Derivative contracts: hedging: Regulation 13: transitional rules example
This guidance applies to certain derivative contracts entered into on or after 1 January 2009
A company with a functional currency of US dollars announces a rights issue of sterling shares on 1 February 2009. The rights issue will be made on 1 May 2009.
On 1 February 2009 it hedges the future proceeds against the fluctuations in the £/$ exchange rate through a combination of three forward currency purchase contracts.
On 1 May 2009, when the proceeds are received in sterling, it closes out the forward purchase currency contracts to convert the sterling proceeds into the company’s functional currency of US dollars.
The gains or losses that would have been made on the contracts if an accounting period had ended on 9 March 2009 are as follows:
The gains or losses made on the contracts on termination on 1 May 2009 are as follows:
So, the first step is to see which contracts have made a loss and where there is a loss, to identify the lower of the actual loss and the latent loss on 9 March 2009.
|Contract 1||=||No loss|
The loss that can be brought into account under Regulation 7A cannot exceed the overall loss made on the aggregate of the three contracts on either the date of termination or the latent loss on 9 March 2009.
The total aggregate latent loss on 9 March 2009 is £70M. (i.e. £60M gain less £120M less £10M)
The total aggregate loss on actual termination is £40M (i.e. £80M gain less £100M less £20M)
Therefore, the total loss to be brought into account under Reg 7A is restricted to £40M.
This should be split on a just and reasonable basis between the contracts. The legislation does not define what that basis should be. Generally, however, there would be no necessity to assign the overall loss between individual contracts.