Chapter Chapter 1616

Appendix 16AAppendix 16AHedgingHedging

Prepared by:

Dragan Stojanovic, CARotman School of Management, University of Toronto

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Derivatives Used For Hedging• Organizations face economic and financial

risks • Derivatives are often used to offset these

risks - hedging• Hedging generally reduces uncertainty/risk,

and therefore volatility, which gives hedging its value

• Must separate the act of hedging (to reduce economic and financial risks) from the accounting

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Derivatives Used For Hedging• Symmetry in accounting - if gains/losses

offset then no need for special hedge accounting

• No symmetry in accounting – gains/losses do not offset in same period - may choose to apply hedge accounting so that the gains/losses do offset– Under IFRS, two types of hedges

identified for hedge accounting – fair value and cash flow hedges

– Under ASPE, only certain transactions qualify for optional hedge accounting

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Optional Hedge AccountingOptional hedge accounting may be available when the following are met:1. When the hedge is entered into

a. Identify the exposureb. Designate that hedge accounting appliedc. Document risk management objectives and

strategies2. Reasonable assurance should exist that the firms’

risk management policy is being maintaineda. Hedge effectiveness can be reliably measuredb. Hedging relationship is reassessed at regular

intervalsc. If involves forecasted transactions, probable that

transactions will occur

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Hedging

• Fair Value Hedge– To offset exposure to fair value changes of

recognized asset or liability– Under IFRS, hedged item valued at fair value

and gains/losses booked to net income• Cash Flow Hedge

– Offset risks of future cash flow variability– Under IFRS, gains/losses on hedging item

reported as part of Other Comprehensive Income– Under PE GAAP, not recognized until the

transaction is settled

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Put Options as Fair Value Hedge

• Option to sell an instrument/investment at a pre-determined price

• Eliminates the risk of a price decrease

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Fair Value Hedge - Example

• Investment (intended for sale) purchased at a cost of: $1,000

Investment (FVOCI) 1,000 Cash 1,000

• Option contract to sell shares at $1,000 purchased for $10

Financial Instrument – Derivative 10Cash

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Fair Value Hedge - Example

• At year end, assume investment value is $1,050Journal entry:Investment (FVOCI) 50 Gain/Loss 50andGain/Loss 50 Financial Instrument - Derivative 50

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Fair Value - Put Option - Example

• Under hedge accounting gain is recorded on the hedged item through net income

• Loss is recorded on the underlying derivative• The gain is offset by the loss on the derivative• Hedge accounting allows for a modifying of

the way we normally account for available for sale investments

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Cash Flow Hedge - Examples

• Interest rate swaps used as hedges• Similar in nature to forward contracts• Requires two parties to enter into• Payments are made under a fixed or floating

rate of interest • Payments then made by the second party

– Terms are the opposite of the original payment terms

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Interest Rate Swap

Party AParty A Party BParty BFinancialFinancialIntermediaryIntermediary

A pays B at a fixed (or floating) rate

B pays A using the opposite rate of A

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Interest Rate Swap

Given:Jones Corp enters into a 5-year interest rate swap with BTerms are:•Principal sum involved is $1 million•Jones will make payments at the fixed rate of 8%•Jones will receive payments at variable or floating rates

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Interest Rate Swap

• Value of the swap determined at the end of each year– Function of the difference between the fixed

(contract) rate and the prevailing rate of interest

• Value of the swap contract reported on the Balance Sheet using discounted cash flow model

• Under IFRS, any gain reported as part of Comprehensive Income

• Value at the end of the swap contract is zero

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Forward Contract as a Cash Flow Hedge

• Forwarding contracts may be used to hedge anticipated future transactions (and the associated cash flow risks) i.e. a purchase commitment

• Gives the holder the right to purchase at a preset price

• Under IFRS, recorded in Other Comprehensive Income

• Under PE GAAP, not recognized until settled

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