Hedged item Risk components Market structure – Q: What is the relationship between a risk component in an eligible hedged component of a non-financial item and the market structure in which the hedging activity takes place? Hedged item Risk components Market structure
Considerations: Hedged item Risk components Market structure
To be eligible for designation as a hedged item, a risk component must be a separately identifiable component, and the changes in cash flows or fair value of the item attributable to a change in that component must be reliably measurable. (IFRS 9 paragraph B6.3.8). Hedged item Risk components Market structure
IFRS 9 requires the qualifying criteria for an eligible risk component to be assessed in the context of the particular market structure to which the risks relate and in which the hedging activity takes place (IFRS 9 paragraph B6.3.9). Hedged item Risk components Market structure
Consequential Explanation and Reasoning: Hedged item Risk components Market structure
In the case of a non-financial item, for there to be a hedgeable risk component it would generally be necessary for the price of the entire item to be built up from various components using a ‘building block’ approach to demonstrate an appropriate market structure.
For example, it should be clear that informed buyers and sellers of this non-financial item would consider the price of the component proposed to be hedged (such as raw materials) in establishing the price of the overall non-financial item. Consideration of the approach of other market participants is necessary to demonstrate that the market structure supports the designation as a risk component. Hedged item Risk components Market structure
The evidence required to support the market structure is a matter of judgment based on facts and circumstances, but should not rely solely on the entity’s own negotiating position or standard costing systems.
Market structure analysis
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.
For example, a manufacturer of woollen jumpers might want to hedge its exposure to wool prices. This manufacturer considers that wool prices are separately identifiable and reliably measurable because the amount of wool used in a jumper can be computed from product specifications and wool prices are available in the market.
Is the physical presence of wool in its products enough, or should additional considerations be taken into account regarding the market structure?
Would the market structure differ between a manufacturer of generic woollen jumpers, as compared to a manufacturer of a well-known, expensive brand of woollen jumpers, or for manufacturers in different geographic locations? This will be an area subject to a high degree of judgement based on specific facts and circumstances.
The market structure relevance is to be 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 below. 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.
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
Hedged item Risk components Market structure
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