Definition
Hedging effectiveness quantifies the degree to which a hedge reduces portfolio risk. A perfect hedge eliminates 100% of targeted risk. In practice, basis risk, timing mismatches, and imperfect correlations reduce effectiveness. Accounting standards (ASC 815) require documented effectiveness testing for hedge accounting treatment.
functions Formula
Effectiveness = 1 − (Variance of hedged portfolio / Variance of unhedged portfolio)
lightbulb Example
An airline hedges jet fuel with crude oil futures. Unhedged fuel cost variance is $5M. With the crude hedge, variance drops to $1.5M. Effectiveness = 1 - ($1.5M/$5M) = 70%—the hedge removes 70% of price risk.
verified_user Key Points
- Measures risk reduction from hedging
- 100% = perfect hedge (rarely achieved)
- Basis risk reduces effectiveness
- 80-125% required for hedge accounting treatment