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9.7 Change-in-variable-cash-flows method
Publication date: 31 Mar 2024
us Derivatives & hedging guide
The change-in-variable-cash-flows method under ASC 815-30-35-16 through ASC 815-30-35-24 and ASC 815-30-55-91 may be used to assess the effectiveness of a cash flow hedge that does not meet the requirements for use of the shortcut method that involves either (1) a receive-floating, pay-fixed interest rate swap designated as a hedge of the variable interest payments on an existing floating-rate liability or (2) a receive-fixed, pay-floating interest rate swap designated as a hedge of the variable interest receipts on an existing floating-rate asset.
ASC 815-30-35-14 states that the change-in-variable-cash-flows method cannot be used if the swap has a fair value that is not zero (or “somewhat near zero”) at the inception of the hedging relationship, not at the inception of the swap. Thus, if a swap with a fair value of zero at the inception of the swap was designated in a hedging relationship at any point after the inception of the swap, use of the change-in-variable-cash-flows method to that hedging relationship would be precluded because the swap’s fair value would likely have changed enough to no longer be considered somewhat near zero.
As described in ASC 815-30-35-18 through ASC 815-30-35-20, the change-in-variable-cash-flows method is applied by comparing the present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap with the expected future interest cash flows on the variable-rate asset or liability.
The change-in-variable-cash-flows method is consistent with the cash flow hedge objective of effectively offsetting the changes in the hedged cash flows attributable to the hedged risk. The method is based on the premise that only the floating-rate component of the interest rate swap provides the cash flow hedge, and any change in the interest rate swap’s fair value attributable to the fixed-rate leg is not relevant to the variability of the hedged interest payments (receipts) on the floating-rate liability (asset).
An entity shall assess hedge effectiveness under this method by comparing the following amounts:
- The present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap
- The present value of the cumulative change in the expected future interest cash flows on the variable-rate asset or liability.
Because the focus of a cash flow hedge is on whether the hedging relationship achieves offsetting changes in cash flows, if the variability of the hedged cash flows of the variable-rate asset or liability is based solely on changes in a variable-rate index, 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 shall be calculated using the discount rates applicable to determining the fair value of the interest rate swap.
If the four conditions in ASC 815-30-35-22 are met, a reporting entity can qualitatively assess that the hedge results in perfect effectiveness and is therefore not required to quantitatively assess hedge effectiveness.
The change-in-variable-cash-flows method will result in a perfectly effective hedge if all of the following conditions are met:
- The variable-rate leg of the interest rate swap and the hedged variable cash flows of the asset or liability are based on the same interest rate index (for example, three-month London Interbank Offered Rate (LIBOR) swap rate).
- The interest rate reset dates applicable to the variable-rate leg of the interest rate swap and to the hedged variable cash flows of the asset or liability are the same.
- The hedging relationship does not contain any other basis differences (for example, if the variable leg of the interest rate swap contains a cap and the variable-rate asset or liability does not).
- The likelihood of the obligor not defaulting is assessed as being probable.
If any of the four criteria are not met, a quantitative assessment is needed to determine if the hedge is highly effective. See DH 9.11.
An assumption of perfect effectiveness would not be appropriate under the change-in-variable-cash-flows method for hedging relationships involving variable-rate debt and an interest rate swap that meet the four conditions if the interest payment dates on the debt and swap do not match. It would be unlikely that a mismatch of a few days related to the date cash is exchanged could cause a hedging relationship to fail to be highly effective; however, reporting entities should nevertheless acknowledge this difference in their hedge documentation and assess its potential impact on the overall effectiveness of the hedging relationship by applying a long-haul quantitative effectiveness test at inception of the hedging relationship.
As also discussed in DH 9.4.2 in the context of using the shortcut method, special consideration should be given to applying a qualitative assessment under the variable cash flow method when entering into a hedge relationship involving a SOFR based asset or liability and a SOFR hedging instrument. Qualifying for the ability to use a qualitative assessment with SOFR based instruments (without an initial quantitative assessment – see DH 9.12) may be difficult in practice. We understand that different SOFR products may have varying calculation methodologies including calculation periods, settlement dates, and reset periods. These differences in conventions may violate the criteria necessary for applying a qualitative assessment under the variable cash flow method.
Use of the change-in-variable-cash-flows method is limited to certain circumstances, such as when the fair value of the swap is zero (or “somewhat near zero”) at inception of the hedging relationship and only to hedges of interest rate 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.
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