Hedging of a highly probable debt issuance

Hedging of a highly probable debt issuance – Q: Does IFRS 9 allow a highly probable forecast foreign currency debt issuance as eligible as a hedged item in a cash flow hedge of interest rate risk if the currency of issuance is not yet known?

Considerations:

At 1 January 200X, entity A, whose functional currency is the Euro, intends to issue a variable interest rate debt in six months’ time in order to finance future activities. Depending on the market conditions existing at 1 July 200X, entity A will decide Hedging of a highly probable debt issuance whether the debt is issued in Euros or in US dollars. If the debt is issued in US dollars, then at the debt issuance date (1 July 200X) entity A will enter into a cross-currency swap in order to convert the US dollar exposure on the debt to a Euro exposure.

Management wants to hedge its exposure to variable interest rates. On 1 January 200X, it contracts a forward-starting interest rate swap (that is, an interest rate swap that will start on 1 July 200X) which is denominated in Euros.

Consequential Explanation and Reasoning:

Yes. Hedging of a highly probable debt issuance

Under IFRS 9, an aggregated exposure that is a combination of a forecast transaction that could qualify as a hedged item and a derivative can be designated as a hedged item, provided that the aggregated exposure is highly probable and, once it has occurred and is therefore no longer forecast, it is eligible as a hedged item.

As a result, the proposed designation is acceptable, provided that it is in line with entity A’s risk management strategy and objectives. In the illustration, the designated hedged item would be the highly probable variable interest payments in Euros (entity A’s functional currency), arising either from the Euro debt or the aggregated exposure (US dollar debt swapped into Euros by using the cross-currency swap).

Forecast foreign currency debt issuance – Q: Is a highly probable forecast foreign currency debt issuance eligible as a hedged item in a cash flow hedge of foreign currency risk?

Considerations:

On 1 January 20X1, it is highly probable that company X (with EUR functional currency) will issue, on 1 July 20X1, USD 100 million of five–year, fixed–rate debt, with quarterly coupons. On 1 January 20X1, the EUR: USD spot and six–month forward exchange rates are 1:1. The proceeds from the issuance of the debt are needed to finance the expansion of the company’s production facilities in Europe. The company is concerned that the EUR:USD exchange rate will fluctuate, such that additional USD debt will need to be issued in order to lock in the desired EUR 100 million in proceeds, which in turn will affect the interest incurred on the foreign currency debt to be issued.

Therefore, on 1 January 20X1, company X enters into a six–month forward to buy EUR and sell USD at 1:1. This transaction is on market at zero cost, because the six–month forward rate is 1:1.

Is the variability in functional currency equivalent proceeds, expected to be received from the forecast issuance of debt denominated in a currency other than the reporting entity’s functional currency, eligible for designation as the hedged transaction in a cash flow hedge of foreign currency risk? Hedging of a highly probable debt issuance

Consequential Explanation and Reasoning:

No. Hedging of a highly probable debt issuance

The hedged item (risk of changes in foreign exchange rates before the forecast issuance of foreign currency debt) does not affect profit or loss when the transaction is settled or in subsequent periods. In this situation, company X is concerned about foreign exchange spot movements between the hedge inception date and the debt issuance date, specifically the risk associated with converting the foreign currency denominated debt proceeds into its functional currency. While this represents a risk from an economic and cash flow perspective and will impact interest expense in future periods, the impact on future interest expense is not the risk being hedged. Hedging of a highly probable debt issuance

Hedging of a highly probable debt issuance

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