International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 794
value of demand deposits will not vary with the hedged risk, and fair value hedge
accounting is precluded.
An alternative consideration is whether it is possible to designate a core deposit
intangible (representing the value of this source of funding to the financial institution)
as an eligible hedged item. The term ‘core deposit intangible’ could be used to represent
the difference between:
(a) the fair value of a portfolio of core deposits; and
(b) the aggregate of the individual fair values of the liabilities within the portfolio,
normally calculated in accordance with the requirements of IFRS 13.
Generally, an internally-generated core deposit intangible cannot be a hedged item
because it is not a recognised asset. However, if a core deposit intangible is acquired
together with a related portfolio of deposits, it is required to be recognised separately
as an intangible asset (or as part of the related acquired portfolio of deposits) if it
meets the recognition criteria in IAS 38 – Intangible Assets, which it normally will
(see Chapter 9 at 5.5.2).
Theoretically, therefore, a recognised purchased core deposit intangible asset could be
designated as a hedged item. However this will only be the case if it meets the conditions
for hedge accounting, including the requirement that the effectiveness of the hedge can
be measured reliably. The implementation guidance of IAS 39 explains that because it
is often difficult to measure reliably the fair value of a core deposit intangible asset other
than on initial recognition, it is unlikely that this requirement will be met. [IAS 39.F.2.3]. In
fact, this probably understates the difficulty.
For the reasons set out above, financial institutions are rarely, if ever, able to designate
core deposits with the associated hedging instruments in hedge accounting relationships,
despite the economic validity of these risk management activities. Accordingly, many
financial institutions apply the special portfolio or macro hedge accounting guidance
(see 11 below).
2.7 Aggregated
exposures
2.7.1 Introduction
IFRS 9 introduced a new hedge accounting concept known as ‘an aggregated exposure’;
the purpose of which was to facilitate hedge accounting that reflects the effect of risk
management undertaken for a hedged position that includes a derivative. An aggregated
exposure is described as a combination of an exposure that could qualify as a hedged
item, and a derivative together designated as a hedged item. [IFRS 9.6.3.4]. The guidance
does not change the unit of account for instruments making up the aggregated exposure,
specifically it is not accounted for as a ‘synthetic’ single item. Instead, an entity should
consider the combined effect of the aggregated exposure for the purpose of assessing
hedge effectiveness and measuring hedge ineffectiveness.
Whilst the ability to designate an aggregated exposure as a hedged item in a hedge
relationship should allow an entity to reflect better the effect of its risk management in the
financial statements, the steps required to achieve this hedge accounting are quite complex.
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Furthermore, although some detailed examples of hedge accounting for aggregated
exposures are provided in the implementation guidance in the standard, there are still some
areas of uncertainty. [IFRS 9.IE115-147]. We outline below the general requirements for hedge
accounting for aggregated exposures.
2.7.2 Background
Entities often purchase or sell items (in particular commodities) that expose them to
more than one type of risk (e.g. commodity and foreign exchange risk). When hedging
those risk exposures, entities do not always hedge each risk for the same time period.
This is best explained with an example:
Example 49.22: Aggregated exposure – copper purchase in a foreign currency
An entity manufacturing electrical wires is expecting to purchase copper in 12 months. The functional
currency of the entity is Euro (EUR). The copper price is fluctuating and is denominated in US dollars (USD),
which is a foreign currency for the entity. The entity is exposed to two main risks, the copper price risk and
the foreign exchange risk.
The entity first decides to hedge the copper price fluctuation risk, using a copper futures contract. By doing
so, the entity now has a fixed-price copper purchase denominated in a foreign currency and is therefore still
exposed to foreign exchange risk. (In this example we assume there is no ‘basis risk’ between the copper
price exposures in the expected purchase and the futures contract, such as the effect of quality and the location
of delivery). (See 8.2.1 below).
Three months later, the entity decides to hedge the foreign exchange risk by entering into a foreign exchange
forward contract to buy a fixed amount of USD in nine months. By doing so, the entity is hedging the
aggregated exposure, which is the combination of the original exposure to variability of the copper price and
the copper futures contract. The diagram below illustrates the two economic hedging relationships.
1st level relationship
Copper
USD
purchase
Foreign
exchange
USD
forward
contract
EUR
Copper futures
USD
contract
2nd level relationship
Key:
Cash inflows
Cash outflows
In the above example it would be possible for the entity to initially designate the copper
futures contract as hedging variations in the copper purchase price in a cash flow hedge
relationship. This is on the assumption that the relevant hedge accounting eligibility
criteria are met. (See 6 below). However, when the entity transacts the foreign exchange
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forward contract three months later the general hedge accounting guidance would
provide the entity with two choices (see 8.3 below):
• discontinue the first hedging relationship (i.e. the copper price risk hedge) and re-
designate a new relationship with joint designation of the copper futures contract
and the foreign exchange forward contract as the hedging instrument. This is likely
to lead to some ‘accounting’ hedge ineffectiveness as the copper futures contract
will now have a non-zero (i.e. off market) fair value on designation of the new
relationship (see 7.4.4.B below); or
• maintain the copper price risk hedge and designate the foreign exchange forward
contract in a second relationship as a hedge of the variable USD copper purchase
price. Even if the other hedge accounting requirements could be met, this means that
the volume of hedged item is constantly changing as it is the variable copper
purchase price that is now hedged for foreign exchange risk, (i.e. without
consideration of the effect of the copper futures). This will likely have an impact on
the effectiveness of the hedging relationship, in particular if the variable USD copper
price falls, as there may not be sufficient volume of USD cash flows from the
designated hedged item in order to match the foreign currency forward contract.
As mentioned ab
ove, IFRS 9 includes an additional accounting choice for such a
strategy which is to permit designation as hedged items the aggregated exposures that
are a combination of an exposure that could qualify as a hedged item and a derivative.
[IFRS 9.6.3.4].
Consequently, in the scenario described in Example 49.22 above, the entity could designate
the foreign exchange forward contract in a cash flow hedge of the combination of the original
exposure and the copper futures contract (i.e. the aggregated exposure) without affecting the
first hedging relationship. In other words, it would not be necessary to discontinue and re-
designate the first hedging relationship, as summarised in the table below:
IFRS 9 designations
1st level hedge relationship
2nd level hedge relationship
Hedge relationship
Cash flow hedge
Cash flow hedge
Hedged risk
Copper price
USD/EUR exchange rate
Hedged item
Combination of copper purchases and
Copper purchases
copper futures contract
Hedging instrument
Copper futures contracts
Foreign exchange forward contract
Designation
Designated when copper futures are
Designated when foreign exchange
transacted. Hedge is not affected by 2nd
forward contract is transacted
level hedge designation
It is important to keep in mind that the individual items in the aggregated exposure are
accounted for separately, applying the normal requirements of hedge accounting (i.e.
there is no change in the unit of account; the aggregated exposure is not treated as a
‘synthetic’ single item). For example, when hedging a combination of a variable rate loan
and a pay fixed/receive variable interest rate swap (IRS), the loan would still be
accounted for at amortised cost with the IRS accounted for at fair value through profit
or loss, and presented separately in the statement of financial position. An entity would
not be allowed to present the IRS and the loan (i.e. the aggregated exposure) together
in one line item (i.e. as if it was one single fixed rate loan). [IFRS 9.B6.3.4].
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However, when assessing the effectiveness and measuring the ineffectiveness of a
hedge of an aggregated exposure, the combined effect of the items in the aggregated
exposure has to be taken into consideration. [IFRS 9.B6.3.4]. (See 6.4 and 7.4 below
respectively). This is of particular relevance if the terms of the hedged item and the
hedging instrument in the first hedging relationship do not perfectly match, e.g. if there
is basis risk. Any ineffectiveness in the first level relationship would automatically also
lead to some ineffectiveness in the second level relationship. However, this does not
mean that the same ineffectiveness is recognised twice.
2.7.3
Accounting for aggregated exposures
The following three examples, partly derived from illustrative examples in the
implementation guidance of IFRS 9, help explain the concept of a hedge of an
aggregated exposure. We have not repeated the detailed calculations provided in the
illustrative examples, but have focused instead on explaining the required approach:
Example 49.23: Fixed rate loan in a foreign currency – cash flow hedge of an
aggregated exposure
This fact pattern is based on Example 17 in the implementation guidance. [IFRS 9.IE128-137]. An entity has a
fixed rate borrowing denominated in a foreign currency (FC) and is therefore exposed to foreign exchange
risk and fair value risk due to changes in interest rates. The entity decides to swap the borrowing into a
functional currency (LC) floating rate borrowing using a cross currency interest rate swap (CCIRS). The
CCIRS is designated as the hedging instrument in a fair value hedge (first-level relationship). By doing so,
the entity has eliminated both the foreign exchange risk and the fair value risk due to changes in interest rates.
However, it is now exposed to variable functional currency interest payments.
Later, the entity decides to fix the amount of functional currency interest payments by entering into an interest
rate swap (IRS) to pay fixed and receive floating interest in its functional currency. By doing so, the entity is
hedging the aggregated exposure, which is the combination of the original exposure and the CCIRS. The IRS
is designated as the hedging instrument in a cash flow hedge (second-level relationship). [IFRS 9.IE131(b)]. The
diagram below illustrates the interest flows in the two hedging relationships.
1st level relationship
Fix rate
FC
borrowing in
FC
Interest rate
LC
swap LC
Cross currency
FC
interest rate
swap
LC
2nd level relationship
As noted above, the accounting for aggregated exposures can be complex. In this
example the complexity lies in the calculation of the present value (PV) of the variability
of cash flows of the aggregated exposure. This calculation is necessary in order to
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calculate the ineffectiveness in the second level relationship, in line with the usual hedge
accounting requirements for cash flow hedges. [IFRS 9.6.5.11(a)(ii)].
The implementation guidance in Example 17 demonstrates that the variability of the
cash flows of the aggregated exposure can be calculated by creating a ‘synthetic’
aggregated exposure for calculation purposes only. [IFRS 9.IE.134(a)]. This is similar to
creating what is often referred to as a ‘hypothetical derivative’ for hedge relationships
that do not include aggregated exposures. (See 7.4.4.A below).
One leg of the synthetic aggregated exposure is based on the gross cash flows from the
aggregated exposure, and the other leg is ‘fixed at a blended rate’ such that the present
value of the whole synthetic aggregated exposure is nil on initial hedge designation.
Similar to the role of the fixed leg in a hypothetical derivative, the fixed leg in the
synthetic aggregated exposure is designed to reflect the level at which the hedged risk
in the aggregated exposure could be locked in on initial designation of the second level
relationship. The purpose of this is to capture the present value of the variability of cash
flows of the aggregated exposure from that point onwards.
In this particular fact pattern, the leg in the synthetic aggregated exposure that
represents the cash flows of the aggregated exposure is a combination of the future
foreign currency cash outflows on the liability and the local and foreign currency cash
outflows and inflows on the CCIRS. The ‘blended’ rate for the fixed leg of the synthetic
aggregated exposure is calibrated so that the present value of the synthetic aggregated
exposure in total is nil on designation of the second level relationship.
In the example in the implementation guidance, all the cash flows contributing to the
leg that represents the cash flows of the aggregated exposure, are recorded and valued
on a gross basis. It follows that if the cash flows from the foreign currency fixed rate
liability and t
hose from the receive fixed foreign currency leg of the CCIRS do not
exactly offset, then the resultant ‘net cash flow’ will contribute to the synthetic
aggregated exposure leg that represents the cash flows of the aggregated exposure.
However, the need to consider gross cash flows could also indicate that the valuation
techniques used to calculate the local currency present value for each cash flow making
up the leg that reflects the aggregated exposure, must be appropriate for the instrument
from which the cash flows arise. Consequently, even if the cash flows from the foreign
currency liability and the foreign currency leg of the CCIRS offset completely, the local
currency present value of each may not. This could be due to valuation differences such
as cross currency basis spreads or the credit risk of the CCIRS. Accordingly, gross cash
flows must be considered without any netting of cash flows from separate instruments.
[IFRS 9.IE134(a)].
The diagram below illustrates the methodology described above. The grey field
identifies the output from the calculation, which is the calibrated fixed leg of the
synthetic aggregated exposure that results in a zero present value for the overall
synthetic aggregated exposure on initial designation of the second level relationship.
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PV synthetic
PV of overall
PV CCIRS
PV of FX liability +
aggregated
synthetic
receive fix in FC
+
=
pay fix in FC
exposure receive
aggregated exposure
pay variable in LC
fix in LC
= nil
PV of cash flows representing the aggregated exposure
While, as stated above, the implementation guidance indicates that valuation techniques
used to calculate the present value for each gross cash flow making up the leg that
represents the aggregated exposure, must be appropriate for the instrument from which
the cash flows arise, it is not entirely clear which valuation basis should be used when
calibrating the synthetic fixed rate leg such that the overall synthetic aggregated
exposure has a zero present value on designation.
In each subsequent period, the present values are updated for the changes in the cash