Hedge accounting requirements

Hedge accounting requirements

Hedge accounting requirements comprise the following items: Hedge accounting requirements

  • Formal designation and documentation of: Hedge accounting requirements
    • Risk management objective and strategy – Formal designation and documentation must be in place at the inception of the hedge relationship. Hedge accounting requirements

    • Hedging instrument – The main changes to hedging instruments in IFRS 9 are: how to account for the time value of options; the interest element of forward contracts; and the currency basis of cross-currency swaps when used as hedging instruments. Eligible hedging instruments are: Hedge accounting requirements
      • Derivative financial instruments. IFRS 9 does not restrict the circumstances in which a derivative can be designated as a hedging instrument (provided the hedge accounting criteria are met), except for some written options. Hedge accounting requirements
      • Non-derivative financial instruments measured at fair value through P&L. IFRS 9 allows non-derivative financial instruments as hedging instruments to hedge other risks if measured at fair value through P&L. The only exception is for financial liabilities accounted for at fair value for which the changes in the liability’s ownHedge accounting requirements credit risk are presented in OCI – these are not eligible for designation as hedging instruments.For financial instruments that an entity has originally elected to designate at inception at fair value through P&L to mitigate an accounting mismatch (commonly referred as the ‘fair value option’), a designation as hedging instruments is allowed only if such designation mitigates an accounting mismatch, without recreating another one (that is, no conflict should exist between the purpose of the fair value option and the purpose of hedge accounting).
      • Embedded derivatives. Under the requirements of IFRS 9 concerning the classification and measurement of financial instruments, embedded derivatives in financial assets are not accounted for separately. If there is an embedded derivative in a financial asset that would have been separated under IAS 39, the whole instrument will (in most cases) be carried at fair value through P&L.As a result, embedded derivatives in financial assets will no longer be eligible as hedging instruments on their own. As an alternative, entities could designate the instrument in its entirety (or a proportion of it) at fair value through P&L as a hedging instrument, as noted above. Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements                 However, entities should note that designation at fair value through P&L is allowed only at inception; therefore, they can do this only for new financial instruments.For financial liabilities, on the other hand, most of the classification and measurement requirements in IAS 39 have been transferred into IFRS 9, including the paragraphs for separating embedded derivatives that are not closely related to the host instrument.This means that derivatives embedded in financial liabilities continue to be separated in some circumstances. If an embedded derivative is separated from the host instrument and accounted for separately, it continues to be eligible as a hedging instrument.
      • Hedging with purchased options. IFRS 9 changed the accounting requirements on using purchased options as hedging instruments. It views a purchased option as similar to purchasing insurance cover with the time value being the associated cost. If an entity elects to designate only the intrinsic value of the option as the hedging instrument, it must account for the changes in the time value in OCI.This amount will be removed from OCI and recognised in P&L, either over the period of the hedge if the hedge is time related (for example, six-month fair value hedge of inventory), or when the hedged transaction affects P&L if the hedge is transaction related (for example, a forecast sale). This should result in less volatility in P&L for these option-based hedges, and it removes an obstacle to sensible risk management practice. Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements                                          An entity needs to take into consideration that, once it designates the intrinsic value of the option, the accounting introduced by IFRS 9 is not optional, but mandatory. In addition, the aforementioned accounting for the initial time value of purchased options applies only to the extent that the time value relates to the hedged item. This is called the ‘aligned time value’. Where the hedging instrument and hedged item are not fully aligned, entities need to determine the aligned time value – that is, how much of the time value included in the premium paid (actual time value) relates to the hedged item – and apply this accounting treatment to that portion. This can be determined using the valuation of the option that would have critical terms that perfectly match the hedged item. The residual amount is recognised in P&L. Hedge accounting requirements
      • Hedging with forward contracts. A forward is a contract to exchange a fixed amount of a financial or non-financial asset on a fixed future date at a fixed price. The fair value of a forward contract is affected by changes in the spot rate and changes in the forward points (in the case of an FX forward contract, the forward points arise from the interest rate differential between currencies specified in a forward contract).For hedges of foreign currency risk, an entity has a choice of whether to hedge using either the forward rate or the spot rate:
        • If the forward rate is used, the entity is hedging with the full fair value of the forward contract. Changes in the fair value of the forward are accounted for in accordance with the type of hedge (such as fair value hedge or cash flow hedge). In this type of designation, some ineffectiveness would generally arise if the hedged item is not similarly affected by interest rate differentials (inherited from IAS 39).
        • Where an entity designates only the change in the value of the spot element as the hedging instrument, the entity is only concerned about movements in the spot rate (and not changes due to interest rates, which is the forward element). Changes in the spot rate are part of the hedge relationship, and so they are accounted for in accordance with the type of hedge, whereas the changes in fair value due to the forward points are immediately recognised in P&L (inherited from IAS 39).
        • Where an entity designates only the change in the spot element as the hedging instrument an additional accounting approach exists for the forward element of the forward contracts (as compared to IAS 39 accounting). Even though a forward contract can be considered to be related to a time period, IFRS 9 states that the relevant aspect for its accounting is the characteristic of the hedged item and how it affects profit or loss.An entity must assess the type of hedge on the basis of the nature of the hedged item, regardless of whether the hedging relationship is a cash flow hedge or a fair value hedge. Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements                       An entity assesses whether the hedge is transaction related (for example, the hedge of a forecast purchase ofHedge accounting requirements inventory in foreign currency) or whether it is time- period related (for example, a hedge of the fair value of commodity inventory for the next six months using a commodity forward contract) (nature of risk being hedged). The accounting treatment to be applied to the forward element of a forward contract is the same as for the time value of hedging with options. However, unlike the accounting for options, this accounting treatment is optional rather than mandatory. This additional approach helps to reduce volatility in P&L as compared to the accounting under IAS 39 (new in IFRS 9). Hedge accounting requirements
      • Accounting for currency basis spreads. IFRS 9 states that a hypothetical derivative cannot include features that do not exist in the hedged item. It clarifies that a hypothetical derivative cannot simply impute a charge for exchanging different currencies (that is, the currency basis spread), even though actual derivatives under which different currencies are exchanged might include such a charge (for example, cross-currency interest rate swaps). Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Under IFRS 9, where an entity separates the foreign currency basis spread from a financial instrument and excludes it from the designation of that financial instrument as the hedging instrument, the entity can account for the changes in the currency basis spread in the same manner (that is, transaction related or time-period related) as applied to the forward element of a forward contract.
    • Nature of risk being hedged – An entity assesses whether the hedge is transaction related (for example, the hedge of a forecast purchase of inventory in foreign currency) or whether it is time- period related (for example, a hedge of the fair value of commodity inventory for the next six months using a commodity forward contract). The accounting treatment to be applied to the forward element of a forward contract is the same as for the time value of hedging with options. However, unlike the accounting for options, this accounting treatment is optional rather than mandatory.
    • Hedge effectiveness (including sources of ineffectiveness and how the hedge ratio is determined) – IFRS 9 does not prescribe a specific method for assessing whether a hedging relationship meets the hedge effectiveness requirements. An entity must use a method that captures the relevant characteristics of the hedging relationship, including the sources of hedge ineffectiveness that are expected to affect the hedging relationship during its term. Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Depending on those factors, entities can perform either a qualitative or a quantitative assessment. For example, in aHedge accounting requirements simple hedge where all the critical terms match (or are only slightly different), a qualitative test might be sufficient. On the other hand, in highly complex hedging strategies, some type of quantitative analysis would likely need to be performed.The assessment relates to expectations about hedge effectiveness, and so is only forward looking. Such assessment should be performed at inception and on an on-going basis at each reporting date or on a significant change in circumstances, whichever comes first. The intention behind these requirements is to ensure that only economically viable hedging strategies (that is, those reflecting the underlying economic relationship and aligned to the risk management strategy) qualify for hedge accounting purposes. Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements Hedge accounting requirements One of the more onerous requirements of IAS 39 is that the hedge relationship should be expected to be highly effective (in other words, entities are required to perform quantitative assessments on a prospective and retrospective basis, to demonstrate that actual results of the hedge are within a range of 80-125% effectiveness). This meant that many valid economic hedges failed because they were not close enough for hedge accounting purposes. As described above, IFRS 9 relaxes the requirements for hedge effectiveness, removing the 80-125% bright line.

    • Hedged item – changes primarily remove restrictions that prevent some economically rational hedging strategies from qualifying for hedge accounting. The following are eligible hedged item:
      • a hedged item can be a recognised asset or liability, an unrecognised firm commitment, a forecast transaction or a net investment in a foreign operation. The hedged item can be:
        • A single item, or Hedge accounting requirements
        • A group of items. Hedge accounting requirements

If the hedged item is a forecast transaction, it must be highly probable.

      • Risk components of non-financial items. Under IFRS 9, risk components can be designated for non-financial hedged items (as well as financial hedged items as well as a mix of both), 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.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. Hedge accounting requirements

        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. Hedge accounting requirements

        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. Hedge accounting requirements

      • 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. To illustrate what is meant by a net position, consider the following example.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).

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.
    • Hedging layers of a group. 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 remeasure 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.

    • Aggregated exposures. An aggregated position that incorporates a derivative along with a non-derivative exposure can be designated as a hedged item.

  • Hedging relationship consists only of eligible hedging instruments and eligible hedged items (see above)

  • Hedge effectiveness requirements (prospective). These are the three requirements for a hedge in IFRS 9:
    • Economic relationship exists – IFRS 9 requires the existence of an economic relationship between the hedged item and the hedging instrument. So there must be an expectation that the value of the hedging instrument and the value of the hedged item would move in the opposite direction as a result of the common underlying or hedged risk. For example, this is the case for forecast fixed interest payments and an interest rate swap that receives fixed interest payments and pays variable interest.
    • Credit risk does not dominate value changes – Even if there is an economic relationship, a change in the credit risk of the hedging instrument or the hedged item must not be of such magnitude that it dominates the value changes that result from that economic relationship. Because the hedge accounting model is based on a general notion of there being an offset between the changes of the hedging instrument and those of the hedged item, the effect of credit risk must not dominate the value changes associated with the hedged risk; otherwise, the level of offset might become erratic.

      For example, where an entity wants to hedge its forecast inventory purchases for commodity price risk, it enters into a derivative contract with Bank X to purchase a commodity at a fixed price and at a future date. If the derivative contract is uncollateralised and Bank X experiences a severe deterioration in its credit standing, the effect arising from changes in credit risk might have a disproportionate effect on the change in the fair value of the derivative contract arising from changes in commodity prices; whereas the changes in the value of the hedged item (forecast inventory purchases) would depend largely on the commodity price changes and would not be affected by the changes in the credit risk of Bank X.

    • Designated hedge ratio is consistent with risk management strategy – The hedge ratio is defined as the relationship between the quantity of the hedging instrument and the quantity of the hedged item in terms of their relative weighting. IFRS 9 requires that the hedge ratio used for hedge accounting purposes should be the same as that used for risk management purposes.One of the key objectives in IFRS 9 was to align hedge accounting with risk management objectives. There is no retrospective effectiveness testing required under IFRS 9, but there is a requirement to make an on-going assessment of whether the hedge continues to meet the hedge effectiveness criteria, including that the hedge ratio remains appropriate.This means that entities will have to ensure that the hedge ratio is aligned with that required by their economic hedging strategy (or risk management strategy).A deliberate imbalance is not permitted. This requirement is to ensure that entities do not introduce a mismatch of weightings between the hedged item and the hedging instrument to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting. This does not imply that the hedge relationship must be perfect, but only that the weightings of the hedging instruments and hedged item actually used are not selected to introduce or to avoid accounting ineffectiveness.In some cases, there are commercial reasons for particular weightings of the hedged item and the hedging instrument even though they create hedge ineffectiveness.This is the case, for example when using standardised contracts that have a defined contract size (for instance, 1 standard aluminium future contract in the LME has a contract size of 25 tonnes). When an entity wants to hedge 90 tonnes of aluminium purchases with standard aluminium future contracts, due to the standard contract size, the entity could use either 3 or 4 future contracts (equivalent to a total of 75 and 100 tonnes respectively).

      Such designation would result in a hedge ratio of either 0.83:1 or 1.11:1. In that situation the entity designates the hedge ratio that it actually uses, because the hedge ineffectiveness resulting from the mismatch would not result in an accounting outcome that is inconsistent with the purpose of hedge accounting. Hedge ineffectiveness is still required to be measured and accounted for in P&L.

  • 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 and whether the hedge continues to meet the hedge effectiveness criteria, including that the hedge ratio remains appropriate.

Examples Hedging layers of a group

When an entity has an option to prepay a loan, at fair value, the fair value of the option is not affected by changes in the hedged risk. Consequently, an entity would be able to designate a hedge as described in this example: Hedge accounting requirements

Hedging a top layer of a loan

An entity borrows money by issuing a CU10m five-year fixed rate loan. The entity has a prepayment option to pay back CU5m at fair value. The entity wants to be able to make use of the prepayment option without the amount repayable on early redemption being affected by interest rate changes.

Consequently, the entity would like to hedge the fair value interest rate risk of the prepayable part of the loan. To achieve this, the entity enters into a five-year receive fixed/pay variable Interest Rate SWAP (IRS) with a notional amount of CU5m.

The entity designates the IRS in a fair value hedge of the interest rate risk of the CU5m top layer of the loan attributable to the benchmark interest rate. As a result, the top layer is adjusted for changes in the fair value attributable to changes in the hedged risk. The bottom layer, which cannot be prepaid, remains at amortised cost.

The gain or loss on the IRS will offset the change in fair value on the top layer attributable to the hedged risk. On prepayment, the fair value hedge adjustment of the top layer is part of the gain or loss on the early repayment of the loan.

This example above, of a hedge of a top layer of a loan, would not often be found in practice as most prepayment options in loan agreements allow, in our experience, for prepayment at the nominal amount (instead of at fair value). Hedge accounting requirements

Should prepayment be at the nominal amount, the fair value of the prepayment option would be affected by changes in the hedged interest rate risk. Therefore, the top layer would not normally qualify for hedge accounting. However, such a layer will still qualify for hedge accounting if the effect of the related prepayment option is included when measuring the fair value change of the hedged item. Hedge accounting requirements

So, bottom layer hedging strategies can be applied if the hedged layer is not affected by the prepayment risk. This is best demonstrated based on the example below, making use of the new IFRS 9 designation for nominal components. Hedge accounting requirements

Hedging a bottom layer of a loan portfolio (IFRS 9)

A bank holds a portfolio of fixed rate loans with a total nominal amount of CU100m. The borrowers can, at any time during the tenor, prepay 20% of their (original) loan amount at par.

For risk management purposes, the loans are considered together with variable rate borrowings of CU100m. As a result, the bank is exposed to an interest margin risk resulting from the fixed-to-floating rate mismatch. The bank expects CU20m of loans to be prepaid.

As part of the risk management strategy, the bank decides to hedge a part of the interest margin by entering into a pay fixed/receive variable IRS. The objective is to hedge 95% of the amount of loans that is not prepayable using an IRS with a notional amount of CU76m. The hedged layer does not include a prepayment option. Therefore, the IRS is designated in a fair value hedge of the interest rate risk of the CU76m bottom layer of the CU100m loan portfolio.

As a result, the bottom layer is adjusted for changes in the fair value attributable to changes in the hedged risk (i.e., benchmark interest rate risk). The extent to which the borrowers exercise their prepayment option does not affect the hedging relationship. Also, if the bank were to derecognise any of the loans for any other reason, the first CU4m of non-prepayable amount of derecognised loans would not be part of the hedged item (i.e., the CU76m bottom layer).

As mentioned above, IFRS 9 does not preclude hedge accounting for layers including a prepayment option. However, changes in fair value of the prepayment option as a result of changes in the hedged risk have to be included when measuring the change in fair value of the hedged item. The following example illustrates what this means in practice: Hedge accounting requirements

Hedging a bottom layer including prepayment risk

A bank originates a CU10m five-year fixed rate loan with a prepayment option to pay back CU5m at any time at par.Hedge accounting requirements

For risk management purposes, the loan is considered together with variable rate borrowings of CU10m. As a result, the bank is exposed to an interest margin risk resulting from the fixed-to-floating rate mismatch. The bank expects the borrower to prepay CU2m and, therefore, wishes to hedge CU8m only.

The bank enters into a five-year pay fixed/receive variable IRS with a notional amount of CU8m and designates CU5m of the IRS in a fair value hedge of the benchmark interest rate risk of the CU5m layer of the non-prepayable loan amount. In addition, the bank enters into a swaption with a notional amount of CU3m that is jointly designated with CU3m of the IRS to hedge the benchmark interest rate risk of the last remaining CU3m of the CU5m prepayable amount of the loan (a bottom layer).

As a result, the non-prepayable loan amount is adjusted for changes in the fair value attributable to changes in the hedged risk (the fixed rate benchmark interest rate risk of a fixed term instrument). However, the CU3m bottom layer of the prepayable amount also needs to be adjusted for the effect of the prepayment option on the changes in the fair value attributable to changes in the interest rate risk. The CU2m top layer remains at amortised cost.

Therefore, the first CU2m of prepayments would have a gain or loss on derecognition determined as the difference between the amortised cost of the prepaid amount and par. For any further prepayments exceeding CU2m, the gain or loss on derecognition would be determined as the difference between the amortised cost including the fair value hedge adjustment and par.

Also read: Hedge accounting requirements

Hedge accounting requirements

Hedge accounting requirements

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