## FASB Hedging-General Hedged Exposure Is Limited but Derivative's Exposure Is Not

# Derivatives Implementation Group

## Statement 133 Implementation Issue No. E11

Title: |
Hedging—General: Hedged Exposure Is Limited but Derivative's Exposure Is Not |

Paragraph
references: |
20(b), 28(b) |

Date cleared by
Board: |
December 6, 2000 |

QUESTION

If the hedged item or hedged forecasted transaction has a risk exposure that is limited, may an entity designate as the hedging instrument in a fair value or cash flow hedge a derivative that does not have comparable limits with respect to that same hedged risk exposure?

BACKGROUND

Paragraphs 20(b) and 28(b) require that, to qualify for fair value or cash flow hedge accounting, the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value (or cash flows) attributable to the hedged risk during the period that the hedge is designated. Paragraph 20(b) states, "If the hedging instrument (such as an at-the-money option contract) provides only one-sided offset of the hedged risk, the increases (or decreases) in the fair value of the hedging instrument must be expected to be highly effective in offsetting the decreases (or increases) in the fair value of the hedged item." Paragraph 28(b) contains a similar provision for options that provide only one-sided offset of the hedged risk in a cash flow hedge.

The following examples illustrate situations where the hedged item or hedged forecasted transaction may have a risk exposure that is limited, but the derivative that the entity desires to designate as a hedging instrument does not have comparable limits. (For the purposes of these examples, it is assumed that the shortcut method may not be applied.)

__Example 1-Fair Value Hedge__

Company A issues 10-year fixed-rate debt that is callable at the end of the fifth year. It decides to convert the interest payments on the bond from fixed-rate to floating-rate by entering into a 10-year receive-fixed, pay-floating interest rate swap. The interest rate swap is not cancelable at the end of the fifth year. From Company A's perspective, if interest rates increase, there is a gain on the debt (the liability's fair value decreases) and a loss on the swap (fair value either decreases as an asset or increases as a liability). If interest rates decrease, there is a loss on the debt (the liability's fair value increases) and a gain on the swap (fair value either increases as an asset or decreases as a liability). However, during the first five years, if interest rates decrease, the gain on the swap will exceed the loss on the debt because the debt's fair value change will consider the impact of the call feature, which is in-the-money when interest rates fall below the stated rate on the debt. Company A wishes to designate the interest rate swap as the hedging instrument in a fair value hedge of interest rate risk of the fixed-rate debt.

__Example 2-Cash Flow Hedge__

Company B issues 10-year, floating-rate debt that reprices based on 6-month LIBOR. The interest rate on the debt is capped at 9 percent. Company B decides to convert the interest payments on the debt from floating-rate to fixed-rate by entering into a receive-floating, pay-fixed interest rate swap. There is no cap on the floating rate leg of the interest rate swap. From Company B's perspective, if interest rates decrease, there will be a cumulative reduction in the expected future cash outflows on the debt and a cumulative reduction in the expected future cash inflows on the swap. If interest rates increase, there will be a cumulative increase in the expected future cash outflows on the debt and a cumulative increase in the expected future cash inflows on the swap. However, if interest rates increase such that the floating rate on the swap would be greater than 9 percent, the cumulative increase in the expected future cash inflows on the swap will exceed the cumulative increase in the expected future cash outflows on the debt because of the interest rate cap on the debt, which is in-the-money if interest rates increase such that the floating rate on the debt would exceed 9 percent. Company B wishes to designate the interest rate swap as the hedging instrument in a cash flow hedge of interest rate risk of the floating-rate debt.

RESPONSE

It depends. An entity may designate as the hedging
instrument in a fair value or cash flow hedge a derivative that
does not have a limited exposure comparable to the limited exposure
of the hedged item to the risk being hedged. However, in order to
make that designation, in accordance with paragraph 20(b) of
Statement 133, the entity must establish that the hedging
relationship is *expected* to be highly effective in achieving
offsetting changes in fair value or cash flows attributable to the
hedged risk during the period that the hedge is designated. The
assessment of hedge effectiveness must consider the possible
changes in fair value or cash flows of the derivative and may not
be limited to the likely or expected changes in fair value or cash
flows of the derivative for the period used to assess whether the
requirement for expectation of highly effective offset is
satisfied. Generally, the process of formulating an expectation
regarding the effectiveness of a proposed hedging relationship
involves a probability-weighted analysis of the possible changes in
fair value or cash flows of the derivative for the hedge period.
Therefore, a probable change in fair value or cash flows will be
more heavily weighted than a reasonably possible change. That
calculation technique is consistent with the definition of the term
*expected cash flow* in FASB Concepts Statement No. 7,
*Using Cash Flow Information and Present Value in Accounting
Measurements.* The glossary of terms in Concepts Statement 7
defines expected cash flow as "the sum of probability-weighted
amounts in a range of possible estimated amounts; the estimated
mean or average."

Under the guidance in Statement 133 Implementation Issue No. F5, "Basing the Expectation of Highly Effective Offset on a Shorter Period Than the Life of the Derivative," in accordance with its documented risk management strategy for a fair value hedge, an entity may consider the possible changes in the fair value of the derivative and the hedged item over a shorter period than the remaining life of the derivative in formulating its expectation that the hedging relationship will be highly effective in achieving offsetting changes in fair value for the risk being hedged.

It is inappropriate under Statement 133 for an entity to designate a derivative as the hedging instrument when the entity expects that the derivative will not be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the period that the hedge is designated, unless the entity has documented undertaking a dynamic hedging strategy in which it has committed itself to an ongoing repositioning strategy for its hedging relationship. Statement 133 cites the following examples:

- For fair value hedges, in a delta-neutral dynamic hedging strategy, the entity commits to constant monitoring of the option's "delta"-the ratio of changes in the option's price to changes in the price of the hedged item. As the delta ratio changes, that entity must rebalance the portfolio of options (that is, buy or sell options) so that the next change in the fair value of all of the options held can be expected to counterbalance or offset the next change in the value of the hedged item. Thus, in a delta-neutral hedging strategy, the hedging instrument is constantly being changed and the assessment of effectiveness considers only the next change in fair value. (Refer to paragraphs 86 and 87.)
- For cash flow hedges, in a tailing strategy, the entity commits to adjusting the size or contract amount of futures contracts used as the hedging instrument so that earnings (or expense) from reinvestment (or funding) of daily settlement gains (or losses) on the futures do not distort the results of the hedge. (Refer to paragraph 64.)

For the examples in the Background section, the entity must assess, based on an appropriate methodology, whether the changes in fair value or cash flows of the interest rate swap could be expected to be highly effective in offsetting changes in fair value or cash flows of the debt attributable to interest rate risk taking into account the impact of the embedded call option (Example 1) or the impact of the interest rate cap (Example 2). As required by paragraph 21(f), "the effect of an embedded derivative of the same risk class must be considered in designating a hedge of an individual risk." Therefore, if the options in Example 1 and Example 2 are expected to be out-of-the-money based on a probability-weighted analysis of the range of possible changes in interest rates, then those options would be expected to have a minimal impact on changes in fair value or cash flows of the debt, and the hedging relationships could meet the requirement for an expectation of high effectiveness.

*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.*