relationship including the sources of ineffectiveness. [IFRS 9.B6.4.13]. Which methods,
including statistical methods such as regression or sensitivity analysis, as well as the
thresholds attached to them, is an area where we expect that best practice will emerge
over time. No ‘bright lines’ are mandated by the guidance, nor is there a requirement for
an entity to determine their own bright lines. Instead, judgement is required in
determining whether an economic relationship exists or not. However, it follows from
the objective of the hedge accounting requirements to represent the effect of an entity’s
risk management activities, that the main source of information to perform the
assessment would be an entity’s risk management activities. [IFRS 9.6.1.1, B6.4.18]. In
practice, an entity will normally have assessed the economic relationship for risk
management purposes and, in most cases, assuming sound risk management, we would
expect that this assessment to be appropriate for accounting purposes as well. However,
in some cases, existing risk management techniques might not adequately consider all
sources of ineffectiveness, such that additional quantitative analysis may be required,
although this is likely to be rare. The chosen quantitative technique should depend on
the complexity of the relationship, availability of data, the time value of money and the
level of uncertainty of offset in the hedge relationship. If there are changes in
circumstances that affect hedge effectiveness, an entity may have to change the method
for assessing whether an economic relationship exists. [IFRS 9.B6.4.17].
The standard also mentions that a quantitative method, (e.g. regression analysis), might
help demonstrate a suitable hedge ratio (see 6.4.3 below). [IFRS 9.B6.4.16].
The following example illustrates an approach that uses a qualitative assessment.
Example 49.53: Economic relationship between HKD and USD
An entity has foreign currency exposures in both Hong Kong dollars (HKD) and US dollars (USD). The entity
aggregates its exposures in the two currencies and only uses USD linked hedges to hedge those currency exposures.
Because the HKD is pegged to the USD in a way that allows fluctuations only within a very narrow band
(between HKD 7.75 – HKD 7.85 per USD) the entity concludes that an economic relationship exists between
its USD linked hedges (with the USD as the underlying) and its HKD denominated foreign currency exposures.
The entity monitors the currency peg for changes and treats the movements of the HKD within the narrow
band as a source of some ineffectiveness for all hedges in which the hedged item relates to amounts
denominated in HKD.
When using a statistical method such as regression analysis, either to corroborate an
economic relationship or to determine a suitable hedging ratio, an entity is required to
consider its expectations of future developments. A prominent recent example is
negative interest rates in some European countries. Many variable debt instruments
such as mortgages include an explicit or implicit floor while the interest rates swaps
used to hedge the variability of cash flows of those exposures usually do not.
Financial instruments: Hedge accounting 4065
Although the interest cash flows of the hedged item and the variable leg of the hedging
instrument may well have been highly correlated in the past, in an environment where
interest rates are expected to be negative in the foreseeable future, this may no longer
be expected because of the floor in the hedged item. This means that an entity needs to
incorporate changes in expectations and re-calibrate its regression analysis accordingly.
6.4.2
Credit risk and the effectiveness assessment
IFRS 9 requires that, to achieve hedge accounting, the impact of credit risk should not
be of a magnitude such that it dominates the value changes, even if there is an economic
relationship between the hedged item and hedging instrument. Credit risk can arise on
both the hedging instrument and the hedged item in the form of counterparty credit risk
or the entity’s own credit risk.
Judgement has to be used in determining when the impact of credit risk is ‘dominating’
the value changes. But clearly, to ‘dominate’ would mean that there would have to be a
very significant effect on the fair value of the hedged item or the hedging instrument.
The standard provides guidance that small effects should be ignored even when, in a
particular period, they affect the fair values more than changes in the hedged risk.
[IFRS 9.B6.4.7]. An example of credit risk dominating a hedging relationship would be when
an entity hedges an exposure to commodity price risk with an uncollateralised
derivative and the credit standing of the counterparty to that derivative deteriorates
severely, such that the effect of the changes in the counterparty’s credit standing might
outweigh the effect of changes in the commodity price on the fair value of the hedging
instrument. [IFRS 9.B6.4.8].
The assessment of the effect of credit risk on value changes for hedge effectiveness
purposes, which often may be made on a qualitative basis, should not be confused with
the requirement to measure and recognise the impact of credit risk on the hedging
instrument and, where appropriate, the designated hedged item, which will normally
give rise to hedge ineffectiveness recognised in profit or loss (see 7.4 below).
6.4.2.A
Credit risk on the hedging instrument
IFRS 13 is clear that the effect of credit risk, both the counterparty’s credit risk and the
entity’s own credit risk, has to be reflected in the measurement of fair value (see
Chapter 14 at 11.3.2). The effect of counterparty and own credit risk on the
measurement of the hedging instrument will obviously result in some hedge
ineffectiveness, as the same credit risk does not usually arise in the hedged item. The
expected effect of that ineffectiveness should not be of a magnitude that it frustrates the
offsetting impact of a change in the values of the hedging instrument and the hedged
item that results from the economic relationship (as explained at 6.4.1 above).
We expect the assessment of the effect of credit risk to be a qualitative assessment in
most cases. For example, entities typically have counterparty risk limits defined as part
of their risk management policy. The credit standing of the counterparties is monitored
on a regular basis. However, a quantitative assessment of the impact of credit risk on
the value changes of the hedging relationship might be required in some instances, if the
counterparty’s credit standing deteriorates.
4066 Chapter 49
Nowadays, most over-the-counter derivative contracts between financial institutions
are cash collateralised. Furthermore, current initiatives in several jurisdictions, such as,
the European Market Infrastructure Regulation (EMIR) in the European Union or the
Dodd-Frank Act in the United States, have resulted in more derivative contracts being
collateralised by cash (see 8.3.2.A below). Cash collateralisation significantly reduces
the credit risk for both parties involved, meaning that credit risk is unlikely to dominate
the change in fair value of such hedging instruments.
6.4.2.B
&nb
sp; Credit risk on the hedged item
The analysis of the hedged item is somewhat different, as credit risk does not apply to
all types of hedged items. For example, while loan assets typically have counterparty
credit risk and financial liabilities bear the issuing entity’s own credit risk, inventory and
forecast transactions do not pose credit risk.
Credit risk is defined as ‘risk that one party to a financial instrument will cause a financial
loss for the other party by failing to discharge an obligation’. [IFRS 7 Appendix A]. Credit risk
cannot dominate the value change in a hedge of a forecast transaction as the transaction
is, by definition, only anticipated but not committed. [IFRS 9 Appendix A]. Similarly,
inventory does not involve credit risk.
This should be contrasted with the assessment of whether a forecast transaction is highly
probable. Even though such a transaction does not involve credit risk, depending on the
possible counterparties for the anticipated transaction, the credit risk that affects them can
indirectly affect the assessment of whether the forecast transaction is highly probable. For
example, assume an entity sells a product to only one particular customer abroad for which
the sales are denominated in a foreign currency and the entity does not have alternative
customers to sell the product to in that currency (or other sales in that currency). In that
case, the credit risk of that particular customer would indirectly affect the likelihood of the
entity’s forecast sales in that currency occurring. Conversely, if the entity has a wider
customer base for sales of its product that are denominated in the foreign currency then
the potential loss of a particular customer would not significantly (or even not at all) affect
the likelihood of the entity’s forecast sales in that currency occurring.
It is noted in IFRS 9 that a magnitude that gives rise to dominance is one that would result
in the loss (or gain) from credit risk frustrating the effect of changes in the underlying on
the value of the hedging instrument or the hedged item, even if those changes were
significant. [IFRS 9.B6.4.7]. The guidance refers to both a loss and a gain due to changes in
credit risk for the hedged item and the hedging instrument. However it will only be
relevant to consider a decrease in credit risk for the hedged item, if such a change in credit
risk would frustrate the hedge relationship. For example, a decrease in credit risk in a
hedged financial asset is unlikely to cause the level of offset within the hedge relationship
to become erratic, if credit risk is excluded from the hedge relationship. In contrast, this
would not be the case for an increase in the credit risk of hedged financial assets, as higher
levels of credit risk could affect the hedged cash flows themselves.
Financial instruments: Hedge accounting 4067
For regulatory and accounting purposes, banks usually have systems in place to
determine the credit risk on their loan portfolios. Therefore, banks should be able to
identify loans for which credit risk is so high that it would require an assessment of
whether credit risk is dominating the value changes in the hedging relationship.
The introduction of the new impairment model of IFRS 9 (see Chapter 47) has raised
the question of whether there is a linkage between:
• the impairment model concept of a significant increase in credit risk (i.e. the move
from ‘stage one’ to ‘stage two’) and the subsequent transfer of a credit-impaired
financial assets to ‘stage three’; and
• the concept of when the effect of credit risk dominates the value changes of the
hedged item that represent the hedged risk.
There is no direct link between the stages of the impairment model and credit risk
eligibility criterion of the hedge accounting model. However in practice, an entity may
consider the indicators cited in the definition of a credit-impaired financial asset (see
Chapter 47 at 3.1). This is because those indicators characterise situations with a
magnitude of credit risk that normally suggests that its effect would dominate the value
changes of the hedged item that represent the hedged risk. This suggests that normally
the hedge effectiveness criteria would cease to be met no later than when a financial
asset is classified as credit-impaired (i.e. in stage three). How much earlier the hedge
effectiveness criteria might be failed is a matter of judgement, which may need to be
supported by quantitative assessment in some situations. But also, in the context of
stage three of the impairment model, it should be remembered that the effect of credit
risk on the fair value of an item involves not only the probability of default but also
the loss given default, whereas the indicators cited in the definition of a credit-
impaired financial asset relate only to the probability of default. That difference is
relevant when assessing whether credit risk is dominant in the case of items that are
highly collateralised.
In practice, we expect that entities with a sound risk management would be unlikely
to struggle with the assessment of when the effect of credit risk dominates the value
changes of the hedged item that represent the hedged risk. This is because such
entities would have developed suitable criteria for when risk exposures can no
longer be economically hedged because credit risk creates too much uncertainty as
to whether that exposure will eventually crystallise as per the terms in the contract
from which it arises. Entities normally evaluate this for risk management purposes
because they want to avoid being ‘over-hedged’ as a result of the offset from the
hedged item for the gains or losses on the hedging instrument being eroded by credit
risk. In other words, this is predominantly an economic question rather than an
accounting consideration (similar to the discussion at 6.4.2.A above regarding the
credit risk of hedging instruments and entities’ criteria for selecting counterparties
for those instruments).
4068 Chapter 49
It has been suggested that there is also interaction between the hedge accounting model
and the impairment model regarding the effect that a fair value hedge might have on the
measurement of the expected credit loss (ECLs). Specifically, as IFRS 9 requires that
expected cash flows are discounted at the effective interest rate (EIR) for the purposes
of calculation of the ECL, the question is whether fair value hedge accounting changes
the EIR of hedged financial assets for this purpose.
If an accounting policy choice was made that fair value hedges do change the EIR, then
the EIR used for discounting the ECL should be adjusted for the effect of fair value
hedging. Under IFRS 9 every debt instrument recorded at amortised cost or at fair value
through other comprehensive income has an associated ECL. This would mean, for
every fair value hedge in relation to such financial assets, the measurement of the ECL
would require taking into account the effect of the fair value hedge accounting.
However, as a fair value hedge adjustment is only required to be amortised when the
hedged item ceases to be adjusted for changes in fair value attributable to the risk being
hedged, arguably there is no need to adjust the EIR until then, and
hence the rate used
to discount ECLs. We believe the requirement is not clear and that there is an
accounting policy choice on the matter. (See Chapter 47 at 7.5.)
The systems used to assess the credit risk of loans would also usually permit banks to
determine the appropriate economic hedge when hedging the interest rate risk of such
loans, as illustrated by Example 49.54 below:
Example 49.54: Designating interest rate hedges of loan assets when credit risk is
expected
Assume a bank wishes to hedge the interest rate risk of a portfolio of loans that have similar credit risk
characteristics. Economically, the bank should hedge only the cash flows it expects to collect. When expecting
to collect 95% of all cash flows in a loan portfolio, the bank should designate the first 95% of cash flows
only. A designation of more than 95% would result in an economic over-hedge and would also increase the
risk of credit risk dominating the value changes of the hedging relationship.
The designation of such a nominal component (often referred to as a bottom layer) is possible under IFRS 9
(as discussed at 2.3.12 above). This type of designation would require that all items included in the layer are
exposed to the same hedged risk so that the measurement of the hedged layer is not significantly affected by
items that make up the 95% layer from the overall 100% of the portfolio. [IFRS 9.6.6.3(c)]. Therefore, the entity
has to designate the same kind of benchmark interest rate risk component of each loan to make up the bottom
layer. If there is a deterioration in the credit risk of a particular loan that results in credit risk dominating the
economic relationship with the benchmark interest rate, such that its benchmark interest rate risk component
will no longer qualify to be designated as a hedged item, it would not be considered to be part of the bottom
layer unless and until those loans for which credit risk dominates the economic relationship would exceed
5% of the portfolio.
The example should not be taken to imply that for an individual loan with an expected
loss of, say, 5% an entity may not hedge the interest rate risk using an interest rate swap
that has a notional amount equal to the loan’s face value. However, if the loan
deteriorated in its credit quality to an extent where the credit risk-related changes in
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 805
