Reporting Requirements for Annual Financial Reports of State Agencies and Universities

Notes & Samples

NOTE 7 – Derivative Instruments
Hedging Derivative Instruments Disclosures

Agencies must disclose the following information for all hedging derivative instruments using a combination of text and tables:

1. Objectives of derivative instruments:
   • Objectives for entering into the derivative instrument
   • Context needed to understand those objectives
   • Strategies for achieving those objectives
   • Types of derivative instruments
2. Significant terms:
   • Notional amount
   • Reference rates (such as indexes or interest rates)
   • Embedded options (such as caps, floors or collars)
   • Dates — when the derivative instrument was entered into and the date it is scheduled to terminate or mature
   • Amount of cash paid or received (if any) at the time a forward contract or swap (including swaptions) was entered into
3. Risks — the GASB 53 risk disclosures for hedging derivative instruments are comprehensive. Address the following specific risks in Note 7:
   • Credit risk
   • Interest rate risk
   • Basis risk
   • Termination risk
   • Rollover risk
   • Market-access risk
   • Foreign currency risk

   The following contains more detailed information for each of these risks:

   • Credit risk — the risk that a counterparty will not fulfill its obligations.
     
     Credit risk disclosures do not extend to derivative instruments that are exchange traded (such as futures contracts). For those derivative instruments, amounts held by broker/dealers are evaluated by applying the custodial credit risk disclosures.
     
     If a hedging derivative instrument is reported as an asset exposing the agency to credit risk, the agency must disclose the following information:
     • Credit quality ratings of counterparties as described by nationally recognized statistical rating organizations (rating agencies) as of the end of the reporting period. If a credit risk disclosure is required and the counterparty is not rated, the disclosure must indicate that fact.
     • Maximum amount of loss, due to credit risk based on the fair value of the hedging derivative instrument as of the end of the reporting period, that the agency would incur if the counterparties to the hedging derivative instrument failed to perform according to the terms of the contract (without respect to any collateral or other security) or netting arrangement.
     • If the agency requires collateral (or other security) to support hedging derivative instruments subject to credit risk, the agency must disclose the:
       • Agency’s policy on requiring the collateral (or other security)
       • Summary description of the collateral (or other security)
       • Aggregate amount of the collateral (or other security) that reduces the credit risk
       • Information about the agency’s access to that collateral (or other security)
     • The agency’s policy of entering into any master netting arrangements. This disclosure includes a summary description and aggregate amount of the liabilities associated with those arrangements.
     • Aggregate fair value of hedging derivative instruments in asset (positive) positions net of collateral posted by the counterparty and the effect of master netting arrangements.
     • Significant concentrations of net exposure to credit risk (gross credit risk reduced by collateral, other security and setoff) with individual counterparties and groups of counterparties.
   • Interest rate risk — the risk that changes in interest rates will adversely affect the fair values of an agency’s financial instruments or the agency’s cash flows.
     
     If a derivative instrument increases the agency’s exposure to interest rate risk, the agency must disclose the derivative instrument’s terms that increase such a risk.
   • Basis risk — the risk that arises when variable interest rates on a derivative instrument and an associated bond or other interest-paying financial instrument are based on different indexes.
     • When relationships between different indexes vary and that variance adversely affects the agency’s calculated payments, basis risk is realized.
     • If a derivative instrument exposes the agency to basis risk, the agency must disclose the derivative instrument’s terms as well as payment terms of the hedged item that creates the basis risk.
   • Termination risk — the risk that a derivative instrument’s unscheduled end will affect an agency’s asset and liability strategy or presents the agency with potentially significant unscheduled termination payments to the counterparty.
     
     For example, the agency may be relying on an interest rate swap to insulate it from the possibility of increasing interest rate payments. However, if the swap has an unscheduled termination, that protection would not be available.
     
     If a derivative instrument exposes an agency to termination risk, the agency must disclose the following information (as applicable):
     • Any termination events that occurred
     • Dates that a derivative instrument may be terminated
     • Out-of-the-ordinary termination events contained in contractual documents (such as additional termination events contained in the Schedule to the International Swap Dealers Association Master Agreement)
   • Rollover risk — the risk that a hedging derivative instrument associated with a hedgeable item does not extend to the maturity of that hedgeable item.
     
     For example, an interest rate swap that pays the agency a variable-rate payment designed to match the term of the variable-rate interest payments on the agency’s bonds:
     • If the derivative instrument’s term is 10 years and the associated debt’s term is 30 years – after 10 years the agency loses the benefit of the swap payments.
     • If a derivative instrument exposes the agency to rollover risk, the agency must disclose the maturity of the derivative instrument and the maturity of the associated debt.
   • Market-access risk — the risk that the agency will be unable to enter credit markets or that credit will become more costly.
     
     If a derivative instrument creates market-access risk, the agency must disclose that exposure as market-access risk.
   • Foreign currency risk — the risk that changes in exchange rates will adversely affect the fair values of the agency’s financial instruments or cash flows.
     
     If a derivative instrument exposes the agency to foreign currency risk, the agency must disclose the U.S. dollar balances of such hedging derivative instruments (organized by currency denomination and investment type).