2.1.1 Derivative Definition

Under IFRS 9, a derivative is a financial instrument (or other contract within the scope of IFRS 9) with all of the following characteristics:

1. Its value changes in response to changes in a specified “underlying” interest rate, financial instrument price, commodity price, foreign exchange (FX) rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.
2. It requires no initial investment, or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
3. It is settled at a future date.

Some commodity-based derivatives are not considered derivatives under IFRS 9. See Chapter 10 for a detailed discussion regarding which commodity contracts can be treated as IFRS 9 instruments.

2.1.2 Hedge Accounting

The objective of hedge accounting is to represent, in the financial statements, the effect of an entity's risk management activities that use financial instruments to manage market risk exposures that could affect profit or loss (or OCI in the case of equity investments at FVOCI).

2.1.3 Accounting for Derivatives

I mentioned earlier that all derivatives are recognised at fair value on the balance sheet, no matter whether or not they are part of a hedge accounting relationship. Fluctuations in the derivative's fair value can be recognised in different ways, depending on the type of hedging relationship:

• undesignated or speculative;
• fair value hedge;
• cash flow hedge;
• net investment hedge.

2.1.4 Undesignated or Speculative

Some derivatives are termed “undesignated” or “speculative”. They include derivatives that do not qualify for hedge accounting. They also include derivatives that the entity may decide to treat as undesignated even though they could qualify for hedge accounting. These derivatives are recognised as assets or liabilities for trading. The gain or loss arising from their fair value fluctuation is recognised directly in profit or loss.

2.2.1 Fair Value Hedge

The objective of the fair value hedge is to reduce the exposure to changes in the fair value of an asset or liability already recognised in the balance sheet, or a previously unrecognised firm commitment (or a component of any such item), that is attributable to a particular risk and could affect reported profit or loss. Therefore, the aim of the fair value hedge is to offset in profit or loss the change in fair value of the hedged item with the change in fair value of the hedging instrument (e.g., a derivative). See Figure 2.1.

If the hedged item is an equity instrument designated at FVOCI, the hedged exposure must be one that could affect OCI.

The recognition of the hedging instrument is as follows:

• Losses or gains from remeasuring the hedging instrument at fair value are recognised in profit or loss (or in OCI, including hedge ineffectiveness, if the hedged item is an equity instrument classified at FVOCI).
• If the hedging instrument is a non-derivative hedging the foreign currency risk component of a hedged item, the amount recognised in profit or loss related to the hedging instrument is the gain or loss from remeasuring, in accordance with IAS 21, the foreign currency component of its carrying amount.

The recognition of the hedged item is as follows:

• If the hedged item is measured at amortised cost or a debt instrument at FVOCI, the hedging gain or loss on the hedged item adjusts the carrying amount of the hedged item (if applicable) and is recognised in profit or loss. The adjustment of the carrying amount is amortised to profit or loss. Amortisation may begin as soon as an adjustment exists and shall begin no later than when the hedged item ceases to be adjusted for hedging gains and losses. In theory the amortisation is based on a recalculation of the effective interest rate for the hedged item. In practice, to ease the administrative burden of amortising the adjustment while the hedged item continues to be adjusted for changes in fair value attributable to the hedged risk, it may be easier to defer amortising the adjustment until the hedged item ceases to be adjusted for the designated hedged risk. An entity must apply the same amortisation policy for all of its debt instruments. In other words, an entity cannot defer amortising on some items and not on others.
• If the hedged item is an equity instrument at FVOCI, the hedging gain or loss on the hedged item shall remain in OCI.
• If the hedged item is an unrecognised firm commitment (or a component thereof), the subsequent cumulative change in the fair value of the unrecognised firm commitment attributable to the hedged risk is recognised as an asset or a liability with a corresponding gain or loss recognised in profit or loss. If the firm commitment is to acquire an asset or assume a liability, the initial carrying amount of the asset or liability that results from the entity meeting the firm commitment is adjusted to include the cumulative change in the fair value of the commitment attributable to the hedged risk that was recognised in the statement of financial position.

A hedge of the FX risk of a firm commitment may be accounted for as a fair value hedge or a cash flow hedge.

2.2.2 Cash Flow Hedge

A cash flow hedge is a hedge of the exposure to variability in cash flows that:

• is attributable to a particular risk associated with all, or a component, of a recognised asset or liability (such as all or some future interest payments on variable rate debt), or a highly probable forecast transaction; and
• could affect reported profit or loss.

A hedge of the FX risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge.

Effective and Ineffective Parts

The change in the hedging instrument fair value is split into two components (see Figure 2.2): an effective and an ineffective part.

The effective part represents the portion that is offset by a change in fair value of the hedged item and is calculated as the lower of the following (in absolute amounts):

• the cumulative gain or loss on the hedging instrument from inception of the hedge; and
• the cumulative change in fair value (present value) of the hedged item (i.e., the present value of the cumulative change in the hedged expected future cash flows) from inception of the hedge.

The ineffective part represents the hedge ineffectiveness, or in other words, the portion of the change in fair value of the hedging instrument that has not been offset by a change in fair value of the hedged item. It is calculated as the difference between the cumulative change in fair value of the hedging instrument and its effective part.

The ineffective part includes specific components excluded, as documented in the entity's risk management strategy, from the assessment of hedge effectiveness. Common sources of ineffectiveness for a cash flow hedge are (i) the time value of an option or the forward points of a forward or the foreign currency basis spread included in the hedging relationship (this situation is quite unusual as commonly these elements are excluded from the hedging relationship), (ii) structured derivative features embedded in the hedging instrument, (iii) changes in timing of the highly probable forecast transaction, (iv) credit/debit valuation adjustments and (v) differences between the risk being hedged and the underlying of the hedging instrument.

Accounting Recognition of the Effective and Ineffective Parts

The recognition of the change in fair value of the hedging instrument is as follows:

• The effective portion of the gain or loss on the hedging instrument is recognised directly in a separate reserve in OCI –the “cash flow hedge reserve”.
• The ineffective portion of the fair value movement on the hedging instrument is recorded immediately in profit or loss.

The amount that has been accumulated in the cash flow hedge reserve of OCI is reclassified, or “recycled”, as follows (see Figure 2.3):

• If the hedged item is a forecast transaction that will result in the recognition of a non-financial asset or non-financial liability (e.g., a purchase of raw material or inventory), or a firm commitment, the entity removes the amount from the cash flow hedge reserve and includes it directly in the initial cost or other carrying amount of the asset or the liability (e.g., within “inventories”).
• For cash flow hedges other than those covered in the previous paragraph, the amount that has been accumulated in the cash flow hedge reserve of OCI is reclassified to profit or loss in the same period or periods during which the hedged expected future cash flows affect profit or loss, therefore offsetting to the extent that the hedge is effective. For example, if the hedged item is a variable rate borrowing, the reclassification to profit or loss is recognised in profit or loss within “finance costs”, therefore offsetting the borrowing's interest cost. To take another example, if the hedged item is an export sale, the reclassification to profit or loss is recognised in the profit or loss statement within “sales”, therefore adjusting the revenue amount.
• If the amount accumulated in the cash flow hedge reserve of OCI is a loss and the entity expects that all or a portion of that loss will not be recovered in one or more future periods, it immediately reclassifies the amount that is not expected to be recovered into profit or loss in the same way as in the previous paragraph.

2.2.3 Net Investment Hedge

A net investment hedge, or hedge of a net investment in a foreign operation, is a hedge of the foreign currency exposure arising from the reporting entity's interest in the net assets of a foreign operation. The hedging instrument may be either a derivative or a non-derivative financial instrument (e.g., a borrowing denominated in the same currency as the net investment). Figure 2.4 highlights the accounting treatment of net investment hedges.

• The effective portion of the gain or loss on the hedging instrument is recognised in the “foreign currency translation reserve” of OCI. As the exchange difference arising on the net investment is also recognised in OCI, the objective is to match both exchange rate differences.
• The ineffective portion of the gain or loss on the hedging instrument is recognised immediately in profit or loss.
• On disposal (or partial disposal) or liquidation of the foreign operation, the cumulative balance in the foreign currency translation reserve of OCI related to its hedge and its related net investment exchange differences are simultaneously transferred from OCI to profit or loss.

2.3.1 Hedged Item Candidates

The following can be designated as hedged items:

• A recognised asset or liability (or a component thereof).
• An unrecognised firm commitment (or a component thereof). A firm commitment is a legally binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.
• A highly probable forecast transaction (or a component thereof). A forecast transaction is an anticipated transaction that is not yet legally committed.
• A net investment in a foreign operation (on a consolidated basis only).
• A group of the above items.
• An aggregated exposure that is a combination of an exposure that could qualify as a hedged item and a derivative, if the aggregated exposure creates a different aggregated exposure that is managed as one exposure for a particular risk (or risks). For example, a utility with the EUR as functional currency may designate as hedged item the combination of highly probable crude oil purchases and USD-denominated crude oil futures (i.e., a string of fixed amounts of EUR–USD FX risk). The items that constitute the aggregated exposure remain accounted for separately.
• The FX risk component of an intragroup monetary item (e.g., a payable/receivable between two subsidiaries) in the consolidated financial statements if it results in an exposure to FX rate gains or losses that are not fully eliminated on consolidation in accordance with IAS 21 (i.e., when the intragroup monetary item is transacted between two group entities that have different functional currencies).
• The FX risk component of a highly probable forecast intragroup transaction in the consolidated financial statements provided that the transaction is denominated in a currency other than the functional currency of the entity entering into that transaction and the foreign currency risk will affect consolidated profit or loss. For this purpose an entity can be a parent, subsidiary, associate, joint arrangement or branch. The relevant period or periods during which the FX risk of the hedged transaction affects profit or loss is when it affects consolidated profit or loss.

2.3.2 Forecast Transaction versus Firm Commitment

Commonly, a transaction before becoming a firm commitment is a forecast transaction. A forecast transaction itself typically is expected to occur before it becomes highly expected to occur, as shown in Figure 2.5.

• A forecast transaction is an anticipated transaction that is not yet legally committed. In assessing “highly probable” the entity must consider, among other things, the frequency of similar past transactions.
• A firm commitment is a legally binding agreement for the exchange of a specified quantity of resources at a specified price on a specified future date or dates.

2.6.1 Qualifying Criteria for Hedge Accounting

To qualify for hedge accounting, there are three requirements that a hedging relationship must meet (see Figure 2.6):

1. The hedging relationship consists only of eligible hedging instruments and eligible hedged items.
2. At the inception of the hedging relationship there is formal designation and documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge. That documentation shall include identification of the hedging instrument, the hedged item, the nature of the risk being hedged and how the entity will assess whether the hedging relationship meets the hedge effectiveness requirements (including its analysis of the sources of hedge ineffectiveness and how it determines the hedge ratio).
3. The hedging relationship meets all three hedge effectiveness requirements.

The three hedge effectiveness requirements are as follows:

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 weightings of the hedged item and the hedging instrument (i.e., the hedge ratio of the hedging relationship) are the same as those resulting from the quantity of the 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. However, that designation shall not reflect an imbalance between the weightings of the hedged item and the hedging instrument that would create hedge ineffectiveness (irrespective of whether recognised or not) that could result in an accounting outcome that would be inconsistent with the purpose of hedge accounting.

The first effectiveness requirement means that the hedging instrument and the hedged item must be expected to move in opposite directions as a result of a change in the hedged risk (i.e., there is an economic relationship and not just statistical correlation). For example, it would be possible to hedge a West Texas Intermediate (WTI) crude oil exposure using a Brent crude oil forward instrument. A perfect correlation between the hedged item and the hedging instrument is not required and, indeed, would not be sufficient on its own.

The second requirement indicates that the impact of changes in credit risk should not be of a magnitude such that it dominates the value changes, even if there is an economic relationship between the hedged item and hedging derivative. This implies that when the creditworthiness of the entity or the counterparty to the hedging instrument notably deteriorates, the hedging relationship may not qualify for hedge accounting going forward because the change in the credit risk may be the largest factor affecting the hedging instrument's fair value change.

The third requirement indicates that the actual hedge ratio used for accounting should be the same as that used for risk management purposes, unless the ratio is inconsistent with the purpose of hedge accounting. IFRS 9 tries to avoid deliberate underhedging, either to minimise recognition of ineffectiveness in cash flow hedges or the creation of additional fair value adjustments to the hedged item in fair value hedges.

2.6.2 Hedge Ratio

IFRS 9 does not define the term hedge ratio, but I have assumed throughout this book that it is the designated amount (i.e., notional) of the hedged item compared with the designated amount (i.e., notional) of the hedging instrument within the hedging relationship (alternatively, it may be defined the other way around).

In most simple hedges, where the underlyings of the hedging instrument and the hedged item match, the hedge ratio is 1:1. For example, a highly probable forecast sale denominated in USD of an entity whose functional currency is the EUR hedged with a EUR–USD FX forward will result in a 1:1 hedge ratio.

In other hedging relationships the hedge ratio may differ from 1:1, especially where the underlyings of the hedged item and the hedging instrument differ. This is the case where there is an underlying for which its market is notably more liquid than that of the hedged item underlying, and both underlyings are highly correlated (a “proxy hedge”). For example, an entity whose functional currency is the EUR may decide to hedge a highly probable forecast sale denominated in Norwegian krone (NOK) with a more liquid Swedish krona (SEK) proxy: a SEK–EUR FX option. The entity may decide that 1 NOK is best hedged with 0.94 SEK, and as a result, the hedge ratio is set at 1:0.94. Such an assessment is usually made by considering historical and current market data for the hedged item and hedging instrument where possible, taking into account their relative performance in the past.

2.6.3 Effectiveness Assessment

Periodically the entity shall assess whether the hedging relationship meets the hedge effectiveness requirements – hedge effectiveness assessment. This assessment is probably the most operationally challenging aspect of applying hedge accounting. At a minimum, whichever comes first, IFRS 9 requires that hedge effectiveness be evaluated (see Figure 2.7):

• at the inception of the hedge;
• at each reporting date, including interim financial statements; and
• upon a significant change in the circumstances affecting the hedge effectiveness requirements.

Each effectiveness assessment relates to future expectations about hedge effectiveness and is therefore only forward-looking.

2.6.4 Effectiveness Assessment Methods

One of the effectiveness requirements is that an economic relationship exists between the hedging instrument and the hedged item, or in other words, that the hedging instrument and the hedged item have values that will generally move in opposite directions. IFRS 9 does not specify a method for assessing whether an economic relationship exists between a hedging instrument and a hedged item. However, an entity shall use a method that captures the relevant characteristics of the hedging relationship, including its sources of hedge ineffectiveness.

IFRS 9 states that an entity's risk management is the main source of information to perform the assessment of whether a hedging relationship meets the hedge effectiveness requirements. This means that the management information (or analysis) used for decision-making purposes can constitute a basis for assessing whether a hedging relationship meets the hedge effectiveness requirements.

The effectiveness requirement of an existence of an economic relationship between the hedged item and the hedging instrument (the “economic relationship requirement”) is commonly assessed by applying one of the following methods:

• The critical terms method. This is a qualitative method (i.e., no numerical analysis is performed).
• The simple scenario analysis method: assessing how the hedging relationship would behave under various future scenarios. This is a quantitative method.
• The linear regression method: assessing, using historical information, how the hedging relationship would have behaved if it had been entered into in the past. This is a quantitative method.
• The Monte Carlo simulation method: assessing how the hedging relationship would behave under a large number of future scenarios. This is a quantitative method.

IFRS 9 requires an entity to specify at hedge inception, in the hedge documentation, the method it will apply to assess the hedge effectiveness requirements and to apply that method consistently during the life of the hedging relationship. The method chosen by the entity has to be applied consistently to all similar hedges unless different methods are explicitly justified.

If there are changes in circumstances that affect hedge effectiveness, an entity may have to change the method for assessing whether a hedging relationship meets the hedge effectiveness requirements in order to ensure that the relevant characteristics of the hedging relationship, including the sources of hedge ineffectiveness, are still captured.

A quantitative method may also be used to assess whether the hedge ratio used for designating the hedging relationship meets the hedge effectiveness requirements. An entity can use the same method as that used to assess the economic relationship requirement, or a different method.

2.6.5 The Critical Terms Method

The critical terms method is the simplest way to assess whether the economic relationship requirement is met. Under IFRS 9, an entity may conclude that there is an economic relationship between the hedged item and the hedging instrument if the critical terms of the hedged item and hedging instrument match or are closely aligned. At a minimum, the following critical terms must be the same or closely aligned:

• the notional amounts;
• the maturity and interim periods (e.g., interest periods); and
• the underlying (e.g., Euribor 3-month rate).

This conclusion is valid while the credit risk associated with the entity or the counterparty to the hedging instrument is considered to be very low.

2.6.6 The Simple Scenario Analysis Method

The simple scenario analysis method is the simplest quantitative method to assess whether a hedging relationship meets the economic relationship requirement. The goal of this method is to reveal the behaviour of changes in fair value of both the hedging item and the hedging instrument under specific scenarios.

Normally a few scenarios (e.g., four) are simulated. Each scenario assumes that the underlying risk being hedged will move in a specific way over a certain period of time. The main drawback of the scenario analysis method is the subjectivity in selecting the scenarios. The scenarios chosen may not be followed by the underlying hedged risk once the hedge is in place, and therefore the conclusions of the analysis may not depict the realistically expected behaviour of the hedge. As a result, this method is used to assess hedging relationships in which the critical terms method cannot be used but it is quite clear that the changes in fair value of the hedge item and hedging instrument will almost fully offset each other.

For example, assume that an entity, with the EUR as its functional currency, enters into a 12-month GBP–EUR FX forward with a forward rate of 0.8015 to hedge a highly expected GBP-denominated sale expected to occur in 15 months. The spot rate was 0.8000 at the time. The significantly different maturities of the hedged item (15 months) and the hedging instrument (12 months) make the use of the critical terms method inappropriate. However, the entity concludes that a scenario analysis captures the relevant characteristics of the hedging relationship. The economic relationship requirement can be assessed under the following three scenarios:

1. a two-standard deviation depreciation of the GBP relative to the EUR during the next 12 months;
2. an unchanged 0.80 spot rate in 12 months' time;
3. a two-standard-deviation appreciation of the GBP relative to the EUR during the next 12 months.

Establishing the FX Rate of a Scenario

At the moment of the analysis, a currency pair is trading at its spot rate. However, it is impossible to know with certainty what would be the FX spot rate at the end of the analysis horizon. Assuming a normal distribution of FX rate, it is possible to calculate a range in which, with a specific probability, the FX rate is expected to be on a specific date in the future. The boundaries of the range can be calculated according to the following formula:

where:

1. σ is the standard deviation. Normally, σ is set at the volatility of an option with strike at-the-money forward with term coinciding with the analysis horizon and a currency pair coinciding with that of the hedge item.
2. N is the number of standard deviations. Figures based on a 95% confidence interval of require N = 1 and N = –1. For a 99% confidence interval, N = 2 and N = –2 are used.
3. T is the number of years elapsed from the current date to the end of the analysis horizon.

In our example, assuming a 12% volatility of the GBP–EUR FX rate, the FX spot rates at the end of the 12-month period would be:

• under the first scenario, 1.0170 (=0.8000 × exp(2 × 12% × 1));
• under the second scenario, 0.8000;
• under the third scenario, 0.6293 (=0.8000 × exp(–2 × 12% × 1)).

The movements under the first and third scenario are very large . The entity expected the GBP–EUR FX rate to be between 0.8293 and 1.0170 with a 99% probability.

2.6.7 The Regression Analysis Method

The regression analysis method is typically applied when a proxy hedge is used (i.e., when the underlying of the hedged item and that of the hedging instrument differ). The idea is to analyse the behaviour of the hedging relationship using historical market rates. Regression analysis is a statistical technique that assesses the level of correlation between one variable (the dependent variable) and one or more other variables (known as the independent variables). In the context of hedge effectiveness testing, the primary objective is to determine whether changes in the fair value of the hedged item and the hedging instrument attributable to a particular risk were highly correlated in the past, and thus supportive of the assertion that there will be a high degree of offset in changes in the fair value of the hedged item and the hedging instrument in the future. The regression analysis is a process that can be divided into three major steps, as shown in Figure 2.8.

The first step in the regression analysis is to obtain the inputs to the analysis: the X and Y observations. Figure 2.9 outlines this process. This step is quite complex and requires a computer program (e.g., Microsoft Excel) to perform it. The idea is to go back to a specific date (the simulation period start date), assume that the hedging relationship started on that date and observe the behaviour of the hedging relationship using the historical market data of the simulation period. The simulation period ends on a date such that the term of the simulation is equal to the term of the actual hedge. This process is repeated several times.

The second step of the regression analysis is to plot the values of the X and Y variables and to estimate a line of best fit. A pictorial representation of the variables in the standard regression equation is shown in Figure 2.10.

Regression analysis uses the “least squares” method to fit a line through the set of X and Y observations. This technique determines the slope and intercept of the line that minimises the size of the squared differences between the actual Y observations and the predicted Y values. The linear equation estimated is commonly expressed as:

where

1. X is the change in the fair value (or cash flow) of the hedging instrument attributable to the risk being hedged;
2. Y is the change in the fair value (or cash flow) of the hedged item attributable to the risk being hedged;
3. α is the intercept (where the line crosses the Y axis);
4. β is the slope of the line;
5. ε is the random error term.

The third step of the regression process is to interpret the statistical results of the regression and determine whether the regression suggests that there is an economic relationship between the hedged item and the hedging instrument. The following three statistics must achieve acceptable levels to provide sufficient evidence for such a conclusion:

• R-squared, or the coefficient of determination, measures the degree of explanatory power or correlation between the dependent and the independent variables in a regression. R-squared indicates the proportion of variability in the dependent variable that can be explained by variation in the independent variable. By way of illustration, an R-squared of 95% indicates that 95% of the movement in the dependent variable is “explained” by variation in the independent variable. R-squared can never exceed 100% as it is not possible to explain more than 100% of the movement in the independent variable. IFRS 9 does not provide a minimum reference R-squared level, but an R-squared greater than or equal to 80% may probably indicate a high correlation between the hedged item and the hedging instrument. In my view, and this is notably subjective opinion, an R-squared below 70% is likely to imply an absence of economic relationship between the hedged item and the hedging instrument. In any case, it is important to remember that a pure high correlation is not sufficient; there also has to be an economic justification for such a high correlation. Moreover, from a statistical perspective, R-squared by itself is an insufficient indicator of hedge performance.
• The slope β of the regression line. There is no bright line for the slope. Under the previous financial instruments accounting standard (IAS 39) the slope was required to be between –0.80 and –1.25. Judgement is required to decide whether a given slope means that the economic relationship requirement has been met. The slope can provide an indication of the appropriate hedge ratio.
• The t-statistic or F-statistic. These two statistics measure whether the regression results are statistically significant. The t-statistic or F-statistic must be compared to the relevant tables to determine statistical significance. A 95% or higher confidence level is generally accepted as appropriate for evaluating the statistical validity of the regression.

2.6.8 The Monte Carlo Simulation Method

One way to draw meaningful conclusions about an economic relationship assessment is to test the behaviour of the changes in fair value of both the hedging item and the hedging instrument under a very large number of scenarios of the underlying risk being hedged. For some highly structured products, the use of the scenario analysis method may miss a potential scenario that has a substantial effect in the hedging instrument's payout. Monte Carlo simulation is a tool that provides multiple scenarios by repeatedly estimating hundreds of different paths of the risk being hedged, based on the probability distribution of the risk. In my view, a well-performed Monte Carlo simulation can be very effective in assessing hedge effectiveness when the payout of the hedging instrument is highly dependent on the behaviour of the underlying risk during the life of the instrument.

2.6.9 Suggestions Regarding the Assessment Methods

The entity shall use the method that captures the relevant characteristics of the hedging relationship, including the sources of hedge ineffectiveness. What follows is just my own personal recommendation (remember that an entity's external auditors always have the last word) regarding which method to use (see Figure 2.11):

• Use the critical terms method when the critical terms of the hedged item and the hedging instrument perfectly match. Remember, the critical term method is a qualitative assessment and therefore relatively simple to document.
• Use the critical terms method coupled with a single scenario analysis when there is a slight mismatch between the critical terms of the hedged item and the hedging instrument – for example, where there is a relatively short time lag between the interest periods of a swap and those of a hedged loan.
• Use the scenario analysis method when there is a mismatch in dates or notionals of the hedged item and the hedging instrument, and the latter is a vanilla hedging instrument (e.g., a swap, a forward, a standard option).
• Use the regression analysis method when there is a mismatch in underlyings of the hedged item and the hedging instrument (i.e., a proxy hedge has been used), and this instrument is a vanilla hedging instrument (e.g., a swap, a forward, a standard option).
• Use the Monte Carlo simulation method when the hedging instrument is complex and/or when its payout is highly dependent on the behaviour of the underlying risk during the life of the instrument (e.g., a range accrual with knock-out barriers).

2.8.1 Accounting for Rebalancings

Rebalancing is accounted for as a continuation of the hedging relationship. On rebalancing, the hedge ineffectiveness of the hedging relationship is determined and recognised immediately before adjusting the hedging relationship.

Risk Management Strategy versus Risk Management Objective

It is important to distinguish between risk management strategy and risk management objective. A risk management strategy is established at the highest level at which an entity determines how it manages its risk. This strategy is normally set out in a general document identifying the risks to which the entity is exposed and setting out how the entity responds to them, and may include some flexibility to react to changes in circumstances that occur while that strategy is in place (e.g., different interest rate or commodity price levels that result in a different extent of hedging). This document is commonly cascaded down through the entity by way of policies containing more specific guidelines.

In contrast, the risk management objective for a hedging relationship applies at the level of a particular hedging relationship. It relates to how the particular hedging instrument that has been designated is used to hedge the particular exposure that has been designated as the hedged item. Hence, a risk management strategy can involve many different hedging relationships whose risk management objectives relate to executing that overall risk management strategy. Thus, a risk management objective may change while its related risk management strategy remains unchanged.

The discontinuation of hedge accounting can affect:

• a hedging relationship in its entirety; or
• a part of a hedging relationship (which means that hedge accounting continues for the remainder of the hedging relationship, or in other words, when only a part of the hedging relationship ceases to meet the qualifying criteria).

A hedging relationship is discontinued in its entirety when as a whole it ceases to meet the qualifying criteria. For example:

• The hedging relationship no longer meets the risk management objective on the basis of which it qualified for hedge accounting (i.e., the entity no longer pursues that risk management objective); or
• The hedging instrument or instruments have been sold or terminated (regarding the entire volume that was part of the hedging relationship). It is not a termination or expiration if the hedging instrument is replaced or rolled over into another hedging instrument, if such replacement or roll-over is part of the entity's documented hedging strategy; or
• There is no longer an economic relationship between the hedged item and the hedging instrument or the effect of credit risk starts dominating the value changes that result from that economic relationship.
• The hedged item ceases to exist if either (i) the recognised hedged item matures, is sold or terminated, or (ii) the forecast transaction is no longer highly probable.

A part of a hedging relationship is discontinued (and hedge accounting continues for its remainder) when only a part of the hedging relationship ceases to meet the qualifying criteria. For example:

• On rebalancing of the hedging relationship, the hedge ratio might be adjusted by decreasing the volume of the hedged item that is part of the hedging relationship; hence, hedge accounting is discontinued only for the volume of the hedged item that is no longer part of the hedging relationship; or
• When the occurrence of some of the volume of the hedged item that is (or is a component of) a forecast transaction is no longer highly probable, hedge accounting is discontinued only for the volume of the hedged item whose occurrence is no longer highly probable. However, if an entity has a history of having designated hedges of forecast transactions and having subsequently determined that the forecast transactions are no longer expected to occur, the entity's ability to predict forecast transactions accurately is called into question when predicting similar future forecast transactions. This affects the assessment of whether similar forecast transactions are highly probable and hence whether they are eligible as hedged items.

An entity can designate a new hedging relationship that involves the hedging instrument or hedged item of a previous hedging relationship for which hedge accounting was (in part or in its entirety) discontinued. This does not constitute a continuation of a hedging relationship but is a restart. For example:

• A hedging instrument experiences such a severe credit deterioration that the entity replaces it with a new hedging instrument. This means that the original hedging relationship failed to achieve the risk management objective and is hence discontinued in its entirety. The new hedging instrument is designated as the hedge of the same exposure that was hedged previously and forms a new hedging relationship. Hence, the changes in the fair value or the cash flows of the hedged item are measured starting from, and by reference to, the date of designation of the new hedging relationship instead of the date on which the original hedging relationship was designated.
• Following rebalancing of a hedging relationship, the volume of the hedging instrument is reduced. The excess hedging instrument in that hedging relationship can be designated as the hedging instrument in another hedging relationship.

There are different accounting treatments depending upon the kind of hedge and the cause of discontinuance:

1. The hedging instrument of a cash flow hedge is terminated or sold. The hedging gains or losses that were previously recognised in equity remain in equity and are transferred to profit or loss when the hedged item is ultimately recognised in profit or loss.
2. The hedging instrument of a fair hedge is terminated or sold. There is no further fair valuing of the hedged item. Any previous adjustments to the carrying amount of the hedged item are amortised over the remaining maturity of the hedged item.
3. The fair value hedge fails the hedge effectiveness requirements. Adjustments to the carrying amount of the hedged item previously recorded as of the last assessment (which met the hedge effectiveness requirements) remain part of the hedged item's carrying value. If the entity can demonstrate exactly when the assessment failed, it can record the change in the fair value of the hedged item up to the last moment the hedge met the effectiveness requirements. From this moment there is no further fair valuing of the hedged item. The adjustments to the carrying value of the hedged item to date are amortised over the life of the hedged item. When the hedged item is carried at amortised cost, the amortisation is performed by recalculating its effective interest rate.
4. The firm commitment to a fair value hedge is no longer firm or the fair value hedged item no longer exists. Any amounts recorded on the statement of financial position (i.e., balance sheet) related to the change in fair value of the hedged item are reversed out to profit or loss.
5. A cash flow hedge fails the hedge effectiveness requirements, but the hedged forecast transaction is still expected to occur. The hedging gains or losses that were previously recorded in equity as of the last assessment (which met the hedge effectiveness requirements) remain deferred and are transferred from the cash flow hedge reserve to profit or loss when the forecast transaction is ultimately recognised in profit or loss. If the entity can demonstrate exactly when the cash flow hedge failed the effectiveness requirements, it can record the change in fair value on the hedging instrument up to the last moment the requirements were met.
6. The forecasted transaction of a cash flow hedge is either no longer highly probable or no longer expected to take place. Two different treatments are possible: (i) if the forecasted transaction is no longer highly probable but it is still expected to occur, the cumulative hedge gains or losses that were previously recorded in equity remain deferred in equity until the hedged cash flow is recognised in profit or loss; or (ii) if the forecasted transaction is no longer expected to take place, the cumulative hedge gains or losses that had been deferred up to that point in equity are immediately reclassified to profit or loss.

In any type of termination, if any derivatives from the terminated hedges are still outstanding, then any subsequent change in the fair value of these derivatives should be recorded in profit or loss, unless they are designated as the hedging instrument in a new cash flow hedge hedging relationship.

The following table summarises the accounting treatment for some of the hedging discontinuation events:

2.10 OPTIONS AND HEDGE ACCOUNTING

2.10.1 Intrinsic Value versus Time Value

The total value of an option before expiry is the sum of two components: its intrinsic value and its time value.

• The intrinsic value is the value that an option would have if it were exercised immediately. The intrinsic value of an option can be calculated using either the spot rate or the forward rate. In the case of equity and FX options, the intrinsic value is usually calculated using spot prices/rates. In the case of interest rate options, the intrinsic value is commonly calculated using forward rates.
• The time value is any value of the option other than its intrinsic value. As a result, options that have zero intrinsic value are comprised entirely of time value.

The intrinsic value of a call option on a stock is calculated as follows:

• When the stock price is above the strike price, the call option is said to have intrinsic value. This is because, were the call to expire at that moment, there would be a positive cash payout (ignoring the effect of dividends).
• When the stock price is below or at the strike price, the call option is said to have no intrinsic value. This is because, were the call to expire at that moment, there would be no cash payout.

The intrinsic value of a put option on a stock is calculated as follows:

• When the stock price is below the strike price, the put is said to have intrinsic value. This is because, were the put to expire at that moment, there would be a positive cash payout.
• When the stock price is above or at the strike price, the put is said to have no intrinsic value. This is because, were the put to expire at that moment, there would be no cash payout (ignoring the effect of dividends).

The time value of an option is the portion of the value of an option that is due to the fact that it has some time to expiration. The time value of an option represents the possibility that the option may finish in-the-money or further in-the-money. The time value will progressively erode as the option approaches its expiration date. At expiry there will be no time value. The time value component is calculated as the difference between the total value of an option and its intrinsic value:

Figure 2.14 illustrates the intrinsic value and time value components of a call option on 1 million IBM shares, a USD 180 strike and 6 months to expiration (note that the y axis has not been graphed using a linear scale to better highlight the concepts). The total value of the option has been calculated using an option pricing model. For example, assuming IBM's spot price at USD 210, the total value of the call option would be USD 37 million. The intrinsic value would be USD 30 million (=1 million × (210 – 180)). Therefore, the option time value would be USD 7 million (=37 million – 30 million). The following table summarises the intrinsic value and time value components for three stock price scenarios:

Spot price	USD 150	USD 180	USD 210
Intrinsic value	0	0	USD 30 million
Time value	USD 4 million	USD 13 million	USD 7 million
Total value	USD 4 million	USD 13 million	USD 37 million

2.10.2 In-, At- or Out-of-the-Money

Options which have intrinsic value are described as being in-the-money. By the same reasoning, options which have no intrinsic value (e.g., in a call option, if the share price is below the strike price) are called out-of-the-money. If the option expires out-of-the-money, the holder will not exercise the option. An option is called at-the-money if the stock price (in the case of an equity option) is at the strike price.

Based on our previous call option on IBM with a strike price of USD 150:

At expiry, there will be no time value and there will be two different scenarios:

• the option expires in-the-money, resulting in a positive cash payout for the option buyer; or
• the option expires out-of-the-money, being worthless.

2.10.3 Accounting Treatment for the Time Value of Options

When an option is used in a hedging strategy and hedge accounting is applied, IFRS 9 gives entities two choices:

• To designate the option in its entirety as the hedging instrument. This is seldom chosen, unless the hedged item is an equity investment classified at FVOCI.
• To separate the option's intrinsic value and time value, and only designate the intrinsic value as the hedging instrument in the hedging relationship. The time value is, therefore, excluded from the hedging relationship. This is the alternative commonly chosen because it enhances hedge effectiveness as the option time value is not replicated in the hedged item.

Therefore, unless specifically stated, I will assume throughout this book that the second alternative is selected in hedging strategies involving options. The IFRS 9 accounting treatment of the time value of an option considers that the time value of an option at the start of a hedging relationship represents a premium for protection against risk (similar to paying a premium for insuring a risk).

The accounting of the time value for instruments other than equity investments can be viewed as a two-step process (relatively similar to the mechanics of cash flow hedge accounting, as shown in Figure 2.15).

2.10.4 Example of Option Hedging a Transaction Related Item – Actual Time Value Exceeding Aligned Time Value

Imagine that on 1-Jan-X1 an entity bought a 3-year out-of-the-money option for an up-front premium of 14 million (i.e., the fair value of the option's time value component was 14 million). The option hedged a highly expected forecast purchase of natural gas expected to be received on 31-Dec-X3. The intrinsic value of the purchased option was designated as hedging instrument in a hedging relationship that started on 1-Jan-20X1. As a result, the option's time value was excluded from the hedging relationship. Suppose that at the start of the hedging relationship (hedge inception), the entity estimated that the time value of an option that replicated the main terms of the hedged item (i.e., the aligned time value) was 12 million. Suppose further that the time values at each relevant date were as portrayed in the following table:

Because at hedge inception, the actual time value was higher than the aligned time value, the amount that was subsequently recognised in OCI was determined only on the basis of the aligned time value.

On 31-Dec-X1 the change in aligned time value since hedge inception was a 3 million loss (=9 mn – 12 mn). Therefore, a 3 million loss was recognised in OCI. The change in actual time value since hedge inception was a loss of 2 million (=12 mn – 14 mn). The difference between both changes, a gain of 1 million (= <2 mn> – <3 mn>), was recognised in profit or loss.

On 31-Dec-X2 the change in aligned time value during the period was a 2 million loss (=7 mn – 9 mn). Therefore, a 2 million loss was recognised in OCI. The change in actual time value during the period was a loss of 7 million (=5 mn – 12 mn). The difference between both changes, a loss of 5 million (= <7 mn> – <2 mn>), was recognised in profit or loss.

On 31-Dec-X3 the change in aligned time value during the period was a 7 million loss (=0 – 7 mn). Therefore, a 7 million loss was recognised in OCI. The change in actual time value during the period was a loss of 5 million (=0 – 5 mn). The difference between both changes, a gain of 2 million (= <5 mn> – <7 mn>), was recognised in profit or loss.

Also on 31-Dec-X3 the natural gas was purchased and the amount accumulated in OCI, a negative 12 million (corresponding to the aligned time value at hedge inception) was reclassified, adjusting the initial carrying value of the natural gas. In other words, the value of the bought natural gas was increased by 12 million on the entity's statement of financial position.

The following table shows the amounts being recognised in OCI and in profit or loss at each relevant period and the carrying value of the options time value reserve of OCI:

Figure 2.16 depicts the effects in the entity's statement of financial position. The carrying amount of the natural gas purchased was increased by the amount of aligned time value at hedge inception (i.e., 12 million). This amount was recycled from the options time value reserve of OCI. Therefore, just prior to that reclassification, the carrying value of the options time value reserve of OCI was <12 million>, the aligned time value at hedge inception. The amount recognised in profit or loss since hedge inception was a 2 million loss, the difference, at hedge inception, between the aligned time value and the actual time value.

2.10.5 Example of Option Hedging a Transaction Related Item – Actual Time Value Lower Than Aligned Time Value

Imagine the situation described in the previous example, but with time values at each relevant date as portrayed in the following table:

Because at hedge inception the actual time value was lower than the aligned time value, the amount that was subsequently recognised in OCI was determined by the lower of the cumulative change of the aligned time value and that of the actual time value. Any remainder of the change of the actual time value was recognised in profit or loss.

On 31-Dec-X1 the cumulative change in actual time value since hedge inception was a 1 million loss (=10 mn – 11 mn). On that date, the cumulative change in aligned time value since hedge inception was a 3 million loss (=9 mn – 12 mn). The lower of these amounts (ignoring their signs) was a 1 million loss. Therefore, a 1 million loss was recognised in OCI. The change in actual time value since hedge inception was a loss of 1 million (=10 mn – 11 mn), and since this amount would be fully recognised in OCI, no amount remained to be recognised in profit or loss.

On 31-Dec-X2 the cumulative change in actual time value since hedge inception was a 7 million loss (=4 mn – 11 mn). On that date, the cumulative change in aligned time value since hedge inception was a 5 million loss (=7 mn – 12 mn). The lower of these amounts (ignoring their signs) was a 5 million loss, to be recognised in OCI. As already a 1 million loss was recognised in OCI as of the previous reporting date, the amount to be recognised in OCI on 31-Dec-X2 was a 4 million loss. The change in actual time value during the period was a loss of 6 million (=4 mn – 10 mn), and since a 4 million loss would be recognised in OCI, a 2 million loss remained to be recognised in profit or loss.

On 31-Dec-X3 the cumulative change in actual time value since hedge inception was an 11 million loss (=0 – 11 mn). On that date, the cumulative change in aligned time value since hedge inception was a 12 million loss (=0 – 12 mn). The lower of these amounts (ignoring their signs) was an 11 million loss, to be recognised in OCI. As already a 5 million loss was recognised in OCI as of the previous reporting date, the amount to be recognised in OCI on 31-Dec-X3 was a 6 million loss. The change in actual time value during the period was a loss of 4 million (=0 – 4 mn), and since a 6 million loss would be recognised in OCI, a 2 million gain remained to be recognised in profit or loss.

Also on 31-Dec-X3 the natural gas was purchased and the amount accumulated in OCI, a negative 11 million was reclassified, adjusting the initial carrying value of the natural gas. In other words, the value of the bought natural gas was increased by 11 million on the entity's statement of financial position.

Figure 2.17 depicts the effects in the entity's statement of financial position. The carrying amount of the natural gas purchased was increased by the amount accumulated in OCI since hedge inception (i.e., 11 million). This amount was recycled from the options time value reserve of OCI. The amount recognised in profit or loss since hedge inception was nil, the difference between the actual time value at hedge inception (11 million) and the accumulated amount recognised in OCI (11 million as well). The fact that the amount accumulated in OCI coincided with the actual time value at hedge inception will not necessarily hold in all other instances. All that can be inferred is that the amount accumulated in OCI never exceeds the actual time value at hedge inception.

2.10.6 Example of Option Hedging a Time-Period Related Item – Actual Time Value Exceeding Aligned Time Value

Imagine that on 1-Jan-20X1 an entity bought a 3-year out-of-the-money option for an up-front premium of 14 million (i.e., the fair value of the option's time value component was 14 million). The option hedged the market value of a strategic quantity of natural gas stored by the entity with a view to selling it in 3 years' time (i.e., on 31-Dec-X3). The intrinsic value of the purchased option was designated as hedging instrument in a hedging relationship that started on 1-Jan-20X1. As a result, the option's time value was excluded from the hedging relationship. Suppose that at hedge inception the entity estimated that the time value of an option that replicated the main terms of the hedged item (i.e., the aligned time value) was 12 million. Suppose further that the time values at each relevant date were as portrayed in the following table:

The hedged item in this example was a time-period item: it was already in the entity's statement of financial position and the hedged protected its value over a specific period of time (3 years). Because at hedge inception the actual time value was higher than the aligned time value, the amount that was subsequently recognised in OCI was determined only on the basis of the aligned time value. As the hedged item was a time-period related item, the amount recognised in OCI was amortised through profit or loss. In our example, a linear amortisation of the aligned time value at hedge inception (12 million), which was the amount that would be recognised in OCI, over the hedging relationship's 3-year term implied a 4 million (=12 mn/3) annual amortisation.

On 31-Dec-X1 the change in aligned time value since hedge inception was a 3 million loss (=9 mn – 12 mn), representing a 1 million (= <3 mn> – <4 mn>) deficit relative to the 4 million annual amortisation amount. As a result, a 1 million gain was recognised in OCI. The period change in actual time value was a 2 million loss (=12 mn – 14 mn). The difference between (i) such change and (ii) the period change in aligned time value (i.e., 1 mn = <2 mn> – <3 mn>) was recognised in profit or loss, in addition to the amortisation amount. Therefore the total amount recognised in profit or loss on 31-Dec-X1 was a 3 million loss (= <4 mn> + 1 mn).

On 31-Dec-X2 the change in aligned time value during the period was a 2 million loss (=7 mn – 9 mn), representing a 2 million (= <2 mn> – <4 mn>) deficit relative to the 4 million annual amortisation amount. Therefore, a 2 million gain was recognised in OCI. The change in actual time value during the period was a loss of 7 million (=5 mn – 12 mn). The difference between (i) such change and (ii) the period change in aligned time value (i.e., <5 mn> = <7 mn> – <2 mn>) was recognised in profit or loss, in addition to the amortisation amount. Therefore the total amount recognised in profit or loss on 31-Dec-X2 was a 9 million loss (= <4 mn> + <5 mn>).

On 31-Dec-X3 the change in aligned time value during the period was a 7 million loss (=0 – 7 mn), representing a 3 million (= <7 mn> – <4 mn>) excess relative to the 4 million annual amortisation amount. Therefore, a 3 million loss was recognised in OCI. The change in actual time value during the period was a loss of 5 million (=0 – 5 mn). The difference between (i) such change and (ii) the period change in aligned time value (i.e., 2 mn = <5 mn> – <7 mn>) was recognised in profit or loss, in addition to the amortisation amount. Therefore the total amount recognised in profit or loss on 31-Dec-X3 was a 2 million loss (= <4 mn> + 2 mn).

Also on 31-Dec-X3, the natural gas was purchased. However, its carrying amount was not adjusted as a result of the option time value.

The following table shows the amounts being recognised in OCI and in profit or loss at each relevant period and the carrying value of the options time value reserve of OCI:

Figure 2.18 depicts the effects in the entity's statement of financial position. The option's time value had no effect on the carrying amount of the natural gas. The carrying amount of the time value reserve in OCI ended up being nil. The total amount recognised in profit or loss (14 million) corresponded to the actual time value at the start of the hedging relationship. In theory, through the amortisation such amount would have been gradually recorded in profit or loss over the 3 years. In practice, due to the significantly different behaviour of the actual time value relative to the aligned time value, the recognition in profit or loss notably differed from the targeted 4 million annual losses.

2.10.7 Example of Option Hedging a Time-Period Related Item – Actual Time Value Lower Than Aligned Time Value

Imagine the situation described in the previous example, but with time values at each relevant date as portrayed in the following table:

Because at hedge inception the actual time value was lower than the aligned time value, the amount that was subsequently recognised in OCI was determined by the lower of the cumulative change of the aligned time value and that of the actual time value. As the hedged item was a time-period related item, the actual time value at the date of designation, to the extent that it related to the hedged item, was amortised through profit or loss. The amortisation was performed on a systematic and rational basis over the period during which the option's intrinsic value could affect profit or loss in accordance with hedge accounting (i.e., 3 years in our case). Any remainder of the change of the actual time value was recognised in profit or loss. The entity decided to amortise the 11 million actual time value at hedge inception on a linear basis over the 3-year hedge horizon, resulting in a 3.7 million annual amortisation amount (3.6 million for the third year).

On 31-Dec-X1 the cumulative change in actual time value since hedge inception was a 1 million loss (=10 mn – 11 mn). On that date, the cumulative change in aligned time value since hedge inception was a 3 million loss (=9 mn – 12 mn). The lower of these amounts (ignoring their signs) was a 1 million loss. A <3.7 million> amortisation amount was recognised in profit or loss. The 2.7 million difference between those amounts (<1 million> and <3.7 million>) was recognised in OCI. No additional amounts were recorded in profit or loss.

On 31-Dec-X2 the cumulative change in actual time value since hedge inception was a 7 million loss (=4 mn – 11 mn). On that date, the cumulative change in aligned time value since hedge inception was a 5 million loss (=7 mn – 12 mn). The lower of these amounts (ignoring their signs) was a 5 million loss. A <3.7 million> amortisation amount would be recognised in profit or loss on 31-Dec-X2, bringing the cumulative amortisation figure to <7.4 million>. The 2.4 million difference between those amounts (<5 million> and <7.4 million>) became the target amount in OCI (i.e., the carrying value of the time value reserve in OCI after recording all the accounting entries on 31-Dec-X2). As already a 2.7 million amount was recognised in OCI as of the previous reporting date, the amount to be recognised in OCI on 31-Dec-X2 was <0.3 million> (=2.4 mn – 2.7 mn). The change in the actual time value during the period was <6 million>, of which <0.3 million> would be recognised in OCI and the remainder <5.7 million> would be recognised in profit or loss. The <5.7 million> amount in profit or loss was split between a <3.7 million> amortisation of the time value and an additional <2 million> representing the hedge's ineffective amount.

On 31-Dec-X3 the cumulative change in actual time value since hedge inception was an 11 million loss (=0 – 11 mn). On that date, the cumulative change in aligned time value since hedge inception was a 12 million loss (=0 – 12 mn). The lower of these amounts (ignoring their signs) was an 11 million loss. A <3.6 million> amortisation amount would be recognised in profit or loss on 31-Dec-X3, bringing the cumulative amortisation figure to <11 million>. The nil difference between those amounts (<11 million> and <11 million>) became the target amount in OCI (i.e., the carrying value of the time value reserve in OCI after recording all the accounting entries on 31-Dec-X3). As already 2.4 million was recognised in OCI as of the previous reporting date, the amount to be recognised in OCI on 31-Dec-X3 was <2.4 million> (=0 – 2.4 mn). The change in the actual time value during the period was <4 million>, of which <2.4 million> would be recognised in OCI and the remaining <1.6 million> would be recognised in profit or loss. The <1.6 million> amount in profit or loss was split between a <3.6 million> amortisation of the time value and an additional 2 million hedge ineffective amount.

2.10.8 Written Options

Whilst a written (i.e., sold) option on its own cannot be designated as hedging instrument in a hedging relationship, IFRS 9 permits a combination of purchased options and written options (e.g., in a tunnel or a collar) to be designated as a hedging instrument provided the following conditions are met:

• no net premium is received either at inception or over the life of the options; and
• it is designated as an offset to a purchased option, including one that is embedded in another financial instrument (e.g., a written call option used to hedge a callable liability).

The no net premium requirement may create illogical situations, as when an entity with a floating rate liability is interested in buying a collar (i.e., the combination of a cap and a floor). The entity initially buys only a cap and at a later date it sells a floor once floor options become more valuable. If at the start of the hedging relationship the premium of the floor was larger than the premium of the bought option, IFRS 9 forbids designating the collar as hedging instrument.

Another illogical situation is a collar (a combination of a purchased cap and a sold floor) that was part of a previous hedging relationship that has been discontinued, and that the entity wants to designate as hedging instrument in a new hedging relationship. The collar was zero cost when it was traded. If interest rates have declined since trade date, it is probable that on the date of designation of the new hedging relationship the floor sold would be worth more than the cap, resulting in a net written option, and thus invalidating the designation of the collar as a hedging instrument.