Hedging Foreign Exchange Risk

71

Hedging Relationship Documentation

Hedging instrument

Hedged item
Assessment of effectiveness testing

The FX tunnel contract with reference number 012349.

The counterparty to the tunnel is XYZ Bank and the
credit risk associated with this counterparty is
considered to be very low.
USD 100 million sale of finished goods expected to take
place on 31 March 20X5.
Hedge effectiveness will be assessed by comparing
changes in the intrinsic value of the hedging instrument
to changes in the intrinsic value of a hypothetical
derivative. The intrinsic value of the options will be
measured as the difference between the spot exchange
rate and the strike price. Effectiveness will be assessed
only during those periods in which there is a change in
intrinsic value. Changes in the time value of the options
will be excluded from the assessment of effectiveness
and will be recognised directly in P&L in each period.
The terms of the hypothetical derivative are such that its
fair value changes exactly offset the changes in fair
value of the hedged highly expected cash flow for the
risk being hedged. In this hedging relationship, all the
terms of the hypothetical derivative coincide with the
terms of the hedging instrument except that the
hypothetical derivative has the same maturity as the
hedge and that it has no credit risk.
Prospective test
A prospective test will be performed, at hedge inception
and at each reporting date, using the critical terms
method. Because the terms of the hedging instrument
and those of the hypothetical derivative match and that
the credit risk to the counterparty to the hedging
instrument is very low, the hedge is expected to be
highly effective prospectively. The credit risk of the
counterparty of the hedging instrument will be
monitored continuously.
Retrospective test
A retrospective test will be performed, at each reporting
date and at hedge maturity, using the ratio analysis
method. The ratio will compare the cumulative change
since hedge inception in the intrinsic value of the
hypothetical derivative with the cumulative change
since hedge inception in the intrinsic value of the
hedging instrument. The hedge will be assumed to be
highly effective on a retrospective basis if the ratio is
between 80 % and 125 %.

Prospective Tests
A prospective test was performed at hedge inception and at each reporting date. ABC used
the critical terms method to assess prospective effectiveness. Because (i) the terms of the
hypothetical derivative and the hedging instrument matched, and (ii) the credit risk associated