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In a hedging relationship there are two elements: the hedged item and the hedging instrument. The hedged item is the element that is designated as being hedged. The fundamental principle is that the hedged item creates an exposure to risk that could affect profit or loss (or OCI in the case of equity instruments investments at FVOCI).

2.3.1 Hedged Item Candidates

The following can be designated as hedged items:

• A recognised asset or liability (or a component thereof).

• An unrecognised firm commitment (or a component thereof). A firm commitment is a legally binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

• A highly probable forecast transaction (or a component thereof). A forecast transaction is an anticipated transaction that is not yet legally committed.

• A net investment in a foreign operation (on a consolidated basis only).

• A group of the above items.

• An aggregated exposure that is a combination of an exposure that could qualify as a hedged item and a derivative, if the aggregated exposure creates a different aggregated exposure that is managed as one exposure for a particular risk (or risks). For example, a utility with the EUR as functional currency may designate as hedged item the combination of highly probable crude oil purchases and USD-denominated crude oil futures (i.e., a string of fixed amounts of EUR–USD FX risk). The items that constitute the aggregated exposure remain accounted for separately.

• The FX risk component of an intragroup monetary item (e.g., a payable/receivable between two subsidiaries) in the consolidated financial statements if it results in an exposure to FX rate gains or losses that are not fully eliminated on consolidation in accordance with IAS 21 (i.e., when the intragroup monetary item is transacted between two group entities that have different functional currencies).

• The FX risk component of a highly probable forecast intragroup transaction in the consolidated financial statements provided that the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and the foreign currency risk will affect consolidated profit or loss. For this purpose an entity can be a parent, subsidiary, associate, joint arrangement or branch. The relevant period or periods during which the FX risk of the hedged transaction affects profit or loss is when it affects consolidated profit or loss.

An entity may hedge the foreign currency risk for the entire term of a 10-year fixed rate debt denominated in GBP. However, the entity requires fixed rate exposure in its functional currency (the EUR) only for 2 years and floating rate exposure in EUR for the remaining term to maturity. At the end of each of the 2-year intervals (i.e., on a 2-year rolling basis) the entity fixes the next 2 years' interest rate exposure (if the interest level is such that the entity wants to fix interest rates). In such a situation an entity may enter into a 10-year GBP fixed-to-EUR floating cross-currency interest rate swap that swaps the fixed rate GBP debt into a variable rate EUR exposure. This is overlaid with a EUR 2-year interest rate swap that swaps EUR variable rate debt into EUR fixed rate debt. In effect, the fixed rate GBP debt and the 10-year fixed-to-floating cross-currency interest rate swap in combination can be designated as a hedged item, viewed as a EUR 10-year variable rate debt exposure for risk management purposes.

The way in which a derivative is included as part of an aggregated exposure must be consistent with the designation of that derivative as the hedging instrument at the level of the aggregated exposure. For example, if an entity excludes the forward element of a derivative from its designation as the hedging instrument for the hedging relationship between the items that constitute the aggregated exposure, it must also exclude the forward element when including that derivative as a hedged item as part of the aggregated exposure. Otherwise, the aggregated exposure shall include a derivative, either in its entirety or a proportion of it.

An example of this sort of transactions is a forecast sale or purchase of inventory between members of the same group (including parent, subsidiary, associate, joint venture or branch) if there is an onward sale of inventory to party external to the group.

Another example is a forecast intragroup sale of equipment from the group entity that manufactured it to a group entity that will use the equipment in its operations (it affects profit or loss because the equipment will be depreciated by the purchasing entity, and the amount initially recognised may change if it is denominated in a currency other than the functional currency of the purchasing entity).

If the foreign currency risk of a forecast intragroup transaction does not affect consolidated profit or loss, the intragroup transaction cannot qualify as a hedged item. This is usually the case for royalty payments, interest payments or management charges between members of the same group, unless there is a related external transaction.

Components of an Item Eligible for Designation as a Hedged Item

An entity may designate an eligible item (or group of eligible items) in its entirety as the hedged item in a hedging relationship. An entire item comprises all changes in the cash flows or fair value of an item.

A proportion of an eligible item (or group of eligible items) provided that designation is consistent with the entity's risk management objective. An example would be 50 % of the contractual cash flows of a loan.

An entity may designate a risk component of an eligible item (or group of eligible items) as the hedged item in a hedging relationship. A component comprises less than the entire fair value change or cash flow variability of an item. In that case, an entity may designate only the following types of components (including combinations) as hedged items:

a. Only changes in the cash flows or fair value of an item attributable to a specific risk or risks (risk component), provided that, based on an assessment within the context of the particular market structure, the risk component is separately identifiable and the changes in the cash flows or the fair value of the item attributable to changes in that risk component must be reliably measurable. For example, it is possible to hedge only the USD Libor 6-month interest rate component in a loan with interest calculated as USD Libor 6-month plus a margin on its notional amount. Risk components include a designation of only changes in the cash flows or the fair value of a hedged item above or below a specified price or other variable (a one-sided risk).

b. One or more selected contractual cash flows.

c. Components of a nominal amount (i.e., a specified part of the amount of an item).

When identifying what risk components qualify for designation as a hedged item, an entity assesses such risk components within the context of the particular market structure to which the risk or risks relate and in which the hedging activity takes place. Such a determination requires an evaluation of the relevant facts and circumstances, which differ by risk and market.

When designating risk components as hedged items, an entity considers whether the risk components are explicitly specified in a contract (contractually specified risk components) or whether they are implicit in the fair value or the cash flows of an item of which they are a part (non-contractually specified risk components). Non-contractually specified risk components can relate to items that are not a contract (e.g., forecast transactions) or contracts that do not explicitly specify the component (e.g., a firm commitment that includes only a single price instead of a pricing formula that references different underlyings).

For example, an entity has a long-term supply contract for natural gas that is priced using a contractually specified formula that includes references to crude oil prices, fuel oil prices and other components such as transport charges. The entity hedges the crude oil component in that supply contract using a crude oil futures contract. Because the crude oil component is specified by the terms and conditions of the supply contract it is a contractually specified risk component, and therefore the entity concludes that the gas oil price exposure is separately identifiable. At the same time, there is a market for crude oil futures and forward contracts. Hence, the entity concludes that the crude oil price exposure is reliably measurable. Consequently, the crude oil price exposure in the supply contract is a risk component that is eligible for designation as a hedged item.

An entity may also designate only changes in the cash flows or fair value of a hedged item above or below a specified price or other variable (a “one-sided risk”).

CAP

An entity may buy a 6 % cap to hedge the variability of the Libor-linked flows of a floating rate liability. The entity can designate the hedged risk as the variability of future cash flow outcomes resulting from a Libor increase above 6 %.

COMBINATION OF A CAP AND A FLOOR

An entity buys a 6 % cap to hedge the variability of the Libor-linked flows of a floating rate liability. The entity simultaneously sells a 4 % floor to avoid paying a premium. Assuming that the combination of the cap and the floor (i.e., a collar) is an eligible hedging instrument, the entity can designate the hedged risk as the variability of future cash flow outcomes resulting from a Libor increase above 6 % and a Libor decline below 4 %.

CAP SPREAD

An entity buys a 6 % cap to hedge the variability of the Libor-linked flows of a floating rate liability. The entity simultaneously sells an 8 % cap to reduce the overall premium to be paid. Assuming that the combination of both caps (i.e., a cap spread) is an eligible hedging instrument, the entity can designate the hedged risk as the variability of future cash flow outcomes resulting from a Libor increase between 6 % and 8 %.

A layer component of an overall group of items (e.g., a bottom layer) only if:

a. it is separately identifiable and reliably measurable;

b. the risk management objective is to hedge a layer component;

c. the items in the overall group from which the layer is identified are exposed to the same hedged risk (so that the measurement of the hedged layer is not significantly affected by which particular items from the overall group form part of the hedged layer);

d. for a hedge of existing items (e.g., an unrecognised firm commitment or a recognised asset) an entity can identify and track the overall group of items from which the hedged layer is defined (so that the entity is able to comply with the requirements for the accounting for qualifying hedging relationships); and e. any items in the group that contain prepayment options meet the requirements for components of a nominal amount.

A layer component may be specified from a defined, but open, population, or from a defined nominal amount. Examples include:

a. A part of a monetary transaction volume denominated in foreign currency. For example, related to a sale denominated in USD, the next USD 10 cash flows after the first USD 20 in March 201X.

b. A part of a physical volume. For example, the bottom layer, measuring 5 million cubic metres, of the natural gas stored in location XYZ.

c. A part of a physical or other transaction volume. For example, the first 100 barrels of the oil purchases in June 201X or the first 100 MWh of electricity sales in June 201X.

d. A layer from the nominal amount of the hedged item. For example, the last EUR 80 million of a EUR 100 million firm commitment, the bottom layer of EUR 20 million of a EUR 100 million fixed rate bond or the top layer of EUR 30 million from a total amount of EUR 100 million of fixed rate debt that can be prepaid at fair value (the defined nominal amount is EUR 100 million).

Items Not Eligible for Designation as Hedged Items

A derivative alone cannot be designated as a hedged item. The only exception is an embedded purchased option that is hedged with a written option.

An entity's own equity instrument cannot be a hedged item because it does not expose the entity to a particular risk that could impact profit or loss. Similarly, a forecast dividend payment by the entity cannot be a hedged item as its distribution to equity holders is debited directly to equity and therefore does not impact profit or loss.

A firm commitment to acquire a business in a business combination cannot be a hedged item, except for foreign currency risk, because the other risks being hedged cannot be specifically identified and measured. Those other risks are general business risks.

An equity method investment cannot be a hedged item in a fair value hedge. This is because the equity method recognises in profit or loss the investor's share of the investee's profit or loss, rather than changes in the investment's fair value.

An investment in a consolidated subsidiary cannot be a hedged item in a fair value hedge. This is because consolidation recognises in profit or loss the subsidiary's profit or loss, rather than changes in the investment's fair value. A hedge of a net investment in a foreign operation is different because it is a hedge of the foreign currency exposure, not a fair value hedge of the change in the value of the investment.

A layer component that includes a prepayment option is not eligible to be designated as a hedged item in a fair value hedge if the prepayment option's fair value is affected by changes in the hedged risk, unless the designated layer includes the effect of the related prepayment option when determining the change in the fair value of the hedged item.

Other Restrictions

IFRS 9 imposes the following restrictions or conditions regarding the hedge item:

• The hedged item must be reliably measurable.

• The party to the hedged item has to be external to the reporting entity. Hedge accounting can be applied to transactions between entities in the same group only in the individual or separate financial statements of those entities and not in the consolidated financial statements of the group, except for the consolidated financial statements of an investment entity, as defined in IFRS 10, where transactions between an investment entity and its subsidiaries measured at fair value through profit or loss will not be eliminated in the consolidated financial statements. The only exceptions to this external condition are the intragroup transactions mentioned above.

2.3.2 Forecast Transaction versus Firm Commitment

Commonly, a transaction before becoming a firm commitment is a forecast transaction. A forecast transaction itself typically is expected to occur before it becomes highly expected to occur, as shown in Figure 2.5.

• A forecast transaction is an anticipated transaction that is not yet legally committed. In assessing “highly probable” the entity must consider, among other things, the frequency of similar past transactions.

• A firm commitment is a legally binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

Figure 2.5 Scale of probability of a forecasted transaction.