Cost-Effective Hedges and Accounting Standards

Using return data from other studies, we show that traditional short hedgers often face a cost in the form of a positive derivative risk premium. Consequently, the hedge ratio chosen should be significantly less than the traditional risk minimum hedge ratio since marginal cost rises dramatically as the risk minimum position is approached. We present a modified hedge ratio and hedge effectiveness measures to replace the commonly used risk minimum equivalents. The use of these alternative measures is permissible under SFAS No. 133 and IAS No. 39 and leads to improved hedging decisions.