Who wants to talk some more about hedging?!? This is the third installment of my series of blogs about the recent improvements made to ASC 815. Last time we covered hedges of non-financial risks, so now it’s time to show some love to financial risks, specifically fair value hedges of interest rate risk where an entity would like to hedge a partial term or prepayment risk. Once again, we will be illustrating how the FASB has amended the guidance, not by changing “what can be hedged”, but instead expanding the ways that the hedge can be defined for the purposes of establishing effectiveness.

To illustrate two hedging strategies that have been improved by the new guidance, let’s consider the following example:

Messi Corp. takes out a 7% fixed rate, 10-year loan with Ronaldo Bank. Under the terms of the loan, Messi may repay the loan at its option, or Ronaldo may call for repayment of the loan in its entirety, after 5 years.

In this example, Messi is exposed to interest rate risk (i.e. if interest rates go down, Messi would be required to pay a higher rate than market over the period of the loan). Let’s assume Messi wants to hedge this risk by entering into a fair value hedge using an interest rate swap. Given the prepayment features in the loan, they have two hedging options:

1. Hedge the loan for only 5 years with a 5-year interest-rate swap (IRS), and assume either they (Messi) or Ronaldo will cause prepayment.
2. Hedge the loan for the entire period with a 10-year IRS, but purchase a mirror call option to match the prepayment feature of the hedged item.

We look at each of these strategies separately:

1. Partial term hedges

The first option is what we call a “partial term hedge”, where Messi is hedging interest rate risk associated with the 10-year loan for only the first five years.

While this hedging strategy was allowed under the previous version of ASC 815, the ability to prove that this was a highly effective hedge was nearly impossible. This was due to the fact that in a fair value hedging relationship, you are inherently hedging the change in fair value of the loan due to changes in interest rate risk, not simply hedging select cash flows (as you would do in a cash flow hedge). As a result, when measuring the change in fair value of the loan due to interest rate risk and considering the loan’s five extra years of exposure to risk until principal repayment, significant differences are likely to exist as compared to the 5-year IRS. As a result, many entities would not meet the effectiveness requirements and could not receive hedge accounting for this risk management strategy.

ASU 2017-12 improved this risk management strategy by allowing a company to calculate the change in fair value (due to interest rate risk) of the hedged item with an “assumed” term that correlates with the hedging instrument. In other words, for the purposes of effectiveness testing only, Messi may “assume” a prepayment of the loan after 5-years. As a result, the change in fair value of the loan (due to changes in interest rates) and the change in fair value of the 5-year IRS will be more “perfect” and result in a highly effective hedging relationship.

In order to take advantage of this improvement, an entity will need to clearly document their intention to “assume” prepayment on this date as part of their hedge documentation as this is not required, but elected by an entity, for purposes of effectiveness testing. The end result of this improvement is that an entity may essentially hedge a series of fixed cash flows in a manner similar to how a cash flow hedge allows for the hedge of a series of variable rate cash flows.

2. Hedging instruments with prepayment risk

The second option involves a hedging strategy where both interest rate risk and prepayment risk over the entire term of the loan are being hedged. This is achieved by holding both an IRS for the entire term of the loan, but also holding a “mirror call option” to match the prepayment rights of the loan.

At first glance, it would appear that this hedging arrangement is perfect and would result in no ineffectiveness, assuming the terms match up on both the hedging instrument and the hedged item. Unfortunately, it is NOT perfect and could result in the hedging relationship not qualifying for hedge accounting.

How? It all comes down to the measurement of the prepayment risk. The change in fair value of the mirror call option on the IRS is entirely driven by how changes in interest rates impact the likelihood of that call option being exercised. There are no other risk factors, other than interest-rate risk, impacting this valuation. The prepayment option on the loan, however, is impacted by more factors. Of course, interest rate movements will change the likelihood that prepayment be exercised or not, but other factors such as the debtor’s credit risk also factor into the likelihood that the prepayment option be exercised. These factors, other than interest rate risk, will be the source of potential ineffectiveness in the hedging relationship.

ASU 2017-12 improves this hedging relationship by allowing an entity to consider changes in fair value of the prepayment option on the hedged item due only to interest rate risk, and ignore other factors impacting its fair value. By omitting these other factors affecting the fair value of the prepayment right on the loan, the hedging IRS with the mirror call option is more “perfect” leading to an even more highly effective relationship. Once again, in order to take advantage of this hedging strategy, hedge documentation must clearly specify an entity’s intent to only consider the prepayment risk due to interest rate risk for purposes of proving effectiveness in its hedge documentation.

Aligning Accounting with Risk Management

There you have it. Two more hedging strategies that improve the alignment of ASC 815 with the risk management strategies an entity might seek to apply related to fair value hedges of interest rate risk. You may be starting to realize that many of the improvements to ASC 815 are specific in nature and relate to quite narrow hedging scenarios. The purpose of these changes is to address issues raised in the past by entities where the accounting did not align with an otherwise valid risk management strategy.

In future blogs, we will look at more hedging strategies that have been improved and aligned with the way an entity is managed. Stay tuned!

Disclaimer  

This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.