FAS 138 contains important amendments to FAS 133 specifically in the area of hedging interest rate risk. The key concept created in FAS 138 is the benchmark interest rate.
Benchmark Interest Rate
FAS 133 defined the appropriate hedged risk, in a hedge of interest rate risk, as the market interest rate. The market interest rate was defined as the risk-free rate plus the credit sector spread appropriate for that hedged item at the inception of the hedge. In order to address discrepancies surrounding the understanding of market interest rate risk by market participants, and to ensure that a clear separation of interest rate risk from credit risk occurred, the concept of the benchmark interest rate was established.
In the United States, 2 benchmark interest rates were established:
The risk-free rate on U. S. Treasury securities; and,
Libor-based interest rate swap rates.
By their nature, swap rates contain some degree of a credit risk premium over the risk-free Treasury rates. Despite this, FASB recognized that Libor-based swap rates were not only inherently liquid, stable and a reliable indicator of interest rates, but also that the Libor swap rates were the most commonly used hedging instruments in the U. S. financial markets.
Implications for Shortcut Method
In order to avoid hedge ineffectiveness, which is a requirement for the use of the shortcut method with fair value hedges, the index on the floating leg of the swap hedging the risk must match the designated benchmark interest rate. Similarly, to qualify for the shortcut method on cash flow hedges, not only must the cash flows of the hedged item and the hedging instrument be based upon the same index, but that index must be the designated benchmark interest rate.
Practical Application
To qualify for shortcut accounting, the designated interest rate risk being hedged must be the Libor-based swap rates, and the hedge instrument must be a Libor-indexed interest rate swap. Generally, we recommend that clients avoid the shortcut method.
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Click here to view FAS 138 and the Benchmark Interest Rate as a PDF.