Hedge Risk components General requirements

Risk components General requirements is about hedging risk components be it financial or non-financial risks (new in IFRS 9).

Instead of hedging the total changes in fair values or cash flows, risk managers often enter into derivatives to only hedge specific risk components. Managing a specific risk component reflects that hedging all risks is often not economical and hence not desirable, or not possible (because of a lack of suitable hedging instruments). Risk components – General requirements

However, under IAS 39, a non-financial item can only be designated as the hedged item for its foreign currency risk or all its risks in their entirety. There is no such restriction for financial items, Risk components General requirementstherefore creating an inconsistency in hedge accounting for risks of financial and non-financial items. This results in many risk management activities, in particular those of non-financial services entities, not qualifying for hedge accounting under IAS 39, or else hedge ineffectiveness being artificially overstated. Hedge Risk components General requirements

The hedge accounting requirements in IFRS 9 now permit an entity to designate a risk component of a non-financial item as the hedged item in a hedging relationship, provided the risk component is separately identifiable and reliably measurable. This is likely to enable many more common risk management strategies to qualify for hedge accounting and will result in less ineffectiveness in profit or loss. Risk components – General requirements

A risk component may be contractually specified or it may be implicit in the fair value or the cash flows of the item to which the component belongs. However, the mere fact that a physical component is part of the make-up of the whole item does not mean that the component necessarily qualifies as risk component for hedge accounting purposes.

A physical component is neither required nor by itself sufficient to meet the criteria for risk components that are eligible as a hedged item. However, depending on the market structure, a physical component can help meet those criteria (see ‘Non-contractually specified risk components‘).

For example, just because rubber is a physical component of car tyres that does not mean that an entity can automatically designate rubber as a risk component in a hedge of forecast tyre purchases or sales, since the price of tyres, may be related only indirectly to the price of rubber. Further analysis of the pricing structure of the whole car tyre would be required.

Questions and answers Hedge Risk components General requirements

In determining whether a risk component is an eligible hedged component of a non-financial item, what is meant by the market structure in which the hedging activity takes place?

Illustration Hedge Risk components General requirements

To be eligible for designation as a hedged item, a risk component must be a separately identifiable component, and the changes in cash flows or fair value of the item attributable to a change in that component must be reliably measurable. (IFRS 9 B6.3.8)

IFRS 9 requires the qualifying criteria for an eligible risk component to be assessed in the context of the particular market structure to which the risks relate and in which the hedging activity takes place (IFRS 9 B6.3.9).

Solution Hedge Risk components General requirements

In the case of a non-financial item, for there to be a hedgeable risk component it would generally be necessary for the price of the entire item to be built up from various components using a ‘building block’ approach to demonstrate an appropriate market structure.

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For example, it should be clear that informed buyers and sellers of this non-financial item would consider the price of the component proposed to be hedged (such as raw materials) in establishing the price of the overall non-financial item. Consideration of the approach of other market participants is necessary to demonstrate that the market structure supports the designation as a risk component.

The evidence required to support the market structure is a matter of judgement based on facts and circumstances, but should not rely solely on the entity’s own negotiating position or standard costing systems.

How should an entity determine whether changes in cash flows or fair value attributable to changes in a hedged component are separately identifiable? Is it sufficient for a risk component to be an input in the manufacturing process of a non-financial item?

Illustration Hedge Risk components General requirements

To be eligible for designation as a hedged item, a risk component must be a separately identifiable component, and the changes in cash flows or fair value of the item attributable to change in that component must be reliably measurable (IFRS 9 B6.3.8).

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An entity wishes to hedge a non-contractually specified risk component of a non-financial item. If the risk component is an input in the manufacturing process of the non-financial item, is this sufficient for the risk component to be a separately identifiable hedged item?

Solution Hedge Risk components General requirements

No. In general, it will be necessary for the risk component to be an input in the manufacturing process in order to be considered as ‘separately identifiable’, and so meet the criteria in IFRS 9. However, merely being an input in the manufacturing process is not, in itself, sufficient. IFRS 9 B6.3.9 requires that the qualifying criteria for an eligible risk component should be assessed in the context of the particular market structure to which the risks relate and in which the hedging activity takes place.

For example, wool is an input in the manufacturing process for woollen sweaters. Whether the wool price is a hedgeable risk component of the total price of the sweater depends on the market structure for the particular sweater. In the luxury apparel market, the price of the raw material (wool) will often have a low impact on the price of a woollen sweater that will instead mainly reflect the perceived value of the brand.

In such a market, the wool price is unlikely to be an eligible risk component for a retailer. On the other hand, the price of a ‘no frills’ sweater of a generic design might be driven by the cost of the inputs into the manufacturing process (such as raw materials, labour and overheads) and a production margin. This is likely to give rise to a hedgeable risk component for the wool price component.

While it will, in general, be necessary for the risk component to be an input into the manufacturing process, there might be rare cases where the market structure is clear that a non-financial risk component is a separately identifiable component, even in the absence of a physical presence.

For example, in some markets a long-term supply contract for natural gas may be based on a contractually specified formula that refers to indices including, inter alia, the price of crude oil. If a supply contract is in place, the crude oil price component would be considered to be an eligible risk component, because it is ‘explicitly specified’ in the contract. Equally, if a supply contract is not yet in place but the market commonly prices purchases of natural gas under long-term contracts in this manner, the crude oil price component would still be a hedgeable non-contractually specified risk component.

This would be true for a highly probable forecast purchase of natural gas beyond the period for which liquid derivatives are available, despite crude oil not being an input in the manufacturing process for natural gas, when such pricing mechanism for natural gas (that is, the linkage to the crude oil prices) is the ‘industry norm’. A different conclusion may be reached in a jurisdiction where pricing for natural gas is not based on crude oil, for example, where there is a liquid spot and forward market for natural gas for the period being hedged.

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How should an entity determine whether changes in cash flows or fair value attributable to changes in a hedged component are reliably measurable?

Illustration

To be eligible for designation as a hedged item, a risk component must be a separately identifiable component, and the changes in cash flows or fair value of the item attributable to change in that component must be reliably measurable (IFRS 9 B6.3.8).

Company A wishes to designate a risk component as a hedged item. How should company A assess if the ‘reliably measurable’ criterion is met?

Solution Hedge Risk components General requirements

Changes in cash flows or fair value attributable to changes in the hedged component would be considered reliably measurable where the price of a non-contractually specified risk component has a predictable and direct impact on the price of the entire item. A linear relationship, where changes in the price of the risk component have an equivalent (though not necessarily one-to-one) impact on the price of the entire item, in the absence of changes in other inputs, would generally create such a predictable and direct impact.

Nevertheless, a non-linear relationship might also be sufficient for a risk component to be considered an eligible hedged component. For example, the prices of many items are only updated periodically, or where input prices increase or decrease beyond a reasonable threshold, creating ‘stepped’ changes in the link between the price of the risk component and the price of the entire item. Accordingly, an entity will need to analyse the nature of the non-linear relationship, and the reasons for that relationship, to establish whether the risk component is implicit in the fair value or cash flows of the entire item and hence is an eligible hedged component. Hedge Risk components General requirements

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Hedge Risk components General requirements

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