A hedge is a financial instrument or investment made to reduce the risk of unfavorable price movements in an asset. Hedges are used in practice by both large businesses and smaller businesses alike. Small companies may be more inclined to use strategies such as forwards, options, or futures to hedge themselves against risks spanning from a foreign currency, interest rate increases, or fluctuations in commodity prices.
Traditionally, hedging involves taking a position that offsets a position on a related security already held in a portfolio. For businesses, they may wish to hedge risk from foreign currency fluctuations if they have invested overseas, interest rate hikes for any funds borrowed, or oscillating prices in commodities if that is where capital is invested.
While reducing risk is great, there is an offset as reducing risks reduces the overall potential for gains. Hedging can be compared against an insurance policy, in which monthly premiums are paid to cover the potential for substantial losses. Even if no loss occurs, that is money going out the door every month. However, many people and businesses would rather have a predictable reoccurring loss than lose everything they have in one fell swoop.
Measuring hedge effectiveness is often done through a measurement known as delta or the hedge ratio. The delta is the amount the price of the hedge or derivative moves per $1 change in the original asset's price. For example, if a business holds 5,000 shares of company XYZ, they may also hold 50 put option contracts for XYZ. The delta will compare the fluctuating premium of the option contract to the price XYZ is trading on the stock exchange. Through international and U.S. accounting standards, hedge effectiveness must be tested on both prospective and retrospective levels.
For businesses taking on a new hedge position to qualify for hedge accounting, they must run a prospective hedge effectiveness test to determine an expected efficacy level. This is a forward-looking test that speculates whether or not the hedge will offset the underlying item.
After the initial test, businesses must conduct subsequent tests quarterly or at least as often as financial statements are prepared. Both a prospective and retrospective test are required at each milestone to review if the hedging strategies have been successful and will continue to project a level of effectiveness for the remainder of the relationship.
While International and U.S. accounting standards do not specify an exact formula to calculate the productivity of hedging strategies, they allow for specific qualitative or quantitative methods to extrapolate the necessary data. Most businesses look to quantitative methods as qualitative methods require a rigorous set of criteria. Each company must formulate a method in line with its dedicated risk management policies to reinforce hedging strategies' productivity. Some common examples of acceptable quantitative methods include the Dollar Offset Method and Regression Analysis.
About Daniel Calugar
Daniel Calugar is a versatile and experienced investor with a background in computer science, business, and law. He developed a passion for investing while working as a pension lawyer and leveraged his technical capabilities to write computer programs that helped him identify more profitable investment strategies. When Dan Calugar is not working, he enjoys spending time working out and being with friends and family and volunteering with Angel Flight.