## FASB Net Settlement Provisions

# Derivatives Implementation Group

## Statement 133 Implementation Issue No. A23

Title: |
Definition of a Derivative: Prepaid Interest Rate Swaps |

Paragraph
references: |
6, 9, 13 |

Date cleared by Board: |
July 30, 2003 |

Date revision posted to website: |
February 28, 2007 |

Affected by: |
FASB Statement No. 157, Fair Value MeasurementsRevised September 15, 2006 |

**Note:**The guidance in this Issue supersedes the guidance in Statement 133 Implementation Issue No. A9, "Prepaid Interest Rate Swaps."

QUESTION

How does Statement 133 affect the accounting for a prepaid interest rate swap contract?

BACKGROUND

A *prepaid interest rate swap contract,* as that term is used in this Issue, obligates one party to make periodic payments to another party that are based on a variable interest rate applied to an effective notional amount. It is characterized as an at-the-money interest rate swap contract for which the fixed leg has been fully prepaid, with the result that the party that receives the variable-leg-based payments has no obligation whatsoever to make any future payments under the contract. Under that characterization, the fair value of the fixed leg and the fair value of the variable leg are equal and offsetting because the at-the-money interest rate swap contract has an overall fair value of zero.

The following is an example of a prepaid interest rate swap:

__Example 1__Entity A pays $1,228,179 to enter into a prepaid interest rate swap contract that requires the counterparty to make quarterly payments based on a $10,000,000 effective notional amount and a variable interest rate equal to 3-month US$ LIBOR. The prepaid interest rate swap contract is characterized as an at-the-money 2-year, interest rate swap with a $10,000,000 notional amount, a fixed interest rate of 6.65 percent, and a variable interest rate of 3-month US$ LIBOR (that is, the same terms as the swap in Example 5 of Statement 133, which has a zero fair value at inception), for which the fixed leg has been fully prepaid. The amount of $1,228,179 is the present value of the 8 quarterly fixed payments of $166,250 [$10,000,000 × LIBOR swap rate

^{1}of 6.65 percent / 4]; the present value

^{2}is based on the implied spot rate for each of the 8 payment dates under the assumed initial yield curve in that example.

The prepaid interest rate swap contract could also be characterized as a 2-year, structured note ("contract") with a principal amount of $1,228,179 and loan payments based on a formula equal to 8.142 times 3-month US$ LIBOR. (Note that 8.142 = 10,000,000 / 1,228,179.) The terms of the structured note specify no repayment of the principal amount either over the two-year term of the structured note or at the end of its term. The 8.142 leverage factor causes the *effective notional amount*of the structured note also to be $10,000,000, pursuant to footnote * to paragraph 8, as amended by FASB Statement No. 149, *Amendment of Statement 133 on Derivative Instruments and Hedging Activities.*

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^{1}The LIBOR *swap rate* is defined in paragraph 540 of Statement 133 (as amended) as follows:

^{2}The examples in this Issue assume both parties to the contract have the same AA credit rating. If the party that is obligated to make the variable payments has a different credit rating (such as BBB), the effect of that different creditworthiness should be reflected in the discount rate used to determine the present value of the amounts payable by that party under the contract.

The prepaid interest rate swap contract meets the characteristic of a derivative in paragraph 6(a) of Statement 133 because it has an underlying and an effective notional amount. It also meets the characteristic of a derivative in paragraph 6(c) of Statement 133 because neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (refer to paragraph 9(a)). At issue is whether the prepaid interest rate swap contract meets the characteristic of a derivative described in paragraphs 6(b) and 8 related to the initial net investment in a contract.

Paragraph 6 of Statement 133 (as amended by Statement 149) states in part:

A derivative instrument is a financial instrument or other contract with all three of the following characteristics:… b. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.

Paragraph 8 of Statement 133 (as amended by Statement 149), which elaborates on the application of paragraph 6(b), states:

Initial net investment.Many derivative instruments require no initial net investment. Some require an initial net investment as compensation for time value (for example, a premium on an option) or for terms that are more or less favorable than market conditions (for example, a premium on a forward purchase contract with a price less than the current forward price). Others require a mutual exchange of currencies or other assets at inception, in which case the net investment is the difference in the fair values of the assets exchanged. A derivative instrument does not require an initial net investment in the contract that is equal to the notional amount (or the notional amount plus a premium or minus a discount) or that is determined by applying the notional amount to the underlying. If the initial net investment in the contract (after adjustment for the time value of money) is less, by more than a nominal amount, than the initial net investment that would be commensurate with the amount that would be exchanged either to acquire the asset related to the underlying or to incur the obligation related to the underlying, the characteristic in paragraph 6(b) is met. The amount of that asset acquired or liability incurred should be comparable to the effective notional amount of the contract. [Footnote reference omitted.]

RESPONSE

The prepaid interest rate swap contract does not meet the definition of a derivative because it does not satisfy the characteristic of a derivative described in paragraphs 6(b) and 8 related to the initial net investment in the contract. Specifically, the prepaid interest rate swap contract is excluded from the definition of a derivative by the clarifying guidance in paragraph 8, which states that "a derivative instrument does not require an initial net investment in the contract that is equal to the [effective] notional amount…or that is determined by applying the [effective] notional amount to the underlying." The prepaid interest rate swap contract in Example 1 requires an initial net investment that is determined by applying the effective notional amount of $10,000,000 to the underlying (3-month US$ LIBOR) for each of the 8 payment dates specified by the terms of the contract. The initial net investment of $1,228,179 required to enter into the contract is the present value of the 8 quarterly fixed-leg swap payments of $166,250 [$10,000,000 x 6.65 percent / 4]. Because the LIBOR swap rate reflects the applicable portions of the forward three-month US$ LIBOR rate curve for the settlement dates that relate to the specific payments under the swap, the initial net investment is considered to have been "determined by applying the [effective] notional amount to the underlying" and then adjusted for the time value of money.

The last portion of the sentence in paragraph 8 quoted in the previous paragraph also applies the same conclusion to contracts that require larger initial net investments. That is, a contract that requires an initial net investment in the contract that is in excess of the amount determined by applying the effective notional amount to the underlying is also not a derivative in its entirety. Consider the following examples that involve modifications to the assumed facts in Example 1.

__Example 2__Entity B pays $1,782,245 to enter into a prepaid interest rate swap contract that requires the counterparty to make quarterly payments based on a $10,000,000 effective notional amount and a variable interest rate equal to the sum of 3-month US$ LIBOR and 300 basis points. The prepaid interest rate swap contract is characterized as an at-the-money 2-year interest rate swap with a $10,000,000 notional amount, a fixed interest rate of 9.65 percent, and a variable interest rate of 3-month US$ LIBOR plus 300 basis points, for which the fixed leg has been fully prepaid. The amount of $1,782,245 is the present value of the 8 quarterly fixed payments of $241,250 [$10,000,000 Í the fixed rate of 9.65 percent / 4]; the present value is based on the implied spot rate for each of the 8 payment dates under the assumed initial yield curve in that example.

Under Example 2, the underlying is 3-month US$ LIBOR (even though the variable rate is 3-month US$ LIBOR plus 300 basis points) and the amount determined by applying the effective notional amount to the underlying (and then adjusted for the time value of money) is $1,228,179, the same as in Example 1. The initial net investment for the prepaid interest rate swap in Example 2 is $1,782,245, an amount that is in excess of $1,228,179—the amount referred to in paragraph 8 as being determined by applying the effective notional amount to the underlying. Consequently, the prepaid interest rate swap in Example 2 is not a derivative in its entirety.

__Example 3__Entity C pays $1,043,490 to enter into a contract that requires the counterparty to make quarterly payments based on a $10,000,000 effective notional amount and a variable interest rate equal to the 3-month US$ LIBOR minus 100 basis points. In the event that 3-month US$ LIBOR is less than 100 basis points, Entity C is obligated to make payments to the counterparty. The prepaid interest rate swap contract is characterized as an at-the-money 2-year, interest rate swap with a $10,000,000 notional amount, a fixed interest rate of 5.65 percent, and a variable interest rate of 3-month US$ LIBOR minus 100 basis points, for which the fixed leg has been fully prepaid. The amount of $1,043,490 is the present value of the 8 quarterly fixed payments of $141,250 [$10,000,000 Í the fixed rate of 5.65 percent / 4]; the present value is based on the implied spot rate for each of the 8 payment dates under the assumed initial yield curve in that example.

Under Example 3, the underlying is 3-month US$ LIBOR (even though the variable rate is 3-month US$ LIBOR minus 100 basis points) and the amount determined by applying the effective notional amount to the underlying (and then adjusted for the time value of money) is $1,228,179, the same as in Example 1. The initial net investment for the contract in Example 3 is $1,043,490, an amount that is *less than* $1,228,179. (The contract is considered not to be fully prepaid because Entity C has not "prepaid" all obligations imposed on it by the contract; Entity C is obligated to make future payments under certain conditions, as noted above.) The difference of $184,689 (about 15 percent^{3}) is more than a nominal amount when compared to $1,228,179. Consequently, the contract in Example 3 is a derivative in its entirety.

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^{3}The amounts in Example 3 are not intended to provide quantitative guidance for distinguishing between being "less, by more than a nominal amount" and being "less by only a nominal amount." The initial net investment for a contract could be less than the amount determined by applying the effective notional amount to the underlying by a percentage lower than 15 percent and still be considered to be "less, by more than a nominal amount" under paragraph 8.

Because the prepaid interest rate swap contract is not a derivative in its entirety, it should be evaluated to determine whether the contract contains an embedded derivative that, pursuant to paragraph 12, requires separate accounting as a derivative. The prepaid interest rate swap contracts in Examples 1 and 2 are hybrid instruments that are composed of a debt instrument (the host contract) and an embedded derivative based on three-month US$ LIBOR. The embedded derivative contains a provision that could result in the investor (that is, the entity receiving the variable payments) not recovering substantially all of its initial recorded investment in the hybrid instrument under its contractual terms. That is, LIBOR may possibly decrease to such a level that the investor may not recover its initial net investment. Therefore, the embedded interest rate swap is not considered clearly and closely related to the host contract under paragraph 13(a) of Statement 133 with respect to the accounting by both parties to the contract. Paragraph 61(a), which further explains paragraph 13(a), states that if an embedded interest rate derivative contains a provision that permits any possibility whatsoever that the investor’s (or creditor’s) undiscounted net cash inflows over the life of the instrument would not enable the investor to recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms, the embedded derivative and the debt host contract are not clearly and closely related. Therefore, unless the contracts described in Examples 1 and 2 are remeasured at fair value with changes in value recorded in earnings as they occur, both prepaid interest rate swap contracts should be bifurcated by both parties to the contract into a debt host contract whose initial carrying amount is equal to the fair value of the prepaid interest rate swap contracts ($1,228,179 and $1,782,245, respectively) and an interest rate swap whose fair value is zero at inception of the hybrid instrument, consistent with the guidance in Statement 133 Implementation Issue No. B20, "Must the Terms of a Separated Non-Option Embedded Derivative Produce a Zero Fair Value at Inception?" The bifurcated interest rate swap contains no financing element that would require special cash flow reporting under paragraph 45A of Statement 133, as amended by Statement 149. The reporting of the cash flows for the related debt host contract would be subject to the provisions of FASB Statement No. 95, *Statement of Cash Flows.*

EFFECTIVE DATE AND TRANSITION

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of the first fiscal quarter beginning after August 8, 2003. The implementation guidance in this Issue should be applied prospectively to all contracts entered into on or after the effective date. Early application to all contracts entered into or substantively modified on or after August 1, 2003, is permitted. If an entity had been accounting for a contract entered into prior to the effective date as a derivative in its entirety under Implementation Issue A9 but, under the guidance in this Issue, that contract would not be a derivative in its entirety, the entity should continue accounting for that contract as a derivative in its entirety.

*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.*