Hedge Effectiveness Testing

Derivatives serve as economic hedges, utilized by entities for risk management rather than speculation. There is a clear distinction between an economic hedge and an accounting hedge. Companies must assess their business risks and determine if using derivatives can mitigate them. Failing to use derivatives may result in increased exposure to risks.  To accurately track the value of derivatives, they are marked to market in each reporting period. If not designated as a hedge, any changes in fair value are reflected in earnings, leading to potential earnings volatility. To mitigate this, companies can assess the effectiveness of their hedging strategy through mathematical or statistical methods, such as hedge effectiveness analysis, to determine the expected volatility they may face.

Hedge effectiveness refers to the degree to which changes in the value of the hedged item are offset by corresponding changes in the value of the hedging instrument. In hedge accounting, it is evaluated using three criteria, including economic relationship, which requires an inverse correlation between the change in the value of the hedged item and the change in the value of the hedging instrument.

There are several methods commonly used for testing hedge effectiveness, but many organizations opt for simpler methods that do not provide adequate continuity for the hedge relationship due to their extreme sensitivity. The most commonly used methods, such as dollar offset, regression, and variability reduction, require careful consideration and analysis of various variables.

At Shasat, our valuation specialists can aid corporate and treasury departments in conducting effectiveness testing to ensure their hedging align with risk management and complies with IFRS and US GAAP standards. Despite this, organizations must still perform prospective testing as critical terms matching between hedged items and derivatives can prove challenging.  Our specialists bring a combination of experience, confidentiality, quantitative abilities, IFRS, USGAAP technical accounting proficiency, and practical knowledge to deliver accurate fair value assessments and disclosures. Our team also creates valuation models for a variety of instruments, including complex structured products, as standard software tools cannot adequately value them.

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To seek valuation support, contact our Valuation Desk.