Hedge Accounting Requirements – FAQ | IFRS

Hedge accounting requirements

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Hedge accounting requirements – IFRS 9 now allows, for fair value hedges, the designation of layer components from a defined nominal amount or a defined, but open, population. IFRS 9 stillHedge accounting requirements includes some restrictions, in particular that a layer component that includes a prepayment option does not qualify as a hedged item in a fair value hedge if the fair value of the prepayment option is affected by changes in the hedged risk. Hedge accounting requirements

When an entity has an option to prepay a loan, at fair value, the fair value of the option is not affected by changes in the hedged risk. Consequently, an entity would be able to designate a hedge as described in this example: Hedge accounting requirements

Hedging a top layer of a loan

An entity borrows money by issuing a CU10m five-year fixed rate loan. The entity has a prepayment option to pay back CU5m at fair value. The entity wants to be able to make use of the prepayment option without the amount repayable on early redemption being affected by interest rate changes.

Consequently, the entity would like to hedge the fair value interest rate risk of the prepayable part of the loan. To achieve this, the entity enters into a five-year receive fixed/pay variable IRS with a notional amount of CU5m. The entity designates the IRS in a fair value hedge of the interest rate risk of the CU5m top layer of the loan attributable to the benchmark interest rate. As a result, the top layer is adjusted for changes in the fair value attributable to changes in the hedged risk. The bottom layer, which cannot be prepaid, remains at amortised cost.

The gain or loss on the IRS will offset the change in fair value on the top layer attributable to the hedged risk. On prepayment, the fair value hedge adjustment of the top layer is part of the gain or loss on the early repayment of the loan.

This example above, of a hedge of a top layer of a loan, would not often be found in practice as most prepayment options in loan agreements allow, in our experience, for prepayment at the nominal amount (instead of at fair value). Hedge accounting requirements

Should prepayment be at the nominal amount, the fair value of the prepayment option would be affected by changes in the hedged interest rate risk. Therefore, the top layer would not normally qualify for hedge accounting. However, such a layer will still qualify for hedge accounting if the effect of the related prepayment option is included when measuring the fair value change of the hedged item. Hedge accounting requirements

So, bottom layer hedging strategies can be applied if the hedged layer is not affected by the prepayment risk. This is best demonstrated based on the example below, making use of the new IFRS 9 designation for nominal components. Hedge accounting requirements

Hedging a bottom layer of a loan portfolio (IFRS 9)

A bank holds a portfolio of fixed rate loans with a total nominal amount of CU100m. The borrowers can, at any time during the tenor, prepay 20% of their (original) loan amount at par.

For risk management purposes, the loans are considered together with variable rate borrowings of CU100m. As a result, the bank is exposed to an interest margin risk resulting from the fixed-to-floating rate mismatch. The bank expects CU20m of loans to be prepaid.

As part of the risk management strategy, the bank decides to hedge a part of the interest margin by entering into a pay fixed/receive variable IRS. The objective is to hedge 95% of the amount of loans that is not prepayable using an IRS with a notional amount of CU76m. The hedged layer does not include a prepayment option. Therefore, the IRS is designated in a fair value hedge of the interest rate risk of the CU76m bottom layer of the CU100m loan portfolio.

As a result, the bottom layer is adjusted for changes in the fair value attributable to changes in the hedged risk (i.e., benchmark interest rate risk). The extent to which the borrowers exercise their prepayment option does not affect the hedging relationship. Also, if the bank were to derecognise any of the loans for any other reason, the first CU4m of non-prepayable amount of derecognised loans would not be part of the hedged item (i.e., the CU76m bottom layer).

As mentioned above, IFRS 9 does not preclude hedge accounting for layers including a prepayment option. However, changes in fair value of the prepayment option as a result of changes in the hedged risk have to be included when measuring the change in fair value of the hedged item. The following example illustrates what this means in practice: Hedge accounting requirements

Hedging a bottom layer including prepayment risk

A bank originates a CU10m five-year fixed rate loan with a prepayment option to pay back CU5m at any time at par.Harvested products

For risk management purposes, the loan is considered together with variable rate borrowings of CU10m. As a result, the bank is exposed to an interest margin risk resulting from the fixed-to-floating rate mismatch. The bank expects the borrower to prepay CU2m and, therefore, wishes to hedge CU8m only. The bank enters into a five-year pay fixed/receive variable IRS with a notional amount of CU8m and designates CU5m of the IRS in a fair value hedge of the benchmark interest rate risk of the CU5m layer of the non-prepayable loan amount. In addition, the bank enters into a swaption with a notional amount of CU3m that is jointly designated with CU3m of the IRS to hedge the benchmark interest rate risk of the last remaining CU3m of the CU5m prepayable amount of the loan (a bottom layer).

As a result, the non-prepayable loan amount is adjusted for changes in the fair value attributable to changes in the hedged risk (the fixed rate benchmark interest rate risk of a fixed term instrument). However, the CU3m bottom layer of the prepayable amount also needs to be adjusted for the effect of the prepayment option on the changes in the fair value attributable to changes in the interest rate risk. The CU2m top layer remains at amortised cost.

Therefore, the first CU2m of prepayments would have a gain or loss on derecognition determined as the difference between the amortised cost of the prepaid amount and par. For any further prepayments exceeding CU2m, the gain or loss on derecognition would be determined as the difference between the amortised cost including the fair value hedge adjustment and par.

See also: The IFRS Foundation

Hedge accounting requirements

Hedge accounting requirements

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