Contractually specified risk components

Purchase or sales agreements sometimes contain clauses that link the contract price via a specified formula to a benchmark price of a commodity. Examples of contractually specified risk components are each of the price links and indexations in the contracts below:

  • Price of natural gas contractually linked in part to a gas oil benchmark price and in part to a fuel oil benchmark price
  • Price of electricity contractually linked in part to a coal benchmark price and in part to transmission charges that include an inflation indexation
  • Price of wires contractually linked in part to a copper benchmark price and in part to a variable tolling charge reflecting energy costs
  • Price of coffee contractually linked in part to a benchmark price of Arabica coffee and in part to transportation charges that include a diesel price indexation

In each case, it is assumed that the pricing component would not require separation as an embedded derivative . When contractually specified, a risk component would usually be considered separately identifiable. Further, the risk component element of a price formula would usually be referenced to observable data, such as a published price index. Therefore, the risk component would usually also be considered reliably measurable. However, entities would still have to consider what has become termed the ‘sub-LIBOR issue’ (see ‘The sub-LIBOR issue’).

Under IAS 39, only risk components of financial items (such as the LIBOR rate in a loan that bears interest at a floating rate of LIBOR plus a spread) could be designated as a hedged item, provided they are separately identifiable and reliably measurable. Under IFRS 9, risk components can be designated for non-financial hedged items, provided the component is separately identifiable and the changContractually specified risk componentses in fair value or cash flows of the item attributable to the risk component are reliably measurable. This requirement could be met where the risk component is either explicitly stated in a contract (contractually specified) or implicit in the fair value or cash flows (non-contractually specified).

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