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The shortcut method allows a reporting entity, for certain limited plain-vanilla hedging relationships, to assume that a hedge is perfectly effective without having to perform the quantitative effectiveness assessments otherwise required to apply hedge accounting either at inception or on an ongoing basis. In a fair value hedge, the shortcut method also absolves the entity from having to measure the change in value of the hedged item attributable to the hedged risk. Instead, the entire change in fair value of the derivative is considered a proxy for this amount and is used as the amount of the basis adjustment on the hedged item.
Accordingly, in this situation, a reporting entity’s assessment of hedge effectiveness, as required by ASC 815-20-25-75, would involve documenting only the terms discussed in ASC 815-20-25-102 through ASC 815-20-25-117, as appropriate, for the hedging instrument and the hedged item.
Unlike the other methods described in Figure DH 9-2 that permit an assumption of perfect effectiveness, if the hedging relationship qualifies to use the shortcut method, no periodic evaluation of the critical terms is required over the life of the hedging relationship. However, if the critical terms of the hedging instrument or the hedged item change such that the hedging relationship no longer qualifies for use of the shortcut method, its application would no longer be permitted. See DH 9.4.5 regarding potential application of a quantitative effectiveness assessment method in this case.
Given the potential for recognizing a perfectly effective hedge without performing quantitative assessments of effectiveness, the application of the shortcut method is narrow in scope by design, and the qualification for use of the shortcut method should be assessed with particular rigor. Reporting entities should never analogize to the shortcut method for transactions that do not precisely meet its requirements. Even transactions that are economically perfect hedges may nevertheless fail to meet all of the requirements for use of the shortcut method.

9.4.1 Fundamental considerations

There are three fundamental criteria in ASC 815-20-25-102 to qualify for the shortcut method.
  1. Interest rate risk is the only hedged risk (DH 9.4.1.1)
  2. The hedging instrument is an interest rate swap (DH 9.4.1.2)
  3. The hedged item is a recognized interest-bearing asset or liability (DH 9.4.1.3)
Other criteria in ASC 815-20-25-103 through ASC 815-20-25-117 are addressed in DH 9.4.2 through DH 9.4.4.4.

9.4.1.1 Interest rate risk is the only hedged risk

Interest rate risk (i.e., changes in fair value or cash flows attributable to changes in either the benchmark interest rate or the contractually specified rate) must be the only risk identified as the hedged risk. If the hedging relationship is a hedge of (1) foreign exchange and interest rate risk or (2) credit risk and interest rate risk, use of the shortcut method is not permitted.
For a fair value hedge of a fixed-rate instrument, ASC 815-20-55-71(b) requires that the designated interest rate be a benchmark interest rate, and ASC 815-20-25-105(f) requires that the index on the variable leg of the swap match the benchmark interest rate designated as the risk being hedged. For a cash flow hedge of a variable-rate instrument, ASC 815-20-55-71(bb) requires that the designated interest rate (1) be the contractually specified rate of the variable-rate financial asset or liability and (2) match the interest rate index of the variable leg of the interest rate swap.
Question DH 9-1
Can the shortcut method be applied to a hedge of changes in fair value due to benchmark interest rate risk of an available-for-sale debt security with an interest rate swap?
PwC response
Yes. Assuming that all of the relevant conditions in ASC 815-20-25-104 and ASC 815-20-25-105 are met, a reporting entity may apply the shortcut method to a fair value hedge of an available-for-sale debt security that uses an interest rate swap. This is true even though the actual change in the fair value of an available-for-sale debt security may differ from the gain or loss on the interest rate swap because the change in the fair value of the hedged item may be partly attributable to unhedged risks. For example, an available-for-sale debt security may change in value due to changes in credit risk or foreign-exchange risk, which are not the risks that are being hedged with an interest rate swap.
After applying the shortcut method in a hedge of an available-for-sale debt security, it is necessary to apply the measurement provisions of ASC 320, which require that the available-for-sale debt security be carried at its full fair value. The full fair value of the debt security is then compared to the carrying amount that resulted from applying the shortcut method (i.e., the carrying value of the available-for-sale debt security, as adjusted by the change in the fair value of the interest rate swap), and the difference between the change in the adjusted carrying value and the change in fair value is recorded through OCI. As a result, changes in fair value of the available-for-sale debt security that are attributable to risks other than interest rate risk should remain in AOCI, pursuant to ASC 320.

9.4.1.2 Hedging instrument is an interest rate swap

The shortcut method is available for hedging relationships only when the hedging instrument is an interest rate swap with a variable-rate leg indexed to either:
  • a benchmark interest rate (for a fair value hedge of a fixed rate financial asset or liability), or
  • the contractually specified interest rate that matches the contractually specified rate in a variable rate financial asset or liability (for a cash flow hedge).
In addition, a compound hedging instrument composed of such an interest rate swap and a mirror-image call or put option and/or, in the case of cash flow hedges, a floor or cap on the swap’s variable interest rate that is comparable to the floor or cap on the variable-rate asset or liability, is also permitted in certain circumstances. However, the shortcut method cannot be used when the hedging instrument is a compound hedging instrument composed of an interest rate swap and any mirror-image features other than puts, calls, floors, or caps.
Forwards, futures, other types of swaps, options (including options to enter into a swap), forward starting swaps, and other instruments are not eligible for the shortcut method. For example, a partial-term hedge using a forward starting interest rate swap in which the term is either the middle or latter part of the contractual term of the hedged item is not eligible for the shortcut method. See further discussion on the use of the shortcut method in partial-term hedges in DH 9.4.3.1.

9.4.1.3 Hedging a recognized interest-bearing asset or liability

The shortcut method is available only for fair value or cash flow hedges involving a recognized interest-bearing asset or liability (or portfolio of recognized interest-bearing assets or liabilities). The most common example of a recognized interest-bearing asset or liability is a debt security (i.e., a liability to the issuer and asset to the holder). The shortcut method is not available for forecasted or anticipated debt issuances, or other forecasted transactions, such as forecasted purchases or sales of inventory or commodities because they are not recognized interest-bearing assets or liabilities (and, in some cases, not interest rate hedges).
Trade date/settlement date differences and the shortcut method
Notwithstanding that the shortcut method is applicable only for recognized assets and liabilities, it may still be applied in certain cases when the hedged item may not be considered “recognized,” i.e., when the hedging instrument is entered into on the pricing date (trade date) of the hedged item but the hedged item is not recognized until settlement date. Criteria for meeting the shortcut method requirement that the hedged item is a recognized asset or liability when it is entered into on the trade date but settles on the settlement date are as follows.
  • There must be a firm commitment arising on the trade (pricing) date to purchase or issue an interest-bearing asset or liability between the reporting entity and the underwriter (i.e., the entity is obligated to borrow and the underwriters are obligated to fund the settlement of the borrowing) that contains terms with a fixed element that create a fair value exposure to interest rate risk.
  • The period between the trade date and the settlement date of the debt is within the time generally established by regulations or conventions (i.e., it settles within the customary period for transactions in the marketplace or exchange in which the transaction is being executed - analogous to the “regular way” scope exception in ASC 815-10-15-15, see DH 3.2.3).
  • If this issue is significant to the reporting entity because it frequently enters into fixed-rate debt instruments that are hedged using the shortcut method, appropriate disclosure is made of the policy of applying hedge accounting on the trade date, the accounting rationale, and the length of the market settlement convention.

9.4.2 Detailed shortcut requirements

In addition to the fundamental considerations in DH 9.4.1, all of the required conditions specified in ASC 815-20-25-104 through ASC 815-20-25-106 must be strictly met to qualify for use of the shortcut method.
In general, the terms of the hedged item and hedging instrument must match, including notional amounts, dates, calendar adjustments for business days for payments and fixing the variable rate, interest calculation periods, interest rate fixing and payment conventions (in arrears versus in advance), and day count convention. As it relates to the shortcut method, “match” means “match exactly.” There is no concept of “close enough” when it comes to applying the shortcut method.
In addition, as discussed in ASC 815-20-25-111 and ASC 815-20-25-122, comparable credit risk at inception is not a condition for assuming perfect effectiveness; however, implicit in the criteria for the shortcut method is the requirement that a basis exists for concluding that the hedging relationship is expected to be highly effective in achieving offsetting changes in fair values or cash flows throughout the life of the hedging relationship. Accordingly, reporting entities need to consider the likelihood of their own and the counterparty’s compliance with the contractual terms of the interest rate swap. If the likelihood that the counterparty (or the reporting entity) 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. When using the shortcut method, a reporting entity is required to monitor hedges for adverse developments in credit risk.
SOFR considerations
With the replacement of LIBOR, new reference rates such as the Secured Overnight Financing Rate (SOFR) are used in fixed income instruments and derivative instruments including interest rate swaps. SOFR can be computed in several different ways (in advance, in arrears, compounded, etc.) and, similar to LIBOR, term rates have developed that reference SOFR. Special consideration should be given to applying the shortcut method if entering into a hedge relationship involving a SOFR based asset or liability and/or a SOFR hedging instrument.
Qualifying for the shortcut method for cash flow hedges involving SOFR based instruments may be difficult in practice. We understand that different SOFR products may have varying calculation methodologies including calculation periods, settlement date, and reset periods. These differences in conventions may violate the criteria necessary for applying the shortcut method for cash flow hedges as discussed in this section. Consideration should also be given to the criteria in ASC 815-20-25-104(g)(2) for fair value hedges if the settlement terms on the fixed leg of a SOFR derivative do not match settlement terms of the fixed rate cash instrument being hedged.

9.4.2.1 Notional amount

ASC 815-20-25-104(a) requires that the notional amount of the hedging instrument match the principal of the hedged item. However, the condition in ASC 815-20-25-104(a) need not be applied so literally that only a hedge of the entire debt instrument with a single interest rate swap would qualify. This criterion could be satisfied by:
  • A proportion of an interest-bearing asset or liability in a hedging relationship (in accordance with ASC 815-20-25-105(d) and ASC 815-20-25-106(e))
  • A cash flow hedging relationship consisting of a group of forecasted transactions (interest payments) arising from a group of existing assets or liabilities in which the notional amount of the aggregated group matches the swap notional amount, in accordance with ASC 815-20-25-106(f)(1)

    ASC 815-20-25-106(f) permits the hedged item to be a group of forecasted interest payments on a group of existing interest-bearing assets or liabilities if both (1) the notional amount of the swap matches the notional amount of the aggregated group and (2) the remaining criteria to qualify for the shortcut method with respect to the interest rate swap and the individual transactions in the group are met (e.g., all the reset dates need to be identical to the interest rate swap).
  • A proportion of an interest rate swap (in accordance with ASC 815-20-25-45)

    In designating the hedging relationship, the notional amount derived from the designated proportion of the principal amount of the interest-bearing asset or liability must match the notional amount derived from the designated proportion of the notional amount of the interest rate swap.

    In a fair value hedge, both the designated proportion of the swap and the designated proportion of the principal amount of the hedged item must be considered as a percentage of the total notional or principal amount, respectively, and not as a set dollar amount. For example, an interest rate swap with a notional of $50 million could qualify for the shortcut method as a hedge of 50% of a $100 million debt security.

    However, if no proportion is specified, 100% is assumed.

    Alternatively, two shortcut method hedging relationships could be created if one interest rate swap is used to hedge two items. For example, 40% of an interest rate swap with a notional amount of $50 million could be designated against Loan A with $20 million principal, and 60% of the interest rate swap could be designated against Loan B with $30 million principal. In this instance, two separate hedging relationships must be documented and evaluated under the shortcut method requirements.
Question DH 9-2
DH Corp issued fixed-rate debt with an amortizing notional amount. It executed a swap that has the same critical terms as the debt that pays LIBOR and has the same fixed interest rate and the same payment dates and maturity as the debt. Neither the swap nor the debt is prepayable. The notional amount of the swap exactly matches that of the debt, and the swap and the debt amortize on the exact same dates.

If all other requirements for the shortcut method are met, can DH Corp apply the shortcut method to this hedging relationship?
PwC response
Yes, the shortcut method may be applied when the notional amount of the interest-bearing debt and the interest rate swap changes throughout the life of the hedge, provided that at all times the notional amount of the swap matches the principal amount of the debt (i.e., the swap has a specific amortization schedule that exactly matches that of the hedged debt).
We do not believe that ASC 815-20-25-104(a) requires that the notional amount not change. The requirement is simply that the notional amount of the swap match the principal amount of the debt at all times throughout the term of the hedging relationship.
We believe the amortization of the notional amount is a typical feature in both debt and swap agreements and does not invalidate the assumption of perfect effectiveness required by ASC 815-20-25-104(g) since the swap and the debt have the same notional amount at all times.
Question DH 9-3
May the shortcut method be applied to a hedge of a zero-coupon bond or significantly discounted notes?
PwC response
No. We do not believe that the shortcut method may be used for hedges of zero-coupon bonds or significantly discounted notes when the notional amount of the interest rate swap equals the proceeds received from the issuance of the zero-coupon bonds (or the deep discount notes). This is because the proceeds would be discounted relative to the principal amount. For example, an interest rate swap with a notional amount of $80 million could not be used to match the $80 million proceeds received from the discounted issuance of $100 million principal zero-coupon bonds.
In addition to the notional amount of the fixed leg of the swap not matching the notional amount of the variable leg of the swap throughout the life of the hedging relationship, we believe that a hedge of a zero-coupon financial instrument would not qualify for the shortcut method because the interest rate swap contains a financing element (payments on the fixed leg of the swap are being financed).

9.4.2.2 Portfolio of hedged items

When applying the shortcut method to a portfolio of interest-bearing assets or liabilities:
  • Each asset or liability in the portfolio needs to individually meet the shortcut criteria, as discussed in ASC 815-20-25-116 and ASC 815-20-25-117.
  • The assets or liabilities in the portfolio should all be identical, except for the notional amounts, counterparties, the spread over the contractually specified interest rate for cash flow hedges, and the spread over the benchmark interest rate for fair value hedges of the benchmark rate component of the contractual coupon.
  • The aggregate designated principal amounts of the hedged interest-bearing assets or liabilities must equal the designated notional amount of the swap.

    For example, a loan with a principal amount of $100 million and a loan with a principal amount of $50 million could be included in the portfolio and they could be hedged by an interest rate swap with a notional amount of $150 million.

9.4.2.3 Fair value of zero

Except as provided in ASC 815-20-25-104(b), the fair value of the interest rate swap designated in a hedging relationship under the shortcut method must always be zero at hedge inception.

ASC 815-20-25-104(b)

If the hedging instrument is solely an interest rate swap, the fair value of that interest rate swap at the inception of the hedging relationship must be zero, with one exception. The fair value of the swap may be other than zero at the inception of the hedging relationship only if the swap was entered into at the relationship’s inception, the transaction price of the swap was zero in the entity’s principal market (or most advantageous market), and the difference between transaction price and fair value is attributable solely to differing prices within the bid-ask spread between the entry transaction and a hypothetical exit transaction. The guidance in the preceding sentence is applicable only to transactions considered at market (that is, transaction price is zero exclusive of commissions and other transaction costs, as discussed in 820-10-35-9B). If the hedging instrument is solely an interest rate swap that at the inception of the hedging relationship has a positive or negative fair value, but does not meet the one exception specified in this paragraph, the shortcut method shall not be used even if all other conditions are met.

Because of this requirement, it is highly unlikely that a hedging relationship could qualify for the shortcut method unless the designation is made at the inception (trade) date for the interest rate swap. Any designation after that point, even one day later, would likely result in the swap having a fair value other than zero because of market movements in interest rates and the passage of time.
ASC 820-10-35-9B indicates that an interest rate swap with a non-zero fair value at inception of the hedging relationship may still qualify for the shortcut method if the swap was entered into at the hedge’s inception for a transaction price of zero and the non-zero fair value is due solely to the existence of a bid-ask spread in the reporting entity’s primary market (or most advantageous market, as applicable).
A question arises as to how to apply this requirement when the swap counterparty agrees to pay brokerage or debt issuance costs on behalf of the issuer (or make any up-front payments) and includes such costs as a part of the swap agreement. This results in either (1) the fair value of the contract not being zero or (2) one or both legs of the swap being at a non-market rate. Reporting entities need to consider all such unstated rights and privileges that may have been considered in the pricing of the swap.
Reporting entities should also examine the terms of the individual instruments if they are entered into through a basket transaction. The simultaneous issuance or exchange of instruments when no cash changes hands is not a guarantee that an interest rate swap included in the transaction has a fair value of zero. The swap could be off-market in an equal and opposite amount to another instrument.

9.4.2.4 Consistency in formula for calculating net settlements

ASC 815-20-25-104(d) requires that the terms of the interest rate swap designated in a shortcut hedging relationship have a constant fixed interest rate component and use a consistent floating interest rate index throughout its term.

ASC 815-20-25-104(d)

The formula for computing net settlements under the interest rate swap is the same for each net settlement. That is, both of the following conditions are met:
  1. The fixed rate is the same throughout the term.
  2. The variable rate is based on the same index and includes the same constant adjustment or no adjustment. The existence of a stub period and stub rate is not a violation of the criterion in (d) that would preclude application of the shortcut method if the stub rate is the variable rate that corresponds to the length of the stub period.

There is a view that the words in ASC 815-20-25-104(d) could be interpreted as requiring that both the fixed and variable legs of the swap settle on the same dates. Under this view, any interest rate swap that had its fixed and variable legs settling on different dates, e.g., the floating leg settling quarterly and the fixed leg settling semi-annually, albeit using a constant fixed interest rate and a consistent index, would fail this condition and be ineligible for the shortcut method. We think such an approach is overly rigid. Even though cash settlements on the fixed and variable legs of the interest rate swap may not occur simultaneously, we believe that as long as the formulas for calculating both of the settlements on the fixed and variable legs do not change over the life of the swap, the criterion is met.
Forward starting swaps
A forward-starting swap will not meet the criterion in ASC 815-20-25-104(d) because the formula for computing net settlements during the forward period (when there are no settlements) will differ from the settlements that occur after the effective date of the swap (when settlements occur).
Stub periods
The existence of a shortened or stub period and stub rate (for a partial period) is not a violation of the criterion in ASC 815-20-25-104(d) if the stub rate is the variable rate that corresponds to the length of the stub period.
Coupons and spreads
While the formula for computing net settlements needs to be consistent, the coupon does not have to be identical between the fixed leg of a swap and the fixed-rate hedged item (for a fair value hedge), nor does the spread on the floating leg of the swap need to be the same as the spread on the floating-rate hedged item (for a cash flow hedge).

ASC 815-20-25-109

The fixed interest rate on a hedged item need not exactly match the fixed interest rate on an interest rate swap designated as a fair value hedge. Nor does the variable interest rate on an interest-bearing asset or liability need to be the same as the variable interest rate on an interest rate swap designated as a cash flow hedge. An interest rate swap’s fair value comes from its net settlements. The fixed and variable interest rates on an interest rate swap can be changed without affecting the net settlement if both are changed by the same amount. That is, an interest rate swap with a payment based on LIBOR and a receipt based on a fixed rate of 5 percent has the same net settlements and fair value as an interest rate swap with a payment based on LIBOR plus 1 percent and a receipt based on a fixed rate of 6 percent.

Swap in arrears
ASC 815-20-25-107 permits the shortcut method to be applied to a hedging relationship that involves the use of an interest rate swap in arrears, provided all of the applicable conditions are met.
In a cash flow hedge, a reporting entity would only be able to apply the shortcut method to a swap when the floating leg of the swap is reset in arrears if the interest rate on the hedged item is also calculated in arrears.

9.4.2.5 Hedged item is not prepayable

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:

  1. 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.
Make-whole provisions
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(e).
Prepayment at fair value
ASC 815-20-25-114 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
ASC 815-20-25-6B 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.
Mirror-image options
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 9.4.4.2 related to ASC 815-20-25-106(c)(2).
The terms that must match exactly include:
  • Maturities
  • 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)
ASC 815-20-25-108 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?
PwC response
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).

9.4.2.6 Match in the manner of payment of premium on compound instrument

In most cases when reporting entities issue debt with embedded prepayment options (calls or puts), the premium for the options is paid as an adjustment to the interest rate on the debt. For example, if a reporting entity issues callable debt (e.g., prepayable by the issuer), the interest rate on that debt would be higher than if the reporting entity had issued non-callable debt. This is because the reporting entity purchased a call option from the investor, and is paying the premium for that option as an adjustment to the interest rate over time. In such instances, the hedging instrument in a qualifying shortcut hedging relationship may only be a compound derivative comprised of an interest rate swap and a mirror image put or call that is also paid over time (e.g., zero fair value at inception).

ASC 815-20-25-104(c)

If the hedging instrument is a compound derivative composed of an interest rate swap and mirror-image call or put option as discussed in [ASC 815-20-25-104](e), the premium for the mirror-image call or put option shall be paid or received in the same manner as the premium on the call or put option embedded in the hedged item based on the following:

  1. If the implicit premium for the call or put option embedded in the hedged item is being paid principally over the life of the hedged item (through an adjustment of the interest rate), the fair value of the hedging instrument at the inception of the hedging relationship shall be zero (except as discussed previously in (b) regarding differing prices due to the existence of a bid-ask spread).
  2. If the implicit premium for the call or put option embedded in the hedged item was principally paid at inception-acquisition (through an original issue discount or premium), the fair value of the hedging instrument at the inception of the hedging relationship shall be equal to the fair value of the mirror-image call or put option.

The only explicit exception to the ASC 815-20-25-104(b) requirement for zero fair value at inception is when the hedged interest-bearing asset or liability has an embedded put or call option. In such instances, the hedging instrument in a qualifying shortcut hedging relationship must be a compound derivative composed of an interest rate swap and a mirror-image put or call, and the premium for that option must be paid or received in the same manner as the premium for the call or put option embedded in the hedged item. Therefore, if the prepayable interest-bearing asset or liability in a shortcut method hedge is issued at a premium or discount equal to the fair value of the embedded call or put option, the interest rate swap must be issued at a rate that would result in its having an inception fair value equal to the value of its mirror-image put or call option. Consequently, in these cases, the fair value of the swap, including the mirror-image put or call, will not have a fair value of zero. While this amount may approximate the discount or premium on the hedged item, it would not be expected to be the same because of credit spread differences between the instruments. Because prepayable interest-bearing assets and liabilities are generally issued at or near their par values, the circumstances when the interest rate swap would be allowed to have a fair value other than zero are expected to be rare.
Question DH 9-5
DH Corp issues fixed-rate debt that is callable at par at its option on specified dates.

On the date the debt is issued, DH Corp simultaneously enters into a receive-fixed, pay-variable interest rate swap that can be cancelled on the same dates that the debt is callable, at its discretion.

Can the reporting entity apply the shortcut method in this scenario?
PwC response
No. ASC 815 indicates that the call option included in the interest rate swap is considered a mirror-image of the call option embedded in the hedged item if (1) the terms of the two call options match and (2) the reporting entity is the writer of one call option and the holder (or purchaser) of the other call option. Since DH Corp is the purchaser of both options, the transaction does not qualify for the shortcut method.

9.4.2.7 Terms that do not invalidate perfect effectiveness

The shortcut method criteria include a general requirement that no terms invalidate the assumption of perfect effectiveness.

ASC 815-20-25-104(g)

Any other terms in the interest-bearing financial instruments or interest rate swaps meet both of the following conditions:
  1. The terms are typical of those instruments.
  2. The terms do not invalidate the assumption of perfect effectiveness.

Under ASC 815-20-25-104(g), the only difference explicitly permitted in the shortcut method is a difference in counterparty credit spreads, as discussed in ASC 815-20-25-111. Any other differences in a hedging relationship should serve as an alarm that the application of the shortcut method is likely not appropriate.
The wording about terms “typical of those instruments [interest rate swaps]” suggests that any highly structured interest rate swap would violate this criterion. The challenge with this view is how to determine when a feature is non-standard, given the constant evolution in the marketplace. Such a determination requires judgment.
Trust-preferred securities
Trust-preferred securities often include features that allow the issuers (usually banks) to defer the payment of interest or dividends for one or more payment periods. A hedge of the interest rate risk in a trust-preferred or similar security does not qualify for the shortcut method regardless of whether (1) the swap contains a mirror-image interest or dividend deferral feature and (2) that feature affects one or both legs of the swap.
In executing a hedge, some reporting entities enter into swaps that permit the swap counterparty to defer interest payments on the fixed-rate receive leg of the swap if the issuer exercises its right to defer interest/dividend payments on its trust-preferred securities. In doing this, reporting entities believe that they have exactly matched the terms of the interest rate swap with the terms of the trust-preferred securities. However, most interest deferral features are options that would violate the provision in ASC 815-20-25-104(d) requiring the formula for computing net settlements to be the same each period (i.e., no payments in one period, a large payment the next, and so on).
Alternatively, a reporting entity may also enter into a plain-vanilla swap that does not include the mirror-image interest deferral feature. However, in a hedging relationship of trust-preferred securities with a plain-vanilla swap, the criterion in ASC 815-20-25-104(g), which requires that any other terms in the trust-preferred securities or interest rate swaps are typical of those instruments and do not invalidate the assumption of perfect effectiveness, is not met. If the issuer elects to defer interest, the trust-preferred securities will be valued like a zero-coupon bond, rather than as a current-pay, fixed-rate obligation. As a result, the duration of the bonds will differ from that of the plain-vanilla swap, thus invalidating the assumption of perfect effectiveness.

9.4.2.8 Late-term hedges

Late-term hedging refers to the practice of establishing a hedging relationship after issuance of the hedged item.
When a hedging relationship satisfies all of the shortcut method criteria but the interest rate swap was executed after the acquisition or issuance of the designated recognized asset or liability, the hedging relationship can qualify for use of the shortcut method. To use the shortcut method (or hedge accounting in general) there is no explicit requirement that the swap be executed at the inception or acquisition date of the interest-bearing asset or liability that is being hedged.
Measuring the hedged item using the full contractual coupon cash flows
There is some question about whether a late hedge designated subsequent to issuance of the hedged item contains terms that invalidate the assumption of perfect effectiveness in ASC 815-20-25-104(g). Specifically, the primary concern is when measuring the hedged item using the full contractual coupon cash flows, the duration (interest rate sensitivity) of the hedged item and interest rate swap in a late hedge will differ from the duration of the hedged item and the interest rate swap that would have been executed at issuance of the hedged item. This duration difference could lead to decreased effectiveness in the late hedging relationship in comparison to the hedging relationship that would have qualified for the shortcut method at the issuance date. However, in other cases, a late hedge may not be significantly less effective (and could be more effective) than a hedging relationship that would have qualified for the shortcut method at the issuance date.
Consider, for example, a reporting entity that enters into an interest rate swap and designates it as a fair value hedge of a fixed-rate debt instrument that was issued a number of years ago. When the debt was issued (and the debt coupon was established), benchmark interest rates were 10%. In the current interest rate environment, benchmark rates are 1%. As a result, assuming the swap is transacted such that it has a fair value of zero at inception, the fair value of the swap will be more sensitive to interest rate movements than the debt.
We believe that if a reporting entity is going to utilize the shortcut method, it should ensure, at a minimum, that the hedging relationship is highly effective and would not invalidate the assumption of perfect effectiveness. One way this could be achieved is by performing a prospective effectiveness analysis on both the late hedging relationship and a hypothetical hedging relationship that would have met the requirements for the shortcut method at the issuance date of the instrument (i.e., one that is not a "late" hedge).
In this analysis, the terms of the interest rate swap in the hypothetical "at issuance" hedging relationship would mirror the terms of the interest rate swap executed in the late hedge, except that the coupon on the fixed rate leg of the interest rate swap would be adjusted so that it would have been at market at the issuance date of the instrument. The reporting entity would then compare the effectiveness of the late hedging relationship with the effectiveness of the hypothetical "at issuance" hedging relationship. If the analysis demonstrates that the late hedging relationship is as effective as the hypothetical hedging relationship (or less effective by 0nly a de minimis amount), this would indicate that the late hedge does not invalidate the assumption of perfect effectiveness in ASC 815-20-25-104(g).
Another approach to demonstrating that the late hedge does not invalidate the assumption of perfect effectiveness is by reference to the fair value of the hedged item. If the fair value of the hedged item is at or near par, the entity may be able to conclude that the hedging relationship is as effective as it would have been at the issuance date. The reporting entity should ensure that there is robust contemporaneous documentation that includes how the shortcut criteria were met, including the quantitative evidence of “perfect effectiveness.”
If the reporting entity’s analysis demonstrates that the late hedge invalidates the assumption of perfect effectiveness, it should not use the shortcut method but instead should use the long-haul method.
Measuring the hedged item using the benchmark component of the contractual coupon cash flows
As an alternative to using the full contractual coupon cash flows, a reporting entity may choose to measure the hedged item based on the benchmark rate component of the contractual coupon cash flows, as discussed in DH 6.4.6.2. When hedging the benchmark rate component of the hedged item’s contractual coupon in a late hedge, it will likely be easier for reporting entities to demonstrate that the hedging relationship meets the criterion in ASC 815-20-25-104(g).
Paragraph BC96 in the Basis for Conclusions of ASU 2017-12 states the Board’s view on this.

Excerpt from ASU 2017-12, BC96

Given the ability to achieve perfect offset in a late-term hedge, the Board observes that its decision allows fair value hedging to be applied to late-term hedges under both the long-haul method and the shortcut method without raising a concern in paragraph 815-20-25-104(g)(2)...

9.4.3 Shortcut requirements applicable to fair value hedges only

The following are additional requirements beyond those in DH 9.4.2 for use of the shortcut method applicable to fair value hedges only.

9.4.3.1 Matched maturity dates

The maturity of the hedged item and hedging instrument must match. ASC 815-20-25-105(a) permits application of the shortcut method to partial-term hedges if the maturity of the hedging instrument matches the assumed maturity of the hedged item in a partial-term hedge.

ASC 815-20-25-105(a)

The expiration date of the interest rate swap matches the maturity date of the interest-bearing asset or liability or the assumed maturity date if the hedged item is measured in accordance with paragraph 815-25-35-13B.

In evaluating this criterion, reporting entities should review the impact of weekend and holiday rules on this assessment. Generally, if a maturity/expiration date was scheduled to fall on a Saturday or Sunday, the terms in both instruments should provide for the same-business-day rule, such as on the subsequent business day (often referred to on trade confirmations as the “following” business day convention). Or the terms may provide for a subsequent business day unless that subsequent business day is in the next month, in which case it is the preceding business day (often referred to on the trade confirmations as the “modified following” business day convention).

9.4.3.2 Prohibition of caps and floors on the swap’s floating leg

ASC 815-20-25-105(b) requires that there be no floor or cap on the variable interest rate of the interest rate swap.
As noted in DH 9.4.2.6, ASC 815-20-25-104(c) allows the embedded puts and calls in the hedged interest-bearing asset or liability to be mirrored in the interest rate swap under the shortcut method. However, ASC 815-20-25-105(b) precludes floors, caps, and other embedded features from being included in an interest rate swap in a fair value hedge qualifying for the shortcut method because the introduction of such options would result in not all of the interest rate risk in the fixed-rate hedged item being eliminated through the hedge relationship.

9.4.3.3 Interval of resets of swap’s floating leg

Theoretically, an interest rate swap that resets continuously would be necessary to ensure that its variable leg always reflects a market rate. However, for practical reasons, ASC 815-20-25-105(c) allows the frequency of the reset to extend up to an interval of six months.

ASC 815-20-25-105(c)

The interval between repricings of the variable interest rate in the interest rate swap is frequent enough to justify an assumption that the variable payment or receipt is at a market rate (generally three to six months or less).

9.4.3.4 Swap’s floating leg matches the benchmark interest rate

The swap’s floating leg must be based on a benchmark interest rate. Benchmark interest rates are discussed in DH 6.4.5.1.

9.4.4 Shortcut requirements applicable to cash flow hedges only

Since many variable-rate financial instruments contain prepayment options, we have observed that application of the shortcut method to cash flow hedging relationships is less common than fair value hedges of fixed-rate financial instruments.
The following are additional requirements beyond those in DH 9.4.2 for use of the shortcut method applicable to cash flow hedges only. When the hedged forecasted transaction is a group of individual transactions, the criteria for applying the shortcut method must be met for each individual transaction that makes up the group, in accordance with ASC 815-20-25-106(f)(2).

9.4.4.1 The swap hedges all payments within the hedge term

All interest receipts/payments during the term of the hedging relationship need to be designated as the hedged item, and no cash flows beyond the hedge term may be designated.

ASC 815-20-25-106(a)

All interest receipts or payments on the variable-rate asset or liability during the term of the interest rate swap are designated as hedged.
No interest payments beyond the term of the interest rate swap are designated as hedged.

The inclusion of interest receipts or payments on the variable-rate asset or liability in the hedge designation that are beyond the term of the interest rate swap would result in a portion of the interest rate exposure not being hedged and thus violate the shortcut method’s assumption of perfect effectiveness. An example of a cash flow hedging relationship that would violate this condition is a 24-month floating-rate debt instrument (in which all cash flows are designated as being hedged) that is hedged with a 12-month swap. Because the cash flows in the hedged item that are designated as being hedged extend beyond the cash flows on the interest rate swap, the condition in ASC 815-20-25-106(a) is not met. However, if only the first 12 months of interest payments were designated as being hedged, then the criterion in ASC 815-20-25-106(a) would be met because all interest payments on the hedged item during the term of the swap would be designated as hedged.

9.4.4.2 Comparable floor or cap (or lack thereof)

If the hedged item has a floor or cap, the interest rate swap must have a comparable floor or cap and vice versa.

ASC 815-20-25-106(c)

Either of the following conditions is met:
  1. There is no floor or cap on the variable interest rate of the interest rate swap.
  2. The variable-rate asset or liability has a floor or cap and the interest rate swap has a floor or cap on the variable interest rate that is comparable to the floor or cap on the variable-rate asset or liability. For the purpose of this paragraph, comparable does not necessarily mean equal. For example, if an interest rate swap’s variable rate is based on LIBOR and an asset’s variable rate is LIBOR plus 2 percent, a 10 percent cap on the interest rate swap would be comparable to a 12 percent cap on the asset.

It is important to understand how the interest rate terms are defined in the governing documents for the hedged item and the master agreement for the swap to determine what could happen if the underlying referenced interest rate were to become negative, even if not explicitly stated in term sheets and trade confirmations. If the hedged item or interest rate swap’s terms prevent the rate from become negative, such a feature would be considered a floor.
To satisfy ASC 815-20-25-106(c), the floor or cap in the hedged interest-bearing asset or liability is not required to equal the floor or cap in the hedging instrument; rather, they must be comparable. If a swap’s variable rate is LIBOR and an asset’s variable rate is LIBOR plus 2%, a 10% cap on the swap would not be comparable to a 10% cap on the asset because the entity would be exposed to interest rate variability in the combination of the interest rate swap’s variable-leg payments and the hedge item’s cash flows when interest rates ranged from 10 to 12%. Reporting entities should also ensure that any differences between the floors or caps do not violate the assumption of perfect effectiveness in ASC 815-20-25-104(g).

9.4.4.3 Matched reset and fixing dates and interest calculations

The reset and fixing dates on the hedged item and hedging instrument must match.

ASC 815-20-25-106(d)

The repricing dates of the variable-rate asset or liability and the hedging instrument occur on the same dates and be calculated the same way (that is, both shall be either prospective or retrospective). If the repricing dates of the hedged item occur on the same dates as the repricing dates of the hedging instrument but the repricing calculation for the hedged item is prospective whereas the repricing calculation for hedging instrument is retrospective, those repricing dates do not match.
The remaining criteria for the shortcut method are met with respect to the interest rate swap and the individual transactions that make up the group. For example, the interest rate repricing dates for the variable-rate assets or liabilities whose interest payments are included in the group of forecasted transactions shall match (that is, be exactly the same as) the reset dates for the interest rate swap.

The interest rate and payment conventions (whether in advance or in arrears) for the floating leg of the interest rate swap and the hedged item must be the same. The day count convention, such as actual/360, must also match.
Calendar adjustments for business days for making payments, determining the interest calculation periods, and fixing the variable rate should match. Reporting entities should review the impact of weekend and holiday rules on this assessment. Generally, if a repricing date was scheduled to fall on a Saturday or Sunday, the terms in both instruments should provide for the same-business-day rule, such as on the subsequent business day (known typically as the “following” business day convention). Or the terms may provide for a subsequent business day unless that subsequent business day is in the next month, in which case it is the preceding business day (often referred to on trade confirmations as the “modified following” business day convention).
As noted in DH 9.4.2, this criterion may be difficult to achieve when entering into a hedge relationship using SOFR based derivatives and/or SOFR assets or liabilities.

9.4.4.4 Floating leg of swap equals contractually-specified rate

A hedging relationship involving a financial asset or liability with a floating interest rate is eligible to be hedged with a swap with a variable leg based on the same contractually specified interest rate as the hedged item.

ASC 815-20-25-106(g)

The index on which the variable leg of the interest rate swap is based matches the contractually specified interest rate designated as the interest rate risk being hedged for that hedging relationship.

The contractually specified index must be an interest rate. It would not be appropriate to use an underlying that does not represent an interest rate.

9.4.5 Documenting a quantitative method at inception

ASC 815-20-25-3(b)(2)(iv)(04) states that a reporting entity applying the shortcut method may elect to document at hedge inception a quantitative method to assess hedge effectiveness if the entity later determines that the use of the shortcut method was not or no longer is appropriate.
If a reporting entity documents a quantitative method at inception, it can apply that quantitative method at the time the entity determines that the use of the shortcut method was not or no longer is appropriate to determine (a) whether the hedging relationship was/is highly effective in the periods in which the requirements for the shortcut method were not met, and (b) the basis adjustment to the hedged item in a fair value hedge.
ASC 815-20-25-117A through ASC 815-20-25-117D describe how the quantitative method is to be used. In the period when a reporting entity determines that use of the shortcut method was not or no longer is appropriate, it can use a quantitative method without dedesignating the hedging relationship if it meets two criteria.
  • It must have documented the quantitative method it would use at hedge inception.
  • The hedging relationship must be highly effective under the quantitative method in all periods when the hedge did not qualify for the shortcut method. If the reporting entity is not able to identify when the hedge ceased to qualify for the shortcut method, it should perform the quantitative assessment for every period since initial designation.
In assessing effectiveness, the terms of the hedged item and hedging instrument as of the date the hedge no longer qualified for shortcut should be used. However, if the hypothetical derivative method is used in a cash flow hedge, the fair value of the hypothetical derivative should be set to zero as of the inception of the hedge.
The reporting entity should consider the error correction guidance in ASC 250, Accounting Changes and Error Corrections.
If the hedge would have been highly effective using the quantitative method in the periods in which the shortcut method could not be applied, the amount of the error would be the difference between the amounts recorded using the quantitative assessment and the shortcut method.
If the reporting entity documented the quantitative method, but the hedging relationship was not highly effective using that method, the hedging relationship would be considered invalid in the periods when the effectiveness assessment failed. The error would be the difference between the amount actually recorded and what would have been recorded if hedge accounting had not been applied.

9.4.5.1 Failing to document a quantitative method at inception

If a reporting entity does not document a quantitative method at hedge inception and subsequently realizes that application of the shortcut method was not appropriate, it is prohibited from retroactively identifying a quantitative method of hedge effectiveness assessment at a subsequent date. It must view the past application of hedge accounting as an error. This holds true even if the hedging relationship would have been deemed highly effective under another method of assessing effectiveness and even if it represented a perfect economic hedge. Accordingly, an incorrect application of the shortcut method results in an accounting error that must be evaluated for materiality and potential correction if the reporting entity did not document a quantitative method at inception.

9.4.6 Accounting under the shortcut method

Under the shortcut method, the change in fair value or cash flow of the hedged interest-bearing asset or liability attributable to the hedged risk is assumed to equal the change in fair value of the interest rate swap.
ASC 815-25-55-43 and ASC 815-30-55-25 describe the specific steps that a reporting entity should take in applying the shortcut method for a fair value hedge of a fixed-rate interest-bearing liability and a cash flow hedge of a variable-rate interest-bearing asset. Reporting entities should follow comparable steps for a fair value hedge of a fixed-rate interest-bearing asset and a cash flow hedge of a variable-rate interest-bearing liability.
Fair value hedge of a liability
Cash flow hedge of an asset
a.
Determine the difference between the fixed rate to be received on the interest rate swap and the fixed rate to be paid on the bonds.
Determine the difference between the variable rate to be paid on the interest rate swap and the variable rate to be received on the bonds.
b.
Combine that difference with the variable rate to be paid on the interest rate swap.
Combine that difference with the fixed rate to be received on the interest rate swap.
c.
Compute and recognize interest expense using that combined rate and the fixed-rate liability’s principal amount. (Amortization of any purchase premium or discount on the liability also must be considered.)
Compute and recognize interest income using that combined rate and the variable-rate asset’s principal amount. (Amortization of any purchase premium or discount on the asset must also be considered.)
d.
Determine the fair value of the interest rate swap.
Determine the fair value of the interest rate swap.
e.
Adjust the carrying amount of the interest rate swap to its fair value and adjust the carrying amount of the liability by an offsetting amount.
Adjust the carrying amount of the interest rate swap to its fair value and adjust other comprehensive income by an offsetting amount.

9.4.7 Novations

A reporting entity applying the shortcut method also needs to monitor whether the critical terms of the hedged item or interest rate swap have been amended. Per ASC 815-20-55-56, such a change in the terms of the hedged item or the interest rate swap would require a dedesignation, and thus, loss of the shortcut method.
However, per ASC 815-20-55-56A, a change in the counterparty to a derivative instrument (a novation) would not, in and of itself, be considered a change in a critical term of the hedging relationship that would warrant a dedesignation. Novations are further discussed in DH 10.2.2.2.

9.4.8 Legal nature of collateral

Collateral that is considered a legal settlement of a derivative (i.e., in a settled-to-maturity (STM) contract) would not disqualify a swap from being designated in a shortcut hedging arrangement provided that there are no other criteria for use of the shortcut method that are not met. This is true notwithstanding the fact that there may be additional payments in an STM contract not contemplated in the guidance.
See DH 1.3.2.1 for additional discussion of the legal nature of collateral.
1 This approach is only available for hedging relationships using the shortcut method. It is not available for other methods.
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