Hedge effectiveness

A hedge is meant to move opposite to the thing it protects. In practice the two rarely move by exactly the same amount. The futures contract may not match the exposure's date, its size or the precise price it tracks.

Hedge effectiveness measures how much of the hedged item's change the hedge actually offset. The workbook's definition: the degree to which changes in the fair value or cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the fair value or cash flows of the hedging instrument.

Its mirror image is hedge ineffectiveness: the extent to which the changes in the fair value or the cash flows of the hedging instrument are greater or less than those of the hedged item. Note both directions. A hedge that over-performs is ineffective by the amount of the excess, just as one that under-performs is ineffective by the shortfall.

Effectiveness matters because hedge accounting treats the two parts differently: the effective part is matched with the hedged item, and the ineffective part goes to profit and loss.

No single method. The ICAI Guidance Note, as summarised in Chapter 9, does not prescribe one single method for effectiveness testing and measuring ineffectiveness. The right method depends on the facts of each hedging programme and is driven by the entity's risk management objective. The workbook names three commonly used measures:

Where ineffectiveness lands:

Documentation. Among the minimum conditions for hedge accounting, the entity must specify how it will measure the derivative's fair value if the derivative contract is effective in meeting its risk management objective (including the relevant hedge ratio), and document this at inception and at every reporting period. Ind AS 109 adds an economic relationship, credit risk not dominating, and a consistent hedge ratio.

Offset achieved = Change in hedging instrument ÷ Change in hedged item

Ineffectiveness  = |Change in hedging instrument| − |Change in hedged item|
                   (positive: over-hedge; negative: under-hedge)

Illustrative. The company, amounts and rates are hypothetical; the definitions and treatment are the workbook's.

Malabar Exports expects a highly probable receipt of USD 2,00,000 and sells 200 lots of USDINR futures, designating them as a cash flow hedge.

Case 1 — under-offset. The rupee strengthens. The expected rupee value of the receipt falls by Rs 1,40,000; the futures gain Rs 1,26,000.

Offset achieved  = 1,26,000 ÷ 1,40,000 = 90%
Ineffectiveness  = 1,26,000 − 1,40,000 = −Rs 14,000 (hedge fell short)

By the workbook's definition the hedge is ineffective by Rs 14,000: the instrument's change was less than the hedged item's. That Rs 14,000 of the fall was never covered. Chapter 9 does not spell out the entries for a shortfall, so read a question on it carefully.

Case 2 — over-offset. The receipt's value falls by Rs 1,40,000, but the futures gain Rs 1,50,000.

Offset achieved  = 1,50,000 ÷ 1,40,000 = about 107%
Ineffectiveness  = 1,50,000 − 1,40,000 = Rs 10,000 (hedge overshot)

Rs 1,40,000 goes to equity; the Rs 10,000 excess is ineffective and goes to profit and loss immediately.

The definition's phrase greater or less than is why both cases count: an overshoot is as much a mismatch as a shortfall.

Chapter 9 (Accounting and Taxation), section 9.1.1, gives the definitions of hedge effectiveness and ineffectiveness under the ICAI Guidance Note, the statement that no single testing method is prescribed, and the three named measures; the net investment hedging principles and the Ind AS 109 summary in section 9.1.3 say where the ineffective portion goes. Expect a definition question and one on which methods are acceptable.

• Effectiveness is about offset, not profit. A hedge can lose money and still be highly effective if the hedged item gained by the same amount.
• Ineffectiveness runs both ways: the hedge moving more or less than the hedged item.
• The ineffective portion goes to profit and loss — for cash flow and net investment hedges, immediately.
• No single method is prescribed. Critical terms match, dollar offset and regression are all named as commonly used.
• Chapter 9 of this workbook states no numerical pass range for effectiveness. Do not answer a Series I question with a range the chapter does not give.
• The method is chosen according to the entity's risk management objective and the facts of the hedging programme, and documented from inception.