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New at the William Margrabe Group: FAS 133 valuations have been a significant part of our business since September 2000, and are a large part of the reason we did not update "The Derivatives 'Zine" from July 2000 to July 2001. Over that time we have learned .... [more]
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7/16/01 Volatility Reduction Measure (7/16/01)
Dear Dr. Risk
Please explain the
term 'Volatility Reduction Measure' as used in reference to FAS 133
effectiveness testing. Thanks.
Dear Rob FAS 133 requires corporations to mark all derivatives positions to market, but permits hedge accounting treatment for certain derivatives positions that qualify. A qualifying derivatives position must be a sufficiently good hedge for something else on the balance sheet, and the corporation must document this. The definition of a "sufficiently good hedge" is open to debate. This has good and bad implications. We hope that that debate does not end in the near future, because hedging effectiveness is an open issue. However, this opens the door for a certain amount of accounting manipulation -- perhaps whole truckloads.
Dr. Andrew Kalotay, President of Andrew Kalotay Associates, proposed (Andrew Kalotay, "Volatility Reduction Measure," Derivatives Strategy, 3/99) a measure of hedging effectiveness that has a bit of the flavor of R2. Namely, his Volatility Reduction Measure (VRM) equals one minus the ratio of the standard deviation of the "hedge package" -- the hedge and the item being hedged -- to the standard deviation of the item being hedged.
However, VRM is not R2. Before we explain why, we need to briefly review some aspects of regression. In a simple univariate regression, R2 is the percentage of the total sum of squares of the dependent variable that the independent variable explains, after one optimizes the intercept and the slope coefficient of the independent variable. In other words, R2 is the percentage by which volatility of a linear combination of the dependent and independent variables and a constant declines after choosing the optimal intercept and slope coefficient.
To approach Kalotay's VRM, consider a regression in which the hedge instrument's P&L is the independent variable in the regression and the P&L of the instrument to be hedged is the dependent variable. Now, constrain the regression intercept to be zero and the slope coefficient to be unity. The R2 in this constrained regression is related to, but different from VRM. Namely, VRM = 1 - Ö(1- R2).
See Kalotay's article for additional details. Dr. Risk
Derivatives DictionaryTM Terms and definitions relating to currency. The main Derivatives DictionaryTM is here.
7/4/00 "Life under FAS 133." CFO (2001 July) By Andrew Osterland.
"THE RULES OF ACCOUNTING ISSUED BY THE Financial Accounting Standards Board rarely generate enthusiasm in the corporate reporting community. But few have caused more outright resentment among business leaders than FAS 133, 'Accounting for Derivative Instruments and Hedging Activities.' "
"FASB 'could have achieved 98 percent of [the goals of FAS 133] at about 10 percent of the cost.' -- Philip Ameen, Controller, General Electric"
The initial FAS proposal in 1991 "was simply to mark all derivatives to market on a quarterly basis and recognize the gains and losses on the contracts, realized or not, through the income statement." That was simple and effective, except that it could create swings in income as the derivatives changed value.
Corporate managements tend to hate swings in income and smooth them out whenever the rules allow smoothing. Many managers cross the line and smooth earnings, even when that isn't kosher. Managers pressured the FAS to come up with a way that allowed them to smooth earnings.
The solution: "Hedge accounting" -- letting gains and losses of derivatives offset losses and gains on the hedged items -- allows corporations to reduce earnings volatility.
However, a corporation that wants hedge accounting treatment has to jump through various hoops:
This doesn't come cheap, requiring systems and the personnel to operate them. GE spent about $8 million over two years to comply with FAS 13*3. The FASB "has effecively imposed a tax on companies to discourage the practice" of hedge accounting, according to Ira Kawaller, a sitting member of the Derivatives Implementation Group (DIG).
The controversy over accounting treatment for ESO's was also extraordinary.
7/6/01 "FASB Enacts Standards Prohibiting 'Pooling' in Mergers." The Wall Street Journal, 7/6/01.
FASB unanimously eliminated "pooling of interests" accounting treatment for mergers, leaving only "purchase" accounting treatment. This move is all about "goodwill" -- the excess of acquisition price over "fair value" -- and how to treat it.
"Pooling" allowed merging companies to combine their assets without recording, then amortizing "goodwill". Opponents of pooling believe that it inflates the reported the value of acquisitions.
"Purchasing" required companies to record goodwill, then amortize it some, each quarter. This reduced reported earnings, which management opposed.
FASB has crafted a compromise that allows acquisitive companies to halt the routine amortization of goodwill. Instead, the companies must determine if and when goodwill asset values exceed fair value, and then write them down to fair value.
Once more, we see the hand of corporate management
pulling the strings that control FASB. This old issue never goes away. The old
joke has more than a molecule of truth:
In fairness to accountants, they are not the only professionals who must deal with a conflict between their purported missions and the agendas of those who pay them or can essentially hire or fire them. Others include schoolteachers, ministers, police, ...
7/16/01 FAS 133 (Dr. Risk, 7/16/01)
Some of our clients have shown keen interest in FAS 133 valuations since September 2000, and that is a large part of the reason we did not update "The Derivatives 'Zine" from July 2000 to July 2001. Over that time we have learned or seen more evidence for a few lessons.
....fairly lucrative for me, if not quite a “gold
mine”. FAS 133 requires breaking out some embedded derivatives, and accounting
separately for them and related loans. I’ve seen some doozies – some are
easy to describe, but extremely complicated to price. Then there’s the problem
breaking off-market swaps into par swaps and loans. Since I’ve been involved
with option pricing for nearly 30 years, a few people have dragged me into these
– a physically existing spark spread. – Dr. Risk
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