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9.9 Assessing effectiveness in net investment hedges
Publication date: 31 Jul 2022
us Derivatives & hedging guide
In accordance with ASC 815-35-35-4, a reporting entity must make an election to use either the spot method or the forward method to assess effectiveness for derivatives that are designated as net investment hedges.
- Spot method (applies to forwards, options, cross currency swaps, and foreign-denominated nonderivatives): The change in fair value attributable to changes in the undiscounted spot rate is recorded in CTA. All other changes in fair value are treated as excluded components. See DH 8.3.1.1 for recognition guidance and DH 9.3.3 for additional information on excluded components. The entire spot forward difference must be excluded from the assessment of effectiveness. See ASC 815-35-35-5 through ASC 815-35-35-11.
- Forward/full fair value method (applies to forwards, options, and cross-currency swaps): All changes in fair value of the derivative are recorded in CTA. No components are permitted to be excluded from the assessment of effectiveness. See ASC 815-35-35-17 through ASC 815-35-35-26.
Some reporting entities may wish to use the spot method because they believe it provides a better offset to the foreign currency translation impact in CTA from the hedged net investment (which under ASC 830 is performed using spot FX rates). However, under the spot method, the excluded component will be recognized in earnings over the life of the hedging instrument. Others may choose to use the forward method to avoid recognizing any part of the change in fair value of the derivative through earnings until the hedged net investment is sold or substantially liquidated.
As discussed in DH 9.3.3, DH 9.3.4 and ASC 815-35-35-4, a reporting entity must use the same method for all its net investment hedges in which the hedging instrument is a derivative. Use of the spot method for some derivatives designated as net investment hedges and the forward method for others is not permitted.
As discussed in DH 9.3.5 and ASC 815-35-35-4, a reporting entity that wishes to change from the spot method to the forward method of assessing effectiveness (or vice versa), must apply the same considerations regarding a method change for net investment hedges as for method changes for fair value and cash flow hedges: the new method needs to be an improved method but it need not be considered “preferable” under ASC 250.
For a nonderivative that is designated as the hedging instrument in a net investment hedge, the spot method must be used to assess effectiveness.
9.9.1 Net investment hedge under the spot method
The spot method refers to excluding from the assessment of effectiveness (a) the difference between the spot price and the forward price (sometimes referred to as forward points) from a forward contract (or an eligible cross currency swap), or (b) the time value of an option that is designated as a hedging instrument in a net investment hedge, in accordance with ASC 815-20-25-82.
When the hedging derivative instrument is a cross-currency interest rate swap, it must be eligible for designation in a net investment hedge in accordance with paragraph 815-20-25-67. That is, the cross-currency interest rate swap must either be (1) a fixed-for-fixed cross-currency swap, or (2) a float-for-float cross-currency swap with the interest rates based on the same currencies in the swap and both legs resetting at the same intervals and dates. This would mean that a float-for-float cross-currency swap indexed to SOFR that resets daily and 1-month EURIBOR that resets monthly would not be eligible as a hedging instrument in a net investment hedge.
ASC 815-20-25-3(b)(2)(iv)(01)(G) states that if a reporting entity uses the spot method to assess effectiveness, it does not have to perform an initial quantitative effectiveness assessment if certain criteria are met.
For derivative hedging instruments designated as net investment hedges under the spot method, the hedge will be perfectly effective and no initial quantitative effectiveness assessment is required if the following criteria (from ASC 815-35-35-5 and ASC 815-35-35-9) are met:
- The notional amount of the derivative instrument designated as a hedge of a net investment in a foreign operation equals the portion of the net investment designated as being hedged.
- The derivative instrument’s underlying exchange rate is the exchange rate between the functional currency of the hedged net investment and the investor’s functional currency.
- For a float-for-float cross-currency swap, both legs must be based on comparable interest rate curves (e.g., a swap that pays foreign currency based on three-month LIBOR, and receives functional currency based on three-month commercial paper rates would not be considered perfectly effective).
For nonderivative hedging instruments (e.g., foreign-denominated debt), the net investment hedge will be perfectly effective and no initial quantitative effectiveness assessment is required if the following criteria in ASC 815-35-35-12 are met:
- The notional amount of the nonderivative instrument matches the portion of the net investment designated as being hedged.
- The nonderivative instrument is denominated in the functional currency of the hedged net investment.
For cross-currency swaps, the net gain or loss on the periodic payments are part of the excluded component.
If the reporting entity employs an after-tax hedging methodology, the reporting entity should consider the tax effects in the assessment of effectiveness, as discussed in ASC 815-35-35-26. Hedge effectiveness will need to be reconsidered in after-tax hedging strategies when tax rates change.
If the actual hedging instrument does not meet the criteria for assuming perfect effectiveness, the hedging relationship is required to be assessed using a long-haul method and the hedge item should be modelled with a hypothetical instrument that meets the criteria for the assumption of perfect effectiveness.
9.9.2 Net investment hedge under the forward method
ASC 815-35-35-4 permits reporting entities to assess effectiveness of derivatives designated in a net investment hedge using a method based on changes in forward exchange rates (the entire change in fair value). This applies to forwards, options, and cross-currency swaps. Use of the forward method is not permitted for nonderivative hedging instruments (such as foreign-denominated debt).
When the hedging derivative instrument is a cross-currency interest rate swap, it must be eligible for designation in a net investment hedge in accordance with ASC 815-20-25-67. That is, the cross-currency interest rate swap must either be (1) a fixed-for-fixed cross-currency swap, or (2) a float-for-float cross-currency swap with the interest rates based on the same currencies in the swap and the both legs resetting at the same intervals and dates. This would mean that a float for float cross currency swap indexed to SOFR that resets daily and 1 month EURIBOR that resets monthly would not be eligible to be a hedging instrument in a net investment hedge.
ASC 815-20-25-3(b)(2)(iv)(01)(H) states that that if a reporting entity uses the forward exchange rate method to assess effectiveness, it does not have to perform an initial quantitative effectiveness assessment if certain requirements are met.
For derivative hedging instruments designated as net investment hedges under the forward method, the hedge will be perfectly effective and no initial quantitative effectiveness assessment is required if the following criteria are met:
- The notional amount of the derivative instrument designated as a hedge of a net investment in a foreign operation equals the portion of the net investment designated as being hedged
- The derivative’s underlying relates only to the foreign exchange rate between the functional currency of the hedged net investment and the investor’s functional currency
- For a float-to-float cross currency swap, both legs must be based on comparable interest rate curves (e.g., a swap that pays foreign currency based on the three-month LIBOR, and receives functional currency based on three-month commercial paper rates would not be considered perfectly effective)
For cross currency swaps, the net gain or loss on the periodic payments is also included in CTA.
If the reporting entity employs an after-tax hedging methodology, the reporting entity should appropriately consider the tax affects in the assessment of effectiveness, as discussed in ASC 815-35-35-26. Hedge effectiveness will need to be reconsidered in after tax hedging strategies when tax rates change.
If the actual hedging instrument does not meet the criteria for the assumption of perfect effectiveness, the hedging relationship is required to be assessed using a long-haul method and the hedged item should be modelled with a hypothetical instrument that meets the criteria for perfect effectiveness.
9.9.3 Ongoing assessments for net investment hedges
Reporting entities should monitor their net investment hedging relationships to ensure the hedged net investment balance is greater than the notional of the hedging instruments (adjusted for taxes if hedging after tax), the functional currency of the entity with the hedging instrument and the entity being hedged has not changed (and any intervening subsidiaries as appropriate), and that tax rates have not changed (if hedging after tax).
If an entity documents that the effectiveness of its hedge of the net investment in a foreign operation will be assessed based on the beginning balance of its net investment and the entity’s net investment changes during the year, the entity shall consider the need to redesignate the hedging relationship (to indicate what the hedging instrument is and what numerical portion of the current net investment is the hedged portion) whenever financial statements or earnings are reported, and at least every three months. An entity is not required to redesignate the hedging relationship more frequently even when a significant transaction (for example, a dividend) occurs during the interim period. Example 1 (see paragraph 815-35-55-1) illustrates the application of this guidance.
A reporting entity is not required to dedesignate and redesignate the hedging relationship if (1) the only thing that has changed is the amount of equity in the hedged subsidiary, (2) that amount is still greater than the notional of the hedging instruments (adjusted for taxes if hedging after tax), and (3) the entity has specified this approach in its hedging relationship.
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