Foreign currency forward contracts

Foreign currency forward contracts is about one of the other changes from IAS 39 to IFRS 9 in respect of hedge accounting Foreign currency forward contracts

What is a forward element of forward contracts?

A forward exchange contract is a special type of foreign currency transaction. Forward contracts are agreements between two parties to exchange two designated currencies at a specific time in the future. These contracts always take place on a date after the date that the spot contract settles and are used to protect the buyer from fluctuations in currency prices. Foreign currency forward contracts

Forward contracts are not traded on exchanges, and standard amounts of currency are not traded in these agreements. Forward exchange contracts are a mutual hedge against risk as it protects both parties from unexpected or adverse movements in the currencies’ future spot rates.

The change from IAS 39 to IFRS 9

Under IAS 39, entities using foreign currency forward contracts in hedging relationships can designate the instrument in its entirety or designate the spot element only. Designating the spot element only results in the forward points (often also called the ‘forward element’) to be accounted for at fair value.

When designating the entire instrument, IAS 39 allows the hedged item alternatively to be measured at the forward rate instead of the spot rate. For example, when hedging a highly probable forecast transaction, the hedged item, once transacted, would be measured at the forward rate at designation.

This is often referred to as the ‘forward rate method’. However, IAS 21 requires monetary financial assets and liabilities denominated in a foreign currency to be measured at the spot rate. As a result, the forward rate method does not provide a similar solution for hedges of such monetary items because of how IAS 21 works.

IFRS 9 introduces an optional treatment similar to the accounting for time value of options when the spot element only is designated. This is, however, not an accounting policy choice, but an election for each designation. Foreign currency forward contracts

When designating the spot element only, the change in fair value of the (actual) forward element is recognised in OCI and accumulated in a separate component of equity. The (aligned) forward element that exists at inception is amortised from the separate component of equity to profit or loss on a rational basis.

As a result of the above accounting, fluctuations in the fair value of the forward element over time will affect other comprehensive income only, while the amount recognised in profit or loss will be stable. Foreign currency forward contracts

Funding swaps – designating the spot risk only

A bank, having the Singapore Dollar (SGD) as its functional currency, borrows money by entering into a two-year fixed rate loan denominated in Japanese Yen (JPY). The bank transfers the JPY funds into its functional currency and lends the money as a SGD denominated two-year fixed rate loan. To hedge the SGD/JPY exchange risk, the bank enters into a foreign exchange forward contract to buy JPY against SGD in two years time. The fair value of the forward element at inception is SGD20,000 and it is SGD13,000 at the end of the first year.

From an economic standpoint, the bank has now hedged the foreign exchange risk and locked in the interest margin for the entire two-year period.

In economic theory, the forward points represent the difference in interest rates between the two currencies involved. Hence, the forward element that exists at inception is seen as one element of the interest margin (however, see Foreign currency basis spreads).

Applying the IFRS 9 accounting requirements to the forward element of the forward contract results in the following movement within OCI and the hedging reserve:

SGD ‘000 Foreign currency forward contracts

Year 1

Year 2

Reserve in equity at beginning of year Foreign currency forward contracts

3.0

Change in fair value of forward element

-7.0

-13.0

Amortisation of forward element at inception

10

10.0

Reserve in equity at end of year

3.0

Effect on OCI for the year

3.0

-3.0

Effect on profit or loss for the year

-10.0

-10.0

The bank would present the amortisation of the forward element in the income statement within the interest margin, together with the interest income from the loan and the interest expense from the borrowing, showing the economically fixed interest margin in SGD of the transaction.

 

Foreign currency forward contracts

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