risk, there is no economic relationship between the aggregated exposure and the IRS for interest rate risk. This is
because the USD floating interest rate cash flows on the CCIRS are not offset by the USD net investment, as it
does not have cash flow variability that is closely linked to interest rates. Furthermore, aggregated exposures can
only be designated if they are managed as one exposure for a particular risk, which is unlikely to be the case in
this fact pattern given the lack of interest risk associated with the net investment. [IFRS 9.B6.3.3].
3 HEDGING
INSTRUMENTS
3.1 General
requirements
The basic requirement for a hedging instrument is for it to be one of the following:
• a derivative measured at fair value through profit or loss, except for some written
options (see 3.2 below);
• a non-derivative financial asset or liability measured at fair value through profit or
loss (see 3.3 below); or
• for a hedge of foreign currency risk, the foreign currency risk component of a non-
derivative financial asset or liability (see 3.3.1 below). [IFRS 9.6.2.1, 6.2.2].
Hedging instruments must also involve a party that is external to the reporting group.
[IFRS 9.6.2.3]. Two or more financial instruments can be jointly designated as hedging
instruments (see 3.5 below). [IFRS 9.6.2.5].
There is no requirement to designate a hedging instrument only on initial recognition.
Designation of a hedging instrument sometime after its initial recognition (e.g. after a
previous hedge relationship is discontinued) is permitted, although some additional
ineffectiveness may arise (see 7.4.4.B below). [IFRS 9.B6.5.28].
3.2
Derivatives as hedging instruments
The distinction between derivative and non-derivative financial instruments is covered
in Chapter 42. The standard does not restrict the circumstances in which a derivative
measured at fair value through profit or loss may be designated as a hedging instrument,
except for some written options. A written options does not qualify as a hedging
instrument, unless the written option is designated to offset a purchased option.
Purchased options include those that are embedded in another financial instrument and
not required to be accounted for separately (see Chapter 42 at 4). [IFRS 9.B6.2.4]. Although
not specifically mentioned, we believe that embedded purchased options in non-
financial instruments that are not required to be bifurcated could also be designated as
being hedged by a written option.
Financial instruments: Hedge accounting 4021
A single instrument combining a written option and a purchased option, such as an
interest rate collar, cannot be a hedging instrument if it is a net written option at the date
of the designation. Similarly, options that are transacted as legally separate contracts
may be jointly designated as hedging instruments if the combined instrument is not a
net written option at the date of designation. [IFRS 9.6.2.6]. There appears to be no
requirement for the jointly designated options to be with the same counterparty. See
3.2.2 below for further discussion as to what constitutes a net written option.
A contract that is considered a normal sale or purchase, and is therefore accounted for
as an executory contract (see Chapter 41 at 4), cannot be an eligible hedging instrument
as it is not measured at fair value though profit or loss.
In addition, a forecast transaction or planned future transaction cannot be the hedging
instrument as it is not a recognised financial instrument, [IFRS 9.B3.1.2(e)], and is therefore
not a derivative.
3.2.1
Offsetting external derivatives
Where two offsetting derivatives are transacted at the same time, it is generally not
permitted to designate one of them as a hedging instrument in a hedge when the
derivatives are viewed as one unit. [IFRS 9.6.2.4]. Indicators that the two derivatives should
be accounted for as one unit are as follows:
• the second derivative was entered into at the same time and in contemplation of
the first;
• there is a no apparent economic need or substantive business purpose for
structuring the transactions separately, that could not also have been accomplished
in a single transaction;
• they relate to the same risk; and
• the derivatives are with the same counterparty. [IFRS 9.IG B.6].
This issue is also discussed in Chapter 42 at 3.2 and 8. It is emphasised that judgement
should be applied in determining what a substantive business purpose is. For example,
a centralised treasury entity may enter into third party derivative contracts on behalf of
other subsidiaries to hedge their interest rate exposures and, to track those exposures
within the group, enter into internal derivative transactions with those subsidiaries. It
may also enter into a derivative contract with the same counterparty during the same
business day with substantially the same terms as a contract entered into as a hedging
instrument on behalf of another subsidiary as part of its trading operations, or because
it wishes to rebalance its overall portfolio risk. In this case, there is a valid business
purpose for entering into each contract. However, a desire to achieve hedge accounting
for the hedged item is deemed not to be a substantive business purpose. [IAS 39.F.1.14].
3.2.2 Net
written
options
It was explained in IAS 39 that an option an entity writes is not effective in reducing the
profit or loss exposure of a hedged item. In other words, the potential loss on a written
option could be significantly greater than the potential gain in value of a related hedged
item. [IAS 39.AG94]. This is the rationale for prohibiting a written option from qualifying
as a hedging instrument unless it is designated as an offset to a purchased option,
4022 Chapter 49
including one that is embedded in another financial instrument and not required to be
accounted for separately (see Chapter 42 at 4). An example of this might be a written
call option that is used to hedge a callable liability. [IFRS 9.B6.2.4]. In contrast, a purchased
option has potential gains equal to or greater than losses and therefore has the potential
to reduce profit or loss exposure from changes in fair values or cash flows. Accordingly,
a purchased option can qualify as a hedging instrument.
It follows that a derivative such as an interest rate collar that includes a written option
cannot be designated as a hedging instrument if it is a net written option. However if the
interest rate collar was deemed to be a net purchased option or zero cost collar then it
would be an eligible hedging instrument.
Example 49.28: Hedging foreign exchange risk of a forecast transaction using a
combined option instrument
An entity is exposed to foreign exchange risk resulting from a highly probably forecast transaction in a foreign
currency. In order to hedge that exposure, the entity enters into a collar by combining a long call and a short
put option. The premium paid on the long call option equals the premium received on the short put option
(i.e. it is what is termed a ‘zero cost collar’).
The entity designates the combination of the two
instruments in a cash flow hedge of its highly probable
forecast transaction.
Accordingly, determining whether an option contract or a combination of options
(see 3.5 below) constitutes a net written option is an important step in hedge
designation, and can require judgement. The following factors, taken together, indicate
that an instrument or combination of instruments is not a net written option:
• no net premium is received, either at inception or over the life of the combination
of options – the distinguishing feature of a written option is the receipt of a
premium to compensate for the risk incurred;
• except for the strike prices, the critical terms and conditions of the written and
purchased option components are the same, including underlying variable(s),
currency denomination and maturity date; and
• the notional amount of the written option component is not greater than that of
the purchased option component. [IFRS 9.BC6.153].
The application of these requirements is illustrated in the following two examples.
Example 49.29: Foreign currency collar (or ‘cylinder option’)
Company E, which has sterling as its functional currency, has forecast that it is highly probable it will receive
€1,000 in six months’ time in respect of an expected sale to a customer in France.
E is concerned that sterling might have appreciated by the time the payment is received and wishes to protect
the profit margin on the sale without paying the premium that would be required with an ordinary currency
option. E also wishes to benefit from some of the upside in the event that sterling depreciates, so would prefer
not to use a forward contract.
Accordingly, E enters into an instrument under which it effectively:
• purchases an option that allows it to buy sterling for €1,000 from the counterparty at €1.53:£1.00; and
• sells an option that allows the counterparty to sell sterling to E for €1,000 at €1.47:£1.00.
Financial instruments: Hedge accounting 4023
In the foreign currency markets, such an instrument is often called a ‘cylinder option’ rather than a ‘collar’
and it operates as follows. If, in six months’ time, the spot exchange rate exceeds €1.53:£1.00, E will exercise
its option to sell €1,000 at €1.53:£1.00, effectively fixing its minimum proceeds on the sale (in sterling terms)
at £654. Similarly, if the rate is below €1.47:£1.00, the counterparty will exercise its option to buy €1,000 at
€1.47:£1.00, effectively capping E’s maximum proceeds on the sale at £680. If the rate is between
€1.47:£1.00 and €1.53:£1.00, both options will lapse unexercised and E will be able to sell its €1,000 for
sterling at the spot rate, generating between £654 and £680.
The premium that E would pay to acquire the purchased option equals the premium it would receive to sell the
written option and therefore no premium is paid or received on inception. The critical terms and conditions,
including the notional amounts, of the written and purchased option components are the same except for the
strike price. Therefore, E concludes that the instrument is not a net written option and, consequently, it may be
used as the hedging instrument in a hedge of the foreign currency risk associated with the future sale.
It is possible that the counterparty might, instead, have offered E a variation on the instrument described above. If
the notional amount on E’s purchased option component had been reduced, say to €500, the counterparty could
have offered a better rate on that component, say €1.51. However, in this case, the notional amount on the written
option component is twice that of the purchased option component and the instrument would be seen as a net written
option. Accordingly, even if E had very good business reasons for using such an instrument to manage its foreign
exchange risk, it could not qualify as a hedging instrument. Therefore, hedge accounting would be precluded.
Example 49.30: ‘Knock-out’ swap
Company Y has a significant amount of long-dated floating rate borrowings. In order to hedge the cash flow
interest rate risk arising from these borrowings, Y has entered into a number of matching pay-fixed, receive-
floating interest rate swaps that effectively convert the interest rates on the borrowings to fixed-rate.
Under the terms of one of these swaps, on each fifth anniversary of its inception until maturity the swap counterparty
may choose to simply terminate the swap at no cost. This is often referred to as a knock-out feature. In return for
agreeing to this, Y benefits by paying a lower interest rate on the fixed leg of the swap than it would on a conventional swap. In other words, Y receives a premium for taking on the risk of the counterparty cancelling the swap.
This instrument contains a net written option, i.e. the knock-out feature, and therefore cannot be used as a
hedging instrument unless it is used in a hedge of an equivalent purchased option. (In practice, it is unlikely
that the hedged borrowings will contain such an option feature.)
3.2.3 Embedded
derivatives
Only derivatives that are measured at fair value through profit or loss are eligible hedging
instruments. [IFRS 9.6.2.1]. Derivatives that are embedded in hybrid contracts, but that are
not separately accounted for, cannot be designated as separate hedging instruments.
[IFRS 9.B6.2.1]. Given that embedded derivatives in financial assets are not accounted for
separately under IFRS 9, this guidance precludes designation of embedded derivatives in
financial assets as separate hedging instruments. [IFRS 9.BC6.117-122].
However, an embedded derivative that is accounted for separately from its host contract
(either a financial liability or non-financial host) (see Chapter 42 at 4), is measured at fair
value through profit or loss, and therefore could be an eligible hedging instrument.
Example 49.31: Hedging with a sales commitment
Company J has the Japanese yen as its functional currency. J has issued a fixed-rate debt instrument with
semi-annual interest payments that matures in two years with principal due at maturity of US$5 million. It
has also entered into a fixed price sales commitment for US$5 million that matures in two years and is not
accounted for as a derivative because it qualifies for the normal sales exemption.
4024 Chapter 49
Because the sales commitment is accounted for as a firm commitment rather than a derivative instrument it
cannot be a hedging instrument in a hedge of the foreign currency risk associated with the debt instrument.
However, if the foreign currency component of the sales commitment was required to be separated as an
embedded derivative (essentially a forward contract to buy US dollars for yen) that component could be
designated as the hedging instrument in such a hedge. [IAS 39.F.1.2].
3.2.4
Credit break clauses
It is not uncommon for certain derivatives (e.g. long-term interest rate swaps) to contain
terms that allow the counterparties to settle the instrument at a so-called ‘fair value’ in
certain circumstances. The ‘fair value’ is usually not a true fair value as it excludes changes
in credit risk. Such terms, often called ‘credit break clauses’, enable the counterparties to
manage their credit risk in markets where collateral or margin accounts and master netting
agreements are not used. They are particularly common
where a long-duration derivative
is transacted between a financial and non-financial institution. For example, the terms of
a twenty-year interest rate swap may allow either party to settle the instrument at fair
value on the fifth, tenth and fifteenth anniversary of its inception.
These terms can be seen as options on counterparty credit risk. However, provided the
two parties have equivalent rights to settle the instrument at ‘fair value’, the credit break
clause will generally not prevent the derivative from qualifying as a hedging instrument.
Particularly, in assessing whether a premium is received for agreeing to the incorporation
of such terms into an instrument, care needs to be exercised. For example, marginally
better underlying terms offered by one potential counterparty (as a result of market
imperfections) should not be mistaken for a very small option premium.
3.2.5 Basis
swaps
A derivative which does not reduce risk at the transaction level cannot be a hedging
instrument. Consider a ‘basis swap’ that effectively converts one variable interest rate
index (say a central bank base rate) on a liability to another (say LIBOR). A relationship
of this nature would not normally qualify for hedge accounting because the hedging
instrument does not reduce or eliminate risk in any meaningful way – it simply converts
one risk to another similar risk. For this reason, such an economic strategy would not
qualify as either a fair value or cash flow hedge relationship (see 5.1 and 5.2 below).
A basis swap or similar instrument may qualify as a hedging instrument when considered
in combination with another instrument (see 3.5 below). For example, the basis swap
described above and a pay-fixed, receive-LIBOR interest rate swap may qualify as a
hedging instrument in a cash flow hedge of a borrowing that pays interest based on a
central bank rate. It may also be notionally decomposed and designated in hedges of
offsetting gross asset and liability positions (see 3.6.2 below).
However, a currency basis swap that converts foreign currency variable rate interest
and principal cash flows from a financial liability into variable rate interest and
principal cash flows in functional currency may be eligible as a hedging instrument in
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