FAS 133 and Hedge Documentation

FAS 133 and Hedge Documentation
FAS 133 requires all derivative transactions to be marked-to-market with gains and losses generally flowed through earnings. Hedge accounting treatment may be elected to help match the timing of the income effects of both the underlying hedged item and the hedge. One of the biggest stumbling blocks to qualifying for hedge accounting is FAS 133’s emphasis on documentation.

To qualify for hedge accounting, the hedge relationship must be documented at the inception of the hedge. Documentation must include:

1. Identification of the hedged item;
2. Selection of the type of hedge accounting;
3. Description of the hedging instrument (derivative);
4. Risk management objectives and strategy; and,
5. Explanation of the plan to assess hedge effectiveness and recognize hedge accounting adjustments.

Identification of Hedged Item
The hedged item must be specifically identifiable as a) an entire recognized asset or liability, or an unrecognized firm commitment, b) a portfolio of similar assets or similar liabilities, or c) a specific portion of a recognized asset or liability, unrecognized firm commitment, or a portfolio of similar items. For planning purposes, if you wish to hedge only a few of a group of similar items, a smaller portfolio containing only those items must first be identified. Generally, the description of the hedged item must be sufficiently detailed for a third party to accurately identify it without ambiguity.

Type of Hedge Accounting
Explicit selection of fair value, cash flow, foreign currency exposure or no hedging purpose must be made. Please refer to our overviews of fair value and cash flow hedges for more information. Generally, risk exposures will fall into one of the following categories:

Risk Exposure	Example	Type of Hedge Accounting
Price Risk on Fixed Rate Asset/Liability	Fixed Rate AFS Security	Fair Value
Variable Interest Expense/Income	Prime-based Loan	Cash Flow
Expected Debt Issuance Capture	Current Cost for Future Debt Issue	Cash Flow
Expected Investment	Forward Purchase of Bonds	Cash Flow

As the name implies, hedges in changes of the fair value or price of a specific asset or liability will be fair value hedges, while hedges of expected future cash flows will be cash flow hedges.

Description of Hedge Instrument
Similarly as with the hedged item, the hedging instrument must be described with detailed specificity. For most typical transactions that we are involved with, the critical terms of the hedging instrument so closely match the hedged item that the identification is clear.

Risk Management Objectives and Strategies
Effective senior management and board oversight form the basis of the risk management objectives and strategies documentation. Bank policies and procedures provide a framework within which risk exposures, hedging and transactions should occur. Beyond overall limits and guidelines, specific policies for each type of risk exposure, noted above under “Type of Hedge Accounting”, should exist. These policies should identify hedging goals, approved instruments, approved hedging strategies, and approved methods for assessing hedge effectiveness. The documentation must explicitly state whether the objective of the hedge is to offset changes in the benchmark rate only, or to fully offset the entire interest rate change of the hedged item.

Hedge Effectiveness and Recognition of Accounting Adjustments
Both at inception and on an ongoing basis, the hedging relationship must be expected to be highly effective. A listing of both the methodology and standard for measuring hedge effectiveness, as well as a schedule for when hedge effectiveness testing will be performed, is required. An assessment of hedge effectiveness is required whenever financial statements or earnings are reported, and at least every three months.

Sometimes it will be easy to assess that a hedging relationship qualifies as highly effective. Often, this will be the case when the critical terms of the hedge exactly match those of the underlying hedged item. In this case, perfect effectiveness may be assumed.

More generally, when critical terms do not exactly match, a more explicit documentation of hedge effectiveness expectations and assessment testing will be required. Typically, this will require some statistical testing to demonstrate the expectation of ongoing (prospective) hedge effectiveness as well as a more straightforward process to measure past (retrospective) hedge effectiveness. This documentation must include testing methodology and standards, as well as details needed to allow a third party to replicate the testing protocol.

Click here to view FAS 133 and Hedge Documentation as a PDF.