A company enters into a 5-year receive-fixed interest rate swap to hedge a variable-rate loan. The loan is prepaid after 2 years. Under IFRS 9, the swap was designated as a cash flow hedge. What happens to the hedge accounting and the swap?
An advanced Corporate Treasury question — expect it in final rounds and case-heavy interviews (IB, PE, Big-4 Transaction Services).
THE SHORT ANSWER
When the loan is prepaid, the hedged forecast cash flows are no longer expected to occur. The hedge relationship is discontinued prospectively. The cumulative gain or loss in the cash flow hedge reserve (OCI) remains until the forecast cash flows affect profit or loss. Since the loan is prepaid, the cash flows are considered no longer probable, so the amount in OCI is immediately reclassified to profit or loss as a recycling adjustment. The swap continues to exist as a derivative; it can be held to maturity or terminated. If terminated, any settlement gain/loss is recognized immediately in P&L.
WHAT INTERVIEWERS LISTEN FOR
- ✓Hedge discontinuation
- ✓OCI recycling to P&L upon prepayment
- ✓Swap remains as standalone derivative
- ✓No longer probable criterion
- ✓Immediate reclassification of OCI
COMMON MISTAKES
- ✗Saying OCI stays until maturity
- ✗Ignoring recycling trigger
- ✗Thinking swap automatically terminates
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