Cash flow hedge protects against variable cash flow risk caused by assets or liabilities generating income differently than expected. It uses derivative instruments like call or put options to limit exposure to risks like currency, price, or financial instruments. To qualify, the hedge must meet certain criteria.
A cash flow hedge is a type of investment strategy established to protect an individual against the variable cash flow risk of a specific hedged item. Such risk may be caused by particular assets or liabilities that generate income differently than expected, possibly reducing expected gains or increasing losses. For example, a cash flow hedge could protect against increases in the repayment of a variable rate loan, increases in the exchange rate of a foreign currency in which the individual expects to conduct a future transaction, or increases in prices. of planned inventory purchases. . This financial strategy uses derivative instruments such as call options or put options to help limit an individual’s exposure to such risks. Specific information, such as the strategy and risk of the original hedge, must be documented before a cash flow hedge can be properly established; In most cases, a financial adviser can help investors create financial protection for covered items.
Types of Risks
In general, a cash flow hedge is established to help protect against currency risks, price risks or exposure to cash flow effects of financial instruments. Foreign exchange risks include those associated with a future transaction in a foreign currency or a debt denominated in a foreign currency. Price risks refer to the possibility that the purchase price of non-financial assets will increase or the sale price of non-financial assets will decrease. Fluctuating income from financial instruments could be due to price changes, changes in the benchmark interest rate, changes in the credit spread between the interest rate of the hedged item and the benchmark interest rate, and defaults or changes in credit quality.
Call vs. Sell Options
Two common instruments used to create a cash flow hedge are call and put options. Both options are legal agreements between two parties, the buyer and the seller, and both allow a transaction to occur, without requiring it. A call option allows an investor to purchase a predetermined amount of assets during a specified period of time from the seller, but a purchase is not mandatory. Put options are the opposite in that the buyer of a put option can sell assets to the seller, in which case the seller must buy them, but the buyer is not required to sell if they wish.
For example, a farmer suspects that wheat prices could fall in the near future, reducing the selling price of his next crop. The farmer establishes a cash flow hedge by buying put options on wheat futures, which would produce a profit if wheat prices fall. In this way, the gains from the put options would offset the losses from the reduced sales price if the price of wheat actually falls. If the price of wheat increases, the farmer would lose the amount of money he used to purchase the options, but would benefit from the higher price of wheat.
qualified investments
To qualify for cash flow hedge accounting treatment, a hedge fund must meet certain criteria. At the beginning of the original hedge fund process, the person setting up the investment must prepare documents stating both their objective and strategy, as well as the method that will be used to determine the effectiveness of the investment. Investors must also provide details about the risk and the date, or time period, in which the cash flow would occur. The cash flow hedge has to sufficiently compensate for changes in income related to the hedged item. The transaction must be probable and must be made with another entity in addition to the original coverage.
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