Interest rate swap as a hedging instrument
An interest rate swap is usually designated as a hedging instrument in spite of the fact that the fair value of an interest rate swap oscillates between positive and negative fair values. Explain the anomaly.
At the outset, it may seem rather strange that an interest rate swap which has the potential of having a fair value that oscillates between positive and negative values is permitted to be designated as a hedging instrument while a written option which has a negative fair value at all times is prohibited from being designated as a hedging instrument. The reason is that in a written option, the risk exposure is unlimited while the profit potential is pegged at the premium received on such written option. Hence, written option always shows a negative fair value which represents a liability at all times. However, at the time of expiry, if an option expires worthless, then the premium received on such option is treated as income.
An interest rate swap on the other hand is taken to convert a fixed rate instrument into a variable rate instrument or vice versa. At the risk management objective level, the purpose of interest rate swap instrument is achieved by merely converting a variable rate instrument into a fixed rate instrument or vice versa. The risk management objective is drafted so as to achieve the risk management strategy of the enterprise. The specific interest rate swap instrument taken may or may not minimise the risk as a result of which it is likely that the interest rate swap instrument may show a negative fair value at times. However, considering the risk management strategy at the enterprise level, the interest rate swap instrument in fact seeks to achieve the goals of the risk management strategy; hence, the interest rate swap is permitted to be designated as a hedging instrument.