Accounting for Interest Rate Derivatives FAS ASC 815

#AICPAcu

Accounting for Interest Rate DerivativesFAS ASC 815

Presented by Frank Wilary and Douglas WinnOctober 20, 2014

American Institute of CPAs 2#AICPAcu

Frank Wilary, Principal and Co-founderMr. Wilary has over twenty years of diversified experience in the financial services industry. Areas of expertise include asset-liability management, capital markets, asset-backed securitization, derivatives and information systems.

Mr. Wilary's primary responsibility is to lead the firm’s asset liability management and non-Agency MBS business lines.

Prior to co-founding Wilary Winn, Mr. Wilary held senior positions in treasury, capital markets, accounting, finance and systems within two organizations.


Douglas Winn, President and Co-Founder

Mr. Winn co-founded Wilary Winn in the summer of 2003 and his primary responsibility is to set the firm's strategic direction. Since inception, Wilary Winn has grown rapidly and currently has more than 375 clients located in 47 states and the District of Columbia. Wilary Winn’s clients include community banks, 43 of which are publicly traded, and credit unions, including 26 of the top 100.

Mr. Winn is a nationally recognized expert regarding the accounting and regulatory rules for financial institutions and has recently led seminars on the subject for many of the country's largest public accounting firms, the AICPA, the FDIC, and the NCUA.


Overall Agenda

NCUA rule

• Requirements

• Limits

• Application process

How derivatives can reduce IRR

“Hedge accounting”

• Can be very complex

• Elective

• Permitted derivatives are “vanilla”


Agenda – The New Rule

Eligibility

Permitted derivatives

Limits

Hedging example

Alternatives for managing IRR

Counterparties and margining

Policies and internal controls

Required reporting

Application process


Agenda – Hedge Accounting

Describe hedge accounting and provide examples

Address hedge effectiveness testing

Define hedge ineffectiveness – testing vs. bookkeeping

Provide alternative to hedge accounting


Why Now?

Changes in interest rates over one-year time periods from 1955 to 2008

• 30% of the time periods experienced changes of interest rates of over 200 bps

• 16% of the time periods experienced changes of interest rates of over 300 bps.

• 9% of the time periods experienced changes of interest rates of over 400 bps

Source: FDIC Supervisory Insights, Winter 2009


Who is Eligible

Federal Credit Unions with more than $250 million in total assets

Must have CAMEL 3 or better

Must have management CAMEL of 2 or better

Credit unions with less than $250 million can apply to NCUA field director for authority


Hedging Instruments

NCUA authorizes credit unions to use only the following derivatives:

Interest Rate Swaps• An agreement to exchange future payments of interest on a

notional amount at specific times and for a specific time period

Interest Rate Caps• A contract, based on a reference interest rate, for payment to the

purchaser when the reference interest rate rises above the level specified in the contract

Interest Rate Floors• A contract, based on a reference interest rate, for payment to the

purchaser when the reference interest rate falls below the level specified in the contract


Hedging Instruments

NCUA authorizes credit unions to use only the following derivatives:

Basis Swaps• An agreement between two parties in which the parties make

periodic payments to each other based on floating rate indices multiplied by a notional amount

Treasury Note Futures• A U.S. Treasury note financial contract that obligates the buyer to

take delivery of Treasury notes (or the seller to deliver Treasury notes) at a predetermined future date and price. Futures contracts are standardized to facilitate trading on an exchange

Note: Wilary Winn Risk Management believes all of the derivatives permitted by the NCUA meet the definition of a derivative under GAAP.


Other Restrictions

Swaps, caps, and floors can be amortizing and include a forward start date (90 day maximum)

Amortization cannot be linked to another financial instrument – e.g. a reference pool of mortgage loans

Treasury futures are limited to notes (maturity of 10 years or less)

Derivatives cannot be leveraged


Other Restrictions

Must be based on domestic interest rates (LIBOR)

Must be denominated in U.S. Dollars

Maximum maturity is 15 years (except for Treasury Futures)

Must meet the definition of derivative under GAAP


Economic Considerations

OTC swaps pricing varies considerably• Consider engaging independent third party advisor that can

obtain multiple bids

• We also recommend having an advisor help with the purchase of interest rate caps and floors

Treasury futures are exchange traded• Pricing is the same for everyone

• Must post collateral


Derivatives Limits

Notional Amount

• Takes into account type of derivative, time to maturity and net worth

Fair Value Loss Limit

• Loss limit does not include hedge benefit – measures the derivatives only

• Limit is based on net aggregate loss of derivatives and net worth

Entry Limits

Standard Limits

Total fair value 15 25Weighted average remaining maturity - notional 65 100


Weighted Average Remaining Maturity Notional

Cannot net offsetting transaction – calculation is cumulative

WARMN = Adjusted notional * (WARM/10)

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


Hedging Example

2-Year Interest Rate Swap – Pay Fixed, Receive Floating

Entry Limit Calculations

$ MM $ MMNet Worth 50.0 Net Worth 50.0Fair Value Limit 15% Notional Limit 65%Limit $ 7.5 Maximum 32.5

Maximum Notional 162.5Adjustment Factor 100%Time to Maturity 2.00 Time Factor 20%Verification 32.5

Fair Value Limit Notional Amount Limit


Hedging Example


Entry Limit Calculations

$ MM $ MMNet Worth 50.0 Net Worth 50.0Fair Value Limit 15% Notional Limit 65%Limit $ 7.5 Maximum 32.5

Maximum Notional 65.0Adjustment Factor 100%Time to Maturity 5.00 Time Factor 50%Verification 32.5

Fair Value Limit Notional Amount Limit


Hedging Example

Balance Sheet & 2 Year Net Interest Income ProjectionBalance SheetAssets $ MM -200 -100 Base +100 +200 +300

Cash 30 0.01 0.05 0.15 0.61 1.08 1.54Investments 140 2.44 3.70 4.34 5.12 5.85 6.58Loans 310 24.49 27.28 29.14 31.00 33.48 35.34Other Assets 20 - - - - - -

500 26.94 31.03 33.63 36.74 40.41 43.46

LiabilitiesNon-maturity 300 0.15 0.30 1.05 3.27 5.52 7.77Time 150 1.80 2.10 3.75 5.55 7.05 8.85

450 1.95 2.40 4.80 8.82 12.57 16.62

Net 50 24.99 28.63 28.83 27.92 27.84 26.84-0.91 -0.99 -1.99

2 Year Net Interest Income Position $ MM


Hedging Example


Base Case Swap Cash Flows on $50 MM Notional

Pay Date Pmts (Rcv) Rate (Rcv) Pmts (Pay) Rate (Pay) Net Pmts Discount PV

Q2 2014 29,106 0.23 (69,706) 0.56 (40,600) 0.9994 (40,576)

Q3 2014 32,739 0.26 (69,706) 0.56 (36,967) 0.9987 (36,921)

Q4 2014 38,641 0.30 (72,804) 0.56 (34,164) 0.9980 (34,094)

Q1 2015 43,702 0.37 (66,608) 0.56 (22,907) 0.9971 (22,840)

Q2 2015 61,569 0.49 (69,706) 0.56 (8,138) 0.9958 (8,104)

Q3 2015 85,779 0.69 (69,706) 0.56 16,073 0.9941 15,978

Q4 2015 120,688 0.92 (72,804) 0.56 47,884 0.9917 47,486

Q1 2016 149,682 1.20 (69,706) 0.56 79,975 0.9887 79,071

Total / Avg. 561,905 0.56 -560,748 0.56 1,156 0

$50 MM Interest Rate Swap - Base Case Cash Flow


Hedging Example

2 Year Net Interest Income Projection with Swap

-200 -100 Base +100 +200 +300Interest Income 26.94 31.03 33.63 36.74 40.41 43.46Interest Expense 1.95 2.40 4.80 8.82 12.57 16.62Net 24.99 28.63 28.83 27.92 27.84 26.84

Change from Base (3.84) (0.20) (0.91) (0.99) (1.99)Swap Impact * (0.56) (0.54) 1.01 2.01 3.02 Change from Base w/ Swap (4.40) (0.74) 0.09 1.02 1.03

2 Year Net Interest Income Position $ MM


Hedging Alternatives

Originate floating-rate loan products

Purchase floating-rate securities

Sell long-term fixed rate assets

Purchase of short-term assets

Increased use of share certificates – longer term with higher early withdrawal penalties


Counterparty Agreements, Collateral, and Margining

Can have exchange traded, centrally cleared, or non-cleared derivatives

Exchange traded and cleared:• Comply with Commodity Futures Trading Commission Rules• Dealers must be CFTC registrants• Comply with margining rules set by futures commission

merchant

Non-cleared derivatives:• Must have ISDA master service agreement• Must have minimum daily margining of $250,000• Marginal collateral can include only cash, US Treasuries, GSE

debt, GSE residential MBS


Counterparty Agreements, Collateral, and Margining

Must have systems in place to manage collateral and margining requirements

System must include posting, tracking, valuing and reporting of collateral

Must assess liquidity needs in light of margining requirements


Operational Support

Required Experience and Competencies

Board – must receive derivatives training – updated annually

Senior Executive Officers must understand, approve, and provide oversight

Qualified Derivatives Personnel• Must understand ALM, including use of derivatives

• Must know how to evaluate counterparty, collateral and margining risks

• Must understand accounting and financial reporting in accordance with GAAP


External Service Providers

Can use ESPs, provided ESP:• Is not a counterparty

• Is not a principal or agent in the derivatives transactions

• Does not have discretionary authority to execute trades

CU must be capable of overseeing ESP

ESP’s role must be documented

ESP cannot conduct ALM or liquidity risk management in lieu of credit union


Internal Controls

Transaction support - must identify transaction and show how it will be effective

Internal controls review – must perform review for 2 years (internal audit or external auditor)

Financial statement audit – must have financial statement audit performed

Must have written processes in place including schematic (flow chart or organization chart)

Must have appropriate segregation of duties

Must have legal review of derivatives contracts

Must have written policies and procedures


Elements of a Derivatives Policy

Key participants

Participants’ responsibilities and internal controls - including who is permitted to enter into derivatives transaction

Objective of hedge and nature of risk being hedged

Hedge period

Authority for implementation of the derivatives program

Purpose and implementation guidelines

Permissible derivative instruments

Hedge limits

Hedge designations

Hedge effectiveness

Reporting requirements


Derivatives Reporting Requirements

Quarterly board reports

Monthly reporting to senior executives and ALCO, if applicable. At a minimum, the reports must show:• Any areas of noncompliance

• Comparison to internal limits

• Itemization of individual positions and current fair values with comparison to NCUA limits

• NEV calculations with and without derivatives

• Evaluation of effectiveness in mitigating IRR

• Evaluation of “hedge accounting”


Credit Unions Must Apply for Authority to Use Derivatives

Demonstrate how derivatives will mitigate IRR

Detail derivatives the CU intends to use and why

Have policies in place

Detail how credit union will acquire appropriate resources, controls and systems to implement sound program

Specify how ESPs will be used

Address margining and collateral

Describe how it will meet GAAP


Credit Unions Must Apply for Authority to Use Derivatives

Cannot enter into derivative transactions until approved

Entry limits when approved

Standard limits apply after CU has been using derivatives for one year and NCUA has not voiced any safety and soundness concerns

Pilot program participants must be fully compliant within 12 months


Accounting for Derivatives

Derivatives must be accounted for and reported at fair value

Three options to decrease resulting income statement volatility:

1. Fair Value Hedge Accounting

2. Fair Value Accounting

3. Cash Flow Hedge Accounting



Two types of hedge accounting

1. Fair value hedge

Change in fair value of the hedging instrument runs through the income statement, along with the change in the fair value of the item being hedged – used for existing financial assets and liabilities

2. Cash flow hedge

“Effective” portion of the hedge is reported in Other Comprehensive Income, while the ineffective portion is reported in current earnings – used for forecasted transactions or variable payments on existing financial assets and liabilities



Type of accounting depends on the item being hedged – Credit Union enters into a Pay Fixed, Receive Floating Interest Rate Swap

Fair Value Hedge Example:

CU wants to hedge against the decrease in fair value of a fixed rate loan portfolio defines hedge as change in benchmark interest rate

If benchmark interest rate increases, fair value of the loans will decrease, and the fair value of the swap will increase. Change in each runs through the income statement

Cash Flow Hedge Example:

CU wants to hedge against increase in dividend payments on CD accounts as they renew

Defines hedge as risk of an increase in the forecasted payments to its members. Effective portion will run through OCI


Hedge Documentation

Formal designation and documentation required at inception

The CU’s objective and strategy for the hedge must include (815-20-25-3b 2):

• The hedging instrument – the derivative (interest rate swap, interest rate floor, interest rate cap, etc.)

• The hedged item or transaction – the asset or liability being hedged

• The nature of the risk being hedged – interest rate risk

• The method that will be used to retrospectively and prospectively measure the hedge’s effectiveness


Hedge Documentation

• The method that will be used to measure hedge ineffectiveness

• Benchmark interest rate being hedged

Eligible benchmark rates are (815-20-25-6A):

Treasury rates

Federal funds effective swap rate

LIBOR


Hedge Documentation

Fair Value Hedge• Can hedge the change in fair value of an entire or a portion of

an asset or liability (815-20-25-11)

Cash Flow Hedge – Variability in Expected Future Cash Flows Related to:• An existing recognized asset or liability (such as all or certain

future interest payments on variable rate debt)• A forecasted transaction (such as a forecasted purchase or

sale) (815-20-25-13)


Hedge Effectiveness

To qualify for hedge accounting, the hedging relationship (both at inception of the hedge and on an ongoing basis), shall be expected to be highly effective in achieving either of the following (815-20-25-75):

• Offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated - a fair value hedge

• Offsetting cash flows attributable to the hedged risk during the term of the hedge - a cash flow hedge


Hedge Effectiveness

Hedge Effectiveness can be measured in two ways:

1. Dollar-offset approach (815-20-35-5a)• Compares changes in fair value or cash flow of the hedged item and the

derivative

• Can be applied period by period (cannot be less than 3 months) or cumulatively

• Most believe a dollar offset range of 80%-125% would be considered highly effective

2. Statistical methodologies

• May permit a CU to continue to use hedge accounting for the current period even though the dollar-offset approach appears ineffective (815-20-55-68)

• Complex to implement and requires multiple observation periods


Hedge Effectiveness: Dollar-Offset Approach Example

$50 MM pay fixed / receive floating 5-year interest rate swap

Hedged item – a group of fixed rate investments held AFS

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


Hedge Effectiveness: Statistical Approaches

Regression Analysis

Minimum of 30 observations

Must consider changes in the value of the derivative and the hedged item

Time horizon must coincide or be less than the time horizon of the hedge relationship

Must consider whether to regress value changes or value levels

Must review distribution of error terms

EY Derivatives and Hedging, October 2013 4.9.2.4



Regression Analysis continued

R-squared result must exceed a pre-specified level (e.g. 0.80)

Hedge relationship must correspond to beta (the slope of the regression line)

Standard error must be used to calculate the reliability using the t statistic

T-test must be passed at a 95% confidence level

Must consider y-intercept

Must compare results to dollar offset results

EY Derivatives and Hedging, October 2013 4.9.2.4



R-squared Analysis

Hedged item – floating dividend rate on money market shares

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

0.00 1.00 2.00 3.00 4.00 5.00 6.00

Div

iden

d R

ate

1 Mo LIBOR

1 Mo LIBOR Line Fit Plot

Div. Rate

Predicted Div. Rate


Hedge Effectives

A credit union shall consider hedge effectiveness in two different ways:

1. Prospective Considerations

2. Retrospective Evaluations


Hedge Effectiveness

Prospective Considerations (815-20-25-79a)

Can be based on regression or other statistical analysis of past changes in fair values or cash flows as well as on other relevant information

Shall consider all reasonably possible changes in fair value (if a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of the derivative instrument and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied

Not be limited only to the likely or expected changes in fair value (if a fair value hedge) or in fair value or cash flow (if a cash flow hedge)

Generally involves a probability-weighted analysis – consistent with FASB Concepts Statement No. 7


Hedge Effectiveness

Retrospective Considerations (815-20-25-79a)

An assessment of effectiveness shall be performed whenever financial statements or earnings are reported, and at least every three months

Can be based on dollar offset or statistical approaches

Dollar-offset measurement can be for period or cumulative

Statistical methods must be similar period to period (e.g. same number of data points)


Hedge Effectiveness

Other Considerations for Cash Flow Hedges

Effectiveness testing for a cash flow hedge involving an interest rate swap can be done using one of three methods:

• Change in variable cash flows method (815-30-35-16 through 24) • Hypothetical derivative method (815-30-35-25 through 30) • Change in fair value method (815-30-35-31 through 32)

We will show examples of each later on in the presentation


What if the Hedge is No Longer Effective?

The hedge accounting is discontinued prospectively, resulting in potential income statement volatility as the derivative is marked to market with no offset to the hedged item (fair value hedge 815-25-40-1 and cash flow hedge 815-30-40-1)

Fair value adjustments for fixed rate financial instruments related to fair value hedges are recognized prospectively using the effective interest rate method when hedge accounting is discontinued (815-25-35-9)

Cash flow hedge - the net gain or loss remains in AOCI unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period plus a 2 month extension (815-30-40-4)


Hedge Ineffectiveness

Hedge ineffectiveness is measured by the Dollar-offset method

Fair Value Hedge:

Hedge ineffectiveness flows through the income statement based on any difference between the change in the value of the derivative and the change in value of the hedged item (815-20-35-1b)

Cash Flow Hedge:

Ineffectiveness must be separately measured and recorded on the income statement. If the fair value of the derivative changes by more than the present value of hedged cash flows, the difference is the ineffective amount. If the fair value of the hedged cash flows changes by more than the change in the fair value of the derivative then no ineffectiveness (815-20-35-1c)


Short-Cut Method

Entities can assume no ineffectiveness in an interest rate swap in two instances:

1. A private company that enters into a pay fixed, receive floating interest rate swap (this exemption does not apply to financial institutions) (815-20-25-131B)

2. A swap can be examined to determine if it can be accounted for under the Short-Cut Method (this applies to all companies, including financial institutions)


Short-Cut Method

To conclude no hedge ineffectiveness in a hedge with an interest rate swap, all of the following conditions must be met for both fair value and cash flow hedges (815-20-25-104):

a) Notional amount of swap matches principal amount of item being hedged

b) Fair value of the swap is zero at inception

Note: For the purposed of determining zero: can ignore bid/ask spread at inception, commissions, and other transaction costs


Short-Cut Method

d) Formula for computing net settlements remains the same throughout the swap

− Fixed rate remains the same− Variable rate index does not change

e) Interest bearing asset or liability is not pre-payable− Unless the prepayment is due to an embedded call (put) option and

the swap has a mirror option call (put) option - options must mach exactly

− Because the NCUA does not allow a credit union to enter into a swap with this feature, we believe a swap involving loans that can be prepaid will not qualify for the short-cut method

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


Short-Cut Method

WW Risk Management does not recommend the short-cut method, because if you fail, you cannot reassess.

We recommend that a credit union account for the swap using the long-haul method, recognizing that swaps that would qualify for the short-cut method will easily pass the effectiveness testing


Fair Value Hedges - Eligibility

As asset or liability is eligible for designation as a hedged item in a fair value hedge if all of the following criteria are met:

The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment (815-20-25-12a)

The hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings (815-20-25-12c)



The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or similar liabilities (or a specific portion thereof) (815-20-25-12b)

• If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or liabilities shall share the risk exposure – generally proportionate change in fair value

• If the specific portion of an asset or liability then the hedged item is one of the following:

- One or more selected contractual cash flows, including one or more individual interest payments during a selected portion of the term of a debt instrument (such as the portion of the asset or liability representing the present value of the interest payments in the first two years of a four-year debt instrument).

- A put option or call option (including an interest rate cap or price cap or an interest rate floor or price floor) embedded in an existing asset or liability that is not an embedded derivative accounted for separately



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 (815-20-25-12f): • The risk of changes in the overall fair value of the entire hedged item • The risk of changes in its fair value attributable to changes in the

designated benchmark interest rate (referred to as interest rate risk) • The risk of changes in its fair value attributable to both of the following

(referred to as credit risk): - Changes in the obligor’s creditworthiness - Changes in the spread over the benchmark interest rate with

respect to the hedged item’s credit sector at inception of the hedge


Fair Value Hedges

Change in fair value for each item in the portfolio must be within a fairly narrow range – such as 9 to 11%. On the other hand, a range of 7 to 13% would not meet the similar portfolio requirement (815-20-55-14)


Fair Value Hedges

In aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate (815-20-55-15):

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


Fair Value Hedges

Non-performance risk

Credit valuation adjustments (CVAs)

Counterparty risk 815-20-35-16

Credit union non-performance risk – implied EY 4.11.1

For derivatives such as swaps the CVAs adjustments can swing from party to party as each entity comes into / goes out of the money


Fair Value Hedges

Credit unions considering a fair value hedge should be aware of the following:

Fair value hedge cannot be used to hedge interest rate risk on held-to-maturity securities (815-20-43c 2)

If a fair value hedge is used to hedge interest rate risk on available-for- sale securities then the change in the value of the hedged item runs through the income statement and not through OCI

A partial-term hedge of a fixed rate financial instrument using a shorter-term, notionally matched swap will generally not "be effective" (e.g. hedging a 30-year loan with a 3-year swap)


Fair Value Hedges vs. Fair Value Accounting

Fair value hedge accounting is restrictive and complex, and a CU could elect to account for the financial instrument at fair value in order to avoid these complications and limitations. However, fair value election has several disadvantages:

• Hedge-accounting election can be terminated at any time, while the fair value election is irrevocable

• Nearly all of the change in value of an interest rate derivative over time will be due to changes in the market interest rates, while fair value of the loans will be affected by changes in interest rate and credit conditions

• The CU will need to develop systems to estimate the fair value of loans over their entire lives



We recommend that if a credit union elects to account for loans at fair value, that it:

Select high credit borrowers to minimize the change in value arising from deterioration of the borrower’s credit or the

widening out of credit spreads

We note that we have systems in place to estimate the fair value of loans over their entire lives



Fixed Rate Mortgage Fair Value Example

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%


Cash Flow Hedges - Eligibility

An entity may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with either of the following (815-20-25-13):

• Payments on an existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt or variable rate liabilities – share accounts)

• A forecasted transaction (such as a forecasted purchase or sale)



A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if all of the following criteria are met (815-20-25-15):

a) A forecasted transaction is specifically identified as either:

1. A single transaction

2. 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.



b) The occurrence of the forecasted transaction is probable.

c) The forecasted transactions meets both of the following conditions:

1. It is a transaction with a party external to the reporting entity

2. It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings

d) The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be re-measured with changes in fair value attributable to the hedged risk reported currently in earnings.

e) If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not re-measured with changes in fair value attributable to the hedged risk reported currently in earnings.



f) If the hedged transaction is the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is any of the following:1. The risk of overall changes in the hedged cash flows related to the

asset or liability, such as those relating to all changes in the purchase price or sales price

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

3. The risk of changes in its cash flows attributable to all of the following (referred to as credit risk):

i. Default ii. Changes in the obligor’s creditworthiness iii. Changes in the spread over the benchmark interest rate with respect to the related financial asset’s or liability’s credit sector at inception of the hedge.


Cash Flow Hedge Accounting

Accounting for cash flows

AOCI reclassified into earnings in the same period that the in which the forecasted transaction affects earnings


Hedge Accounting Examples

Fair Value of the Derivative• Interest Rate Swap• Interest Rate Cap

Cash Flow Hedges• Rollover of FHLB Advances – hypothetical derivatives method• Rollover of Share CDs – change in variable cash flows method• Rollover of Share CDs – change in fair value method• Money Market Share Accounts – change in variable cash flows

Fair Value Hedge• Loan Portfolio Method

Forgo Hedge Accounting• Fair Value Option for loan portfolio• Interest Rate Cap


Fair Value of Derivatives

$50 MM 3-year pay fixed / receive floating interest rate swap

At inception and without the credit valuation adjustment (CVA), the fair value of the swap is zero.

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 -




Credit valuation adjustment (CVA) is applied to the discount rate on both legs of the swap to determine fair value

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




Fair value of the swap changes as interest rates move and with the passage of time

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



$25 MM 5-year interest rate cap with a 3.50% strike price

Since the cap strike price of 3.50% exceeds the anticipated forward rate in all periods, this cap is out-of-the-money at inception.

Quarter Cap Reset Rate Discount Intrinsic PV Time PV Cap Cost1 3.50% 0.23% 0.9994 - - -

2 3.50% 0.26% 0.9987 - - -

3 3.50% 0.37% 0.9978 - 0 0

4 3.50% 0.58% 0.9963 - 38 38

5 3.50% 0.81% 0.9943 - 58 58

6 3.50% 1.05% 0.9916 - 582 582

7 3.50% 1.30% 0.9884 - 2,345 2,345

8 3.50% 1.56% 0.9844 - 5,916 5,916

9 3.50% 1.82% 0.9799 - 6,007 6,007

10 3.50% 2.08% 0.9748 - 11,170 11,170

11 3.50% 2.30% 0.9691 - 17,170 17,170

12 3.50% 2.48% 0.9630 - 23,154 23,154

13 3.50% 2.46% 0.9571 - 19,463 19,463

14 3.50% 2.62% 0.9509 - 24,590 24,590

15 3.50% 2.79% 0.9441 - 31,310 31,310

16 3.50% 2.94% 0.9370 - 38,087 38,087

17 3.50% 2.84% 0.9303 - 32,029 32,029

18 3.50% 2.96% 0.9236 - 35,915 35,915

19 3.50% 3.09% 0.9162 - 43,603 43,603

20 3.50% 3.20% 0.9089 - 46,751 46,751

Total - 338,186 338,186



$25 MM 5-year interest rate cap with a 3.50% strike price

Fair value of the interest rate cap changes as interest rates move and with the passage of time

Time -300 -200 -100 0 100 200 300Inception 0 5,946 81,174 338,186 799,566 1,435,252 2,197,990

1 Year Out 0 4,401 71,131 315,122 756,148 1,347,453 2,056,018

2 Years Out 0 3,533 62,564 279,964 666,519 1,192,560 1,880,248

3 Years Out 0 3,730 50,556 206,421 494,152 985,180 1,515,716

4 Years Out 0 1,757 23,375 89,439 269,609 557,555 860,821



Cash Flow Hedges – Using Interest Rate Swaps

Rollover of FHLB Advances• Analogous to hedging commercial paper (815-20-05-5 though 05-9)

• Hypothetical derivatives method no ineffectiveness

Rollover of CDs• Change in variable cash flows method with ineffectiveness (815-

20-05-10)

Rollover of CDs • Change in fair value method with ineffectiveness (815-20-05-10)

Money Market Share Accounts – First Payments Method• Change in variable cash flows method with ineffectiveness



Non-performance Risk for Cash Flow Hedges Using Interest Rate Swaps• The discount rate used for the change in variable cash flows

method and the hypothetical derivative method is the rate applicable to determining the fair value of the swap (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. Issue arises if default of counterparty is “probable”.

• Non-performance risk can result in effectiveness using the change in fair value method (815-30-35-17)


Cash Flow Hedge Example:Rollover of Existing Debt

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

Hedging item used - pay fixed, receive floating interest rate swap with a fair value of zero at inception

Hedged item – forecasted quarterly issuances of fixed rate FHLB advances (rollovers)

Nature of the risk being hedged - variability in cash flows in the interest element of the final cash flows at maturity attributable to changes in the LIBOR swap rate – benchmark interest rate



Critical terms

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

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

Index on the swap’s variable interest rate leg matches the benchmark interest rate designated as the risk being hedged (3 month LIBOR)

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

No caps or floors on the variable interest rate leg and no embedded optionality in the FHLB advance

Swap and borrowings re-price on the same day

Determination that the it is probable that the swap counterparty will not default on its obligations



Credit Union must perform effectiveness testing. Effectiveness testing can be based on the changes in LIBOR only – because the borrowing is fixed rate and based on the risk free rate. Hedge of benchmark interest rate.

Ineffectiveness will measured using the change in hypothetical derivatives method.


Cash Flow Hedge Example:Hypothetical Derivatives Method

Hedge ineffectiveness based on a comparison of the following amounts:

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

b. The change in fair value of a hypothetical interest rate swap having terms that identically match the critical terms of the floating-rate asset or liability, including all of the following:

1. The same notional amount

2. The same repricing dates

3. The same index (that is, the index on which the hypothetical interest rate swap’s variable rate is based matches the index on which the asset or liability’s variable rate is based)

4. Mirror image caps and floors

5. A zero fair value at the inception of the hedging relationship



Short-Cut Method Cash Flow Hedge (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 repricing dates of the variable-rate asset or liability and the hedging instrument occur on the same dates and be calculated the same way (that is, both shall be either prospective or retrospective).

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:• Notional amount of swap equals total of individual transactions• Remaining short cut criteria are also met



Essentially the hypothetical derivatives method needs to satisfy all of the criteria of the short-cut method with the exception of ASC 815-20-25-104 (e) relating to prepayment which was written for “fair value” hedges.



Cumulative change in the fair value of the actual swap will be compared to the cumulative change in the fair value of the hypothetical swap

Critical terms of the hypothetical swap match hedged transactions (i.e. the FHLB borrowings) and will thus be expected to be “highly effective” and perfectly offset the hedged cash flows

Change in fair value of the perfect hypothetical swap will be regarded as a proxy for the present value of the cumulative change in expected cash flows on the FHLB borrowings (815-30-35-27)

Use dollar offset method to measure effectiveness



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

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)



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

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



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



A pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows on reissuances of the credit union's share certificates


Hedged item – forecasted quarterly re-issuances of fixed rate share certificates

Nature of the risk being hedged - variability in cash flows arising from reissuances of share certificates



Critical terms

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

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

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

Swap and CDs re-price on the same day

Determination that the it is probable that the swap counterparty will not default on its obligations


Cash Flow Hedge Example:Change in Variables Cash Flow Method

Credit Union must perform effectiveness testing. To be effective, changes in certificates of deposit must closely track changes in LIBOR. Effectiveness testing could be based on the changes in LIBOR only – as a benchmark interest rate.

In this example, we will test using the rate on the CDs.

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


Change in Variables Cash Flow Method

Hedge ineffectiveness is based on a comparison of:

Variable leg of the interest rate swap

Hedged variable-rate cash flows on the share certificates

Based on the premise that only the floating-rate component of the interest rate swap provides the cash flow hedge

The interest rate swap is recorded at fair value on the balance sheet. The calculation of ineffectiveness involves a comparison of the following amounts:

a. The present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap

b. The present value of the cumulative change in the expected future interest cash flows on the CDs



Hedge ineffectiveness results when the present value of the cumulative cash flows on the swap exceed the present value of the cumulative cash flows of the designated share certificate accounts. Conversely, there is no ineffectiveness if the PV of the designated share certificate payments exceed the PV of the swap (FAS ASC 815-30-35-3(b))



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

Pay Receive Net Present

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

At inception hedge value is $0. LIBOR rates increase 25 basis points after 1 quarter.



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

$310,706 is the effective portion of the hedge. $27,017 is ineffective.

Projected Updated Increase Discount Present Projected Updated Increase Discount Present

at Inception Projection (Decrease) Factor Value at Inception Projection (Decrease) Factor Value32,702 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


Change in Variable Cash Flows Method

Interest Expense $ 124,395 Cash $ 124,395

Record net payments on swap

Derivative Asset $ 459,906 Interest Income $ 27,017 OCI $ 432,889

Record fair value of swap and ineffective portion


Change in Fair Value Method

Ineffectiveness based on a calculation that compares:• Present value of the cumulative change in expected variable

cash flows that are designated as the hedged items• Cumulative change in the fair value of the interest rate swap

designated as the hedging instrument

Non-performance risk could result in some ineffectiveness using this technique because while the credit valuation adjustment would affect end of period cash flows as in methods 1 and 2 – it would also affect the beginning of the period cash flows for the swap as part of its determination of fair value


Change in Fair Value Method

Pay Receive Net Discount Present Projected Updated Increase Discount Present

Qtr Fixed Floating Payments Factor Value at Inception Projection (Decrease) Factor Value1 (153,706) 29,311 (124,395) N/A (124,395)

2 (155,414) 64,299 (91,115) 0.9987 (90,998) 32,740 61,809 29,069 0.9987 29,032

3 (151,998) 77,225 (74,774) 0.9972 (74,562) 46,371 74,802 28,431 0.9972 28,350

4 (153,706) 103,408 (50,299) 0.9951 (50,053) 72,195 100,945 28,750 0.9951 28,610

5 (153,706) 132,604 (21,103) 0.9925 (20,944) 101,416 130,166 28,750 0.9925 28,534

6 (153,706) 162,870 9,164 0.9893 9,065 131,658 160,408 28,750 0.9893 28,441

7 (153,706) 193,853 40,146 0.9854 39,562 162,653 191,403 28,750 0.9854 28,331

8 (153,706) 226,368 72,661 0.9810 71,281 195,180 223,930 28,750 0.9810 28,204

9 (153,706) 258,943 105,236 0.9759 102,705 227,730 256,480 28,750 0.9759 28,058

10 (153,706) 292,459 138,753 0.9703 134,628 261,296 290,046 28,750 0.9703 27,895

11 (153,706) 318,304 164,598 0.9641 158,694 287,079 315,829 28,750 0.9641 27,719

12 (153,706) 342,233 188,526 0.9576 180,529 311,008 339,758 28,750 0.9576 27,530

Total (1,844,475) 2,201,874 357,399 335,511 1,829,325 2,145,575 316,250 310,706

Fair Value of the Swap Change in Cash Flows on the Future Share Certificates


Cash Flow Hedge:Change in Fair Value Method

Interest Expense $ 124,395 Cash $ 124,395

Record net payments on swap

Derivative Asset $ 459,906 Interest Income $ 24,805 OCI $ 435,101

Record fair value of swap and ineffective portion


Cash Flow Hedge:First Payments Method

A pay fixed, receive floating interest rate swap is used to hedge against the risk of increases in interest rate-related cash flows for a credit union's money market share accounts


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


Cash Flow Hedge:First Payments Method

A pay fixed, receive floating interest rate swap is used to hedge against the risk of increasing interest rates for a credit union's money market share accounts

Re-pricing beta is 0.50 compared with 60-day LIBOR and money market accounts have an estimated life of 3 years

Credit union enters into a 3-year 60-day LIBOR swap with a notional amount of $25 million and quarterly settlements


Cash Flow Hedge Example:Change in Variables Cash Flow Method

Credit Union must perform effectiveness testing. To be effective, changes in dividends on money market shares must closely track changes in LIBOR. Effectiveness testing cannot be based on the changes in LIBOR only – must consider actual payments made because the dividend rate is variable and is not explicitly based on a benchmark interest rate (815-20-25-43(d)(3)) . Ineffectiveness will measured using the change in variable cash flows method.


Change in Variable Cash Flow Method Example


Hedged item – variability in cash flows on its quarterly interest payments on $50 million principal of money market share accounts

Fair value of the interest rate swap after 1 quarter and an increase in LIBOR interest rates of 15 basis points.

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

Fair Value of the Swap


Change in Variable Cash Flow Method Example


Hedged item – variability in cash flows on its quarterly interest payments on $50 million principal of money market share accounts

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


Change in Variable Cash Flows Method

Derivative Asset $147,289

Interest Income $37,306

OCI $109,983



Fair Value Hedge• Portfolio Method using an interest rate swap

o For sake of simplicity we will ignore CVAs

Forgo Hedge Accounting• Loan portfolio – fair value option• Purchase of an interest rate cap


Fair Value Hedge Example:Portfolio Method

A pay fixed, receive floating interest rate swap is used to hedge against the change in the fair value of a portfolio of fixed rate single family mortgages


Hedged item - portfolio of fixed rate single family mortgage loans

Nature of the risk being hedged - interest rate risk defined as the change in the fair value of the mortgage loan portfolio in relation to the change in benchmark interest rate (LIBOR)

The portfolio of loans meets the similar assets criteria



A pay fixed, receive floating interest rate swap is used to hedge against the change in the fair value of a portfolio of fixed rate single family mortgages

Stated maturity of swap is consistent with the stated maturities of the loans

Swap amortizes on a schedule that equates to scheduled amortization of the loans



As part of its documented risk management strategy associated with this hedging relationship, on a quarterly basis, the credit union intends to do both of the following: • Assess effectiveness of the existing hedging relationship for the past

three-month period.• Consider possible changes in value of the hedging derivative and the

hedged item over the next three months in deciding whether it has an expectation that the hedging relationship will continue to be highly effective at achieving offsetting changes in fair value.

Loans can prepay – credit union considers prepayment risk of the portfolio in its prospective testing

If loans prepay faster than expected resulting in an over-hedge – credit union de-designates a portion of the swap for the next three month period



$50 MM amortizing 15 year pay fixed / receive floating interest rate swap

Hedged item – a pool of 15-year fixed rate loans Market

Amortizing Rate Change in Change inHedge Change Net Swap Swap 15 Year Loan De-designation

Notional From Swap Fair Fair Loan Pool Portfolio Dollar Effective NotionalMonth Amt Inception Payment Value 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% yes

Mo. 2 49,592,968 +5bps (97,316) 372,325 623,586 49,017,968 (508,479) 122.6% yes

Mo. 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



Month 1

Interest expense

104,527

Cash 104,527

Non-interest income

251,261

Derivative liability 251,261

Residential real estate loans

257,100

Non-interest income

257,100

Month 2

Interest expense 97,316

Cash 97,316

Derivative liability 251,261

Derivative asset 372,325

Non-interest income 623,586


Residential real estate loans 508,479

Month 3

Interest expense 94,583

Cash 94,583

Derivative asset 266,718



Residential real estate loans 301,068


Fair Value Election Accounting

Fixed Rate Mortgage Fair Value Example

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%


Fair Value Election Accounting

Example with Default and Interest Rate Shock

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%


Fair Value Election

a

Non-interest expense (interest rate) $ 1,065,609

Non-interest expense (credit) $ 44,113

Residential real estate loans $ 1,109,722


Purchase of Interest Rate Cap

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

Forgo hedge accounting


Purchase of Interest Rate Cap

The value of a cap has two components – intrinsic and time. When measuring effectiveness of an option credit union can include all of its gain or loss or it may exclude all or part of the time value as follows (815-20-25-82):

Assess on intrinsic value only Assess on present value intrinsic value only Exclude any of the time value elements:

Passage of time (theta)

Volatility (vega)

Change in interest rates (rho)


Interest Rate Cap Example

$100 MM quarterly 5-year with a cap strike price of 2.75%Quarterly Cap Reset Intrinsic Time TotalPayment Notional Strike Rate PV PV PV

1 100,000,000 2.75% 0.24% - - -

2 100,000,000 2.75% 0.27% - - -

3 100,000,000 2.75% 0.39% - 2 2

4 100,000,000 2.75% 0.61% - 402 402

5 100,000,000 2.75% 0.87% - 1,060 1,060

6 100,000,000 2.75% 1.14% - 7,012 7,012

7 100,000,000 2.75% 1.41% - 22,908 22,908

8 100,000,000 2.75% 1.68% - 49,234 49,234

9 100,000,000 2.75% 1.97% - 60,568 60,568

10 100,000,000 2.75% 2.25% - 96,022 96,022

11 100,000,000 2.75% 2.47% - 133,149 133,149

12 100,000,000 2.75% 2.67% - 166,456 166,456

13 100,000,000 2.75% 2.81% 14,578 161,993 176,572

14 100,000,000 2.75% 2.78% 6,156 168,714 174,870

15 100,000,000 2.75% 2.95% 46,948 157,741 204,690

16 100,000,000 2.75% 3.10% 82,322 152,868 235,190

17 100,000,000 2.75% 3.04% 70,144 156,890 227,034

18 100,000,000 2.75% 3.18% 97,975 145,243 243,218

19 100,000,000 2.75% 3.31% 129,806 144,344 274,150

20 100,000,000 2.75% 3.42% 154,328 143,222 297,550

Total 602,258 1,767,829 2,370,087


Interest Rate Cap Example

Horizon analysis with interest rate shocks

Time -300 -200 -100 0 100 200 300Inception 533 98,238 756,946 2,370,087 4,806,006 7,885,507 11,489,787

1 Year Out 255 74,902 670,717 2,223,093 4,568,204 7,454,541 10,967,524

2 Years Out 179 63,440 589,132 1,986,337 4,095,532 6,931,227 9,886,034

3 Years Out 155 54,789 435,973 1,468,130 3,419,319 5,601,930 7,835,500

4 Years Out 43 28,249 227,538 837,000 2,024,340 3,278,028 4,551,417


Other Considerations

Call Report References• Other Assets,32–d Non-Trading Derivatives Assets, net• Liabilities, 7 Non-Trading Derivative

Liabilities, net• Schedule D: Pages 20-24

Risk Based Capital• AOCI not included in capital so no regulatory benefit for cash

flow hedge


How We Can Help

Identify the optimal derivative(s) to be used given your credit union's ALM profile

Work with you to amend your ALM policies to allow for the use of derivatives

Work with you to draft derivatives policies and procedures that ensure you have the proper internal controls in place and that you meet all of the NCUA requirements regarding the use of derivatives

We can provide estimates of ongoing fair value for loans, investments, and liabilities which you have elected to account for at fair value. We can also help you with the initial selection of the items


How We Can Help

For those electing hedge accounting we can:• Develop the appropriate interest rate hedge and hedging item(s)

to be used given your credit union's ALM profile• Work with you to identify the item(s) to be hedged and the

nature of the risk being hedged• Ensure you are able to achieve hedge accounting - including

prospective and retrospective effectiveness testing on a dollar offset or statistical basis

• Provide you with the journal entries needed to report hedging activities


Wilary Winn Resources


Wilary Winn Risk Management

Wilary Winn Risk Management LLCFirst National Bank Building

332 Minnesota Street, Suite W1750Saint Paul, MN 55101

651-224-1200

www.wilwinn.com


Wilary Winn Risk Management

Services and Contact Information

Asset Liability Management, Derivatives and Private Label MBS/CMOs:

Frank Wilary [email protected]

Mergers and Acquisitions, Fair Value Footnotes, ASC 310-30, and TDRs:

Brenda Lidke [email protected]

Mortgage Servicing Rights and Mortgage Banking Derivatives:

Eric Nokken [email protected]

mailto:[email protected]



Accounting for Interest Rate Derivatives FAS ASC 815

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