>Hedge effectiveness is the test applied to a hedging instrument to ascertain whether it will be eligible for hedge accounting. Hedge accounting allows a heding instrument (normally a derivative) to be exempt fromt he mark-to-market requirement of FAS 133 and IAS 39, instead the instrument is carried on the balance at its fairmarket value but the gains and losses are instead posted to reserves and not to the Income Statement.
There are two types of hedge – cash flow hedge and fair value hedge. A cash flow hedge matches cash flows from an instrument with predictable cash flows from a hedging instrument. A fair value hedge matches the changes in fair value in the underlying insturmnet with the cahnges in fair value of the hedging instrument.
To qualify for hedge accounting a hedging effectiveness of 0.80 – 1.25 is normally required. This hedge effectiveness is calculated by performing a regression analysis on the underlying instrument and the hedge.
Derivatives ONE provides a free set of tool which can assist in the calculation of hedge effectiveness by valuing a range of cash flow instruments (such as interest rate swaps) and a wide range of derivative instruments.
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