5.11.1 Hedging Relationship Documentation

Under the approach covered in this section the hedging instrument would be the knock-in forward in its entirety. The hedged item was the cash flow stemming from the USD 100 million of a highly expected forecast sale (see previous cases). The risk management objective was to mitigate its variability against movements in the EUR–USD FX rate. ABC documented the hedging relationship as follows:

5.11.2 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 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:

(*) Market credit risk-free forward rate for 30 June 20X5

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.

Hedge effectiveness assessment will be performed, 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 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.

5.11.3 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 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. Of note is that the hedged item was valued using forward rates (i.e., on a forward basis).

Notes:

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

(2) 100,000,000/1.3585

(3) 79,365,000 – 73,611,000

(4) 5,754,000 × 1.0000

(5) 5,754,000 – Nil

(6) 5,754,000/6,261,000

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. Under that scenario the 1.1620 barrier was reached and, as a result, the knock-in forward became a 1.2600 standard forward.

Based on the results of the quantitative assessment, 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.

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). That assessment was very similar to the one performed at inception and has been omitted to avoid unnecessary repetition. Similarly, the hedge ratio was assumed to be 1:1 on that assessment date.

5.11.4 Fair Valuations of Hedging Instrument 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

5.11.5 Calculation of Effective and Ineffective Amounts

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

Notes:

(1) Lower of 2,777,000 and 2,920,000

(2) 1,719,000, the sum of all prior effective amounts

(3) 2,777,000 – 1,719,000

(4) Change in the fair value of the hedging instrument during the period (i.e., since the last fair valuation)

(5) Lower of 1,058,000 (available amount) and 867,000 (period change in fair value of hedging instrument)

(6) 867,000 (period change in fair value of hedging instrument) – 867,000 (effective part)

5.11.6 Accounting Entries

The required journal entries were as follows.

1. To record the knock-in forward trade on 1 October, 20X4

   No on-balance-sheet accounting entries were required as initial fair value of the knock-in forward was zero.

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

   The change in fair value of the knock-in forward since the last valuation was a EUR 1,910,000 gain, of which EUR 1,719,000 was deemed to be effective and recorded in the cash flow hedge reserve of equity, while EUR 191,000 was deemed to be effective 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.

   The change in fair value of the knock-in forward since the last valuation was a gain of EUR 867,000, deemed to be fully effective and recorded in the cash flow hedge reserve of OCI.

   The recognition of the sales transaction in profit or loss caused the release to profit or loss of the EUR 2,586,000 deferred hedge results accumulated in OCI.

4. To record the settlement of the receivable, the knock-in 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 receivable was paid by the customer, and thus USD 100 million was received. The spot rate on payment date was 1.32, so the USD 100 million payment was valued at EUR 75,758,000 (=100 million/1.32).

   The change in fair value of the knock-in forward since the last valuation was a gain of EUR 830,000, fully deemed to be effective and recorded in the cash flow hedge reserve of OCI.

   The recognition of the receivable revaluation in profit or loss caused the reclassification of the EUR 830,000 amount in the cash flow hedge reserve to profit or loss.

   The settlement of the knock-in forward resulted in the payment of USD 100 million cash in exchange for EUR 79,365,000, representing an additional EUR 3,607,000 relative to the amount that settled the receivable.

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

   	Cash	Knock-in forward	Accounts receivable	Cash flow hedge reserve	Profit or loss
   1-Oct-20X4
   Knock-in forward trade
   31 Dec-20X4
   Knock-in forward revaluation		1,910,000		1,719,000	191,000
   31-Mar-20X5
   Knock-in forward revaluation		867,000		867,000
   Reserve reclassification				<2,586,000>	2,586,000
   Sale shipment			77,220,000		77,220,000
   30-Jun-20X5
   Knock-in forward revaluation		830,000		830,000
   Knock-in forward settlement	3,607,000	<3,607,000>
   Receivable revaluation			<1,463,000>		<1,463,000>
   Reserve reclassification				<830,000>	830,000
   Receivable settlement	75,758,000		<75,758,000>
   TOTAL	79,365,000	-0-	-0-	-0-	79,365,000

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

5.12.1 Quantity of Hedged Item Estimation

The rebalancing approach is an interesting alternative for the application of hedge accounting when exotic options are involved and either (i) it is not feasible a split of the derivative between a hedge accounting friendly part and an undesignated part or (ii) designating the derivative in its entirety results in economic assessments that are too dependent on the path followed by the underlying market variable. The rebalancing approach starts by estimating the quantity of hedged item that would be hedged with the quantity of derivative actually traded.

Previously, it was mentioned that our knock-in forward could be split into two contracts (see Figure 5.23): (i) an FX forward at 1.2600, and (ii) a purchased knock-out USD call option with a 1.2600 strike and a 1.1620 barrier. Let us analyse two extreme scenarios:

• The option was knocked out (i.e., the 1.1620 barrier was reached). The hedge would then consist of just a 1.2600 forward (i.e., a standard forward). The hedge ratio would be 1:1 as in order to hedge USD 100 million of the forecast sale ABC would use USD 100 million of the forward, because any change value of the sale would be almost fully offset by the change in the fair value of the resulting forward.
• The option had a very high probability of being exercised (i.e., the option had a short time to expiry, was in-the-money and the probability of reaching the barrier was very low). In this scenario, it is as if the knock-in forward never existed as the changes in fair value of the forward would be almost fully offset by the changes in fair value of the option. The hedge ratio would be almost 0:1 (i.e., as if the forecast sale was unhedged).

The quantity of hedged item (i.e., the forecast sale) could be viewed as the difference between the quantity of forward and the quantity of (knock-out) option:

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

Whilst the quantity of forward was known, the quantity of option to be used by ABC depended on its probability of being exercised –whether the barrier would not be reached before the end of the hedging relationship and whether the option would be in-the-money (i.e., when a EUR–USD spot rate lower than 1.2600 results at expiry). If both the option exists and it is in-the-money at expiry, ABC would fully exercise the option, which can be interpreted as ABC using a USD 100 million quantity of the option. Alternatively, if either (i) the 1.1620 barrier was reached during the option's life or (ii) the spot rate was at or above 1.2600 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.

In order to have the appropriate hedge ratio, the quantity of hedged item to be used should equal the quantity of knock-in forward. As noted above, the quantity of knock-in 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 100 million as the probability of “exercising” the forward was 100%. The probability of exercising an option can be approximated by its delta. Therefore, the quantity of hedged item can be estimated as:

The absolute value of an option's delta can be loosely interpreted as an approximate measure of the probability that it will expire in-the-money. If a knock-out option is very deep in-the-money and has a very low probability of reaching its barrier (i.e., it has a very high probability of being in-the-money at expiry), the absolute value of its delta will be close to 100%. Conversely, if a knock-out option is very deep out-of-the-money or it is close to its barrier (i.e., it has a low probability of being in-the-money at expiry), the absolute value of its delta will be close to zero. In our case, on 1 October 20X4 the delta of our knock-out option was 29%. The knock-out option delta as a function of the EUR–USD spot rate on that date had the profile depicted in Figure 5.26, showing that, for example, had the spot rate been 1.2600 the delta would have been 35%.

As a result, the hedge ratio was established at 0.71:1, and USD 71 million of the hedged item was hedged using USD 100 million of the knock-in forward.

In our case, the hedging relationship would end on 30 June 20X5, when the knock-in forward contract matured (see Figure 5.27).

• Until 31 March 20X5, the effective parts of the changes in fair value of the knock-in forward would be recorded in OCI, while the ineffective parts would be recognised in profit or loss.
• On 31 March 20X5, the hedged cash flow (i.e., the sale) would be recognised in ABC's profit or loss and, simultaneously, cause the amounts previously recorded in equity (OCI) to be reclassified to profit or loss. Also on 31 March 20X5 a receivable denominated in USD would be recognised in ABC's statement of financial position.
• During the period from 31 March 20X5 until 30 June 20X5, the hedged item would be the USD accounts receivable resulting from the sale. This receivable would be revalued through profit or loss on 30 June 20X5.
• Also on 30 June 20X5, the effective part of the change in fair value of the knock-in forward would be recorded in OCI, while the ineffective part would be recognised in profit or loss. The amounts recognised in OCI would be reclassified to profit or loss, as the revaluation of the hedged item (i.e., the receivable) had impacted profit or loss. Therefore, there was no need to have a hedging relationship in place because already there would be an offset between the FX gains and losses on the revaluation of the USD accounts receivable and the revaluation gains and losses of the knock-in forward contract.

5.12.2 Hedging Relationship Documentation

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

5.12.3 Hedge Effectiveness Assessment

Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of the hedged item.

The change 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, adjusting the sales amount and thereafter 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 and 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, is reliably measurable and affects profit or loss. 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 quantitative basis using the scenario analysis method for four 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 ±1 and ±0.5 standard deviations, and the changes in fair value of the hedging instrument with those of the hedging instrument compared.

5.12.4 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.
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.

An assessment was performed at hedge inception using the scenario analysis method for four scenarios, as follows. The EUR–USD spot rates at the end of the hedging relationship (30 June 20X5) for each scenario (1.1325, 1.1827, 1.2897 and 1.3467) were simulated by shifting the EUR–USD spot rate prevailing on the assessment date (1.2350) by ±1 and ±0.5 standard deviations, assuming a 10% volatility. In the case of ±1 standard deviations, the expression used to calculate the FX rates was:

As shown in the table below, 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. The calculations related to the ±1 standard deviation shifts:

Notes:

(1) The hedging instrument became a standard forward at 1.2600 as the embedded option was knocked out because the 1.1620 barrier was reached

(2) The credit risk-free forward rate for 30 June 20X5 prevailing at the start of the hedging relationship

(3) 79,365,000 – 88,300,000 = 100 mn/1.2600 – 100 mn/1.1325

(4) 52,721,000 – 56,891,000

(5) 100 mn/1.2600 – 100 mn/1.3467

The results of the quantitative assessments were as follows:

Notes:

(1) The knock-in forward matured worthless as the EUR–USD spot rate ended up below 1.2600 and the barrier was assumed not to have been reached during the life of the instrument

(2) 100 mn/1.2600 – 100 mn/1.2897

(3) 71 mn/1.1827 – 71 mn/1.2480

(4) 71 mn/1.2897 – 71 mn/1.2480

The overall degree of offset was notably different from the expected 100%, being insufficient to conclude that the economic relationship criterion was met. Several factors contributed to such a difference:

• The degree of offset was highly dependent on the EUR–USD spot rate path simulated. If instead of four scenarios, ABC had simulated a large number of risk-neutral scenarios (e.g., a thousand) using a Monte Carlo simulation method (see Figure 5.28), the average degree of offset would have been close to 100%.
• The four scenarios used were not risk-neutral: the probability of a spot rate being shifted by, for example, +1 standard deviation is much lower than for a shift by +0.5 standard deviations. The degree of offsets should have been weighted by their probability of occurring.

Suppose that a more robust Monte Carlo analysis resulted in an overall degree of offset much closer to 100% and that, as a result, ABC concluded that 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.

As calculated previously, the hedge ratio was established at 0.71:1, resulting from the USD 71 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. I assume that the hedge ratio was set at 0.76:1. As a result the quantity of hedged item changed to USD 76 million.

The hedge ratio was also estimated on 31 March 20X5, resulting in 0.95:1. As a result the quantity of hedged item changed to USD 95 million.

5.12.5 Fair Valuations at the Relevant Dates

The fair values of the knock-in forward (see Section 5.11) at each relevant date were as follows:

The fair values of the hedged item at each relevant date were as follows:

Notes:

(1) (71 mn/1.2800 – 71 mn/1.2520) × 0.9839

(2) (76 mn/1.3000 – 76 mn/1.2520) × 0.9901

(3) (95 mn/1.3200 – 95 mn/1.2520) × 1.0000

5.12.6 Effective and Ineffective Amounts at the Relevant Dates

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

Notes:

(1) Lower of 2,777,000 and 2,219,000

(2) Nil + 1,221,000, the sum of all prior effective amounts

(3) 2,219,000 – 1,221,000

(4) Change in the fair value of the hedging instrument during the period (i.e., since the last fair valuation)

(5) Lower of 998,000 (available amount) and 867,000 (period change in fair value of hedging instrument)

(6) 867,000 (period change in fair value of hedging instrument) – 867,000 (effective part)

5.12.7 Accounting Entries

The required journal entries were as follows.

1. To record the knock-in forward contract trade on 1 October 20X4

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

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

   The change in fair value of the knock-in forward since the last valuation was a EUR 1,910,000 gain, of which the effective part was EUR 1,221,000 and recorded in OCI, and the ineffective part was EUR 689,000 and recorded 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 are recognised (1.2950). Therefore, the sales EUR amount was EUR 77,220,000 (=100 million/1.2950). Because the machinery sold was not 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 knock-in forward since the last valuation was a gain of EUR 867,000, fully effective and recorded in OCI. No ineffectiveness was present.

   The recognition of the sales transaction in profit or loss caused the release to profit or loss of the EUR 2,088,000 deferred hedge results accumulated in OCI.

4. To record the settlement of the receivable and the knock-in 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 receivable was paid by the customer, and thus USD 100 million was received. The spot rate on payment date was 1.32, so the USD 100 million payment was valued at EUR 75,758,000 (=100 million/1.32).

   The change in fair value of the knock-in forward since the last valuation was a gain of EUR 830,000, fully deemed to be effective and recorded in the cash flow hedge reserve of OCI.

   The recognition of the receivable revaluation in profit or loss caused the recycling of the EUR 830,000 amount in the cash flow hedge reserve to profit or loss.

   The settlement of the knock-in forward resulted in the payment of USD 100 million cash in exchange for EUR 79,365,000, representing an additional EUR 3,607,000 relative to the amount that settled the receivable.

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.

5.13.1 Hedge Accounting Optimisation

One of the main issues that ABC faced regarding the KIKO forward was how to split the instrument into two parts, a first part eligible for hedge accounting and a second part treated as undesignated, to minimise the overall impact on profit or loss volatility. ABC considered the following choices:

1. Divide the KIKO into two contracts (see Figure 5.31): (i) a 1.2300 forward and (ii) a “residual” derivative.
2. Divide the KIKO into two contracts (see Figure 5.32): (i) a USD put option with a 1.2300 strike and (ii) a “residual” derivative.
3. Consider the KIKO in its entirety as eligible for hedge accounting, if the corresponding requirements were met.
4. Consider the whole KIKO as undesignated.

5.13.2 Hedge Accounting Application for Approach 1 – Forward plus Residual Derivative

Suppose that ABC believed that the probability of crossing the 1.10 barrier was notably greater than that of crossing the 1.35 barrier. As a result, ABC selected the first approach, consisting of dividing the KIKO forward into two separate legal contracts: (i) a 1.2300 standard forward and (ii) a “residual” derivative.

The standard forward was designated as the hedging instrument in a cash flow hedging relationship. Hedge effectiveness was assessed by comparing the changes in fair value of the hedging instrument with the changes in fair value of a hypothetical derivative. The hypothetical derivative was a forward with zero initial fair value. The main terms of the actual forward (i.e., the hedging instrument) and the hypothetical derivative were as follows:

5.13.3 Hedging Relationship Documentation

The hedging relationship documentation was very similar to that in Section 5.10.2. The only differences are the terms of the hedging instrument, so we omit the documentation to avoid unnecessary repetition.

5.13.4 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.
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.

Based on the results of the quantitative assessment performed, it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions. The assessment consisted of two scenarios being analysed 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%. As shown in the table below, 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.

Notes:

(1) Assumed spot rate on hedging relationship end date

(2) 100,000,000/1.3585

(3) 81,301,000 – 73,611,000

(4) 7,690,000 – 850,000

(5) 6,840,000/6,261,000

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. Under that scenario I assume that the 1.1000 barrier was not reached.

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.

5.13.5 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 (I assumed that on 15-Nov-20X4 the 1.1000 barrier was reached):

(*) Credit risk-free forward rate

Fair Valuation of the Residual Derivative

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.

On 15 November 20X4 the EUR–USD spot rate crossed the 1.1000 barrier. As a result, at that moment the knock-out USD call element of the residual derivative ceased to exist and the knock-in USD call of the KIKO became a standard USD call option from that date. The residual derivative fair value was calculated as follows:

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

	1-Oct-20X4	31-Dec-20X4	31-Mar-20X5	30-Jun-20X5
KIKO fair value (FV)	-0-	2,188,000	1,450,000	5,543,000
Forward fair value	850,000	3,120,000	4,333,000	5,543,000
Residual deriv. FV	<850,000>	<932,000>	<2,883,000>	-0-
Res. deriv. FV change	—	<82,000>	<1,951,000>	2,883,000

5.13.6 Accounting Entries

The required journal entries were as follows.

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

   At their inception, the fair values of the FX forward and the residual derivative were EUR 850,000 and <850,000>, 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 gain of EUR 2,270,000, of which EUR 1,719,000 was considered to be effective, and thus, recorded in the cash flow hedge reserve of OCI. The EUR 551,000 remainder represented the ineffective part, and was therefore recognised in profit or loss.

   The change in fair value of the residual derivative since the last valuation was a EUR 82,000 loss, recognised in profit or loss as it was undesignated.

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.

   The change in fair value of the forward since the last valuation was a gain of EUR 1,213,000, of which EUR 1,201,000 was considered to be effective and recorded in the cash flow hedge reserve of OCI, while EUR 12,000 was considered to be ineffective and recorded in profit or loss.

   The change in fair value of the residual derivative since the last valuation was a EUR 1,951,000 loss, recognised in profit or loss as it was undesignated.

   The recognition of the sales transaction in profit or loss caused the release to profit or loss of the EUR 2,920,000 deferred hedge results accumulated in OCI.

4. To record the settlement of the receivable and the 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 receivable was paid by the customer, and thus USD 100 million was received. The spot rate on payment date was 1.32, so the USD 100 million payment was valued at EUR 75,758,000 (=100 million/1.32).

   The change in the fair value of the forward since the last valuation was a gain of EUR 1,210,000, of which EUR 1,197,000 was considered to be effective and recorded in the cash flow hedge reserve of OCI, while EUR 13,000 was considered to be ineffective and recorded in profit or loss.

   The settlement of the FX forward resulted in the payment of USD 100 million cash in exchange for EUR 81,301,000, representing an additional EUR 5,543,000 relative to the amount that settled the receivable.

   The change in the fair value of the residual derivative since the last valuation was a gain of EUR 2,883,000. The residual derivative ended up worthless and, as a result, not exercised by either ABC or XYZ Bank.

   The revaluation of the receivable in profit or loss caused the release to profit or loss of the EUR 1,197,000 deferred hedge results accumulated in OCI.

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.

5.13.7 Additional Remarks

Figure 5.33 summarises the effects of the strategy on ABC's profit or loss. The strategy worked very well. The total proceeds from the strategy were EUR 81,300,000, equivalent to a EUR–USD rate of 1.2300. Sales were translated at a 1.2478 rate. The strategy was successful in hedging the FX exposure because the 1.35 barrier was not crossed.

Figure 5.34 illustrates the effects of the strategy on ABC's profit or loss, were the whole KIKO forward undesignated. All the change in fair value of the KIKO would have been recognised in profit or loss. The total proceeds from the strategy were EUR 81,300,000, equivalent to a EUR–USD rate of 1.2300. Sales were translated at a 1.2950 rate.

The story would have been dramatically different had the 1.35 barrier been reached during the instrument's life. Suppose that the 1.35 barrier was crossed before the maturity of the KIKO forward (remember that the 1.1000 barrier was already crossed in November 20X4). At that moment the knock-in USD put embedded in the residual derivative would have been triggered, becoming a standard USD put with strike 1.2300. As a result, under the combination of the 1.2300 forward and the short position in the 1.2300 standard USD put, ABC would have been exposed to a rising EUR–USD rate while not being able to benefit from a declining EUR–USD rate below 1.2300. The total proceeds from the whole strategy would have been EUR 75,757,000, equivalent to a 1.3200 exchange rate.

5.15.1 Hedging Relationship Documentation

ABC denominated the range accrual contract as the hedging instrument in a foreign currency cash flow hedge, and the highly expected forecast sale as the hedged item. The hedging relationship would end on 30 June 20X5, when the range accrual matured (see Figure 5.36).

ABC decided to base its assessment of hedge effectiveness on variations in forward FX rates. In other words, the forward points (i.e., the forward element) of the hypothetical derivative were included in the hedging relationship. ABC documented the hedging relationship as follows:

5.15.2 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 a hypothetical derivative. The fair valuation of the hypothetical derivative will include both the forward and the spot elements. 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:

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, adjusting the sales amount or 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 and 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 assessment will be performed on a forward-forward basis. In other words, the forward element of the hypothetical derivative will be included in the assessment.

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 through 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 quantitative basis using a regression analysis method based on the EUR–USD FX rate during the previous 15 years and comparing the change in fair value of both the hypothetical derivative and the hedging instrument.

5.15.3 Hedge Effectiveness Assessment Performed at Hedge Inception

A regression analysis was performed on 1 October 20X4 to assess whether there is an economic relationship between the hedged item and the hedging instrument. The regression analysis was based on the EUR–USD FX rate actual performance during the previous 15 years and comparing the change in fair value of both the hypothetical derivative and the hedging instrument. The historical time horizon of 15 years was divided into 65 “simulation periods” of 9 months each. Each simulation period had an inception date and two subsequent balance sheet dates. In each simulation period, the behaviour of an equivalent hedging relationship using the historical data was simulated. Each observation pair (X, Y) was generated by computing the cumulative change in the fair value of a range accrual (variable X) and the cumulative change in fair value of a hypothetical derivative (observation Y), as shown in Figure 5.37. The terms of the range accrual and hypothetical derivative (accrual range and forward rates) were adjusted to conform to the market rates prevailing at the beginning of each simulation period. The results of the analysis were:

• A slope of 1.0. This was no coincidence as, prior to entering into the range accrual, its terms were designed to achieve such a slope.
• An R-squared of 82%.

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 analysis performed, the entity 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.

The hedge ratio was established at 1:1.43, based on the slope of the regression analysis. In other words, USD 100 million of hedged item was the quantity that the entity actually hedged and USD 143 million maximum USD notional was the quantity 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), when the EUR–USD spot rate was 1.2700. On that date, 66 days had already accrued within the accrual range, implying a minimum notional of USD 72.6 million. This assessment encompassed another regression in which each period already had 66 days accrued, 63 business days remaining to accrue and a relative position between the spot rate and the range accrual as shown in Figure 5.38. Suppose that after performing such regression its slope was 0.9, implying a 1:1.29 hedge ratio. In other words, USD 100 million of hedged item was the quantity that the entity actually hedged and USD 129 million maximum USD notional was the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. That hedge ratio meant that the hedging instrument represented 90% of the range accrual, while the 10% remainder was undesignated.

5.15.4 Fair Valuations and Calculations of Effective/Ineffective Amounts

The behaviour of the EUR–USD spot rate during the life of the instrument is shown in Figure 5.39. The actual spot and forward exchange rates prevailing at the relevant dates were as follows:

Note:

(1) Assuming that an excess USD 10 million nominal was sold on 31-Mar-20X5 to eliminate the overhedged situation

5.15.5 Accounting Entries

The required journal entries were as follows.

1. To record the range acccrual trade on 1 October 20X4

   There were no accounting entries as the range accrual forward had zero fair value at hedge inception.

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

   The change in fair value of the range accrual since the last valuation was a gain of EUR 2,611,000, of which EUR 1,719,000 was considered to be effective and recorded in the cash flow hedge reserve of OCI, and EUR 892,000 was considered 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.

   The change in fair value of the range accrual since the last valuation was a gain of EUR 2,157,000, of which a EUR 1,941,000 gain corresponded to the hedging instrument (90% of the range accrual) and a EUR 216,000 gain corresponded to the undesignated part (10% of the range accrual). Regarding the EUR 1,941,000 gain related to the hedging instrument, EUR 1,201,000 was considered to be effective and recorded in the cash flow hedge reserve of OCI, while EUR 740,000 was considered to be ineffective and recorded in profit or loss. The EUR 216,000 gain related to the undesignated part was recognised in profit or loss.

   The recognition of the sales transaction in profit or loss caused the release to profit or loss of the EUR 2,920,000 deferred hedge results accumulated in OCI.

   The partial sale of the range accrual resulted in EUR 433,000 proceeds.

4. To record the settlement of the receivable and the range accrual 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 receivable was paid by the customer, and thus USD 100 million was received. The spot rate on payment date was 1.32, so the USD 100 million payment was valued at EUR 75,758,000 (=100 million/1.32).

   The change in the fair value of the range accrual since the last valuation was a gain of EUR 1,208,000, of which EUR 1,194,000 was considered to be effective and recorded in the cash flow hedge reserve of OCI, and EUR 14,000 was considered to be ineffective and recorded in profit or loss. Its settlement resulted in the payment of USD 100 million cash in exchange for EUR 81,301,000, representing an additional EUR 5,543,000 relative to the amount that settled the receivable.

   The revaluation of the receivable in profit or loss caused the release to profit or loss of the EUR 1,194,000 deferred hedge results accumulated in OCI.

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.

5.16.1 Accounting Entries

The transaction's journal entries were as follows.

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

   At their inception, the fair values of the FX forward and the residual derivative were EUR 850,000 and <850,000> 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 gain of EUR 2,270,000, of which EUR 1,719,000 was considered to be effective, and thus recorded in the cash flow hedge reserve of OCI. The EUR 551,000 remainder represented the ineffective part, and was therefore recognised in profit or loss.

   The change in fair value of the residual derivative since the last valuation was a EUR 341,000 gain, recognised in profit or loss as it was undesignated.

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.

   The change in fair value of the forward since the last valuation was a gain of EUR 1,213,000, of which EUR 1,201,000 was considered to be effective and recorded in the cash flow hedge reserve of OCI, while EUR 12,000 was considered to be ineffective and recorded in profit or loss.

   The change in fair value of the residual derivative since the last valuation was a EUR 944,000 gain, recognised in profit or loss as it was undesignated.

   The recognition of the sales transaction in profit or loss caused the release to profit or loss of the EUR 2,290,000 deferred hedge results accumulated in OCI.

   The residual derivative was sold, resulting in EUR 433,000 proceeds.

4. To record the settlement of the receivable and the 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 receivable was paid by the customer, and thus USD 100 million was received. The spot rate on payment date was 1.32, so the USD 100 million payment was valued at EUR 75,758,000 (=100 million/1.32).

   The change in the fair value of the forward since the last valuation was a gain of EUR 1,210,000, of which EUR 1,197,000 was considered to be effective and recorded in the cash flow hedge reserve of OCI, while EUR 13,000 was considered to be ineffective and recorded in profit or loss.

   The settlement of the FX forward resulted in the payment of USD 100 million cash in exchange for EUR 81,301,000, representing an additional EUR 5,543,000 relative to the amount that settled the receivable.

   The revaluation of the receivable in profit or loss caused the release to profit or loss of the EUR 1,197,000 deferred hedge results accumulated in OCI.

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.

5.16.2 Final Remarks

This case highlighted the accounting challenge when hedging with range accrual forwards. Whilst the strategy worked very well from an economic point of view, it added volatility to the profit or loss statement (see Figure 5.40). The increase in profit or loss volatility was caused by the fair value volatility of the ineffective and undesignated parts. The objective of the hedging strategy – to notably reduce the FX exposure of the hedged cash flow – was achieved through the range accrual.

Two approaches were analysed: a first approach designating the whole range accrual as the hedging instrument, and a second approach splitting the range accrual into a standard forward and a residual derivative. Whilst both approaches resulted in an identical profit or loss structure, as shown in Figure 5.40, this outcome is not to be generalised because it is largely dependent on the behaviour of the EUR–USD spot rate during the life of the hedge.

ABC expected 70% of the EUR–USD fixings to fall within the accrual range. A large deviation from this percentage meant that ABC could be either overhedged or underhedged, adding undesired exposure to the EUR–USD rate. In our case, ABC was fortunate because while it ended up being overhedged, it unwound the excess hedge at favourable market rates. From an economic perspective, the range accrual performed very well. The USD 100 million sale proceeds were exchanged for EUR 81,735,000, implying a 1.2235 exchange rate, notably better than the 1.2500 original forward rate.

5.17.1 Accounting Implications at Subsidiary Level

At a subsidiary level the hedges posed no particular accounting issues when preparing their entity-only financial statements. For example, in the case of Subsidiary A (see Figure 5.43), it could apply hedge accounting, assuming all other requirements were met, as the counterparty to the forward (the treasury centre) was an entity external to Subsidiary A and as the forecast transaction was highly probable and would be affecting profit or loss. Subsidiary A would designate the EUR–GBP forward as the hedging instrument in a cash flow hedge of its foreign currency denominated highly probable revenues of GBP 30 (the hedged item). Effective amounts of the changes in the fair value of the FX forward would be recorded in the cash flow hedge reserve of equity and reclassified to profit or loss when the hedged revenues ultimately affected profit or loss.

Whilst hedge accounting could not be applied (a derivative in itself cannot be a hedged item), from an accounting perspective the three internal hedges in conjunction with the external hedge did not pose a major challenge to the treasury centre. It measured all the FX forwards at fair value with changes in fair value recorded in profit or loss. As all the changes in these fair values were largely offset, the treasury centre had no volatility in profit or loss other than that caused by the CVAs/DVAs to the fair valuations of the forwards.

5.17.2 Accounting Implications at Consolidated Level

A key requirement of hedge accounting under IFRS 9 is that all hedging derivatives must involve a counterparty external to the entity (or group entities) being accounted for. Intragroup derivatives are not eligible for hedge accounting treatment in the consolidated accounts, causing significant difficulties where a group operates through a treasury centre. In these circumstances and in order to achieve hedge accounting it is usually necessary to identify, on a one-to-one basis, exposures in the group with external parties that may be designated as hedged items. In other words, the treasury centre would need to identify sufficient exposures in each of its various subsidiaries and designate, on a potentially arbitrary basis, some of those exposures on a one-to-one basis with its external contract.

Need to Split the JPY–GBP Forward?

The JPY–GBP forward hedged two separate risks: (i) a JPY–EUR exchange rate risk and (ii) a EUR–GBP exchange rate risk. The first the parent company needed to assess was whether it needed to split the JPY–GBP forward into two separate instruments: a JPY–EUR forward (selling EUR and buying JPY) and a EUR–GBP forward (selling GBP and buying EUR), as shown in Figure 5.44. This split, if needed, would undermine one of the main advantages of treasury centres: to lower the transaction costs of hedging.

Fortunately, IFRS 9 allows a single hedging instrument to be designated as a hedging instrument for more than one type of risk, provided that there is a specific designation of the hedging instrument and of the different risk positions as hedged items. In our case there was no need to split the external hedge into two separated contracts, or in other words, the single forward contract could be designated as hedging instrument in two separate hedging relationships:

• In a first hedging relationship, the risk being hedged was clearly identified as the exposure to variations in the JPY–EUR exchange rate. The hedged item was the cash flow stemming from highly expected purchases denominated in JPY, whose fair value could be reliably measured. The hedging instrument was the JPY receipt on the forward contract, whose fair value could be reliably measured.
• In a second hedging relationship, the risk being hedged was clearly identified as the exposure to variations in the EUR–GBP exchange rate. The hedged item was the cash flow stemming from highly expected sales denominated in GBP, whose fair value could be reliably measured. The hedging instrument was the GBP payment on the forward contract, whose fair value could be reliably measured.

JPY Risk: Hedge Item Candidate 1 Eligibility

The group could apply hedge accounting on consolidation in a cash flow hedging relationship in which the JPY leg of the JPY–GBP forward taken out by the treasury centre would be the hedging instrument and the cash flow stemming from Subsidiary A's highly expected forecast JPY purchase would be the hedged item, as shown in Figure 5.45, assuming all other requirements for hedge accounting were met.

This qualification was due to the direct future incorporation of Subsidiary A's JPY purchase in consolidated profit or loss, being converted into the group's EUR presentation currency. The exposure to movements in the JPY–EUR exchange rate constituted a cash flow risk, and therefore could be subject to cash flow hedge accounting.

5.18.1 Example of Hedge of Forecast Intragroup Transaction

ABC is a group that comprises operating subsidiaries A and B. The group has the EUR as its functional currency. Subsidiary A's functional currency is the GBP while Subsidiary B's functional currency is the USD.

Subsidiary A incurs most of its production costs in EUR. It sells most of its production to Subsidiary B, and these transactions are denominated in USD. In turn, Subsidiary B sells the product on to external customers, also in USD. Subsidiary A forecasts in March 20X6 that it will sell in June 20X6 USD 100 million of inventory to Subsidiary B. These sales are highly probable, and all the other IFRS 9 conditions for hedge accounting are met. Subsidiary B expects to sell this inventory to external customers in early September 20X6.

In January 20X6 Subsidiary A enters into a EUR–USD derivative to hedge its expected sale of USD 100 million to Subsidiary B in June 20X6.

The USD 100 million forecast intragroup sales can be designated in the consolidated financial statements as a hedged item in a foreign currency cash flow hedge (see Figure 5.46) as:

1. the sales are highly probable, and all other conditions for using hedge accounting are met;
2. the hedge is a cash flow hedge of foreign currency risk;
3. the sales are denominated in a currency (USD) other than Subsidiary A's functional currency (EUR); and
4. the existence of the expected onward sale of the inventory to third parties results in the hedged exposure affecting consolidated profit or loss.

Gains and losses on the EUR–USD derivative would be recognised in consolidated equity, to the extent that the hedge is effective. These amounts would be reclassified to consolidated profit or loss in September 20X6 when the external sales occur (i.e., when the hedged transaction affects consolidated profit or loss).