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A reporting entity can hedge a single recognized asset or liability, a firm commitment, or a portion of one of these items, or hedge a forecasted transaction to reduce its exposure to changes in the fair value or cash flows resulting from changes in foreign currency exchange rates.
The item or transaction being hedged must present an earnings exposure and cannot be something that is already measured at fair value through earnings. Eligibility of a hedged item or hedged risk is also dependent on the type of hedge (cash flow, fair value, or net investment), as discussed in DH 8.4, DH 8.5, and DH 8.6, respectively.
The contemporaneous hedge documentation requirements for fair value or cash flow hedges of foreign currency risk are the same as for hedges of other risks. See DH 5.7 for information on hedge documentation.
ASC 815-20-25-30 specifies additional qualifying criteria for foreign currency hedges. The application of ASC 815-20-25-30(a)(2) is illustrated in ASC 815-20-55-130.

ASC 815-20-25-30

Both of the following conditions shall be met for foreign currency cash flow hedges, foreign currency fair value hedges, and hedges of the net investment in a foreign operation:
  1. For consolidated financial statements, either of the following conditions is met:
    1. The operating unit that has the foreign currency exposure is a party to the hedging instrument.
    2. Another member of the consolidated group that has the same functional currency as that operating unit is a party to the hedging instrument and there is no intervening subsidiary with a different functional currency. See guidance beginning in paragraph 815-20-25-52 for conditions under which an intra-entity foreign currency derivative can be the hedging instrument in a cash flow hedge of foreign exchange risk.
  2. The hedged transaction is denominated in a currency other than the hedging unit’s functional currency.
Excerpt from ASC 815-20-55-130
If a dollar (US Dollar) functional, second-tier subsidiary has a euro (EUR) exposure, the US Dollar-functional consolidated parent company could designate its US Dollar-EUR derivative instrument as a hedge of the second-tier subsidiary’s exposure provided that the functional currency of the intervening first-tier subsidiary (that is, the parent of the second-tier subsidiary) is also the US Dollar. In contrast, if the functional currency of the intervening first-tier subsidiary was the Japanese yen (JPY) (thus requiring the financial statements of the second-tier subsidiary to be translated into JPY before the JPY-denominated financial statements of the first-tier subsidiary are translated into US Dollar for consolidation), the consolidated parent company could not designate its US Dollar-EUR derivative as a hedge of the second-tier subsidiary’s exposure.

Under the functional currency concept in ASC 830, each foreign entity (as defined in ASC 830) of a multinational corporation is treated as a separate entity.
The criterion in ASC 815-20-25-30(a) is included so that the hedging model is consistent with the functional currency concept in ASC 830 (i.e., only the entity with the foreign currency risk can be the hedging entity). In addition, when a parent company’s functional currency differs from that of its subsidiary, the parent is not directly exposed to the foreign currency risk in the subsidiary’s foreign currency transactions. Accordingly, a parent company that has a different functional currency may not directly hedge a subsidiary’s foreign currency-denominated assets and liabilities, unrecognized firm commitments, or forecasted transactions.
Sometimes, one operating unit (such as a centralized treasury center) enters into a third-party hedging instrument on behalf of another operating unit within the consolidated entity. When the functional currencies of the units are not the same, ASC 815 requires an intercompany derivative contract to be created to apply hedge accounting. The unit with the foreign currency exposure would then designate the intercompany derivative as a hedge of its foreign currency exposure. See DH 8.8 for information on treasury center hedging.

8.3.1 Assessing the effectiveness of foreign currency hedges

The effectiveness assessment of foreign currency cash flow and fair value hedges is similar to that of all other cash flow and fair value hedges (discussed in DH 9); however, the currency basis spread in cross-currency swaps can be excluded from the effectiveness assessment of a foreign currency hedge. Excluded components

As discussed in DH 9, a reporting entity may elect to exclude certain components of the change in fair value of the hedging instrument from the assessment of hedge effectiveness. The components a reporting entity may choose to exclude are:
  • Time value (or a portion) of options
  • Difference between the spot rate and the forward rate in a forward contract (i.e., forward points in a foreign currency forward contract)
  • Currency basis spreads in cross-currency interest rate swaps
If a reporting entity elects to exclude a component, ASC 815 provides two alternatives for recognition: an amortization approach or a mark-to-market approach.
  • If the amortization approach is elected, the reporting entity should quantify and recognize the initial value attributable to the excluded component. It should be recognized in earnings using a systematic and rational amortization method over the life of the hedging instrument. Any difference between the change in fair value of the hedging instrument attributable to the excluded component and amounts recognized in earnings is recognized in other comprehensive income.
  • If the mark-to-market approach is elected, all changes in fair value attributable to an excluded component are recognized currently in earnings.
The initial value attributable to an excluded component depends on the type of derivative. When the time value of an option contract is the excluded component, the time value generally is the option premium paid (provided the option is at or out of the money at inception). The value attributable to forward points in a forward contract is the undiscounted difference between the market forward rate and the spot rate. The fair values of the excluded components will change over time as markets change but must converge to zero by the maturity of the hedging instrument. Because of that, the FASB permits a systematic and rational amortization method.
Currency basis spreads
Theoretically, the difference between the spot and forward exchange rates for currency forward contracts should be equal to the difference between the risk-free nominal interest rates in each currency. Any differences (other than a minor dealer profit) should be eliminated through arbitrage. However, theory ignores certain market realities, such as transaction and hedging costs, dealer profit, and credit risk, and assumes ready access to funding and liquidity in currency money markets. For these reasons, the difference between the spot and forward exchange rates might not equal the difference in interest rates. The currency basis spread is essentially this excess spread over what is predicted by arbitrage pricing theory.
There are no observable spot-to-forward differences in cross-currency interest rate swaps. Therefore, the ability to specifically consider a currency basis spread as an excluded component and recognize it through an amortization approach is helpful in reducing earnings volatility.
For currency swaps involving the US dollar, the currency basis spread can be thought of as the difference between (1) the direct US dollar interest rate and (2) the synthetic US dollar interest rate earned by swapping a foreign currency investment into a US dollar investment. Theoretically, there should be no difference in the rates earned from this synthetic approach as compared to simply holding US dollars and earning US dollar interest rates. A difference in the actual US dollar yield and the yield earned from this synthetic approach means that a currency basis spread exists.
For example, a European bank can borrow in euro, paying three-month Euribor on the debt, and then execute a swap under which it initially receives US dollars and pays euro for the principal amount. Under the swap, it receives periodic payments of three-month Euribor and pays three-month US dollar LIBOR. At the end of the swap, the bank receives the same amount of euro it paid at the beginning of the swap and pays back the same US dollar principal amount it received at the beginning of the swap.
Typically, the principal exchanged at the beginning and end of the swap is exchanged at the same exchange rate: the spot rate at inception. This allows currency swaps to be quoted to participants as US dollar LIBOR rate versus the Euribor rate plus or minus a spread (e.g., three-month Euribor minus 20). If LIBOR and Euribor were equal, the expected swap spread would be zero, and thus the “minus 20” would represent the currency basis spread. If these base rates are not equal, the rate differential explains some of the swap pricing, but if the rate differential does not account for all of the difference, a currency basis spread is implied.
Thus, Euribor “minus” that is not explained by a difference in rates could occur when US dollar funding has been difficult for European banks to obtain (as has sometimes been the case since the financial crisis), leading them to borrow in euro and swap into US dollar. The European bank would be receiving less than Euribor on the swap contract, but still paying full US dollar LIBOR. Over the term of the swap, this excess currency swap spread effectively represents a cost to the European bank, and can be regarded as an excluded component. Although the whole swap spread has been locked in on the swap contract, the change in fair value of the swap attributable to the currency basis spread will fluctuate as market conditions change, and might be particularly volatile if there is a credit or liquidity scare.

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