On hedge effectiveness and risk decomposition

A new approach to hedge accounting in the US as prescribed by the Statement of Financial Accounting Standards No.133 will be applicable to all fiscal years beginning June 1999. The Financial Accounting Standards Board requires both ex-ante and ex-post assessment of hedge effectiveness. The hedging entity is responsible for establishing its own effectiveness criteria. The Board further requires that a hedging entity provides documentation of its risk-management objective and strategy, including how the derivative's effectiveness in hedging exposure will be assessed. This paper presents mathematical formulae that lay a foundation for a coherent strategy to address these business needs. We present a conceptual overview of the proposed approach. We present the first and second-order VaRHedge solutions as they will appear in the FlexHedge report. This is the basis of our proposed hedge effectiveness model, by which we can separate the cashflows of a hedge trade into effective and ineffective parts. We present formulae based on the parametric and scenario-based methodologies to express portfolio Value-at-Risk as the sum of marginal risk contributions due to each of the component assets. This computation will also produce a correlation matrix for the asset components. Then we proceed to discuss how these measures can be applied to the designation of hedging relationships. We present formulae for the Best Hedges report, which can be used to assign hedge trades from a centrally managed hedge book to identified strategies for different subportfolios. We establish practical criteria to assess the potential need to rehedge due to changing market conditions.