Cash Flow Hedge vs Fair Value Hedge: A Comprehensive Guide

As we dive into the world of hedging, it's essential to understand the two primary types: cash flow hedges and fair value hedges. A cash flow hedge is used to manage exposure to variability in future cash flows.

Cash flow hedges are typically used for transactions that involve physical commodities or assets, such as futures contracts or forward contracts. This type of hedge aims to reduce the uncertainty of future cash flows.

For example, a company may enter into a futures contract to lock in a price for a commodity it plans to purchase in the future. This reduces the risk of price fluctuations affecting the company's cash flow.

Hedging is a financial strategy used to minimize and mitigate risk. It's like buying insurance for your property to protect against potential damage.

A hedge is a financial instrument that helps reduce risk, and it's often used to protect assets or investments. Derivatives, such as contracts whose value goes in the opposite direction of the hedged item, are a common type of hedging.

To create a hedging relationship, you need both a hedged item and a hedging instrument. This is the basic requirement for a hedging relationship to exist.

Fair value hedges can be used to mitigate the risk of changes in the fair market value of liabilities, assets, or other firm commitments.

There are three types of hedging relationships under FRS 102 paragraph 12.19. A fair value hedge is normally used where there is concern over a value in the financial statements, such as inventory.

A fair value hedge is used to reduce the volatility of a financial statement value, like inventory. This type of hedge is often used by companies that have a large inventory of goods.

A cash flow hedge is normally used where there is concern over future cash flows. This type of hedge is used to reduce the risk of changes in cash flows due to fluctuations in interest rates or foreign exchange rates.

A hedge of a net investment in a foreign operation is the third type of hedging relationship. This type of hedge is used to reduce the risk of changes in the value of a foreign operation due to fluctuations in exchange rates.

Here are the three types of hedging relationships summarized:

Hedge accounting is not mandatory under FRS 102, but it's a complex area that requires specialist valuers to determine fair values or calculate the effectiveness of hedging relationships.

There are three types of hedging relationships under FRS 102: fair value hedge, cash flow hedge, and hedge of a net investment in a foreign operation.

To qualify for hedge accounting, a hedging relationship must consist only of a hedging instrument and a hedged item, be consistent with the entity's risk management objectives, have an economic relationship between the hedged item and the hedging instrument, and be documented with clear identification of the risk being hedged, the hedged item, and the hedging instrument.

The entity must also determine and document causes of hedge ineffectiveness.

Here are the three types of hedging relationships in brief:

The objective of hedge accounting is to match the timing of income statement recognition of the effects of the hedging instrument with the timing of recognition of the hedged risk.

A cash flow hedge is used to mitigate the exposure to variability in future cash flows, such as a foreign currency denominated loan.

These hedges are often used in conjunction with a foreign currency forward contract, which locks in an exchange rate for a future transaction.

The goal of a cash flow hedge is to stabilize the future cash flows of a company.

Fair value hedges, on the other hand, are used to mitigate the exposure to variability in the value of an asset or liability.

The value of a fair value hedge is marked to market each period, which means its value is adjusted to reflect changes in market conditions.

This type of hedge is often used in conjunction with a derivative instrument, such as a swap or option.

The key difference between the two hedge models is the timing of the hedge's impact on the company's financial statements.

A hedging instrument is a specific type of financial instrument that helps mitigate risk. It must meet three key conditions: it's measured at fair value through profit or loss, it's a contract with an external party, and it's not a written option.

In simpler terms, a hedging instrument is often a forward exchange contract or a futures contract.

To qualify as a hedging instrument, the contract must be with a party outside of the reporting entity.

The flexibility in identifying hedging instruments is quite broad. It can be a full contract, a portion of a contract, or even a combination of different instruments.

Here are some examples of hedging instruments that meet the specified conditions: ul>Forward exchange contractFutures contract

Foreign currency hedges can be a crucial tool for managing cash flow risks. A foreign currency hedge is essentially a hedging instrument that meets specific conditions, including being a financial instrument measured at fair value through profit or loss.

To qualify as a hedging instrument, a foreign currency hedge must be a contract with a party external to the reporting entity, such as a forward exchange contract or a futures contract.

These contracts can be used in their entirety or in proportions, and a combination of such instruments may also be employed. A key takeaway is that there's flexibility in identifying hedging instruments, allowing companies to tailor their approach to their specific needs.

A recognised foreign currency liability can be a real challenge for businesses. If the liability is denominated in a foreign currency and the entity has taken out a forward exchange contract to minimise the risk, cash flow hedging won't help reduce variability in the profit or loss account.

The liability must be translated at the closing rate at each year end, with the exchange difference going through the profit or loss account. This is a requirement regardless of whether cash flow hedge accounting is used or not.

The exchange rate movement on the forward exchange contract will also go through the profit and loss account if cash flow hedge accounting isn't used. This can help minimise the overall impact on profit for the year.

If cash flow hedge accounting is used, however, the effective part of the gain or loss on the forward exchange contract will go through other comprehensive income, delaying the impact on profit or loss and increasing volatility in profit or loss.

Overall, it's often best not to use a cash flow hedge in these circumstances as it doesn't achieve the aim of hedge accounting, which is to reduce volatility in profits over a period of time.

A net investment in a foreign operation is a key concept in foreign currency hedges, and it's defined as the amount of the reporting entity's interest in the net assets of that operation.

To qualify for hedge accounting, the underlying assets and liabilities of the foreign operation must be reflected in the financial statements, which can happen either in consolidated financial statements or in individual financial statements where the foreign operation is a branch.

In consolidated financial statements, a subsidiary's underlying assets and liabilities are reflected, making hedge accounting possible. However, this is not the case when the foreign operation is a subsidiary in individual financial statements.

Hedges of a net investment in a foreign operation must be accounted for similarly to cash flow hedges, with the effective portion being recognized in other comprehensive income (OCI) and the ineffective portion in profit or loss.

The amounts accumulated in equity are not reclassified from equity to profit or loss on disposal or partial disposal of the foreign operation.