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IFRS 9 — Hedging variability in cash flows due to real interest rates

Date recorded:

IFRS 9 Financial Instruments—Hedging variability in cash flows due to real interest rates (Agenda Paper 6)

Background

The Committee received a submission about applying the hedge accounting requirements in IFRS 9 for which the objective is to fix the cash flows in real terms. In the fact pattern described, an entity wants to hedge a floating rate (LIBOR) debt with an inflation swap (which swaps the variable interest cash flows of the floating debt for variable cash flows based on inflation index) in a cash flow hedge. The submitter asked whether a hedge of the variability in cash flows arising from the changes in the real interest rate, could rebut the presumption in IFRS 9.B6.3.13 and be accounted for as a cash flow hedge. The staff asked if the Committee agrees with the analysis presented in the agenda paper and the recommendation not to add a standard-setting project to its agenda.

Staff analysis

The staff did not perform any outreach on the matter because there are limited cases in which the rebuttable presumption in IFRS 9:B6.3.13 could be overcome. Also, they considered outreach would not be effective due to the narrow and new IFRS 9 hedge accounting requirements for inflation.

The staff considered that the non-contractually specified real interest rate component described in the fact pattern is not able to rebut the presumption in IFRS 9:B6.3.13 which disallows inflation risk that is not contractually specified to be designated as a risk component of a financial instrument. Given the limited demand for inflation-linked bonds described in the fact pattern, the staff are of the view that the market for inflation-linked bonds in the fact pattern described is not sufficiently liquid, and therefore does not meet the criteria in the example in IFRS 9:B6.3.14 where inflation is a relevant factor that is separately considered by that debt markets illustrated.

Moreover, an inflation index is not considered a uniform measure and can vary within the same currency environment based on the underlying methodology used to determine it. Accordingly, it is questionable whether the inflation component can be measured reliably within a selected currency environment. The staff consider that the cash flows on the LIBOR debt in the submission do not vary directly with changes in the real interest rate or expected inflation but only lead to the different allocations of the values of the real interest rate component and inflation risk component of the total cash flows. The entity could not separate the cash flows into different cash flow streams attributable to the two risk components reliably. Therefore, it could not meet the objective to eliminate the exposure to variability in cash flows that are attributable to a particular risk, to qualify as a cash flow hedge.

Staff recommendation

Based on the above analysis, the staff conclude that the principles and requirements in IFRS Standards provide an adequate basis to determine whether the real interest rate component could be designated in a cash flow hedging relationship in the fact pattern described and not to add the matter to the Committee's standard-setting agenda.

Discussion

The Committee members generally agreed with the conclusion that hedge accounting cannot be applied to the inflation swap in the fact pattern described. The Committee members discussed extensively whether to add clarity or an explanation in the agenda decision to make the flow and analysis clearer.

Some Committee members considered that it is not clear why "cash flows on a floating rate debt do not vary directly with changes in the real interest rate" would automatically fail the hedge accounting requirement and suggested adding the reference in IFRS 9 to explain it. The staff replied that, in the fact pattern described, it is not possible to distinguish if the changes in cash flows are solely due to the real interest rate or due to other factors. It therefore cannot satisfy the objective of hedging specific risk because there is no direct link between the change in the real interest rate and the variability in cash flows. One Committee member suggested adding a definition for nominal interest rate (comprising of real interest rate, inflation risk premium and other premium) which may help to explain that the real interest rate is the residual of the equation and is not separately identifiable.

A number of Committee members showed sympathy with the submitter or other stakeholders with regard to the concern that cash flow hedging could not be applied. This is because the economic substance of the natural hedge with inflation in the fact pattern submitted and the first example in IFRS 9:B6.3.14 look similar. Nonetheless, the accounting treatment is different. However, they agreed with the staff analysis and considered that it is well elaborated that the real interest rate in the fact pattern is not a distinct risk component.

All Committee members agreed not to add the matter to the Committee's standard-setting agenda. 12 of the 14 Committee members agreed with a number of proposed amendments in wordings in the agenda decision.

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