Discussion on hedge effectiveness

In July 2010, the Board tentatively agreed not to proscribe a required methodology in performing a hedge effectiveness assessment for determining whether a hedging relationship initially and continues to qualify for hedge accounting. Additionally, the Board had agreed rather than requiring a bifurcated approach to hedge effectiveness (qualitative for non-complex hedging relationships where the critical terms matched and quantitative for complex hedging relationships) the model should consider whether the initial hedging relationship was designed to be highly effective and any ineffectiveness should be considered and documented as part of the risk management policy.

In consideration of these Board decisions, the staff had concerns that the existing brightlines within IAS 39 (the 80% to 125% effectiveness threshold) would continue in practice in part because of the use of the term "highly effective" in the effectiveness assessment. Additionally, the staff had concerns over the use of percentage based effectiveness assessment techniques (e.g., dollar offset) and whether they may provide results that give the appearance of a highly effective hedging relationship when in fact a statistical effectiveness assessment may identify the relationship as not being highly effective.

The staff did not ask for any Board decisions during this session, but rather wanted to address these concerns in determining how to further develop the Board's previous decisions.

One Board member disagreed with the staff's premise that the use of a statistical effectiveness assessment technique in isolation would properly identify a hedging relationship as being highly effective and felt that one may need to consider both percentage based and statistical based techniques in determining effectiveness.

The Board revisited the decision reached at their previous meeting that the hedge relationship should seek a one-to-one offset with an upfront understanding of why one-to-one would not be achieved as part of the risk management decision making (i.e., from basis differential). Given the concern over the carryover of the term "highly effective" the Board shifted to utilizing the term "neutral" for describing the initial hedge relationship (i.e., that one is not overhedged or underhedged) with an understanding of the sources of ineffectiveness.

The staff summarised the Board discussion and direction provided as an entity has multiple tools available to them for assessing hedge effectiveness including qualitative considerations (including the level of matching between the various terms of the hedging instrument and the hedged item), quantitative consideration, percentage based assessment techniques, and statistical based assessment techniques. Companies will need to consider based on their specific circumstances what techniques will be utilised to assess that the hedging relationship is "neutral" at inception and that future sources of ineffectiveness are identified as part of the initial hedging documentation.

Identifying portions of a hedged item

The staff introduced the topic of whether it would be appropriate to identify part of an existing item that is designated as a hedged item in a hedge relationship as a portion of the entire item. The discussion focused on differentiating between a proportion (e.g. 80% of an entire $100 million firm commitment) and a portion (e.g., a component other than a proportionate part of the entire item). The importance of being able to identify a portion as a hedged item primarily relates to assessing and measuring the level of effectiveness in the hedging relationship.

The staff provided the Board with two examples illustrating the concepts, the first a firm commitment purchase in a foreign currency when there exists uncertainty as to the counterparty's ability to deliver under the commitment and the second a fixed rate loan with options to prepay at fair value.

In the first example, an entity decides to hedge the foreign currency risk for 70% of the firm commitment purchase of PP&E because of its risk management policy and uncertainty on the counterparty's ability to deliver in full under the contract. The counterparty delivers 9 of the 10 ordered items (a 90% fulfilment) and the remainder of the contract was cancelled. If the entity had hedged a 70% proportion of the purchase in the hedge relationship, the hedge would have encountered 10% ineffectiveness (because 10% of the contract was cancelled) resulting in 10% of deferred gains and losses recognised in OCI reclassified to profit in loss for a cash flow hedge and 10% of the commitment recognised in the balance sheet being derecognised and charged to profit and loss for a fair value hedge. However, if the entity had hedged a 70% portion of the purchase in the hedge relationship, ineffectiveness would not arise so long as 70% or the order had been fulfilled (e.g., the first 7 purchases were the hedged item). The differences between the two approaches result in significant differences in profit and loss recognition as a result of the measured ineffectiveness.

In the second example, an entity issues £100 million of five year debt at a 7% fixed interest rate and an issuer option to prepay any of the outstanding principal and unpaid interest at fair value. The entity's risk management policy limits fixed rate debt exposure to 50% of total issued debt. Also, the entity believes it may prepay up to £30 million prior to maturity. The entity enters into a swap of 5% fixed for 3-month UK Libor floating on £50 million of notional. If the entity had designated a 50% proportion of the debt as the hedged item and prepaid £30 million, then the £30 million and any fair value hedge adjustment related to the debt would be derecognised and the redemption amount paid would be recognised in profit or loss. In order to maintain an effective hedging relationship, the entity would have to designate £15 million of previously unhedged debt using an off-market swap (which also results in an impact to profit and loss). However, if a £50 million portion of the debt were the hedged item, the above mentioned issues would not arise as the hedge relationship would continue for the initially designated £50 million of debt.

One Board member expressed concern about the application to instruments with prepayment features, but the staff confirmed that the question at hand related to prepayment features whose fair value was not impacted by the hedged risk and the Board would be brought the issue related to other prepayment features at a later date.

Another Board member expressed that this will add emphasis on the robustness of the initial hedge designation documentation to clearly specify which portion is part of the hedge relationship.

The Board tentatively agreed with the staff's recommendation to permit part of an existing item to be identified and designated as a portion (or layer) of the entire item in cases where:

• The portion is identified and documented at inception of the hedge,
• The designation is in line with the entity's risk management strategy, and
• The fair value of any prepayment/termination clause is not affected by the hedged risk.