Unchanged from IAS 39, to qualify for hedge accounting, a hedging relationship has to consist of eligible hedging instruments and eligible hedged items. Also, at inception of the hedging relationship, there still has to be a formal designation and documentation. This would include the entity’s risk management objective underlying the hedging relationship and how that fits within the overall risk management strategy.
The documentation has to include an identification of the hedging instrument, the hedged item, the nature of the risk being hedged and how the entity will assess whether the hedging relationship meets the hedge effectiveness requirements. Qualifying criteria Designation
However, compared to IAS 39, the entity’s risk management strategy and objective are more important under IFRS 9 because of the effect on discontinuation of hedge accounting and the hedge accounting related disclosures. IFRS 9 also requires documentation of the hedge ratio and potential sources of ineffectiveness (that may have to be updated as part of a continuing hedging relationship). Qualifying criteria Designation
Like IAS 39, entities can still only designate one of three types of hedging relationships: a fair value hedge, a cash flow hedge or a hedge of a net investment in a foreign operation. For hedges of the foreign currency risk of a firm commitment, an entity may designate either a fair value hedge or a cash flow hedge. Qualifying criteria Designation
Unlike IAS 39, entities are no longer required to perform an onerous quantitative effectiveness assessment to demonstrate that the hedge in any period was highly effective, using the 80 -125% bright line. Instead, IFRS 9 uses a new approach to the effectiveness assessment that is only prospective, does not involve any bright lines and, depending on the circumstances, may also be qualitative.
This approach can also require that the method for assessing effectiveness is changed in response to changes in circumstances, in which case the hedge documentation is updated but without resulting in discontinuation of the hedging relationship.Qualifying criteria Designation
Under IFRS 9, a hedging relationship qualifies for hedge accounting if it meets all of the following effectiveness requirements: Qualifying criteria Designation
- There is ‘an economic relationship’ between the hedged item and the hedging instrument. Qualifying criteria Designation
- The effect of credit risk does not ‘dominate the value changes’ that result from that economic relationship. Qualifying criteria Designation
- The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.However, that designation shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting.Qualifying criteria Designation
The required steps for designating a hedging relationship can be summarised in a flow chart, as follows: Qualifying criteria Designation
Qualifying criteria designation
The individual steps in the effectiveness assessment are summarised below, with links to more detailed pages.
The first requirement means that the hedging instrument and the hedged item must be expected to move in opposite directions as a result of a change in the hedged risk. This should be based on an economic rationale rather than just by chance, as could be the case if the relationship is based only on a statistical correlation. However, a statistical correlation may provide corroboration of an economic rationale. Qualifying criteria Designation
So there must be an expectation that the value of the hedging instrument and the value of the hedged item would move in the opposite direction as a result of the common underlying or hedged risk. For example, this is the case for forecast fixed interest payments and an interest rate swap that receives fixed interest payments and pays variable interest.
An on-going analysis of the possible behaviour of the hedging relationship during its term is required in order to ascertain whether it can be expected to meet the risk management objective.
Whilst the requirement for an economic relationship is new, it would be unlikely that an entity would use an instrument that did not provide a valid economic relationship for risk management purposes, and so this is unlikely to be an onerous requirement in most cases. Qualifying criteria Designation
The Board has regarded ‘proxy hedging’ (which is a designation that does not exactly represent an entity’s actual risk management) as an eligible way of designating the hedged item under IFRS 9, as long as designation reflects the risk management in that it relates to the same type of risk that is managed and the instruments used for that purpose.
As part of the basis for conclusions in IFRS 9, the Board included as an example the fact that because IFRS 9 (in the same way as IAS 39) does not allow cash flow hedges of interest rate risk to be designated on a net position basis, entities must instead designate part of the gross positions.
This requires the use of proxy hedging, because the designation for hedge accounting purposes is on a gross position basis, even though risk management typically uses a net position basis. Qualifying criteria Designation
Corporates refer to proxy hedging where for example they hedge commodity price risk but as a result of the availability of commodity derivatives, entities use a hedging instrument referenced to a commodity different to the actual commodity they are economically hedging (for example, jet fuel as compared to Brent oil), but the price of the two commodities are correlated enough to make the hedge relationship work. Qualifying criteria Designation
In addition, some financial institutions use intragroup derivatives for risk management purposes. However, as intragroup derivatives do not qualify for hedge accounting, they are required to define external derivatives as proxy hedges. Qualifying criteria Designation
IFRS 9 requires that, to achieve hedge accounting, the impact of changes in credit risk should not be of a magnitude such that it dominates the value changes, even if there is an economic relationship between the hedged item and hedging instrument. Credit risk can arise on both the hedging instrument and the hedged item in the form of counterparty’s credit risk or the entity’s own credit risk. Qualifying criteria Designation
The hedge ratio is the ratio between the amount of hedged item and the amount of hedging instrument. For many hedging relationships, the hedge ratio would be 1:1 as the underlying of the hedging instrument perfectly matches the designated hedged risk. Qualifying criteria Designation
Even if there is an economic relationship, a change in the credit risk of the hedging instrument or the hedged item must not be of such magnitude that it dominates the value changes that result from that economic relationship. Because the hedge accounting model is based on a general notion of there being an offset between the changes of the hedging instrument and those of the hedged item, the effect of credit risk must not dominate the value changes associated with the hedged risk; otherwise, the level of offset might become erratic. Qualifying criteria Designation
For example, where an entity wants to hedge its forecast inventory purchases for commodity price risk, it enters into a derivative contract with Bank X to purchase a commodity at a fixed price and at a future date.
If the derivative contract is uncollateralised and Bank X experiences a severe deterioration in its credit standing, the effect arising from changes in credit risk might have a disproportionate effect on the change in the fair value of the derivative contract arising from changes in commodity prices; whereas the changes in the value of the hedged item (forecast inventory purchases) would depend largely on the commodity price changes and would not be affected by the changes in the credit risk of Bank X. Qualifying criteria Designation
IFRS 9 does not provide a definition of ‘dominate’. However, it is clear that the effect of credit risk should be considered on both the hedging instrument and the hedged item. For example, an entity hedging the interest rate or foreign currency risk of a financial asset (such as a bond) will need to look at the credit risk of the bond. If the bond has high credit risk, the bond might not qualify for hedge accounting. Qualifying criteria Designation
During the financial crisis, there were many situations where entities purchased loans to troubled financial institutions, and the amount that would ultimately be realised was very uncertain. These might not have qualified for hedge accounting. Currently changes to regulations relating to derivatives in different countries have been or are in the process of being introduced. One of the main objectives of these changes is to mitigate credit risk and it is expected they will result in more collateralised derivatives. Once these regulations start being effective, this hedge effectiveness requirement is less likely to be a problem.
For a hedging relationship with a correlation between the hedged item and the hedging instrument that is not a simple 1:1 relationship, risk managers will generally set the hedge ratio so as to adjust for the type of relation in order to improve the effectiveness (i.e., the hedged ratio may be different to 1:1). Qualifying criteria Designation
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. Qualifying criteria Designation
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. Qualifying criteria Designation
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). Qualifying criteria Designation
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. Qualifying criteria Designation
The objective of IFRS 9 Hedge accounting is to represent, in the financial statements, the effect of an entity’s risk management activities. However, this does not mean that an entity can only designate hedging relationships that exactly mirror its risk management activities. In fact, in many cases entities will designate so called proxy hedges (i.e., designations that do not exactly represent the actual risk management). During the re-deliberations leading to the final standard, the Board decided that proxy hedging is permitted, provided the designation is ‘directionally consistent’ with the actual risk management activities. Qualifying criteria Designation
Formal designation and documentation Qualifying criteria Designation
The nature of IFRS 9’s documentation requirements is not very different from the requirements in IAS 39. Formal designation and documentation must be in place at the inception of the hedge relationship. As a result, from the documentation point of view, there is not much relief from the administrative work necessary to start hedge accounting.
Entities should also take into consideration that, as a result of the new hedge accounting requirements under IFRS 9, documentation will no longer be static but must be updated from time to time. Examples of situations where modification of the hedge documentation would be required are where the hedge ratio is rebalanced (see below) or where the analysis of sources of hedge ineffectiveness is updated. Qualifying criteria Designation
In addition, at the date of transition to IFRS 9, entities will need to update their hedge documentation for all their existing hedging relationships under IAS 39 that continue to be eligible under the new standard, in order to comply with the IFRS 9 documentation requirements. Some of the expected changes are the incorporation of the hedge ratio and the expected sources of ineffectiveness (since this is not required by IAS 39) and the removal of the retrospective effectiveness test (which is no longer required under IFRS 9). Qualifying criteria Designation
IFRS 9 introduces the concept of ‘rebalancing’. Rebalancing refers to adjustments to the designated quantities of either the hedged item or the hedging instrument of an existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements.
This allows entities to respond to changes that arise from the underlying or risk variables. This is good news, as rebalancing does not result in de-designation and re-designation of a hedge, but it is accounted for as a continuation of the hedging relationship. However, on rebalancing, hedge ineffectiveness is determined and recognised immediately before adjusting the hedge relationship.
Rebalancing is consistent with the requirement of avoiding an imbalance in weightings at inception of the hedge, but also at each reporting date and on a significant change in circumstances, whichever comes first. Qualifying criteria Designation
When rebalancing a hedging relationship, an entity must update its documentation of the analysis of the sources of hedge ineffectiveness that are expected to affect the hedging relationship during its remaining term. Qualifying criteria Designation
In some circumstances, rebalancing is not applicable (for example, where the changes in the hedge relationship – which might arise from changes in the derivative counterparty credit risk – cannot be compensated by adjusting the hedge ratio). In addition, if the risk management objective has changed, rebalancing is not allowed, and hedge accounting should be discontinued.
|Rebalancing not required
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.
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).
Rebalancing is not required where ineffectiveness arises merely because of fluctuations in exchange rates within the narrow trading range around the hedge ratio.
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.
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.
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.
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. Qualifying criteria Designation
Qualifying criteria Designation
Qualifying criteria Designation
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