Alternative approaches to testing hedge effectiveness under SFAS No. 133

Statement of Financial Accounting Standards (SFAS) standardizes the accounting treatment for derivative instruments by requiring all entities to report their derivatives as assets and liabilities on the balance sheet and to measure them at fair value. Reporting changes in the fair value of a derivative in earnings each quarter could create a matching problem. This article examines the test choices that firms must make. The hedger must select the methodology, such as regression analysis, choose the measurement period, and specify an appropriate test statistic like adjusted RI along with the critical value to distinguish a highly effective hedge from one that is not. 4 existing methods of testing hedge effectiveness are described.