Hedging instruments and hedged items
A hedging instrument should normally have one or more of the following characteristic features
- It should help minimise risk.
- It should protect the profit still unrealised by locking the same.
- It should not have the effect of realising the unrealised profit.
- It should not increase the existing risk by taking a changed exposure or additional exposure to risk.
- It should usually have a positive net present value, ie, it should be an asset in the books and should not be a liability at any point of time. (There are exceptions to this feature explained later.)
- It usually has a zero cost or a cost that is very low at the inception of the instrument.
- It should normally be a derivative instrument, even though there are exceptions for this too.
The following financial instruments can be designated as hedging instrument:
- A derivative measured at fair value through profit or loss except written options.
- A non-derivative financial asset or a non-derivative financial liability measured at fair value through profit or loss except where it is a financial liability designated as at fair value through profit or loss for which the amount of its change in fair value that is attributable to changes in the credit risk of that liability is presented in other comprehensive income.
- For a hedge of foreign currency risk, the foreign currency risk component of a non-derivative financial asset or a non-derivative financial liability provided that it is not an investment in an equity instrument for which an entity has elected to present changes in fair value in other comprehensive income.
- Only contracts with a party external to the reporting entity (ie, external to the group or individual entity that is being reported on) can be designated as hedging instruments.
Financial instruments eligible as hedging instrument
The following financial instruments are eligible to be designated as hedging instrument:
- Bought call options
- Bought put options
- Index futures
- FX futures/forwards
- FX Options
- FX Swaps
- Interest rate swaps
- Bought interest rate cap/floor
- Interest rate collars (so long as the fair value is positive)
- Interest rate reverse collars (so long as the fair value is positive)
Designation of hedging instruments
A qualifying instrument must be designated in its entirety as a hedging instrument. The exceptions permitted are:
- Separating the intrinsic value and time value of an option contract and designating as the hedging instrument only the change in intrinsic value of an option and not the change in its time value;
- Separating the forward element and the spot element of a forward contract and designating as the hedging instrument only the change in the value of the spot element of a forward contract and not the forward element; similarly, the foreign currency basis spread may be separated and excluded from the designation of a financial instrument as the hedging instrument;
- A proportion of the entire hedging instrument, such as 50% of the nominal amount, may be designated as the hedging instrument in a hedging relationship. However, a hedging instrument may not be designated for a part of its change in fair value that results from only a portion of the time period during which the hedging instrument remains outstanding.
An entity may view in combination, and jointly designate as the hedging instrument, any combination of the following (including those circumstances in which the risk or risks arising from some hedging instruments offset those arising from others):
- derivatives or a proportion of them; and
- non-derivatives or a proportion of them
However, a derivative instrument that combines a written option and a purchased option (for example, an interest rate collar) does not qualify as a hedging instrument if it is, in effect, a net written option at the date of designation. Similarly, two or more instruments (or proportions of them) may be jointly designated as the hedging instrument only if, in combination, they are not, in effect, a net written option at the date of designation.
A hedged item can be:
- A recognised asset or liability
- An unrecognised firm commitment
- A forecasted transaction
- A net investment in a foreign operation
- The hedged item can be a single item or a group of items. A hedged item can also be a component of such an item or group of items.
The component of a nominal amount is a portion of the entire amount of that item For example, if the hedged item is say Rs 100 crore, a portion of the entire loan say 70% may be designated as the hedged item. Such component can also be a layered component, say for example, the bottom Rs 20 crore of the Rs 100 crore loan. Some of the examples of the components of the nominal amount which can be designated as a hedged item are as follows:
- A part of the firm commitment to buy or sell a non-financial asset, say 500 tonnes of grade ‘B’ coffee out of the firm commitment of 800 tonnes.
- Part of a monetary transaction; say for example, the first two years of cash collected from a customer in the first quarter.
- A layer of the loan that has a pre-payment option, eg, first 10% of the loan that can be pre-paid during the first year.
The layer component of a group of items qualifies as a hedged item for hedge accounting purposes only if the following conditions are satisfied:
- The layer should be separately identified and readily measurable.
- The risk management objective satisfies to hedge a layer component.
- All the items in the group share the same risk.
- The new items in the group are identifiable and can be tracked.
- Investment in equity instruments for which the entity has elected to present changes in fair value in other comprehensive income.
- An aggregated exposure that is a combination of an exposure that could qualify as a hedged item and a derivative may be designated as a hedged item.
An entity is permitted to designate as hedged item, an aggregate exposure consisting of a hedged item and a hedging instrument. As shown in the above example, a hedging instrument, viz, three months copper futures designated in USD terms (functional currency being INR) is taken for the purpose of hedging the price risk contained in the hedged item of a highly probable forecasted purchase of copper after three months. Both the hedged item and the hedging instrument together can be designated as a hedged item where the hedging instrument could be FX forward contract maturing after three months to hedge the currency risk.
Where the hedging relationship is designated between the items that constitute the aggregated exposure, the way in which a derivative is included as part of an aggregated exposure must be consistent with the designation of that derivative as the hedging instrument at the level of the aggregated exposure. If an entity excludes the forward element of a derivative from its designation as the hedging instrument for the hedging relationship between the items that constitute the aggregated exposure, it must also exclude the forward element when including that derivative as a hedged item as part of the aggregated exposure. Otherwise, the aggregated exposure shall include a derivative, either in its entirety or a proportion of it.
In the above example, there are two hedging instruments, viz, (1) three months copper futures, and (2) three months FX forward contract. The first hedging instrument is a part of the hedged item for the second hedging instrument. In this case, if the forward element of three month’s copper futures is excluded while designating it as a hedging instrument for highly probable forecasted purchase of copper, then the forward premium should also be excluded from the three month’s FX forward contract while designating the same as hedging instrument of the aggregated exposure of hedged item.
Aggregated exposure 2
In the above example, a 10-year fixed rate debt security issued by USD terms is the hedged item. The corresponding hedging instrument to hedge the currency risk is a 10-year cross currency swap where the receive leg is fixed rate in dollar terms and the pay leg is variable rate in the functional currency (INR) terms. Since the hedging instrument is a cross currency swap, this is also hedging the interest rate risk by converting the fixed rate debt instruments in dollar terms to variable rate debt instrument in INR terms. The aggregated exposure of both these instruments has the effect of having a 10-year variable rate debt instrument in the functional currency and this can be designated as a hedged item. Hedging instrument for this aggregated hedged item to mitigate the interest rate risk would be an interest rate swap having the receive leg as variable rate and pay leg has fixed rate. The entity can also get into multiple interest rate swaps on a shorter term rolling basis so as to watch the interest rate movements before jumping into long term interest rate commitment.
When designating the hedged item on the basis of aggregated exposure, the combined effect of both the hedged item and the hedging instrument, which constitute the aggregated exposure, should be considered for the purpose of assessing a hedge effectiveness or ineffectiveness. It should be noted that the accounting should be done for these two exposures separately and not on a combined basis. Derivatives that are part of an aggregated exposure are recognised as separate assets or liabilities measured at fair value.
A firm commitment to acquire a business in a business combination cannot be a hedged item, except for foreign currency risk, because the other risks being hedged cannot be specifically identified and measured. Those other risks are general business risks.
An equity method investment cannot be a hedged item in a fair value hedge. This is because the equity method recognises in profit or loss the investor’s share of the investee’s profit or loss, instead of changes in the investment’s fair value.
For a similar reason, an investment in a consolidated subsidiary cannot be a hedged item in a fair value hedge. This is because consolidation recognises in profit or loss the subsidiary’s profit or loss, instead of changes in the investment’s fair value. A hedge of a net investment in a foreign operation is different because it is a hedge of the foreign currency exposure, not a fair value hedge of the change in the value of the investment.
Qualifying criteria for hedged items
- If a hedged item is a forecast transaction (or a component thereof), that transaction must be highly probable.
- For hedge accounting purposes, only assets, liabilities, firm commitments or highly probable forecast transactions with a party external to the reporting entity can be designated as hedged items.
- Hedge accounting can be applied to transactions between entities in the same group only in the individual or separate financial statements of those entities and not in the consolidated financial statements of the group, except for the consolidated financial statements of an investment entity, as defined in Ind AS 110 where transactions between an investment entity and its subsidiaries measured at fair value through profit or loss will not be eliminated in the consolidated financial statements.
In the consolidated financial statements the foreign currency risk of a highly probable forecast intragroup transaction may qualify as a hedged item in a cash flow hedge, provided that the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and that the foreign currency risk will affect consolidated profit or loss. For this purpose an entity can be a parent, subsidiary, associate, joint arrangement or branch. If the foreign currency risk of a forecast intragroup transaction does not affect consolidated profit or loss, the intragroup transaction cannot qualify as a hedged item. This is usually the case for royalty payments, interest payments or management charges between members of the same group, unless there is a related external transaction.
- However, as an exception to (2) and (3) above, the foreign currency risk of an intragroup monetary item (for example, a payable/receivable between two subsidiaries) may qualify as a hedged item in the consolidated financial statements if it results in an exposure to foreign exchange rate gains or losses that are not fully eliminated on consolidation in accordance with Ind AS 21 ‘The Effects of Changes in Foreign Exchange Rates’. In accordance with Ind AS 21, foreign exchange rate gains and losses on intragroup monetary items are not fully eliminated on consolidation when the intragroup monetary item is transacted between two group entities that have different functional currencies.
When the foreign currency risk of a forecast intragroup transaction affects the consolidated profit or loss, the intragroup transaction can qualify as a hedged item. An example is forecast sales or purchases of inventories between members of the same group if there is an onward sale of the inventory to a party external to the group. Similarly, a forecast intragroup sale of plant and equipment from the group entity that manufactured it to a group entity that will use the plant and equipment in its operations may affect consolidated profit or loss. This could occur, for example, because the plant and equipment will be depreciated by the purchasing entity and the amount initially recognised for the plant and equipment may change if the forecast intragroup transaction is denominated in a currency other than the functional currency of the purchasing entity.
If a hedge of a forecast intragroup transaction qualifies for hedge accounting, any gain or loss is recognised in, and taken out of, other comprehensive income. The relevant period or periods during which the foreign currency risk of the hedged transaction affects profit or loss is when it affects consolidated profit or loss.
Designation of hedged items
- An entity may designate an item in its entirety or a component of an item as the hedged item in a hedging relationship. An entire item comprises all changes in the cash flows or fair value of an item. A component comprises less than the entire fair value change or cash flow variability of an item. In that case, an entity may designate only the following types of components (including combinations) as hedged items:
- only changes in the cash flows or fair value of an item attributable to a specific risk or risks (risk component), provided that, based on an assessment within the context of the particular market structure, the risk component is separately identifiable and reliably measurable. Risk components include a designation of only changes in the cash flows or the fair value of a hedged item above or below a specified price or other variable (a one-sided risk).
- one or more selected contractual cash flows.
- components of a nominal amount, ie, a specified part of the amount of an item.
A component is a hedged item that is less than the entire item. Consequently, a component reflects only some of the risks of the item of which it is a part or reflects the risks only to some extent (for example, when designating a proportion of an item).