Search within this section
Select a section below and enter your search term, or to search all click Derivatives and hedging
Favorited Content
9.13 Effects of credit risk on effectiveness and other requirements
Publication date: 31 Mar 2024
us Derivatives & hedging guide
The fair value of a derivative is impacted by credit risk, both of the counterparty and the reporting entity. Given the impact on the assessment of effectiveness, ASC 815-30-35-14 through ASC 815-30-35-18 and ASC 815-20-25-103 and ASC 815-20-25-122 discuss the effects of credit risk (nonperformance risk) on hedge accounting.
9.13.1 Measuring hedged items in a fair value hedge
ASC 820, Fair Value Measurement, applies to assets and liabilities designated as the hedged item in a fair value hedge of the overall change in fair value. We believe the change in fair value of the hedged item in a fair value hedge of the overall change in fair value should be measured at exit value based on the fair value measurement framework that includes the effects of credit risk (nonperformance risk).
The change in fair value of the hedged item attributable to the risk being hedged should be measured over the hedge period and reported as an adjustment of the hedged item’s carrying value. The risk being hedged may be the overall change in fair value or only the change in value attributable to a specific risk. In the latter situation, the change in fair value is based on the hedged risk and not on the asset or liability designated as the hedged item in a fair value hedge. The hedged item may be an item that is reported at fair value with changes in fair value reported in OCI (e.g., an available-for-sale debt security) or it may be reported based on some other measurement basis (e.g., a debt instrument reported at amortized cost). However, it is the change in the fair value of the hedged item due to changes in the hedged risk that is measured.
9.13.2 How nonperformance risk impacts hedge effectiveness
Reporting entities need to consider nonperformance risk for derivatives used as hedging instruments in both fair value and cash flow hedges. Also, nonperformance risk will impact the measurement of the hedged item in a fair value hedge when the hedged risk is the total change in fair value.
Often, a reporting entity will have a master netting agreement in place with a counterparty. Consequently, it needs to (1) allocate the impact of nonperformance risk for the counterparty to the individual derivatives with that counterparty that are used in hedging relationships and (2) use the fair value, inclusive of nonperformance risk, in assessing effectiveness. When there is no master netting agreement, step (1) is not necessary; the calculation of counterparty credit risk is done at the individual instrument level.
The impact of considering nonperformance risk may vary depending on the type of hedge (fair value versus cash flow), the hedged risk (i.e., whether it is a hedge of total changes in fair value for a fair value hedge), and the method used to assess hedge effectiveness.
Different approaches, including qualitative ones, may be acceptable. However, even if a qualitative approach is appropriate for the assessment of effectiveness, reporting entities need to use a quantitative approach to allocating the nonperformance risk to the appropriate income statement line items or to other comprehensive income.
The assessment should take into account the effect on both the derivative’s carrying amount and on hedge effectiveness. For example, if a hedging relationship is near 100% effective before considering the effect of credit risk, it may be easier to demonstrate that any adjustment would not materially affect the financial statements than if a hedge is, say, close to 80% effective before considering the effect of credit risk. In the latter circumstance, even a minor change could result in the hedge not meeting the 80%—125% threshold to qualify for hedge accounting.
9.13.2.1 Fair value hedges
Reporting entities should consider nonperformance risk for derivatives used as hedging instruments in fair value hedges. In the case of a fair value hedge, a change in the creditworthiness of the derivative’s counterparty would have an immediate impact because it would affect the change in the derivative’s fair value, which would immediately affect both:
- The assessment of whether the relationship qualifies for hedge accounting
- The difference between the change in fair value of the hedged item attributable to the hedged risk and the change in fair value of the derivative recognized in earnings under fair value hedge accounting
Nonperformance risk is calculated based on multiple derivatives and collateral when master netting agreements are used. A reporting entity may make a qualitative assessment as to whether nonperformance risk, if allocated, would impact the determination of effectiveness of an individual hedging relationship. If, as a result of the qualitative analysis, the reporting entity concludes that the allocation of nonperformance risk is unlikely to affect its assessment of hedge effectiveness, it would not be required to allocate the impact of nonperformance risk to the individual derivatives for purposes of assessing effectiveness. However, this analysis does not affect the requirement to calculate the risk of nonperformance in the measurement of fair value and record the actual amount in the appropriate income statement line item.
If, on the other hand, the reporting entity concludes through its qualitative analysis that the risk of nonperformance could impact its assessment of hedge effectiveness, the reporting entity should allocate the effect of nonperformance risk to the individual derivative hedging instruments and consider that risk in evaluating hedge effectiveness.
9.13.2.2 Cash flow hedges
For a reporting entity to conclude on an ongoing basis that a cash flow hedge is expected to be highly effective, it cannot ignore whether it will collect the payments it would be owed under the contractual provisions of the derivative instrument. The entity should assess the possibility that the counterparty to the derivative will default by failing to make any contractually-required payments to the entity. In making that assessment, the entity should also consider the effect of any related collateralization or financial guarantees. The entity should be aware of the counterparty’s creditworthiness (and changes in it) in determining the fair value of the derivative. Although a change in the counterparty’s creditworthiness would not necessarily indicate that the counterparty would default on its obligations, such a change would warrant further evaluation.
The effect of counterparty credit risk on cash flow hedging relationships is slightly different than in a fair value hedge. If the likelihood that the counterparty will not default ceases to be probable, a reporting entity would be unable to conclude that the hedging relationship in a cash flow hedge is expected to be highly effective in achieving offsetting cash flows.
We believe a reporting entity may be able to apply a qualitative approach as to whether nonperformance risk, if allocated, would impact the determination of effectiveness in cash flow hedges. In addition, we believe a qualitative approach may be applied when evaluating the impact of nonperformance risk on the assessment of hedge effectiveness for all derivatives, not just those subject to master netting arrangements. However, in the absence of a master netting arrangement, the reporting entity will need to consider the nonperformance risk for each individual derivative position.
If the likelihood that the counterparty will not default is still probable, the impact of credit risk when assessing effectiveness of a cash flow hedge could vary depending on the method applied:
- Change in variable cash flows method: When applying this method, the present value of the cumulative changes in expected future cash flows on both the variable-rate leg of the interest rate swap and the variable-rate asset or liability is calculated using the discount rates applicable to determining the fair value of the interest rate swap (see ASC 815-30-55-92). Credit risk has an impact only when there are other differences between the floating leg of the swap and the variable-rate asset or liability or if default is probable.
- Hypothetical derivative method: The determination of the fair value of both the perfect hypothetical interest rate swap and the actual interest rate swap uses discount rates based on the relevant interest rate swap curves (see ASC 815-30-35-29). Credit risk has an impact only when there are other differences between the actual and hypothetical derivative or if default is probable.
- Change in fair value method: A change in the creditworthiness of the derivative instrument’s counterparty in a cash flow hedge has an immediate impact under this method because credit and nonperformance risk are considered in determining the fair value of the swap in each period.
In summary, under the first two scenarios, hedge effectiveness is generally not significantly impacted by credit risk if it is probable that the counterparties will comply with the contractual provisions of the instrument and there are no other differences present. Credit risk more directly impacts hedge effectiveness under the third method, which is less commonly used in practice.
See FV 8 for a discussion of nonperformance risk.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
Link copied
