The term "hedging" describes the securing of an unsettled position by setting up an offsetting position. "Hedge accounting" is the term used when opposing value developments for a hedged item subject to a risk and a hedging instrument are offset in accounting practice. The aim of hedge accounting is to eliminate the net influence on the profit and loss account. Comprehensive regulations on hedge accounting are required due to the valuation concept in IAS 39 and IFRS 9, which values some financial instruments at fair value and some at amortised cost, and also due to the different effects on profit and loss. Some sections of IAS 39 were revised and extended in IFRS 9.
While the general rules for valuation call for hedging derivatives to be recognised at fair value and for value adjustments to be captured as directly affecting net income, changes in fair value – in so far as they lead to a book value that lies above the cost of purchase – are to be recognised as not affecting net income. If there were no accounting regulations, hedging relationships would lead to uneven P&L effects in this case. Therefore, the aim of the hedge accounting regulations in IAS 39 and IFRS 9 is to capture the value changes of the hedging instruments and the hedged items as largely compensating each other and as affecting or not affecting net income to the same degree.
The Flex Finance hedge solution fully supports the hedge management requirements of IFRS and reduces the P&L effects of the Mixed Model Approach.
The Flex Finance blueprint for Hedge offers users a solution that covers the full lifecycle of a hedge from designation to termination.
It fully supports IFRS requirements for documentation and the audit trail of a hedge relationship.
The effectiveness test can be carried out daily and its results can be tracked to the individual deal level via drilldown. The effectiveness tests can also be manually overridden whenever ineffectiveness should occur.
The blueprint “Hedge” entails the following components.
Diagram: Valuation elements supported by Jabatix Finance Hedge.
Since the financial crisis, due to market evolvements, tenor basis spread and currency basis spread have significant impact on valuation of financial instruments. At the same time the multi-curve valuation approach has been commonly adopted. In multi-curve valuation for collateralised transactions, the OIS curve is applied as the discount factor while cash flow forecasting is based on the forward rate curve related to specific tenor (3M, 6M etc).
In case of uncollateralised transactions, the followings options are provided:
The OIS curve can be still used as a discount factor to calculate the so-called “no default” fair value. The fair value of the financial instruments will be then adjusted by CVA and DVA. As practice in some banks, regular LIBOR/EURIBOR can also be used as discount factor. Or,
The credit spread is applied on top of benchmark curve like the OIS or the LIBOR curve as part of the discount factor. This can be used in case the fair value of the financial instrument is always positive (as asset) or always negative (as liability)
FlexFinance measures the effectiveness of a hedge relationship according to a pre-defined measurement schedule, which is configured according to your risk management strategy. At the most rudimentary level, the measurement takes place at the initial valuation of the deal and when the bank prepares its financial statements. The measurement takes place automatically.
The following prospective and retrospective effectiveness tests are supported:
1. Prospective test:
2. Retrospective test:
The value of the expected highly effective compensation of future value changes for the hedged item and the hedging instrument is to be calculated (prospective effectiveness test).
Mandatorily in IAS 39 and optionally in IFRS 9, it is checked if the actual compensation lies in the range between ‘80% and 125%’ (retrospective effectiveness test). In addition to the range of ‘80% to 125%’ required by IAS 39, Flex Finance enables users to define an internal range that can, in turn, be used as an early warning system.
If a hedge becomes ineffective over time, Flex Finance supports the termination (IAS 39) or it can rebalanced (IFRS 9).
Different hedge types are permitted under hedge accounting. Flex Finance supports the creation of fair value hedges and cash flow hedges.
Safeguards against different types of risk can be implemented for one hedge. Jabatix Finance supports hedging against the following types of risk: