PT - JOURNAL ARTICLE
AU - Kawaller, Ira G.
AU - Koch, Paul D.
TI - Hedge Effectiveness Testing Revisited
AID - 10.3905/jod.2013.21.1.083
DP - 2013 Aug 31
TA - The Journal of Derivatives
PG - 83--94
VI - 21
IP - 1
4099 - http://jod.pm-research.com/content/21/1/83.short
4100 - http://jod.pm-research.com/content/21/1/83.full
AB - A long-running debate in the derivatives world involves how accounting should be handled for hedgers. The key issue is that when a derivative instrument is held for speculation, the mark-to-market cash flows are recognized immediately in profit and loss accounting, but when the derivatives component in a legitimate hedge generates mark-to-market cash flows, these are only offsetting changes in the value of the item being hedged, which are not recognized in the hedger’s P&L until the position is liquidated. “Hedge accounting” treatment allows recognition of the P&L on the derivative to also be deferred. The difficulty is how to draw the line between a legitimate hedge and a speculative position in which there is little connection between a derivative and some item it is supposedly hedging. Current practice is to determine “hedge effectiveness” by considering the “dollar offset ratio,” which is the realized cash flow on the derivatives position as a fraction of the change in value of the hedged item, or alternatively, the R-squared statistic from regressing returns on the hedged item on the contemporaneous returns on the derivative. In this article, Kawaller and Koch demonstrate that both of these measures are flawed and can be quite misleading. They propose two alternative measures that are better behaved in practice.TOPICS: Derivatives, statistical methods