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Holdings In. Subjects subject. Derivative securities--Accounting. Financial instruments--Accounting--Standards. Hedging Finance --Accounting. More Details author.

Ramirez, Juan, Wiley finance series. Chichester, West Sussex, U. The theoretical framework : recognition of financial instruments -- The theoretical framework : hedge accounting -- Fair valuation : credit and debit valuation adjustments -- An introduction to derivative instruments -- Hedging foreign exchange risk -- Hedging foreign subsidiaries -- Hedging interest rate risk -- Hedging foreign currency liabilities -- Hedging equity risk -- Hedging stock-based compensation plans -- Hedging commodity risk -- Hedging inflation risk -- Hedge accouting : a double-edge sword.

Written by a Big Four advisor, this book shares the author's insights from working with companies to minimise the earnings volatility impact of hedging with derivatives. This second edition includes new chapters on hedging inflation risk and stock options, with new cases on special hedging situations including hedging components of commodity risk.

[PDF] Accounting for Derivatives: Advanced Hedging under IFRS 9 (The Wiley Finance Series) Full

This new edition also covers the accounting treatment of special derivatives situations, such as raising financing through commodity-linked loans, derivatives on own shares and convertible bonds. Hedging Finance Accounting. F54R35 Risk 54Case 3. Case 4. Case 5. Case 8. The increasing globalisation of financial markets led companies in many countries to applyfrom the IFRS principles.

The main goal of IFRS is to safeguard investors by achievinguniformity and transparency in the accounting principles. One of the most challenging aspectsof the IFRS rules is the accounting treatment of derivatives, a challenge that has strengthenedthe relationship between risk management and accounting. Simultaneously, banks have developed increasingly sophisticated derivatives that have in-creased the gap between derivatives for which generally accepted accounting interpretationsexist and derivatives for which there is no accounting treatment consensus.

Accounting for Derivatives: Advanced Hedging under IFRS 9, 2nd Edition [Book]

This gap will con-tinue to widen as the resources devoted to financial innovation hugely exceed those devoted toaccounting interpretation. The objective of this book is not to provide the authors accounting interpretation for asmany hedging strategies involving derivatives as possible because the readers will always findmany new ones that are not included in our cases. Instead, the objective of this book is toprovide a conceptual framework based on an extensive use of cases so that readers can createtheir own accounting interpretation of the hedging strategy being considered.

The hypothetical hedging instrument should have terms that meet the following four conditions: 1. The critical terms of the hedging instrument such as its notional amount, underlying and maturity date, etc.

The hedging instrument can be exercised only on a single date. As there is a gradual process of convergence between FAS and IAS 39, we hope that IAS 39 will finally allow the inclusion of option time value in a hedging relationship which in our opinion makes a great deal of sense. A written option cannot be a hedging instrument, either on its own or in combination with other derivatives unless it is designated as an offset of a purchased option e.

Also the notional amount of the written option is not greater than the notional amount of the purchased option. If the premium of the sold option was larger than the premium of the bought option, IAS 39 forbids designating the combination of the purchased and the sold options as a hedging instrument. Vanilla options, also called standard or regular options, have all their terms fixed and predetermined at their start. Exotic options group any other options that are not considered to be vanilla. In general, exotic options have some terms that depend on specific conditions being met during their life.

The rationale behind most exotic options is to have a lower premium than their vanilla equivalents. It is not easy to classify the exotic options into small groups because their characteristics are very wide-ranging. Also, it would be unrealistic to try to list all the different exotic options being developed, as banks come up continuously with new ones.

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The payoff of a path-dependent option depends on how the underlying price or rate has traded over the life of the option. The most popular path-dependent options are average-rate options, barrier options, and range accrual options. Barrier options are the most popular exotic options and we will cover them in detail next.

Range accrual options are options with payoffs determined by the number of days that the underlying stays within a specific range during a pre-specified period of time. The payoff of a correlation option is affected by more than one underlying. The most popular correlation options are basket options, quanto options and spread options.

Basket options are options on a portfolio of underlyings. Quanto options are options with payoffs denominated in one currency whose underlying is denominated in another currency. Spread options are options with payoffs determined by the difference of two prices or indices or rates. This broad category groups all other options not included in the previous two categories. The most common options in this category are digital options.

Digital options are options with payoffs that are either a fixed amount of cash or other asset or nothing. Barrier options allow entities to tailor their hedging strategies to very specific market views. Payoff at Expiry Excluding Premium. The existence of the barrier lowers the probability of exercise, and therefore, barrier options are cheaper than their vanilla counterparts.

Entities which are willing to keep some residual risk on their hedging strategy can reduce their hedging costs by using barrier options. This option disappears if the barrier is crossed. The entity buys a 6-month EUR knock-out call with strike 1. The premium of a knock-out option is lower than the premium of its equivalent standard option because the protection disappears if the barrier is crossed.

Payoff at Maturity 0. The entity buys a 6-month EUR knock-in put with strike 1. The premium of a knock-in option is lower than the premium of its equivalent standard option due to the possibility of no activation of the option.

It is equivalent to the entity having no protection see Figure 2. The two barrier options we just covered are the most common ones. Our two examples had a single barrier. More complex barrier options can be obtained with double barriers that activate or extinguish an option if, for example, the two barriers are crossed during the life of the option. In our example, the exchange rate was also monitored continuously to check if the barrier was crossed. Some barrier options observe the barrier only on specific dates.


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In summary many different variations of barrier options can be found in the market. For example, let us assume that an investor buys an accrual option on the Eurostoxx 50 index Payoff at Expiry 0. The option has 6 months to expiration and pays EUR 10, for each day that the index closes in the range 3, to 3, the accrual range. The investor pays a EUR , premium for the option. There are trading days in the accrual observation period. In the interest rate market, interesting alternatives to standard interest rate swaps are range accrual swaps.

Unlike a standard swap, the floating rate is conditional on how many days an observation rate in our example the Euribor month rate is within a predefined range 3. The aim of the range accrual swap is to lower the fixed rate of the swap by assuming the risk that the Euribor month rate fixes outside the accrual range. The interest flows are as follows see Figure 2. FX range accrual forwards are an alternative to hedging with FX forwards. For each of the daily fixings up to maturity that the spot rate remains within a predetermined range, the forward nominal accrues a certain amount at a forward rate.

The accrual forward rate is a better than market rate. Instead of entering into a standard forward at 1. The accrual observation period has 65 observation days. As a consequence, the exporter ended up with a contract to sell USD 50 million at a rate of 1. The exporter then used the first USD 40 million of the range accrual forward to hedge the sale, but was left with a USD 10 million excess.

Entities that have foreign currency transactions and operations are exposed to the risk that exchange rates can vary, causing unwanted fluctuations in earnings and in cash flow. Chapters 3, 4 and 6 deal with the accounting implications of FX hedges through the extensive use of cases.

Chapter 3 covers the hedging of anticipated sales and purchases and their resulting receivables and payables. Chapter 4 examines the hedging of net investments in foreign entities. Chapter 6 covers the hedging of foreign currency denominated debt. A summary of IAS 39 was depicted in Chapter 1. Some of the concepts of IAS 21 are outlined in this chapter and Chapter 4. For example, a European car manufacturer is exposed to FX risk if a major Japanese competitor builds its cars in Japan, even if the European entity has all its manufacturing and sales denominated in Euros.

In this case, unfavourable shifts in the EUR against the JPY can adversely affect the competitive position of the company. IAS 21 defines the functional currency of an entity as the currency of the primary economic environment in which the entity operates. Within a group, the functional currency of each entity must be determined individually based on its particular circumstances. IAS 21 ensures that the selection of the functional currency is a question of fact rather than management choice.

Accounting for Derivatives: Advanced Hedging under IFRS (The Wiley Finance Series)

The primary indicators are: 1 The currency that mainly influences sales prices for goods and services, and of the country whose competitive forces and regulations mainly determine the sale prices of its goods and services. If these primary indicators do not provide an obvious answer, then the entity need to turn to the secondary indicators, as follows: 1 The currency in which funds from financing activities i. IAS 21 also describes some other factors to consider in determining whether the functional currency of a foreign operation is the same as that of the parent company.

For example, this would apply where a foreign subsidiary is used to market goods from the parent company and its cash is all remitted back to the parent. However, the group sometimes has a functional currency that differs from its local currency. This is often the case of oil companies and high-tech companies. Monetary items are items that are settled in a fixed or determinable number of units of currency. All other assets and liabilities are non-monetary. Equity and income statement accounts are neither monetary nor non-monetary Hedging Foreign Exchange Risk 53 items.

Examples of monetary and non-monetary items are: Monetary Items Assets Liabilities Accounts Receivable Long-term receivables Deferred income tax receivables Intercompany receivables Investments in bonds Accounts payable Long-term debt Deferred income tax payables Intercompany payables Accrued liabilities Non-monetary Items Assets Liabilities Inventory Property, plant and equipment Investments in equities of another entity Prepayments for goods Provisions settled by delivery of a non-monetary asset 3. In other words, there are no further retranslations.

It is also possible to use the exchange rate prevailing on each transaction date, but in reality few entities adopt this alternative. Usually there is a span of time between when the transaction is initiated and when the foreign currency is to be paid or received, as shown in Figure 1. First, the entity expects, without a high probability, the occurrence of the FX transaction. At a later stage, the entity expects the FX transaction to happen with a high probability.

FX transaction is legally formalised, becoming a firm commitment. An entity does not have to wait until the FX transaction is recorded in the balance sheet to apply hedge accounting. IAS 39 allows both highly probable transactions and firm commitments, to be designated as hedged items. Effectiveness assessment can be based either on spot or on forward rates. Treated quite unfavourably by IAS Hedge accounting only includes intrinsic value changes. Written option subject to stringent conditions to qualify for hedge accounting.

Better IAS 39 treatment than stand-alone options. Suggested split between a forward and an option. Therefore, strategy implications are already outlined for a FX forward and a FX option. Suggested split between a forward eligible for hedge accounting and a residual derivative undesignated.

Hedge accounting treatment is less challenging than KIKO or range accruals. If knock-in barrier not expected to be reached, suggested split between an option eligible for hedge accounting and a residual derivative undesignated. Accounting treatment can be specially challenging if knock-out barrier is crossed. Very challenging to meet requirements of hedge accounting. If hedge initially eligible for hedge accounting, there may a notable risk of subsequent hedge relationship termination.

Range accrual forward CASE 3. The sale was expected to occur on 31 March 20X5, and the sale receivable was expected to be settled on 30 June 20X5. The highly expected sale would become a foreign currency receivable upon the sale of the finished goods. ABC designated the forward contract as the hedging instrument in a foreign currency cash flow hedge, and the highly expected sale as the hedged item.

IAS 39 permits the entity to choose whether or not to include the FX forward points in the hedge relationship assessment. ABC decided to base its assessment of hedge effectiveness on total variations in forward FX rates. In other words, the forward points of the FX forward were included in the hedge relationship. USD million sale of finished goods expected to take place on 31 March 20X5. Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of the expected cash flow.

Hedging Foreign Exchange Risk 57 Hedging Relationship Documentation Hedge effectiveness assessment will be performed on a forward-forward basis. Prospective test A prospective test will be performed at hedge inception and at each reporting date. The ratio will compare the cumulative change since hedge inception in fair value of the expected cash flow arising from the forecast sale with the cumulative change since hedge inception in fair value of the hedging instrument.

Prospective Tests ABC used the critical terms method to assess prospective effectiveness. Because i the terms of the forecast transaction and the forward coincided exactly, and ii the credit risk associated with the counterparty to the hedging instrument was considered to be very low, ABC expected that changes in the fair value of the expected cash flow of the forecasted transaction to be completely offset by changes in fair value of the FX forward. Retrospective Tests A retrospective test was performed at each reporting date and at hedge maturity. ABC used the ratio analysis method. The ratio compared the change since hedge inception in the fair value of the expected cash flow with the change since hedge inception in fair value of the FX forward.

The hedge relationship ended on 31 March 20X5, before the FX forward matured. Until 31 March 20X5, the changes in fair value of the forward were recorded in equity. Accounting Entries The required journal entries were as follows: 1 To record the forward contract trade on 1 October, 20X4 No entries in the financial statements were required as the fair value of the forward contract was zero. As the hedge had no ineffectiveness, all this change was also recorded in equity. The spot rate on payment date was 1. Without the hedge, the proceeds from the sale would have been EUR 4,, lower.

The ratio compared i the change since hedge inception in the fair value due to changes in the spot rate of the expected cash flow with ii the change since hedge inception in fair value due to changes in the spot rate of the FX forward.

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All the changes in fair value of the FX forward due to changes in the forward points were excluded from the hedge relationship, and consequently were considered ineffective. The hedge relationship terminated on 31 March 20X5, so no further calculations of the hedge effective and ineffective parts were needed after that date. Effective Effective part part of of hedge hedge Ineffective Ineffective part part of of hedge hedge Net Net FX FX loss loss receivable receivable 66 Accounting for Derivatives Concluding Remarks It is worth noting a couple of issues: i the effects of the spot-to-spot or forward-to-forward method and ii the accounting treatment of the forward points when using the spot-to-spot method.

Spot-to-Spot versus Forward-to-Forward In a FX forward, the forward points represent the expected depreciation of one currency relative to the other currency during a specific period. The forward points are caused by the interest rate differential between both currencies. Under IAS 39, the measurement of the hedge effectiveness between the forecasted transaction and the FX forward may be based on either the spot rates i. No method is best as both approaches have potential benefits and drawbacks.


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  8. In our case we covered the hedge of a highly expected sale. If the expected transaction were a purchase, the effect would have been the opposite: a lower EBITDA under the spot-to-spot method. If the time span between hedge inception and the sale recognition is very long, there could be important timing differences between the recognition of the forward points and the recognition of the sale. In our case, the period between hedge inception and sale recognition was quite short so the differences in timing recognition caused by the spot-to-spot method were not relevant.

    Accounting Treatment of the Forward Points Under the Spot-to-Spot Method Under the spot-to-spot method, the forward points are excluded from the hedge relationship. In our view this quite an aggressive interpretation of accounting guidelines. CASE 3. The hedging instrument in this case is a tunnel. This case highlights the unfavourable treatment of options under IAS 39 due to the exclusion of the time value from the hedging relationship.

    The starting point of this case is identical to the previous case. At the same time, ABC wanted to have a protection, were its view wrong. Additionally, a call on one of the two currencies is a put on the other currency. The combination of both options is called a tunnel in the FX market. The same strategy in the interest rate market would be called a collar.

    Because the premium to be paid for the purchased option equalled the premium to be received for the written sold option, this hedging strategy is called a zero-cost tunnel. Figure 3. The tunnel could be designated as the hedging instrument because: 1 no net premium was received; 2 the underlying of the USD put and the USD call was the same i.

    Hedge effectiveness was assessed by comparing the changes in the intrinsic value of the options with the changes in the fair value of a hypothetical derivative for the risk being hedged. In our case, all the terms of the hypothetical derivative coincided with the terms of the tunnel, except that the hypothetical derivative had no credit exposure. ABC also decided to base its hedge effectiveness assessment on variations in spot exchange rates.

    In other words, when calculating the intrinsic value of the options, the forward points were excluded from this calculation i. As a consequence, effectiveness was required to be assessed only during those periods in which there was a change in intrinsic value. The counterparty to the tunnel is XYZ Bank and the credit risk associated with this counterparty is considered to be very low.

    Hedge effectiveness will be assessed by comparing changes in the intrinsic value of the hedging instrument to changes in the intrinsic value of a hypothetical derivative. The intrinsic value of the options will be measured as the difference between the spot exchange rate and the strike price. Effectiveness will be assessed only during those periods in which there is a change in intrinsic value. The terms of the hypothetical derivative are such that its fair value changes exactly offset the changes in fair value of the hedged highly expected cash flow for the risk being hedged. In this hedging relationship, all the terms of the hypothetical derivative coincide with the terms of the hedging instrument except that the hypothetical derivative has the same maturity as the hedge and that it has no credit risk.

    Prospective test A prospective test will be performed, at hedge inception and at each reporting date, using the critical terms method. Because the terms of the hedging instrument and those of the hypothetical derivative match and that the credit risk to the counterparty to the hedging instrument is very low, the hedge is expected to be highly effective prospectively.

    The ratio will compare the cumulative change since hedge inception in the intrinsic value of the hypothetical derivative with the cumulative change since hedge inception in the intrinsic value of the hedging instrument. Prospective Tests A prospective test was performed at hedge inception and at each reporting date. ABC used the critical terms method to assess prospective effectiveness. Because i the terms of the hypothetical derivative and the hedging instrument matched, and ii the credit risk associated 72 Accounting for Derivatives with the counterparty to the hedging instrument was considered to be very low, ABC expected that changes in expected cash flows from the forecasted transaction beyond 1.

    The credit risk of the counterparty to the hedging instrument was monitored at each testing date, but there was no significant deterioration in its credit. The intrinsic value was calculated using the spot rates. It is worth noting that although the tunnel had no time value at the beginning and at the end of its life, its time value change showed a remarkable volatility.

    Note also, that the hedging relationship ended on 31 March, 20X5. From that date, there was no need to split the option fair value into its intrinsic and time values. The hedged item was substituted by a hypothetical derivative with the same terms as the tunnel. ABC used the ratio analysis method to assess retrospective effectiveness.

    The ratio compared i the change since hedge inception in the hypothetical derivative intrinsic value due to changes in the spot rate with ii the change since hedge inception in the tunnel intrinsic value due to changes in the spot rate. Of this amount, a gain of EUR , was due to the change in the tunnel intrinsic value, thus considered effective and recorded in equity. The hedging relationship finished on this date. The participating forward is one of the most basic and conservative hedges available. The hedge also provides a guaranteed protection. The risk being hedged in this case is the same as in the previous cases.

    At the same time, ABC wanted to have a protection were its view wrong. The forward rate was a function of the spot at maturity. The maximum forward rate was 1. The forward rate participated in half of the USD appreciation below 1. Hedging Foreign Exchange Risk 77 Figure 3. Hedge Accounting Optimisation of the Participating Forward One of the fundamental issues that ABC faced regarding the participating forward was how to formalise the instrument to maximise its eligibility for hedge accounting.

    ABC considered the following choices: 1 To divide the hedging instrument into the following two parts see Figure 3. Under this alternative, both the forward and the option were considered eligible for hedge accounting. The friendlier treatment by IAS 39 of forwards relative to options indicated that the first alternative was better choice than the second alternative. The FX forward contract with reference number USD 50 million sale of finished goods expected to be agreed on 31 March 20X5. 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.

    Hedging Foreign Exchange Risk 79 Hedge 1: Hedging Relationship Documentation The terms of the hypothetical derivative are such that its fair value changes offset exactly the changes in fair value of the hedged highly expected cash flow for the risk being hedged. The hypothetical derivative in this hedging relationship is a forward with maturity the end of the hedging relationship 31 March 20X5 , nominal USD 50 million, a 1. In other words, the forward points of both the hedging instrument and the hypothetical derivative are included in the assessment.

    Prospective test A prospective test will be performed at inception and at each reporting date, using the scenario analysis method. The ratio will compare the cumulative change since hedge inception in the fair value of the hypothetical derivative with the cumulative change since hedge inception in the fair value of the hedging instrument.

    The FX option contract with reference number The counterparty to the option is XYZ Bank and the credit risk associated with this counterparty is considered to be very low. USD 50 million sale of finished goods expected to take place on 31 March 20X5. The intrinsic value of the options will be measured as the difference between the forward exchange rate and the strike price. Continued 80 Accounting for Derivatives Hedge Hedging Relationship Documentation The terms of the hypothetical derivative are such that its fair value changes offset exactly the changes in fair value of the hedged highly expected cash flow for the risk being hedged.

    In this hedging relationship, the terms of the hypothetical derivative coincide with the terms of the hedging instrument except the expiry date and the credit risk. Prospective test A prospective test will be performed at each reporting date, using the scenario analysis method. Two scenarios will be considered: a two standard deviation upward movement in the exchange rate, and a two standard deviation downward movement in the exchange rate. For each hedging relationship, ABC used the scenario analysis method to assess prospective effectiveness.

    For the prospective test of the first hedging relationship involving the FX forward , ABC chose two scenarios: i a two-standard deviation upward movement in the forward and spot rates in the next six months, and ii a two-standard deviation downward movement in the forward and spot rates in the next six months. For the prospective test of the second hedging relationship involving the option , ABC also used the scenario analysis method. The test was performed in a similar way to the test performed for the first hedging relationship, but computing instead the changes in intrinsic value of the hedging instrument and the hypothetical derivative.

    After studying at the test results, ABC concluded that it expected the second hedge to be highly effective on a prospective basis. We would like to highlight that there could be ineffectiveness for small changes in the fair value of the derivatives, as we will see in the retrospective test. The following table shows the prospective test for the second hedging relationship, performed at its inception. Retrospective Tests Two retrospective tests, one for each hedging relationship, were performed at each reporting date during the hedge life and at hedge maturity.

    Remember that the hedging relationship finished on 31 March 20X5, so only two retrospective tests were needed. It was assumed no significant deterioration in the credit of the counterparty of the hedging instrument during the hedge life. The results of the retrospective tests of the first hedging relationship involving the FX forward are shown in the next two tables. It can be seen that the changes in the fair value of the hedging instrument were slightly different to those of the hypothetical derivative because their forward rate and maturity were different.

    Because the accumulated change in the fair value of the hedged item the hypothetical derivative exceeded the accumulated change in the fair value of the hedging instrument, there was no ineffectiveness to be recorded. It can be seen that the hedge was ineffective during the period between 1-Oct-X4 and Dec-X4 because there was no change in the intrinsic value of the hypothetical derivative while there was change in the intrinsic value of the hedging instrument. This problem could have been reduced by calculating the intrinsic value based changes in the spot rates instead of changes in the forward rates, or by entering into a participating forward with maturity coinciding with the end of the hedging relationship.

    ABC concluded that the problem was very particular and that there was a low probability of repetition. As a consequence, ABC did not terminate the hedge relationship. All the amount was considered to be effective, and thus, recorded in equity. Of this amount, EUR , was considered to be effective and recorded in equity.

    The hedging instrument used in this case, a knock-in forward, involves an exotic option. At the moment, the IFRS accounting treatment of exotic options is unclear. A potential solution is to split the exotic instrument into two parts: a first part that involves a group of standard derivatives for which the accounting treatment is clear, and a second part that includes the rest.

    The first part is eligible for hedge accounting and the second part is treated as undesignated. This process of splitting the exotic instrument into the two parts is quite challenging as it generally turns out to be different solutions. Therefore, readers seeking an optimal accounting solution to be etched in stone are bound to be disappointed.

    Our objective is that the reader develops and exercises his own judgment. ABC did not have to pay a premium to enter into the knock-in forward. It can be seen how ABC could benefit if the exchange rate at maturity was below 1. It shows that the product secured a worst-case rate of 1. It can be seen that once the 1. Resulting FX Rate Resulting rate is 1.

    ABC considered the following choices: 1 Divide the hedging instrument into two parts see Figure 3. The forward would be considered eligible for hedge accounting, and the knock-out option would be undesignated i. Part i would be considered eligible for hedge accounting. Part ii would be considered undesignated. This choice was the simplest, saving the effort in complying with hedge accounting. Hedge effectiveness would be tested using a hypothetical derivative whose terms exactly matched those of the hedging instrument but with a 31 March maturity.

    This accounting treatment, in our view, is very controversial and we think that many auditors will question its validity. Besides, when Payoff 0. Hedging Foreign Exchange Risk 91 the hedging relationship ended on 31 March 20X5, the barrier may still be operative, so there might be still uncertainty about the resulting profile of the hedging instrument on that date, complicating things further.

    A simple way to perform this analysis was to compute the changes in the fair value of the ineffective parts in different scenarios. To keep the analysis simple, the forward points and the discount factors were considered unchanged in the analysis. See Case 1 for a detail description on how FX forward r fair values are computed. All the change in fair value of the FX forward was considered to be effective. The knock-out USD call was valued using a closed-end formula for barrier options. All the change in its fair value was considered to be ineffective.

    It is important to note that the result of this analysis Hedging Foreign Exchange Risk 93 is not a general solution to be etched in stone. It depends on the terms of the knock-in forward and the market conditions. Resulting Instruments Terms As a consequence of the previous analysis, ABC decided to adopt the first alternative formalising the transaction through two different contracts: a FX forward and a knock-out USD call.

    The FX forward was designated as the hedging instrument in a hedging relationship of a highly expected cash flow. Note that because the settlement of the FX forward was by physical delivery, the knock-out option settlement had to be in cash, so ABC did not delivered the USD million twice. The terms of the knock-out USD call were as follows. ABC also decided to base its 94 Accounting for Derivatives assessment of hedge effectiveness on variations in forward FX rates.

    Sash flow hedge. USD million sale of finished goods expected to be agreed on 31 March 20X5. Prospective test A prospective test will be performed at hedge inception and at each reporting date, using the scenario analysis method. Due to the fact that the terms of the hedging instrument and those of the expected cash flow are similar, the hedge is expected to be highly effective. The ratio will compare the cumulative change since hedge inception in the fair value of the hedging instrument with the cumulative change since hedge inception in the fair value of the expected cash flow arising from the forecast sale.

    Prospective Tests ABC performed a prospective test at hedge inception and at each reporting date. ABC used the scenario analysis method to assess prospective effectiveness. ABC chose two scenarios: i a two-standard deviation upward movement in the forward rate, and ii a two-standard deviation downward movement in the forward rate. Retrospective Tests A retrospective test was performed at each reporting date and also at the maturity of the hedging relationship.

    There was no significant deterioration in the credit of the counterparty of the hedging instrument during the life of the hedging relationship. Remember that the hedging relationship finished on 31 March 20X5, so only two retrospective tests were performed. It can be seen that the changes in the fair value of the hedging instrument were slightly different to those of the hedged item because it was an off-market FX forward.

    Because the accumulated change in the fair value of the hedged item exceeded the accumulated change in the fair value of the hedging instrument, there was no ineffectiveness to be recorded. The fair value of the option was computed using a closed-end formula to value barrier options. The forward rate was 1.

    This hedging instrument is created in this case by combining the purchase of a knock-out USD put and the sale of a knock-in USD call with the same strikes. In this case we will cover how the KIKO could be split to make part of it eligible for hedge accounting, and how the split affects the accounting treatment of the hedge strategy.

    ABC had a protection and participated in USD appreciation Good scenario, ABC ended up with a forward rate better than market forward market forward rate would have been 1. Once the hedging instrument and the expected cash flow are combined, the resulting EUR amount to be received by ABC in exchange for the USD million in each of the four scenarios is shown in Figure 3.