hedge effectiveness 2

IAS 39 HedgingAligning theory with practice

February 2005

2Preface

Contents Page

Preface 1

Introduction 3

Hedge accounting under IAS 39 3

Hedge accounting at a glance 4

What is the fair value of a derivative? 7

Hedge effectiveness testing 8

Hedge documentation 17

Derivative presentation within the balance sheet 18

Presentation of results within the income statement 18

Contacts 19

Inserts

Hedging interest rate risk

Hedging foreign exchange risk

Hedging commodity price risk

Other publications on IFRSPricewaterhouseCoopers has published the following publications on InternationalFinancial Reporting Standards and corporate practices; they are available from yournearest PricewaterhouseCoopers office.

Acquisitions Accounting and transparency under IFRS 3Applying IFRS Finding the right solution (available on Comperio IFRS1)Adopting IFRS IFRS 1, First-time adoption of IFRSFinancial instruments under IFRSFinancial Reporting in Hyperflationary Economies Understanding IAS 29IFRS Disclosure Checklist 2004IFRS Measurement Checklist 2004IFRS Pocket Guide 2004Illustrative Consolidated Financial Statements 2004 BanksIllustrative Consolidated Financial Statements 2004 InsuranceIllustrative Consolidated Financial Statements 2004 Investment PropertyIllustrative Corporate Consolidated Financial Statements 2004Illustrative Financial Statements 2004 Investment FundsIllustrative Interim Financial Statements for First-time AdoptersShare-based Payment A practical guide to applying IFRS 2Similarities and Differences A comparison of IFRS and US GAAPUnderstanding IAS 29 Financial Reporting in Hyperinflationary EconomiesIFRS News Shedding light on the IASBs activitiesMaking the Change to International Financial Reporting StandardsReady to take the plunge? IFRS readiness survey 2004Ready for take off? IFRS readiness survey (December 2004 update)World Watch Governance and Corporate ReportingAudit Committees Good Practices for Meeting Market ExpectationsBuilding the European Capital Market Common Principles for a Capital MarketThese publications and the latest news on IFRS can be found at www.pwc.com/ifrs1 Comperio IFRS can be purchased from the website www.pwc.com/ifrs

This publication is based on International Accounting Standard 39 Financial Instruments: Recognition and Measurement (December 2003) as amended by the provisions set out in Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk (March 2004), includinginterpretations as at 31 March 2004.

As International Financial Reporting Standards are an evolving area subject to new guidance and interpretations, companies should confirm the appropriateness of their proposed hedging strategies and accounting designations with their external advisors.

1IAS 39 HedgingAligning theory with practice

Preface

IAS 39 Financial Instruments: Recognition and Measurementis a complex accounting standard and has been the subjectof much debate for companies converting to InternationalFinancial Reporting Standards (IFRS).

The debate has focused on a number of issues such asmeasurement of instruments at fair value, provisioning and hedge accounting. In this publication we focus on theonerous hedge accounting requirements of IAS 39 whichtreasurers are required to align against current hedgingobjectives and practices. Whether in a financial institution or a corporate, treasurers and finance managers face thesame basic question how to effectively deliver the hedgeaccounting results when the actual economic hedgingactivities typically reflect a best fit approach to riskmanagement in terms of costs and benefits?

The hedging requirements of IAS 39 are onerous as a resultof the detailed rules and documentation standards to beachieved. For example, the underlying premise of hedgingwithin IAS 39 is that cash flows on the hedging instrumentand the hedged item should match exactly in timing,quantum and currency if a hedge relationship is to beeffective from an accounting perspective; there is littleallowance for the best fit hedging solution. However, theintroduction of measurement rules for derivative instrumentshas provided companies with the opportunity to re-evaluatetheir risks and risk management strategies.

Alignment with practice

Many problems may arise when applying a technical theoryto practical situations. For example, a groups riskmanagement policy may be to consolidate group-widecurrency exposures within a central treasury function and to manage the net exposure by currency with externalderivatives, thereby generating economies of scale andpricing efficiency. These practices may meet the riskmanagement approach but will not necessarily achieve the same accounting result.

Alternatively, in applying the hedge accounting rules, specificconstructions of hedge relationships may be developed anddocumented. However, review of the hedge documents maynot necessarily provide the reader with a good understandingof the economic risk approaches being adopted by thecompany. In addition, as more of the processes for hedgeaccounting are automated there may be some difficultreconciliations to be completed between management andfinancial information. Such a disconnect between statutoryaccounting results and internal management reporting andperformance measures is an issue that many groups haveyet to resolve.

It is often extremely difficult to achieve perfect hedgeeffectiveness from an accounting perspective. As a result the approach adopted by individual companies is likely to vary from:

electing not to apply hedge accounting in any form despitevolatility and rely on robust communication strategies tothe market in explaining the resultant income statementvolatility introduced by derivative instruments; to

undertaking detailed hedge accounting processes toensure that the hedge accounting benefits are obtained.

Ongoing application of hedging requirements

Most treasury and financial reporting areas have beenconcentrating on developing the technical understanding of both the hedging requirements and the initial implications.They have not progressed to developing the actual practicesfor implementation.

There are many implementation issues for the relatedtreasury activities, including the extent to which additional or alternative practices may be required to be applied byindividual companies. This includes undertaking more ordifferent types of instruments and being able to undertakethe necessary reporting, monitoring and measurementrequirements for hedge accounting.


Preface (continued)

IAS 39 hedging requirements also impacts processes for data collection, analysis, modelling requirements and management information requirements and thereforeintroduce more complexities into daily processes.

Clearly these IAS 39 hedging requirements will be part ofbusiness as usual in the future as companies adopt andembed IFRS. There is an initial timing consideration onadoption to ensure that all hedge requirements can be metfor that reporting period. Thereafter, there will need to bedetailed consideration of new products and strategies toensure that all relevant processes are established to supporthedge accounting under IAS 39. Many operations will alsonow move to automate these practices in order to helpimprove the efficiency of such processes.

In order to support IAS 39, a number of major softwarehouses have modules in development which support certainaspects of IAS 39.

Conclusion

It is therefore only to be expected that different approacheswill be adopted, reflecting the philosophy and managementstyle of each company. The resulting impact on theconsistency and clarity of the financial information reportedcompleted across each sector, a key goal of IFRS, is yet to be determined. The resulting impact on the control andreporting processes that are required to support these newpractices will undoubtedly be an additional burden fortreasury and finance managers.

We have set out in this publication some of the complexitiesassociated with hedge accounting and highlighted additionalpractices that are developing to address such complexities.The strategies and solutions presented are not exhaustive. I am sure that the following pages will answer many of yourquestions on the application of hedge accounting under IAS 39. It is likely that more will arise as IAS 39 is embeddedin each individual organisation.

Stephanie Bruce

Partner, Treasury Solutions Group,

PricewaterhouseCoopers.


Introduction

Hedge accounting under IAS 39

This publication provides a broad overview of a number of common issues associated with hedge accounting under IAS 39,Financial Instruments: Recognition and Measurement, including construction of hedge effectiveness tests and suggests somestrategies that may minimise hedge ineffectiveness.

There are separate sections dealing with hedging interest rate risk, hedging foreign exchange risk and hedging commodityprice risk. One major development has been a carved out version of IAS 39 called Euro-IFRS.

Update on EU-ADOPTED IFRSsTo apply in the EU, International Financial ReportingStandards must be adopted in the EU. To date, themajority of International Accounting Standards andIFRSs have been adopted in the EU.

However, the European Commission has adopted acarved-out version of IAS 39. The carved out version is sometimes referred to as Euro-IAS 39 as opposed toFull-IAS 39.

There are two key differences between Euro-IAS 39 andthe IASBs Full-IAS 39:

the fair value option for financial liabilities is removed;and

certain aspects of portfolio fair value hedge accountingof interest rate risk have been relaxed.

The carve-out is intended to be a temporary measure to ensure that EU listed companies have a standardthat deals with recognition and measurement of financial instruments.

The EU Regulation (EC 2086/2004) specifically states that companies using Euro-IAS 39 will be regarded asequivalent to first time adopters of Full-IFRS. Thereforecompanies would still qualify to use the exemptions andexceptions in the Euro-adopted version of IFRS 1.

The result of this is that European listed groups must use Euro-IAS 39 and the financial statement accountingpolicy note will need to state clearly that Euro-IFRS hasbeen adopted.

It is possible to comply with Full-IAS 39 and Euro-IAS 39if the fair value option for financial liabilities is not usedand the more restricted hedge accounting rules underFull-IAS 39 are implemented.

Update on cash flow hedge accounting of forecast intra group transactionsIAS 39 may still be subject to change in relation to hedge accounting.

The IASB released a further exposure draft in June 2004on the ability to cash flow hedge highly probable forecastexternal transactions denominated in the functionalcurrency of the entity (subsidiary) concerned, providedthat the transaction gives rise to an exposure that has aneffect on consolidated profit or loss ie is denominated ina currency other than the group's presentation currency.

The exposure draft also proposes changes to theaccounting treatment for economic hedge relationshipsinvolving highly probable forecast intragroup transactions.Highly probable forecast intragroup transactions wereoriginally permitted to qualify as hedged items under IGC137-14. However, this allowance was withdrawn whenthe revised IAS 39 (2003) was issued.

The ongoing debate has contributed to the uncertainty of the appropriate IFRS transition adjustment andongoing accounting requirements for entities thatcurrently economically hedge highly probable forecastintragroup transactions under their local GAAP.

As an interim measure, entities are advised to preparetwo sets of hedge documentation on transition to IAS 39:in one set the hedged item could be designated as ahighly probable forecast external transaction at a grouplevel, and in the other, the hedged item could bedesignated as a highly probable forecast intragrouptransaction at the subsidiary level.


Hedge accounting at a glance

The underlying principle

Hedge accounting enables gains and losses on the hedginginstrument to be recognised in the same performancestatement, and in the same period, as offsetting losses andgains on the hedged item ie the matching concept.

The key issues:

in order to apply hedge accounting, strict criteria, includingthe existence of formal documentation and theachievement of effectiveness tests, must be met atinception and throughout the term of the hedgerelationship.

hedge accounting can be applied to three types of hedgingrelationships; fair value hedges, cash flow hedges andhedges of a net investment in a foreign operation.

hedge accounting must be discontinued prospectively ifthe hedging relationship comes to an end (eg, the hedginginstrument is sold), one of the hedge accounting criteria isno longer met (eg, the hedge does not pass effectivenesstests) or the hedging relationship is revoked.

Criteria for hedge accounting:

IAS 39 requires that hedges meet certain criteria in order toqualify for hedge accounting. These include requirements forformal designation of the hedging relationships as well asrules on hedge effectiveness.

A hedging relationship qualifies for hedge accounting if, at inception of the hedge, there is formal documentation of the hedging relationship and the entitys risk managementobjective and strategy for undertaking the hedge.

What instruments can be designated as hedging instruments?

All derivatives that involve an external party may bedesignated as hedging instruments except for most writtenoptions. An external non-derivative financial asset or liabilitymay not be designated as a hedging instrument under IAS 39 except as a hedge of foreign exchange risk.

In addition, intercompany foreign currency loans are notpermissible hedging instruments within the consolidatedgroup financial statements.

What items/transactions can be hedged?

The fundamental principle is that the hedged item creates an exposure to risk that could affect the income statement.

The hedged item can be:

a single asset, liability, firm commitment or highly probableforecasted external transaction;

a group of assets, liabilities, firm commitments or highlyprobable forecasted external transactions with similar riskcharacteristics;

a non-financial asset or liability (such as inventory) foreither foreign exchange risk, for the risk of changes in thefair value of the entire item or for the risk of changes in thefair value of the entire item excluding foreign exchange risk;

a held to maturity investment for either foreign exchangerisk or credit risk (but not interest rate risk);

a portion of cash flows of any financial asset or liability;

for a portfolio hedge of interest rate risk only, a portion ofthe portfolio of financial assets or financial liabilities thatshare the risk being hedged; or

a net investment in a foreign operation (group accounts only).

Hedging

Managementinformation-

ongingvolatilty

Managementinformation-

ongoingvolatilty

HedgecriteriaHedgecriteria de

signate

track

monitor

selectrisk

document effective

test

Trading


Hedge accounting is prohibited for hedges of net positionsbut it is often possible to identify within the net position, a specific element of the gross position and to designate a portion of the gross position as the hedged item if it meetsthe other criteria for hedge accounting. It is also prohibited to claim hedge accounting for derivatives that manage thetranslation exposure on subsidiary profit and loss accountbalances.

Categories of hedge relationships

Hedge accounting may be applied to three types of hedgerelationships; fair value hedges, cash flow hedges andhedges of a net investment in a foreign operation. Thedistinction of these types of relationships impacts the relatedaccounting entries.

Fair value hedges

A fair value hedge is a hedge of the exposure to changes inthe fair value of a recognised asset or liability or a previouslyunrecognised firm commitment that is attributable to aparticular risk and could affect reported profit or loss.

In a fair value hedge, the gain or loss from remeasuring thehedging instrument at fair value (derivative) or foreigncurrency component of its carrying amount (non-derivative) is recognised immediately in the income statement.

At the same time, the carrying amount of the hedged item isadjusted for the loss or gain attributable to the hedged riskwith the corresponding entry recognised immediately in theincome statement. Where perfectly effective, this movementshould offset the value change on the derivative in theincome statement. Any difference between the two values is the automatic measurement of hedge ineffectiveness.

Cash flow hedges

A cash flow hedge is a hedge of the exposure to variability in cash flows that:

is attributable to a particular risk associated with arecognised asset or liability or highly probable externalforecasted transaction;

could affect reported profit or loss.

A hedge of the foreign currency risk associated with firmcommitments may be designated as a cash flow hedge or as a fair value hedge.

The portion of the gain or loss on the hedging instrumentthat is determined to be an effective hedge is recogniseddirectly in equity within a cash flow hedge reserve. Anyineffective element of the fair value movement on thederivative should be recorded in the income statement.

This gain or loss deferred in equity (cash flow hedge reserve)is recycled to the income statement when the hedged itemalso affects income, therefore offsetting to the extent that thehedge is effective.

If the hedged cash flows result in the recognition of a non-financial asset or liability on the balance sheet (eg stock), theentity can choose to adjust the recorded asset or liability bythe amount deferred in equity. The choice has to be appliedconsistently to all such hedges. However, such a basisadjustment is not permitted where a financial asset or liability(eg trade debtors) results from the hedged cash flows.

Cash flowhedge

Floating rate assets/liabilitiesForecasted transactionsForeign currency firm commitments

Fixed rate assets/liabilitiesUnrecognised firm commitments

Foreign exchange risk

Fair valuehedge

Netinvestment

hedge

TRADING INSTRUMENTSTRADING INSTRUMENTS


Hedge accounting at a glance (continued)

Hedge of a net investment in a foreign operation(group accounts only)

Under IAS 21, the net investment in a foreign operation is theamount of the reporting entitys interest in the net assets ofthat operation. A key issue in determining effective hedgingis to determine the functional currency of the subsidiaryentity as set out in IAS 21.

If a derivative or non-derivative is designated as a hedge ofthe foreign currency exposure on that interest, the portion ofthe gain or loss on the hedging instrument that is determinedto be an effective hedge is recognised directly in equity asthis matches the foreign currency translation movement onthat interest.

Translation gains and losses (and associated hedging lossesand gains) are required to be tracked through equity on anentity-specific basis. On disposal of the entity, theseassociated gains and losses are incorporated within theoverall gain or loss on disposal of the related net investment.

Discontinuing hedge accounting

Hedge accounting must be discontinued prospectively if any of the following occurs:

a hedge fails the effectiveness test;

the hedging instrument is sold, terminated or exercised;

the underlying hedge position is settled;

management decides to revoke the hedging relationship; or

in a cash flow hedge, the forecast transaction that ishedged is no longer highly probable.

IAS 39 prescribes how any existing hedge accountinggains/losses already recorded in previous reporting periods should be addressed. The objective is to avoidhedge accounting being claimed in one period and then to cherry pick an alternative accounting result in thesubsequent period.

In a fair value hedge relationship (for example, when a debtinstrument balance has been adjusted for changes in fairvalue relative to interest rate risk) the adjusted carryingamount becomes the amortised cost balance of the debtinstrument. Upon cessation of the hedge relationship, anypremium or discount that is included in the carrying coston such a debt instrument is then released to the incomestatement on an effective interest basis over the remainingperiod to maturity of the debt instrument.

If a cash flow hedge relationship ceases, the amountaccumulated in equity will be maintained in equity until thehedged item affects profit or loss. This includes the scenariowhere the hedged item was a forecasted transaction whichoriginally, in order to establish the hedge relationship, hadbeen highly probable but whose occurrence is now onlyconsidered expected to occur. However, if hedge accountingceases because the forecast transaction that was the subjectof the hedge is no longer expected to occur, gains andlosses deferred in equity have to be recognised immediatelyin the income statement as there is no longer a flow againstwhich this will be offset in future periods.

Similarly, any amounts accumulated in equity for an effectivehedge of a net investment in a foreign operation should, ifthe hedge relationship becomes ineffective, remain in equityuntil disposal of the related net investment.


What is the fair value of a derivative?

Underlying the definition of fair value is the presumption thatan entity is a going concern without any intention or need toliquidate or curtail materially the scale of its operations or toundertake a transaction on adverse terms.

When determining the fair value of a financial instrument, IAS 39 sets out a hierarchy to be applied to the valuation.

If quoted prices or rates exist in an active market for theinstrument, they must be used to determine the fair value.

Where there is no active market available from which todraw quoted prices, a valuation technique should be used.

Value techniques include inter alia:

recent market prices or rates where available, adjusted for known events;

reference to the current fair value of another instrumentthat is substantially the same;

discounted cash flow analysis;

option pricing models; and

a standard industry valuation technique that has beendemonstrated to provide reliable estimates of pricesobtained in actual market transactions.

Fair value should reflect the credit quality of the instrument.For those items in an open market, this is likely to beincorporated in the price.

The fair value of exchange traded derivative instruments maybe determined by reference to quoted market prices or rates.

For the majority of over the counter derivative instruments,the fair value will be determined by the company usingdiscounted cash flow analysis using quoted market rates as an input into the valuation model. The fair value of aderivative may therefore be defined as the net present value of the cash flows on the derivative.

Where derivatives are transacted at current market rates, the opening fair value is nil. Alternatively any off market rates need to be considered for their impact on the fair value at inception.

Where a valuation model is being used to determine fairvalue, there are a number of issues associated with observableand non-observable market data that are beyond the scopeof this publication.

What rates should be used in determining the fair value of a derivative?

Under IAS 39, the appropriate quoted market price for an asset held is the bid price, and for a liability issued, the offer price.

The credit quality of the derivative counterparty is a furtherfactor that should be considered within the valuation. Thestandard approach to valuing derivative instruments is to usethe AA rated libor curve (ie gilt rates) in the valuation model.Where the credit quality of the derivative counterparty isbelow AA rating, the market quoted rates used in thevaluation model should be adjusted for credit risk. Anymovements between periods, of the credit quality, will needto be considered as they may affect the hedge effectivenesstest in a later reported period.


Hedge effectiveness testing

To qualify for hedge accounting, IAS 39 requires the hedge to be highly effective.

There are two separate tests which require to be applied:

1. Prospective effectiveness test; and

2. Retrospective effectiveness test.

What is prospective hedge effectiveness testing?

The objective of the prospective hedge effectiveness test isto prove that the hedge relationship is expected to be highlyeffective in offsetting the designated hedged risk.

A hedge is regarded as highly effective if, at inception andthroughout the life of the hedge, the prospective effective testresults are within a range of -80 to -125 per cent. For example,if the loss on the hedging instrument is 120 and the gain onthe hedged item is 100, prospective effectiveness can bemeasured by -120/100, which is -120%, or by 100/-120,which is -83%. In this example, the entity would concludethat the hedge is highly effective on a prospective basis.

Prospective effectiveness is assessed, at a minimum, at thetime an entity prepares its interim and annual financialstatements.

IAS 39 does not specify a single method for assessingprospective hedge effectiveness. The method an entity adoptsdepends upon its risk management strategy and the principalterms of the hedging instrument and the hedged item.

Where the principal terms of the hedging instrument and the hedged item match exactly, for example, notional andprincipal amounts, credit risk (AA), term, pricing, repricingdates (aligned to test date), timing, quantum and currency of cash flows, then the hedge relationship is likely to beperfectly effective. Such an assessment is consideredqualitative in nature.

In future periods, ineffectiveness may arise where part of the change in fair value of the derivative or hedged item isdue to counterparty credit risk. For this reason, assessmentof credit risk forms part of the ongoing qualitative tests of effectiveness.

Where the principal terms of the hedging instrument andhedged item do not match exactly, the prospective hedgeeffectiveness test should be enhanced to include bothqualitative and quantitative testing. Sensitivity analysis is one method that may be used to satisfy the quantitativeprospective test.

In practice, the principal terms approach will apply in limitedcircumstances, and is most commonly used when hedgingforeign currency risk.

Principal terms Practical approach

Matched At hedge inception: qualitative testing

Subsequent test date: reconfirm terms including credit risk assessment

Unmatched At hedge inception: qualitative and quantitativetesting. Sensitivity analysis may be used

Subsequent test date: qualitative and quantitativetesting. Sensitivity analysis may be used


What is sensitivity analysis within the prospective hedge effectiveness test?

What is retrospective effectiveness testing?

Regardless of whether or not the principal terms of the hedging instrument and the hedged item match, retrospectiveeffectiveness testing must be performed in full. As a minimum, this should be completed at each reporting date, as set out in the table below, in order to prove that the actual relationship was effective in practice and in order to generate theaccounting entries.

Such a test is both qualitative and quantitative in nature.


Matched Qualitative assessment, including credit risk consideration.

If there is no change in credit risk of the derivative or hedged item, it is not necessary to performfurther quantitative sensitivity analysis; where all the principal terms match the test will proveperfectly effective.

Unmatched Where the principal terms do not match, one quantitative method of prospective effectivenesstesting involves flexing the hedged risk rate across a number of scenarios. For example, if liboris the designated hedge risk, an entity may choose to flex libor rates over the hedging period.The method of flexing may include parallel and swing shifts in the libor curve for a number ofbasis points over the term of the hedge relationship.

Qualitative testing includes reassessment to confirm anticipated timing and quantum of thehedged item.

When flexing the hedged risk, an entity may replicate historic rate movements or incorporate theabsolute rate movement required before the hedge relationship is no longer considered effective.Where the latter approach is adopted, it is necessary to consider the probability of occurrence ofthe rate movement as part of the effectiveness test; where the movement is likely to occur, theprospective test would fail hedge effectiveness; where it is not likely to occur, the prospectivetest would pass hedge effectiveness.


Matched At hedge inception: no retrospective test performed

Subsequent test date: qualitative and quantitative testing

Unmatched At hedge inception: no retrospective test performed

Subsequent test date: qualitative and quantitative testing


Hedge effectiveness testing (continued)

Common techniques used for retrospective effectiveness testing

IAS 39 does not specify a single method for assessing hedge effectiveness. The method an entity adopts for assessing hedgeeffectiveness depends on its risk management strategy. In some cases, an entity adopts different methods for different typesof hedges. The table below sets out two common techniques used for assessing retrospective hedge effectiveness.

What is the limitation with the dollar offset technique when measuring hedge effectiveness?

Consider the following example.

Example 1

Entity A has a firm commitment with foreign currency that it wishes to hedge with a derivative instrument. Upon entering the derivative transaction, Entity A completes all relevant hedge documentation and prepares and satisfies the prospectiveeffectiveness test at that time. The hedge documentation sets out the dollar offset methodology being used on a cumulative basis.

Information table:

Method Advantages Disadvantages

Dollar offset using the hypotheticalbond approach, benchmark fixed rateapproach or hypothetical derivativeapproach.1

Regression analysis

Simple to use compared to othertechniques.

May support more hedgerelationships to pass the hedgeeffectiveness test.

May result in ineffective hedgerelationships where fair valuechanges are relatively small.

More complex to use compared tothe dollar offset technique.

Requires a large data population.Inefficient if performed manually likely to require system support.

Does not generate the requiredaccounting entries; ineffectiveness is still required to be calculated and the accounting entries generated.

1 These approaches are described in the hedge design sections of the publication

Test date Cumulative change in fair value of Cumulative change in fair valuethe derivative hedging instrument of the hedged item

T0 0 0

T1 10 -7


At T1, Entity A is required to perform a retrospective test of effectiveness using the dollar offset method as set out in the hedge documentation. The dollar offset test is a measure of the change in fair value of the derivative divided by thechange in fair value of the hedged item relative to the designated hedged risk: denotes the change in fair value in thefollowing examples.

The test result of -143% fails the hedge effectiveness test and hedge accounting may not be applied for the period T0 to T1.In absolute terms, there is a difference of 3 (ignoring the -) between the movement on the derivative and the hedged item.However, where there are relatively small movements in both the derivative and the hedged item the difference represents a more significant element of that movement. Accordingly, it is much more susceptible to ineffectiveness.

Example 2

The situation is the same as example 1 above, but this time there is a more significant change in fair value of the derivativeinstrument and the hedged item.

Information table:

At T1, Entity A is required to perform a retrospective test of effectiveness using the dollar offset method as set out in thehedge documentation.

Test date Cumulative change in fair value of Cumulative change in fair valuethe derivative hedging instrument of the hedged item

T0 0 0

T1 100 -97

fair value (FV) of derivative

FV of hedged item relative to hedged risk

FV derivative T1 FV derivative T0

FV hedged itemr T1 FV hedged itemr T0

10-7

-143%

=

=

=

r designated hedged risk


Hedge effectiveness testing (continued)

In absolute terms, there is again a difference of 3 (ignoringthe -) between the movement on the derivative and thehedged item. However, as the absolute difference is a smallerpercentage of the total movements amount, the hedgerelationship now satisfies the effectiveness test range of 80 to 125% using the dollar offset method.

The key requirements underlying the use of regression analysis

In the context of hedge effectiveness tests, regressionanalysis investigates the statistical relationship between the hedged item and the hedging instrument. Regressionanalysis is often called line of best fit.

It provides a means of expressing the extent by which onevariable, the dependent, will vary against a key variable,the independent in a systematic fashion. For example, are changes in the fair value of the hedged item for thedesignated hedge risk and changes in the fair value of thehedging derivative highly correlated.

The independent variable reflects the change in the fair value of the hedged item for the designated hedge risk, the dependent variable reflects the change in fair value of the hedging instrument.

Conclusion

Although practical in approach, the dollar offset method ofassessing hedge effectiveness can result in a higher numberof hedge relationships failing hedge effectiveness than ifassessed using alternative techniques, as the dollar offsettest is not able to address refinements within the movements.

Entities typically use the dollar offset technique foreffectiveness testing where:

Principal terms of the hedging instruments and the hedgeditem match; or

Principal terms do not match but the extent of difference is very slight and unlikely to generate significant differencesin fair value movements between the hedging instrumentand the hedged item, thereby causing the hedgerelationship to fail.

Entities typically use regression analysis to measureeffectiveness, both prospectively and retrospectively, wherethey undertake portfolio hedging strategies and practices. A number of software packages are available to performregression analysis. Where such an approach is adopted, it is not uncommon for the software output to reflect only a pass or fail hedge effectiveness result; the calculationsperformed within the black box may not be visible tomanagement. However, consistent with good corporategovernance practices, entities adopting such an approachwill be required to gain a thorough understanding of thecalculations and data used within the software in supportingthe hedge effectiveness calculations.

r designated hedged risk

FV of derivative

FV of hedged item relative to hedged risk

FV derivative T1 FV derivative T0

FV hedged itemr T1 FV hedged itemr T0

100-97

-103%

=

=

=


Hedge effectiveness tests under US GAAP & IAS 39

US GAAP has prescribed hedge testing rules within FAS 133 Accounting for Derivatives and Hedging Activities and manycompanies have adopted these or related practices in the past. However there are key differences between US GAAP andIAS 39 on hedge effectiveness. These are summarised below for a number of simple hedging relationships:

Typical US GAAP approach to assessing hedge effectiveness

Hedge risk Hedging Fair value hedge Cash flow hedgeinstrument effectiveness test effectiveness test

Interest rate risk

Foreign exchange risk

Foreign exchange andinterest rate risk

Interest rateswaps

Foreign exchangeforward contracts

Cross currencyinterest rate swaps

Short cut method

OR

Fair value to Fair value method

Generally not applied as the hedgedrisk is naturally recorded through theprofit and loss account onretranslation of the hedged item

Fair value to Fair value method

Short cut method (see over page)

OR

Change in variable cash flow method(see over page)

Quasi short cut method

OR

Change in variable cash flow method

Using either the spot element or fullfair value of the forward contracts

Change in variable cash flow method

Net investment hedge effectiveness test

Foreign exchange risk onnet investments


Cross currencyinterest rateswaps:

Fixed/fixedprofile

Floating/floatingprofile


Hypothetical derivative method

Dollar offset using either the spot element or full fair value of the forwardcontracts


Hedge effectiveness tests under US GAAP & IAS 39

Typical IAS 39 approach to assessing hedge effectiveness

Hedge risk Hedging Fair value hedge Cash flow hedgeinstrument effectiveness test effectiveness test

Interest rate risk

Foreignexchange risk

Foreignexchange andinterest rate risk

Interest rateswaps


Cross currencyinterest rate swaps

Dollar offset:Fair value to Fair value method

OR

Regression analsis

Generally not applied as the hedgedrisk is naturally recorded through theprofit and loss account onretranslation of the hedged item

Dollar offset: Fair value to Fair value method

OR

Regression analysis

Dollar offset method: variability of riskrelative to a benchmark reference rate

OR

Regression analysis



Cross currencyinterest rateswaps:

Fixed/fixedprofile

Floating/floatingprofile

Fixed/floatingprofile


Dollar offset method

Dollar offset using either the spot element or full fair value of the forward contracts

Net investment hedge effectiveness test


Key differences in hedge effectiveness approach between US GAAP and IAS 39

Short cut method of hedge accounting US GAAP

The short cut method of assessing hedge effectiveness isexplicitly permitted under US GAAP for cash flow or fairvalue hedge relationships of interest rate risk involving arecognised interest bearing asset or liability and an interestrate swap. The benefit of such an approach is that itsignificantly simplifies the computations necessary to recordthe hedge accounting entries as an entity may assumeperfect hedge effectiveness where the hedge relationshipsatisfies certain criteria (critical terms test). Comparablecredit risk at inception is not a condition for assuming noineffectiveness even though actually achieving perfect offsetwould require that the same discount rate be used todetermine the fair value of the hedging instrument and of the hedged item. Where the short cut method of accountingis applied, an entity does not need to perform quantitativetests of hedge effectiveness.

The quasi short cut method of assessing hedge effectiveness(known otherwise as the abbreviated method) is sometimesused where it is apparent from the terms of the derivative

and the nature of the hedged item that the hedge is perfectlyeffective and there should be no hedge ineffectiveness.Whilst the short cut method is restricted to hedge relationshipsof interest rate risk, the quasi short cut method may beapplied to hedge relationships of foreign currency orcommodity price risk, but not to hedge relationships ofinterest rate risk or multiple risks.

Is the short cut method of hedge accountingpermitted under IAS 39?

No. IAS 39 requires an entity to assess hedge relationshipson an ongoing basis for hedge effectiveness. It is notpossible to assume hedge effectiveness even if the principalterms of the hedging instrument and the hedged item are thesame, since hedge ineffectiveness may arise because ofother attributes such as the liquidity of the instruments ortheir credit risk.

Therefore effectiveness tests still require to be performed andcomputations of ineffectiveness still need to be undertaken inaccordance with the documentation processes.

The table below sets out the key differences in approach when assessing hedge effectiveness under current US GAAP and IAS 39. The key difference is that the short cut method of assessing hedge effectiveness is not permitted under IAS 39,whereas a specific allowance is provided under US GAAP for this approach. There are a number of additional differences in respect of hedge accounting between US GAAP and IAS 39. Full convergence of these accounting standards on the topicof hedge accounting is not anticipated.

US GAAP IAS 39

Short cut method

Dollar offset: Change in variable cashflow method

Dollar offset: Fair value to fair valuemethod

Dollar offset: Hypothetical derivative/hypothetical bond

Regression analysis

3 73 73 3

3 33 3


Key differences in hedge effectiveness approach between US GAAP and IAS 39 (continued)Change in variable cash flow method of hedge accounting US GAAP

Under this approach, the measurement of hedgeeffectiveness may be based on a comparison of the floating-rate leg of the swap and the floating-rate cash flows on theasset or liability being hedged. The change in variable cashflows method is consistent with the cash flow hedgeobjective of effectively offsetting the changes in the hedgedcash flows attributable to the hedged risk.

This method is based on the premise that only the floating-rate component of the swap provides the cash flow hedge,and any change in the swaps fair value attributable to the fixed-rate leg is not relevant to the variability of thehedged interest payments (receipts) on the floating-rateliability (asset).

Can the fixed leg of a swap be ignored whenperforming hedge effectiveness in a cash flowhedge of interest rate risk under IAS 39?

No. However, careful designation and documentation of thehedged risk and strategy can achieve the same result, whilstsatisfying the IAS 39 requirement to use the full fair value ofthe derivative when assessing hedge effectiveness.

Set out within the section on hedging interest rate risk are a number of approaches to consider when designating anddocumenting the hedged risk and strategy in order toaddress this requirement.


Hedge documentation

The hedge documentation should contain the followinginformation:

Risk management objective and strategy

An explanation of the rationale for contracting the hedge.This should include the evidence that the hedge is consistentwith the entitys risk management objectives and strategies,or provide a cross reference to the entitys risk managementstrategies that govern the type of hedge relationship.

Type of hedging relationship

Statement of the type of hedging relationship involved ie a fair value hedge, cash flow hedge or a hedge of a net investment in a foreign operation.

Nature of risk being hedged

Details of whether the entity is hedging changes in fair valueor cash flows of the hedged item due to, for example,interest rate risk, foreign exchange risk, credit risk. The entityshould designate precisely the risk, or the portion thereof,being hedged (for example, for interest rate risk, the portionof the yield curve being hedged).

Hedged item

A sufficiently detailed description of the hedged item, in order that it can be uniquely identified (micro hedging).

Forecasted transactionsWhere the entity is hedging a forecasted transaction,management needs to document support for theachievement of certain criteria, for example:

whether the transaction is highly probable of occurrence.This is typically interpreted to mean the transaction isalmost 100% certain to occur;

whether the transaction is with a party external to thereporting entity and presents an exposure to variations incash flows for the hedged risk that could affect reportedprofit and loss.

The information relating to the hedged forecasted transactionmust be documented because the hedged item (that is, theforecasted transaction) is not an existing asset or liability, ora firm commitment supported by an agreement that is normallylegally enforceable. The documentation of a forecastedtransaction should include reference to the timing, the natureand amount (that is, the hedged quantity or amount) of theforecasted transactions.

Hedging transaction

A sufficiently detailed description of the hedging instrumentshould be prepared so that it can be uniquely identified. A copy of the trade ticket or equivalent may be referencedand attached.

The mechanism by which hedge effectivenesswill be assessed

At inception of the hedge, the entity must specify how hedgeeffectiveness will be assessed throughout the life of therelationship, on both a prospective and a retrospective basis,including:

whether the entire change in the derivatives fair value willbe used in the calculation of effectiveness, or if a specificportion will be excluded from the calculation ofeffectiveness (this is only permitted for purchased optionsand foreign currency forward contracts);

the calculation methodology and/or source of derivative fairvalues used in calculating effectiveness;

the calculation methodology and/or source of changes inhedged item fair values or cash flows based on the riskbeing hedged used in calculating effectiveness; and

at inception and on an ongoing basis, the hedge must beexpected to be highly effective.

IAS 39 requires an entity to define how it will measure theeffectiveness of a hedge during its life on both a prospectiveand a retrospective basis.


Derivative presentation within the balance sheet

Derivatives should be presented on the balance sheet at fair value in accordance with IAS 39. Where a companys underlyingsystems and processes already capture and record the interest accruals arising on interest rate swap contracts for thepurposes of legacy GAAP accounting, to create the full fair value of the derivative for the purposes of IAS 39, it is necessaryto include these derivative accruals within the derivative carrying balance. Consequently, where these circumstances exist, a reclassification of the swap interest accruals to the carrying balance of the derivative instrument will be required. The sameapproach would also apply where the forward points on foreign currency forward contracts are presented separately from theremaining fair value under legacy GAAP.

Presentation of results within the income statementIAS 1 describes the line items that shall be included, as a minimum, on the face of the income statement. Additional lineitems, headings and sub-totals must be presented to comply with other standards or to present fairly an entitys financialperformance.

Income statement presentation of unrealised and realised gains and losses from derivatives should be consistent with a companys risk management strategy and accounting policies.

The following classification may be appropriate:

Purpose of derivative

Held for trading or hedge accountingnot applied

Hedge of recognised financialinstruments typically fair valuehedge of foreign currency and / orinterest rate risk

Hedge of recognised non-financialitems fair value hedge ofcommodity price risk

Hedge of highly probable forecasttransactions or unrecognised firmcommitments typically cash flowhedge of foreign currency risk,interest rate risk or commodity price risk

Line item(s) in income statement

As a component of other income/expenses (but not as a gross profit item) or in a separate trading line item if significant.

Effective portion: same line item as the hedged item (eg finance costs if fairvalue hedge of borrowing fixed interest rate risk, translation line item if fair valuehedge of borrowing translation risk)

Ineffective portion: as a component of other income/expenses (but not as a gross profit item) or in a separate line if significant

Effective portion: same line item as the hedged item (eg cost of sales if fairvalue hedge of commodity stock).

Ineffective portion: as a component of other income/expenses (but not as a gross profit item) or in a separate line if significant.

Effective portion: initially recorded in equity (cash flow hedge reserve) andsubsequently recycled through to the same line item as the hedged item in theincome statement (eg finance costs if cash flow hedge of borrowing floatinginterest rate risk, translation line item if cash flow hedge of foreign currencyborrowing repayment, cost of sales if cash flow hedge of commodity purchases).

Ineffective portion: as a component of other income/expenses (but not as a gross profit item) or in a separate line if significant.

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2005 PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom) or,as the context requires, other member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. Designed by studio ec417205 (01/05).

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Hedging interest rate risk

Designation of hedged risk

To increase the effectiveness of the hedge relationshipfrom an accounting perspective, the swap should beredefined to have a flat libor leg: any credit spread on the libor leg can introduce ineffectiveness. As a swapsfair value derives from its net settlements, the fixed and variable rates on a swap can be changed withoutaffecting the net settlement if both are changed by thesame amount. In this example, the swap may therefore be viewed as a swap to receive 7% and pay 5 yearlibor flat rather than a swap to receive 9% and pay 5 year libor plus 2%.

Within the hedge documentation, the swap isdesignated as a fair value hedge of a portion of thebond. The designated portion reflects the exposure to changes in fair value of the bond relative to libormovements (the interest rate risk inherent in the bond).This is defined as bondr in the following examples.

Careful designation of risk improves thehedge effectiveness test


Example:Entity A issues 10m 5 year bond paying 9% fixed.

At date of issue, 5 year libor is 7%.

The bond interest rate can therefore be considered as 5 year libor plus 2% credit spread.

At the same time, Entity A transacts 10m notionalswap to receive 9% and pay 5 year libor plus 2%.

The bond is issued and the swap is entered into on 1 January 200X. Net settlement and payment of interest will occur in each and every 12 months.

As set out in the tables below, at the inception of thehedge relationship the swap is contracted at marketvalue, and has a nil fair value, and the fixed rate bond is worth par.

Hedge ineffectiveness: the interest accruals debate should the dirty or clean price be used withinthe hedge effectiveness test?

SWAP Yield Curve Discount Pay Forward Net (Pay)/ Present valueFactors rate Receive

1 5.00% 0.953 (5.00%) 2.00% 190,476.19

2 5.50% 0.898 (6.03%) 0.97% 87,113.52

3 6.00% 0.839 (7.10%) (0.10%) (8,665.36)

4 6.50% 0.775 (8.24%) (1.24%) (95,720.43)

5 7.00% 0.708 (9.45%) (2.45%) (173,203.92)

Present value at inception 0

BOND Actual Flows Designated Discount Factors Present ValueLIBOR Flows

1 (900,000) (700,000) 0.953 (666,666.67)

2 (900,000) (700,000) 0.898 (628,751.97)

3 (900,000) (700,000) 0.839 (587,051.78)

4 (900,000) (700,000) 0.775 (542,384.43)

5 (900,000) (700,000) 0.708 (7,575,145.15)

Present value at inception (10,000,000)

The hedge test is the movement of the fair values between reporting periods.

swap = swap t2 swap t1 = (200,000) 0 = (200,000)

bondr = bond t2 bond t1 = (9,800,000) (10,000,000) = 200,000

Using the dollar offset methodology, retrospective hedge effectiveness is assessed as:

swap

bondr= -100%

With this construction of the hedge effectiveness test, the hedge relationship is 100% effective.

Retrospective testing after 12 months (clean)

Assume the rates move in the 12 month periodaccording to the rate implied by the forward rate ie the12m rate for year 2 is 6.03%. If the accrued interest isexcluded from the accrued value of the bond and theswap, the swaps clean price has moved to a 200,000loss position and the bonds fair value is 9,800,000*.

SWAP Fwd rates Discount Pay Forward Net (Pay)/ Present valueFactors rate Receive

2 6.03% 94.31% 6.03% 0.97% 91,469.19

3 7.10% 88.06% 6.55% (0.10%) (9,098.63)

4 8.24% 81.36% 7.07% (1.24%) (100,506.45)

5 9.45% 74.34% 7.59% (2.45%) (181,864.11)

Fair value (200,000.00)

BOND Designated Discount Factors Present ValueLIBOR Flows

2 (700,000) 0.943127962 (660,189.57)

3 (700,000) 0.880577663 (616,404.36)

4 (700,000) 0.813576652 (569,503.66)

5 (10,700,000) 0.743355365 (7,953,902.41)

Present value (9,800,000)*

r relative to the designated hedged risk

* ignoring one day of discounting


swap = swap t2.5 - swap t2 = (205,583) (200,000) = (5,583)

bondr = bond t2.5 - bond t2 = (10,086,829) (9,800,000) = (286,829)


swap

bondr= 1.94%

With this construction of the hedge effectiveness test, the hedge relationship isineffective and would not qualify for hedge accounting.

Conclusion

The use of dirty prices creates ineffectiveness in the most basic fair value hedge.

Retrospective testing after 18 months (dirty)

Assume that rates move in the second year accordingto the rate implied by the forward rate ie the 6m ratefor the remaining 6 months of the year is 6.03% statedon an annualised basis.

If the accrued interest for the 6 month period sincereset is included in the value of the swap and the bondthen, as highlighted in the tables, ineffectiveness isintroduced when measuring fair value using the swapsdirty price.

SWAP Forward Discount Rield Pay Forward Net (Pay)/ Present valuerates Factors Curve Rate Receive

2.5 3.02% 0.97 6.03% 6.03% 0.97% 94,146.34

3 7.10% 0.91 6.55% 7.10% (0.10%) (9,364.93)

4 8.24% 0.84 7.07% 8.24% (1.24%) (103,448.10)

5 9.45% 0.77 7.59% 9.45% (2.45%) (187,186.97)

Fair value (205,583.66)


2 (700,000) 0.970731707 (679,512.20)

3 (700,000) 0.906350667 (634,445.47)

4 (700,000) 0.837388652 (586,172.06)

5 (700,000) 0.765112107 (535,578.48)

5 (10,000,000) 0.765112107 (7,651,121.07)

Present value (10,086,829.27)

Accruals createineffectiveness in the most basic fair value hedge



swap = swap t2.5 - swap t2 = (252,926.83) (200,000) = (52,927)

bondr = bond t2.5 - bond t2 = (9,747,073) (9,800,000) = 52,927


swap

bondr= -100%


Conclusion

When testing for hedge effectiveness under IAS 39, the whole fair value movementon the swap should be taken into account. However, in a number of circumstances it may be appropriate to use clean prices when testing effectiveness where this isconsistent with the risk management strategy of the company.

Retrospective testing after 18 months (clean)

Assume that rates move in the second year accordingto the rate implied by the forward rate ie the 6m ratefor the remaining 6 months of the year is 6.03% statedon an annualised basis.

For the purpose of the effectiveness test, the elementof accrued interest is excluded in order to use the cleanprice. This is completed by extracting 50% of the fullyears interest at present value. The swaps clean pricehas moved to a 252,926 loss position and the bondsfair value is 9,747,073.

SWAP Fwd rates Discount Rield Pay Forward Net (Pay)/ Present valueFactors Curve rate Receive

2.5 3.02% 0.97 6.03% 6.03% 0.97% 94,146.34 /2

3 7.10% 0.91 6.55% 7.10% (0.10%) (9,364.93)

4 8.24% 0.84 7.07% 8.24% (1.24%) (103,448.10)

5 9.45% 0.77 7.59% 9.45% (2.45%) (187,186.97)

Fair value (252,926.83)


2 (700,000) 0.970731707 (679,512.20 /2)

3 (700,000) 0.906350667 (634,445.47)

4 (700,000) 0.837388652 (586,172.06)

5 (700,000) 0.765112107 (535,578.48)

5 (10,000,000) 0.765112107 (7,651,121.07)

Present value (9,747,073)

2005 PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom) or, as the context requires, other member firms of PricewaterhouseCoopersInternational Limited, each of which is a separate and independent legal entity. Designed by studio ec4 17205 (01/05).

Excluding accrualsimproves the measure of hedge effectivenessin a fair value hedgerelationship


The previous example highlighted how ineffectiveness could be reduced by carefuldesignation of the hedge relationship to exclude accruals from the assessment ofhedge effectiveness. In that example, the fixed rate on the swap matched thedesignated proportion of fixed rate interest on the debt being hedged.

Additional ineffectiveness can arise where the interest rates do not move inaccordance with the rate implied by the forward rate.

Taking the same example, the cash flows on the fixed leg of the swap will continue to offset the designated proportion of fixed interest cash flows on the bond. However, if interest rates do not move in accordance with the rate implied by the forward rate(eg the 6 month rate for the period 18 months to 24 months is not 6.03%) the changein fair value of the bond principal will be calculated using current floating rates as thediscount factor, which are different to those priced within the existing floating leg of the swap at the last repricing date.

Consequently, when measuring effectiveness, if rates do not move in accordancewith forward rates, the floating leg of a swap may no longer perfectly offset thechange in fair value of the bond principal.

What techniques can be used to eliminate this source of ineffectiveness?

To fully eliminate this source of ineffectiveness would involve one of the following:

use of daily resetting swaps; or

align swap reset dates with hedge effectiveness test dates

Both of these mechanisms ensure that the swap rates within the hedge test takeaccount of movements that will impact the bond and allows greater matching thanexists on swaps which have longer or different reset dates. However, for manyentities, it will not always be practicable or desirable to adopt either of these strategies.

What alternative strategies are available to reduce this source of ineffectiveness?

Where neither of the above strategies are adopted, it will not be possible to removecompletely this source of ineffectiveness.

Where the extent of ineffectiveness is considered significant and risks underminingthe entire hedging relationship, one strategy is to use swaps with a frequent resetprofile (eg 3 monthly) to reduce the extent of the ineffectiveness arising.


Hedge ineffectiveness: addressing the issue of ineffectiveness arising from the floating leg of a swap ina fair value hedge of interest rate risk


Hedge design: interest rate swaps hedging floating rate debt

Common conceptual problems encountered in a cash flowhedge of interest rate risk

In this example, it is clear that the floating leg of the swap provides anatural offset to the libor portions of the floating interest cash flows onthe debt. However, it is more difficult to identify a natural offset withinthe debt for the fair value movements on the swap caused by the fixedleg of the swap.

To address this issue, it is necessary to clearly identify and designatethe hedged risk.


In order to create an effective hedge test, it is necessary to introduce a benchmark fixed rate against which to measure variability in cashflows on the debt.

In this example, the swap is designated as a cash flow hedge. Thelibor portion of the debt cash flows is designated as the hedged item.The hedged risk represents the variability of the designated liborportions of debt cash flows around a benchmark rate: this is definedas bondr. The benchmark rate selected is equal to the fixed rate ofthe swap, being 5%. This construction reflects the risk managementobjective of the hedging relationship; to swap a series of futurevariable cash flows back to a fixed rate.

Practical approach

This method of hedge construction enables entities to manageongoing tests of effectiveness by recording the bond as a notional ordummy swap within the treasury management and valuation systemsfor the purposes of automating hedge effectiveness calculations.

Retrospective effectiveness testing at the next reportingdate (ie 3 months)

Entity A is required to measure effectiveness, at a minimum, at eachreporting date.

Hedging instrument

The calculation of the change in fair value of the swap, excluding thepresent value of accrued interest, would be as follows:

Swap = swap t1 swap t0


Example:Entity A issues 10m 5 year bond paying 3 month libor plus 3% on 1 January 200X.

At the same time, Entity A transacts 10m notional swap to receive 3 month libor and pay 5%.

Net settlement and payment of interest will occur every 3 months on 1 April, 1 July, 1 October and 1 January each year.

At inception of the hedge relationship, the swap is contracted atmarket rates, and has a nil fair value, and the floating rate bond isworth par.

Careful selection of thehedge risk can improvethe measure ofaffectiveness andsimplify calculations

Benchmark fixed rate approach

Hedged item

The calculation of the change in fair value of the hedged item is thechange in the present value of the libor portions of the variable interestflows around the benchmark rate of 5%. Note that the present value of accrued interest cash flows is excluded from the calculation.

bondr = bond t1 bond t0

Effectiveness methodology

In this example, the relevant hedge effectiveness methodology beingapplied, both prospectively and retrospectively, is the dollar offset test.

Using the dollar offset methodology, hedge effectiveness is assessed as:

swap

bondr

With this construction of the hedge effectiveness test, the hedgerelationship is likely to be perfectly effective.

Conclusion

Careful selection of the hedged risk can improve the measure of effectiveness and also simplify calculations. When testing hedge effectiveness under IAS 39, the whole fair value movement on the swap should be taken into account. However, in a number of circumstances it may be appropriate to use clean prices whentesting effectiveness where this is consistent with the riskmanagement strategy of the entity.




One year later:The business cash flow profiles evolve and Group A wishes to re-profile a portion of the debt to bear floating rates of interest.

To achieve this objective, Group A transacts a 2 year 100m interest rate swap to receive-fixed and to pay-floating interest. This is swap 2.

Hedge design: using a portfolio of offsetting interest rate swaps in combination as the hedging instrument

Does this relationship qualify for hedge accounting under IAS 39?

Cash flow hedge accounting for such a swap is permitted, subject to satisfying hedge documentation and effectiveness criteria.

A diagram of the combined derivative instrument position is set out below.

+

100m

1 year passed

100m

Pay fixed,Recieve floating.9 years remaining

Swap 1

Pay fixed,Recieve floating

7 years

Economic End Position

Pay floating, recieve fixed2 years

Pay floating interest2 years

=

Example:Group As risk management policy is to hold fixed rate debt

Group A holds 100m floating rate debt

Group A transacts 10 year 100m interest rate swap to receive-floating and to pay-fixed interest. This is swap 1. The interest rate swap floating cash flows exactlymatch the timing and amount of debt floating interest flows.

What accounting strategies are available to Group A?

There are a number of common accounting strategies that may beapplied to this type of scenario. Set out below are two examples ofbasic accounting alternatives.

1) Do not hedge account Swap 2

Designate only Swap 1 as a cash flow hedge of the floating rate debt.Consider Swap 2 a trading instrument and do not apply hedgeaccounting. Volatility will arise in the profit and loss account as a resultof fair value movements on Swap 2 being recognised immediatelythrough the income statement.

2) Hedge de-designation and re-designation

By transacting Swap 2, Group A has changed the amount of hedge coverover 9 years of variable cash flows to 7 years of variable cash flows.

Group A therefore changes the portion of hedged exposure.

Group A first de-designates the existing hedge relationship (Swap 1),enters into a new interest rate swap to modify its position (Swap 2),and then re-designates the new combination of derivative instruments(Swap 1 plus Swap 2) as the hedging instrument of the portion of cashflows covering the latter seven years of underlying debt interest flows.

Periodic de-designation and re-designation of the cash flow hedgerelationship is permitted provided that such a mechanism of de-designation and re-designation is properly documented as part ofGroup As strategy and consistent with As risk management policy.

Assuming that the other hedge accounting criteria are met, theaccounting treatment at the date of de-designation and re-designationis as follows:

Cash flow hedge accounting may be applied to the original hedgerelationship for Swap 1 until the date of its de-designation;

Cash flow hedge accounting may be applied to the second hedgerelationship, which includes the combined impact of Swaps 1 and 2,starting from the date of re-designation and covering the entire termof the combined position;

The change in the fair value of the initial hedging instrument (Swap 1) that had been reported in equity remains in equity if theforecasted cash flows are still expected to occur. As the debt cashflows are contractual in nature, this requirement would be satisfied.

However, the change in the fair value of the initial hedging instrument(Swap 1) that had been reported in equity is reclassified into theincome statement if the forecasted transactions are no longerexpected to occur. This would be the case where Group A intends on repaying the debt prematurely.

Conclusion

The choice of strategy will depend upon, inter alia, the anticipatedvolatility arising on Swap 2. Where the anticipated volatility is forecastto be low, the first strategy of measuring Swap 2 as a tradinginstrument through the profit and loss account may be the preferredroute as it is likely to be easier to manage.

Where the anticipated volatility of Swap 2 is forecast to be significant,the ability to achieve hedge accounting may take priority and strategy2 may be the preferred route.

The de-designation/re-designation strategy will require sufficientdocumentation to support the de-designation/ re-designation process.Group A will also have to disclose in the financial statements theobjective of this hedging strategy and the corresponding policies,together with a discussion of the associated risks and the businessobjectives pursued.


The availability ofalternative accountingtreatments increases the importance ofperforming scenarioanalysis


Example:Entity A issues 1m 25 year mortgage receivingmonthly fixed interest of 5% on an annualised basisfor the first 5 years, and floating rates of interestthereafter.

At the same time, Entity A transacts a 5 year 1millionnotional swap to receive 1 month libor and pay 5%.

The asset is issued and the swap is entered into on 1 January 200X.

At inception of the hedge relationship, the swap has a zero fair value.

Hedge design: using an interest rate swap to hedge part of the hedged item (partial term hedge: Years 1-5)

Hedging only a portion of the time period to maturity of the hedged time

As with all hedge relationships, it is necessary to use the full timeperiod to maturity of the derivative. However, it is possible to hedgeonly a portion of the time period to maturity of the hedged item wherethis is clearly stated in the hedge documentation.


In order to create an effective hedge test in this example it is necessaryto state that the hedged risk is the fair value exposure of the fixedinterest flows until year 5 and the change in value of the principalpayment due at maturity, to the extent affected by changes in the yield curve relating to the five years of the swap.

In practical terms, the hedged item is implicitly split into two structures:the first structure is a five year fixed rate bond with repayment ofprincipal occurring on year five; the second structure is a twenty yearvariable rate bond with principal investment taking place in year five.

This construction reflects the risk management objective of thehedging relationship; to manage the fair value exposure associatedwith the five year yield curve.

Practical approach

This method of hedge construction enables entities to manageongoing tests of effectiveness by recording the asset as a notional ordummy five year bond within the treasury management and valuationsystems, for the purposes of automating hedge effectivenesscalculations.

Retrospective effectiveness testing at the next reporting date


Hedging instrument

Calculate the change in fair value of the swap, excluding the presentvalue of accrued interest.

swap = swap t1 swap t0

Hypothetical bond approach

Hedged item

Entity A should identify the specific cash flows that are being hedgedfor the purpose of hedge designation. These may be defined as thefixed coupon cash flows on the bond in the first five years and 100%of the deemed principal repayment at the end of year 5.

The change in fair value of the defined bond is calculated bydiscounting the cash flows, including a notional repayment of theprincipal after five years, using the five-year rate as only the first fiveyears of the bond have been designated as hedged: this is definedas bondr. Note that the present value of accrued interest cash flowsis excluded from the calculation.



In this example, the relevant hedge effectiveness methodology beingapplied both prospectively and retrospectively is the dollar offset test.


swap

bondr

With this construction of the hedge effectiveness test, the hedgerelationship is likely to be highly effective.

Conclusion

Careful selection of the hedged risk and designation of the hedgeditem can improve the measure of effectiveness and simplify calculations.

When testing for hedging effectiveness under IAS 39, the whole fairvalue movement on the swap should be taken into account. However,in a number of circumstances it may be appropriate to use cleanprices when testing effectiveness where this is consistent with the riskmanagement strategy of the entity.

In practice, quarterly interest rate swaps may also be used. However,these are likely to introduce ineffectiveness into the hedge relationshipdue to mismatch of cash flows. In addition, swaps that reprice ondates that differ from the hedge effectiveness test date will alsointroduce ineffectiveness into the hedge relationship as explained inthe example titled: Addressing the issue of ineffectiveness arising fromthe floating leg of a swap in a fair value hedge of interest rate risk.



Hedging only a portion of the time period to maturity of the hedged item

As with all hedge relationships, it is necessary to use the full timeperiod to maturity of the derivative. However, it is possible to hedgeonly a portion of the time period to maturity of the hedged item wherethis is clearly stated in the hedge documentation and provided thathedge effectiveness can be measured.


In this example, the objective of the hedge relationship is to lock intodays (1 Jan Year 1) forward five year yield curve as applicable inYear 6 for the period through to Year 10.

In order to create an effective hedge test, it is necessary to view theswap as though it was hedging a forward starting 5 year bond yieldcurve as applicable in Year 6 ie to offset changes in the fair value ofthe bond to be issued at the start of Year 6, maturing at the end ofYear 10, due to the changes in interest rates applicable for the period(Years 6 10): this is defined as bondr.

In practical terms, it is necessary to construct the hedge relationshipas though the debt comprises two elements: the first element maturesat the end of Year 5 and is simultaneously reissued at the start of Year6 to mature at the end of Year 10.

This construction reflects the risk management objective of thehedging relationship ie to manage the fair value exposure associatedwith the designated five year yield curve.


Example:Entity A issues a 5% fixed rate debt instrument with a term to maturity of 10 years.

Entity A measures the debt at amortised cost.

Entity A believes that interest rates will decline during years 6 10 of the debtsterm and wishes to hedge its exposure for only that 5 year period.

Consequently, Entity A acquires a forward starting five year receive fixed, payfloating interest rate swap, commencing in five years time with a notional amountequal to the debt principal.

The diagram below sets out the cash flows on the debt and the associated swap.

Hedge design: using an interest rate swap to hedge part of the hedged item (partial term hedge: Years 6-10)

Swap

Debt

1 6Time (years)

10

Pay fixed interest 5%Repay 100m

Recieve fixed 5%, Pay floating

100m notional principal

Hypothetical bond approach


Practical approach

This method of hedge construction enables entities to manageongoing tests of effectiveness by recording the asset as a notional ordummy five year bond (Year 6 10) within the treasury managementand valuation systems for the purposes of automating hedgeeffectiveness calculations

Retrospective effectiveness testing at the next reporting date


Hedging instrument

The change in fair value of the swap is calculated, excluding thepresent value of accrued interest. This is defined as swap.

swap = swap t1 swap t0

Hedged item

Entity A should identify the specific cash flows that are being hedgedfor the purpose of hedge designation.

These may be defined as the fixed coupon cash flows on the bond inyears 6-10 and 100% of the deemed principal investment at the startof year 6 and repayment at the end of year 10. Note that the presentvalue of accrued interest cash flows is excluded from the calculation.



In this example, the relevant hedge effectiveness methodology beingapplied, both prospectively and retrospectively, is the dollar offset test.


swap

bondr

With this construction of the hedge effectiveness test, the hedgerelationship is likely to be highly effective.

Conclusion

Careful selection of the hedged risk and designation of the hedgeditem can improve the measure of effectiveness and simplifycalculations.

When testing for hedging effectiveness under IAS 39, the whole fairvalue movement of the swap should be taken into account. However,in a number of circumstances it may be appropriate to use cleanprices when testing effectiveness where this is consistent with the risk management strategy of the entity.

In addition, swaps that reprice on dates that differ from the hedgeeffectiveness test date will also introduce ineffectiveness into thehedge relationship as explained in the example titled: Addressing theissue of ineffectiveness arising from the floating leg of a swap in a fairvalue hedge of interest rate risk.




Hedging foreign exchange risk

Identification of the hedged item

In this example, the hedged item is identified as the highly probable forecast sale of FC 15 million expected to take place on 28 July 200X.

Construction of the hedge test

Entity A is required to measure effectiveness, at a minimum, at each reporting date. In this example, the test date is 1 March 200X and the relevant hedge effectivenessmethodology being applied, both prospectively and retrospectively, is the dollar offset test.

Hedge design: hedging a single forecast currency sale cash flow


In this example, the forward contract is designated as a cash flow hedge.

In order to create an effective hedge test, it isnecessary to select a benchmark rate against which tomeasure variability in cash flow of the hedged item.

The hedged risk is documented as the variability offoreign currency cash flow relative to Entity As functionalcurrency: this is defined as hedged itemr. As Entity Abases its assessment of hedge effectiveness andmeasure of ineffectiveness on changes in forwardprices, the benchmark exchange rate selected is theforward GBP/FC exchange rate at date of hedgedesignation. In this example, the benchmark rateselected would be GBP1:FC30, which equates toGBP0.5million.

Where perfectly hedged, the benchmark fixed rate isthe same as the actual derivative terms.

This construction reflects the risk managementobjective of the hedging relationship ie to swap a futurevariable cash flow back into a fixed amount of sterling.


Example:Entity A has a sterling functional currency

Entity A forecasts a highly probable foreign currency sale of foreign currency (FC)15million due to be received on 28 July 200X. In accordance with its authorisedtreasury strategy, Entity A transacts a foreign currency forward contract to sell FC 15million and buy GBP 0.5million on 28 July 200X.

At inception of the hedge relationship, the foreign currency contract has a zero fair value.

Benchmark fixed rate approach

Derivative Days to Sell FC Forward Buy GBP Fair value millionmaturity million rate million

Inception 209 15.0 30 0.5m 0

1 March 0X 150 15.0 35 0.428m 0.072

Hedged item Days to Receive FC Rate GBP Fair value millionmaturity million million

Inception 209 15.0 30 (0.5 m) 0

1 March 200X 150 15.0 35 (0.428m) (0.072)

Benchmark rate

Forward rate


Construction of the hedge test

Entity A is required to measure effectiveness, at a minimum, at eachreporting date. In this example, the test date is 1 March 200X and therelevant hedge effectiveness methodology being applied, bothprospectively and retrospectively, is the dollar offset test.


derivative=

0.072 = -100%

hedged itemr (0.072)


Conclusion

Careful selection of the hedged risk and designation of the hedged item can improve the measure of effectiveness and simplify calculations.


Hedge design: hedging forecast currency sales over a period of time

Identification of the hedged item

For cash flow hedges, the forecast transaction must be highlyprobable. It is possible to determine the level of sales that meet thisrequirement based on past experience.

Construction of the hedge effectiveness test and designation of the hedged risk


There are a number of hedge accounting strategies that may beapplied to this type of scenario

hedge effectiveness 2

Documents

comparison of ifrs

ifrs measurement checklist

ifrs readiness survey

fair value hedge accounting

ifrs disclosure checklist

ifrs pocket guide

accounting designations

acquisitions accounting