What is hedging: a hedge is an investment position intended to offset potential losses or gains by a companion investment. In simple terms, it is a risk management strategy. It deals with reducing or eliminating the risk of uncertainty. We can further say it is hedging one investment by investing in some other investment.
A hedge is an investment that protects your finances from a risky situation. Hedging is done to minimize or offset the chance that your asset will lose value. It also limits your loss to a known amount if the asset does lose value.
Fulfilling hedge accounting requirements under IAS 39has been a major challenge to treasurers since it came into effect in 2005, often requiring complex hedge designation, documentation and new and measure ineffectiveness processes to access hedge effectiveness.
In many cases, treasury professionals have found out that accounting considerations have become more important in defining risk management policy than the risks themselves. Whilst IFRS 9hedge accounting still involves complexity and detailed requirement, the alignment to risk management activities could offer a variety of advantages for treasury practitioners.
There are three parts to IFRS 9:
- Classification and measurement
- Impairment; and
- Hedge accounting
In the first place, having classified how assets and liabilities are managed, IFRS 9 introduces a principles-based model that then uses cash flow-based characteristics to further determine the classification of assets, replacing the more rule-based requirement under IAS 39 that can sometimes be difficult to apply.
The new standard better recognizes credit risk inherent in financial instruments by introducing a requirement to recognize expected credit losses on a timelier basis, thus addressing weaknesses of the incurred loss model in IAS 39. The new approach allows treasury professionals to focus more on hedging financial risk with more of their activities qualifying foe hedge accounting.
These elements could represent a change for corporate treasurers in the way that they address risk and determine appropriate hedging policies, easing the hedge accounting burden and enabling them to pursue a hedging strategy that better reflects their economic risks. They are as follows:
- Commodity hedging
- Hedges of net position
- Inclusion of derivatives in designated hedge exposures
- Reduced P&L volatility from time value of options, forward point and currency basis
- Qualification based on economic relationships
- Hedge re-balancing
- Hedge effectiveness; and
- Fair value options for credit risk hedges.
Commodity hedging: under IAS 39, treasurers cannot designate non-financial items in hedge relationships on a risk component basis (with exception of FX risks) so it can be difficult for treasurers to qualify for hedge accounting in respect of hedges of commodity price risk due to high amounts of hedge ineffectiveness. IFRS 9 simplifies hedge accounting for commodities by allowing the risk component of a non-financial items (e.g., the nickel component of stainless steel) to be hedged, so long as that component is separately identifiable and reliably measured
Hedges of net position: IFRS 9 permits corporates to designate a single derivative to hedge the FX risk of a specifically identifiable, gross amount of forecast sales and gross amount of purchases in a cash-flow hedge, but the accounting result is not then grossed up to affect both the sales and the cost of sales lines. Instead, the hedging result is shown as a single line item on the P&L.
Inclusion of derivatives in designated hedged exposures- IAS 39 prohibits the designation of a combination of an exposure that could qualify as a hedged item and a derivative i.e., aggregated exposure even though there may be economic reasons for hedging such risks. For example, a Naira functional borrower issues a USD dominated fixed rate bond and uses a cross-currency interest rate swap to convert the bond into a floating Naira borrowing. Over time the borrower decided to use a short time Naira swap to convert it into a fixed rate borrowing. Under the IAS 39, only the first hedge qualifies for hedge accounting and the derivative designated in the second relationship would be considered a trading derivatives.
Reduced P&L volatility from time value options, forward points and currency basis: in contrast to IAS 39 which allows an option to be designated in a hedge relationship excluding the fair value changes associated with its time value all leading to volatility in the P&L: the IFRS 9 excluded time vale and is amortized to the P&L on systematic and rational basis over the duration of the hedge thereby avoiding P&L volatility. Further any subsequent changes in fair value are recorded in equity it further allows currency basis to be excluded from designated derivatives and recorded in the same way as the time value of options.
Qualifications based on economic relationships: to qualify for hedge accounting, IFRS 9 requires an economic relationship between the hedging instrument and the hedge item that endures over the life span of the hedge relationship which may lead to to more economically hedge exposure thereby qualifying for hedge accounting. For example, a risk on the price of oil based on one index could be hedged using a derivative based on another price index as long as there is economic relationship between the two.
Hedge re-balancing: if a previously strong correlation between two linked variables (e.g., bonny light/ Brent crude)starts to weaken, suggesting a structural change in the relationship, under IFRS 9, the treasurer is required to maintain the hedge consistently with what is done for risk management purposes by rebalancing the hedge the hedge ratio i.e., increasing or reducing the size of the hedge item or the hedge itself.
Hedge effectiveness: treasurers need to perform quantitative prospective testing at inception and subsequently on both a productive and prospective basis. IFRS 9 requires only ongoing prospective assessment which can be quantitative provided that the method captures the relevant characteristics of the hedge relationships. The method of assessing the hedge effectiveness can be changed after inception of the hedge due to subsequent changes without triggering the need to discontinue the hedge.
Fair value options for credit hedges: under IFRS 9 treasurers are now able to account for items (bonds and credit default swaps) at fair value through credit and loss when the credit risks is hedged with a CDS (bonds credit default swaps) this can de de-designated if the relationship to the CDS ceases.
In summary, while treasurers will have already been maintaining risk management strategy as part of their ordinary functions, under IFRS 9, there will be a closer link between qualifying for hedge accounting and the strategy adopted by the organization. The hedge strategy frame work in place should be closely linked to the risk management policy in place for effectiveness.