Accounting for Dynamic hedging Strategies – Interest rate risk

    Companies are often looking to structure their hedging transactions in very specific ways to achieve what accounting views as perfectly effective hedges (i.e. shortcut, critical terms matched, terminal value approach for options, etc.). Meeting the requirements for these hedge accounting methods benefited the company in two key ways: (1) allowed for qualitative assessment of the hedge and (2) results in no ineffectiveness in earnings.

    Under new hedge accounting rules in the US (Accounting Standards Update 2017-12), companies have been given some reliefs from the hedge assessment exercise and from accounting for ineffectiveness1. These reliefs provide a path to some very practical risk management solutions that historically were not considered due to potential accounting noise.

    In this two part write up, I want to discuss how the application of these accounting rule changes can simplify the use of derivatives as a risk management tool. In this month’s newsletter we will look at pre-issue hedging of interest rate risk, next newsletter we will look at hedging foreign currency risk with structured products.

    Under old accounting rules, the derivative may be perfectly effective at the 6-month date, but ineffectiveness would have to be recognised in earnings as the potential timing of the bond deal changes.

    Simplified pre-issue hedging (interest rate risk management)

    There are a number of instruments that companies can consider when hedging interest rate risk ahead of issuing debt. For example: treasury locks, forward starting swaps, and swaptions are all examples of instruments that provide protection against interest rate movements on future debt issuances. A key challenge under legacy accounting rules is dealing with uncertainty around the bond deal. While a company may be very confident that they will issue a bond, knowing the exact timing is near impossible. As such companies would have to designate their hedge accounting in a way that contemplates a window of time when the debt could be issued.

    Hedge accounting could be achieved, but, it would not be possible to assert that the hedge is perfectly effective. For example, a company may plan for an issuance in 6 months, but contemplate the timing to be anywhere from in 5 to 7 months. The derivative may be perfectly effective at the 6-month date, but ineffectiveness would have to be recognised in earnings as the potential timing of the bond deal changes. There were also issues with certain instruments; auditors in the US has viewed T-locks and swaptions as containing terms that created the potential for ineffectiveness at the onset, which may have encouraged the use of forward starting swaps (irrespective of what the ideal trade was from an economic perspective). On top of this, the hedge would need to be reassessed quantitatively each financial statement period.

    Hedge accounting changes:

    1. Simplified effectiveness assessments – under new rules ongoing assessments can be done qualitatively
      • Initial assessment of the window done quantitatively (test the performance of the hedge at the beginning of the window, end of the window and the forecasted date)
      • Assuming the issuance occurs as forecasted (within the window), then the hedge can be deemed to continue being highly effective (provide 80-125 per cent offset), thus qualifying for hedge accounting
    2. No separate accounting for ineffectivenessno more need to introduce volatility into earnings because of the forecasted issue date moving (assuming it still falls within the designated window)

    A quick note on swaptions, a key benefit of the new rules is the ability to amortise the swaption time value (instead of marking to market into earnings). Doing this allows hedge effectiveness to be assessed based on the swaption’s intrinsic value over the window the company plans to issue. Time value can be amortised over the expiry period of the swaption. This substantially reduces the potential volatility in earnings, especially when the option expiry period spans multiple reporting dates. Other designation strategies may also be possible where the initial time value of swaptions can be deferred (as always, companies should carefully evaluate these accounting nuances with their internal accountants and external auditors). In addition, if using a no cost swaption collar, there is may be no initial time value and therefore no additional earnings impact. In the past, companies using swaptions often had to accept some earnings volatility.

    The situation we’ve just discussed has hopefully shown how the new accounting rules can work in practice – simplifying the operational burden of applying hedge accounting and resulting in more intuitive financial statement results.

    In next month’s newsletter we will see how these rule changes can benefit hedges of FX risk.

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