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

Notes & Samples

# NOTE 7 – Derivatives

## Introduction

Disclosure of derivative information in Note 7 is required by GASB 53, paragraphs 68–79.

All agencies must submit Note 7 (as described in the Note 7 Sample) with separate disclosure for discrete component units (if applicable).

GASB 53 requires derivative instruments be reported at fair value, except for fully benefit-responsive synthetic guaranteed investment contracts, which are reported at contract value. GASB 53 supersedes GASB TB 2003-1.

GASB 64 clarifies the existing requirements in GASB 53 for the termination of hedge accounting. For more information, see Termination of Hedge Accounting.

GASB 72 clarifies fair value measurement for financial reporting purposes and requires disclosures for the fair value measurement technique used and the valuation hierarchy of the investment.

## Definition of Derivative [+]

A derivative instrument is a financial instrument or other contract containing **all** of the following characteristics:

- Settlement factors – It has (1) one or more reference rates (or underlyings) and (2) one or more notional amounts or payment provisions or both. These terms determine the amount of the settlement(s) and, in some cases, whether or not a settlement is required.
- Leverage – It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Net settlement – Its terms require or permit net settlement, it can readily be settled net by a means outside the contract or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

For example, assume that Sample Agency issued $100 million variable-rate demand bonds. The bonds pay the SIFMA swap index plus 10 basis points. At the same time, Sample Agency enters into a pay-fixed, receive-variable interest rate swap with the notional amount of $100 million. Assume that the variable rate is the SIFMA swap index and the fixed rate is 3.704 percent.

In this example, the potential hedgeable items are the variable-rate bonds. The reference rate is the SIFMA swap index. No payments are required for Sample Agency at the inception of the derivative contract. The contract fulfills the net settlement requirements because either party to the contract will pay or receive the notional amount times the difference between the 3.704 percent fixed rate and the variable SIFMA swap index.

The diagram below depicts the payment terms of the swap and the variable-rate demand bonds:

## GASB 53 Scope Exceptions [+]

The following derivatives are excluded from the scope of GASB 53:

- Normal purchases and normal sales contracts
- Certain financial guarantee contracts
- Certain contracts that are not exchange-traded
- Loan commitments and insurance contracts accounted for under GASB 10
- Derivatives that do not have leverage as of the trade date

### Normal Purchases and Sales Contracts

Normal purchases and sales contracts generally involve the purchase or sale of a commodity in the normal course of the agency’s operations. These contracts provide protection from price changes in commodities the state acquires to use or sell in the future. If a normal purchase or sales contract represents a significant commitment, disclose the nature and amount of that commitment within Note 15. Conduct an evaluation at least annually to determine if a contract meets the normal purchases and normal sales scope exception.

In the event that delivery of the commodity is not taken under a normal purchase and normal sales contract, and the commodity contemplated in the purchase contract is acquired through another contract, the scope exception does **not** apply. Evaluate the contract to determine if the contract is an effective hedging derivative instrument.

If the contract:

- Is an effective hedge — the fair value increase or decrease is included as an adjustment to the cost of the commodity.
- Is
**not**an effective hedge — the fair value increase or decrease is reported within the investment revenue classification.

### Certain Financial Guarantee Contracts

The financial guarantee contracts included in the scope of GASB 53 are limited to the financial guarantee contracts considered to be investment derivative instruments entered into primarily for the purpose of obtaining income or profit. This amended scope was made in GASB 59. An example is a credit default swap that an agency enters into to take a position for gain or income in response to changes in a reference rate (such as a contract that provides for payments to be made if the credit rating of a debtor falls below a particular level).

A financial guarantee contract that meets the definition of a derivative instrument and is **not** entered into as an investment derivative instrument primarily for the purpose of obtaining income or profit is outside the scope of GASB 53. An example is a bond insurance for which the agency pays the premium. The bond insurance is associated with the agency’s debt, and the debt holder is the beneficiary.

### Impact of Trade Date Accounting

Transactions of derivative instruments — either exchange-traded (such as a commodity futures contract) or non-exchange-traded (such as a forward contract) — are accounted for based on the **trade date**. The trade date is the date when the transaction occurred (such as the date the agency acquires or sells ownership of the derivative instrument). Make GASB 53 disclosures and recognize changes in fair value starting on the trade date. It is not correct for agencies following GASB to account for derivative activity based upon the settlement date (such as the date on which the securities are delivered or received in exchange for the cash payment).

To determine if a contract is a derivative instrument, consider if there is leverage or not. Contracts to purchase “when announced” or “to-be announced” securities do not meet the GASB 53 definition of a derivative. The securities are reported at their full amount as an investment with a corresponding payable to purchase the security on the trade date. Since the contract was already reported as an investment, no leverage exists.

Apply similar logic to foreign currency exchange “spot” contracts. These are contracts of a very short-term nature that are used for the management of transactions that will be settled in foreign currencies. Because these contracts are outside the scope of GASB 53, do not include them in any GASB 53 disclosures and do not use USAS GLs 0059 and 0105.

### Governmental Funds

GASB 53 does not address the issue of reporting derivative instruments at fair value in the governmental fund statements. Derivative instruments measured at fair value are only reported in the proprietary, fiduciary and government-wide statements.

## Derivative Terminology [+]

The following terminology is used extensively within the requirements of GASB 53, as amended by GASB 64.

A derivative instrument’s variable payment is linked to a rate known as the **reference rate**. Common reference rates are **LIBOR**, the **SIFMA** swap index, the AAA general obligations index and the pricing point of a commodity.

A **notional amount** is a number of currency units, shares, bushels, pounds or other units specified in the contract. The settlement of a derivative instrument with a notional amount is determined by interaction of that notional amount with the underlying.

A **payment provision** specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner.

An **investment derivative instrument** is a derivative entered into primarily for the purpose of obtaining income or profit, or a derivative that does not meet the criteria of a hedging derivative instrument.

A **hedging derivative instrument** is a derivative associated with a hedgeable item and is effective in significantly reducing an identified financial risk by substantially offsetting changes in cash flows or fair values of the hedgeable item. **Hedgeable items** can be all or a specific portion of a single asset or liability, groups of similar assets or liabilities or an expected transaction. Assets and liabilities measured at fair value (such as investments in many debt securities) do not qualify as hedgeable items. A transaction wholly within a primary government cannot be a hedgeable item. For more information, see Evaluating Effectiveness above.

A **cash flow hedge** protects against the risk of either changes in total variable cash flows or adverse changes in cash flows caused by variable prices, costs, rates or terms that cause future prices to be uncertain.

A **fair value hedge** protects against the risk of either total changes in fair value or adverse changes in fair value caused by fixed terms, rates or prices.

An **assignment** occurs when a swap agreement is amended to replace the original swap counterparty, or the counterparty’s credit support provider. All of the other terms of the swap agreement remain unchanged.

An **in-substance assignment** occurs when all of the following criteria are met:

- The original swap counterparty or the counterparty’s credit support provider is replaced.
- The original swap agreement is ended and the replacement swap agreement is entered into on the same date.
- The terms that affect changes in fair value and cash flows in the original and replacement swap agreements are identical.
- Any difference between the original swap agreement’s exit price and the replacement swap’s entry price is attributable to the original swap agreement’s exit price being based on a computation specifically permitted under the original swap agreement.

## Recognition and Measurement of Derivatives [+]

Under GASB 53 requirements, derivatives are broken into two categories: **investment** and **hedging**. If a derivative instrument does not meet the criteria for hedging classification it must be reported as an investment derivative.

Derivative instruments are reported on the statement of net position. The classification of derivative instruments depends on whether they represent an asset or a liability.

**Note:** For purposes of GASB 53, the term *statement of net position* includes the government-wide statements, proprietary fund statements of net position and the statement of fiduciary net position.

Investment derivative instruments are recognized as investments even if their fair value is negative. Changes in fair values of investment derivative instruments are reported within the investment revenue classification in the flow of resources statement.

**Note:** For purposes of GASB 53, the term *flow of resources statement* includes the statement of activities, the statement of revenues, expenses and changes in net position, and the statement of changes in fiduciary net position.

Hedging derivative instruments are reported as **assets** or **liabilities** — depending on their fair value. Changes in fair values of hedging derivative instruments are reported as **deferred inflows** or **deferred outflows** in the statement of net position. For example, the increase in fair value of an interest rate swap that is a hedging derivative instrument is reported as deferred inflows in the statement of net position. In proprietary and fiduciary fund financial statements, the fund that reports or is expected to report the hedged item should report the hedging derivative instrument.

GASB 72 requires investments to be measured at fair value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Hedge accounting termination occurs upon any one of the following events:

- Ineffectiveness
- Likelihood that a hedged expected transaction will occur is no longer probable
- Hedged asset or liability is sold or retired
- The hedging derivative instrument is terminated
- A current refunding or advanced refunding resulting in the defeasance of the hedge debt
- The hedged expected transaction occurs (sale of bonds or purchase of commodity)

If the termination event is the occurrence of the hedged expected transaction, the disposition of the deferral balance depends on whether the hedged expected transaction results in a financial instrument or a commodity.

If a termination event occurs, hedge accounting is not applied and the balance in the deferred account is reported within the investment revenue classification in the statement of revenues, expenses and changes in net position.

## Termination of Hedge Accounting [+]

The termination of hedge accounting occurs upon one of the following events:

- The hedging derivative instrument is no longer effective.
- The likelihood that a hedged expected transaction will occur is no longer probable.
- Hedged asset or liability is sold or retired but not reported as a current refunding or advanced refunding resulting in the defeasance of debt.
- The hedging derivative instrument is terminated unless an effective hedging relationship continues.
- A current refunding or advanced refunding results in the defeasance of the hedge debt.
- The hedged expected transaction occurs (sale of bonds or purchase of commodity).

### Events A through D

If any event described in **A** through **D** above occurs, report the balance in the deferred account in the investment revenue section of the statement of revenues, expenses and changes in net position and captioned *increase/decrease upon hedge termination*.

### Event D

If an event described in **D** occurs, an *effective hedging relationship continues* if all of the following criteria are met:

- The collectability of swap payments is considered probable.
- The counterparty or the counterparty’s credit support provider of the swap agreement is replaced with assignment or in-substance assignment.
- The government enters into assignment or in-substance assignment in response to a default or termination event by the counterparty or counterparty’s credit support provider.

### Event E

If an event described in **E** occurs, include the deferral balance related to the hedging derivative instrument in:

- The computation of the difference between the reacquisition price and the net carrying amount of the old debt in accordance with GASB 23.
- The computation of the difference between the cash flows required to service the old debt and the cash flows required to service the new debt and complete the refunding.
- The computation of economic gain or loss from the transaction as required by GASB 7.

### Event F

If an event described in **F** occurs, the disposition of the deferral balance depends on if the hedged expected transaction results in a financial instrument or a commodity.

- If the hedged expected transaction results in a financial instrument, the accounting treatment depends on if the agency is re-exposed to hedged risk:
- The agency i
**s re-exposed**to hedged risk — Recognize the deferral balance in the investment revenue section of the statement of revenues, expenses and changes in net position. - The agency
**is not re-exposed**to hedged risk — Report the deferral balance in the statement of revenues, expenses and changes in net position in a manner consistent with the accounting treatment of the hedged item.

- The agency i
- If the hedged expected transaction results in a commodity, report the deferral balance related to the hedging derivative instrument as an adjustment to the cost of the commodity.

## Hybrid Instruments [+]

A hybrid instrument is composed of an embedded derivative instrument and a companion instrument. A companion instrument (such as a debt instrument, lease, insurance contract or sale or purchase contract) is recognized and measured in accordance with applicable reporting requirements. The derivative instrument that is a component of a hybrid instrument is recognized and measured in accordance with GASB 53. A hybrid instrument exists when the instrument meets **all** of the following criteria:

- The companion instrument is not measured on the statement of net position at fair value.
- A separate instrument with the same terms as the derivative instrument would meet the definition of a derivative instrument.
- The economic characteristics and risks of the derivative instrument are not closely related to the economic characteristics and risks of the companion instrument. This would be the case in any of the following circumstances:
*Up-front payment with off-market terms*

An up-front payment is received as a result of a derivative instrument that has off-market terms. For example, an agency enters into a pay-fixed, receive-variable interest rate swap that has an above-market fixed payment, resulting in an up-front payment to the agency.*Written option that is in-the-money*

An agency that writes or sells such an option to a counterparty receives an up-front payment, resulting in a borrowing for financial reporting purposes.*Inconsistent reference rate*

The derivative instrument has a reference rate that is inconsistent with the market of the companion instrument.*Potential negative yield*

A hybrid instrument could be settled in such a way that an investor would not recover substantially all of its investment.*Leveraged yield*

The yield of the companion instrument is leveraged. A leveraged yield occurs if the embedded derivative instrument meets**both**of the following criteria:- The holder’s initial rate of return in the companion instrument is at least doubled.
**–AND–** - The rate of return is at least twice the market return for an instrument with the same terms as the companion instrument.

- The holder’s initial rate of return in the companion instrument is at least doubled.

If an agency reports a hybrid instrument, disclosures of the companion instrument must be consistent with disclosures required of similar transactions (such as disclosures of debt instruments). In that case, the existence of an embedded derivative instrument with the companion instrument is indicated in the disclosures of the companion instrument.

## Accounting for Derivative Instruments in USAS [+]

When an agency determines a derivative instrument to be effective, establish a derivative instrument asset/liability and corresponding deferred inflows/outflows account. Changes in fair value of *effective* hedging derivative instruments are recognized through the application of hedge accounting.

Derivative instruments are reported as investments if the derivative instrument is entered into for investment purposes or is an ineffective hedge. Changes in the fair value of investment derivatives flow through investment income.

Report derivatives associated with governmental funds in the basis conversion (BC) general ledger accounts. These amounts are not reported in the governmental fund statements, but are included in the government-wide financial statements.

Use the following USAS general ledger accounts for recording hedging derivative instruments in accordance with GASB 53.

### Derivatives General Ledger Accounts – Proprietary and Fiduciary Funds

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

#### Hedging Derivatives

- GL 1143 – CL Hedging Derivative Instrument Liability
- GL 1471 – NC Hedging Derivative Instrument Liability
- GL 0170 – CA Hedging Derivative Instrument Asset
- GL 0481 – NC Hedging Derivative Instrument Asset
- GL 0482 – Deferred Outflows of Resources
- GL 1472 – Deferred Inflows of Resources

#### Investment Derivatives

- GL 0059 – CA ST INV – Derivative Instruments
- GL 0105 – NC INV – Derivative Instruments

### Derivatives General Ledger Accounts - Basis Conversion

#### Hedging Derivatives

- GL 1543 – BC CL Hedging Derivative Instrument Liability
- GL 1971 – BC NC Hedging Derivative Instrument Liability
- GL 0570 – BC CA Hedging Derivative Instrument Asset
- GL 0781 – BC NC Hedging Derivative Instrument Asset
- GL 0782 – BC Deferred Outflows of Resources
- GL 1972 – BC Deferred Inflows of Resources

#### Investment Derivatives

- GL 0559 – BC CA INV – Derivative Instruments
- GL 0705 – BC NC INV – 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**.

## 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 LIBOR. 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.
- 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 LIBOR).**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.
- 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.
- 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.
- 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** 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.
- 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** 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.
- 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.
- 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 period 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.
- 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
- 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 LIBOR, the independent variable would be a rate based upon 68 percent of LIBOR for a relevant period of time).
- For a cash flow hedge evaluated using fair value, the dependent variable is the changes in fair values of the hypothetical derivative instrument. The independent variable is the changes in fair value of the potential hedging derivative instrument. The hypothetical derivative instrument should have terms that exactly match the critical terms of the variable-rate hedgeable item (such as same notional amount and 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 values, the dependent variable is changes in fair value of the hypothetical derivative instrument and the independent variable is changes in the fair value of the potential hedging derivative instrument. Generally, hypothetical derivative instruments should 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** 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.
- Substantive characteristics of the hedgeable item and the potential hedging derivative instrument that could affect their cash flows or fair values are considered.

## Disclosure Requirements Overview [+]

The primary focus of this note is to provide an overview of the agency’s derivative activity and to serve as a central place for the summary disclosure of all derivatives, both investment and hedging. Organize the note into the following sections:

- Introduction
- Summary of derivative activity and discussion of fair value determination
- Hedging derivatives
- Objectives
- Terms
- Risks
- Swap payments and associated debt

- Investment derivatives
- Contingent features
- Synthetic guaranteed investment contracts

Derivatives terminated during the fiscal year:

- For hedging derivatives, disclose the:
- Hedging derivative on the summary of derivative activity table
- Terms
- Timing of termination (terminated during the fiscal year)

- For investment derivatives, disclose the:
- Investment derivative on the summary of derivative activity table
- Timing of termination (terminated during the fiscal year)

For specific examples of the disclosure requirements, see Sample.