Excellent Study IFRS 9 Eligible Hedged items

IFRS 9 Eligible Hedged items

the insured items of business risk exposures

Although the popular definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a real-world hedge.

Every entity is exposed to business risks from its daily operations. Many of those risks have an impact on the cash flows or the value of assets and liabilities, and therefore, ultimately affect profit or loss. In order to manage these risk exposures, companies often enter into derivative contracts (or, less commonly, other financial instruments) to hedge them. Hedging can, therefore, be seen as a risk management activity in order to change an entity’s risk profile.

The idea of hedge accounting is to reduce (insure) this mismatch by changing either the measurement or (in the case of certain firm commitments) FRS 9 Eligible Hedged itemsrecognition of the hedged exposure, or the accounting for the hedging instrument.

The definition of a Hedged item

A hedged item is an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that

  1. exposes the entity to risk of changes in fair value or future cash flows and
  2. is designated as being hedged

The hedge item can be:

Only assets, liabilities, firm commitments and forecast transactions with an external party qualify for hedge accounting. As an exception, a hedge of the foreign currency risk of an intragroup monetary item qualifies for hedge accounting if that foreign currency risk affects consolidated profit or loss. In addition, the foreign currency risk of a highly probable forecast intragroup transaction would also qualify as a hedged item if that transaction affects consolidated profit or loss. These requirements are unchanged from IAS 39.

Risk components of non-financial items

Under IAS 39, only risk components of financial items (such as the LIBOR rate in a loan that bears interest at a floating rate of LIBOR plus a spread) could be designated as a hedged item, provided they are separately identifiable and reliably measurable.

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).

Entities that hedge commodity price risk that is only a component of the overall price risk of the item, are likely to welcome the ability to hedge separately identifiable and reliably measurable components of non-financial items.

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An example of a contractually specified risk component that you could 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.

When identifying the non-contractually specified risk components that are eligible for designation as a hedged item, entities need to assess such risk components within the context of the particular market structure to which the risks relate and in which the hedging activity takes place. Such a determination requires an evaluation of the relevant facts and circumstances, which differ by risk and market.

The Board believes that there is a rebuttable presumption that, unless inflation risk is contractually specified, it is not separately identifiable and reliably measurable, and so it cannot be designated as a risk component of a financial instrument.

However, the Board considers that, in limited cases, it might be possible to identify a risk component for inflation risk, and provides the example of environments in which inflation-linked bonds have a volume and term structure that result in a sufficiently liquid market that allows a term structure of zero-coupon real interest rates to be constructed.

Food for thought

Although allowing hedges of risk components of non-financial item is very beneficial for entities, the wording in IFRS 9 is unclear. IFRS 9 requires an entity to assess risk components (that are separately identifiable and reliably measurable) within the context of the particular market structure to which the risk or risks relate and in which the hedging activity takes place. However, there are no criteria specified to be used in the analysis of the market structure, nor are there any definitions of the market to be analysed.

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
  • 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’.

Case – 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 contracts for coal loaded at the Newcastle Coal Terminal in Australia, plus a logistic 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 its self against the 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 future 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 the variability in the coals 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.

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.

Something else -   Reclassification adjustments

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

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 is 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 in ‘Contractually specified risk components‘. 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.

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

Case – Hedge of a non-contractually specific risk component – coffee purchases with a bench mark price risk component

Coffee physical trading Delivery versus Hedging
Coffee physical delivery and Hedging

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.

Note

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 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.

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 of 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.

Food for thought

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).

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IFRS 9 Inflation as a risk component

Under IAS 39, inflation cannot be designated as a hedged risk component for financial instruments, unless the inflation risk compoIFRS 9 Eligible Hedged itemsnent is contractually specified. For non-financial instruments, inflation risk cannot be designated under IAS 39 as a risk component at all.

For financial instruments, IFRS 9 introduces a rebuttable presumption that, unless contractually specified, inflation is not separately identifiable and reliably measureable. This means that there are limited cases under which it is possible to identify a risk component for inflation and designate that inflation component in a hedging relationship. Similar to other non-contractually specified risk components, the analysis would have to be based on the particular circumstances in the respective market, which is, in this case, the debt market.

The example below, derived from the application guidance of IFRS 9, explains a situation in which the presumption that inflation does not qualify as a risk component of a financial instrument can be rebutted.

Case – Inflation as eligible risk component of a debt instrument

An entity wishes to hedge the inflation risk component of a debt instrument. The debt instrument is issued in a currency and country in which inflation-linked bonds are actively traded in a significant volume. the volume, liquidity and term structure of these inflation-linked bonds allow the computation of a real interest yield curve. This situation support that inflation is a factor that is separately considered in the debt market in a way that it is a separately identifiable and reliable measurable risk component.

Note

For financial instruments, IFRS 9 opens the door for designating a non-contractually specified inflation component as a hedged risk component – but only in limited circumstances. For non-financial instruments, the inflation component will be eligible for designation as the hedged item in a hedging relationship provided that it is separately identifiable and reliably measurable.

There are not many currencies with a liquid market for inflation-linked debt instruments, therefore, limiting the availability of designating non-contractually specified inflation risk of financial instruments.

IFRS 9 does not specify whether the analysis of inflation as eligible risk component has to be made by currency or by country, or both. This is particularly relevant for countries forming a monetary union together with other countries, but having different inflation rates (e.g., within the Eurozone). The relevant ‘market structure’ for inflation will usually be given by the currency.

While IFRS 9 defines in what circumstances inflation can be a risk component for a financial instrument, inflation can, in future, be treated as a risk component for non-financial items in the same manner as any other risk component (as described in ‘Contractually specified risk components‘ and ‘Non-contractually specified risk components’, i.e., the rebuttable presumption described in this section applies only to financial instruments). For example, a contractually specified inflation risk component would normally qualify as a hedged item (e.g., a sales contract with a price formula linked to the consumer price index) under IFRS 9, whereas it would not under IAS 39.

The ‘sub-LIBOR issue’

Some financial institutions are able to raise funding at interest rates that are below a benchmark interest rate (e.g., LIBOR minus 15 basis points IFRS 9 Eligible Hedged items(bps)). In such a scenario, the entity may wish to remove the variability in future cash flows caused by movements in LIBOR benchmark interest rates. However, IFRS 9, like IAS 39, does not allow the designation of a ‘full’ LIBOR risk component (i.e., LIBOR flat), as a component cannot be more than the total cash flows of the entire item. This is often referred to as the ‘sub-LIBOR issue’.

The reason for this restriction is that a contractual interest rate cannot normally be less than zero. Hence, for a borrowing at, say, LIBOR minus 15bps, if benchmark interest rates fall below 15bps, any further reduction in the benchmark would not cause any cash flow variability for the hedged item.

Consequently, any designated component has to be less than or equal to the cash flows of the entire item.

In the above scenario, where the interest rate is at LIBOR minus 15bps, the entity could instead designate, as the hedged item, the variability in cash flows of the entire liability (or a proportion of it) that is attributable to LIBOR changes. This would result in some ineffectiveness for financial instruments that have an interest rate ‘floor’ of zero in situations in which the forward curve for a part of the remaining hedged term is below 15bps because the hedged item will have less variability in cash flows as a result of interest rate changes than a swap without such a floor.

Something else -   What is Useful Financial Information?

The sub-LIBOR issue is also applicable to non-financial items where the contract price is linked to a benchmark price minus a differential. This is best demonstrated using an example derived from the application guidance of IFRS 9.

Case – Sub-LIBOR issue – Selling crude oil at below benchmark price

Assume an entity has a long-term sales contract to sell crude oil of a specific quality to a specified location. The contract includes a clause that sets the price per barrel at West Texas Intermediate (WTI) minus USDE 10 with a minimum price of USD30. The entity wishes to hedge the WTI benchmark price risk by entering into a WTI future. As outline above, the entity cannot designate a full WTI component, i.e., a WTI component that ignores the price differential and the minimum price.

However, the entity could designate the WTI future as a hedge of the entire cash flow variability under the sales contract that is attributable to the change on the benchmark price. When doing so, the hedged item would have the same cash flow variability as a sale of crude oil at the WTI price (or above), as long as the forward price for the remaining hedged term does not fall below USD40.

IFRS 9 Hedging groups of net positions

IFRS 9 provides more flexibility for hedges of groups of items, although, as noted earlier, it does not cover macro hedging. Treasurers commonly group similar risk exposures and hedge only the net position and so IFRS 9 allows the potential to align the accounting approach with the risk management strategy.

For cash flow hedges of a group of items that are expected to affect P&L in different reporting periods, the qualifying criteria are:

  • Only hedges of foreign currency risk are allowed.
  • The items within the net position must be specified in such a way that the pattern of how they will affect P&L is set out as part of the initial hedge designation and documentation (this should include at least the reporting period, nature and volume).

Food for thought

The ability to hedge net positions under IFRS 9 is a step forward, in that it allows hedge designation in a way that is consistent with an entity’s risk management strategy. However, IFRS 9 requires the presentation of the gains and losses on recycling as a separate line item in P&L (separate from the hedged items), and so it does not allow an entity to present the post-hedging results of its commercial activities for those line items. This may mean the ability to hedge net positions is not as widely used as it might otherwise have been.

In addition, net nil positions (that is, where hedged items among themselves fully offset the risk that is managed on a group basis) are now allowed to be designated in a hedging relationship that does not include a hedging instrument, provided that all the following criteria are met:

  • The hedge is part of a rolling net risk hedging strategy (that is, the entity routinely hedges new positions of the same type);
  • The hedged net position changes in size over the life, and the entity uses eligible hedging instruments to hedge the net risk;
  • Hedge accounting is normally applied to such net positions; and
  • Not applying hedge accounting to the net nil position would give rise to inconsistent accounting outcomes.

The Board expects that hedges of net nil positions would be coincidental and therefore rare in practice.

IFRS 9 Hedging layers of a group

IAS 39 allowed hedging layers of a group in very limited circumstances (for example, in specified cash flow hedges). IFRS 9 allows a layer of a group to be designated as the hedged item. A layer component can be specified from a defined, but open, population or from a defined nominal amount. Examples include:

  • A part of a monetary transaction volume (such as the next CU10 cash flows from sales denominated in a foreign currency after the first CU20 in March 201X);
  • A part of a physical or other transaction volume (such as the first 100 barrels of the oil purchases in June 201X, or the first 100 MWh of electricity sales in June 201X); or
  • A layer of the nominal amount of the hedged item (such as the last CU80 million of a CU100 million firm commitment, or the bottom layer of CU20 million of a CU100 million fixed rate bond, where the defined nominal amount is CU100 million).

If a layer component is designated in a fair value hedge, an entity must specify it from a defined nominal amount. To comply with the requirements for qualifying fair value hedges, an entity must re-measure the hedged item for fair value changes attributable to the hedged risk. The fair value adjustment must be recognised in P&L no later than when the item is derecognised.

Therefore, it is necessary to track the item to which the fair value hedge adjustment relates. Entities are required to track the nominal amount from which the layer is defined in order to track the designated layer (for example, the total defined amount of CU100 million sales must be tracked in order to track the bottom layer of CU20 million sales or the top layer of CU30 million sales).

A layer of a contract that includes a prepayment option (if the fair value of the prepayment option is affected by changes in the hedged risk) is only eligible as a hedged item in a fair value hedge if the layer includes the effect of the prepayment option when determining the change in fair value of the hedged item. In this situation, if an entity hedges with a hedging instrument that does not have option features that mirror the layer’s prepayment option, hedge ineffectiveness would arise.

IFRS 9 Hedging aggregated exposures

Entities often purchase or sell items (in particular, commodities) that expose them to more than one type of risk. When hedging those risk exposures, entities do not always hedge each risk for the same time period. This is best explained with an example:

Case – Aggregated exposure – copper purchase in a foreign currency

An entity manufacturing electrical wires is expecting to purchase copper in 12 months. The copper price is fluctuating and is denominated in US dollars (USD), which is a foreign currency for the entity. The entity is exposed to two main risks, the copper price risk and the foreign currency risk.

The entity first decides to hedge the copper price fluctuation risk using a copper futures contract. By doing so, the entity now has a fixed-price copper purchase denominated in a foreign currency and is therefore still exposed to foreign exchange risk <fn>for simplicity it is assumed there is no basis risk between the copper price exposures in the expected purchase and the future contract such as the effect of quality and the location of delivery</fn>.

Three months later, the entity decides to hedge the foreign exchange risk by entering into a foreign exchange forward contract to buy a fixed amount of USD in nine months. By doing so, the entity is hedging the aggregated exposure, which is the combination of the original exposure to variability of the copper price and the copper price futures contract.

IAS 39 precluded derivatives from being designated as part of a hedged item for accounting purposes. Applying IAS 39 to the scenario in the case above, an entity would have two choices:

  • Discontinue the first hedging relationship (i.e., the copper price risk hedge) and re-designate a new relationship with joint designation of the copper futures contract and the foreign exchange forward contract as the hedging instrument. This is likely to lead to some ‘accounting’ hedge ineffectiveness as the copper futures contract will now have a non-zero fair value on designation of the new relationship.

Or

  • Maintain the copper price risk hedge and designate the foreign exchange forward contract in a second relationship as a hedge of the variable USD copper price. Even if the other IAS 39 requirements could be met, this means that the volume of hedged item is constantly changing as the variable copper price is hedged for foreign exchange risk, which will likely have an impact on the effectiveness of the hedging relationship.

IFRS 9 expands the range of eligible hedged items by including aggregated exposures that are a combination of an exposure that could qualify as a hedged item and a derivative.

Consequently, in the scenario described in the case above, the entity could designate the foreign exchange forward contract in a cash flow hedge of the combination of the original exposure and the copper futures contract (i.e., the aggregated exposure) without affecting the first hedging relationship. In other words, it would no longer be necessary to discontinue and re-designate the first hedging relationship.

The individual items in the aggregated exposure are accounted for separately, applying the normal requirements of hedge accounting (i.e., there is no change in the unit of accounting; the aggregated exposure is not treated as a ‘synthetic’ single item).

For example, when hedging a combination of a variable rate loan and a pay fixed/receive variable interest rate swap (IRS), the loan would still be accounted for at amortised cost with the IRS presented separately in the statement of financial position. An entity would not be allowed to present the IRS and the loan (i.e., the aggregated exposure) together in one line item (i.e., as if it were one single fixed rate loan).

However, when assessing the effectiveness and measuring the ineffectiveness of a hedge of an aggregated exposure, the combined effect of the items in the aggregated exposure has to be taken into consideration.

This is of particular relevance if the terms of the hedged item and the hedging instrument in the first hedging relationship do not perfectly match, e.g., if there is basis risk. Any ineffectiveness in the first level relationship would automatically also lead to ineffectiveness in the second level relationship.

Basis risk, in the context of hedge accounting, refers to any difference in the underlyings of the hedging instrument and the hedged item. Basis risk usually results in a degree of hedge ineffectiveness. For example, hedging a cotton purchase in India with NYMEX cotton futures contracts is likely to result in some ineffectiveness, as the hedged item and the hedging instrument do not share exactly the same underlying price.

Something else -   Example fair value hedge - How 2 best understand it

The following examples, partly derived from illustrative examples in the implementation guidance of IFRS 9, help to further explain the concept of a hedge of an aggregated exposure:

Case – Fixed rate loan in a foreign currency – cash flow hedge of an aggregated exposure

An entity has a fixed rate borrowing denominated in a foreign currency and is therefore exposed to foreign excahnge risk and fair value risk due to changes in interest rates. The entity decides to swap the borrowing into a functional currency floating rate borrowing using a cross currency interest rate swap (CCIRS). The CCIRS is designated as hedging instrument in a fair value hedge (first-level relationship).

By doing so, the entity has eliminated both the foreign exchange risk and the fair value risk due to changes in interest rates. However, it is now exposed to variabele functional currency interest payments.

Later, the entity decides to fix the amount of functional currency interest payments by entering into a IRS to pay fix and receive floating interest in its functional currency. By doing so, the entity is hedging the aggregated exposure, which is the combination of the original exposure and the CCIRS. The IRS is designated as a hedging instrument in a cash flow hedge (second-level relationship).

Case – Floating rate loan in a foreign currency – fair value hedge of an aggregated exposure

An entity has a floating rate borrowing denominated in a forei9gn currency and is therefore exposed to foreign exchange risk and cash flow risk due to the changes in interest rates. The entity decides to swap the borrowing rate into a functional currency fixed rate borrowing using a cross currency interest rate swap (CCIRS).

The CCIRS is designated as hedging instrument in a cash flow hedge (first-level relationship). By doing so, the entity has eliminated both the foreign exchange risk and the cash flow risk due to changes in interest rates. However, it is now exposed to a fair value risk resulting from changes in the functional currency interest rate curve.

Later, the entity decides to hedge this fair value risk and enters into an IRS that receives fixed rate and pays floating rate interest in its functional currency. By doing so, the entity is hedging the aggregated exposure, which is the combination of the original exposure and the CCIRS. The IRS is designated as a hedging instrument in a fair value hedge (second-level relationship).

The concept of hedging aggregated exposures as such is straightforward. However, the accounting for such relationships includes some (necessary) complexity. The accounting mechanics are explained in detail in the illustrative examples in paragraphs IE7-IE39 of the implementation guidance of IFRS 9.

In the last Case – ‘Floating rate loan in a foreign currency – fair value hedge of an aggregated exposure‘ above, where an entity has a cash flow hedge in the first-level relationship that is then designated as the hedged item in a fair value hedge, the cross-currency interest rate swap is both a hedging instrument and part of a hedged item at the same time but in different hedging relationships.

Its fair value changes are recognised in OCI, but at the same time, should also offset the fair value changes in profit or loss of the interest rate swap in the second-level relationship. This requires a reclassification of the amounts recognised in OCI to profit or loss (to the extent they relate to the second-level relationship) to achieve the offset in the fair value hedging relationship.

As explained in the illustrative examples in the implementation guidance, the application of hedge accounting to an aggregated exposure gets even more complicated when basis risk is involved in one of the hedging relationships, in particular if basis risk is present in the first-level relationship.

The definition of an aggregated exposure includes a forecast transaction of an aggregated exposure. An example, where this might be helpful is when pre-hedging the interest rate risk in a forecast foreign currency debt issue:

Case – Aggregated exposure – interest rate pre-hedge of forecast foreign currency debt issue

Assume it is highly probable that an entity will issue fixed rate foreign currency debt in six month’s time. It is also highly probable that on issuance the entity will transact a cross currency interest rate swap (CCIRS), converting the debt to functional currency variable rate. The combination of the forecast foreign currency fixed rate debt issuance and the forecasted conclusion of the CCIRS is a forecast functional currency variable rate debt issuance.

The entity wishes to hedge itself against increases in the variable functional currency interest rate between today and the issue of the debt in six months as well as over the term of the debt.

Therefore, the entity enters into a forward starting pay fixed/receive variable IRS. The entity designates the IRS as a hedging instrument in a cash flow hedge of the forecasted aggregated exposure.

As an aggregated exposure is a combination of an exposure and a derivative, the aggregated exposure is often a hedging relationship itself (the first-level relationship). IFRS 9 only requires the first-level relationship to be one that could qualify for hedge accounting.

The application of hedge accounting for the first-level relationship is not required in order to qualify for hedge accounting for the aggregated exposure. However, applying hedge accounting to the aggregated exposure is more complex when hedge accounting is not applied to the first-level relationship.

Hedges of exposures affecting other comprehensive income

Only hedges of exposures that could affect profit or loss qualify for hedge accounting. The sole exception to this rule is when an entity is hedging an investment in equity instruments for which it has elected to present changes in fair value in OCI, as permitted by IFRS 9. Using that election, gains or losses on the equity investments will never be recognised in profit or loss.

For such a hedge, the fair value change of the hedging instrument is recognised in OCI. Ineffectiveness is also recognised in OCI. On sale of the investment, gains or losses accumulated in OCI are not reclassified to profit or loss.

Consequently, the same also applies for any accumulated fair value changes on the hedging instrument, including any ineffectiveness.

Q: Does IFRS 9 allow the following cash flow hedge designations of future interest flows?

Considerations:
Consider the following cases. Note: In all scenarios both the swap and the hedged debt are denominated in Company A’s functional currency.

Case 1
Company A enters into a forward starting swap in which it pays a fixed rate and Hedged item Cash flow hedges Future interest flowsreceives a floating interest rate to hedge a highly probable forecast debt issuance. The date of issuance is known, but it is not known whether the debt will be at fixed– or floating– rates. Company A designates the swap as a cash flow hedge of the variability in cash flows of the debt to be issued, due to changes in interest rates. As a result, the company considers the following:

  • If the forecast issuance is at fixed rate, the swap will be terminated (or an opposing swap with the same residual maturity will be taken out to close the swap position) and hedge accounting will be discontinued.
  • If the forecast issuance is at floating–rate, then the hedge relationship is maintained with the existing swap and therefore hedge accounting will continue to be applied. Hedged item Cash flow hedges Future interest flows

Case 2
Company B enters into an interest rate swap in which it pays a fixed rate and receives a floating interest rate. Company B designates the swap as a cash flow hedge of the variability, due to changes in interest rates, of the cash flows resulting from a combination of current floating rate debt (with a maturity shorter than that of the swap), followed by a highly probable forecast issuance of either fixed or floating rate debt for the remaining term of the swap (the latter is similar to case 1).

Case 3
Company C enters into a similar structure as in case 2 above. However, in this case the precise date when the existing floating debt will be rolled over into either floating– or fixed–rate debt is not known. The company can demonstrate that it has a highly probable funding requirement of at least CU1 million throughout the life of the swap, which will be satisfied by issuing either fixed– or variable–rate debt. The swap is designated as a cash flow hedge of the variability of future interest cash flows on the first CU1 million of debt in issue over the life of the swap.

Consequential Explanation and Reasoning:
Yes, all of the above designations are allowed under IFRS 9 provided all the qualifying criteria in IFRS 9 6.4.1 are met, including for example that the intention to hedge changes in interest rates is in line with the entity’s risk management strategy. Entities may designate their hedge relationships in alternative ways depending on their facts and circumstances. Designation of the risks associated with forecast transactions is permitted as long as they are highly probable. Hedged item Cash flow hedges Future interest flows

In case 3, in which a layer is designated as the hedged item, IFRS 9 6.6.3 requires Promiseamong other aspects that the layer must be separately identifiable and reliably measurable. The forecast transaction must be identified and documented with sufficient specificity so that when the transaction occurs it is clear whether the transaction is or is not the hedged item. A drawback of designation of a layer is the complexity in proving that the designated level of funding is highly probable. Hedged item Cash flow hedges Future interest flows

For example, when entities specify the interest payment for a particular loan, then there is no need to prove that the cash flows are highly probable since those are contractually specified. When entities do not designate a specific contract then it is necessary to demonstrate that it is highly probable that there will be a need for a certain level of financing of a kind that meets the designated hedged item.

In all of the above cases, where the hedged item is issued floating–rate debt, ineffectiveness may arise, for example if the reset dates or interest basis of the swap differ from those of the issued debt.

Also read: Hedged items

IFRS 9 Eligible Hedged items

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Something else -   Contractually specified risk components
RS 9 Eligible Hedged items IFRS 9 Eligible Hedged items

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