Prospective effectiveness testing
Also written Prospective hedge effectiveness test
The 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.
In plain language
Before a company can use hedge accounting, it must show that its hedge actually works. There are two checks for this, and prospective testing is the first one.
Prospective testing looks ahead. It asks: if prices move, will this hedge offset almost all of that move? The company must ask this question when it first sets up the hedge. It must ask it again at every reporting date after that, for as long as the hedge lasts.
The partner check, retrospective effectiveness testing, looks back. It checks what the hedge actually did, not what it was expected to do.
How it works
Chapter 9, section 9.1, sets the standard directly: prospective testing "has to be performed at inception of the hedge and at each subsequent reporting date during the life of the hedge." The test must show that the company expects changes in the fair value or cash flows of the hedged item to be almost fully offset — that is, nearly 100 per cent — by changes in the fair value or cash flows of the hedging instrument.
The ICAI Guidance Note does not prescribe one fixed method for this. It gives examples instead: regression analysis, the Dollar offset test, critical item matching, and a plain check of the economic relationship between the underlying and the hedging instrument. Whichever method is used, it must be recorded, and it sits alongside board-approved formal hedge documentation as one of the two conditions the workbook sets for hedge accounting.
A worked example
A jewellery exporter plans to buy 200 kg of gold in six months to fill a confirmed export order. Today, it buys gold futures for the same 200 kg to lock in its cost.
At the moment it designates this hedge, it runs the prospective test. Gold futures on this exchange track the exporter's physical gold cost almost one for one — the exporter's own study shows a historical offset of about 98 per cent between changes in the futures price and changes in its landed gold cost. That clears the "almost fully offset" bar, so the hedge qualifies for hedge accounting from day one.
Six months is a long life for one contract, so the exporter must run this same forward-looking check again at each quarterly reporting date, not just once at the start. If gold's price relationship to the futures contract weakens — say a change in import duty starts moving spot and futures apart — the test could fail at a later date even though it passed at inception.
Why NISM asks about it
Chapter 9 (Accounting and Taxation), section 9.1, under "Hedge effectiveness / ineffectiveness," sets prospective and retrospective testing side by side as the two mandatory checks. Expect a question asking which test is run at inception — prospective, not retrospective — and which offset standard applies to it: nearly 100 per cent, not the 80-125 per cent band used for the backward-looking check.
Common exam traps
- Prospective testing runs at inception too, not only at each reporting date. Retrospective testing has no inception leg — the hedge has not lived yet.
- The offset standard is "almost fully" — nearly 100 per cent — not 80-125 per cent. That range belongs to the retrospective test.
- The ICAI Guidance Note names example methods; it does not mandate one. Regression, Dollar offset and critical item matching are illustrations.
- Passing the prospective test does not excuse the company from testing again later. It is required at every subsequent reporting date, not once and done.
Where this is taught
Free preparation for NISM Series XVIRelated terms
- Fair valueThe theoretical futures price — spot plus the cost of carrying the commodity to expiry — at which a buyer is indifferent between buying today and buying forward.
- Accounting mismatchThe gap between a derivative, measured at fair value, and the exposure it hedges, usually measured at cost — the very mismatch hedge accounting exists to offset.
- 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.
- 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.
- Hedged itemThe 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.