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FRM Module 7 Hedge Effectiveness and Documentation For Download

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FRM Module 7 Hedge Effectiveness and Documentation For Download

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yzn5zf6nmf
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Financial Risk Management

Module 7
Accounting for derivatives and hedge relationships
Financial Risk Management
Module 7
Accounting for derivatives and hedge relationships
Section 9 – Hedge effectiveness
Hedge effectiveness
Quiz – Dollar offset method

To be considered effective, the hedge must meet the 80% - 125% range
under the dollar offset method.

True Under IFRS 9, there is no longer a ‘rule’ of 80%-125% for hedge effectiveness.

This is a guideline, as the effectiveness test now considers a wider range of


False
more qualitative information (e.g. matched terms).
Hedge effectiveness

Prospective assessment at inception and ongoing

Measure and recognise hedge ineffectiveness each period

Principles-based approach to hedge effectiveness testing


Hedge effectiveness – conditions

Economic relationship must exist


• Between hedged item and hedged instrument (i.e. must move in opposite
directions)
• Objective basis (e.g. matched terms; quantitative assessment), but also requires
judgment
Credit risk cannot dominate fair value changes
• Requires judgment
• Could arise from counterparty’s credit risk or the entity’s own credit risk
Hedge ratio for accounting must match that for risk management
• Quantity of the hedging instrument and quantity of the hedged item
• Will usually match in notional terms, but can differ and the hedge ratio may require
rebalancing
Measuring hedge effectiveness

Qualitative:
• Matched terms method
• Effective if critical terms of hedge item and hedge instrument are aligned

Quantitative:
• Dollar offset method
• Effective if single period or cumulative period offset calculation is within a benchmark
range (e.g. 80% - 125%):
[Change in FV of derivative / Change in FV of hedged item]

• Regression
• Effective if the spread against the line of best fit (R2) is between e.g. 0.80 - 1.00
• Effective if the slope of the line of best fit (X variable 1) is between e.g. -0.80 and -1.25
Hypothetical derivative

Theoretical derivative Not a hedge


that will create a effectiveness method
perfect hedge in itself

Used in a quantitative
Fair value of zero at
process to assess an
inception Only relevant
economic relationship
for cash flow
hedges and net
investment
Terms that match the Used to determine hedges
critical terms of the any ineffectiveness in
hedged item a hedge (to P&L)
Measurement of ineffectiveness

Fair value hedge


• Changes in both the FV of the derivative AND the FV of the hedged item are
recognised in P&L
• Ineffectiveness in the hedge is already recognised in P&L

Cash flow hedge


• Effective component of hedge gains/losses deferred to OCI
• Ineffectiveness where an entity is over-hedged:
[e.g. Change in FV of actual derivative > Change in FV of hypothetical derivative]
• No ineffectiveness where an entity is under-hedged (unintentionally):
[e.g. Change in FV of hypothetical derivative > Change in FV of actual derivative]
Hedge effectiveness – example

Want to hedge the exposure to floating interest rates…so enter a pay-fixed


interest rate swap

Based on economic relationship, hedge is deemed effective prospectively

Assess any ineffectiveness in the hedge using the hypothetical derivative –


which would eliminate exposure perfectly

Effective portion of the hedge gain/loss goes to OCI

• i.e. the lessor of the change in the hypothetical or the actual

Ineffective portion of the hedge gain/loss goes to P&L

• i.e. any over-hedged amount where the change in actual > change in hypothetical
Hedge effectiveness – example

Change in FV of actual
derivative $150 increase $140 increase
Over-hedged,
ineffective
component to P&L

Change in FV of hypothetical $120 increase $160 increase


derivative

Actual derivative 150 DR


Equity reserve 120 CR
Profit & Loss 30 CR
Hedge effectiveness – example

Change in FV of actual
derivative $150 increase
Under-hedged, no
ineffective
$140 increase
component

Change in FV of hypothetical $120 increase $160 increase


derivative

Actual derivative 140 DR


Equity reserve 140 CR
Financial Risk Management
Module 7
Accounting for derivatives and hedge relationships
Section 10 – Hedge accounting documentation
Learning Objectives – FRM Module 7
• Explain the definition of a derivative and embedded derivative under IFRS 9
1

• Apply the accounting classification as it relates to derivatives and hedged items


2

• Explain hedging and what qualifies as a hedge item and instrument


3

• Explain the various rules of hedge accounting


4

• Discuss and account for cash flow, fair value and net investment hedges
5,6

• Calculate, assess and measure the effectiveness of a hedge


7

• Outline the documentation required under IFRS 9


8

All objectives are © CPA Australia


IFRS 9 documentation

Hedging policy (overarching – general)


• Management intent
• Set by senior management/board/audit and risk committee
• Includes:

Highly
Permitted Embedded Effectiveness Ineffectiveness
Purpose probable Documentation
hedges derivatives assessment measurement
forecast basis
IFRS 9 documentation

Hedge documentation (specific)


• Created at/before inception
• Formal designation and documentation of hedge relationship

Risk
Hedged Assessment
Hedging management Nature of risk
item/ of
instrument strategy / being hedged
transaction effectiveness
objective

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