Currency risk

Currency risk – The risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates.

Currency risk (or foreign exchange risk) arises on financial instruments that are denominated in a foreign currency, ie in a currency other than the functional currency in which they are measured. For the purpose of this IFRS, currency risk does not arise from financial instruments that are non-monetary items or from financial instruments denominated in the functional currency. [IFRS 7 B23]

Currency risk is part of the market risk component, that is part of the risk disclosures under IFRS 7 Financial Instruments: Disclosures. Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises three types of risk: currency risk, interest rate risk, and other price risk.

A sensitivity analysis is disclosed for each currency to which an entity has significant exposure. [IFRS 7 B24]

The disclosure of currency risk is part of the capital and/or risk management strategy of an entity. Entities tend disclose a significant amount of text and tables to facilitate users of financial statements with lots of opportunities for analysing and comparing this data. Captions in the capital and/or risk management caption in the notes to the financial statements are:

  • Hedging and financial derivatives,
  • Currency risk,
  • Interest-rate risks,
  • Share-price risks,
  • Other price risks,
  • Credit risks,
  • Liquidity risks.

Some cases

Case: An investment entity invests in a foreign currency bond maturing in one year and simultaneously enters into an FX forward contract with a corresponding maturity to offset the foreign currency risk. IFRS 7 34(b) requires specific risk disclosures for material risks. Is the materiality of the foreign currency risk on the bond assessed with or without the FX forward contract?

The materiality of the foreign currency risk on the bond is assessed without the FX forward contract. The bond and the FX forward are dissimilar items [IAS 1 29]; the materiality assessment of the foreign currency risk is therefore performed without considering the FX forward contract.

If it is established that the foreign currency risk is material, the disclosure required in the sensitivity analysis [IFRS 7 40-41] is based on the net FX exposure − that is, after offsetting the foreign currency bond against the FX forward contract.

The same approach would apply for the assessment of credit risk, liquidity risk and other market risk.

Case: The management of an investment entity claims it does not ‘manage’ currency risk, it simply ‘trades’ it. Management does not therefore intend to make any risk disclosures under IFRS 7. Does IFRS 7 still require risk disclosure in situations where management believes risks are not managed?

Yes. IFRS 7 requires qualitative [IFRS 7 33(a)] and quantitative [IFRS 7 34] disclosures of risk, irrespective of whether such risks are considered by management to be managed. IFRS 7 IG15(b) refers to the need for management to disclose the reporting entity’s policies and processes for accepting risk, in addition to those for measuring, monitoring and controlling risk.

Case: Investment entity ABC Ltd, with a functional currency of New Zealand dollars, invests in a global equity portfolio. As a result, it has significant foreign currency exposure through its investments in the yen, euro and US dollar. Is ABC Ltd considered to have currency risk for the purpose of meeting the IFRS 7 requirements?

No. IFRS 7 does not consider currency risk to arise from financial instruments that are non-monetary [IFRS 7 B23], such as equity investments. The foreign currency exposure arising from investing in non-monetary financial instruments would be reflected in the other price risk disclosures as part of the fair value gains and losses.

Exhibit

Here is an exhibit from the Bosch Annual report 2017:

Currency risk

Currency risks of the operative business are mitigated by the central management of selling and purchasing currencies. The currency risk is determined on the basis of the worldwide consolidated cash flow in the respective currencies. Based on the business plan, estimated inflows and outflows in the various countries for the planning period are aggregated in a foreign exchange balance plan. The resulting net position is used for the central management of currency exposures.

The largest net currency positions of the planned cash flow are in CNY, GBP, and USD.

Hedging largely takes the form of forward exchange contracts; currency options and currency swaps to secure group financing are used to a lesser extent. These transactions, which are only entered into with banks, are subject to minimum requirements with respect to nature, scope, and complexity.

The risk attaching to material operating foreign currency items is determined using the value-at-risk concept, supplemented by worst-case analyses. These risk analyses and the hedge result are determined monthly and presented to management.

To present the currency risks in accordance with IFRS 7 Financial Instruments: Disclosures for the most important foreign currencies, all monetary assets and monetary liabilities denominated in foreign currency for all consolidated companies were analysed at balance sheet date and sensitivity analyses carried out for the respective currency pairs, in terms of the net risk.

A change in the EUR of 10 percent (taking the closing rate as the baseline) against the foreign currencies listed in the table would have the following implications for the profit before tax:

Currency risk Currency risk Currency risk Currency risk

Example Foreign currency risk disclosure

Note 12(b) Market risk

IFRS References: IFRS 7 33, IFRS7 21C, IFRS 7 31, IFRS 7 34(c), IFRS 7 22A(c)

(i) Foreign exchange risk

Exposure

The group’s exposure to foreign currency risk at the end of the reporting period, expressed in FX-land currency units, was as follows:

The aggregate net foreign exchange gains/losses recognised in profit or loss were:

IFRS References: IAS 21 52(a), IAS 23 6(e)

Instruments used by the group IFRS 7 Nature and extent Financial instruments risks

The group operates internationally and is exposed to foreign exchange risk, primarily the US dollar. Foreign exchange risk arises from future commercial transactions and recognised assets and liabilities denominated in a currency that is not the functional currency of the relevant group entity. The risk is measured through a forecast of highly probable US dollar expenditures. The risk is hedged with the objective of minimising the volatility of the FX-land currency cost of highly probable forecast inventory purchases. [IFRS 7 33(b), IFRS 7 22A(a)]

The group treasury’s risk management policy is to hedge between 65% and 80% of forecast US dollar cash flows for inventory purchases up to one quarter in advance, subject to a review of the cost of implementing each hedge. For the year ended 31 December 2019, approximately 80% of inventory purchases were hedged in respect of foreign currency risk. At 31 December 2019, 90% of forecasted US dollar inventory purchases during the first quarter of 2020 qualified as ‘highly probable’ forecast transactions for hedge accounting purposes (for 2018, approximately 85% of inventory purchases were hedged and 93% of the purchases qualified as ‘highly probable’ as at 31 December 2018). [IFRS 7 22A(b),(c)]

The US dollar-denominated bank loans are expected to be repaid with receipts from US dollar denominated sales. The foreign currency exposure of these loans has therefore not been hedged.

The group uses a combination of foreign currency options and foreign currency forwards to hedge its exposure to foreign currency risk. Under the group’s policy, the critical terms of the forwards and options must align with the hedged items. [IFRS 7 22B(a)]

The group only designates the spot component of foreign currency forwards in hedge relationships. The spot component is determined with reference to relevant spot market exchange rates. The differential between the contracted forward rate and the spot market exchange rate is defined as the forward points. It is discounted, where material. [IFRS 9 6.5.16]

The intrinsic value of foreign currency options is determined with reference to the relevant spot market exchange rate. The differential between the contracted strike rate and the discounted spot market exchange rate is defined as the time value. It is discounted, where material. [IFRS 9 6.5.15]

The changes in the forward element of the foreign currency forwards and the time value of the options that relate to hedged items are deferred in the costs of hedging reserve. [IAS 1 117, IFRS 7 21]

The group also entered into foreign currency forwards in relation to projected purchases for the next 12 months that do not qualify as ‘highly probable’ forecast transactions and hence do not satisfy the requirements for hedge accounting (economic hedges). The foreign currency forwards are subject to the same risk management policies as all other derivative contracts. However, they are accounted for as held for trading, with gains (losses) recognised in profit or loss. [IFRS 7 7, IFRS 7 21]

Hedge of net investment in foreign entity

In 2019, Reporting Entity Plc has entered into a bank loan amounting to CU1,699,000 which is denominated in Chinese renminbi (RMB) and which was taken out to fund an additional equity investment in the Chinese subsidiary. The forward rate of the loan has been designated as a hedge of the net investment in this subsidiary. There was no ineffectiveness to be recorded from net investments in foreign entity hedges. [IFRS 7 22A]

Effects of hedge accounting on the financial position and performance

The effects of the foreign currency-related hedging instruments on the group’s financial position and performance are as follows:

IFRS References: IFRS 7 24A, IFRS 7 23B, IFRS 7 22B, IFRS 7 24B

* The foreign currency forwards and options are denominated in the same currency as the highly probable future inventory purchases (US$), therefore the hedge ratio is 1:1. [IFRS 7 22B(c)]

IFRS References: IFRS 7 24A, IFRS 7 23B, IFRS 7 22B, IFRS 7 24B

* The foreign currency forwards and options are denominated in the same currency as the highly probable future inventory purchases (US$), therefore the hedge ratio is 1:1. [IFRS 7 22B(c)]

IFRS References: IFRS 7 24A, IFRS 7 23B, IFRS 7 22B, IFRS 7 24B

Sensitivity

As shown in the table on page 122 above, the group is primarily exposed to changes in US/CU exchange rates. The sensitivity of profit or loss to changes in the exchange rates arises mainly from US dollar-denominated financial instruments and the impact on other components of equity arises from foreign forward exchange contracts designated as cash flow hedges. [IFRS 7 40(a),(b),(c)]

Amounts in CU ‘000

Impact on post-tax profit

Impact on other components of equity

2019

2018

2019

2018

USD/CU exchange rate – increase 9% (2018 – 10%) *

-1,494

-1,004

-806

-743

USD/CU exchange rate – decrease 9% (2018 – 10%) *

1,223

822

660

608

* Holding all other variables constant IFRS 7 Nature and extent Financial instruments risks

Profit is more sensitive to movements in the FX-land currency unit/US dollar exchange rates in 2019 than 2018 because of the increased amount of US dollar denominated borrowings. Equity is more sensitive to movements in the FX-land currency unit/US dollar exchange rates in 2019 than 2018 because of the increased amount of foreign currency forwards. The group’s exposure to other foreign exchange movements is not material.

Foreign currency risk

IFRS7(B23)

1. Foreign currency risk can only arise on financial instruments that are denominated in a currency other than the functional currency in which they are measured. Translation-related risks are therefore not included in the assessment of the entity’s exposure to currency risks.

Translation exposures arise from financial and non-financial items held by an entity (for example, a subsidiary) with a functional currency different from the group’s presentation currency. However, foreign currency-denominated inter-company receivables and payables which do not form part of a net investment in a foreign operation would be included in the sensitivity analysis for foreign currency risks; this is because, even though the balances eliminate in the consolidated balance sheet, the effect on profit or loss of their revaluation under IAS 21 is not fully eliminated.

IFRS7(B23)

For the purpose of IFRS 7, currency risk does also not arise from financial instruments that are non-monetary items. IFRS Reporting Entity Corp. has therefore excluded its US dollar-denominated equity securities from the analysis of foreign exchange risk. The foreign currency exposure arising from investing in non-monetary financial instruments is reflected in the other price risk disclosures as part of the fair value gains and losses.

Currency risk Currency risk Currency risk Currency risk

 

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