What is a hedge effectiveness testing?
it’s a numerical test in hedge accounting to determine if hedging financial instrument effectively hedges underlying loan.
In case when hedge is effective company can apply “hedge accounting” and would not be obliged to appy derivatives profit/loss to accounts , helping reduce accounts volatility.
if company has a 10 years loan of 1 million euros with floating rate euribor 6m
as a heding instrument company chooses fixed-floating interest rate swap with fixed rate 2% and loan and swap payment dates coincide
hedge effectivness test would consist in 2 parts:
1) retrospective test
which measures ratio (dollar offset) between change in value of hypothetical derivative (ideal hedge) and hedging instrument
if R(t) is real derivative fair value at time t (derivative bought for hedging)
and H(t) is Hypothetical derivative fair value at time t (derivative which would be an ideal hedge for the loan)
and T is valuation date for hedge effectiveness testing and t is inception date (when the hedge instrument was bought)
then dollar offset D would be
and this value normally supposed to be between 80% and 125%
2) prospective test
it would measure statistically correlation (R squared) and slope by changing current yield curve and calculating the ratio for various interest rate scenarios
in this hedge effectiveness testing we would take the yield curve for valuation date and then shift it for example 1% up , then recalculate change of value for real and hypothetical derivative , thus obtaining various points ,
then just feed these points to excel RSQR function and it will give the ratio and to excel SLOPE function to get the slope