The hypothetical derivative method under ASC 815-30-35-25
through ASC 815-30-35-29
may be used to assess effectiveness for a cash flow hedge of any eligible risk (e.g. interest rate, commodity price, or foreign currency). The hypothetical derivative method can be used in the same scenarios as the change-in-variable-cash-flows method plus others. In addition, many systems are able to accommodate the hypothetical derivative method. Consequently, the hypothetical derivative method is more commonly used in practice than the change-in-variable-cash-flows method.
The hypothetical derivative method may be used for a hedging relationship of interest rate risk that does not meet the requirements for use of the shortcut method and that involves (1) a receive-floating, pay-fixed interest rate swap designated as a hedge of the variable interest payments on an existing floating-rate liability, (2) a receive-fixed, pay-floating interest rate swap designated as a hedge of the variable interest receipts on an existing floating-rate asset, or (3) cash flow hedges of the variability of future interest payments on interest bearing assets to be acquired or interest-bearing liabilities to be incurred. The interest rate swap is permitted to have embedded options (caps and floors).
If a reporting entity uses the hypothetical derivative method to assess hedge effectiveness involving an interest rate swap and determines that the terms of the hypothetical derivative exactly match the terms of the actual hedging instrument, ASC 815-20-25-3(b)(2)(iv)(01)(F)
states that it does not need to perform an initial prospective quantitative effectiveness test. Instead, it may qualitatively assume the hedging relationship is perfectly effective. The perfect hypothetical derivative is a derivative that has terms that identically match the critical terms of the hedged item and has a fair value of zero at inception of the hedging relationship. However, if the terms do not exactly match, an initial quantitative assessment is needed to determine if the hedge is highly effective. See DH 9.11
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 hypothetical derivative method if entering into a hedge relationship using a SOFR based asset or liability and a SOFR hedging instrument. Qualifying for the 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 since the terms of the hypothetical derivative may not match the actual derivative exactly.
While the hypothetical derivative method was written in the context of a cash flow hedge of forecasted interest payments with an interest rate swap, it is commonly used as a proxy for the change in the hedged cash flows attributable to the hedged risk when assessing effectiveness of other hedging strategies, such as commodity hedges or certain foreign currency hedging strategies. In these cases, the hedging relationship will not explicitly fall within the guidance that permits an assumption of perfect effectiveness under the hypothetical derivative method (see Figure DH 9-2). However, it is possible that in some cases the actual derivative will exactly match the hypothetical derivative, in which case we believe an initial quantitative assessment is not required, as indicated by ASC 815-20-25-3(b)(2)(iv)(01)(F)
Under the hypothetical derivative method, the assessment of hedge effectiveness is based on a comparison of (1) the change in fair value of the actual swap designated as the hedging instrument and (2) the change in fair value of a hypothetical swap. The hypothetical swap must have a fair value of zero at the inception of the hedging relationship and terms that exactly match the critical terms of the floating-rate asset or liability, including the same:
states that the hypothetical derivative would need to satisfy all of the applicable conditions in ASC 815-20-25-104
and ASC 815-20-25-106
necessary to qualify for use of the shortcut method, as described in DH 9.4
, except the criterion in ASC 815-20-25-104
(e), which requires that the asset or liability not be prepayable. Thus, the hypothetical interest rate swap would be expected to perfectly offset the hedged cash flows.
through ASC 815-20-55-110
provides guidance on how to determine the appropriate hypothetical derivative for variable-rate debt that is prepayable at par at each reset date. The prepayment provisions of a debt instrument should not be considered in determining the appropriate hypothetical derivative as long as (1) the debt is probable of not being prepaid or (2) it is probable that the replacement debt that would be issued has interest payments with the same relevant critical terms as the existing debt. If a reporting entity can not demonstrate that cash flows are probable of occurring, those cash flows would not be eligible to be included in a cash flow hedge.
If the actual derivative and perfectly-effective hypothetical derivative have identical terms, a reporting entity is not required to perform a quantitative assessment of effectiveness. However, if a reporting entity is hedging forecasted transactions (e.g., forecasted interest payments on the forecasted issuance/purchase of debt, or forecasted interest payments on prepayable variable-rate debt [including a future replacement if the original debt is prepaid]), we recommend that the reporting entity specify and document at the inception of the hedging relationship a long-haul approach using the hypothetical derivative method. If done properly, this will help ensure that if the terms of the hedged forecasted transactions differ from the hedging instrument subsequent to hedge inception, the reporting entity will not automatically have to dedesignate the hedging relationship because the terms of the actual and hypothetical derivatives differ.
The determination of the fair value of both the perfect hypothetical swap and the actual swap should use discount rates based on the relevant interest-rate swap curves and consider credit risk.