Fair Value Hedges
When hedging exposures associated with the price of an asset, liability, or a firm commitment, the total gain or loss on the derivative is recorded in earnings. In addition, the carrying value of the underlying exposure must be adjusted by an amount attributable to the risk being hedged; and these results flow through current income, as well. This treatment is called a “fair value hedge.” Hedgers may elect to hedge all or a specific identified portion of any potential hedged item.
Fair value hedge accounting is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying for fair value accounting, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, gains or losses of the derivative will continue to be recorded in earnings, but no further basis adjustments to the original hedged item would be made. (815-25-40)
Reporting entities have complete discretion to de-designate fair value hedge relationships at will and later re-designate them, assuming all hedge criteria remain. (815-25-40) As noted earlier, this provision is under consideration and subject to change.
Examples of exposures that qualify for fair value hedge accounting (815-25-40)
- Interest exposures associated with the opportunity cost of fixed rate debt
- Price exposures for fixed rate assets
- Price exposures for firm commitments associated with prospective purchases or sales
- Price exposures associated with the market value of inventory items
- Price exposures on available-for-sale securities
Eligible risks (815-20-25)
- The risk of the change in the overall fair value
- The risk of changes in fair value due to changes in the benchmark interest rates (i.e., the risk-free rate of interest or the rate associated with LIBOR-based swaps), foreign exchange rates, credit worthiness, or the spread over the benchmark interest rate relevant to the hedged item’s credit risk.
- Currency risk associated with (a) an unrecognized firm commitment, (b) a recognized foreign-currency-denominated debt instrument, or (c) an available-for-sale security
Prerequisite requirements to qualify for fair value accounting treatment (815-20-25)
- Hedges must be documented at the inception of the hedge, with the objective and strategy stated, along with an explicit description of the methodology used to assess hedge effectiveness.
- The hedge must be expected to be “highly effective,” both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to those changes in the fair value of the hedged item that are due to the risk being hedged.
- If the hedged item is a portfolio of similar assets or liabilities, each component must share the risk exposure, and each item is expected to respond to the risk factor in comparable proportions.
- Portions of a portfolio may be hedged if they are (a) a percentage of the portfolio; (b) one or more selected cash flows; (c) an embedded option (provided it is not accounted for as a stand-alone option); (d) the residual value in a lessor’s net investment in a direct financing or sale-type lease.
- A change in the fair value of the hedged item must present an exposure to the earnings of the reporting entity.
- Fair value hedge accounting is permitted when cross currency interest rate swaps result in the entity being exposed to a variable rate of interest in the functional currency
Dis-allowed situations (i.e., when fair value accounting may not be applied) (815-20-25)
- In general, written options may not serve as hedging instruments. An exception to this prohibition (i.e., when a written option may qualify for cash flow accounting treatment) is when the hedged item is a long option. Any combinations that include written options and involve the net receipt of premium—either at the inception or over the life of the hedge—are considered to be a written option position.
- Assets or liabilities that are re-measured with changes in value attributable to the hedged risk reported in earnings—e.g., non-financial assets or liabilities that are denominated in a currency other than the functional currency—do not qualify for hedge accounting. The prohibition does not apply to foreign-currency-denominated debt instruments that require re-measurement of the carrying value at spot exchange rates.
- Investments accounted for by the equity method do not qualify for hedge accounting.
- Equity investments in consolidated subsidiaries are not eligible for hedge accounting.
- Firm commitments to enter into business combinations or to acquire or dispose of a subsidiary, a minority interest or an equity method investee are not eligible for hedge accounting.
- A reporting entity’s own equity is not eligible for hedge accounting.
- For held-to-maturity debt securities the risk of a change in fair value due to interest rate changes is not eligible for hedge accounting. Fair value hedge accounting may be applied to a prepayment option that is embedded in a held-to-maturity security, however, if the entire fair value of the option is designated as the exposure.
- Prepayment risk may not be designated as the risk being hedged for a financial asset.
- Except for currency derivatives, derivatives between members of a consolidated group cannot be considered to be hedging instruments in the consolidated statement, unless offsetting contracts have been arranged with unrelated third parties on a one-off basis.