of ineffectiveness (see 7.4.4.B below).
6.3.1 Business
combinations
In a business combination accounted for using the purchase method of accounting
where the acquiree has designated hedging relationships, the question arises of whether
the acquirer should:
• be permitted to continue to apply the hedge accounting model to hedge
relationships designated previously by the acquiree, assuming it is consistent with
the acquirer’s strategies and policies; or
• be required to re-designate hedge relationships at the acquisition date.8
IFRS 3 – Business Combinations – provides guidance that in order to obtain hedge
accounting in their consolidated financial statements, acquirers are required to
redesignate the acquiree’s hedges. [IFRS 3.15, 16(b)]. Further, the acquirer should not
recognise in its consolidated financial statements any amounts in equity in respect of
any cash flow hedges of the acquiree relating to the period prior to acquisition.
Redesignating the hedge relationships at the acquisition date means that if the hedging
instrument has a fair value other than zero (see 7.4.4.B below), it is likely that
ineffectiveness will be introduced in a hedge that may have been nearly 100% effective
prior to the acquisition, particularly for cash flow hedges. To mitigate this, the
acquirer may, subsequent to the combination, choose to settle the hedging
instruments and replace them with more effective ones. Furthermore, the existence
of this source of ineffectiveness may influence the chosen methodology used to
demonstrate the existence of an economic relationship in order to qualify for hedge
accounting in the acquirer’s consolidated financial statements (see 6.4 1 below).
[IFRS 9.B6.4.15].
For business combinations under common control, for which IFRS 3 is not applicable,
see further discussion in Chapter 10 at 3.3.3.
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6.3.2
Dynamic hedging strategies
A dynamic risk management strategy is one where the entity uses a dynamic process in
which the risk exposure and/or risk management instruments used to manage the
exposure do not remain the same for long. [IFRS 7.23C].
IFRS 9 permits, but does not require, separation of the intrinsic and time value of an
option contract and designation only of the intrinsic value as the hedging instrument
(see 3.6.4 above). [IFRS 9.6.2.4(a)]. For a dynamic hedging strategy that assesses both the
intrinsic value and time value of an option contract, it is helpful that there is no
requirement to exclude the time value of hedging option contracts from the hedge
relationship. Accordingly, it is possible for a delta-neutral option hedging strategy (i.e. a
strategy that is designed to create net risk positions (including the full option value) that
are unlikely to be affected by small movements in the price of the underlying) to achieve
hedge accounting without excluding the option time value, as long as the other
qualifying criteria are met (see 6.1 above).
Similarly, other dynamic hedging strategies under which the quantity of the hedging
instrument is constantly adjusted in line with the risk management strategy in order to
maintain a desired hedge ratio (e.g. to achieve a delta-neutral position, insensitive to
changes in the fair value of the hedged item), may qualify for hedge accounting.
For a dynamic hedging strategy to qualify for hedge accounting, the documentation
must specify how the hedge will be monitored and updated and how the effectiveness
criteria will be assessed. Consideration must also be made as to whether the periodic
changes made as part of dynamic hedging strategy should be treated as a rebalancing of
the hedge relationship (see 8.2 below) or a discontinuation and redesignation of the
hedge relationship (see 8.3 below). Such a determination is not a choice but based on
facts and circumstances; for example, treatment as rebalancing is only permitted where
changes to the hedge ratio are made (i.e. the quantity of hedged item compared to the
quantity of hedging instrument). In contrast, the introduction of new types of hedging
instruments would most likely be treated as a discontinuation and redesignation.
The guidance on rebalancing is applicable when the quantity of the hedging instrument
is constantly adjusted in order to maintain a desired hedge ratio for the existing hedged
item(s), often referred to as a closed portfolio (see 8.2 below). Accounting for dynamic
risk management of the associated risk in an open portfolios, to which new exposures
are frequently added, existing exposures mature, where frequent changes also occur to
the hedged item(s) is the subject of a live project for the IASB (see 11.1 below).
6.3.3 Forecast
transactions
In the case of a hedge of a forecast transaction, the documentation should identify the
date on, or time period in which, the forecast transaction is expected to occur. This is
because, in order to qualify for hedge accounting:
• the hedge must relate to a specific identified and designated risk;
• it must be possible to measure its effectiveness reliably; and
• the hedged forecast transaction must be highly probable (see 2.6.1 above).
To meet these criteria, entities are not required to predict and document the exact date
a forecast transaction is expected to occur. However, the time period in which the
Financial instruments: Hedge accounting 4061
forecast transaction is expected to occur should be identified and documented within a
reasonably specific and generally narrow range of time from a most probable date, as a
basis for measuring hedge ineffectiveness. Consideration of the effectiveness criteria
would need to reflect differences in timing of the hedged and hedging cash flows in a
manner consistent with the designated hedged risk (see 6.4.1 and 7.4.4.A below).
If a forecast transaction such as a commodity sale is properly designated in a cash flow
hedge relationship and, subsequently, its expected timing changes to an earlier (or later)
period, this does not affect the validity of the original designation. If the entity can
conclude that this transaction is the same as the one designated as being hedged, then
hedge accounting may be able to continue. However, ineffectiveness may arise due to the
change in timing, as the calculation would be based on the up to date expectation of the
timing of the hedged forecast transaction. For example, if the forecast transaction was
now expected earlier than originally thought, the hedging instrument will be designated
for the remaining period of its existence, which will exceed the period to the forecast sale.
Further, hedged forecast transactions must be identified and documented with
sufficient specificity so that when the transaction occurs, it is clear whether the
transaction is, or is not, the hedged transaction. Therefore, a forecast transaction may
be identified as the sale of the first 15,000 units of a specific product during a specified
three-month period (see 2.3.1 above), but it could not be identified as the last
15,000 units of that product sold because they cannot be identified when they occur.
For the same reason, a forecast transaction cannot be specified solely as a percentage
6.4
Assessing the hedge effectiveness requirements
A hedging relationship can only qualify for hedge accounting if all the hedge
effectiveness requirement are met, assuming the other qualifying criteria are also met
(see 6.1 above).
The hedge effectiveness requirements are as follows:
• there is ‘an economic relationship’ between the hedged item and the hedging
instrument (see 6.4.1 below);
• the effect of credit risk does not ‘dominate the value changes’ that result from that
economic relationship (see 6.4.2 below); and
• ‘the hedge ratio of the hedging relationship is the same as that resulting from the
quantity of the hedged item that the entity actually hedges and the quantity of the
hedging instrument that the entity actually uses to hedge that quantity of the
hedged item. However, that designation shall not reflect an imbalance between the
weightings of the hedged item and the hedging instrument that would create hedge
ineffectiveness (irrespective of whether recognised or not) that could result in an
accounting outcome that would be inconsistent with the purpose of hedge
accounting’. The second part of this requirement is an anti-abuse clause that is
explained in more detail in at 6.4.3 below. [IFRS 9.6.4.1].
An entity shall assess at the inception of the hedging relationship, and on an ongoing basis
whether the hedge effectiveness requirements are met. The standard does not specify a
particular method for assessing whether the effectiveness requirements are met, however
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the methods selected must be documented within the hedge documentation (see 6.3
above). [IFRS 9.B6.4.12, B6.4.13, B6.4.19].
6.4.1 Economic
relationship
The first effectiveness requirement means that the hedging instrument and the hedged item
must generally be expected to move in opposite directions as a result of a change in the
hedged risk. This is within the context of how the hedged item and hedging instrument have
been designated as described at 2 and 3 above. [IFRS 9.B6.4.1]. The guidance does not require
that the value changes of the hedging instrument and the hedged item are expected to move
in the opposite direction for the hedged risk in all circumstances, but that generally there is
an expectation that they will systematically move in opposite directions. It is clear therefore,
that there can be instances where the value changes in the hedged item and hedging
instrument are expected to move in the same direction. The standard discusses an example
where the price of the hedged instrument is based on the West Texas Intermediate (WTI)
price of oil whereas the price of the hedged item is based on the Brent crude oil price. The
values of the hedging instrument and the hedged item can both move in the same direction
if, for example, there is only a minor change in the relative underlyings of each of the hedged
item and hedging instrument (i.e. the WTI and Brent oil prices) but there is a change in the
price differential between the two. However no guidance is provided as to how frequently
this would have to happen so as to lead us to reject the expectation that they would
‘generally’ move in opposite directions. One possibility might be to use correlation analysis
to demonstrate that there is, over time, a reliable and systematic price relationship. We
expect practice to evolve in this area. [IFRS 9.B6.4.4, B6.4.5, BC6.238].
The assessment of whether there is an economic relationship should be based on an
economic rationale rather than it just arising by chance, as could be the case if the
relationship is based only on a statistical correlation. That is, causality cannot be
assumed purely from correlation or, to quote the IASB, ‘the mere existence of a
statistical correlation between two variables does not, by itself, support a valid
conclusion that an economic relationship exists’. [IFRS 9.B6.4.6].
Conversely, a statistical correlation may provide corroboration of an economic
rationale. For example, if it can be seen that value drivers exist such that there is an
expectation that the value of the hedged item and hedging instrument would generally
move in opposite directions, but that significant sources of ineffectiveness exist within
a relationship that may counteract the offset, then quantitative analysis may assist in
determining whether an economic relationship exists or not. For example, in the case
of a fair value hedge of an inflation risk component in a fixed rate bond (assuming it is
determined that an eligible risk component exists (see 2.2.6 above)), quantitative
analysis may provide additional evidence as to whether an economic relationship exists
or not. In summary, a quantitative assessment alone is not enough to establish an
economic relationship, but it may be useful in a small number of cases to support a
qualitative analysis that an economic relationship exists.
The requirement of an economic relationship will automatically be fulfilled for many hedging
relationships, as the underlying of the hedging instrument often matches, or is closely aligned
with, the hedged risk. [IFRS 9.B6.4.14]. Even though it is not sufficient to focus solely on changes
in value due to the hedged risk, where there are differences between the hedged item and
Financial instruments: Hedge accounting 4063
the hedging instrument such that there are other value drivers, the economic relationship will
often still be capable of being demonstrated using a qualitative assessment. A qualitative
assessment may also be used to determine that an economic relationship does not exist. For
example, a hedge of one-sided risk in forecast purchases is designated as being hedged by an
out-of-the-money call option. If the main driver of value change in the option is expected to
be the time value of the option, (perhaps as the option is expected to remain out of the
money) then it can easily be seen the hedged item and hedging instrument are generally not
expected to move in opposite directions with respect to the hedged risk. Of course, if the
time value of the option was excluded from the hedge relationship (see 3.6.4 above), then it
will be easier to demonstrate that there is an economic relationship.
When the critical terms of the hedging instrument and hedged item are not closely aligned,
and there is increased uncertainty about the extent of offset, such that hedge effectiveness
is more difficult to predict, as noted above, IFRS 9 suggests that ‘it might only be possible
for an entity to conclude [that there is an economic relationship] on the basis of a
quantitative assessment.’ [IFRS 9.B6.4.16, BC6.269]. The standard does not provide any further
guidance on when a quantitative assessment might be required or how it would be made.
However, it would seem to be most relevant when the hedged item and the hedging
instrument are each based on prices derived from different markets, as in the example of
WTI and Brent crude oil, cited earlier, where there is a reasonable chance that the value
changes of the hedging instrument and the hedged item will frequently move in the same
direction. This is an area where practice will develop, but we expect the need for a
quantitative assessment over
and above what is already undertaken for risk management
purposes, to be relatively infrequent. [IFRS 9.B6.4.18].
The standard also mentions hedging relationships where a derivative with a non-zero fair
value is designated as the hedging instrument, as an example of a situation where a
quantitative assessment might be required to establish an economic relationship. It depends
on the particular circumstances as to whether hedge effectiveness arising from the non-zero
fair value could potentially have a magnitude that a qualitative assessment would not
adequately capture. [IFRS 9.B6.4.15]. However, as noted above, the standard does not provide
guidance on how large the non-zero fair value would have to be for a quantitative
assessment to be required, or for an economic relationship to be considered not to exist.
The assessment of the economic relationship, whether qualitative or quantitative,
would need to consider, amongst other possible sources of mismatch between the
designated hedged item and the hedging instrument, the following:
• maturity;
• volume or nominal amount;
• cash flow dates;
• interest rate basis, or quality and location basis differences;
• day count methods;
• features that arise only in either the designated hedged item or hedging instrument;
• differences in valuation methods and inputs such as discount rates or credit risk; and
• the extent that the hedging instrument is already ‘in the money’, or ‘out of the
money’ when designated.
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The assessment should also include an analysis of the possible behaviour of the hedging
relationship during its term to ascertain whether it can be expected to meet the risk
management objective. [IFRS 9.B6.4.6]. The assessment must be forward looking at all
times, without solely relying on actual retrospective offset. This does not mean that
retrospective offset is never relevant, but it should only be relied upon if there is a
reasonable expectation that it is representative of the future.
IFRS 9 does not specify a method for assessing whether an economic relationship exists.
An entity should use a method capturing all the relevant characteristics of the hedging
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 804
