Published: June 01, 2008
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.
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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IAS 39 does not describe which hedge effectiveness testing method to use; therefore every company is free to choose the method that fits their situation best. However, the choice of the hedge effectiveness testing method should be consistent for similar types of hedge relationships. The current methods available for hedge effectiveness testing include the Dollar-Offset method (DO), the Volatility Reduction Method (VRM) and Regression Analysis (RA).
Each method has several advantages and disadvantages. For example, the DO method is often recommended because of its simplicity and is intuitively clear regarding whether fair value changes are offset sufficiently. Furthermore, this method is in line with the actual ineffectiveness that has to be reported in the financial statements, as the actual ineffectiveness is the cumulative difference of fair value changes. The DO method is often used in practice. The VRM is slightly more complicated, but is more in line with the economic perspective of hedging, namely volatility reduction of changes in fair value or cash flows of the hedged item. Regression analysis is complicated in the way of designing a good method, because many decision rules on the outcome of the regression analysis are possible to determine whether the hedge relation is assessed as effective or ineffective. The guidance of Ernst & Young on the RA method is to assess the hedge relation as effective when the following conditions are met:
In order to compare different hedge effectiveness testing methods, it is important not to focus on one test case, but examine different perspectives. The objective is to compare how the hedge effectiveness testing methods perform in practice and not for one test case in particular. Ernst & Young Financial Services Risk Management performed research on the performance of these hedge effectiveness testing methods. This research focuses on practical test cases as well as theoretical setups and further on retrospective as well as prospective hedge effectiveness testing. The goal of this research is to determine the probability that a hedge relationship is assessed as effective for each of the three hedge effectiveness testing methods. When comparing the results of the different perspectives, a conclusion can be formulated regarding the performance of the different testing methods.
It is important not to focus on one test case, but examine different perspectives.
While the test setups differ significantly, all tests yield similar results. For example, table 1 shows the results of hedge effectiveness tests using a historical yield curve simulation. In this prospective simulation the yield curve of the next month is simulated and is used to calculate fair value changes of the hedged item and hedging instrument. The hedged item is a fixed rate bond, used by a company for funding purposes. Consider that the company wishes to reduce interest rate risk on the fair value of the bond and hedges the funding with a fixed-for-floating interest rate swap. All characteristics of the hedged item and hedging instrument, such as maturity date, notional amounts and accrual methods, are the same (i.e. the critical terms are equal). The only fluctuating parameter is the difference in coupon between the bond and the fixed leg of the swap.
When there is no difference between the coupons of the hedged item and hedging instrument, the fixing of the floating leg of this ‘perfect’ hedge relationship still yields some ineffectiveness. While the RA method and the VRM assess this hedge relation as effective in all simulation steps, the DO method assesses the hedge relation in some cases as ineffective. As a result, even for highly effective hedges the DO method does not guarantee that the hedge relation is tested as effective every testing period. In practice, hedge effectiveness testing is performed multiple times per year. The probability that the hedge relation is ineffective in one of these periods using the DO method is significant. When this happens, hedge accounting for this hedge relation will have to be terminated with possibly a significant impact on the P&L. [[[PAGE]]]
The VRM and RA methods perform better, as both show a clear cut off point. The location of the cut off point depends on the decision rules that are chosen. Highly effective hedges are always assessed as effective, while clearly ineffective hedge relations are always assessed as ineffective. This is important as these methods will be consistent in assessing the hedge relation as effective or ineffective for multiple periods.
A reason for the differences between the methods is that the DO method uses only one data point, while the other methods are based on multiple data points. The RA method sometimes even uses multiple statistics. These methodological differences make the DO method less robust than the other methods. Next to this, the DO method suffers from the small number problem. For example, when the change in fair value of the hedged item is minus 1 cent and the change in fair value of the hedging instrument is plus 2 cents, the Dollar-Offset ratio is 200%. So, the hedge relation is assessed as ineffective, while the absolute ineffectiveness is very small.
While the DO method is easy to use and easy to understand, the use of this method is not recommended. The ease of testing the hedge relation does not compensate the significant probability of major problems when the hedge relation is assessed as ineffective. When the hedge relationship is assessed as ineffective the complete fair value change of the hedging instrument for the current period should be recorded in profit or loss, which could have a significant impact. A prudent advice would be to choose the RA method according to Ernst & Young standards or the VRM. Although the implementation will be a little more complex, these methods are more consistent in assessing hedge effectiveness. This will reduce the costs of repairing the problems of ineffective periods, as ineffectiveness is unlikely to happen for well-designed hedge relationships.
References:
Ernst & Young (2007), Hedge effectiveness: regression analysis
Kalotay, A. and L. Abreo (2001), Testing Hedge Effectiveness for FAS 133: The Volatility Reduction Measure, Volume 13 Number 4 of Winter edition of Journal of Applied Corporate Finance.
Wijnands, J.S. (2007), Hedge effectiveness testing for hedge accounting. Methods analysed
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