Part A1 - Accounting for Derivative Instruments and ... · Part A1 - Accounting for Derivative...

The Supervisor of Banks: Reporting Provisions to the Public [2](10/02)

Annual Financial Report Page 661-22

Part A1 - Accounting for Derivative Instruments and Hedging Activities

Introduction (10/02) a. This Provision addresses the accounting for derivative instruments, including certain derivative

instruments embedded in other contracts, and hedging activities. b. In developing the standards in these Provisions, the following four fundamental decisions

should serve as cornerstones underlying those standards:

1. Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.

2. Fair value is the most relevant measure for financial instruments and the only relevant

measure for derivative instruments. Derivative instruments should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (that is, gains or losses) that are attributable to the risk being hedged and that arise while the hedge is in effect.

3. Only items that are assets or liabilities should be reported as such in financial statements. 4. Special accounting for items designated as being hedged should be provided only for

qualifying items. One aspect of qualification should be an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged.

c. This Provision standardizes the accounting for derivative instruments, including certain

derivative instruments embedded in other contracts, by requiring that a banking corporation recognise those items as assets or liabilities in the statement of financial position and measure them at fair value. If certain conditions are met, a banking corporation may elect to designate a derivative instrument as follows:

1. To hedge the exposure to changes in the fair value of a recognized asset or liability, or of

an unrecognized firm commitment,1 that are attributable to a particular risk (referred to as a fair value hedge).

1 An unrecognized firm commitment can be viewed as an executory contract that represents both a right and an

obligation. When a previously unrecognized firm commitment that is designated as a hedged item is accounted for in accordance with this Provision, an asset or a liability is recognized and reported in the statement of financial position related to the recognition of the gain or loss on the firm commitment. Consequently, subsequent references to an asset or liability in this Provision include a firm commitment.

The Supervisor of Banks: Reporting Provisions to the Public [2](10/02) Annual Financial Report

Page 661-23

2. To hedge the exposure to cashflow variability of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk (referred to as a cash flow hedge).

3. To hedge the foreign currency exposure of*:

(a) An unrecognized firm commitment (a foreign currency fair value** hedge). (b) An available-for-sale equity security (a foreign currency fair value hedge). (c) A forecasted transaction (a foreign currency cash flow hedge).

This Provision generally provides for matching between the timing of gain or loss recognition on the hedging instrument and the recognition of: (a) the changes in the fair value of the hedged asset or liability that are attributable to the

hedged risk, or (b) the effect of earnings on the hedged forecasted transaction. The Implementation Guidance provides guidance on identifying derivative instruments subject to the scope of this Provision and on assessing hedge effectiveness and is an integral part of the standards provided in this Provision.

* Including exposure to foreign currency of a recognized asset or liability (fair value or cashflow hedge). ** Or cashflow hedge in foreign currency.

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Page 661-24 22B. Derivative instruments (10/02) (2/06) a. A derivative instrument is a financial instrument or other contract with all three of the following

characteristics:

(1) It has (1) one or more underlyings and (2) one or more notional amounts1 or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.2

(2) It 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.

(3) Its terms require or permit net settlement, it can readily be settled net by a means outside the

contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Notwithstanding the foregoing, loan commitments that relate to the origination of mortgage loans

that will be held for sale shall be accounted for as derivative instruments by the issuer of the loan commitment (that is, the potential lender). Paragraph 22B.(e)(7) provides a scope exception for the accounting for loan commitments by issuers of certain commitments to originate loans and all holders of commitments to originate loans (that is, the potential borrowers).

b. Underlying, notional amount, and payment provision. An underlying is a specified interest rate,

security price, commodity price, foreign exchange rate, index of prices or (foreign or interest) rates, or other variable (including the occurrence or non-occurrence of a specified event such as a scheduled payment under a contract). An underlying may be a price or rate of an asset or liability but is not the asset or liability itself. A notional amount is a number of currency units, shares, bushels, pounds or other units specified in the contract. The settlement of a derivative instrument with a notional amount is determined by interaction of that notional amount with the underlying. The interaction may be simple multiplication, or it may involve a formula with leverage factors or other constants. A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner.

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1 Sometimes other names are used. For example, the notional amount is called a face amount in some contracts. 2 The terms underlying, notional amount, payment provision, and settlement are intended to include the plural

forms. Including both the singular and plural forms used in this paragraph is more accurate but much more awkward and impairs the readability.

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Page 661-24.1 c. Initial net investment. Many derivative instruments require no initial net investment. Some require

an initial net investment as compensation for time value (for example, a premium on an option) or for terms that are more or less favourable than market conditions (for example, a premium on a forward purchase contract with a price less than the current forward price). Others require a mutual exchange of currencies or other assets at inception, in which case the net investment is the difference in the fair values of the assets exchanged. A derivative instrument does not require an initial net investment in the contract that is equal to the notional amount (or the notional amount plus a premium or minus a discount) or that is determined by applying the notional amount to the underlying. If the initial net investment in the contract (after adjustment for the time value of money) is less, by more than a nominal amount, than the initial net investment that would be commensurate with the amount that would be exchanged either to acquire the asset related to the underlying or to incur the obligation related to the underlying, the characteristic in paragraph (a)(2) is met. The amount of that asset acquired or liability incurred should be comparable to the effective notional amount of the contract.42

d. Net settlement. A contract fits the description in paragraph a(3) if its settlement provisions meet one

of the following criteria:

(1) Neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount). For example, most interest rate swaps do not require that either party deliver interest-bearing assets with a principal amount equal to the notional amount of the contract.

(2) One of the parties is required to deliver an asset of the type described in paragraph d(1) but

there is a market mechanism that facilitates net settlement, for example, an exchange that offers a ready opportunity to sell the contract or to enter into an offsetting contract.

(3) One of the parties is required to deliver an asset of the type described in paragraph d(1) but

that asset is readily convertible to cash2 or is itself a derivative instrument. An example of that type of contract is a forward contract that requires delivery of an exchange-traded equity security. Even though the number of shares to be delivered is the same as the notional amount of the contract and the price of the shares is the underlying, an exchange-traded security is readily convertible to cash. Another example is a swaption - an option to require delivery of a swap contract, which is a derivative.

42 The effective notional amount is the stated notional amount adjusted for any leverage factor. 2 Assets that are readily convertible to cash have (1) interchangeable (fungible) units and (2) quoted prices

available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price. For contracts that involve multiple deliveries of the asset, the phrase “in an active market that can rapidly absorb the quantity held by the entity” should be applied separately to the expected quantity in each delivery.


Page 661-25

Derivative instruments embedded in other contracts are addressed in paragraphs 22C. e. Notwithstanding the conditions in paragraphs a - d, the following contracts are not subject to the

requirements of this Provision: (1) “Regular-way” security trades. Regular-way security trades are contracts that provide for

delivery of a security within the time generally established by regulations or conventions in the marketplace or exchange in which the transaction is being executed. However, a contract for an existing security does not qualify for the regular-way security trades exception if it requires or permits net settlement (as discussed in paragraphs d(1) and paragraph 22K.(a)(3)(a) or if a market mechanism to facilitate net settlement of that contract (as discussed in paragraphs (d)(2) and paragraph 22K.(a)(3)(b)) exists, except as provided in the following sentence. If an entity is required to account for a contract to purchase or sell an existing security on a trade-date basis, rather than a settlement-date basis, and thus recognizes the acquisition (or disposition) of the security at the inception of the contract, then the entity shall apply the regular-way security trades exception to that contract. A contract for the purchase or sale of when-issued securities or other securities that do not yet exist is addressed in paragraph 22K.(c).

(2) Normal purchases and normal sales. Normal purchases and normal sales are contracts

that provide for the purchase or sale of something other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business.


Annual Financial Report 61-26

The following guidance should be considered in determining whether a specific type of contract qualifies for the normal purchases and normal sales exception: (a) Forward contracts (non-option-based contracts). Forward contracts are eligible to

qualify for the normal purchases and normal sales exception. However, forward contracts that contain net settlement provisions as described in either sub-paragraphs (d)(1) or (d)(2), are not eligible for the normal purchases and normal sales exception unless it is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery. Net settlement (as described in sub-paragraphs (d)(1) and (d)(2)), of contracts in a group of contracts similarly designated as normal purchases and normal sales would call into question the classification of all such contracts as normal purchases or normal sales. Contracts that require cash settlements of gains or losses or are otherwise settled net on a periodic basis, including individual contracts that are part of a series of sequential contracts intended to accomplish ultimate acquisition or sale of a commodity, do not qualify for this exception.

(b) Freestanding option contracts. Option contracts that would require delivery of the

related asset at an established price under the contract only if exercised are not eligible to qualify for the normal purchases and normal sales exception.

(c) Forward contracts that contain optionality features. Forward contracts that contain

optionality features that do not modify the quantity of the asset to be delivered under the contract are eligible to qualify for the normal purchases and normal sales exception. If an option component permits modification of the quantity of the assets to be delivered, the contract is not eligible for the normal purchases and normal sales exception, unless the option component permits the holder only to purchase or sell additional quantities at the market price at the date of delivery. In order for forward contracts that contain optionality features to qualify for the normal purchases and normal sales exception the criteria discussed in sub-paragraph (e)(2)(a) must be met.

However, contracts that have a price based on an underlying that is not clearly and closely related to the asset being sold or purchased (such as a price in a contract for the sale of a grain commodity based in part on changes in the S&P Index) or that are denominated in a foreign currency that meets none of the criteria in paragraphs 22C.d.(1)- (4) shall not be considered normal purchases and normal sales. For contracts that qualify for the normal purchases and normal sales exception, the entity shall document the designation of the contract as a normal purchase or normal sale. For contracts that qualify for the normal purchases and normal sales exception, under sub-paragraphs 2(a) and (2)(c) the entity shall document the basis for concluding that it is probable that the contract will not settle net and result in physical delivery. The documentation requirements can be applied either to groups of similarly designated contracts or to each individual contract. Failure to comply with the documentation requirements precludes application of the normal purchases and normal sales exception to contracts that would otherwise qualify for that exception.

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Page 661-26.1 (3) Certain insurance contracts. Generally a contract of the type that is not subject to the

requirements of this Provision, if it entitles the holder to be compensated only if, as a result of an identifiable insurance event (other than a change in price), the holder incurs a liability or there is an adverse change in the value of a specific asset or liability for which the holder is at risk. The following types of contracts written by insurance enterprises or held by the banking corporation insured are not subject to the requirements of this Provision for the reasons given: (a) Traditional life insurance contracts. The payment of death benefits is the result of

an identifiable insurable event (death of the insured) instead of changes in a variable.

(b) Traditional property and casualty contracts. The payment of benefits is the result of an identifiable insurable event (for example, theft or fire) instead of changes in a variable.

However, insurance enterprises enter into other types of contracts that may be subject to the provisions of this Provision. In addition, some contracts with insurance or other enterprises combine derivative instruments, as defined in this Provision with other insurance products or non-derivative contracts, for example, indexed annuity contracts, variable life insurance contracts, and property and casualty contracts that combine traditional coverage with foreign currency options. Contracts that consist of both derivative portions and non-derivative portions are addressed in paragraph 22C.a..

(4) Financial guarantee contracts. Financial guarantee contracts are not subject to this

Provision only if: (a) they provide for payment to be made solely to reimburse the guaranteed party for

failure of the debtor to satisfy its required payment obligations under a non-derivative contract, either at pre-specified payment dates or accelerated payment dates as a result of the occurrence of an event of default (as defined in the financial obligation covered by the guarantee contract) or notice of acceleration being made to the debtor by the creditor.

(b) Payment under the financial guarantee is made only if the debtor’s obligation to make payments as a result of conditions as described in sub-paragraph (4)(a) above is past due.

(c) The guaranteed party is, as a pre-condition in the contract (or in the back-to-back arrangement, if applicable) for receiving payment of any claim under the guarantee, exposed to the risk of non-payment both at inception of the financial guarantee contract and throughout its term either through direct legal ownership of the guaranteed obligation or through a back-to-back arrangement with another party that is required by the back-to-back arrangement to maintain direct ownership of the guaranteed obligation.

In contrast financial guarantee contracts are subject to this Provision if they do not meet all of the above three criteria, for example, if they provide for payments to be made in response to changes in another underlying such as a decrease in a specified debtor’s creditworthiness.


Page 661-27

(5) Certain contracts that are not traded on an exchange. Contracts that are not exchange-traded are not subject to the requirements of this Provision if the underlying on which the settlement is based is one of the following: (a) A climatically or geological variable or other physical variable. (b) The price or value of

(1) a non-financial asset of one of the parties to the contract provided that the asset is not readily convertible to cash or

(2) a non-financial liability of one of the parties to the contract provided that the liability does not require delivery of an asset that is readily convertible to cash.

(c) Specified volumes of sales or service revenues of one of the parties to the contract.

If a contract has more than one underlying and some, but not all, of them qualify for one of the exceptions in paragraphs e.(5)(a), e.(5)(b) and e.(5)(c), the application of this Provision to that contract depends on its predominant characteristics. That is, the contract is subject to the requirements of this Provision if all of its underlyings, considered in combination, behave in a manner that is highly correlated with the behaviour of any of the component variables that do not qualify for an exception.

(6) Derivatives that serve as impediments to sales accounting. A derivative instrument

(whether freestanding or embedded in another contract) whose existence serves as an impediment to recognizing a related contract as a sale by one party or a purchase by the counter-party is not subject to this Provision. For example, the existence of a guarantee of the residual value of a leased asset by the lessor may be an impediment to treating a contract as a sales-type lease, in which case the contract would be treated by the lessor as an operating lease.

(7) Loan commitments. The holder of any commitment to originate a loan (that is, the

potential borrower) is not subject to the requirements of this Provision. Issuers of commitments to originate mortgage loans that will be held for investment purposes, are not subject to this Provision. In addition, issuers of loan commitments to originate other types of loans (that is, other than mortgage loans) are not subject to the requirements of this Provision.

f. Notwithstanding the conditions of paragraphs a - e, the reporting banking corporation shall not

consider the following contracts to be derivative instruments for purposes of this Provision: (1) Contracts issued or held by that reporting banking corporation that are both:

(a) indexed to its own stock, and (b) classified in stockholders’ equity in its statement of financial position.

(2) Contracts relating to share-based payment transactions, addressed in the Reporting Provisions to the Public - Paragraph 41A.

(3) Contracts issued by the banking corporation which reports consideration from a business combination. In applying this sub-paragraph, the issuer is consider to be the banking corporation that is accounting for the combination using the purchase method.

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Page 661-27.1 In contrast, the above exceptions do not apply to the counter-party in those contracts except for investment contracts in investee corporations addressed in Provision 32 of the Reporting Provision. In addition, a contract that a banking corporation either can or must settle by using its own equity instruments but that is indexed in part or in full to something other than its own stock can be a derivative instruments for the issuer under paragraphs a - e in which case it would be accounted for as a liability or an asset in accordance with the requirements of this Provision.

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Page 661-28 22C. Embedded derivative instruments (10/02) a. Contracts that do not in their entirety meet the definition of a derivative instruments (refer to

paragraphs 22B.a - d), such as bonds, insurance policies, and leases, may contain “embedded” derivative instruments - implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument. The effect of embedding a derivative instruments in another type of contract (“the host contract”) is that some or all of the cash flows or other exchanges that otherwise would be required by the host contract, whether unconditional or contingent upon the occurrence of a specified event, will be modified based on one or more underlyings. An embedded derivative financial instrument shall be separated from the host contract and accounted for as a derivative instrument pursuant to this Provision if and only if all of the following criteria are met:

1. The economic characteristics and risks of the embedded derivative instruments are not

clearly and closely related to the economic characteristics and risks of the host contract. Additional guidance on applying this criterion to various contracts containing embedded derivative instruments is included in the Schedule to the Provision.

2. The contract (“the hybrid instrument”) that embodies both the embedded derivative

instruments and the host contract is not remeasured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur.

3. A separate instrument with the same terms as the embedded derivative instruments

would, pursuant to paragraph 22B, be a derivative instruments subject to the requirements of this Provision. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative).

b. For purposes of applying the provisions of paragraph a., an embedded derivative instruments in

which the underlying is an interest rate or interest rate index1 that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract is considered to be clearly and closely related to the host contract unless either of the following conditions exist:

1. The hybrid instrument can contractually be settled in a such a way that the investor

(holder) would not recover substantially all of its initial recorded investment. 2 2. The embedded derivative meets both of the following conditions:

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1 Examples are an interest rate cap or an interest rate collar. An embedded derivative instrument that alters net

interest payments based on changes in a stock price index (or another non-interest-rate index) is not addressed in this paragraph.

2 The condition set out in this paragraph does not apply to situation which the terms of the hybrid instrument permit, but do not require, the investor to settle the hybrid instrument in a manner that causes it not to recover substantially all of its initial recorded investment, provided that the issuer does not have the contractual right to demand settlement that causes the investor not to recover substantially all of its initial net investment.


Page 661-28.1 (a) There is a possible future interest rate scenario (even though it may be remote) under

which the embedded derivative would at least double the investor’s initial rate of return on the host contract.

(b) For each of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed under sub-paragraph (b)(2)(a)), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under each of those future interest rate scenarios) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.

Even though the above conditions focus on the investor’s rate of return and the investor’s

recovery of its investment, the existence of either of those conditions would result in the embedded derivative instruments not being considered clearly and closely related to the host contract by both parties to the hybrid instrument. Because the existence of those conditions is assessed at the date that the hybrid instrument is acquired (or incurred) by the reporting banking corporation, the acquirer of a hybrid instrument in the secondary market could potentially reach a different conclusion than could the issuer of the hybrid instrument due to applying the conditions in this paragraph at different points in time.

c. However, interest-only strips and principal-only strips are not subject to the requirements of this

Provision provided they: (1) initially resulted from separating the rights to receive contractual cash flows of a financial

instrument that, in and of itself, did not contain an embedded derivative that otherwise would have been accounted for separately as a derivative pursuant to the provisions of paragraphs a. and b., and

(2) do not incorporate any terms not present in the original financial instrument described above.

d. An embedded foreign currency derivative instrument shall not be separated from the host

contract and considered a derivative instrument under paragraph a. if the host contract is not a financial instrument and it requires payment(s) denominated in: (1) the functional currency of any substantial party to that contract , (2) the currency in which the price of the related good or price that is acquired or delivered is

routinely denominated in international commerce,1 (3) The local currency of any substantial party to the contract, or (4) The currency used by a substantial party to the contract as if it were the functional

currency because the primary economic environment in which the party operates is highly inflationary.

1 If similar transactions for a certain product or service are routinely denominated in international commerce

in various different currencies, the transaction does not qualify for the exception.


Page 661-29 The evaluation of whether a contract qualifies for the exception in this paragraph should be

performed only at the inception of the contract. Unsettled foreign currency transactions, including financial instruments, that are monetary items and have their principal payments, interest payments, or both denominated in a foreign currency are subject to the Reporting Provisions to the Public - paragraphs 11 and 12 to recognize any foreign currency transaction gain or loss in earnings and shall not be considered to contain embedded foreign currency derivative instruments under this Provision. The same proscription applies to available-for-sale or trading securities that have cash flows denominated in a foreign currency.

e. In these provisions, both (1) a derivative instruments included within the scope of this Provision

by paragraph 22B., and (2) an embedded derivative instrument that has been separated from a host contract as required by paragraph a. are collectively referred to as derivative instruments. If an embedded derivative instrument is separated from its host contract, the host contract shall be accounted for based on generally accepted accounting principles applicable to instruments of that type that do not contain embedded derivative instruments. If a banking corporation cannot reliably identify and measure the embedded derivative instrument that paragraph a. requires be separated from the host contract, the entire contract shall be measured at fair value with gain or loss recognized in earnings, but it may not be designated as a hedging instrument pursuant to this Provision.


Page 661-30 22D. Recognition of Derivatives and Measurement of Derivatives and Hedged Items (10/02) a. A banking corporation shall recognize all of its derivative instruments in its statement of

financial position as either assets or liabilities depending on the rights or obligations under the contracts. All derivative instruments shall be measured at fair value. The guidance in the Reporting Provisions to the Public shall apply in determining the fair value of financial instruments (derivative or hedged item). If expected future cash flows are used to estimate fair value, those expected cash flows shall be the best estimate based on reasonable and supportable assumptions and projections. All available evidence shall be considered in developing estimates of expected future cash flows. The weight given to the evidence shall be commensurate with the extent to which the evidence can be verified objectively. If a range is estimated for either the amount or the timing of possible cash flows, the likelihood of possible outcomes shall be considered in determining the best estimate of future cash flows.

b. The accounting for changes in the fair value (that is, gains or losses) of a derivative depends on

whether it has been designated and qualifies as part of a hedging relationship and, if so, on the reason for holding it. Either all or a proportion of a derivative may be designated as the hedging instrument. The proportion must be expressed as a percentage of the entire derivative so that the profile of risk exposures in the hedging portion of the derivative is the same as that in the entire derivative. (Thus, a banking corporation is prohibited from separating a compound derivative into components representing different risks and designating any such component as the hedging instrument except as permitted at the date of initial application by the transitional provisions for 2003, in paragraph 1). Subsequent references in this Provision to a derivative as a hedging instrument include the use of only a proportion of a derivative as a hedging instrument. Two or more derivatives, or proportions thereof, may also be viewed in combination and jointly designated as the hedging instrument. Gains and losses on derivative instruments are accounted for as follows:

(1) No hedging designation. The gain or loss on a derivative instrument not designated as a

hedging instrument shall be recognized currently in earnings. (2) Fair value hedge. The gain or loss on a derivative instrument designated and qualifying

as a fair value hedging instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk shall be recognized currently in earnings in the same accounting period, as provided in paragraph 22E.c.- d..

(3) Cash flow hedge. The effective portion of the gain or loss on a derivative instrument

designated and qualifying as a cash flow hedging instrument shall be reported as a component of other comprehensive income (outside earnings) under earnings (losses) net, in respect of cashflow hedges and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings, as provided in paragraphs 22F.c. and d.. The remaining gain or loss on the derivative instrument, if any, shall be recognized currently in earnings, as provided in paragraph22Fc..



(4) Foreign currency hedge. The gain or loss on a derivative instrument or nonderivative financial instrument designated and qualifying as a foreign currency hedging instrument shall be accounted for as follows: (a) The gain or loss on the hedging derivative or nonderivative instrument in a hedge

of a foreign currency-denominated firm commitment and the offsetting loss or gain on the hedged firm commitment shall be recognized currently in earnings in the same accounting period, as provided in paragraph22G.c..

(b) The gain or loss on the hedging derivative instrument in a hedge of an available-for-sale security and the offsetting loss or gain on the hedged available-for-sale security shall be recognized currently in earnings in the same accounting period as provided in paragraph 22G.e.

(c) The effective portion of the gain or loss on the hedging derivative instrument in a hedge of a forecasted foreign-currency-denominated transaction shall be reported as a component of other comprehensive income (outside earnings) under earnings (losses) net, in respect of cashflow hedges and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings, as provided in paragraph 22G.k. The remaining gain or loss on the hedging instrument shall be recognized currently in earnings.


Page 661-32 22E. Fair Value Hedges (10/02) (2/06)

General a. A banking corporation 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. Designated hedging instruments and hedged items qualify for fair value hedge accounting if all of the following criteria and those in paragraph b. are met: (1) At inception of the hedge, there is formal documentation of the hedging relationship and

the banking corporation’s risk management objective and strategy for undertaking the hedge, including identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value attributable to the hedged risk will be assessed. There must be a reasonable basis for how the banking corporation plans to assess the hedging instrument’s effectiveness. (a) For a fair value hedge of a firm commitment, the banking corporation’s formal

documentation at the inception of the hedge must include a reasonable method for recognizing in earnings the asset or liability representing the gain or loss on the hedged firm commitment.

(b) A banking corporation’s defined risk management strategy for a particular hedging relationship may exclude certain components of a specific hedging derivative’s change in fair value, such as time value, from the assessment of hedge effectiveness, as discussed in paragraph b. of Chapter 2 of the Implementation Guidance.

(2) Both at inception of the hedge and on an ongoing basis, 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. An assessment of effectiveness is required whenever the financial statements or earnings are reported, and at least every three months. If the hedging instrument (such as an at-the-money option contract) provides only one-sided offset of the hedged risk, the increases (or decreases) in the fair value of the hedging instrument must be expected to be highly effective in offsetting the decreases (or increases) in the fair value of the hedged item. All assessments of effectiveness shall be consistent with the risk management strategy documented for that particular hedging relationship (in accordance with paragraph a(1) above).

(3) If a written option is designated as hedging a recognized asset or liability, or an

unrecognized firm commitment, the combination of the hedged item and the written option provides at least as much potential for gains as a result of a favourable change in

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the fair value of the combined instruments1 as exposure to losses from an unfavourable change in their combined fair value. That test is met if all possible percentage favourable changes in the underlying (from zero to 100 percent) would provide at least as much gain as the loss that would be incurred from an unfavourable change in the underlying of the same percentage.

A combination of options (for example, an interest rate collar) entered into contemporaneously shall be considered a written option if either at inception or over the life of the contracts a net premium is received in cash or as a favourable rate or other term. (Thus, a collar can be designated as a hedging instrument in a fair value hedge without regard to the test in paragraph a.(3) unless a net premium is received). Furthermore a derivative instrument that results from combining a written option and any other non-option derivative shall be considered a written option.

A non-derivative instrument, such as a Government bond, shall not be designated as a

hedging instrument, except as provided in paragraph 22G.c. to this Provision. The Hedged Item b. An asset or a liability is eligible for designation as a hedged item in a fair value hedge if all of

the following criteria are met:

(1) 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.2 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). (a) If similar assets or similar liabilities are aggregated and hedged as a portfolio, the

individual assets or individual liabilities must share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio must be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk. That is, 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 to 11 percent.

1 The reference to combined instruments refers to the written option and the hedged item, such as an

embedded purchased option. 2 A firm commitment that represents an asset or liability that a specific accounting standard prohibits

recognizing (such as a non-cancellable operating lease) may nevertheless be designated as the hedged item in a fair value hedge. A supply contract which the contract price is fixed only in certain circumstances (such as when the selling price is above an embedded price cap or below an embedded price floor) meets the definition of a firm commitment for purposes of designating the hedged item in a fair value hedge. Provided the embedded price cap or floor is considered clearly and closely related to the host contract and therefore is not accounted for separately under paragraph 22C.(a), either party to the supply contract can hedge the fair value exposure arising from the cap or floor.



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 to 13 percent would be inconsistent with this Provision. In aggregating loans in a portfolio to be hedged, a banking corporation may choose to consider some of the following characteristics, as appropriate: loan type, loan size, nature and location of collateral, interest rate type (fixed or variable) and the coupon interest rate (if fixed), scheduled maturity, prepayment history of the loans (if seasoned) and expected prepayment performance in varying interest rate scenarios.

(b) If the hedged item is a specific portion of an asset or liability (or of a portfolio of similar assets or a portfolio of similar liabilities), the hedged item is one of the following: (1) a percentage of the entire asset or liability (or of the entire portfolio). (2) one or more selected contractual cash flows (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).

(3) a put option or a call option (including an interest rate or price cap or an interest rate or price floor) embedded in an existing asset or liability that is not an embedded derivative accounted for separately pursuant to paragraph 22C.a. of this Provision;

(4) The residual value in a lessor’s net investment in a direct financing or sales-type lease.

If the entire asset or liability is an instrument with variable cash flows, the hedged item cannot be deemed to be an implicit fixed-to-variable swap (or similar instrument) perceived to be embedded in a host contract with fixed cash flows.

(2) The hedged item presents an exposure to the banking corporation to changes in fair value

attributable to the hedged risk that could affect reported earnings. (3) The hedged item is not:

(a) An asset or liability that is re-measured with the changes in fair value attributable to the hedged risk reported currently in earnings,

(b) an investment accounted for by the equity method, (c) a minority interest in one or more consolidated subsidiaries, (d) an equity investment in a consolidated subsidiary, (e) a firm commitment either to enter into a business combination or to acquire or

dispose of a subsidiary, a minority interest, or an equity method investee, or (f) an equity instrument issued by the banking corporation and classified in

stockholders’ equity in its financial position.



(4) If the hedged item is all or a portion of a debt security (or a portfolio of similar debt securities), that is classified as held-to-maturity in accordance with the Reporting Provisions to the Public, the designated risk being hedged is the risk of changes in its fair value attributable to credit risk, foreign exchange risk, or both. If the hedged item is an option component of a held-to-maturity security that permits its pre-payment, the designated risk being hedged is the risk of changes in the entire fair value of that option component. (The designated hedged-risk of a held-to-maturity debt security cannot be the risk of changes in fair value attributable to an interest rate risk.

If the hedged item is other than an option component that permits its pre-payment, the designated hedged risk also may not be the risk of changes in its overall fair value).

(5) If the hedged item is a non-financial asset or liability (other than a non-financial firm

commitment with financial components), the designated risk being hedged is the risk of changes in the fair value of the entire hedged asset or liability (reflecting its actual location if a physical asset). That is, the price risk of a similar asset in a different location or of a major ingredient may not be the hedged risk.

(6) If the hedged item is a financial asset or liability, or a non-financial firm commitment

with financial components, the designated risk being hedged is: (a) The risk of changes in the overall fair value of the entire hedged item, (b) the risk of changes in its fair value attributable to changes in the designated

benchmark interest rate, (hereinafter: "interest-rate risk"). (c) the risk of changes in its fair value attributable to changes in the related foreign

currency exchange rates (referred to as foreign exchange risk) (refer to paragraphs 22G. c.-e.), or

(d) the risk of changes in its fair value attributable to both changes in the obligor’s credit-worthiness and changes in the spread over the benchmark interest rate with respect to the hedged item's credit sector at inception of the hedge (referred to as credit risk).

If the risk designated as being hedged is not the risk in paragraph b.(6)(a) above, two or more of the other risks (interest rate risk, foreign currency exchange risk, and credit risk) may simultaneously be designated as being hedged. The benchmark interest rate being hedged in a hedge of interest rate risk must be specifically identified as part of the designation and documentation at the inception of the hedging relationship. Ordinarily, an entity should designate the same benchmark interest rate as the risk being hedged for similar hedges, consistent with paragraph a of Chapter 2 of the Implementation Guidance;


Page 661-36

the use of different benchmark interest rates for similar hedges should be rare and must be justified. In calculating the change in the hedged item's fair value attributable to changes in the benchmark interest rate, the estimated cash flows used in calculating fair value must be based on all of the contractual cash flows of the entire hedged item. Excluding some of the hedged item's contractual cash flows (for example, the portion of the interest coupon in excess of the benchmark interest rate) from the calculation is not permitted.1 A banking corporation may not simply designate pre-payment risk as the risk being hedged for a financial asset. However, it can designate the option component of a pre-payable instrument as the hedged item in a fair value hedge of the banking corporation’s exposure to changes in the overall fair value of that “pre-payment” option, perhaps thereby achieving the objective of the banking corporation's desire to hedge pre-payment risk. The effect of an embedded derivative of the same risk class must be considered in designating a hedge of an individual risk. For example, the effect of an embedded pre-payment option must be considered in designating a hedge of interest-rate risk.

c. Gains and losses on a qualifying fair value hedge shall be accounted for as follows:

(1) The gain or loss on the hedging instrument shall be recognized currently in earnings. (2) The gain or loss (that is, the change in fair value) on the hedged item attributable to the

hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings.

If the fair value hedge is fully effective, the gain or loss on the hedging instrument, adjusted for

the component, if any, of that gain or loss that is excluded from the assessment of effectiveness under the banking corporation’s defined risk management strategy for that particular hedging relationship (as stated in paragraph b. in Chapter 2 of the Implementation Guidance), would exactly offset the loss or gain on the hedged item attributable to the hedged risk. Any difference that does arise would be the effect of hedge ineffectiveness, which consequently is recognized currently in earnings. The measurement of hedge ineffectiveness for a particular hedging relationship shall be consistent with the banking corporation’s risk management strategy and the method of assessing hedge effectiveness that was documented at the inception of the hedging relationship, as discussed in paragraph a.(1). Nevertheless, the amount of hedge ineffectiveness recognized in earnings is based on the extent to which exact offset is not achieved. Although a hedging relationship must comply with the banking corporation’s established policy of what is considered “highly effective” pursuant to paragraph a.(2) in order for that relationship to qualify for hedge accounting, that compliance does not assure zero

1 The first sentence of paragraph b.(1) that specifically permits the hedged item to be identified as either all or

a specific portion of a recognized asset or liability or of an unrecognized firm commitment is not affected by the provisions in this sub-paragraph.



ineffectiveness. Chapter 2 of the Implementation Guidance illustrates assessing hedge effectiveness and measuring hedge ineffectiveness. Any hedge ineffectiveness directly affects earnings because there will be no offsetting adjustment of a hedged item’s carrying amount for the ineffective aspect of the gain or loss on the related hedging instrument.

d. If a hedged item is otherwise measured at fair value with changes in fair value reported in other

comprehensive income (such as an available-for-sale security), the adjustment of the hedged item’s carrying amount discussed in paragraph c., shall be recognized in earnings rather than in other comprehensive income in order to offset the gain or loss on the hedging instrument.

e. The adjustment of the carrying amount of a hedged asset or liability required by paragraph c.,

shall be accounted for in the same manner as other components of the carrying amount of that asset or liability. For example, an adjustment of the carrying amount of a hedged asset held-for-sale would remain part of the carrying amount of that asset until the asset is sold, at which point the entire carrying amount of the hedged asset would be recognized as the cost of the item sold in determining earnings. An adjustment of the carrying amount of a hedged interest-bearing financial instrument shall be amortized to earnings; amortization shall begin from the date of the inception of the hedge, according to the uniform yield method.

f. A banking corporation shall discontinue prospectively the accounting specified in paragraphs c.,

and d., for an existing hedge if any one of the following occurs:

(1) Any criterion in paragraphs a., and b., is no longer met. (2) The derivative expires or is sold, terminated, or exercised. (3) The banking corporation removes the designation of the fair value hedge.

In those circumstances, the banking corporation may elect to designate prospectively a new hedging relationship with a different hedging instrument or, in the circumstances described in paragraphs f.(1) to f.(3) above, a different hedged item or a hedged transaction if the hedging relationship meets the criteria specified in paragraphs a. and b. for a fair value hedge or paragraphs 22F. a., and b., for a cash flow hedge.

g. In general, if a periodic assessment indicates non-compliance with the effectiveness criterion in

paragraph a.(2), a banking corporation shall not recognize the adjustment of the carrying amount of the hedged item described in paragraphs c., and d., after the last date on which compliance with the effectiveness criterion was established. However, if the event or change in



circumstances that caused the hedging relationship to fail the effectiveness criterion can be identified, the banking corporation shall recognize in earnings the changes in the hedged item’s fair value attributable to the risk being hedged that occurred prior to that event or change in circumstances. If a fair value hedge of a firm commitment is discontinued because the hedged item no longer meets the definition of a firm commitment, the banking corporation shall derecognize any asset or liability previously recognized pursuant to paragraph c., (as a result of an adjustment to the carrying amount for the firm commitment) and recognize a corresponding loss or gain currently in earnings.

Impairment h. An asset or liability that has been designated as being hedged and accounted for pursuant to

paragraphs c., - e., remains subject to the applicable requirements in generally accepted accounting principles for assessing impairment for that type of asset or for recognizing an increased obligation for that type of liability. Those impairment requirements shall be applied after hedge accounting has been applied for the period and the carrying amount of the hedged asset or liability has been adjusted pursuant to paragraph c., of this Provision. Because the hedging instrument is recognized separately as an asset or liability, its fair value or expected cash flows shall not be considered in applying those impairment requirements to the hedged asset or liability.



22F. Cash Flow Hedges (10/02)

General a. A banking corporation 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 an existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt) or a forecasted transaction (such as a forecasted purchase or sale)1. Designated hedging instruments and hedged items or transactions qualify for cash flows hedge accounting if all of the following criteria and those in paragraph b., are met:

(1) At inception of the hedge, there is formal documentation of the hedging relationship and

the banking corporation’s risk management objective and strategy for undertaking the hedge, including identification of the hedging instrument, the hedged transaction, the nature of the risk being hedged, and how the hedging instrument’s effectiveness in hedging the exposure to the hedged transaction’s variability in cash flows attributable to the hedged risk will be assessed. There must be a reasonable basis for how the banking corporation plans to assess the hedging instrument’s effectiveness.

(a) A banking corporation’s defined risk management strategy for a particular hedging

relationship may exclude certain components of a specific hedging derivative’s change in fair value from the assessment of hedge effectiveness, as discussed in paragraph b. in Chapter 2 of the Implementation Guidance.

(b) Documentation shall include all relevant details, including the date on or period

within which the forecasted transaction is expected to occur, the specific nature of asset or liability involved (if any), and the expected currency amount or quantity of the forecasted transaction.

(1) The phrase expected currency amount refers to hedges of foreign currency

exchange risk and requires specification of the exact amount of foreign currency being hedged.

(2) The phrase expected quantity refers to hedges of other risks and requires

specification of the physical quantity (that is, the number of items or units of measure) encompassed by the hedged forecasted transaction. If a forecasted sale or purchase is being hedged for price risk, the hedged transaction cannot be specified solely in terms of expected currency amounts, nor can it be specified as a percentage of sales or purchases during a period. The current price of a forecasted transaction also should be identified to satisfy the criterion of paragraph a.(2) for offsetting cash flows.

1 For purposes of paragraphs 22F., the individual cash flows related to a recognized asset or liability and the

cash flows related to a forecasted transaction are both referred to as a forecasted transaction or hedged transaction.



The hedged forecasted transaction shall be described with sufficient specificity so that

when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction. Thus, the forecasted transaction could be identified as the sale of either the first 15,000 units of a specific product sold during a specified 3-month period or the first 5,000 units of a specific product sold in each of 3 specific months, but it could not be identified as the sale of the last 15,000 units of that product sold during a 3-month period (because the last 15,000 units cannot be identified when they occur, but only when the period has ended).

(2) Both at inception of the hedge an on an ongoing basis, the hedging relationship is

expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge, except as indicated in paragraph a.,(4) below. An assessment of effectiveness is required whenever financial statements are reported, and at least every three months. If the hedging instrument, such as an at-the-money option contract, provides only one-sided offset against the hedged risk, the cash inflows (outflows) from the hedging instrument must be expected to be highly effective in offsetting the corresponding change in the cash outflows or inflows of the hedged transaction. All assessments of effectiveness shall be consistent with the originally documented risk management strategy for that particular hedging relationship.

(3) If a written option is designated as hedging the variability in cash flows for a recognized

asset or liability or an unrecognized firm commitment, the combination of the hedged item and the written option provides at least as much potential for favourable cash flows as exposure to unfavourable cash flows. That test is met if all possible percentage favourable changes in the underlying (from zero to 100 percent) would provide at least as much favourable cash flows as the unfavourable cash flows that would be incurred from an unfavourable change in the underlying of the same percentage (see paragraph.a.(3) of paragraph 22E).

(4) If a hedging instrument is used to modify the interest receipts or payments associated

with a recognized financial asset or liability from one variable rate to another variable rate, the hedging instrument must be a link between an existing designated asset (or group of similar assets) with variable cash flows and an existing designated liability (or group of similar liabilities) with variable cash flows and be highly effective at achieving offsetting cash flows. A link exists if the basis (that is, the rate index on which the interest rate is based) of one leg of an interest rate swap is the same as the basis of the interest receipts for the designated asset and the basis of the other leg of the swap is the same as the basis of the interest payments for the designated liability. In this situation, the criterion in the first sentence in paragraph b.(1) is applied separately to the designated asset and the designated liability.

A non-derivative instrument such as a Government bond shall not be designated as a hedging

instrument for a cash flow hedge.


Page 661-41 The Hedged Forecasted Transaction b. A forecasted transaction is eligible for designation as a hedged transaction in a cash flows hedge

if all of the following additional criteria are met:

(1) The forecasted transaction is specifically identified as a single transaction or a group of individual transactions. If the hedged transaction is a group of individual transactions, those individual transactions must share the same risk exposure for which they are designated as being hedged. Thus, a forecasted purchase and a forecasted sale cannot both be included in the same group of individual transactions that constitute the hedged transaction.

(2) The occurrence of the forecasted transaction is probable (3) The forecasted transaction is a transaction with a party external to the reporting banking

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

(4) 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.

(5) If the variable cash flows of the forecasted transaction relate to a debt security that is

classified as held-to-maturity, the risk being hedged is the risk of changes in its cash flows attributable to credit-risk, foreign exchange risk, or both. For those variable cash flows, the risk being hedged cannot be the risk of changes in cash flows attributable to interest rate risk.

(6) The forecasted transaction does not involve a business combination and is not a

transaction (such as a forecasted purchase, sale, or dividend) involving: (a) a parent company’s interests in consolidated subsidiaries, (b) a minority interest in a consolidated subsidiary, (c) an equity-method investment, or (d) a banking corporation’s own equity instruments.

(7) If the hedged transaction is the forecasted purchase or sale of a non-financial asset, the

designated risk being hedged is:

(a) the risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates, or

(b) The risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset, reflecting its actual location if a physical asset, (whether

.



such price and the related cash flows functional are denominated in the banking corporation's currency or foreign-currency-denominated) not the risk of changes in the cash flows relating to the purchase or sale of a similar asset in a different location or of a major ingredient.

(8) 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:

(a) 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 (regardless of whether that price and the related cash flows are stated in the banking corporation’s functional currency or a foreign currency),

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

(c) the risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates (referred to as foreign exchange risk) (refer to paragraphs 22G., g. - j.,), or

(d) the risk of changes in its cash flows attributable to default, changes in the obligor’s credit-worthiness, and changes in the spread over the benchmark interest rate with respect to the hedged item's credit sector at inception of the hedge (referred to as credit risk).

Two or more of the above risks may be designated simultaneously as being hedged. The benchmark interest rate being hedged in a hedge of interest rate risk must be specifically identified as part of the designation and documentation at the inception of the hedging relationship. Ordinarily, an entity should designate the same benchmark interest rate as the risk being hedged for similar hedges, consistent with paragraph a., of Chapter 2 of the Application Guide; the use of different benchmark interest rates for similar hedges should be rare and must be justified. In a cash flow hedge of a variable-rate financial asset or liability, either existing or forecasted, the designated risk being hedged cannot be the risk of changes in its cash flows attributable to changes in the specifically identified benchmark interest rate if the cash flows of the hedge transaction are explicitly based on a different index, for example, based on a specific bank's prime rate, which cannot qualify as the benchmark rate. However, the risk designated as being hedged could potentially be the risk of overall changes in the hedged cash flows related to the asset or liability,


Page 661-43

provided that the other criteria for a cash flow hedge have been met. A banking corporation may not designate the risk of pre-payment as the risk being hedged (refer to paragraph 22 E.b.(6)).

c. The effective portion of the gain or loss on a derivative designated as a cash flow hedge is

reported in other comprehensive income, in earnings (losses) net in respect of cashflow hedges, and the ineffective portion is reported in earnings. More specifically, a qualifying cash flow hedge shall be accounted for as follows:

(1) If a banking corporation’s defined risk management strategy for a particular hedging

relationship excludes a specific component of the gain or loss, or related cash flows, on the hedging derivative from the assessment of hedge effectiveness (as discussed in paragraph b., Chapter 2 of the Implementation Guidance), that excluded component of the gain or loss shall be recognized currently in earnings. For example, if the effectiveness of a hedge with an option contract is assessed based on changes in the option’s intrinsic value, the changes in the option’s time value would be recognized in earnings. Time value is equal to fair value of the option less its intrinsic value.

(2) Accumulated other comprehensive income associated with the hedged transaction shall

be adjusted to a balance that reflects the lesser of the following (in absolute amounts):

(a) The cumulative gain or loss on the derivative from inception of the hedge less: (1) the excluded component discussed in paragraph c.(1) above and (2) the derivative’s gains or losses previously reclassified from accumulated

other comprehensive income into earnings pursuant to paragraph d.

(b) The portion of the cumulative gain or loss on the derivative necessary to offset the cumulative change in expected future cash flows on the hedged transaction from inception of the hedge less the derivative’s gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraph d.

That adjustment of accumulated other comprehensive income shall incorporate recognition in other comprehensive income of part or all of the gain or loss on the hedging derivative, as necessary.

(3) A gain or loss shall be recognized in earnings, as necessary, for any remaining gain or

loss on the hedging derivative or to adjust other comprehensive income to the balance specified in paragraph (c)(2) above.

(4) In a cash flow hedge of the variability of the functional-currency-equivalent cash flows

for a recognized foreign-currency-denominated asset or liability that is remeasured according to the Reporting Provisions to the Public, the following will apply: (a) If a non-option based contract is the hedging instrument in a cashflow hedge of the

variability of the cashflows for a recognized foreign currency denominated asset or liability that is remeasured as stated, an amount that will offset the related transaction gain or loss arising from that remeasurement shall be reclassified each period from other comprehensive income to earnings.



If the assessment of effectiveness and measurement of ineffectivess are based on total changes in the non-option based instruments cashflows.

(b) If an option contract is used as the hedging instrument in a cashflow hedge of the

variability of the functional-currency-denominated asset or liability that is remeasured as stated, to provide only one-sided offset against the hedged foreign exchange risk, an amount shall be reclassified each period to or from other comprehensive income with respect to the changes in the underlying that result in a change in the hedging option’s intrinsic value. In addition, if the assessment of effectiveness and measurement of ineffectiveness are also based on total changes in the option’s cash flows (that is, the assessment will include the hedging instrument’s entire change in fair value – its entire gain or loss), an amount that adjusts earnings for the amortization of the cost of the option on a rational basis shall be reclassified each period from other comprehensive income to earnings.1

Section 2 of the Implementation Guidance illustrates assessing hedge effectiveness and

measuring hedge ineffectiveness. d. Amounts in accumulated other comprehensive income shall be re-classified into earnings in the

same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs). If the hedged transaction results in the acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the asset acquired or liability incurred affects earnings (such as in the periods that depreciation expense or interest expense is recognized). However, if a banking corporation expects at any time that continued reporting of a loss in accumulated other comprehensive income would lead to recognizing a net loss on the combination of the hedging instrument and the hedged transaction (and related asset acquired or liability incurred) in one or more future periods, a loss shall be reclassified immediately into earnings for the amount that is not expected to be recovered. For example, a loss shall be reported in earnings for a derivative that is designated as hedging a forecasted credit-advance transaction to the extent that the carrying amount of the advanced plus the related amount reported in accumulated other comprehensive income exceeds the amount expected to be recovered on the credit advanced. (Impairment guidance is provided in paragraphs g. and h.).

e. A banking corporation shall discontinue prospectively the accounting specified in paragraphs c.,

and d., for an existing hedge if any one of the following occurs:

(1) Any criterion in paragraphs a. and b. is no longer met.

Next page 661-44.1

1 The guidance in this sub-paragraph is limited to foreign currency hedging relationships because of their

unique attributes. That accounting guidance is an exception for foreign currency hedging relationships.


Page 661-44.1 (2) The derivative expires or is sold, terminated, or exercised. (3) The banking corporation removes the designation of the cash flow hedge. In those circumstances, the net gain or loss shall remain in accumulated other comprehensive income and be reclassified into earnings as specified in paragraph d. Furthermore, the banking corporation may elect to designate prospectively a new hedging relationship with a different hedging instrument or, in the circumstances described in paragraphs e.(1) and e.(3), a different hedged transaction or a hedged item if the hedging relationship meets the criteria specified in paragraphs a., and b., for a cash flow hedge or paragraphs 22E. a., and b., for a fair value hedge.

f. The net derivative gain or loss related to a discontinued cash flow hedge shall continue to be reported in accumulated other comprehensive income unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period (as documented at the inception of the hedging relationship) or within an additional two-month period of time thereafter, except as indicated in the following sentence. In rare cases, the existence of extenuating circumstances that are related to the nature of the forecasted transaction and are outside the control or influence of the reporting entity may cause the forecasted transaction to be probable of occurring on a date that is beyond the additional two-month period of time, in which case the net derivative gain or loss related to the discontinued cash flow hedge shall continue to be reported in accumulated other comprehensive income until it is reclassified into earnings pursuant to paragraph d. If it is probable that the hedged forecasted transaction will not occur either by the end of the originally specified time period or within the additional two-month period of time and the hedged forecasted transaction also does not qualify for the exception described in the preceding sentence, that derivative gain or loss reported in accumulated other comprehensive income shall be reclassified into earnings immediately.

g. Existing requirements in generally accepted accounting principles for assessing asset

impairment or recognizing an increased obligation apply to an asset or liability that gives rise to variable cash flows (such as a variable-rate financial instrument), for which the variable cash flows (the forecasted transactions) have been designated as being hedged and accounted for pursuant to paragraphs c. and d. Those impairment requirements shall be applied each period after hedge accounting has been applied for the period pursuant to paragraphs c. and d. of this Provision. The fair value or expected cash flows of a hedging instrument shall not be considered in applying those requirements. The gain or loss on the hedging instrument in accumulated other comprehensive income shall, however, be accounted for as discussed in paragraph d.

Next page 661-45


Page 661-45 h. If, under existing requirements in generally accepted accounting principles, an impairment loss

is recognized on an asset or an additional obligation is recognized on a liability to which a hedged forecasted transaction relates, any offsetting net gain related to that transaction in accumulated other comprehensive income shall be reclassified into earnings. Similarly, if a recovery is recognized on the asset or liability to which the forecasted transaction relates, any offsetting net loss that has been accumulated in other comprehensive income shall be reclassified immediately into earnings.


Page 661-46 22G. Foreign Currency Hedges (10/02) (2/06) a. If the hedged item is denominated in foreign currency, a banking corporation may designate the

following types of hedges of foreign currency exposure,1 as specified in paragraphs b. - k:

(1) A fair value hedge of an unrecognized firm commitment or a recognized asset or liability (including an available-for-sale security).

(2) A cash flow hedge of a forecasted transaction, an unrecognized firm commitment, the forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability, or a forecasted intercompany transaction.

The recognition in earnings of the foreign currency transaction gain or loss on a foreign-

currency-denominated asset or liability based on changes in the foreign currency spot rate is not considered to be the remeasurement of that asset or liability with changes in fair value attributable to foreign exchange risk recognized in earnings, which is discussed in the criteria in paragraphs 22E.b.(3)(a) and b.(4) of paragraph 22F. Thus, those criteria are not impediments to either a foreign currency fair value or cash flow hedge of such a foreign-currency-denominated asset or liability or a foreign currency cash flow hedge of the forecasted acquisition or incurrence of a foreign-currency-denominated asset or liability whose carrying amount will be remeasured at spot exchange rates according to the Reporting Provisions to the Public. A foreign currency derivative instrument that has been entered into with another member of a consolidated group can be a hedging instrument in a fair value hedge or in a cash flow hedge of a recognized foreign-currency-denominated asset or liability in the consolidated financial statements only if that other member has entered into an offsetting contract with an unrelated third party to hedge the exposure it acquired from issuing the derivative instrument to the affiliate that initiated the hedge.

b. The provisions of paragraph a., that permit a recognized foreign-currency-denominated asset or

liability to be the hedged item in a fair value or cash flow hedge of foreign currency exposure also pertain to a recognized foreign-currency-denominated receivable or payable that results from a hedged forecasted foreign-currency-denominated sale or purchase on credit. A banking corporation may choose to designate a single cash flow hedge that encompasses the variability

Next page 661-46.1

1 Notwithstanding the foregoing, a banking corporation is entitled not to vary the accounting treatment of

foreign currency – hedged relationships that will be applied in the financial statements of a subsidiary or branch abroad, that are the “remote extension” of the banking corporation, if the financial statements are: (a) Drawn according to the U.S. GAAP (accepted accounting rules in the U.S.) or according to International

Financial Reporting Standards published by the International Accounting Standards Board, and (b) Have been included in the report of the extension, to its own governing authority.


Page 661-46.1 of functional currency cash flows attributable to foreign exchange risk related to the settlement of the foreign-currency-denominated receivable or payable resulting from a forecasted sale or purchase on credit. Alternatively, a banking corporation may choose to designate a cash flow hedge of the variability of functional currency cash flows attributable to foreign exchange risk related to a forecasted foreign-currency-denominated sale or purchase on credit and then separately designate a foreign currency fair value hedge of the resulting recognized foreign-currency-denominated receivable or payable. In that case, the cash flow hedge would terminate (be dedesignated) when the hedged sale or purchase occurs and the foreign-currency-denominated receivable or payable is recognized. The use of the same foreign currency derivative instruments for both the cash flow hedge and the fair value hedge is not prohibited though some ineffectiveness may result.

Next page 661-47


Page 661-47 Foreign Currency Fair Value Hedges c. Unrecognized firm commitment. A derivative instrument or a nonderivative financial

instrument1 that may give rise to a foreign currency transaction gain or loss under the Reporting Provisions to the Public can be designated as hedging changes in the fair value of an unrecognized firm commitment, or a specific portion thereof, attributable to foreign currency exchange rates. The designated hedging relationship qualifies for the accounting specified in paragraphs c., - h., of paragraph 22E, if all the fair value hedge criteria in paragraphs a., and b., of paragraph 22E. and the conditions in paragraphs h., and i., are met.

d. Recognized asset or liability. A nonderivative financial instrument shall not be designated as the

hedging instruments in a fair value hedge of the foreign currency exposure of a recognized asset or liability. A derivative instruments can be designated as hedging the changes in the fair value of a recognized asset or liability (or a specific portion thereof) for which a foreign currency transaction gain or loss is recognized in earnings under the provisions of the Reporting Provisions to the Public. All recognized foreign-currency-denominated assets or liabilities for which a foreign currency transaction gain or loss is recorded in earnings may qualify for the accounting specified in paragraphs c., - h., of paragraph 22E., if all the fair value hedge criteria in paragraphs a., and b., of paragraph 22E. and the conditions mentioned in paragraphs h., and i., are met.

e. Available-for-sale security. A nonderivative financial instrument shall not be designated as the

hedging instrument in a fair value hedge of the foreign currency exposure of an available-for-sale security. An available-for-sale equity security can be hedged for changes in the fair value attributable to changes in foreign currency exchange rate and qualify for the accounting specified in paragraphs c., - h., of paragraph 22E/ only if the fair value hedge criteria in paragraphs a., and b., of paragraph 22E. are met and the following two conditions are satisfied: (1) The security is not traded on an exchange (or other established marketplace) on which

trades are denominated in the investor’s functional currency. (2) Dividends or other cash flows to holders of the security are all denominated in the same

foreign currency as the currency expected to be received upon sale of the security.

1 This Provision does not relate to the carrying basis for a nonderivative financial instrument that gives rise to

a foreign currency transaction gain or loss under our Provisions.


Page 661-48 The change in fair value of the hedged available-for-sale equity security attributable to foreign

exchange risk is reported in earnings pursuant to paragraph d., of paragraph 22E. and not in other comprehensive income.

f. Gains and losses on a qualifying foreign currency fair value hedge shall be accounted for as

specified in paragraphs c. - h. of paragraph 22E. The gain or loss on a nonderivative hedging instrument attributable to foreign currency risk is the foreign currency transaction gain or loss as determined under the Reporting Provisions to the Public - Annual Financial Statements paragraphs 11 - 12.1 That foreign currency transaction gain or loss shall be recognized currently in earnings along with the change in the carrying amount of the hedged firm commitment.

Foreign currency Cash flow Hedges g. A nonderivative financial instrument shall not be designated as a hedging instrument in a

foreign currency cash flows hedge. A derivative instruments designated as hedging the foreign currency exposure to variability in the functional-currency-equivalent cash flows associated with a forecasted transaction, a recognized asset or liability, an unrecognized firm commitment, or a forecasted intercompany transaction qualifies for hedge accounting if all the following criteria are met:

(1) For consolidated financial statements, either (1) the operating unit that has the foreign

currency exposure is a party to the hedging instruments or (2) another member of the consolidated group that has the same functional currency as that operating unit (subject to the restrictions in this sub-paragraph and related footnote) is a party to the hedging instrument. To qualify for applying the guidance in (2) above, there may be no intervening subsidiary with a different functional currency.2 (Refer to paragraphs a., h., and i., for conditions for which an intercompany foreign currency derivative can be the hedging instrument in a cash flow hedge of foreign exchange risk).

1 The foreign currency transaction gain or loss on a hedging instrument is determined, consistent with the

Reporting Provisions to the Public as the increase or decrease in functional currency cash flows attributable to the change in spot exchange rates between the functional currency and the currency in which the hedging instrument is denominated.

2 For example, if a dollar-functional, second-tier subsidiary has a Euro exposure, the dollar-functional consolidated parent company could designate its U.S. dollar-Euro derivative as a hedge of the second-tier subsidiary's exposure provided that the functional currency of the intervening first-tier subsidiary (that is, the parent of the second-tier subsidiary) is also the U.S. dollar. In contrast, if the functional currency of the intervening first-tier subsidiary was the Japanese yen (thus requiring the financial statements of the second-tier subsidiary to be translated into yen before the yen-denominated financial statements of the first-tier subsidiary are translated into U.S. dollars for consolidation), the consolidated parent company could not designate its U.S. dollar-Euro derivative as a hedge of the second-tier subsidiary's exposure.



(2) The hedged transaction is denominated in a currency other than the hedging unit’s functional currency.

(3) All of the criteria in paragraph a., and b., of paragraph 22F. are met. (4) If the hedged transaction is a group of individual forecasted foreign-currency-

denominated transactions, a forecasted inflow of a foreign currency and a forecasted outflow of the foreign currency cannot both be included in the same group.

(5) If the hedged item is a recognized foreign-currency-denominated asset or liability, all the

variability in the hedged item's functional-currency-equivalent cash flows must be eliminated by the effect of the hedge. (for example: a cash flow hedge cannot be used with a variable-rate foreign-currency-denominated asset or liability and a derivative based solely on changes in exchange rates because the derivative does not eliminate all the variability in the functional currency cash flows).

h. Internal derivative. A foreign currency derivative contract that has been entered into with

another member of a consolidated group (such as a treasury center) can be a hedging instrument in a foreign currency cash flow hedge of a forecasted borrowing, purchase or sale or an unrecognized firm commitment in the consolidated financial statements only if the following two conditions are satisfied: (that foreign currency derivative instrument is hereafter in this section referred to as internal derivative). (1) From the perspective of the member of the consolidated group using the derivative as a

hedging instrument (hereinafter in this section referred to as the hedging affiliate), the criteria for foreign currency cash flow hedge accounting in paragraph g., must be satisfied.

(2) The member of the consolidated group not using the derivative as a hedging instrument (hereinafter in this section referred to as the issuing affiliate) must either (1) enter into a derivative contract with an unrelated third party to offset the exposure that results from that internal derivative or (2) if the conditions in paragraph i., are met, enter into derivative contracts with unrelated third parties that would offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivative contracts.

i. Offsetting net exposures. If an issuing affiliate chooses to offset exposure deriving from multiple

internal derivative contracts on an aggregate or net basis, the derivatives issued to hedging affiliates may qualify as cash flow hedges in the consolidated financial statements only if all of the following conditions are satisfied:



(1) The issuing affiliate enters into a derivative contract with an unrelated third party to offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivative contracts, and the derivative contract with the unrelated third party generates equal or closely approximating gains and losses when compared with the aggregate or net losses and gains generated by the derivative contracts issued to affiliates.

(2) Internal derivatives that are not designated as hedging instruments are excluded from the

determination of the foreign currency exposure on a net basis that is offset by the third- party derivative. In addition, non-derivative contracts may not be used as hedging instruments to offset exposures arising from internal derivative contracts.

(3) Foreign currency exposure that is offset by a single net third-party contract arises from

internal derivative contracts that mature within the same 31-day period and that involve the same currency exposure as the net third-party derivative. The offsetting net third-party derivative related to that group of contracts must offset the aggregate or net exposure to that currency, must mature within the same 31-day period, and must be entered into within 3 business days after the designation of the internal derivatives as hedging instruments.

(4) The issuing affiliate tracks the exposure that it acquires from each hedging affiliate and

maintains documentation supporting linkage of each internal derivative contract and the offsetting aggregate or net derivative contract with an unrelated third party.

(5) The issuing affiliate does not alter or terminate the offsetting derivative with an unrelated

third party unless the hedging affiliate initiates that action. If the issuing affiliate does alter or terminate the offsetting third-party derivative (which should be rare), the hedging affiliate must prospectively cease hedge accounting for the internal derivatives that are offset by that third-party derivative.

j. A member of a consolidated group is not permitted to offset exposures arising from multiple

internal derivative contracts on a net basis for foreign currency cash flow exposures related to recognized foreign-currency-denominated assets or liabilities. That prohibition includes situations in which a recognized foreign-currency-denominated asset or liability in a fair value hedge or cash flow hedge results from the occurrence of a specifically identified forecasted transaction initially designated as a cash flow hedge.

k. A qualifying foreign currency cash flows hedge shall be accounted for as specified in

paragraphs c - h of paragraph 22F.



22H. Presentation in the financial statements a. Embedded derivative instruments -

(1) Embedded derivative instruments that have been separated for measuring purposes according to paragraph 22C., will be presented in the balance sheet together with the host contract.

(2) It is clarified that an option that is added or attached to an existing debt instrument by a third party, causing the investor in the debt instrument to have different counter parties to the option and to the debt instrument, is not deemed to be an embedded derivative. The term "embedded derivative" in a hybrid contract relates to the conditions comprised in a single contract, and not to those included in separate contracts between different counter parties.

(3) Notwithstanding this, gains (losses) net in respect of embedded derivative instruments are to be classified similarly to the net gains (expenses) classification in respect of freestanding derivative instruments, as set out below.

b. Changes in the fair value of an unrecognized firm commitment designated as hedged by a

fair value hedge, which can be attributed to the risk hedged, are to be presented in the balance sheet under "other assets" or "other liabilities" (as appropriate). Presentation of these changes in earnings will be as follows:

(1) The amount of the ineffectiveness will be presented in Note 20 (gains from financing

activity before provisions for doubtful debts) under the item "in respect of derivative instruments and hedging activities - ineffective portion in hedging relationships."

(2) If a derivative instrument hedges the firm commitment, the effective portion of the hedge will be presented in the same item as the gains or expenses in respect of the hedging instrument.

(3) All other changes will be presented in Note 20 (Gains from financing activity before provisions for doubtful debts), under the heading "in respect of assets - from other assets" or "in respect of liabilities - other liabilities".

c. Gains from financing activity (before provisions for doubtful debts) in respect of

derivative instruments and hedging activities - the information will be included in Note 20 (Gains from financing activity before provisions for doubtful debts) and be divided into the following four components:

(1) Effective component of the hedge, that will be presented together with gains or expenses

in respect of the hedged item.1 This component will include the following three parts:

1 If the hedged item is an equity security, the effective component may be presented under gains (losses) from

net equity securities.


Page 661-52

(a) The effective portion of the hedge. (b) Interest accrued (including linkage and exchange rate differentials) in respect of the

hedging derivative, that have not been included in the effective portion of the hedge (sub-paragraph (a) above).

(c) Amortization of the adjustment of the carrying value of the hedged item. In relation to a fair value hedge, the effective portion of the hedge will be immediately posted to earnings. In relation to a cashflow hedge, the effective portion of the hedge will be posted to equity capital as a component of other comprehensive income in gains (losses) net in respect of cashflows. This portion will be reclassified in earnings according to the rules set out in this Provision, and be presented together with the results of the hedged item. The other two portions will be posted currently to earnings. Disclosure will be given of the net effect of hedging derivative instruments on financing income in respect of assets, financing expenses in respect of other liabilities and earnings (expenses) included in financing activity gains, that are not included in the ineffective component of the hedging ratios.

(2) The ineffective component of the hedging relationships - this paragraph will include:

(a) the amount of the ineffectiveness of the hedges - the gain (loss) component in respect of derivative instruments deriving from the ineffectiveness of the hedge, as well as the amount of the ineffectiveness of fair value hedges, resulting from changes in fair value of the hedged item attributable to the hedged risk,

(b) The gain (loss) component in respect of derivative instruments, which has been removed to evaluate the effectiveness of the hedge.

(c) Net gains (losses) in respect of a firm commitment that is no longer qualified to be a fair value hedge.

(d) Gains (losses) that have been reclassified due to the probability that the forecasted transactions will not take place.

(3) Net gains (expenses) in respect of ALM derivative instruments - this item will include

changes in the balance sheet balance of derivative instruments, which were not designated for hedging relationships, and which constitute part of the bank's assets and liability management set up, except for changes deriving from revenues or payments.

(4) Net gains (expenses) in respect of other derivative instruments - which item will include

the changes in the balance sheet balance of non-hedging derivative instruments which do not constitute part of the bank's assets and liability management setup, except for changes deriving from revenues or payments.


Page 661-53

22I. Disclosures (10/02) a. A banking corporation that holds or issues derivative instruments (or nonderivative instruments

that are designated and qualify as hedging instruments pursuant to paragraph b., of paragraph 22G) shall disclose its objectives for holding or issuing those instruments, the context needed to understand those objectives, and its strategies for achieving those objectives. The description shall distinguish between derivative instruments (and nonderivative instruments) designated as fair value hedging instruments, derivative instruments designated as cash flows hedging instruments, and all other derivatives. The description also shall indicate the banking corporation’s risk management policy for each of those types of hedges, including a description of the items or transactions for which risks are hedged. For derivative instruments not designated as hedging instruments, the description shall indicate the purpose of the derivative activity. Qualitative disclosures about a banking corporation’s objectives and strategies for using derivative instruments may be more meaningful if such objectives and strategies are described in the context of a banking corporation’s overall risk management profile. If appropriate, a banking corporation is encouraged, but not required, to provide such additional qualitative disclosures.

b.. A banking corporation’s disclosures for every reporting period for which a complete set of

financial statements is presented also shall include the following: Fair value hedges

(1) For derivative instruments, as well as nonderivative instruments that may give rise to foreign currency transaction gains or losses under the Reporting Provisions to the Public - paragraphs 11 and 12, that have been designated and have qualified as fair value hedging instruments and for the related hedged items: (a) The net gain or loss recognized in earnings during the reporting period

representing: (1) The amount of the hedges’ ineffectiveness and (2) The component of the derivative instruments’ gain or loss, if any, excluded

from the assessment of hedge effectiveness, and a description of where the net gain or loss is reported in earnings.

(b) The amount of net gain or loss recognized in earnings, when a hedged firm commitment no longer qualifies as a fair value hedge.


Page 661-54 Cash flow hedges (2) For derivative instruments that have been designated and have qualified as cash flows

hedging instruments and for the related hedged transactions: (a) The net gain or loss recognized in earnings during the reporting period

representing: (1) The amount of the hedges’ ineffectiveness and (2) The component of the derivative instruments’ gain or loss, if any, excluded

from the assessment of hedge effectiveness, and a description of where the net gain or loss is reported in the earnings

(b) A description of the transactions or other events that will result in the reclassification into earnings of gains or losses that are reported in accumulated other comprehensive income, and the estimated net amount of the existing gains or losses at the reporting date that is expected to be reclassified into earnings within the next 12 months.

(c) The maximum length of time over which the banking corporation is hedging its exposure to the variability in future cash flows for forecasted transactions excluding those forecasted transactions related to the payment of variable interest on existing financial instruments.

(d) The amount of gains or losses reclassified into earnings as a result of the discontinuance of cash flows hedges because it is probable that the original forecasted transactions will not occur by the end of the originally specified time period or within the additional period of time discussed in paragraph 22F.f.

The quantitative disclosures about derivative instruments may be more useful and less likely to

be perceived to be out of context or otherwise misunderstood, if similar information is disclosed about other financial instruments or nonfinancial assets and liabilities to which the derivative instruments are related by activity. Accordingly, in those situations, a banking corporation is encouraged, but not required, to present a more complete picture of its activities by disclosing that information.

.


Page 661-55

Activities in derivative instruments - volume, credit risks and details of maturity dates c. The following information may be presented by a banking corporation in other sections of the

annual report if, in the opinion of the banking corporation's management, it is desirable in the circumstances in order to assist the user of the reports to understand activity in derivative instruments and if it has been clarified by appropriate reference in the body of the annual financial report, that they constitute part of the financial statement itself.

d. According to the format included in the example contained in Note 18.B. information will be

disclosed of the nominal amount, gross positive fair value and gross negative fair value of derivative instruments. Each contract is to be reported according to the risk exposure of its underlying, as follows:

(1) Interest rate:

(a) Contracts to buy or sell a CPI-linked shekel in Israel in exchange for an unlinked shekel.

(b) Other interest contracts. (2) Foreign currency exchange rate. (3) Equity instruments, or (4) Commodities and others. The information is to be included distinguishing between hedging derivative instruments and derivative instruments that are part of the banking corporation's assets and liability management setup (ALM) which have not been designated for hedging relationships, and other derivative instruments. As to credit derivatives and foreign currency swap contracts, separate disclosure is to be given. In addition, the following data is to be detailed in the sample Note concerning: (1) Credit risk in respect of derivative instruments:

(a) Gross positive fair value is to be presented of derivative instruments, the effect of netting agreements, arrangements for net accounting and off-balance sheet credit risk of derivative instruments, distinguishing between the different types of counter parties to the derivative instruments.

(b) Disclosure is to be given of credit losses recognized in earnings from derivative instruments.

(c) Disclosure is to be given of gross positive fair value of embedded derivative instruments.

(d) Information is to be provided of the banking corporation's policy for the collateral requirement against credit risks which exceed the activity in derivative instruments, including:

(1) A general description of the material cash requirements for each type of

derivative instrument, including margin deposits and daily cash settlement. (2) A description of the types of liquid collateral that are specifically required

against activity in derivative instruments.


Page 661-56

(3) Quantitative disclosure of such liquid collateral held by the banking corporation on the report date, and the amount of the credit risk of the derivative instruments secured by such liquid collateral.

(4) Information on the accessibility and realization of such collateral.

(2) A breakdown of the face value amounts according to maturity dates, distinguishing between the foregoing bases.

e. With respect to Note 18.B.:

(1) A spot foreign currency swap contract is an agreement for immediate delivery, generally

within two business days, of a foreign currency according to the prevailing cash market rate.

(2) Interest contracts do not include contracts involving one or more foreign currency swaps (such as: cross-currency IRS and currency options) and other contracts whose characterizing dominant risk is a foreign currency exchange rate risk, which will be reported as foreign currency contracts;

(3) Foreign currency contracts include, inter alia, forward contracts for foreign currency exchange which are generally settled after three or more business days following the transaction date.

(4) Gross fair value and face value - all the transactions within the consolidated banking corporation are to be reported on a net basis, that is, internal transactions within the banking corporation do not need to be reported in Note 18.B. Other offsetting arrangements of contracts for the purpose of presentation in Note 18.B., are not permitted. Thus, setoffs are not to be made of: (a) commitments of banking corporations to buy from third parties against commitments of the banking corporation to sell to third parties, (b) options that have been written against options bought, (c) positive fair value against negative fair value, or (d) contracts subject to bilateral netting agreements.

(5) It is clarified for the purpose of the presentation in Note 18.B., the face value is to be given in shekel terms, as follows: (a) In currency contracts, the contract amount will be presented according to one side

of the transaction: (1) Where the transaction has one side in shekels and the other in foreign

currency, the amount in shekels will be presented as expressing the foreign currency side.

(2) Where the transaction has two sides in foreign currency, the shekel amount will be presented of the purchased side (asset receivable).

(b) In equity, commodities and other contracts - the face value amount multiplied by the contract unit will be presented, where the contract unit price is the face value of the contract.

(c) As to CPI-linked shekel swap contracts in unlinked shekels, the face value is the amount of the contract in shekels (unlinked track).


Page 661-57

22J. Reporting Changes in the Components of Comprehensive income (10/02)

a. A banking corporation shall display as a separate classification within other comprehensive income the net gain or loss on derivative instruments designated and qualifying as cash flows hedging instruments that are reported in comprehensive income pursuant to paragraphs 22F.c and 22G. k..

b. As part of the disclosures of accumulated other comprehensive income, a banking

corporation shall separately disclose the beginning and ending accumulated derivative gain or loss, the related net change associated with current period hedging transactions, and the net amount of any reclassifications into earnings.



22K. Implementation Guidance - Chapter 1: Scope and Definitions (10/02) Application of paragraph 22B. a. The following discussion further explains the three characteristics of a derivative instrument

discussed in paragraphs 22B. a.-d..

(1) Underlying. An underlying is a variable that, along with either a notional amount or a payment provision, determines the settlement of a derivative. An underlying usually is one or a combination of the following: (a) A security price or security price index. (b) A commodity price or commodity price index. (c) An interest rate or interest rate index. (d) A credit rating or credit index. (e) An exchange rate or exchange rate index. (f) An insurance index or catastrophe loss index. (g) A climatical or geological condition (such as temperature, earthquake severity or

rainfall), another physical variable, or a related index. However, an underlying may be any variable whose changes are observable or otherwise

objectively verifiable. Paragraph 22B.e.(5) specifically excludes a contract with settlement based on certain variables unless the contract is exchange-traded. A contract based on any variable that is not specifically excluded is subject to the requirements of this Provision if it has the other two characteristics identified in paragraph 22B.a. (which also are discussed in paragraphs.a.(2) and a.(3) below).

(2) Initial net investment. A derivative requires no initial net investment or a small initial net

investment than other types of contracts and have a similar response to changes in market factors. For example, entering into a commodity futures contract generally requires no initial net investment, while purchasing the same commodity requires an initial net investment equal to its market price. However, both contracts reflect changes in the price of the commodity in the same way (that is, similar gains or losses will be incurred). A swap or forward contract also generally does not require an initial net investment unless the terms favour one party over the other. An option generally requires that one party make an initial net investment (a premium) because that party has the rights under the contract and the other party has the obligations.



The phrase initial net investment is stated from the perspective of only one party to the contract, but it determines the application of the Provision for both parties1.

(3) Net settlement. A contract that meets any one of the following criteria has the characteristic described as net settlement: (a) Its terms implicitly or explicitly require or permit net settlement. For example, a

penalty for non-performance in a purchase order is a net settlement provision if the amount of the penalty is based on changes in the price of the items that are the subject of the contract. Net settlement may be made in cash or by delivery of any other asset, whether or not it is readily convertible to cash. A fixed penalty for non-performance is not a net settlement provision.

(b) There is an established market mechanism that facilitates net settlement outside the contract. The term market mechanism is to be interpreted broadly. Any institutional arrangement or other agreement that enables either party to be relieved of all rights and obligations under the contract and to liquidate its net position without incurring a significant transaction cost is considered net settlement. The evaluation of whether a market mechanism exists and whether items to be delivered under contract are readily convertible into cash must be performed at inception and an ongoing basis throughout a contract’s life.

(c) It requires delivery of an asset that is readily convertible to cash.2 The definition of readily convertible to cash includes for example, a security or commodity traded in an active market and a unit of foreign currency that is readily convertible into the functional currency of the reporting entity. A security that is publicly traded but for which the market is not very active is readily convertible to cash if the number of shares or other units of the security to be exchanged is small relative to the daily transaction volume. That same security would not be readily convertible if the number of shares to be exchanged is large relative to the daily transaction volume. The ability to use a security that is not publicly traded or another commodity without an active market as collateral in a borrowing does not, in and of itself, mean that the security or the commodity is readily convertible into cash. Shares of a publicly traded company to be received upon the exercise of a stock purchase warrant do not meet the characteristic of being readily convertible to cash if both of the following conditions exist:

Next page 661-59.1

1 Even though a contract may be a derivative as described in paragraphs 22B.a.-e. for both parties, the

exceptions in paragraph 22B.f. apply only to the issuer of the contract and will result in different reporting by the two parties. The exception in paragraph 22B.e.(2) also may apply to one of the parties but not the other.

2 The evaluation of whether the asset is readily convertible into cash will be performed throughout a contract’s life.


Annual Financial Report Page 661-59.1

(1) The stock purchase warrant is issued by an entity for only its own stock (or stock of its consolidated subsidiaries) and

(2) The sale or transfer of the issued shares is restricted (other than in connection with being pledged as collateral) for a period of 32 days or more from the date of the stock purchase warrant is exercised.

In contrast, restrictions are imposed by a stock purchase warrant on the sale or transfer of stock that are received from the exercise of that warrant issued by an entity for other than its own stock (whether those restrictions are for more or less than 32 days) do not affect the determination of whether those shares are readily convertible to cash. The accounting for restricted stock to be received upon exercise of a stock purchase warrant should not be analogized to any other type of contract.

b. The following discussion further explains some of the exceptions discussed in paragraph 22B.e.

(1) “Regular-way” security trades. The exception in paragraph 22B.e.(1) applies only to a contract that requires delivery of securities that are readily convertible to cash1 other than (a) contract to purchase or sell when-issued securities or other securities that do not yet exist, pursuant to sub-paragraph (c) below, and (b) contracts that the banking corporation accounts for on a transaction date basis. To qualify, a contract must require delivery of such a security within the period of time after the trade date that is customary in the market in which the trade takes place. This Provision does not change the date on which a banking corporation recognizes regular way security trades. However, trades that do not qualify for the regular way exception are subject to the requirements of this Provision regardless of the method a banking corporation uses to report its security trades.

(2) Normal purchases and normal sales. The exception in paragraph 22B.e.(2) applies only

to a contract that involves future delivery of assets (other than financial instruments or derivative instruments). Also in order for a contract that meets the net settlement provisions of paragraphs 22B d.(1) and a.(3)(a) the market mechanisms provisions of paragraphs 22B.d.(2).or a..(3).(b) to qualify for the exception, it must be probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery.

Next page 661-60

1 Contracts that require delivery of securities that are not readily convertible to cash are not subject to the

requirements of this Provision unless there is a market mechanism outside the contract to facilitate net settlement (according to paragraphs 22B.(d)(2) and 22L.(a)(3)(b)).


Page 661-60 (3) Certain contracts that are not traded on an exchange. A contract that is not traded on an

exchange is not subject to the requirements of this Provision if the underlying is: (a) A climatic or geological variable or other physical variable. Climatic, geological,

and other physical variables include things like the number of inches of rainfall or snow in a particular area and the severity of an earthquake as measured by the Richter scale.

(b) The price or value of (1) A non-financial asset of one of the parties to the contract unless that asset is

readily convertible to cash, or (2) a non-financial liability of one of the parties to the contract unless that

liability requires delivery of an asset that is readily convertible to cash. This exception applies only to non-financial assets that are unique and only if a non-financial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the price or value of the non-financial asset. If the contract is a call option contract, the exception applies only if that non-financial asset is owned by the party that would not benefit under the contract from an increase in the price or value of the non-financial asset above the option's strike price.

(c) Specified volumes of sales or service revenues by one of the parties. That exception is intended to apply to contracts with settlements based on the volume of items sold or services rendered. It is not intended to apply to contracts based on changes in sales or revenues due to changes in market prices.

If a contract’s underlying is the combination of two or more variables, and one or more would not qualify for one of the exceptions above, the application of this Provision to that contract depends on the predominant characteristics of the combined variable. The contract is subject to the requirements of this Provision if the changes in its combined underlying are highly correlated with changes in one of the component variables that would not qualify for an exception.

c. The following discussion illustrates the application of paragraphs 22B in certain situations.

(1) Forward purchases or sales of when-issued securities or other securities that do not yet exist. Contracts for the purchase or sale of when-issued securities or other securities that do not yet exist are excluded from the requirements of this Statement as a regular-way trade only if: (a) there is no other way to purchase or sell that security, (b) delivery of that security and settlement will occur within the shortest possible

period possible for that type of security, and


Page 661-61 (c) It is probable at inception and throughout the term of the individual contract that

the contract will not settle net and will result in physical delivery of a security when it is issued.

A contract for the purchase or sale of when-issued securities or other securities that do not yet exist is eligible to qualify for the regular-way securities trades exception even though that contract permits net settlement (as discussed in paragraphs 22B(d)(1) and 22K.(a)(3)(a)) or a market mechanism to facilitate net settlement of that contract (as discussed in paragraphs 22B.(d)(2) and 22K(d)(1) and (d)(2)) exists. The banking corporation shall document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery. Net settlement (as described in paragraphs 22B(d)(1) and (d)(2) of contracts in a group of contracts similarly designated as regular-way security trades would call into question the continued exemption of such contracts. In addition, if a banking corporation is required to account for a contract for the purchase or sale of when-issued securities or other securities that do not yet exist on a trade-date basis, rather than a settlement-date basis, and thus recognizes the acquisition or disposition of the securities at the inception of the contract, that entity shall apply the regular-way security trades exception to those contracts.

(1A) Credit-indexed contracts (often referred to as credit derivatives). Many different types of contracts are indexed to the credit-worthiness of a specified entity or group of entities, but not all of them are derivative instruments. Credit-indexed contracts that have certain characteristics described in paragraph 22B.e.(4), are guarantees and are not subject to the requirements of this Provision. Credit-indexed contracts that do not have the characteristics necessary to qualify for the exception in paragraph 22B.e.(4), are subject to the requirements of this Provision. One example of the latter is a credit-indexed contract that requires a payment due to changes in the credit-worthiness of a specified entity even if neither party incurs a loss due to the change (other than a loss caused by the payment under the credit-indexed contract).

(2) Short sales (sales of borrowed securities).1 Short sales typically involve the following activities: (a) Selling a security (by the short seller to the purchaser). (b) Borrowing a security (by the short seller from the lender). (c) Delivering the borrowed security (by the short seller to the purchaser) (d) Purchasing a security (by the short seller from the market). (e) Delivering the purchased security (by the short seller to the lender)

Next page 661-61.1

1 This discussion applies only to short sales with the characteristics described here. Some groups of

transactions that are referred to as short sales may have different characteristics. If so, a different analysis would be appropriate, and other derivative instruments may be involved.


Page 661-61.1 These five activities involve three separate contracts. A contract that distinguishes a short sale involves activities c.(2)(b) and c.(2)(e), borrowing a security and replacing it by delivering an identical security. Such a contract has two of the three characteristics of a derivative instrument. The settlement is based on an underlying (the price of the security) and a notional amount (the face amount of the security or the number of shares), and the settlement is made by delivery of a security that is readily convertible to cash. However, the other characteristics, little or no initial net investment that is smaller by more than a nominal amount than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, is not present. (Refer to paragraph 22B.(c)). The borrowed security is the lender’s initial net investment in the contract. Consequently, the contract relating to activities c.(2)(b) and c.(2)(e) is not a derivative instrument. The other two contracts (one for activities c.(2)(a) and c.(2)(c) and the other for activity c.(2)(d)) are routine and do not generally involve derivative instruments. However, if a forward purchase or sale is involved, and the contract does not qualify for the exception in paragraph 22B.e.(1), it is subject to the requirements of this Provision.

Next page 661-62


Page 661-62

Application of the Clearly and Closely Related Criterion - Paragraph 22C. d. In discussing whether a hybrid instrument contains an embedded derivative instrument (also

simply referred to as an embedded derivative) that warrants separating accounting, paragraph 22C. a. focuses on whether the economic characteristics and risks of the embedded derivative are clearly and closely related to the economic characteristics and risks of the host contract. If the host contract encompasses a residual interest in a corporation, then its economic characteristics and risks should be considered that of an equity instrument and an embedded derivative would need to possess principally equity characteristics (related to the same corporation), to be considered clearly and closely related to the host contract. However, most commonly, a financial instrument host contract will not embody a claim to the residual interest in a corporation and thus, the economic characteristics and risks of the host contract should be considered that of a debt instrument. For example, even though the overall hybrid instrument that provides for repayment of principal may include a return based on the market price (the underlying as defined in this Provision) of Corporation A common stock, the host contract does not involve any existing or potential residual interest rights (that is, rights of ownership) and thus would not be an equity instrument. The host contract would instead be considered a debt instrument, and the embedded derivative that incorporates the equity-based return would not be clearly and closely related to the host contract. If the embedded derivative is considered not to be clearly and closely related to the host contract, the embedded derivative must be separated from the host contract and accounted for as a derivative instrument by both parties to the hybrid instrument, except as provided in paragraph 22B.f.(1).

e. The following guidance is relevant in deciding whether the economic characteristics and risks of

the embedded derivative are clearly and closed related to the economic characteristics and risks of the host contract.

(1) Interest rate indexes. An embedded derivative in which the underlying is an interest rate

or interest rate index and a host contract that is considered a debt instrument are considered to be clearly and closely related unless as discussed in paragraph 12, the embedded derivative contains a provision that: (a) permits any possibility whatsoever that the investor’s (or creditor’s) undiscounted

net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms or


Page 661-63

(b) could under any possibility whatsoever at least double the investor’s initial rate or return on the host contract and at the same time result in a rate of return that is at least twice what otherwise would be the then-current market returning a contract that has the same terms as the host contract and that involves a debtor with a similar credit quality. The requirement to separate the embedded derivative from the host contract applies to both parties to the hybrid instrument even though the above tests focus on the investor’s net cash inflows. Plain-vanilla servicing rights, which involve an obligation to perform servicing and the right to receive fees for performing that servicing, do not contain an embedded derivative that would be separated from those servicing rights and accounted for as a derivative.

(2) Inflation-indexed interest payments. The interest rate and the rate of inflation in the economic environment for the currency in which a debt instrument is denominated are considered to be clearly and closely related. Thus, non-leveraged inflation-indexed contracts (debt instruments, capitalized lease obligations, pension obligations and so forth) would not have the inflation-related embedded derivative separated from the host contract.

(3) Credit-sensitive payments. The credit-worthiness of the debtor and the interest rate on a debt instrument are considered to be clearly and closely related. Thus, for debt instruments, that have the interest rate reset in the event of: (a) default (such as violation of a credit-risk related covenant). (b) a change in the debtor’s published credit rating, or (c) a change in the debtor’s credit-worthiness indicated by a change in its spread over

Treasury bonds, the related embedded derivative would not be separated from the host contract.

(4) Calls and puts on debt instruments. Call options (or put options) that can accelerate the repayment of principal on a debt instrument are considered to be clearly and closely related to a debt instrument that requires principal repayments unless both: (a) The debt involves a substantial premium or discount (which is common with zero-

coupon bonds); and (b) the put or call option is only contingently exercisable, provided the call options (or put options) are also considered to be clearly and closely related to the debt-host contract under paragraph 22C.(b).


Page 661-64 Thus, if a substantial premium or discount is not involved, embedded calls and puts

(including contingent call or put options that are not exercisable unless an event of default occurs) would not be separated from the host contract. However, for contingently exercisable calls and puts to be considered clearly and closely related, they can be indexed only to interest rates or credit risk, not some extraneous event or factor. In contrast, call options (or put options) that do not accelerate the repayment of principal on a debt instrument but instead require a cash settlement that is equal to the price of the option at the date of exercise would not be considered to be clearly and closely related to the debt instrument in which it is embedded.

In light of the foregoing, and given the conditions that were laid down in the Banking (Prepayment Commissions) Order, prepayment options, embedded in housing loans, (as defined in the Proper Banking Management Directive no. 451 - "Procedures on Advancing Housing Loans") are deemed to be clearly and closely attached to the host housing loan.

(5) Calls and puts on equity instruments. A put option that enables the holder to require the issuer of an equity instrument to re-acquire that equity instrument for cash or other assets is not clearly and closely related to that equity instrument. Thus, such a put option embedded in a publicly traded equity instrument to which it relates should be separated from the host contract by the holder of the equity instrument, if the criteria in paragraphs 22.C.(a)(2) and (a)(3) are also met. That put option also should be separated from the host contract by the issuer of the equity instrument except in those cases in which the put option is not considered to be a derivative instrument pursuant to paragraph 22B.f.(1) because it is classified in stockholders’ equity. A purchased call option that enables the issuer of an equity instrument (such as common stock) to reacquire that equity instrument would not be considered to be a derivative instrument by the issuer of the equity instrument pursuant to paragraph 22B.f.(1). Thus, if the call option were embedded in the related equity is, it would not be separated from the host contract by the issuer. However, for the holder of the related equity instrument, the embedded written call option would not be considered to be clearly and closely related to the equity instrument and, if the criteria in paragraphs 22.C.(a)(2) and (a)(3) were met, should be separated from the host contract.

(6) Floors, caps and collars. Floors or caps (or collars, which are combinations of caps and

floors) on interest rates and the interest rate on a debt instrument are considered to be clearly and closely related, unless the conditions in either paragraph 22.C.(b)(1) or paragraph (b)(2) are met, in which case the floors or the caps are not considered to be clearly and closely related.


Page 661-65 (7) Term-extending options. An embedded derivative provision that either:

(a) unilaterally enables one party to extend significantly the remaining term to maturity or

(b) automatically extends significantly the remaining term triggered by a specific events or conditions

is not clearly and closely related to the interest rate on a debt instrument unless the interest rate is concurrently reset to the approximate current market rate for the extended term and the debt instrument initially involved no significant discount. Thus, if there is no reset of interest rates, the embedded derivative is not clearly and closely related to the host contract. That is, a term-extending option cannot be used to circumvent the restriction in paragraph e.(1) regarding the investor’s not covering substantially all of its initial recorded investment.

(8) Equity-indexed interest payments. The changes in fair value of an equity interest and the

interest yield on a debt instrument are not clearly and closely related. Thus, an equity-related derivative embedded in an equity-indexed debt instrument (whether based on the price of specific common stock or on an index that is based on a basket of equity instruments) must be separated from the host contract and accounted for as a derivative instrument.

(9) Commodity-indexed interest or principal payments. The changes in fair value of a

commodity (or other asset) and the interest yield on a debt instrument are not clearly and closely related. Thus, a commodity-related derivative embedded in a commodity-indexed debt instrument must be separated from the non-commodity host contract and accounted for as a derivative instrument.

(10) Indexed Rentals.

(a) Inflation-indexed rentals. Rentals for the use of leased assets and adjustments for inflation on similar property are considered to be clearly and closely related. Thus, unless a significant leverage factor is involved, the inflation-related derivative embedded in an inflation-indexed lease contract would not be separated from the host contract.

(b) Contingent rentals based on related sales. Lease contracts that include contingent rentals based on certain sales of the lessee would not have the contingent-rental- related embedded derivative separated from the host contract because, under paragraph 22B.e.(5)(c), a non-exchange-traded contract whose underlying is specified volumes of sales by one of the parties to the contract would not be subject to the requirements of this Provision.


Page 661-66

(c) Contingent rentals based on a variable interest rate. The obligation to make future payments for the use of leased assets and the adjustment of those payments to reflect changes in a variable-interest-rate-index are considered to be clearly and closely related. Thus, lease contracts that include contingent rentals based on changes in the prime rate would not have the contingent-rental-related embedded derivative separated from the host contract.

(11) Convertible debt. The changes in fair value of an equity interest and the interest rates on a

debt instrument are not clearly and closed related. Thus, for a debt security that is convertible into a specified number of shares of the debtor’s common stock or another corporation’s common stock, the embedded derivative (that is, the conversion option) must be separated from the debt host contract and accounted for as a derivative instrument provided that the conversion option would, as a freestanding instrument, be a derivative instrument subject to the requirements of this Provision. (For example, if the common stock was not readily convertible to cash, a conversion option that requires purchase of the common stock would not be accounted for as a derivative). That accounting applies only to the holder (investor) - to which the exception under paragraph 22B.f. does not apply - if the debt is convertible to the debtor’s common stock because, under paragraph 22B.f.(1) a separate option with the same terms would not be considered to be a derivative for the issuer.

(12) Convertible preferred stock. Because the changes in fair value of an equity interest and

interest rates on a debt instrument are not clearly and closely related, the terms of the preferred stock (other than the conversion option) must be analyzed to determine whether the preferred stock (and thus the potential host contract) is more akin to an equity instrument or a debt instrument. A typical cumulative fixed-rate preferred stock that has a mandatory redemption feature is more akin to debt, whereas cumulative participating perpetual preferred stock is more akin to an equity instrument.


Page 661-67

22L. Implementation Guidance - Chapter 2: Assessment of Hedge Effectiveness (10/02)

Hedge Effectiveness Requirements of this Provision a. This Provision requires that a banking corporation define at the time it designates a hedging

relationship the method it will use to assess the hedge’s effectiveness in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged. It also requires that a banking corporation use that defined method consistently throughout the hedge period:

(1) To assess at inception of the hedge and on an ongoing basis whether it expects the

hedging relationship to be highly effective in achieving offset and (2) To measure the ineffective part of the hedge.

If the banking corporation identifies an improved method and wants to apply that method prospectively, it must discontinue the existing hedging relationship and designate the relationship anew using the improved method. This Provision does not specify a single method for either assessing whether a hedge is expected to be highly effective or measuring hedge ineffectiveness. The appropriateness of a given method of assessing hedge effectiveness can depend on the nature of the risk being hedged and the type of hedging instrument used. Ordinarily, however, a banking corporation should address effectiveness for similar hedges in a similar manner; use of different methods for similar hedges should be justified.

b. In defining how hedge effectiveness will be assessed, a banking corporation must specify

whether it will include in that assessment all of the gain or loss on a hedging instrument. This Provision permits (but does not require) a banking corporation to exclude all or a part of the hedging instrument’s time value from the assessment of hedge effectiveness, as follows:

(1) If the effectiveness of a hedge with an option contract is assessed based on changes in the

option’s intrinsic value, the change in the time value of the contract would be excluded from the assessment of hedge effectiveness.

(2) If the effectiveness of a hedge with an option contract is assessed based on changes in the

option’s minimum value, that is, its intrinsic value plus the effect of discounting, the change in the volatility value of the contract would be excluded from the assessment of hedge effectiveness.

(3) If the effectiveness of a hedge with a forward or futures contract is assessed based on

changes in fair value attributable to changes in spot prices, the change in fair value of the contract, related to the changes in the difference between the spot price and the forward or futures price would be excluded from the assessment of hedge effectiveness.

In each circumstance above, changes in the excluded component would be included currently in

earnings, together with any ineffectiveness that results under the defined method of assessing


Page 661-68

ineffectiveness. As noted in paragraph a, the effectiveness of similar hedges generally should be assessed similarly; that includes whether a component of the gain or loss on a derivative is excluded in assessing effectiveness. No other components of gain or loss on the designated hedging instrument may be excluded from the assessment of hedge effectiveness.

c. In assessing the effectiveness of a cash flow hedge, a banking corporation generally will need to

consider the time value of money if significant in the circumstances. Considering the effect of the time value of money is especially important if the hedging instrument involves periodic cash settlements. An example of a situation in which a banking corporation likely would reflect the time value of money is a tailing strategy with futures contracts. When using a tailing strategy, a banking corporation adjusts the size or contract amount of futures contracts used in a hedge so that earnings (or expense) from reinvestment (or funding) of daily settlement gains (or losses) on the futures do not distort the results of the hedge. To assess offset of expected cash flows when a tailing strategy has been used, a banking corporation could reflect the time value of money, perhaps by comparing the present value of the hedged forecasted cash flow with the results of the hedging instrument.

d. Whether a hedging relationship qualifies as highly effective sometimes will be easy to assess

and there will be no ineffectiveness to recognize in earnings during the term of the hedge. If the critical terms of the hedging instrument and of the entire hedged asset or liability (as opposed to selected cash flows) or hedged forecasted transaction are the same, the entity could conclude that changes in fair value or cash flows attributable to the risk being hedged are expected to completely offset at inception and on an ongoing basis.

e. Assessing hedge effectiveness and measuring the ineffective part of the hedge, however, can be

more complex. For example, hedge ineffectiveness would result from the following circumstances, among others: (1) A difference between the basis of the hedging instrument and the hedged item or hedged

transaction (such as a Deutsche mark - based hedging instrument and Dutch guilder-based hedged item), to the extent that those bases do not move in tandem.

(2) Differences in critical terms of the hedging instrument and hedged item or hedged

transaction, such as differences in notional amounts, maturities, quantity, location or delivery dates.


Page 661-69 Ineffectiveness also would result if part of the change in the fair value of a derivative is

attributable to a change in the counter-party’s credit-worthiness. f. A hedge that meets the effectiveness test specified in paragraphs 22E.a.(2) and 22F.a.(2) (that is,

both at inception and on an ongoing basis, the banking corporation expects the hedge to be highly effective at achieving offsetting changes in fair values or cash flows) also must meet the other hedge accounting criteria to qualify for hedge accounting. If the hedge initially qualifies for hedge accounting, the banking corporation would continue to assess whether the hedge meets the effectiveness test and also would measure any ineffectiveness during the hedge period. If the hedge fails the effectiveness at any time (that is, if the entity does not expect the hedge to be highly effective at achieving offsetting changes in fair values or cash flows), the hedge ceases to qualify for hedge accounting. The discussions of measuring hedge ineffectiveness in the examples in the remainder of this section of the Schedule, assume that the hedge satisfied all of the criteria for hedge accounting at inception.

Assuming No Ineffectiveness in a Hedge with an Interest Rate Swap g. An assumption of no ineffectiveness is especially important in a hedging relationship involving

an interest-bearing financial instrument and an interest rate swap because it significantly simplifies the computations necessary to make the accounting entries. A banking corporation may assume no ineffectiveness in a hedging relationship of interest rate risk involving a recognized interest-bearing asset or liability and an interest rate swap (or a compound hedging instrument composed of interest rates swap and a mirror-image call or put option as discussed in paragraph (g)(4) below), if all of the applicable conditions in the following list are met:

Conditions applicable to both fair value hedges and cash flows hedges

(1) The notional amount of the swap matches the principal amount of the interest-bearing asset or liability.

(2) If the hedging instrument is solely an interest rate swap, the fair value of that swap at the inception of the hedging relationship is zero. If the hedging instrument is a compound derivative composed on an interest rate swap and mirror-image call or put option as discussed in paragraph (g)(4), the premium for the mirror-image call or put option embedded in the hedged item. That is, the reporting banking corporation must determine whether the implicit premium for the purchased call or written put option embedded in


Page 661-69.1

the hedged item was principally paid at inception-acquisition (through an original issue discount or premium) or is being paid over the life of the hedged item (through an adjustment of the interest rate). If the implicit premium for the call or put option embedded in the hedged item was principally paid at inception-acquisition, the fair value of the hedging instrument at the inception of the hedging relationship must be equal to the fair value of the mirror-image call or put option. In contrast, if the implicit premium for the call or put option embedded in the hedged item is principally being paid over the life of the hedged item, fair value of the hedging instrument at the inception of the hedging relationship must be zero.

(3) The formula for computed net settlements under the interest rate swap is the same for each net settlement. (That is, the fixed rate is the same throughout the term, and the variable rate is based on the same index and includes the same constant adjustment or no adjustment).

(4) The interest-bearing asset or liability is not prepayable (that is, able to be settled by either party prior to its scheduled maturity), except as indicated in the following sentences. This criterion does not apply to an interest-bearing asset or liability that is prepayable solely due to an embedded call option provided that the hedging interest is a compound derivative composed of an interest rate swap and a mirror-image put option. The call option embedded in the swap is considered


Page 661-70

a mirror image of the call option embedded in the hedged item if (1) the terms of the two call options match (including matching maturities, strike price, related notional amounts, timing and frequency of payments, and dates on which the instruments may be called) and (2) the banking corporation is the writer of one call option and the holder (or purchaser) of the other call option. Similarly, this criterion does not apply to an interest-bearing asset or liability that is prepayable solely due to an embedded put option provided the hedging instrument is a compound derivative composed of an interest rate swap and a mirror-image put option.

(5) The index on which the variable leg of the swap is based matches the benchmark interest rate designated as the interest rate risk being hedged for the hedging relationship.1

(6) Any other terms in the interest-bearing financial instruments or interest rate swaps are typical of those instruments and do not invalidate the assumption of no ineffectiveness.

Conditions applicable to fair value hedges only

(7) The expiration date of the swap matches the maturity date of the interest-bearing asset or liability.

(8) There is no floor or cap on the variable interest rate of the swap. (9) The interval between repricings of the variable interest rate in the swap is frequent

enough to justify an assumption that the variable payment or receipt is at a market rate (generally three to six months or less).

Conditions applicable to cash flows hedges only

(10) All interest receipts or payments on the variable-rate asset or liability during the term of the swap are designated as hedged, and no interest payments beyond the term of the swap are designated as hedged.

(11) There is no floor or cap on the variable interest rate of the swap unless the variable-rate

asset or liability has a floor or cap. In that case, the swap must have a floor or cap on the variable interest rate that is comparable to the floor or cap on the variable-rate asset or liability. (For this purpose, comparable does not necessarily mean equal. For example, if a swap’s variable rate is LIBOR and an asset’s variable rate is LIBOR plus 2 percent, a 10 percent cap on the swap would be comparable to a 12 percent cap on the asset).

1 For cash flow hedge situations in which the cash flows of the hedged item and the hedging instrument are

based on the same index but that index is not the benchmark interest rate, the shortcut method is not permitted. However, the entity may obtain results similar to results obtained if the shortcut method was permitted.


Page 661-71 (12) The repricing dates match those of the variable-rate asset or liability.

h. The fixed rate on a hedged item need not exactly match the fixed rate on a swap designated as a fair value hedge. Nor does the variable rate on an interest-bearing asset or liability need to be the same as the variable rate on a swap designated as a cash flow hedge. A swap’s fair value comes from its net settlements. The fixed and variable rates on a swap can be changed without affecting the net settlement if both are changed by the same amount. That is, a swap with a payment based on LIBOR and a receipt based on a fixed rate of 5 percent has the same net settlements and fair value as a swap with a payment based on LIBOR plus 1 percent and a receipt based on a fixed rate of 6 percent.

i. Comparable credit risk at inception is not a condition for assuming no ineffectiveness even

though actually achieving perfect offset would require that the same discount rate be used to determine the fair value of the swap and of the hedged item or hedged transaction. To justify using the same discount rate, the credit risk related to both parties to the swap as well as to the debit on the hedged interest-bearing asset (in a fair value hedge) or the variable-rate asset on which the interest payments are hedged (in a cash flow hedge) would have to be the same. However, because that complication is caused by the interaction of interest rate risk and credit risk, which are not easily separable, comparable creditworthiness is not considered a necessary condition to assume no ineffectiveness in a hedge of interest rate risk.

After-Tax Hedging of Foreign Currency Risk j. This Provision permits hedging of foreign currency risk on an after-tax basis. The portion of the

gain or loss on the hedging instrument that exceeded the loss or gain on the hedged item is required to be included as an offset to the related tax effects in the period in which those tax effects are recognized.

Examples of Assessing Effectiveness and Measuring Ineffectiveness k. The following examples illustrates some of the ways in which a banking corporation may assess

hedge effectiveness and measures hedge ineffectiveness for specific strategies. The examples are not intended to imply that other reasonable methods are precluded. However, not all possible


Page 661-72 methods are reasonable or consistent with this Provision. This section also discusses some methods of assessing hedge effectiveness and determining hedge ineffectiveness that are not consistent with this Provision and thus may not be used.

Example 1: Fair value hedge of equity securities through option contracts l. Bank A holds 10,000 shares of the Reshet company. It buys put option contracts on 20,000

Reshet shares with a strike price equal to the present price of the share in order to hedge its exposure to changes in the fair value of its investment position attributable to changes in the Reshet share price. Bank A manages the position using the “delta-neutral” strategy, that is, it monitors the “delta” of the option - the ratio between changes in the option price and changes in the Reshet share price. As the delta ratio changes, Bank A buys or sells put options so that the next change in the fair value of all the options held can be expected to counter-balance the next change in the fair value of its investment in the Reshet share. The delta ratio for put options moves closer to one as the share price drops, and moved closer to zero as the share price rises. The delta ratio also changes with the shortening of the exercise term, changes in interest rates and changes in expected volatility. Bank A designates the put options as a fair value hedge of its investment in the Reshet share.

Assessing expected effectiveness of the hedge and measuring ineffectiveness m. As Bank A intends to vary the number of options that it holds to the extent required to maintain

a delta - neutral position, it may not automatically assume that the hedge will be highly effective in achieving offsetting changes in fair value. Moreover, as the delta neutral hedge strategy is based on changes expected in the fair value of the option, the Bank may not assess the effectiveness based on changes in the intrinsic value of the option. Instead, Bank A must assess: (a) the gain or loss on the open position deriving from various rises or drops in the market price of the Reshet share and (b) the loss or the gain on its investment in the Reshet shares in respect of the same changes in the market price. In order to assess the effectiveness of the hedge both at the inception of the hedge and on an ongoing basis, the Bank could compare the matching gains and losses of the different changes in the market price. The continuing assessment of the effectiveness must also take account of actual changes in the fair value of the put options held and the investment in the Reshet shares during the hedge period.

n. Consistent with the Bank’s method of assessing effectiveness, the hedge would be ineffective to

the same extent that the gains or losses which are actually realized and unrealized from changes in the fair value of the options held are greater or less than the change in the value of the


Page 661-73 investment in the Reshet shares. The underlying of the put options is the market price of the Reshet shares. This being the case, if Bank A continually monitors the delta ratio and adjusts the number of options held accordingly, the changes in the fair value of the options and of the item hedged may almost be completely offset resulting in only a small amount of ineffectiveness to be recognized in earnings.

Example 2: fair value hedge of Treasury Bonds through a put option contract o. Bank B holds a Treasury Bond and wishes to protect itself against fair value exposure to

declines in the price of the Treasury Bond. The Bank acquires an at-the-money put option on a Treasury security with the same terms (remaining maturity, notional amount and interest rate) as the Treasury bond it holds, and designates the option as a fair value exposure hedge of the Treasury bond. Bank B intends holding the put option until its expiry.

Assessing the expected effectiveness of the hedge and measuring ineffectiveness p. As Bank B intends holding the put option (a static hedge) rather than manage the position using

a delta-neutral strategy, it can assess whether it expects that the hedge will be highly effective in achieving changes offsetting fair value by calculating and comparing the changes in the intrinsic value of the option and changes in the price (fair value) of the Treasury bond for different possible market prices. In assessing the expectation of the effectiveness on a continuing basis, the Bank must also take into account the actual changes in the fair value of the government bond and in the intrinsic value of the option during the hedge period.

q. However, because the pertinent critical terms of the option and of the bond are the same in this

example, the Bank could expect the changes in the value of the bond attributable to changes in the interest rates and the changes in the intrinsic value of the option to offset completely during the period that the option is in the money. That is, there will be no ineffectiveness since the Bank has elected to exclude changes in the time value of the option from the test of effectiveness. Having so elected, Bank B must recognize changes in the time value of the option directly in earnings.

Example 3: Fair value hedge of an embedded option purchased through a written option r. Bank C issues a five-year fixed interest rate debt note with an embedded call option (purchased)

with prepayment and writes a call option with a counter-party in order to neutralize the call feature for prepayment contained in the promissory note. The embedded call option and the written call option have the same effective notional amount, underlying fixed interest rate and


Page 661-74 strike price. (The strike price of the option contained in the debt note is generally called the call price). The embedded option can also be at the same times as the written option. Bank C designates the written option as a fair value hedge of the embedded prepayment option component in the fixed interest rate debit note.

Assessment of expected effectiveness of the hedge and measuring ineffectiveness s. In order to assess whether the hedge is likely to be highly effective in achieving offsetting

changes in the fair value, Bank C could assess and compare the changes in fair values of the two options for different market interest rates. As this Provision precludes the separation into components of derivatives, including embedded derivatives, whether they are required to be accounted for separately or not, Bank C can only designate a hedge of the entire change in fair value of the embedded call option that was purchased. The changes obtained in the fair value will be included currently in earnings. Changes in the fair value of the written option will similarly be included in earnings, and accordingly; any ineffectiveness will thus automatically be currently reflected in earnings. (It is probable that the hedge will have a certain extent of ineffectiveness as it is unlikely that the premium in respect of the call option written will be the same as the premium in respect of the embedded call option purchased).

Example 4: Cash flow hedge through a basis swap t. Bank D has a 5-year variable-interest $100,000 asset and a 7-year variable-interest liability of

$150,000. The interest for the asset is payable by the counter-party at the end of each month based on the Eurodollar interest rate on the first of the month. The interest in respect of the liability is payable by Bank D at the end of each month based on the LIBOR on the tenth of the month (the liability‘s anniversary date). The Bank enters into a five-year interest rate swap under which it pays at the end of each month, interest according to the Eurodollar and receives interest according to the LIBOR, based on a notional amount of $100,000. Both interest rates are determined on the first of the month. Bank D designates the swap as a hedge of the variable interest to be received over five years in respect of the $100,000 variable-rate asset and the first five years of interest payments in respect of the $100,000 liability.

Assessing the expected effectiveness of the hedge and measuring the ineffectiveness u. Bank D may not automatically assume that the hedge will always be highly effective in

achieving offsetting changes in cash flows as the reset date on the receive leg of the swap is different to the reset date of the variable interest in respect of the corresponding liability. The company’s assessment both at the inception of the hedge and on an ongoing basis of the expected effectiveness may be based on the extent to which changes have occurred in the LIBOR during the comparative past ten-day period. The assessment of Bank D on an ongoing


Page 661-75 basis of the expected effectiveness and measuring the actual ineffectiveness would be on a cumulative basis and include the actual changes in the interest rate until the date of the measurement. The hedge would be ineffective to the extent the cumulative change in the cash flows from the Eurodollar leg of the swap did not offset the cumulative change in the cash flows expected from the asset, and the cumulative change on the LIBOR cash flow leg of the swap did not offset the change in the expected cash flow of the portion of the liability hedged. The terms of the swap, the asset and the portion hedged of the liability are the same, apart from the reset dates on the liability and the receive leg of the swap. Accordingly, the hedge will be ineffective only to the extent the LIBOR rate has changed during the period from the first of the month (the reset date of the swap) until the first of the month (the reset date of the liability).

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