Setting the hedge ratio

Setting the hedge ratio is about this ratio between the amount of hedged item and the amount of hedging instrument.

Setting the hedge ratio

For many hedging relationships, the hedge ratio would be 1:1 (or 1 or 100%, notation varies between people) as the underlying of the hedging instrument perfectly matches the designated hedged risk. Setting the hedge ratio

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). Setting the hedge ratio

Accordingly, the third effectiveness requirement is that the hedge ratio used for accounting should be the same as that used for risk management purposes.

This does not mean that an entity must designate hedging relationships to the same extent as it hedges for risk management purposes. Setting the hedge ratio

For example, if an entity uses a hedge ratio of a quantity of hedging instrument to a quantity of hedged item of 1.1:1 (or 1,1 or 110%) and for risk management purposes hedges a notional amount of hedged items of 100 using a notional amount of hedging instruments of 110, it could decide to designate only a notional amount of 80 of hedged items and designate a notional amount of 88 of its hedges as hedging instruments for accounting purposes. Setting the hedge ratio Setting the hedge ratio

Setting the hedge ratio

An entity purchases a raw material whose price is at a discount to the commodity benchmark price, reflecting that the raw material is not yet processed to the same extent as the benchmark commodity, as well as quality differences. The entity runs a rolling 12-month regression analysis at each month end to ascertain that the price of the commodity in the futures market and the price of the raw material remain highly correlated. The slopes of the regression analyses (commodity benchmark price to raw material price) over recent months varied between 1.237 and 1.276.

The entity considers that the pattern of its regression analyses is consistent with its longer term view that the raw material trades at an approximately 20% discount to the commodity benchmark price and does not indicate a change in trend but fluctuations around that discount. Therefore, the entity uses a notional amount of 1 tonne of a forward contract for the benchmark commodity to hedge highly probable forecast purchases of 1.25 tonnes of the raw material. Note that this is not exactly the same as the particular slope of the most recent monthly regression, which is not required because the standard requires only that the entity uses the hedge ratio that it actually uses for risk management purposes, and not that it is required to minimise ineffectiveness. The example also illustrates what the standard acknowledges:

– there is no ‘right’ answer, as different entities would run different regression analyses (e.g., in terms of frequency and data inputs used, which means there is no one hedge ratio that could be required). The fluctuation of the actual discount around the particular hedge ratio chosen for designating the hedging relationship will give rise to some ineffectiveness.

However, the standard requires the hedge ratio for accounting purposes to be different from the hedge ratio used for risk management if the hedge ratio reflects an imbalance that would create hedge ineffectiveness that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting. This complex language was introduced because the IASB is specifically concerned with deliberate under-hedging, either to minimise recognition of ineffectiveness in cash flow hedges or the creation of additional fair value adjustments to the hedged item in fair value hedges. Setting the hedge ratio  Setting the hedge ratio

SCENARIO 1 – Deliberate under-hedging in a cash flow hedge to minimise ineffectiveness

Consistent with the equivalent requirements of IAS 39, paragraph 6.5.11(a) of IFRS 9 requires the cash flow hedge reserve to be adjusted for the lower of (a) the cumulative gain or loss on the hedging instrument or (b) the cumulative change in fair value of the hedged item. If (a) exceeds (b), the difference is recognised in profit or loss as ineffectiveness. On the other hand, no ineffectiveness is recognised if (b) exceeds (a).

An entity has highly probable forecast purchases of a raw material used in its manufacturing process. The average volume of raw material purchases is expected to be Russian Ruble (RUB)200m per month. The entity wishes to hedge the commodity price risk on those forecast purchases. The only derivative available does not have an underlying risk exactly matching the one from the actual raw material hedged. The slope of a linear regression analysis is 0.93, indicating the ideal hedge ratio.

To seek to avoid recognition of accounting ineffectiveness, the entity ensures (b) will exceed (a), applying the accounting requirement discussed above. It enters into derivatives with a notional amount of only RUB150m per month and designates the RUB150m of forward contracts as hedging instruments in cash flow hedges of highly probable forecast purchases of RUB200m (thereby setting the hedge ratio at 0.75:1).

In this scenario, the hedge ratio would be considered unbalanced and only entered into to avoid recognition of accounting ineffectiveness. For hedge accounting purposes, the hedge ratio would have to be based on the expected sensitivity between the hedged item and the hedging instrument (in this example possibly around the 0.93:1 based on the linear regression analysis). As a result, if the relative change in the fair value of the hedging instrument is greater than that on the hedged item because the relationship between the underlyings changes, some ineffectiveness will have to be recognised.

SCENARIO 2 – Deliberate under-hedging in a fair value hedge to create fair value accounting

An entity acquires a CU50m portfolio of debt instruments. The debt instruments fail the ‘cash flow characteristics test’ in paragraphs 4.1.2(b) and 4.1.3 of IFRS 9 (i.e., the contractual cash flows do not solely represent payments of principal and interest on the principal amount outstanding) and are therefore accounted for at fair value through profit or loss.

The treasurer dislikes the profit or loss volatility resulting from the fair value accounting. He realises that one of the entity’s fixed rate bank borrowings has a similar term structure and that fair value changes on the liability would more or less offset the fair value changes on the asset portfolio. However, at the time of entering into the bank borrowing, the entity did not apply the fair value option to this liability.

The treasurer enters into a CU1m receive fixed/pay variable IRS and designates the IRS in a fair value hedge of CU50m of fixed rate liability (thereby setting the hedge ratio at 0.02:1). As a result, the entire CU50m of liability would be adjusted for changes in the hedged interest rate risk.

In this scenario, the hedge ratio is unbalanced as the real purpose of the hedging relationship is to achieve fair value accounting (related to changes in interest rate risk) for CU49m of the liability. The hedge ratio used for hedge accounting purposes would have to be different (likely close to 1:1).

The above examples are of course extreme scenarios and instances of unbalanced hedge designations are likely to be rare; IFRS 9 does not require an entity to designate a ‘perfect hedge’. For instance, if the hedging instrument is only available in multiples of 25 metric tonnes as the standard contract size, an imbalance due to using, say, 400 metric tonnes nominal value of hedging instrument to hedge 409 metric tonnes of forecast purchases, would not be regarded as resulting in an outcome ‘that would be inconsistent with the purpose of hedge accounting’ and so would meet the qualifying criteria. Setting the hedge ratio

Setting the hedge ratio

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