crack spread, if it can be traded or is otherwise sufficiently observable that it may be
regarded as reliably measurable.
So in order to conclude that benchmark components are eligible risk components of an
item, there is an expectation that any residual building block component would either
be relatively stable or else any fluctuations can be explained rationally within the
particular market structure (e.g. quality differences or transportation costs).
Accordingly, just because the full price of an item may approximate to, or is highly
correlated with, a particular benchmark price, that will be insufficient on its own to
demonstrate that the benchmark price can be identified as a component within the
context of the particular market structure.
Extending the example of crude oil, it is also a major input in the production
process for plastic. However, the manufacturing process is complex and involves a
number of steps. The process starts with crude oil being distilled into its separate
‘fractions’, of which only one (naphtha) is used for making plastic. Naphtha then
undergoes a number of further processes before the various types of plastic are
finally produced. Consequently any impact of a change in the price of crude oil on
the price of plastic is likely to be significantly diluted by the costs of manufacturing
and the passage of time.
Generally, the further ‘downstream’ in the production process an item is, the more
difficult it is to find a distinguishable effect of any single pricing factor. The mere fact
that a commodity is a major physical input in a production process does not
automatically translate into a separately identifiable effect on the price of the item as a
whole. For example, the price for pasta at food retailers in the medium to long term also
responds to changes in the price for wheat, but there is no distinguishable direct effect
of wheat prices changes on the retail price for pasta, which remains unchanged for
longer periods even though the wheat price changes. If retail prices are periodically
adjusted in a way that also directionally reflects the effect of wheat price changes, that
is not sufficient to constitute a separately identifiable risk component.
Determining whether non-contractually specified risk components are eligible as
hedged items requires judgement. The economic analysis ordinarily undertaken by an
entity prior to undertaking risk management activity will most likely form the basis in
making this judgement. However, care needs to be taken to ensure the existing
economic analysis sufficiently meets the requirements of the standard, that a risk
component is separately identifiable and reliably measurable within the relevant market
structure. [IFRS 9.B6.3.8, B6.3.9]. Practice will evolve in this area as to what are commonly
accepted non-contractual risk components and the approach taken to determine their
existence. However judgement will need to continue to be applied to the particular facts
and circumstances.
2.2.4
Partial term hedging
A common risk management technique is to hedge a risk for only a partial term for
which it is outstanding, as illustrated in Example 49.5 below. The example, which is
Financial instruments: Hedge accounting 3987
based on the Implementation Guidance of IAS 39, illustrates that a time portion of
interest rate risk can be a separately identifiable and reliably measurable risk component
of a financial instrument, and so remains relevant under IFRS 9. Accordingly it is
possible to designate a financial instrument as a hedged item for the portion of risk that
represents only part of the term that a hedged item remains outstanding.
Example 49.5: Partial term hedging
Company A acquires a 10% fixed-rate government bond with a remaining term to maturity of ten years and
classifies it as at amortised coast. To hedge against the fair value exposure on the bond associated with the
first five years’ interest payments, it acquires a five year pay-fixed receive-floating swap.
The swap may be designated as hedging the fair value exposure of the interest rate payments on the
government bond until year five and the change in value of the principal payment due at maturity to the extent
affected by changes in the yield curve relating to the five years of the swap. [IAS 39.F.2.17].
Whilst the above implementation guidance uses the example of a financial instrument,
the same conclusion could be reached for hedging a partial term of a non-financial
instrument. For example, an entity might wish to hedge the foreign currency risk for the
next three months from a highly probable forecast purchase cash flow in six months’
time. The six month forward foreign exchange rate is driven by the relationship
between spot rates and forward rates for any given yield curve. Furthermore, the market
is built on the premise that a six month forward rate is a combination of the three month
forward rate (i.e. the market rate for months one to three), plus the three month forward
rate (i.e. the market rate for months four to six). This market structure would appear to
support being able to hedge a partial risk component of a highly probable forecast
purchase cash flow.
2.2.5
Foreign currency as a risk component
One risk component that is frequently designated as an eligible risk component is
foreign currency risk. [IFRS 9.BC6.176]. It is relatively easy to determine that foreign
currency risk is a separately identifiable component of a financial instrument
denominated in a foreign currency, and that the changes in the cash flows or fair value
of the instrument attributable to changes in foreign currency risk are reliably measurable
– at least for most frequently traded currency pairs.
A similar conclusion might also be reached for non-financial hedged items denominated
in a foreign currency; however further consideration is required to ensure the foreign
currency is not just a ‘settlement currency’. A settlement currency might arise where the
price is determined in one foreign currency, but settled in another (i.e. the settlement
currency) at the prevailing foreign currency rate on settlement. In that instance it is
difficult to argue that changes in the foreign currency risk between an entity’s functional
currency and the settlement currency have a reliably measurable impact on the cash
flows or fair value of the hedged item. In fact, it is the foreign currency risk between an
entity’s functional currency and the currency that drives the pricing of the hedged item
that is more likely to be an eligible risk component. The potential difficulties in
determining that foreign currency risk is a separately identifiable component of a non-
financial instrument are illustrated in the following example from the implementation
guidance of IAS 39.
3988 Chapter 49
Example 49.6: Foreign currency borrowings hedging fixed assets
A Danish shipping company, D, has a US subsidiary that has the same functional currency as the parent, the
Danish krone. Accordingly in D’s consolidated financial statements, ships owned by the subsidiary, which
are carried at depreciated historical cost, are reported in Danish krone using historical exchange rates. To
hedge the potential currency risk o
n the disposal of the ships in US dollars, purchases of ships are normally
financed with loans denominated in US dollars.
US dollar borrowings cannot be classified as fair value hedges of a ship because ships do not contain any
separately measurable foreign currency risk even if their purchase was, and sale is likely to be, denominated
in US dollars.
The proceeds from the anticipated sale of the ship may, however, be designated in a cash flow hedge, provided
all the hedging criteria are met. Those conditions require that the sale is highly probable, which is usually
only likely if the sale is expected to occur in the immediate future. [IAS 39.F.6.5].
Unfortunately, the statement that a ship does not contain any separately measurable
foreign currency risk is not explained any further, which makes it difficult to apply this
guidance in other situations. For example, it is hard to argue that a commodity such as
crude oil, which is traded throughout the world in US dollars, does not contain a
measurable exposure to US dollars. If another commodity is regularly traded and quoted
both in US dollars and in euro (the implementation guidance suggests this might be the
case for natural gas – see Chapter 42 at 5.2.1.B) it might seem sensible to treat that
commodity as containing both US dollar and euro exposures. However, additional
guidance in the implementation guidance of IAS 39 contradicts this assumption if one
of the currencies in which the commodity is traded is the functional currency of the
entity: the guidance explains that the foreign currency risk associated with a holding of
publicly traded shares may only be hedged if they give rise to a clear and identifiable
exposure to changes in foreign exchange rates. It is asserted that this will be the case if:
• the shares are not traded on an exchange, or other established market, in which
trades are denominated in the same currency as the functional currency of the
holder; and
• dividends on the shares are not denominated in the functional currency of the holder.
Consequently, if the share trades in multiple currencies, one of which is the holder’s
functional currency, hedge accounting would not be permitted. [IAS 39.F.2.19].
However, this restriction does not stand up to close scrutiny, as illustrated in the
following example.
Example 49.7: Foreign currency risk associated with equity shareholding
ABC plc, a UK company whose functional currency is sterling, acquires a small shareholding in IJK Limited.
IJK is a South African company whose operations are based solely in that country and whose income,
expenditure and dividends are all denominated in South African rand. IJK’s shares are listed on the
Johannesburg Stock Exchange where trades are denominated in rand.
The IAS 39 implementation guidance suggests that, potentially, ABC could hedge the foreign currency risk
arising from the sterling/rand exchange rate on its IJK holding, which appears quite sensible. If, on day 1, the
shares trade at R50 and the exchange rate is R10 to £1, the shares would have a sterling value of £5.00 (= R50
÷ 10). If, on day 2, the exchange rate moves to R8 to £1, all other things being equal, the rand value of IJK should
not change, but its sterling value would be £6.25 (= R50 ÷ 8), exactly mirroring the exchange rate movement.
If IJK subsequently obtained a secondary listing on the London Stock Exchange where trades were
denominated in sterling, but its business fundamentals were unchanged, in the scenario outlined above ABC’s
foreign exchange exposure would be exactly the same. In fact, the operation of the markets should ensure
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that the share price in London on the equivalent of days 1 and 2 is £5.00 and £6.25 respectively. However,
the guidance suggests that because of the secondary listing, ABC no longer has a clear and identifiable
exposure to changes in foreign exchange rates on the IJK shares and therefore hedge accounting would not
be permitted. [IAS 39.F.2.19].
Consequently, prior to designation of foreign currency risk in a non-financial
instrument careful analysis and judgement is usually required prior to determining that
foreign currency risk is a separately identifiable component of a non-financial
instrument for which the changes in the cash flows or fair value of the non-financial
asset attributable to changes in that foreign currency risk are reliably measurable.
Although, as noted above, careful consideration is required to determine that foreign
currency risk is an eligible risk component in a non-financial instrument, in many
scenarios it will be. For example, when the price of forecast foreign currency purchases
or sales are determined in the local environment in which the foreign currency is used,
it is likely that the foreign currency is more than just a settlement currency and foreign
currency risk is a separately identifiable component of the foreign currency purchases
or sales.
Furthermore, although it is not explicit in the standard, it seems reasonable that an entity
may identify a risk component of an exposure for risk(s) excluding foreign currency risk.
The designation of a foreign currency risk component, and a risk component excluding
foreign currency risk are both illustrated in the following example.
Example 49.8: Hedge of foreign currency denominated commodity risk
Company P has the Rand as its functional currency. It has forecast, with a high probability, the need to
purchase a 1,000 barrels quantity of crude oil for US Dollars in twelve months’ time.
Scenario 1: designation of a risk component excluding foreign currency risk
To hedge part of its exposure to the price risk inherent in this purchase, P enters into an exchange traded
twelve-month cash-settled crude oil forward contract. The strike price of the forward is denominated in US
dollars (there is no active market in Rand denominated crude oil futures) and P therefore fixes the US dollar
price of the 1,000 barrels of oil to be purchased. P chooses not to hedge the risk associated with Rand to
US dollar exchange rates. This might be because of illiquidity in the foreign currency markets for Rand or,
perhaps, because P has forecast US dollar inflows that provide a natural hedge of the foreign exchange risk.
Scenario 2: designation of foreign currency as a risk component
To hedge part of the risk associated with Rand to US dollar exchange rates, P may transact a forward contract
to buy US dollar and sell Rand in twelve months’ time. The forward contract can be designated as the hedging
instrument in a hedge of the foreign currency risk exposure to the US dollar denominated price risk associated
with its forecast purchase of crude oil.
The forward contract would hedge an amount of US dollar, e.g. USD 10,000, so Company P would also need
to ensure that it was highly probable that a cash flow of at least USD 10,000 will arise from forecast purchases
of oil (see 2.6.1 below).
2.2.6
Inflation as a risk component
A contractually specified inflation risk component of the cash flows of a recognised
inflation-linked bond liability (assuming that there is no requirement to account for an
embedded derivative separately (see Chapter 42 at 4)) is separately identifiable and
reliably measurable, as long as other cash flows of the instrument are not affected
by
the inflation risk component. [IFRS 9.B6.3.15].
3990 Chapter 49
However, IFRS 9 includes a rebuttable presumption that for financial instruments,
unless contractually specified, inflation is not separately identifiable and reliably
measurable. This means that there are limited cases under which it is possible to identify
inflation as a non-contractually specified risk component of a financial instrument and
designate that inflation component in a hedging relationship. Similar to other non-
contractually specified risk components, the analysis would have to be based on the
particular circumstances in the respective market, which is, in this case, the debt market.
[IFRS 9.B6.3.13].
The example below, derived from the application guidance of IFRS 9, explains a
situation in which the presumption that inflation does not qualify as a risk component
of a financial instrument can be rebutted.
Example 49.9: Inflation risk as an eligible risk component of a debt instrument
An entity wishes to hedge the inflation risk component of a debt instrument. The debt instrument is issued in
a currency and country in which inflation-linked bonds are actively traded in a significant volume. The
volume, liquidity and term structure of these inflation-linked bonds allow the computation of a real interest
yield curve. This situation supports that inflation is a factor that is separately considered in the debt market
in a way that it is a separately identifiable and reliably measurable risk component. [IFRS 9.B6.3.14].
There are not many currencies with a liquid market for inflation-linked debt
instruments, therefore limiting the availability of designating non-contractually
specified inflation risk components of financial instruments. Of course, even where the
presumption is successfully rebutted, the other qualifying criteria must be met in order
to apply hedge accounting, as described at 6 below. In particular, demonstrating that the
hedged item and the hedging instrument have values that are generally expected to
move in opposite directions may prove challenging. [IFRS 9.B6.4.4].
While IFRS 9 defines in what circumstances inflation can be a risk component for a
financial instrument, inflation can be treated as a risk component for non-financial items
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 789
