Basic Topics in Interest Rate Derivatives

By Timothy Woods, CPA, MBA

CBIZ MHM Webinar May 21, 2009

Presentation Overview
Most Common Interest Rate Derivatives
Interest Rate Swaps Interest Rate Cap Agreements

Risk Characteristics Pros and Cons of each Accounting and Reporting Valuation CBIZ MHM, LLC Services Questions
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Interest Rate Swaps

Most common is a plain vanilla interest rate swap where:
A Company agrees to pay cash flows equal to interest at a predetermined fixed rate on a stated notional principal for a stated period and, in return, the Company receives interest at a floating rate on the same notional principal for the same period of time. Company can be the fixed rate payer and the floating rate receiver or vice versa.

Interest Rate Swaps

For Example:
Company XYZ has outstanding $10,000,000 of non-amortizing variable rate debt for which interest payments are due on a quarterly basis. The note accrues interest at the 3 month London Interbank Offered Rate (LIBOR) plus 5% and matures via a bullet payment in 5 years. In this case, in order to hedge the Companys interest rate risk, the Company would enter into a 5 year interest rate swap for a notional amount of $10,000,000 at a current swap rate (fixed rate) of 2.60% (as of April 30, 2009).

Interest Rate Swaps

Example, contd:
The Company would pay the fixed rate of 2.6% on the $10,000,000 notional amount on a quarterly basis and would receive the 3 month LIBOR rate on a quarterly basis. The LIBOR received is set a quarter prior to payment so the payment is made 3 months in arrears. Accordingly, the Company knows 3 months in advance what the payment will be. Payments are settled on a net basis so if the 3 month LIBOR is greater than 2.6% then the Company will receive a payment. Therefore, the Company has effectively turned its variable rate debt into fixed rate debt with an effective interest rate of 7.6% (2.6% fixed + 5% spread).
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Interest Rate Swaps

Example contd:
FIXED RATE PAYMENT = $10,000,000 * .026 / 4 = $65,000 VARIABLE RATE PAYMENT = $10,000,000 * 3 MONTH LIBOR (3.0%) or .030 / 4 = $75,000 THEREFORE COMPANY RECEIVES:
$75,000 - $65,000 = $10,000 AT QUARTERLY SETTLEMENT. THE FIXED RATE PAYMENT WILL BE $65,000 AT EACH SETTLEMENT THE VARIABLE RATE PAYMENT IS THE MOVING COMPONENT AS THE THREE MONTH LIBOR WILL CHANGE.
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Interest Rate Cap Agreement

An interest rate cap is an option that provides a payoff when a specified interest rate above a certain level (the cap rate). The specified rate is a floating rate that is set periodically.

Interest Rate Caps -Terms

Interest rate caps can be described by a term sheet
Maturity (for example - 5 years) Notional amount (usually set equal to borrowed amount) Strike price (sometimes called the protection level) Frequency (how many payments per year)
Payments per year times maturity tells you how many caplets

Basis (how youre going to count days) Underlying rate (usually LIBOR of some maturity)

Interest Rate Cap

For Example:
Company XYZ has outstanding $10,000,000 of non-amortizing variable rate debt for which interest payments are due on a quarterly basis. The note accrues interest at the 3 month LIBOR plus 5% and matures via a bullet payment in 5 years. In this case, in order to hedge the Companys interest rate risk, the Company would purchase a 5 year interest rate cap agreement for a notional amount of $10,000,000 which has a cap rate of 2.6% (for example) and designated maturities of 3 months. For purposes of this example, the purchase price is $200,000 for the interest rate cap agreement. Therefore, given that the Company purchased an interest rate cap agreement with a term of 5 years and quarterly settlements, the interest rate cap agreement is comprised of 20 individual cap agreements, or caplets, that are settled on a quarterly basis. As with the interest rate swap, the cap rate is set 3 months prior to settlement and as such, the settlement amount is know 3 months in advance.
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Interest Rate Cap For Example, contd:

With an interest rate cap, the Company that purchased the cap agreement will only receive a payment if the 3 month LIBOR closes above the cap rate. At no time will the Company be required to pay additional funds at any of the caplet settlements. For example, if the 3 month LIBOR rate closes at 3%, the Company will receive a payment equal to (3% - 2.6%) *10,000,000 / 4 = $10,000. Therefore, the Company has ensured that the effective rate of its debt will not go above 7.6% (LIBOR of 2.6%, the cap rate, plus the 5% margin on the underlying debt). However, the Companys effective rate can go as low as the market will take it; which as we will see, is not the situation with the interest rate swap.
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Risk Characteristics
Risk Characteristics of Interest Rate Swaps:
As we discussed before, the swap rate is the fixed rate of interest that the receiver (variable rate payer) demands in exchange for the uncertainty of having to pay the short term 3 month LIBOR (floating rate) over the term of the swap. Therefore, at the time that the interest rate swap is entered, the total present value of the fixed rate payments to be received (made) is equal to the expected value of the variable rate payments to be made (received). As such, at the date the swap is entered the value of the swap is $0, which is why there is no purchase price for the swap (without commissions).
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Risk Characteristics
Interest rate swaps involve two primary risks: 1) interest rate risk and 2) credit, or counterparty, risk. Interest Rate Risk:
When a Company enters into an interest rate swap for purposes of risk management, they are stating that they are comfortable with the effective interest rate that has been set as a result of entering into the swap. Therefore, because actual interest rate movements do not always match expectations, from the standalone viewpoint of the swap only, swaps entail interest rate risk. For example, the variable rate receiver will profit if interest rates rise and will lose if interest rates fall and vice versa for the fixed rate receiver. However, when viewed in conjunction with the cash flows of the underlying debt being hedged, the variable rate receiver has effectively locked in the hedged interest rate at the time the swap was entered into as the any fluctuations in the variable rate being received will be offset by the variable rate being paid on the underlying debt and the Company is effectively left with the fixed rate + the margin on the underlying debt.
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Risk Characteristics
While we will get into the accounting for interest rate swaps later in the webinar, it is important to note that interest rate swaps are marked to market at each reporting date; that is, they are recorded at estimated fair value, with the change either being reported in earnings or through other comprehensive income. Therefore, depending upon whether the Company designates the interest rate swap as a hedge under SFAS 133 or as an investment, the change in fair value could have a material effect on the Companys earnings, even though the Company has effectively locked in the same interest rate over the period of the interest rate swap. For example, if the Company has not designated hedge accounting and as the variable rate payer under an interest rate swap, interest rates drop by a large amount, the value of the interest rate swap will be significantly decreased such that the Company will need to record the change in fair value through earnings. However, the Company does not get an offset to the drop in fair value of the swap by reducing the value of its debt. Therefore, Companies must keep this is mind before they enter into interest rate swaps and make the determination of whether hedge accounting will be utilized (note there are specific and stringent criteria to qualify for hedge accounting).
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Risk Characteristics
Credit, or Counterparty, Risk
Swaps are also subject to the counterpartys credit risk: the chance that the other party in the contract will default on its responsibility. Although this risk is very low banks that deal in LIBOR and interest rate swaps generally have very high credit ratings of double-A or above it is still higher than that of a riskfree U.S. Treasury bond.

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Risk Characteristics - Caps

Interest rate caps are option products, and as such, share certain common characteristics with all options:
An upfront premium is required to purchase a cap. The value of a cap depends upon the variability of interest rates; that is, the projected volatility of interest rates, over the life of the cap. The longer the maturity of the cap, the more expensive. A cap provides insurance against higher interest rates. The farther out-of-the-money a cap is, that is, the higher the cap rate, the cheaper it will be.
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Risk Characteristics - Caps

As stated before, the only value at risk with an interest rate cap is the premium paid for the cap agreement. The value of the interest rate cap agreement will increase with increases in interest rates and will decrease with decreases in interest rates. All other aspects of the value of the interest rate cap are the same as for other types of options:
Increase in interest rate volatility increases the value of the interest rate cap Increase in term, increases the value of the interest rate cap Increase in cap rate, decreases the value of the interest rate cap And vice versa
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Pros and Cons Interest Rate Swaps

PROS
No upfront cash outlay Effective hedging vehicle Locks in an effective rate

CONS
No upside participation (no gain from decline or rise in interest rates) Mark to Market accounting can have large effect on net income Credit, non-performance risk

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Pros and Cons Interest Rate Caps

PROS
Effective interest rate risk hedging vehicle with participation in gains from decrease in interest rates. Can only lose premium paid, cannot go to below zero (re: no liability treatment) Caps interest rate

CONS
Upfront cash outlay Mark to Market accounting can have large effect on net income although losses only to the extent premium paid. Credit, non-performance risk
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Accounting and Reporting

Primary accounting guidance comes from SFAS 133, Accounting for Derivatives and Hedging Activities. Primary issue is the treatment of the gains or losses resulting from the adjustment of the derivatives carrying value to fair value. Hedge accounting: gain or loss from the derivative impacts earnings in the same period as the gain or loss resulting from underlying exposure being hedged.

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Accounting and Reporting

If Company does not elect to use hedge accounting under SFAS 133 for its interest rate swaps and/or caps, the change in the fair value of the derivatives is recognized in earnings during the period of the change.

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Accounting and Reporting Hedge Accounting

However, if the Company wishes to elect hedge accounting, they must first meet the following criteria: 1) The Determination of the Nature of the Hedged Risk
While there are three different types of exposures to hedge (fair value exposure, cash flow exposure, and the exposure to changes in the value of a net investment in a foreign operation), for purposes of this webinar we are referring to HEDGES OF CASH FLOW EXPOSURE, which is defined as a cash flow hedge. Accordingly, the Company declares the interest rate swaps and or caps to be hedges of the variability in the Companys future interest rate payments related to its variable rate debt. In order for this to be a valid cash flow hedge, the Company must be able to properly forecast the cash flows being hedged, the transactions must be probable, and must be with a party external to the reporting entity.

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Accounting and Reporting Hedge Accounting

2) In addition to the preceding, the Company must have Hedge Documentation prepared at the inception of hedge and must include:
Identification of the hedging instrument. Identification of the hedged risk. Risk management objective and strategy for undertaking the hedge. Documentation supporting managements expectation that the hedge will be effective. Procedure to be followed for measuring hedge effectiveness.

WITHOUT THE PRECEEDING, HEDGE ACCOUNTING CANNOT BE UTILIZED AND ALL CHANGES IN FV WILL BE RECOGNIZED IN EARNINGS.
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Accounting and Reporting Hedge Accounting

3) As noted in the documentation requirement, the Company must document that the derivative will be highly effective in hedging the variability in the forecasted cash flows related to its debt service requirements. Furthermore, the Company must measure the effectiveness of the cash flow hedge at each reporting date.

Must be highly effective to continue to use hedge accounting.

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Accounting and Reporting Hedge Accounting

The company must select a method to measure the portion of the change in the value of the derivative intended to offset changes in the hedged exposure and to evaluate hedge effectiveness: 1) at the inception of the hedge and 2) on an ongoing basis while the hedge is in place.

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Accounting and Reporting Hedge Accounting

In measuring the effectiveness of a cash flow hedge, the Company must measure the correlation of the expected (hedged) result and the actual result (difference should be minimal for an effective hedge). In terms of a fair value hedge, the Company must measure the correlation of the change in fair value of the hedged item and the change in fair value of the derivative being utilized in the hedge.

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Accounting and Reporting Hedge Accounting

Hedge Effectiveness Example:
In terms of the interest rate swap and cap examples that we discussed, we would need to measure the effectiveness of the swap or cap to properly hedge the interest rate risk that we are hedging. In terms of the swap, we entered into the hedge with the goal of locking in an effective rate of 7.6%. Accordingly, we would need to calculate the actual interest rate at the reporting date and compare this to the 7.6%. However, if we determine a portion of the interest rate swap to be ineffective (for example, if we paid off a portion of the underlying debt and the notional amount of the swap is now greater than the underlying debt being hedged), that portion of the change in fair value of the swap that is deemed to be ineffective must be recognized in earnings.

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Accounting and Reporting

If Company does not elect to use hedge accounting under SFAS 133 for its interest rate swaps and/or caps, the change in the fair value of the derivatives is recognized in earnings during the period of the change.

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Hedge Accounting
Provided that the Company meets the burden of SFAS 133 and can properly implement hedge accounting, the changes in the fair value of the derivative (interest rate swap and/or cap) are deferred in accumulated other comprehensive income (AOCI) until the forecasted transaction being hedged is recognized in earnings. At that point, that portion of the hedge that is deferred in AOCI is transferred from AOCI to earnings and recognized in the same category as the underlying item being hedged; in this case, interest expense.
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Reporting
While it is outside of the scope of this webinar, the disclosure requirements for derivatives and hedged activities changed as a result of SFAS 161, Disclosures about Derivative Instruments and Hedging Activities an Amendment of SFAS 133, which was effective January 1, 2009. In addition, SFAS 157, Fair Value Measurements, which was effective for financial assets and liabilities on January 1, 2008, requires certain disclosures as to the nature of the fair value measurements of derivatives in the context of the SFAS 157 fair value hierarchy (re level 1,2 or 3).

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Valuation
As just noted, SFAS 157, provides a fair value hierarchy under which among other items, derivatives, must be measured and disclosed. Given that interest rate swaps and caps into which your companies will enter will not be able to be valued by obtaining market quotes, the fair values must be estimated via cash flow and option pricing models. Typically, your banker will provide a statement of the fair value of these instruments, however, if considered material in relation to your financial statements, your auditors will need to audit that value and it is rare that the banker will provide them access to their pricing models as they are deemed to be proprietary.
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Valuation
Therefore, in the situation of a non-publicly traded entity, the auditor maybe able to estimate the value of the interest rate swap and/or cap for the Company, in the context of auditing the confirmation received from the bank. However, auditors cannot derive the valuation assumptions for management.

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Valuation Interest Rate Swaps

Interest rate swaps are valued by taking the net present value of the estimated cash flows over the life of the swap. Given that the fixed rate payments are known, the variable rate payments must be estimated.
The future variable rate payments can be estimated by extracting the forward rates for the variable rate and using these as our estimates of the variable rate that will be in effect at settlement. By definition, a forward interest rate is the interest rate for a future period of time that is implied by the interest rates prevailing in the market today.
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Valuation Forward Rates

Forward Rates example
Forward rates are derived from the current rates in the market for example: 3 month LIBOR = 2% 6 month LIBOR = 4% The implied 3 month LIBOR rate from the 4th 6th month is 6%. This is because if an investor can invest $1,000 for 3 months @ 2% and can invest for 6 months @ 4% then the sum of the three month periods must be equivalent to the 6 month return of 4%. Therefore: the investor earns $20 for the 6 months at 4%, and earns $5 for the 3 months at 2%, then he must earn $15 for the second three months which is equivalent to a rate of 6%. This is the logic being forward rates and how they are determined from the yield curve for the underlying base rate
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Valuation Interest Rate Swaps

Example
1 Swap Rate: 2 2.60% Total Days 90.00 181.00 273.00 365.00 3 4 Period Days 90.00 91.00 92.00 92.00 Notional Principal $10,000,000 $10,000,000 $10,000,000 $10,000,000 $10,000,000 5 6 7 Annualized Period 3 Month LIBOR 3 Month LIBOR Payer Forward Forward Fixed Rate Rate Cash Flow
2.0000% 2.2500% 2.5000% 2.7500% 0.5000% 0.5625% 0.6250% 0.6875% ($64,110) ($64,822) ($65,534) ($65,534)

8 Receiver Floating Cash Flow

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Date 12/31/2008 3/31/2009 6/30/2009 9/30/2009 12/31/2009

Net Discount Cash Flow Factor

0.99502 0.98946 0.98331 0.97660

11 Present Value of Net Cash Flow

($14,039) ($8,482) ($2,984) $3,141 ($22,364)

$50,000 ($14,109.59) $56,250 ($8,571.92) $62,500 ($3,034.25) $68,750 $3,215.75

Therefore, based upon the following swap terms: Notional Amount: Swap Rate: Fixed Rate Payer: Floating Rate Payer: Settlement Floating Rate: Maturity; $10,000,000 2.60% XYZ Company & Floating Rate Receiver ABC Bank & Fixed Rate Receiver Every 3 months 3 month LIBOR 12/31/2009
($22,364)

The value of the interest rate swap to XYZ Bank, that is using the swap to hedge its 10,000,000 variable rate debt is Which would be recorded as follows as of 12/31/08: AOCI $22,364 ST Derivative Liability ($22,364)

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Valuation Interest Rate Cap

Given that interest rate caps are options, we must use an option pricing model to estimate the fair value thereof. The most widely used option pricing model for interest rate caps is a derivation of the Black Scholes Option Pricing model, called the Black Option Pricing model.

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Valuation Interest Rate Caps

While going through the math that is behind the valuation of an interest rate cap using the Black Model is beyond the scope of this webinar, we will touch upon the variables that must be input / estimated for the Black Model.

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Valuation Interest Rate Caps

flag = X = ndays = basis = ep = z= f= Vol = "caplet" for pricing European call options on interest rates option strike price (e.g. 2.6%) the number of days in the protection period ( = life of option) the number of days used in the forward market for quoting interest rates ( e.g., 360 days or 365 days) length of the exposure period (also called the reset period), measured in years (e.g., 0.5 yrs, or 2.75 yrs, etc.) the continously compounded zero coupon rate over the exposure period the forward rate over the protection (or reset period) period volatility of the forward interest rate

For example, suppose we want to cap the interest rate on a 182 day loan taken out in 6 months. The six-month forward rate embedded in the yield curve today is 8% and
z= f= Protection Period

Exposure Period

t=0

t= 6 Life of

t = 1 year

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Valuation Interest Rate Caps

1 2 3 4 5 6 X Notional: $10,000,000 Base Rate: 3 month LIBOR Period From 31-Dec-08 1 1-Apr-09 2 1-Jul-09 3 1-Oct-09 To 31-Mar-09 30-Jun-09 30-Sep-09 31-Dec-09 Days 90.00 90.00 91.00 91.00 Life of Caplet 0.3 0.5 0.8 1.0 Option Strike Price 2.60% 2.60% 2.60% 2.60% 7 8 9 ep (Reset Period) Exposure Period (yrs) 0.3 0.5 0.8 10 11 12 13 14 ndays basis # of Days # of Days In In Fwrd Protection Market Period Quotes 90.0 360.0 90.0 360.0 91.0 360.0 91.0 360.0 z f Vol zero Forward Volatility Rate for Rate for 3 mn LIBOR Exposure Protection Forward Caplet Period (yrs) Period (yrs) Rate Price 2.00% 60.00% 2.25% 2.25% 60.00% 0.0003628 2.38% 2.50% 60.00% 0.0009437 2.50% 2.75% 60.00% 0.0015457

Value of Caplet $3,628 $9,437 $15,457 $28,522

Therefore, in this example, the Company has purchased an interest rate cap for a period of 1 year, with 3 remaining settlements. The notional amount is $10,000,000 and the cap rate is $2.60%. Given the forward rate curve as of 12/31/08 (hypothetical not actual), and an estimated volatiltiy of the 3 month LIBOR of 60%, the total value of the entire interest rate cap agreement is $28,522

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Derivatives - Taxation
While this webinar is not specifically coming from the income tax perspective, generally derivatives and hedging activities become taxable events upon the realization of gains and losses (i.e. the unrealized gains and losses from mark to market of derivatives are not taxable events). Generally, for Federal income tax purposes, the cost basis of option premiums are amortized over the life of the option to expense. However, as always, you should consult your tax advisor prior to entering into any derivatives or hedging transactions.

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Interest Rate Swaps Current Market Rate

Given the decrease in interest rates experienced over the past year, the current index for swap rates is very low from a historical perspective. Current swap rate (www.federalreserve.gov) 5/18/09 Fixed for 3 month LIBOR
1 yr = .85% 2 yr = 1.25% 3 yr = 1.74% 4 yr = 2.14% 5 yr = 2.44% 7 yr = 2.88% 10 yr = 3.22%
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CBIZ MHM, LLC

We are available to consult with you in terms of your current, projected, and/or desired implementation of an interest rate risk hedging program.
Accounting and Reporting (disclosures) Effectiveness testing Valuation Structuring Sensitivity Analyses

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Conclusion
Questions? Please contact:
Timothy Woods, CPA, MBA CBIZ MHM, LLC 8181 E. Tufts Avenue, Suite 600 Denver, Colorado 80237 twoods@cbiz.com 720-200-7043

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