Published: October 01, 2010
Re-designation of non-zero fair value derivatives is one of the most problematic areas in post-trade hedge accounting under IFRS in Asia, given the relatively more manual post-trade hedging processes and procedures involved. Many corporations in Asia often made the incorrect assumption of perfect effectiveness in many different scenarios. For example, a typical scenario includes rolling over into new hedging relationships derivatives that have originated in the past which have fair values other than zero. This is often the case when the recent volatilities in the Asian markets requires hedging strategies to be more dynamically rebalanced given the relatively lesser liquidity and wider spreads than other markets.
IAS 39 does not prohibit such re-designation as long as the new hedge relationship is considered to be ‘highly effective’. Many Asian corporations are making such an inappropriate assumption without quantifying the impact of the ‘off-market’ nature of the ‘old’ derivatives on the new hedging relationship. Such ‘off-market’ nature is economically the embedded financing within the derivative representing the amount that would have to be paid if the entity were to settle the derivative at the date of re-designation. This embedded financing would create a source of ineffectiveness that must be evaluated especially as interest rates increase.
This article provides practitioner insights into pitfalls of re-designation and practical recommendations to minimise such effectiveness.Commonplace scenariosIn Asia, using off-market derivatives in hedging relationships is more common than many corporations realise; three examples include:
1. Renegotiation of terms with derivative counterparty
Given the current low interest rate environment, market participants could lock themselves into an interest rate swap pre-financial crisis paying a high fixed leg and receiving a low variable leg. Such an ‘under-water’ interest rate swap, which is a liability, is renegotiated with the counterparty to include less onerous terms on the pay fixed leg, which has created the overall negative fair value, while extending the time to maturity. The hedger therefore avoids cashing out the ‘under-water’ derivative at a realised loss because it agrees to enter into a new derivative at the identical ‘under-water’ fair value. These common strategies are known in the market as ‘blends and extends’. Effectively, the counterparty has financed the payoff of the original interest rate swap by restructuring the financing into the terms of the new swap, while simultaneously reflecting the shape of the current interest rate curve over the new time horizon. In Asia, without properly assessing the financing element, companies often would re-designate the swap in a new cash flow hedge, as they have eligible forecasted transactions during the new and extended time frame of the swap.
2. Temporary interruption of hedging strategy
A company using a derivative in a highly effective hedge decides to de-designate the hedge and default to regular derivative accounting on a prospective basis due to the administrative burden using a manual process. Later, perhaps because of a change in treasury department management to utilise hedging software, the company decides to attempt hedge accounting again with the same derivative. In this case, the derivative does not have a fair value of zero at the inception of the proposed new hedge relationship. In this region, very often the derivative’s off-market nature has not been fully considered when trying to resume hedge accounting.
3. Attempt to restate hedge accounting following a documentation deficiency
A company believes it has qualified for hedge accounting, but, a few months later, its auditor identifies deficiencies in the company’s hedge documentation in that not all of the requirements in IAS 39 are met. The company corrects the deficiencies, and revises its financial statements to reflect the failure to achieve hedge accounting for the period from the inception of the hedge to the date the documentation was corrected. However, now the company notes that the derivative’s fair value has moved significantly off-market relative to a new derivative that would begin on the date the documentation is corrected. In correcting the documentation and re-establishing the hedge, Asian companies frequently have been fully able to support an expectation of ‘highly effective’ for the ‘new’ hedge relationship using the now off-market derivative, even if the initial hedge that failed due to inadequate documentation was perfectly effective. [[[PAGE]]]
IAS 39 is clear that the re-designation of a derivative in a new hedge is the beginning of a new hedge relationship. When an existing derivative is re-designated, it typically no longer has a fair value of zero, due to market changes that have occurred since the instrument’s inception. In fact, the potential consequence of such a financing element is that the derivative’s fair value may have drifted so far from zero, and the remaining time to maturity might be so lengthy, that it may be impossible for a newly re-designated hedge to even qualify for hedge accounting at all.
As a general observation, forward contracts that require only a single cash flow at maturity are least likely to have a significant problem with a financing element causing hedge ineffectiveness. In contrast, swaps requiring multiple cash flows over a lengthy period of time are the most likely to have ineffectiveness issues. The reason is that the changes in fair value for the financing element is based on the level of changes in discount interest rates associated with each financing cash flow which would be more frequent for swaps, which is a series of forward contracts, as compared to a simple forward contract. If the swaps have a longer maturity, meaning the discounting of the future cash flows is more pronounced, there are more cash flows to be affected by changes in underlying interest rates. Re-designation of non-zero fair value mainly applies to forward and swap contracts. In contrast, options usually have non-zero fair value with the upfront premium even without re-designation. In addition to the type of derivatives, whether the financing element is a significant problem depends on if the new hedge is a fair value hedge or a cash flow hedge:
Cash flow hedge
A derivative’s fair value represents the expected net cash flows of the derivative discounted at an appropriate discount rate. Whether it is a commodity, foreign exchange or interest rate swap, the expected net cash flow is the difference between the current forward price and the price fixed in the derivative contract. The fixed price would typically be the former forward price on the date of the derivative’s inception.
IAS 39 establishes the ‘hypothetical derivative method’ as one of the practical methods of measuring ineffectiveness, and assessing effectiveness, for cash flow hedges. The hypothetical derivative method involves establishing a notional derivative that would be the ideal hedging instrument for the hedged exposure (normally an interest rate swap or forward contract with no unusual terms and a zero fair value at inception of the hedge relationship). The fair value of the hypothetical derivative is then used as a proxy for the net present value of the hedged future cash flows against which changes in value of the actual hedging instrument are compared to assess effectiveness and measure ineffectiveness.
The expected net cash flows of an ‘off-market’ derivative re-designated would be different than an ‘at market’ hypothetical derivative at the time of re-designation. The reason is that the fixed prices are different between the old and re-designated new contracts, even though the forward prices and discount rates could be the same. Therefore, due to the financing element, the fair values between the actual and hypothetical derivatives are different because of differences in the expected cash flows.
The financing element embedded in the actual derivative, but not in the hypothetical derivative, is the reason the actual derivative has either extra positive or negative fair value. This extra fair value is the source of ineffectiveness in the hedge not captured by the hypothetical derivative which is assumed to be perfect without the financing element.
Hedgers should therefore not neglect the presence of the financing element. Hedge accounting should only be applied after assessing the degree of ineffectiveness from the imperfect derivative to be minor. If the overall effectiveness is still within the acceptable 80% to 125% range, such minor ineffectiveness should be immediately reclassified into income statement. If the ineffectiveness has not been assessed, too much of the subsequent changes in fair value of the derivative would be recorded in accumulated other comprehensive income.
The worst case scenario is such that an erroneous build up of an improper balance could remain ‘orphaned’ in accumulated other comprehensive income for hedge relationships that have already ended. In this case, not only would such hedge ineffectiveness continue to build up, companies might gradually lose track of the circumstances under which such balances will be eventually reclassified into earnings.
Fair value hedge
On the contrary, fair value hedge accounting does not have the same pitfalls of ineffectiveness build up, since the accumulated other comprehensive income is not used. However, the need to assess the impact of the financing element to hedge effectiveness at inception of a re-designated hedging derivative is still applicable to fair value hedge.
Re-designation of non-zero fair value derivatives has been a problem for some time. Under the current IAS 39 hedge accounting, companies are not able to isolate the financing element of the re-designated derivative and exclude it from the assessment of hedge effectiveness. As the current interest rate environment changes, Asian companies doing such re-designations would always have to assess the impacts of the financing element of the re-designated hedging derivative as interest rates increase or otherwise risk future restatements.
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