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Over the past decades, banks significantly increased their efforts to implement adequate frameworks for managing interest rate risk in the banking book (IRRBB). These efforts typically focus
Find out moreDerivatives are often used to mitigate or offset risks (such as interest or currency risk) that arise from corporate activities. The standard accounting treatment for hedge instruments is that changes in fair value will have to be recorded in Profit and Loss (P&L). As opposed to the hedge instruments, the hedged assets or liabilities are often measured at (amortized) cost or fair value through equity, or are forecasted items which are not recognized in the Balance Sheet.
The aim of hedging is to mitigate the impact of non-controllable risks on the performance of an entity. Common risks are foreign exchange risk, interest rate risk, equity price risk, commodity price risk and credit risk.
The hedge can be executed through financial transactions. Examples in which hedging is used include:
There are three types of hedge accounting: fair value hedges, cash flow hedges and hedges of the net investment in a foreign operation.
Under the accounting standard IAS 39, all derivatives are recorded at fair value in the income statement. However these derivatives are often used to hedge recognized assets and liabilities, which are recorded at amortized cost or forecasted transactions that are not yet recognized on the Balance Sheet yet. The difference between the fair value measurement for the derivative and the amortized cost for the asset/liability leads to a mismatch in the timing of income statement recognition.
Hedge accounting seeks to correct this mismatch by changing the timing recognition in the income statement. Fair value hedge accounting treatment will accelerate the recognition of gains or losses on the hedged item into the P&L, whereas cash flow hedge accounting and net investment hedge accounting will defer the gains or losses on the hedge instrument.
The hedge relation consists of a hedged item and a hedge instrument. A hedged item exposes the entity to the risk of changes in fair value or future cash flows that could affect the income statement currently or in the future. For example, a hedged item could be a loan in which the entity is paying a floating rate (e.g., Euribor 6 month + spread) to a counterparty.
If the hedge instrument is a derivative, it can be designated entirely or as a proportion as a hedging instrument. Even a portfolio of derivatives can be jointly designated as a hedge instrument. The hedge instrument can be a swap in which the entity is receiving a floating rate and paying a fixed rate. With this relation the entity is offsetting the floating rate payments and will only pay the fixed rate.
Hedge accounting is an exception to the usual accounting principles, thus it has to meet several criteria:
Complying with IAS 39 requires two types of effectiveness tests:
Both tests need to be highly effective at the start of the hedge. A prospective test is highly effective if, at the inception of the hedge relation and during the period for which the hedge relation is designated, the expected changes in fair value of cash flows are offset. Meaning that during the life of the hedge relation, the change in fair value (due to change in the market conditions) of the hedged item should be offset by the change in fair value of the hedged instrument.
A retrospective test is highly effective if the actual results of the hedge are within the range 80%-125%.
IAS 39 does not specify a single method for the calculation of the effectiveness of the hedge. The method used depends on the risk management strategy. The most common methods are:
A hedge relation has to be terminated going forward when any of the following occur:
Please note that these requirements described previously may change as the IASB is currently working to replace IAS39 by IFRS9 (new qualification of hedging instruments, hedged items, hedge effectiveness…)
Hedge accounting is a complex process involving numerous and technical requirements with the objective to avoid temporary undesired volatility in P&L. This volatility is the result of valuation and or timing mismatch between the hedged item and the hedge instrument. If you are considering hedge accounting, we have a dedicated team on the valuation desk. We can offer advices on the calculation of the market values of the underlying risks and the hedge instruments, as well as setting up the hedge relation, preparing documentation and helping on the accounting treatment of the results.
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