Hedge Effectiveness Testing

Effectiveness Testing

The effectiveness assessment in the current hedge accounting framework under IAS 39 is based on a rule-based approach (e.g. quantitative test uses a range of 80-125%) that is onerous and has an arbitrary outcome. This effectiveness test to be performed prospectively and retrospectively on each reporting date. This means that companies are required to perform two tests: a prospective test to ensure that the hedging relationship is expected to be highly effective and a quantitative retrospective test to ensure that the hedging relationship has been highly effective throughout the reporting period.  However, this effectiveness range (8-125%) has been removed under the new IFRS 9 but it does not remove a fundamental need to test the prospective effectiveness for internal and external reporting as well.

Methods to test Hedge effectiveness

In order to test the hedge effectiveness, there are commonly used methods for testing. Due to the complexity of certain methods, most organisation opt for the easy methods.  However, many of these easy methods do not provide adequate longevity/continuity to the hedge relationships because the extreme sensitivity of these methods allow hedges to fail the effectiveness tests.  Following are the most common methods require careful consideration and analysis of a number of variables:

  • Dollar offset
  • Regression
  • Variability reduction

Our valuation experts help corporates and treasury teams in carrying out the effectiveness testing to ensure that their hedges are within the acceptable range.  Even under the new framework IFRS 9, the organisation shall require to do the prospective testing since it is very difficult to have exactly matching critical terms between the hedged items and derivative instruments.

The valuation team at Shasat shall help you in your hedge effectiveness determination both for internal and external reporting purposes.  Our experts build valuation models for plain vanilla instruments to structured products in order to derive fair value measurement since most of these products cannot be valued using even the most sophisticated software tools.

We bring together experience, confidentiality, quantitative skills, technical accounting IFRS/US GAAP knowledge and also knowledge of typical practice issues to help entities in providing a reliable fair value and also disclosure of a broad range of valuation input to meet the disclosure requirements.

Contact our valuation desk to seek valuation support.