Introduction (Including Several Appendix B Examples)

Selected FAS 133 Appendix A Illustrations of Hedge Effectiveness Analysis

Fair Value Hedge of Natural Gas Inventory with Futures Contracts

Cash Flow Hedge–Forecasted Purchase of Inventory with a Forward Contract

Cash Flow Hedge of Forecasted Sale with a Forward Contract

Attempted Hedge of a Forecasted Sale with a Written Call Option

Terms used in this document are defined in my glossary at

FAS 133 allows some discretion in how hedge ineffectiveness will be assessed. It must, however, pre-define some means of testing for ineffectiveness and then charge the ineffectiveness to current earnings (as opposed to, say OCI in a cash flow or FX hedge). Different methods can be specified for different hedges, but for a given contract the testing must be consistent throughout the life of the contract.

Three Types of Exclusions from Effectiveness Testing

Only in three instances can a portion of the hedges change in value be excluded from effectiveness tests. Paragraph 63 in FAS 133 reads as follows:

In defining how hedge effectiveness will be assessed, an entity must specify whether it will include in that assessment all of the gain or loss on a hedging instrument. This Statement permits (but does not require)an entity to exclude all or a part of the hedging instruments time value from the assessment of hedge effectiveness,as follows:

a. If the effectiveness of a hedge with an option contract is assessed based on changes in the options intrinsic value, the change in the time value of the contract would be excluded from the assessment of hedge effectiveness.

b. If the effectiveness of a hedge with an option contract is assessed based on changes in the options 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.

c. 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, thechange in the 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 ineffectiveness. As noted in paragraph 62, 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 a gain or loss on the designated hedging instrument may be excluded from the assessment of hedge effectiveness.

Effectiveness testing in value lock hedges are less troublesome in this regard since there is no partitioning of value changes between OCI and current earnings. In a value lock hedge, all changes in value are posted to current earnings.

Example 9 illustrates the partitioning of value changes in the hedge derivative (a call option in Example 9) into intrinsic (Commodity X spot price minus the call options strike price) and time value (call options strike price minus the call options forward value) components. In cash flow hedge, only the changes in intrinsic value are deferred in OCI. Changes in time value are posted to current earnings. In effectiveness testing, the change in the time value is excluded from effectiveness measurements since time value is posted to earnings and does not affect OCI. If effectiveness is based on a minimum value of intrinsic value plus the effect of discounting, the change in the volatility value of the option is excluded in effectiveness tests (that is not illustrated in Example 9).

The main purpose of Example 9 is to illustrate how hedge effectiveness of an option is based only upon intrinsic value changes. My spreadsheet solution for Example 9 can be downloaded as the 133ex09a.xls file from the listing of files at

Example 9 as illustrated in my133ex09a.xlsfile at

Hedged Item:Forecasted purchase price of a commodity at the end of Period 5

Hedge Derivative:Theex postintrinsic value (spot value price I(t) minus the strike value of $125) of anAmerican call optionpurchased at t=0 for a premium of $9.25.

W(0)= $9.25 since the call option contract has a value equal to the premium at t=0

W(t)=ex anteforward value of the call optionex postat the end of Period t.

= [Ex postIntrinsic Value] + [Ex AnteTime Value]

Hedged Items Account Receivable Carrying Value C(t) and Ineffectiveness

I(t)= hedged itemsex postcommodity spot value at the end of Period t

X(t)= the time value component of W(t) depicting the difference between the Period tex postintrinsic value and theex anteforward value of the call option.

C(t)= $0 since the purchase is only a forecasted transaction rather than a recognized firm commitment.

C(5)= I(5) + $9.25 – [I(5) – $125 Strike Price] =$115.75if I(5)$125 for a call option that is in-the-money

=I(5) + $9.25if I(5)$125 for a call option that is out-of-the-money

Ineffectiveness= $0 for reasons explained in Paragraph 164 of FAS 133

The amount reflected in earnings relates to the component excluded from the effectiveness test, that is, the time value component. No reclassifications between other comprehensive income and earnings of the type illustrated in Example 6 are required because no hedge ineffectiveness is illustrated in this example. (The change in cash flows from the hedged transaction was not fully offset in period 3. However, that is not considered ineffectiveness. As described in paragraph 20(b), a purchased call option is considered effective if it provides one-sided offset.)

The risk is that the cash flow lock using an option may force the company to lose its $9.25 premium paid on the call option. Unlike futures contracts, however, the call option does afford an opportunity for the XYZ Company to take advantage of a decline in the price of the commodity between t=0 and t=4. Futures contracts would deny this opportunity, but options contracts do not destroy the opportunity value of price declines in forecasted purchases.

Example 10 illustrates FX cash flow effectiveness testing based upon a forward contracts change in spot prices. Example 10 assesses hedge effectiveness based upon changes is spot FX German mark prices.

One purpose of Example 10 is to illustrate how hedge ineffectiveness amounts exclude the FX spot minus derivatives forward prices. My spreadsheet solution for Example 10 can be downloaded as the 133ex10a.xls file from the listing of files at

Example 10 as illustrated in my133ex10a.xlsfile at

Hedged Item:FX receivables of forecasted royalty paymentsin German marks in Periods 2, 3, and 4

Hedge Derivative:The I(4) spot value of aforward contractto sell DM3 million estimated as the sum of royalties accrued at the ends of Periods 2,3, and 4 (payment is received in Period 4). Accrued royalties are posted to earnings when earned rather than when paid. The proportion of the total royalty to be earned determines the proportion of the hedges OCI accumulation that is transferred to current earnings.

W(0)= 0 since the forward contract has a zero starting value

W(t)=ex anteforward value of the forward contract at the end of Period t

Hedged Items Account Receivable Carrying Value C(t) and Ineffectiveness

I(t)= hedged items ex post spot value at the end of Period t

X(t)= component of W(t) depicting the difference between the Period tex postspot value less theex anteforward value.

C(0)= $0 since none of the royalty income has been earned at t=0

C(t)= C(t-1)+(DM1 million)(ex postFX spot rate at the end of Period t)

Ineffectiveness= $0 and DELTA(t) = 1 for reasons explained in Paragraph 168 of FAS 133

This FX lock forces the value of the account receivable to fluctuate with FX rate movements. The DEF Company, thereby, loses all opportunity of gaining from a weakening of the German mark against the dollar. However, it also will not lose from a strengthening of the German mark since the FX hedge locked in the exchange rate without any possibility of hedge ineffectiveness.

Rules for Defining Effectiveness are Not Set in Stone

When a hedge is defined as a change in the spot values of the hedging instrument, Paragraph 63(c) states the 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. However, it is possible to declare in advance that the

change in fair (spot) value of a futures contract [W(t)-W(t-1)] as a hedge against price changes of the hedged item [I(t)-I(t-1)] and avoid testing for effectiveness based upon only the spot components of the W(t) and W(t-1) spot values.

Example 7 beginning in Paragraph 144 of FAS 133 illustrates when the the spot minus forward ratesdo not matterin effectiveness tests. The reason is that the JKL Company in Example 7 bases hedge effectiveness testing on the entire difference in the forward rates of the derivative futures contracts. The key sentence is the first line in Paragraph 147. The entire paragraph reads as follows:

JKL chooses toassess effectiveness by comparing the entire change in fair value of the futures contracts to changes in the cash flows on the forecasted transaction.JKL estimates its cash flows on the forecasted transaction based on the futures price of corn adjusted for the difference between the cost of corn delivered to Chicago and the cost of corn delivered to Minneapolis. JKL does not choose to use a tailing strategy (as described in paragraph 64). JKL expects changes in fair value of the futures contracts to be highly effective at offsetting changes in the expected cash outflows for the forecasted purchase of corn because (a) the futures contracts are for the same variety and grade of corn that JKL plans to purchase and (b) on May 20, 20X1, the futures price for delivery on May 20, 20X1 will be equal to the spot price (because futures prices and spot prices converge as the delivery date approaches). However, the hedge may not be perfectly effective. JKL will purchase corn for delivery to its production facilities in Minneapolis, but the price of the futures contracts is based on delivery of corn to Chicago. If the difference between the price of corn delivered to Chicago and the price of corn delivered to Minneapolis changes during the period of the hedge, the effect of that change will be included currently in earnings according to the provisions of paragraph 30 of this Statement.

One purpose of Example 7 is to illustrate how hedging can be based upon entire changes in derivative contract fair values. My spreadsheet solution for Example 7 can be downloaded as the 133ex07a.xls file from the listing of files at

Define that the full value (intrinsic value plus time value) is the hedge of value changes in the hedged item. In that case the time value does not have to be excluded in effectiveness testing.

Designate a portion of the derivative instruments gain or loss as a hedge of cash flows or fair value of a hedged item.

Designate a portion of the derivative instruments gain or loss as a component in a hedging relationship.

Declare a delta-neutral strategy as illustrated in the example in Paragraphs 85-87 of FAS 133. In such a strategy, the hedge ratio is periodically adjusted by buying and selling options so that the fair value of all options will continue to offset the expected change in the hedged items fair value.

If it can be demonstrated in advance that a hedge will always be perfect, it is not necessary to perform hedge effectiveness tests. Paragraph 65 of FAS 133 provides some examples.

For example, an entity may assume that a hedge of a forecasted purchase of a commodity with a forward contract will be highly effective and that there will be no ineffectiveness to be recognized in earnings if:

a. The forward contract is for purchase of the same quantity of the same commodity at the same time and location as the hedged forecasted purchase.

b. The fair value of the forward contract at inception is zero.

c. Either the change in the discount or premium on the forward contract is excluded from the assessment of effectiveness and included directly in earnings pursuant to paragraph 63 or the change in expected cash flows on the forecasted transaction is based on the forward price for the commodity.

Other situations where effectiveness need not be tested are provided in Paragraph 68-71 of FAS 133. Ineffectiveness testing in many other situations, however, can be exceedingly complex.

Just prior to Appendix A in FAS 138, the FASB states that The provisions of this Statement need not be applied to immaterial items. This means that ineffectiveness can be ignored if it is deemed immaterial in amount. The ineffectiveness may still be charged to current earnings, but the firm does not lose hedge accounting privileges for ineffectiveness that is not material in amount.

For value lock hedges a popular test of ineffectiveness is the DELTA(t) orDratio defined as follows:

DELTA(t)=D= (-Doption value at time t)/(Dhedged item value at time t)

range [.80D1.25] or [80%D%125%](FAS 133 Paragraph 85)

Delta-neutral strategies are discussed at various points (e.g., FAS 133 Paragraphs 85, 86, 87, and 89)

The above ratio can be significant in terms of falling outside the effectiveness bounds when the amount of ineffectiveness is not material. The FASB has never discussed the combinations of alternatives, but presumably hedge accounting will be denied in any period for which the ineffectiveness of a value lock hedge is both significant and material. What is more ambiguous is what happens when the ineffectiveness is deemed insignificant because it falls within the 0.80-1.25 bounds but is material in amount. In this document, it will be assumed that hedge accounting will be permitted in such an instance unless management concedes that ineffectiveness will be significant and material in most future periods of the hedge.

A hedge is normally regarded as highly effective if, at inception and throughout the life of the hedge, the enterprise can expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument, and actual results are within a range of80-125%(SFAS 39 Paragraph 146).The FASB requires that an entity define at the time it designates a hedging relationship the method it will use to assess the hedges effectiveness in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged (FAS 133 Paragraph 62). In defining how hedge effectiveness will be assessed, an entity must specify whether it will include in that assessment all of the gain or loss on a hedging instrument. The Statement permits (but does not require) an entity to exclude all or a part of the hedging instruments time value from the assessment of hedge effectiveness. (FAS 133 Paragraph 63).

Hedge ineffectiveness would result from the following circumstances, among others:

a) difference between the basis of the hedging instrument and the hedged item or hedged transaction, to the extent that those bases do not move in tandem.

b) 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.

c) part of the change in the fair value of a derivative is attributable to a change in the counterpartys creditworthiness (FAS 133 Paragraph 66)

Appendix A Example 1: Fair Value Hedge of Natural Gas Inventory with Futures Contracts

73. Company A has 20,000 MMBTUs of natural gas stored at its location in West Texas. To hedge the fair value exposure of the natural gas, the company sells the equivalent of 20,000 MMBTUs of natural gas futures contracts on a national mercantile exchange. The futures prices are based on delivery of natural gas at the Henry Hub gas collection point in Louisiana.

Hedged Item: Inventory spot value of 20,000 MMBTUs ofTexasnatural gas

Hedge Derivative:Ex postspot value of futures contracts onLouisiananatural gas assuming

the contracts are sold at t=0 to lock in the hedged item value.

W(0)= 0 since futures contracts have zero starting value

W(t)=ex anteforward values of futures contracts at the end of Period t

Hedged Items Carrying Value C(t) and Ineffectiveness

I(t)= hedged itemsex postspot value at the end of Period t

X(t)= component of W(t) depicting the difference between the Period t spot and forward values of Henry Hub futures contracts (which might be viewed as a time value difference).

If the company designates that it will exclude from tests of effectiveness any portion of the change in W(t)-W(t-1) forward value attributable to the X(t)-X(t-1) differences between ex post spot rates and ex ante forward rates. The carrying value becomes the following:

C(t)= C(t-1)+[I(t)-I(t-1)] -[X(t)-X(t-1)]if hedge accounting is allowed in Period t

=C(t-1)if ineffectiveness is deemed both significant and material in amount

Ineffectiveness= [W(t) -X(t) -W(t-1)+X(t-1)]-[I(t-1)-I(t)]

If the company designates that it will base effectiveness on the entire W(t)-W(t-1) forward value changes in the hedging derivative, the carrying value becomes the following:

C(t)= C(t-1)+[I(t)-I(t-1)]if hedge accounting is allowed in Period t

=C(t-1)if ineffectiveness is deemed both significant and material in amount

This value lock forces cash flow risk to the extent that the hedge is ineffective. The hedge also precludes taking advantage of increases in spot prices of the natural gas.

The above Example 1 in Appendix A is not so simple as Example 1 of Appendix B. In the Appendix B version it is stated in Paragraph 105 that it is assumed that the derivative hedges have no time value. It is stressed in that Paragraph 105 that this is an unrealistic assumption in Example 1.

74. The price of Company As natural gas inventory in West Texas and the price of the natural gas that is the underlying for the futures it sold will differ as a result of regional factors (such as location, pipeline transmission costs, and supply and demand). \19/ Company A therefore may not automatically assume that the hedge will be highly effective at achieving offsetting changes in fair value, and it cannot assess effectiveness by looking solely to the change in the price of natural gas delivered to the Henry Hub.

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\19/ The use of a hedging instrument with a different underlying basis than the item or transaction being hedged is generally referred to as a cross-hedge. The principles for cross-hedges illustrated in this example also apply to hedges involving other risks. For example, the effectiveness of a hedge of market interest rate risk in which one interest rate is used as a surrogate for another interest rate would be evaluated in the same way as the natural gas cross-hedge in this example.

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75. Both at inception of the hedge and on an ongoing basis, Company A might assess the hedges expected effectiveness based on the extent of correlation in recent years for periods similar to the spot prices term of the futures contracts between the spot prices of natural gas in West Texas and at the Henry Hub. \20/ If those prices have been and are expected to continue to be highly correlated, Company A might reasonably expect the changes in the fair value of the futures contracts attributable to changes in the spot price of natural gas at the Henry Hub to be highly effective in offsetting the changes in the fair value of its natural gas inventory. In assessing effectiveness during the term of the hedge, Company A must take into account actual changes in spot prices in West Texas and at the Henry Hub.

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\20/ The period of time over which correlation of prices should be assessed would be based on managements judgment in the particular circumstance.

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76. Company A may not assume that the change in the spot price of natural gas located at Henry Hub, Louisiana, is the same as the change in fair value of its West Texas inventory. The physical hedged item is natural gas in West Texas, not natural gas at the Henry Hub. In identifying the price risk that is being hedged, the company also may not assume that its natural gas in West Texas has a Louisiana natural gas component. Use of a price for natural gas located somewhere other than West Texas to assess the effectiveness of a fair value hedge of natural gas in West Texas would be inconsistent with this Statement and could result in an assumption that a hedge was highly effective when it was not. If the price of natural gas in West Texas is not readily available, Company A might use a price for natural gas located elsewhere as a base for estimating the price of natural gas in West Texas. However, that base price must be adjusted to reflect the effects of factors, such as location, transmission costs, and supply and demand, that would cause the price of natural gas in West Texas to differ from the base price.

77. Consistent with the companys method of assessing whether the hedge is expected to be highly effective, the hedge would be ineffective to the extent that (a) the actual change in the fair value of the futures contracts attributable to changes in the spot price of natural gas at the Henry Hub did not offset (b) the actual change in the spot price of natural gas in West Texas per MMBTU multiplied by 20,000.That method excludes the change in the fair value of the futures contracts attributable to changes in the difference between the spot price and the forward price of natural gas at the Henry Hub in determining ineffectiveness. The excluded amount would be reported directly in earnings.

: Cash Flow Hedge of a Forecasted Purchase of Inventory with a Forward Contract

Example 7 in Appendix A is a variation of Example 9 in Appendix B. Whereas Example 9 in Appendix B could never have hedge ineffectiveness, ineffectiveness may arise in Example 7 of Appendix A.

93. Company G forecasts the purchase of 500,000 pounds of Brazilian coffee for U.S. dollars in 6 months. It wants to hedge the cash flow exposure associated with changes in the U.S. dollar price of Brazilian coffee. Rather than acquire a derivative based on Brazilian coffee, the company enters into a 6-month forward contract to purchase 500,000 pounds of Colombian coffee for U.S. dollars and designates the forward contract as a cash flow hedge of its forecasted purchase of Brazilian coffee. All other terms of the forward contract and the forecasted purchase, such as delivery locations, are the same.

Assessing the hedges expected effectiveness and measuring ineffectiveness

94. Company G bases its assessment of hedge effectiveness and measure of ineffectiveness on changes in forward prices, with the resulting gain or loss discounted to reflect the time value of money. Because of the difference in the bases of the forecasted transaction (Brazilian coffee) and forward contract (Colombian coffee), Company G may not assume that the hedge will automatically be highly effective in achieving offsetting cash flows. Both at inception and on an ongoing basis, Company G could assess the effectiveness of the hedge by comparing changes in the expected cash flows from the Colombian coffee forward contract with the expected net change in cash outflows for purchasing the Brazilian coffee for different market prices. (A simpler method that should produce the same results would consider the expected future correlation of the prices of Brazilian and Colombian coffee, based on the correlation of those prices over past six-month periods.)

95. In assessing hedge effectiveness on an ongoing basis, Company G also must consider the extent of offset between the change in expected cash flows on its Colombian coffee contract and the change in expected cash flows for the forecasted purchase of Brazilian coffee. Both changes would be measured on a cumulative basis for actual changes in the forward price of the respective coffees during the hedge period.

96. Because the only difference between the forward contract and forecasted purchase relates to the type of coffee (Colombian versus Brazilian), Company G could consider the changes in the cash flows on a forward contract for Brazilian coffee to be a measure of perfectly offsetting changes in cash flows for its forecasted purchase of Brazilian coffee. For example, for given changes in the U.S. dollar prices of six-month and three-month Brazilian and Colombian contracts, Company G could compute the effect of a change in the price of coffee on the expected cash flows of its forward contract on Colombian coffee and of a forward contract for Brazilian coffee as follows:

Estimate of Hedging Forecasted Instrument: Transaction: Forward Forward Contract on Contract on Colombian Brazilian Coffee Coffee

Forward price of Colombian and Brazilian coffee:

At hedge inception — 6-month price $ 2.54 $ 2.43

Cumulative change in price — gain $ .09 $ .10

x 500,000 pounds of coffee x 500,000 x 500,000 ——— ———- Estimate of change in cash flows $45,000 $50,000 ========= ==========

97. Using the above amounts, Company G could evaluate effectiveness 3 months into the hedge by comparing the $45,000 change on its Colombian coffee contract with what would have been a perfectly offsetting change in cash flow for its forecasted purchase — the $50,000 change on an otherwise identical forward contract for Brazilian coffee. The hedge would be ineffective to the extent that there was a difference between the changes in the present value of the expected cash flows on (a) the companys Colombian coffee contract and (b) a comparable forward contract for Brazilian coffee (the equivalent of the present value of $5,000 in the numerical example).

98. Company H has a 5-year, $100,000 variable-rate asset and a 7-year, $150,000 variable-rate liability. The interest on the asset is payable by the counterparty at the end of each month based on the prime rate as of the first of the month. The interest on the liability is payable by Company H at the end of each month based on LIBOR as of the tenth day of the month (the liabilitys anniversary date). The company enters into a 5-year interest rate swap to pay interest at the prime rate and receive interest at LIBOR at the end of each month based on a notional amount of $100,000. Both rates are determined as of the first of the month. Company H designates the swap as a hedge of 5 years of interest receipts on the $100,000 variable-rate asset and the first 5 years of interest payments on $100,000 of the variable-rate liability.

Assessing the hedges expected effectiveness and measuring ineffectiveness

99. Company H may not automatically assume that the hedge always will be highly effective at achieving offsetting changes in cash flows because the reset date on the receive leg of the swap differs from the reset date on the corresponding variable- rate liability. Both at hedge inception and on an ongoing basis, the companys assessment of expected effectiveness could be based on the extent to which changes in LIBOR have occurred during comparable 10-day periods in the past. Company Hs ongoing assessment of expected effectiveness and measurement of actual ineffectiveness would be on a cumulative basis and would incorporate the actual interest rate changes to date. The hedge would be ineffective to the extent that the cumulative change in cash flows on the prime leg of the swap did not offset the cumulative change in expected cash flows on the asset, and the cumulative change in cash flows on the LIBOR leg of the swap did not offset the change in expected cash flows on the hedged portion of the liability. The terms of the swap, the asset, and the portion of the liability that is hedged are the same, with the exception of the reset dates on the liability and the receive leg of the swap. Thus, the hedge will only be ineffective to the extent that LIBOR has changed between the first of the month (the reset date for the swap) and the tenth of the month (the reset date for the liability).

: Cash Flow Hedge of Forecasted Sale with a Forward Contract

100. Company I, a U.S. dollar functional currency company, forecasts the sale of 10,000 units of its principal product in 6 months to French customers for FF500,000 (French francs). The company wants to hedge the cash flow exposure of the French franc sale related to changes in the US$-FF exchange rate. It enters into a 6-month forward contract to exchange the FF500,000 it expects to receive in the forecasted sale for the U.S. dollar equivalent specified in the forward contract and designates the forward contract as a cash flow hedge of the forecasted sale.

Assessing the hedges expected effectiveness and measuring ineffec