A presentation by DHL at EuroFinance’s recent 12th Annual Conference on International Cash and Treasury Management in Barcelona stirs controversy about IAS 39 hedge accounting effectiveness test requirements.

Implementation of IAS 39/FAS 133 is complicated enough without corporates trying to over think things. In the FAS 133 environment, most MNCs have found ways to live within its hedge accounting constraints without resorting to complex mathematics (or hedging structures) to justify hedge accounting effectiveness. IAS 39 should not be that different. Suggestions that it is in a presentation by DHL’s head of corporate treasury, Oliver Schick, and its head of treasury risk management, Leo Daums, at EuroFinance’s recent conference therefore stirred controversy.

DHL is an interesting case, since the express and logistics company went from being a FAS 133- to a primarily IAS 39-reporting company with its acquisition by Deutsche Post World Net in 2001.

Active long-term hedging . . . DHL employs an active FX hedging program that among other things targets annual budget rates set in Q3 of the prior year. This means it is hedging out 12 months based for periods beginning three to six months hence. Hedging anticipated exposures up to 18 months in introduces the possibility for significant forecast error as well as volatility in the currencies impacting the exposures. For this reason, DHL favors options when it hedges with financial instruments. Options allow treasury to protect the business, and not “look stupid in hindsight” when rates move in the business’ favor.

. . . with zero cost option structures. Because it is part of a low margin business, treasury has difficulty justify outlays for option premiums, so it uses zero cost option hedges that involve multiple options.

Per the DHL presentation, the typical option combination consists of the purchase of a vanilla option, the sale of a vanilla option, the purchase of a knock-out option, the sale of knock-out option, and/or the purchase of an “at expiry” digital instrument.

This zero-cost option approach and the relatively long-term horizon of its hedges, DHL argues, creates problems for its IAS 39 hedge effectiveness testing, in particular. Indeed, according to DHL, complex option structures require state of the art quantitative resources and systems and the “software available to corporates on the market are still way behind the complexities of today’s financial products.”

Reliance on bank partner. Accordingly, DHL turned to its bank, Dresdner Kleinwort Wasserstein, to help it perform the perceived necessary analytics for treasury’s effectiveness tests. It uses on “off-line” spreadsheet to demonstrate its forecaste reliability and inputs Dresdner’s analytics of prospective effectiveness test and to track effectiveness over the life the hedges.

To show prospective and retrospective effectiveness for its zero cost option combinations DHL considered several effectiveness test methods: 1) a risk reversal-variance reduction method; 2) a risk reversal-80/125 (dollar offset) method; 3) a risk reversal-regression analysis method using the slope; and 4) a risk reversal-regression analysis using the R-square.

The first, or variance reduction method, is the one DHL found produced the most consistent effectiveness results. The variance reduction method measures the ability of the hedging strategy to reduce/eliminate the impact of the underlying risk.

With Dresdner’s assistance, DHL runs Monte carlo simulations of all outcomes to indicate prospective effectiveness and factors this analysis into the option combination structures it puts on as hedges.

By taking into account the daily changes in fair value of the combined position (the underlying and the zero-cost option combination) relative to the daily changes in fair value of the hedged item, DHL is able to prospectively show high rates of effectiveness averaging over 96%, and more than meet the minimum 80% threshold over the life of the typical hedging relationship.

The right approach? During the Q&A following the presentation, at least one FAS 133 “expert” in the audience questioned whether DHL was actually required to employ this level of complexity in its effectiveness testing under IAS 39. One of the reasons for DHL going to such lengths to show prospective effectiveness, for example, is the perception that IAS 39 requires a 95% threshold vs. FAS 133’s 80%. The questioner pointed out that the IASB, in its more recent tentative guidance, has indicated that it was moving toward the FAS 133 threshold.

Also, in the questioner’s view, the global audit firms were inclined, given the lack of specific guidance under IAS 39, to allow a quasi-G20, FAS 133/149 approach to prevail. This approach keys on the risk management objective and lets entities assess effectiveness based on total changes in the fair value of the option hedge’s cash flows using the hedging instrument’s terminal value (that is, its expected future pay-off amount at its maturity date)—or assume effectiveness under critical match criteria.

DHL’s bank advisor from Dresdner responded that the option structure was too complex to meet such G20-like guidance.

Such back and forth suggests that corporates implementing IAS 39 should consider pushing back harder on their auditors to keep them up to date on IAS 39 convergence with FAS 133 and determine if they cannot indeed win an interpretation closer to FAS 133 guidance (when this is advantageous). Meanwhile, MNCs should question the true cost/benefit of employing bank-recommended hedging structures that require complex effectiveness testing, merely to avoid paying option premiums.