2.4 Items That May Be Designated as the Hedging Instrument
ASC 815-20
25-45
Either all or a proportion of a derivative instrument
(including a compound embedded derivative that is accounted
for separately) may be designated as a hedging instrument.
Two or more derivative instruments, or proportions thereof,
may also be viewed in combination and jointly designated as
the hedging instrument. A proportion of a derivative
instrument or derivative instruments designated as the
hedging instrument shall be expressed as a percentage of the
entire derivative instrument(s) so that the profile of risk
exposures in the hedging portion of the derivative
instrument(s) is the same as that in the entire derivative
instrument(s). Subsequent references in the Derivatives and
Hedging Topic to a derivative instrument as a hedging
instrument include the use of only a proportion of a
derivative instrument as a hedging instrument. Whether a
written option may be designated as a hedging instrument
depends on the terms of both the hedging instrument and the
hedged item as discussed beginning in paragraph
815-20-25-94.
25-58
A derivative instrument or a nonderivative financial
instrument that may give rise to a foreign currency
transaction gain or loss under Topic 830 can be designated
as hedging changes in the fair value of an unrecognized firm
commitment, or a specific portion thereof, attributable to
foreign currency exchange rates. The designated hedging
relationship qualifies for the accounting specified in
Subtopic 815-25 if all the fair value hedge conditions in
this Section and the conditions in paragraph 815-20-25-30
are met.
25-66
A derivative instrument or a nonderivative financial
instrument that may give rise to a foreign currency
transaction gain or loss under Subtopic 830-20 can be
designated as hedging the foreign currency exposure of a net
investment in a foreign operation provided the conditions in
paragraph 815-20-25-30 are met. A nonderivative financial
instrument that is reported at fair value does not give rise
to a foreign currency transaction gain or loss under
Subtopic 830-20 and, thus, cannot be designated as hedging
the foreign currency exposure of a net investment in a
foreign operation.
Hedge accounting typically involves the use of a derivative instrument to hedge a
risk exposure. Much of the hedging guidance in ASC 815 applies to derivative
instruments, which can be a single derivative, a combination of derivatives, or a
proportion of derivatives. However, in a few limited circumstances,
foreign-currency-denominated debt instruments can be designated as the hedging
instrument in a foreign currency hedge (see Section
2.4.2). The discussion below addresses the “dos and don’ts” of
designating qualifying hedging instruments in more detail.
2.4.1 Hedging With Derivatives
An entity may use a derivative, a proportion of
a derivative, or a combination of derivatives (or proportions thereof) as the
hedging instrument in a hedging relationship, with some limitations. The table
below summarizes both the acceptable and the prohibited uses of derivatives as
hedging instruments. All references to freestanding derivatives also include
bifurcated embedded derivatives.
|
Qualifies as Hedging Instrument
|
Prohibited as Hedging Instrument
|
|---|---|
|
|
2.4.1.1 Combinations of Derivatives
Sometimes, an entity with exposure to multiple risks has multiple derivatives
that it would like to designate in combination as the hedging instrument in
a single hedging relationship. For instance, in the example discussed in
Section 2.3.2.1.1, an entity
forecasts purchases that vary on the basis of changes in the Midwest
transaction price of aluminum, which is composed of two component risks —
the LME aluminum price and the Midwest Transaction Premium. Derivatives
commonly trade with an underlying that is referenced to each of the risk
components. If the entity wants to hedge the total changes in the Midwest
transaction price, it could separately enter into (1) financially settled
fixed-price forward purchase contracts based on the LME and (2) financially
settled forwards based on the Midwest Transaction Premium. The entity could
then designate a combination of the two forwards as the hedging instrument
in a cash flow hedge against the risk of changes in the cash flows of its
forecasted aluminum purchases that are attributable to changes in the
contractually specified Midwest transaction price component of the aluminum
price.
2.4.1.2 Portions Versus Proportions of Derivatives
Under ASC 815-20-25-45, an entity is permitted to designate a proportion of a
derivative (or combination of derivatives) as the hedging instrument as long
as that proportion is “expressed as a percentage of the entire derivative
instrument(s) so that the profile of risk exposures in the hedging portion
of the derivative instrument(s) is the same as that in the entire derivative
instrument(s).” We believe that this principle is satisfied if an entity
designates as the hedging instrument either (1) a percentage of the
derivative(s) or (2) a stated amount of the derivative(s), provided that it
is clear that the entity intends to use a proportion of that derivative to
offset its risk exposure.
For example, an entity may enter into an interest rate swap with a notional
amount of $100 million and want to designate $60 million of that swap as the
hedging instrument in a hedge of $60 million of outstanding debt. We believe
that the entity could designate as the hedging instrument either (1) 60
percent of the outstanding swap or (2) $60 million of the $100 million
notional swap.
In accordance with ASC 815-20-25-71(a)(2), an entity is prohibited from
designating a component of a compound derivative as the hedging instrument
in a hedging relationship. For example, assume that an entity enters into a
receive-fixed, pay-floating interest rate swap with an interest rate cap on
the variable leg. The entity would not be permitted to designate only the
interest rate cap component of the swap as the hedging instrument in a hedge
of the interest rate risk associated with the interest payments on the
variable-rate debt. Similarly, the entity could not designate only the
interest rate component (without the cap) of the swap as the hedging
instrument in a hedge of interest payments on a fixed-rate debt
liability.
2.4.1.3 Prohibited Derivatives
As discussed in the previous section, an entity is precluded from designating
a component of a compound derivative as the hedging instrument in a hedging
relationship. The discussion below addresses a few other types of
derivatives that cannot be designated as hedging instruments in hedging
relationships.
2.4.1.3.1 Intra-Entity Derivatives
Intra-entity derivatives that hedge risks other than foreign currency
risk (e.g., interest rate risk, credit risk, the risk of changes in a
contractually specified component, or the risk of changes in overall
fair value or cash flows) cannot be designated as hedging instruments in
hedging relationships recognized in an entity’s consolidated financial
statements because such derivative contracts would be eliminated in
consolidation. ASC 815 provides an exception for certain foreign
currency hedges, which is discussed further in Section
5.1.2.3. Intra-entity derivatives could, however, qualify
for designation as hedging instruments in hedging relationships
recognized in a subsidiary’s stand-alone financial statements if the
required hedging criteria are satisfied. In such cases, the entity would
be required to disclose the related-party nature of the transaction
under ASC 850-10-50.
Because ASC 815 does not require the operating unit with interest rate,
market price, or credit risk exposure to be a party to the hedging
instruments, an entity can, in its consolidated financial statements,
hedge a subsidiary’s exposure to these risks by (1) having a parent
entity’s central treasury function enter into derivatives with third
parties and (2) designating those contracts as the hedging instruments
in hedges of the subsidiary’s risk exposures (for more information, see
ASC 815-20-25-46A and 25-46B).
If an entity uses a central treasury function for all derivatives and
would like to achieve hedge accounting in both the consolidated
financial statements and the stand-alone financial statements of a
subsidiary, the central treasury function would need to enter into both
(1) a derivative with an unrelated third party and (2) a mirrored
derivative with the subsidiary that is exposed to the hedged risk. In
this case, the derivative with an unrelated third party would be
designated as the hedging instrument in the consolidated financial
statements, and the intra-entity derivative would be designated as the
hedging instrument in the subsidiary’s stand-alone financial statements.
Alternatively, the subsidiary could simply enter into a derivative with
an unrelated third party (i.e., not use the central treasury function)
and designate that derivative as the hedging instrument; in such case,
hedge accounting would be allowed at the subsidiary level and would
survive consolidation.
Note that an entity that enters into a derivative with
an equity method investee would not be permitted to use the derivative
as a hedging instrument in its consolidated financial statements unless
(1) the derivative is designated as a hedge of foreign currency exposure
and (2) the conditions in ASC 815-20-25-61 are met (see
Section 5.1.2.3).
ASC 815-20-25-52 through 25-56 address hedging with intra-entity
derivatives. Although the guidance initially mentions only derivatives
between two members of a consolidated group, it also addresses
related-party derivatives. In clarifying what type of derivative can be
used to hedge permitted risks other than foreign exchange risk
(specifically, overall cash flow or fair value, interest rate risk,
credit risk, or contractually specified component risk), ASC
815-20-25-46B states, in part, that “[o]nly a derivative instrument with
an unrelated third party can be designated as the hedging instrument in
a hedge of those risks in consolidated financial statements.” An
“unrelated party” is any entity that is not a related party. Since the
definition of a related party in ASC 850 includes an equity method
investee, a derivative entered into with an equity method investee
cannot be used as a hedging instrument in the consolidated financial
statements.
2.4.1.3.2 Written Options
Under a written option, an entity (the option writer) must perform as
stated in the option if it is exercised by the counterparty (the option
purchaser). For the option writer, the upside is limited to the option
premium received; however, the downside could be unlimited. Because
written options generally do not reduce an entity’s risk, they do not
qualify as hedging instruments for hedge accounting unless they meet
what is commonly referred to as the “written option test.”
ASC 815-20
25-94 If a
written option is designated as hedging a
recognized asset or liability or an unrecognized
firm commitment (if a fair value hedge) or the
variability in cash flows for a recognized asset
or liability or an unrecognized firm commitment
(if a cash flow hedge), the combination of the
hedged item and the written option provides either
of the following:
- At least as much potential for gains as a result of a favorable change in the fair value of the combined instruments (that is, the written option and the hedged item, such as an embedded purchased option) as exposure to losses from an unfavorable change in their combined fair value (if a fair value hedge)
- At least as much potential for favorable cash flows as exposure to unfavorable cash flows (if a cash flow hedge).
The exposure draft for FASB Statement 133 prohibited the use of written
options in a hedging relationship because of concerns that such options
increase risk for the option writer. However, on the basis of feedback
from constituents, the FASB decided to permit the use of hedge
accounting with written options on a very limited basis. The written
option test outlined in ASC 815-20-25-94 allows hedge accounting in
scenarios in which the written option and the hedged item provide
symmetrical upside and downside potential on a combined basis. The next
sections discuss:
- The criteria for determining whether a derivative is a written option (see Section 2.4.1.3.2.1).
- How to evaluate a combination of options (see Section 2.4.1.3.2.2).
- When to perform the analysis (see Section 2.4.1.3.2.3).
- When a written option can be used in a hedging relationship (i.e., the written option test) (see Section 2.4.1.3.2.4).
2.4.1.3.2.1 Definition of Written Option
As noted above, a written option requires the option
writer to perform as stated in the option if it is exercised by the
option purchaser.
Example 2-8
Cactus Co. writes an option to Fish’s Donuts
that allows the donut shop to acquire 1,000
gallons of agave syrup for $1.00 per gallon at any
time over the next three months. Fish’s Donuts
pays Cactus Co. $30 for this option to call agave
syrup. From the perspective of Cactus Co., its
upside is limited to the premium received (i.e.,
$30). However, its downside is unlimited. For each
$0.01 per gallon increase in the price of agave
syrup, Cactus Co. will lose $10 on the option
(1,000 gallons × $0.01/gallon).
The identification of a written option is fairly easy in the context
of a freestanding option such as that described above, especially
since Cactus Co. receives compensation (i.e., the $30 premium) upon
entering into the contract. However, sometimes options are combined
either with other options or with other nonoption derivatives. ASC
815 provides a framework for determining whether compound
derivatives are considered written options under the hedge
accounting requirements. Any derivative that results from combining
a written option with a nonoption derivative (e.g., a forward or
swap) is considered a written option in accordance with ASC
815-20-25-88, regardless of whether a premium is received under the
arrangement.
Example 2-9
Swap With a Cap on Variable Leg
BigBank enters into a
pay-fixed, receive-three-month term SOFR interest
rate swap with a customer. The bank agrees to cap
the amount it can receive on the SOFR leg at 5
percent. The swap is a combination of a
traditional interest rate swap (a nonoption
derivative) and a written cap whose strike price
is based on a three-month term SOFR of 5 percent.
The combination of the written option (the cap)
and the nonoption derivative (the swap) is
considered a written option.
Example 2-10
Knock-Out Swap
BigBank enters into a
knock-out swap, which is structured as a
pay-fixed, receive-three-month term SOFR interest
rate swap. However, under one of its provisions,
the swap is terminated if the three-month term
SOFR increases above 6 percent. This embedded
termination option is a written option for BigBank
because the swap terminates when the three-month
term SOFR increases above 6 percent and BigBank
receives three-month term SOFR under the terms of
the swap. Therefore, the knock-out swap is
considered a written option because the instrument
combines a nonoption derivative (the interest rate
swap) with a written option (the automatic
termination provision).
Example 2-11
Swap With Termination Option
Cactus Co. issues a 10-year
fixed-rate corporate bond that it can call at any
time after five years. It then enters into a
10-year receive-fixed, pay-three-month term SOFR
interest rate swap with BigBank that can be
terminated by BigBank at any time after five
years. The swap with a termination option is a
written option for Cactus Co. because it is the
combination of a nonoption derivative (the swap)
and a written option (the termination option held
by BigBank).
Connecting the Dots
Interest rate swaps often contain a provision that permits
one of the counterparties to terminate the swap. Such a
provision can have many different characteristics. For
example, if the option is exercised, the payoff may be at
fair value, there may be no payoff, or there may be some
calculation of the payoff amount. The option may be a
European-style option that the counterparty can only
exercise on one specific day or an American-style option
that allows the counterparty to terminate the option at any
time during its term.
If the termination option is written by the counterparty that
seeks to apply hedge accounting to the swap, the written
option embedded into the nonoption derivative (the interest
rate swap) makes the entire contract a written option.
Generally, the counterparty that can exercise the
termination option has a purchased, not a written,
option.
We believe that if the payoff upon exercise of a termination
option is the fair value of the swap, the entire contract
would not be considered a written option. A termination
option with a fair value payoff has a fair value of zero at
all times during its term; therefore, such an option would
not affect the swap’s fair value and does not have the
payoff profile of a written option (i.e., the option does
not expose the writer to unlimited risk).
2.4.1.3.2.2 Combination of Options
ASC 815-20
Determining Whether a
Combination of Options Is Net Written
25-88
This guidance addresses how an entity shall
determine whether a combination of options is
considered a net written option subject to the
requirements of paragraph 815-20-25-94. A
combination of options (for example, an interest
rate collar) entered into contemporaneously shall
be considered a written option if either at
inception or over the life of the contracts a net
premium is received in cash or as a favorable rate
or other term. Furthermore, a derivative
instrument that results from combining a written
option and any other non-option derivative
instrument shall be considered a written option.
The determination of whether a combination of
options is considered a net written option depends
in part on whether strike prices and notional
amounts of the options remain constant.
Strike Prices and Notional Amounts Remain
Constant
25-89 For
a combination of options in which the strike price
and the notional amount in both the written option
component and the purchased option component
remain constant over the life of the respective
component, that combination of options would be
considered a net purchased option or a zero cost
collar (that is, the combination shall not be
considered a net written option subject to the
requirements of paragraph 815-20-25-94) provided
all of the following conditions are met:
- No net premium is received.
- The components of the combination of options are based on the same underlying.
- The components of the combination of options have the same maturity date.
- The notional amount of the written option component is not greater than the notional amount of the purchased option component.
25-90 If
the combination of options does not meet all of
those conditions, it shall be subject to the test
in paragraph 815-20-25-94. For example, a
combination of options having different underlying
indexes, such as a collar containing a written
floor based on three-month U.S. Treasury rates and
a purchased cap based on three-month London
Interbank Offered Rate (LIBOR), shall not be
considered a net purchased option or a zero cost
collar even though those rates may be highly
correlated.
Entities need to evaluate whether specific combinations of options
meet the definition of a net written option. If any of the four
criteria in ASC 815-20-25-89 are not met, the combination is
considered a written option. All of the component options must
mature on the same date and be based on the same underlying;
otherwise, the combination of options is a net written option. The
notional amounts of the component options do not need to match, but
if the notional amount of the written option is greater than that of
the purchased option, the combination of options is a net written
option.
If an entity receives a premium as compensation for entering into the
combination of options, such a combination represents a net written
option, even if the premium is paid on a future date or over time.
Common examples of combinations of options are collars and capped
calls. By its definition, a costless collar does not involve the
payment of a premium by either party. Capped calls generally require
the purchaser to pay a premium to the writer. Both types of
combinations are described in the examples below.
Example 2-12
Costless Collar
Reprise is concerned about the rising costs of
aluminum, so it enters into the following
combination option on the LME aluminum price:
Such a combination option would be considered a
net purchased option because (1) the notional
amount and strike prices are fixed, (2) no net
premium is received because the fair values of the
component options offset, (3) the put and call are
based on the same underlying (i.e., LME aluminum
price), and (4) the maturity dates and notional
amounts of the component options match.
Example 2-13
Capped Call
Instead of entering into a costless collar,
Reprise purchases a capped call based on the LME
aluminum price. The call option has a notional of
2 million pounds and a strike price of $0.95 per
pound, but it also has a cap on the payout such
that Reprise will receive $100,000 if the price of
aluminum exceeds $1.00 per pound (2 million pounds
× $0.05 per pound). Reprise pays $4,500 for the
capped call. This combination option is a net
purchased option because (1) a premium is paid by
Reprise, (2) the purchased option (i.e., call) and
the written option (i.e., cap) are both based on
the same underlying (i.e., LME aluminum price),
(3) the components mature at the same time, and
(4) the notional amount for each component is the
same.
ASC 815-20
Strike Prices and Notional
Amounts Do Not Remain Constant
25-91 If either the written
option component or the purchased option component
for a combination of options has either strike
prices or notional amounts that do not remain
constant over the life of the respective
component, the assessment to determine whether
that combination of options can be considered not
to be a written option under paragraph
815-20-25-88 shall be evaluated with respect to
each date that either the strike prices or the
notional amounts change within the contractual
term from inception to maturity.
25-92 Even though that
assessment is made on the date that a combination
of options is designated as a hedging instrument
(to determine the applicability of paragraph
815-20-25-94), it shall consider the receipt of a
net premium (in cash or as a favorable rate or
other term) from that combination of options at
each point in time that either the strike prices
or the notional amounts change, such as either of
the following circumstances:
- If strike prices fluctuate over the life of a combination of options and no net premium is received at inception, a net premium will typically be received as a favorable term in one or more reporting periods within the contractual term from inception to maturity.
- If notional amounts fluctuate over the life of a combination of options and no net premium is received at inception, a net premium or a favorable term will typically be received in one or more periods within the contractual term from inception to maturity.
25-93 In addition, a
combination of options in which either the written
option component or the purchased option component
has either strike prices or notional amounts that
do not remain constant over the life of the
respective component shall satisfy all of the
conditions in paragraph 815-20-25-89 to be
considered not to be a written option (that is, to
be considered to be a net purchased option or zero
cost collar) under paragraph 815-20-25-88. For
example, if the notional amount of the written
option component is greater than the notional
amount of the purchased option component at any
date that the notional amount changes within the
contractual term from inception to maturity, the
combination of options shall be considered to be a
written option under paragraph 815-20-25-88 and,
thus, subject to the criteria in the following
paragraph.
If the notional amounts or the strike prices of the component options
are not constant over the options’ life, an entity must assess
whether the combination of options is a written option. Such an
assessment must be performed by analyzing the options’ terms as of
each date that either the strike prices or the notional amounts
change within the contractual term from inception to maturity. ASC
815 provides the examples below, which are based on changing strike
prices and notional amounts.
ASC 815-20
Example 20: Combinations of Options in Which
Strike Prices or Notional Amounts Do Not Remain
Constant
55-179 The following Cases
illustrate the application of paragraph
815-20-25-91 to combinations of options in which
either the strike price or the notional amount in
either the written option component or the
purchased option component can fluctuate over the
life of the respective component:
- Changes in strike prices (Case A)
- Changes in notional amounts (Case B).
55-180 Cases A and B share
the following assumptions:
- An entity wishes to hedge its forecasted sales of a commodity by entering into a five-year commodity-price collar.
- Under the collar, the entity will do both of
the following:
- Purchase commodity-price put option components (a floor)
- Write commodity-price call option components (a cap).
- Each of the alternative collars discussed
otherwise meets the criteria established in
paragraphs 815-20-25-89 through 25-90 including
all of the following:
- No net premium is received at inception of the combination of options. Paragraph 815-20-25-94 addresses, in part, whether a net premium is received at any point during the life of the combination of options that the strike price or notional amount is changed.
- The components of the combination of options are based on the same underlying (that is, the same commodity price).
- The components of the combination of options have the same maturity date.
- The notional amount of the written option component is not greater than the notional amount of the purchased option component. Paragraph 815-20-25-94 addresses, in part, whether this criterion should be applied to only the entire contractual term to maturity or to some part thereof.
Case A: Changes in Strike
Prices
55-181 The following table
presents both of the following:
- Commodity prices implied by the forward price curve based on market prices
- The strike prices of two alternative collars.
The minimum prices for each
collar represent the strike prices of the
purchased put options. The maximum prices for each
collar represent the strike prices of the written
call options. (Assume that the notional amounts of
the two option components are identical and
constant over the life of the option
components.)
55-182 Note that the 5-year
averages of the minimum prices (98.3 cents) and
the maximum prices (110.6 cents) of the 2 collars
are identical and are consistent with the 5-year
average implied by the forward price curve. (That
is, 104.5 cents equals the average of the
98.3-cent minimum strike price and the 110.6-cent
maximum strike price.) No net premium is received
at inception for either collar taking into
consideration the entire contractual term of the
combination of options from inception to
maturity.
55-183 For Collar 2, premiums
are received in early periods as consideration for
entering into net written options in later
periods. Specifically, the (higher-than-average)
strike prices in years 20X2 and 20X3 are received
(that is, receipt of a net premium) in return for
accepting less favorable (lower-than-average)
strike prices in years 20X4 through 20X6 (that is,
net written options). Thus, at the inception of
the hedge and over its life, Collar 2 would be
subject to the provisions of paragraph
815-20-25-94.
Case B: Changes in Notional
Amounts
55-184
The following table presents the notional amounts
of two alternative collars. (Assume that the
strike prices of the two collars are identical and
constant over the life of the collars.)
55-185 Note that both the sum
and average of the notional amounts of the written
option component for all periods are not greater
than the sum and average of the notional amounts
of the purchased option component for all
periods.
55-186 For Collar 4,
favorable terms are received in early periods (net
purchased options) as consideration for entering
into net written options in later periods.
Specifically, the (higher-than-average) notional
amounts on the purchased put option in years 20X2
through 20X4 are received in return for accepting
a less favorable notional amount in years 20X5 and
20X6. Thus, at the inception of the hedge and over
its life, Collar 4 in Case B would be subject to
the provisions of paragraph 815-20-25-94.
2.4.1.3.2.3 Timing of Evaluation
Note that an entity is required to determine whether
an option (or combination of options) is a written option only at
the time of hedge designation. If an entity plans to designate a
preexisting option or combination of options as the hedging
instrument in a hedging relationship, the option’s fair value at the
inception of the hedge is considered to be the premium. Therefore,
an option with a negative fair value at hedge inception (i.e., it is
in a liability position) would be considered a written option. If
the option’s fair value is zero or positive, the condition in ASC
815-20-25-89(a) that no net premium is received is considered to be
met and the entity should evaluate the other conditions in ASC
815-20-25-89. An entity would perform this analysis every time an
option or combination of options is designated as a hedging
instrument in a hedging relationship.
Consider a hedging strategy that is based on the
delta of a combination of options and is periodically designated as
a hedge of a commodity inventory. As the delta of the option
position changes, the units of inventory that are being designated
as hedged items also changes, resulting in a dedesignation and a
redesignation of the combination option position. If, on any
redesignation date, the combination of options results in an
economic net liability position, the combination does not qualify as
a net purchased option.
If a combination of options satisfies the criteria
to be considered a net purchased option on the designation date but
subsequently market conditions change and the combination is then
considered a net written option, the hedging relationship would not
be affected as long as the relationship remains in effect. Although
the change in market conditions may create a potential mismatch in
the extent to which the change in the fair value or cash flows of
the hedging instrument offsets the change in the fair value or cash
flows of the hedged item or hedged transaction, there would be no
need to perform the written option test discussed in Section
2.4.1.3.2.4. This is because (1) the combination of
options was considered a net purchased option on the date of
designation and (2) the evaluation of whether an option is a written
option is performed only at hedge inception.
For a combination of options to be designated as a
hedging instrument, the options do not necessarily have to be
entered into at the same time. The requirement for designating a
combination of options is that the tests in ASC 815-20-25-89 through
25-93 (see examples in ASC 815-20-55-179 through 55-186, which
illustrate the application of ASC 815-20-25-91) must be performed on
the date on which the combination is designated in the hedging
relationship.
Example 2-14
Cactus Co. purchases an option on January 1
and writes a new option on June 1. It would like
to combine the new written option with the option
that it purchased on January 1 and designate the
combined option as a hedging instrument. On June
1, Cactus Co. should compare the then fair value
of the purchased option with the fair value
(premium received) of the written option as a
basis for determining whether a net premium was
received and then consider the other requirements
of ASC 815-20-25-89 through 25-93.
Note that if an entity enters into an interest rate
swap with an embedded written option that does not qualify for hedge
accounting under ASC 815 but it subsequently settles the written
option component of the instrument, it can designate the stand-alone
interest rate swap as a hedging instrument without having to apply
the guidance for written options.
According to ASC 815-20-25-88, a nonoption
derivative (such as an interest rate swap) with an embedded written
option is considered a written option for hedge accounting purposes.
Examples of such instruments include an interest rate swap with an
embedded option for the counterparty to terminate (see Example 2-11)
or an interest rate swap with an embedded option in which the swap
will automatically terminate if the variable interest rate increases
above a specified rate (“knock-out swap”) (see Example
2-10). Since both of these types of swaps are written
options under ASC 815-20-25-88, they will only qualify for hedge
accounting if the written option test is passed (see Section
2.4.1.3.2.4).
However, if the embedded option expires
out-of-the-money or, after the inception of the instrument, the
company negotiates with the counterparty to terminate the option,
the resulting stand-alone interest rate swap may be designated as a
hedging instrument without having to satisfy the hedge criteria for
a written option. Presumably, the swap will not qualify for the
shortcut method discussed in Section 2.5.2.2.1 because it
is not likely to satisfy the criterion in ASC 815-20-25-104(b),
which requires a swap to have a fair value of zero upon inception of
the hedging relationship.
2.4.1.3.2.4 The Written Option Test
As previously noted, an entity’s ability to
designate a written option as a hedging instrument in a qualifying
hedging relationship is limited. A written option may be designated
as a hedging instrument in a hedge of the fair value or variability
in cash flows of a recognized asset or liability or of an
unrecognized firm commitment only if the written option test
outlined in ASC 815-20-25-94 and 25-95 is passed. All of the other
criteria for hedge accounting must also be met. (Note that for the
remainder of this section, all references to a written option also
include combinations of options that are considered net written
options.) The purpose of the written option test, sometimes referred
to as the “symmetrical gain and loss test,” is to prove that the
combination of the written option and the hedged item has at least
as much potential for gains (or favorable cash flows) as it does
exposure to losses (or unfavorable cash flows). Like the evaluation
of whether a combination of options is a net written option (see
Section
2.4.1.3.2.3), this test is performed only upon the
inception of a hedge.
Changing Lanes
At the October 11, 2023, FASB meeting, the
Board directed the staff to draft proposed amendments to the
guidance on applying the written option test when the
designated hedging instrument in a cash flow hedge is a
compound derivative made up of a written option and a
nonoption derivative. The amendments would permit entities
to assume that certain terms of the hedged forecasted
transactions match those of the hedging instrument when
applying the net written option test. These proposed
amendments were included in the FASB’s September 2024
proposed ASU. As of the date of this
publication, the FASB has not issued a final ASU.
ASC 815-20-55-45 specifically states that a covered
call strategy would not pass the written option test unless the
hedged item was a call option embedded in another instrument. As
illustrated below, a covered call strategy involves writing call
options on assets that the option writer owns.
Example 2-15
FarmHouse Inc. has 5,000
bushels of corn. The current market value of corn
is $3.81 per bushel. FarmHouse writes an option
that allows the counterparty to call 5,000 bushels
of corn at $4.00 per bushel at any time over the
next month. It receives a $1,000 premium for
writing the option. If the price of corn increases
above $4.00 per bushel, the corn will be called
away from FarmHouse and its overall gain will be
capped at $1,950 ($1,000 premium + $0.19 per
bushel × 5,000 bushels). However, if the price of
corn were to drop to $0, FarmHouse would lose
$18,050 ($3.81 loss per bushel multiplied by 5,000
bushels, partially offset by the $1,000 premium on
the call option).
ASC 815-20-25-96 permits an entity to exclude the
time value of a written option (or net written option) from the
test, provided that, in its documentation of how the hedge will be
assessed for effectiveness, the entity specifies that the
effectiveness tests will be based solely on changes in the option’s
intrinsic value (see Section 2.5.2.1.2.2).
Example 2-16
InvestorPlus issued $100
million of floating-rate debt; the interest rate
is equal to three-month term SOFR plus 300 basis
points. To hedge its exposure to variability in
the expected future cash outflows attributable to
changes in three-month term SOFR (the
contractually specified interest rate), the
company enters into an interest rate collar when
three-month term SOFR is 5 percent. The collar has
the following terms:
- Notional — $100 million.
- Underlying — three-month term SOFR.
- Cap strike — 7 percent per year.
- Floor strike — 4 percent per year.
The purchased cap goes into
effect when three-month term SOFR increases above
7 percent, and the written floor goes into effect
when three-month term SOFR decreases below 4
percent. Thus, the interest rate collar has the
effect of limiting the interest rate of the
floating-rate debt to a range between 7 and 10
percent. On the basis of market conditions as of
the collar transaction date, InvestorPlus received
a net premium from the bank.
To determine whether the
hedging relationship between the debt and the
collar qualifies for cash flow hedge accounting,
InvestorPlus must apply the written option test in
ASC 815-20-25-94 and 25-95. To pass this test, the
combination of the hedged item and the written
option must have “[a]t least as much potential for
favorable cash flows as exposure to unfavorable
cash flows” for all possible percentage changes
(from 0 to 100 percent) in three-month term
SOFR.
The table below illustrates
the potential impacts on cash flows associated
with the combination of the hedged item and net
written option, provided that three-month term
SOFR changes by the same percentage in opposite
directions.
As indicated in the table
above, given comparable favorable and unfavorable
changes in the three-month term SOFR, the gains
(favorable cash flows) from a favorable change
would not be at least as large as the losses
(unfavorable cash flows) from a comparable
unfavorable change in three-month term SOFR.
Accordingly, the combination of options would not
be considered eligible for hedge accounting.
Example 2-17
Reprise has $100 million of
existing floating-rate debt that is repriced
semiannually on the basis of changes in six-month
term SOFR (note that there is no credit spread in
this example). Reprise’s risk management objective
is to mitigate its exposure to variability in
expected future cash outflows that are
attributable to changes in six-month term SOFR. To
achieve this goal, Reprise purchased an interest
rate corridor (also known as a capped call) that
consists of the following interest rate caps:
Both of the interest rate caps
have the same underlying (six-month term SOFR) and
notional amounts ($100 million). As a result of
the market conditions on the transaction date,
Reprise paid a premium of $2.5 million to the
counterparty to the corridor. Regardless of the
premium paid, the corridor does not meet the
criteria in ASC 815-20-25-89 to be considered a
net purchased option (because of the differing
maturity dates of the options and interest rate
caps); therefore, the corridor is subject to the
test in ASC 815-20-25-94 and 25-95 for cash flow
hedges. Under this test, written options that are
designated as a hedge must provide “[a]t least as
much potential for favorable cash flows as
exposure to unfavorable cash flows” for all
possible percentage changes (from 0 to 100
percent) in six-month term SOFR.
When Reprise entered into the
corridor, six-month term SOFR was 5.0 percent. The
following table illustrates the potential impacts
on the cash flows associated with the combination
of the hedged item and the net written option if
six-month term SOFR changes by the same percentage
in opposite directions:
The calculations in the table
above show comparable favorable and unfavorable
moves in six-month term SOFR. The favorable change
(a decrease from 5.0 to 0.0 percent) would result
in a 100 percent decrease in interest cash flows,
while a similar unfavorable change (an increase
from 5.0 to 10.0 percent) would result in a 70
percent increase in overall interest expense (from
5.0 to 8.5 percent). Therefore, given a 100
percent fluctuation in rates, the interest rate
corridor provides at least as much potential for
favorable cash flows as exposure to unfavorable
cash flows.
The corridor would have a
similar effect for percentage changes in six-month
term SOFR that range from 31 to 99 percent. In
such scenarios, the favorable changes in six-month
term SOFR (i.e., percentage declines) would result
in comparable declines in the effective interest
rate on Reprise’s variable-rate debt; however,
unfavorable changes (i.e., percentage increases)
would be reduced by 1.5 percent because of the
impact of the corridor. In all cases, the
favorable percentage changes in six-month term
SOFR would produce changes in cash flows that are
at least as great as the unfavorable cash flows
that would be incurred from an unfavorable change
of the same percentage.
Finally, percentage changes in
six-month term SOFR that range from 0 to 30
percent would fall within the corridor. In such
cases, favorable changes (i.e., percentage
declines) would reduce Reprise’s effective
interest rate on its variable-rate debt, while
unfavorable changes (i.e., percentage increases)
would produce an effective rate of 5 percent (a 0
percent unfavorable change) because of the
corridor.
On the basis of this analysis
of the effect of all possible favorable percentage
changes in six-month term SOFR (the underlying)
from 0 to 100 percent and the comparable
unfavorable percentage changes, the interest rate
corridor satisfies the test in ASC 815-20-25-94
and 25-95 and is eligible to be designated as the
hedging instrument in a cash flow hedge.
Also note that the written
interest rate cap expires before the purchased
interest rate cap. Therefore, there are no
additional possible scenarios to consider in which
the symmetry test would have been failed after the
written interest rate cap expired but the
purchased interest rate cap was still in
place.
2.4.1.3.3 Basis Swaps
ASC 815-20
25-50 If a hedging instrument
is used to modify the contractually specified
interest receipts or payments associated with a
recognized financial asset or liability from one
variable rate to another variable rate, the
hedging instrument shall meet both of the
following criteria:
- It is a link between both of
the following:
- An existing designated asset (or group of similar assets) with variable cash flows
- An existing designated liability (or group of similar liabilities) with variable cash flows.
- It is highly effective at achieving offsetting cash flows.
25-51 For purposes of
paragraph 815-20-25-50, a link exists if both of
the following criteria are met:
- The basis (that is, the rate index on which the interest rate is based) of one leg of an interest rate swap is the same as the basis of the contractually specified interest receipts for the designated asset.
- The basis of the other leg of the swap is the same as the basis of the contractually specified interest payments for the designated liability.
In this situation, the criterion in paragraph
815-20-25-15(a) is applied separately to the
designated asset and the designated liability.
ASC 815-20-25-50 and 25-51 address the use of interest
rate basis swaps in hedge accounting for a specific hedging strategy
under which the entity uses the basis swap as a link between existing
variable-rate assets and existing variable-rate liabilities. Although
the guidance may appear to limit the use of basis swaps, some believe
that it actually provides an exception to the general hedge accounting
model by allowing a strategy that would not otherwise be available.
Without this guidance, an entity would be prohibited from (1) including
both assets and liabilities in the same hedging relationship and (2)
hedging forecasted interest payments on variable-rate debt instruments
that do not vary with the same index (see Section 2.2.2.2.2). The guidance
on hedging with basis swaps allows an entity to link assets and
liabilities with interest payments that vary on the basis of different
contractually specified interest rates and hedge their interest rate
risk exposures with a single derivative in a single hedging
relationship. It is also extremely unlikely that a basis swap would have
been highly effective at hedging a variable-rate asset or liability for
changes that are attributable to the contractually specified rate in the
asset or liability since the basis swap would not eliminate the
variability.
The guidance in ASC 815-20-25-50 and 25-51 is not meant
to prohibit the use of basis swaps in combination with other derivatives
in a single relationship. For example, if an entity issues debt that is
repriced on the basis of changes in the prime rate, it could enter into
a traditional interest rate swap with a pay-fixed leg and a receive-term
SOFR leg. It could also enter into a prime-to-term SOFR basis swap,
combine that basis swap with the interest rate swap, and hedge the
variability in interest payments that are attributable to changes in the
contractually specified interest rate (prime).
2.4.1.3.4 Net Investment Hedges With Compound Derivatives
ASC 815-20
25-67
Hedging instruments that are eligible for
designation in a net investment hedge include,
among others, both of the following:
- A receive-variable-rate, pay-variable-rate
cross-currency interest rate swap, provided both
of the following conditions are met:
- The interest rates are based on the same currencies contained in the swap.
- Both legs of the swap have the same repricing intervals and dates.
- A receive-fixed-rate, pay-fixed-rate cross-currency interest rate swap. A cross-currency interest rate swap that has two fixed legs is not a compound derivative instrument and, therefore, is not subject to the criteria in (a).
25-68 A
cross-currency interest rate swap that has either
two variable legs or two fixed legs has a fair
value that is primarily driven by changes in
foreign exchange rates rather than changes in
interest rates. Therefore, foreign exchange risk,
rather than interest rate risk, is the dominant
risk exposure in such a swap.
25-68A
Under the guidance in paragraph
815-20-25-71(d)(1), a cross-currency interest rate
swap with one fixed-rate leg and one floating-rate
leg cannot be designated as the hedging instrument
in a net investment hedge.
25-71
Besides those hedging instruments that fail to
meet the specified eligibility criteria, none of
the following shall be designated as a hedging
instrument for the respective hedges: . . .
d. With respect to net investment hedges
only:
1. A compound derivative
instrument that has multiple underlyings — one
based on foreign exchange risk and one or more not
based on foreign exchange (for example, the price
of gold or the price of an S&P 500 contract),
except as indicated in paragraph 815-20-25-67 for
certain cross-currency interest rate swaps
2. A derivative
instrument and a cash instrument in combination as
a single hedging instrument (that is, an entity
shall not consider a separate derivative
instrument and a cash instrument as a single
synthetic instrument for accounting
purposes).
The only risk that can be designated in a hedge of a net investment in
foreign operations is foreign currency risk. Accordingly, the most
plain-vanilla derivative that an entity can use to hedge its foreign
currency risk is a forward contract.
Example 2-18
Kasvot is a Swedish subsidiary of TreyCo. The
functional currency of Kasvot is the Swedish krona
(SEK), and the functional currency of TreyCo is
the USD. TreyCo could enter into a forward
contract to sell SEK and buy USD to hedge its net
investment.
TreyCo could also consider designating a cross-currency interest rate swap as the hedging instrument in its net investment hedge. Even before the issuance of FASB Statement 133, it was
common for entities to also use such swaps to
hedge their foreign currency risk for net
investments in foreign subsidiaries. For example,
assume that TreyCo enters a fixed-for-fixed
cross-currency interest rate swap to hedge its net
investment in Kasvot of SEK 50 million. At the
inception of the hedge, TreyCo pays USD 5.402
million in exchange for SEK 50 million. The
following amounts are returned on the maturity
date of the swap:
Fixed-for-Fixed Cross-Currency Interest Rate
Swap
The fair value of a cross-currency interest rate swap is based on changes
in foreign currency exchange rates, interest rates, and the
cross-currency basis spread. ASC 815-20-25-68 allows either a
fixed-for-fixed or a float-for-float cross-currency interest rate swap
to be the hedging instrument in a net investment hedge because for such
swaps, the changes in foreign currency exchange rates are the primary
sources of the changes in fair value. A float-for-float cross-currency
interest rate swap would look just like the example above, except that
the periodic interest settlements would be based on two variable-rate
legs.
Entities are prohibited from designating a fixed-for-float cross-currency
interest rate swap (i.e., with one fixed interest leg and one variable
interest leg) as the hedging instrument because the impact of interest
rate risk on the swap’s fair value is too pronounced.
In addition, entities are prohibited from designating in a net investment
hedging relationship any compound derivative that incorporates an
underlying other than foreign currency risk. The only compound
derivatives that can be designated in such hedges are the two types of
cross-currency interest rate swaps that are specifically mentioned in
ASC 815-20-25-67.
See Section 5.4 for further
discussion of net investment hedges.
2.4.2 Hedging With a Nonderivative Financial Instrument
Most hedging relationships involve a derivative that hedges a risk exposure; however, ASC 815 does provide guidance on hedging with a nonderivative foreign-currency-denominated financial instrument in certain foreign currency hedges. This guidance resulted from the FASB’s decision that Statement 133 retain the accounting previously provided in FASB Statement 52.
Under ASC 815, unrecognized firm commitments are the only item that may be
hedged with a nonderivative instrument in a foreign currency fair value hedge.
Recognized assets and liabilities (including AFS securities) are precluded from
designation in such hedges by ASC 815-20-25-71(b). ASC 815-20-25-58 states, in
part, that “a nonderivative financial instrument that may give rise to a foreign
currency transaction gain or loss under Topic 830 can be designated as hedging
changes in the fair value of an unrecognized firm commitment, or a specific
portion thereof, attributable to foreign currency exchange rates.”
In a manner similar to the exception for intra-entity
derivatives discussed in Section 2.4.1.3.1, ASC 815-20-25-60 allows an entity to
designate “an intra-entity loan or other payable as the hedging instrument in a
foreign currency fair value hedge of an unrecognized firm commitment” as long as
the counterparty to that loan or payable has entered into a mirrored loan or
payable with an external third party. We believe that although not explicitly
addressed by ASC 815, an entity may also designate intra-entity
foreign-currency-denominated debt as the hedging instrument in a hedge of a net
investment in foreign operations as long as the counterparty to that debt has
entered into a mirrored debt instrument with an external third party.
In addition, ASC 815-20-25-66 states, in part, that “a nonderivative financial
instrument that may give rise to a foreign currency transaction gain or loss
under Subtopic 830-20 can be designated as hedging the foreign currency exposure
of a net investment in a foreign operation provided the conditions in paragraph
815-20-25-30 are met.” However, an entity cannot designate a synthetic
instrument composed of a derivative and a financial instrument as a hedging
instrument in a net investment hedge. For example, an entity whose functional
currency is the USD may not hedge a net investment in a subsidiary whose
functional currency is the EUR with a synthetic EUR-denominated debt instrument
composed of Japanese yen (JPY)-denominated debt and a JPY-EUR cross-currency
interest rate swap. This was addressed by DIG Issue H10 and codified in ASC
815-20-25-71(d)(2).
A nonderivative instrument cannot be designated as the hedging instrument in a
foreign currency cash flow hedge. In addition, hybrid instruments that are
measured at fair value, with changes in fair value recognized in earnings, are
prohibited from designation as the hedging instrument in any hedging
relationship.
See Section
5.2.1.2 for further discussion of a foreign currency fair value
hedge of an unrecognized firm commitment. Also, see Section 5.4 for a discussion of net
investment hedges.