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Fair Value Hedge A fair value hedge is a hedge of the exposure to changes (that are attributable to a particular risk) in the fair value of a recognized asset, liability, or unrecognized firm commitment. Changes in fair value of derivatives that do not meet the criteria of one of these three categories of hedges are included in income. When hedging exposures associated with the price of an asset, liability, or firm commitment, the total gain or loss on the derivative is recorded in earnings. In addition, the underlying exposure due to the risk being hedged must also be marked-to-market to the extent of the change due to the risk being hedged; and these results flow through current income as well. This treatment is called a fair value hedge. Hedgers may elect to hedge all or a specific identified portion of any potential hedged item. Fair value hedge accounting is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying for fair value accounting, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, gains or losses on the derivative will continue to be recorded in earnings, but no further basis adjustments to the original hedged item would be made. Reporting entities have complete discretion to de-designate fair value hedge relationships at will and later re-designate them, assuming all hedge criteria remain. Examples of exposures that qualify for fair value hedge accounting include: At inception, there must be formal documentation (designation) of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge, including identification of the derivative, the related hedged item, the nature of the particular risk being hedged, and how the hedging instrument’s effectiveness will be assessed – including any decision to exclude certain components of a specific derivative’s change in fair value, such as time value, from the assessment of hedge effectiveness. At inception and on an ongoing basis (at least quarterly), the hedge must be expected to be highly effective as a hedge of the identified item. The effectiveness in achieving offsetting changes to the risk being hedged must be assessed consistently with the originally documented risk management strategy A change in the fair value of the hedged item must present an exposure to the earnings of the reporting entity. Fair value hedge accounting is permitted when cross currency interest rate swaps result in the entity being exposed to a variable rate of interest in the functional currency. Generates the risk attributed fair value for the hedged item and hedging derivative. The risk attributed fair value for the hedged item is computed using the benchmark curve, rather than the true mark-to-market curve; therefore, the computed fair value will vary from the true mark-to-market value. For example, in calculating the true mark-to-market value for a treasury bond a treasury curve should be used, whereas in the case of the risk attributed fair value, a model generated BA/swap curve is used. In producing a risk attributed fair value for the hedging instrument, there will be negligible discrepancy between this value and the true mark-to-market value because both computations utilize the BA/swap curve. For each hedging program, there are pairs of positions, namely the hedged items and the hedging derivatives, of which the latter are used to reduce the volatility of the period-over-period fair value (cash flow) changes of the former positions. Assuming a hedge program is effective, the fair value (cash flow) change of the hedged item over a specified period (i.e. a quarter) should be in the same magnitude as the fair value (cash flow) change of the hedging derivative over the same period, but with an opposite sign (due to natural inverse relationship). Fair Value Hedge |