A financial hedge is an instrument used to reduce the risk of severe price changes of an underlying product. Hedging is the act of taking an offsetting position in a related product, thereby minimizing risk exposure. Hedges come in many forms, such as insurance policies, forward contracts, options, swaps and futures. While hedges such as futures and options can reduce risk, organisations have to measure hedge effectiveness in accordance with accounting standards before determining the level of risk eliminated.
For accounting purposes and in accordance with International Accounting Standards (IAS), a hedging instrument is "an instrument whose fair value or cash flows are expected to offset changes in the fair value or cash flows of a designated hedge item" (IAS 39.9).
Hedge effectiveness is the test applied to a financial instrument to determine whether it is eligible for hedge accounting, which exempts the hedging instrument, whether it is an option or a futures contract, from the mark-to-market requirement of FAS133. The instrument is recorded at fair value, and gains or losses are written to the equity side of the Balance Sheet, not to the Income Statement of the entity. Hedge accounting only applies for hedges with an effectiveness rating of 0.80-1.25.
Calculating hedge effectiveness
There are three main ways of assessing hedge effectiveness: the dollar offset method, regression and matching terms. The dollar offset method is one of the most common methods used to calculate hedge effectiveness. Businesses should note that IAS 39 does not specify a single method that should be used for calculating hedge effectiveness however, the Standard does require entities to document the method chosen at the beginning of the hedging relationship. This method must then be applied consistently for the entirety of the hedge.
Effective hedges that fall within the 0.80-125 rating set by the IAS must also calculate hedge ineffectiveness as this portion cannot be offset against reserves and must be recognised in the Income Statement for that period. Only the effective portion of the hedge can be recognised in reserves.
An illustration of a hedging strategy that is ineffective is where an entity uses a hedging instrument that has a different maturing period than the forecast transaction. For example, A 3-month forward contract used to hedge foreign currency risk exposure of a transaction forecast to occur in 6 months is an ineffectual hedge and any gains or losses must be recognised in the Income Statement.