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Derivatives – Disclosure Considerations

Derivatives – Disclosure Considerations. May 26, 2011 Christina K. Catalina, CPA Phone: 631-414-4414 Email: tina.catalina@marcumllp.com. Derivatives.

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Derivatives – Disclosure Considerations

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  1. Derivatives – Disclosure Considerations May 26, 2011 Christina K. Catalina, CPA Phone: 631-414-4414 Email: tina.catalina@marcumllp.com

  2. Derivatives • The Financial Accounting Standards Board (FASB) sought to address the concerns about transparency in the disclosures of derivative activities by issuing Statement No. 161 (“SFAS 161”), Disclosures About Derivative Instruments and Hedging Activities (codified in ASC 815). SFAS 161 follows SFAS 157 (codified in ASC 820), which revised financial reporting requirements for the alternative investment community in 2008, and included increased disclosures relating to the fair value measurements of securities and derivatives.

  3. ASC 815- Derivatives and Hedging • Why Issued • Expands existing disclosure requirements to improve transparency of financial reporting and provide users of financial statements with an enhanced understanding of: • How and why derivatives are used • How derivatives and related hedged items are accounted for • How derivative instruments affect an entity’s financial position, results of operations and its cash flows

  4. ASC 815- Derivatives and Hedging • Qualitative disclosures include: • Objectives for holding or issuing derivative instruments, the context needed to understand those objectives, associated risk exposures, and strategies for achieving those objectives • Disclose information in the context of each instrument’s primary underlying risk exposure • e.g., interest rate risk, credit, foreign exchange rate, equity price, commodity price risks • Information to understand the volume of entity’s derivative activity (e.g., notional amounts, Number of contracts)

  5. ASC 815- Derivatives and Hedging • Significant disclosure requirements (continued): • Quantitative disclosures in tabular format, presented by major type of instrument • Location and fair value amounts of derivative instruments in the statement of assets and liabilities • Fair value amounts must be presented gross in tabular disclosure, even if qualify for net balance sheet presentation or are subject to master netting arrangements with their counterparties • Collateral amounts should be excluded • May need rational allocation methodology for portfolio-level valuation adjustments (i.e. nonperformance risk) • Location and amounts of gains and losses from derivative instruments in the statement of operations

  6. ASC 815- Derivatives and Hedging • Significant disclosure requirements (continued): • Present as separate asset and liability values • Segregate between derivatives designated and qualifying as hedging instruments and those that are not • By type of contract (ie: interest rate, foreign currency, commodity, equity, credit, etc) • Further separate derivatives qualified as hedges by the following: • Fair value hedges • Cash flow hedges • Net Investment hedges

  7. ASC 815 – Derivatives and Hedging • Significant disclosures include the “balance sheet” and “income statement” disclosures, both of which are required to be presented in a tabular format. • Most of ASC 815’s other required disclosures are qualitative and are usually in the footnotes to the financial statements. These disclosures address trading activities and related risks. • ASC 815 also requires that any disclosure within the notes be cross-referenced to other relevant disclosures of the derivative activity of the entity.

  8. ASC 815 Derivatives Sample Disclosures (Qualitative) • Futures contracts • The Fund uses futures contracts to gain exposure to, or hedge against, changes in the value of equities and commodities, interest rates or foreign currencies. A futures contract is a firm commitment to buy or sell a specified quantity of currency or securities, or a standardized amount of a deliverable grade commodity, at a specified price and specified future date, unless the contract is closed before the delivery date. Upon entering into a futures contract, the Fund is required to pledge to the broker an amount of cash, U.S. government securities, or other assets, equal to a certain percentage of the contract amount (initial margin deposit). Subsequent payments, known as “variation margin”, are made or received by the Fund each day, depending on the daily fluctuations in the fair value of the underlying security. The Fund records an unrealized gain or loss equal to the daily variation margin. When the contract is closed, the Fund records a realized gain or loss equal to the difference between the value of the contract at the time it was opened and the value at the time it was closed. • The purchase and sale of futures contracts requires margin deposits with a Futures Commission Merchant (“FCM”). Subsequent payments (variation margin) are made or received by the Fund each day, depending on the daily fluctuations in the value of the contract, and are recorded for financial statement purposes as unrealized gains or losses by the Fund. Futures contracts provide reduced counterparty risk to the Fund since futures are exchange-traded; and the exchange’s clearinghouse, as the counterparty to all exchange-traded futures, guarantees the futures against default. • The Commodity Exchange Act requires an FCM to segregate all customer transactions and assets from the FCM's proprietary activities. A customer's cash and other equity deposited with an FCM are considered commingled with all other customer funds subject to the FCM’s segregation requirements. In the event of an FCM’s insolvency, recovery may be limited to the Fund’s pro rata share of segregated customer funds available. It is possible that the recovery amount could be less than the total of cash and other equity deposited.

  9. ASC 815 Derivatives Sample Disclosures (Qualitative) • Credit Default Swaps • The Fund enters into credit default swaps to manage its exposure to the market or certain sectors of the market, to reduce its risk exposure to defaults of corporate and sovereign issuers, or to create exposure to corporate or sovereign issuers to which it is not otherwise exposed. Credit default swap contracts involve an arrangement between the Fund and a counterparty which allow the Fund to protect against losses incurred as a result of default by a specified reference entity. The Fund pays a premium and the counterparty agrees to make a payment to compensate the Fund for losses upon the occurrence of a specified credit event. Generally, the Fund pays a premium upfront and the counterparty agrees to make a payment to compensate the Fund for losses upon the occurrence of a specified credit event. The payment flows are usually netted against each other, with the difference being paid by one party to the other. During the term of the contracts, changes in value are recognized as unrealized gains or losses by marking the contracts to fair value. Additionally, the Fund records a realized gain (loss) when a contract is terminated and when periodic payments are received or made at the end of each measurement period, but prior to termination. The Fund’s credit default swap contracts are scheduled to terminate from 20XX through 20XX. • The fair value of open swaps may differ from that which would be realized in the event the Fund terminated its position in the contract. Risks may arise as a result of the failure of the counterparty to the swap contract to comply with the terms of the swap contract. The loss incurred by the failure of a counterparty is generally limited to the aggregate fair value of swap contracts in an unrealized gain position as well as any collateral posted with the counterparty. The risk is mitigated by having a master netting arrangement between the Fund and the counterparty and by the posting of collateral by the counterparty to the Fund to cover the Fund’s exposure to the counterparty. Therefore, the Fund considers the creditworthiness of each counterparty to a swap contract in evaluating potential credit risk. Additionally, risks may arise from unanticipated movements in the fair value of the underlying investments. • A Fund could be exposed to credit or market risk due to unfavorable changes in the fluctuation of interest rates or if the counterparty defaults on its obligation to perform. Risk of loss may exceed amounts recognized on the statement of assets and liabilities. Such risks involve the possibility that there will be no liquid market for these agreements, that the counterparty to the agreement may default on its obligation to perform and that there may be unfavorable changes in the fluctuation of interest rates. In connection with swap agreements, securities/cash may be set aside as collateral by a Fund’s custodian. A Fund may enter into swap agreements in order to, among other things, change the maturity or duration of the investment portfolio; protect a Fund’s value from changes in interest rates; or expose a Fund to a different security or market.

  10. ASC 815’s -Sample Tabular Disclosure Requirement for Fair Value of Derivative Instruments • The following table identifies the fair value amounts of derivative instruments included in the statement of financial condition as derivative contracts, categorized by primary underlying risk, at December 31, 2010. Balances are presented on a gross basis, prior to the application of the impact of counterparty and collateral netting. Total derivative assets and liabilities are adjusted on an aggregate basis to take into consideration the effects of master netting arrangements and have been reduced by the application of cash collateral receivables and payables with its counterparties.The Fund does not designate any derivative instruments as hedging instruments under ASC 815.

  11. ASC 815 - Sample Tabular Disclosure Requirement for the Effect of Derivative Instruments of the Statement of Operations The following table identifies the net gain and loss amounts included in the statement of operations as net gain (loss) from derivative contracts, categorized by primary underlying risk, for the year ended December 31, 2010.

  12. ASC 815 Derivatives Disclosures, Continued • Trading exemption to required tabular disclosure • For derivatives not designated or qualifying as hedging instruments, where they are included as part of an entity’s trading activities, an entity can elect not to separately disclose gains and losses if: • Quantitative gains/losses of the trading activities (including both derivative and non-derivative instruments) are disclosed separately by major category • The line items in the income statement in which the trading activity gains and losses are included • A description of the nature of the trading activities and related risks, and how an entity manages that risk is included in qualitative disclosures

  13. Alternative Sample Disclosure for Gains/Losses using Trading Exemption

  14. ASC 815 Derivative- disclosure of volume At December 31, 2010, the volume of the Fund’s derivative activities based on their notional amounts (a) and number of contracts, categorized by primary underlying risk, are as follows:

  15. ASC 815 – Derivative disclosures • Significant disclosure requirements (continued) • Credit-risk-related contingent features: • Existence and nature of credit-risk-related contingent features and the circumstances in which those features could be triggered • Aggregate fair value amounts of derivative instruments in a net liability position that contain credit-risk-related contingent features • Aggregate fair value of assets posted as collateral • Adequate cross-referencing if required disclosures presented in multiple footnotes

  16. ASC 815 - disclosure example Credit-risk-related contingent features The Fund’s derivative contracts are subject to International Swaps and Derivatives Association (“ISDA”) Master Agreements which contain certain covenants and other provisions that may require the Fund to post collateral on derivatives if the Fund is in a net liability position with its counterparties exceeding certain amounts. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a net liability position at December 31, 2010 is $16,000,000 for which the Fund has posted $12,000,000 as collateral in the normal course of business. If the credit-risk-related contingent features underlying these agreements were triggered as of December 31, 2010, the Fund would have been required to post additional collateral of $6,000,000 to its counterparties. Additionally, counterparties may immediately terminate these agreements and the related derivative contracts if the Fund fails to maintain sufficient asset coverage for its contracts or its net assets decline by stated percentages or amounts. As of December 31, 2010, the termination values of these derivative contracts were approximately $3,000,000 less than their fair values. 

  17. ASC 815 - Derivatives • Challenges in ASC 815 disclosures: • Magnitude of derivative activities • Complexity of derivative activities • Sufficiency of information systems resources to manage data • Determining meaningful measurement of volume of derivative activities • Evaluating and tracking credit-risk-related contingent features

  18. ASC 820 (Fair Value – old SFAS 157) disclosures for ASC 815-Derivatives NOTE: This is an excerpt from Fair value measurements table. Determine “class” on the basis of the nature and risks of the investments - consider, for example activity or business sector, vintage, geographic concentration, credit quality, and economic characteristic In addition to nature and risks, also consider placement in fair value hierarchy (i.e., Levels 1, 2, or 3)—e.g., greater number of classes may be necessary for fair value measurements with significant unobservable inputs (Level 3) due to increased uncertainty and subjectivity.

  19. ASC 820 (SFAS 157) disclosures for ASC 815 - Derivatives (1) Assigned derivative assets should be presented in sales line. Assignment of a derivative liability should be disclosed as a settlement. (2) All ongoing contractual cash payments (or other consideration) made under the derivative contract should be disclosed in the settlements line item.

  20. ASC 820 (SFAS 157) disclosures for ASC 815 - Derivatives • Valuation Techniques • Derivative Instruments • Listed derivatives that are actively traded are valued based on quoted prices from the exchange and are categorized in level 1 of the fair value hierarchy. Over the counter (OTC) derivative contracts include [forward, future, swap, warrant and option contracts related to interest rates, foreign currencies, credit standing of reference entities, equity prices, or commodity prices]. Depending on the underlying security and the terms of the transaction, the fair value of certain OTC derivatives may be able to be modeled using a series of techniques, including closed-form analytic formula (such as the Black-Scholes option-pricing model), simulation models, or a combination thereof. Pricing models take into account the contract terms (including maturity) as well as multiple inputs, including, where applicable, time value, implied volatility, equity prices, interest rate yield curves, prepayment speeds, interest rates, loss severities, credit risks, credit curves, default rates and currency rates. Certain pricing models do not entail material subjectivity as the methodologies employed include pricing inputs that are observed from actively quoted markets. In the case of more established derivative contracts, the pricing models used by the Fund are widely accepted by marketplace participants. OTC derivatives contracts are generally categorized in Levels 2 or 3 of the fair value hierarchy. The Fund considers the effects of credit risk and counterparty risk when determining the fair value of its derivatives.

  21. ASC 820 (SFAS 157) disclosures for ASC 815 - Derivatives • Credit Default Swaps — Credit default swaps are valued by independent pricing services using pricing models that take into account, among other factors, information received from market makers and broker-dealers, default probabilities from index specific credit spread curves, recovery rates, and cash flows. To the extent that these inputs are observable, the values of credit default swaps are categorized as Level 2. To the extent that these inputs are unobservable the values are categorized as Level 3.

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