Finance:Hedge relationship

Hedge relationship describes the criteria for including the fair value of derivatives on balance sheet as part of an effort to regulate and normalize the use of hedging in corporate accounting. A hedge relationship can be conceptualized as a type of insurance contract for risk mitigation on an underlying asset and a set of tests and methods for valuation of this insurer/insuree contract in corporate accounting and reporting. In general, the use of hedges and financial derivatives to protect against risk should reflect a fair value assessment of the hedge and should not appear as items in corporate income. For companies operating outside of the financial services sector an effective hedge should protect against undue loss without being a major component of company income statements. These contracts are valuable to a company and standardized means of including their fair value on corporate balance sheets is of interest to lenders and investors.

To account for the value of these contracts all of the criteria noted in IAS section 39R.88 must be met for a hedge relationship to be deemed to exist and for hedge accounting to apply. Testing must be performed on both elements of the hedge relationship to ensure that the risk mitigation value of the hedge would be effectively reflected in the insurees profit and loss ledger. Effectiveness measures the strength of this relationship.

Measures of effectiveness

For the hedge relationship to be allowable for inclusion in the accounts of a corporate entity testing must be applied. There are several generally accepted measures of effectiveness.

• 80:125 rule.
• Regression analysis.
• Comparison of the value or cash flows of the hedged item and those of the hedging instrument.

Sources

• Recognition of previous GAAP hedge relationship when it first applies IAS 39, Accountancy; Jun2004, Vol. 133 Issue 1330, p90-91.
• Accounting for electricity derivatives under IAS 39, Journal of Derivatives & Hedge Funds (2007) 13, 233–246.