The introduction of Eris SOFR Swap futures in 2020 broadened the accessibility and transparency of interest rate swaps by making them available in a listed futures form. The product’s unique construction integrates the economics of a swap with the simplicity and ease of futures, reducing counterparty risk due to the robust margin and clearing processes at CME Group. 

Eris SOFR is unique: Its innovative design involves matching the economic performance and the multi-year life of swaps, making the product well suited for hedge accounting – a distinctive feature among futures contracts.

Eris SOFR Swap futures can be used as hedges in place of interest rate swaps because they possess the same fixed and floating cash flows that drive the economic performance of swaps. In fact, a side-by-side comparison of the net present value and fixed-for-floating cash flows between Eris SOFR and a comparable OTC interest rate swap shows that the economics are nearly identical. Due to these swap-like cash flows, as we demonstrate in the accompanying case studies, using Eris SOFR allows a hedger to track the hedge’s income/expense over time on the income statement as an offset for interest rate risk exposures facing the financial institution. For example, in fair value hedges, Eris SOFR enables users to observe changes in SOFR driving fair value remeasurement, which will counterbalance the change in fair value of an institution’s hedged exposures. Critically, the IM required for an Eris SOFR position is typically 60 – 70% lower than the IM required for a cleared swap as computed by CME CORE margin tool.

As a hedging instrument, Eris SOFR offers multiple advantages over swaps. First, Eris SOFR enables cost-effective, straightforward access to a broad array of participants. Any firm with an account at a CME Group FCM (Futures Commission Merchant) can transact Eris SOFR with any other CME Group participant, which is especially valuable for smaller firms who struggle to gain cost-effective access to OTC swap counterparties.

ISDA Master Agreements (ISDAs) are contractual arrangements between a swap dealer and end user and are needed to trade OTC swaps. ISDAs are complex and can take months to negotiate. For financial institutions with an existing FCM relationship, adding Eris SOFR likely requires no additional legal documents. For those new to hedging with cleared derivatives like futures, setting up a new futures FCM relationship involves signing a clearing agreement. As they are generally standardized, futures clearing agreements may require as little as 1 – 2 weeks to complete. This onboarding process takes less time, and has considerably less cost, than is generally required to trade OTC swaps.

Financial institutions with more than $10 billion in assets are subject to mandatory clearing of interest rate swaps, but frequently find the cost of such clearing arrangements prohibitive. The cost structure FCM’s clearing futures like Eris SOFR, however, is often significantly lower than for swaps, enabling them to pass these savings on to clients. For example, whereas the minimum fees FCM’s charge clients for clearing interest rate swaps can amount to $180,000 or more annually, many FCM’s offer client clearing of Eris SOFR Swap futures with no monthly minimums. 

The second area where Eris SOFR differentiates itself from swaps is transparent, competitive execution. Financial institutions who trade OTC interest rate swaps are limited to the bank counterparties with whom they have ISDA documentation. With limited counterparties, market participants frequently report transacting swaps at price levels one to three basis points (bp) from mid-market, and sometimes considerably more. This spread of 1 – 3 bp from mid-market can contribute substantially to the cost of hedging, adding as much as $135,000 to the cost of a $100 million 5-year swap.

Eris SOFR Swap futures, on the other hand, trade anonymously in an open market on the CME Globex electronic trading platform. Multiple market makers and other counterparties compete on price by posting actionable bids and offers, often resulting in trades at spreads of one-quarter to one-third of a basis point from mid-market. And instead of having counterparty risk with a bank, the trades are backed by a central counterparty, CME Clearing.

Exhibit 1 is a screenshot from the Eris Innovations homepage showing the best bid and ask prices for the front-month Eris SOFR contracts as of February 2024. Note the tenors of 1 – 10 years, the bid and ask futures prices, and the quantity of contracts (BidQty and AskQty, each contract is $100,000 notional) available at the best bid and ask.

The third area where Eris SOFR differentiates itself from swaps is in the significant reduction of initial margin (IM). Like all futures and centrally cleared swaps, holding Eris SOFR positions requires market participants to post IM as performance bond at trade inception, in the form of cash, U.S. Treasuries or other eligible securities. Participants receive back their IM in full after they exit the position or hold it to maturity, but the cost of tying up this capital can reflect a sizeable portion of hedging cost. Critically, the IM required for an Eris SOFR position is typically 60 – 70% lower than the IM required for a cleared swap.

For financial institutions using Eris SOFR instead of cleared swaps, these savings can be substantial. For example, a bank with a $100 million 5-year pay fixed swap will be required to post at least $3.63 million in IM, noting that CME Clearing margin requirements are subject to change and FCM’s may require additional margin. For an equivalent position in Eris SOFR, CME Clearing requires only $1.13 million, allowing the bank in this example to set aside $2.5 million, or 69% less capital, to secure the same risk exposure. 

An often-overlooked advantage of moving from U.S. dollar LIBOR to SOFR as the benchmark U.S. interest rate is the reduction in risk and complexity from standardizing on a single forward curve. This simplification enables a broad array of assets and liabilities to be hedged with standardized SOFR swaps and Eris SOFR Swap futures without introducing significant basis risk. SOFR users don’t have to make the same tradeoffs between hedge customization and efficient cost that LIBOR required.

USD LIBOR-based commercial agreements and derivatives referenced a much wider scope of indices (e.g., 1-month, 3-month, 6-month) and typically referenced individual dates of LIBOR fixings to derive obligation amounts. SOFR agreements and derivatives, on the other hand, almost all reference overnight SOFR (directly or indirectly) averaged across many days. Even CME Term SOFR, which drives interest in most commercial loans, is based on overnight SOFR.

The implications of this change for hedgers are dramatic: Hedgers no longer need to match precise LIBOR reset dates or use less-liquid index variations. Rather than requiring highly customized (and expensive) swaps to achieve “sleep-at-night” hedge effectiveness, SOFR users can employ standardized instruments like Eris SOFR Swap futures that require less margin and trade transparently in competitive marketplaces. 

Fueled by the LIBOR-to-SOFR migration and the introduction of new IM efficiencies, Eris SOFR use expanded significantly in 2023, adding dozens of participants and seeing record trading activity and open interest, shown in Exhibit 2. An expanding roster of swap dealers, proprietary trading firms, regional banks, asset managers and non-bank financials managing interest rate risk using Eris SOFR creates even deeper liquidity accessible to new participants. 

In parallel to Eris SOFR emerging as a simple, cost-effective alternative to using interest rate swaps for hedging, recently updated guidance from FASB has simplified the burden of hedge accounting. Among other enhancements, FASB has dramatically reduced the analysis and documentation required to designate derivatives like Eris SOFR for hedge accounting. These enhancements make it easier for financial institutions to reduce the earnings volatility that would otherwise beset end users of derivatives.

Regulated financial institutions often face pressure internally from investors and externally from regulators to evaluate the effect of stressed market scenarios on their operating activity and capital. With recent rate moves causing increased scrutiny, many financial institutions are ramping up hedging activity to mitigate potentially existential impacts to their profitability or capital structure.

Without applying the appropriate hedge accounting treatment, hedging this interest rate risk with derivatives usually introduces unwelcome earnings fluctuation. The default accounting treatment for derivatives is “mark-to-market,” creating gains or losses that must be recorded immediately in earnings (typically in a non-operating income or expense line item such as Other Gains/Losses or Other Income/Expense). On the other hand, the item being hedged is often not treated as mark-to-market.

As interest rates change over time, causing the mark-to-market value of the derivative to fluctuate (sometimes violently), this mismatch in accounting treatment will drop straight to the bottom line. Thus, the fundamental purpose of hedging – reducing exposure to interest rate volatility – is undermined by the baseline accounting impact. In a sense, absent hedge accounting, entities hedging with derivatives are exchanging one source of volatility for another.

Exhibit 3 demonstrates this concept: While the “risk” and the “hedge” ultimately offset in the end, the large swings in hedge value along the way fail to align with the reported changes in value of the risk hedged. This mismatch causes swings in earnings.

For decades, designating derivatives for “hedge accounting” has been available for firms to mitigate the earnings volatility introduced by derivative hedges. Originally codified in FAS 133, and now in FASB Accounting Standards Codification topic 815 (ASC 815), hedge accounting enables financial institutions to forgo mark-to-market treatment and choose from different methods for aligning more closely the accounting of hedges with the hedged asset(s) or liability(ies): Cash Flow treatment and Fair Value treatment.

Exhibit 4 illustrates the base case for financial statement impact of hedging without hedge accounting, where the potentially large swings in projected future cash flows of the derivative flow into the Non-Interest Income account (for gains) or Non-Interest Expense account (for losses) on the income statement. 

Cash Flow hedge accounting modifies treatment solely of the derivative, allowing financial institutions to accumulate and defer derivative gains/losses on the balance sheet, instead of having them flow immediately to earnings. Financial institutions can then release deferred gains/losses into earnings over time as an offset to the earnings impact from item(s) being hedged. Exhibit 5 demonstrates how Cash Flow hedge accounting allows for the gain or loss in the value of the derivative hedge to be recorded on the balance sheet (in an account like Accumulated Other Comprehensive Income), leaving the income statement impacts to occur in future periods in amounts that offset with the hedged item(s). 

Fair Value treatment, on the other hand, allows for a more direct path toward accounting alignment without creating new accounts on the balance sheet. By modifying the treatment of the hedged item(s) to incorporate anticipated future cash flows, Fair Value treatment allows changes in the value of the hedged item to offset directly the change in value of the derivatives (which occurs in either the interest income or interest expense line, depending on whether the hedge is for assets or liabilities).

Exhibit 6 demonstrates this concept, with anticipated cash flows from both the derivative and the hedged item flowing to the income statement in amounts that offset each other, rather than accumulating on the balance sheet. This accounting outcome can buoy an institution’s net interest income and strengthen its capital ratios during periods of economic stress. 

For many end users, mitigating risk with hedging instruments is a far less attractive solution without the corresponding benefits of hedge accounting. But while the outcome of hedge accounting is attractive, the process for obtaining it is known for being onerous, requiring specialized technical expertise for documentation and analysis at the commencement of each hedge and in monthly reporting cycles thereafter.

In 2017, in an effort to simplify the burden and increase the flexibility of hedge accounting, FASB issued Accounting Standards Update (ASU) 2017-12, Targeted Improvements to Accounting for Hedging Activities. Among multiple changes, ASU 2017-12 offers end users greater latitude when hedging the fair value of prepayable fixed rate assets.

Most notably, it allows financial institutions to do the following, each of which simplifies analysis or provides additional flexibility:

1. hedge the fair value of the component of contractual cash flows driven by benchmark rates (like SOFR), instead of the entire coupon
2. hedge a partial term of the weighted-average portfolio life instead of the entire term
3. presume that the portion of the portfolio being hedged is the “layer” last affected by prepayments, defaults and other events affecting the timing and amount of cash flows

These three changes, in particular, form the foundation of what became known as the “last-of-layer method” for Fair Value hedge accounting. Whereas many ASUs portend unwelcome and time-consuming requirements for financial reporting, ASU 2017-12 was received enthusiastically by accounting practitioners. They viewed it as helpful for derivatives users, removing the quantitative obstacles for Fair Value hedge qualification and reducing it to a documentation exercise.

In 2022, FASB added even more flexibility by issuing ASU 2022-01, Fair Value Hedging – Portfolio Layer Method. Now referring to what they renamed the “Portfolio Layer method,” the guidance enables Fair Value hedging of multiple layers within a closed portfolio of prepayable or non-prepayable fixed rate assets. Illustrated conceptually in Exhibit 7, this enhancement provides financial institutions the ability to hedge several layers without needing to assemble a new portfolio of assets each time they execute a new hedging instrument.

By enabling financial institutions to expend fewer resources obtaining preferred accounting treatment for much-needed hedges, these changes have contributed to a broader application of Fair Value hedge accounting, especially among banks and credit unions.

Taken together, ASU 2017-12 and ASU 2022-01 provide a framework for financial institutions to designate derivatives like Eris SOFR Swap futures as hedges against undesirable interest rate moves. 

The combination of these enhancements in trading derivatives and hedge accounting guidelines profoundly expands both the audience and the use cases for which hedging is accessible. CME Group is aware of institutions as small as $500 million in assets currently applying hedge accounting to Eris SOFR positions, without needing to convince swap dealers to sign them as counterparties (which would be required to trade swaps).

For existing swap users, these developments make possible more efficient trade execution, and dramatic cost savings compared to cleared swaps. Compared to swaps traded under previous hedge accounting regimes, modifying existing hedges is now a more straightforward exercise.

In the case studies that follow, we review examples of applying Cash Flow and Fair Value hedge accounting treatment to Eris SOFR Swap futures in an additional level of detail.

• Financial institutions use derivatives, such as Eris SOFR Swap futures, to hedge interest rate risk and mitigate its effects on their profitability and capital structure.
• They subsequently apply ASC 815 hedge accounting to mitigate earnings volatility.
• The purpose of these use cases is to familiarize financial institutions with the steps involved in identifying balance sheet risk, hedging with Eris SOFR, and applying Fair Value or Cash Flow hedge accounting treatment.

Practical steps to identify, hedge and monitor interest rate risk

Hedge accounting signals to key stakeholders that an institution is a prudent steward of their capital. Beyond the benefit of reduced earnings volatility, FASB’s improved derivative accounting guidance (ASU 2017-12 and ASU 2022-01) renders hedge accounting a more accessible and fundamentally less burdensome experience.

Streaming bid and ask levels on Eris SOFR products are delineated clearly and active marks are visible on erisfutures.com, providing users with transparent trade execution. CME Group publishes daily the price component data on Eris SOFR Swap futures including (but not limited to) net present value, cash flows, accruals and price alignment adjustment information. For these and many other reasons, Eris SOFR eases the practical application of Fair Value and Cash Flow hedge accounting.

The following use cases outline the typical steps involved in identifying balance sheet risk, then selecting, executing and monitoring an Eris SOFR hedge. They focus on the steps required for hedge accounting designation, where recent changes allow Fair Value and Cash Flow treatment without the “critical terms matching” or quantitatively rigorous effectiveness testing required under ASC 815 prior to the 2017 update.

The five steps below provide a general framework. In practice, risk management and hedging are a multi-faceted process where the steps may be executed iteratively or in different orders. Steps 1 and 2 are common between both use cases. Beginning in Step 3, this splits into the Fair Value track (Steps 3a, 4a, 5a) and the Cash Flow track (Steps 3b, 4b, 5b).

Additionally, the use cases assume the financial institution (in this use case, a bank) has already opened an account with a futures clearing firm. For futures clearing firms accepting new customers for Eris SOFR, please see the full list of FCMs and Brokers.

Step 1: Determine hedging goals

• Conduct scenario analysis: Financial institutions typically assess their sensitivity to changes in rates by evaluating the impact of stressed market scenarios on their discounted future cash flows of assets and liabilities. A commonly used metric is Economic Value of Equity (EVE), which seeks to determine the largest capital impacts based on the direction and magnitude of interest rate changes.
  
  • Use case: We consider a bank whose EVE analysis shows they will breach board-mandated capital ratios if interest rates rise by 200 basis points or more.
• Articulate the hedging goal: The result of this analysis is a decision to employ derivatives to hedge against the negative effects of interest rate movements.
  
  • Exhibit 8: Hedging and Strategy
    

    To Hedge Against…	Eris SOFR direction (Buy/Sell)	Effect on balance sheet
    Rates rising	Sell / Pay fixed (Pay fixed rate, receive overnight SOFR)	Reduce asset duration OR Extend liability duration
    Rates falling	Buy / Receive fixed (Receive fixed rate, pay overnight SOFR)	Extend asset duration OR Reduce liability duration

  • Use Case
    
    • Based on EVE analysis, the bank decides to hedge against the negative consequences of rising rates by selling Eris SOFR Swap futures.
    • As shown in Exhibit 8, this hedge will have the same effect as would either 1) extending the duration of its liabilities, or 2) reducing the duration of its assets.
    • To mitigate potential earnings volatility, they seek to employ hedge accounting treatment, which will require them to specify the assets or liabilities being hedged.

Step 2: Choose the assets/liabilities to hedge, which drives accounting treatment

• Choose assets or liabilities: Employing in-house or outsourced hedge advisory expertise, a financial institution prepares for hedge accounting treatment by identifying which assets or liabilities to utilize for hedge designation, which will drive its decision to apply Fair Value or Cash Flow treatment.
• As the hedging goal can be accomplished using either side of the balance sheet, the decision will be driven by the characteristics of specific assets and liabilities, and by the feasibility of applying the Fair Value or Cash Flow treatment.
• Using assets to hedge against interest rate increases Fair Value treatment
  • When EVE analysis reveals the need to hedge against rising interest rates by paying a fixed rate with derivatives, selecting the asset side of the balance sheet for hedge accounting implies shortening the duration of fixed-rate assets.
  • The bank assembles an asset portfolio (e.g., mortgage loans or bonds) by selecting seasoned, prepayable, fixed-rate assets of similar (need not be identical) coupons, credit quality and term to maturity. Satisfying the accounting guidance for portfolio homogeneity requires only that the average life of the assets meet or exceed the term of the hedge.
  • In this scenario, financial institutions typically apply hedge accounting using Fair Value treatment, which allows them to mitigate earnings volatility by accounting for the changes in the value of the hedge and the hedged item with offsetting entries in interest income.
  • Use case: The bank selects a $120 million portfolio of fixed-rate loans with an average life span of at least five years. (Please proceed to Fair Value track Step 3a)
• Using liabilities to hedge against interest rate increases Cash Flow treatment
  • When EVE analysis reveals the need to hedge against interest rate rises by paying a fixed rate with derivatives, utilizing the liability side of the balance sheet for hedge accounting implies extending the duration of variable-rate funding sources.
  • For depository institutions, these sources are typically some combination of maturing deposits, non-maturing deposits and advances, with common examples being share certificates, money market accounts and Federal Home Loan Bank (FHLB) borrowing programs.
  • In this scenario, financial institutions typically apply hedge accounting using Cash Flow treatment, which allows them to lock in the rate of liabilities for the term of the derivative utilized, while also mitigating earnings volatility by deferring changes in the derivative’s value on the balance sheet and releasing them over time to the income statement. This treatment allows institutions to focus on the immediate cash flow and accrued interest offset between hedge and hedged item, while storing future cash flows on balance sheet for later.
  • Use case: The bank elects to hedge against rate increases by applying hedge accounting to its FHLB Loan liabilities. (Please proceed to Cash Flow track Step 3b)

Fair Value track (Steps 3a, 4a, 5a)

Step 3a: Identify a highly effective hedge accounting relationship

Having selected a portfolio of assets (in this use case, a portfolio of loans with average life span of approximately five years), a financial institution will identify the tenors and dollar durations for their hedge, then document the hedge effectiveness using the portfolio layer method of Fair Value treatment.

• Perform Key Rate Duration (KRD) analysis: The bank uses KRD analysis to determine at which tenors along the curve its assets are most sensitive to interest rate changes. This analysis informs which tenors of Eris SOFR to trade as hedges.
  • Use case: Here, the bank concludes that the duration risk is highest at the 3-, 5- and 7-year points.
• Quantify dollar duration: At each tenor point, the bank measures the dollar value change (in the value of the assets) given a one-basis point change in interest rates (DV01). This analysis informs the quantity of Eris SOFR contracts to trade as hedges.
  • Use case: The bank concludes to trade the following contract amounts.
    • 200 3-year Eris SOFR contracts ($20M notional; 5,600 DV01)
    • 400 5-year Eris SOFR contracts ($40M notional; 18,000 DV01)
    • 300 7-year Eris SOFR contracts ($30M notional; 13,500 DV01)
• Draft the hedge memorandum: The bank documents its selection of the “portfolio layer method” of Fair Value hedge accounting in a draft hedge memorandum, identifying the layers and the benchmark driving the benchmark rate portion of the contractual cash flows. The portfolio layer method significantly simplifies the demonstration of hedge effectiveness, by 1) allowing the financial institution to address the loans in collective layers, and 2) isolating the analysis to change in value of the assets based on the change in value of a benchmark interest rate, such as SOFR.
  • Use case: The bank records its intention to hedge the $20M, $40M and $30M quantities along the 3-, 5- and 7-year horizons as the layers within the portfolio and demonstrates hedge effectiveness by performing scenario analysis of portfolio layer DV01 against Eris SOFR Swap futures DV01 under base case and stressed market scenarios.

Step 4a: Execute the hedge

• Trade Eris SOFR: The bank executes the desired hedges by selling the 3-, 5- and 7-year Eris SOFR contracts in the sizes determined in the previous step, either directly by using Bloomberg or another electronic interface or by instructing their futures broker to do so.
• File the hedge memorandum: On the day the Eris SOFR trades are executed, the bank documents the trades as hedges by finalizing and storing the hedge memorandum, including the trade prices and effectiveness assessment results. 

Step 5a: Monitor performance on an ongoing basis

• Monitor hedged item: At the end of each month, the financial institution considers the effect of prepayment risk on the portfolio layer(s) principal balance(s) relative to the size of the hedge(s). It performs prepayment analysis using current Conditional Prepayment Rates (CPR) to ascertain whether there is a current or prospective breach (i.e., to determine whether the portfolio layer principal balance is less than hedge notional [current] or anticipated to be less than the hedge notional in the future [prospective]).
  • Use case: The bank performs a prepayment analysis using a CPR of 8. It determines that there is no current or anticipated breach of principal for its hedging relationships. As such, the bank will not make any changes to its hedging portfolio.
• Observe change in value: At the end of each month, the bank observes the change in value of the Eris SOFR hedge and the hedged assets. For a well-designed hedge, these values should substantially offset.
  • Use case: Let’s assume that interest rates increased by 50 basis points. At the end of the month, the short Eris SOFR positions increased in value by $1.855M, while the portfolio of hedge assets (loans) decreased in value by $1.855M.
• Record accounting entries: The bank records offsetting entries to the interest income (or interest expense) account, achieving its desired effect of reducing earnings volatility.
  • Use case: As demonstrated in Exhibit 9, the bank records the following journal entries, with the net impact on Interest Income being zero, or a nominal figure near zero.
    • Increase in value of the Eris SOFR position (the hedge):
      • Debit the Eris SOFR derivative asset account (balance sheet)
      • Credit the Interest Income account (income statement)
    • Decrease in value of the loans (the assets being hedged):
      • Debit the Interest Income account (income statement)
      • Credit the Loans Asset (Cost Basis) account (balance sheet)
  • Exhibit 9: Fair Value hedge

Cash Flow track (Steps 3b, 4b, 5b)

Step 3b:  Identify a highly effective hedge accounting relationship

Having selected one or more liabilities (in this use case, an FHLB 3-month Fixed-Rate Advance (FRA) lending program), a financial institution will quantify the desired hedge as an offset to the cash flows and timeframe of the liabilities, then document the hedge effectiveness using Cash Flow treatment.

• Identify cash flows and tenors: The financial institution evaluates funding sources based on the institution’s strategic objectives, size of current or prospective balance, and desired hedge horizon. For example, an institution’s strategy may be to create a new money market tier that will be indexed to market interest rates, or to start a new FHLB funding program expected to remain for at least five years. This evaluation exercise should inform the funding source to be hedged and tenors of Eris SOFR to trade as hedges.
  • Use case: Here, the bank projects it will draw $100mm from the FHLB facility quarterly, for approximately three years.
• Perform regression analysis: The institution performs a regression analysis on cash flows from the selected funding source to determine suitability of the hedged cash flows to a given interest rate index, for example, SOFR.
  • Use case: The bank observes a strong correlation between the FHLB facility and SOFR. It demonstrates hedge effectiveness through the results of its regression analysis, showing an r² of 0.99 and ꞵ of 1.01. Thus, it will pursue a hedge using SOFR as the underlying interest rate index.
• Determine the hedge(s): Informed by the expected cash flows and tenors, the financial institution determines the quantity of Eris SOFR contracts to trade, with contracts tradable in increments of $100,000 notional and at quarterly points on the yield curve.
  • Use case: The bank concludes to trade 1,000 3-year Eris SOFR contracts ($100M notional; 28,000 DV01)
• Draft the hedge memorandum: The bank documents its selection of Cash Flow hedge accounting in a draft hedge memorandum, articulating the hedged risk and risk management objective, demonstrating hedge effectiveness by using the regression analysis performed previously, and documenting the financial statement impact of the cash flow hedges.
  • Use case:  The bank notes it is mitigating the risk of variability of future interest payments on the first $100M of FHLB advances by executing Eris SOFR Swap futures.

Step 4b: Execute the hedge

• Trade Eris SOFR: The bank executes the desired hedges by selling the 3-year Eris SOFR contracts in the size determined in the previous step, either by trading directly using Bloomberg or another electronic interface or by instructing their futures broker to do so.
• File the hedge memorandum: On the day the Eris SOFR trades are executed, the bank documents the trades as hedges by finalizing and storing the hedge memorandum, including the trade prices. 

Step 5b: Monitor performance on an ongoing basis

• Monitor hedged item: At the end of each month, the bank observes the outstanding balance of the hedged item to ensure that the current balance exceeds the notional size of the hedge and that it is expected to continue to exceed the notional size of the hedge.
  • Use case: The bank has not changed the amount drawn on its FHLB FRA facility and does not anticipate changing the outstanding balance. Furthermore, senior management intends to sustain the FHLB FRA facility for at least the next three years.
• Observe change in value: At the end of each month, the bank observes accrued interest and cash settlements from the Eris SOFR hedge relative to the interest expense of its hedged liabilities. For a well-designed hedge, these amounts should substantially offset.
  • Use case: Let’s assume that interest rates increased by 50 basis points. At the end of the month, accrued interest income from the short Eris SOFR positions increased by $500k, while interest expense of the hedged liability (FHLB FRA facility) increased $500k as well. The interest income from the Eris SOFR position offsets the interest expense from the FHLB FRA facility.
• Record accounting entries: The bank records the change in value of the projected future cash flows of the hedge on the balance sheet, while recording offsetting changes in accrued interest to the interest income (or interest expense) account.
• This outcome achieves the objective of locking in a fixed interest rate by offsetting its variable interest payments with the variable interest income from the Eris SOFR Swap position, thereby reducing earnings volatility.
  • Use case: As demonstrated in Exhibit 10, the bank records the following journal entries.
    • Increase in value of the Eris SOFR position (the hedge) with respect to the present value of future cash flows, (affects only the balance sheet):
      • Debit the Eris SOFR derivative asset account (balance sheet)
      • Credit the Accumulated Other Comprehensive Income account – Unrealized Gains on the Derivative (balance sheet)
    • Increase in the Eris SOFR position (the hedge) with respect to accrued interest (i.e., fixed and floating payments)
      • Debit the Accrued Interest Income liability account (balance sheet)
      • Credit the Interest Expense account (income statement)
    • Decrease in the FHLB FRA facility (the liability being hedged), recorded as an accrued interest expense:
      • Debit the Interest Expense account (income statement)
      • Credit the Accrued Interest Expense liability account (balance sheet)
      • Exhibit 10: Cash Flow hedge, accounting impact

Exchange-traded futures enable systematic hedge accounting

Practitioners of hedge accounting will be pleased to learn that the accounting entries described in these use cases may be substantially automated. CME Group and Eris Innovations distribute detailed public data quantifying the change in value of Eris SOFR positions attributable to changes in forward-looking, accrued, and fully settled cash flows, enabling accounting departments to automate the calculation of monthly reporting numbers. For more information and a detailed guide, contact Eris Innovations (questions@erisfutures.com).