Macro hedging

Macro hedging – IFRS 9 hedge accounting applies to all hedge relationships, with the exception of fair value hedges of the interest rate exposure of a portfolio of financial assets or financial liabilities (commonly referred as ‘fair value macro hedges’). This exception arises because IASB has a separate project to address the accounting for macro hedges. In the meantime, until this project is completed, companies using IFRS 9 for hedge accounting can continue to apply IAS 39 requirements for fair value macro hedges.

The reason for addressing such hedges separately is that hedges of open portfolios introduce additional complexity. Risk management strategies tend to have a time horizon over which an exposure is hedged; so, as time passes, new exposures are continuously added to such hedged portfolios, and other exposures are removed from them.

This scope exception is not applicable when hedging closed portfolios. IFRS 9 addresses the accounting for hedges of closed portfolios or groups of items that constitute a gross or net position (refer to ‘Hedging groups of net positions‘ below for further details).

It is expected that the macro hedging project will be most relevant for financial institutions, but it is still possible that IASB may broaden the scope to consider other than fair value macro hedges of interest rate risk (for example, macro hedges of commodity price risk).

Hedging groups of net positions

IFRS 9 provides more flexibility for hedges of groups of items, although, as noted earlier, it does not cover macro hedging. Treasurers commonly group similar risk exposures and hedge only the net position and so IFRS 9 allows the potential to align the accounting approach with the risk management strategy.

For cash flow hedges of a group of items that are expected to affect P&L in different reporting periods, the qualifying criteria are: Macro hedging

  • Only hedges of foreign currency risk are allowed.
  • The items within the net position must be specified in such a way that the pattern of how they will affect P&L is set out as part of the initial hedge designation and documentation (this should include at least the reporting period, nature and volume).

The ability to hedge net positions under IFRS 9 allows hedge designation in a way that is aligned to an entity’s risk management strategy. But, IFRS 9 requires the presentation of the gains and losses on recycling as a separate line item in profit or loss (separate from the hedged items), and so it does not allow an entity to present the post-hedging results of its commercial activities for those line items. This may mean the ability to hedge net positions is not as widely used as it might otherwise have been.

In addition, net nil positions (that is, where hedged items among themselves fully offset the risk that is managed on a group basis) are now allowed to be designated in a hedging relationship that does not include a hedging instrument, provided that all the following criteria are met:

  • The hedge is part of a rolling net risk hedging strategy (that is, the entity routinely hedges new positions of the same type, think of qualifying for hedge accounting and  hedge documentation!);
  • The hedged net position changes in size over the life, and the entity uses eligible hedging instruments to hedge the net risk;
  • Hedge accounting is normally applied to such net positions; and
  • Not applying hedge accounting to the net nil position would give rise to inconsistent accounting outcomes.

IASB expects that hedges of net nil positions would be coincidental and therefore rare in practice.

Macro hedging in the financial industry

In IFRS 9 6.1.3 it is allowed (as mentioned above) fair value hedge of the interest rate exposure of a portfolio of financial assets or financial liabilities (and only for such a hedge), an entity may apply the hedge accounting requirements in IAS 39 instead of those in IFRS 9. In that case, the entity must also apply the specific requirements for the fair value hedge accounting for a portfolio hedge of interest rate risk and designate as the hedged item a portion that is a currency amount (see paragraphs 81A, 89A and AG114–AG132 of IAS 39). See the following narrative below.

  • Introduction IAS 39 81 A macro hedge accounting.

Financial institutions that advance fixed rate loans are exposed to interest rate risk and credit risk. The economic impact of interest rate risk is typically hedged through the use of interest rate derivative instruments. However, with the advent of fair value accounting rules, which require derivative instruments to be marked-to-market, the use of such derivatives can generate volatility in the Profit & Loss statement as interest rates rise and fall. To reduce such volatility, special accounting treatment, or hedge accounting, can be applied when specified criteria and conditions are met.

When the volume of loans is relatively low, hedging and hedge accounting can be applied at the individual loan level. For higher volume portfolios – particularly mortgages and personal finance loans – the costs and manual effort involved with documentation, monitoring and measuring means that it is impractical to apply hedge accounting at the individual loan level.

  • Economic factors

When a financial institution grants a fixed rate loan, it will be exposed to changes in market levels of interest rates and credit spreads. First, earnings may vary as funding costs rise and fall. Second, the economic value of the loan portfolio will rise when rates fall and vice versa.

Interest rates risk can also affect prepayment behaviour. With fixed rate loans such as mortgages and personal lending, there is an implicit call option written by the financial institution. That is, the customer has the right to repay their loan before the contractual maturity date. If interest rates fall, customers may re-finance their loans at a lower rate (and potentially elsewhere) and the financial institution will have to re-lend the funds at a lower rate thus reducing interest income.

  • Strategy of financial institutions

Financial institutions typically seek to manage their interest rate margin by converting fixed rate assets and fixed rate liabilities to floating rates, respectively. Interest rate derivatives such as interest rates swaps and swaptions are typically utilised for this purpose.

For larger volume portfolios, financial institutions will hedge at the portfolio level, not at the level of an individual loan. For example, a tranche of 500 million 3 year fixed rate mortgages may be offered to the market at a rate of 3.45% for a period of time. Once drawn down, this tranche will consist of many smaller individual loans. In this example, the financial institution may transact a Pay Fixed Receive Libor interest rate swap as a hedge. From an economic perspective, this transforms the tranche to a floating rate portfolio and locks in an interest rate margin (assuming floating rates funding of the same basis/tenor and no prepayments).

Prepayment risk may also be hedged through the use of derivatives (for example, amortising swaps representing the expected prepayment behavior of the portfolio or through the use of swaptions). In some markets, prepayment risk is mitigated by the inclusion of prepayment penalties in the loan contract. Macro hedging

Hedge Accounting With IAS 39 81.A Macro hedging

How Does Paragraph 81.A Address Hedging Individual Loans? Macro hedging

IAS 39 81.A addresses this issue in a fair value macro hedge of the interest rate exposure by allowing you to designate an amount of a currency rather than individual assets as the exposure. This better aligns with the internal risk management process whereby portfolio exposures are aggregated into tranches and time buckets representing the re-pricing period. The gain or loss related to the hedged items are reported as one of two separate line items, rather than allocated across many hedged items.(Note that while a financial institution will often hedge economically on a net basis after aggregating assets and liabilities, this is not allowable under IAS 39 paragraph 81.A – the amount designated will therefore represent the gross amount of loans re-pricing in a period).

How Does Paragraph 81.A Address The Issue Of Pre-Payments? Macro hedging

When aggregating individual loans into re-pricing time buckets, IAS 39 paragraph 81.A supports aggregation based on the expected, rather than contractual, re-pricing dates.

The re-pricing date is the earlier of the dates when the item is expected to mature, or the date when the interest rate resets to a market rate. In many cases, it will be possible for an item to be prepaid – for example, a borrower might repay a bank loan early. In such cases, the entity must use the expected re-pricing date (based on its own or industry experience), rather than the contractual date. The time ‘buckets’ that the company identifies must be sufficiently narrow so that all the items within a ‘bucket’ are homogeneous with respect to the interest rate risk being hedge.  Macro hedging

The expected re-pricing dates can be estimated at the inception of the hedge and throughout the term of the hedge, based on historical experience and other available information, including information and expectations regarding prepayment rates, interest rates and the interaction between them.

How Does Paragraph 81.A Address the Issue of Over-Hedging? Macro hedging

There is a risk that expectation does not match reality with regard to the actual level of prepayments and that those prepayments are higher than anticipated, resulting in an over-hedged portfolio.

When designating the amount of a currency as the exposure, it is recommended that some headroom is built in. That is, an amount reflecting 80-90% of the expected exposure is designated as the hedged exposure, thereby allowing similar loans to drop into the exposure in the event of a higher degree of prepayments occurring. Macro hedging

Macro hedging

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