The 1 Best Complete Read – Mechanics of rebalancing

Mechanics of rebalancing

Whether an entity has to rebalance a hedging relationship is first and foremost a matter of fact, which is, whether the hedge ratio has changed for risk management purposes. An entity has to rebalance a hedging relationship if that relationship still has an unchanged risk management objective but no longer meets the hedge effectiveness requirements regarding the hedge ratio. This will, in effect, be if the hedge ratio is no longer that actually used for risk management.

Requirement to rebalance

Whether an entity has to rebalance a hedging relationship is first and foremost a matter of fact, which is, whether the hedge ratio hasMechanics of rebalancing changed for risk management purposes. An entity has to rebalance a hedging relationship if that relationship still has an unchanged risk management objective but no longer meets the hedge effectiveness requirements regarding the hedge ratio. This will, in effect, be if the hedge ratio is no longer that actually used for risk management (see ‘Setting the hedge ratio‘). Mechanics of rebalancing

However, as on initial designation, the hedge ratio for hedge accounting purposes would have to differ from the hedge ratio used for risk management if the latter would result in ineffectiveness that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting. Mechanics of rebalancing

IFRS 9 clarifies that ‘not every change in the extent of offset between the … hedging instrument and the hedged item … constitutes a change in the relationship’ that requires rebalancing. For example, hedge ineffectiveness arising from a fluctuation around an otherwise valid hedge ratio cannot be reduced by adjusting the hedge ratio. Mechanics of rebalancing

A trend in the amount of ineffectiveness on the other hand might suggest that retaining the hedge ratio would result in increased ineffectiveness going forward. IFRS 9 further clarifies that an accounting outcome that would be inconsistent with the purpose of hedge accounting as the result of failing to adjust the hedge ratio for risk management purposes, would not meet the qualifying criteria for hedge accounting. Mechanics of rebalancing Mechanics of rebalancing

This simply means that the qualifying criteria treat inappropriate hedge ratios in the same way, irrespective of whether they were achieved by acting (inappropriate designation) or failure to act (by not adjusting a designation that has become inappropriate).

Examples – Rebalancing assessment

Example: Rebalancing not required Rebalancing of hedged item or hedging instrument

An entity with a EUR functional currency has a forecast purchase in HKD in six months’ time amounting to HKD7.8 million. In order to hedge its future exposure, the entity wants to purchase foreign currency (that is, enter into foreign currency forward contracts) to effectively fix the purchase price in EUR. Mechanics of rebalancing Mechanics of rebalancing

HKD is pegged to the USD (which means that the exchange rate is maintained within a band or at an exchange rate set by the Hong Kong Monetary Authority). Mechanics of rebalancing

The entity could enter into a forward contract to buy HKD and pay EUR. However, entering into a forward contract to buy HKD and pay EUR is more expensive than entering into an agreement to buy USD and pay EUR (as there is a smaller market and less liquidity in HKD compared with USD). The entity decides instead to enter into a USD:EUR forward. As long as the HKD remains pegged to the USD, using a USD derivative as a hedging instrument will provide an economic hedge of the forecast HKD purchase.

The peg ratio is HKD7.8:USD1. However, even though it is pegged, it is not completely fixed (as the HKD is allowed to trade within the narrow range of HKD7.75 to 7.85). Since the range is very small, the entity is willing to accept this risk, so it enters into a forward contract for USD1 million (HKD7.8 million).  Mechanics of rebalancing

Rebalancing is not required where ineffectiveness arises merely because of fluctuations in exchange rates within the narrow trading range around the hedge ratio. Rebalancing of hedged item or hedging instrument

Example: Rebalancing required

Consider the facts of the previous example, but assume that the exchange rate HKD:USD is re-pegged to, say, HKD7.2:USD1. If the derivative continues to be for USD1 million, the hedge ratio will no longer reflect the relationship between the hedging instrument and hedged item, and so will result in mandatory rebalancing. Mechanics of rebalancing

Rebalancing should reflect the entity’s risk management strategy, which could either be reducing the hedged item to HKD7.2 million of the forecast purchase of HKD7.8 million, or increasing its hedging instrument by buying another derivative to cover the remaining HKD600,000 of the hedged item. Mechanics of rebalancing

Example: Rebalancing not applicable

Continuing the above example, assume that sometime after the inception of the hedge, the peg between HKD and USD is removed, such that the currency exchange rate is floating (instead of pegged) within a very broad range such that now it is not possible to demonstrate that an economic correlation exists between the two currencies. In this situation, a change in the hedge ratio would not be applicable, since this may not ensure that the hedging relationship continues to meet that hedge effectiveness requirement. Accordingly, the hedge cannot be rebalanced but may need to be discontinued. Mechanics of rebalancing

Observation

Originally, the requirement to rebalance was seen as onerous, but it might actually be a pragmatic solution that avoids discontinuing hedging relationships that would have failed the effectiveness test in the past. In practice, entities will not need to rebalance very often if they have a good risk management strategy in place and the economic relationship is stable. There is always some volatility in any hedging relationship but, if the initial hedge ratio is appropriate and in line with the risk management strategy, rebalancing should only be necessary if the ‘ideal’ hedge ratio changes significantly. Entities should document their tolerance to such variations. Mechanics of rebalancing

Rebalancing

However, as on initial designation, the hedge ratio for hedge accounting purposes would have to differ from the hedge ratio used for risk management if the latter would result in ineffectiveness that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting.Mechanics of rebalancing

Rebalancing can be achieved by: Mechanics of rebalancing Mechanics of rebalancing

  • Increasing the volume of the hedged item Mechanics of rebalancing
  • Increasing the volume of the hedging instrument Mechanics of rebalancing
  • Decreasing the volume of the hedged item Mechanics of rebalancing

Or Mechanics of rebalancing Mechanics of rebalancing

Decreasing the volume of the hedging instrument or hedged item does not mean that the respective transactions or items no longer exist or are no longer expected to occur. As demonstrated in the example below, rebalancing only changes what is designated in the particular hedging relationship. Mechanics of rebalancing

Rebalancing the hedge ratio by decreasing the volume of the hedging instrument

At 1 January 20×1 an entity expects to purchase 1m barrels of West Texas Intermediate (WTI) crude oil in 12 months. The entity designates a futures contract of 1.05m barrels of Brent crude oil in a cash flow hedge to hedge the highly probable forecast purchase of 1m barrels of WTI crude oil (hedge ratio of 1.05:1).

At 30 June 20×1, the cumulative changes in fair value of hedged item is CU200, while the cumulative change in fair value of hedging instrument is CU229.

The entity would account for the hedging relationship, as follows:

Hedging gain/loss – other comprehensive income

CU200

Hedge ineffectiveness –profit or loss

CU29

\ Derivatives – hedging instruments

CU229

To account for the fair value change in the hedging instrument.

Under the requirements of IAS 39, the hedging relationship would still be considered effective (87.3%/114.5% effectiveness). However, the treasurer of the entity is very sensitive to ineffectiveness and therefore considers rebalancing the hedging relationship.

The analysis of the treasurer shows that the sensitivity of Brent crude oil to WTI crude oil prices was not as expected. Going forward, the treasurer expects a different relationship between the two benchmark prices and decides to reset the hedge ratio to 0.98:1.

To rebalance at 30 June 20×1, the treasurer can either designate more WTI exposure or de-designate part of the hedging instrument. The entity decides to do the latter, that is, discontinue hedge accounting for 0.07m barrels of Brent crude oil derivatives.

Of the total of 1.05m barrels of Brent derivative 0.07m barrels are no longer part of the hedging relationship. Therefore, the entity needs to reclassify 7/105 (or 6.7%) of the hedging instrument in the statement of financial position to a held for trading derivative, measured at fair value through profit or loss. The hedge documentation is updated accordingly.

The entity accounts for the rebalancing, as follows:

Derivatives – hedging instruments

CU15

\ Derivatives – trading

CU15

To reflect that a part of the derivative is no longer part of a hedging relationship.

Mechanics of rebalancing Mechanics of rebalancing Mechanics of rebalancing Mechanics of rebalancing Mechanics of rebalancing

In the example above, the entity no longer needs to hold this portion of the derivative any longer for hedging purposes and could, therefore, close it out. As mentioned, the entity could have also rebalanced by designating more WTI exposure (assuming that the higher level of exposure is highly probable of occurring). In that case, there would not be any immediate accounting entries; the entity would simply designate more WTI exposure. The same would be true when rebalancing by increasing the volume of hedging instrument, in which case the entity would simply designate additional volume of hedging instrument (provided, of course, it is available).

Rebalancing the hedge ratio by decreasing the volume of hedged item

At 1 April 20×1, an entity has highly probable forecast purchases of diesel over the next 12 months. The entity expects to get monthly deliveries of 10,000 metric tonnes at the local market price. The entity designates futures contract referenced to the Platts Diesel D2 price with a nominal amount of 9,500 metric tonnes in a cash flow hedge, to hedge 10,000 metric tonnes of highly probable diesel purchases in September (giving a hedge ratio of 1:0.95).

At 30 June 20×1, the cumulative change in fair value of hedged item is CU820, while the cumulative change in fair value of hedging instrument is CU650.The entity would account for the hedging relationship, as follows:

Hedging reserve – other comprehensive income

CU650

\ Derivatives – hedging instruments

CU650

To account for the fair value change in the hedging instrument.

Despite the hedge only being 79% effective, no hedging ineffectiveness is recorded as a result of the ‘lower of test’ in IFRS 9 6.5.11. As per that paragraph, the amount accumulated in other comprehensive income has to be the lower of:

i) The cumulative gain or loss on the hedging instrument

ii) The cumulative change in fair value of the hedged item, with any remaining gain or loss on the hedging instrument being recorded in profit or loss

Based on an analysis, the entity now believes that the appropriate hedge ratio going forward is 1:1.05. Consequently, the entity can either increase the volume of hedging instrument or decrease the volume of hedged item. Based on a cost-benefit analysis the entity decides to reduce the volume of hedging instrument by 952 metric tonnes.

At 30 June 20×1, rebalancing a hedge ratio by decreasing the volume of hedged item is considered a partial discontinuation of the hedging relationship. The entity is discontinuing 952 (10,000 – (9,500/1.05) = 952) metric tonnes of diesel purchases while 9,048 metric tonnes of forecast purchases remain in the hedging relationship. The hedge documentation is updated accordingly.

No accounting entry is required.

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Watch out !!

Even though the standard allows for adjustments to either the quantity of hedging instrument or the quantity of the hedged item, when rebalancing, entities should consider that adjusting the hedged item will be operationally more complex than adjusting the hedging instrument because of the need to track the history of different quantities that were designated during the term of the hedging relationship.

For example, if a quantity of 10 tonnes of a hedged item were added to increase the quantity of hedged item and later deducted to decrease it, those 10 tonnes would have been part of the hedged item for only a part of the life of the hedging relationship. However, any cash flow hedge adjustment would still, in part, relate to that quantity. This can get more complex in situations in which the hedging relationship needs frequent rebalancing, if not all hedged transactions occur at the same time, or in conjunction with the cost formulae used for the measurement of the cost of inventory.

In addition, adjusting the hedged item might suggest the entity is using an accounting driven approach to hedge accounting, because risk management would normally adjust the quantity of the designated hedging instruments when rebalancing since the hedged exposure is the ‘given’ and drives what hedges are needed.

Mechanics of rebalancing

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