Embedded derivatives Equity kicker

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

IFRS 9 Inflation as a risk component

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

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

Foreign currency basis spreads

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

Hedge of a net position

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

Example fair value hedge

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. Example fair value hedge

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

Accounting for macro hedging

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

Cash flow hedge of a net position

Cash flow hedge of a net position has changed from IAS 39 to IFRS 9, this section illustrates these changes for hedge accounting of a net position, by discussing the application under IAS 39 and the changes thereto under IFRS 9.

Many entities are exposed to foreign exchange risk arising from purchases and sales of goods or services denominated in foreign currencies. Cash inflows and outflows occurring on forecast transactions in the same foreign currency are often economically hedged on a net basis. For example, consider an entity that has forecast foreign currency sales of FC100 and purchases of FC80, both in 6 months. It hedges the net exposure using a single foreign exchange forward contract to sell FC20 in Read more

Foreign currency forward contracts

Foreign currency forward contracts is about one of the other changes from IAS 39 to IFRS 9 in respect of hedge accounting Foreign currency forward contracts

What is a forward element of forward contracts?

A forward exchange contract is a special type of foreign currency transaction. Forward contracts are agreements between two parties to exchange two designated currencies at a specific time in the future. These contracts always take place on a date after the date that the spot contract settles and are used to protect the buyer from fluctuations in currency prices. Foreign currency forward contracts

Forward contracts are not traded on exchanges, and standard amounts of currency are not traded in these agreements. Forward exchange contracts are a mutual hedge against risk … Read more

Rebalancing of hedged item or hedging instrument

Rebalancing of hedged item or hedging instrument Rebalancing of hedged item or hedging instrument – 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 … Read more