HEDGE EFFECTIVENESS TESTS FOR FOREIGN EXCHANGE DEALS

Transcription

1 HEDGE EFFECTIVENESS TESTS FOR FOREIGN EXCHANGE DEALS 1. Introduction 2. How to run hedge effectiveness tests in Bloomberg 3. Case study testing the hedge effectiveness of a FX forward hedge 4. Appendix - Field definitions 1. Introduction Under Internal Accounting Standard (IAS) 39 and FAS 133 (the US equivalent), companies are required to report their derivatives on the balance sheet at fair value. However, under certain conditions the derivatives can be deemed part of a hedge relationship that qualifies for preferential hedge accounting treatment meaning the derivative hedge s gain and losses do not need to be reported at fair market value.

2 The Bloomberg hedge effectiveness tool (HEFF) allows you test your hedges prospectively and retrospectively using both regression and dollar offset methods. We can categorize your hedges as fair value, dollar offset or net investment. We can test changes in total value or time value. We have built these tests to be very flexible to handle almost any combination of products from our pricing function OVML. 2. How to run hedge effectiveness tests in Bloomberg 1. Directly from the HEFF function For example run EURUSD <Curncy> HEFF and the following screen will appear.

3 2. Via OVML From our FX pricer OVML simply set up the hedge, select 90) Actions and then Run HEFF Analysis from the dropdown menu.

4 3. Case study testing the hedge effectiveness of a FX forward hedge We will run through a simple example where a corporation has a simple FX exposure and would like to test the hedge effectiveness on its forward contact. Run EUR Curncy HEFF and the following screen will appear A breakdown of the screen components and how they are used: The Hedging Objectives will usually be required to be recorded with the trade and Cashflow hedge is the default setting. Under a Cashflow hedge we compare changes between the Hedge and the Hypothetical whereas under a Fair Value we compare changes between the Hedge and the Exposure. A net Investment Hedge will follow the Cashflow format. The Changes In box refers to what results will be produced by the tests. For Forwards this will always apply to the Total Value (market value) of the contract but if we proposed hedging with an Option we could use Intrinsic Values.

5 Most corporations will start with an exposure: in our example we assume that we are a US-based company which needs to pay 1 million EUR for services on or around 1 Dec To hedge this EUR payment we hedge using a FX forward contact where we buy EUR. About 80% of corporations that qualify for some form of hedge effectiveness use FX forwards as they typically pass the relevant tests. The HEFF screen has assumed this will be your default hedge (a forward generated at the current market rates). To hedge to a different date you can change the delivery date box. To change to a different strategy you can either input a deal number into the OVML Ticker field or, the More button with take you to OVML where you can input any strategy which will then populate this screen. The hypothetical is the key part of this Cashflow test. If you recall the company has an exposure of 1 million EUR payment and hedges by buying a EURUSD forward to the same date with the same notional so surely the hedge is effective? The answer is that for foreign exchange we test for the possibility of the payment not occurring on the date hedged (1 December); we typically test for the payment being required up to a month earlier or later. On the example above we have hypothetical as the 15 th day of the same month. We can enter this using a formula (rolling delivery) or input the date (fixed delivery). By default for our cashflow hedge the hypothetical strategy will be the same as hedge but this can also be changed using the method described previously. Essentially what we are testing here is, If the payment is not made on the exact hedged delivery date, will the hedge still be appropriate? Retrospective analysis signifies a hedge which is already on our books and prospective analysis signifies that it is pre-trade. These can be selected by ticking one or both of these boxes. In our example we are running a regression test which gives us an R-squared coefficient which measures the correlation of total variation between of our Hedge and the Hypothetical hedge and a Beta value which measures the slope of the regression; to pass, i.e. achieve hedge effectiveness, with regression, R² > 0.8. We also offer dollar-

6 offset testing which would mean we are ensuring that changes in valuation of the Hypothetical Hedge fall within 80 and 125 percent of the Hedge. The tenor is constant which means if we look back to replicate the forward in our test it will always be a constant delivery i.e. we are always pricing a 6 month forward at inception and regressing the changes each month with the hypothetical. If you select Rolling tenor then we would be regressing monthly changes, over the last 32 months, in the prices of a forward with delivery today. The advanced tab allows the user to effect more specialised choices while keeping the main screen streamlined for quick use. Users may use the advanced tab to set option strikes as set percentage from the at-the-money, to change the notional amount or change reporting currency. From the HEFF screen upon selection of 1) Generate Report the above box appears prompting for a report name. Reports can be shared and can be run either live or at a scheduled time.

7 A list of the reports that the user has run is shown together with their status. Click on an individual report to see the detailed results. We can see this report has a R-squared score of 1 and passes the hedge effectiveness test. By clicking on the Chart/Table button you can see the results on screen.

8 A limited amount of these reports can be exported to either Excel PDF within the standard terminal model.

9 4. Appendix - Field definitions Main Exposure & Hedge Tab Hedging Objectives section Corporations typically need to store the reason for the hedge and this is what this section achieves. Hedge type Fair Value, Cashflow, Net Investment These fields allow you to label your hedging for reporting purposes. With Cashflow and Net investment the tests compare changes in the Hedge against changes in the Hypothetical. For Fair Value the tests compare changes in the Hedge against changes in the Exposure. Changes in Total Value The data input into the regression or dollar offset reports will be the total value of the instruments Changes in Intrinsic value (spot) - The data input into either the regression or dollar offset reports will be the intrinsic value only (difference between the contract rate and market spot). Changes in Intrinsic value (forward) - The data input into either the regression or dollar offset reports will be the intrinsic value only (difference between the contract rate and the market forward).

10 Exposure section Going directly to the HEFF screen this allows you to start by simply inputting the exposure. No need to input notional and dates more than once - they will automatically flow through the reports as default. Currency pair The currency pair of your exposure. Delivery date The date of the payment or receipt which you wish to hedge Notional The amount and currency to which you are exposed. Direction This indicates whether you are due to pay or receive the notional. If you enter this screen from OVML this will be populated automatically and will not be editable. Hedge Details section This section allows you to input your hedge. Coming from OVML this will be populated with your strategy or, if you enter directly to the HEFF screen, it will default to a forward which can be edited. OVML Ticker This box is optional but allows entry of a deal number from OVML More Auto-Generate This generates a forward contact to the set dates More Edit Strategy in OVML This loads the existing strategy in OVML for editing. More New Strategy in OVML This takes the user to OVML to setup a new strategy Strategy This describes the hedging strategy. Rate For a forward this will be populated with the market rate and we will take market end-of-day rates for our tests, for a vanilla it will display the strike and for complex instruments this information will display N.A. and the strikes and barriers will be shown under Advanced Regression Details. Currency pair In the event that this is different to the hedge you can edit using the More..Edit/ New Strategy in OVML. Delivery Date The delivery date of the hedge Hypothetical Hedge Details section This section sets up the hypothetical hedge which we use in the regression or dollar offset tests against the hedge. More Implied from Hedge The hypothetical will be the same strategy as the hedge More Edit Strategy in OVML This loads the hypothetical hedge in OVML for editing. More New Strategy in OVML This takes the user to OVML to setup a new hypothetical hedge. Strategy Describes the strategy type of the hypothetical hedge. Rate For a forward this will be populated with the market rate and we will take market end-of-day rates for our tests, for a vanilla it will display the strike and for complex instruments this information will display N.A. and the strikes and barriers will be shown under Advanced Regression Details. Fixed delivery Used to input a hypothetical delivery date Rolling delivery Allows input of the hypothetical delivery as a function of the hedge. For example the 15 th day of the same month and if this is a not working day roll the date

11 forward. When we do regression or dollar offset test the dates of past tests also are set on the 15 th of the month. Retrospective and Prospective Analysis section This section sets the details of the available tests. Test Regression The hedge effectiveness test will be regression based Test Dollar offset - The hedge effectiveness test will be using the dollar offset method Tenor Constant The replicated strategy will always be a constant delivery from the pricing date i.e. at each pricing date we value a 6-month deal Tenor Rolling The replicated strategy will have a fixed delivery throughout i.e. at each pricing date we value a hedge which expires on the run date with delivery two working days hence. FV Changes Period to Period Tests, both regression and dollar offset, are applied to period to period changes in prices. FV Changes Cumulative Tests, both regression and dollar offset, are applied to cumulative changes in prices. FV Changes Absolute value In regression and dollar offset tests with a constant tenor the test is applied to the actual value of the hedge (rather than period to period or cumulative changes in prices). Beta The gradient of a regression analysis slope; to be acceptable as an effective hedge this slope can be between 0.80 and 1.25 Start First pricing date for the test End Final pricing date for the test Frequency Frequency of the historical pricing dates Num. Obs Number of observations: the number of dates used in the tests Advanced Regression Details Tab Contract Details sections Strikes/Barriers Constant The strikes and barriers will be constant value in the tests for example Strikes/Barriers % OTMF constant The strikes and barriers will always be a set percentage away from the forward by setting the percentage out-the-money. Strikes/Barriers % OTMS constant The strikes and barriers will always be a set percentage away from the spot by setting the percentage out-the-money. Hypothetical Hedge Contract Details section Same as Hedge - This option allows all contract details for the hypothetical to be set to the same as the hedge. This applies to all contract details except delivery date.

12 Configure Report section Hedge Inception Date The date the hedge started Run Report as of Allows the user to run a report as of today or a past date. Reporting currency The currency in which the output values are required.