This chapter focuses on one of the most common financial risks that an entity may hedge: interest rate risk. This risk arises from entities holding interest-bearing financial assets and/or liabilities, or from forecasted or committed future transactions including an interest-bearing element. An entity's ability to manage interest rate exposure can enhance financial exposure, mitigate losses, and reduce funding costs.
The most common interest rate exposures stem from the following situations:
- An already recognised financial liability (or asset) that pays (or receives) a fixed interest rate. In this case, the interest rate risk relates to the fair value change in the financial liability (or asset) due to movements in interest rates.
- An already recognised financial liability (or asset) that pays (or receives) a floating interest rate (i.e., future interest payments are linked to a benchmark interest index). In this case, the interest rate risk relates to variations in future cash flows.
- Highly probable anticipated future issuance of an interest-bearing financial liability (or asset). In this case, the interest rate risk relates to variations in future cash flows.
The objective of this chapter is not to identify the appropriate hedging strategy to mitigate exposure to changes in interest rates. Instead, its objective is to provide practical insight into the accounting implications of a chosen interest rate hedging strategy. In order to emphasise ...