Qualifying Criteria for Hedge Accounting and Effectiveness Testing

IAS 39/ FAS 133 requires that certain criteria be met for all types of hedges in order for them to qualify for hedge accounting:

• Identification of hedged item (underlying exposure)

• Identification of hedging instruments (derivatives)

• Identification of nature of risk being hedged

• Documentation of how the hedging instrument´s effectiveness in offsetting value changes in the hedged item will be assessed.

• Determine the algorithm (method) used for assessing effectiveness

• Determine the components of the derivative´s value change that is included in the subsequent effectiveness assessment

• Derivative needs to be linked with the exposure in a hedging relationship

Effectiveness testing

• The effectiveness of a hedging relationship is a measure of how well a derivative protects against the underlying risk (exposure).

• Effectiveness is measured through the “effectiveness ratio”. The effectiveness ratio has to fall within a certain range in order for the hedging relationship to be considered ‘highly effective’. Only then can hedge accounting take place.

• A hedging relationship has to be considered effective at inception of the hedge as well as on an ongoing basis.

• An effectiveness test has to be carried out at every balance sheet date, and at least every 3 months.

  Prospective vs. Retrospective

  There are two kinds of effectiveness tests:

• prospective test(is the hedging relationship expected to continue to be highly effective in the future?)

• retrospective test(has the hedging relationship been effective in the past period or periods?)
  

  

  Calculation Methods

  For calculation of the value changes, different methods may be used depending on the derivative and on the hedge category:

• Fair value changes

• Changes in cash flows, based on spot rates or forward rates

• Changes of intrinsic value for options

• Changes of a value of a hypothetical derivate

• Regression analysis

Note that components of value changes may be excluded, e.g. the time value of options.

For calculating the effectiveness ratio, a period-to-period approach or a cumulative approach may be used.

Effectiveness Testing - When it is not needed (US- GAAP)

In the case of a perfect hedge, a hedge may qualify for the

• shortcut method for interest-rate hedges

• the ‘matching of critical terms‘ method for FX hedges 

In both cases, no effectiveness test is needed, and perfect effectiveness is assumed. This means that

• all fair value changes of the derivative are posted to OCI/Equity directly (cash flow hedges)

• all fair value changes of the derivative are posted to P/L, and the same amount is posted to P/L for the underlying exposure (fair value hedge)to