International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 790
under IFRS 9 in the same manner as any other risk component (as described at 2.2.2
and 2.2.3 above), i.e. the rebuttable presumption described in this section applies only
to financial instruments. For example, linkage to a consumer price index in a sales
contract would normally qualify as a hedged item).
2.3
Components of a nominal amount
2.3.1 General
requirement
A component of a nominal amount is a specified part of the amount of an item.
[IFRS 9.6.3.7(c)]. This could be a proportion of an entire item (such as, 60% of a fixed rate
loan of EUR 100 million) or a layer component (for example, the ‘bottom layer’ of
EUR 60 million of a EUR 100 million fixed rate loan that can be prepaid at fair value.
‘Bottom layer’ here refers to the portion of the loan that will be prepaid last). The type
of component changes the accounting outcome. An entity must designate the
component for accounting purposes consistently with its risk management objective
(see 6.2 below). [IFRS 9.B6.3.16].
A component must be less than the entire item, [IFRS 9.B6.3.7], and must be defined in such
a way that it is possible to determine whether the usual effectiveness criteria are met
and ongoing ineffectiveness can be measured. (See 6.4 and 7.4 respectively below).
Financial instruments: Hedge accounting 3991
An example of a component that is a proportion is 50 per cent of the contractual cash
flows of a loan. [IFRS 9.B6.3.17].
Nominal layer components are frequently used in risk management activities in
practice. For hedge accounting purposes it is possible to designate a layer in a defined,
but open, population (see examples i), and iii) below), or from a defined nominal amount
(see examples ii) and iv) below). An open population is one where the items within the
population are not restricted to items that already exist. Examples of layers that could
be eligible for hedge designation include:
i)
part of a monetary transaction volume, for example, the first USD 1 million cash
flows from sales to customers in a given period;
ii) part of a physical volume, for example, the 50 tonnes bottom layer of 200 tonnes
of coal inventory in a particular location (i.e. the portion that will be used last);
iii) a part of a physical or other transaction volume, for example, the sale of the first
15,000 units of widgets during January 2020; and
iv) a layer from the nominal amount of the hedged item, for example, the top layer of
a CHF 100 million fixed rate liability that can be prepaid at fair value. ‘Top layer’
refers to the portion of the liability that will be prepaid first. [IFRS 9.B6.3.18].
The ability to designate a ‘bottom layer’ nominal component for a group of forecast cash
flows, such as the sale of the first 15,000 units of widgets, used as an example above,
accommodates the fact that there may be a level of uncertainty as to the quantity of the
hedged item. The bottom layer designation mean that any uncertainty in forecast cash
flows ‘above’ the bottom layer does not negatively impact the assessment as to whether
the bottom layer itself is eligible as a hedged item (i.e. meets the highly probable
requirement) (see 2.6.1 above). However, it would not be possible to designate a ‘top
layer’ nominal component for a group of forecast cash flows, as it is not possible to
determine when that top layer occurs, as more forecast cash flows could always follow
(see 6.3.3 below).
2.3.2
Layer component for fair value hedges
Although IFRS 9 allows the designation of layer components from a defined nominal
amount or a defined, but open, population as long as it is consistent with an entity’s risk
management objective (see 2.3.1 above), there are some additional restrictions for fair
value hedges). [IFRS 9.B6.3.18, B6.3.16].
If a layer component is designated in a fair value hedge, an entity must specify it from a
nominal amount, e.g. the top CHF 20 million layer of a CHF 100 million fixed rate
liability. Accounting for a fair value hedge requires remeasurement of the hedged item
for fair value changes attributable to the hedged risk (see 7.1.1 below). In addition, that
fair value hedge adjustment must be recognised in profit or loss no later than when the
hedged item is derecognised (see 7.1.2 below). Accordingly, it is necessary to track the
designated hedged item so it can be determined when the hedged item has been
derecognised. Applying this requirement to the example of a top CHF 20 million layer
of a CHF 100 million fixed rate liability, the total defined nominal amount of
CHF 100 million fixed rate liability must be tracked in order to identify when the
specified CHF 20 million layer top layer is derecognised. [IFRS 9.B6.3.19].
3992 Chapter 49
Further, a layer component that includes a prepayment option does not qualify as a
hedged item in a fair value hedge if the fair value of the prepayment option is affected
by changes in the hedged risk (unless the changes in fair value of the prepayment option
as a result of changes in the hedged risk are included when measuring the change in fair
value of the hedged item (see Example 49.11 below). [IFRS 9.B6.3.20]. However, if the
prepayment option with a layer component is prepayable at fair value, the fair value of
the option is not affected by changes in the hedged risk, and hence it would be possible
to designate a layer component in a fair value hedge (see Example 49.10 below).
Example 49.10: Hedging a top layer of a loan prepayable at fair value
An entity borrows money by issuing a $10m five-year fixed rate loan. The entity has a prepayment option
to pay back $5m at fair value. The entity wants to be able to make use of the prepayment option without
the amount repayable on early redemption being affected by interest rate changes. Consequently, the entity
would like to hedge the fair value interest rate risk of the prepayable part of the loan. To achieve this, the
entity enters into a five-year receive fixed/pay variable interest rate swap (IRS) with a notional amount of
$5m. The entity designates the IRS in a fair value hedge of the interest rate risk of the $5m top layer of the
loan attributable to the benchmark interest rate. As a result, the top layer is adjusted for changes in the fair
value attributable to changes in the hedged risk. The bottom layer, which cannot be prepaid, remains at
amortised cost.
The gain or loss on the IRS will offset the change in fair value on the top layer attributable to the hedged risk.
On prepayment, the fair value hedge adjustment of the top layer is part of the gain or loss from derecognition
of a part of the loan as the result of the early repayment.
The situation illustrated by Example 49.10 above, of a hedge of a top layer of a loan
would not often be found in practice, as most prepayment options in loan agreements
allow, in our experience, for prepayment at the nominal amount (instead of at fair value).
Moreover, if a financial asset included an option that allowed prepayment at fair value,
that would affect the assessment of the characteristics of the contractual cash flows.
That assessment is a part of the classification of financial assets and such a prepayment
option may not be consistent with payments
that are solely principal and interest (see
Chapter 44 at 6.4.5). However, the ability to designate a top layer in a fair value hedge
could be helpful when hedging a group of fixed rate readily transferable financial
instruments, see 2.5.2 below.
As already mentioned above, IFRS 9 does not preclude hedge accounting for layers
including a prepayment option that are affected by changes in the hedged risk.
However, in order to achieve hedge accounting for such a designation, changes in fair
value of the prepayment option as a result of changes in the hedged risk have to be
included in the assessment of whether the effectiveness requirements are met and when
measuring the change in fair value of the hedged item. Example 49.11 illustrates what
this means in practice:
Example 49.11: Hedging a bottom layer including prepayment risk
A bank originates a $10m five-year fixed rate loan with a prepayment option to pay back $5m at any time at par.
For risk management purposes, the loan is considered together with variable rate borrowings of $10m. As a
result, the bank is exposed to an interest margin risk resulting from the fix-to-floating rate mismatch. The
bank expects the borrower to prepay $2m and, therefore, wishes to hedge $8m only. The bank enters into a
five-year pay fixed/receive variable interest rate swap (IRS) with a notional amount of $8m and designates
$5m of the IRS in a fair value hedge of the benchmark interest rate risk of the $5m layer of the non-prepayable
loan amount. In addition, the bank enters into a five year pay variable/receive fixed interest rate swaption
Financial instruments: Hedge accounting 3993
with a notional amount of $3m that is jointly designated with $3m of the IRS to hedge the benchmark interest
rate risk of the last remaining $3m of the $5m prepayable amount of the loan (a bottom layer of the prepayable
portion of the loan).
As a result, the $5m non-prepayable loan amount is adjusted for changes in the fair value attributable to
changes in the hedged risk (the fixed rate benchmark interest rate risk of a fixed term instrument). This is also
true for the $3m bottom layer of the prepayable amount, but in addition it must also be adjusted for the effect
of the prepayment option on the changes in the fair value attributable to the interest rate risk. The $2m top
layer remains at amortised cost.
Therefore, the first $2m of prepayments would have a gain or loss on derecognition determined as the
difference between the amortised cost of the prepaid amount and par. For any further prepayments exceeding
$2m, the gain or loss on derecognition would be determined as the difference between the amortised cost
including the fair value hedge adjustment and par.
When deciding on which instruments to transact in order to manage the interest rate
risk in a prepayable portfolio, an entity will usually consider the likelihood of
prepayment in a bottom layer. In particular it will consider whether the risk of
prepayment is sufficient to justify the added expense of transacting a hedging instrument
that can also be cancelled (e.g. an interest rate swap cancellable at zero cost). As part of
these considerations it is relatively common that from an economic perspective, an
entity might view a bottom layer as having no prepayment risk attached at all and
transact a non-cancellable hedging instrument accordingly. Despite this economic view,
the hedge accounting guidance requires consideration of the fair value changes of that
bottom layer based on the contractual terms of the hedged item, which would include
the prepayment option. Hence, for many economic hedges of bottom layers of
prepayable hedged items, the changes in the fair values of the hedging instrument and
the hedged item will not normally be the same, at least from an accounting perspective.
The consequence is that there is likely to be a level of ineffectiveness in the accounting
hedge relationship, to be measured and recognised.
‘Bottom layer’ hedging strategies that avoid this source of ineffectiveness can only be
applied if the hedged layer is not affected by the prepayment risk. This is best
demonstrated based on an example.
Example 49.12: Hedging a bottom layer (no prepayment risk) of a loan portfolio
A bank holds a portfolio of fixed rate loans with a total nominal amount of GBP 100m. The borrowers can,
at any time during the tenor, prepay 20% of their (original) loan amount at par.
For risk management purposes, the loans are considered together with variable rate borrowings of GBP 100m.
As a result, the bank is exposed to an interest margin risk resulting from the fix-to-floating rate mismatch.
The bank expects GBP 20m of loans to be prepaid.
As part of the risk management strategy, the bank decides to hedge a part of the interest margin by entering
into a pay fixed/receive variable interest rate swap (IRS). The objective is to hedge 95% of the amount of
loans that is not prepayable using an IRS with a notional amount of GBP 76m (95% of GBP 80m). The hedged
layer does not include a prepayment option. Therefore, the IRS is designated in a fair value hedge of the
interest rate risk of the GBP 76m bottom layer of the GBP 100m loan portfolio (i.e. 95% of GBP 80m).
As a result, the bottom layer is adjusted for changes in the fair value attributable to changes in the hedged
risk (i.e. benchmark interest rate risk). The extent to which the borrowers exercise their prepayment option
(i.e. up to 20% of the original loan) does not affect the hedging relationship. Also, if the bank were to
derecognise any of the loans for any other reason, the first GBP 4m of non-prepayable amount of derecognised
loans would not be part of the hedged item (i.e. the GBP 76m bottom layer). However, if the nominal amount
of the loan fell below GBP 76m, this would start to affect the hedging relationship.
3994 Chapter 49
So while IFRS 9 provides an effective solution for portfolios that feature a bottom layer
that is not prepayable, as explained in Example 49.12 above, it does not provide an
answer for portfolios that are fully prepayable (for example, a residential fixed rate
mortgage portfolio). The IASB decided to address hedging of such portfolios in its
separate macro hedging project. Until that project is finalised, entities are allowed to
apply the portfolio fair value hedging guidance in IAS 39 (see 11 below).
Given the current lack of effective solution within IFRS 9 for portfolios that feature a
bottom layer that is prepayable, it is not uncommon for entities to consider alternative
‘proxy’ hedge accounting designations (see 6.2.1 below). For example, an entity wishing
to hedge an economic bottom layer within a group of items prepayable at par within a
fair value hedge could identify specific items within the group (and designate those
items only) or designate a percentage of the total as the hedged item. Both these
approaches are still likely to result in ineffectiveness. If specific items within the group
were designated, and those specific items prepaid, then the designated hedged item
would no longer exist, even if there was sufficient ‘non-designated’ items within the
group to cover the amount designated. The issues arising from designation of a
proportion are best explained with an example.
Example 49.13: Hedging a proportion of a prepayable loan portfolio
A ba
nk holds a portfolio of fixed rate loans with a total nominal amount of $100m. The borrowers can, at any
time, prepay all of their (original) loan amount at par, plus an exit fee. The bank only expects 20% of the
original loan amount to be prepaid before maturity.
For risk management purposes, the loans are considered together with variable rate borrowings of $100m. As
a result, the bank is exposed to an interest margin risk resulting from the fix-to-floating rate mismatch. The
bank expects $20m of loans to be prepaid.
As part of the risk management strategy, the bank decides to hedge the interest margin by entering into a pay
fixed/receive variable interest rate swap (IRS). The objective is to hedge the amount of loans that they do not
expect to prepay using an IRS with a notional amount of $80m. The IRS is designated as a fair value hedge
of 80% of the $100m loan portfolio.
After two years loans of $10m are prepaid, which is less than 20% and therefore does not affect the economic
hedge in place. However, because of the proportionate designation, this is considered a reduction in the
hedged amount for hedge accounting purposes. As a result, the entity now has an IRS of $80m designated as
a hedge of loans of $72m ([$100m – $10m] × 80%), which will inevitably lead to some ineffectiveness.
Another source of ineffectiveness will be fair value changes attributable to the embedded prepayment option
within the loan portfolio (see 7.4 9 below).
2.4
The ‘sub-LIBOR issue’
Some financial institutions are able to raise funding at interest rates that are below a
benchmark interest rate (e.g. LIBOR minus 15 basis points (bps)). In such a scenario, the
entity may wish to remove the variability in future cash flows caused by movements in
LIBOR benchmark interest rates. IFRS 9 does not allow the designation of a ‘full’ LIBOR
risk component (i.e. LIBOR flat) in this situation, as a component cannot be more than
the total cash flows of the entire item. This is sometimes referred to as the ‘sub-LIBOR
issue’. [IFRS 9.B6.3.21-22].
Part of the reason for this restriction is that a contractual interest rate is often ‘floored’
at zero, so that interest will never become negative. Hence, if debt is issued at LIBOR
minus 15bp and LIBOR decrease below 15bps, any further reduction in LIBOR would