Morgan Stanley 2014 Annual Report Download - page 243

MORGAN STANLEY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Hedge Accounting.
The Company applies hedge accounting using various derivative financial instruments to hedge interest rate and
foreign exchange risk arising from assets and liabilities not held at fair value as part of asset and liability
management and foreign currency exposure management.
The Company’s hedges are designated and qualify for accounting purposes as one of the following types of
hedges: hedges of exposure to changes in fair value of assets and liabilities being hedged (fair value hedges) and
hedges of net investments in foreign operations whose functional currency is different from the reporting
currency of the parent company (net investment hedges).
For all hedges where hedge accounting is being applied, effectiveness testing and other procedures to ensure the
ongoing validity of the hedges are performed at least monthly.
Fair Value Hedges—Interest Rate Risk. The Company’s designated fair value hedges consisted primarily of
interest rate swaps designated as fair value hedges of changes in the benchmark interest rate of fixed rate senior
long-term borrowings. The Company uses regression analysis to perform an ongoing prospective and
retrospective assessment of the effectiveness of these hedging relationships (i.e., the Company applies the “long-
haul” method of hedge accounting). A hedging relationship is deemed effective if the fair values of the hedging
instrument (derivative) and the hedged item (debt liability) change inversely within a range of 80% to 125%. The
Company considers the impact of valuation adjustments related to the Company’s own credit spreads and
counterparty credit spreads to determine whether they would cause the hedging relationship to be ineffective.
For qualifying fair value hedges of benchmark interest rates, the changes in the fair value of the derivative and
the changes in the fair value of the hedged liability provide offset of one another and, together with any resulting
ineffectiveness, are recorded in Interest expense. When a derivative is de-designated as a hedge, any basis
adjustment remaining on the hedged liability is amortized to Interest expense over the remaining life of the
liability using the effective interest method.
Net Investment Hedges. The Company may utilize forward foreign exchange contracts to manage the currency
exposure relating to its net investments in non-U.S. dollar functional currency operations. To the extent that the
notional amounts of the hedging instruments equal the portion of the investments being hedged and the
underlying exchange rate of the derivative hedging instrument relates to the exchange rate between the functional
currency of the investee and the parent’s functional currency, no hedge ineffectiveness is recognized in earnings.
If these exchange rates are not the same, the Company uses regression analysis to assess the prospective and
retrospective effectiveness of the hedge relationships and any ineffectiveness is recognized in Interest income.
The gain or loss from revaluing hedges of net investments in foreign operations at the spot rate is deferred and
reported within AOCI. The forward points on the hedging instruments are excluded from hedge effectiveness
testing and are recorded in Interest income.
During 2012, the Company recognized an out-of-period pre-tax gain of approximately $109 million in its
Institutional Securities business segment’s Other sales and trading net revenues related to the reversal of amounts
recorded in cumulative other comprehensive income due to the incorrect application of hedge accounting on
certain derivative contracts previously designated as net investment hedges of certain non-U.S. dollar-
denominated subsidiaries. The Company evaluated the effects of the incorrect application of hedge accounting,
both qualitatively and quantitatively, and concluded that it did not have a material impact on any prior annual or
quarterly consolidated financial statements. Subsequent to the identification of the incorrect application of net
investment hedge accounting, the Company appropriately redesignated the forward foreign exchange contracts
and reapplied hedge accounting.
239