The Financial Economics of Hedge Accounting of Interest Rate Risk according to IAS 39

Hedge accounting of interest rate risk according to IAS 39 is applied to avoid P&L volatility resulting from accounting mismatch, and it is a common practice. However, issues concerning hedge accounting have not ceased to be items of topical interest. This analysis will show that hedge accounting of interest rate risk relies upon modern approaches of financial economics which are related to the pricing of interest rate derivatives. Derivative markets play a fundamental role for hedge accounting and are used to derive the valuation model used under IAS 39. This paper provides a setup for interest rate hedging and demonstrates the connection of hedge accounting under IAS 39, valuation practices and risk management. The alignment of hedge accounting and risk management is also a principle advocated in the Exposure Draft for hedge accounting (ED 2010/13) published last year; therefore the analysis leads over to current discussions on hedge accounting.