Accounting for Derivatives. Ramirez Juan

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      The three hedge effectiveness requirements are as follows:

      The first effectiveness requirement means that the hedging instrument and the hedged item must be expected to move in opposite directions as a result of a change in the hedged risk (i.e., there is an economic relationship and not just statistical correlation). For example, it would be possible to hedge a West Texas Intermediate (WTI) crude oil exposure using a Brent crude oil forward instrument. A perfect correlation between the hedged item and the hedging instrument is not required and, indeed, would not be sufficient on its own.

      The second requirement indicates that the impact of changes in credit risk should not be of a magnitude such that it dominates the value changes, even if there is an economic relationship between the hedged item and hedging derivative. This implies that when the creditworthiness of the entity or the counterparty to the hedging instrument notably deteriorates, the hedging relationship may not qualify for hedge accounting going forward because the change in the credit risk may be the largest factor affecting the hedging instrument's fair value change.

      The third requirement indicates that the actual hedge ratio used for accounting should be the same as that used for risk management purposes, unless the ratio is inconsistent with the purpose of hedge accounting. IFRS 9 tries to avoid deliberate underhedging, either to minimise recognition of ineffectiveness in cash flow hedges or the creation of additional fair value adjustments to the hedged item in fair value hedges.

      IFRS 9 does not define the term hedge ratio, but I have assumed throughout this book that it is the designated amount (i.e., notional) of the hedged item compared with the designated amount (i.e., notional) of the hedging instrument within the hedging relationship (alternatively, it may be defined the other way around).

      In most simple hedges, where the underlyings of the hedging instrument and the hedged item match, the hedge ratio is 1:1. For example, a highly probable forecast sale denominated in USD of an entity whose functional currency is the EUR hedged with a EUR–USD FX forward will result in a 1:1 hedge ratio.

      In other hedging relationships the hedge ratio may differ from 1:1, especially where the underlyings of the hedged item and the hedging instrument differ. This is the case where there is an underlying for which its market is notably more liquid than that of the hedged item underlying, and both underlyings are highly correlated (a “proxy hedge”). For example, an entity whose functional currency is the EUR may decide to hedge a highly probable forecast sale denominated in Norwegian krone (NOK) with a more liquid Swedish krona (SEK) proxy: a SEK–EUR FX option. The entity may decide that 1 NOK is best hedged with 0.94 SEK, and as a result, the hedge ratio is set at 1:0.94. Such an assessment is usually made by considering historical and current market data for the hedged item and hedging instrument where possible, taking into account their relative performance in the past.

2.6.3 Effectiveness Assessment

Periodically the entity shall assess whether the hedging relationship meets the hedge effectiveness requirements – hedge effectiveness assessment. This assessment is probably the most operationally challenging aspect of applying hedge accounting. At a minimum, whichever comes first, IFRS 9 requires that hedge effectiveness be evaluated (see Figure 2.7):

      • at the inception of the hedge;

      • at each reporting date, including interim financial statements; and

      • upon a significant change in the circumstances affecting the hedge effectiveness requirements.

Figure 2.7 Frequency of hedge effectiveness assessments.

      Each effectiveness assessment relates to future expectations about hedge effectiveness and is therefore only forward-looking.

2.6.4 Effectiveness Assessment Methods

      One of the effectiveness requirements is that an economic relationship exists between the hedging instrument and the hedged item, or in other words, that the hedging instrument and the hedged item have values that will generally move in opposite directions. IFRS 9 does not specify a method for assessing whether an economic relationship exists between a hedging instrument and a hedged item. However, an entity shall use a method that captures the relevant characteristics of the hedging relationship, including its sources of hedge ineffectiveness.

      IFRS 9 states that an entity's risk management is the main source of information to perform the assessment of whether a hedging relationship meets the hedge effectiveness requirements. This means that the management information (or analysis) used for decision-making purposes can constitute a basis for assessing whether a hedging relationship meets the hedge effectiveness requirements.

      The effectiveness requirement of an existence of an economic relationship between the hedged item and the hedging instrument (the “economic relationship requirement”) is commonly assessed by applying one of the following methods:

      • The critical terms method. This is a qualitative method (i.e., no numerical analysis is performed).

      • The simple scenario analysis method: assessing how the hedging relationship would behave under various future scenarios. This is a quantitative method.

      • The linear regression method: assessing, using historical information, how the hedging relationship would have behaved if it had been entered into in the past. This is a quantitative method.

      • The Monte Carlo simulation method: assessing how the hedging relationship would behave under a large number of future scenarios. This is a quantitative method.

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