The presence of a prepayment option in an interest-bearing asset or liability would typically be expected to violate the assumption of perfect effectiveness necessary for applying the shortcut method unless a mirror-image call or put option is incorporated into the interest rate swap.
Excerpt from ASC 815-20-25-104(e)
The interest-bearing asset or liability is not prepayable, that is, able to be settled by either party before its scheduled maturity or the assumed maturity date if the hedged item is measured in accordance with paragraph 815-25-35-13B, with the following qualifications:
- This criterion does not apply to an interest-bearing asset or liability that is prepayable solely due to an embedded call option (put option) if the hedging instrument is a compound derivative composed of an interest rate swap and a mirror-image call option (put option).
Prepayment options that do not violate the criterion that the asset/liability is not prepayable
Debt instruments may contain terms that permit either the debtor or creditor to cause the prepayment of the debt prior to maturity that would not violate the shortcut criterion that the asset/liability is not prepayable. ASC 815-20-25-113
through ASC 815-20-25-115
and ASC 815-20-55-74
through ASC 815-20-55-78
provide guidance on which provisions are considered prepayable for the purposes of applying the shortcut method. If a prepayment option will at all times be uneconomic for the party with the option to exercise, it is not considered to be prepayable when applying the shortcut method. Therefore, mirror-image prepayment options would not be required to be incorporated in the interest rate swap in this scenario to qualify for the shortcut method.
A typical call option enables the issuer to benefit from the option’s exercise by prepaying debt when a decline in market interest rates causes the fair value of the debt to rise above the option’s settlement price. In contrast, a make-whole provision typically does not yield such a benefit, and, as a result, the hedge would not need a mirror-image prepayment option in the interest rate swap.
The settlement price in a make-whole provision is a variable amount that is generally determined by discounting the debt’s remaining contractual cash flows at the current Treasury rate plus a small spread specified in the agreement. The specified spread is usually significantly lower than the issuer’s credit spread over the Treasury rate, making the settlement amount greater than the debt’s fair value. In this way, the make-whole provision results in a premium settlement amount that penalizes the issuer.
Reporting entities should consider whether the specified spread in the make-whole provision is small enough to constitute a penalty relative to the issuer’s credit spread. The greater the spread added to the discount rate to determine the settlement amount, the less cash will have to be paid, and therefore, the lower the penalty to the issuer. The lower the penalty, the more likely the option is to violate the criterion against the asset/liability being prepayable.
Contingent acceleration clauses
A contingent acceleration clause may permit the lender to accelerate the maturity of an outstanding liability only if a specified event relating to the debtor’s credit risk occurs (e.g., a deterioration of credit or other change such as failure to make a timely payment, meet specific covenant ratios or a restructuring by the debtor). ASC 815-20-55-75
(b) specifically states that a debt instrument that includes a contingent acceleration clause that permits acceleration of the maturity only upon the occurrence of a specified event related to the debtor’s credit deterioration does not result in the debt being considered prepayable under ASC 815-20-25-104
Prepayment at fair value
notes that a provision that allows either counterparty to settle an interest-bearing asset or liability at its fair value would not violate the assumption of perfect effectiveness. Therefore, even if the provisions of ASC 815-20-25-104
(e) were extended to the hedging instrument, a swap prepayable at fair value would not be considered prepayable.
As a result, the existence of a fair value cancellation right in a long-term swap agreement should not, in and of itself, preclude the application of the shortcut method.
Prepayment options in partial-term hedges
When there is a prepayment (e.g., put or call) feature in a financial asset or liability that cannot be exercised until a certain point in the future, a reporting entity may choose to designate only the portion of the term of the financial asset or liability up until that prepayment date as being hedged (a partial-term hedge). In these cases, since the prepayment option only becomes exercisable at or after the end of the designated partial-term period, the reporting entity need not consider the hedged item to be prepayable during the life of the hedge.
Considering only changes in the benchmark interest rate in evaluating a prepayment feature
permits a reporting entity to only consider how changes in the benchmark interest rate affect the decision to settle the hedged item before its scheduled maturity. A reporting entity need not consider other factors (e.g., credit risk) that could affect an obligor’s decision to call a debt instrument when it has the right to do so. However, this guidance does not apply when determining whether a hedged item is considered to be prepayable when applying the shortcut method. Thus, it is possible that certain prepayment features might preclude the application of the shortcut method but not have a significant impact on the assessment of effectiveness under a long-haul method.
For those interest-bearing assets and liabilities that contain an embedded put or call option or cap or floor that must be mirrored in the interest rate swap, all
terms must match exactly, as stated in ASC 815-20-25-104
(e)(2), except as discussed in DH 126.96.36.199
related to ASC 815-20-25-106
The terms that must match exactly include:
- Notification/election dates (the option notification date partially defines the term of the option, which is a key factor in determining its fair value)
- Strike prices (ASC 815-20-55-79 provides guidance on determining whether the strike price of the prepayment feature in the hedged item matches the strike price of the prepayment option in the swap)
- Notional amounts
- Timing and frequency of payments
- Dates on which the instruments may be exercised
- How premiums are paid
- Style of option (e.g., American, Bermudan, or European)
clarifies that the carrying amount of the debt has no direct impact on whether the swap contains a mirror-image option because it is economically unrelated to the amount that would be required to be paid to exercise the embedded option. Per ASC 815-20-25-108
, any discount or premium, including any related deferred issuance costs, is irrelevant in determining whether the criterion in ASC 815-20-25-104
(e) is met. Therefore, a swap is not permitted to contain a termination payment equal to the deferred debt issuance costs that remain unamortized on the date the option is exercised if the shortcut method is to be applied.
Question DH 9-4
DH Corp issues variable-rate debt with an interest rate that resets quarterly based on three-month LIBOR plus a fixed spread. DH Corp can call the instrument at par on the quarterly interest rate reset dates.
If DH Corp hedges its exposure to changes in the benchmark interest rate with an interest rate swap that perfectly matches the debt in terms of notional amount, interest rate index, reset dates, payment dates, etc. and that may be terminated by the counterparty at fair value on the interest rate reset dates, does it qualify for the shortcut method?
No. The debt is considered prepayable under the provisions of ASC 815-20-25-104
(e) because the call provision permits the issuer to cause settlement of the debt at an amount that is potentially below the contract’s fair value. Because the credit spread on the debt is not reset, the interest rate reset provisions on the debt instrument are insufficient to ensure that the par amount would equal the fair value at the call dates.
Although the interest rate swap includes a termination option, this feature is not the mirror image of the debt’s prepayment option as would be necessary to qualify for the shortcut method. Because the debt has an interest rate that resets to the index, plus a fixed spread, DH Corp will likely exercise the prepayment option only if it can refinance the borrowing at a lower credit spread. The termination option in the interest rate swap, however, is at fair value, and therefore, the swap counterparty should be indifferent as to exercising it based on movements in the issuer’s credit spread. Thus, the termination option in the interest rate swap would not necessarily be exercised in a fashion that mirrors the issuer’s exercise of the debt’s prepayment option. Additionally, if it were exercised, DH Corp would incur the loss or receive the benefit associated with the forecasted movement in LIBOR relative to the fixed leg of the swap over its remaining term, because the swap was terminated at its fair value. However, DH Corp would not have any further exposure to interest payments for that period because the debt was extinguished at par.
Since many variable-rate financial instruments contain prepayment options, application of the shortcut method to cash flow hedging relationships is less common than fair value hedges of fixed-rate financial instruments.
While this hedging relationship may not qualify for the shortcut method, it might qualify for hedge accounting using a long-haul method, assuming that the hedged forecasted interest payments are probable of occurring. Because of the presence of the debt prepayment option, DH Corp would have to (1) assert that if it were to prepay the debt, it would immediately replace it with a similar variable-rate debt instrument, and (2) define the hedged item as the forecasted interest payments on its existing variable-rate debt or its subsequent variable-rate refinancing. Alternatively, DH Corp might decide to hedge only those interest payments from the existing debt deemed probable of occurring (i.e. before the ability to exercise the prepayment option begins).