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.
A fair value hedge is a type of hedge where the risk being hedged is the fair value of an asset or liability or unrecognised firm commitment or an unidentified portion of an asset, liability or firm commitment that is attributable to a particular risk and could affect the income statement. The hedge of a firm commitment to buy or sell a financial or non-financial asset is accounted for as a fair value hedge provided the economic relationship of hedging meets the risk management objective of the enterprise and fulfils other qualifying criteria. A hedge of the foreign currency risk associated with such firm commitments may be designated as a cash flow hedge or as a fair value hedge. The reason is that as far as the foreign exchange risk is concerned, it affects both the fair value of the hedged item and the cash flows associated with the same.
Fair value hedges
A fair value hedge is accounted for as follows:
- The gain or loss on the hedging instrument is recognised in profit or loss. If the hedging instrument hedges an equity instrument classified as fair value through other comprehensive income (FVOCI), then it is recognised in other comprehensive income.
- The hedging gain or loss on the hedged item is adjusted against the carrying amount of the hedged item and be recognised in profit or loss. If the hedged item is a financial asset measured at FVOCI the hedging gain or loss on the hedged item is recognised in profit or loss. If the hedged item is an equity instrument classified as FVOCI, those amounts should remain in other comprehensive income.
- When a hedged item is an unrecognised firm commitment, the cumulative change in the fair value of the hedged item subsequent to its designation is recognised as an asset or a liability with a corresponding gain or loss recognised in profit or loss.
- When a hedged item in a fair value hedge is a firm commitment (or a component thereof) to acquire an asset or assume a liability, the initial carrying amount of the asset or the liability that results from the entity meeting the firm commitment is adjusted to include the cumulative change in the fair value of the hedged item that was recognised in the Balance Sheet.
- Any adjustment arising from above shall be amortised to profit or loss if the hedged item is a financial instrument (or a component thereof) measured at amortised cost. Amortisation may begin as soon as an adjustment exists and shall begin no later than when the hedged item ceases to be adjusted for hedging gains and losses.
- The amortisation is based on a recalculated effective interest rate at the date that amortisation begins. In the case of a financial asset (or a component thereof) that is a hedged item and that is measured at FVOCI, amortisation applies in the same manner but to the amount that represents the cumulative gain or loss previously recognised instead of by adjusting the carrying amount.
The ‘Effective Interest Rate’ is calculated for a financial instrument when it is purchased or originated. It is normally not recalculated subsequently even when some of the cash flows associated with the instrument undergo minor changes due to prepayment/delayed payment, etc. However, there are certain circumstances which call for recalculation of the effective interest rate. When the hedged item ceases to be adjusted for hedging gains and losses, effective interest rate is recalculated based on the carrying value at that point of time. Amortisation begins at the recalculated effective interest rate.