A company may enter into an interest rate swap as a hedge strategy. The idea is to protect the company's assets in the event of movements in prevailing interest rates that are contrary to the company's current market position. While this is a broad and accepted accounting practice, measuring an interest rate swap's hedge effectiveness can be a complex process.
Hedging is a protective investment strategy. Hedging strategies are designed to help individual investors as well as companies manage their risk. In its simplest form a hedge strategy means purchasing an equal but opposite position in a security. If you own a 100 shares of XYZ stock, you can hedge your position by purchasing a put option for XYZ stock. Theoretically, if the price of XYZ stock declines, the value of your option will increase, effectively offsetting your loss and protecting your assets.
Interest Rate Swaps
An interest rate swap is an investment agreement between two counterparties who agree to swap interest payments on a fixed amount of principal for a fixed period of time. The principal amount does not change hands, only the interest payments. Interest rate swaps are used to convert the basis for interest payments from a fixed rate to a variable rate, or from a variable rate to a fixed rate. Each counterparty enters into an interest rate swap due to a perceived advantage that he may obtain from the swap.
There are a number of accounting methods that may be used to measure hedge effectiveness, but there is no single method that is required by the Financial Accounting Standards Board. You may measure hedge effectiveness using the hedge ratio method, the accidental offsetting method, the qualitative assessment method, regression analysis, the change in variable cash flows method or numerous others.
A plain vanilla interest rate swap typically involves payments from one counterparty that are based on a fixed rate such as the 30-year U.S. Treasury bond yield, and payments from the other counterparty that are based on a variable rate, such as the London Interbank Offer Rate. The appropriate hedge can be determined by determining the frequency of payments and the present value of the payments, which should be equal. Whether or not the hedge is effective can only be determined after the fact, based on whether prevailing interest rates rose or fell beyond prescribed parameters.
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