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Portfolio (Macro) Hedge Accounting in SFAS 133 and IAS 39
Bob Jensen at Trinity University

 

Key Paragraphs from SFAS 133

Key Supplement to IAS 39 

Bob Jensen's SFAS 133 and IAS 39 Glossary

 

SFAS 133 Paragraph 21

The Hedged Item

21. 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:

a. 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. \8/ 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).

1) 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 percent to 11 percent. 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 percent to 13 percent would be inconsistent with this provision. In aggregating loans in a portfolio to be hedged, an entity 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.

Footnote 9
\9/ Mortgage bankers and other servicers of financial assets that designate a hedged portfolio by aggregating servicing rights within one or more risk strata used under SFAS 133 Paragraph 37(g) of Statement 125 would not necessarily comply with the requirement in this SFAS 133 Paragraph for portfolios of similar assets. The risk stratum under SFAS 133 Paragraph 37(g) of Statement 125 can be based on any predominant risk characteristic, including date of origination or geographic location.

SFAS 133 Paragraph 56

56. At the date of initial application, mortgage bankers and other servicers of financial assets may choose to restratify their servicing rights pursuant to SFAS 133 Paragraph 37(g) of Statement 125 in a manner that would enable individual strata to comply with the requirements of this Statement regarding what constitutes "a portfolio of similar assets." As noted in footnote 9 of this Statement, mortgage bankers and other servicers of financial assets that designate a hedged portfolio by aggregating servicing rights within one or more risk strata used under SFAS 133 Paragraph 37(g) of Statement 125 would not necessarily comply with the requirement in SFAS 133 Paragraph 21(a) of this Statement for portfolios of similar assets, since the risk stratum under SFAS 133 Paragraph 37(g) of Statement 125 can be based on any predominant risk characteristic, including date of origination or geographic location. The restratification of servicing rights is a change in the application of an accounting principle, and the effect of that change as of the initial application of this Statement shall be reported as part of the cumulative-effect-type adjustment for the transition adjustments.

SFAS 133 Paragraphs 241 and 242

241. The Board believes that accounting requirements should be neutral and should not encourage or discourage the use of particular types of contracts. That desire for neutrality must be balanced with the need to reflect substantive economic differences between different instruments. This Statement is the product of a series of many compromises made by the Board to improve financial reporting for derivatives and hedging activities while giving consideration to cost-benefit issues, as well as current practice. The Board believes that most hedging strategies for which hedge accounting is available in current practice have been reasonably accommodated. The Board recognizes that this Statement does not provide special accounting that accommodates some risk management strategies that certain entities wish to use, such as hedging a portfolio of dissimilar items. However, this Statement clarifies and accommodates hedge accounting for more types of derivatives and different views of risk, and provides more consistent accounting for hedges of forecasted transactions than did the limited guidance that existed before this Statement.

242. Some constituents have said that the requirements of this Statement are more complex than existing guidance. The Board disagrees. It believes that compliance with previous guidance was more complex because the lack of a single, comprehensive framework forced entities to analogize to different and often conflicting sources of guidance. The Board also believes that some constituents' assertions about increased complexity may have been influenced by some entities' relatively lax compliance with previous guidance. For example, the Board understands that not all entities complied with Statement 80's entity-wide risk reduction criterion to qualify for hedge accounting, and that also may have been true for requirements for hedging a portfolio of dissimilar items. The Board also notes that some of the more complex requirements of this Statement, such as reporting the gain or loss on a cash flow hedge in earnings in the periods in which the hedged transaction affects earnings, are a direct result of the Board's efforts to accommodate respondents' wishes.

SFAS 133 Paragraph 317

Valuation of Deposit Liabilities

317. The guidance in Statement 107 precludes an entity from reflecting a long-term relationship with depositors, commonly known as a core deposit intangible, in determining the fair value of a deposit liability. SFAS 133 Paragraph 12 of Statement 107 states, in part:

In estimating the fair value of deposit liabilities, a financial entity shall not take into account the value of its long-term relationships with depositors, commonly known as core deposit intangibles, which are separate intangible assets, not financial instruments. For deposit liabilities with no defined maturities, the fair value to be disclosed under this Statement is the amount payable on demand at the reporting date.

Some respondents to the Exposure Draft requested that this Statement permit the fair value of deposit liabilities to reflect the effect of the core deposit intangible. The Board decided to make no change to the guidance in Statement 107 on that issue because it will be addressed as part of the Board's current project on measuring financial instruments at fair value. Issues of whether the fair values of certain liabilities (or assets) should reflect their values as if they were settled immediately or whether they should be based on their expected settlement dates, as well as issues of whether or when it would be appropriate to measure portfolios of assets or liabilities rather than individual items in those portfolios, are central to that project.

 

SFAS 133 Paragraphs 432-436

Additional Qualifying Criteria for Fair Value Hedges Specific Identification

432. This Statement requires specific identification of the hedged item. The hedged item must be (a) an entire recognized asset or liability, or an unrecognized firm commitment, (b) a portfolio of similar assets or similar liabilities, or (c) a specific portion of a recognized asset or liability, unrecognized firm commitment, or portfolio of similar items. If an entity hedges a specified portion of a portfolio of similar assets or similar liabilities, that portion should relate to every item in the portfolio. If an entity wishes to hedge only certain similar items in a portfolio, it should first identify a smaller portfolio of only the items to be hedged.

433. The Exposure Draft would not have permitted designation of a portion of an asset or a liability as a hedged item. Under the Exposure Draft, those items could only have been hedged in their entirety or on a percentage basis. Some respondents to the Exposure Draft objected to that limitation because it precluded identification of only selected contractual cash flows as the item being hedged (referred to as partial-term hedging for a debt security). For example, it would have prohibited identification of the interest payments for the first two years of a four-year fixed-rate debt instrument as the hedged item and, therefore, would have precluded hedge accounting for a hedge of that debt with a two-year interest rate swap.

434. The Board was reluctant to permit identification of a selected portion (rather than proportion) of an asset or liability as the hedged item because it believes that, in many cases, partial-term hedge transactions would fail to meet the offset requirement. For example, the changes in the fair value of a two-year interest rate swap cannot be expected to offset the changes in fair value attributable to changes in market interest rates of a four-year fixed-rate debt instrument. For offset to be expected, a principal repayment on the debt (equal to the notional amount on the swap) would need to be expected at the end of year two. The Board decided to remove the prohibition against partial-term hedging and other designations of a portion of an asset or liability to be consistent with the modification to the Exposure Draft to require an entity to define how the expectation of offsetting changes in fair value or cash flows would be assessed. However, removal of that criterion does not necessarily result in qualification for hedge accounting for partial-term or other hedges of part of an asset or a liability.

435. The criterion in SFAS 133 Paragraph 21(a) that permits a hedged item in a fair value hedge to be a designated portion of an asset or liability (or a portfolio of similar assets or similar liabilities) makes the following eligible for designation as a hedged item:

a. A percentage of the entire asset or liability (or of the entire portfolio)

b. One or more selected contractual cash flows (such as the asset or liability representing the interest payments in the first two years of a four-year debt instrument) \32/

c. A put option, a call option, an interest rate cap, or an interest rate floor embedded in an existing asset or liability that is not an embedded derivative accounted for separately under this Statement

d. The residual value in a lessor's net investment in a direct-financing or sales-type lease.

If the entire asset or liability is a variable-rate instrument, the hedged item cannot be a fixed-to-variable interest rate swap (or similar instrument) perceived to be embedded in a fixed-rate host contract. The Board does not intend for an entity to be able to use the provision that a hedged item may be a portion of an asset or liability to justify hedging a contractual provision that creates variability in future cash flows as a fair value hedge rather than as a cash flow hedge. In addition, all other criteria, including the criterion that requires a hedge to be expected to be highly effective at achieving offset, must still be met for items such as the above to be designated and to qualify for hedge accounting.

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\32/ However, as noted in SFAS 133 Paragraph 434, it will likely be difficult to find a derivative that will be effective as a fair value hedge of selected cash flows.

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436. As discussed in SFAS 133 Paragraphs 414 and 415, in designating a hedge of a component of an asset or liability, an entity must consider the effect of any derivatives embedded in that asset or liability related to the same risk class. To disregard the effects of an embedded derivative related to the same risk class could result in a designated hedge that is not effective at achieving offsetting changes in fair value or cash flows. The same unacceptable result would occur if a freestanding derivative that was accounted for as hedging a particular item was ignored in considering whether another derivative would qualify as a hedge of the same risk in that item.

SFAS 133 Paragraphs 443-450

443. This Statement retains the provision from the Exposure Draft that prohibits a portfolio of dissimilar items from being designated as a hedged item. Many respondents said that hedge accounting should be extended to hedges of portfolios of dissimilar items (often called macro hedges) because macro hedging is an effective and efficient way to manage risk. To qualify for designation as a hedged item on an aggregate rather than individual basis, the Exposure Draft would have required that individual items in a portfolio of similar assets or liabilities be expected to respond to changes in a market variable in an equivalent way. The Exposure Draft also included a list of specific characteristics to be considered in determining whether items were sufficiently similar to qualify for hedging as a portfolio. Respondents said that, taken together, the list of characteristics and the "equivalent way" requirement would have meant that individual items could qualify as "similar" only if they were virtually identical.

444. To deal with the concerns of respondents, the Board modified the Exposure Draft in two ways. First, the Board deleted the requirement that the value of all items in a portfolio respond in an equivalent way to changes in a market variable. Instead, this Statement requires that the items in a portfolio share the risk exposure for which they are designated as being hedged and that the fair values of individual items attributable to the hedged risk be expected to respond proportionately to the total change in fair value of the hedged portfolio. The Board intends proportionately to be interpreted strictly, but the term does not mean identically. For example, a group of assets would not be considered to respond proportionately to a change in interest rates if a 100-basis-point increase in interest rates is expected to result in percentage decreases in the fair values of the individual items ranging from 7 percent to 13 percent. However, percentage decreases within a range of 9 percent to 11 percent could be considered proportionate if that change in interest rates reduced the fair value of the portfolio by 10 percent.

445. The second way in which the Board modified the Exposure Draft was to delete the requirement to consider all specified risk characteristics of the items in a portfolio. The Board considered completely deleting the list of risk characteristics included in the Exposure Draft, and the Task Force Draft did not include that list. However, respondents to that draft asked for additional guidance on how to determine whether individual assets or liabilities qualify as "similar." In response to those requests, the Board decided to reinstate the list of characteristics from the Exposure Draft. The Board intends the list to be only an indication of factors that an entity may find helpful.

446. Those two changes are consistent with other changes to the Exposure Draft to focus on the risk being hedged and to rely on management to define how effectiveness will be assessed. It is the responsibility of management to appropriately assess the similarity of hedged items and to determine whether the derivative and a group of hedged items will be highly effective at achieving offset. Those changes to the Exposure Draft do not, however, permit aggregation of dissimilar items. Although the Board recognizes that certain entities are increasingly disposed toward managing specific risks within portfolios of assets and liabilities, it decided to retain the prohibition of hedge accounting for a hedge of a portfolio of dissimilar items for the reasons discussed in the following SFAS 133 Paragraphs.

447. Hedge accounting adjustments that result from application of this Statement must be allocated to individual items in a hedged portfolio to determine the carrying amount of an individual item in various circumstances, including (a) upon sale or settlement of the item (to compute the gain or loss), (b) upon discontinuance of a hedging relationship (to determine the new carrying amount that will be the basis for subsequent accounting), and (c) when other generally accepted accounting principles require assessing that item for impairment. The Board decided that a hedge accounting approach that adjusts the basis of the hedged item could not accommodate a portfolio of dissimilar items (macro hedging) because of the difficulties of allocating hedge accounting adjustments to dissimilar hedged items. It would be difficult, if not impossible, to allocate derivative gains and losses to a group of items if their values respond differently (both in direction and in amount) to a change in the risk being hedged, such as market interest rate risk. For example, some components of a portfolio of dissimilar items may increase in value while other components decrease in value as a result of a given price change. Those allocation difficulties are exacerbated if the items to be hedged represent different exposures, that is, a fair value risk and a cash flow risk, because a single exposure to risk must be chosen to provide a basis on which to allocate a net amount to multiple hedged items.

448. The Board considered alternative approaches that would require amortizing the hedge accounting adjustments to earnings based on the average holding period, average maturity or duration of the items in the hedged portfolio, or in some other manner that would not allocate adjustments to the individual items in the hedged portfolio. The Board rejected those approaches because determining the carrying amount for an individual item when it is (a) impaired or (b) sold, settled, or otherwise removed from the hedged portfolio would ignore its related hedge accounting adjustment, if any. Additionally, it was not clear how those approaches would work for certain portfolios, such as a portfolio of equity securities.

449. Advocates of macro hedging generally believe that it is a more effective and efficient way of managing an entity's risk than hedging on an individual-item basis. Macro hedging seems to imply a notion of entity-wide risk reduction. The Board also believes that permitting hedge accounting for a portfolio of dissimilar items would be appropriate only if risk were required to be assessed on an entity-wide basis. As discussed in SFAS 133 Paragraph 357, the Board decided not to include entity-wide risk reduction as a criterion for hedge accounting.

450. Although this Statement does not accommodate designating a portfolio of dissimilar items as a hedged item, the Board believes that its requirements are consistent with (a) the hedge accounting guidance that was in Statements 52 and 80, (b) what the Board generally understands to have been current practice in accounting for hedges not addressed by those Statements, and (c) what has been required by the SEC staff. The Board's ultimate goal of requiring that all financial instruments be measured at fair value when the conceptual and measurement issues are resolved would better accommodate risk management for those items on a portfolio basis. Measuring all financial instruments at fair value with all gains or losses recognized in earnings would, without accounting complexity, faithfully represent the results of operations of entities using sophisticated risk management techniques for hedging on a portfolio basis.

SFAS 133 Paragraph 477

477. This Statement also makes an exception to permit an entity to designate a financial instrument denominated in a foreign currency (derivative or nonderivative) as a hedge of the foreign currency exposure of a net investment in a foreign operation. Net investment hedges are subject only to the criteria in SFAS 133 Paragraph 20 of Statement 52. The net investment in a foreign operation can be viewed as a portfolio of dissimilar assets and liabilities that would not meet the criterion in this Statement that the hedged item be a single item or a group of similar items. Alternatively, it can be viewed as part of the fair value of the parent's investment account. Under either view, without a specific exception, the net investment in a foreign operation would not qualify for hedging under this Statement. The Board decided, however, that it was acceptable to retain the current provisions of Statement 52 in that area. The Board also notes that, unlike other hedges of portfolios of dissimilar items, hedge accounting for the net investment in a foreign operation has been explicitly permitted by the authoritative literature.

 

Key Supplement to IAS 39

Excerpts from the IAS 39 Supplement

Supplement to the Publication
Accounting for Financial Instruments - Standards, Interpretations, and Implementation Guidance
http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf

When the IASC Board voted to approve IAS 39: Financial Instruments: Recognition and Measurement in December 1998, it instructed the staff to monitor implementation issues and to consider how IASC can best respond to such issues and thereby help financial statement preparers, auditors, financial analysts, and others understand IAS 39 and those preparing to apply it for the first time.

In March 2000, the IASC Board approved an approach to publish implementation guidance on IAS 39 in the form of Questions and Answers (Q&A) and appointed an IAS 39 Implementation Guidance Committee (IGC) to review and approve the draft Q&A and to seek public comment before final publication. Also, the IAS 39 IGC may refer some issues either to the Standing Interpretations Committee (SIC) or to the IASB.

In July 2001, IASB issued a consolidated document that includes all questions and answers approved in final form by the IAS 39 Implementation Guidance Committee as of 1 July 2001, including the fifth batch of proposed guidance (issued for comment in December 2000). The Q&A respond to questions submitted by financial statement preparers, auditors, regulators, and others and have been issued to help them and others better understand IAS 39 and help ensure consistent application of the Standard.

There is also a publication, Accounting for Financial Instruments - Standards, Interpretations and Implementation Guidance, which is available from IASB Publications. This book contains the current text of IAS 32 and IAS 39, SIC Interpretations related to the accounting for financial instruments as well as the IAS 39 Implementation Guidance Questions and Answers.

In November 2001, the IGC issued a document with the final versions of 17 Q&A and two illustrative examples that were issued in draft form for public comment in June 2001. That document replaces pages 477-541 in the publication Accounting for Financial Instruments - Standards, Interpretations, and Implementation Guidance, which was published in July 2001. Draft Questions 10-22, 18-3, 38-6, 52-1, and 112-3 were eliminated in the final document, primarily because the issues involved are being addressed in the Board’s current project to amend IAS 39.  In November 2001, the IASB issued the following free document:

Supplement to the Publication
Accounting for Financial Instruments - Standards, Interpretations, and Implementation Guidance
http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf

 

Appendix to the IAS 39 Implementation Guidance
Illustrative example of applying the approach in Question 121-2

 

The purpose of this example is to illustrate the process of establishing, monitoring, and adjusting hedge positions and of qualifying for cash flow hedge accounting in applying the approach to hedge accounting described in Question 121-2 when a financial institution manages its interest rate risk on an enterprise-wide basis.  To this end, this example identifies a methodology that allows for the use of hedge accounting and takes advantage of existing risk management systems so as to avoid unnecessary changes to it and to avoid unnecessary bookkeeping and tracking.

The approach being illustrated herein reflects only one of a number of risk management processes that could be employed and could qualify for hedge accounting.  Its use is not intended to suggest that other alternatives could not or should not be used.  The approach being illustrated also could be applied in other circumstances (such as for cash flow hedges of commercial companies), for example, hedging the rollover of commercial paper financing.

Identifying, assessing and reducing cash flow exposures

The discussion and illustrations that follow focus on the risk management activities of a financial institution that manages its interest rate risk by analyzing expected cash flows in a particular currency on an enterprise-wide basis.  The cash flow analysis forms the basis for identifying the interest rate risk of the enterprise, entering into hedging transactions to manage the risk, assessing the effectiveness of risk management activities, and qualifying for and applying cash flow hedge accounting.

The illustrations that follow assume that an enterprise, a financial institution, had the following expected future net cash flows and hedging positions outstanding in a specific currency, consisting of interest rate swaps, at the beginning of Period X0.  The cash flows shown are expected to occur at the end of the period and, therefore, create a cash flow interest exposure in the following period as a result of the reinvestment or repricing of the cash inflows or the refinancing or repricing of the cash outflows.

The illustrations assume that the enterprise has an ongoing interest rate risk management program.  Schedule I shows the expected cash flows and hedging positions that existed at the beginning of Period X0.  It is included herein to provide a starting point in the analysis.  It provides a basis for considering existing hedges in connection with the evaluation that occurs at the beginning of Period X1.

 

 

The schedule depicts five quarterly periods.  The actual analysis would extend over a period of many years, represented by the notation, "...n".  A financial institution that manages its interest rate risk on an enterprise-wide basis re-evaluates its cash flow exposures periodically.  The frequency of the evaluation depends on the enterprise's risk management policy.

For purposes of this illustration, the enterprise is re-evaluating its cash flow exposures at the end of Period X0.  The first step in the process is the generation of forecasted net cash flow exposures from existing interest-earning assets and interest-bearing liabilities, including the rollover of short-term assets and short-term liabilities.  Schedule II below illustrates the forecast of net cash flow exposures.  A common technique for assessing exposure to interest rates for risk management purposes is an interest rate sensitivity gap analysis showing the gap between interest rate-sensitive assets and interest rate-sensitive liabilities over different time intervals.  Such an analysis could be used as a starting point for identifying cash flow exposures to interest rate risk for hedge accounting purposes (see Question 121-2-a).

 

 

  1. The cash flows are estimated using contractual terms and assumptions based on management intent and market factors.  It is assumed that short-term assets and liabilities will continue to be rolled over in succeeding periods.  Assumptions about prepayments and defaults and the withdrawal of deposits are based on market and historical data.  It is assumed that principal and interest inflows and outflows will be reinvested and refinanced, respectively, at the end of each period at the then current market interest rates and share the benchmark interest rate risk to which they are exposed.

  2. Forward interest rates obtained from Schedule VI are used to forecast interest payments on variable-rate financial instruments and expected rollovers of short-term assets and liabilities.  All forecasted cash flows are associated with the specific time periods (3 months, 6 months, 9 months, and 12 months) in which they are expected to occur.  For completeness, the interest cash flows resulting from reinvestments, refinancings, and repricings are included in the schedule and shown gross even though only the net margin may actually be reinvested.  Some entities may choose to disregard the forecasted interest cash flows for risk management purposes because they may be used to absorb operating costs and any remaining amounts would not be significant enough to affect risk management decisions.

  3. The cash flow forecast is adjusted to include the variable-rate asset and liability balances in each period in which such variable-rate asset and liability balances reprice.  The principal amounts of these assets and liabilities are not actually being paid and, therefore, do not generate a cash flow.  However, since interest is computed on the principal amounts each period based on the then current market interest rate, such principal amounts expose the entity to the same interest rate risk as if they were cash flows being reinvested or refinanced.

  4. The forecasted cash flow and repricing exposures that are identified in each period represent the principal amounts of cash inflows that will be reinvested or repriced and cash outflows that will be refinanced or repriced at the market interest rates that are in effect when those forecasted transactions occur.

  5. The net cash flow and repricing exposure is the difference between the cash inflow and repricing exposures from assets and the cash outflow and repricing exposures from liabilities.  In the illustration, the enterprise is exposed to interest rate declines because the exposure from assets exceeds the exposure from liabilities and the excess (that is, the net amount) will be reinvested or repriced at the current market rate and there is no offsetting refinancing or repricing of outflows.

Note that some banks consider some portion of their non-interest bearing demand deposits to be economically equivalent to long-term debt.  However, these deposits do not create a cash flow exposure to interest rates and, therefore, would be excluded from this analysis for accounting purposes.

Schedule II, Forecasted Net Cash Flow and Repricing Exposures, only provides a starting point for assessing cash flow exposure to interest rates and for adjusting hedging positions. The complete analysis includes outstanding hedging positions and is shown in Schedule III, Analysis of Expected Net Exposures and Hedging Positions.  It compares the forecasted net cash flow exposures for each period (developed in Schedule II) with existing hedging positions (obtained from Schedule I), and provides a basis for considering whether adjustment of the hedging relationship should be made.

 

 

The notional amounts of the interest rate swaps that are outstanding at the analysis date are included in each of the periods in which the interest rate swaps are outstanding to illustrate the impact of the outstanding interest rate swaps on the identified cash flow exposures.  The notional amounts of the outstanding interest rate swaps are included in each period because interest is computed on the notional amounts each period, and the variable rate components of the outstanding swaps are repriced to the current market rate quarterly.  The notional amounts create an exposure to interest rates that in part is similar to the principal balances of variable-rate assets and variable-rate liabilities.

The exposure that remains after considering the existing positions is then evaluated to determine the extent to which adjustments of existing hedging positions are necessary.  The bottom portion of Schedule III shows the beginning of Period X1 using interest rate swap transactions to further reduce the net exposures to within the tolerance levels established under the enterprise's risk management policy.

Note that in the illustration, the entire cash flow exposure is not eliminated.  Many financial institutions do not fully eliminate risk but rather reduce it to within some tolerable limit.

Various types of derivative instruments could be used to manage the cash flow exposure to interest rate risk identified in the schedule of forecasted net cash flows (Schedule II).  However, for purposes of the illustration, it is assumed that interest rate swaps are used for all hedging activities.  It is also assumed that in periods in which interest rate swaps should be reduced, rather than terminating some of the outstanding interest rate swap positions, a new swap with the opposite return characteristics is added to the portfolio.

In the illustration in Schedule III above, swap 1, a receive-fixed, pay-variable swap, is used to reduce the net exposure in Periods X1 and X2.  Since it is a 10-year swap, it also reduces exposures identified in other future periods not shown.  However, it has the effect of creating an over-hedged position in Periods X3 to X5.  Swap 2, a forward starting pay-fixed, receive-variable interest rate swap, is used to reduce the notional amount of the outstanding receive-fixed, pay-variable interest rate swaps in Periods X3 to X5 and thereby reduce the over-hedged positions.

It also is noted that in many situations, no adjustment or only a single adjustment of the outstanding hedging position is necessary to bring the exposure to within an acceptable limit.  However, in situations in which there is a very low tolerance for risk specified in the risk management policy of the enterprise, a greater number of adjustments to the hedging positions over the forecast period would be needed to further reduce any remaining risk.

To the extent that some of the interest rate swaps fully offset other interest rate swaps that have been entered into for hedging purposes, it is not necessary that they be included in a designated hedging relationship for hedge accounting purposes.  These offsetting positions can be combined, de-designated as hedging instruments, if necessary, and reclassified for accounting purposes from the hedging portfolio to the trading portfolio.  This procedure limits the extent to which the gross swaps must continue to be designated and tracked in a hedging relationship for accounting purposes.  If an offsetting swap only partially offsets another interest rate swap that is designated as a hedge, the net position does not qualify as a hedging instrument because that would result in a portion of the hedging instrument being designated as a hedge, which is not permitted for accounting purposes.  To the extent that both swaps are designated as hedging instruments and they do not fully offset each other, the effect of hedge accounting would be to take out of equity any excess gain or loss recognized in equity over the remaining contractual life of the interest rate swap to correspond with the timing of the designated hedged forecasted transactions.  For purposes of this illustration it is assumed that 500 of the pay-fixed, receive-variable interest rate swaps fully offset 500 of the receive-fixed, pay-variable interest rate swaps at the beginning of period X1 and for periods X1 through X5, and are de-designated as hedging instruments and reclassified to the trading account.

After reflecting these offsetting positions, the remaining gross interest rate swap positions from Schedule III are shown in Schedule IV as follows:

 

 

For purposes of the illustrations, it is assumed that Swap 2, entered into at the beginning of Period X1, only partially offsets another swap being accounted for as a hedge and, therefore, continues to be designated as a hedging instrument.

 

Hedge accounting considerations

Illustrating the designation of the hedging relationship

The discussion and illustrations thus far have focused primarily on economic and risk management considerations relating to the identification of risk in future periods and the adjustment of that risk using interest rate swaps.  These activities form the basis for designating a hedging relationship for accounting purposes.

The examples in IAS 39 focus primarily on hedging relationships involving a single hedged item and a single hedging instrument, but there is little discussion and guidance on portfolio hedging relationships for cash flow hedges when risk is being managed on a centralized basis.  In this illustration, the general principles are applied to hedging relationships involving a component of risk in a portfolio having multiple risks from multiple transactions or positions.

While designation is necessary to achieve hedge accounting, the way in which the designation is described also affects the extent to which the hedging relationship is considered to be effective for accounting purposes and the extent to which the enterprise's existing system for managing risk will be required to be modified to track hedging activities for accounting purposes.  Accordingly, an enterprise may wish to designate the hedging relationship in a manner that avoids unnecessary systems changes by taking advantage of the information already generated by the risk management system and avoids unnecessary bookkeeping and tracking.  In designating hedging relationships, the enterprise may also consider the extent to which ineffectiveness is expected to be recognized for accounting purposes under alternative designations.

There are a number of things that should be specified in the designation of the hedging relationship.  These are illustrated and discussed here from the perspective of the hedge of the interest rate risk associated with the cash inflows, but the guidance also can be applied to the hedge of the risk associated with the cash outflows.  It is fairly obvious that only a portion of the gross exposures relating to the cash inflows are being hedged by the interest rate swaps.  Schedule V, The General Hedging Relationship, illustrates the designation of the portion of the gross reinvestment risk exposures identified in Schedule II being hedged by the interest rate swaps.

 

 

The hedged exposure percentage is computed as the ratio of the notional amount of the receive-fixed, pay-variable swaps that are outstanding divided by the gross exposure.  Note that in Schedule V there are sufficient levels of forecasted reinvestments in each period to more than offset the notional amount of the receive-fixed, pay-variable swaps and satisfy the accounting requirement that the forecasted transaction is probable of occurring.

It is not as obvious, however, how the interest rate swaps are specifically related to the cash flow interest risks designated as being hedged and how the interest rate swaps are effective in reducing that risk.  The more specific designation is illustrated in Schedule VI, The Specific Hedging Relationship, shown below.  It provides a meaningful way of depicting the more complicated narrative designation of the hedge by focusing on the hedging objective to eliminate the cash flow variability associated with future changes in interest rates and to obtain an interest rate equal to the fixed rate inherent in the term structure of interest rates that exists at the commencement of the hedge.

The expected interest from the reinvestment of the cash inflows and repricings of the assets is computed by multiplying the gross amounts exposed by the forward rate for the period.  For example, the gross exposure for Period 2 of 14100 is multiplied by the forward rate for Period 2 to 5 of 5.50%, 6.00%, 6.50%, and 7.25%, respectively, to compute the expected interest for those quarterly periods based on the current term structure of interest rates.  The hedged expected interest is computed by multiplying the expected interest for the applicable three-month period by the hedged exposure percentage.

 

 

It does not matter whether the gross amount exposed is reinvested in long-term fixed-rate debt or variable-rate debt, or in short-term debt that is rolled over in each subsequent period.  The exposure to changes in the forward interest rate is the same.  For example, if the 14100 is reinvested at a fixed rate at the beginning of Period 2 for six months, it will be reinvested at 5.75%.  The expected interest is based on the forward interest rates for Period 2 of 5.50% and for Period 3 of 6.00% which is equal to a blended rate of 5.75% (1.055 x 1.060)0.5, which is the Period 2 spot rate for the next six months.

However, only the expected interest from the reinvestment of the cash inflows or repricing of the gross amount for the first three-month period after the forecasted transaction occurs is designated as being hedged.  The expected interest being hedged is represented by the shaded cells.  The exposure for the subsequent periods is not hedged.  In the example, the portion of the interest rate exposure being hedged is the forward rate of 5.50% for Period X2.  In order to assess hedge effectiveness and compute actual hedge ineffectiveness on an ongoing basis, the enterprise may use the information on hedged interest cash inflows in Schedule VI and compare it with updated estimates of expected interest cash inflows (for instance, in a table that looks like Schedule II).  As long as expected interest cash inflows exceed hedged interest cash inflows, the enterprise may compare the cumulative change in the fair value of the hedged cash inflows with the cumulative change in the fair value of the hedging instrument to compute actual hedge effectiveness.  If there are insufficient expected interest cash inflows, there will be ineffectiveness.  It is measured by comparing the cumulative change in the fair value of the expected interest cash flows to the extent they are less than the hedge cash flows with the cumulative change in the fair value of the hedging instrument.

 

Describing the designation of the hedging relationship

As mentioned previously, there are a number of matters that should be specified in the designation of the hedging relationship that complicate the description of the designation but are necessary to limit ineffectiveness to be recognized for accounting purposes and to avoid unnecessary systems changes and bookkeeping.  The example that follows describes the designation more fully and identifies additional aspects of the designation not apparent from the previous illustrations.

Example designation

Hedging objective

The hedging objective is to eliminate the risk of interest rate fluctuations over the hedging period, which is the life of the interest rate swap, and effectively obtain a fixed interest rate during this period that is equal to the fixed interest rate on the interest rate swap.

Type of hedge

Cash flow hedge

Hedging instrument

The receive-fixed, pay-variable swaps are designated as the hedging instrument.  They hedge the cash flow exposure to interest rate risk.

Each repricing of the swap hedges a 3-month portion of the interest cash inflows that results from

  • the forecasted reinvestment or repricing of the principal amounts shown in Schedule V.

  • unrelated investments or repricings that occur after the repricing dates on the swap over its life and involve different borrowers or lenders.

The hedged item - General

The hedged item is a portion of the gross interest cash inflows that will result from the reinvestment or repricing of the cash flows identified in Schedule V and expected to occur within the periods shown on such schedule.  The portion of the interest cash inflow that is being hedged has three components: 1) the principal component giving rise to the interest cash inflow and the period in which it occurs, 2) the interest rate component, and 3) the time component or period covered by the hedge.

The hedged item - The principal component

The portion of the interest inflows being hedged is the amount that results from the first portion of the principal amounts being invested or repriced in each period:

  • that is equal to the sum of the notional amounts of the received-fixed, pay-variable interest rate swaps that are designated as hedging instruments and outstanding in the period of the reinvestment or repricing, and

  • that corresponds to the first principal amounts of cash flow exposures that are invested or repriced at or after the repricing dates of the interest rate swaps.

The hedged item - The interest rate component

The portion of the interest rate change that is being hedged is the change in the:

  • credit component of the interest rate being paid on the principal amount that is invested or repriced that is equal to the credit risk inherent in the interest rate swap.  It is that portion of the interest rate on the investment that is equal to the interest index of the interest rate swap, such as LIBOR, and

  • the yield curve component of the interest rate that is equal to the repricing period on the interest rate swap designated as the hedging instrument.

The hedged item - The hedged period

The period of the exposure to interest rate changes on the portion of the cash flow exposures being hedged is:

  • the period from the designation date to the repricing date of the interest rate swap that occurs within the quarterly period in which, but not before, the forecasted transactions occur, and

  • its effects for the period after the forecasted transactions occur equal to the repricing interval of the interest rate swap.

It is important to recognize that the swaps are not hedging the cash flow risk for a single investment over its entire life.  The swaps are designated as hedging the cash flow risk from different principal investments and repricings that occur in each repricing period of the swaps over their entire term.  The swaps hedge only the interest accruals that occur in the first period following the reinvestment.  They are hedging the cash flow impact resulting from a change in interest rates that occurs up to the repricing of the swap.  The exposure to changes in rates for the period from the repricing of the swap to the date of the hedged reinvestment of cash inflows or repricing of variable-rate assets is not hedged.  When the swap reprices, the interest rate on the swap is fixed until the next repricing date and the accrual of the net swap settlements is determined.  Any changes in interest rates after that date that affect the amount of the interest cash inflow is no longer hedged for accounting purposes.

 

Designation objectives

Systems considerations

A considerable amount of the tracking and bookkeeping requirements is eliminated by designating each repricing of an interest rate swap as hedging the cash flow risk from forecasted reinvestments of cash inflows and repricings of variable rate assets for only a portion of the lives of the related assets.  A considerable amount of tracking and bookkeeping would be necessary if the swaps were instead designated as hedging the cash flow risk from forecasted principal investments and repricings of variable rate assets over the entire lives of these assets.

This type of designation avoids basis adjustment upon the occurrence of the forecasted transactions (IAS 39.160) because the portion of the cash flow risk being hedged is that portion that will be recognized in earnings in the period immediately following the forecasted transactions that corresponds with the periodic net cash settlements on the swap.  If the hedge were to cover the entire life of the assets being acquired, it would be necessary to associate a specific interest rate swap with the asset being acquired.  If a forecasted transaction is the acquisition of a fixed-rate instrument, the fair value of the swap that hedged that transaction would be reclassified out of equity to adjust the basis of the asset acquired.  The swap would then have to be terminated or redesignated in another hedging relationship.  If a forecasted transaction is the acquisition of a variable-rate asset, the swap would continue in the hedging relationship but it would have to be tracked back to the asset acquired so that any fair value amounts on the swap recognized in equity could be recognized in earnings upon the subsequent sale of the asset.

It also avoids the necessity of associating any portion of the fair value of the swaps that is recognized in equity with variable-rate assets.  Accordingly, there is no portion of the fair value of the swap that is recorded in equity that should be reclassified out of equity upon the occurrence of a forecasted transaction or upon the sale of a variable-rate asset.

This type of designation also permits considerable flexibility in deciding how to reinvest cash flows when they occur.  Since the hedged risk relates only to a single period that corresponds with the repricing period of the interest rate swap designated as the hedging instrument, it is not necessary to determine at the designation date whether the cash flows will be reinvested in fixed-rate or variable-rate assets or to specify at the date of designation the life of the asset to be acquired.

 

Effectiveness considerations

Ineffectiveness is reduced considerably by designating a specific portion of the cash flow exposure as being hedged.

  • Ineffectiveness due to credit differences between the interest rate swap and hedged forecasted cash flow is eliminated by designating the cash flow risk being hedged as the risk attributable to changes in the interest rates that correspond with the rates inherent in the swap, such as the AA rate curve.  This type of designation prevents changes resulting from changes in credit spreads from being considered as ineffectiveness.

  • Ineffectiveness due to duration differences between the interest rate swap and hedged forecasted cash flow is eliminated by designating the interest rate risk being hedged as the risk relating to changes in the portion of the yield curve that corresponds with the period in which the variable-rate leg of the interest rate swap is repriced.

  • Ineffectiveness due to interest rate changes that occur between the repricing date of the interest rate swap and the date of the forecasted transactions is eliminated by simply not hedging that period of time.  The period from the repricing of the swap and the occurrence of the forecasted transactions in the period immediately following the repricing of the swap is simply unhedged.  Therefore, the difference in dates does not result in ineffectiveness.

 

Accounting considerations

The ability to qualify for hedge accounting using the methodology described herein is founded on a number of provisions in IAS 39 and on interpretations of its requirements.  Some of the key provisions and interpretations that provide the foundation for hedge accounting are described in the answer to Question 121-2, Hedge accounting considerations when interest rate risk is managed on a net basis.  Some additional and supporting provisions and interpretations are identified below.

Hedging a portion of the risk exposure

The ability to identify and hedge only a portion of the cash flow risk exposure resulting from the reinvestment of cash flows or repricing of variable-rate instruments is founded in IAS 39.128 as interpreted in the answers to Questions 121-2-k, 128-2, Partial term hedging, and 128-3, Hedge accounting: risk components.

Hedging multiple risks with a single instrument

The ability to designate a single interest rate swap as a hedge of the cash flow exposure to interest rates resulting from various reinvestments of cash inflows or repricings of variable-rate assets that occur over the life of the swap is founded in IAS 39.131 as interpreted in the answer to Question 131-1, Hedges of more than one type of risk.

Hedging similar risks in a portfolio

The ability to specify the forecasted transaction being hedged as a portion of the cash flow exposure to interest rates for a portion of the duration of the investment that gives rise to the interest payment without specifying at the designation date the expected life of the instrument and whether it pays a fixed or variable rate is founded in the answer to Question 121-2-1 which specifies that the items in the portfolio do not necessarily have to have the same overall exposure to risk, providing they share the same risk for which they are designated as being hedged.

Hedge terminations

The ability to de-designate the forecasted transaction (the cash flow exposure on an investment or repricing that will occur after the repricing date of the swap) as being hedged is provided for in IAS 39.163 dealing with hedge terminations.  While a portion of the forecasted transaction is no longer being hedged, the interest rate swap is not de-designated, and it continues to be a hedging instrument for the remaining transactions in the series that have not occurred.  For example, assume that an interest rate swap having a remaining life of one year has been designated as hedging a series of three quarterly reinvestments of cash flows.  The next forecasted cash flow reinvestment occurs in three months.  When the interest rate swap reprices in three months at the then current variable rate, the fixed rate and the variable rate on the interest rate swap become known and no longer provide hedge protection for the next three months.  If the next forecasted transaction does not occur until three months and ten days, the ten-day period that remains after the repricing of the interest rate swap is not hedged.