From the February 2009 issue of Treasury & Risk magazine

Around the Hedges

Corporate treasurers have long complained about the restrictiveness of FAS 133: If they want to qualify for hedge accounting treatment and avoid hedge volatility making a mess of their earnings, they are limited to vanilla products used in a textbook way. Often that's all a treasurer wants to do-but in some cases these simple hedges aren't ideal, creating demand for more flexible products, which still qualify for hedge accounting. Aiming to meet this demand, big derivatives dealers have lured away FAS 133 experts from the big public accounting firms to structure and vet new solutions-but their efforts have had mixed success.

"By and large, most people are sticking pretty closely to vanilla instruments if they want to get hedge accounting," says Helen Kane, founder and president of Cupertino, Calif.-based hedging adviser Hedge Trackers "The only cases I have seen where a company was using anything other than plain vanilla instruments and was taking hedge accounting are those where a bank has told them it was okay."

A treasury official at a large U.S. corporate says that his preferred dealer has an edge over its competition by virtue of being able to provide products that give the company a bit more freedom to hedge. He wouldn't give any details-and the bank in question wouldn't comment either, on or off the record.

This fear of being caught trying to bend the accounting rules is one of the reasons that banks have struggled to launch blockbuster "133-compliant" products. Corporates are terrified of being forced into a restatement and auditing firms are not willing to flirt with reputational damage by giving the go-ahead to anything that looks even slightly off kilter.

"When an auditing firm gives a company the go-ahead to use hedge accounting, they are at risk of being second-guessed, so it's a lot easier and cleaner for them to say that derivatives users haven't complied with the standard," says Ira Kawaller, who runs an independent New York City-based derivatives consulting business, Kawaller & Co. "The auditing firms have set a very high bar for compliance and it's my feeling that sometimes they're being
overly conservative."

What the standard says is that a derivative has to be paired up with an underlying exposure and that if the changes in value of the two halves of the hedge are highly correlated--an "effective" hedge in the standard's language-then companies don't need to report those changes as profits and losses. But a huge volume of extra interpretation in the form of speeches and semi-official guidance has been layered on top of the standard since its 1998 publication. Opinions on how to comply have evolved over time and often differ from one auditor to the next. Some banks have sought to make the most of this shifting ground and the standard's gray areas and sometimes, they've found companies willing to listen.

Compliance in those cases has been questionable, says Hedge Trackers' Kane, citing an example of clients who had been seeking to lower the cost of a bought option by simultaneously selling an out-of-the-money forward----a once-popular way of financing a hedge. Because the option and the forward were a single transaction with the dealer, some companies had sought to achieve hedge accounting on both derivatives. Kane says that's not possible: although the option ought to correlate well with an underlying exposure, simultaneous changes in the value of the forward would typically mean that the package as a whole was uncorrelated.

Companies still sell forwards in order to finance options purchases, of course, but the only way to achieve hedge accounting is to split up the two derivatives so that the option is paired with the exposure and qualifies, while volatility associated with the forward appears in earnings, she says.

Jiro Okochi, chief executive officer and co-founder of Reval, the New York-based hedge accounting software provider, says that banks are typically exploring two avenues. The first is the creation of designer products that will not only obtain hedge accounting treatment but are also more likely to remain effective; the second is to do more careful prospective analysis of the hedge using regression or simulation techniques, so that effectiveness is more likely to be reliable. "There are some clever tricks of the trade, but at the end of the day, effectiveness is determined by the movement of the market and changes in the value of the exposure, so it's very hard to guarantee-and these things are not free of cost to corporates," he says.

Sometimes, advice provided by banks may not be totally reliable. Hedge Trackers' Kane once bumped heads with a bank which had advised her client that a somewhat-funky structure would achieve hedge accounting. Kane disagreed and the company put her on the phone with a FAS 133 expert-and former accountant-at the bank. "This person told me that a particular phrase in the standard had been interpreted in an unintended way, but I was looking at a piece of subsequent guidance, which completely contradicted that," says Kane. "The bank was basically offering out-of-date advice. I don't think this kind of thing is done maliciously, but I do think companies need to bear in mind that dealers are motivated to sell products."

Because the key criterion for judging effectiveness is the degree of offset achieved by a derivative against an underlying exposure, some products have sought to make it easier to achieve that offset. For example, so-called "look-back" options have been promoted as one solution: by pairing a three-month look-back option with a longer-dated swap, the hedger can pick any rate from the first three months of the trade as the swap fixing rate, giving the hedger a little more security without needing to obtain hedge accounting for the option which expires between reporting periods.

"That's problematic," says Kawaller. His advice is to keep things simple - in most cases that will be enough: "There are some instances where there's a good economic argument to use a type of derivative that won't achieve hedge accounting, but those cases are few and far between. My belief is that for all practical purposes, vanilla products will get the
job done."

Companies seem to be following that advice. Bob Richardson, president and chief executive of Bala Cynwyd, Pa.-based FXpress Corp, says that the firm's clients are sticking to tried and tested products: "We don't see people doing anything more exotic. They lean towards more conservative hedges, particularly in light of the financial meltdown we've recently seen."

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