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HMRC internal manual

Corporate Finance Manual

Accounting for corporate finance: hedging: IAS 39: macro hedging: conditions

How macro hedging works

IAS 39 permits fair value hedge accounting for macro hedging as follows:

  1. The entity must identify a portfolio of items whose interest rate risk it wishes to hedge - for example, a bank may want to hedge all or part of its loan book.
  2. It then analyses the portfolio into time periods according to the expected re-pricing date of the items. The repricing date is the earlier of the dates when the item is expected to mature, or the date when the interest rate resets to a market rate. In many cases, it will be possible for an item to be prepaid - for example, a borrower might repay a bank loan early. In such cases, the entity must use the expected repricing date (based on its own or industry experience), rather than the contractual date. The time ‘buckets’ that the company identifies must be sufficiently narrow so that all the items within a ‘bucket’ are homogeneous with respect to the interest rate risk being hedge - if interest rates move, their fair value moves proportionately.
  3. For each ‘bucket’ the company designates an amount (expressed as an amount in a particular currency - £X, $Y and so on) of assets or liabilities as hedged items. It cannot designate a net amount. For example, suppose that at the inception of the hedge, a particular bucket contains assets with a fair value of £1.0 million, and liabilities with a fair value of £0.8 million. The company cannot designate ‘the excess of assets over liabilities’ as a hedged item; but it can designate ‘assets of £200,000’.

Demand deposits and similar items with a demand feature cannot be designated as the hedged item for any period beyond the shortest period in which the counterparty can demand repayment. Deposits payable immediately cannot, therefore, be a hedged item - although they can be included in a portfolio and be included in the assessment of the amount of assets or liabilities the entity wants to hedge.

  1. The entity designates the interest rate risk it is hedging (for example, changes in LIBOR).
  2. It then designates one or more derivatives as hedging instruments for each time ‘bucket’.
  3. The entity assesses at inception and in subsequent periods that the hedge is expected to be highly effective.
  4. The entity measures the change in the fair value of the hedged item from step (c) that is attributable to the hedged risk (from step (d)). The result is recognised in the income statement and in one of two separate line items in the balance sheet. The balance sheet line item depends on whether the hedged item is an asset (in which case the change in fair value is reported in a separate line item within assets) or is a liability (in which case the fair value change is reported in a separate line item within liabilities). The change in fair value need not be allocated to individual assets or liabilities.
  5. The entity measures the change in the fair value of the hedging instrument and recognises this as a gain or loss in the income statement. It recognises the fair value of the hedging instrument as an asset or liability in the balance sheet.
  6. Ineffectiveness is the difference in the income statement between the amounts determined in step (g) and step (h).

A change (up or down) in the amounts that are expected to be repaid or mature in a time period will result in ineffectiveness. Thus, in the example in (c) above, £200,000 of total assets £1 million, or 20%, were designated as a hedged item. These were hedged with an interest rate derivative with notional principal amount £200,000. When hedge effectiveness was next assessed, the fair value of assets in the ‘bucket’ had increased by 10%. If there was no change in the amounts expected to be repaid or mature in that time period, the fair value of the hedged assets would increase by £1 million x 20% x 10% = £20,000. The fair value of the derivative would decrease by £20,000 and the hedge would be 100% effective. However, if the estimate of the assets in that time bucket was revised to £1.2 million, the fair value increase would be £1.2 million x 20% x 10% = £24,000. This would result in hedge effectiveness, calculated as £24,000 - £20,000 = £4,000, or 24,000/20,000 x 100% = 120%.