CFM16290 - Accounting for financial instruments: IAS 32 and IAS 39: examples of fair value hedges

Fair value hedges

A fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or liability, or a firm commitment to buy or sell an asset at a fixed price, that is attributable to a particular risk and could affect profit or loss.

Example 1

A company borrows £10 million at a fixed interest rate of 8%. Its cash flows will not change, however interest rates move – it will pay a fixed £800,000 interest a year – but the fair value of its liability will change as interest rates move. The liability will become more onerous if interest rates fall. It can hedge its exposure to fair value changes by entering into an interest rate swap, under which it receives fixed rate payments and pays floating rate.

Example 2

A chocolate manufacturer enters into a contract to buy 5,000 tonnes of cocoa beans in six months' time, at a fixed price. The company knows what its future cash flow will be. But the fair value of this firm commitment will change as the price of cocoa beans changes (even though the commitment won't be shown on the company's balance sheet). The company might hedge the changes in fair value by entering into a futures contract over cocoa beans.

Under IAS 39, it is necessary to be clear about the particular risk you are hedging. Suppose that, in the second example, the company (which accounts in sterling) had a contract to pay for the cocoa beans in US dollars. In addition to the commodity price risk, the company is exposed to foreign currency risk. Any hedge of the currency risk would need to be considered separately. (Fluctuations in exchange rates will affect both the fair value of the firm commitment, and the actual sterling amount the company must pay – so a hedge of the foreign currency risk could be accounted for either as a fair value hedge or a cash flow hedge).