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What is net investment hedge?
It is a specific type of foreign currency cash flow hedge used to reduce or eliminate risk arises to foreign currency of an entity’s net investment in a foreign operation. In other words, it is the hedge designed to remove entity’s changes in net investment value to foreign investment in a foreign operation. That foreign operation occurs due to change in foreign exchange rates between local currency of foreign investee and reporting currency of investor.
The hedging instrument in his hedge can be derivative, non-derivatives or a combination of both. Derivatives like foreign exchange forward contract and non-derivative like foreign currency denominated debt instruments.
Derivative financial instruments are considered as net investment hedge as a part of cumulative transaction agreement, effective proportions of profit or loss (hedging instrument) are entered in accumulated comprehensive income and ineffective portions are entered in other expenses during period of change.
If derivative hedging instrument is used, then
- Effective change in fair value is identified in equity.
- Ineffective portion is identified in profit or loss.
If non-derivative instrument is used, then gain or loss in foreign currency translation is identified in equity.
Net investment hedge can be explained by simple diagram as follows
a) Measurement of derivative, b) Recognition and c) net investment in foreign operation.
Net investment hedge in foreign operations
Overseas equity investment (subsidiary, joint venture or associate) is hedged by derivative or non-derivative contract. It comes under IAS21
Other comprehensive income (OCI) − effective portion of foreign currency Gain/loss on hedging instrument
Profit/loss − ineffective portion
When disposed of cumulative Gains/Loss in OCI shall be recognized as part of Profit/Loss (on disposal)
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