ISDA / GARP

1. ISDA / GARP Overview and Implications of FAS 133 (718)-694-6270 kawaller@idt.net www.kawaller.com Presented by Ira G. Kawaller Kawaller & Company, LLC The accompanying presentation has been compiled by Ira G. Kawaller for general information purposes. Examples are hypothetical, used for explanatory purposes only. Although every attempt has been made to ensure the accuracy of the information, Mr. Kawaller assumes no responsibility for any errors or omissions.

2. INSTRUCTOR PROFILE Before founding Kawaller and Company, Ira Kawaller held positions with the Chicago Mercantile Exchange, J. Aron & Company, AT&T, and the Board of Governors of the Federal Reserve System Mr. Kawaller is currently a member of the Financial Accounting Standards Board’s Derivatives Implementation Group (DIG). In prior years he was a trustee of both the Futures Industry Institute and the Securities Industry Institute and a member of the board of directors of the International Association of Financial Engineers. Mr. Kawaller received a Ph.D. in economics from Purdue University and has held adjunct professorships at Columbia University and Polytechnic University.

3. FASB 133 - FOUNDATIONS • Qualifying derivatives must be recorded as assets or liabilities on the balance sheet, measured at fair value • Special hedge accounting may apply in restrictive situations • Hedges must be expected to be “highly effective” in offsetting changes in fair values or changes in forecasted cash flows

4. FASB 133 - KEY ISSUES • Identification • Hedge qualifications • Valuation

5. DERIVATIVE DEFINITION • A derivative is a contract with all three of the following characteristics • An underlying and either a notional amount or a payment provision or both • At most, a relatively small initial net investment • Net settlement or its equivalent • Derivatives may be freestanding or be embedded in other (“host”) contracts • A number of exclusions exist

6. EXEMPTED DERIVATIVES • Normal purchases and normal sales • “Regular-way” security trades • Traditional insurance contracts • Most financial guarantee contracts • OTC contracts with certain underlyings (e.g., climatic, physical, or geologic variables) • Derivatives based on sales or revenues of one of the parties

7. EXEMPTED DERIVATIVES • Derivatives that are an impediment to sales accounting • Instruments indexed to an entity’s own stock and classified in stockholders’ equity • Stock-based compensation covered by Statement 123 (issuer only) • Contingent consideration in a business combination (purchaser only)

8. NEW ACCOUNTING FOR DERIVATIVES* • Speculative: - Mark derivatives to market - Post results to current income • Fair value hedges of recognized assets, liabilities, and firm commitments: - Mark-to-market both (a) the derivative and (b) the exposure relating to the risk being hedged - Post both to current income *Effective for all fiscal years beginning after June 15, 2000

9. ACCOUNTING TREATMENT (Con’t) • Cashflow hedges of uncertain forecasted transactions: • “Effective” hedge results are initially recorded in other comprehensive income • “Ineffective” results go to current income • Allocations must be based on cumulative outcomes • OCI is reclassified to income coincidentally with the hedged item’s income effects

10. ALLOCATING CASH FLOW RESULTS Derivative Exposure Period Change 100 94 (162) (101) 30 Cum Change 100 194 32 (69) (39) Period Change (96) (101) 160 103 (32) Cum Change (96) (197) (37) 66 34 Lesser Cum 96 194 32 (66) (34) Per. 1 2 3 4 5 Inc. 4 (4) 0 (3) (2) OCI 96 194-96 =98 32-194 =(162) (66)-32 =(98) (34)-(66) =32

11. ACCOUNTING TREATMENT (Con’t) • Net investments in foreign operations: • Consistent with current FAS52 treatment • Effective hedge results are posted to translation account • Ineffective hedge results go to earnings • Forward points no longer allocated ratably

12. Effectiveness Considerations

13. ACCOUNTING EFFECTIVENESS • Fair value hedges • Derivatives should offset the changes in fair value of the hedged item attributable to the hedged risk • Cash flow hedges • Derivatives should offset cash flows of the hedged item attributable to the hedged risk

14. Gain (Loss) on the Derivative Gain (Loss) on the Hedged Item 0.8  -1   1.2 CRITICAL CONSIDERATIONS • Dollar offset ratio calculations may be used to pass the “highly effective” criteria • Calculations may rely on period-by-period or cumulative analysis • Income allocations for cash flow hedges must be based on cumulative results

15. SPOT/FORWARD PRICES Price Forward Spot Time

16. “EXCLUDABLE” HEDGE RESULTS • Changes in forward points • Assessment based on changes in spot prices or forward prices • Changes in the time value of options • Assessment based on intrinsic value • Changes in the option’s volatility value • Assessment based on an option’s minimum value

17. CRITICAL CONSIDERATIONS • If dollar offset justifies hedge accounting but the 0.8 - 1.2 range is violated, no hedge accounting is permitted for the period • If an alternative statistical analysis justifies hedge accounting, hedge accounting rules will apply even if the 0.8 - 1.2 range is violated • If the 0.8 - 1.2 range is violated, a new analysis is required to qualify for subsequent periods

18. USING REGRESSION • Should the regression use price levels or price changes? • What is the proper frequency of the observations? • Can overlapping samples be used? • Is measuring correlation sufficient?

19. PRICE LEVELS VS. CHANGES Levels are uncorrelated; changes are perfectly correlated

20. HIGHLY CORRELATED PRICES

21. GUIDING PRINCIPLES • To assess effectiveness over a given time span (e.g., quarterly) price changes should be that same length (e.g., quarterly) • Correlations using price levels may be indicative of long term effectiveness, but not over a single period • Paragraph 75 implies that high correlation of price levels is sufficient

22. CAVEATS • Price changes of the hedged item should reflect only the effect of the risk being hedged • Price changes of the hedging derivative should not include “excluded items” • Price changes of fixed income securities should appropriately reflect “aging” of the security* • In general, interest accruals (on both debt and swaps) should not be included in price change measures *Relevant only for fair value hedges

23. Required Disclosures

24. REQUIRED DISCLOSURES • Discussion relating to the rationale and objectives of derivatives positions -- whether for hedging or not • If hedges, identification of hedge type (i.e., fair value, cash flow, hedge of a net investment in foreign operation)

25. REQUIRED DISCLOSURES • The amount of ineffectiveness recognized in earnings • The derivative results excluded from hedge effectiveness considerations • Description of where derivative results are reported

26. REQUIRED DISCLOSURES • Cashflow hedges • Description of transactions and estimated amounts to be reclassified from OCI over the coming 12 months • Maximum time for which the hedge will be maintained • Reclassified OCI due to discontinuing hedges because the forecasted event in the required time frame

27. REQUIRED DISCLOSURES • Fair value • Net gain or loss recognized in earnings when hedges of firm commitments no longer qualify for fair value treatment • Hedges of net investments in foreign operations • Amount included in cumulative translation adjustments

28. FINDING HELPSelected Articles Posted on www.kawaller.com • Implementing FAS 133: From Theory to practice • Futures Versus Forwards: Implications of FAS 133 • Meeting the “Highly Effective Expectation” Criterion for Hedge Accounting • The 80/125 Problem • Partial-Term Hedging

29. K AWALLER & COMPANY, LLC www.kawaller.com PHONE 718-694-6270 EMAIL kawaller@idt.net