What is a cash flow hedge?

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 specific assets or liabilities that are generating income that is different than expected and possibly reducing expected gains or increasing losses. For example, a cash flow hedge may protect against increases in the installments of a variable rate loan, increases in the exchange rate of a foreign currency in which the individual expects to trade in the future, or increases in the prices of planned purchases of inventory. . This financial strategy uses derivative instruments, such as call options or put options, to help limit an individual's exposure to these risks. Specific information, such as the original hedge strategy and risk, must be documented before a cash flow hedge can be properly established; In most cases, a financial advisor can help investors create financial protection for covered items.

types of risks

Generally, a cash flow hedge is established to help protect against currency risk, price risk or exposure to the cash flow effects of financial instruments. Currency risks include those associated with a future transaction in a foreign currency or debt denominated in 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 returns on financial instruments may be due to changes in prices, 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 options versus put 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 take place, without the need to. A call option allows the investor to purchase a predetermined amount of assets over a period of time specified by the seller, but a purchase is not required. options offer are the opposite, as the buyer of an option offer I can sell goods to the seller, in which case the seller must buy them, but the buyer is not obliged to sell if he so wishes.

For example, a farmer suspects that wheat prices may fall in the near future, lowering the selling price of his next crop. The farmer sets up a cash flow hedge by buying puts on wheat futures, which would produce a profit if wheat prices fell. In this way, the gains from the puts would offset the losses from the reduced sell price if the price of wheat actually falls. If the price of wheat rises, the farmer would lose the amount of money he used to buy 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 hedge fund's original process, the person setting up the investment must prepare documents outlining its objective and strategy, as well as the method to be used to determine the effectiveness of the investment. Investors must also provide details about the risk and the date or time period when the cash flow would occur. The cash flow hedge must sufficiently offset changes in income related to the hedged item. The transaction must be probable and must be carried out with an entity other than the original hedge.

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