International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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Financial instruments: Hedge accounting 3995
not cause any cash flow variability for the hedged item. Consequently, any designated
component has to be less than or equal to the cash flows of the entire item.
[IFRS 9.B6.3.21, BC6.226-228].
In this scenario, the entity could instead designate, as the hedged item, the variability in
cash flows of the entire liability (or a proportion of it) but only for changes attributable
to LIBOR. [IFRS 9.B6.3.24]. Such a designation will improve effectiveness as changes in the
credit risk of the borrower are excluded from the hedge relationship, however it will
not be perfectly effective. Ineffectiveness could arise as follows:
• For financial instruments that have an interest rate floor of zero in situations in
which the forward curve for a part of the remaining hedged term is below 15 basis
points. This is because the hedged item will have less variability in cash flows as a
result of interest rate changes than a swap without such a floor. In fact, an
expectation that LIBOR will consistently be below 15 basis points may cause the
hedge relationship to fail the effectiveness criteria as there is no economic
relationship between the hedged item and hedging instrument. This would
preclude hedge accounting at all (see 6.4.1 below).
• However, if LIBOR is above 15 basis points and is not expected to go below it, this
source of ineffectiveness would not be expected to arise. The hedged item will
have the same cash flow variability as a liability without a floor as long as LIBOR
remains above 15 basis points.
• Ineffectiveness is also likely to occur from changes in the time value of the
embedded floor in the hedged item, as no offset will arise from the fair value
changes of a swap without a floor (see 7.4.9 below).
• Even if the variability of cash flows in the hedged item and hedging instrument may
be the same, the absolute cash flows are not, due to the inclusion of the negative
spread in the hedged item. Accordingly, the discounted cash flows will not
perfectly offset (see 7.4 below).
• The discount curve used to discount the hedged cash flows needs to reflect LIBOR
(as the hedged risk). However, there is a choice between discounting the hedged
cash flows at LIBOR or at LIBOR minus the negative credit spread (15 basis points
in the example above) as the guidance is not prescriptive. The negative credit
spread would not need to be updated for changes in the borrower’s credit risk as
that risk is excluded from the hedge relationship. This is consistent with the general
hedge accounting approach of calculating a change in the present value of the
hedged item with respect to the hedged risk and not a full fair value. The second
option for discounting may improve effectiveness but some ongoing
ineffectiveness is likely to remain.
While the example in the standard uses LIBOR as the benchmark component, it is clear
that the requirement relates not just to financial items in general, or to the LIBOR
benchmark component in particular, but is a general prohibition on the cash flows of
hedged risk components being larger than the cash flows of the entire hedged item. This
means that the sub-LIBOR issue is also applicable to non-financial items where the
contract price is linked to a benchmark price minus a differential. This is best
demonstrated using an example derived from the application guidance of IFRS 9.
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Example 49.14: Sub-LIBOR issue – Selling crude oil at below benchmark price
An entity has a long-term sales contract to sell crude oil of a specific quality to a specified location. The
contract includes a clause that sets the price per barrel at West Texas Intermediate (WTI) minus USD 10 with
a minimum price of USD 30. The entity wishes to hedge the WTI benchmark price risk by entering into a
WTI future. As outlined above, the entity cannot designate a ‘full’ WTI component, i.e. a WTI component
that ignores the price differential and the minimum price.
However, the entity could designate the WTI future as a hedge of the entire cash flow variability under the
sales contract that is attributable to the change in the benchmark price. When doing so, the hedged item would
have the same cash flow variability as a sale of crude oil at the WTI price (or above), as long as the forward
price for the remaining hedged term does not fall below USD 40. [IFRS 9.B6.3.25].
Where the hedged item has the same cash flow variability as the hedging instrument
there may be an expectation that the hedge relationship will meet the effectiveness
criteria. However any ineffectiveness needs to be measured and recorded in profit or
loss (see 7.4 below).
In some cases the contract price may not be defined as a benchmark price minus a fixed
differential but as a benchmark price plus a pricing differential (the ‘basis spread’) that
is sometimes positive and sometimes negative. The market structure may reveal that
items are priced that way and there may even be derivatives available for the basis
spread (i.e. basis swaps, for example the benchmark gas oil crack spread derivative
which is a derivative for the price differential between crude oil and gas oil which
reflects the refining margin [IFRS 9.B6.3.10(c)(i)]). Similar to Example 49.14 above, an entity
could not designate the benchmark price component as the hedged item given that the
cash flows of the benchmark component could be more than the total cash flows of the
entire item. Unfortunately, the standard does not provide any guidance as to how an
entity has to assess whether the basis spread could be negative or not. For example, it
is not clear whether an entity is only required to look at the forward benchmark prices
or whether it has to consider all reasonably possible scenarios. The use of ‘reasonably
possible scenarios’ in other places in IFRS 9 might indicate that the latter is the case.
A related question is whether the entity could designate the entire cash flow variability
that is attributable to changes in only the benchmark risk (as the entity alternatively does
in Example 49.14 above) if that risk is a non-contractually specified risk component.
This assessment is likely to be similar to whether a non-contractually specified risk
component is separately identifiable and reliably measurable (as outlined at 2.2.3
above), which would be required in order to determine the variability of the entire cash
flows with respect to changes in the benchmark.
However, the presence of a spread that is sometimes negative could make this
assessment more difficult. An entity needs to prove that the benchmark cash flows plus
or minus the spread make up the total cash flows. This might be the case, for example,
if it can be proven that there are quality differences, such that the benchmark is
sometimes of better quality and sometimes worse than the hedged exposure. On the
other hand, if the basis spread switches between positive and negative because of
individual supply and demand drivers in the benchmark price and the price of the
hedged exposure, this may indicate that the benchmark is not implicit in the fair value
or cash flows of the hedged exposure. To illustrate this with an example, take WTI and
Brent crude oil prices. While both price
s might be highly correlated, WTI could not be
identified as a benchmark component in Brent because both prices have their own
Financial instruments: Hedge accounting 3997
supply and demand drivers. Furthermore, it would not be possible to determine
whether either WTI is a risk component of Brent or vice versa, which demonstrates that
there is no risk component that can be designated in a hedge relationship. In that case,
hedge accounting would only be permitted if the full cash flows were designated for all
changes in the contract price, and assuming the other eligibility requirements are met.
The negative interest rate environment in some countries, mainly countries in the
Eurozone and Switzerland has further implications on the designation of risk
components in connection with the sub-LIBOR issue. (See 2.4.2 below).
2.4.1
Late hedges of benchmark portions of fixed rate instruments
There is no requirement in IFRS 9 for hedge accounting to be designated on initial
recognition of either the hedged item or the hedging instrument. [IFRS 9.B6.5.28]. In
particular, it is not uncommon for risk management and/or hedge accounting to be
applied sometime after initial recognition of the hedged item. This is often referred to
as a ‘late hedge’. There is no additional guidance in IFRS 9 in order to apply hedge
accounting to ‘late hedges’ over and above the usual criteria. However the identification
of eligible risk components in fixed rate hedged items in late hedges can be problematic.
The prohibition on identifying a LIBOR risk component in a variable instrument priced
at sub-LIBOR (i.e. LIBOR minus a spread) is outlined at 2.4 above. A similar issue arises
where a fixed rate item is originally priced based on LIBOR minus a spread, for example,
a fixed-rate financial liability for which the contractual interest rate is priced at 100 basis
points below LIBOR. It would not be possible to identify the hedged item as having fixed
interest cash flows equal to LIBOR, however an entity can designate as the hedged item
the entire liability (i.e. principal plus interest (equal to LIBOR minus 100 basis points))
for changes in value attributable to changes in LIBOR. [IFRS 9.B6.3.23].
Another issue discussed in the guidance is where a fixed rate financial instrument is
hedged sometime after its origination, and interest rates have changed in the meantime,
such that the fixed rate on the instrument is now below LIBOR. In this case it may be
possible for the entity to designate a risk component equal to the benchmark rate that
is higher than the contractual rate paid on the item. This is provided that the benchmark
rate is still less than the effective interest rate calculated as if the instrument had been
purchased on the day it was first designated as the hedged item. [IFRS 9.B6.3.23]. This is
illustrated below.
Example 49.15: Hedge of a portion of an existing fixed rate financial asset
following a rise in interest rates
Company B originates a fixed rate financial asset of €100 that has an effective interest rate of 6% at a time
when LIBOR is 4%. B begins to hedge that asset some time later when LIBOR has increased to 8% and the
fair value of the asset has decreased to €90.
B calculates that if it had purchased the asset on the date it first designated it as the hedged item for its then
fair value of €90, the effective yield would have been 9.5%. Because LIBOR is less than this recalculated
notional effective yield, the entity can designate a LIBOR component of 8% that consists partly of the
contractual interest cash flows and partly of the difference between the current fair value (€90) and the amount
repayable on maturity (€100). [IFRS 9.B6.3.23].
The guidance illustrated in Example 49.15 above will assist entities in designating hedges
in a way that significantly reduces ineffectiveness.
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2.4.2
Negative interest rates
The negative interest rate environment in some countries, mainly Switzerland and
certain countries in the Eurozone, has further implications on the designation of risk
components in connection with the sub-LIBOR issue. The following example
illustrates this.
Example 49.16: Negative interest rates and fair value hedges
Assume the following scenarios:
a) Bank A enters into a €1 million loan to a corporate at a fixed coupon of 3.5%. The coupon has been
determined considering the negative EONIA rate (the benchmark) of –0.15% plus a credit spread of 3.65%.
b) Bank B acquires a €1 million government debt security with a fixed coupon of 3.5% in the secondary
market. In this fact pattern the debt was issued some years ago when benchmark interest rates were much
higher. The purchase price of the debt was €1.185 million which results in an effective interest rate of –
0.18%, consisting of the negative EONIA rate (the benchmark) when the debt is acquired of –0.15% and
a credit spread of –0.03%.
Both Bank A and Bank B want to hedge the fixed rate benchmark component and enter into an interest rate
swap paying fixed –0.15% and receiving EONIA. The banks wish to designate the benchmark component in
a fair value hedge for changes in EONIA.
In scenario a) it seems acceptable for the bank to designate the benchmark risk component because:
• it is included in the pricing of the hedged item and therefore separately identifiable and reliably measurable;
• the benchmark can be positive or negative, therefore the cash flows representing that benchmark rate
can also be positive or negative, even if they are part of overall positive cash flows (which is similar to
a benchmark component of 4% hedging the benchmark risk in a coupon of 5%, except that the
benchmark is negative in this case); and
• the benchmark cash flows are less than the cash flows in the hedged items (i.e. minus 0.15% which is
less than 3.5%).
We would find it difficult to reach the same conclusion for scenario b) as the benchmark rate is higher than
the effective interest rate (i.e. minus 0.15% which is greater than minus 0.18%). [IFRS 9.B6.3.23]. This is
consistent with the fact that if a debt instrument were to be issued at par bearing a coupon of –0.18%, which
included credit spread of –0.03% when the benchmark rate was –0.15% it would not be possible to identify
a benchmark component for hedge accounting purposes. [IFRS 9.B6.3.21].
In both scenarios, the banks would not be permitted to designate a payment of –0.15% of the principal as an eligible
component of a receipt of a 3.5% coupon, as it is difficult to argue that a payment of a negative 0.15% of the principal
is a portion of a receipt of 3.5% of that principal. However, this is not that relevant in scenario a) as it would be
possible to designate a separately identifiable benchmark component in the total cash flows, as noted above.
Notwithstanding the above, in both cases, the banks can designate all the cash flows in
the financial asset for changes in the benchmark rate, although this is likely to result in
some ineffectiveness. [IFRS 9.B6.3.21].
2.5
Groups of items
2.5.1 General
requirements
Under IFRS 9, hedge accounting may be applied to a group of items if:
• the group consists of items or components of items that would individually qualify
for hedge accounting; and
• for risk management purposes, the items in the group are managed together on a
group basis. [IFRS 9.6.6.1].
Financial instruments: Hedge accounting 3999
Example 49.17: Hedging a portfolio of shares
An entity holds a portfolio of shares of Swiss companies that replicates the Swiss Market Index (SMI). The
entity elected to account for the shares at fair value through other comprehensive income without subsequent
reclassification to profit or loss, as allowed by IFRS 9. The entity decides to lock in the current value of the
portfolio by entering into corresponding SMI futures contracts.
The individual shares would be eligible hedged items if hedged individually. As the objective of the portfolio
is to replicate the SMI, the entity can also demonstrate that the shares are managed together on a group basis.
The entity also assesses the compliance with the criteria for hedge accounting (see 6 below). Consequently,
the entity designates the SMI futures contracts as the hedging instrument in a hedge of the fair value of the
portfolio. As a result, the gains or losses on the SMI futures are accounted for in OCI (without subsequent
reclassification to profit or loss) in the same manner as the shares, thus eliminating the accounting mismatch.
Whether the items in the group are managed together on a group basis is a matter of fact,
i.e. it depends on an entity’s behaviour and cannot be achieved by mere documentation.
The IFRS 9 eligibly criteria for groups of items for hedge accounting also permit
designation of net positions, however some restrictions for cash flow hedges of net
positions are retained (see 2.5.3 below). [IFRS 9.BC6.435, BC6.436]. Net hedged positions are
permitted as eligible hedged items under IFRS 9 only if an entity hedges on a net basis
for risk management purposes. Whether an entity hedges in this way is a matter of fact
(not merely of assertion or documentation). Hence an entity cannot apply hedge
accounting on a net basis solely to achieve a particular accounting outcome, if that
would not reflect its risk management approach. [IFRS 9.B6.6.1].
IFRS 9 also contains special presentation requirements when hedging net positions,
which are discussed at 9.3 below.