TESTING HEDGE EFFECTIVENESS FOR FAS 133: THE VOLATILITY REDUCTION MEASURE

Although the authors of this article praise the spirit of the new FASB guidelines for hedge accounting, they find flaws in the recommended tests for determining if a hedge qualifies for such treatment. In some cases, the tests recommended by the FASB pass hedges that clearly should fail, and in others they fail hedges that should be accepted. In place of the recommended testing procedures, the authors propose the use of the volatility reduction measure (VRM)—a measure that is fully compliant with the spirit of the FASB's recommendations, while correcting their major shortfalls.
While the illustrations in this article are from the realm of fixed income, the VRM approach is applicable to any hedge, whether designated as "fair value" or "cash flow." Moreover, by expressing volatility in the units of the widely used "Value at Risk" measure, VRM establishes a natural link between accounting and risk management.     

FAS 133: What Is Accounting Truth?

FAS 133, the rule that governs accounting for derivatives, has been controversial since its inception. Besides being expensive to implement and maintain, the rules often cause accounting treatment to diverge markedly from economic reality, making financial statements less transparent and less useful. For example, by marking to market only one side of what are in fact two‐sided (hedged) positions, FAS 133 often introduces artificial volatility into earnings and, in so doing, discourages companies from hedging. How should companies tackle financial disclosure and balance the economic and accounting effects of hedging? This article recommends that companies make economically sensible hedging decisions and then present two sets of earnings numbers to the investment community: (1) the first prepared and audited in strict accordance with GAAP; and (2) a supplemental calculation showing what earnings would have been had the firm qualified for hedge accounting treatment. This kind of supplemental disclosure should be viewed by companies as an opportunity to explain to their investors, creditors, and counterparties how they conceptualize, measure, and manage risk.     

A COMPARABLES APPROACH TO MEASURING CASHFLOW-AT-RISK FOR NON-FINANCIAL FIRMS

Cashflow-at-Risk (C-FaR) is an attempt to create an analogue to Value at Risk (VaR) that can be used by non-financial firms to quantify various kinds of risk exposures, including interest rate, exchange rate, and commodity price risks. There are two basic ways to attack this problem. One is from the "bottom up," which involves building a detailed model of all of a company's specific exposures. The C-Far approach presented here is a "top-down" method of comparables that looks directly at the ultimate item of interest—the companies' cashflows. The fundamental challenge facing the top-down strategy is that, for any one company, there is not enough data on its own cashflows to make precise statements about the likelihood of rare events. To get around this problem, the authors match a target company with a large set of comparable companies that are expected to have similar cashflow volatility. The comparables are chosen to be close to the target company on four dimensions: (1) market cap; (2) profitability; (3) industry risk; and (4) stock price volatility.
C-FaR can be useful to managers addressing a variety of corporate finance decisions. For example, by providing estimates of the probability of financial distress, the C-FaR method can be used in conjunction with capital structure data to help formulate debt-equity tradeoffs in a more precise, quantifiable fashion. It can also be used to evaluate a firm's overall risk management strategy, including the expected benefits of using derivatives to hedge commodity-price exposures or the purchase of insurance policies. Moreover, C-FaR may even have a use in investor relations: by disclosing the results of a comparables-based C-FaR analysis ahead of time, a company may be able to cushion earnings shocks by furnishing investors or analysts with credible, objective estimates of what is likely to happen to their cash flows under different economic scenarios.