Wondering what the benefits and limitations of cash flow and fair hedge are? Look no further than this short guide.
Hedge - Definition
In simple terms, a hedge describes a financial instrument used to minimize and mitigate risk. A good example is insurance for your property - there always is a chance, even a small one, that an incident happens and substantial damage is done to your property. Just to be safe in case this happens, you get insurance. This is basically what a hedge is. There is a number of different methods for hedging that can be used to mitigate risk associated with your assets or investments. A common type of hedging is derivatives (i.e. contracts whose value goes in the opposite direction to the hedged item).
Fair value hedges
This type of hedge is commonly used to work against risks arising from changes in the fair market value of liabilities, assets, or other commitments. They tend to move in the opposite direction of the hedged item - this means they can cancel out any losses incurred by your company. Fair value hedge accounting is great for the particular risk of changing market value.
Example: Company A has an asset valued at GPB 8,000 - however, the senior management is worried about the asset's value dropping to GPB 6,000. To offset the loss, the company would enter into an offsetting position through a derivative contract which has a value of GPB 8,000. Being in the offsetting position, Company A's derivative contract will move in the opposite direction of the hedged item. This covers the company against potential changes to the fair market value of its assets and liabilities.
Cash flow hedges
Sudden changes in cash flows of assets and liabilities (not the asset or liability itself) can be mitigated by cash flow hedges. Changes in the cash flows of assets and liabilities can be caused by eg increases/decreases in foreign exchange rates, changes in interest rates, and changes in asset prices.
Example: Company B has purchased 10,000 liters of olive oil. This sells for GPB 8 per liter. This means the company would spend GPB 80,000 on the product. However, if the price of oil spikes to GPB 10 per liter, the company would be left with around EUR 20,000 in expenses that they weren’t anticipating. This is where a cash flow hedge comes in handy. Company B can enter into a forward contract with another party to purchase the olive oil off them. This ensures that, even if the price of the oil increases, their net payment will remain the same, making the forward contract the hedging instrument.
So, what's the difference?
The key difference between the two types of hedges is the hedged item. When hedging the changes in cash flow from assets and liabilities, you are using what is called a cash flow hedge. Fair value hedges, on the other hand, help to mitigate your exposure to changes in the value of assets or liabilities. So, while fair value hedges are good for fixed-rate items, the benefits of cash flow hedges make them a good instrument for variable rate items.