**Reporting Requirements for Annual Financial Reports of State Agencies and Universities**

Notes & Samples

# NOTE 7 – Derivative Instruments

Hedging Derivative Instruments – Evaluating Effectiveness

Evaluate a potential hedging derivative instrument in the first reporting period for effectiveness using the Consistent Critical Terms Method. If the criteria are not met, apply at least one Quantitative Method before concluding ineffectiveness.

Reevaluate all hedging derivative instruments as of the end of each subsequent reporting period using the method applied in the prior reporting period. Once the method is applied, if the hedging derivative instrument is ineffective, the agency may (but is not required to) apply another method(s) before concluding the hedging derivative instrument is ineffective.

The following methods of evaluating effectiveness are allowed by GASB 53:

- Consistent critical terms
- Quantitative methods
- Synthetic instrument method
- Dollar-offset method
- Regression analysis method
- Other quantitative methods

Each method has specific instructions depending on whether the hedgeable item is an existing or expected **financial transaction** or an existing or expected **commodity transaction**.

**Or click on the headings below to open a topic individually.**

## Consistent Critical Terms Method [+]

The consistent critical terms method evaluates effectiveness by qualitative consideration of critical terms of the hedgeable item and the potential hedging derivative instrument. If the critical terms of the hedgeable item and the potential hedging derivative instrument are the same (or very similar) the changes in cash flows or fair values of the potential hedging derivative instrument will substantially offset the changes in cash flows or fair values of the hedgeable item.

GASB 53 divides effective hedges into the categories of **cash flow hedges** and **fair value hedges**.

### Interest Rate Swaps – Cash Flow Hedges

An interest rate swap is an effective cash flow hedge under the consistent critical terms method if **all** of the following criteria are met:

- The notional amount of the swap is the same as the principal amount of the hedgeable item throughout the life of the hedging relationship.
- Upon association with the hedgeable item, the swap has a zero fair value.
- The formula for computing net settlements under the swap is the same for each settlement.
- The reference rate of the swap’s variable payment is consistent with one of the following:
- Reference rate or payment of the hedgeable item

**–OR–** - A benchmark interest rate.
**Note:**Variable payment is based upon a benchmark interest rate without multiplication by a coefficient (such as 68 percent of SOFR). The benchmark interest rate may be adjusted by addition or subtraction of a constant (such as the SIFMA swap index plus 10 basis points).

- Reference rate or payment of the hedgeable item
- Interest receipts or payments of the swap occur only during the term of the hedgeable item.
- The designated maturity or time interval of the reference rate employed in the variable payment of the swap is the same as the time interval of the rate reset period of the hedgeable item.
- Reference rate of the swap does not have a floor or cap unless the hedgeable item has a floor or cap.
- The frequency of the rate resets of the swap and the hedgeable item is the same.
- The rate reset dates of the swap are within six days of the rate reset dates of the hedgeable item.
**–AND–** - The periodic swap payments are within 15 days of the periodic payments of the hedgeable item.

### Interest Rate Swaps – Fair Value Hedges

An interest rate swap is an effective fair value hedge if **all** of the following criteria are met:

- The notional amount of the swap is the same as the principal amount of the hedgeable item throughout the life of the hedging relationship.
- Upon association with the hedgeable item, the swap has a zero fair value.
- The formula for computing net settlements under the swap is the same for each settlement.
- Variable payment is based upon a benchmark interest rate
**without**multiplication by a coefficient (such as 68 percent of SOFR).**Note:**The benchmark interest rate may be adjusted by addition or subtraction of a constant (such as the SIFMA swap index plus 10 basis points) provided that the constant is specifically attributed to the effect of state-specific tax rates. - The hedgeable item is not prepayable.
**Note:**This criterion does not apply to a call option in an interest-bearing hedgeable item if it meets**both**of the following criteria:- Maturities, strike price, related notional amounts, timing and frequency of payments and dates on which the instruments may be called matches the terms of the mirror-image call option in the interest rate swap.
- The agency is the writer of one call option and the holder of the other call option.

- The expiration date of the swap is on or about the maturity date of the hedgeable item (so the agency will not be exposed to interest rate risk or market risk).
- The reference rate of the swap has neither a floor nor a cap.
**–AND–** - The reference rate of the swap resets at least every 90 days (so the variable payment or receipt is considered to be at a market rate).

### Commodity Swaps – Cash Flow Hedges

A commodity swap is an effective cash flow hedge under the consistent critical terms method if **all** of the following criteria are met:

- The commodity swap is for the purchase or sale of the same quantity (notional amount) of the same hedgeable item at the same time and delivery location as the hedgeable item.
- Upon association with the hedgeable item, the commodity swap has a zero fair value.
- The reference rate of the swap is consistent with the reference rate of the hedgeable item.
**–AND–** - The reference rate of the swap does not have a floor or cap unless the hedgeable item has a floor or cap.

### Commodity Swaps – Fair Value Hedges

A commodity swap is an effective fair value hedge if **all** of the following criteria are met:

- The commodity swap is for the purchase or sale of the same quantity (notional amount) of the same hedgeable item at the same time and delivery location as the hedgeable item.
- Upon association with the hedgeable item, the commodity swap has a zero fair value.
- The hedgeable item is not prepayable.
**Note:**This criterion does**not**apply to a call option in a hedgeable item that is matched by a mirror image call option in a commodity swap if**both**of the following criteria are met:- A mirror-image call option matches the terms of the call option in the hedgeable item. Terms include maturities, strike price, related notional amounts, timing and frequency of payments and dates on which the instruments may be called.
- The agency is the writer of one call option and the holder (or purchaser) of the other call option.

- The expiration date of the swap is on or about the maturity or termination date of the hedgeable item (so the agency will not be exposed to market risk).
- The reference rate of the swap doesn’t have a floor or a cap.
**–AND–** - The reference rate of the swap resets at least every 90 days (so that the variable payment or receipt is considered to be at a market rate).

### Forward Contracts

A forward contract with a financial instrument hedgeable item is effective under the consistent critical terms method if **all** of the following criteria are met:

- The forward contract is for the purchase or sale of the same quantity (notional amount) and at the same time as the hedgeable item.
- Upon association with the hedgeable item, the contract has a zero fair value.
**–AND–** - The reference rate of the forward contract is consistent with the reference rate of the hedgeable item.

A forward contract with a commodity hedgeable item is effective if **all** of the following criteria are met:

- The forward contract is for the purchase or sale of the same quantity (notional amount) of the same hedgeable item and at the same time and location as the hedgeable item.
- Upon association with the hedgeable item, the contract has a zero fair value.
**–AND–** - The reference rate of the forward contract is consistent with the reference rate of the hedgeable item.

## Quantitative Methods [+]

Quantitative methods of evaluating effectiveness may use historical data (such as past rates, prices or payments). However, if there are new market conditions, the evaluation of effectiveness is limited to using fair values (such as in the application of the dollar-offset method or, in certain instances, regression analysis of fair values).

New market conditions are caused by asymmetrical changes in market supply or demand. Examples of events that suggest new financial market conditions:

- A change in income tax rates of individual taxpayers that affect the demand for tax-exempt debt
- New sources of commodity supplies (such as a new natural gas pipeline)
- Supply disruptions arising from natural disasters (such as hurricanes and earthquakes)

### Synthetic Instrument Method

The synthetic instrument method evaluates effectiveness by combining the hedgeable item and the potential hedging derivative instrument to simulate a third synthetic instrument. This method is limited to cash flow hedges in which the hedgeable items are interest bearing and carry a variable rate and to commodity-related cash flow hedges in which the hedgeable item has a variable price or rate.

In order to apply the synthetic instrument method to a derivative instrument with a financial instrument hedgeable item, **all** of the following criteria must be met:

- The notional amount of the potential hedging derivative instrument is the same as the principal amount of the associated variable-rate asset or liability throughout the life of the hedging relationship.
- Upon association with the variable-rate asset or liability, the potential hedging derivative instrument has a zero fair value or the forward price is at-the-market.
- The formula stays the same for computing net settlements through the term of the potential hedging derivative instrument.
**–AND–** - The interest receipts or payments of the potential hedging derivative instrument occur only during the term of the variable-rate asset or liability.

A potential hedging derivative instrument is effective if the actual synthetic rate is substantially fixed. The synthetic rate is substantially fixed if it is within the required range of 90 to 111 percent of the fixed rate of the potential hedging instrument. If the derivative instrument’s actual synthetic rate is outside the required range, the actual synthetic rate is calculated on a life-to-date basis. If the rate on a life-to-date basis is within the required range, the actual synthetic rate is substantially fixed.

If a short time has elapsed since the inception of the hedge and the actual synthetic rate is outside the required range, the evaluation may include hypothetical payments, as if the hedge was established at an earlier date.

To apply the synthetic instrument method to a derivative instrument with a commodity hedgeable item, **both** of the following criteria must be met:

- The notional quantity of the potential hedging derivative instrument is the same as the quantity of the hedgeable item.
**–AND–** - Upon association with the hedgeable item, the potential hedging derivative instrument has a zero fair value or the forward price is at-the-market.

A potential hedging derivative instrument is effective if the synthetic price is substantially fixed. An effective percentage is calculated by comparing the synthetic price as of the evaluation date (the end of the reporting period) to the synthetic price expected at the establishment of the hedge. The synthetic price is substantially fixed if the effectiveness percentage is within a range of 90 to 111 percent.

### Dollar-Offset Method

The dollar-offset method compares the changes in expected cash flows or fair value of the potential hedging derivative instrument with the changes in expected cash flows or fair value of the hedgeable item.

This evaluation may be made using changes in the current period or on a life-to-date basis. If the changes of either the hedgeable item or the potential hedging derivative instrument are divided by the other and the result is within a range of 80 to 125 percent in absolute terms, these changes substantially offset and the potential hedging derivative instrument is effective.

### Regression Analysis Method

The regression analysis method evaluates effectiveness by considering the statistical relationship between the cash flows or fair value of the potential hedging derivative instrument and the hedgeable item.

The potential hedging derivative instrument is effective if the changes in cash flows or fair value of the potential hedging derivative instrument substantially offset the changes in cash flows or fair value of the hedgeable item. For a potential hedging derivative instrument to be effective, the results of the regression analysis must meet **all** of the following criteria:

- The R-squared is at least 0.80
- The F-statistic demonstrates that the model is significant using a 95 percent confidence interval
**–AND–** - The regression coefficient for the slope is between -1.25 and -0.80

### Cash Flow Hedges

For financial instrument hedgeable items, analyze the relationship between relevant cash flows, rates or fair value of the potential hedging derivative instrument and the hedgeable item. Conduct the regression analysis as follows:

- For a cash flow hedge evaluated using cash flows or rates, the dependent variable is relevant cash flows or rates of the hedgeable item and the independent variable is relevant cash flows or rates of the potential hedging derivative instrument. (For example, if the potential hedging derivative instrument’s variable payment is 68 percent of SOFR, the independent variable is a rate based upon 68 percent of SOFR for a relevant period of time).
- For a cash flow hedge evaluated using fair value, the dependent variable is the changes in fair value of the hypothetical derivative instrument. The independent variable is the changes in fair value of the potential hedging derivative instrument. The hypothetical derivative instrument must have terms that exactly match the critical terms of the variable-rate hedgeable item (such as same notional amounts, repricing dates and mirror-image caps and floors).

For commodity hedgeable items, analyze the relationship between relevant cash flows, prices or fair value of the potential hedging derivative instrument and the hedgeable item. Conduct the regression analysis as follows:

- For a cash flow hedge evaluated using cash flows or prices, the dependent variable is relevant cash flows or prices of the hedgeable item and the independent variable is relevant cash flows or prices of the potential hedging derivative instrument.
- For a cash flow hedge evaluated using fair value, the dependent variable is changes in fair value of the hypothetical derivative instrument. The independent variable is changes in fair value of the potential hedging derivative instrument. Generally, hypothetical derivative instruments must have terms that exactly match the critical terms of the variable-price hedgeable item (such as same notional amounts and repricing dates and mirror-image caps and floors).

### Fair Value Hedges

For financial instrument hedgeable items, analyze the relationship between the changes in fair value of the potential hedging derivative instrument and the hedgeable item. Conduct the regression analysis as follows:

- The dependent variable is changes in fair value of the hedgeable item (for example, fixed-rate bonds).
- The independent variable is changes in fair value of the potential hedging derivative instrument (for example, a pay-variable, received-fixed interest rate swap).

For commodity hedgeable items, the relationship analyzed is the changes in fair value of the potential hedging derivative instrument and the hedgeable item. Conduct the regression analysis as follows:

- The dependent variable is changes in fair value of the hedgeable item (for example, a fixed-price commodity contract).
- The independent variable is changes in fair value of the potential hedging derivative instrument (for example, a pay-variable, receive-fixed commodity swap).

### Other Quantitative Methods

Other quantitative methods may be used for evaluating effectiveness of a potential hedging derivative instrument with either underlying financial instrument hedgeable items or underlying commodity hedgeable items. These other methods must meet **all** of the following criteria:

- Changes in cash flows or fair value of the potential hedging derivative instrument substantially offset the changes in cash flows or fair value of the hedgeable item.
- Replicable evaluations of effectiveness are sufficiently completed and documented such that different evaluators, using the same method and assumptions, would reach substantially similar results.
**–AND–** - Substantive characteristics of the hedgeable item and the potential hedging derivative instrument that could affect their cash flows or fair values are considered.