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Hedge effectiveness is the test applied to a hedging instrument to ascertain whether it will be eligible for hedge accounting. Hedge accounting allows entities to override the normal accounting treatment for derivatives (fair value through profit or loss) and hence avoid much of the volatility that would arise if the derivative gains and losses were recognized in the income statement, as required by FAS 133, IAS 39 or AS 30 accounting principles.

Methods for measuring Hedge Effectiveness:

	Dollar Offset Method
	The dollar-offset method compares the changes in the fair value or cash flow of the hedged item and the derivative. The dollar-offset method can be applied either period by period or cumulatively. For a perfect hedge, the change in the value of the derivative exactly offsets the change in the value of the hedged item. Therefore, the ratio of the cumulative sum of the periodic changes in the value of the derivative and the cumulative sum of the periodic changes in the value of the hedged item would equal one in a perfect hedge. Of course, perfection is not necessary to qualify for hedge accounting. Dollar Offset = [Change in Fair Value of Hedge] / [Change in Fair Value of Hedged Item].

	Variability Reduction Method
	The Variability- Reduction Method compares the variability of the fair value or cash flow of the hedged (combined) position to the variability of the fair value or cash flow of the hedged item alone. This method places greater weight on larger deviations than smaller ones by using the squared changes in value to measure ineffectiveness.

	Regression Method
	The Regression Method uses regression analysis to identify the size of hedge to implement and to test hedge effectiveness. Applying the principles of modern portfolio theory formulates the hedger's problem and derives a formula for the hedge ratio that minimizes the variance of the price changes of the hedged position. The variance minimizing hedge ratio is the estimated slope coefficient of a regression in which the change in the value of the hedged item is the dependent variable and the change in the value of the hedging instrument is the independent variable.

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