Measuring ineffectiveness in hedging

Measuring ineffectiveness – Hedge ineffectiveness is typically measured using a dollar-offset basis, i.e., by comparing the cumulative change in fair value of the hedging instrument with that of the hedged item. Therefore, any part of the change in fair value of the hedging instrument that does not offset a corresponding change in the fair value of the hedged item is treated as ineffectiveness.

IFRS 9 has not proposed significant changes to the rules for measurement of ineffectiveness in profit or loss, as currently required by IAS 39. Therefore, entities must continue to measure ineffectiveness by considering the effect of credit risk and the time value of money (due to differences in the timing o f cash flows) on the value of the hedged item and the hedging instrument.

Recognition

Recognition of ineffectiveness will differ based on whether the hedge is a cash flow hedge or a fair value hedge: Measuring ineffectiveness in hedging

  • For cash flow hedges, the ‘lower of’ test will continue to apply. There will be no ineffectiveness for under-hedges, i.e., where the cumulative change in fair value of the hedging instrument is less than the cumulative change in fair value of the hedged item. If the cumulative change in the hedging instrument exceeds the change in the hedged item (sometimes referred to as an ‘over-hedge’), ineffectiveness will be recognised. Measuring ineffectiveness in hedging Measuring ineffectiveness in hedgingIf the cumulative change in the hedging instrument is less than the change in the hedged item (sometimes referred to as an ‘under-hedge’), no ineffectiveness will be recognised. This is different from a fair value hedge, in which ineffectiveness is recognised on both over – and under-hedges.
  • For fair value hedges, any difference between the change in the fair value of the hedging instrument and that of the designated hedged component is ineffectiveness which must be transferred from OCI. Measuring ineffectiveness in hedging

Under IAS 39, entities would, on occasion, include ‘more’ of the hedged item in their cash flow hedges to avoid recognising ineffectiveness. However, entities may not be able to continue with this practice under IFRS 9 because of the requirement to designate a hedge relationship that will produce an unbiased result and minimise ineffectiveness.

The requirement to recognise all ineffectiveness combined with the proposals to: (i) align hedge accounting to risk management activities; and (ii) relax the stringent rules around hedge effectiveness testing will be seen as an improvement by many preparers. Therefore, while entities will have some flexibility in assessing hedge effectiveness, the income statement will still reflect the actual performance of the hedging instrument and the hedged item. Measuring ineffectiveness in hedging

Economic relationship as basis

So there is no discontinuance of hedge accounting under IFRS 9 due to the results of the assessment of hedge effectiveness, but calculation infective portions and recognition in P&L still required. Here is a graphic showing the over- and under hedges: Measuring ineffectiveness in hedging

Measuring ineffectiveness

Rebalancing
As a consequence of ineffectiveness detected a prospective adjustment of the actual hedge ratio for the optimal hedge ratio might be necessary (IFRS 9 B6.5.14 (a)). However, the economic relationship is mandatory. Measuring ineffectiveness in hedging

Simple example measurement

The hedge ratio is defined as the relationship between the quantity of the hedging instrument and the quantity of the hedged item in terms of their relative weighting. IFRS 9 requires that the hedge ratio used for hedge accounting purposes should be the same as that used for risk management purposes. Measuring ineffectiveness in hedging

One of the key objectives in IFRS 9 is to align hedge accounting with risk management objectives. There is no retrospective effectiveness testing required under IFRS 9, but there is a requirement to make an on-going assessment of whether the hedge continues to meet the hedge effectiveness criteria, including that the hedge ratio remains appropriate.

This means that entities will have to ensure that the hedge ratio is aligned with that required by their economic hedging strategy (or risk management strategy). A deliberate imbalance is not permitted. This requirement is to ensure that entities do not introduce a mismatch of weightings between the hedged item and the hedging instrument to achieve an accounting outcome that is inconsistent with the purpose of hedge accounting.

This does not imply that the hedge relationship must be perfect, but only that the weightings of the hedging instruments and hedged item actually used are not selected to introduce or to avoid accounting ineffectiveness.

In some cases, there are commercial reasons for particular weightings of the hedged item and the hedging instrument even though they create hedge ineffectiveness. This is the case, for example when using standardised contracts that have a defined contract size (for instance, 1 standard aluminium future contract in the LME has a contract size of 25 tonnes). When an entity wants to hedge 90 tonnes of aluminium purchases with standard aluminium future contracts, due to the standard contract size, the entity could use either 3 or 4 future contracts (equivalent to a total of 75 and 100 tonnes respectively). Such designation would result in a hedge ratio of either 0.83:1 or 1.11:1.

In that situation the entity designates the hedge ratio that it actually uses, because the hedge ineffectiveness resulting from the mismatch would not result in an accounting outcome that is inconsistent with the purpose of hedge accounting. Hedge ineffectiveness is still required to be measured and accounted for in P&L.

In situations such as the above, where due to the standard size of contracts the hedge relationship may result in an under-hedge, an alternative that entities might want to consider is the possibility of designating as hedge item a layer component.

Additions in IFRS 9

IFRS 9 adds only two paragraphs in the application guidance on measuring ineffectiveness, dealing with the time value of money and hypothetical derivatives. Although intended as a clarification, these two paragraphs might have wider implications for some practices currently applied by entities.

The effect of the time value of money

Entities have to consider the time value of money when measuring hedge ineffectiveness. This means that an entity has to determine the value of the hedged item on a present value basis (thereby including the effect of the time value of money).

IFRS 9 does not clarify more than what was already clear under IAS 39. In valuation practice, the effect of the time value of money is also included when measuring the fair value of financial instruments. Consequently, it is more than logical to apply the same principle to the hedged item as well.

Example – Impact of time value of money when measuring ineffectiveness

A manufacturing company in India, having the Indian Rupee as its functional currency, is expecting forecast sales in USD. The company assesses sales of USD1m per month for the next twelve months to be highly probable and wishes to hedge the related foreign currency exposure. The company also holds a borrowing of USD20m. Instead of entering into foreign currency forward contracts, the company designates the US dollar borrowing as a hedging instrument in hedges of the spot risk of the monthly highly probable US dollar sales.

This hedge is a pure accounting hedge as the cash flows of the sales and the borrowing do not match. When measuring hedge ineffectiveness, the foreign currency revaluation of the forecast sales would have to be discounted, whereas the revaluation of the hedging instrument would not.

Hypothetical derivatives for measuring ineffectiveness

When measuring ineffectiveness of cash flow hedges under IAS 39, entities often make use of a so-called ‘hypothetical derivative’. This involves establishing a notional derivative that has terms that match the critical terms of the hedged exposure (normally an interest rate swap or forward contract with no unusual terms and a zero fair value at inception of the hedging relationship). The fair value of the hypothetical derivative is then used to measure the change in the value of the hedged item against which changes in value of the actual hedging instrument are compared, to assess effectiveness and measure ineffectiveness. However, although commonly used in practice, use of a hypothetical derivative is not specifically addressed in IAS 39.

IFRS 9 clarifies that use of a hypothetical derivative is one possible way of determining the change in the value of the hedged item when measuring ineffHypothetical derivativesectiveness. However, IFRS 9 also clarifies that a hypothetical derivative has to be a replication of the hedged item and that any different method for determining the change in the value of the hedged item would have to have the same outcome. Consequently, an entity cannot include features in the hypothetical derivative that only exist in the hedging instrument, but not in the hedged item.

What appears to be a logical requirement may have wider implications for cash flow hedges than many would have expected. IFRS 9 is clear that the hypothetical derivative is supposed to represent the hedged item and not the ‘perfect hedge’. In other words, an entity cannot simply assume no ineffectiveness for a cash flow hedge with matching terms (e.g., where the terms of the hedging instrument exactly match the terms of a hedged forecast transaction).

For example, IFRS 13 requires an entity to reflect both the counterparty’s credit risk and the entity’s own credit risk in the measurement of a derivative. The counterparty credit risk of a derivative designated in a hedging relationship is likely to be different from the counterparty credit risk in the hedged item (if there is any). The difference in credit risk would result in some ineffectiveness (see ‘Impact of credit risk‘).

IFRS 9 is clear that, when using a hypothetical derivative for measuring ineffectiveness in a cash flow hedge, the counterparty credit risk on the hedging instrument could not be deemed to equally be a feature also present in the hedged item. For example, if the hedged item is a forecast transaction it would not involve any credit risk, so that there is no offset for any credit risk affecting the fair value of the hedging instrument, which would give rise to some ineffectiveness. Also, if the hedged item involves credit risk, the effect of that has to be established independently of the hedging instrument.

Another (maybe unexpected) source of ineffectiveness is the discount rate used for measuring the fair value of cash collateralised IRS. Historically, the fair values of interest rate swaps have been calculated using LIBOR-based discount rates. As per its definition, LIBOR is the average rate at which the reference banks can fund unsecured cash in the interbank market for a given currency and maturity.

However, the use of LIBOR as the standard discount rate ignores the fact that many derivative transactions are now collateralised. For cash-collateralised trades, a more relevant discount rate is an overnight rate rather than LIBOR. Overnight index swaps (OIS) are interest rate swaps where the floating leg is linked to an interest rate for overnight unsecured lending to a bank. OIS rates much better reflect the funding cost of cash collateralised IRS.

When measuring the fair value of cash-collateralised LIBOR indexed interest rate swap, an entity would have to use a LIBOR-based forward curve to determine the future floating cash flows, but these are then discounted using an OIS swap curve. This would obviously result in a different fair value compared to a non-collateralised IRS for which both the forward rates and the discount rates are derived from the LIBOR swap curve. The resulting ineffectiveness is sometimes referred to as the ‘multi curve issue’.

Historically, the difference between LIBOR and OIS rates has been equal to a few basis points only. However, the basis differential widened significantly during the financial crisis and is not expected to revert in the foreseeable future.

For cash-collateralised derivatives, both parties to the contract would have equal collateral requirements, significantly reducing the credit risk of both parties to the contract. This would improve the economic effectiveness of a hedging relationship while at the same time, may also result in more accounting ineffectiveness.

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Measuring ineffectiveness

 

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