“Swaptions” (options on fixed/swap rates) are hedging instruments that many of our clients, both in Project Finance and Real Estate, consider to hedge the interest rate risk of the financings of their assets.
As an economic hedging tool, a swaption can be a very efficient instrument for Infrastructure/Renewable Energy investors, as it allows them to forward hedge the market risk (i.e. prior to financial closing, as a “pre-hedging” strategy). A swaption is also a good alternative when a deal contingent hedge is not available, or there is no parent guarantee or collateral for a forward starting swap. For Real Estate investors and Project Finance transactions, a swaption is an optimal hedging solution to protect against higher interest rates in a future fixed, or variable rate, refinancing of an asset, providing certainty to the interest cost of the financing, whilst preserving flexibility and avoiding the difficulties and costs associated with long dated credit lines.
In essence, the borrower/swaption buyer will pay an upfront premium that will protect the entity from a rising fixed swap rate above a certain level (“strike”), at a future date (“expiry”). Depending on the swaption terms, if the swap rate at expiry is above the strike rate (“in the money”), the entity will be able to either cash settle its value or physically enter into a swap at the strike fixed rate, lower than the market one (“off-market”). If the swap rate is lower than the strike, the option expires worthless and the borrower can take advantage of the lower market rates.
We are often asked how to account for the swaption premium and the pay out or the off-market swap that our clients enter into, if the option expires “in the money”. Unfortunately, the accounting under IFRS (and similar fair value accounting standards) for such a relatively simple product is anything but simple.
In our experience with clients we have seen a diversity of accounting treatments for a swaption, arising from different interpretations of whether it’s possible or not to apply hedge accounting to such an instrument. Provided the premium and/or the fair value become material to the financial statements, we have listed key considerations that may guide a swaption buyer when facing the challenge of accounting for the instrument:
- How important (depending on KPIs, covenants) is it to avoid P&L volatility while the swaption is outstanding or is it exercised into the future swap?
- If the option expires “in the money”, would the entity want to reflect the positive pay out of the swaption or the fixed rate of the off-market swap as interest expense of the hedged debt?
If cash flow hedge accounting is necessary to avoid P&L volatility:
- What’s the hedged risk? Is it the variation of the floating rate (i.e. Libor) of a future highly probable variable rate financing? Or the fixed rate of the future swap to be entered into to hedge that future liability?
- How much of the premium paid is “time value” vs “intrinsic value”? Does the entity have access to ongoing valuations of the intrinsic value vs the time value, separately, for accounting purposes?
- Can the time value be deferred into OCI, and if so, when would it be released to the P&L (either during the life of the option, until expiry, or over the lifetime of the cashflows that were being hedged)?
Swaption buyers will do well in discussing the above, both internally with their accounting teams and with their external auditors, prior to entering into a swaption. It is a simple and efficient hedge, but a complex instrument to account for. As pre-hedges, swaptions are often dealt in large notionals and long tenors, which, under volatile market scenarios can produce very large changes in fair value and P&L/balance sheet volatility that need to be well understood and explained to shareholders.