Contractually specified risk components

– Contractually specified risk components –

Under IFRS 9, risk components can be designated for non-financial hedged items, provided the component is separately identifiable and the changes in fair value or cash flows of the item attributable to the risk component are reliably measurable. There are two types of risk components:

  1. Contractually specified risk components – those that are explicitly specified in a contract.
  2. Non-contractually specified risk components – those that are implied in the fair value or cash flows of an item and can relate to items that are not a contract (e.g. forecast transactions) or contracts that do not explicitly specify the risk component (e.g. firm commitment with only one single price vs. a pricing formula that references different underlyings). Contractually specified risk components

Contractually specified risk components

Purchase or sales agreements sometimes contain clauses that link the contract price via a specified formula to a benchmark price of a commodity. Examples of contractually specified risk components are each of the price links and indexations in the contracts below:

  • Price of natural gas contractually linked in part to a gas oil benchmark price and in part to a fuel oil benchmark price Contractually specified risk components
  • Price of electricity contractually linked in part to a coal benchmark price and in part to transmission charges that include an inflation indexation
  • Price of wires contractually linked in part to a copper benchmark price and in part to a variable tolling charge reflecting energy costs
  • Price of coffee contractually linked in part to a benchmark price of Arabica coffee and in part to transportation charges that include a diesel price indexation

In each case, it is assumed that the pricing component would not require separation as an embedded derivative. When contractually specified, a risk component would usually be considered separately identifiable. Further, the risk component element of a price formula would usually be referenced to observable data, such as a published price index.

Therefore, the risk component would usually also be considered reliably measurable. However, entities would still have to consider what has become termed the ‘sub-LIBOR issue’. Contractually specified risk components

Example – Hedge of a contractually specified risk component

Coal supply contract linked to the coal benchmark price and the Baltic Dry Index

An entity purchases coal from its coal supplier under a contract that sets out a variable price for coal linked to the coal benchmark price, represented by futures Contractually specified risk componentscontracts for coal loaded at the Newcastle Coal Terminal in Australia, plus a logistics charge that is indexed to the Baltic Dry Index, reflecting that the delivery is at an overseas location. The contract sets out minimum purchase quantities for each month covered by its term.

The entity wishes to hedge itself against price changes related to the benchmark coal price but does not want to hedge the price variability resulting from the logistics costs represented by the indexation of the coal price to the Baltic Dry Index. Therefore, the entity enters into Newcastle coal futures contracts whereby it purchases coal for the relevant delivery months.

For each relevant delivery month the entity designates the futures contracts as a hedging instrument in a cash flow hedge of the benchmark coal price risk  component of the future coal purchases under its supply contract.

In this case, the risk component is contractually specified by the pricing formula in the supply contract. This means it is separately identifiable, because the entity knows exactly which part of the change in the future purchase price of coal under its particular supply contract results from changes in the benchmark price for coal and what part of the price change results from changes in the Baltic Dry Index.

The risk component can also be reliably measured using the price in the futures market for the relevant delivery months as inputs for calculating the present value of the cumulative change in the hedged cash flows. An entity could also decide to only hedge its exposure to variability in the coal price that is related to transportation costs.

For example, the entity could enter into forward freight agreements and designate them as hedging instruments, with the hedged item being only the variability in the coal price under its supply contract that results from the indexation to the Baltic Dry Index.

Example contract to purchase a product

An example of a contractually specified risk component that we have come across in practice is a contract to purchase a product (such as aluminium cans), in which a metal (such as aluminium) is used in the production process. Contracts to purchase aluminium cans are commonly priced by market participants based on a building block approach, as follows:

  • The first building block is the London Metal Exchange (LME) price for a standard grade of aluminium ingot.
  • The next building block is the grade premium or discount to reflect the quality of aluminium used, as compared to the standard LME grade.
  • Additional costs will be paid for conversion from ingot into cans and delivery costs.
  • The final building block is a profit margin for the seller.
Something else -   Setting the hedge ratio

Many entities may want to use aluminium LME futures or forwards to hedge their price exposure to aluminium. However, IAS 39 did not allow just the LME component of the price to be the hedged item in a hedge relationship. All of the pricing elements had to be designated as being hedged by the LME future.

This caused ineffectiveness, which was recorded within P&L; and, in some cases, it caused sensible risk management strategies to fail to qualify for hedge accounting. By contrast, IFRS 9 allows entities to designate the LME price as the hedged risk, provided it is separately identifiable and reliably measurable.

Example – Contractually specified risk component

Company B has a long-term supply contract to buy natural gas. The contract is priced using a contractually specified formula that references gas oil, fuel oil and transportation charges. B’s risk management strategy is to hedge 100% of its exposure to gas oil price risk, and B enters into a gas oil forward contract to hedge that price risk. [IFRS 9.B6.3.10]

The contract explicitly specifies how the gas oil component is determined. In addition, there is a market for gas oil forward instruments that extends to the maturity of the supply contract. Thus, B determines that the gas oil price exposure is separately identifiable and reliably measurable. Therefore, the gas oil price exposure is an eligible risk component for designation as a hedged item.

Example Western Canadian Select

Entity B has a firm commitment to purchase crude oil under a contract that references to the quoted price for Western Canadian Select, plus a variable logistics and delivery charge based on a published market survey of transportation costs. The contract sets out a range of minimum and maximum purchase quantities for every month.

Assessment: The entity wants to hedge itself against changes in the price for crude oil. If it were to hedge the entirety of the forecasted purchases, the logistics and delivery charge would become a source of hedge ineffectiveness.

Instead, Entity B enters into futures contracts for the purchase of Western Canadian Select crude oil for the relevant months, and designates them as the hedging instrument in a cash flow hedge of the benchmark Western Canadian Select price risk component of the firm commitment. This eliminates the requirement for Entity B to assess the impact of changes in the market survey on its logistics and delivery charges for the purposes of calculating hedge effectiveness.

Contractually specified interest rate for cash flow hedges

For cash flow hedges of interest rate risk of variable-rate financial instruments or forecasted issuances or purchases of variable-rate financial instruments, IFRS 9 permits an entity to designate the hedged risk as the variability in cash flows attributable to a contractually specified interest rate explicitly referenced in the agreement.

The contractually specified interest rate does not need to be a benchmark interest rate. An entity can designate non-benchmark rates (e.g. prime lending rates) as the hedged risk instead of hedging the overall changes in cash flows.

However, an entity is not permitted to designate an implied rate embedded in a contractually specified interest rate. For example, if an entity issues variable-rate debt based on its own prime rate, it cannot designate the hedged risk as exposure to the Fed Funds Target rate or the Wall Street Journal prime rate.

Hedge effectiveness

If the hedged item’s contractually specified rate (e.g. entity-specific prime rate) does not exactly match the hedging instrument’s variable rate, an entity needs to consider this difference in its hedge effectiveness assessment. Contractually specified risk components

For example, assume a debt contract specifies the rate as a specified bank’s prime lending rate plus 100 basis points. Although the specified bank’s prime lending rate is not a benchmark interest rate, it can be the hedged risk because it is contractually specified. If the bank entered into a LIBOR-based interest rate swap to hedge the variable prime-based cash flows, it should consider the variability in the prime lending rates compared to the LIBOR interest rates in assessing hedge effectiveness. Contractually specified risk components

Non-contractually specified risk components

Not all contracts define the various pricing elements and, therefore, specify risk components. In fact, we expect most risk components of financial and non-financial items not to be contractually specified. While it is certainly easier to determine that a risk component is separately identifiable and reliably measurable if it is specified in the contract, IFRS 9 is clear that there is no need for a component to be contractually specified in order to be eligible for hedge accounting.

The assessment of whether a risk component qualifies for hedge accounting (i.e., whether it is separately identifiable and reliably measurable) has to be made ‘within the context of the particular market structure to which the risk or risks relate and in which the hedging activity takes place’.

Food for thought – Market structure

The relevance of the market structure is that the risk component must have a distinguishable effect on changes in the value or the cash flows that an entity isNon-contractually specified risk components exposed to. Depending on the situation, the market structure can reflect a ‘market convention’ that establishes, for example, a benchmark interest rate that has a pervasive effect on the value and cash flows for debt instruments. In other situations, the market structure reflects the particular purchasing or selling market of an entity.

For example, this is the case when an entity buys goods from its particular supplier based on a benchmark price plus other charges, as in the examples listed above. Even if the pricing under such a supply arrangement is not a wider market convention, its pricing formula represents the exposure of the particular entity to variability in cash flows from its purchases.

The assessment is normally straightforward for contractually specified risk components, which can also be a relevant factor in the assessment of the market structure of non-contractually specified risk components such as risk components of forecast transactions.

Something else -   Hedge accounting

The assessment of whether a risk component is separately identifiable and reliably measurable

has to be made ‘within the context of the particular market structure’

to which the risk or risks relate and in which the hedging activity takes place.

The following example from the application guidance of IFRS 9 illustrates the ‘separately identifiable and reliably measurable’ assessment.

Example  — Hedge of a non-contractually specified risk componentNon-contractually specified risk components

Coffee purchases with a benchmark price risk component

An entity purchases a particular quality of coffee of a particular origin from its supplier under a contract that sets out a variable price linked to the benchmark price for coffee. The price is represented by the coffee futures price plus a fixed spread, reflecting the different quality of the coffee purchased compared to the benchmark plus a variable logistics services charge reflecting that the delivery is at a specific manufacturing site of the entity.

The fixed spread is set for the current harvest period. For the deliveries that fall into the next harvest period this type of supply contract is not available.

The entity analyses the market structure for its coffee supplies, taking into account how the eventual deliveries of coffee that it receives are priced. The entity can enter into similar supply contracts for each harvest period once the crop relevant for its particular purchases is known and the spread can be set.

In that sense, the knowledge about the pricing under the supply contracts also informs the entity’s analysis of the market structure more widely, including forecast purchases which are not yet contractually specified. This allows the entity to conclude that its exposure to variability of cash flows resulting from changes in the benchmark coffee price is a risk component that is separately identifiable and reliably measurable for coffee purchases under the variable price supply contract for the current harvest period as well as for forecast purchases that fall into the next harvest period.

In this case, the entity may enter into coffee futures contracts to hedge its exposure to the variability in cash flows from the benchmark coffee price and designate that risk component as the hedged item. This means that changes in the coffee price from the variable logistics services charge as well as future changes in the spread reflecting the different coffee qualities would be excluded from the hedging relationship.

The assessment of whether a risk component qualifies for hedge accounting is mainly driven by an analysis of whether there are different pricing factors that have a distinguishable effect on the item as a whole (in terms of its value or its cash flows). This evaluation would always have to be based on relevant facts and circumstances.

The standard uses the refinement of crude oil to jet fuel as an example to demonstrate how the assessment of the market structure could be made to conclude that crude oil in a particular situation is an eligible risk component of jet fuel. Crude oil is a physical input of the most common production process for jet fuel and there is a well established price relationship between the two.

Something else -   Forecast transaction

Extending this example, crude oil is also a major input in the production process for plastic. However, the manufacturing process is complex and involves a number Contractually specified risk componentsof steps. The process starts with crude oil being distilled into its separate ‘fractions’, of which only one (naphtha) is used for making plastic. Naphtha then undergoes a number of further processes before the various types of plastic are finally produced.

Generally, the further downstream in the production process an item is, the more difficult it is to find a distinguishable effect of any single pricing factor. The mere fact that a commodity is a major physical input in a production process does not automatically translate into a separately identifiable effect on the price of the item as a whole.

For example, crude oil price changes are unlikely to have a distinguishable effect on the retail price of plastic toys even though, in the longer term, changes in the crude oil price might influence the price of such toys to some degree.

Similarly, the price for pasta at food retailers in the medium to long term also responds to changes in the price for wheat, but there is no distinguishable direct effect of wheat prices changes on the retail price for pasta, which remains unchanged for longer periods even though the wheat price changes. If retail prices are periodically adjusted in a way that also directionally reflects the effect of wheat price changes, that is not sufficient to constitute a separately identifiable risk component.

Allowing non-contractually specified risk components as eligible hedged items opens up a new area of judgement.

The assessment of the market structure will normally require the involvement of personnel with a good understanding of the drivers of market prices

(e.g., members of the sales or procurement departments responsible for the underlying transactions).

Example – Non-contractually specified risk component

Company C has a long-term supply contract to buy jet fuel. C’s risk management strategy is to hedge a portion of its exposure to jet fuel price risk based on expected consumption up to 24 months before delivery. C then increases the coverage volume as delivery gets nearer. C uses the following derivatives as hedging instruments based on the liquidity of the respective derivative markets and the time remaining until the forecast purchase: [IFRS 9.B6.3.10]

  • 12 months to 24 months: crude oil contracts;
  • six months to 12 months: gas oil contracts; and
  • under six months: jet fuel contracts.

Example – Forecasted loans to customers

Lender A has highly probable forecast transactions to make loans to customers at fixed rates in the coming months. The rates charged will be based on a variety of factors, including but not limited to, the prime lending rate at the time the loan is made, local economic conditions, the lending market and the consumers’ credit risk. Lender A evaluates the market structure for the loans it makes and analyzes the way fixed interest rates are determined.

It determines that it is has exposure to variability in future cash flows arising from changes in the prime lending rate (i.e., the fixed rate granted to a borrower in the future depends on the level of the prime rate), and that while the effect this rate will have on its future interest income is not contractually specified, it is separately identifiable and measurable.

Assessment: As a result, Lender A can specify the variability in its cash flows arising from changes in the prime lending rate as the hedged item in a hedging relationship. It can choose to hedge this risk with a variety of hedging instruments, including interest rate swaps or collared options. Changes in the fixed interest rate eventually charged to consumers that arise from factors other than the prime lending rate are excluded from consideration of the hedging relationship.

Contractually specified risk components

 

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Something else -   Hedge accounting

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