A hedge must be assessed as 'highly effective' both when it is
entered into, and on an ongoing basis.
For this purpose the standard so regards a hedge if the
entity expects changes to the fair value or cash flows of the
hedged item to be almost fully offset by the changes in the fair
value or cash flows of the hedging instrument, and actual results
are within a range of 80% to 125%. For example, if the loss on the
hedging instrument is 120 and the gain on the cash instrument being
hedged is 100, offset can be measured by 120/100, which is 120%, or
by 100/120 which is 83%. In each case the entity will conclude the
hedge is highly effective.
IAS 39 does not prescribe a single method for assessing hedge
effectiveness, if only because this will be dependent upon an
entity's own risk management strategy and policy. However, it all
needs to be properly documented.
Any difference which arises due to hedge ineffectiveness is
recognised in the income statement immediately. In the example
above, 100 of the loss on the hedging instrument could be offset
against the 100 gain on the hedged item. But the remaining 20 of
the loss would have to be recognised in the income statement.
Saying that a hedge is "highly effective" because its effectiveness
falls within the 80% - 125% limits doesn't exempt the entity from
recognising the ineffective portion of the hedge.
In practice, few hedges are 100% efficient, and it may not be
possible to find a derivative that is a perfect hedge for a
particular risk. For example, an interest rate swap where the
floating rate payments were based on LIBOR would not be a perfect
hedge for borrowing where the interest payments were based on some
other commercial interest rate, even if the periodic payments under
the swap fell due on the same days as interest payments on the
borrowing.
