The new hedging guidance, including new guidance around hedging the benchmark interest rate component, allows entities to better align their hedge accounting with their risk management activities. Specifically, the new guidance allows companies to elect to include only the benchmark rate component of the contractual coupon cash flows of the hedged item when calculating the change in the hedged item's fair value attributable to changes in the benchmark interest rate. This video covers the concepts of this election and details an illustrative example of the new guidance.
Hi! I'm Alan Lee, a Partner from PwC's Banking and Capital Markets practice. I recently joined our national office to focus on the accounting and reporting of Financial Instruments.
This is the second video in our hedging series to highlight and explain key changes to the hedge accounting guidance as the effective date draws near for public companies. Many companies enter into interest rate swaps to manage the interest rate risk associated with their fixed-rate assets or liabilities. To reflect this risk management activity in their financial statements, they often seek hedge accounting.
In this video, I will discuss important changes made to the hedge accounting guidance relevant to these hedge relationships and highlight through an example how certain sources of ineffectiveness can be eliminated by implementing the new guidance. So to start, let's go through what has changed with the new guidance?
As a reminder, under both previous guidance and the new guidance, companies are allowed to designate the benchmark interest rate as the hedged risk in a fair value hedge of fixed rate assets or liabilities. This enables companies to ignore the impact of changes in credit spreads when discounting the hedged item’s cash flows because these changes are not part of the designated hedge risk.
The focus of our discussion today is on the cash flows to be discounted when measuring the change in value of the hedged item. Under previous guidance, companies were required to include the hedged item's total contractual coupon cash flows when measuring the change in value of the hedged item. In many cases, the coupon on the hedged item was higher than the fixed rate on the hedging instrument. As a result, these coupon differences likely created a source of hedge ineffectiveness under the old standard.
Under the new guidance, companies have the flexibility to include only the benchmark rate component of the contractual coupon cash flows when measuring the change in value of the hedged item. So let's delve into what exactly is the benchmark rate component of the contractual coupon.
In its simplest terms, it's the fixed rate on an at-market interest rate swap on the date of hedge designation. Specifically, the benchmark rate component is the rate on the fixed leg of a swap that has a fair value of zero on the designation date, has a floating leg with no spread and has the same terms, such as notional and maturity, as the hedged item.
So the key point here is that under the new guidance, entities will have the flexibility to use only the benchmark rate component cash flows when measuring the hedged item which should eliminate a key source of hedge ineffectiveness.
Now, let's walk through an example to illustrate some of these points. Let's assume a company issues a 5 year bond that pays a fixed 5% total coupon. 3% of that coupon equates to the benchmark rate component and the other 2% is deemed to be the "credit spread." At the same time, the company enters into an at-market 5 year interest rate swap with a receive fixed rate of 3% and a pay variable rate based on LIBOR with no spread.
The net effect of issuing the bond and entering into the swap is that the company has converted its fixed payment into a floating payment plus a 2% credit spread. Due to the credit spread, the bond will have a higher coupon and therefore a different duration than the swap.
Or, said another way, the bond's price sensitivity to changes in benchmark interest rates will be different than the swap and will likely create a source of hedge ineffectiveness. Under the old guidance, a preparer would have had to consider the full contractual coupon, including the 2% credit spread cash flow, when measuring the benchmark rate value change of the bond.
However, under the new guidance, the company can elect to include only the benchmark rate component of the hedged item's cash flows, or the 3% in our example, when calculating the benchmark rate change, and importantly, the credit spread of 2% can be excluded from the cash flows in the calculation. As a result, the cash flows of both the bond and the swap will be equal and therefore the price sensitivity of the bond and swap due to changes in benchmark interest rates will better align and this source of ineffectiveness should be eliminated.
In summary, the new hedging standard provides flexibility and helpful guidance to improve the accounting effectiveness of fair value hedges of benchmark interest rate risk. As entities prepare for the upcoming effective date, there are many resources available to help. For more information, please refer to the Derivatives and hedge accounting page on CFOdirect.com. Thank you.