At the very minimum, a company should keep shareholders informed about the types of financial instruments used and their purposes. It must make a distinction between instruments that are used for hedging and those that are not, as well as the relevant accounting policies. It should disclose the notional principal of these instruments, their maturity, cash requirements, market value and credit risk. It should also tell shareholders how the firm monitors the values of these instruments. Where possible, firms should also disclose the firm’s market risks; if quantitative information is not possible then a qualitative discussion should be included.

Box 12

Apple bares its core

Shareholders reading Apple’s 1995 annual report will come away with a clear idea of the financial exposures facing the company, as well as management’s policy towards hedging and using derivatives. The following excerpt can be used as a template against which other annual reports may be judged; which explains its length. "To mitigate the impact of fluctuations in US interest rates, the Company has entered into interest rate swap and option transactions. Certain of these swaps are intended to better match the Company’s floating-rate interest income on its cash, cash equivalents, and short-term investments with the fixed-rate interest expense on its long-term debt. The Company also enters into interest rate swap and option transactions in order to diversify a portion of the Company’s exposure away from fluctuations in short-term US interest rates. These instruments may extend the Company’s cash investment horizon up to a maximum effective duration of three years." Apple’s interest rate swaps generally require it to pay 3- or 6 -month Libor (weighted average of 5.88% as at September 29, 1995) and receive fixed (weighted average of 6.38% as at the same date) . These swaps have a maturity ranging from one to 10 years. Most of the interest rate options were collars and expire within three years. Unrealised losses on these agreements were about $9 million as at September 29, 1995. The bulk of these losses was due to a 10-year interest rate swap. "The Company enters into foreign exchange forward and option contracts with financial institutions primarily to protect against currency exchange risks associated with certain firmly committed and certain other probable, but not firmly committed transactions. The Company’s foreign exchange risk management policy requires it to hedge a majority of its existing material foreign exchange transaction exposures. However, the Company may not hedge certain foreign exchange transaction exposures that are immaterial either in terms of their minimal US dollar value or in terms of their high correlation with the US dollar. "Probable, but not committed transactions comprise sales of the Company’s products in currencies other than the US dollar. A majority of these non-US dollar-based sales are made through the Company’s subsidiaries in Europe, Asia (particularly Japan), Canada, and Australia. The Company also purchases foreign exchange option contracts to hedge certain other probable, but not firmly committed transactions. The Company also sells foreign exchange option contracts [maturity ranging from one to six months], in order to partially finance the purchase of foreign exchange option contracts used to hedge both firmly committed and certain other probable, but not firmly committed transactions. The duration of foreign exchange hedging instruments whether for firmly committed transactions or for probable, but not firmly committed transactions, currently does not exceed one year." The deferred gains and losses on the foreign exchange contracts were minimal. The company does not engage in leveraged hedging. "The company monitors its interest rate and foreign exchange positions daily based on applicable and commonly used pricing models. The correlation between the changes in the fair value of hedging instruments and the changes in the underlying hedged instruments is assessed periodically over the life of the hedged instrument. In the event that it is determined that a hedge is ineffective, the Company recognises in income the change in market value of the instrument beginning on the date that it was no longer an effective hedge. "Gains and losses on accounting hedges of existing assets or liabilities are included in the carrying amounts of those assets or liabilities and are ultimately recognised in income as part of those carrying amounts. Gains and losses related to qualifying accounting hedges of firm commitments or anticipated transactions are also deferred and are recognised in income or as adjustments of carrying amounts when the hedged transaction occurs. Realised and unrealised gains and losses on interest rate and foreign exchange contracts that do not qualify as accounting hedges are recognised quarterly as a component of interest and other income (expense), net. Apple also published details of its financial instruments. The estimates of fair value of its derivative portfolio in Table 8 are based on commonly used models and easily available market data. If the company is unsure about the fair value estimated, it obtained price quotes from counterparty financial institutions.

Apple’s Derivative Portfolio
		1995			1994
(in million $)
		Notional Principal	Fair Value	Credit Risk Amount	Notional Principal	Fair Value	Credit Risk Amount
Transactions Qualifying as Accounting Hedges
Interest rate instruments
Swaps	$	450	(7)	2	669	(40)	--
Interest rate collars	$	105	--A	--A	--	--	--
Sold options	$	150	--A	--	--	--	--
Foreign exchange instruments
Spot forward contracts	$	1,211	16	23	2,385	(23)	15
Purchased options	$	1,441	32	32	1,510	17	21
Sold options	$				302	(1)	--
Transactions Other Than Accounting Hedges
Interest rate instruments
Swaps	$	10	--A	--	--	--	--
Sold options	$	100	(1)	--	148	--A	--
Foreign exchange instruments
Spot forward contracts	$	--	--	--	300	--A	--A
Purchased options	$	3,046	134	134	1,600	32	32
Sold options	$	6,082	(83)	--	5,511	(45)	--
(A) Fair value is less than $ 0.5 million

It is even more important that financial institutions disclose quantitative market risk imformation, because market risks can have a severe impact on their performance, and thus on their share prices.

Box 13

Deutsche Bank’s information evolution

There is no doubt that financial institutions have improved their financial risk disclosure by leaps and bounds. Part of this has been driven by national and international regulation; part by the industry itself which realises that greater voluntary disclosure may stave off further unwanted intervention by the regulatory authorities. The latter point is particularly true for derivatives which by virtue of being off-balance sheet have escaped inclusion in traditional financial statements. Yet, because derivatives figure so prominently in the portfolios of financial institutions, their exclusion from the financial statements means that a shareholder does not receive the full picture of the financial risks facing a bank. The disclosure has improved both in quantitative and qualitative terms, and naturally focuses on the two main risk areas facing financial institutions - credit and market. Comparing Deutsche Bank’s disclosure of such information in its 1993 and 1995 annual reports is like comparing chalk and cheese. Shareholders cannot help but notice the marked improvement in the type and quality of information given in the latter document and the great strides the German bank has made to better inform its shareholders and to improve transparency. (a) Credit risk - Deutsche disclosed that the risk-adjusted credit equivalent of its derivative portfolio was about DM 11 billion at the end of December, 1993 (the notional was DM 1,341 billion). It also divided this credit equivalent into three main asset classes - interest rates (DM 4.8 billion), equities (DM 196 million) and foreign exchange (DM 6 billion). It disclosed comparable historical numbers for 1992 and 1991 in the same bar chart. This risk-adjusted credit equivalent is not the same as gross or net current replacement value because it is weighted by maturity and counterparty in accordance with the European Union Solvency Directive. Deutsche’s 1995 annual report contained the following tables which detailed the firm’s derivative credit exposure by counterparty rating and also by maturity structure. A shareholder can see immediately that the bank’s main credit exposure is to double- and single-A credits (72% of current replacement cost). Further, a shareholder will also realise that its derivative portfolio is concentrated in instruments which have a maturity of one year or less, these are substantially less risky than longer-dated contracts.

Table 9 OTC Derivatives of Deutsche Bank Group by Rating Rating (corresponding to a Standard & Poor's equivalent) Notional volume in DM bn Current replacement cost in DM bn As % of notional volume AAA 173.49 3.46 1.99 AA 666.89 12.49 1.87 A 750.83 13.64 1.82 BBB 128.00 2.65 2.07 Non-investment grade 59.08 1.35 12.29 Other 226.97 2.39 1.05 Total 2005.26 35.98 1.79 Table 10 Maturity Structure of OTC Derivatives Rating (corresponding to a Standard & Poor's equivalent) Notional volume in DM bn with remaining life of Total notional volume in DM billion up to 1 year 1 - 5 years >5year AAA 113.02 36.08 24.39 173.49 AA 418.21 175.49 73.19 666.89 A 523.84 163.68 63.31 750.83 BBB 76.98 37.25 13.77 128.00 Non-investment grade 36.09 17.85 5.14 59.08 Other 187.59 36.83 2.55 226.97 Total 1355.73 467.19 182.35 2005.26

(b) Notwithstanding the increased credit risk transparency, the greatest stride in disclosure has been made in market risk. All a shareholder gleaned from reading the 1993 annual report was a rough breakdown of Deutsche’s derivative portfolio in risk-adjusted credit equivalent terms: interest rates (43.6%), foreign exchange (54.6%) and equities (1.8%). There was no breakdown of product types within each category. Also, the bank only released information about its over-the-counter derivative activities, which accounted for 46% of its derivative portfolio. It did not disclose any information on its exchange-traded portion. On market risk, the report noted, "In addition to credit risk, derivatives are also subject to market risks derived from fluctuations in interest rates, foreign exchange rates and the prices of other financial instruments. These can be considerable during periods of high volatility." In the 1995 annual report, Deutsche released two sets of VAR for its dealing sections including cash and derivatives. The first set of VAR numbers (line 1 in table 11) are based on a holding period of one day and a confidence interval of two standard deviations (97.5% confidence). On this basis, the aggregate one-day VAR for the bank at the end of 1995 was DM 65 million. The bank also calculated its VAR using the BIS benchmarks of 10-day holding period and 2.33 standard deviation (99% confidence). Its aggregate BIS-VAR at the end of 1995 was DM 241 million (line 2 in table 11).

Table 11 VAR for Dealing Sections (in DM millions) DM Fixed Income Money Mkt OTC Deriv Foreign Exchange Metals Proprietary Trading Equities Emerging Markets 1 day, 2SD 19.25 4.96 6.66 4.04 1.23 7.14 6.30 15.75 10 days, 2.33SD (Basle) 70.93 18.29 24.53 14.89 4.53 26.31 23.53 58.03

In addition, Deutsche also produced a table which detailed all of its derivative products by risk category, product type, over-the-counter and exchange-traded and remaining life. See table 12 attached.

Box 14
Deutsche Bank (excerpt from annual report 1995)
The following table shows the derivatives transactions from our dealing activities still outstanding on balance sheet date. In addition to analysis by product group, the maturity structure is shown on the basis of notional amounts. The current replacement costs are also given. Notional amounts and current replacement costs in derivatives business by product type as at December 31, 1995 :
Table 12
	Notional amount with remaining life of				Current replacement costs*
in DM millions	Up to 1 year	1-5 years	Over 5 years	Total
Interst-rate-related transactions	652,493	465,812	206,447	1,324,752	18,115
OTC products
FRAs	274,377	24,693	-	299,070	504
Interest rate swaps (same currency)	167,310	329,574	141,521	633,406	16,190
Interest rate option purchases	25,611	34,181	26,031	85,823	1,406
Interest rate option sales	13,276	29,455	32,908	76,638
Other interest rate trades	372	416		788	16
Exchange traded products
Interset rate futures	162,295	47,350	6,431	215,075
Interset rate options	9,253	143	556	9,952
Currency-related transactions	902,140	77,779	14,805	994,724	17,629
OTC products
Forward exchange trades	829,704	39,396	293	869,393	13,105
Cross-currency swaps	10,785	36,756	14,512	62,053	3,827
Forex option purchases	28,986	718	-	29,703	682
Forex option sales	29,403	383	-	29,786
Other Forex trades	1,050	215	-	1,765	15
Exchange traded products
Forex futures	2,061	311	-	2,372
Forex options	152	-	-	152
EQUITY/INDEX-RELATED TRANSACTIONS	11,220	928	-	12,148	95
OTC products
Equity/index swaps	327	108	-	435	37
Equity/index option purchases	3,501	370		3,871	57
Equity/index sales	2,194	175	-	2,369
Other equity/index trades	319		-	319	1
Exchange traded products
Equity/index futures	2,892	-	-	2,892
Equity/index options	1,987	275	-	2,262
OTHER TRANSACTIONS	33,864	1,382	-	35,246	141
OTC products
Precious metal trades	829,704	39,396	293	869,393	13,105
Non-ferrous trades	10,785	36,756	14,512	62,053	3,827
Exchange-traded products
Futures	2,061	311	-	2,372
Options	152	-	-	152
TOTAL	1,599,717	545,901	221,252	2,366,870	35,980
*Since exchange traded products and short positions in optioins do not involve counterpary risk, no replacement costs are given here.