 Hello, and welcome to the session in which we will discuss if we have a highly effective hedge And why do we have to know whether we have a highly effective hedge or not? Here's the reason very simple Derivative instruments are risky are very very risky financial statements So that's why we want to know as accountant whether our hedge is an effective hedge And if it is an effective hedge, it will qualify for hedge accounting now. I said very risky I didn't say only risky. I said very risky matter of fact Warren Buffett called financial derivatives as Weapons of mass destruction What does that mean? Well, it means they are risky business Warren Buffett is the best investor of all time He once called those instrument Financial weapons of mass destruction because they were part of our financial crisis What happened during the financial crisis of 2007 2008? Many companies had had derivative instrument without understanding the effect on the financial statements So find remember derivatives instrument can be used for speculation which we talked about this or it can be used for hedging So if it is for hedging Show me it's for hedging because if it's used for speculation, it doesn't qualify for hedge accounting I hope I make the point here So the point is if you have a derivative derivative instrument and the purpose is hedging you're gonna have to show me It's for hedging you're gonna have to show me mean the company will have to show the users Therefore they would qualify for hedge accounting. Otherwise you otherwise you are misleading the users You have weapons of mass destruction inside your financial statements That could explode and destroy the company's value actually in 2007 2008 those derivative derivative instrument Destroyed the whole economy not a particular company the whole system almost went down So to qualify for hedge accounting which is hedging it means to protect your hedge whether it's a cash flow or a fair value Must be effective Otherwise your speculator and if your speculator you need to let us know you that your speculator investors want to know How do we know that the hedge is effective? Well the hedge item and the hedge instrument must be effective. What does that mean? It means they have to be negatively correlated. Well, what does that mean? It means if the hedge item if we're trying to protect oil or gasoline that we have From a plunge in value if they do indeed plunge the hedging instrument go up If their value goes up then our hedging instrument goes down. It means they are negatively related How negatively they have to be we'll see what's the what's that level now in all my examples I show you it was a perfect hedge now. That's not that's not true So for example, you could have you cannot for example say i'm hedging my oil prices With a contract of coffee. Well, those are not related to each other They have to make sense So the hedging instrument and the hedge item has to have to make sense under those circumstances That's that's basically mere speculation. What's what's the relationship between the oil prices and buying a future contract of coffee? Whether it's a put or Or call it doesn't really matter So fast be required that companies assess the effectiveness at the end of each quarter when they publish the financial statements Here we are dealing with publicly traded companies. They must document basically the effectiveness explain themselves Now not at the time They don't have to do it at the time at the inception of the contract by by the issue date They have to do it. So now we're going to have to learn How how do we measure effectiveness of that hedge? 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Well, the first thing I need to tell you The relationship does not have to be 100 to be effective For example, if we have a hedging instrument and it went up in value and the hedged item went down in $100 in value Well one divided by one is negative one in this example. We call this is a perfect hedge. It means they are perfectly correlated Really what's going to happen if you look from an income statement perspective if you add 100 reduced by 100 the net effect is zero It means really there is no effect and you are protecting the item you are trying to protect Now how about if the hedging instrument went up to $110 in value And the hedged item Went down by $90. What do we have to do under those circumstances? Let's compute. Let's compute our relationship 100 divided by 90 is 1.22 or 122 Well, is this still considered effective? What is the limit? What's the boundary? Well, here's the boundary As long as you you are between 125 On the upper side and 80 on the lower side, then you are good. How do you measure this? Simply put you will take the dollar change and the hedging instrument The dollar change and the hedging instrument relative to the dollar change and the hedged item Just relative means you take 110 divided by 90 one's going to be positive one's going to be negative So the slope will be negative obviously although I don't you know, I did not put you you know I did not mention it here. It's negative 1. 1.22 it's a negative slope But as long as the slope is between 125 and 180 then it's considered highly effective. Simply put if it's more Then really this is not you're not you're not entering into this transaction for for hedging purposes You're entering into this transaction for speculation purposes, which is the accounting will change the accounting will change Okay, so if higher or lower than the boundary then you cannot use hedge accounting as long as you're within that boundary Also, companies could use Software to do this use and regression to compute that boundary limitation if they have many hedge instrument if it's complicated Also, some companies they don't have to do this computation If they can show that the that the that the hedge is effective at the inception of the contract Then guess what they don't have to do this quantitative assessment You may think this is easy the quantitative assessment But if you have many hedging instruments and those hedging instruments are changing in value of there's sometimes There's no fair value for them Then it's a lot of work for the company So they would like to show if it's effective so you don't they don't have to do all this work There's a shortcut method for example If you have a perfect interest rate swap agreement For example, if you have if you have a loan with a variable interest rate Then you can get another loan and a swap agreement with a fixed interest rate The loan balances are the same the interest rate are exactly the opposite of what you want Then it's a perfect hedge. Then you're good to go. This is called the shortcut method Sometime you could use also something called the critical term match method. Those are methods used to To not to not go through all the computation For example, if you have a forecast the transaction and you can show there's a perfect hedge between the two So the point I'm trying to make here is The hedge has to be highly effective to be highly effective The boundary has to be between 125 and 80 percent now You have to disclose everything that we said remember the users must understand your risk Why because we are dealing with weapons of mass destruction and that's not me. That's Warren Buffett That what would the company will have to disclose the objectives of the strategy What is their objective from the hedging they have to spell it out? What strategy are they using to reach that objective? What are you are using calls options futures? What are you using tell us swaps if it's a fair value hedge explain the income statement item Give us the detail how how things are listed on the income statement reconcile them If it's a cash flow hatch explain the oci or any reclassification needed that leaves oci to the income statement Simply put for disclosure purposes explain to the users So they understand the risk that they are taking And how you are managing those risks how you are managing those risks through derivative instruments Which are what weapons of mass destruction if not disclosed or used properly? What should you do now go to farhat lectures dot com and work multiple choice questions to reinforce those concepts If you're an accounting student take your education seriously if you're a cpa exam make make an investment in my in my in my course It will help you tremendously along your cpa review course. Good luck study hard and of course stay safe