A Regressive Approach To Hedge Accounting At Novelis
A Regressive Approach to Hedge Accounting at Novelis
One of the more important decisions to be made during the life of a hedge is how to
assess its effectiveness. Both ASC 815 (FAS 133) and IAS 39 require companies to
assess hedge effectiveness at the inception of the relationship and on a periodic basis
throughout its life. This requirement includes a forward-looking prospective assessment and a
backward-looking retrospective assessment. Choosing the right method is important because
if your test results fail to meet the criteria you establish for them, you must discontinue hedge
accounting for that hedge and changes in fair value must be recognised in earnings.
Moreover, once you have selected a method, you cannot change it without de-designating
the hedge relationship.
Companies may elect to forgo periodic
effectiveness testing by asserting that the
critical terms of the exposure match those of
the derivative. The problem with this method
is that auditors and regulators have taken a
very narrow definition of the term "match'. A
payment date that is different by as little as
one day may make the critical terms match
method inappropriate. Many companies have
been burned by using critical terms match and
then being told by their auditors or the SEC
that the method was inappropriate. This has
led to more than a few financial restatements.
Given the risks of the critical terms match,
many companies now use the dollar offset
method as their default method for assessing
hedge effectiveness. The popularity of this
method arises from its ease of use. The
change in the value of the derivative is
compared to the change in the value of the
hedged item. If the ratio of the two changes
lies within a predetermined range - say 80%
to 125% - the hedge may be deemed to be
highly effective.
Small changes, big problems
The risk of the dollar offset method is that a
seemingly good hedge can fail this test without
warning, especially if markets are relatively
stable. Assume you have $500m in variablerate
debt, hedged with an interest rate swap. If
the derivative changes in value by $15,000 and
the hedged item changes by $10,000, the
hedge will fail because the ratio of the two
changes falls outside of the 80-125 range. It
does not matter that both changes are small
relative to the notional amount. This can be
frustrating when you know that most of the
time, the hedge would have been effective, but
dollar offset is not a "most of the time' method
of testing.
Companies not wanting to bear the risks
associated with critical terms match or the
dollar offset method are increasingly turning to
regression analysis to assess hedge
effectiveness. Regression analysis is a
statistical method where changes in the
derivative and changes in the hedged item are
measured at regular intervals over time and a
line is mathematically drawn through the
measurements. The slope of that line is an
important output; it represents the overall ratio
of derivative to hedged item. It is like doing a
series of dollar offset tests and then averaging
the results. Therefore, a few measurements may
fall outside the range without causing the
overall hedge relationship to fail. Regression
analysis is also useful when there is basis
difference between the derivative and the
exposure, as is often the case with commodity
hedges.
Image 1
Image 2
Regression analysis, however, is more
complicated than dollar offset and can be
confusing to set up. You must specify the
number of samples to be used, the sampling
frequency, whether measurements will be made
on a periodic or cumulative basis, and what
range of slope values will constitute a highly
effective hedge. Because regression analysis is
a statistical technique, it is also important to
assess how strongly the data support the
conclusion and whether or not the results could
merely be the effect of random chance. For
this, you must specify limits for R-squared and
either the F-statistic or T-statistic. While it is
possible to perform these calculations in a
spreadsheet, if you have more than one or two
hedges, it may be a good idea to find a system
to maintain the underlying data and to perform
the mathematical heavy lifting.
Practical application
As the largest supplier of flat-rolled
aluminium products and the largest recycler of
used beverage cans in the world, Novelis has
significant exposures to commodity and
energy prices, exchange rates and interest
rates. We manage these exposures through
an active programme of derivative
transactions. Given that the notional value of
these programmes is greater than 50% of
annual revenue, it is critical that we account
for them properly.
Novelis has used Reval since 2005.
Initially, we used the system to support
hedge accounting for our interest rate swaps
and long-term energy contracts. In 2008, as
a part of our adoption of FAS 157, we
expanded our use of Reval to include the
valuation of more than 10,000 metal and
exchange rate derivatives, which we account
for as economic hedges at fair value through
profit and loss.
Novelis has two credit facilities of almost
$2bn (US), which are priced at LIBOR plus a
spread. Under these facilities, we have the
option to reset the interest rate calculation
basis from 1-month to 3-month LIBOR. That
means that on a given day each month, we
may elect to set the rate for the following
month at that day's 1-month LIBOR rate.
Alternatively, at quarter end, we may elect
to lock the rate in at 3-month LIBOR for the
following quarter, after which time we
would again choose either a 1-month or 3-
month reset period. At each reset date, we
consider the spreads and take an active view
on whether a 1-month or 3-month reset
would be most economic.
Despite the flexibility in this arrangement,
we wanted to further reduce our exposure to
interest rate fluctuations and so elected to
swap the majority of our debt to fixed rate
using interest rate swaps with a variable leg
that reset against 3-month LIBOR on a
quarterly basis. Assessing hedge
effectiveness in this case is not
straightforward. Although the LIBOR rates of
the loan and the swap generally track each
other, they are not linked; moreover, the
spread also changes and could even reverse
in certain market conditions. To counter this,
we conduct our effectiveness testing on the
assumption that, if our only option was to
base our interest rate exposure on 3-month
LIBOR, the hedge would be more effective
than if we could only re-price our debt
monthly using 1-month LIBOR. We therefore
set up our hedge relationship to compare a
quarterly interest rate swap with a term
borrowing with monthly resets, and apply
regression analysis to establish the changes
in the relationship over a period of time.
Reval has made the process of using
regression analysis relatively easy. When we
set up the hedge designation, we select
regression analysis for both prospective and
retrospective testing and specify the number
of measurements and their frequency - in our
case, we chose 36 months. We also
establish limits for slope (80% to 125%), Rsquare
(at least 80%), and the F-statistic and
T-statistic appropriate for our sample size
and our desired 95% confidence level. To
perform our initial prospective assessment,
Reval creates proxy trades for the derivative
and the exposure. These will be backdated
by 37 months and their valuations will be
measured at monthly intervals using historic
market data. The system generates the
regression results which it then compares to
the limits we established; this determines
whether the hedge passes or fails.
We use regression analysis as a dualpurpose
test, combining prospective and
retrospective testing into a single process.
Each month, the system replaces the oldest
backdated values with current values and
regenerates the results. We can see at a
glance, whether or not each hedge is
effective and we can identify any hedges
that may be at risk of failing in the future.
This is a highly efficient process.
Using regression analysis will not
guarantee that our hedges will always be
effective, nor can it make a bad hedge look
good, but we believe it reduces the risk of
false failure inherent with the dollar offset
method. From Novelis' standpoint, the fact
that Reval supports regression analysis and
allows us to have a highly efficient closing
process is a double-win. As we consider
applying hedge accounting to our metal and
foreign exchange derivatives, we expect that
we will continue to use regression analysis
for effectiveness testing.
by: Reval
Mitigating Risk At Transport For London Broken Down Compressor: A Common Problem In Air Conditioning Repair Dermatologist: Common Reasons To Make An Appointment Go Viral - Blog Posts Gone Wild! Do Forex Robots Get The Job Done - The Difficult Truth Choosing Banks With Features Worth Switching For Coach Outlet Could Be Listed Less Costly Finding The Right Contractor For Your Interior Renovation Drum Loops How To Keep Heat Pumps Pumping Perfectly Day Spas: How Do You Spend Your Time Doc Holiday: Famous Dentist Of History Extend Your Boating Pleasure With A Marine Battery Charger