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Accounting for Derivatives

The third step of the regression process is to interpret the statistical results of the regression
and determine if the regression suggests that the hedging relationship is expected to be highly
effective. All the following three statistics must achieve acceptable levels to provide sufficient
evidence for the expectation that the hedge will be highly effective in the future:
The R-squared. The R-squared must be greater or equal to 80 %. R-squared, or coefficient
of determination, measures the degree of explanatory power or correlation between the
dependent and the independent variables in the regression. The R-squared indicates the
proportion of variability in the dependent variable that can be explained by variation in
the independent variable. By way of illustration, an R-squared of 95 % indicates that 95 %
of the movement in the dependent variable is explained by variation in the independent
variable. R-squared can never exceed 100 % as it is not possible to explain more than 100 %
of the movement in the independent variable. The R-squared by itself is an insufficient
indicator of hedge performance.
The slope of the regression line. Usually a slope between 0.80 and 1.25 is accepted.
The t-statistic or F-statistic. These two statistics measure whether the regression results
are statistically significant. The t-statistic or the F-statistic must be compared to ttables or F-tables to determine statistical significance. A 95 % or higher confidence
level is generally accepted as appropriate for evaluating the statistical validity of the
regression.

1.9.4 The Scenario Analysis Method

The scenario analysis method is another method of performing prospective tests. The goal of
this method is to reveal the behaviour of changes in fair value of both the hedging item and
the hedging instrument under specific scenarios. Each scenario assumes that the risk being
hedged will move in a specific way over a certain period of time.
For example, a structured swap hedging the interest rate risk of a floating rate liability may
be tested under the following scenarios:
1) A parallel shift of +200 basis points (bps) and 200 bps in the interest rate curve.
2) A steepening move of 200 bps in the interest rate curve.
3) An inversion move of 200 bps in the interest rate curve.
When a reduced number of scenarios are used, the main drawback of the scenario analysis
method is the subjectivity in selecting the scenarios. The scenarios chosen may not be followed
by the underlying hedged risk once the hedge is in place, and therefore the analysis conclusions
may not depict a realistic expectation of hedge effectiveness.
One way to draw meaningful conclusions to the analysis is to test the behaviour of the
changes in fair value of both the hedging item and the hedging instrument under a very large
number of scenarios of the underlying risk. The Monte Carlo simulation is a tool that provides
multiple scenarios by repeatedly estimating thousands of different paths of the risk being
hedged, based on the probability distribution of the risk. In our view, a well-performed Monte
Carlo simulation can be very appropriate to assess prospective effectiveness, as there is a high
likelihood that one of the paths will become the actual path of the underlying risk.