Hedge effectiveness is the extent to which changes in the value of a given exposure (the hedged item) are offset by an opposing change in the value of the financial derivative (the hedging instrument). Under hedge accounting, hedge effectiveness is measured with three criteria:
Economic relationship. There must be an inverse relationship between the change in the value of the hedged item and the change in the value of the hedging instrument.
Credit risk. Changes in the credit risk of the hedging instrument or hedged item should not be large enough as to dominate the value changes associated with the economic relationship.
Hedge ratio. The appropriate hedge ratio should be maintained throughout the life of the hedge.