11.2.1 Definitions of Lease, Derivative and Own-Use Contracts

In general, from an accounting perspective a commodity contract is treated as a lease contract, a derivative contract or an own-use instrument (see Figure 10.2).

11.2.2 Use of Similar Contracts for both Own-Use and Trading Purposes

In theory, a contract is treated as an own-use contract only if the entity intends to take delivery of the underlying to meet its purchase, sale or usage requirements. In practice, these conditions may be difficult to interpret.

Entities in the energy and utility sectors frequently engage in trading activities to benefit from market opportunities by buying and selling commodity contracts (e.g., futures on natural gas), profiting from short-term price fluctuations or from bid–offer spreads.

These entities may also engage in the purchase and/or sale of identical, or similar, commodity contracts for their own needs, taking physical delivery. For example, a utility may sell expected electricity generation or buy natural gas for its own consumption in its generation business.

The distinction between these two purposes is essential in defining own-use contract treatment. If this distinction cannot be made and all commodity contracts are deemed to be similar, then own-use contract treatment will not be possible. From this perspective the problem stems from interpreting what the standard means by “similar” contracts.

The market practice is to consider “similar” on a substance rather than form basis. Therefore, management intention and actual use of the contracts, rather than their legal form, are key ingredients in assessing whether to apply derivative or own-use accounting treatment. It is possible to apply, within the same entity, both derivatives and own-use accounting for contracts with identical legal form when the intended and actual usages of the contracts differ. The key issue is therefore being able to demonstrate the separation of both activities: trades for physical purposes and those for the purpose of short-term profit-making. This can be demonstrated through the use of appropriate organisational and portfolio structures, covering risk management policies and procedures.

11.3.1 Physically Settled Commodity Contracts

A commodity contract entered into, and continuing to be held, for the purpose of the physical delivery of the underlying commodity, in accordance with the entity's expected purchase, sale or usage requirements, does not fall within the scope of IFRS 9, and is therefore treated as an own-use contract (or executory contract). An exception would be when for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or from a dealer's margin.

11.3.2 Net Settled Commodity Contracts

A commodity contract is net settled, if it may be settled in cash, or by the delivery of another financial asset or by exchanging financial assets. There are various ways in which a contract to buy or sell a non-financial item can be net settled. These include:

1. When the terms of the contract may permit either party to settle it net in cash or another financial instrument or by exchanging financial instruments.
2. When the ability to settle net in cash or another financial instrument, or by exchanging financial instruments, is not explicit in the terms of the contract, but the entity has a practice of settling similar contracts net in cash or another financial instrument or by exchanging financial instruments (whether with the counterparty, by entering into offsetting contracts or by selling the contract before its exercise or lapse).
3. When, for similar contracts, the entity has a practice of taking delivery of the underlying and selling it within a short period after delivery for the purpose of generating a profit from short-term fluctuations in price or dealer's margin.
4. When the non-financial item that is the subject of the contract is readily convertible to cash.

11.3.3 Commodity Contracts with Choice of Physical Delivery or Net Settlement

If the commodity contract allows the entity to choose between physical settlement and net settlement, it would need to assess whether:

• it has the stated intention of delivering the commodity;
• it will be able to meet the delivery requirements under the physical settlement alternative, based on its inventory levels and its production capacity.
• its past sales practices indicated that it would be choosing and meeting the delivery requirements.

11.6.1 Hedging Strategy

The sale at a fixed price exposed ABC to rising silver prices, as it could end up paying a price to acquire the 10 million troy ounces of silver higher than the EUR 5 per ounce selling price. In order to avoid being exposed to changes in silver prices, ABC's hedging policy was to pay and receive fixed prices in all its contracts.

To protect the sale from rising silver prices, on 1 February 20X7 ABC entered into a forward with the following terms (see Figure 11.4):

The instrument's EUR 4.50 per ounce forward rate was the forward rate for 31 May 20X7 prevailing on 1 February 20X7. Thus, ABC did not have to pay any premium for entering into the hedge. In other words, because it was an on-market forward, it had a nil fair value at inception.

The forward contract was a derivative because there was no initial net investment, it was linked to the price of silver and it was to be settled at a future date. First, ABC needed to evaluate whether the forward fell within the own-use exception of IFRS 9. At its maturity, the contract could only be settled in cash based on the silver spot price at maturity. A net settled commodity contract was treated as an IFRS 9 instrument (as a derivative in our case), and as a result, it was recognised in ABC's statement of financial position at fair value.

Next, ABC had to decide whether to apply hedge accounting to avoid mismatches in profit or loss.

• If the firm commitment (i.e., the planned sale of silver) was classified as a derivative contract, a hedging relationship would not be needed as both the firm commitment and the forward would be fair valued with changes in their fair value recognised in profit or loss. Both changes in fair value would be expected to almost fully offset.
• However, in our case ABC classified the firm commitment as an “own-use” commitment. Therefore, the firm commitment would not be fair valued unless it was designated as hedged item in a fair value hedge. Without hedge accounting application, only the forward contract would be fair valued through profit or loss, potentially increasing ABC's profit or loss volatility. Thus, ABC designated the commodity forward in a fair value hedge of the firm commitment.

11.6.2 Hedging Relationship Documentation

ABC designated the forward contract as the hedging instrument in a fair value hedge of its forecasted silver sale. At its inception, ABC documented the hedging relationship as follows:

11.6.3 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. The hedged item will be valued at the silver EUR/oz forward price for 31 May 20X7.

• The change in fair value of the hedging instrument will be recognised in profit or loss.
• The change in fair value of the hedged item will also be recognised in profit or loss and adjusting the carrying amount of the hedged item.

Hedge effectiveness will be assessed prospectively at hedging relationship inception and 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 firm commitment 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 and it 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 the EUR/oz silver spot price at the end of the hedging relationship (31 May 20X7) will be calculated by shifting the spot price prevailing on the assessment date by +10% and –10%, and the change in fair value of both the hedge item and the hedging instrument compared.

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

Suppose that the silver spot price at hedge inception (1 February 20X7) was EUR 4.47 per ounce. The hedge effectiveness assessment at inception was performed by analysing the change in fair value of both the hedge item and the hedging instrument under two scenarios:

1. The silver price at the end of the hedging relationship was calculated by shifting the spot price by +10% to EUR 4.92 per ounce. The change in fair value of the hedging instrument was EUR 4.2 million (=10 mn × (4.92 – 4.50) − 0). The change in fair value of the hedge item was EUR <4.15 million> (=10 million × (5.00 − 4.92) − 4,950,000). The degree of offset was 101.2% (=4.2 mn/4.15 mn).
2. The silver price at the end of the hedging relationship was calculated by shifting the spot price by −10% to EUR 4.02 per ounce. The change in fair value of the hedging instrument was EUR <4.8 million> (=10 mn × (4.02 − 4.50) − 0). The change in fair value of the hedge item was EUR 4.85 million (=10 mn × (5.00 − 4.02) − 4,950,000). The degree of offset was 99.0% (= <4.8 mn>/<4.85 mn>).

Based on these results (see Figure 11.5), ABC concluded that there was an economic relationship between the hedged item and the hedging instrument that gave rise to offset: the fair values of both elements moved in opposite directions and in relatively similar absolute magnitudes.

The assessment also included the determination of the relationship hedge ratio and the identification of the sources of potential ineffectiveness.

Regarding the hedge ratio and based on the results of the quantitative assessment, ABC concluded that the notional of the hedging instrument, 10 million silver ounces, was the quantity necessary to meet the risk management objective to hedge 10 million silver ounces of hedged item. As a result the hedge ratio was set to 1:1.

ABC identified the following as the main sources of potential ineffectiveness: firstly, a significant deterioration in the creditworthiness of the counterparty to the hedging instrument (Megabank); and secondly, a restructuring of the terms of the firm commitment.

ABC concluded that the hedge qualified for hedge accounting as it met all the qualifying criteria (see Figure 11.6):

• The firm commitment and the silver forward contract were an eligible hedged item and hedging instrument respectively.
• There was a formal designation and documentation of the hedge.
• There was an economic relationship between the hedged item and the hedging instrument that gave rise to offset.
• The hedge's short-term tenor and Megabank's strong credit standing led ABC to conclude that the effect of credit did not dominate the hedge fair value changes. Moreover, there was a collateral agreement with daily margin calls that noticeably reduced credit exposure between the two parties to the hedging instrument.
• The hedge ratio resulted from the quantity of hedging instrument and hedged item used to hedge to meet risk management objectives, and it did not attempt to avoid recognising ineffectiveness.

There was another effectiveness assessment performed on 31 March 20X7. The process followed by ABC was very similar to that performed at hedge inception. It has been omitted to avoid unnecessary repetition.

11.6.5 Fair Valuations of Hedging Instrument and Hedged Item

The forward silver prices and the discount factor on the relevant dates were as follows:

The following table outlines the fair value calculation of the hedging instrument. Due to the short-term maturity of the forward contract and the existence of a collateral agreement with Megabank, there were no credit valuation adjustments on the hedging instrument.

Notes:

(1) 10 mn ounces × (forward price – 4.50) × Discount factor = 10 mn × (4.50 – 4.50) × 0.9900

(2) 10 mn ounces × (forward price – 4.50) × Discount factor = 10 mn × (4.60 – 4.50) × 0.9950

(3) 10 mn ounces × (forward price – 4.50) × Discount factor = 10 mn × (4.80 – 4.50) × 1.0000

(4) 3,000,000 – 995,000

The following table outlines the fair value calculation of the hedged item:

Notes:

(1) 10 mn ounces × (5.00 – forward price) × Discount factor = 10 mn × (5.00 – 4.50) × 0.9900

(2) 10 mn ounces × (forward price – 4.50) × Discount factor = 10 mn × (5.00 – 4.60) × 0.9950

(3) 10 mn ounces × (forward price – 4.50) × Discount factor = 10 mn × (5.00 – 4.80) × 1.0000

(4) 3,980,000 – 4,950,000

(5) 2,000,000 – 3,980,000

11.6.6 Accounting Entries

The required journal entries were as follows.

1. To record the forward contract on 1 February 20X7

   No journal entries were required as the fair value of the forward contract was zero.

2. To record the closing of the accounting period on 31 March 20X7

   The change in fair value of the forward contract produced a EUR 995,000 gain. The change in fair value of the firm commitment was EUR <970,000>.

3. To record the end of the hedging relationship and the sale of the silver on 31 May 20X7

   The change in fair value of the forward contract produced a EUR 2,005,000 gain. The change in fair value of the firm commitment was EUR <1,980,000>. On this date, the forward contract matured and ABC received from Megabank EUR 3 million in cash.

4. ABC acquired 10 million silver ounces from a mining company at the spot on 31 May 20X7, or EUR 4.80 per ounce, paying EUR 48 million. Simultaneously, ABC sold 10 million silver ounces to the electronics company at EUR 5.00 per ounce, receiving EUR 50 million, derecognising the firm commitment and that quantity of its inventory. The derecognition of the silver inventory (EUR 43 million) was recorded at the average price of such inventory in ABC's balance sheet, which was assumed to be EUR 4.30 per ounce.

In this case, the loss on the firm commitment was almost fully offset by the gain on the forward contract. The sales proceeds were the original EUR 50 million plus the EUR 2.95 million change in fair value of the firm commitment. There was an additional EUR 50,000 gain stemming from the difference between the change in fair value of the forward and that of the firm commitment. The hedge preserved ABC's EBITDA from changes in the silver price, as shown in Figure 11.7. ABC effectively sold the silver at the spot price prevailing on 31 May 20X7, even though the sales price was fixed on 1 February 20X7.

11.7.1 Recognition of Inventories according to IAS 2

In the mining industry, inventories of metal are physically measured or estimated and valued at the lower of (i) cost and (ii) net realisable value (NRV). Costs of finished products are measured in terms of raw material cost, labour cost and a proportion of manufacturing overhead expenses. NRV is the amount estimated to be obtained from the sale of the item of inventory in the normal course of business, less any anticipated costs to be incurred to complete their production and those necessary to carry out the sale.

A write-down of an inventory is required if the NRV is lower than cost. The amount of any write-down of inventories from cost to NRV and all losses of inventories are recognised as an expense in the period the write-down or loss occurs.

A write-down may be reversed if the NRV recovers. The amount of any reversal of any write-down of inventories, arising from an increase in NRV, is recognised as a reduction in the amount of inventories recognised as an expense in the period in which the reversal occurs. Because an inventory valuation cannot exceed its cost, the maximum amount of reversal is the amount that revalues the inventory to cost.

When inventories are sold, the carrying amount of those inventories is recognised as an expense (i.e., as “cost of goods sold”) in the period in which the related ordinary revenue is recognised.

11.7.2 Applying Hedge Accounting to Inventory

Even though an inventory is held at the lower of cost and net realisable value under IAS 2, an entity can apply hedge accounting (assuming that all other requirements are met) because the change in fair value of the inventory will affect profit or loss (as cost of goods sold) when the inventories are sold or their carrying amount is written down. Hence an entity can in theory apply a fair value hedge when hedging an inventory.

The adjusted carrying amount following the fair value adjustments becomes the cost basis for the purpose of applying the lower of cost and NRV under IAS 2.

11.7.3 Background Information

On 1 February 20X7 ABC, a gold mining company, held 100,000 ounces of gold of inventory carried at an average cost of USD 600 per ounce. The presentation and functional currency of ABC was the USD. To protect the inventory from a decline in gold prices, ABC hedged its position by selling 1,000 gold June futures contracts on the COMEX futures exchange on 1 February 20X7. Each contract was for 100 ounces of gold at USD 700 per ounce. The futures contracts matured on 21 June 20X7. The main terms of the futures contracts were:

To avoid physical delivery of the gold, ABC planned to repurchase the futures position on 20 June 20X7, just prior to its expiry.

11.7.4 Hedging Relationship Documentation

ABC designated the futures contracts as the hedging instrument in a fair value hedge of its gold inventory. At its inception, ABC documented the hedging relationship as follows:

11.7.5 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. The hedged item will be valued at the gold USD/oz spot rate rather than at the futures price.

• The change in fair value of the hedging instrument will be recognised in profit or loss.
• The change in fair value of the hedged item will also be recognised in profit or loss and adjusting the carrying amount of the hedged item.

Hedge effectiveness will be assessed prospectively (i.e., forward looking) at hedging relationship inception and 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 inventory item that exposes the entity to fair value risk and is reliably measurable. The hedging instrument is eligible as it is a derivative and 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 regression analysis method.

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

A regression analysis (see Figure 11.8) was performed by measuring the cumulative change in the fair value of 100,000 gold ounces in Colorado during a hedging period of 4 months and comparing it with that of the nearest gold futures contract on the COMEX. Each observation assumed that a 4-month hedge was put in place each month during the previous 15 years. The sign of the change in the fair value of the hedged item has been inverted to provide a clearer view. The results of the regression provided a R-squared coefficient of 98.8%. The t-statistic showed that the regression results were statistically valid.

Based on the results of the regression analysis using historical data, ABC determined that the spot price of gold in Colorado and the spot price of gold on the COMEX had a strong positive correlation. Accordingly, ABC concluded that the changes in the fair value of the futures contracts related to changes in the spot price of gold at the COMEX and the changes in the fair value of the gold inventory located in Colorado generally moved in opposite directions, and hence that an economic relationship existed between the hedged item and the hedging instrument.

The assessment also included the determination of the relationship hedge ratio and the identification of the sources of potential ineffectiveness.

Regarding the hedge ratio and based on the results of the quantitative assessment, ABC concluded that the notional of the hedging instrument, 100,000 gold troy ounces, was the quantity necessary to meet the risk management objective to hedge 100,000 gold troy ounces of hedged item. As a result the hedge ratio was set to 1:1.

ABC identified the following as the main sources of potential ineffectiveness: firstly, a significant deterioration in the creditworthiness of the counterparty to the hedging instrument (the COMEX); and secondly, a reduction of ABC's gold inventory levels below the hedging instrument notional.

ABC concluded that the hedge qualified for hedge accounting as it met all the qualifying criteria (see Figure 11.9):

• The firm commitment and the gold futures contracts were an eligible hedged item and hedging instrument, respectively.
• There was a formal designation and documentation of the hedge,
• There was an economic relationship between the hedged item and the hedging instrument that gave rise to offset,
• Despite ABC being exposed to the initial margin posted to the COMEX, the hedge's short-term tenor and the COMEX's strong credit standing led ABC to conclude that the effect of credit did not dominate the hedge fair value changes.
• The hedge ratio resulted from the quantity of hedging instrument and hedged item used to hedge to meet risk management objective, and it did not attempt to avoid recognising ineffectiveness.

There was another effectiveness assessment performed on 31 March 20X7. The process followed by ABC was very similar to that performed at hedge inception. It has been omitted to avoid unnecessary repetition.

11.7.7 Fair Valuations of Hedging Instrument and Hedged Item

11.7.8 Accounting Entries

The required journal entries were as follows.

1. To record the futures contracts trade on 1 February 20X7

   In theory, no entries in the financial statements were required as the fair value of the futures contracts was zero. However, ABC had to post a margin in the futures exchange to guarantee the futures position. Suppose that the initial margin was 10% of the position, or USD 7,000,000 in cash.

2. To record the closing of the accounting period on 31 March 20X7

   The futures contracts were revalued daily. When the futures position showed a gain from the previous day, the gain was posted in ABC's margin account with the broker (the broker in its capacity as member of the exchange). Conversely, when the futures position showed a loss, ABC had to post the lost amount in ABC's margin account with the broker. Therefore, at the end of each day the futures position was reset to keep its fair value at nil. The futures contracts did not appear on ABC's statement of financial position as assets or liabilities due to their nil fair value. Income earned on the margin account has been ignored for the purposes of this case.

   For the sake of simplicity, I will summarise all the daily journal entries since 1 February 20X7 in one entry. The change in fair value of the futures contracts since 1 February 20X7 was a gain of USD 4,965,000. Because it was a fair value hedge, this amount was recorded in profit or loss.

3. As noted above, the margin account was updated daily to take into account the daily profit or loss of the futures position. Suppose that ABC maintained a USD 7,000,000 initial margin at all times and withdrew any excess (or deposited any deficit). As the futures position showed a gain of USD 4,965,000, the exchange through the futures broker deposited this amount in ABC's margin account at the broker, and this amount was transferred immediately to another bank account of the entity.
4. The gold inventory was revalued according to the change in fair value of the hedged item for the risk being hedged (a USD 4,500,000 loss).
5. To record the end of the hedging relationship and the repurchase of the futures contracts on 20 June 20X7

   For the sake of simplicity, I will summarise all the daily journal entries since 31 March 20X7 in one. The change in fair value of the futures contracts since 31 March 20X7 was a gain of USD 4,017,000, recorded in profit or loss.

   Suppose that ABC bought back its futures position, effectively closing its position. The margin account showed a balance of USD 11,017,000 (=7,000,000+4,017,000) and ABC immediately transferred this amount. The change in fair value of the hedged item (i.e., the inventory) represented a USD 3,600,000 gain recognised in profit or loss.

6. To record the sale of the gold inventory on 31 July 20X7

   Suppose that the 100,000 ounces of gold were sold to a metal refining customer external to the ABC group on 31 July 20X7 at the spot price prevailing on that date. Assuming that the gold spot price on 31 July 20X7 was USD 720 per ounce, the sale proceeds were USD 72 million (=100,000 ounces × 720). The inventory was valued at cost plus the inventory fair value gains/losses since hedge inception, or USD 51,900,000 (=60,000,000 – 4,500,000 – 3,600,000).

Gold prices can be highly volatile. By entering into the gold futures contracts, ABC essentially protected its price exposure associated with its gold inventory until the hedge maturity. The hedge protected ABC's EBITDA as well (see Figure 11.10). Had ABC not hedged its inventory, its EBITDA and its pre-tax profit would have been USD 8,100,000 and USD 8,982,000 lower, respectively.

Because there was some ineffectiveness, ABC recognised an unexpected additional gain of USD 882,000 (=8,982,000 – 8,100,000). This ineffectiveness arose due to the basis differential between COMEX gold prices and Colorado gold prices. To the extent the variability in the price of gold for these two locations was exactly the same (the basis differential remained constant), ABC would have offset its entire exposure to the variability in the price of gold associated with its inventory. Ineffectiveness caused by futures contracts can be substantial, as the futures price relates to a commodity with specific characteristics and for delivery in specific locations, which may differ considerably from the inventory being hedged. Similarly, actively traded (“liquid”) futures contracts can be denominated in a currency different from that of the entity, creating additional hedging challenges for non-USD-based entities.

11.8.1 Background Information

On 1 February 20X7, ABC, a European oil refining company, forecasted the purchase of 2 million barrels of Brent crude oil from an oil producer, expected to be priced on 31 May 20X7 at the USD/barrel spot price of Brent crude oil prevailing on this date. Delivery and payment would take place simultaneously on 7 June 20X7. ABC's presentation and functional currency was the EUR. ABC was worried that the EUR value of the oil purchase might increase before the oil purchase price was set. To hedge its exposure, ABC entered into an ICE long June futures position on the Intercontinental Exchange (ICE) for 2 million barrels at a price of USD 51 per barrel. The futures contracts were to expire on 21 June 20X7. The main terms of the futures contracts were as follows:

Simultaneously, ABC entered into an FX forward to buy USD 100 million at an exchange rate of 1.2500 on 31 May 20X7, and to be cash settled, as follows:

11.8.2 Hedging Relationship Documentation

ABC designated the combination of the oil futures contracts and the FX forward as the hedging instrument in a cash flow hedge of its highly expected purchase. At its inception, ABC documented the hedging relationship as follows:

11.8.3 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. The hedged item will be valued at the Brent crude oil spot price on the ICE rather than at the futures price and at the EUR–USD FX forward rate with maturity 31 May 20X7. The hedge will be accounted as follows:

• The portion of the change in fair value of the hedging instrument that is determined to be an effective hedge will be recognised directly in the cash flow hedge reserve of OCI.
• The ineffective portion of the change in fair value of the hedging instrument will be recognised in profit or loss.

The effective portion would be the lesser of the following (taking into account their signs):

• The cumulative change in fair value of the hedging instrument from hedging relationship inception.
• The cumulative change in fair value of the hedged item from hedging relationship inception.

Hedge effectiveness will be assessed prospectively (i.e., forward looking) at hedging relationship inception and 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 highly expected forecast transaction 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 combination of derivatives 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 regression analysis method.

11.8.4 Hedge Effectiveness Assessment Performed at Hedging Relationship Inception

An effectiveness assessment was performed at inception of the hedging relationship and at each reporting date. The assessment also included the relationship hedge ratio and an identification of the sources of potential ineffectiveness.

A regression analysis (see Figure 11.11) was performed measuring the cumulative change in the EUR fair value of 2 million barrels of Brent crude oil during a hedging period of 4 months. Each observation assumes that a new hedge was put in place each month during the previous 5 years. The results of the regression provided an R-squared coefficient of 99.9%. The t-statistic showed that the regression results were statistically valid. The correlation coefficient was not 100% because the USD/barrel portion of the hedged item was valued using ICE's Brent crude oil spot prices and the EUR–USD spot prices using the European Central Bank fixing, while the hedging instrument was valued using the ICE futures prices and the EUR–USD forward prices.

Based on the results of the regression analysis using historical data, ABC determined that the EUR spot price of the Brent crude oil to be purchased and the combination of the long 4-month USD futures price of ICE Brent crude oil and the 4-month EUR–USD FX forward rate had a strong negative correlation. Accordingly, ABC concluded that the changes in the fair value of these variables will generally move in opposite directions, and hence that an economic relationship existed between the hedged item and the hedging instrument.

ABC concluded that the hedge qualified for hedge accounting as it met all the qualifying criteria (see Figure 11.12):

• The highly probable forecasted purchase transaction and the combination of crude oil futures contracts and the EUR–USD FX forward were an eligible hedged item and hedging instrument, respectively.
• There was a formal designation and documentation of the hedge.
• There was an economic relationship between the hedged item and the hedging instrument that gave rise to offset.
• Despite being exposed to the initial margin posted to the ICE, the hedge's short-term tenor and the strong credit standing of ICE and Megabank led ABC to conclude that the effect of credit did not dominate the hedge fair value changes.
• The hedge ratio resulted from the quantity of hedging instrument and hedged item used to hedge to meet risk management objectives, and it did not attempt to avoid recognising ineffectiveness.

Regarding the hedge ratio and based on the results of the quantitative assessment, ABC concluded that the notional of the hedging instrument, 2 million crude oil barrels and USD 100 million, was the quantity necessary to meet the risk management objective to hedge 2 million crude oil barrels of hedged item. As a result the hedge ratio was set to 1:1.

There were two main sources of potential ineffectiveness: firstly, a significant credit deterioration of the counterparties to the hedging instrument (the ICE and Megabank); and secondly, a change in the notional, date or probability of occurrence of the forecasted purchase.

There was another effectiveness assessment performed on 31 March 20X7. The process followed by ABC was very similar to that performed at hedge inception. It has been omitted to avoid unnecessary repetition.

11.8.5 Fair Valuations of Hedging Instrument and Hedged Item

11.8.6 Accounting Entries

1. To record the futures contracts on 1 February 20X7

   ABC had to post a margin in the futures exchange to guarantee the futures position. Suppose that the initial margin was 10% of the USD 102 million initial position, or USD 10,200,000 in cash. As the EUR–USD spot exchange rate on that date was 1.2400, the equivalent EUR amount was EUR 8,226,000 (=10.2 mn/1.2400). The FX forward was not recognised on ABC's statement of financial position as its initial fair value was nil.

2. To record the closing of the accounting period on 31 March 20X7

   The futures contracts were revalued daily. When the futures position showed a gain from the previous day, the gain was posted in ABC's margin account at the broker acting as intermediary to the futures exchange. Conversely, when the futures position showed a loss, ABC had to post the lost amount in its margin account at the futures exchange. Therefore, at the end of each day the futures position was reset to keep its fair value at nil.

   For the sake of simplicity, I have summarised all the daily journal entries since 1 February 20X7 in one entry on 31 March 20X7. The change in fair value of the hedging instrument since 1 February 20X7 was a gain of EUR 5,197,000, split between a gain of EUR 7,059,000 related to the futures contracts and a loss of EUR 1,862,000 related to the FX forward. The effective part of the change in fair value of the hedging instrument was EUR 5,197,000, while the ineffective part was nil. The effective part was recognised in the cash flow hedge reserve in OCI. As there was no ineffective part, no amount was recorded in profit or loss.

   The USD cash received in the futures contracts margin account was immediately converted into EUR and deposited in ABC's EUR bank deposit account, to avoid being exposed to the EUR–USD rate.

3. I am assuming that the initial cash margin did not change during the position's life of the position (in reality, it was adjusted on a daily basis to equal 10% of the contract position). The initial cash margin of USD 10,200,000 had an initial value of EUR 8,226,000. This was a monetary item and, therefore, had to be revalued at the EUR–USD spot rate on 31 March 20X7 (1.2750). The margin new value was EUR 8,000,000 (=USD 10,200,000/1.2750), showing a loss of EUR 226,000 (=8,000,000 – 8,226,000):
4. To record the end of the hedging relationship and the oil purchase on 31 May 20X7

   For the sake of simplicity, I have summarised all the daily journal entries of the futures contracts since 31 March 20X7 in just one entry. The change in fair value of the hedging instrument since 31 March 20X7 was a gain of EUR 8,803,000, split between a gain of EUR 10,018,000 related to the futures contract and a loss of EUR 1,215,000 related to the FX forward. The effective part of the change in fair value of the hedging instrument was EUR 8,803,000, while the ineffective part was nil. The effective part was recognised in the cash flow hedge reserve in OCI. As there was no ineffective part, no amount was recorded in profit or loss.

   The USD 13,200,000 cash received in the futures contract margin account was converted into EUR 10,154,000 (=13,200,000/1.3000) at the 1.3000 FX spot rate and deposited in ABC's EUR bank deposit account, to avoid being exposed to the EUR–USD rate.

   The initial cash margin of USD 10,200,000 had a value of EUR 8,000,000 on 31 March 20X7. This was a monetary item and, therefore, had to be revalued at the EUR–USD spot rate on 31 May 20X7 (1.3000). The margin new value was EUR 7,846,000 (=USD 10,200,000/1.3000), showing a loss of EUR 154,000 (=7,846,000 – 8,000,000).

5. ABC resold the futures contracts and received the initial USD 10,200,000 margin, which was immediately converted into EUR 7,846,000 at the 1.3000 EUR–USD spot rate on that date. Simultaneously, ABC settled the FX forward paying EUR 3,077,000.
6. The purchase of the 2 million barrels of Brent crude oil was agreed at the ICE Brent crude oil spot price (USD 62.00 per barrel), or a total of USD 124 million. As a result, from 31 May 20X7 the highly expected purchase became a firm commitment until its receipt. The hedging relationship was terminated.
7. To record the payment and receipt of the crude oil on 7 June 20X7

   Suppose that the EUR–USD spot rate was 1.3050 on 7 June 20X7. The amount in EUR to exchange for USD 124,000,000 was EUR 95,019,000 (=124 million/1.3050). ABC paid this amount in exchange for the crude oil.

8. The cash flow hedge reserve showed a carrying amount of EUR 14 million (=5,197,000 + 8,803,000). If a forecast transaction subsequently results in the recognition of a non-financial asset or liability, IFRS 9 requires an entity to adjust the initial cost (or the carrying amount) of the asset/liability, what is known as basis adjustment. Therefore, in our case the amount accumulated in the cash flow hedge reserve was adjusted out of equity and offset against the carrying amount of the crude oil inventory.

We conclude this section by observing, regarding the EUR–USD FX forward, that while retaining the determination of the settlement amount on 31 May 20X7, ABC probably should have included a settlement date on 7 June 20X7, to coincide with the oil payment.

11.9.1 Background Information

ABC Airlines, an entity with the USD as functional currency, planned to consume around 2.4 million tonnes of jet fuel (jet kerosene) over the next 24 months, on a uniform consumption basis. Jet fuel consumption was a major item of expenditure, making up over 20% of its operating expenses. Severe fluctuations in fuel prices could therefore have a considerable effect on the company's operating results.

ABC's procurement department bought jet fuel through long-term supply contracts or “term contracts” with several oil companies, based upon a projected volume for a given period. The purchase price was indexed to Platts spot prices (jet fuel price North West Europe (NWE) CIF Rotterdam barge) plus a fixed cost (USD 36 per tonne). This fixed cost included the cost of logistics, charges, the supplier margin and an amount that incorporated ABC's credit history, rating, and the volume it used at the location.

ABC's hedging policy of anticipated jet fuel requirements, as approved by its Board, was a rolling hedging programme of its consumption forecast up to 24 months before delivery, increasing the volume that it hedged over time (see Figure 11.13). ABC used crude oil futures to hedge the longer-term horizon (6–24 months) and switched from oil futures to jet fuel swaps in the short term (0–6 months) once these swaps became reasonably liquid. At the end of each quarter, the following hedging strategy was in place:

• 100% of fuel consumption was hedged for the time horizon within 6 months to delivery using jet fuel swaps on the NWE jet fuel;
• 50% of fuel consumption was hedged for the time horizon between 6 and 15 months using Brent crude oil futures;
• 10% of fuel consumption was hedged for the time horizon between 15 and 24 months using Brent crude oil futures;
• not to enter into any jet fuel hedging contracts with respect to its expected fuel purchases beyond the eighth quarter.

This strategy took into account that jet fuel swap prices were only sufficiently liquid within 6 months of delivery. In contrast, Brent crude oil was one of the world's most widely-used commodities and among the most actively hedged and traded products worldwide. Whilst ABC took advantage of the high liquidity of Brent crude oil futures, it was exposed to the jet fuel crack spread (i.e., the difference between the price of oil and the price of jet fuel) for the time horizon between 6 and 24 months.

It is worth noting that there were several “jet fuel crack spreads” throughout the world. For example, the crack between the US Gulf Coast jet fuel price and the WTI crude oil price behaved differently than the crack between the NWE jet fuel price and the Brent crude oil price. Additionally, there were crack spread variations over time (see Figure 11.14).

On 1 April 20X5 ABC entered into a jet fuel swap with Megabank as follows:

Pursuant to the terms of the jet fuel swap, ABC and Megabank agreed to exchange monthly payments equal to the difference between a fixed price (USD 900) for a given monthly quantity of jet fuel (100,000 tonnes) and the monthly average market price for such quantity of jet fuel, with ABC receiving the amount of any excess of such market price over such fixed price and paying to Megabank the amount of any deficit of such fixed price under such market price. For example, on 30 April 20X5 there was a USD cash settlement based on the average NWE jet fuel price per tonne from 1 April 20X5 to 30 April 20X5 (the “floating price”).

If the settlement amount was positive, ABC received the settlement amount; if it was negative, ABC paid the absolute value of the settlement amount.

Additionally, on 1 April 20X5 ABC entered into the following Brent crude oil futures contracts:

11.9.2 Hedging Risk Components

Under IFRS 9 an entity may hedge a specific risk (or risk component) in a financial and non-financial item provided the component is separately identifiable and reliably measurable.

Risk components can be (see Chapter 2):

• contractually specified (i.e., the risk component is explicitly specified in a contract);
• non-contractually specified (i.e., the risk component is only implicit in the fair value or cash flows of an items of which they are a part).

Therefore, a risk component does not necessarily have to be contractually specified for it to be separately identifiable. However, if the risk component is not contractually specified it may be more difficult to isolate parts of the market price into identifiable and measurable risk components. An entity would need to demonstrate whether a risk component is separately identifiable and reliably measurable.

Although the crude oil price was not a contractually specified component of its jet fuel purchase price, ABC determined that, based on the analysis of the market structure for oil and oil products, there was a relationship between crude oil and jet fuel prices. Its evaluation of the relevant facts and circumstances was as follows.

ABC operated in a geographical area in which Brent was the crude oil benchmark. Crude oil was the main driver of the price of jet fuel because of the production process for oil products: jet fuel was obtained through refining (i.e., converting crude oil into jet fuel), as shown in Figure 11.15. Moreover, the pricing of refined oil products did not depend on which particular crude oil was processed by a particular refinery because jet fuel was a standardised product.

Thus, jet fuel purchase prices could be separated into two components:

• A crude component that represented the raw material cost a refiner incurred when producing jet fuel. Crude oil was unrefined and its price excluded any cracking spread.
• A jet fuel crack spread, or refining margin, component that represented the sum of the operational and fixed costs of operating a refinery, refiners' profit margins, and demand–supply imbalances in refining capacity and storages volumes. This component could be traded in the derivatives market as jet fuel crack spread. The benchmark in the geographical area in which ABC operated was indexed to Brent crude oil.

Based on these considerations, ABC concluded that, despite not being specified in any contractual arrangement, the crude oil component was a separately identifiable component of its forecast jet fuel purchases.

ABC determined that the crude oil component was reliably measurable due to the existence of an observable liquid forward market for crude oil for the entire relevant period for which ABC planned to hedge.

11.9.3 Hedging Relationship Documentation

ABC designated the jet fuel swap and the crude oil futures contracts as the hedging instrument in a cash flow hedge of its highly probable forecast purchase of jet fuel. At its inception, ABC documented the hedging relationship as follows:

11.9.4 Hedge Effectiveness Assessment

Hedge effectiveness will be assessed prospectively (i.e., forward looking) at hedging relationship inception and on an ongoing basis at least at each reporting date and upon occurrence of a significant change in the circumstances affecting the hedge effectiveness requirements. For effectiveness assessment purposes, the hedged item will be replaced with a hypothetical derivative that exactly matches the critical terms of the hedged item.

Hedge effectiveness will be assessed by comparing changes in the fair value of the hedging instrument to changes in the fair value of the hypothetical derivative. The hypothetical derivative will be valued at spot prices rather than at forward prices.

The effective part of the change in fair value of the hedging instrument will be determined as the lower, taking into account their signs, of this fair value change and that of the hedged item.

• The effective part of the change in fair value of the hedging instrument will be recognised in the cash flow hedge reserve of OCI. This amount will be reclassified to adjust the carrying amount of the jet fuel inventory when the purchased hedged jet fuel is recorded.
• The ineffective part of the change in fair value of the hedging instrument will be recognised in profit or loss.

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 inventory item that exposes the entity to fair value risk, impacts profit or loss and is reliably measurable. The hedging instrument is eligible as it is a combination of derivatives 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.

Regarding the first hedging relationship, whether there is an economic relationship between the hedged item and the hedging instrument will be assessed on a qualitative basis.

Regarding the second hedging relationship, 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. On each assessment date, the change in fair value of both the hedged item and the hedging instrument will be compared under two scenarios in which the Brent crude oil spot price of the risk being hedged will be shifted upwards and downwards by 10%.

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

Second Hedging Relationship

Regarding the second hedging relationship, the hypothetical derivative was a crude oil swap with the following terms:

	Hypothetical derivative terms
Trade date	1 April 20X5
Counterparties	ABC Airlines and credit risk-free counterparty
Effective date	1 October 20X5
Maturity	31 March 20X7
Notional quantity	3,595,500 bbl for the 9-month period from October 20X5 to June 20X6 (i.e., 399,500 bbl per month) 719,100 bbl for the 9-month period from July 20X6 to March 20X7 (i.e., 79,900 bbl per month)
Calculation period	Quarterly during the term of the transaction
Fixed price payer	ABC Airlines
Fixed price	USD 99.00 per bbl
Floating price payer	Counterparty
Commodity reference price	The closing price of the first nearby futures contract of Brent crude oil as quoted in USD/bbl on the International Petroleum Exchange
Floating price	The unweighted arithmetic mean of the commodity reference price for each successive day of the calculation period during which such prices are quoted
Payment date(s)	The last day of the calculation period
Pricing date(s)	Each commodity business day from and including 1-Oct-X5 up to and including 31-Mar-X7

When designating a risk component as a hedged item, the hedge accounting requirements apply to that risk component in the same way as they apply to other hedged items that are not risk components. For example, the qualifying criteria apply, including that the hedging relationship must meet the hedge effectiveness requirements, and any hedge ineffectiveness must be measured and recognised.

To assess whether there was an economic relationship between the hedged item and the hedging instrument that gave rise to offset, a scenario analysis (see Figure 11.16) was performed by measuring the cumulative change in the fair value of the hypothetical derivative and the hedging instrument (i.e., the string of futures contracts) under two scenarios:

• Under a first scenario, the price of the first nearby futures contract of Brent crude oil in 6 months' time was assumed to have increased by 10% to from USD 97.4 per barrel to USD 107.1 per barrel. The cumulative change in fair value of the hedging instrument over that of the hypothetical derivative resulted in a degree of offset of 104% (=39.1 mn/37.6 mn).
• Under a second scenario, the price of the first nearby futures contract of Brent crude oil in 6 months' time was assumed to have declined by 10% to from USD 97.4 per barrel to USD 87.7 per barrel. The cumulative change in fair value of the hedging instrument over that of the hypothetical derivative resulted in a degree of offset of 96% (= <42.4 mn>/<44.3 mn>).

Based on the results of the scenario analysis, ABC concluded that an economic relationship existed between the hedged item and the hedging instrument.

The assessment also included the determination of the relationship hedge ratio and the identification of the sources of potential ineffectiveness.

Regarding the hedge ratio for the second hedging relationship and based on the spot prices of jet fuel and crude oil (see Figure 11.17), ABC concluded that the quantity necessary to hedge the crude oil component of 1 tonne of jet fuel was 7.99 (=898/112.4) barrels of crude oil. As a result the hedge ratio was set to 1:7.99.

ABC identified the following as the main sources of potential ineffectiveness: firstly, a significant deterioration in the creditworthiness of the counterparty to the hedging instrument (the ICE Futures Exchange); and secondly, a change in the (timing of) highly probable forecasted quantities and actual uplift of jet fuel by the entity below the hedging instrument notional.

ABC concluded that both hedges qualified for hedge accounting as they met all the qualifying criteria (see Figure 11.18):

• The forecast purchases of jet fuel, and the jet fuel swap and the crude oil futures were an eligible hedged item and hedging instruments, respectively.
• There was a formal designation and documentation of the hedges.
• There was an economic relationship between the hedged item and the hedging instruments that gave rise to offset.
• Despite ABC being exposed to Megabank through the jet fuel swap and the initial margin posted to the ICE to secure the crude oil futures contracts, the jet fuel's short-term tenor and the ICE's strong credit standing led ABC to conclude that the effect of credit did not dominate the hedge fair value changes.
• The hedge ratio resulted from the quantity of hedging instruments and hedged item used to hedge to meet risk management objectives, and it did not attempt to avoid recognising ineffectiveness.

There were other effectiveness assessments performed at each reporting date. The processes followed by ABC were very similar to that at hedge inception. They have been omitted to avoid unnecessary repetition.

11.9.6 Fair Valuations and Accounting Entries on 30 June 20X5

Suppose that ABC reported its financial statements on a half-yearly basis, on 30 June and 31 December.

Fair Valuation and Accounting Entries Related to the Jet Fuel Swap

Recall that hypothetical derivative 1 was a jet fuel swap with terms identical to those of the contracted jet fuel swap but without any counterparty credit risk. The main terms of hedging instrument 1 were as follows:

Hedging instrument	Notional	Fixed price	Expiry date
Jet fuel swap	600,000 tonnes	USD 900/tonne	30-Sep-X5

Therefore, the jet fuel swap had three periods already settled (corresponding to 30 April, 31 May and 30 June 20X5) and three upcoming settlement periods outstanding (corresponding to 31 July, 30 August and 30 September 20X5). The credit risk-free fair valuation of the jet fuel swap on 30 June 20X5, assuming that the then prevailing swap rate was USD 1,020 per tonne, was as follows:

Settlement date	Market swap rate	Jet fuel swap rate	Interest rate	Days from 30-Jun-X5	Expected settlement amount	Present value
31-Jul-X5	1,020	900	5%	31	12 mn	11,949,000
30-Aug-X5 (1)	1,020	900	5.10%	61	12 mn (2)	11,897,000 (3)
30-Sep-X5	1,020	900	5.20%	91	12 mn	11,844,000
				Total	36 mn	35,690,000

Notes:

(1) Assuming 31-Aug-X5 is a non-business day

(2) 12,000,000 = [100,000 × (1,020 – 900)]

(3) 11,897,000 = [12,000,000 /(1 + 5.10% × 61/360)]

The change in fair value of the hypothetical derivative was thus a gain of 35,690,000, as its initial fair value was nil.

USD 12 million was the expected credit risk-free settlement amount to be received each remaining month by ABC under the jet swap. ABC had to subtract the CVA. Let us go over the CVA calculation for the 31-Sep-X5 settlement amount. Recall from Chapter 3 that the exponential CDS default method was as follows:

where PD is the probability of default, CDS is the credit default swap spread or bond spread (in our case 1-, 2- and 3-month CDS protection on Megabank was trading at 30 basis points), LGD is the loss given default (in our case LGD was assumed to be 45%, constant over the remaining life of the swap) and Maturity is the time to settlement date, in years (in our case this is 91 days out of 365, or 0.25). Therefore PD was 0.17% (=1 – exp(–0.003 × 0.25/0.45)). The CVA was USD 9,000 (=12,000,000 × 0.17% × 45%).

The fair valuation of the jet fuel swap on 30 June 20X5, including CVA, was as follows:

Settlement date	Market swap rate	Jet fuel swap rate	Interest rate	Days from 30-Jun-X5	Expected settlement amount	CVA	Present value
31-Jul-X5	1,020	900	5%	31	12 mn	3,000	11,946,000
30-Aug-X5	1,020	900	5.10%	61	12 mn	6,000 (1)	11,891,000 (2)
30-Sep-X5	1,020	900	5.20%	91	12 mn	9,000	11,835,000
				Total	36 mn		35,672,000

Notes:

(1) 6,000 = 12,000,000 × [1 – exp((–0.003 × (61/365)/0.45)]× 0.45

(2) 11,891,000 = [(12,000,000 – 6,000)/(1 + 5.10% × 61/360)]

The change in fair value of the jet swap – hedging instrument 1 – from inception until the reporting date was then USD 35,672,000, as its initial fair value was nil.

The effective part of this fair value change was USD 35,672,000, the minimum of the fair value change of the hypothetical derivative (USD 35,690,000) and that of the hedging instrument (USD 35,672,000). The effective part was recognised in the cash flow hedge reserve of OCI.

The ineffective part was nil, the difference between the fair value change of the hedging instrument (USD 35,672,000) and the effective part (USD 35,672,000 as well). The ineffective part would have been recognised in profit or loss.

The accounting entries to record the change in fair value of the jet fuel swap were as follows (in USD):

On the last day of each month (i.e., 30 April 20X5, 31 May 20X5 and 30 June 20X5) ABC and Megabank settled the jet fuel swap. The settlement amounts totalled USD 22.5 million:

Period start	Period end	Average jet fuel	Settlement amount
1-Apr-X5	30-Apr-X5	939	3,900,000
1-May-X5	31-May-X5	978	7,800,000
1-Jun-X5	30-Jun-X5	1,008	10,800,000
		Total	22,500,000
Cash (Asset)		22,500,000
	Jet fuel cost (Profit or loss)		22,500,000

This amount was recognised in profit or loss (“jet fuel cost”) rather than adjusting an inventory account (i.e., a basis adjustment), as the jet fuel purchased went straight into ABC's airplanes rather than into storage.

Hedge Adjustment to Maintain Rolling Hedging Strategy

On 30 June 20X5 ABC's hedging strategy had the profile shown in Figure 11.19 (left). Because at the end of each quarter ABC's target hedging profile was as shown in Figure 11.19 (right) ABC had to do the following:

1. Replace the crude oil futures contracts expiring on 15 December 20X5 with a 3-month jet fuel swap with a notional of 100,000 tonnes per month (i.e., a total notional of 300,000 tonnes). Thus, ABC sold all its 15 December 20X5 crude oil futures contracts, locking in a USD 16,456,000 gain. The jet fuel swap had a start date of 1 October 20X5, a maturity date of 31 December 20X5, and a USD 1,023 per tonne swap rate.
2. Purchase an additional 958,800 bbl (=1,198,500 – 239,700) of crude oil futures contracts expiring on 15 September 20X6 at USD 113.1 per barrel. The overall position crude oil futures position expiring on this date became 1,198,500 bbl at an average price of USD 110.30 (=239,700 bbl at USD 99/bbl and 958,800 bbl at USD 113.1/bbl).
3. Purchase 239,700 bbl of crude oil futures contracts expiring on 15 June 20X7 at USD 113.7 per barrel.

The accounting entries to record the sale of the crude oil futures expiring on 15 December 20X5 were as follows (in reality, due to the daily margining mechanism, any daily gain/loss was realised by adjusting the margin amount posted by ABC at the exchange, but to keep the calculations simple I have assumed a lump-sum receipt from the ICE on 30 June 20X5):

The new 3-month jet fuel swap and the newly purchased futures contracts remained off the balance sheet as I assume they were traded at market rates (i.e., their initial fair value was nil).

Following the execution of the rollover strategy the outstanding hedging instruments as of 30 June 20X5 were as follows:

Hedging instrument	Notional	Price	Expiry date
Jet fuel swap	300,000 tonnes	USD 900/tonne	30-Sep-X5
Jet fuel swap	300,000 tonnes	USD 1,023/tonne	31-Dec-X5
Crude oil futures	1,198,500 bbl	USD 98.3/bbl	15-Mar-X6
Crude oil futures	1,198,500 bbl	USD 98.6/bbl	15-Jun-X6
Crude oil futures	1,198,500 bbl	USD 110.3/bbl	15-Sep-X6
Crude oil futures	239,700 bbl	USD 99.3/bbl	15-Dec-X6
Crude oil futures	239,700 bbl	USD 99.7/bbl	15-Mar-X7
Crude oil futures	239,700 bbl	USD 113.7/bbl	15-Jun-X7

Additionally on 30 June 20X5, ABC had to recalculate the hedge ratio, using a process similar to that of 1 April 20X5.

The fair valuations and accounting entries on the subsequent reporting dates followed a similar process and have been omitted to avoid unnecessary repetition.

11.9.7 Concluding Remarks

In this case, the benchmark variables used to set the purchased jet fuel price and that of the jet fuel swap were identical – the CIF NWE/Basis ARA jet fuel price. It is not uncommon for European airlines to purchase jet fuel at prices linked to variables (e.g., NWE barges FOB Rotterdam jet fuel price) different from that of the hedging instrument. For example, some airports price relative to a CIF benchmark price (which excludes transport costs), whereas other airports rely on a FOB benchmark price (which includes transport costs). Having different benchmark variables would mean that the hypothetical derivative was different from the hedging instrument, bringing another layer of operational complexity.

Similarly, while jet fuel was a standardised product not dependent on which particular crude oil was processed by a particular refinery, the benchmark jet fuel crack spread derivatives market in the geographical area in which ABC operated was indexed to Brent crude oil. Moreover, ABC operated in a geographical area in which Brent was the crude oil benchmark. This meant that if, for example, ABC used crude oil futures based on WTI crude oil as the hedging instrument of the crude oil component, changes in the price differential between Brent crude oil and WTI crude oil would cause hedge ineffectiveness. In other words, the hypothetical derivative would be linked to Brent crude oil, while the hedging instrument would be linked to WTI crude oil.