Hedging a component of a group provides clear examples of hedge accounting in practice. A group designation can also consist of hedging a component of a group of items, such as a layer component of a group. A component could also be a proportion of a group of items, such as 50% of a fixed rate bond series with a total volume of CU 100m. Whether an entity designates a layer component or a proportionate component depends on the entity’s risk management objective.
The benefits of identifying a layer component, discussed at ‘Hedge accounting requirements in IFRS 9‘, may be even more relevant when applied to a group of items. A bottom layer hedging strategy is, in fact, a designation of a component of a group (see below example – Hedging a bottom layer of a loan portfolio (IFRS 9)).
Examples are as follows: Hedging a component of a group
- A bond issue of CU 50m that is made up of 50,000 fixed rate bonds with a face value of CU 1,000 each. If the issuer expects that it might repurchase up to CU 10m of the issue volume before maturity it could hedge the benchmark component of the fair value interest rate risk with a receive fixed/pay variable interest rate swap that has a notional amount of CU10m. From an economic perspective, that hedge would allow repurchases of up to CU 10m total face value for which the gain or loss from changes in the benchmark interest rate would be compensated by the gain or loss on the swap.However, this can only be reflected in the accounting if the entity can designate a CU 10m top layer (i.e., for the first CU 10m of face value that are repurchased, the entity would include a fair value hedge gain or loss on the full face value when determining the gain or loss on derecognition of the bonds).If it was not permitted to designate a layer of a group of items, entities would in such cases either have to identify individual items within the group and designate them on a standalone basis or prorate the fair value hedge gain or loss to the entire bond issue volume. The IASB believes this would result in arbitrary accounting results and decided to allow layer component designations for group of items.
- 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); Hedging a component of a group
- 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 Hedging a component of a group
- 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).
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).
A layer component of a group of items only qualifies for hedge accounting if: Hedging a component of a group
- The layer is separately identifiable and reliably measurable. H edging a component of a group
- The risk management objective is to hedge a layer component. Hedging a component of a group
- The items in the group from which the layer is identified all share the same risk. Hedging a component of a group
- For a hedge of existing items, the items in the group can be identified and tracked. Hedging a component of a group
- Any items in the group containing prepayment options meet the requirements for components of a nominal amount (see ‘Hedge accounting requirements in IFRS 9‘).
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. Hedging a component of a group
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 CU 100 million sales must be tracked in order to track the bottom layer of CU 20 million sales or the top layer of CU 30 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.
Illustration – Designate layers of hedged items
An entity intends to designate a layer component as a hedged item and is considering the following scenarios:
|Part of monetary transaction||The next USD10,000 cash flows from sale denominated in USD after the first USD20,000 in March 200X|
|Part of physical or other transaction volume||The first 100 barrels of oil purchases in June 200X
The first 100 MWh of electricity sales in June 200X
|Layer from a nominal amount||The last EUR80,000 to be paid of a EUR100,000 firm commitment
The last GBP20,000 to be paid of a GBP100,000 fixed rate bond
The first of CAD30,000 to be paid from a total CAD100,000 of fixed-rate debt that can be prepaid at fair value
The layer components in the scenarios above are eligible hedged items. Under IFRS 9 a layer component might be specified from either a defined nominal amount or a defined, but open, population. It must be sufficiently specific so that, when a transaction occurs or the value of some items in the population change, it is clear whether or not the transaction (or item) was part of the hedge relationship. Hedging a component of a group Hedging a component of a group
A layer component that includes a prepayment option is an eligible hedged item only if the designated layer includes the effect of the related prepayment option when determining the change in fair value of the hedged item. Hedging a component of a group Hedging a component of a group
For a layer component of a nominal amount in a fair value hedge, the total defined nominal amount must be tracked in order to track the designated bottom/top layer.
Hedging a component of a group
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