Fair value hedge

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Fair value hedge
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Fair value hedge- is "a hedge of the changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk" (O. Ray Whittington 2015, s. 197).

Hedge accounting applies to both recognized assets and liabilities, but also unrecognized liabilities. An unrecognized permanent liability is a contractual obligation that has not yet been recognized in the balance sheet, but will become an asset or liability in the future when it appears in the balance sheet. A firm commitment must relate to a specific quantity, price and date and must be legally binding on each party (customer and supplier). To apply hedge accounting to cover fair value risk, the hedging position must be a single asset or a group of assets, liabilities or liabilities whose values change together (D. Sahilian, M. Botea, D.L. Trasca 2013, s. 100).

"All changes that occur in the process of hedging will be reported in current earnings, the carrying value of the derivative is adjusted to fair value on the balance sheet, and the change in that carrying value from period to period is included on the income statement. At the same time, the balance sheet carrying value of the hedged item is also adjusted so that unrealized gains and losses due to the hedged risk offset the gains and losses on the derivative" (D. Sahilian, M. Botea, D.L. Trasca 2013, s. 100).

Discontinuance of a fair value hedge

"The accounting for a fair value hedge should not continue if any of the events below occur (B.J. Epstein, R. Nach, S.M. Bragg 2009, s. 306):

  1. The criteria are no longer met;
  2. The derivative instruments expire or are sold, terminated or exercised; or
  3. The designation is removed".

If the fair value hedge is waived, a new hedging relationship can be created with another hedging instrument and / or another item that has been decided to hedge, provided the criteria in ASC 815 are met (B.J. Epstein, R. Nach, S.M. Bragg 2009, s. 306).

Ineffectiveness of a fair value hedge

Unless the abbreviation method is applicable, the notifying entity must assess the effectiveness of the hedge at the start of the hedge and then at least every three months. In addition, ASC 815 requires that at the beginning of the collateral the method to be used to assess the effectiveness of the collateral. "To comply, the reporting entity should decide which changes in the derivative's fair value will be considered in assessing the effectiveness of the hedge, and the method to be used to assess hedge effectiveness". Some derivatives (options) have two components: intrinsic value and time value. The internal value is the possible surplus of the market price over the strike price. Internal value means that the price of a given item may be higher than the strike price (in the case of a call) or less than the strike price (in the case of a sale) during the implementation period. The enterprise decides to measure efficiency by including or excluding time value; it must do it consistently after the determination. That is why, if a company does not take into account its consequences in the long run when making a decision, securing the value of a given item may prove ineffective (B.J. Epstein, R. Nach, S.M. Bragg 2009, s. 306).


Author: Patrycja Czerwiec