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Tuesday 23 May 2017

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IFRS 9: Financial Instruments

Exposure draft and Comment letters [Dec 2010]


 Hedge Effectiveness

(paragraphs 19, B27-B39 and BC75-BC90)


Throughout this project we have undertaken extensive outreach with investors, preparers and auditors. In particular, we have tried to understand how they view the requirements for the hedge effectiveness assessment in the context of the qualifying criteria for hedge accounting. The responses received provided us with clear feedback that the effectiveness qualification criteria are arbitrary, too rule-based and have hardly any relationship with risk management. In addition, investors also had difficulties understanding the outcome of the effectiveness testing particularly because of the erratic results of using the range of 80 to 125 per cent as a requirement of the effectiveness assessment.

Participants in the outreach urged the Board to develop a principle based effectiveness assessment with a closer relationship with risk management activities.

Click here for a summary the feedback received (refer to paragraphs 8 to 13 of the paper).  

What is the problem?

The effectiveness assessment in the current hedge accounting model is based on a rule-based approach that is onerous and has arbitrary results. This assessment has to be performed prospectively and retrospectively. This means that companies are required to perform two tests: a prospective test to ensure that the hedging relationship is expected to be highly effective and a quantitative retrospective test to ensure that the hedging relationship has been highly effective throughout the reporting period. The quantitative test uses a range of 80 to 125 per cent for the �highly effective� criterion.

Application of the current effectiveness assessment has resulted in arbitrary discontinuation of hedge accounting because in many circumstances a percentage range is not an appropriate measure to assess hedge effectiveness. For example, if the hedged exposure remains largely unchanged it can result in changes in the value of the hedging instrument and the hedged item that are small amounts but result in high percentages suggesting a mismatch that does not exist (eg if a 100m CU (currency units) nominal amount interest rate swap and hedged debt change by 1,000 CU versus 2,000 CU in their respective fair values, which means they are essentially unchanged but the hedge would only be considered 50 per cent effective; however, in periods when interest rates change significantly the changes might be 200,000 CU versus 203,000 CU resulting in an almost perfectly effective hedge). Therefore, this effectiveness assessment has not provided useful information to users of financial statements because it is difficult to understand how the 80 to 125 per cent range applies and what the effects are. The fact that the same hedging relationship might qualify or fail depending on the particular assessment method chosen (eg �dollar-offset� or regression analysis) has added to the confusion. In addition, the effectiveness assessment for accounting purposes is not aligned with risk management.

Because of the complexity and rule-based approach there is a significant number of companies that do not apply hedge accounting. This creates difficulties for investors and other users of the financial statements because of the widespread use of non-GAAP information that has resulted from the effect of the percentage test based hedge effectiveness assessment. 

What are the proposals?

The Board is proposing an objective based effectiveness test as follows:

  • The objective of the effectiveness assessment is to ensure that the hedging relationship will produce an unbiased result and minimise expected hedge ineffectiveness. Consequently, for accounting purposes hedging relationships should not reflect a deliberate mismatch between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness.
  • In addition to that objective, hedging relationships must be expected to achieve offsetting of fair value changes between the hedged item and the hedging instrument that are not merely accidental(other than accidental offsetting).
  • The assessment is only forward looking and is performed at inception and on an ongoing basis.
  • The methods used for the assessment (quantitative or qualitative) depend on the nature of the hedging relationship and on the potential sources of ineffectiveness. The main source of information to perform the effectiveness assessment is entities� risk management. For example, if the critical terms of the hedged item and hedging instrument match or are closely aligned, a qualitative assessment is likely to be appropriate, whereas if the critical terms are not closely aligned a quantitative assessment would be needed.
  • No particular methods for assessing hedge effectiveness are prescribed. However, the method used must capture the relevant characteristics of the hedging relationship including the sources of ineffectiveness.
  • Changes in the method for assessing effectiveness are required if there are changes in circumstances that affect hedge effectiveness, eg unexpected sources of ineffectiveness (ie new sources not initially anticipated).

An example

During the project the board has discussed several examples illustrating the main features of the effectiveness testing. Some of them are described below:

Definition of the hedge ratio

Assume that an entity hedges a purchase of 100t of a commodity of a certain grade in Location A and that the commodity usually trades at 90 per cent of the price for the exchange‑traded benchmark grade of the same commodity in Location B. If the entity wants to hedge the entire purchase volume with an exchange‑traded forward contract, then a forward contract to purchase 90t of the benchmark grade of the commodity in Location B would give the best effectiveness (ie a hedge ratio of 1.11 to one [1]).

Accidental offsetting

Using the same example above, assume that the forward contract was not an exchange traded instrument but a bilateral, uncollateralised contract. If the counterparty to the forward contract had a sudden, severe deterioration in its credit standing then the offset between the change in the value of the future commodity purchase and the change in fair value of the hedging instrument would be accidental. This is because the effect of the change in the credit standing of the counterparty is unrelated to and dominates the effect of changes in the commodity price. The optimal hedge ratio of 1.11 to one (ie hedging 100t of purchases with a forward contract volume of 90t) would still be driven by the commodity price changes but because of the credit risk related change of the value of the forward contract the hedging relationship would no longer have the systematic offset of fair value changes regarding the commodity risk that would otherwise result from a hedge ratio of 1.11 to one.

Qualitative assessment

An entity acquired a 100,000 CU debt instrument that pays 6-month Libor semi‑annually. The maturity of the instrument is 2 years. Entity A is exposed to interest rate decreases and would like to eliminate the risk of changes in the variability in the cash flows by entering into an interest rate swap whereby it would pay 6-month Libor semi-annually (aligned with the cash flows received on the bond) and would receive a fixed rate. For simplification the effect of credit risk is being ignored in this example.

Entity A wants to hedge the exposure to the variability of the cash flows using an existing interest rate swap with the same remaining maturity and variable payments but a different fixed rate (reflecting the interest level when the swap was originally entered into). Entity A considered the fair value of the swap at the inception of the swap to be immaterial. Hence, if there are no differences in the other critical terms, hedge ineffectiveness would result from the swap�s fair value at the time of designating it as the hedging instrument. This hedge ineffectiveness arises because of the effect of interest rate changes on that fair value as well as the unwinding of the discount on that amount. Entity A determines that a qualitative effectiveness assessment would be appropriate as a different hedge ratio than one-to-one would not systematically reduce expected hedge ineffectiveness (ie on a forward looking basis). 

Questions and answers

Click here  for other questions and answers on effectiveness assessment and other topics.  

Staff papers

As part of our due process, discussions of technical issues take place during public IASB meetings. For these meetings, the staff prepare technical papers on the specific technical topics. The Board then uses these papers as a basis for their proposals.

The papers that have been prepared for the Board to discuss hedge effectiveness are listed below. Click on the paper reference number to access the specific paper. Click on the related month to access the summary of decisions taken at that month�s IASB meeting. 


TopicPaper refMonth discussed
Hedge Effectiveness�General ApproachAgenda paper 7July 2010
Hedge Effectiveness�Definition of thresholds in the context of effectiveness assessmentAgenda papers 7AJuly 2010
Hedge Effectiveness�MethodsAgenda papers 7BJuly 2010
Hedge Effectiveness�Overview of approachAgenda paper 2August 2010
Hedge Effectiveness�Relationship between methods and qualifying criteria for effectiveness assessmentAgenda paper 2AAugust 2010
Main Features of the Hedge Effectiveness Test (cover paper)Agenda paper 4August 2010
Main Features of the Hedge Effectiveness TestAgenda paper 4AAugust 2010
Effectiveness testing�Use of the hypothetical derivativeAgenda paper 19BSeptember 2010

How to get involved

The exposure draft specifically asks for your views on this (and other) topics. Question 6 of the invitation to comment in the exposure draft asks:

Do you agree with the hedge effectiveness requirements as a qualifying criterion for hedge accounting? Why or why not? If not, what do you think the requirements should be?

You may choose to answer all the questions in the invitation or only some of them and you are welcome to comment on any other matter that you think we should consider in finalising the proposals. Comment letters will be posted on our website.

We will carefully consider all feedback and will discuss responses to the proposals in public meetings. We plan to issue the new standard in mid-2011.


[1] A quantity of 100t of commodity purchases is hedged with 90t of the benchmark commodity, ie 100/90. When determining the optimal hedge ratio using a statistical analysis (eg regression) the optimal ratio hedge ratio is given by the inverse of the slope of the regression line (or the slope‑depending on whether the hedged item is used as the independent or dependent variable).