How to Distinguish Fair Value Hedge and Cash Flow Hedge PDF

Preview

Summary

Distinguish Fair Value Hedge and Cash Flow Hedge...

Description

How to Distinguish Fair Value Hedge and Cash Flow Hedge? What I’m going to explain right now is my own logic of looking at this issue. It’s not covered in any book. It’s how I look at most hedging transactions and this is a very simplified view. But maybe it opens up your mind to logical thinking about hedges. Please, ask first: What kind of item are we hedging? Basically, you can hedge a fixed item or a variable item.

Hedging a Fixed Item A fixed item means that the item has a fixed value in your accounts and it may provide or require fixed amount of cash in the future. The same applies for unrecognized firm commitments that have not been sitting in your accounts yet, but they will be in the future. And when it comes to hedging fixed items, then you’re practically dealing with the fair value hedge. Why is that? Well, here, you are worried, that in the future, you would be paying or receiving a different amount than the market or fair value will be. So, you don’t want to FIX the amount, you want to GET or PAY exactly in line with the market. I’m referring to “GET” or “PAY” only for the sake of simplicity. In fact, you don’t even need to get or pay anything in the future – you’re just worried that the item will have a different carrying amount in your books that its’ fair value. Hedging a Variable Item A variable item means that the expected future cash flows from this item change as a result of certain risk exposure, for example, variable interest rates or foreign currencies. When it comes to hedging variable items, you’re practically speaking of a cash flow hedge. Why is that? Here, you are worried that you will get or pay a different amount of money in certain currency in the future that you would get now. In fact, in a cash flow hedge, you want to FIX the amount of money you’ll get or pay – so that this amount would be the same NOW and IN THE FUTURE. To Sum This All Up Now you can see that the same derivative – interest rate swap – can be a hedging instrument in a cash flow hedge as well as in a fair value hedge.

The key to differentiate is WHAT RISK you hedge. Always ask yourself, why you undertake the hedging instrument. But it’s not that simple as it seems because there are some exceptions in IAS 39 and IFRS 9. For example, even when you have a fixed item, you can still hedge it under cash flow hedge and protect it against foreign currency risk. Equally, you can hedge a variable rate debt against fair value changes – and that’s the fair value hedge. Therefore, please refer to the following table summarizing the types of hedges according to risks and items hedged: Item hedged Risk hedged Type of hedge Fixed-rate assets and liabilities Interest rates, Fair value, Termination Fair value hedge Options Fixed-rate assets and liabilities Foreign currency, credit risk Fair value hedge or cash flow hedge Unrecognized firm commitmentsInterest rates, Fair value, Credit risk Fair value hedge Unrecognized firm commitmentsForeign currency Fair value hedge or cash flow hedge Variable-rate assets and Fair value, termination options Fair value hedge liabilities Variable-rate assets and Interest rates, foreign currencies, credit risk Cash flow hedge (most cases) liabilities Highly probable forecast Fair value, interest rates, credit risk, foreign Cash flow hedge transactions currency...