International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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[IFRS 9.B6.5.4]. The inclusion of the words ‘the changes in the fair value or cash flows’ in
the definition of ineffectiveness is unhelpful, but the need for consideration of the time
value of money is clear based on the noted application guidance of IFRS 9. In valuation
practice, the effect of the time value of money is also included when measuring the fair
value of financial instruments. Consequently, it is logical to apply the same principle to
the hedged item as well.
It is possible to designate a spot element of a hedged item if it can be determined to be
an eligible risk component (see 2.2 above). Whilst a spot designation is relatively
common place for both foreign exchange and commodity risk, the need to consider the
time value of money for effectiveness purposes for spot designations has been a matter
of some debate. The IAS 39 Implementation Guidance contains an example in which an
entity designates changes in the spot element only (see 7.4.5 below). The example
indicates that the time value of money is still relevant for the measurement of
ineffectiveness even when the spot element is designated in a hedge relationship. See
Example 49.68 below for the detailed example in the IAS 39 Implementation Guidance,
but Example 49.65 below more simply demonstrates how ineffectiveness can arise
when there are differences in the timing of hedged and hedging cash flows.
Example 49.65: Impact of time value of money when measuring ineffectiveness
A manufacturing company in India, having the Indian Rupee as its functional currency, is expecting forecast
sales in USD. The company assesses sales of USD 1m per month for the next twelve months to be highly
probable and wishes to hedge the related foreign currency exposure. The company also holds a borrowing of
USD 20m with a bullet repayment in fourteen months’ time. Instead of entering into foreign currency forward
contracts, the company designates the US dollar borrowing as a hedging instrument in hedges of the spot risk
of the monthly highly probable US dollar sales.
When measuring hedge ineffectiveness, the revaluation of the forecast sales for foreign currency risk would
have to be made on a discounted basis (i.e. a present value calculation reflecting the time between the
reporting date and the future cash flow date), whereas the revaluation of the hedging instrument would not
(as this follows the requirements of IAS 21).
The requirement to calculate ineffectiveness on a present value basis intuitively makes
sense in cases where the cash flows of the hedged item and hedging instrument are not
aligned. It would seem inappropriate to have no ineffectiveness under a spot
designation, for example in the situation described at 3.3.1 above, where a 7-year
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financial liability denominated in a foreign currency is used as the hedging instrument
for a 12 month forecast sale in that foreign currency.
7.4.3 Calculation
of
ineffectiveness
The calculation of ineffectiveness compares the monetary amounts of the change in fair
value of the hedging instrument with the monetary amount of the change in fair value
or cash flows of the hedged item or transactions attributable to the hedged risk over the
assessment period as per the hedge ineffectiveness requirements (see 7.4.1 above). This
is illustrated by the following simple example:
Example 49.66: Calculation of ineffectiveness
An entity issues fixed rate debt at par of £100, with a fixed interest rate of 3%. On the same day, the entity
designates an existing interest rate swap in a hedge relationship with the issued debt, for changes in LIBOR.
The existing swap has a notional of £100, a receive leg of 2.5% and a floating leg paying LIBOR.
Hedged
item
Hedging instrument
(issued debt)
(existing swap)
Fair value on initial designation
£100 CR
£4.5 CR
Fair value on first reporting date
£107 CR
£2.4 DR
Change in fair value of the hedging instrument
£6.9
gain
over the assessment period
Change in fair value of the hedged item
attributable to the hedged risk over the
£7 loss
assessment period
Hedge ineffectiveness is calculated by comparing the £6.9 gain on the hedging instrument to the £7 loss on
the hedged item over the assessment period.
Whilst it may be relatively obvious how to calculate the change in fair value or cash
flows of a hedged item with fixed flows for changes in the hedged risk since designation
(typically a fair value hedge) (see 5.1 above), it is less obvious how this might be achieved
where the hedged flows are not fixed. In particular as hedged items with variable flows
do not tend to attract fair value risk. This is discussed in more detail at 7.4.4 below.
7.4.4
Other ineffectiveness measurement issues
7.4.4.A Hypothetical
derivatives
A method commonly used in practice to calculate ineffectiveness of cash flow hedges
(and net investment hedges) is the use of a so-called ‘hypothetical derivative’. The
method involves establishing a notional derivative that has terms that match the critical
terms of the hedged exposure (normally an interest rate swap or forward contract with
no unusual terms) and a zero fair value at inception of the hedging relationship. The fair
value of the hypothetical derivative is then used as a proxy to measure the change in
the value of the hedged item against which changes in value of the actual hedging
instrument are compared to calculate ineffectiveness. The use of a hypothetical
derivative is one possible way of determining the change in the value of the hedged item
when measuring ineffectiveness. [IFRS 9.B6.5.5].
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IFRS 9 is clear that a hypothetical derivative has to be a replication of the hedged item
and not the ‘perfect hedge’. Also the standard makes clear that any different method for
determining the change in the value of the hedged item would have to give the same
outcome. Consequently, an entity cannot include features in the hypothetical derivative
that only exist in the hedging instrument, but not in the hedged item. [IFRS 9.B6.5.5]. Whilst
this appears to be a logical requirement, it may have wider implications for cash flow
hedges than many would have expected. An entity cannot simply assume no
ineffectiveness for a cash flow hedge because the principal terms of the hedging
instrument exactly match the principal terms of a hedged item, if there are differences
in other features of the hedging instrument and the hedged item. For example, IFRS 13
requires an entity to reflect both the counterparty’s credit risk and the entity’s own
credit risk when determining the fair value of a derivative. The same credit risk cannot
be assumed in the hypothetical derivative. This difference in credit risk would result in
some ineffectiveness (see 7.4.6 below).
It is possible to exclude the credit risk in the hedged item from the hedge relationship, for
example by designating interest rate risk as the hedged risk (see 2.2 above). This does not
eliminate ineffectivenes
s from changes in the credit risk of the hedging derivative, but
prevents additional ineffectiveness from changes in the credit risk of the hedged item. (This
assumes that credit risk is not of a magnitude such that it dominates the value changes of
the hedged item (see 6.4.2 above)). The example below demonstrates this point.
Example 49.67: Impact on ineffectiveness of changes in credit risk in the hedged
item when the hedged risk is a benchmark component
Entity A has issued floating rate debt, paying a benchmark floating rate plus a credit spread of 1%. Entity A
also transacts a pay fixed, receive benchmark interest rate swap in order to eliminate variability in cash flows
from changes in the benchmark rate. The entity designates this swap as a hedge of the benchmark component
of the issued debt and excludes credit risk on the debt from the hedge relationship. Accordingly, if
subsequently Entity A’s credit rating changes such that the current credit spread is now 0.95%, this will have
no impact on the change in value of the hedged item for the purposes of measuring ineffectiveness, as credit
risk in the hedged item has been excluded from the hedge relationship. Conversely, if there is a change in the
credit risk with respect to the interest rate swap (either that of the counterparty or the entity itself), resulting
in a change in the fair value of the interest rate swap, this would affect the measurement of hedge
ineffectiveness. The credit risk associated with the interest rate swap includes both counterparty and own
credit risk (see 7.4.6 below).
When considering the credit risk of the hedged item, any changes must not be of a magnitude that it dominates
the value changes in the hedged item (see 6.4.2.B above. That is unlikely to be the case for a change in credit
spread from 1% to 0.95%.
One other example of when the features of the hedging instrument and the hedging item
are likely to differ is when an entity hedges a debt instrument denominated in a foreign
currency in a cash flow hedge (irrespective of whether it is fixed-rate or variable-rate
debt). IFRS 9 is explicit that when using a hypothetical derivative to calculate
ineffectiveness, the hypothetical derivative cannot simply impute a charge for exchanging
different currencies (i.e. the foreign currency basis spread) even though actual derivatives
(for example, cross currency interest rate swaps) under which different currencies are
exchanged might include such a charge. [IFRS 9.B6.5.5]. Although cross currency interest rate
swaps are used to highlight the fact that foreign currency basis spreads should not be
replicated in hypothetical derivatives, this issue is also likely to arise in other foreign
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exchange contacts settled in the future. To address this, IFRS 9 includes the ability to
account for the foreign currency basis spread as a cost of hedging (see 7.5 below).
In many cases where the critical terms of the hedged item are closely matched by a
hedging instrument which had a zero fair value on designation, the hypothetical
derivative is likely to have similar terms to the actual hedging derivative – subject to the
known differences mentioned above (e.g. foreign currency basis spreads and credit risk).
As a consequence of the guidance in B6.5.5, a further (maybe unexpected) source of
ineffectiveness is the discount rate used for measuring the fair value of cash
collateralised interest rate swaps (IRS). This is discussed further at 7.4.4.C below.
Example 49.68 (see 7.4.4.E below) contains a very comprehensive illustration of the
calculation of infectiveness based on implementation guidance in IAS 39.
7.4.4.B
Hedging using instruments with a non-zero fair value
There is no requirement for hedge accounting to be designated on initial recognition of
either the hedged item or the hedging instrument. [IFRS 9.B6.5.28]. However, there is often
a hidden danger when designating a derivative as a hedging instrument subsequent to
its inception. For non-option derivatives, such as forwards or interest rate swaps, any
fair value is likely to create ‘noise’ in measuring hedge ineffectiveness that may not be
fully offset by changes in the hedged item, especially in the case of a cash flow hedge.
This is because the derivative contains a ‘financing’ element (the initial fair value), gains
and losses on which will not be replicated in the hedged item and therefore the hedge
contains an inherent source of ineffectiveness. For example, if applying the hypothetical
derivative method for measurement of ineffectiveness (see 7.4.4.A above) this financing
element will be evident as the hypothetical derivative will be based on the prevailing
market rates on designation, which will result in cash flows that differ from those of the
actual now ‘off market’ derivative.
Consequently, there is likely to be more ineffectiveness recognised and, in extremis, a
quantitative assessment in order to demonstrate the existence of an economic
relationship may be required. It depends on the circumstances whether hedge
ineffectiveness arising from the financing element on designation could have a
magnitude that a qualitative assessment would not adequately capture. [IFRS 9.B6.4.15].
Only by coincidence will a derivative still have a fair value that is zero, or close to zero,
which would minimise this problem.
This situation can arise when a derivative is designated or redesignated in a hedging
relationship subsequent to its initial recognition or in a business combination
(see 6.3.1 above).
This same issue does not arise for hedged items that are designated after initial
recognition, however difficulties can occur identifying eligible risk components
(see 2.4.1 above).
7.4.4.C
Discount rates for calculating the fair value of actual and hypothetical
derivatives
Historically, the fair values of interest rate swaps have been calculated using LIBOR-
based discount rates. As per its definition, LIBOR is the average rate at which the
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reference banks can fund unsecured cash in the interbank market for a given currency
and maturity.14 However, the use of LIBOR as the standard discount rate ignores the fact
that many derivative transactions are now collateralised and have therefore a lower
credit risk than LIBOR would suggest. For cash-collateralised trades, a more relevant
discount rate is an overnight rate rather than LIBOR. Overnight index swaps (OIS) are
interest rate swaps where the floating leg is linked to a benchmark interest rate for
overnight unsecured lending. OIS rates much better reflect the credit risk of cash
collateralised IRS.
When measuring the fair value of a cash-collateralised LIBOR indexed interest rate
swap, an entity would have to use a LIBOR-based forward curve to determine the future
floating cash flows, but these are then discounted using an OIS swap curve. This would
result in a different fair value compared to a non-collateralised interest rate swap for
which both the forward rates and the discount rates are derived from the LIBOR swap
curve. The significance of this is that when, for example, a collateralised LIBOR-based
interest rate swap is used as the designated hedging instrument in a fair value hedge of
a
fixed rate bond for changes in LIBOR, this will likely lead to recorded hedge
ineffectiveness. This is because the calculation of the change in fair value of the bond
for hedge accounting purposes will be based on a discount rate that includes the credit
risk associated with the hedged risk (i.e. LIBOR), whereas the hedging interest rate swap
will be discounted at an OIS rate. The resulting ineffectiveness is sometimes referred to
as the ‘multi curve issue’.
In the case of cash flow hedges, the situation is less clear and comes back to the
discussion about the use of the ‘hypothetical derivative’ method set out above at 7.4.4.A
above. The application guidance in IFRS 9 on hypothetical derivatives in paragraph
B6.5.5 which precludes including features in the value of the hedged item that only exist
in the hedging instrument, but not in the hedged item provides some clarity. This implies
that it is not permissible to assume a hypothetical derivative is subject to the credit risk
inherent in an OIS rate just because the associated hedged item is hedged using a
collateralised derivative. This will likely result in ineffectiveness.
A derivative that is novated to a central clearing party may, as a result, become cash
collateralised (see 8.3.2.A below). The application guidance clarifies that the change in
the fair value of the hedging instrument that results from the changes to the contract in
connection with the novation (e.g. a change in the collateral arrangements) must be
included in the measurement of hedge ineffectiveness. [IFRS 9.B6.4.3].
As a result of the reforms mandated by the Financial Stability Board following the
Financial Crisis, regulators are pushing for IBOR (including LIBOR) to be replaced by
new ‘official’ benchmark rates, known as Risk Free Rates (RFRs). Such a change will
necessarily impact both forecasting and discounting curves for financial instruments.
Hence the occurrence of the ‘multi curve issue’ should reduce, as the forecasting and
discounting curves may be the same. However the change in benchmark rates also
raises a number of other hedge accounting questions. On 20 June 2018 the IASB,
noting the urgency, decided to add a research project to its active research programme
(see 8.3.2.C below).15