Explanatory Note to CVM Instruction No. 475 of December 17, 2008

EXPLANATORY NOTE TO CVM INSTRUCTION NO. 475, OF DECEMBER 17, 2008 Ref. CVM Instruction No. 475, of December 17, 2008, which provides for the presentation of information on financial instruments, in a specific explanatory note, and for the disclosure of the Sensitivity Analysis Schedule. The objective of this Explanatory Note is to present the conceptual bases that guided the encouragement to disclose the Sensitivity Analysis Schedule in CVM Deliberation 550, of October 17, 2008, and its mandatory nature in this Instruction. The aforementioned Schedule aims to ensure that Brazilian publicly-held companies present information that allows users of financial statements to adequately assess the risk profile inherent in operations with financial instruments, particularly derivatives. This objective aligns with the Framework for the Preparation and Presentation of Financial Statements issued by the IASB:
“The users of financial statements include present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public. They use financial statements in order to satisfy some of their different needs for information. These needs include the following:
(a) Investors. The providers of risk capital and their advisers are concerned with the risk inherent in, and return provided by, their investments. They need information to help them determine whether they should buy, hold or sell. Shareholders are also interested in information which enables them to assess the ability of the entity to pay dividends”.1 (underlines added) It can be observed that the above definition clearly points to the need for accounting statements to provide information that allows users to adequately assess the risk inherent in the company's operations. This need becomes even more pressing in operations with derivatives. This is because, due to the operational characteristics of these products, the company involved may assume risks much higher than its capital needs. In this sense, professors Iran Siqueira Lima and Alexsandro Broedel Lopes2 comment:
“Degree of leverage: operations with derivatives have the ability to leverage a huge volume of resources with relatively small initial outlays. Allied to this fact, the possibility of losses in volumes quite superior to those initially invested, as is the case with positions launched in options, is quite characteristic of operations with derivatives and quite difficult to be found in other products, activities or processes, whether financial 1 Extracted from the Framework for the Preparation and Presentation of Financial Statements. © IASC Foundation. 2 Alexsandro Broedel Lopes and Iran Siquera Lima. Accounting and Control of Derivatives Operations. Thomson Publisher, São Paulo, 2003, pg. 113.

EXPLANATORY NOTE TO CVM INSTRUCTION NO. 475, OF DECEMBER 17, 2008 or not. This problem is quite clear in that the greater the possibility of losses, the greater the need for organizational control;” (u.a.) Thus, it is clear that financial derivative instruments increase the leverage potential of institutions that use them. That is, they increase the potential for large profits, but with the risk of large losses. In addition to the enormous risk mentioned above, professors Alexsandro Broedel Lopes and Iran Siqueira Lima3 emphasize the great complexity inherent in operations with derivatives:
“Complexity of operations: this point has significant importance in that all control procedures emphasize that professionals involved in the controlling activity must possess an operational knowledge of the activities being performed sufficient to be able to follow all relevant aspects of their development. However, this apparently simple aspect is fraught with some problems in the operation of derivatives in that the understanding of the mechanism of functioning of these products is not so simple; it is also added, the fact that the modern pricing mechanisms and development of operational strategies involves a quantitative instrument that accountants normally do not master.” (u.a.) That is, it can be perceived that operations carried out with derivatives may compromise the continuity of organizations that use them. Due to the complexity inherent in operations with derivatives, the disclosure of the fair value of operations is not sufficient for external users to adequately assess the risk profile of institutions. Losses can be much greater and more leveraged than the fair value of operations may suggest. Thus, for users of accounting statements to adequately assess the risks inherent in companies' activities, it is necessary that quantitative information based on simulations be provided. In this sense, the IASB, in IFRS 7, requires companies to present a sensitivity analysis for operations carried out with derivative financial instruments. This sensitivity analysis was already required by the Securities and Exchange Commission (SEC) since 19974. The IASB standard requires that the sensitivity analysis be disclosed within the following terms:
“40 Unless an entity complies with paragraph 41, it shall disclose:
(a) a sensitivity analysis for each type of market risk to which the entity is exposed at the end of the reporting period, showing how profit or loss and equity would have been affected by changes in the relevant risk variable that were reasonably possible at that date; 3 Alexsandro Broedel Lopes and Iran Siquera Lima. Accounting and Control of Derivatives Operations. Thomson Publisher, São Paulo, 2003, pg. 114 4 SECURITIES AND EXCHANGE COMMISSION (SEC). Disclosure of Accounting Policies for Derivatives Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information About Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments. Releases No 33-7386; 34-38223; IC-22487; FR 48; International Series No. 1047; File No S7-35-95. Washington, DC., (January 1997)

EXPLANATORY NOTE TO CVM INSTRUCTION NO. 475, OF DECEMBER 17, 2008 (b) the methods and assumptions used in preparing the sensitivity analysis; and (c) changes from the previous period in the methods and assumptions used, and the reasons for such changes. 41 If an entity prepares a sensitivity analysis, such as value-at-risk, that reflects interdependencies between risk variables (eg interest rates and exchange rates) and uses it to manage financial risks, it may use that sensitivity analysis in place of the analysis specified in paragraph 40. The entity shall also disclose:
(a) an explanation of the method used in preparing such a sensitivity analysis, and of the main parameters and assumptions underlying the data provided; and (b) an explanation of the objective of the method used and of limitations that may result in the information not fully reflecting the fair value of the assets and liabilities involved”.5 That is, to meet the objectives of accounting statements, the IASB standard requires that a sensitivity analysis be presented considering reasonably possible variations in the considered risk variables. Regarding the understanding of the meaning of reasonable variations in the considered risk variables, doctrine presents the following understanding:
“In determining what a reasonably possible change in the relevant variable is, the economic environment (s) in which the entity operates and the time frame over which it is making the assessment should be considerable6”. That is, we can see that the economic environment in which the company operates must be taken into account in the choice of variations in the considered risk variables. In this sense, the Brazilian economic environment, especially regarding exchange rate variation, deserves attention. It is relative consensus among economists that the Brazilian exchange rate presents one of the highest volatilities in the world. In a study by FIESP7, conducted without considering the devaluation of 1999, it can be seen that Brazil had the highest exchange rate volatility in the world. During the analyzed period, the average volatility of the Brazilian exchange rate was 22%. An observation of Figure 1 shows that the volatility of the exchange rate in Brazil is extremely high and that annual changes close to or exceeding 50% occurred on four occasions between 1999 and 2008. In this sense, the question arises: What rate of variation can be considered reasonably possible within the spirit of IFRS 7? IFRS 7 specifies that stress scenarios should not be disclosed, as we can see below:
5 Extracted from IFRS 7, Financial Instruments: Disclosures. © IASC Foundation.
6 Ernst & Young. International GAAP. Page 1665.
7 Available at www.fiesp.com.br/economia/pdf/volatilidade_cambio.pdf

EXPLANATORY NOTE TO CVM INSTRUCTION NO. 475, OF DECEMBER 17, 2008 “In determining what a reasonably possible change in the relevant risk variable is, an entity should consider:
(a) the economic environments in which it operates. A reasonably possible change should not include remote or 'worst case' scenarios or 'stress tests'. Moreover, if the rate of change in the underlying risk variable is stable, the entity need not alter the chosen reasonably possible change in the risk variable. For example, assume that interest rates are 5 per cent and an entity determines that a fluctuation in interest rates of ±50 basis points is reasonably possible. It would disclose the effect on profit or loss and equity if interest rates were to change to 4.5 per cent or 5.5 per cent. In the next period, interest rates have increased to 5.5 per cent. The entity continues to believe that interest rates may fluctuate by ±50 basis points (ie that the rate of change in interest rates is stable). The entity would disclose the effect on profit or loss and equity if interest rates were to change to 5 per cent or 6 per cent. The entity would not be required to revise its assessment that interest rates might reasonably fluctuate by ±50 basis points, unless there is evidence that interest rates have become significantly more volatile”.8 (u.a.) According to the International Monetary Fund9 – also used in works by the Bank for International Settlements (BIS)10 – a stress scenario is one in which “exceptional but plausible economic shocks” occur (Sorge, 2004). This Instruction works with 3 (three) scenarios, namely, a most likely scenario (of expected occurrence), in the assessment of management, a scenario with an adverse variation of at least 25% in the considered risk variable, and a last scenario of adverse variation of at least 50% in the considered risk variable. This adverse variation scenario, taking into account the Brazilian reality, can be considered as a stress scenario - exceptional? It can be clearly seen that it is not. In the last 10 years, variations close to or exceeding 50% occurred on four occasions – see Figure 1. This statistical frequency shows us that oscillations around 50% are not exceptional in the Brazilian reality. Quite the contrary, they are relatively frequent. The average variation of the exchange rate in Brazil itself is higher than 20%. In this year of 2008, this phenomenon occurred exactly. The exchange rate variation between the 2nd and 3rd quarters of 2008 was around 50%. If the sensitivity analysis with the 50% variation had been disclosed from the beginning, it would have been possible to obtain (perhaps more clearly even for the management of many societies) an idea very close to what actually occurred in the third quarter. Thus, it is understood that the 50% variation does not constitute a stress scenario in the context of the Brazilian last decade. Therefore, it is aligned with what is provided for in international standards. Furthermore, the public hearing and comments made by the press strongly evidence the usefulness and acceptance of the suggested sensitivity analysis schedule. 8 Extracted from IFRS 7,
Financial Instruments: Disclosures. © IASC Foundation. 9 Blaschke, W. M. T. Jones, G Majnoni, and S. M. Peria (2001) Stress Testing of Financial Systems: an overview of issues, methodologies and FSAP experiences. International Monetary Fund. 10 Sorge, M. (2004) Stress testing financial systems: an overview of current methodologies.BIS Working Papers No 165.

EXPLANATORY NOTE TO CVM INSTRUCTION NO. 475, OF DECEMBER 17, 2008 These considerations led the Securities and Exchange Commission to make, by this Instruction, this schedule mandatory. Originally signed by MARIA HELENA DOS SANTOS FERNANDES DE SANTANA President

EXPLANATORY NOTE TO CVM INSTRUCTION NO. 475, OF DECEMBER 17, 2008
Figure 1 – Maximum Annual Variation of the Dollar against the Real 1999-2008