FASB Hedging - General Application of the Shortcut Method

FASB: Hedging - General: Application of the Shortcut Method

Derivatives Implementation Group

Statement 133 Implementation Issue No. E4

Title: Hedging—General: Application of the Shortcut Method
Paragraph references: 68-70, 114, 132
Date cleared by Board: July 28, 1999
Date latest revision posted to website: May 1, 2003
Affected by: FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities
FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
(Revised March 26, 2003)

QUESTIONS

  1. Can the shortcut method be applied if most but not all of the applicable conditions in paragraph 68 are met?

  2. Can the shortcut method be applied to hedging relationships that involve hedging instruments other than interest rate swaps or that involve hedged risks other than interest rate risk?

  3. Can the shortcut method be applied to a fair value hedge of a callable interest-bearing debt instrument if the hedging interest rate swap has matching call provisions?

BACKGROUND

The conditions for assuming no ineffectiveness and thus being able to apply the shortcut method are listed in paragraph 68, which states in part:

An entity may assume no ineffectiveness in a hedging relationship of interest rate risk involving an interest-bearing asset or liability and an interest rate swap if all of the applicable conditions in the following list are met.

Paragraphs 114 and 132 discuss the steps to be used in applying the shortcut method to Examples 2 and 5, respectively.

RESPONSE

Question 1

No. The shortcut method can be applied only if all of the applicable conditions in paragraph 68 are met. That is, all the conditions applicable to fair value hedges must be met to apply the shortcut method to a fair value hedge and all the conditions applicable to cash flow hedges must be met to apply the shortcut method to a cash flow hedge. A hedging relationship cannot qualify for application of the shortcut method based on an assumption of no ineffectiveness justified by applying other criteria.

Given the potential for not recognizing hedge ineffectiveness in earnings under the shortcut method, Statement 133 intentionally limits its application only to hedging relationships that meet each and every applicable condition in paragraph 68. Thus, if the interest rate swap at the inception of the hedging relationship has a positive or negative fair value, the shortcut method cannot be used even if all the other conditions are met. (See condition 68(b).) Similarly, because a callable financial instrument is prepayable, the shortcut method cannot be applied to a debt instrument that contains an embedded call option (unless the hedging interest rate swap in a fair value hedge contains a mirror-image call option, as discussed in Question 3). (See condition 68(d).) The verb match is used in the specified conditions in paragraph 68 to mean be exactly the same or correspond exactly.

Question 2

No. Because paragraph 68 specifies only a hedging relationship that involves only an interest rate swap as the hedging instrument, the shortcut method cannot be applied to relationships hedging interest rate risk that involve hedging instruments other than interest rate swaps. Similarly, the shortcut method described in paragraphs 114 and 132 cannot be applied to hedging relationships that involve hedged risks other than the risk of changes in fair value (or cash flows) attributable to changes in the designated benchmark interest rates. However, the inability to apply the shortcut method to a hedging relationship does not suggest that that relationship must result in some ineffectiveness. Paragraph 65 points out a situation in which a hedging relationship involving a commodities forward contract would be considered to result in no ineffectiveness.

Question 3

An entity is not precluded from applying the shortcut method to a fair value hedging relationship of interest rate risk involving an interest-bearing asset or liability that is prepayable 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 (a) the terms of the two call options match exactly (including matching maturities, strike price, related notional amounts, timing and frequency of payments, and dates on which the instruments may be called) and (b) the entity is the writer of one call option and the holder (or purchaser) of the other call option.

Similarly, an entity is not precluded from applying the shortcut method to a fair value hedging relationship of interest rate risk involving an interest-bearing asset or liability that is prepayable due to an embedded put option provided the hedging interest rate swap contains an embedded mirror-image put option.

In instances where the hedging instrument is a compound derivative composed of an interest rate swap and mirror-image call or put option, paragraph 68(b), as amended by Statement 149, requires that the premium for the mirror-image call or put option must be paid or received in the same manner as the premium on the call or put option embedded in the hedged item. Specifically, if the implicit premium for the call or put option embedded in the hedged item was principally paid at inception-acquisition of the instrument, the fair value of the hedging instrument at the inception of the hedging relationship must be equal to the fair value of the mirror-image call or put option. If instead the implicit premium for the call or put option embedded in the hedged item is principally being paid over the life of the hedged item, the fair value of the hedging instrument at the inception of the hedging relationship must be zero.

General Comments

Statement 133 acknowledges in paragraph 70 that a hedging relationship that meets all of the applicable conditions in paragraph 68 may nevertheless involve some ineffectiveness (notwithstanding the supposed "assumption of no ineffectiveness"). Yet Statement 133 permits application of the shortcut method, which does not recognize such ineffectiveness currently in earnings. For example, the change in the fair value of an interest rate swap may not offset the change in the fair value of a fixed-rate receivable attributable to the hedged risk (resulting in hedge ineffectiveness) due to a change in the creditworthiness of the counterparty on the swap . Although an expectation of such hedge ineffectiveness potentially could either (a) preclude fair value hedge accounting at inception or (b) trigger current recognition in earnings under regular fair value hedge accounting, the shortcut method masks that ineffectiveness and does not require its current recognition in earnings. In fact, the shortcut method does not even require that the change in the fair value of the hedged fixed-rate receivable attributable to the hedged risk be calculated.

Although a hedging relationship may not qualify for the shortcut method, the application of regular fair value hedge accounting may nevertheless result in recognizing no ineffectiveness. For example, the characteristics of the hedged item and the hedging derivative may, in some circumstances, cause an entity's calculation of the change in the hedged item's fair value attributable to the hedged risk to be an amount that is equal and offsetting to the change in the derivative's fair value. In those circumstances, because there is no ineffectiveness that needs to be reported, the result of the fair value hedge accounting would be the same as under the shortcut method.

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.