Derivative novation refers to the replacement of one party to a derivative instrument with a new party, whereby the original party transfers all rights and obligations to the latter party. In some situations, the derivative instrument that is the subject of the novation might be designated as the hedging instrument in a hedging relationship.
A novation is not considered a termination of the hedging instrument, but rather is a change in the counterparty to a derivative instrument. Therefore, when a novation occurs an entity is typically not required to discontinue the hedging relationship. Derivative novation
However, if a derivative instrument novation involves a new counterparty with creditworthiness different from that of the old counterparty, the entity should consider that change in creditworthiness in determining whether the hedging relationship continues to be highly effective and qualifies for hedge accounting.
Similarly, if a novation leads to changes in security or cash collateral posting requirements, those changes should also be incorporated into an entity’s assessment of hedge effectiveness.
Derivative novation may occur for a variety of reasons including but not limited to: Derivative novation
- in response to laws or regulatory requirements; Derivative novation
- when the derivative counterparty merges with and into a surviving entity that assumes the same rights and obligations that existed under a preexisting derivative instrument of the merged entities; Derivative novation
- when the derivative counterparty novates a derivative instrument to an entity under common control with the derivative counterparty;
- when the derivative counterparty decides to exit a particular derivative business or relationship; or Derivative novation
- for an over-the-counter (OTC) derivative entered into after applying the mandatory clearing requirement of the Dodd-Frank Act, when the counterparties agree in advance to clear the contract through a central counterparty according to standard market terms and conventions. Derivative novation
Novation example Derivative novation
As part of the effectiveness testing, entities should assess at each reporting date whether past credit changes have dominated and whether future credit changes are likely to dominate the hedge relationship. This assessment should be for the remaining term of the hedging relationship and not only for the period immediately prior to the reporting date.
This assessment should also take into consideration the entity’s risk management policies, to the extent they are part of the hedge documentation. For example, an entity’s risk management policy might be to mitigate the significance of credit risk by requiring the replacement of counterparties when they are downgraded and/or experience a severe deterioration in their financial condition.
When such a replacement of counterparty is included in the hedge documentation (or when it complies with the criteria for novation of derivatives) it does not result in the extinguishment of the hedge relationship. Derivative novation
Novation of a derivative previously designated as hedging instrument
Q – What is the accounting for the novation of a derivative which was designated as a hedging instrument in a hedge relationship? Derivative novation
In general, the novation of a derivative to a new counterparty causes the de-designation of the hedging relationship in which this derivative was designated as a hedging instrument.
The new derivative then needs to be re-designated as the hedging instrument in a new hedging relationship. IFRS 9 allows for an exception to this general rule, where the novation has the following cumulative characteristics: Derivative novation
- it is done as a consequence of laws and regulations; Derivative novation
- the parties to the hedging instrument agree that one or more central clearing counterparties replace the original counterparties to become the new counterparty to each of the parties; and
- any changes to the derivative are limited to the changes that are necessary to effect such replacement. Derivative novation
If a novation of a derivative meets these strict criteria, the original hedge relationship is not discontinued and the original hedging instrument is replaced by the novated derivative.
Other elements of the hedging relationship (such as characteristics of the hypothetical derivative, and amounts accumulated in other comprehensive income) should not be modified.
There may be additional limited circumstances where a novation may not result in the discontinuation of hedge accounting, but that will depend on specific facts and circumstances.
Consider this hint Derivative novation
In order to deal with any potential issues from novation of derivatives or roll-over in new hedging instruments, a company could include reference to potential rollover of the derivative within the hedge documentation. IFRS 9 6.5.6 notes that a replacement of rollover of a hedging instrument is not an expiration or termination if such replacement or rollover is part of the documented risk management objective.
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