Effectiveness is the core of FAS 133. Whether
or not a hedge is expected to qualify under whatever
test a company chooses to run prospectively will
determine the application of special accounting. It’s
therefore, important that companies understand the
alternative methodologies and test their selected
approach on their hedges before making the designation.
Once a test methodology is elected for a particular set
of hedges, it cannot be changed no matter how
unattractive the results.
Some methods, like
the dollar offset, are simple but may end up generating
more ineffectiveness than other methods – mostly
statistical. So, in electing the test for prospective
and actual measurement of effectiveness (remember, the
same test need not be elected for both), companies must
consider the following:
(1) Do you want a
liberal or conservative test? i.e., will the test
be used solely for accounting/reporting or will it also
be utilized for measuring risk management goals?
(2) What sort of
test fits the particular hedge strategy being employed?
Some strategies are unlikely to generate much
noise, other “ineffectiveness-prone” strategies are.
Statistical tests are probably the best ones for
anything other than “perfect” hedges.
(3) What time
period to use in making the assessment? Cumulative
changes are often better at smoothing out daily
volatilities.
(4) What are the
tests contained within the existing risk management or
accounting software package? Some vendors offer only
basic testing. If dollar offset is less than what you
need, you may need an add-on, analytical tool or else a
different package.
(5) What will your
auditors accept? Different auditors will have different
approval levels. Some may have particular regression
variables that they find acceptable for particular
hedges.
(6) Is an
alternative test, such as VRM, needed? Some companies
are less averse to new methods, particularly when these
might allow them to continue their economic hedge
programs. Others would rather wait for market standards
to evolve.
(7) Finally, how
much volatility in income is acceptable? No matter what
methodology is used, some hedges will generate
ineffectiveness. Examining the overall impact on the
P/(L) will help quantify what movement can be expected.
If the volatility proves too much, there are steps
companies can take to mitigate that impact using hedge
instruments, or by adjusting the notional amount of
their hedges.
