FASB Cash Flow Hedges Need to Consider Possibility of Default by the Counterparty to the Hedging Derivative

FASB: Cash Flow Hedges: Need to Consider Possibility of Default by the Counterparty to the Hedging Derivative

Derivatives Implementation Group

Statement 133 Implementation Issue No. G10

Title: Cash Flow Hedges: Need to Consider Possibility of Default by the Counterparty to the Hedging Derivative
Paragraph references:
28(b), 29(b), 68
Date cleared by Board: June 28, 2000

QUESTION

To comply with the requirements of paragraph 28(b) of Statement 133 on an ongoing basis, must an entity consider the likelihood of the counterparty's compliance with the contractual terms of the hedging derivative that require the counterparty to make cash payments to the entity?

BACKGROUND

Paragraph 28(b) of Statement 133 states, in part, the following criterion to qualify for cash flow hedge accounting:

   Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge, except as indicated in paragraph 28(d) below.

Paragraph 28(d) provides a special criterion for hedging with "basis" swaps.

RESPONSE

Yes, an entity must consider the likelihood of the counterparty's compliance with the contractual terms of the hedging derivative that require the counterparty to make payments to the entity. For an entity to conclude on an ongoing basis that the hedging relationship is expected to be highly effective in achieving offsetting changes in cash flows, the entity cannot ignore whether it will collect the payments it would be owed under the contractual provisions of the derivative. In complying with the requirements of paragraph 28(b), the entity must assess the possibility of whether the counterparty to the derivative will default by failing to make any contractually required payments to the entity as scheduled in the derivative instrument. In making that assessment, the entity should also consider the impact of any related collateralization or financial guarantees.

The entity must be aware of the counterparty's creditworthiness (and changes therein) in determining the fair value of the derivative. Although a change in the counterparty's creditworthiness would not necessarily indicate that the counterparty would default on its obligations, such a change would warrant further evaluation. If the likelihood that the counterparty will not default ceases to be probable, an entity would be unable to conclude that the hedging relationship in a cash flow hedge is expected to be highly effective in achieving offsetting cash flows. In contrast, a change in the creditworthiness of the derivative's counterparty in a fair value hedge would have an immediate impact because that change in creditworthiness would affect the change in the derivative's fair value, which would immediately affect both the assessment whether the relationship qualifies for hedge accounting and the amount of ineffectiveness recognized in earnings under fair value hedge accounting. (A change in the creditworthiness of the derivative's counterparty in a cash flow hedge of interest rate risk would also have an immediate impact if ineffectiveness were measured under the Change in Fair Value Method discussed in Statement 133 Implementation Issue No. G7, "Measuring the Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method Is Not Applied.")

In applying the shortcut method for hedges of interest rate risk with interest rate swaps (as discussed in paragraphs 68, 114, and 132), an entity must similarly consider the likelihood of the counterparty's compliance with the contractual terms of the hedging derivative that require the counterparty to make payments to the entity. Implicit in the criteria for the shortcut method is the requirement that a basis exists for concluding on an ongoing basis that the hedging relationship is expected to be highly effective in achieving offsetting changes in fair values or cash flows.

In addition to assessing the creditworthiness of the derivative's counterparty, an entity using a cash flow hedge must also assess the creditworthiness of the counterparty to the hedged forecasted transaction in determining whether the forecasted transaction is probable, as required by paragraph 29(b), particularly if the hedged transaction involves payments pursuant to a contractual obligation of the counterparty.

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.