Prepayment Options Take care if the underlying item has an embedded prepayment option. It must be considered if it is in the same class as the designated risk being hedged by a derivative. The borrower has the option to prepay the loan, without penalty, after year two. A swap, cancelable at BankGroup's option after year two, would be a better hedge of the change in value of the loan attributable to interest rate risk. But in neither case would the swap be eligible for the shortcut method, because the hedged commercial loan is prepayable.
Correct designation is critical.
Neighborhood is comfortable with the fixed yield of the portfolio. However, it wants to hedge the prepayment risk. To do so, the designated risk must be the change in the fair value of the embedded prepayment options. For assessing effectiveness, Neighborhood must have a reasonable basis for determining changes in the fair value of the embedded prepayment options to compare against the changes in the fair value of the derivative used as a hedge.