Family Finance Co. (FFC), a publicly traded commercial bank located in South Carolina, has a December 31 year-end. FFC invests in a variety of securities to enhance returns, managing its investment portfolio in an effort to earn returns greater than interest paid on bank deposits and other liabilities. As of December 31, 2020, FFCs investments primarily consist of (1) mortgage-backed securities (MBS), (2) equity securities of nonpublic companies, and (3) plain vanilla interest rate swaps that FFC uses to hedge its exposure to variable interest rates on its corporate debt. All cash payments made under these instruments are in U.S. dollars.

FFC accounts for the MBS and equity securities at fair value with changes in fair value reflected in earnings. Because FFC uses the interest rate swap in a cash-flow hedge, it measures the derivative at fair value, presenting the fair value change in OCI.

Facts related to specific securities and derivatives owned by FFC are described below.

Instrument 3 Interest Rate Swap

In January 2015, FFC executed a plain-vanilla over-the-counter (OTC) fixed-for-float interest rate (IR) swap as an economic hedge of its cash flow variability to changes in the London Interbank Offered Rate (LIBOR) on its six-year variable-rate term note. The terms of the IR swap require FFC to pay a fixed rate and receive a floating rate (three-month LIBOR). The IR swap net cash settles on a quarterly basis. If the fixed rate exceeds the floating rate, FFC makes a net payment to the counterparty, and if the floating rate exceeds the fixed rate, FFC receives a net payment from the counterparty. As of the measurement date (December 31, 2020), the remaining life of the IR swap was four years.

FFC uses an income approach (i.e., a discounted cash flow model), which is widely accepted for valuing IR swaps. Key inputs into the valuation model are the LIBOR yield curve and an adjustment, if any, for nonperformance risk, which is the risk that a party to the contract will not satisfy its obligation (also known as a credit valuation adjustment (CVA)). FFC obtained a quoted LIBOR yield curve for the entire term of the IR swap. In addition, FFC concluded that no CVA was necessary on the basis of (1) the creditworthiness of both FFC and the IR swap counterparty and (2) credit enhancements related to the IR swap by virtue of the International Swap Dealers Association agreement between FFC and the IR swap counterparty.

An active OTC market exists for IR swaps having the same underlying (three-month LIBOR) and tenor (five years) as FFCs IR swap.

Required:

Determine the appropriate classification in the fair value hierarchy for each of the instruments referenced in the case as of December 31, 2020. Provide support for your classification. Cite appropriate authoritative guidance where necessary.