Points Well Taken: Revisiting Effectiveness Methods, in the Context of Proposed Hedge Accounting Rules

The FASB’s proposed changes to its hedge accounting model may provide an impetus for hedgers to reassess their current approaches to effectiveness testing and consider how they might best benefit from the future rules as they are likely to be structured.

An example of a strategy that may warrant reconsideration is the common strategy of using FX forward contracts as cash flow hedges of forecasted FX-denominated transactions and excluding the forward points on those contracts from effectiveness assessment.

Excluding forward points on FX hedges offers some benefit under the rules as currently written. Effectiveness testing using statistical regression under this approach is typically simple, with fairly minor data requirements (generally a series of FX spot rates and interest rates). OCI balances are easily reconciled under this approach, since they are mainly a function of spot FX rates effective at the point of hedge designation, and the spot rate on the date of measurement. The component of the change in the fair value of the FX forward contract due to forward points flows to income under this approach, and is generally small in this era of low interest rates globally, especially for the major currencies.

Effectiveness testing using statistical regression under this approach is typically simple, with fairly minor data requirements (generally a series of FX spot rates and interest rates).

FX hedgers can likely continue with this approach under the proposed changes to hedge accounting rules, but the inclusion of forward points may be worth consideration in light of the coming rule changes. Although the forward point impacts are not always material, they can be significant for large trades, trades with long maturities, and trades in emerging market currencies. In addition, in some cases, in the first reporting period after trade execution for a designated FX trade which has forward points excluded from effectiveness, there can be an outsized hiccup in the P&L due to changes in forward points, as the points effective on the contract traded with the FX bank may be re-measured against a different forward point data source for financial reporting purposes. Most hedgers would agree it would be beneficial to defer as much of the change in value of the FX forward contract in OCI, and there is more potential deferral with an effectiveness method which includes forward points.

Based on the elimination of ineffectiveness as a reporting concept, the new rules could make the inclusion of forward points in effectiveness assessment more attractive. Under current accounting rules, an FX hedger that is including the forward points in effectiveness assessment must first value an actual and a hypothetical forward contract (which typically will have different contract rates and maturity dates, unless some aggressive forecasting assumptions regarding the timing of the hedged transaction are made), then determine if the derivative over or under-performed the hypothetical, and finally book the appropriate amount to OCI. Once the new rules are in play, much of this administration goes away; the full fair value of an FX forward that was designated as a cash flow hedge from trade inception will be booked in OCI, assuming an initial effectiveness test remains valid.

Most hedgers would agree it would be beneficial to defer as much of the change in value of the FX forward contract in OCI, and there is more potential deferral with an effectiveness method which includes forward points.

A small trade-off if is that the quantitative effectiveness testing for an FX forward contract with forward points included is slightly more involved vs. the approach when excluding forward points, and requires the regression of changes in FX forward rates for various contract maturities against the changes in FX forward rates for other maturities. So the data requirements are somewhat increased, but this is a small price to pay to book the full fair value of the hedge in OCI and not be saddled with the ongoing administration, disclosure requirements, and P&L impact that results from excluding the forward points from effectiveness assessment. With a forward rate data source established and regression model built, the quantitative effectiveness testing should be fairly mechanical.

For these reasons, once the new rules are written, current FX hedgers excluding forward points on effectiveness testing may want to consider a future transition to a hedge accounting approach that includes forward points. Those who are considering but have not yet established FX cash flow hedging programs using forward contracts, might consider inclusion of forward points even with the drawbacks under the current rules, as this may simplify transitioning to a new approach based on the inclusion of forward points once the new rules are effective.