What is meant by Hedging

Requirements for hedging

Hedging is a mechanism to either minimise the loss or to protect unrealised profits, if any. Maximising the profit is not an objective of hedging. Hedging is a risk management tool. There has to be two components – one underlying instrument – known as the ‘hedged item’ and the other usually a derivative instrument – known as the ‘hedging instrument’. The fair value changes of one instrument would more or less offset the fair value changes of the other instrument. For example, if there is a loss in the underlying instrument, there would be a corresponding profit in the derivative instrument and vice versa. Derivative instruments are used for hedging purposes, even though non-derivative instruments can also be used as hedging instruments in certain cases.

The derivative instruments used as hedging instruments should be in the opposite direction of that of underlying position (hedged item). For example, if the hedged item is an underlying stock of say, Tata Steel, then the hedging instrument can be put option of Tata Steel. A put option is directionally opposite to that of the underlying shares, as put option entitles the buyer of the option contract to sell the underlying at predetermined price known as the ‘strike price’. The derivative of selling Tata Steel stock futures is also directionally opposite to that of the underlying security. However, stock futures cannot be designated as hedging instruments for hedging the price risk, which is explained later here.

The objective of hedging in this case is to ensure that the profits accrued till that date (unrealised) are protected. It also ensures that the risk of a fall in the price of the underlying is compensated by a corresponding increase in the value of the put option.

If the hedging instrument is stock futures, then the potential for incurring a loss on such futures of contract is theoretically the same as that of realising a profit on such position. However, if the derivative instrument is a put option, when the price of the underlying hedged item, viz, the shares of Tata Steel goes down, the value of the put option will go up thereby compensating the erosion in the value of the underlying. If the price of Tata Steel stock goes up, then the put option which is a right to sell the underlying at the strike price will expire worthless. This effectively provides a mechanism to minimise the risk while at the same time, protecting the unrealised profits as on the date of getting into the hedging contract. So, buying a put option as a hedging instrument to protect the price risk can be said to be a case of having a cake and eating it too!

Speculation

A trade taken in the derivative segment without a corresponding underlying position is called ‘speculative trade’. In the case of speculation, there are no underlying shares held by the investor. Any position taken in the derivative segment becomes speculation if the investor does not hold a corresponding underlying position. Speculation as per the financial markets should not be confused with speculation understood as per the Income Tax Act. A speculative trade does not mean that it is a trade taken as ‘settled without delivery’.

Gambling

When the open interest exceeds the sum total of the underlying, then to the extent open interest exceeds the underlying it is known as the gambling portion. Let us assume that the total shares issued by a listed company, ABC Limited, are Rs 100 crore and assuming that the open interest outstanding in the derivatives segment as on a given date is say Rs 105 crore. Then to the extent of Rs 5 crore of derivative contracts is known as the gambling portion. However, this example is given just to understand the meaning of gambling as this situation can never happen in the case of an exchanged traded environment. However, in OTC market (over the counter market), there is a possibility that open interest can exceed underlying especially in the case of Credit Default Swap (CDS) contract.

Open Interest

Open interest is the total number of derivative contracts (futures and/or option contracts) that are not yet settled on a given date. In the derivative segment, the buyer and seller come together to create a contract. Let’s assume, eg, ‘A’ buys 100 call option contracts from ‘B’, the seller. Here, A and B have come together to create the derivative contract. They have also created an open interest to the extent of the number of option contracts that they have entered into. The open interest created by this deal would be 100 only. One should not add the number of option contracts bought by ‘A’ and the option contract sold by ‘B’. Both combined together add up to 100 option contracts only as ‘open interest’. The contract has life till the expiry date. If the buyer of a derivative contract sells his position to another person who already has a ‘sold position’, the open interest would shrink. If the same is sold to some other person who does not have any position, then the open interest would remain the same.

Let’s assume C buys 100 option contracts from D. The total open interest now will be 200. Let’s assume that ‘A’ who now holds 100 option contracts sells it to ‘C’. The open interest would continue to remain at 200 contracts only. If ‘B’ who holds a ‘sold position’ buys 100 option contracts from ‘C’ who has a ‘bought position’, the open interest would shrink by 100 option contracts. The open interest thus would become 100 contracts.

Theoretically, the total number of option contracts outstanding in the derivative segment is unlimited, as it does not depend upon the total number of underlying shares issued by the issuer. However, there are several restrictions placed by the regulatory body in an exchange traded environment. For example, in India, the Security and Exchange Board of India effectively controls the open interest through the two exchanges – NSE and BSE.

As per the regulatory requirements, open interest for an exchange traded security cannot exceed a pre-determined percentage of the total underlying shares.

Open interest restrictions

As mentioned above, in an exchange traded environment, the open interest on any given date can never exceed a percentage of the total underlying equity shares issued by the company. This is effectively monitored on real time basis by the regulatory authority.

What happens without proper hedge accounting?

Debt security issued with a fixed rate

Let us assume that an entity has issued a Rs 20 crore – 8% debt security which is payable after five years. The chief economist of the enterprise expects interest rates to go down over a period of the next five years and perhaps may become 5%. Since the entity has already issued the debt at a fixed rate, the Chief Financial Officer decides to enter into an interest rate swap with the receivable leg pegged at 8% and the payable leg as variable in order to effectively hedge the fixed rate debt security.

End of year 1

At the end of the first year, as expected by the chief economist, the interest rate slips to 7% as a result of which, the interest rate swap gains Rs 1.5 crore. The interest rate swap being a derivative instrument is classified and measured at fair value through profit or loss account. The hedged item, namely the 8% debt security, would be classified and measured at amortised cost. At the end of year-1, the debt security will continue to be shown in the books with the carrying value of Rs 20 crore as its amortised cost. On the other hand, the gain on the interest rate swap of Rs 1.5 crore will be shown in the profit or loss account. In this case, the profit or loss account is subject to unnecessary fluctuations on account of having the hedging instrument. The objective of having the interest rate swap is merely to act as an economic hedge that would effectively hedge the exposure on account of the fixed rate debt security.

End of year 2

Let us assume that at the end of second year, the interest rate takes a U-turn and goes up to 9% resulting in the interest rate swap becoming a liability of say Rs 1.25 crore. The debt security being valued at amortised cost will continue to be shown at Rs 20 crores even at the end of the second year. In the second year, the profit and loss account will show a loss of Rs 3.75 crore (Rs 1.5 crore reversed relating to year-1 and the current year loss of Rs 1.25 crore) on account of the interest rate swap. The profit or loss account undergoes unnecessary fluctuations which was totally unintended by the entity.

Choices available with the entity

In order to overcome this accounting anomaly, there are two choices available to the entity. The first choice is to designate the debt security at fair value by exercising the fair value option (FVO) at the inception of the debt security. If the FVO option is exercised, then at the end of the first year, the 8% security will be valued at fair value based on the interest rate of 7% thereby resulting in an increased liability to the tune of approximately Rs 1.5 crore. The changes in the fair value will be taken to the profit and loss account which would effectively off set the profit booked by the entity on account of the interest rate swap thereby nullifying the undue fluctuations in the profit or loss account. At the end of the second year, since the interest rate goes up, the fair value of the debt instrument would fall resulting in booking profit in respect of the debt security. This profit of say Rs 3.75 crore (Rs 1.5 crore reversed relating to year-1 and the current year loss of Rs 1.25 crore) would, in effect, compensate the loss booked by the entity on account of the interest rate swap, thereby nullifying the effect of unintended fluctuations in the profit or loss account.

Flip side of electing FVO

The flip side of this type of treatment of designating the debt security which should normally be classified and measured at amortised cost at fair value through profit or loss, are as follows:

  • The option to designate the debt security at fair value should be exercised at the inception of the debt.
  • The option to designate the debt security at fair value can be exercised only if there is an existing accounting mismatch and not otherwise.
  • The option once exercised is irrevocable and the entity has to live with it for the rest of the life of the financial instrument.
  • If the interest rate swap is liquidated before the maturity of the debt security, the debt security will continue to be valued at fair value, thereby causing fluctuations in the profit or loss depending upon the interest rate fluctuations till maturity. The remedy in this case will be worse than the disease.

The second choice, of course, is to adopt hedge accounting for this transaction. This would result in minimising or altogether eliminating the fluctuations in the profit/loss arising on accounting for the interest rate swap.

Objectives of hedge accounting

The objective of hedge accounting is to represent, in the financial statements, the effect of an entity’s risk management activities that use financial instruments to manage exposures arising from particular risks that could affect profit or loss or other comprehensive income. This approach aims to convey the context of hedging instruments for which hedge accounting is applied in order to allow insight into their purpose and effect.

An entity may choose to designate a hedging relationship between a hedging instrument and a hedged item. For hedging relationships that meet the qualifying criteria, an entity shall account for the gain or loss on the hedging instrument and the hedged item in accordance with the standard. When the hedged item is a group of items, an entity shall comply with the additional requirements.

Hedge accounting is optional. However, once an entity applies hedge accounting for any relationship, then hedge accounting cannot be voluntarily discontinued unless the risk management objective of entering into the particular hedge is no longer valid or relevant. The objective is to disclose the effect of an entity’s risk management activities that use the financial instruments to manage exposures arising from different types of risks that could affect the profit or loss account. In the case of investments in equity instruments that are designated as fair value through other comprehensive income, the objective of hedge accounting is to represent in the financial statement the effect of risk management activities that could affect the other comprehensive income.

While the objectives of hedging can be said to be protecting the profit from undue fluctuations (minimising risk), one can say that the objective of hedge accounting is to protect the profit or loss account from unintended fluctuations in the profit or loss account.

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