assessment has increased relevance for non-contractual risk components for which is it
important to undertake a careful analysis of the specific facts and circumstances of the
relevant markets. [IFRS 9.BC6.176].
As noted above, 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. [IFRS 9.B6.3.10].
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 a 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 relevant market structure, a physical component can help meet
those criteria. The example of an eligible risk component that is often quoted is that of
the crude oil component of refined products such as jet fuel. However, 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.
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The determination of eligible non-contractually specified risk components is a
judgemental area where we expect practice to evolve (see 2.2.3 below).
It was reaffirmed by the IASB in developing IFRS 9 that it is not considered possible to
determine that credit risk is an eligible risk component of a debt instrument. It was
explained that a portion cannot be a residual; i.e. an entity is not permitted to designate
as a portion the residual fair value or cash flows of a hedged item or transaction if that
residual does not have a separately measurable effect on the hedged item or transaction.
[IFRS 9.BC6.470]. However, IFRS 9 does introduce an alternative accounting solution for
entities undertaking economic credit risk hedging activity (see 12.1 below).
2.2.2
Contractually specified risk components
Potential hedged items such as financial instruments, purchase or sales agreements may
contain clauses that link the contractual cash flows via a specified formula to a
benchmark rate or price. The examples below all include a contractually specified risk
component:
• the interest rate on a financial instrument contractually linked to a benchmark
interest rate plus a fixed incremental spread
• the coupon on a financial instrument contractually linked to an inflation or other
financial index plus a determinable incremental spread
• the price of natural gas contractually linked in part to a gas oil benchmark price
and in part to a fuel oil benchmark price;
• the price of electricity contractually linked in part to a coal benchmark price and
in part to transmission charges that include an inflation indexation;
• the price of wires contractually linked in part to a copper benchmark price and in
part to a variable tolling charge reflecting energy costs; and
• the price of coffee contractually linked in part to a benchmark price of Arabica
coffee and in part to transportation charges that include a diesel price indexation.
In each of the above examples, for items other than financial assets, it is assumed that
the contractual pricing component would not require separation as an embedded
derivative (see Chapter 42 at 4 and 5). The example below provides a fuller illustration
of the circumstances under which a contractually specified risk component might
usefully be designated in a hedge relationship.
Example 49.1: Hedge of a contractually specified risk component – coal supply
contract linked to the coal benchmark price and the Baltic Dry
Index
An entity purchases coal from its coal supplier under a contract that sets out a variable price for coal linked
to the coal benchmark price, represented by futures contracts for coal loaded at the Newcastle Coal Terminal
in Australia, plus a logistics charge that is indexed to the Baltic Dry Index, reflecting that the delivery is at
an overseas location. The contract sets out minimum purchase quantities for each month covered by its term.
The entity wishes to hedge itself against price changes related to the benchmark coal price but does not want to hedge
the price variability resulting from the logistics costs represented by the indexation of the coal price to the Baltic Dry Index. Therefore, the entity enters into Newcastle coal futures contracts whereby it purchases coal for the relevant
delivery months. For each relevant delivery month the entity designates the futures contracts as a hedging instrument
in a cash flow hedge of the benchmark coal price risk component of the future coal purchases under its supply contract.
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In this case the risk component is contractually specified by the pricing formula in the
supply contract. This means it is separately identifiable, because the entity knows
exactly which part of the change in the future purchase price of coal under its particular
supply contract results from changes in the benchmark price for coal and what part of
the price change results from changes in the Baltic Dry Index. The risk component can
also be reliably measured using the price in the futures market for the relevant delivery
months as inputs for calculating the present value of the cumulative change in the
hedged cash flows. An entity could also decide to hedge only its exposure to variability
in the coal price that is related to transportation costs. For example, the entity could
enter into forward freight agreements and designate them as hedging instruments, with
the hedged item being only the variability in the coal price under its supply contract that
results from the indexation to the Baltic Dry Index.
Although it is generally easier to determine that a contractually specified risk
component is separately identifiable and reliably measurable, than one that is non-
contractual, the requirement must still be met. When contractually specified, a risk
component would usually be considered separately identifiable. [IFRS 9.BC6.174]. Further,
the risk component element of an index/price formula would usually be referenced to
observable data, such as a published index/price index. Therefore, the risk component
would most likely also be considered reliably measurable.
Nevertheless, difficulties can still arise where there is a contractual negative spread
exists in the hedged item, as a risk component must be less than the entire item.
[IFRS 9.B6.3.7]. A negative spread arises when the formula for the contractual coupon/price
includes a spread that is subtracted from the hedged risk component, so that the full
contractual coupon/price is lower than the identified risk component. This has become
termed the ‘sub-LIBOR issue’ (discussed at 2.4 below).
2.2.3
Non-contractually specified risk components
Not all contracts define the various pricing elements and, therefore, specify risk
components. In fact, we expect most risk components of financial and non-financial
items not to be contractually specified. While it
is certainly easier to determine that a
risk component is separately identifiable and reliably measurable if it is specified in
the contract, IFRS 9 is clear that there is no need for a component to be contractually
specified in order to be eligible for hedge accounting. The assessment of whether a
risk component qualifies for hedge accounting (i.e. whether it is separately identifiable
and reliably measurable) has to be made ‘within the context of the particular market
structure to which the risk or risks relate and in which the hedging activity takes
place’. [IFRS 9.B6.3.9]. We understand ‘market structure’ here to mean the basis upon
which market prices are established or market conventions that are in evidence.
Prices are typically established through a number of ‘building blocks’. So, for instance,
a benchmark interest rate such as LIBOR may form the first building block in the
valuation of a debt instrument, while a benchmark price, such as the LME price for
copper, may form the first building block for the pricing of a non-financial item. The
‘sub-LIBOR’ issue, (see 2.4 below) will arise from negative spread building blocks, if
as a result the identified non-contractually specified risk component is larger than the
full contract itself.
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2.2.3.A
Non-contractual risk components in financial instruments
It is usually acceptable to identify a non-contractually specified risk-free interest rate
or other benchmark interest rate component of the total interest rate exposure of a fixed
rate or zero coupon hedged financial instrument.
Example 49.2: Identification of a benchmark interest rate component in fixed
rate debt
Entity A has issued five year debt with a fixed coupon of 5%. The debt is issued in an environment with a
market in which a large variety of similar debt instruments are compared by their spreads to a benchmark rate
(for example LIBOR) and variable rate instruments in that environment are typically indexed to that
benchmark rate. Interest rate swaps are frequently used to manage interest rate risk on the basis of the
benchmark rate, irrespective of the spread on the debt instruments to that benchmark rate. The price of fixed
rate debt instruments vary directly in response to changes in that benchmark rate as they happen. Accordingly
Entity A concludes that the benchmark rate is a separately identifiable and reliably measurable risk
component of the fixed rate debt. [IFRS 9.B6.3.10(d)].
When the debt was issued, the prevailing 5 year benchmark rate was 2%. In pricing the debt, Entity A
included an additional spread of 3% above the benchmark rate to reflect credit risk and other factors. Entity A
then transacted an interest rate swap at the prevailing five year benchmark rate (i.e. pay benchmark, receive
2%). Entity A is able to designate the issued debt as the hedged item in a fair value hedge for changes in the
benchmark interest rate with the interest rate swap as the hedging instrument.
The example below provides another example of a non-contractually specified risk
component of a financial instrument. It also illustrates how the market structure might
be used to support the eligibility of the benchmark rate as a risk component for the
particular hedged item.
Example 49.3: Identification of a benchmark interest rate component in
Government bonds
Entity B holds Dutch government bonds and has chosen to hedge the associated interest rate risk with German
government bonds futures. It is generally understood that Germany and the Netherlands are strongly linked
economically. Furthermore, pricing for Dutch government bonds is generally performed in relation to German
government bonds. As a result, bond yields for German government bonds and Dutch government bonds are
highly correlated. In addition, German bond yields are lower than Dutch bond yields.
Based on the market structure presented above, one might conclude that for Dutch government bonds,
German bond yields represent an eligible risk component as it is a separately identifiable risk component that
can be reliably measured.
2.2.3.B
Non-contractual risk components in non-financial instruments
An entity may be able to identify a non-contractual component in a non-financial item
if within the particular market structure for that item, price negotiations ordinarily
reflect a benchmark price plus other charges, similar to the contractual examples listed
at 2.2.2 above, even if this formula is not explicitly stated in the contract. The existence
of contractually specified risk components in similar transactions can be a relevant
factor in the assessment of the market structure and so help identify risk components
when they are not contractually specified.
It may also be possible to identify non-contractually specified risk components in highly
probable forecast items that are the subject of a cash flow hedge. Once such forecast
items become contractual commitments it is possible that the risk components will be
specified in the contract. In this case, if the entity has a past practice of entering into
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similar contracts, it may be relatively straightforward to demonstrate that a risk
component can be identified in the context of the market structure.
The following example from the application guidance of IFRS 9 illustrates the
‘separately identifiable and reliably measurable’ assessment.
Example 49.4: Hedge of a non-contractually specified risk component – coffee
purchases with a benchmark price risk component
An entity purchases a particular quality of coffee of a particular origin from its supplier for the current harvest
under a contract that sets out a variable price linked to the benchmark price for coffee. The price is represented
by the coffee futures price plus a fixed spread, reflecting the different quality of the coffee purchased
compared to the benchmark plus a variable logistics services charge reflecting that the delivery is at a specific
manufacturing site of the entity. The fixed spread is set for the current harvest period only. For any deliveries
that fall into the next harvest period this type of supply contract is not yet available.
The entity may wish to lock in the benchmark coffee price for future harvests, even though it does not yet
have a supply contract. For such hedges of future coffee harvests, the entity analyses the market structure for
its coffee supplies, taking into account how the eventual deliveries of coffee that it receives are priced. The
entity has an expectation that it will enter into similar supply contracts for each future harvest period once the
crop relevant for its particular purchases is known and the spread can be set. In that sense, the knowledge
about the pricing under existing supply contracts also informs the entity’s analysis of the market structure
more widely, including forecast purchases which are not yet contractually specified. This allows the entity to
conclude that its exposure to variability of cash flows resulting from changes in the benchmark coffee price
is a risk component that is separately identifiable and reliably measurable for forecast coffee purchases that
fall into the next harvest period (i.e. prior to the existence of a supply contract), as well as those for the current
harvest period which
are under a supply contract. [IFRS 9.B6.3.10(b)].
In this case the entity can enter into coffee futures contracts to hedge its exposure to
the variability in cash flows from the benchmark coffee price and designate that risk
component as the hedged item for harvests for which the pricing is not yet subject to a
supply contract. This means that changes in the contractual price due to the variable
logistics services charge and future changes in the spread reflecting the quality of the
coffee, would be excluded from the hedging relationship.
The assessment of whether a risk component qualifies for hedge accounting is mainly
driven by an analysis of whether there are different pricing factors that have a
distinguishable effect on the item as a whole (in terms of its fair value or its cash flows).
This evaluation would always have to be based on relevant facts and circumstances.
While it is probably not necessary that each component of the price of the non-financial
item is observable in the market (for instance, transport costs may be specific to a
particular transaction), it will be necessary to demonstrate that components that are
designated as hedged items do have a distinguishable effect, and are not ‘drowned out’
by the variability of other, unobservable components.
The standard uses the refinement of crude oil to jet fuel as an example to demonstrate
how the assessment of the market structure could be made to conclude that crude oil
in a particular situation is an eligible risk component of jet fuel. [IFRS 9.B6.3.10(c)]. Crude
oil is a physical input of the most common production process for jet fuel and there is
a well-established price relationship between the two. The components of jet fuel will
include the price of crude oil and the various ‘crack spreads’ relating to the refining
process, plus possibly transport costs. While there may be no market to measure
reliably the crack spreads beyond a certain time horizon, if it can be shown that the
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market does regard the crude oil price as a building block, and it has a distinguishable
effect on the price of jet fuel, then the crude oil component may be designated as the
hedged item for longer time periods. Similarly, it may be possible to designate the
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 788
