1. User Guide
  2. Hedge Management Effectiveness Process
  3. Hedge Effectiveness Testing
  4. Quantitative Attributes

Quantitative Attributes

Economic Relationship: This attribute tests if an economic relationship exists between the hedged item and the hedging instrument. The process requires the fair values of both the hedged item and the hedging instrument for a set of dates. The system compares the fair values of both the hedged item and hedging instrument and calculates the correlation factor for the same. The correlation range that is acceptable to the entity is stored in the system and is compared with the correlation factor of the specific hedge.

If the correlation value of the hedge is within the range, then an economic relationship exists and the hedge is effective, else it is considered ineffective. If there are multiple hedging instruments present, then multiple correlation values are calculated as output. Economic Relationships can be computed using Retrospective, Prospective, or Scenario-Based methods. Prospective testing is possible only if the hedge consists entirely of Level 3 accounts. If the hedge consists of Level 1 or Level 2 instruments, then only retrospective testing is possible.

Hedge Ratio: This is computed using one of the three methods.

  • Dollar Offset Method
  • Variability Reduction Method
  • Regression and F-Test

The entity can choose to select one of the methods to compute the Hedge Ratio. Hedge Ratio can be computed either retrospectively or prospectively. Prospective testing is possible only if the hedge consists entirely of Level 3 accounts. If the hedge consists of Level 1 or Level 2 instruments, then only retrospective testing is possible.

Hedge Ratio can be computed using cumulative period or net period. If a Cumulative period is selected, then fair values of multiple dates are considered for the calculation. For the retrospective method, if the period selected is Net, then fair values of only the hedge effectiveness date and previous date should be considered for calculation. For Prospective if the period selected is Net, then for the execution date, fair values between the start date index zero and one are considered.

The resulting value is compared with the range present in the system stored earlier. If the value is within the specified range, then the hedge is effective, else it is considered ineffective.

Fair Values of different Scenarios are considered for Scenario-based Hedge Effectiveness Testing. Hedge Ratio is computed by considering Fair Values across all Scenarios. Scenario-Based Hedge Effectiveness Testing requires at least 30 Scenarios to be defined.

In Hedge Effectiveness Testing and Economic Relationship processes, where the application computes Hedge Ratio and Correlation respectively, if there are instruments with different currencies, the Fair Values are converted to a common reporting currency (as defined through the application UI) using the exchange rates as of the corresponding dates/start date indices.

Note:

For historical dates, the Exchange Rates as provided as a download on those dates are used. For forward or prospective start date indices, the exchange rates computed through ALM are used.

If the exchange rate is not provided, the default value will be taken as 1.

In the case where a Hedge Definition has both Assets and Liabilities as part of its Hedged Item, the Fair Value of Liabilities is deducted while doing the aggregation.