7.5.1 Hedging Relationship Documentation

ABC documented the hedging relationship as follows:

7.5.2 Hedge Effectiveness Assessment

Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of a hypothetical derivative. The terms of the hypothetical derivative are such that its fair value changes exactly offset the changes in fair value of the hedged item for the risk being hedged. The hypothetical derivative is a theoretical interest rate swap with no counterparty credit risk and with zero initial fair value, whose main terms are as follows:

The fixed rate of the hypothetical derivative is higher than that of the hedging instrument due to the absence of CVA in the former.

Changes in the fair value of the hedging instrument will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in the cash flow hedge reserve of OCI in equity. The accumulated amount in equity will be reclassified to profit or loss in the same period during which the hedged expected future cash flow affects profit or loss, adjusting interest expense.
• The ineffective part of the gain or loss on the hedging instrument will be recognised immediately in profit or loss.

Hedge effectiveness will be assessed prospectively at hedging relationship inception, on an ongoing basis at least upon each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

The hedging relationship will qualify for hedge accounting only if all the following criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a group of highly expected forecast cash flows that exposes the entity to fair value risk, affects profit or loss and is reliably measurable. The hedging instrument is eligible as it is a derivative that does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis comparing the critical terms (notional, interest periods, underlying and fixed rates) of the hypothetical derivative and the hedging instrument. The assessment will be complemented by a quantitative assessment using the scenario analysis method for one scenario in which Euribor interest rates will be shifted upwards by 2% and the changes in fair value of the hypothetical derivative and the hedging instrument compared.

7.5.3 Hedge Effectiveness Assessment Performed at the Start of the Hedging Relationship

The hedging relationship was considered effective as the following three requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the qualitative assessment performed supported by a quantitative analysis, ABC concluded that the change in fair value of the hedged item was expected to be substantially offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that economic relationship as the credit ratings of both the entity and XYZ Bank were considered sufficiently strong.
3. The hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

Due to the fact that the terms of the hedging instrument and those of the expected cash flow closely matched and the low credit risk exposure to the counterparty of the swap contract, it was concluded that the hedging instrument and the hedged item had values that would generally move in opposite directions. This conclusion was supported by a quantitative assessment, which consisted of one scenario analysis performed as follows. A parallel shift of +2% occurring on the assessment date was simulated. The fair values of the hedging instrument and the hypothetical derivatives were calculated and compared to their initial fair values. As shown in the table below, the high degree of offset implied that the change in fair value of the hedged item was expected to largely be offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.

The degree of offset would have been slightly larger than 100%, had the hedging instrument had no CVA. In this case, the large positive amount and the 5-year remaining term resulted in a substantial CVA.

The following potential sources of ineffectiveness were identified:

• a substantial deterioration in credit risk of either the entity or the counterparty to the hedging instrument; and
• a change in the timing or amounts of the hedged highly expected cash flows.

The hedge ratio was set at 1:1.

ABC also performed assessments on each reporting date, yielding the same conclusions. These assessments have been omitted to avoid unnecessary repetition.

7.5.4 Fair Valuations, Effective/Ineffective Amounts and Cash Flow Calculations

7.5.5 Accounting Entries

The required journal entries were the following.

1. Entries on 31 December 20X0

   To record the issuance of the bond:

2. No journal entries were required to record the swap since its fair value was zero at inception.
3. Entries on 31 December 20X1

   The bond paid a EUR 4,775,000 coupon.

4. The change in fair value of the swap since the last valuation was a EUR 3,243,000 gain, of which EUR 3,237,000 was deemed to be effective and recorded in the cash flow hedge reserve of equity, while EUR 6,000 was deemed to be ineffective and recorded in profit or loss.
5. Under the swap the entity paid a EUR 659,000 settlement amount.
6. Entries on 31 December 20X2

   The bond paid a EUR 5,789,000 coupon. The change in fair value of the swap since the last valuation was a EUR 2,393,000 loss, fully effective and recorded in the cash flow hedge reserve of equity. Under the swap the entity received a EUR 354,000 settlement amount.

7. Entries on 31 December 20X3

   The bond paid a EUR 5,282,000 coupon. The change in fair value of the swap since the last valuation was a EUR 574,000 loss, fully effective and recorded in the cash flow hedge reserve of equity. Under the swap the entity paid a EUR 152,000 settlement amount.

8. Entries on 31 December 20X4

   The bond paid a EUR 5,374,000 coupon. The change in fair value of the swap since the last valuation was a EUR 363,000 loss, of which EUR 348,000 was deemed to be effective and recorded in the cash flow hedge reserve of equity, while EUR 15,000 was deemed to be ineffective and recorded in profit or loss. Under the swap the entity paid a EUR 61,000 settlement amount.

9. Entries on 31 December 20X5

   The bond paid a EUR 5,526,000 coupon and repaid the EUR 100 million principal. The change in fair value of the swap since the last valuation was a EUR 87,000 gain, of which EUR 78,000 was deemed to be effective and recorded in the cash flow hedge reserve of equity, while EUR 9,000 was deemed to be ineffective and recorded in profit or loss. Under the swap the entity received a EUR 91,000 settlement amount.

7.5.5 Final Remarks

The total interest expense/income recognised during the interest period ending 31 December 20X1 was EUR 5,434,000 (=4,775,000 + 659,000). The objective of entering into the hedge was to fix the overall interest rate at 5.36%, which represented a EUR 5,434,000 (=100 mn × (3.86% + 1.50%) × 365/360) interest expense. Therefore, the objective was fully met during that interest period. This was true for all interest periods in which the swap fair value change was fully effective. In periods during which ineffectiveness was present, the difference between the actual and the target interest expenses was notably small.

The end date of the interest periods coincided with the reporting dates. This resulted in no accrual amounts to be recorded. When there are accrual amounts, the fair valuation of the swap should exclude these amounts, or otherwise a double counting in profit or loss would occur.

7.6.1 Hedging Relationship Documentation

ABC documented the hedging relationship as follows:

7.6.2 Hedge Effectiveness Assessment

Hedge effectiveness will be assessed by comparing changes in the fair value of the ­hedging instrument to changes in the fair value of a hypothetical derivative. Effectiveness will be assessed only during those periods in which there is a change in intrinsic value.

The terms of the hypothetical derivative are such that its fair value changes exactly offset the changes in fair value of the hedged item for the risk being hedged. As the risk being hedged was the cash flow exposure to adverse movements in the Euribor 12-month rate above 4.85% while paying no up-front premium, the hypothetical derivative is a theoretical interest rate collar with no counterparty credit risk, with zero fair value at the start of the hedging relationship, a cap rate of 4.85% and a floor rate such that the collar results in a zero-cost option combination. The main terms of the hypothetical derivative were as follows:

(1) * The floor rate of the hypothetical derivative (3.20%) was different from that of the hedging instrument (3.18%) due to the absence of CVA in the hypothetical derivative (the counterparty to the hypothetical derivative is assumed to be credit risk-free).

Changes in the fair value of the hedging instrument (i.e., the collar's intrinsic value) will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in the cash flow hedge reserve of OCI in equity. The accumulated amount in equity will be reclassified to profit or loss in the same period during which the hedged expected future cash flow affects profit or loss, adjusting interest expense.
• The ineffective part of the gain or loss on the hedging instrument will be recognised immediately in profit or loss.

The change in time value of the collar (the “actual time value”) will be excluded from the hedging relationship. Due to the absence of actual time value at the beginning and end of the hedging relationship, the changes in actual time value will be recognised temporarily in the time value reserve of OCI. No reclassification from OCI to profit or loss will be carried out during the term of the hedging relationship as the carrying value of the time value reserve in OCI is expected to be nil at the end of the hedging relationship.

Hedge effectiveness will be assessed prospectively at hedging relationship inception, on an ongoing basis at least upon each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

The hedging relationship will qualify for hedge accounting only if all the following criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is a group of highly expected forecast cash flows that exposes the entity to fair value risk, affects profit or loss and is reliably measurable. The hedging instrument is eligible as it is a derivative combination that does not result in a net written option and the option sold is designated as an offset to the purchased option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a quantitative basis using the scenario analysis method for two scenarios in which Euribor interest rates will be shifted upwards and downwards by 2% and the changes in fair value of the hypothetical derivative and the hedging instrument compared.

7.6.3 Hedge Effectiveness Assessment Performed at the Start of the Hedging Relationship

The hedging relationship was considered effective as the following three requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the quantitative assessment performed, the entity concluded that the change in fair value of the hedged item was expected to be substantially offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that economic relationship as the credit ratings of both the entity and XYZ Bank were considered sufficiently strong.
3. The hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

A quantitative assessment was performed to support the conclusion that the hedging instrument and the hedged item had values that would generally move in opposite directions. The quantitative assessment consisted of two scenario analyses performed as follows.

A parallel shift of +2% occurring on the assessment date was simulated. The fair values of the hedging instrument and the hypothetical derivatives were calculated and compared to their initial fair values. As shown in the table below, the assessment resulted in a high degree of offset, corroborating that both elements had values that would generally move in opposite directions.

Similarly, a parallel shift of –2% occurring on the assessment date was also simulated. As shown in the table below, the assessment resulted in a high degree of offset, again corroborating that both elements had values that would generally move in opposite directions.

The following potential sources of ineffectiveness were identified:

• a substantial deterioration in credit risk of either the entity or the counterparty to the hedging instrument; and
• a change in the timing or amounts of the hedged highly expected cash flows.

The hedge ratio was set at 1:1.

ABC also performed assessments on each reporting date, yielding the same conclusions. These assessments have been omitted to avoid unnecessary repetition.

7.6.4 Fair Valuations, Effective/Ineffective Amounts and Cash Flow Calculations

Fair Valuations of Hedging Instrument

As an example, the following tables detail the split between the intrinsic value and the time value of the collar on 31 December 20X0 and 31 December 20X1. The fair value of the collar was calculated using the Black–Scholes model and incorporating CVA/DVA.

IFRS 9 does not specify how to calculate the intrinsic value of cap (or a collar). The most accurate way is to calculate for each caplet/floorlet the present value of an undiscounted intrinsic amount by comparing the implied forward interest rate with the cap/floor rate. The sum of the discounted values yields the intrinsic value of the cap/floor. The time value of the collar was calculated as follows:

Collar fair valuation on 31 December 20X0
Date	Euribor 12M	Discount factor	Cap intrinsic value (undiscounted) (1)	Floor intrinsic value (undiscounted) (2)	Total intrinsic value (present value) (3)
31-Dec-20X1	3.21%	0.9685	-0-	-0-	-0-
31-Dec-20X2	3.40%	0.9667	-0-	-0-	-0-
31-Dec-20X3	3.90%	0.9299	-0-	-0-	-0-
31-Dec-20X4	4.37%	0.8904	-0-	-0-	-0-
31-Dec-20X5	4.60%	0.8507	-0-	-0-	-0-
CVA/DVA					-0-
Total intrinsic value
Time value (4)					-0-
Fair value (5)					-0-

Notes:

(1) 100 mn × max(Euribor 12M – 4.85%; 0) × 365/360, assuming 365 calendar days in the interest period

(2) <100 mn> × max(3.18% – Euribor 12M; 0) × 365/360, assuming 365 calendar days in the interest period

(3) (Undiscounted cap intrinsic value + Undiscounted floor intrinsic value) × Discount factor

(4) Fair value – Intrinsic value

(5) Initial fair value was nil, calculated using the Black–Scholes model

Collar fair valuation on 31 December 20X1
Date	Euribor 12M	Discount factor	Cap intrinsic value (undiscounted)	Floor intrinsic value (undiscounted)	Total intrinsic value (present value)
31-Dec-20X2	4.21%	0.9591			-0-
31-Dec-20X3	4.80%	0.9146			-0-
31-Dec-20X4	5.00%	0.8705	152,000		132,000
31-Dec-20X5	5.12%	0.8275	274,000		227,000
CVA/DVA					<4,000>
Total intrinsic value					355,000
Time value					217,000
Fair value					572,000

The following table summarises the split between the collar's intrinsic and time value at each reporting date:

Date	Collar intrinsic value	Collar time value	Collar total fair value	Period change in intrinsic value	Period change in time value	Period change in total fair value
31-Dec-20X0	-0-	-0-	-0-	—	—	—
31-Dec-20X1	355,000	217,000	572,000	355,000	217,000	572,000
31-Dec-20X2	130,000	300,000	430,000	<225,000>	83,000	<142,000>
31-Dec-20X3	-0-	170,000	170,000	<130,000>	<130,000>	<260,000>
31-Dec-20X4	-0-	20,000	20,000	-0-	<150,000>	<150,000>
31-Dec-20X5	-0-	-0-	-0-	-0-	<20,000>	<20,000>

7.6.5 Accounting Entries

The required journal entries were as follows.

1. Entries on 31 December 20X0

   To record the issuance of the bond:

2. No journal entries were required to record the collar since its fair value was zero at inception.
3. Entries on 31 December 20X1

   The bond paid a EUR 4,775,000 coupon.

4. The change in the fair value of the collar since the last valuation was a gain of EUR 572,000. Of this amount, a gain of EUR 355,000 was due to a change in the collar's intrinsic value, split between a 345,000 effective amount recorded in equity, and a EUR 10,000 ineffective amount recorded in profit or loss. The remainder, a gain of EUR 217,000, was due to a change in the collar's time value and taken to the time value reserve in OCI.
5. No settlement amounts were paid or received under the collar.
6. Entries on 31 December 20X2

   The bond paid a EUR 5,789,000 coupon. The change in the fair value of the collar since the last valuation was a EUR 142,000 loss. Of this amount, a EUR 225,000 loss was due to a change in the collar's intrinsic value, split between a EUR <217,000> effective amount recorded in equity, and a EUR <8,000> ineffective amount recorded in profit or loss. The remainder, a EUR 83,000 gain, was due to a change in the collar's time value and taken to the time value reserve in OCI. No settlement amounts were paid or received under the collar.

7. Entries on 31 December 20X3

   The bond paid a EUR 5,282,000 coupon. The change in the fair value of the collar since the last valuation was a EUR 260,000 loss. Of this amount, a EUR 130,000 loss was due to a change in the collar's intrinsic value, split between a EUR <128,000> effective amount recorded in equity, and a EUR <2,000> ineffective amount recorded in profit or loss. The remainder, a EUR 130,000 loss, was due to a change in the collar's time value and taken to the time value reserve in OCI. No settlement amounts were paid or received under the collar.

8. Entries on 31 December 20X4

   The bond paid a EUR 5,374,000 coupon. The change in fair value of the collar since the last valuation was a EUR 150,000 loss, all of which was due to a change in the collar's time value and recorded in the time value reserve of equity. No settlement amounts were paid or received under the collar.

9. Entries on 31 December 20X5

   The bond paid a EUR 5,526,000 coupon and repaid the EUR 100 million principal. The change in fair value of the collar since the last valuation was a EUR 20,000 loss, all of which was due to a change in the collar's time value and recorded in the time value reserve of equity. No settlement amounts were paid or received under the collar.

7.6.6 Final Remarks

In the case just covered, the collar had no intrinsic value at the start of the hedging relationship because both the cap rate (4.85%) and the floor rate (3.18%) were well “away” from the 3.86% swap rate. The accounting for the time value component of a collar that has a zero time value both at the start and end of the hedging relationship is relatively simple, as all the changes in time value are recognised in the time value reserve of OCI and no reclassification is needed.

Imagine instead a zero-cost collar in which the cap and floor rates were 4.50% and 3.52%, respectively. Ignoring CVAs/DVAs, this floor would have had a EUR <336,000> intrinsic value at the start of the hedging relationship. Because the collar had an initial zero fair value at the start of the hedging relationship, it would have had a EUR 336,000 time value at that moment, as shown in the following table:

7.7.1 Background Information

On 31 March 20X0, ABC issued at par a EUR 100 million, 2-year fixed rate bond with a 3.78% annual coupon. ABC's hedging policy was to swap all new issues to floating and at a later stage decide, on a portfolio basis, the proportion of fixed versus floating exposure. Accordingly, on the date on which the bond was issued ABC considered entering into an interest rate swap in which it would receive 3.78% annually and would pay Euribor 12-month annually. However, because the yield curve on 31 March 20X0 was very steep, ABC preferred instead to enter into a swap in which it would receive 3.78% annually and pay Euribor 3-month quarterly. The main terms of the bond and the swap were as follows:

Figure 7.1 shows the cash flows of the two legs of the swap. Under the floating leg, ABC had to pay Euribor 3-month each quarter. Under the fixed leg, ABC had to receive 3.78% each year.

Figure 7.2 depicts the strategy's interest flows. Through the swap ABC paid quarterly Euribor 3-month and received 3.78% annually. ABC used the 3.78% cash flows it received under the swap to partially pay the bond interest. As a result, ABC obtained synthetically a EUR floating liability in which it paid Euribor plus 100 basis points.

7.7.2 Credit Spread and Hedge Accounting

ABC designated the swap as the hedging instrument in a fair value hedge of the bond. Hedge effectiveness was assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of the hedged item. One decision ABC had to make was whether to include the credit spread in the hedging relationship. In other words, when defining in the hedge documentation the risk being hedged, to choose between:

• Hedging all the risks (i.e., credit and interest rate risks in our case). The hedged item would be fair valued in its entirety.
• Hedging only interest rate risk and, as a result, excluding credit risk from the hedging relationship. The hedged item would be defined as the bond cash flows representing a 3.78% interest rate (i.e., the first EUR 3.87 million). The hedged item would be fair valued for changes in interest rates only.

Because the swap only hedged interest rate risk, the latter was chosen. Therefore, the hedged item was the cash flows corresponding to the first EUR 3.87 million of each coupon payment.

7.7.3 Interest Accruals and Fair Valuations

A key element, when derivatives with several settlement dates are involved, is the interaction between interest accruals and fair valuations. Suppose that ABC reported its financial statements on an annual basis every 31 December. Therefore, the first reporting date after hedge inception was 31 December 20X0. By that date and regarding the floating leg of the hedging instrument, four quarterly Euribor 3-month fixings had already been set and interest for three quarters had already being paid, as shown in the following table:

Regarding the fixed leg of the hedging instrument, the rates were already known but no interest was paid by 31 December 20X0:

The fair value of the swap on 31 December 20X0 was the following, ignoring CVAs/DVAs:

If no further adjustments are applied, the profit or loss statement on 31-December-20X0 was as follows:

(*) 3,780,000 × (275 days from 31-Mar-X0 to 31-Dec-X0)/(365 days from 31-Mar-X0 to 31-Mar-X1)

A profit of EUR 3,734,000 is great news for ABC. The bad news is that this profit or loss statement is wrong as it is double counting the accrual of the amounts to be received on 31-Mar-X1. ABC is recognising the accrual corresponding to the swap's fixed leg (EUR 2,848,000) to be settled on 31 March 20X1. Simultaneously, ABC is including that amount when fair valuing the swap: a EUR 3,780,000 cash flow corresponding to 31 March 20X1 (see “fixed leg cash flow” amount in the first line of the swap fair valuation).

ABC should have fair valued the swap excluding any accruals amounts, as shown in the following table:

(*) 3,780,000 × 90/365

ABC's profit or loss statement on 31-December-20X0 was as follows:

(*) 3,780,000 × (275 days from 31-Mar-X0 to 31-Dec-X0)/(365 days from 31-Mar-X0 to 31-Mar-X1)

ABC reported a EUR 984,000, mostly stemming from the differential between the 2.75% average interest rate paid during the period (2.75% = (2.00% + 2.50% + 3.00% + 3.50%)/4) and the 3.78% interest rate received. An additional EUR 32,000 was due to the change in fair value of the swap, excluding accrual amounts.

Regarding the hedged item, the conclusion is identical: interest accruals have to be excluded from the fair valuation of the hedged item. Otherwise, a double counting in profit or loss would occur.

7.8.1 Background Information

On 31 July 20X0, ABC issued at par a fixed rate bond with the following characteristics:

ABC's policy was to immediately swap to floating all new debt issues and later, as part of its overall hedging policy, decide what fixed-floating mix was the most appropriate for the whole corporation. Accordingly, simultaneously with the issuance of the bond, ABC entered into a receive-fixed pay-floating interest rate swap with XYZ Bank with the following terms:

Under the swap, ABC paid annually Euribor 12-month and received annually 4.34%. ABC then used the 4.34% received and added 0.60% to pay the 4.94% bond interest. The combination of the bond and the swap resulted in ABC paying an interest of Euribor 12-month plus 60 bps, as shown in Figure 7.3. The 60 bps credit spread was the difference between the bond's coupon rate (4.94%) and the swap's fixed rate (4.34%).

The swap was designated as the hedging instrument in a fair value hedge of the bond.

7.8.2 Hedging Relationship Documentation

ABC documented the hedging relationship as follows:

7.8.3 Hedge Effectiveness Assessment

Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of the hedged item. Changes in the fair value of the hedging instrument (i.e., the swap) will be recognised as follows:

• The effective part of the gain or loss on the hedging instrument will be recognised in profit or loss, adjusting interest income/expenses.
• The ineffective part of the gain or loss on the hedging instrument will be recognised in profit or loss, as other financial income/expenses.

Hedge effectiveness will be assessed prospectively at hedging relationship inception, on an ongoing basis at least upon each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements.

The hedging relationship will qualify for hedge accounting only if all the following criteria are met:

1. The hedging relationship consists only of eligible hedge items and hedging instruments. The hedge item is eligible as it is an already recognised liability that exposes the entity to fair value risk, affects profit or loss and is reliably measurable. The hedging instrument is eligible as it is a derivative that does not result in a net written option.
2. At hedge inception there is a formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge.
3. The hedging relationship is considered effective.

The hedging relationship will be considered effective if the following three requirements are met:

1. There is an economic relationship between the hedged item and the hedging instrument.
2. The effect of credit risk does not dominate the value changes that result from that economic relationship.
3. The hedge ratio of the hedging relationship is the same as that resulting from the quantity of hedged item that the entity actually hedges and the quantity of the hedging instrument that the entity actually uses to hedge that quantity of hedged item. The hedge ratio should not be intentionally weighted to create ineffectiveness.

Whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a quantitative basis using the scenario analysis method for two scenarios in which Euribor interest rates will be shifted upwards and downwards by 2% and the changes in fair value of the hedged item and the hedging instrument compared.

7.8.4 Hedge Effectiveness Assessment Performed at the Start of the Hedging Relationship

On 31 July 20X0 ABC performed a hedge effectiveness assessment which was documented as described next.

The hedging relationship was considered effective as the following three requirements were met:

1. There was an economic relationship between the hedged item and the hedging instrument. Based on the quantitative assessment performed, the entity concluded that the change in fair value of the hedged item was expected to be substantially offset by the change in fair value of the hedging instrument, corroborating that both elements had values that would generally move in opposite directions.
2. The effect of credit risk did not dominate the value changes resulting from that economic relationship as the credit ratings of both the entity and XYZ Bank were considered sufficiently strong.
3. The hedge ratio of the hedging relationship was the same as that resulting from the quantity of hedged item that the entity actually hedged and the quantity of the hedging instrument that the entity actually used to hedge that quantity of hedged item. The hedge ratio was not intentionally weighted to create ineffectiveness.

A quantitative assessment was performed to support the conclusion that the hedging instrument and the hedged item had values that would generally move in opposite directions. The quantitative assessment consisted of two scenario analyses performed as follows.

A parallel shift of +2% occurring on the assessment date was simulated. The fair values of the hedging instrument and the hedged item were calculated and compared to their initial fair values. As shown in the table below, the assessment resulted in a high degree of offset, corroborating that both elements had values that would generally move in opposite directions.

Similarly, a parallel shift of –2% occurring on the assessment date was also simulated. As shown in the table below, the assessment resulted in a high degree of offset, corroborating that both elements had values that would generally move in opposite directions.

The following potential sources of ineffectiveness were identified:

• a substantial deterioration in credit risk of either the entity or the counterparty to the hedging instrument; and
• a change in the timing or amounts of the hedged highly expected cash flows.

The hedge ratio was set at 1:1.

ABC also performed assessments at each reporting date, yielding similar conclusions. These assessments have been omitted to avoid unnecessary repetition.

7.8.5 Fair Valuations, Effective/Ineffective Amounts and Cash Flow Calculations

7.8.6 Accounting Entries

The required journal entries were the following.

1. Entries on 31 July 20X0

   To record the issuance of the bond:

2. No journal entries were required to record the swap since its fair value was zero at inception.
3. Entries on 31 December 20X0

   To record the EUR 2,071,000 accrual of the bond coupon:

4. To record the EUR 247,000 accrual of the settlement amount of the swap:
5. The change in fair value of the swap since the last valuation was a EUR 334,000 loss, fully effective and recorded as interest expense in profit or loss.
6. The change in fair value of the bond, for the risk being hedged, since the last valuation was a EUR 399,000 gain, of which a EUR 334,000 gain was considered to be effective and recorded as interest income in profit or loss. The excess EUR 65,000 gain was considered to be ineffective and recorded as other financial income in profit or loss.
7. Entries on 31 July 20X1

   To record the EUR 2,869,000 accrual of the bond coupon:

8. To record the EUR 342,000 accrual of the settlement amount of the swap:
9. ABC paid the EUR 4,940,000 bond coupon.
10. ABC received the EUR 589,000 settlement amount under the swap.
11. Entries on 31 December 20X1

    These recognised the EUR 2,071,000 accrual of the bond coupon and the EUR 183,000 accrual of the settlement amount of the swap. The change in fair value of the swap since the last valuation was a EUR 702,000 gain, fully considered to be effective and recorded as interest income in profit or loss. The change in fair value of the bond, for the risk being hedged, since the last valuation was a EUR 713,000 loss, split between a EUR 702,000 loss considered to be effective and recorded as interest expense in profit or loss, and a EUR 11,000 loss considered to be ineffective and recorded as other financial expenses in profit or loss.

12. Entries on 31 July 20X2

    These recognised the EUR 2,869,000 accrual of the bond coupon, the EUR 254,000 accrual of the settlement amount of the swap, the payment of the EUR 4,940,000 bond coupon, and the payment of the EUR 437,000 settlement amount under the swap.

13. Entries on 31 December 20X2

    These recognised the EUR 2,071,000 accrual of the bond coupon and the EUR 98,000 accrual of the settlement amount of the swap. The change in fair value of the swap since the last valuation was a EUR 236,000 loss, fully considered to be effective and recorded as interest expense in profit or loss. The change in fair value of the bond, for the risk being hedged, since the last valuation was a EUR 264,000 gain, split between a EUR 236,000 gain considered to be effective and recorded as interest income in profit or loss, and a EUR 28,000 gain considered to be ineffective and recorded as other financial income in profit or loss.

14. Entries on 31 July 20X3

    These recognised the EUR 2,869,000 accrual of the bond coupon, the EUR 136,000 accrual of the settlement amount of the swap, the payment of the EUR 104,940,000 bond coupon and principal, and the payment of the EUR 234,000 settlement amount under the swap. The change in fair value of the swap since the last valuation was a EUR 132,000 loss, split between a EUR <50,000> effective amount recorded as interest expense in profit or loss and a EUR <82,000> ineffective amount recorded as other financial expenses in profit or loss. The change in fair value of the hedged item since the last valuation was a EUR 50,000 gain, fully deemed to be effective and recorded as interest income in profit or loss

The following table gives a summary of the accounting entries.

Note: Total figures may not match the sum of their corresponding components due to rounding.

7.8.7 Concluding Remarks

By excluding the credit risk from the hedging relationship, ABC did not need to calculate the change in fair value of the bond due to all risks, but rather just due to interest rate risk.

In order to assess whether ABC achieved its objective of funding itself at Euribor 12-month plus 60 bps, let us take a look at ABC's profit or loss statement during the first interest period (from 31 July 20X0 to 31 July 20X1):

The total interest expense for the period was EUR 4,351,000. This expense implied an interest rate of 4.29% on an actual/360 basis. ABC's objective was to fund itself at Euribor 12-month (set at 3.70% for the interest period) plus the 0.60% spread, or incurring an overall interest expense of EUR 4,360,000 (=100 mn × (3.70% + 0.60%) × 365/360). Therefore, ABC incurred an interest expense remarkably close to its funding objective. Additionally, ABC's profit or loss during the period recognised other financial income of EUR 65,000 due to hedge ineffectiveness.