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Navigating intercompany financing in 2024
In January 2022, the OECD incorporated Chapter X to the latest edition of their Transfer Pricing Guidelines, a pivotal step in regulating financial transactions globally. This addition
Find out moreThe aim of the DRM model is to tie together hedge accounting with risk management strategy so that an entity’s effort to mitigate interest rate risk is better reflected within their financial statement.
In the second instalment of the Zanders series on the DRM model, the Risk Management Strategy (“RMS”) and the DRM process are introduced and with it the new concepts that the IASB have established. The RMS sets out how an entity will manage its interest rate risk, which is the basis of every other part of the DRM model. The IASB has laid out the following expectations for a company’s RMS1:
Changes to the RMS that result in a change in the target profile (“TP”), lead to a discontinuation of the hedge2. The IASB will further deliberate on when the discontinuation occurs and whether such changes lead to discontinuation of the model at a future date3.
The overall aim of the model is to compare the target profile (“TP”) with the current net open positions (“CNOP”) and thereby produce a risk mitigation intention (“RMI”), which represents the amount of risk that the entity intends to mitigate through the use of designated derivatives. The IASB has tentatively decided that each separate currency should have its own DRM model.
Below a figure of the DRM process can be found that shows how the different components of the model relate to each other. In the following sections a detailed explanation will be provided for each of these elements.
Figure 1: DRM process
As part of the RMS the entity is required to define the target risk metric. The company cannot change this metric for each period and must stick to the metric specified within the RMS. However, the RMS can specify the use of a different metric over different future time horizons. E.g. the company’s RMS could be to stabilise NII for the first three years on notional exposure and then the present value using PV01 for the following years.
The first step in implementing the model is to decide on the assets and liabilities that should be hedged through the DRM framework. The eligible assets and liabilities are currently:
Furthermore, the IASB has imposed the following criteria on the eligible assets/liabilities that can be designated in the CNOP4, 5; an asset/liability is only eligible if all the criteria are met:
No. | Eligibility criteria for the Assets/Liabilities as hedged items |
1 | The effect of credit risk does not dominate the changes in expected future cashflows. |
2 | Future transactions must be highly probable except in the case of transactions that are the reinvestment or refinancing of existing financial assets/liabilities6. |
3 | Items already designated in a hedge accounting relationship are not eligible. |
4 | Items must be managed on a portfolio basis for interest rate risk management purposes. |
Table 2: Criteria for Assets & Liabilities
An asset/liability is eligible for the CNOP if all the above criteria are met. The IASB has explored other eligible assets/liabilities and have concluded that assets/liabilities that are FVOCI7 are recommended to be eligible while the ones that are FVPL8 were not recommended to be eligible. Equity was deemed not to be eligible for designation in the CNOP. Since the DRM model is still under review, the eligible assets/liabilities could change before the draft is finalised. Therefore, we advise companies to stay up to date with the latest information.
The Target Profile (TP) is linked to a company’s RMS. It sets the risk limits on the CNOP, before risk mitigation actions can be initiated. When the company assesses the risk over different time buckets, it needs to be consistent with the company’s RMS. All of this should be clearly documented within the company’s RMS. The TP should be set at the time when the hedge relationship is designated. The company can also take action to mitigate risks even before the limits are breached. Stakeholders have raised concerns regarding the granularity for the TP. Therefore, the IASB will conduct further research in this area to identify a common principle to be used universally for the allocation of risk limits for the TP.9
The Risk Mitigation Intention (RMI) is a calculated metric based on the company's efforts, through the use of derivatives, to reduce its CNOP for each period to align with the TP outlined in the RMS. Once the RMI is set, it cannot be changed retrospectively. When an entity is deciding on its RMI the following should be considered10:
Stakeholders have been concerned that they may not be able to faithfully mitigate the risk with market traded instruments due to liquidity. E.g. there may be little liquidity for a nine-year interest rate swap to hedge an asset that reprices in nine years in the CNOP. Therefore, the IASB has tentatively stated that an entity could use a 10-year swap for a 9-year hedge. Then in the model the RMI is set to be 0 for the 10th year and the benchmark derivative matures on the 9th year. Therefore, the misalignment due to the extra year for the designated derivative would be reported in the profit and loss11.
Designated derivatives are the instruments that mitigate interest risk for the company. These are entered into with external counterparties. They are also used to evidence the RMI that a company is taking. The full list of designated derivatives has not been set, it is expected it will contain interest rate swaps (including basis swaps), forward starting swaps and forward rate agreements12. In Staff Paper 4C – July 2023, the AISB recommended that non-linear derivatives, except for net written options, are eligible as designated derivatives.
Benchmark derivatives (BD) are based on the same concepts as IFRS 9’s hypothetical derivatives. These are used to measure the efficacy of the hedging. The benchmark derivatives are based on the following specified characteristics13:
Transitioning to the new DRM model can be difficult due to the dynamic nature of the model, especially with a more complex balance sheet. Zanders can provide a wide range of expertise to support in the onboarding of the DRM model into your company’s hedging and accounting. We have successfully supported various clients with hedge accounting– including impact analyses, derivative pricing and model validation, and are familiar with the underlying challenges. Zanders can manage the whole project lifecycle from strategizing the implementation, alignment with key stakeholders and then helping design and implement the required models to successfully carry out the hedge accounting at every valuation period. As the deadline is quickly approaching it would benefit entities to start assessing the key characteristics of the DRM model in order to understand how to change their current framework to the new one.
For further information, please contact Pierre Wernert, or Alexander Oldroyd.
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