a closer look assessing hedge effectiveness under ifrs 9 - ias plus

The requirement to measure and recognise hedgeineffectiveness is not changed under these proposals.

BackgroundTo qualify for hedge accounting under IAS 39 there mustbe an expectation that the hedge will be highly effective(ie the prospective test) and that expectation must berealised for each hedged period (ie the retrospective test).Therefore under IAS 39 it is not known whether hedgeaccounting will apply for each period until the end ofeach period. IAS 39 defines a hedge as highly effective ifthe offset is in the range of 80-125 per cent. This resultsin entities being required to perform numericaleffectiveness tests to demonstrate offset within this rangeif it wishes to qualify for hedge accounting. Theserequirements are seen to be onerous, not in line with riskmanagement practices and vulnerable to technicalfailures (rather than a breakdown in the economics of thehedge). In addition, it is difficult to explain an entity’s riskmanagement strategy when hedge accounting is notallowed because of an ‘accounting-based threshold’ of80-125 per cent. This approach also fails to show thetrue performance of a hedge when the offset fallsoutside the 80-125 per cent range.

To address these issues the IASB decided to replace thequalifying criteria in IAS 39 with more principles-basedqualifying criteria, avoiding any specific offset thresholdsthat could be inconsistent with risk managementapproaches. Under the proposals a hedging relationshipmust comply with the following to qualify for hedgeaccounting:

• there should be an economic relationship betweenthe hedging instrument and the hedged item;

• the effect of credit risk should not dominate the valuechanges that result from that economic relationship; and

• the hedge ratio should reflect the actual quantity ofhedging instrument used to hedge the actual quantityof hedged item (ie consistent with the ratio used forrisk management purposes), provided this does notdeliberately attempt to achieve an inappropriateaccounting outcome.

A Closer LookAssessing hedge effectivenessunder IFRS 9

IntroductionIn September 2012 the International AccountingStandards Board (IASB) issued a draft of the newproposals for hedge accounting under IFRS. These longawaited reforms will eventually form part of the newstandard on financial instrument accounting, IFRS 9,and are expected to be effective from 1 January 2015.The draft will be available on the IASB website untilearly December.

The IASB has proposed a number of significant changesto the current IAS 39 hedge accounting requirements.The overall effect will be more opportunities to applyhedge accounting and consequently less profit or lossvolatility arising from risk management activities.To date, IAS 39’s restrictive accounting rules have ledto some companies not applying hedge accountingor in some cases changing their risk managementapproach to become eligible. Hence, the lifting of theserestrictions could prompt changes in risk managementand more application of hedge accounting.

To highlight the practical effect of some of the newproposals we have written a series of examplescontrasting the current IAS 39 requirements with thenew proposals. This publication is the third in thatseries1 and will explore the changes to the hedgeeffectiveness requirements.

Under the proposals a hedging relationship must meetcertain hedge effectiveness requirements in order toqualify for hedge accounting. Those requirements aresignificantly different to those in IAS 39. The key changesto the effectiveness testing requirements include:

• the removal of the 80 – 125 per cent offsetrequirement and replacement with a principles basedeffectiveness test;

• the removal of retrospective effectiveness testingrequirements leaving only a prospective assessmentrequired at the beginning of each hedged period; and

• increased flexibility in how hedge effectiveness isdemonstrated.

1 The first publicationexplored the changes tothe accounting of optioncontracts designated ashedging instruments andthe second focussed onhedging risk componentsin non-financial items.Both can be found athttp://www.iasplus.com/en/tag-types/global-publications/a-closer-look.

A Closer Look Assessing hedge effectiveness under IFRS 9 2

The new effectiveness assessment regime will requirejudgement to determine whether an economicrelationship exists between the hedged item and hedginginstrument. Depending on how complex the hedgingrelationship is, that judgement may need to be supportedby a qualitative or a quantitative assessment of thehedging relationship.

The examples below set out in a more practical contexthow an entity could go about meeting the effectivenesstesting requirements of IFRS 9. The examples comparethe IFRS 9 requirements to IAS 39 to illustrate thepractical differences between the two standards.The examples focus on cash flow hedges of interest raterisk, however, the principles can apply to other hedges.The numbers used in these examples are for illustrativepurposes only.

(X axis): -ΔFV of hedged item/ΔFV hedging instrument as %.

100

80 100 125

Y

X

(Y axis): % change in fair value (FV) of hedging instrumentrecognised in profit or loss net of any fair value hedgeadjustments on hedged items in a fair value hedge.

No hedge accounting under IAS 39 or IFRS 9

100

80 100 125

Y

X

Fair value hedge under IAS 39

What is hedge effectiveness?Hedge effectiveness is the extent to which changes inthe fair value or cash flows of the hedging instrumentoffset changes in the fair value or cash flows of thehedged item

Assessment vs MeasurementHedge effectiveness assessment is different fromhedge effectiveness measurement. Assessmentdetermines whether a hedge relationship is eligible forhedge accounting. If hedge accounting is applied thenany hedge ineffectiveness (except for a cash flowunder-hedge) must be measured and recognised inprofit or loss. The requirements of IFRS 9 and IAS 39are very different in respect of assessment but bothrequire actual hedge ineffectiveness to be measuredand recognised in the same way.

The graph below shows that in the absence of hedgeaccounting, 100 per cent of the change in fair valueof the hedging instrument is recognised in profit orloss with no offsetting amounts from remeasuringhedged items (in the case of a fair value hedge).

The chart below illustrates the effect of fair value hedgeaccounting under IAS 39 which applies when the hedgeis assessed as effective within the 80 to 125 per centrange.

100

80 100 125

Y

X

Cash flow hedge under IAS 39


Under IAS 39, hedge accounting cannot be appliedoutside the 80-125% range. Outside this range offsetbetween hedged item and hedging instrument is notreflected.

Both IAS 39 and IFRS 9 have the same mechanicsfor cash flow hedge accounting where the amountsdeferred in reserves is the lower of:

(i) The cumulative gain or loss on the hedginginstrument from inception of the hedge; and

(ii) The cumulative change in present value of theexpected future cash flows on the hedged itemfrom inception of the hedge.

The consequence of this is that no ineffectiveness isrecognised in profit or loss for an effective hedge wherethe cumulative change in value of the hedging instrumentis less than the hedged item.

Under IFRS 9 there is no defined numerical range ofeffectiveness necessary for hedge accounting to beapplied. If there is an economic relationship, notdominated by credit risk, and the appropriate hedge ratiois designated, the hedge effectiveness criteria are met.However, where hedge ineffectiveness arises it would benecessary to consider whether it calls into question theeconomic relationship or prompts reconsideration of thehedge ratio. For example, if a hedge is consistently90 per cent effective this might indicate that the hedgeratio should be different.

100

80 100 125

Fair value hedge under IFRS 9

100

80 100 125

Cash flow hedge under IFRS 9

The chart below illustrates the effect of cash flowhedge accounting under IAS 39 which applies when thehedge is assessed as effective within the 80 to 125 percent range.

The chart below illustrates the effect of fair value hedgeaccounting under IFRS 9 when the hedge is assessed aseffective.

The chart below illustrates the effect of cash flow hedgeaccounting under IFRS 9 when the hedge is assessed aseffective.


The swap is on-market and transacted for nilconsideration. The hedge is formally designated on1 May 2013 as a cash flow hedge of the variability ofthe highly probable interest cash flows on the forecastbond issuance up to the date of issue and on the actualbond issued to maturity for changes in 3M LIBOR.

Hedge effectiveness under IAS 39

• Designation of the quantity of hedged item andquantity of hedging instrument (ie hedge ratio):Given that IAS 39 requires a hedge to achieve anoffset within 80-125% in order to be regarded as aneffective hedge, the hedge ratio would need to be setin order to expect to meet this level of effectiveness.Also, IAS 39 prohibits an entity from deliberately‘under-hedging’ by designating the amount of thehedging instrument lower than the amount ofhedged item in order to artificially reduce hedgeineffectiveness. This is particularly relevant for cashflow hedges. In this example the entity has hedged100% of the exposure and hence this is not relevant.

• Method for assessing hedge effectiveness:The hedge documentation must specify the methodEntity A will apply to assess hedge effectiveness bothprospectively and retrospectively and apply thisconsistently for the duration of the hedgerelationship.

Detailed examplesThe numbers used in these examples are for illustrativepurposes only.

Example 1 – matched termsEntity A plans to issue a floating rate bond on1 July 2013. The bond will have principal of £100mand pay interest quarterly in arrears on 1 January,1 April, 1 July and 1 October each year up to andincluding the maturity date of 1 July 2023. Interestwill be paid at a rate of 3M LIBOR + margin.

Entity A has an interest rate risk management policyunder which interest rate swaps may be used to hedgeinterest rate risk. On 1 May 2013 the entity transacts apay fixed, receive float, forward starting interest rateswap with the following terms:

Trade date 1 May 2013

Effective date 1 July 2013

Maturity date 1 July 2023

Notional £100,000,000

Pay 2.2%

Receive 3M LIBOR

Payment dates 1 January, 1 April, 1 July and1 October each year up to andincluding 1 July 2023

• Prospective hedge effectiveness: On 1 May 2013,and at the beginning of each reporting period,Entity A is required to carry out prospectiveeffectiveness testing to demonstrate that the hedge isexpected to be highly effective (ie 80 to 125 per centoffset). More frequent testing is permitted.The method of testing adopted in this example iscritical terms matching. As the critical terms of thehedged cash flows and hedging interest rate swapmatch, credit risk is insignificant and the fair value ofthe swap is nil on designation, the hedge is expectedto be a highly effective. Note that if the effect ofcredit risk was expected to be more than insignificantthen this would call into question whether criticalterms matching would be a sufficient test todemonstrate an expectation of high effectiveness.

• Retrospective hedge effectiveness: At the end ofeach reporting period whilst the hedge accountingrelationship remains designated, Entity A is requiredto perform retrospective effectiveness testing todemonstrate that the hedge has actually been highlyeffective during the period. More frequent testing ispermitted. This cannot be limited to principal termsmatching, instead a quantitative assessment isrequired. The entity chooses to test effectivenessusing simple ratio analysis (also referred to as a dollaroffset test) based on cumulative changes in fair valueusing a hypothetical derivative to measure the hedgeditem. This test would capture the effect of credit riskon the hedging instrument not replicated in thehedged item and if it was significant enough to pushthe hedge outside of the 80 to 125 per centthreshold then hedge accounting would not bepermitted for that period.

• Measurement of hedge ineffectiveness: For eachreporting period during the life of the hedge, hedgeineffectiveness must be measured and recognisedaccordingly.

Hedge effectiveness under IFRS 9

• Prospective hedge effectiveness: At inception ofthe hedge and at each reporting date an entitymust demonstrate that it meets the following threecomponents of the hedge effectiveness requirementsof the proposed IFRS 9:

(1) There is an economic relationship betweenthe hedged item and the hedging instrument.

The requirement that an economic relationshipexists means that the hedging instrument and thehedged item have values that generally move inthe opposite direction because of the samehedged risk or related underlying. The proposedIFRS 9 does not specify a method for assessingeffectiveness.


However, when the critical terms of the hedginginstrument and the hedged item match it wouldmost likely be possible to conclude on the basis ofa qualitative assessment that the hedged item andhedging instrument have values that generallymove in the opposite direction because of thesame risk and hence an economic relationshipexists. In this case, because the terms of thehedged item and hedging instrument match andthe fair value of the swap is nil at inception of thehedge, Entity A determines on a qualitative basisthat an economic relationship exists between thehedged item and hedging instrument.

(2) The effect of credit risk does not dominate thevalue changes that result from that economicrelationship.

A change in credit risk on the hedged itemor hedging instrument could be of such amagnitude that it could negate the economicrelationship that would otherwise exist betweenthe hedged item and hedging instrument.Therefore it is necessary that the effect of credit riskdoes not dominate the value changes that resultfrom the economic relationship. In this exampleuntil the debt is issued it is not necessary toconsider credit risk on the hedged item as it is aforecast transaction and cannot be exposed tocredit risk. Note that under both IAS 39 and theproposed IFRS 9, a forecast transaction must behighly probable in order to be eligible as a hedgeditem. However, consideration should be given tothe effect of credit risk on the value changes ofthe hedging instrument. In this case Entity Adetermines that its own credit standing and thecredit standing of the swap counterparty is highand is expected to stay that way and henceconcludes that changes in credit risk would notdominate the value changes that result from theeconomic relationship.

(3) The hedge ratio is consistent with that usedfor risk management purposes without adeliberate imbalance to derive aninappropriate accounting outcome (egdeliberate under-hedging by designating theamount of the hedging instrument to be lowerthan the amount of the hedged itemto artificially reduce hedge ineffectiveness).

Entity A economically hedges a bond withprincipal of £100m using a swap with matchedterms and notional of £100m. This actual hedgeratio does not reflect an imbalance (that couldresult in an accounting outcome that would beinconsistent with the purpose of hedgeaccounting) and hence represents an eligiblehedge ratio. If it had attempted to designate only£80m of the £100m notional of the swap actuallytransacted in a hedge of £100m of the bond thenthis would be regarded as a deliberate under-hedge and not meet the effectivenessrequirements in respect of the hedge ratio andnot be eligible for hedge accounting. It should benoted that in this example there is no incentive tounder-hedge as the hedge has matched termsand minimal sources of hedge ineffectiveness.

• Documented method of assessing hedgeeffectiveness: The hedge documentation mustspecify the method Entity A will use to assess hedgeeffectiveness. That method may need to change ifcircumstances change so that the currentmethodology no longer captures the relevantcharacteristics of the hedge relationship and thedocumentation should be amended to reflect thiswhen it happens. In addition the documentationshould contain:

– an analysis of the sources of ineffectiveness; and – how the hedge ratio has been determined.

In this example this can be limited to a qualitativeanalysis as discussed above.

• Measurement of hedge ineffectiveness: At eachreporting date during the life of the hedge,ineffectiveness must be measured and recognisedaccordingly. Retrospective hedge effectivenessassessment is not required.


Example 2 – Closely matched termsThe facts are the same as in the example abovewith the exception that, the forecast bond issuancedoes not become highly probable until 1 June 2013.Therefore Entity A cannot designate the swap transactedon 1 May 2013 in an eligible hedging relationshipunder the proposed IFRS 9 until 1 June 2013 (norwould it be eligible under IAS 39) by which time thehedging instrument is off-market.

On designation the swap is in a liability position of£1.3m (referred to below as the embedded financing).Interest rates have reduced such that an on marketswap at this date would have a fixed leg of 1.9%.

The hedge is formally designated on 1 June 2013 as acash flow hedge of the variability of the highly probableinterest cash flows on the forecast bond issuance up tothe date of issue and on the actual bond issued tomaturity for changes in 3M LIBOR.


• As noted in the matched terms example abovethe entity designates a hedge ratio that does notdeliberately under-hedge in order to avoid recognisinghedge ineffectiveness in profit or loss. The entity isalso required to select and document a method ofassessing hedge effectiveness both prospectively andretrospectively, and measure and recognise hedgeineffectiveness accordingly.

• In this example as the derivative hedging instrumentis off market at the date of designation, critical termsmatching would not be considered to be an adequateprospective hedge effectiveness test. Instead Entity Amust perform sufficient quantitative analysis tosupport the expectation that the hedge will be highlyeffective. Entity A uses the ‘hypothetical derivative’method to measure the hedged item.

The terms of the hypothetical derivative are the sameterms as the actual swap with the exception of therate paid on the fixed leg which is 1.9% rather than2.2%. Entity A considers the relative fair value gainsor losses that would arise on the hypothetical andactual derivatives in a range of scenarios based onpast market data. Entity A uses regression analysis todemonstrate prospective effectiveness. It selects thismethod as it is less likely to fail the 80 to 125 percent test using regression analysis than if it used asimple ratio analysis (or dollar offset test). Entity Aalso uses regression analysis for its retrospectivehedge effectiveness testing.


• Prospective hedge effectiveness: As noted in theexample above, at inception of the hedge and ateach reporting date an entity must demonstrate thatit meets the following three components of thehedge effectiveness requirements of the proposedIFRS 9:

(1) There is an economic relationship betweenthe hedged item and the hedging instrument.

As noted above the proposed IFRS 9 does notspecify a method for demonstrating an economicrelationship. In this example the critical termsclosely match, however, due to the delayeddesignation the fixed leg of the actual swap isdifferent to the fixed leg of the hypothetical swap.Hence some hedge ineffectiveness is expecteddue to the £1.3m embedded financing in theswap. Entity A must determine whether despitethis embedded financing an economic relationshipexists between the hedged item and hedginginstrument.

In this example Entity A performs basic numericalanalysis of discount rates considering a range ofpossible scenarios of changes in interest rates todemonstrate that possible changes in fair value ofthe embedded financing (which is deemed by theentity to be the main source of hedge ineffectiveness)are not sufficient to negate the underlyingeconomic relationship between the hedged itemand hedging instrument. Entity A concludes thatan economic relationship between the hedgeditem and hedging instrument exists.


The analysis here would be the same as thatperformed for the matched terms example above.


(3) The hedge ratio is consistent with that usedfor risk management purposes without adeliberate imbalance to derive aninappropriate accounting outcome.

Entity A economically hedges a bond with principalof £100m using a swap with closely matched termsand notional of £100m. The embedded financingin the swap is a source of hedge ineffectivenessand it should be considered if this affects therequired hedge ratio. Entity A determines on aqualitative basis that the existence of theembedded financing in this case would give riseto hedge ineffectiveness but a hedge ratio of100% would not result in an imbalance as basedon a forecast range of possible changes in interestrates the ineffectiveness in each period could be positive or negative by similar amounts (rather than consistently over or under-hedged).Hence the entity selects a hedge ratio of 100%.

• Documented method of assessing hedgeeffectiveness: As noted above the hedgedocumentation must specify the method Entity Awill use to assess hedge effectiveness and contain:


In this example this will include documenting thequalitative analysis performed (ie on comparing termsand the effect of credit risk) and quantitative analysisperformed (ie on the hedge ineffectiveness arisingfrom the embedded financing) that was used todemonstrate compliance with the three componentsof the effectiveness requirements.

• Measurement of hedge ineffectiveness: As notedabove, at each reporting date during the life of thehedge, ineffectiveness must be measured andrecognised accordingly. Retrospective hedgeeffectiveness assessment is not required.

In some cases the embedded financing in the actualswap may be more significant than that considered inthe example above and may warrant a morecomprehensive quantitative analysis to demonstratecompliance with the effectiveness requirements.

Example 3 – Significantly mismatched terms butrelated underlyingsThe terms of the hedged item are the same as inExample 1 above, however, the terms of the hedginginstrument are different because the entity uses a pre-existing swap to hedge the interest rate risk where theterms do not match the hedged item. The terms of thehedging instrument are as follows:

Trade date 1 August 2008 (ie transacted 5 yearsbefore being designated in this hedgerelationship)

Effective date 1 August 2008

Maturity date 1 August 2023

Notional £100,000,000

Pay 5.2%

Receive 6M LIBOR

Payment dates 1 August, 1 February each year up toand including 1 August 2023

2 It is noted that alternativehedge designations maybe permitted, however,Entity A chooses todesignate 3M LIBORwhich is consistent withits risk managementobjective.

It is noted that in practice, most cases of latehedge accounting designations are the result ofexisting hedging instruments being used tohedge either new, existing or restructuredhedged items. There are various commercialreasons for retaining existing off-marketderivatives to hedge items rather than closethem out and transact new on marketderivatives. These reasons include the increasedcost incurred (ie dealer’s margin) for closingpositions and transacting new positions andliquidity constraints when the derivative is in aliability position.

The hedge is formally designated on 1 May 2013 as acash flow hedge of the variability of the highly probableinterest cash flows on the forecast bond issuance up tothe date of issue and on the actual bond issued tomaturity for changes in 3M LIBOR.2 The fair value of thederivative at the point of designation is a liability of £13m.


• The hedge effectiveness testing requirements andmethodologies applied for this example are the sameas in Example 2 above. Given the more significantmismatch in terms and embedded financing, thehedge effectiveness assessment tests may not passthe rigid 80-125 per cent offset test for the durationof the hedge in which case hedge accounting wouldnot be permitted for some or all of the period of thehedge.



• Prospective hedge effectiveness: At inception of thehedge and at each reporting date an entity mustdemonstrate that it meets the following threecomponents of the hedge effectiveness requirementsof the proposed IFRS 9:

(1) There is an economic relationship between thehedged item and the hedging instrument.

Given the significant mismatch in terms aqualitative assessment would not appropriatelyconsider the sources of hedge ineffectiveness andbe sufficient to demonstrate that there is aneconomic relationship between the hedged itemand hedging instrument. Consequently, Entity Aperforms quantitative analysis of the possiblebehaviour of the hedging relationship during its term. Entity A considers the relative fair valuegains or losses that would arise on thehypothetical derivative with nil fair value at thepoint of designation (and consequently a fixedrate of 2.2% as was the case for the interest rateswap in Example 1) and the actual derivative in arange of scenarios based on past market data.Entity A uses regression analysis to demonstratethe economic relationship. It should be noted that:

i) although it must be expected that the presentvalue of the hedged cash flows and the fairvalue of the swap will typically move in theopposite direction when the hedged 3M LIBORrates change, it is not necessary for the offsetto be within the 80-125 per cent range; and

ii) demonstrating statistical correlation between3M LIBOR and 6M LIBOR would not by itself besufficient to support a valid conclusion that aneconomic relationship exists for this hedgingrelationship. It is necessary to analyse thebehaviour of the specific hedging relationshipduring its term to determine whether it can beexpected to meet the risk managementobjective for the hedge.


The analysis here would be the same as thatperformed for the matched terms example above.

(3) The hedge ratio is consistent with that usedfor risk management purposes without adeliberate imbalance to derive aninappropriate accounting outcome.

Entity A economically hedges a bond withprincipal of £100m using a swap with a matchednotional of £100m but mismatched terms.The mismatch terms and the embedded financingin the swap are sources of hedge ineffectivenessand should be considered if they affect the requiredhedge ratio. In this example, Entity A uses theresults of its regression analysis to demonstratethat the hedge ratio selected for risk managementpurposes (which was based on a qualitative riskmanagement assessment) does not result in animbalance of the hedged item and hedginginstrument. It should be noted that the proposedIFRS 9 permits the use of a hedge ratio that isdifferent to the optimal hedge ratio if there is acommercial reason for the existence of theimbalance. The IASB provides the example wheredue to lot sizes of futures contracts it is notpossible for the entity to match the weightingsof the hedged item with the weightings of thehedging instrument and in such cases theimbalance is permitted. The proposals do notprovide further examples of what may beconsidered valid commercial reasons for animbalance and hence judgement would berequired in such situations where an imbalanceexists between the hedged item and hedginginstrument.

In subsequent periods, if the designated hedgeratio no longer meets the hedge ratiorequirements discussed above, the quantities ofthe hedged item and the hedging instrument mayneed to be “rebalanced” in order to continue tocomply with the requirements. This is anotherarea where judgement will be required as towhether rebalancing is necessary. The proposedIFRS 9 does clarify however that not all changes inthe extent of offset between the hedged item andhedging instrument would lead to rebalancing –for example fluctuations around a constant hedgeratio would not require or permit rebalancing ofthe hedge ratio.


• Documented method of assessing hedgeeffectiveness: As noted above the hedgedocumentation must specify the method Entity A willuse to assess hedge effectiveness and contain:


In this example this will include documenting thequantitative analysis performed that was used todemonstrate compliance with the three componentsof the effectiveness requirements.

• Measurement of hedge ineffectiveness: As notedabove, at each reporting date during the life ofthe hedge, ineffectiveness must be measuredand recognised accordingly. Retrospective hedgeeffectiveness assessment is not required. Hence, incontrast to IAS 39, hedge accounting may bepermitted under IFRS 9 for the full duration of thehedge regardless of whether the offset is within the80 – 125 per cent range. For example, if a hedge isonly 60% effective in a period, the resulting hedgeineffectiveness would still be measured andrecognised accordingly. This results in a closerreflection of the performance of the hedge.

It should be noted that it is possible in an examplesuch as this (where the underlyings are not the samebut are economically related), for hedge accountingto be applied when the values of the hedged itemand hedging instrument move in the same directionin a particular period (rather than the opposite, so arenot an offset in the period), provided, they are stilltypically expected in future periods to move in theopposite direction when the underlyings move. Hencethe initial analysis of effectiveness for each period willbe one of the key factors as to whether hedgeaccounting can be applied.

What is rebalancing?Rebalancing refers to adjustments to the designatedquantities of the hedged item or hedging instrumentof an already existing hedging relationship for thepurpose of maintaining a hedge ratio that complieswith the hedge effectiveness requirements. This is anew requirement that is mandatory under theproposed IFRS 9. Rebalanced hedges are regarded ascontinuing hedges for the amounts that continue tobe hedged. This is in contrast to IAS 39 whererebalancing a hedge is elective and generally treatedas a dedesignation of the original hedge and the startof a new hedge.


Summary comparison of IAS 39 and IFRS 9 hedge effectiveness requirements

Assessing hedge effectiveness: For hedge accounting to be applied results of both prospective an retrospective testing mustbe within the 80 – 125 per cent range. The methodology used to demonstrate hedge effectiveness must be specified atinception and applied consistently throughout the life of the hedge. Methods of testing that would generally be acceptablefor different hedges are discussed below.

Hedge ratio: The offset threshold of 80 – 125 per cent restricts the hedge ratios of hedged item and hedging instrument thatwould be eligible for hedge accounting. Furthermore, deliberate under-hedging in a cash flow hedge is not permitted.

Matched termsHedged item and hedging instrumenthave matched terms and the fair valueof the hedging instrument is nil atinception of the hedge.

Closely matched terms The terms of the hedged item andhedging instrument are closelymatched.

Significantly mismatched terms There is significant mismatch betweenthe terms of the hedged item andhedging instrument but underlyings ofeach are the same or related.

Prospective hedge effectiveness:Critical terms matching, with dueconsideration for credit risk, isgenerally sufficient for assessingprospective hedge effectiveness whenthe terms of the hedged item andhedging instrument match and thehedging instrument has nil fair valueat inception.

Retrospective hedge effectiveness:IAS 9 requires quantitative analysis todemonstrate that a hedge hasperformed within the 80 – 125 percent range. Where the terms matchsimple ratio analysis or “dollar offset”is usually sufficient to demonstrateeffectiveness in the 80-125% range.

Prospective hedge effectiveness:Critical terms matching will not besufficient for assessing prospectivehedge effectiveness when there is amismatch in terms of the hedged itemand hedging instrument. As a resultsufficient quantitative analysis wouldbe necessary.

Retrospective hedge effectiveness:IAS 39 requires quantitative analysis todemonstrate that a hedge hasperformed within the 80 – 125 percent range. Where the terms do notmatch simple ratio analysis or “dollaroffset” may fail to demonstrate hedgeeffectiveness in the 80-125% range. Insuch cases more advanced statisticalanalysis may be required, such asregression analysis.

Prospective hedge effectiveness:In this case sufficient quantitativeanalysis considering a range ofpotential changes in market rateswould be necessary to demonstratethat the hedging relationship isexpected to comply with the80 – 125% offset requirement.In general as the level of mismatchincreases it becomes less likely thehedge will comply with the offsetrequirements for all of the hedgedperiods and as a result hedgeaccounting may not be permitted.

Retrospective hedge effectiveness:In this case it is likely that a moreadvanced statistical analysis would berequired, such as regression analysis,to demonstrate offset within the rangeof 80 – 125 per cent range. With agreater level of mismatch there is anincreased likelihood that the hedgewill not comply with the strict80 – 125 per cent requirementresulting in no hedge accountingbeing permitted.

IAS 39 summary of hedge effectiveness requirements


IFRS 9 summary of hedge effectiveness requirements

Assessing hedge effectiveness: For hedge accounting to be applied the proposals require the following:

(1) there should be an economic relationship between the hedging instrument and the hedged item;

(2) the effect of credit risk should not dominate the value changes that result from that economic relationship; and

(3) the hedge ratio should reflect the actual quantity of hedging instrument used to hedge the actual quantity of hedged item(provided this does not deliberately attempt to achieve an inappropriate accounting outcome).

These requirements are a prospective test; retrospective hedge effectiveness is not required. The proposed IFRS 9 states that thelevel of analysis required to assess compliance with its hedge effectiveness requirements may vary for different hedgingrelationships. The methodology adopted must be documented at inception of a hedge and may change if the method originallyset out ceases to capture all the relevant characteristics of the hedge relationship.

Given that these requirements do not include a numerical threshold for offset, there is more scope for a qualitative assessmentof effectiveness to be sufficient to comply with the requirements. An analysis of the potential sources of ineffectiveness and thereason for the hedge ratio used must be documented. Methods of testing that would generally be acceptable for differenthedges are discussed below. Deliberate under-hedging for a cash flow hedge to mask hedge ineffectiveness is not permitted.Matched terms

Hedged item and hedging instrumenthave matched terms and the fair valuehedging instrument is nil at inceptionof the hedge.

Closely matched terms The terms of the hedged item andhedging instrument are closelymatched.

Significantly mismatched terms There is significant mismatch betweenthe terms of the hedged item andhedging instrument but underlyings ofeach are the same or related.

Critical terms matching wouldgenerally be sufficient to demonstratean economic relationship and supportthe use of a 1:1 hedge ratio.An analysis of sources of hedgeineffectiveness, such as credit risk,would be required which would inmost cases where terms match bequalitative.

Judgement would be required todetermine whether a qualitativeassessment would be sufficient todemonstrate compliance with thethree components of the effectivenessrequirements listed above. Rudimentaryquantitative analysis may well benecessary to demonstrate that themismatch in terms does not negatethe underlying economic relationshipand to support the hedge ratio used.

Analysis that adequately capturesthe potential sources of hedgeineffectiveness, such as credit risk,should be documented.

Where there are significant mismatchesin terms or differences in underlyings,quantitative analysis would benecessary to demonstrate an economicrelationship and compliance with thehedge ratio requirements. The analysisis likely to be similar to that performedunder IAS 39 for such hedges(eg. regression analysis). However,with the absence of the 80 – 125 percent offset requirement it is morelikely that hedge accounting would beachieved under the proposed IFRS 9(although statistical correlation aloneis not sufficient and the economicrelationship should be explained).

Analysis that adequately capturesthe potential sources of hedgeineffectiveness, such as credit riskand basis risk, should be documented.


Alternative examples where the terms of the hedged item and hedging instrument match to varying degrees

Below is a summary of alternative examples of hedging relationships which would warrant varying degrees of analysis to demonstrate compliancewith the effectiveness requirements of IFRS 9 discussed in this paper.

Hedge type

Cash flow hedge

Fair value hedge

Net investment hedge(consolidated financialstatements)Foreign exchange Commodity

Hedged item A sale of goods for Chinese¥15m on 31 March 2013 byan entity with GBP functionalcurrency (highly probableforecast sale).

Purchase of 1,000 metrictonnes of Gasoil on 30 April2013. The purchase price willbe the benchmark Cargoesgasoil spot price (NorthwestEurope) plus a fixed marginagreed with the supplier(highly probable forecastpurchase).

Investment in fixed rate EURbond with principal of€100m, interest of 5%payable semi-annually inarrears and maturity of25 June 2015.

The first $50m of net assetsof a USD subsidiaryconsolidated by a parentwith GBP functional currency.

Hedging instrument:with matched terms

Intrinsic value component ofa purchased option contractto sell ¥15m on 31 March2013 in exchange for a£1.4m to hedge for changesin the ¥/£ exchange rateabove 10.7.

Gas oil forward to receivethe benchmark Cargoesgasoil spot price (NorthwestEurope) for 1,000 metrictonnes on 30 April 2013 inexchange for a fixed amountin the same currency tohedge the benchmarkCargoes gasoil NorthwestEurope component of theforecast purchase.

On market interest rate swapwhich pays 5% and receives6M EURIBOR + margin wherethe terms of the fixed legexactly match those of thebond to hedge the interestrate risk on the bond.

Issued bond with principal ofUS$50m

Hedging instrument:with closely matchedterms

On-market foreign exchangeforward to sell ¥15m on28 August 2013 in exchangefor a £1.5m to hedge forchanges in ¥/£ exchangerates.

Gas oil forward to receivethe benchmark Barges gasoilspot price (Rotterdam) for1,000 metric tonnes of theunderlying on 30 April 2013in exchange for a fixedamount in the same currencyto hedge the benchmarkCargoes gasoil (NorthwestEurope) component of theforecast purchase.

On-market interest rate swapwhich pays 5% and receives6M EURIBOR + margin wherethe terms of the fixed legexactly match those of thebond with the exception ofthe payment dates whichare the end of June andDecember each year ratherthan the 25th to hedge theinterest rate risk on thebond.

On-market cross currencyinterest rates swap that paysfloating USD and receivesfloating GBP with $50mnotional exchanged (paid) for£31m on maturity designatedas a hedge of spot foreignexchange risk.

Note: The hedged risk is spotforeign exchange risk,so movements in the fairvalue of the derivative dueto currency basis will result inineffectiveness under theproposed IFRS 9 guidance ondetermining the hypotheticalderivative.

Hedging instrument:with significantmismatch terms ordifferent underlying tothe hedged item

On-market foreign exchangeforward to sell US$2.4m inexchange for £1.5mdesignated as a proxy hedgefor changes in ¥/£ exchangerates.

Crude oil forward to receivethe Brent crude spot price for7,300 barrels of Brent crudeoil on 30 April 2013 inexchange for a fixed amountin the same currencydesignated as a proxy hedgeof the benchmark Cargoesgasoil (Northwest Europe)component of the forecastpurchase.

Note: This is a proxy hedge.If the entity was able toseparately identify andreliably measure a crude oilrisk component in the gas oilprice as an alternative theanalysis required todemonstrate effectivenessrequirements may be moresimple due to fewer sourcesof hedge ineffectiveness.However, the analysisrequired to demonstrate thatthere is such a componentmay itself be complex.

Off-market cross currencyinterest rate swap that pays5.2% and receives 6M UKLIBOR + 330 bps withpayment dates which are theend of June and Decembereach year rather than the25th to hedge the interestrate and foreign exchangerisk on the bond.

Purchased option contractto sell $50m for £28mdesignated in its entirety(ie. time value and intrinsicvalue) as a hedge of spotforeign exchange risk forincreases in the $/£ rateabove 1.79.

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Key contacts

IFRS global officeGlobal IFRS Leader – Clients and MarketsJoel [email protected]

Global IFRS Leader – TechnicalVeronica [email protected]

Global IFRS Communications DirectorMario [email protected]

IFRS centres of excellence

AmericasCanada Karen Higgins [email protected] Fermin del Valle [email protected] States Robert Uhl [email protected]

Asia-PacificAustralia Anna Crawford [email protected] Stephen Taylor [email protected] Shinya Iwasaki [email protected] Shariq Barmaky [email protected]

Europe-AfricaBelgium Thomas Carlier [email protected] Jan Peter Larsen [email protected] Laurence Rivat [email protected] Andreas Barckow [email protected] Franco Riccomagno [email protected] Eddy Termaten [email protected] Ralph ter Hoeven [email protected] Michael Raikhman [email protected] Africa Graeme Berry [email protected] Cleber Custodio [email protected] Kingdom Elizabeth Chrispin [email protected]

a closer look assessing hedge effectiveness under ifrs 9 - ias plus

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