In Accounting, a Hedge relationship refers to the treatment of an

insurance contract In insurance, the insurance policy is a contract (generally a standard form contract) between the insurer and the policyholder, which determines the claims which the insurer is legally required to pay. In exchange for an initial payment, known as ...

for risk mitigation on an underlying

asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...

, and the set of tests for the valuation of this insurer/insuree contract. More specifically, the accounting term "Hedge relationship" describes the criteria for including the

fair value In accounting and in most schools of economic thought, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. The derivation takes into account such objective factors as the costs associated ...

derivative In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. ...

s on

balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a busine ...

as part of an effort to regulate and normalize the use of hedging in corporate accounting. These contracts are valuable to a company and standardized means of including their fair value on corporate balance sheets is of interest to lenders and investors. In general, the use of hedges and financial derivatives to protect against risk should reflect a

assessment of the hedge and should not appear as items in corporate income. For companies operating outside of the financial services sector an effective hedge should protect against undue loss without being a major component of company

income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''stateme ...

s. To account for the value of these contracts, specified criteria - as noted in IAS section 39 R.88 and updated by

IFRS 9 IFRS 9 is an International Financial Reporting Standard (IFRS) published by the International Accounting Standards Board (IASB). It addresses the accounting for financial instruments. It contains three main topics: classification and measuremen ...

- must be met for a hedge relationship to be deemed to exist and for hedge accounting to apply: so called "hedge effectiveness". Testing must be performed on both elements of the hedge relationship to ensure that the risk mitigation value of the hedge would be effectively reflected in the insurees

profit and loss An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''stateme ...

ledger. "Effectiveness" measures the strength of this relationship; there are several generally accepted "measures of effectiveness": * The "Dollar Offset Method". The method calculates the ratio: ''cumulative'' change in value of the hedging instrument over its life, compared to the same for the hedged item. Value here may be either

, or the

present value In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has in ...

of future expected cash flows; the modelling is usually under simulation. If the ratio is between 0.8 and 1.25 (4/5 - 5/4) under all scenarios - the " 80:125 rule" - then hedge accounting may be applied. *

Regression analysis In statistical modeling, regression analysis is a set of statistical processes for estimating the relationships between a dependent variable (often called the 'outcome' or 'response' variable, or a 'label' in machine learning parlance) and one ...

. A similar approach, but here regressing the expected changes in these values at relevant future time periods - usually financial reporting dates - so as to demonstrate the strength of the hedge-relationship. The modelling uses ''current'' market variables, such as forward rates recovered from the

yield curve In finance, the yield curve is a graph which depicts how the yields on debt instruments - such as bonds - vary as a function of their years remaining to maturity. Typically, the graph's horizontal or x-axis is a time line of months or ye ...

. Here the 80:125 rule applies to the estimated slope; additionally, for the hedge to be deemed effective, the R squared must be better than 0.8. * "Variance-reduction test". Also a comparison of the value or cash flows of the hedged item and those of the hedging instrument, but here returning: Andrew Kalotay (2001)
The Volatility Reduction Measure
''Derivatives Strategy'' ::''1 - (

standard deviation In statistics, the standard deviation is a measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates that the values tend to be close to the mean (also called the expected value) of the set, w ...

of the hedge instrument / standard deviation of the instrument being hedged)''

Sources

Resources * Recognition of previous GAAP hedge relationship when it first applies IAS 39, Accountancy; Jun2004, Vol. 133 Issue 1330, p90-91.
Accounting for electricity derivatives under IAS 39
Journal of Derivatives & Hedge Funds (2007) 13, 233–246. References {{Reflist Derivatives (finance) Accounting terminology Market risk