Derivatives Implementation Group

Statement 133 Implementation Issue No. G26

QUESTIONS

In a cash flow hedge of a variable-rate financial asset or liability for which the interest rate is not based solely on an index, including situations in which an interest rate is reset through an auction process, can the designated risk being hedged be:

1. The risk of overall changes in the hedged cash flows related to the variable-rate financial asset or liability?

    

2. The risk of changes attributable to interest rate risk as defined in Statement 133 (that is, the risk of changes in cash flows attributable to changes in a specifically designated benchmark interest rate) even though the cash flows of the hedged transaction are not explicitly based on that designated benchmark interest rate?

    

BACKGROUND

Auction rate notes are an example of a variable-rate financial instrument whose interest rate is not explicitly based on a benchmark rate. Auction rate notes generally have long-term nominal maturities and interest rates that reset periodically through a Dutch auction process, typically every 7, 28, or 35 days. At an auction, existing holders of auction rate notes and potential buyers enter a competitive bidding process through a broker-dealer, specifying the number of shares (units) to purchase with the lowest interest rate they are willing to accept. Generally, the lowest bid rate at which all shares can be sold at the notes' par value establishes the interest rate, also known as the "clearing rate," to be applied until the next auction.

Paragraph 29(h) of Statement 133 defines interest rate risk for an existing financial asset or liability as "the risk of changes in cash flows attributable to changes in the designated benchmark rate." That paragraph further requires the following:

    In a cash flow hedge of a variable-rate financial asset or liability, either existing or forecasted, the designated risk being hedged cannot be the risk of changes in its cash flows attributable to changes in the specifically identified benchmark interest rate if the cash flows of the hedged transaction are explicitly based on a different index, for example, based on a specific bank’s prime rate, which cannot qualify as the benchmark rate. [Emphasis added.]

Statement 133, as amended by FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, identifies rates on direct Treasury obligations of the U.S. government and the interest rate swap rates based on the London Interbank Offered Rate (LIBOR) as the only rates that can be designated as benchmark interest rates in the United States for purposes of applying the definition of interest rate risk. Some have suggested that because an auction rate is not an index, it is not subject to the limitation in paragraph 29(h).

Statement 133 Implementation Issue No. G19, "Cash Flow Hedges: Hedging Interest Rate Risk for the Forecasted Issuances of Fixed-Rate Debt Arising from a Rollover Strategy," provides guidance for the planned issuance of a series of fixed-rate debt instruments, such as commercial paper (thereby resulting in a variable interest expense pattern) and states:

    The restriction against hedging interest rate risk in paragraph 29(h) of Statement 133 is not intended to apply to scenarios whereby the cash flow hedging model is being applied to the forecasted issuance of fixed-rate debt. Provided the entity meets all the other cash flow hedging criteria, an entity may hedge the risk of changes in either (a) the coupon payments (or the interest element of the final cash flow if interest is paid only at maturity) or (b) the total proceeds attributable to changes in the benchmark interest rate related to the forecasted issuance of fixed-rate debt. It should be noted that the derivative used to hedge either of these risks must provide offsetting cash flows in order for the hedging relationship to be effective in accordance with paragraph 30 of Statement 133.

Issue G19 addresses its applicability to variable-rate debt as follows:

    Although the variable-rate debt does, after each reset, have a fixed rate for each monthly period, it is inappropriate to characterize that debt as a series of fixed-rate debt instruments whose issuances would not be subject to the restriction against hedging interest rate risk in paragraph 29(h). When each reset occurs, it is not a new issuance of fixed-rate debt based on current market interest rates for that debtor; instead, it is a contractual continuation of a debtor-creditor relationship and the "fixed rate" for each month is explicitly (and contractually) based on a specific index (a specified bank’s Prime rate) that is different from a designated benchmark interest rate. Thus, the restriction against hedging interest rate risk in paragraph 29(h) must be applied to the variable-rate debt instrument.

In conjunction with resolving this Issue, the last sentence of the third paragraph under the Commercial Paper heading in the Background section of Issue G19, "Those short-term instruments are not 'indexed' to any market rate," has been deleted because it has caused confusion in practice.

RESPONSE

Question 1
Yes. Provided all of the other cash flow hedging criteria in Statement 133 are met, an entity may hedge the variability in cash flows (for example, in auction rate notes) pursuant to paragraph 29(h)(1) of Statement 133 by designating the hedged risk as the risk of overall changes in cash flows.

Question 2
No. In a cash flow hedge of a variable-rate financial asset or liability, the risk being hedged cannot be designated as interest rate risk (that is, the risk of changes in cash flows attributable to changes in the designated benchmark interest rate) unless the cash flows of the hedged transaction are explicitly based on that same benchmark interest rate. For example, a variable-rate financial asset or liability that is reset through an auction process is not based on a benchmark interest rate. Although the interest rate may be described as a designated benchmark interest rate plus or minus an adjustment specified by the bidder, the "clearing rate" is effectively established by a bidding process that does not provide for transparent separation of interest rate risk and credit risk. Thus, the designated risk being hedged in an auction rate note cannot be interest rate risk. Additionally, Issue G19 explicitly prohibits entities from characterizing their variable-rate debt as fixed-rate debt that, at each interest rate reset, rolls over to another issuance of fixed-rate debt that has a new fixed interest rate until the next reset date.

EFFECTIVE DATE AND TRANSITION

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 the date that the Board-cleared guidance was posted on the FASB website.

Pursuant to Statement 133 Implementation Issue No. K5, "Miscellaneous: Transition Provisions for Applying the Guidance in Statement 133 Implementation Issues," entities that have previously designated an otherwise qualifying hedging relationship that no longer qualifies for hedge accounting based on the guidance in this Issue, must dedesignate the hedging relationships prospectively as of the effective date of this Issue. The derivative’s gain or loss for the period prior to the effective date shall remain in accumulated other comprehensive income and be reclassified into earnings consistent with the provisions of paragraphs 32 and 33 of Statement 133.

The above response has been approved by the Board by written ballot.