Hedged item – Cash flow hedges – Future interest flows

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

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 receives 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.

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.

In case 3, in which a layer is designated as the hedged item, IFRS 9 6.6.3 requires among 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.

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.

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