Hedging strategies and effectiveness - Hedge performance mea...

Learning Outcomes

By reading this article, you will be able to evaluate hedging strategies in financial management, identify key measures for assessing hedge performance, and explain the accounting impacts of hedging and hedge effectiveness testing. You will also understand the practical and regulatory context of hedge accounting and be able to apply core concepts and calculations likely to be tested in the ACCA AFM exam.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand both the practical and technical aspects of hedge effectiveness and related accounting issues. In particular, you should be able to:

• Assess the rationale for using hedging strategies and their effectiveness in managing financial risks
• Apply and evaluate performance measures for financial hedges
• Explain the key accounting impacts of different hedging arrangements, including the requirements for hedge accounting under IFRS
• Assess the requirements for (and implications of) hedge effectiveness testing under international standards
• Discuss the implications of hedge ineffectiveness and associated disclosures

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best defines hedge effectiveness?
   1. The ability of a hedge to eliminate all risk
   2. The accounting process of recognising hedge gains and losses
   3. The degree to which changes in a hedging instrument offset changes in the hedged item
   4. The cost of entering the hedge

2. True or false? Under IFRS, only perfectly effective hedges may qualify for hedge accounting.

3. Name two commonly used quantitative measures for evaluating hedge effectiveness.

4. If a company designates a cash flow hedge under IFRS 9, where are effective and ineffective portions of the hedge gain or loss reported in the financial statements?

5. Give one reason why a hedge might fail hedge effectiveness testing and explain a possible impact on the financial statements.

Introduction

Risk management through hedging is a major area tested at ACCA AFM. While understanding hedge instruments is important, it is equally essential to know how hedges are assessed, how performance is measured, and what the accounting implications are. Measurement of hedge effectiveness impacts both financial management decisions and compliance with financial reporting requirements. This article covers the key methods for evaluating hedge performance, the implications for financial statements, and what happens when a hedge is ineffective.

Key Term: hedging
A risk management strategy that uses financial instruments or contracts to offset the impact of adverse price movements in an identified exposure.

Key Term: hedge effectiveness
The degree to which changes in the value or cash flows of a hedging instrument offset changes in the value or cash flows of the hedged item attributable to the hedged risk, as required for hedge accounting under IFRS.

Measuring Hedge Performance

Hedge performance refers to how well a hedge achieves its objective of risk reduction. Both management and accounting standards require a systematic evaluation of this performance, usually through effectiveness testing.

Quantitative Measures

Several approaches are used to measure hedge effectiveness:

• Dollar offset ratio: Compares the change in value (or cash flows) of the hedging instrument to the change in value (or cash flows) of the hedged item over a defined period. A ratio near 1 indicates high effectiveness.
• Regression/correlation analysis: Statistical methods that assess the strength and consistency of the offset relationship between the hedge and the exposure. High correlation (e.g., R² above 0.8) supports effectiveness.
• Critical terms matching: Qualitative approach, relevant where hedge instrument and the exposure have matching key characteristics (amount, timing, maturity, rate).

Key Term: dollar offset ratio
A quantitative measure of hedge effectiveness, calculated as the ratio between the change in the hedging instrument and the change in the hedged item over the period tested.

Effectiveness Thresholds

Under IFRS 9, a hedge is considered effective if the hedge relationship meets all the following:

• There is an economic relationship between the hedged item and the hedging instrument.
• The effect of credit risk does not dominate value changes.
• The hedge ratio is consistent with the risk management objective.

Although IFRS 9 does not prescribe a strict pass/fail ratio (unlike the old 80–125% rule under IAS 39), quantitative and qualitative evidence must support the existence of an effective offset.

Worked Example 1.1

A company is exposed to payments in euros in six months. It enters into a forward contract to hedge this exposure. Over three months, the hedged item’s fair value increases by $1,000, while the hedge instrument’s value decreases by $900.

Calculate the dollar offset ratio and assess effectiveness.

Answer:
Dollar offset ratio = |–$900| / |$1,000| = 0.9 or 90%. The ratio is reasonably close to 1, indicating a high degree of effectiveness. Supporting documentation and the economic relationship would be required for hedge accounting under IFRS 9.

Accounting Impacts of Hedging

Correct accounting for hedges is heavily dependent on whether the hedge meets effectiveness criteria.

Designation and Accounting Models

Hedges must be formally documented at inception to qualify for hedge accounting under IFRS 9. There are three main hedge accounting models:

• Fair value hedge: Hedging exposure to changes in fair value of a recognised asset or liability (e.g., fixed-rate debt). Gains/losses on both the hedging instrument and the hedged item are recognised in profit or loss.
• Cash flow hedge: Hedging exposure to variability in cash flows associated with a recognised asset/liability or forecasted transaction. The effective portion of hedge gains/losses goes to other comprehensive income (OCI), with amounts subsequently reclassified to P&L when the hedged item affects profit or loss. The ineffective portion is recognised directly in P&L.
• Net investment hedge: Hedging exposures to the translation of net investments in foreign operations.

Key Term: hedge accounting
An accounting method allowing matching of gains and losses on hedging instruments and hedged items in the same reporting period, reducing income statement volatility.

Worked Example 1.2

A UK company uses a forward contract to hedge a highly probable purchase of inventory in USD. At year-end, the forward contract is showing a $12,000 gain. Only $11,000 of this amount offsets changes in the expected cash flows from the purchase; $1,000 is considered ineffective.

How are these amounts accounted for under IFRS 9?

Answer:
The $11,000 effective portion is recognised in OCI (cash flow hedge reserve). The $1,000 ineffective portion is reported in profit or loss.

Hedge Ineffectiveness

If a hedge relationship is found to be ineffective (e.g., due to basis risk, mismatches in timing or amount, or early termination), hedge accounting may be discontinued. Future gains and losses are then reported as they arise, which can increase reported earnings volatility.

Key Term: hedge ineffectiveness
The portion of the gain or loss on the hedging instrument that does not offset the loss or gain on the hedged item.

Hedge Effectiveness Testing under IFRS

To use hedge accounting, ongoing effectiveness testing is required. The company must demonstrate prospectively (at inception) and retrospectively (throughout the hedge life) that:

• There is an economic relationship between the hedged item and the hedging instrument
• The hedge is expected to be (and remains) effective in offsetting changes in value or cash flows arising from the hedged risk

Companies must document the risk management objective, the method of effectiveness assessment, and all results.

Worked Example 1.3

A UK exporter uses a currency option to hedge expected sales receipts in six months. A fall in foreign exchange rates means the hedge gains $50,000, but sales ultimately decrease by $100,000 in GBP terms, due to lower overseas volume as well as rates. Is the hedge fully effective?

Answer:
No. Hedge effectiveness relates only to offsetting FX risk, not business volume risk. Only that portion of option gains that offset the FX rate movement is effective; the rest (volume component) is not covered by the hedge.

Exam Warning

Beware: Only the risk specifically identified and documented in the hedge relationship may be included in effectiveness testing. Hedging unrelated risks (e.g., sales volumes) does not qualify for hedge accounting.

Revision Tip

Remember, effectiveness testing is principles-based under IFRS 9. Focus on demonstrating an economic relationship and consistent intent, instead of strict numerical limits.

Summary

To secure hedge accounting treatment, companies must design robust hedging relationships, measure hedge performance with both quantitative and qualitative methods, and meet ongoing documentation and testing requirements. Hedge ineffectiveness can cause volatility in reported earnings and may result in discontinuation of hedge accounting.

Key Point Checklist

This article has covered the following key knowledge points:

• The main goals and types of hedging strategies in risk management
• How hedge effectiveness is defined and measured quantitatively (e.g., dollar offset ratio) and qualitatively
• The accounting models for hedges (fair value, cash flow, net investment) and their impact on financial statements
• Hedge accounting requirements under IFRS 9, including documentation and effectiveness tests
• The treatment of hedge ineffectiveness and consequences of failing effectiveness tests

Key Terms and Concepts

• hedging
• hedge effectiveness
• dollar offset ratio
• hedge accounting
• hedge ineffectiveness