What is a Hedge?
A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite positions in a related security. Investments in hedge instruments are not necessarily made to earn profits but are made to curb losses.
How hedging takes place?
Usually, Hedge are taken on investments via transacting in derivatives. Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined. It's possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.
Derivatives have three key features under IND AS 109 (IFRS 9)
A) Derives its value from an underlying asset
p>B) Low or no initial investment
C) Future Settled (Net settled US GAAP)
In a typical hedging arrangement, there is a "Hedge Item" and a "Hedging Instrument" which necessarily need to have a hedging relationship.
Hedge item is the investment/asset of which one intends to reduce risk of,
Hedge Instrument is the financial instrument which helps in reduction of risk.
Applicable accounting principles allow hedge accounting to be recorded on net basis. Instead of showing gains and losses separately they will be shown on net basis in PL/OCI. A Similar treatment goes into hedge item and hedge instrument recognition in balance sheet.
The hedge relationship must meet the hedge effectiveness criteria at the beginning of each hedged period which requires that:
• 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; and
• The hedge ratio of the hedging relationship is the same as that actually used in the economic hedge.
A special emphasis could be drawn on economic relationship which implies that changes in one factor of economy would affect both the hedged item and hedge instrument (not necessarily in same proportion [we will use hedge ratio)]
Types of hedge
Further hedging relation can be classified into three types
Fair Value Hedge
A fair value hedge is a hedge of the exposures to changes in fair value of a recognized asset or liability or an unrecognized firm commitment or a component of any such item that is attributable to a particular risk and could affect profit and loss
Here your intention is to protect the non-operating revenue (eg Maturity Value of investment)
Gain/Loss on hedge item will go to PL
Gain/Loss on hedge instrument will be transferred to PL
However, where hedge item is equity shares on which irrevocable choice was taken to account via OCI both the gain/loss on hedge item and instrument will be recorded in OCI (Mismatch arrangements
Cash Flow Hedge
A cash flow hedge is a hedge of the exposures to variability and cash flow that is attributable to a particular risk associated with all or a component of a recognized asset or liability such as all or some future interest payments on variable debt or a highly probable forecast transaction and could affect profit or loss
Here your intention is
Here gain or loss on hedge instrument would be parked in OCI under "Hedging Reserve", this reserve is re-classifiable, once the hedge item is recognized in P/L the balance in Hedging reserve will be transferred to PL and we will record gain/losses on the same.
Hedge of net investment in foreign operation
Hedge of net investment in foreign operation including hedge of a monetary item that is accounted for as part of the net investment shall be accounted for similarly to cash flow hedges
Here gain/losses on foreign operations will be recoded in Foreign Currency Translation Reserve (FCTR) (OCI) as per IAS 21, this reserve will be transferred to profit and loss account at the time of sale of foreign operation any exchange gain or losses on Hedge Instrument taken to protect such foreign operation will be taken to "Hedging Reserve" OCI and will be transferred to P&L in the same year when FCTR is transferred to P&L
Rebalancing and Discontinuation [IFRS 9 paragraph 6.5.5 to 6.5.6]
If a hedging relationship ceases to meet the hedge effectiveness requirement relating to the hedge ratio but the risk management objective for that designated hedging relationship remains the same, an entity adjusts the hedge ratio of the hedging relationship (i.e. rebalances the hedge) so that it meets the qualifying criteria again.
An entity discontinues hedge accounting prospectively only when the hedging relationship (or a part of a hedging relationship) ceases to meet the qualifying criteria (after any rebalancing). This includes instances when the hedging instrument expires or is sold, terminated or exercised. Discontinuing hedge accounting can either affect a hedging relationship in its entirety or only a part of it (in which case hedge accounting continues for the remainder of the hedging relationship).
References: IAS 109 , IFRS 9 , ASC 815