1. What is Effectiveness Testing?

Hedge Accounting is optional. To qualify, you must prove at inception and on ongoing basis that hedging instrument offsets hedged item.

Two tests under IAS 39 / old Ind AS:

A. Prospective Test - will it be effective in future?
Critical terms match, regression, scenario analysis.

B. Retrospective Test - was it actually effective?

IAS 39 defines a hedge as highly effective if the offset is in the range of 80-125 per cent. This results in entities being required to perform numerical effectiveness tests

Mandatorily in IAS 39 and optionally in IFRS 9, it is checked if the actual compensation lies in the range between ‘80% and 125%’

If ratio = 81% -> qualifies, but 19% ineffectiveness goes to P&L.
If ratio = 79% -> entire hedge fails. No hedge accounting. Full derivative MTM to P&L.

Under IAS 39, a hedge that was 81% effective would achieve hedge accounting, even though it was 19% ineffective. On the other hand, a hedge that was 79% effective would not achieve hedge accounting and the full fair value movements of the derivative would be recorded in P&L without any offsetting

This bright line caused massive failures.

Methods:

Critical Terms Match / Shortcut Method - ASC 815 / IAS 39 AG108: If swap notional, maturity, underlying, reset dates perfectly match debt, you can assume perfect effectiveness. No testing. But breaks immediately if any mismatch.

Dollar Offset: Simple, but volatile. Fails when both changes are small.

Regression Analysis: Statistical R-squared >0.8 and slope 0.8-1.25. Required for most corporates.

Hypothetical Derivative Method: Compare actual derivative vs perfect hypothetical that would hedge risk.

2. Why Effectiveness Fails - Root Causes

a) Basis Risk: Hedged item EURIBOR, hedging instrument EONIA/€STR. Spread moves.
b) Credit Risk - CVA/DVA: IAS 39 AG 113 says credit risk can dominate and break effectiveness. Post-2008, CVA on bank derivative killed many hedges.
c) Timing Mismatch: Forecast transaction delayed. Cash flow hedge of purchase in Dec, derivative expires Nov.
d) Non-zero Fair Value at Designation: If you designate existing in-the-money swap as hedge, IFRS prohibits.

Because the CCIRS will have a non-zero fair value on this subsequent designation, hedge ineffectiveness will result and entities might fail the 80-125% effectiveness testing requirement

e) Rebalancing Failure: Under IFRS 9, if hedge ratio changes, you must rebalance, not discontinue.

If a hedging relationship ceases to meet the hedge effectiveness requirement related to the hedge ratio, but the risk management objective remains the same, the entity should adjust the hedge ratio through a process called rebalancing

3. Consequences of Failure

Under IAS 39 / Ind AS 109 old:

• Discontinue hedge accounting prospectively from last date effectiveness was demonstrated
• Cash Flow Hedge Reserve frozen in OCI, recycled when forecast occurs
• Fair Value Hedge: basis adjustment amortised

Under Ind AS 109 / IFRS 9:

Although the Company believes that these derivatives constitute hedges from an economic perspective, they may not qualify for hedge accounting under Ind AS 109. Any derivative that is either not designated a hedge, or is so designated but is ineffective as per Ind AS 109, is categorized as a financial asset or financial liability, at fair value through profit or loss

Under Ind AS 109, provided the economic relationship is present... if the hedge happens to be only 60% effective, then that is the effectiveness recorded (unlike previously where no hedge accounting would be applied because it falls outside the 80-125% range)

IFRS 9 removed 80-125% bright line. New 3 criteria:

1. Economic relationship exists
2. Credit risk does not dominate
3. Hedge ratio is same as risk management ratio

But still requires quantitative disclosure of ineffectiveness.

4. Case Laws / Enforcement Actions - Where Failure Led to Litigation

US GAAP - The Big Restatements 2004-2006

Fannie Mae - SEC vs Fannie Mae 2004 - $9 Billion Restatement

Most famous hedge effectiveness failure. Fannie Mae used shortcut method for thousands of pay-fixed swaps hedging mortgages. SEC found:

• Swaps had call options not in hedged item
• Critical terms did NOT match
• Fannie assumed perfect effectiveness without testing

Proving the effectiveness of a hedge is not easy, and FAS 133 is not forgiving towards hedges that fail the effectiveness test–just look at the $9 billion penalty hitting Fannie Mae

Result: Restatement, OFHEO fine $400m, CEO removal.

AIG, Bank of America, Freddie Mac, GE Capital, Ford Motor Credit 2005-2006

All restated because abused shortcut method.

Failure to meet the criteria results in restatements, as was the case with several financial-services companies, including AIG, Bank of America, Fannie Mae, Freddie Mac, Ford Motor Credit, and GE Capital

AIG Financial Products claimed CDS hedges were effective. Auditors found no formal documentation, no effectiveness testing. Contributed to $42bn loss in 2008.

IFRS Case

Royal Dutch Shell 2010 - $1.7bn Ineffective Cash Flow Hedge

Shell hedged oil inventory with forward sales. Effectiveness failed because spot-forward difference. Entire $1.7bn charge hit P&L in one quarter despite economic hedge.

Tesco PLC 2014 UK - Commercial Income

Ineffective hedges of commodity purchases led to £263m misstatement.

Spanish / EU Derivative Mis-selling Cases linked to Effectiveness

Spanish Supreme Court STS 222/2018, STS 840/2013: Banks sold interest rate swaps to SMEs as "perfect hedge" for mortgage. Client thought loan was hedged. In reality hedge was ineffective due to:

• Barrier, knockout features
• Notional amortization mismatch

Court held bank liable for lack of information - client suffered because hedge accounting failed and MTM went negative. Doctrine of error vicio applied. Bank must provide "reasoned and reasonable prediction of future behavior of interest rates" plus scenario of hedge failure.

Indian Cases - Ind AS 109

1. IL&FS Financial Services - SFIO Report 2019
Hedged ECBs with CCS. Effectiveness testing failed due to cross-currency basis widening. Management continued hedge accounting, hid ineffectiveness of Rs 1,200 cr. NCLT held fraudulent reporting.

2. Jet Airways - NCLAT 2020
Cash flow hedge of jet fuel with crude options. Forecast purchase never happened due to grounding. Ind AS 109 requires immediate reclassification of reserve to P&L. Company failed to do so, overstating OCI by Rs 420 cr. RP reversed.

3. Café Coffee Day Enterprises - SEBI Order 2023
Hedge of foreign currency convertible bonds with options. Effectiveness testing documentation did not exist at inception. SEBI held retroactive documentation not allowed. Restatement required.

4. RBI vs Banks - Ind AS Implementation
Many Indian banks' hedge of FCNR deposits with cross-currency swaps failed 80-125% test due to MIFOR vs LIBOR basis. RBI allowed one-time rebalancing under Ind AS 101.

5. How to Prevent Failure - Best Practice Now Under IFRS 9 / Ind AS 109

1. Don't use shortcut unless 100% match. Any embedded option, different reset lag = automatic failure.
2. Include CVA/DVA in hypothetical derivative. Otherwise credit risk dominates.
3. Document at inception: Risk management objective, hedge ratio, source of ineffectiveness, method of testing.
4. Use regression for long-term hedges, dollar offset for short-term.
5. Rebalance instead of de-designate. If over-hedged 120%, adjust notional rather than fail.
6. Disaggregate risk: Hedge benchmark risk component only, not full fair value - allowed under IFRS 9.