Derivatives Implementation Group

Statement 133 Implementation Issue No. F2

QUESTION

May a company designate an interest rate swap with a term of 3 years and a notional amount equal to the principal amount of its 10-year nonamortizing fixed-rate debt as the hedging instrument in a hedge of the exposure to changes in fair value, attributable to changes in the designated benchmark interest rate, of the company's obligation to make interest payments during the first 3 years of the debt? For example, a company that has issued $100 million of 10-year nonamortizing fixed-rate debt with a coupon rate of 8.25 percent may wish to enter into a 3-year receive-fixed, pay-variable interest rate swap with a notional amount of $100 million. The company believes that interest rates will decline during the first three years of the debt's term and it wishes to hedge its exposure for only that three-year period.

BACKGROUND

Paragraph 21(a)(2)(b) of Statement 133 indicates that if the hedged item in a fair value hedge is a specific portion of an asset or liability (or a portfolio of similar assets or a portfolio of similar liabilities), the hedged item may be the right to receive or obligation to pay one or more selected contractual cash flows (such as the portion of the asset or liability representing the present value of the interest payments in the first two years of a four-year debt instrument).

Paragraph 434 of the basis for conclusions, which relates to the qualifying criteria for fair value hedges, states:

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.

Footnote 32 to paragraph 435, which relates to paragraph 21(a)(2)(b), states, "However, as noted in paragraph 434, it likely will be difficult to find a derivative that will be effective as a fair value hedge of selected cash flows."

RESPONSE

No. A company may not designate a 3-year interest rate swap with a notional amount equal to the principal amount of its nonamortizing debt as the hedging instrument in a hedge of the exposure to changes in fair value, attributable to changes in the designated benchmark interest rate, of the company's obligation to make interest payments during the first 3 years of its 10-year fixed-rate debt instrument. There would be no basis for expecting that the change in that swap's fair value would be highly effective in offsetting the change in fair value of the liability for only the interest payments to be made during the first three years. Even though under certain circumstances a partial-term fair value hedge can qualify for hedge accounting under Statement 133, the provisions of that Statement do not result in reporting a fixed-rate 10-year borrowing as having been effectively converted into a 3-year floating-rate and 7-year fixed-rate borrowing as was previously accomplished under synthetic instrument accounting prior to Statement 133. Synthetic instrument accounting is no longer acceptable under Statement 133, as discussed in paragraphs 349 and 350.

By indicating that the hedged item in a fair value hedge may be one or more selected contractual cash flows, paragraph 21(a)(2)(b) permits a company to hedge one or more individual interest payments during a selected portion of the term of a debt instrument. For example, a company may hedge the fair value of its obligation to make the interest payments occurring during the first 3 years of a 10-year debt instrument, as described in the example in the Question. The derivative selected as the hedging instrument in a partial-term fair value hedge must be highly effective at offsetting changes in fair value of the group of selected individual cash flows designated as being hedged. A partial-term fair value hedge of one or more selected contractual cash flows may be achieved under paragraph 21(a)(2)(b) by designating an appropriate derivative instrument (or instruments) as the hedging instrument. For example, the instrument designated as hedging those individual coupon payments could be described as a derivative that can hedge the changes in the fair value of a zero-coupon bond that corresponds to the timing and amount of each individual interest payment.

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.