Scope

GASBS 53 defines a derivative instrument as a financial instrument or other contract that has all of the following characteristics:

1. Settlement factors. A derivative instrument has (1) one or more reference rates (including indexes or underlyings) and (2) one or more notional amounts (sometimes called the face amount) or payment provisions or both. Those terms determine the amount of the settlement or settlements and, in some cases, whether or not a settlement is required. GASBS 53 describes a reference rate as a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event such as a scheduled payment under a contract). A reference rate may be a price or rate of an asset or liability but is not the asset or liability itself and may be any variable that has changes that are observable or otherwise objectively verifiable. GASBS 53 provides the following examples of reference rates:
   1. A security price or security price index.
   2. A commodity price or commodity price index.
   3. An interest rate or interest rate index.
   4. A credit rating or credit index.
   5. An exchange rate or exchange rate index.
   6. An insurance index or catastrophe loss index.
   7. A climatic or geological condition (such as temperature, earthquake severity, or rain‐fall), another physical variable, or a related index.

   Common reference rates are the London Interbank Offered Rate (LIBOR), the Securities Industry and Financial Markets Association (SIFMA) swap index, the AAA general obligations index published by Municipal Market Data, or a commodity pricing point.

   The notional amount is the number of currency units, shares, bushels, pounds, or other units specified in the derivative instrument. The notional amount and reference rate are key factors of a derivative instrument’s settlement payment. Other factors, such as the change in a reference rate over time, also may enter the calculation of a settlement payment. Finally, a payment provision may specify a payment to be made if the reference rate behaves in a specified manner, such as the three‐month average of fuel prices at a certain pricing point that exceeds a certain price.

2. Leverage. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. GASBS 53 uses an interest rate swap as an example of leverage, in that an interest rate swap generally requires no initial net investment. The swap’s fair value, however, will change as if the holder of the swap had made an initial net investment in a fixed‐rate instrument with a principal amount equal to the swap’s notional value.
3. Net settlement. Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

GASBS 53 provides that a financial instrument or other contract meets the net settlement characteristic if its settlement provisions meet one of the following criteria:

1. Neither party is required to deliver an asset that is associated with the reference rate and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount) of the financial instrument. For example, most interest rate swaps do not require that either party deliver cash or interest‐bearing assets with a principal amount equal to the notional amount of the contract.
2. One of the parties is required to deliver an asset, but there is a market mechanism that facilitates net settlement. An example of that type of market mechanism is a futures exchange that offers a ready opportunity to enter into an offsetting contract.
3. One of the parties is required to deliver an asset, but that asset is readily convertible to cash or is itself a derivative instrument.

GASBS 53 also identifies specific types of financial instruments that are not included in its scope:

1. Normal purchases and sales contracts.
2. Insurance contracts.
3. Certain financial guarantee contracts. (Financial guarantee contracts that provide for payments to be made in response to changes in a reference rate would be included in the scope of GASBS 53 if they meet the other definition criteria described above.)
4. Certain contracts which are not exchange traded. GASBS 53 provides that a contract is not included in its scope if the contract is not exchange‐traded and its reference rate is based on one of the following:
   1. A climatic, geological, or other physical variable.
   2. A price or value of a nonfinancial asset. The nonfinancial asset should not be readily convertible to cash.
5. Loan commitments.

   The GASB issued Statement No. 59 (GASBS 59), Financial Instruments Omnibus, which clarifies whether certain contracts (including financial guarantee contracts) are included in its scope. Specifically:

• Contracts with nonperformance penalties.

Contract nonperformance penalties do not meet the net settlement characteristic included in the definition of a derivative instrument. GASBS 59 amends GASBS 53, paragraph 13, by adding the following sentences at the end of the paragraph:

Some construction or purchase contracts include nonperformance penalty provisions. A penalty payment for nonperformance, either fixed or variable, that is dependent on the failure of the counterparty to comply with a contract term does not meet the net settlement characteristic.

• Certain financial guarantee contracts.

Financial guarantee contracts included in the scope of GASBS 53 are limited to financial guarantee contracts that are considered to be investment derivative instruments entered into primarily for the purpose of obtaining income or profit. GASBS 59 supersedes GASBS 53, paragraph 16, as follows:

Certain financial guarantee contracts. A financial guarantee contract that meets the definition of a derivative instrument and is not entered into as an investment derivative instrument primarily for the purpose of obtaining income or profit is outside the scope of this Statement. Examples are as follows:

1. A federal guarantee that protects a university from loss in its student accounts receivables.
2. A guarantee a state government provides for the nonpayment of the debt of an industrial development corporation.
3. Bond insurance in which the government pays the premium, the bond insurance is associated with the government’s debt, and the debt holder is the beneficiary.

Financial guarantee contracts are included in the scope of GASBS 53 if they meet the definitions of a derivative instrument and an investment derivative instrument entered into primarily for the purpose of obtaining income or profit. An example is a credit default swap that a government enters into to take a position for gain or income in response to changes in a reference rate, such as a contract that provides for payments to be made if the credit rating of a debtor falls below a particular level.

Recognition and Measurement of Derivative Instruments

GASBS 53 provides that derivative instruments should be reported on the statement of net position and should be measured at their fair value. (An exception to fair value measurement relates to fully benefit‐responsive synthetic guaranteed investment contracts, which are discussed later.) Fair value should be measured by the market price if there is an active market for the derivative instrument. If a market price is not available, a forecast of the expected cash flows may be used, provided that the expected cash flows are discounted. GASBS 53 also provides that formula‐based methods and mathematical models are also acceptable means of determining fair value.

The real complexities of GASBS 53 come into play in determining how changes in the fair value of derivative instruments from period to period are presented in the financial statements. The determination of how changes in the fair value of derivatives are reported in the financial statements is based upon whether or not the derivative instrument meets the criteria to be considered a hedging derivative instrument.

• Changes in the fair values of investment derivative instruments (i.e., a derivative that is entered into primarily for the purpose of obtaining income or profit, or a derivative that does not meet the criteria of a hedging derivative instrument) should be reported within the investment revenue classification in the “flow of financial resources” statement—the statement of activities, statement of revenues, expenses and changes in fund net position, or statement of changes in fiduciary net position.
• Changes in fair value of hedging derivative instruments are recognized through the application of hedge accounting. In hedge accounting, changes in the fair values of derivatives are reported as deferred inflows or deferred outflows on the statement of net position.

Clearly, determining whether a derivative instrument meets the criteria to be considered a hedging derivative instrument is critical to determining the proper accounting for changes in the fair value of these instruments. Changes in the fair values of hedging derivative instruments are only recorded on the “balance sheet” while changes in the fair values of investment derivative instruments flow through the “income statement.” A significant part of GASBS 53 is devoted to setting the criteria that must be met to qualify a derivative for hedge accounting.

GASBS 53 also provides guidance for when hedge accounting should be terminated. Specifically, GASBS 53 provides that hedge accounting should cease to be applied upon the occurrence of one of the following termination events:

1. The hedging derivative instrument is no longer effective as determined by applying the criteria for hedge accounting.
2. The likelihood that a hedged expected transaction will occur is no longer probable.
3. The hedged asset or liability, such as a hedged bond, is sold or retired but not reported as a current refunding or advanced refunding resulting in a defeasance of debt.
4. The hedging derivative instrument is terminated.
5. A current refunding or advanced refunding resulting in the defeasance of the hedged debt is executed.
6. The hedged expected transaction occurs, such as the purchase of an energy commodity or the sale of bonds.

If a termination in hedge accounting is required by one of the above events, any balance in the deferred inflow or outflow accounts should be reported on the flow of resources statement within the investment revenue classification.

Hedging Derivative Instruments

GASBS 53 provides that a hedging derivative instrument is established if both of the following criteria are met:

1. The derivative instrument is associated with a hedgeable item (described below). Association is established by consideration of the facts and circumstances of the derivative instrument, including whether:
   1. The notional amount of the derivative instrument is consistent with the principal amount or quantity of the hedgeable item.
   2. The derivative instrument will be reported in the same fund, if applicable, as the hedgeable item.
   3. The term or time period of the derivative instrument is consistent with the term or time period of the hedgeable item.

   A derivative instrument that is associated with a hedgeable item, but has yet to be determined effective in significantly reducing the identified financial risk, is referred to in GASBS 53 as a potential hedging derivative instrument.

2. The potential hedging derivative instrument is effective in significantly reducing the identified financial risk. Effectiveness is established if the changes in cash flows or fair values of the potential hedging derivative instrument substantially offset the changes in cash flows or fair values of the hedgeable item.

   GASBS 53 defines hedgeable items as those that expose a government to identified financial risks that can be expressed in terms of exposure to adverse changes in cash flows or fair values. Hedgeable items can be all or a specific portion of:

3. A single asset or liability, for example, an entire bond issue or a specific portion of a bond issue.
4. Groups of similar assets or liabilities. If similar assets or similar liabilities are aggregated and hedged as a group, all of the individual assets or individual liabilities in the group are required to be exposed to the same identified financial risk that is being hedged.
5. An expected transaction.

Assets and liabilities that are measured at fair value—such as investments in many debt securities—do not qualify as hedgeable items.

For an expected transaction to be a hedgeable item, GASBS 53 provides that the occurrence of the expected transaction should be probable, supported by observable facts such as:

1. The frequency, volume, and amount of past transactions.
2. The financial, operational, and legal ability of the government to carry out the transaction (for example, whether the voters have approved a bond issue or tax levy).
3. The extent of loss or disruption to a government’s activities that could result if the transaction does not occur.
4. The government’s budget or other planning documents.

If an expected transaction is a hedgeable item, the evaluation of effectiveness should consider the probable terms of the expected transaction compared to the terms of the potential hedging derivative instrument.

GASBS 53 also provides that a transaction or expected transaction between a primary government and a discretely presented component unit can be a hedgeable item. However, a transaction wholly within a primary government—for example, a commitment to sell electricity by a city’s electric utility (an enterprise fund of the city) to the city’s general fund governmental operations—cannot be a hedgeable item.

Evaluating the Effectiveness of a Hedge

Since the determination of whether or not a derivative instrument is considered an effective hedge has a significant impact on the treatment of changes in its fair value on a government’s activities statement, determining whether a hedge is effective or not comprises a significant portion of GASBS 53’s discussions and requirements.

Under GASBS 53, potential hedging derivative instruments should be evaluated for effectiveness as of the end of each reporting period using a method described in the following pages. GASBS 53 specifies the extent to which these methods are required to be applied in the evaluation of effectiveness as follows:

1. Evaluation of effectiveness in the first reporting period. If a potential hedging derivative instrument is first evaluated using the consistent critical terms method (described below) and does not meet the criteria for effectiveness of that method, at least one quantitative method (also described below) also should be applied before concluding that the potential hedging derivative instrument is ineffective.

   If a potential hedging derivative instrument is first evaluated using a quantitative method and does not meet the criteria for effectiveness of that method, a government may, but is not required to, apply another quantitative method before concluding that the potential hedging derivative instrument is ineffective. However, if it is determined that a potential hedging derivative instrument is ineffective in the first reporting period, evaluation of effectiveness in subsequent reporting periods should not be performed for financial reporting purposes.

2. Evaluation of effectiveness in subsequent reporting periods. All potential hedging derivative instruments that were determined to be hedging derivative instruments in the prior reporting period should be reevaluated at the end of the current reporting period using the method that was applied in the prior reporting period. If that method is applied and the hedging derivative instrument no longer meets the criteria for effectiveness of that method, a government may, but is not required to, apply another method before concluding that the hedging derivative instrument is no longer effective.

Some potential hedging derivative instruments are designed to offset changes in cash flows or fair values of the hedgeable item in one direction. They are referred to as “one‐sided hedges.” Examples are options (such as caps and floors) that provide increases in cash flows or fair values if a market price exceeds or declines below a certain price or rate. In such cases, effectiveness should be evaluated consistent with the objective of the potential hedging derivative instrument. In other words, does the derivative instrument provide the hedge that the government sought by entering into the derivative contract? Other considerations may still be necessary such as whether relevant dates of the potential hedging derivative instrument are consistent with those of the hedgeable item.

GASBS 53 provides that effectiveness generally should be evaluated by considering overall changes in fair values or cash flows of the potential hedging derivative instrument. In a hybrid instrument, the potential hedging derivative instrument should be separated from the companion instrument for purposes of this assessment. Some potential hedging derivative instruments, however, have characteristics that permit separate evaluation of time value or interest. That separation may be significant in the evaluation of effectiveness if the hedging portion of the potential hedging derivative instrument excludes either the time value or the interest portion. GASBS 53 provides that separation is permissible if either of the following criteria is met:

1. The potential hedging derivative instrument is an option and effectiveness is evaluated by consideration of only the change in either:
   1. The option’s intrinsic value, excluding the option’s change in time value from the assessment of effectiveness.
   2. The option’s minimum value, excluding the option’s change in volatility value from the assessment of effectiveness. The option’s minimum value is its intrinsic value adjusted for the effect of discounting. The volatility value is a key input in an option’s fair value.
2. The potential hedging derivative instrument is a forward contract and effectiveness is evaluated by consideration of only the change in spot prices, excluding either the change in time value or the interest portion.

Methods for Determining the Effectiveness of a Hedge

The two basic methods to determine whether or not a derivative instrument is an effective hedge are categorized as the consistent critical terms method and the quantitative method, which is really comprised of several different quantitative methods. GASBS 53 discusses the application of these two methods separately for hedgeable items that are existing or expected financial instruments and hedgeable items that are existing or expected commodity transactions.

The Hedgeable Item Is an Existing or Expected Financial Instrument

If the hedgeable item is an existing financial instrument or an expected transaction that is expected to result in a financial instrument, GASBS 53 provides that effectiveness should be evaluated using the criteria in this section.

Certain financial risks may cause variability in portions of the overall changes in cash flows or fair values of financial instruments. Those risks may be individually hedged, provided that effectiveness can be measured. Risks that may be hedged include interest rate, tax, credit, and foreign currency risks. If interest rate risk is the hedged risk, the evaluation of effectiveness should be based on an appropriate benchmark interest rate. For tax‐exempt debt, GASBS 53 provides that the Securities Industry and Financial Markets Association (SIFMA) swap index and the AAA general obligations index are appropriate benchmark interest rates. For taxable debt, the appropriate benchmark interest rates are the interest rate on direct Treasury obligations of the U.S. government and the London Interbank Offered Rate (LIBOR). However, if LIBOR or a percentage of LIBOR is employed as a hedge of tax‐exempt debt, hedge effectiveness should be evaluated using one of the quantitative methods.

Consistent Critical Terms Method

The consistent critical terms method, as defined by GASBS 53, evaluates effectiveness by qualitative consideration of the critical terms of the hedgeable item and the potential hedging derivative instrument. If the critical terms of the hedgeable item and the potential hedging derivative instrument are the same or similar in certain circumstances, then the changes in cash flows or fair values of the potential hedging derivative instrument will substantially offset the changes in cash flows or fair values of the hedgeable item.

GASBS 53 provides the following discussions as to how to apply the consistent critical terms method to various types of financial instruments:

Interest rate swaps—cash flow hedges. (As interest rate swaps are probably the most common derivative instrument used by state and local governments, the application of the consistent critical terms method to interest rate swaps is important for governments to understand. Fortunately, this represents one of the most straightforward applications of a method to determine the effectiveness of a hedge.) An interest rate swap is an effective cash flow hedge under the consistent critical terms method if all of the following criteria are met:

1. The notional amount of the interest rate swap is the same as the principal amount of the hedgeable item throughout the life of the hedging relationship. This criterion is met if the notional amount of the interest rate swap and principal amount of the hedgeable item are equal for each hedged interest payment, even if the hedged item amortizes or otherwise adjusts subsequent to the inception of the hedge.
2. Upon association with the hedgeable item, the interest rate swap has a zero fair value.
3. The formula for computing net settlements under the interest rate swap is the same for each net settlement. That is, the fixed rate is the same throughout the term of the interest rate swap. Likewise, each variable payment of the interest rate swap is based on the same variable, such as the same reference rate or index.
4. The reference rate of the interest rate swap’s variable payment is consistent with one of the following:
   1. The reference rate or payment of the hedgeable item. For example, an interest rate swap provides variable payments to the government equal to the total variable payments of variable‐rate bonds. This is a cost‐of‐funds hedge.
   2. A benchmark interest rate if interest rate risk is the hedged risk. The reference rate cannot be multiplied by a coefficient, such as some specified percentage of LIBOR, but it may be adjusted by addition or subtraction of a constant, such as the SIFMA swap index plus 10 basis points, provided that the constant is specifically attributable to the effects of state‐specific tax rates.
5. The interest receipts or payments of the interest rate swap occur during the term of the hedgeable item, and no interest receipts or payments of the interest rate swap occur after the term of the hedgeable item. For example, an interest rate swap that hedges the first 10 years of a 15‐year variable‐rate bond meets this criterion.
6. The reference rate of the interest rate swap does not have a floor or cap unless the hedgeable item has a floor or cap. If the hedgeable item has a floor or cap, the interest rate swap has a floor or cap on the variable interest rate that is comparable to the floor or cap on the hedgeable item.
7. The time interval of the reference rate, commonly referred to as the designated maturity, employed in the variable payment of the interest rate swap is the same as the time interval of the rate reset periods of the hedgeable item. Examples that meet this criterion include an interest rate swap with a variable payment referenced to:
   1. The SIFMA swap index—a seven‐day index—that hedges variable‐rate bonds with a rate reset every seven days; and
   2. An interest rate swap with a variable payment referenced to the one‐month LIBOR index that hedges taxable variable‐rate bonds with a monthly rate reset.
8. The frequency of the rate resets of the variable payment of the swap and the hedgeable item are the same.
9. The rate reset dates of the interest rate swap are within six days of the rate reset dates of the hedgeable item.
10. The periodic interest rate swap payments are within 15 days of the periodic payments of the hedgeable item.

Interest rate swaps—fair value hedges. GASBS 53 provides that an interest rate swap is an effective fair value hedge under the consistent critical terms method if all of the following criteria are met:

1. The notional amount of the interest rate swap is the same as the principal amount of the hedgeable item throughout the life of the hedging relationship. This criterion is met if the notional amount of the interest rate swap and principal amount of the hedgeable item are equal over the entire term of the hedgeable item, even if the hedgeable item amortizes or otherwise adjusts subsequent to the inception of the hedge.
2. Upon association with the hedgeable item, the interest rate swap has a zero fair value.
3. The formula for computing net settlements under the interest rate swap is the same for each net settlement. That is, the fixed rate is the same throughout the term of the interest rate swap. Likewise, each variable payment of the interest rate swap is based on the same variable, such as the same reference rate or index.
4. An interest rate swap that hedges interest rate risk has a variable payment based on a benchmark interest rate without multiplication by a coefficient, such as some specified percentage of LIBOR. The benchmark interest rate, however, may be adjusted by addition or subtraction of a constant, such as the SIFMA swap index plus 10 basis points, provided that the constant is specifically attributed to the effect of state‐specific tax rates.
5. The hedgeable item is not prepayable (that is, the hedgeable item is not able to be settled by either party prior to its scheduled maturity). This criterion does not apply to a call option in an interest‐bearing hedgeable item that is matched by a mirror‐image call option in an interest rate swap if both of the following criteria are met:
   1. A mirror‐image call option matches the terms of the call option in the hedgeable item. The terms include maturities, strike price, related notional amounts, timing and frequency of payments, and dates on which the instruments may be called.
   2. The government is the writer of one call option and the holder (or purchaser) of the other call option. For example, a government issues callable fixed‐coupon bonds and enters into an interest rate swap as a fair value hedge. The government has “purchased” and holds a call option in its issued bonds because those bonds carry a higher interest rate due to the bond’s call option. In regard to the interest rate swap, it has a similar call option held by the interest rate swap’s counterparty. If the callable bonds and the interest rate swap contain these features, the changes in fair value generated by the similar call options offset. A similar exception applies if the put option in an interest‐bearing asset or liability is matched by a mirror‐image put option in the interest rate swap.
6. The expiration date of the interest rate swap is on or about the maturity date of the hedgeable item so that the government will not be exposed to interest rate risk or market risk.
7. The reference rate of the interest rate swap has neither a floor nor a cap.
8. The reference rate of the interest rate swap resets at least every 90 days so that the variable payment or receipt is considered to be at a market rate.

Forward contracts. GASBS 53 provides that a forward contract is effective under the consistent critical terms method if all of the following criteria are met:

1. The forward contract is for the purchase or sale of the same quantity or notional amount and at the same time as the hedgeable item.
2. Upon association with the hedgeable item, the forward contract has a zero fair value.
3. The reference rate of the forward contract is consistent with the reference rate of the hedgeable item.

The change in the discount or premium on the forward contract should be excluded from the assessment of effectiveness and included within the investment revenue classification, or the change in expected cash flows of the expected transaction should be based on the forward price of the hedgeable item.

Quantitative Methods

GASBS 53 specifies three quantitative methods that may be used to evaluate effectiveness: the synthetic instrument method, the dollar‐offset method, and the regression analysis method. Quantitative methods other than those specifically described in this Statement also may be used to evaluate effectiveness, provided that they meet the criteria of paragraph 48.

The quantitative methods of evaluating effectiveness may use historical data—past rates, prices, or payments. If there are new market conditions, however, the evaluation of effectiveness should be limited to using fair values, such as in the application of the dollar‐offset method, or in certain instances, regression analysis of fair values. New market conditions are caused by asymmetrical changes in market supply or demand. GASBS 53 identifies a change in income tax rates of individual taxpayers that affects the demand for tax‐exempt debt as an example of an event that suggests new market conditions.

Synthetic Instrument Method

The synthetic instrument method evaluates effectiveness by combining the hedgeable item and the potential hedging derivative instrument to simulate a third synthetic instrument. A potential hedging derivative instrument is effective if its total variable cash flows substantially offset the variable cash flows of the hedgeable item. This method is limited to cash flow hedges in which the hedgeable items are interest bearing and carry a variable rate. An example is the combination of a pay‐fixed, receive‐variable interest rate swap with a variable‐rate bond to create a synthetic fixed‐rate bond. GASBS 53 specifies that the synthetic instrument method may be applied to evaluate a potential hedging derivative instrument’s effectiveness if all of the following criteria are met:

1. The notional amount of the potential hedging derivative instrument is the same as the principal amount of the associated variable‐rate asset or liability throughout the life of the hedging relationship. This criterion is met if the notional amount of the swap and principal amount of the hedgeable item match for each hedged interest payment, even if the hedged item amortizes or otherwise adjusts subsequent to the inception of the hedge.
2. Upon association with the variable‐rate asset or liability, the potential hedging derivative instrument has a zero fair value or the forward price is at‐the‐market.
3. The formula for computing net settlements under the potential hedging derivative instrument is the same for each net settlement, that is, the same fixed rate, reference rate, and constant adjustment, if any, throughout the term of the potential hedging derivative instrument.
4. The interest receipts or payments of the potential hedging derivative instrument occur during the term of the variable‐rate asset or liability, and no interest receipts or payments occur after the term of the variable‐rate asset or liability. For example, a swap that hedges the first 10 years of a 15‐year variable‐rate bond meets this criterion.

Under the synthetic instrument method, GASBS 53 provides that a potential hedging derivative instrument is effective if the actual synthetic rate is substantially fixed. The actual synthetic rate represents the aggregate payment experience of the variable‐rate asset or liability and the potential hedging derivative instrument. GASBS 53 specifies that the actual synthetic rate should be within a range of 90% to 111% of the fixed rate of the potential hedging derivative instrument to be substantially fixed. It uses the example of when a swap’s fixed payment rate is 5%, an actual synthetic interest rate that falls within a range between 4.50% (90% of 5.00%) and 5.55% (111% of 5.00%) is substantially fixed. Further, the results of this analysis should be evaluated as follows:

1. If the actual synthetic rate is within the required range for the current reporting period, the actual synthetic rate is substantially fixed.
2. If the actual synthetic rate is outside the required range for the current reporting period, the actual synthetic rate should be calculated on a life‐to‐date basis. If the actual synthetic rate on a life‐to‐date basis is within the required range, the actual synthetic rate is substantially fixed.
3. If a short time period has elapsed since inception of the hedge and the actual synthetic rate is outside the required range, the evaluation may include hypothetical payments, as if the hedge had been established at an earlier date. Effectiveness should then be reevaluated. For example, the first reporting period ends 90 days into a 10‐year hedge, and when the government prepares its financial statements, it finds that the actual synthetic rate for the 90‐day period is outside the 90% to 111% range. In that case, hypothetical payments from periods prior to the establishment of the hedge may be added to the evaluation. If that analysis shows a synthetic rate within the required range, the actual synthetic rate is substantially fixed.

Dollar‐Offset Method

The second quantitative method that can be used under GASBS 53 to determine hedge effectiveness is the dollar‐offset method. The dollar‐offset method evaluates effectiveness by comparing the changes in expected cash flows or fair values of the potential hedging derivative instrument with the changes in expected cash flows or fair values of the hedgeable item. GASBS 53 provides that this evaluation may be made using changes in the current period or on a life‐to‐date basis. If the changes of either the hedgeable item or the potential hedging derivative instrument are divided by the other and the result is within a range of 80 to 125% in absolute terms, these changes substantially offset and the potential hedging derivative instrument is effective. For example, if actual results are such that the fair value decrease of the potential hedging derivative instrument is $120 and the fair value increase of the hedgeable item is $100, the dollar‐offset percentage can be measured as 120/100, which is 120%, or as 100/120, which is 83%. In either case, the potential hedging derivative instrument is determined to be effective.

Regression Analysis Method

The third quantitative method that can be used under GASBS 53 to determine hedge effectiveness is the regression analysis method. The regression analysis method evaluates effectiveness by considering the statistical relationship between the cash flows or fair values of the potential hedging derivative instrument and the hedgeable item. GASBS 53 provides that the changes in cash flows or fair values of the potential hedging derivative instrument substantially offset the changes in cash flows or fair values of the hedgeable item if all of the following criteria are met:

1. The R‐squared of the regression analysis is at least 0.80.
2. The F‐statistic calculated for the regression model demonstrates that the model is significant using a 95% confidence interval.
3. The regression coefficient for the slope is between −1.25 and −0.80.

The regression analysis should be based on sufficient data to determine if the potential hedging derivative instrument is effective as of the end of the reporting period. In assessing the sufficiency of the data, the period of time that the potential hedging derivative instrument is expected to hedge an identified financial risk in the future should be considered. Other results of the regression analysis method may need to be considered when evaluating effectiveness. The use of the regression analysis method requires appropriate interpretation and understanding of the statistical inferences. These statistical techniques are beyond the scope of this book and if this method is utilized, an individual with sufficient knowledge of statistics may need to be consulted to ensure that calculations and interpretations of calculations are appropriate.

GASBS 53 provides separate guidance in using the regression analysis method for cash flow hedges and fair value hedges, as follows.

Cash flow hedges. If a potential hedging derivative instrument is employed as a cash flow hedge, the relationship analyzed should be relevant cash flows, rates, or fair values of the potential hedging derivative instrument and the hedgeable item. GASBS 53 provides that the regression analysis should be conducted as follows:

1. The dependent variable for a cash flow hedge evaluated using cash flows or rates should be relevant cash flows or rates of the hedgeable item. The independent variable should be the relevant cash flows or rates of the potential hedging derivative instrument. If the evaluation is based on rates, the rates used as data in the regression analysis should be representative of the hedging relationship.
2. The dependent variable for a cash flow hedge evaluated using fair values should be the changes in fair values of the hypothetical derivative instrument. The independent variable should be the changes in fair values of the potential hedging derivative instrument. The hypothetical derivative instrument generally should have terms that exactly match the critical terms of the variable‐rate hedgeable item. That is, the hypothetical derivative instrument and the hedgeable item should have the same notional amount and repricing dates, and mirror‐image caps and floors, if applicable. The maturity of the hypothetical derivative instrument, however, should be the same as the maturity of the potential hedging derivative instrument. The hypothetical derivative instrument’s reference rate should be consistent with the reference rate of the hedgeable item. The hypothetical derivative instrument should have a zero fair value upon association of the hedging relationship.

Fair value hedges. If a potential hedging derivative instrument is employed as a fair value hedge, the relationship analyzed should be the changes in fair values of the potential hedging derivative instrument and the hedgeable item. The dependent variable in the regression analysis represents changes in fair values of the hedgeable item (for example, fixed‐rate bonds), and the independent variable represents changes in fair values of the potential hedging derivative instrument (for example, a pay‐variable, receive‐fixed interest rate swap).

Other Quantitative Methods

In addition to the three quantitative methods discussed above, GASBS 53 permits the use of other quantitative methods to determine hedge effectiveness if the specific method meets all of the following criteria:

1. Through identification and analysis of critical terms, the method demonstrates that the changes in cash flows or fair values of the potential hedging derivative instrument substantially offset the changes in cash flows or fair values of the hedgeable item.
2. Replicable evaluations of effectiveness are generated that are sufficiently complete and documented such that different evaluators using the same method and assumptions would reach substantially similar results.
3. Substantive characteristics of the hedgeable item and the potential hedging derivative instrument that could affect their cash flows or fair values are considered.

The Hedgeable Item Is an Existing or Expected Commodity Transaction

As mentioned previously in this section, GASBS 53 has separate guidance for using the consistent critical terms method and quantitative methods for evaluating the effectiveness of hedges of existing or expected commodity transactions. This guidance is provided in the following sections.

Consistent Critical Terms Method

GASBS 53 provides that the consistent critical terms method evaluates effectiveness by qualitative consideration of the critical terms of the hedgeable item and the potential hedging derivative instrument. If the critical terms of the hedgeable item and the potential hedging derivative instrument are the same, or similar in certain circumstances as described in the following sections, the changes in cash flows or fair values of the potential hedging derivative instrument will substantially offset the changes in cash flows or fair values of the hedgeable item.

Commodity swaps—cash flow hedges. GASBS 53 provides that a commodity swap is an effective cash flow hedge under the consistent critical terms method if all of the following criteria are met:

1. The commodity swap is for the purchase or sale of the same quantity (notional amount) of the same hedgeable item at the same time and delivery location as the hedgeable item.
2. Upon association with the hedgeable item, the commodity swap has a zero fair value.
3. The reference rate of the commodity swap is consistent with the reference rate of the hedgeable item.
4. The reference rate of the commodity swap does not have a floor or cap unless the hedgeable item has a floor or cap. Floors and caps place limits on expected cash flows. If the hedgeable item has a floor or cap, the commodity swap has a comparable floor or cap on the variable commodity price.

Commodity swaps—fair value hedges. GASBS 53 provides that a commodity swap is an effective fair value hedge under the consistent critical terms method if all of the following criteria are met:

1. The commodity swap is for the purchase or sale of the same quantity (notional amount) of the same hedgeable item at the same time and delivery location as the hedgeable item.
2. Upon association with the hedgeable item, the commodity swap has a zero fair value.
3. The hedgeable item is not prepayable (that is, the hedgeable item is not able to be settled by either party prior to its scheduled maturity). GASBS 53 provides that this criterion does not apply to a call option in a hedgeable item that is matched by a mirror‐image call option in a commodity swap if both of the following criteria are met:
   1. A mirror‐image call option matches the terms of the call option in the hedgeable item. The terms include maturities, strike price, related notional amounts, timing and frequency of payments, and dates on which the instruments may be called.
   2. The government is the writer of one call option and the holder (or purchaser) of the other call option.
4. The expiration date of the commodity swap is on or about the maturity or termination date of the hedgeable item so that the government will not be exposed to market risk.
5. The reference rate of the commodity swap has neither a floor nor a cap.
6. The reference rate of the commodity swap resets at least every 90 days so that the variable payment or receipt is considered to be at a market rate.

Forward contracts. GASBS 53 provides that a forward contract is effective under the consistent critical terms method if all of the following criteria are met:

1. The forward contract is for the purchase or sale of the same quantity (notional amount) of the same hedgeable item at the same time and location as the hedgeable item.
2. Upon association with the hedgeable item, the fair value of the forward contract is zero.
3. The reference rate of the forward contract is consistent with the reference rate of the hedgeable item.

The change in either the discount or premium on the forward contract should be excluded from the assessment of effectiveness and included within the investment revenue classification, or the change in expected cash flows of the expected transaction should be based on the forward price of the hedgeable item.

Quantitative Methods

GASBS 53 provides the following guidance in applying the quantitative methods for determining hedge effectiveness of existing or expected commodity transactions. The quantitative methods of evaluating effectiveness may use historical data—past rates, prices, or payments. If there are new market conditions, however, the evaluation of effectiveness should be limited to using fair values, such as in the application of the dollar‐offset method, or in certain instances, regression analysis of fair values. New market conditions are caused by asymmetrical changes in market supply or demand. The examples of events that suggest new market conditions exist provided by GASBS 53 are new sources of commodity supplies, such as a new natural gas pipeline, and supply disruptions arising from natural disasters, such as hurricanes and earthquakes.

Synthetic Instrument Method

GASBS 53 provides that the synthetic instrument method evaluates effectiveness by combining the hedgeable item and the potential hedging derivative instrument to simulate a third synthetic instrument. A potential hedging derivative instrument is effective if its variable cash flows will substantially offset the variable cash flows of the hedgeable item. This method is limited to cash flow hedges in which the hedgeable items have a variable price or rate; that is, the variable cash flows of the potential hedging derivative instrument offset the variable cash flows of the hedgeable item to create an essentially fixed price or rate. GASBS 53 provides that this method may be applied to evaluate a potential hedging derivative instrument’s effectiveness if both of the following criteria are met:

1. The notional quantity of the potential hedging derivative instrument is the same as the quantity of the hedgeable item.
2. Upon association with the hedgeable item, the potential hedging derivative instrument has a zero fair value or the forward price is at‐the‐market.

Under the synthetic instrument method, GASBS 53 provides that a potential hedging derivative instrument is effective if the synthetic price is substantively fixed. The synthetic price as of the evaluation date—the end of the reporting period—is compared to the synthetic price expected at the establishment of the hedge by calculation of an effectiveness percentage. If the effectiveness percentage is within a range of 90% to 111%, the synthetic price is substantively fixed.

Dollar‐Offset Method

GASBS 53 provides that the dollar‐offset method evaluates effectiveness by comparing the changes in expected cash flows or fair values of the potential hedging derivative instrument with the changes in expected cash flows or fair values of the hedgeable item. This evaluation may be made under GASBS 53 using changes in the current period or on a life‐to‐date basis. If the changes of either the hedgeable item or the potential hedging derivative instrument are divided by the other and the result is within a range of 80 to 125% in absolute terms, these changes will substantially offset and the potential hedging derivative instrument is determined to be effective. The example provided by GASBS 53 is that if actual results are such that the fair value decrease on the potential hedging derivative instrument is $120 and the fair value increase on the hedgeable item is $100, the dollar‐offset percentage can be measured as 120/100, which is 120%, or as 100/120, which is 83%. In either case, the potential hedging derivative instrument is effective.

Regression Analysis Method

The regression analysis method evaluates effectiveness under GASBS 53 by considering the statistical relationship between the cash flows or fair values of the potential hedging derivative instrument and the hedgeable item. GASBS 53 provides that the changes in cash flows or fair values of the potential hedging derivative instrument substantially offset the changes in cash flows or fair values of the hedgeable item if all of the following criteria are met:

1. The R‐squared of the regression analysis is at least 0.80.
2. The F‐statistic calculated for the regression model demonstrates that the model is significant using a 95% confidence interval.
3. The regression coefficient for the slope is between −1.25 and −0.80.

The regression analysis should be based on sufficient data to determine if the potential hedging derivative instrument is effective as of the end of the reporting period. In assessing the sufficiency of the data, the period of time that the potential hedging derivative instrument is expected to hedge an identified financial risk in the future should be considered. Other results of the regression analysis method may need to be considered when evaluating effectiveness. The use of the regression analysis method requires appropriate interpretation and understanding of the statistical inferences. As mentioned earlier in the previous discussion on regression analysis, it may be necessary to obtain the consultation of someone familiar with statistical techniques to ensure that the calculations and interpretations of calculations under this method are appropriate.

In addition, GASBS 53 provides specific guidance on the use of regression analysis for evaluating the effectiveness of cash flow hedges and fair value hedges. These are described as follows.

Cash flow hedges. If a potential hedging derivative instrument is employed as a cash flow hedge, GASBS 53 provides that the relationship analyzed should be relevant cash flows, prices, or fair values of the potential hedging derivative instrument and the hedgeable item. The regression analysis should be conducted as follows:

1. The dependent variable for a cash flow hedge evaluated using cash flows or prices should be relevant cash flows or prices of the hedgeable item. The independent variable should be the relevant cash flows or prices of the potential hedging derivative instrument. If the evaluation is based on prices, the prices used as data in the regression analysis should be representative of the hedging relationship.
2. The dependent variable for a cash flow hedge evaluated using fair values should be the changes in fair values of the hypothetical derivative instrument. The independent variable should be the changes in fair values of the potential hedging derivative instrument. The hypothetical derivative instrument generally should have terms that exactly match the critical terms of the variable‐price hedgeable item. That is, the hypothetical derivative instrument and the hedgeable item should have the same notional amount and repricing dates, and mirror‐image caps and floors. The maturity of the hypothetical derivative instrument, however, should be the same as the maturity of the potential hedging derivative instrument. The hypothetical derivative instrument’s reference rate should be consistent with the reference rate of the hedgeable item. The hypothetical derivative instrument should have a zero fair value upon association of the hedging relationship.

Fair value hedges. If a potential hedging derivative instrument is employed as a fair value hedge, the relationship analyzed should be the changes in fair values of the potential hedging derivative instrument and the hedgeable item. The dependent variable in the regression analysis represents changes in fair values of the hedgeable item (for example, a fixed‐price commodity contract), and the independent variable represents changes in fair values of the potential hedging derivative instrument (for example, a pay‐variable, receive‐fixed commodity swap).

Other Quantitative Methods

In addition to the three quantitative methods discussed above, GASBS 53 permits the use of other quantitative methods to determine hedge effectiveness if the specific method meets all of the following criteria:

1. Through identification and analysis of critical terms, the method demonstrates that the changes in cash flows or fair values of the potential hedging derivative instrument substantially offset the changes in cash flows or fair values of the hedgeable item.
2. Replicable evaluations of effectiveness are generated that are sufficiently complete and documented such that different evaluators using the same method and assumptions would reach substantially similar results.
3. Substantive characteristics of the hedgeable item and the potential hedging derivative instrument that could affect their cash flows or fair values are considered.

Hybrid Instruments

GASBS 53 also provides guidance for evaluating the effectiveness of hedging derivatives that are part of hybrid instruments. While derivative instruments often are stand‐alone instruments, such as futures contracts, a derivative instrument also may accompany a companion instrument such as a debt instrument, a lease, an insurance contract, or a sale or purchase contract. An embedded derivative instrument may be a call option in a bond, a cap or floor in a sale or purchase contract, or an interest rate swap in a debt instrument. Alternatively, some derivative instruments may include investing or borrowing transactions. These instruments may give rise to hybrid instruments, which consist of a derivative instrument and a companion instrument.

GASBS 53 defines a hybrid instrument to be an instrument that meets all of the following criteria:

1. The companion instrument is not measured on the statement of net position at fair value.
2. A separate instrument with the same terms as the derivative instrument would meet the definition of a derivative instrument.
3. The economic characteristics and risks of the derivative instrument are not closely related to the economic characteristics and risks of the companion instrument. GASBS 53 considers that this would be the case in any of the following circumstances:
   1. Up‐front payment with off‐market terms. As a result of a derivative instrument that has off‐market terms, an up‐front payment is received. Off‐market terms that generate an up‐front payment—a borrowing—are not closely related to the characteristics and risks of the derivative instrument. For example, a government enters into a pay‐fixed, receive‐variable interest rate swap that has an above‐market fixed payment, resulting in an up‐front payment to the government.
   2. Written option that is in‐the‐money. A written option that is in‐the‐money has intrinsic value. A government that writes or sells such an option to a counterparty receives an up‐front payment, resulting in a borrowing for financial reporting purposes. The initial intrinsic value of the written option is not closely related to the characteristics and risks of the derivative instrument.
   3. Inconsistent reference rate. The derivative instrument has a reference rate that is inconsistent with the market of the companion instrument. For example, a debt instrument that has a variable coupon rate based on an equity index would not be closely related to the embedded derivative instrument (the variable‐rate coupon). The economic characteristics and risks of the derivative instrument—an equity‐based reference rate—are not closely related to the economic characteristics and risks of the companion instrument—a debt instrument. Alternatively, a variable coupon based on LIBOR would be closely related to the companion instrument.
   4. Potential negative yield. A hybrid instrument could be settled in such a way that an investor would not recover substantially all of its investment. For example, a government issues a note at an above‐market interest rate with terms that provide that if market rates exceed a certain level, the coupon rate resets to zero for the remaining term‐to‐maturity of the instrument. The embedded derivative—the terms of the note which provide for the possibility of a rate reset and a negative yield—would not be closely related to the economic characteristics and risks of the companion instrument.
   5. Leveraged yield. The yield of the companion instrument is leveraged. A leveraged yield occurs if the embedded derivative instrument meets both of the following criteria:
      1.  (i) The holder’s initial rate of return on the companion instrument is at least doubled.
      2. (ii) The rate of return is at least twice what the market return would be for an instrument with the same terms as the companion instrument.

An embedded derivative instrument that is a component of a hybrid instrument should be recognized and measured in accordance with the requirements of GASBS 53. Such a derivative instrument also may be a hedging derivative if it meets the requirements of GASBS 53, which provides that the companion instrument should be recognized and measured in accordance with the reporting requirements that are applicable to that companion instrument—such as the financial reporting requirements for a debt instrument, a lease, or an insurance contract.

On‐behalf payments included in derivative instrument payments. A government may enter into a derivative instrument with off‐market terms that are intended to recover costs assumed by the counterparty on behalf of the government. For example, a government enters into a pay‐fixed, receive‐variable interest rate swap with a fixed rate that has been increased to compensate the counterparty for legal and advisory fees. GASBS 53 provides that those costs should be reported as expenditures or expenses consistent with the manner in which those payments would have been reported if the government had made payment directly.

The GASB issued Statement No. 64 (GASBS 64), Derivative Instruments: Application of Hedge Accounting to Termination Provisions, to clarify whether certain events relating to replacing a counterparty to a derivative (or the counterparty’s credit support providers) would be subject to the termination provision of GASBS 53 as described above. GASBS 64 amends paragraph 22d of GASBS 53 to clarify when the application of hedge accounting should continue upon the replacement of a swap counterparty or a swap counterparty’s credit support provider. Under GASBS 64, under certain circumstances, the replacements would not trigger the termination provisions of GASBS 53, as described below.

Under GASBS 53, as revised by GASBS 64, the hedging derivative instrument is terminated unless an effective hedging relationship continues as provided in the following provisions. An effective hedging relationship continues when all of the following criteria are met:

1. Collectability of swap payments is considered to be probable. (When collectability of payments is not probable, such as when a swap counterparty, or a swap counterparty’s credit support provider, has entered into bankruptcy and the swap is not collateralized or does not remain insured, an effective hedging relationship does not continue.)
2. The swap counterparty of the interest rate swap or commodity swap, or the swap counter‐party’s credit support provider, is replaced with an assignment or in‐substance assignment. (Bold terms are defined below.)
3. The government enters into the assignment or in‐substance assignment in response to the swap counterparty, or the swap counterparty’s credit support provider, either committing or experiencing an act of default or a termination event as both are described in the swap agreement.

GASBS 64 provides the following definitions of assignment and in‐substance assignment:

Assignment. An assignment occurs when a swap agreement is amended to replace an original swap counterparty, or the swap counterparty’s credit support provider, but all of the other terms of the swap agreement remain unchanged.

A swap counterparty replaced in the current reporting period may have previously replaced another swap counterparty in the past. As used in GASBS 64, the term original as it applies to the swap counterparty or the swap counterparty’s credit support provider may include a swap counterparty that has replaced the original swap counterparty, or a credit support provider that has replaced the swap counterparty’s original credit support provider.

In‐substance assignment. An in‐substance assignment occurs when all of the following criteria are met:

• The original swap counterparty, or the swap counterparty’s credit support provider, is replaced.
• The original swap agreement is ended, and the replacement swap agreement is entered into on the same date. GASBS 64 notes that a swap agreement replaced in the current reporting period may have previously replaced another swap agreement in the past. Accordingly, as used in GASBS 64, the term original swap agreement may include a replacement swap agreement.
• The terms that affect changes in fair values and cash flows in the original and replacement swap agreements are identical. These terms include, but are not limited to, notional amounts; terms to maturity; variable payment terms; reference rates; time intervals; fixed‐rate payments; frequencies of rate resets; payment dates; and options, such as floors and caps.
• Any difference between the original swap agreement’s exit price and the replacement swap’s entry price is attributable to the original swap agreement’s exit price being based on a computation specifically permitted under the original swap agreement. Exit price represents the payment made or received as a result of terminating the original swap. Entry price represents the payment made or received as a result of entering into a replacement swap.

Synthetic Guaranteed Investment Contracts

GASBS 53 provides that fully benefit‐responsive Synthetic Guaranteed Investment Contracts (SGICs), which are the combination of the underlying investments and the wrap contract, should be reported at contract value. Under GASBS 53, an SGIC is fully benefit‐responsive if all of the following criteria are met:

1. The SGIC prohibits the government from assigning or selling the contract or its proceeds to another party without the consent of the issuer.
2. Prospective interest crediting rate adjustments are provided to plan participants and the government on a designated pool of investments by a financially responsible third party. Those adjustments provide assurance that the probability of future rate adjustments that would result in an interest crediting rate of less than zero is remote. The pool of investments in total meets both of the following criteria:
   1. Is of high credit quality such that the possibility of credit loss is remote.
   2. May be prepaid or otherwise settled in such a way that the government and plan participants would recover contract value.
3. The terms of the SGIC require all permitted participant‐initiated transactions with the government to occur at contract value with no conditions, limits, or restrictions. Permitted participant‐initiated transactions are those transactions allowed by the government, such as withdrawals for benefits, loans, or transfers to other investment choices.
4. Some events may limit a government’s ability to transact with participants at contract value. Examples are premature termination of contracts, layoffs, plan terminations, bankruptcies, and early retirement incentives. The probability of such an event occurring within one year of the date of the financial statements is remote.
5. The government allows participants reasonable access to their investments. GASBS 53 provides that the following conditions do not affect the benefit responsiveness of an SGIC:
   1. In plans with a single investment choice, restrictions on access to assets by active participants are consistent with the objective of the plan (for example, retirement benefits).
   2. Participants’ access to their account balances is limited to certain specified times during the plan year (for example, semiannually or quarterly) to control the administrative costs of the plan.
   3. Administrative provisions that place short‐term restrictions (for example, three or six months) on transfers to competing fixed‐income investment options to limit arbitrage among those investment options (that is, equity wash provisions). If plan participants are allowed access at contract value to all or a portion of their account balances only upon termination of their participation in the plan, participants would not have reasonable access to their investments.

Notes to the Financial Statements

GASBS 53 has many specific disclosure requirements for derivative instruments that are listed in this section. Disclosure information for similar derivative instrument types may be provided individually or aggregated. GASBS 53 directs that to determine whether derivative instruments are the same type, the commonly known term for the derivative instrument (for example, swaps, swaptions, rate caps, futures contracts, and options written or purchased), the nature of the derivative instrument (for example, receive‐fixed or pay‐fixed interest rate swaps), the hedged item, if any, and the reference rate should be considered.

Summary Information

GASBS 53 requires that governments provide a summary of their derivative instrument activity during the reporting period and balances at the end of the reporting period. The information disclosed should be organized by governmental activities, business‐type activities, and fiduciary funds. The information should then be divided into the following categories—hedging derivative instruments (distinguishing between fair value hedges and cash flow hedges) and 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). Information presented in the summary should include:

1. Notional amount.
2. Changes in fair value during the reporting period and the classification in the financial statements where those changes in fair value are reported.
3. Fair values as of the end of the reporting period and the classification in the financial statements 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. However, if the fair value is developed by a pricing service, there is no requirement to disclose significant assumptions if the pricing service considers those assumptions to be proprietary and, after making every reasonable effort, the pricing service declines to make that information available. This fact, however, should be disclosed.
4. Fair values of derivative instruments reclassified from a hedging derivative instrument to an investment derivative instrument. There also should be disclosure of the deferral amount that was reported within investment revenue upon the reclassification.

GASBS 53 permits the disclosure of the information required above in a columnar display, narrative form, or a combination of both.

Hedging Derivative Instruments

GASBS 53 provides that the following note disclosures be provided for all hedging derivative instruments.

Objectives. For hedging derivative instruments, governments should disclose their objectives 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.

Terms. For hedging derivative instruments, governments should disclose significant terms, including:

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

Risks. For hedging derivative instruments, governments should disclose, if applicable, their exposure to the following risks that could give rise to financial loss. Risk disclosures are limited to hedging derivative instruments that are reported as of the end of the reporting period. Disclosures required by this paragraph may contain information that also is required by other paragraphs. However, these disclosures should be presented in the context of a hedging derivative instrument’s risk:

1. Credit risk. If a hedging derivative instrument reported by the government as an asset exposes a government to credit risk, the government should disclose that exposure as credit risk and disclose the following information. These credit risk disclosures do not extend to derivatives that are exchange‐traded, such as futures contracts. For those derivatives, disclosures for amounts held by broker/dealers are evaluated by applying the custodial credit risk disclosures found in Statements 3, Deposits with Financial Institutions, Investments (including Repurchase Agreements), and Reverse Repurchase Agreements, and 40, Deposit and Investment Risk Disclosures.
   1. The credit quality ratings of counterparties as described by nationally recognized statistical rating organizations—rating agencies—as of the end of the reporting period. If the counterparty is not rated, the disclosure should indicate that fact.
   2. The maximum amount of loss due to credit risk, based on the fair value of the hedging derivative instrument as of the end of the reporting period, that the government would incur if the counterparties to the hedging derivative instrument failed to perform according to the terms of the contract, without respect to any collateral or other security, or netting arrangement.
   3. The government’s policy of requiring collateral or other security to support hedging derivative instruments subject to credit risk, a summary description and the aggregate amount of the collateral or other security that reduces credit risk exposure, and information about the government’s access to that collateral or other security.
   4. The government’s policy of entering into master netting arrangements, including a summary description and the aggregate amount of liabilities included in those arrangements. Master netting arrangements are established when (1) each party owes the other determinable amounts, (2) the government has the right to set off the amount owed with the amount owed by the counterparty, and (3) the right of setoff is legally enforceable.
   5. The aggregate fair value of hedging derivative instruments in asset (positive) positions net of collateral posted by the counterparty and the effect of master netting arrangements.
   6. Significant concentrations of net exposure to credit risk (gross credit risk reduced by collateral, other security, and setoff) with individual counterparties and groups of counterparties. A concentration of credit risk exposure to an individual counterparty may not require disclosure if its existence is apparent from the disclosures required by other parts of this paragraph; for example, a government has entered into only one interest rate swap. Group concentrations of credit risk exist if a number of counterparties are engaged in similar activities and have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions.
2. Interest rate risk. If a hedging derivative instrument increases a government’s exposure to interest rate risk, the government should disclose that increased exposure as interest rate risk and also should disclose the hedging derivative instrument’s terms that increase such a risk. The determination of whether a hedging derivative instrument increases interest rate risk should be made after considering, for example, the effects of the hedging derivative instrument and any hedged debt.
3. Basis risk. If a hedging derivative instrument exposes a government to basis risk, the government should disclose that exposure as basis risk and also should disclose the hedging derivative instrument’s terms and payment terms of the hedged item that creates the basis risk.
4. Termination risk. If a hedging derivative instrument exposes a government to termination risk, the government should disclose that exposure as termination risk and also the following information, as applicable:
   1. Any termination events that have occurred.
   2. Dates that the hedging derivative instrument may be terminated.
   3. Out‐of‐the‐ordinary termination events contained in contractual documents, such as “additional termination events” contained in the schedule to the International Swap Dealers Association master agreement.
5. Rollover risk. If a hedging derivative instrument exposes a government to rollover risk, the government should disclose that exposure as rollover risk and also should disclose the maturity of the hedging derivative instrument and the maturity of the hedged item.
6. Market‐access risk. If a hedging derivative instrument creates market‐access risk, the government should disclose that exposure as market‐access risk.
7. Foreign currency risk. If a hedging derivative instrument exposes a government to foreign currency risk, the government should disclose the U.S. dollar balance of the hedging derivative instrument, organized by currency denomination and by type of derivative instrument.

Hedged debt. If the hedged item is a debt obligation, governments should disclose the hedging derivative instrument’s net cash flows based on the requirements established by Statement 38, Certain Financial Statement Note Disclosures, paragraphs 10 and 11.

Other quantitative methods of evaluating effectiveness. If effectiveness is evaluated by application of a quantitative method not specifically identified in GASBS 53, governments should disclose the following information. However, there is no requirement to disclose information that a pricing service considers to be proprietary and after making every reasonable effort the pricing service declines to make available. This fact, however, should be disclosed.

1. The identity and characteristics of the method used.
2. The range of critical terms the method tolerates.
3. The actual critical terms of the hedge.

Investment Derivative Instruments

For investment derivative instruments, GASBS 53 requires governments to disclose their exposure to the following risks that could give rise to financial loss. Risk disclosures are limited to investment derivative instruments that are reported as of the end of the reporting period. Disclosures required by this section may contain information that also is required by other sections. However, these disclosures should be presented in the context of an investment derivative instrument’s risk:

1. Credit risk. If an investment derivative instrument exposes a government to credit risk (that is, the government reports the investment derivative instrument as an asset), the government should disclose that exposure.
2. Interest rate risk. If an investment derivative instrument exposes a government to interest rate risk, the government should disclose that exposure consistent with the disclosures required by GASBS 40, paragraphs 14 and 15. Further, an investment derivative instrument that is an interest rate swap is an additional example of an investment that has a fair value that is highly sensitive to interest rate changes as discussed in GASBS 40, paragraph 16. The fair value, notional amount, reference rate, and embedded options should be disclosed.
3. Foreign currency risk. If an investment derivative instrument exposes a government to foreign currency risk, the government should disclose that exposure consistent with the disclosures required by GASBS 40, paragraph 17.

Contingent Features

GASBS 53 provides that governments should disclose contingent features that are included in derivative instruments held at the end of the reporting period, such as a government’s obligation to post collateral if the credit quality of the government’s hedgeable item declines. For derivative instruments with contingent features reported as of the end of the reporting period, disclosure should include:

1. The existence and nature of contingent features and the circumstances in which the features could be triggered.
2. The aggregate fair value of derivative instruments that contain those features.
3. The aggregate fair value of assets that would be required to be posted as collateral or transferred in accordance with the provisions related to the triggering of the contingent liabilities.
4. The amount, if any, that has been posted as collateral by the government as of the end of the reporting period.

Hybrid Instruments

If a government reports a hybrid instrument, GASBS 53 requires that disclosures of the companion instrument be consistent with disclosures required of similar transactions, for example, disclosures for debt instruments. In that case, the existence of an embedded derivative with the companion instrument should be indicated in the disclosures of the companion instrument. For example, if a government has entered into a hybrid instrument that consists of a borrowing for financial reporting purposes and an interest rate swap, the government’s disclosure should indicate the existence of the interest rate swap within the debt disclosure.

Synthetic Guaranteed Investment Contracts

Governments that report an SGIC that is fully benefit‐responsive, as described above, are required to disclose the following information in the notes to the financial statements as of the end of the reporting period:

1. A description of the nature of the SGIC.
2. The SGIC’s fair value (including separate disclosure of the fair value of the wrap contract and the fair value of the corresponding underlying investments).