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U.S. Securities and Exchange Commission

Questions and Answers
About the New “Market Risk”
Disclosure Rules

July 31, 1997

Prepared by the staffs
of the Office of the Chief Accountant
and the Division of Corporation Finance.

On January 28, 1997, the Commission adopted new rules that require disclosures about the policies used to account for derivatives, and certain quantitative and qualitative information about market risk exposures. (See Securities Act Release No. 7386, published in the Federal Register on February 10, 1997.)

The required disclosures about accounting policies are specified in new Rule 4-08(n) of Regulation S-X and Item 310 of Regulation S-B. The required disclosures about market risk exposures are specified in new Item 305 of Regulation S-K and Item 9A of Form 20-F.

Frequently asked questions and answers about the new rules are presented on the following pages. The interpretive answers were prepared by the staffs of the Office of the Chief Accountant and the Division of Corporation Finance. Related questions are grouped under appropriate topic headers.

Contents

Companies Affected by the New Rules

When is Compliance Required

Market Risks Addressed by the Rules

Accounting Policy Disclosures

Quantitative Disclosures – General

Quantitative Disclosures – Interim Reports

Quantitative Disclosures – Tabular Information

Quantitative Disclosures – Sensitivity Analysis

Quantitative Disclosures – Value-At-Risk

Qualitative Disclosure Requirements

Safe Harbor Requirements

If you have additional questions concerning the new rules, please call Cathy Cole, Armando Pimentel or Robert Uhl in the Office of the Chief Accountant at (202) 942-4400. This publication and subsequent revisions and additions, will be posted at the Commissions's internet site: www.sec.gov..

Companies Affected by the New Rules

Question

1.Which companies must comply with the new rules? Do the rules apply to small business issuers? Investment companies? Foreign companies?

Answer

The accounting policy disclosures must be furnished by all companies that must comply with Regulations S-X or S-B. Registered investment companies, small business issuers, and foreign private issuers filing under Item 18 of Form 20-F must comply. The rule does not apply to foreign private issuers filing under Item 17 of Form 20-F. Those issuers should consider Staff Accounting Bulletin Topic 1:D to determine if information regarding accounting policies for derivatives is necessary in MD&A.

The quantitative and qualitative disclosures of market risk must be furnished by companies that must provide MD&A, except small business issuers. These requirements also do not apply to registered investment companies, who are not required to comply with Regulation S-K, but do apply to foreign private issuers that must comply with Item 9A of Form 20-F.

When Compliance is Required

Question

2.When must companies begin furnishing the accounting policy disclosures required by the new rules?

Answer

All companies must furnish the derivative accounting policy disclosures specified by the rule in filings that include financial statements for either an annual or interim fiscal period ending after June 15, 1997. If the accounting policy disclosures are not included in the company's most recently filed Form 10-K, the disclosures are required in the company's interim financial statements filed on Form 10-Q.

Question

3.When must companies begin furnishing the quantitative and qualitative disclosures of market risk?

Answer

All companies with market capitalizations of more than $2.5 billion on January 28, 1997, and all banks and thrifts of any size market capitalization, must provide the quantitative and qualitative information in filings that include audited financial statements for fiscal years ended after June 15, 1997. For all other companies except small business issuers, the disclosures are required in filings that include audited financial statements for fiscal years ended after June 15, 1998.

Question

4. How is market capitalization defined?

Answer

Market capitalization is the aggregate market value of common equity calculated for Form S-3 eligibility (General Instruction I.B.1 of that form), with two exceptions. First, market capitalization includes common equity held by both affiliates and nonaffiliates. Second, the determination is made as of January 28, 1997, rather than the 60 day period before the filing.

Question

5.Must a nonbank or nonthrift company that has no public common equity outstanding at January 28, 1997, such as a first time company or a company with only public debt securities outstanding, comply with the new rule before it files audited financial statements for a fiscal year ending after June 15, 1998?

Answer

No.

Question

6.Must a foreign private issuer with common equity held by public shareholders outside the U.S. comply with the new rule before it files audited financial statements for a fiscal year ending after June 15, 1998, if it has no common equity listed in the U.S. at January 28, 1997?

Answer

Yes. Disclosures are required if its aggregate market capitalization exceeds $2.5 billion at January 28, 1997.

Question

7.When do Item 305 or Item 9A disclosures apply to a foreign bank not regulated in the U.S.? A nonbank U.S. company that has a bank subsidiary?

Answer

The rules define a bank or thrift as any company that has control over a depository institution. A depository institution is further defined as:

(a) a depository institution as defined by the Federal Deposit Insurance Act, or

(b) an institution organized under the laws of the United States, any state in the U.S., the District of Columbia, and any U.S. territory, which accepts demand deposits or deposits that the depositor may withdraw by check or similar means.

If a foreign private issuer with banking operations has a market capitalization of less than $2.5 billion at January 28, 1997, and none of its banks meet the definition of a depository institution in the rule, the market risk disclosures specified by Item 9A of Form 20-F are not required until it includes audited financial statements for fiscal years ended after June 15, 1998. Many foreign banks must furnish the disclosure because they own at least one banking subsidiary organized under U.S. laws.

Question

8.Must a company primarily engaged in nonbanking businesses furnish the disclosures in filings that include audited financial statements for fiscal years ended after June 15, 1997 because it has a single bank subsidiary that conducts credit card activities?

Answer

Yes. If one of its subsidiaries meets the definition of a depository institution, then the company is subject to the disclosure requirements when its filing includes audited financial statements for a fiscal year ended after June 15, 1997, regardless of its market capitalization at January 28, 1997.

Question

9.The Commission release contains interpretive guidance. When is that guidance effective?

Answer

The Commission's release reminds companies of the requirements of Rule 12b-20 under the Exchange Act and Rule 408 under the Securities Act. Specifically, the release observes that companies provide information about specific terms, fair values, and cash requirements of assets, liabilities, and anticipated transactions. If derivatives are used to alter the characteristics of these items, disclosure of how derivatives, either directly or indirectly, affect terms, fair values, or cash flows of those items is necessary to keep the disclosures about the hedged item from being misleading.

That interpretive guidance was contained in the proposing release issued in December 1995. It applied to all companies immediately upon its publication in the Federal Register.

Market Risks addressed by the Rules

Question

10.What types of market risk exposures are addressed by the new disclosure rules?

Answer

The rules address risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices, and other market changes that affect market risk sensitive instruments.

Question

11.What types of assets, liabilities and transactions must be considered for the market risk disclosures? Do the rules address liabilities from issuing insurance contracts or investments accounted for using the equity method?

Answer

The rules require disclosure about market risk exposures arising from derivative financial instruments, as well as all other financial instruments, and derivative commodity instruments. The term "derivative financial instruments" is defined by generally accepted accounting principles (GAAP). (See, for example, FASB Statement 119.) It includes futures, forwards, swaps, options, and other financial instruments with similar characteristics.

"Other financial instruments" also is defined by GAAP. It excludes instruments such as insurance contracts, warranty contracts, equity method investments, and other items that have been excluded from fair value disclosure standards. (See FASB Statement 107,paragraph 8). It also excludes trade accounts receivable and payable if their carrying value approximates fair value.

"Derivative commodity instruments" is defined in the release to include commodity futures, forwards, swaps, options, and other commodity instruments with similar characteristics that are permitted by contract or business custom to be settled in cash or with another financial instrument.

Question

12.A company can have market risk exposure because of a nonfinancial asset, liability or transaction, such as its inventory or sales commitments. Those risks may or may not be hedged using derivative financial instruments. Must the market risk exposure of the nonfinancial position be included in the disclosures responsive to the new rule?

Answer

No. Companies are encouraged but not required to include other market risk sensitive transactions or positions. If a company elects to include a particular type of instrument, position, or transaction in the quantitative disclosures, the registrant must include all of the transactions and positions that create market risk in that risk exposure category.

Example 1

If a company's policy is to hedge 60% of the next period's German sales, then voluntary disclosures about the sales transactions must include 100% of the next period's German sales. Including only 60% of the next periodís sales will not comply with the rules.

Example 2

Assume an agricultural producer has a policy of hedging 100% of next period's wheat deliveries in Chicago but none of its wheat deliveries in Toledo. Voluntary information about earnings or cash flow risks must include 100% of next period's wheat deliveries in both cities. Next, assume the policy was to hedge wheat being delivered to Chicago but not hedge pork belly deliveries to Toledo. The market risk exposures of the two commodities are sufficiently different that only the Chicago wheat deliveries are required in the voluntary disclosures of market risk sensitive positions.

Accounting Policy Disclosures

Question

13.Are the company's policies for accounting for derivatives required to be disclosed regardless of materiality?

Answer

No. The guidance applicable to accounting policy disclosures is APB 22. That opinion requires disclosure of accounting policies that materially affect the determination of financial position, cash flows, or results of operations. Regulation S-X limits the required information to those matters about which an average prudent investor should reasonably be informed.

In assessing materiality, the Commission expects companies to consider the effect on the financial statements of all derivatives, including those not recognized in the statement of financial position. For example, three basic methods are commonly used to account for derivatives: accrual, deferral, and fair value. To determine if the selected accounting policy is material, the effects of that method should be compared to the effects had the company used either of the other methods.

Question

14.Must a company's disclosure address all seven items listed by the new rule? For example, if a registrant has never terminated a swap early, must it disclose its accounting policy for terminated swaps?

Answer

The disclosures are required only when material. For example, accounting policy disclosure for terminations is not required if a company never terminated a derivative prior to its maturity.

Question

15.If a company is a broker-dealer that marks all financial instruments to market through income, how much detail about its accounting policies must be in the footnotes?

Answer

Only material accounting policies must be disclosed. Many of the disclosure items may not be applicable to financial statements of a broker-dealer because all derivative instruments are marked to market.

Question

16.Must the disclosures about accounting policies for derivatives be in one place? Can disclosures be placed in various footnotes throughout the financial statements?

Answer

Companies are free to disclose the information in the format they believe most appropriate.

Question

17.Will the accounting policy disclosure requirements change when the FASB issues a final accounting standard for derivatives and hedging activities?

Answer

The staff will review the FASB's new accounting standard when it is issued, and will make appropriate recommendations to the Commission regarding changes to the accounting policy disclosures.

Quantitative Disclosures – General

Question

18.Which filings require quantitative and qualitative disclosures specified by the rule?

Answer

All filings that include annual financial statements of the company must include or incorporate by reference the information where permitted by the Form. Also, the information must be included in the annual report delivered to shareholders.

Question

19.May the quantitative disclosures be included in notes to the financial statements?

Answer

No. The information must be placed outside the financial statements.

Question

20.Must the quantitative market risk information be presented in a separate section, or may it be included in MD&A?

Answer

A separate section is not necessary, although it is usually most appropriate to present the responsive information in a single location outside of MD&A. Management may elect to integrate the disclosures with MD&A and the description of business sections of filings. Duplicative information need not be repeated, but cross-references may be necessary to make a particular disclosure complete.

Question

21.How do the market risk disclosures required by Item 305 differ from the information required by MD&A? Is a separate discussion of market risk in MD&A still necessary?

Answer

Item 303 requires discussion in MD&A of known events, trends, or uncertainties that are reasonably likely to impact the registrant materially. If a known market risk affected reported trends or financial condition in the period presented, or is reasonably likely to affect materially future reported results or liquidity, discussion of the market risk and its effects is necessary in MD&A.

Item 305 requires more information than Item 303 because it requires specific descriptive and quantitative disclosures about losses from market risk sensitive instruments that could result from reasonably possible market changes. For example, a sensitivity analysis responsive to Item 305 presents quantitative information about possible future losses from reasonably possible near-term changes in market rates and prices.

Question

22.How does a company determine whether its market risk exposures are material enough to require the quantitative and qualitative disclosures specified by the new rules?

Answer

To determine if the quantitative and qualitative disclosures must be furnished, a company must perform the following procedure:

Step 1: Categorize its market risk sensitive instruments into two portfolios: instruments entered into for trading purposes, and all other instruments.

Step 2: further categorize instruments within the two portfolios by type of market risk exposure category (interest rate risk, foreign currency exchange rate risk, commodity price risk, etc.).

Step 3: the company must assess the materiality of the market risk exposure for each category within each portfolio. This assessment must evaluate both (1) the materiality of the fair values of market sensitive instruments as of the end of the latest fiscal year, and (2) the materiality of potential, near-term losses in future earnings, fair values and cash flows from reasonably possible near-term changes in market rates or prices. If either is material, then the company should disclose the quantitative and qualitative information for that particular market risk exposure. For these tests, registrants should not net favorable and unfavorable fair values, except where allowed under generally accepted accounting principles.

For example, assume a company has both a trading and non-trading portfolio. Each portfolio contains instruments that expose the company to changes in interest rates, foreign currency exchange rates, and commodity prices.

The company initially determines whether the fair values of market risk sensitive instruments were material at period end. If they were material, disclosure is material. If the fair values at period end were not material, the company would assess whether the interest rate sensitive instruments in its trading portfolio create a material exposure to changes in interest rates. That assessment should be made based on of fair values, cash flows, or earnings. If any of those measures is material, the company would provide quantitative information regarding its interest rate sensitive trading portfolio. Similar assessments are necessary for interest rate sensitive instruments in its non-trading portfolio, and all other exposures.

Quantitative disclosures are required only for material exposures. Thus, if the company's only material exposure is to changes in interest rates in its trading portfolio, it must present quantitative information only for that specific exposure. Quantitative disclosures about other, immaterial exposures are elective.

Question

23.If a company does not use derivatives, are quantitative disclosures of market risk required?

Answer

A company that does not use derivatives may have material exposures to market risks from non-derivative financial instruments that must be disclosed under the new rule. For example, a company that borrowed amounts in a currency different from its functional currency has a risk exposure requiring disclosure if reasonably possible changes in exchange rates or interest rates would be material.

Question

24.The release encourages quantitative disclosures about market risk inherent in positions and contracts outside the scope of the rule. What types of disclosures may be useful to investors? How may these elective disclosures be presented?

Answer

Companies are encouraged to provide quantitative disclosures that include the market risks in commodity positions, anticipated transactions, and derivative commodity instruments.

Companies selecting the sensitivity analysis or value at risk disclosure approaches are not required to provide separate market risk information for instruments, positions, or transactions included voluntarily. Instead, quantitative disclosures may report the market risk exposures of items within the scope of the rule combined with the risk exposures in voluntarily disclosed instruments, positions, or transactions.

Question

25. The new rules require a discussion of "limitations" that cause the quantitative information about market risk not to reflect fully the net market risk exposures of the entity. What types of limitations are expected to be disclosed?

Answer

The discussion should include a description of any market sensitive instruments, positions, and transactions that are omitted from the quantitative disclosures. Also, the features of instruments, positions, and transactions that are included, but not reflected fully in the quantitative information, should be disclosed.

For example, assume that a company had corn in inventory and entered into a futures contract to sell half of that inventory. The new rules require disclosure of the market risk inherent in the futures contact, but only encourages disclosures of the market risks inherent in the corn inventory. If the company discloses the market risk inherent in both the corn inventory and the futures contract, no discussion about limitations is necessary. If the quantitative information is limited to the market risks in the futures contact, the company must disclose that the reported information does not include market risk exposures inherent in the corn inventory. Also, it should describe how that exclusion may affect the measure's usefulness.

Also, the quantitative information alone may not adequately inform investors of the degree of market risk inherent in instruments with leverage, option, or prepayment features (e.g., written options, structured notes, CMOs, leverages swaps, and embedded options). If these features are triggered by changes in market rates or prices outside those reflected in thevalue at risk and sensitivity analysis disclosures, the potential loss may be significantly larger than implied by the disclosure. Accordingly, a discussion of the limitation created by these features, including a summary of the features is required.

Question

26.If a company has material risk of loss in earnings or cash flows, but immaterial risk of loss based on fair values, may it present its quantitative disclosure of market risk based on fair values, rather than earnings or cash flows?

Answer

No. The quantitative disclosures are required for material market risk exposures. In this fact pattern, the company must present the risk of loss in either earnings or cash flows. If both risks are material, the company may disclose the one that is most appropriate. The company also may supplement that disclosure by presenting other disclosures measuring risk of loss (e.g. fair value, cash flow, or earnings).

Question

27. Are short-term receivables and payables required to be included in the quantitative information?

Answer

If the carrying amounts of short-term receivables and payables approximate their fair values, they are not considered "other financial instruments." Otherwise, the amounts are within the scope of the disclosure rule, and disclosure of their market risk, if material, is required.

Question

28. May different disclosure alternatives be used to present quantitative information about risk of loss in the trading and non-trading portfolios or separate market risk exposure categories within those portfolios?

Answer

Yes. Companies may choose one of three alternatives for all of the required quantitative disclosures about market risk. A company may choose one disclosure alternative for market risk sensitive instruments entered into for trading purposes and another alternative for all other market risk sensitive instruments. Also, a company may choose any of the three disclosure alternatives for each risk exposure category within the trading and other than trading portfolios.

For example, a company may use value-at-risk (VAR) to present information about the trading portfolio and a sensitivity analysis to present information about the end-user portfolio. It may also use VAR to present information about interest rate exposures, but use a sensitivity analysis to present information about risk of loss for derivative commodity instruments.

Question

29. May a company present separate quantitative disclosures for each different business segment?

Answer

Yes, but the presentation should not prevent a reader from understanding the aggregate market risk inherent in each of the individual market risk exposure categories (interest rate, exchange rate, commodity risk) within the trading and other than trading portfolios.

Question

30.May a company change from one quantitative disclosure alternative to another? What must be disclosed if the company changes the parameters used in providing quantitative information?

Answer

If a company changes the disclosure alternative or key model characteristics, assumptions, or parameters used in providing the quantitative information, the reasons for the change and comparable information must be provided, if material. A change from one disclosure alternative to another is presumed to be material.

For example, if a company used a sensitivity analysis for its interest rate sensitive trading portfolio in prior years and adopts VAR to report the same exposure in the current year, it must present comparable information for the prior year. This can be accomplished in either of two ways. The company may present comparable VAR information for both years, or it may present sensitivity analyses for both years, along with the current VAR information.

Question

31.Must a company provide comparative quantitative disclosures in the first year that it complies with the rule?

Answer

No. But filings containing annual financial statements for any year after the first year must include comparative information for the prior year.

Question

32. Is credit risk a market risk exposure that must be disclosed under the rules?

Answer

No. But if a company uses credit derivatives disclosure may be required. Certain credit derivatives are derivative financial instruments and must be included in the quantitative market risk disclosures if the instruments have exposure to changes in interest rates or foreign currency.

Quantitative Disclosures - Interim Reports

Question

33. What type of quantitative disclosures are required in interim filings?

Answer

Interim disclosures must enable the reader to assess the sources and effects of material changes in market risk exposures that affect the quantitative and qualitative disclosures presented as of the end of the preceding fiscal year. Interim information is not required until after the first fiscal year end in which the rule is effective.

Question

34. How can a company determine if a material change occurred requiring discussion in interim reports without having to recompute or reassemble the quantitative information during the interim period?

Answer

Companies are expected to have reasonable procedures in place to monitor whether material changes in market risk are likely to have occurred since year-end. The nature and extent of disclosures required for interim reports are considered consistent with customary management practices and information systems of companies that are exposed to material market risk.

Quantitative Disclosures – Tabular Information

Question

35. What information is expected to be disclosed if the tabular disclosure option is selected?

Answer

The tabular disclosures must include fair values of the market risk sensitive instruments and their contract terms, categorized by expected maturity date. The terms must be sufficiently descriptive to enable readers to determine the amount and timing of future cash flows from the instruments. This information is required for each of the five years following the balance sheet date, and for the remaining years in aggregate.

Within each of the risk exposure categories (e.g., interest rate, foreign currency exchange rate, commodity price risk, etc.), market risk sensitive instruments must be grouped based on common characteristics. Within the foreign currency exchange rate risk category, the market risk sensitive instruments must be grouped by functional currency. Within the commodity price risk category, market risk sensitive instruments must be grouped by type of commodity. The release provides examples of how tabular information is presented.

Question

36. What information is expected to be reported for interest rate swaps?

Answer

Interest rate swaps should be grouped based on common characteristics. For example, "pay fixed, receive variable" and "pay variable, receive fixed" should be grouped separately. Information about the swaps that should be provided include:

1) fair value of the swap at reporting date,

2) the notional amount of the swap,

3) the pay and receive characteristics of the swap, and

4) the expected interest rates of both sides of the swap throughout the term presented.

The company must disclose the method used for determining the expected cash flows from the variable leg of a swap.

Question

37.What disclosures are expected for options?

Answer

Option contracts should be grouped based on common characteristics. For example, written and purchased option contracts should be grouped separately. Options on different underlyings or with materially different strike prices should be grouped separately. Information about option contracts that should be provided include:

1) fair value,

2) the contract value amounts, and

3) the weighted average strike prices.

Question

38.Is the contractual maturity date of a market sensitive instrument the same as its expected maturity date?

Answer

If a financial instrument is subject to significant prepayment risk, such as a mortgage-backed security, its expected maturity date would be the contractual date adjusted for expectations of prepayments. Also, certain financial instruments, such as demand deposits of banks, have no maturities. The bank would estimate the period over which the deposits will be outstanding.

Question

39.What assumptions are expected to be disclosed with a tabular presentation?

Answer

Key assumptions necessary for understanding the table may include:

1) the method for determining variable interest rates,

2) prepayment or reinvestment assumptions on the timing of cash flows,

3) other material assumptions.

Question

40.Instruments within a market risk category may be grouped in the tabular disclosures based on common characteristics. What are examples of common characteristics?

Answer

Some examples of categories include:

1) fixed or variable rate instruments;

2) long or short forwards and futures;

3) forwards or options on commodities grouped by commodity;

4) written or purchased put or call options, with similar strike prices;

5) the currency in which the instrument's cash flows are denominated;

6) hedges of net investments in foreign entities or intercompany foreign currency transactions of a long-term investment nature, and

7) derivatives designated to anticipated transactions.

Within the foreign currency exchange rate risk disclosure, instruments must be grouped by functional currency. Different functional currencies may be aggregated when currencies are economically related, managed together for internal risk management purposes, and have statistical correlations of greater than 75% over each of the past three years.

Question

41.How should an instrument that has exposure to two or more market risks be presented in the tables?

Answer

An instrument that is exposed to more than one market risk category should be presented in the tabular information for each of the risk categories. For example, a foreign denominated bond is exposed to both interest rate and foreign currency risk.

The only exception to this requirement is a currency swap that offsets all foreign currency risk in the cash flows of a foreign currency denominated debt instrument. In that case, neither instrument must be disclosed in the foreign currency risk exposure category. The interest rate risk disclosure must include both instruments.

Question

42.Does the interest rate "gap" or "sensitivity" table routinely prepared by some banks meet the requirement in the new rule for tabular information?

Answer

Yes, with some exceptions. Necessary revisions commonly would include:

1) conforming the maturity categories to those specified in the release;

2) grouping cash flows by maturity dates rather than repricing dates;

3) providing the level of detail required by the release;

4) providing average interest rates on the instruments;

5) providing fair values.

Question

43.What types of limitations should be disclosed regarding the tabular information?

Answer

The limitations disclosed can vary significantly by company. They may include:

1) summarized descriptions of instruments, positions and transactions omitted from the quantitative market risk disclosure information;

2) descriptions of the features of instruments, positions, and transactions (like embedded options) that are not apparent from the more summarized information;

3) prepayment and reinvestment assumptions and other estimates reflected in the information presented.

Disclosure is required when the table fails to depict the effect on the risk positions and assumptions created by a significant change in the economy or change in managementís expectations or intentions.

Question

44. Must the equity price risk disclosures present each individual equity security or can the information be summarized?

Answer

Either alternative is appropriate. But if each equity security is not listed separately, they must be summarized based on common risk characteristics, such as similar industry.

Quantitative Disclosures – Sensitivity Analysis

Question

45. What is sensitivity analysis and how is it developed?

Answer

Sensitivity analysis is the measurement of potential loss in future earnings, fair values, or cash flows of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates, foreign currency rates, commodity prices, and other market rates or prices over a selected time.

For example, banks commonly disclose the effects on net income of a 100 or 200 basis point (1 or 2 percentage points) instantaneous, parallel shift in the yield curve. The rule requires only that potential losses, be disclosed. Disclosure of anticipated gains iselective.

Preparation of a sensitivity analysis of the fair values of interest rate sensitive instruments, for example, involves the following procedures:

Step 1: Schedule expected cash flows using interest rates in effect at period end,

Step 2: Discount expected cash flows to determine fair value at period end,

Step 3: Select a hypothetical change in interest rates. Absent justification for another amount, the rules specified a 10% change in period end rates,

Step 4: Schedule expected cash flows using hypothetical interest rates. Expected cash flows would include results of prepayments and other effects caused by interest rate change.

Step 5: Discount expected cash flows to determine fair value using hypothetical rates.

The difference between the results in step (2) and step (5) is the gain or loss of a 10% change in interest rates on the fair value of interest sensitive instruments.

Sensitivity of earnings analysis is similar, but, under this alternative, the effect on GAAP earnings of a hypothetical change in rates or prices over a specific time horizon are disclosed. For example, the effect on twelve month forward GAAP earnings of a 1% change in interest rates applied to a fixed rate instrument is zero, though the effect of that change on the fair value could be significant. The sensitivity of twelve month GAAP earnings to a 1% shift in the yield curve for a variable rate instrument could be significant because earnings are affected by changes in interest rates.

The sensitivity of cash flows is measured by estimating the effect of a hypothetical change of rates on cash flows over a specific time horizon. In a simple analysis, the contractual cash flows are scheduled and the effect of a hypothetical market rate or price change on the cash flows is computed. More sophisticated analyses consider the elasticity of the cash flows to changes in rates and prices.

Question

46.Is "duration" analysis an acceptable variation of sensitivity analysis?

Answer

Yes. The term "sensitivity analysis" describes a general class of models that assess the risk of loss in market sensitive instruments based on hypothetical changes in market rates

or prices. Duration analysis is a form of sensitivity analysis.

Question

47.Is the sensitivity analysis disclosure required to depict the market risk exposure existing as of the end of the fiscal year?

Answer

Companies must measure the potential loss in future earnings, fair values, or cash flows for market risk sensitive instruments at the end of the fiscal year. Companies must select hypothetical market changes that are expected to reflect reasonably possible near-term changes in those rates and prices. Near-term means a period going forward up to one year from the date of the financial statements.

Alternatively, the average, high and low amounts of risk exposure during the fiscal year may be presented. Companies using this alternative must measure sensitivity of outstanding instruments and positions at least quarterly during the fiscal year. Companies do not need to indicate the period in which the high or low risk levels occurred.

Question

48.If a company is exposed to different currencies, must it assume the same percentage change for each currency?

Answer

No. Companies may use different percentages for different currencies. Companies should use changes that are not less than 10% different from the end of period market rates, unless there is economic justification for another amount.

Question

49.Assume a company has a long and short position that are affected by the same market risk exposure. Must the company choose opposite hypothetical changes to the long and short positions?

Answer

The rules do not require a "worst case scenario" approach of applying a 10% decrease in the rate or price to the long position and a 10% increase to the short position. That answer does not appear useful given the low probability of opposite shifts in the same market risk exposure.

Question

50.What types of assumptions would have to be disclosed regarding the sensitivity analysis?

Answer

Companies must provide a description of the model, assumptions, and parameters underlying its analysis that are necessary to understand the market risk disclosures. For example, companies should disclose:

1) how "loss" is defined by the model (i.e. fair values, cash flows, or earnings),

2) a general description of the modeling technique,

3) the types of instruments covered by the model, and

4) other information about the model's assumptions and parameters. For example, the magnitude and timing of selected hypothetical changes in market rates or prices used and the effects of expected correlation between various foreign currencies.

Question

51.What assumptions concerning shifts in the yield curve may a company use in estimating the effects of interest rate changes?

Answer

A company may choose the period over which the assumed changes occur. Those changes cannot be less than 10% of the end-of-period market rates unless there is an economic justification to the contrary.

Question

52.If a company is concerned about disclosing proprietary trading positions, can it disclose a sensitivity analysis for a time other than the end of the period?

Answer

Companies may report the average, high and low amounts for the reporting period instead of period-end amounts. Companies using this alternative should measure sensitivity analysis amounts at least quarterly.

Question

53.Must sensitivity analysis be provided in the aggregate as well as by individual risk categories?

Answer

No. A sensitivity analysis measure must be presented for each market risk category within trading and non-trading portfolio. Presentation of the aggregate quantitative information is encouraged, but not required.

Question

54.Are any parameters for the sensitivity analysis specified? For example, what is the percentage change in the index against which the risk exposure is measured?

Answer

Companies using sensitivity analysis should select hypothetical changes in market rates or prices that are expected to reflect reasonably possible near-term changes in those rates and prices. Companies should use changes not less than 10% of end-of-period market rates or prices unless there is economic justification for a different amount. The rule provides that the magnitude of selected hypothetical changes in rates or prices may differ among and within market risk exposure categories.

Question

55.How does a company select the appropriate hypothetical change in market rates or prices for sensitivity analysis in the case of multiple risk exposures within the same risk category? Should the hypothetical changes to each position be in the same direction (e.g., assume all foreign currency rates increase) or should the hypothetical changes be chosen to report the maximum possible loss (e.g., assume the foreign exchange rates increase or decrease depending on whether the registrant has a long or short position)?

Answer

All of the shocks within a given risk category should move in the one direction that results in the largest overall potential loss. For example, assume a company reporting in U.S. dollars has a net long position in Deutsche Marks and a net short position in French Francs. Assume the company selects a 10% shock to each exchange rate as the appropriate hypothetical change under the rules. In these circumstances, the company would do the following:

Step 1: Compute the unrealized gain or loss if 10% more dollars can be acquired per unit of each currency and calculate the net gain or loss for all its currency positions,

Step 2: Compute the unrealized gain or loss if 10% fewer dollars can be acquired per unit of each currency and calculate the net gain or loss for all its currency positions,

Step 3: Report the larger loss in step 1 or step 2.

The company's description of the model needs to disclose how the magnitudes and the direction of the hypothetical changes were selected. Companies are encouraged to provide information regarding the gross potential losses if all prices or rates in this risk categoryincrease (e.g. the sum of the losses computed in (a) prior to netting against gains) and if all prices or rates decrease. In the example here, the encouraged information would be the loss on the net short Franc position if the Dollar-per-Franc exchange rate increases and the loss on the net long Mark position if the Dollar-per-Mark exchange rate decreases.

The rules do not require sensitivity analyses based on a "worst case scenario" approach to selecting the directions of the hypothetical changes. That approach assumes changes in one direction for long positions and changes in the opposite direction for short positions so as to maximize the potential loss. The worst case answer would not appear to be useful in most cases because of the low probability of opposite movements in prices or rates within a single risk category. However, if companies provide the encouraged disclosures mentioned above, then investors can use either reported potential loss based on hypothetical changes in one direction only, or they can compute the "worse case scenario" exposure by summing the gross losses.

A limitation arises from assuming that hypothetical changes in market rates and prices move in the same direction within a risk category. The resulting sensitivity analysis does not incorporate information regarding the sign and amount of co-movements in prices or rates. This limitation of the model needs to be disclosed. Companies concerned with this limitation should consider using VAR, which incorporates correlations in measuring risk.

Question

55. May long and short foreign exchange contracts in the same currency be combined when presenting quantitative information?

Answer

There is no requirement to analyze separately short and long positions in the same currency when determining the potential near-term loss to foreign currency exposures.

Question

56.How may a company justify using less than a 10% hypothetical change in rates or prices?

Answer

Companies must select hypothetical changes in market rates or prices that are expected to reflect reasonably possible near-term changes in those rates and prices. The rules specified the use of a change that is not less than 10%, unless there is justification for using another amount. If a company has sufficient historical data indicating that a reasonably possible near-term change will be an amount less than 10%, it may use that amount. The Company should disclose why it chose a hypothetical change less than 10%.

Quantitative Disclosures – Value-At-Risk

Question

57.What is value-at-risk (VAR), and how is it computed? How do earnings at risk and cash flow at risk differ from VAR?

Answer

"Value at risk" describes a general class of probabilistic models that measure the risk of loss in market risk sensitive instruments. These models measure the potential loss that could occur in normal markets, over a defined period, within a certain confidence level. VAR can measure the uncorrelated risks of single transactions or the correlated risks of several different exposures in a portfolio.

VAR models include variance/co-variance, historical simulation, and Monte Carlo simulation. The variance/co-variance model, for example, relies on statistical relationships to describe how changes in different markets can affect a portfolio of instruments with different characteristics and market exposures.

Earnings at risk and cash flow at risk are also probabilistic measures developed from statistical analysis. VAR measures loss based on the present value of all future cash flows. Cash flow at risk may only incorporate the cash flows over a certain period (e.g., one year) and may not discount those cash flows. Earnings at risk measures loss in a company's earnings, rather than cash flow or the present value of cash flows.

Question

58.Is VAR required to depict the market risk exposure existing as of the end of the year?

Answer

Companies may express the potential loss in future earnings, fair values, or cash flows of market risk sensitive instruments as of year end. Alternatively, companies may report the average, high and low amounts for the year. Companies using this alternative must determine VAR amounts at least quarterly.

Question

59.Are parameters for VAR analysis specified by the new rules?

Answer

The rule does not require uniform parameters for all companies. But, ruleinstructions specify the use of a confidence interval 95 percent or higher unless there is economic justification for a different amount. In addition, companies must disclose important assumptions and parameters that are material to an understanding of the company's VAR model and market risk disclosure.

Question

60. What quantitative disclosures must supplement VAR information?

Answer

A company disclosing a VAR measure at year-end also must provide supplemental quantitative information that enables investors to understand the context of the company's general risk levels. The eight contextual disclosure options specified by the new rules are:

1) The average VAR amounts for the period;

2) High and low VAR amounts for the period;

3) The distribution of VAR amounts for the period;

4) The average of actual changes in fair value, earnings, or cash flows from market risk sensitive instruments during the reporting period;

5) High and low amounts of actual changes in fair value, earnings, or cash flows from market risk sensitive instruments during the reporting period;

6) The distribution of actual changes in fair value, earnings, or cash flows from market risk sensitive instruments during the reporting period;

7) The percentage of times the actual changes in fair values, earnings, or cash flows from market risk sensitive instruments exceeded the year-end value at risk measure during the reporting period; and

8) The number of times the actual changes in fair values, earnings, or cash flows from market risk sensitive instruments exceeded the year-end value at risk measure during the reporting period.

Companies are required to provide only one of the disclosures listed.

These contextual disclosures are not required for the first fiscal year-end for which a company must present the quantitative and qualitative disclosures.

Question

61.If a company provides average and high and low VAR amounts instead of period end VAR amounts, are additional contextual disclosures required?

Answer

No.

Question

62.Must a company electing to disclose VAR amounts provide a VAR measure of the aggregate market risk exposure in the trading and non-trading portfolios?

Answer

No. VAR amounts are required for each market risk category within the trading and non-trading portfolios. No aggregate measure is required, although it is encouraged.

Question

63.What types of assumptions should be disclosed regarding VAR.

Answer

Companies must provide a description of the model, and identify assumptions and parameters that are material to an understanding of the model and the market risk disclosures. For example, companies should disclose:

1) how "loss" is defined by the model (i.e. fair values, cash flows, or earnings),

2) the type of model used,

3) the types of instruments covered by the model, and

4) holding periods and confidence intervals.

Question

64.If a company is concerned about disclosing proprietary trading positions, what alternatives to disclosing the period-end VAR amounts are available?

Answer

Companies may report the average amount and high and low amounts for the reporting period instead of period end amounts. Companies using this alternative should measure VAR analysis amounts at least quarterly.

Question

65. How are average VAR amounts computed?

Answer

The rules permit disclosure of average VAR in lieu of period-end VAR. When presenting this information, the average is computed using at least four equal periods throughout the reporting period. Companies may use four quarter-end amounts, 12 month-end amounts, or 52 week-end amounts in computing the average.

Average VAR disclosure is also required to supplement the period-end VAR disclosure. Companies providing this disclosure may compute average VAR in any meaningful manner. The staff expects that companies will compute average VAR using a minimum of four equal periods throughout the reporting period.

Question

66. Assume a company uses a derivative financial instrument to hedge its foreign currency exposure on anticipated foreign currency denominated sales for all or part of the next period. If the company elects to include anticipated transactions in its market risk disclosure, should the company include all of its anticipated sales in that foreign currency for the upcoming period?

Answer

Yes. The company should include all of its anticipated exposure from foreign currency denominated sales for the next period in its VAR computations.

For example, if the company hedges six months into the future but reports earnings at risk for the upcoming 12 month period, voluntary disclosures would have to include 12 months of anticipated foreign currency denominated sales. If 100% of anticipated sales in one currency are hedged for 12 months, but anticipated sales in another currency are not, then the answer depends on the similarity of market risks in the two currencies. If the currencies essentially move in tandem and the company reports earnings at risk for the upcoming 12 month period, then sales in both currencies would be included for 12 months. If the changes in exchange rates are sufficiently different, then the VAR analysis would include 100% anticipated sales in the hedged currency for 12 months.

Question

67.Assume a U.S. company has a subsidiary with a functional currency of the German mark (DM). That subsidiary has DM cash balances and trade receivables and payables denominated in the DM. Which of the two exposures are included in the VAR analysis?

Answer

The DM cash balances are included in the VAR computation. Cash is a financial instrument as defined in FASB Statement 107.

Trade receivables and payables are financial instruments. But the rule allows for the exclusion of trade accounts receivable and trade accounts payable in the VAR analysis whenthe carrying amounts approximate fair value.

Qualitative Disclosure Requirements

Question

68.If quantitative disclosures of market risk are not presented, are qualitative disclosures required?

Answer

No.

Question

69.What types of qualitative disclosures about market risks are required?

Answer

Qualitative disclosure about interest rate risk in a non-trading portfolio would include:

1) the nature of the interest rate exposure,

2) how interest rate risks are managed,

3) changes in interest rate exposures or how the interest rate exposures were managed when compared to the conditions that existed during the most recently completed fiscal year, and

4) known trends in interest rates, or anticipated rates in future reporting periods.

Question

70.How detailed must disclosures of the "primary risk exposures" be?

Answer

The qualitative information should be in detail that is sufficient to inform the reader of the particular markets that present the primary risk of loss to the company. For example, if a company determines that it has a material exposure to foreign currency exchange rate risk, the company would disclose particular foreign currencies to which it is most vulnerable (e.g. dollar/pound, yen/peso, etc.).

Question

71.If a company is exposed to several market risks but only one of the risk exposures is material, is disclosure of other immaterial market risks required?

Answer

No. If quantitative disclosure is provided for a particular market risk exposure within the trading and non-trading portfolios, qualitative disclosures are also required. Disclosure of other exposures is optional.

Question

72.How are the qualitative disclosures required by Item 305(b) different from those required by FASB Statement 119?

Answer

The disclosures required by Item 305(b) are more extensive than those of FASB Statement 119 because they address a broader range of financial instruments.

Item 305(b) expands the qualitative disclosures of FASB Statement 119. It requires information about non-derivative non-trading instruments, including derivative commodity instruments, other financial instruments, and derivative financial instruments entered into for trading purposes. Item 305(b) also requires the evaluation and description of material changes in a company's primary risk exposures and how those risks are managed.

Safe Harbor Requirements

Question

73.Does the safe harbor for forward looking statements provided in Section 27A of the Securities Act and Section 21E of the Exchange Act apply to market risk information included in the financial statements and the related notes?

Answer

No. The release specifies that the quantitative and qualitative information required by Items 305 of Regulation S-K and Item 9A of Form 20-F must appear outside the financial statements and the related notes.

Question

74.Is meaningful cautionary language required to qualify for the safe harbor for the market risk disclosures?

Answer

The requirement for "meaningful cautionary statements" is satisfied if disclosures responsive to Items 305(a) and 9A(a) is provided, including disclosure of all material assumptions and limitations of the disclosures. For disclosures responsive to other parts of Items 305 and 9A, the company must consider what additional information is necessary to alert investors to important factors that could cause actual results to differ materially from the information given in the forward looking statements.

Question

75.Does the safe harbor apply to small business issuers that provide quantitative and qualitative disclosures voluntarily? Does the safe harbor apply even if only a portion of the disclosures are provided?

Answer

The safe harbors are available to those small business issuers that voluntarily choose to disclose such quantitative and qualitative information. The safe harbor applies to any Item 305 disclosure that is voluntarily provided by a small business issuer.

Question

76.Does the safe harbor extend to auditors and other experts that might be associated with the market risk information?

Answer

Companies may obtain the assistance of third parties in compiling the required information, assessing the reasonableness of management's assumptions, testing the mathematical computations that translate the assumptions into the required disclosure, or review of the information before disclosure. The Commission considers such assistance and reviews to be "made by an outside reviewer retained by the issuer making a statement on behalf of the issuer" and covered by the safe harbor.

http://www.sec.gov/divisions/corpfin/guidance/derivfaq.htm


Modified:08/15/1997