ipsas 29—financial instruments: recognition and measurement - IFAC

FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT
above, this may be regarded and designated either as a fair value hedge of CU40 of the
fixed rate assets or as a cash flow hedge of CU40 of the variable rate liabilities.
Issue (b) – What are the critical considerations in deciding whether a derivative that
is used to manage interest rate risk on a net basis should be designated as a hedging
instrument in a fair value hedge or a cash flow hedge of a gross exposure?
Critical considerations include the assessment of hedge effectiveness in the presence
of prepayment risk and the ability of the information systems to attribute fair value
or cash flow changes of hedging instruments to fair value or cash flow changes,
respectively, of hedged items, as discussed below.
For accounting purposes, the designation of a derivative as hedging a fair value
exposure or a cash flow exposure is important because both the qualification
requirements for hedge accounting and the recognition of hedging gains and losses
for these categories are different. It is often easier to demonstrate high effectiveness
for a cash flow hedge than for a fair value hedge.
Effects of Prepayments
Prepayment risk inherent in many financial instruments affects the fair value of an
instrument and the timing of its cash flows and impacts on the effectiveness test for
fair value hedges and the highly probable test for cash flow hedges, respectively.
Effectiveness is often more difficult to achieve for fair value hedges than for cash
flow hedges when the instrument being hedged is subject to prepayment risk. For a
fair value hedge to qualify for hedge accounting, the changes in the fair value of the
derivative hedging instrument must be expected to be highly effective in offsetting
the changes in the fair value of the hedged item (IPSAS 29.98(b)). This test may be
difficult to meet if, for example, the derivative hedging instrument is a forward
contract having a fixed term and the financial assets being hedged are subject to
prepayment by the borrower. Also, it may be difficult to conclude that, for a portfolio
of fixed rate assets that are subject to prepayment, the changes in the fair value for
each individual item in the group will be expected to be approximately proportional
to the overall changes in fair value attributable to the hedged risk of the group. Even
if the risk being hedged is a benchmark interest rate, to be able to conclude that fair
value changes will be proportional for each item in the portfolio, it may be necessary
to disaggregate the asset portfolio into categories based on term, coupon, credit, type
of loan and other characteristics.
In economic terms, a forward derivative instrument could be used to hedge assets
that are subject to prepayment but it would be effective only for small movements in
interest rates. A reasonable estimate of prepayments can be made for a given interest
rate environment and the derivative position can be adjusted as the interest rate
environment changes. If an entity’s risk management strategy is to adjust the amount
of the hedging instrument periodically to reflect changes in the hedged position, the
entity needs to demonstrate that the hedge is expected to be highly effective only for
the period until the amount of the hedging instrument is next adjusted. However, for
1247
IPSAS 29 IMPLEMENTATION GUIDANCE
PUBLIC SECTOR