Illustrative example (AASB139_08-15_COMPsep20_01-21)

On 1 January 20X1, Entity A identifies a portfolio comprising assets and liabilities whose interest rate risk it wishes to hedge. The liabilities include demandable deposit liabilities that the depositor may withdraw at any time without notice. For risk management purposes, the entity views all of the items in the portfolio as fixed rate items.

For risk management purposes, Entity A analyses the assets and liabilities in the portfolio into repricing time periods based on expected repricing dates. The entity uses monthly time periods and schedules items for the next five years (ie it has 60 separate monthly time periods).^[8] The assets in the portfolio are prepayable assets that Entity A allocates into time periods based on the expected prepayment dates, by allocating a percentage of all of the assets, rather than individual items, into each time period. The portfolio also includes demandable liabilities that the entity expects, on a portfolio basis, to repay between one month and five years and, for risk management purposes, are scheduled into time periods on this basis. On the basis of this analysis, Entity A decides what amount it wishes to hedge in each time period.

This example deals only with the repricing time period expiring in three months’ time, ie the time period maturing on 31 March 20X1 (a similar procedure would be applied for each of the other 59 time periods). Entity A has scheduled assets of CU100 million^[9] and liabilities of CU80 million into this time period. All of the liabilities are repayable on demand.

Entity A decides, for risk management purposes, to hedge the net position of CU20 million and accordingly enters into an interest rate swap^[10] on 1 January 20X1 to pay a fixed rate and receive LIBOR, with a notional principal amount of CU20 million and a fixed life of three months.

This example makes the following simplifying assumptions:

(a)            the coupon on the fixed leg of the swap is equal to the fixed coupon on the asset;

(b)            the coupon on the fixed leg of the swap becomes payable on the same dates as the interest payments on the asset; and

(c)            the interest on the variable leg of the swap is the overnight LIBOR rate. As a result, the entire fair value change of the swap arises from the fixed leg only, because the variable leg is not exposed to changes in fair value due to changes in interest rates.

In cases when these simplifying assumptions do not hold, greater ineffectiveness will arise. (The ineffectiveness arising from (a) could be eliminated by designating as the hedged item a portion of the cash flows on the asset that are equivalent to the fixed leg of the swap.)

It is also assumed that Entity A tests effectiveness on a monthly basis.

The fair value of an equivalent non-prepayable asset of CU20 million, ignoring changes in value that are not attributable to interest rate movements, at various times during the period of the hedge is as follows:

The fair value of the swap at various times during the period of the hedge is as follows:

On 1 January 20X1, Entity A designates as the hedged item an amount of CU20 million of assets in the three-month time period. It designates as the hedged risk the change in the value of the hedged item (ie the CU20 million of assets) that is attributable to changes in LIBOR. It also complies with the other designation requirements set out in paragraphs 88(d) and AG119 of the Standard.

Entity A designates as the hedging instrument the interest rate swap described in paragraph IE4.

End of month 1 (31 January 20X1)

On 31 January 20X1 (at the end of month 1) when Entity A tests effectiveness, LIBOR has decreased. Based on historical prepayment experience, Entity A estimates that, as a consequence, prepayments will occur faster than previously estimated. As a result it re-estimates the amount of assets scheduled into this time period (excluding new assets originated during the month) as CU96 million.

The fair value of the designated interest rate swap with a notional principal of CU20 million is (CU47,408)^[11] (the swap is a liability).

Entity A computes the change in the fair value of the hedged item, taking into account the change in estimated prepayments, as follows.

(a)            First, it calculates the percentage of the initial estimate of the assets in the time period that was hedged. This is 20 per cent (CU20 million ÷ CU100 million).

(b)            Second, it applies this percentage (20 per cent) to its revised estimate of the amount in that time period (CU96 million) to calculate the amount that is the hedged item based on its revised estimate. This is CU19.2 million.

(c)            Third, it calculates the change in the fair value of this revised estimate of the hedged item (CU19.2 million) that is attributable to changes in LIBOR. This is CU45,511 (CU47,408^[12] × (CU19.2 million ÷ CU20 million)).

Entity A makes the following accounting entries relating to this time period:

The net result on profit or loss (excluding interest income and interest expense) is to recognise a loss of (CU1,897). This represents ineffectiveness in the hedging relationship that arises from the change in estimated prepayment dates.

Beginning of month 2

On 1 February 20X1 Entity A sells a proportion of the assets in the various time periods. Entity A calculates that it has sold 8¹/₃ per cent of the entire portfolio of assets. Because the assets were allocated into time periods by allocating a percentage of the assets (rather than individual assets) into each time period, Entity A determines that it cannot ascertain into which specific time periods the sold assets were scheduled. Hence it uses a systematic and rational basis of allocation. Based on the fact that it sold a representative selection of the assets in the portfolio, Entity A allocates the sale proportionately over all time periods.

On this basis, Entity A computes that it has sold 8¹/₃ per cent of the assets allocated to the three-month time period, ie CU8 million (8¹/₃ per cent of CU96 million). The proceeds received are CU8,018,400, equal to the fair value of the assets.^[13] On derecognition of the assets, Entity A also removes from the separate line item in the statement of financial position an amount that represents the change in the fair value of the hedged assets that it has now sold. This is 8¹/₃ per cent of the total line item balance of CU45,511, ie CU3,793.

Entity A makes the following accounting entries to recognise the sale of the asset and the removal of part of the balance in the separate line item in the statement of financial position:

Because the change in the amount of the assets is not attributable to a change in the hedged interest rate no ineffectiveness arises.

Entity A now has CU88 million of assets and CU80 million of liabilities in this time period. Hence the net amount Entity A wants to hedge is now CU8 million and, accordingly, it designates CU8 million as the hedged amount.

Entity A decides to adjust the hedging instrument by designating only a proportion of the original swap as the hedging instrument. Accordingly, it designates as the hedging instrument CU8 million or 40 per cent of the notional amount of the original swap with a remaining life of two months and a fair value of CU18,963.^[14]  It also complies with the other designation requirements in paragraphs 88(a) and AG119 of the Standard. The CU12 million of the notional amount of the swap that is no longer designated as the hedging instrument is either classified as held for trading with changes in fair value recognised in profit or loss, or is designated as the hedging instrument in a different hedge.^[15]

As at 1 February 20X1 and after accounting for the sale of assets, the separate line item in the statement of financial position is CU41,718 (CU45,511 – CU3,793), which represents the cumulative change in fair value of CU17.6 million^[16] of assets. However, as at 1 February 20X1, Entity A is hedging only CU8 million of assets that have a cumulative change in fair value of CU18,963.^[17] The remaining separate line item in the statement of financial position of CU22,755^[18] relates to an amount of assets that Entity A still holds but is no longer hedging. Accordingly Entity A amortises this amount over the remaining life of the time period, ie it amortises CU22,755 over two months.

Entity A determines that it is not practicable to use a method of amortisation based on a recalculated effective yield and hence uses a straight-line method.

End of month 2 (28 February 20X1)

On 28 February 20X1 when Entity A next tests effectiveness, LIBOR is unchanged. Entity A does not revise its prepayment expectations. The fair value of the designated interest rate swap with a notional principal of CU8 million is (CU9,518)^[19] (the swap is a liability). Also, Entity A calculates the fair value of the CU8 million of the hedged assets as at 28 February 20X1 as CU8,009,518.^[20]

Entity A makes the following accounting entries relating to the hedge in this time period:

The net effect on profit or loss (excluding interest income and interest expense) is nil reflecting that the hedge is fully effective.

Entity A makes the following accounting entry to amortise the line item balance for this time period:

End of month 3

During the third month there is no further change in the amount of assets or liabilities in the three-month time period. On 31 March 20X1 the assets and the swap mature and all balances are recognised in profit or loss.

Entity A makes the following accounting entries relating to this time period:

The net effect on profit or loss (excluding interest income and interest expense) is nil reflecting that the hedge is fully effective.

Entity A makes the following accounting entry to amortise the line item balance for this time period:

The tables below summarise:

(a)            changes in the separate line item in the statement of financial position;

(b)            the fair value of the derivative;

(c)            the profit or loss effect of the hedge for the entire three-month period of the hedge; and

(d)            interest income and interest expense relating to the amount designated as hedged.