Hedge ineffectiveness in uncertain times
Beyond its disastrous health impact on the world, the COVID-19 pandemic also brought many adverse secondary effects on businesses around the world. However, it would be short-sighted to designate COVID-19 as the sole culprit for all corporate woes. Other factors have also contributed to these adversities.
One of these secondary effects is mentioned in an article in the Financial Times, which indicates that Ryanair will post €300 million losses on fuel hedges in 2020 and expects a huge ineffectiveness in 2021. According to the article, this is due to a wrong way bet on fuel prices. A large portion of Ryanair’s expected jet fuel consumption is hedged against rising oil prices. The sharp decrease in oil prices in the past months, in part due to the COVID-19 pandemic, has triggered this loss. However, we believe that the situation is more complex than just a wrong way bet and is related to the application of hedge accounting. This article guides you through the mechanisms of hedge accounting, which ultimately led to their results.
What is hedge accounting?
Hedge accounting is an accounting practice that provides an opportunity to change the booking treatment of the hedging instrument. In hedge accounting, a hedge relation consists of two parts: ▪ The hedging instrument, usually a derivative. ▪ The hedged item. Many hedge relations with several hedged items or hedging instruments can be applied. Without hedge accounting, the hedging instrument is booked at fair value. The change in fair value, over the accounting period, goes to P&L. As the fair value of derivative can fluctuate significantly over its lifetime, this accounting treatment may generate substantial P&L volatility. By applying hedge accounting, this P&L volatility can be avoided by booking the fair value of derivative in OCI (other comprehensive income) rather than P&L. This is allowed only for the so-called ‘effective part’ of the hedge. The ‘ineffective part’ stays in P&L.
Figure 1: Fair value booking with and without hedge accounting
The most important requirement for the application of hedge accounting is that the derivative is used to hedge an underlying risk and is not used as a speculative instrument. This needs to be proved by means of a risk management strategy and objective, a definition of the risk hedge, a hedge effectiveness assessment, and a hedge documentation.
Hedged item impact
Going back to the hedge relation, let’s focus on the hedged item. This product typically has one of the following characteristics:
- Quasi-certain risk exposure (e.g. a floating rate loan).
- An FX exposure in the form of sales or revenues forecast in non-functional currency.
- A highly probable exposure, such as a future jet fuel consumption in the case of Ryanair.
Now what happens when the expected exposure is reduced or even becomes non-existent? In Ryanair’s case, there is almost no air traffic anymore and therefore Ryanair has no need for jet fuel.
According to the accounting rules, the hedge relation needs to be partially or totally de-designated. So, when the hedge relation ceases to exist, so does the right to apply hedge accounting. This triggers a reclassification from OCI to P&L. The reclassification can be either one-off or linear, depending on the status of the exposure. There will be a one-off reclassification if there is no exposure anymore, or a linear amortization if the exposure is reduced. That is the first P&L volatility trigger.
Figure 2: De-designation from the hedged item event
Hedging instrument impacts
Commonly used hedge instruments are: ▪ An interest rate swap (IRS) for interest rate exposure. ▪ An FX forward for FX exposure. ▪ A commodity future, such as Ryanair may have used to protect itself against price increases in fuel.
There are two factors that can have severe consequences when hedge accounting is applied and could have contributed to the disastrous impact for Ryanair. The first factor is if the derivative becomes partially or totally naked. It does not offset any risk anymore and becomes a speculative instrument. Ryanair’s reduced need for jet fuel also reduced the need for protection against rising fuel prices. Therefore, the most important requirement for the application of hedge accounting is violated and hence hedge accounting cannot be applied anymore. As a result, the future change in market value goes to P&L.
Figure 3: Hedging instrument events
The second factor is the occurrence of adverse market conditions such as:
- Higher volatility
- Extreme market movement
- A huge drop in fuel prices, as was the case for Ryanair
In these events, the fair value of the derivative goes down, thereby triggering a loss. Hence the derivative impacts the P&L even more. The bigger the change in market value, the bigger the P&L impact.
Furthermore, adverse market conditions may not only lead to more P&L volatility but also to:
- An increase of the cost of hedging through wider spreads or higher forward points.
- The inability to hedge due to restricted markets or banned products.
Three events trigger three advices
We have described three events that may create more P&L volatility:
- On the hedged item side, the reclassification from OCI to P&L.
- On the hedging instrument side, the market value change of the derivative.
- The adverse market movement
We would like to provide three pieces of advice regarding these events. First, review and, if necessary, adapt the hedging policy and strategy. Think of:
- The type of derivatives allowed.
- The hedging percentage.
- The way exposure is calculated.
It may be too late for Ryanair but a different strategy, for example with a partial protection on price decrease, may have lowered the P&L impact. The strategy should of course fit the risk appetite of the company. It should be noted that the use of derivatives and hedge accounting may be avoided in certain cases, for example using a fixed rate loan in place of an IRS and a floating rate loan.
Second, closely monitor the hedge relation and be aware of the impact of the different components of the hedge.
Finally, take actions to mitigate the effects, if required. This means, among other things, timely unwinding of positions or taking opposite positions.
We can ask ourselves, at the end, was it a one-way bet, or even a wrong way bet? Or an imperfect hedge strategy hit by a sequence of three events during uncertain times? In our opinion, it was the latter and by being prepared and by taking actions when necessary, it is possible to reduce the P&L impact.