Embedded derivatives Equity kicker – A more specific type of embedded derivative that is often found in practice relates to a type of funding provided by venture capital entities is the equity kicker. It is many times part of a sales of a part of a business of a listed company, financed by the venture capital entity. The intention is to prepare the separated business for an IPO within 3 – 5 years after this separation. Embedded derivatives Equity kicker
Example Mezzanine financing Equity kicker
A venture capitalist provides a subordinated loan, that in addition to interest and repayment of principal, contains terms that entitle the venture capitalist to receive shares of the borrower (separated business) free of charge or … Read more
Inflation as a risk component – Under IAS 39, inflation cannot be designated as a hedged risk component for financial instruments, unless the inflation risk component is contractually specified. For non-financial instruments, inflation risk cannot be designated under IAS 39 as a risk component at all. Inflation as a risk component
Highlight – For financial instruments, IFRS 9 opens the door for designating a non-contractually specified inflation component as a hedged risk component – but only in limited circumstances. For non-financial instruments, the inflation component will be eligible for designation as the hedged item in a hedging relationship provided that it is separately identifiable and reliably measurable. Inflation as a risk component
For financial instruments, IFRS 9 introduces a rebuttable … Read more
Hedge accounting of hedges for commodity risks – Under the old rules of IAS 39, hedge accounting could be difficult to achieve in relation to commodity exposures. This was largely due to the fact that IAS 39 did not permit hedging of specific risk components of non-financial items (with the exception of FX risk). Hedge accounting of hedges for commodity risks
For example, a company with a known diesel purchase requirement over the next two to three years may wish to hedge its exposure using a diesel swap. Even though the swap is designed to be a valid economic hedge of the wholesale diesel price risk, the company would not be able to define the hedged risk specifically as such. … Read more
Q: When can an entity make use of a hedge of a net position?
Considerations: Hedge of a net position
A EUR-functional currency entity has a sales department that sells certain items in USD. At the same time, the purchasing department buys certain products in USD. Each department is unaware of the other’s activities, but both want to hedge their forecast USD sales and purchases respectively. Assume that the sales department has USD 100,000 of sales in six months’ time, so it enters into a forward contract with the entity’s central treasury department (that is a separate entity within the same group). Hedge of a net position
The purchasing department has highly probable forecast purchases of USD 90,000, also … Read more
Fair value hedge of changes in the benchmark interest rate for a variable-rate debt obligation Example fair value hedge
On January 1, Year 1 ABC Corp. issues a floating-rate non-amortizing debt instrument with a maturity of two years. The variable-rate liability resets every six months at the six-month LIBOR rate.
The six-month LIBOR rate on January 1, Year 1 is 2.5%. Example fair value hedge
At the same time, ABC enters into a six-month interest rate swap agreement with a notional amount equal to the face amount of the debt instrument. Under the terms of the swap agreement, ABC will receive the six-month LIBOR rate and pay the one-month LIBOR rate (for example 2.3%).
ABC wants to designate the interest … Read more
Foreign currency basis spreads is about one of the other changes from IAS 39 to IFRS 9 in respect of hedge accounting
What is the cross currency basis spread
In general, the cross currency basis is a measure of dollar shortage in the market. The more negative the basis becomes, the more severe the shortage. For dollar-funded investors, negative basis can work in their favour when they hedge currency exposures. In order to hedge foreign currency exposure, the dollar-funded investors lend out dollar today and receive it back in the future, earning additional cross currency basis spread on top of the yield of their foreign investments. Foreign currency basis spreads
In fact, for years the Reserve Bank of Australia has … Read more
Accounting for macro hedging – Financial institutions, particularly retail banks, have as a core business, the collection of funds by depositors that are subsequently invested as loans to customers. This typically includes instruments such as current and savings accounts, deposits and borrowings, loans and mortgages that are usually accounted for at amortised cost. The difference between interest received and interest paid on these instruments (i.e., the net interest margin) is a main source of profitability.
A bank’s net interest margin is exposed to changes in interest rates, a risk most banks (economically) hedge by entering into derivatives (mainly interest rate swaps). Applying the hedge accounting requirements (as defined in IAS 39 or IFRS 9) to such hedging strategies on … Read more