Inflation as a risk component – Under IAS 39, inflation cannot be designated as a hedged risk component for financial instruments, unless the inflation risk component is contractually specified. For non-financial instruments, inflation risk cannot be designated under IAS 39 as a risk component at all. Inflation as a risk component
Highlight – For financial instruments, IFRS 9 opens the door for designating a non-contractually specified inflation component as a hedged risk component – but only in limited circumstances. For non-financial instruments, the inflation component will be eligible for designation as the hedged item in a hedging relationship provided that it is separately identifiable and reliably measurable. Inflation as a risk component
For financial instruments, IFRS 9 introduces a rebuttable presumption that, unless contractually specified, inflation is not separately identifiable and reliably measurable. This means that there are limited cases under which it is possible to identify a risk component for inflation and designate that inflation component in a hedging relationship. Similar to other non-contractually specified risk components, the analysis would have to be based on the particular circumstances in the respective market, which is, in this case, the debt market.
However, IFRS 9 standard notes that in limited cases it is possible to designate non-contractually specified inflation as a risk component of a financial instrument because of the particular circumstances of the inflation environment and the relevant debt market. Inflation as a risk component
Qualifying items: inflation
If an entity wishes to hedge non-contractually specified inflation as a risk component, then it will have to determine whether it is capable of constructing an inflation curve based on observable real interest rates from a liquid market for the hedge period to rebut the presumption that non-contractually specified inflation is not separately identifiable and reliably measurable. This may be challenging in some environments. Inflation as a risk component
The existence of a government-sponsored price index for a country – e.g. a consumer price index or producer price index – is not sufficient to construct an inflation curve using real interest rates for the hedge period. This is because price indexes are generally developed using historical and current prices, whereas an inflation curve represents expectations of future prices.
And here is also an example below, derived from the application guidance of IFRS 9, explains a situation in which the presumption that inflation does not qualify as a risk component of a financial instrument can be rebutted. Inflation as a risk component
There are not many currencies with a liquid market for inflation-linked debt instruments, therefore, limiting the availability of designating non-contractually specified inflation risk of financial instruments. Inflation as a risk component
IFRS 9 does not specify whether the analysis of inflation as eligible risk component has to be made by currency or by country, or both. This is particularly relevant for countries forming a monetary union together with other countries, but having different inflation rates (e.g., within the Eurozone). The relevant ‘market structure’ for inflation will usually be given by the currency.
While IFRS 9 defines in what circumstances inflation can be a risk component for a financial instrument, inflation can, in future, be treated as a risk component for non-financial items in the same manner as any other risk component (as described in ‘Contractually specified risk components‘ and ‘Non-contractually specified risk components‘, i.e., the rebuttable presumption applies only to financial instruments). For example, a contractually specified inflation risk component would normally qualify as a hedged item (e.g., a sales contract with a price formula linked to the consumer price index) under IFRS 9, whereas it would not under IAS 39. Inflation as a risk component
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. 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. Inflation as a risk component
Non-contractually specified inflation: Entities will have to determine whether they are capable of constructing an inflation curve based on observable real interest rates from a liquid market to assert that an inflation component of a fixed-rate debt instrument is separately identifiable and reliably measurable. Inflation as a risk component
Inflation linked derivatives are becoming a popular method to hedge underlying exposures that are exposed to movements in inflation – either implicit or implied. Such hedging instruments have unique characteristics different from (say) a typical interest rate swap in how they are structured. This, in turn, impacts how the cash flows are modeled and the instrument must be valued.
It is an increasingly common occurrence to see fixed, floating and inflation linked debt in a corporate portfolio. At the very least, inflation linked products are useful additions to a well-diversified investment portfolio. These instruments allow investors to maintain the instrument’s relative purchasing power. That is, investors want to make sure that the purchasing power of their dollars in year one will be the same at maturity.
There are many users of index linked instruments. For example, some governments and regulated utilities have issued inflation-linked debt to investors, such as pension funds, foundations and individuals whom are looking for protection against inflation. Other market participants trade and use inflation-linked derivatives to economically hedge assets and liabilities (revenues and costs) specifically linked to inflation. Doing so allows them to diversify interest rate risk by creating exposure to changes in real (as opposed to nominal) interest rates and for protection during periods of low inflation.
The two most common types of inflation protected securities are:
- Capital Indexed Bond: Capital Indexed bonds have a fixed real rate and a nominal principal value that rises with inflation. The periodic coupon payments are calculated as the real rate times the inflation adjusted principal, and the inflation adjusted principal itself is repaid at maturity.
- Interest Indexed Bond: Interest Indexed bonds have a fixed real rate plus an indexation of the fixed principal every period. The principal repayment at maturity is not adjusted (i.e., the nominal principal is repaid at par, as for a conventional bond). All inflation adjustment comes through the coupons, which are calculated simply by adding the real rate to the periodic inflation rate.
To hedge these, users will typically use inflation-linked swaps. These allow entities to swap inflation-linked payments for fixed payments, and vice versa. Therefore, an entity could swap inflation-linked payments for fixed payments over a predetermined period, effectively creating a fixed rate borrowing. They will be attracting investment from investors wishing to diversify into government type borrowing, but wanting to earn a higher rate of return than the government rate. An investor may wish to do so to match its inflation linked cost base.
Inflation may only be hedged when changes in inflation are a contractually-specified portion of cash flows of a recognised financial instrument. This may be the case where an entity acquires or issues inflation- linked debt.
Cash Flow Hedge Inflation as a risk component
For example, if an entity holds an inflation-indexed bond that pays interest at inflation plus 1.501 per cent, the inflation portion is identifiable and separately measurable, because inflation is a contractually specified cash flow and the remaining cash flows of the instrument (1.501 per cent) do not change when the inflation portion changes. In such circumstances, the entity has a cash flow exposure to changes in future inflation that may be designated as a cash flow hedge.
Fair Value Hedge Inflation as a risk component
The amendment does not permit an entity to designate an inflation component of issued or acquired fixed-rate debt in a fair value hedge as the Board considers that such a component is not separately identifiable and reliably measurable. To illustrate, if one were to swap a fixed rate liability to indexed linked debt via a receive fixed pay RPI, this strategy would not qualify for hedge accounting treatment under IAS 39 as the inflationary component in the fixed rate is not separately identifiable and reliably measureable.
A Practical Example
Company A has undertaken a large capital expenditure project and wishes to attract investors who want to diversify into government type risk in order to hedge the inflation risk inherent in their own business. Company A then swaps the issued RPI debt to a fixed rate to match the duration of its assets. Inflation as a risk component
Suppose, on the 19 June 2007 they issue 10 year GBP 50m index linked debt with a coupon of 1.501%. The reference gilt is the 10 year 1¼% Index-linked Treasury 2017. The coupon and redemption amount are to be indexed to UK RPI according to the 3 month lag convention. Inflation as a risk component
If Company A were to swap this out to a fixed rate of 3.1% semi-annual basis they will have changed their borrowing to fixed rate debt, as follows: Inflation as a risk component
In the above instance the changes in inflation are a contractually-specified portion of the cash flows of the index linked debt and qualify for hedge accounting treatment under IFRS 9. Company A would still be required to comply with the other requirements of IFRS 9 in order to qualify for hedge accounting treatment. By designating the index-linked debt in a cash flow hedge relationship and creating a hypothetical derivative to assess the extent of hedge effectiveness, the hedge is highly effective and the impact to the Income statement is nil. Inflation as a risk component
In the absence of hedge accounting, the full mark-to-market value of the swap would be booked to the income statement, generating income statement volatility as the underlying bond would be accounted for on an amortised cost basis. Inflation as a risk component
However, if an entity was to issue a bond and swap it to indexed-linked debt, the entity would not be able to hedge the inflation component of the debt. Although the benchmark rate can be hedged, the inflationary portion cannot, as it is not a contractually-specified portion of the cash flows. Instead, the swap is marked-to-market and the debt is booked on an amortised cost basis through the income statement. Inflation as a risk component
Many consider inflation has simply one other uncertainty in their business that derivatives can manage – much like interest rates. While this is generally true economically, the recent IASB ruling has presented some challenges from an accounting perspective. Fortunately, IFRS 9 Financial Instruments is favourable to entities issuing inflation indexed debt and converting an inflation adjusted rate to a fixed rate through the use of an inflation indexed swap. Inflation as a risk component
However, by outlining a relatively narrow definition of eligible hedged items, the IASB has denied a fair value hedging scenario for users such as the example described above. As such, all changes to mark to market values in these derivatives must be taken to P&L. Given inflation-linked instruments tend to be very long term, this could mean large P&L movements for an extended period of time. Many users will need to consider this accounting impact if they are looking to fair value hedge their fixed inflation exposure. Inflation as a risk component
The IASB’s implementation of IFRS 9 eligible hedged items is favourable to entities issuing inflation-indexed debt and converting an inflation adjusted rate to a fixed rate through the use of an inflation indexed swap. Inflation as a risk component
Interest Rate Components: Inflation, Liquidity, and Risk
Interest rates are the “price” that lenders charge for lending their money to borrowers. There are many interest rate components, each reflecting a form of compensation to the lender.
Defining Interest Rate Components
The interest rate components are the factors that determine the interest rate for investments. Inflation as a risk component
Interest Rate Components
Real Interest Rates
One of the interest rate components is the real interest rate, which is the compensation, over and above inflation, that a lender demands to lend his money. Inflation as a risk component
Since a lender is giving the use of his or her money to someone else, he or she is giving up or “forgoing” spending that money or “consuming”. Obviously, the lender would not be interested in giving the use of his money to someone else for nothing in return. This compensation is called the “real interest rate.” Inflation as a risk component
Economists have attributed the movement in interest rates to changes in inflation, or its expected level. However, there is now evidence that “real interest rates” change substantially and in short periods of time. This rate increases when the demand for capital and borrowing is high in an economy, and falls when it is low. Inflation as a risk component
Another of the interest rate components is inflation, which is defined as the change in the level of prices. Most of the time, people mean the “Consumer Price Index” or “CPI” when they discuss inflation within a country. This is the change in the price “shopping basket” of consumer goods for a country that the national statistics agency has sampled over time on a monthly basis.
The “core CPI” is the change in prices without the food and energy components. Since food and energy prices are volatile, the “core CPI” is thought to be a more accurate measure of underlying inflation. Inflation as a risk component Inflation as a risk component
The main challenge in measuring inflation as the change in level of prices is establishing which prices to use for the calculation. National statistics agencies usually measure various inflation rates, the Consumer Price Index among them.
Since economists, market strategists, and politicians are usually concerned with chan ges in consumer prices, the CPI is the most frequently used measure of price change. Across a country, however, prices vary with market conditions, availability, transportation costs and other factors.
All factors considered, the CPI in most modern industrial countries is thought to be a fairly accurate reflection of the change in the retail price level. This is important since CPI is used to index government pensions and benefits, as well as tax brackets.
The CPI is also used to convert the nominal national accounting statistics, such as “Gross National Product” to a “real” or after-inflation basis. With the issuing of inflation-linked bonds, CPI has also been used to calculate the principal increase for this “real” bond.
Liquidity Risk Premium
The liquidity risk premium is a third consideration for interest rate components and can be described as the compensation that a lender receives for investing funds in something that is difficult to sell.
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Inflation as a risk component
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