Hedging is a risk management strategy designed to mitigate the impact of economic

risks on a bank's performance. Many banks will engage in hedging activity to limit
economic risk. IFRS provide for special accounting treatment for economic hedges,
provided that certain criteria are met. Some of the strategies that banks use under
other GAAPs to hedge risks may need to be revised in order to meet the IFRS criteria
for hedge accounting.

Hedge accounting means designating a hedging instrument, normally a derivative, as

an offset to changes in the fair value or cash flows of a hedged item. Non-derivative
financial instruments may be used as hedging instruments in certain limited
circumstances. A hedged item can be an asset, liability, firm commitment, or
forecasted future transaction that is exposed to a risk of change in value or changes in
future cash flows [IAS39.10] or a portfolio of similar assets and liabilities. Hedge
accounting matches the offsetting effects of the fair value changes in hedged items
and hedging instruments and recognizes them in net profit or loss at the same time.

The normal rules for financial instruments call for all derivatives to be carried at fair
value with gains and losses in the income statement. Hedge accounting allows
departures from the normal recognition rules. Accounting rules for hedging are
necessary to reflect the economics of hedging relationships in reporting performance.
A bank using hedge accounting can impact on the timing of recognition of gains and
losses from fair value changes in hedged items and hedging instruments, and avoid
the significant volatility that might arise if the gains and losses were recognized in the
income statement under normal accounting rules.

Hedge accounting is an exception to the usual rules for financial

instruments; there are strict criteria that must be met before it can be
used. Management must identify, document and test the effectiveness of
those transactions for which it wishes to achieve hedge accounting. The
requirements are [IAS39.142]:

a) The hedged item and the hedging instrument are specifically identified;
b) The hedging relationship is formally documented ;
c) The documentation of the hedged relationship must identify the hedged risk
and how the hedge's effectiveness will be assessed;
d) At the inception of the hedge, it must be expected to be highly effective; that
is, the gains and losses on the hedged item and the hedging instrument
should almost fully offset over the hedge's life ;
e) Retrospective effectiveness of the hedge must be tested regularly throughout
its life. Effectiveness should fall within a range of 80 to 125% over its life. This
leaves some scope for short-term ineffectiveness, provided that overall
effectiveness falls within this range ;
f) A hedge must be capable of being designated against specific assets and
liabilities. Therefore if hedges are established for net positions, it must be
possible to trace them back to the underlying gross asset, liability or forecast
transactions ; and
f) Hedges of forecast transactions are allowed if the forecast transaction is
'highly probable'.

The criteria to achieve hedge accounting are onerous and have significant systems
implications for banks because of the volume of derivatives used to hedge economic
exposures. Management should always consider the relative costs and benefits of
using hedge accounting.
Hedge accounting can be applied to qualifying hedged items. A hedged item must
create an exposure to risk that could affect the income statement, currently or in
future periods. The usual types of risks that are hedged include interest-rate risk,
foreign currency risk, credit risk and equity-price risk.

Macro hedging - that is, hedging the open position arising from a number of similar
hedged items - does not meet the requirements for hedge accounting [IAS39.131,
132]. Hedge accounting for hedges of net open positions is not permitted [IAS39.133]
[IGC127-1].

Any financial asset or liability that creates exposure to risk can be a hedged item,
with two specific exclusions. Held-to-maturity investments cannot be hedged items
for interest-rate risk, nor in consolidated financial statements can any investments
that the bank has in subsidiaries or associates that are consolidated or measured
using the equity method [IAS39.127] [IGC172-2] [IAS39.150]. However, the net
investment in a foreign entity can be hedged. Some examples of exposures that can
be hedged are:

a) originated loans (risk of changes in interest rates);

b) fixed-interest debt security classified as available-for-sale (risk of changes in
interest rates or credit risk);
c) foreign currency monetary items (risk of changes in foreign exchange rate).

An exposure to general business risks cannot be hedged, including risk of

obsolescence of trading systems, risk of decline in depositor base or the risk of
systems failure, because these risks cannot be reliably measured. For similar reasons,
a commitment to acquire another entity in a business combination cannot be a
hedged item, other than for foreign exchange risk [IAS39.135].

Only an external derivative instrument can be used as a hedging instrument in

most cases [IAS39.134]. An external non-derivative financial instrument can be
used as a hedging instrument only for foreign currency risk [IAS39.122]. A
foreign currency borrowing, for example, can be designated as a hedge of a net
investment in a foreign entity.

Banks with complex group balance sheet management operations will often use
intra-group derivatives to manage currency and interest-rate risk across the bank.
Intra-group derivatives are not external derivative instruments, and must be
eliminated on consolidation [IAS39.134].

The group balance sheet management function may net all of the foreign currency
exposures and enter into a single external derivative transaction. The external
derivative may qualify for hedge accounting provided all the other standard criteria
are met [IAS39.139].

Netting of internal positions relating to interest-rate risk with a single external

derivative instrument used to hedge risk does not qualify for hedge accounting
[IGC134-1(a)]. The external derivative must be designated as the hedging
instrument. A gross position, similar in amount and timing to the net position, is
designated as the hedged item at the group level [IAS39.133].

A single derivative with several elements, such as a cross-currency interest-rate

swap, can be designated as a hedge of separate risks, provided that the individual
components designated as hedging each risk meet the hedge accounting criteria
[IAS39.131] [IGC131-2].

IFRS recognize three types of hedge accounting: fair value hedges, cash flow
hedges and hedges of the net investment in a foreign entity [IAS39.137]. Each has
specific requirements on accounting for the fair value changes.

Fair value hedges

The risk being hedged in a fair value hedge is a change in the fair value of an asset
or liability that will affect the income statement [IAS39.138]. Changes in fair value
might arise through changes in interest rates in relation to fixed-rate components
of a mortgage, changes in the credit spread on a fixed-rate loan or from changes in
prices of equity investments classified as available-for-sale . The impact on the
income statement can be immediate or expected to happen in future periods. An
available-for-sale equity security, where gains and losses are deferred in equity,
would impact on the income statement when sold.

The hedged asset or liability is adjusted for fair value changes due to the risk being
hedged, and those fair value changes are recognized in the income statement
[IAS39.153 (b)]. The hedging instrument is measured at fair value with all changes
recognized in the income statement [IAS39.153 (a)]. Ineffectiveness is therefore
taken to the income statement to the extent that the adjustment to the hedged
item does not offset the change in fair value of the hedging instrument. Examples
of fair value hedges might be an interest-rate swap hedging a fixed-rate loan .

Cash flow hedges

The risk being hedged is the potential volatility in future cash flows that will affect
the income statement. Future cash flows might relate to existing assets and
liabilities such as future interest payments or receipts on floating-rate loans
advanced to customers. Future cash flows can also relate to highly probable future
transactions such as hedging of mortgage pipeline sales or purchases in a foreign
currency [IAS39.137]. Potential volatility might also result from changes in interest
rates, changes in exchange rates or changes in commodity prices. Many fair value
hedges can also be designated as cash flow hedges of different items, but to
qualify they must include an exposure to variability in cash flows as a result of the
item being hedged. Hedges of firm commitments are cash flow hedges.

Changes in the hedging instrument's fair value, to the extent that the hedge is
effective, are deferred in a 'hedging reserve' in equity [IAS39.158 (a)] [IAS1.86 (b)]
and recycled to the income statement when the hedged transaction affects the
income statement [IAS39.162]. Fair value changes from cash flow hedges that
relate to firm commitments or forecast transactions, and result in the recognition
of assets or liabilities, are included in the initial measurement of those assets or
liabilities [IAS39.160].

An example of a common cash flow hedge is the use of an interest-rate swap

converting a floating-rate loan to fixed-rate.

Hedge of net investment in a foreign entity

A bank may have subsidiaries that meet the test and qualify for treatment as
foreign entities of the parent. Exchange differences arising on consolidation are
deferred in equity until the subsidiary is disposed of [IAS21.17]. On disposal or
liquidation, the differences are recognized in the income statement as part of the
gain or loss on disposal [IAS21.37, 38]. The net investment in a subsidiary can be
hedged with a foreign currency borrowing or a derivative. The fair value changes of
the hedging instrument, if effective, are deferred in equity until the subsidiary is
disposed of, when they become part of the gain or loss on disposal [IAS21.19].

The hedging instrument for a net investment hedge, in order to be effective, will
almost always be denominated in the foreign entity's local currency.

Hedges must be expected to be highly effective at designation to qualify for

hedge accounting. A hedge can be expected to be highly effective when the
changes in fair value or cash flows of the hedged item and the hedging
instrument are expected to almost fully offset each other (after eliminating the
changes in fair value or cash flows of the hedged item that arise due to risks
that are not being hedged) [IAS39.146] .

The standard gives rise to two separate effectiveness requirements. First, at

inception of the hedge, the hedging relationship must be shown to be effective on
a prospective basis; that is, the hedge is expected to be effective. The level of
effectiveness required for prospective effectiveness in IAS 39 is that the risks are
"almost fully offset". No numerical range has been formally given as meeting the
"almost fully offset" criteria. However, the changes in the value or cash flows of the
hedged item are expected to be at least between 95% and 105% of the changes in
value or cash flows of the hedging instrument.

The effectiveness over the life of the hedge must then be shown retrospectively to
be within 80% to 125% for the hedge to continue to be considered effective and for
hedge accounting to continue [IAS39.146].

When a hedge fails the effectiveness test, hedge accounting is discontinued

prospectively [IAS39.156, 163,165].

Hedges are seldom, if ever, perfectly effective. Any hedge ineffectiveness, even if
the hedge continues to be considered effective overall, must be recognized in
income in the current period. Hedge ineffectiveness can arise for a number of
reasons; the hedged item and the hedging instrument may:

a) Have different maturities;

b) Use different underlying interest or equity indices;
c) Use commodity prices in different markets; or
c) Be subject to different counter-party risks.

Careful definition of the hedged risk and the components of the hedging
instrument are the best ways to improve hedge effectiveness.

Hedge accounting should cease prospectively when any of the following occurs
[IAS39.156,163,165]:

a) A hedge fails the effectiveness tests;

b) The hedged item is settled;
c) The hedging instrument is sold, terminated or exercised;
d) Management decides to change the designation; or
e) For a cash flow hedge the forecast transaction is no longer highly probable.

Hedge accounting ceases prospectively from the beginning of the period in which
the hedge effectiveness test is failed. All further fair value changes in a derivative
hedging instrument are recognized in the income statement. Future changes in the
fair value of the hedged item, and any non-derivative hedging instruments, are
accounted for as they would be absent hedge accounting.

Gains and losses arising on cash flow hedges from the effective period will remain
in equity until the related cash flows occur. Where a forecast transaction is no
longer highly probable but still expected to take place, previous gains continue to
be deferred. However, once a forecast transaction is no longer expected to occur,
any gain or loss is released immediately to the income statement [IAS39.163].

The presentation and disclosure requirements for financial instruments,

including hedging, are extensive and detailed. Some of the specific and
significant disclosures for hedging are [IAS39.169]:
a) a description of the entity's financial risk management policies and objectives,
including its policy for hedging each major type of forecast
transaction ;

b) for each category of hedge (fair value, cash flow and net investment):
- a description of the hedge,
- the hedging instruments used,
- the risks being hedged,
- the fair values of the hedging instruments at the balance sheet date,
- the periods in which forecasted transactions are expected to occur and
when they are expected to impact on the income statement, and
- a description of any forecasted transaction that is no longer expected to
occur but for which hedge accounting had previously been used.
c) If gains or losses have been recognized on hedging instruments and included
in equity, disclose the following in the statement of changes in equity:
e) For a cash flow hedge the forecast transaction is no longer highly probable.
- the amount that was recognized in equity in the current period,
- the amount removed from equity and recognized in the income statement
in the current period, and
- the amount removed from equity and included in the initial carrying
amount of assets or liabilities in the current period