Hedging fixed rate debt instrument with IRS

Hypothetical derivative

To calculate the change in the value of the hedged item for the purpose of measuring hedge ineffectiveness, an entity may use a derivative that would have terms that match the critical terms of the hedged item (this is commonly referred to as a ‘hypothetical derivative’), and, for example, for a hedge of a forecast transaction, would be calibrated using the hedged price (or rate) level.

Calculating the change in the value of the hedged item is possible with the help of creating a hypothetical derivative. The way hypothetical derivative is structured is that it replicates the hedged item taking into account, as much as possible, all of the features that are present in the hedged item. The valuation of hypothetical derivative results in the same outcome as that of valuing the hedged item itself. Using a hypothetical derivative is not a method in its own right, but merely a simulated approach to calculate the value of the hedged item. So, it is obvious that a hypothetical derivative cannot be used to include features that exist only in the hedging instrument and not in the hedged item. The change in the value of the hedged item determines selling and hypothetical derivative can be used to assess the hedge effectiveness requirements.

Steps in a cash flow hedge

Identify the hedged item Identify the hedging instrument Designation/qualifying criteria of the hedge Hedge effectiveness requirements to be fulfilled Account for the hedging relationship Rebalancing and discontinuance of hedge accounting
Read More

What is a fair value hedge?

Fair value hedging as the name implies strives to hedge the fair value of an existing asset or liability and certain other firm commitments. In a fair value hedge, the fair value changes to the hedging instrument and the hedged item are recognised in profit and loss account.
Read More

Steps involved in fair value hedge accounting

Identify the hedged item Identify the hedging instrument Designation/qualifying criteria of the hedge Hedge effectiveness requirements to be fulfilled Account for the hedging relationship Rebalancing and discontinuance of hedge accounting
Read More

Accounting for fair value hedge

The hedge should be designated at the inception of the hedging relationship and a formal designation and documentation of the same required. The documentation should contain the entity’s risk management strategy and objective for undertaking the hedge. The effect of the credit risk involved in the hedging instrument, viz, the counterparty credit risk should not be such that it would vitiate the fair value changes of the hedging instrument.
Read More

Accounting for the forward element

Change in the fair value of the forward element of a forward contract that hedges a transaction related hedged item should be recognised in other comprehensive income to the extent it relates to the hedged item. The cumulative change in the fair value arising from the forward element of the forward contract shall be accounted for as follows:
Read More

Treatment of time value /forward points in derivatives

An entity is allowed to designate only the change in the intrinsic value of an option contract in a hedging instrument. Similarly an entity can also designate only the change in the spot value of a forward contract in a hedging instrument. In such cases, the time value of the option/forward points is accounted for depending upon the type of the hedged item that the option/forward contract hedges. The option/forward contract could be to either to hedge a transaction-related hedged item or a time-period-related hedged item.
Read More

Accounting for the time value of options

The time value of options contract may be separated from the fair value of options contracts and the entity can designate only the change in the intrinsic value of the option. If the entity chooses to do so, then the time value of the option contract is dealt with in the following manner:
Read More

Hedge effectiveness requirements

Rebalancing is permitted for the purpose of maintaining the hedge ratio to comply with the hedge effectiveness requirements. Changes to designate quantities of a hedged item or hedging instrument for a different purpose do not constitute rebalancing.
Read More

Rebalancing by changing the hedge ratio

Rebalancing is a new concept introduced by a major amendment to IFRS 9 during November 2013. Rebalancing means adjustments made to the quantities of the hedged item or the hedging instrument of an existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements.
Read More

What is a Cash flow hedge?

A cash flow hedge is a hedge of the exposure to variability in cash flows attributable to a particular risk associated with a recognised asset or liability or a component thereof. It covers future interest payments on variable-rate debt. It also covers a highly probable forecast transaction. The requirement is that such cash flows should affect the profit and loss account.
Read More
Scroll to Top