FASB Hedging-General How Paragraph 68(c) Applies to an Interest Rate Swap that Trades at an Interim Date

FASB: Hedging-General: How Paragraph 68(c) Applies to an Interest Rate Swap that Trades at an Interim Date

Derivatives Implementation Group

Statement 133 Implementation Issue No. E12

Title: Hedging—General: How Paragraph 68(c) Applies to an Interest Rate Swap that Trades at an Interim Date
Paragraph references: 68(c)
Date cleared by Board: December 6, 2000

QUESTION

Does a swap that involves a stub period violate the paragraph 68(c) requirement that "the formula for computing net settlements under the interest rate swap is the same for each net settlement" such that the shortcut method may not be applied?

BACKGROUND

Paragraph 68 of Statement 133 sets forth the requirements that must be met to assume no ineffectiveness in a hedge with an interest rate swap (the shortcut method). Paragraph 68(c) states, "The formula for computing net settlements under the interest rate swap is the same for each net settlement. (That is, the fixed rate is the same throughout the term, and the variable rate is based on the same index and includes the same constant adjustment or no adjustment.)"

Interest rate swaps with floating rates based on LIBOR typically reset at three-month or six-month intervals. Often, swaps may trade on interim dates that do not correspond to a swap reset date. Calendar dates that are swap reset and payment dates are set by market convention. A swap that resets quarterly may have a first payment period that is shorter than a full quarter, such as 30 days versus 90 days. Because the first payment period is not equal to a full quarter, it is referred to as a "stub period." That stub period is the period that begins on the date coupon payments begin to accrue and ends on the first payment date. The floating rate set for that shorter period is the "stub rate." The stub rate is the floating rate that corresponds to the length of the stub period. It is unclear whether the existence of the stub rate would violate the requirement in paragraph 68(c) that the "...variable rate is based on the same index and includes the same constant adjustment or no adjustment."

RESPONSE

No. The existence of a stub period and stub rate is not a violation of paragraph 68(c) that would preclude application of the shortcut method provided that the stub rate is the floating rate that corresponds to the length of the stub period. It is acknowledged that the stub rate presents an apparent inconsistency with the requirement in paragraph 68(c) that the "...variable rate is based on the same index and includes the same constant adjustment or no adjustment," because the stub rate is a floating rate that is adjusted to reflect the number of the days in the stub period, and is therefore not reflective of a floating rate that is applicable to a full reset period similar to the floating rates that would be in effect for the remaining periods of the swap. However, the existence of the stub rate is a market convention that is necessary for determining the prices of interest rate swaps that are traded on dates that do not coincide with swap reset dates. Because many swaps are traded on interim dates, the existence of a stub rate for a single period is a necessary adjustment in a significant number of contracts. The objective of the conditions in paragraph 68 for qualifying for the shortcut method is to ensure that the hedging relationship does not violate the assumption of no ineffectiveness necessary for applying the shortcut method. The adjustment of the swap's floating rate in a stub period as a necessary pricing adjustment does not present an inconsistency with the assumption of no ineffectiveness in a hedging relationship.

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.