Hedge Economic relationship

Last update 27/11/2019

Hedge Economic relationship is the basis why hedging has been invented in the first place – your loss is my profit to put it simple, just like buying a piece of art and pay it by cash, win and loose.

Under IFRS 9, a hedging relationship qualifies for hedge accounting if it meets all of the following effectiveness requirements:

• There is ‘an economic relationship’ between the hedged item and the hedging instrument.
• The effect of credit risk does not ‘dominate the value changes’ that result from that economic relationship.
• The hedge ratio of the hedging relationship is the same as that resulting from the quantity of 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. However, that designation shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting.

This first requirement means that the hedging instrument and the hedged item must be expected to move in opposite directions as a result of a change in the hedged risk. This should be based on an economic rationale rather than just by chance, as could be the case if the relationship is based only on a statistical correlation. However, a statistical correlation may provide corroboration of an economic rationale.

This requirement will automatically be fulfilled for many hedging relationships, as the underlying of the hedging instrument often matches, or is closely aligned with, the hedged risk. Even when there are differences between the hedged item and the hedging instrument, the economic relationship will often be capable of being demonstrated using a qualitative assessment. However, when the critical terms of the hedging instrument and hedged item are not closely aligned, IFRS 9 suggests that ‘it might only be possible for an entity to conclude [that there is an economic relationship] on the basis of a quantitative assessment.’

This assessment, whether qualitative or quantitative, would need to consider, amongst other possible sources of mismatch between the designated hedged item and the hedging instrument:

• Maturity
• Volume or nominal amount
• Cash flow dates
• Interest rate basis, or quality and location basis differences
• Day count methods
• Credit risk, including the effect of collateral
• The extent that the hedging instrument is already ‘in the money, or ‘out of the money’ when designated

IFRS 9 does not specify a method for assessing whether an economic relationship exists. An entity should use a method capturing all the relevant characteristics of the hedging relationship. A possible method is to use statistical analysis, such as regression analysis, to support the assessment of whether an economic relationship exists. This will also help demonstrate a suitable hedge ratio. However, as already mentioned, to quote the IASB, ‘the mere existence of a statistical correlation between two variables does not, by itself, support a valid conclusion that an economic relationship exists.’ The assessment of the hedging relationship is obviously a key component of the hedge documentation.

The following example illustrates an approach that uses a qualitative assessment:

See also: The IFRS Foundation

Economic relationship