IFRS 9 requires that, to achieve hedge accounting, the impact of changes in credit risk should not be of a magnitude such that it dominates the value changes, even if there is an economic relationship between the hedged item and hedging instrument. Credit risk can arise on both the hedging instrument and the hedged item in the form of counterparty’s credit risk or the entity’s own credit risk.
Judgement has to be used in determining when the impact of credit risk is ‘dominating’ the value changes. But clearly, to ‘dominate’ would mean that there would have to be a very significant effect on the fair value of the hedged item or the hedging instrument. The standard provides guidance that small effects should be ignored even when, in a particular period, they affect the fair values more than changes in the hedged risk. In other words, it is not only a relative but also an absolute assessment.
Credit risk on the hedging instrument Impact of credit risk Credit risk on the hedged item
IFRS 13 Fair Value Measurement is clear that the effect of credit risk, both the counterparty’s credit risk and the entity’s own credit risk, has to be reflected in the measurement of fair value. The effect of credit risk on the measurement of the hedging instrument would obviously result in some hedge ineffectiveness. The expected effect of that ineffectiveness should not be of a magnitude that it neutralises the offsetting impact of a significant change in the values of the hedging instrument and the hedged item (see ‘Economic relationship‘).
We expect the assessment of the effect of credit risk to be a qualitative assessment in most cases. For example, entities typically have counterparty risk limits defined as part of their risk management policy. The credit standing of the counterparties is monitored on a regular basis.
The risk management policy may include measures to be taken once a significant deterioration in the credit risk is identified. Such measures could include settling the derivative and possibly novating it to another party (in which case, the hedging relationship would have to be discontinued), or negotiating collateral or other credit enhancements (which would significantly improve the hedging relationship).
However, a quantitative assessment of the impact of credit risk on the value changes of the hedging relationship might be required in some instances, e.g., to find out what factors contribute to a low offset between the changes in the value of the hedging instrument and the hedged item and the magnitude of their influence.
Nowadays, most over-the-counter derivative contracts between financial institutions are cash collateralised. Furthermore, current initiatives in several jurisdictions, such as, the European Market Infrastructure Regulation (EMIR) in the European Union or the Dodd-Frank Act in the United States, will result in more derivative contracts being collateralised by cash. Cash collateralization significantly reduces the credit risk for both parties involved, meaning that credit risk is unlikely to dominate the change in fair value of such hedging instruments.
Credit risk on the hedged item Impact of credit risk Credit risk on the hedged item