Negative interest rates and embedded floors

Negative interest rates and embedded floors

In September 2016, we published the article ‘How Negative interest-rates will affect treasury’. We now delve into one of the problems mentioned concerning hedge effectiveness calculations.

The article mentioned the problem of hedge effectiveness calculations when an interest rate floor of zero is included in the loan documentation but excluded in the interest rate swap. We offer a possible solution.

Corporates mainly hedge to mitigate or offset risks that arise from their operational or financing activities. A common example of hedging is to offset the interest rate risk in a floating interest rate loan with an interest rate swap. Occasionally, the loan documentation includes an interest floor of zero, while this floor is not included in the swap. If this is the case, one of two situations can occur:

1. The floating reference rate is positive.
From a cash flow perspective, the swap fully offsets the interest rate risk. The floating rate receivable of the swap offsets the floating rate payment of the loan (visualized below).

positive floating reference

2. The floating reference rate is negative.
From a cash flow perspective the swap does not offset the interest rate risk. The floating rate receivable of the swap reverts to a floating rate payment due to the negative reference rate. The floor, however, puts a lower limit of zero on the floating rate of the loan so there are no receivables from the loan (illustrated below).

negative floating reference

In a negative interest rate environment, a swap does not offset the interest rate risk in a floating rate loan when a floor of zero is included in the loan documentation. In fact, the corporate needs to pay twice: the fixed interest rate on the swap plus the floating reference rate for the loan.

Furthermore, a negative interest rate environment may make the hedge ineffective from a hedge accounting perspective. IAS 39 requires two types of periodical effectiveness tests:

  • A prospective (forward-looking) test to see whether the hedging relationship is expected to be highly effective in future periods.
  • A retrospective (backward-looking) test to assess whether the hedging relationship has actually been highly effective in past periods. This test triggers the journal entries.

If both tests are passed, (a part of) the market value change of the swap can be booked as Other Comprehensive Income (OCI) instead of in P&L, thereby reducing P&L volatility. However, in a negative interest rate environment, the prospective test fails when negative interest rates are expected to persist in the future. The retrospective test fails when past floating rate cash flows of the swap did not sufficiently offset past floating rate cash flows of the loan. If either of these tests fail, the hedge relation needs to be discontinued. Consequently the market value change of the swap (over the last booking period) is booked in P&L and the amount temporarily booked in OCI moves to P&L.

Besides the hedge effectiveness tests mentioned before, IAS 39 also prescribes the accounting treatment of embedded derivatives. A floor of zero in the loan documentation is an embedded derivative. If the floor is ‘in the money’ when the loan was issued, IAS 39 requires the separation of the floor from the loan and accounted for as a standalone derivative.1 A floor of zero is ‘in the money’ when the market rate of interest is below 0% when the loan was issued.

When the floor is separated from the loan, the loan (excluding the floor) can be used in a hedge relation, providing a solution for the abovementioned problems. However, note that nothing changed from a cash flow perspective.

To conclude, there are three different accounting treatments when a corporate enters into a swap to hedge the floating interest rate risk of a loan with an embedded floor:

  1. The floating reference rate is positive. 
    The hedge relation is fully effective and (a part of) changes in the market value of the swap can be booked in OCI.
  2. The floating reference rate is negative and the floor is not accounted for as a standalone derivative.
    In general, the hedge relation needs to be discontinued and changes in the market value of the swap should be booked in P&L.
  3. The floating reference rate is negative and the floor is accounted for as a standalone derivative. 
    The hedge relation consists of the swap and the floating rate loan excluding the floor. This hedge relation is fully effective and (a part of) changes in the market value of the swap can be booked in OCI.

The table below gives an example of the OCI and P&L bookings in each of the different situations.

OCI and P&L bookings
Table 1: An example of the OCI and P&L bookings in each of the three situations.

Note that P&L volatility is inevitable under situation 3, because the floor will be accounted for as a standalone derivative and hence it will be recorded at fair value through P&L.

1 Note that under IFRS 9, replacing IAS 39 from 1 January 2018, an embedded floor cannot be separated from a loan. IAS 39 states that an embedded derivative needs to be separated from the host if ‘the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract’. Furthermore, ‘An embedded floor or cap on the interest rate on a debt contract or insurance contract is closely related to the host contract, provided the cap is at or above the market rate of interest and the floor is at or below the market rate of interest when the contract is issued’.