Practical guide on general hedge accounting Dec 2013 | Page 12

Practical guide

into a USD:EUR forward. As long as the HKD remains pegged to the USD, using a USD derivative as a hedging
instrument will provide an economic hedge of the forecast HKD purchase.
The peg ratio is HKD7.8:USD1. However, even though it is pegged, it is not completely fixed (as the HKD is
allowed to trade within the narrow range of HKD7.75 to 7.85). Since the range is very small, the entity is willing
to accept this risk, so it enters into a forward contract for USD1 million (HKD7.8 million).
Rebalancing is not required where ineffectiveness arises merely because of fluctuations in exchange rates within
the narrow trading range around the hedge ratio.
Rebalancing required
Consider the facts of the previous example, but assume that the exchange rate HKD:USD is re-pegged to, say,
HKD7.2:USD1. If the derivative continues to be for USD1 million, the hedge ratio will no longer reflect the
relationship between the hedging instrument and hedged item, and so will result in mandatory rebalancing.
Rebalancing should reflect the entity’s risk management strategy, which could either be reducing the hedged
item to HKD7.2 million of the forecast purchase of HKD7.8 million, or increasing its hedging instrument by
buying another derivative to cover the remaining HKD600,000 of the hedged item.
Rebalancing not applicable
Continuing the above example, assume that sometime after the inception of the hedge, the peg between HKD
and USD is removed, such that the currency exchange rate is floating (instead of pegged) within a very broad
range such that now it is not possible to demonstrate that an economic correlation exists between the two
currencies. In this situation, a change in the hedge ratio would not be applicable, since this may not ensure that
the hedging relationship continues to meet that hedge effectiveness requirement. Accordingly, the hedge cannot
be rebalanced but may need to be discontinued (see section 3.4 below).
PwC insight:
Originally, the requirement to rebalance was seen as onerous, but it might actually be a pragmatic solution
that avoids discontinuing hedging relationships that would have failed the effectiveness test in the past. In
practice, entities will not need to rebalance very often if they have a good risk management strategy in place
and the economic relationship is stable. There is always some volatility in any hedging relationship but, if the
initial hedge ratio is appropriate and in line with the risk management strategy, rebalancing should only be
necessary if the ‘ideal’ hedge ratio changes significantly. Entities should document their tolerance to
such var