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Pitfalls of Hedge Effectiveness Testing The choice of a hedge effectiveness testing method at the beginning of a hedge relation could make a major impact at a later date. This article describes some of the pitfalls that corporates may encounter. After describing the most important of the available methods, including the DO, VRM and RA methods, the author advises on the best way to compare how they perform in practice and comes down in favour of the RA and VRM which are more complex to implement but more consistent in assessing hedge effectiveness.

Pitfalls of Hedge Effectiveness Testing

by Jasper Wijnands, Advisor, Ernst & Young Financial Services Risk Management

Hedging can reduce the impact of negative events on assets, liabilities, firm commitments or forecasted transactions. Financial instruments in the market are used to offset the risk of any adverse price movements of the hedged item. Hedging will usually also limit the upside potential of positive events.

An important step when applying hedge accounting is the choice of a hedge effectiveness testing method.

It is preferable that the fair values of the hedged item and hedging instrument are accounted for in a similar manner on the balance sheet, as this will possibly decrease the volatility of the P&L. Therefore many companies will have to deal with hedge accounting to account for their hedge relationships, as fair values are then recorded in the same manner. Not all hedge relations, however, are qualified for the use of hedge accounting, as the hedge relationship should comply with several rules from the hedge accounting framework IAS 39.

One of the most important rules is that the hedge relation should be highly effective, for which testing is required. For hedge effectiveness testing various methods can be applied, resulting in different outcomes. With the chosen method, determined at inception of the hedge relationship, the hedge relationship must be tested periodically, on at least all reporting dates, until the end of the hedge relation. If in one of these tests the hedge relation is assessed as ineffective, hedge accounting is terminated as determined by IAS 39 and the result could be a large volatility of the P&L. Therefore, an important step when applying hedge accounting is the choice of a hedge effectiveness testing method.

Hedge effectiveness testing is a quantitative subject which requires subject matter expertise. As the choice of a hedge effectiveness testing method at inception of a hedge relation could have a potentially large impact further in time, this article focuses on the pitfalls of hedge effectiveness testing.

Hedging and effectiveness testing

In the hedging framework a hedged item is hedged with a hedging instrument, which should offset the cash flow changes or fair value changes of the hedged item. When the fair values or cash flows of the hedged item are not perfectly offset, there is an amount of ineffectiveness which results in volatility of the P&L. Even more, if the hedge relation is not highly effective the entire fair value change of the hedging instrument for that period should be recognised in profit or loss. The hedge accounting rules therefore require hedge effectiveness testing, which is used to assess whether the changes in cash flows or fair value of the hedged item are sufficiently offset by the hedging instrument.

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