Hedging Net Investment in Foreign Currency Risk

Query:

A Bank has fixed investment bond portfolio spread across globally. It recently invested

US$50 million foreign currency bond yielding 15% maturing in 3 years and to hedge

against currency did cross currency swap. Advise if the hedging of risks is complete for this

new investment only and how to set up hedge effectiveness test to ensure full compliance

with IFRS? Discuss in detail?

Answer:

Hedging Foreign Currency Risk and Hedge Effectiveness Testing for

Cross Currency Swap

1. Introduction

This response addresses the bank’s investment in a US$50 million foreign currency bond

and the use of a cross currency swap to hedge against currency risk. We will analyze the

completeness of the hedging strategy and provide guidance on setting up a hedge

effectiveness test in compliance with IFRS.

2. Relevant Standard/Law References

2.1 Hedge Accounting Eligibility

Under IFRS 9, for a hedging relationship to qualify for hedge accounting, it must meet all of

the following criteria:

1. a) The hedging relationship consists only of eligible hedging instruments and eligible

hedged items. b) At inception, there is formal designation and documentation of the

hedging relationship and the entity’s risk management objective and strategy for

undertaking the hedge. c) The hedging relationship meets all of the hedge effectiveness

requirements.

IFRS 9, para 6.4.1, page 61

2.2 Hedge Effectiveness Requirements

The hedging relationship must meet all of the following hedge effectiveness requirements:

1. i) There is an economic relationship between the hedged item and the hedging instrument.
2. ii) The effect of credit risk does not dominate the value changes that result from that

economic relationship. iii) The hedge ratio of the hedging relationship is the same as that

resulting from the quantity of the hedged item that the entity actually hedges and the

quantity of the hedging instrument that the entity actually uses to hedge that quantity of

hedged item.IFRS 9, para 6.4.1(c), page 61

3. Detailed Explanations

3.1 Completeness of Hedging Strategy

The bank’s current hedging strategy involves using a cross currency swap to hedge against

currency risk for the US$50 million foreign currency bond investment. While this approach

addresses the foreign exchange risk, it may not provide complete protection against all

potential risks associated with the investment. Here’s an analysis of the hedging strategy:

1. Foreign Currency Risk: The cross currency swap effectively hedges against fluctuations

in exchange rates between the bank’s functional currency and the US dollar. This protects

the value of the investment from currency movements.

1. Interest Rate Risk: The cross currency swap likely includes an interest rate component,

which can help manage interest rate risk associated with the bond. However, the

completeness of this hedge depends on how well the swap’s terms match the bond’s

interest rate characteristics.

iii. Credit Risk: The current hedging strategy does not address the credit risk of the bond

issuer. This remains an unhedged exposure.

1. Liquidity Risk: The hedging strategy does not directly address liquidity risk associated

with the bond investment.

To ensure a more complete hedging strategy, the bank should consider:

1. a) Matching the terms of the cross currency swap closely with the bond’s characteristics

(e.g., maturity, interest payment dates). b) Evaluating whether additional hedging

instruments are needed to address other risk factors, such as credit default swaps for

credit risk. c) Regularly reviewing and adjusting the hedging strategy as market conditions

and the bank’s risk appetite change.

3.2 Setting Up Hedge Effectiveness Test

To ensure full compliance with IFRS, the bank should establish a robust hedge

effectiveness testing process. Here’s a guide on setting up the hedge effectiveness test:

1. Designate the Hedging Relationship: Formally document the hedging relationship,

specifying the hedged item (US$50 million bond), the hedging instrument (cross

currency swap), the nature of the risk being hedged (foreign currency risk), and the risk

management objective.2. Define the Hedge Ratio: Establish the hedge ratio based on the actual quantities of

the hedged item and hedging instrument. In this case, it would likely be 1:1 if the

notional of the swap matches the bond amount.

3. Choose the Effectiveness Assessment Method: Select an appropriate method for

assessing hedge effectiveness. Common methods include:

4. Set Effectiveness Thresholds: Define what constitutes an effective hedge. While IFRS

9 doesn’t specify numerical thresholds, many entities consider a hedge effective if the

offset is within a range of 80-125%.

5. Determine Assessment Frequency: Specify how often effectiveness will be assessed.

At a minimum, effectiveness should be assessed at inception and at each reporting

date.

6. Identify Sources of Ineffectiveness: Analyze and document potential sources of hedge

ineffectiveness, such as:

º Differences in the timing of cash flows between the bond and the swap

º Changes in counterparty credit risk

º Any basis risk between the hedged item and hedging instrument

7. Implement Measurement Approach: Develop a system to measure and calculate the

changes in fair value or cash flows of both the hedged item and hedging instrument

attributable to the hedged risk.

8. Document Prospective and Retrospective Tests:

º Prospective test: Demonstrate the expectation of high effectiveness at inception

and on an ongoing basis.

º Retrospective test: Measure the actual results of the hedge to confirm

effectiveness.9. Establish Reporting Procedures: Set up processes to report hedge effectiveness

results, including any ineffectiveness to be recognized in profit or loss.

10. Review and Adjust: Regularly review the effectiveness testing approach and adjust if

necessary, especially if there are changes in market conditions or the hedging

relationship.

4. Used Cases/Interpretations & Disclosures by the listed entities

Case 1: Imperial Brands PLC (2021)

Imperial Brands PLC provides an example of hedge accounting for foreign currency risk

using cross currency swaps:

“The Group has investments in foreign operations which are consolidated in its financial

statements and whose functional currencies are Euros or US dollars. Where it is

practicable and cost effective to do so, the foreign exchange rate exposures arising from

these investments are hedged through the use of cross currency swaps and foreign

currency denominated debt.”

“The Group establishes the hedging ratio by matching the notional balance of the hedging

instruments with an equal notional balance of the net assets of the foreign operation. Given

that only the undiscounted spot element of hedging instruments is designated in the

hedging relationship, no ineffectiveness is expected unless the notional balance of the

designated hedging instruments exceeds the total balance of the foreign operation’s net

assets during the reporting period.”

Imperial Brands PLC, 2021, page 201

Case 2: ECO WORLD INTERNATIONAL BERHAD (2019)

ECO WORLD INTERNATIONAL BERHAD demonstrates the use of cross-currency swaps

for hedging foreign currency risk:

“The Group and the Company used cross-currency swaps to hedge their foreign currency

risk arising from AUD and GBP denominated equity contribution to subsidiaries, that is a

net investment in a foreign operation. The Group and the Company closely monitor their

exposure to foreign currency risk and the fluctuation in foreign currencies.”

“The Group and the Company had assessed and determined that the critical terms of the

cross-currency swap contracts (“hedge instrument”) align with the hedged item. In

assessing the critical terms of the hedge instrument, the Group and the Company

determined the existence of an economic relationship between the hedging instrument and

hedged item based on the currency, amount and timing of their respective cash flows.”ECO WORLD INTERNATIONAL BERHAD, 2019, page 68

Case 3: Standard Bank Group Limited (2022)

Standard Bank Group Limited provides insights into their hedge effectiveness assessment

approach:

“Hedge effectiveness is determined at the inception of the hedge relationship, and through

periodic prospective effectiveness assessments to ensure that an economic relationship

exists between the hedged item and hedging instrument. For hedges of foreign currency

risk, the group enters hedge relationships where the critical terms of the hedging

instrument match exactly with the terms of the hedged item. The group therefore performs

a qualitative assessment of effectiveness.”

“In hedges of foreign currency risk of highly probable forecast commercial transactions,

ineffectiveness may arise if the timing of the forecast transaction changes from what was

originally estimated, or if there are changes in the credit risk of the group or the derivative

counterparty.”

Standard Bank Group Limited, 2022, page 220

5. Summary

The bank’s current hedging strategy using a cross currency swap addresses the primary

foreign currency risk associated with the US$50 million bond investment. However, to

ensure a comprehensive risk management approach, the bank should consider additional

measures to address other potential risks such as interest rate fluctuations, credit risk, and

liquidity risk.

To set up an effective hedge effectiveness test in compliance with IFRS:

1. Formally designate and document the hedging relationship.
2. Establish a clear hedge ratio, likely 1:1 for this scenario.
3. Choose an appropriate effectiveness assessment method (e.g., critical terms match,

dollar offset, or regression analysis).

4. Define effectiveness thresholds and assessment frequency.5. Identify and document potential sources of ineffectiveness.
5. Implement a robust measurement approach for fair value or cash flow changes.
6. Conduct both prospective and retrospective effectiveness tests.
7. Establish clear reporting procedures for hedge effectiveness results.
8. Regularly review and adjust the hedging strategy and effectiveness testing approach

as needed.

By following these steps and learning from the practices of other entities, the bank can

ensure a robust hedge accounting process that complies with IFRS requirements and

effectively manages its foreign currency risk exposure.

6. Attribution

The information provided in this response is based on IFRS 9 Financial Instruments as

issued by the International Accounting Standards Board (IASB). The specific standard

referenced is IFRS 9, paragraph 6.4.1. For complete and authoritative guidance, please

refer to the full IFRS 9 Financial Instruments standard available through the IFRS

Foundation website.