2. Risk and Hedging
Hedging would seem to be a new term
BUT it is only a new word for what we have been
doing for years
3. Risk and Hedging
Hedging would seem to be a new term
BUT it is only a new word for what we have been
doing for years
We have not invented anything – we have just:
•formally acknowledged it and
•developed accounting methods for recording it and
•established a management framework for it
that was not there before.
4. Risk and Hedging
Hedging would seem to be a new term
BUT it is only a new word for what we have been
doing for years
We have not invented anything – we have just:
•formally acknowledged it and
•developed accounting methods for recording it and
•established a management framework for it
that was not there before.
We are here to discuss Formal Accounting for Risks that
can be designated, measured and hedged
5. Risk and Hedging
Traditional Business risk =
1. Market risk (Sales)
2. Operational risk ($Sales-$Cost)
3. Financial risk (Gearing of Co)
Lately other Financial risks are recognized:
Commodity Price risk
Interest rate risk
Currency (Fx) risk
Again - we can formally designate, measure and hedge these
risks
6. Natural Hedging
Examples Include:
1. Borrow long and Invest short
2. Informal arrangements that tend to compensate for risks
- Forward contracts of materials
- Loans to amend the finance of the company (gearing)
SME’s may do this type of thing
Hedge accounting is used ONLY when there is a formal hedge
accounting policy – so a company will make this a formal decision
So we are talking about IF YOU WANT TO ADOPT HEDGE
ACCOUNTING then this what you will do
7. Contents - Hedging
1. Risk Management
2. Hedge Accounting mechanics
2. Objectives of hedging (Strategy and Objectives)
3. What can you hedge
4. Qualifying Hedging Instruments
5. Designation as a Hedge
6. Criteria as a Hedge
7. Types of Hedge (FV, Cash flow, Foreign ops)
8. Hedge Effectiveness Ratio
9. Time/Value of Options
10. Hedging Components
11. Credit Exposure
12. Where US GAAP diverges
Please pay careful attention to these section headings –
Designated with Green headings
9. PwC
Hedge accounting Timeline
June 2008:
FASB issues ED with
goal of simplification;
defers changes to joint
financial instruments
project
9
10. PwC
Hedge accounting Timeline
June 2008:
FASB issues ED with
goal of simplification;
defers changes to joint
financial instruments
project
May 2010:
FASB issues hedge
accounting
proposals as part of
financial
instruments project
10
11. PwC
Hedge accounting Timeline
June 2008:
FASB issues ED with
goal of simplification;
defers changes to joint
financial instruments
project
December 2010:
IASB issues ED on
general model;
comment period
ended March 2011
May 2010:
FASB issues hedge
accounting
proposals as part of
financial
instruments project
11
12. PwC
Hedge accounting Timeline
June 2008:
FASB issues ED with
goal of simplification;
defers changes to joint
financial instruments
project
December 2010:
IASB issues ED on
general model;
comment period
ended March 2011
May 2010:
FASB issues hedge
accounting
proposals as part of
financial
instruments project
February 2011:
FASB issues
discussion paper
seeking views on
IASB’s proposal;
comment period
ended April 2011
12
13. PwC
Hedge accounting Timeline
June 2008:
FASB issues ED with
goal of simplification;
defers changes to joint
financial instruments
project
December 2010:
IASB issues ED on
general model;
comment period
ended March 2011
May 2010:
FASB issues hedge
accounting
proposals as part of
financial
instruments project
February 2011:
FASB issues
discussion paper
seeking views on
IASB’s proposal;
comment period
ended April 2011
September 2012:
IASB issues review
draft of the general
hedging final
standard;
effective Jan, 2015
13
14. PwC
Hedge accounting Timeline
FASB timing to be
determined on
general hedging
and has nothing
pending on
macro hedging
June 2008:
FASB issues ED with
goal of simplification;
defers changes to joint
financial instruments
project
December 2010:
IASB issues ED on
general model;
comment period
ended March 2011
May 2010:
FASB issues hedge
accounting
proposals as part of
financial
instruments project
February 2011:
FASB issues
discussion paper
seeking views on
IASB’s proposal;
comment period
ended April 2011
September 2012:
IASB issues review
draft of the general
hedging final
standard;
effective Jan, 2015
14
15. Risk - General
Examples are discussed in session
But we will not be able to think up new scenarios
- Time contraints
- The complexity of the issues may result in wrong
decisions because it is easy to make mistakes in an
environment where judgment is difficult
In practice a checklist may simplify decisions
16. Risk - General
Examples are discussed in session
But we will not be able to think up new scenarios
- Time contraints
- The complexity of the issues may result in wrong
decisions because it is easy to make mistakes in an
environment where judgment is difficult
In practice a checklist may simplify decisions
Note: Hedge accounting only takes place when you use
FV accounting.
17. Business today
Most business activity involves risks and uncertainties, and
the role of today's financial manager is more complex than
ever, being faced with the necessity of elaborating effective
financial strategies in order to manage these risks and
uncertainties.
18. Business today
Most business activity involves risks and uncertainties, and
the role of today's financial manager is more complex than
ever, being faced with the necessity of elaborating effective
financial strategies in order to manage these risks and
uncertainties.
One way in which this can be done is to enter into transactions
that expose the entity to risk and uncertainty that fully or
partially offsets one or more of the entity’s other risks and
uncertainties, transactions known as ‘hedges’.
19. Hedging item
How many times have you heard:
“The unders and overs tend to cancel out so the net effect
is about zero”
20. Hedging item
How many times have you heard:
“The unders and overs tend to cancel out so the net effect
is about zero”
Note: The instrument acquired to offset risk or uncertainty
is known as ‘hedging instrument’ and the risk or
uncertainty hedged is known as ‘hedged item’
21. Hedging aims to minimize risks
Hedging is applied to minimize the risks to business transactions
and/or balance-sheet items
22. Hedging aims to minimize risks
Hedging is applied to minimize the risks to business transactions
and/or balance-sheet items
The desired effect of a hedging relationship is that the changes of
the hedging instrument and the hedged item compensate each
other
23. Hedging aims to minimize risks
Hedging is applied to minimize the risks to business transactions
and/or balance-sheet items.
The desired effect of a hedging relationship is that the changes of
the hedging instrument and the hedged item compensate each
other.
The intention of hedge accounting is to report the net effects of the
hedged item and the hedging instrument so that gains of one item
compensate the losses of the other item, in the same period of
time
24. Hedging aims to minimize risks
Hedging is applied to minimize the risks to business transactions
and/or balance-sheet items
The desired effect of a hedging relationship is that the changes of
the hedging instrument and the hedged item compensate each
other
The intention of hedge accounting is to report the net effects of the
hedged item and the hedging instrument so that gains of one item
compensate the losses of the other item, in the same period of
time
From a pure economic perspective, the entity would not face
a gain or loss at all, since the net performance of the hedged
pair/set would minimize the effect
25. Phase 3 Hedge accounting
IFRS 9 updates the guidance for hedge accounting
Intention:
26. Phase 3 Hedge accounting
IFRS 9 updates the guidance for hedge accounting
Intention:
1. to align the accounting treatment with risk management
activities
27. Phase 3 Hedge accounting
IFRS 9 updates the guidance for hedge accounting
Intention:
1. to align the accounting treatment with risk management
activities
2. enable entities to better reflect these activities in their
financial statements
28. Phase 3 Hedge accounting
IFRS 9 updates the guidance for hedge accounting
Intention:
1. to align the accounting treatment with risk management
activities
2. enable entities to better reflect these activities in their
financial statements
3. make it more feasible for non-financial entities to use
hedge accounting.
29. Phase 3 Hedge accounting
IFRS 9 updates the guidance for hedge accounting
Intention:
1. to align the accounting treatment with risk management
activities
2. enable entities to better reflect these activities in their
financial statements
3. make it more feasible for non-financial entities to use
hedge accounting.
4. permit more use of hedge accounting for components of
instruments and groups of contracts,
30. Phase 3 Hedge accounting
IFRS 9 updates the guidance for hedge accounting
Intention:
1. to align the accounting treatment with risk management
activities
2. enable entities to better reflect these activities in their
financial statements
3. make it more feasible for non-financial entities to use
hedge accounting.
5. ease the hedge effectiveness test.
4. permit more use of hedge accounting for components of
instruments and groups of contracts,
32. Hedging is talked about more
than it is explained
Portfolio protection is often just as important as portfolio
appreciation
33. Hedging is talked about more
than it is explained
Portfolio protection is often just as important as portfolio
appreciation
Hedging occurs almost everywhere, and we see it everyday.
E.G. house insurance hedges you against fires, break-ins or
other unforeseen disasters
34. Hedging is talked about more
than it is explained
Portfolio protection is often just as important as portfolio
appreciation
Hedging occurs almost everywhere, and we see it everyday.
E.G. house insurance hedges you against fires, break-ins or
other unforeseen disasters
Portfolio managers, individual investors and corporations
use hedging techniques to reduce their exposure to risks
35. Hedging is talked about more
than it is explained
Portfolio protection is often just as important as portfolio
appreciation
Hedging occurs almost everywhere, and we see it everyday.
E.G. house insurance hedges you against fires, break-ins or
other unforeseen disasters
Portfolio managers, individual investors and corporations
use hedging techniques to reduce their exposure to risks
Note: Hedging instruments and hedged items are reported
differently from normal accounting methods
The aim of hedge accounting is to match and net the
accounting effect of the hedged item and of the hedging
instrument
37. Why learn about Hedging
when you may never use it?
Because if you know nothing about it, your decision
has already been made
38. Why learn about Hedging
when you may never use it?
Because if you know nothing about it, your decision
has already been made
Risk is an essential element of investing –
understand it and deal with it
40. The life of a Bookie
In Bookie terms ‘not hedging’ is termed ‘taking a
position’ – this is what the punter does, not the bookie.
41. The life of a Bookie
In Bookie terms ‘not hedging’ is termed ‘taking a
position’ – this is what the punter does, not the bookie.
A Bookie tries to balances his betting book
- so that the bets pay off each other and
- he cannot lose by way of the bets
- he earns Vigorish.
42. The life of a Bookie
Example:
Receive bets of $15,000 on A
Receive bets of only $5,000 on B
His vigorish is 15%.
So he lays off $10,000 on A so he has
Bets of $15,000 – 10,000 = 5,000 on A
Bets of $5,000 on B
43. The life of a Bookie
Example:
Receive bets of $15,000 on A
Receive bets of only $5,000 on B
His vigorish is 15%.
So he lays off $10,000 on A so he has
Bets of $15,000 – 10,000 = 5,000 on A
Bets of $5,000 on B
No matter who wins he earns $750 vigorish.
44. The life of a Bookie
Example:
Receive bets of $15,000 on A
Receive bets of $5,000 on B
His vigorish is 15%.
So he lays off $10,000 on A so he has
Bets of $15,000 – 10,000 = 5,000 on A
Bets of $5,000 on B
No matter who wins he earns $750 vigorish.
This is NOT the end of the concept as you saw when we
discussed exchanges
45. Life Assurance =
A BET that you will die before you expect
Example:
Probability of death = 100%
Time/value of money = EMV
Insurance Co ≡ a bookie
Timing of premiums
Timing of death
Can’t lose
46. Life Assurance =
A BET that you will die before you expect
Example:
Probability of death = 100%
Time/value of money = EMV
Insurance Co » a bookie
Timing of premiums
Timing of death
Can’t lose
NB: under normal business practices
47. Insurance ≡ a ‘BET’ that covers a risk
Examples:
Mortgage insurance
Unemployment
Health insurance
Car insurance
Liability insurance
Key-man policy/insurance
Fire insurance
Theft insurance
49. Hedging vs Insurance
Hedging is offsetting a bet with an opposing bet
both are a BET that covers a risk
Insurance is offsetting a bet with an fee (premium)
50. Hedging ≠ Insurance =
Hedging is offsetting a bet with an opposing bet
A BET that covers a risk
51. Hedging ≠ Insurance =
Hedging is offsetting a bet with an opposing bet
Example Strategic Business Hedge:
General Motors buys a Brewery
A BET that covers a risk
52. Hedging ≠ Insurance =
Hedging is offsetting a bet with an opposing bet
Example Strategic Business Hedge:
Example Strategic Investor Hedge:
General Motors buys a Brewery
Invest in GM but Hedge with ‘Miller’ brewery shares
A BET that covers a risk
54. Risk avoidance
Downside = cost
Every hedge has a cost,
so before you decide to use hedging, you must ask
if the benefits received from it justify the expense.
55. Risk avoidance
Downside = cost
Every hedge has a cost,
so before you decide to use hedging, you must ask
if the benefits received from it justify the expense.
Remember, the goal of hedging isn't to make money
but to protect from losses.
The cost of the hedge - whether it is the cost of an
option or lost profits from being on the wrong side of a
futures contract - cannot be avoided.
57. 1. Risk Management
Initially both the FASB and the IASB wanted to
eliminate the need for hedge accounting or, at
least, simplify it.
Hedging is a risk management activity
58. 1. Risk Management
Initially both the FASB and the IASB wanted to
eliminate the need for hedge accounting or, at
least, simplify it.
That has not happened!
Hedging is a risk management activity
59. 1. Risk Management
Initially both the FASB and the IASB wanted to
eliminate the need for hedge accounting or, at
least, simplify it.
That has not happened!
You would not be wrong to say that IFRS 9 seeks to
represent the effect of management’s strategies in
the financial statements
Hedging is a risk management activity
60. 1. Risk Management
Initially both the FASB and the IASB wanted to
eliminate the need for hedge accounting or, at
least, simplify it.
That has not happened!
You would not be wrong to say that IFRS 9 seeks to
represent the effect of management’s strategies in
the financial statements
Remember that hedge accounting is voluntary and
only allowed if the requirements are followed
Hedging is a risk management activity
61. Hedge accounting
Comparing the board’s proposals
• Objective is simplification;
targeted changes
proposed
• Easier to qualify for hedge
accounting (reasonably
effective)
• Less onerous hedge
effectiveness assessment
requirements
• Removal of shortcut and
critical terms match
methods
• Cannot elect to “stop”
hedge accounting
FASB 2010 proposal
Cliff Beacham (c) 2015
62. Hedge accounting
Comparing the board’s proposals
• Objective is simplification;
targeted changes
proposed
• Easier to qualify for hedge
accounting (reasonably
effective)
• Less onerous hedge
effectiveness assessment
requirements
• Removal of shortcut and
critical terms match
methods
• Cannot elect to “stop”
hedge accounting
• Objective is simplification
and linkage to risk
management activities
• Proposals are broader and
in some cases more
flexible than the FASB’s
• Concept of effectiveness,
as well as what can be
hedged, is different from
FASB’s proposal
• Cannot elect to “stop”
hedge accounting
• Requires new disclosures
FASB 2010 proposal IASB revised draft
Cliff Beacham (c) 2015
63. Hedge accounting
Comparing the board’s proposals
• Objective is simplification;
targeted changes
proposed
• Easier to qualify for hedge
accounting (reasonably
effective)
• Less onerous hedge
effectiveness assessment
requirements
• Removal of shortcut and
critical terms match
methods
• Cannot elect to “stop”
hedge accounting
• Sought views on
understandability and
auditablity of the IASB
proposals
• Asks whether FASB should
aim for convergence, or
targeted improvements to
US GAAP for hedge
accounting
• Objective is simplification
and linkage to risk
management activities
• Proposals are broader and
in some cases more
flexible than the FASB’s
• Concept of effectiveness,
as well as what can be
hedged, is different from
FASB’s proposal
• Cannot elect to “stop”
hedge accounting
• Requires new disclosures
FASB 2010 proposal IASB revised draft FASB Discussion paper
Cliff Beacham (c) 2015
64. 2. Objectives – Strategy & Objectives
IFRS 9 distinguishes between
a Risk Management Strategy and
a Risk Management Objective
64
65. 2. Objectives – Strategy & Objectives
IFRS 9 distinguishes between
a Risk Management Strategy and
a Risk Management Objective
Strategy:
- identifies the Risks addressed
- how those risks will be dealt with
66. 2. Objectives – Strategy & Objectives
IFRS 9 distinguishes between
a Risk Management Strategy and
a Risk Management Objective
Strategy:
- identifies the Risks addressed
- how those risks will be dealt with
Example:
Strategy identifies the Risks of changing interest rates
Those risks will be dealt with by maintaining a fixed to
floating ratio for those loans
67. Risk Management Strategy
A Risk-management Strategy is established at the highest level of
management
IFRS9.B6.5.24
It typically identifies:
• To what risks the entity is exposed
• How the entity will deal with these risks
This strategy will typically last for some time (but deviations can
be tolerated)
68. Risk Management Objectives
A Risk-management Strategy is set at the individual hedging
relationship
IFRS9.B6.5.24
It typically identifies:
• The hedging relationship
• How it will be addressed
This Risk Strategy would be applied to many Risk objectives
70. Examples Strategy and Risk Objectives
Maintain 40% debt at
floating interest rate
IFRS9.B6.5.24
Designate an interest rate
swap as a FV hedge of
£100m fixed rate liability
Risk Strategy Risk Objectives
71. Examples Strategy and Risk Objectives
Maintain 40% debt at
floating interest rate
IFRS9.B6.5.24
Hedge Foreign currency risk
up to 70% of forecast sales
in USD up to 12mths
Designate a foreign
exchange forward contract
to hedge against $120m in
sales in 2015
Designate an interest rate
swap as a FV hedge of
£100m fixed rate liability
Risk Strategy Risk Objectives
72. Hedging against Risk
Example:
Purchase 1000b oil for $50 at 180 days ahead.
Price is expected to decease to $40 in 180 days.
If it does we would make loss = 1000b at $10 = $10,000.
The loss can be a premium of a forward purchase contract
73. Hedging against Risk
Example:
Purchase 1000b oil for $50 at 180 days ahead.
Price is expected to decease to $40 in 180 days.
If it does we would make loss = 1000b at $10 = $10,000.
If the probability of this price fluctuation is 50% the we
have EMV (Expected Monetary Value) of $5,000 and we
would be prepared to pay up to $5,000 to ensure this does
not happen.
The loss can be a premium of a forward purchase contract
74. Hedging against Risk
Example:
Purchase 1000b oil for $50 at 180 days ahead.
Price is expected to decease to $40 in 180 days.
If it does we would make loss = 1000b at $10 = $10,000.
If the probability of this price fluctuation is 50% the we
have EMV of $5,000 and we would be prepared to pay up
to $5,000 to ensure this does not happen.
Of course, it is not a switch so the price will not go to $40
but something other than that.
The loss can be a premium of a forward purchase contract
75. Hedging against Risk (cont)
Consider these probabilities:
We may have 90% > $50 say $60
50% = $50
10% < $50 say $40
The loss can be a premium of a forward purchase contract
76. Hedging against Risk (cont)
Consider these probabilities:
We may have 90% > $50 say $60
50% = $50
10% < $50 say $40
The loss can be a premium of a forward purchase contract
We do not care what happens to the price now because we
have a contract that will ensure we pay $50.
If the premium (or cost of the Price Guarantee) = $1,000 we
take that hit into our costs.
77. Hedging against Risk (cont)
Consider these probabilities:
We may have 90% > $50 say $60
50% = $50
10% < $50 say $40
The loss can be a premium of a forward purchase contract
We do not care what happens to the price now because we
have a contract that will ensure we pay $50.
If the premium (or cost of the Price Guarantee) = $1,000 we
take that hit into our costs.
So we have an uncertain loss/gain converted to a sure $1,000
loss instead of the result of fluctuations in the oil price.
80. Hedging examples:
Laying off bets
Option to purchase a house (5yr lease with option to buy)
Presuming a broad definition of ‘HEDGING’
81. Hedging examples:
Laying off bets
Option to purchase a house (5yr lease with option to buy)
Forward contract
Presuming a broad definition of ‘HEDGING’
82. Hedging examples:
Laying off bets
Option to purchase a house (5yr lease with option to buy)
Forward contract
Buy Gold as a hedge against inflation
Presuming a broad definition of ‘HEDGING’
83. Hedging examples:
Laying off bets
Option to purchase a house (5yr lease with option to buy)
Forward contract
Buy Gold as a hedge against inflation
Buy property as hedge against inflation risk (but see also gearing
effect which lowers investment amount)
Presuming a broad definition of ‘HEDGING’
84. Hedging examples:
Laying off bets
Option to purchase a house (5yr lease with option to buy)
Forward contract
Buy Gold as a hedge against inflation
Buy property as hedge against inflation risk (but see also gearing
effect which lowers investment amount)
So we have been doing it for years – almost all investments
designed to result in a CONTRA effect are hedges if done
deliberately
Presuming a broad definition of ‘HEDGING’
87. Hedging is:
A speculation/bet/gamble
Additional thought:
How many times have you heard “Investor” when they
mean Speculator or Gambler.
Sales people and others often use the wrong term
deliberately but as Accountants we should NEVER get
confused
88. Make a Profit maybe but
No Losses
IFRS 9
Paired
Underlying
Assets
Hedging
against a
risk to the
Asset
Effective?
89. Hedging example:
The CBC Inc has purchased a financial asset for $95,000 and also
a derivative and designates it as a hedge.
The value of the financial asset gains $7,000
While the hedge loses $6,000
CBC recognizes a gain of $1,000 in PoL (Profit or Loss)
Note: Hedges are often ‘geared’ by hedging that yields a
multiplied result
EG: An option
90. How Do Investors Hedge?
Hedging techniques generally involve the use of
complicated financial instruments known as derivatives,
the two of the most common are options and futures.
91. How Do Investors Hedge?
Hedging techniques generally involve the use of
complicated financial instruments known as derivatives,
the two of the most common are options and futures.
We're not going to get into how these instruments work,
- just keep in mind that with these instruments you can
develop trading strategies where a loss in one investment is
offset by a gain in a derivative.
92. Hedge Accounting
Risk management is considered a necessity from an economic
standpoint but it is a very complex and controversial topic
from an accounting and financial reporting perspective
93. Hedge Accounting
Risk management is considered a necessity from an economic
standpoint but it is a very complex and controversial topic
from an accounting and financial reporting perspective
But no matter the complexity, understanding how to use
risks management tools affects financial statements and
can make a significant impact on reported earnings.
94. Cliff’s Tequila Corporation
Say you own shares of Cliff's Tequila Corporation (Ticker: CTC).
Although you believe in this company for the long run, you are a
little worried about some short-term losses in the tequila
industry.
To protect yourself from a fall in CTC you can buy a put option (a
derivative) on the company, which gives you the right to sell CTC
at a specific price (strike price).
This strategy is known as a married put.
If your stock price tumbles below the strike price, these losses
will be offset by gains in the put option.
95. Cliff’s Tequila Corporation (2a)
The other classic hedging example involves a company that
depends on a certain commodity.
Let's say Cliff's Tequila Corporation is worried about the
volatility in the price of agave, the plant used to make tequila.
96. Cliff’s Tequila Corporation (2b)
The other classic hedging example involves a company that
depends on a certain commodity.
Let's say Cliff's Tequila Corporation is worried about the
volatility in the price of agave, the plant used to make tequila.
The company would be in deep trouble if the price of agave
were to skyrocket, which would severely eat into profit margins.
To protect (hedge) against the uncertainty of agave prices, CTC
can enter into a futures contract (or its less regulated cousin,
the forward contract), which allows the company to buy the
agave at a specific price at a set date in the future.
Now CTC can budget without worrying about the fluctuating
commodity.
97. Cliff’s Tequila Corporation (3a)
If the price of agave skyrockets above that price specified by
the futures contract, the hedge will have paid off because CTC
will save money by paying the lower price.
However, if the price goes down, CTC is still obligated to pay the
price in the contract and actually would have been better off
not hedging.
98. Cliff’s Tequila Corporation (3b)
If the price of agave skyrockets above that price specified by
the futures contract, the hedge will have paid off because CTC
will save money by paying the lower price.
However, if the price goes down, CTC is still obligated to pay the
price in the contract and actually would have been better off
not hedging.
Keep in mind that because there are so many different types of
options and futures contracts an investor can hedge against
nearly anything, whether a stock, commodity price, interest
rate and currency - investors can even hedge against the
weather.
99. 3. What can you hedge?
You can hedge a Financial Instrument Risk Component
which is separately identifiable and
the changes in the cash flows or FV of the item
attributable to the changes in that risk component
must be reliably measurable.
IFRS 9.B6.3.8
99
100. Hedged Item can include:
1. Asset or Liability on BS
IAS39.9
2. A firm commitment (not on BS)
3. Forecast transaction
4. Investment in foreign operation
101. Hedged Coffee purchase
Example: Coffee
IAS39.9
an entity may hedge a given quantity of highly probable coffee
purchases in 15 months’ time against price risk (based on US
dollars) using a 15-month futures contract for coffee
The highly probable coffee purchases and the futures contract
for coffee in combination can be viewed as a 15-month fixed-
amount US dollar foreign currency risk exposure for risk
management purposes (ie like any fixed-amount US dollar cash
outflow in 15 months’ time)
102. Risks as Categories
B6.3.10
Categorizing risks helps users to identify, understand and monitor an entities' potential risks.
The components of financial risk related to financial instruments are:
Market risk: the risk that the FV or future cash flows of a financial instrument
will fluctuate because of changes in market prices
103. Risks as Categories
B6.3.10
Categorizing risks helps users to identify, understand and monitor an entities' potential risks.
The components of financial risk related to financial instruments are:
Market risk: the risk that the FV or future cash flows of a financial instrument
will fluctuate because of changes in market prices;
the factors of market risk are the risk that FV or cash flows will be affected by:
104. Risks as Categories
B6.3.10
Categorizing risks helps users to identify, understand and monitor an entities' potential risks.
The components of financial risk related to financial instruments are:
Market risk: the risk that the FV or future cash flows of a financial instrument
will fluctuate because of changes in market prices;
the factors of market risk are the risk that FV or cash flows will be affected by:
- currency risk: changes in foreign exchange rates
105. Risks as Categories
B6.3.10
Categorizing risks helps users to identify, understand and monitor an entities' potential risks.
The components of financial risk related to financial instruments are:
Market risk: the risk that the FV or future cash flows of a financial instrument
will fluctuate because of changes in market prices;
the factors of market risk are the risk that FV or cash flows will be affected by:
- currency risk: changes in foreign exchange rates
- interest rate risk: changes in market interest rates
106. Risks as Categories
B6.3.10
Categorizing risks helps users to identify, understand and monitor an entities' potential risks.
The components of financial risk related to financial instruments are:
Market risk: the risk that the FV or future cash flows of a financial instrument
will fluctuate because of changes in market prices;
the factors of market risk are the risk that FV or cash flows will be affected by:
- currency risk: changes in foreign exchange rates;
- interest rate risk: changes in market interest rates;
- price risk: change as a result of market prices changes, caused by
- factors specific to the individual financial instrument or its issuer, or
- factors affecting all similar financial instruments traded in the market
107. Risks as Categories
B6.3.10
Categorizing risks helps users to identify, understand and monitor an entities' potential risks.
The components of financial risk related to financial instruments are:
Market risk: the risk that the FV or future cash flows of a financial instrument
will fluctuate because of changes in market prices;
the factors of market risk are the risk that FV or cash flows will be affected by:
- currency risk: changes in foreign exchange rates;
- interest rate risk: changes in market interest rates;
- price risk: change as a result of market prices changes, caused by
- factors specific to the individual financial instrument or its issuer, or
- factors affecting all similar financial instruments traded in the market
Credit risk: the risk that one party to a financial instrument will cause a
financial loss for the other party by failing to discharge an obligation
108. Risks as Categories
B6.3.10
Categorizing risks helps users to identify, understand and monitor an entities' potential risks.
The components of financial risk related to financial instruments are:
Market risk: the risk that the FV or future cash flows of a financial instrument
will fluctuate because of changes in market prices;
the factors of market risk are the risk that FV or cash flows will be affected by:
- currency risk: changes in foreign exchange rates;
- interest rate risk: changes in market interest rates;
- price risk: change as a result of market prices changes, caused by
- factors specific to the individual financial instrument or its issuer, or
- factors affecting all similar financial instruments traded in the market
Credit risk: the risk that one party to a financial instrument will cause a
financial loss for the other party by failing to discharge an obligation
Liquidity risk: the risk that an entity will encounter difficulty in meeting
obligations associated with financial liabilities or in selling quickly a
financial asset, at its fair value
109. Risk Components
B6.3.10
An entity considers whether the risk components are explicitly
contractually specified or
whether they are implicit in the fair value or the cash flows of an
item of which they are a part
110. Risk Components
B6.3.10
An entity considers whether the risk components are explicitly
contractually specified or
whether they are implicit in the fair value or the cash flows of an
item of which they are a part
Non-contractually specified risk components can relate to items
that are not a contract (for example, forecast transactions) or
contracts that do not explicitly specify the component
(EG: a firm commitment that includes only one single price instead of
a pricing formula that references different underlyings).
111. Hedging example:
Entity A has a long-term supply contract for natural gas that is
priced using a contractually specified formula that references
commodities and other factors (for example, gas oil, fuel oil and
other components such as transport charges).
112. Hedging example:
Entity A hedges the gas oil component in that supply contract
using a gas oil forward contract. Because the gas oil component is
specified by the terms and conditions of the supply contract it is a
contractually specified risk component.
Entity A has a long-term supply contract for natural gas that is
priced using a contractually specified formula that references
commodities and other factors (for example, gas oil, fuel oil and
other components such as transport charges).
113. Hedging example:
Entity A hedges the gas oil component in that supply contract
using a gas oil forward contract. Because the gas oil component is
specified by the terms and conditions of the supply contract it is a
contractually specified risk component.
Entity A has a long-term supply contract for natural gas that is
priced using a contractually specified formula that references
commodities and other factors (for example, gas oil, fuel oil and
other components such as transport charges).
Because of the pricing formula, Entity A concludes that the gas oil
price exposure is separately identifiable.
114. Hedging example:
Entity A hedges the gas oil component in that supply contract
using a gas oil forward contract. Because the gas oil component is
specified by the terms and conditions of the supply contract it is a
contractually specified risk component.
At the same time, there is a market for gas oil forward contracts.
Entity A concludes the gas oil price exposure is reliably measurable.
Entity A has a long-term supply contract for natural gas that is
priced using a contractually specified formula that references
commodities and other factors (for example, gas oil, fuel oil and
other components such as transport charges).
Because of the pricing formula, Entity A concludes that the gas oil
price exposure is separately identifiable.
115. Mismatched terms in a pair
Example:
IIFRS9.B6.3.3
Hedge the foreign currency risk for a 10yr fixed-rate debt
116. Mismatched terms in a pair
Example:
IIFRS9.B6.3.3
Hedge the foreign currency risk for a 10yr fixed-rate debt
The entity requires (in its functional currency)
1. fixed-rate exposure only for 2yrs and
2. floating rate exposure for the remaining term
At the end of each 2-year intervals (ie on a 2yr rolling basis) the entity
fixes the next 2 yrs’ interest rate exposure (if the interest level is
such that the entity wants to fix interest rates)
117. Mismatched terms in a pair
Example:
IIFRS9.B6.3.3
The entity could enter into a 10-year fixed-to-floating cross-currency
interest rate swap that swaps the fixed-rate foreign currency debt
into a variable-rate functional currency exposure
Hedge the foreign currency risk for a 10yr fixed-rate debt
The entity requires (in its functional currency)
1. fixed-rate exposure only for 2yrs and
2. floating rate exposure for the remaining term
At the end of each 2-year intervals (ie on a 2yr rolling basis) the entity
fixes the next 2 yrs’ interest rate exposure (if the interest level is
such that the entity wants to fix interest rates)
118. Mismatched terms in a pair
Example:
IIFRS9.B6.3.3
The entity could enter into a 10-year fixed-to-floating cross-currency
interest rate swap that swaps the fixed-rate foreign currency debt
into a variable-rate functional currency exposure
Hedge the foreign currency risk for a 10yr fixed-rate debt
The entity requires (in its functional currency)
1. fixed-rate exposure only for 2yrs and
2. floating rate exposure for the remaining term
At the end of each 2-year intervals (ie on a 2yr rolling basis) the entity
fixes the next 2 yrs’ interest rate exposure (if the interest level is
such that the entity wants to fix interest rates)
This is overlaid with a 2yr interest rate swap - variable-rate debt into
fixed-rate debt.
119. Mismatched terms in a pair
Example:
IIFRS9.B6.3.3
The entity could enter into a 10-year fixed-to-floating cross-currency
interest rate swap that swaps the fixed-rate foreign currency debt
into a variable-rate functional currency exposure
Hedge the foreign currency risk for a 10yr fixed-rate debt
The entity requires (in its functional currency)
1. fixed-rate exposure only for 2yrs and
2. floating rate exposure for the remaining term
At the end of each 2-year intervals (ie on a 2yr rolling basis) the entity
fixes the next 2 yrs’ interest rate exposure (if the interest level is
such that the entity wants to fix interest rates)
This is overlaid with a 2yr interest rate swap - variable-rate debt into
fixed-rate debt.
In effect, in combination, they are viewed as a 10-year variable-rate
debt functional currency exposure for risk management purposes.
120. Mismatched terms in a pair
Example:
Hedge the foreign currency risk for a 10yr fixed-rate debt
IIFRS9.B6.3.3
121. Mismatched terms in a pair
Example:
Hedge the foreign currency risk for a 10yr fixed-rate debt
IIFRS9.B6.3.3
In effect,
the fixed-rate foreign currency debt and
the 10-yr fixed-to-floating cross-currency interest rate swap
in combination
are viewed as a 10-yr variable-rate debt functional currency
exposure for risk management purposes.
122. Mismatched terms in a pair
Example:
Hedge the foreign currency risk for a 10yr fixed-rate debt
IIFRS9.B6.3.3
In effect,
the fixed-rate foreign currency debt and
the 10-yr fixed-to-floating cross-currency interest rate swap
in combination
are viewed as a 10-yr variable-rate debt functional currency
exposure for risk management purposes.
Note:
We are now accounting for our intentions
123. Mismatched terms in a pair
Hedge accounting modifies the traditional accounting treatment of
hedging instrument and/or hedged item - to enable gains and
losses on the hedging pair to be recognized in the income
statement. This is a matching exercise
IIFRS9.B6.3.3
124. Mismatched terms in a pair
Hedge accounting modifies the traditional accounting treatment of
hedging instrument and/or hedged item - to enable gains and
losses on the hedging pair to be recognized in the income
statement. This is a matching exercise
IIFRS9.B6.3.3
A pre-requisite for hedge accounting is that a hedging instrument,
normally a derivative, is designated as an offset to changes in the
fair value or cash flows of a hedged item
125. Mismatched terms in a pair
Hedge accounting modifies the traditional accounting treatment of
hedging instrument and/or hedged item - to enable gains and
losses on the hedging pair to be recognized in the income
statement. This is a matching exercise
IIFRS9.B6.3.3
Hedge accounting seeks to correct any mismatch by changing the
timing of recognition of gains and losses on either the hedged
item or the hedging instrument. This avoids much of the volatility
that would otherwise arise if the derivative gains and losses were
recognized in the income statement per normal accounting
A pre-requisite for hedge accounting is that a hedging instrument,
normally a derivative, is designated as an offset to changes in the
fair value or cash flows of a hedged item
126. 4. Qualifying Hedge Instruments
Hedge accounting only takes place when you use FV accounting
6.2.1 A derivative
(measured at FV_PoL)
may be designated as a hedging instrument
126
127. 4. Qualifying Hedge Instruments
Hedge accounting only takes place when you use FV accounting
6.2.1 A derivative
(measured at FV_PoL)
may be designated as a hedging instrument
6.2.2 A non-derivative financial asset or liability
(measured at FV_PoL)
may be designated as a hedging instrument
128. 4. Qualifying Hedge Instruments
Hedge accounting only takes place when you use FV accounting
6.2.1 A derivative
(measured at FV_PoL)
may be designated as a hedging instrument
6.2.2 A non-derivative financial asset or liability
(measured at FV_PoL)
may be designated as a hedging instrument
6.2.3 For hedge accounting purposes, only contracts with a
party external to the reporting entity can be designated as
a hedging instrument
129. Types of Hedge Instruments
Stocks
Funds (exchange traded)
Insurance
Forward contracts
Swaps
Options
Many types of Over-The-Counter (OTC) and Derivative products
Remember the session where we discussed the Chicago Exchange
130. Derivatives as Hedge Instruments
Because the value of a derivative is contingent on the value
of the underlying, the notional value of derivatives is
recorded off the balance sheet of an institution, although
their fair market value is recorded on the balance sheet
131. Derivatives as Hedge Instruments
Because the value of a derivative is contingent on the value
of the underlying, the notional value of derivatives is
recorded off the balance sheet of an institution, although
their fair market value is recorded on the balance sheet
Derivatives can be used to mitigate the risk of economic loss
arising from changes in the value of the underlying.
This activity is known as hedging.
132. Derivatives as Hedge Instruments
Because the value of a derivative is contingent on the value
of the underlying, the notional value of derivatives is
recorded off the balance sheet of an institution, although
their fair market value is recorded on the balance sheet
Derivatives can be used to mitigate the risk of economic loss
arising from changes in the value of the underlying.
This activity is known as hedging.
Alternatively, derivatives can be used by investors to increase
their profits - bearing extra risk by speculations
(if the value of the underlying moves in the direction they expect)
133. 5. Designation as a Hedge
6.2.4 A qualifying instrument must be designated in its
entirety as a hedging instrument.
133
134. Designation requirements
a) formal designation
IAS39.88
b) Expected to be highly effective
c) Highly probable forecast
d) Highly probable effectiveness
e) Assessed as effective - ongoing
135. How to Account for Hedging
Define Risk Management Strategy
Identify eligible hedged instruments
Identify eligible hedging instruments
Designation +
Documentation
Ask – does effect of credit risk dominate the FV changes
Ask – is there an economic relationship
NO
NO
IFRS 9.6.4.1
Ask - Effective Hedge Ratio
NO
136. Balance your portfolio risk
Mutual funds - the fund manager might balance a
portfolio
- But it can be biased/dedicated towards a theme
EG Real Estate
137. How do I create
a Hedging Relationship?
1. Documentation
• formal,
• stated objective and strategy at start,
• how measured
2. Cash flow probability
3. Measurable reliably
4. Effective offset 80%-120%
138. Designation
– Whole or Part H/Inst to Diff Risks
B6.2.5 For hedges other than hedges of foreign currency
risk, when an entity designates a non-derivative financial
asset/liability measured FV_PoL as a hedging instrument,
it may designate it in its entirety or a proportion of it.
IFRS9.6.2.6
139. Designation
– Whole or Part H/Inst to Diff Risks
B6.2.5 For hedges other than hedges of foreign currency
risk, when an entity designates a non-derivative financial
asset/liability measured FV_PoL as a hedging instrument,
it may designate it in its entirety or a proportion of it.
IFRS9.6.2.6
B6.2.6 A single hedging instrument may be designated as a
hedging instrument of more than one type of risk,
provided there is a specific designation of:
- the hedging instrument and of
- the different risk positions as hedged items.
Those hedged items can be in different hedging relationships.
142. 6. Criteria for Hedge accounting
(a) the hedging relationship consists only of eligible
hedging instruments and eligible hedged items.
IFRS9.6.4.1
142
143. 6. Criteria for Hedge accounting
(a) the hedging relationship consists only of eligible
hedging instruments and eligible hedged items.
IFRS9.6.4.1
(b) at inception of the hedging relationship there is formal
designation and documentation of the entity’s:
- risk management objective and
- strategy for undertaking the hedge.
144. 6. Criteria for Hedge accounting
(a) the hedging relationship consists only of eligible
hedging instruments and eligible hedged items.
IFRS9.6.4.1
(c) the hedging relationship meets all of the following:
(b) at inception of the hedging relationship there is formal
designation and documentation of the entity’s:
- risk management objective and
- strategy for undertaking the hedge.
145. 6. Criteria for Hedge accounting
(a) the hedging relationship consists only of eligible
hedging instruments and eligible hedged items.
IFRS9.6.4.1
(c) the hedging relationship meets all of the following:
(b) at inception of the hedging relationship there is formal
designation and documentation of the entity’s:
- risk management objective and
- strategy for undertaking the hedge.
(i) there is an economic relationship between
- the hedged item and
- the hedging instrument
146. 6. Criteria for Hedge accounting
(a) the hedging relationship consists only of eligible
hedging instruments and eligible hedged items.
IFRS9.6.4.1
(c) the hedging relationship meets all of the following:
(ii) the effect of credit risk does not dominate the value
(b) at inception of the hedging relationship there is formal
designation and documentation of the entity’s:
- risk management objective and
- strategy for undertaking the hedge.
(i) there is an economic relationship between
- the hedged item and
- the hedging instrument
147. 6. Criteria for Hedge accounting
(a) the hedging relationship consists only of eligible
hedging instruments and eligible hedged items.
IFRS9.6.4.1
(c) the hedging relationship meets all of the following:
(ii) the effect of credit risk does not dominate the value
(b) at inception of the hedging relationship there is formal
designation and documentation of the entity’s:
- risk management objective and
- strategy for undertaking the hedge.
(i) there is an economic relationship between
- the hedged item and
- the hedging instrument
(iii) the hedge ratio is the same as that resulting from
- the quantity of the hedged item and
- the quantity of the hedging instrument used
148. 3.
Net Accounting
Hedge accounting works in two ways:
IFRS9.6.5.2(b)
1. it either defers the recognition of losses or
2. it brings forward the recognition of gains in the profit and
loss statement.
149. How do I do the Accounting
1. Hedge accounting Project Manager
IFRS9.6.5.2(b)
2. Establish a Relational Database Sub-ledger
3. Hedging Control accounts in GL
4. Training
6. Implementation
5. SOP and Internal Controls
150. 7. Types of Hedge Relationships
1. Fair Value Hedge
3. Net Investment in Foreign Operation
2. Cash Flow Hedge
150
151. 7.1 Fair value hedge
Protection against Loss from defined risks effecting value.
Primary Asset 7,000
Loss 7,000
Gain 6,000
Hedged asset 6,000
The Hedged pair must be split and the Hedge accounting terminated
if the qualifying criteria are no longer met (incl undesignation)
Hedged Item
Hedging Item
152. 7.1 Fair value hedges
A fair value hedge is a hedge of the exposure to changes in
the fair value of a recognised asset or liability or an
unrecognised firm commitment, or an identified portion of
such an asset, liability or firm commitment, that is
attributable to a particular risk and could affect profit or loss
IFRS9.6.5.2(b)
153. 7.1 Fair value hedges
Example – Fair Value Hedge:
During year 1, Entity A purchases a debt security for €300
and classifies it as available-for-sale. Gains and losses arising
on it are therefore taken to equity according to IAS 39.
At the end of year 1, the current fair value of the security is
€320. To protect this value, the entity enters into a hedge in
year 2 by purchasing a derivative.
At the end of year 2 the fair value of the debt security is
€310. The journal entries are presented below:
IFRS9.6.5.2(b)
154. 7.2 Cash flow hedge
A hedge of the exposure to variability in cash flows
that is attributable to a particular risk
associated with all, or a component of
- a recognised asset or liability or
- a highly probable forecast transaction, and
could affect profit or loss
For a CF hedge:
the amount of fluctuation in PV is recognized in OCI,
however, you may transfer this to PoL
when you judge it to be permanent
IFRS9.6.5.2(b)
155. Equity PoL
The separate component of equity associated with the
hedged item is adjusted to the lesser of the following (in
absolute amounts):
(i) the cumulative gain or loss on the hedging instrument
from inception of the hedge; and
(ii) the cumulative change in fair value (the present value) of
the expected future cash flows on the hedged item from
the inception of the hedge. Any remaining gain or loss on
the hedging instrument is recognized in profit or loss.
IFRS9.6.5.2(b)
156. Example: Equity PoL
Example – Cash Flow Hedge:
Entity A is a producer which expects to sell on December 31,
20X8, 1,000 pieces of its products.
To hedge the risk of price decline, on January 1, 20X7, it enters
into a net-settled forward contract on 1,000 pcs for delivery on
December 31, 20X8.
Suppose that in 20X7 the forward contract fair value decreased
by €10,000 and during 20X8, increased by €6,000.
On December 31, 20X8, Entity A sells 1,000 pcs. for €50,000
and settles the forward contract by paying €4,000.
Assuming that all conditions for hedge accounting are met, the
journal entries are as follows:
IFRS9.6.5.2(b)
157. Example: Equity PoL
Year 20X7
1. Jan01: No entry required for the forward contract.
IFRS9.6.5.2(b)
Example – Cash Flow Hedge:
158. Example: Equity PoL
Year 20X7
1. Jan01: No entry required for the forward contract.
2. Dec31: Recording the decreasing in FV of the contract:
Dr Equity 10,000
Cr Derivative liability 10,000
IFRS9.6.5.2(b)
Example – Cash Flow Hedge:
159. Example: Equity PoL
Year 20X7
1. Jan01: No entry required for the forward contract.
2. Dec31: Recording the decreasing in FV of the contract:
Dr Equity 10,000
Cr Derivative liability 10,000
Year 20X8
3. Dec31: Recording the inc in FV of the forward contract:
Dr Derivative liability 6,000
Cr Equity 6,000
IFRS9.6.5.2(b)
Example – Cash Flow Hedge:
160. Example: Equity PoL
Year 20X7
1. Jan01: No entry required for the forward contract.
2. Dec31: Recording the decreasing in FV of the contract:
Dr Equity 10,000
Cr Derivative liability 10,000
Year 20X8
3. Dec31: Recording the inc in FV of the forward contract:
Dr Derivative liability 6,000
Cr Equity 6,000
4. Dec31: Forward contract settlement:
Dr Derivative liability 4,000
Cr Cash 4,000
IFRS9.6.5.2(b)
Example – Cash Flow Hedge:
161. Example: Equity PoL
Year 20X7
1. Jan01: No entry required for the forward contract.
2. Dec31: Recording the decreasing in FV of the contract:
Dr Equity 10,000
Cr Derivative liability 10,000
Year 20X8
3. Dec31: Recording the inc in FV of the forward contract:
Dr Derivative liability 6,000
Cr Equity 6,000
4. Dec31: Forward contract settlement:
Dr Derivative liability 4,000
Cr Cash 4,000
5. Dec31: Sale and associated amt deferred in equity related to hedge of the sale:
Dr Cash 50,000
Cr Equity 4,000
Cr Sales revenue 46,000
IFRS9.6.5.2(b)
Example – Cash Flow Hedge:
162. 7.3 Net Investment in Foreign Operation
Accounting rules:
Gain or loss on hedging instrument:
(1) effective portion is recognized in equity;
(2) ineffective portion is recognized in profit or loss.
The foreign currency gains or losses on the hedging
instrument are deferred in equity, to the extent the hedge is
effective, until the subsidiary is disposed of or liquidated.
IFRS9.6.5.2(b)
163. 7.3 Net Investment in Foreign Operation
Accounting rules:
Gain or loss on hedging instrument:
(1) effective portion is recognized in equity;
(2) ineffective portion is recognized in profit or loss.
The foreign currency gains or losses on the hedging
instrument are deferred in equity, to the extent the hedge is
effective, until the subsidiary is disposed of or liquidated.
When the foreign operation is disposed of gain or loss
recognized in equity is reclassified to profit or loss as a
reclassification adjustment. Net investment exchange
differences are recognized in equity, until the net investment
is sold or liquidated.
IFRS9.6.5.2(b)
164. Example: 7.3a
Investment in Foreign Operation (Net)
CBC Inc invests in a Brazilian oil refinery.
A loan of R20m is hedged by a forward contract
The cost is offset against or added to the fluctuation in currency
exchange (USD-BrazilianReal)
Thus the hedge is the purchase in € not £
165. Example: 7.3b
Foreign Investment Hedge
UK Co A invests by buying CoB in France for €300 when £1 = €1.5
Therefore Co A has Asset of £200
Exchange rate moves to £1 = €1.75
Co A now has asset of £172m _a loss of £28m
If Co A had purchased a Financial Instrument of €300 at the
time of purchase
Liability was £200 but is now £172m – gain of £28m
These net +28m – 28m = 0
167. Hedge effectiveness testing (1)
Effectiveness tests should be both prospective and retrospective
To be classified as effective, the hedge does not have to be perfect.
168. Hedge effectiveness testing (1)
Effectiveness tests should be both prospective and retrospective
To be classified as effective, the hedge does not have to be perfect.
The constraint is rather that the hedge is expected to be:
(i) highly effective at inception
(ii) effective in practice throughout the life of the hedging relationship
169. Hedge effectiveness testing (1)
Effectiveness tests should be both prospective and retrospective
To be classified as effective, the hedge does not have to be perfect.
The constraint is rather that the hedge is expected to be:
(i) highly effective at inception
(ii) effective in practice throughout the life of the hedging relationship
i.e. the ratio of the change in FV of the hedged item and the hedging
item under IAS 39 was a range of 80% to 125%. IFRS 9 has substituted
judgement (EG: a policy of 75% is now acceptable)
170. Hedge effectiveness testing (1)
Effectiveness tests should be both prospective and retrospective
To be classified as effective, the hedge does not have to be perfect.
The constraint is rather that the hedge is expected to be:
(i) highly effective at inception
(ii) effective in practice throughout the life of the hedging relationship
i.e. the ratio of the change in FV of the hedged item and the hedging
item under IAS 39 was a range of 80% to 125%. IFRS 9 has substituted
judgement (EG: a policy of 75% is now acceptable)
If during its life the hedging relationship fails to remain within the
effective pre-set range:
1. the derivative will be accounted for at its mark-to-market
2. the primary assets or liabilities at historical cost.
171. Hedge effectiveness testing (2)
1. Critical terms comparison:
This method is prospective and is the simplest method because
it does not require any calculations and may be used only in
limited cases, demonstrate that a hedge is expected to be highly
effective (prospective effectiveness testing)
consists of comparing the critical terms of the hedging
instrument with those of the hedged item
The hedge relationship is expected to be highly effective
where all the principal terms of the hedging instrument and
the hedged item match exactly and there are no features that
would invalidate an assumption of perfect effectiveness
A separate assessment is required for a retrospective effectiveness
test, as ineffectiveness may arise even when critical terms match
172. Hedge effectiveness testing (3)
is a quantitative method that compares:
1. the change in FV or cash flows of the hedging instrument 2.
with the change in FV or cash flows of the hedged item attributable
to the hedged risk.
2. Dollar offset method
This test can be performed either on a cumulative basis, or on a
period-by-period basis
A hedge is highly effective if the results are within the range of
80%-125%.
When using the method for retrospective effectiveness tests,
it has the advantage of determining the amount of ineffectiveness
required for the accounting treatment.
173. Hedge effectiveness testing (4)
Example – Testing Hedge Effectiveness: Dollar offset Method
An entity has inventory valued at €100,000 as a hedged item;
the hedge is a short position in a futures contract.
174. Hedge effectiveness testing (4)
Example – Testing Hedge Effectiveness: Dollar offset Method
At the end of the quarter, inventory value increased by 1% (€1,000)
An entity has inventory valued at €100,000 as a hedged item;
the hedge is a short position in a futures contract.
the value of short futures position will decrease by €1,000
175. Hedge effectiveness testing (4)
Example – Testing Hedge Effectiveness: Dollar offset Method
At the end of the quarter, inventory value increased by 1% (€1,000)
An entity has inventory valued at €100,000 as a hedged item;
the hedge is a short position in a futures contract.
the value of short futures position will decrease by €1,000
offsetting the change in the value of the underlying asset
(inventory)
plus or minus the change in the futures’ basis
176. Hedge effectiveness testing (4)
Example – Testing Hedge Effectiveness: Dollar offset Method
EG: If a change in the basis is as little as 0.33% of the notional
value, the dollar-offset method could imply that the hedge is
ineffective because the short futures’ value change is ±33% of the
inventory’s value change
At the end of the quarter, inventory value increased by 1% (€1,000)
An entity has inventory valued at €100,000 as a hedged item;
the hedge is a short position in a futures contract.
the value of short futures position will decrease by €1,000
offsetting the change in the value of the underlying asset
(inventory)
plus or minus the change in the futures’ basis
177. Hedge effectiveness testing (5)
3. Regression analysis
Investigates the strength of the statistical relationship
between the hedged item and the hedging instrument.
It involves determining a ‘line of best fit’ and then assessing
the ‘goodness of fit’ of this line.
178. Hedge effectiveness testing (5)
3. Regression analysis
Investigates the strength of the statistical relationship
between the hedged item and the hedging instrument.
It involves determining a ‘line of best fit’ and then assessing
the ‘goodness of fit’ of this line.
In the context of assessing hedge effectiveness, it establishes
whether changes in the hedged item and hedging instrument
are highly correlated.
179. Hedge effectiveness testing (5)
3. Regression analysis
Investigates the strength of the statistical relationship
between the hedged item and the hedging instrument.
It involves determining a ‘line of best fit’ and then assessing
the ‘goodness of fit’ of this line.
In the context of assessing hedge effectiveness, it establishes
whether changes in the hedged item and hedging instrument
are highly correlated.
The independent variable reflects the change of the hedged
item value, and the dependent variable reflects the change of
the hedging instrument value.
180. Hedge documentation
Complete hedge documentation involves the following:
this extensive documentation is necessary to comply with the
requirements of IFRS 7 “Financial Instruments: Disclosures”.
(1) Description of risk management objective and strategy
(2) Type of hedging relationship (FV or cash flow hedge)
(3) Nature of the risk being hedged (commodity)
This standard requires disclosure of certain management information
to allow shareholders to view financial instruments and risk
management activities ‘through the eyes of management’.
Thus, reporting entities have to disclose the sensitivity of their results
to movements in market risks as a consequence of their financial
instruments.
181. Hedge summary
Phase I
Designation Formal documentation Risk management strategy
Type Risk and of Hedge
Pairing Hedged Item & Hedging Instrument
Plan for Effectiveness testing
Prospective testing at inception
Hedge Accounting entries
Phase II
Maintenance Verification of Effectiveness
Hedge Accounting entries
Retrospecitive & Prospective testing at each reporting date
Phase III
Termination Specify cause No longer qualifies, not effective
Expiration of Hedged Item or Hedging Instrt
Forecast transaction no longer expected
Management decision
Hedge Accounting entries
182. Hedge summary
Phase I
Designation Formal documentation Risk management strategy
Type Risk and of Hedge
Pairing Hedged Item & Hedging Instrument
Plan for Effectiveness testing
Prospective testing at inception
Hedge Accounting entries
Phase II
Maintenance Verification of Effectiveness
Hedge Accounting entries
Retrospecitive & Prospective testing at each reporting date
Phase III
Termination Specify cause No longer qualifies, not effective
Expiration of Hedged Item or Hedging Instrt
Forecast transaction no longer expected
Management decision
Hedge Accounting entries
183. Hedge summary
Phase I
Designation Formal documentation Risk management strategy
Type Risk and of Hedge
Pairing Hedged Item & Hedging Instrument
Plan for Effectiveness testing
Prospective testing at inception
Hedge Accounting entries
Phase II
Maintenance Verification of Effectiveness
Hedge Accounting entries
Retrospecitive & Prospective testing at each reporting date
Phase III
Termination Specify cause No longer qualifies, not effective
Expiration of Hedged Item or Hedging Instrt
Forecast transaction no longer expected
Management decision
Hedge Accounting entries
185. Hedge effectiveness
Stocks
There is no required method of measuring
– it can be Period based or Cumulative
but it should be consistently applied
Cummulative basis (Life to date) (Curr Period)
Hedge Hedge Hedge
PeriodInstrument Item Ratio (%) Item Ratio (%)
Qtr 1 52 50 100% 50 100%
Qtr 2 75 72 98% 72 96%
Qtr 3 87 85 108% 85 181%
Qtr 4 121 120 99% 120 350%
186. 9. Time/Value of Options
6.5.15
Time/Value of money is the difference between the
Maturity value and the PV
186
187. 9. Time/Value of Options
6.5.15
In or out of the money means whether it makes sense or not
Time/Value of money is the difference between the
Maturity value and the PV
188. 9. Time/Value of Options
6.5.15
In or out of the money means whether it makes sense or not
Time/Value of money is the difference between the
Maturity value and the PV
Time/Value is the premium a rational investor would pay in excess
of the intrinsic value (current exercise price) because they think the
price will rise.
189. 9. Time/Value of Options
6.5.15
In or out of the money means whether it makes sense or not
Example: Price = $1.00 – I will pay you 10c for an option to
purchase these shares because I think the price will go up to $1.20
Time/Value of money is the difference between the
Maturity value and the PV
Time/Value is the premium a rational investor would pay in excess
of the intrinsic value (current exercise price) because they think the
price will rise.
190. 9. Time/Value of Options
6.5.15
In or out of the money means whether it makes sense or not
Example: Price = $1.00 – I will pay you 10c for an option to
purchase these shares because I think the price will go up to $1.20
Time/Value of money is the difference between the
Maturity value and the PV
Time/Value is the premium a rational investor would pay in excess
of the intrinsic value (current exercise price) because they think the
price will rise.
American option: Always > 0
European option can be < 0
Can be thought of as a Risk Premium
192. Time/Value of Option
6.5.15
When an entity separates the time/value and the intrinsic value and
then designates as the hedging instrument
only the change in intrinsic value of the option
it shall account for the time value of the option as follows:
193. Time/Value of Option
6.5.15
a) an entity shall distinguish the time value of options by
the type of hedged item that the option hedges
(i) a transaction related hedged item; or
(ii) a time-period related hedged item
When an entity separates the time/value and the intrinsic value and
then designates as the hedging instrument
only the change in intrinsic value of the option
it shall account for the time value of the option as follows:
194. Time/Value of Option
6.5.15
a) an entity shall distinguish the time value of options by
the type of hedged item that the option hedges
(i) a transaction related hedged item; or
(ii) a time-period related hedged item
(b) the change in FV shall be recognized in OCI
to the extent that it relates to the hedged item and
shall be accumulated in a separate component of equity
When an entity separates the time/value and the intrinsic value and
then designates as the hedging instrument
only the change in intrinsic value of the option
it shall account for the time value of the option as follows:
195. Time/Value of Option
IFRS9.6.5.15
The cumulative change in fair value arising from the time value of
the option that has been accumulated in a separate component of
equity (the ‘amount’) shall be accounted for as follows:
(b) (i) Non-fin >> to add to cost [carrying amount]
(ii) unless not justified (then W/O PoL)
(c)(i) Fin >> amortize (add) to OCI
(ii) If discontinued hedge >> PoL
196. 10. Hedging Components
Probably biggest change from IAS39 -
Can designate what risk is hedged
Either contractually specified
Or implicit in FV or Cash flows of the Instrument
(hedged item)
196
197. Hedging Components
Probably biggest change from IAS39 -
Can designate what risk is hedged
Either contractually specified
Or implicit in FV or Cash flows of the Instrument
(hedged item)
198. 11. Credit Exposure
Examples are discussed in session
But we will not be able to think up new scenarios
- Time contraints
- The complexity of the issues may result in wrong
decisions because it is easy to make mistakes in an
environment where judgment is difficult
In practice a checklist may simplify decisions
198
199. 12. Where US GAAP
diverges/disagrees
Examples are discussed in session
But we will not be able to think up new scenarios
- Time contraints
- The complexity of the issues may result in wrong
decisions because it is easy to make mistakes in an
environment where judgment is difficult
In practice a checklist may simplify decisions
199
201. Some conclusions
IFRS9.BC6.82
Risk management often fails to meet expectations
One of the basic requirements of a risk management plan is to
understand the pros and cons of hedge accounting
202. Some conclusions
IFRS9.BC6.82
Risk management often fails to meet expectations
Hedging and key risk management principles have not yet been
experienced and applied as financial tools by many participants
in capital markets
One of the basic requirements of a risk management plan is to
understand the pros and cons of hedge accounting
203. Some conclusions
IFRS9.BC6.82
Risk management often fails to meet expectations
Hedging and key risk management principles have not yet been
experienced and applied as financial tools by many participants
in capital markets
One of the basic requirements of a risk management plan is to
understand the pros and cons of hedge accounting
Companies have substantial documentation costs and ongoing
monitoring of designated hedges, thus applying Risk
Management is thought to be not worth doing
204. Some conclusions
IFRS9.BC6.82
Risk management often fails to meet expectations
Hedging and key risk management principles have not yet been
experienced and applied as financial tools by many participants
in capital markets.
Lack of available and reliable information on capital markets has
been questioned.
One of the basic requirements of a risk management plan is to
understand the pros and cons of hedge accounting
Companies have substantial documentation costs and ongoing
monitoring of designated hedges, thus applying Risk
Management is thought to be not worth doing
206. Some conclusions (2)
IFRS9.BC6.82
Entities are not ready to use derivatives - mostly due to the lack of
knowledge
Lack of reliable information on capital markets has been questioned
207. Some conclusions (2)
IFRS9.BC6.82
Entities are not ready to use derivatives - mostly due to the lack of
knowledge
The guarantees required by banks to conduct such transactions
are a deterrent for small and medium enterprises and protection
against the risk involves a cost that usually is quite large, as in
approx 99% of cases it is transferred to the beneficiary of service
Lack of reliable information on capital markets has been questioned
208. Some conclusions (2)
IFRS9.BC6.82
Accountants are not comfortable with hedging activities
because of the lack of practical experience
The 1st step should be towards acquiring solid knowledge
about: risk management strategies, hedging with financial
derivatives, accounting and disclosing hedging derivatives
Entities are not ready to use derivatives - mostly due to the lack of
knowledge
The guarantees required by banks to conduct such transactions
are a deterrent for small and medium enterprises and protection
against the risk involves a cost that usually is quite large, as in
approx 99% of cases it is transferred to the beneficiary of service
Lack of reliable information on capital markets has been questioned