Hedging fixed rate debt instrument with IRS
To calculate the change in the value of the hedged item for the purpose of measuring hedge ineffectiveness, an entity may use a derivative that would have terms that match the critical terms of the hedged item (this is commonly referred to as a ‘hypothetical derivative’), and, for example, for a hedge of a forecast transaction, would be calibrated using the hedged price (or rate) level.
Calculating the change in the value of the hedged item is possible with the help of creating a hypothetical derivative. The way hypothetical derivative is structured is that it replicates the hedged item taking into account, as much as possible, all of the features that are present in the hedged item. The valuation of hypothetical derivative results in the same outcome as that of valuing the hedged item itself. Using a hypothetical derivative is not a method in its own right, but merely a simulated approach to calculate the value of the hedged item. So, it is obvious that a hypothetical derivative cannot be used to include features that exist only in the hedging instrument and not in the hedged item. The change in the value of the hedged item determines selling and hypothetical derivative can be used to assess the hedge effectiveness requirements.