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The hypothetical derivative approach is a useful simplification when assessing whether a cash flow (or a net investment) hedge meets the effectiveness requirements and when measuring hedge effectiveness/ineffectiveness. Whilst IFRS 9 does not preclude the use of the hypothetical derivative in fair value hedges, in my view, auditors will not allow its use in fair value hedges as a hypothetical derivative does not fully replicate the fair value changes of a hedged item. Therefore, I will use the hypothetical derivative simplification only in cash flow and net investment hedges throughout this book.

IFRS 9 allows determining the changes in the fair value of the hedged item using the changes in fair value of the hypothetical derivative. The hypothetical derivative replicates the hedged item and hence results in the same outcome as if that change in fair value was determined by a different approach. Hence, using a hypothetical derivative is not an assessment method in its own right but a mathematical expedient that can only be used to calculate the fair value of the hedged item.

The hypothetical derivative is a derivative whose changes in fair value perfectly offset the changes in fair value of the hedged item for variations in the risk being hedged. The changes in the fair value of both the hypothetical derivative and the real derivative (i.e., the hedging instrument) are then used to assess whether the hedge effectiveness requirements are met and to calculate a hedge's effective and ineffective parts. The terms of the hypothetical derivative are assumed to be the following:

• Its critical terms match those of the hedged item (notional, underlying, maturity, interest periods).

• For hedges of risks that are not one-sided, the hypothetical derivative is a non-option instrument (e.g., a forward, a swap) and its rate (or price) is the at-the-money rate (or price) at the time of designation of the hedging relationship. For one-sided risks (i.e., a risk hedged from a certain value), the hypothetical derivative is an option with strike determined in accordance with the risk being hedged (e.g., the strike of the hypothetical derivative –a cap – is 6 % when the hedged risk in a floating rate loan is a potential movement in the Euribor rate above 6 %). Similarly, for two-sided risks (i.e., risks that are hedged up to a certain level and from another level) the strike of the hypothetical derivative – a combination of a bought and sold options – is determined by the ranges of the risk being hedged. The hypothetical derivative strike cannot be in-the-money.

• Its counterparty is free of credit risk (i.e., the counterparty will always pay any settlement amounts due to the entity).

• The hypothetical derivative has no time value, in the case of it being a single option or a combination of options.

For example:

• When hedging the FX exposure of a highly expected foreign currency cash flow, the hypothetical derivative would be an FX forward rate with an FX rate that gives the forward an initial zero cost, a currency pair that equals the entity's functional currency and the currency in which the hedged cash flow is denominated, a notional that equals the amount of the expected cash flow, and a maturity that represents the date on which the cash flow is expected to occur.

• When hedging the interest rate exposure of a bullet floating rate liability (i.e. its principal is repaid at maturity only and its periodic interest is linked to a short-term interest rate such as the 3-month Euribor), the hypothetical derivative would be an interest rate swap with a notional equal to that of the debt, interest periods matching those of the debt and a fixed interest rate that gives the swap an initial zero cost.

Ineffectiveness will be measured as the difference between changes in fair value of the hypothetical derivative and the hedging instrument. Ineffectiveness will in principle arise due to differences in their terms and the presence of counterparty credit risk in the hedging instrument.