Hedging solutions for corporate and financial institutions
Hedging is a practice which involves taking a market position to manage risks. Derivatives are often used to manage exposures to interest rate, currency, price and credit risks that corporate and financial institutions are not willing to accept on their balance sheet. What hedging solutions are available to corporate and financial institutions?
There are three categories of formal hedges in International Financial Reporting Standards (IFRS):
Fair value hedge
This is a hedge of the exposure to changes in fair value of the hedged item. For example, a bank carries interest rate risk on a fixed rate lending transaction. It enters into receive floating, pay fixed interest rate swap to convert the fixed rate exposure to floating (market) rate. Since the swap is mark to market through income statement, the bank may designate the loan as a hedged item and mark to market the same to offset the volatility created in the income statement by the swap.
Cash flow hedge
This is a hedge of the exposure to variability in cash flows. The hedging instrument (derivative) is used to convert a variable rate exposure to fixed rate. For example, an airline company may fix the price of future purchase of jet fuel through forward contracts. A variable rate loan taken by a corporate may be converted to a fixed rate exposure by entering into receive floating, pay fixed interest rate swap. The hedging instrument is mark to market through other comprehensive income instead of the income statement. The hedged item is not mark to market since the risk management objective is different compared to the fair value hedge.
Net investment hedge
This is treated in the same way as a cash flow hedge. It can exist only at group (consolidated) level where the results incorporate the impact of exchange rate movements on investments in foreign subsidiaries and associates.
It is important to note that hedging can be at micro or macro (portfolio) level. Appropriate documentation is required and hedge effectiveness testing has to be done on a regularly basis. Though hedging is entirely optional, it can be an effective tool to manage exposures and achieve the risk management objectives.