HEDGE ACCOUNTING

What Does Hedge Mean?

Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.

Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).

DE-HEDGE

The process of closing out positions that were originally put in place to act as a hedge in one's portfolio. De-hedging involves going back into the marketplace and closing out hedged positions, which were previously taken to limit an investor's risk of price fluctuations in relation to their underlying asset.

De-hedging is done when holders of an underlying asset have a bullish outlook on their investment. Therefore, the investor would prefer to remove their hedged position to gain exposure to the expected upward price fluctuations of their investment.

For example, a hedged investor in gold who feels the price of their asset is about to go up would buy back any gold futures contracts they had sold in the futures market. By doing this, the investor will have positioned themselves to reap the rewards of an increase in the price of gold if their bullish prediction on gold is correct.

HEDGE RATIO

1. A ratio comparing the value of a position protected via a hedge with the size of the entire position itself.

2. A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged.

1. Say you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk.

2. The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk

HEDGE FUND

An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.

For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.

It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

HEDGE ACCOUNTING-SUMMARY

The accounting treatment of call options prima facie will depend upon the intention with which the options are purchased: for hedging or speculation (nonhedging).

If the position is taken as a hedge against some other position, then the relevant accounting standards will be applicable and there are certain conditions that are to be fulfilled for the same.

Only long calls and long puts are eligible for hedge accounting, as written calls or puts limit the profitability while exposing the investor to unlimited risks and as such are not eligible for hedge accounting.

The standards require that the potential for gains should be at least equal to the potential for losses; this is known as a symmetrical risk-reward situation. For a written option the risk-reward is asymmetrical; hence, written options per se do not qualify for hedge accounting.

However, a combination of written options and certain other derivative instruments that results in a symmetrical risk-reward may qualify for hedge accounting.

To qualify for hedge accounting, either the upside and downside potential of the net position must be symmetrical or the upside potential must be greater than the downside potential.

Written options based on symmetry of the gain and loss potential of the combined hedged position qualify for hedge accounting as per the accounting standard.

If a written option is designated as hedging a recognized asset or liability, the combination of the hedged item and the written option provides at least as much potential for gains (as a result of a favorable change in the fair value of the combined instruments) as it does exposure to losses from an unfavorable change in their combined fair value.

Hedge accounting is not permitted for covered calls. This prohibition is also specifically mentioned in the standard itself.

It is permissible to separate the intrinsic value and time value of an option contract, designate as the hedging instrument only the change in intrinsic value of an option, and exclude change in its time value.

The accounting standards permit an entity to apply hedge accounting for a delta-neutral hedging strategy and other dynamic hedging strategies under which the quantity of the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio.