Hedge effectiveness testing: example for a loan and swap transaction

Selecting an appropriate hedge effectiveness methodology is vitally important, since the wrong choice can produce spurious and misleading results. There are accounting standards (IAS39, FAS133) in place for hedge accounting, but these are based on very general principles and allow a significant amount of flexibility.

The four main methods to measure hedge effectiveness are:

• Critical Term Match Method
• Dollar-Offset Method
• Regression Analysis
• Risk Reduction Method

We will examine the first three below.

The Critical Term Match Method

Allows the assumption that a hedge can be considered  “perfect” without an on-going assessment of effectiveness. For instance, an interest rate swap is likely to be a perfect hedge if the following parameters in both loan (hedged instrument) and swap (hedge) are identical:

• notional amounts
• terms
• payment and fixing dates
• amortisation schedules
• reference rates
• day conventions

Often, however, these parameters do not (fully) match, so other methods should be applied. Before introducing these, let us turn our attention to the term  “reference exposure”. It is possible to review an underlying with an existing hedging instrument or to compare it to an Ideal Designated-Risk Hedge (IDRH). We use the IDRH as the reference exposure, on the basis of which we define an ideal hedge for an underlying instrument. Intuitively for a floating rate loan, the IDRH is an interest rate swap in which we receive floating rate and pay fixed rate. Note: The ideal swap’s floating leg has identical terms to those of the loan.

Dollar Offset Method and Regression Analysis  

In both cases - Dollar Offset Method and Regression Analysis – the cumulative change of the hypothetical swap cash flows (net payments) is compared to the cumulative change of the actual swap cash flows (net payments). The next step is to use this data to implement either the Dollar Offset Method or Regression Analysis for both retrospective and prospective analysis. Note: It is important to perform analyses for both historical and future periods.

Now consider a loan and a swap in relation to which an analysis of hedge accounting is to be performed. The instruments have the parameters outlined in table 1. As you can see, the actual swap is not an ideal hedge for this loan. The receive leg pays semi-annually according to 6-month Euribor. For an ideal swap, there should be monthly payments (1-month Euribor). Common sense tells one that the actual swap has fairly reasonable hedging properties, as 1-month and 6-month Euribor rates behave similarly. This would not be the case, however, for 1-month Euribor versus 10-year swap rate.

Table 1. Details of the hedged item (loan) and hedging instrument (swap)

Please note: Actual hedge instrument is not identical in all terms with ideal Swap!

The results of any effectiveness test need to be interpreted in the context of hedging objectives. This interpretation is usually facilitated by defining effectiveness ’thresholds’ for the test (referred to as ’lower’ and ’upper’ in our explanation). For example, the actual swap is an effective hedge according to the Regression Analysis if the correlation is between 0.8 and 1.0, the slope of the regression line is between 0.8 and 1.25 and the determination coefficient (R-squared) is above 0.64.

The results show that the hedge surpasses both Dollar Offset and Regression Analysis for prospective periods. But there is a different outcome in the retrospective analysis: According to the regression test, it is an effective hedge but fails the Dollar Offset test.

Dollar-Offset Analysis (retrospective)

Dollar-Offset Analysis (prospective)

Regression Analysis (retrospective)

Regression Analysis (prospective)