by Yin Toa Lee, Partner and Leader of Financial Accounting Advisory Services, Ernst & Young, Financial Services, Far East Area
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