Hedging is a risk management
strategy designed to mitigate the impact of economic risks on
a bank's performance. Many banks will engage in hedging
activity to limit economic risk. IFRS provide for special
accounting treatment for economic hedges, provided that
certain criteria are met. Some of the strategies that banks
use under other GAAPs to hedge risks may need to be revised in
order to meet the IFRS criteria for hedge
accounting.
Hedge accounting means designating a
hedging instrument, normally a derivative, as an offset to
changes in the fair value or cash flows of a hedged item.
Non-derivative financial instruments may be used as hedging
instruments in certain limited circumstances . A hedged
item can be an asset, liability, firm commitment, or
forecasted future transaction that is exposed to a risk of
change in value or changes in future cash flows [IAS39.10] or
a portfolio of similar assets and liabilities. Hedge
accounting matches the offsetting effects of the fair value
changes in hedged items and hedging instruments and recognises
them in net profit or loss at the same time.
The
normal rules for financial instruments call for all
derivatives to be carried at fair value with gains and losses
in the income statement . Hedge
accounting allows departures from the normal recognition
rules. Accounting rules for hedging are necessary to reflect
the economics of hedging relationships in reporting
performance. A bank using hedge accounting can impact on the
timing of recognition of gains and losses from fair value
changes in hedged items and hedging instruments, and avoid the
significant volatility that might arise if the gains and
losses were recognised in the income statement under normal
accounting rules.
Hedge accounting is an exception
to the usual rules for financial instruments; there are strict
criteria that must be met before it can be used. Management
must identify, document and test the effectiveness of those
transactions for which it wishes to achieve hedge accounting.
The requirements are [IAS39.142]:
a)
The hedged item and the hedging instrument
are specifically identified;
b)
The hedging relationship is formally
documented ;
c)
The documentation of the hedged
relationship must identify the hedged risk and how the
hedge's effectiveness will be assessed;
d)
At the inception of the hedge, it must be
expected to be highly effective; that is, the gains and
losses on the hedged item and the hedging instrument
should almost fully offset over the hedge's life ;
e)
Retrospective effectiveness of the hedge
must be tested regularly throughout its life.
Effectiveness should fall within a range of 80 to 125%
over its life. This leaves some scope for short-term
ineffectiveness, provided that overall effectiveness
falls within this range ;
f)
A hedge must be capable of being
designated against specific assets and liabilities.
Therefore if hedges are established for net positions,
it must be possible to trace them back to the underlying
gross asset, liability or forecast transactions ;
and
f)
Hedges of forecast transactions are
allowed if the forecast transaction is 'highly
probable'.
The criteria to
achieve hedge accounting are onerous and have significant
systems implications for banks because of the volume of
derivatives used to hedge economic exposures. Management
should always consider the relative costs and benefits of
using hedge accounting.
Hedge accounting can be applied to
qualifying hedged items. A hedged item must create an exposure
to risk that could affect the income statement, currently or
in future periods. The usual types of risks that are hedged
include interest-rate risk, foreign currency risk, credit risk
and equity-price risk .
Macro hedging - that is, hedging the open position
arising from a number of similar hedged items - does not meet
the requirements for hedge accounting [IAS39.131,132]. Hedge
accounting for hedges of net open positions is not permitted
[IAS39.133] [IGC127-1] .
Any financial asset or liability that creates exposure
to risk can be a hedged item, with two specific exclusions.
Held-to-maturity investments cannot be hedged items for
interest-rate risk, nor in consolidated financial statements
can any investments that the bank has in subsidiaries or
associates that are consolidated or measured using the equity
method [IAS39.127] [IGC172-2] [IAS39.150]. However, the net
investment in a foreign entity can be hedged. Some examples of
exposures that can be hedged are:
a)
originated loans (risk of changes in
interest rates);
b)
fixed-interest debt security classified as
available-for-sale (risk of changes in interest rates or
credit risk);
c)
foreign currency monetary items (risk of
changes in foreign exchange
rate).
An exposure to
general business risks cannot be hedged, including risk of
obsolescence of trading systems, risk of decline in depositor
base or the risk of systems failure, because these risks
cannot be reliably measured. For similar reasons, a commitment
to acquire another entity in a business combination cannot be
a hedged item, other than for foreign exchange risk
[IAS39.135].
Only an external derivative
instrument can be used as a hedging instrument in most cases
[IAS39.134]. An external non-derivative financial instrument
can be used as a hedging instrument only for foreign currency
risk [IAS39.122]. A foreign currency borrowing, for example,
can be designated as a hedge of a net investment in a foreign
entity.
Banks with complex group balance
sheet management operations will often use intra-group
derivatives to manage currency and interest-rate risk across
the bank. Intra-group derivatives are not external derivative
instruments, and must be eliminated on consolidation
[IAS39.134].
The group balance sheet management
function may net all of the foreign currency exposures and
enter into a single external derivative transaction. The
external derivative may qualify for hedge accounting provided
all the other standard criteria are met [IAS39.139].
Netting of internal positions relating to
interest-rate risk with a single external derivative
instrument used to hedge risk does not qualify for hedge
accounting [IGC134-1(a)]. The external derivative must be
designated as the hedging instrument. A gross position,
similar in amount and timing to the net position, is
designated as the hedged item at the group level [IAS39.133].
A single derivative with several elements, such as a
cross-currency interest-rate swap, can be designated as a
hedge of separate risks, provided that the individual
components designated as hedging each risk meet the hedge
accounting criteria [IAS39.131] [IGC131-2].
IFRS recognise three types of
hedge accounting: fair value hedges, cash flow hedges and
hedges of the net investment in a foreign entity [IAS39.137].
Each has specific requirements on accounting for the fair
value changes.
Fair value
hedges
The risk being hedged in a fair value hedge
is a change in the fair value of an asset or liability that
will affect the income statement [IAS39.138]. Changes in fair
value might arise through changes in interest rates in
relation to fixed-rate components of a mortgage, changes in
the credit spread on a fixed-rate loan or from changes in
prices of equity investments classified as available-for-sale
. The
impact on the income statement can be immediate or expected to
happen in future periods. An available-for-sale equity
security, where gains and losses are deferred in equity, would
impact on the income statement when sold.
The hedged
asset or liability is adjusted for fair value changes due to
the risk being hedged, and those fair value changes are
recognised in the income statement [IAS39.153(b)]. The hedging
instrument is measured at fair value with all changes
recognised in the income statement [IAS39.153(a)].
Ineffectiveness is therefore taken to the income statement to
the extent that the adjustment to the hedged item does not
offset the change in fair value of the hedging instrument . Examples
of fair value hedges might be an interest-rate swap hedging a
fixed-rate loan .
Cash flow hedges
The
risk being hedged is the potential volatility in future cash
flows that will affect the income statement. Future cash flows
might relate to existing assets and liabilities such as future
interest payments or receipts on floating-rate loans advanced
to customers. Future cash flows can also relate to highly
probable future transactions such as hedging of mortgage
pipeline sales or purchases in a foreign currency [IAS39.137]
. Potential
volatility might also result from changes in interest rates,
changes in exchange rates or changes in commodity prices. Many
fair value hedges can also be designated as cash flow hedges
of different items, but to qualify they must include an
exposure to variability in cash flows as a result of the item
being hedged. Hedges of firm commitments are cash flow
hedges.
Changes in the hedging instrument's fair value
, to the extent that the hedge is effective, are deferred in a
'hedging reserve' in equity [IAS39.158(a)] [IAS1.86(b)] and
recycled to the income statement when the hedged transaction
affects the income statement [IAS39.162]. Fair value changes
from cash flow hedges that relate to firm commitments or
forecast transactions, and result in the recognition of assets
or liabilities, are included in the initial measurement of
those assets or liabilities [IAS39.160].
An example of
a common cash flow hedge is the use of an interest-rate swap
converting a floating-rate loan to fixed-rate .
Hedge of net investment in a foreign
entity
A bank may have subsidiaries that meet the
test and qualify for treatment as foreign entities of the
parent. Exchange differences arising on consolidation are
deferred in equity until the subsidiary is disposed of
[IAS21.17]. On disposal or liquidation, the differences are
recognised in the income statement as part of the gain or loss
on disposal [IAS21.37,38]. The net investment in a subsidiary
can be hedged with a foreign currency borrowing or a
derivative. The fair value changes of the hedging instrument,
if effective, are deferred in equity until the subsidiary is
disposed of, when they become part of the gain or loss on
disposal [IAS21.19].
The hedging instrument for a net
investment hedge, in order to be effective, will almost always
be denominated in the foreign entity's local currency .
Hedges must be expected to be
highly effective at designation to qualify for hedge
accounting. A hedge can be expected to be highly effective
when the changes in fair value or cash flows of the hedged
item and the hedging instrument are expected to almost fully
offset each other (after eliminating the changes in fair value
or cash flows of the hedged item that arise due to risks that
are not being hedged) [IAS39.146] .
The standard gives rise to two
separate effectiveness requirements. First, at inception of
the hedge, the hedging relationship must be shown to be
effective on a prospective basis; that is, the hedge is
expected to be effective. The level of effectiveness required
for prospective effectiveness in IAS 39 is that the risks are
"almost fully offset". No numerical range has been formally
given as meeting the "almost fully offset" criteria. However,
the changes in the value or cashflows of the hedged item are
expected to be at least between 95% and 105% of the changes in
value or cashflows of the hedging instrument.
The
effectiveness over the life of the hedge must then be shown
retrospectively to be within 80% to 125% for the hedge to
continue to be considered effective and for hedge accounting
to continue [IAS39.146].
When a hedge fails the
effectiveness test, hedge accounting is discontinued
prospectively [IAS39.156,163,165].
Hedges are seldom,
if ever, perfectly effective. Any hedge ineffectiveness, even
if the hedge continues to be considered effective overall,
must be recognised in income in the current period. Hedge
ineffectiveness can arise for a number of reasons; the hedged
item and the hedging instrument may:
a)
Have different maturities;
b)
Use different underlying interest or
equity indices;
c)
Use commodity prices in different markets;
or
c)
Be subject to different counter-party
risks.
Careful
definition of the hedged risk and the components of the
hedging instrument are the best ways to improve hedge
effectiveness .
Hedge accounting should cease
prospectively when any of the following occurs
[IAS39.156,163,165]:
a)
A hedge fails the effectiveness
tests;
b)
The hedged item is settled;
c)
The hedging instrument is sold, terminated
or exercised;
d)
Management decides to change the
designation; or
e)
For a cash flow hedge the forecast
transaction is no longer highly probable.
Hedge accounting ceases
prospectively from the beginning of the period in which the
hedge effectiveness test is failed. All further fair value
changes in a derivative hedging instrument are recognised in
the income statement. Future changes in the fair value of the
hedged item, and any non-derivative hedging instruments, are
accounted for as they would be absent hedge
accounting.
Gains and losses arising on cash flow
hedges from the effective period will remain in equity until
the related cash flows occur. Where a forecast transaction is
no longer highly probable but still expected to take place,
previous gains continue to be deferred. However, once a
forecast transaction is no longer expected to occur, any gain
or loss is released immediately to the income statement
[IAS39.163] .
The presentation and disclosure
requirements for financial instruments, including hedging, are
extensive and detailed. Some of the specific and significant
disclosures for hedging are [IAS39.169]:
a)
a description of the entity's financial
risk management policies and objectives, including its
policy for hedging each major type of forecast
transaction ;
b)
for each category of hedge (fair value,
cash flow and net investment):
-
a description of the hedge,
-
the hedging instruments used,
-
the risks being hedged,
-
the fair values of the hedging
instruments at the balance sheet date,
-
the periods in which forecasted
transactions are expected to occur and when they
are expected to impact on the income statement,
and
-
a description of any forecasted
transaction that is no longer expected to occur
but for which hedge accounting had previously been
used .
c)
If gains or losses have been recognised on
hedging instruments and included in equity, disclose the
following in the statement of changes in equity:
e)
For a cash flow hedge the forecast
transaction is no longer highly probable.
-
the amount that was recognised in
equity in the current period,
-
the amount removed from equity and
recognised in the income statement in the current
period, and
-
the amount removed from equity and
included in the initial carrying amount of assets
or liabilities in the current period .
