DIVERGENT FAS-133 AND IAS-39 INTEREST RATE RISK HEDGE EFFECTIVENESS: PROBLEM AND REMEDIES
Abstract
Generally, it is presumed that an interest rate swap hedge of fixed income assets and liabilities will be 100% effective. Specifically, SFAS-133.68 actualizes this effectiveness through its short-cut method (SCM) interest rate risk hedge specification. We show that this presumption is false. This negative finding leads to a severe IAS-39 implementation problem because IAS-39 explicitly precludes the SCM. Furthermore, this problem has major implications for bank (and insurance) capital requirements. We specify a series of remedies for this problem. We believe that the best remedy falls in the fine print of IAS-39.F.5.5 guidance. In this guidance, a "theoretical swap" hedge effectiveness method, (B), effectively, provides FAS-133 SCM treatment for analogous IAS-39 interest rate risk hedges.
This problem was posed by Pierre Schroeder. I thank him and his Société Générale (SG) DEFI team, as well as Gary Davis, Charles Lee, Patricia Fairfield, Eric Leininger, Rick Lynch, Prem Jain, Rob Royall, Dan Thornton, and Teri Yohn for helpful comments. During the Fall of 2003, a gift from SG provided release time for this work.