Derivatives Implementation Group

Statement 133 Implementation Issue No. E16

QUESTION

Can the shortcut method be applied to a hedging relationship that involves the use of an interest rate swap-in-arrears?

BACKGROUND

Plain-vanilla interest rate swaps are contractual arrangements that require the periodic exchange of two cash flows (usually settled net) - one relating to an interest calculation involving a fixed interest rate, and the other relating to an interest calculation involving a floating interest rate. In plain-vanilla interest rate swaps, the fixed interest rate does not change, while the floating interest rate is determined (that is, reset) at the beginning of each period; thus, on that date, the scheduled net cash flow for the period will be known. The net cash flow does not actually occur, however, until the payment date, which is at the end of the period. That is, if the swap interest rates are reset every three months, the cash flows occur at the end of each three-month period based upon the interest rates determined at the beginning of the three-month period. Thus, for plain-vanilla interest rate swaps, the floating interest rate is applied prospectively.

An interest rate swap-in-arrears works the same way as a plain-vanilla swap except that the floating interest rate for a swap-in-arrears is applied retrospectively. With an interest rate swap-in-arrears, the net cash flow occurs immediately at the interest rate reset date (which is at the end of the reset period). That is, if the swap interest rates are reset every three months, the cash flows occur at the end of each three-month period based upon the interest rates determined at that same time applied to the three-month period just ended. Note that generally, both plain-vanilla swaps and swaps-in-arrears are initiated with market values equal to zero. At any given time, however, there will be some difference between the fixed interest rates on the two respective swaps or between the variable interest rates on the two respective swaps unless the yield curve is perfectly flat.

RESPONSE

Yes. The shortcut method may be applied to a hedging relationship that involves the use of an interest rate swap-in-arrears provided all of the applicable conditions in paragraph 68 are met. Paragraphs 68 - 70, 114 and 132 of Statement 133 set forth the requirements and guidance concerning use of the shortcut method to account for fair value or cash flow hedges involving interest rate swaps. For cash flow hedging transactions accounted for under the shortcut method, paragraph 68(k) requires that the repricing dates of the variable rate asset or liability that is the hedged item match the repricing dates of the interest rate swap that is the hedging instrument.

Pursuant to the guidance in question 1 of Statement 133 Implementation Issue E4, "Application of the Shortcut Method", the verb match is used in the specified conditions in paragraph 68 to mean be exactly the same or correspond exactly. Therefore, for purposes of paragraph 68(k), if the repricing dates of the hedged item occur on the same dates as the repricing dates of the hedging instrument but the repricing calculation for the hedged item is prospective whereas the repricing calculation for the hedging instrument is retrospective, those repricing dates do not match. In order to match for purposes of paragraph 68(k), the repricing dates of the hedged item and the hedging instrument must occur on the same dates and be calculated the same way (that is, both must be either prospective or retrospective).

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.