Derivatives Implementation Group

Statement 133 Implementation Issue No. E20

QUESTION

Prior to entering a hedge, the carrying amount of a debt instrument is often different from its redemption amount at maturity, perhaps because of an issuance premium or discount or deferred debt issuance costs, and, if the debt instrument is callable, different from the strike price of the call option. How does this carrying amount impact the determination of whether a swap contains a mirror-image call option under paragraph 68(d)?

BACKGROUND

Paragraph 68 of Statement 133 (as amended) lists the requirements that must be met in order to apply the shortcut method. Paragraph 68(d) states:

    The interest-bearing asset or liability is not prepayable (that is, able to be settled by either party prior to its scheduled maturity), except as indicated in the following sentences. This criterion does not apply to an interest-bearing asset or liability that is prepayable solely due to an embedded call option provided that the hedging interest rate swap contains an embedded mirror-image call option. The call option embedded in the swap is considered a mirror image of the call option embedded in the hedged item if (1) the terms of the two call options match (including matching maturities, strike price, related notional amounts, timing and frequency of payments, and dates on which the instruments may be called) and (2) the entity is the writer of one call option and the holder (or purchaser) of the other call option. Similarly, this criterion does not apply to an interest-bearing asset or liability that is prepayable solely due to an embedded put option provided that the hedging interest rate swap contains an embedded mirror-image put option. [Emphasis added.]

RESPONSE

The debt's carrying amount has no direct impact on the determination of whether a swap contains a mirror-image call option under paragraph 68(d). The phrase strike price in paragraph 68(d)(1) should be read to mean the actual amount for which the debt instrument could be called. Typically, the call price is greater than the par or face amount of the debt instrument.¹

The carrying amount of the debt is economically unrelated to the amount the issuer would be required to pay to exercise the call embedded in the debt. Any discount or premium in carrying amount (including any related deferred issuance costs) is therefore irrelevant in the determination of whether a call option meets the mirror-image requirements of paragraph 68(d). Thus, for example, to meet the requirements of paragraph 68(d) regarding embedded mirror-image call options, a swap is not permitted to contain a termination payment equal to the deferred debt issuance costs that remain unamortized on the date the debt is called.

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.

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¹It is common to quote the call prices (strike prices) on debt as a percentage of par value. In contrast, the strike prices of options embedded in interest rate swaps are generally quoted as a rate or current yield (the current fixed-rate coupon on a non-callable/non-putable swap having zero fair value at inception). One means of determining whether these strike prices are the same would be to (a) impute the yield to maturity at a price equal to the call price for a non-callable/non-putable debt instrument that is otherwise identical to the hedged debt instrument and (b) compare that yield to the call or put yield embedded in the swap.

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.