Practical guide on general hedge accounting Dec 2013

Practical guide hedging, because the designation for hedge accounting purposes is on a gross position basis, even though risk management typically uses a net position basis. Corporates refer to proxy hedging where for example they hedge commodity price risk but as a result of the availability of commodity derivatives, entities use a hedging instrument referenced to a commodity different to the actual commodity they are economically hedging (for example, jet fuel as compared to Brent oil), but the price of the two commodities are correlated enough to make the hedge relationship work. In addition, some financial institutions use intragroup derivatives for risk management purposes. However, as intragroup derivatives do not qualify for hedge accounting, they are required to define external derivatives as proxy hedges. 3.3.2. Credit risk Even if there is an economic relationship, a change in the credit risk of the hedging instrument or the hedged item must not be of such magnitude that it dominates the value changes that result from that economic relationship. Because the hedge accounting model is based on a general notion of there being an offset between the changes of the hedging instrument and those of the hedged item, the effect of credit risk must not dominate the value changes associated with the hedged risk; otherwise, the level of offset might become erratic. For example, where an entity wants to hedge its forecast inventory purchases for commodity price risk, it enters into a derivative contract with Bank X to purchase a commodity at a fixed price and at a future date. If the derivative contract is uncollateralised and Bank X experiences a severe deterioration in its credit standing, the effect arising from changes in credit risk might have a disproportionate effect on the change in the fair value of the derivative contract arising from changes in commodity prices; whereas the changes in the value of the hedged item (forecast inventory purchases) would depend largely on the commodity price changes and would not be affected by the changes in the credit risk of Bank X. PwC insight: IFRS 9 does not provide a definition of ‘dominate’. However, it is clear that the effect of credit risk should be considered on both the hedging instrument and the hedged item. For example, an entity hedging the interest rate or foreign currency risk of a financial asset (such as a bond) will need to look at the credit risk of the bond. If the bond has high credit risk, the bond might not qualify for hedge accounting. During the financial crisis, there were many situations where entities purchased loans to troubled financial institutions, and the amount that would ultimately be realised was very uncertain. These might not have qualified for hedge accounting. Currently changes to regulations relating to derivatives in different countries have been or are in the process of being introduced. One of the main objectives of these changes is to mitigate credit risk and it is expected they will result in more collateralised derivatives. Once these regulations start being effective, this hedge effectiveness requirement is less likely to be a problem. 3.3.3. Hedge ratio The hedge ratio is defined as the relationship between the quantity of the hedging instrument and the quantity of the hedged item in terms of their relative weighting. IFRS 9 requires that the hedge ratio used for hedge accounting purposes should be the same as that used for risk management purposes. One of the key objectives in IFRS 9 is to align hedge accounting with risk management objectives. There is no retrospective effectiveness testing required under IFRS 9, but there is a requirement to make an on-going assessment of whether the hedge continues to meet the hedge effectiveness criteria, including that the hedge ratio remains appropriate. This means that entities will have to ensure that the hedge ratio is aligned with that required by their economic hedging strategy (or risk management strategy). A deliberate imbalance is not permitted. This requirement is to ensure that entities do not introduce a mismatch of weightings between the hedged item and the hedging General hedge accounting PwC  8

Practical guide on general hedge accounting Dec 2013 | Page 10