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.