Hedged item
Also written Hedged items · Underlying exposure
The asset, liability, cash flow or firm commitment that carries the risk being protected — the exposure a hedging instrument is designated against, and without which there is no hedge at all.
In plain language
Hedging has two halves, and the workbook names both.
The hedged item is the thing at risk. The hedging instrument is the thing that reduces that risk.
A jeweller's stock of gold is a hedged item. A short gold futures position is the hedging instrument. One carries the risk; the other cancels it.
The workbook is strict about the order in which they must exist. A hedge presupposes an underlying exposure in the commodity. No exposure means no hedged item, and no hedged item means no hedge — only a derivative bet.
A hedged item can be an asset, a liability, a cash flow, or a firm commitment. What matters is that the risk was already there before the derivative was bought.
And the label is not free. To get hedge accounting, the firm must designate the item and the instrument, and document both.
How it works
The pairing. Hedging is an action taken to minimise or eliminate uncertainty in the value of assets, the value of liabilities, cash flows or firm commitments. It involves two components: the hedged item, which is carrying the risk, and the hedging instrument, which helps reduce the risk of the hedged item. Forward contracts, commodity futures and commodity options are the workbook's examples of hedging instruments.
Where the hedged item's gain or loss lands depends on the hedge type.
| Hedge type | What the hedged item is | Where its gain or loss goes |
|---|---|---|
| Fair value hedge | A recognised asset or liability, or a previously unrecognised firm commitment to buy or sell at a fixed price, whose fair value change is attributable to a particular risk and could affect reported net profit | The carrying amount of the hedged item is adjusted, and the change is recognised immediately in the income statement to offset the derivative |
| Cash flow hedge | A recognised asset or liability, an unrecognised firm commitment (currency risk only), or a highly probable forecast transaction | The hedged item's cash flow differential is recognised in equity, not profit and loss; the instrument's impact also sits in equity, and both are moved to profit and loss together on a net basis |
| Net investment hedge | A net investment in a foreign operation | Equity, as the third accounting hedge type the workbook names |
Firm commitments have their own rule. A hedge of a firm commitment is accounted for as a fair value hedge, provided all the hedge accounting criteria are met. But a hedge of the foreign currency risk on a firm commitment may be designated as either a cash flow hedge or a fair value hedge, because that currency risk affects both the cash flows and the hedged item's fair value.
The tests are written against the hedged item, with two numbers. Prospective effectiveness testing, at inception and at each reporting date, must demonstrate that changes in the fair value or cash flows of the hedged item are expected to be almost fully offset — nearly 100% — by changes in the hedging instrument. Retrospective effectiveness testing, at each reporting date, must show actual results within 80% to 125%. Both tests are mandatory.
The paperwork. There must be formal documentation of the hedge, including a board-approved risk management policy with the risk management strategy, and hedge effectiveness must be assessed and recorded on an ongoing basis throughout the reporting period.
A worked example
The workbook's own Company Z, a producer and wholesaler of copper with a year ending 31 March. On 1 January 2024 it forecasts sales of 100 tons of copper in September 2024, and sells a futures contract to sell 100 tons of the same grade maturing 30 September 2024.
The same derivative, on the same tonnage, is run twice in the chapter against two different hedged items — and that is the whole lesson.
Put the copper at Rs 8,50,000 per ton, so the 100 tons are worth Rs 8,50,00,000. By 31 March 2024 copper has risen 4%, giving a mark-to-market loss on the short futures of Rs 34,00,000 and a matching rise in the value of the physical copper.
| Designation | Hedged item | Treatment at 31 March 2024 |
|---|---|---|
| Cash flow hedge | The highly probable forecast sale of 100 tons in September 2024 | The Rs 34,00,000 goes to the Cash Flow Hedging Reserve and stays in the balance sheet. The hedged item is not recognised at all yet, so nothing offsets it in profit and loss until the sale is booked in September 2024 |
| Fair value hedge | A portion of the inventory — 100 tons of copper | The Rs 34,00,000 derivative loss is debited to profit and loss now, and the inventory is written up by Rs 34,00,000 as a separate inventory hedge accounting adjustment, also through profit and loss. Net profit and loss impact: nil |
Now test the hedge. Suppose the physical copper exposure moved Rs 36,00,000 while the derivative moved Rs 34,00,000:
34,00,000 / 36,00,000 = 94% — inside the 80% to 125% retrospective band, so the hedge stands.
If the derivative had moved only Rs 24,00,000, the ratio is 67%, the hedge fails the retrospective test, and hedge accounting is lost for the period. The hedged item did not change in either case. Only the quality of the match did.
Why NISM asks about it
Chapter 9 (Accounting and Taxation), section 9.1, which opens on hedge accounting and defines the hedged item and the hedging instrument as a pair before anything else.
Expect: hedging involves two components — the hedged item and the hedging instrument; and the chapter's own sample question, which of the following can be used as a hedging instrument, whose answer is all of commodity forwards, commodity futures and commodity options. The discriminating question asks where the hedged item's gain or loss lands: the income statement for a fair value hedge, equity for a cash flow hedge. The nearly 100% prospective and 80-125% retrospective figures are also examined, and both are stated in terms of the hedged item.
Common exam traps
- The hedged item carries the risk; the hedging instrument removes it. Swapping the two inverts every accounting entry that follows.
- A hedge presupposes an underlying exposure. Without a hedged item there is no hedge, whatever the derivative is called on the trading screen.
- Fair value hedge adjusts the hedged item's carrying amount; cash flow hedge sends its differential to equity. Two hedges, two destinations, and this is the most-swapped pair in the chapter.
- Forwards, futures and options are instruments, not items. Inventory, receivables, firm commitments and forecast sales are the items.
- A firm commitment hedge is a fair value hedge — except that the foreign currency risk on a firm commitment may be designated either way, because it affects cash flows and fair value both.
- One derivative can hedge two different items. The workbook runs the same 100-ton copper short as a cash flow hedge of a forecast sale and then as a fair value hedge of inventory, with completely different entries.
- Two effectiveness tests, two numbers, both mandatory. Nearly 100% expected offset prospectively; 80% to 125% actual retrospectively. Neither substitutes for the other.
Check yourself
1.Which of the following can be used as a hedging instrument?
- a)Commodity forwards only
- b)Commodity futures only
- c)Commodity options only
- d)Commodity forwards, futures and options
Show the answer
Answer: (d) Commodity forwards, futures and options
(This is a sample question from the NISM workbook.)
"FORWARD CONTRACTS, COMMODITY FUTURES AND COMMODITY OPTIONS ARE EXAMPLES OF HEDGING INSTRUMENTS in general available to a commodity market stakeholder."
Options qualify even though the workbook separately warns that "options generally do not create a perfect hedge to an underlying" — because "it is a PROTECTION PRODUCT AND NOT JUST A HEDGING PRODUCT." Being a hedging instrument and being a perfect one are different questions, and the imperfection is an accounting inconvenience rather than a disqualification.
The framework these sit within: "Hedging involves TWO COMPONENTS: THE HEDGED ITEM (WHICH IS CARRYING THE RISK) AND THE HEDGING INSTRUMENT (WHICH HELPS REDUCE THE RISK)."
And the precondition: ⚠️ "HEDGE PRESUPPOSES THE EXISTENCE OF AN UNDERLYING EXPOSURE IN THE COMMODITY." No exposure, no hedge — which is the same distinction between hedging and speculation drawn throughout the syllabus.
2.What must retrospective hedge effectiveness testing demonstrate?
- a)That the entity expects changes in the hedged item to be nearly 100% offset by the hedging instrument
- b)That actual results of the hedge are within the value range of 80-125%
- c)That the hedge produced a profit over the reporting period
- d)That regression analysis was the methodology used
Show the answer
Answer: (b) That actual results of the hedge are within the value range of 80-125%
"RETROSPECTIVE EFFECTIVENESS TESTING is performed AT EACH REPORTING DATE THROUGHOUT THE LIFE OF THE HEDGE, following a methodology set out in the hedge documentation. THE OBJECTIVE IS TO DEMONSTRATE THAT THE HEDGING RELATIONSHIP HAS BEEN HIGHLY EFFECTIVE BY SHOWING THAT ACTUAL RESULTS OF THE HEDGE ARE TO BE WITHIN THE VALUE RANGE OF 80-125%."
Option (a) is the prospective standard, and the two are deliberately different:
⚠️ PROSPECTIVE ⚠️ RETROSPECTIVE When At INCEPTION and at each subsequent reporting date At each reporting date Standard ⚠️ Expects offset "ALMOST FULLY... i.e. NEARLY 100%" ⚠️ Actual results in the 80-125% band The asymmetry is not sloppiness. Looking forward, you must design for near-perfect offset — a hedge you expect to work only partly is not a hedge at all. Looking backward, reality is given a wide tolerance, because spot and futures prices "tend to move in tandem" but never "necessarily identically." That residual gap is basis risk, and a rule demanding exactly 100 per cent in hindsight would disqualify every honest hedge ever placed.
Option (c) misunderstands what a hedge is for. A hedge is not supposed to make a profit — it is supposed to offset. A hedge that made money while the hedged item lost an equal amount is a perfectly effective hedge.
Option (d) overstates the requirement: "The ICAI Guidance Note DOES NOT PRESCRIBE ANY SPECIFIC TESTING METHODOLOGY" — it merely offers examples including regression analysis, the dollar offset test, critical item matching, economic relationship, negligible impact of credit risk and review of sources of ineffectiveness.
Both tests are MANDATORY.
Where this is taught
Free preparation for NISM Series XVIRelated terms
- Cash flow hedgeA hedge of the variability of future cash flows — such as a highly probable foreign currency receipt — whose effective gains and losses are held in equity until the hedged cash flow hits profit and loss.
- Fair value hedgeA hedge of the exposure to changes in fair value of a recognised asset or liability, or an unrecognised firm commitment, attributable to a particular risk that could affect profit and loss.
- Hedge accountingAn optional accounting treatment that matches the timing of gains and losses on a designated hedging derivative with the item it hedges, instead of taking the derivative's fair value changes straight to profit and loss.
- Hedge effectivenessThe degree to which changes in the fair value or cash flows of a hedged item, attributable to the hedged risk, are offset by changes in the fair value or cash flows of the hedging instrument.
- Net investment hedgeA hedge of the foreign exchange risk on a net investment in a non-integral foreign operation, with the effective gains and losses on the hedging instrument recognised directly in equity.
- Cash Flow Hedging ReserveThe equity account in which the fair-value gains and losses of a derivative designated as a cash flow hedge are parked until the hedged forecast transaction hits profit and loss.
- Hedging instrumentIn hedge accounting, the derivative — a forward, future or option — used to reduce the risk of the hedged item, whose gains and losses are matched against that item under the ICAI Guidance Note.
- Inventory hedge accounting adjustmentA separate basis adjustment carrying the fair value change of hedged inventory, kept apart from the AS 2 valuation, and released to cost of goods sold when the inventory is finally sold.
- Prospective effectiveness testingThe forward-looking test, done at hedge inception and at every reporting date after, that checks whether a hedge is expected to offset nearly all of the change in the hedged item.
- Retrospective effectiveness testingThe mandatory check, at each reporting date, that a designated hedge actually was highly effective — its results falling within 80 to 125 per cent — as a condition of continuing hedge accounting.
- ICAI Guidance NoteICAI's revised 2021 note on accounting for derivative contracts, effective for accounting periods beginning on or after 1 April 2021, requiring every derivative on the balance sheet at fair value.