Setting The Hedge Ratio – FAQ | IFRS

Setting the hedge ratio

The hedge ratio is the ratio between the amount of hedged item and the amount of hedging instrument. For many hedging relationships, the hedge ratio would be 1:1 as the underlying of the hedging instrument perfectly matches the designated hedged risk.

For a hedging relationship with a correlation between the hedged item and the hedging instrument that is not a simple 1:1 relationship, risk managers will generally set the hedge ratio so as to adjust for the type of relation in order to improve the effectiveness (i.e., the hedged ratio may be different to 1:1).

Accordingly, the third effectiveness requirement is that the hedge ratio used for accounting should be the same as that used for risk management purposes.

This does not mean that an entity must designate hedging relationships to the same extent as it hedges for risk management purposes.

For example, if an entity uses a hedge ratio of a quantity of hedging instrument to a quantity of hedged item of 1.1:1 and for risk management purposes hedges a notional amount of hedged items of 100 using a notional amount of hedging instruments of 110, it could decide to designate only a notional amount of 80 of hedged items and designate a notional amount of 88 of its hedges as hedging instruments for accounting purposes.

However, the standard requires the hedge ratio for accounting purposes to be different from the hedge ratio used for risk management if the hedge ratio reflects an imbalance that would create hedge ineffectiveness that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting. This complex language was introduced because the IASB is specifically concerned with deliberate under-hedging, either to minimise recognition of ineffectiveness in cash flow hedges or the creation of additional fair value adjustments to the hedged item in fair value hedges.

The above examples are of course extreme scenarios and instances of unbalanced hedge designations are likely to be rare; IFRS 9 does not require an entity to designate a ‘perfect hedge’. For instance, if the hedging instrument is only available in multiples of 25 metric tonnes as the standard contract size, an imbalance due to using, say, 400 metric tonnes nominal value of hedging instrument to hedge 409 metric tonnes of forecast purchases, would not be regarded as resulting in an outcome ‘that would be inconsistent with the purpose of hedge accounting’ and so would meet the qualifying criteria. Setting the hedge ratio

Setting the hedge ratio

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