660a1 e

The Supervisor of Banks: Reporting Provisions to the Public [2](10/02)
Annual Financial Report

Page 661-22

Part A1 - Accounting for Derivative Instruments and Hedging Activities

Introduction (10/02)

a. This Provision addresses the accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and hedging activities.

b. In developing the standards in these Provisions, the following four fundamental decisions
should serve as cornerstones underlying those standards:

1. Derivative instruments represent rights or obligations that meet the definitions of assets or
liabilities and should be reported in financial statements.

2. Fair value is the most relevant measure for financial instruments and the only relevant
measure for derivative instruments. Derivative instruments should be measured at fair
value, and adjustments to the carrying amount of hedged items should reflect changes in
their fair value (that is, gains or losses) that are attributable to the risk being hedged and
that arise while the hedge is in effect.

3. Only items that are assets or liabilities should be reported as such in financial statements.

4. Special accounting for items designated as being hedged should be provided only for
qualifying items. One aspect of qualification should be an assessment of the expectation
of effective offsetting changes in fair values or cash flows during the term of the hedge
for the risk being hedged.

c. This Provision standardizes the accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, by requiring that a banking corporation
recognise those items as assets or liabilities in the statement of financial position and measure
them at fair value. If certain conditions are met, a banking corporation may elect to designate a
derivative instrument as follows:

1. To hedge the exposure to changes in the fair value of a recognized asset or liability, or of
an unrecognized firm commitment,
1
that are attributable to a particular risk (referred to as
a fair value hedge).

1
An unrecognized firm commitment can be viewed as an executory contract that represents both a right and an
obligation. When a previously unrecognized firm commitment that is designated as a hedged item is accounted
for in accordance with this Provision, an asset or a liability is recognized and reported in the statement of
financial position related to the recognition of the gain or loss on the firm commitment. Consequently,
subsequent references to an asset or liability in this Provision include a firm commitment.
Page 661-23

2. To hedge the exposure to cashflow variability of a recognized asset or liability, or of a
forecasted transaction, that is attributable to a particular risk (referred to as a cash flow
hedge).

3. To hedge the foreign currency exposure of
*
:

(a) An unrecognized firm commitment (a foreign currency fair value
**
hedge).

(b) An available-for-sale equity security (a foreign currency fair value hedge).

(c) A forecasted transaction (a foreign currency cash flow hedge).

This Provision generally provides for matching between the timing of gain or loss recognition
on the hedging instrument and the recognition of:

(a) the changes in the fair value of the hedged asset or liability that are attributable to the
hedged risk, or

(b) the effect of earnings on the hedged forecasted transaction.

The Implementation Guidance provides guidance on identifying derivative instruments subject
to the scope of this Provision and on assessing hedge effectiveness and is an integral part of the
standards provided in this Provision.

*
Including exposure to foreign currency of a recognized asset or liability (fair value or cashflow hedge).
**
Or cashflow hedge in foreign currency.
28
Page 661-24

22B. Derivative instruments (10/02) (2/06)

a. A derivative instrument is a financial instrument or other contract with all three of the following
characteristics:

(1) It has (1) one or more underlyings and (2) one or more notional amounts
1
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.
2

(2) 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.

(3) 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.

Notwithstanding the foregoing, loan commitments that relate to the origination of mortgage loans
that will be held for sale shall be accounted for as derivative instruments by the issuer of the loan
commitment (that is, the potential lender). Paragraph 22B.(e)(7) provides a scope exception for the
accounting for loan commitments by issuers of certain commitments to originate loans and all
holders of commitments to originate loans (that is, the potential borrowers).

b. Underlying, notional amount, and payment provision. An underlying is a specified interest rate,
security price, commodity price, foreign exchange rate, index of prices or (foreign or interest) rates,
or other variable (including the occurrence or non-occurrence of a specified event such as a
scheduled payment under a contract). An underlying may be a price or rate of an asset or liability
but is not the asset or liability itself. A notional amount is a number of currency units, shares,
bushels, pounds or other units specified in the contract. The settlement of a derivative instrument
with a notional amount is determined by interaction of that notional amount with the underlying.
The interaction may be simple multiplication, or it may involve a formula with leverage factors or
other constants. A payment provision specifies a fixed or determinable settlement to be made if the
underlying behaves in a specified manner.

Next page 661-24.1

1
Sometimes other names are used. For example, the notional amount is called a face amount in some contracts.
2
The terms underlying, notional amount, payment provision, and settlement are intended to include the plural
forms. Including both the singular and plural forms used in this paragraph is more accurate but much more
awkward and impairs the readability.
28
Page 661-24.1

c. Initial net investment. Many derivative instruments require no initial net investment. Some require
an initial net investment as compensation for time value (for example, a premium on an option) or
for terms that are more or less favourable than market conditions (for example, a premium on a
forward purchase contract with a price less than the current forward price). Others require a mutual
exchange of currencies or other assets at inception, in which case the net investment is the
difference in the fair values of the assets exchanged. A derivative instrument does not require an
initial net investment in the contract that is equal to the notional amount (or the notional amount
plus a premium or minus a discount) or that is determined by applying the notional amount to the
underlying. If the initial net investment in the contract (after adjustment for the time value of
money) is less, by more than a nominal amount, than the initial net investment that would be
commensurate with the amount that would be exchanged either to acquire the asset related to the
underlying or to incur the obligation related to the underlying, the characteristic in paragraph (a)(2)
is met. The amount of that asset acquired or liability incurred should be comparable to the effective
notional amount of the contract.
42

d. Net settlement. A contract fits the description in paragraph a(3) if its settlement provisions meet one
of the following criteria:

(1) Neither party is required to deliver an asset that is associated with the underlying 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).
For example, most interest rate swaps do not require that either party deliver 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 of the type described in paragraph d(1) but
there is a market mechanism that facilitates net settlement, for example, an exchange that
offers a ready opportunity to sell the contract or to enter into an offsetting contract.

(3) One of the parties is required to deliver an asset of the type described in paragraph d(1) but
that asset is readily convertible to cash
2
or is itself a derivative instrument. An example of
that type of contract is a forward contract that requires delivery of an exchange-traded equity
security. Even though the number of shares to be delivered is the same as the notional
amount of the contract and the price of the shares is the underlying, an exchange-traded
security is readily convertible to cash. Another example is a swaption - an option to require
delivery of a swap contract, which is a derivative.

42
The effective notional amount is the stated notional amount adjusted for any leverage factor.
2
Assets that are readily convertible to cash have (1) interchangeable (fungible) units and (2) quoted prices
available in an active market that can rapidly absorb the quantity held by the entity without significantly
affecting the price. For contracts that involve multiple deliveries of the asset, the phrase in an active market that
can rapidly absorb the quantity held by the entity should be applied separately to the expected quantity in each
delivery.
Page 661-25

Derivative instruments embedded in other contracts are addressed in paragraphs 22C.

e. Notwithstanding the conditions in paragraphs a - d, the following contracts are not subject to the
requirements of this Provision:
(1) Regular-way security trades. Regular-way security trades are contracts that provide for
delivery of a security within the time generally established by regulations or conventions
in the marketplace or exchange in which the transaction is being executed. However, a
contract for an existing security does not qualify for the regular-way security trades
exception if it requires or permits net settlement (as discussed in paragraphs d(1) and
paragraph 22K.(a)(3)(a) or if a market mechanism to facilitate net settlement of that
contract (as discussed in paragraphs (d)(2) and paragraph 22K.(a)(3)(b)) exists, except as
provided in the following sentence. If an entity is required to account for a contract to
purchase or sell an existing security on a trade-date basis, rather than a settlement-date
basis, and thus recognizes the acquisition (or disposition) of the security at the inception
of the contract, then the entity shall apply the regular-way security trades exception to
that contract. A contract for the purchase or sale of when-issued securities or other
securities that do not yet exist is addressed in paragraph 22K.(c).

(2) Normal purchases and normal sales. Normal purchases and normal sales are contracts
that provide for the purchase or sale of something other than a financial instrument or
derivative instrument that will be delivered in quantities expected to be used or sold by
the reporting entity over a reasonable period in the normal course of business.

Page 661-26

The following guidance should be considered in determining whether a specific type of
contract qualifies for the normal purchases and normal sales exception:

(a) Forward contracts (non-option-based contracts). Forward contracts are eligible to
qualify for the normal purchases and normal sales exception. However, forward
contracts that contain net settlement provisions as described in either sub-paragraphs
(d)(1) or (d)(2), are not eligible for the normal purchases and normal sales exception
unless it is probable at inception and throughout the term of the individual contract
that the contract will not settle net and will result in physical delivery. Net settlement
(as described in sub-paragraphs (d)(1) and (d)(2)), of contracts in a group of contracts
similarly designated as normal purchases and normal sales would call into question
the classification of all such contracts as normal purchases or normal sales. Contracts
that require cash settlements of gains or losses or are otherwise settled net on a
periodic basis, including individual contracts that are part of a series of sequential
contracts intended to accomplish ultimate acquisition or sale of a commodity, do not
qualify for this exception.

(b) Freestanding option contracts. Option contracts that would require delivery of the
related asset at an established price under the contract only if exercised are not eligible
to qualify for the normal purchases and normal sales exception.

(c) Forward contracts that contain optionality features. Forward contracts that contain
optionality features that do not modify the quantity of the asset to be delivered under
the contract are eligible to qualify for the normal purchases and normal sales
exception. If an option component permits modification of the quantity of the assets to
be delivered, the contract is not eligible for the normal purchases and normal sales
exception, unless the option component permits the holder only to purchase or sell
additional quantities at the market price at the date of delivery. In order for forward
contracts that contain optionality features to qualify for the normal purchases and
normal sales exception the criteria discussed in sub-paragraph (e)(2)(a) must be met.

However, contracts that have a price based on an underlying that is not clearly and
closely related to the asset being sold or purchased (such as a price in a contract for the
sale of a grain commodity based in part on changes in the S&P Index) or that are
denominated in a foreign currency that meets none of the criteria in paragraphs 22C.d.(1)-
(4) shall not be considered normal purchases and normal sales. For contracts that qualify
for the normal purchases and normal sales exception, the entity shall document the
designation of the contract as a normal purchase or normal sale. For contracts that qualify
for the normal purchases and normal sales exception, under sub-paragraphs 2(a) and
(2)(c) the entity shall document the basis for concluding that it is probable that the
contract will not settle net and result in physical delivery. The documentation
requirements can be applied either to groups of similarly designated contracts or to each
individual contract. Failure to comply with the documentation requirements precludes
application of the normal purchases and normal sales exception to contracts that would
otherwise qualify for that exception.

Next page 661-26.1
Page 661-26.1

(3) Certain insurance contracts. Generally a contract of the type that is not subject to the
requirements of this Provision, if it entitles the holder to be compensated only if, as a
result of an identifiable insurance event (other than a change in price), the holder incurs a
liability or there is an adverse change in the value of a specific asset or liability for which
the holder is at risk. The following types of contracts written by insurance enterprises or
held by the banking corporation insured are not subject to the requirements of this
Provision for the reasons given:
(a) Traditional life insurance contracts. The payment of death benefits is the result of
an identifiable insurable event (death of the insured) instead of changes in a
variable.
(b) Traditional property and casualty contracts. The payment of benefits is the result
of an identifiable insurable event (for example, theft or fire) instead of changes in a
variable.
However, insurance enterprises enter into other types of contracts that may be subject to
the provisions of this Provision. In addition, some contracts with insurance or other
enterprises combine derivative instruments, as defined in this Provision with other
insurance products or non-derivative contracts, for example, indexed annuity contracts,
variable life insurance contracts, and property and casualty contracts that combine
traditional coverage with foreign currency options. Contracts that consist of both
derivative portions and non-derivative portions are addressed in paragraph 22C.a..

(4) Financial guarantee contracts. Financial guarantee contracts are not subject to this
Provision only if:
(a) they provide for payment to be made solely to reimburse the guaranteed party for
failure of the debtor to satisfy its required payment obligations under a non-
derivative contract, either at pre-specified payment dates or accelerated payment
dates as a result of the occurrence of an event of default (as defined in the financial
obligation covered by the guarantee contract) or notice of acceleration being made
to the debtor by the creditor.
(b) Payment under the financial guarantee is made only if the debtors obligation to
make payments as a result of conditions as described in sub-paragraph (4)(a) above
is past due.
(c) The guaranteed party is, as a pre-condition in the contract (or in the back-to-back
arrangement, if applicable) for receiving payment of any claim under the
guarantee, exposed to the risk of non-payment both at inception of the financial
guarantee contract and throughout its term either through direct legal ownership of
the guaranteed obligation or through a back-to-back arrangement with another
party that is required by the back-to-back arrangement to maintain direct ownership
of the guaranteed obligation.

In contrast financial guarantee contracts are subject to this Provision if they do not meet
all of the above three criteria, for example, if they provide for payments to be made in
response to changes in another underlying such as a decrease in a specified debtors
creditworthiness.

Page 661-27

(5) Certain contracts that are not traded on an exchange. Contracts that are not exchange-
traded are not subject to the requirements of this Provision if the underlying on which the
settlement is based is one of the following:
(a) A climatically or geological variable or other physical variable.
(b) The price or value of
(1) a non-financial asset of one of the parties to the contract provided that the
asset is not readily convertible to cash or
(2) a non-financial liability of one of the parties to the contract provided that the
liability does not require delivery of an asset that is readily convertible to
cash.
(c) Specified volumes of sales or service revenues of one of the parties to the contract.

If a contract has more than one underlying and some, but not all, of them qualify for one
of the exceptions in paragraphs e.(5)(a), e.(5)(b) and e.(5)(c), the application of this
Provision to that contract depends on its predominant characteristics. That is, the contract
is subject to the requirements of this Provision if all of its underlyings, considered in
combination, behave in a manner that is highly correlated with the behaviour of any of
the component variables that do not qualify for an exception.

(6) Derivatives that serve as impediments to sales accounting. A derivative instrument
(whether freestanding or embedded in another contract) whose existence serves as an
impediment to recognizing a related contract as a sale by one party or a purchase by the
counter-party is not subject to this Provision. For example, the existence of a guarantee of
the residual value of a leased asset by the lessor may be an impediment to treating a
contract as a sales-type lease, in which case the contract would be treated by the lessor as
an operating lease.

(7) Loan commitments. The holder of any commitment to originate a loan (that is, the
potential borrower) is not subject to the requirements of this Provision. Issuers of
commitments to originate mortgage loans that will be held for investment purposes, are
not subject to this Provision. In addition, issuers of loan commitments to originate other
types of loans (that is, other than mortgage loans) are not subject to the requirements of
this Provision.

f. Notwithstanding the conditions of paragraphs a - e, the reporting banking corporation shall not
consider the following contracts to be derivative instruments for purposes of this Provision:
(1) Contracts issued or held by that reporting banking corporation that are both:
(a) indexed to its own stock, and
(b) classified in stockholders equity in its statement of financial position.
(2) Contracts relating to share-based payment transactions, addressed in the Reporting
Provisions to the Public - Paragraph 41A.
(3) Contracts issued by the banking corporation which reports consideration from a business
combination. In applying this sub-paragraph, the issuer is consider to be the banking
corporation that is accounting for the combination using the purchase method.

Next page 661-27.1
Page 661-27.1

In contrast, the above exceptions do not apply to the counter-party in those contracts except for
investment contracts in investee corporations addressed in Provision 32 of the Reporting
Provision. In addition, a contract that a banking corporation either can or must settle by using its
own equity instruments but that is indexed in part or in full to something other than its own
stock can be a derivative instruments for the issuer under paragraphs a - e in which case it would
be accounted for as a liability or an asset in accordance with the requirements of this Provision.

Next page 661-28
Page 661-28

22C. Embedded derivative instruments (10/02)

a. Contracts that do not in their entirety meet the definition of a derivative instruments (refer to
paragraphs 22B.a - d), such as bonds, insurance policies, and leases, may contain embedded
derivative instruments - implicit or explicit terms that affect some or all of the cash flows or the
value of other exchanges required by the contract in a manner similar to a derivative instrument.
The effect of embedding a derivative instruments in another type of contract (the host
contract) is that some or all of the cash flows or other exchanges that otherwise would be
required by the host contract, whether unconditional or contingent upon the occurrence of a
specified event, will be modified based on one or more underlyings. An embedded derivative
financial instrument shall be separated from the host contract and accounted for as a derivative
instrument pursuant to this Provision if and only if all of the following criteria are met:

1. The economic characteristics and risks of the embedded derivative instruments are not
clearly and closely related to the economic characteristics and risks of the host contract.
Additional guidance on applying this criterion to various contracts containing embedded
derivative instruments is included in the Schedule to the Provision.

2. The contract (the hybrid instrument) that embodies both the embedded derivative
instruments and the host contract is not remeasured at fair value under otherwise
applicable generally accepted accounting principles with changes in fair value reported in
earnings as they occur.

3. A separate instrument with the same terms as the embedded derivative instruments
would, pursuant to paragraph 22B, be a derivative instruments subject to the requirements
of this Provision. (The initial net investment for the hybrid instrument shall not be
considered to be the initial net investment for the embedded derivative).

b. For purposes of applying the provisions of paragraph a., an embedded derivative instruments in
which the underlying is an interest rate or interest rate index
1
that alters net interest payments
that otherwise would be paid or received on an interest-bearing host contract is considered to be
clearly and closely related to the host contract unless either of the following conditions exist:

1. The hybrid instrument can contractually be settled in a such a way that the investor
(holder) would not recover substantially all of its initial recorded investment.
2

2. The embedded derivative meets both of the following conditions:

Next page 661-28.1

1
Examples are an interest rate cap or an interest rate collar. An embedded derivative instrument that alters net
interest payments based on changes in a stock price index (or another non-interest-rate index) is not
addressed in this paragraph.
2
The condition set out in this paragraph does not apply to situation which the terms of the hybrid instrument
permit, but do not require, the investor to settle the hybrid instrument in a manner that causes it not to
recover substantially all of its initial recorded investment, provided that the issuer does not have the
contractual right to demand settlement that causes the investor not to recover substantially all of its initial net
investment.
Page 661-28.1

(a) There is a possible future interest rate scenario (even though it may be remote) under
which the embedded derivative would at least double the investors initial rate of return
on the host contract.
(b) For each of the possible interest rate scenarios under which the investors initial rate of
return on the host contract would be doubled (as discussed under sub-paragraph
(b)(2)(a)), the embedded derivative would at the same time result in a rate of return that is
at least twice what otherwise would be the then-current market return (under each of
those future interest rate scenarios) for a contract that has the same terms as the host
contract and that involves a debtor with a credit quality similar to the issuers credit
quality at inception.

Even though the above conditions focus on the investors rate of return and the investors
recovery of its investment, the existence of either of those conditions would result in the
embedded derivative instruments not being considered clearly and closely related to the host
contract by both parties to the hybrid instrument. Because the existence of those conditions is
assessed at the date that the hybrid instrument is acquired (or incurred) by the reporting banking
corporation, the acquirer of a hybrid instrument in the secondary market could potentially reach
a different conclusion than could the issuer of the hybrid instrument due to applying the
conditions in this paragraph at different points in time.

c. However, interest-only strips and principal-only strips are not subject to the requirements of this
Provision provided they:
(1) initially resulted from separating the rights to receive contractual cash flows of a financial
instrument that, in and of itself, did not contain an embedded derivative that otherwise
would have been accounted for separately as a derivative pursuant to the provisions of
paragraphs a. and b., and
(2) do not incorporate any terms not present in the original financial instrument described
above.

d. An embedded foreign currency derivative instrument shall not be separated from the host
contract and considered a derivative instrument under paragraph a. if the host contract is not a
financial instrument and it requires payment(s) denominated in:
(1) the functional currency of any substantial party to that contract ,
(2) the currency in which the price of the related good or price that is acquired or delivered is
routinely denominated in international commerce,
1

(3) The local currency of any substantial party to the contract, or
(4) The currency used by a substantial party to the contract as if it were the functional
currency because the primary economic environment in which the party operates is highly
inflationary.

1
If similar transactions for a certain product or service are routinely denominated in international commerce
in various different currencies, the transaction does not qualify for the exception.
Page 661-29

The evaluation of whether a contract qualifies for the exception in this paragraph should be
performed only at the inception of the contract. Unsettled foreign currency transactions,
including financial instruments, that are monetary items and have their principal payments,
interest payments, or both denominated in a foreign currency are subject to the Reporting
Provisions to the Public - paragraphs 11 and 12 to recognize any foreign currency transaction
gain or loss in earnings and shall not be considered to contain embedded foreign currency
derivative instruments under this Provision. The same proscription applies to available-for-sale
or trading securities that have cash flows denominated in a foreign currency.

e. In these provisions, both (1) a derivative instruments included within the scope of this Provision
by paragraph 22B., and (2) an embedded derivative instrument that has been separated from a
host contract as required by paragraph a. are collectively referred to as derivative instruments. If
an embedded derivative instrument is separated from its host contract, the host contract shall be
accounted for based on generally accepted accounting principles applicable to instruments of
that type that do not contain embedded derivative instruments. If a banking corporation cannot
reliably identify and measure the embedded derivative instrument that paragraph a. requires be
separated from the host contract, the entire contract shall be measured at fair value with gain or
loss recognized in earnings, but it may not be designated as a hedging instrument pursuant to
this Provision.

Page 661-30

22D. Recognition of Derivatives and Measurement of Derivatives and Hedged Items (10/02)

a. A banking corporation shall recognize all of its derivative instruments in its statement of
financial position as either assets or liabilities depending on the rights or obligations under the
contracts. All derivative instruments shall be measured at fair value. The guidance in the
Reporting Provisions to the Public shall apply in determining the fair value of financial
instruments (derivative or hedged item). If expected future cash flows are used to estimate fair
value, those expected cash flows shall be the best estimate based on reasonable and supportable
assumptions and projections. All available evidence shall be considered in developing estimates
of expected future cash flows. The weight given to the evidence shall be commensurate with the
extent to which the evidence can be verified objectively. If a range is estimated for either the
amount or the timing of possible cash flows, the likelihood of possible outcomes shall be
considered in determining the best estimate of future cash flows.

b. The accounting for changes in the fair value (that is, gains or losses) of a derivative depends on
whether it has been designated and qualifies as part of a hedging relationship and, if so, on the
reason for holding it. Either all or a proportion of a derivative may be designated as the hedging
instrument. The proportion must be expressed as a percentage of the entire derivative so that the
profile of risk exposures in the hedging portion of the derivative is the same as that in the entire
derivative. (Thus, a banking corporation is prohibited from separating a compound derivative
into components representing different risks and designating any such component as the
hedging instrument except as permitted at the date of initial application by the transitional
provisions for 2003, in paragraph 1). Subsequent references in this Provision to a derivative as a
hedging instrument include the use of only a proportion of a derivative as a hedging instrument.
Two or more derivatives, or proportions thereof, may also be viewed in combination and jointly
designated as the hedging instrument. Gains and losses on derivative instruments are accounted
for as follows:

(1) No hedging designation. The gain or loss on a derivative instrument not designated as a
hedging instrument shall be recognized currently in earnings.

(2) Fair value hedge. The gain or loss on a derivative instrument designated and qualifying
as a fair value hedging instrument as well as the offsetting loss or gain on the hedged item
attributable to the hedged risk shall be recognized currently in earnings in the same
accounting period, as provided in paragraph 22E.c.- d..

(3) Cash flow hedge. The effective portion of the gain or loss on a derivative instrument
designated and qualifying as a cash flow hedging instrument shall be reported as a
component of other comprehensive income (outside earnings) under earnings (losses) net,
in respect of cashflow hedges and reclassified into earnings in the same period or periods
during which the hedged forecasted transaction affects earnings, as provided in
paragraphs 22F.c. and d.. The remaining gain or loss on the derivative instrument, if any,
shall be recognized currently in earnings, as provided in paragraph22Fc..

Page 661-31

(4) Foreign currency hedge. The gain or loss on a derivative instrument or nonderivative
financial instrument designated and qualifying as a foreign currency hedging instrument
shall be accounted for as follows:
(a) The gain or loss on the hedging derivative or nonderivative instrument in a hedge
of a foreign currency-denominated firm commitment and the offsetting loss or gain
on the hedged firm commitment shall be recognized currently in earnings in the
same accounting period, as provided in paragraph22G.c..
(b) The gain or loss on the hedging derivative instrument in a hedge of an available-
for-sale security and the offsetting loss or gain on the hedged available-for-sale
security shall be recognized currently in earnings in the same accounting period as
provided in paragraph 22G.e.
(c) The effective portion of the gain or loss on the hedging derivative instrument in a
hedge of a forecasted foreign-currency-denominated transaction shall be reported
as a component of other comprehensive income (outside earnings) under earnings
(losses) net, in respect of cashflow hedges and reclassified into earnings in the
same period or periods during which the hedged forecasted transaction affects
earnings, as provided in paragraph 22G.k. The remaining gain or loss on the
hedging instrument shall be recognized currently in earnings.

Page 661-32

22E. Fair Value Hedges (10/02) (2/06)

General

a. A banking corporation may designate a derivative instrument as hedging the exposure to
changes in the fair value of an asset or a liability or an identified portion thereof (hedged
item) that is attributable to a particular risk. Designated hedging instruments and hedged items
qualify for fair value hedge accounting if all of the following criteria and those in paragraph b.
are met:
(1) At inception of the hedge, there is formal documentation of the hedging relationship and
the banking corporations risk management objective and strategy for undertaking the
hedge, including identification of the hedging instrument, the hedged item, the nature of
the risk being hedged, and how the hedging instruments effectiveness in offsetting the
exposure to changes in the hedged items fair value attributable to the hedged risk will be
assessed. There must be a reasonable basis for how the banking corporation plans to
assess the hedging instruments effectiveness.
(a) For a fair value hedge of a firm commitment, the banking corporations formal
documentation at the inception of the hedge must include a reasonable method for
recognizing in earnings the asset or liability representing the gain or loss on the
hedged firm commitment.
(b) A banking corporations defined risk management strategy for a particular hedging
relationship may exclude certain components of a specific hedging derivatives
change in fair value, such as time value, from the assessment of hedge
effectiveness, as discussed in paragraph b. of Chapter 2 of the Implementation
Guidance.

(2) Both at inception of the hedge and on an ongoing basis, the hedging relationship is
expected to be highly effective in achieving offsetting changes in fair value attributable to
the hedged risk during the period that the hedge is designated. An assessment of
effectiveness is required whenever the financial statements or earnings are reported, and
at least every three months. If the hedging instrument (such as an at-the-money option
contract) provides only one-sided offset of the hedged risk, the increases (or decreases) in
the fair value of the hedging instrument must be expected to be highly effective in
offsetting the decreases (or increases) in the fair value of the hedged item. All
assessments of effectiveness shall be consistent with the risk management strategy
documented for that particular hedging relationship (in accordance with paragraph a(1)
above).

(3) If a written option is designated as hedging a recognized asset or liability, or an
unrecognized firm commitment, the combination of the hedged item and the written
option provides at least as much potential for gains as a result of a favourable change in

1

Page 661-33

the fair value of the combined instruments
1
as exposure to losses from an unfavourable
change in their combined fair value. That test is met if all possible percentage favourable
changes in the underlying (from zero to 100 percent) would provide at least as much gain
as the loss that would be incurred from an unfavourable change in the underlying of the
same percentage.
A combination of options (for example, an interest rate collar) entered into
contemporaneously shall be considered a written option if either at inception or over the
life of the contracts a net premium is received in cash or as a favourable rate or other
term. (Thus, a collar can be designated as a hedging instrument in a fair value hedge
without regard to the test in paragraph a.(3) unless a net premium is received).
Furthermore a derivative instrument that results from combining a written option and any
other non-option derivative shall be considered a written option.

A non-derivative instrument, such as a Government bond, shall not be designated as a
hedging instrument, except as provided in paragraph 22G.c. to this Provision.

The Hedged Item

b. An asset or a liability is eligible for designation as a hedged item in a fair value hedge if all of
the following criteria are met:

(1) The hedged item is specifically identified as either all or a specific portion of a
recognized asset or liability or of an unrecognized firm commitment.
2
The hedged item is
a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or
a portfolio of similar liabilities (or a specific portion thereof).
(a) If similar assets or similar liabilities are aggregated and hedged as a portfolio, the
individual assets or individual liabilities must share the risk exposure for which
they are designated as being hedged. The change in fair value attributable to the
hedged risk for each individual item in a hedged portfolio must be expected to
respond in a generally proportionate manner to the overall change in fair value of
the aggregate portfolio attributable to the hedged risk. That is, if the change in fair
value of a hedged portfolio attributable to the hedged risk was 10 percent during a
reporting period, the change in the fair values attributable to the hedged risk for
each item constituting the portfolio should be expected to be within a fairly narrow
range, such as 9 to 11 percent.

1
The reference to combined instruments refers to the written option and the hedged item, such as an
embedded purchased option.
2
A firm commitment that represents an asset or liability that a specific accounting standard prohibits
recognizing (such as a non-cancellable operating lease) may nevertheless be designated as the hedged item
in a fair value hedge. A supply contract which the contract price is fixed only in certain circumstances (such
as when the selling price is above an embedded price cap or below an embedded price floor) meets the
definition of a firm commitment for purposes of designating the hedged item in a fair value hedge. Provided
the embedded price cap or floor is considered clearly and closely related to the host contract and therefore is
not accounted for separately under paragraph 22C.(a), either party to the supply contract can hedge the fair
value exposure arising from the cap or floor.

Page 661-34

In contrast, an expectation that the change in fair value attributable to the hedged
risk for individual items in the portfolio would range from 7 to 13 percent would be
inconsistent with this Provision. In aggregating loans in a portfolio to be hedged, a
banking corporation may choose to consider some of the following characteristics,
as appropriate: loan type, loan size, nature and location of collateral, interest rate
type (fixed or variable) and the coupon interest rate (if fixed), scheduled maturity,
prepayment history of the loans (if seasoned) and expected prepayment
performance in varying interest rate scenarios.

(b) If the hedged item is a specific portion of an asset or liability (or of a portfolio of
similar assets or a portfolio of similar liabilities), the hedged item is one of the
following:
(1) a percentage of the entire asset or liability (or of the entire portfolio).
(2) one or more selected contractual cash flows (such as the portion of the asset
or liability representing the present value of the interest payments in the first
two years of a four-year debt instrument).
(3) a put option or a call option (including an interest rate or price cap or an
interest rate or price floor) embedded in an existing asset or liability that is
not an embedded derivative accounted for separately pursuant to paragraph
22C.a. of this Provision;
(4) The residual value in a lessors net investment in a direct financing or sales-
type lease.
If the entire asset or liability is an instrument with variable cash flows, the hedged
item cannot be deemed to be an implicit fixed-to-variable swap (or similar
instrument) perceived to be embedded in a host contract with fixed cash flows.

(2) The hedged item presents an exposure to the banking corporation to changes in fair value
attributable to the hedged risk that could affect reported earnings.

(3) The hedged item is not:
(a) An asset or liability that is re-measured with the changes in fair value attributable
to the hedged risk reported currently in earnings,
(b) an investment accounted for by the equity method,
(c) a minority interest in one or more consolidated subsidiaries,
(d) an equity investment in a consolidated subsidiary,
(e) a firm commitment either to enter into a business combination or to acquire or
dispose of a subsidiary, a minority interest, or an equity method investee, or
(f) an equity instrument issued by the banking corporation and classified in
stockholders equity in its financial position.

Page 661-35

(4) If the hedged item is all or a portion of a debt security (or a portfolio of similar debt
securities), that is classified as held-to-maturity in accordance with the Reporting
Provisions to the Public, the designated risk being hedged is the risk of changes in its fair
value attributable to credit risk, foreign exchange risk, or both. If the hedged item is an
option component of a held-to-maturity security that permits its pre-payment, the
designated risk being hedged is the risk of changes in the entire fair value of that option
component. (The designated hedged-risk of a held-to-maturity debt security cannot be the
risk of changes in fair value attributable to an interest rate risk.
If the hedged item is other than an option component that permits its pre-payment, the
designated hedged risk also may not be the risk of changes in its overall fair value).

(5) If the hedged item is a non-financial asset or liability (other than a non-financial firm
commitment with financial components), the designated risk being hedged is the risk of
changes in the fair value of the entire hedged asset or liability (reflecting its actual
location if a physical asset). That is, the price risk of a similar asset in a different location
or of a major ingredient may not be the hedged risk.

(6) If the hedged item is a financial asset or liability, or a non-financial firm commitment
with financial components, the designated risk being hedged is:
(a) The risk of changes in the overall fair value of the entire hedged item,
(b) the risk of changes in its fair value attributable to changes in the designated
benchmark interest rate, (hereinafter: "interest-rate risk").
(c) the risk of changes in its fair value attributable to changes in the related foreign
currency exchange rates (referred to as foreign exchange risk) (refer to paragraphs
22G. c.-e.), or
(d) the risk of changes in its fair value attributable to both changes in the obligors
credit-worthiness and changes in the spread over the benchmark interest rate with
respect to the hedged item's credit sector at inception of the hedge (referred to as
credit risk).
If the risk designated as being hedged is not the risk in paragraph b.(6)(a) above, two or
more of the other risks (interest rate risk, foreign currency exchange risk, and credit risk)
may simultaneously be designated as being hedged. The benchmark interest rate being
hedged in a hedge of interest rate risk must be specifically identified as part of the
designation and documentation at the inception of the hedging relationship. Ordinarily, an
entity should designate the same benchmark interest rate as the risk being hedged for
similar hedges, consistent with paragraph a of Chapter 2 of the Implementation Guidance;

Page 661-36

the use of different benchmark interest rates for similar hedges should be rare and must be
justified. In calculating the change in the hedged item's fair value attributable to changes
in the benchmark interest rate, the estimated cash flows used in calculating fair value
must be based on all of the contractual cash flows of the entire hedged item. Excluding
some of the hedged item's contractual cash flows (for example, the portion of the interest
coupon in excess of the benchmark interest rate) from the calculation is not permitted.
1
A
banking corporation may not simply designate pre-payment risk as the risk being hedged
for a financial asset. However, it can designate the option component of a pre-payable
instrument as the hedged item in a fair value hedge of the banking corporations exposure
to changes in the overall fair value of that pre-payment option, perhaps thereby
achieving the objective of the banking corporation's desire to hedge pre-payment risk. The
effect of an embedded derivative of the same risk class must be considered in designating
a hedge of an individual risk. For example, the effect of an embedded pre-payment option
must be considered in designating a hedge of interest-rate risk.

c. Gains and losses on a qualifying fair value hedge shall be accounted for as follows:

(1) The gain or loss on the hedging instrument shall be recognized currently in earnings.

(2) The gain or loss (that is, the change in fair value) on the hedged item attributable to the
hedged risk shall adjust the carrying amount of the hedged item and be recognized
currently in earnings.

If the fair value hedge is fully effective, the gain or loss on the hedging instrument, adjusted for
the component, if any, of that gain or loss that is excluded from the assessment of effectiveness
under the banking corporations defined risk management strategy for that particular hedging
relationship (as stated in paragraph b. in Chapter 2 of the Implementation Guidance), would
exactly offset the loss or gain on the hedged item attributable to the hedged risk.
Any difference that does arise would be the effect of hedge ineffectiveness, which consequently
is recognized currently in earnings. The measurement of hedge ineffectiveness for a particular
hedging relationship shall be consistent with the banking corporations risk management
strategy and the method of assessing hedge effectiveness that was documented at the inception
of the hedging relationship, as discussed in paragraph a.(1). Nevertheless, the amount of hedge
ineffectiveness recognized in earnings is based on the extent to which exact offset is not
achieved. Although a hedging relationship must comply with the banking corporations
established policy of what is considered highly effective pursuant to paragraph a.(2) in order
for that relationship to qualify for hedge accounting, that compliance does not assure zero

1
The first sentence of paragraph b.(1) that specifically permits the hedged item to be identified as either all or
a specific portion of a recognized asset or liability or of an unrecognized firm commitment is not affected by
the provisions in this sub-paragraph.

Page 661-37

ineffectiveness. Chapter 2 of the Implementation Guidance illustrates assessing hedge
effectiveness and measuring hedge ineffectiveness. Any hedge ineffectiveness directly affects
earnings because there will be no offsetting adjustment of a hedged items carrying amount for
the ineffective aspect of the gain or loss on the related hedging instrument.

d. If a hedged item is otherwise measured at fair value with changes in fair value reported in other
comprehensive income (such as an available-for-sale security), the adjustment of the hedged
items carrying amount discussed in paragraph c., shall be recognized in earnings rather than in
other comprehensive income in order to offset the gain or loss on the hedging instrument.

e. The adjustment of the carrying amount of a hedged asset or liability required by paragraph c.,
shall be accounted for in the same manner as other components of the carrying amount of that
asset or liability. For example, an adjustment of the carrying amount of a hedged asset held-for-
sale would remain part of the carrying amount of that asset until the asset is sold, at which point
the entire carrying amount of the hedged asset would be recognized as the cost of the item sold
in determining earnings. An adjustment of the carrying amount of a hedged interest-bearing
financial instrument shall be amortized to earnings; amortization shall begin from the date of the
inception of the hedge, according to the uniform yield method.

f. A banking corporation shall discontinue prospectively the accounting specified in paragraphs c.,
and d., for an existing hedge if any one of the following occurs:

(1) Any criterion in paragraphs a., and b., is no longer met.
(2) The derivative expires or is sold, terminated, or exercised.
(3) The banking corporation removes the designation of the fair value hedge.

In those circumstances, the banking corporation may elect to designate prospectively a new
hedging relationship with a different hedging instrument or, in the circumstances described in
paragraphs f.(1) to f.(3) above, a different hedged item or a hedged transaction if the hedging
relationship meets the criteria specified in paragraphs a. and b. for a fair value hedge or
paragraphs 22F. a., and b., for a cash flow hedge.

g. In general, if a periodic assessment indicates non-compliance with the effectiveness criterion in
paragraph a.(2), a banking corporation shall not recognize the adjustment of the carrying
amount of the hedged item described in paragraphs c., and d., after the last date on which
compliance with the effectiveness criterion was established. However, if the event or change in

Page 661-38

circumstances that caused the hedging relationship to fail the effectiveness criterion can be
identified, the banking corporation shall recognize in earnings the changes in the hedged items
fair value attributable to the risk being hedged that occurred prior to that event or change in
circumstances. If a fair value hedge of a firm commitment is discontinued because the hedged
item no longer meets the definition of a firm commitment, the banking corporation shall
derecognize any asset or liability previously recognized pursuant to paragraph c., (as a result of
an adjustment to the carrying amount for the firm commitment) and recognize a corresponding
loss or gain currently in earnings.

Impairment

h. An asset or liability that has been designated as being hedged and accounted for pursuant to
paragraphs c., - e., remains subject to the applicable requirements in generally accepted
accounting principles for assessing impairment for that type of asset or for recognizing an
increased obligation for that type of liability. Those impairment requirements shall be applied
after hedge accounting has been applied for the period and the carrying amount of the hedged
asset or liability has been adjusted pursuant to paragraph c., of this Provision. Because the
hedging instrument is recognized separately as an asset or liability, its fair value or expected
cash flows shall not be considered in applying those impairment requirements to the hedged
asset or liability.

Page 661-39

22F. Cash Flow Hedges (10/02)

General

a. A banking corporation may designate a derivative instrument as hedging the exposure to
variability in expected future cash flows that is attributable to a particular risk. That exposure
may be associated with an existing recognized asset or liability (such as all or certain future
interest payments on variable-rate debt) or a forecasted transaction (such as a forecasted
purchase or sale)
1
. Designated hedging instruments and hedged items or transactions qualify for
cash flows hedge accounting if all of the following criteria and those in paragraph b., are met:

(1) At inception of the hedge, there is formal documentation of the hedging relationship and
the banking corporations risk management objective and strategy for undertaking the
hedge, including identification of the hedging instrument, the hedged transaction, the
nature of the risk being hedged, and how the hedging instruments effectiveness in
hedging the exposure to the hedged transactions variability in cash flows attributable to
the hedged risk will be assessed. There must be a reasonable basis for how the banking
corporation plans to assess the hedging instruments effectiveness.

(a) A banking corporations defined risk management strategy for a particular hedging
relationship may exclude certain components of a specific hedging derivatives
change in fair value from the assessment of hedge effectiveness, as discussed in
paragraph b. in Chapter 2 of the Implementation Guidance.

(b) Documentation shall include all relevant details, including the date on or period
within which the forecasted transaction is expected to occur, the specific nature of
asset or liability involved (if any), and the expected currency amount or quantity of
the forecasted transaction.

(1) The phrase expected currency amount refers to hedges of foreign currency
exchange risk and requires specification of the exact amount of foreign
currency being hedged.

(2) The phrase expected quantity refers to hedges of other risks and requires
specification of the physical quantity (that is, the number of items or units of
measure) encompassed by the hedged forecasted transaction. If a forecasted
sale or purchase is being hedged for price risk, the hedged transaction cannot
be specified solely in terms of expected currency amounts, nor can it be
specified as a percentage of sales or purchases during a period. The current
price of a forecasted transaction also should be identified to satisfy the
criterion of paragraph a.(2) for offsetting cash flows.

1
For purposes of paragraphs 22F., the individual cash flows related to a recognized asset or liability and the
cash flows related to a forecasted transaction are both referred to as a forecasted transaction or hedged
transaction.

Page 661-40

The hedged forecasted transaction shall be described with sufficient specificity so that
when a transaction occurs, it is clear whether that transaction is or is not the hedged
transaction. Thus, the forecasted transaction could be identified as the sale of either the
first 15,000 units of a specific product sold during a specified 3-month period or the first
5,000 units of a specific product sold in each of 3 specific months, but it could not be
identified as the sale of the last 15,000 units of that product sold during a 3-month period
(because the last 15,000 units cannot be identified when they occur, but only when the
period has ended).

(2) Both at inception of the hedge an on an ongoing basis, the hedging relationship is
expected to be highly effective in achieving offsetting cash flows attributable to the
hedged risk during the term of the hedge, except as indicated in paragraph a.,(4) below.
An assessment of effectiveness is required whenever financial statements are reported,
and at least every three months. If the hedging instrument, such as an at-the-money option
contract, provides only one-sided offset against the hedged risk, the cash inflows
(outflows) from the hedging instrument must be expected to be highly effective in
offsetting the corresponding change in the cash outflows or inflows of the hedged
transaction. All assessments of effectiveness shall be consistent with the originally
documented risk management strategy for that particular hedging relationship.

(3) If a written option is designated as hedging the variability in cash flows for a recognized
asset or liability or an unrecognized firm commitment, the combination of the hedged
item and the written option provides at least as much potential for favourable cash flows
as exposure to unfavourable cash flows. That test is met if all possible percentage
favourable changes in the underlying (from zero to 100 percent) would provide at least as
much favourable cash flows as the unfavourable cash flows that would be incurred from
an unfavourable change in the underlying of the same percentage (see paragraph.a.(3) of
paragraph 22E).

(4) If a hedging instrument is used to modify the interest receipts or payments associated
with a recognized financial asset or liability from one variable rate to another variable
rate, the hedging instrument must be a link between an existing designated asset (or group
of similar assets) with variable cash flows and an existing designated liability (or group of
similar liabilities) with variable cash flows and be highly effective at achieving offsetting
cash flows. A link exists if the basis (that is, the rate index on which the interest rate is
based) of one leg of an interest rate swap is the same as the basis of the interest receipts
for the designated asset and the basis of the other leg of the swap is the same as the basis
of the interest payments for the designated liability. In this situation, the criterion in the
first sentence in paragraph b.(1) is applied separately to the designated asset and the
designated liability.

A non-derivative instrument such as a Government bond shall not be designated as a hedging
instrument for a cash flow hedge.
Page 661-41

The Hedged Forecasted Transaction

b. A forecasted transaction is eligible for designation as a hedged transaction in a cash flows hedge
if all of the following additional criteria are met:

(1) The forecasted transaction is specifically identified as a single transaction or a group of
individual transactions. If the hedged transaction is a group of individual transactions,
those individual transactions must share the same risk exposure for which they are
designated as being hedged. Thus, a forecasted purchase and a forecasted sale cannot both
be included in the same group of individual transactions that constitute the hedged
transaction.

(2) The occurrence of the forecasted transaction is probable

(3) The forecasted transaction is a transaction with a party external to the reporting banking
corporation and presents an exposure to variations in cash flows for the hedged risk that
could affect reported earnings.

(4) The forecasted transaction is not the acquisition of an asset or incurrence of a liability that
will subsequently be re-measured with changes in fair value attributable to the hedged
risk reported currently in earnings. If the forecasted transaction relates to a recognized
asset or liability, the asset or liability is not re-measured with changes in fair value
attributable to the hedged risk reported currently in earnings.

(5) If the variable cash flows of the forecasted transaction relate to a debt security that is
classified as held-to-maturity, the risk being hedged is the risk of changes in its cash
flows attributable to credit-risk, foreign exchange risk, or both. For those variable cash
flows, the risk being hedged cannot be the risk of changes in cash flows attributable to
interest rate risk.

(6) The forecasted transaction does not involve a business combination and is not a
transaction (such as a forecasted purchase, sale, or dividend) involving:
(a) a parent companys interests in consolidated subsidiaries,
(b) a minority interest in a consolidated subsidiary,
(c) an equity-method investment, or
(d) a banking corporations own equity instruments.

(7) If the hedged transaction is the forecasted purchase or sale of a non-financial asset, the
designated risk being hedged is:

(a) the risk of changes in the functional-currency-equivalent cash flows attributable to
changes in the related foreign currency exchange rates, or
(b) The risk of changes in the cash flows relating to all changes in the purchase price
or sales price of the asset, reflecting its actual location if a physical asset, (whether

.

Page 661-42

such price and the related cash flows functional are denominated in the banking
corporation's currency or foreign-currency-denominated) not the risk of changes in
the cash flows relating to the purchase or sale of a similar asset in a different
location or of a major ingredient.

(8) If the hedged transaction is the forecasted purchase or sale of a financial asset or liability
(or the interest payments on that financial asset or liability) or the variable cash inflow or
outflow of an existing financial asset or liability, the designated risk being hedged is:

(a) the risk of overall changes in the hedged cash flows related to the asset or liability,
such as those relating to all changes in the purchase price or sales price (regardless
of whether that price and the related cash flows are stated in the banking
corporations functional currency or a foreign currency),
(b) the risk of changes in its cash flows attributable to changes in the designated
benchmark interest rate (referred to as interest rate risk),
(c) the risk of changes in the functional-currency-equivalent cash flows attributable to
changes in the related foreign currency exchange rates (referred to as foreign
exchange risk) (refer to paragraphs 22G., g. - j.,), or
(d) the risk of changes in its cash flows attributable to default, changes in the obligors
credit-worthiness, and changes in the spread over the benchmark interest rate with
respect to the hedged item's credit sector at inception of the hedge (referred to as
credit risk).
Two or more of the above risks may be designated simultaneously as being hedged. The
benchmark interest rate being hedged in a hedge of interest rate risk must be specifically
identified as part of the designation and documentation at the inception of the hedging
relationship. Ordinarily, an entity should designate the same benchmark interest rate as
the risk being hedged for similar hedges, consistent with paragraph a., of Chapter 2 of the
Application Guide; the use of different benchmark interest rates for similar hedges should
be rare and must be justified. In a cash flow hedge of a variable-rate financial asset or
liability, either existing or forecasted, the designated risk being hedged cannot be the risk
of changes in its cash flows attributable to changes in the specifically identified
benchmark interest rate if the cash flows of the hedge transaction are explicitly based on a
different index, for example, based on a specific bank's prime rate, which cannot qualify
as the benchmark rate. However, the risk designated as being hedged could potentially be
the risk of overall changes in the hedged cash flows related to the asset or liability,
Page 661-43

provided that the other criteria for a cash flow hedge have been met. A banking
corporation may not designate the risk of pre-payment as the risk being hedged (refer to
paragraph 22 E.b.(6)).

c. The effective portion of the gain or loss on a derivative designated as a cash flow hedge is
reported in other comprehensive income, in earnings (losses) net in respect of cashflow hedges,
and the ineffective portion is reported in earnings. More specifically, a qualifying cash flow
hedge shall be accounted for as follows:

(1) If a banking corporations defined risk management strategy for a particular hedging
relationship excludes a specific component of the gain or loss, or related cash flows, on
the hedging derivative from the assessment of hedge effectiveness (as discussed in
paragraph b., Chapter 2 of the Implementation Guidance), that excluded component of the
gain or loss shall be recognized currently in earnings. For example, if the effectiveness of
a hedge with an option contract is assessed based on changes in the options intrinsic
value, the changes in the options time value would be recognized in earnings. Time
value is equal to fair value of the option less its intrinsic value.

(2) Accumulated other comprehensive income associated with the hedged transaction shall
be adjusted to a balance that reflects the lesser of the following (in absolute amounts):

(a) The cumulative gain or loss on the derivative from inception of the hedge less:
(1) the excluded component discussed in paragraph c.(1) above and
(2) the derivatives gains or losses previously reclassified from accumulated
other comprehensive income into earnings pursuant to paragraph d.

(b) The portion of the cumulative gain or loss on the derivative necessary to offset the
cumulative change in expected future cash flows on the hedged transaction from
inception of the hedge less the derivatives gains or losses previously reclassified
from accumulated other comprehensive income into earnings pursuant to paragraph
d.
That adjustment of accumulated other comprehensive income shall incorporate
recognition in other comprehensive income of part or all of the gain or loss on the
hedging derivative, as necessary.

(3) A gain or loss shall be recognized in earnings, as necessary, for any remaining gain or
loss on the hedging derivative or to adjust other comprehensive income to the balance
specified in paragraph (c)(2) above.

(4) In a cash flow hedge of the variability of the functional-currency-equivalent cash flows
for a recognized foreign-currency-denominated asset or liability that is remeasured
according to the Reporting Provisions to the Public, the following will apply:
(a) If a non-option based contract is the hedging instrument in a cashflow hedge of the
variability of the cashflows for a recognized foreign currency denominated asset or
liability that is remeasured as stated, an amount that will offset the related
transaction gain or loss arising from that remeasurement shall be reclassified each
period from other comprehensive income to earnings.

Page 661-44

If the assessment of effectiveness and measurement of ineffectivess are based on
total changes in the non-option based instruments cashflows.

(b) If an option contract is used as the hedging instrument in a cashflow hedge of the
variability of the functional-currency-denominated asset or liability that is
remeasured as stated, to provide only one-sided offset against the hedged foreign
exchange risk, an amount shall be reclassified each period to or from other
comprehensive income with respect to the changes in the underlying that result in a
change in the hedging options intrinsic value. In addition, if the assessment of
effectiveness and measurement of ineffectiveness are also based on total changes in
the options cash flows (that is, the assessment will include the hedging
instruments entire change in fair value its entire gain or loss), an amount that
adjusts earnings for the amortization of the cost of the option on a rational basis
shall be reclassified each period from other comprehensive income to earnings.
1

Section 2 of the Implementation Guidance illustrates assessing hedge effectiveness and
measuring hedge ineffectiveness.

d. Amounts in accumulated other comprehensive income shall be re-classified into earnings in the
same period or periods during which the hedged forecasted transaction affects earnings (for
example, when a forecasted sale actually occurs). If the hedged transaction results in the
acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other
comprehensive income shall be reclassified into earnings in the same period or periods during
which the asset acquired or liability incurred affects earnings (such as in the periods that
depreciation expense or interest expense is recognized). However, if a banking corporation
expects at any time that continued reporting of a loss in accumulated other comprehensive
income would lead to recognizing a net loss on the combination of the hedging instrument and
the hedged transaction (and related asset acquired or liability incurred) in one or more future
periods, a loss shall be reclassified immediately into earnings for the amount that is not expected
to be recovered. For example, a loss shall be reported in earnings for a derivative that is
designated as hedging a forecasted credit-advance transaction to the extent that the carrying
amount of the advanced plus the related amount reported in accumulated other comprehensive
income exceeds the amount expected to be recovered on the credit advanced. (Impairment
guidance is provided in paragraphs g. and h.).

e. A banking corporation shall discontinue prospectively the accounting specified in paragraphs c.,
and d., for an existing hedge if any one of the following occurs:

(1) Any criterion in paragraphs a. and b. is no longer met.

Next page 661-44.1

1
The guidance in this sub-paragraph is limited to foreign currency hedging relationships because of their
unique attributes. That accounting guidance is an exception for foreign currency hedging relationships.
Page 661-44.1

(2) The derivative expires or is sold, terminated, or exercised.
(3) The banking corporation removes the designation of the cash flow hedge.

In those circumstances, the net gain or loss shall remain in accumulated other comprehensive
income and be reclassified into earnings as specified in paragraph d. Furthermore, the banking
corporation may elect to designate prospectively a new hedging relationship with a different
hedging instrument or, in the circumstances described in paragraphs e.(1) and e.(3), a different
hedged transaction or a hedged item if the hedging relationship meets the criteria specified in
paragraphs a., and b., for a cash flow hedge or paragraphs 22E. a., and b., for a fair value hedge.
f. The net derivative gain or loss related to a discontinued cash flow hedge shall continue to be
reported in accumulated other comprehensive income unless it is probable that the forecasted
transaction will not occur by the end of the originally specified time period (as documented at
the inception of the hedging relationship) or within an additional two-month period of time
thereafter, except as indicated in the following sentence. In rare cases, the existence of
extenuating circumstances that are related to the nature of the forecasted transaction and are
outside the control or influence of the reporting entity may cause the forecasted transaction to be
probable of occurring on a date that is beyond the additional two-month period of time, in which
case the net derivative gain or loss related to the discontinued cash flow hedge shall continue to
be reported in accumulated other comprehensive income until it is reclassified into earnings
pursuant to paragraph d. If it is probable that the hedged forecasted transaction will not occur
either by the end of the originally specified time period or within the additional two-month
period of time and the hedged forecasted transaction also does not qualify for the exception
described in the preceding sentence, that derivative gain or loss reported in accumulated other
comprehensive income shall be reclassified into earnings immediately.

g. Existing requirements in generally accepted accounting principles for assessing asset
impairment or recognizing an increased obligation apply to an asset or liability that gives rise to
variable cash flows (such as a variable-rate financial instrument), for which the variable cash
flows (the forecasted transactions) have been designated as being hedged and accounted for
pursuant to paragraphs c. and d. Those impairment requirements shall be applied each period
after hedge accounting has been applied for the period pursuant to paragraphs c. and d. of this
Provision. The fair value or expected cash flows of a hedging instrument shall not be considered
in applying those requirements. The gain or loss on the hedging instrument in accumulated other
comprehensive income shall, however, be accounted for as discussed in paragraph d.

Next page 661-45
Page 661-45

h. If, under existing requirements in generally accepted accounting principles, an impairment loss
is recognized on an asset or an additional obligation is recognized on a liability to which a
hedged forecasted transaction relates, any offsetting net gain related to that transaction in
accumulated other comprehensive income shall be reclassified into earnings. Similarly, if a
recovery is recognized on the asset or liability to which the forecasted transaction relates, any
offsetting net loss that has been accumulated in other comprehensive income shall be
reclassified immediately into earnings.
Page 661-46

22G. Foreign Currency Hedges (10/02) (2/06)

a. If the hedged item is denominated in foreign currency, a banking corporation may designate the
following types of hedges of foreign currency exposure,
1
as specified in paragraphs b. - k:

(1) A fair value hedge of an unrecognized firm commitment or a recognized asset or liability
(including an available-for-sale security).
(2) A cash flow hedge of a forecasted transaction, an unrecognized firm commitment, the
forecasted functional-currency-equivalent cash flows associated with a recognized asset
or liability, or a forecasted intercompany transaction.

The recognition in earnings of the foreign currency transaction gain or loss on a foreign-
currency-denominated asset or liability based on changes in the foreign currency spot rate is not
considered to be the remeasurement of that asset or liability with changes in fair value
attributable to foreign exchange risk recognized in earnings, which is discussed in the criteria in
paragraphs 22E.b.(3)(a) and b.(4) of paragraph 22F. Thus, those criteria are not impediments to
either a foreign currency fair value or cash flow hedge of such a foreign-currency-denominated
asset or liability or a foreign currency cash flow hedge of the forecasted acquisition or
incurrence of a foreign-currency-denominated asset or liability whose carrying amount will be
remeasured at spot exchange rates according to the Reporting Provisions to the Public. A
foreign currency derivative instrument that has been entered into with another member of a
consolidated group can be a hedging instrument in a fair value hedge or in a cash flow hedge of
a recognized foreign-currency-denominated asset or liability in the consolidated financial
statements only if that other member has entered into an offsetting contract with an unrelated
third party to hedge the exposure it acquired from issuing the derivative instrument to the
affiliate that initiated the hedge.

b. The provisions of paragraph a., that permit a recognized foreign-currency-denominated asset or
liability to be the hedged item in a fair value or cash flow hedge of foreign currency exposure
also pertain to a recognized foreign-currency-denominated receivable or payable that results
from a hedged forecasted foreign-currency-denominated sale or purchase on credit. A banking
corporation may choose to designate a single cash flow hedge that encompasses the variability

Next page 661-46.1

1
Notwithstanding the foregoing, a banking corporation is entitled not to vary the accounting treatment of
foreign currency hedged relationships that will be applied in the financial statements of a subsidiary or
branch abroad, that are the remote extension of the banking corporation, if the financial statements are:
(a) Drawn according to the U.S. GAAP (accepted accounting rules in the U.S.) or according to International
Financial Reporting Standards published by the International Accounting Standards Board, and
(b) Have been included in the report of the extension, to its own governing authority.
Page 661-46.1

of functional currency cash flows attributable to foreign exchange risk related to the settlement
of the foreign-currency-denominated receivable or payable resulting from a forecasted sale or
purchase on credit. Alternatively, a banking corporation may choose to designate a cash flow
hedge of the variability of functional currency cash flows attributable to foreign exchange risk
related to a forecasted foreign-currency-denominated sale or purchase on credit and then
separately designate a foreign currency fair value hedge of the resulting recognized foreign-
currency-denominated receivable or payable. In that case, the cash flow hedge would terminate
(be dedesignated) when the hedged sale or purchase occurs and the foreign-currency-
denominated receivable or payable is recognized. The use of the same foreign currency
derivative instruments for both the cash flow hedge and the fair value hedge is not prohibited
though some ineffectiveness may result.

Next page 661-47
Page 661-47

Foreign Currency Fair Value Hedges

c. Unrecognized firm commitment. A derivative instrument or a nonderivative financial
instrument
1
that may give rise to a foreign currency transaction gain or loss under the Reporting
Provisions to the Public can be designated as hedging changes in the fair value of an
unrecognized firm commitment, or a specific portion thereof, attributable to foreign currency
exchange rates. The designated hedging relationship qualifies for the accounting specified in
paragraphs c., - h., of paragraph 22E, if all the fair value hedge criteria in paragraphs a., and b.,
of paragraph 22E. and the conditions in paragraphs h., and i., are met.

d. Recognized asset or liability. A nonderivative financial instrument shall not be designated as the
hedging instruments in a fair value hedge of the foreign currency exposure of a recognized asset
or liability. A derivative instruments can be designated as hedging the changes in the fair value
of a recognized asset or liability (or a specific portion thereof) for which a foreign currency
transaction gain or loss is recognized in earnings under the provisions of the Reporting
Provisions to the Public. All recognized foreign-currency-denominated assets or liabilities for
which a foreign currency transaction gain or loss is recorded in earnings may qualify for the
accounting specified in paragraphs c., - h., of paragraph 22E., if all the fair value hedge criteria
in paragraphs a., and b., of paragraph 22E. and the conditions mentioned in paragraphs h., and
i., are met.

e. Available-for-sale security. A nonderivative financial instrument shall not be designated as the
hedging instrument in a fair value hedge of the foreign currency exposure of an available-for-
sale security. An available-for-sale equity security can be hedged for changes in the fair value
attributable to changes in foreign currency exchange rate and qualify for the accounting
specified in paragraphs c., - h., of paragraph 22E/ only if the fair value hedge criteria in
paragraphs a., and b., of paragraph 22E. are met and the following two conditions are satisfied:
(1) The security is not traded on an exchange (or other established marketplace) on which
trades are denominated in the investors functional currency.
(2) Dividends or other cash flows to holders of the security are all denominated in the same
foreign currency as the currency expected to be received upon sale of the security.

1
This Provision does not relate to the carrying basis for a nonderivative financial instrument that gives rise to
a foreign currency transaction gain or loss under our Provisions.
Page 661-48

The change in fair value of the hedged available-for-sale equity security attributable to foreign
exchange risk is reported in earnings pursuant to paragraph d., of paragraph 22E. and not in
other comprehensive income.

f. Gains and losses on a qualifying foreign currency fair value hedge shall be accounted for as
specified in paragraphs c. - h. of paragraph 22E. The gain or loss on a nonderivative hedging
instrument attributable to foreign currency risk is the foreign currency transaction gain or loss as
determined under the Reporting Provisions to the Public - Annual Financial Statements
paragraphs 11 - 12.
1
That foreign currency transaction gain or loss shall be recognized currently
in earnings along with the change in the carrying amount of the hedged firm commitment.

Foreign currency Cash flow Hedges

g. A nonderivative financial instrument shall not be designated as a hedging instrument in a
foreign currency cash flows hedge. A derivative instruments designated as hedging the foreign
currency exposure to variability in the functional-currency-equivalent cash flows associated
with a forecasted transaction, a recognized asset or liability, an unrecognized firm commitment,
or a forecasted intercompany transaction qualifies for hedge accounting if all the following
criteria are met:

(1) For consolidated financial statements, either (1) the operating unit that has the foreign
currency exposure is a party to the hedging instruments or (2) another member of the
consolidated group that has the same functional currency as that operating unit (subject to
the restrictions in this sub-paragraph and related footnote) is a party to the hedging
instrument. To qualify for applying the guidance in (2) above, there may be no
intervening subsidiary with a different functional currency.
2
(Refer to paragraphs a., h.,
and i., for conditions for which an intercompany foreign currency derivative can be the
hedging instrument in a cash flow hedge of foreign exchange risk).

1
The foreign currency transaction gain or loss on a hedging instrument is determined, consistent with the
Reporting Provisions to the Public as the increase or decrease in functional currency cash flows attributable
to the change in spot exchange rates between the functional currency and the currency in which the hedging
instrument is denominated.
2
For example, if a dollar-functional, second-tier subsidiary has a Euro exposure, the dollar-functional
consolidated parent company could designate its U.S. dollar-Euro derivative as a hedge of the second-tier
subsidiary's exposure provided that the functional currency of the intervening first-tier subsidiary (that is, the
parent of the second-tier subsidiary) is also the U.S. dollar. In contrast, if the functional currency of the
intervening first-tier subsidiary was the Japanese yen (thus requiring the financial statements of the second-
tier subsidiary to be translated into yen before the yen-denominated financial statements of the first-tier
subsidiary are translated into U.S. dollars for consolidation), the consolidated parent company could not
designate its U.S. dollar-Euro derivative as a hedge of the second-tier subsidiary's exposure.

Page 661-49

(2) The hedged transaction is denominated in a currency other than the hedging units
functional currency.

(3) All of the criteria in paragraph a., and b., of paragraph 22F. are met.

(4) If the hedged transaction is a group of individual forecasted foreign-currency-
denominated transactions, a forecasted inflow of a foreign currency and a forecasted
outflow of the foreign currency cannot both be included in the same group.

(5) If the hedged item is a recognized foreign-currency-denominated asset or liability, all the
variability in the hedged item's functional-currency-equivalent cash flows must be
eliminated by the effect of the hedge. (for example: a cash flow hedge cannot be used
with a variable-rate foreign-currency-denominated asset or liability and a derivative based
solely on changes in exchange rates because the derivative does not eliminate all the
variability in the functional currency cash flows).

h. Internal derivative. A foreign currency derivative contract that has been entered into with
another member of a consolidated group (such as a treasury center) can be a hedging instrument
in a foreign currency cash flow hedge of a forecasted borrowing, purchase or sale or an
unrecognized firm commitment in the consolidated financial statements only if the following
two conditions are satisfied: (that foreign currency derivative instrument is hereafter in this
section referred to as internal derivative).
(1) From the perspective of the member of the consolidated group using the derivative as a
hedging instrument (hereinafter in this section referred to as the hedging affiliate), the
criteria for foreign currency cash flow hedge accounting in paragraph g., must be
satisfied.
(2) The member of the consolidated group not using the derivative as a hedging instrument
(hereinafter in this section referred to as the issuing affiliate) must either (1) enter into a
derivative contract with an unrelated third party to offset the exposure that results from
that internal derivative or (2) if the conditions in paragraph i., are met, enter into
derivative contracts with unrelated third parties that would offset, on a net basis for each
foreign currency, the foreign exchange risk arising from multiple internal derivative
contracts.

i. Offsetting net exposures. If an issuing affiliate chooses to offset exposure deriving from multiple
internal derivative contracts on an aggregate or net basis, the derivatives issued to hedging
affiliates may qualify as cash flow hedges in the consolidated financial statements only if all of
the following conditions are satisfied:

Page 661-50

(1) The issuing affiliate enters into a derivative contract with an unrelated third party to
offset, on a net basis for each foreign currency, the foreign exchange risk arising from
multiple internal derivative contracts, and the derivative contract with the unrelated third
party generates equal or closely approximating gains and losses when compared with the
aggregate or net losses and gains generated by the derivative contracts issued to affiliates.

(2) Internal derivatives that are not designated as hedging instruments are excluded from the
determination of the foreign currency exposure on a net basis that is offset by the third-
party derivative. In addition, non-derivative contracts may not be used as hedging
instruments to offset exposures arising from internal derivative contracts.

(3) Foreign currency exposure that is offset by a single net third-party contract arises from
internal derivative contracts that mature within the same 31-day period and that involve
the same currency exposure as the net third-party derivative. The offsetting net third-party
derivative related to that group of contracts must offset the aggregate or net exposure to
that currency, must mature within the same 31-day period, and must be entered into
within 3 business days after the designation of the internal derivatives as hedging
instruments.

(4) The issuing affiliate tracks the exposure that it acquires from each hedging affiliate and
maintains documentation supporting linkage of each internal derivative contract and the
offsetting aggregate or net derivative contract with an unrelated third party.

(5) The issuing affiliate does not alter or terminate the offsetting derivative with an unrelated
third party unless the hedging affiliate initiates that action. If the issuing affiliate does
alter or terminate the offsetting third-party derivative (which should be rare), the hedging
affiliate must prospectively cease hedge accounting for the internal derivatives that are
offset by that third-party derivative.

j. A member of a consolidated group is not permitted to offset exposures arising from multiple
internal derivative contracts on a net basis for foreign currency cash flow exposures related to
recognized foreign-currency-denominated assets or liabilities. That prohibition includes
situations in which a recognized foreign-currency-denominated asset or liability in a fair value
hedge or cash flow hedge results from the occurrence of a specifically identified forecasted
transaction initially designated as a cash flow hedge.

k. A qualifying foreign currency cash flows hedge shall be accounted for as specified in
paragraphs c - h of paragraph 22F.

Page 661-51

22H. Presentation in the financial statements

a. Embedded derivative instruments -
(1) Embedded derivative instruments that have been separated for measuring purposes
according to paragraph 22C., will be presented in the balance sheet together with the host
contract.
(2) It is clarified that an option that is added or attached to an existing debt instrument by a
third party, causing the investor in the debt instrument to have different counter parties to
the option and to the debt instrument, is not deemed to be an embedded derivative. The
term "embedded derivative" in a hybrid contract relates to the conditions comprised in a
single contract, and not to those included in separate contracts between different counter
parties.
(3) Notwithstanding this, gains (losses) net in respect of embedded derivative instruments are
to be classified similarly to the net gains (expenses) classification in respect of
freestanding derivative instruments, as set out below.

b. Changes in the fair value of an unrecognized firm commitment designated as hedged by a
fair value hedge, which can be attributed to the risk hedged, are to be presented in the balance
sheet under "other assets" or "other liabilities" (as appropriate). Presentation of these changes in
earnings will be as follows:

(1) The amount of the ineffectiveness will be presented in Note 20 (gains from financing
activity before provisions for doubtful debts) under the item "in respect of derivative
instruments and hedging activities - ineffective portion in hedging relationships."
(2) If a derivative instrument hedges the firm commitment, the effective portion of the hedge
will be presented in the same item as the gains or expenses in respect of the hedging
instrument.
(3) All other changes will be presented in Note 20 (Gains from financing activity before
provisions for doubtful debts), under the heading "in respect of assets - from other assets"
or "in respect of liabilities - other liabilities".

c. Gains from financing activity (before provisions for doubtful debts) in respect of
derivative instruments and hedging activities - the information will be included in Note 20
(Gains from financing activity before provisions for doubtful debts) and be divided into the
following four components:

(1) Effective component of the hedge, that will be presented together with gains or expenses
in respect of the hedged item.
1
This component will include the following three parts:

1
If the hedged item is an equity security, the effective component may be presented under gains (losses) from
net equity securities.
Page 661-52

(a) The effective portion of the hedge.
(b) Interest accrued (including linkage and exchange rate differentials) in respect of the
hedging derivative, that have not been included in the effective portion of the hedge
(sub-paragraph (a) above).
(c) Amortization of the adjustment of the carrying value of the hedged item.

In relation to a fair value hedge, the effective portion of the hedge will be immediately
posted to earnings.
In relation to a cashflow hedge, the effective portion of the hedge will be posted to equity
capital as a component of other comprehensive income in gains (losses) net in respect of
cashflows. This portion will be reclassified in earnings according to the rules set out in
this Provision, and be presented together with the results of the hedged item. The other
two portions will be posted currently to earnings.
Disclosure will be given of the net effect of hedging derivative instruments on financing
income in respect of assets, financing expenses in respect of other liabilities and earnings
(expenses) included in financing activity gains, that are not included in the ineffective
component of the hedging ratios.
(2) The ineffective component of the hedging relationships - this paragraph will include:

(a) the amount of the ineffectiveness of the hedges - the gain (loss) component in
respect of derivative instruments deriving from the ineffectiveness of the hedge, as
well as the amount of the ineffectiveness of fair value hedges, resulting from
changes in fair value of the hedged item attributable to the hedged risk,
(b) The gain (loss) component in respect of derivative instruments, which has been
removed to evaluate the effectiveness of the hedge.
(c) Net gains (losses) in respect of a firm commitment that is no longer qualified to be
a fair value hedge.
(d) Gains (losses) that have been reclassified due to the probability that the forecasted
transactions will not take place.

(3) Net gains (expenses) in respect of ALM derivative instruments - this item will include
changes in the balance sheet balance of derivative instruments, which were not designated
for hedging relationships, and which constitute part of the bank's assets and liability
management set up, except for changes deriving from revenues or payments.

(4) Net gains (expenses) in respect of other derivative instruments - which item will include
the changes in the balance sheet balance of non-hedging derivative instruments which do
not constitute part of the bank's assets and liability management setup, except for changes
deriving from revenues or payments.
Page 661-53

22I. Disclosures (10/02)

a. A banking corporation that holds or issues derivative instruments (or nonderivative instruments
that are designated and qualify as hedging instruments pursuant to paragraph b., of paragraph
22G) shall disclose its objectives for holding or issuing those instruments, the context needed to
understand those objectives, and its strategies for achieving those objectives. The description
shall distinguish between derivative instruments (and nonderivative instruments) designated as
fair value hedging instruments, derivative instruments designated as cash flows hedging
instruments, and all other derivatives. The description also shall indicate the banking
corporations risk management policy for each of those types of hedges, including a description
of the items or transactions for which risks are hedged. For derivative instruments not
designated as hedging instruments, the description shall indicate the purpose of the derivative
activity. Qualitative disclosures about a banking corporations objectives and strategies for
using derivative instruments may be more meaningful if such objectives and strategies are
described in the context of a banking corporations overall risk management profile. If
appropriate, a banking corporation is encouraged, but not required, to provide such additional
qualitative disclosures.

b.. A banking corporations disclosures for every reporting period for which a complete set of
financial statements is presented also shall include the following:

Fair value hedges

(1) For derivative instruments, as well as nonderivative instruments that may give rise to
foreign currency transaction gains or losses under the Reporting Provisions to the Public
- paragraphs 11 and 12, that have been designated and have qualified as fair value
hedging instruments and for the related hedged items:
(a) The net gain or loss recognized in earnings during the reporting period
representing:
(1) The amount of the hedges ineffectiveness and
(2) The component of the derivative instruments gain or loss, if any, excluded
from the assessment of hedge effectiveness,
and a description of where the net gain or loss is reported in earnings.
(b) The amount of net gain or loss recognized in earnings, when a hedged firm
commitment no longer qualifies as a fair value hedge.

Page 661-54

Cash flow hedges

(2) For derivative instruments that have been designated and have qualified as cash flows
hedging instruments and for the related hedged transactions:
(a) The net gain or loss recognized in earnings during the reporting period
representing:
(1) The amount of the hedges ineffectiveness and
(2) The component of the derivative instruments gain or loss, if any, excluded
from the assessment of hedge effectiveness,
and a description of where the net gain or loss is reported in the earnings
(b) A description of the transactions or other events that will result in the
reclassification into earnings of gains or losses that are reported in accumulated
other comprehensive income, and the estimated net amount of the existing gains or
losses at the reporting date that is expected to be reclassified into earnings within
the next 12 months.
(c) The maximum length of time over which the banking corporation is hedging its
exposure to the variability in future cash flows for forecasted transactions
excluding those forecasted transactions related to the payment of variable interest
on existing financial instruments.
(d) The amount of gains or losses reclassified into earnings as a result of the
discontinuance of cash flows hedges because it is probable that the original
forecasted transactions will not occur by the end of the originally specified time
period or within the additional period of time discussed in paragraph 22F.f.

The quantitative disclosures about derivative instruments may be more useful and less likely to
be perceived to be out of context or otherwise misunderstood, if similar information is disclosed
about other financial instruments or nonfinancial assets and liabilities to which the derivative
instruments are related by activity. Accordingly, in those situations, a banking corporation is
encouraged, but not required, to present a more complete picture of its activities by disclosing
that information.

.
Page 661-55

Activities in derivative instruments - volume, credit risks and details of maturity dates

c. The following information may be presented by a banking corporation in other sections of the
annual report if, in the opinion of the banking corporation's management, it is desirable in the
circumstances in order to assist the user of the reports to understand activity in derivative
instruments and if it has been clarified by appropriate reference in the body of the annual
financial report, that they constitute part of the financial statement itself.

d. According to the format included in the example contained in Note 18.B. information will be
disclosed of the nominal amount, gross positive fair value and gross negative fair value of
derivative instruments. Each contract is to be reported according to the risk exposure of its
underlying, as follows:

(1) Interest rate:
(a) Contracts to buy or sell a CPI-linked shekel in Israel in exchange for an unlinked
shekel.
(b) Other interest contracts.
(2) Foreign currency exchange rate.
(3) Equity instruments, or
(4) Commodities and others.

The information is to be included distinguishing between hedging derivative instruments and
derivative instruments that are part of the banking corporation's assets and liability management
setup (ALM) which have not been designated for hedging relationships, and other derivative
instruments. As to credit derivatives and foreign currency swap contracts, separate disclosure is
to be given.
In addition, the following data is to be detailed in the sample Note concerning:

(1) Credit risk in respect of derivative instruments:
(a) Gross positive fair value is to be presented of derivative instruments, the effect of
netting agreements, arrangements for net accounting and off-balance sheet credit
risk of derivative instruments, distinguishing between the different types of counter
parties to the derivative instruments.
(b) Disclosure is to be given of credit losses recognized in earnings from derivative
instruments.
(c) Disclosure is to be given of gross positive fair value of embedded derivative
instruments.
(d) Information is to be provided of the banking corporation's policy for the collateral
requirement against credit risks which exceed the activity in derivative instruments,
including:

(1) A general description of the material cash requirements for each type of
derivative instrument, including margin deposits and daily cash settlement.
(2) A description of the types of liquid collateral that are specifically required
against activity in derivative instruments.

Page 661-56

(3) Quantitative disclosure of such liquid collateral held by the banking
corporation on the report date, and the amount of the credit risk of the
derivative instruments secured by such liquid collateral.
(4) Information on the accessibility and realization of such collateral.

(2) A breakdown of the face value amounts according to maturity dates, distinguishing
between the foregoing bases.

e. With respect to Note 18.B.:

(1) A spot foreign currency swap contract is an agreement for immediate delivery, generally
within two business days, of a foreign currency according to the prevailing cash market
rate.
(2) Interest contracts do not include contracts involving one or more foreign currency swaps
(such as: cross-currency IRS and currency options) and other contracts whose
characterizing dominant risk is a foreign currency exchange rate risk, which will be
reported as foreign currency contracts;
(3) Foreign currency contracts include, inter alia, forward contracts for foreign currency
exchange which are generally settled after three or more business days following the
transaction date.
(4) Gross fair value and face value - all the transactions within the consolidated banking
corporation are to be reported on a net basis, that is, internal transactions within the
banking corporation do not need to be reported in Note 18.B. Other offsetting
arrangements of contracts for the purpose of presentation in Note 18.B., are not permitted.
Thus, setoffs are not to be made of: (a) commitments of banking corporations to buy from
third parties against commitments of the banking corporation to sell to third parties, (b)
options that have been written against options bought, (c) positive fair value against
negative fair value, or (d) contracts subject to bilateral netting agreements.
(5) It is clarified for the purpose of the presentation in Note 18.B., the face value is to be
given in shekel terms, as follows:
(a) In currency contracts, the contract amount will be presented according to one side
of the transaction:
(1) Where the transaction has one side in shekels and the other in foreign
currency, the amount in shekels will be presented as expressing the foreign
currency side.
(2) Where the transaction has two sides in foreign currency, the shekel amount
will be presented of the purchased side (asset receivable).
(b) In equity, commodities and other contracts - the face value amount multiplied by
the contract unit will be presented, where the contract unit price is the face value of
the contract.
(c) As to CPI-linked shekel swap contracts in unlinked shekels, the face value is the
amount of the contract in shekels (unlinked track).

Page 661-57

22J. Reporting Changes in the Components of Comprehensive income (10/02)

a. A banking corporation shall display as a separate classification within other
comprehensive income the net gain or loss on derivative instruments designated and
qualifying as cash flows hedging instruments that are reported in comprehensive income
pursuant to paragraphs 22F.c and 22G. k..

b. As part of the disclosures of accumulated other comprehensive income, a banking
corporation shall separately disclose the beginning and ending accumulated derivative
gain or loss, the related net change associated with current period hedging transactions,
and the net amount of any reclassifications into earnings.

Page 661-58

22K. Implementation Guidance - Chapter 1: Scope and Definitions (10/02)

Application of paragraph 22B.

a. The following discussion further explains the three characteristics of a derivative instrument
discussed in paragraphs 22B. a.-d..

(1) Underlying. An underlying is a variable that, along with either a notional amount or a
payment provision, determines the settlement of a derivative. An underlying usually is
one or a combination of the following:
(a) A security price or security price index.
(b) A commodity price or commodity price index.
(c) An interest rate or interest rate index.
(d) A credit rating or credit index.
(e) An exchange rate or exchange rate index.
(f) An insurance index or catastrophe loss index.
(g) A climatical or geological condition (such as temperature, earthquake severity or
rainfall), another physical variable, or a related index.

However, an underlying may be any variable whose changes are observable or otherwise
objectively verifiable. Paragraph 22B.e.(5) specifically excludes a contract with
settlement based on certain variables unless the contract is exchange-traded. A contract
based on any variable that is not specifically excluded is subject to the requirements of
this Provision if it has the other two characteristics identified in paragraph 22B.a. (which
also are discussed in paragraphs.a.(2) and a.(3) below).

(2) Initial net investment. A derivative requires no initial net investment or a small initial net
investment than other types of contracts and have a similar response to changes in market
factors. For example, entering into a commodity futures contract generally requires no
initial net investment, while purchasing the same commodity requires an initial net
investment equal to its market price. However, both contracts reflect changes in the price
of the commodity in the same way (that is, similar gains or losses will be incurred). A
swap or forward contract also generally does not require an initial net investment unless
the terms favour one party over the other. An option generally requires that one party
make an initial net investment (a premium) because that party has the rights under the
contract and the other party has the obligations.

Page 661-59

The phrase initial net investment is stated from the perspective of only one party to the
contract, but it determines the application of the Provision for both parties
1
.
(3) Net settlement. A contract that meets any one of the following criteria has the
characteristic described as net settlement:
(a) Its terms implicitly or explicitly require or permit net settlement. For example, a
penalty for non-performance in a purchase order is a net settlement provision if the
amount of the penalty is based on changes in the price of the items that are the
subject of the contract. Net settlement may be made in cash or by delivery of any
other asset, whether or not it is readily convertible to cash. A fixed penalty for non-
performance is not a net settlement provision.
(b) There is an established market mechanism that facilitates net settlement outside the
contract. The term market mechanism is to be interpreted broadly. Any institutional
arrangement or other agreement that enables either party to be relieved of all rights
and obligations under the contract and to liquidate its net position without incurring
a significant transaction cost is considered net settlement. The evaluation of
whether a market mechanism exists and whether items to be delivered under
contract are readily convertible into cash must be performed at inception and an
ongoing basis throughout a contracts life.
(c) It requires delivery of an asset that is readily convertible to cash.
2
The definition of
readily convertible to cash includes for example, a security or commodity traded in
an active market and a unit of foreign currency that is readily convertible into the
functional currency of the reporting entity. A security that is publicly traded but for
which the market is not very active is readily convertible to cash if the number of
shares or other units of the security to be exchanged is small relative to the daily
transaction volume. That same security would not be readily convertible if the
number of shares to be exchanged is large relative to the daily transaction volume.
The ability to use a security that is not publicly traded or another commodity
without an active market as collateral in a borrowing does not, in and of itself,
mean that the security or the commodity is readily convertible into cash. Shares of
a publicly traded company to be received upon the exercise of a stock purchase
warrant do not meet the characteristic of being readily convertible to cash if both of
the following conditions exist:

Next page 661-59.1

1
Even though a contract may be a derivative as described in paragraphs 22B.a.-e. for both parties, the
exceptions in paragraph 22B.f. apply only to the issuer of the contract and will result in different reporting
by the two parties. The exception in paragraph 22B.e.(2) also may apply to one of the parties but not the
other.
2
The evaluation of whether the asset is readily convertible into cash will be performed throughout a contracts
life.

Page 661-59.1

(1) The stock purchase warrant is issued by an entity for only its own stock (or stock of its
consolidated subsidiaries) and
(2) The sale or transfer of the issued shares is restricted (other than in connection with being
pledged as collateral) for a period of 32 days or more from the date of the stock purchase
warrant is exercised.

In contrast, restrictions are imposed by a stock purchase warrant on the sale or transfer of stock
that are received from the exercise of that warrant issued by an entity for other than its own stock
(whether those restrictions are for more or less than 32 days) do not affect the determination of
whether those shares are readily convertible to cash. The accounting for restricted stock to be
received upon exercise of a stock purchase warrant should not be analogized to any other type of
contract.

b. The following discussion further explains some of the exceptions discussed in paragraph 22B.e.

(1) Regular-way security trades. The exception in paragraph 22B.e.(1) applies only to a
contract that requires delivery of securities that are readily convertible to cash
1
other than
(a) contract to purchase or sell when-issued securities or other securities that do not yet
exist, pursuant to sub-paragraph (c) below, and (b) contracts that the banking corporation
accounts for on a transaction date basis. To qualify, a contract must require delivery of
such a security within the period of time after the trade date that is customary in the
market in which the trade takes place. This Provision does not change the date on which a
banking corporation recognizes regular way security trades. However, trades that do not
qualify for the regular way exception are subject to the requirements of this Provision
regardless of the method a banking corporation uses to report its security trades.

(2) Normal purchases and normal sales. The exception in paragraph 22B.e.(2) applies only
to a contract that involves future delivery of assets (other than financial instruments or
derivative instruments). Also in order for a contract that meets the net settlement
provisions of paragraphs 22B d.(1) and a.(3)(a) the market mechanisms provisions of
paragraphs 22B.d.(2).or a..(3).(b) to qualify for the exception, it must be probable at
inception and throughout the term of the individual contract that the contract will not
settle net and will result in physical delivery.

Next page 661-60

1
Contracts that require delivery of securities that are not readily convertible to cash are not subject to the
requirements of this Provision unless there is a market mechanism outside the contract to facilitate net
settlement (according to paragraphs 22B.(d)(2) and 22L.(a)(3)(b)).
Page 661-60

(3) Certain contracts that are not traded on an exchange. A contract that is not traded on an
exchange is not subject to the requirements of this Provision if the underlying is:
(a) A climatic or geological variable or other physical variable. Climatic, geological,
and other physical variables include things like the number of inches of rainfall or
snow in a particular area and the severity of an earthquake as measured by the
Richter scale.
(b) The price or value of
(1) A non-financial asset of one of the parties to the contract unless that asset is
readily convertible to cash, or
(2) a non-financial liability of one of the parties to the contract unless that
liability requires delivery of an asset that is readily convertible to cash.
This exception applies only to non-financial assets that are unique and only if a
non-financial asset related to the underlying is owned by the party that would not
benefit under the contract from an increase in the price or value of the non-
financial asset. If the contract is a call option contract, the exception applies only if
that non-financial asset is owned by the party that would not benefit under the
contract from an increase in the price or value of the non-financial asset above the
option's strike price.
(c) Specified volumes of sales or service revenues by one of the parties. That
exception is intended to apply to contracts with settlements based on the volume of
items sold or services rendered. It is not intended to apply to contracts based on
changes in sales or revenues due to changes in market prices.

If a contracts underlying is the combination of two or more variables, and one or more
would not qualify for one of the exceptions above, the application of this Provision to that
contract depends on the predominant characteristics of the combined variable. The
contract is subject to the requirements of this Provision if the changes in its combined
underlying are highly correlated with changes in one of the component variables that
would not qualify for an exception.

c. The following discussion illustrates the application of paragraphs 22B in certain situations.

(1) Forward purchases or sales of when-issued securities or other securities that do not yet
exist. Contracts for the purchase or sale of when-issued securities or other securities that
do not yet exist are excluded from the requirements of this Statement as a regular-way
trade only if:
(a) there is no other way to purchase or sell that security,
(b) delivery of that security and settlement will occur within the shortest possible
period possible for that type of security, and

Page 661-61

(c) It is probable at inception and throughout the term of the individual contract that
the contract will not settle net and will result in physical delivery of a security
when it is issued.

A contract for the purchase or sale of when-issued securities or other securities that do not
yet exist is eligible to qualify for the regular-way securities trades exception even though
that contract permits net settlement (as discussed in paragraphs 22B(d)(1) and
22K.(a)(3)(a)) or a market mechanism to facilitate net settlement of that contract (as
discussed in paragraphs 22B.(d)(2) and 22K(d)(1) and (d)(2)) exists. The banking
corporation shall document the basis for concluding that it is probable that the contract
will not settle net and will result in physical delivery. Net settlement (as described in
paragraphs 22B(d)(1) and (d)(2) of contracts in a group of contracts similarly designated
as regular-way security trades would call into question the continued exemption of such
contracts. In addition, if a banking corporation is required to account for a contract for the
purchase or sale of when-issued securities or other securities that do not yet exist on a
trade-date basis, rather than a settlement-date basis, and thus recognizes the acquisition or
disposition of the securities at the inception of the contract, that entity shall apply the
regular-way security trades exception to those contracts.

(1A) Credit-indexed contracts (often referred to as credit derivatives). Many different types of
contracts are indexed to the credit-worthiness of a specified entity or group of entities, but
not all of them are derivative instruments. Credit-indexed contracts that have certain
characteristics described in paragraph 22B.e.(4), are guarantees and are not subject to the
requirements of this Provision. Credit-indexed contracts that do not have the
characteristics necessary to qualify for the exception in paragraph 22B.e.(4), are subject
to the requirements of this Provision. One example of the latter is a credit-indexed
contract that requires a payment due to changes in the credit-worthiness of a specified
entity even if neither party incurs a loss due to the change (other than a loss caused by the
payment under the credit-indexed contract).

(2) Short sales (sales of borrowed securities).
1
Short sales typically involve the following
activities:
(a) Selling a security (by the short seller to the purchaser).
(b) Borrowing a security (by the short seller from the lender).
(c) Delivering the borrowed security (by the short seller to the purchaser)
(d) Purchasing a security (by the short seller from the market).
(e) Delivering the purchased security (by the short seller to the lender)

Next page 661-61.1

1
This discussion applies only to short sales with the characteristics described here. Some groups of
transactions that are referred to as short sales may have different characteristics. If so, a different analysis
would be appropriate, and other derivative instruments may be involved.
Page 661-61.1

These five activities involve three separate contracts. A contract that distinguishes a short
sale involves activities c.(2)(b) and c.(2)(e), borrowing a security and replacing it by
delivering an identical security. Such a contract has two of the three characteristics of
a derivative instrument. The settlement is based on an underlying (the price of the
security) and a notional amount (the face amount of the security or the number of shares),
and the settlement is made by delivery of a security that is readily convertible to cash.
However, the other characteristics, little or no initial net investment that is smaller by
more than a nominal amount than would be required for other types of contracts that
would be expected to have a similar response to changes in market factors, is not present.
(Refer to paragraph 22B.(c)). The borrowed security is the lenders initial net investment
in the contract. Consequently, the contract relating to activities c.(2)(b) and c.(2)(e) is not
a derivative instrument. The other two contracts (one for activities c.(2)(a) and c.(2)(c) and
the other for activity c.(2)(d)) are routine and do not generally involve derivative
instruments. However, if a forward purchase or sale is involved, and the contract does not
qualify for the exception in paragraph 22B.e.(1), it is subject to the requirements of this
Provision.

Next page 661-62
Page 661-62

Application of the Clearly and Closely Related Criterion - Paragraph 22C.

d. In discussing whether a hybrid instrument contains an embedded derivative instrument (also
simply referred to as an embedded derivative) that warrants separating accounting, paragraph
22C. a. focuses on whether the economic characteristics and risks of the embedded derivative
are clearly and closely related to the economic characteristics and risks of the host contract. If
the host contract encompasses a residual interest in a corporation, then its economic
characteristics and risks should be considered that of an equity instrument and an embedded
derivative would need to possess principally equity characteristics (related to the same
corporation), to be considered clearly and closely related to the host contract. However, most
commonly, a financial instrument host contract will not embody a claim to the residual interest
in a corporation and thus, the economic characteristics and risks of the host contract should be
considered that of a debt instrument. For example, even though the overall hybrid instrument
that provides for repayment of principal may include a return based on the market price (the
underlying as defined in this Provision) of Corporation A common stock, the host contract does
not involve any existing or potential residual interest rights (that is, rights of ownership) and
thus would not be an equity instrument. The host contract would instead be considered a debt
instrument, and the embedded derivative that incorporates the equity-based return would not be
clearly and closely related to the host contract. If the embedded derivative is considered not to
be clearly and closely related to the host contract, the embedded derivative must be separated
from the host contract and accounted for as a derivative instrument by both parties to the hybrid
instrument, except as provided in paragraph 22B.f.(1).

e. The following guidance is relevant in deciding whether the economic characteristics and risks of
the embedded derivative are clearly and closed related to the economic characteristics and risks
of the host contract.

(1) Interest rate indexes. An embedded derivative in which the underlying is an interest rate
or interest rate index and a host contract that is considered a debt instrument are
considered to be clearly and closely related unless as discussed in paragraph 12, the
embedded derivative contains a provision that:
(a) permits any possibility whatsoever that the investors (or creditors) undiscounted
net cash inflows over the life of the instrument would not recover substantially all
of its initial recorded investment in the hybrid instrument under its contractual
terms or

Page 661-63

(b) could under any possibility whatsoever at least double the investors initial rate or
return on the host contract and at the same time result in a rate of return that is at
least twice what otherwise would be the then-current market returning a contract
that has the same terms as the host contract and that involves a debtor with a
similar credit quality. The requirement to separate the embedded derivative from
the host contract applies to both parties to the hybrid instrument even though the
above tests focus on the investors net cash inflows. Plain-vanilla servicing rights,
which involve an obligation to perform servicing and the right to receive fees for
performing that servicing, do not contain an embedded derivative that would be
separated from those servicing rights and accounted for as a derivative.
(2) Inflation-indexed interest payments. The interest rate and the rate of inflation in the
economic environment for the currency in which a debt instrument is denominated are
considered to be clearly and closely related. Thus, non-leveraged inflation-indexed
contracts (debt instruments, capitalized lease obligations, pension obligations and so
forth) would not have the inflation-related embedded derivative separated from the host
contract.
(3) Credit-sensitive payments. The credit-worthiness of the debtor and the interest rate on a
debt instrument are considered to be clearly and closely related. Thus, for debt
instruments, that have the interest rate reset in the event of:
(a) default (such as violation of a credit-risk related covenant).
(b) a change in the debtors published credit rating, or
(c) a change in the debtors credit-worthiness indicated by a change in its spread over
Treasury bonds, the related embedded derivative would not be separated from the
host contract.
(4) Calls and puts on debt instruments. Call options (or put options) that can accelerate the
repayment of principal on a debt instrument are considered to be clearly and closely
related to a debt instrument that requires principal repayments unless both:
(a) The debt involves a substantial premium or discount (which is common with zero-
coupon bonds); and
(b) the put or call option is only contingently exercisable,
provided the call options (or put options) are also considered to be clearly and closely
related to the debt-host contract under paragraph 22C.(b).
Page 661-64

Thus, if a substantial premium or discount is not involved, embedded calls and puts
(including contingent call or put options that are not exercisable unless an event of default
occurs) would not be separated from the host contract. However, for contingently
exercisable calls and puts to be considered clearly and closely related, they can be
indexed only to interest rates or credit risk, not some extraneous event or factor. In
contrast, call options (or put options) that do not accelerate the repayment of principal on
a debt instrument but instead require a cash settlement that is equal to the price of the
option at the date of exercise would not be considered to be clearly and closely related to
the debt instrument in which it is embedded.
In light of the foregoing, and given the conditions that were laid down in the Banking
(Prepayment Commissions) Order, prepayment options, embedded in housing loans, (as
defined in the Proper Banking Management Directive no. 451 - "Procedures on
Advancing Housing Loans") are deemed to be clearly and closely attached to the host
housing loan.
(5) Calls and puts on equity instruments. A put option that enables the holder to require the
issuer of an equity instrument to re-acquire that equity instrument for cash or other assets
is not clearly and closely related to that equity instrument. Thus, such a put option
embedded in a publicly traded equity instrument to which it relates should be separated
from the host contract by the holder of the equity instrument, if the criteria in paragraphs
22.C.(a)(2) and (a)(3) are also met. That put option also should be separated from the host
contract by the issuer of the equity instrument except in those cases in which the put
option is not considered to be a derivative instrument pursuant to paragraph 22B.f.(1)
because it is classified in stockholders equity. A purchased call option that enables the
issuer of an equity instrument (such as common stock) to reacquire that equity instrument
would not be considered to be a derivative instrument by the issuer of the equity
instrument pursuant to paragraph 22B.f.(1). Thus, if the call option were embedded in the
related equity is, it would not be separated from the host contract by the issuer. However,
for the holder of the related equity instrument, the embedded written call option would
not be considered to be clearly and closely related to the equity instrument and, if the
criteria in paragraphs 22.C.(a)(2) and (a)(3) were met, should be separated from the host
contract.

(6) Floors, caps and collars. Floors or caps (or collars, which are combinations of caps and
floors) on interest rates and the interest rate on a debt instrument are considered to be
clearly and closely related, unless the conditions in either paragraph 22.C.(b)(1) or
paragraph (b)(2) are met, in which case the floors or the caps are not considered to be
clearly and closely related.

Page 661-65

(7) Term-extending options. An embedded derivative provision that either:
(a) unilaterally enables one party to extend significantly the remaining term to
maturity or
(b) automatically extends significantly the remaining term triggered by a specific
events or conditions
is not clearly and closely related to the interest rate on a debt instrument unless the
interest rate is concurrently reset to the approximate current market rate for the extended
term and the debt instrument initially involved no significant discount. Thus, if there is no
reset of interest rates, the embedded derivative is not clearly and closely related to the
host contract. That is, a term-extending option cannot be used to circumvent the
restriction in paragraph e.(1) regarding the investors not covering substantially all of its
initial recorded investment.

(8) Equity-indexed interest payments. The changes in fair value of an equity interest and the
interest yield on a debt instrument are not clearly and closely related. Thus, an equity-
related derivative embedded in an equity-indexed debt instrument (whether based on the
price of specific common stock or on an index that is based on a basket of equity
instruments) must be separated from the host contract and accounted for as a derivative
instrument.

(9) Commodity-indexed interest or principal payments. The changes in fair value of a
commodity (or other asset) and the interest yield on a debt instrument are not clearly and
closely related. Thus, a commodity-related derivative embedded in a commodity-indexed
debt instrument must be separated from the non-commodity host contract and accounted
for as a derivative instrument.

(10) Indexed Rentals.
(a) Inflation-indexed rentals. Rentals for the use of leased assets and adjustments for
inflation on similar property are considered to be clearly and closely related. Thus,
unless a significant leverage factor is involved, the inflation-related derivative
embedded in an inflation-indexed lease contract would not be separated from the
host contract.
(b) Contingent rentals based on related sales. Lease contracts that include contingent
rentals based on certain sales of the lessee would not have the contingent-rental-
related embedded derivative separated from the host contract because, under
paragraph 22B.e.(5)(c), a non-exchange-traded contract whose underlying is
specified volumes of sales by one of the parties to the contract would not be subject
to the requirements of this Provision.
Page 661-66

(c) Contingent rentals based on a variable interest rate. The obligation to make future
payments for the use of leased assets and the adjustment of those payments to
reflect changes in a variable-interest-rate-index are considered to be clearly and
closely related. Thus, lease contracts that include contingent rentals based on
changes in the prime rate would not have the contingent-rental-related embedded
derivative separated from the host contract.

(11) Convertible debt. The changes in fair value of an equity interest and the interest rates on a
debt instrument are not clearly and closed related. Thus, for a debt security that is
convertible into a specified number of shares of the debtors common stock or another
corporations common stock, the embedded derivative (that is, the conversion option)
must be separated from the debt host contract and accounted for as a derivative
instrument provided that the conversion option would, as a freestanding instrument, be a
derivative instrument subject to the requirements of this Provision. (For example, if the
common stock was not readily convertible to cash, a conversion option that requires
purchase of the common stock would not be accounted for as a derivative). That
accounting applies only to the holder (investor) - to which the exception under paragraph
22B.f. does not apply - if the debt is convertible to the debtors common stock because,
under paragraph 22B.f.(1) a separate option with the same terms would not be considered
to be a derivative for the issuer.

(12) Convertible preferred stock. Because the changes in fair value of an equity interest and
interest rates on a debt instrument are not clearly and closely related, the terms of the
preferred stock (other than the conversion option) must be analyzed to determine whether
the preferred stock (and thus the potential host contract) is more akin to an equity
instrument or a debt instrument. A typical cumulative fixed-rate preferred stock that has a
mandatory redemption feature is more akin to debt, whereas cumulative participating
perpetual preferred stock is more akin to an equity instrument.
Page 661-67

22L. Implementation Guidance - Chapter 2: Assessment of Hedge Effectiveness (10/02)

Hedge Effectiveness Requirements of this Provision

a. This Provision requires that a banking corporation define at the time it designates a hedging
relationship the method it will use to assess the hedges effectiveness in achieving offsetting
changes in fair value or offsetting cash flows attributable to the risk being hedged. It also
requires that a banking corporation use that defined method consistently throughout the hedge
period:

(1) To assess at inception of the hedge and on an ongoing basis whether it expects the
hedging relationship to be highly effective in achieving offset and

(2) To measure the ineffective part of the hedge.

If the banking corporation identifies an improved method and wants to apply that method
prospectively, it must discontinue the existing hedging relationship and designate the
relationship anew using the improved method. This Provision does not specify a single method
for either assessing whether a hedge is expected to be highly effective or measuring hedge
ineffectiveness. The appropriateness of a given method of assessing hedge effectiveness can
depend on the nature of the risk being hedged and the type of hedging instrument used.
Ordinarily, however, a banking corporation should address effectiveness for similar hedges in a
similar manner; use of different methods for similar hedges should be justified.

b. In defining how hedge effectiveness will be assessed, a banking corporation must specify
whether it will include in that assessment all of the gain or loss on a hedging instrument. This
Provision permits (but does not require) a banking corporation to exclude all or a part of the
hedging instruments time value from the assessment of hedge effectiveness, as follows:

(1) If the effectiveness of a hedge with an option contract is assessed based on changes in the
options intrinsic value, the change in the time value of the contract would be excluded
from the assessment of hedge effectiveness.

(2) If the effectiveness of a hedge with an option contract is assessed based on changes in the
options minimum value, that is, its intrinsic value plus the effect of discounting, the
change in the volatility value of the contract would be excluded from the assessment of
hedge effectiveness.

(3) If the effectiveness of a hedge with a forward or futures contract is assessed based on
changes in fair value attributable to changes in spot prices, the change in fair value of the
contract, related to the changes in the difference between the spot price and the forward
or futures price would be excluded from the assessment of hedge effectiveness.

In each circumstance above, changes in the excluded component would be included currently in
earnings, together with any ineffectiveness that results under the defined method of assessing
Page 661-68

ineffectiveness. As noted in paragraph a, the effectiveness of similar hedges generally should be
assessed similarly; that includes whether a component of the gain or loss on a derivative is
excluded in assessing effectiveness. No other components of gain or loss on the designated
hedging instrument may be excluded from the assessment of hedge effectiveness.

c. In assessing the effectiveness of a cash flow hedge, a banking corporation generally will need to
consider the time value of money if significant in the circumstances. Considering the effect of
the time value of money is especially important if the hedging instrument involves periodic cash
settlements. An example of a situation in which a banking corporation likely would reflect the
time value of money is a tailing strategy with futures contracts. When using a tailing strategy, a
banking corporation adjusts the size or contract amount of futures contracts used in a hedge so
that earnings (or expense) from reinvestment (or funding) of daily settlement gains (or losses)
on the futures do not distort the results of the hedge. To assess offset of expected cash flows
when a tailing strategy has been used, a banking corporation could reflect the time value of
money, perhaps by comparing the present value of the hedged forecasted cash flow with the
results of the hedging instrument.

d. Whether a hedging relationship qualifies as highly effective sometimes will be easy to assess
and there will be no ineffectiveness to recognize in earnings during the term of the hedge. If the
critical terms of the hedging instrument and of the entire hedged asset or liability (as opposed to
selected cash flows) or hedged forecasted transaction are the same, the entity could conclude
that changes in fair value or cash flows attributable to the risk being hedged are expected to
completely offset at inception and on an ongoing basis.

e. Assessing hedge effectiveness and measuring the ineffective part of the hedge, however, can be
more complex. For example, hedge ineffectiveness would result from the following
circumstances, among others:

(1) A difference between the basis of the hedging instrument and the hedged item or hedged
transaction (such as a Deutsche mark - based hedging instrument and Dutch guilder-based
hedged item), to the extent that those bases do not move in tandem.

(2) Differences in critical terms of the hedging instrument and hedged item or hedged
transaction, such as differences in notional amounts, maturities, quantity, location or
delivery dates.

Page 661-69

Ineffectiveness also would result if part of the change in the fair value of a derivative is
attributable to a change in the counter-partys credit-worthiness.

f. A hedge that meets the effectiveness test specified in paragraphs 22E.a.(2) and 22F.a.(2) (that is,
both at inception and on an ongoing basis, the banking corporation expects the hedge to be
highly effective at achieving offsetting changes in fair values or cash flows) also must meet the
other hedge accounting criteria to qualify for hedge accounting. If the hedge initially qualifies
for hedge accounting, the banking corporation would continue to assess whether the hedge
meets the effectiveness test and also would measure any ineffectiveness during the hedge
period. If the hedge fails the effectiveness at any time (that is, if the entity does not expect the
hedge to be highly effective at achieving offsetting changes in fair values or cash flows), the
hedge ceases to qualify for hedge accounting. The discussions of measuring hedge
ineffectiveness in the examples in the remainder of this section of the Schedule, assume that the
hedge satisfied all of the criteria for hedge accounting at inception.

Assuming No Ineffectiveness in a Hedge with an Interest Rate Swap

g. An assumption of no ineffectiveness is especially important in a hedging relationship involving
an interest-bearing financial instrument and an interest rate swap because it significantly
simplifies the computations necessary to make the accounting entries. A banking corporation
may assume no ineffectiveness in a hedging relationship of interest rate risk involving a
recognized interest-bearing asset or liability and an interest rate swap (or a compound hedging
instrument composed of interest rates swap and a mirror-image call or put option as discussed in
paragraph (g)(4) below), if all of the applicable conditions in the following list are met:

Conditions applicable to both fair value hedges and cash flows hedges
(1) The notional amount of the swap matches the principal amount of the interest-bearing
asset or liability.
(2) If the hedging instrument is solely an interest rate swap, the fair value of that swap at the
inception of the hedging relationship is zero. If the hedging instrument is a compound
derivative composed on an interest rate swap and mirror-image call or put option as
discussed in paragraph (g)(4), the premium for the mirror-image call or put option
embedded in the hedged item. That is, the reporting banking corporation must determine
whether the implicit premium for the purchased call or written put option embedded in
Page 661-69.1

the hedged item was principally paid at inception-acquisition (through an original issue
discount or premium) or is being paid over the life of the hedged item (through an
adjustment of the interest rate). If the implicit premium for the call or put option
embedded in the hedged item was principally paid at inception-acquisition, the fair value
of the hedging instrument at the inception of the hedging relationship must be equal to the
fair value of the mirror-image call or put option. In contrast, if the implicit premium for
the call or put option embedded in the hedged item is principally being paid over the life
of the hedged item, fair value of the hedging instrument at the inception of the hedging
relationship must be zero.
(3) The formula for computed 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, and the
variable rate is based on the same index and includes the same constant adjustment or no
adjustment).
(4) The interest-bearing asset or liability is not prepayable (that is, able to be settled by either
party prior to its scheduled maturity), except as indicated in the following sentences. This
criterion does not apply to an interest-bearing asset or liability that is prepayable solely
due to an embedded call option provided that the hedging interest is a compound
derivative composed of an interest rate swap and a mirror-image put option. The call
option embedded in the swap is considered

Page 661-70

a mirror image of the call option embedded in the hedged item if (1) the terms of the two
call options match (including matching maturities, strike price, related notional amounts,
timing and frequency of payments, and dates on which the instruments may be called)
and (2) the banking corporation is the writer of one call option and the holder (or
purchaser) of the other call option. Similarly, this criterion does not apply to an interest-
bearing asset or liability that is prepayable solely due to an embedded put option provided
the hedging instrument is a compound derivative composed of an interest rate swap and a
mirror-image put option.
(5) The index on which the variable leg of the swap is based matches the benchmark interest
rate designated as the interest rate risk being hedged for the hedging relationship.
1

(6) Any other terms in the interest-bearing financial instruments or interest rate swaps are
typical of those instruments and do not invalidate the assumption of no ineffectiveness.

Conditions applicable to fair value hedges only
(7) The expiration date of the swap matches the maturity date of the interest-bearing asset or
liability.

(8) There is no floor or cap on the variable interest rate of the swap.

(9) The interval between repricings of the variable interest rate in the swap is frequent
enough to justify an assumption that the variable payment or receipt is at a market rate
(generally three to six months or less).

Conditions applicable to cash flows hedges only
(10) All interest receipts or payments on the variable-rate asset or liability during the term of
the swap are designated as hedged, and no interest payments beyond the term of the swap
are designated as hedged.

(11) There is no floor or cap on the variable interest rate of the swap unless the variable-rate
asset or liability has a floor or cap. In that case, the swap must have a floor or cap on the
variable interest rate that is comparable to the floor or cap on the variable-rate asset or
liability. (For this purpose, comparable does not necessarily mean equal. For example, if a
swaps variable rate is LIBOR and an assets variable rate is LIBOR plus 2 percent, a 10
percent cap on the swap would be comparable to a 12 percent cap on the asset).

1
For cash flow hedge situations in which the cash flows of the hedged item and the hedging instrument are
based on the same index but that index is not the benchmark interest rate, the shortcut method is not
permitted. However, the entity may obtain results similar to results obtained if the shortcut method was
permitted.
Page 661-71

(12) The repricing dates match those of the variable-rate asset or liability.

h. The fixed rate on a hedged item need not exactly match the fixed rate on a swap designated as a
fair value hedge. Nor does the variable rate on an interest-bearing asset or liability need to be
the same as the variable rate on a swap designated as a cash flow hedge. A swaps fair value
comes from its net settlements. The fixed and variable rates on a swap can be changed without
affecting the net settlement if both are changed by the same amount. That is, a swap with a
payment based on LIBOR and a receipt based on a fixed rate of 5 percent has the same net
settlements and fair value as a swap with a payment based on LIBOR plus 1 percent and a
receipt based on a fixed rate of 6 percent.

i. Comparable credit risk at inception is not a condition for assuming no ineffectiveness even
though actually achieving perfect offset would require that the same discount rate be used to
determine the fair value of the swap and of the hedged item or hedged transaction. To justify
using the same discount rate, the credit risk related to both parties to the swap as well as to the
debit on the hedged interest-bearing asset (in a fair value hedge) or the variable-rate asset on
which the interest payments are hedged (in a cash flow hedge) would have to be the same.
However, because that complication is caused by the interaction of interest rate risk and credit
risk, which are not easily separable, comparable creditworthiness is not considered a necessary
condition to assume no ineffectiveness in a hedge of interest rate risk.

After-Tax Hedging of Foreign Currency Risk

j. This Provision permits hedging of foreign currency risk on an after-tax basis. The portion of the
gain or loss on the hedging instrument that exceeded the loss or gain on the hedged item is
required to be included as an offset to the related tax effects in the period in which those tax
effects are recognized.

Examples of Assessing Effectiveness and Measuring Ineffectiveness

k. The following examples illustrates some of the ways in which a banking corporation may assess
hedge effectiveness and measures hedge ineffectiveness for specific strategies. The examples
are not intended to imply that other reasonable methods are precluded. However, not all possible

Page 661-72

methods are reasonable or consistent with this Provision. This section also discusses some
methods of assessing hedge effectiveness and determining hedge ineffectiveness that are not
consistent with this Provision and thus may not be used.

Example 1: Fair value hedge of equity securities through option contracts

l. Bank A holds 10,000 shares of the Reshet company. It buys put option contracts on 20,000
Reshet shares with a strike price equal to the present price of the share in order to hedge its
exposure to changes in the fair value of its investment position attributable to changes in the
Reshet share price. Bank A manages the position using the delta-neutral strategy, that is, it
monitors the delta of the option - the ratio between changes in the option price and changes in
the Reshet share price. As the delta ratio changes, Bank A buys or sells put options so that the
next change in the fair value of all the options held can be expected to counter-balance the next
change in the fair value of its investment in the Reshet share. The delta ratio for put options
moves closer to one as the share price drops, and moved closer to zero as the share price rises.
The delta ratio also changes with the shortening of the exercise term, changes in interest rates
and changes in expected volatility. Bank A designates the put options as a fair value hedge of
its investment in the Reshet share.

Assessing expected effectiveness of the hedge and measuring ineffectiveness

m. As Bank A intends to vary the number of options that it holds to the extent required to maintain
a delta - neutral position, it may not automatically assume that the hedge will be highly effective
in achieving offsetting changes in fair value. Moreover, as the delta neutral hedge strategy is
based on changes expected in the fair value of the option, the Bank may not assess the
effectiveness based on changes in the intrinsic value of the option. Instead, Bank A must assess:
(a) the gain or loss on the open position deriving from various rises or drops in the market price
of the Reshet share and (b) the loss or the gain on its investment in the Reshet shares in respect
of the same changes in the market price. In order to assess the effectiveness of the hedge both at
the inception of the hedge and on an ongoing basis, the Bank could compare the matching gains
and losses of the different changes in the market price. The continuing assessment of the
effectiveness must also take account of actual changes in the fair value of the put options held
and the investment in the Reshet shares during the hedge period.

n. Consistent with the Banks method of assessing effectiveness, the hedge would be ineffective to
the same extent that the gains or losses which are actually realized and unrealized from changes
in the fair value of the options held are greater or less than the change in the value of the
Page 661-73

investment in the Reshet shares. The underlying of the put options is the market price of the
Reshet shares. This being the case, if Bank A continually monitors the delta ratio and adjusts the
number of options held accordingly, the changes in the fair value of the options and of the item
hedged may almost be completely offset resulting in only a small amount of ineffectiveness to
be recognized in earnings.

Example 2: fair value hedge of Treasury Bonds through a put option contract

o. Bank B holds a Treasury Bond and wishes to protect itself against fair value exposure to
declines in the price of the Treasury Bond. The Bank acquires an at-the-money put option on a
Treasury security with the same terms (remaining maturity, notional amount and interest rate) as
the Treasury bond it holds, and designates the option as a fair value exposure hedge of the
Treasury bond. Bank B intends holding the put option until its expiry.

Assessing the expected effectiveness of the hedge and measuring ineffectiveness

p. As Bank B intends holding the put option (a static hedge) rather than manage the position using
a delta-neutral strategy, it can assess whether it expects that the hedge will be highly effective in
achieving changes offsetting fair value by calculating and comparing the changes in the intrinsic
value of the option and changes in the price (fair value) of the Treasury bond for different
possible market prices. In assessing the expectation of the effectiveness on a continuing basis,
the Bank must also take into account the actual changes in the fair value of the government
bond and in the intrinsic value of the option during the hedge period.

q. However, because the pertinent critical terms of the option and of the bond are the same in this
example, the Bank could expect the changes in the value of the bond attributable to changes in
the interest rates and the changes in the intrinsic value of the option to offset completely during
the period that the option is in the money. That is, there will be no ineffectiveness since the
Bank has elected to exclude changes in the time value of the option from the test of
effectiveness. Having so elected, Bank B must recognize changes in the time value of the option
directly in earnings.

Example 3: Fair value hedge of an embedded option purchased through a written option

r. Bank C issues a five-year fixed interest rate debt note with an embedded call option (purchased)
with prepayment and writes a call option with a counter-party in order to neutralize the call
feature for prepayment contained in the promissory note. The embedded call option and the
written call option have the same effective notional amount, underlying fixed interest rate and
Page 661-74

strike price. (The strike price of the option contained in the debt note is generally called the call
price). The embedded option can also be at the same times as the written option. Bank C
designates the written option as a fair value hedge of the embedded prepayment option
component in the fixed interest rate debit note.

Assessment of expected effectiveness of the hedge and measuring ineffectiveness

s. In order to assess whether the hedge is likely to be highly effective in achieving offsetting
changes in the fair value, Bank C could assess and compare the changes in fair values of the two
options for different market interest rates. As this Provision precludes the separation into
components of derivatives, including embedded derivatives, whether they are required to be
accounted for separately or not, Bank C can only designate a hedge of the entire change in fair
value of the embedded call option that was purchased. The changes obtained in the fair value
will be included currently in earnings. Changes in the fair value of the written option will
similarly be included in earnings, and accordingly; any ineffectiveness will thus automatically
be currently reflected in earnings. (It is probable that the hedge will have a certain extent of
ineffectiveness as it is unlikely that the premium in respect of the call option written will be the
same as the premium in respect of the embedded call option purchased).

Example 4: Cash flow hedge through a basis swap

t. Bank D has a 5-year variable-interest $100,000 asset and a 7-year variable-interest liability of
$150,000. The interest for the asset is payable by the counter-party at the end of each month
based on the Eurodollar interest rate on the first of the month. The interest in respect of the
liability is payable by Bank D at the end of each month based on the LIBOR on the tenth of the
month (the liabilitys anniversary date). The Bank enters into a five-year interest rate swap
under which it pays at the end of each month, interest according to the Eurodollar and receives
interest according to the LIBOR, based on a notional amount of $100,000. Both interest rates
are determined on the first of the month. Bank D designates the swap as a hedge of the variable
interest to be received over five years in respect of the $100,000 variable-rate asset and the first
five years of interest payments in respect of the $100,000 liability.

Assessing the expected effectiveness of the hedge and measuring the ineffectiveness

u. Bank D may not automatically assume that the hedge will always be highly effective in
achieving offsetting changes in cash flows as the reset date on the receive leg of the swap is
different to the reset date of the variable interest in respect of the corresponding liability. The
companys assessment both at the inception of the hedge and on an ongoing basis of the
expected effectiveness may be based on the extent to which changes have occurred in the
LIBOR during the comparative past ten-day period. The assessment of Bank D on an ongoing
Page 661-75

basis of the expected effectiveness and measuring the actual ineffectiveness would be on a
cumulative basis and include the actual changes in the interest rate until the date of the
measurement. The hedge would be ineffective to the extent the cumulative change in the cash
flows from the Eurodollar leg of the swap did not offset the cumulative change in the cash flows
expected from the asset, and the cumulative change on the LIBOR cash flow leg of the swap did
not offset the change in the expected cash flow of the portion of the liability hedged. The terms
of the swap, the asset and the portion hedged of the liability are the same, apart from the reset
dates on the liability and the receive leg of the swap. Accordingly, the hedge will be ineffective
only to the extent the LIBOR rate has changed during the period from the first of the month (the
reset date of the swap) until the first of the month (the reset date of the liability).

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The Supervisor of Banks: Reporting Provisions to the Public [2](10/02)

Annual Financial Report

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