Hedging Relationship 1 – Documentation

At the inception of the first hedging relationship, ABC documented the relationship as follows:

Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument in its entirety (i.e., both the forward and the spot elements are included in the hedging relationship) to changes in the fair value of a hypothetical derivative. The terms of the hypothetical derivative – a EUR–USD forward contract for maturity 30 June 20X5 with nil fair value at the start of the hedging relationship – reflected the terms of the hedged item. The terms of the hypothetical derivative are as follows:

(*) The forward rate of the hypothetical derivative (1.2520) was different from the forward rate of the hedging instrument (1.2760) – this was due to (i) their different initial fair values and (ii) the absence of CVA in the hypothetical derivative (the counterparty to the hypothetical derivative is assumed to be credit risk-free).

Changes in the fair value of the hedging instrument will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in the cash flow hedge reserve of OCI. The accumulated amount in equity will be reclassified to profit or loss in the same period during which the hedged expected future cash flow affects profit or loss, initially adjusting the sale amount when the sale is recognised and thereafter adjusting the revaluation of the receivable.
• The ineffective part of the gain or loss on the hedging instrument will be recognised immediately in profit or loss.

Hedge effectiveness will be assessed prospectively at hedging relationship inception, on an ongoing basis at least upon each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

Hedge effectiveness will be assessed, and effective/ineffective amounts will be calculated, on a forward-forward basis. In other words, the forward element of both the hedging instrument and the hypothetical derivative will be included in the hedging relationship.

The hedging relationship will qualify for hedge accounting only if all the following criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a highly expected forecast transaction that exposes the entity to fair value risk, affects profit or loss and is reliably measurable. The hedging instrument is eligible as it is a derivative and it does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. 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. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis. The assessment will be complemented by a quantitative assessment using the scenario analysis method for one scenario in which the EUR–USD FX rate at the end of the hedging relationship (30 June 20X5) will be calculated by shifting the EUR–USD spot rate prevailing on the assessment date by +10%, and the change in fair value of both the hypothetical derivative and the hedging instrument compared.

Hedging Relationship 2 – Documentation

Additionally, at the inception of the second hedging relationship, ABC documented the relationship as follows:

Hedge effectiveness will be assessed, and effective/ineffective amounts will be calculated, by comparing changes in the fair value of the hedging instrument to changes in the fair value of a hypothetical derivative. The terms of the hypothetical derivative – a USD put/EUR call contract for maturity 30 June 20X5 with strike price 1.2760 reflected the terms of the hedged item. The terms of the hypothetical derivative are as follows:

Changes in the fair value of the hedging instrument (i.e., the option's intrinsic value) will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in the cash flow hedge reserve of OCI. The accumulated amount in equity will be reclassified to profit or loss in the same period during which the hedged expected future cash flow affects profit or loss, initially adjusting the sales amount when the sale is recognised and thereafter adjusting the revaluation of the receivable.
• The ineffective part of the gain or loss on the hedging instrument will be recognised immediately in profit or loss.

The change in time value of the option will be excluded from the hedging relationship, and compared to the change in “aligned time” value. The aligned time value will be the time value of an option that has critical terms identical to those of the hedged item. Because, at the start of the hedging relationship, the aligned time value (EUR 820,000) exceeds the actual time value (EUR 799,000), the lower of their accumulated changes in fair value will be recognised temporarily in the time value reserve of OCI and reclassified to profit or loss when the hedged item impacts profit or loss. Any remainder will be recognised immediately in profit or loss.

Hedge effectiveness will be assessed prospectively at inception of the hedging relationship, on an ongoing basis at least upon each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

The hedging relationship will qualify for hedge accounting only if all the following ­criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a highly expected forecast transaction that exposes the entity to fair value risk, affects profit or loss and is reliably measurable. The hedging instrument is eligible as it is a bought financial option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. 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. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis. The assessment will be complemented by a quantitative assessment using the scenario analysis method for one scenario in which the EUR–USD FX rate at the end of the hedging relationship (30 June 20X5) will be established by shifting the EUR–USD spot rate prevailing on the assessment date by +10%, and the change in fair value (i.e., in time value) of both the hypothetical derivative and the hedging instrument compared.

Hedging Relationship 1 – Hedge Effectiveness Assessment Performed at Hedge Inception

The hedging relationship was considered effective as the following three requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the qualitative assessment performed and supported by a quantitative analysis, ABC concluded that the change in fair value of the hedged item was expected to be substantially offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that economic relationship as the credit ratings of both the entity and XYZ Bank were considered sufficiently strong.
3. The hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

Due to the fact that the main terms (USD notional, underlying and expiry date) of the hedging instrument and those of the expected cash flow closely matched (with the exception of the forward rate) and the low credit risk exposure to the counterparty of the forward contract, it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions. This conclusion was supported by a quantitative assessment. This assessment consisted of one scenario analysis performed as follows. A EUR–USD spot rate at the end of the hedging relationship (1.3585) was assumed by shifting the EUR–USD spot rate prevailing on the assessment date (1.2350) by +10%. As shown in the table below, the change in fair value of the hedged item is expected to be substantially offset by the change in fair value of the hedging instrument, corroborating that both elements have values that will generally move in opposite directions.

Notes:

(1) Assumed spot rate on hedging relationship end date

(2) 50,000,000/1.3585

(3) 39,185,000 – 36,805,000

(4) 2,380,000 – (<799,000>)

(5) 3,179,000/3,131,000

The hedge ratio was established at 1:1, resulting from the USD 50 million of hedged item that the entity actually hedged and the USD 50 million of the hedging instrument that the entity actually used to hedge that quantity of hedged item.

Another hedge assessment was performed on 31 December 20X4 (reporting date). This assessment was very similar to the one performed at inception and has been omitted to avoid unnecessary repetition. Additionally, the hedge ratio was assumed to be 1:1 on that assessment date.

Hedging Relationship 2 – Hedge Effectiveness Assessment Performed at Hedge Inception

The hedging relationship was considered effective as the following three requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the qualitative assessment performed and supported by a quantitative analysis, ABC concluded that the change in fair value of the hedged item was expected to be substantially offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that economic relationship as the credit ratings of both the entity and XYZ Bank were considered sufficiently strong.
3. The hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

Due to the fact that the terms (notionals, underlying, strike price and expiry date) of the hedging instrument and those of the expected cash flow closely matched and the low credit risk exposure to the counterparty to the option contract, it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions. This conclusion was supported by a quantitative assessment. This assessment consisted of one scenario analysis performed as follows. A EUR–USD spot rate at the end of the hedging relationship (1.3585) was simulated by shifting the EUR–USD spot rate prevailing on the assessment date (1.2350) by +10%. The fair value of the hedging instrument was calculated taking only the option intrinsic value. As shown in the table below, the change in fair value of the hedged item was expected to largely be offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.

Notes:

(1) Assumed spot rate on 30 June 20X5 (hedging relationship end date)

(2) 2,380,000 = max[ 50,000,000/1.2760 – 50,000,000/1.3585, 0]

(3) 2,380,000 = 2,380,000 – Nil

(4) 100% = 2,380,000/2,380,000 = Change in fair value of hedging instrument/Change in fair value of hypothetical derivative. Remember that both fair values were only composed of intrinsic value.

The hedge ratio was established at 1:1, resulting from the USD 50 million of hedged item that the entity actually hedges and the USD 50 million of the hedging instrument that the entity actually uses to hedge that quantity of hedged item.

Another hedge assessment was performed on 31 December 20X4 (reporting date). This assessment was very similar to the one performed at inception and has been omitted to avoid unnecessary repetition. Additionally, the hedge ratio was assumed to be 1:1 on that assessment date.

Hedging Relationship 1 – Fair Valuations of Derivative Contracts and Hypothetical Derivative at the Relevant Dates

The actual spot and forward exchange rates prevailing at the relevant dates were as follows:

(*) Credit risk-free forward rate

The fair value calculation of hedging instrument 1 at each relevant date was as follows:

Notes:

(1) Credit risk-free forward rate

(2) 38,462,000 = 50,000,000/1.3000

(3) 723,000 = 39,185,000 – 38,462,000

(4) 716,000 = 723,000 × 0.9901

(5) 714,000 = 716,000 – 2,000

(6) 1,513,000 = 714,000 – <799,000>

(7) 595,000 = 714,000 – 119,000

The fair value calculation of hypothetical derivative 1 at each relevant date was as follows:

The calculation of the effective and ineffective amounts of the change in fair value of the hedging instrument 1 was as follows:

Notes:

(1) Lower of 1,513,000 and 1,459,000

(2) Nil +859,000, the sum of all prior effective amounts

(3) 1,459,000 – 859,000

(4) Change in the fair value of the hedging instrument since the last fair valuation

(5) Lower of 600,000 (available amount) and 595,000 (period change in fair value of hedging instrument)

(6) 595,000 (period change in fair value of hedging instrument) – 595,000 (effective part)

Hedging Relationship 2 – Fair Valuations of Hedged Item and Hypothetical Derivative at the Relevant Dates

Using the spot rates and discount factors from hedging relationship 1, the fair value of the option was calculated using the Black–Scholes model, and incorporating CVA/DVA. The intrinsic value was calculated using the spot rates. The time value of the option was calculated as follows:

The following table details the calculation of the changes in the option's intrinsic and time values from the option's total value. It is worth noting that although the option had no time value at the beginning and end of its life, its time value change showed a significant volatility.

Notes:

(1) Calculated using Black–Scholes model

(2) 39,185,000 = 50,000,000/1.2760

(3) 38,610,000 = 50,000,000/1.2950

(4) 575,000 = max(39,185,000 – 38,610,000; 0)

(5) 569,000 = 575,000 × 0.9901

(6) 568,000 = 569,000 + <1,000>

(7) 76,000 = 1,017,000 – 941,000

(8) 568,000 = 568,000 – Nil

(9) <492,000> = 449,000 – 941,000

The following table shows the change in fair value of the hypothetical derivative. Remember that hypothetical derivatives have no time value, so only the change in its intrinsic value was calculated (it is noted below that the time value – the “aligned time value” – also needs to be calculated).

The calculation of the effective and ineffective parts of the change in fair value of the hedging instrument (i.e., the change in intrinsic value of the option) was calculated as follows:

Notes:

(1) 568,000 = Lower of 568,000 and 575,000

(2) Nil = Sum of all prior effective amounts

(3) 568,000 = 568,000 – Nil = (1) – (2)

(4) Change in the fair value of the hedging instrument since the last fair valuation

(5) Lower of 568,000 (available amount) and 568,000 (period change in fair value of hedging instrument) = Lower of (3) and (4)

(6) Nil = 568,000 (period change in fair value of hedging instrument) – 568,000 (effective part)

Under IFRS 9 the cumulative change in fair value of the time value component of an option from the date of designation of the hedging instrument, is accumulated in OCI to the extent that it relates to the hedged item.

The time value related to the hedged item is called the “aligned time value”. This time value represents the time value of an option that would have critical terms perfectly matching those of the hedged item. In our case, the aligned time value corresponds to the time value of an option that has main terms identical to those of the hypothetical derivative (i.e., notional, strike rate, expiry date and underlying). Therefore, ABC had to compute the value changes in the hypothetical derivative, as if this derivative had time value (the “aligned option”). To do that, ABC had to compute first the fair value of the aligned option using Black–Scholes, and then the time value as follows:

The following table shows the calculations of the cumulative change in the aligned time value. The intrinsic value was the hypothetical derivative's intrinsic value, taken from the previous table.

Because at the start of the hedging relationship the actual time value (EUR 799,000) was lower than the aligned time value (EUR 820,000), the part of the cumulative fair value change of the actual time value recognised in OCI was calculated as the lower of the following (in absolute terms):

• the cumulative fair value change of the actual time value; and
• the cumulative fair value change of the aligned time value.

Any excess of the cumulative change in the option's time value over that of the aligned time value was recognised in profit or loss.

The comparison of the aligned amounts and the option's time value amounts was calculated as follows (the mechanics are similar to the previous calculation of effective and ineffective amounts related to the hedging instrument):

Accounting Entries

The required journal entries were as follows.

1. To record the forward and the option trades on 1 October, 20X4

   At their inception, the fair values of the FX forward and the FX option were EUR <799,000> and 799,000 respectively.

2. To record the closing of the accounting period on 31 December 20X4

   The change in fair value of the forward since the last valuation was a EUR 918,000 gain, of which EUR 859,000 was considered to be effective and recorded in the cash flow hedge reserve of OCI, while EUR 59,000 was deemed to be ineffective and recorded in profit or loss.

3. The change in fair value of the option since the last valuation was a gain of EUR 142,000, all due to a change in the option's time value. Of this amount 131,000 corresponded to an “aligned” time value change (recognised in the time value reserve of OCI) and the EUR 11,000 remainder was recognised in profit or loss.
4. To record the sale agreement on 31 March 20X5

   The sale agreement was recorded at the spot rate prevailing on that date (1.2950). Therefore, the sale EUR proceeds were EUR 77,220,000 (=100 million/1.2950). Because the machinery sold was not yet paid, a receivable was recognised. Suppose that the machinery was valued at EUR 68 million in ABC's statement of financial position.

5. The change in fair value of the forward since the last valuation was a gain of EUR 595,000, fully considered to be effective, and thus recorded in the cash flow hedge reserve of OCI. No ineffective amounts existed.
6. The change in fair value of the option since the last valuation was a gain of EUR 76,000, split into a EUR 568,000 gain in the option's intrinsic value and a EUR 492,000 loss in the option's time value. All the change in the option's intrinsic value was considered to be effective and recorded in the cash flow hedge reserve of OCI. Regarding the change in time value, <481,000> corresponded to an “aligned” time value change (recognised in the time value reserve of OCI) and the EUR <11,000> remainder was recognised in profit or loss.
7. The recognition of the sales transaction in profit or loss caused the release to profit or loss of the deferred hedge results accumulated in equity: EUR 1,454,000 from the cash flow hedge reserve and EUR <350,000> from the time value reserve. The hedging relationship ended on this date.
8. To record the settlement of the receivable and the derivatives on 30 June 20X5

   The receivable was revalued at the spot rate prevailing on this date, showing a loss of EUR 1,463,000 (=100 million/1.3200 – 100 million/1.2950):

9. The change in the fair value of the forward since the last valuation was a gain of EUR 592,000, fully deemed to be effective.
10. The change in fair value of the option since the last valuation was a gain of EUR 289,000, split into a EUR 738,000 gain in the option's intrinsic value and a EUR 449,000 loss in the option's time value. All the change in the option's intrinsic value was considered to be effective and recorded in the cash flow hedge reserve of OCI. Regarding the change in time value, <449,000> corresponded to an “aligned” time value change (recognised in the time value reserve of OCI) and no amounts were recognised in profit or loss.
11. The recognition of the revaluation of the accounts receivable in profit or loss caused the release to profit or loss of the deferred hedge results accumulated in equity: EUR 1,330,000 (=592,000 + 738,000) from the cash flow hedge reserve and EUR <449,000> from the time value reserve. The hedging relationship ended on this date.
12. On 30 June, 20X5 ABC received the USD 100 million from the client and eliminated the related account receivable. The USD 100 million receipt was valued at that date's exchange rate, EUR 75,758,000 (=100 mn/1.3200):
13. Simultaneously, both the forward and the option expired being exercised. Through the forward and the option, ABC sold USD 50 million, worth EUR 37,879,000, and received EUR 39,185,000. The fair value of the forward and the option just prior to settlement was EUR 1,306,000 (= 50 million × (1/1.2760 – 1/1.3200)).

The following table gives a summary of the accounting entries, excluding the entries related to the cost of goods sold:

(1) Note: Total figures may not match the sum of their corresponding components due to rounding.

Hedging Relationship Documentation

Consequently, the hedging relationship was documented as follows:

Hedge Effectiveness Assessment

Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument in its entirety to changes in the fair value of the hedged cash flows for the risks being hedged.

Changes in the fair value of the hedging instrument will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in the cash flow hedge reserve of OCI. The accumulated amount in equity will be reclassified to profit or loss in the same period during which the hedged expected future cash flow affects profit or loss, initially adjusting the sales amount when the sale is recognised and thereafter adjusting the revaluation of the receivable.
• The ineffective part of the gain or loss on the hedging instrument will be recognised immediately in profit or loss.

Hedge effectiveness will be assessed prospectively at hedging relationship inception, on an ongoing basis at least upon each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

The hedging relationship will qualify for hedge accounting only if all the following criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a highly expected forecast transaction that exposes the entity to fair value risk, affects profit or loss and is reliably measurable. The hedging instrument is eligible as it is a derivative that does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. 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. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a quantitative basis using the scenario analysis method for two scenarios in which the EUR–USD FX rate at the end of the hedging relationship (30 June 20X5) will be calculated by shifting the EUR–USD spot rate prevailing on the assessment date by ±10%, and the change in fair value of both the hedging instrument and the hedged item compared.

Hedge Effectiveness Assessment Performed at the Start of the Hedging Relationship

The hedging relationship was considered effective as the following three requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the quantitative assessment performed (see below), the entity concluded that the change in fair value of the hedged item was expected to be largely offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that economic relationship as the credit ratings of both the entity and XYZ Bank were considered sufficiently strong.
3. The hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

A quantitative assessment was performed using the scenario analysis method in which the performance of the hedging instrument and the hedged item was assessed under two scenarios.

In a first scenario, a EUR–USD spot rate at the end of the hedging relationship (1.3585) was assumed by shifting the EUR–USD spot rate prevailing on the assessment date (1.2350) by +10%. As shown in the table below, the change in fair value of the hedged item was expected to be largely offset by the change in fair value of the hedging instrument, corroborating that both elements have values that will generally move in opposite directions. Of note is that the hedged item was valued using forward rates (i.e., on a forward basis).

Notes:

(1) Instrument forward rate when final FX rate was 1.3585

(2) According to its risk management objective, the 1st hedged item was fully protected (i.e., from 1.2520, the expected rate on 30-Jun-X5 as of the start of the hedging relationship)

(3) According to its risk management objective, the 2nd hedged item was protected from 1.2760

(4) 100,000,000/1.2760

(5) 50,000,000/1.2520

(6) 50,000,000/1.2760

(7) Spot rate at the end of the hedging relationship

(8) 100,000,000/1.3585

(9) 50,000,000/1.3585

(10) 78,370,000 – 73,611,000

(11) 36,805,000 – 39,936,000

(12) 36,805,000 – 39,185,000

(13) 4,759,000 – Nil

(14) 4,759,000/(– <5,511,000>)

In a second scenario, a EUR–USD spot rate at the end of the hedging relationship (1.1115) was assumed by shifting the EUR–USD spot rate prevailing on the assessment date (1.2350) by –10%. As shown in the table below, the change in fair value of the hedged item was expected to be largely offset by the change in fair value of the hedging instrument, corroborating that both elements have values that will generally move in opposite directions.

Notes:

(1) Instrument forward rate when final FX rate was 1.1115

(2) According to its risk management objective, the 1st hedged item was fully protected (i.e., from 1.2520, the expected rate on 30-Jun-X5 as of the start of the hedging relationship)

(3) 100,000,000/1.1938

(4) 50,000,000/1.2520

(5) Spot rate at the end of the hedging relationship

(6) 100,000,000/1.1115

(7) 50,000,000/1.1115

(8) 83,766,000 – 89,969,000

(9) 44,984,000 – 39,936,000

(10) According to its risk management objective, the 2nd hedged item was protected from 1.2760. Because the spot rate (1.1115) was below the spot rate at which the protection kicked in, the 2nd hedged item was not taken into account for this scenario analysis

(11) <6,202,000> – Nil

(12) <6,202,000>/(–5,048,000)

Under the two scenarios, the degree of offset was notably high. Under the second scenario, the degree of offset exceeded 100% because the hedging instrument benefited on just half of the appreciation of the USD relative to the EUR below 1.2760, while the hedged item benefited fully from such appreciation. In any case, the entity concluded that the degree of offset under the two scenarios were large enough to conclude that an economic relationship existed between the hedging instrument and the hedged item.

The hedge ratio was established at 1:1, resulting from the USD 100 million of hedged item that the entity actually hedged and the USD 100 million of the hedging instrument that the entity actually used to hedge that quantity of hedged item.

Another hedge assessment was performed on 31 December 20X4 (reporting date). This assessment was very similar to the one performed at inception and has been omitted to avoid unnecessary repetition. Additionally, the hedge ratio was assumed to be 1:1 on that assessment date.

Fair Valuations on 31 December 20X4

The fair valuations of the hedging instrument were calculated in the previous subsection. The fair value of the participating forward (EUR 1,060,000) was the sum of the fair values of the forward (EUR 119,000) and option (EUR 941,000) embedded contracts.

The fair valuation of the hedged item on 31 December 20X4 was performed on a forward basis based on a forward rate for 30 June 20X5 of 1.2800 and a 0.9839 discount factor as follows:

Notes:

(1) 50,000,000/1.2520

(2) 50,000,000/1.2760

(3) Forward rate for 30 June 20X5 as of the valuation date

(4) 50,000,000/1.2800

(5) 39,063,000 – 39,936,000

(6) <873,000> × 0.9839

(7) <859,000> minus its initial fair value, which was nil

(8) <859,000> + <120,000>

The following table summarises the changes in values of both the hedging instrument and the hedged item:

Fair Valuations on 31 March 20X5

The fair valuations of the hedging instrument were calculated in the previous subsection. The fair value of the participating forward (EUR 1,731,000) was the sum of the fair values of the forward (EUR 714,000) and the option (EUR 1,017,000) embedded contracts.

The fair valuation of the hedged item on 31 March 20X5 was performed on a forward basis based on a forward rate for 30 June 20X5 of 1.3000 and a 0.9901 discount factor as follows:

The following table summarises the changes in values of both the hedging instrument and the hedged item:

Fair Valuations on 30 June 20X5

The fair valuations of the hedging instrument were calculated in the previous subsection. The fair value of the participating forward (EUR 2,612,000) was the sum of the fair values of the forward (EUR 1,306,000) and the option (EUR 1,306,000) embedded contracts.

The fair valuation of the hedged item on 30 June 20X5 was performed based on a spot rate of 1.3200 and a 1.0000 discount factor as follows:

The following table summarises the changes in values of both the hedging instrument and the hedged item:

Calculation of Effective and Ineffective Amounts

The calculation of the effective and ineffective parts of the period change in fair value of the participating forward was performed as follows:

Accounting Entries

The required journal entries were as follows.

1. To record the forward and the option trades on 1 October, 20X4

   At their inception, the fair value of the participating forward was zero. Consequently, no on-balance-sheet accounting entries were required.

2. To record the closing of the accounting period on 31 December 20X4

   The change in fair value of the participating forward since the last valuation was a EUR 1,060,000 gain, of which EUR 979,000 was deemed to be effective and recorded in the cash flow hedge reserve of equity, while EUR 81,000 was deemed to be ineffective and recorded in profit or loss.

3. To record the sale agreement on 31 March 20X5

   The sale agreement was recorded at the spot rate prevailing on that date (1.2950). Therefore, the sale EUR proceeds were EUR 77,220,000 (=100 million/1.2950). Because the machinery sold was not yet paid, a receivable was recognised. Suppose that the machinery was valued at EUR 68 million in ABC's statement of financial position.

4. The change in fair value of the participating forward since the last valuation was a gain of EUR 671,000, fully considered to be effective and recorded in the cash flow hedge reserve of OCI.
5. The recognition of the sales transaction in profit or loss caused the release to profit or loss of the EUR 1,650,000 deferred hedge results accumulated in the cash flow hedge reserve of equity.
6. To record the settlement of the receivable and the derivatives on 30 June 20X5

   The receivable was revalued at the spot rate prevailing on this date, showing a loss of EUR 1,463,000 (=100 million/1.3200 – 100 million/1.2950):

7. The change in the fair value of the participating forward since the last valuation was a gain of EUR 881,000, fully deemed to be effective.
8. The recognition of the revaluation of the accounts receivable in profit or loss caused the release to profit or loss of the EUR 881,000 deferred hedge results accumulated in the cash flow hedge reserve equity. The hedging relationship ended on this date.
9. On 30 June, 20X5, ABC received the USD 100 million from the client and eliminated the related account receivable. The USD 100 million receipt was valued at that date's exchange rate, EUR 75,758,000 (=100 mn/1.3200):
10. Simultaneously, the participating forward was settled: ABC sold USD 100 million, worth EUR 75,758,000, and received EUR 78,370,000. The fair value of the participating forward just prior to its settlement was EUR 2,612,000 (= 100 million × (1/1.2760 – 1/1.3200)).

The following table gives a summary of the accounting entries, excluding the entries related to the cost of goods sold:

(1) Note: Total figures may not match the sum of their corresponding components due to rounding.

Preliminary Hedge Ratio Estimation Using Implied Delta

It was shown earlier that our participating forward could be split into two contracts (see Figure 5.15): (i) an FX forward at 1.2760 and a nominal of USD 50 million, and (ii) a purchase of a USD put with strike 1.2760 and USD 50 million nominal. The quantity of participating forward was the sum of the quantities of the forward and the option:

The quantity of forward to be used by ABC was USD 50 million as its probability of being exercised was 100% (i.e., there is no optionality in a forward as both parties will be obliged to exchange the notional amounts at maturity).

Whilst the quantity of forward was known, the quantity of option to be used by ABC depended on the EUR–USD spot rate at expiry. If the EUR–USD spot rate was above 1.2760, ABC would fully exercise the option, which may be interpreted as ABC using a USD 50 million quantity of the option. Alternatively, if the spot rate was at or below 1.2760 at expiry, ABC would not exercise the option, or in other words, ABC would not use any quantity of the option. Whilst ex ante ABC did not know whether the option would be exercised, the entity could estimate the option's probability of being exercised, which is approximated by the option's delta.

In order to calculate the appropriate hedge ratio, the quantity of hedged item should equal the quantity of participating forward. As noted above, the quantity of participating forward is unknown at the commencement of the hedging relationship and can be estimated according to the following expression:

As mentioned previously, the quantity of forward was USD 50 million as the probability of “exercising” the forward was 100%. The probability of exercising an option can be approximated by using its delta. Therefore, the quantity of hedged item can be estimated as:

An option delta indicates the theoretical change in an option price with respect to changes in the price of the underlying price/rate. When the underlying price/rate changes by a small amount, the option price changes by the delta multiplied by that amount. The delta is commonly expressed as a percentage, measuring the change in an option price for a 1% change in the underlying price/rate.

The absolute value of the delta can be loosely interpreted as an approximate measure of the probability that an option will expire in-the-money (i.e., be exercised). If an option is very deep in-the-money, and therefore has a very high probability of being in-the-money at expiry, the absolute value of the delta will be close to 100%. If an option is very deep out-of-the-money, it has a low probability of being in-the-money at expiry, and therefore the absolute value of its delta will be close to zero. At-the-money options have a delta close to 50%, meaning roughly a 50% probability of being exercised at expiry. In our case, on 1 October 20X4 the delta of our option was 38%, using the Black–Scholes pricing model. The option delta as a function of the EUR–USD spot rate on that date had the profile depicted in Figure 5.17, showing that for example had the spot rate been 1.2028 the delta would have been 25%.

As a result, the hedge ratio was established at 0.69:1, and USD 69 million of the hedged item was hedged using USD 100 million of the participating forward.

Preliminary Hedge Ratio Estimation Using Historical Data

A second method to estimate a preliminary hedge ratio is to simulate the historical performance of the hedging relationship using actual EUR–USD spot rate past behaviour and calculating the quantity of participating forward that the entity would have used. The following table details a hedge ratio estimation using monthly observations during the previous 2 years. For example, on 1 May 20X2 the EUR–USD spot rate was 1.3197, a 6-month hedging relationship would have finished on 31 October 20X2 and the spot rate on this date was 1.2489, while the participating forward rate would have been 1.3607, resulting in a USD 50 million quantity being used as the option element would not have been exercised.

According to the behaviour of the EUR–USD spot rate during the period from 1-May-X2 to 1-Apr-X4, the average quantity would have been USD 64,583,000, implying a 0.65:1 hedge ratio.

In order to avoid unnecessary repetition, I will cover next only the elements of the hedge that are particularly specific to this case. I will be using a preliminary hedge ratio of 0.69:1

Hedged Item Description in the Hedging Relationship Documentation

The hedged item was defined in the hedge documentation as follows: “USD 69 million sale of finished goods expected to take place on 31 March 20X5. This sale is highly probable as similar transactions have occurred in the past with the potential buyer, for sales of similar size, and the negotiations with the buyer are at an advanced stage. The amount of hedged item will be adjusted in accordance with the hedge ratio.”

Hedging Instrument Description in the Hedging Relationship Documentation

The hedged item was defined in the hedge documentation as follows: “The participating forward contract with reference number 014565. The notional of the instrument is USD 100 million, its rate is 1.2760 and its maturity on 30 June 20X5. The counterparty to the instrument is XYZ Bank and the credit risk associated with this counterparty is considered to be very low.”

Hypothetical Derivative

The initial terms of the hypothetical derivative were as follows:

The notionals of the hypothetical derivative will be adjusted to reflect adjustments to the quantity of hedged item as a result of changes to the hedge ratio.

Fair Valuations at Inception and on 31 December 20X4

The fair valuations were calculated in the previous subsection. The fair value of the participating forward was the sum of the fair values of the embedded forward and option contracts.

(*) 859,000 × 69 mn/50 mn, where EUR 859,000 was the fair value of “hedged item 1” on 31-Dec-20X4 (which had a USD 50 mn notional) from Section 5.8.3 (Fair Valuations on 31 December 20X4).

The calculation of the effective and ineffective parts of the period change in fair value of the participating forward was performed as follows:

Re-estimation of the Hedge Ratio on 31 December 20X4

The hedge ratio was re-estimated on 31 December 20X4 using the implied delta of the participating forward. Remember that the quantity of the hedged item was estimated using the following expression:

The embedded option's delta was 47% (see Figure 5.18), higher than at inception because the increase in the spot rate increased the option's probability of exercise. The estimate of the hedged item quantity was USD 74 million, calculated as follows:

The terms of the hypothetical derivative were adjusted, as shown below:

Fair Valuations on 31 March 20X5

(*) 1,459,000 × 74 mn /50 mn, where EUR 1,459,000 was the fair value of “hedged item 1” on 31-Mar-20X5 (which had a USD 50 mn notional) from Section 5.8.3 (Fair Valuations on 31 March 20X5).

The calculation of the effective and ineffective parts of the period change in fair value of the participating forward was performed as follows:

Re-estimation of the Hedge Ratio on 30 March 20X5

The hedge ratio was re-estimated on 30 March 20X5 using the implied delta of the participating forward. Remember that the quantity of the hedged item was estimated using the following expression:

The embedded option's delta was 76% (see Figure 5.19), higher than at inception because the increase in the spot rate increased the option's probability of exercise. The estimate of the hedged item quantity was USD 88 million, calculated as follows:

The terms of the hypothetical derivative were adjusted, as shown below:

Fair Valuations on 30 June 20X5

(*) 2,057,000 × 88 mn/50 mn, where EUR 2,057,000 was the fair value of “hedged item 1” on 30-Jun-20X5 (which had a USD 50 mn notional) from Section 5.8.3 (Fair Valuations on 30 June 20X5).

The calculation of the effective and ineffective parts of the period change in fair value of the participating forward was performed as follows:

Accounting Entries

The required journal entries were as follows.

1. To record the participating forward contract trade on 1 October 20X4

   No entries in the financial statements were required as the fair value of the participating forward contract was zero.

2. To record the closing of the accounting period on 31 December 20X4

   The change in fair value of the participating forward since the last valuation was a gain of EUR 1,060,000. As the hedge was fully effective, all this change in fair value was recorded in OCI and none in profit or loss.

3. To record the sale agreement and the end of the hedging relationship on 31 March 20X5

   The sale agreement was recorded at the EUR–USD spot rate prevailing on the date the sales were recognised (1.2950). Therefore, the sales EUR amount was EUR 77,220,000 (=100 million/1.2950). Because the machinery sold was not yet paid, a receivable was recognised. Suppose that the machinery was valued at EUR 68 million in ABC's statement of financial position. The change in the fair value of the participating forward since the last valuation was a gain of EUR 671,000, fully effective and recognised in OCI. The recognition of the sales transaction in profit or loss caused the release to profit or loss of the EUR 1,731,000 deferred hedge results accumulated in OCI.

4. To record the settlement of the receivable and the participating forward on 30 June 20X5

   The receivable was revalued at the spot rate prevailing on this date, showing a loss of EUR 1,463,000 (=100 million/1.3200 – 100 million/1.2950).

   The USD payment from the receivable was exchanged for EUR as soon as it was received. The spot rate on payment date was 1.32, so the USD 100 million payment was exchanged for EUR 75,758,000 (=100 million/1.32).

   The change in the fair value of the participating forward since the last valuation was a gain of EUR 881,000, fully effective and recognised in OCI.

   The revaluation of the receivable in profit or loss caused the release to profit or loss of the EUR 881,000 deferred hedge results accumulated in OCI.

   The settlement of the FX participating forward resulted in the exchange of USD 100 million, worth EUR 75,758,000, for EUR 78,370,000. The fair value of the participating forward was EUR 2,612,000 (=100 million × (1/1.2760 – 1/1.32)).

The following table gives a summary of the accounting entries, excluding the entries related to the cost of goods sold:

(1) Note: Total figures may not match the sum of their corresponding components due to rounding.

Fair Valuation of the Hedging Instrument (Standard Forward Contract)

The fair value calculation of the hedging instrument (i.e., the standard forward contract) at each relevant date was as follows (for the sake of simplicity I have included all CVAs/DVAs in the fair valuation of the undesignated part):

Notes:

(1) 76,923,000 = 100,000,000/1.3000

(2) 2,442,000 = 79,365,000 – 76,923,000

(3) 2,417,000 = 2,442,000 × 0.9901

(4) 1,197,000 = 2,417,000 – 1,220,000

(5) 3,039,000 = 1,197,000 – <622,000>

Fair Valuation of the Hypothetical Derivative

The fair value calculation of the hypothetical derivative at each relevant date was as follows:

Notes:

(1) (100 mn/1.2520 – 100 mn/1.2800) × 0.9839

(2) (100 mn/1.2520 – 100 mn/1.3000) × 0.9901

(3) (100 mn/1.2520 – 100 mn/1.3200) × 1.0000

Fair Valuation of the Knock-out Option

The fair value of the knock-out option was computed using a closed-ended formula to value barrier options. Remember that all the change in the fair value of this option was recorded in profit or loss, as this option contract was undesignated. The fair value of the knock-out option at each relevant date was as follows: