Forwards and Futures

1
Forwards and Futures
Go To Bob Jensens Flow Chart
http//www.trinity.edu/rjensen/acct5341/speakers/1
33flow.htm
2
TRANSACTION MARKETS

• Spot or Cash Immediate exchange of property
  for payment
• Forward Later exchange of property for
  payment, t terms fixed today
• Futures Like forwards, but...

3
FORWARD CONTRACTS

• Price setting mechanisms for deferred value dates
• Totally flexible in terms of timing and size of
  transactions
• Negotiated on a principal-to-principal basis
• Introduce credit risk exposure to counterparties
  for profitable positions

4
FUTURES CONTRACTS

• Price setting mechanisms for deferred value dates
• Designed with specific value dates and fixed
  contract sizes
• Exchange traded, with bids and offers provided by
  exchange members
• Daily cash settlements insure against the risk of
  counter-party defaults

5
FINANCIAL INTEGRITY

• Variation Margin One days gain or loss
  of the futures position (contracts ?
  price change ? multiplier)
• Initial Margin Good faith deposit or
  collateral
• Maintenance Level Minimum below
  which account cannot fall

6
CUSTOMER PERFORMANCE BONDSAlternative Qualifying
Instruments

• U.S. currency and Government securities
• Bank letters of credit
• GNMA pass-throughs
• Selected Brady bonds
• Selected sovereign securities
• NYSE, AMEX, SP500 and SPMidCap stocks
• Selected mutual funds

7
Forecasted Transactions VersusFirm Commitments

• Forecasted transactions that are highly probable
  with a known notional and cash flow risk from an
  unknown spot price or rate
• Firm commitments that are contracted with a
  specified notional and transaction price that
  eliminates cash flow risk but creates value risk
  equal to the difference between spot versus
  contracted price or rate

8
Accounting for Forecasted Transactions Versus
Firm Commitments

• Forecasted transactions are not booked or even
  disclosed under present accounting standards.
• Firm commitments (more generally known as
  purchase commitments in the case of purchases)
  are to be disclosed but are not to be booked
  unless a significant loss anticipated. Then
  conservatism in dictates booking an anticipated
  loss reserve that is much like an allowance for
  warranty or bad debt expense.

9
Examples 1 and 4 FAS 133 Appendix BFair Value
vs. Cash Flow Hedges

• See 133ex01a.xls at http//www.cs.trinity.edu/rje
  nsen/

10
Delta Ratio Effectiveness Testing80ltDeltalt125
Bounds

• Paragraph 146 in
  IAS 39
• 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 of 80 per
  cent to 125 per cent. For example, if the loss on
  the hedging instrument is 120 and the gain on the
  cash instrument is 100, offset can be measured by
  120/100, which is 120 per cent, or by 100/120,
  which is 83 per cent. The enterprise will
  conclude that the hedge is highly effective. 

11
Example 4 from FAS 133 Paragraph 128With 100
Delta Effectiveness

• Forecasted Transaction Inventory
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  25,000
• 25,000 Change in Hedged Item
  Value
• 25,000 Change in Hedge
  Contract Value Delta 1.00 or
  100
• 
  

12
Example 4 from FAS 133 Paragraph 128With 100
Delta Effectiveness

• Forecasted Transaction Inventory
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  25,000
• 
  Debit Credit
• Jan. 31 Forward Contract 25,000
  PL 0
  OCI
  25,000
• For cash flow hedges, adjust hedging derivative
  to fair value and offset to OCI to the extent of
  hedge effectiveness.

13
Example 4 from FAS 133 Paragraph 128With 90
Delta Effectiveness

• Forecasted Transaction Inventory
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  22,500
• 25,000 Change in Hedged Item
  Value
• 22,500 Change in Hedge
  Contract Value Delta 0.90 or
  90
• 
  

14
Example 4 from FAS 133 Paragraph 128With 90
Delta Effectiveness

• Forecasted Transaction Inventory
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  22,500
• 
  Debit Credit
• Jan. 31 Forward Contract 22,500
  PL 2,500
  OCI
  25,000
• Hedge accounting is allowed only to the degree
  of effectiveness if Delta is within 80-125
  range.

15
Example 4 from FAS 133 Paragraph 128With 75
Delta Effectiveness

• Forecasted Transaction Inventory
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  18,750
• 25,000 Change in Hedged Item
  Value
• 18,750 Change in Hedge
  Contract Value Delta 0.75 or
  75
• 
  

16
Example 4 from FAS 133 Paragraph 128With 75
Delta Effectiveness

• Forecasted Transaction Inventory
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  18,750
• 
  Debit Credit
• Jan. 31 Forward Contract 18,750
  PL
  18,750 OCI
  0
• When the hedge effectiveness lies outside the
  80-125 range, hedge accounting is not allowed.

17
Example 4 Modified As Follows

• Forecasted Transaction Inventory
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  18,750
• Feb. 28 1,025,000 0
  25,000
• Mar. 31 1,050,000 1,050,000
  50,000
• 
  
• Suppose the inventory is purchased on March 31.
• Suppose the inventory is sold on April 30 for
  1,100,000.

18
Example 4 ModifiedFebruary 28 Adjustment of
Forward Contract

• Forecasted Transaction Inventory
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  18,750
• Feb. 28 1,025,000 0
  25,000
• 
  Debit Credit Bal.
• Feb. 28 Forward Contract 6,250
  25,000 PL
  18,750 0
  OCI 25,000
  25,000
• Hedge effectiveness can be initially designated
  as being tested on a cumulative basis.

19
Example 4 ModifiedMarch 31 Adjustment of Forward
Contract

• Forecasted Transaction Inventory
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Feb. 28 1,025,000 0
  25,000
• Mar. 31 1,050,000 1,050,000
  50,000
• 
  Debit Credit Bal.
• Mar. 31 Forward Contract 25,000
  50,000 PL
  0 0
  OCI
  25,000 50,000
• The forward contract is settled for 50,000 in
  cash to offset the increase to 1,050,000 of the
  hedged items price. FAS 133 says carry forward
  OCI balance until inventory is sold. IAS 39 has
  an OCI basis adjustment on March 31, unlike FAS
  133.

20
Example 4 ModifiedMarch 31 Purchase of Inventory

• 
  Debit Credit Bal.
• Mar. 31 Cash 50,000
  50,000
  Forward contract 50,000
  0
• Mar. 31 Inventory 1,050,000
  1,050,000 Cash
  1,050,000 (1,000,000)
• Under IAS 39, there will also be an entry to
  close the 50,000 in OCI to PL. Under FAS 133,
  there will be no such basis adjustment until the
  inventory is sold.

21
Example 4 from FAS 133 Paragraph 128April 30
Basis Adjustment of OCI

• Forecasted Transaction Inventory
  Cash Flow Sales
  Book Hedge
• Date Amount Value
  Value
• Jan. 01 0
  0 0
• Apr. 30 1,100,000 1,050,000
  0
• 
  Debit Credit Bal.
• Apr. 30 OCI 50,000
  0 PL
  50,000 (50,000)
  
• The sales profit of 1.1 million less 1.05
  million is 50,000 without hedging. With a cash
  flow hedge, retained earnings is increased by
  another 50,000 that locked in inventory value at
  1 million.

22
Basis Adjustment Alternatives

• The carrying value of a hedging offset account
  (OCI, Firm Commitment, or Balance Sheet Item) may
  be written off prematurely whenever the hedge
  becomes severely ineffective.
• Under IAS 39, the carrying value of an effective
  hedge is written off when the hedge expires or is
  dedesignated. See Paragraphs 162 and 163 of IAS
  39.
• Under FAS 133, the carrying value of an effective
  hedge is carried forward until the ultimate
  disposition of the hedged item (e.g. inventory
  sale or depreciation of equipment). See
  Paragraph 31 of FAS 133.

23
Example 4 ModifiedApril 30 Sale of Inventory

• Debit
  Credit Bal.
• Apr. 30 PL (CGS) 1,050,000
  1,000,000 Inventory
  1,050,000 0
• Apr. 30 Cash 1,100,000
  100,000
  PL (Sales) 1,100,000
  (100,000)
• The sales profit of 1.1 million less 1.05
  million is 50,000 without hedging. With a cash
  flow hedge, retained earnings is increased by
  another 50,000 that locked in inventory value at
  1 million.

24
Cash Flow Hedge of a Precious Metalor Any Hedged
Item to be Carried at Value

• Forecasted Transaction Gold
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  22,500
• 25,000 Change in Hedged Item
  Value
• 22,500 Change in Hedge
  Contract Value Delta 0.90 or
  90
• 
  

25
Cash Flow Hedge of a Precious Metalor Any Hedged
Item to be Carried at Value

• Forecasted Transaction Gold
  Cash Flow Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 0
  0
• Jan. 31 1,025,000 0
  22,500
• 
  Debit Credit
• Jan. 31 Forward Contract 22,500
  PL
  22,500 OCI
  0
• Paragraph 29(d) of FAS 133 prohibits the hedged
  item to be any item that is or will be carried on
  the books at fair value after acquisition.

26
New Example

• New Example Coming Up

27
Firm Commitment with Contracted PriceWith 100
Delta Effectiveness

• Firm Commitment Inventory
  Fair Value Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000
  0 0
• Jan. 31 975,000
  0 25,000
• -25,000 Change in Value of Hedged
  Item 25,000 Change in Value of Hedge
  Contract Delta 1.00 100

28
Firm Commitment with Contracted PriceWith 100
Delta Effectiveness

• Firm Commitment Inventory
  Fair Value Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000
  0 0
• Jan. 31 975,000
  0 25,000
• 
  Debit Credit
• Jan. 31 Forward contract 25,000
  PL 0
  Firm commitment
  25,000
• For firm commitments, the fair value hedge is
  adjusted to full value with the effective portion
  to firm commitment.

29
Firm Commitment with Contracted PriceWith 90
Delta Effectiveness

• Firm Commitment Inventory
  Fair Value Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000
  0 0
• Jan. 31 975,000
  0 22,500
• 
  Debit Credit
• Jan. 31 Forward contract 22,500
  PL 2,500
  Firm commitment
  25,000
• Hedge accounting is allowed only to the degree of
  effectiveness if Delta is within 80-125 range.

30
Firm Commitment with Contracted PriceWith 75
Delta Effectiveness

• Firm Commitment Inventory
  Fair Value Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000
  0 0
• Jan. 31 975,000 975,000
  18,750
• 
  Debit Credit
• Jan. 31 Forward contract 18,750
  PL
  18,750 Firm
  commitment 0
• When the hedge effectiveness lies outside
  the 80-125 range, hedge accounting is not
  allowed.

31
New Example

• New Example Coming Up

32
Example 1 from FAS 133 Paragraph 105With 100
Delta Effectiveness

• Inventory on Hand Inventory
  Fair Value Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 1,000,000
  0
• Jan. 31 975,000
  975,000 25,000
• 
  Debit Credit
• Jan. 31 Forward contract 25,000
  PL
  0 Inventory
  25,000
• When the hedged item is already booked at
  historical cost, change its accounting to fair
  value during hedging period.

33
Example 1 from FAS 133 Paragraph 105With 90
Delta Effectiveness

• Inventory on Hand Inventory
  Fair Value Entry
  Book Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 1,000,000
  0
• Jan. 31 975,000 975,000
  22,500
• 
  Debit Credit
• Jan. 31 Forward contract 22,500
  PL
  2,500 Inventory
  25,000
• Hedge accounting is allowed only to the degree of
  effectiveness if Delta is within 80-125 range.

34
Example 1 from FAS 133 Paragraph 105With 75
Delta Effectiveness

• Inventory on Hand Inventory
  Fair Value Entry
  Book
  Hedge
• Date Value
  Value Value
• Jan. 01 1,000,000 1,000,000
  0
• Jan. 31 975,000
  1,000,000 (no change) 18,750
• 
  Debit Credit
• Jan. 31 Forward contract
  18,750 PL
  
  18,750 When the hedge effectiveness lies
  outside the 80-125 range, hedge accounting is
  not allowed.

35
Cumulative Dollar Offset Hedging Actually is
More Complicated

• See 133ex07a.xls at http//www.cs.trinity.edu/rje
  nsen/

36
Forward Versus Futures ContractsQuotations from
Walter Teets
September 7, 2000 email message to Bob JensenThe
error in our case is simply that the futures
values (due to changes in either spot or futures
prices) shouldn't be present valued, since there
is daily settling up. But the (change in) values
of the anticipated cash flows of the hedged item
should be present valued, because there is
usually no periodic settling of the cash flows
associated with the hedged item. The change to
the case is minor the major point of the futures
case is to show exclusion of the change in the
difference between future and spot price from the
determination of effectiveness. Present valuing
the cash flow associated with the anticipated
transaction, while not present valuing the
futures (change in) value adds additional
ineffectiveness to the hedging relation. Walter
Teets at Gonzaga University

37
KPMG Example 4.2Cumulative Dollar Offset
38
New Example

• New Example Coming Up

39
Fair Value FX HedgingExample 3 from FAS 133
Paragraph 121
Example 3 illustrates a firm commitment to
purchase a machine on May 2 for 270,000Dfl Dutch
guilders which exposes the firm to both a fair
value risk and a foreign exchange (FX) risk.
MNO enters a forward contract FX fair value
hedge in which this company enters elects to
hedge the 270,000Dfl with equivalent 240,000DM in
German marks that it apparently had on hand on
February 3. Although the example hedges in German
DM currency, the firm declares this a fair value
hedge of the firm commitment in U.S. dollars. To
the extent of hedge effectiveness, the account
Firm Commitment is used to offset changes in the
value of the forward contract during the hedging
period.

•  

40
Cash Flow FX HedgingExample 10 from FAS 133
Paragraph 165
Example 10 illustrates DEF Companys hedging of
foreign currency risk of on three expected
installments of 1,000,000DM German marks. As a
cash flow hedge, other comprehensive income is
used to offset changes in the value of the
hedging forward contract to the extent that the
contract is effective in hedging FX risk. But
the effectiveness tests are very complicated as
explained in Paragraph 169

•  

41
Cash Flow FX HedgingExample 10 from FAS 133
Paragraph 169
169. As each royalty is earned, DEF recognizes a
receivable and royalty income. The forecasted
transaction (the earning of royalty income) has
occurred. The receivable is an asset, not a
forecasted transaction, and is not eligible for
cash flow hedge accounting. Nor is it eligible
for fair value hedge accounting of the foreign
exchange risk because changes in the receivable's
fair value due to exchange rate changes are
recognized immediately in earnings. (paragraph
21(c) prohibits hedge accounting in that
situation.) Consequently, DEF will dedesignate a
proportion of the forward contract corresponding
to the earned royalty. As the royalty is
recognized in earnings and each proportion of the
derivative is dedesignated, the related
derivative gain or loss in accumulated other
comprehensive income is reclassified into
earnings. After that date, any gain or loss on
the dedesignated proportion of the derivative and
any transaction loss or gain on the royalty
receivable will be recognized in earnings and
will substantially offset each other.

•  

42
Example 10 in FAS 133 Appendix BCash Flow
Hedging of FX Risk

• See 133ex10.doc at http//www.cs.trinity.edu/rjen
  sen/
• See 133ex10a.xls at http//www.cs.trinity.edu/rje
  nsen/

43
FORWARD/FUTURES PRICING
Spot Price
Expense of holding (financing,
Cost of Carry
storage, insurance, etc.) less
income generated from spot
Futures/Forward Price
Basis /-(Futures - Spot)
44
BASIS AND CONVERGENCE
Price
F
S
e
e
F
O
S
O
Time
45
SPECULATIVE TRADES

• Outright positions
• Basis trades / arbitrage
• Calendar spreads
• Inter-market spreads - TEDs, LEDs, BEDs, NOBs,
  etc.

46
FUTURES HEDGING Sources of Uncertainty

• Rounding error
• Cross-market (spread) risk
• Mismatching value dates (basis risk)
• Timing of variation settlement cashflows

47
TIMING CONSIDERATION
Problem Futures results are realized daily, the
effect on the exposure occurs in a deferred period
Solution Tail the hedge to generate the present
value of the desired price effects
48
Tailing Futures Hedges/Tailing Spreads
http//www.kawaller.com/pdf/tails.pdf An
untailed hedge ignores the difference between the
time futures gains or losses are realized and the
time the price effects on the associated cash
market exposures are realized. A tailed hedge, on
the other hand, takes these timing considerations
into consideration. Put another way, an untailed
hedge ignores the effects of financing costs or
investment returns associated with daily
variation margin settlements of futures
contracts a tailed hedge these effects.
49
Tailing Futures Hedges/Tailing Spreads
http//www.kawaller.com/pdf/tails.pdf While
tailed hedges should be recognized as more
perfect from an economic perspective, untailed
hedges have the advantage of offering the
appearance of a better offset from an accounting
point of view when deferral accounting methods
are employed. Moreover, maintaining a correctly
tailed hedge position requires an ongoing
adjustment of the hedge position, while untailed
hedges need no analogous adjustments.
50
Tailing Futures Hedges/Tailing Spreads
http//www.kawaller.com/pdf/tails.pdf
Importantly, the correct number of contracts for
this latter case will tend to increase as the
passage of time erodes the difference between
present values and future values. Ultimately,
by the time the hedge value date is reached, the
discounted present value will converge to the
500 amount. Thus, over time the required hedge
will gradually rise to twenty contracts. This
second case is an example of a tailed hedge,
where the tail is the number of contracts needed
to adjust for this present valuing effect.
51
MARK-TO-MARKET VALUATIONSForward Contracts

• MV Market Value
• F(i) Forward Price at time i
• r Zero coupon rate (to forward value date)
• d Days to the forward value date
• n Compounding periods to forward value date
  

52
Complexities of Paragraph 63(c) of FAS 133

• See KPMG 1A Sheet in 133ex07a.xls at
  http//www.cs.trinity.edu/rjensen/
• 63(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, the change 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.

53
CASE 3 - Firm Commitment Hedged with Forward
Contract

• On 9/30/2001, GlobalTechCo, a U.S. company issues
  a purchase order to a foreign supplier for
  equipment to be delivered and paid for at
  3/31/2002. The terms of the agreement meet the
  criteria for a firm commitment.
• The price is denominated in the foreign
  currencyFC10,000,000.
• The company simultaneously enters into a forward-
  exchange contract, which matures 3/31/2002, in
  order to receive FC10,000,000 and pay U.S.
  6,600,000.

54
CASE 3 - Firm Commitment Hedged with Forward
Contract
Forward Rates Spot Rates for
3/31/2002 9/30/2001 FC1 0.65 FC1
0.66 12/31/2001 FC1 0.67 FC1
0.69 3/31/2002 FC1 0.69 FC1 0.69
55
CASE 3 - Firm Commitment Hedged with Forward
Contract

• The entity documents the following
• Effectiveness will be measured by (a) comparing
  the change in the fair value of the forward
  contract attributable to changes in spot rates
  with (b) the changes in the fair value of the
  firm commitment attributable to changes in the
  spot rates
• The spot-forward difference will be excluded from
  the assessment of effectiveness and recorded
  through earnings

56
CASE 3 - Firm Commitment Hedged with Forward
Contract

• The following demonstrates the journal entries to
  record this hedge under Statement 133
• At 9/30/2001, no entry is recorded under
  Statement 133 because a cash payment is not made
  and the contract has a zero value.

57
CASE 3 - Firm Commitment Hedged with Forward
Contract

• Entries recorded at 12/31/2001
• Forward contract 295,567
• Earnings 295,567
• To record the forward contract fair value
  (present value at a 6 discount rate of ((.69
  .66) x FC10 million) includes both effective
  portion of hedge and ineffectiveness due to
  changes in the forward rate.
• Earnings 197,044
• Firm commitment 197,044
• To record the change in the fair value of the
  foreign-currency component of the firm commitment
  attributable to the change in spot rates ((.65
  .67) x FC10 million), discounted at 6.

58
CASE 3 - Firm Commitment Hedged with Forward
Contract

• Entries recorded at 3/31/2002
• Forward contract 4,433
• Earnings 4,433
• To record time value change as there was no
  change in the forward rate (assumption for
  illustrative purposes only).
• Earnings 202,956
• Firm commitment 202,956
• To record the change in the fair value of the
  foreign-currency component of the firm commitment
  attributable to the change in spot rates ((.65
  .69) x FC10 million) 197,044

59
CASE 3 - Firm Commitment Hedged with Forward
Contract

• 3/31/2002 (continued)
• Cash 300,000
• Forward contract 300,000
• To record cash receipt upon maturity of forward
  contract
• Equipment 6,500,000
• Firm commitment 400,000
• Cash 6,900,000
• To record purchase of equipment

60
CASE 4 Example 7 from Appendix B of FASB
Statement 133

• Designation and Discontinuance of a Cash Flow of
  the Forecasted Purchase of Inventory