Hedge Accounting Under FAS 133/138
The Financial Accounting Standards Board (FASB) has issued a Statement of Financial Accounting Standards (SFAS 133) and a subsequent amendment (SFAS 138) governing the accounting treatment of hedge positions and stand-alone derivative instruments. Wagner Associates has developed a spreadsheet application to perform (i) the mark-to-market instrument valuations and other calculations required to determine hedge effectiveness and (ii) the accounting calculations to determine the allocation of gains and losses in the hedge position between current income and deferred income.
The application handles fair value hedges, cash flow hedges, and derivative speculations. The underlying market exposure can be either to interest rate risk or to foreign currency exchange (FX) risk. In the case of interest rate risk, the hedged transactions covered include term loans and bonds. The derivative instruments covered include interest rate swaps, swaptions, caps, floors, collars, and corridors. In the case of FX risk, the hedged transactions covered include firm commitments and forecasted transactions. The derivative instruments include FX forwards, futures and futures options.
The valuation methodology is based on a factor model for the stochastic evolution of the forward curve associated with the underlying risk variable. The initial forward curve and the parameters governing the term structure of forward rate volatility are calibrated to market data. Mark-to-market valuations are based on the methods of arbitrage pricing using computationally efficient recursive methods.
Hedge effectiveness is assessed based on the dollar offset ratio method (as described in SFAS 133). For fair value hedges, the application determines the appropriate allocation of gains and losses to earnings for the hedged transaction and the hedging derivative. In the case of cash flow hedges, the application determines the allocation of gains and losses in the hedging derivative between earnings and accumulated other comprehensive income (AOCI). The application also calculates the amount to be reclassified from AOCI to earnings as the cash flows being hedged are settled.
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