Retrospective effectiveness testing
Also written Retrospective hedge effectiveness test
The 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.
In plain language
Hedge accounting is a privilege: it lets a company match a derivative's gains and losses with the item it hedges, instead of reporting them separately. The accounting standards grant it only to hedges that are highly effective.
Effectiveness is tested twice over. Prospective testing asks whether the hedge is expected to work. Retrospective testing asks whether it did — looking back at actual results at each reporting date.
The retrospective test passes if the hedge's actual results fall within 80 to 125 per cent.
How it works
The two mandatory tests (Chapter 9, section 9.1):
| Prospective | Retrospective | |
|---|---|---|
| When | At inception and at each subsequent reporting date | At each reporting date through the life of the hedge |
| Question | Is the hedge expected to offset the hedged item? | Has the hedge been highly effective? |
| Standard | Changes in fair value or cash flows expected to be almost fully offset (nearly 100%) | Actual results within 80-125% |
| Method | — | Follows the methodology set out in the hedge documentation |
Methods. The ICAI Guidance Note does not prescribe a specific methodology. It gives examples: regression analysis, the Dollar offset test, critical item matching, the economic relationship between underlying and hedging instrument, negligible impact of credit risk, and a review of sources of ineffectiveness.
Why it matters. Effectiveness assessed and recorded on an ongoing basis throughout the reporting period is one of the two conditions for hedge accounting, with formal documentation under a board-approved risk management policy. And where hedging is not 100 per cent effective, the mismatch shows up in profit and loss.
A worked example
A soybean oil refiner has designated short soy oil futures as a hedge of its oil inventory. At each reporting date it compares the change in the hedging instrument with the change in the hedged item — one simple way to express an offset test. (All figures illustrative.)
Offset ratio = Change in value of hedging instrument ÷ Change in value of hedged item
| Quarter | Inventory value change | Futures MTM | Offset ratio | Within 80-125%? |
|---|---|---|---|---|
| Q1 | Rs -50,00,000 | Rs +45,00,000 | 90% | Yes |
| Q2 | Rs -50,00,000 | Rs +60,00,000 | 120% | Yes |
| Q3 | Rs -50,00,000 | Rs +35,00,000 | 70% | No |
| Q4 | Rs -50,00,000 | Rs +65,00,000 | 130% | No |
Q1 passes, but it is not perfect: the Rs 5 lakh by which the futures under-compensated is ineffectiveness that affects profit and loss.
Q3 fails. The hedge offset only 70 per cent of the inventory loss. Perhaps the futures were on a different grade or delivery centre and the basis moved. The retrospective test is exactly what surfaces this.
Q4 also fails, from the other side — the hedge over-compensated. An instrument that moves far more than the item is not an effective hedge either; it is partly a separate position.
Why NISM asks about it
Chapter 9, section 9.1 (Important Accounting Aspects Related to Trading in Commodity Derivatives), under "Hedge effectiveness / ineffectiveness", sets out the prospective and retrospective tests, the 80-125 per cent range and the examples of methodology from the ICAI Guidance Note. Expect a question on the retrospective range, on which test expects nearly 100 per cent offset, and on whether the Guidance Note prescribes a method.
Common exam traps
- 80 to 125 per cent is the retrospective range. Prospective testing expects nearly 100 per cent offset.
- Both tests are mandatory.
- Retrospective testing happens at each reporting date, following the methodology in the hedge documentation; prospective testing at inception and each reporting date.
- The ICAI Guidance Note does not prescribe a method. Regression, Dollar offset and critical item matching are examples, not requirements.
- Over-hedging fails too. Above 125 per cent is outside the range.
- Passing the test does not mean zero P&L impact. Where the hedge is not 100 per cent effective, the difference shows in profit and loss.
- The offset ratio in the example is an illustration of a Dollar offset style comparison; the workbook names the method but does not print a formula.
Check yourself
1.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
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- Basis riskThe risk left over after hedging, because the exposure and the contract used to hedge it do not move identically — in size, in expiry date, or in what they are written on.
- 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.
- 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.
- 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.
- 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.
- 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.