What is the effect of credit risk in an eligible hedged item?

In the context of hedging, credit risk refers to the risk of loss due to a borrower's failure to repay a loan or meet contractual obligations. When evaluating eligible hedged items, particularly in cash flow hedging, the effect of credit risk should be negligible in the relationship between the hedged item and the hedging instrument.

This is important because, for a hedge to be effective, changes in the fair value or cash flows of the hedged item should ideally correlate closely with the changes in the fair value or cash flows of the hedging instrument. If credit risk significantly affected these changes, it could distort that relationship and complicate the assessment of hedge effectiveness. Therefore, for the purposes of meeting hedge accounting criteria, credit risk should not dominate the value changes of the hedged item, allowing both the effectiveness of the hedge to be assessed accurately and ensuring that the hedge accounting treatment reflects the underlying economic relationship between the hedged item and the hedging instrument appropriately.