Macro hedging - IASB responds to concerns

The IASB is proposing an amendment to IAS 39 for portfolio hedges of interest rate risk.

Soon after it began work in 2001 the International Accounting Standards Board announced its intention to make limited improvements to the standard on financial instruments (

IAS 39, Financial Instruments: Recognition and Measurement). Much has happened since then: in 2002 the board published its proposed improvements as an exposure draft, which attracted over 170 responses; in March 2003 it held nine public roundtable debates, in which more than 100 individuals and organisations took part; and board members and staff have held many meetings with interested parties.

One particular issue was raised by many, in particular banks and their representatives during this due process: that of 'macro hedging' or, more precisely, hedge accounting for a portfolio hedge of interest rate risk.

IAS 39 provides for two kinds of hedge accounting - fair value hedge accounting and cashflow hedge accounting. Whilst there is extensive guidance on how to apply cashflow hedge accounting to a macro hedge, fair value hedge accounting is, at present, very difficult to achieve. The June 2002 exposure draft had proposed no changes to this position, reflecting the IASB's objective to make only limited improvements to IAS 39.

However, the difficulty of obtaining fair value hedge accounting for a macro hedge emerged as one of the greatest concerns expressed, both in the comment letters on the exposure draft and in the roundtable discussions.

The board therefore decided to explore whether and, if so, how

IAS 39 might be amended to enable fair value hedge accounting to be used more readily for a portfolio hedge of interest rate risk. The board's aim was to develop an approach that was both consistent with the principles that underlie IAS 39 and workable in practice, given the way that entities manage interest rate risk on a portfolio basis. The result of this further consideration was a firm proposal to amend IAS 39, which the board published as an exposure draft in August.

The problem

To understand the proposals in this latest ED, it is necessary to know why fair value hedge accounting is so difficult to obtain for a portfolio hedge of interest rate risk. There are three main reasons:

•   Typically, many of the assets that are included in a portfolio hedge are prepayable, ie the counterparty has a right to repay the item before its contractual maturity. Such assets contain a prepayment option whose fair value changes as interest rates move. However, the derivative that is used as the hedging instrument is typically not prepayable, ie it does not contain a prepayment option. When interest rates change, the resulting change in the fair value of the hedged item (which is prepayable) will differ from the change in fair value of the hedging derivative (which is not prepayable), with the result that the hedge may not meet

IAS 39's effectiveness test.


IAS 39 prohibits the designation of an overall net position (eg, the net of fixed rate assets and fixed rate liabilities) as the hedged item.

Rather it requires that individual assets (or liabilities) or groups of similar assets (or liabilities) equal in amount to the net position are designated as the hedged item. For example, if an entity has a portfolio of 100m of assets and 20m of liabilities,

IAS 39 requires that individual assets that sum to 20m are designated as the hedged item. However, for risk management purposes, entities often seek to hedge the net position.

This net position changes each period (as items re-price or are derecognised and new items are originated). Hence, the individual items that are designated as the hedged item also need to be changed each period. This requires de-designation and re-designation of the individual items that constitute the hedged item, a process that makes heavy systems demands.

•   Fair value hedge accounting requires the carrying amount of the hedged item to be adjusted for the effect of changes in the hedged risk. Applied to a portfolio hedge, this could involve changing the carrying amounts of many thousands of individual items. Also, for any items subsequently de-designated from being hedged, the revised carrying amount must be amortised over the item's remaining life. This, too, carries significant implications for systems.

The proposed solution

The new ED sets out proposals designed to meet these difficulties while complying with the principles the underlie

IAS 39. Two of those principles are that all derivatives should be measured at fair value and that, to the extent a hedge is not perfect, the resulting ineffectiveness should be recognised in profit or loss.

The main proposals in the exposure draft are:

•   Where hedged assets are prepayable, the prepayment risk they contain may be incorporated by scheduling the assets into time periods based on their expected prepayment dates. This proposal, if adopted, would allow the scheduling used for risk management to be used also for accounting.

It would also avoid the need to value separately the prepayment option that is contained in a prepayable asset.

•   The hedged amount may be designated as an amount of currency (eg, 20m of assets) rather than as individual assets (eg, 1,000 separately identified loans). This proposal, if adopted, would reduce the systems changes that would otherwise be required for fair value

•   The change in the fair value of the hedged item need not be attributed to the individual assets (or liabilities) that comprise the hedged item. Rather it may be reported:

•   in a separate line item within assets if the hedged item for a particular maturity time period is an asset; or

•   in a separate line item within liabilities if the hedged item for a particular time period is a liability.

This proposal, if adopted, would also reduce the systems changes that would otherwise be required to adopt fair value hedge accounting.

Comments requested

There are two aspects of its proposed approach on which the IASB is specifically requesting comments. These are the proposals that:

•   if the hedged item contains prepayable assets and an entity revises its estimate of the date(s) on which the items will prepay, hedge ineffectiveness will arise. The ED notes that, had individual assets been designated as required by the original

IAS 39, ineffectiveness would have arisen. The board believes that the simplifications proposed in the ED should give rise to the same effect.

•   if the hedged item is a financial liability that the counterparty can redeem on demand (eg, demand deposits and some time deposits), it cannot qualify for fair value hedge accounting for any period beyond the shortest period in which the counterparty can demand repayment. This proposal is consistent with the board's decision that the fair value of such a liability is not less than the amount repayable on demand. (For example, if a customer deposits 100 in a current account at a bank, the fair value of the deposit liability for the bank cannot be less than 100 - this being the amount the customer could withdraw on demand). A consequence of the proposal is that demand deposits would not qualify for fair value hedge accounting since their fair value (100 in the above example) does not vary.

However, the proposal to designate an amount of assets (or liabilities) alleviates this issue to some extent. For example, if a bank has, in a particular time period, 100m of assets and 80m of demand deposit liabilities, it may designate 20m of the assets as the item it is hedging and achieve hedge accounting under the proposals.

Conversely, if the bank had 80m of assets and 100m of demand deposit liabilities, it could not designate 20m of the demand deposit liabilities as the item it is hedging and hence could not achieve hedge accounting.

The IASB aims to complete all of the improvements to

IAS 39 by early next year, in time for the improved standard to be adopted by those implementing IFRSs for the first time in 2005.

The deadline for comments on the proposed amendment for macro hedging is 14 November. If confirmed, the proposals would be effective for periods beginning on or after 1 January 2005, though early application would be permitted.

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