FASB Transition Provisions Using Either the Fair Value or Cash Flow Hedging Model to Hedge a Structured Note

FASB: Transition Provisions: Using Either the Fair Value or Cash Flow Hedging Model to Hedge a Structured Note

Derivatives Implementation Group

Statement 133 Implementation Issue No. J14

Title: Transition Provisions: Using Either the Fair Value or Cash Flow Hedging Model to Hedge a Structured Note
Paragraph references:

4, 21(a)(2)(c), 21(f), 29(h)

Date cleared by Board: December 6, 2000

QUESTION

During January 1998, Company A issued a $100 million structured note that pays quarterly a 3 percent annual rate of interest plus an additional quarterly return based on any increase in the S&P 500 index for that quarter, with a guaranteed return of principal at maturity. Upon adoption of Statement 133, Company A chose to grandfather those embedded derivatives that existed in hybrid instruments that were issued, acquired or substantively modified before January 1, 1999. Therefore, the embedded equity derivative is not separated from the debt host contract.

Based on the guidance in paragraph 21(f) and paragraph 29(h) of Statement 133 (as amended), may Company A designate the following hedging relationships involving the example structured note:

  1. Fair value hedge of the risk of changes in the structured note's overall fair value
  2. Fair value hedge of the risk of changes in the fair value of the embedded equity derivative that is not being accounted for separately
  3. Fair value hedge of the risk of changes in the structured note's fair value attributable to changes in the designated benchmark interest rate (for example, the U.S. Treasury rate)
  4. Cash flow hedge of the risk of changes in the structured note's total quarterly cash flows
  5. Cash flow hedge of the risk of changes in the structured note's cash flows attributable to changes in the designated benchmark interest rate (for example, the U.S. Treasury rate)?

BACKGROUND

Paragraph 4 of Statement 133 describes the exposures that may be hedged under Statement 133. Paragraph 4 states, in part:

   If certain conditions are met, a derivative instrument may be designated as a hedging instrument for the following exposures:
  1. A hedge of the exposure to changes in fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk (referred to as a fair value hedge)

  2. A hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk (referred to as a cash flow hedge).... [Footnote reference omitted.]

Paragraph 21(f) sets forth the types of risks that may be designated as being hedged in a fair value hedge. Paragraph 21(f) (as amended), states, in part:

   If the hedged item is a financial asset or liability, a recognized loan servicing right, or a nonfinancial firm commitment with financial components, the designated risk being hedged is [the following]:
  1. The risk of changes in the overall fair value of the entire hedged item,
  2. The risk of changes in its fair value attributable to changes in the designated benchmark interest rate (referred to as interest rate risk),
  3. The risk of changes in its fair value attributable to changes in the related foreign currency exchange rates (referred to as foreign exchange risk)…, or
  4. The risk of changes in its fair value attributable to both changes in the obligor's creditworthiness and changes in the spread over the benchmark interest rate with respect to the hedged item's credit sector at inception of the hedge (referred to as credit risk).

If the risk designated as being hedged is not the risk in paragraph 21(f)(1) above, two or more of the other risks (interest rate risk, foreign currency exchange risk, and credit risk) may simultaneously be designated as being hedged.

Paragraph 29(h) sets forth the risks that may be designated as being hedged in a cash flow hedge. Paragraph 29(h) (as amended) states, in part:

   If the hedged transaction is the forecasted purchase or sale of a financial asset or liability (or the interest payments on that financial asset or liability) or the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is [the following]:
  1. The risk of overall changes in the hedged cash flows related to the asset or liability, such as those relating to all changes in the purchase price or sales price (regardless of whether that price and the related cash flows are stated in the entity's functional currency or a foreign currency),
  2. The risk of changes in its cash flows attributable to changes in the designated benchmark interest rate (referred to as interest rate risk),
  3. The risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates (referred to as foreign exchange risk)..., or
  4. The risk of changes in its cash flows attributable to default, changes in the obligor's creditworthiness, and changes in the spread over the benchmark interest rate with respect to the hedged item's credit sector at inception of the hedge (referred to as credit risk).

Two or more of the above risks may be designated simultaneously as being hedged.

RESPONSE

The following guidance relates to Company A's ability to designate various fair value and cash flow hedging relationships involving the example structured note in the Question section:

  1. Company A may designate a fair value hedge of the risk of changes in the structured note's overall fair value. Because Company A must have an expectation at the inception of the hedge and on an ongoing basis that the hedging relationship will be highly effective in achieving offsetting changes in fair value during the period the hedge is designated, it must obtain a derivative instrument or combination of derivatives that would be a highly effective hedge of changes in the structured note's overall fair value. While this strategy is permitted, it may be difficult to construct a hedging instrument that is highly effective in offsetting the interest-rate-based and equity-based components of the structured note's return while also encompassing a hedge of credit risk exposure. However, if it is expected that the embedded equity-based component of the structured note will generate de minimis changes in fair value during the hedge period, an expectation of high effectiveness may be established.

  2. Company A may designate a fair value hedge of the risk of changes in the fair value of the embedded equity derivative that is not being accounted for separately. The equity-based component of the structured note is an equity derivative that provides the holder of the structured note with potential gains resulting from increases in the S&P 500 index. That equity derivative can be identified as the hedged item because it is a portion of a recognized liability that meets the requirements in paragraph 21(a)(2)(c). Paragraph 21(a)(2) states, in part, "If the hedged item is a specific portion of an asset or liability...the hedged item is one of the following:...(c) A put option, a call option, an interest rate cap, or an interest rate floor embedded in an existing asset or liability that is not an embedded derivative accounted for separately pursuant to paragraph 12 of this Statement...."

  3. Company A may designate a fair value hedge of the risk of changes in the structured note's fair value attributable to changes in the designated benchmark interest rate (for example, the U.S. Treasury rate). Similar to (a), Company A must have an expectation at the inception of the hedge and on an ongoing basis that the hedging relationship will be highly effective in achieving offsetting changes in fair value attributable to the benchmark interest rate during the period the hedge is designated. However, it is unlikely that Company A could establish an expectation that a derivative based on the benchmark interest rate would be highly effective as a hedge of the structured note's fair value attributable to interest rate risk because of the impact of the equity-based-component on the calculation of that change in fair value attributable to interest rate risk. As required by paragraph 21(f) of Statement 133 (as amended), the estimated cash flows used in calculating the change in the hedged item's fair value attributable to changes in the benchmark interest rate must be based on all of the contractual cash flows of the entire hedged item; excluding some of the hedged item's contractual cash flows is not permitted. Therefore, in employing this hedging strategy, Company A must incorporate into that calculation the cash flows that will be generated by both the structured note's interest-rate-based component (based on the 3 percent fixed rate) and an estimation of the cash flows that will be generated by the equity-based component (based on expected increases in the S&P 500 index). While this hedging relationship would typically be expected not to qualify as a fair value hedge of interest rate risk, if it is expected that the embedded equity-based component of the structured note will have a de minimis effect on the changes in fair value of the structured note during the hedge period, an expectation that the hedging relationship will be highly effective in achieving offsetting changes in fair value attributable to interest rate risk may be established.

  4. Company A may designate a cash flow hedge of the risk of changes in the structured note's total quarterly cash flows. In order to be highly effective, the entity would be required to designate as the hedging instrument a derivative that is expected to produce offsetting cash flows as the S&P 500 index increases.

  5. Company A may not designate a cash flow hedge of the risk of changes in the structured note's cash flows attributable to changes in the designated benchmark interest rate (for example, the U.S. Treasury rate). In accordance with paragraph 29(h) of Statement 133 (as amended), in order to designate a hedge of cash flow variability attributable to changes in the benchmark interest rate, the hedged variable interest flows must be explicitly based on the designated benchmark rate (that is, either the U.S. Treasury rate or the LIBOR swap rate in the U.S.). If the hedged transaction's variability is based on an index other than the designated benchmark rate, the risk being hedged must be the risk of overall changes in the hedged cash flows, as discussed in (d) above. In the example structured note in the Question section, the variability in the structured note's cash flows is based on changes in the S&P index, not the designated benchmark rate.

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.