Derivative contracts: hedging: hedging relationship: intention
‘Intended to act as a hedge’
A ‘hedging relationship’, as defined in regulation 2(5), will exist where the hedging instrument ‘is intended to act as a hedge’ of variation in fair value or cash flows, as well as where a hedge is accounted for as such.
A company’s intention in undertaking a financial transaction is expressed through the intentions of its directors, although in many cases decisions will be delegated to a lower level of management. Particularly in large companies, the board of directors (or the group board) is likely to have set out a detailed policy on risk management. A company that has adopted IFRS, New UK GAAP, or FRS 26 under Old UK GAAP and wishes to use hedge accounting must have such documentation.
In the majority of cases, it will be clear that the company has entered into a particular derivative contract (or liability) with the intention of hedging a particular asset, liability or forecast transaction. This will particularly be so where:
- such hedges are in line with the company’s normal risk management policy, and
- there is a readily-discernable relationship between fair value changes or cash flows in the derivative, and those in the hedged item.
For example, a company issuing US$100 million of fixed rate debt might at the same time enter into cross-currency swaps with a total notional principal amount of US$100 million, which have the effect of converting the debt into a sterling floating rate liability. It is clear in such circumstances that the company will have entered into the swaps with the intention of hedging the debt issue, even if no hedge is designated.
Particularly under FRS 26 and IAS 39, but also under FRS 102 and IFRS 9, there are certain accounting requirements that have to be satisfied for hedge accounting to be applied e.g. around the effectiveness of the hedge. It is not directly relevant for regulation 2(5)(b) whether these accounting conditions are satisfied, the key question is what the derivative is there to do. If the company enters into the derivative with the intention of hedging a particular risk of the company then there will be hedging relationship under regulation 2(5).
It is important to note that the regulations operate on a company by company basis and the derivative contract must be hedging a risk of that company.