Measuring Ineffectiveness – FAQ | IFRS

Measuring ineffectiveness

IFRS 9 adds only two paragraphs in the application guidance on how to measure ineffectiveness, dealing with the time value of money and hypothetical derivatives. Although intended as a clarification, these two paragraphs might have wider implications for some practices currently applied by entities.

The effect of the time value of money

Entities have to consider the time value of money when measuring hedge ineffectiveness. This means that an entity has to determine the value of the hedged item on a present value basis (thereby including the effect of the time value of money).

IFRS 9 does not clarify more than what was already clear under IAS 39. In valuation practice, the effect of the time value of money is also included when measuring the fair value of financial instruments. Consequently, it is more than logical to apply the same principle to the hedged item as well.

Hypothetical derivatives for measuring ineffectiveness

When measuring ineffectiveness of cash flow hedges under IAS 39, entities often make use of a so-called ‘hypothetical derivative’. This involves establishing a notional derivative that has terms that match the critical terms of the hedged exposure (normally an interest rate swap or forward contract with no unusual terms and a zero fair value at inception of the hedging relationship). The fair value of the hypothetical derivative is then used to measure the change in the value of the hedged item against which changes in value of the actual hedging instrument are compared, to assess effectiveness and measure ineffectiveness. However, although commonly used in practice, use of a hypothetical derivative is not specifically addressed in IAS 39.

IFRS 9 clarifies that use of a hypothetical derivative is one possible way of determining the change in the value of the hedged item when measuring ineffectiveness. However, IFRS 9 also clarifies that a hypothetical derivative has to be a replication of the hedged item and that any different method for determining the change in the value of the hedged item would have to have the same outcome. Consequently, an entity cannot include features in the hypothetical derivative that only exist in the hedging instrument, but not in the hedged item.

What appears to be a logical requirement may have wider implications for cash flow hedges than many would have expected. IFRS 9 is clear that the hypothetical derivative is supposed to represent the hedged item and not the ‘perfect hedge’. In other words, an entity cannot simply assume no ineffectiveness for a cash flow hedge with matching terms (e.g., where the terms of the hedging instrument exactly match the terms of a hedged forecast transaction).

For example, IFRS 13 requires an entity to reflect both the counterparty’s credit risk and the entity’s own credit risk in the measurement of a derivative. The counterparty credit risk of a derivative designated in a hedging relationship is likely to be different from the counterparty credit risk in the hedged item (if there is any). The difference in credit risk would result in some ineffectiveness (see ‘Impact of credit risk‘). IFRS 9 is clear that, when using a hypothetical derivative for measuring ineffectiveness in a cash flow hedge, the counterparty credit risk on the hedging instrument could not be deemed to equally be a feature also present in the hedged item. For example, if the hedged item is a forecast transaction it would not involve any credit risk, so that there is no offset for any credit risk affecting the fair value of the hedging instrument, which would give rise to some ineffectiveness. Also, if the hedged item involves credit risk, the effect of that has to be established independently of the hedging instrument.

Another (maybe unexpected) source of ineffectiveness is the discount rate used for measuring the fair value of cash collateralised IRS. Historically, the fair values of interest rate swaps have been calculated using LIBOR-based discount rates. As per its definition, LIBOR is the average rate at which the reference banks can fund unsecured cash in the interbank market for a given currency and maturity.

However, the use of LIBOR as the standard discount rate ignores the fact that many derivative transactions are now collateralised. For cash-collateralised trades, a more relevant discount rate is an overnight rate rather than LIBOR. Overnight index swaps (OIS) are interest rate swaps where the floating leg is linked to an interest rate for overnight unsecured lending to a bank. OIS rates much better reflect the funding cost of cash collateralised IRS.

When measuring the fair value of cash-collateralised LIBOR indexed interest rate swap, an entity would have to use a LIBOR-based forward curve to determine the future floating cash flows, but these are then discounted using an OIS swap curve. This would obviously result in a different fair value compared to a non-collateralised IRS for which both the forward rates and the discount rates are derived from the LIBOR swap curve. The resulting ineffectiveness is sometimes referred to as the ‘multi curve issue’.

Historically, the difference between LIBOR and OIS rates has been equal to a few basis points only. However, the basis differential widened significantly during the financial crisis and is not expected to revert in the foreseeable future.

For cash-collateralised derivatives, both parties to the contract would have equal collateral requirements, significantly reducing the credit risk of both parties to the contract. This would improve the economic effectiveness of a hedging relationship while at the same time, may also result in more accounting ineffectiveness.

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