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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.

Relationship between components – cash flow hedge

If a component of the cash flows of a financial or a non-financial item is designated as the hedged item, that component must be less than or equal to the total cash flows of the entire item. However, all of the cash flows of the entire item may be designated as the hedged item and hedged for only one particular risk (for example, only for those changes that are attributable to changes in LIBOR or a benchmark commodity price).
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Hedging a net position – cash flow hedge

The previous conversion of IFRS 9, viz, IAS 39 did not allow a net position to be hedged. However, for several group companies, it is a normal practice for the risks to be transferred to one central business unit within the enterprise and take hedging position on a net basis. The risks transferred to the central business unit usually off sets one another’s risk. This enables the entity to reduce the transaction cost and also minimise the counter party credit risk. Ind AS 109 effectively allows hedging on the basis of net position for fair value hedge and for cash…
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Hedges of a net investment in a foreign operation

As per Ind AS 21, net investment in any foreign operation is the amount of the reporting entity’s interest in the net asset of that operation. Such foreign operations may be subsidiaries, associates, joint ventures or branches. Ind AS 21 requires an entity to determine the functional currency of each of its foreign operations as the currency of the primary economic environment of that operation. When translating the results and financial position of a foreign operation into a presentation currency, the entity is required to recognise foreign exchange differences in other comprehensive income until the foreign operation is disposed off.
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Accounting for net investment hedge – Only functional currency

Hedge accounting is applicable only to the foreign exchange differences arising between the functional currency of the foreign operation and the parent entity’s functional currency. It is not applicable for translation differences arising on account of presentation currency.
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Illustration of a net investment hedge by a parent entity

Entity A is the Parent having INR as its functional currency. Subsidiary B has Euro as its functional currency. Subsidiary C has GBP as its functional currency and the functional currency of Subsidiary D is USD. Subsidiary B has ECB amounting to $ 50 million. The following diagram best illustrates the hierarchy with corresponding investments in the subsidiary entities.
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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
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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
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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.
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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:
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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.
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