What is the meaning of hedge effectiveness?

hedge effectiveness is the extent to which a hedge transaction results in the offsetting changes in value or cash flow that the transaction was and is intended to provide. FAS 133 requires users to regularly assess the effectiveness of hedges. Furthermore, under FAS 133 only the portion of a transaction that is deemed effective may qualify for hedge accounting treatment. Under FAS 133, any part of fair value changes in a derivative that are not perfectly correlated with the fair value (or variable cash flow) changes of the hedged item must be reported in current earnings. FAS 133 does not delineate a specific methodology for assessing whether a hedge is expected to be highly effective or for measuring hedge ineffectiveness. Hedge effectiveness is a very broad concept, and FASB believes each company must define it relative to the intent of its hedging activities. The only requirement is that there be a reasonable basis for assessing hedge effectiveness. The focus on hedge effectiveness in FAS 133 contributes to a significant difference between previous practice and the new accounting standard. Whereas the earnings effect of minor hedge ineffectiveness was spread over the life of the hedge in the past, the FAS 133 rules result in anything other than perfect correlation being recorded in current earnings. Thus under FAS 133 there is the potential (and even likelihood) that hedges may have both an effective component and an ineffective component even for a highly effective hedge. The fact that some portion of a derivative is ineffective does not preclude a hedge from being deemed highly effective. See: cash flow hedge, fair value hedge, and FAS 133.