FASB Transition Provisions Floating-Rate Currency Swaps

FASB: Transition Provisions: Floating-Rate Currency Swaps

Derivatives Implementation Group

Statement 133 Implementation Issue No. J5

Title: Transition Provisions: Floating-Rate Currency Swaps
Paragraph references: 18, 523, 524, Footnote 13 (to paragraph 49)
Date cleared by Board: November 23, 1999
Affected by: FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities
(Revised September 25, 2000)

QUESTION

Upon initial application of Statement 133, may a company separate a currency swap that has two floating-rate legs (for example, a receive-EUR-floating, pay-USD-floating swap) into three components in applying paragraph 49 and related footnote 13?

BACKGROUND

Footnote 13 to paragraph 49 of Statement 133 states:

     For a compound derivative that has a foreign currency exchange risk component (such as a foreign currency interest rate swap), an entity is permitted at the date of initial application to separate the compound derivative into two parts: the foreign currency derivative and the remaining derivative. Each of them would thereafter be accounted for at fair value, with an overall limit that the sum of their fair values could not exceed the fair value of the compound derivative. An entity may not separate a compound derivative into components representing different risks after the date of initial application.

As discussed in paragraphs 523 and 524 of the basis for conclusions, footnote 13 to paragraph 49 permits bifurcation of a compound derivative with a foreign currency exchange risk component upon initial application of Statement 133. The Board's decision to allow bifurcation upon initial application of Statement 133 acknowledged that a company may have entered into a long-term derivative that combines foreign currency exchange and interest rate risk components. Prior to being amended by Statement 138, Statement 133 prohibited hedge accounting for hedges of foreign currency risk of financial assets and liabilities for which transaction gains and losses are recognized currently in earnings as required by paragraph 15 of FASB Statement No. 52, Foreign Currency Translation. The result of the amendment permits such compound derivatives to qualify for hedge accounting in certain foreign currency hedges, and therefore, reduces the need for bifurcation upon initial application of Statement 133 of a currency swap that has two floating-rate legs into three components. Statement 133 otherwise prohibits bifurcation of a compound derivative. Paragraph 18 states, "…an entity is prohibited from separating a compound derivative into components representing different risks and designating any such component as the hedging instrument, except as permitted at the date of initial application by the transition provisions in paragraph 49."

RESPONSE

Yes. Upon initial application, a company may separate a currency swap that has two floating-rate legs into three components (two interest rate swaps and a currency swap), as follows:

Receive Leg Pay Leg
Existing Compound Swap EUR floating USD floating
Separated Swaps:
   Interest Rate Swap 1 EUR floating EUR fixed
   Currency Swap EUR fixed USD fixed
   Interest Rate Swap 2 USD fixed USD floating

A currency swap that has two floating-rate legs can be separated only into the following three derivatives: a currency swap and two interest rate swaps.

The above guidance applies only to the transition provisions for compound derivatives that include a foreign currency exchange risk component existing at the date of the initial application of Statement 133. A swap that has two floating legs is a compound derivative, and therefore is subject to those transition provisions, because the cash flows that arise under that type of contract are based on multiple underlyings-interest rates in the relevant currencies and the foreign currency exchange rate. The conclusion in this issue should not be applied by analogy to derivatives entered into after Statement 133 has been adopted.

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.