Hedge ratio in hedge accounting requirements
What is meant by hedge ratio and how it is helpful in meeting the hedge accounting requirements?
Hedge ratio refers to the number of units that are used as hedging instrument for the purpose of hedging a hedged item. Usually, the ratio is 1:1 for most of the financial instruments. For example, if the entity wants to hedge a fixed rate debt instrument of say Rs 10 crore, then if the hedging instrument happens to be an interest rate swap, then the notional amount of the interest rate swap would also be Rs 10 crore. This means that the hedge ratio is 1:1.
In accordance with the hedge effectiveness requirements, the hedge ratio of the hedging relationship must be the same as that resulting from the quantity of the hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.
If an entity hedges 85% of the exposure on a hedged item, then the entity should use the same hedge ratio of 85% while designating a hedging relationship using the same hedge ratio. For example, if an entity hedges only 60% of the fixed rate debt exposure as per its risk management strategy, then while designating the hedging relationship the entity should designate only 60% of the value of debt security as the hedging instrument. The entity is not allowed to increase or decrease the hedge ratio that is in accordance with the actual hedge that the entity undertakes as per its risk management strategy.
The designation of the hedging relationship using the same hedge ratio that the entity actually uses in its risk management strategy should not create an imbalance between ratings of the hedged item and the hedging instrument that is used by the entity for hedging purposes.
As per the previous version of hedge accounting, viz, IAS 39, once the hedge ratio is determined, it was not permitted to be changed during the life of the hedging relationship. This caused enormous hardship for the entities and many times the hedge accounting had to be discontinued because of a change in the hedge ratio that is warranted as per the real life scenario. Considering the need for addressing this issue, IFRS 9 and Ind AS 109 now permits the hedge ratio to be modified even during the course of hedging relationship without the entity having to discontinue hedge accounting. The hedge ratio is modified by either increasing or decreasing the hedged item or the hedging instrument so as to achieve the desired relationship. The accounting treatment when such hedge ratio is modified is very elaborately given in this Standard.