# 9.4 Derivatives

Derivatives are financial instruments whose value is derived from the value of something else. They generally take the form of contracts under which the parties agree to payments between them based upon the value of an underlying asset or other data at a particular point in time. *Derivatives are leveraged*, which means they require minimal or no initial investment on the part of a government but nevertheless achieve changes in fair value that would have required a far larger initial investment. Also, these *financial instruments can be settled early* with a cash payment or the transfer of an equivalent asset. The main types of derivatives are futures, forwards, options, and swaps.

Derivatives are used to minimize risk for one party while offering the potential for a high return (at increased risk) to another. The diverse range of potential underlying assets and payoff alternatives leads to a huge rate of derivatives contracts available to be traded in the market. They can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, or exchange rates. They can also be based on various indices such as a stock market index, consumer price index (CPI) as in inflation derivatives, or even an index of weather conditions, along with other derivatives. Their performance can determine both the amount and the timing of the payoffs.

Derivatives will primarily affect USG institutions at the foundation level. However, institutions must review any derivative calculations for their respective foundations and document that they understand the derivative transactions and their impact to the financials for the period being audited.

**Note:** Governmental Accounting Standards Board (GASB) Statement No. 53, *Accounting and Financial Reporting for Derivative Instruments*, was created to enhance transparency and improve consistency as they relate to the use of derivative instruments being reported in the financial statements. The financial statement users now get a clearer look into the risks to which their investments are sometimes exposed when they enter into these transactions and how those risks are managed. Derivative instruments are required to be reported at fair value in the entity-wide, proprietary, and fiduciary fund level financial statements.

#### GASB Statement No. 53 does not apply to:

Normal purchases and sales contracts that are typical transactions in which it is probable that a government will receive or deliver the purchased commodity, such as electricity or natural gas. In other words, the transaction takes place with an expectation that the commodity will actually be used by the purchaser. This contrasts with the futures contract discussed above, in which there is no expectation that the commodity covered by the contract will actually be purchased and received.

Insurance contracts that are accounted for under GASB Statement No. 10,

*Accounting and Financial Reporting for Risk Financing and Related Insurance Issues*.Financial guarantee contracts under which the holder is reimbursed when a specified debtor fails to make required payments.

Contracts that are not traded on an exchange and have rates based on:

- A climate, geological, or other physical attribute; or,
- The price or value of an asset that cannot be readily converted to cash.

Loan commitments, such as to first-time home buyers for mortgages.

## 9.4.1 Disclosure Requirements for Derivatives

GASB Statement No. 53 requires that the fair value of derivatives be reported in the financial statements. Fair value is either the price an item is expected to garner if sold on the open market between two unrelated willing parties, or the value of future cash flows in today’s dollars. A synthetic guaranteed investment contract, which is one type of derivative, is reported at contract value instead of fair value. Contract value is the amount that contract holders would receive in a permitted participant-initiated transaction.

Footnote disclosures related to derivative instruments are required and must include the following items:

A summary of derivative instrument activity during the reporting period and balances at the end of the reporting period.

Derivative instruments are to be divided into the following categories

- Hedging derivative instruments, distinguished between fair value hedges and cash flow hedges. Refer to Section 9.4.2 for more information on hedging derivative instruments.
- Investment derivative instruments

Within each category, derivative instruments should be aggregated by type (for example, receive-fixed swaps, pay-fixed swaps, swaptions, rate caps, basis swaps, or futures contracts.

Required information presented should include the following information:

Notional amount

Change in fair value during the reporting period and the classification in the financial statements where those changes in fair value are reported.

Fair value as of the end of the reporting period and the classification in the financial statement where those fair values are reported – if derivative instrument fair values are based on other than quoted market prices, the methods and significant assumptions used to estimate those fair values should be disclosed.

Fair value of derivative instruments reclassified from hedging derivative instruments to investment derivative instruments. There are also should be disclosure of the deferral amount that was reported within investment income upon the reclassifications.

## 9.4.2 Hedging Derivative Instruments

Hedging derivative instruments, like investment derivatives instruments, require that effectively hedged derivatives be reported in the statement of net assets as deferred inflows/outflows of resources utilizing hedge accounting. Changes in the fair value of derivatives entered into with the intent of producing investment income are to be reported within investment income. Changes in the fair value of hedging derivative instruments that have been determined ineffective (ineffective hedging derivative instruments) are also required to be recognized within investment income for the remaining life of the instrument and no longer recognized as deferred inflows/outflows of resources.

Disclosures specifically required for hedging derivative instruments include the following:

Objectives, including:

- The reason for entering into those instruments;
- The context needed to understand those objectives;
- The strategies for achieving those objectives; and,
- The types of derivative instruments entered into.

Significant terms, including:

- Notional amount;
- Reference rates, such as indexes or interest rates;
- Embedded options, such as caps, floors, or collars;
- The dates when the hedging derivative instrument was entered into and when it is scheduled to terminate or mature; and,
- The amount of cash paid or received, if any, when a forward contract or swap (including swaptions) was entered into.

The following risk disclosures for hedging derivatives are required at year-end:

Credit risks based on a nationally recognized statistical rating organization should be disclosed.

Maximum amount of loss due to credit risk the institution would include if the counterparties to the hedging derivative instrument fail to perform according to the terms, without respect to any collateral or other security or netting arrangement, should be disclosed.

Policy of requiring collateral to support hedging derivative instruments should be disclosed.

Policy of entering into master netting arrangements, including summary description of liabilities and amount included in those arrangements, should be disclosed.

Aggregate fair value of hedging derivative instruments in an assets position, net of collateral posted by the counterparties, and the effect of master netting arrangements should be disclosed.

Significant concentrations of net exposure to credit risks should be disclosed.

Interest rate risks of hedging derivative instruments should be evaluated and disclosed if hedging instrument exposes institution to these risks

Basis risks should be disclosed.

Termination risks such as any terminations events that have occurred, dates that the hedging derivative instrument may be terminated, and out of the ordinary termination events should be disclosed.

Rollover risks should be disclosed, including the maturity of the hedging derivative instrument and the maturity of the hedged item.

Market-access risks should be disclosed.

Foreign currency risks should be disclosed.

## 9.4.3 Definitions

**BASIS RISK.**The risk that arises when variable rates or prices of a hedging derivative instrument and a hedged item are based on different reference rates.**CALL OPTION.**An option that gives its holder the right but not the obligation to purchase a financial instrument or commodity at a certain price for a period of time.**CASH FLOW HEDGE.**A hedge that 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.**COMMODITY SWAP.**A swap that has a variable payment based on the price or index of an underlying commodity.**CREDIT RISK.**The risk that a counter-party will not fulfill its obligations.**CRITICAL TERM.**A significant term of the hedgeable item and potential hedging derivative instrument that affects whether the changes in cash flows or fair values substantially offset. Examples are the notional or principal amounts, payment dates, and in some cases, fair values at inception, indexes, rates, and options.**FOREIGN CURRENCY RISK.**The risk that changes in exchange rates will adversely affect the cash flows or fair value of a transaction.**FORWARD CONTRACT.**A contractual agreement to buy or sell a security, commodity, foreign currency, or other financial instrument, at a certain future date for a specific price. An agreement with a supplier to purchase a quantity of heating oil at a certain future time, for a certain price, and a certain quantity is an example of a forward contract.Forward contracts are not securities and are not exchange-traded. Some forward contracts, rather than taking or making delivery of a commodity or financial instrument, may be settled by a cash payment that is equal to the fair value of the contract.

**FUTURES CONTRACT.**An exchange-traded security to buy or sell a security, commodity, foreign currency, or other financial instrument at a certain future date for a specific price. A futures contract obligates a buyer to purchase the commodity or financial instrument and a seller to sell it, unless an offsetting contract is entered into to offset one’s obligation. The resources or obligations acquired through these contracts are usually terminated by entering into offsetting contracts.**HEDGE ACCOUNTING.**The financial reporting treatment for hedging derivative instruments that requires that the changes in fair value of hedging derivative instruments be reported as either deferred inflows or deferred outflows.**HEDGEABLE ITEM.**An asset or liability, or expected transaction that may be associated with a potential hedging derivative instrument.**HEDGING DERIVATIVE INSTRUMENT.**A derivative instrument that is associated with a hedgeable item and significantly reduces an identified financial risk by substantially offsetting changes in cash flows or fair values of the hedgeable item.**INTEREST RATE RISK.**The risk that changes in interest rates will adversely affect the fair values of a government’s financial instruments or a government’s cash flows.**INTEREST RATE SWAP.**A swap that has a variable payment based on the price of an underlying interest rate or index.**INVESTMENT DERIVATIVE INSTRUMENT.**A derivative instrument that is entered into primarily for the purpose of obtaining income or profit, or a derivative instrument that does not meet the effectiveness criteria of a hedging derivative instrument.**LEVERAGE.**The means of enhancing changes in fair value while minimizing or eliminating an initial investment. A leveraged investment has changes in fair value that are disproportionate to the initial net investment. An unleveraged investment requires a far greater initial investment to replicate similar changes in fair values. Derivative instruments are leveraged instruments because their changes in fair value are disproportionate to the initial net investment. For example, an interest rate swap that has a notional value of $100 million is entered into with no initial net investment. Thereafter, as interest rates change, the swap produces changes in fair value consistent with a $100 million fixed-rate financial instrument.**MARKET RISK.**The risk that changes in market prices will reduce the fair value of an asset, increase the fair value of a liability, or adversely affect the cash flows of an expected transaction.**MARKET-ACCESS RISK.**The risk that a government or institution will not be able to enter credit markets or that credit will become more costly. For example, to complete a derivative instrument’s objective, an issuance of refunding bonds may be planned in the future. If at that time the government is unable to enter credit markets, expected cost savings may not be realized.**NOTIONAL AMOUNT.**The number of currency units, shares, bushels, pounds, or other units specified in the derivative instrument. It is a stated amount on which payments depend. The notional amount is similar to the principal amount of a bond.**OPTION.**A contract that gives its holder the right but not the obligation to buy or sell a financial instrument or commodity at a certain price for a period of time.**PUT OPTION.**An option that gives its holder the right but not the obligation to sell a financial instrument or commodity at a certain price for a period of time.**QUALITATIVE METHOD.**A method of evaluating effectiveness by qualitative consideration of the critical terms of the hedgeable item and the potential hedging derivative instrument.**QUANTITATIVE METHOD.**A method of evaluating effectiveness using a mathematical relationship. Synthetic instrument, dollar-offset, and regression analysis are the quantitative methods specifically addressed in GASB Statement No. 53 and this policy.**REFERENCE RATE.**The rate to which a derivative instrument’s variable payment is linked. Common reference rates are LIBOR, the SIFMA swap index, the AAA general obligations index, and the pricing point of a commodity.**REGRESSION ANALYSIS METHOD.**A statistical technique that measures the relationship between a dependent variable and one or more independent variables. The future value of the dependent variable is predicted by measuring the size and significance of each independent variable in relation to the dependent variable. Regression analysis included in the text of this policy and GASB Statement No. 53 uses only one independent variable.**ROLLOVER RISK.**The risk that a hedging derivative instrument associated with a hedgeable item does not extend to the maturity of that hedgeable item. When the hedging derivative instrument terminates, the hedgeable item will no longer have the benefit of the hedging derivative instrument.**SWAP.**A type of derivative instrument in which there is an agreement to exchange future cash flows. These cash flows may be either fixed or variable and may be either received or paid. Variable cash flows depend on a reference rate.**SWAPTION.**An option to enter into a swap. When a swaption is an interest rate option, it may be used to hedge long-term debt. When a government sells a swaption a cash payment may be received. Options pricing theory, including time and volatility measures, is used to value swaptions.**SYNTHETIC INSTRUMENT METHOD.**A method of evaluating effectiveness that combines a hedge item and a potential hedging derivative instrument into a hypothetical financial instrument to evaluate whether the hypothetical financial instrument pays a substantively fixed rate.**TERMINATION RISK.**The risk that a hedging derivative instrument’s unscheduled end will affect a government’s asset and liability strategy or will present the government with potentially significant unscheduled termination payments to the counterparty.**ZERO FAIR VALUE.**Value of a derivative instrument that is either entered into or exited with no consideration being exchanged. A zero fair value should be within a dealer’s normal bid/offer spread.

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