Accounting for Derivatives. Ramirez Juan

(i.e., the counterparty will always pay any settlement amounts due to the entity).

      • The hypothetical derivative has no time value, in the case of it being a single option or a combination of options.

      For example:

      • When hedging the FX exposure of a highly expected foreign currency cash flow, the hypothetical derivative would be an FX forward rate with an FX rate that gives the forward an initial zero cost, a currency pair that equals the entity's functional currency and the currency in which the hedged cash flow is denominated, a notional that equals the amount of the expected cash flow, and a maturity that represents the date on which the cash flow is expected to occur.

      • When hedging the interest rate exposure of a bullet floating rate liability (i.e. its principal is repaid at maturity only and its periodic interest is linked to a short-term interest rate such as the 3-month Euribor), the hypothetical derivative would be an interest rate swap with a notional equal to that of the debt, interest periods matching those of the debt and a fixed interest rate that gives the swap an initial zero cost.

      Ineffectiveness will be measured as the difference between changes in fair value of the hypothetical derivative and the hedging instrument. Ineffectiveness will in principle arise due to differences in their terms and the presence of counterparty credit risk in the hedging instrument.

      2.8 REBALANCING

Rebalancing refers to adjustments to the hedge ratio, or in other words, to adjustments in the designated quantities of the hedged item or the hedging instrument of an already existing hedging relationship for the purpose of maintaining a hedge ratio that complies with the hedge effectiveness requirements (see Figure 2.12).

Figure 2.12 Rebalancing of a hedging relationship.

      An entity at each assessment date must evaluate whether an existing hedging relationship needs rebalancing. Rebalancing is required when maintaining the existing hedge ratio would reflect an imbalance that would create hedge ineffectiveness that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting (i.e., an entity must not create an imbalance by omitting to adjust the hedge ratio).

      Adjusting the hedge ratio allows an entity to respond to changes in the relationship between the hedging instrument and the hedged item that arise from their underlyings or risk variables, and to continue the hedging relationship. The adjustment to the hedge ratio can be effected in different ways:

      • increasing (or decreasing) the quantity of the hedged item; or

      • increasing (or decreasing) the quantity of the hedged instrument.

      If a hedging relationship ceases to meet the hedge effectiveness requirement regarding the hedge ratio but the risk management objective for that designated hedging relationship remains the same, an entity shall adjust the hedge ratio of the hedging relationship so that it meets the qualifying criteria again. Rebalancing does not apply (or is not required) if:

      • The risk management objective for a hedging relationship has changed. Instead, hedge accounting for that hedging relationship shall be discontinued (notwithstanding that an entity might designate a new hedging relationship that involves the hedging instrument or hedged item of the previous hedging relationship).

      • Fluctuation around a constant hedge ratio (and hence the related hedge ineffectiveness) cannot be reduced by adjusting the hedge ratio in response to each particular outcome. Hence, in such circumstances, the change in the extent of offset is a matter of measuring and recognising hedge ineffectiveness but does not require rebalancing.

      Example: Hedging a HKD-EUR exposure

      A EUR-based entity hedges a highly expected HKD 500 million cash flow using a EUR–USD FX forward with a USD notional of USD 65 million, when the HKD is pegged to the USD in a 7.75:1 ratio. If the Chinese authorities decide to devalue the HKD by changing the USD–HKD peg to a 10:1 exchange rate, rebalancing the hedging relationship to reflect the new exchange rate would ensure that the hedging relationship would continue to meet the hedge effectiveness requirement regarding the hedge ratio in the new circumstances. The entity may either reduce the amount of hedging instrument to USD 50 million notional (the excess 15 million would be considered speculative) or, less likely, increase the amount of hedged item to HKD 650 million.

      In contrast, if there were a default on the FX forward, changing the hedge ratio could not ensure that the hedging relationship would continue to meet that hedge effectiveness requirement. Hence, rebalancing does not facilitate continuing a hedging relationship in situations where the relationship between the hedging instrument and the hedged item changes in a way that cannot be compensated for by adjusting the hedge ratio.

      When rebalancing a hedging relationship, an entity shall update its analysis of the sources of hedge ineffectiveness that are expected to affect the hedging relationship during its remaining life. The documentation of the hedging relationship shall be updated accordingly.

2.8.1 Accounting for Rebalancings

      Rebalancing is accounted for as a continuation of the hedging relationship. On rebalancing, the hedge ineffectiveness of the hedging relationship is determined and recognised immediately before adjusting the hedging relationship.

      Example (Part 1)

      Suppose that an entity determined, based on historical data, that in order to hedge 100 tonnes of a future purchase of commodity A it should transact 120 tonnes of notional value of derivatives on benchmark commodity B. The entity designated this as a cash flow hedging relationship.

      On the next reporting date, the effectiveness assessment demonstrated that the basis for benchmark commodity B had changed such that only 110 tonnes were required to hedge 100 tonnes of commodity A. The entity believed this was part of a trend leading away from the hedge ratio rather than just a temporary fluctuation. To rebalance the hedge ratio, the entity could:

      • de-designate 10 tonnes of the hedging derivative (i.e., decreasing the volume of the hedging instrument to 110 tonnes); or

      • designate an additional 9.1 (=100 × 120/110 – 100) tonnes of the hedged item (i.e., increasing the volume of the hedged item to 109.1 tonnes), if highly probable to occur.

      Adjusting the Hedge Ratio by Decreasing the Volume of the Hedging Instrument

      Adjusting the hedge ratio by decreasing the volume of the hedging instrument does not affect how the changes in the value of the hedged item are measured. The measurement of the changes in the fair value of the hedging instrument related to the volume that continues to be designated also remains unaffected.

      However, from the date of rebalancing, the volume by which the hedging instrument was decreased is no longer part of the hedging relationship (by 10 tonnes in our previous example). The entity may decide whether to unwind the excess hedge or retain it. If the excess hedge is retained, such a proportion of the hedging instrument would be designated as speculative and, as a result, its fair value change recognised in profit or loss (unless after the rebalancing it was designated in a different hedging relationship).

      Adjusting the Hedge Ratio by Increasing the Volume of the Hedged Item

      Rebalancing by increasing the volume of the hedged item does not affect how the changes in the fair value of the hedging instrument are measured. The measurement of the changes in the value of the hedged item related to the previously designated volume also remains unaffected. However, from the date of rebalancing, the changes in the value of the hedged item also include the change in the value of the additional volume of the hedged item.

      These changes are measured starting from, and by reference to, the date of rebalancing instead of the date on which the hedging relationship was designated. In our previous example, the entity would designate an additional 9.1 tonnes of the hedged item.

      Example (Part 2)

      Based on our previous