The Nitty Gritty of Hedge - Chatham Financialinfo.chathamfinancial.com/rs/chatham/images/Chatham...

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The Nitty‐Gritty of Commodity Hedge Accounting

June 2013

Aaron Cowan, CFA, CPA Steve Arveseth, CPA

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Webinar Administrative Details

• Technical Issues?• Contact WebEx: 1.866.569.3239

• CPE/CTP Credit• Listen to the entire broadcast• Answer 3 of 4 polling questions• Certificates will be emailed within 10 business days

• Slides• Will be sent out in follow up email

• Recording• Available on our website within the week: http://www.chathamfinancial.com/thought‐leadership/webinars/see‐all‐webinars/

• Questions?• Use the Q&A window provided to submit any questions to All Panelists• If we do not get to your question, we will answer them afterwards individually

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DisclaimerTRANSACTIONS IN OVER‐THE‐COUNTER DERIVATIVES (OR “SWAPS”) HAVE SIGNIFICANT RISKS, INCLUDING, BUT NOT LIMITED TO, SUBSTANTIAL RISK OF LOSS. YOU SHOULD CONSULT YOUR OWN BUSINESS, LEGAL, TAX AND ACCOUNTING ADVISERS WITH RESPECT TO PROPOSED SWAP TRANSACTION AND YOU SHOULD REFRAIN FROM ENTERING INTO ANY SWAP TRANSACTION UNLESS YOU HAVE FULLY UNDERSTOOD THE TERMS AND RISKS OF THE TRANSACTION, INCLUDING THE EXTENT OF YOUR POTENTIAL RISK OF LOSS.THIS MATERIAL HAS BEEN PREPARED BY A SALES OR TRADING EMPLOYEE OR AGENT OF CHATHAM HEDGING ADVISORS AND COULD BE DEEMED A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION. THIS MATERIAL IS NOT A RESEARCH REPORT PREPARED BY CHATHAM HEDGING ADVISORS. IF YOU ARE NOT AN EXPERIENCED USER OF THE DERIVATIVES MARKETS, CAPABLE OF MAKING INDEPENDENT TRADING DECISIONS, THEN YOU SHOULD NOT RELY SOLELY ON THIS COMMUNICATION IN MAKING TRADING DECISIONS.

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Today’s Speakers

Aaron CowanDirector,

Hedge Accounting

Steven ArvesethDirector,

Hedge Accounting

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Hedge Accounting Advisory Interest Rate Hedging FX Hedging Commodity Hedging Regulatory Advisory Debt & Capital Advisory

ChathamDirect, our SaaS platform Financial risk management modules Debt management module Covered by SSAE 16 audit

Serving 1000+ clients Trading > $300 billion annually 5 locations globally inU.S., Europe, and Asia

The Chatham Difference – Technology and Advisory from independent experts leading the derivatives and debt markets

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Today’s Agenda

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Commodity Hedging Overview

Key Considerations for Commodity Hedge Accounting

Defining the Hedged Risk

Identifying the Hedged Forecasted Transactions

Hypothetical Derivative Method

Determining the Timing for Reclassifications to Earnings of Amounts Deferred in OCI

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On Track for a Best‐in‐Class Commodity Hedging Program

Procurement /Sales

Procurement /Sales AccountingAccounting TreasuryTreasury

Foundational KnowledgeCommon Language & Framework

Organizational Alignment

Policy Design

Core Risk Management

Execution

Accounting and ReportingASC 815 and ASC 820

Monitoring (Performance/Counterparties)

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Case Study: DMP Electronics

Natural Gas RiskManufacturing facilityburns a significant

amount of natural gas

Gold RiskComponents use gold as a primary input

Fuel RiskFuel surcharges and direct fuel expenses

Manufacturing

Product

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Hedging Program Focus

Manage margin risk from commodity inputs Limit cost of hedging through optimized program

DMP Electronics

Manufactures and sells electronic components

Natural Gas

Manufacturing facility burns significant amount of natural gas

Gold

Most COGS variability driven by spot gold (gold changes faster than customer pricing)

INPUTS

OUTPUT


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Identify Exposures and Quantify Risks

How much pain can I handle?Variation in key metrics,Variation from budget,

Debt covenants

How much can prices change?

Commodities have been volatile.

How much exposure do I have?

Effective cross‐functional forecasting is critical.

How much pain can I handle?Variation in key metrics,Variation from budget,

Debt covenants

How much can prices change?

Commodities have been volatile.

How much exposure do I have?

Effective cross‐functional forecasting is critical.

What are my objectives for hedging and how will I accomplish them?What are my objectives for hedging and how will I accomplish them?

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Polling Question 1

• What is your company’s main objective for managing commodity risk? (Check all that apply)A. Reduce reported earnings volatilityB. Reduce cash flow/budgeting volatilityC. Provide pricing alternatives to customers while keeping our risk the

sameD. Provide disaster protectionE. Other objectivesF. Currently not hedging commodities; planning to hedgeG. Currently not hedging commodities; not planning to hedge

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Risk Owner Risk Management Approach Notes

Procurement Fixed‐Price Supply ContractProcurement and Treasury worked together considering efficiency of pricing and ability to get free credit.

Treasury OTC ForwardsTreasury consulted with Procurement, but financial contracts were a better way to manage the risk.

TBD TBDTreasury and Procurement have tabled this while they manage the other risks. Less significant overall.

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• DMP Electronics had a process in place that required significant contracts to be evaluated for accounting issues before final signing

• DMP Electronics determined that the supply contract was a derivative

• The contract qualified for NPNS• Terms were normal in relation to the

Company’s business• Past experience had shown that the

Company would take physical delivery

• When considering the use of a fixed‐price supply contract DMP Electronics was aware of the accounting ramifications and knew that this contract could avoid the need for hedge accounting

Evaluation Process

NPNS Election


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Polling Question 2

• What contracts does your organization use for commodity risk?A. Fixed‐price purchase/sale contracts with suppliers/customersB. All floating‐price contracts with suppliers and customersC. Mostly fixed, with some floatingD. Mostly floating, with some fixedE. Financial contracts to fix commodity exposures from floating‐price

contractsF. Unsure

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Gold forwards

Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14

DCA B

TODAY

Forward Execution

With the forwards, as gold prices go up the forward contracts offset the increase to maintain a fixed price locked via the forward contract.

OBJECTIVE: Protect margin from gold price risk = ACHIEVED

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Commodity Hedge AccountingKey Considerations

AccountingAccounting TreasuryTreasury

Determining the Timing for Reclassifications to Earnings of Amounts Deferred in OCI




Procurement /Sales

Procurement /Sales

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Why Hedge Accounting?Without it, all MTM changes on hedges flow directly into earnings

Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10

Changes in MTMChanges in MTMEverything flows immediately

into earningsEverything flows immediately

into earnings

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Why Hedge Accounting?With hedge accounting, recognition of gains / losses on hedges is initially deferred in equity (other comprehensive income or “OCI”) and subsequently reclassified to earnings to align with the recognition of the associated hedged transactions

Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10

Equity

Hedge AccountingHedge Accounting• Effective portion of MTM changes flow to equity, equity

reclassified to earnings as hedged transactions occur• Ineffective portion of MTM changes flow to earnings

• Effective portion of MTM changes flow to equity, equity reclassified to earnings as hedged transactions occur

• Ineffective portion of MTM changes flow to earnings

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AccountingAccounting TreasuryTreasuryProcurement /

SalesProcurement /

Sales


Determining the Timing for OCI Reclassifications to Earnings




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Procurement /Sales

Procurement /Sales


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Limitations for “Non‐financial” Items

ASC 815ASC 815For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits

designating the hedged risk as overall changes in cash flows relating to all changes in price.For cash flow hedges of non-financial items (e.g. commodity price risk), ASC 815 only permits

designating the hedged risk as overall changes in cash flows relating to all changes in price.

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While not a part of the economic hedging program, these items must be included as part of the hedged

risk for applying hedge accounting


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Limitations for “Non‐financial” ItemsFactoring in “All Changes in Price”

‐2.5

‐2

‐1.5

‐1

‐0.5

0

0.5

1

1.5

2

2.5

Price Va

riabiliyt p

er Unit ‐

USD

Au Mfg / Tport Total Au Contract

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‐2.5

‐2

‐1.5

‐1

‐0.5

0

0.5

1

1.5

2

2.5

Price Va

riabiliyt p

er Unit ‐

USD


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‐2.5

‐2

‐1.5

‐1

‐0.5

0

0.5

1

1.5

2

2.5

Price Va

riabiliyt p

er Unit ‐

USD


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‐2.5

‐2

‐1.5

‐1

‐0.5

0

0.5

1

1.5

2

2.5

Price Va

riabiliyt p

er Unit ‐

USD


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‐2.5

‐2

‐1.5

‐1

‐0.5

0

0.5

1

1.5

2

2.5

Price Va

riabiliyt p

er Unit ‐

USD


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The ability to aggregate or even hedge exposures arising from multiple contracts

Monitoring of hedging relationships from forecasts through earnings recognition

Assessing hedge effectiveness and measuring hedge ineffectiveness


Organization alignment across functional units (e.g. purchasing, accounting, treasury)

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Polling Question 3• IFRS 9 allows for bifurcation by risk for commodities. In the FASB’s project

to revisit hedge accounting, do you believe that the new guidance should include the option to bifurcate by risk for commodity exposures?A. Yes, new guidance should be based on the IFRS 9 approach. B. Yes, but not necessarily based on the IFRS 9 approach.C. Maybe. I don’t have strong feelings one way or the other.D. No. I think it is too difficult to identify the risk that should be hedged.

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Factoring in “All Changes in Price”Defining the “Hypo”

• What is a hypothetical derivative?• A derivative that would perfectly

offset the variability in cashflowson the hedged transactions

• Must reflect the terms of the hedged transactions

• Let’s take another look at the DMP purchase contract, what would have been the “perfect” hedge?

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Factoring in “All Changes in Price”Defining the “Hypo”

• What is a hypothetical derivative?• A derivative that would perfectly

offset the variability in cashflowson the hedged transactions

• Must reflect the terms of the hedged transactions

• Let’s take another look at the DMP purchase contract, what would have been the “perfect” hedge?

• Actual trade is the trade you get done with the bank or on the exchange• Based on liquid and/or available

indices• Close, but doesn’t always match

your actual exposure

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Delivery LocationDerivative based on delivery at point A, hedged forecasted purchase expected to occur at point B

Off‐Market HedgesDerivatives with a fair value other than zero at the

inception of the hedging relationship

Product SpecificationDifferences in grade and/or quality between the

hedging derivative and the hedged CF’s

Settlement DatesSwap contracts (derivatives) may settle on the 2nd day of the delivery month, while hedged purchases

may settle 60 days after that month end

PricingIndex Reference Date or Period, Fixed spreads, caps

or floors, transportation costs (if included)

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Procurement /Sales

Procurement /Sales


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Grouping Forecasted Transactions

• CF hedging guidance doesn’t explicitly define what sharing the same risk means, which gives rise to diversity

• Shared risk can affect the level of aggregation of forecasted transactions, which can impact the way that other requirements of hedge accounting are met and supported

ASC 815ASC 815Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.Forecasted transactions may be grouped and hedged together if they share the same risk exposure for which they are hedged.

Qualitative Factors:

• Similar product type, indexation, pricing, etc.

• Exposures are managed together as part of a program and/or hedged with same derivatives

• Time period covered

Quantitative Factors:

• Simple analysis of pricing characteristics and cash flows

• Regression or other more complex analysis

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Case Study: DMP ElectronicsDMP has 3 products that it is considering hedging as a group

• Product 1 Price = 0.01 t oz.* gold price + freight + manufacturing• Product 2 Price = 0.0098 t oz.* gold price + freight + manufacturing• Product 3 Price = 0.06 t oz.* gold price + 0.002 lbs. * copper price

+ freight + manufacturing


Qualitative Factors:

• Indexation: Products 1 and 2 have similar weights, purity, and index for gold

• Other Variability: Products 1 and 2 have other charges that are similar in terms of the absolute size and the variability of the charge

Quantitative Factors:

• Simple Analysis: Products 1 and 2 have similar changes in $ and %

• Regression: Products 1 and 2 have a strong relationship as measured by correlation and the slope is close to 1

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• As an example, DMP could look at the products that it determines to analyze using a quantitative approach to support that they share the same risk

• The Company performs its analysis to show that the cash flows of the various product types share the same risk (see example below) – if they do, then they can be grouped together


y = 0.8624x + 1.2051R² = 0.988

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17

20

14 17 20

Price Product 1 vs. 2

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y = 0.8624x + 1.2051R² = 0.988

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17

20

14 17 20


y = 2.3459x ‐ 0.558R² = 0.9859

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40

50

13 18 23


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y = 1.1241x + 0.0027R² = 0.8545

(1.5)

‐

1.5

(1.0) ‐ 1.0 2.0


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y = 1.1241x + 0.0027R² = 0.8545

(1.5)

‐

1.5

(1.0) ‐ 1.0 2.0


y = 2.0785x + 0.0105R² = 0.8753

(3.0)

‐

3.0

6.0

(1.0) ‐ 1.0 2.0 3.0


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Impact on the Hypo from Grouping Transactions

Delivery Location

Product Specification

Settlement Dates

Pricing / Indexation

Grouping transactions adds complexity to the hypoThe key features of each transaction in the group will influence the hypo

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Probability of Occurrence


DCA B

TODAY

Forward Execution

Hedged forecasted transactions must be “probable” of occurringGenerally interpreted as >80% likely to occur

Consider tradeoffs between level of transaction grouping, probability assertion, OCI release, and shared risk assessment.

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DCA B

TODAY

Forward Execution

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8

10

12

14

16

6 7 8 9 10 11 12 13 14

Thou

sand

s of U

nits

Forecast Actual

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DCA B

TODAY

Forward Execution

6

8

10

12

14

16

6 7 8 9 10 11 12 13 14

Thou

sand

s of U

nits

Forecast Actual

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DCA B

TODAY

Forward Execution

6

8

10

12

14

16

6 7 8 9 10 11 12 13 14

Thou

sand

s of U

nits

Forecast Actual

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DCA B

TODAY

Forward Execution

6

8

10

12

14

16

6 7 8 9 10 11 12 13 14

Thou

sand

s of U

nits

Forecast Actual

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Procurement /Sales

Procurement /Sales


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Hypo Revisited

Delivery Location

Product Specification

Settlement Dates

Pricing / Indexation

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Building Hypo Curves

ASC 815ASC 815The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important.

Select a “base” forward curve to use

• DMP Electronics’ case is fairly easy, the base curve would be the gold forward curve

• It often makes sense to use the index in the actual hedging derivative as the base

Step 1 Find and summarize the relationship between the actual and the hypo (i.e., the exposure)

• DMP Electronics has a few options, but they opted to look at the spot prices of gold compared to the actual prices paid for its components to establish the relationship

• There are a few different approaches that could be used (discussed later)

Step 2 Apply the findings in Step 2 to the base curve to develop the hypothetical forward curve

• DMP Electronics found a relationship between gold spot prices and its components’ pricing that it applied to the gold forward curve to calculate the hypothetical forward curve

Step 3

Various approaches can be used to calculate a hypo curve.

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1,380

1,410

1,440

1,470

1,500

1w 1m 2m 3m 6m 9m 12m 2y 3y 5y

Base CurveGold Fwd Curve

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1,380

1,410

1,440

1,470

1,500

1w 1m 2m 3m 6m 9m 12m 2y 3y 5y

1,670

1,700

1,730

1,760

1w 1m 2m 3m 6m 9m 12m 2y 3y 5y

T3M Regression Flat Curve


Hypo CurveGold Fwd + T3M Basis

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1,380

1,410

1,440

1,470

1,500

1w 1m 2m 3m 6m 9m 12m 2y 3y 5y


Hypo Curve0.87* Gold Fwd + 272

14.00

16.00

18.00

20.00

22.00

11.00 13.00 15.00 17.00 19.00

Product Price vs. Gold Price

y = mx + b

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1,380

1,410

1,440

1,470

1,500

1w 1m 2m 3m 6m 9m 12m 2y 3y 5y

1,670

1,700

1,730

1,760

1w 1m 2m 3m 6m 9m 12m 2y 3y 5y



Hypo Curve0.87* Gold Fwd + 272

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1,380

1,410

1,440

1,470

1,500

1w 1m 2m 3m 6m 9m 12m 2y 3y 5y


Hypo CurveGold Spot+T3M Basis

1,670

1,700

1,730

1,760

1w 1m 2m 3m 6m 9m 12m 2y 3y 5y


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Challenges in Building Hypo Curves

ASC 815ASC 815The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important………The requirement to hedge the changes in all cash flows makes data on actual purchases/exposures very important………

Gathering DataHow many contracts are there and are they easily accessible?How do contracts change over time and how often are the negotiated?

Analyzing Purchase DataIs purchase data captured for analysis and is it accurate/reliable?How well is it organized and is it granular enough?How long is the history? Does historical data represent expectations going forward?

Developing forward basis estimates and forward curves for hedged exposuresDetermining approach for calculating forward basisProcess for updating dataUnderstanding potential for ineffectiveness

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What does assessing effectiveness mean?

ASC 815ASC 815The guidance requires that a hedge be highly effective at offsetting cash flows for the risk being hedged.The guidance requires that a hedge be highly effective at offsetting cash flows for the risk being hedged.

Changes in MTMChanges in MTM

Everything flows immediately into earnings

Everything flows immediately into earnings

Equity

Hedge AccountingHedge Accounting





NOTHighly Effective

An effectiveness assessment is the means to hedge accountingIt demonstrates that a hedge is highly effective and eligible for hedge accounting

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Assessing Effectiveness

Long Haul Methods:

ASC 815ASC 815The guidance does not prescribe a specific method for assessing the effectiveness of hedge accounting relationships.The guidance does not prescribe a specific method for assessing the effectiveness of hedge accounting relationships.

Reg

ress

ion

Ana

lysi

sR

egre

ssio

n A

naly

sis Pro: Robust approach with greater flexibility

Con: Higher degree of difficulty to apply and interpret

Pro: Robust approach with greater flexibility

Con: Higher degree of difficulty to apply and interpret

One

-Per

iod

Dol

lar O

ffset

One

-Per

iod

Dol

lar O

ffset Pro: Simple to perform and straightforward to interpret

Con: Easier to fail the effectiveness assessment, especially when small changes occur

Pro: Simple to perform and straightforward to interpret


Cum

ulat

ive

Dol

lar O

ffset

Cum

ulat

ive

Dol

lar O

ffset Pro: Simple to perform and straightforward to interpret


Pro: Simple to perform and straightforward to interpret


REGRESSION ANALYSIS

y = 0.988x + 92.54R2 = 0.9995

-150,000

-100,000

-50,000

0

50,000

100,000

150,000

200,000

-150,000 -100,000 -50,000 0 50,000 100,000 150,000 200,000

Hypothetical Derivative Change

Hedg

e Ch

ange

REGRESSION ANALYSIS

y = 0.988x + 92.54R2 = 0.9995

-150,000

-100,000

-50,000

0

50,000

100,000

150,000

200,000

-150,000 -100,000 -50,000 0 50,000 100,000 150,000 200,000

Hypothetical Derivative Change

Hedg

e Ch

ange

∆∆

∆∆

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Assessing Effectiveness

ASC 815ASC 815The guidance does not prescribe a specific method for assessing the effectiveness of hedge accounting relationships.The guidance does not prescribe a specific method for assessing the effectiveness of hedge accounting relationships.

Even with regression assessments there are different approaches to consider:Sp

ot v

s.

Spot

Spot

vs.

Sp

ot

Pros: Simple to implement, easier data gathering exercise

Con: Only supports deferral of changes in spot rates (i.e., changes for other components would run through P&L)

Pros: Simple to implement, easier data gathering exercise

Con: Only supports deferral of changes in spot rates (i.e., changes for other components would run through P&L)

Forw

ard

vs.

Forw

ard

Forw

ard

vs.

Forw

ard Pro: Provides a more robust basis to defer full changes in FV (avoid P&L

volatility)

Cons: Does not consider discounting and misses some sources of ineffectiveness like “offmarket” elements

Pro: Provides a more robust basis to defer full changes in FV (avoid P&L volatility)

Cons: Does not consider discounting and misses some sources of ineffectiveness like “offmarket” elements

Fair

Valu

eFa

ir Va

lue Pro: Captures all components of fair value and resulting ineffectiveness,

most robust

Con: Most complicated method since trades are fully valued (calculation intense)

Pro: Captures all components of fair value and resulting ineffectiveness, most robust

Con: Most complicated method since trades are fully valued (calculation intense)

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Measuring Ineffectiveness

ASC 815ASC 815ASC 815’s hypothetical derivative method is the most common method for measuring ineffectiveness.ASC 815’s hypothetical derivative method is the most common method for measuring ineffectiveness.

Ineffectiveness measurement is the degree to which the hedge actually offsets the risk being hedged

OCI Ineffectiveness

None

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Procurement /Sales

Procurement /Sales


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Reclassifying Amounts Deferred in OCI

• How do the hedged transactions affect earnings?• Are the hedged commodities part of overhead, inventory, and/or sales?• For inventory, the earnings is unaffected until cost of goods sold is recognized based on a sale to an

external party.

• Other inventory considerations• What inventory includes the commodities that are hedged?• How long will it take for the hedged commodities in inventory to be included in a transaction with an

external party that will affect earnings?• Does the inventory behave in a predictable way such that inventory turnover can be used to

determine the timing for OCI reclassifications?

ASC 815ASC 815Amounts deferred in OCI related to cash flow hedges are reclassified to earnings as the hedged transactions affect earnings.Amounts deferred in OCI related to cash flow hedges are reclassified to earnings as the hedged transactions affect earnings.

Earnings

OCI

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Reclassifying Amounts Deferred in OCI

OCI Reclass

HypoDesign

Probability

Interrelationships among hedge accounting decision points

Grouping transactions may help probability assertions, but increases the complexity of hypo design and OCI reclasses.

Grouping Transactions

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Polling Question 4

• What is the greatest challenge your company faces in applying hedge accounting for commodities? (Check all that apply)A. Challenges with flow of data and analyzing data in a timely and

effective mannerB. Assessing effectiveness is difficult (e.g., building and performing

regressions)C. Assessing sources of ineffectiveness is difficult, including building the

hypothetical derivative with its unique forward curvesD. Internal knowledge and processes for hedge accounting are limitedE. Other challenges not listed above

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Connecting with Chatham

Aaron Cowan, CFA, CPADirector, Corporate Hedge [email protected]: 720.221.3514

Kennett Square235 Whitehorse LaneKennett Square, PA 19348610.925.3120

Denver10026 West San Juan Way, Ste 150Littleton, CO 80127United States720.221.3500

London4th Floor, 16 Garrick StreetLondon WC2E 9BAUnited Kingdom+44 (0)20.7557.7000

Singapore20 Cross StreetChina Square Central #02‐16/17Singapore, 048422+65 6507.0680

Krakowul. Rakowicka 7, III p.31‐511 KrakówPoland+48 (0)12.294.6160

www.ChathamFinancial.com

Steve Arveseth, CPADirector, Corporate Hedge [email protected]: 484.731.0033

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