The analysis of the hedged item is somewhat different, as credit risk does not apply to all types of hedged items. For example, inventory and forecast transactions would not have credit risk. Loan assets typically have counterparty credit risk, while financial liabilities bear the issuing entity’s own credit risk.
Credit risk cannot dominate the value change in a hedge of a forecast transaction as the transaction is, by definition, only anticipated but not committed. Credit risk is defined as ‘risk that one party to a financial instrument will cause a financial loss for the other party by failing to discharge an obligation’. For the same reason, inventory also does not involve credit risk.
Consequently, credit risk can only apply if the entity enters into a contract (e.g., if the hedged item is a firm commitment or a financial instrument).
This should be contrasted with the assessment of whether a forecast transaction is highly probable. Even though such a transaction does not involve credit risk, depending on the possible counterparties for the anticipated transaction, the credit risk that affects them can indirectly affect the assessment of whether the forecast transaction is highly probable. For example, assume an entity sells a product to only one particular customer abroad for which the sales are denominated in a foreign currency and the entity does not have alternative customers to sell the product to in that currency (or other sales in that currency). In that case, the credit risk of that particular customer would indirectly affect the likelihood of the entity’s forecast sales in that currency occurring. Conversely, if the entity has a wider customer base for sales of its product that are denominated in the foreign currency then the potential loss of a particular customer would not significantly (or even not at all) affect the likelihood of the entity’s forecast sales in that currency occurring.
For regulatory and accounting purposes, banks usually have systems in place to determine the credit risk on their loan portfolios. Therefore, banks should be able to identify loans with a significant deterioration in the credit standing that would require a qualitative assessment of whether credit risk is dominating the value changes in the hedging relationship.
The systems to assess the credit risk of loans would also permit banks to determine the appropriate economic hedge when hedging the interest rate risk of such loans, as illustrated by the example below:
The example should not be taken to imply that for an individual loan with an expected loss of 5% an entity could not hedge the interest rate risk using an interest rate swap that has a notional amount equal to the loan’s face value. In such a situation the credit risk of the loan would not dominate the interest rate related changes unless and until the credit risk changes. However, if the loan deteriorated in its credit quality to an extent where the credit risk related changes start dominating the interest rate risk related changes, the hedging relationship would have to be discontinued.
The assessment of the effect of credit risk on value changes for hedge effectiveness purposes, which, in many cases, may be carried out on a qualitative basis, should not be confused with the requirement to measure and recognise the impact of credit risk on the hedging instrument and the designated hedged item, which will normally give rise to hedge ineffectiveness recognised in profit or loss.