In both of these scenarios, there is no ineffectiveness in the hedging relationship. The second and third alternatives incorporate ineffectiveness. Since the Hong Kong dollar is pegged within a range of the U.S. dollar, the forward will be highly effective in hedging the purchase transaction. However, there will be some ineffectiveness, as there is some variation in the exchange rate between the U.S. dollar and the Hong Kong dollar. Purchased put options are used to hedge an investment in available for sale equity securities.
Effectiveness is determined based on changes in the intrinsic value of the options.
Changes in option values due to passage of time are excluded from determination of hedging effectiveness, and are included in net income during the period of the change. The effectiveness of hedging with options with different strike prices is illustrated in the second part of the case. An Excel spreadsheet for determining option values and changes in values is included in the .ZIP file. Second, futures relating to three different delivery months for each of the three commodities are used as hedges. Third, the company specifies that hedge effectiveness will be assessed based on changes in fair value attributable to changes in spot prices.