Derivatives Implementation Group

Statement 133 Implementation Issue No. H16

QUESTION

Is the reference in paragraph 40(e) to the elimination of all variability in the functional-currency-equivalent cash flows intended to require that the hedging instrument be perfectly effective?

BACKGROUND

Statement 133 (as amended) allows an entity to designate a derivative instrument as a hedge of the foreign currency exposure of the forecasted foreign-currency-equivalent cash flows associated with a recognized foreign-currency-denominated asset or liability. Paragraph 40(e) specifically states that:

    If the hedged item is a recognized foreign-currency-denominated asset or liability, all the variability in the hedged item's functional-currency-equivalent cash flows must be eliminated by the effect of the hedge. (For example, a cash flow hedge cannot be used with a variable-rate foreign-currency-denominated asset or liability and a derivative based solely on changes in exchange rates because the derivative does not eliminate all the variability in the functional currency cash flows.)

The issue is whether that paragraph's reference to the elimination of all variability in cash flows is intended to require that the hedging instrument be perfectly effective. Consider the following examples:

Example 1
An entity has issued a fixed-rate foreign-currency-denominated debt obligation that is callable (that is, by that entity) and desires to hedge its foreign currency exposure related to that obligation with a fixed-to-fixed cross currency swap. Assuming that the swap otherwise would be highly effective in hedging the foreign currency exposure of the debt instrument and it is probable that the call option will not be exercised by the entity, must the swap contain a mirror image call option to qualify for hedge accounting?

Example 2
An entity has issued a variable-rate foreign-currency-denominated debt obligation and desires to hedge its foreign currency exposure related to that obligation. The entity uses a floating-to-fixed cross-currency interest rate swap in which it receives the same foreign currency based on the variable rate index contained in the debt obligation and pays a fixed amount in its functional currency. Assuming that the swap would otherwise meet Statement 133's definition of providing high effectiveness in hedging the foreign currency exposure of the debt instrument, but there is a one day difference between the reset dates in the debt obligation and the swap (that is, the one day difference in reset dates results in the hedge being highly effective, but not perfectly effective), does paragraph 40(e) preclude the swap from qualifying for hedge accounting?

Example 3
The same facts as in Example 2, except that there is no difference in the reset dates. However, there is a slight difference in the notional amount of the swap and the hedged item. Assuming that the swap would otherwise meet Statement 133's definition of providing high effectiveness in hedging the foreign currency exposure of the debt instrument, does paragraph 40(e) preclude the swap from qualifying for hedge accounting because the notional amounts do not exactly match?

RESPONSE

No. Paragraph 40(e) does not require that the derivative instrument used to hedge the foreign currency exposure of the forecasted foreign-currency-equivalent cash flows associated with a recognized asset or liability be perfectly effective. To qualify for cash flow hedge accounting, Statement 133 requires an expectation that the derivative instrument will be highly effective at offsetting the exposure to the hedged transaction's variability in cash flows attributable to the hedged risk. The requirement in paragraph 40(e) to eliminate all variability is intended to ensure that the hedging relationship is highly effective at offsetting all risks that impact the variability of cash flows. Thus, paragraph 40(e) precludes only the specific exclusion of a risk from the hedge that will affect the variability in cash flows. As long as no element of risk that affects the variability in foreign-currency-equivalent cash flows has been specifically excluded from a foreign currency cash flow hedge and the hedging instrument is highly effective at providing the necessary offset in the variability of all cash flows, a less-than-perfect hedge would meet the requirement in paragraph 40(e).

Accordingly, in Example 1 above, a fixed-to-fixed currency swap could be used to hedge the fixed-rate foreign-currency-denominated debt instrument that is callable even though the swap does not contain a mirror image call option. This would be true as long as the terms of the swap and the debt instrument are such that they would be highly effective at providing offsetting cash flows and as long as it was probable that the debt instrument would not be called and would remain outstanding. Likewise in Examples 2 and 3, a floating-to-fixed cross-currency interest rate swap could be used to hedge the variable-rate foreign-currency-denominated debt instrument even though there is a one-day difference between the reset dates or a slight difference in the notional amounts in the debt instrument and the swap. This would be true as long as the difference in reset dates or notional amounts is not significant enough to cause the hedge to fail to be highly effective at providing offsetting cash flows. (In Example 3, the ineffectiveness attributable to the slight difference in the notional amount of the swap and the hedged item could be eliminated by designating only a portion of the contract with the larger notional amount as either the hedging instrument or hedged item (as appropriate).)

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 October 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.