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. This requirement could be met where the risk component is either explicitly stated in a contract (contractually specified) or implicit in the fair value or cash flows (non-contractually specified). 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 Contractually specified risk components
  • 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’ (see ‘The sub-LIBOR issue’). Contractually specified risk components

Contractually specified risk components t


Example:

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.

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.

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

Read more on FAQ | IFRS:

Hedge Risk components General requirements
Non-contractually specified risk components
Inflation as a risk component
The ‘sub-LIBOR issue’

Contractually specified risk components

 

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