TESTING HEDGE EFFECTIVENESS FOR FAS 133: THE VOLATILITY REDUCTION MEASURE |
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| Authors: | Andrew Kalotay Leslie Abreo |
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| Affiliation: | Founder and owner of Andrew Kalotay Associates, a New-York based firm specializing in risk management and capital markets advisory. Dr. Kalotay is a member of the Fixed Income Analysts' Society Hall of Fame.;A senior financial analyst at Kalotay Associates. He has an M.S. in financial engineering and has co-authored papers on various aspects of corporate debt management. |
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| Abstract: | 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. |
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