Derivatives Implementation Group

Statement 133 Implementation Issue No. G21

QUESTION

What is the appropriate hypothetical derivative under Statement 133 Implementation Issue No. G7, "Measuring the Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method Is Not Applied," for the following cash flow hedging relationship, which involves the use of an interest rate swap designated as a hedge of the variable interest payments on floating-rate debt that is prepayable at par at each interest rate reset date?

Company A issues floating-rate debt that is prepayable at par on each interest rate reset date. The credit sector spread on the debt issuance is not reset on the interest rate reset dates. For example, the debt bears interest at a rate of LIBOR plus 100 basis points, with LIBOR reset every quarter. Company A also enters into a receive-floating, pay-fixed interest rate swap that is designated as a hedge of the variability in the debt interest payments due to changes in the benchmark interest rate (LIBOR). During the term of the hedging relationship (that is, the specific term of the swap), Company A expects to issue new floating-rate debt (in the event the original debt is repaid prior to maturity) to maintain an aggregate debt principal balance equal to or greater than the notional amount of the swap, and expects the new debt (if any) to share the key characteristics of the original debt issuance (specifically quarterly repricing to the LIBOR index and no minimum, maximum, or periodic constraints of the debt interest rate). The hedging relationship meets all of the criteria for shortcut method accounting in paragraph 68 of Statement 133 except for criterion 68(d); the debt is prepayable and the swap does not contain a mirror-image call option to match the call option embedded in the debt instrument, as required by paragraph 68(d).

BACKGROUND

Company A wishes to apply the hypothetical derivative method described in Implementation Issue G7 to calculate the amount of ineffectiveness in the hedging relationship to be recognized in earnings in accordance with paragraph 30(b). Implementation Issue G7 states that "the hypothetical derivative would need to satisfy all of the applicable conditions in paragraph 68 (as amended) necessary to qualify for use of the shortcut method except criterion 68(dd). Thus, the hypothetical swap would be expected to perfectly offset the hedged cash flows." Since the actual interest rate swap used in Company A's hedging relationship already meets all of the criteria in paragraph 68 except criterion 68(d), this guidance would seem to suggest that the hypothetical swap would need to be the same as the actual swap except that a mirror-image call option would need to be added in order to meet criterion 68(d) and the guidance in Implementation Issue G7. However, Company A observes that since the hedged transactions are the variable interest payments (on debt with a principal amount equal to the notional amount of the swap) due to changes in the benchmark interest rate (LIBOR), and since the transaction had to be probable of occurring under paragraph 29(b) in order for it to qualify for hedge accounting, the actual swap would be expected to perfectly offset the hedged cash flows.

RESPONSE

In this fact pattern, the hypothetical swap under Implementation Issue G7 would be the same as the actual swap described in the Background section. Since Company A has concluded that if the original debt issuance is repaid prior to maturity, it is probable that a sufficient principal amount of floating-rate debt with key characteristics that match those of the original debt issuance (specifically quarterly repricing to the LIBOR index and no minimum, maximum, or periodic constraints of the debt interest rate) will be issued and remain outstanding during the term of the hedging relationship (providing exposure to benchmark-interest-rate-based variable cash payments), the prepayment provisions of the debt instrument should not be considered in determining the appropriate hypothetical derivative under Implementation Issue G7. The prepayment of the original floating-rate debt eliminates the contractual obligation to make those interest payments; however, Statement 133 permits replacing the hedged interest payments that are no longer contractually obligated to be paid without triggering the dedesignation of the original cash flow hedging relationship. Replacing the original debt issuance with a new floating-rate debt issuance is permissible in a cash flow hedge of interest rate risk and does not automatically result in the discontinuation of the original cash flow hedging relationship. Paragraph 29(a) of Statement 133 does not require that the variable interest payments relate to a specific unchanging obligation or group of floating-rate obligations when those obligations are prepayable.

Implementation Issue G7 incorporates all of the requirements of paragraph 68 except criterion 68(dd) for purposes of determining the hypothetical derivative. Since the requirements of paragraph 68(d) were developed with an emphasis on fair value hedging relationships, they do not fit the more general principle in Implementation Issue G7 that the hypothetical derivative in a cash flow hedging relationship should be expected to perfectly offset the hedged cash flows. Although the company can terminate the debt at any interest rate reset date for reasons that may be totally unrelated to changes in the benchmark interest rate (which is the hedged risk), it expects to be at risk for variability in cash flows due to changes in the benchmark interest rate in an amount based upon debt principal equal to or greater than the notional amount of the swap during the specific term of the swap. Therefore, the prepayment feature of the debt is not relevant for purposes of determining the appropriate hypothetical swap under Implementation Issue G7 as long as the relevant conditions to qualify for cash flow hedge accounting have been met with respect to the hedged transaction.

EFFECTIVE DATE

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of its first fiscal quarter beginning after July 10, 2001, the date that the Board-cleared guidance was posted on the FASB website.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.