Evidence of hedge effectiveness: Practical tips for commodity hedges

Evidence of hedge effectiveness:

When hedging against price risks for raw materials, it's often difficult to find evidence of its effectiveness, even for non-standardized commodity futures or derivatives (e.g. price-based forwards on the London Metal Exchange/LME), which are entered into to hedge against individual commodity price risks. Difficulties occur especially due to the interaction between hedged and unhedged risks and the formal approach to the standards. However, many problems can be diffused if risk management has a clear understanding of the issues and the applicable rules. The following article looks at key topics and outlines practical solutions.

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In order to assess hedge effectiveness within the meaning of IAS 39, the complete performance of a commodity price must be compensated by the performance of a derivative that hedges only one price component. This evidence can often be provided by preparing a regression analysis, which was described in the June/14 issue.

Especially for commodity price risks, it's common to hedge against exposures with different maturities using one single derivative (mismatched maturities). This situation must be taken into account when determining effectiveness in the case of designating the entire change in value of the hedging instrument. If effectiveness cannot be evidenced on this basis, then changes in value could be voluntarily designated according to the spot rate. Thus, ineffectiveness, which is the result of different maturities, is then no longer considered when determining effectiveness. However, when changing the forward price components of the derivate, this solution will have an effect on profit or loss, as it is not a part of the hedging relationship. However, this drawback can be tolerated for many standard commodities, because during price developments the entire forward price structure is typically shifted in parallel and its structures change only marginally (a structural change would be, for instance, a change from a contango to a backwardation situation). Especially when taking such an approach, to ensure proper results even if there is high intraday volatility, it's important that the spot rate is the effective date of the derivative and not the daily closing price.

Another common cause of ineffectiveness can also be due to the market data and assessment methods used for valuation. Derivatives are often assessed by a broker who derives the performance of the underlying transaction using the prices from a market data provider (Reuters; Superderivatives, Bloomberg) or another source (LME, oanda, westmetall). However, to determine effectiveness, the market data should ideally be consistent. If you cannot assess the hedging instruments, then an outside provider can help with assessment. During our implementation projects, we often noticed that it is sometimes sufficient when making your own assessment of the underlying transaction to use the broker's market data for the valuation date.

Our experience has shown that it's generally easier to designate a cash flow hedge for the planned sale of goods as the underlying transaction than to try and set up a fair value hedge of inventory or a contract procurement transaction at fixed prices. This approach can prevent undesired conflicts with the assessment regulations stipulated by other standards.

Furthermore, in order to properly record the value added by the hedging instruments, which was previously defined by hedge accounting, the company needs data on the underlying transaction. For example, if procurement transactions are generated and stored as mass data, then there should be at least reliable information on the average time between delivery and price setting and possibly payment. In addition, you should know the average age of inventory (or frequency of inventory turnover).

If you are familiar with the mechanisms, it's possible to set up commodity hedges – both in the formal rules found in IAS 39 as well as using commercial hedges under Section 254 of the German Commercial Code [HGB]. The source-related recording of results helps both external and internal accounting to accurately report the company's net assets, financial position and results of operations.

Author: Felix Wacker-Kijewski, Manager, fwackerkijewski@kpmg.com

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