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Explain the hedging instruments which are designated in IFRS 9
Changes in fair value or cash flows of designated financial instruments should offset the change in fair value/cash flow of designated hedged items. That instrument is called a hedging instrument.
Most oil companies need to hedge their exposure to energy prices which are volatile in nature. Choosing a suitable hedging instrument for the market is a hectic task. For a bearish environment, purchasing a put option is a superior strategy.
To determine which instrument suits you, first you need to determine at what time exposure is priced. After exposure is priced, then determine the choice of instrument based on region (American, Asian etc.).
If you pay at the beginning of the month, companies don’t want to hedge on the average monthly price (one of the reasons is the issue of potential cash flow) due to many reasons.
Additional questions like at what price you want to buy or sell are to be answered. And the most important thing is that the price fix for hedging strategy is to be determined.
International Financial Reporting Standards 9 (IFRS9)
To address accounting for financial instruments, the International Accounting Standards Board (IASB) published International Financial Reporting Standards 9 (IFRS 9). IFRS 9 covers classification, measurement (financial instruments), impairment (financial assets) and hedge accounting.
IFRS 9 came into effect on 1st Jan 2018 by replacing International Accounting Standards 39 (IAS 39). IAS 39 is complex and inconsistent in the way entities manage the business, risk and defer recognition of credit losses (on loans) and receivables.
Main changes in IFRS 9 are as follows −
- How to account for the time value of options.
- Interest element (forward contracts).
- Cross-currency swaps (currency basis).
According to International financial reporting standards 9 (IFRS 9) hedging instruments are designated as follows −
- Derivatives are designated as hedging instruments, which meet the criteria of hedge accounting except some written options.
- Non-derivative financial instruments are continued to be allowed for hedging only FX risk. Non-derivative financial instruments, measured at fair value through profit and loss are also allowed for hedging FX risk.
- Derivatives embedded (financial assets) are no longer accounted for separately. Derivatives embedded in financial liabilities or non-financial contracts are allowed to be accounted separately and designated as hedge instruments.
- Reclassification of profit and loss depends on the nature of the hedged item.
- For recognising the fair value changes of forward points, additional alternatives are introduced.
Currency basis spreads may be considered as a cost of hedge relationship, changes (if any) in them be able to be recognised through other comprehensive income.
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