Late Term Hedging of IR Risk Under FAS 133

Given the steepness of the yield curve , many companies are considering (and many banks are pitching) the strategy of swapping existing fixed rate debt into variable so companies can enjoy positive carry-over over the next few resets. While this strategy may make sense for certain companies from an economic perspective, the accounting ramifications under FAS 133 of hedging existing fixed rate debt also needs to be considered.

This strategy poses two primary concerns from an accounting perspective: the first is whether to use short-cut or long-haul methods and the second is what to do with a mark-to-risk to par difference if a company chooses long-haul. Although short-cut is technically allowed in this circumstance (the FASB eliminated from the exposure draft the explicit prohibition of this scenario in the final passage of DIG E23), most of the audit firms are strongly encouraging clients to go long-haul on this strategy. Some of the audit firms have taken a more lenient stance, but one thing is clear in this environment, beware of the short-cut method.

If a company chooses the long-haul method for this particular strategy (probably the smart thing to do considering the direction that’s being given by the Big 4) another problem arises: since the existing fixed rate liability is being hedged post-issuance, its initial mark-to-risk will ostensibly move away from par, thereby creating an additional calculation that will need to be performed. Namely, the difference between the initial mark-to-risk (assuming that the company is hedging the changes in fair value attributable to changes in the benchmark) and par will need to be amortized over the life of the relationship. If companies don’t do this extra calculation, they will end up having to explain maturity gains and losses at the end of the hedging relationship.