There are two basic effectiveness test,
and two basic methodologies for testing effectiveness
discussed in FAS 133 and outlined in subsequent guidance
by the Derivatives
Implementation Group (DIG).
“DIG Issue E7 clarifies that an entity
must assess effectiveness in two ways,” notes Tony
Capozzoli with Bank of America Global Risk Analysis. “It
must consider how the hedge may perform in the future
(prospective) and it must evaluate how the hedge has
performed in the past (retrospective or actual.)” The
prospective assessment determines whether or not the
company can designate the hedge and hedged item in a
hedging relationship. If there’s no expectation of
highly effective offset, there’s no hedge accounting.
Retrospective, or actual assessment examines how the
relationship fared over the past quarter or since the
inception of the hedge. “If the retrospective test is
failed, hedge accounting will not apply to that
quarter,” Mr. Capozzoli says.
In general, there are two ways to
assess or measure effectiveness: Dollar offset and
statistical analysis.
“The dollar offset ratio is simply
the change in the fair value of the hedge instrument as
specified in the documentation by the change in the fair
value of the hedged item’s hedged risk,” notes Jeffrey
Wallace, managing director at Greenwich Treasury
Advisors. Hedgers can look at the change in value on a
period-by-period basis, or cumulatively from the hedge’s
inception. “This ratio, typically calculated as a
percent, should be within a user-specified floor and
ceiling,” The most common range is referred to as the
80-120% or 80-125% rule. It’s not really a rule. It’s
more of an evolving market practice and a carry over
from the old days of FAS 80 (more on this
below).
Statistical analysis is a rather
vague term. Again, the FASB does not dictate a
particular method. "There are no standards in place
yet," notes Deveaux Barron, director of client services
for Principia Partners, a software vendor. "Each client
can interpret the regulations in a way that is
appropriate for their business, and system flexibility
is key to that process. Many of our clients are waiting
to see which test gives them the most favorable result,
as well as whether their March-end numbers are approved
by their auditors," she says. "Although currently we see
regression as the most popular, users are beginning to
examine the ‘Volatility Reduction Method’ (VRM)."
Hedgers can decide to use dollar
offset or their statistical method of choice for either
the actual or prospective analysis, and they don’t need
to choose the same methodology for both. However, once a
decision is made, the methodology cannot be changed for
the life of the hedge. Also, the FASB directs companies
to use similar methodologies for similar hedges.
In general, if a hedge fails the
actual test for a period, there’s no hedge accounting
for that period. However, if the hedge continues to show
good promise when tested prospectively (i.e., there’s
still an expectation of high correlation), the company
may redesignate the hedge at the next period.
In practice, notes Brian May, senior
manager with Arthur Andersen, it’s unlikely that many
hedges would fall out of bed and still look like
effective hedges going forward. Mr. May’s feeling is
that hedgers will have a hard time making a case for
re-designating the hedge by arguing that whatever
generated the ineffectiveness is not going to repeat
itself or happen again. Using cumulative dollar offset
or regression analysis (or other statistical method) may
lower the chances of failing the retrospective test on a
quarterly basis. Still, even with these latter methods,
it’s important to remember that if a hedge is 80%
effective, the 20% of change in its fair value still
needs to be recognized in income, currently.
In addition, to meet the
effectiveness requirements, it will often be necessary
to exclude a certain portion of the derivatives fair
value, for example forward points or time value. Those
excluded portions must be recognized in income on a
current basis as well. So while the test may give an
“effective” answer, there still may be significant
volatility in the income statement.
DIG issues E7
and E8
form the core of the current effectiveness
guidance.
