This site uses cookies to provide you with a more responsive and personalised service. By using this site you agree to our use of cookies. Please read our cookie notice for more information on the cookies we use and how to delete or block them.
The full functionality of our site is not supported on your browser version, or you may have 'compatibility mode' selected. Please turn off compatibility mode, upgrade your browser to at least Internet Explorer 9, or try using another browser such as Google Chrome or Mozilla Firefox.

Financial Instruments: Macro hedging

Date recorded:

The Board considered an initial analysis of the comment letters received. It was noted that commentators in general were supportive of the Board addressing the issue but many believed the Board had not gone far enough in the proposals.

Question 1: Designation and effectiveness

Question 1 in the ED was on the designation of the hedged item and the resulting measurement of ineffectiveness. The ED proposed that the hedged item be designated in terms of an amount of currency (rather than in terms of individual items) and be expressed as a percentage of assets or liabilities in a time period (rather than as a layer, or as the net position of assets and liabilities). As a result, ineffectiveness would arise both if a change in prepayment expectations caused the entity to be over-hedged (because hedged items were now expected to prepay earlier than expected) and if such a change caused it to be under-hedged (because hedged items were now expected to prepay earlier than expected).The ED also proposed that the change in the fair value of the hedged item may be reported in one of two line items in the balance sheet, and need not be allocated to the many individual assets or liabilities that comprise the hedged position.

The main points made in the responses were as follows:

  • All who commented supported the proposal that the hedged item be designated in terms of an amount of currency (rather than in terms of individual items).
  • Similarly, all who commented supported the proposal that that the change in the fair value of the hedged item may be reported in one of two line items in the balance sheet (rather than being allocated to the many individual assets or liabilities that comprise the hedged position).
The staff noted that a minority of those who commented on the issue supported the Board's proposal to designate the hedged item as a percentage of the assets of liabilities in a time period but many did not.

The main views expressed by those who disagreed included:

  • The Board should not specify a method of designation. Rather entities should be allowed to choose whichever method best reflects their risk management strategies and objectives, or that minimises systems changes.
  • The net position should be designated as the hedged item, at least for the purpose of testing effectiveness, since this reflects how interest rate risk is assessed and managed by the entity.
  • A top layer of assets or liabilities (approach B/C in the ED) should be designated as the hedged item, since this most closely reflects the risk management objective. This objective is to take account of the extent to which liabilities form a natural offset to assets, and to hedge only (some or all of) the resulting net position with derivatives.
Many stated that no ineffectiveness should arise if a change in prepayment expectations caused the entity to be under-hedged (because hedged items are now expected to prepay earlier than expected). The main reasons given were:
  • The entity is hedging only interest rate risk and not prepayment risk. Prepayment risk may be managed by deliberately hedging less than the full risk position, but it is not hedged. Accordingly, any changes in prepayment risk are changes in a risk that is not hedged and should not give rise to ineffectiveness, unless they cause the amount of the derivative to exceed the amount of the hedged position.
  • The entity is hedging the assets (or liabilities) for a part of their life - the period up to the expected repayment date. Such partial term hedging is explicitly permitted by the implementation guidance to IAS 39. The entity is not hedging interest rate risk for the period after the expected repricing date. Accordingly, if prepayment expectations for this unhedged period change, there is no ineffectiveness.

Question 2: Core deposits

The ED proposed that a financial liability that the counterparty can redeem on demand cannot qualify for fair value hedge accounting for any time period beyond the shortest period in which the counterparty can demand payment.

A minority of respondents of those who commented on this proposal agreed with it. However, most did not. The main reasons given by those disagreeing were:

  • The ED's proposal does not reflect the 'economic reality', supported by historical data, that core deposits are a stable source of long-term funding.
  • It is inconsistent to schedule prepayable assets based on their expected prepayment dates, but not to schedule demand deposits based on their expected withdrawal dates.
  • The ED's proposals could result in a bank being able to adopt fair value hedge accounting for some time periods (those for which it has more fixed rate assets than fixed rate liabilities) but not for others. This could result in the bank using a mix of fair value hedge accounting and cash flow hedge accounting for a single macro hedge, that would be both impractical to apply and difficult for users to understand.
  • Portfolios are different from individual items. It is the economic behaviour of the portfolio that is being hedged and the hedge is successful as long as there are sufficient amounts, on a portfolio basis, to cover the hedging derivative. When viewed on a portfolio basis, core deposits behave as a liability with a repricing profile that is longer than that defined by the contractual terms. Furthermore, the details of individual transactions are lost at a portfolio level and the distinction between 'old' and 'new' money has no real meaning.
  • The ED's proposals do not reflect the way that banks manage interest rate risk.
The staff noted that a few respondents urged the Board to continue to work on how to fair value core deposits and similar items in its measurement project. Some of these support the ED's proposals in the meantime, whilst others do not.

The Board members provided comment to assist the staff in preparing a more detailed analysis of the comments.

The staff noted a number of other issues raised and requested guidance from the Board on which issues should be addressed. The issues together with the staff's recommendations were:

Portfolio hedges of other risks

Some respondents suggest that the scope of the proposals be expanded to cover portfolio hedges of other risks, including foreign currency risk (this is the risk that was mentioned most often), commodity price risk, precious metal price risk, equity price risk, credit risk, energy price risk and the currency risk of portfolios of commercial bids.

The staff believes these reasons for limiting any amendment to only portfolio hedges of interest rate risk as set out in paragraph BC4 of the ED still hold, and proposes that the Board should not address these issues in finalising the ED's proposals.

Amortisation of balance sheet amounts

A significant number of comments were received on when or how to amortise any amounts reported in the balance sheet for changes in the fair value of the hedged item (ie the amounts that would be reported in the proposed separate line items). The ED was silent on this issue, though guidance is given in IAS 39.

The staff believes that the comments revealed considerable confusion over when amortisation is needed in order for an economically hedged position to be reported as such and recommends that this issue be addressed in finalising the ED' s proposals, perhaps by extending the application guidance or the illustrative example.

IAS 39's effectiveness requirements

IAS 39 requires that a hedge can qualify for hedge accounting only if it is expected to be highly effective (the 'prospective effectiveness test') and is determined actually to have been highly effective (the 'retrospective effectiveness test'). For the purposes of the prospective effectiveness test, the changes in the fair value or cash flows of the hedging instrument must be expected to "almost fully offset" those of the hedged item arising from the hedged risk. For the purposes of the retrospective effectiveness test, a 80-125 per cent range is applied. Some respondents request clarification of how these requirements apply to a macro hedge.

The staff recommends that this issue be considered by the Board in finalising the ED so that it is clear what the effectiveness requirements are for a macro hedge, and whether macro hedges will meet them.

Transitional provisions

The ED proposed that it be applied prospectively. Comments raised on this proposal ask that it be clarified whether 'prospectively' means the amendments can be applied to accounting periods after the effective date, or only to new transactions occurring after that date, and that the Board address how an entity that already reports under IAS 39 and that uses cash flow hedge accounting for its macro hedges should transition to using fair value hedge accounting.

The staff recommends that the Board should address these issues in finalising the ED's proposals.

Other points

A large number of smaller points were raised.

The staff recommends that these smaller points be considered in the first instance by the Board members assigned to the project, and that their proposed resolution be presented to the full Board for approval on an exceptions-only basis.

The Board agreed with the staff's recommendations.

The staff noted that the project plan proposed discussing designation and effectiveness and core deposits in January and all other issues in February.

Correction list for hyphenation

These words serve as exceptions. Once entered, they are only hyphenated at the specified hyphenation points. Each word should be on a separate line.