fair FICO Score Range Range FICO LTV CDR % CDR % Value% Rate Rate Value% Value%

780+ under 50% 821 32% 0.0% 0.1% 0.0% 4.2% 6.2% -7.1% -7.1%780+ 50% - 75% 809 60% 0.0% 0.1% 0.0% 4.3% 6.3% -9.6% -9.6%780+ 75% - 100% 780 79% 0.0% 0.1% 0.0% 4.3% 6.3% -11.1% -11.1%780+ 815 42% 0.0% 0.1% 0.0% 4.2% 6.2% -8.0% -8.0%

720 - 779 under 50% 762 25% 0.1% 0.2% 0.0% 4.2% 6.2% -7.5% -7.6%720 - 779 50% - 75% 757 59% 0.1% 0.2% -0.1% 4.3% 6.3% -9.2% -9.2%720 - 779 75% - 100% 747 77% 0.1% 0.2% -0.1% 4.3% 6.3% -10.6% -10.8%720 - 779 756 54% 0.1% 0.2% -0.1% 4.2% 6.2% -9.0% -9.1%

660 - 719 under 50% 687 15% 0.2% 0.4% -0.1% 4.4% 6.4% -5.6% -5.7%660 - 719 50% - 75% 688 60% 0.2% 0.4% -0.2% 4.6% 6.6% -9.6% -9.8%660 - 719 75% - 100% 687 79% 0.3% 0.6% -0.3% 5.4% 7.4% -9.9% -10.2%660 - 719 688 63% 0.3% 0.5% -0.2% 5.0% 7.0% -9.2% -9.5%

620 - 659 under 50% 648 42% 1.0% 2.0% -0.5% 4.6% 6.6% -9.3% -9.9%620 - 659 50% - 75% 630 66% 1.3% 2.5% -1.1% 4.9% 6.9% -9.5% -10.6%620 - 659 75% - 100% 630 78% 2.1% 4.1% -1.6% 6.3% 8.3% -8.9% -10.5%620 - 659 632 67% 1.5% 2.9% -1.2% 5.2% 7.2% -9.3% -10.5%



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3. Rollover of share CDs – change in fair value method 4. Money market advances – first payments and change in variable cash flows method

Rollover of FHLB Advances Our first example of a cash flow hedge is the use of a pay fixed, receive floating interest rate swap to hedge against the risk of increasing interest rates on rollovers of a credit union's Federal Home Loan Bank advances. The technique is based on FAS ASC 815-20-05 paragraphs 5 through 9 which address hedging the risk of increasing interest expense on rollovers of commercial paper. Our example assumes no ineffectiveness under the hypothetical derivatives method of effectiveness testing. We assume the following:

Hedging item used - pay fixed, receive floating interest rate swap with a notional amount of $50 million, a term of 3 years and 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

We further assume that all of the critical terms of the FHLB advance and the swap match as follows:

The notional amount of the swap and FHLB advance match at $50 MM

The fixed rate on the swap is the same throughout the term and the variable rate equals LIBOR

The 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 it is probable that the swap counterparty will not default on its obligations Because the critical terms match, we will use the hypothetical derivative method to test for ineffectiveness. Under this method, hedge ineffectiveness is based on a comparison of the following amounts:

The change in fair value of the actual interest rate swap designated as the hedging instrument

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:

o The same notional amount o The same re-pricing dates o 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) o Mirror image caps and floors o A zero fair value at the inception of the hedging relationship



22

To use the hypothetical derivatives method, the hedge must meet all of the requirements for the short-cut method, except FAS ASC 815-20-25-104 item (e) with regard to prepayments which applies to fair value hedges only. The short-cut method criteria are shown below (FAS ASC 815-20-25-106):

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.

b. 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 2. 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.

d. The re-pricing 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).

e. 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 815-20-25-104[a]) matches the principal amount of the portion of the asset or liability on which the hedged interest payments are based.

f. For a cash flow hedge in which the hedged forecasted transaction is a group of individual transactions (as permitted by paragraph 815-20-25-15[a]), if both of the following criteria are met:

1. Notional amount of swap equals total of individual transactions 2. Remaining short cut criteria are also met

The effectiveness of the swap will be measured by comparing the cumulative change in the fair value of the actual swap with the cumulative change in the fair value of the hypothetical swap. Because the critical terms of the hypothetical swap match the hedged transactions (i.e. the FHLB borrowings) the hedge will be expected to be “highly effective” and perfectly offset the hedged cash flows. The 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 in accordance with FAS ASC 815-30-35-27.



23

If we assume market interest rates increase 50 basis points, the fair value of the swap will be $792,709. At the same time, the fair value of the FHLB advances will have decreased by $792,709 as shown in the table below. We note that the change in fair value also reflects the payments actually made and received during the first quarter.

The summarized results are shown below.

Pay Receive Net Present Pay Receive Net Present

Qtr Days Fixed Floating Payments Value Qtr Days Fixed Floating Payments Value1 90 (153,706) 29,311 (124,395) (124,318) 1 90 153,706 (29,311) 124,395 124,318

2 91 (155,414) 32,702 (122,713) (122,556) 2 91 155,414 (32,702) 122,713 122,556

3 89 (151,998) 46,322 (105,676) (105,442) 3 89 151,998 (46,322) 105,676 105,442

4 90 (153,706) 72,157 (81,549) (81,248) 4 90 153,706 (72,157) 81,549 81,248

5 90 (153,706) 101,353 (52,353) (52,053) 5 90 153,706 (101,353) 52,353 52,053

6 90 (153,706) 131,620 (22,086) (21,901) 6 90 153,706 (131,620) 22,086 21,901

7 90 (153,706) 162,603 8,896 8,793 7 90 153,706 (162,603) (8,896) (8,793)

8 90 (153,706) 195,117 41,411 40,766 8 90 153,706 (195,117) (41,411) (40,766)

9 90 (153,706) 227,693 73,987 72,500 9 90 153,706 (227,693) (73,987) (72,500)

10 90 (153,706) 261,209 107,503 104,796 10 90 153,706 (261,209) (107,503) (104,796)

11 90 (153,706) 287,054 133,347 129,231 11 90 153,706 (287,054) (133,347) (129,231)

12 90 (153,706) 310,982 157,276 151,433 12 90 153,706 (310,982) (157,276) (151,433)

Total (1,844,475) 1,858,124 13,649 - Total 1,844,475 (1,858,124) (13,649) -

Fair Value of the Swap Fair Value of the FHLB Advance (hypothetical derivative)

Pay Discounted Receive Discounted Fair Value

Quarter Days Fixed Pay Fixed Leg Floating Rcv Float Leg with CVA

2 91 (155,414) (155,117) 95,896 95,713 (59,404)

3 89 (151,998) (151,380) 108,128 107,688 (43,692)

4 90 (153,706) (152,670) 134,658 133,750 (18,920)

5 90 (153,706) (152,171) 163,854 162,217 10,046

6 90 (153,706) (151,583) 194,120 191,438 39,855

7 90 (153,706) (150,903) 225,103 220,998 70,094

8 90 (153,706) (150,130) 257,618 251,623 101,493

9 90 (153,706) (149,263) 290,193 281,805 132,541

10 90 (153,706) (148,303) 323,709 312,330 164,027

11 90 (153,706) (147,274) 349,554 334,925 187,651

12 90 (153,706) (146,182) 373,483 355,199 209,017

Total (1,690,769) (1,654,975) 2,516,313 2,447,685 792,709



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The journal entries to reflect the cash flows for the first quarter and the increase in the fair value of the swap at the end of the first quarter are shown below.

WW Risk Management notes that 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.

Fair value of the interest rate swapFixed leg

Gross cash flow (1,690,769) Discounted cash flow (1,654,975)

Variable legGross cash flow 2,516,313 Discounted cash flow 2,447,685

Swap fair value 792,709

Fair value of the FHLB advance (hypothetical derivative)Fixed leg

Gross cash flow 1,690,769 Discounted cash flow 1,654,975

Variable legGross cash flow (2,516,313) Discounted cash flow (2,447,685)

Swap fair value (792,709)

Effectiveness 100%

First Quarter

Interest expense 153,706$

Cash 153,706$

To record fixed payment

Cash 29,311$

Interest expense 29,311$

To record receipt of floating

End of First Quarter ‐ Rates Increase .50%

Derivative Asset 792,709$

Other Comprehensive Income 792,709$

To record change in swap's fair value after Q 1 payment



25

Rollover of Share CDs Our second example of a cash flow hedge is the use of a pay fixed, receive floating interest rate swap to hedge against the risk of interest-related cash flows related to reissuances of a credit union’s share CDs. The technique is based on FAS ASC 815-20-05 paragraphs 5 through 9 which address hedging the risk of increasing interest expense on rollovers of commercial paper. Our example assumes hedge ineffectiveness under the change in variable cash flows method of effectiveness testing. We assume the following:

Hedging item used - pay fixed, receive floating interest rate swap with a notional amount of $50 million, a term of 3 years and a fair value of zero at inception

Hedged item – forecasted quarterly reissuances of fixed rate share certificates (rollovers)

Nature of the risk being hedged - variability in cash flows in the interest element arising from reissuances of the credit union’s share certificates.

We further assume that the:

The notional amount of the swap and share certificates match at $50 MM

The fixed rate on the swap is the same throughout the term and the variable rate equals 3 month LIBOR

No interest payments beyond the term of the swap are designated as hedged

Swap and the CDs re-price on the same day

Determination that it is probable that the swap counterparty will not default on its obligations The credit union must perform effectiveness testing. To be effective, changes in the share 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. However, in this example, we will test using the rate on the CDs. Ineffectiveness will measured using the change in variable cash flows method. The change-in-variable-cash-flows method is described in FAS ASC 815-30-35 paragraphs 16 through 20. “Hedge ineffectiveness is based on a comparison of the following items:

a. The variable leg of the interest rate swap, and b. The hedged variable-rate cash flows on the asset or liability.

The change-in-variable-cash-flows method is consistent with the cash flow hedge objective of effectively offsetting the changes in the hedged cash flows attributable to the hedged risk. The method is based on the premise that only the floating-rate component of the interest rate swap provides the cash flow hedge, and any change in the interest rate swap’s fair value attributable to the fixed-rate leg is not relevant to the variability of the hedged interest payments (receipts) on the floating-rate liability (asset).



26

Under this method, the interest rate swap designated as the hedging instrument would be 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 variable-rate asset or liability.

Because the focus of a cash flow hedge is on whether the hedging relationship achieves offsetting changes in cash flows, if the variability of the hedged cash flows of the variable-rate asset or liability is based solely on changes in a variable-rate index, the present value of the cumulative changes in expected future cash flows on both the variable-rate leg of the interest rate swap and the variable-rate asset or liability shall be calculated using the discount rates applicable to determining the fair value of the interest rate swap.” Hedge ineffectiveness results when the present value of the cumulative cash flows on the swap exceeds the present value of the cumulative cash flows of the designated share certificate accounts. Conversely, there is no ineffectiveness if the present value of the designated share certificate payments exceeds the present value of the swap. 19 At inception, the expected cash flows on the swap are as follows:

At the end of the quarter, we assume that a quarter one payment has been made by each counterparty and that LIBOR has increased by .25%. The fair value of the swap at the end of the quarter is:

19 FAS ASC 815‐30‐35‐3(b)


Quarter Days Fixed Floating Payments Value1 90 (153,706) 29,311 (124,395) (124,318)

2 91 (155,414) 32,702 (122,713) (122,556)

3 89 (151,998) 46,322 (105,676) (105,442)

4 90 (153,706) 72,157 (81,549) (81,248)

5 90 (153,706) 101,353 (52,353) (52,053)

6 90 (153,706) 131,620 (22,086) (21,901)

7 90 (153,706) 162,603 8,896 8,793

8 90 (153,706) 195,117 41,411 40,766

9 90 (153,706) 227,693 73,987 72,500

10 90 (153,706) 261,209 107,503 104,796

11 90 (153,706) 287,054 133,347 129,231

12 90 (153,706) 310,982 157,276 151,433

Total (1,844,475) 1,858,124 13,649 -



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In reaction to the increase in LIBOR, the credit union plans to increase its offering by .23%. The effectiveness testing is done by comparing the change in the cash flows on the variable leg of the swap to the change in cash flows on the to be issued share CDs.

In our example, the hedge has been, and is expected to be, highly effective in offsetting the increase in the interest cost of the share CDs. The ratio of the present value of the variable leg of the swap to the present value of the share cds payments over the term of the swap is 109%. WW Risk Management notes that for this hedge to be effective, the credit union will have to continually change its dividend rate on its share certificates in response to the changes in 90-day LIBOR. The ineffective portion of the hedge is the amount by which the present value of the swap of $337,723 exceeds the change in the expected interest related cash flows on the share CDs of $310,706 or $27,017. The journal entries to reflect the cash flows for the first quarter and the increase in the fair value of the swap at the end of the first quarter are shown below.


Qtr Fixed Floating Payments Value2 (155,414) 64,299 (91,115) (90,998)

3 (151,998) 77,225 (74,774) (74,562)

4 (153,706) 103,408 (50,299) (50,053)

5 (153,706) 132,604 (21,103) (20,944)

6 (153,706) 162,870 9,164 9,065

7 (153,706) 193,853 40,146 39,562

8 (153,706) 226,368 72,661 71,281

9 (153,706) 258,943 105,236 102,705

10 (153,706) 292,459 138,753 134,628

11 (153,706) 318,304 164,598 158,694

12 (153,706) 342,233 188,526 180,529

Total (1,690,769) 2,172,563 481,794 459,906

Fair Value of the Swap

Projected Updated Increase Discount Present Projected Updated Increase Discount Present

at Inception Projection (Decrease) Factor Value at Inception Projection (Decrease) Factor Value

32,702 64,299 31,597 0.9987 31,557 32,740 61,809 29,069 0.9987 29,032

46,322 77,225 30,903 0.9972 30,815 46,371 74,802 28,431 0.9972 28,350

72,158 103,408 31,250 0.9951 31,097 72,195 100,945 28,750 0.9951 28,610

101,354 132,604 31,250 0.9925 31,015 101,416 130,166 28,750 0.9925 28,534

131,620 162,870 31,250 0.9893 30,914 131,658 160,408 28,750 0.9893 28,441

162,603 193,853 31,250 0.9854 30,795 162,653 191,403 28,750 0.9854 28,331

195,118 226,368 31,250 0.9810 30,656 195,180 223,930 28,750 0.9810 28,204

227,693 258,943 31,250 0.9759 30,498 227,730 256,480 28,750 0.9759 28,058

261,209 292,459 31,250 0.9703 30,321 261,296 290,046 28,750 0.9703 27,895

287,054 318,304 31,250 0.9641 30,129 287,079 315,829 28,750 0.9641 27,719

310,983 342,233 31,250 0.9576 29,924 311,008 339,758 28,750 0.9576 27,530

1,828,813 2,172,563 343,750 337,723 1,829,325 2,145,575 316,250 310,706

Change in Cash Flows on the Future Share CertificatesChange in Cash Flows on the Variable Leg of the Swap



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Money Market Shares Our third example of a cash flow hedge is the use of the first payments method in which 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. The technique is based on FAS ASC 815-20-55 paragraphs 33A through 33F which address hedging against the risk of decreasing payments on a floating rate loan portfolio. We believe the method is analogous because the member can withdraw its shares at any time with no prepayment penalty just as a borrower could prepay its loan. The technique is used to ensure that the credit union can conclude the forecasted transaction is probable because it is not trying to forecast which specific member will be paid. We further note that FAS ASC 815-20-25-33B specifically permits this technique to be used for financial liabilities. We believe this hedging technique has several advantages over a fair value hedge when considering the "portfolio" of money market share accounts. First, cash flow hedges are not subject to the similar portfolio restriction. Second, because a cash flow hedge includes forecasted transactions, the fact a member withdraws funds does not create problems with effectiveness testing, because the hedge can be applied to other members' share accounts. Third, a cash flow hedge does not require a static portfolio of money market accounts thus avoiding the de-designation process described in our portfolio method fair value hedge example. In our cash flow hedge example, we assume the following:

Hedging item used - pay fixed, receive floating interest rate swap with a notional amount of $25 million and 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.

The credit union has calculated that its historical re-pricing beta for the account is 0.50 compared to changes in 60-day LIBOR. It further determines that the weighted average life for the accounts is 3 years. It enters into a 3-year LIBOR-based interest rate swap that provides for quarterly net settlements based on

Interest Expense 124,395$

Cash 124,395$

Record net payments on swap


Interest Income 27,017$

OCI 432,889$

Record fair value of swap and ineffective portion



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the paying a fixed interest rate on a $25 million notional amount and receiving 60-day LIBOR based on a $25 million notional amount.

The credit union identifies the hedged forecasted transactions as the first payments made during each 4 week period that begins 1 week before each quarterly payment due date on the swap over the next 3 years that, in aggregate for each quarter, are divided payments on $50 million of money market share accounts.

The hedged forecasted transactions in this case are described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction. Provided that the credit union determines it is probable that it will continue to make interest payments on at least $50 million principal of its then existing money market share accounts, it can conclude that the hedged forecasted transactions in the documented cash flow hedging relationships are probable of occurring.

The credit union cannot assume no ineffectiveness in such a hedging relationship as described in paragraph FAS ASC 815-20-25-102 because the hedging relationship does not involve directly hedging a floating benchmark interest rate. FAS ASC 815-20-25-43 (d) (3) prohibits an entity from designating interest rate risk as the hedged risk if the cash flows of the hedged transaction are explicitly based on an index different from the benchmark interest rates permitted. WW Risk Management notes that a credit union could designate interest rate as the hedged item in a cash flow hedge of the issuance of fixed rate certificates of deposit as in our previous example.

Effectiveness will measured using the change in variable cash flows method.

At inception the expected cash flows on the swap are as follows:

At the end of the quarter, we assume that a quarter one payment has been made by each counterparty and that LIBOR has increased by .15%. The fair value of the swap at the end of the quarter is:

Pay Receive Net PresentPayment Fixed Floating Payments Value

Year 1, Quarter 1 (58,467) 12,094 (46,374) (46,347)

Year 1, Quarter 2 (59,767) 14,328 (45,439) (45,385)

Year 1, Quarter 3 (57,818) 15,396 (42,422) (42,344)

Year 1, Quarter 4 (57,818) 19,259 (38,559) (38,458)

Year 2, Quarter 1 (59,767) 25,647 (34,120) (33,990)

Year 2, Quarter 2 (57,818) 38,106 (19,712) (19,605)

Year 2, Quarter 3 (57,818) 52,796 (5,022) (4,983)

Year 2, Quarter 4 (59,767) 69,886 10,119 10,012

Year 3, Quarter 1 (57,168) 89,047 31,879 31,423

Year 3, Quarter 2 (58,467) 106,193 47,726 46,834

Year 3, Quarter 3 (58,467) 123,719 65,252 63,701

Year 3, Quarter 4 (59,117) 140,036 80,919 79,142

(702,257) 706,506 4,250 -




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The following table illustrates the application of the change-in-variable-cash-flows method. This table reflects a comparison of the change in the present value of the variable leg swap cash flows to the change in the present value of money market share / deposit payments.

In our example, the hedge has been, and is expected to be, highly effective in offsetting the increase in the dividend share payments. The ratio of the present value of the variable leg to the present value of the share payments over the term of the swap is 105%. WW Risk Management notes that for this hedge to be effective, the credit union will have to continually change its dividend rate on money market shares in response to the changes in 60-day LIBOR. The ineffective portion of the hedge is the amount by which the present value of the swap of $783,430 exceeds the change in the expected interest related cash flows on the share CDs of $746,124 or $37,306. The journal entries to reflect the cash flows for the first quarter and the increase in the fair value of the swap at the end of the first quarter are shown below.

Pay Receive Net PresentPayment Fixed Floating Payments Value

Year 1, Quarter 1

Year 1, Quarter 2 (59,767) 23,703 (36,064) (36,030)

Year 1, Quarter 3 (57,818) 24,771 (33,046) (32,982)

Year 1, Quarter 4 (57,818) 28,634 (29,183) (29,093)

Year 2, Quarter 1 (59,767) 35,022 (24,745) (24,634)

Year 2, Quarter 2 (57,818) 47,481 (10,337) (10,271)

Year 2, Quarter 3 (57,818) 62,171 4,353 4,315

Year 2, Quarter 4 (59,767) 79,261 19,495 19,262

Year 3, Quarter 1 (57,168) 98,422 41,254 40,601

Year 3, Quarter 2 (58,467) 115,568 57,100 55,938

Year 3, Quarter 3 (58,467) 133,094 74,627 72,721

Year 3, Quarter 4 (59,117) 149,411 90,294 87,464

(643,789) 797,537 153,748 147,289


Expected Present Expected Present Present Present IneffectiveSwap Variable Value of Share Value of Value of Value of Portion of

Payment Receipts Variable Leg Payments Share Pmts Variable Leg Share Pmts the HedgeYear 1, Quarter 1 12,094 12,088 12,094 12,088

Year 1, Quarter 2 14,328 14,312 14,328 14,312 23,680 22,552

Year 1, Quarter 3 15,396 15,371 15,396 15,371 24,723 23,546

Year 1, Quarter 4 19,259 19,212 19,259 19,212 28,546 27,187

Year 2, Quarter 1 25,647 25,558 25,647 25,558 34,865 33,205

Year 2, Quarter 2 38,106 37,916 38,106 37,916 47,179 44,932

Year 2, Quarter 3 52,796 52,422 52,796 52,422 61,622 58,688

Year 2, Quarter 4 69,886 69,198 69,886 69,198 78,314 74,584

Year 3, Quarter 1 89,047 87,857 89,047 87,857 96,864 92,251

Year 3, Quarter 2 106,193 104,331 106,193 104,331 113,215 107,823

Year 3, Quarter 3 123,719 120,952 123,719 120,952 129,694 123,518

Year 3, Quarter 4 140,036 136,141 140,036 136,141 144,729 137,837

706,506 695,359 706,506 695,359 783,430 746,124 37,306

At Inception Testing After Initial Quarter



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WW Risk Management notes that we have provided these examples for illustrative purposes in order to help the reader better understand hedge accounting. Many other alternatives are available and we strongly encourage credit unions to thoroughly discuss potential derivatives transactions with their providers prior to entering into a transaction.


Interest Income 37,306$

OCI 109,983$



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Authors

Douglas Winn President and Co-founder Mr. Winn has more than twenty-five years of executive level financial experience and has served as a management consultant for the most recent seventeen years. Areas of expertise include financial strategy, financial accounting and reporting, and asset liability management.

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 49 states and the District of Columbia. Wilary Winn’s clients include 27 of the top 100 credit unions and 43 publicly traded community banks.

Mr. Winn is a nationally recognized expert regarding the accounting and regulatory rules related to fair value 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.

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 research, development and implementation of Wilary Winn's new business lines. Frank works to ensure that new products and services meet our firm's standards for quality before transferring primary responsibility to one of our business line leaders. Mr. Wilary makes the critical determination of whether to buy or build valuation software and how to best utilize the system selected. Frank ensures that valuation models are consistent, and that best practices are used, across the firm's lines of business. He is currently focused on building our asset liability management business.

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