Rebalancing Definition

Rebalancing Definition – The newly introduced concept of rebalancing only comprises changes to the hedge ratio to reflect expected changes in the relationship between the hedged item and the hedging instrument. 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.

Any other changes made to the quantities of the hedged item or hedging instrument would not be rebalancing (with the consequence that it would most likely need to be treated as a partial discontinuation if the entity reduces the extent to which it hedges, and a new designation of a hedging relationship if the entity increases it).

Therefore, rebalancing is only relevant if there is basis risk between the hedged item and the hedging instrument. It only affects the expected relative sensitivity between the hedged item and the hedging instrument going forward, as ineffectiveness from past changes in the sensitivity will have already been recognised in profit or loss. Rebalancing Definition

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 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 (see ‘Setting the hedge ratio‘). Rebalancing Definition

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. Rebalancing Definition

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.

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.

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). Requirement to rebalance

Rebalancing Definition

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.

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.

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 assessment

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.

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).

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.

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.

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 (see Discontinuation of hedge accounting).

Rebalancing Definition

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