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Hedge Accounting and Hedge Effectiveness

Introduction

Hedging is an investment strategy that uses investments to minimize potential investment losses by taking an offsetting position in a related derivative whose value changes inversely with respect to the investment. The goal of the strategy is not to make money but to protect oneself from different risks such as interest rate risk, foreign exchange risk, or commodity risk.

Since all derivatives are carried on the balance sheet at fair value and fair value can change from period to period, the primary issue in accounting for derivatives is the treatment of the gains or losses resulting from marking to market. This creates unnecessary earnings volatility that can negatively impact your organization's financials. Hedge accounting under the International Accounting Standards is covered by IFRS 9 (IAS 39) and, in the U.S., under the Financial Accounting Standards Board by Topic 815 (FAS 133), which modifies the normal basis for recognizing gains and losses (or revenues and expenses) associated with a hedged item or a hedging instrument to enable gains and losses on the hedging instrument to be recognized in P&L in the same period as offsetting losses and gains on the hedged item.

Hedge effectiveness is the extent to which a hedge transaction results in offsetting changes in fair value or cash flow that the transaction was intended to provide (as identified by the hedging entity). For example, a hedge is considered to be highly effective if the changes in fair value or cash flow of the hedged item and the hedging derivative offset each other to a significant extent (80% to 125%). Under Topic 820 and IFRS 9, only the portion of a transaction that is considered effective may qualify for hedge accounting treatment.

Technical Details

FINCAD Hedge Accounting Insight offers comprehensive capabilities in complying with hedge accounting rules such as:

  • Marking all derivatives to market historically as of financial reporting dates.
  • Performing prospective hedge effectiveness tests for hedging relationships prior to executing the transaction.
  • Performing retrospective hedge effectiveness tests throughout the life of the hedging relationship with quantification of the effective and ineffective parts to drive accounting entries.

Hedges Supported

Foreign Exchange Cash Flow Hedge

An FX forward is used to hedge an anticipated future payment or receipt of a fixed amount of foreign currency. And a cross currency swap is used to hedge a foreign currency debt or asset. The testing for the hedge is based on the Hypothetical Derivative Method.

Interest Rate Cash Flow Hedge

An IR cash flow hedge is a specific type of hedge under hedge accounting guidelines that allows corporates to hedge interest rate risk of a floating rate debt or investment using a variable-to-fixed rate swap or interest rate options such as caps and floors. The testing for the hedge can be based on fair value (Hypothetical Derivatives Method).

Interest Rate Fair Value Hedge

A fair value hedge is used to hedge the changes in the fair value of a bond that is attributable to changes in a benchmark interest rate, such as LIBOR, i.e. an interest rate fair value hedge where fixed rate debt is swapped for floating rate debt. Hedge effectiveness is evaluated by comparing the change in value of the bond to the change in value of the swap.

Commodity Hedge

A commodity hedge is a specific type of hedge under hedge accounting guidelines that allows the hedging of a commodity contract using a commodity forward. The testing for the hedge can be based on fair value (Hypothetical Derivatives Method).

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