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In December 2015, the Federal Reserve raised its benchmark key interest rate by 0. In June 2017, the Federal Reserve raised its benchmark key interest rate by a quarter-point for the third time since its first rate increase in December 2015. Companies routinely utilize interest rate swaps to reduce their exposure to changes in the fair value of assets and liabilities or cash flows due to fluctuations in interest rates. This article provides a background on interest rate swap programs and fair value hedging. It discusses the benefits and limitations of different methods of hedging programs and provides guidance for the use of the shortcut method on perfect fair value hedge contracts. Companies must recognize their derivative instruments at fair value on their balance sheets. If a derivative does not meet the criteria for hedge accounting, any fluctuations in its fair value will be reflected in earnings.

Hedges of net investment in foreign operations, which hedge the translation exposure to changes in foreign exchange rates in other comprehensive income. Fair value and cash flow hedges are the most prominent and complex hedge types. Companies use fair value or cash flow hedge interest rate swap contracts to mitigate risks associated with changes in interest rates. The swap contract converts the fixed-rate payments into floating rates.

In contrast to fair value hedges, cash flow hedges for interest rate swap contracts address risks that arise due to interest rates that are variable, either by contract or because they may be entered into at interest rates that would be in effect at a future date. Cash flow hedges allow companies to manage their risks by locking in or eliminating the variability of the interest rate in their debt, changing variable interest expense into a fixed interest expense. The measurement of hedge effectiveness must be consistent with company’s risk management strategies and the method of assessing hedge effectiveness that company has initially documented. Any ineffectiveness in a fair value hedge program may affect the earnings of the company. The shortcut method simplifies hedge accounting for interest rate swap contracts significantly.

The notional amount of the swap must match the principal amount of the interest-bearing liability being hedged . The formula for computing net settlements under the interest rate swap agreement must be the same for each net settlement . That is, the following two conditions must be met:The fixed rate remains the same throughout the term of the contract. The floating rate is based on the same index and includes the same constant adjustment or no adjustment. The index for the variable leg of the swap must match the benchmark interest rate designated as the interest rate risk being hedged . The expiration date of the swap must match the maturity date of the interest-bearing liability .

There must not be any floor or ceiling on the variable interest rate of the swap . For fair value hedges of a proportion of the principal amount of the interest-bearing liability, the notional amount of the interest rate swap designated as the hedging instrument must match the portion of liability being hedged . Finally, ASC 815-20-25-103 requires companies applying the shortcut method to initially review and document the creditworthiness of their counterparties and only consider the likelihood of the counterparty’s compliance on an ongoing basis subsequent to initiation of the hedge program. Periodic evaluation of hedge effectiveness is not required. Changes in the fair value of hedged items are exactly the same as changes in the fair value of derivatives, and as a result there is no impact on earnings.