Key points
- Current requirements (IFRS 9 / CAS 24): there is an economic relationship between the hedged item and the hedging instrument; the effect of credit risk does not dominate; and the hedge ratio is consistent with the ratio actually used for risk management.
- The 80–125% range comes from the quantitative “highly effective” test in IAS 39 and the former Chinese hedging standard; the current standards have removed this mandatory band.
- Assessment may be qualitative or quantitative. Common methods include the critical terms match, ratio analysis (the dollar-offset method) and regression analysis. Testing comprises prospective assessment and retrospective measurement.
In practice
Effectiveness is usually assessed prospectively at the inception of the hedge, then reassessed at least at each reporting date or whenever circumstances change significantly. The actual degree of offset for the period is also calculated retrospectively, to determine the ineffective portion to be recognised in profit or loss.
In commodity hedges, common factors affecting effectiveness include basis arising from differences in grade or delivery location between futures and physical, mismatches between the futures contract month and the timing of the physical transaction, and differences between hedged and physical quantities. Companies should set out the test method and thresholds in the hedge documentation and keep the workings for every period; where the ratio drifts persistently, they should rebalance in line with the standard and record the reasons.
How Tranexio supports it
Tranexio runs prospective and retrospective effectiveness tests for each hedge relationship. Quantitative thresholds can be set to match the company’s accounting policy, test results and workings are retained, and the ineffective portion flows automatically into hedge accounting entries. See Hedging and hedge accounting.