International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
Page 811
Financial instruments: Hedge accounting 4093
7.4.4.D
Foreign currency basis spreads
One phenomenon of the financial crisis was the increase in currency basis spreads. The
currency basis is the charge above the risk-free rate in a foreign country to compensate
for country and liquidity risk. Historically, basis spreads had been low, but increased
significantly after the financial crisis and the following sovereign debt crisis. Volatility in
currency basis can create hedge ineffectiveness when using a cross currency interest
rate swap (CCIRS) to hedge the foreign exchange and interest rate risk of a debt
instrument issued in a foreign currency.
When designating the CCIRS in a fair value hedge, the gain or loss on the hedged item
attributable to changes in the hedged interest rate risk is determined based on the
foreign currency interest rate curve, therefore excluding currency basis. IAS 21 then
requires such a monetary item in a foreign currency to be translated to the functional
currency using the spot exchange rate. [IAS 21.23]. Conversely, the fair value of the CCIRS
incorporates the currency basis spread which results in ineffectiveness.
For a cash flow hedge, IFRS 9 is explicit that when using a hypothetical derivative to
calculate ineffectiveness, the hypothetical derivative cannot simply impute a charge for
exchanging different currencies (i.e. the foreign currency basis spread) even though
actual derivatives (for example, cross-currency interest rate swaps) under which
different currencies are exchanged might include such a charge (see 7.4.4.A above).
[IFRS 9.B6.5.5].
Although cross currency interest rate swaps are used to highlight the fact that foreign
currency basis spreads should not be replicated in hypothetical derivatives, this issue is
also likely to arise in other foreign exchange contacts settled in the future. This is also
an issue for net investment hedges for which the hedging instrument is a derivative
(see 7.5.2.A below).
To address this, IFRS 9 identifies cross currency basis spread as a ‘cost of hedging’.
Application of the costs of hedging accounting permits an appropriate portion of the
change in the fair value of cross currency basis spreads to be taken to OCI rather than
immediately recognised in profit or loss, see 7.5.3 below.
7.4.4.E
Detailed example of calculation of ineffectiveness for a cash flow hedge
Example 49.68 below contains a very comprehensive illustration of the calculation of
ineffectiveness for a cash flow hedge that is based on the implementation guidance to
IAS 39. Method B describes, but is not explicitly named as the hypothetical derivative
method. Method A in the example is also an acceptable of calculating ineffectiveness
for a cash flow hedge, but is not widely applied.
Although the example is somewhat esoteric, and many accountants will find the calculations
difficult to follow, it is an important example that remains relevant under IFRS 9.
Example 49.68: Measuring effectiveness for a hedge of a forecast transaction in a
debt instrument
A forecast investment in an interest-earning asset or forecast issue of an interest-bearing liability creates a
cash flow exposure to interest rate changes because the related interest payments will be based on the market
rate that exists when the forecast transaction occurs. The objective of a cash flow hedge of the exposure to
interest rate changes is to offset the effects of future changes in interest rates so as to obtain a single fixed
4094 Chapter 49
rate, usually the rate that existed at the inception of the hedge that corresponds with the term and timing of
the forecast transaction. However, during the period of the hedge, it is not possible to determine what the
market interest rate for the forecast transaction will be at the time the hedge is terminated or when the forecast
transaction occurs.
During this period, effectiveness can be measured on the basis of changes in interest rates between the
designation date and the interim effectiveness measurement date. The interest rates used to make this
measurement are the interest rates that correspond with the term and occurrence of the forecast transaction
that existed at the inception of the hedge and that exist at the measurement date as evidenced by the term
structure of interest rates.
Generally it will not be sufficient simply to compare cash flows of the hedged item with cash flows generated
by the derivative hedging instrument as they are paid or received, since such an approach ignores the entity’s
expectations of whether the cash flows will offset in subsequent periods and whether there will be any
resulting ineffectiveness.
It is assumed that Company X expects to issue a €100,000 one-year debt instrument in three months. The
instrument will pay interest quarterly with principal due at maturity. X is exposed to interest rate increases
and establishes a hedge of the interest cash flows of the debt by entering into a forward starting interest rate
swap. The swap has a term of one year and will start in three months to correspond with the terms of the
forecast debt issue. X will pay a fixed rate and receive a variable rate, and it designates the risk being hedged
as the LIBOR-based interest component in the forecast issue of the debt.
Yield curve
The yield curve provides the foundation for computing future cash flows and the fair value of such cash flows
both at the inception of, and during, the hedging relationship. It is based on current market yields on applicable
reference bonds that are traded in the marketplace. Market yields are converted to spot interest rates (‘spot
rates’ or ‘zero coupon rates’) by eliminating the effect of coupon payments on the market yield. Spot rates
are used to discount future cash flows, such as principal and interest rate payments, to arrive at their fair
value. Spot rates also are used to compute forward interest rates that are used to compute the estimated
variable future cash flows. The relationship between spot rates and one-period forward rates is shown by the
following formula:
Spot-forward relationship
(1 + SRt)t
F =
– 1
(1 + STt – 1)t – 1
where
F = forward rate (%)
SR = spot rate (%)
t = period in time (e.g. 1, 2, 3, 4, 5)
It is assumed that the following quarterly-period term structure of interest rates using quarterly compounding
exists at the inception of the hedge.
Yield curve at inception (beginning of period 1)
Forward periods
1
2
3
4
5
Spot rates
3.75%
4.50%
5.50%
6.00%
6.25%
Forward rates
3.75%
5.25%
7.51%
7.50%
7.25%
The one-period forward rates are computed on the basis of spot rates for the applicable maturities. For
example, the current forward rate for Period 2 calculated using the formula above is equal to [1.04502 ÷
1.0375] – 1 = 5.25%. The current one-period forward rate for Period 2 is different from the current spot rate
for Period 2, since the spot rate is an interest rate from the begin
ning of Period 1 (spot) to the end of Period 2,
while the forward rate is an interest rate from the beginning of Period 2 to the end of Period 2.
Financial instruments: Hedge accounting 4095
Hedged item
In this example, X expects to issue a €100,000 one-year debt instrument in three months with quarterly
interest payments. X is exposed to interest rate increases and would like to eliminate the effect on cash flows
of interest rate changes that may happen before the forecast transaction takes place. If that risk is eliminated,
X would obtain an interest rate on its debt issue that is equal to the one-year forward coupon rate currently
available in the marketplace in three months. That forward coupon rate, which is different from the forward
(spot) rate, is 6.86%, computed from the term structure of interest rates shown above. It is the market rate of
interest that exists at the inception of the hedge, given the terms of the forecast debt instrument. It results in
the fair value of the debt being equal to par at its issue.
At the inception of the hedging relationship, the expected cash flows of the debt instrument can be calculated
on the basis of the existing term structure of interest rates. For this purpose, it is assumed that interest rates
do not change and that the debt would be issued at 6.86% at the beginning of Period 2. In this case, the cash
flows and fair value of the debt instrument would be as follows at the beginning of Period 2.
Issue of fixed rate debt (beginning of period 2) – no rate changes (spot based on forward rates)
Total
Original forward periods
1
2
3
4
5
Remaining periods
1
2
3
4
Spot rates
5.25%
6.38%
6.75%
6.88%
Forward rates
5.25%
7.51%
7.50%
7.25%
€
€
€
€
€
Cash flows:
Fixed interest at 6.86% 1,716
1,716
1,716
1,716
Principal
100,000
Fair value:
Interest* 6,592
1,694
1,663
1,632
1,603
Principal* 93,408
93,408
100,000
*
cash flow discounted at the spot rate for the relevant period, e.g. fair value of principal is calculated as
€100,000 ÷ (1 + [0.0688 ÷ 4])4 = €93,408
Since it is assumed that interest rates do not change, the fair value of the interest and principal amounts equals
the par amount of the forecast transaction. The fair value amounts are computed on the basis of the spot rates
that exist at the inception of the hedge for the applicable periods in which the cash flows would occur had the
debt been issued at the date of the forecast transaction. They reflect the effect of discounting those cash flows
on the basis of the periods that will remain after the debt instrument is issued. For example, the spot rate of
6.38% is used to discount the interest cash flow that is expected to be paid in Period 3, but it is discounted for
only two periods because it will occur two periods after the forecast transaction.
The forward interest rates are the same as shown previously, since it is assumed that interest rates do not
change. The spot rates are different but they have not actually changed. They represent the spot rates one
period forward and are based on the applicable forward rates.
Hedging instrument
The objective of the hedge is to obtain an overall interest rate on the forecast transaction and the hedging
instrument that is equal to 6.86%, which is the market rate at the inception of the hedge for the period from
Period 2 to Period 5. This objective is accomplished by entering into a forward starting interest rate swap that
has a fixed rate of 6.86%. Based on the term structure of interest rates that exist at the inception of the hedge,
the interest rate swap will have such a rate. At the inception of the hedge, the fair value of the fixed rate
payments on the interest rate swap will equal the fair value of the variable rate payments, resulting in the
interest rate swap having a fair value of zero. The expected cash flows of the interest rate swap and the related
fair value amounts are shown as follows:
4096 Chapter 49
Interest rate swap
Total
Original forward periods
1
2
3
4
5
Remaining periods
1
2
3
4
€
€
€
€
€
Cash flows:
Fixed interest at 6.86% 1,716
1,716
1,716
1,716
Forecast variable interest*
1,313
1,877
1,876
1,813
Forecast based on forward rate
5.25%
7.51%
7.50% 7.25%
Net interest (403)
161
160
97
Fair value
Discount rate (spot)
5.25%
6.38%
6.75% 6.88%
Fixed interest 6,592
1,694
1,663
1,632
1,603
Forecast variable interest 6,592
1,296
1,819
1,784
1,693
Fair value of interest rate swap
0
(398)
156
152
90
*
forecast variable rate cash flow based on forward rate, e.g. €1,313 = €100,000 × (0.0525 ÷ 4)
At the inception of the hedge, the fixed rate on the forward swap is equal to the fixed rate X would receive if
it could issue the debt in three months under terms that exist today.
Measuring hedge effectiveness
If interest rates change during the period the hedge is outstanding, the effectiveness of the hedge can be
measured in various ways.
Assume that interest rates change as follows immediately before the debt is issued at the beginning of Period 2
(this effectively uses the yield curve existing at Period 1 with a 200 basis point (2%) shift).
Yield curve assumption
Forward periods
1
2
3
4
5
Remaining periods
1
2
3
4
Spot rates
5.75%
6.50%
7.50%
8.00%
Forward rates
5.75%
7.25%
9.51%
9.50%
Under the new interest rate environment, the fair value of the pay-fixed at 6.86%, receive-variable interest
rate swap that was designated as the hedging instrument would be as follows.
Fair value of interest rate swap
Total
Original forward periods
1
2
3
4
5
Remaining periods
1
2
3
4
€
€
€
€
€
Cash flows:
Fixed interest at 6.86% 1,716
1,716
1,716
1,716
Forecast variable interest 1,438
1,813
2,377
2,376
Forecast based on new forward rate
5.75%
7.25%
9.51% 9.50%
Net interest (279)
97
661
660
Financial instruments: Hedge accounting 4097
Total
Original forward periods
1
2
3
4
5
Remaining periods
1
2
3
4
€
€
€
€
€
Fair value
New discount rate (spot)
5.75%
6.50%
7.50% 8.00%
Fixed interest 6,562
1,692
1,662
1,623
1,585
Forecast variable interest 7,615
1,417
1,755
2,248
2,195
Fair value of interest rate swap
1,053
(275)
93
625
610
In order to compute the effectiveness of the hedge, it is necessary to measure the change in the present value
of the cash flows or the value of the hedged forecast transaction. There are at least two methods of
accomplishing this measurement.
Method A – Compute change in fair value of debt
Total