Financial instruments — Macro hedging

Date recorded:

The IASB continued its discussion on development of an accounting model for macro hedging activities on the basis of the ’11 steps’ that the Board initially discussed at its November 2011 meeting. Similar to previous meetings, this session was an educational session where no decisions were made.

The purpose of this meeting was to discuss how some entities incorporate capital management objectives into their overall risk management. In an interest rate risk context, this is generally referred to as an 'equity model book'. When applying this approach, capital is typically considered as a fixed interest rate risk profile, which is then included in interest rate risk management.

The IASB staff noted that mechanically, the equity model book approach shares similarities with the core demand deposit discussion (previously discussed by the Board) in that both are managed under the transfer price mechanisms based on modelling and (typically) replication. However, there are also differences between the two. The equity model book approach is based on a target for the base return for equity funding, while the core demand deposit model is based on expected behaviour of liabilities. Consequently, the impact of the management decisions might be larger, as it includes the judgement about the target of the base return for equity funding on which the valuation of the equity model book is based.

Bearing the features of the equity model book in mind, the decision whether to ignore or accept it is about what information users find useful. Information conveyed through profit or loss volatility depends on whether an equity model book approach is accepted:

  1. if not, fair value changes in derivatives represent opportunity gains/losses.
  2. if so, (an absence of) net profit or loss volatility represents the accuracy of hedging activities based on the objective to lock in the base return for equity funding.

In receiving a high-level overview of the equity model book, many Board members questioned whether the equity model book was generally limited to banks. The staff noted that they had not performed outreach at this stage, but believed the equity model book was generally limited to banks and insurance companies. Board members then asked whether an equity model book was a central feature to a macro hedging model. The staff indicated that there were some trade-offs to using the equity model book for accounting purposes as compared to a simple model design. That being, providing understandability and operational feasibility versus using a model which provides consistency with the Conceptual Framework and limits arbitrage opportunities. However, the staff noted that the absence of an equity model book would not in and of itself make the macro hedge model irrelevant, but rather, would limit the inputs which are eligible for use in a macro hedging model.

Many Board members requested clarification as to how the equity model book worked in practice. The staff noted that the valuation of the book economically represents an adjustment of the overall valuation of the entire risk position that represents management targets. Therefore, the change in the valuation of the equity model book cannot, in most cases, be allocated to items of the risk position as an adjustment of their respective carrying amounts. The acceptance of the valuation for recognition and measurement purposes would imply using a separate presentation (e.g., accumulated other comprehensive income or other portion of equity) in order to reduce complexity. Hearing this explanation, one Board member saw the equity model book as a placeholder to achieve an effective cash flow hedge. However, he expressed concern that the book essentially resulted in the recognition of opportunity gains or losses where he did not believe the gains or losses were achieved economically. However, others saw benefits arising from use of the equity model book consistent with that which was outlined in the staff’s analysis. This spoke to the fact that the decision as to whether to ignore or accept the equity model book is derived by the information users find useful.

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