Measuring Hedge Effectiveness for FAS 133 Compliance

Abstract

Financial Accounting Standard (FAS) 133 requires business entities to document their anticipation of hedge effectiveness in order to qualify for hedge accounting treatment of gains and losses from financial derivatives. Meaningful assessment of anticipated hedge effectiveness must consider two distinct aspects of a firm’s hedging strategy: (i) the strength of the hedging relation, which depends on the correlation between price changes in the hedged item and the hedging instrument under consideration; and (ii) the position taken in the hedging instrument relative to the optimal position. We propose an operational definition of hedge effectiveness that addresses both aspects of the hedging strategies under consideration. We then develop alternative measures of hedge effectiveness that take into consideration both the strength of the hedging relation and the hedge actually employed. This approach enables the user to evaluate the relative merits of alternative hedging strategies and thereby support risk management decisions, and to document the anticipation that a selected hedging strategy will be effective for compliance with FAS 133.