Accounting for corporate finance: hedging: qualifying hedging instrument
This guidance applies to companies which apply IFRS, New UK GAAP or FRS 26.
Qualifying hedging instruments
A hedging instrument is a designated derivative or, for a hedge of the risk of changes in foreign currency exchange rates only, a designated non-derivative financial asset or non-derivative financial liability, whose movement in fair values or cash flows is expected to offset the movement in fair values or cash flows of a designated hedged item.
Most derivatives can be designated as hedging instruments (provided that the hedge accounting rules are met) except for some written options. A written option exposes the grantor to unlimited downside risk, so it will not normally be effective in reducing the profit or loss exposure of a hedged item, unless designated as an offset to a purchased option.
For hedge accounting purposes, only derivative contracts with an external counterparty may be designated as hedging instruments. ‘External counterparty’ means a party external to the entity preparing accounts - so, for a group preparing consolidated accounts, it means a party outside of the group. CFM27040 provides further detail about hedging risks within a group.
Under IAS 39 and FRS 26, a non-derivative financial asset or non-derivative financial liability may be designated as a hedging instrument only for a hedge of a foreign currency risk. Under IFRS 9 and Section 12 of FRS 102, a non-derivative instrument may be designated as a hedging instrument for other risks, but only if it is measured at fair value through profit and loss.
An entity’s own equity instruments are not financial assets or financial liabilities of the entity and therefore cannot be designated as hedging instruments.
Further rules about what may be designated as a hedging instrument are covered in CFM27050.