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6.2 Eligibility criteria — hedges of financial assets and liabilities
Publication date: 31 Jul 2022
us Derivatives & hedging guide
ASC 815 prescribes eligibility criteria for all hedges. The following sections address the general criteria applicable to all hedges of financial instruments. DH 6.3.2 through DH 6.3.3.4 and DH 6.4.3 through DH 6.4.3.8 address the requirements specific to cash flow and fair value hedges, respectively. ASC 815-20-25-43(b) details items prohibited from being the hedged item or transaction in either a fair value or cash flow hedge. For eligible items in a net investment hedge, refer to DH 8.
Excerpt from ASC 815-20-25-43
b. With respect to both fair value hedges and cash flow hedges:
1. An investment accounted for by the equity method of accounting in accordance with the requirements of Subtopic 323-10 or in accordance with the requirements of Topic 321
2. A noncontrolling interest in one of more consolidated subsidiaries
3. Transactions with stockholders as stockholders, such as either of the following:
i. Projected purchases of treasury stock
ii. Payments of dividends.
4. Intra-entity transactions (except for foreign-currency-denominated forecasted intra-entity transactions) between entities included in consolidated financial statements
5. The price of stock expected to be issued pursuant to a stock option plan for which recognized compensation expense is not based on changes in stock prices after the date of grant.
6.2.1 Eligibility of the risk to be hedged
The risk associated with the hedged item or transaction must qualify for hedge accounting. The basic risks reporting entities may address when designating hedging transactions are:
- Price risk (the total change in fair value or cash flows)
- Interest rate risk
- Foreign exchange risk
- Credit risk
ASC 815 focuses on these four risks because a change in the price associated with one of those risks will ordinarily have a direct effect on the fair value of an asset or liability in a determinable or predictable manner. The hedged risk must result in exposure to a change in fair values or cash flows that could affect reported earnings, which is a requirement for all hedge accounting relationships.
Figure DH 6-1 illustrates the risks eligible for hedge accounting in a financial instrument.
Figure DH 6-1
Four eligible hedged risks in financial instruments
Four eligible hedged risks in financial instruments
In practice, credit risk has proven to be difficult for reporting entities to designate within an effective hedging relationship. The terms of hedging instruments available in the marketplace generally do not correspond precisely to the default risk of an individual issuer or specific instrument, and the basis difference between the credit risk in the derivative market and the credit spread of the hedged item may create a mismatch between the hedged item and the hedging instrument. For example, a downgrade in the credit rating of an individual security may trigger a payment under a credit derivative but may not offset the expected variability in cash flows of the hedged item to the same degree.
Figure DH 6-2 details different financial instruments and whether they may be hedged for each of the four eligible risks.
Figure DH 6-2
Eligibility of financial instruments as hedged items
Eligibility of financial instruments as hedged items
Eligible hedged risks |
|||||
Instrument type |
Recognition model |
Interest rate |
Foreign exchange |
Credit |
Market price |
Loans |
Held for investment |
Yes |
Yes |
Yes |
Yes |
Held for sale |
Yes |
Yes |
Yes |
Yes |
|
Fair value option
|
No |
No |
No |
No |
|
Debt securities |
Available for sale |
Yes |
Yes |
Yes |
Yes |
Held to maturity |
No |
Yes |
Yes |
No |
|
Trading1 |
No |
No |
No |
No |
|
Equity securities accounted for under ASC 321 |
Fair value through earnings1 |
No |
No |
No |
No |
Measurement alternative |
No |
No |
No |
No |
|
Liabilities and other assets |
Amortized cost |
Yes |
Yes |
Yes |
Yes |
Fair value option1 |
No |
No |
No |
No |
|
6.2.1.1 Component hedging
ASC 815 allows reporting entities to designate as being hedged certain portions, or components, of the total risk within the hedged item. In these situations, when determining how effective a hedging relationship is, a reporting entity may compare the changes in the value (or cash flows) of the derivative to just the changes in the component that it is managing, rather than needing to compare the derivative to the entire risk exposure, thereby achieving an accounting outcome that better reflects the risk management objective of the arrangement. For example, a reporting entity may invest in fixed-rate debt (i.e., it is the lender). As the market interest rate increases, the value of the investment decreases. The value of the investment may also decrease for other reasons (e.g., as the creditworthiness of the issuer declines). Rather than managing the total risk associated with all changes in the value of the debt, including creditworthiness and other factors, the reporting entity may wish to manage just the component of the risk driven by changes in the benchmark interest rate, and may enter into a derivative linked to just that risk.
For variable-rate instruments, the component risk can be the change in cash flows due to the contractually specified interest rate. Rather than managing the total risk associated with all changes in the cash flows on a hedged item, the reporting entity may wish to manage just the component of the risk driven by changes in the contractually specified interest rate, and may enter into a derivative linked to just that risk.
6.2.1.2 Hedging multiple risks
ASC 815 requires each designated risk to be accounted for separately. Reporting entities most commonly hedge multiple risks in financial instruments when they want to mitigate the impact of fluctuations in both foreign exchange rates and interest rates, as discussed in DH 8.2.1.2. ASC 815 permits a reporting entity to simultaneously hedge the fair value and cash flow exposures of a financial instrument. Since ASC 815 requires each designated risk to be accounted for separately, simultaneous hedging of the fair value and cash flow exposures associated with different risks of a financial instrument is not precluded. As originally described in paragraph 423 of FAS 133, Accounting for Derivative Instruments and Hedging Activities, which was codified in ASC 815, in certain circumstances it would be reasonable to hedge an existing asset or liability for a fair value exposure to one risk and a cash flow exposure to another risk. For example, a reporting entity might decide to hedge both the interest rate risk associated with a variable-rate financial asset (i.e., a cash flow hedge) and the credit risk associated with that same asset (i.e., a fair value hedge). However, simultaneous fair value and cash flow hedge accounting is not permitted for simultaneous hedges of the same risk because there is only one earnings exposure. Each risk can be hedged only once.
Once the change in the value of a hedged item that is attributable to a particular risk has been offset by the change in the value of a hedging derivative, another derivative cannot be an effective hedge of the same risk. However, if a reporting entity were to hedge only 75% of a designated risk with one derivative, it could use a second derivative to hedge the remaining 25% of the designated risk.
6.2.2 Eligibility of item or transaction to be hedged
Reporting entities can hedge a single recognized asset or liability (fair value or cash flow hedge), a firm commitment (fair value hedge), or a forecasted transaction (cash flow hedge) or a proportion of any one of these to reduce their exposure to changes in the fair value or cash flows associated with recognized balances and future transactions. Under a portfolio layer method hedge strategy, reporting entities can hedge a closed portfolio of financial assets. Refer to DH 6.5 for further discussion specific to portfolio layer method hedges.
6.2.2.1 Equity investments/noncontrolling interests
ASC 815-20-25-43(b)(1) precludes an investment accounted for under the equity method under ASC 323, Investments—Equity Method and Joint Ventures, or under ASC 321, Investments—Equity Securities, from being a hedged item. The Board explained in the Basis for Conclusions to FAS 133 that hedge accounting for an equity method investment conflicts with the accounting in ASC 323.
Excerpt from FAS 133, Basis for Conclusions, paragraph 455
Under the equity method of accounting, the investor generally records its share of the investee’s earnings or losses from its investment. It does not account for changes in the price of the common stock, which would become part of the basis of an equity method investment under fair value hedge accounting. Changes in the earnings of an equity method investee presumably would affect the fair value of its common stock. Applying fair value hedge accounting to an equity method investment thus could result in some amount of double counting of the investor’s share of the investee’s earnings.
In addition to the conceptual issues, the Board thought it might be difficult to develop a method of implementing hedge accounting for equity method investments and that the results of any method may be difficult for users of financial statements to understand. An exception applies to a net investment hedge of an equity investment in a foreign operation (see DH 8). ASC 815-20-25-43(b)(1) also precludes any investment accounted for under ASC 321 as being a hedged item in a cash flow or fair value hedge.
For reasons similar to those related to equity method investments, ASC 815-20-25-43(b)(2) precludes a noncontrolling interest in a consolidated subsidiary from being a hedged item and ASC 815-20-25-43(c)(5) states that a hedged item in a fair value hedge cannot be a firm commitment to enter into a business combination or to acquire or dispose of a subsidiary, a noncontrolling interest, or an equity method investee.
As an alternative to hedge accounting, ASC 825-10-15-4(a) allows reporting entities to elect the fair value option for eligible financial assets, including equity method investments.
6.2.2.2 Dynamic hedging strategies
The guidance permits use of a dynamic hedging strategy, either (1) increasing or decreasing the quantity of hedging instruments necessary to achieve the hedging objective or (2) changing the percentage of the hedged item that is designated. For example, a reporting entity may hedge the interest rate risk on 80% of a debt issuance and adjust the hedge strategy so that 100% of it is hedged in the following period. However, the reporting entity could never designate more than 100% of the hedged item. The use of dynamic hedging strategies may require dedesignation and redesignation of hedging relationships and may create additional complexities.
6.2.3 Eligibility of instruments used to hedge
6.2.3.1 Using proportions of derivatives
ASC 815 indicates that a reporting entity may designate all or a proportion of a derivative or a group of derivatives as the hedging instrument in one or more hedging relationships. ASC 815-20-25-45 requires that the proportion of the derivative being designated be expressed as a percentage of the entire derivative notional amount over the entire term so that the profile of risk exposures in the hedging portion of the derivative will be the same as that for the entire derivative.
In some instances, that percentage may not be explicitly documented. If (1) the designated proportion of the notional amount and (2) the total notional amount of the derivative hedging instrument are documented in such a way that the percentage can be calculated, then the hedge designation would meet the requirement. We believe that the term “expressed as a percentage” was meant to emphasize that the proportion of the derivative designated as the hedging instrument needs to have the same profile of risk exposures as that of the entire derivative. For example, consider two $1 million interest-bearing assets being hedged with a single derivative that has a $2 million notional amount. Documentation that identifies the first asset designated as being hedged with $1 million of the derivative and the second asset designated as being hedged with $1 million of the derivative would comply with the requirements because there is no uncertainty about what is being hedged (i.e., it is clear what proportion of the $2 million derivative is intended to hedge each asset).
If different portions of the same derivative are in separate hedging relationships, each one would have to be assessed separately to determine whether it meets the requirements for hedge accounting. For example, if a reporting entity has a ten-year interest rate swap with a notional amount of $500 million, it could designate 20% of the swap as a hedge of $100 million ten-year, fixed-rate debt and designate the remaining 80% of the swap as a hedge of another $400 million ten-year, fixed-rate debt, if all of the other qualifying criteria are satisfied. The remaining 80% of the swap is not required to be designated in a hedging relationship, and may be recognized at fair value through earnings as a derivative with no hedge designation.
6.2.3.2 Separating a derivative into components
Separating a derivative into components representing different risks so that a component can be designated as a hedging instrument is not permitted. For example, if a reporting entity were to enter into a cross-currency interest rate derivative (e.g., one party receives a fixed amount of foreign currency and pays a variable amount denominated in US dollars), the entity would not be permitted to separate the interest rate swap component to solely hedge interest rate risk. This would not be a proportion of a total derivative. However, the reporting entity is permitted to designate the cross-currency swap as a fair value hedge of both the interest rate and foreign-currency risk in foreign-currency-denominated debt. See DH 8.
6.2.3.3 Using multiple derivatives as a hedging instrument
Multiple derivatives, whether entered into at the same time or at different times, may be designated as a hedge of the same item. ASC 815-20-25-45 clarifies that two or more derivatives may be viewed in combination and jointly designated as the hedging instrument. For example, a reporting entity can designate two purchased options as a hedge of the same hedged item even if the options are acquired at different times. Multiple derivatives can be used to hedge the same risk or different risks, provided that all of the other hedge criteria are met and there is no duplicate hedging of the same risk.
Question DH 6-1
DH Corp has variable-rate debt that is based on the prime rate and would like to hedge the variability in the interest payments, but it would be more expensive to obtain a prime-rate-to-fixed-rate swap of the appropriate term. Could DH Corp enter into (1) a prime-to-LIBOR (pay-LIBOR, receive-prime) interest rate basis swap and (2) a LIBOR-to-fixed (pay-fixed, receive-LIBOR) interest rate swap and qualify for cash flow hedge accounting?
DH Corp has variable-rate debt that is based on the prime rate and would like to hedge the variability in the interest payments, but it would be more expensive to obtain a prime-rate-to-fixed-rate swap of the appropriate term. Could DH Corp enter into (1) a prime-to-LIBOR (pay-LIBOR, receive-prime) interest rate basis swap and (2) a LIBOR-to-fixed (pay-fixed, receive-LIBOR) interest rate swap and qualify for cash flow hedge accounting?
PwC response
Yes, assuming that DH Corp satisfies all of the hedge criteria. ASC 815-20-25-45 clarifies that two or more derivatives or proportions of derivatives may be viewed in combination and jointly designated as the hedging instrument. Accordingly, the two swaps jointly designated would achieve DH Corp’s objective of hedging the variability of its contractually specified interest payment cash flows on the prime-based debt.
6.2.3.4 Written options as hedging instruments
A written option requires the seller (writer) of the option to fulfill the obligation of the contract should the purchaser (holder) choose to exercise it. In return for providing that option to the holder, the writer receives a premium from the holder. For example, a written call option provides the purchaser of that option the right to call, or buy the commodity, financial or equity instrument at a price during or at a time specified in the contract. The writer would be required to honor that call. As a result, written options provide the writer with the possibility of unlimited loss, but limit any gain to the amount of the premium received. In other words, written options can have the opposite effect of what a hedge is intended to accomplish. Thus, they are generally not permitted to be used as hedging instruments.
However, there are circumstances when a written option may be a more cost-effective strategy for entities than using other instruments—for example, when used to hedge the call option feature in fixed-rate debt rather than issuing fixed-rate debt that is not callable. If a reporting entity wishes to use a written option as a hedging instrument, the instrument must pass the “written option test.” The test includes a requirement to ensure that, when considering the written option in combination with the hedged item, the “upside” potential (for gains or favorable cash flows) is equal to or greater than the “downside” potential (for losses or unfavorable cash flows), as described in ASC 815-20-25-94.
The written option test applies specifically to recognized assets, liabilities, or unrecognized firm commitments. As a result, we do not believe that a written option (or a net written option) can qualify as a hedging instrument in a hedge of a forecasted transaction.
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 combined position’s relative potential for gains and losses is only evaluated at hedge inception. It is based on the effect of a change in price, and the possibility for upside should be as great as the possibility of downside for all possible price changes.
Excluding time value from the written option test
ASC 815-20-25-96 allows a reporting entity to exclude the time value of a written option from the written option test, provided that the entity also specifies that it will base its assessment of effectiveness only on the changes in the option’s intrinsic value.
Covered calls
ASC 815-20-55-45 precludes hedge accounting for “covered call” strategies. In writing a covered call option, a reporting entity provides a counterparty with the option of purchasing an underlying (that the entity owns) at a certain strike price. In some cases, the reporting entity may then purchase an option to buy the same underlying at a higher strike price. A reporting entity may enter into this type of structure to generate proceeds by selling some, but not all, of the upside potential of the securities that it owns. Under such a strategy, the net written option does not qualify for hedge accounting because the potential gain is less than the potential loss.
Combination of options
Hedging strategies can include various combinations of instruments (e.g., forward contracts with written options, swaps with written caps, or combinations of one or more written and purchased options). A derivative that results from combining a written option and a non-option derivative is considered a written option. Reporting entities considering using a combination of instruments that include a written option as a hedging derivative should evaluate whether they have, in effect, a net written option, and therefore, are required to meet and document the results of the written option test.
ASC 815-20-25-89 outlines certain requirements for a combination of options to qualify as a net purchased option or zero-cost collar, in which case the written option test is not required.
For a combination of options in which the strike price and the notional amount in both the written 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 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.
ASC 815-20-25-89 applies only when the strike price and the notional amount in both the written and purchased option components of a combination of options remain constant over the life of the respective components. If either or both the strike price or notional amounts change, the assessment to determine whether the combination of options is a written option is evaluated with respect to each date that either the strike price or the notional amount changes.
If a combination of options fails to meet all of the criteria in ASC 815-20-25-89, it cannot be considered a net purchased option and is subject to the written option test. For example, if a collar includes a written floor based on the three-month Treasury rate and a purchased cap based on three-month LIBOR, the underlyings of the components are not the same, and therefore, the collar would be considered a net written option subject to the written option test.
A combination of options entered into contemporaneously is considered a written option if either at inception or over the life of the options a net premium is received in cash or as a favorable rate or other term. Further, a derivative that results from combining a written option and any other non-option derivative is a written option.
Under certain circumstances, a reporting entity that has combined two options might be able to satisfy the requirement that the hedge provides as much potential for gains as it does for losses. However, the entity would not be permitted to apply hedge accounting to the combined position unless it were to satisfy this requirement for all possible price changes.
Redesignation of a combination of options
When redesignating a hedging relationship involving a zero-cost collar or a combination of options that was considered a net purchased option, a reporting entity needs to re-assess whether the combination of options is a net purchased option or a net written option. The new assessment is based on the current fair values. For example, assume a reporting entity has a collar that at its inception was not considered a net written option and was designated in a hedging relationship. The reporting entity later dedesignates the original hedging relationship and wants to designate the existing collar in a new hedging relationship. In this situation, if the existing collar is deemed a net written option on the date of redesignation, the reporting entity would need to perform the written option test at the inception of the new hedging relationship based on the economics of the collar on that date.
Question DH 6-2
If a noncancellable swap with no embedded options has an initial value of $100,000, would it be considered a written option?
If a noncancellable swap with no embedded options has an initial value of $100,000, would it be considered a written option?
PwC response
No. The $100,000 received at the initiation of the contract is not a premium received for a written option. The swap contract does not contain an option element. Rather, the initial value of $100,000 is an indication that the contract is off-market. The counterparty to the contract is paying for this initial value and expects to be repaid through future periodic settlements.
In essence, the swap contract contains a financing element. If it is more than insignificant, a reporting entity needs to consider ASC 815-10-45-11 through ASC 815-10-45-15. If the $100,000 financing element is significant enough to disqualify the entire swap contract from meeting the definition of a derivative, then the contract should be accounted as a debt host and evaluated for whether it contains an embedded derivative that should be bifurcated (see DH 4 for a discussion of embedded derivatives).
6.2.3.5 Items ineligible as hedging instruments
In addition to the guidance in DH 6.2.3 through DH 6.2.3.4, ASC 815-20-25-71(a)(3) through ASC 815-20-25-71(a)(5) list certain instruments ineligible for designation as the hedging instrument in any hedge.
- A hybrid financial instrument that is measured in its entirety at fair value under the fair value option
- A hybrid financial instrument that would have an embedded derivative separated from it but it cannot be reliably measured
- Any of the individual components of a compound embedded derivative that is separated from the host contract
1 An asset or liability that is measured using the fair value option in ASC 825-10 or ASC 815-15, a debt security that is classified as trading, or an equity security not measured using the measurement alternative in ASC 321-10-35-2 do not qualify as hedged items under ASC 815 since the instrument is remeasured with changes in fair value reported currently in earnings.
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