6.11.1 Hedging Relationship Documentation

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

6.11.2 Hedge Effectiveness Assessment

Hedge effectiveness will be assessed by comparing the change in fair value of the hedging instrument to the foreign currency gains and losses on the net investment that are attributable to the hedged risk (i.e., changes in spot exchange rates).

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 foreign operation that exposes the group to currency retranslation risk and it is reliably measurable. The hedging instrument is eligible as it is a derivative instrument other than a 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 fair value changes in the hedging relationship.
3. The weightings of the hedged item and the hedging instrument (i.e., hedge ratio) are designated based on the quantities of hedged item and hedging instrument that the entity actually uses to meet the risk management objective, unless doing so would deliberately create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis by comparing the critical terms of the hedging instrument and the hedged item. The critical terms considered will be the notional amount, the term and the underlying.

The effective and ineffective amounts of the change in fair value of the hedging instrument will be computed by comparing the cumulative change in fair value of the hedging instrument with that of the hedged item. The effective amount will be recognised in the “translation differences” reserve in OCI. Any part of the cumulative change in fair value of the hedging instrument that does not offset a corresponding cumulative change in the fair value of the hedged item will be treated as ineffectiveness and recorded in profit or loss.

6.11.3 Hedge Effectiveness Assessment Performed at Hedge Inception

An effectiveness assessment was performed at inception and at each reporting date. The assessment also included the relationship hedge ratio and an identification of the sources of potential ineffectiveness.

The hedge qualified for hedge accounting as it met the three effectiveness requirements:

1. The critical terms (such as the nominal amount, maturity and underlying) of the hedging instrument and the hedged item matched. Although the CCS had interest payments/receipts not present in the net investment, the change in fair value of the CCS was expected to be largely offset by the change in the translation amount of the net investment due to (i) the floating profile of both legs of the CCS and (ii) the concurrence of the dates on which the CCS's intermediate payments/receipts were made and the reporting dates. As a result it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions, and hence that an economic relationship existed between the hedged item and the hedging instrument.
2. Because the credit rating of counterparty to the hedging instrument was relatively strong (rated A+ by Standard & Poor's) the effect of credit risk did not dominate the value changes resulting from that economic relationship.
3. The hedge ratio designated (1:1) was the one actually used for risk management and it did not attempt to avoid recognising ineffectiveness. Therefore, it was determined that a hedge ratio of 1:1 was appropriate.

There were three main sources of potential ineffectiveness: firstly, a significant credit deterioration of the counterparty to the hedging instrument (XYZ Bank); secondly, a reduction of the net assets of the hedged foreign operation below the hedging instrument notional; and finally, a substantial increase in the CCS basis.

6.11.4 Other Relevant Information

The net investment translation into EUR was calculated using the EUR–USD spot rate at each relevant date as follows:

(*) Net investment in EUR = 500 million/Spot rate

The fair values of the CCS, including credit valuation adjustments and excluding accrued interest, at each reporting date were as follows:

The effective and ineffective parts of the change in fair value of the CCS were the following (see Section 5.5.6 for an explanation of the calculations):

The interest flows/expenses related to the USD leg of the CCS were as follows:

Notes:

(1) Interest payment (USD) = USD 500 million × (5.20%+0.10%) × 365/360

(2) Interest expense (EUR) = Interest payment (USD)/Annual average FX rate = 26,868,000/1.2650

(3) Interest payment (EUR) = Interest payment (USD)/Spot FX rate = 26,868,000/1.2700

The interest flows/expenses related to the EUR leg of the CCS were as follows:

(*) Interest received = EUR 400 million × 4.00% × 365/360

6.11.5 Accounting Entries

Assuming that ABC closed its books annually at year's end, the accounting entries related to the hedge were as follows.

1. To record the CCS trade on 1 January 20X0

   No entries in the financial statements were required as the fair value of the CCS was zero.

2. To record the closing of the accounting period on 31 December 20X0

   The net investment lost EUR 6,299,000 in value over the period when translated into EUR. In practice all the net assets of SubCo would have been translated. In our case, the retranslation of just USD 500 million of net assets are assumed and summarised in a “net investment in subsidiary” figurative account for illustrative purposes.

3. The CCS fair value change, excluding accrued interest, was a gain of EUR 6,335,000. The effective part (EUR 6,299,000) was recognised in the translation differences account. The ineffective part (EUR 36,000) was recognised in profit or loss.
4. Under the USD leg of the CCS, ABC paid the equivalent of EUR 21,156,000 and recognised a EUR 21,240,000 interest expense. The EUR 84,000 difference between these amounts was recognised in profit or loss. Under the EUR leg of the CCS, ABC received EUR 16,222,000, recognised as interest income.
5. To record the closing of the accounting period on 31 December 20X1
6. To record the closing of the accounting period on 31 December 20X2
7. Additionally on 31 December 20X2, a settlement amount was received under the CCS related to the notionals. The EUR–USD spot rate on that date was 1.2900. ABC received EUR 12,403,000 (= EUR 400 mn – USD 500 mn/1.2900):

6.11.6 Final Remarks

In our case the hedge performed very well, as the decline in value of the net investment due to the depreciation of the USD relative to the EUR was completely offset by the change in fair value of the CCS. Several comments are worth noting:

• The pay floating/receive floating CCS is an effective way to implement long-term hedges of net investments in foreign operations.
• ABC's profit or loss statement was temporarily exposed to the ineffective part of the hedge (i.e., to the excess of the CCS fair value change relative to the net investment retranslation gain/loss). Ineffectiveness was due to changes in the CCS basis and to credit valuation adjustments. In our case, ABC's profit or loss was not exposed to changes in the fair value of the CCS due to movements in the USD and EUR interest rate curves because both legs were linked to floating interest rates and the absence of accrued interest. In reality, slight ineffectiveness may arise when the ends of the CCS interest periods do not coincide with the reporting dates.
• In our case, the sum of all the ineffective parts during the life of the CCS was zero. In other words, the translation differences account showed no deficit because the changes in the net investment translation were perfectly offset by the fair value changes in the CCS.
• IFRS 9 allows an entity to choose whether to exclude the basis component of a CCS from a hedging relationship and to recognise changes in this component in equity to the extent that they relate to hedged item.
• At CCS maturity, ABC received EUR 12,403,000 in cash. In this case, the outcome was very favourable to ABC, but it could have been the other way around. In other words, a hedge of a large investment in a foreign operation through a CCS may have strong implications in an entity's cash resources.
• The amount in the translation differences account will be reclassified from equity to profit or loss on disposal or liquidation of SubCo.

6.12.1 Hedging Relationship Documentation

ABC designated the CCS as the hedging instrument in a net investment hedge. At its inception, ABC documented the hedging relationship as follows:

6.12.2 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 a hypothetical derivative. In this hedging relationship, the terms of the hypothetical derivative mirror those of the hedging instrument except, due to the absence of CVA risk, the EUR leg fixed rate which is 4.99%.

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 foreign operation that exposes the group to currency retranslation risk and it is reliably measurable. The hedging instrument is eligible as it is a derivative instrument other than a 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 fair value changes in the hedging relationship.
3. The weightings of the hedged item and the hedging instrument (i.e., hedge ratio) are designated based on the quantities of hedged item and hedging instrument that the entity actually uses to meet the risk management objective, unless doing so would deliberately create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis by comparing the critical terms of the hedging instrument and the hypothetical derivative. The critical terms considered will be the notional amounts, the interest periods and the fixed rates. The assessment will be complemented by a quantitative assessment using the scenario analysis method for one scenario in which a EUR–USD exchange rate will be simulated by shifting the spot price prevailing on the assessment date by +10%, and the change in fair value of the hedging instrument with that of the hypothetical derivative compared.

The effective and ineffective amounts of the change in fair value of the hedging instrument will be computed by comparing the cumulative change in fair value of the hedging instrument with that of the hypothetical derivative. The effective amount will be recognised in the “translation differences” reserve in OCI. Any part of the cumulative change in fair value of the hedging instrument that does not offset a corresponding cumulative change in the fair value of the hypothetical derivative will be treated as ineffectiveness and recorded in profit or loss.

6.12.3 Hedge Effectiveness Assessment Performed at Hedge Inception

An effectiveness assessment was performed at inception and at each reporting date. The assessment also included the relationship hedge ratio and an identification of the sources of potential ineffectiveness.

The hedge qualified for hedge accounting as it met the three effectiveness requirements:

1. Because the critical terms (such as notional amounts, interest periods and fixed rates) of the hedging instrument and the hypothetical derivative matched (or almost matched) it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions, and hence that an economic relationship existed between the hedged item and the hedging instrument. This conclusion was supported by the qualitative analysis documented below.
2. Because the credit rating of counterparty to the hedging instrument was relatively strong (rated A+ by Standard & Poor's) the effect of credit risk did not dominate the value changes that result from that economic relationship.
3. The hedge ratio designated (1:1) was the one actually used for risk management and it did not attempt to avoid recognising ineffectiveness. Therefore, it was determined that a hedge ratio of 1:1 was appropriate.

A test EUR–USD spot rate (1.3750) was simulated by shifting the EUR–USD spot rate prevailing on the assessment date (1.2500) 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 had values that would generally move in opposite directions.

The fair value of the hypothetical derivative at inception of the hedging relationship, prior to the shift in the EUR–USD spot rate, was calculated as follows:

The fair value of the hypothetical derivative at inception of the hedging relationship, after the shift in the EUR–USD spot rate, was calculated as follows:

The change in fair value of the hedging instrument was calculated in a similar way, resulting in a EUR 36,347,000 gain. The difference between the fair value changes of the two instruments was mainly due to changes in CVA in the hedging instrument.

The hedge ratio is established at 1:1.

There were three main sources of potential ineffectiveness: firstly, a significant credit deterioration of the counterparty to the hedging instrument (XYZ Bank); secondly, a reduction of the net assets of the hedged foreign operation below the hedging instrument notional; and finally, a substantial increase in the basis element of the CCS.

6.12.4 Other Relevant Information

The net investment translation into EUR was calculated using the EUR–USD spot rate at each relevant date as follows:

(*) Net investment in EUR = 500 million/Spot rate

The fair values of the CCS and the hypothetical derivative, excluding accrued interest, at each reporting date are shown in the following table. Differences between both fair values arose primarily due to the CVA performed on the CCS.

The ineffective part of the change in fair value of the CCS was the excess of its cumulative change in fair value over that of the hypothetical derivative. In our case, no ineffectiveness was recognised. The effective and ineffective parts of the change in fair value of the CCS were the following (see Section 5.5.6 for an explanation of the calculations):

The interest flows/expenses related to the USD leg of the CCS were as follows:

Notes:

(1) Interest payment (USD) = USD 500 million × 6.10%

(2) Interest expense (EUR) = Interest payment (USD)/Annual average FX rate = 30,500,000/1.2650

(3) Interest payment (EUR) = Interest payment (USD)/Spot FX rate = 30,500,000/1.2700

The interest flows/expenses related to the EUR leg of the CCS were as follows:

(*) Interest received/income = EUR 400 million × 5.00%

6.12.5 Accounting Entries

Assuming that ABC closed its books annually at year's end, the accounting entries related to the hedge were as follows.

1. To record the CCS trade on 1 January 20X0

   No entries in the financial statements were required as the fair value of the CCS was zero.

2. To record the closing of the accounting period on 31 December 20X0

   The net investment lost EUR 6,299,000 in value over the period when translated into EUR. In practice all the net assets of SubCo would have been translated. In our case, the retranslation of just USD 500 million of net assets is assumed and summarised in a “net investment in subsidiary” figurative account for illustrative purposes.

3. The CCS fair value change, excluding accrued interest, was a gain of EUR 7,559,000. All this gain was effective and recognised in the translation differences account. There was no ineffective part, and therefore, no amount was recognised in profit or loss.
4. Under the USD leg of the CCS, ABC paid the equivalent of EUR 24,016,000 and recognised a EUR 21,111,000 interest expense. The EUR 95,000 difference between these amounts was recognised in profit or loss. Under the EUR leg of the CCS, ABC received EUR 20,000,000, recognised as interest income.
5. To record the closing of the accounting period on 31 December 20X1
6. To record the closing of the accounting period on 31 December 20X2
7. Additionally on 31 December 20X2, a settlement amount was received under the CCS representing a net amount related to the final exchange of notionals. The EUR–USD spot rate on this date was 1.2900. ABC received EUR 12,403,000 (= EUR 400 mn – USD 500 mn/1.2900):

6.13.1 Effects of Intercompany Foreign Dividends on Individual and Consolidated Statements

Suppose that ABC, a group whose presentation currency is the EUR, has a 100% owned US foreign subsidiary. The foreign subsidiary declared, and later paid, a dividend of USD 100 million to ABC. The exchange rates at the relevant dates were as follows:

In order to analyse the FX exposure caused by the dividend, let us review the accounting of intragroup dividends from the subsidiary, parent and group perspectives.

Summary of Impacts on the Financial Statements

On dividend declaration date, 1 January 20X1, the accounting effects were the following (see Figure 6.17):

• In the subsidiary's financial statements, a dividend payable and a corresponding reduction in retained earnings were recognised.
• In the parent's financial statements, the declared dividend was valued at the then prevailing EUR–USD exchange rate and recognised as dividend income and dividend receivable. The recognition in profit or loss had a tax impact.

• In the consolidated financial statements, there was still no effect as no consolidation

  process took place.

On the first reporting date, 31 March 20X1, the accounting effects were the following:

• In the subsidiary's financial statements, there was no effect (see Figure 6.18).
• In the parent's financial statements, the declared dividend was revalued at the then prevailing EUR–USD exchange rate and recognised as FX gains or losses (a loss in our case) in profit or loss. The recognition in profit or loss had a tax impact. Figure 6.18 highlights these effects.
• In the consolidated financial statements, the declared dividend still remained part of the net investment, as it was still unpaid. Therefore, the FX gains and losses due to the net investment revaluation were recorded in the translation differences account in equity (see Figure 6.19). In our case, as the USD depreciated against the EUR, a translation loss was recorded.

On 30 June 20X1, the USD 100 million dividend was paid. This USD cash was transferred from the subsidiary's USD cash account to the parent's USD cash account. The accounting effects on the three different reported financial statements were the following:

• In the subsidiary's financial statements, the balance of the USD cash account showed a USD 100 million reduction and the dividend payable was cancelled (see Figure 6.20).
• In the parent's financial statements, there were several effects (see Figure 6.20). Firstly, there was an FX loss due to the revaluation of the dividend receivable. This loss was recognised in profit or loss, which also had a tax impact. Secondly, the balance of the USD cash account increased by USD 100 million and the dividend receivable was cancelled.
• In the consolidated financial statements, at first sight, the dividend payment seemed to have no effect on a consolidated basis as the two USD cash accounts are grouped together. However, there was an important effect: the FX gains or losses from the revaluation of the USD 100 million were recognised differently, as explained next.

Before the dividend was paid, the USD 100 million cash was part of the net investment in the US subsidiary. Thus, foreign exchange gains or losses on the USD 100 million cash remeasurement in EUR were recorded in the translation differences account in equity.

After the dividend was paid, the USD 100 million cash was part of the monetary items of a group entity (i.e., the parent) that had the same functional currency as the group. Thus, foreign exchange gains or losses arising from the USD 100 million cash remeasurement impacted consolidated profit or loss.

Consequently, the effect of the dividend payment on a consolidated basis was a reduction in the net investment in the US subsidiary and an increase in the monetary items of the parent company (see Figure 6.21).

The FX risk would have been eliminated from 30 June 20X1 had the parent exchanged the USD 100 million for EUR in the FX spot market on that date.

6.13.2 Hedging Intercompany Foreign Dividends with an FX Forward

Many companies seek to hedge forecast foreign currency dividends distributed by their foreign subsidiaries. Next, the implications of hedging foreign intragroup dividends are discussed in detail.

Suppose that on 1 January 20X1 ABC (the parent company) hedged the declared dividend through an FX forward with the following terms:

Suppose further that the fair value of the FX forward at each relevant date was as follows:

Summary of Impacts of the Hedge on the Financial Statements

On 31 March 20X1, the effects on the financial statements of the entities involved were the following:

• In the subsidiary's financial statements, there was no effect as the subsidiary was not a party to the FX forward.
• In the parent's profit or loss statement, the EUR 1,222,000 gain on the hedge largely offset the EUR 1,300,000 loss on the revaluation of the dividend receivable (see Figure 6.22). Therefore, the hedge performed well at the parent level.
• In the consolidated statements, the EUR 1,222,000 gain on the hedge showed up in profit or loss. This FX gain had no offsetting FX losses in profit or loss. The only FX loss showed up in the translation differences account, and as a result, the hedge largely eliminated the FX exposure (relating to the USD 100 million portion of the net investment in the subsidiary) of the consolidated equity. Therefore, while the FX forward offset the changes in the translation of USD 100 million of net assets, it exposed the consolidated profit or loss to movements in the EUR–USD exchange rate, as shown in Figure 6.23.

On 30 June 20X1, the effects on the financial statements of the entities involved were the following:

• In the subsidiary's financial statements, there was no effect as the subsidiary was not a party to the FX forward.
• In the parent's profit or loss statement, the effect was similar to that on 31 March 20X1. The EUR 2,126,000 gain on the hedge largely offset the EUR 2,100,000 loss on the revaluation of the dividend receivable. Therefore, the hedge performed well at the parent level.
• In the consolidated statements, the effect was similar to that on 31 March 20X0. The FX forward showed a EUR 2,126,000 gain that was recognised in the consolidated profit or loss statement, while there was a EUR 2,179,000 gain in the translation differences account. Therefore, the consolidated profit or loss was exposed to movements in the EUR–USD exchange rate.

In summary, the hedge worked well at the individual financial statements, but created distortions in the consolidated profit or loss.

Optimised Solution: Consolidated Accounting Entries Related to the FX Forward

The accounting entries at the parent and consolidated levels resulting from the FX forward were as follows.

1. Entries on 1 January 20X1

   None required.

2. Entries on 31 March 20X1 (reporting date)

   The EUR 1,222,000 gain recognised at the parent level was reversed. At the consolidated level, the FX forward was designated as hedging instrument in a net investment hedge. Assuming that the hedge was completely effective, the changes in the fair value of the FX forward were recognised in the translation differences account.

3. Entries on 30 June 20X1

   The EUR 2,126,000 gain on the forward was recorded similarly to the 31 March 20X0 adjustment.

Now the hedge performed very well at both the parent-only and consolidated levels, as shown in Figure 6.24.

6.14.1 Hedging Relationship Documentation

The four hedging relationships, one for each quarter, were documented in a similar way. ABC documented the first quarter hedging relationship as follows:

6.14.2 Hedge Effectiveness Assessment

Hedge effectiveness will be assessed by comparing, on a spot-spot basis, changes in the fair value of the hedging instrument to changes in the fair value of the highly expected cash flows.

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 cash flow that exposes the entity to FX risk and it is reliably measurable. The hedging instrument is eligible as it is a derivative instrument other than a 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 fair value changes in the hedging relationship.
3. The weightings of the hedged item and the hedging instrument (i.e., hedge ratio) are designated based on the quantities of hedged item and hedging instrument that the entity actually uses to meet the risk management objective, unless doing so would deliberately 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 scenario analysis, comparing the cumulative change since hedge inception in the fair value of the expected cash flow arising from the forecast sale with the cumulative change since hedge inception in the fair value of the hedging instrument. The scenario to be analysed would be a 10% adverse move in the EUR–USD exchange rate.

The effective and ineffective amounts of the change in fair value of the hedging instrument will be computed by comparing the cumulative change in fair value of the hedging instrument with that of the hedged item. The effective amount will be recognised in the “cash flow hedge” reserve in equity. Any part of the cumulative change in fair value of the hedging instrument that does not offset a corresponding cumulative change in the fair value of the hedged item will be treated as ineffectiveness and recorded in profit or loss.

6.14.3 Hedge Effectiveness Assessment Performed at Hedge Inception

An effectiveness assessment was performed at inception and at each reporting date. The assessment also included the relationship hedge ratio and an identification of the sources of potential ineffectiveness. The conclusion that an economic relationship existed between the hedged item and the hedging instrument was justified by analysing one scenario in which the EUR–USD FX rate suffered a 10% unfavourable move during the quarter, as follows. The EUR–USD spot rate was 1.2392 at hedge inception (1 January 20X0). The hedged highly probable forecast sales for the first quarter were USD 100 million, split into three monthly forecast amounts of USD 33,333,000 for the months ending 31 January 20X0, 28 February 20X0 and 31 March 20X0. A 10% unfavourable move in the exchange rate implied a 1.3631 (=1.2392 × 1.10) EUR–USD spot rate on 31 March 20X0. Assuming a gradual move in the FX spot rate during the quarter, it implied a 1.2805 spot rate (= 1.2391 + 1/3 × (1.3631 – 1.2392)) on 31 January 20X0 and a 1.3218 spot rate (= 1.2391 + 2/3 × (1.3631 – 1.2392)) on 28 February 20X0.

The expected cash flows hedged under the first hedging relationship were USD 33,333,000 at the end of each month within the quarter. The overall change in fair value of these cash flows was a EUR 4,993,000 loss as evidenced in the following table:

Notes:

(1) 33,333,000/1.2392 = 26,899,000

(2) 33,333,000/1.2805 = 26,031,000

(3) 26,031,000 – 26,899,000

The change in fair value of the hedging instrument was calculated as follows:

1. Fair value at inception: <475,000> (i.e., ABC received EUR 475,000 at the inception of AVRF 1).
2. Fair value at maturity: 4,346,000 (= 100 mn/1.25 – 100 mn/1.3218), where 1.3218 was the quarterly average rate (= (1.2805 + 1.3218 + 1.3631)/3)).
3. Hence, the change in fair value of the hedging instrument was a EUR 4,821,000 (= 4,346,000 + 475,000) gain.

The hedge qualified for hedge accounting as it met the three effectiveness requirements:

1. Because in the scenario analysed the change in fair value of the hedged item (a loss of EUR 4,993,000) and the change in fair value of the hedging instrument (a gain of EUR 4,891,000) moved in opposite directions, it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions, and hence that an economic relationship existed between the hedged item and the hedging instrument.
2. Because the credit rating of counterparty to the hedging instrument was relatively strong (rated A+ by Standard & Poor's) the effect of credit risk did not dominate the value changes resulting from that economic relationship.
3. The hedge ratio designated (1:1) was the one actually used for risk management and it did not attempt to avoid recognising ineffectiveness. Therefore, it was determined that a hedge ratio of 1:1 was appropriate.

There were three main sources of potential ineffectiveness: firstly, a significant credit deterioration of the counterparty to the hedging instrument (XYZ Bank); secondly, a reduction of the net assets of the hedged foreign operation below the hedging instrument notional; and finally, a substantial increase in the CCS basis. The credit risk of the counterparty of the hedging instrument would be continuously monitored.

Similar assessments were performed for the other three hedging relationships with similar results. The group concluded that all four hedging relationships met the requirements for the application of hedge accounting. The assessments performed at each reporting date yielded similar conclusions.

6.14.4 Other Relevant Information

The spot EUR–USD exchange rates and the fair value of the AVRFs on the relevant dates were as follows:

6.14.5 Accounting Entries

The required journal entries were as follows.

1. Entries on 1 January 20X0

   The following entries were required as the fair value of the AVRFs at their inception were not zero.

2. To record the closing of the accounting period on 31 March 20X0

   The change in fair value of the AVRFs since the last valuation were as follows:

   1. AVRF 1, a gain of EUR 1,110,000 (=635,000+475,000);
   2. AVRF 2, a gain of EUR 2,207,000 (=2,057,000+150,000);
   3. AVRF 3, a gain of EUR 2,173,000 (=2,333,000-160,000);
   4. AVRF 4, a gain of EUR 2,137,000 (=2,602,000-465,000).

   For simplicity, all hedges were assumed to have been fully effective (in practice, a small ineffective part would have arisen due to the FX forward points), and hence, all the changes in the fair value of the AVRFs were recorded in equity:

3. USD 100 million sales of the parent entity, designated as the hedged item in the first hedging relationship, were recorded in the profit or loss statement of the parent and the group. As a consequence, the amounts related to AVRF 1 accumulated in equity (EUR 1,110,000) were reclassified to profit or loss:
4. Finally, AVRF 1 matured and ABC received EUR 635,000 (=100 mn ×(1/1.25 – 1/Average)), where “Average” was the average of the spot rates at the end of each month during the first quarter (= (1.24+1.26+1.28)/3).
5. To record the closing of the accounting period on 30 June 20X0

   The change in fair value of the three remaining AVRFs since the last valuation was as follows:

   1. AVRF 2, a gain of EUR 223,000 (=2,280,000 – 2,057,000);
   2. AVRF 3, a loss of EUR 882,000 (=1,451,000 – 2,333,000);
   3. AVRF 4, a loss of EUR 864,000 (=1,738,000 – 2,602,000).

   As the hedges were assumed to be fully effective, all these changes in fair value were recorded in equity:

6. USD 100 million sales of the parent entity, designated as the hedged item in the second hedging relationship, were recorded in the profit or loss statement of the parent and the group. As a consequence, the amounts related to AVRF 2 accumulated in equity (EUR 2,430,000 = 2,207,000 + 223,000) were recycled to profit or loss:
7. Finally, AVRF 2 matured and ABC received EUR 2,280,000 (=100 mn × (1/1.25 – 1/Average)), where “Average” was the average of the spot rates at the end of each month during the second quarter (= (1.30+1.29+1.27)/3).
8. To record the closing of the accounting period on 30 September 20X0

   The change in fair value of the two remaining AVRFs since the last valuation were as follows:

   1. AVRF 3, a loss of EUR 607,000 (=844,000 – 1,451,000);
   2. AVRF 4, a loss of EUR 1,527,000 (=211,000 – 1,738,000).

   As the hedges were assumed to be fully effective, all these changes in fair value were recorded in equity:

9. USD 100 million sales of the parent entity, designated as the hedged item in the third hedging relationship, were recorded in the profit or loss statement of the parent and the group. As a consequence, the amounts related to AVRF 3 accumulated in equity (EUR 684,000 = 2,173,000 – 882,000 – 607,000) were recycled to profit or loss:
10. Finally, AVRF 3 matured and ABC received EUR 844,000 (=100 mn × (1/1.25 – 1/Average)), where “Average” was the average of the spot rates at the end of each month during the third quarter (= (1.28+1.26+1.25)/3).
11. To record the closing of the accounting period on 31 December 20X0

    The change in fair value of AVRF 4 since the last valuation was a gain of EUR 2,270,000 (=2,481,000 –211,000). As the hedge was assumed to be completely effective, this change in fair value was recorded in equity:

12. USD 100 million sales of the parent entity, designated as the hedged item in the fourth hedging relationship, were recorded in the profit or loss statement of the parent and the group. As a consequence, the amounts related to AVRF 4 accumulated in equity (EUR 2,016,000) were reclassified to profit or loss.
13. Finally, AVRF 4 matured and ABC received EUR 2,481,000 (=100 mn × (1/1.25 – 1/Average)), where “Average” was the average of the spot rates at the end of each month during the fourth quarter (= (1.27+1.29+1.31)/3).

6.14.6 Final Remarks

The hedge worked well as the objective of protecting the EUR translation value of USD 400 million of the US subsidiary's profit or loss at an exchange rate of 1.2500, or EUR 320 million, was achieved on a pre-tax basis, as shown in Figure 6.26.

However, specific issues may arise as a result of implementing a hedging strategy like the one just covered. Five in particular are worth noting:

• Firstly, ABC needed to arbitrarily identify within the group external highly expected USD-denominated forecast sales and designate them as hedged items in the four hedging relationships. If the group were to hedge those identified forecast sales as well, they would be part of an additional hedging relationship and, therefore, not available to their designation as hedged items in our four hedging relationships.
• Secondly, when deciding the USD nominal of the AVRFs, ABC needed to forecast its foreign subsidiary earnings and inefficiencies may arise from inaccurate forecasts.
• Thirdly, there could be undesired tax effects in profit or loss. In our case both the hedging instruments and the hedged items were booked in the parent entity, allowing it to consider the application of hedge accounting in the parent's stand-alone financial statements. However, were the hedged items located in an entity different from the parent, the four AVRFs would have been classified as undesignated, and as a result, the change in fair value of the AVRFs would have been recorded in profit or loss, increasing the volatility of the parent's profit or loss statement. If this entity was a tax-paying entity, losses on the AVRFs would be tax deductible, while gains on the AVRFs would be taxed. These tax effects may affect the parent entity's ability to distribute dividends. In reality, most corporations execute consolidation-related hedges in a treasury centre, reducing undesired tax effects on their group hedges.
• Fourthly, the hedge may distort EBITDA figures if the hedging instrument gains/losses were not recorded, adjusting the sales line. This did not apply in our case, as the AVRF results adjusted the USD sales figures.
• Finally, the average EUR–USD exchange rate used to translate the subsidiary's profit or loss may differ from the average rate used in the AVRFs. Often, a subsidiary's profit or loss is translated using the daily average rate during the accounting period ,while the group may decide to use monthly average rate in the AVRFs in order to reduce their administrative load. Average mismatches may create hedge ineffectiveness and result in undesired effects on profit or loss.

Hedge 1: Hedging Year-end Net Assets

The expected year-end net investment was USD 720 million, as shown in Figure 6.29. In order to hedge the year-end revaluation of the USD 720 million, ABC entered into a standard FX forward (“forward 1”) with a nominal of USD 720 million and maturity 31 December 20X1. The forward rate for 31 December 20X1 was 1.2700. The forward payoff at maturity compensated ABC for any appreciation of the year-end rate:

With this forward, ABC hedged the “net assets at year-end”, as shown in Figure 6.31 (first line of the table).

Hedge 2: Hedging the Subsidiary's Expected Net Earnings

The subsidiary's expected profit or loss was USD 120 million. This amount was to become part of the net investment at the average rate for 20X1 and was to be revalued at year's end. The revaluation at year's end was already included in hedge 1. Therefore, ABC needed to hedge the translation of the subsidiary's expected profit or loss at the average rate for the year 20X1. This hedge covered the third line of Figure 6.32.

As seen in the case study in Section 6.14, the appropriate hedging instrument was an average rate forward (forward 2).

The average rate forward had a USD 120 million nominal amount and a 31 December 20X1 maturity. The market expected the average rate to be 1.26. Its payoff at maturity was:

Hedge 3: Hedging the Expected New Capital Injection into the Subsidiary

ABC's parent entity expected to add USD 200 million capital to its US subsidiary. From a “net investment” perspective, ABC was exposed to the year-end appreciation of the EUR–USD rate relative to the rate prevailing on the capital investment date (30 September 20X1). The first part (the year-end revaluation) was already hedged through hedge 1. ABC needed then to hedge (“hedge 3”) the exposure to rate prevailing on the capital investment date, which was equivalent to hedge the fourth line of Figure 6.33.

The appropriate instrument was an FX forward (“forward 3”) with a nominal of USD 200 million, maturity 30 September 20X1 and the following payoff at maturity:

Hedge 4: Hedging the Expected Dividends Paid by the Subsidiary

ABC's parent entity expected to receive USD 100 million dividends from its US subsidiary on 31 May 20X1. As a result, ABC's parent company was exposed to an appreciation of the EUR–USD FX rate prevailing on the dividend payment date (31 May 20X1).

The appropriate hedge was an FX forward (“forward 4”) with a nominal of USD 100 million and maturity 31 May 20X1. This hedge covered the exposure outlined in the fifth line of Figure 6.34. The payoff of forward 4 at maturity compensated ABC from any appreciation of the 31 May 20X1 exchange rate:

Expected Translation Differences Adjustment for the Year 20X1

As a result of these four hedges, ABC expected to recognise a translation differences deficit of EUR 6,921,000, as shown in Figure 6.35.

Hedge Performance Analysis

Let us assess whether the integral hedge worked well in practice. Suppose that the market EUR–USD FX rates during 20X1 were as follows:

The following table shows the translation exchange differences for the year 20X1, excluding the hedge. It highlights that without the hedge, the translation differences account would have shown a deficit of EUR 50,161,000.

Fortunately, ABC had a hedge in place. The hedge was implemented through four instruments, each designed to eliminate the exposure to the EUR–USD rate of each component of the net investment in the US subsidiary. The following table details the payoffs of each instrument:

Through the integral hedge, ABC received EUR 43,240,000. Therefore, the translation differences account showed “only” an adjustment of a EUR 6,921,000 deficit (see the following table). The hedge worked very well, as this amount was exactly the amount that ABC expected (see Figure 6.35).