CFA CFA Level 2 Effective vs Ineffective Hedge?

Effective vs Ineffective Hedge?

  • This topic has 15 replies, 3 voices, and was last updated Mar-17 by Zee Tan.
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    • vincentt
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      Hi guys, came across this term briefly in FRA (Study Session 7 Reading 22 – The Lessons We Learn).
      Could someone explain this further?

      According to schweser:

      An effective hedge is one in which the change in fair value, cash flow, or net investment is exactly offset by changes in the hedging instrument. If the change in the hedging instrument is more or less than the change in value, cash flow, or net investment, the extra change is referred to as the portion of the hedge that is not effective.

      Not too sure if I should group another 2 questions into this same discussion (since it’s related).

      In the same reading there’s another challenge problem at the back of the reading (question 4) in schweser notes.

      Q4. RGH Corporation is a coffee distributor. Next year, RGH anticipates purchasing 100 tons of coffee beans. Concerned that coffee bean prices will increase next year, RGH immediately purchases a futures contract and designates the contract as a cash flow hedge. At the end of this year, the price of coffee beans is higher than the contract purchase date. Next year, when the contract is settled, the price of coffee beans has increased even more. If all of the coffee beans are consumed next year, where in the financial statements are the gains on the futures contract recognized this year and next year?
      This Year Next Year
      A. NI OCI
      B. OCI NI
      C. OCI OCI

      According to the notes, gains and losses (effective) are reported in equity, G/L (ineffective) are reported in income statement.

      And since the question mentioned that the coffee price went up, it should fall into the “ineffective’ category (hedging instrument is more or less than the change in value) in this case more than the ‘exercise price’, so it should be in NI for this year and next but the answer was B.

    • MattyJ
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      I think the key is noting that
      i) the company hedges the full 100 tonnes
      ii) all 100 tonnes are used in the following year
      iii) at year end the spot price is higher than the contract price
      iv) the following year when the contract is settled the spot price is higher than the contract price

      Given the above, the hedge can be considered fully effective as the 100 tonnes contract matches the 100 tonnes expected to be utilised and that the contract allows the company to purchase the coffee cheaper than it otherwise would in the spot market.

    • Zee Tan
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      I’ve read this question a few times, and I’m not sure if this question has an effective and ineffective hedge aspect to it to be honest.

      At the end of this year, all the distributor has is a futures contract that has increased in value (since coffee prices went up). Since you’d report a gain in the NI only if you sold the contract, the gain in value is therefore reported in OCI.

      In the following year, the merchant exercises his futures contracts, purchases the coffee beans and sells them all in the same year. The profit gained from the sale would have included the gain in value from the futures contract (since the merchant would exercised the contract to purchase beans) and since the beans have been sold (and are not held as inventory) you would report it in NI.

      That’s my take on it. Hope that helps 😀

    • vincentt
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      But from my understanding ‘held-for-trading’ securities would always recognised it’s realised or unrealised G/L in income statement and never in equity?

    • Zee Tan
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      But in this case it is not held-for-trading. RGH Corporation is a coffee distributor, the purchase of the coffee futures is to hedge against a possible rise of coffee (inventory) rather than with an intent to sell. But this is less relevant for this question as this is a hedge accounting question.

      As @mattjuniper states, the futures can be assumed to be 100% effective as it is a direct hedge against a rise in coffee bean prices. The gain in the first year is therefore recognized in OCI (effective hedge).

      In the second year, futures contract is exercised, coffee beans acquired and sold. Profit from sales is recognized in NI, not because it’s from an ineffective hedge, but rather because the gains has now been transferred to inventory, and profit from sales.

      e.g. If the futures contract price was $50 per unit, and the spot price at time of exercise was $55, and if RGH sold it on as a distributor at $65, RGH made $5 more profit per unit of coffee beans than it would have had it not purchased a futures contract. But all $15 of profit would be reported in NI.

      So as long as it is a cash flow hedge, as long as the exercise and sale has not occurred, any gains will be reported in OCI, and once it has been exercised it will depend on what the gain has been translated to. E.g. in this case if the merchant did not manage to sell any of the stock they acquired through the futures contract, there would be no profit reported until this happens.

    • vincentt
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      ok got it thanks to the both of you @mattjuniper @zee

    • Zee Tan
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      No problem! If you want to group the other 2 questions here go right ahead @vincentt

    • MattyJ
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      I’ll be honest, I dug out last years L2 text book before answering and managed to find a paragraph, that was it. Was also in a different SS, so unsure whether it’s one of the bits they have significantly changed this year?

    • vincentt
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      @zee ops that was a typo just 1 additional question which was already mentioned in the discussion.

    • Zee Tan
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      I’ll be honest, I dug out last years L2 text book before answering and managed to find a paragraph, that was it. Was also in a different SS, so unsure whether it’s one of the bits they have significantly changed this year?

      Points for dedication!

    • vincentt
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      @mattjuniper i realised CFAI loves doing things like this, just stuff in some tiny bits without much explanation just to fill up the reading. It’s much like just know it and don’t bother understanding why.

    • vincentt
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      I’ll be honest, I dug out last years L2 text book before answering and managed to find a paragraph, that was it. Was also in a different SS, so unsure whether it’s one of the bits they have significantly changed this year?

      Points for dedication!

      +1 Indeed!!

    • MattyJ
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      I think they do it to separate the men from the boys. Some questions they ask are based on topics that were covered in a couple of sentences and almost swept under the carpet, but it’s these questions that really highlight the excellent candidates from the good candidates (or the lucky from the not-so-lucky?!?)

    • Zee Tan
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      Some of them are just evil, from what I remember. BTW @vincentt was there a detailed answer for the question from Schweser?

    • vincentt
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      @zee
      this is the detailed explanation

      Because the futures contract is designated as a cash flow hedge, the unrealized gain at the end of this year is reported in shareholders’ equity as a component of other comprehensive income. All of the gains from the futures contract are recognized in net income next year when the coffee beans are consumed.

      Since the question mentioned ‘cash flow hedge’, which was mentioned on the last page of the reading and it’s only mentioned in a few lines.

    • Zee Tan
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      woohoo – matches my answer! 🙂

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