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 still 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.
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:
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.
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.
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