"Ways to Test Hedge Effectiveness: Reconsidering Regression Analysis"

For companies that use derivatives to manage financial risk — be it interest rate risk, currency risk or commodity risk — some are lucky and some aren’t.

The lucky ones are those with derivative contracts tailored to the risk being hedged, where all critical terms of the derivative correspond to critical terms of the risk being hedged. Unlucky companies are those where these terms don’t line up.

Differences in underlying derivative terms vs. exposure, timing of the relevant value or repricing dates, or location differences that are relevant for commodity exposure, mean that the hedges can’t be assumed to be effective. Therefore, some documentation is required to validate the expectation that these hedges will be effective.

Guidance on how to construct hedge effectiveness tests is fairly non-specific, leaving considerable flexibility to each reporting entity. But this flexibility comes at a cost. An overly-permissive criterion might create a window of opportunity for second-guessing on the part of the auditing firm or, worse yet, the U.S. Securities and Exchange Commission (SEC). In the latter case, the
reporting firm could face the unenviable prospect of having to restate company earnings.

Historical Perspective
To qualify for special hedge accounting, companies should assess hedge effectiveness both prospectively and retrospectively. This type of accounting ensures that losses or gains of a derivative will be recognized in earnings
in the same time interval as losses or gains associated with the hedged item.

Companies also should measure and disclose any ineffectiveness that may have occurred. Dollar-offset ratios compare the results of the derivative to those of the hedged item. Many firms rely on these ratios for effectiveness testing and measurement purposes.

The commonly accepted criterion for passing an effectiveness test is that the ratio must fall within the bounds of 0.8 and 1.2, where the effects of the two
components of the ratio are in opposing directions — when one gains, the other loses, for instance. It became apparent early on, however, that reliance on this ratio for hedge effectiveness testing proved problematic, with an unexpectedly high failure rate.

Particularly with quiescent market conditions, when small market changes are recorded, these ratios often return outcomes well outside of the prescribed bounds. As an example, if the hedged item remains stable (with a result of zero) and the derivative generates a single dollar gain, the dollar-offset ratio is infinity.

For more information please contact:
Kawaller & Company, LLC
162 State Street
Brooklyn, NY 11201
Phone: (718) 694-6270
Fax: (413) 460-1819

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