Designating proxy hedges
Designating proxy hedges is a direct result from IASB’s IFRS 9 Hedge accounting ambition to align hedge accounting more to/into the risk management activities of a reporting entity. But not on a scholastic, black/white, way.
The objective of IFRS 9 Hedge accounting is to represent, in the financial statements, the effect of an entity’s risk management activities. However, this does not mean that an entity can only designate hedging relationships that exactly mirror its risk management activities.
In fact, in many cases entities will designate so called proxy hedges (i.e., designations that do not exactly represent the actual risk management). During the redeliberations leading to the final standard, the Board decided that proxy hedging is permitted, provided the designation is ‘directionally consistent’ with the actual risk management activities. The examples below are common proxy hedging designations. [IFRS 9 6.6.1(c)] Designating proxy hedges
Common proxy hedging designations
Net position cash flow hedging
IFRS 126.96.36.199(c) limits the designation of net positions in cash flow hedges to hedges of foreign exchange risk (discussed in Cash flow hedge for a net provision). However, in practice, entities often hedge other types of risk on a net cash flow basis. Such entities could still designate the net position as a gross designation.
An entity holds Australian Dollar (AUD)2m of variable rate loan assets and AUD10m of variable rate borrowings. The treasurer is hedging the cash flow risk exposure on the net position of AUD8m, by entering into a pay fixed/receive variable IRS with a nominal amount of AUD8m. The entity designates the IRS in a hedge of variable rate interest payments on a portion of AUD8m of its AUD10m borrowing.
Macro hedging strategies
Permitting proxy hedging is of particular relevance for banks wishing to apply macro cash flow hedging strategies. Typically, banks manage the interest margin risk resulting from fixed-floating mismatches of financial assets and financial liabilities held at amortised cost on their banking books. Assume the assets are floating and the liabilities are fixed. The fixed-floating mismatches are closed by entering into receive fixed/pay variable interest rate swaps.
There is no hedge accounting model that perfectly accommodates such hedges of the interest margin. Consequently, banks in such a scenario are forced to use either fair value hedge accounting for the liabilities or cash flow hedge accounting for the assets, although the actual risk management activity is neither to hedge fair values nor cash flows, but to hedge the interest margin. Both, cash flow hedge accounting and fair value hedge accounting would be directionally consistent with the risk management activity.
Background proxy hedging
An on-going analysis of the possible behaviour of the hedging relationship during its term is required in order to ascertain whether it can be expected to meet the risk management objective. Designating proxy hedges
Whilst the requirement for an economic relationship is new, it would be unlikely that an entity would use an instrument that did not provide a valid economic relationship for risk management purposes, and so this is unlikely to be an onerous requirement in most cases.
The Board has regarded ‘proxy hedging’ (which is a designation that does not exactly represent an entity’s actual risk management) as an eligible way of designating the hedged item under IFRS 9, as long as designation reflects the risk management in that it relates to the same type of risk that is managed and the instruments used for that purpose. As part of the basis for conclusions in IFRS 9, the Board included as an example the fact that because IFRS 9 (in the same way as IAS 39) does not allow cash flow hedges of interest rate risk to be designated on a net position basis, entities must instead designate part of the gross positions. Designating proxy hedges
This requires the use of proxy hedging, because the designation for hedge accounting purposes is on a gross position basis, even though risk management typically uses a net position basis. Designating proxy hedges
Corporates refer to proxy hedging where for example they hedge commodity price risk but as a result of the availability of commodity derivatives, entities use a hedging instrument referenced to a commodity different to the actual commodity they are economically hedging (for example, jet fuel as compared to Brent oil), but the price of the two commodities are correlated enough to make the hedge relationship work. Designating proxy hedges
In addition, some financial institutions use intra-group derivatives for risk management purposes. However, as intragroup derivatives do not qualify for hedge accounting, they are required to define external derivatives as proxy hedges. Designating proxy hedges
Also read: Company hedging policies
Designating proxy hedges
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